The tax challenges of an asset sale can be very different from those of a stock sale, and the use of a buyer’s stock as acquisition currency may produce very different tax treatment than the use of cash or other property.
First, it is important to understand that the tax code makes the presumption that either a gain or a loss results on the sale or exchange of property. Second, when a transaction is taxable under the tax code, the seller’s taxable gain is determined like this:
Less: Adjusted Tax Basis
Equals: Taxable Gain
The adjusted tax basis of each asset sold is generally the amount originally paid for the asset, plus amounts expended to improve the asset (which were not deducted when paid), less depreciation or amortization deductions (if any) previously allowable with respect to the asset.
The character of a taxable gain or loss can be critical in determining the amount of tax due upon a sale of assets. This is because gains can be classified as either ordinary income or as capital gain. To further complicate matters, C Corporations are subject to identical federal income tax rates on both their ordinary and capital gain income, so the character of a C Corporations gain can often be irrelevant.
It is usually very important (and sometimes required) for the seller and the buyer to agree upon an allocation of the sales price among the assets sold. This agreement will largely determine the character of the gain recognized by the seller, along with the characterization of the gain recognized (which can of course can have varying tax rates depending on how they are characterized). And, although tax authorities certainly can challenge such an allocation, they rarely do, as long as the negotiation between the buyer and seller were done at arm’s length.
In an asset sale, a buyer is basically agreeing to purchase all or a select group of assets from the seller. If both the buyer and seller are corporations and the sales price consists of or includes stock of the buyer, the transaction may constitute a “tax-free reorganization.” Otherwise, the seller will usually recognize taxable gain or loss with respect to the sale of each asset. A seller that is a C Corporation will pay federal and state income taxes on the net taxable gain from the asset sale. If the C Corporation then wants to distribute the proceeds to its shareholders, each shareholder will be taxed on the amount they receive. To avoid this “double-tax problem,” and various other taxes (sales, use, transfer, etc.), a C Corporation should avoid asset sales. The owners are better off selling their stock.
However, there is a flipside problem for the buyer in buying the stock. If the buyer acquires a corporation’s assets, they can deduct virtually the entire purchase price over time through depreciation and amortization deductions. If, on the other hand, the outstanding stock of the corporation is purchased, the buyer will be limited to deducting depreciation and amortization based on the adjusted tax basis in the corporation’s assets immediately prior to the acquisition.
If the seller is an S Corporation, the buyer and seller may jointly elect to treat the transfer of stock as an asset sale. The more obvious benefit of this is that the buyer can get an increase in the adjusted tax basis of the assets of the corporation and may be willing to pay an increased price (so, the seller benefits as well) due to the increased tax savings available to the buyer in the future.
The tax code allows for several transaction structures that are actually tax-free. These are known as “reorganizations” and are available where both the buyer and seller are corporations (C or S). To qualify, a transaction must meet certain requirements; if met, the seller is not taxed on the portion of the sales price that consists of shares of the buyer corporation. Now, if the seller is concerned about taking stock in the buyer due to the investment risk, you may consider one of the following:
- Require that the stock be freely tradable upon receipt, such that the seller may sell all or a portion of the shares received whenever they want.
- Negotiate price protection, such that the seller will get additional consideration if the buyer’s stock goes down in value over a stated period of time.
- Arrange an investment hedge from a 3rd
All of these may be structured in a manner that will still allow the transaction to qualify as tax-free.
Another option is called a “Straight Merger”. This is a fairly flexible form of reorganization whereby the seller may receive as much as 60% of the sales price in cash or other non-stock consideration without being taxed on it.
A potential issue with this form of reorganization is that the acquirer directly assumes the liabilities of the seller, which can pose a risk to the buyer’s existing assets. This can be solved, however, by simply merging the seller into a wholly owned LLC of the seller.
Yet another option is a stock-for-stock reorganization. In this scenario, the seller gives 80% of their stock to the buyer solely in exchange for the buyer’s voting stock. This is less flexible than the straight merger, however, the buyer can now avoid assuming the liabilities of the seller. It should also be noted that the same result may be accomplished through the use of a subsidiary merger (which I will discuss later).
In contrast to the stock-for-stock reorganization, there is also an option to do a stock-for-assets reorganization. This involves the buyer acquiring “substantially all” of the assets of the seller solely in exchange for its voting stock. Again, this method allows the buyer to avoid assuming the liabilities of the seller.
Finally, there is an option to do what is called a “subsidiary merger.” In this scenario, the buyer forms a subsidiary and either merges the seller into the subsidiary or merges the subsidiary into the seller (known as a reverse subsidiary merger). Though the merger is between the subsidiary and the seller, the stock of the company that owns the subsidiary is given as consideration to the shareholders of the seller.
The reverse subsidiary merger is the typical form of reorganization chosen, because:
- It protects the buyer from the liabilities of the seller by keeping those liabilities separate from itself.
- It avoids having to transfer legal title to assets, which often results in the avoidance of sales, use, and other transfer taxes.
- It often avoids anti-assignability provisions in the contracts of the seller.
- It allows up to 20% of the transaction consideration to be paid in cash.
The one downside to the reverse subsidiary merger is that it does not permit 60% of the transaction to be in cash, as does the straight merger and the forward subsidiary merger.
Where the consideration in the transaction will include at least 40% stock consideration but greater than 20% non-stock consideration, the forward merger would be the preferred format. However, if any requirement of the forward merger is not met, the potential downside is quite serious. Careful analysis of this method is certainly needed.
In conclusion, this is not a simple area to navigate when selling your business, but sadly, it is often overlooked or even ignored. Please do not fall into the trap of “it is what it is”, because, when it comes to taxation, that is rarely the case!
Dan Lucas, CPA, ABV