Business buyers and sellers negotiate and structure transactions to address a number of conflicting interests. Tax considerations often play a substantial role. The seller aims to minimize recognition of income and to qualify the purchase price as much as possible as capital gain, as opposed to ordinary income. Documentation plays an important part in achieving this aim and may be determinative, as illustrated by a recent Tax Court decision involving the sale of Solomon Colors, Inc. (“Colors”).
Colors pulverized and sold Mather ore, a red iron oxide mined in the Upper Peninsula of Michigan. It was operated by Robert Solomon and his son, Richard. Robert, Richard and their respective spouses controlled ownership. Each of the four Solomons served as directors. Robert served as President and Richard as Vice-President. Neither Richard nor Robert ever had an employment agreement, although each was heavily involved in developing and maintaining customer relationships.
Solomon’s sole Mather ore competitor, Prince Manufacturing Company (“Prince”), offered to buy Solomon’s Mather ore business. During lengthy negotiations between the Solomons and Prince, the parties discussed various matters but did not address payments for non-compete agreements for any of the family members, nor for Solomon’s customer list. A sale agreement was completed at a price of $1,500,000, which Colors unilaterally allocated as follows: $880,000 to Colors; $425,000 to Robert; $145,000 to Richard; and $25,000 to each of the spouses. Each of the Solomons executed non-compete agreements. Subsequently, Colors and Robert then allocated $1,100,000 of the purchase price to a customer list at $550,000 each. Based on this allocation, Colors and Robert reported most of the amounts received as capital gain tied to the goodwill associated with the customer list, and a small portion as ordinary income tied to the non-compete agreements.
The IRS determined that Colors had distributed to the Solomons partial interests in the customer list which represented dividend distributions resulting in assessment of a tax deficiency of approximately $202,000. It assessed an additional deficiency of approximately $419,000 against Colors as a result of the dividend distributions.
Colors and the Solomons contested the deficiency assessments, claiming that Colors did not distribute any interests in the customer list and that the relationships and goodwill associated with the customers belonged to Robert and Richard personally. They argued that Prince was not concerned with the list because it already knew all of the customers, that its interests were tied to the non-competes executed by the Solomons.
The Tax Court agreed with Colors and the Solomons. Prince did not need the list. It did not include it as an asset in the purchase agreement. Prince needed promises not to compete. It insisted that non-compete agreements be signed. Prince never required any portion of the price to be allocated to the list, because it considered it to have little, if any, value. The goodwill associated with the customer relationships belonged to the Solomoms personally and was not an asset of the company. Consequently, there was no dividend distribution and the deficiency assessment was erroneous.
Business sales are complicated and require careful evaluation and documentation to obtain the desired results. We would be pleased to address your concerns regarding any proposed transaction.