Hall-of-Fame NHL star Wayne Gretzky was once quoted saying, “I skate to where the puck is going to be, not where it has been.” His approach to the game during his playing career was to place himself where he needed to be or needed to go in order to take advantage of an opportunity to score. There is a lot of relevance in this quote as it relates to a desire you may have to buy or sell a financial practice. You must consider all of the different factors involved when making this type of decision, especially from a taxation standpoint.

When discussing the purchase or sale of a financial practice, skating to where the puck is going to be, means you have in mind an idea of where it is you want (and need) to be at the end of the transaction. Knowing the result helps guide your decision making. It starts with fully understanding the tax consequences you will face; whether a buyer or seller of the practice. The type of transaction, whether through what are known as Mergers & Acquisitions (M&A), a succession plan, or other acquisition of an independent advisory group will dictate the consequences you face from a tax perspective.

There are at least three types of deals that you will make to acquire or discard of a financial practice: a transaction involving the transfer or acquisition of the business’s assets; the sale or purchase of stock that may be authorized, issued and outstanding; or in the case of the buyer or seller retaining some small percentage of the practice an arrangement to share in future revenue.

Let’s begin with a discussion of the types of scenarios present to both a buyer and seller and what tax implications may occur. It should be noted that it may not be feasible to outline every possible scenario when buying or selling an investment management; moreover, this paper is not an attempt to provide specific legal or tax advice. You should consult with a qualified tax or legal professional for specific information relevant to your personal desire to buy or sell a financial practice.

The Acquisition/Sale of Stock or Partnership Interest in a Financial Practice

How the practice is organized will give you insight as to the type of tax implications you could face. The acquisition or sale of stock, in the case of a C-Corporation (as organized under 26 USC Subchapter C), or a partnership interest in either a Limited Liability Corporation (which may elect taxation as a corporation through the use of Form 8832), or Limited/General Partnership, bring different tax consequences.

Selling stock creates a taxable event for the seller. If such stock interest were held less than a year, any gain (presumably a reason to sell the practice is to receive a capital gain) would be taxed at the higher short-term capital gains rate. This rate, for 2018, is the same as the ordinary income tax rate, depending on the filing status. This rate could be between 10% – 37%. If the stock sold was held for longer than a year, the long-term capital gain rate of 0% to 20% may apply.

The value assigned in Form 8594 establishes the cost basis for the buyer and the capital gain (or loss) for the seller. All assets listed in the form must use its current fair market value, with the exception of assets listed in Class VII, as this is goodwill, a §127 intangible whose value may not be readily ascribed but must be agreed upon by the buyer and seller.

The seller of a partnership interest is required to determine their capital gain or loss, within the provisions of §741 of the IRS Code. This determination takes in account the amount realized through the disposition of their interest (resulting in an adjusted partnership basis in accordance with §752) against the partner’s pro rata share in the partnership’s liabilities. Again, any resulting gain will be treated as a short or long-term gain, depending on the holding period of the partnership interest.

The Purchase or Sale of Assets in a Financial Practice

You may choose to purchase the assets of an existing financial practice (or dispose of them to a buyer in the case of a sale). Doing so requires the filing of IRS Form 8594, “Asset Acquisition Statement Under Section 1060.” The form, which must be filed by both the buyer and seller of the practice’s assets, must disclose the names of both parties in the transaction, the date and total price of the sale. Assets listed fall in one of seven categories, which are defined by the IRS as:

• Class I – this class includes cash and cash equivalents held by the practice, such as checking and savings accounts, money market funds, etc.;
• Class II – personal property that is actively traded is considered under this class; this includes certificates of deposit, government securities and publicly traded stock;
• Class III – this class includes assets that are marked-to-market on no less than an annual basis as well as certain (not all) debt instruments which may include the practice’s account receivables;
• Class IV – items in trade or inventory are considered class IV assets;
• Class V – the instructions for Form 8594 defines this class as anything that is not Class I – IV; generally, the assets defined under this section include furniture, buildings, and equipment of the practice. This may be listed on the practice’s balance sheet under current assets as “PP&E (property, plant, and equipment);”
• Class VI – intangibles defined in 26 USC §197; these would also be listed on the balance sheet under current assets and include such items as copyrights, trademarks, patents, and computer software that is proprietary to the practice. This class does not include goodwill; and,
• Class VII – includes goodwill.

The sum value of these classes establishes the total value that must agree between the buyer and seller. When a value is assigned to an asset listed on the form, it could create a taxable gain. Again, based on the amount of time the asset was held by the practice, the gain could result in a short or long-term capital gain, which are taxed at different rates (see the section above for the specific rates applicable to short and long-term capital gains).

Revenue Sharing Arrangements

A revenue-sharing arrangement is one in which the seller of the practice seeks to retain some interest in the business concern and may be ideal in a situation where the buyer is acquiring from the seller proprietary software or another unique asset that the seller wishes to continue to profit from. It may also be used in the case of practice where the influence of the seller is needed to retain existing clients or may be used to attract additional business, through referrals. Finally, a revenue sharing arrangement may be used as an incentive by the seller to a buyer where the business may have operating losses that the buyer does not want to absorb but is willing to share (for some period of time) in order to close the deal.

Such an arrangement must be codified under a contractual agreement between the involved parties. It will also result in reportable income that the buyer must report to the IRS via Form 1099-MISC. The buyer would also be responsible for providing the 1099-MISC to the seller each and every year of the revenue sharing arrangement. Receipt of the income by the seller will require that they report it on their annual Form 1040 filing.

Other Considerations

A buyer of an existing financial practice needs to account for any agreement and other controlling documents that may be in place (it’s important to also understand any additional consideration for an Office of Supervisory Jurisdiction or OSJ). Such agreements represent existing relationships that more than likely will continue once the transaction between buyer and seller has been completed. These agreements may include any and all existing employment agreements (which would be true of a larger financial practice with back office support, associate brokers or planners, etc.) and consulting agreements.

The buyer should look to review any and all employment and consulting agreements and create new ones reflecting the values of the successor practice. Employment agreements results in W-2 income (as reported to the IRS) while any compensation paid under a consulting arrangement will appear on the 1099-MISC.

Conclusion

This article presents different tax consequences that are present when buying or selling a financial practice. The discussion presented here is only a brief overview of what you may face when and should not be viewed as an exhaustive look of all the scenarios you may encounter. A discussion with a financial advisor or other professional who is certified and qualified (i.e. CPA, tax attorney, or other tax professional) can help you navigate the intricacies of the tax code as it relates to your desire to buy or sell.

For additional information on acquiring a practice, contact our Branch Development officer, Soliman Popal at (360) 918-9438 or spopal@financialadvocates.com

This material is for generation information only and is not intended to provide specific advice or recommendations for an individual.