Significant income tax reduction and estate planning benefits are achievable via a sale of business assets to a controlled, unrelated entity.

Capital Gain.   As a general rule, the capital gains tax rate is 15%.  The seller of business assets is entitled to report capital gain as the principal portion of each installment payment is received.  (Unless, of course, the seller is a C corporation.)  The primary exceptions relate to accounts receivable of cash method taxpayers and depreciable property.   The former is not important because selling accounts receivable merely accelerates income which would have been recognized soon anyway.  To the extent gain is caused by a lowering of depreciable basis, the gain is either "recaptured" as ordinary income or, in the case of real estate, taxed at a 25% rate.  The tax can be avoided via leasing selected assets (e.g., equipment) to the buyer.   But a sale of any depreciable property to a related person converts what would have been capital gain into ordinary income.  

The Seller’s Economics. Now imagine that you are the seller in an installment sale and the buyer is an unrelated party. Presumably, the face value of the note reflects the discounted future income of the business, at least to the extent the purchase price is allocated to goodwill. In essence, selling goodwill in exchange for a secured note converts your expected future income stream to capital gain and (arguably) protects that cash-flow via a lien securing the installment note. (Essentially the same thing happens whenever rental real estate is sold, at least to the extent the price reflects the discounted value of the future rental stream.)

Post-sale compensation. It is common for the seller to provide services to the buyer after the sale of the business and to receive compensation for such services.

The buyer’s tax posture. The buyer gets all of the available depreciation and amortization deductions stemming from the purchased assets. If the buyer and seller are not related persons, then goodwill is amortized over a 15 year period. For example, if $1.8m of the purchase price is allocated to goodwill, the buyer gets a $10,000 deduction for each of the next 180 months. The buyer also deducts the interest payments on the note and any reasonable compensation paid to the seller, but cannot deduct the principal payments on the note. As an extreme example, if the goodwill deductions and the principal payments are coordinated and if the buyer’s income in excess of the note payments is paid to the seller as compensation, the net effect would be that the buyer would have no taxable income, while the seller would be converting $1.8m of ordinary income to capital gain.

Unrelated persons. Obviously, a major key to the transaction is that the seller and buyer are not "related persons" for tax purposes. This is not a particularly difficult hurdle because the issue can often be determined solely by reference to ownership, rather than control.  Separating control and ownership is common. A classic example is where the 1% general partner controls a limited partnership. The ownership question tends to get resolved via estate planning and business considerations.   

Estate planning. The sale replaces your business with an installment note. The installment note declines in value as the payments are made. In many cases the transaction is also an excellent vehicle to address succession concerns.

Tax risks. Clearly, the transaction can be structured to meet all the requirements of the Internal Revenue Code. The question is whether some judicial doctrine (e.g., sham transaction, step transaction, substance over form) is applicable. There are traps for the unwary, but the issue often breaks down to whether your nontax motives - asset protection, estate planning, and so on - were substantial. With careful planning the tax risks are minimal.

It should be noted that any intended change in equity positions presents a business purpose for the transaction  (e.g., sale to a controlled entity as a means of having a doctor join a practice).

Miscellaneous. The transaction is an asset sale. Accordingly, all of the changes inherent in a sale of a business would be involved. The new entity would have a new taxpayer identification number, sales tax number, unemployment tax number, checking account, etc. Most, if not all, of the seller’s contractual relationships would have to be shifted to the new entity (but the new entity can have the seller’s name.) Note also that dissenters rights might be created and fringe benefits might vest.

However, it is possible to avoid a lot of the difficulties of assigning contracts, etc.  For example, assume seller is an S corporation (Oldco) and that the stockholders contribute all of their stock in Oldco to a new S corporation (Parent S) which makes a QSUB election for its subsidiary.  Oldco would be a disregarded entity.  Parent S could then sell its stock in Oldco to the buyer.  Such sale would be treated as an asset sale for income tax purposes, but the set of transactions would not involve an assignment of contracts or other assets, nor a change of name. 

Summary. The combination of asset protection, conversion of ordinary income to capital gain and the possibility of sundry other benefits makes the sale of a business to a controlled entity in exchange for a secured long-term note a very attractive technique in a surprisingly broad range of circumstances. However, it is a major transaction which cannot be approached in a "one size fits all" fashion. The transaction must be carefully structured to fit the facts and avoid traps.

(c)2008 Steven M. Chamberlain.  All rights reserved.  Republication with attribution is permitted.