When the owner of a closely-held business dies, his or her estate immediately encounters what may be a major challenge: liability for the estate tax resulting from the value of the decedent’s interest in the closely-held business.  In general, this tax must be paid within nine months of the decedent’s death, and it is often the case that neither the estate nor the business has sufficient liquid assets from which to satisfy the estate tax: it is not unusual for the decedent’s interest in the business to represent the most valuable asset of the estate.  In order to satisfy this liability, the estate may be faced with a “forced” sale of the business, or it may have to leverage the business and other assets, relying upon the cash flow from the business to service the debt.

Section 6166 to the Rescue

Fortunately for the estate, there are alternative options to consider that may allow it to avoid the immediate sale or leveraging of the business.  One such option is found in Section 6166 of the Internal Revenue Code.  Under this provision, which was enacted to help preserve closely-held businesses, the estate may elect to pay the estate tax attributable to the value of the decedent’s interest in the closely held business over a period of ten years.  Furthermore, these payments are due beginning five years after the estate tax return is filed (with only interest payable until the fifth year).

In order to qualify for this benefit, the value of the interest in the closely-held business must exceed 35% of the decedent’s adjusted gross estate.  In addition, the business entity must be carrying on an active trade or business.

However, the estate is not in the clear just yet: if any portion of the interest in the closely-held business is distributed, sold or otherwise disposed of, or if money or other property is withdrawn from the business, and the aggregate of such transactions equals or exceeds fifty percent of the value of such trade or business, then the extension of time for payment of the tax ceases to apply, and the IRS may demand payment of the unpaid portion of the estate tax.

The logic behind this acceleration rule is fairly obvious.  If the interest is sold, for example, and the estate thereby becomes liquid, then the justification for installment payments—to preserve the interest in the closely-held business—no longer exists.

An Exception to the Acceleration Rule: Reorganizations

But what if the disposition involves neither a sale, nor a withdrawal of cash, and is undertaken for a valid business reason?  The IRS addressed this issue in a recent letter ruling.

The decedent died owning interests in various closely-held businesses, including a real estate partnership that owned several properties.  His estate elected to pay the estate tax in installments under Section 6166.

For what were represented to be good business reasons, the real estate partnership proposed to distribute each of its real properties pro rata to the estate (as the successor to the decedent’s interest) and to the other partners.  Thereafter, these distributees would contribute their respective interests in the properties to separate LLCs in return for pro rata interests therein.  Each LLC would own a separate real property and would continue the active business previously conducted by the partnership with respect to the particular property.

The IRS ruled that the proposed distributions from the partnership and the subsequent contributions to the various LLCs, would not constitute proscribed distributions or dispositions that would terminate the installment privilege, because they did not materially alter the business or the interest of the estate in the business.  Rather, the relative ownership interests were not changed, the operation of the business continued in substantially the same manner as before, and no money or other property was withdrawn from the business formerly conducted by the partnership.

Conclusion

This ruling, and several others, demonstrate that it may be possible for a decedent’s estate to restructure the business entity in which the decedent held an interest without sacrificing the benefit of paying the estate tax in installments, provided the conditions set forth in the ruling are satisfied.  It also reflects a practical approach by the IRS in recognizing that an estate may have valid business reasons for a reorganization of its holdings. Thus, for example, it may be possible to remove the assets of a business from a corporation and contribute them to an LLC, without losing the installment privilege.  However, it is important to consider the potential impact of income taxes before embarking on any restructuring, including the change in the adjusted basis of a decedent’s interest in a business that occurs upon his death.

 

Taxpayers sometimes employ a so-called “defined value clause” (“DVC”) in connection with a gift of property that is difficult to value, such as an equity interest in a closely-held business.  In the case of such a gift, the value of the business interest – the amount of the gift – is never really “established” for tax purposes unless the IRS audits the gift tax return.  DVCs are aimed at such audits.

What is it?

A DVC may be used where the donor seeks to keep the value of the gift at or below his remaining gift tax exemption amount.  In the event the IRS successfully determines that the value of the shares of stock (or partnership units) gifted by the taxpayer exceeds the taxpayer’s available exemption amount, a DVC provides that some of these shares or units would be “returned” to the taxpayer, as if they had never been transferred.

The IRS has challenged DVCs as being against public policy, on the grounds that they enable the donor-taxpayer to retroactively adjust the number of shares transferred, depending upon an IRS challenge years after the transfer.

However, a number of courts have found that DVCs are acceptable where the “excess” amount was not returned to the donor but, rather, was redirected to a charity.  (Alternatively, some taxpayers have directed that the excess be used to fund a zeroed-out GRAT.)

 

Wandry

More recently, however, the Tax Court in Wandry, T.C. Memo. 2012-88, approved a DVC where the “excess” was returned to the donor, and not to a charity.  In that case, the taxpayers gifted LLC interests to their issue, but instead of stating the number of LLC units being transferred, they phrased the gift in terms of “that number of units which had a value equal to the taxpayers’ remaining exemption amount” (in other words, a fixed dollar amount).  If the appraised value of the LLC interests was successfully challenged by the IRS as too low, then the number of units originally calculated as having been gifted (on the basis of the taxpayer’s appraisal) would be adjusted downward, to reflect the greater value per unit determined by the IRS, and the donor’s relative interest in the LLC (post-gift) would increase.  The Tax Court ruled that what the taxpayers had gifted was LLC units having a specific dollar value – the exemption amount – and not a specific number of LLC units.

Other Consequences

The Wandry decision may encourage more taxpayer-donors to employ DVCs, notwithstanding  that the IRS did not acquiesce in the decision.  Before doing so, however, it is important that taxpayers look beyond the immediate transfer tax consequences of such an arrangement.  They also need to consider various income and other gift tax consequences that may result from an adjustment triggered by a DVC.

Closely-held businesses, the transfers of interests in which are the usual target of DVCs, are often formed as pass-throughs such as partnerships, LLCs or S corporations.  A gift transfer of an interest in such an entity carries with it certain “tax attributes.” For example, every member, including the recipient of the gift, must include his allocable share of the partnership’s income on his income tax return, whether or not the entity distributes such income.  If the donor-member had contributed built-in gain property to the partnership, a portion of the donor’s income tax liability as to such built-in gain shifts over to the donee-member as a result of the gift; on a subsequent sale of the property, a portion of the built-in gain would be taxed to the donee.  In addition, if the pass-through entity makes cash distributions to its owners, the donor and the donee would each receive an amount in accordance with their respective pro rata shares (before any Wandry-adjustment).  What if the original transfer was treated as a part-sale/part-gift because it resulted in a reallocation of partnership debt among the members?

It is unclear how the operation of a DVC interplays with these tax rules.  In other words, what happens if the IRS successfully challenges the valuation of the gifted business interest?  Pursuant to the DVC, a lesser number of units or shares is deemed gifted than was initially thought; the donor-taxpayer only gifted a value amount, not a percentage or number of units.  The income tax consequences to the members of the entity were based on this initial figure. Now, a couple of years later, how are they to be “corrected” where the donor-taxpayer, in retrospect, may have been allocated too little of the entity’s net income and may have received too little in the way of distributions.

How should these inconsistencies be planned for or addressed?  For example, should the gift transfer be made in trust for the benefit of the donee-family members, with the trust structured as a grantor trust? In the case of a grantor trust, the donor-taxpayer is treated as the owner of the trust property for income tax purposes and, so, is taxed on the income and gains therefrom, regardless of whether the ultimate number of shares is adjusted.

If a grantor trust is not feasible, the donees will have reported the income or gains allocated to the equity and paid the tax thereon though, by operation of the DVC, these should have been reported by, and taxed to, the donor.  Should amended returns be filed? Should the donees file protective refund claims for the “excess” income taxes paid, pending the resolution of the gift tax matter? Failing these, have the donees, themselves, made a gift to the donor by satisfying his income tax liability?

What about distributions made to the donees in respect of the equity interests that were later “returned” to the donor pursuant to the DVC?  Presumably, these amounts should have been paid by the entity to the donor.  Must they be returned by the donee?  If so, should they be returned with interest (as in the case of a loan)? If the distributions are retained by the donee, it may be that the donor has made gifts thereof.  What if the distribution itself were taxable to the donee-recipient?

What if the gifted equity interests carried voting rights, and the gift caused the donor’s equity in the family business to fall below fifty percent?  This is not an uncommon reason for the donor’s having made the gift in the first place.  Assume the donor then passes away owning, he believed, a minority interest.  In valuing this interest for estate tax purposes, a lack of control discount is applied.  During the course of the estate tax audit, the IRS challenges the earlier gift valuation and, consequently, part of the gifted equity ends up back in the donor’s estate, causing him to hold more than fifty percent of the business.  In the resulting revaluation of the donor’s equity for purposes of the estate tax, a premium may be applied, rather than the discount he had intended to achieve by virtue of the gift.

The foregoing highlights some of the issues that need to be considered before embarking on a gifting program which depends upon the use of DVCs. While a DVC is a useful estate planning tool, it does not lessen the need for a solid appraisal.  Moreover, as with all estate planning in the context of a closely-held business, the donor and his beneficiaries have to consider the possible ancillary consequences of their gifting decisions.

 

A recapitalization is an exchange between one corporation and its shareholders or security shareholders.  It has been described as a “reshuffling of a capital structure within the framework of an existing corporation,”  and it is one of the most common forms of reorganization encountered in the case of a closely-held business.  Simple examples include the exchange of voting common stock for both voting and nonvoting common stock, and the exchange of common stock for preferred stock.

 

Recapitalizations as Tax-Free Reorganizations

In general, recapitalizations are treated as tax-free reorganizations:  the gain realized in the exchange is not recognized and taxed because the substance and value of the corporation has not changed.  Generally speaking, however, in order to qualify for this treatment, the fair market value of the stock received in the exchange must equal the fair market value of the stock given up.  In an arm’s-length transaction, it is assumed that the parties will exchange property of approximate equal value.

 

Reorganizations Involving Related Parties

In the case of a reorganization transaction in which related parties exchange property of differing values, the IRS will give tax effect to the substance of the transaction by recasting it as a “value for value” exchange, accounting for any difference in value by characterizing that difference as a taxable transaction.  Thus, depending upon the particular facts and circumstances, if an exchanging taxpayer receives new stock having a fair market value in excess of the fair market value of the stock surrendered, the amount of the excess may be treated as compensation, a gift, a payment to satisfy an obligation, or something else supported by the facts; the excess amount will not be eligible for nonrecognition treatment.

 

Example

A recent IRS Field Attorney Advice illustrated the application of these rules.  A corporation had two shareholders, with the majority owner also serving as the CEO.  As part of a recapitalization, the corporation converted its debt into two new classes: (A) a new class of common stock, and (B) a class of non-voting preferred stock.  The existing common was exchanged for new common and for class B preferred, and the majority shareholder thereby gave up his controlling interest.

The IRS analyzed the fair market value of the corporation before the recapitalization.  It concluded that because the corporation’s shareholders had given up stock that was less valuable than the stock that they had received in the exchange, the exchange did not entirely qualify for tax-free treatment.  Based on the facts, the IRS determined that the excess amount was paid to the majority shareholder to convince him to give up his majority interest; i.e. income paid as an inducement for agreeing to the transaction. The excess amount therefore needed to be treated separately from the exchange according to its character.

 

Conclusion

The foregoing highlights how important it is for a closely-held business to examine the potential tax consequences of even seemingly innocuous reorganization transactions, including the recapitalization of a corporation’s own equity.  It also underscores the importance of valuation.  This is especially so for the family-owned business, reorganizations of which are likely to attract closer scrutiny by the IRS.  The failure to consider the reorganization structure from a tax perspective may easily result in taxable income (including a dividend or compensation) or a taxable gift, depending upon the facts and circumstances of the particular corporation and transaction.

We noted earlier that sales tax is often viewed as a “sideshow” to income tax considerations in structuring a deal.  Regardless, it represents real economic cost to the payor.  To appreciate its “true” cost, however, one must also consider its income tax consequences.

In the case of the seller or transferor who pays the tax, the sales tax is treated, for income tax purposes, as a reduction in the amount realized, thereby reducing the income tax burden from the sale.

In the case of the buyer who pays the tax, the sales tax is added to the basis of the property acquired.  Thus, it may be depreciable or amortizable over a period of time dependent upon the nature of the asset acquired.

In the case of a stock purchase (without a 338(h)(10) election), the sales tax will reduce the gain on a subsequent sale of such stock.

 

Some Practical Considerations: Planning for the Sales Tax

We noted that sales tax applies to the sale of tangible personal property (“TPP”), but not to the sale of intangibles, including shares of stock.  We also noted that the transfer of property to a corporation in exchange for equity therein is not treated as a retail sale.

What if tangible personal property were contributed to an LLC, and the LLC interests were then sold to the buyer?  New York has ruled that there would be no sales tax where a seller-corporation transferred its property to a newly-formed single-member LLC and then sold the LLC interest to the buyer.  The fact that the sale was pre-arranged does not appear to matter.  A seller and buyer who want to effect an asset transfer for income tax purposes, but who also want to avoid sales taxes in the transaction, may be able to accomplish that goal through a sale of stock for which an IRC Sec. 338(h)(10) election is made.  The stock sale is not subject to sales tax and the deemed asset sale is only hypothetical – there is no actual sale of assets.

Of course, business considerations may make this approach impractical, and step transaction principles may apply if the buyer promptly liquidates the LLC, thereby causing a taxable transaction.

 

The Asset Purchase Agreement

There are a number of items to consider where the tax on the sale cannot be avoided.  Moreover, the issue of transferee liability or assumption of liabilities must also be addressed.

In a state like New York, which imposes a payment obligation on the buyer, practical impediments may prevent a seller from collecting the tax after a transaction is closed.  Absent an express provision to the contrary in the agreement, it is good practice for the seller to collect the tax from the buyer at closing.

However, nothing prevents a buyer and seller from allocating contractual liability for any sales tax in connection with a corporation acquisition.  The allocation of contractual responsibility for sales tax is an important element of any asset purchase agreement (“APA”), especially where the extent of such tax liabilities is unknown.

For example, an APA will typically provide that the seller and its shareholders shall be responsible for all sales tax liabilities arising out of the operation of the business for all tax periods or portions thereof ending on or prior to the closing date.  In the case of a stock sale, the APA also typically provides that any sales tax return will be prepared by the buyer.  As for the sales tax imposed upon the sale of the business itself, it is not unusual for the APA to allocate the cost either to one of the parties or to be split between both.

A contractual provision will not prevent the taxing authority from proceeding against any party it can legally pursue.  As between each other, however, the buyer and seller are bound by their agreement.  Thus, in an asset sale that triggers the bulk sale rules, unless the buyer complies with those rules, the buyer will be responsible for the seller’s pre-existing sales tax liabilities notwithstanding a legally effective contractual protection which allocates those liabilities to the seller.

Despite this potentially large unknown cost, the parties to an M&A deal are often eager to close the deal and are unwilling to set in motion the bulk sale notification/withholding process, which may not be resolved for many weeks.  In order to help protect the buyer from this unknown liability, a due diligence investigation will be important.  The target’s tax returns and payment history, including any audit reports, need to be reviewed by the buyer’s tax advisers.

The APA should include a tax representation as to sales taxes that includes representations such as the following:

–          That all returns have been properly completed and timely filed;

–          That all taxes have been remitted;

–          That there has never been an audit;

–          That the target has no liability (contractually or otherwise) for another’s taxes;

–          That a deficiency has never been asserted (or, if it has, that it has been paid)

The representations should be made as of the date of execution of the agreement and then should be “brought down” to the closing date.

The APA should also include indemnification provisions for any breach thereof.  Be mindful:  not all indemnifications are equal.  The value of a contractual protection will vary depending on the financial condition and the integrity of the seller.  A holdback (escrow) or deferred payment (installment note), or other form of security arrangement, can enhance the buyer’s protection.

If significant sales taxes may be applicable to the sale transaction, it is generally advantageous, from a sales tax perspective, to allocate purchase price away from taxable assets in order to reduce the liability.  Of course, the allocation must be supportable, and it must be consistent with the allocation for income tax purposes (See IRC Sec. 1060; IRS Form 8594).  The preferences for one tax may be at odds with those of the other.

 

Conclusion

The foregoing highlights the importance of sales taxes in assessing the overall economic benefits and burdens of a purchase and sale transaction. In evaluating such a transaction, it behooves both the seller and the buyer to consider, as early in the process as possible, the impact of such taxes and to plan for them accordingly. For example, the seller may want to negotiate an adjustment to the purchase price so as to account for the sales tax liability and, thereby, to achieve the net economic result he expected before sales taxes came into play. The buyer may want to increase the amount and term of any promissory note given in consideration of assets being purchased so as to provide a cushion for any unexpected sales tax liabilities. Both parties may want to consider some allocation of the sales tax liability arising from the transaction itself. In any case, a party that chooses to ignore the impact of sales taxes on a transaction may come to regret its decision.

Overview

The buyer in a “bulk sale” transaction – i.e., the sale and purchase in bulk of the whole or part of the “business assets” of a person required to collect sales tax – must file a notice of bulk sale at least ten days before taking possession of such assets or paying for them (whichever comes first).

A bulk sale is one that is made other than in the ordinary course of business.  Whether a sale is other than in the ordinary course is based upon all the facts and circumstances surrounding the transaction; however, where a major part of the assets are sold, the sale is clearly not in the ordinary course and is considered a bulk sale.

“Business assets” means any assets pertaining directly to the conduct of a business, whether such assets are intangible, tangible or real property.  Any asset owned by a corporation is considered a business asset.

 

Seller’s Obligations

Before a bulk sale, the seller must give each prospective buyer of the business assets a copy of the notice requirements relating to bulk sales.  It should be noted, however, that the buyer is not excused from his liability simply because of the seller’s failure to provide such copy.

Prior to, or in anticipation of, a bulk sale, the seller may request, and the State may perform (in its discretion), an audit of the seller to determine its sales tax liability through the date of sale of the business assets.  If such an audit is conducted, the State will issue a bulk sale certificate to the seller indicating the seller’s tax liability up to the date of the certificate.  Despite the audit request, the seller will remain liable for taxes due from the seller to the State.  The seller also remains liable for taxes due from him whether or not the buyer has been relieved of his obligations to pay the Seller’s taxes.

 

The Notice

The notice to the buyer must set forth, among other things:

–          The names of the seller, buyer and escrow agent, if any;

–          The scheduled date of the sale;

–          The total sales price;

–          The allocation of the sales price among various classes of assets, including receivables, goodwill, inventory, real property, manufacturing equipment and others;

–          The amount of escrow funds, if any; and

–          The terms and conditions of the sale.

 

The notice must be given even where the seller has represented to the buyer that no sales taxes are owed.

 

Buyer’s Obligations

The buyer must withhold the lesser of (i) the consideration payable to the seller, or (ii) the total tax due from the seller as contained in the notice of tax due sent to the buyer by the State.  If the buyer files a proper and timely notice, and the State notifies the buyer of a possible claim for taxes due, the buyer is forbidden to pay over any funds or property due the seller (except the portion of such funds in excess of the State’s claim) until the seller is relieved of such obligation in accordance with the bulk sale rules.

Because it is unlikely that the State will issue a notice of total tax due prior to the sale closing, a buyer wishing to avoid derivative liability for the seller’s taxes should withhold the entire consideration to be paid the seller until the consideration is released by the State or the tax liability is satisfied.

 A buyer who fails to provide notice of the bulk sale to the State is not released of his obligation to withhold consideration from the seller.  Furthermore, failing to provide such notice will lead to personal liability for the buyer for any sales taxes owed by the seller, up to the greater of the sales price or the FMV of the business assets transferred (including intangibles).

On the other hand, a buyer is relieved if notice has been given to the State and, within five business days of receipt of the notice, the State fails to inform the buyer that there may be a claim for taxes against the Seller.

Within ninety days of the notice of bulk sale, the State will give notice to both the buyer and the seller of the actual amount due from the seller.  Upon receipt of the notice, the buyer may pay the amount of the claim to the State and be relieved of all further liability with respect to such amounts to the seller.

If the State does not respond within such ninety-day period, then the buyer may release the funds to the seller.  The buyer will be relieved from his obligation to further withhold such funds, and from his liability for the taxes due from the seller, except for any sales taxes due on the sale of tangible personal property (“TPP”) from the seller to the buyer.

Of course, the buyer may also release funds if the State informs the buyer that it may do so, or if the seller provides the buyer with a bulk sale certificate from the State stating that all taxes due up to the sale date have been paid.

It bears repeating that a buyer’s failure to file a proper and timely notice of bulk sale will result in personal liability for the buyer for taxes due from the seller.  This liability is limited to the purchase price or the FMV of the business assets sold (whichever is greater).

It should also be noted that the buyer’s personal liability does not extend to the penalties and interest owed by the seller up to the sale date.  However, penalties and interest will accrue on the buyer’s derivative liability.

 

Sales Tax for TPP

In addition to any sales tax liability of the seller arising from the seller’s historical operations, the buyer and the seller must also consider the sales tax that will be imposed upon the sale of TPP as part of the bulk sale, excluding TPP sold for resale (like inventory) and TPP that is exempt from sales tax (like manufacturing equipment), provided proper exemption certificates have been produced.

Of course, the tax is not imposed upon any real property or any intangible personal property (such as goodwill or accounts receivable).

 

…Stay tuned for Part III, The Income Tax Impact of Sales Tax!

Why are taxes so important to the sale of a closely-held business?  Economics.  Any deal, whether from the perspective of the seller or of the buyer, is about economics, and few items will impact the economics of a deal more immediately and certainly than taxes.  The deal involves the receipt and transfer of value, with each party striving to maximize its economic return on the deal.  Simply put, the more that a party to the deal pays in taxes as a result of the deal structure, the lower is the party’s economic return.

Depending upon the deal structure and the assets of the target business, several kinds of taxes may have to be paid and several kinds of returns may have to be filed, thereby making the taxing authorities de facto parties to the deal: they too will have an opportunity to review the deal structure, and its tax consequences, after the relevant tax returns have been filed.

 

Deal Taxes

When many practitioners consider the taxes arising out of the purchase and sale of a business, they tend to focus upon federal income taxes.  Often overlooked are state and local transfer taxes, including sales taxes.  These transfer taxes, however, can have a significant impact upon the economics of the deal.

 

Deal Structures & Questions Re Transfer Taxes

Before delving into sales tax considerations in M&A transactions, it would be helpful to review the basic deal structures.  In an asset sale, the selling corporation sells its business to the buyer.  In a stock sale, the shareholders of the target corporation sell their shares of stock in the target to the buyer.

In the context of these basic transaction structures, two questions must be addressed:

(1) Will the asset or stock sale trigger the imposition of sales tax?

(2) Will the buyer become directly or indirectly liable for the seller’s unpaid transfer tax liabilities as a result of the transaction?

 

Sales Tax Basics

Except as specifically exempted or excluded, the sales tax is imposed on the receipt of consideration from every “retail sale” of tangible personal property (TPP).  The consideration may take many forms, including money, notes, or other property (including equity in the buyer), and includes the assumption of liabilities.  In general, a sale “at retail” means any sale of TPP to any person for any purpose.  It is essentially a transaction tax, with the liability for the tax occurring at the time of the transaction.

The time or method of payment of the consideration is immaterial.  When a sale is made for which payment is not received at the time of delivery, the sale must still be reported on the sales tax return covering the period in which the sale is made, and the full amount of the tax must be remitted with the return.  There is no installment reporting.

The tax is a “consumer tax” in that the person required to collect the tax—the seller, who collects it as trustee for an on account of the state—must collect it from the buyer when collecting the sales price for the transaction to which the tax applies.  This includes one who is selling a business – there is no “casual sale” exception.

Corporate Transfers

Certain transfers of property that occur as part of a corporate or partnership transaction are not treated as retail sales.  For example, there is a “merger exemption” under which the transfer of property to a corporation solely in consideration for the issuance of its stock, pursuant to a statutory merger, is not treated as a retail sale and, so, is not taxable.

However, the exemption does not apply to the extent that the consideration received in the merger consists of cash or other property, including the assumption of liabilities other than those that are secured by the transferred assets.

Moreover, in order for the merger exemption to apply, the stock issued in consideration for the transfer of the TPP to the acquiring corporation must be the stock of the acquiring corporation receiving the property.  A transaction in which the stock of a parent corporation is issued does not qualify for the exclusion.

Note that the availability of the merger exemption is not linked to its qualification as a tax free reorganization for federal income tax purposes under IRC Sec. 368.

 

Tangible Personal Property

TPP does not include real property or intangible personal property.  Thus, where shareholders sell all the stock of a corporation, no sales tax is owed since no TPP was transferred.  In the case of an asset sale, the transfer of accounts receivable, investments in securities, shares of subsidiaries, and goodwill/going concern value are all excluded from the reach of the sales tax since they represent transfers of intangible assets.

 

“Assuming” Target’s Liabilities

It should be noted, however, that a corporate merger or acquisition of stock, which is not itself subject to sales tax, may not be free of sales tax consequences.

In the case of a merger, while the transfer itself may not be taxable, the buyer is “assuming” the seller’s pre-existing sales tax liabilities by operation of law, and the buyer’s other assets will now be exposed to the target’s sales tax liabilities.

In the case of a stock acquisition, the buyer takes the target corporation as is, including any pre-existing sales tax liabilities for which the corporation is liable; those liabilities continue to reside within that corporation (unless the corporation is subsequently liquidated into the buyer).

 

Exemptions in an Otherwise Taxable Deal

In addition to certain excluded transactions, the sales tax provides exemptions for the sale of certain types of TPP.  These exemptions are strictly construed, and the burden of proving non-taxability is on the person claiming the exemption.

The two most commonly encountered exemptions in the sale of a business are the “resale” and “exempt use” exemptions.

 

Exempt Use

An exemption is allowed for receipts from the sale of machinery or equipment used or consumed directly and predominantly in the production for sale of TPP.

Resale

In addition, an exemption is allowed for the sale of property for resale of the property as such (inventory) or when the property is purchased for resale as a physical component part of other TPP.

 

It bears repeating that every person required to collect the tax acts as a trustee for and on account of the State with respect to the taxes collected by such person.  It also bears repeating that all sales of property are deemed taxable until the contrary is established.  The burden of proving that a sale is not taxable is upon the seller and the buyer.  Thus, notwithstanding that a transaction may not be taxable, the parties must pay careful attention to the documentation as to any exemptions claimed.

A seller who in good faith accepts from a buyer a timely and properly completed exemption certificate evidencing exemption from the tax is relieved from liability for failure to collect the sales tax with respect to that transaction.  However, reasonable ordinary due care should be exercised.  A seller may not have knowledge that the exemption certificate is false.

Although the certificate is considered timely if it is received within ninety days of delivery of the property, such an extended period is usually impractical in the context of a sale of a business.  It behooves both parties to make the production of any such certificate one of the items to be delivered at the closing.

In all cases, the parties to the sale transaction must maintain records sufficient to verify all sales tax-related aspects of the transaction.

 

Final Return

In the case of someone who sells his business and ceases operations, a final return must be filed within twenty days after the occurrence of such event.  The return will cover the period from the first day of the actual tax period in which the event occurred to the final day of business.

This final return must be marked as such.

It must be accompanied with payment of all taxes due through the final day of business, including any tax collected from the buyer on the sale of the business.

 

…Stay tuned for Part II, Bulk Sales!

 

In the recent case Thousand Oaks Residential Care Home I, Inc. v. Commissioner, the Tax Court considered whether a corporation’s compensation packages for its owner-employees were unreasonable and thus disallowable as deductions.  The facts can be summarized as follows: in 1973, Petitioners “Mr. and Mrs. F.” purchased a struggling corporation called Thousand Oaks Residential Care I (“TORCH”).  Mr. and Mrs. F. both provided services to TORCH following the purchase.  However, because the corporation initially struggled financially, neither received compensation for these services between 1973 and 1983.  Additionally, Mr. F. received zero compensation in several of the years that followed, despite being a full-time employee.  All of the other employees were paid for their services at market rate.

Mr. and Mrs. F. sold TORCH in 2002.  Effective on January 1, 2003, TORCH created a defined benefit plan in which Mr. and Mrs. F. and their daughter were the only three participants.  Including the amounts they received from this plan, Mr. and Mrs. F’s total compensation for 2002 – 2005 was as follows:

Mr. F.              $880,939

Mrs. F.             $820,348

TORCH’s board minutes from November, 2003 state that compensation had been approved for “payment of back salaries that were not paid in prior years due to insufficient cash flow”; the minutes from 2004 and 2005 contain similar statements of approval.

It is not unusual for the founder of a closely-held business to forego the receipt of any compensation for services rendered to the business, at least until such time as the business can stand on its own.  At that point, however, can the founder seek to recover the value of these services for the preceding years?  Moreover, will the business be allowed to deduct currently the amount of compensation paid to these individuals in respect of their prior years of service?

As a general matter, compensation for prior years’ services is deductible in the current year as long as the employee was actually under-compensated in prior years, and the current payments are intended as compensation for past services.  When the compensation was actually for prior years of service, it need not be reasonable in the year it is paid; it does, however, have to be reasonable in light of the services provided.

Despite the fact that Mr. and Mrs. F. were not compensated for several years while they worked to overhaul TORCH, the Court found that the amounts paid to them in 2002 – 2005 were not reasonable.  The reasonableness of compensation, the Court said, is determined on a case-by-case basis, generally using a broad, five-factor test; no one factor is dispositive.  The factors are: (1) the employee’s role in the company; (2) comparison with salaries paid by similar companies; (3) character and condition of the company; (4) potential conflicts of interest; and (5) internal consistency.  The Court also considered an additional factor: (6) whether an independent investor would be willing to compensate the employee as he was so compensated.

1.  The Employee’s Role in the Company

The Court considered Mr. and Mrs. F’s overall significance to TORCH.  As they were “hands-on owner-operators,” and had turned the company around in 18 months from one that was losing money to one that was moderately profitable, the Court found that this factor weighed in Mr. and Mrs. F.’s favor.

2.  Comparison With Salaries Paid by Similar Companies

The Commissioner presented an expert witness to compare Mr. and Mrs. F.’s compensation with nationwide data from 1973 – 2002.  After adjusting for inflation there was a large difference between the actual compensation and the relevant numbers presented by the expert.  Thus, the Court found that this factor weighed against Mr. and Mrs. F.

3.  Character and Condition of the Company

This factor considers the character and condition of the company.  In its analysis, the Court highlighted that a company’s profitability is not the only indication of the character and condition of a company, and emphasized that Mr. and Mrs. F. made the decision to aggressively pay down TORCH’s loans in lieu of paying themselves compensation.  Had Mr. and Mrs. F. chosen to strike a balance between the two, the Court pointed out, they would have received a lower sale price when they sold the company.  However, because Mr. and Mrs. F. did improve the Company’s financial condition significantly, the Court found that this factor “slightly” favored Mr. and Mrs. F.

4.  Potential Conflicts of Interest

This factor focuses on whether there is a relationship between the employee and the company that may facilitate the concealment of nondeductible corporate distributions as compensation payments.  The Court quickly found that such a conflict of interest did exist, and that this factor weighed against Mr. and Mrs. F.

Internal Consistency

Though the compensation for Mr. and Mrs. F. was not consistent with that of other TORCH employees, this was not because Mr. and Mrs. F. received much more but, rather, much less than the other employees.  Therefore, the Court found that this factor weighed in favor of Mr. and Mrs. F.

6.  Additional Factor:  The Independent Investor

This factor considers whether, after compensation is paid, the remaining profits would still represent a reasonable return on an independent shareholder’s equity in the company.  The Court has found in the past that a return on investment of between 10% and 20% is reasonable.  After compensation was paid to Mr. and Mrs. F., there were insufficient assets for even a 10% return on a hypothetical investor’s investment in TORCH.  Thus, the Court found that this factor weighed against Mr. and Mrs. F.

 

Conclusion

 After reviewing the factors discussed above, the Court found that the compensation paid to Mr. and Mrs. F. between 2002 – 2005 was not reasonable.  In applying the holding of this case to an analysis of whether or not a compensation package would be considered reasonable by the IRS, it is worth noting that the Court seemed to weigh heavily the “additional” factor—the independent investor test.  Thus, when a closely-held business is determining compensation packages, in addition to taking into account the first five factors, it should also ensure that enough money will remain in the business following payment that an independent investor would realize a sufficient return on his investment.

 

In the choice of entity debate, the ability to divide the corporation’s business assets and activities into two or more separate corporations, owned by different shareholders, without incurring taxable gain, is often said to be one of the more significant advantages enjoyed by the corporate form of business.  However, though the partnership provisions of the Code do not have comparable rules that speak specifically to the tax-free separation of a partnership’s business, the income tax rules generally applicable to partnerships may, nonetheless, enable a partnership to achieve the same objectives.  This is especially helpful to know where, in the context of a family business, differences of opinion develop among family members that may ultimately impact the continued well-being of the business.

For example, Partnership may have been formed by Parent with Son and Daughter to operate one or more lines of business.  Over time, each of Son and Daughter may have gravitated toward one line or the other, or they may have focused on different aspects of a single business.  Their differing interests may eventually lead to dissension within Partnership, with a liquidation or division of the Partnership being the best option to keep the peace and allow each child to go his or her separate way.  The income tax consequence of such a division will depend upon the manner in which the division is effected.

Types of Partnership Separations

Generally speaking, there are three types of partnership separations.  The first is a liquidation of the partnership or of the partner’s interest in the partnership.  For example, if Partnership (above) distributed the assets of one line of business to the Son alone, with Parent and Daughter remaining in Partnership, Son’s interest in Partnership has been liquidated.  The other two types are partnership divisions.

According to IRS Regulations, in order for there to have been a division of a partnership, there must be two or more resulting partnerships, and at least two members of the prior partnership must be members of each resulting partnership.  In the example above, if Father, Son and Daughter separated, such that Father and Son became members of one partnership, and Father and Daughter became members of another, then it may be said that there has been a division of Partnership.

Assets-Up Division

A division is treated as an “assets-up” form of division where the prior partnership distributes certain assets to some or all of its partners in partial or complete liquidation of their interests in the prior partnership and, immediately thereafter, such partners contribute the distributed assets to a new, resulting partnership in exchange for interests in such resulting partnership.

Assets-Over Division

A division is treated as an “assets-over” form of division where the prior partnership (“Prior Partnership”) contributes certain assets and liabilities to a new, resulting partnership (“Resulting Partnership”) in exchange for interests therein and, immediately thereafter, Prior Partnership distributes the interests in Resulting Partnership to some or all of its partners (those who are designated to receive such interests) in partial or complete liquidation of the partners’ interests in the Prior Partnership.

In the example above, if Partnership (the Prior Partnership) contributed the assets and liabilities associated with one line of business to a new Resulting Partnership in exchange for the equity therein, then immediately distributed that equity to Son and Parent, with Daughter and Parent still owning Prior Partnership, an assets-over form of division will have occurred.

The assets-over form of division appears to provide more favorable tax treatment than an assets-up division.  Of course, when dealing with the taxation of partnerships, even the “more favorable” tax treatment is fraught with risks, some of which are highlighted below.

The transitory ownership by Prior Partnership of 100% of Resulting Partnership would be ignored.  The in-kind distribution by Prior Partnership to Son in complete liquidation of his interest in Prior Partnership, and the distribution to Parent in partial liquidation of his interest in Prior Partnership, would be tax-free, at least at first blush.  The Resulting Partnership would take the assets from Prior Partnership with the same basis and holding period as they had in Prior Partnership.  The partners would take their interests in Resulting Partnership with the same basis they had in Prior Partnership, though they may have split holding periods, depending on the assets contributed.

However, the “split-off” of a line of business by a Prior Partnership may cause a decrease in a partner’s share of the Prior Partnership liabilities.  Such a decrease is treated as a distribution of money by Prior Partnership; if the amount of the deemed distribution exceeds the partner’s adjusted basis in the partnership, the partner will recognize taxable gain.

If a partner receives a distribution of Prior Partnership property (including money) other than unrealized receivables (or substantially appreciated inventory; together “hot assets”) in exchange for his interest in such hot assets, the transaction may be considered a taxable sale or exchange of such property between the distributee partner and Prior Partnership.

If a partner in Prior Partnership had contributed appreciated property (“built-in gain” property) to the partnership, and Prior Partnership is divided in an assets-over transaction, the interest in Resulting Partnership will itself be treated as built-in gain property to the extent the interest is received by Prior Partnership in exchange for the contributed built-in gain property.  In that case, the distribution by Prior Partnership of the interest in Resulting Partnership to one other than the partner who contributed the built-in gain Property to Prior Partnership, generally will trigger gain to such contributor-partner if the division occurs within seven years of the contribution.  That gain may also be triggered where the contributing partner receives an interest in Resulting Partnership that is not attributable to such built-in gain property.

Conclusion

As the foregoing discussion demonstrates, the interplay of the partnership tax rules in the context of a division can be very complex, and there are a number of potential pitfalls.  That is not to say that it is impossible for partners to separate from one another on a tax-efficient basis.  In order to achieve a tax-free division of a partnership, however, these rules need to be navigated carefully and with plenty of planning in advance.

 

It is not unusual for a parent to have successfully started and grown a business, only to find that his children either have no interest in continuing the business or are incapable of doing so.  Prior to that moment of realization, however, Parent may have transferred equity in the business to his children, either as an incentive to keep them engaged in the business, or as part of his estate planning.  There are several benefits to having Parent maintain a reduced equity position.

Favorable Estate Tax Valuation

If Parent were to pass away holding a reduced equity position in the business, his ownership interest would, of course, be included in his gross estate for purposes of the estate tax.  In assigning a value to that interest, an appraiser would consider the fact that the business was closely-held, that there was no ready market for its equity, and that Parent’s interest represented something less than a controlling interest.  Thus, the value of Parent’s equity would be determined by applying discounts for lack of marketability and lack of control (though the latter may be tempered by some swing vote premium).  In other words, it would likely be valued at less than what his equity interest would receive in the way of proceeds on a liquidation of the business.

Stepped-Up Basis

In addition to a favorable estate tax valuation at the Parent’s death, his equity in the business would pass to his estate or other beneficiaries with a stepped-up basis; i.e. increased from what was essentially a zero basis to the fair market value of the equity at the date of his death.  This would, of course, benefit the holder with respect to the tax liability generated by any later sale or liquidation of the equity.

Conflicting Plans

However, what happens when Parent’s children begin to push for a sale of the business?  They want cash and they don’t want the business; from their perspective, a sale makes sense, and the sooner the better.  The equity may be sold to a third party, or the assets may be sold and the business liquidated.  Each owner, including Parent, will end up with cash from the equity sale, or asset sale/liquidation, and will pay income tax on the gain realized.  Since Parent’s basis is very low, the full amount received by him is subject to income tax (albeit as capital gain).  In addition, because cash is not subject to valuation discounting, the full amount thereof held by Parent at his death would be subject to estate tax.  If Parent is older, he may prefer to hold on to his equity, both for estate tax valuation purposes and for the basis step-up.

Is there some way to accommodate both Parent’s desire to hold his equity in the business until his death, while also generating the liquidity desired by his children?

The IRS OK’s a Compromise

The IRS once considered the following scenario: Taxpayer owned 14% of Target Corp’s common stock, with the balance being widely held; Taxpayer was of an advanced age and had very low basis in his Target stock; and Buyer Corp sought to purchase all of Target Corp’s stock for cash and to operate Target Corp as a subsidiary.  While the other Target Corp shareholders were willing to accept cash for their stock, Taxpayer was not because a sale would result in recognition of substantial taxable gain.  In order to accommodate Taxpayer’s wish to avoid gain recognition, Buyer Corp and Taxpayer agreed to organize a new corporation, Sub, for the purpose of acquiring and holding all of the Target Corp stock.  Buyer Corp transferred cash and other property to Sub in exchange for all of Sub’s common stock, and Taxpayer transferred his shares of Target Corp stock in exchange for all of Sub’s preferred stock.  The transaction was intended to be a tax free exchange under IRC Sec. 351.  Sub then used the cash to acquire all the stock of Target Corp (other than that contributed by taxpayer to Sub).  Both Sub and Target Corp remained in existence as a holding company and an operating company, respectively.

Although it hesitated at first, the IRS eventually concluded that the transaction would qualify as tax-free exchange under IRC Sec. 351.  Thus, taxpayer did not recognize a gain on his exchange of Target Corp stock for preferred stock in Sub.

Partnership

Under other rulings issued by the IRS, it may be possible to arrive at a similar result in connection with the acquisition of a partnership’s business, when an older partner does not want to “liquidate” his interest and recognize gain.  For example, Partner Taxpayer may contribute his membership interest in Target LLC to Buyer LLC in exchange for a membership interest therein.  In general, this exchange would be tax-free.  Buyer LLC may acquire the other Target LLC membership interests in exchange for cash, thereby making Target LLC a wholly-owned division.

It may also be possible to combine a Sec. 351 exchange with another form of tax-free corporate exchange in order to effect the same result.  For example, Parent and the other members of Target LLC may contribute the LLC’s assets to a newly-formed corporation, Newco, in exchange for Newco common stock, which it then distributes to its members.  At the same time, Buyer Corp merges into Newco, on a tax-free basis, with the Buyer Corp shareholders receiving Newco common stock in cancellation of their Buyer Corp stock.  The two asset transfer transactions, as a whole, constitute a tax-free Section 351 exchange.  Moreover, this treatment should not be affected if Newco subsequently uses cash received in the merger with Buyer Corp to redeem the Newco shares held by the former members of Target LLC, other than parent.

 

Conclusion

In light of the foregoing, when presented with a situation where the younger generation wants to cash out of a business, while the older generation would prefer to defer gain recognition and possibly achieve a more favorable estate valuation and a basis step-up, consideration should be given to some variation, or combination, of the partially tax-free, partially taxable exchange transactions described above.  Although there are a number of other issues that need to be considered (based upon the unique facts and circumstances of the particular parties), achieving the appropriate structure to accommodate the older generation of a target company may be a pre-requisite to getting a deal done.

 

In the context of a family business, we are sometimes presented with situations in which the business wishes to sell property to, or acquire property from, a family member or an affiliated business in which he is involved. The transferors are often surprised by the tax consequences of these transactions.

Assume that Taxpayer owns land and buildings that he leases to various businesses.  Taxpayer has depreciated the buildings over several years, and the value of the properties has appreciated.  If Taxpayer were to sell the property to an unrelated Purchaser, in an arm’s‑length transaction, in exchange for cash and an installment note, Taxpayer would realize gain equal to the excess of the amount realized (the sum of the cash and the note) over the adjusted basis in the property.  In general, such gain would be long-term capital gain, which, in the case of an individual, would be subject to federal income tax, in part at the 20% capital gain rate and in part at a 25% rate.  (A 3.8% surtax may also apply.)  Part of the gain would be recognized in the year of the sale, and the balance would be recognized, under the installment method, as payments are received on the note.

These results change significantly if Purchaser is related to Taxpayer.  The definition for “related person” varies slightly depending on the context of the particular transaction, but it generally includes a person and any entity in which such person owns, directly or indirectly, a greater than 50% equity interest. It also generally includes business entities that are under common control.  When Taxpayer sells to a related person, there are several risks of which he should be aware.  

 Risk #1: Loss of Capital Gain Treatment

The Internal Revenue Code provides that in a sale of property between “related persons,” any gain recognized to the transferor shall be treated as ordinary income (taxable, in the case of an individual, at a maximum rate of 39.6%) if such property is depreciable in the hands of the transferee.

Similarly, in the case of a sale of property (whether or not depreciable) between a partnership and a person owning more than 50% of the capital or profit interests in the partnership, or between two commonly controlled partnerships, any gain recognized shall be considered ordinary income if the property is other than a capital asset.

If Taxpayer, above, were to sell the property to a Purchaser “related” to Taxpayer, the portion of the gain attributable to the depreciable buildings may be taxed as ordinary income.  If the sale was between related partnerships, the entire gain may be taxed as ordinary income, because neither real property (land) used in a trade or business nor depreciable property (buildings) used in a trade or business is a “capital asset.”

Risk #2: Loss of Installment Reporting

Moreover, if Taxpayer’s sale is to a related Purchaser, the Taxpayer may not be entitled to report under the installment method the gain realized on the sale that is attributable to depreciable property (the buildings); in that case, all payments to be received under the note will be treated as received, and  included in Taxpayer’s income, for the year of the sale, unless the Taxpayer can establish that the sale did not have tax avoidance as one of its principal purposes.  The gain attributable to the land (which is not depreciable) may still be reported on the installment method, subject to one exception.

If a taxpayer (the original seller) sells property to a related person and, before the taxpayer receives all the installment payments with respect to such sale, the related purchaser disposes of the property, then the amount realized at the time of the second sale will generally be treated as received at that time by the taxpayer, provided the second sale is not more than two years after the first sale.

 Risk #3: Scrutiny of “Bargain” Transfers

In other situations, the Taxpayer may want to transfer property to a related entity for an amount of consideration that is less than the property’s fair market value.  From the Taxpayer’s perspective, there may be reasonably good business reasons for doing so; however, the IRS will closely scrutinize any such transfer.  On examination of a “bargain” transfer, the IRS may conclude that the transfer was not a bona fide business transfer, and that the transferor Taxpayer intended to make a gift to the transferee or, where the transferee is an entity, to the owners thereof (who are related to the transferor).

Similar considerations apply where the sale is between commonly controlled or related business entities, and the purchase  price reflects a premium or discount.  In that case, the IRS will inquire as to the reasons why one entity paid too much, or too little, for the property sold.  Was income being shifted to an owner in a lower tax bracket?  Did one of the entities have tax characteristics (such as losses) that the “other than arm’s length” sale sought to utilize?  In these situations, the IRS may reallocate the gain or income between the related parties so as to prevent the avoidance of tax.

 Risk #4: Disallowed Losses

Where the sale of property between related parties results in the realization of a loss, the seller’s deduction in the year of the sale in respect of the loss will be disallowed. However, if the related party purchaser subsequently sells the property at a gain, such gain will be recognized only to the extent it exceeds the previously disallowed loss.

 Risk #5: Loss of a Tax-Free Like-Kind Exchange

Even an otherwise tax-free exchange may be adversely impacted where the parties to the transaction are related.  For example, if a Taxpayer exchanges property with a related person in a tax-free like-kind exchange, the Taxpayer may nevertheless be forced into recognizing gain if the related person disposes of the property exchanged within two years of the original transaction.  Even where the Taxpayer’s transaction is part of a deferred exchange with an unrelated purchaser, if the qualified intermediary acquires the replacement property from a person that is related to the Taxpayer, the transaction will result in an immediately taxable event.

You May Not Choose Your Related Parties, But You Can Plan

The foregoing describes only some of the pitfalls of which a seller of property must be aware when dealing with a related party buyer.  Any sale that may involve a related party should be examined closely to take these and other tax consequences into account. Once the tax issues and the business factors have been identified, the taxpayer can plan accordingly.