Sale of a Corporation
Shareholders in a sale of a Corporation have many options depending on the motivation of the parties. For example, minimizing tax paid through the transactions may not be synonymous with maximum proceeds, so true motivation of the parties matters. Shareholders have an option to sell to an acquiring corporation as a 1) taxable asset sale, 2) taxable stock sale, 3) taxable stock sale treated as an asset sale under IRC, or 4) as a non-taxable merger or consolidation, otherwise known as a reorganization. Straight stock sales provide the simplest form of sale for the seller, where shareholders are assured a single level of taxation at the most favorable long-term capital gains rates. This form of sale will be least appealing to the acquirer (A) because a stock purchase allows no recovery or amortization to A as an investment.
The law, however, allows a stock sale to be treated as an asset sale, which could provide the acquirer high incentive due to stepped up bases in the assets. The taxable stock form of sale and acquisition will require that both the target corporation (T), its shareholder sellers (SH), and acquirer (A) make a decision under the IRC whether or not to make a Section 338(h)(10) or a Section 336(e) election. If T is a C-Corporation as intended by regulatory application of Section 336, not a common parent, and is not a member of an affiliated group as defined by Section 1504, or as intended in regulatory application of Section 338, then a stock sale treated as an asset sale would require a Section 336(e) election. Section 336 election will provide the potentially large incentive to A for stepped up bases in assets. T could engage in a Section 336(e) election, which provides the benefit to SH of a single level of taxation like a straight stock sale, but may, however, expose SH to ordinary income due to the asset sale treatment of the sale under Section 1245 recapture requirements.
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Tax Free Mergers
Shareholders (SH) of a corporation may have an option to enter into a non taxable reorganization with an acquirer (A). A tax free merger is a “reorganization” under the tax code. In such a deal, A would use its stock as a significant portion of the consideration paid to SH rather than cash or debt. This requires SH taking equity, and thus risk in an investment stake in A. The buyer may prefer a merger. Tax is effectively deferred under such a merger, except for cash or boot taken in the transaction. In this case, A would be able to pay for a significant part of the acquisition price with its equity. The motivation for such a deal may be that A cannot offer consideration other than equity. A may have little cash, and may have trouble financing the acquisition with debt. Here, A and SH could pursue a non-taxable exchange of stock under a Section 368 statutory merger transaction. Continuity and non-tax avoidance criteria must be met. A and SH can pursue a reorganization such that A will be required to continue with target (T) business for a minimum of 2 years.
Taxes are only deferred, not avoided. A will defer taxes on the asset acquisition of T. SH will defer taxes until it sells its stock in A. A will pay taxes on the amount of boot taken in the deal. A will assume the tax structure of the assets of T, and take all carryover bases in those assets. This could be an incentive or disincentive depending on the spread between the bases and the market values of those assets. If and when A sells those assets it will realize taxable gain inherent in those assets. Under Section 368, up to 60% of the aggregate deemed asset disposition price (ADADP) can be money or other property received by SH.
SH may, in such a deal, take on what could be an undue risk with equity in A, deferring taxes, and limit and defer cash flows for A. If acquirer is a large solid firm, with a market for its shares, the risk to SH would be much lower. If the stock received in the transaction is higher risk, that stock could become worthless in a worst case scenario.
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A Section 351 Transfer under Section 351(a) allows that no gain or loss “shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation” as long as those persons control the corporation immediately after the transfer. Control means 80% ownership in terms of all stock and is defined in Section 368(c). In a hypothetical example, H (a person) transfers appreciated property in a Section 351 transfer, with a FMV and adjusted basis of $100,000 and $95,000 respectively.
In exchange H receives stock with a FMV of $85,000, plus boot in the form of a short-term note worth $15,000. It is provided that this is a Section 351 transaction so the control requirement is assumed met, and the gains or losses will be deferred but for exceptions to non-recognition of gains under Section 351(b). The issue here is to calculate and clarify what is H’s basis in the stock, given he has received other property in a Section 351 transfer.
If property or “money” other than stock is received in the exchange, then the recipient shall recognize a gain per Section 351(b)(1) equal to the amount of money received plus the FMV of other property received. Section 351(b) states that the transferor’s gain is limited to the gain on transferred property or the FMV of boot received.
In this example, H received stock with a FMV of $85,000, along with a short-term note, considered to be money worth $15,000. The old basis given up is $95,000. With non-recognition property under Section 358(a) the basis would be the old basis, minus the FMV of other property or money received, plus any recognized dividend or gain. Here, H’s adjusted basis transferred is $95,000, his boot received is $15,000, and his gain recognized is limited to the $5,000 difference between FMV and Adjusted basis of property transferred.
Thus, his basis is $95,000 minus $15,000 plus $5000, or $85,000. In conclusion, H’s basis in stock received is $85,000 because his recognized gain is limited to the lesser of the $5,000 gain on property he transferred in the exchange, rather than the $15,000 FMV of boot he received.
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The basics of U.S. tax law on worldwide income of U.S. Citizens
First in a series of short posts to cover international taxation of U.S. Citizens, expatriates, people with dual or more citizenship, and people with alien or green card statuses.
U.S. citizens must pay tax on worldwide income. The only way to change that is to no longer be a U.S. citizen. There are some common sense protections from double taxation. The IRS websites are quite helpful, for example FAQ on international tax matters at https://www.irs.gov/individuals/international-taxpayers/frequently-asked-questions-about-international-individual-tax-matters, and Information for U.S. Citizens or Dual Citizens Residing Outside the U.S. at https://www.irs.gov/uac/newsroom/information-for-u-s-citizens-or-dual-citizens-residing-outside-the-u-s. If you have been filing your 2555 or 2555EZ along with your federal tax forms, then you already know this. If you have not been filing, it is a good idea to get this corrected and file your taxes going back six years.
The first most important basic understanding is where you reside. Whether you are an individual citizen or an employee of your own company, physical residence is what truly controls your taxation. It does not matter if your business is “purely” online, so get past that understanding quickly. The Tax treaties and the Internal Revenue Code both say the same things. For example, Article 4 of the U.S. – Sweden Tax Treaty states, a person “under the laws of that State, is liable to tax therein by reason of his domicile, residence, place of management, place of incorporation, or any other criterion of a similar nature.”
The next most important thing to understand is that if you are a U.S. citizen, you have rights and responsibilities regarding tax. You are taxed on “worldwide”
International tax – Worldview Consulting & Accounting, Inc.
income. U.S. tax law is all about not allowing improper avoidance of taxation, so it is not surprising that you must report worldwide income. If you have not been filing U.S. taxes, and should be, it should also not surprise you that they will want you to report in such a way as to show where you keep your accounts and assets. You may be required to file Foreign Bank and Financial Account Reporting and Foreign Financial Asset Reporting. Reporting just tells the nations involved what is going on, and does not in and of itself figure your tax.
The next point to understand is that the U.S. has treaties with many countries, which protect the taxpayer, and of course protect the foreign nations involved in the treaties. You can find these treaties online at https://www.irs.gov/businesses/international-businesses/united-states-income-tax-treaties-a-to-z. Let’s take Sweden (https://www.irs.gov/businesses/international-businesses/sweden-tax-treaty-documents) and Italy (https://www.irs.gov/businesses/international-businesses/italy-tax-treaty-documents) as examples. Both have a treaty with the U.S. Each treaty protects you from double taxation, stated explicitly. Also, these treaties protect Italy or Sweden by virtue of the rule that which country has the right to collect the single level of taxation depends on where you physically operate. See Article 4 in the U.S. – Sweden tax treaty, for example.
Next up in this series of posts is information on repatriation of funds.
Forms, publications, and links of interest on this subject:
- Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad
- Publication 514, Foreign Tax Credit for Individuals
- Publication 334, Tax Guide for Small Business
- Form 1116, Foreign Tax Credit
- Form 2555, Foreign Earned Income
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Let’s say a company, a C corporation, is to make a distribution to you as a shareholder. With proper purpose and execution within the tax code, this is fine, so we leave out the why. This is also a serious matter, so it should be transacted under the IRC correctly. If you are a major shareholder, or exert control over the corporation, then you are considered a related party shareholder. If you own the majority of shares in a small business and your business is to distribute equipment to you, an old truck for example, that is not fully depreciated on the books of the company, then it has a book value. Let’s say, for example, it has been depreciated down to a basis of $25,000. Let us also say that the truck is worth something in the market, hypothetically $40,000, the fair market value (FMV). If the basis is less than the FMV, then we say the property is “appreciated.” If the company also distributes cash to you in this example, let’s say $5000, then that must also be valued and cared for in the transaction.
In this case, we need to describe the character and amount of the gain or loss to both the corporation and you as the recipient of a dividend of both cash and appreciated property. Also in this case we need to define the character of the gain given the corporation has no earnings and profits (for a good explanation of E&P, I suggest the following link written by Kaiser at http://www.thetaxadviser.com/issues/2013/oct/kaiser-oct2013.html.)
Let’s move on with our simplified example with some tax code in effect at the time of writing this blog (tax code does change so you should check with your accountant in a real life example).
Section 311(a) states, in general, that except as provided in 311(b), no gain or loss will be recognized to a corporation in its distribution of its stock or of property. Section 311(b)(1)(A) and 311(b)(1)(B) also provide that when a corporation distributes appreciated property to a shareholder the disposition of the property will be as if the corporation sold it. It states in part, “then gain shall be recognized to the distributing corporation as if such property were sold to the distributee at its fair market value.” This means the difference between its FMV and its adjusted basis will be recognized as gain to the corporation.
Section 301(c)(1) states that the amount considered a dividend as defined in Section 316(a) shall be included in gross income. The amount not considered a dividend reduces the adjusted basis of the stock according to Section 301(c)(2). The amount not recognized as a dividend, and in excess of adjusted basis, shall be treated as a gain from sale of property per Section 301(c)(3).
Section 316(a)(1) and Section 316(a)(2) defines a dividend as “any distribution of property made by a corporation to its shareholders” out of current or accumulated earnings and profits.
In our hypothetical, the corporation made a current distribution of $5,000 cash and an appreciated truck worth $40,000, as defined in Section 311(b). Since this is a dividend distribution in relation to your stock holding in the corporation, the corporation must include the gain on the appreciated property as if it sold the property to you, and also must include in gross income per 301(c). This will be ordinary income as to the truck. Since the truck has a current FMV of $40,000, and it basis to the corporation is $25,000, the gain is $15,000, and it is ordinary income.
Per section 301(c) you must recognize the distribution, to him or her, first as dividend income if the corporation has any current or accumulated E&P. The corporation has no E&P. Thus, there is no dividend income. Next you must reduce your basis in the corporation stock. Since your total dividend is $45,000 your potential gain is reduced by first reducing your basis in stock as a shareholder. If your basis in stock was, let’s say $20,000, then your gain is reduced from $40,000 potential to $25,000, due to reduction first of your $20,000 stock basis to $0. The balance per Section 301(c)(3) is, therefore, recognized as capital gain of $25,000.
The corporation recognizes an increase in ordinary income of $15,000 on the distribution of appreciated property. It recognizes no gain on the $5,000 cash because it is not appreciated property.
You recognize a capital gain equal to the $25,000 balance of your distribution after the total $45,000 is first reduced by your $20,000 basis in stock. There is no dividend income recognized before reduction of your stock basis because the corporation has no E&P current or accumulated.
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A corporation may be subject to ordinary income and tax rates in an asset sale, or if in a contemplated taxable stock sale (treated as an asset sale) where a Section 336(e) or a Section 338(h)(10) election is made, shareholders (SH) are taxed on asset sales resulting in recapture for Section 1245 property.
For example, if a corporation in such a sale sold equipment for $300,000 that it held for two years, the equipment’s cost was $270,000, and accumulated depreciation was $60,000, and adjusted basis was $210,000, realized gain would be $90,000, $60,000 of that would be recaptured as ordinary income, and only $30,000 would be at favorable long term capital gains (LTCG) tax rates (Section 1231 property).
The issue is how a corporation must treat the realized gain on the sale of its assets, what kind of property is each asset under the law, and what is the character of the gain on sale of each asset. Section 1245 property is defined in Section 1245(a)(1)(3)(A) and Section 1245(a)(1)(3)(B) as any property subject to depreciation under Section 167, and is either personal property or other tangible property used “as an integral part of manufacturing, production, or extraction or of furnishing transportation, communications, electrical energy, gas, water, or sewage disposal services…”.
Section 167 allows depreciation deductions to be taken on property subject to wear and tear, if used in trade or business or used in production of income. Section 1245(a)(1) provides that if Section 1245 is sold, the amount by which the sales price exceeds the adjusted basis shall be treated as ordinary income. This means that all depreciation taken against the original basis shall be recovered as ordinary income.
If a corporation has Section 1245 property, much of which has been fully depreciated, then the equipment is Section 1245 property as defined by the IRC. The assets sold would be allocated part of the aggregate deemed asset disposition price (ADADP), thus the gains subject to recapture rules will be all previously taken depreciation represents to the difference between the ADADP and the adjusted basis (a very low basis, thus large potential gain). Under Section 1245 and Reg. Sec. 1-1245-1, the treatment of this gain shall be the recapture of all depreciation taken, with only the balance of gain taxed at the applicable and favorable capital gains tax rates.
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