Business Sale 101: Structuring the Sale
Previous articles in Business Briefs have discussed two initial steps in a typical business sale: drafting the letter of intent and conducting the due diligence process. This article will discuss another key consideration, the structure of the transaction. How a sale is structured has an impact on both the buyer and seller. Unfortunately, too often parties in a business sale transaction negotiate the structure prior to seeking legal and tax counsel to assist them in determining which structure will produce the best results.
In any given transaction, there are many variables which must be considered when analyzing structure. The considerations differ depending on whether the business is owned inside a C corporation, an S corporation, or a limited liability company, which is usually treated like a general partnership for tax purposes. For purposes of this article, we will focus on the sale of a business owned by a C corporation. Future articles may consider alternative ownership structures and their impact on business sale structure.
When a business is owned inside a C corporation, the two primary alternatives are to either (a) have the corporation sell all of its assets, and then liquidate and dissolve the corporation and distribute the net proceeds to the shareholders, or (b) sell the corporation itself by selling the shares of the corporation, i.e., a stock sale. There are advantages and disadvantages to either structure for both the buyer and seller. The structure that is ultimately chosen will depend on the specific characteristics of parties to the transaction as well as the type of business to be sold. The primary forces driving the structure of the transaction are liability and taxes.
An asset sale generally involves the sale of some or all of the assets of the acquired business. Under this structure, a buyer and seller agree on the specific assets to be sold and any liabilities that will be assumed by the buyer. A buyer typically prefers this structure because it can purchase only the desired assets of the business and only those liabilities that a buyer affirmatively agrees to assume will become the responsibility of the buyer following closing. In addition, regardless of what the tax basis of the seller is in the acquired assets, the buyer will be entitled to depreciate assets based upon the portion of the purchase price actually allocated to it.
Due diligence is also extremely important to a buyer of assets. A buyer wants to ensure that it will own all of the assets of the business that it wishes to acquire (and that it is paying for) following closing. A buyer also wants to ensure that there are no undisclosed liabilities attached to the assets purchased, such as leases on equipment, judgments liens or secured debt.
The mechanics of an asset sale can be quite involved. An asset sale will typically include the assignment of contracts necessary to the business being sold, as these contracts may be a substantial asset of the business. Most contracts will require the consent of the other party to the contract before assignment, and so it will be necessary to contact these third parties to obtain consent. Many sellers will not want the buyers to contact any of its suppliers, customers or creditors until all contracts have been finalized and signed. This may include landlords, equipment lessors, contractors and customers, among a variety of others. Different assets also require different transfer documents, increasing the complexity and documentation of the sale. If one of the acquired assets is real estate, title issues may arise.
The tax effect to the parties in an asset sale depends on the assets purchased and how the parties agree to allocate the purchase price among these assets. The purchase and sale of inventory, equipment, personal goodwill, real estate and accounts receivable will have different tax consequences. Each class of assets will have a different depreciation period, and typically the buyer wants to structure the deal so that the greatest portion of the price is allocated to assets that have the shortest useful life for depreciation purposes. This enables the buyer to recover the purchase price paid through faster tax deductions. The rules which govern how the purchase price is allocated among the acquired assets is set forth in the Internal Revenue Code.
In a C corporation, the sale of assets by the company will result in tax on any gain at the corporate level. Unfortunately, the favorable tax rate for capital gains is not available to a C Corporation. Special care should be taken to consider depreciation recapture. If the company has fully depreciated an asset on its books, but at the time of sale it has a fair market value which is higher than the book value, then the difference will be taxed immediately at ordinary income rates as the depreciation is recaptured. Once the corporate level taxes are determined and paid, and all liabilities satisfied, then the corporation can be liquidated and dissolved, and the proceeds will be distributed to the shareholders in proportion to their stock ownership. This will result in a second level of tax payable by each shareholder. Most of the tax planning on the sale of assets by a C Corporation involves efforts to mitigate this double tax.
A stock sale involves the sale and acquisition of all or substantially all of the shares of stock of the corporation. At its most basic level, the buyer of the business becomes the sole shareholder of the company. The company continues to own all of its assets, be subject to all of its liabilities, and operate its business just as it did before, but under new ownership and possibly new management. The advantage to the seller is that this type of sale is the most tax favored. All sale proceeds received for the shares being sold will result in capital gains income. If the shares have been held more than 12 months, then it will be long term capital gains, and consequently taxed at the lowest federal income tax rate. However, the purchaser of the shares is not entitled to a deduction for any portion of the purchase price paid. Instead, after-tax money will be used to pay for the shares, and the buyer will have a basis equal to the purchase price, which can only be recovered tax free on a subsequent sale or liquidation of the acquired company.
In addition to the tax consequences, there may be other business reasons for structuring a deal as a stock purchase. For instance, because ownership of the assets of the company will not change, there will be no need to retitle assets in the name of the new owner, or to seek the consent of key customers or suppliers who may have contracts with the company that may prohibit assignment by the company. The acquired company may have important regulatory licenses or permits that can be more easily transferred in a stock sale. Because the company continues to be the owner of all assets and the party to all contracts and licenses, these continue unaffected after closing. In certain types of businesses this is very important. For instance, in a construction company which has a significant number of municipal contracts which may not be assigned, the only practical solution will be to buy the company and keep the contracts in place. The same may be true of a utility company that may have hundreds of customers and deposits/accounts. However, one caveat to consider is that certain contracts and regulatory licenses or permits may include a provision providing that a mere change of control of the company will be deemed to be an assignment of the contract or license. If so, consent to the sale must be obtained from that contracting or licensing party.
One downside to a stock purchase is that the buyer will take the company subject to all its liabilities, both know and unknown. This is why the buyer’s due diligence investigation is so important. Liabilities to consider include accounts payable, employee obligations, contract performance, potential litigation, debt, contingent claims, guaranty liability, etc. In some instances, the due diligence process will reveal surprising liabilities of the company, which may cause a buyer to reconsider the stock sale structure. It is not necessary for a buyer to assume all the liabilities of the corporation, as a buyer may require a seller to pay or resolve liabilities before the closing of a sale, and the seller should be required to indemnify the buyer from any claim or loss that may result from such liability. Nevertheless, buyers must be aware that by buying stock in a corporation, they are assuming the risk of unknown liabilities.
Another reason stock sale transactions take place is that publicly held companies who are buying may not want to create tax deductions. Public companies are frequently valued based upon a multiple of earnings. Thus, while the typical taxpayer would like to create deductions to reduce the after tax cost of the purchase price, public companies are generally less motivated by such deductions. Accordingly, the earnings obtained through the acquisition are not reduced by additional deductions, so they have a more positive impact on the purchaser’s earnings and thus enhance the purchaser’s stock value. Thus, in limited cases, we have found that while a typical buyer would want to avoid a stock purchase for tax reasons, a seller who is fortunate enough to sell to a publicly held buyer may find that a stock sale is actually attractive to that buyer.
As noted above, most frequently the adverse tax consequences for a buyer push deals toward an asset sale structure and away from a stock sale. We have previously written about the sale of personal goodwill. In some cases, if sufficient money can be allocated to the personal goodwill of a principal shareholder, the buyer will be willing to pay some amount for shares (which will be non-deductible) and the balance for the shareholder’s goodwill and/or a covenant not to compete, both of which result in deductions for the buyer.
How a business sale is structured will have a significant effect on the seller, the buyer and the business following closing. Numerous factors, including many which are beyond the scope of this article, must be carefully evaluated. That evaluation is best undertaken early in the sale process, most often before a letter of intent is signed. On occasion, relative bargaining power alone will dictate the structure of the deal. If you are considering selling or acquiring a business, it is important to meet with both your tax and legal advisors prior to commencing negotiations with the other party to ensure that the structure has been evaluated carefully to benefit you. Feel free to contact our office if you have any questions on this article or business sales in general.