Corporation


In my last newsletter I offered some tips on issues to consider when buying a business.   The ink well isn’t dry yet…so here are a few more:

3. Ask the Seller to stick around.

When you buy a business, you are not just buying the Seller’s assets, you are buying their relationships, their goodwill, and a part of their life.  Having the Seller stay involved in the business for some time as a consultant or employee (a few months or even a year after the purchase) can be invaluable in ensuring a smooth transition.  The Seller may be the only one who knows where to find the extra set of keys to the cash register, or the Seller may be the key to keeping several big customer relationships.  These are the kinds of issues that can’t be completely addressed in the purchase documents and require continued cooperation from the Seller.  Of course, the Seller will expect to be paid for this service, but this is usually negotiated as part of the purchase price, so the Seller’s continued involvement is an integral part of the deal.  Often the Seller welcomes the opportunity to stay involved; they may seek the continued interaction with employees and customers and they will certainly want the business, their pride and joy, to continue to succeed.

 

4.  Watch out for surprise liens or judgments.

If bank financing is involved in your purchase, you can rest assured that your attorney will be required to make sure that the assets are free and clear of liens.  However many transactions these days do not involve bank financing and in those cases it is important  to have your attorney do a basic lien and judgment search as part of your due diligence.  If your Seller has a bank equity line of credit, the bank may have a UCC lien filed against all the Seller’s assets and unless that lien is released at closing it will follow the assets even though you as Buyer may have nothing to do with that equity line.   There are also possibilities of tax liens or other judgments which the Seller may have “forgotten” about.  Don’t rely simply on the representations and warranties given by your Seller in the purchase documents; those provisions are not binding on a third party creditor and will not help you when you are trying to get a release from the creditor so that you can get your own equity line in the future.

 

5.  LLC vs Corporation.

As you are making plans on a business purchase, you’ll have to decide the type of entity you want to use.  I don’t have space here to give you a full comparison of the options, but generally you will be looking at using either an LLC or a corporation.  If real estate is an asset in the business then an LLC will almost always be the preferred choice; remember my general rule – never put real estate in a corporation – if you need a refresher see my Nov 09 Newsletter on my blog.  A corporation is still the most common form of entity for operating businesses and can occasionally offer some tax savings opportunities.  Your best resource on this decision will be your CPA, since they will be handling your tax filings.

 

Give these issues consideration before you get too far into negotiations and don’t be afraid to call your attorney; your attorney can advise on these and other things to consider before you ever start discussions with the Seller and will save you time and expense in the long run.

 

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Do you have real estate owned in your corporation?  Watch out for a tax surprise!

Many of you have heard from your advisors (including yours truly) that if you own real estate either for your business or for investment then you need to protect yourself from liability by having the property titled in some form of corporate entity; see my June newsletter.  However, it is very important that you choose the right type of entity to own your real estate.  As a general rule, you should not use a corporation.  Why?  Corporate tax law is not friendly to the real estate owner.

I will spare you a lengthy discourse on the ins and outs of corporate tax laws, although I assure you that it’s fascinating!  The short answer is that real estate owned inside of a corporation generates an unexpected tax liability if you ever wish to move that property out of the corporation.  Let’s say that you acquire a couple of rental properties with a friend and you set up a corporation as the owner, but some years later you and your friend decide to part ways and split up the properties.  This would typically involve dissolving the corporation and transferring property out to each owner.  The problem is that the tax law treats that transfer of property as a “deemed sale.”  If the property has appreciated then that deemed sale triggers a capital gains tax for the corporation.  It is irrelevant that you haven’t actually sold the property or that no cash has changed hands.

For this reason, you should avoid using a corporation to own real estate in most cases.  Keep in mind that I am talking about real estate that you buy and hold (e.g. a location for your operating business, rental or investment property).  If, on the other hand, you are in the business of buying and selling real estate on a short term basis, then a corporation may work perfectly well for your needs, since you will recognize a tax liability anyway when you sell property; there is not the same potential for a deemed sale surprise.

Enter stage left….the limited liability company (LLC).  An LLC is typically taxed as a partnership, which operates under entirely different tax rules.  In particular, real estate can almost always be moved in and out of the name of an LLC without generating a tax liability.  Since the LLC still provides the same basic limited liability protection available in a corporation, the LLC has become the entity of choice for owning real estate.

What about an “S” corporation?  An “S” corporation is, in many ways, taxed like a partnership, however one important difference is that the deemed sale rule described above will still apply for an S corporation.  Although there may be special circumstances that help decrease this tax liability with an S corporation, the better option is to stay away from a corporation altogether.

If you are unfortunate enough to have a corporation that owns real estate already, then you may be stuck with this potential tax issue until you are ready to sell the property.  But please talk to your tax advisors before you take any action; you may have planning options to help minimize the tax liability.

Remember, tax time is no time for surprises.

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