Before you sign on the dotted line, understand this: Your decision to sell your company’s stock (or ownership interest) versus your company’s assets can have a massive impact on the taxes that Uncle Sam will take from you and ultimately, what ends up in your pocket. The following is a high-level summary of what you need to understand when comparing a stock (i.e., ownership interest) sale vs. an asset sale:
Determine How Your Entity is Taxed for Federal Income Tax Purposes:
Please note that many clients and advisors tell me that the entity involved in the transaction is taxed as an LLC. Please refrain from saying that your entity is taxed as an LLC. The entity may be formed as a state law limited liability company (i.e., LLC), but it is not taxed as an LLC.
To begin with, obtain the entity’s prior year federal income tax return from the CPA and/or your internal files. If your entity is filing:
- an 1120-S, your entity is an S corporation for federal income tax purposes;
- an 1120, your entity is a C corporation for federal income tax purposes;
- a 1065, your entity is a Partnership for federal income tax purposes; and
- if your entity is not filing a separate return, but the results of the entity’s operations are reported on the parent entity's federal income tax return, an individual owner’s Schedule C, or the parent of the parent (and so forth) entity’s federal income tax return, your entity is a disregarded entity for federal income tax purposes.
Next, Analyze the Likelihood of An Asset Sale or Stock (i.e., Ownership Interest) Sale:
Generally, smaller transactions (below $25 million entity value) are normally transacted as an “asset” sale and not a “stock” or ownership interest sale. Over the last 24 years of practicing law, outside of massive transactions at large law firms, I have probably handled 99% of asset deals ($1 million to $50 million in entity size) compared to approximately 1% of stock (or ownership interest) sales. Based on buyer’s strong desire for asset transactions, if you are receiving the advice to put your entity into a C corporation and do a stock transaction in the future for 1202 treatment, please get a second, third and fourth opinion prior to incorporating this advice.
One of the main reasons for an asset sale is it allows the buyer to write off the new basis in the assets purchased (i.e., shield future taxable income with depreciation, amortization and other immediate deductions) versus a stock (or ownership interest) transaction (that is not treated as an asset transaction for federal income tax purposes), allows simply a new asset on the balance sheet that will be analyzed again when the entity just acquired is sold in the future. Consider that when you purchase Exxon stock as an investment, the next time you will look at the purchase price or basis in such stock is when you sell Exxon stock, and the same generally goes for a stock transaction. Alternatively, in an asset transaction the purchase price could be shielding (i.e., lowering) taxable income for the buyer for years, thus allowing a higher purchase price offered to the seller.
Another reason for an asset transaction is no matter how much the attorneys cover the transaction with representations/warranties/indemnities, in a stock transaction, the buyer is potentially inheriting certain liabilities that might not be taken on in an asset transaction. Think of a stock acquisition of an asbestos company. Regardless of the representations/warranties/indemnities, when the seller is completely broke, the buyer will inherit liabilities that arose before the closing that might not have been inherited in an asset transaction.
Finally, look at your contracts in your business to determine if they are assignable without much energy or effort. If you have contracts that cannot be easily assigned, or a massive number of contracts to get assigned to accommodate an asset sale, you might be able to obtain a stock (i.e., ownership interest) sale.
C Corporation or S Corporation:
If your entity is filing its tax returns as an S corporation or a C corporation:
- proceeds from the sale of your entity’s stock (or ownership interest) that has been held for greater than 1 year will generally be taxed at the capital gains rate, which has a graduated rate structure and a ceiling of 20%, plus an additional tax of 3.8% for Net Investment Income Tax (NIIT) could apply;
- proceeds from the sale of your entity’s assets of a C corporation will be subject to double taxation, 21% at the corporate level and up to 23.8% (20% capital gains + 3.8% NIIT) at the individual level, roughly a 39.8% tax burden in total; and
- proceeds from the sale of your entity’s assets of an S corporation will be subject to a mixture of tax rates, some ordinary tax (up to 37%) and some capital gain tax (20%).
If you are currently in a C corporation, analyze the potential for a stock transaction and then dig into Code Section 1202 (Qualified Small Business Stock) to potentially mitigate the tax. If a stock transaction is not likely, then consider if you have a solid argument for allocating a good portion of the sales price to personal goodwill (subject to capital gains tax rate only) in an asset purchase. Finally, if a stock transaction is not likely and/or Code Section 1202 does not apply, look at flipping the C corporation to an S corporation five years before the transaction to allow the built-in gains tax to run its course.
If your entity is an S corporation selling the assets of the entity, investigate the Code Section 1060 allocation of the purchase price to the various assets (ordinary income taxable assets and capital gain taxable assets), way before the closing (in my opinion, before the LOI). I have seen deals where the allocation of the purchase price under Code Section 1060 is completed after closing, usually resulting in the seller getting nailed with massive amounts of the gain allocated to ordinary income assets (37% tax rate versus 20% tax rate).
Finally, if your entity is an S corporation, be on the lookout for an ownership interest (i.e., stock) acquisition treated as an asset acquisition under Code Section 338(h)(10). The buyer should be compensating the seller to some extent for the additional taxes the seller is incurring in such a transaction. However, I have seen Code Section 338(h)(10) transactions more favorable to the seller via higher basis in assets than stock (in basis analysis remember this little example: I sell an asset with a basis of $100 for a total sales price (amount realized) of $100, I don’t care what the tax rate is as the taxable gain is $0 and $0 x any tax rate is $0 tax), and the majority of the gain was allocated to going concern and goodwill (capital gain assets). I have seen deals where the seller was not even aware that the stock transaction (20% to 23.8% capital gain tax and/or NIIT if applicable) was being treated as an asset acquisition under Code Section 338(h)(10) and the Seller ended up with a large portion of the tax at 37% (ordinary income) as the seller’s counsel was uninformed. Furthermore, don’t put off rolling forward your stock basis in your S corporation, as many CPAs do not track this information (or if you have changed CPAs and such information was not tracked by a prior CPA), and that project is a time-consuming effort that is necessary.
Partnership:
If your entity is taxed for federal income tax purposes as a partnership, in general, the taxation of the sale of the ownership interest and the taxation of the sale of the entity’s assets is the same, or substantially the same. You look through the “partnership interest” in an ownership interest acquisition to the underlying assets character (ordinary versus capital) and taxation thereto, the same as when you are selling the underlying assets of the partnership. Therefore, the Code Section 1060 allocation of the purchase price to the various assets is crucial in determining the character of the gain and the taxation (ordinary income up to 37% and capital gain up to 20%) on the transaction. Furthermore, the debt relief from liability shifts is a crucial analysis in determining the amount realized (i.e., $1 in cash consideration and $150,000 debt relief is $150,001 amount realized and potential taxable gain thereto) and must be analyzed by tax professionals.
Disregarded Entity:
If your entity is disregarded (e.g., you complete Schedule C on IRS Form 1040 for reporting your entity’s operations yearly) for federal income tax purposes, the sale of your entity's ownership interest is treated as a deemed asset sale for federal income tax purposes. In other words, the IRS treats the proceeds from the sale of your disregarded entity’s ownership interest in the same way that it treats proceeds from the sale of your entity’s assets. Once again, the Code Section 1060 allocation to the various assets should be analyzed before the LOI.
More on the 1060 Allocation:
In an asset sale (or deemed asset sale, or stock sale treated as an asset sale for federal income tax purposes), buyers and sellers allocate the purchase price across seven asset classes, which are in general; (i) cash and cash equivalents; (ii) actively traded personal property; (iii) accounts receivable and other debt instruments; (iv) inventory; (v) all other tangible assets such as land, buildings, vehicles, and equipment; (vi) §197 intangibles (except goodwill and going concern); and (vii) goodwill and going concern value. In general, if the buyers and sellers agree to the 1060 allocation and it is not a situation where only the IRS loses, the IRS will respect such allocation.
This is a key point of negotiation, as portions of the purchase price resulting in gain thereto that are allocated to assets like accounts receivable, inventory, or depreciation recapture on vehicles or equipment are treated as ordinary income (up to 37% tax rate) and are preferred by the buyer. Alternatively, the allocation of the purchase price to seller’s basis in its assets triggers no taxable gain (see above $100 sales price - $100 basis = $0 and $0 x any tax rate is $0 tax), and then allocation of purchase price to land, maybe buildings, and goodwill and going concern results in capital gain tax (up to 20% tax rate), and is thus preferred by the seller. I strongly suggest you start analyzing this 1060 allocation PRIOR TO THE LOI so you can be prepared for the upcoming battle.
Further Help:
If you would like us to help you analyze any of the above issues, please do not hesitate to contact us.