Business owners contemplating a sale of their business need to understand the different types of transaction structures and the related tax implications of each. Generally, transactions are structured as either a sale of equity or as a sale of the company’s assets. There are many factors to consider in determining whether to sell equity or assets. Ultimately, the structure will be negotiated between seller and buyer. This article will discuss the main differences in the tax consequences of the two types of transactions.
In an equity sale, the business owner sells their ownership interests in the company directly to the buyer. All of the assets and liabilities of the company remain with the company, and the buyer simply “steps into the shoes” of the seller. While the overall consideration in an equity sale is typically determined with reference to the value of the underlying assets and liabilities, the buyer does not receive a “step-up” in basis for the acquired assets. Instead, the buyer has a carryover basis which results in no immediate tax deduction for the purchase. The buyer also assumes all of the company’s liabilities, regardless of whether they are known at the time of the purchase. A common example of an unknown liability that the buyer becomes liable for is a tax assessment that arises after the transaction, even though it relates to a period before acquisition. The amount paid becomes the buyer’s basis in the equity, which will only be recovered upon a subsequent disposition.
The seller, on the other hand, has a much more favorable tax outcome. Any gain from the sale of the equity will likely be treated as capital gain and will be taxed at potentially favorable tax rates. Further, the sale of equity will typically be treated as the sale of an intangible asset, potentially resulting in gain only taxed in the seller’s resident state.
In an asset sale, the buyer has the option to choose which assets (and liabilities) they want to acquire (or assume) directly from the business. Unlike the equity sale, in an asset sale the buyer receives a “step-up” in basis for the assets acquired based on an allocation of the overall purchase price. The buyer and seller must agree on how to assign values to each asset acquired. This allocation is referred to as the “purchase price allocation” and is generally based on the fair market value of the assets. If the overall purchase price exceeds the aggregate fair market value of the assets acquired, the residual is allocated to goodwill. Generally, the buyer can immediately recover the purchase price through depreciation and amortization deductions on the “stepped-up” assets, including goodwill.
Unlike an equity sale, which generally results in capital gain, an asset sale could result in some portion of the gain being treated as ordinary income, which is not subject to favorable tax rates. Gain from the sale of assets such as appreciated inventory, accounts receivable, fixed assets, and others will generally result in ordinary income instead of capital gain.
From the seller’s perspective, the gain must be reported on the company’s tax return. Depending upon the company’s tax structure, additional tax may be due at the shareholder level, resulting in double taxation. For example, if the company is taxed as a C corporation, the C corporation will pay tax on the gain from the asset sale and, when the shareholders take distributions of the net sale proceeds from the C corporation, they too would be subject to tax on the distribution received.
From a state tax perspective, some states will require that the gain from an asset sale be apportioned to the state based on the same apportionment methodology used to apportion operating income. Unlike an equity sale, where the gain is only taxed in the resident state of the selling shareholder, an asset sale generally results in tax liabilities in multiple jurisdictions.
As you can see, the tax consequences for the buyers and sellers vary greatly depending on the deal’s structure. Depending on the circumstances, one structure may be more beneficial than the other, and sometimes legal issues may necessitate one form over the other. Buyers generally want to acquire assets and sellers generally want to sell equity. The possibility does exist for both buyer and seller to get what they want. One of the most common negotiated provisions is a “tax gross-up,” whereby the buyer will gross-up the purchase price for the additional taxes owed by the seller as a result of structuring a deal as an asset sale instead of an equity sale. The seller will be in the same net cash flow position as if the deal was structured as a equity sale and the buyer benefits from the stepped-up basis in the assets. For more information, please reach out to your WG advisor.