By: David Kolan, PKF Advisory Managing Director
The emotional aspects of selling a business you nurtured and built over the course of your life can often cloud some of the economic realities that a sale will bring, not just immediately after the deal closes, but far into the future. One factor entrepreneurs must consider when selling their businesses is how they will eventually structure the transaction – either as an asset sale or a stock sale. Understanding the difference between the two is critical.
As the name implies, an asset sale involves the sale of a company’s individual assets, which can include its equipment, buildings, furniture, vehicles, leasehold improvements, intellectual property, trade secrets, goodwill, inventory, accounts payable and accounts receivables. Buyers may also purchase a company’s customer lists, employees and non-compete agreements. However, with asset sales, sellers will typically retain ownership of the legal entity and most of its liabilities, which can become an important point of sale negotiations. This ability to avoid long-term liability risk is one reason why buyers purchasing a business typically prefer asset sales.
Another favorable benefit buyers receive from an asset sale is the ability to improve their tax position by annually taking depreciation deductions on eligible assets. Moreover, buyers receive a step-up in the tax basis of the assets they acquired, meaning the price they pay at the time of purchase becomes the asset’s new tax basis. This ultimately allows buyers to reduce their exposure to future gains, which, depending on the type of assets, may be subject to tax at a long-term capital gain rate or a higher individual income tax rate.
By contrast, with an asset sale, sellers are exposed to the prospect of higher tax liabilities than a stock sale, especially when there is a significant difference between the original tax basis of those assets and the amount they sell for to a buyer. Again, a seller’s tax liability on an asset sale could be as high as the top individual income tax rate, which is currently 37 percent. When the seller is structured as a C corporation, there is a risk of double taxation, first on the taxable gain realized from the asset sale and then again when those proceeds are distributed to shareholder.
Unlike an asset sale, buyers may instead purchase all or a portion of a seller’s equity interests in a business, taking ownership in the business entity, its assets and its liabilities. With a stock sale, ownership title to acquired assets remains with the corporation and not with the individual buyer. The seller recognizes a gain based upon the difference between the amount realized and his or her adjusted tax basis in the stock sold. However, the federal tax rate that applies is at the lower capital gains rate (currently 20 percent) rather than the ordinary income tax rate. On a side note, if both buyer and seller are structured as corporations, the transaction may be treated for tax-purposes as a tax-free reorganization.
As a general rule, buyers do not like stock purchases for two reasons. First, the purchase of stock includes ownership in all the entity’s current and future liabilities, which may or may not be known at the time the transaction closes. Secondly, buyers lose the benefit of a step-up in cost-basis on the assets they acquire. While buyers may claim depreciation deductions for those assets and use them to offset taxable income, the amount of the deductions will be lower than if the transaction involved a sale of assets.
As is the case with many provisions of the tax laws, there are certain elections buyers and sellers may make to change the tax treatment of a stock or asset sale. These are often used as negotiation tools to bring buyer and seller together on terms from which each can receive a benefit. Working with experienced advisors and tax accountants is critical to weighing pros and cons of each type of transaction and structuring a sale that meets your specific needs and goals.
David Kolan, CPA