The Tax Aspects

of Acquiring a Business
The Tax Aspects
of Acquiring a Business

Second Edition

W. Eugene Seago
The Tax Aspects of Acquiring a Business, Second Edition

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 Abstract
Tax considerations are seldom the determining factor in deciding whether
to purchase a business. However, taxes often affect the price and form
(e.g., purchase of stock or purchase of assets) the acquisition takes. This is
true because the form of the transaction affects the buyer’s present value
of after-tax future cash flows and therefore the price the seller will receive.
The tax implications of the purchase and sale of a business largely
depend upon who the buyer and seller are and what is being bought and
sold. The business being purchased may be an unincorporated proprietor-
ship, a single owner limited liability company (LLC), a partnership (or an
LLC with more than one member), a C corporation, or an S corporation.
The form of the sale (asset or stock) affects the character of the seller’s gain
(ordinary or capital) and the buyer’s basis of the assets. The buyer’s basis
will eventually become tax deductions.
Just as the price the buyer is willing to pay is based on the projected
present value of the after-tax proceeds, the price that is acceptable to the
seller will depend upon his or her expected after-tax proceeds. Each party
must be aware of the other party’s tax consequences to achieve a rational
agreement.

Keywords
applicable federal rate (AFR), contingent liabilities, contract price, cost
recovery period, covenant to not compute, depreciation recapture, good-
will, gross profit ratio, installment sale, limited liability company (LLC),
qualified indebtedness, section 197 intangible assets, tax basis, tax lives
 Contents
Acknowledgments....................................................................................ix
Chapter 1 The Purchase and Sale of an Unincorporated Business........1
Chapter 2 The Purchase and Sale of an Incorporated Business..........25
Chapter 3 The Purchase and Sale of an S Corporation......................47
Chapter 4 The Purchase of a Corporation’s Subsidiary......................61
Chapter 5 Tax-Deferred Acquisitions of C Corporations..................71
Chapter 6 Business Investigation Costs.............................................83

About the Author...................................................................................87

Index....................................................................................................89
 Acknowledgments
I am grateful for my opportunity to learn from teaching so many students
at Virginia Tech for the past 48 years.
 CHAPTER 1

The Purchase and Sale of an

Unincorporated Business

The value of a business is the present value of the future net-of-taxes cash
flows the business will produce. A tax adviser has little influence over the
pattern of future revenues a corporation may earn, but the tax adviser
may have some influence over the deductions allowed in calculating the
taxable income. An important determinant of future tax deductions is
how the purchase price is allocated among the assets.

Assets Valuations
The basic assets of an unincorporated business can be viewed as future tax
deductions that will yield cash flow equal to the owner’s marginal tax rate
in the year of the deduction multiplied by the amount of the deduction.
The tax lives that are used to allocate the assets’ costs over their lives are
established by the Internal Revenue Code and Regulations. Therefore,
once the costs of the various assets, their tax lives, the tax owner’s expected
tax rate, and discount rate are determined, the present value of future tax
benefits can easily be determined. Assuming the tax rate does not change,
the shorter the cost recovery period, the greater the present value of the
cash flow from the asset.
The purchase of an existing business is the acquisition of more than
identifiable tangible assets. Tangible assets generally can be purchased in
an open market for a price that is based on the expected present value
of the asset’s future after-tax cash flow. The unique value of a particu-
lar business lies in its intangible assets. The intangible assets can create
a return above and beyond what can be derived solely from the replace-
able tangible assets. The business may have a variety of intangible assets
2 THE TAX ASPECTS OF ACQUIRING A BUSINESS

(e.g., a workforce in place, technical know-how, satisfied clientele, books

and records, going concern value), some of which may be difficult to
isolate. Often, the intangibles are lumped together into something called
goodwill. It is generally not necessary for tax purposes to identify specific
intangible assets, because the intangibles acquired with a business are all
treated the same, with a few exceptions.1
A commonly used method of valuing the business as a whole is the
capitalization of expected future cash flows. That is, the business is worth
a multiple of its expected annual cash flow. For example, a business may
be valued at 10 times its expected annual cash flows. Once total price of
the unincorporated business is determined, for tax purposes, the price
must be allocated among the assets that constitute the business. The Tax
Code and regulations (Reg. §§1.1060 and 1.338-6, and 7) provide a spe-
cific order for allocating the total purchase price to specific assets on the
basis of their fair market values.2 The intangibles are usually the most dif-
ficult to value because each intangible is unique. Internal Revenue Service
(IRS) is aware of the valuation problems, and therefore, the regulations
require that the purchase price of the business must first be allocated to
assets such as marketable securities whose value is easily determined.3
Next, the remaining purchase price must be allocated to tangible assets,
such as plant and equipment, to the extent of their market values. Gener-
ally, the remaining purchase price is allocated to the business intangibles.
More specifically, the regulations place each assets into one of the follow-
ing seven classes of assets:

Class I: cash and cash equivalents;

Class II: actively traded personal property as defined in section 1092(d),
certificates of deposit, and foreign currency;
Class III: accounts receivable, mortgages, and credit card receivables
which arise in the ordinary course of business;
Class IV: stock in trade of the taxpayer or other property of a kind,
which would properly be included in the inventory of the taxpayer

1
See IRC §197.
2
Section 1060.
3
Reg.§1.1060.
 The Purchase and Sale of an Unincorporated Business 3

if on hand at the close of the taxable year, or property held by the

taxpayer primarily for sale to customers during the ordinary course
of his trade or business;
Class V: all assets not in Class I, II, III, VI, or VII;
Class VI: all Section 197 intangibles except goodwill or going concern
value; and
Class VII: goodwill and going concern value.

Goodwill and going concern value is the residual after the price has
been allocated to the other classes.
Generally, classes VI and VII are the section 197 intangible assets
acquired as a part of existing business purchased by the taxpayer. With a
few exceptions, their cost can be amortized over 15 years. This is generally
true regardless of the legal or economic life of the particular asset.4 Thus,
if the buyer of an extended care center paid a premium for the fact that
the facility was operating at a certain capacity, the premium paid must be
amortized over 15 years, although the patients might not be expected to
remain in the facility for another 15 years.
Some of the exceptions to the 15-year amortization of intangibles are
leaseholds and mortgaging service contracts.5 These assets can be amor-
tized over their legal lives. Also, off-the-shelf computer software can be
amortized over 5 years,6 but the seller’s custom-made software is a section
197 intangible that is subject to 15-year amortization.
As previously discussed, the present value of the future deductions for
the cost of assets depends upon the cost recovery period for tax purposes
as well as the owner’s marginal tax rate and discount rate. The following
are some asset classes, their cost recovery periods, cost recovery methods,
and the present value of the cost recovery deductions, assuming a 37 per-
cent marginal tax rate for an individual, or a 21 percent marginal tax rate
for a corporation and a 10 percent discount rate. Thus, an individual’s
tax benefits are 29 percent of the cost of a tractor, whose cost recovery
period is 3 years, and 11 percent of the cost of a commercial building.

4
Section 197(c).
5
Section 197(e).
6
Section 197(e)(3).
4 THE TAX ASPECTS OF ACQUIRING A BUSINESS

For intangible assets, the tax benefits are almost 11 percent (0.107) of the
cost of the asset.
Under the modified asset cost recovery system (MACRS), all depre-
ciable assets are assigned to a class. Typical assets with their class lives and
depreciation methods, along with expected tax benefits, are available for
bargaining with the buyer as shown in Table 1.1.
As discussed earlier, the purchase price of the business must be allo-
cated among the assets acquired and the final allocations can affect the
present value of the tax benefits of the depreciation and amortization.
Obviously, there can be differences of opinions among experts about the
value of an asset. In the following example involving a corporation with
a 21 percent tax rate, Appraisal 2 allocates more value to the land and
building than Appraisal 1. Because the land will produce no tax benefits
until it is sold, and the cost recovery period for the building is 31.5 years,
the present value of the tax benefits of Appraisal 2 is 20 percent less than
the Appraisal 1 tax benefits.
Under the 2017 Tax Act, all of the cost of tangible personal property
with a depreciable life of less than 20 years can be expensed in the year of
purchase. (The immediate write-off is referred to as bonus depreciation.)
Therefore, the cost of equipment in Table 1.2 can be deducted in the year
of purchase, and the present value of the tax benefit for the Appraisal
1 is .21 × $450,000 = $94,500, and the value of the tax benefits for
Appraisal 2 is .21 × $300,000 = $63,000.
As a practical matter, the buyer and seller must agree on the alloca-
tion of the purchase price. This is true because tax forms must be filed by
the buyer and the seller disclosing the allocations.7 Differences between
the buyer’s and the seller’s allocations will likely trigger an IRS exami-
nation. In the previous example, the buyer would prefer the allocations
in Appraisal 1 because of the greater present value of the tax benefits.
But the seller would benefit from Appraisal 2 because it yields a greater
gain from the land and building, which are eligible for capital gain treat-
ment, and less ordinary income ($20,000) from the accounts receivable
and equipment ($150,000 as recapture of depreciation). Appraisal 2
yields $170,000 more capital gain and $170,000 less ordinary income

7
Form 8594, Asset Acquisition Statement Under Section 1060.
 Table 1.1  Tax benefits as a proportion of cost
Present value of Tax benefits as a Tax benefits as a
Depreciation ­depreciation @ 0.10 p­ roportion of asset’s p­ roportion of asset’s
Class Typical assets method discount rate cost (0.37 tax rate) cost (0.21 tax rate)
1year Supplies Expense 1.0 0.37 0.21
3year Small tools, tractors, 200% decl. bal. 0.83 0.307 0.175
horses, specialized man-
ufacturing devices
5year Computers, autos, light 200% decl. bal. 0.773 0.286 0.162
trucks, small aircraft,
construction equipment
7year Office furniture, 200% decl. bal. 0.722 0.267 0.152
fixtures and equipment,
commercial aircraft,
and most machinery
10year Specialized heavy man- 200% decl. bal. 0.654 0.242 0.137
ufacturing machinery,
mobile homes
15year Intangibles Straight line 0.508 0.188 0.107
27.5year Residential real estate Straight line 0.337 0.125 0.071
property
31.5year Office and other non- Straight line 0.30 0.112 0.063
residential real estate

5
6 THE TAX ASPECTS OF ACQUIRING A BUSINESS

Table 1.2  Tax benefits under different appraisals

Appraised Present Appraised Present
value of value of tax value of value of tax
assets 1 benefits assets 2 benefits
Accounts $70,000 $14,700 $50,000 $10,500
receivable
Equipment $450,000 $94,500 $300,000 $63,000
Building $600,000 $37,870 $720,000 $45,444
Land $250,000 $0 $400,000 $0
Secret formulas $130,000 $13,843 $50,000 $5,324
Goodwill and $300,000 $31,946 $280,000 $29,816
going concern
value
Total $1,800,000 $192,409 $1,800,000 $158,084

for the seller. For the seller, the capital gain and ordinary income dif-
ference could be the difference between the ordinary and capital gains
rates multiplied by $170,000. Typically, this would be (0.21 − 0.15)
$170,000 = $10,200. Because of these differences, and the need for con-
sistency between the buyer and seller, it becomes necessary for the buyer
and seller to renegotiate the allocation of the purchase price. Thus, for
example, the seller may agree to the first allocation only if the price is
increased to $1,820,000. The increase in price would be allocated to the
goodwill, since goodwill is the residual. As such, the buyer will recover (in
present values) $20,000 × 0.107 (see Table 1.1) = $2,140 in tax benefits,
for an after-tax increase in cost of $20,000 − $2,140 = $17,860.
The bonus depreciation rules will be phased out between 2023 and
2027. Section 179, which is not to be phased, allows expensing up to
$1,000,000 per year the cost of tangible personal property and certain
building improvements.

Class IIIA

As a result of the 2013 tangible personal property regulations, a new class

of property may have been created. That is, under the tangible personal
property regulations, taxpayers can elect to expense de minimis amounts
paid for the property. Small supplies costing $200 or less per item can be
 The Purchase and Sale of an Unincorporated Business 7

expensed. Moreover, other tangible property such as equipment can be

expensed in the year of purchase, provided the taxpayer has adopted a
policy of expensing those items for financial accounting purposes. The per
item maximum deduction is $5,000.8 The election cannot be made for
inventory or real estate. Under the financial conformity requirements, the
taxpayer, generally, must issue certified financial statements. However, tax-
payers who do not issue certified financial statements can expense as much
as $500 per item. For example, if the business being purchased included
10 laptop computers with a value of $400 each, the cost of those comput-
ers could be expensed in the year the business was purchased. Likewise,
small tools and office supplies purchased could also be expensed.

Recap

In short, the allocation of the purchase price affects the future tax benefits
to the buyer and the present tax cost to the seller. Moreover, as a practical
matter, the buyer and seller must agree to the allocations as well as the
total price. It follows that the allocations will often affect the price.

Contingent Amounts

The contract for the purchase of the business may contain contingent
amounts. For example, the seller may receive 10 percent of earnings for
a period of years. Generally, the contingent amounts paid will be added
to the cost of the intangible asset, assuming the noncontingent amount
is equal to or greater than the fair market value of the assets in Classes I
through IV. The amortization period is the remaining number of years
from the original purchase. Thus, a contingent payment in the 3rd year
after the original transactions will be amortized over 12 years.

Effects of Cost Classifications

Table 1.3 illustrates the benefits to the buyer and detriment to the seller of
reclassifying $1 of cost from one of the other asset classes to intangibles.

8
Reg. §1.263(a)-1(f ).
8
Table 1.3  Present value of tax benefits of the cost of tangible versus intangible assets
Tax benefits as a
proportion of asset’s From intangible—buyer From intangibles—selle’s
Class Typical assets cost (0.21 tax rate) benefit (detriment) benefit (detriment)
1 year Supplies, and tangible property eligible 0.21 0.21 − 0.107 = 0.103 0.15 − 0.21 = (0.06)
for bonus depreciation
3year Small tools, tractors, horses, specialized 0.175 0.175 − 0.107 = 0.068 0.15 − 0.21 = (0.06)
manufacturing devices
5year Computers, autos, light trucks, small 0.162 0.162 − 0.107 = 0.055 0.15 − 0.21 = (0.06)
aircraft, construction equipment
7year Office furniture, fixtures and equipment, 0.152 0.152 − 0.107 = 0.045 0.15 − 0.21 = (0.06)
commercial aircraft, and most
machinery
10year Specialized heavy manufacturing 0.137 0.137 − 0.107 = 0.02 0.15 − 0.21 = (0.06)
machinery, mobile homes
15year Intangibles 0.107 0 0
27.5year Residential real estate property 0.071 0.071 − 0.107 = (.036) 0
31.5 year Office and other nonresidential real 0.063 0. 63 − 0.107 = 0.044 0
estate
N/A Land 0 0.0 − 0.107 = 0.107 0
 The Purchase and Sale of an Unincorporated Business 9

Generally, the buyer will benefit if the cost of the intangible is allocated to
tangible personal property whose depreciable lives are less than 15 years.
On the other hand, this same reclassification is a detriment to the buyer
of an almost equal amount, because the gain is reclassified as ordinary,
rather than capital gain. However, both the buyer and the seller benefit
from reclassifying the price from real estate to intangibles. This is not to
suggest that the buyer and seller are free to allocate the price in any man-
ner they can agree to. However, the real estate and intangible assets are
frequently the most difficult to value, and thus, the buyer and seller have
some ability to allocate in a tax efficient manner.

The Use of Debt

The price paid for the business, regardless of how the purchase is financed,
becomes the purchaser’s total basis in the assets, and therefore, future
deductions. However, the actual cash required of the buyer at the time of
the purchase is reduced by any of the seller’s liabilities the buyer assumes,
any amounts the buyer borrows from third parties, and the amount of
seller financing. That is, the cost of the assets includes the buyer’s equity
and debt undertaken for the purchase, and not merely the purchaser’s
equity in the property.9 The buyer can increase the present value of the
tax benefits of depreciation and amortization through the use of debt.
The buyer may be able to borrow from the seller, or third parties, which
might include the seller’s creditors, with the buyer anticipating paying the
liability out of the cash flow from earnings. Thus, the buyer can enjoy the
tax benefits of amortization or depreciation before he or she actually pays
the purchase money. For example, assume that the buyer in the previous
example used $1,200,000 of his or her money and borrowed $600,000 to
acquire the business. The cost of the assets is $1,800,000, and the buyer
enjoys the same depreciation and amortization whether the asset is pur-
chased from the buyer’s capital or from borrowed funds.
Often the use of debt may not be out of necessity but rather out of a
desire to leverage the owner’s equity. On the other hand, the buyer’s own
cash may be inadequate to complete the acquisition, but the seller is will-
ing to be a creditor.

9
Beulah B. Crane v. Commissioner, 331 U.S. 1 (1947).
10 THE TAX ASPECTS OF ACQUIRING A BUSINESS

Installment Sales

Borrowing from the seller can be in the form of an installment sale of

the assets. In an installment sale, the seller can defer the taxable gain,
spread it over the years the payments are received, and thereby, increase
the present value of the after-tax proceeds. With an installment sale, each
dollar the seller receives will include a portion of his or her basis in the
assets, interest income, and taxable gain. The buyer’s cost of an asset—and
therefore the buyer’s cost recovery deductions—is based on the total pur-
chase price, regardless of whether the total price has been paid in cash and
regardless of whether the seller has recognized his or her gain.
The installment method may be attractive to the seller because he or
she can earn a return on the installment gain (included in the interest
bearing installment note) before the tax on the gain is due.
For example, assume that seller had no basis in the assets and
can sell the asset for $1,000,000 cash on the date of the sale, or for
$1,000,000 to be paid in 1 year plus interest at 8 percent in 1 year.
The interest rate on the note is the same as the seller’s return on alter-
native investments, and the seller’s tax rate is 20 percent in all years.
With an all cash sale, the seller would receive in the year of sale after
tax (1 − 0.20) × $1,000,000 = $800,000, which he would invest for
1 year at 8 percent before tax. In 1 year, the seller would have $800,000 ⋅
(1 − 0.20)(0.08)($800,000) = $851,200. With an installment sale, the
seller will collect in 1 year (1.08)($1,000,000) = $1,080,000 and pay
tax of (0.20)($1,080,000) = $216,000, leaving an after-tax amount of
$864,000. Mathematically, deferring the installment sales gain is equiva-
lent to taxing the gain in the year of the sale and exempting the return
on the investment of the assets.

After-tax proceeds in year of sale (1 − .20)($1,000,000) = $800,000

Return @ 8 percent on the after-tax proceeds $64,000
$864,000

The seller does incur the risk that the installment obligation will not
be paid, but that risk would also be incurred on alternative investments
made from the proceeds of a cash sale.
 The Purchase and Sale of an Unincorporated Business 11

The gains on some assets cannot be reported by the installment

method, and losses cannot be reported by the installment method. Gains
on depreciable equipment used in the business (i.e., depreciation recap-
ture on tangible personal property) and gains from the sale of inventory,
which are taxable in the year of the sale, are not eligible for the installment
method10; however, generally, these assets do not sell for a great deal more
than their book value. The gains from the sale of capital assets, including
intangible assets (e.g., goodwill), and land and buildings used in the busi-
ness are eligible for installment sale treatment. As discussed earlier, the
real value of a business will lie in the intangible assets, which are eligible
for installment reporting.
It may be feasible to separate the assets sold for cash and those sold
for installment notes. The property that is not eligible for installment sale
treatment can be specified in the contract as sold for cash, and the eli-
gible property deemed sold for cash and installment notes. For example,
assume the seller in the previous example will pay $1,200,000 at closing
and a 5-year 6 percent installment note for $600,000. The valuations and
bases are presented in Table 1.4:
Rather than a cash sale with the seller recognizing $1,020,000 income
in the year of the sale, the parties could structure the transaction as a
cash sale of the accounts receivable and equipment for $520,000 yielding

Table 1.4  Assets eligible for installment sale

Appraised Seller’s
value of Seller’s gain IS = Eligible for
assets basis (loss) installment sale
Accounts receivable $70,000 $80,000 ($10,000)
Equipment $450,000 $300,000 $150,000
Building $600,000 $300,000 $300,000 IS
Land $250,000 $100,000 $150,000 IS
Secret formulas $130,000 $0 $130,000 IS
Goodwill and going $300,000 $0 $300,000 IS
concern value
Total $1,800,000 $780,000 $1,020,000

10
Sections 453(b) and (i).
12 THE TAX ASPECTS OF ACQUIRING A BUSINESS

$140,000 ordinary income ($520,000 − $80,000 − $300,000). The

other assets, all eligible for capital gains, are sold for $680,000 cash at
closing and an installment note for $600,000. The installment sale gain
from the capital assets will be reported as payments are received according
to the following formula11:

(Installment Sale Gain/Contract Price) × Collection

Installment Sale Contract Price = ($1,800,000 − $520,000
ordinary income assets) = $1,280,000
Installment Sale Gain = ($1,280,000 − $300,000 −
$100,000) = $880,000
Gross Profit Ratio = $880,000/$1,280,000 = 0.6375
Gain recognized at closing, ordinary income from
receivables and equipment =  $140,000
Installment sale gain from collections in year of
sale = (0.6375) × $680,000 =$467,500
Deferred installment sale gain (0.6375) × $600,000 =  $412,500
Total gain =$1,020,000

Generally, liabilities of the seller assumed by the buyer are treated as

a reduction in the contract price. In the previous example, assume the
seller had a $300,000 mortgage on the land and building, which was
assumed by the buyer. After the cash sale of assets that are ineligible for
installment sale, and the debt assumed by the buyer, the seller will only
directly receive as installment sales proceeds $1,800,000 − $520,000 −
$300,000 = $980,000. The assumption of the liability would not be treated
as an amount received by the seller; rather the numerator of the installment
sales formula, the contract price, would be reduced by $300,000, and the
installment sale gain ($880,000) would be spread over the installment sales
payments that the seller directly receives from the buyer ($1,800,000 −
$520,000 − $300,000 = $980,000). An obvious ploy would be for
the seller to borrow on the property shortly before the installment sale,
receive the cash from the creditor, and defer the gain. Therefore, the regula-
tions limit the deferral treatment for the liabilities assumed to “qualified

11
Reg. §15A.453-1(b)(2).
 The Purchase and Sale of an Unincorporated Business 13

indebtedness,”12 which generally means the debt must have been used to
finance the property or the business.

Explicit and Imputed Interest

The previous discussion was based on the assumption that the buyer’s
installment note bears interest at least equal to the applicable federal
interest rate (AFR). If the debt instrument does not bear interest at the
federal rate or greater, the installment obligation will be revalued (down-
ward), by imputing interest. The purpose of the imputed interest rules is
to prevent the seller from converting ordinary interest income into capital
gain from the sale of the assets. To avoid these complications, the notes
should bear interest at the federal rate or greater. AFRs are published
monthly by the IRS.13

• Current Short-Term AFRs for instruments having a term of 3 years

or less
• Current Mid-Term AFRs for instruments having a term in excess of
3 years but no greater than 9 years
• Current Long-Term AFRs for instruments having a term in excess
of 9 years

The required rates are those for the month the purchase and sale occur.
Thus, if the installment note is to be paid over 10 years, the note should
bear interest throughout its term at the federal long-term rate published
for the month of the sale.

When the Buyer Assumes the Seller’s Accrued Expenses

The seller may owe money for services that have been performed, but
have not been taken into account as an expense in calculating the seller’s
taxable income. If the purchaser assumes these obligations, the amount
owed becomes a part of the total cost of the assets acquired. Therefore,

12
Reg. §15A-1(b)(2)(iv).
13
http://apps.irs.gov/app/picklist/list/federalRates.html
14 THE TAX ASPECTS OF ACQUIRING A BUSINESS

the purchaser is not permitted a deduction when the liability is actu-

ally paid. However, the regulations allow the seller to deduct the accrued
expense at the time the buyer assumes the liability. For example, assume
the value of the assets is $1,000,000 and the buyer’s basis in those assets
is $600,000. The seller’s only liability is $10,000 accrued property taxes.
The obligation is generally not recognized until it is paid. The buyer
agrees to pay the seller $990,000 cash and assume the seller’s property
tax liability for $10,000. Under the regulations, the seller is permitted
to accrue the property tax expense when the buyer assumes the obliga-
tion, and the seller is permitted a $10,000 deduction in the year of sale.
The seller also includes the liability assumed by the buyer as the amount
realized. Thus, the correct result is achieved—the seller has ($990,000 +
$10,000 − $600,000) = $400,000 gain and $10,000 expense. This was
made possible by the regulations, which bend the tax accounting rules.
The buyer will not be permitted a deduction when the buyer pays the
seller’s accrued expenses. Instead, the buyer will add the amount paid for
the seller’s expense to the cost of the assets acquired, for a total cost of
$990,000 + $10,000 = $1,000,000.
The previous rules do not apply to contingent liabilities and other lia-
bilities for which the necessary conditions for accrual have not occurred at
the time of the sale. For example, assume the seller has sold goods subject
to a warranty. Further, assume that based on past experience, service under
the warranty will cost 3 percent of sales, and as of the date of the sale, the
estimated future claims totaled $10,000. These claims cannot be taken into
account at the time of the sale as a liability or an expense of the seller. If the
buyer assumes the liability for future service, the cash paid for the business
will be reduced by $10,000, and thus, reduce the seller’s gain from sale
of the assets. This may mean that what should be an ordinary deduction
for service under warranties becomes a reduction in capital gain from the
sale of goodwill or other intangibles. On the other hand, the buyer should
reduce by $10,000 the cash he or she was willing to pay for the asset; how-
ever, the buyer will deduct $10,000 warranty expense when the obligations
are satisfied. In this case, $10,000 is deductible as paid by the buyer, rather
than $10,000 added to intangibles to be amortized over 180 months.
Thus, the tax treatment of liabilities that will be paid by the buyer,
although economically accrued by the seller, yield a tax benefit to the
 The Purchase and Sale of an Unincorporated Business 15

buyer. In the previous example, if the seller had retained the liability for the
warranty expense, the price of the business would have been $1,000,000.
If the buyer assumes the liability, the price would be reduced by the esti-
mated amount that will be paid. The seller will then be permitted to
deduct as an expense the actual payments for services under the warranty.

Lease Rather than Purchase

Another form of debt financing often used is leasing. The buyer can lease
the seller’s real estate used in the business. Leasing is especially appealing
in the case of an anxious seller and a buyer who is cash strapped, or is sim-
ply interested in investing in an operating business rather than real estate.
All of the seller’s income from rent is ordinary, rather than section 1231
gain (potentially taxed as a capital gain), but the income is deferred until
the rent is collected, and the seller retains the possibility of the benefits of
appreciation in the property.

Covenant to Not Compete

Part of the purchase price usually includes an amount for the existing cus-
tomer base, whether or not it is expressed in the purchase agreement. The
benefits of the customer base could be stolen by the former owner starting
a new business in competition with the business he or she just sold. There-
fore, the buy–sell agreement will usually include a covenant to not com-
pete, which prohibits the seller from competing with the sold business for a
period of years. The seller will generally expect to be compensated for enter-
ing into this agreement. From the buyer’s perspective, the payments under
the covenant to not compete are a payment to preserve the customer base,
which is an intangible asset. According to the regulations, “If, in connection
with an applicable asset acquisition, the seller enters into a covenant (e.g., a
covenant not to compete) with the purchaser, that covenant is treated as an
asset transferred as part of a trade or business.”14 The tax law treats the cost
of the covenant as if it were an additional cost of the goodwill; it follows
that the buyer must amortize the payments for the covenant over the same

14
Reg. §1.1060-1(b)(7).
16 THE TAX ASPECTS OF ACQUIRING A BUSINESS

15-year period as other intangibles. From a tax point of view, the buyer
is indifferent between an allocation to intangibles or to a covenant to not
compete. However, for the seller, the payments received for the covenant
to not compete is ordinary income rather than capital gain. Therefore, the
seller would prefer more of the price allocated to the customer base or other
intangible assets and less to the covenant to not compete, but the buyer is
indifferent. As discussed earlier, the buyer and seller generally should be
consistent in the allocation of the purchase price. This may give the buyer
some bargaining power over the terms. That is, the seller may accept more
in deferred payments for assets, rather than a covenant to not compete.
The payments over time for a covenant to not compete are installment
sale payments for property.15 As such, the cost of the property must be dis-
counted for the imputed interest. The imputed interest can be deducted
as it accrues. Thus, if the buyer agrees to pay the seller $100,000 at closing
and $100,000 each year for the next 4 years, and the imputed interest rate
is 4 percent, the capitalized amount is $100,000 plus the present value
of an annuity of $100,000 per year for 4 years with a 4 percent interest
rate = $100,000 + $362,990 = $462,990. In year 1, the buyer is permit-
ted to begin amortizing the entire $462,990 over 15 years, and deduct
the imputed interest on that amount over the 5 years as the payments are
made. The seller is allowed to spread the payments as ordinary income
received over the 5 years.16
In the final analysis, typically a covenant to not compete should be
included in the purchase agreement. The important tax issue is how much
of the total amount that will be paid to the seller should be allocated to
the covenant. For the seller, any amount allocated to the covenant is to the
seller’s disadvantage, when the alternative is to allocate that amount to the
intangible assets eligible for capital gain and installment sales treatment.

The Former Owner as an Employee

As discussed earlier, there are tax consequences of allocating the costs

among the different assets because of the differences in the cost recovery

15
Reg. §1.197-2(k) Example 6.
16
Rev. Rul. 69-643.
 The Purchase and Sale of an Unincorporated Business 17

periods. Another possible reallocation is from property to services. The

seller could become an employee of the purchaser. For example, the for-
mer owner may become an employee to smoothen the transition to new
ownership. Assuming it makes good business sense for the former owner
to become an employee, the employment contract will be intertwined
with the asset purchase. As a matter of negotiation, this may result in a
reallocation from intangibles—amortized over 15 years—to the employ-
ment contract, whose cost is deducted as the services are provided—­
usually in less than 3 years. Thus, the present value of the tax benefits
of the employment contract deduction is much greater than the same
amount allocated to the intangibles.
From the point of view of the seller, the tax benefits from the employ-
ment contract are equal to the marginal ordinary tax rate times the amount
paid. On the other hand, an amount paid for the intangible asset yields
tax benefits with a present value of 10.7 percent of the amount paid (see
Table 1.1). For the seller, the amount received for the intangibles is taxed
as capital gain, whereas the amount received as compensation for services
is taxed as ordinary income. For a taxpayer with a 37 percent marginal
tax rate, the difference between the capital gains and ordinary income
rates is generally 20 percent (e.g., capital gains rate of 20 percent and
ordinary income rate of 37 percent). Therefore, a reallocation of $1,000
from intangibles to compensation would save the buyer in the 37 percent
marginal bracket (0.37)($1,000) − 0.188 ($1,000) = $182, but would
cost the seller 0.20($1,000) = $200. With a different set of tax rates, and
assumed rates of return, the results could be different, as will be seen later
in these materials. The important point is that employment contracts are
another possible means for the buyer to shorten the cost recovery period
for the investment, but this would come at the expense of the buyer.

Former Owner as a Consultant

The former owner may serve as a consultant as the business goes through
the transitional effects of a change in ownership. The compensation is
ordinary income for the seller, much the same as the amounts received
under a covenant to not compete. However, for the buyer, if payments
under the consulting agreement are diverted from goodwill, the buyer
18 THE TAX ASPECTS OF ACQUIRING A BUSINESS

Table 1.5  Benefit or detriment from allocations of price to covenant

versus intangible assets
Covenant to Compensation
Intangibles not compete for consulting Benefit or detriment
100 0 0

80 0 20 Buyer benefits
0.103 × 20 = 2.06
80 20 Seller’s detriment
(0.15 − 0.37) × $20 = ($4.40)

gains a tax benefit—the acceleration of the deductions for the cost of the
business. Instead of amortizing over 15 years as intangibles, the compen-
sation can be deducted as paid. As discussed earlier, the present value of
the tax benefits of the 15-year amortization of intangibles is 10.7 percent
of their cost, when the buyer’s tax rate is 21 percent, but the tax benefit
of currently deductible compensation is 21 percent of the amount paid.
Thus, unlike payments under a covenant to not compete, the buyer
benefits from classifying part of the price as compensation for services of
the former owner, rather than as goodwill or for a covenant to not compete.
The seller is indifferent between a covenant to not compete and consulting
fees, but prefers payments for intangibles. Table 1.5 illustrates the effects of
a $20 reallocation from intangibles to covenant to not compete or a con-
sulting agreement, assuming the seller is in the 37 percent marginal ordi-
nary income bracket and his capital gain rate is 15 percent and the buyer
is in the 37 percent marginal bracket and has a 10 percent discount rate.
The different effects on the buyer and the seller could be used as follows:
The buyer makes an offer for the business, and the seller rejects but offers to
sell for a larger amount. The buyer responds as follows, “I accept your offer
if x amount is allocated to the consulting agreement,” which is tantamount
to making an offer between the buyer’s original offer and the seller’s offer.

The Limited Liability Company or Partnership

as the Target
A single-member limited liability company (LLC) is a disregarded entity
for tax purposes. Thus, the purchase of the LLC is a purchase of the assets
of the LLC from the former single member. Legally, the original LLC may
 The Purchase and Sale of an Unincorporated Business 19

Table 1.6  Purchase of a partner’s interest

Appraised value
of assets Seller’s basis
Accounts receivable $70,000 $80,000
Equipment $450,000 $300,000
Building $600,000 $300,000
Land $250,000 $100,000
Secret formulas $130,000 $0
Goodwill and going $300,000 $0
concern value
Total $1,800,000 $780,000
A Capital $600,000 $260,000
B Capital $600,000 $260,000
C Capital $600,000 $260,000
$1,800,000 $780,000

be deemed to continue, unless it is formally dissolved. Therefore, the new

owner of the business should take steps to prevent unknown liabilities
from following the assets to the new owner.
The purchase of an LLC with more than member or a partnership can
be structured as a purchase of the former owners’ interests, or a purchase
of the assets. With a purchase of the other members’ interests, the entity
terminates whenever there is a sale or exchange of 50 percent or more of
the total interests in the LLC or partnership.17 Upon termination, the
assets are deemed distributed to the members or partners who then sell
the assets to the purchaser. Thus, the purchaser’s basis in the assets is equal
to the purchase price, the same as purchasing proprietorship assets. The
seller (i.e., the former LLC member or partner) derives his or her basis in
the assets sold from his or her basis in the LLC or partnership; that is, the
entity is deemed liquidated upon the 50 percent or more change in own-
ership, without taxable gain or loss from the liquidation, and the member
or partner derives his or her basis in the assets from his or her basis in the
LLC or partnership.
Table 1.6 depicts a sale of an interest in an LLC. The LLC with
three members with equal capital and profit and loss sharing ratios.

17
Section 706.
20 THE TAX ASPECTS OF ACQUIRING A BUSINESS

If D purchased each of the three members’ interests in the LLC, it will
be treated for tax purposes as though the LLC distributed all the assets
equally to A, B, and C. Neither the LLC nor the members would recog-
nize gain or loss from the liquidating distributions; their bases in the LLC
would be allocated among the assets received, and then the former LLC
members would sell the assets to the new owner. The former LLC mem-
bers will recognize gains and losses, a total of $340,000 each ($600,000 −
$260,000 = $340,000); the character of the gain or loss (ordinary or
capital) will generally depend upon the character of the asset to the LLC,
and the new owner will get a cost basis in the assets $1,800,000.

Purchase of a Partnership Interest

When the member’s interests are bought or sold, the LLC (or partner-
ship) continues. The exiting partner recognizes his or her share of the
LLC’s income up until the date of the sale, and then recognizes ordinary
income and capital gain from the sale of his or her interest generally the
same as if the LLC sold the assets and allocated the gains and losses to the
exiting partner.18 However, under the general rules applicable to partner-
ships, the partnership’s bases in its assets are unaffected by the new part-
ner.19 This gives rise to a difference between the LLC’s inside basis (the
basis of the assets inside the LLC) and the member’s outside basis (the
member’s basis in his or her LLC interest).
For example, if D purchased C’s one-third interest in the aforemen-
tioned LLC for $600,000, D’s basis in the partnership for purposes
of determining D’s gain or loss on the sale of his interest would be
$600,000. However, the LLC would treat D as having a $260,000 basis
in the assets within the LLC. D’s basis in the building, for example, would
be $300,000/3 = $100,000. If the LLC sold the building for $600,000,
D would be required to recognize a $100,000 gain [($600,000 −
$300,000)/3 = $100,000]. This is true even though D paid C the fair
market value of C’s interest in the building and all other assets.

18
Sections 731 and 751.
19
Section 743.
 The Purchase and Sale of an Unincorporated Business 21

Requiring D to recognize the gain on the building in the earlier exam-

ple would clearly be an inequitable result. Therefore, the Code (in Section
754) permits the LLC to elect to adjust the partnership’s bases in its assets
with respect to the new partner to reflect the value he or she paid for
the interest.20 If the election were made, the LLC’s basis in the building
will be increased from $300,000 to $400,000. However, the basis in the
building (and the other assets) is adjusted only with respect to D. Thus, if
the building is sold for $600,000, the gain will be $200,000 ($600,000 −
$400,000), and that gain will be allocated entirely to A and B. The elec-
tion creates the same result as if C’s share of the assets was distributed to
him, and he sold the assets to D, who in turn contributed the assets to the
LLC. However, as mentioned earlier, D is at the mercy of the other LLC
members to make the election to adjust bases with respect to him. If the
election is not to be made, D should pay less for the interests than if the
election is made.

The Purchasing Entity

Generally, to limit the purchaser’s exposure to liability, the acquisition
should be made through a separate legal entity, such as an LLC, or a
corporation, rather than in the name of an individual purchaser. The use
of a legal entity does not absolve the owner from all liability, but it can
eliminate exposure to certain types of claims.
The use of more than one entity can help avoid some major tax prob-
lems when the business (or parts of the business) is sold at a later date.
For example, it is generally advisable to put real estate and identifiable
intangible assets in entities separated from easily replaceable assets such
as inventory and equipment. The real estate and intangible assets can be
leased or licensed to the operating company. With two or more entities,
new investors can be brought into the business, while the original owner
retains the benefits of the real estate and intangibles. Also, for example,
when the business is resold, the purchaser may not desire to purchase the
real estate. Having the real estate in a separate entity may facilitate the
sale of the business. For income tax and estate tax planning, the buyer

20
Sections 743 and 754.
22 THE TAX ASPECTS OF ACQUIRING A BUSINESS

may decide to give family members an interest in the real estate but not
the operating business. This is easily accomplished with the real estate in
a separate entity.
Another consideration regarding who should acquire the business is
how the business investigation and start-up costs will be treated. As will
be discussed in Chapter 6, if the purchaser is operating a business in the
same line of business as the business purchased, the business investigation
costs and start-up costs are deductible as business expansion costs, rather
than capitalized and amortized over 180 months.
Other than business investigation cost and start-up cost consider-
ations, the primary consideration in the choice of the entity to make
the acquisition is whether the income from the business should be sub-
jected to corporate tax. As discussed in Chapter 2, generally the corporate
­double-tax system renders the use of a C corporation at a considerable
disadvantage. However, in the case of a small business whose earnings do
not reach the highest corporate rate, and whose after-tax earnings are used
to retire the purchase money indebtedness, the C corporation may be the
preferred entity particularly if the shareholder has a high marginal tax rate.

Example: A taxpayer invested $150,000 and borrowed $300,000 to

purchase a business. Assume that income earned by the business ­operating
as a C corporation will be taxed at 21 percent, the shareholder is in the
37  percent marginal tax bracket, and all of the after-tax income will be
used to retire debt incurred to purchase the business. The business earns
$400,000 over a number of years. If doing business as a C corporation, the
entity would pay tax of $84,000 over that period.21 The $316,000 after-tax
income is used to pay down the debt incurred to purchase the business. At a
6p­ ercent interest rate, the interest paid over 5 years would be $56,000. The
corporate deduction would save 0.21 × $56,000 = $11,760 compared with
the tax benefits of an individual deduction of 0.37 × $56,000 = $20,720.
The after-tax income will not be available for distribution to the owner, and
therefore, will not be subject to a double-tax while the investor owns the
stock. A second tax will be incurred by the owner when the stock is sold,
but the present value of that tax may be very small.

21
If the business were not incorporated, the income tax would be $148,000.
 The Purchase and Sale of an Unincorporated Business 23

Table 1.7  Corporation and proprietor compared

Unincorporated Incorporated
Ordinary income over 5 years $400,000 $400,000
Income tax @ 0.37 and 0.21, respectively ($148,000) ($84,000)
Interest expense ($56,000) ($56,000)
Tax benefit for interest deduction @ 0.37 +$20,720 +$11,760
and 0.21, respectively
After-tax before capital gain on sale $271,760
Capital gain on sale of incorporated entity
($400 − $84,000 − $56,000 + $11,760)
Individual capital gains tax @ 0.15 ($40,764)
Present value of individual capital gains tax ($25,311)
@ 0.10 in 5 years
Total tax ($127,280) ($96,061)

Before consideration of any tax on the sale of the business, the tax sav-
ings as a result of organizing the business as a C corporation is $64,000 of
income tax [(0.37 individual rate − 0.21 corporate rate) × $400,000] less
the $6,400 reduction in tax benefit related to the interest deduction on
the debt. Assuming the individual’s capital gain rate is 15 percent, the tax
upon the sale of the stock will be 0.15 × $271,760 = $40,764. However,
assuming the stock will be held for 5 years, present value of the tax upon
the sale of the stock will be far less than the additional tax paid on ordi-
nary income by the unincorporated entity. To recap let’s look at Table 1.7.
It should be noted that if the corporate tax rate had been higher (say
30 percent), incorporating would be more expensive in terms of total
tax paid.
The new owners must also be concerned with personal liability. There-
fore, the acquired business must ultimately be inside of an LLC or a cor-
poration. The purchaser is not necessarily the entity that operates the
business. For example, an individual could purchase a proprietorship and
then transfer the assets to a corporation in exchange for stock. The trans-
fer will be nontaxable provided the individual has 80 percent control over
the transferee corporation. Or, the individual could transfer the assets to
an LLC. The transfer to the LLC would be a nontaxable event regardless
of whether the individual controls the LLC. However, arrangements with
creditors will be necessary for the new entity to assume liabilities.
 Index
A reorganization, 73–76 Class IIIA, and asset valuations, 6–7
AFR. See Applicable federal interest Code, tax, 21, 35, 36, 62
rate Consultant, former owner as, 17–18
Aggregate grossed-up basis (AGUB), Contingent amounts, 7
66–67 Contingent liabilities, 27
AGUB. See Aggregate grossed-up Corporate reorganizations, 71–73
basis Corporation versus proprietor, 23
Applicable federal interest rate (AFR), 13 Corporation’s subsidiary
Assets avoiding triple taxation, 62
character of, 48 Code, 62
eligible for installment sale, 11 election, 68–69
hypothetical sale of, 52–53 liabilities, complications of, 66–68
under installment method, 56–58 taxpayers, groups of, 61
intangible, 1–2 Cost recovery period, 3
sale, versus stock sale, 47–51 Covenant to not compete, 15–16, 44
seven classes of, 2–3 consultant, former owner as, 17–18
tangible, 1 employee, former owner as,
valuations, 1–6 16–17, 44
Class IIIA, 6–7
contingent amounts, 7 Debt, use of, 9
cost classifications, 7–9 installment sales, 10–13
recap, 7 Double taxation, 25, 61
tangible versus intangible assets, 8
tax benefits as proportion of cost, 5 Election, 68–69
Employee, former owner as,
B reorganization, 76–78 16–17, 44
Basis, of assets, 48 Employment agreement, 43–44
versus value, 26 Explicit interest, 13
Bonus depreciation, 4, 6
Business investigation expense, 83 Forward triangular reorganization,
business new to taxpayer, 84–86 79–80
expansion of an existing business, 86
Goodwill, 1–3
C corporations, 25
versus S corporation debt Imputed interest, 13
financing, 42 Incorporated business
tax-deferred acquisitions of covenants to not compete, 44
statutory patterns, 73–79 employment agreement, 43–44
triangular reorganizations, 79–80 net operating loss
unwanted assets, 80–81 built-in gains, 36
versus unincorporated business, built-in losses, 36, 38–39
purchase of, 25 in liquidation, 39–40
C reorganization, 78 personal goodwill, 44–45
90 INDEX

Incorporated business (continued) Modified asset cost recovery system

purchase and sale of stock, 25–27 (MACRS), 4
purchasing C corporation, 27–30 Net operating loss (NOL), 26, 34–36
alternatives to liquidation, 30–31 built-in gains, 36
contingent liabilities, 27 built-in losses, 36, 38–39
seller’s S election prior to asset in liquidation, 39–40
sale, 31 LTTER, 35–36
resizing transaction NOL. See Net operating loss
borrowing from target
shareholders, 41 Off-the-shelf, computer software, 3
S corporation versus
C corporation debt Partnership interest, purchase of,
financing, 42 20–21
S election with debt, 41–42 Personal goodwill, 44–45
third-party debt, 40–41 Proprietor, versus corporation, 23
unwanted assets, 43 Purchase entity, 21–23
seller’s deferred/excluded gain, 33 Purchase price, of business, 2, 4
stock deal, 31–32
Installment sale, 10–13, 53 Qualified purchase, 52
of assets, 54–56 Qualified small business stock, 33–34
hypothetical sale, 56–58
purchase of minority interest in S Reverse triangular merger, 79–80
corporation, 58–59
of stock, 54 S corporation
Intangible assets, 1–2 asset sale versus stock sale, 47–49
15-year amortization, 3 versus C corporation debt
section 197, 3, 44 financing, 42
versus tangible assets, 8 hypothetical sale of assets, 52–53
Internal Revenue Code and installment sale, 53
Regulations, 1 of assets, 54–56
Internal Revenue Service (IRS), 2 hypothetical sale of assets under
Investigatory costs, 83–86 installment method, 56–58
IRS. See Internal Revenue Service purchase of minority interest in S
corporation, 58–59
Lease, 15 of stock, 54
Liabilities shareholder purchase stock for more
complications of, 66–68 than book value, 51–52
contingent, 27 S election with debt, 41–42
Limited liability company (LLC), Section 1045, 33
18–21 Section 1202, 33
more than one member/ Seller’s accrued expenses, 13–15
partnership, 19 Seller’s deferred/excluded gain, 33
partnership interest, 20–21 Seller’s S election, 31
single-member, 18–19 Start-up costs, 84
Liquidation, 30–31 Stock deal, 31–32
net operating loss in, 39–40 Stock, purchase and sale of, 25–27
LLC. See Limited liability company Stock sale versus asset sale, 47–51
 INDEX
91

Tangible assets, 1 S corporation versus C corporation

versus intangible assets, 8 debt financing, 42
Target corporation S election with debt, 41–42
A reorganization, 73–76 third-party debt, 40–41
B reorganization, 76–78 unwanted assets, 43
built-in gains, 36 Triangular reorganizations, 79–80
built-in losses, 36, 38 Triple taxation, avoiding, 62
C reorganization, 78
failed B followed by liquidation, 79 Unincorporated business
liabilities, 66 asset valuations, 1–6
net operating loss, 34 Class IIIA, 6–7
ownership, change, 25–26 contingent amounts, 7
sale of assets, 52–53 cost classifications, 7–9
shareholders, 71 recap, 7
third-party debt, 40–41 tangible versus intangible assets, 8
unwanted assets, 80–81 tax benefits as proportion of
Tax adviser, 1 cost, 5
Tax benefits covenant to not compete
under different appraisals, 6 consultant, former owner as,
present value of, 28 17–18
as proportion of cost, 5 employee, former owner as,
Tax Code and regulations, 2 16–17
Tax-deferred acquisitions, of C debt use, 9
corporations explicit and imputed interest, 13
corporate reorganizations, 71–73 installment sales, 10–13
statutory patterns lease, 15
A reorganization, 73–76 seller’s accrued expenses, 13–15
B reorganization, 76–78 limited liability company
B/failed B followed by more than one member/
liquidation, 79 partnership, 19
C reorganization, 78 partnership interest, 20–21
triangular reorganizations, 79–80 single-member, 18–19
unwanted assets, 80–81 purchase price, 2, 15
Tax lives, 1 purchasing entity, 21–23
Taxpayers, groups of, 61 Unknown liabilities. See Contingent
Third-party debt, 40–41 liabilities
Trade/business expenses, 84 Unwanted assets, 43, 80–81
Transaction, resizing
borrowing from target Value, of assets, 48
shareholders, 41 versus basis, 26
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• The Tax Aspects of Acquiring a Business by W. Gene Seago
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