Once a business owner decides to sell their business, we are very often asked the question of should I sell the equity or should I sell the assets? This question needs to be looked at from a number of different aspects – (1) legal; and (2) the tax aspects.
Legal aspects of selling assets or equity
From a legal perspective, there can be situations where a seller doesn’t have much of a choice. The business may have critical assets that are not easily transferred. This situation typically occurs when a business has permits or licenses with a government or municipal agency, or maybe substantial long-term contracts that are non-transferable (or not easily transferred without the possibility of a vendor trying to renegotiate terms). In these instances, the owner may be forced to sell the legal equity of the entity in order to transfer these items.
Tax aspects of selling assets or equity
If a seller’s business doesn’t face these hurdles to transferring the assets, then you want to examine the tax aspects of selling assets versus selling equity. The tax cost between the two options ranges from minimal to very substantial. The distinction will be driven by the mix of assets making up the business as well as the legal form of the entity (e.g., corporation, partnership, S-corporation, etc.). For example, if the business that is being sold operates as a partnership for tax purposes (which can be either a true legal partnership or an LLC that files a partnership tax return), then there will be no difference in selling assets or equity. The tax mechanics of selling the equity in a partnership get you to the same place as selling assets.
If you own a corporation, then the assets in the business that are going to be sold need to be evaluated. The difference in tax cost is because some of the assets are categorized as capital assets and some are categorized as ordinary assets.
In the sale of equity of a corporation, the gain is taxed 100% at capital gain rates, which are much lower than ordinary income rates. But if the parties structure the transaction as an asset sale, you have to calculate the tax on an asset by asset basis and apply the capital gain rates and the ordinary income rates as applicable. So the more ordinary income assets that make up the business, the more difference there will be in selling assets versus selling equity. Common ordinary income assets include accounts receivable of a business that uses cash basis accounting for tax purposes and depreciable equipment and improvements that may have to recapture depreciation.
Generally speaking, buyers want to acquire assets and sellers want to sell equity. One significant reason for this is that a buyer may want to avoid historical legal liability that could be connected with a legal entity. Acquisition of the assets protects a buyer from a plaintiff bringing suit against the business for something that occurred prior to the buyer’s acquisition. Also, if the transaction is an asset acquisition, the buyer gets what is known as a “step up” in the assets acquired which generate more depreciation and amortization deductions.
The best advice is to consult with your tax and legal advisors prior to any potential sale so that the tax costs can be analyzed and quantified, and any legal hurdles can be evaluated. The structure of the transaction can sometimes be negotiated, so it’s critical to understand the different results in advance of talking to a buyer.