The tax advantages of including debt in a C corporation capital structure

Let’s say you plan to use a C corporation to operate a newly acquired business or you have an existing C corporation that needs more capital. You should know that the federal tax code treats corporate debt more favorably than corporate equity. So for shareholders of closely held C corporations, it can be a tax-smart move to include in the corporation’s capital structure:

  • Some third-party debt (owed to outside lenders), and/or
  • Some owner debt.

Tax rate considerations

Let’s review some basics. The top individual federal income tax rate is currently 37%. The top individual federal rate on net long-term capital gains and qualified dividends is currently 20%. On top of this, higher-income individuals may also owe the 3.8% net investment income tax on all or part of their investment income, which includes capital gains, dividends and interest.

On the corporate side, the Tax Cuts and Jobs Act (TCJA) established a flat 21% federal income tax rate on taxable income recognized by C corporations.

Third-party debt

The non-tax advantage of using third-party debt financing for a C corporation acquisition or to supply additional capital is that shareholders don’t need to commit as much of their own money.

Even when shareholders can afford to cover the entire cost with their own money, tax considerations may make doing so inadvisable. That’s because a shareholder generally can’t withdraw all or part of a corporate equity investment without worrying about the threat of double taxation. This occurs when the corporation pays tax on its profits and the shareholders pay tax again when the profits are distributed as dividends.

When third-party debt is used in a corporation’s capital structure, it becomes less likely that shareholders will need to be paid taxable dividends because they’ll have less money tied up in the business. The corporate cash flow can be used to pay off the corporate debt, at which point the shareholders will own 100% of the corporation with a smaller investment on their part.

Owner debt

If your entire interest in a successful C corporation is in the form of equity, double taxation can arise if you want to withdraw some of your investment. But if you include owner debt (money you loan to the corporation) in the capital structure, you have a built-in mechanism for withdrawing that part of your investment tax-free. That’s because the loan principal repayments made to you are tax-free. Of course, you must include the interest payments in your taxable income. But the corporation will get an offsetting interest expense deduction — unless an interest expense limitation rule applies, which is unlikely for a small to medium-sized company.

An unfavorable TCJA change imposed a limit on interest deductions for affected businesses. However, for 2024, a corporation with average annual gross receipts of $30 million or less for the three previous tax years is exempt from the limit.

An example to illustrate

Let’s say you plan to use your solely owned C corporation to buy the assets of an existing business. You plan to fund the entire $5 million cost with your own money — in a $2 million contribution to the corporation’s capital (a stock investment), plus a $3 million loan to the corporation.

This capital structure allows you to recover $3 million of your investment as tax-free repayments of corporate debt principal. The interest payments allow you to receive additional cash from the corporation. The interest is taxable to you but can be deducted by the corporation, as long as the limitation explained earlier doesn’t apply.

This illustrates the potential federal income tax advantages of including debt in the capital structure of a C corporation. Contact us to explain the relevant details and project the tax savings.

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Don’t skip out on planning for the GST tax

Does your estate plan call for making gifts to your grandchildren or other loved ones more than one generation below you? Or, perhaps to you want to leave assets to nonrelatives who are decades younger than you? If so, your plan must address not only gift and estate taxes, but also the generation-skipping transfer (GST) tax.

What is the GST tax?

The GST tax is one of the harshest in the Internal Revenue Code. It’s a flat 40% tax on asset transfers to “skip persons” — that is, your grandchildren, other family members who are more than one generation below you or nonfamily members who are more than 37½ years younger than you. The GST tax is calculated independently from, and is in addition to, gift and estate taxes, so it can take a significant bite out of your hard-earned wealth.

Fortunately, the law provides a generous GST tax exemption. Indeed, under the Tax Cuts and Jobs Act, for the estates of persons dying after December 31, 2017, and before January 1, 2026, the GST tax exemption amount is an inflation-adjusted $10 million ($13.61 million for 2024). Without congressional action, the exemption will revert to an inflation-adjusted $5 million beginning January 1, 2026.

Careful planning is required, however, to make the most of the exemption. In some cases, for an exemption to apply, you must allocate it to particular assets via an affirmative election on a timely filed gift tax return. In other cases, the exemption is allocated automatically (unless you opt out), which can lead to unwanted results if you prefer to allocate your exemption elsewhere.

To avoid costly mistakes, it’s a good idea to review each transfer for potential GST tax liability. Also, take steps to ensure that your exemption is allocated in the most advantageous manner.

What transfers are taxable?

The GST tax applies to direct gifts to skip persons, as well as to these two types of transfers involving trusts:

  1. Taxable terminations. Trust assets pass to your grandchildren when your child dies and the trust terminates.
  2. Taxable distributions. Trust income or principal is distributed to a skip person.

The GST tax doesn’t apply to direct gifts that are covered by the annual gift tax exclusion (currently, $18,000 per recipient or $36,000 for “split” gifts per recipient by a married couple).

What protection do automatic allocation rules provide?

The automatic allocation rules are intended to protect you against inadvertent loss of GST tax exemptions. For example, if you make a direct gift in excess of the annual gift tax exclusion to a grandchild or other skip person, your unused GST tax exemption is automatically applied to the gift without the need to make an allocation on a gift tax return. The exemption is also allocated automatically to “GST trusts.” The rules are complex, but in general, a trust is considered a GST trust if there’s a possibility it will benefit your grandchildren or other skip persons in the future.

In many cases, the automatic allocation rules work well, ensuring that the GST tax exemption is used where it’s needed most. But in some cases, the rules may lead to unintended — and potentially costly — results.

GST exemption amount isn’t permanent

Thanks to the currently high GST tax exemption amount, fewer families will be affected by the tax. But there are still reasons to plan for this tax. Indeed, after 2025, and without action from Congress, the GST tax exemption amount will be significantly less. Contact us with questions regarding the GST tax.

© 2024

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Health care self-insurance and stop-loss coverage: What business owners need to know

For businesses, cost-effectively sponsoring a health insurance plan for employees is an ongoing battle. In the broadest sense, you have two options: fully insured or self-funded.

A fully insured plan is simply one you buy from an insurer. Doing so limits your financial risk while offering the most predictable costs. The other option is what’s commonly known as “self-insurance.” Under this approach, your company funds and manages the plan, usually with the help of a third-party administrator.

If you’re tired of dealing with big insurers, and you’re prepared to design your own plan and handle the claims process, self-insurance may be for you. However, bear in mind that your business will incur the full financial risk of a self-funded plan — and health care costs can be unpredictable and potentially catastrophic. That’s why, if you’re seriously considering self-insurance, you’ll also need to familiarize yourself with stop-loss coverage.

Basic features

Stop-loss coverage is essentially insurance for your health insurance. These high-deductible policies help protect against unpredictably high or catastrophic losses.

More specifically, stop-loss coverage kicks in once an individual claim and, if the self-insured policy is so designed, annual aggregate claims reach a contracted threshold known as the “attachment point.” Some stop-loss policies cover only individual claims — known as “specific” coverage — instead of providing both specific and aggregate claims protection.

Typically, the larger and more profitable the business, the higher the stop-loss deductible and attachment point. This is because larger companies are usually less financially vulnerable to an occasionally catastrophic medical claim. Self-insurance generally isn’t economically advantageous for companies with fewer than about 75 employees.

Claims and coverage

Aggregate claims protection typically works like this: You and your broker or claims administrator agree on an estimate of what total claims will be in the upcoming year, based on your recent claims experience. Let’s say it’s $1 million. The aggregate attachment point generally will be set at 125% of that amount — that is, claims will be covered when you have already paid out $1.25 million.

There can be a complicating factor, however, known as a “laser.” A stop-loss carrier, or you, might decide that an employee with a high medical risk profile needs to be “lasered” out of the terms that apply to other employees covered by the stop-loss policy. Instead, you’ll remain on the hook for a much higher amount before stop-loss protection kicks in. You might request a laser to lower your premium, or the stop-loss carrier might demand it to manage its risk.

What’s a typical specific coverage amount? As with the decision of whether to include an aggregate claims limit on your stop-loss coverage, the answer generally varies according to business size. Many stop-loss buyers pick an attachment point for individual claims at below $250,000, with some businesses setting the limit below $75,000. However, some set higher limits as well.

Basically, it’s a question of how much financial protection you’re willing to pay for. Going with a higher attachment gets you lower premiums. For example, a premium per covered employee with a $100,000 deductible might be around twice as high as it would be for one with a $200,000 deductible, and more than five times as high as one with a $500,000 attachment point.

Many challenges

As you can see, self-insurance has many challenges — starting with stop-loss coverage, which is a necessity. Nevertheless, it can be an effective approach under the right circumstances. We can help you assess the costs, risks and potential advantages of self-insuring vs. fully insuring.

© 2024

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7 common payroll risks for small to midsize businesses

If your company has been in business for a while, you may not pay much attention to your payroll system so long as it’s running smoothly. But don’t get too complacent. Major payroll errors can pop up unexpectedly — creating huge disruptions costing time and money to fix, and, perhaps worst of all, compromising the trust of your employees.

For these reasons, businesses are well-advised to conduct payroll audits at least once annually to guard against the many risks inherent to payroll management. Here are seven such risks to be aware of:

1. Inaccurate recordkeeping. If you don’t keep detailed and accurate records, it will probably come back to haunt you. For example, the Fair Labor Standards Act (FLSA) requires businesses to maintain records of employees’ earnings for at least three years. Violations of the FLSA can trigger severe penalties. Be sure you and your staff know what records to keep and have sound policies and procedures in place for keeping them.

2. Employee misclassification. Given the widespread use of “gig workers” in today’s economy, companies are at high risk for employee misclassification. This occurs when a business engages independent contractors but, in the view of federal authorities, the company treats them like employees. Violating the applicable rules can leave you owing back taxes and penalties, plus you may have to restore expensive fringe benefits.

3. Manual processes. More than likely, if your business prepares its own payroll, it uses some form of payroll software. That’s good. Today’s products are widely available, relatively inexpensive and generally easy to use. However, some companies — particularly small ones — may still rely on manual processes to record or input critical data. Be careful about this, as it’s a major source of errors. To the extent feasible, automate as much as you can.

4. Privacy violations. You generally can’t manage payroll without data such as Social Security numbers, home addresses, birth dates and bank account numbers. Unfortunately, possessing such information puts you squarely in the sights of hackers and those pernicious purveyors of ransomware. Invest thoroughly in proper cybersecurity measures and regularly update these safeguards.

5. Internal fraud. Occupational (or internal) fraud remains a major threat to businesses. Schemes can range from “cheating” on timesheets by rank-and-file workers to embezzlement by those higher on the organizational chart. Among the most fundamental ways to protect your payroll function from fraud is to require segregation of duties. In other words, one employee, no matter how trusted, should never completely control the process. If you don’t have enough employees to segregate duties, consider outsourcing.

6. Legal compliance. As a business owner, you’re probably not an expert on the latest regulatory payroll developments affecting your industry. That’s OK; laws and regulations are constantly evolving. However, failing to comply with the current rules could cost you money and hurt your company’s reputation. So, be sure to have a trustworthy attorney on speed dial that you can turn to for assistance when necessary.

7. Tax compliance. Employers are responsible for calculating tax withholding on employee wages. In addition to deducting federal payroll tax from paychecks, your organization must contribute its own share of payroll tax. If you get it wrong, the IRS could investigate and potentially assess additional tax liability and penalties. That’s where we come in. For help conducting a payroll audit, reviewing your payroll costs and, of course, managing your tax obligations, contact us.

© 2024  

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Address mental health care in your estate plan with a psychiatric advance directive

It’s not uncommon for people to address the fact that they may one day become physically incapacitated and unable to make critical medical decisions themselves. They do this by including health care powers of attorney or advance directives in their estate plans.

But what if your family has history of mental illness? Is there a way to memorialize your wishes in the event a psychiatric episode renders you unable to make decisions about your treatment? A psychiatric advance directive may be the answer.

Health care directives

To cover all the health care bases, it’s a good idea to have two documents: an advance health care directive (sometimes referred to as a “living will”) and a health care power of attorney (HCPA). Some states allow you to combine the two in a single document.

An advance directive expresses your preferences for the use of life-sustaining medical procedures — such as artificial feeding and breathing, surgery, invasive diagnostic tests, and pain medication — specifying the situations when these procedures should be used or withheld.

However, a document prepared in advance can’t account for every scenario or contingency so it’s wise to pair an advance directive with an HCPA. This allows you to authorize your spouse or other trusted representative to make medical decisions or consent to medical treatment on your behalf when you’re unable to do so. An HCPA can include specific instructions to your representative, as well as general guidelines or principles to follow in dealing with complex medical decisions or unanticipated circumstances.

Psychiatric advance directive

Many states allow generic HCPAs and advance directives to address mental as well as physical health issues. But some states limit or prohibit mental health treatment decisions by general health care representatives. Around half of the states have psychiatric advance directive statutes, which authorize special advance directives to outline one’s wishes with respect to mental health care and appoint a representative to make decisions regarding that care.

A psychiatric advance directive may address a variety of mental health care issues, including:

  • Preferred hospitals or other providers,
  • Treatment therapies and medications that may be administered,
  • Treatment therapies and medications that may not be administered, such as electroconvulsive therapy or experimental drugs,
  • A statement of general values, principles or preferences to follow in making mental health care decisions, and
  • Appointment of a representative authorized to make decisions and carry out your wishes with respect to mental health care in the event you’re incapacitated.

Although requirements vary from state to state, to be effective, a psychiatric advance directive must be signed by you and your chosen representative, and in some states by two witnesses. Be sure to discuss the terms of the psychiatric advance directive with your family, close friends, physicians and mental health care providers.

Ease your concerns

If you’re concerned about the possibility of mental illness and want to properly address it in your estate plan, a psychiatric advance directive is worth looking into. Consider one if it’s available in your state or look into options for using generic advance directives and HCPAs to address mental health care.

© 2024

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Scrupulous records and legitimate business expenses are the key to less painful IRS audits

If you operate a business, or you’re starting a new one, you know records of income and expenses need to be kept. Specifically, you should carefully record expenses to claim all the tax deductions to which you’re entitled. And you want to make sure you can defend the amounts reported on your tax returns in case you’re ever audited by the IRS.

Be aware that there’s no one way to keep business records. On its website, the IRS states: “You can choose any recordkeeping system suited to your business that clearly shows your income and expenses.” But there are strict rules when it comes to deducting legitimate expenses for tax purposes. And certain types of expenses, such as automobile, travel, meal and home office costs, require extra attention because they’re subject to special recordkeeping requirements or limitations on deductibility.

Ordinary and necessary

A business expense can be deducted if a taxpayer establishes that the primary objective of the activity is making a profit. To be deductible, a business expense must be “ordinary and necessary.” In one recent case, a married couple claimed business deductions that the IRS and the U.S. Tax Court mostly disallowed. The reasons: The expenses were found to be personal in nature and the taxpayers didn’t have adequate records for them.

In the case, the husband was a salaried executive. With his wife, he started a separate business as an S corporation. His sideline business identified new markets for chemical producers and connected them with potential customers. The couple’s two sons began working for the business when they were in high school.

The couple then formed a separate C corporation that engaged in marketing. For some of the years in question, the taxpayers reported the income and expenses of the businesses on their joint tax returns. The businesses conducted meetings at properties the family owned (and resided in) and paid the couple rent for the meetings.

The IRS selected the couple’s returns for audit. Among the deductions the IRS and the Tax Court disallowed:

  • Travel expenses. The couple submitted reconstructed travel logs to the court, rather than records kept contemporaneously. The court noted that the couple didn’t provide “any documentary evidence or other direct or circumstantial evidence of the time, location, and business purpose of each reported travel expense.”
  • Marketing fees paid by the S corporation to the C corporation. The court found that no marketing or promotion was done. Instead, the funds were used to pay several personal family expenses.
  • Rent paid to the couple for the business use of their homes. The court stated the amounts “were unreasonable and something other than rent.”

Retirement plan deductions allowed

The couple did prevail on deductions for contributions to 401(k) accounts for their sons. The IRS contended that the sons weren’t employees during one year in which contributions were made for them. However, the court found that 401(k) plan documents did mention the sons working in the business and the father “credibly recounted assigning them research tasks and overseeing their work while they were in school.” Thus, the court ruled the taxpayers were entitled to the retirement plan deductions. (TC Memo 2023-140)

Lessons learned

As this case illustrates, a business can’t deduct personal expenses, and scrupulous records are critical. Make sure to use your business bank account for business purposes only. In addition, maintain meticulous records to help prepare your tax returns and prove deductible business expenses in the event of an IRS audit.

Contact us if you have questions about retaining adequate business records.

© 2024

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Choosing your M&A Superhero Structure – F Reorganization or 338(h)(10)

In the thrilling world of mergers and acquisitions, where the stakes are as high as the skyscrapers housing the big financial firms, two particular strategies stand out in the crowd: the 338(h)(10) transaction and the F Reorganization. These two are like the superheroes of tax election strategies, each with their own superpowers, weaknesses, and origin stories.

Let’s start with the 338(h)(10) transaction, which is like the financial world’s version of a shapeshifter. It allows a stock purchase to magically transform into an asset purchase for tax purposes. Imagine you’re buying a vintage car, but for the price tag, you want it to be brand new under the hood. That’s what a 338(h)(10) does; it gives the buyer a fresh tax basis in the assets, allowing for depreciation and amortization benefits that can shield profits from taxes faster than a superhero deflects bullets with their wristbands.

But every superhero has their kryptonite, and for the 338(h)(10), it’s the limitations. It’s only available for S corporations, and the buyer must be a corporation too. Plus, the buyer needs to acquire at least 80% of the target company’s stock. It’s like needing to collect all the infinity stones to use the gauntlet – it’s powerful, but boy, do you have to work for it.

Now, let’s talk about the F Reorganization. This strategy is like the financial world’s teleporter, allowing a company to change its form or place of organization without triggering a tax event. It’s like being able to move your house to a sunnier place without packing a single box. The F Reorganization is a nifty way to restructure a company, often used when an S corporation wants to become part of a larger group without losing its S status or when a company wants to move to a different state without the tax hassle.

The F Reorganization is more flexible than Elasta Girl, with fewer restrictions on who can use it and how it can be structured. It’s the superhero who can bend in all sorts of ways to save the day, making it a popular choice for businesses looking to restructure.

For example with a 338(h)(10) transaction, imagine a company, let’s call it Stark Industries, is being sold. Stark Industries is an S corporation with a legacy of innovative tech. A larger corporation, Wayne Enterprises, wants to buy Stark but also wants a step-up in the tax basis of Stark’s assets. They opt for a 338(h)(10) transaction, which allows Wayne Enterprises to treat the stock purchase as an asset purchase, stepping up the basis and reaping the tax benefits as if they bought new gadgets for their Batcave.

On the flip side, an example of an F Reorganization could involve a company, let’s say, Xavier’s School for Gifted Youngsters. The school is an S corporation but wants to join forces with a larger educational group without losing its S corporation benefits. Through an F Reorganization, the school can transfer its assets to a new entity, which then becomes part of the larger group. This way, the school moves to a new organizational structure as smoothly as Professor X reads minds.

Choosing between a 338(h)(10) transaction and an F Reorganization depends on the specific needs and structure of the companies involved. It’s like choosing between a flying superhero and one with super speed – both are fantastic, but the best choice depends on the mission at hand. So, next time you’re in the financial superhero business, choose your strategy wisely, and may the tax gods be ever in your favor!


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Coordinating Sec. 179 tax deductions with bonus depreciation

Your business should generally maximize current year depreciation write-offs for newly acquired assets. Two federal tax breaks can be a big help in achieving this goal: first-year Section 179 depreciation deductions and first-year bonus depreciation deductions. These two deductions can potentially allow businesses to write off some or all of their qualifying asset expenses in Year 1. However, they’re moving targets due to annual inflation adjustments and tax law changes that phase out bonus depreciation. With that in mind, here’s how to coordinate these write-offs for optimal tax-saving results.

Sec. 179 deduction basics

Most tangible depreciable business assets — including equipment, computer hardware, vehicles (subject to limits), furniture, most software and fixtures — qualify for the first-year Sec. 179 deduction.

Depreciable real property generally doesn’t qualify unless it’s qualified improvement property (QIP). QIP means any improvement to an interior portion of a nonresidential building that’s placed in service after the date the building is placed in service — except for any expenditures attributable to the enlargement of the building, any elevator or escalator, or the internal structural framework. Sec. 179 deductions are also allowed for nonresidential building roofs, HVAC equipment, fire protection systems and security systems.

The inflation-adjusted maximum Sec. 179 deduction for tax years beginning in 2024 is $1.22 million. It begins to be phased out if 2024 qualified asset additions exceed $3.05 million. (These are up from $1.16 million and $2.89 million, respectively, in 2023.)

Bonus depreciation basics

Most tangible depreciable business assets also qualify for first-year bonus depreciation. In addition, software and QIP generally qualify. To be eligible, a used asset must be new to the taxpayer.

For qualifying assets placed in service in 2024, the first-year bonus depreciation percentage is 60%. This is down from 80% in 2023.

Sec. 179 vs. bonus depreciation

The current Sec. 179 deduction rules are generous, but there are several limitations:

  • The phase-out rule mentioned above,
  • A business taxable income limitation that disallows deductions that would result in an overall business taxable loss,
  • A limited deduction for SUVs with a gross vehicle weight rating of more than 6,000 pounds, and
  • Tricky limitation rules when assets are owned by pass-through entities such as LLCs, partnerships, and S corporations.

First-year bonus depreciation deductions aren’t subject to any complicated limitations. But, as mentioned earlier, the bonus depreciation percentages for 2024 and 2023 are only 60% and 80%, respectively.

So, the current tax-saving strategy is to write off as much of the cost of qualifying asset additions as you can with Sec. 179 deductions. Then claim as much first-year bonus depreciation as you can.

Example: In 2024, your calendar-tax-year C corporation places in service $500,000 of assets that qualify for both a Sec. 179 deduction and first-year bonus depreciation. However, due to the taxable income limitation, the company’s Sec. 179 deduction is limited to only $300,000. You can deduct the $300,000 on your corporation’s 2024 federal income tax return. You can then deduct 60% of the remaining $200,000 ($500,000 − $300,000), thanks to first-year bonus depreciation. So, your corporation can write off $420,000 in 2024 [$300,000 + (60% x $200,000) = $420,000]. That’s 84% of the cost! Note that the $200,000 bonus depreciation deduction will contribute to a corporate net operating loss that’s carried forward to your 2025 tax year.

Manage tax breaks

As you can see, coordinating Sec. 179 deductions with bonus depreciation deductions is a tax-wise idea. We can provide details on how the rules work or answer any questions you have.

© 2024

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2024 Q2 tax calendar: Key deadlines for businesses and employers

Here are some of the key tax-related deadlines that apply to businesses and other employers during the second quarter of 2024. Keep in mind that this list isn’t all-inclusive, so there may be additional deadlines that apply to you. Contact us to ensure you’re meeting all applicable deadlines and to learn more about the filing requirements.

April 15

  • If you’re a calendar-year corporation, file a 2023 income tax return (Form 1120) or file for an automatic six-month extension (Form 7004) and pay any tax due.
  • For corporations, pay the first installment of 2024 estimated income taxes. Complete and retain Form 1120-W (worksheet) for your records.
  • For individuals, file a 2023 income tax return (Form 1040 or Form 1040-SR) or file for an automatic six-month extension (Form 4868) and pay any tax due.
  • For individuals, pay the first installment of 2024 estimated taxes, if you don’t pay income tax through withholding (Form 1040-ES).

April 30

  • Employers report income tax withholding and FICA taxes for the first quarter of 2024 (Form 941) and pay any tax due.

May 10

  • Employers report income tax withholding and FICA taxes for the first quarter of 2024 (Form 941), if they deposited on time, and fully paid, all of the associated taxes due.

May 15

  • Employers deposit Social Security, Medicare and withheld income taxes for April if the monthly deposit rule applies.

June 17

  • Corporations pay the second installment of 2024 estimated income taxes.

© 2024

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Tax tips when buying the assets of a business

After experiencing a downturn in 2023, merger and acquisition activity in several sectors is rebounding in 2024. If you’re buying a business, you want the best results possible after taxes. You can potentially structure the purchase in two ways:

  1. Buy the assets of the business, or
  2. Buy the seller’s entity ownership interest if the target business is operated as a corporation, partnership or LLC.

In this article, we’re going to focus on buying assets.

Asset purchase tax basics

You must allocate the total purchase price to the specific assets acquired. The amount allocated to each asset becomes the initial tax basis of that asset.

For depreciable and amortizable assets (such as furniture, fixtures, equipment, buildings, software and intangibles such as customer lists and goodwill), the initial tax basis determines the post-acquisition depreciation and amortization deductions.

When you eventually sell a purchased asset, you’ll have a taxable gain if the sale price exceeds the asset’s tax basis (initial purchase price allocation, plus any post-acquisition improvements, minus any post-acquisition depreciation or amortization).

Asset purchase results with a pass-through entity

Let’s say you operate the newly acquired business as a sole proprietorship, a single-member LLC treated as a sole proprietorship for tax purposes, a partnership, a multi-member LLC treated as a partnership for tax purposes or an S corporation. In those cases, post-acquisition gains, losses and income are passed through to you and reported on your personal tax return. Various federal income tax rates can apply to income and gains, depending on the type of asset and how long it’s held before being sold.

Asset purchase results with a C corporation

If you operate the newly acquired business as a C corporation, the corporation pays the tax bills from post-acquisition operations and asset sales. All types of taxable income and gains recognized by a C corporation are taxed at the same federal income tax rate, which is currently 21%.

A tax-smart purchase price allocation

With an asset purchase deal, the most important tax opportunity revolves around how you allocate the purchase price to the assets acquired.

To the extent allowed, you want to allocate more of the price to:

  • Assets that generate higher-taxed ordinary income when converted into cash (such as inventory and receivables),
  • Assets that can be depreciated relatively quickly (such as furniture and equipment), and
  • Intangible assets (such as customer lists and goodwill) that can be amortized over 15 years.

You want to allocate less to assets that must be depreciated over long periods (such as buildings) and to land, which can’t be depreciated.

You’ll probably want to get appraised fair market values for the purchased assets to allocate the total purchase price to specific assets. As stated above, you’ll generally want to allocate more of the price to certain assets and less to others to get the best tax results. Because the appraisal process is more of an art than a science, there can potentially be several legitimate appraisals for the same group of assets. The tax results from one appraisal may be better for you than the tax results from another.

Nothing in the tax rules prevents buyers and sellers from agreeing to use legitimate appraisals that result in acceptable tax outcomes for both parties. Settling on appraised values becomes part of the purchase/sale negotiation process. That said, the appraisal that’s finally agreed to must be reasonable.

Plan ahead

Remember, when buying the assets of a business, the total purchase price must be allocated to the acquired assets. The allocation process can lead to better or worse post-acquisition tax results. We can help you get the former instead of the latter. So get your advisor involved early, preferably during the negotiation phase.

© 2024

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