Overview

The consummation of an asset sale transaction may have significant income tax consequences for both the seller and buyer. The primary income tax considerations for the seller are the determination of the amount of gain or loss recognized from the disposition of the subject property. The amount of gain or loss realized by the seller will determine the amount of income, if any, subject to tax in connection with the transaction. The characterization of the gain or loss as capital or ordinary will determine the tax rate applicable to the transaction and the amount of any deductible losses. The buyer will be concerned with the establishment of a correct initial basis for the property purchased. The basis of the property will determine the amount of depreciation deductions allowable with respect to the property and, as adjusted, will eventually be used to determine the amount of gain or loss realized by the buyer following any subsequent sale or disposition of the property.


Buying and Selling a Business

The following are factors to be taken into consideration whenever buying or selling a business:

Preliminary Stage

The parties' motivations for making the sale and purchase.
The parties' valuation of the business to be sold or purchased and examine whether additional consideration needs to be given to this matter.
The terms of any proposed broker or finder agreement.
Whether a confidentiality agreement is required to protect the parties and their trade secrets during preliminary negotiations.
The appropriate form for the business sale-asset sale, ownership interest sale, merger, etc.
The tax aspects of the transaction.
Alternative means of payment of the purchase price, such as allocation of price to covenants not to compete or consulting agreements.
The applicability of federal and state securities laws to the transaction and determine what will be required for compliance.

Due Diligence Investigation of Seller's Business

Verify that the seller is duly incorporated and in good standing in the state of its incorporation.
Verify that the seller is qualified to do business in all states in which it transacts business.
Review the articles of incorporation and bylaws of the seller and any amendments.
Review the minute book of the seller.
Review securities law filings under state and federal securities laws.
Determine the number and type of the authorized and issued shares of stock of the seller.
Determine who are the registered owners of the issued and outstanding shares.
Determine whether there are options, warrants, or other rights to acquire shares outstanding.
Review stock transfer records of the seller.
Review all agreements between the seller and its shareholders

A Partial List of Other Considerations include:

Real Property
Personal Property
Financial and Tax Information
Employment and Labor Matters
Creation and Distribution of Products or Services
Legal Compliance and Litigation Matters
Subsidiaries
Partnership and Joint Venture Agreements
Continuing Obligations
Letter of Intent
Purchase Agreement
Assets and Liabilities
Purchase Price and Payment Terms
Closing Conditions and Procedures
Covenants and Agreements
Representations and Warranties
Indemnification of the Buyer
Buyers Checklist for Compliance with California Bulk Sales Law
Defaults and Termination

Sale of Assets of Ongoing Business

Acquisition or sale of an ongoing business enterprise through the purchase and sale of all, or substantially all, of the assets used by a seller in the operation of the business. The assets of any business will typically consist of a variety of tangible and intangible property rights including real property, tangible personal property (such as inventory and trade fixtures), and intangible personal property (such as contract rights, accounts receivable, and patent and trademark rights). While the consideration in many sale of assets of transactions is cash paid by the buyer to the seller, it is also possible to structure a sale of assets to permit the buyer to deliver a promissory note or debt or equity securities as consideration. In those situations, the seller will need to evaluate the creditworthiness of the buyer, a payment is made by promissory note, or the value and liquidity of any securities of the buyer in the event that payment is made in that manner.

Acquisition of a Business Through a Corporate Merger.

A sale of assets is distinguished from the acquisition of a business through a corporate merger, reorganization, or other acquisition of an ownership interest in an existing business entity where there is no transfer of ownership in the assets owned by the acquired entity. [For discussion and forms relating to sale of assets.

Although structured as a single transaction, an asset sale is essentially a number of separate transactions involving different types of property that must each be transferred in accordance with the particular laws applicable to each separate category of property. Depending on the circumstances, the parties may be required to comply with specific statutory restrictions applicable to asset sale transactions. An asset sale may also have significant tax consequences for both buyer and seller.

Capital asset defined

Generally, the sale or other disposition of a capital asset will give rise to capital gain or loss treatment. A "capital asset" is defined as property held by the taxpayer, whether or not connected with the taxpayer's trade or business, excluding the following five categories of property:

1. Inventory and property held by the taxpayer primarily for sale to customers in the ordinary course of his or her trade or business;
2. Property used in a trade or business that is subject to depreciation
3. Certain copyrights and other intellectual property;
4. Accounts or notes receivable acquired for services rendered or property sold in the ordinary course of business or
5. Certain government publications

Examples of Other Business Transactions:

Fictitious Business Names
Formation of Business Entities: Partnerships, Limited Partnership, Limited Liability Companies, Corporations
Sale of Assets of Proprietorship
Limited Liability Buy-Sell Agreement
License to Sell Proprietary Products Seller Assisted Marketing Plan
Disclosure Statement and Information Sheet
Buy-Sell Agreements
Franchise Agreements
Non Competition Clauses
Consultant Agreements
Assignments of Interest in Corporation, Partnership or Limited Liability Companies
Mergers and Acquisitions



Which one is right for you?

Many factors enter into this decision, including the facts of your circumstances, your desires and your goals.

Sole Proprietorship: This is the simplest form in which to conduct a business. A sole proprietorship is not a legal entity itself. Rather, the term refers to a natural person who directly owns the business and is directly responsible for its debts. Unlimited personal liability for losses: While all profits belong to the business owner, so do all losses. Thus, if the business is unprofitable, or other liabilities are incurred, the owner (sole proprietor) is personally liable therefor. I.e., the owner puts his or her entire personal assets and wealth at risk in a proprietorship. Management: The business owner (sole proprietor) has total management authority, but may act through agents or employees. (Their acts may increase the risk of personal liability, under agency and respondeat superior principles.)

General Partnership: A general partnership is a form of business entity in which two or more co-owners engage in business for profit. So long as the parties have jointly agreed to carry on a business for profit, they are general partners even though they have no specific intent to be "general partners" or have not reached agreement on how to share profits or losses.

Characteristics: A general partnership has some of the attributes of a separate legal entity: It can hold and convey legal title to real property in its own name (rather than in the names of the partners).
It can sue and be sued in the partnership name.
It continues in existence notwithstanding the "dissociation" of one or more partners (but "dissociation" may trigger buy-out rights.
But in most other important respects, a general partnership is simply a form of co-ownership by several persons; i.e., the partners together own the business assets and (except in a limited liability partnership), are personally liable for all business debts. Each general partner puts his or her entire personal resources at risk for debts and obligations of the partnership business: Each is jointly and severally liable to the partnership creditors.

Management and control: As co-owners, each general partner has equal right to participate in management and control of the business. Disagreements as to matters in the ordinary course of partnership business are decided by a majority of the partners. Disagreements over extraordinary matters and amendments to the partnership agreement require consent of all partners. (Of course, the partnership agreement may vary these "default" rules.)
No partner has the right to receive compensation for services performed for the partnership, unless the partners agree otherwise by written agreement or conduct. Unless otherwise provided in the partnership agreement, no one can be admitted as a partner without the consent of all general partners (and a majority in interest of any limited partners).

Joint ventures as partnerships: A joint venture is a general partnership, but is typically a business formed to undertake a particular transaction or project rather than one intended to continue indefinitely. Joint ventures are commonly used in real estate matters where, e.g., two or more persons or entities form a joint venture to develop a specific parcel of property.

Limited Partnership: A limited partnership is comprised of one or more "general" partners who manage the business and who are personally liable for partnership debts, and one or more "limited" partners who contribute capital and share in the profits, but who normally take no part in running the business and who incur no liability with respect to partnership obligations beyond their capital contributions. The purpose of this form of business entity is to encourage passive investors to invest in the enterprise, allowing them to reap a share of the profits if it succeeds, but without risking more than their capital contributions.

General partners' liability: Except as otherwise provided by law or agreement, the general partners of a limited partnership are subject to the same liabilities as partners of a general partnership: i.e., joint and several liability for all debts and obligations of the partnership. every general partner is an agent of the limited partnership and may thus bind the partnership in matters concerning partnership business.

Limitation on liability to limited partners: Although general partners are jointly and severally liable to third parties for tortious acts committed in the course of partnership business by other general partners, they are not liable to limited partners for another general partner's misdeeds unless they participated in the wrongdoing (through consent or otherwise) or negligently permitted it to occur. (Even so, the "innocent" general partners may be forced to share in any resulting loss to partnership capital in accordance with the allocation of profits and losses under the partnership agreement.

Liability for Partnership Debts . A limited partner is normally not liable for partnership debts (his or her liability is limited to his or her investment in the partnership). However, a limited partner who participates in control of the partnership business may be held personally liable to creditors who actually knew of such participation at the time of extending credit and who, based on the limited partner's conduct, reasonably believed the limited partner to be a general partner.

Limited Liability Company ("LLC"): A hybrid between a partnership and a corporation, a "limited liability company" ("LLC") combines the "pass-through" treatment of a partnership with the limited liability accorded corporate shareholders. Like a corporation, which can have as few as one shareholder, an LLC need have only one "member" (i.e., owner).

Separate legal entity: Like limited partnerships and corporations, an LLC is recognized as a legal entity separate and apart from its "members" (i.e., its owners).

Limited liability of members: Ordinarily, only the LLC can be held responsible for the entity's debts. Subject to narrow exceptions (below), the LLC members are not personally liable for the entity's obligations and/or liabilities and thus enjoy the same "limited liability" as corporate shareholders

LLC members' management and control . Where the articles do not provide for managers, LLC members' management and control rights are more akin to those of general partners of a general partnership than to limited partners or corporate shareholders.

Each member has the right to vote in proportion to such member's interest in the current profits of the LLC ... unless the articles of organization or operating agreement provides otherwise. Except for certain fundamental LLC matters (below), the vote of a majority in interest suffices

1. Exceptions
   • Guarantor liability: LLC members may be personally liable for the entity's obligations if they have personally guaranteed the obligations.
   • "Alter ego" liability: A member may also be liable for an LLC's obligations under the common law "alter ego doctrine" (see ¶ 2:50 ff.) ... except that the failure to hold or observe formalities pertaining to LLC member or manager meetings shall not be a factor establishing alter ego liability if the LLC's articles or operating agreement do not expressly require such meetings.

Centralized management optional: Management of an LLC's business and affairs is vested in all its members unless the articles of organization provide otherwise. Where the articles do not provide for managers, LLC members' management and control rights are more akin to those of general partners of a general partnership than to limited partners or corporate shareholders.
Right to Vote. Each member has the right to vote in proportion to such member's interest in the current profits of the LLC ... unless the articles of organization or operating agreement provides otherwise. Except for certain fundamental LLC matters, the vote of a majority in interest suffices.

Unless the LLC's articles of organization or written operating agreement provides otherwise, a unanimous vote of all members is required to amend the articles or operating agreement

Where the LLC is managed by all its members, each member is deemed an agent of the LLC in dealings with third persons and can bind the LLC in the same way a general partner can bind the partnership.

A member's acts may bind the LLC, but since members are generally not personally liable for LLC obligations, the acts would not subject the other members to personal liability. This is in contrast to general partners, whose acts could lead to personal liability on the part of other partners

Centralized Management. An LLC's articles of organization may provide for "centralized management"-i.e., that the LLC's business and affairs shall be managed by or under the authority of one or more designated managers. Managers need not be members

Compensation. As with partnerships, no member has the right to receive compensation for "acting in the limited liability company's business" except as provided in the operating agreement (or any other agreement among the members).

Fiduciary Duties. LLC managers owe the same fiduciary duties of care and loyalty to the LLC and all its members as are owed by a partner to a partnership and its partners.

Personal Liability. No LLC manager is personally liable for any LLC debt, obligation or liability solely by reason of being a manager. (But a manager may agree to personal liability in the LLC articles of organization, a written operating agreement or a written contract.)

Membership. Unless otherwise provided in the LLC's articles of organization or operating agreement, no one can become a member of the LLC-either by issuance of a new membership or transfer of an existing one-without the consent of members having a majority in interest, excluding the vote of the person acquiring the membership interest.

Rights to Share in Profits. Like a partner in a partnership, an LLC member can freely assign his or her rights to share in profits, losses, distributions, etc. (i.e., "economic rights") without causing a dissolution of the LLC, unless otherwise provided in the articles or operating agreement. However, such assignment may not transfer or effect any substitution of the member's voting, inspection and other rights except with the required consent of the other members.

LLC profits and losses are distributed among the members as allocated by the operating agreement; otherwise, they are allocated in proportion to each member's capital contribution

Likewise, distributions of LLC money or property are made as provided in the operating agreement; otherwise, distributions representing a return of capital are made in proportion to contributions, and distributions not a return of capital are made in proportion to the allocation of profits.

*****Corporation
1. a. [2:37] Separate legal entity status, generally: A corporation is a separate legal entity existing under authority granted by state law. It has its own identity, separate and apart from the persons who created it and from its shareholders.

Broad range of powers: As a separate legal entity, a corporation has the power to act in any way permitted by the law that created it and by its own charter; e.g., to contract, to own and convey property, to sue and be sued. It is even capable of committing torts or crimes.

Limitations
1. (a) [2:37.2] Generally cannot appear in court in "pro per": Although a corporation can sue or be sued in its name, it cannot appear in court "in propria persona." Nor can it appear on its own behalf as defendant in a criminal proceeding. Except in limited circumstances (¶ 2:37.3-37.3a), the corporation must be represented by a lawyer in all cases.

A complaint improperly filed by a self-represented corporation raises a "curable defect" (the complaint is not void). As such, neither dismissal nor striking of the pro per corporation's complaint is warranted where the other party suffered no prejudice thereby. Rather, the self-represented corporation should be given a reasonable opportunity to amend its complaint to show representation by a licensed attorney ... on such terms as the court may deem just. Exception: Small claims suit: Any officer, director or employee may appear on the corporation's behalf in small claims court, or in superior court on a small claims appeal.

Liability for corporate debts: As a separate legal entity, the corporation is responsible for its own debts. Normally, the shareholders, directors or officers of the corporation are not legally responsible for corporate liabilities. If there are losses in the business, the corporation bears them to the extent of its own resources; the stockholders indirectly bear them in that the value of their stock declines more or less in proportion to such losses.

Distinguish-liability as guarantor, "alter ego" or culpable tortfeasor: However, the shareholders may be held personally liable for corporate obligations if they have personally guaranteed them or if "alter ego liability" is imposed. They may also be liable for their own tortious conduct in ordering, authorizing or participating in corporate wrongdoing.

Management and control: Normally, management and control is vested in the board of directors, elected by the shareholders of the corporation. The directors generally make policy and major decisions but do not individually represent the corporation in dealing with third persons. Rather, such dealings are conducted through officers and employees, to whom authority is delegated by the directors. The same persons may be stockholders, directors and officers of the corporation (and usually are in small corporations). Although the shareholders elect the board of directors, they do not directly control the board's activities or decisions.


Formalities: A corporation can be created only by substantial compliance with the General Corporation Law, which requires filing of articles of incorporation containing certain essential provisions, prepayment of certain fees, etc.


Duration: As a separate legal entity, the corporation is capable of continuing indefinitely. Its existence is not affected by death or incapacity of its shareholders, officers or directors, or by transfer of its shares from one person to another.

Constitutional protections: Corporations may exercise some-but not all-of the constitutional protections granted to natural persons.
1. (1) [2:43.2] Not "citizens" within privileges and immunities clause: Corporations are not "citizens" protected by the "privileges and immunities" clause of the Fourteenth Amendment to the U.S. Constitution (which prohibits states from abridging the "privileges and immunities" of U.S. citizens).

Right to due process and equal protection: However, corporations do have the right to equal protection and due process of law under the Fourteenth and Fifth Amendments, and under similar provisions of the California Constitution

Freedom of speech: So too, corporations enjoy First Amendment freedom of speech protection: i.e., absent narrowly-drawn restrictions serving compelling state interests, corporations have the right to express themselves on matters of public importance, whether or not those issues "materially affect" corporate business.

Right to counsel: Although a corporation cannot be imprisoned, a criminal action can result in fines and other penalties that could harm innocent shareholders, officers and other persons. A corporate criminal defendant thus has a Sixth Amendment right to counsel

Additional Privileges or lack or Protection:
No privilege against self-incrimination

No officer's or director's "derivative" privilege

No privilege for former officers/directors:

Compare-sole proprietorships: In contrast, a sole proprietor can assert the privilege against self-incrimination in response to a subpoena of proprietorship records. Reason: Such records are the personal property of the owner; in producing them, the proprietor acts for himself or herself, not in a representative capacity

 

S corporations: An alternative approach to taxation of business income is to organize as a corporation but have the corporation elect to be taxed under Subchapter S of the IRC. [ 1. IRC §§ 1361-1379]

The effect is that the corporation will be taxed like a partnership. Each item of income and expense is "passed through" directly to the shareholders, and is not taxed at all at the corporate level. This gives the owners of closely-held corporations the advantages of the corporate form (e.g., centralized management, limited personal liability), while avoiding the double-taxation of corporate profits discussed above.

California law: A corporation that is an S corporation under federal tax law is an S corporation under California tax law. Thus, profits and losses are "passed through" to the shareholders for state income tax purposes. However, a 1.5% franchise tax is imposed on the S corporation's net taxable income, Nonresident shareholders of a California S corporation are taxed for their share of the corporation's income that is attributable to California sources.

Advantages over regular corporation: As stated, an S corporation pays no tax at the corporate level (except for a 1.5% corporate surtax in California, above). Each item of corporate income and expense is "passed through" to the shareholders in exactly the same form as received by the corporation-i.e., as ordinary income or loss, capital gain or loss, tax credits, charitable contributions, etc. (But see ¶ 2:132 re characterization of gains/losses on sales of property contributed by the shareholder to the corporation.)

Losses "passed through" to shareholders: Any ordinary business losses passed through to the shareholders can be used to offset their other taxable income, subject to basis limitations and "passive activity" loss limitations discussed below.
1. 1) [2:122.1] Tax planning: This makes an S corporation particularly attractive to investors in new businesses. Start-up businesses are likely to generate operating losses. These losses get "passed through" to the shareholders ... so that they can deduct them against other income, subject to basis limitations and the "passive activity" loss limitations (below). And, if the business is profitable, the taxable earnings "pass through" to the shareholders to be taxed at their individual (and potentially lower) rates.
"Passive activity" loss limitation: Since an S corporation shareholder is taxed on an individual basis, he or she can only deduct losses from "passive" activities (i.e., activities in which the shareholder does not "materially participate") against passive activity income

Basis limitation on loss write-offs: Shareholders in an S corporation can write off its operating losses only to the extent of their investment in shares or loans to the corporation. (E.g., if the total investment is $10,000, no more than $10,000 in "passed through" operating losses can be deducted by the shareholders.) But while losses in excess of that amount cannot be deducted, they can be carried forward to future tax years and applied against any profits earned by the corporation, or against additional investments made by the shareholders. However, any "passed through" operating losses reduce the basis of the shareholder's stock and corporate debts (but not below zero), in that order. This prevents double deductions-i.e., one deduction for operating loss and another for capital loss on sale of the stock.

Limitation-loans from other shareholders excluded from basis: Amounts borrowed from a third party and loaned to the corporation will not increase the shareholder's basis in his or her S corporation stock if the third party is another shareholder (or a person "related" to another shareholder) in the S corporation. This is so even where the borrowing shareholder is regarded as primary obligor on the loan. However, an S corporation shareholder needs sufficient basis against which to deduct whatever losses he or she is able to deduct. If you are planning to use an S corporation's losses as a write-off against other income (subject to the "passive activity" loss limitations, above), be sure you contribute sufficient capital and loans to the corporation to cover its potential operating losses. Otherwise, you will be unable to write off all those operating losses!

No loss carryovers between C and S years: If a C corporation converts to an S corporation, neither the corporation nor its shareholders may claim a carryover deduction for losses arising when the entity was a C corporation. This prohibition is effective for so long as the corporation retains S status. If there is any realistic possibility that a corporation will experience initial operating losses, it should seriously consider electing S status at the onset. A C corporation's losses cannot be utilized by converting to an S corporation, and a conversion may have other adverse consequences.

S and C corporations compared: For income tax purposes, the S corporation is analogous to a sole proprietorship, partnership or LLC.
As stated (¶ 2:102), corporations whose taxable income falls between approximately $2.85 million and $17.5 million may pay less tax than a pass-through entity. In such a situation, shareholders could pay more to operate in S form than in C form.

Although a C corporation can avoid corporate taxes by distributing all of its profits to its shareholders in the form of salaries, bonuses, rent, etc., bear in mind that excessive compensation may be treated as constructive dividends (see ¶ 2:106). Also, both the corporation and its shareholders will be taxed when the corporation's assets are sold or liquidated (see ¶ 2:128.1).

Safe method for distribution of profits: An S corporation also makes sense where the owners want to distribute most of the net profits, and such income would be taxed to either the corporation or individual shareholders at roughly the same effective tax rates.

S corporation compared to partnership and LLC: Although S corporations, partnerships and LLCs have many of the same tax attributes, there are some significant differences.

S corporation advantageous as investment vehicle: Some of the risks and disadvantages of investments in partnerships and LLCs can be avoided through an S corporation.

Management and control (general partners share management and control powers, while limited partners usually have none; LLC can have centralized management, but cannot switch between centralized and noncentralized management without amending articles; S corporation shareholders have maximum flexibility and can manage or not at will).
Partnership or LLC advantageous for loss write-offs: If a new business is expected to generate operating losses, a partnership or LLC may be more advantageous than a corporation. This is because S shareholders cannot write off losses exceeding their actual investments (in shares or loans to the corporation; see ¶ 2:124). On the other hand, partners can write off losses equalling their investment plus any other amounts for which they are "at risk"; and LLC members can write off losses equalling their investment plus their allocable share of LLC debt

Partnership or LLC advantageous for allocating profits and losses: Another possible advantage of the partnership or LLC is more flexibility in sharing profits and losses. With an S corporation, profits and losses are allocated among the shareholders in proportion to their stock ownership throughout the year. In contrast, subject to rather stringent limitations (see 1. Treas.Regs. § 1.704-1), partners and LLC members can agree to allocate profits and losses disproportionately; and often allocate profits on one basis and losses on another

Partnership and LLC avoidance of S corporation restrictions: Certain restrictions applicable to S corporations do not apply to partnerships or LLCs

Compare-S corporation shareholders: An S corporation, like a C corporation, may establish a qualified retirement plan for its employees, including employee shareholders. However, S corporation shareholders are not considered "self-employed" under the Code provisions governing retirement plans, and thus may not deduct pass-through income contributed to a shareholder's Keogh plan.

Election of an S or C corporation. These are only a sample of the many factors and tax issues to be considered. There are many other factors, regulations and tax issues which need to be addressed when making the election to be an S Corporation or a C Corporation. For these reasons, the election of an S or C corporation should be carefully considered and discussed with your Business Attorney, CPA or Tax Attorney.