There are two primary ways to structure the sale of a business; an asset sale or a stock sale. Although, many potential business buyers and sellers do not have a good understanding of the differences between a stock and an asset sale, the format of the structure can have significant tax and liability ramifications.
In a stock sale, the buyer buys all or a portion of the outstanding stock of the target business. As a result of the transaction, the buyer receives all of assets, including cash, of the selling company. The buyer also gets all of the liabilities, known and unknown, of the target business. It is the unknown liabilities component of the transaction that is one of the two main reasons that cause buyers and their advisors to refuse to acquire the stock of a small business. Unknown liabilities can include tax liabilities and possible litigation. The other reason that buyers usually avoid stock transactions is that buyers don’t usually receive favorable tax benefits, which can include higher depreciation for a stepped-up basis of assets and amortization of goodwill.
Although there are situations where a stock sale may be desirable, such as the transfer of certain contracts or a lease, the assumption of all liabilities and unfavorable tax considerations usually pushes most transactions toward an asset sale structure.
In an asset sale, which is typically the way most small and midsize transactions are structured, only defined assets are acquired and only defined liabilities are assumed. For example, most businesses are sold cash free/debt free, which means that the selling entity retains the cash and pays off any debt. The assets that are sold would include tangible assets, such as the furniture, equipment, and inventory, as well as intangible assets, including the trade name and goodwill.
One of the desirable attributes of an asset transaction is its flexibility. For example, accounts receivable and/or accounts payable can be included or excluded by definition in the purchase contract.
The other attractive attribute of an asset sale is the favorable tax benefits to the buyer. Although sometimes the tax consequences to the seller can be more onerous in an asset sale, most sellers are structured as sole proprietorships, Sub Chapter S Corporations, or LLCs and the tax “pass through” nature of the entities is manageable from a tax standpoint.
That tax situation can change drastically for a C Corporation or a C Corporation that recently converted to an S Corporation. The tax consequences are different because the C Corporation is a separate taxable entity that pays tax on the gain in an asset transaction and the individual shareholders pay a second tax when the funds are distributed to them. The good news is that there are strategies that can be used to mitigate these double taxes.
The consequences and complexities of its transaction structure can be significant to most sellers and buyers, which is why it is beneficial to get us involved early on in the process to work with the seller’s attorneys and tax advisors to properly structure a potential transaction.
(originally published in the February 2014 eNewsletter)