Selling a business: asset versus stock sale

In short

A friend of mine once sold his machine shop and learned a hard lesson at the closing table. The words "asset sale" and "stock sale" sound like paperwork, but they decide who pays how much tax. If you own a business and a buyer calls, ask early which structure is on the table. Buyers often want an asset sale, while sellers often want a stock sale, and both sides have good reasons. The same price can leave you with very different money in your pocket after tax. Talk to a tax adviser before you sign a letter of intent, because that letter often locks in the structure.

The whole of it

What it is

I once watched a baker try to sell her shop to a neighbor, and the whole thing nearly fell apart over two small words. She wanted to sell the company. The buyer wanted to buy the oven, the recipes, and the lease. Those are not the same deal.

In a stock sale, the owner sells the shares of the company itself. The buyer steps into the owner's shoes and gets the whole entity, with its contracts, its debts, and its history. In an asset sale, the company stays with the seller. The buyer picks the pieces to buy, such as equipment, inventory, customer lists, and goodwill, which is the value of the name and the customer relationships.

Neither one is better in every case. Each moves the tax bill and the risk to a different person.

How it works

You have probably heard that sellers prefer stock sales. There is good reason for it, and it helps to see why.

In a stock sale, the seller usually pays tax once, on the gain from the shares. The gain is the sale price minus what the seller paid into the shares, called basis. For shares held longer than a year, the gain is generally taxed at long term capital gains rates, which are lower than ordinary income rates. The IRS explains basis and capital gains in Publication 551 and Topic 409.

An asset sale works differently. Each piece of the business is sold on its own, and each piece can be taxed in its own way. Gain on equipment that was written off earlier may be taxed as ordinary income through depreciation recapture, which means the tax code takes back some of the old write off. Inventory can produce ordinary income too. Goodwill is often taxed at capital gains rates. The buyer and seller report how the price is split among the pieces on IRS Form 8594, so both sides tell the IRS the same story.

Here is the catch for owners of a C corporation, which is a company that pays its own income tax. An asset sale can be taxed twice. The company pays tax on the sale, and then the owner pays tax again when the cash comes out as a dividend or a final payout. An S corporation avoids that second layer because its income passes through to the owners. Even so, the pieces can still be taxed as ordinary income.

Why would a buyer want assets? The buyer gets a stepped up basis, which means the buyer can start depreciating the purchased assets from the new, higher price. That creates tax savings for years. The buyer also leaves old liabilities behind, such as past lawsuits or tax trouble. Those two reasons explain why the push for an asset sale is so common.

The numbers, and where to find yours

I know you want one tidy figure, and I wish I could hand it over. The honest answer is that your numbers sit in your own records and in the law for the year of sale.

The long term capital gains rate depends on your income. The top federal rate on long term gains is the current figure, which the official source publishes each year, and it applies above an income level of the current figure, which the official source publishes each year. A separate tax on investment income may also apply, at a rate of the current figure, which the official source publishes each year once your income passes the current figure, which the official source publishes each year. Ordinary income rates run higher, and the top one is the current figure, which the official source publishes each year. Your state may add its own tax on top.

Your basis lives in your tax returns and your company records. For a stock sale, look at what you paid for the shares plus any money you added later. For an asset sale, look at the depreciation schedules your accountant keeps, because they show how much of each asset was already written off. The purchase price allocation, the split of the price among the assets, will come from the deal itself and goes on Form 8594.

If you hold qualified small business stock, a special exclusion may apply to some or all of the gain. The limit and the holding rules are set by law, so check the current figure, which the official source publishes each year and read Internal Revenue Code Section 1202 with your adviser.

A worked example

Let me tell you about Ruth, a printing company owner. She is fifty eight and holds all the shares of an S corporation. A buyer offers $2,000,000 for the business. Ruth paid $200,000 into the shares over the years, so her basis is $200,000.

Take the stock sale first. Her gain is $2,000,000 minus $200,000, which is $1,800,000. If all of it is taxed at a flat 20 percent for this example, the federal tax is 20 percent of $1,800,000, which is $360,000. She keeps $2,000,000 minus $360,000, or $1,640,000, before any other taxes.

Now the asset sale at the same price. Suppose the buyer and Ruth split the $2,000,000 this way. Equipment gets $400,000, and Ruth had already written off $350,000 of its cost through depreciation. Goodwill gets $1,600,000 and has no basis.

The $350,000 of depreciation recapture is taxed as ordinary income. Say her rate on it is 35 percent. That tax is 35 percent of $350,000, which is $122,500. The remaining gain on the equipment, $50,000, plus the $1,600,000 of goodwill, makes $1,650,000. At 20 percent, that tax is $330,000. The total tax is $122,500 plus $330,000, which is $452,500. She keeps $2,000,000 minus $452,500, or $1,547,500.

Compare the two. $1,640,000 minus $1,547,500 is $92,500. Ruth would keep $92,500 more in the stock sale. The figures are made up and the rates are plain guesses, so they only show the shape of the thing. But the gap is real.

Ruth and her buyer might meet in the middle. The buyer may pay a higher price to make up for lost tax savings. Ruth might accept the asset sale if the price rises enough. Splitting the difference is a fair way to deal with a real difference in cost.

Where it goes wrong

I have seen smart people trip on this, and it is never because they were careless. They were busy running a business, and nobody told them to ask the question early.

The first trouble is waiting too long. Once a letter of intent says asset sale or stock sale, changing course gets hard. Bring in a tax adviser before that letter is signed.

The second trouble is the allocation. If the price is split badly among the assets, more of it may be taxed as ordinary income. The buyer wants more value placed on assets that can be written off fast. The seller wants more placed on goodwill. Both sides have to agree and report the same split on Form 8594.

The third trouble is the entity type. A C corporation seller faces possible double tax in an asset sale, so the gap can be much wider than in Ruth's case. Some sellers look at other structures, such as an election under Section 338(h)(10) of the tax code. That election lets the buyer treat a stock purchase as an asset purchase for tax purposes. It works only for certain companies, so ask whether yours qualifies.

The fourth trouble is forgetting everything outside the tax bill. A stock sale hands the buyer the old liabilities, so the buyer may ask for a lower price or a promise from the seller to cover problems. Contracts and licenses may not move with an asset sale unless the other side agrees. Employees, leases, and permits all need a plan.

Last, an installment sale, where the buyer pays over several years, can spread the tax. But the seller must still report certain recapture income in the year of sale. Read IRS Form 6252 and its instructions.

Questions to answer before you leave this page

What kind of company do you own, and does that change how the sale is taxed? What did you pay into the shares, and where are those records kept? Have your depreciation schedules been pulled so the recapture can be figured? Has a buyer already used the words asset or stock, and has anything been signed? What price would make you comfortable in either structure, and have you run both numbers side by side? Does your state add a tax on the sale? Who will sit with you at the table, a tax adviser, an attorney, or both, and have they seen the deal yet?