There are two primary ways to structure the taxable purchase and sale of an incorporated business.
The parties may engage in an asset acquisition, in which the buyer purchases assets directly from the target corporation. Alternatively, the parties may engage in a stock sale, in which the buyer purchases the target corporation's stock directly from the selling shareholders.
For uninitiated buyers and sellers, it may be surprising to learn that these alternative deal structures can yield substantially different commercial, legal, and tax consequences to the buyer, the seller, and the target corporation. Consequently, whether to structure a deal as an asset acquisition or a stock sale is often a threshold issue that, once determined, can influence and inform the parties' negotiation of nearly every other key aspect of the transaction, including the purchase price. Indeed, because of its significance to the overall transaction, parties typically specify the type of deal structure to be implemented in their up-front statement of the material deal terms (i.e., a term sheet or letter of intent).
For those reasons, and to mitigate the risk of unwanted post-transaction surprises, including unexpected legal and tax liabilities, buyers and sellers should approach the acquisition or disposition of a corporate business with at least a basic understanding of the key differences between asset acquisitions and stock sales. This article highlights those distinctions and summarizes the important issues and negotiation considerations.
This discussion applies only to target businesses that are organized as corporations taxed under subchapter C of the Internal Revenue Code (i.e., C-corporations), or are otherwise taxed as C-corporations (i.e., a limited liability company that has elected C-corporation tax treatment). Acquisitions and dispositions of subchapter S corporations and businesses organized and taxed as partnerships or sole proprietorships involve other unique business, legal, and tax issues that should be separately discussed.n the selling shareholder's holding period in the shares.
Asset Acquisitions
As noted above, the buyer in an asset acquisition purchases assets directly from the target corporation. The parties typically enter into an "asset purchase agreement," which, among other documents, sets forth the binding deal terms, including identifying the specific assets the buyer will acquire (e.g., equipment, inventory, real property, customer contracts, trade secrets, and licenses, etc.,), and the specific liabilities the buyer will assume, if any.
Upon closing of the transaction, the buyer becomes the legal and beneficial owner of the acquired assets. The target corporation remains in existence immediately after the transaction and continues to be legally owned by the same shareholders. The target corporation also continues to own any assets not purchased by the buyer and remains liable for any obligations not expressly or implicitly assumed by the buyer under the asset purchase agreement.
Asset and Liability Considerations
The flexibility in an asset acquisition to acquire only select assets can be significantly attractive to a buyer. This permits the buyer to acquire the assets that it views as congruent with its own business or otherwise valuable and to avoid expending funds on unwanted assets.
The buyer's ability to limit its exposure to the target corporation's liabilities is another primary benefit of an asset acquisition. The asset purchase agreement typically states in clear terms which liabilities, if any, the buyer has agreed to assume. This enables the buyer to reduce its exposure to the target corporation's liabilities and obligations, including liabilities that were unknown or not disclosed in the transaction. Even in an asset acquisition, however, buyers' assumption of certain liabilities may be implied or otherwise arise as a matter of law. For those reasons, the buyer may negotiate with the seller to include in the asset purchase agreement indemnification provisions, purchase price holdbacks, escrow agreements, or other devices designed to provide the buyer with some post-transaction liability protection.
As noted, the target corporation remains in existence immediately after the transaction. This presents the target corporation's shareholders with a decision about what to do with the remaining assets, including the sales proceeds received from the buyer. The target corporation may reinvest the sales proceeds and continue its business operations, or it can distribute the sales proceeds to the shareholders in non-liquidating or liquidating distributions. As discussed below, such distributions could trigger taxable income to the shareholders.
Deal Complexity and Third-Party Consents
Possible drawbacks of an asset acquisition include its potential for complexity and lengthier timeline for completion. If buyer is acquiring a substantial number of assets, it may take considerable time, effort, and expense to identify the specific assets that will be acquired, value each target asset, and undertake all necessary due diligence. Additionally, transferring certain assets may require a separate bill of sale, assignment and assumption agreements, or other specific agreements for the transfer of intellectual property rights.
Furthermore, certain assets, such as customer or vendor contracts, may contain anti-assignment clauses or other transfer restrictions that require the parties to negotiate and obtain third-party consents for the transfer. For example, if buyer is assuming a lease agreement, the landlord would likely need to consent to buyer as the new lessee and execute an assignment of the existing lease or execute a new lease with the buyer. Similarly, certain license agreements may need consent from the licensee or licensor. Additionally, certain contracts such as loan agreements may contain payment or termination provisions that are triggered when a corporation transfers a set percentage of its assets. Accordingly, the parties should review the terms of all contracts being transferred to ensure any required consents are timely obtained.
Tax Treatment and Consequences
Potential Tax Benefit to the Buyer
Buyers in an asset acquisition may obtain a substantial tax benefit by receiving a fair market value basis in the acquired assets. Such a "stepped-up" asset basis provides the buyer with higher depreciation and amortization deductions going forward, which can offset future taxable income and tax liability. A higher asset basis also generates less taxable gain to the buyer if it sells some of the assets shortly after acquiring them.
The tax rules provide the buyer with a stepped-up asset basis through the allocation of the purchase price among the various acquired assets. In general, buyers prefer to allocate more of the purchase price to assets with shorter tax lives such as equipment and other fixed assets, which provides for a quicker recovery of the purchase price through higher depreciation expenses. Sellers, on the other hand, generally prefer that more of the purchase price be allocated to intangible assets and goodwill, which are taxed at lower capital gain rates when sold versus the higher ordinary income tax rates that apply to the sale of inventory, equipment, and other tangible assets. Each party files a purchase price allocation schedule with the Internal Revenue Service (the "Service"). Although agreement on the allocation is not technically required, any disparity between the parties' respective schedules could trigger an audit and potential reallocation of the purchase price by the Service.
Because the tax benefit to a buyer from obtaining a stepped-up asset basis may be substantial, the buyer may be willing to pay a higher purchase price for an asset acquisition. Recognizing this, a savvy seller may negotiate for a higher purchase price, especially given the potential for double taxation to the seller as discussed below. As a result, to understand the limit of the purchase price that should be paid, a buyer in an asset deal may calculate the present value of the anticipated tax benefits from the depreciation and amortization deductions.
Potential for "Double Taxation" to the Seller
In contrast to the tax benefit provided to the buyer, an asset acquisition may trigger "double taxation" for the seller, which may ultimately result in the seller receiving less of the sales proceeds than in a stock sale.
The first level of tax is imposed on the target corporation from the sale of its assets. The target corporation recognizes gain if the amount received from the buyer (the purchase price plus any assumed liabilities) exceeds the corporation's tax basis in the assets. The amount of gain, and its character as capital gain or ordinary income is determined on an asset-by-asset basis. In general, the sale of inventory, depreciable property, real property used in trade or business, and other non-capital assets will trigger ordinary income which is subject to higher tax rates. The sale of most intangible assets will trigger capital gain, which can be long-term or short-term gain depending on the holding period. Long-term capital gain is generally taxed at lower rates while short-term capital gains are taxed at ordinary income tax rates. Notably, a target corporation's net operating losses ("NOLs") may offset some or all of the target corporation's gain from an asset sale and should be factored into the tax considerations.
The second level of tax occurs at the shareholder level once the target corporation distributes the sales proceeds to its shareholders. The distribution can be non-liquidating or made in the complete liquidation and dissolution of the target corporation. A non-liquidating distribution is taxable to the shareholder if it constitutes a dividend, or if any portion of the dividend is treated as a capital gain. The tax rules treat a liquidating distribution as a sale of the target corporation's stock in exchange for the sales proceeds and are taxable as short-term or long-term capital gain depending on the shareholder's holding period in the stock.
As a result of the two levels of tax, the net proceeds received by the target corporation's shareholders may be significantly less than they may have received from a direct sale of the target corporation's stock (which, as discussed below, triggers only a single layer of tax at the shareholder level). Thus, in negotiating an asset deal, the selling shareholders should consider the impact of such double taxation, as well as the allocation of the purchase price to the various classes of assets.
Stock Sales
In a stock sale, the buyer purchases the target corporation's outstanding shares of stock (or other equity interests) directly from the selling shareholders. The parties typically set forth the terms of a stock sale in a "stock purchase agreement," together with other ancillary documents. Immediately after a stock sale, the target corporation continues to exist under the new ownership. Note that for purposes of this article, it is assumed that the buyer acquires all of the target corporation's issued and outstanding stock or other equity interests such that the buyer is the sole shareholder/owner of the target corporation post-transaction.
Asset and Liability Considerations
As the result of acquiring a target corporation's stock, the buyer is treated as a matter of law as having acquired all the corporation's assets and assumed all of its liabilities. More specifically, as the new shareholder, the buyer indirectly owns all the target corporations' assets and has indirect exposure to all of the target's obligations and liabilities, including unknown and undisclosed liabilities.
From the seller's perspective, the ability to eliminate or substantially reduce post-transaction liability is a key advantage of a stock sale over an asset sale. The seller is also able to avoid having to wind down the target corporation and sell or distribute any of its remaining assets.
From the buyer's perspective, however, the shift in liability exposure, including the risk of unknown and undisclosed liabilities, can be a significant concern. To mitigate that exposure, the buyer typically negotiates to include provisions in the stock purchase agreement that shift at least some financial liability back to the seller. As indicated above, such protective provisions may include general and specific indemnification provisions, escrow agreements, and/or purchase price holdback provisions. Those provisions, which may specify certain liability triggering events, minimum and/or maximum liability amounts, and/or time limitations, among other terms, can be very complex and are often heavily negotiated.
Deal Complexity and Third-Party Consents
A stock sale may involve less complexity than an asset acquisition. Because the target corporation retains ownership of its assets, stock sales typically do not require the parties to obtain third-party asset transfer consents or assignments of licenses and other intellectual property rights. In conducting due diligence, however, buyers should review the target corporation's employee compensation agreements, loan agreements, vendor and customer contracts, and other contracts for any "change-of-control" provisions that may be triggered by a change in the target corporation's stock ownership. Additionally, stock sales may involve negotiating with minority shareholders or may require certain securities or other regulatory filings (e.g., in transactions involving publicly traded corporations), which could add complexity. All these potential issues should be considered.
Tax Treatment and Consequences
Single Level of Tax to the Seller
One of the main reasons why sellers typically prefer to sell stock over assets is that stock sales generally result in only a single layer of tax. Indeed, the sale of C-corporation stock should not generate taxable income to the target corporation; tax should only be triggered at the shareholder level.
Specifically, the selling shareholder is taxed on any gain realized from selling the stock. Seller should recognize gain to the extent the amount realized (i.e., the purchase price) exceeds the seller's tax basis in the shares sold. Any such gain should be characterized as long-term or short-term capital gain, depending on the selling shareholder's holding period in the shares.
The Target Corporation Takes a "Carryover Basis" in Assets
Absent the special election discussed below, the buyer in a stock acquisition does not automatically receive a stepped-up tax basis in the acquired assets, and thus does not benefit from higher depreciation and amortization deductions. Rather, the target corporation's basis in its assets remains unchanged and it continues to follow the same pre-transaction depreciation and amortization schedule. If the target corporation's basis in its assets is close to fair market value, this may not matter. If, however, the tax basis has already been substantially depleted, buyer's inability to obtain a stepped-up asset basis may be a significant disadvantage.
In certain circumstances, it may be advantageous to acquire the target corporation in a stock sale despite the inability to obtain a fair market value tax basis in assets. The target corporation may have other valuable tax attributes that will remain with the target corporation post-transaction. For example, the target corporation may have significant NOLs that could offset future taxable income. Note, however, a change in ownership may trigger certain tax rules that limit or reduce the target corporation's NOLs and other tax attributes.
The buyer in a stock sale does receive a cost basis in the acquired stock equal to the purchase price plus any assumed liabilities. A higher stock basis would typically not be immediately beneficial unless the buyer disposed of the stock in a taxable transaction shortly after purchase. The buyer may, however, prefer the higher stock basis if it acquired the target corporation with an eye towards a future sale.
Elections to Treat Stock Deals as Asset Deals for Tax Purposes
When certain requirements are met, the parties can elect to treat a stock sale as an asset acquisition for tax purposes. Specifically, by making an election under section 338(h)(10) of the Internal Revenue Code (a "338(h)(10) election"), the transaction remains a stock sale for legal purposes, but is treated solely from a tax perspective as an asset acquisition.
To make a section 338(h)(10) election, the buyer must be a corporation that acquires control of the target corporation in a "qualified stock purchase" (a "QSP"). A QSP requires the purchase of at least 80 percent of the total voting power and value of the target corporation's stock during a twelve-month acquisition period. The target corporation must also be a corporation (including an S corporation) or a member of a consolidated group of corporations. Additionally, the QSP must be completed within twelve months of the buyer's first purchase of the target corporation's stock. Finally, the section 338(h)(10) election must be made jointly by the buyer and the seller and timely filed with the Service.
The section 338(h)(10) election enables the target corporation to obtain a stepped-up tax basis in its assets and the corresponding increase in depreciation and amortization deductions. A buyer may prefer this transaction where, for example, there is a benefit to acquiring the target corporation as a whole or where the transfer of assets would involve too much complexity or take too long to accomplish.
From, the seller's perspective, a section 338(h)(10) implicates the same potential for double taxation and resulting reduced net sales proceeds as discussed above. Consequently, the seller may insist on an increased purchase price or other compensation for the increased tax liability attendant to the election.
Conclusion
There are numerous non-tax and tax considerations that buyers and sellers of incorporated businesses should understand and evaluate in determining whether to structure the transaction as an asset acquisition or a stock sale. In general, a buyer may prefer to buy assets whereas a seller may prefer to sell stock. While this general rule is often true, it is not always the case. To fully prepare to negotiate the deal, the parties should evaluate the business, legal, and tax issues discussed above under the unique facts and circumstances of the transaction.
