Asset Sale vs. Stock Sale When Selling a Business
The life of a business owner is often defined by competition. Competing for customers, talent, brand recognition and more are second nature. Selling a business also involves competition in the form of the competing interests of the seller and the buyer. Generally, the seller prefers a stock sale while the buyer prefers an asset sale.
In this article, we’ll highlight some of the most important differences between the two structures and point out the tax implications both parties should be aware of.
We also recommend engaging a CPA early in the sales process to receive a thorough breakdown of the tax differences between an asset sale and a stock sale in your particular situation.
An Important Note About Different Business Types
Before diving into the differences between asset sales and stock sales, we should point out that transactions involving certain types of businesses can’t be structured as stock sales.
Sole proprietorships, partnerships and LLCs do not have stock. Instead, they have partnership interests or membership interests.
Transactions involving these types of businesses can be structured as asset sales or as sales of interests, and the tax treatment will be the same for both.
That’s because, due to certain tax rules, all sales of these entities are treated as asset sales. The seller and buyer can frame the transaction as a sale of an interest or the sale of an asset, but the tax implications are the same either way.
The asset sale versus stock sale question arises only when the selling company is incorporated, either as a C-corporation or an S-corporation, or if an LLC has previously elected to be taxed as an S corporation. For the rest of this article, we’ll assume we’re dealing with a corporation.
Asset Sales: Buyers’ and Seller’s’ Viewpoints
In an asset sale, the business sells individual assets to the buyer. Often, the buyer forms a new entity, and it is that entity that purchases the assets.
The assets can be goodwill, equipment, inventory, customer lists, intellectual property, real property or anything else the selling company owns.
The buyer also purchases the company name and branding. Asset sales normally don’t include cash, and typically the seller has to retain any long-term debt obligations.
The Buyer’s Tax Perspective on Asset Sales
We stated that buyers usually prefer asset sales over stock sales. A major reason for this is that IRS guidelines require the seller to sell the assets at market value.
As a result, the buyer receives a stepped-up tax basis on those assets. Buyers want the stepped-up basis because it gives more room for the buyer to depreciate those assets in future years.
Additionally, within IRS rules, assets that depreciate quickly, such as equipment and other tangible items, can be assigned a higher value at the time of sale.
Likewise, slowly depreciating assets, such as goodwill, can be allocated a lower value. This strategy helps the buyer reduce taxes sooner and frees up cash flow.
Buyers also prefer asset sales for another reason: The buyer can typically avoid taking on the liabilities of the selling company. Sellers usually remain responsible for debts. More importantly, sellers cannot usually transfer contingent liabilities to the buyer.
Contingent liabilities are problems going on inside the company that the buyer doesn’t really have a way of knowing about. Examples include contract disputes, warranty claims, or potential employee lawsuits alleging discrimination or harassment.
The Seller’s Tax Perspective on Asset Sales
Asset sales typically bring some tax disadvantages for sellers. For one thing, asset sales lead to higher taxes because many “hard” assets are subject to ordinary income tax rates, not the lower capital gains taxes.
For example, gain on the sale of buildings, equipment and other tangible items will be taxed at ordinary income tax rates to the extent the seller has claimed depreciation expense. Intangible assets, such as goodwill, are taxed at capital gains rates.
This mixed tax treatment means sellers often want to negotiate to allocate as much value to intangibles as possible because any gain on the sale of intangibles is taxed at the lower capital gains rate.
This is in opposition to the buyer’s preference which, as mentioned above, is to have more value assigned to hard assets because those depreciate quicker than intangibles.
At the end of the day, for sellers, asset sales normally result in gains that generate both ordinary income taxes and capital gains. Moreover, sellers should keep in mind that any capital gains could also be subject to the federal 3.8% net investment income tax (NIIT).
Your CPA can help you understand how NIIT affects the tax picture of the transaction.
Stock Sales: Buyers’ and Sellers’ Viewpoints
In a stock sale, the buyer purchases the equity (stock) from the selling company’s shareholders.
The buyer thereby acquires ownership of the seller’s legal entity (this differs from an asset sale, where the seller sells assets, including the company name, but retains the legal entity). Stock sales are simpler to execute because they don’t require numerous transfers of individual assets.
The Buyer’s Tax Perspective on Stock Sales
Buyers usually don’t like stock sales because such sales don’t allow the buyer to get the stepped-up tax basis discussed above. Instead, the buyer inherits the tax basis of the seller in the underlying assets of the company. Thus, the buyer cannot re-depreciate the acquired assets. This results in lower depreciation expenses for the buyer and higher future tax bills.
Tax law does contain one possible way for a stock sale buyer to receive a stepped-up basis: by performing a 338(h)(10) election. This is an intricate step and one that you’ll want to be sure to ask a CPA about so you don’t miss a potential opportunity.
Additionally, buyers in a stock sale end up purchasing all the risks, including the unknown contingent risks. This means the buyer is taking on a lot more potential liability than they would take on through an asset sale.
The Seller’s Tax Perspective on Stock Sales
Sellers generally favor stock sales over asset sales because all the gains of a stock sale are taxed at the lower capital gains rate. In fact, in C-corporations, the corporate level taxes are bypassed altogether. Sellers also prefer stock sales because the buyer takes on all the company’s risks and liabilities.
In Practice, Most Deals Are Asset Deals
The large majority of business sales, at least in the small- and medium-sized business world, are asset sales. There’s no hard and fast rule, but if the company being sold is valued at around $50 million or less, it’s highly likely that your transaction will be an asset sale.
The reasons for the domination of asset sales are the two main reasons we’ve covered in this article: Buyers really want the stepped-up tax basis, and they don’t want to assume any unknown, contingent liabilities.
Asset sales allow the buyer to accomplish both of those goals. And, because the buyer is usually in a more powerful position than the seller, the buyer often gets what the buyer wants.
Meet With a Tax Advisor
While you may be laser-focused on the sales price when it comes time to buy or sell a business, don’t fall victim to tunnel vision. Engage a Certified Public Accountant early in the process so you can get tax projections and understand post-sale after-tax cash flow.
You don’t want your deal to get right up to the finish line only to realize that you might be paying too much in taxes. The CPA can also prepare quality of earnings reports and other essential tools for evaluating the business.
Boeckermann Grafstrom & Mayer has extensive experience helping buyers and sellers structure tax-efficient sales. As an entrepreneurial CPA firm, we take pride in helping other business-minded people succeed. If you’d like to discuss your situation with a qualified CPA, call us today at 952-844-2500 or send us a message.