When starting a new business, many costs are incurred before the company begins operating. These costs can generally be classified in one of three categories:
Organization costs are incurred in creating an entity such as a corporation or a partnership. Organization costs include the costs of legal services incident to the
organization of a corporation or partnership, such as drafting the corporate charter, by-laws, minutes or organizational meetings, terms of original stock certificates, partnership agreement and the like, and necessary accounting services and filing fees.
Start-up costs are incurred in connection with the establishment of new business after the entity has been formed, but before operations begin. Start-up costs include costs investigating the creation or acquisition of an active trade or business or values of creating an active trade or business.
Note: Organization and start-up costs are capital costs that cannot be cur-
recently expensed for tax purposes. An election to amortize organization and
start-up costs over not less than 180 months can be made in the year the business begins.
Syndication costs are incurred in connection with the issuing and marketing of interests in a corporation or partnership-type entity. Syndication costs include:
(1) Brokerage fees,
(2) Registration fees,
(3) Charges of the underwriter or placement agent,
(4) Legal fees for securities advice and advice about the adequacy of tax disclosures in the prospectus or placement memorandum,
(5) Accounting fees for preparation of representations to be included in the
offering materials, and
(6) Costs of printing the prospectus, placement memorandum, and other selling and promotional material.
Syndication costs cannot be amortized or even deducted when the entity is liquidated. Syndication costs are charged against capital and never deducted by the entity for income tax purposes. They do not reduce the cost basis of an owner’s equity in the company and may reduce the gain if and when the owner’s investment is sold.
Buying an Existing Business
Buying an existing business can have considerable advantages over starting from scratch. Advantages include:
(1) The chance to start with an established customer base;
(2) The possibility of a regular draw or salary right from the start;
(3) Less risk of business failure, since you know, there is a viable market if the business is already profitable;
(4) Opportunity to have the seller stay on as an employee or consultant for a
(5) Ability to focus more attention on service and operations.
Finding a Business for Sale
There are several ways to find a business that is up for sale:
1. Brokers. These are an excellent source. The seller pays Their fee (usually 10% of the selling price).
2. Advertisements. The business opportunities section of the local newspaper,
regional magazine, or trade journal is a major source of leads to businesses
that are for sale.
3. Customers & Suppliers. Every industry has customers and suppliers. These
companies are great for leads on business where the owners may be ready to
retire or sell for other reasons.
4. Attorneys & Accountants. These professionals are sometimes a good
source for information on businesses for sale.
5. Local Chambers of Commerce. These people usually know a great deal
about the local business community and may be able to give you some free
leads to firms that are for sale.
6. Direct Approach. If you see a business that you might like to buy, some-
times the simplest approach will be to talk to the owner and see if they are interested in selling.
Why is the business for sale?
What reputation does the business have?
How profitable is the business?
What are the business’ assets and liabilities?
Will you have to negotiate a new lease?
Can assets be acquired instead of stock, so that the buyer
does not incur unknown and unmeasurable liabilities?
Is there adequate value about cost on a rate of return
basis? Is the purchase price fixed with defined liabilities and exposures?
Is there protection against the future competition by the seller?
What warranties are given to assure values, and with what security?
Will key customers, contracts, and employees remain?
How can the purchase be financed at the least cost?
Can post-acquisition business integration be achieved successfully?
What is the seller’s experience rating for unemployment tax purposes?
What are the real costs of existing benefit plans?
How will employee benefits be affected by the acquisition?
Will the acquisition adversely affect employee relations?
Is there a union?
What is the financial condition of existing benefit plans?
How should benefit plans be handled – terminated, continued,
In the negotiations, each party must carefully consider the tax objectives of the
other party. Otherwise, it may not be possible to reach an agreement.
In particular, if the sellers have substantial unrealized appreciation in their
own interests in the business, the buyers will often find that they cannot ac-
quire the business unless they structure the transaction so as to either minimize
or postpone any potential taxable income of the sellers.
How much of the purchase price is deductible, and how soon?
Is any of the seller’s tax liability being assumed?
Will the sale result in a sales tax liability?
Can acquired tax attributes be used? How can the risk of losing these benefits are reduced? How soon can the earned benefits be used?
How can post-acquisition tax benefits be maximized?
What are the implications of state and local taxes?
A business held in corporate form can be acquired in one of two ways – by acquiring stock or acquiring assets. In either case, the transaction can be nontaxable,
partly taxable, or fully taxable to the sellers.
In general, if a buyer acquires all of the stock of a corporation in a transaction that is nontaxable or only partially taxable to the seller, the tax basis of the
assets in the acquired corporation will remain the same as they were before
the acquisition; that is, the base will be carried over. The purchasing corporation will not be able to “step up” the basis of its assets, even if the buyer pays
more than the tax book value for the stock.
If a buyer acquires all of the stock of an unrelated corporation in a fully
the taxable transaction, an election can be made to step up the basis of the as-
sets of the purchasing corporation to the extent that the purchase price of
the stock exceeds the tax basis of the corporation’s net assets. This election is referred to as a §338 election.
The acquisition of assets in a nontaxable transaction will result in the buyer
having the same basis in the acquired assets as the seller had (such as carryover basis). The acquisition of assets in a partially taxable transaction will, in
general, result in the buyer having a base in the assets equal to the seller’s
base, increased by the amount of the gain recognized by the seller. If the buyer acquires the assets of a business in a fully taxable transaction, the basis
of the assets in the hands of the buyer is the purchase price.
Allocation of Purchase Price to Assets
In the past, buyers and sellers were often pitted against each other in allocating
the purchase price. This game is now over.
If a business is purchased through the acquisition of assets or if a §338 election is made, the categories and the method of allocating the purchase price
are: Class I Assets: cash and cash equivalents. The purchase price is first applied to these assets to give each a basis equivalent to its face amount.
Class II Assets: liquid investment assets such as certificates of deposit and readily marketable stocks and securities. The purchase price remaining
after application to the Class, I assets is then allocated to Class II assets
based on relative fair market values of such assets, but no amount can be
assigned to an asset more than its fair market value.
Class III Assets: all assets other than Class I, II, and IV assets, including such major items as inventory, depreciable assets, amortizable intangible
assets, and some unamortizable intangible assets such as trademarks. The purchase price remaining after application to the Class I and Class II assets are applied to these assets based on their relative fair market values,
but no amount can be allocated to an asset more than its fair market value.
Class IV Assets: nonamortizable intangible assets such as goodwill and going concern value. The purchase price remaining to be allocated after
application to Class I, II, and III assets are assigned to these assets. Despite this four-step allocation formula, it is still a good idea to have a provision mentioning intangible assets (such as customer lists, technical knowhow, and covenant not to compete) that are the subject of the sale. This may be helpful to create a rationale for allocating some part of the purchase price to such items.
Form 8594. Any time a business is bought or sold, both the buyer and
seller must file Form 8594 with the IRS reporting certain information about the purchase price allocation. Penalties for failure to submit this form are substantial. The information on the buyer’s and seller’s arrangements should be identical, or you will invite an audit.
Allocation Regulations The IRS has issued final, temporary, and proposed regulations (T.D.
8711) under §1060 and §338(b) concerning purchase price allocations in taxable asset acquisitions and deemed asset purchases. The amendments
revise the treatment of intangible assets in such acquisitions to take into account the enactment of §197 by the Omnibus Budget Reconciliation
Act of 1993. This document also makes conforming amendments to the
final regulations under §338. The regulations guide
taxable asset acquisitions and deemed asset purchases resulting from
elections under §338. (REG-252665-96)
Before the 1993 Act, acquired goodwill and going concern value were
not amortizable. Still, other acquired intangible assets were amortizable if
they could be separately identified, and their useful lives determined with reasonable accuracy.
The temporary and final regulations conform to the legislative history of the 1993 Act by placing all amortizable §197 intangibles other than good-
will and going concern value in Class IV.
Note: However, the new regulations also include nonamortizable §197 intangibles in Class IV. Some section 197 intangibles are amortizable by the buyer
though they were not amortizable by the seller. Other §197 intangibles may not be amortizable because of the application of the anti-churning rules of
§197(f)(9). Although §338(b) and §1060 do not require conformity between the buyer and seller on purchase price allocations, they reflect strong policies
encouraging compliance in cases where the parties have agreed to the assignment, and a reporting system designed to reveal situations where the parties’
allocations are inconsistent. These policies favoring conformity are best served by requiring both parties to include the same assets in each Class.
Moreover, this rule is also more consistent with §1060(b). Section 1060(b)(1)
requires the parties to report, under regulations, “the amount of consideration received for the assets which are allocable to section 197 intangibles.” The term “§197 intangibles” is more inclusive than amortizable §197 intangibles.
The goals of consistency, simplification, and administrability will be better achieved concerning allocations to §197 intangibles if all such assets are removed from Class III and isolated in a junior class (or classes). Accordingly, these regulations classify all §197 intangibles (other than goodwill and going concern value) as Class IV assets.
These regulations provide that goodwill and going concern value will be assigned to a right residual class, Class V. Allocating goodwill and going
concern value to Class V avoids the need for determining the value of goodwill and going concern value through a non-residual method.
Use an Escrow: In general, both buyer and seller will be better protected if an escrow is used.
Bulk Sales Transfer Compliance: Most states require that the buyer of a retail or
wholesale business notify creditors of that business of the sale. If this is not done correctly, the seller’s creditors may be able to attach the property.
Recorded Security Interests: Before closing the purchase, check to see if anyone
has filed a lien against the personal property of the seller’s business. Employment & Sales Tax Release: The buyer should require that the seller obtain
a release from the state agency that collects payroll taxes and sales taxes, showing that all taxes have been paid.
Holdbacks: The buyer should structure the purchase so that a part of the price is held back for some period (e.g., a year) in case the seller has made any misreported- sensations.
Reorganizations – §368
The corporate restructuring may be either a taxable or a nontaxable event. In the event of a taxable transaction, §1001 provides that gain or loss will be recognized to the seller to the extent that the amount realized from the sale
exceeds the seller’s basis in the surrendered property. The purchaser receives a new foundation for the amount paid. Certain types of transactions are exempt from taxation under the provisions of §1031 (like-kind exchanges), §1033 (involuntary conversions), §351 (transfers to a controlled corporation), and, §§ 361 and 368 (relating to certain reorganizations).
Types of Reorganizations
Section 368(a) lists seven types of transactions that qualify as nontaxable reorganizations. Generally, however, you would be well advised to seek a letter ruling from the IRS before you engage in one of these transactions. Under §368(a)(1),
a reorganization is defined as:
1. A statutory merger or consolidation.
2. The acquisition by a corporation, in exchange solely for all or part of its voting stock, of stock in another corporation, if, immediately after the reorganization, the acquiring corporation has control of the other corporation.
3. The acquisition by a corporation, in exchange solely for all or part of its
voting stock, or substantially all of the property of another corporation.
4. A transfer by a corporation of all or part of its assets to another corporation. If immediately after such transfer, the transferor or one or more of its
shareholders, or any combination thereof, is in control of the corporation to which the assets were transferred, but only if the securities of the recipient
corporation are distributed in a transaction that qualifies under §§354, 355 or 356.
5. A recapitalization.
6. A mere change in identity, form, or place of organization, no matter how much change is effected.
Transfers incident to a bankruptcy or receivership proceeding, if the securities of the transferee corporation are distributed in a transaction that qualifies under §354, §355 or §356.
The preceding Types of reorganizations shall be referred to throughout the remainder of this Chapter, by their numbers (i.e., type 1, type 2, etc.)
Type 1 Reorganizations
Both mergers and consolidations may be classified as Type 1 reorganizations.
The basic difference between a merger and a consolidation is that in a merger,
one of the corporations involved will retain its identity and simply absorb the
other. A consolidation, on the other hand, consists of the creation of a new corporation out of two or more prior corporations. The predecessor corporations to the merger will lose corporate existence.
Benefits and Considerations
The Type 1 reorganization will allow greater flexibility than any other proposal, in as much as there is no statutory requirement concerning the
voting stock, as is the case with Types 2 and 3.
Boot Furthermore, this plan allows for cash or other property to change hands
without disqualifying the transaction as a tax-free reorganization. The cash or other property will constitute boot, and some gain or loss may be
recognized. However, the receipt of such a boot will not alter the tax-free treatment of the receipt of stock as consideration.
If the boot is to be used, however, care should be taken to ensure compliance with the continuity of interest test. This test requires that at least 50% of
the consideration used in a reorganization must be stock or the entire transaction will become taxable.
Type 2 Reorganizations
This plan is essentially an exchange of stock for voting stock. Voting stock must
constitute the sole consideration used, however, and this rule is strictly construed
and enforced. 80% Control Requirement
Stock may be acquired either directly from the corporation or the shareholders. After the acquisition, the purchaser corporation must own at least 80% of the corporation so purchased. That is an across the board requirement. The new parent corporation must possess at least 80% of the voting power and 80% of the number of all non-voting issues.
Voting Stock as Sole Consideration If any consideration other than voting stock is used, the reorganization will not meet the statutory requirements. This rule can be a tremendous disadvantage to this type of plan.
Generally, the shareholders of the acquired corporation will act individually
in transferring their shares, and as a result, the affairs of the corporation itself are not directly involved. Consequently, no formal action is necessary on
the part of the shareholders of the acquired corporation. Furthermore, if the
acquiring corporation has sufficient treasury stock or unissued shares to affect the transaction without the need to have additional issues authorized,
the shareholders of the acquiring corporation need not take any formal action either. That is an excellent advantage in the form of simplicity.
Type 3 Reorganizations
This plan mainly involves an exchange of voting stock for a property. In order to qualify, the acquired corporation must distribute the stock, securities, and other property it receives in the reorganization, as well as any of it,’s property,
as provided in §368(a)(1)(G).
Consideration in this plan will generally consist of voting stock. There are, however, some exceptions to this general rule. §368(a)(2)(B) provides that
the use of boot will not disqualify the reorganization if at least 80% of the
value of the acquired corporation is acquired by using voting stock as consideration. Assumptions of liabilities are also disregarded in determining the
value of assets received under §368(a)(1)(C).
Transfer of Assets
This plan requires that substantially all of the assets of the acquired corporation be transferred. This requirement is somewhat nebulous in as much as there is
no statutory definition of “substantially all.” The IRS has established a general guideline for determining whether or not the substantially all test has been met.
90/70 Test. To obtain a favorable ruling from the IRS on this type of plan, the requirements of R.R. 77-37 and R.P. 86-42 must be met. These requirements are that at least 90% of the fair market value of the net assets of the corporation and at least 70% of the fair market value of the gross
assets of the corporation must be distributed.
Liquidation of Acquired Corporation
Although there is no legal requirement calling for the liquidation of a corporation acquired in this type of reorganization, the condition that
substantially all of the acquired corporation’s assets be distributed usually makes a complete distribution and liquidation the most attractive route.
Type 4 Reorganizations
This type of reorganization, unlike the first three, is not designed for mergers,
consolidations, or acquisitions in the general sense of the word. It is designed rather for corporate divisions.
Section 354 requires that substantially all of the assets of one corporation be distributed to the other corporation. Furthermore, all property received by
the transferor corporation must be distributed to such a corporation’s shareholders.
Continuity of Business
There are additional requirements, as well. Most notably that both corporations must be actively engaged in a trade or business after the reorganization, that only the assets of an active trade or business may be transferred and that there be a business purpose for the transaction.
If property other than stock or qualifying securities is distributed, such other property becomes boot and will be taxed pursuant to §356.
Type 5 Reorganizations
This type of reorganization is known as a recapitalization. That is, its purpose is
to affect a change in the capital structure of the corporation.
Type 6 Reorganizations
This type of reorganization is merely a change in identity, form, or place of organization. The remaining corporation in this plan is the same as was its predecessor. As a result, the tax characteristics of the new corporation will be the same as those of the predecessor corporation. Furthermore, NOLs’
continue to be available to carry back or forward. This type of reorganization will not affect the status of §1244 stock, nor will it terminate a valid subchapter S
Type 7 Reorganizations
The Bankruptcy Act of 1980 brought about this plan. The plan calls for the transfer of all or part of the assets of a debtor corporation in bankruptcy, receiver-
ship or similar proceeding in a federal or state court, to an acquiring corporation and the distribution of stock or other securities of the acquiring corporation
in a transaction that qualifies under §354, §355, or §356.
The creditors of the debtor corporation must receive voting stock of the acquiring corporation equal to 80% or more of the total fair market value of the debt
of the debtor corporation to such creditors.
Bona Fide Business Purpose
The requirement that a reorganization must be for a bona fide business purpose is judicial in origin and is now substantiated by regulation.
The requirements for a bona fide business purpose, as well as what may constitute a shareholder purpose, are not well defined. In the Parshelsky case,
(Estate of Parshelsky v. Comm., 62-1 USTC 9460, 9 AFTR 2d 1382, 303 F.2d 14 (CA-2, 1962), the court implied that it is sometimes impossible to draw a
line between a shareholder purpose and a business purpose.
Carryover of Corporate Tax Attributes
Determining the specific tax characteristics of an acquired corporation which are to be carried over to the acquiring or successor corporation is a significant problem in any corporate reorganization, as well as in the liquidation of a subsidiary corporation.
The recipient corporation will welcome items of credit and deduction. Other tax attributes of the acquired or liquidated corporation may hold less charm. The desirability of the tax attributes is immaterial since the carryover rules, if applicable, are mandatory.
Effect of Carry-Over on Acquisition
The carryover rules should be reviewed carefully to determine any possible application since these tax considerations may very well dictate the form that
the acquisition will take. That is perhaps most evident in the case of a liquidation of a subsidiary corporation according to §332
Application of Rules to Subsidiary Liquidations
The carryover rules will apply in the liquidation of a controlled subsidiary under §332 if the nature of the transaction results in a carryover of the basis of
the assets transferred to the parent corporation. However, if the base of assets is determined according to the single transaction approach of §338, the carryover will not apply.
10-13Loss or Tax Credit Carryovers
If the corporation being sold has net operating loss or credit carryovers, the extent such losses or credits will be available to the buyer depends on:
(1) The degree of the change in ownership
(2) Whether the acquired corporation’s business is continued
(3) The value of the acquired corporation
(4) The long-term tax-exempt rate; and
(5) Whether there is a tax-avoidance motive.
If there is an ownership change, the amount of any net operating loss carryover that can be used in any post-acquisition tax year is equal to the product of:
(1) The value of the corporation determined immediately before the ownership change, and
(2) The “long-term tax-exempt rate.”
An “ownership change” occurs for federal tax purposes only when the beneficial interest of one or more 5% shareholders increases by more than 50 percentage points within a limited period.
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