What Are You Selling? Assets or Stocks?
The decision whether to structure your sale as a transfer of assets or stocks is truly a tax issue. The short answer is that a stock sale is better for you, the seller, while the buyer benefits from an asset sale. But, since we’re talking about the IRS, there are infinite variations and complications. As such, you will want to get professional tax and legal advice before proceeding.
What Happens in an Asset Sale
In an asset sale, you transfer a collection of the assets your business owns to a buyer. Some of the assets are tangible, like your building if you own it—or your lease if you don’t—and your inventory. Others are intangible, like your customer list and the value of your brand. There may also be liabilities, such as the mortgage on your building or your accounts payable.
Whether you sell all of your assets and liabilities to the buyer is a matter of negotiation, and this can add unwanted complexity to the deal.
The tax consequences depend on the legal structure of your business. C corporations are subject to two levels of taxation, first at the corporate rate when you receive the proceeds of the sale, and again at the individual rate on the distribution to shareholders.
S corporations, limited liability companies, and partnerships are only taxed once as gains are passed through to the owners. But you would pay at the individual rate, which is higher than the capital gains rate that would be applied to an equity sale.
Of course buyers don’t really care about your tax rate. However, they will be strongly motivated by the fact that, in an asset sale, everything they purchase will have a valuation as of the date of the acquisition. This is known as “stepped-up cost basis,” which will be of great value to them when they go to sell the asset. Buyers also receive a “restart” of depreciation and amortization schedules. This is another valuable tax break. And neither of these tax features apply in equity sales. That’s why the asset sale deal structure is strongly preferred by buyers, but not by sellers.
What Happens in an Equity Sale
In an equity sale, the buyer simply purchases all of the owners’ shares in the business and thus acquires all of its assets and liabilities. That makes it a cleaner deal from your perspective as the seller because, unlike in an asset sale, the starting point is that everything’s included.
You’ll also benefit from preferential tax treatment, as you’ll only be paying the capital gains rate on the profit. Congress is constantly adjusting the rates paid on capital gains and ordinary income. Definitions of short- versus long-term capital gains are subject to change as well. Generally speaking, over the last three decades, long-term capital gains rates have been significantly lower than the rate on ordinary income. This is the case as of mid-year 2014.
Again, buyers will care less about your tax rate and more about the fact that they don’t get that stepped-up cost basis and a new start to their depreciation/amortization schedules.
Clearly, it’s in your interest to sell equity rather than assets. It doesn’t really matter if you are not structured properly for an equity sale. You can always restructure and issue shares (or units if you’re an LLC) as needed. However, you’ll want to issue the shares or units at least a year in advance of the sale so you’ll qualify for the long-term capital gains rate.
Professional advice is critical here. Selling your business may be the biggest, most important single transaction that you make in your life. There are lots of options and variations on these two basic deal types, and you should consult with an M&A advisor to find out more about the specifics.