Buying a business as an asset purchase

Small business entrepreneurs typically have two options for structuring the purchase of a business: an asset sale or a stock sale. While an asset sale may sound like you’re just buying the fixed assets, it really can include nearly everything a stock sale does (e.g., goodwill, employees, equipment, inventory, the name, etc). The difference between the two lies into how the transaction is structured and its implications for taxes, liabilities, etc.

The purpose of an asset sale is to allow the buyer to acquire only the assets it needs or wants while leaving behind the remaining liabilities or obligations of the seller. This can be a significant advantage for buyers who want to avoid assuming the seller's debts, legal liabilities, or contractual obligations. Buyers and sellers can negotiate the terms of the transaction, including the purchase price and any warranties or representations, without being bound by the existing corporate structure of the seller.

An asset purchase agreement (APA) is the central document in an asset sale that outlines the terms and conditions of the transaction, including

1. Description of the assets being sold: This includes a detailed list of the specific assets, such as equipment, inventory, real estate, intellectual property, contracts, and goodwill.

2. Purchase price and payment terms: The APA specifies the purchase price for the assets together, the allocation to each specific asset and outlines how and when the buyer will make payments. It may also include provisions for adjustments to the price based on factors like working capital.

3. Representations and warranties: The seller provides assurances about the condition of the assets being sold, any legal issues, and other relevant matters. The buyer may make representations regarding its ability to complete the transaction.

4. Covenants and conditions: The agreement may include various covenants and conditions that the parties must fulfill before or after closing. These can relate to the conduct of the business before closing, obtaining necessary approvals, or meeting regulatory requirements.

5. Closing procedures: The APA may outline the steps to be taken at the closing, such as the transfer of titles and possession of assets. It may also detail post-closing obligations, such as the transition of employees, customer notifications, or other necessary actions.

By contrast, a stock sale is when a buyer purchases the existing shares of the company directly from the existing shareholders (the sellers). This means the ownership and control of the entire company, including its assets and liabilities, are transferred to the new owners. The taxes from a stock sale are typically limited to capital gains tax (e.g., the increase in value from the point the seller “bought” the stock to the point the seller sold it). 

Example purchase price allocation

Purchase price allocation (PPA) involves allocating the total purchase price paid by the acquiring company to the specific assets and liabilities of the acquired company. Because there will be more tax consequences than just capital gains, the purchase price allocation is often negotiated between the buyer and seller. In the simplified example below, the sale price is allocated between three accounts. 

This allocation is typically included as an exhibit to the asset purchase agreement.

The tax implications of an asset sale

From the seller’s perspective, many will want to argue for a stock sale since she can typically qualify for capital gains tax treatment, which can result in lower tax liabilities compared to an asset sale (e.g., up to 20% for long-term capital gains vs. 37% for income). In the table below, we can see that there’s a delta of $51,000 in our example mainly attributable to the ordinary income tax that’s present in the asset sale but not in the stock sale.

* This example assumes a state with no income tax to make the math easy.

As you can see from the example, the business is sold for the same amount in either structure: $3.5M. The owner pays $300K in fees (business brokers, attorneys, CPAs), and gains $3.2M from the sale. The difference lies in how that gain is taxed.

In the stock sale, the entire gain is taxed as long-term capital gains (20%) in this example. 

In the asset sale, the gain is taxed according to the purchase price allocation. The $300K of fixed assets being sold are taxed as ordinary income, whereas the remaining amount allocated to other intangibles and goodwill are taxed as capital gains.

The $51K less in after-tax proceeds are because the fixed assets in an asset sale are being taxed at a higher rate. 

Allocating the delta between the purchase price and value of assets

Because of this delta, there will often be a negotiation on the difference between the purchase price of the business and the true fair market value of the “net assets”, which are the assets that you can easily recognize separately and assign a value to. This allocation is used to determine the amount of goodwill associated with the transaction. Here's how the process typically works:

1. Determine Identifiable Net Assets: These assets and liabilities are typically identified through due diligence and valuation efforts.

2. Calculate the Delta: The delta, in this context, is the difference between the total purchase price paid by the buyer and the FMV of the identifiable net assets acquired. Mathematically, it can be expressed as: Delta = Total Purchase Price - FMV of Identifiable Net Assets

3. Allocate the Delta: The delta represents the unallocated portion of the purchase price. This unallocated amount is allocated to goodwill, which is recorded on the buyer's balance sheet. Goodwill represents the excess of the purchase price over the fair value of the net assets acquired. It often includes intangible elements such as the company's reputation, brand value, customer relationships, and future growth potential.

A seller will want to argue for the lower fair market value of net assets and assign a large delta to goodwill for tax purposes.

Typical negotiating stance of buyers and sellers in an asset sale

In general, buyers prefer allocating more of the purchase price to tangible assets. This allows them to capture the benefits of depreciation for themselves. On the other hand, sellers are trying to maximize their after-tax proceeds. In order to do this, they will want to argue for allocating more of the purchase price to goodwill, which can be taxed as long-term capital gains and potentially save them on their tax bill.

Choosing between an asset sale and stock sale

Choosing between an asset sale and a stock sale is a critical decision in the context of a business acquisition or sale. The choice depends on a variety of factors, including the buyer’s willingness to take on the seller’s liabilities, the capital gains treatment for the seller, depreciation recapture, and any available tax incentives. 

In the small business market, most transactions are done as asset sales. The main reason for this is that buyers are simply not willing to take on the seller’s liabilities. In a stock sale, they would be exposed if the IRS came after them for issues under the prior owner. They would also be open to liability if a customer sued or made a claim based on work done by the prior owner.

If the buyer is open to a stock sale, then other issues may guide the parties to one transaction structure over another.

For instance, what is the capital gains treatment for the seller? If the seller is a new owner of the business herself, she may not qualify for long-term capital gains. This would really defeat the tax savings of a stock sale for the seller.

Another discussion topic is depreciation recapture. It is a tax provision that applies to depreciable assets used in businesses. If you sell an asset that you claimed depreciation deductions on, you are required to recognize and report as income a portion of those deductions if you sell at a gain. The recapture rate for depreciation depends on the type of asset. Generally, for real property, the recapture rate is 25%, while for most other depreciable assets, it is 100% (i.e., the entire depreciation claimed is recaptured as ordinary income). 

A stepped-up basis refers to the adjustment of the tax basis of an asset to its fair market value at the time of sale or inheritance. When an entity then sells an asset, the capital gain is calculated on a stepped-up basis. This can result in a lower capital gain (or even no capital gain) because the difference between the FMV and the sale price is smaller compared to the difference between the original cost and the sale price.

Section 338(h)(10)

For those buyers who agree to a stock sale with a seller but still want to benefit from the depreciation benefits of an asset sale, they should explore making a Section 338(h)(10) election.

This election allows the stock acquisition to be treated as if it were a deemed asset acquisition for tax purposes, specifically a "deemed purchase" of the target corporation's assets. The buyer can then step up the tax basis of the target corporation's assets to their fair market value as of the acquisition date. This step-up in basis can result in higher depreciation and amortization deductions, which can reduce the buyer's taxable income in future years.

Information posted on this page is not intended to be, and should not be construed as tax, legal, investment or accounting advice. You should consult your own tax, legal, investment and accounting advisors before engaging in any transaction.