When it comes to taxes, the proverbial bottom line is how much of your income you end up with, i.e., your take-home.

Tax inclusive. Income tax rates are typically computed on a "tax inclusive" basis, which means that your tax liability is determined as a percentage of what you make. The tax is computed on the sum of your take-home and the tax itself. You are paying taxes on the tax.

Tax exclusive. A better way to compare taxes is on a "tax exclusive" basis. That is, with the tax exclusive method you compare the tax paid with your take-home. Tax exclusive computations show how much you pay to the IRS for each dollar you get to keep.

Example. The highest marginal income tax rate for Florida residents is 35% on ordinary income (OI). In comparison, the long-term capital gains (LTCG) tax rate is only 15%. The following figures show the difference between the tax inclusive and tax exclusive methods of analyzing tax liabilities, and helps show relative, bottom line efficiencies.

Tax inclusive computations:

100% - 35% = 65% take-home (OI)

100% - 15% = 85% take-home (LTCG)

Difference in tax rate = 20%

20% ÷ 65% = 30.77% = relative improvement in take-home (bottom line efficiency). In other words, you get to keep almost 31% more money if your income is taxed at the LTCG tax rate of 15%, instead of the OI tax rate of 35%.

Tax exclusive computations:

35% ÷ 65% = 53.85% = tax rate as a percentage of take-home (OI)

15% ÷ 85% = 17.65% = tax rate as a percentage of take-home (LTCG)

At the OI tax rate of 35%, you pay almost 54¢ to the IRS for each dollar you keep. At the LTCG tax rate of 15%, you pay less than 18¢ to the IRS for each dollar you keep. On a tax exclusive basis, the OI tax rate is 306% of the LTCG tax rate. Now you know what the goal is…

ACHIEVING LTCG

First, some basic rules. As a general proposition, LTCG is income realized from the taxable sale of an asset which was held for more than one year, but only if the asset was not an OI asset. That is, the Internal Revenue Code says that gain from the sale of any asset held for more than one year is eligible for LTCG treatment, except for the gain on sales of certain assets which have to be treated as OI. (It’s a negative definition.) For example, inventory and accounts receivables are OI assets.

Of course, there are exceptions. For example, the "recapture" rules say that if you previously deducted depreciation with respect to sold equipment, the gain on sale will not be eligible for LTCG treatment to the extent it represents the previously deducted depreciation.

Another major exception is that if the asset is eligible for depreciation, then gain on a sale to a related party is not eligible for LTCG treatment. But it is important to note that it is entirely possible for the seller and buyer to be unrelated even though the seller controls the buyer and has an equity position (up to 50%) in the buyer.

Converting business income to LTCG. As a general proposition, business income generates OI. That’s because the business involves selling inventory or services, neither of which is eligible for LTCG treatment. (Services are not assets.)

But the business itself is not an OI asset. A taxpayer selling his or her business can generate LTCG to the extent the selling price is not allocated to OI assets. OK, time out. Let’s take a little side trip. For income tax purposes there is no such thing as the sale of a business. Rather, the sale is treated as lots of sales. Each of the assets which make up the business is sold, and each such sale generates its own tax consequences. If the total price exceeds the value of all of such assets the excess is called "goodwill".

Economists think of goodwill as the ability to generate future income. The value of goodwill is thought of as the present value of the future income stream of the business. The key tax point is that goodwill is not an OI asset. Thus, the sale of goodwill can generate LTCG treatment.

And the icing on the cake is that the buyer can deduct the price paid for goodwill over a 15 year period. Thus the seller can report LTCG on the sale of goodwill, but the buyer gets to write off the price against OI. (For that reason, LTCG is only available if the buyer and seller are unrelated.)

Putting it all together, the IRS loses every time goodwill is sold. The total price allocated to goodwill represents income converted from OI to LTCG. If the OI would have been taxed at 35% had there not been a sale of the business, and if the seller reports the proceeds as LTCG, the net effect is that the government loses 20% of the price of the goodwill. In short, the present value of the future income stream has been converted from OI to LTCG – a very big deal indeed!

Leveraged buy outs.  You may have heard of leveraged buy outs (LBO’s). They are all the rage on Wall Street. Sounds exotic, but they’re not. An LBO is nothing more than a sale of the assets of a business with part or all of the consideration consisting of a promise to pay in the future (i.e., an installment note).  The buyer operates the business and pays the debt off with income generated by the business.  For private companies the tax reduction can be as much as 20% of the purchase price.  And typically the debt is secured by a lien on all of the business assets, which means the transaction also generates asset protection.

Three examples. LBO’s are not as common as they should be. Businessmen are missing lots of opportunities. For example, two doctors operating separate PA’s who merge their businesses miss the opportunity to structure the transaction as two sales of businesses. The two physicians could form a new entity which in turn buys the assets of each PA via an LBO. The physicians end up essentially in the same place, except much of their future income has been converted to LTCG and there are liens on the business assets.

Similarly, two physicians who are equal stockholders in a PA could separate their practices by dissolving the PA. They should instead consider separating via LBO’s. They could each form a separate PA which would purchase the goodwill associated with that physician. As a practical matter, the net effect would be the same as a simple dissolution, except for the tax and asset protection benefits.

As a final example, consider a typical Stockholders Agreement. Assume two physicians operate a PA and are equal stockholders. Their Stockholders Agreement provides that if one dies the other will buy the decedent’s stock for a price determined by a formula. Buying the decedent’s stock does not provide a tax benefit to the survivor until he sells the purchased stock.

The missed opportunity is that the Stockholders Agreement could have given the survivor the option to form a new PA to buy the assets of the old PA for double the price the buyer would have had to pay for the decedent’s stock. If the option is exercised, the selling PA immediately dissolves. Half of the price goes to the decedent’s estate, so the decedent’s estate is in essentially the same position as if it had sold the stock to the survivor. The other half goes to the survivor. As an economic matter the survivor is in essentially the same position as if he had bought the stock. But because he exercised the option, the buying PA gets to deduct an amount equal to double the price he would have paid for the decedent’s stock and the surviving physician only has to report half of that amount as LTCG. Sweet!

ESOP’s. Another way to convert OI to LTCG without losing control is for the business to install an employee stock ownership plan, or ESOP. The company sets up a qualified retirement plan which is designed to invest primarily in the company stock. The ESOP borrows from a bank secured by a lien on the company assets (asset protection); the ESOP buys the stock with the borrowed money (LTCG); the company makes deductible contributions to the ESOP; the ESOP pays the bank; and the Board of Directors of the company votes the ESOP stock (control).