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Those that are considering selling their business or buying one would be well served to think about taxes from the onset. The way a transaction is structured impacts the amount of taxes owed, when those taxes are due, and the tax benefits assumed by the buyer. These differences can be significant.

There are three basic transaction structures: 1) sale of the stock; 2) sale of the assets; or 3) statutory merger. Each structure has unique tax advantages and disadvantages. What makes agreeing on structure so difficult is that what is best for the seller from a tax perspective is usually not best for the buyer, and vice versa.

In this article, I aim to provide a cursory overview of how business sales are treated from a tax perspective and explore some of the various tax strategies buyers and sellers have to think about when structuring a transaction.

While this article attempts to address common tax issues one can expect, the specific facts of any business sale vary on a case by case basis and federal and state tax laws are continually changing. For those reasons, potential buyers and sellers should always consult with a professional tax or accounting adviser.

Tax Overview

It is essential to have a basic understanding of tax basis when considering the impact of taxes on a business sale. There are two types of tax basis:

Inside Basis: The inside basis is the tax basis of the company’s assets.

Outside Basis: The outside basis is the tax basis of the company’s shares.

The tax basis of an asset or stock is initially equal to the cost paid, referred to as the initial basis. For an asset, the tax basis is adjusted over time for any amount paid to improve the assets, less any accumulated depreciation. For stock, the tax basis is adjusted over time for any return of capital. The resulting basis is referred to as the adjusted basis.[1] When a business is sold, the adjusted tax basis determines the gain or loss that will be taxed and the transaction structure determines the type of taxes that will be applied.

(It is important to note that the tax basis of an asset should not be confused with the accounting book value. These can be different and diverge over time due to different depreciation methods – e.g., straight-line depreciation for accounting purposes versus accelerated depreciation for tax purposes).[2]

Stock Deal

A stock sale is the simplest transaction structure and is often the least expensive to execute in terms of taxes and transaction expenses. In a stock sale, the seller transfers their ownership interests in the company (i.e., stock for C corporation and membership interests for limited liability company) to a buyer in exchange for an agreed upon payment. Upon sale, the selling shareholders recognize a taxable gain or loss on the sale equal to the difference in the sale price and the adjusted outside basis. No taxes are applied to proceeds up to the adjusted outside basis; return of capital up until this point is considered a non-taxable return of the initial amount invested in the company. All taxes are paid for at the shareholder level.

Regardless of entity type, the sale will be taxed at the prevailing capital gains tax rate. For investments held over a year, the long-term capital gains tax rate applies. The long-term capital gains tax rate is currently 0%, 15%, or 20% depending on your tax bracket. Investments held for less than a year are considered short-term capital gains and are taxed at ordinary income tax rates.[3]

To illustrate how taxes work in a stock deal, it’s helpful to look at an example. Let’s assume that a company agrees to sell its stock for $10 million and the stock has an adjusted outside basis of $1.5 million. Let’s further assume that the investment has been held for over a year and that the applicable long-term capital gains tax rate of 20% applies.

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In this case, the selling shareholders pay $1.7 million in long-term capital gains taxes and realize net proceeds after taxes of $8.3 million.

Importantly, from the buyer’s perspective, the buyer’s outside basis becomes the purchase price of the stock, and the buyer assumes the adjusted inside basis of the seller’s assets.

Sale of the Assets

In an asset sale, the buyer agrees to purchase all, or a select group, of a company’s assets. The selling company will recognize a taxable gain or loss on the sale of the assets equal to the difference in the purchase price and the adjusted inside basis of the assets. The type and amount of taxes owed from the sale is determined by the kind of legal entity selling the assets.

If the selling entity is a C corporation, federal and state corporate taxes are initially paid at the entity level. If the after-tax proceeds are then distributed to the shareholders in the form of a dividend, which is often the case in a sale of substantially all of the assets of a company, then capital gains taxes are paid on the amount distributed. This is known as a liquidating corporate dividend. Because the sale is taxed twice, this is referred to as the “double taxation problem.”

If the selling entity is an S corporation, a limited liability company (that elects to be taxed as a pass-through entity), or another form of a pass-through entity, the double taxation problem is avoided. Capital gains taxes are paid on the sale of the assets at the shareholder level, and corporate level taxes do not apply. (Note, certain assets are not eligible for capital gains treatment and any gains on such assets are taxed as ordinary income).

To illustrate the difference in net after tax proceeds available to a C corporation that sells its assets versus a pass-through entity, let’s continue with our previous example. In addition to our previous assumptions, let’s further assume that the assets have an adjusted inside basis of $5 million, and that the combined effective federal and state corporate tax rate is 31%.

Due to double taxation, the C corporation generates $7.06 million in after-tax proceeds, while the pass-through entity generates $8.3 million in after-tax proceeds (i.e., the same amount as in a stock stale).

Importantly, the magnitude of the difference in after-tax proceeds between seller entity types is greatly impacted by the size of the gain / (loss) on the sale of the assets which is not always as material as illustrated in the above example. The difference is also impacted by the various tax rates and laws, which are subject to change.

Lastly, it is important to note that from the buyer’s perspective, the buyer’s inside basis becomes the purchase price of the acquired assets.

Statutory Merger

A statutory merger is a transaction in which one legal entity is legally absorbed into another, and the surviving legal entity succeeds to all of the assets or liabilities of the absorbed entity. The entire transfer occurs by operation of law.[4] There are several types of mergers. The two most common are:

Forward Merger: In a forward merger, the target company mergers into the buyer, the target legal entity legally ceases to exist, and the combined companies continue to operate under the buyer’s entity and structure going forward.
Backward Merger: In a backward merger, the target absorbs the buyer, the buyer entity legally ceases to exist, and the combined companies continue to operate under the target’s entity and structure going forward.

For federal income tax purposes, forward mergers are generally taxed in a similar manner as an asset sale, and backward mergers are generally taxed in a similar manner as a stock sale.

Other Considerations

The ultimate structure of a business sale is frequently the subject of intense negotiation, due in part to the differences in tax treatment for the seller and buyer. Frequently, sellers prefer stock deals due to the higher expected after-tax proceeds. Conversely, buyers prefer asset deals because they can record the tax basis of the purchased assets at the price paid (referred to as a “step-up” in basis) which can have favorable tax-benefits for the buyer to the extent they are able to deduct any of the asset values in the form of depreciation against future taxable income.

In practice, the considerations above result in buyers willing to pay slightly more for the assets of a company than they would for the stock. However, this is not always the case, and other tax and non-tax considerations can impact the choice of transaction structure and price.

Net Operating Losses

If a selling company has previously reported a net loss for tax purposes, it may have a net operating loss (NOL). Determining the amount of NOL a company has and whether it is eligible to use in a given taxable year is outside the scope of this article, but in general, the Internal Revenue Service (IRS) allows companies to carry NOLs forward for 20 years to reduce their taxable income and annual NOL deductions are limited to 80% of that year’s taxable income.[5][6] To the extent a selling company has an NOL at their disposal, they may be able to limit the impact of corporate-level taxes that result when a C corporation sells its assets for more than the adjusted inside basis. As a result, the seller may be indifferent as to whether the deal is structured as an asset sale or stock sale from a tax perspective. NOLs can also be relevant to the buyer of a company’s stock. In a stock deal, the buyer assumes any NOLs of the target company, although their future use is subject to limitations under Section 382 of the Internal Revenue Code (IRC).[7]

Seller’s Note, Deferred Consideration, or Contingent Consideration

Another way to mitigate the amount and timing of taxes owed on a business sale is to structure the purchase price to include a seller’s note, deferred consideration, or contingent consideration. Each of these structures has the impact of delaying the receipt of some of the sales proceeds to a future period in time and thus deferring any tax payments that would otherwise be owed at closing. Structuring transactions to include one of these forms of consideration may be a good middle ground for a buyer that prefers to purchase the assets of the business and a seller who is interested in reducing their immediate tax bill and willing to receive consideration over time.

Undisclosed Liabilities

Stock deals expose buyers to significant unknown risks that asset deals do not. In a stock deal, the buyer of the company assumes all of the assets and liabilities of the company, whether disclosed or not. However, in an asset deal, the buyer can pick and chooses which assets and liabilities to acquire and is thus protected from any undisclosed liabilities, which remain with the selling company. Undisclosed liabilities can take many forms, especially when dealing with private companies. Examples include liability for products sold or services rendered; violation of tax, labor, or environmental laws and regulations; threatened lawsuits; and verbal contracts or promises. Such liabilities can lead to future claims or lawsuits which are challenging to quantify and anticipate.[8] As a result, buyer’s usually prefer asset sale. However, an asset sale is not the only means of protection from undisclosed liabilities available to a buyer. In stock deals, the buyer can protect themselves by requiring the seller provide certain representations and warranties stating that all known liabilities have been disclosed and providing indemnification protection to the buyer against future losses from any undisclosed liabilities.

Transaction Costs

Asset deals can have high transaction costs making them cost prohibitive. This is because in an asset deal the buyer picks and chooses which assets and liabilities to acquire which can be expensive and time consuming to document, or simply unfeasible. This may be the case because of the number of contracts that need to be assigned. It may also be that a contract requires counter-party approval to transfer, which may not be granted. For example, in a below-market lease, the counter-party may not consent to a transfer and instead require the buyer to enter into a new lease at the higher prevailing market rates. For some businesses, there also may be a number required licenses and permits which can be difficult to transfer. In deals where asset sales are cost or time prohibitive, a stock deal or backward merger may be a more feasible transaction structures.

While less common, in certain instances, selling 100% of the stock of a company may be difficult. This can be the case if there are many minority interest owners that must consent to a sale and are holding out for a higher price or don’t want to sell. In this instance, a stock sale may be undesirable and more expensive than an asset sale.

Section 338 Election

Section 338(g) of the IRC allows a buyer to elect that the transaction that is structured as a stock sale be treated as an asset sale for federal tax purposes. In this instance, the selling company recognizes a taxable gain on the deemed asset sale which usually becomes the liability of the buyer, and the selling shareholders are still only taxed on the actual stock sale.[9] A Section 338 election can often be a middle ground for a buyer who wants the benefit of a stepped-up inside basis in an asset deal and a seller to sell their entire business, including liabilities.

Summary

The choice of how to structure a business sale is often dependent on deal-specific tax issues. The type of structure used often has the most meaningful impact on the after-tax proceeds available to the seller outside of the actual sales price. Further, what is best for the seller from a tax perspective is often directly opposed to what is best for the buyer. This dynamic can lead to intense negotiations and sometimes prevent a deal from occurring. Tax laws are continually changing and any buyer or seller should always consult with a professional tax or accounting adviser. That said, having a working understanding of the various issues prior to beginning sales discussions can help buyers and sellers address deal structure issues early on in discussions and avoid the possibility of the deal falling apart due to last-minute structural and tax considerations. For the thoughtful and well-advised buyer and seller, there are also many other means outside of choosing between an asset deal, stock deal, or merger, to alter or mitigate the tax consequences of a deal through the use of deferred consideration, NOLs, or Section 338 elections. Taking advantage of some of these options can help buyers and sellers bridge differences, lead to a higher probability of a successful business sale, and ultimately result in higher after-tax proceeds.

The partners at Cronkhite Capital have over 10 years of experience buying, selling, and operating small to medium-sized businesses across industries. If you are interested in learning more about Cronkhite Capital, visit www.cronkhitecapital.com and/or please reach out directly to Ryan Hammon. Email - rhammon@cronkhitecapital.com Phone - (415) 847-8103.