Most small business owners sell the assets of their business, not the stock of the corporate entity. For example, let’s say a business called “ABC Manufacturing” is owned by the “S” corporation “ABC Manufacturing Inc.” The officers of ABC Manufacturing are a husband and wife who each own 50% of the corporation. Typically, the owners will sell all of the tangible and intangible assets of ABC Manufacturing Inc., not the stock of the corporation. The assets include all of the furniture, fixtures and equipment of the business, the goodwill, the inventory, the website, and the business name (ABC Manufacturing). The assets generally do not include, unless otherwise specified, any cash, accounts receivable, or accounts payable. The new owner(s) form their own corporation, which can be called anything, but the DBA remains ABC Manufacturing. The former owners file a final tax return for “ABC Manufacturing” and eventually close the corporation.
With a stock sale, the Buyer acquires literally all of the assets and liabilities of the business; in fact, the agreed upon purchase price is tied to a balance sheet at a specific point in time. Any variances between that balance sheet and an updated balance sheet are accounted for at close of escrow. The calculations are based on the concept of “net current assets,” defined as the current assets (cash and accounts receivable) minus the current liabilities (accounts payable). If the agreed upon purchase price of $2 million was based on net current assets of $500,000, but the balance sheet for the corporation a couple months later, just prior to close of escrow, shows net current assets of only $400,000, the purchase price is lowered to $1.9 million.
Most Buyers prefer an asset sale because of the legal peril (e.g., undisclosed lawsuits or existing workers comps claims) of buying the stock, and because an asset sale allows the Buyer to “step up” the depreciable basis of the assets based on the purchase price of the business. In the years following the purchase, the Buyer can amortize and depreciate those assets, thereby reducing taxes and improving cash flow.
The tax consequences of an asset sale for the Seller and Buyer depend in part on an exercise in compromise called “Allocation of the Purchase Price.” During escrow, the Seller and Buyer must agree on how to allocate the purchase price among asset categories such as goodwill; furniture, fixtures and equipment (FF&E); the covenant not to compete; inventory; and leasehold improvements. Each category is taxed differently, but ultimately the parties will pay one of two rates: the long-term capital gains tax rate (e.g., goodwill), or the ordinary income tax rate (e.g., furniture, fixtures and equipment).
The most beneficial allocation for the Seller would be to allocate as much of the purchase price towards goodwill as possible and match the FF&E allocation to the book value of the FF&E. This allows the Seller to get taxed mostly at the long-term capital gains rate, as opposed to an ordinary income tax rate. Additionally, if the Seller matches the value of the FF&E to its book value, the Seller reduces the amount subject to the ordinary income tax rate.
Buyers benefit the most if they can have more allocated to FF&E and the non-compete agreement, as it will allow them to write off more on their taxes early on. That said, at close of escrow, Buyers must pay sales tax on the amount allocated to FF&E based on the sales tax rate for the jurisdiction in which the business is located. Buyers are able to write off goodwill, but it’s amortized over a 15-year period.
If the selling entity is an “S” corporation, the Seller and Buyer will usually find a way to allocate the purchase price such that an asset sale is agreeable to both parties. However, when the selling entity is a “C” corporation, the Seller may need to incentivize the Buyer to accept a stock sale so that the Seller can avoid double taxation. When the assets of a “C” corporation are sold, the selling entity is taxed when the assets are conveyed to the Buyer, and subsequently, the selling entities’ owners are taxed when the proceeds are distributed to the shareholders. When the stock of a “C” corporation is sold, the corporate level taxes are bypassed.
By accepting a stock sale, the Buyer loses the aforementioned ability to gain a stepped up basis in the assets and thus does not get to re-depreciate certain assets. The adjusted basis of the assets at the time of sale sets the depreciation basis for the new owner. As a result, the lower depreciation deduction can result in higher future taxes for the Buyer, as compared to an asset sale. Consequently, the Seller of a “C” corporation may need to agree to a lower purchase price in order to convince the Buyer to accept a stock sale.
This dilemma faced by owners of a “C” corporation can easily be avoided with a proper exit strategy; namely, converting from a “C” corporation to an “S” corporation prior to undertaking the sale of the business.