Sale of Business

[Elisabeth]

My client is selling her business, which is taxed as a partnership. The asset allocation of the sales price is to four categories:

a.equipment and other fixed assets - sale will be reported on Form 4797, not subject to SE, ordinary or capital gain depending on depreciation recapture

b. inventory - this is ordinary income but does sale go on the Form 4797 Part II or is it included in the ordinary business income on page 1 on the Form 1065 and thus subject to SE?

c. covenant not to compete - this is ordinary income

d.goodwill - capital gain


Questions:

1. I haven't been able to find any specific references on which form to report the sale of inventory assets - I know it is ordinary income, but is it subject to SE Tax? Should it go on part II of 4797 on be included in ordinary business income on page 1 on the form 1065?

2. Convenant not to compete - does it go on Form 4797, Part II as ordinary income?

3. Goodwill - does this go on schedule D because it is a capital asset?

4. Re selling expenses such as broker's fee - does one allocate a portion of the expense to each of the asset categories to get the net sale proceeds?

Thanks for your help. I have been researching this topic for a while -- and just want to make sure I am on the right track. This is my first business sale.

Elisa Steele, CPA

[Bees Knees]

IRS Pub 544, page 21 says:

“A business usually has many assets. When
sold, these assets must be classified as capital
assets, depreciable property used in the busi-
ness, 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. The
sale of real property or depreciable property
used in the business and held longer than 1 year
results in gain or loss from a section 1231 trans-
action (discussed in chapter 3). The sale of
inventory results in ordinary income or loss.”


That tells me that you treat the sale of each asset as if sold separately in separate transactions. So for example, if you just sell inventory in a separate transaction, how is it handled? It goes on page 1 of the 1065, subject to SE tax. If you sell depreciable property, how is it handled? It goes on the 4797.

In other words, just because it is the sale of ALL of the assets, it does not convert what normally would go on Schedule D or on page 1 of the 1065 to the 4797. You still treat each asset as if sold separately.

That means the sale inventory is subject to SE tax.

The sale of a covenant not to compete is treated as compensation, subject to SE tax (Parker v. Commissioner, T.C. Memo 2002-305)

The sale of goodwill is a sale of a capital asset, reported on Schedule D.

Selling expenses should be allocated between each separate asset.

This is also supported by the wording in Code Section 1402(a)(3)(C) which clearly states that a sale of inventory is subject to self-employment tax. The code uses the terms “exchange, involuntary conversion, or other disposition of property…”

Those terms seem all inclusive, as if any and all means of getting rid of inventory for money is subject to SE tax. There does not appear to be an exception for if the inventory is part of a complete sale of all business assets.

[Elisabeth]

Thanks, Bees Knees

Thanks for your input. I had read the info in the Pub before, but you clarified it for me. I also looked up the tax court memo and that is very helpful in understanding what is subject to the SE Tax. I appreciate your specific cites and pub references.

[Roland Slugg]

Some other views

As a point of interest, when one of my clients sells his business, I usually advise him to credit the portion allocated to the sale of inventory as a credit to the "purchases" account on the company's books. Then if an income statement is prepared, that sale of inventory will not skew the COGS ratio. The net tax effect is the same.

The Tax Court case referred to above is wildly off point, dealing with a cancelled contract with a manager for an insurance company. A covenent not to compete, arising in connection with the sale of a business, produces ordinary income but is not subject to SE tax. Report on F-4797, Part II.

[Bees Knees]

I agree

Roland,

I have to agree with you. You are correct that case did not address the issue. In looking at further cases, I find this:

Milligan V. Commissioner (9th Cir. 1994), "It would appear that Milligan received the Termination Payments because he stopped working for State Farm and did not compete with State Farm. The payments derived from termination of the Agent's Agreement(termination of Milligan's business activity for State Farm), and Milligan's compliance with the contractual covenant not to compete (and return of State Farm property). Payments derived from the cessation of Milligan's business activity are not subject to self employment tax...("Noncompetition does not constitute the carrying on of a trade or business.").

[Bird Legs]

Covenant not to Compete

This may be taxable as capital gain, depending on certain situations.
Rev. Rul. 65-180 - "if a Covenant not to compete accompanies the transfer of
goodwill in the sale and serves the primary function of assuring the purchaser
of the beneficial enjoyment of the goodwill acquired, the covenant not to compete
is not severable from the goodwill and the entire amount is treated as a
capital asset, the entire amount is treated as a capital gain."
Let us say that the seller is getting on up in years, or in ill health, where there
is no way for the individual to go back in business, there really is no need
for a noncompete agreement.

[Bees Knees]

Bird Legs,

I think in that case, what the ruling is saying is that it really is not a covenant not to compete, but rather, goodwill. Obviously if the guy is too old to go down and start up a new business across the street, or finance someone else to do it, then the payment is really goodwill.

I don't think that would be your typical covenant not to compete situation. In most cases, the covenant not to compete is in place because there is a real possibility the seller (or key employees) could re-group and form a new business competing with the business they just sold.

[Bird Legs]

Bees Knees True to what you are saying

however, I have had several cases just like this. One was a dentist Sold his
practice, retired, almost 70 years old.
The sales agreement specifically stated a set amount for non compete agreement.
I reported this on Sched. D as a non compete agreement with an explanation
that this was just an extension of Goodwill.

[Roland Slugg]

Bargaining issue

Prior to Code §197 goodwill was not deductible, so many business buyers insisted on allocating as much as possible to a non-compete covenant. The goodwill vs covenant allocation was usually one of the most highly contested issues in the purchase/sale of a business.

Now that §197 treats both goodwill and non-compete covenants the same, there should no longer be any buyer resistance to goodwill. However, I have seen no legislation or rulings that say non-comp income is anything other than ordinary income, although some courts may now be ruling that it's the same as additional goodwill and, hence, qualifies as capital gain income. Due to the uncertainy of this, and the 15-year deductibility of goodwill, buyers of a business should not insist on a large (or in some cases any) allocation to a non-compete covenant. This produces a better tax result for the seller at no tax loss to the buyer.