Because of taxes, the type of entity you have selected for your company may substantially impact the amount of money shareholders take home after sale of the company. The following is a cheat sheet to help you identify the pros and cons of each entity type in light of these tax implications.
Are you a “C” or “S” corporation?
- Stock sale:
- A seller generally prefers a stock purchase (over an asset purchase) because it disposes of the entity, there is only one level of tax (at the shareholder level), and all tax is at the capital gains rate.
- There are no federal tax consequences for the target corporation whose stock is sold.
- A buyer generally is disadvantaged by a stock purchase because it cannot step-up the basis in the assets held by the target corporation.
- A stock sale is easier to accomplish from a corporate perspective because the buyer steps into the seller’s shoes without change in the employee-employer relationship and often without need for third party consents to the change of control.
- Asset sale:
- Asset purchases are generally preferred by buyers because the buyer avoids acquiring any unknown liabilities of the seller and because of favorable tax treatment. (The purchase price is allocated among the acquired assets, and the tax basis in the assets purchased is determined by the buyer’s allocation of the purchase price. Rather than inheriting the historical cost basis of the seller’s assets, the buyer allocates the purchase price to the fair market value of those assets. After closing, the buyer receives deductions for depreciable or amortizable assets, including goodwill.)
- A C-Corp seller is faced with double-taxation. The corporation must recognize gain on the sale, reducing the net amount of cash available for distribution to the shareholders. Then, the shareholders must pay income tax on the dividend.
- An S-Corp seller does not face double-taxation but may still be disadvantaged by an asset sale because the gain or loss to the seller and the asset character (capital or ordinary) is computed as if each asset on the corporation’s balance sheets were sold for the allocated amount of the purchase price. Because some of the assets will be ordinary rather than capital, sellers may be worse off in an asset purchase than in a stock purchase.
- Typically, an asset sale requires obtaining the consent of landlords, banks, and contracting parties before assigning business contracts to the buyer.
- Tax-free reorganization may be available under certain circumstances
Are you an LLC?
- Unit/Interest sale:
- An LLC member’s sale of all or part of his interest to a third party produces capital gain or loss (calculated as the difference between the amount realized and the basis), though some of the proceeds may be subject to ordinary income treatment (§751 property). Under certain circumstances, the tax basis of the assets in the LLC can be adjusted when the interest is sold.
- The unit/interest sale is easier to accomplish from a company perspective because the buyer steps into the seller’s shoes without change in the employee-employer relationship and often without need for third party consents to the change of control.
- Asset sale:
- Asset purchases are generally preferred by buyers because the buyer avoids acquiring any unknown liabilities of the seller and because of favorable tax treatment.
- The LLC entity does not recognize gain or loss. The tax applicable to each member is based on distributions in excess of the adjusted basis of that member’s interest in the LLC.
- Typically, an asset sale requires obtaining consent of landlords, banks, and contracting parties before assigning business contracts to the buyer.
Because of the above tax implications, it is crucial to determine the deal structure before agreeing on a deal price.