Evaluating a Stock Sale of a Company compared to an Asset Sale
Sale of Stock; If the transaction is structured as a sale of stock, then each shareholder is selling his or her shares of stock to the buying entity and the gain on the sale of stock is taxed as capital gains tax rates. Currently, the highest capital gains tax rate is 20% for Federal and the Wisconsin highest capital gain rate is 5.35 (after the permitted 30% deduction for long term capital gains in WI). So, the combined State and Federal effective rate is approximately 25.35% on long term capital gain. This rate is much lower than the ordinary income rates that will apply to certain asset categories if you sold the assets of the company verses the stock.
Generally, a buying entity does not want to buy the stock and prefers an asset purchase for two reasons. First, if they buy stock, all of their investment is allocated to purchase of equity and provides no immediate tax deductions. The investment results in tax basis in the equity of the purchased entity and may only benefit the buying entity if there is a future sale of the stock.
Enter the Section 338(h)(10) Election. It allows an entity buying stock to treat the purchase solely for tax purposes as an asset purchase and allocate the purchase price among the assets purchased resulting in an increase in the basis of assets that can be potentially deducted, depreciated, or amortized all of which give significant tax benefits to the buying entity. So, the Election essentially can eliminate or reduce the tax impact to the buyer when buying stock. If a Section 338(h) (10) is made, then the selling company must report the additional tax resulting from the increase in basis of the assets. Therefore, in negotiating a sale of stock with a 338 Election, the seller would want the buyer to pay, as additional purchase price, any incremental tax resulting from the 338(h)(10) election. If the seller is required to pay the incremental tax resulting from the election, then there is really very little or no tax benefit to selling the stock verses and asset purchase. The second concern that a buyer has when purchasing the stock is the potential liabilities that the buyer would be responsible for.
Essentially, in a stock sale the buyer is buying the existing company with all known and unknown liabilities including claims or liabilities that are unknown at this time but can arise in the future including company taxes, environmental, employee claims, customer claims, vendor disputes, state or federal law violations, etc. With this increased risk of inheriting a liability, a buying entity will want to conduct a more thorough due diligence with the intent of discovering any potential liabilities so that they can be addressed at or prior to closing.
Also, the buyer will want a more rigid indemnification as to any claims arising post-closing along with a larger escrow fund withheld at closing to support any future claims. Bottom line is that the structure as a stock sale can save the seller a substantial amount in taxes if: the buyer is agreeable to paying some or all of the incremental tax if they want the 338 Election to be made and most buyers will want the election made, and as seller they are willing to accept the terms of a more detailed indemnification and larger posting closing escrow amount.
Sale of Assets. In comparison, if the transaction is structured as an asset sale, then the buying entity only purchases the agreed upon assets and the buyer only assumes the agreed upon liabilities.
The net closing proceeds are paid to the selling company and distributed to the shareholders based on their percentage ownership. The asset sale will typically result in significantly more taxes than the stock sale because the tax rates will be higher on specific asset categories, depending upon how the purchase price is allocated to the purchased assets. For example, generally all gain, the sale of fixtures, furniture, machinery, equipment, and vehicles will be taxed at ordinary income rates. Currently, the highest federal rate is 37% and the highest WI rate is 7.65% for a combined rate on ordinary income of 44.65%. Generally, real estate and Improvements are taxed at 25% federal and 5.35% WI for a combined rate of 30.35%.
Amounts allocated to intangible assets such as goodwill is taxed at capital gains rates. So ultimately, the total tax paid when there is a sale of assets will depend in large part on the allocation of the purchase price to the asset categories. This is part of the negotiation of the asset purchase agreement. Buyers like to purchase assets because they can deduct most of the purchase price with a portion qualifying for a “Section 179” or an immediate write off and most of the balance qualifies for a depreciation deduction or amortization. Generally, buyers will want to allocate as much as possible to the fixtures, machinery and equipment because it qualifies for the immediate “Section 179” deduction and normally the balance can be depreciated over a 5 to 7 years. Goodwill and other intangibles can be deducted over 15 years.
As a buyer, it provides them the tax benefits they are looking for without the 338 Election. The other reason buyers prefer asset purchases is because they can limit their liabilities to only those liabilities that they assume as part of the purchase agreement. They are not responsible for the company’s unknown liabilities or claims because they are not buying the company. As a result, indemnification provisions within the agreement are not as detailed and typically limited to 2 or 3 years and the supporting escrow amount will be less, because there is less risk. Bottom line is that total taxes in an asset sale will depend in large part on the current tax basis of company assets and how the gain will be allocated among the assets.