In an M&A corporate sale, transactions can be organized into one of two categories: as an asset sale, or a stock sale. However, each category can be negotiated and structured in different ways which produce varied tax results to the buyer and seller. The following is a high-level overview of the differences between asset and stock sales.
In an asset sale, the buyer has the option to purchase all of the assets and liabilities or specific assets (and assume certain liabilities) item-by-item of a target corporation. This provides the buyer and seller the opportunity to exclude certain items that are deemed to be “non-core” to the business (e.g., owner vehicle, life insurance, related party receivables/payables, etc.). This requires the buyer and seller to retitle/transfer all the acquired assets to the buyer.
After an asset sale, the seller retains ownership of the legal entity which has cash from the sale and excluded assets and liabilities that were “non-core” to the business. In nearly all asset sales, the seller will retain excess cash but must pay down retained debt upon closing the transaction. The seller will also be required to provide a sufficient level of working capital to operate the business, which tends to be a heavily negotiated item.
Benefits and Drawbacks for Buyers and Sellers
Buyers typically prefer asset sales because they are able to “step” up the basis in acquired assets (particularly equipment and goodwill), which provides a future tax benefit through higher depreciation expenses leading to higher after-tax cash flows to the purchaser. Due to the desire for the higher after-tax cash flows, buyers may pay a higher purchase price. The new tax legislation will increase this point of negotiation with the new 100% bonus deduction on tangible personal property acquired after September 27, 2017.
Another reason that buyers generally prefer asset deals is because they can typically avoid certain liabilities that may not have been discovered during due diligence. It is also possible that a liability could surface later that was not even possible to have known during due diligence (e.g., lawsuits, etc.).
While an asset sale may be good for the buyer, the seller may have adverse tax consequences. These consequences can range from minimal to catastrophic. The adverse consequences are determined by whether the corporate seller is an S or a C corporation, the asset price allocation, and other facts and circumstances.
The primary drawback for a seller is that an asset sale can result in higher taxes because a portion of the sale proceeds of the transaction will be considered ordinary income rather than capital gains. For this reason, sellers usually prefer a stock sale, at least from a tax perspective. However, if a seller’s company has a large goodwill component (i.e., it’s a service business and/or not asset-intensive), then the tax differences may not be materially different. Because each asset is assumed to be purchased separately, each will have its own tax rate depending on what type of asset it is. This often results in a mix of ordinary and capital gain income.
C-Corp vs. S-Corp
It’s important to note that if the company’s legal structure is a C-Corporation, the seller faces additional tax implications that can make an asset deal an unattractive option. C-Corporations are legally considered a separate tax-paying entity. Thus, they face two levels of taxation – company and shareholder. In an asset sale, the corporation first pays taxes at ordinary rates (there are no capital gains rates for C-Corps). When sale proceeds are distributed to shareholders, they then pay taxes at capital gains rates. Given this double taxation, owners of C-Corps will almost always seek a stock sale given its more favorable one level of capital gains tax treatment. The tax law changes recently enacted in December of 2017 reduce the tax ‘pain’ C-Corp owners will face if selling assets. The C-Corp tax rate reduction to 21% (from 35%) minimizes the double tax problem, but it does not eliminate the problem.
Conversely, S-Corps are pass-through entities that do not face double taxation. When S-Corps sell assets, they are only taxed once – at the shareholder level. While most shareholder taxes will usually be capital gains (goodwill), there may also be ordinary income recognized on depreciation recapture for property, plant, and equipment.
Given the negative M&A tax consequences of being a C-Corp, many smaller businesses choose the S-Corp structure. However, companies should be aware that if they convert from being a C-Corp to an S-Corp prior to a sale, they can still face the negative tax consequences of being a C-Corp. This is because when a company converts to S status, the corporation is required to measure any built-in-gains (BIG) upon conversion, and if any of those BIG assets are sold within 5 years of conversion then a “BIG” tax would be applied as if the company had remained a C-Corp. Essentially this means that any inherent gain at the date of conversion would be “locked in” for 5 years. Any appreciation after the date of conversion would not be subject to BIG Tax.
Benefits and Drawbacks for Buyers and Sellers
In most cases, the seller is motivated to structure the deal as a stock sale. However, if there are contracts or other assets that the corporation cannot easily transfer/retitle which are necessary, the buyer would be motivated to structure the deal as a stock sale.
There are many ways a buyer and seller can structure a stock deal and the consequences to each can be very different, however, the most common are the following:
- A sale where the target corporation is an S corporation
- A sale where the target corporation is a C corporation
- A sale where the buyer and seller make a 338(h)(10) election
As noted above, one of the difficulties of an asset deal is that it may be more difficult to transfer certain contracts and leases. If such contracts are integral to the target business and are difficult to transfer (e.g., a government contract or leases), then an asset deal may be difficult.
In many cases transferring contracts may become more time consuming while the parties await third-party consents to transfer such agreements to the buyer. In some cases, these third-parties may not move as quickly as buyer and seller would like. Further, the third-party may even want to conduct its own due diligence on the new buyer, all of which can take time, energy, and money. This fact pattern or the seller’s desire for a stock sale may result in the transaction being structured as a stock deal.
C-Corp vs. S-Corp
In a stock sale of a C or S corporation, the buyer would simply purchase the outstanding shares directly from the shareholder and take over the entire business, including all assets and liabilities. For the seller, this is a favorable transaction from a tax perspective, as share sales are taxed as capital gains. The tax benefit to the seller is amplified if the target entity is a C-Corporation that would be subject to double taxation. In general, sellers are relieved of most ongoing liabilities after a stock sale, although some of this can be shifted back to the seller via the purchase agreement.
For the buyer, they do not get favorable tax treatment as they would in an asset deal (see above) because there is no basis “step-up” to allow for higher depreciation expense. Rather, the assets carry over at their historical basis. Buyers are also at risk for future or contingent liabilities, since all such risk is assumed (unless mitigated within a purchase agreement).
When the buyer desires to purchase the assets of the target company but the target company owns problem assets, tax rules and regulations allows for a middle ground. As a compromise, sometimes buyer and seller agree to a 338(h)(10) election. A 338(h)(10) election allows the buyer and seller to enter into a stock purchase agreement which generally does not require transfer or consent for transfer of assets. However, the election states that the IRS will not recognize the transaction as a stock sale, but the IRS will treat it as if the buyer purchased the assets and liabilities of the target corporation. This results in the same tax consequences as an asset sale as discussed above.
The seller may have a mix of capital and ordinary income and the buyer gets a stepped-up basis in the corporation’s assets. A 338(h)(10) could be an attractive option for a seller if they were an S-Corp with a heavy goodwill component and certain contracts or leases that might be difficult to transfer. In such a case, the stock sale is an easier avenue to complete the deal, while the tax impacts should be tolerable for the seller.
If you are contemplating a sale, careful planning can be informative and may reduce the overall tax bill for the buyer and the seller. We suggest consulting with a tax expert before you consider a transaction.