If you're considering selling part ownership to a valued associate, you need to know the tax traps for buyers and sellers.
Getting ready to buy or sell? Once you agree to terms, the transaction must be structured, and the taxes you'll pay depend largely on your business entity. In most instances, you'll form a partnership (limited liability company). If you operate as a corporation, the question is what kind, "C" or "S"?
If you're buying a partnership interest, you should get a tax deduction for the underlying assets purchased that are identified as depreciable or amortizable. But a "Section 754 Basis Adjustment" election must be made and attached to the tax return in the year of purchase to obtain these deductions.
Sellers, most of the sale proceeds should be taxed as capital gain. But be careful—some may be taxed as ordinary income. The interest your associate pays on the buy-in note is tax deductible, and if you finance, it counts as ordinary income to you, taxed at your standard federal income rate of up to 35 percent.
If you sell a corporate interest, you're selling stock. Unlike the purchase of a partnership interest, associates receive no tax deduction for what they purchase. Their purchase is made with after-tax dollars. The seller pays 15 percent federal capital gains tax.
The difference between "C" and "S" corporation status can be huge for the associate. Associates who purchase "C" corporation stock make an investment purchase, and the interest they pay on their note is investment interest only deductible against investment income. Most associates don't have investment income, which makes the interest they pay very difficult to deduct. Interest paid to purchase "S" corporation stock is business interest and fully deductible.
Some associates like to work out arrangements and make their purchase with sweat equity, so they receive an ownership interest instead of compensation. Sweat equity is taxable to the associate just like compensation and converts the owner's receipt-of-sale proceeds from capital gains (15 percent rate) to ordinary income (up to a 35 percent rate). So think carefully before you choose this route for a buy-in. And as with any complicated transaction, always work with a team of competent financial advisors.
Gary I. Glassman, CPA, is a partner with Burzenski and Co. PC in East Haven, Conn., and a Veterinary Economics Editorial Advisory Board member.
Gary I. Glassman, CPA