When beginning to prepare for a potential deal, sellers too often do not spend enough time considering the tax and other issues caused by the transaction structure. There are many ways in which a corporate acquisition or merger may be structured, but most small sales of privately-held companies will be structured as an asset purchase or as a stock purchase. Whether a transaction is structured as a stock purchase as opposed to an asset purchase can have huge financial implications for the seller and the selling owners.
In general, most purchasers will prefer to buy the assets of a company, as opposed to the company’s stock, for two primary reasons. First, in an asset purchase transaction, a purchaser can pick and choose those liabilities of the company that it agrees to assume, and it is not generally liable for all liabilities of the company as it would be if the purchaser purchased the stock of the company. The buyer will generally only be liable for those liabilities of the company that the buyer agrees to assume under the purchase agreement. Second, there are usually tax advantages to an asset purchase transaction for a purchaser. Specifically, in an asset purchase transaction, a purchaser receives a step up in basis of the assets it acquires equal to the purchase price, which allows the purchaser higher depreciation and amortization deductions. When a purchaser buys stock, however, there is no step up in basis.
In general, an asset purchase transaction will have less favorable tax consequences for selling owners and the company than a stock purchase transaction. For instance, if the company is structured as a C corporation and the transaction is structured as an asset purchase, then the selling owners will have to incur a double tax (the company is taxed on any gain in the assets sold at the corporate level and the selling owners are taxed at the individual level once proceeds are distributed to the shareholders). Even if the company is not a C corporation, but is a pass through entity (such as a limited liability company or S corporation), the likelihood is that, in an asset purchase transaction, a portion of the purchase price will be taxed at ordinary income rates, whereas all of the purchase price would be taxed at capital gains rates in a stock purchase transaction.
In a transaction where a buyer is purchasing the stock of the selling C corporation, there is no tax to the company (obviously, the shareholders own the stock of the company and therefore it is the sellers who are taxed upon the sale). The shareholders will be taxed at capital gains rates upon the sale, meaning if the stock has been held for more than one year by a shareholder, no ordinary income rates (i.e., short term capital gains rates) will apply. Though a purchase of stock can sometimes have advantages for the buyer because certain of seller’s tax attributes carry over to the buyer (such as net operating losses and credit carryforwards), a stock acquisition will typically not be as favorable to the buyer because the seller’s basis in its assets is carried over to the buyer and there is no step up in basis.
Though the tax effects of a transaction are often the key driver in how the buyer and seller will want to structure a transaction, that is not always the case. Sometimes, other issues, such as third party contractual consent requirements and shareholder approval for the transaction will dictate a structure other than an asset transaction. For example, if the selling company’s contracts have provisions prohibiting assignment of the contract without the consent of the other party, then the consents must be received before the contracts can be transferred. If there are too many contracts with these anti-assignment provisions, it may be impractical to obtain the consents on all of the agreements the buyer would require in order to close. If this is the case, a stock acquisition or merger would be the way to go (assuming the contracts do not have change of control provisions requiring the consent of the other parties).
Another example of a non-tax issue possibly dictating the transaction structure involves the capitalization structure of the selling entity. In order for a buyer to acquire the stock of a company, all of the shareholders must agree to sell. For a seller with a lot of shareholders, it may not be practical to expect to receive the consent of all of the shareholders for the closing. It would be a rare transaction in which the buyer would agree to close without acquiring one hundred percent of the stock (i.e., allowing a few minority shareholders to stick around). Thus, when a seller has a lot of shareholders, it may not make a lot of sense to structure the deal as a stock acquisition and a merger or asset acquisition would be a better structure.
Depending on the structure employed, an acquisition or merger may be entirely tax free, partially tax free or entirely taxable to the seller. The key is to understand the net after-tax effects for a sale of the company in an asset purchase transaction and a stock purchase transaction (or merger). Sellers should meet with their tax advisors before marketing the company. The net after tax effects to selling owners and the company can vary quite substantially depending on the structure of the transaction. By understanding the implications of the structure of the deal to the bottom line early on in the process, sellers will be in a better position to negotiate with the purchaser on the issue. One strategy could be to offer a purchaser two different purchase prices depending on the structure of the transaction. If a seller tries to negotiate this issue too late in the game, it will likely find that the purchaser is not going to be too willing to accommodate the seller on the issue.