When you are buying or selling a business and the business is operated by a corporation or LLC, you have the option of an asset sale versus a stock sale. What is the difference, you ask. Let me explain.
LIABILITIES FOR DEBTS
Scenario 1: The business is operated by a corporation. All of the business’ assets (equipment, reputation, customer lists, leases for physical locations) are owned by a legal entity, the corporation. By buying the corporation, you will certainly get everything that the corporation owns, i.e. the business. You would buy the corporation from its owners (called shareholders), who would transfer all their ownership in the corporation to you by way of transferring all of their shares of the corporation. However, by buying the corporation, you will automatically also get everything else the corporation “owns”, such as debts and liabilities, even the ones you never knew existed. This makes buying a business in a stock sale a somewhat risky undertaking. You will be saddled with all liabilities of the corporation.
Enter scenario 2: You buy the business by buying individually every piece that makes the business. Because a business is just a collection of many assets. So you would buy all the equipment, leases, reputation, inventory piece by piece. Liabilities don’t travel with these pieces, they will stay with the corporation, which you are not buying. So one advantage to a buyer of a business is that the buyer can rest easy knowing that he doesn’t buy undisclosed liabilities attached to the corporation.
Then there are important tax consequences resulting from the questions of asset sale versus stock sale. In most cases, Seller and Buyer of the business are in conflict with respect to their desired tax consequences. What is good for the Seller tax wise, may be bad for the Buyer.
The Seller usually favors a stock deal, since this will assure that he has to pay capital gains tax on any gain achieved from the sale. Capital gains tax rates are much lower than ordinary income tax rates.
The Buyer usually favors an asset deal, because he can take depreciation or amortization deductions on the purchased assets with the purchase price of the assets as his cost.
Even if both parties can agree on an asset deal, there are remaining conflicts of interest with respect to the so called allocation of the purchase price, because, again, the allocation will have tax consequences for Seller and Buyer. Seller and Buyer must agree on these points, since they both have to allocate the purchase price in the same way when reporting to the IRS later. Allocation of the purchase price addresses the question of what part of the purchase price is allocated to which assets included in the deal. In very general terms, a Seller usually prefers that as much as possible of the purchase price is allocated to capital assets, such as goodwill, rather than depreciable business property, in order to avoid having to pay ordinary income tax on the gain.
Photo courtesy of cosmoflash