What To Remember Before Buying An Established Business

Buying An Established Business
One of the customary methods of going into business is to buy a going concern. Advantages of
this method include the following:
The business may be bought at a bargain. Someone who is desirous of getting out, for reasons
such as health or advancing age, may be anxious to sell and willing to take a low price.
The previous owner has brought together those assets which are necessary to conduct the
business. The new owner can benefit from his knowledge and experience, and avoid making
some of the mistakes which he might otherwise make.
When buying a going business, the new owner acquires customers. Thus, a certain volume of
business can be accurately predicted. To that extent the risk is reduced.
Figure 1 photo credit to http://www.gaebler.com/
Stepping into a going business gives the new operator the benefit of a running start. He does not
have that initial waiting period. The income can start more quickly. There will be less drain on
the resources during the period when trade is being developed.
As with so many things, these benefits may be offset by disadvantages.
The previous business may have been a failure. Such a business would carry a handicap because
it is difficult to overcome its reputation.
There are some locations where a business venture is almost certain to fail. It may not always be
wise to take advantage of the bargain offered by a predecessor. It may be that sufficient business
could not be developed at that location, regardless of the owner's ability.
While it is an advantage to step into a going concern and receive the benefit of someone else's
skill and judgment, buying a going business may result in saddling the buyer with his

predecessor's mistakes. The previous owner may have made poor choice of equipment or been
unwise in his inventory purchases.
Although the going business inherits certain customers, it also penalizes the new owner.
Potential customers may have formed the habit of not trading with it. It may be some time before
they have a chance to become acquainted with the new owner or even become aware of the fact
that the business has changed hands. (This difficulty may be overcome by good management and
advertising.)
But even though a going concern is bought, it can become a new venture—under new
management and new policies—perhaps with a new front and new interior layout. The new
venture, clearly so labeled, often attracts people who like to try new things and trade at new
places.
Investigating Another Business
What are your steps in a purchase? Here is a useful list of things to do:
Make your plans to study at least three things: your opportunity for profit if you go ahead; the
history of the business (its legal, financial, and other points); the tax aspects of your purchase.
How do you find your opportunities for profit? What first, are the risks in the purchase? That
requires you to find: the long- and short-term chances for profits—your chances of getting a fair
return on your investment. It means study of extra investment you might have made in
rehabilitation, repairs and improvements to get profits. Is the return on the total investment
adequate?
You should audit the business thoroughly. Break this process up into four parts:
1. Get a competent CPA who knows the business to give you a full record of its financial and
operating history. Make sure he finds out all about the following things for you:
 Contractual commitments at higher-than-market prices.
 Unfilled contracts for sales at too low prices.
 Contracts and claims that affect future financial conditions of prospective customers.
 Whether or not some accounts or inventory have been pledged or assigned, without being
so indicated.
 Receivables for goods shipped on memo or consignment or accounts for goods sold but
not shipped.
 Status of contingent liabilities—if they are adequately disclosed in the financial
statement.
 Whether the company has indorsed or otherwise guaranteed any obligations of others.
This includes negotiable instruments sold or discounted.

 If individual firm members or partners have become contingently liable by endorsements
and guaranties on obligations of others.
 Damage claims, lawsuits, disputed assessments or possible tax liabilities.
 If the business is liable on a mortgage bond where the mortgaged property has been sold
to others subject to the mortgage. Attempt to estimate the probability of a deficiency
judgment. Amount of cumulative dividends in arrears.
2. Get a lawyer to check:
 The chain of legal title.
 Leases, including machinery rented or leased.
 Patent arrangements and registration of*patents, trademarks, formulas, and copyrights,
franchises, and their transferability.
 Encumbrances on the property—mortgages, liens, chattel mortgages against machinery
and fixtures, judgments against the seller, condemnation proceedings under way, taxes in
arrears.
 Zoning restrictions (for example, those which may come into effect for the first time with
change of owner, whether area may be restricted to residences or as to type of building
material, sewage-disposal arrangements).
 Restrictions on ownership.
 Public use of property for street, waterway, highway, etc.
 Renting regulations.
 Smoke-nuisance legislation.
 Other building regulations—sprinklers, fire escapes, roofs, and sidewalks.
 Whether you have the right of way over someone else's land to get to your property.
 Rights to oil, gas, minerals, and timber; quarrying rights.
 Legal duties and obligations you will become subject to (for example, filing frequent and
numerous reports to government agencies).
 Labour restrictions, health laws—workmen's compensation, fire, liability and automobile
insurance; local health and inspection laws.
3. Get a full record of the labour relations of the business.
Government agencies to which the business is subject. Relationship that exists as to compliance
or violations in connection with Federal, state labour laws, etc. Union contracts in force, previous
labour disputes, present relations with the union. Wage, hours, and working conditions. Age and
sex of employees. Possible turnover in post war period.
4. Make sure you fully investigate the business among its banks, customers and creditors, and in
its community.

Determine the real reasons the present owner has for wanting to sell the business; try to find out
from his creditors, competitors, bank, business agent, employees, trade associations, etc. Take
nothing for granted—double-check every possible contingency.
How To Buy A Business Tax-Wisely
Consider your own tax problem—by what method shall you buy the business? Shall it be one to
give you the seller's tax basis of assets? Or shall it be one giving you the fair market value of
what you buy as your tax basis?
If you use cash to buy, that determines the value used later in depreciating or in selling. If you
use stock or securities, you might get considerable tax advantages in some cases to the seller or
yourself. Study, too, whether you should buy stock of the company or its assets. They may make
a great difference in your tax position. This section is an effort to aid you in making these
decisions.
Sometimes a business has been made successful because of the personal efforts of one or two
principals in that company. It may be advisable to employ these principals. Your payment of
their compensation gives you a full tax deduction. Perhaps agreement to pay them the highest
possible reasonable compensation for a long period will get you a good reduction in purchase
price.
Consider a long-term lease instead of a purchase of the assets of the other business. You will still
get a tax depreciation deduction, if you also agree: to replace losses caused by depreciation or
obsolescence; or return the property in as good condition as when delivered.
Figure 2 photo credit to http://www.bsm.uk.com/
Control your interest deductions carefully in your purchase. It may be to your advantage to
decrease the annual installments of selling price and increase the yearly interest. The latter is a
tax deduction when paid over a period of years.

If you buy a building or other property with the intention of demolishing, neither the cost nor the
expenses of demolition are deductible. They are added to your cost of a new building. But if you
do not have the intention at the time of purchase, but later decide to demolish, you get the loss
deduction. This means you want a good record to show your intentions.
If you are buying a business and you have an agreement that the sellers or others will not
compete, be sure that you get a value on this part of the sale. And set a definite period of time for
the restraint. This kind of payment to an individual can be deducted over the period of the
restraint.
Arrange your transaction to avoid paying a tax on part of the purchase price. Here is the sort of
planning you can do:
Assume you agree to buy corporate stock. Assume, too, that your price of the stock reflects the
higher market values (over corporate costs) of inventories, real estate, etc. When these assets are
sold both the corporation and you (when dividends are distributed) will pay a tax on a book
profit. That contains a return on your capital invested. Make sure your buying plan does not
include that penalty. Seek a purchase of assets, or get an adjustment for the penalty you are
assuming. Of course your deal to buy stock may give you a real advantage. You may pay $100
for stock of a company whose assets cost it $1,000 and are worth only $100. Then you may get
deductions based on the $1,000.
Take another case—you want to purchase the stock of a company that has an accumulated
surplus. When any corporate distributions occur they will be taxed as dividends to you. This is
so, even though in reality they represent in whole or in part a return of your capital. Assume your
stock will cost $100. The company has assets costing $50 ($40 of surplus and $10 of capital)
which are now worth $ 100. If it pays dividends you will have ordinary dividend income up to
$40. You really should get no income until you have recovered your $100. You ought to avoid
that penalty.
But the seller may insist on selling the stock of his corporation. You may want to buy the assets
rather than the stock. You may be helped by having him liquidate his corporation. Then he sells
the assets to you. If that is not possible, see if you can get a contract from the seller to indemnify
you for your tax losses.
When you buy a business you have to decide if you want the seller's tax basis of its assets. Or do
you want the fair market value of what you buy as your tax basis? That choice comes when you
make your plans to acquire the property. If you acquire property or stock in a tax-free transfer,
you usually take the other fellow's cost of property or stock. If you buy, the purchase price then
becomes the tax basis on your later sale of the property. You may get more or less than his cost
basis.
Get your CPA to explain these tax principles involving your cost basis:

If you use cash or property to buy property that determines the value used later in getting tax
deductions, depreciating assets, or selling.
You may buy stock of a company, or buy its property by stock or securities following it by a tax-
free reorganization plan. Then you sometimes get considerable tax advantages by exchanging
your stock for the seller's. In another case, you may get an advantage by purchase of property.
Whether you buy stock of a company or its assets may make a great difference in your tax
position. The method you decide on may involve material tax cost or tax savings.
You have a bargaining point in preserving the seller's tax advantages. There is another very
important point to remember: many advantages accruing to your vendor may be lost when you
buy the assets of the company and it loses its identity. Check this problem with your tax adviser.
You may even face this same problem of preserving the seller's tax advantages when you
continue the old business identity. Here you have to be wary of the following two rules:
Tax-evasion or -avoidance rule. This gives the Treasury the power to take from you any
deduction, credit, or allowance which you got on buying another corporation if it can show that
you bought the company for the principal purpose of getting the benefit of the particular
deduction, credit, or allowance.
For example, if you buy a loss corporation just to get its loss deduction, you could be hit with
this rule and lose the deduction. To help prove its case, the Treasury can use this added rule: If
what you pay for the corporation is substantially disproportionate to (a) the total of the tax basis
of the corporation's property and to (b) the tax benefits which could only have been gotten
through the purchase—then this fact is primafacie evidence that the principal purpose of your
purchase was to avoid or evade income taxes. If the Treasury can show this, then you have to
show facts to rebut this presumption or lose the tax benefit received on the purchase of the
corporation. For example, you might show a specific business purpose for the acquisition like
enlarging your productive facilities and show that the price was a fair one, despite the tax
benefits received. Note: You might clear this hazard but still be covered by the next rule.
Change-of-ownership rule. Here you are safe as long as you continue the corporation's business
or trade and do not run afoul of the tax-avoidance rule explained above. The net operating loss is
disallowed where the corporation's trade or business is changed and 50 percent or more of the
corporation's stock changes hands during a period of two years as a result of purchases.
How does the 50 percent rule work? The law says that one or more of the 10 largest unrelated
stockholders must own, at the end of the tax year, a percentage of the fair market value of the
outstanding stock which is at least 50 percentage points more than such person or persons owned
at either the beginning of the tax year or the prior tax year. This does not apply unless the 10
largest stockholders own at least 50 percent of the fair market value of the outstanding stock.

And then it is only applicable if one or more of such 10 persons has increased the percentage of
the fair market value of the outstanding stock he or they own by 50 percentage points or more
during the specified period. An increase of 50 percentage points does not mean the same as a 50
percent increase. For example, a stockholder who owns 4 percent of the fair market value of the
outstanding stock and who increases his ownership to 6 percent has had a 50 percent increase in
ownership but only a 2-percentage-point increase.
Figure 3 photo credit to http://applemagazine.com/
You cannot avoid the limitation through the purchase of an interest in a corporation, partnership
or trust owning stock in the corporation with the net-operating-loss carry-over. But an increase in
percentage of stock owned resulting from a purchase by some other person, a tax-free
reorganization, a gift or a devise is not counted. The law says that persons so related to each
other that the stock of one is attributed to the other shall be considered as only one person solely
for the purpose of selecting the 10 persons (more or less) who own the greatest percentage of the
fair market value of the stock.
How to break down the purchase price to your best tax advantage. You may be buying an entire
business. Then you generally get your greatest tax advantage by insisting that the seller allocate
your purchasing price to assets that give you your greatest tax deductions and the greatest capital
gain on disposal. To do that, you should seek to place the following values:
 Value merchandise inventory, stock in trade, at a high price. A high cost will reduce
profit since your costs would be fully deductible.
 Value supplies and similar items not used in the manufacture of the product at a high
price. These supplies will be used as expense items in the ordinary course of the
business—your cost is fully deductible.
 Value accounts receivable at a high price. Loss from bad debts would be business bad
debts and fully deductible.

 Value machinery and equipment of short life at a high price. The short span of
depreciation gives you little time to recover the cost. Loss on sale or abandonment is fully
deductible.
 Value buildings, building improvements, machinery, equipment of long life at a low
price. You have a long period of depreciation to recover cost. The loss on sale or
abandonment will be fully deductible.
 Value land at a low price. You get no depreciation deduction to recover cost. Gain on sale
would be a capital gain.
 Value patents, copyrights, franchises, etc., amortizable intangibles, at a high price, if the
remaining life is short. You recover cost rapidly by getting reduction of income over the
short period left for amortization. But value these at low figures if you propose to sell the
asset. Then you may get the 25 percent rate on a sale.
 Value stocks, bonds and securities at a low price. You get no annual depreciation. Gain
would be taxed at capital gain rates.
 Value goodwill at a low price. You get no annual deduction for depreciation. The cost
would be recovered only through eventual sale of the business. But place some value on
goodwill in order to have a cost basis. Any profits in a sale would be capital gains.
 Value any covenant of the seller not to compete with you at a high price. The payment is
fully deductible over the period of the covenant. This covenant must be carefully defined
(sum and period covered) in the contract or else the sum for it may be held to be payment
for goodwill.
Check List When You Close Title
Generally, you should have counsel approve what you do and how you get approval of a seller's
stockholders, partners, creditors, etc. Essentials to study with him or your CPA are—
What is the closing date of the payment and what do you get on that day?
If you are buying personal property (merchandise, stock in trade, fixtures), check with counsel
on how to comply with the state bulk-sales act. How does the seller (or do you) satisfy any
chattel mortgages, liens, conditional bills of sale, etc?
If you are buying real property, consider whether you want a full covenant and warranty deed;
consider assuming the mortgage. You will be responsible for the payment of interest and
amortization. Provide for risk of loss between the period of the contract and closing in the event
of a fire or other casualty. Make sure you get adjustment for all payments of land taxes, water
rents, payments to mortgagee, utility services (electricity, gas, telephone, etc.) insurance
payments on policies of fire, casualty, plate glass, etc.
Note this well about your real estate taxes when you are buying property: You can buy real estate
and still get a deduction for taxes paid by your seller if you and the seller are both on the cash

basis or if you or the seller are on the accrual basis and have elected prior to the date of sale to
prorate the real estate taxes over the period covered by the tax. Real property taxes for property
sold during the year are divided between the seller and buyer. Each gets a deduction for a portion
of the current property tax this way: the seller, for that portion of the tax up to the day before
sale; the buyer, from the day of the sale. What about the seller's back taxes? These are the seller's
deduction. The buyer gets no deduction for paying the seller's back taxes. It becomes part of the
buyer's purchase price if he agrees to pay the back taxes.
How is the obligation to employees to be fully met? If there is a pension plan or profit-sharing
trust, ask counsel what happens to it in a sale.
Check your union contracts to find if there is severance pay.
How are the accounts receivable to be handled? The seller might do the following: assign them
for collection; sell them outright, the buyer doing the collecting; sell them as part of the business;
sell them to a similar business. Here you may get something for the possibility of the
continuance of business from the customer.
How do you adjust all your uncompleted contracts and commitments—deals with unions, sales,
service agencies, contractors of every kind, insurance companies, creditors, etc.?
If there are inventions, patents or copyrights, or if the seller has been operating under licenses, do
you want a release from your obligations under the license agreements?
What government agencies must be notified (for example, Internal Revenue Service, Social
Security Board, state unemployment-insurance agencies, etc.)?
How do you get all legal documents (titles, leases, mortgages, etc.) to show the change?
How are insurance policies to be converted to cover the new ownership?
How should customers be advised? If possible, explain the reason for change in terms of better
service, products, etc.
How do you tell employees? They will find out about it in due course, and it will help personnel
relationships for you to tell them.
How do you tell suppliers to get full advantages from a credit point of view? Be the first to give
the information, and present it in the most favourable light. First to be informed from this
standpoint should be the seller's bank.
Every possible advantage should be secured from the change. Perhaps you should think of
advertising it as a source of community goodwill and benefit to the general public.

Buying an on-going business can reduce the risks you might encounter as a beginner. Making the
right choice about choosing the right business can be very difficult and it comes with specific
risks too. If you want to take control of a scenario like that, explore other relevant information
here.

What To Remember Before Buying An Established Business

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What To Remember Before Buying An Established Business