In our last installment (read it here), we discussed the Buy-Sell Agreements necessary if you are selling your business interest to your partner(s). This week, we return to the premise of sale to an outside buyer, and consider how to structure the sale.
There numerous ways to structure a merger, divestment, or acquisition. However, most sales of closely-held businesses are structured as either a stock sale or an asset sale. Both have advantages and drawbacks:
In a stock sale, the buyer purchases the seller’s interest in the company via a purchase of the seller’s stock.
If the business is a C Corporation, there is no tax liability to the company – since the shareholders are selling their stock, which eliminates the possibility of double taxation to C Corporation shareholders. For owners, sales of stock (providing the stock has been held for over one year) are taxed as capital gains, rather than corporate or individual taxable income.
There is one major exception to tax treatment of stock sales – under IRS Code Section 1202, there is an exception for qualified small business stock. For such stock to be qualified, there are a number of requirements, but there can be a significant reduction in capital gains tax.
We will discuss IRS Code Section 1202 next week.
Stock sales are often preferred by sellers due to tax consequences such as those listed above.
Buyers, too, may gain some advantages in a stock sale, such as the assumption of any net operating loss (NOL) and/or tax credit carryforwards.
In an asset sale, the buyer will often not agree to take on every liability of the business. They can pick and choose which assets to purchase, and which liabilities they are willing to assume. Many times, buyers are unwilling to assume any of the seller’s liabilities, and the seller may have to pay off all debt prior to closing the sale.
Buyers also receive a tax advantage in an asset purchase over a stock sale, as they receive a step-up in basis on the assets purchased equal to the price allocated to those assets. This, in turn, provides the buyer with higher depreciation and amortization tax deductions. Many times, buyers pay an amount greater than the fair market value and this part of the sales price is generally allocated to goodwill. Note that the allocation of the purchase price for both buyers and sellers must be agreed to in advance, and this information must be provided to the IRS on Form 8594, so that the purchase price is appropriately allocated among the assets being purchased.
The seller, conversely, may incur significant tax liabilities under an asset sale. If the business is a C Corporation, it will be liable for tax on the gain in value of the assets sold, and the selling owners may, when the proceeds of the sale are distributed out of the C Corporation, incur tax at the individual tax level.
For pass-through entities, such as S Corporations and limited liability companies/partnerships, an asset sale will likely be taxed on at least a portion of the purchase price at the individual level, but at a reduced capital gains rate.
One exception would be that if you sell assets which have been depreciated, you may have to recapture that depreciation at ordinary income tax rates, rather than capital gains rates.
So, competing interests and tax consequences can put buyer and seller at odds from the start. This is one reason the specifics of your Letter of Intent (link to blog post) are so crucial. The more variables that can be resolved at the start, the better. (A comprehensive Letter of Intent makes the subsequent Purchase Agreement less complicated for your transaction attorneys to negotiate and draft, as well.)
While the simplistic view is that sellers will want to sell stock, and buyers will prefer to purchase assets, it’s not always that cut-and-dried. Other factors can play a role in how the sale is eventually structured.
One such factor can be contractual consent requirements, meaning that the contract cannot be transferred to a new business owner without the consent of the third party involved. A business may have one, or multiple, such contracts, such as a lease of physical premises, a franchise agreement, a key supplier agreement, etc. If there are too many of these contracts, an asset sale may become much more complicated, and such contracts need to be dealt with in advance – neither buyer nor seller should leave this until the last minute.
Another factor, if there is more than one owner of the business being sold, is whether all the owners agree to sell. If even one stock owner refuses to sell, both the buyer and the selling owner may find that a merger or an asset sale would be a more advantageous move with regard to tax consequences.
Less Common – 338 and 336 Elections:
The IRS has created rules under which a corporate buyer can, with the seller’s compliance, elect to treat a stock sale as an asset sale for Federal tax purposes.
Navigating these waters is a task requiring the acumen and skills of your Transaction Advisory Team. Your team will assist you in determining the salient factors of the contemplated transaction, and what structure will be most advantageous for you. 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, I recommend strongly that you consult with us before making any final decisions.
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Until next time –