Generally, an asset sale provides the best after-tax outcome to a business buyer and a stock sale results in the best after-tax consequences for the business seller. However, since there are many factors to consider besides tax consequences when buying or selling a business, the tax effect cannot be considered in a vacuum. There will always be an adverse tax effect. Uncle Sam will always get his cut. So, the question becomes which party to the transaction will be responsible for Uncle Sam’s cut. Naturally, each party will want the other to pay Uncle Sam. So, there will be negotiations. There will be give and take. To avoid being taken, it is necessary to understand the tax laws and assemble the most knowledgeable team of professionals to guide you through the transaction process.
If the business being sold is structured as a C Corporation, and the transaction is structured as an asset sale, the result will be a double tax on the seller. The seller will be taxed at the corporate level when the assets are sold (consideration is received by the existing corporation in which the seller is the primary shareholder) and again at the individual level when the corporation distributes the proceeds to the shareholders. When a C Corporation is sold as a stock sale there is only level of tax on the seller as the proceeds transfer directly to the individual selling the entity.
If the entity being sold is not a C Corp but a pass through tax entity, there remains a great probability that the negative tax effect will remain with the seller if the deal is structured as an asset sale. In an asset sale the IRS requires that the purchase price for the assets purchased be allocated to the individual assets at fair market value (the price at which the ownership of the asset would transfer between a willing buyer and a willing seller, neither acting under compulsion and both having reasonable knowledge of relevant facts). This “step-up” in basis to fair market value at the time of transfer from the historical carrying cost of the seller provides a tax benefit to the buyer in the form of an additional depreciation write-off. Before this depreciation can be determined, the IRS requires that the assets are divided into seven asset classes: (1) cash and cash equivalents (2) actively traded personal property (3) accounts receivable and debt instruments (4) inventory (5) all other assets not previously classified (furniture, fixtures, equipment, land, vehicles, etc) (6) section 197 intangibles (7) goodwill and going concern value. The classification of each asset determines how quickly or slowly the buyer can depreciate the stepped-up asset and offset his/her operating income.
This allocation of purchase price to the different asset classes is critical to the seller because the seller’s gain on the assets will be taxed at ordinary income rates or capital gains rates depending upon how they are classified. While buyers will lobby that minimal value be allocated to land (not depreciable), buildings, equipment and goodwill (long depreciable life, slower offset to income) and the majority of the purchase price be allocated to inventory (expensed when sold). Seller’s will prefer that the majority of the value be allocated to buildings and equipment (which generally receive capital gains treatment) with minimal amounts allocated to inventory and non-compete agreements which are taxed at ordinary income rates for the seller. The seller will also be taxed at ordinary income rates on any depreciation recapture that must be claimed as a result of the sale. Depreciation recapture is the amount of depreciation expense taken by the seller during ownership of the assets in excess of straight-line depreciation (i.e. accelerated depreciation).
Note: The allocation of the purchase price in an asset sale is only critical to the seller when the entity being sold is a pass-through entity (LLC, LLP, S-Corp, sole proprietorship, partnership) because capital gains rates are preferential to ordinary income rates ONLY at the individual level. There is no preferential tax treatment given to capital gains rates at the corporate level. The negative tax effect on a C Corporation asset sale is due in most instances to the double tax treatment of the sale.
In addition to tax considerations, there are numerous other considerations, including legal, which will factor into the decision of whether a specific deal is best completed as an asset deal or a stock deal. We will address some of these issues in future segments. However, I cannot stress enough the importance of a quality team. One of the team members must be a quality tax professional. The cost of these professionals is typically offset by the benefits they bring to you through their involvement in the transaction. You get what you pay for so don’t cheap out when assembling your team!