CPA-HQ: August Edition

Tax Tips When Buying the Assets of a Business

After experiencing a downturn in 2023, merger and acquisition activity in several sectors is rebounding in 2024. If you’re buying a business, you want the best results possible after taxes. You can potentially structure the purchase in two ways:

1. Buy the assets of the business
2. Buy the seller’s entity ownership interest if the target business is operated as a corporation, partnership or LLC.

In this article, we’re going to focus on buying assets.

Asset Purchase Tax Basics

You must allocate the total purchase price to the specific assets acquired. The amount allocated to each asset becomes the initial tax basis of that asset.

For depreciable and amortizable assets (such as furniture, fixtures, equipment, buildings, software and intangibles such as customer lists and goodwill), the initial tax basis determines the post-acquisition depreciation and amortization deductions.

When you eventually sell a purchased asset, you’ll have a taxable gain if the sale price exceeds the asset’s tax basis (initial purchase price allocation, plus any post-acquisition improvements, minus any post-acquisition depreciation or amortization).

Asset Purchase Results with A Pass-through Entity

Let’s say you operate the newly acquired business as a sole proprietorship, a single-member LLC treated as a sole proprietorship for tax purposes, a partnership, a multi-member LLC treated as a partnership for tax purposes or an S corporation. In those cases, post-acquisition gains, losses and income are passed through to you and reported on your personal tax return. Various federal income tax rates can apply to income and gains, depending on the type of asset and how long it’s held before being sold.

Asset Purchase Results with A C Corporation

If you operate the newly acquired business as a C corporation, the corporation pays the tax bills from post-acquisition operations and asset sales. All types of taxable income and gains recognized by a C corporation are taxed at the same federal income tax rate, which is currently 21%.

A Tax-smart Purchase Price Allocation

With an asset purchase deal, the most important tax opportunity revolves around how you allocate the purchase price to the assets acquired.

To the extent allowed, you want to allocate more of the price to:

• Assets that generate higher-taxed ordinary income when converted into cash (such as inventory and receivables)
• Assets that can be depreciated relatively quickly (such as furniture and equipment)
• Intangible assets (such as customer lists and goodwill) that can be amortized over 15 years.

You want to allocate less to assets that must be depreciated over long periods (such as buildings) and to land, which can’t be depreciated.

You’ll probably want to get appraised fair market values for the purchased assets to allocate the total purchase price to specific assets. As stated above, you’ll generally want to allocate more of the price to certain assets and less to others to get the best tax results. Because the appraisal process is more of an art than a science, there can potentially be several legitimate appraisals for the same group of assets. The tax results from one appraisal may be better for you than the tax results from another.

Nothing in the tax rules prevents buyers and sellers from agreeing to use legitimate appraisals that result in acceptable tax outcomes for both parties. Settling on appraised values becomes part of the purchase/sale negotiation process. That said, the appraisal that’s finally agreed to must be reasonable.

Plan Ahead

Remember, when buying the assets of a business, the total purchase price must be allocated to the acquired assets. The allocation process can lead to better or worse post-acquisition tax results. We can help you get the former instead of the latter. So get your advisor involved early, preferably during the negotiation phase.

What Expenses Can’t Be Written Off by Your Business?

If you check the Internal Revenue Code, you may be surprised to find that most business deductions aren’t specifically listed there. For example, the tax law doesn’t explicitly state that you can deduct office supplies and certain other expenses. Some expenses are detailed in the tax code, but the general rule is contained in the first sentence of Section 162, which states you can write off “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.”

Basic Definitions

In general, an expense is ordinary if it’s considered common or customary in the particular trade or business. For example, insurance premiums to protect a store would be an ordinary business expense in the retail industry.

A necessary expense is one that’s helpful or appropriate. For example, a car dealership may purchase an automatic defibrillator. It may not be necessary for the business operation, but it might be helpful if an employee or customer suffers a heart attack. It’s possible for an ordinary expense to be unnecessary — but, to be deductible, an expense must be ordinary and necessary.

A deductible amount must be reasonable in relation to the benefit expected. For example, if you’re attempting to land a $3,000 deal, a $65 lunch with a potential client should be OK with the IRS. (The Tax Cuts and Jobs Act eliminated most deductions for entertainment expenses but retained a 50% deduction for business meals.)

Proceed with Caution

The deductibility of some expenses is clear, while others are more complicated. Keep careful records to substantiate expenses you plan to deduct. Generally, if an expense seems like it’s not normal in your industry — or could be considered personal or extravagant — proceed with caution. Not surprisingly, the IRS and courts don’t always agree with taxpayers about what is ordinary and necessary. (See examples in “Relevant U.S. Tax Court cases” below.) Contact us with questions about deductibility.

Relevant U.S. Tax Court Cases

Here are three recent U.S. Tax Court cases in which specific taxpayer deductions were disallowed:

1. A married couple owned an engineering firm. For two tax years, they claimed depreciation of $76,264 on three vehicles, but didn’t provide required details, including each vehicle’s ownership, cost and useful life. They claimed $34,197 in mileage deductions and provided receipts and mileage logs, but the court found they didn’t show related business purposes. The court also found the mileage claimed included commuting costs, which can’t be written off. The court disallowed these deductions and assessed taxes and penalties. (TC Memo 2023-39)
2. The court ruled that a married couple wasn’t entitled to business tax deductions because the husband’s consulting company failed to show that it was engaged in a trade or business. In fact, invoices produced by the consulting company predated its incorporation. And the court ruled that even if the expenses were legitimate, they weren’t properly substantiated. (TC Memo 2023-80)
3. A physician specializing in gene therapy deducted legal expenses of $360,295 for two years on Schedule C of his joint tax returns. The court found that most of the legal fees were to defend the husband against personal conduct issues. The court denied the deduction for personal legal expenses but allowed a deduction for $13,000 for business-related legal expenses. (TC Memo 2023-42)

On today’s episode of Tax Insights, Jeff simplifies the Augusta rule. Discover how this special tax provision, linked to Augusta, Georgia, and the Masters, benefits homeowners nationwide. Jeff explores the conditions for tax-free rental income, explaining how you can maximize short-term rentals during events like the NFL draft. Join us as we uncover the rules and opportunities of the Augusta rule to empower your financial decisions. Let’s jump in!

Getting a New Business Off the Ground

New businesses are launched every day, as evidenced by the number of Employer Identification Numbers requested, according to the U.S. Census Bureau. In the aftermath of the COVID-19 pandemic, there was a large increase in the number of businesses formed. For 2023, roughly 5.5 million new business applications were filed.

How to Treat Expenses for Tax Purposes

Entrepreneurs often don’t know that many of the expenses incurred by start-ups can’t be currently deducted on their tax returns. Be aware that the way you handle some of your initial expenses can make a large difference in your federal tax bill. Here are three rules to keep in mind if you’re starting or planning to launch a new business:

1. Start-up costs include those incurred or paid while creating an active trade or business — or investigating the creation or acquisition of one.
2. Under the tax code, taxpayers can elect to deduct up to $5,000 of business start-up and $5,000 of organizational costs in the year the business begins. As you know, $5,000 doesn’t go very far these days! And the $5,000 deduction is reduced dollar-for-dollar by the amount by which your total start-up or organizational costs exceed $50,000. Any remaining costs must be amortized over 180 months on a straight-line basis.
3. No deductions, including amortization deductions, are allowed until the year when “active conduct” of your new business begins. Generally, that means the year when the business has all the pieces in place to start earning revenue. To determine if a taxpayer meets this test, the IRS and courts generally ask questions such as: Did the taxpayer undertake the activity intending to earn a profit? Was the taxpayer regularly and actively involved? Did the activity actually begin?

Eligible Expenses

In general, start-up expenses are those you make to:

• Investigate the creation or acquisition of a business
• Create a business
• Engage in a for-profit activity in anticipation of it becoming an active business

To qualify for the election, an expense also must be one that would be deductible if it were incurred after a business began. One example is money you spend analyzing potential markets for a new product or service.

To be eligible as an “organization expense,” an expense must be related to establishing a corporation or partnership. Some examples include legal and accounting fees for services related to organizing a new business and filing fees paid to the state of incorporation.

Plan Now

If you have start-up expenses that you’d like to deduct this year, you need to decide whether to take the election described above. Recordkeeping is critical. Contact us about your start-up plans. We can help with the tax and other aspects of your new business.

If Your Business Has Co-owners, You Probably Need a Buy-sell Agreement

Are you buying a business that will have one or more co-owners? Or do you already own one fitting that description? If so, consider installing a buy-sell agreement. A well-drafted agreement can do these valuable things:

• Transform your business ownership interest into a more liquid asset
• Prevent unwanted ownership changes
• Avoid hassles with the IRS.

Agreement Basics

There are two basic types of buy-sell agreements: Cross-purchase agreements and redemption agreements (sometimes called liquidation agreements).

A cross-purchase agreement is a contract between you and the other co-owners. Under the agreement, a withdrawing co-owner’s ownership interest must be purchased by the remaining co-owners if a triggering event, such as a death or disability, occurs.

A redemption agreement is a contract between the business entity and its co-owners (including you). Under the agreement, a withdrawing co-owner’s ownership interest must be purchased by the entity if a triggering event occurs.

Triggering Events

You and the other co-owners specify the triggering events you want to include in your agreement. You’ll certainly want to include obvious events like death, disability and attainment of a stated retirement age. You can also include other events that you deem appropriate, such as divorce.

Valuation and Payment Terms

Make sure your buy-sell agreement stipulates an acceptable method for valuing the business ownership interests. Common valuation methods include using a fixed per-share price, an appraised fair market value figure, or a formula that sets the selling price as a multiple of earnings or cash flow.

Also ensure the agreement specifies how amounts will be paid out to withdrawing co-owners or their heirs under various triggering events.

Life Insurance to Fund the Agreement

The death of a co-owner is perhaps the most common, and catastrophic, triggering event. You can use life insurance policies to form the financial backbone of your buy-sell agreement.

In the simplest case of a cross-purchase agreement between two co-owners, each co-owner purchases a life insurance policy on the other. If one co-owner dies, the surviving co-owner collects the insurance death benefit proceeds and uses them to buy out the deceased co-owner’s interest from the estate, surviving spouse or other heir(s). The insurance death benefit proceeds are free of any federal income tax, so long as the surviving co-owner is the original purchaser of the policy on the other co-owner.

However, a seemingly simple cross-purchase arrangement between more than two co-owners can get complicated, because each co-owner must buy life insurance policies on all the other co-owners. In this scenario, you may want to use a trust or partnership to buy and maintain one policy on each co-owner. Then, if a co-owner dies, the trust or partnership collects the death benefit proceeds tax-free and distributes the cash to the remaining co-owners. They then use the money to fund their buyout obligations under the cross-purchase agreement.

To fund a redemption buy-sell agreement, the business entity itself buys policies on the lives of all co-owners and then uses the death benefit proceeds buy out deceased co-owners. However, please talk to your tax professional with regards to corporate owned life insurance. This will impact the value of the shareholder’s stock for purposes of Federal Estate Tax. Currently, there is a U.S. Supreme Court case that may impact this determination – see Supreme Court Docket 23-146, Connelly v. United States.

Specify in your agreement that any buyout that isn’t funded with insurance death benefit proceeds will be paid out under a multi-year installment payment arrangement. This gives you (and any remaining co-owners) some breathing room to come up with the cash needed to fulfill your buyout obligation.

Create Certainty For Heirs

If you’re like many business co-owners, the value of your share of the business comprises a big percentage of your estate. Having a buy-sell agreement ensures that your ownership interest can be sold by your heir(s) under terms that you approved when you set it up. Also, the price set by a properly drafted agreement establishes the value of your ownership interest for federal estate tax purposes, thus avoiding possible IRS hassles.

As a co-owner of a valuable business, having a well-drafted buy-sell agreement in place is pretty much a no-brainer. It provides financial protection to you and your heir(s) as well as to your co-owners and their heirs. The agreement also avoids hassles with the IRS over estate taxes.