Buyer and Seller Save Big With Creative Tax Solutions

Situation Overview:

The owner of a service company that installs and maintains heavy equipment for commercial buildings was interested in selling his company and had found a buyer. The seller knew the buyer and was confident his company would be in good hands. However, the buyer did not have cash available to purchase the company up front, so the seller agreed to accept an installment note in lieu of cash.

A stock sale would have been the most beneficial to the seller because it would allow the entire sale to be taxed at the lower capital gain rates and avoid some of the problems (discussed below) that are involved with assets sold under an installment note. At the same time, a stock sale would not have been attractive enough to appeal to a buyer because it would not offer the significant tax deductions available under an asset sale*. As such, the best course of action (and the only course of action for the seller) was an asset sale.

Issues:

The owner, a longtime client of WBL, asked the firm to review his deal and identify any tax-related issues. Upon review, WBL identified two potential barriers to the transaction:

  • Because the seller had fully depreciated his fixed assets, his overall net tax basis in the assets of the company was very low but he had significant stock basis due to the cumulative earnings of the company. Therefore, the asset sale would generate a much larger gain due to the agreed-upon purchase price allocation and thus a much larger tax liability than a stock sale.
  • Assets and liabilities transferred in the sale include fully depreciated fleet vehicles and their notes-payable. Tax rules require that transfer of these assets and liabilities be recognized as additional income to the seller in the initial year of sale rather than over the life of the installment note. Therefore, as a result of the installment sale, the seller would not receive enough cash in the first year to cover his first-year tax.

Action:

To avoid triggering additional income in the initial year of sale and help reduce some of the seller’s overall taxable gain, WBL recommended:

  • The seller should retain the title and the note obligations of the fleet vehicles and instead lease the vehicles to the buyer under a bona fide operating lease.
  • Use the proceeds of the installment note coming into the seller’s company to redeem the selling company’s stock.

Outcome:

The lease arrangement reduced the overall gain on the assets and the sales proceeds being recognized in the initial year.  This reduced the seller’s initial year tax liability by almost 50% and his overall tax liability by almost 4% compared to his liability had he included the fleet vehicles in the asset sale. The proceeds from the installment note were now sufficient to cover the tax in the year of sale.

Redeeming the seller’s stock created a capital loss for the seller, partially offsetting the gain on the sale of the assets and making it equal to the gain that would have been realized under a stock sale. The redemption of stock reduced the seller’s overall tax liability by over 20% compared to an asset sale with no redemption of stock.

As a result of these two actions, the deal now had beneficial tax and cash flow outcomes for both parties by:

  • Creating an overall tax liability savings to the seller of around 25%, including almost 50% in the initial year of sale, and
  • Providing the buyer with significant tax deductions that can be claimed during the 15 years following the purchase.
* An asset sale can be the purchase of all or some of the assets and liabilities of a company. The sales price of an asset sale is allocated amongst the assets according to each asset’s fair market value and becomes the buyer’s tax basis in these assets. Often, the value allocated to the asset is greater than the seller’s tax basis, resulting in an increase in the basis of these assets in the hands of the buyer. This can generate significant tax deductions for the buyer during the tax life of the assets purchased.