The merger and acquisition market is strong, and some experts don’t see a slowdown anytime soon. One question most business owners know to ask is whether an asset sale or a stock sale would be preferable. “Complicated” is an understatement when it comes to understanding the numerous economic decisions that a business owner needs to contemplate before deciding on any specific deal structure.
“Should I be looking at an Asset Deal or a Stock Deal?”
An asset sale is the purchase of individual assets and liabilities, whereas a stock sale is the purchase of the owner’s shares of an entity. The deal structure of any transaction can have a major impact on the future for both the buyer and seller. Many other factors, such as the company's structure and the industry, can also influence the decision. After the business considerations have been evaluated, the tax implications come into play – as well as additional economic matters such as contingent liabilities.
It is important for both parties to consult with their legal counsels, and tax professionals early in the process to fully understand the issues and reach a decision that will produce the desired results.
Among the many issues that need to be considered are the following:
- Company structure: C-Corp, S-Corp. LLC or other. If the business in question is a sole proprietorship, a partnership, or a limited liability company (LLC), the transaction cannot be structured as a stock sale since none of these entity structures have stock. Instead, owners of these entity types can sell their partnership or membership interests as opposed to the entity selling its assets. If the business is incorporated, either as a regular C-corporation or as a sub-S corporation, the buyer and seller must decide whether to structure the deal as an asset sale or a stock sale.
- Number of shareholders or unitholders
- Does one individual person or entity own greater than 50%?
- Economic goal of the seller. You can either opt for a full sale or decide to sell only a certain amount of the company to “cash out” at the current value and hedge against a down market while maintaining a significant market share.
In general, buyers prefer asset sales, whereas sellers prefer stock sales. Let’s look at the issues facing buyers and sellers in both asset and stock sales.
Asset Sale Issues for Sellers
For sellers, asset sales generate higher taxes because while intangible assets, such as goodwill, are taxed at capital gains rates, other "hard" assets can be subject to higher ordinary income tax rates. Federal capital gains rates are approximately currently 20%. Ordinary income tax rates depend on the seller's tax bracket.
Furthermore, if the entity sold is a C-corporation, the seller faces double taxation. The corporation is first taxed upon selling the assets to the buyer. The corporation's owners are then taxed again when the proceeds transfer outside the corporation. In addition, if the company is an S-corporation that was formerly a C-corporation, and if the sale is within the 5-year built-in gains (BIG) tax recognition period, the S-corporation's asset sale could trigger corporate-level BIG taxes, under IRS Sec. 1374.
Asset Sale Issues for Buyers
Within IRS guidelines, asset sales allow buyers to "step-up" the company's depreciable basis in its assets. By allocating a higher value for assets that depreciate quickly (like equipment, which typically has a 3-7 year life) and by allocating lower values on assets that amortize slowly (like goodwill, which has a 15-year life), the buyer can gain additional tax benefits. This reduces taxes sooner and improves the company's cash flow during the vital first years. As mentioned, buyers also prefer asset sales because they more easily avoid inheriting potential liabilities, especially contingent liabilities in the form of product liability, contract disputes, product warranty issues, or employee lawsuits.
However, asset sales may also present problems for buyers. Certain assets are more difficult to transfer due to issues of assignability, legal ownership, and third-party consents. Examples of more difficult to transfer assets include certain intellectual property, contracts, leases, and permits. Obtaining consents and refiling permit applications can slow down the transaction process.
Stock Sale Issues for Sellers
Sellers often favor stock sales because all the proceeds are taxed at a lower capital gains rate, and in C-corporations the corporate level taxes are bypassed. Likewise, sellers are sometimes less responsible for future liabilities, such as product liability claims, contract claims, employee lawsuits, pensions, and benefit plans. However, the purchase agreement in a transaction can shift responsibilities back to a seller.
Stock Sale Issues for Buyers
With stock sales, buyers lose the ability to gain a stepped-up basis in the assets and thus do not get to re-depreciate certain assets. The basis of the assets at the time of sale, or book value, sets the depreciation basis for the new owner. As a result, the lower depreciation expense can result in higher future taxes for the buyer, as compared to an asset sale. Additionally, buyers may accept more risk by purchasing the company's stock, including all contingent risk that may be unknown or undisclosed. Future lawsuits, environmental concerns, OSHA violations, employee issues, and other liabilities become the responsibility of the new owner. These potential liabilities can be mitigated in the stock purchase agreement through representations and warranties and indemnifications.
If the business in question has a significant number of copyrights or patents or if it has significant government or corporate contracts that are difficult to assign, a stock sale may be the better option because the corporation, not the owner, retains ownership. Also, if a company is dependent on a few large vendors or customers, a stock sale may reduce the risk of losing these contracts.
So how many deals are asset sales vs stock sales? According to Pratt’s Stats database, approximately 70% of all transactions were asset based sales. However, this figure varies significantly by company size, with larger transactions having a greater likelihood of being stock sales.
As you can tell, there are many complex questions to answer about the sale of a business before solid tax advice can be issued. LGA considers the broad array of issues from valuation, negotiation, economic planning, and succession planning, to structuring and closing a deal that will work for you. We work closely with outside legal counsel and investment bankers through the due diligence process with the intention of making sure you are fully advised of the economics, potential risks, and tax issues associated with the contemplated deal.
Please contact us to discuss the specific issues about selling or buying a business.
Written by Steve Smyth.