This is the third article in our six-part series: Buying and Selling During a Pandemic. As the country begins to emerge from the COVID-19 pandemic, the LaPorte Transaction Advisory Services team members will share a series of educational blogs designed to inform you of key elements of the transaction life cycle.
With almost any business sale, one of the biggest issues buyers and sellers have to address is how the business is transferred. Generally, this choice is between an asset sale or a sale of the interest in the business. Unlike an asset sale, a sale of interest would include sale of shares of a corporation, membership units of a limited liability company (“LLC”), or partnership interest if the entity is organized as a partnership under state law.
Transaction structuring considerations
A major consideration in the determination of how the transaction should be structured is how the entity is taxed for federal income tax purposes. Is the entity taxed as a C Corporation, S Corporation, partnership, or disregarded entity if it is a single member LLC?
Buyers: When dealing with a C Corporation (an entity that files a Form 1120) or an S Corporation (an entity that files a Form 1120-S), buyers typically will want to buy the assets of the company for tax purposes. This option allows the buyers to allocate the purchase price over the business assets and either depreciate or amortize the portion of the price allocated to those assets. For shorter-lived assets, this could result in bonus depreciation from which the purchaser will take an immediate deduction. If the acquiror were to purchase solely the stock of the entity, then the cost basis is allocated to the stock/units acquired. This approach does not result in any depreciation or amortization for the buyer.
Sellers: Sellers typically want to sell the interest in their corporation, as any gains will be taxed at capital gains rate. Moreover, if the entity is a C Corporation and meets the definition of a “qualified small business,” the gain could potentially be excluded from taxation. If the assets of the corporation are sold instead, then some of the gain will be subject to ordinary income tax rates (21 percent for C Corporations and up to 37 percent for S Corporation shareholders – depending on whether the qualified business income deduction applies). It should also be noted that if the assets of a C Corporation are sold, then the sale will be subject to double taxation: tax at the corporate level on the sale of the assets and taxed again at the shareholder level upon distribution of the sale proceeds. When looking at the double-tax exposure, C Corporation shareholders are looking at a potential 41 percent blended rate, explaining the desire to sell stock instead of assets. In addition to these tax rates, there may also be state level income taxes to pay.
Many times, the purchase price is negotiated to cover a portion of the additional taxes that result from an asset sale. Another negotiation tool is the purchase price allocation. This will particularly matter for S Corporation shareholders, as S Corporations are flow-through entities. S Corporation shareholders will want to allocate the purchase price away from those assets that generate ordinary income and towards assets that generate capital gains (typically goodwill).
With entities taxed as partnerships, the analysis is simpler. Whether the partners are selling the partnership interest or the assets of the entity, there will be ordinary income based on the purchase price allocation. To the extent the purchase price is allocated to “hot assets” (such as inventory, cash-basis receivables, and fixed assets) and the allocation results in gain on the sale of those assets, then the gain will be taxed at ordinary rates. Typically, buyers of a partnership interest are more tax-neutral because they will get the benefit of depreciation either way. That is, if the purchase is for the partnership interest, then the buyers will make “754 elections,” which allow the acquirors to recover some of their costs through depreciation.
In summary, not every transaction is the same, but many transactions have similar issues that must be addressed from a tax perspective. It is imperative for parties to a transaction to consult with their tax professional to make sure they are maximizing the tax benefits.