When you decide to sell your business, you and the buyer will need to agree on a way to structure the sale — either as an asset sale or a stock sale. But because you’ll have competing interests, what’s good for the buyer may not necessarily work for you. Understanding the differences in how asset and stock sales are structured is key to ensuring you benefit optimally from the transaction.
Among the many considerations when negotiating the structure of the sale are your tax implications and potential liabilities. Stock and asset sales affect these issues in different ways. For this reason, we find that buyers typically prefer asset sales, while sellers generally opt for stock sales.
An asset sale involves the purchase of individual assets and liabilities. Asset sales, like most transactions, are generally cash-free, debt-free transactions. The seller retains its cash and long-term debt obligations and stays in control of the legal entity.
The buyer purchases the company’s individual assets — such as equipment, fixtures, leasehold improvements, licenses, goodwill, intellectual property, trade secrets, and trade names — and assumes certain agreed-on liabilities.
Net working capital (i.e., accounts receivable, inventory, and accounts payable) is also typically included in a sale. To get a better understanding of working capital and why it is an important deal point, be sure to view our M&A University presentation “Negotiating the Letter of Intent.”
Asset sales are less appealing to sellers for one simple reason: higher taxes. In an asset sale, sellers are subject to potentially higher taxes than in a stock sale. While intangible assets, such as goodwill, are taxed at capital gains rates, other “hard” assets may be taxed at higher ordinary income tax rates. Currently, federal capital gains rates are around 20%, while state rates vary. For example, Florida’s capital gains rate is currently 0%, and California’s is 13.3%. Ordinary income tax rates depend on the seller’s tax bracket.
In addition, if the selling company is a C corporation, the seller faces double taxation: The selling company is first taxed when selling the assets to the buyer and again when the proceeds transfer outside the corporation. Further, if the company is an S corporation that meets the following requirements, the asset sale could trigger corporate-level built-in gains (BIG) tax: · The company was formerly a C corporation · The sale takes place within the first five years after switching to a S corporation
On the bright side, in light of their higher tax cost, sellers may have more leverage in negotiating a higher purchase price.
Buyers typically prefer the asset sale structure because, under IRS regulations, the buyer will receive a step-up in basis of the selling company’s depreciable assets. This means the price paid for the asset is the new tax basis for the property. The buyer can increase its tax deductions for (1) depreciation, by allocating a higher value to assets that depreciate quickly, and (2) amortization, by assigning lower values to assets that amortize slowly, like goodwill. The step-up ultimately reduces the tax liability faster and improves the company’s cash flow during the early years when cash flow is most important. Not surprisingly, this issue can be contentious due to the benefits and costs associated with the outcome.
Another reason buyers prefer asset sales is that they can choose which, if any, liabilities they will assume. Contingent liabilities such as contract disputes, product warranty issues, or employee lawsuits, are of particular concern. Buyers also can opt not to purchase certain assets (e.g., accounts receivable the buyer determines are likely uncollectable).
A potential hurdle for buyers in an asset sale relates to the transfer of certain assets (e.g., intellectual property, contracts, leases, permits), which can raise questions around assignability, legal ownership, and third-party consent. The time it takes to obtain consents and refile permit applications often delays the transaction process.
In some ways a stock sale might be less complex than an asset sale, but asset and stock sales both present challenges. In a stock sale, the buyer purchases the seller’s share in a corporation or the seller’s interest in an LLC or membership in a partnership, in all cases securing ownership of the seller’s legal entity, as well as all assets and liabilities. Any assets and liabilities the buyer doesn’t want can be distributed or paid off before or at the close of the transaction. In contrast to an asset sale, stock sales usually do not require as many third-party consents be obtained because the title of each asset remains with the corporation. The one exception is a change-of-control provision. A contract that contains such a provision will require the consent of all interested parties before ownership can be transferred.
Sellers often prefer stock sales because of their simplicity and the preferential tax treatment they receive. All the proceeds from the sale are taxed at a lower capital gains rate, and corporate-level taxes for C corporations are bypassed altogether. Further, sellers may be able to avoid responsibility for future liabilities, such as product liability claims, contract claims, and employee lawsuits, although the buyer may insist the seller assume these responsibilities.
Buyers typically do not wish to undertake stock purchases since they do not have the ability to step up the basis of the assets and redepreciate 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 will lead to higher taxes for the buyer in the future, compared with its tax liability following an asset sale.
Additionally, buyers may accept more risk by purchasing the company’s stock, including all unknown or undisclosed contingent risk. Future lawsuits, environmental concerns, Occupational Safety and Health Administration violations, employee issues, and other liabilities become the responsibility of the new owner through a stock purchase, unless the parties (1) exclude these unwanted liabilities in the purchase agreement or (2) limit potential liabilities in the stock purchase agreement through representations and warranties and indemnifications.
If the business in question has a large 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 relies on a few large vendors or customers, a stock sale may reduce the risk of losing these contracts.
One benefit of a stock sale to a buyer of 80% or more of a target corporation is provided by Section 338(h)(10) of the Internal Revenue Code. A 338(h)(10) election allows a buyer of stock to treat the transaction as an acquisition of 100% of the assets of the target for tax purposes. Similar to an asset sale, this election may provide significant tax savings to the buyer.
Which Structure Is Right for You?
Asset purchases are less risky for the buyer. In an asset purchase, the buyer selects the specific assets it will acquire and the liabilities the seller will assume. This selection process limits the buyer’s risk but causes the seller to pay more taxes. In a stock purchase, a seller’s tax cost is lower, but the buyer assumes more risk — both known and unknown associated with the seller’s assets and liabilities — but this risk can be offset with careful structuring.
Take time to carefully weigh your options before deciding how to structure your transaction. Partner with a trusted investment banker, attorney, and CPA early in the process to fully understand which option will give you the outcome you want.