One of the key questions Buyers and sellers face in every business sale is the related tax implications. Tax implications are based on how the transaction is structured. Without proper consideration, there can be unintended consequences and unexpected costs. Corporations can be sold as either stock or asset transactions. This post lists the differences between stock and asset transactions for both Buyers and sellers.
A stock sale involves the sale of a company’s equity, assets and all liabilities as listed on the balance sheet. Legally, the transaction occurs between the Buyer and selling company’s shareholders. It does not involve the sale of assets individually. After the sale, the target corporation remains in existence and intact and is owned entirely by the Buyer.
In an C Corp or S Corp, the shareholders recognize a gain or loss on the difference between the selling price and their basis in the stock/equity interests. A stock transaction is often highly desirable for the selling shareholders because it results in one layer of taxation (by the shareholders) and avoids double taxation that occurs with asset sales by C Corps. S Corps are not subject to the double taxation dilemma as they are pass through entities.
Furthermore, if there is a gain it is recognized generally as a long-term capital gain, which is taxed at favorable rates under the current system. Buyers may also find a stock sale to be favorable if there are significant tax attributes within the corporation that the Buyer can utilize or if the Buyer needs to keep the legal entity in existence (for example, customer contractual obligations, union contracts, and the like).
Buyers most likely will reject a stock purchase for one major reason. Typically, the assets owned by the corporation are depreciated to some extent leaving the Buyer to inherit the level of depreciation remaining on the balance sheet. However, if the Buyer acquires the target company through an asset purchase, she gets to depreciate the full market value of assets at the time of purchase of the business.
Additionally, a Buyer of stock generally inherits the target company’s undisclosed liabilities and uncertain tax consequences. Thus, the Buyer could be liable for additional taxes or potential lawsuits that are brought against the business. In an asset sale, the Buyer can easily include only items and liabilities she wants but in a stock sale the Buyer must specifically spell out all the items known and unknown that she does not want to accept in the transaction.
For target companies taxed as a partnership (including limited liability companies), the selling members need to consider if the company has any “hot assets” as defined by the IRS. “Hot assets” could alter the characterization of assets from capital gain to ordinary income causing the items to be taxed at the partner’s marginal tax rate.
When a Buyer acquires assets from a company, the transaction occurs between the Buyer and the target company. Accordingly, any consideration is paid to the target company for its assets and liabilities. Whether the Corp liquidates, dissolves or otherwise ceases to exist does not alter the fact that the proceeds from the sale are distributed to the equity owners after the transaction in the form of dividends.
The target company recognizes a gain or loss on the difference between the sales price allocated to the assets and the tax basis of the assets on an asset-by-asset basis. Buyers typically pursue an asset sale to avoid the potential of undisclosed tax or nontax liabilities that she does not want to assume. As mentioned earlier asset transactions generally have tax benefits to the Buyer. The Buyer gets a step-up in the basis to fair market value at the time of the transaction. This allows the Buyer to increase the amount of future tax deductions.
Sellers of C-Corps will find tax pitfalls from an asset transaction. The way the tax code is setup, the Sellers of the C-Corp can be subject to double taxation or depreciation recapture. In general, S-Corps and partnerships are generally not subject to double taxation unless there was some conversion from a C-Corp within the previous 5 years.
Another option for owners of C-Corps is to sell their business as assets but allocate all or some of the goodwill of the business as “Personal Goodwill”. Personal goodwill is defined as the portion of goodwill that the owner of a C-Corp can consider related to his close relationship with the customers. For instance, a small business where the owner talks to all the customers on a regular basis and is the main point of contact for customers would have a situation where most of the goodwill created by the business is personal goodwill.
The advantages of claiming this allocation during the business sale is that the personal goodwill portion is treated as long term capital gains for taxation and exempt from double taxation. The tax court in several cases in the past several decades has ruled in support of this approach to claiming personal goodwill in the case of C-Corps and allowed this asset to be taxed as if it was not part of the corporation.
Tax attributes are an important consideration for both the Buyer and sellers, as they can be a contributing factor in how the transaction is structured. A Buyer needs to carefully evaluate situations in which a C Corp target company has tax attributes that provide future benefit, such as net operating loss and/or tax credit carryforwards.