Could sellers avoid tax on an asset sale by first contributing the assets to a new LLC and concurrently selling the LLC interest for cash?

Plain-English summary

Two sellers originally agreed to sell manufacturing-business assets directly to a purchaser. They later amended the deal so the sellers would contribute the California facility's tangible assets to a newly formed LLC, receive its membership interest, and concurrently sell that interest to the purchaser for cash. Multiple related agreements had to close together, and the entire sequence occurred within about 24 hours.

The Board concluded that this was one integrated taxable asset sale. Regulation 1595(b)(4) protects a contribution to a commencing entity only when the transferor receives solely an interest in that entity. Here, the purchaser's binding commitment to pay cash for the membership interest was additional consideration received as part of the asset transfer.

Civil Code sections 1436 and 1642 reinforced the result because the asset contribution and related contracts were conditions of the same closing and had to be read together. The memorandum said it did not need the step-transaction doctrine: the documents themselves established one transfer of tangible property for cash.

The food-manufacturing assets were not exempt as property of a separate nonselling activity. The facility was an integrated operation manufacturing and selling food and related nonfood products, required a seller's permit even though food sales could be exempt, and was not essentially a service enterprise.

Record reviewed and limits

This publication is an April 26, 2002 Legal Division memorandum to Senior Tax Auditor Pardip N. Dayaram, not a taxpayer-requested private letter ruling. It answered Dayaram's September 13, 2001 request and referred to his September 19, 2000 memorandum, a January 18, 2001 Legal Division response, audit working papers, transaction materials, a September 5, 2001 memorandum from purchaser's counsel, and a July 6, 2001 letter from the taxpayer's representative. None of those communications is included as a separate record in the PDF.

Legal staff reviewed the August 7, 1998 Acquisition Agreement and its First Amendment. The agreement was incomplete because its schedules were not supplied. The memorandum also says the closing depended on a Supply Agreement, Services Agreement, Employee Benefits Agreement, Trademark License Agreement, leased-real-property agreement, and other transaction documents, but those documents were not provided. Its understanding of the concurrent closing and supply commitment therefore came from the materials and representations described in the memorandum, not a complete published closing set.

The source reports that the LLC was formed August 27, 1998 and that the asset contribution and cash purchase of its membership interest occurred August 28. It also says the amendment included an indemnity from the purchaser for sales, use, and other tax, penalties, interest, and fines. It does not supply the schedules, complete asset list, prices or allocations, indemnity, closing records, tax invoices, seller's permit, returns, audit calculations, assessment, payment, claim, appeal, or later outcome.

The food-business analysis also has stated limits. The representative argued that much of the transfer was exempt because most assets served food manufacturing and sales. The memorandum instead understood the division to be an integrated food and related nonfood operation, said the two sides did not appear to be entirely separate endeavors, and applied the rule for a business that is not essentially a service enterprise. It did not supply operational records, sales data, product lists, or the cited supporting Annotation 395.1255.

The live annotation preserves the new-LLC structure, concurrent cash sale, interdependent agreements, integrated-transaction conclusion, Civil Code sections 1436 and 1642, Regulation 1595(b)(4), and April 26, 2002 date. It omits the earlier audit correspondence, the incomplete agreement and missing closing documents, the tax indemnity, the parties' business explanations, the separate food-business analysis, the cited seller-permit provisions and Annotation 395.1255, and the absence of implementation or outcome records.

What this means for you

Business sellers and M&A teams

An entity wrapper does not isolate an asset contribution when the same closing obligates a buyer to purchase the new entity interest for cash. Review all linked agreements as one transaction.

Food manufacturers

Exempt sales of food do not mean the business lacks seller-permit obligations. Assets of an integrated food and nonfood sales operation can remain within the taxable business-asset rules.

Accountants and tax professionals

Identify every form of consideration, including contractual commitments, assumed debt, cash, notes, and other property—not merely what the transferor receives at the first formal step. Preserve the complete agreement, amendments, schedules, related contracts, closing records, asset allocation, permits, returns, and tax calculations.

Common questions

Q: Why did the commencing-entity rule not apply?
A: The sellers received more than an LLC interest: they also received the purchaser's concurrent commitment to buy that interest for cash.

Q: Did forming the LLC one day before closing matter?
A: It supported the finding that the LLC had no prior operating history and was created to carry out the integrated closing.

Q: Why were the separate contracts read together?
A: They involved the same parties and matters, were interdependent closing conditions, and formed substantially one transaction under Civil Code section 1642.

Q: Was a step-transaction analysis required?
A: No. The memorandum said Regulation 1595(b)(4) already failed because the contribution was not solely for a membership interest.

Q: Were the food-operation assets exempt because most sales were exempt food sales?
A: No. The integrated food and nonfood operation was required to hold a seller's permit and was not a separate service enterprise.

Q: Did legal staff review every agreement involved in the closing?

A: No. The acquisition agreement's schedules and the identified transaction documents were not provided with the published record.

Q: Does the source show what the audit ultimately assessed or collected?

A: No. It gives the Legal Division's analysis but no assessment, payment, claim, appeal, or later outcome.

Citations and references

• California Revenue and Taxation Code § 6066
• California Civil Code §§ 1436 and 1642
• California Sales and Use Tax Regulation 1595(a)(3), (a)(5)(B)1–2, (b)(1), and (b)(4)
• California Sales and Use Tax Regulation 1699
• Sales and Use Tax Annotation 395.1255 (December 21, 1992) — cited source not included
• August 7, 1998 Acquisition Agreement and First Amendment — reviewed, but agreement schedules were not provided
• Supply, Services, Employee Benefits, Trademark License, leased-real-property, and other transaction agreements — identified but not provided
• September 19, 2000 audit memorandum, January 18, 2001 Legal Division response, September 13, 2001 request, September 5, 2001 purchaser-counsel memorandum, and July 6, 2001 representative letter — referenced but not separately included
• Complete asset, allocation, indemnity, closing, permit, return, tax, audit, assessment, payment, claim, appeal, and later-outcome records — implicated but not documented

Verbatim support

From the official April 26, 2002 memorandum:

However, the Agreement was incomplete since none of the attached schedules were provided.

In that regard, Sellers did not contribute tangible personal property in exchange solely for a membership interest in the commencing LLC as they also received a contractual commitment from Purchaser to purchase this interest for cash, concurrent with such transfer of assets.

Because Regulation 1595(b)(4) does not apply when the transfer of property is not solely in exchange for a membership interest, as is the case here, it is unnecessary to apply tests of the step transaction doctrine.

That is, the operations of manufacturing, processing and packaging of food and related non-food products appear to be a single, non-service operation engaged in sales operations requiring the holding of a permit, and not that of a service enterprise with a separate selling activity like that of a movie theater that sells popcorn.

Source

• Annotated Legal Opinions collection: CDTFA Annotated Legal Opinions
• Annotation page: Annotation 395.0007
• Original supporting opinion: 395.0007 PDF

Original ruling text

State of California

Board of Equalization
Legal Division-MIC: 82

Memorandum
395.0007
To :

Pardip N. Dayaram
Senior Tax Auditor, AA

From :

Trecia M. Nienow
Tax Counsel

Subject:

R--- - S--Permit No. SR -- XX-XXXXXX

Date:

Telephone:
CalNet:

April 26, 2002

(916) 445-3723
485-3723

Your September 13, 2001 memorandum to Program Planning Manager Charlotte Paliani regarding the above taxpayer was assigned to me for response. We apologize for the delay in our response. You attached your September 19, 2000 memorandum to the Legal Division, a copy of the Legal Division’s memorandum in response to you dated January 18, 2001, as well as some audit working papers and certain documents pertaining to the sale. You indicate that as a result of a meeting with the taxpayer and his representatives, additional information is presented in a memorandum dated September 5, 2001 from Purchaser’s attorney, A--- L. S---, Esq. You note that Mr. S--- was primarily responsible for putting together the asset sales contract. You attached the memorandum from Mr. S--- requesting our review of this new information presented and request an opinion as to whether sales tax applies to the transaction between R--- F---, LLC, a Delaware limited liability company (“Purchaser”), U--S--- F---, Inc., a Delaware corporation (“USFI”), and J--- S--- & Co., a Delaware corporation (“JSC”). USFI and JSC are collectively referred to as “Sellers.” DISCUSSION The transaction between the parties is a single integrated transaction, in which Sellers transferred tangible personal property into a newly formed LLC in exchange for cash. This transaction was carried out (within a 24 hour period) pursuant to several interdependent agreements, which required Sellers to transfer tangible personal property to a commencing entity, receive an interest in the entity, and to transfer that interest to the Purchaser for cash. This transaction does not qualify as a non-taxable transfer to a commencing entity under Regulation 1595(b)(4). Regulation 1595(b)(4) explains that a transfer of property to a commencing entity (e.g., a limited liability company) in exchange solely for an interest in that commencing entity is not a sale; however, the transfer is a sale if the transferor receives any consideration, and tax applies to that sale unless it otherwise qualifies for exemption. Here, in addition to the membership interest, Sellers received consideration at the time of transfer, that

Pardip N. Dayaram

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April 26, 2002
395.0007

being the commitment by Purchaser to buy Sellers’ interest for cash concurrent with Sellers’ transfer of tangible personal property to the commencing entity. Moreover, Regulation 1595(b)(4) does not provide a means by which to avoid tax when the transfer of property to a commencing entity in exchange for a membership interest also includes the simultaneous sale of such membership interest. This transaction was originally structured as an asset sale whereby Sellers agreed to sell to Purchaser specific assets owned and used by USFI in its manufacturing division (the “Business”). After all parties had reached agreement, as reflected by the execution of the Acquisition Agreement dated August 7, 1998 (“Agreement”), the parties executed a First Amendment to the Acquisition Agreement (“Amendment”). This Amendment changed the transaction, in part, from the transfer of tangible personal property directly to the Purchaser in exchange for cash, to a transfer of tangible personal property to a newly created Delaware limited liability company (“LLC”) formed on August 27, 1998, followed immediately by Sellers’ transfer of its LLC interest to the Purchaser in exchange for cash. Copies of the Agreement and Amendment were provided to us for review. However, the Agreement was incomplete since none of the attached schedules were provided. Moreover, the transaction as structured was contingent on the finalization prior to closing of the Transaction Documents specified in the Agreement at ¶6.10 and defined on page 6 to mean the Supply Agreement, the Services Agreement, the Employee Benefits Agreement, the Trademark License Agreement, the Agreement Concerning the Leased Real Property, and the Employee Benefits Agreement, among others, copies of which were not provided to us for review. We understand however, that there was a concurrent closing, dependent upon the closing of the Agreement, as amended, of each of these Transaction Documents and other related documents on August 28, 1998. Mr. S--- in his September 5, 2001 memorandum states that the Purchaser would not have entered into the Agreement without the Sellers’ committing to purchase a certain volume of product required under the Supply Agreement. 1 In addition, we understand that the Amendment to the Agreement was created in order to finalize the Supply Agreement to meet the condition of closing. Mr. S--- further states that Sellers “agreed to contribute all of the assets comprising the
[California] facility to a wholly owned subsidiary . . .” (i.e., LLC), but not the tangible personal property located at the manufacturing facility in ---, Indiana “which was acquired directly by the Purchaser . . .” or the assets of other business operations owned by Sellers 2 “and to sell that subsidiary . . . to the Purchaser.” In that regard, we note that the terms of the Amendment 3 are consistent with Mr. S---’s statements and bind Sellers to sell all the membership interests in the LLC after Sellers transferred tangible personal property into the LLC.

1

The Supply Agreement was a long-term agreement under which the Purchaser would supply food and non-food products to Sellers who committed to purchase significant volumes of products from the Purchaser each year over a six-year period. 2 The Agreement indicates at page 2, as part of the definition of “Business,” that certain business operations of Sellers will be excluded from the sale. 3 Sellers, in order to avoid a potential sales tax liability they anticipated might arise as a result of the restructure, obtained an indemnification from Purchaser with respect to any tax liability (specifically including sales, use and other applicable tax, as well as related penalty, interest or fines). (See Amendment, Art. 5.)

Pardip N. Dayaram

-3-

April 26, 2002
395.0007

Since the transaction was contingent upon the parties completion of the Transaction Documents prior to close, and dependent on Seller’s contribution of the tangible personal property comprising the [California] facility to a commencing LLC prior to close, these requirements were conditions precedent to close. (See Civ. Code § 1436. 4 ) Moreover, the law contemplates that several contracts are parts of one transaction and are to be taken together, if they relate to the same matters, are between the same parties and are made as parts of substantially one transaction. (See Civ. Code § 1642. 5 ) By the very terms of the Agreement and Amendment provided to us, it is clear that this is a single integrated transaction for the transfer of tangible personal property in exchange for cash. The documents provided and information obtained indicate a newly formed LLC with no prior operating history was created on August 27, 1998. Sellers were required to and did transfer the tangible personal property located at the [California] facility, which included the assets related to the Business 6 (see Agreement, ¶2.1.1), to the LLC for the purpose of its concurrent sale to Purchaser. On August 28, 1998 (one day after the LLC was formed), Sellers transferred its LLC interest to Purchaser for cash as required by the Agreement, as amended. As indicated above, a transfer of tangible personal property to a commencing entity in exchange solely for an interest therein is not a sale for purposes of Regulation 1595(b)(4). This is true because the interest received by the transferor is not regarded as having measurable value at the time of the transfer. However, the transfer is a sale if the transferor receives any consideration other than the interest in that commencing entity. Regulation 1595(b)(1) describes consideration received by the transferor to include cash, notes, and any other property as well as any indebtedness assumed by the transferee. In that regard, Sellers did not contribute tangible personal property in exchange solely for a membership interest in the commencing LLC as they also received a contractual commitment from Purchaser to purchase this interest for cash, concurrent with such transfer of assets. The commitment by Purchaser to pay cash to Sellers for their membership interest constitutes consideration above and beyond the membership interest received by Sellers. Since Sellers received consideration in addition to the membership interest it received in exchange for the transfer of the property involved, such a transfer is a sale and tax applies to that sale unless it otherwise qualifies for exemption. Furthermore, in a single integrated transaction, the Sellers, initially owning tangible personal property, as evidenced by the Agreement, transferred its tangible personal property, and concluded the transaction with the receipt of cash. This is clearly evidenced by the Agreement, Amendment and related documents that, pursuant to Civil Code section 1642, must be regarded as part of a single integrated transaction resulting in the transfer of tangible personal property for 4

Civil Code section 1436 states “A condition precedent is one which is to be performed before some right dependent thereon accrues, or some act dependent thereon is performed.” 5 Civil Code section 1642 states “Several contracts relating to the same matters, between the same parties, and made as parts of substantially one transaction, are to be taken together.” 6 The Business was an integrated operation defined as “the manufacturing, processing and packaging [of] food and related non-food products of Sellers, as such businesses are currently conducted by the manufacturing division of Sellers . . .” (see Agreement, Art. 1).

Pardip N. Dayaram

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April 26, 2002
395.0007

cash. Accordingly, when the Sellers transferred tangible personal property to a commencing LLC contingent upon a concurrent contract to sell the membership interests in that LLC for cash, such a transaction is a sale of tangible personal property for cash and is subject to tax. Mr. S--- goes on to explain that the Purchaser from the outset sought to obtain the Business as a legal entity rather than as a collection of assets. It appears however, this desire was not compelling enough to prevent the Purchaser from originally entering into the transaction on August 7, 1998 when it was structured as an asset sale. Mr. S--- also explains that the Sellers agreed to restructure the transaction in order to finalize the Supply Agreement. These explanations however, do not rebut the fact that this was a single integrated transaction entered into for a specific purpose, that being to sell tangible personal property to Purchaser for cash. Clearly, a structure that meets the business needs of the owners is important. However, the reason for the restructure is merely an explanation as to why assets were transferred to the LLC prior to the sale of its membership interests, and is irrelevant to the issue of whether there was a transfer of tangible personal property for consideration, to which no exemption applies. Because Regulation 1595(b)(4) does not apply when the transfer of property is not solely in exchange for a membership interest, as is the case here, it is unnecessary to apply tests of the step transaction doctrine. Lastly, we understand that taxpayer’s representative, A--- A---, ---, believes (e.g., see letter dated July 6, 2001) that if the transaction is deemed a transfer of tangible personal property, a significant portion of this transfer would be exempt from tax under Regulation 1595(a)(3) since most of the assets were used in the manufacture and sale of food products. Regulation 1595(a)(3) explains that persons may be engaged in entirely separate endeavors that do not require the holding of a seller’s permit, such as a business which sells services and no tangible personal property. Where this occurs, tax does not apply to the transfer of property held or used by that person in its non-selling endeavors which do not require the holding of a seller’s permit, unless the transfer is one of a series of sales sufficient in number, scope and character as to require the holding of a seller’s permit. As noted above, the tangible personal property transferred at the [California] facility included assets related to the Business that was conducted by the manufacturing division of Sellers. Under these facts, we understand that the division constituted an integrated operation consisting of the selling of food and related non-food products. Every person engaged in the business of selling tangible personal property of a kind the gross receipts from the retail sale of which are required to be included in the measure of sales tax is required to hold a seller’s permit. (Rev. & Tax. Code § 6066; Reg. 1699.) As such, the Business was required to hold a seller’s permit notwithstanding the fact that the Business’ sales of food are exempt. In particular, the food and related non-food products do not appear to be entirely separate endeavors (see Regulation 1595(a)(5)(B)1. 7 or Regulation 1595(a)(5)(B)2.) That is, the operations of manufacturing, processing and packaging of food and related non-food 7

Tax applies to the sale of assets of a business that is not essentially a service enterprise. Examples of this are sales of grocery stores making both exempt sales of food products for human consumption and taxable sales of other tangible personal property.

Pardip N. Dayaram

-5-

April 26, 2002
395.0007

products appear to be a single, non-service operation engaged in sales operations requiring the holding of a permit, and not that of a service enterprise with a separate selling activity like that of a movie theater that sells popcorn. Since the Business was required to hold a seller’s permit, tax applies to the transfer of tangible personal property related to the food product business as well as to the non-food product business in accordance with Regulation 1595(a)(5)(B)1. (See also Sales and Use Tax Annot. 395.1255 (12/21/92).) Please let me know if you have any further questions.

TMN
cc:
Mr. Ray Harispe (AA)
Mr. Michael Templeton (AA)
Ms. Charlotte Paliani (MIC:92)
Mr. Vic Anderson (MIC 40)