Author Archives: franbiz

Purchase Price Allocation

Generally speaking when you purchase another business, you are only buying the assets of that business. In other words, you are not buying the entity. Why not? Well, the entity could have a lot of skeletons in the closet. Using our accounting firm example above, if the previous owner had made a mistake on a tax return and that mistake led to $100,000 in damages for the client, as the new owner do you want that responsibility or exposure? Nope.

There are circumstances where an asset sale is NOT ideal. At times the entity holds a license that is non-transferrable such as a liquor license or the entity has a contract with the government that took 7 years to bid and be awarded, and is also non-transferrable. But for most transactions, you will be executing an asset sale.

Within that asset sale is allocation of assets. Buyers and sellers have competing interests on price of course, but they also have competing interests on tax consequences. And to add to the complication, based on each party’s unique circumstances, a buyer and seller’s interests might be in concert with each other. In other words, an asset allocation might provide a favorable tax position for the buyer because of his or her own tax world, while still providing a favorable or at least neutral tax position for the seller. And these issues can affect the purchase price as well.

As business consultants and tax accountants, the Watson CPA Group is very aware of these competing interests and how they interplay with price negotiations. Let us help!

Let’s review some basics.

AssetPriorityBuyerSeller
CashClass INANA
InvestmentsClass IINANA
Accounts Receivable*Class IIINAOrdinary Income
Inventory, Book ValueClass IVNANone
Fixed AssetsClass VAmortized, VariesRecapture / Gain
IntangiblesClass VIAmortized, 15 YearsCapital Gain
GoodwillClass VIIAmortized, 15 YearsCapital Gain
Non-CompeteNAAmortized, 15 YearsOrdinary Income
Consulting AgreementsNAExpensedIncome + SE Tax

* Sellers using an accrual method of accounting would not recognize income for the sale of their Accounts Receivable

The IRS breaks assets into classes, and essentially once you’ve allocated everything to Class I thru Class VI, whatever is left over is then considered Goodwill. So if the price is $200,000 and all your assets add up to $150,000, then you are also purchasing $50,000 in Goodwill.

Some more notes. Cash and investments are usually kept by the seller in an asset sale. And commonly so is Accounts Receivable- most sellers will say that they earned this income, and it is just a matter of collecting. Buyers are usually accepting since collections can be tough- why pay for an asset that might not fulfill its value. If, however, a seller does transfer his or her Accounts Receivable (AR) to you, that will be considered ordinary income for a seller who is uses the cash method of accounting. Who would have Accounts Receivable yet use a cash method of accounting? Lots. The Watson CPA Group invoices clients but does not recognize income until payment is made. We use the cash method of accounting, and use our AR as a way to maintain the naughty list and the good list.

Ok. Back to the competing interests.

Generally speaking, the buyer wants as much allocation to items that are currently deductible such as a consulting agreement and to assets that have short depreciation schedules. However, there are always circumstances where the buyer might want to defer deductions to later years, or some other unique scenarios. When people ask us this question it takes about 10 seconds to ask the question, about 30 seconds to give the generalizations, and about two hours of consultation, projection and review to ensure allocation is being handled correctly.

The seller typically wants as much of the purchase allocated to assets that enjoy capital gains treatment, rather than to assets that bring ordinary income. Capital gains max out at 23.8% (including the net investment income tax) where as ordinary income could be as high at 39.6%. Again, there are always scenarios that might make sense to flip this around- perhaps there is a net operating loss from previous years that needs to be used before expiration, or some other situation.

Bottom line is that price and asset allocation must be handled carefully. It is commonly used a negotiation tactic, and to properly negotiate you as a buyer or a seller should know what the other side is thinking. That’s just smart business.

Recapture of Depreciation

Assets that are eligible for depreciation might have two elements of gain. One is recapture of depreciation and the other is capital gain. Let’s say you had $50,000 in furniture that is being sold with the business, and you depreciated it to $10,000. If $65,000 was allocated to furniture, you would have a $40,000 recapture taxed as ordinary income and another $15,000 in capital gains taxed at your capital gains rate. Here is in table format-

Furniture Purchase Price50,000
Accumulated Depreciation40,000
Tax Book Value10,000
Price Allocation to Asset65,000
Tax Book Value10,000
Recapture, Ordinary Income40,000
Remainder, Capital Gains15,000

Non-Compete Agreements

Even though non-compete agreements are tough to enforce they still show up in business asset sale and purchase agreements. As an aside, you should consider using a non-disclosure agreement in addition to your non-compete agreement. Typically these are bad for both parties from a tax perspective- non-compete agreements or covenants not to compete, whatever you want to call them, at taxed to the seller as ordinary income but then are amortized over 15 years for the buyer. This is one area that both parties have an interest in keeping low (but you should consult an attorney at to actual value of the non-compete agreement, it might have some repercussions from a litigation perspective).

Sales Tax and Assumed Liabilities

Sales tax might need to be collected on the sale assets, and are usually collected by the buyer. Most sellers will want the buyer to simply back out sales tax from the purchase price. So, if a $500,000 deal would incur $10,000 in sales tax, the buyer is essentially paying $510,000 since the seller still wants $500,000 in proceeds. Sales tax will vary by state and by purchase price allocation, and is only due on certain assets. Again, this needs to be vetted out and modeled by experienced tax accounts- we suggest us.

Of course if the transaction is a stock sale as opposed to an asset sale, then sales tax does not usually apply.

Assumed liabilities. Messy. Try not to do it. There are instances where you must, and it can get complicated beyond the scope of this book.

Employment / Consulting Agreements

Transition between owners is critical. A tax and accounting firm can buy another tax and accounting firm, and even though the work is nearly identical, the seller is usually retained to help with client transition. This is true in most businesses, especially those in the service industry.

The value of the employment or consulting agreement is an instant tax deduction to the buyer, but it incurs ordinary income tax PLUS self-employment tax for the seller. Unless that seller was smart, read our book and elected to be treated as an S Corp. Remember, most deals will be an asset sale, so the seller retains the business entity. And if that entity is an S Corp then that income can be sent through the entity and shelter some of the self-employment tax.

Some more thoughts. At times the buyer and seller will use the employment/consulting agreement as quasi-seller financing without calling it seller financing. This can help with debt ratios, and debt service calculations (more on that later) since the bank will want you to be able to service all debt instruments including their own. These agreements at times can bypass some of that scrutiny.

Also, some attorneys do not like these agreements lasting for more than one year. Some cases have been litigated, and purchase contracts have been considered null and void because there was not an effective transfer of ownership because the seller was under an employment / consulting contract. Seems crazy, but true.

There have been instances where a seller was retained through a consulting agreement, and misrepresented the company to customers. Lawsuits have been successfully litigated resulting in damages being awarded based on the behavior and representations of the seller while contracted as a consultant for the buyer. Be careful.

As a buyer you should get in, use the seller during a short transition, and get going. As a seller, you should help your buyer, defer future client interaction to the new owners, and get out. Transition is one of the toughest things to agree upon, execute and find success. Good luck.

For more information please visit: https://www.watsoncpagroup.com/kb/purchase-price-allocation_251.html

Health Care Expenses, Premiums, HRAs, HSAs – Section 105

An LLC or S-Corp allows you set up a plan to reimburse shareholders (and employees) for medical premiums and expenses plus make contributions to a Health Savings Account (HSA). And this can actually save a significant amount of Social Security and Medicare taxes. Read on.

Health Insurance Premiums

In IRS Notice 2008-1 premiums paid under individual medical and health insurance plans may be deductible on your personal tax return (the usual Form 1040) if the following conditions are met:

  • The S-Corp must establish an Accountable Plan for the payment of health insurance premiums on behalf of the shareholder.
  • The S-Corp must either directly pay the premiums for the plan or reimburse the shareholder for the premiums paid. Proper recordkeeping habits must be followed.
  • Here’s the kicker- premiums paid or reimbursed must be included in Box 1 of the shareholder’s W-2. The health insurance premiums are not included in Box 3 Social Security Wages and Box 5 Medicare Wages (thus they are exempt from employment taxes). This might take some payroll coordination, but it certainly is worthwhile.

By including the cost of health insurance as wages in Box 1 on your W-2, the S-Corp gets a “wage expense” deduction, which in turn reduces the K-1 income for all shareholders (but each shareholder gets comparable a bump in W-2 income as a part of his or her reasonable salary). On your personal tax return, you will get a dollar for dollar deduction for health insurance premiums paid. This directly reduces your adjusted gross income, and is not a Schedule A itemized deduction (which is good). If this procedure is not followed, the premiums can only be deducted on Schedule A subject to the 7.5% or 10.0% income thresholds for medical expenses (which is not good).

The policy can be in the name of the shareholder yet the S-Corp can make the premium payments directly. Or the shareholder can pay the premiums and be reimbursed- we suggest keeping the paper trail to a minimum and having the company pay directly.

Health Reimbursement Arrangement (HRA)

Update- it appears that the Affordable Care Act (Obamacare) has made health reimbursement arrangements obsolete. However, the following information remains in our article in case things change-

An S-Corp can also adopt a Section 105 Health Reimbursement Arrangement (HRA). Two providers seem to have the best handle on it- BASE and ZaneBenefits. Here is the summary from BASE-www.watsoncpagroup.com/BASE-HRA.pdf

By adopting an HRA you can maintain your current reasonable salary yet reclassify a portion of it (and perhaps a large portion of it) as reimbursement for health care expenses. For example, let’s say your salary is $36,000 and your health care premiums plus other expenses are $500 per month or $6,000 a year. As a result, only $30,000 will be subjected to Social Security and Medicare taxes, while $36,000 is being reported as wages. A win-win scenario since higher reported wages and lower taxes is good. As in real good.

Health Savings Account (HSA)

Unlike an HRA whose fate might be sealed with ACA, the S-Corp can also make HSA contributions associated with your high-deductible health insurance plan. As mentioned in other areas of this article, even with a Health Reimbursement Arrange (HRA), an HSA is a great way to save taxes today on money you need when you retire. It is a foregone conclusion that when you get older you’ll need more medical attention. When you need a new hip at age 72, you’ll be drawing money from somewhere- either your 401k or your HSA. So in some regards, your HSA becomes a retirement vehicle.
And, most HSAs have investment choices within them such as choice of funds and other options. Talk to your HSA provider.

Flexible Spending Accounts (FSA)

If you do not use a high deductible insurance plan (e.g., CDHP), you might be ineligible or not have access to a Health Savings Account (HSA). Your only choice is the Flexible Spending Account (FSA). FSAs act very similarly to an HSA from an instant tax savings perspective. But, and this is a whammy, it might be a use it or lose it program. So, if you have $1,000 in medical expenses yet deducted $2,500 in pre-tax dollars for your FSA, you better round up another $1,500 in qualified medical expenses such as contact solution to not lose the money.

All FSA payments for the prior tax year must be made by February 15, such as medical procedure performed on December 31 yet billed in January of the following year. And the reimbursement request must be submitted by March 15 (this is a generalization depending on your plan provisions).

However, there is an interesting caveat to the use or lose it system- if you lose the money because you didn’t have enough qualified medical expenses, the money is returned to the company. And if you administer your own FSA plan, this money becomes a weird slush fund of sorts (at this time we do not have a good handle on how to treat or label this returned FSA money- it certainly warrants looking into).

Starting in 2014, FSA programs can either extend reimbursements until March 15 or allow you to rollover $500 to the next year.

How Health Expenses Reduces Self-Employment Taxes

As mentioned earlier, self-employment taxes and Social Security / Medicare taxes are the same thing. When you pay health insurance and / or make health savings account contributions, this must be reported in Box 1 of your W-2. This income is subject to income taxes, but not Social Security and Medicare taxes. And you get a $1 for $1 deduction as well on your personal tax return, so the income is a wash.

But extra savings kick in with the reasonable salary testing. As mentioned, 50% of net income is a jumping off point for a reasonable salary. But what if a big chunk of the 50% is actually health insurance premiums and HSA contributions? Example-

 With
Health Insurance
Without
Health Insurance
Net Income$100,000$100,000
Reasonable Salary at 50%$50,000$50,000
Health Insurance Premiums$12,000$0
HSA Contribution$5,000$0
W-2, Box 1 Income$50,000$50,000
W-2, Box 3 Social Security Income$33,000$50,000
W-2, Box 5 Medicare Income$33,000$50,000
Social Security, Medicare Taxes$5,049$7,650

So, by having the company pay for your health insurance premiums and / or make HSA contributions on your behalf, you could save thousands of dollars in Social Security and Medicare taxes. In this example the savings are over $2,600, and frankly the health related figures above might be low.

For more information please visit www.watsoncpagroup.com/kb/19