The Problem

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A CPA called us to inquire about deferring capital gains tax on intellectual property to be sold by one of his clients.

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The client, small closely held LLC in the software industry, was preparing for a sale of its assets to a larger firm.

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As part of the tax planning for the acquisition, the CPA had considered whether some of the firm’s intellectual property assets, which would be subject to tax on the sale, would be eligible for capital gains tax treatment. (The Tax Reform and Jobs Act of 2017 eliminated capital gains tax treatment for some types of intellectual property.

 

Click here to read an article discussing how capital gains tax treatment has changed due to this legislation.

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The CPA had concluded that certain assets of the client firm would properly be considered capital assets eligible for capital gains treatment, including trademarks, trade names, goodwill and customer lists.

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The CPA wanted to learn whether it would be possible to avoid capital gains tax on this intellectual property at time of sale and instead defer the tax for an extended period, while still obtaining a high degree of liquidity from the sale of the intellectual property assets.

Facts and Circumstances

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Sale price: $2,600,000

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Cost Basis: $980,000

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Gain on Sale: $1,620,000

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Long-Term Capital Gains Tax + NIIT (37%): $599,400

Proposed Solution

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We recommended a tax-deferred cash out of the intellectual property, because this would allow the owners to avoid immediate capital gains tax instead defer the capital gains tax for 30 years.

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The monetized installment sale approach, briefly summarized:

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1. Seller already had a buyer lined up and had negotiated a purchase and sale contract.

2. Seller would be introduced to a dealer who would buy the assets under an installment sale agreement. The installment sale would feature interest-only payments for 30 years followed by a final balloon payment of principal. After 30 years, when the balloon payment from the dealer to the seller is completed, the capital gains tax would come due.

3. Upon close of the installment sale transaction, the dealer immediately resells the asset to the originally intended buyer for cash, keeping in place all the terms and conditions that had been negotiated between buyer and seller.

4. Simultaneous to the installment sale transaction, the seller is introduced to a third-party private lender who is ready to provide a loan to the seller, in an amount equivalent to 93.5% of the net sales proceeds. The loan includes repayment terms matching those of the dealer’s installment sale agreement: interest-only payments for 30 years with a final balloon payment of principal.

5. All payments from the dealer would be used to fund the seller’s payments to the lender, making them net out to zero, after tax.

6. The loan agreement to the seller provides that if the dealer stops making payments to the seller, then the seller is no longer obligated to make payments to the lender.

Result

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The seller hired a tax attorney with special expertise in this area to review and advise on the transaction. The seller decided to utilize a tax-deferred cash out to avoid immediate capital gains tax on the intellectual property that was subject to capital gains tax treatment.

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The seller deferred capital gains tax on the sale of the intellectual – for 30 years, in the amount of approximately $11,620,000. At the same time the seller obtained up-front cash in the for of loan proceeds equal to 93.5% of the net sales proceeds, or $2,431,000. These loan proceeds were tax-free, and the seller was able to re-invest that cash without restriction. The seller walked way with taxes deferred for 30 years and $430,000 more cash than if a conventional cash sale had taken place.