Buying and Selling Pass-Through Entities Presented By Sno Barry, CPA, MST, Principal Justin Morren, CPA, Senior Tax Specialist
Agenda 1 Asset vs. Stock Sale 3 Partnerships Buyer and Seller perspective Form 8594 Treatment Potential complications Installment Sales Income Allocation 2 S corporations Treatment Section 338(h)(10) Potential Complications Installment Sales Income Allocation 2
Generations Baby Boomers Born between 1946 and 1964 Millennials Born between 1977 and 1995 3
Asset Sale Asset vs. Stock Sale Stock Sale Assets Liabilities Other unknowns Stock 4
Asset Purchase with Liquidation Owners Acquiring Before After $ $ Acquiring $$ Assets Target Target
Allocation Method Form 8594 Allocate the purchase price to the assets using the residual method Section 1060. Asset Classes Class I: Cash Class II: Actively traded personal property, cds, foreign currency Class III: A/R, mortgages, credit card receivable Class IV: Inventory Class V: All assets not in classes I IV, VI & VII (PP&E) Class VI: Section 197 intangibles, except goodwill Class VII: Goodwill 6
Stock Purchase Before Owners After Acquiring Acquiring Target Target
S corporation Example Stock Sale X is an S Corporation 100% owned by A A s basis in X stock is $2,000 B purchases A s stock in X for $5,000 Proceeds $5,000 Basis $2,000 Taxable gain $3,000 Taxes (20%) $600 After-tax cash $4,400 8
S corporation Example Asset Sale X is an S Corporation 100% owned by A A s basis in X stock is $2,000 B purchases X s assets (other than cash) for $5,000 Cost A/D AB FMV Cash 1,000 1,000 1,000 Inventory 200 200 200 Equipment 2,300 1,800 500 1,200 Land 1,500 1,500 1,600 Building 3,000 1,200 1,800 2,000 Debt (1,000) 0 (1,000) (1,000) Total 7,000 3,000 4,000 5,000 9
S corporation Example Asset Sale B purchases X s assets (other than cash) for $5,000 FMV AB Gain Inventory 200 200 0 Equipment 1,200 500 700 1245 Land 1,600 1,500 100 1231 Building 2,000 1,800 200 1250 Total 5,000 4,000 1,000 10
S corporation Example Asset Sale Tax on asset sale Gain Tax Rate Tax Inventory 0 0 Equipment 700 35% 245 Land 100 20% 20 Building 200 25% 50 Total 1,000 315 11
S corporation Example Asset Sale A s Stock Basis BOY 2,000 Gain -assets sold 1,000 Distributions (5,000) Distributions in excess of basis (2,000) Tax Rate 20% Tax 400 Tax on Gain assets sold 315 Total taxes 715 Distributions 5,000 Total taxes (715) After-tax cash $4,285 12
S corporation Example Comparison Stock Sale Asset Sale After-tax cash= $ 4,400 After-tax cash = $ 4,285 Taxes= $600 Taxes= $715 Additional proceeds gross-up: X-(LTCG rate * X)= after-tax cash X (.20X) =$115.80X = $115 X= $575 13
S corporation Section 338(h)(10) Section 338(h)(10) Election Best of both worlds stock sale treated as asset sale for tax purposes How does it work? Deemed sale of assets by target and subsequent distribution of proceeds to its shareholders Target reports gain on sale of assets Stock sale ignored for tax purposes Target is new corporation for tax purposes has stepped-up basis in the assets 14
S corporation Section 338(h)(10) Section 338(h) Election Requirements Purchaser must acquire at least 80% of target stock in a taxable transaction Buyer must be a C corporation For non C corporation buyers consider section 336(e) The target entity must be one of the following An S corporation A subsidiary that filed with a consolidated group A corporation that is 80% controlled without filing consolidated The election requires that both parties agree Both the buyer and seller need to complete Form 8594 15
S corporation Potential Complications Potential S Corporation Complications Missing copies of S election and/or Qsub elections Missing spousal consent Impermissible Shareholders (certain trusts) More than one class of stock Non-arm s-length related party transactions Unreasonably low compensation Built-in gains tax 16
S corporation Installment Sale Installment Sale Stock sale Asset sale S Corporation asset sale with liquidation - distribution of installment note will trigger gain unless section 453b(h) rules are followed 17
S corporation Income Allocation Income Allocation in the Year of Sale S corporations If 50% or more of stock is transferred in year of S termination then must close the books, if less than 50% stock transfer a prorata allocation based on days is the default. One tax return is filed. Changes in ownership Per-share, per-day rules Election to use specific accounting is allowed under certain circumstances 18
Liquidation Partnership Liquidation Partnership assets are distributed at their inside basis except for hot assets which are distributed at FMV if disproportionate distribution A partnership liquidating distribution generally does not result in a gain or loss unless.. money is distributed in excess of basis capital gain only money and/or hot assets are distributed and these are less than basis capital loss 19
Partnership Liquidation Partnership Liquidating Distribution of Cash and Other Property Basis before distribution $23,300 Less cash distribution ($15,100) Subtotal $8,200 Less equipment at tax basis ($5,900) Loss not recognized $2,300 No capital loss to partner. Instead, the equipment now has tax basis of $8,200 in his hands, his partnership interest basis after the cash distribution. 20
Partnership Liquidating Distribution of Hot Assets Partnership Liquidation Basis before distribution $20,623 Less inventory at tax basis ($13,200) Loss recognized $7,423 Now the partner recognizes capital loss. The inventory has a basis of $13,200. 21
Partnership Interest Sale three categories Partnership Sale of Interest 1) Sale of less than 50% of partnership interest with a continuing partnership 2) Technical Terminations caused by sale of a partnership interest 3) Actual terminations caused by sale of a partnership interest 22
1) Sale of less than 50% of partnership interest with a continuing partnership standard rules Partnership Sale of Interest Example - Partner s basis schedule for the first three years of ABC partnership. A sells his entire interest in the partnership to B for $50,000 at the end of year 3. A B C Total Capital contribution 50,000 50,000 50,000 150,000 Assumed share of 283,333 283,333 283,333 850,000 partnership liabilities Year 1 Loss (30,000) (30,000) (30,000) (90,000) Year 2 Loss (30,000) (30,000) (30,000) (90,000) Year 3 Loss (30,000) (30,000) (30,000) (90,000) Ending basis 243,333 243,333 243,333 730,000 23
1) Sale of less than 50% of partnership interest with a continuing partnership standard rules Partnership Sale of Interest Seller s Treatment - Partner A recognizes a gain: Cash Proceeds 50,000 Partnership debt transferred 283,333 Amount Realized 333,333 Adjusted Basis in the partnership 243,333 (remaining debt basis) Gain recognized 90,000 24
1) Sale of less than 50% of partnership interest with a continuing partnership standard rules Partnership Sale of Interest Buyer s Treatment - Partner B gets an increase in outside basis: A B C Total Capital contribution 50,000 50,000 50,000 150,000 Assumed share of 283,333 283,333 283,333 850,000 partnership liabilities Year 1 Loss (30,000) (30,000) (30,000) (90,000) Year 2 Loss (30,000) (30,000) (30,000) (90,000) Year 3 Loss (30,000) (30,000) (30,000) (90,000) Ending basis 243,333 243,333 243,333 730,000 Transfer (243,333) 283,333-40,000 Cash Paid 50,000-50,000 Ending basis 0 576,666 243,333 820,000 25
1) Sale of less than 50% of partnership interest with a continuing partnership standard rules Partnership Sale of Interest Buyer s Treatment Continued - Partner B gets an increase in inside basis if Section 754 election in place: B s share of inside basis after purchasing A: Cash 30,000 Building 1,000,000 A/D (300,000) 730,000 243,333 A s inside basis sold to B (1/3 of total) 333,333 B s outside basis purchased from A 90,000 Section 743 Step up 26
Practical Considerations of Section 754 election Partnership Sale of Interest Keep a copy of Section 754 election in perm file Must have a triggering event to make 754 election In year of initial section 754 transaction election must be signed by the due date of the return, including extensions For section 743 transactions a statement must be included with the return that includes the following Name & EIN of transferee partner Computation of section 743 adjustment Partnership properties to which the adjustment is allocated The recovery of the adjustment should be included on the face of the K-1 Consider ongoing cost of Section 754 election 27
2) Technical Terminations caused by sale of a partnership interest Partnership Sale of Interest A technical termination occurs when there is a sale or exchange of 50% or more of partnership capital and profits interests within a 12 month period Seller recognizes gain in the same way as in 1 Buyer calculates outside basis same way as in 1 28
Practical Considerations of a Technical Termination Partnership Sale of Interest Two tax years final return and technical termination boxes checked, statement attached, practitioners disagree on whether or not to zero out final Schedule L Depreciation lives restarted New partnership has clean slate for tax accounting methods, year end, and elections Old partnership basis adjustments from section 754 carryover to new partnership however the new partnership will need to make a new Section 754 election to cover future exchanges EIN stays the same If an upper tier partnerships is technically terminated this can cause lower tiers to technically terminate as well 29
3) Actual terminations caused by sale of a partnership interest Rev. Rul. 99-6 Partnership Sale of Interest Situation 1 pre-existing ownership Partner A $$ Partner B (Acquiring) Target 30
3) Actual terminations caused by sale of a partnership interest Rev. Rul. 99-6 Partnership Sale of Interest Situation 2 no pre-existing ownership Acquiring Partner A Partner B Target 31
Potential Partnership Complications Probably need to amend partnership agreement Partnership Potential Complications Stepping into the shoes of your predecessor s economic and tax attributes Capital accounts Do tax allocations make sense? Partnership year end change Required change from cash to accrual Entity level taxes (withholding, employment, state, etc.) Disguised sale rules Anti churning regulations Form 8308 32
Partnership Installment Sale Installment Sale Sale of assets for installment note follow normal installment sale rules Distribution of installment note no gain recognized unless disproportionate distribution (hot asset rules) Sales of partnership interest qualify for installment sale treatment (except for hot assets). This can result in beneficial treatment for seller and buyer Distinction between partnership interest redemption and sale is important 33
Income Allocation in the Year of Sale - Partnerships Partnership Income Allocations Must close the books for all partners if the partnership terminates; two tax returns are filed for technical terminations. Changes in interest varying interest rules The interim closing method The proration method 34
Questions? Sno Barry Principal sbarry@berrydunn.com 207-991-5191 Justin Morren Senior jmorren@berrydunn.com 207-991-5137 35