Sale of sole proprietorship

[TAXOH]

Sole proprietor sold 50% of business and is now a partnership.

Total value of sole proprietorship $600,000.00

Sold 50% to buyer for $295,000.00

Received $15,000.00 down, leaving a balance of $280,000.00

In the purchase agreement it states the following:

                The sale shall be treated as an installment sale, including 3 separate payments.

                First payment of $93,333.33 due December 31, 2020.

                Second payment of $93,333.33 due December 31, 2021.

                Third payment of $93,333.34 due December 31, 2022.

                The sole proprietor is personally financing each installment with a promissory note with interest of 6.25% per annum, computed quarterly for a term of 15 years.

The sole proprietor doesn’t want to spread the gain over 15 years and wants to do it in 3 years.  Can the sole proprietor spread over 3 years even though he is financing the payments?  He knows he will include interest over the 15 years for each promissory note.

[George4Tacks · Accepted solution]

So, Mike & Bill decide they like to work together. Mike has a thriving business and sells 1/2 to Bill. Bill is a bit shy of cash, so Mike loans Bill enough money each year to make the payment for the business, paying off the sale in 3 years. There is now a personal loan, (unsecured?) between Mike & Bill that is not associated with the new partnership. Bill can establish that the loan was to fund his business interest and could therefore take the interest expense as a UPE on his Schedule E. Mike should be able to take the gain over 3 years, while still receiving P&I from Bill for the 3 separate loans over a longer period.

Does this work for you? I think it does for me. 

[TAXOH]

Thanks!  That definitely works for me and makes it easier.  It was just throwing me off and getting me confused since the seller is personally financing the 3 notes.

[IRonMaN]

But George had me thinking we were working on a word problem and I was getting ready to try and figure what time Mike's and Bill's trains were going to meet in Chicago. 😅

[BobKamman]

I didn't wade through this but you probably should:

In Revenue Rulings 99-5 and 99-6 the Internal Revenue Service ("IRS") discusses the federal income tax consequences of a single-member, disregarded LLC acquiring a second member and of a two-member LLC becoming a single-member LLC. In addition, in Notice 99-6 the IRS provides two temporary safe harbors regarding employment tax reporting and payment compliance by certain disregarded entities, including single-member LLCs, and invites comment on various aspects of application of the federal employment tax regime to these entities.

http://pmstax.com/part/disllc9901.shtml 

[George4Tacks]

You forgot to throw in the fly that left Bill's train and flew towards Mike's train. As soon as it touched Mike's train it reversed direction until ....

When will the fly be squashed by the two trains?
Will either Bill or Mike survive the collision?

[TAXOH]

Thanks Bob.  I'll check it out.

[joshuabarksatlcs]

I had a minor in physics (technically a double minor - physics and bourbon) and would need to know the coefficient of air resistance to determine the time for the trains to meet the fly...  

Not that I care about flies.

I also wonder how the number of years (15) was picked in the tax problem.  Did it have to do with George's Level 15?  My clients would have a colossal disadvantage - I'm only Level 4.

(A never-announced Lacerte community rule: After you marked a response as the solution, the comments that followed are game.)  

Joking aside, my 2 cents:

For the 3-year installment sale idea to fly (nothing to do with the aforementioned fly), I would need to see three cancelled checked from the Seller to the Buyer, and three (each of equal amount to the purported installment amounts) from Buyer to Seller for the so-called (refinancing) loans.  Otherwise, substance-over-form rules and the installment sale is really for15 years. 

Even if my clients had the cancelled checks, I would still need to consider whether the deal could be collapsible transactions. 

But then, why would the IRS care?  The tax payments for the sale transaction were accelerated.  Which brings me to my curiosity as to why pay the tax in three when you could pay in 15 years?  Because the capital gain rate may go up?  On the flip side of that, even today, a dollar definitely feels like it's worth a lot less than a dollar last year....   But then, it's me.

[TAXOH]

I have no idea why he was aiming for 3 years instead of 15 other than that everyone involved in this transaction (2 attorneys and a CPA) thought this was a good idea.  

[BobKamman]

I see those all the time for real-estate deals:  The payments are based on 15-year amortization, but there is a balloon payment requiring the balance to be paid sooner.  Only difference here is that there are three balloons.  But since when can intangibles, inventory, assorted personal property, whatever else is involved with this business (we don't know, do we?) be reported as an instalment sale?  I see it as all taxable in the first year, unless shown otherwise.  

To determine whether any of the gain on the sale of the business can be reported on the installment method, you must allocate the total selling price and the payments received in the year of sale between each of the following classes of assets.

1. Assets sold at a loss.

2. Real and personal property eligible for the installment method.

3. Real and personal property ineligible for the installment method, including:

   1. Inventory,

   2. Dealer property, and

   3. Stocks and securities.

   https://www.irs.gov/publications/p537#en_US_2020_publink1000221691 

[TAXOH]

It is a law firm.

Selling price consists of:

Tangible personal property (furniture, equipment)   $10,000

Intangible personal property/Goodwill $420,000

Work in Progress $170,000

[joshuabarksatlcs]

Joshua was a simple dog.  He ate, pooped, ran, retrieved and barked... in his simple ways.  

When he barks here, he does it based on the info as posted, at its face value.

If you told me it was an installment sale, I would talk about the issues relevant to installment sales, that I could think of. 

If you told me the IRS disallowed the Recovery Rebate Credit, I wouldn't question whether you knew how to compute the correct amount.  I would take your statement (that you didn't know why the IRS disallowed it) at the face value, and give you the benefit of the doubt that you KNOW what you knew the correct amount.

If you told me your client had checked the EIP payments, I wouldn't ask you how they did it - I would approach it as if they KNEW how to check it, and had the correct amount.

That is, until your info gave me a clue that the info couldn't be taken at its face value, or your were stepping into some Joshua do-do. 

That said, your other points are well taken. 

To me, it was possible that the deal was fully eligible for installment sale - e.g. 100% was for good will/client list.  I have handled it several times in my career.

Oh, boy.  I do miss my dog.

[joshuabarksatlcs]

Regarding: 

"I see those all the time for real-estate deals:  The payments are based on 15-year amortization, but there is a balloon payment requiring the balance to be paid sooner.  Only difference here is that there are three balloons. " 

For a deal amortized over 15 years with a balloon payment, your installment reporting would include the respective principal amounts received in the beginning years AND the balloon payment for the balloon-payment year.

Here, the loans were practically amortized (and paid) over 15 years and you reported the "balloon payments" in the first three years.  How could that be the same as your real estate example???

Form: installment payments in three years.

Substance: installment payments in 15 years

Let's twist the facts.  The seller found out he had cancer with a life expectancy of 3 years and he had a HUGE capital loss carryover from his Enron and JC Penny investments.  He accelerated the capital gain from the sale over three years, and used up the CLCO.  His heirs inherited the note and pay NO tax on the principal receipts.  Based on these facts, should a responsible IRS agent reverse the installment sales from 3 back to 15 years, even if there were three sets of cancelled checks, and pursue the angle that those were collapsible transactions, made up for tax evasion purposes?

As I said, I don't dwell on facts not given in this forum.  My twisted example (pun intended) was just to illustrate the difference between the real estate with a balloon payment deal from the question in issue.

Billable work calls, and I digress.