acquisitions

Frank J. Vari, JD, MTAx, CPA

Much has certainly been written about the recently proposed regulations on IRC §951A known more famously as the Global Intangible Low-Taxed Income (“GILTI”) regime. What has not been widely publicized are the basis adjustment rules for consolidated groups. This may not be the most easily understood topic but it may be one of the most important topics to groups that are active or expect to be active in the merger & acquisition arena. The GILTI basis adjustment rules are a new area of complexity and risk.

Overview

The GILTI basis adjustment rules are rather simple to understand but are very complex in practice. They require basis adjustments for consolidated group members and Controlled Foreign Corporations (“CFC”) that contribute tested losses to the group. They are intended to prevent the “double dipping” of tax benefits where a member’s GILTI tested loss is used to reduce a current year consolidated group GILTI income inclusion and then again when the contributing member’s outside tax basis remains high when that group member is sold. The rule’s required downward basis adjustment which corresponds with the member’s GILTI tested loss ensures the benefit is only taken once.

That all seems simple enough in theory but practice is another matter. Maintaining regular individual member and CFC federal tax basis calculations is sufficiently difficult and cumbersome that most consolidated groups fail to do it at all. The price for this is that there is usually a very time crunched calculation performed to model or calculate gain or loss when a group member becomes involved in a proposed transaction. When you take into account that many states have not decided whether to join GILTI or not, you are left with calculating three separate basis calculations for each group member – US federal tax, state tax, and US GAAP/IFRS – all potentially reflecting differences due to GILTI basis adjustments.

The Basis Adjustment Rules

Let’s take a look at the basis adjustment rules in detail. As noted above, the basis adjustments relate to the use of tested losses by the group. The Proposed Regulations provide a complex set of rules intended to prevent US consolidated groups from receiving dual benefits for a single tested loss that results if a domestic corporation benefiting from the tested losses of a tested loss CFC could also benefit from those same losses upon a direct or indirect taxable disposition of the tested loss CFC.

The rules apply to any domestic corporation – not including any Regulated Investment Company (“RIC”) or Real Estate Investment Trust (“REIT”) – that is a US shareholder of a CFC that has what the Regulations call a “net used tested loss amount”. The US group must reduce the adjusted outside tax basis of the member’s stock immediately before any disposition by the member’s “net used tested loss amount” with respect to the CFC that is attributable to such member’s stock. Please be further aware that if this basis reduction exceeds the adjusted outside tax basis in the stock immediately prior to the disposition then this excess is treated as gain from the sale of the stock and recognized in the year of the disposition.

The term “net used tested loss amount” is the excess of:

the aggregate of the member’s “used tested loss amount” with respect to the CFC for each US group inclusion year, over;
the aggregate of the member’s “offset tested income amount” with respect to the CFC for each US group inclusion year.

The amount of the used tested loss amount and the offset tested income amount vary depending on whether the member has net CFC tested income for the US group inclusion year.

For a very basic example, let’s take a US group member with two CFCs. In year one, CFC1 has a $100 tested loss that offsets $100 of tested income from CFC2. In year two, CFC1 has $20 of tested income that is offset by a $20 tested loss from CFC2. The rules tell us that the $100 used tested loss attributable to the CFC1 stock from year one is reduced by the $20 of CFC1’s tested income from year two that was used to offset CFC2’s tested loss. The result is a net used tested loss amount of $80 to CFC1 at the end of year two. If we changed the facts a bit and assumed that CFC1 and CFC2 were held by separate US consolidated tax group members you can see the true complexity emerge regarding outside tax basis determinations at both the CFC and consolidated group member levels.

The Proposed Regulations provide guidance for tracking and calculating the net used tested loss amount of separate CFCs when those CFCs are held through a chain of CFCs. In certain cases, a disposition of an upper-tier CFC may require downward basis adjustments with respect to multiple CFCs that are held directly or indirectly by the upper-tier CFC. Further, the Proposed Regulations provide guidance with respect to tracking and calculating the net used tested loss amount with respect to a US shareholder attributable to stock of a CFC when the CFC’s stock is transferred in a nonrecognition transaction or when the relevant CFC is a party to an IRC §381 transaction.

Conclusion

There is no need to detail any and all adjustments here because the regime is simply too complex to easily summarize. The point is that the outside basis calculation for CFCs and consolidated group members before GILTI has just become much more difficult and complex. Consolidated tax group contemplating current or future transaction activity are well advised to maintain these basis adjustments annually lest they be forced to perform these very difficult – yet meaningful – calculations in the crunch time of a transaction.

Frank J. Vari, JD, MTax, CPA is the practice leader of FJV Tax which is a CPA firm specializing in complex international and U.S. tax planning. FJV Tax has offices in Wellesley and Boston. The author can be reached via email at frank.vari@fjvtax.com or telephone at 617-770-7286/800-685-2324. You can learn more about FJV Tax at fjvtax.com.

Frank J. Vari, JD, MTax, CPA

Personal Goodwill is a popular planning tool for sellers of closely held C Corporations. This timely article explains this often misunderstood and improperly applied tax planning technique.

In our practice, we see a number of closely held C corporations with shareholders either actively looking to sell and/or examining the possibilities of selling their business.[1] Many of these shareholders are actively engaged in these businesses and many have been so engaged for long periods of time. These businesses include, but are not limited to, legal and CPA practices, insurance agencies, medical practices, and other similar entities where the shareholder’s relationships are integral to the business and customer relationships.

What we also see are a potential buyer’s general avoidance of closely held C corporation share purchases largely for tax reasons.[2] The buyer’s primary tax reason is often goodwill.[3] As an asset buyer, they will enjoy the tax amortizable goodwill generally resulting from an asset purchase.

For the seller, a C corporation share sale allows them to enjoy lower preferential capital gain tax rates. On the other hand, an asset sale results in double taxation. The asset sale proceeds are first taxed at the C corporation level and again at the individual shareholder level when the sale proceeds are distributed. However, in practice, a C corporation share buyer can be difficult to find which forces sellers to look for ways to lower their tax bill.

For the C corporation shareholder facing a corporate asset sale and the selling shareholder has a strong relationship with his or her customers forming the basis of the business itself, attributing goodwill to the shareholder instead of the business may result in substantial tax savings to the seller. In essence, the buyer is making two separate purchases. First, the assets of the business are purchased from the C corporation and, second, the personal goodwill from the shareholder.

The concept that personal goodwill is a separate transferable asset in a corporate asset sale is not new or terribly unique.[4] In general, to establish personal goodwill, one must support the premise that the goodwill’s value is attributable to the continued presence and/or abilities of a certain person and that this person is the legal owner of this goodwill and, as such, is the only person who can sell or transfer it. The taxpayer must successfully demonstrate that the value of their personal relationships was far more valuable than the business entity itself without them. If you envision a long time CPA practice with one primary member who built and sustained the practice you can see where this is quite often the case.

The primary issue with using personal goodwill as part of a business asset sale is that it relies almost exclusively on facts and circumstances. This means that all relevant facts must be understood and addressed under the prism of tax case law and that the transaction must be supported by adequate supporting documentation in order to withstand audit. Make no mistake, these transactions are quite frequently audited and the IRS is often successful when favorable facts, misapplied law, and adequate documentation are lacking.

As far as facts and circumstances, the IRS places the burden of proof on the taxpayer to demonstrate the valid separation of corporate goodwill from individual goodwill. How, in general is this done? In the seminal case of Martin Ice Cream v. Commissioner[5], the selling shareholder of an ice cream distributor successfully claimed that he had built his distribution business on the foundations of his personal relationships with supermarket owners and, further, that his relationships were still considerably valuable to the business at the time of sale. One very key fact in Martin was that the selling shareholder had never transferred his personal goodwill to the corporation via an employment agreement or covenant not to compete. That was, and is, a very significant fact (more about that later). As a result, this personal goodwill was valued separately and was deemed to be sold separately for tax purposes. Later cases continue to apply this same logic.

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As noted in Martin and related authority, the existence of an employment agreement or covenant not to compete agreement, or the lack therof, can significantly impact a personal goodwill analysis.[6] These agreements can be fatal to a personal goodwill position especially where these contracts either restrict the seller’s activities outside of those benefiting the business and/or transferring their goodwill to the business itself.

In one landmark case[7], a dentist sold his C corporation practice that he had built and maintained for years. He took the position that his personal goodwill was integral to the business and was his to sell separately to the buyer. Points well taken, but the dentist had executed a covenant not to compete with his corporation where he was restricted from practicing with fifty miles of his corporate practice’s location. In this case, the IRS was victorious by arguing that, by virtue of this agreement, his goodwill with his existing patients was almost nil as they would likely not travel over fifty miles to retain him as their dentist. Even though the dentist, as sole shareholder, could have renounced this agreement prior to the sale he failed to do so. The bottom line here is to understand all of the facts and especially any written agreements that could impact the value of personal goodwill and that a little upfront planning goes a long way.

What must a practitioner do to ensure the tax benefits of a personal goodwill sale are realized and will withstand IRS audit scrutiny? Here are some hallmarks of a successful personal goodwill analysis:

Begin any personal goodwill analysis in advance of any sale discussion. This is easier said than done but trying to perform a thoughtful analysis during the timeline of negotiations is difficult and inherently dangerous particularly when the detailed analysis of historical data is required.
Thoroughly understand the history and the substance of the personal relationships involved in the business. Facts and circumstances are often unclear and documentation can be ambiguous. It is absolutely essential that time and effort be taken to understand all of the facts and that they are appropriately documented. You never want facts to come out during audit that you did not address and/or fully consider their impact.
Understand the authority around personal goodwill. This is especially true of authority that addresses your specific facts and circumstances that you are relying upon to support your personal goodwill position. As with facts, you never want the IRS for any taxing authority to outline negative authority that you’ve not previously evaluated.
Discover and understand any existing legal agreements, written, oral, or otherwise that impact the position that the shareholder’s personal goodwill belongs exclusively to them and that this goodwill is a considerably valuable asset at the time of the sale. Is it possible that you need a lawyer’s opinion that the goodwill does not belong to the corporation and is exclusively the shareholder’s transferable legal property? If you do, please proceed in that direction.
Have the buyer separately contract with the selling shareholder for the purchase of their personal goodwill. This contract should be as separate and distinct as possible from the corporate asset purchase and should recognize the personal goodwill as separate and distinct from any corporate goodwill.
Obtain a separate independent valuation of the seller’s personal goodwill. This valuation should be performed in accordance with Generally Accepted Valuation Principles and should properly measure both the value and ownership of the goodwill.
One should also consider performing an overall valuation of the entire business asset values including and excluding the selling shareholder’s personal goodwill. You may want to do this to ensure that the asset values support the economic value of the transaction. For those that have performed IRC 1060 asset value allocations, one knows that although those allocations are binding on the taxpayers, they are not binding on the IRS per the longstanding Danielson[8] This valuation can provide valuable substance to the transaction.
Analyze securing a covenant not to compete agreement with the buyer contemporaneous with the sale. Properly constructed, this helps support the position that the seller had a valuable asset that the business requires to maintain its value.
Raise the personal goodwill issue with the potential buyer early in the process. The buyer will likely need time to consider it with their advisors and its simply bad practice not to raise it if it will be the seller’s course of action.

Personal goodwill is a popular planning tool and is very effective at lowering a selling shareholder’s tax bill when the facts are right and the transaction is properly structured and supported. Understanding these rules and practices will make sure your clients can enjoy this valuable tool with minimal risk.

[1] This may also apply to S corporation with earnings and profits or an S corporation subject to the built-in gains tax.

[2] There are also driving legal concerns particularly avoiding legacy legal issues around the selling corporation. This is especially often true of smaller closely held corporations.

[3] Other tax reasons include a “stepped up” basis in depreciable assets and avoiding any undisclosed tax liabilities within the selling corporation.

[4] see Thompson v. Thompson , 576 So.2d 267 (Fla. 1991); Martin Ice Cream Co. v. Commissioner, 110 TC 189 (1998); Norwalk, TC Memo 1998-279.

[5] id.

[6] see Kennedy, T.C. Memo. 2010-206.

[7] Howard v. US, 106 AFTR2d 2010-5533 (DC WA, 2010).

[8] Commissioner v. Danielson, 378 F.2d 771 (3d Cir. 1967); see also Peco Foods, Inc., T.C. Memo. 2012-18.

acquisitions

Beware of GILTI Basis Adjustments

Why is Personal Goodwill Good for Closely Held Corporation Shareholders?