On strictly a tax level, an asset sale benefits the buyer because the revaluation of assets attendant to an asset sale allows the buyer to "step up" the value of the company's assets-within the framework of IRS guidelines and negotiation with the seller, of course. By setting higher values for assets that depreciate quickly, and lower values for assets that depreciate slowly or not at all, the buyer can reap tax benefits from the price paid, as depreciable assets can be written off in future fiscal years.
(Exception: The buyer is still able obtain this "step up" in a stock sale by electing under IRC section 338, but the buyer will then be liable for the corporate level tax mentioned below.)
For the seller, an asset sale creates a double tax situation. The entity being sold is taxed because of the appreciation of assets (tax No. 1), and, if the corporation is a C corporation (as opposed to an S corporation) and is liquidated, the seller must pay capital gains on the deemed sale of his/her stock (tax No. 2). If the deal is done as a stock sale, however, the seller will only pay once-on capital gains from the appreciation of stock.
Negotiations between buyer and seller can get extremely bogged down over the asset sale vs. stock sale dilemma. However, a good advisor can identify common mitigating circumstances for one or both parties that will make the negotiations run more smoothly.
For instance, in an asset sale, there are assets that can easily be transferred in a physical and legal sense, like furniture, computers, etc. However, legal transfer of assets can be much more complicated with items like automobiles, as the titles must be transferred at the DMV, or real estate, as deeds must be recorded with the local government.
The parties must also determine whether or not contracts can be transferred legally, and who will be responsible for future liabilities. The buyer may find that transfer of physical assets is so costly, time-consuming and/or problematic, that a stock sale, despite the lost tax benefits, is the path of least resistance.
On the other hand, the selling party may have its reasons for desiring an asset sale. One scenario in which a seller may avoid the dreaded double tax is if he/she as a shareholder has made personal loans to the company. The proceeds from the sale of the company's assets can be used to pay off the principal of the loan-and the seller receives that amount as a return of principal, which is not taxable. Exception: The seller can recoup his/her stock basis in the ordinary asset sale, thus avoiding incurring gain on the deemed sale of stock and the double tax, but, typically, the seller has a low or nominal stock basis.
Additionally, a stock deal transfers an entire company -- assets, employees, real estate - everything, including the kitchen sink. In certain cases, the seller may not want to sell everything. And the buyer may not want to buy everything.
For instance, often the seller wants to retain some of the corporation's real estate, either for other uses or to lease back to the buyer as an extra source of income. Often a buyer is interested in only a specific line of business. Unless the business already has a multi-level corporate structure, an asset deal is necessary in this scenario.
(Exception: The seller can restructure the company at the time of the deal, but such a restructuring requires compliance with the complex, and fact specific, tax regulations regarding spin offs or split ups.)
Whether buying a motorcycle or contracting a printer, there is a certain amount of give and take in any business transaction. Whether representing a buyer or a seller, be sure to examine all issues, tax-related or not, and fully understand the client's goals before you make a recommendation.
Contract Considerations
Negotiations between buyer and seller in the sale of a business are often seen as wrangling over the deal's structure and the purchase price. However, there is a great deal of behind the scenes work that must also be done and can significantly affect the negotiations. Many extremely thorny legal issues must be considered in depth, and the results of the review of these issues may lead to changes in purchase price or deal structure.
One of the most important issues to consider in a business sale is the assignment of contracts.
Assignment of contracts is usually more an issue in an asset sale than a stock sale. In an asset sale, of course, some or all of the salient assets of one entity are sold to another entity. Sometimes the name of the corporation itself is sold and the seller finds a new name. The ownership of everything from fax machines to the company box at the opera must be transferred. This can be somewhat of a nuisance when dealing with items like automobiles. When it comes to contracts, however, it can get more problematic than even a trip to the DMV.
Contracts that are purchased as part of an asset sale of a corporation must permit assignment of those contracts without consent. If they do not permit assignment without consent, then consent must be obtained. This can lead to significant additional work as well as risk to the buyer.
Contracts that commonly are issues in sale negotiations are commercial real estate leases, contracts with employees, and contracts involving business relationships.
Leases-
The asset sale of a business can create a golden opportunity with respect to a company's lease of commercial space. If the seller has a below market lease, the buyer may be eager to hold onto it. Alternatively, the buyer may want to try to realize the built in value of the lease by sub-leasing the space or turning it back to the landlord for a termination fee.
Conversely, if the lease is an expensive one, or if the buyer and seller are using the sale to consolidate back office operations, they may want an excuse to attempt to break the lease. A more generous lease can represent a major savings for the buyer, and the cost or benefit of assuming an above or below market lease can be a bargaining chip in price negotiations.
Employee Contracts-
While an employee whose contract is transferable will be required to work for new ownership, it is generally not a good idea for a buyer to simply rely upon such contractual clauses. Employees, unsure about their status under new ownership, are much more unpredictable than office space.
It behooves a new employer to sit down with the company's most valuable employees and communicate his or her vision of the business to them. Barring this, the selling party should explain the transition to the employees before negotiations are finalized. A deal can go sour if a substantial number of top employees express unwillingness to work with the new owners. Without experienced people, the transition between owners will be much more costly and time-consuming, and could even cause the business to fail.
Employee-related contracts that may come into play go beyond simple employment agreements, and include stock options, benefits, and retirement plans, as well as consideration of whether or not the employees are subject to restrictive covenants and/or confidentiality agreements.
Contractual and Non-Contractual Business Relationships-
Many corporations have a few contracts with clients or customers that supply most of their revenue. Contractual business relationships will vary from industry to industry. A company that licenses rights to produce brand name or special interest products, needs to retain those licenses to remain competitive. The licensor may try to use a contract assignment to reopen the license to bidding. Similarly, if a company has a franchising arrangement, the franchiser will probably have the right to approve any ownership changes.
On the other hand, maintaining goodwill in non-contractual business relationships may be the most important part of the deal. Briefly returning to the topic of employees, if the company's success depends on selling a product to long-time customers, it will be vital that the buyer is able to retain the company's sales staff. In the worst-case scenario, the sales force could defect to competitors, turning the company's goodwill against it.
While the above shows that the issue of effective contract assignment is as much about business considerations and legal considerations, many of the legal concerns can be limited by structuring the sale of the target corporation as a stock deal.
In a transfer of stock the target company remains intact, albeit under new ownership. As such, the legal entity that is the party to the contract continues, and the general rule is that the contract simply remains in force between its original parties. No assignment occurs and no consent to assignment is needed.
However, this is not always the case. Some contracts state that a change in ownership of the company is considered an assignment of the contract. If such an arrangement is stipulated in the contract, the same issues will arise as with an asset deal.
Before advising on the structure or viability of a business deal, an accountant must conduct due diligence on all of the selling company's contracts. Only then can he or she make an informed recommendation about deal structure and purchase price.
Liability Considerations
When negotiating a purchase price for a corporation, everything from employee morale to reputation to future growth potential is examined and quantified. Liabilities, both known and unknown, are a similar, though potentially more nebulous, consideration.
Known liabilities might include a bank debt, accrued and unpaid commissions or bonuses, a lawsuit that is pending against the company, or an unprofitable contract. Unknown liabilities generally refers to future lawsuits or other damage that could result from the company's past activity (which are difficult to anticipate and quantify) but may also include debts (which are matured and quantifiable) that have been forgotten or otherwise went undiscovered during due diligence. For example, the buyer might discover that he or she is responsible for settling the claims of workers that were underpaid for overtime hours or that an order filled several months ago was actually short some merchandise.
If the deal is structured as a sale of stock, all liabilities, known and unknown, are effectively assumed by the buyer, since the buyer will own the selling entity. Thus, the risk of unknown liabilities must be considered when determining a purchase price.
In an asset deal, liability is less of an issue from the buyer's perspective, but is still an issue.
First, the buyer will likely assume some liabilities, and the value of these liabilities will be counted in the price. This assumption will either be because the seller insists that it wants to be free of certain items, such as bank debt, or because the buyer wants to assure that certain creditors are paid without problem, such as vendors whose goodwill is important to the buyer.
While it is generally the case that any un-assumed liabilities remain with the seller, and are not the responsibility of the buyer, as with most legal issues, there are important exceptions. One major exception is that most states have a "bulk sales" law that requires, in covered transactions, that notice be given to the seller's creditors that the seller is transferring substantially all of its assets to the buyer. If this notice is not given, an unpaid creditor can collect from the buyer up to the amount of the purchase price paid to the seller for the assets.
Another exception is based upon the concept of "fraudulent conveyance." This refers to a transaction in which the buyer does not pay full value for the assets purchased with the intent of assisting the seller in avoiding certain debts. This should not usually be an issue in a true arms length purchase negotiation between unrelated parties.
There is also a concept in the law of "successor liability" that can be used to hold a buyer liable for certain of the seller's liabilities. This happens when the buyer is found to be inseparable by the public from the seller, such as in a case where the buyer continues the seller's business from the same location using most of the same employees and the same name.
Liabilities can reach into all areas of a company. Potential liabilities might relate to a defective product, a breach of contract, or even a disgruntled employee.
Environmental issues are a liability that may in practice have no statute of limitations. Any real estate, airspace or below-ground environment anywhere near where the entity has ever been located or where its products have been used could be subject to liability.
Buyers sometimes worry that liability is motivating the seller to sell. For instance, what if, soon after the papers signed, the company suddenly discovers that it is responsible for an environmental cleanup of a long-forgotten factory site?
The usual protection against such a situation is that the sales agreement will contain representations from the seller, and a typical representation is that there are no liabilities besides those that have been disclosed. Armed with this representation, the buyer has a viable claim against the seller if the buyer is ever held liable for an undisclosed liability.
However, there are limits to the comfort that a buyer can take from reliance on seller's representations. First, most contractual representations survive for only a fixed period of time after the closing of the sale. Claims cannot be brought for breaches discovered after this period lapses. Second, the agreement may contain limitations such that the buyer cannot bring an action against the seller unless and until all claims exceed a given dollar amount, usually called a "basket," or for an amount in excess of a given dollar amount, usually called a "cap."
Third, a claim against the seller, which arises after the buyer has had to pay an undisclosed creditor is only as helpful as the seller's actual financial ability to make good. Often the buyer will try to protect himself on this last point by arranging a hold back or escrow of part of the purchase price. Then, if the buyer should become aware of a claim against the seller, he can pay himself for that claim by keeping part of the purchase price.
While unknown liabilities can be addressed as contingencies, their real impact is after the closing. On the other hand, how the parties treat known liabilities is part of the pre-closing bargaining process. If the company being sold is under investigation, or being sued, the buyer may be able to use that information to get a more attractive price.
In certain situations, a company may have exposed itself to so much liability, known and unknown, that a stock deal is an impossibility. For instance, in today's marketplace a buyer would be very hesitant to take over a tobacco manufacturer, as its potential product liability would be enormous but cannot be easily estimated. If the company being bought is in a similar position, it may be necessary to structure the deal as a sale of assets.
Future liability can cause major headaches for buyers of corporations. Before beginning negotiations, the prudent advisor must review the present and past activities of a company. From products to contracts to real estate to employees, any and all potential liability risks must be thoroughly assessed.
As this article demonstrates, the considerations involved in structuring the sale or acquisition of a company are complex. Thus buyers and sellers should always involve their brokers or intermediaries, legal, and tax professionals early in the negotiation process.
For additional information contact Ron Schwab at 530 269-1143 or visit http://www.ronschwab.com/ .
