By Kenneth H. Bridges, CPA, PFS November 2015
Thinking about selling your company? How you structure the transaction could have a significant impact on the after-tax amount you realize.
Asset sale or stock sale – As a general rule, buyers prefer asset deals and sellers prefer stock deals. From the buyer’s perspective, with an asset deal the buyer avoids taking on potentially unknown liability claims against the business and gets a “basis step-up” in the assets purchased (generally meaning that the buyer can begin writing off its purchase price for tax purposes over a period of 15 years or less, depending on the nature of the assets purchased). From the seller’s perspective, a stock sale is generally cleaner, usually results in more favorable tax treatment, and means that liabilities go with the business to the buyer. There are exceptions to this general rule of buyers preferring asset deals and sellers preferring stock deals (e.g. there may be valuable contracts which are unassignable), but even then the buyer will generally want a structure that results in the transaction being treated as an asset deal for tax purposes (e.g. a “Section 338(h)(10) election”, as discussed below). Ultimately, the deal structure will most likely be dictated by the seller’s entity type; although this can have a direct impact on the deal price.
C-corps – If the selling entity is a C-corp, then the transaction will most likely have to be a stock sale. With a sale of assets by a C-corp, two levels of taxation result: one at the corporate level, and then a second level of tax at the shareholder level. And C-corps do not enjoy a lower rate on long-term capital gains like individuals do. Accordingly, assuming substantially appreciated assets, the total Federal and state tax bite on a sale of assets by a C-corp can be well in excess of 50% (versus Federal and state tax on a stock sale that would more likely be less than 30%). For this reason, a C-corp seller will generally insist on a stock sale, but, as a result, may have to accept a lower price or a smaller pool of potential suitors.
S-corps – When it comes time to sell the business, the S-corp business has a great advantage over the C-corp business. Similar to a C-corp, an S-corp can be sold in a stock transaction (including a tax-free stock-for-stock transaction as discussed further below). However, unlike with a C-corp, an S-corp can also sell appreciated assets and generally get a tax result similar to that of a stock transaction (i.e. one level of taxation at the favorable long-term capital gains rates that apply for individuals). Assuming the buyer prefers a transaction that is a stock sale for legal purposes but treated as an asset deal for tax purposes, the S-corp can also accommodate this by agreeing to a “Section 338(h)(10) election”, whereby tax law permits a stock transaction to be treated for tax purposes as an asset deal. While an asset deal and a stock deal generally have similar tax results for an S-corp, there can be differences between the two. For example, the S-corp may have ordinary income assets which it is selling (e.g. cash basis receivables, appreciated inventory, or fixed assets subject to depreciation recapture) or its shareholders might be resident in a state with a lower tax rate than that of the state(s) in which the S-corp operates. Also, if the S-corp has been an S-corp for less than 10 years and was at one time a C-corp, then consideration will have to be given to potential exposure to the “built-in gains tax” (corporate level tax which potentially applies to any gain which existed at date the S election was made).
Limited liability companies (LLCs) – LLCs enjoy the single level of tax benefit enjoyed by S-corps, while providing greater flexibility in terms of number and type of owners, equity structure, and allocations. Similar to the purchase of an S-corp, a buyer can generally get asset sale treatment for tax purposes, even if the transaction is structured legally as a purchase of LLC units. Unlike an S-corp or a C-corp, however, an LLC generally cannot be merged tax-free with a corporate purchaser, and (because of look-through rules that apply to partnerships) the owners of an LLC generally cannot avoid having ordinary income with respect to cash basis receivables, appreciated inventory and depreciation recapture. An LLC can often be merged tax-free with another LLC.
Nature of the consideration – The nature of the consideration received in the sale can also have bearing on the resulting tax. If a significant portion of the consideration is in the form of buyer’s stock, then (assuming a C-corp or S-corp target) the stock may be received tax-free (assuming a properly structured tax-free reorganization transaction). Similarly, assuming an LLC seller and an LLC buyer, units of the LLC buyer may be received tax free. If a portion of the consideration is buyer’s note or earn-out, then the gain associated with that consideration can generally be deferred.
Covenants not to compete and consulting arrangements – The buyer will often insist on a covenant not to compete and a consulting arrangement with key shareholders of the seller. Under current law, covenants not to compete generally receive the same tax treatment for the buyer as goodwill and going concern value (i.e. 15 year amortization for asset transaction), regardless of the length of the agreement. Amounts properly classified as payments for consulting services, however, can generally be deducted by the buyer over the period to which the services relate. For the seller, amounts allocated to covenant not to compete or consulting agreement result in ordinary income (and also self-employment tax for consulting services). Accordingly, the seller will generally prefer to maximize the allocation to stock proceeds (generally taxed as long-term capital gain) and minimize the allocation to covenant not to compete and consulting agreement.
Kenneth H. Bridges, CPA, PFS is a partner with Bridges & Dunn-Rankin, LLP an Atlanta-based CPA firm.
This article is presented for educational and informational purposes only, and is not intended to constitute legal, tax or accounting advice. The article provides only a very general summary of complex rules. For advice on how these rules may apply to your specific situation, contact a professional tax advisor.