Purchasing shares of Corporation

[Jack B]

Jurisdiction

California

Hello,
I own a small Sole Proprietorship. Another company wishes to purchase 40% of my business but wants it to be changed to a C-corporation. Which is the correct way to do this? Does this other company purchase 40% of my sole proprietorship from me and then the new C-corporation is set up with myself 60% shareholder and other Company 40% owner OR does the other company and myself purchase shares of the new C-corporation so that the C-corporation then has the funds to purchase my sole proprietorship business?
Thanks,
Jack

 

[Tax Counsel]

Hello,
I own a small Sole Proprietorship. Another company wishes to purchase 40% of my business but wants it to be changed to a C-corporation. Which is the correct way to do this? Does this other company purchase 40% of my sole proprietorship from me and then the new C-corporation is set up with myself 60% shareholder and other Company 40% owner OR does the other company and myself purchase shares of the new C-corporation so that the C-corporation then has the funds to purchase my sole proprietorship business?
Thanks,
Jack

How is that other company organized? Do you want the cash out of this or would it be possible for you to take shares of the other company (if it is a corporation) as payment for your 40% share? And what kind of business is your company and what sort of assets does it have?

 

[adjusterjack]

Which is the correct way to do this?

There's only one correct way to do it. You hire a business/contracts attorney to advise you and guide you through.

 

[Jack B]

How is that other company organized? Do you want the cash out of this or would it be possible for you to take shares of the other company (if it is a corporation) as payment for your 40% share? And what kind of business is your company and what sort of assets does it have?

Thank you, the other company is a foreign corporation and I am looking for cash out (not shares of the other company). It is a small medical consulting and manufacture business with a unique line of business. Assets are mostly Intellectual Property and a Trademark.

 

[Tax Counsel]

Thank you, the other company is a foreign corporation and I am looking for cash out (not shares of the other company). It is a small medical consulting and manufacture business with a unique line of business. Assets are mostly Intellectual Property and a Trademark.

Well then, you have a sole proprietorship that has pretty much all intellectual property (IP) since a trademark is itself IP. There are several different ways you could do it, all of which can get you to the same place in the end: having the business in a corporation in which you own 60% and the foreign corporation owns 40%. But how you do it will have significantly different tax consequences for you.

For example, one common way to do it would be for you to form a corporation, contribute all of you assets to that corporation, and then sell 40% of the shares of that corporation to the foreign corporation. But since you are an individual and presumably a U.S. citizen or resident (at least for tax purposes) this may lead to a potentially bad outcome for you. The reason is that the corporation will take the IP with whatever basis you have in them (which may be very low) and the basis you get in the stock of the corporation you created will be the same as the assets you contributed. You promptly sell 40% of the stock. Since the stock was held for less than a year all the gain on that stock is short term capital gain, which is taxed at ordinary income tax rates rather than the more favorable long term capital gains rates. And the corporation is left with IP that has a low basis, meaning if it sells the IP it will recognize a lot of gain from that sale. It also limits the ability to amortize the IP.

Another way you could do it is have the foreign corporation form the new corporation and contribute the cash to the corporation that will be used to buy out the 40% of your business. Then have the new corporation buy the assets of the business from for a mix of cash and company stock, with you getting enough stock to end up as the 60% owner. Here, you would recognize gain on all the IP (not just 40% of stock as in my first example) but assuming you have had those assets for more than a year you would end up being taxed at the lower long term capital gains rates. So more gain, but at a lesser rate. The basis of the stock you get back would then be the fair market value of the assets you sold, and the corporation would get those assets with a basis equal to fair market value. (You'd need the sale price to be at fair market value for that result.)

Those are just two of the possibilities. There are a number of other ways to do it, too. Each with differing tax effects. The details of your business — what the assets are worth, what basis you have, how long you've had them, etc., matter a lot in which way will be the most tax efficient for you and for the foreign corporation. So you really want to see a tax lawyer before you structure the deal to make sure you do it in a way that keeps the taxes as low as legally possible. It can make a huge difference.

 

[Jack B]

Thank you very much for such a detailed response this gives me a fantastic base of understanding from which to discuss with an attorney. I really appreciate your help.

 

[zddoodah]

Since a small proprietorship has no legal existence separate from its owner (you), there is no way for this other company to purchase any or all of your sole proprietorship. You could transfer X% of your business assets, but that's probably not the smart way to do it. Likely, the best way is to form the corporation and then you transfer your business assets to the corporation.

I strongly suggest you not do this without first consulting with a local business attorney.

 

[Tax Counsel]

Since a small proprietorship has no legal existence separate from its owner (you), there is no way for this other company to purchase any or all of your sole proprietorship.

Certainly the OP could transfer all of his sole proprietorship business. It would amount to a sale of assets, but it can be done. As for a transfer of part of the business, that could be done with the result of forming a partnership. But since they evidently want the business to be in the form of a corporation, I only discussed possible ways of achieving that end.

I strongly suggest you not do this without first consulting with a local business attorney.

I suggest the OP actually start first by consulting a tax attorney. There are several ways they can reach the goal they want and none of them terribly difficult. But the tax effects of each one can be significantly different. By getting the tax advice first and narrowing down the options to the most tax desirable ones, the OP then may consult a business attorney if the tax attorney can't do the rest of it for some reason. I would have no trouble advising the client on the other legal aspects of it and drafting the documents needed, but perhaps some tax attorneys wouldn't go beyond just the tax advice.