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August 23, 2023
When selling a business, the buyer and seller must decide whether to structure the transaction as an asset sale or a stock sale.
While asset sales are far and away the most common structure, they are not right for every deal.
Most common
An asset sale tends to be the most straightforward transaction.
The buyer creates a new business entity and transfers substantially all of the assets of the old company into that new corporation.
So, technically, they never owned the past company.
This is the simplest (i.e. the most legally cost-effective) way to shield the new owner from residual liability from the original business, generally protecting the new entity from lawsuits, past employee issues or environmental concerns.
From a tax standpoint, an asset sale allows buyers to step up the depreciable basis of the acquired assets.
Buyers are generally looking to allocate a higher portion of the purchase price to the “hard” assets with shorter useful lives or higher depreciation rates versus the intangible assets with a longer depreciation rate.
Hard assets, like equipment, can generally be depreciated over five years versus goodwill, which can be depreciated over 15.
When done appropriately, according to IRS guidelines, an asset sale can be tax advantageous to the buyer, resulting in reduced taxable income.
For sellers, asset sales can result in higher taxes.
Generally, any gain on hard assets is taxable at the seller’s ordinary income tax rate.
This is typically higher than the capital gains tax rate paid on intangible assets like goodwill.
If the seller has depreciated the assets over time, they may have to recapture some of the depreciation deductions when they sell.
This means they will have to pay taxes on the amount of depreciation they have taken, even though they have not actually received any cash from the sale of the assets.
If the seller is a C-corporation, they could face a double taxation issue.
The corporation will be taxed on the gain from the sale of the assets, and this gain will then be taxed again when the seller distributes the proceeds of the sale to the shareholders.
When a stock sale makes sense
In a stock sale, the buyer acquires the stock or membership interest of the company – this includes the transfer of the company’s assets, liabilities, contracts and permits.
The buyer assumes the target company as a whole, including any liabilities that may exist (unless negotiated otherwise).
Stock sales are generally unattractive to buyers due to legal complexities, residual risk and the loss of certain tax advantages.
There are occasions when a stock sale is justified, however, such as when business contracts would be difficult to transfer to the new business entity.
For example, we represented a software company that specialized in state government work. Had the deal been structured as an asset sale, most of the company’s contracts would have had to go before state budgetary committees for reapproval.
Some contracts even had an exit clause that would have triggered a whole new bid process. Overall, the logistics and risks made an asset sale impractical.
On occasion, we might also see a stock sale when there is a lot of competitive interest in the business.
Because a stock sale is generally tax advantageous to the seller, offering to do a stock sale can help make the buyer’s offer more attractive.
Be aware, however, that stock sales can require greater legal work and negotiations because there’s not a clean line of separation like an asset sale.
The buyer’s attorneys will also be looking to shield their client from risk with a laundry list of representations, warranties and indemnifications.
Stock sales can benefit sellers because the proceeds are taxed at the lower capital gains rate. And if the seller is a C-corporation, the double taxation issue is eliminated because there are no corporate-level taxes.
Buyers, meanwhile, cannot take a stepped-up basis (or book value) on the assets they acquire.
The current basis sets their depreciation basis – this means the buyer loses out on certain tax advantages they would have gotten in an asset sale.
Case-by-case basis
Ultimately, the decision of whether to sell the business through an asset sale or a stock sale is a complex one that should be made on a case-by-case basis.
Business owners should consult with an experienced M&A intermediary, along with specialized tax and legal advisors, to discuss the most advantageous way to sell their business.
