The Butcher, The Baker And The Business Rainmaker

admin   January 12, 2010   Comments Off on The Butcher, The Baker And The Business Rainmaker

You won’t find it written anywhere in the Internal Revenue Code, but accountants, insurance salesmen and celebrity race car drivers pay less in taxes than the rest of us.

This tax anomaly occurs on the sale or liquidation of a business. When a business sells its assets (probably the most common, though not exclusive, structure for a buyout of a privately held firm), it is the selling company, naturally, that reports and pays the tax. 

Depending on what kind of entity the seller is (a C corp, an S corp or a limited liability company), the seller may pay state and federal taxes on over 40 percent of the sale proceeds. 

When the company distributes the sales proceeds remaining after paying taxes, the owners will pay additional state and federal taxes as if the distribution were a wholly separate transaction from the asset sale. 

Total tax bite? Pushing 70 percent in some cases. Not much reward — barely 30 cents on the dollar — for the president and chief bottle washer of a privately held firm. 

Now consider the tax result of an asset sale if the business is an accounting practice or an insurance agency, or if it has traded on the celebrity status of its owner — Paul Newman’s salad dressing, for example — or one of those car dealerships that retired football and baseball stars used to invest in. What is an accounting firm’s book of business worth without its rainmaking accountants? Do you think Paul Newman’s salad dressing is sold in major supermarket chains because it tastes better than competing fare? 

If the success of a business depends on the personal drawing power of an owner or other key employee (because of that person’s personal skills and contacts or because of star power), the value to a buyer of that business lies not only in corporate assets, but in the individuals who, through their personal efforts or presence, generate business activity. Consequently, on the sale of that business, the IRS will let the parties allocate some of the purchase price directly to the shareholders, thereby eliminating some of the corporate level tax. 

Payments made directly to the owner may not qualify for capital gains treatment; that is, they may be taxed at ordinary income rates. All the same, a single tax at the higher ordinary income rate is still better, sometimes by more than 20 percentage points, than the double tax that would apply if all the consideration on the sale of a business is paid to the entity. 

The right to allocate is most likely to generate large tax savings in two situations. The first is when the seller is a C corp (where income is taxed once to the corporation, then taxed again upon distribution to shareholders). The second situation arises when a professional corporation (such as an accounting firm) or a sales organization (such as an insurance agency or brokerage) that has operated as a C corp liquidates or converts to a limited liability company. (Heaven knows you’re a fool to do that without a compelling reason.) 

Here’s some useful news for the celebrity-impaired among us. 

If you’ve labored for years at a low salary to build the company, it works from a tax standpoint to award yourself a bonus equal to the value of those years of undercompensated services around the time the money from your buyer comes in. 

This strategy does not call for the buyer to pay directly. Rather, the money from the buyer goes to your company. Your company, however, then gives you a catch-up bonus that it can deduct as compensation. This has the same tax effect as the payment diverted to the celebrity. 

These tax minimization strategies are complex and fact specific. Furthermore, advanced planning pays. You can’t make eleventh-hour adjustments. Any rushed, last-minute attempt to restructure ownership to mitigate the tax cost of a transaction is likely to be ignored by the IRS. 

Some business owners who do plan ahead parcel out the parts of their business to different entities. 

Assets best held by limited liability companies, such as real estate and certain intellectual property, are owned by a limited liability company. Other operating assets may be owned by another, commonly held entity, perhaps a C corp or an S corp. 

The various entities contract with each other (and with the owner — that’s important) to facilitate the parts functioning together. 

© Maryland Gazette. Reprinted with permission.