This article discusses the application of tax to transfers of business (capital) assets, when a business is sold, reorganized, or dissolved. It also discusses problems which can occur when transactions are not properly structured, and sales tax issues that may arise.
Generally, sales tax applies to the retail sales of tangible personal property. Thus, when a business is sold, tax does not apply to intangibles, inventory for resale, or realty. Tax applies to any remaining sales of tangible personal property (capital assets) used in a business, unless an exemption or exclusion from tax is available.
Regulation 1595 discusses the rules for exempt occasional sales, different types of business reorganizations and dissolutions that involve the transfer of capital assets which are not sales, and sales which are either taxable or exempt. Thus, the first thing you have to determine is whether you have a sale. A “sale” is generally defined as a transfer of title or possession of tangible personal property for consideration, which means something of value such as money, property in trade, the purchaser’s assumption of liabilities, etc. Thus, where a person transfers title to tangible personal property in exchange for something of value, a sale is created for sales and use tax purposes.
There are two types of occasional sales exemptions that apply to the sale of capital assets. If a business is not required to hold a seller’s permit because it is strictly engaged in services (such as a real estate brokerage), the sale of its capital assets is not subject to tax. The only exception would be where the same person makes at least three sales, during any 12 month period. If that occurs the first two sales would not be taxable but any sales after that would be taxable, unless a new 12 month period applies. Therefore, timing your sales is crucial to avoid unnecessary sales tax liability.
The second occasional sales exemption applies to businesses which are required to hold seller’s permits, because they make sales of tangible personal property. If there is a sale of substantially all the property (assets) held in the permit required activity, without a substantial change in ownership, no tax will apply. The term “substantial” is defined to mean 80 percent. Thus, for the exemption to apply at least 80 percent of all the assets must transfer, and the ownership must be 80 percent similar, after the transfer. This is commonly referred to as the 80/80 rule. To determine if ownership is substantially similar before and after a transfer, the regulation requires looking at stockholders, bondholders or other persons holding an ownership interest in the corporation(s).
The basis for this exemption is that if the ownership of the property remains essentially the same, in reality the seller is only selling to himself. There is also a similar 80/80 rule (exemption) for businesses which are not required to hold seller’s permits but sell vehicles, vessels, and aircraft, which absent the exemption, tax would be due on the sale or use of the property.
Where there is a statutory merger the transfer of capital assets is not considered a sale (so no tax is due), and the surviving corporation stands in the shoes of the constituent (disappearing) corporation(s). However, if the disappearing corporation(s) had any existing tax liability prior to the transfer, that liability would be passed on to the surviving corporation.
A transfer of capital assets to a commencing corporation (or other entity) solely in exchange for the first issue of stock (or interest in the entity) would also not be considered a sale, since the interest received by the transferor would not be regarded as having measurable value, at the time of the transfer. However, if the transferor also receives something of value such as cash, an assumption of indebtedness, property, etc., tax may proportionally apply to the sale of capital assets, unless another exemption is available.
Where a business is being dissolved, the final distribution of assets to persons holding an ownership interest, for nothing more than a cancellation of their interests, is not considered a sale. However, if some form of consideration such as cash or an assumption of liabilities is given for the assets it will be considered a sale, measured by the consideration given.
Where a transfer of capital assets does not qualify as nontaxable under any of the circumstances discussed above, but some of assets will be used in manufacturing or research and development, the sale might qualify for the partial exemption under Revenue and Taxation Code section 6377.1, which is further explained in Regulation 1525.4. This exemption is limited in that it only applies to the state’s share (not local share) of the tax, and generally, only property that is directly used in manufacturing or research and development will qualify for the exemption. Thus, not all property qualifies.
If tax is due on the transfer of capital assets, it is important to make sure that any assets attached to reality, would not be considered tangible personal property. Regulation 1596 provides that if the seller is leasing the realty from a third party, you have to look at the lease agreement to see if it gives the seller/lessee the right to remove the property. If so, the property (i.e., capital assets) will transfer as tangible personal property (despite attachment) and be subject to tax, but an allowance can be made for the value attributable to attachment. It is only where there is no right of removal or the seller also owns (and transfers) the realty, that the transfer qualifies as a nontaxable sale of realty.
Providing that a taxpayer properly claims and documents one of the available exemptions or exclusions from tax, it should be accepted during a sales tax audit. However, there are times where claimed nontaxable transfers of capital assets will be disallowed. This can occur where the transfer involves multiple parties and a series of simultaneous and/or related transfers, and there does not appear to be an independent business purpose for each of the various steps. The Board of Equalization (Board) has issued legal opinions applying the step transaction doctrine over the years, which operates to combine (collapse) a series of transactions and multiple steps into a single transaction, that is subject to sales or use tax. The doctrine was first developed and used in federal income tax cases, to prevent tax abuse.
In determining if the doctrine should be applied the Board considers whether the series of nontaxable steps seemed to have any business purpose, other than tax avoidance. Even where a valid business purpose is shown for some of the steps, the doctrine may still be applied. Where the various transfers occur simultaneously, it is particularly viewed with suspicion. The Board also views with suspicion any alleged nontaxable contribution of capital assets without consideration, if shortly after the transfer the transferor receives some form of consideration such as cash, or the transferee’s assumption of liabilities. Whether the consideration is mentioned in the same agreement or a separate one, it may be considered tied together, as part of the overall agreement.
As you can see, taking full advantage of an available exemption is legal but it requires careful tax planning. It is very important to properly structure the sale of a business, understand how to document the required steps for an 80/80 transfer, merger, or dissolution, and to use proper language in an asset purchase agreement. Mistakes can be costly where the provisions of an agreement are not carefully crafted, and the law is not precisely followed.
