“Tax Questions to Consider When Selling a Business in New York”

Jan
2018
07

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“TAX QUESTIONS TO CONSIDER WHEN SELLING A BUSINESS IN NEW YORK”

Dutchess County Bar Association

CLE Program – December 8, 2017

Presented by James P. Constantino, Esq.

This course is intended to introduce you to the initial issues an attorney should pursue when a client wishes to sell a New York business.  In it, I will focus on tax [footnote*] matters. Of course, there are other issues besides tax an attorney would want to discuss with a client selling a business — not the least would be, for example, when to sell, how to negotiate for the best possible price, etc. Still, I want this course to be an introduction to the tax questions involved in selling a business, so no prior knowledge is assumed (aside from perhaps your income tax class in law school).

Let us focus on the following six key questions:

  1. What sort of business entity does your client have? In this section we will discuss the various entity-types available to business owners in New York and, further, some typical kinds of assets owned by businesses.
  2. Can your client sell? If so, how? In this section we will discuss different entity and asset types and some of the particular issues involved in selling them or, as the case may be, not being able to sell them.
  3. From a tax perspective, how are different assets treated when sold? In this section we will focus on how the sale of certain assets can be characterized for tax purposes, with an eye to potential ambiguities, and how that can ultimately change your client’s tax liability.
  4. What are the different taxes my client might have to pay or collect? In this section, we will discuss how different kinds of entities and assets are subject to different taxes in New York, what those taxes are and how they are administered.
  5. How are these taxes calculated? This section will involve a quick review of basic tax concepts before exploring the mechanics of federal and New York taxes that sellers of businesses must plan for.
  6. What additional issues should I be aware of? In this section we will discuss tax questions beyond calculation and administration that you should consider when planning the sale of a business for a client.

Included in this packet is an outline of the substantive material I will cover in answering these questions, along with citations to primary and secondary sources that you might find helpful in learning more.  I am also going to work through an illustrative contract to show you “thinking points” and “negotiation points” in crucial tax areas.

1.     What sort of entity does your client have?

a.     Sole proprietorship

i.     No distinction between the owner’s property and the business entity.

ii.     Business income is reported on the owner’s personal tax return.

Further reading:

b.     General Partnership

i.     Like a sole proprietorship in that the assets and liabilities are not distinguished from ownership, except that in a general partnership ownership is shared among partners.

ii.     Also like a sole proprietorship, business income to a general partner is reported on the partner’s personal tax return. I.e. the entity does not itself have a return. This is called “flow-through” taxation.

iii.     Partnership agreements—which generally specify how duties, responsibilities, and income are divided among partners—can be extremely complex. As a corollary, the taxation of partnerships is one of the most technical areas of tax law.

Further reading:

c.     Limited Partnership

i.     A business form familiar to attorneys, wherein liability for limited partners does not exceed the amount of their capital contribution.

ii.     As with a general partnership, LP income is taxed at the individual level and not as a separate entity (i.e. “flow-through”). I have included them here for thoroughness.

Further reading:

d.     Corporations

i.     Under the Internal Revenue Code(“IRC” or “code”), a corporation can be taxed as either a “C” corp or an “S” corp. They are so-called because sub-chapters “C” and “S” of Chapter 1 of the IRC respectively deal with the rules of these corporations.

ii.     The key distinction between them is corporate taxation versus flow-through taxation. C-corp income is taxed first at the business level and then shareholders are taxed on corporate distributions. Thus, there are two points of income taxation for shareholders of C-corps.

iii.     Double-taxation for C-corps occurs also in the sale of the corporation. First, the corporation must pay corporate income tax on any gains from the sale of its assets, and then shareholders must pay capital gains tax on their distribution from the liquidation of the corporation.

iv.     S-corps have the limited liability of a C-corp, but they also have the benefit of flow-through taxation. That is, shareholders of an S-corp are only taxed once, at the individual level.

v.     To properly elect to be taxed as an S-corp, an entity must fit within certain parameters: the corporation must be domestic, have no more than 100 shareholders, and the shareholders cannot be non-resident aliens.

vi.     The policy purpose was to create a more business-friendly environment for smaller corporations. In fact, S-corps can be quite large.

Further reading:

e.     Limited Liability Company

i.     These were created in New York State under the Limited Liability Company Law

ii.     They were designed to provide the flexibility of a partnership (in terms of ownership, duties, and division of income) with the limited liability of a corporation. Agreements forming LLCs are called “operating agreements.”

iii.     LLCs benefit from flow-through taxation, as in partnerships

Further reading:

2.     Can your client sell? If so, how?

a.    Sole Proprietorship

In the case of a sole proprietorship, the sale will be properly characterized as the sale of the owner’s personal property. As such, taxable income to your client will possibly take the form of tangible assets, real estate, intangible assets (e.g. contracts, good will, customer lists). Additionally, your client will have a sales tax liability on the sale of tangible property (more on this below).

b.     Corporations, Partnerships, and LLCs

Corporations, partnerships, and LLCs can have more complicated rules about selling. Often, the situation is more complicated than simply finding a buyer. In the case of small partnerships and LLCs, the partnership agreement or operating agreement will frequently specify that the remaining partners/managers have a right of first refusal. In such a case, the attempt to sell to a third party first would be a breach of contract.

3.     From a tax perspective, how are different assets treated when sold?

a.     Capital Asset – IRC § 1221

i.      Expected useful life of more than one year

ii.     The acquisition cost exceeds the capitalization limit

iii.     The asset is not sold in the ordinary course of the business

iv.     Examples include real estate, equipment, furniture, improvements to land, fixtures

b.     Intangible Asset – IRC § 197

These are defined in a list in the Code and include:

i.      Good will

ii.     Going concern value

iii.    Customer lists

iv.    Government permits

v.     Intellectual property

c.     Other Assets

i.     Proceeds from the sale of other assets, such as inventory, consumable office supplies, and accounts receivable, will be considered ordinary income.

d.     To the IRS, the sale of a business is not necessarily the sale of a single item, but rather of all the individual constituent parts that make up the business. For example, the sale of a restaurant might include the sale of underlying real estate (capital asset), the restaurant building (capital asset), equipment such as stoves and dishwashers (capital asset), a trademark of the restaurant’s name or logo (intangible asset), cooking ingredients on hand (ordinary asset), the value of any existing catering contracts or gatherings held at the restaurant (ordinary asset).

e.     In the case of a corporation, the seller has the option of either selling the corporation’s stock or having the corporation sell its assets. In general, the former is preferable for the seller, while the latter is preferable for the buyer.

 4.     What are the different taxes my client might have to pay or collect?

a.     Personal Income Tax – Federal, State, and New York City

b.     Corporate Income Tax – Federal, State, and New York City

NOTE: The New York City General Corporation Tax(“GCT”), does not recognize the S-corp flow-through treatment, and so S-corporations with a GCT liability in New York City are subject to traditional double taxation.

c.     Sales Tax – State and Local

5.     How are these taxes calculated?

a.     Income Tax Basics

i.     Amount Realized on a sale – Basis = Gain or Loss

ii.     Basis is usually the price at which you acquired the asset

  1. Basis for the seller will subtract any depreciation deduction
  2. Basis will also subtract any casualty loss claimed
  3. Basis will also add any expenses of selling an asset

iii.     Amount realized is usually the amount you received when selling it

iv.     That is, an increase in value is not itself income; the gain must be realized

v.     Gain on the asset, with certain proper subtractions, is multiple by the applicable rate.

b.     The allocation of purchase price determines the tax treatment for the sale of the assets that comprise the business. NOTE: the allocation of the purchase price is often a significant part of the overall negotiation, as tax treatment that benefits the seller may be to the buyer’s detriment.

i.     The IRS provides guidance as to the allocation of purchase price at IRC 1060, the underlying regulation, and in the instructions for the filing of Form 8594 – Asset Acquisition Statement Under Section 1060.

c.     Capital gains are generally preferable for the seller over ordinary income because the tax rate is much lower than ordinary income rates.

d.     Sales Tax Basics

i.     In New York, retail sales of tangible personal property are subject to state and local sales tax unless specifically exempted. Certain enumerated services are also taxable.

ii.     For selling a business, the key is to remember that the sales tax must be collected on sales to the final user. A “sale for resale” is specifically exempt.

  1. For example, if a convenience store is being sold, then paper cups, plates, cash registers, and non-affixed furniture will be subject to NYS sales tax, because the purchaser will be the end user of the product.
  2. In the same scenario, the newspapers, food, and drink for sale are inventory with the intent to resell them to customers, who will be the final consumers of the product. Thus, when these assets are included in the sale of the business, they are not subject to NYS sales tax.

Further reading:

6.     What additional issues should I be aware of?

a.     Depreciation

i.     The IRS definition: “Depreciation is an income tax deduction that allows a taxpayer to recover the cost or other basis of certain property. It is an annual allowance for the wear and tear, deterioration, or obsolescence of the property.”

ii.     Most tangible and intangible property is depreciable. Real property is never   depreciable, although improvements to real property are.

iii.     For sellers of a business, the recapture of a depreciation is ordinary income.

  1. For example, you have machine purchased by your business for $10,000. By the time of sale you have taken $5,000 in depreciation deductions in the years you have owned it. When the business is sold, the basis in the machine has become $5,000 dollars. When the machine is sold, your gains up to $5,000 will be taxed as ordinary income, and any amount above that will be taxed as a capital gain.

Further reading:

b.     Installment Sale

i.     If the purchaser is financing the sale of your business, then capital gain income can benefit from installment sale treatment.

ii.     Specifically, the “Gross Profit Percentage” is computed for each asset sold. This is the gain on an asset divided by the selling price.

iii.     When you receive a payment for the business, the principal component of the payment is multiplied by the GPP to determine the taxable gain.

Further reading:

 

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