Selling Your Business – Taxation of a Stock Sale
In our last post on closely held business sales, we discussed how your industry and other factors can impact the valuation of your business. This week, we are discussing the taxation imposed on sales of stock of your closely held business (with a few references to asset sales for context).
In a stock sale, the buyer purchases the seller’s interest in the company through buying the seller’s shares of stock in that company.
While a C Corporation is normally a tax paying entity, there is no income tax liability to the company in a stock sale since the shareholder(s) is/are selling their own stock, rather than the company’s assets, which eliminates the pitfall of double taxation on the sales of stock by C Corporation shareholders. For such owner-shareholders, sales of stock (providing the stock has been held for over one year) are taxed as long-term capital gains, which currently have a top rate of 20%, rather than at potentially higher individual income tax rates.
S Corporations and partnerships are, unlike C Corporations tax reporting entities. Nonetheless, the gains on stock sales are treated similarly, as in all cases these are sales of assets belonging to the shareholder or partner, not the Corporation (whether S or C) or partnership and, providing the stock has been held for over one year, are taxed at the individual level at the appropriate long-term capital gains tax rate.
In an asset sale of an S Corporation, you are likely to lose the benefit of taxation at capital gains rates for the entire sales price. For example, previous depreciation of the business’ assets initially captured as deductions to individual income may need to be added back to the seller’s taxable income and taxed at ordinary income tax rates.
By way of contrast, sales of a C Corporation’s assets generally incur taxation at both the corporate and individual level at ordinary income tax levels. The top corporate income tax rate us currently 21%, and the top individual income tax rate is currently 37%. For some corporate and individual taxpayers, there can be an additional alternative minimum tax (AMT) of 3.8%. That’s a lot of tax. For this reason, it’s often to a seller’s advantage to press a buyer to structure the sale as a stock purchase.
Some sellers may qualify for even more preferential treatment of sales of qualified small business stock (QBS) via IRS Code Section 1202 (see our post on Section 1202 here), via which some long-term gains on QBS sales can be excluded from taxation entirely.
Buyers, too, may gain some advantages in a stock purchase, such as the assumption of any net operating loss (NOL) and/or tax credit carryforwards. In some cases, non-transferrable corporate assets, such as copyrights and/or patents owned by the business, or major governmental, construction, and/or engineering contracts may make a stock sale more attractive to a buyer than attempting to re-negotiate such contracts on behalf of a newly-formed (purchasing) company.
In the real world, however, buyers are often reluctant to purchase a company via a stock sale, as this means they will be acquiring 100% of the business’ assets – and assuming 100% of the business’ liabilities. In an asset sale, the buyer may pick and choose such of the assets as they want to retain in the business, and may also wish to exclude all of the business’ current and long-term liabilities.
Buyers also have other options for assuring themselves favorable tax treatment – if the sellers agree. Via 336(e), 338(g) and 338(h)(10) elections, an eligible buyer can, with the seller’s compliance, elect to treat a stock sale as an asset sale for Federal tax purposes.
By consulting closely with their Transaction Advisory Team, a seller may be able to leverage the buyer’s desire for an asset sale toward a higher purchase price, in consideration of the far greater tax consequences to the seller in an asset sale compared with a stock sale.
Preparing for the tax consequences arising from the sale of your business – and for dealing with and minimizing them – is a task requiring the acumen and skills of your Transaction Advisory Team, particularly your tax advisor(s). Your team will assist you in determining the salient factors of the contemplated transaction, and what you can do to maximize any potential advantage while mitigating against potential disadvantages. They can help you with negotiating the deal, identifying crucial points for you to stand firm on, and other points on which you can be flexible.
If you are considering a potential sale of your business within the next decade, I recommend strongly that you consult with us.
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Until next time –