Archives for May 2024

Structuring Asset Purchases in Business Acquisitions: Key Tax Considerations

Ken Botwinick, CPA | 05/28/2024

After experiencing a downturn in 2023, merger and acquisition activity in several sectors is rebounding in 2024. If you are considering buying a business, optimizing the structure of your purchase for the best post-tax results is crucial. You can potentially structure the purchase in two ways:

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

This article focuses on the asset purchase approach.

Tax Basics of Asset Purchases

When purchasing assets, the total purchase price must be allocated to the specific assets acquired. The amount allocated to each asset becomes its initial tax basis.

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

When you eventually sell a purchased asset, you will 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

If you operate the newly acquired business as a sole proprietorship, single-member LLC treated as a sole proprietorship, partnership, multi-member LLC treated as a partnership, or S corporation, 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 is 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 taxes on 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%.

Optimizing Purchase Price Allocation

A key tax planning opportunity in an asset purchase deal lies in how you allocate the purchase price to the acquired assets. To the extent permitted, you should aim to allocate more of the purchase 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

Conversely, you should allocate less to assets that must be depreciated over long periods (such as buildings) and to land, which cannot be depreciated.

Obtaining appraised fair market values for the purchased assets can help allocate the total purchase price to specific assets. As noted, you will generally want to allocate more of the price to certain assets and less to others for optimal tax results. Since the appraisal process can be subjective, multiple legitimate appraisals may exist for the same group of assets. The tax results from one appraisal may be more favorable for you than 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. Agreeing on appraised values is part of the purchase/sale negotiation process. However, the final agreed-upon appraisal must be reasonable.

Plan Ahead

When buying the assets of a business, remember that the total purchase price must be allocated to the acquired assets. This allocation process can significantly impact your post-acquisition tax results. Engage your advisor early in the negotiation phase to ensure the best tax outcomes. We are here to help you achieve favorable tax results. Contact us for guidance.

Financial and Legal Considerations When Adding a New Partner to a Partnership

Ken Botwinick, CPA | 05/07/2024

Adding a new partner to a partnership involves several financial and legal implications that require careful planning to avoid various tax complications. Let’s consider an example: You and your partners are planning to admit a new partner, who will acquire a one-third interest in the partnership by making a cash contribution. Assume your basis in your partnership interests is sufficient, so the decrease in your portions of the partnership’s liabilities due to the new partner’s entry won’t reduce your basis to zero.

Complexity of Adding a New Partner

While admitting a new partner may seem straightforward, it is crucial to plan the entry meticulously to avoid potential tax issues. Here are two key considerations:

Unrealized Receivables and Substantially Appreciated Inventory Items: Changes in partners’ interests in unrealized receivables and substantially appreciated inventory items are treated as a sale of those items, causing current partners to recognize gain. Unrealized receivables include accounts receivable, depreciation recapture, and certain other ordinary income items. To prevent gain recognition, these items must be allocated to the current partners even after the new partner joins.
Built-In Gain or Loss: The tax code mandates that the “built-in gain or loss” on assets held by the partnership before the new partner’s admission be allocated to the current partners. Built-in gain or loss is the difference between the fair market value and the basis of the partnership property at the time the new partner is admitted. Consequently, the new partner must be allocated a portion of the depreciation equal to their share of the depreciable property based on current fair market value. This allocation reduces the amount of depreciation available to current partners. Additionally, built-in gain or loss on partnership assets must be allocated to the current partners when the assets are sold. These rules are complex and may necessitate special accounting procedures.

Monitoring Partner Basis

When adding a partner or making other changes, a partner’s basis in their interest may frequently adjust. Properly tracking basis is essential as it affects:

Gain or Loss on the Sale of Interest: Accurate basis tracking ensures correct calculation of gain or loss when selling your partnership interest.
Taxation of Partnership Distributions: Your basis determines how partnership distributions to you are taxed.
Deductible Partnership Losses: Basis also affects the maximum amount of partnership loss you can deduct.

We Can Assist

Contact us for assistance with these issues or any other concerns related to your partnership. We can help ensure that the process of adding a new partner is managed effectively, minimizing tax complications and ensuring compliance with relevant regulations.

Tax Treatment of Partner-Incurred Expenses in Service Partnerships

Ken Botwinick, CPA | 05/03/2024

It is not uncommon for partners in service partnerships, such as architecture or law firms, to incur expenses related to the partnership’s business. For example, partners may incur entertainment expenses when developing new client relationships or expenses for transportation to and from client meetings, professional publications, continuing education, and home office expenses. What is the tax treatment of such expenses? Here are the answers.

Reimbursable Expenses

As long as the expenses are those that a partner is expected to pay without reimbursement under the partnership agreement or firm policy (written or unwritten), the partner can deduct these expenses on Schedule E of Form 1040. Conversely, a partner cannot deduct expenses if the partnership would have honored a request for reimbursement.

A partner’s unreimbursed partnership business expenses should also generally be included as deductions in arriving at the partner’s net income from self-employment on Schedule SE.

For instance, suppose you are a partner in a local architecture firm. According to the firm’s partnership agreement, partners are expected to bear the costs of soliciting potential new business except in cases where attracting a large potential new client is a firm-wide goal. If you spend $4,500 of your own money on meal expenses to attract new clients and receive no reimbursement, you should report a deductible item of $2,250 (50% of $4,500) on your Schedule E. This $2,250 should also be included as a deduction in calculating your net self-employment income on Schedule SE.

However, it is crucial to note that a partner cannot deduct expenses if they could have been reimbursed by the firm. No deduction is allowed for “voluntary” out-of-pocket expenses. To avoid any confusion regarding the tax treatment of unreimbursed partnership expenses, it is advisable to establish a written firm policy clearly stating what will and will not be reimbursed. This ensures that partners can deduct their unreimbursed business expenses without issues from the IRS.

Home Office Deduction

Subject to the normal deduction limits under the home office rules, a partner can deduct expenses allocable to the regular and exclusive use of a home office for partnership business. The partner’s deductible home office expenses should be reported on Schedule E in the same manner as other unreimbursed partnership expenses.

If a partner has a deductible home office, the Schedule E home office deduction can provide multiple tax-saving benefits because it is effectively deducted for both federal income tax and self-employment tax purposes.

Additionally, if the partner’s home office qualifies as a principal place of business, commuting mileage from the home office to partnership business temporary work locations (such as client sites) and partnership permanent work locations (such as the partnership’s official office) counts as business mileage.

The principal place of business test can be satisfied in two ways:

The partner conducts most of the partnership’s income-earning activities in the home office.
The partner conducts partnership administrative and management tasks in the home office and does not make substantial use of any other fixed location (such as the partnership’s official office) for these tasks.

Conclusion

When a partner can be reimbursed for business expenses under a partnership agreement or standard operating procedures, they should submit these expenses for reimbursement. Otherwise, the partner cannot deduct the expenses. The partnership should establish a written policy clearly stating what expenses will and will not be reimbursed, including home office expenses if applicable. This applies equally to members of LLCs treated as partnerships for federal tax purposes since those members are considered partners under tax law.

For assistance with these issues or any other concerns related to your partnership, please contact us.