How to Structure the Purchase or Sale of a Business
Portland Business Purchase Structure Attorney
Vancouver Asset Sale Lawyer
A buyer can acquire a business in two general ways. First, he or she can buy company stock from shareholders—a “stock sale.” Second, he or she can buy the company’s assets, from the entity itself—an “asset sale.” Tax and liability consequences vary depending on what, exactly, is bought. Before deciding whether to structure a sale-of-business transaction as a stock sale, asset sale, or both, it is important to understand and evaluate the consequences of the choices.
The simple sale of stock can involve fewer documents and headaches than an asset sale, as the parties usually need to execute only one bill of sale. However, exposure to liability might matter more to a buyer than simplicity. In general, a buyer is often better off avoiding a stock sale so as to avoid acquiring an entity that is still subject to its pre-sale liabilities. These liabilities include legal responsibility for defective products, warranties, and tax obligations, among other things. A seller, on the other hand might prefer a stock sale because it discharges him or her of responsibility for the business’ liabilities, but he or she must make sure to comply with applicable securities regulations. Both parties need to make sure that all liability and compliance issues are covered flawlessly – the only way to do this is to consult a specialist.
The buyer who acquires a business by purchasing its stock can compensate for the extra liability assumed by getting the seller to agree to as many of the following contract terms as possible.
The buyer should seek:
- Seller warranties that the business meets explicit specifications, set out in the written purchase contract and financing statement. For example, the seller may warrant that the entity’s present and foreseeable future liabilities do not exceed a certain amount, or that the operations site is free of contamination that would expose the new owner to environmental liability;
- An indemnification agreement obligating the seller to reimburse the buyer’s extra costs if the business fails to meet the seller’s warranties;
- A buyer-to-seller payment schedule of installments over time, rather than one lump sum. For example, the buyer might place part of the purchase price in escrow with a trusted third party, who holds the money until the buyer is satisfied that the condition of the business is as promised. The buyer might also allocate part of the purchase price to a promissory note, or pay in two closings and perform a final audit in-between; and
- Allocating part of the purchase price to a consulting arrangement, whereby a stock seller sticks around to provide operations advice for cash.
Buyers will never know everything about a prospective acquisition before they purchase it. Contracts can be constructed, however, to insulate a buyer from the risks.
The sale of multiple assets can lead to greater transactional complexity than a stock sale, in that the number of documents involved can increase exponentially with the number of assets transferred. A buyer generally prefers an asset sale to a stock sale because, while he or she might have to share control of business direction with stockholders, the stockholders retain responsibility for the entity’s pre-sale liabilities. The buyer also has greater control over liabilities assumed. For example, an asset buyer may contractually limit his or her liability for business obligations to those that arise post-sale or relate to assets actually acquired. These factors may make an asset sale more attractive than a stock sale for a buyer, despite the greater transactional simplicity and business control gained from the latter.
In addition to liability and transactional complexity considerations, it is important to understand the federal income tax implications of how you structure your sale-of-business transaction.
As with liability, a stock sale is also advantageous for the seller for tax purposes. The reason for this is that when a shareholder sells the stock for a higher price than he or she bought it for, the IRS recognizes that income as capital gain, and taxes it at a lower rate than the ordinary income that would result from the sale of assets. Capital assets, the sale of which results in capital gain or loss, are items used in a business over a long period of time. Besides stock, such assets include real estate, equipment, and community goodwill.
A buyer, on the other hand, generally prefers the tax outcome of an asset sale because of the positive effect on the buyer’s “basis” in the assets acquired. “Basis” is the value tax law assigns investment property to determine the investor’s gain or loss on a transfer of the property. Usually, basis equals what the property cost the buyer. If the buyer acquires the property without paying for it, the buyer usually gets a “carryover basis” in the property, equal to what the seller paid for it. So, in a stock sale, the buyer gets a basis in the stock equal to what he or she paid for it, and a “carryover basis” in the business assets equal to what the seller paid for them previously.
By contrast, in an asset sale the buyer gets a basis in the assets equal to what he chooses to pay for them. Thus, an asset sale gives a buyer more control of how much tax liability he or she incurs, because the buyer can “step up” his or her basis in assets acquired by paying more for them than the seller did. With a higher basis, the buyer will recognize less gain when he or she eventually sells an asset that goes up in value, and can take bigger deductions on depreciable assets in future tax years.
In an asset sale, a seller should try to assign as much of the sale price to capital assets as possible, because of the lower tax rate mentioned above. The seller should avoid selling assets that result in ordinary income, which is more highly taxed. Assets, the sale of which result in ordinary income, include inventory, receivables, and covenants not to compete. A buyer should try to assign as much of the sale price as possible to depreciable assets, which generate deductions for future tax years. Depreciable assets include equipment and buildings, but not land.
Intangible assets can also be part of the asset sale. Under the Internal Revenue Code, the buyer can take depreciation deductions on intangible assets by spreading their initial cost over the “useful life” of the asset, or a fifteen-year period. Intangible assets include community goodwill, business methods, in-place employees, licenses, patents, trademarks, trade names, copyrights, designs, “covenants not to compete,” and supplier and customer loyalties.
Since the corporation itself recognizes no gain or loss when its stock is sold, a stock sale results in “single tax” for the seller. An asset sale, by contrast, can result in “double tax” for a C corporation seller. Double tax occurs as follows: first, the corporation itself is taxed on any gain from selling the assets to the buyer. Second, the shareholders are taxed on proceeds from the corporate liquidation that frequently ensues. A seller can avoid this “double tax” if the business is anything other than a C corporation, including a partnership, S corporation, or limited liability company. For such entities, only shareholders, and not the entity itself, get taxed on gains from the sale of assets.
In general, the seller of a business prefers a stock sale, and the buyer prefers an asset sale, for both liability and tax reasons. Of course, individual situations vary and parties can compensate for unfavorable tax and liability consequences by compromising in other areas, such as sale price and indemnification agreements. To a party unaware of the liability and tax implications, a sale that seems like a great deal at the time can financially break that party down the road. Thus, parties should be sure to understand the basic legal implications of different sale structures before entering negotiations.
Bringing counsel in early is the best way to learn the implications of your options before sale negotiations, which leads to faster and smoother agreements. With less time spent on legal negotiations, you have more time to pursue your business goals.