Owning and operating a small business is becoming more and more common for more and more people. As technology continues to expand resources and as online companies like Google continue to place more and more emphasis on being “local”, the small business owner has continued to make his return. And, when done right, there will come a time when a small business owner receives a knock on the front door from someone looking to purchase the fruits of their years and years of labor.
If that business owner decides to sell their business, one of the key considerations will be the tax consequences of a sale. The tax considerations of a sale are usually determined based on whether the sale will be structured as: (a) an asset sale; or (b) a stock sale. The following article will highlight the differences between the two; and, suggest whether each structure generally benefits the buyer or the seller. Finally, we will conclude with major considerations to keep in mind when negotiating your sale.
An asset sale involves the sale of all or most of the assets and inventory used in the business. The business owner contracts for the sale of specific business assets, and the seller acquires ownership of those assets when the transaction is finalized. Generally, assets that are not specifically transferred in the contract will be retained by the seller, so specificity during the contract negotiations is critical unless a blanket asset sale of all business assets is contemplated. Furthermore, accounts receivable and cash are generally not part of an asset sale unless specifically given in the contract.
A stock sale is a transaction whereby the purchaser acquires all of the outstanding ownership interest (or shares) of a company, thereby assuming ownership. The buyer acquires both the assets and liabilities of the corporation, typically absolving the seller of any carryover liabilities. Importantly, the assets acquired during a sock sale are not adjusted for tax purposes. This may be significant because it allows continued depreciation of business assets acquired under beneficial tax circumstances, or can prevent a taxable realization event on the acquisition of the business assets. While it is often understood using a stock sale for the business removes the seller from any continuing interest in the business, it is often beneficial for the buyer to specifically contract for a complete severance of all seller activities in or relating to the business.
Which Sale is Right for You?
Buyers and sellers will typically disagree whether an asset sale or a stock sale is appropriate. Asset sales tend to benefit the buyer. In an asset sale, (at least some) liabilities are usually retained by the seller, which make asset sales particularly attractive for the buyer because they do not have to worry or budget for hidden liabilities. Furthermore, from a tax perspective a buyer benefits form an asset sale because the purchaser takes a “stepped up” basis in the property when it is acquired. The stepped up basis is the fair market value of the property, not the agreed upon purchase price. Therefore, if the buyer acquires property for less than fair market value in an asset sale, and the property appreciates above fair market value thereafter, the purchaser ultimately pays less tax when they in turn sell the property. Additionally, acquiring the property at a stepped up basis may allow the purchaser to take bigger depreciations on the property, and thus bigger tax deductions in future tax years.
Conversely, sellers tend to prefer stock sales. Stock sales allow a seller to completely sever ties and liability with their former business under most circumstances. Furthermore, sellers of a corporation are not subject to double taxation when their business is purchased under a stock sale. Unlike an asset sale, the profit from the sale is taxed directly to the seller without having to be taxed at the corporate level. This results in considerable tax savings to the seller, especially if the stock sale is taxed at the preferential capital gains level rather than their individual tax bracket. Finally, a stock sale may be beneficial for a seller that wishes to retain some involvement with their former business, such as acting as a consultant or advisor, without having to worry about the company’s day-to-day operations. This can be especially important in the sale of family owned businesses to younger family members or friends as part of a business succession plan.
The Bottom Line
Despite the general rules of thumb above, choosing between an asset or stock sale is a fact intensive, tax and liability driven decision. Although lawyers and accounts will inevitably become involved in such a complex transaction, keep the “golden rule” in mind during your sale negotiations. Maintaining good faith and being up front about the benefits and detriments of structuring the sale as an asset or stock sale can be very important. Conducting the negotiations in an atmosphere of fair dealing and ordinary business practice allows each party to walk away from the table having made an informed and mutually agreeable decision. This may in turn allow for future business dealings. Furthermore, being open about desired sale structure may forestall future litigation if either party feels they were fraudulently induced or that critical facts were materially misrepresented.
Patrick R. Norris, J.D., Norris Legal, L.L.C.
Thank you for reading this article. The information contained in this article is for discussion purposes only. The information contained in this article is not legal advice upon which you should act and simply reading this article does not make you a client of Norris Legal, L.L.C. or any other law firm. Thank you again.