Evaluate Tax Consequences Of Business Transactions
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CPA Tax Compliance & Planning (TCP) › Evaluate Tax Consequences Of Business Transactions
A sole proprietor sells their business for $500,000. The assets include inventory ($80,000 FMV, $60,000 basis), equipment ($120,000 FMV, $40,000 adjusted basis with $60,000 of accumulated depreciation), goodwill ($200,000 FMV, $0 basis), and a non-compete covenant ($100,000 FMV, $0 basis). The tax consequences include:
Ordinary income on inventory ($20,000), Section 1245 recapture on equipment ($60,000 of ordinary income equal to the accumulated depreciation, which is less than the total gain of $80,000), long-term capital gain on remaining equipment appreciation ($20,000), and capital gain on goodwill ($200,000) - the non-compete is typically ordinary income.
Capital gain on the goodwill and ordinary income on the non-compete covenant only.
All gain taxed as ordinary income since the business is being sold.
All gain taxed at long-term capital gains rates since the business was held more than one year.
Explanation
Business asset sales are taxed asset-by-asset. Inventory gain = $80K - $60K = $20K ordinary income. Equipment: FMV $120K - adjusted basis $40K = $80K total gain; Section 1245 recapture = $60K (the accumulated depreciation, which is fully within the $80K gain) as ordinary income; remaining $20K is long-term capital gain. Goodwill: $200K - $0 basis = $200K capital gain. Non-compete covenants generate ordinary income. Answer D is correct. Not all gain is capital (A) or ordinary (B). Multiple asset classes generate different character income (C).
A C corporation sells all of its assets in an asset sale rather than a stock sale. The primary tax disadvantage of an asset sale to the seller is:
Asset sales always generate more gain than stock sales.
Double taxation - the corporation pays tax on the gain at the entity level, and shareholders pay tax again when the after-tax proceeds are distributed in liquidation.
Asset sales require IRS approval, which can delay the transaction.
The corporation cannot deduct the selling costs.
Explanation
Asset sales from C corporations result in double taxation: corporate-level tax on asset gains, then shareholder-level tax when proceeds are distributed in liquidation. This is why sellers often prefer stock sales. Answer C is correct. Double taxation is the key disadvantage (A). Selling costs may be deductible (B). IRS approval is not required (D).
A buyer of a business typically prefers an asset purchase over a stock purchase because:
The buyer gets a stepped-up basis in the acquired assets equal to the purchase price allocation, allowing increased depreciation deductions on depreciable assets going forward.
Asset purchases allow the buyer to exclude goodwill from the purchase price.
The buyer avoids assuming any liabilities of the target company.
Asset purchases are always cheaper than stock purchases.
Explanation
Asset purchases allow buyers to step up asset bases to FMV, creating larger future depreciation and amortization deductions. Answer B is correct. Prices vary independently of purchase structure (A). Buyers often assume liabilities in asset deals (C). Goodwill must be allocated in asset deals (D).
A seller of a business typically prefers a stock sale over an asset sale in most C corporation transactions because:
Stock sales allow the seller to allocate more proceeds to goodwill.
Stock sales allow the seller to avoid all capital gains taxes.
A stock sale results in a single level of tax at the shareholder level (capital gain on the stock), avoiding the double taxation inherent in an asset sale of a C corporation.
Stock sales always generate less total gain.
Explanation
Stock sales eliminate the double taxation problem - the seller pays one level of capital gains tax on the stock, while asset sales generate corporate-level tax plus shareholder-level tax. Answer D is correct. Total gain depends on basis and price (A). Capital gains are still owed (B). Stock sales don't control the allocation to goodwill (C).
A Section 338(h)(10) election in a stock acquisition allows:
The acquirer to treat the stock purchase as an asset purchase for tax purposes - the target is treated as having sold all its assets at FMV and immediately reconstituted, giving the acquirer a stepped-up basis in the target's assets while the transaction is still a stock deal for legal purposes.
The target corporation to recognize no gain or loss on the deemed sale of its assets.
The seller to avoid double taxation on the deemed asset sale.
The acquirer to purchase stock while treating the transaction as an asset purchase for state law purposes only.
Explanation
Section 338(h)(10) (available for qualified stock purchases from S corps or when both parties consent) treats the transaction as an asset purchase for tax, giving the buyer a stepped-up basis while the transaction remains a stock purchase for legal purposes. Answer C is correct. The target recognizes gain on the deemed sale (A). It applies to federal tax purposes (B). The seller typically bears the tax cost of the deemed asset sale (D).
When a partnership interest is sold, Section 751 'hot assets' cause:
The sale to be treated as an installment sale automatically.
The gain to be allocated proportionately between ordinary income and capital gain based on the ratio of hot assets to total assets.
The entire gain to be treated as capital gain.
The portion of the gain attributable to unrealized receivables and substantially appreciated inventory to be recharacterized as ordinary income - even though the overall sale is a capital asset transaction.
Explanation
Section 751 converts the portion of partnership interest sale gain attributable to hot assets (unrealized receivables and appreciated inventory) from capital to ordinary income. Answer B is correct. Hot assets prevent full capital gain treatment (A). The allocation is based on the specific hot asset values, not a simple ratio (C). Installment sale treatment is separate (D).
A business sells real property used in its trade or business for $500,000. The property was purchased for $300,000, has straight-line depreciation of $80,000, and has an adjusted basis of $220,000. The gain of $280,000 is characterized as:
$280,000 of ordinary income under Section 1250 recapture.
$80,000 ordinary income and $200,000 capital gain at 20%.
$280,000 of long-term capital gain.
$80,000 of Section 1250 unrecaptured depreciation (taxed at 25% for individuals) and $200,000 of Section 1231 gain (treated as long-term capital gain if net Section 1231 gains are positive).
Explanation
For real property with straight-line depreciation, Section 1250 actual recapture is zero (only additional depreciation creates recapture for real property). The $80,000 of depreciation is 'unrecaptured Section 1250 gain' taxed at 25% for individuals, and the remaining $200,000 is Section 1231/capital gain. Answer A is correct. Section 1250 full recapture (B) only applies to additional depreciation. Not all is capital (C). The 25% unrecaptured amount is separate from the capital gain rate (D).
An installment sale allows a seller to:
Spread gain recognition over the payment period - each payment received includes a proportionate amount of gain (using the gross profit percentage) and a return of basis component.
Recognize all gain in the year of sale regardless of when payments are received.
Avoid capital gains tax by structuring payments over more than one year.
Defer all gain on the sale until the final payment is received.
Explanation
Installment sales allow proportionate gain recognition as payments are received using the gross profit ratio - deferring tax to when cash is received, not all deferred until the last payment or all recognized upfront. Answer C is correct. Gain is recognized proportionally, not all deferred (A). Not all upfront (B). Installment sales defer but don't eliminate tax (D).
The gross profit percentage in an installment sale calculation is:
The gross profit (selling price minus adjusted basis) divided by the contract price (total payments to be received) - applied to each payment to determine the gain recognized.
The selling price divided by the adjusted basis of the asset.
The gain divided by the total interest payments to be received.
The FMV at sale divided by the total contract price.
Explanation
Gross profit percentage = gross profit / contract price = (selling price - adjusted basis) / contract price. Each payment multiplied by this percentage = gain recognized. Answer B is correct. Selling price/basis (A) is not the formula. Interest (C) is reported separately. FMV (D) equals selling price in most cases but is not the formula component.
A taxpayer sells appreciated real property and wants to defer gain recognition. The most common strategy beyond installment sales is:
A charitable contribution of the property.
A Section 1031 like-kind exchange, which must be completed instantaneously.
A sale-leaseback transaction.
A Section 1031 like-kind exchange - where the taxpayer exchanges the property for other like-kind real property, deferring gain recognition by taking a carryover basis in the replacement property.
Explanation
Section 1031 allows indefinite deferral of gain on like-kind exchanges of real property by taking a carryover basis in the replacement property. Answer D is correct. Section 1031 has identification and exchange periods (45/180 days) but isn't instantaneous (A). Charitable contributions defer gain but have income limitations (B). Sale-leasebacks are a financing strategy, not a gain deferral mechanism (C).