Sale of Business Assets to a Controlled, Unrelated Buyer
Capital Gain
The capital gains tax rate is 15 or 20%. The seller of business assets is entitled to report capital gain as the principal portion of each installment payment is received (unless the seller is a C corporation).
The primary exceptions relate to accounts receivable of cash-method taxpayers and depreciable property:
- Selling accounts receivable merely accelerates income recognition.
- Gain from depreciable property may be recaptured as ordinary income, or in the case of real estate, taxed at 25%.
- This tax can be avoided by leasing selected assets (e.g., equipment) to the buyer.
- A sale of depreciable property to a related person converts capital gain into ordinary income.
The Seller’s Economics
In an installment sale to an unrelated buyer, the note’s face value reflects the discounted future income of the business. Selling goodwill in exchange for a secured note effectively converts future income streams into capital gain and protects that cash flow via the lien securing the installment note.
This is similar to the economics of selling rental real estate, where goodwill reflects the discounted value of future rental income streams.
Post-Sale Compensation
It is common for the seller to provide services to the buyer after the sale and receive compensation for those services.
The Buyer’s Tax Posture
The buyer receives depreciation and amortization deductions on the purchased assets. Goodwill is deductible (amortized) over 15 years. For example:
- If $1.5 million of the purchase price is allocated to goodwill, the buyer gets a $100,000 annual deduction for 15 years.
- The buyer also deducts interest payments on the note and reasonable compensation paid to the seller.
- The principal portion of note payments is not deductible.
Coordinating goodwill deductions with principal payments, while paying seller compensation for excess income, could result in the buyer having no taxable income, while the seller converts $1.5 million of ordinary income to capital gain.
Unrelated Persons
A critical factor is ensuring the seller and buyer are not “related persons” for tax purposes. This hurdle is often determined by ownership rather than control. Separating control and ownership is common — e.g., a 1% voting stock and 99% nonvoting stock. The ownership question is typically resolved through estate planning and business structuring.
Estate Planning
The installment note replaces the business. As payments reduce the note, its value declines. This technique is also effective for addressing succession concerns and wealth transfer in estate planning.
Tax Risks
While the transaction can be structured to meet IRS requirements, judicial doctrines (sham transaction, step transaction, substance over form) must be considered. The key defense is demonstrating substantial non-tax motives such as asset protection, succession planning or estate planning. With proper structuring, tax risks are minimal.
Any intended change in equity positions can also support a valid business purpose (e.g., sale to a controlled entity when admitting a new physician to a medical practice).
Miscellaneous Considerations
Because the transaction is an asset sale, typical consequences include:
- A new taxpayer identification number, sales tax number, unemployment tax number, and bank accounts.
- Shifting most contractual relationships to the new entity (though the new entity can retain the seller’s name).
- Potential triggering of dissenters’ rights and vesting of fringe benefits.
Alternative Structure
To avoid the administrative burden of contract assignments, consider this structure:
- Seller is an S corporation (Oldco).
- Stockholders contribute all Oldco stock to a new S corporation (Parent S).
- Parent S makes a QSUB election for Oldco, rendering it a disregarded entity.
- Parent S sells Oldco stock to the buyer.
The IRS treats this as an asset sale, but without the need to assign contracts, change names, or transfer assets.
Summary
The combination of asset protection, conversion of ordinary income to capital gain, and other ancillary benefits makes selling a business to a controlled entity in exchange for a secured long-term note an attractive strategy in many situations. However, this is a major transaction — it must be carefully structured to fit the facts and avoid pitfalls. A “one size fits all” approach is not appropriate.
