Stock and Asset Sales: Tax Consequences of Each Transaction

As discussed in prior posts, an asset sale transfers only the assets of the business, whereas a stock sale transfers some or all of the ownership interest in the business as well as its obligations and liabilities. In this continuing examination of how to structure a business sale, the next points of consideration are the tax consequences of each transaction and ways they can affect the buyer and seller. These types of structures confer different tax benefits or burdens on each party, so tax treatment is one of the most crucial elements in the sale.

Asset Sale

The asset sale is generally preferable to buyers for tax reasons because it allows them to step up the tax basis of the assets in the transaction to fair market value. The purchase price of the assets is allocated among them according to class and fair market value. The purchaser can then take greater depreciation and amortization deductions on the purchased assets, as well as reporting smaller amounts of gain upon resale. Purchase price that exceeds the fair market value of the acquired assets is then allocated to goodwill, where it will be amortized over a period of 15 years.

The tax burden on the seller in an asset sale can be prohibitive. For instance, if the company in a sale is a C corporation, the gain on the sale could be taxed at both the corporate and shareholder levels since it is both a sale of assets and a liquidating distribution. If the company in the sale is an S corporation, the tax burden will come only once at the shareholder level, but likely in the form of ordinary income taxation instead of at favorable capital gains rates. An asset sale may be acceptable to a seller in certain situations, however, such as when the selling corporation has net operating losses that can offset the gain on the sale. The seller may be able to persuade the buyer to increase the purchase price to offset the seller’s tax burden on the sale if the step up in basis is allocated to assets that will be sold or depreciated quickly.

Stock Sale

From a tax standpoint, a purchase and sale of stock, rather than of assets, is preferable to the seller in the transaction. In this instance, the gain on the transaction is only taxed at the shareholder level and is capital gain, rather than ordinary income. The stock purchase has no effect on the tax bases of the assets, however, so a buyer takes a basis in the stock equal to the purchase amount of the stock. This basis is not recovered until the stock is sold or liquidated, and there is no change in the basis of the assets themselves. Coupled with the buyer’s assumption of the seller’s liabilities and the attendant economic burden, it is easy to understand why sellers prefer a stock sale. The purchase agreement, however, can specify that the seller retains certain liabilities or indemnifies the purchaser against future obligations, making a stock sale more palatable to buyers.

There are circumstances, however, where a stock sale is preferred by the buyer as well, such as when there are major intellectual property rights at stake or large contracts that may be difficult to transfer. Contracts with significant clients and ownership of intellectual property would transfer with the ownership interest in the company.

Stock Sale Treated as an Asset Sale

There is a third option for structuring the sale that meets both parties closer to halfway. If the acquired corporation is part of a consolidated group or is an S corporation, if its shareholders sell a minimum of 80% of the outstanding stock in the company within a period of twelve months, the sale can be treated as an asset sale for tax purposes. An IRC § 338 (h)(10) election treats a stock sale as if the corporation sold all of its assets and distributed all of the proceeds to the shareholders. This transaction avoids double-taxation because the corporation is considered to be liquidated. The acquiring purchaser, however, is now considered to have acquired an entirely new company with stepped-up bases in its assets. This election can still be less favorable to the seller than a true stock sale, but it can still operate as a middle ground between the two other types of structures where applicable.