Question: My wife and I hold contracts to provide property management services to real estate owners. Are we entitled to capital gain treatment if we sell these contracts or do we need to form a limited liability company to do so?
Answer: The specific answer to your question is no. The gain from the sale of service contracts which are an integral part of your business will be taxed to you as ordinary income and will not qualify for capital gain treatment. This means you will be paying tax on the gain at your regular, marginal income tax rates and not at the lower capital gains tax rates. While there are various tests the courts use to determine if gain from the sale of a contract qualifies for capital gain treatment, the sale of your service contracts most certainly will not qualify for the more favorable capital gain treatment.
You also propose forming a limited liability company (“LLC”) and transferring the management services contracts to the LLC and then selling the membership or ownership interests in the LLC. Generally speaking, the sale of membership interests in an LLC is a capital transaction so that the gain is taxed as capital gain, not ordinary income. LLCs, however, are subject to look through rules whereby gain attributable to the sale of certain assets is treated as ordinary income, even when the transaction is structured as a sale of LLC ownership interests. In the case where an LLC is holding accounts receivable, for example, the portion of the gain attributable to the sale of accounts receivable will be taxed as ordinary income, not capital gain. The same holds true with respect to your management contracts which will be treated as one of these so called “hot assets” where the look through rules apply and will cause the gain attributable to these contracts to be treated as ordinary income, not capital gain. Forming an LLC will not convert the gain on the sale of your management contracts from ordinary income to capital gain.
One way to secure capital gain treatment is to form a corporation and transfer the management services contracts to the corporation. The corporation should elect to be treated as an S corporation which means that while the corporation is a separate legal entity, it will not be subject to tax on its income. Rather, S corporation income passes through and is taxed to the S corporation shareholders who report the income on their individual income tax returns and personally pay tax on their share of corporate income. In this case, you can contribute your contracts to the S corporation and structure your sale as a sale of S corporation stock. A taxpayer who sells shares of an S corporation will not be subject to the look through rules that apply in the case of a sale of membership interests in an LLC. This means that any gain on the S corporation stock sale will be treated as capital gain.
Bear in mind there are holding periods that determine the nature of capital gains. In the sale of a capital asset which has not been held for a period of more than one year, the gain is treated as a short-term capital gain which, absent any capital losses, will be taxable at the same tax rates as ordinary income. If, on the other hand, you hold the shares of the corporation for a period of more than one year and then sell the stock, gain from the stock sale will be treated as long-term capital gain which will qualify for the more favorable capital gains tax rates. For planning purposes, if you and your wife form the S corporation, transfer your management services contracts to the corporation and then sell your S corporation stock after more than one year has passed from the date of the transfer of the contracts to the corporation, the gain will qualify as long-term capital gain.
It is noteworthy that if there are other assets in your business that are being sold, then you may be able to mitigate the harshness of ordinary income tax treatment in certain respects. When the assets of a business are sold, the proceeds from the sale must be allocated to each of the assets being disposed of. If you can justifiably allocate as little of the consideration from the sale as possible to your contracts, then you may have a lesser amount of ordinary income. However, if your management contracts constitute the most valuable assets in your business and are the primary focus of the buyer’s acquisition interest, then the S corporation structure will probably work best for you by enabling you to report long-term capital gain from the sale.
The Tax Corner addresses various tax, estate, asset protection and other business matters. Should you have any questions regarding the subject matter or if you have questions, you want answered, you may contact Bruce at (312) 648-2300 or send an e-mail to firstname.lastname@example.org.