Generally, to limit the purchaser’s exposure to liability, the acquisition should be made through a separate legal entity, such as an LLC, or a corporation, rather than in the name of an individual purchaser. The use of a legal entity does not absolve the owner from all liability, but it can eliminate exposure to certain types of claims.
The use of more than one entity can avoid some major tax problems when the business (or parts of the business) is or are sold at a later date.
For example, it is generally advisable to put real estate and identifiable intangible assets in entities separated from the easily replaceable assets, such as inventory and equipment. The real estate and intangible assets can be leased or licensed to the operating company. With two or more entities, new investors can be brought into the business, while the original
* Section 743 and 754.
owner retains the benefits of the real estate and intangibles. Also, for example, when the business is resold, the purchaser may not desire to purchase the real estate. Having the real estate in a separate entity may facilitate the sale of the business. For income tax and estate tax planning, the buyer may decide to give family members an interest in the real estate but not the operating business. This is easily accomplished with the real estate in a separate entity.
Another consideration regarding who should acquire the business is how the business investigation and start-up costs will be treated. As will be discussed in the appendix to these materials, if the purchaser is operat-ing a business in the same line of business as the business purchased, the business investigation costs and start-up costs are deductible as business expansion costs, rather than capitalized and amortized over 180 months.
Other than business investigation cost and start-up cost consider-ations, the primary consideration in the choice of the entity to make the acquisition is whether the income from the business should be subjected to corporate tax. As discussed in Chapter 2, generally the corporate double-tax system renders the use of a C corporation at a considerable disadvantage. However, in the case of a small business whose earnings do not reach the highest corporate rate, and whose after-tax earnings are used to retire the purchase money indebtedness, the C corporation may be the preferred entity particularly if the shareholder has a high marginal tax rate.
Example: A taxpayer invested $150,000 and borrowed $300,000 to purchase a business. Assume that income earned by the business operating as a C corporation will be taxed at 25 percent, the share-holder is in the 35 percent marginal tax bracket, and all of the after-tax income will be used to retire debt incurred to purchase the business. The business earns $400,000 over a number of years. If doing business as a C corporation, the entity would pay tax of $100,000 over that period.*
The $300,000 after-tax income is used to pay down the debt incurred to purchase the business. At a 6 percent interest rate, the interest paid over five years would be $56,000. The corporate deduction would save
* If the business was not incorporated, the income tax would be $140,000.
0.25 × $56,000 = $14,000 compared to the tax benefits of an individual deduction of 0.35 × $56,000 = $19,600. The after-tax income will not be available for distribution to the owner and therefore will not be subject to a double-tax while the investor owns the stock. A second tax will be incurred by the owner when the stock is sold, but the present value of that tax may be very small.
Before consideration of any tax on the sale of the business, the tax savings as a result of organizing the business as a C corporation is $40,000 of income tax [(0.35 individual rate − 0.25 corporate rate) × $400,000]
less the $5,600 reduction in tax benefit related to the interest deduction on the debt. Assuming the individual’s capital gain rate is 15 percent, the tax upon the sale of the stock will be 0.15 × $258,000 = $38,700.
However, assuming that the stock will be held for five years, present value of the tax upon the sale of the stock will be far less than the $34,600 in tax savings. To recap:
It should be noted that if the corporate tax rate had been higher (say 30 percent), incorporating would be more expensive in terms of total tax paid.
The new owners must also be concerned with personal liability.
Therefore, the acquired business must ultimately be inside of an LLC or a corporation. The purchaser is not necessarily the entity that operates the business. For example, an individual could purchase a proprietorship and then transfer the assets to a corporation in exchange for stock. The transfer Unincorporated Incorporated
Ordinary income over five years $400,000 $400,000 Income tax @ 0.35 and 0.25, respectively ($140,000) ($100,000)
Interest expense $56,000 $56,000
Tax benefit for interest deduction @ 0.35 and 0.25, respectively
+$19,600 +$14,000
Total tax before capital gain on sale Capital gain on sale of incorporated entity ($400 − $100 − $56 + $14)
$258,000
Individual capital gains tax @ 0.15 ($38,700)
Present value of individual capital gains tax
@ 0.10 in five years
($24,029)
Total tax ($120,400) ($110,029)
will be nontaxable provided the individual has 80 percent control over the transferee corporation; or, the individual could transfer the assets to an LLC. The transfer to the LLC would be a nontaxable event regardless of whether the individual controls the LLC. However, arrangements with creditors will be necessary for the new entity to assume liabilities.