Partnership Tax Basics, Part 1: Initial Investment & Operational Framework

Nick Eusanio, Esq., LL.M. Leave a comment

By Nick Eusanio & Jared Boswell

A partnership is one of the most common business structures in the United States because it provides strong flexibility to investors and operators. But that flexibility comes with technical rules that can create unexpected tax outcomes if not structured carefully. This article is the first in our Partnership Tax Basics series, focused on the partnership classification for tax purposes.  Below is an overview of the versatility and governing fundamental U.S. federal income tax principles associated with initial investment in, and operation of, partnerships.

TL; DR Highlights

  • Partnerships are commercially flexible and customizable for investors and operators.
  • Tax is generally paid once—at the partner level.
  • Most contributions are tax-deferred, but exceptions can trigger immediate tax.
  • Liability allocation can directly impact each partner’s tax basis and deductions.
  • Contributions of built-in gain property require special tracking and allocation.

Flexbility of the Partnership Form

A key advantage to the partnership form is the flexibility it affords the parties in structuring the arrangement. Subject to certain tax and legal guardrails, some of these points of flexibility include: investor/partner type (individual or legal entity), contribution type (cash, property, services and minority vs. controlling) and impact (nonrecognition), profit and loss allocations, distributions (timing, type), single level of taxation (partner level only), and exit strategies.

What is a Partnership for Tax Purposes? Entity Classification (Default Rules & Check-the-Box Election)

For tax purposes, a partnership is a flow-through entity. The partnership itself does not pay federal income tax. Instead, income, deductions, and credits flow through to the partners (via reporting on Schedule K-1), who report them on their individual returns.

Generally, if an unincorporated U.S. business entity (i.e., a limited liability company (LLC) or state law partnership) has more than one owner, it is automatically classified as a partnership for federal income tax purposes under the default classification rules of Treas. Reg. § 301.7701-3(b)(1). This is true also for a venture between multiple parties even if the parties have not formed a legal entity to carry on the business. But the owners of an unincorporated U.S. business entity can elect a different classification (e.g., corporation) under Treas. Reg. 301.7701-3(c) than the default by filing Form 8832 with the IRS. The rules governing non-U.S. entities, as well as other available elections (e.g., S corporation status via Form 2553) are beyond the scope of this article.

Section 721(a) – General Nonrecognition Rule

Section 721(a) generally provides that no gain or loss is recognized to a partnership or any of its partners on contribution of property to the partnership in exchange for an interest in the partnership. For example, assume Partner A contributes $1 million and Partner B contributes $10 million to a partnership, and each receives a 50% interest in the partnership. There is an economic mismatch because each partner receives a 50% interest while contributing significantly different amounts of capital. Despite this economic disparity,  Section 721(a) generally dictates that no gain or loss is recognized to the partners or the partnership on this transaction, because cash (property) was exchanged for partnership interests. This flexibility allows investors to negotiate economics freely without triggering immediate tax—even where ownership percentages and capital contributions don’t align. That said, other partnership tax rules (such as those governing maintenance of capital accounts for each partner) operate to align the ultimate economic and tax impacts of such an arrangement.

As another point of versatility, Section 721(a) is by its terms more accessible to investors than similar tax-deferred contribution provisions found elsewhere in the Code. For example, Section 351 is an analogous nonrecognition provision in the corporate context. Section 351 generally requires that a transferor (or group of transferors) of property to a corporation have 80% or more of the ownership of the corporation immediately after contribution to qualify for nonrecognition. Section 721(a) is much more permissive because there is no such control requirement for contributors to a partnership. This framework allows multiple investors to contribute property to a partnership in exchange for a partnership interest on a tax-deferred basis, regardless of the resulting ownership structure. This mechanic facilitates unrelated minority investor contributions without immediate tax impact.

Exceptions to Section 721(a)

Although the general rule of Section 721(a) is nonrecognition, the facts and mechanics of partnership formation and operation can create potential tax issues without careful attention to detail and planning.

  • Definitional Exception – Exchange of Partnership Interest for Services

The general nonrecognition rule of Section 721(a) does not apply to the receipt of a partnership interest in exchange for services, because services are not property. Under Section 83(a) and Treas. Reg. § 1.721-1(b)(1) such a “sweat-equity” arrangement may give rise to ordinary income to the partner at the time the partnership interest is issued. This depends on whether the partnership interest received constitutes a capital interest (taxable as ordinary income / compensation at the time of issuance per Treas. Reg. § 1.721-1(b)(1)) or a profits interest (to which Rev. Procs. 93-27 and 2001-43 and / or a protective Section 83(b) election apply, not taxable at the time of issuance and potential long-term capital gain treatment on subsequent sale of the interest). Stay tuned for more in a future article on this complex topic.

  • Investment Company Exception – Section 721(b):

Section 721(b) provides that the general nonrecognition rule doesn’t apply to a transfer of property to a partnership which would be treated as an investment company within the meaning of Section 351(e), (i.e., a company holding as assets stocks and securities making up 80% of the value of its total assets). In that case, application of Section 721(b) triggers recognition of gain on contribution of the property.

  • Appreciated Property & Related Foreign Partners Exception – Section 721(c):

Section 721(c) may require immediate gain recognition in certain situations where a U.S. transferor contributes appreciated property (i.e., property with a FMV exceeding its basis) to a partnership that includes related non-U.S. partners. The Gain Deferral Method rules (Treas. Reg. § 1.721(c)(3)), if properly followed, can permit the U.S. transferor to defer recognition of such built-in gain over time rather than recognizing it immediately in such a scenario. These rules are intended to prevent the shifting of built-in gain outside the U.S. tax system.

  • Disguised Sales – Section 707(a) & Treas. Reg. § 1.707-3:

The “disguised sale” rules of Section 707(a) and Treas. Reg. § 1.707-3 can also override the general nonrecognition rule of Section 721(a). If a partner transfers property to a partnership and receives cash or other consideration from the partnership in a related transaction, the transaction may be treated as a disguised sale and trigger gain recognition to the partner. Under Treas. Reg. § 1.707-3(c), a transfer occurring within two years of the contribution is presumed to be a sale unless facts and circumstances clearly establish otherwise. But transfers after two years are presumed not to be a disguised sale under Treas. Reg. § 1.707-3(d). So, a transaction whereby Partner A and Partner B are entering the partnership to transfer cash from Partner B to Partner A, is expected be categorized as a disguised sale.

Partner Basis and Liabilities (Section 722 & Section 752)

Basis is important in determining the amount of gain or loss, if any, on a taxable disposition of a partnership interest (outside basis) or partnership assets/property (inside basis).

  • Outside Basis

If a contribution satisfies Section 721(a), the partner is expected to have outside basis consistent with the contribution’s adjusted basis at the time of the contribution under Section 722. Such basis is increased by any gain recognized under Section  721(b) to the contributing partner at the time of contribution, and by the amount of partnership recourse liability assumed by the partner.  In our continuing example, Partner A would have $1 million of outside basis and Partner B would have $10 million outside basis (i.e., basis in their respective partnership interests) on contribution. To the extent Partner A and Partner B are subject to partnership liabilities (such as loans), each partner’s outside basis is increased by the partner’s relative share of such liabilities under Section 752 (assuming the liabilities are recourse liabilities for which the partner assumes the economic risk of loss under Treas. Reg. § 1.752-2).

Whether a liability is recourse or nonrecourse affects how it is allocated for a partnership tax purposes. A recourse liability is allocated to the partner who bears the economic risk of loss with respect to the liability. A nonrecourse liability is allocated among the partners based on their respective shares of partnership minimum gain and Section 704(c) gain, with any residual according to their profit-sharing ratios under Treas. Reg. § 1.752-3.

  • Inside Basis

Under Section 723, the inside basis of a partnership asset is the adjusted basis of such asset to the contributing partner at the time of the contribution, increased by the amount of any gain recognized under Section 721(b) to the contributing partner at that time.

Capital Accounts – Section 704(b) and Treas. Reg. § 1.704-1(b)(2)(iv)

Maintenance of capital accounts for partners is an important requirement set forth in Section 704(b) and Treas. Reg. § 1.704-1(b)(2)(iv). Capital accounts track a partner’s net equity in a partnership and are used to support tax allocations and determine economic rights and tax impacts of distributions, transactions and liquidation. A partner’s initial capital account balance generally matches the partner’s initial contribution. Thereafter, certain adjustments are made to the capital account balance of each partner based on future contributions, allocations of income, loss and deduction, distributions, and other items of the partner or partnership as set forth in the regulations. The rules governing maintenance of capital accounts are complex and beyond the scope of this article. But, generally, these rules aim to ensure that any allocation of income, gain, loss, deduction or other partnership item to a partner has substantial economic effect (loosely meaning that the tax impacts of the allocation align to the economic reality of the arrangement).

Built-In Gain Property and Section 704(c)

The type of property contributed to a partnership can have special impacts to the relevant partner capital accounts. For example, contribution of real property can create differences in the book value versus the tax value of capital accounts (i.e., a book-tax disparity). Adjusting our prior example, assume Partner A contributes $1 million in cash, but Partner B now contributes real property worth $10 million (having an adjusted basis of $5 million) to the partnership, each in exchange for a 50% partnership interest. The general nonrecognition rule still applies, such that no gain or loss is recognized on these contributions. But Partner B’s contribution of real estate having a $10 million FMV and $5 million adjusted basis (i.e., a book-tax disparity from appreciated property) creates built-in gain subject to Section 704(c). This built-in gain is attributable to Partner B and is reduced over time through book and tax depreciation differences. Notably, attribution of the Section 704(c) layer may differ based on the allocation method chosen by the partners in the partnership/operating agreement. Common methods include the traditional method, traditional with curative method, or remedial method. Each method has advantages and disadvantages, which are beyond the scope of this article and should be discussed with a tax professional before deciding which method is appropriate.

Special Deductions: Section 199A for Qualified Business Income

In addition to various points of flexibility, the partnership form now offers the potential to access the special tax deduction set forth in Section 199A. Section 199A was implemented in 2017, as part of the Tax Cuts and Jobs Act (TCJA), to better align effective tax rates of the pass-through business forms (like partnerships) with those of the corporate form (21% since TCJA). The Section 199A deduction is available for eligible partners of domestic partnerships for tax years beginning after December 31, 2017. Section 199A permits individuals, trusts and estates with pass-through business income to deduct up to 20% of qualified business income (QBI) from their taxable income. Importantly, eligibility for the Section 199A deduction is subject to various limitations beyond the scope of this article and should be evaluated with a tax professional.

Closing

The tax-deferred nature of a partnership formation is advantageous to investors and allows broad flexibility in the amount and type of capital contributed, number and type of investors, and the terms governing the partners’ economic arrangement and the partnership’s operations. Legislative changes like Section 199A aimed at achieving partnership to corporate tax rate parity have also improved the economics of the partnership business form. As a result, the partnership tax classification is used frequently by private equity groups investing in operating companies and joint ventures, real estate investors developing their portfolios, and by local entrepreneurs pursuing business ventures. Structural and economic versatility make the partnership tax classification an attractive choice for a diverse investor base.

Coming Next

Partnership Tax Basics, Part 2: Sale of a Partnership Interest: In our next article, we’ll examine the tax consequences of sale of a partnership interest to both the partnership and the partners.

Connect with Nick Eusanio, Tax Planning & Compliance Partner at DBL Law and Jared Boswell, Tax Planning & Compliance Associate at DBL Law, to learn how proper investment or transaction structure and tax planning can help you achieve the desired outcome.

Why Should You Hire a Tax Attorney Alongside a CPA?

Nick Eusanio, Esq., LL.M. Leave a comment

Key Takeaways

  • It’s not CPA vs. Tax Attorney, it’s CPA plus Tax Attorney.
    CPAs typically handle tax compliance (return preparation and filing) and planning; Tax Attorneys help structure and support planning and compliance positions on the front end, and provide defense and legal counsel when risk and complexity arises on the back end.
  • Bring in legal counsel before problems arise.
    The biggest value of a Tax Attorney is often proactive; structuring transactions, documenting positions, and advising on strategies to avoid or mitigate exposure up front.
  • Controversy changes everything.
    If you’re facing tax audit, examination, investigation, dispute, controversy, or potential litigation, a Tax Attorney helps protect your position—both strategically and through privilege.

Many individuals and businesses view a CPA as the go-to for tax planning, filings, and financial strategy. But in most scenarios (other than those involving simple individual tax compliance involving W-2 income only), involving a Tax Attorney with your CPA is a best practice. In complex or high-risk situations, hiring a Tax Attorney alongside your CPA can be critical.

Here are some key moments when Tax Counsel should be part of your team:

Tax Controversies & Disputes

If you’re facing a tax audit, examination, investigation, controversy, or dispute with a taxing authority, a Tax Attorney helps protect your position and guide strategy, through tax technical, factual background development, and procedural levers. Just as importantly, attorney-client privilege offers protection that doesn’t exist through a CPA, especially in sensitive matters that may involve criminal allegations.

Criminal Investigations & Litigation

If a tax issue involves criminal investigation and / or escalates to litigation, a Tax Attorney is essential. Tax Counsel protects privilege of attorney-client communications and manages investigations, court proceedings, and defense strategy (again, focused on tax technical, factual background development, and procedural levers), while your CPA provides valuable financial expertise.

Major Transactions & Tax Positions

Before executing a significant transaction, or taking a complex tax position, a Tax Attorney can help structure the deal and provide legal documentation to support your position. Often, structuring a transaction involves one or more of the following: choice of legal entity, implementation of new agreements, restructuring of existing legal entities or agreements, or written tax opinions supporting key tax positions. All these decisions involve tax technical analysis, tax efficiency, legal considerations, and legal drafting.

A Tax Attorney is uniquely qualified to advise and execute on all these matters, ideally in collaboration with a trusted CPA. A CPA can’t form legal entities, draft agreements, or advise as to legal effects or implications of those items. But, combining these unique strengths and abilities of a Tax Attorney with those of a CPA (financial and tax modeling, for one) is a proactive approach that can be a game changer in bolstering your position and reducing risk.

The Verdict: Tax Attorney-CPA Team Approach is Best

It’s not CPA versus Tax Attorney; it’s CPA plus Tax Attorney. The strongest outcomes come from collaboration—combining financial insight with legal strategy to create a plan that is effective, efficient, and defensible.

Bottom line: If your situation involves complexity, risk, or potential dispute, it’s worth involving a Tax Attorney early. The right team doesn’t just solve problems; it helps you avoid them altogether while achieving desired outcomes.

Nick Eusanio holds an LL.M. in Taxation and has worked in public accounting firms alongside CPAs on complex tax compliance and planning matters, bringing both legal insight and practical tax experience to sophisticated transactions and disputes.

Understanding the IRS Appeals Process: A Guide for Businesses and Individuals

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When a taxpayer disagrees with an IRS audit or examination result, the dispute does not necessarily end there. Taxpayers have a right to challenge the proposed adjustments, penalties, or collection actions. The next step is often to take the matter to the IRS Independent Office of Appeals. IRS Appeals is an independent administrative forum designed to resolve tax disputes impartially and without litigation. Understanding the Appeals process can help taxpayers evaluate their options and approach disputes strategically.

What Is the IRS Independent Office of Appeals?

IRS Appeals operates as a separate organization from the IRS’s examination and collections functions. Appeals officers review disputes objectively, focusing on the existing record rather than conducting new audits. The goal is often to reach a compromise, recognizing that both parties may have certain “hazards of litigation.” Appeals is generally the last administrative option before filing in U.S. Tax Court, district court, or the Court of Federal Claims.

When Can a Case Can Go to Appeals?

Taxpayers can seek review by Appeals in various circumstances, including:

  • Disagreements with proposed adjustments from an IRS audit
  • Certain penalty assessments (e.g., accuracy-related, international reporting, or trust fund recovery penalties)
  • Collection actions like liens, levies, or installment agreements
  • Other disputes where Appeals jurisdiction applies

The process typically begins when the IRS issues a Notice of Proposed Adjustment or a 30-day letter giving the taxpayer a chance to ask Appeals for review.

If the taxpayer does not pursue Appeals at that stage, the IRS can issue a statutory notice of deficiency. Then, the taxpayer’s primary recourse is filing a petition in the U.S. Tax Court within 90 days of the notice date.

How Does Appeals Evaluate Cases?

Appeals officers generally analyze disputes through the lens of “hazards of litigation.”

This means they consider how the case might be resolved if it were ultimately litigated in court. The officer evaluates factors like:

  • Strength of the legal arguments and factual evidence
  • Relevant case law, statutes and regulations, and IRS administrative guidance
  • Expected success rate for the parties

The Appeals process often provides opportunities to negotiate settlements because focuses on litigation risk rather than just enforcing the IRS’s original position.

What Happens in the Appeals Process?

Once a case is transferred to Appeals, the process typically involves several stages.

  1. Case Assignment – An Appeals officer is assigned to review the matter. The officer can ask for more information or clarification about the taxpayer’s position.
  2. Appeals Conference – Can occur by telephone, videoconference, or in person. During this conference, the taxpayer or taxpayer’s representative presents arguments challenging relevant audit results.
  3. Settlement Discussions – Appeals officers often explore potential settlement options based on their evaluation of the hazards of litigation. In some cases, disputes are resolved entirely at this stage. In others, partial settlements can narrow the issues that continue in dispute.

Strategic Tips for Successful Appeals

Although Appeals is less formal than litigation, preparation remains critical. Effective Appeals advocacy often involves:

  • File a well-supported and documented written protest
  • Focus on the strongest legal and factual arguments
  • Anticipate and address the IRS’s position
  • Be realistic in evaluating settlement opportunities

In many cases, the Appeals process is the best opportunity to resolve a dispute without costly and time-consuming litigation.

Appeals vs. Tax Court

If a case can’t be resolved in Appeals, taxpayers can pursue litigation in the U.S. Tax Court, federal district court, or the Court of Federal Claims, depending on the type of dispute.

Using the Appeals process before litigation often provides a valuable opportunity to reassess positions and negotiate potential resolutions.

For many taxpayers, the Appeals process is a practical path to resolving disputes and avoiding extra cost and uncertainty from litigation in court.

Get Help from a Tax Appeals Attorney

Tax disputes can involve complex legal and factual issues. This is particularly true where audits involve multi-year adjustments, significant penalties, or technical tax questions.

Professional representation can help taxpayers:

  • Assess the strength or risk of their position
  • Prepare persuasive Appeals protests
  • Negotiate effectively with Appeals officers
  • Decide whether settlement or litigation is the appropriate path

For professional guidance on IRS audit defense and federal tax compliance, connect with DBL Law Partner Nick Eusanio. Nick offers strategic counsel on audit readiness, defense, and proactive tax planning

IRS Enforcement Trends Businesses Should Watch in 2026

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The IRS has experienced significant workforce reductions and budget constraints in recent years. But the IRS continues to pursue enforcement in high-impact areas. This is particularly true for businesses with complex structures, pass-through entities, or cross-border activities. Advanced data analytics and AI help the agency target audits more efficiently, focusing on cases with the greatest revenue potential.

Businesses should track some of the below areas that recent enforcement campaigns have focused on:

These priorities show the IRS’s strategy of deeper, tech-driven examinations on complex returns rather than broad increases in audit volume.

If any of the above areas may impact your business operations, be sure relevant documentation is organized and in proper form. Focus on contemporaneous transfer pricing studies, detailed partnership agreements, other intercompany agreements (service, licensing, IP, etc.), accurate and current organizational charts, and substantiation for any ERC positions. A bit of preparation can be critical if detailed IRS information requests arrive.

For professional guidance on IRS audit defense and compliance strategies, check out our resources here: IRS Audit Defense Help.

If your business is navigating complex tax reporting, cross-border compliance, or heightened IRS scrutiny, connect with DBL Law Partner Nick Eusanio for strategic guidance on audit readiness, defense, and proactive tax planning.

Inbound Investor U.S. Tax Playbook, Part 3: Operating and Repatriating Profits

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Overview:

Once a U.S. structure is established, it’s important to manage day-to-day compliance, withholding obligations, and cash repatriation in a way that aligns commercial objectives and tax efficiency.

This is where many inbound investors run into trouble. Overlooked filings, employee visits, or intercompany payments can inadvertently create additional tax exposure.

This article outlines some key operational compliance considerations for inbound investors — including how to manage U.S. trade or business (USTB) risk, how to comply with withholding and reporting rules, and how to repatriate profits efficiently under U.S. and treaty frameworks.

This article summarizes considerations for entity selection, including notation of federal, treaty, and state regimes, and practical planning points.

1. Core Federal Compliance Framework

Once an inbound structure is live, foreign investors must quickly identify original and extended due dates (and filings necessary to obtain extension), and establish a compliance calendar to track federal, state, and local tax compliance obligations.

Key federal tax filings to note include:

  • Form 1040-NR – For foreign individuals with U.S. income.
  • Form 1120-F – For foreign corporations with U.S. income, even if limited to effectively connected income (ECI) or protective filings.
  • Form 1120 – For investments held through a U.S. C corporation (or LLC taxed as a C corporation).
  • Form 1065 – For investments held through a U.S. partnership (or LLC taxed as a partnership).
  • Form 5472 – For U.S. entities that are at least 25% foreign-owned, reporting related-party transactions.
  • Form 1042 and 1042-S – For withholding on payments to foreign persons (interest, dividends, royalties, services)

Failure to file or report properly can lead to disallowance of deductions, interest, penalties, and loss of treaty benefits.

2. Understanding U.S. Trade or Business (USTB) and Effectively Connected Income (ECI)

A foundational question for any inbound operation is whether the foreign investor itself — or one of its affiliates — has become engaged in a U.S. trade or business.

Once a USTB exists, U.S.-source income that is effectively connected with that business becomes ECI, taxable on a net basis (income minus deductions) through Form 1120-F.

A. When USTB Exposure Arises

A USTB exists where a foreign person conducts regular, substantial, and continuous commercial (profit seeking) activity in the U.S. — either directly or through dependent agents. Examples include:

  • Operating or managing a U.S. branch, office, or fixed place of business.
  • Having employees or dependent agents who habitually conclude contracts in the U.S.
  • Providing services or technical work in the U.S. for U.S. clients.
  • Participating in U.S. real property development or leasing.

In contrast, passive investment (holding stock, notes, or real estate for appreciation) generally does not create a USTB, provided contracting, management and decision-making occur offshore.

B. Treaty Overlay and Permanent Establishment (PE)

Under most U.S. income tax treaties, a nonresident is taxed on business profits only if attributable to a permanent establishment (PE) — generally a fixed place of business or a dependent agent with contracting authority. This overlay provides important protection but can be lost through day-to-day activities by foreign executives or employees.

3. Managing Executive Travel, Employee Presence, and Secondments

One of the most common ways a foreign investor unintentionally creates a USTB or PE is through foreign executives or employees performing services in the U.S.

Even short-term visits can be enough to shift the tax profile of the entire structure if those individuals perform core operational or revenue-generating functions while in the U.S

Risk scenarios include:

  • Executives negotiating or signing contracts during U.S. visits.
  • Technical staff providing services to U.S. customers on-site.
  • Management personnel directing local operations or overseeing projects.\

These activities can create a U.S. fixed place of business or a dependent agent PE, exposing the foreign parent to U.S. net income tax, Branch Profits Tax (IRC §884), and potential treaty complications.

Mitigating Exposure Through Secondment and Intercompany Structures

Inbound groups can mitigate this risk through:

  • Secondment arrangements, where the U.S. affiliate formally “borrows” employees and assumes day-to-day control, paying costs on a reimbursed (no markup) basis.
  • Intercompany service agreements, where cross-border support is formalized with arm’s-length pricing and defined scope under IRC §482.

Properly structured, these arrangements can:

  • Prevent the foreign parent from being viewed as conducting business directly in the U.S. or mitigate the associated amount of income.
  • Preserve treaty protection by keeping activities within the U.S. entity’s control.
  • Support transfer pricing compliance and deduction eligibility.

4. Withholding Obligations and Cross-Border Payments

Even when a foreign investor avoids direct USTB/ECI exposure, U.S. withholding tax applies to certain payments to foreign persons.

Key categories include:

  • FDAP (Fixed, Determinable, Annual, or Periodical) Income: Interest, dividends, rents, royalties, and similar payments are subject to 30% withholding, unless reduced by treaty.
  • Service Fees: Fees for services performed outside the U.S. are generally exempt, but services performed in the U.S. can become ECI.
  • Dividend Equivalent Amounts (DEA): Amounts subject to the Branch Profits Tax (IRC §884) and payments under equity-linked instruments that replicate U.S. stock dividends (IRC §871(m)) can be treated as dividend equivalents and subject to withholding.

U.S. payors must report and remit these withholdings on Forms 1042 and 1042-S, other than for a DEA subject to Branch Profits Tax which is reported on Form 1120-F.
For a reporting corporation (either a 25% foreign-owned U.S. corporation or U.S. disregarded entity, or a foreign corporation engaged in a USTB), Form 5472 remains the key disclosure for any payments to related foreign parties, including royalties, management fees, or cost allocations.

5. State and Local Considerations

Inbound investors often underestimate the complexity of state-level tax exposure.

Key Concepts:

Even absent a federal USTB, a foreign company (or its U.S. affiliate) may face state income or franchise tax based on economic nexus — often triggered by as little as $100,000 of in-state sales or 100,000 in-state transactions. Some state economic nexus thresholds are more favorably based on both the amount of sales and the number of transactions in state for the year.

Some states, such as California, require multinational groups to file combined reports, which can pull in global income under:

  • Worldwide combined reporting, or
  • A water’s-edge election, limiting inclusion to U.S. entities and their CFCs, foreign partnerships and foreign branches.

The water’s-edge election (e.g., California Form 100-WE) can be a significant planning tool for inbound investors, reducing compliance complexity and exposure to foreign-source income inclusion.

6. Repatriation and the Branch Profits Tax

When a foreign corporation earns ECI, it faces not only regular U.S. corporate income tax but also a Branch Profits Tax (BPT) under IRC §884.

The BPT, generally at 30% (potentially treaty-reduced to between 0% and 15%), applies to deemed remittances of after-tax earnings from the U.S. branch to its foreign parent.
Conceptually, it mirrors the dividend withholding tax that would apply if operations were conducted through a U.S. subsidiary instead of a branch.

Practical planning often favors operating through a U.S. subsidiary to simplify compliance and provide clearer control over repatriation timing. Dividends, interest or royalties from a U.S. subsidiary are typically subject to withholding at 30%, potentially reduced by treaty to between 0% and 15%.

7. Practical Compliance and Strategic Takeaways

  • File protective Form 1120-F returns when there’s potential USTB exposure — to preserve deductions and refund rights.
  • Maintain intercompany documentation (service, cost-sharing, royalty, and loan agreements) under IRC §482.
  • Review treaty applicability and PE thresholds before executives or employees travel to the U.S. Consider potential secondment or intercompany service agreements to manage as necessary. Consider documenting treaty positions in a tax-technical opinion, supporting expected rates and treatment of covered income streams or payments.
  • Monitor withholding and information reporting on all cross-border payments.
  • Evaluate annually: state nexus and water’s-edge election options, and state tax credits and incentives compliance and opportunities.
  • Plan repatriation to manage Branch Profits Tax or dividend / interest / royalty / service fee payment withholding efficiently.

In Conclusion

Running a U.S. operation successfully requires implementing the right structure, plus ongoing attention to compliance, withholding, and cross-border activity.

Inbound investors who proactively manage USTB risk, withholding compliance, and repatriation planning can operate confidently and minimize problematic surprises from both the IRS and state tax authorities.

Thinking about investing in the U.S.? Start with a consultation to evaluate your company’s readiness and identify strategies for success. Connect with Nick Eusanio, Tax & Compliance Partner at DBL Law, to learn how proper tax planning and investment structure can help you achieve the best possible outcome.

Inbound Investor U.S. Tax Playbook, Part 2

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Structuring the Investment — Entity Choice & Tax-Efficiency

The United States is one of the most attractive places for foreign capital — deep markets, relative stability, and strong investor Once an inbound investor decides to enter the U.S. market, the next decision — how to structure the investment — can drive the ultimate tax result significantly. The U.S. system taxes differently depending on the type of entity, its ownership, and whether treaty benefits apply.. But the U.S. also has a uniquely complex tax environment.

This article summarizes considerations for entity selection, including notation of federal, treaty, and state regimes, and practical planning points.

1. Balancing Tax Efficiency, Liability Protection & Compliance

Every inbound structure should balance three objectives:

  1. Liability protection — containing business legal risk within the U.S. entity.
  2. Tax efficiency — minimizing both U.S. and home-country tax leakage.
  3. Administrative manageability — minimizing annual administrative tasks and costs.

While the right structure depends on the investor’s facts — activity and income type, treaty position, and cash planning — there are key guardrails to consider.

2. Basic Options: Direct or U.S. Blocker, Foreign Holding Company Considerations

A. Direct Investment by the Non-Resident

This is the simplest on paper — the investor (either a foreign individual or foreign holding company) directly holds the U.S. asset, partnership interest, or LLC (treated as a partnership or disregarded for tax purposes) interest.

  • Tax result: The investor is directly subject to:
    • U.S. tax on ECI and FDAP (with related withholding)
    • Branch Profits Tax (if foreign corporation owner)
    • FIRPTA (if any disposition of USRPI or USRPHC)
    • U.S. estate tax on U.S.-situs assets (if foreign individual owner)
    • Annual filing requirements for Form 1040-NR (individuals) or Form 1120-F (foreign corporations).
      • May require additional U.S. filings at entity level (e.g., U.S. partnership or LLC treated as partnership required to file Form 1065, related Schedules K-1 and Forms 8804 / 8805 / 8813 (withholding statements) issued).
    • Pros: No interposed entity unless desired (e.g., partnership, LLC); may reduce foreign-country complications.
    • Cons: Exposed to above-noted U.S. filing obligations and taxes and potentially no legal liability protections that would exist with a corporate structure (unless using U.S. LLC).
    • Potential use case: Small passive investments or treaty-protected portfolio holdings.U.S. “Blocker” Corporation (or LLC treated as a corporation for tax purposes)

B. U.S. “Blocker” Corporation (or LLC treated as a corporation for tax purposes)

A common approach for institutional or fund investors. The foreign investor capitalizes a U.S. C-corporation to hold the operating business, real estate, partnership or disregarded LLC interest.

  • Tax result / Pros:
    • The Blocker “absorbs” ECI, paying 21% corporate income tax.
    • When profits are distributed, they are dividends subject to 30% withholding under IRC §881 (often reduced by treaty).
    • Avoids the Branch Profits Tax that would otherwise apply to a foreign corporation’s U.S. branch.
    • Potential insulation from FIRPTA (or ability for same with additional tiered structuring).
    • Simplifies compliance — the foreign owner does not file Form 1120-F or 1040-NR; only the U.S. corporation files Form 1120 (and partnership files Form 1065 if there is a U.S. partnership in the structure).
  • Con: “Double” taxation — once at the corporate level and again on distribution — though effective rates can be moderated by treaty reductions or reinvestment strategies.

3. Withholding Tax & Using Treaties Strategically (Without Over-Engineering)

The U.S. imposes withholding tax on most payments to foreign persons, such as: dividends, interest, royalties, rent, service fees, and deemed branch remittances (DEA). This withholding tax is generally levied at a statutory rate of 30%, unless reduced by treaty. U.S. payors are responsible for withholding and reporting this tax via Form 1042 / 1042-S. Failure to withhold properly can shift liability for the original tax, plus penalties and interest, to the payor as withholding agent.

Treaties can dramatically reduce withholding and sometimes exempt outbound payments or business profits from U.S. taxation altogether.

Checklist for claiming treaty benefits:

  1. Confirm investor’s residency certificate from home jurisdiction.
  2. Evaluate specific treaty qualification articles (residency, dividends, interest, royalties, business profits, etc.).
  3. Evaluate Limitation on Benefits (LOB) treaty article — are applicable requirements (such ownership and / or activity tests) satisfied?
  4. Issue Form W-8BEN or W-8BEN-E to payor(s).
  5. Disclose treaty position on Form 8833 if taking a treaty-based return position required to be reported.

4. Financing the U.S. Operation: Debt vs. Equity

Foreign investors often capitalize U.S. ventures through related-party debt, seeking to deduct interest while repatriating profits as interest payments (often subject to lower withholding than dividends).

Consideration:

  • Debt / equity analysis (common law, and IRC §385 if applicable): Debt can be reclassified as equity, disallowing deductions and potentially creating other unintended tax impacts in certain structures.
  • IRC §163(j) (generally applicable to taxpayers with average annual gross receipts of $30 million+) limits interest deductions to 30% of adjusted taxable income.
  • IRC § 267 loss disallowance and matching rules regarding timing of deduction and income recognition for accrued but unpaid interest between related parties.
  • IRC § 267A deduction disallowance for interest (and royalty) payments to related parties in hybrid transactions or with hybrid entities if the payment isn’t included int eh recipient’s income under foreign tax law.
  • Withholding: 30% on interest, unless reduced by treaty or portfolio interest exemption applies.
    • Branch context: If the foreign corporation operates a U.S. branch, adjustments under Treas. Reg. §1.884-4 apply to determine the portion of deemed interest also subject to BPT at 30% (unless reduced by treaty), if any (i.e., the amount of excess interest not apportioned to ECI taxed at 21%).
  • Base Erosion and Anti-Abuse Tax (BEAT) under §59A, which targets large corporations (generally those with $500 million+ in average annual gross receipts) making base-eroding payments like interest to related foreign parties.
  • Documentation: Written loan agreements, arm’s-length terms and pricing / interest rates, contemporaneous intercompany pricing support.

5. State Tax Structuring Overlay

States have their own tax bases, nexus thresholds, and combination rules. Depending on the investment type and amount, and the state or states involved, state tax can be a material consideration.

Key Concepts:

  • Nexus: Physical presence (property, payroll) or economic nexus from sales into a state.
  • Separate vs. Combined Filing:
    • Some states tax entities separately.
    • Others (e.g., California, New York, Illinois) require or permit combined/unitary reporting for related entities.
  • Water’s-Edge Elections:
    • Limit the combined group to U.S. members (and certain CFCs).
    • Usually binding for 7 years (Cal. Rev. & Tax Code §25113).
    • Must be modeled carefully — including impacts on foreign tax credit planning and apportionment.

Practical tips:

  • Where possible, isolate U.S. operations in one entity (or the fewest otherwise necessary entities) per state nexus profile.
  • Consider flexibility in deployment of property / assets, debt, and people in context of state credits and incentives, state apportionment, net worth tax, and separate vs. combined or unitary reporting rules.
  • Evaluate broader U.S. legal entity structure in multi-state operating structures (e.g., corporate holding company with use of wholly-owned disregarded / flow through LLCs or subsidiary corporations) for potential state tax planning or simplification.

6. Key Takeaways

  • Start with cash return in mind. Structure for efficient repatriation.
  • Contain ECI. Blockers or treaty planning can reduce compliance and tax cost.
  • Limit BPT exposure. It’s often the hidden double tax.
  • Remember FIRPTA. Structure real estate holdings to avoid FIRPTA.
  • Treaty benefits aren’t automatic. Evaluate, document, and claim them properly.
  • Don’t ignore state rules. Multiple states with differing rules can complicate matters, determine materiality and perform tax impact diligence and identify opportunities accordingly.

A well-planned structure can provide legal protections and tax efficiencies.

Coming Next

Part 3: Operating and Repatriating Profits: In our next article, we’ll explore what happens once the investment is operational: withholding regimes, filing obligations, profit distributions, and how to repatriate capital without triggering unnecessary tax.

Missed Part 1? Read it here.

Thinking about investing in the U.S.? Start with a consultation to evaluate your company’s readiness and identify strategies for success. Connect with Nick Eusanio, Tax & Compliance Partner at DBL Law, to learn how proper tax planning and investment structure can help you achieve the best possible outcome.

Inbound Investor U.S. Tax Playbook, Part 1

Nick Eusanio, Esq., LL.M. Leave a comment

U.S. Tax Basics for Non-Resident Investors

The United States is one of the most attractive places for foreign capital — deep markets, relative stability, and strong investor protections. But the U.S. also has a uniquely complex tax environment.

For inbound investors (non-U.S. individuals or entities investing in the U.S.), understanding the basic tax framework at the start is essential. This first post in our Inbound Investor U.S. Tax Playbook series outlines how the U.S. taxes inbound investors, some of the key filings required, and how federal and state systems interact in sometimes unexpected ways.

1. Who’s a “Non-Resident” for U.S. Tax Purposes?

The U.S. distinguishes between resident and non-resident taxpayers using two tests for individuals and one for entities.

A. Individuals

  • Green Card Test: If you hold a green card, you are a U.S. tax resident regardless of where you live or how long you spend in the U.S.
  • Substantial Presence Test (SPT): You’re a resident if you are physically present in the U.S. for at least 31 days in the current year and 183 days over a three-year period, counting:
    • All days in the current year,
    • ⅓ of days in the prior year,
    • ⅙ of days in the year before that.

The SPT often surprises executives or investors with recurring business trips. Certain exceptions (teachers or students on certain visa programs, diplomats on certain visa programs, professional athletes participating in charitable sporting events) may apply.

Those who fail both tests are non-resident aliens (NRAs) — taxed only on U.S.-source income.

B. Entities

  • Formed under U.S. law → U.S. tax resident.
  • Formed under foreign law → non-resident entity, unless it has a U.S. trade or business.
  • Note: Check-the-box regulations under Treas. Reg. §301.7701 allow certain foreign entities to elect U.S. classification (corporation, partnership, or disregarded entity)

2. Three Buckets of Income: ECI, FDAP, and DEA

The U.S. system divides taxable income for non-residents into three broad categories:

A. Effectively Connected Income (ECI)

Income that is effectively connected with the conduct of a U.S. trade or business (USTB).

Typical examples:

  • Operating income from a U.S. business.
  • Rents or gains from real estate when the investor has elected to treat them as ECI under IRC §871(d) or §882(d).
  • Income from partnerships or other flow-through entities engaged in a USTB.

Tax treatment:

  • Taxed on a net basis at applicable rates (graduated rate scale for individuals (top rate 37%), flat 21% for corporations; subject to potential treaty reduction).
  • Foreign companies report this income on Form 1120-F (U.S. Income Tax Return of a Foreign Corporation).
  • Non-resident individuals report on Form 1040-NR.
  • Deductions are allowed for related expenses (assuming a return, or protective return, is filed; failure to file a return can result in denial of deductions).

A key concept is the “force of attraction” rule — once a non-resident is engaged in a U.S. trade or business, all U.S.-source income connected to that business can be treated as ECI.

B. Fixed, Determinable, Annual, or Periodical (FDAP) Income

Passive U.S.-source income — dividends, interest, royalties, and certain rents.

  • Taxed on a gross basis at 30% withholding, unless reduced by a tax treaty.
  • No deductions permitted (gross basis tax).
  • Reporting generally handled by the U.S. payor via Form 1042 (annual withholding return) and Form 1042-S (statement to the foreign payee).

C. DEA / The Branch Profits Tax

When a foreign corporation operates a U.S. business directly (without a U.S. subsidiary corporation or LLC taxed as a corporation “blocker”), it may face an additional Branch Profits Tax (BPT) under IRC §884.

  • This tax approximates the dividend withholding that would apply if the U.S. operation were conducted through a domestic corporation.
  • The BPT is imposed at a 30% rate (often reduced by treaty) on the corporation’s “dividend equivalent amount” (DEA) — essentially, the after-tax earnings deemed repatriated out of the U.S. branch during the year.
  • The calculation starts with the U.S. branch’s effectively connected earnings and profits (ECE&P), adjusted for increases or decreases in U.S. net equity.

Many investors assume that forming a “U.S. branch” is simpler than establishing a domestic corporation, but the BPT can make it significantly more expensive from an after-tax standpoint. This is because the BPT applies in addition to the 21% tax on ECI.

Treaty Note: Most modern U.S. tax treaties reduce or eliminate the Branch Profits Tax (e.g., 5% under the U.S.–U.K. treaty), but only if the foreign corporation qualifies under the treaty’s limitation on benefits (LOB) provisions.

3. Tax Treaties: Analyze & Document Relief

The U.S. has income tax treaties with about 60 countries. Key potential benefits common in treaties are:

  • Reduced withholding rates (e.g., sometimes 0% but commonly between 5%–15% on dividends, interest or royalties, instead of 30%).
  • Exemption for business profits if the foreign investor has no permanent establishment (PE) in the U.S.
  • Relief from double taxation through foreign tax credits or exemptions.
  • Legal and dispute resolution mechanisms such as the mutual agreement procedure (MAP) to resolve disputes between the U.S. and treaty partners.

Treaty benefits are claimed via applicable reporting which includes, based on the facts and circumstances, one or more of the following: Form W-8BEN (individuals) or W-8BEN-E (entities), Form 1120-F, Form 8833 Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b), and Forms 1042 and 1042-S, provided the investor is a resident of a treaty country and satisfies the limitation on benefits (LOB) clause.

Avoid treaty shopping: intermediate holding companies without substantive activity may fail LOB tests, precluding treaty relief. The IRS increasingly reviews substance, management location, and beneficial ownership.

Consider obtaining a tax opinion to document the expected comfort level of treaty applicability and associated U.S. tax impact.

4. Structuring the Investment

Choosing an entry structure has long-term tax and compliance implications. The below chart offers a high-level overview of key considerations in structural options for nonresident investment in the U.S.

StructureProsCons
Direct ownership
(individual)		(individual) Simple, transparentExposed to ECI, FIRPTA, U.S. estate tax for U.S. stock holdings, and personal filing obligations (Form 1040-NR, others as applicable), no corporate liability limits.
U.S. corporation or
LLC taxed as
corporation (C-corp
“blocker”)		Generally shielded from ECI and Branch Profits Tax, potentially limits FIRPTA, simplifies compliance, corporate liability limitations for shareholders / membersDouble taxation (21% corporate + dividend withholding)
U.S. LLC (treated as
partnership or
disregarded)		Flow-through taxation, flexibility, corporate liability limitations for membersForeign owner becomes directly taxable and must file Form 1040-NR/Form 1120-F, exposed to FIRPTA
Foreign corporation
holding U.S. assets
(including LLC treated
as disregarded or
partnership)		Potential treaty benefits, estate tax protection, corporate liability limitations for shareholders / membersBranch Profits Tax, 30% withholding on certain payments, complex reporting (Forms 1120-F, 5472, 8833)

5. FIRPTA: The Real Estate Trap

The Foreign Investment in Real Property Tax Act (FIRPTA) taxes foreign persons on gain from the sale of U.S. real property interests (USRPI) (which includes interest in a U.S. real property holding company (USRPHC), very basically, a U.S. real-property rich – at least 50% FMV of its assets – holding company)) as if it were ECI.

  • Withholding: Buyers must withhold 15% of the gross sale price, unless the seller obtains a reduced-withholding certificate on Form 8288-B.
  • Reporting: Withholding submitted on Form 8288; seller receives Form 8288-A as credit evidence.
  • Election: Foreign investors in rental real estate may elect to treat rental income as ECI (thus deductible) under IRC §871(d)/§882(d) — often made by attaching a statement to Form 1040-NR or 1120-F.

6. Key Federal Tax Filings for Inbound Investors

FormDescriptionGeneral Filing Requirements / Purpose
1040-NRNon-resident individual U.S. income tax returnDirect investor or member of U.S. LLC (if disregarded for tax purposes)
1120-FU.S. income tax return for foreign corporationsForeign corporation with ECI or U.S. branch
5472Information return of a 25% foreign-owned U.S. corporation or a foreign corporation engaged in a U.S. trade or businessReporting corporation required to disclose reportable transactions with foreign or domestic related parties
8833Treaty-based return position disclosureClaiming treaty benefits to override domestic law
1042 /
1042-S		Annual withholding return / statement for FDAP incomeU.S. payor with foreign recipient
8288 /
8288-A /
8288-		FIRPTA withholding formsNon-U.S. party disposition of real property interest / interest in U.S. real property holding company
8804 / 8805
/ 8813		Partnership withholding on foreign partnersU.S. partnership with foreign investors

Failure to file can result in steep penalties and the loss of treaty benefits.

7. State Tax Considerations: The Overlooked Layer

Federal planning alone isn’t enough. States operate semi-autonomously, and foreign investors can create state “nexus” — a taxable presence — much more easily than they realize.

A. Key Triggers for State Nexus

  • Owning or leasing property in the state.
  • Having employees, agents, or contractors there.
  • Exceeding sales thresholds under economic nexus standards (post-Wayfair).
  • Holding a partnership interest in an entity operating in that state.

B. Filing Implications

  • Corporate income/franchise tax: Many states follow federal taxable income but have unique state tax addback or deductions based on whether the state conforms to or decouples from federal tax law. Income is also apportioned with state-specific income apportionment formulas.
  • Partnership or pass-through entity tax: Some states impose entity-level taxes or mandatory withholding on non-resident partners.
  • Sales/use tax: Separate compliance system — nexus rules differ from income tax nexus.
  • Net Worth tax: Some states impose taxes on net worth (generally, total assets less total liabilities) in the state as well.

C. Combined Reporting and Water’s-Edge Elections

For foreign corporate groups with U.S. subsidiaries:

  • Worldwide combined reporting: Some states (e.g., California) require or allow combination of worldwide income, including foreign affiliates.
  • Water’s-edge election: Available in certain states (notably California) to limit combined reporting to U.S. entities and controlled foreign corporations (CFCs) meeting specific ownership thresholds.
  • These elections are often binding for 7 years and must be carefully modeled before election — they can dramatically change state tax bases.

D. Apportionment

Most states use a single-sales factor or three-factor formula (sales, property, payroll) to determine what portion of income is taxable. The rules vary widely — meaning two states may tax the same income differently.

8. Common Pitfalls

1. Accidental U.S. Trade or Business: Taking an active role in management, hiring U.S. agents, or signing contracts in the U.S. can trigger ECI.

2. Overlooking FIRPTA: U.S. real estate is always within U.S. tax jurisdiction.

3. Neglecting State Taxes: Many foreign investors assume federal treaties cover states — they don’t necessarily as states may follow or not follow federal tax treaties, so a state-specific review is necessary.

4. Missing or Late Filings: Non-filing penalties can exceed the tax itself and be imposed on information-reporting only (no tax-due) filings that are missed or filed late.

5. Treaty Misuse: Claiming treaty benefits without satisfying LOB tests invites IRS scrutiny.

6. Improper Entity Selection: Legal entity form and tax treatment can differ (e.g., LLC treated as a corporation, partnership, or disregarded entity for tax purposes). These differences can have varying tax implications for inbound investors, so it is important to structure carefully.

9. Getting Started — A Practical Checklist

Before your first investment:

1. Confirm tax residency of all investors and entities.

2. Identify expected income types (ECI vs FDAP).

3. Review potentially applicable treaty benefits, document applicability with a tax opinion.

4. Model federal and state tax exposure, including combined reporting effects.

5. Select optimal entity structure and make elections early.

6. Implement withholding and filing procedures.

7. Keep contemporaneous records to support treaty positions and LOB compliance.

Coming Next

Part 2: Structuring the Investment — Entity Choice & Tax-Efficient Entry Point: In our next article, we’ll examine entity options for inbound investors, how to manage Branch Profits Tax, treaty planning, and how different structures affect ongoing operations and repatriation strategies.

Thinking about investing in the U.S.? Start with a consultation to evaluate your company’s readiness and identify strategies for success. Connect with Nick Eusanio, Tax Planning & Compliance Partner at DBL Law, to learn how proper tax planning and investment structure can help you achieve the best possible outcome.

Business Sale Basics, Part 4: Close & Integrate or Transition

Nick Eusanio, Esq., LL.M. Leave a comment

Closing a business sale is just the beginning. Learn how to manage integration or transition effectively to protect and drive value in Part 4 of our Business Sale Basics series.

Closing the sale is a major milestone, but it’s not the end of the journey. Proper planning for integration or transition ensures long-term success for both you as the seller and the buyer. Again, due consideration for these matters has already been given in Part 2 of our series (Structure the Sale).

Post-Closing Considerations

1. Integration / Transition Planning

Clear documentation in one or more appropriate agreement(s) is key to ensuring the intended transition mechanics. Consider the following factors when drafting appropriate documentation.

  • How and when the buyer will assume operations.
  • How and when will the owner / seller notify existing employees, customers and vendors / suppliers of the sale? What steps are necessary to ensure business continuity for these groups?
  • Whether and what level of involvement the owner / seller will continue to have in the company and for what time period.
    • If the owner / seller remains involved:
      • What type and level of pay and benefits will be continuing?
      • Will the owner / seller retain any percentage ownership in the equity of the company (i.e., a rollover interest)?
    • If the owner / seller is exiting:
      • Address any interim transition period / consulting arrangement, earn-out, or other phased exit plan.

2. Tax and Regulatory Compliance

Post-closing reporting is just as important as pre-closing planning. Consider the following compliance items after closing.

  • Required tax filings for the transaction.
  • Required industry / regulatory filings for the transaction.
  • Tracking for installment sale payments or deferred compensation.

3. Avoiding Post-Closing Disputes

A seller who has successfully navigated the process following our Business Sale Basics: 1. Prepare the Pieces, 2. Structure the Sale (Legal & Tax), 3. Align Team, Finance, & Industry Factors can expect to be in good position to avoid post-closing disputes. Below are some key factors expected to be in place and continuing to achieve that goal.

  • Keep documentation clear to reduce claims risk.
  • Follow through on representations and warranties.
  • Maintain open communication with the buyer during transition.

Thinking about selling your business? Start with a pre-sale consultation to evaluate your company’s readiness and identify strategies to preserve and maximize value. Connect with Nick Eusanio, Tax & Compliance Partner at DBL Law, to learn how proper tax planning and deal structure can help you achieve the best possible outcome.

Business Sale Basics, Part 3: Align Team, Finance, & Industry Factors

Nick Eusanio, Esq., LL.M. Leave a comment

Employees, financing, and industry / regulatory factors can make or break a business sale. Learn how to address these critical elements in Part 3 of our Business Sale Basics series on Aligning these Factors.

Business sales are more than numbers on a balance sheet. Employees, financing, and industry-specific regulatory considerations play a critical role in the success of a transaction. Well-prepared sellers project credibility and value by aligning these items in the deal. This article serves as a continuation of Part 2 of our series (Structure the Sale), as each of these factors is important in structuring the transaction.

1. Employee & Management Factors

Retaining key employees and ensuring the business isn’t overly tied to the selling owner are often key factors for buyer confidence and demonstrating value. A thoughtful seller should align these factors in the deal by considering the items below.

  • Invest the necessary training time and resources to improve management team business / technical capabilities and integration with operations personnel and customers to reduce dependency on the owner.
  • Document steps to accomplish the above and ideally matching metrics to substantiate the value retained or created, for sharing with the buyer team.
  • Ensure key management and operations team members are valued in the deal by negotiating appropriate provisions for continuing employment including roles and levels of salary, benefits and bonuses. Don’t forget to provide for any special items like remote versus on-site work, parking, company phones and cars, or similar benefits.

2. Financing the Transaction

Understanding the buyer’s funding method for the deal is important to both timing and negotiations. Below are some key points to consider with respect to financing, timing and related negotiations.

  • Bank / 3rd party financing versus seller financing.
  • For seller financing, a well-crafted promissory note and security agreement with appropriate collateral are key considerations.
  • Be aware of potential covenants or guarantees, particularly any ‘earn-out’ provisions.

3. Industry and Regulatory Factors

Various industries have unique licensing, permitting, regulatory or other compliance requirements that can impact a sale. Heavily regulated industries like health care, financial services / banking, or insurance may require specific disclosures or approvals. Below are some key items to consider from an industry / regulatory perspective.

  • Review licensing, permits, and regulatory compliance requirements for your industry.
  • Understand other regulatory frameworks that may apply based on the type (e.g., cross-border transaction, involvement of sensitive information or data, etc.) or value of the transaction (for instance, anti-trust, securities, cybersecurity and infrastructure security, export control system, foreign investments, etc.).
  • Ensure necessary additional documents or agreements are prepared and negotiated as part of the sale based on applicable regulatory regimes.

Thinking about selling your business? Start with a pre-sale consultation to evaluate your company’s readiness and identify strategies to preserve and maximize value. Connect with Nick Eusanio, Tax & Compliance Partner at DBL Law, to learn how proper tax planning and deal structure can help you achieve the best possible outcome.

Business Sale Basics, Part 2: Structure the Sale (Legal & Tax)

Nick Eusanio, Esq., LL.M. Leave a comment

Avoid costly mistakes in selling your business. Learn the key legal and tax tips and traps to avoid in Part 2 of our Business Sale Basics series: Structure the Sale.

Selling a business comes with both opportunities and potential pitfalls. The structure of your sale can dramatically influence both your liability exposure and tax outcome. Choosing the right approach and understanding common issues can protect your proceeds and mitigate future risk.

1. Legal Considerations

Structuring the deal as an asset sale versus a stock sale is first a legal consideration (as well as tax, to follow) affecting liability and risk allocation. Buyers often prefer an asset sale to limit liability exposure, while sellers tend to prefer a stock sale for the same reason (as well as for tax purposes, to follow). The deal landscape is a balancing act, especially concerning risk allocation. A wise seller should consider the following items in structuring the sale.

  • Understand the difference between asset and stock sales from a risk / liability allocation standpoint.
  • Review the pieces that should have been prepared in initial seller due diligence (see our prior article: Prepare the Pieces, the first in this series).
  • Carefully evaluate representations, warranties, indemnification, and mandatory dispute resolution clauses.
  • Consider representations and warranties insurance if financially prudent.

2. Tax Considerations

Tax planning is central to structuring the sale. In an asset sale (or stock sale treated as an asset sale for tax purposes), how the purchase price is allocated—between tangible assets, intangible assets, goodwill, and inventory—affects the type and amount of tax you pay. In a stock sale, generally expect capital gains tax treatment assuming appropriate holding requirements are met. Consult with your tax advisor on the following to structure the sale to achieve the intended tax impact.

  • Asset, Stock, or Stock (treated as Asset for tax purposes) sale tax impacts.
    • For an Asset or Stock (treated as Asset for tax purposes), purchase price allocation and related tax implications (e.g., amount subject to ordinary tax / rate treatment vs. capital gains tax / rate treatment).
    • IRS §§ 338(h)(10) or 336(e) elections.
    • Tax gross-up provision in the purchase agreement.
  • Tax compliance considerations (short and final year returns, additional required transactional reporting forms and statements, etc.).
  • State and local tax considerations (are the impacts aligned to federal income tax outcomes / conformity? Or are there significant differences?).

3. Common Traps to Avoid

Certain oversights can erode buyer trust and reduce the purchase price, destroy the deal, or trigger post-closing disputes and liabilities. Smart sellers should anticipate and consider the below items to improve transparency and trust in the process (most of which should be caught in the Prepare the Pieces stage).

  • Deferred compensation or bonuses.
  • Ongoing liabilities, like employee benefits.
  • Proper due diligence documentation and clearly and accurately stating facts.

4. Build Your Professional Advisory Team for a Smooth Sale

Engaging the right professional advisory team early (ideally in the Prepare the Pieces diligence phase, but certainly no later than the Structuring phase) is vital to a smooth, clean deal. Below are some considerations for structuring your deal-team and related processes.

  • Engage legal, business, financial, and tax advisors early (e.g., attorneys, accountants / CPAs, valuations professionals, investment bankers, and wealth advisors).
  • Identify and communicate your key goals and objectives, and chief ‘deal-killer’ items, to your professional advisory team.
  • Communicate clearly with buyers.
  • Follow standardized processes to streamline due diligence.

Thinking about selling your business? Start with a pre-sale consultation to evaluate your company’s readiness and identify strategies to preserve and maximize value. Connect with Nick Eusanio, Tax & Compliance Partner at DBL Law, to learn how proper tax planning and deal structure can help you achieve the best possible outcome