Welcome to CPA at Law, helping individuals and small businesses plan for the future and keep what they have.

This is the personal blog of Sterling Olander, Certified Public Accountant and Attorney at Law. For over five years, I have worked as a tax professional helping clients with tax mitigation strategies, tax controversies, business transactions, wealth preservation structures, tax-exempt organiations, and estate plans.

I write about any legal, tax, or technological information that I find interesting or useful in serving my clients. All ideas expressed herein are my own and don't constitute legal or tax advice.

The Basics of the Tax Consequences of a Business Asset Sale

The sale of a business by a seller to a purchaser generally can take two forms: A sale of the business’s assets or a sale of equity interests in the business. As a general rule, the seller will favor a sale of equity and the purchaser will favor an asset sale. This is because with an equity sale, the seller will have capital gain whereas with an asset sale, the seller generally has some ordinary income. An asset purchase is more appealing to the purchaser because the tax basis of the assets will be equal to their purchase price and can be depreciated on that basis. The sale of a business via an asset sale is treated as if each of the assets of the business were sold separately for purposes of determining gain or loss.

All assets sold in an asset sale must be classified as capital assets, depreciable property used in the business, real property used in the business, or property held for sale to customers, such as inventory or stock in trade. The gain or loss on each asset is figured separately. The sale of capital assets results in capital gain or loss whereas the sale of real property or depreciable property used in the business and held longer than one year results in gain or loss under IRC § 1231. The sale of inventory results in ordinary income or loss to the seller.

In general, both the purchaser and seller of a business must use the “residual method” to allocate the consideration to each business asset transferred. The purchaser’s consideration is the cost of the assets acquired. The seller’s consideration is the amount realized (money plus the fair market value of property received) from the sale of assets. The residual method determines gain or loss from the transfer of each asset and how much of the consideration is for goodwill and certain other intangible property. It also determines the purchaser’s basis in the business assets.

The residual method requires the consideration to be reduced first by the cash and general deposit accounts (including checking and savings accounts but excluding certificates of deposits) and allocated among the various business assets in the following order:

Class I: Cash, demand deposits, and similar cash items.
Class II: Readily marketable stock and securities and certificates of deposit.
Class III: All other tangible and intangible assets not in any other class.
Class IV: IRC § 197 intangibles other than goodwill and going concern value.
Class V: Goodwill and going concern value.

In this way, gain and/or loss is allocated among all the assets of the business.

Probate Assets vs. Non-Probate Assets

Some people are under the mistaken impression that having a will means that the probate process will be avoided upon death. Having a will allows you to appoint who will handle your affairs and who will inherit assets, and it can provide for various methods to lower costs to the estate (such as waiving the bond required of a personal representative). However, a will does not avoid the probate process; it simply gives directions to the probate court, and it must be probated in order to be effective.

If an asset is held in joint tenancy and a joint tenant survives, that asset will be a non-probate asset and pass outside of the probate process. Life insurance, annuities, IRAs, pension plans, or accounts with a P.O.D. (payable on death) or T.O.D. (transfer on death) designation will avoid probate using beneficiary designations, if the beneficiary survives. Any property held in trust, such as a living trust, will be non-probate property. Nearly all other assets cannot be transferred upon death without passing through the probate process.

Personal Residence LLC and Trust Tax Considerations

Some asset protection attorneys recommend placing personal residences into entities, while others prefer trusts. While both have their pros and cons, no decision should be made without ensuring that the federal tax benefits of owning a personal residence are maintained.

The Internal Revenue Code provides a significant tax advantage to taxpayers who own a personal residence. First is the interest deduction of as much as $1 million of acquisition indebtedness and up to $100,000 of home equity indebtedness on a qualified personal residence. Taxpayers who do not hold legal title to a residence but who can establish they are the equitable owners of the property are entitled to deduct mortgage interest paid by them with respect to the property. Transferring a personal residence into an asset protected entity should not affect this deduction as long as the taxpayer remains the equitable owner of the property.

Second, and more important, IRC § 121 provides for an exclusion from taxable income of $250,000 ($500,000 for married couples) worth of gain on the sale of a personal residence. This exclusion may be claimed every two years as long as the taxpayers owned and used the property as their principal residence for two out of the previous five years prior to the sale.

Treas. Reg. § 1.121-1(c)(3)(i) provides that if a taxpayer owns his or her residence in a trust, as long as the taxpayer is treated as the owner of the trust, he or she is treated as owning the residence for purposes of satisfying the two-year ownership requirement. Treas. Reg. § 1.121-1(c)(3)(ii) provides that if an individual taxpayer owns his or her residence in an entity, as long as the entity has the taxpayer as its sole owner and is disregarded for federal tax purposes, he or she is treated as owning the residence for purposes of satisfying the two-year requirement.

One other possibility exists in community property states where a married couple owns the limited liability company 50-50, as the entity can elect to be taxed as a disregarded entity under Rev. Proc. 2002-69. The couple will be able to own their residence in the LLC and satisfy the two-year requirement.