Stock vs. Asset Sales and Purchase Price Allocations

Buying or selling a business can present a number of challenges. One of the most basic–and often most challenging–is the decision to enter into an asset or a stock sale. There are a number of factors to consider in making this decision, one of which is impact of Federal income taxes.

The General Rule

To grossly oversimplify the analysis, the general rule is that buyers prefer asset sales and sellers prefer stock sales. Why?

The Buyer’s Perspective

Buyers generally prefer asset sales as the buyer generally gets a step-up in the tax basis in assets purchased as part of an asset sale. The buyer can then recover the cost for the assets by depreciating the assets or taking an amortization deduction over time.

While not a tax issue, buyers usually prefer asset sales as they can help the buyer avoid liability for costs or events prior to the sale, such as environmental liabilities incurred by the prior owner (this issue can be planned around by purchasing the business with a new corporation or limited liability company and holding the new business as a subsidiary).

Buyers generally do not enter into stock sales as the purchase price is allocated to the stock.  This means that the cost is not recovered by depreciation or amortization deductions.  It can only be recovered when the buyer in turn sells the business, which might not be for quite a long time (Buyers can make a Section 338 election to remedy this issue).

The Seller’s Perspective

Sellers generally prefer stock sales as they are able to take advantage of lower long-term capital gains tax rates. These tax rates are lower than the ordinary tax rates available at the individual shareholder level. Compare this to the sale of corporate assets. The sale of corporate assets is taxed at the corporate level at the higher corporate tax rates and again at the individual shareholder level at the usually lower individual rates. While the seller generally isn’t obligated to pay the corporate level tax, the buyer will factor this into the purchase price–thereby lowering the amount of money the seller receives. And even then, the lower individual rates are often higher than the capital gain rates (this may change as Congress works on changing the tax rates).

Structuring the Asset Sale

Most sales are asset sales. While there are a number of Federal income tax issues to consider, some of the fundamental issues relate to whether and how to allocate the purchase price among the business assets and other assets, such as employment, non-compete, and other agreements.

The Seller’s Perspective

From the seller’s perspective, the tax rates matter. Payments made to the seller that are compensation for services are typically taxed as ordinary income to the seller. Payments made to the seller for non-compete or other agreements are also typically taxed as capital gains to the seller (The non-compete can be taxed as capital gains if it is to effectuate the sale of the business goodwill). Payments made to the seller for business goodwill are taxed as capital gains.

Seller’s often prefer to allocate part of the purchase price to goodwill (or other capital assets).

The Buyer’s Perspective

From the buyer’s perspective, the timing of deductions matter. Payments that are compensation are also immediately deductible by the buyer; whereas, payments for non-compete agreements or goodwill are amortized and deducted over 15 years by the buyer.

Buyer’s prefer to allocate part of the purchase price as compensation.

The Perspectives May Change

The type of entity that is being sold can change the party’s preferences.  For example, a shareholder selling C corp assets may prefer to allocate the purchase price to a non-compete as the payment would be paid directly to the shareholder.  This payment would escape the double tax of the C corp.  Compare this to a shareholder selling an S corp.  The S corp shareholder may prefer to allocate the purchase price to goodwill, which is generally taxed a capital gain rates, so the capital gain will flow through to their personal tax return.

Depreciation recapture can also change the party’s preferences.  Depreciable property may trigger depreciation recapture at ordinary tax rates.  As a result, even a capital asset can be taxed in part at ordinary income rates (for depreciation recapture) and the balance at capital gains rates.  The seller may prefer to allocate just enough of the purchase price to these assets so there is no gain.

These are just a few of the issues that come up in structuring business purchases and sales, but they are often the very issues that can make a marginally not-acceptable deal into an acceptable deal.