Volume 21 Issue 3 -- May/June 2009
In the last issue, we looked at some of the problems that arise when buyers and sellers of businesses mix inconsistent elements of stock sales and asset sales in a single transaction.
Such problems often arise when the parties negotiating the sale do not keep clearly in mind the answer to the fundamental question: who is selling what?
For example, suppose Purch A. Sor (hereafter, “Purch”) wants to buy “the business” of Cecilia Moore (hereafter, “Cel”), which is a corporation named “Doggie Do.” Cel began selling the Doggie Do concept on college campuses while she was still a student.
“Doggie Do” refers not to the substance but to the special method for delivering submarine sandwiches (“Subs”) by trained dogs. The Subs are wrapped in paper bearing advertisements for just about anything – you name it – thus sponsors and ad money. The dogs, mostly large ones, are trained to follow sound beacons keyed into dormitories. When the delivery dog arrives, a message appears on the student’s computer screen directing the student to go to the front door of the dormitory to pick up his Doggie Do Sub order.
This concept was wildly popular and led Cel to build shops near college campuses to assemble Sub sandwiches and other food items. The name Doggie Do caught on and resulted in sales of the Subs and other foods in the sub shops for those who did not want doggie delivery or wanted a beer with their Sub. Cel’s ideas spread throughout the U.S., and Doggie Do became a household name. Purch, who made her money in the oil business, likes the concept and wants to buy the whole business from Cel.
As often happens, the initial discussions focused on the business as an amorphous entity and the valuation of the business as a whole. Purch and Cel each had a clear idea of what they thought the business was worth, but never thought about how specific components should be priced. As a result, they overlooked a number of critical considerations that affect not only the value of the business being transferred but also the tax consequences of the eventual transaction.
If Purch buys the Doggie Do stock, she will acquire control of the corporation and, from a business standpoint, be in much the same position as if she had acquired all of Doggie Do’s assets. In a stock sale, none of the assets or liabilities of Doggie Do change hands, so Purch also bears the economic consequences of any of Doggie Do’s liabilities. For example, unbeknownst to Purch, there were instances of delivery dogs not being as friendly as they should have been and a few students in various states were bitten. As a result, any judgments or settlements that Doggie Do enters into will reduce the value of Purch’s investment.
For this reason, a purchaser of stock will usually expect that the value of a business be discounted to reflect the increased risk of unknown liabilities. In some cases, however, particularly if the entity is a C corporation, it may be beneficial for the seller to take less money for stock than for an asset sale because of the favorable tax treatment for individual long-term capital gains.
If the business has contracts, licenses, or other assets that are not easily transferred to the buyer’s entity, a stock sale may be the only option.
There are many other factors to consider in determining whether a sale should be a sale of assets or of stock. Typically, a buyer and seller will have conflicting interests on this point. Buyers usually will want to buy assets, while sellers want to sell stock. Why?
Cel, for example, has purchased equipment and dogs but these costs have been written off through depreciation. If Purch buys Doggie Do stock, Doggie Do will have nothing additional to depreciate, but if Purch buys assets, she will get a new basis and greater depreciation deductions.
In Cel’s case, Doggie Do also has a lot of good will, because the company is worth far more than the book value of its assets. If Purch buys stock, the effective cost of that good will is merely part of Purch’s basis in her stock, but if she buys assets, that good will can be amortized.
The additional tax deductions for depreciation and amortization, coupled with the freedom from hidden liabilities of the business, usually cause buyers to prefer asset purchases. For sellers, the situation is a bit more complicated. If the assets are owned through a C corporation, an asset sale will usually result in a much larger tax bill than a stock sale, but even in the case of pass-through entities (S corporations and LLCs), there can be significant tax differences between an asset sale and a stock sale.
In the next issue, we will look at other aspects of business sales that come
into play after it is determined what is being sold. If you or a client have
questions related to this topic, keep The Tax and Business Professionals in
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