This post is Part III of the Selling Your Small Business series.
Check out first two parts here:
This Part III of the Selling Your Small Business series of posts discusses the two main options for structuring the sale of a business: the sale of the assets of the business and the sale of the equity interests in the business entity (stock in the case of a corporation, ownership interests in the case of LLCs, LPs, etc.). The two options have very different consequences for each party, especially in terms of their tax implications. Generally, the seller will favor a sale of the equity, while the buyer often will prefer to purchase the assets. This post broadly describes the differences between the two approaches and the tax and liability implications of each upon the purchaser and the seller.
For purposes of this post, we will set out a few defined terms. The company being sold (or the company owning the assets being sold) will be referred to as the “Target Company”. The owners of the Target Company, whether they are individuals or entities, are referred to as the “Owners”, while the purchaser, which will be an entity, is referred to as the “Purchaser”.
Timing of the Determination
The decision to structure the transaction as an asset sale or a sale of equity interests should be made early in the process, as it will fundamentally affect the terms of the transaction and even its ultimate viability. The determination of the transaction’s form is one of the key items in the Term Sheet.
Tax Treatment of Each Option
The difference in tax treatment between an asset sale and a sale of equity stems from the fact that the transfer of tangible and intangible assets (e.g., equipment, materials, facilities, inventory, intellectual property and, “goodwill”, etc.) of the Target Company is treated very differently for tax purposes than the transfer of the equity of the Target Company. In addition, if we assume the Owners are entities, the legal form of the Owners has a fundamental effect on the tax consequences of the transaction to them. The parties must therefore consider taxation at two levels: (1) first, in the case of an asset sale, the tax treatment to the Target Company of the asset purchase price must be considered as well as the tax effects of the purchase of the assets upon the Purchaser, and (2) second, the tax effects of the sale of the Target Company’s equity upon the Owners of the Target Company, as well as the tax benefits to the Purchaser which are lost in a sale of equity as opposed to an asset sale.
Taxation of Entity Types Generally
First, it is important to understand the way in which different business entities are taxed. If an entity is structured as a C-Corporation (a traditional corporation), it is subject to tax itself, whether as capital gains or at the corporate tax rate. Additionally, the owners of the C-Corporation are taxed upon the distribution of any amount to them, effectively resulting in “double taxation.”. Distributions from a C-Corporation are generally taxed to individual owners as dividends, at a reduced rate from the shareholder’s ordinary income tax rate. Conversely, other types of entities, such as LLCs, limited partnerships, or corporations electing to be and qualifying to be treated as “S-Corporations” are afforded “pass-through” tax treatment. “Pass-through” treatment is effectively just as it sounds. Pass-through entities are not taxed; instead, their owners are taxed on the character of the income to the pass-through entity (e.g., as capital gains, ordinary income, etc.).
For example, if an Owner of the Target Company is a C-Corporation, that Owner pays tax on the purchase price received from the Purchaser and then, when that amount is distributed to the Owner’s shareholders, the shareholders will pay tax on their portion as a dividend. Alternatively, if an Owner is a pass-through entity, that Owner will not pay tax on the purchase price; rather, each member or partner of that Owner will pay tax on its respective portion of the purchase price. In a sale of equity, that portion will be capital gains because the character of the income (capital gains) to the Owner entity is passed-through to the partner or member, while, in the case of an asset sale, the portion of the purchase price will be a mix of capital gains and ordinary income.
In deciding between an asset sale or a sale of equity, a seller should consult legal counsel and/or an accountant. These persons can help the seller evaluate the benefits and drawbacks of each type of transaction in depth. Given the direct and potentially very substantial economic effect on the purchase price arising from the choice of the form of the sale, competent advice based on the seller’s particular circumstances is imperative.
Sale of the Assets
In an asset sale, the Purchaser buys the assets and takes on only the liabilities of the Target Company that it chooses. This is particularly useful where the Purchaser is seeking only a portion of the Target Company’s business or only certain of its product lines. Further, in an asset sale the Purchaser will not as a result of purchasing equipment and other assets be subject to undisclosed liabilities tied to the Target Company’s business, such as product liability claims, contractual liabilities, warranty issues, and employment-related claims against the Target Company, among others, as it would in purchasing the Target Company’s equity. Note that under certain limited circumstances, however, liability for past defects and damages caused by the Target Company’s products may be imputed to the Purchaser if it carries on substantially the same business in the same manner as the Target Seller (e.g., keeps the same names of products, uses the same marketing, makes no design or other changes, etc.).
Additionally, an asset sale can provide the Purchaser with tax benefits that the purchase of the Target Company’s equity will not provide. Depending on the amount the Purchaser pays for the Target Company’s hard assets, it may be able to claim a higher basis in the asset and obtain greater depreciation that it can claim over time and apply against what would otherwise be taxable gain. In effect, the purchase may create paper losses for tax purposes that can offset real income, lowering the Purchaser’s tax burden. A full description of the benefits that can be claimed are outside of the scope of this post, but such benefits often lead a Purchaser to favor an asset sale.
Conversely, the amount paid to the Target Company for its assets will result in a mix of capital gains and ordinary income. Compared to the sale of equity option, described below, which results in the entirety of the purchase price being taxed as capital gains, the asset sale is less desirable to a Target Company and its Owners.
Thus, in an asset sale, a buyer has potential tax benefits as well as greater flexibility to tailor the transaction to its specific needs and goals. A seller, however, generally would prefer not to be left with only a portion of the assets needed to run its business as well as liabilities which it must use the purchase price to offset, and finds the equity sale a more tax-advantageous option.
Sale of Equity
In the sale of the equity of the Target Company, the Owners are taxed as an individual or as an entity (whether pass-through or not), depending on the circumstances. Where the Owners have held their equity interests in the Target Company for over one year, the sale of those interests will be capital gains to the Owner. Thus, the treatment of the full purchase price as capital gains is preferable to the Owner over the mixed capital gains and ordinary income paid to the Target Company in the event of an asset sale, as described above.
In addition, in the sale of the Target Company’s equity, the Purchaser is taking on the full assets and liabilities of the Target Company. This is preferable to the Owners, as they are otherwise left with a shell of a company containing some assets and liabilities, but potentially not enough to carry on a business should they even desire to do so. Conversely, as discussed above, the Purchaser is unable to benefit from a higher basis in equipment which would allow it to use the resulting depreciation to offset profits for tax purposes.
The determination of which type of sale to employ is a fundamental structural point of the transaction that the buyer and seller must agree upon. It is of key importance. Given the substantial tax differences that can arise, and the substantial effect such differences can have upon the purchase prices and/or the attractiveness of the deal as a whole, it is a determination that should be conducted in consultation with counsel or a trained accounting professional experienced with these determinations.
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