There are many reasons why entrepreneurs may decide to sell their business. Some build with the intent to sell, others decide to sell their business because there is no one in the family to take over or there is a change in either personal or professional circumstances. Whatever the reason, most are looking to retain as much of the profit and pay as little in tax as legally possible. The one-day note could be the tool to help if the sale is structured properly.
These days, many closely-held businesses are sold in what is called a “deemed asset sale.” Under a deemed asset sale, the buyer legally acquires the stock or equity of the business; however, the buyer and seller agree to make an election for income tax purposes to treat the sale as if the company sold all of its assets and liabilities to the buyer, followed by a deemed liquidation of the seller’s corporation for tax purposes. In conjunction with these deemed asset sales, some business owners have been able to use a very beneficial tool known as a “one-day note” when selling their companies. While the concept of a one-day note has been around for a while, they are still not commonly used by many practitioners.
To put it simply, a one-day note is a note received at closing, in lieu of cash. This note is then paid shortly after closing. While the concept does not change the overall economics of the deal, it does impact the mechanics for how the income tax is calculated. This becomes most beneficial when the deal involves 1) a large escrow, 2) an earn-out, or 3) when there are non-resident state withholding taxes.
In the case of an escrow that will be paid in the following year, the installment sale rules may apply. Under the provisions of IRC Sec. 453, the gain from a deemed asset sale is calculated twice: once at the corporate level, and again at the individual level after the deemed liquidation of the business. Using a simple example, assume a sales price of $10 million: $8 million received at closing, and a $2 million escrow received in the following year, and $-0- of basis.
At closing, the corporation would recognize a gain of $8 million based on the amount of cash received compared to the overall gain. Immediately after closing, the corporation is deemed to have liquidated and the individual shareholder would receive a distribution of cash and a note for the escrow. At this time, the individual shareholder must do a second calculation of the gain on liquidation.
Under the rules for an installment sale, 80% ($8 million out of the total proceeds of $10 million) of the gain is taxable at closing to the individual shareholder. The individual has an overall gain of $2 million from the deemed liquidation ($10 million total proceeds less $8 million gain reported by the corporation), meaning that the shareholder will recognize an additional $1.6 million gain in the year of closing (80% of $2 million). The remaining $400,000 of gain would be recognized when the $2 million escrow is received in the following year.
Utilizing a one-day note in this scenario would effectively avoid the corporate level gain and allow the seller to defer more taxable gain to the year when the escrow is received. In this case, total gain of $8 million would be recognized in the year of close and $2 million would be recognized when the escrow is received. The overall gain is the same, but more is deferred to the year that the escrow is received.
Many sales agreements also include earn-outs to be paid in future years if certain key metrics are met. These earn-outs can be much larger than an escrow and receipt is less certain. Using the example above, assume instead of a $2 million escrow that the agreement contains a $2 million earn-out. The timing for the taxable gain would otherwise be the same, with the one-day note allowing the seller to defer $1.6 million of gain.
However, there is another benefit: if the key metrics are not met and the seller does not receive the earn-out, then a one-day note provides a huge benefit to the seller by reducing the potential capital loss in the year(s) following closing. In this example, without a one-day note, the seller would have a future capital loss of $1.6 million if the earn-out is not received. Under the installment sale rules, this loss cannot be carried back to adjust the gain in the year of sale and will carry forward to future tax years. It could take many years to receive this benefit and is just as likely that these losses may never be used.
Nonresident State Withholding
Lastly, there may be state level benefits from the utilization of a one-day note. Again, the gain from a deemed asset sale is normally taxed at the corporate level first. If the corporation operates in state or states with higher tax rates than the individual owner’s state of residency, the corporation may be required to pay larger state level taxes. Utilizing the one-day note minimizes the amount of corporate level gain that would be subject to state tax, potentially increasing the individual owner’s after-tax cash flow.
In summary, the one-day note is a beneficial tool that many business owners can utilize when selling their company in a deemed asset sale. Every deal is unique and business owners should have a qualified accountant review the tax ramifications of a one-day note against the entire transaction to determine if it is right for them. If you want more information regarding one-day notes, please download our white paper on the topic The One-Day Note: A Sophisticated Tax Savings Strategy for Seller of Closely-Held Businesses in our Resource Library or contact our office at 703.385.8888.