When buying or selling a business, it makes a difference whether the transaction is structured as an asset sale or a stock sale. There are pros and cons to both forms of transactions.
Buyers generally prefer an asset sale because the buyer obtains a step-up in basis. This higher basis allows a Buyer to claim larger deductions for depreciation on their tax returns after closing.
An asset sale also limits the debts and liabilities that Buyer assumes upon completion of the transaction. Generally, a Buyer will not be liable for any of Seller’s debts or liabilities except for ones specifically and expressly assumed by Buyer. The documentation to evidence the assignment and assumption of such debts and liabilities can be quite substantial if Buyer assumes most, or all, of Seller’s debts and liabilities in the purchase.
While Buyer gains a tax advantage through higher depreciation deductions, an asset sale generally results in a Seller paying more taxes on its proceeds from the sale due to depreciation recapture. Depreciation that was taken with respect to the sold assets is “recaptured” by taxing the sales proceeds from the sale of assets at the ordinary income tax rate to the extent of the depreciation claimed with respect to such assets.
Seller also faces potential double taxation on the sales proceeds if the Seller is taxed as a C corporation. This double tax results from the corporation paying tax on the proceeds at the corporate ordinary income tax rate (there is no corporate capital gain rate), followed by the shareholder paying personal income taxes at the qualified dividend rate (equal to the capital gain rate) on the amount distributed to him or her.
A stock sale, or a sale of a member’s interest in an LLC, results in Buyer acquiring all the assets and the liabilities of the Seller, including any unknown or contingent liabilities. For this reason, the sale agreement should contain representations and warranties of the Seller regarding the existence of liabilities, and provisions that require Seller to indemnify Buyer if Buyer becomes subject to liabilities that were not disclosed prior to the closing.
On the tax side, Sellers generally prefer a stock sale because the Seller pays tax only once, at the capital gain rate, regardless of the manner in which the company is taxed (C-Corp., S-Corp, partnership, etc.). But Buyers do not receive a basis step-up or the resulting higher depreciation deductions. These factors combined tend to lower the purchase price paid in a stock sale when compared to the price paid in an asset sale.
Tax laws permit a stock sale to be treated as an asset sale if the parties agree to make a 338 election (referring to Internal Revenue Code Section 338). Under this election, the parties agree to treat the stock sale as an asset sale for federal income tax purposes even though the transaction takes the form of a stock sale. Making such an election provides Buyer with the step-up in basis (and higher depreciation deductions) in the acquired assets, while also transferring all of Seller’s debts and liabilities to Buyer. Seller, though, must pay the higher taxes associated with an asset sale due to depreciation recapture and possible double taxation. To be eligible for a 338 election, both Buyer and Seller must be corporations.
If only the Seller is a corporation, then a stock sale may still be treated as an asset sale by structuring the transaction as an “F” reorganization under Internal Revenue Code Section 368. Here, the Seller adopts a Plan of Reorganization consistent with Revenue Ruling 2008-18 that includes: (a) creation of a new S corporation (“Newco”) to be owned by the Seller; (b) transfer of the stock of the existing corporation to Newco; (c) election of qualified Subchapter S subsidiary status (“QSub”) for the existing corporation; (d) conversion of the QSub from a state law corporation to a state law limited liability company (“Converted Entity”); (e) transfer of the Converted Entity ownership interests by Newco to the Buyer; and (f) payment of the purchase price by Buyer to Newco.
If all the steps outline above are completed, then the Buyer ends up acquiring a state law LLC holding all of the assets and liabilities of the target company and the deal is treated as an asset sale for federal income tax purposes with Buyer receiving the step-up in basis and Seller paying tax as if the deal was an asset sale.