Tax consequences for the sale of a practice vary substantially depending on the business entity status.

In a corporate entity, it is not uncommon for ones stock to be redeemed by the corporation. To the extent that distribution proceeds exceed shareholder basis, the excess is taxable as a capital gain. Redemption can really be viewed as payment received from earnings and profits, and thus, can have dividend attributes with significant impaired tax consequences (i.e. capital gain versus ordinary income). In that event, deduction to the corporation is not available either.

To the extent that a transaction falls within the scope of Internal Revenue Code (IRC) section 302, however, capital gain recognition can be salvaged. This will require the shareholder, either alone or with family members, to relinquish majority or controlling ownership of the entity.

Additionally, there must be a substantial reduction (80%) in both the equity ownership and voting power of the shareholder. A safe haven exception exists if the owner has terminated complete interest in the stock. Unfortunately, where there are other family members, such as a spouse, children, grandchildren and parents with continuing stock ownership, other issues arise.

In essence, the redeeming shareholder is deemed by attribution to own stock of these other family members–frustrating the complete divestiture. Additionally, in redemption, the remaining shareholders do not receive an increase cost basis on their stock for tax purposes.

While redemption arrangements have great complexity, cross-purchase arrangements have the allure of being remarkably simplistic. Cross purchase is a “private” transaction between the parties. This permits some or all of the stock to be sold with proceeds given capital gain treatment. The buyer will receive a new cost basis measured by the purchase price. Since the attribution rules are not applicable, this can be an effective arrangement between family members.

In the realm of partnership and Limited Liability Companies (LLC), the thorny issues involving the “dividend” concept are not applicable. Pursuant to IRC section 731, distributions generally are deemed to first reduce basis, with the excess being capital gain. Sums attributable to goodwill are treated as ordinary income unless other provisos are delineated in the operating agreement. This flexibility is available to a withdrawing general partner in entities where capital is not a material-producing factor.

Obviously, the impact of goodwill and its treatment can have significant and immediate tax consequences for the seller, and an ongoing effect on the buyer.

–Stanley R. Smiley


Reproduced from National Underwriter Edition, February 10, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.