Examples of success while working with the ADC CPA Team
Our client, an S-corp manufacturing company, became engaged in a sale process with a prospective buyer. They were seeking advice regarding the tax implications (personal & business) of the intended sale, as well as preparation of the required corporate and personal filings subsequent to sale.
Additionally, the sellers chose to further engage us to assist in matters concerning buyers’ diligence.
The sale of the S-Corp would be treated as a long-term captial gain to the seller, in this scenario. The challenge in accurately projecting the shareholder’s tax implications of the transaction rests in our ability to accurately estimate or project the shareholder’s selling price, stock basis, expense of sale, and timing of stock sale payments.
In many cases, buyers of a closely-held entity wishes to terminate the S election, since buyer is not a qualified S corporation shareholder (i.e. a foreign corporation acquiring a US subsidiary). In this instance, the challenge is understanding the appropriate cut-off between S Corporation and C Corporation, both in terms of transaction cut-off (closing balance sheet) and required short period federal and state filings.
Upon analizing the Stock Purchase Agrement (term sheet), we were able to determine gross selling price along with any purchase price adjustments such as those related to working capital. Collaborating with banking and advising partners, we re-categorized expenses as either operating expenses or expense of sale, depending on the nature of such expense. This was a priority as there were advantages of offsetting ordinary income (higher tax rate) versus capital gain (lower tax rate).
After reviewing each of the selling shareholders’ varying stock basis activity, we determined the shareholders’ basis as of the end of the tax year immediately preceding the year of sale.
Finally, we assessed each shareholder’s personal tax projection individually, to determine the overall impact of such a sale over one or more future tax periods. On the corporate side, we collaborated with management to audit the closing balance sheet and review the final working capital on the transaction date. Utilizing the cut-off date trial balance, we focused on any state tax implications for the corporation, and subsequently prepared any required short period federal and state tax returns. Utilizing the K-1’s produced off the pass-through entity short period tax returns we then also prepared the shareholders’ personal returns.
We provided value at each stage in the process while maintaining a focus on the tax effect of each decision at the shareholder level. Tax planning strategies are employed at each stage with an ultimate goal of tax minimization. Our selling shareholder clients are informed throughout the process and in many cases, we are able to estimate their tax liabilities within a very narrow margin, and well in advance of filing deadlines.
Additionaly, our involvement in the process helps to build up the buyer’s confidence level and overall assurance as they proceed deeper into the transaction. We are responsive to the buyer, transparent in our communications, detailed in our responses, thorough in our analyses, and resourceful when issues or challenges present themselves.
Our client, an S-corp manufacturing company, became engaged in a complex sale process with a prospective buyer. This unique challenge focused on purchase price allocation and its effect on the seller side tax liabilities. They were seeking advice regarding the tax implications (personal & business) of the intended sale, as well as preparation of the required corporate and personal filings subsequent to sale.
Additionally, the sellers chose to further engage us to assist in matters concerning buyers’ diligence.
Sale of assets (or S Corporation stock with a Section 338 (H)(10) election) is taxable to the selling shareholders depending on how the purchase price is allocated to the underlying assets. Sellers of buildings will report unrecaptured Section 1250 gain to the extent of prior depreciation allowed or allowable. Long-term gain in excess of depreciation is a captital gain under Section 1231. Sellers of equipment or vehicles recognize ordinary gain to the extent of prior depreciation and LTCG for any excess. Sale of inventory, accounts receivable, or any other current assets are generally recognized as ordinary income. Long-term gain is generally recognized on the sale of intangible asset, including goodwill (certain exceptions apply).
Negotiation of the purchase price allocation represents one of the most critical aspects of an asset sale and will have dramatic effects on both buyer and seller tax implications. Equally as important, many transactions between buyer and seller include additional consideration to “gross-up” the purchase price for the inherent differences (primarily higher taxes to the seller) for asset sale treatment. This presents a challenge in determining the appropriate “gross-up” value to compensate the seller for choosing to agree to the asset sale.
In an asset sale, the selling shareholders retain control over the existing S Corporation (survives the transaction) and there is typically no immediate termination of the corporation’s taxable year. The challenge we face involves careful analysis of the APA and the recording of post-closing asset sale entries to properly reflect the activity. The cash proceeds on sale will flow through the S Corporation (directly or indirectly) and typically flow out in the form of a pro-rata S distribution.
Upon reviewing the draft purchase agrement (or term sheet), we were able to determine gross selling price along with any purchase price adjustments such as those related to working capital. Collaborating with banking and advising partners, we re-categorized expenses as either operating expenses or expense of sale, depending on the nature of such expense. This was a priority as there were advantages of offsetting ordinary income (higher tax rate) versus capital gain (lower tax rate).
Next we analyzed the proposed purchase price allocation from both the buyer’s and sellers’ stanpoint. We used this analysis to help guide the final negotiation process as the details of the APA were addressed. We paid particular attention to the impact of the allocation on the character of the sellers’ income (ordinary vs capital gain). Typically, the sellers will favor the preferential rates associated with long-term capital gain treatment while the buyers will seek to allocate price in order to achieve accelerated tax depreciation or amortization. In this situation, we were tasked with developing a “gross-up” value to compensate the sellers for the higher tax expense typically associated with an asset sale (as compared to a traditional stock sale).
After accumulating the information above, our third step was to summarize the transaction utilizing an excel model in which we calculated the estimated amounts of oridinary income and long-term capital gain, incorporating different variables and alternatives.
Our final step was to review each shareholder’s personal tax projection individually, to determine the overall impact of such a sale. When we reviewed this for our client, we determined that it would be most beneficial to recognize long-term capital gain on the portion of the sale associated with goodwill under the installment sale method. This strategy helped to stretch the gain over multiple tax periods, thus taking advantage of the tiered long-term capital gain tax rates. We further analyzed the timing of the shareholders eventual disposal of his or her S corporation stock, which could, if properly planned, produce at least a partial offsetting long-term capital loss
On the corporate side, we worked with management to record the asset sale on the existing company’s books and we begin the planning process, primarily as it related to the entity-level state taxes, such as the MA Sting tax.
We provided value at each stage in the process while maintaining a focus on the tax effect of each decision at the shareholder level. Tax planning strategies are employed at each stage with an ultimate goal of tax minimization. Our selling shareholder clients are informed throughout the process and in many cases, we are able to estimate their tax liabilities within a very narrow margin, and well in advance of filing deadlines.
Additionaly, our involvement in the process helps to build up the buyer’s confidence level and overall assurance as they proceed deeper into the transaction. We are responsive to the buyer, transparent in our communications, detailed in our responses, thorough in our analyses, and resourceful when issues or challenges present themselves.
The client started a small construction business in 2018. He started by repairing things for his friends and family, collecting small fees each time. As word of mouth grew, his small business grew into full time work. He quickly went from making a few thousand dollars a year to netting over $50,000 in 2019. The client reached out to us during 2020 to let us know that he had hired additional staff, and is looking at netting over $150,000 in the current year and asked us what he could do to minimize taxes.
The challenge for our firm was to analyze the 2020 projected earnings, and ask the clients a series of questions to better understand their short term and long term goals. We inquired of whether the client intends to continue growing the business for a period of years and make this his primary career. Given the clients answers, we took a look at prior year income, self employment taxes, and current year projected growth to determine the next and best steps in order to minimize his business and personal tax.
It became clear to us that we should encourage the client to form an LLC and elect to be taxed as an S-Corporation.
After discussion with the client about the options, he agreed that we should form the LLC and file necessary paperwork to formally make the S-Election. WIth the client’s permission, we prepared Forms 8832 and 2553 and had the client sign and file with the IRS. Upon filing, we worked with our Payroll Department to set up payroll for the client so both he and his employees would begin being paid through W2 wages.
By doing this, we reduce the 15.3% self-employment tax that the net income would have been taxed at had it been filed as a Schedule C. Filing as an S-Corp also allows the client numerous options and benefits to more efficiently process payroll and payroll related transactions, such as withholding taxes, bonuses, paying expense reimbursements, and even making required estimated tax payments.
By electing an S-Corp status, we limited the extent of self-employment taxes that would have arose had he continued on as a sole proprietorship. .
Being involved in the clients business, and the client utilizing us for different services such as payroll, taxes, and bookkeeping allows us stay involved with the clients business and notice situations such as this. This allows us to suggest different tax saving methodologies to the client in a timely and efficient manner.
The client is a 100% shareholder of an s-corporation. He received a K-1 and a salary from this business. His wife also has an annual salary, and they receive investment income that adds to their annual income. This year the client asked us to do tax planning to see if we may be able to lower his income tax for 2020.
Our firm was presented with the challenge of reducing his 2020 income taxes. We reviewed the 2019 tax return and considered all factors. During this review, we made notes of all areas where we would be able to help him save money and ultimately help to ensure the client meets minimum safe harbor rules for estimated tax payments.
Safe harbor is the level of withholding that the taxpayer must meet through the year to avoid underpayment penalties. Based on income levels from the year before, the withholding level is typically 100% of the prior year tax balance. If this is not withheld evenly throughout the year, the taxpayer runs the risk of being assessed penalties.
Tax planning requires a level of understanding by the preparer in which they can set up different scenarios running different tax saving strategies. With this particular client, it was critical that we scrutinized several different areas of income and withholdings in order to come up with the best possible tax saving solutions.
By going through the clients past year tax return, we were able to identify certain areas where more tax could have been withheld, or tax strategies that haven’t necessarily been capitalized on in the past.
In this particular case, we first projected the clients 2020 wages and withholdings. Secondly, we took a look at the clients business income through Q3. Based on prior year trends and current year income levels, we project current year business income. Once accounting for necessary adjustments (Ie. depreciation, new fixed asset additions, distributions) we were left with the projected ordinary income amount. Thirdly, we had to account for potential changes in investment income or deductions, which we discussed with the client’s financial advisor.
Once calculated, we updated all information in our tax projection analysis. This allowed us to gauge a baseline understanding of the current year tax situation. From there, we were able to idenitfy tax saving strategies. We started by trying to limit any underpayment penalties by suggesting the client increase their tax withholdings. By using withholdings to catch up on estimated tax, you are able to more effectively reduce the risk of underpayment penalties. Additionally, we were able to set up several alternatives so the client could see different ways in which he could tackle his current tax situation to best reduce current year taxes or eliminate any penalty.
With this client, we ended up being able to offer him alternatives so he could be aware of what his personal tax looked like. We were able to educate the client on his current status, and advise him of potential next steps and scenarios to minimize taxes overall.
Tax planning allows us to proactively service our clients throughout the year and ensures we stay up to date with the client’s business. This way, we can help to quickly advise the client on all the changes that inevitably arise.