There may be errors in spelling, grammar, and accuracy in this machine-generated transcript.
Jeremy Wells: In the previous episode, we discussed s corporation stock sales. When a buyer wants to acquire an S corporation, one option is to purchase all of the stock, whether that's one shareholder or a bunch of shareholders. The buyer can come in and offer to buy [00:00:30] 100% of the stock. And then that buyer. Once that transaction closes, owns the entire entity along with everything owned by it, all of the operations, the brand name, everything. That's one option when it comes to acquiring a business. But buyers often prefer a different approach. And that's what we're going to talk about in this episode, and that's [00:01:00] purchasing just the corporation's assets directly. In other words, instead of buying the entire entity and everything within it, you just buy the stuff that actually produces income for the business. You just buy the assets, you buy the operation itself, but not the entity. One way to think about this is buying the shell and everything that's inside the shell, or just cracking open [00:01:30] that shell and buying only the stuff inside of it and leaving the shell behind. This gives some opportunities to the seller. Also, maybe the seller wants to hang on to the name of that entity that they registered, but they're done with the current business operations going on inside of it. So there are reasons that both a buyer and a seller might prefer an entity sale or a stock sale, as opposed to an asset sale. So [00:02:00] rather than purchase the equity and own the entire corporation, the buyer can just purchase the assets.
Jeremy Wells: And if you understand how a balance sheet works, just owning the assets means you don't own the liabilities that might go along with them. And those would stay with the entity which the seller would keep. So that's one reason that a buyer might prefer an asset sale over a over a stock sale. [00:02:30] Again, there are going to be some advantages and trade offs for both the buyer and the seller, depending on whether they do a stock or an asset sale. But an asset sale requires some additional analysis and some explicit agreements made between the buyer and the seller in order to make the transaction work, both for financial accounting and for tax reporting purposes. So in this episode, we're going to break that down. [00:03:00] We're going to discuss the key considerations of an asset sale, specifically focusing on S corporations, since those tend to be the most common in firms like mine. Although a lot of what we're going to talk about is actually from subchapter C of the Internal Revenue Code. And so it applies to C corporations as well. But we're going to talk about what an asset sale looks like, how to report one, and what the effect of that asset sale is on the corporation and [00:03:30] its shareholders. So in this course, you are going to be able to do the following by the end of it.
Jeremy Wells: First of all, identify the key considerations of S corporation asset sales. What all goes into it. What do we need to be aware of. And toward the end we're going to wrap up with what are some of the questions that we need to be asking. And what are some of the things about the transaction that we need to review. I'm also going to be able to report the. Applicable asset acquisition. [00:04:00] That's the technical term for this kind of transaction using form 8594. We'll talk about form 8594 and the information that goes into that, and how that form categorizes the different kinds of assets that are part of that asset sale. We're also going to explain the tax treatment of goodwill and other section 197 intangible assets. Goodwill is a concept that I see come up quite [00:04:30] a bit in the discussion of small businesses, especially when it comes to mergers, acquisitions, what the balance sheet should look like. So we'll talk about what exactly goodwill is when goodwill comes into play, how it's created in terms of what actually gets reported on the balance sheet and a lot of things that are considered to be like goodwill, but really are a separate category when it comes to reporting an asset [00:05:00] sale. We're going to look at IRC section 1060. And that is the section of the code that tells us how these asset sales work. It also introduces something called the residual method.
Jeremy Wells: And that's the method we're going to use to allocate the purchase price of all of those assets to the individual assets themselves. Because we're also going to look at how to analyze the gains from an asset sale [00:05:30] and how those gains are going to have different characters depending on the assets that are sold. So we know that different kinds of assets are treated differently depending on what kind of asset they are. Some business assets are section 1245. Some business assets are covered by section 1250. A lot of them are section 1231. Some of them are something else, like section 197. So we're going to talk about how all of that plays into [00:06:00] the accounting and reporting of an asset sale. So let's start off with some basics about asset sales. I'm going to start off with a fairly simple example. But this is actually pretty common. And it's like a lot of the examples that the the real cases actually that I've come across in my own firm. So let's call this business lighthouse LLC. It's an S corporation with [00:06:30] a single 100% shareholder, let's call her Jessica. And she has offered a purchase price of $1 million for this S corporation. And her current stock basis is $250,000. Now, if we look at the balance sheet of lighthouse LLC. Then we're going to see the different assets that that's corporation currently has. So I'm going to list these. And I know this might be a little difficult [00:07:00] over sound if you're if you're just listening to this, but I will, uh, we'll come back to this and break it down a little bit further later on.
Jeremy Wells: So don't worry about whether you remember these amounts or not, but I'm just going to list these just to give you an idea of what situations like this can look like in the real world, and what we actually need to know, and how we translate that balance sheet into the form 85, 94. And then eventually, uh, whether there's any taxable gain to [00:07:30] the shareholders. So let's just assume that right now on the, on the date that this sales transaction might actually close, let's say lighthouse LLC has cash of about $50,000 accounts receivable of about $100,000 equipment with a tax basis of $100,000. But because equipment tends to wear out and not retain its value as well over time, let's say that equipment actually has a fair market value of just $50,000. [00:08:00] Then we've got a building that has a tax basis of $300,000, but a fair market value of $400,000, and land with a tax basis of $100,000 and a fair market value of $150,000. Now, beyond that, lighthouse LLC also has some assets that you won't find on the balance sheet. Every business has to sell, whether it sells [00:08:30] goods or services, has to sell to some customers. And some of those customers will be repeat customers, recurring customers. They might be subscribers, or they might be customers that have been buying from this business for years, and their buying pattern is fairly consistent.
Jeremy Wells: So you can track over time, you could use a customer relationship database or CRM to be able to track this information over time. But let's just [00:09:00] say that lighthouse LLC has a customer list, and lighthouse LLC can reliably estimate the periodic income, whether that's monthly or quarterly or annually from that customer list. And so the buyer has a valuation of that customer list of $100,000. Now that's just going to be an amount that maybe [00:09:30] an appraiser comes up with. If we went as far as hiring a business analyst, a business valuation analyst to come in and look at the business, look at its customer relationships, look at its, you know, 5 or 10 largest customers and what kind of, uh, activity they have over time. Maybe compare lighthouse LLC to other similar businesses and how much revenue they tend to generate from their customer list or their most active customers. There's a lot of [00:10:00] different ways that we could go about assigning a value to something like this. But the important thing to keep in mind at this point is that an intangible asset like this, like a customer list, it's not on the balance sheet. It's not on the depreciation schedule. There's no tax basis there. It's what we call a self-created or self-generated intangible asset, which means there's nothing actually reported anywhere for it.
Jeremy Wells: But we know it exists. We know that the business economically [00:10:30] has some value in its customer list, in the top 5 or 10 customer relationships that it has. And that by itself is valuable in the marketplace, even though for tax and accounting purposes, we don't assign a value to that to the balance sheet. Now, this might be one of the criticisms of how accounting works, in that we have economically valuable aspects of businesses that aren't actually reported [00:11:00] on the balance sheet. But the problem is that something like this, like a customer list, it really doesn't have a fixed value. There's no historical cost there. And so we would constantly be guessing at what it's actually worth. And in those kinds of situations, often the best way to figure out what it actually is worth, what something that is an intangible asset that doesn't have an historical cost. The best way to figure out what something like that is worth is to find out what a willing buyer would offer [00:11:30] to pay to a willing seller for it. And in that case, once we have this transaction happen, that will give us an idea of that. So even though these assets don't actually show up in the financial or tax reporting of the business. We know they exist, and we know the market is going to put some sort of value on them. What that value actually is, we really can't know until there's actually a sale.
Jeremy Wells: And at that point, [00:12:00] we need to figure out what amount of value out of the entire purchase price was allocated to it. And that's really what we're going to talk about in this episode. That's what we're trying to get at with that residual method. That's what we're trying to get at with form 8594, and the negotiation and the process that leads up to actually preparing that form. So if we go back and we look at those, that list of assets, and [00:12:30] we compare the actual tax basis to the fair market value, you'll see that the fair market value is a little bit below what that purchase price was. So far I've listed off $850,000 worth of assets, but the purchase price was $1 million even. And that's because like that customer list, there's another intangible asset that will be part of this transaction. And that's goodwill. And I'll talk about goodwill here in a minute. And so [00:13:00] if we use the residual method, we apply the residual purchase price to goodwill. Then that brings us up to that $11 million for the total FMV against a tax basis of approximately $550,000. So in a stock sale, and again, if you haven't listened to the previous episode on stock sales, go back and listen to that. But in a stock sale, Jessica would simply sell her entire [00:13:30] interest in the corporation for $1 million. Right? She'd be selling her stock. So everything that we just talked about, about what's on the balance sheet with the tax basis versus fair market value of all those assets, is none of that would be relevant, at least not as far as Jessica is concerned, because she would be selling her interest in the business.
Jeremy Wells: The entire business along with the entity. Everything would then be sold to the buyer. In that case, the only thing, [00:14:00] the only information we would need to know is what the purchase price is, $1 million, and what Jessica's basis in her stock is, because that's what she's selling. She's selling her stock, she's selling her interest in the corporation. And if her basis in that stock is $250,000 and she sells it for $1 million, then she has a gain of $750,000. And that's fairly straightforward. Stock sales are relatively simple [00:14:30] from especially from the perspective of the seller. I own 100% of this business. My basis that I've tracked over time through preparing timely and correct tax returns, is this much I'm selling the business for this other amount, and my gain on that sale is just a difference between those two numbers. But the buyer usually doesn't want to acquire the entire [00:15:00] interest in the business. There might be other things going on with that entity. There might be aspects of that entity, of that business that the buyer is not interested in purchasing. And in this case, we're going to assume that this buyer is actually not interested in a stock sale.
Jeremy Wells: The buyer only wants the assets of the business because LLC, this this LLC lighthouse LLC has significant liabilities on the balance [00:15:30] sheet related to the purchase of the property, plant and equipment that is listed there in the asset section of the balance sheet. So instead, the buyer just wants to acquire the assets. Now in that case, once that purchase was done and for the same amount of proceeds, once that purchase was done, the corporation would then have cash from those proceeds to be able to pay off those liabilities. And so we'd wind up with a relatively [00:16:00] similar situation, at least as far as Jessica is concerned, but it's not going to be the exact same situation. And so later on, when we wrap up the discussion of how these asset sales work, we'll come back to this example and we'll look at the difference of treating this transaction like a stock sale, which again, is relatively straightforward, simple. We've already calculated what that gain would be. Compare that to what the result of an asset sale would be. Now when a target [00:16:30] corporation, right. So the the corporation that's going to be acquired by the buyer, sells its assets to a buyer, then generally that transaction could be what's called an applicable asset acquisition. And this is where IRC section 1060 comes into play. In an applicable asset acquisition, the assets constituting a trade or business [00:17:00] are sold, and the buyer's basis in those assets is determined by the purchase price.
Jeremy Wells: Those are the two criteria given in section 1060 for an applicable asset acquisition. If the transaction meets both of those criteria, then section 1060 applies to that transaction. It's not optional. Uh, if the transaction meets both of those criteria, then [00:17:30] this code section applies The first criterion is that the assets constitute a trade or business. In other words, it's not just selling 1 or 2 assets in a corporation that has dozens of assets on the depreciation schedule. It's not even maybe just half of the assets, although maybe this business exists as two separate departments. Let's call them, that are operating under the same business. And the [00:18:00] seller wants to divest this target corporation of just one of them. And so maybe it's spinning off an operation. It's possible that the assets that are grouped together might comprise on their own, a trade or business. They might constitute a trade or business. In this case, we're going to stick with a more simplified sort of way of thinking about this. And just look at a single business with a single operation and whether that's a [00:18:30] couple of assets or dozens of assets, but collectively, all of those assets combined are what constitute that trade or business. And then second, the buyer is purchasing those assets with the intent of establishing basis in those assets relative to the purchase price that was offered for them.
Jeremy Wells: This [00:19:00] gets into one of the benefits of an asset sale for a buyer that we'll discuss a little bit later on how this works. But one of the main differences between a stock sale and an asset sale is that after an asset sale, the buyer owns the assets directly in a stock sale, the buyer owns the entity and the entity retains ownership of its assets. So in other words, the depreciation [00:19:30] of those assets doesn't change in the course of a stock sale because the ownership and the valuation of those assets hasn't changed. In an asset sale, though, it's the opposite. Those assets are directly purchased and therefore now have different ownership by the buyer than they did under the seller. And in that case, because [00:20:00] we have purchased them, they now have new owners. We allocate the purchase price to those assets. And the depreciation of those assets resets at their new valuation after the transaction closes. So in other words, if someone buys a business by purchasing its assets, then section 1060 is going to control how the price is allocated to those assets and then the buyer. [00:20:30] It's as if the buyer purchased those assets from the manufacturer or from the retailer. It's going to be an original placement into service of those assets by the buyer. And so depreciation is going to start all over again. And the beginning basis of those assets for depreciation purposes is going to be the allocated purchase price, not the historical cost that [00:21:00] the target paid for them.
Jeremy Wells: So this can provide some pretty significant benefits to the buyer relative to a stock sale in a stock sale. Nothing about the depreciation schedule changes. Nothing about the ownership of those assets changes. And so if you have an asset that is partially depreciated and you have a stock sale, then those assets still have that same amount of depreciation. They still have the same amount of remaining useful life for purposes of depreciation. And none of that information [00:21:30] is going to change. Now, all this matters because the buyer, of course, is going to start depreciating those assets that it just purchased based on the allocated purchase price, not based on the buy, the the target's historical cost, not based on what the target originally paid for them, but based on what the buyer has paid for them now. And so this can be especially important with assets that have appreciated in market value. So [00:22:00] if you take assets that typically appreciate in value, such as real estate, and if real estate is included in an asset sale, then that potentially gives that buyer a step up in the basis offering them an opportunity to claim more depreciation expense over the useful life of that asset. But it's entirely possible that that can happen with any kind of asset. What ends up mattering is how much the purchase price [00:22:30] is, how that purchase price is allocated, how much of it is allocated to each asset, and then compare that to the remaining, uh, adjusted basis of that asset in the hands of the target just before it was sold.
Jeremy Wells: And that might actually lead to a step up in basis as well, even if the asset hasn't appreciated in value. It just depends on how the mathematics of the price allocation, the purchase price allocation works [00:23:00] out. Also, the seller is going to recognize gain or loss on the sale of those assets based on the allocated purchase price as well. And different assets will generate different tax consequences. So we have to look at whether the asset produces ordinary income versus capital gain. Whether there's depreciation recapture and [00:23:30] what code section, and therefore what rules are going to determine what kind of depreciation recapture and how much depreciation we have to recapture. And then some assets are going to be treated separately from other assets. So for example, some of those intangible assets that we talked about, such as that customer list or goodwill, are going to have a separate set of rules about how those assets are amortized under section 197, as [00:24:00] opposed to how they're going to be depreciated under section 167 or 168. And then also whether those depreciation recapture rules under section 1245 or section 1250 are going to apply to that asset. So even though we're lumping all of the assets together and selling them off in this asset sale.
Jeremy Wells: And now we have the purchase price. We're then going to have to go through a process of [00:24:30] allocating the purchase price to those assets. And at that point, treat each individual asset as if it were sold one at a time. And look at the asset and what are the rules as far as depreciation recapture. What are the rules as far as ordinary income versus capital gain? And from there, determine what the gain or loss on each individual asset is. And then add [00:25:00] that all back up and still keeping the different characters of gain or loss separate from each other. And then report that at the entity level to the shareholders, because again, the entity still exists and the entity is still owned by the original shareholders. The entity is not involved in an asset sale, at least as far as being the target. The assets that the entity owns are the target, [00:25:30] not the entity itself. So we'll talk through the mechanics of how a lot of this works. Now, the first step under IRC 1060 to work toward allocating the purchase price is what's called the residual method. And that's that's how we're going to figure out how to allocate that purchase price to assets. That purchase price will get allocated sequentially across seven different asset classes. [00:26:00] And we go in order from class one through class two and three all the way up to class seven. And you can think of these classes, uh, very similarly to the way you would read down the asset section of a balance sheet and the asset section of a balance sheet.
Jeremy Wells: If you're not familiar with balance sheets and how those work, usually, as we read from top to bottom [00:26:30] on a balance sheet, the categories listed toward the top of that page generally are more liquid, meaning they're they're either cash or closer to cash, whereas the assets listed later are going to be less liquid. Those are going to be the heavier assets or the intangible assets. And so as we're going through these classes, really it's just thinking about reading down the sheet of a balance sheet. So the first class [00:27:00] is cash and deposit accounts. Again this is going to be the most liquid kind of asset. So this will be things like checking accounts, savings accounts, money market accounts, accounts that are easy to convert to cash or are already cash Class two is actively traded personal property, certificates of deposit and foreign currency. So these are things that are not necessarily cash. There might be some restrictions [00:27:30] on them. So for example foreign currency would need to be converted into domestic currency into dollars. Certificates of deposit are going to have some limitations on when withdrawals could be made. Otherwise there might be early withdrawal penalties. So even though the cash might be accessible, there would be some cost in doing that and then actively traded personal property. Again, this is going to be things like stocks and bonds.
Jeremy Wells: So [00:28:00] those things could be sold on the open market. But there's probably going to be some brokerage fees or some transaction fees applied to that. There might be a holding period to wait for the money to actually transfer after the transaction closes. So they're going to be some limitations, but they're going to be relatively easy to overcome. Class three is accounts receivable and debt instruments. The main thing here is going to be accounts receivable. So for a lot of businesses that are invoicing [00:28:30] and then collecting payments after those invoices have been sent, they will have accounts receivable on the books. Now the important thing to remember for class three assets for accounts receivable. And I believe I mentioned this earlier when we were looking at the balance sheet of lighthouse LLC in the example, is that accounts receivable for a cash basis, taxpayer is going to have zero basis because accounts receivable [00:29:00] for a cash basis, taxpayer represents uncollected revenue. And we're not dealing with unearned revenue in a cash basis business. And we're not recording revenue that has been invoiced but hasn't been collected yet. We don't record that revenue until the invoice is actually paid. So from a cash basis standpoint, accounts receivable doesn't even show up on a balance sheet. But we know that [00:29:30] there is some value there because that represents future cash basis revenue. And so when a seller is going to sell the business including the accounts receivable, they will expect to get some value back out of that from the seller.
Jeremy Wells: Now it might not be 100% of what accounts receivable is, because there might be some work that goes into collecting on those invoices. There might be some clients or customers that just will never pay. There might be some bad debt there, but in general, there's going [00:30:00] to be some significant value, um, usually somewhere along the lines of 80, 90, maybe even 95% value of accounts receivable that's going to be included in the purchase agreement. Class four is inventory. Inventory can be sold obviously depending on the market. If the market's slower then it's going to be more difficult to sell inventory. Or that inventory is going to be sold [00:30:30] at a lower value than what it could have been sold at in a better market. And so class four inventory, this is still somewhat liquid, but it's definitely not as liquid as cash or CDs or foreign currencies. Class five is tangible assets. And here's where we start getting into more of the fixed assets part of the balance sheet. So here we're talking about furniture, equipment, vehicles, buildings, land, anything that you conjure [00:31:00] up in your mind as an actual tangible asset of a business. Class six is intangibles except for two categories. The first one is goodwill and the second one is going concern of value. We'll talk about those more. Those will be class seven.
Jeremy Wells: But all other intangibles that are held by the business are going to be class six. This is going to be trademarks, customer lists and an important one here is covenant not to compete. That is specifically a class [00:31:30] six intangible that's going to come up and be important here in a minute. When we talk about selling service based and professional businesses. Now those classes are defined in treasury regulation. Section 1.3386 B 2338 is a section that deals with these kinds of asset sales in subchapter C. And so the regulations here are all about how those asset sales work. This particular [00:32:00] section here is about this residual method and the how we think about these assets. And therefore classifying different assets into these different groups in order to facilitate thinking about allocating the purchase price. Now I mentioned goodwill and going concern. Treasury regulation section 1.161 B two defines goodwill as [00:32:30] the value of a trade or business attributable to the expectancy of continued customer patronage. This expectancy may be due to the name or reputation of a trade or business, or any other factor. It also defines going concern value as the additional value that attaches to property because of its existence as an integral part of an ongoing business [00:33:00] activity, and includes the value attributable to the ability of a trade or business or a part of a trade or business to continue functioning or generating income without interruption, notwithstanding a change in ownership.
Jeremy Wells: It also includes the value that's attributable to the immediate use or availability of an acquired trade or business, such as, for example, the use of the revenues or net earnings that otherwise would not be received during [00:33:30] any period if the acquired trade or business were not available or operational. So these two concepts goodwill going, concern, value. They're similar. They're a little bit different, but they're given their own class when it comes to categorizing the assets of a business and an asset sale. And this is going to matter when we talk about reporting these sales on an on form 8954. Now, goodwill and going concern can represent [00:34:00] a few different aspects of the business, such as Reputation. Brand recognition. Having a well-trained workforce. Now the actual equipment that that workforce uses, those would be separately. Those would be separate assets. Those would be tangible assets. But it's not just about the tools or equipment they're using. It's about their ability to use them well, it's whether they're trained or not. So if you have a well-trained workforce that's [00:34:30] going to have higher goodwill, higher going concern value than a more junior or less well-trained workforce, the ability to earn a profit is another example of this standard operating procedures. And this is something that I go over with my clients a lot, especially even if you're just a solo operator and you have in your head all of the knowledge you need of how to operate, how to best serve your clients, it still can be valuable [00:35:00] to document that externally, to put that into writing.
Jeremy Wells: To put that into a set of written out notes that are in a word document, or a Google document or some other kind of external place, so that if you ever did hire staff, or if you ever did want to sell your business, you could be able to point to those SOPs or standard operating procedures as evidence of your business having documentation of the way it [00:35:30] operates. And therein lies a going concern value. It's part of your business that exists absent you. You might be the only worker in the business. You might be the one who wrote up all those SOPs. But if you write them in such a way that someone else who has similar training and education and background to you could step into your position and start following those SOPs, and the business would continue operating, then that makes the business [00:36:00] itself valuable to some extent. Application of modern technology is another factor here in goodwill and going concern. So just because a business has SOPs and just because it has a trained workforce, if it's not taking advantage of the most up to date modern technology, then that could be a hit against its potential value to a buyer. And then another example here is a consistent pipeline [00:36:30] of leads and prospective customers. This is going to tie a lot of these different concepts together.
Jeremy Wells: So things like reputation and brand recognition. A lot of inbound marketing. Those are the kinds of things that are going to generate leads independent of the owner trying to go out and round up business. There are other aspects of the business in place and that are accessible to the market, that are going to generate those leads and prospective customers, independent [00:37:00] of the owners or even the rest of the staff's current efforts to try to bring in business. Now, in many professional and service based businesses, goodwill actually is the largest asset. I work with a lot of small service based businesses, and they might have a couple of employees. They might have some, you know, some technology applied. They might have a well-trained workforce. But really, the what they don't have a lot of is fixed [00:37:30] assets. They don't have much in the way of equipment, no property or plant, nothing like that. But what they do have is a lot of knowledge know how and therefore goodwill. Now, like I said earlier, you won't see that on the balance sheet because goodwill does not exist, or at least it doesn't exist for purposes of financial and tax reporting. Until you can actually assign a value to it, and you can't do that until you have a buyer that is willing to pay for it. [00:38:00] And once that transaction goes through and the buyer and seller assign a value to goodwill, then and only then do you have goodwill on the balance sheet, and it's going to be on the buyer's balance sheet.
Jeremy Wells: Now, it's possible that a target has goodwill on its balance sheet if it acquired a business in the past. And so then you could see goodwill on a balance sheet of a target. [00:38:30] You could purchase a target that has goodwill on its balance sheet. But that goodwill would not have been self-generated. It would have been acquired through the purchase of another business at some point in that Target Corporation's past. Back to thinking about these professional and service based businesses. Yes, goodwill is usually their largest asset, even if you don't see it on the balance sheet yet because it hasn't been acquired yet. Now covenants not to compete are a separate [00:39:00] asset type. Those are class six assets, not class seven. But often those covenants not to compete are a significant part of the acquisition. The purchase agreement between the buyer and seller in purchasing professional and service based businesses, you have one professional firm that buys out another local professional firm, whether that's an accounting firm or a legal firm or an architectural firm. And [00:39:30] as part of that process, the acquiring corporation doesn't want to immediately find itself competing with the owner of the business that it just acquired. And so part of that purchase agreement will usually include a stipulation that there will be a covenant not to compete.
Jeremy Wells: In other words, the owner of the target corporation will agree that for the next year or two years, that individual [00:40:00] won't start a new business that's in the same line of business as the one they just sold. Those are separate intangible assets. They're not part of goodwill. Remember, goodwill is the residual. After we assign value to asset classes one through six. Six is something like a covenant not to compete. Goodwill is the residual after all of that. There are a couple of important tax [00:40:30] court cases that deal with goodwill and covenants not to compete. Leroux v Commissioner 37, Tax Court 391961. And then Martin Ice Cream Company v Commissioner 110 Tax Court 1891998 in Martin Ice Cream. The court distinguished between personal and corporate goodwill. This is another important planning point, especially if you're dealing with the acquisition of a professional firm, [00:41:00] especially a small professional firm. In cases where goodwill exists because of the direct personal relationships between a key individual in the business and vendors, suppliers, customers, then the court held that the goodwill is actually personal to the individual and not an asset of the corporation. So in this case, we would have to separately identify that individual's goodwill and that individual would personally [00:41:30] calculate gain based on the sale, based on whatever proceeds were applied to that. So it's important to understand that even though goodwill exists in a business, we can't allocate value to it until there is a sale.
Jeremy Wells: It might exist economically long before the sale, but internally generated goodwill is generally not recorded on the balance sheet, whether for financial or tax reporting purposes, it's never appropriate to assign [00:42:00] any non-zero value to goodwill until there is a sale. I will sometimes see tax professionals or accountants asking if it's okay to add goodwill to the balance sheet, because the business has some innate value that's separate from. No, it's never appropriate to just add goodwill, especially self-generated goodwill, to a balance sheet, except for when we have a sales transaction. Goodwill is a section 1231 asset for [00:42:30] the seller. It is an amortizable business asset. But then in the hands of the acquirer, it is a section 197 intangible asset for that buyer. So it's going to be amortized over 15 years and straight line. And it's not eligible for IRC section 168 K bonus depreciation or section 179 expensing. There's generally no way to accelerate the amortization of goodwill. It's just going to be 15 year straight line. [00:43:00] So half in the first year and then 14 years of full amortization and then half in that 16th year. Now once we have allocated the assets, the once we have divided the assets into those different classes and we have allocated the purchase price, that is when we start thinking about form 8594. And so in order to get to that point where [00:43:30] we can actually prepare that form, which is the asset acquisition statement under section 1060, then we need to know what the allocated purchase price to all of those different assets is based on their classes.
Jeremy Wells: Now, if you're engaging in or advising on an asset sale, always obtain the signed purchase agreement. That agreement should have the allocation included [00:44:00] with it. Or what I've also seen sometimes is a proforma form 8594 attached to that purchase agreement, and both parties should get an identical copy of that allocation worksheet or the proforma form 8594. They must be identical. Both the buyer and the seller have to agree to the exact same reporting of the [00:44:30] allocated purchase price to those assets. So let's go back to our example with lighthouse LLC and think about the class and what kind of gain that we're going to have. So remember cash is going to be a class one asset and there's no gain or loss on cash. Cash is just cash. In fact, usually I don't even see cash included in these transactions when I've when I've worked with parties in an asset sale. Usually it's just assumed that the seller is going [00:45:00] to distribute all the cash out of the bank account and keep that anyway. So normally cash isn't even included in the transaction, but if it is, then just know that there's no possible way to gain on cash. $50,000 worth of cash is just $50,000, and there's never going to be a gain or loss on that. Now, the accounts receivable that has a tax basis of zero, but a fair market value of $100,000, because that's the actual amount in AR that's going to be a class three [00:45:30] asset.
Jeremy Wells: It's also going to be ordinary gain because accounts receivable would just turn into normal line one gross receipts income. And that's always going to be ordinary. Equipment is going to be section 1231 gain, and that is a class five asset. There might be section 1245 depreciation recapture on that equipment a building. Similarly [00:46:00] is section 1231 property. There might be section 1250 depreciation recapture. That's also a class five asset. And then land is also a class five asset that is subject to section 1231. But remember land is not depreciable. So there's never going to be depreciation recapture on land because it was never depreciated. The customer list is a class six asset. That's also going to be a section 1231 asset. And then goodwill for [00:46:30] the seller is section 1231 and that's class seven. Now note that class five is just one bucket for tangible property. But each asset within that class within that bucket is going to have its own gain or loss character and calculation, especially when it comes to depreciation recapture. So you can't just treat all class five assets the same because they're class five. You're going to report them lumped together on form [00:47:00] 8054. But you're going to have to treat each of them individually when it comes to calculating the gain or loss and then the character of that gain.
Jeremy Wells: Also note that the gain on the sale of the assets will increase the basis of the stock held by shareholders in the target corporation. So whatever gain there is that's going to pass through to the shareholders, that will increase their basis. Then usually what will happen is those shareholders will [00:47:30] distribute pro rata the proceeds from the sale as cash. And so what should happen is that the gain in their stock basis that is the gain from the sale of those assets that's applied to their stock basis will offset those liquidating distributions after that sale closes. Now, briefly, I want to talk about some elections to treat a stock sale like an asset sale. And these get kind of complicated. So [00:48:00] a really in depth discussion is out of scope for this episode. But you should be aware of them. So the first one is available under IRC section 338 H ten. That allows a buyer to elect to treat a stock sale as long as the buyer is acquiring at least 80% of the target as a deemed asset sale, both the buyer and the seller have to make the election. They jointly make the election so both sides of the transaction have [00:48:30] to agree and the buyer must be a corporation. This only works if the buyer is a corporation. It can't be an individual, a sole proprietor, a partnership. It has to be a corporation, and then the parties make that election using form 8023 elections under section 338 for corporations making qualified stock purchases.
Jeremy Wells: The second election is available under IRC section 336 E, which produces a similar result, but it has a little bit more flexibility. [00:49:00] So first of all, the buyer can be a corporation, a partnership or an individual really can be almost any kind of tax entity type or individual. And it does not have to be a corporation. Also, the seller and the target make the election jointly by attaching a statement to their returns. Now it's the seller and the target, right? The buyer does not make this election. This election is solely made by the [00:49:30] seller and the target. And if the seller is an S corporation, then all of the shareholders of that's corporation have to agree to the election. There's a lot more nuance and a lot more details that are necessary to understand if you want to apply one of those elections. So I definitely recommend reading those code subsections and then reading the regulations tied to them and doing some additional research on whether [00:50:00] those elections apply to your specific situation and whether they're advantageous in your situation. I want to give some tips and due diligence ideas here. If you have one of these transactions that you're working on. So the first one is to always, always, always ask for and have the executed purchase agreement before you start preparing any paperwork, any tax returns, you should also have the allocation schedule [00:50:30] or the pro forma form 8594 from both parties.
Jeremy Wells: Uh, you should have that available so that you can rely on that and know that what you're including in the tax return is what was agreed to as part of that transaction. It's also very helpful to have prior depreciation schedules if you don't have those already, along with shareholder basis schedules, so that you can be sure about calculating [00:51:00] the gain and then the liquidating distributions. And if there's any tax implication of those liquidating distributions for the shareholders. And then also look at state tax implications. That's another important one. So look at the state that the target is in. And see if that state has any transfer taxes or sales taxes for tangible personal property. There might be additional state level taxes that come into play [00:51:30] as part of this transaction that could affect the economic feasibility of the transaction for. Especially for the sellers. Be sure to review the character of each asset. Make sure that those assets are properly classified on the 8594 and that the gain and the the character of that gain is correctly calculated. Make sure you know the shareholder stock basis before making those liquidating [00:52:00] distributions so that you can anticipate any tax implications there. And then look at whether the seller benefits from an installment sale under section 453. Sometimes it might make sense to treat the sale of some of the assets as an installment sale.
Jeremy Wells: But keep in mind that that does not apply to depreciation recapture, or inventory. So if it's an inventory heavy business. Section 453 installment sale [00:52:30] may not help. And then if there's any depreciation recapture, Treating it as an installment sale is not going to get the taxpayer out of that. And then one final thing to check if the S corporation ever was a C corporation, it may be subject to the built in gains tax under IRC section 1374. This is generally rare in my experience, but if there. If there is any C corporation history or if [00:53:00] the S Corporation acquired a C corporation or assets of a C corporation, it's possible that there is built in gains with those assets. And if those assets get sold in asset sale, then that built in gains is going to apply to that's corporation as well. So I want to close with a basic workflow for when an S corporation sells its assets. So the first step is to get all of the information and documents. I will not start calculating [00:53:30] gains or preparing tax returns until I'm confident that I have all of the necessary information and documents, especially the executed purchase agreement. That means the one that's actually been signed. And a lot of times these things are signed by a notary public. So whatever the final version of that purchase agreement is, a copy of that along with an allocation schedule, whether that is a separate worksheet or it's a pro [00:54:00] forma form.
Jeremy Wells: 8594 you must have that allocation break down that's been agreed to explicitly by the buyer and seller. You cannot just make those numbers up on the fly when you're preparing the return. They have to match what's going to be reported by the other side of that transaction. So you're going to be doing yourself and your client a disservice if you just try to make those numbers up without insisting [00:54:30] on getting that information from the two parties of that transaction. I've held up preparing returns before, because the purchase documents I had did not include that allocation schedule. The client wanted me to just make up some numbers, and I just simply would not go along with that. You have to insist on getting that from whichever side of that transaction you're working with. Then you're going to allocate the purchase price under section [00:55:00] 1060, you're going to determine the gain amount and character for each asset. Then you're going to report the transaction on form 8594, which is going to be attached to your client's return. That is that was a party to that sale. You're going to pass that gain through to the shareholders, adjust shareholder basis based on those pass through gains, and then apply distribution rules when it comes to those liquidating distributions. And it's it's possible [00:55:30] that there is a gain on those distributions. And remember that gain is capital gain.
Jeremy Wells: It's long term capital gain usually for an S corporation shareholder. And so it's going to be preferential long term capital gains rates on those distributions. Now if you haven't listened to the previous episode 29 on stock sales, check that episode out. I mentioned some things in this episode that might not make as much sense if you haven't heard that episode before. [00:56:00] So go listen to that one. Maybe come back and listen to this one. I've worked with clients who have done both stock sales and asset sales, and in some ways they're similar, but they are very different in very important ways. Sellers generally prefer stock sales because they often produce just a single capital gain, and they avoid the complexity of having to allocate purchase price among assets. They're just a lot easier for sellers to report. However, the trade off for the buyer is [00:56:30] that they don't get the benefits of stepped up basis in the assets and additional depreciation expense. So buyers, in contrast, typically are going to prefer asset sales because they can step up the basis of those acquired assets and avoid assuming unwanted liabilities that are held by the entity, the shell that they don't want to acquire. You must make sure that the purchase documents the agreement makes it clear what's [00:57:00] being purchased. Is the entity being purchased, or are the assets held by that entity being purchased. And then from there, work through these steps to make sure that you're correctly reporting the transaction on behalf of your client. Thanks for listening.