ABILITY TO DEDUCT LOSSES - Basis & "At Risk"
Internal Revenue Code Section 465
A shareholder's ability to deduct losses passing through to the shareholder from an S-Corporation is limited in two ways. First, the shareholder can only deduct losses to the extent that the shareholder has a sufficient basis in the stock and debt of the S-Corporation. (IRC §1366(d)(1)) Second, the shareholder can only deduct losses to the extent that the shareholder has a sufficient amount at-risk with regard to the shareholder's investment in the S-Corporation. (IRC §465) Generally, the term "at-risk" to refer to both of these limitations on the deduction of S-Corporation losses, but the term "at-risk" technically applies only to the latter limitation. Oftentimes a shareholder's stock and debt bases will be the same as the shareholder's amount at-risk; however, the shareholder's amount at-risk can be lower thanthe shareholder's stock and debt bases due to the fact that some transactions that give rise to additional basis do not provide an addition to the shareholder's amount at risk. (IRC §465).
DEEMED ASSET PURCHASE
Internal Revenue Code Section 338
From the seller’s income tax perspective, the same amount of total gain will be recognized by the S corporation shareholders in a sale of all of the S corporation outstanding equity as in a sale of all of the S corporation assets. However, in an asset sale (without the benefit of the Section 338 election), income tax is due on the gain on the sale of the target assets. This income tax is paid by the target company (some at ordinary income tax rates). This is because the target company (and not the S corporation shareholder) is the seller of the company assets. Upon liquidation of the target company, the shareholders also pay a second level of income tax on the remaining asset sale proceeds that are distributed to them.
PURCHASE PRICE ALLOCATION
Internal Revenue Code Section 1060
In buying and selling a business, one of the most important (yet often overlooked) component of the transaction is the "1060 allocation." Under both IRC sections 338 and 1060, the calculated total purchase price is allocated among specifically identified categories-or classes-of acquired assets. The total transaction price is allocated based on the fair market value of the acquired assets. Under Treasury Regulations section 1.338-6, the total transaction price is allocated sequentially to the following seven asset classes: 1) cash and general deposit accounts, 2) actively traded securities, 3) other securities and accounts receivable, 4) inventoiy, 5) tangible personal property and real estate, 6) Section 197 intangible assets except for goodwill, and 7) goodwill and going concern value.
Treasury Regulations section 1.1060-1(c) describes the asset classes that are used to allocate the total consideration paid in a business combination structured as an asset acquisition. Basically, section 1.1060-1(c)(2) refers to the same asset classes described under the IRC section 338 purchase price allocation regulations, but section 1.1060-1(d) also provides a simple, but informative, example of an IRC section 1060 purchase price allocation, which is generally agreed upon by the parties to the transaction
A buy-sell agreement is an extremely important agreement between co-owners of a business that governs what happens if a co-owner dies or is forced/chooses to leave the business. An insured buy-sell agreement is often recommended to guarantee there will be money when the buy-sell event is triggered. A buy-sell agreement is generally used to address business decisions regarding 1) who can purchase a previous owner's interest; 2) events triggering a buyout; and, 3) price of the interest. Buy-sell agreements can be a cross-purchase plan or a repurchase (entity or stock-redemption) plan.
Selecting the right type of business entity can be critical in taking advantage of tax benefits, but also in maximizing the operating goals of the business owners. The following are the main business designations and types:
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Corporate Law: Tax LL.M., MBA, BS - Accounting, Former CFO