Stock vs Asset Sales - Advantages Disadvantages
Asset Sales vs. Stock Sales: What’s The Difference?
Advantages and Disadvantages for Property Management Deal Structures
Deciding whether to structure your property management disposition as an asset sale or a stock sale is complicated because the parties involved benefit from opposing structures. Generally, buyers prefer asset sales, whereas sellers prefer stock sales. This article highlights some primary differences between the two structures.
An asset sale is the purchase of individual assets and liabilities, whereas a stock sale is the purchase of the owner’s shares of a corporation. While there are many considerations when negotiating the type of transaction, tax implications and potential liabilities are the primary concerns.
If the business in question is a sole proprietorship, a partnership, or a limited liability company (LLC), the transaction cannot be structured as a stock sale since none of these entity structures have stock. Instead, owners of these entity types can sell their partnership or membership interests as opposed to the entity selling its assets. If the business is incorporated, either as a regular C-corporation or as a sub-S corporation, the buyer and seller must decide whether to structure the deal as an asset sale or a stock sale.
In an asset sale, the seller retains possession of the legal entity and the buyer purchases individual assets of the company, such as equipment, fixtures, leaseholds, licenses, goodwill, trade secrets, trade names, telephone numbers, and inventory. Asset sales are almost always completed on a “cash-free, debt-free” basis. The sale does do not include cash and the seller retains the long-term debt obligations. Normalized net working capital is also typically included in a sale. Net working capital often includes accounts receivable, inventory, prepaid expenses, accounts payable, and accrued expenses.
Within IRS guidelines, asset sales allow buyers to “step-up” the company’s depreciable basis in its assets. By allocating a higher value for assets that depreciate quickly (like equipment, which typically has a 3-7 year life) and by allocating lower values on assets that amortize slowly (like goodwill, which has a 15 year life), the buyer can gain additional tax benefits. This reduces taxes sooner and improves the company’s cash flow during the vital first years. In addition, buyers prefer asset sales because they more easily avoid inheriting potential liabilities, especially contingent liabilities in the form of product liability, contract disputes, product warranty issues, or employee lawsuits.
However, asset sales may also present problems for buyers. Certain assets are more difficult to transfer due to issues of assignability, legal ownership, and third-party consents. Examples of more difficult to transfer assets include certain intellectual property, contracts, leases, and permits. Obtaining consents and refiling permit applications can slow down the transaction process.
For sellers, asset sales generate higher taxes because while intangible assets, such as goodwill, are taxed at capital gains rates, other “hard” assets can be subject to higher ordinary income tax rates. Federal capital gains rates are currently 20% and state rates vary (Missouri is currently 6% and Kansas is 6.45%). Ordinary income tax rates depend on the seller’s tax bracket.
Furthermore, if the entity sold is a C-corporation, the seller faces double taxation. The corporation is first taxed upon selling the assets to the buyer. The corporation’s owners are then taxed again when the proceeds transfer outside the corporation. In addition, if the company is an S-corporation that was formerly a C-corporation, and if the sale is within the 10-year built-in gains (BIG) tax recognition period, the S-corporation’s asset sale could trigger corporate-level BIG taxes, under IRS Sec. 1374.
Through a stock sale, the buyer purchases the selling shareholders’ stock directly thereby obtaining ownership in the seller’s legal entity. The actual assets and liabilities acquired in a stock sale tend to be similar to that of an assets sale. Assets and liabilities not desired by the buyer will be distributed or paid off prior to the sale. Unlike an asset sale, stock sales do not require numerous separate conveyances of each individual asset because the title of each asset lies within the corporation. A stock purchase is simpler in concept than an asset purchase. Few distinctions (between wanted and unwanted assets or between assumed and un-assumed liabilities) need, or can, be made.
The Acquirer buys all the stock of the Target and takes the corporation as it finds it. All of the target corporation’s assets remain subject to all its liabilities. Most contracts, lease, and franchise rights and permits remain in place (and in effect transfer automatically), although some sophisticated pre-existing agreements with third parties may require their consent to continuation after a transfer of control of the corporation.
With stock sales, buyers lose the ability to gain a stepped up basis in the assets and thus do not get to re-depreciate certain assets. The basis of the assets at the time of sale, or book value, sets the depreciation basis for the new owner. As a result, the lower depreciation expense can result in higher future taxes for the buyer, as compared to an asset sale. Additionally, buyers may accept more risk by purchasing the company’s stock, including all contingent risk that may be unknown or undisclosed. Future lawsuits, environmental concerns, OSHA violations, employee issues, and other liabilities become the responsibility of the new owner. These potential liabilities can be mitigated in the stock purchase agreement through representations and warranties and indemnifications.
If the business in question has a large number of copyrights or patents or if it has significant government or corporate contracts that are difficult to assign, a stock sale may be the better option because the corporation, not the owner, retains ownership. Also, if a company is dependent on a few large vendors or customers, a stock sale may reduce the risk of losing these contracts.
Sellers often favor stock sales because all the proceeds are taxed at a lower capital gains rate, and in C-corporations the corporate level taxes are bypassed. Likewise, sellers are sometimes less responsible for future liabilities, such as product liability claims, contract claims, employee lawsuits, pensions, and benefit plans. However, the purchase agreement in a transaction can shift responsibilities back to a seller.
The deal structure of any transaction can have a major impact on the future for both the buyer and seller. Many other factors, such as the company’s structure and the industry, can also influence the decision. It is important for both parties to consult with their business intermediaries, legal counsels, and accounting professionals early in the process to fully understand the issues and reach a decision that will produce the desired results.
Ratio of asset sales to stock sales
How common are asset sales versus stock sales? Based on an analysis of marketplace transactions from the Pratt’s Stats database, approximately 30% of all transactions were stock sales. However, this figure varies significantly by company size, with larger transactions having a greater likelihood of being stock sales.
Advantage of Asset Purchase over a Stock Purchase
- A major tax advantage is that the buyer can “step up” the basis of many assets over their current tax values and obtain ordinary tax deductions for the depreciation and/or amortization deductions. For example, if the seller has equipment worth $500,000 but the equipment is fully depreciated for tax purposes, a transaction that is treated as a stock sale cannot “step up” the basis to $500,000 for tax purposes since the seller has already depreciated the equipment.
- Goodwill, which is the amount paid for a company less its tangible assets, can be amortized on a straight-line basis over 15 years for tax purposes in an asset transaction. In a stock deal, just like if you were buying shares of a company like IBM, the goodwill cannot be deducted until the stock is sold by the buyer.
- The buyer can dictate what, if any, liabilities it is going to assume in the transaction. This limits the buyer’s exposure to liabilities that are either unknown or not stated by the seller. The buyer can also dictate which assets it is not going to purchase. This is often advantageous if the seller has a lot of accounts receivable that the buyer does not believe will be collected.
- Because the exposure to unknown liabilities is limited, the buyer typically needs to conduct less due diligence.
- Minority shareholders that don’t want to sell may be forced to accept the terms of an asset sale.
- The buyer can select which employees they want to offer jobs without impacting their unemployment rates.
Disadvantages of Asset Purchase Compared to Stock Purchase
- Contracts – especially with customers and suppliers – may need to be renegotiated and/or novated.
- The tax cost to the seller is typically higher, so the seller may want a higher purchase price.
- Assignable contract rights could be limited.
- Assets may need to be retitled.
- In California and most other states, the seller should obtain a bulk sales certificate. Otherwise, the purchaser could become liable for any unpaid taxes.
- Employment agreements with key employees may need to be rewritten.
- The seller still needs to liquidate any assets not purchased, pay any liabilities that have not been assumed, and negotiate any leases that need to be terminated.
Advantages of a Stock Purchase
- The acquirer doesn’t have to bother with costly valuations and retitles.
- In most cases, buyers can assume non-assignable licenses and permits without consent.
- Buyers may also be able to avoid paying state and transfer taxes.
- More simple and common than an asset acquisition. For example, hedge funds are known for conducting M&A transactions, particularly in the form of a simple stock purchase.
Disadvantages of a Stock Purchase
- The main disadvantage is that an acquirer receives neither the “step-up” tax benefit nor the advantage of handpicking liabilities.
- All asset and liabilities transfer at carrying value.
- The only way to eliminate unwanted liabilities is to contractually sell them back to the target.
- Securities laws can complicate situations involving a large number of shareholders.
- It may be difficult to convince some stockholders to sell their shares.
- Goodwill is not tax deductible.
IRC Section 338 allows the buyer to purchase the stock but the transaction is taxed as if it were an asset purchase. However, the seller has to pay the tax bill that arises from the step-up on the basis of assets, which occurs under asset purchase transactions. We often see this election used in purchases of service companies where the customer contracts may be difficult to novate or where the seller has leases and/or other contracts that the buyer does not want to renegotiate.
As you can see, there are many factors to take into consideration when weighing your acquisition method and the decision may not be an easy one. An advisor who is experienced with mergers and acquisitions can assist the buyer and/or seller throughout the process and help provide clarity.
This post intended for informational purposes only. It is not intended to constitute legal, tax or investment advice. There is no guarantee that any claims made are accurate or will come to pass. ManageVisors does not warrant the accuracy of the information. Consult a financial, tax or legal professional for specific information related to your own situation.