IBA, as the premier business brokerage firm in the Pacific Northwest, is firmly established as a respected professional service firm in the legal, accounting, banking, mergers & acquisitions, real estate, and financial planning communities. Periodically, we will post guest blogs from professionals with knowledge to share for the good of owners of privately held companies & family owned businesses. The following blog article has been provided by Troy Niehaus & James Bocinsky of Bernstein (www.bernstein.com):
Structuring Business Sales to Reduce the Impact of the SALT Cap
Key Takeaways
Left unaddressed, the SALT deduction cap may significantly reduce the after-tax proceeds of a business sale for owners in high-tax states.
But with careful structuring, a seller may be able to reduce—or even eliminate—the toll it exacts.
By leveraging a state’s PTE Tax deduction, sellers can increase their overall proceeds from the deal.
Since the introduction of the SALT cap, taxpayers have been searching for ways to restore some of the deduction’s lost benefits. The $10,000 deduction limitation on state and local taxes (“SALT”) has proven particularly burdensome for exiting business owners in high-tax states. Fortunately, relief can be found in the Pass-Through Entity Tax (“PTE Tax”). By strategically leveraging the PTE Tax through careful structuring, business sellers can reduce or eliminate the costs imposed by the SALT deduction cap and successfully close their deals.
State PTE Tax—A Beneficial Bypass
The 2017 Tax Cuts and Jobs Act (“TCJA”)1 constrained the amount of state and local tax (“SALT”) that can be deducted against federal tax to $10,000 annually.2 This limitation, known as the “SALT cap,” is set to expire at the end of 2025.3 In the meantime, many states have enacted Pass-Through Entity Taxes (“PTE Taxes”) for partnerships and S Corporations, allowing them to effectively bypass the SALT deduction cap (Display).
PTE taxes allow pass-through entities to pay an additional tax on proceeds at the entity level, which can be deducted against the income passing through to the entity’s partners and shareholders for federal income tax purposes on an individual level.4 Owners of a pass-through entity subject to a state’s PTE tax can also claim an exclusion or credit on their state tax return for their shares of the PTE Tax paid by the entity. Essentially, PTE Taxes restore some of the relief the SALT cap has taken away.
As more states pursue this path, questions have emerged about whether PTE taxes are subject to the SALT deduction cap at the individual owner level. However, the IRS announced forthcoming regulations clarifying that state and local taxes imposed on and paid by a partnership or S corporation would be allowed as a deduction in computing its non-separately stated federal taxable income or loss for the tax year of payment.5 In other words, pass-through entities may deduct state and local taxes imposed on them.
Strategic Structuring
Notably, state PTE taxes can help pass-through entity sellers bypass the SALT deduction limitation only when the transaction is structured as an asset sale (as opposed to an entity or stock sale). While this may sway some sellers, it’s crucial to weigh the broad pros and cons of both transaction structures before proceeding (Display).
Entity/Stock Sale—In an entity sale, the buyer purchases the seller’s company stock or ownership interest, transferring ownership of the entity to the buyer. Sellers tend to prefer entity sales because they are less complex,6 and gains are taxed at more favorable capital gain rates. Buyers, on the other hand, typically find stock sales less attractive because assets inside the entity keep their current cost basis, resulting in fewer depreciation deductions after the deal closes.7
Asset Sale—In an asset sale, the buyer purchases the company’s assets and liabilities, instead of an ownership stake. Sellers often consider asset sales less appealing because gains on assets (such as equipment, buildings, vehicles, and furniture) may be taxed at higher ordinary income tax rates.8
As for buyers, they usually favor asset sales because the cost basis of each asset “steps up” to the purchase price, allowing more room for future depreciation deductions.
There is a third option, but only for S Corporations.9 It involves structuring the transaction as a stock sale but treating it as an asset sale for tax purposes using a Section 338(h)(10) election (Display). The election avoids some of the complexity and costs of an asset sale—such as certain state taxes—and the need for consent to assign contracts, licenses, or permits to the buyer. Above all, treating the transaction as an asset sale for tax purposes allows sellers to bypass the SALT deduction cap through a state’s PTE tax.
Aligning Interests
Let’s look at an example to see how the PTE tax can better align the buyer’s and seller’s interests.
Anand, who owns 50% of an S Corporation in a high-income-tax state, has received two offers to buy his share of the business, each worth $20 million. One offer is for a stock sale, which would only be subject to the preferential long-term capital gains rate. The other offer is for an asset sale, where 70% of the assets would be taxed as long-term capital gains10 and 30% would be taxed at ordinary income tax rates. Although the tax treatment on the stock sale seems more favorable, there is a higher risk of the deal falling through with the buyer. To determine the best option, we calculated the after-tax proceeds from each offer for Anand.
Stock Sale: The $10 million proceeds are taxed at 20% federal long-term capital gains and 9.85% state tax, resulting in $7.02 million of after-tax proceeds.
Asset Sale: After-tax proceeds decrease to $6.51 million since 30% of the proceeds are subject to the 37% top marginal federal ordinary income tax rate.
Comparing the two offers, the stock sale provides Anand with nearly 8% more after-tax wealth. Could the PTE Tax election narrow the gap? Under the asset sale, if the business elects to pay the state’s PTE tax of 9.85%, Anand’s federal K-1 proceeds decrease to $9.02 million. Anand owes capital gains tax on 70% of the proceeds and ordinary income tax on the remaining 30%. But he receives a $985,000 credit for the PTE taxes paid by the business, which helps offset the state taxes owed. Once the PTE tax is applied, Anand’s after-tax proceeds increase to $6.75 million (Display). Paying the PTE tax results in 10% less pretax wealth for each partner, but the gap between the after-tax proceeds from each deal dwindles to only 4%.
After reviewing the options, Anand decides to pursue the asset sale. He values the certainty of the deal, and the PTE Tax deduction makes going this route less costly. Plus, Anand successfully negotiated a gross-up in the sale price of $780,000 to fully close the after-tax proceeds gap. The additional $390,000 of personal proceeds should yield the same net value as the stock sale assuming Anand can take full advantage of the PTE Tax deduction. In the end, the buyer feels that the depreciation deduction makes up for the gross-up in the sales price and the transaction closes.
Safe Passage through SALTy Seas
Left unaddressed, the SALT deduction cap may significantly reduce the after-tax proceeds of a business sale for owners in high-tax states. But with careful structuring, a seller may be able to reduce—or even eliminate—the toll it exacts. By leveraging a state’s PTE Tax deduction, sellers can increase their overall proceeds from the deal. With that said, the PTE Tax’s compelling benefits don’t eliminate the need for thoughtful analysis. It’s essential to weigh the pros and cons of various transaction structures in the context of the unique needs and circumstances surrounding a seller’s PTE Tax deduction. Contact your Bernstein Advisor, who can work with your tax advisor to determine if paying a PTE tax on business sale proceeds makes sense for your entity.
AUTHORS
Jacob Sheldon, CFA
Senior Analyst—Investment & Wealth Strategies
Robert Dietz, CFA
National Director, Tax Research—Investment & Wealth Strategies
1 P.L. No. 115–97.
2 The $10,000 deduction cap applies for both married taxpayers filing jointly and single filers. The deduction cap is limited to $5,000 for married taxpayers filing separately.
3 The TCJA Permanency Act (H.R. 976), a bill reintroduced in February 2023 by Rep. Vern Buchanan (R-Fla.), would make SALT deduction limitation as well as other expiring provisions of the Tax Cuts and Jobs Act permanent. Conversely, a bipartisan group of lawmakers led by Reps. Andrew Garbarino (R-N.Y.), Josh Gottheimer (D-N.J.), Young Kim (R-Calif.), and Anna Eshoo (D-Calif.), introduced the SALT Deductibility Act (H.R. 25555) in April 2023 which would restore the deductibility of SALT. Several other bills have been introduced that would extend the SALT deduction limitation but with a higher cap.
4 When enacting the SALT deduction cap, Congress stated that “taxes imposed at the entity level, such as a business tax imposed on pass-through entities, that are reflected in a partner’s or S corporation shareholder’s distributive or pro-rata share of income or loss on a Schedule K-1 (or similar form), will continue to reduce such partner’s or shareholder’s distributive or pro-rata share of income as under present law.” See H.R. Rep. No. 115-466 (2017).
5 This clarification was provided in Internal Revenue Service (IRS) Notice 2020-75.
6 When selling a company, a stock sale is less complex than an asset sale because it involves the transfer of ownership of the entire company, including all assets and liabilities. In contrast, an asset sale requires the seller to identify and transfer each individual asset and liability being sold. This requires a detailed analysis of the company’s financial statements, contracts, and other legal documents. Additionally, the seller needs to ensure all necessary approvals and consents are obtained for the transfer of each asset and liability. This can involve negotiations with third parties, such as lenders, landlords, and suppliers, which can further complicate the process.
7 When the buyer acquires the ownership of the entire company, including all of its assets and liabilities, the tax basis of the company’s assets does not change. This means if the buyer sells any of the assets in the future, they may have a larger capital gain than had the assets been acquired through an asset sale. Further, the buyer may have less opportunity to claim depreciation deductions since the acquired cost basis would already reflect any depreciation taken by the prior owner.
8 See IRC § 1245. Additionally, an asset sale may create additional state income tax obligations that would not arise with stock sales.
9 Entities taxed as partnerships may be able to achieve similar results via a Section 754 election.
10 Assumes sale proceeds are exempt from the Net Investment Income Tax (“NIIT”) since Anand is an active owner of the business.
The views expressed herein do not constitute, and should not be considered to be, legal or tax advice. The tax rules are complicated, and their impact on a particular individual may differ depending on the individual’s specific circumstances. Please consult with your legal or tax advisor regarding your specific situation.
If you have questions relating to the content of this article, Troy Niehaus & James Bocinsky would welcome the opportunity to answer them. They are also available to answer questions related to wealth management and estate planning. Mr. Niehaus can be reached at (425) 786-4225 and troy.niehaus@bernstein.com. Mr. Bocinsky can be reached at (425) 445-8222 and james.bocinsky@bernstein.com.
IBA, the Pacific Northwest’s premier business brokerage firm since 1975, is available as an information resource to the media, business brokerage, mergers & acquisitions, real estate, accounting, legal, and financial planning communities on subjects relevant to the purchase & sale of privately held companies and family owned businesses. IBA is recognized as one of the best business brokerage firms in the nation based on its long track record of successfully negotiating “win-win” business sale transactions in environments of full disclosure employing “best practices”.