What to Expect When Buying or Selling a Business Part III
This article continues from the previous one and the one before that about selling and a business. The first article talked about the types of professionals and general agreements involved. The second one went further into potential liability concerns. Today, we will talk a little bit more about non-tax concerns of an asset vs. stock purchase, and review a bit about ordinary income vs. capital gains, especially with respect to the new tax laws that passed in 2018. Next article in the series will deal with specific tax considerations of buying assets v. stock.
Disclaimer: The following information does NOT constitute legal advice and is only for general educational purposes. Each situation is different and specific legal issues usually require additional research and investigation, so do not rely on this article to address a particular legal issue; use this as a starting point to gain a general understanding. This article, although educational in purpose and substance, nevertheless, might be deemed attorney advertising, and prior results do not guarantee future success.
8. Non-Tax Practical Considerations
of Asset v. Stock/Interest Sale
To quickly review, as we discussed last article, a Buyer can obtain a new company either by buying stock from a corporation (or Membership Interest in an LLC or Partnership) or by buying the target company’s assets. The prevailing wisdom is that a Buyer should look to the assets not the stock, because otherwise if the Buyer takes the stock, they are “stepping into the shoes” of the original Seller. From a legal point of view, this means they could be responsible for the previous Seller’s liabilities (such as faulty products, and Seller defaults on contracts and bills).
However, things are not always that black and white. For instance, if the Seller is a service company with a lot of contracts (i.e. Seller Customer Contract 1, 2, 3 … 10,000), in an asset sale, all those contracts might have to be assigned to Buyer, or require a novation, which besides being difficult, might not actually be possible (i.e. customers possibly could cancel the contracts, or might simply use the transfer as an excuse to negotiate better prices, etc.).
The same applies to employment contracts. If Buyer simply steps into the shoes of Seller, it is likely any long term employment contracts would stay similarly positioned and enforceable (although depending on how those contracts were written the employees might still have some kind of recourse to escape). However, if Buyer bought the assets, the Selling company likely will dissolve and go away, and the employees may want to leave rather than work for Buyer. Then again, if Buyer wants to get rid of all those employees, Buyer definitely should buy the assets instead of the stock / interests.
However, practical considerations are not the only issues. Tax concerns significantly drive the way a purchase is handled. The Buyer is typically looking to “step up” Tax Basis and deduct things as quickly as possible, and the Seller is generally looking to treat everything as much as possible as Capital Gain. What does all that mean?
9. Consult with a Tax Professional
First, as I keep saying, before we go into some specifics, when considering a purchase or sale, I highly recommend you first consult with your tax advisor on the best way to approach this.
Some lawyers really do practice in the tax area or truly learn a lot about tax with respect to their business law practice. However, you and your lawyer should be crystal clear how much tax advice they are providing you. What you do not want to happen later on, when the deal is done, is for you be left with unforeseen tax consequences or results and for your lawyer to say they thought you were working with your accountant to address those.
Therefore, I usually make it clear to my clients, I expect to working with their accountants or tax professionals, hand in hand, prospectively to avoid issues. Further, my client’s accountant instinctually will know their tax and financial situation better than me, particularly if I were just hired for this deal and the accountant has been there for years.
The more complex the transaction, the more tax aspects are going to be part of it. For the Seller, certain parts of the transaction could be considered ordinary income taxed at higher rates, and other elements capital gains. For the Buyer, the way tax basis and amortization is calculated could be very important. Also the way assets are handled is critical; for example, common wisdom is you never stuff real estate into a corporation (you use an LLC instead)
10. What is Tax Basis?
We are going to discuss some complicated accounting ideas in a few minutes, but first I want to discuss how the IRS (and others) tend to view taxable income. Please keep in mind I am grossly simplifying these concepts.
“Tax Basis” is generally your taxable “capital investment” in property. If you buy something for $100, your basis in it, usually is $100. If you sell it for $500, you subtract your “tax basis” of $100 from the gross amount collected $500, and you made a “profit” of $400. Simple enough so far, right?
Well, many events can affect your Tax Basis. If you improve the property, that can increase the Tax Basis. Certain types of expenses associate with the property can increase Tax Basis as well, such as title insurance abstract fees, legal fees, survey costs, etc.). However, Tax Basis can also go down. Depreciation for instance. When you buy a computer (for your business) for $1,000, you are allowed to depreciate it (typically over five years I think), so you can deduct $200 of “losses” every year.
What do I mean? Simply owning the computer for your business, you are losing $200 in value every year, because in five years, as far as the IRS is concerned it is worth nothing. So you can write off that $200 of loss against your other income for the year. That’s the same as putting another $200 in your pocket! (well the math doesn’t work out 100% like that in the end because of how tax rates bite into that, but that’s the concept).
Typically, you want your Tax Basis to be higher than lower, because when you sell the property, there will be less of a *difference* between the purchase price and the Tax Basis. For example, if you bought a piece of property for $100 (your Tax Basis is $100), and sold it for $500, that means you earned $400 ($500 - $100) or $400 of taxable income. However, if your Tax Basis was more (your purchase price was $300), and then you sold it for $500, then you *only* earned $200. So, generally, if your Tax Basis is higher, your eventual taxable income will be less; and that means you pass less taxes! That’s the reason Tax Basis is important.
11. Ordinary Income and Capital Gains Explained
However, generally, Tax Basis comes more into play with Capital Gain, not Ordinary Income. What’s the difference? Typically, there are two types of income (again grossly simplifying for education purposes), and they are taxed very differently, which can mean a big difference for you when buying or selling. One is Ordinary Income (what most people think of as income) and other is Capital Gains.
Ordinary Income includes wages and other money earned that isn’t form the sale or transfer of a Capital Asset or things like that. The definition is way more technical than that, especially in application (hey, that’s why CPAs were created!), but that will get us started for the purposes of this conversation. But then, what’s a Capital Asset? Capital Assets include property such as your home or car, as well as investment property, such as stocks and bonds. The rules can get complex, but generally, if you want favorable Capital Gain tax treatment, you usually need to hold the asset for at least a year.
Typically, if you’re a “wage slave,” you get paid $X per hour or per year - that is Ordinary Income. If, however, you bought a stock for $1,000 and sold it over a year later for $4,000, generally speaking, you probably earned a Capital Gain of $3,000; that is the “profit” you made from the sale of your “Capital Asset.”
Of course, you can have Ordinary Losses and Capital Losses as well. Capital Losses are easy to understand; you bought the stock for $15,000 and sold it for $8,000 - Whoops! $7,000 Capital Loss. Ordinary Losses, on the other hand, usually happen when your expenses exceed your income in your business, or there was a theft or loss (like a fire). Say you made $4,000 in your business but had $10,000 in business expenses that year, you would have a $6,000 loss. This likely means your taxable income for that year was zero, and you might be able to carry forward or backward that loss to offset other more profitable years - the rules are complicated so consult a professional.
12. Ordinary Income v. Capital Gains Rates
Why does this matter? Prior 2018’s Tax Cuts and Job Act, there were seven tax brackets for Ordinary Income, ranging from 10% to 39.6% (speaking of federal income taxes, not state, local or FICA). However, back then, Capital Gains tax was only 0, 15% or 20% - and that was tied to your Ordinary Income *tax bracket* for the same year. Confused? I don’t blame you.
For this example, I’m going back to 2016 (because that’s where I found these cool charts…). Let’s say, after deductions, etc. your Adjusted Gross Ordinary Income was $56,000, but you also made $10,000 in Capital Gains. First thing you do, is find your AGI and compute your tax on your Ordinary Income. Back then, the tax table looked like this:
2016 Rate Taxable Single Income Bracket
$0 to $9,275 10%
$9,275 to $37,650 15%
$37,650 to $91,150 25%
$91,150 to $190,150 28%
$191,150 to $413,350 33%
$413,350 to $415,050 35%
See, $54,000 fits between $37,650 and $91,150, you owe 25% on your $54,000 (I’ll let you do the math there). But now, you have to figure the tax on the $10,000 of Capital Gain. Do you use the same rate? Not exactly. But you start with it.
For a minute you now pretend the $10,000 is stacked on top of the $54,000. So that gives you $64,000. Guess what? That’s still in the 25% Ordinary Income Tax column ($64,000 is still between $37,650 and $91,150) but you’re not done yet. You then cross-index the Ordinary Income Tax Rate that with the following table:
2016 Tax Rates
Ordinary Income Tax Rate Long Term Capital Gain Tax
So, that extra $10,000 of income of Capital Gains Tax; *IF* it were Ordinary Income, you should have paid 25% federal income tax on it; however, since it’s not Ordinary Income, it’s Capital Gain Tax, you’re only going to pay 15%. This chart from a different website is a bit clearer:
In the old days, as weird as this sounds, your Capital Gain Tax rate was only indirectly tied to your AGI; it was more tied to your Ordinary Income *tax bracket*. Don’t ask me how that came about; I’m not sure off hand. Anyway, they sort of cleaned that up in 2018. Now your Capital Gains are more directly tied to your AGI.
For Single Filers, it’s something like this:
AGI Capital Gain Rate Ordinary Income Rate
$38,700 or less, 0% 10-12%
$38,701 - $500,000 15% 22%-35%
Over $500,000 20% 37%
As you can see, the rates are still way lower if your sale profit is treated as one involving Capital Assets, as opposed to Ordinary Income.
In the sale of stocks or assets of a business, there are also other tricky factors that come into play as to whether something is considered Ordinary Income or Capital Assets, *and* how the Tax Basis (remember that?) is treated. More to follow in the next article.
 FICA: Federal Income Contributions Act (Medicare and Social Security) usually 15.3% for self-employed individuals or half that for working people (since their employer pays 50%).