As businesses adjust to the post-pandemic economy and private equity firms increase their searches for new acquisitions, a growing number of business owners may find themselves facing intriguing but unnerving questions about whether now is the time to sell—and if so, how to structure the deal. Among the many factors to consider is the tax consequences of the transaction.

Asset Sale or Stock Sale—the Critical Differences

One of the many decisions to make when selling a business is how to structure the transaction. The two basic choices are an asset sale, in which the buyer purchases specific assets and assumes liabilities as spelled out in the sales contract, and a stock sale, in which the buyer purchases the seller’s shares in the company to obtain ownership of the legal entity.

In the case of an unincorporated business, membership interest, not stock, would be sold since entities such as sole proprietorships, partnerships and limited liability companies do not actually issue stock. While the owners of such entities can sometimes sell their ownership interests, such instances are relatively rare for operating businesses. In most cases, the owners of such entities use asset sales when selling their businesses.

On the other hand, if the business is incorporated—as either a C corporation or a subchapter S corporation—the buyer and seller must negotiate whether to structure the deal as an asset sale or a stock sale. There are pros and cons to each approach but, in general, sellers prefer stock sales, while buyers favor asset sales. The reasons for these differences are complicated, but the tax consequences are often the driving factor.

Tax Treatments of Asset and Stock Sales

In the case of an asset sale, the buyer purchases specific company assets such as equipment, fixtures, licenses, accounts receivable, net working capital, trade secrets, inventory, and goodwill. The seller transfers these assets at fair market value and the buyer’s tax basis is “stepped up” to the same value. This allows the new owner to depreciate or amortize the assets each year, gaining valuable tax benefits and improved cash flow during the crucial early years after the deal closes.

For sellers, the tax consequences of an asset sale are less appealing. For example, while some intangible assets such as goodwill can be taxed at lower capital gains rates, the proceeds from other assets can be subject to ordinary income tax rates. Moreover, if the entity is a C corporation, the seller also faces potential double taxation. The corporation will be taxed upon the sale of the assets, and the shareholders will be taxed when the corporation is dissolved or the proceeds of the sale are distributed out to them.

A stock sale lets C corporation shareholders avoid the double taxation issue, and the gain will be taxed at the lower capital gains rate or possibly excluded if qualified small business stock is sold. For buyers, however, a stock sale means the tax basis of the corporation’s assets is unchanged. Losing the step-up in basis means the buyer will face lower depreciation—and thus higher taxes—in coming years.

Beyond Taxes: the Rest of the Picture

In addition to tax questions, other factors influence how a transaction is structured. For example, the buyer in a stock sale purchases the equity in a company, assuming both its assets and liabilities. This includes potential future liabilities such as contract disputes, product warranty or liability claims, employment lawsuits, and other potential claims. A buyer must factor in such risks when negotiating a purchase price.

On the other hand, an asset sale can also present difficulties, such as problems in valuing or transferring ownership of certain assets such as intellectual property, leases, permits, and key customer and supplier contracts. These problems can complicate the transaction and could delay the sale. In addition, other variations on standard asset or stock sales, such as chapter S reorganizations and special elections or partnership look-through rules, can complicate things further.

In all instances, however, one fact is constant: The tax consequences of the sale will have a major impact on the feasibility and benefits of the transaction for all concerned. Both buyers and sellers should consult with their accounting professionals as early as possible to be sure they are negotiating the structure and terms of the sale from an informed and knowledgeable position.

If you are considering selling your business, please reach out to Holbrook & Manter. We would be happy to answer any questions you may have and we can assist you through the entire process.