Selling a business - asset versus stock transactions

by Anja Bernier, President Efficient Evolutions LLC

 

During an asset based acquisition, a buyer acquires those of a seller’s assets and liabilities that are specified in the contract. Non-operating assets & liabilities (such as excess cash and debt) are usually not included. The seller keeps the “legal shell”, including all legal liabilities.

From a tax point of view, an asset transaction generally favors the buyer since it allows him to set higher values for assets that depreciate quickly, and lower values for assets that depreciate slowly or not at all. The buyer acquires a new cost basis in the assets which may allow a larger depreciation deduction to be taken. However, it is important to keep in mind that the IRS pays attention to the question of whether the purchase price allocation is reasonable and treated consistently by both the buyer and the seller.

Most transactions between smaller privately held companies are asset transactions since many buyers are not willing to accept anything else in order to limit their liability. However, the risk of inheriting undisclosed debts or other liabilities of the seller in a stock transaction can be minimized by providing for the right of offset to future payments due to the seller.Also, an asset based transaction might be the only choice if there are minority shareholders who refuse to sell their shares. Shareholders own equity in a company but not in its individual assets which means that minority shareholders have limited options to prevent the sale of company assets if a sale is decided by a majority of shareholders. (Just like a minority shareholder in a public company like e.g. GE cannot prevent GE from selling major assets such as plants, intellectual property etc.). However, minority shareholders would be eligible to receive “fair value” compensation for their shares under such a scenario. “Fair value” usually exceeds “fair market value” since a “minority discount” is applied to a minority ownership interest in order to calculate “fair market value”. An assets based transaction requires more preparation time for ownership transfer as most existing contracts etc. (payroll, insurances, leases etc.) have to either be individually reassigned to the new owner or renegotiated.

In a stock transaction/acquisition, the “legal shell” of the selling company is being transferred to the buyer including all assets and liabilities. Stock deals make the actual transfer of ownership (day-to-day management) easier for the buyer since usually all existing contracts (leases, payroll, employee benefit plans etc.) are transferred to the new owner.The seller must pay taxes on the difference between the seller’s basis in the stock and the price paid by the buyer for the stock but a stock transaction nonetheless offers tax advantages to the sellers (the extent depends on many factors including the legal structure of the selling company: C-Corp versus S-Corp or LLC).

It is important to keep in mind that the sale of the stock of a closely held corporation falls under the umbrella of federal securities laws. Failure by the seller to fully disclose all material information about the business exposes the seller to the risk of securities fraud litigation.

Sole proprietorships and most LLCs or partnerships will be selling the assets of the company since they are not incorporated and there is therefore no stock to sell. Owners of S-Corporations can choose to sell either the assets or the stock of the corporation. Because an S-Corporation’s income flows directly into the stockholders’ personal income, stock and asset sales normally yield similar taxation unless the S-Corp used to be a C-Corp  and switched to S-Corp status within the last 7 years. Owners of C-Corporations should try to sell the stock of the company as opposed to the assets since this brings distinct tax advantages to the seller.  Under an asset based transaction, the seller could be faced with a double taxation situation if the entity being sold is a C corporation:  first the corporation (seller) will have to pay tax on the sale, then owner/seller will personally pay tax again on the after-tax amount that is being removed from the corporation.

Potential tax implications for a C-Corp from a seller’s perspective (example)

Asset Sale

Stock Sale

Sale Price

6,000,000

6,000,000

Seller’s basis for taxation

3,500,000

3,000,000

Capital gains from sale

2,500,000

3,000,000

Ordinary Income Tax at corporate level (graduated rates up to 35%)

840,600

0

Basis for taxation at shareholder level

5,159,400

6,000,000

Individual tax at shareholder level (15%; assuming either LT cap gain treatment or qualified dividend treatment)

773,910

900,000

Realized gains from transaction

4,385,490

5,100,000

Note: assumed tax rates are based on 2008 tax rates

The author would like to emphasize that the comments and examples in this article do not constitute advice for any specific action. A multitude of factors can have a material impact on the actual tax exposure of a company and its shareholders during a company sale. Not all of those factors could be covered in this article. The author strongly recommends that readers obtain tax counsel that is specific to their individual situation, before taking any actions.

 

 

The content of this article is protected by copyright. Unauthorized commercial use is prohibited. Redistribution is allowed as long as Efficient Evolutions' contact information and clear attribution of authorship are included.