Structuring the Purchase or Sale of a Business: Asset Sale vs. Stock Sale

There are three ways to structure the purchase or sale of a business: As a sale of a corporation’s stock or of a limited liability company’s member interests (generically referred to as a “stock sale”), as a sale of some or all of the company’s assets, or through a merger.  Each of these approaches offer its own advantages and considerations for Buyers and Sellers, including tax implications, liability exposure, and the relative complexity of the transaction.  Liability exposure can be a very important consideration, but in this article I will be discussing only the tax implications of selecting between an asset sale and a stock sale.

Tax Advantages to Buyers in an Asset Sale

Beyond gaining protection from assuming the liabilities of the acquired business, a significant benefit for the Buyer in an asset sale is the ability to step up the tax basis of acquired assets to their fair market value. This can yield substantial and ongoing financial benefit to the Buyer. The stepped-up basis mechanism allows Buyers to reset the tax basis of acquired assets to their purchase price, rather than inheriting the Seller’s existing tax basis. As an example, let’s consider a piece of manufacturing equipment:

In a stock purchase, if the original owner purchased the equipment for $200,000, claimed $150,000 in accumulated depreciation, and the equipment at the time of the acquisition has a fair market value of $120,000, the Buyer would inherit a tax basis of $50,000 ($200,000 – $150,000), would have limited future depreciation deductions, and would have a potential taxable gain of $70,000 if the asset is later sold at its $120,000 fair market value.  In an asset purchase, however, the Buyer would receive a new tax basis of $120,000 (the current fair market value), would gain access to fresh depreciation deductions calculated from the stepped-up basis, would minimize or eliminate taxable gain on any future sale at fair market value, and would generate higher annual tax deductions, thereby improving cash flow.  Stepped-up basis extends across various asset categories, including physical assets (buildings, equipment, and furnishings), intangible assets (patents, trademarks, and customer relationships), and goodwill.

For corporations in the 21% corporate tax bracket, the tax savings from stepped-up basis can be substantial. If a transaction includes $500,000 in stepped-up basis, the Buyer could realize tax savings of $105,000 over time, through increased depreciation deductions. These tax advantages often influence acquisition negotiations, since Buyers may be willing to pay a premium for assets due to the long-term tax benefits of stepped-up basis. This benefit has to be weighed against the Seller’s potential need for a higher purchase price to offset its increased tax burden in an asset sale.

Another benefit for the Buyer in an asset sale are opportunities for enhanced depreciation and amortization deductions, thanks to the step-up in basis. Depreciation applies to tangible assets such as buildings, equipment, and vehicles, while amortization applies to intangible assets (patents, customer relationships) and goodwill. Both mechanisms allow companies to deduct the cost of assets over their prescribed useful lives, reducing taxable income and generating tax savings.  As an example, let’s consider a transaction involving manufacturing equipment valued at $500,000, customer relationships valued at $250,000, and a commercial building valued at $1,000,000.  In a stock purchase, the Buyer will inherit the Seller’s existing tax basis. If the Seller has already claimed significant depreciation, the Buyer’s future deductions would then be limited. For instance, if the equipment has a depreciated basis of $100,000, the Buyer could only claim future depreciation on that amount, even though the Buyer presumably paid market value for the equipment in the acquisition transaction.  In an asset purchase, however, the Buyer can claim depreciation and amortization based on the full fair market value of the assets.  In the above example, the manufacturing equipment (valued at $500,000, with a 7-year depreciation schedule), would have annual depreciation of about $71,428, with an annual tax savings of about $15,000 at a 21% corporate tax rate.  That would be a tax savings over the depreciation period of $105,000.  The customer relationships (valued at $250,000 in this example, with a 15-year amortization schedule), would result in an annual amortization of $16,667, and annual tax savings (at a 21% corporate rate) of $3,500, for a total tax savings over the amortization period of $52,500.  The commercial building (valued at $1,000,000 in this example, with a 39-year depreciation schedule), would have annual depreciation of about $25,641, yielding annual tax savings of $5,285 at a 21% corporate rate, resulting in aggregate tax savings over the depreciation period of $210,000.

The tax code may provide further opportunities to accelerate these benefits through its bonus depreciation provisions. Current tax law allows for 100% first-year bonus depreciation on many qualifying assets, enabling immediate write-off of their entire cost. While this provision doesn’t apply to buildings or to most intangibles, it can significantly accelerate tax benefits for eligible assets.

The parties may state, in their purchase-sale agreement, an agreed upon allocation of the purchase price, which can affect the timing of tax benefits. Buyers often benefit from allocating more of the purchase price to assets with shorter recovery periods.  Any agreed-to allocation must be reasonable and supportable, however, in order to pass muster with the IRS.

Enhanced depreciation and amortization can create temporary differences between book and tax income, resulting in deferred tax liabilities. These enhanced deductions represent a significant financial advantage of asset purchases, often justifying higher purchase prices or providing additional negotiating leverage. The present value of accelerated tax savings can materially improve the Buyer’s return on investment and provide additional cash flow for debt service or business reinvestment.

Another significant financial advantage to an asset purchase is the ability to amortize goodwill for tax purposes. This is not available in a stock purchase. Goodwill emerges when a Buyer pays more than the fair market value of identifiable assets, reflecting the additional value attributed to intangible factors such as brand reputation, customer relationships, employee expertise, market position, and potential synergies. This premium often represents a significant portion of the purchase price in business acquisitions. Goodwill can be amortized over a 15-year period, generating substantial tax savings for the acquiring company.

If a Buyer acquires a business for $5 million, but the identifiable assets have a fair market value of $3.5 million. The $1.5 million difference represents goodwill. The tax treatment of this goodwill varies dramatically between asset and stock purchases. In a stock purchase transaction, the Buyer receives no tax benefit from the goodwill premium. While the goodwill is recognized for accounting purposes, it cannot be amortized for tax purposes, resulting in no tax deductions over the life of the asset. In an asset purchase transaction, however, the tax treatment can be far more advantageous. In the above example where there is $1.5 million in goodwill, there would be an annual amortization deduction of $100,000 ($1.5 million over 15 years), which would yield annual tax savings of $21,000 at a 21% corporate tax rate, and total tax savings over 15-year period of $315,000.  This tax treatment not only converts what otherwise would be a non-deductible purchase premium into tax-deductible amortization over the amortization period, but also allows companies to forecast tax benefits with certainty. The present value of goodwill amortization tax savings often justifies paying a higher purchase price.

To secure these tax benefits, Buyers must ensure that the allocation to goodwill stated in the purchase-sale agreement is reasonable and supportable, is based on proper valuations, documented in the purchase agreement, and is reported consistently on tax returns. While tax treatment allows for straight-line amortization, accounting rules require periodic impairment testing, which requires separate tracking systems, deferred tax accounting, regular monitoring and reporting, and compliance with tax and accounting requirements.

The goodwill amortization benefit represents one of the most compelling reasons Buyers generally prefer asset purchase structures. The ability to generate substantial tax savings over a 15-year period often influences both deal structure and purchase price negotiations.

Advantages to Sellers in an Asset Sale

Although the asset sale structure generally favors Buyers, Sellers potentially can receive a higher purchase price in an asset sale, to offset tax implications, and an asset sale gives a Seller the ability to retain particular assets or intellectual property.  If some but not all of the business assets are sold, then the Seller has the option of continuing to operate with its retained assets (if not prohibited from doing so in the purchase-sale agreement), and the Seller may have some flexibility in handling remaining liabilities of the business.

Tax Advantages to Sellers in a Stock Sale

Stock sales typically provide Sellers in corporate acquisitions with more favorable tax treatment than do asset sales, and Sellers therefore often prefer this transaction structure. Tax advantages come in the form of lower effective tax rates and simplified tax treatment. The fundamental tax benefit of a stock sale lies in its single-level taxation at preferential capital gains rates. When corporate shareholders sell their stock, they pay tax only once, on the difference between the sale price and their basis in the stock. Current federal long-term capital gains rates max out at 20%, but with additional state taxes that vary by state. Let’s take the example of a C-Corporation sale with a sale price of $5 million, and a tax basis of $3 million, resulting in a capital gain of $2 million.  With an asset sale, this transaction would result in double taxation.  First, the C-Corporation would recognize the $2 million gain that would be taxed at the federal corporate tax rate of 21%, resulting in a corporate tax liability of $420,000, and net proceeds to the corporation after this tax of $4.58 million.  Thereafter, if or when the proceeds are distributed to shareholders, the federal capital gains rate of 20% will be applied to this $4.58 million, resulting in shareholder tax liability of $916,000.  The combined tax burden at both levels of taxation in this example would be $1.08 million, resulting in an effective tax rate on the gain of about 67%.

The same transaction structured as a stock sale would result in a single level of taxation at the shareholder level.  In the above example, the $2 million gain would be taxed at the 20% federal capital gains rate for a total tax liability of $400,000, for an effective tax rate on the gain of 20%.  In this example, there would be a tax savings for the Seller of $935,000, comparing the tax sale scenario to the asset sale scenario.

Capital gains rates present a substantial advantage over ordinary income tax rates, of course. While ordinary income tax rates can reach 37% at the federal level, long-term federal capital gains rates are typically 20% for high-income Sellers, with additional state tax rates varying by jurisdiction. To secure capital gains treatment, stock must be held for more than one year to qualify for long-term capital gains rates, the transaction must represent a genuine sale or exchange of a capital asset, the Seller must maintain proper documentation of their basis in the stock, and the sale must be properly structured and executed.

C-Corporations benefit most dramatically from stock sale treatment, as a stock sale eliminates the double taxation inherent in the C-Corporation structure. The avoidance of corporate-level taxation represents a pure tax savings that flows directly to shareholders’ bottom line. The above example considered a C-Corporation, but tax treatment depends on entity type.

S-Corporations also benefit from stock sale treatment, though the advantage is more nuanced. While S-Corporations generally avoid double taxation even in asset sales, stock sale treatment ensures the entire gain receives capital gains treatment, rather than having portions potentially taxed as ordinary income depending on the character of underlying assets.

Limited Liability Companies and partnerships, when selling membership interests or partnership interests, typically receive treatment similar to stock sales, providing comparable tax benefits to their owners — but asset sales for partnerships may result in ordinary income treatment for certain assets, and there may be complexity in allocating gain among partners.

In addition to having advantage in applicable rates of taxation, stock sales also eliminate concerns about depreciation recapture that may occur in asset sales, where equipment and machinery gains may be taxed as ordinary income, real estate depreciation may be recaptured at 25% rates, and other asset classes may trigger different tax rates.  Stock sales also eliminate the need to characterize gain on an asset-by-asset basis, thereby reducing complexity in state tax compliance, simplifying tax reporting and compliance, and providing greater certainty in tax outcome.  Stock sales also can avoid multiple state tax filing requirements, reduce exposure to state transfer taxes, and simplify compliance across jurisdictions.

Advantages to Buyers in a Stock Sale

While the stock sale structure typically favors Sellers, a stock sale gives the Buyer a simpler transaction structure, with fewer formal requirements, along with automatic transfer of contracts, licenses, and permits.  There is no need to retitle individual assets, as there would be in an asset sale.  A simpler transaction structure results in reduced transaction costs and complexity.  A stock sale also allows seamless continuation of business operations, preserves existing contracts and relationships of the business, maintains existing permits and licenses, and retains the corporate entity and tax attributes.

 

Section 338(h)(10) Election

In some circumstances, Section 338(h)(10) of the Internal Revenue Code provides a sophisticated mechanism that allows C-Corporations to combine the legal benefits of a stock sale with the tax advantages of an asset sale. This election represents a hybrid approach, where the transaction is legally executed as a stock purchase while being treated as an asset purchase for federal tax purposes. To qualify for this election, the purchasing entity must be a corporation (not an individual or partnership), the Buyer must acquire at least 80% of the target company’s stock in a taxable purchase, the target must be either an S corporation or a subsidiary member of a consolidated group, and both Buyer and Seller must formally agree to make the election.

When a Section 338(h)(10) election is made, the transaction is treated as a hypothetical asset sale followed by a liquidation of the target company. The target company is deemed to have sold all its assets to a new corporation at fair market value, and the Buyer receives a stepped-up tax basis in the acquired assets. For S corporations, shareholders experience a single level of taxation. The transaction avoids double taxation typically associated with C corporation asset sales.

The Buyer obtains stepped-up basis in assets for enhanced depreciation and amortization, benefits from the legal simplicity of a stock acquisition, avoids need to transfer individual assets or obtain third-party consents, and preserves valuable contracts and permits that might be non-transferable.  The Seller achieves potentially higher purchase price due to the Buyer’s tax benefits, maintains transaction efficiency of stock sale, avoids the complications of an asset-by-asset transfer, and might receive more favorable overall tax treatment compared to straight asset sale.  The election process involves specific timing and procedural requirements, however.  The election must be filed by the 15th day of the 9th month following the acquisition month, requires formal agreement between Buyer and Seller, and is irrevocable once made.  In addition, the purchase price must be allocated among assets according to IRS rules.

While potentially advantageous, a Section 338(h)(10) election may result in state tax treatment that differs from federal treatment, and there are complex valuation and allocation requirements.  The election may result in higher taxes for the Seller when compared to a straight stock sale.

Summary

The choice between an asset sale and a stock sale requires careful consideration of a number of factors, including the tax implications discussed above, as well as liability exposure, transaction complexity, and circumstances that may be applicable to the particular business involved. Asset sales generally favor Buyers due to tax benefits and for reasons of risk management, and stock sales often appeal to Sellers due to tax efficiency and transaction simplicity. The optimal structure depends on the specific circumstances of the transaction and the priorities of the parties.

The availability of Section 338(h)(10) elections adds another layer of sophistication to the structure decision, potentially offering a beneficial hybrid approach that combines the advantages of both asset and stock sales. However, this option requires careful analysis and consideration of all parties’ circumstances and objectives.

 

None of the information provided in this article constitutes legal advice or tax advice.  Every situation is different and should be thoroughly reviewed by and discussed with your legal and tax advisors. Please do not rely on the contents of this article as the basis for making decisions regarding your particular situation.  If you are contemplating the purchase or sale of a business in the State of Maryland, Lewicky, O’Connor, Hunt & Meiser stands ready to provide legal support for your contemplated transaction.