I recently finished helping a client sell their business – a small printing business with a few assets. My client had already employed the services of a broker to assist with the deal – a sale to a another print shop looking to expand into the Denver market – and my services were primarily to review existing documents and make necessary changes or draft additional required documents.
As with most transactions, the first document I reviewed was the letter of intent, which expresses the intent of the parties to enter into an agreement and provide for a basis for some of the more material provisions of the eventual contract. In the letter of intent, the broker had set up the sale as an asset sale as opposed to a stock sale. As the attorney for the seller, I highly recommended that this structure be reconsidered, particularly, because my client was structured as an S Corporation.
A asset sale and stock sale look very similar when the transaction is completed – the seller receives the proceeds of the sale and the buyer receives all of the assets of the business. With an asset sale, the business sells to the buyer, all of the assets of the company, the company calculates gain and distributes the sale proceeds to the seller. The seller recognizes gain as calculated and passed through from the entity level (due to the S Corporation being a disregarded entity for tax purposes).
A stock purchase works a little differently. With a stock purchase, the individual shareholder(s) sell their interest in the company to the buyer. The buyer assumes control of all assets by virtue of their ownership of the company itself.
By looking closely at what is actually transferred, it is easy to see how the structure can benefit one party over the other. With a stock sale, the buyer is assuming ownership of both assets and liabilities – including potential liabilities from past actions of the business. The buyer is merely stepping into the shoes of the previous owner and the business continues on. Whereas, the purchase of assets does not inherently include any liabilities other than those attached to the individual assets. The seller continues to be the owner of an asset-less entity until the entity itself is dissolved.
Less clear to people, is the tax ramifications of both transactions. With a stock sale, the owner is treated as making a disposition of a capital asset and any proceeds will receive capital gain treatment, generally taxed at 0 – 23.8%, but dependent on the owner’s income.
The calculation of the asset sale is different. The assets will likely receive capital gains treatment, but could also be subject to depreciation recapture. Business assets or expenses for which no deduction in full can be taken are typically allowed to be depreciated over a number of years, depending on the asset’s category according to IRS tables. This depreciation allows the business owner to take a deduction each year against income of the business. The depreciation is intended to correlate with the useful life of the asset. If an asset is to be depreciated over 5 years according to IRS tables, the IRS’s view of the useful life of the asset is 5 years, after which, the asset is likely obsolete or of little to no value.
However, in situations where an asset sells for more than its depreciated value the gain attributable to the sale will be taxed at ordinary income rates instead of capital gain rates due to the depreciation recapture. While the seller is at a tax disadvantage by possible receiving ordinary income instead of capital gains, the buyer is able to allocate the purchase price to specific assets and receive a step-up in basis. This step-up in basis allows the buyer to “re-depreciate” the same asset – a boon for the buyer. Had the buyer completed a stock sale, the basis of the assets would have remained the same without the aforementioned step-up.
Each situation is different, but with my client, it made more sense to structure the transaction as a stock sale than an asset purchase. There are elections that can be made, particularly with the sale of an S Corporation, that allow some of the benefits of both an asset sale and a stock sale to be utilized. These elections require the cooperation of the parties but can help equalize the benefits between buyer and seller to some degree.
Patrick Curnalia is an estate and tax planning attorney with Curnalia Law, LLC. Patrick has worked with many clients to help them achieve their planning goals. Our firm services the entire Denver area and is located near the Denver Tech Center. Find out more about how our firm can help you by visiting our website at www.curnalialaw.com.