Buying or selling a business is one of the most important transactions in the life cycle of any company. Understanding how transactions are structured provides leverage in negotiations and maximizes after-tax proceeds.
Depending on which side of the transaction you land on, the tax implications can be very different. Each side will want to structure a deal that is favorable to them. What is most favorable to the buyer is often not optimum for the seller, and vice versa. The following information focuses on the tax aspects involved in the sale of an S corporation (S-corp) interest.
Stock Versus Asset Sale
Generally, there are two ways a company is sold: a stock sale or an asset sale. The mechanics of how each transaction is executed and the tax implications are quite different. Selling stock is fairly straightforward. The buyer and seller agree on a price and exchange the stock for cash. The buyer acquires the entire corporation as of the purchase date. An asset sale is a little more complicated.
As with a stock sale, the buyer and seller will agree on a purchase price. The price will be limited to the assets the buyer is purchasing from the corporation. The buyer is not obligated to purchase all of the corporation’s assets, and the buyer does not assume the corporation’s liabilities. Once an agreement is reached regarding assets and purchase price, the buyer and seller also have to agree on how that price will be allocated to the assets. That allocation will have tax consequences to both the buyer and the seller. Let’s look at the consequences of a stock sale first. Upon the sale of stock, the seller will recognize a gain to the extent the sales price is higher than the cost basis of the shares.
This gain will be taxed at capital gains rates, long term if the shares were on hold for more than one year. If the seller takes an installment note for the shares, the capital gains tax can be deferred until receipt of the installment note payments. This is generally the preferred outcome for the seller because capital gain tax rates often maximize after tax cash flow.
However, from the buyer’s perspective, this may not be the best outcome. The purchase price becomes the buyer’s cost basis in the shares, which will remain until the shares are sold. There is no opportunity for the buyer to realize a tax benefit from the cost basis prior to the sale of shares.
Asset sales typically are more advantageous to the buyer. As noted above, an asset sale is a sale of specific assets for a negotiated price. A typical asset sale involves the sale of accounts receivable, inventory and fixed assets. Purchase price is first allocated to these categories of assets. Any purchase price left after the allocation is assigned to intangible goodwill.
Unlike the stock sale, which is all capital gain, in an asset sale, the seller may be subject to tax at ordinary income tax rates and capital gains rates. More specifically, accounts receivable are taxed at ordinary income tax rates to a cash basis entity. Inventory sold for more than its costs is taxed at ordinary income tax rates.
Fixed assets sold for more than tax basis are taxed at ordinary income tax rates up to the amount of accumulated depreciation. Any gain in excess of accumulated depreciation is taxed at capital gains rates. Also, all tax on ordinary income must be paid in the year of the sale. The deferral for installment payments to be received in the future only applies to capital gain items.
From the buyers’ perspectives, the asset sale results in significant tax advantages over the stock sale. The purchase price allocated to inventory reduces ordinary income when the inventory is sold.
The purchase price allocated to fixed assets can be depreciated over different time frames, depending on the type of assets. These differences allow the buyer to realize more immediate tax benefits from the purchase price compared to the stock sale.
S Corporations That Were Formerly C Corporations
S-corps that were formerly taxed as C corporations (C-corps) have some additional considerations in an asset sale. The first of which is the built-in gains tax. S-corps that converted from a C-corp have a 5-year waiting period to sell assets that were held when the company was a C-corp.
If those assets are sold during that period, the seller pays a tax called the built-in gains tax. This taxes the sale at the highest corporate rate (35 percent). There also could be tax consequences if the company has prior earnings from when it was a C-corp. Those could be taxed as qualified dividends at capital gains rates when the sales proceeds are distributed to the selling shareholders.
In transaction negotiations, knowledge is power. By understanding the difference between the two types of transactions, the buyer can negotiate the type of transaction and sale price.
For example, by knowing that the buyer will realize immediate tax benefits from an asset sale, the seller can demand, at a minimum, the additional sale price should compensate for the after-tax cash flow difference between a stock sale and asset sale. The seller can also ask for additional sale price, representing a portion of the tax benefits the buyer would receive from an asset sale.
As with all aspects of your business, careful planning and goal setting for the sale of an asset will make all the difference in your eventual return on investment. Careful review of the tax considerations and thorough research into the options available to your company in its transaction are paramount.