Why should you care when you acquire a business how the person whose business you're acquiring is going to be treated on a tax basis? I'm going to answer that question for you with Harry Sandrowski and we're going to talk about so much more. You need to join us for this episode of The Inside BS Show. Hey now, it's Dave Lorenzo.

I'm the Godfather of Growth and today we're talking about the tax implications when acquiring a business. You heard me right. When you buy a business, the person who you're buying the business from may have a tax event that they need to be aware of.

Now, why should you as the acquirer be concerned about this? You're buying a business and that person's probably going to have to hang around. They're definitely going to have to hang around long enough to do the transition with you and you absolutely need that transition to be smooth. But more often than not, that person's going to be a semi-partner with you for a year, two years, even three years during a workout where they're earning the rest of the compensation that they're getting for selling their business.

You want them to feel good about your relationship because somebody who feels good goes the extra mile for you, the person who's the new owner. So, I want to bring in Harry Sandrowski because he's our expert on taxes and tax policy and this is something that he spends a great deal of time thinking about and working with his clients on. Hello Harry, how are you today? I'm doing great, Dave.

How are you doing? I'm doing fantastic. I want to really dig into this because we're seeing some of our clients go out and acquire other businesses and they're trying to make a good deal but we advise them just like you do during the negotiating process that you might want to leave a little on the table because you want everybody to feel good about the relationship because you're going to have to work with this person for 18 months, 36 months, however long your workout period is. What nobody thinks about and what I didn't realize until just recently when I had a conversation with both the seller and the buyer in a transaction, the buyer doesn't think about the implications to the seller when it comes to taxes.

So, I want to talk about taxes with you and let's start with something that we hear all the time because we're involved in it but a business owner may be just hearing this for the first time and that's asset sale versus stock sale. One side wants one thing almost always and the other side wants the other thing almost always. Can you explain the tax treatment between a stock sale and an asset sale? Sure, of course, Dave.

So, a stock sale is you're actually selling stock. In those cases, most of the time that stock is going to be treated as long-term capital gain to the seller assuming they have the right holding period for the stock. The buyer is not going to be able, in most cases unless there's a special election made, is not going to be able to step up the underlying assets of the company.

So, they bought stock, they have basis in the stock and that's it. If they were to buy assets, then they're able to step up the tax basis of those assets and take write-offs over a shorter time period depending on what type of assets they are. Now, the downside on buying assets is it could have a negative implication for state tax purposes because someone's going to have to pay more in state taxes.

It also could mean that there's something called depreciation recapture. So, depreciation recapture happens when you buy equipment, you depreciate the equipment and then as I'm buying, as the buyer now is buying it, they're going to allocate because you have to allocate for tax purposes, purchase price to, you know, your cash, your receivables, inventory, equipment, you're more than likely are going to have what's called depreciation recapture which is going to be attached to ordinary income rates. So, that is going to be on the seller to incur those obligations.

So, it can be significant. It will be highly dependent on the type of business that you're buying. So, if you don't have depreciation recapture, then it might not have the same benefit.

But at the same time, goodwill is amortizable over 15 years. So, you know, most people are going to want to do an asset acquisition for a couple different reasons though. One is for legal reasons because they don't want to have liabilities that they're unaware of.

And the second one is going to be because of the taxes. So, that's the thing that I think everybody is conscious of is the liability aspect of it. And the tax aspect is secondary.

Usually, the liability as... So, you go out and you get an attorney when you're going through one of these and you're reviewing letter of intent and that sort of thing. And the attorney, if he's smart or she's smart will say, now you got to talk to your accountant about the tax aspect of this. And the way we structure it is going to have an impact on that.

And you got to balance tax liability with legal liability here. So, what are the most common tax pitfalls that buyers overlook when they acquire a company? What do they miss? Okay. So, one of the things they miss is the seller might not have planned properly for the amount of taxes they're going to have to pay.

And if that happens, you might have a new partner that you didn't know you were going to have before because of liens or from the IRS or from a bank or whatever the case may be. That's one of them. The other one comes into state taxes.

State taxes, a lot of times companies will only pay in the state where they're operating and don't understand they have other reporting obligations. So, you could have that type of, you know, obligation. The third one is, and we've run into this before, we have found that some of the owners had substantial IRS tax issues of their own before.

So, you might not be, it might not affect the company directly, but it will impact that person's time and their finances. So, that's something that you really need to be aware of. You find out all that out during due diligence, you know, by doing background checks and everything else to find that out.

I mean, people want to make sure that their investment is secure and you don't want tax liabilities impacting that because if you have a tax liability at any level, it impacts your cash flow, which impacts your rate of return. You know, it's not a hard formula to follow. So, that's an interesting point that you raised there.

So, you're doing due diligence on a company when you're going to purchase it. Do you ask the person who's selling the company, hey, can we also do a personal background check to make sure that you have no IRS liens and you haven't filed for personal bankruptcy? And there's, is that a common thing that's asked? So, normally do a background check. I don't need their permission, but if I am doing one, I might give them the courtesy of telling them I'm going to do that.

You might ask them during the process, you know, do you have any tax liens? Do you have any other issues as we move forward with you that we should be aware of that could impact either you or the company? Because if it impacts you, it impacts the company, right? And impacts their performance. So, you would ask those questions. Where you have to really get their permission is if you wanted to do a credit check.

And then you would have to go through that process. But I find that if you just, if people are upfront about what the criteria is about what they're going to be looking at, because, you know, a lot of this, you know, in doing new diligence, it's the equivalent of a proctology exam. People understand that.

Then that'll all be on the table. And it's really for everyone's best, you know, it's for their benefit. Okay.

So, what should you do from a tax strategy perspective if you're a business owner and you're going to acquire another business? From your perspective as the acquiring company, as the buyer, what do you need to look at from a tax perspective going into that? So, a couple of things there. One is you have to look at your current structure to say, if you're going to be acquiring companies in the future, is your company set up the most tax efficiently to acquire those companies for you to get long-term benefits? You might not be set up the way that you should have. So, should you be setting up another entity to buy this asset or assets down the road in order to structure that? And then I think what you need to do is say, what is my game plan over the next five to seven years? How many companies am I going to be acquiring? And then do a projection on that and say, what's my best way for me to be structured? Because I might need more financing.

I might need to bring in someone else to help me on equity. What's going to make this look attractive to them? So, you really need to take a look at that on both ends. We had a construction company in Chicagoland, that long-standing construction company.

And they were S-Corp for what reason, again, that's a subject of a different day. But they wanted to buy another construction company in Florida. And we told them we should set up a sister company in order to have the flexibility.

And they got it right away. They understood it. So, that gives them flexibility with respect to that because they were to make more acquisitions.

And in the modern era, that was a better way to go. So, sometimes people are not necessarily stuck with their current, but they don't have the inertia to change it. So, an acquisition might be enough of an impetus to really take a good hard look at it.

Okay. So, let's talk a little bit about buying companies that have a lot of equipment or things that can be depreciated. There are people, investors out there who specifically invest in businesses because there are aspects of the business they're acquiring that can be depreciated quickly.

Tell me about the reasoning behind that and why do savvy business owners look at acquiring businesses where there are materials or equipment that can be depreciated and explain that whole process and bonus depreciation and why it makes a transaction more attractive than another transaction? Sure. So, a couple of different examples. One is, if it's an LLC taxed as a partnership, then those deductions are going to flow through to the individual owners of the LLC and reducing their taxes.

So, it makes the after tax rate of return for their investment better because they're taking those deductions at 37%. If you are a C-Corp, even with a faster deduction, what happens is you're able to accumulate more cash over time because you're paying less in taxes. And then you can redeploy that cash in business for working capital.

So, it's kind of a win-win type situation. And then what also happens is in the LLC that I refer to, a lot of times there are tax provisions that say that there are mandatory tax distributions based on net income. So, if you can accelerate depreciation, you're going to have lower tax distribution and then the excess money can be used in the business.

So, there's a lot of very positive things that could happen by getting those deductions early on and then redeploying the capital in the business for expansion or for another acquisition. And then you're going to hold on to it for a long time. That becomes kind of like permanent money because if you keep the money in for seven years, you might be the equivalent of doubling your money by leaving it in the business.

So, a lot of good things can happen with that. And our dispensing provisions have been very robust the last several years. And it looks like President Trump's going to try to bring that back in for 100% dispensing election.

So, that's one of the reasons why car washes have been such an attractive investment, right? In addition to the fact that they've unlocked the recurring revenue model by providing subscription services and car washes, there's also when you acquire a car wash, you can also depreciate that equipment practically in year one, right? Yes. And it's acquiring the equipment or if you're building a new one, it's going to get to the same place. But yes, it's going to get very, very robust tax depreciation.

And we know of a couple of people that have used that by building four or five, completely wiping out their other income that they earned from other places. So, their net tax liability for several years has been zero. So, let's say I own the car wash and I owned it for five years and I depreciated that equipment.

You come in and buy the car wash. Can you then take depreciation on that same equipment? Yeah, you do because you have to recapture the depreciation as the seller. And so, the new owner would be able to write that off again.

Oh, okay. All right. Interesting.

Very, very interesting. Okay. It's like any other thing that the tax ends up being the same because you have to recapture it and therefore, somebody else is buying it.

So, they get to set their depreciation schedule in the courts, whatever the law is at that time. Okay. Now, talk to me about, because you work with a lot of family offices.

You work with a lot of affluent individuals. There was this thing, and I don't know if it still exists. You know the answer to this with the aircraft.

When you were buying an aircraft, there was bonus depreciation and there was something about you could accelerate the depreciation. You didn't have to spread it over the useful life of the aircraft. You could take it in advance.

Does that still exist and is it only on aircraft or is it on other equipment or methods of transportation? Well, it's been around on equipment. Airplanes are a little more complex because it goes back to how are you using the plane. So, in order to maximize depreciation, for example, some of the planning comes in because you only get to depreciate the business portion of the aircraft.

So, if you used it 100% for business, then you can take the full expensing of whatever the depreciation is. However, if let's assume you bought it right before year end, let's say you bought it in October and you used it a lot for business, but then again, and because of Thanksgiving and the holidays, you use it also for personal, you then are going to be permanently not being able to utilize that percentage of depreciation. So, what a lot of people do is in the first year, they make sure that their business use is 100% or let's say 90% and will defer any personal into the next calendar year.

So, they're able to get a full as much of the depreciation. Sometimes you got to go back and recapture. It gets a little complicated, but there are a lot of different ways to plan that out.

It all comes down to the planning. And that surfaces, the usage surfaces, because I know what people are thinking. Well, how are they going to know? I go to Colorado all the time in the winter for business purposes.

I go to Florida all the time in the winter for business purposes. How are they going to know? Well, that comes out in an audit. And if you're at that level of financial affluence, you're highly likely to be audited, correct? Yes.

And then don't forget, they have to have flight logs. You have to put down who's on the plane. So, if you have your two dogs on the plane, and your family, the question is, why are you really going there? And what's the business purpose? So, you got to be very careful there.

And I don't think the pilots are going to be willing to not put people's names on because they would lose their license. But no, it's very easy for the IRS to get at that information. And the question is, what was the business? If you're going to your vacation home, it's kind of hard, why are you doing that? Now, in today's environment, because of COVID and everything else, you might be able to try to round a few other edges here and there.

But at the end of the day, it's probably not going to be worth it. And what most people don't realize is if you have that level of affluence, the amount of money that you would pay in taxes is not worth the reputational damage or any other implications of fines. And like you said, people losing licenses, it's just not worth it.

To save the equivalent of like $25 to the average Joe, it's just not worth it. Well, remember the famous case of Leona Hemsley in New York, what she did. And anytime you take those extremes, it can come back to haunt you.

Yeah. All right. So with tax, with regard to taxes and an acquisition, what is the best time to sit down with your accountant and say, this is what I want to do.

This is the type of company I'm looking at. What are the tax implications? Like how far in advance do you need to do it? Can you do it right when you're entering into the transaction and make the changes? Or do you need to do it like a year in advance? When do you need to talk to your account? You know, preferably, and this kind of goes back to a mantra that we always say, you know, you can either do this at the end of the year or the beginning of the year, but you should really sit down and say, what are my goals and my objectives for the next year and the next three years? And talk to your legal counsel, talk to your tax accountant, say, how am I set up? And if I want to do these things in the future, how should we do this and how should we implement that? So my view is every year you should be doing that anyway. And you should also be looking at your company.

So the idea is if you have that in place, when you're ready to go do that acquisition, then everyone has the right mindset in place. You talk through the issues and you talk through the planning. And that's just a better way, overall, how to be structured and how to work with your professionals.

You just call your professionals at the last minute, you know, the likelihood of you getting the same efficiencies that's not there. And then the communication's not the same. All right, Harry, I want to ask you one more thing before we go, and that's cross-border transactions.

So here in the U.S., we do a lot of business in Canada. We potentially do a lot of business in Mexico. I work with people here in Miami who do a lot of business in South America.

From a tax perspective, do we need to worry or should we be concerned about cross-border transactions? And if so, what should we be concerned about? So in cross-border transactions, you need to have someone from the other country who knows that stuff backwards and sideways. I mean, for example, you know, LLCs, which are great in the U.S., they're horrible in Canada, the tax treatment of them to our, you know, to our taxpayers. And, you know, the same thing with other treaties and other countries.

So what you need to do is, that's where you really need to do a lot of your planning ahead of time and doing your projections, because, you know, in Canada, you have provincial taxes, you have the federal taxes, you know, and you can just get slammed on all that. And then you got to work on what's the U.S. tax impact. So the big question there is, who owns it? What are the citizens of the U.S. or the citizens of whatever other country? You've got to be really careful about how that gets, you know, set up.

And you've got to make sure that, you know, you do your planning, you know, appropriately for that. And, you know, Canada has had some, you know, a lot of complications, you know, with respect to planning. I remember Tim Moody telling me one time, a professor and his wife moved to Canada.

They lived there for seven or eight years. He died, and they never paid Canadian taxes. So what happened was, the estate was charged by Canada for 10 years of taxes.

And then they also had to pay an exit tax, because when he died, the fair market value of the assets was greater than what he paid for the country. So it almost bankrupt the estate. You know, so that's just one thing.

I mean, but I'm saying, when you talk about cross-border, you know, you're going to have complications, and you got to plan for it. And you got to have somebody, you know, competent on the other side to understand what it is. But you should have those relationships ahead of time, not when you're doing it at the last minute.

You want to go out, you want to interview people, you want to make sure they really are experts in the area that you need the expertise. And to do that at last minute, it's not as best business practice. Yeah.

All right, folks. So if you're doing anything that in any way touches on taxes, you're buying a company, you're selling a company, you're doing cross-border transactions, you're doing transactions in multiple states, give Harry a call in advance. Talk to him about it.

If you've screwed up, you can call him afterwards. But I would tell you that it's better to call him he's happier when you call him in advance. He'll still work with you if you call him afterwards, but you can reach him at 866-717-1607.

That's 866-717-1607. An ounce of planning is worth a pound of cure. Believe it or not, in taxes, this is probably doubly true.

I've heard horror stories from Harry over the years about people who didn't at least sit down with him and think things through in advance. And here's how simple that is. You sit down with him and you go, Harry, here's what I'm thinking of doing.

And you tell him and then he'll give you 15 things you didn't think about. And then while you lie awake trying to figure out how to fix that, you can realize I can just call Harry and he can fix this for me since he told me what I should be doing in the first place. I will tell you that your taxes are something that you don't want to until it's too late to address.

There are things you can do in advance and we talk about them here every Monday. And one of those things is planning in advance for how your company will be treated on a tax basis when you sell your company, how your company will be treated from a tax perspective when you're purchasing another company. 866-717-1607 is the number.

Give Harry a call today. They're a CPA firm with a different perspective and now they can help you all over the place, not just in here in the U.S., but all over the place because they're part of Prosperity Partners. 866-717-1607.

Thank you, Harry, for the wisdom today. As always, we appreciate it. Thank you, Dave.

Thank you for having me. It was fun. All righty, folks, we'll talk to you again tomorrow.

We'll see you at 6 a.m. Until then, here's hoping you make a great living and live a great life.