In recent years, merger and acquisition activity has been strong in many industries. If your business is considering merging with or acquiring another business, it’s important to understand how the transaction will be taxed under current law.

Stocks vs. assets

From a tax standpoint, a transaction can basically be structured in two ways:

1. Stock (or ownership interest) sale. A buyer can directly purchase a seller’s ownership interest if the target business is operated as a C or S corporation, a partnership, or a limited liability company (LLC) that’s treated as a partnership for tax purposes.

The now-permanent 21% corporate federal income tax rate under the Tax Cuts and Jobs Act (TCJA) makes buying the stock of a C corporation somewhat more attractive. Reasons: The corporation will pay less tax and generate more after-tax income. Plus, any built-in gains from appreciated corporate assets will be taxed at a lower rate when they’re eventually sold.

The TCJA’s reduced individual federal tax rates may also make ownership interests in S corporations, partnerships and LLCs more attractive. Reason: The passed-through income from these entities also will be taxed at lower rates on a buyer’s personal tax return. However, the TCJA’s individual rate cuts are scheduled to expire at the end of 2025, and, depending on future changes in Washington, they could be eliminated earlier or extended.

2. Asset sale. A buyer can also purchase the assets of a business. This may happen if a buyer only wants specific assets or product lines. And it’s the only option if the target business is a sole proprietorship or a single-member LLC that’s treated as a sole proprietorship for tax purposes.

Note: In some circumstances, a corporate stock purchase can be treated as an asset purchase by making a “Section 338 election.” Ask us if this would be beneficial in your situation.

Buyer vs. seller preferences

For several reasons, buyers usually prefer to purchase assets rather than ownership interests. Generally, a buyer’s main objective is to generate enough cash flow from an acquired business to pay any acquisition debt and provide an acceptable return on the investment. Therefore, buyers are concerned about limiting exposure to undisclosed and unknown liabilities and minimizing taxes after the deal closes.

A buyer can step up (increase) the tax basis of purchased assets to reflect the purchase price. Stepped-up basis lowers taxable gains when certain assets, such as receivables and inventory, are sold or converted into cash. It also increases depreciation and amortization deductions for qualifying assets.

Meanwhile, sellers generally prefer stock sales for tax and nontax reasons. One of their main objectives is to minimize the tax bill from a sale. That can usually be achieved by selling their ownership interests in a business (corporate stock, or partnership or LLC interests) as opposed to selling business assets.

With a sale of stock or other ownership interest, liabilities generally transfer to the buyer and any gain on sale is generally treated as lower-taxed long-term capital gain (assuming the ownership interest has been held for more than one year).

Keep in mind that other areas, such as employee benefits, can also cause unexpected tax issues when merging with, or acquiring, a business.

Professional advice is critical

Buying or selling a business may be the most important transaction you make during your lifetime, so it’s important to seek professional tax advice as you negotiate. After a deal is done, it may be too late to get the best tax results. Contact us for the best way to proceed.

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You generally must pay federal tax on all income you receive but there are some exceptions when you can exclude it. For example, compensatory awards and judgments for “personal physical injuries or physical sickness” are free from federal income tax under the tax code. This includes amounts received in a lawsuit or a settlement and in a lump sum or in installments.

But as taxpayers in two U.S. Tax Court cases learned, not all awards are tax-free. For example, punitive damages and awards for unlawful discrimination or harassment are taxable. And the tax code states that “emotional distress shall not be treated as a physical injury or physical sickness.”

Here are the facts of the two cases.

Case #1: Payment was for personal injuries, not physical injuries

A taxpayer received a settlement of more than $327,000 from his former employer in connection with a lawsuit. He and his spouse didn’t report any part of the settlement on their joint tax return for the year in question. The IRS determined the couple owed taxes and penalties of more than $119,000 as a result of not including the settlement payment in their gross income.

Although the settlement agreement provided the payment was “for alleged personal injuries,” the Tax Court stated there was no evidence that it was paid on account of physical injuries or sickness. The court noted that the taxpayer’s complaint against the employer “alleged only violations of (state) labor and antidiscrimination laws, wrongful termination, breach of contract, and intentional infliction of emotional distress.”

The taxpayer argued that he had a physical illness that caused his employer to terminate him. But he didn’t provide a “direct causal link” between the illness and the settlement payment. Therefore, the court ruled, the amount couldn’t be excluded from his gross income. (TC Memo 2022-90)

Case #2: Legal malpractice payment doesn’t qualify for exclusion

This case began when the taxpayer was injured while at a hospital receiving medical treatment. She sued for negligence but lost her case. She then sued her attorneys for legal malpractice.

She received $125,000 in a settlement of her lawsuit against the attorneys. The amount was not reported on her tax return for the year in question. The IRS audited the taxpayer’s return and determined that the $125,000 payment should have been included in gross income. The tax agency issued her a bill for more than $32,000 in taxes and penalties.

The taxpayer argued that the payment was received “on account of personal physical injuries or physical sickness” because if it wasn’t for her former attorneys’ allegedly negligent representation, she “would have received damages from the hospital.” The IRS argued the amount was taxable because it was for legal malpractice and not for physical injuries. The U.S. Tax Court and the 9th Circuit Court of Appeals agreed with the IRS. (Blum, 3/23/22)

Strict requirements

As you can see, the requirements for tax-free income from a settlement are strict. If you receive a court award or out-of-court settlement, consult with us about the tax implications.

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Are you in the early stages of divorce? In addition to the tough personal issues that you’re dealing with, several tax concerns need to be addressed to ensure that taxes are kept to a minimum and that important tax-related decisions are properly made. Here are five issues to consider if you’re in the process of getting a divorce.

1. Alimony or support payments. For alimony under divorce or separation agreements that are executed after 2018, there’s no deduction for alimony and separation support payments for the spouse making them. And the alimony payments aren’t included in the gross income of the spouse receiving them. (The rules are different for divorce or separation agreements executed before 2019.)
2. Child support. No matter when the divorce or separation instrument is executed, child support payments aren’t deductible by the paying spouse (or taxable to the recipient).
3. Personal residence. In general, if a married couple sells their home in connection with a divorce or legal separation, they should be able to avoid tax on up to $500,000 of gain (as long as they’ve owned and used the residence as their principal residence for two of the previous five years). If one spouse continues to live in the home and the other moves out (but they both remain owners of the home), they may still be able to avoid gain on the future sale of the home (up to $250,000 each), but special language may have to be included in the divorce decree or separation agreement to protect this tax exclusion for the spouse who moves out.
   If the couple doesn’t meet the two-year ownership and use tests, any gain from the sale may qualify for a reduced exclusion due to unforeseen circumstances.
4. Pension benefits. A spouse’s pension benefits are often part of a divorce property settlement. In these cases, the commonly preferred method to handle the benefits is to get a “qualified domestic relations order” (QDRO). This gives one spouse the right to share in the pension benefits of the other and taxes the spouse who receives the benefits. Without a QDRO the spouse who earned the benefits will still be taxed on them even though they’re paid out to the other spouse.
5. Business interests. If certain types of business interests are transferred in connection with divorce, care should be taken to make sure “tax attributes” aren’t forfeited. For example, interests in S corporations may result in “suspended” losses (losses that are carried into future years instead of being deducted in the year they’re incurred). When these interests change hands in a divorce, the suspended losses may be forfeited. If a partnership interest is transferred, a variety of more complex issues may arise involving partners’ shares of partnership debt, capital accounts, built-in gains on contributed property, and other complex issues.

A variety of other issues

These are just some of the issues you may have to deal with if you’re getting a divorce. In addition, you must decide how to file your tax return (single, married filing jointly, married filing separately or head of household). You may need to adjust your income tax withholding and you should notify the IRS of any new address or name change. There are also estate planning considerations. Contact us and we can help you work through all of the financial issues involved in divorce.

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Awards and settlements are routinely provided for a variety of reasons. For example, a person could receive compensatory and punitive damage payments for personal injury, discrimination or harassment. Some of this money is taxed by the federal government, and perhaps state governments. Hopefully, you’ll never need to know how payments for personal injuries are taxed. But here are the basic rules — just in case you or a loved one does need to understand them.

Under tax law, individuals are permitted to exclude from gross income damages that are received on account of a personal physical injury or a physical sickness. It doesn’t matter if the compensation is from a court-ordered award or an out-of-court settlement, and it makes no difference if it’s paid in a lump sum or installments.

Emotional distress

For purposes of this exclusion, emotional distress is not considered a physical injury or physical sickness. So, for example, an award under state law that’s meant to compensate for emotional distress caused by age discrimination or harassment would have to be included in gross income. However, if you require medical care for treatment of the consequences of emotional distress, then the amount of damages not exceeding those expenses would be excludable from gross income.

Punitive damages for any personal injury claim, whether or not physical, aren’t excludable from gross income unless awarded under certain state wrongful death statutes that provide for only punitive damages.

The law doesn’t consider back pay and liquidated damages received under the Age Discrimination in Employment Act (ADEA) to be paid in compensation for personal injuries. Thus, an award for back pay and liquidated damages under the ADEA must be included in gross income.

Attorney’s fees

You can’t deduct attorney’s fees incurred to collect a tax-free award or settlement for physical injury or sickness. However, to a limited extent, attorney’s fees (whether contingent or non-contingent) or court costs paid by, or on behalf of, a taxpayer in connection with an action involving a claim under the ADEA, are deductible from gross income to determine adjusted gross income. Specifically, the amount of this above-the-line deduction is limited to the amount includible in your gross income for the tax year on account of a judgment or settlement resulting from the ADEA claim, whether by suit or agreement, and whether as lump sum or periodic payments.

Best possible tax result

Keep in mind that while you want the best tax result possible from any settlement, lawsuit or discrimination action you’re considering, non-tax legal factors together with the tax factors will determine the amount of your after-tax recovery. Consult with your attorney as to the best way to proceed, and we can provide any tax guidance that you may need.

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A business may be able to claim a federal income tax deduction for a theft loss. But does embezzlement count as theft? In most cases it does but you’ll have to substantiate the loss. A recent U.S. Tax Court decision illustrates how that’s sometimes difficult to do.

Basic rules for theft losses

The tax code allows a deduction for losses sustained during the taxable year and not compensated by insurance or other means. The term “theft” is broadly defined to include larceny, embezzlement and robbery. In general, a loss is regarded as arising from theft only if there’s a criminal element to the appropriation of a taxpayer’s property.

In order to claim a theft loss deduction, a taxpayer must prove:

• The amount of the loss,
• The date the loss was discovered, and
• That a theft occurred under the law of the jurisdiction where the alleged loss occurred.

Facts of the recent court case

Years ago, the taxpayer cofounded an S corporation with another shareholder. At the time of the alleged embezzlement, the other original shareholder was no longer a shareholder, and she wasn’t supposed to be compensated by the business. However, according to court records, she continued to manage the S corporation’s books and records.

The taxpayer suffered an illness that prevented him from working for most of the year in question. During this time, the former shareholder paid herself $166,494. Later, the taxpayer filed a civil suit in a California court alleging that the woman had misappropriated funds from the business.

On an amended tax return, the corporation reported a $166,494 theft loss due to the embezzlement. The IRS denied the deduction. After looking at the embezzlement definition under California state law, the Tax Court agreed with the IRS.

The Tax Court stated that the taxpayer didn’t offer evidence that the former shareholder “acted with the intent to defraud,” and the taxpayer didn’t show that the corporation “experienced a theft meeting the elements of embezzlement under California law.”

The IRS and the court also denied the taxpayer’s alternate argument that the corporation should be allowed to claim a compensation deduction for the amount of money the former shareholder paid herself. The court stated that the taxpayer didn’t provide evidence that the woman was entitled to be paid compensation from the corporation and therefore, the corporation wasn’t entitled to a compensation deduction. (TC Memo 2021-66)

How to proceed if you’re victimized

If your business is victimized by theft, embezzlement or internal fraud, you may be able to claim a tax deduction for the loss. Keep in mind that a deductible loss can only be claimed for the year in which the loss is discovered, and that you must meet other tax-law requirements. Keep records to substantiate the claimed theft loss, including when you discovered the loss. If you receive an insurance payment or other reimbursement for the loss, that amount must be subtracted when computing the deductible loss for tax purposes. Contact us with any questions you may have about theft and casualty loss deductions.

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This is an opt-in program, which means you will not be automatically registered. However, the IRS urges taxpayers to take the time to register an IP PIN to protect themselves against cyber criminals who may try to take advantage of the chaos that COVID-19 has created. Click the links below for more information and to register.

IP PIN Requirements

Register for an IP PIN

IP PIN Frequently Asked Questions

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• Senior Accountant – West Columbia, SC Office
• Specializes in the following: tax return preparation, financial statement preparation, business valuations, fraud investigations, and other litigation support services

Experience

• Intern at Burkett Burkett & Burkett, Certified Public Accountants, P.A. in January 2008
• Staff Accountant at Burkett Burkett & Burkett, Certified Public Accountants, P.A. in June 2009
• Senior Analyst at SCANA Corporation August 2016 – January 2018
• Senior Accountant at Burkett Burkett & Burkett, Certified Public Accountants, P.A. in January 2018

Professional and Civic Activities

• South Carolina Association of Certified Public Accountants – Member
• American Institute of Certified Public Accountants – Member

Education

• Columbia College – Graduated: 2008 – SC Bachelors of Arts in Accounting, Magna Cum Laude
• Columbia College – Graduated: 2008 – Honors Program
• University of South Carolina – Graduated: 2009 – SC Masters of Accountancy

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• Executive Vice President
• Prepares tax returns for individuals, partnerships, corporations and not for-profit entities
• Manages Business Valuations, Litigation support cases, Forensic Accounting & Fraud Investigations and Economic Damages Cases

Experience

• Accredited in Business Valuation (ABV) – Completed 2013
• Certified Fraud Examiner (CFE) – Completed 2006
• Certified Public Accountant (CPA) – Completed 2002
• Chartered Accountant (CA) – Completed 1990
• Public limited company in India—1993-1999
  • Last Position Held: President of Finance
  • Responsibilities: Managed relations with banks and financial institutions at senior levels, obtain financing, tax planning, financing functions, auditing the accounts, filing of tax returns
  • Appointed a Director on the Board of all the group companies
• Public Accounting, India, 1988-1993—Performed audits, compilations, reviews and prepared tax returns for individuals, partnerships and corporations

Professional and Civic Activities

• South Carolina Association of Certified Public Accountants
• American Institute of Certified Public Accountants
• Association of Certified Fraud Examiners
• Institute of Internal Auditors
• Institute of Chartered Accountants of India
• Past Treasurer of Hindu Temple & Cultural Center of SC
• Past Board Member of Immigrant Community Access Point

Education

• University of Bombay with Honors – Graduated: March 1987

Interesting Facts

• Born in Bombay, India
• Resides in Columbia, South Carolina

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• Executive Vice President
• CPA with Burkett since 1997
• Specializes in the following areas: small business consulting and software support,  litigation support, forensic accounting, fraud examination, tax preparation and planning for individuals and businesses, and non-profit and church accounting and tax preparation.

Professional and Civic Activities

• South Carolina Association of Certified Public Accountants
  • Past President, Vice President and Treasurer of Central Chapter
  • Chaired Young CPAs Committee (Represented South Carolina in June 2004 at the AICPA Young CPAs forum in Orlando, FL)
• American Institute of Certified Public Accountants
• Association of Certified Fraud Examiners
• National Association of Certified Valuation Analysts
• Lexington Chamber of Commerce—former Ambassador
• Leadership Lexington County Class of 2001—Alumnus
• Lexington School District One School-to-Career Committee—chairperson for fiscal years 2000-2001 and 2001-2002
• Lexington Technology Center Advisory Board—Assisted with student interviews for the 2002, 2003 & 2004 Doris Burkett Technology Center Award
• Lexington Rotary Club – Board of Directors, Past President
  • Rotary District 7770 Youth Exchange Committee – Treasurer
• Children’s Chance Charity—Past Treasurer, Vice-President and President
• Ronald McDonald House of Columbia—Treasurer
• Pilgrim Community Preschool—Treasurer
• SOAR Columbia—Treasurer

Education

• Winthrop University—Graduated: June 1996
  • Bachelor of Science Degree in Accounting

Interesting Facts

• Lifelong Resident of South Carolina
• Married to Eric Ford

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• Executive VP & Firm Administration
• Specializes in: tax return preparation, financial statement preparation, business valuations, and litigation support services

Experience

• International Paper Company: Worked in Regional Office, Georgetown, SC and the Division Office, Mobile, Alabama
• Received CPA designation in South Carolina in 1979
• Received CVA designation in 1997

Professional and Civic Activities

• South Carolina Association of Certified Public Accountants
• Central Chapter of Certified Public Accountants
• American Institute of Certified Public Accountants
• Awarded Certificate of Educational Achievement for completion of an integrated program in Business Valuation by AICPA
• National Association of Certified Valuation Analysts
• Presented seminars for the following state associations of CPAs: Nevada, Arizona, New York, Ohio, Florida, Oklahoma, Texas, Illinois, Indiana, Alabama, Georgia, West Virginia and South Carolina
  • Topics include: Individual, Partnership, Corporate, and Non-Profit Tax Return preparation and Tax Planning, Business Valuation and CPA’s Role in Litigation, Arbitration and Dispute Resolution, and Compilation, Review and Audit of Financial Statements
• Midlands Technical College Board of Commissioners
  • Past Chairman currently on the Board

Education

• University of South Carolina—Graduated: June 1974
  • Bachelor of Science Degree in Accounting

Interesting Facts

• Resides in West Columbia, South Carolina
• Married to Mary E. Burkett
• They have four children, six grandchildren, and one great-grandchild

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