You can structure the purchase ownership interest or assets in two basic ways.
If the target business is operated as a C or an S corporation, a partnership, or an LLC that is treated as a partnership for tax purposes, you have two options:
- Buying the ownership interest of the seller.
- Buy the entity’s assets.
If the target business is a sole proprietorship or a single-member (one-owner) LLC that is treated as a sole proprietorship for tax purposes, you have only one option—an asset purchase.
Today we cover federal income tax implications of the two options.
Buyers and Sellers Have Conflicting Goals
Unfortunately, business buyers and sellers typically have differing financial and tax objectives.
What the Buyer (You) Typically Wants
As the buyer, you have one main objective: generating sufficient cash flow from the newly acquired business to service any acquisition-related debt and provide an acceptable return on your investment. In keeping with your main objective, you want to minimize your exposure to undisclosed and unknown liabilities of the acquired business and to minimize taxes on the income from the newly acquired business. For legal reasons, buyers usually prefer to purchase the assets of a business rather than ownership interests.
A straight asset purchase transaction generally protects the buyer from exposure to undisclosed, unknown, or contingent liabilities. In contrast, when the buyer structures the acquisition as the purchase of an ownership interest, the business-related liabilities generally come along for the ride even if they were unknown at the time the acquisition occurred.
Buyers also typically prefer asset purchases for tax reasons. With the asset purchase, the buyer steps up (increases) the tax basis of purchased assets to reflect the purchase price. This results in (1) higher depreciation and amortization deductions for depreciable and amortizable assets, and (2) lower taxable gains when you sell or convert to cash any other assets, such as inventory and receivables.
What the Seller (the Other Guy) Typically Wants
The seller’s two main non-tax objectives are probably:
- insulating himself or herself from business-related liabilities after the sale, and
- collecting the full amount of the sales price if he or she provides seller financing to you (an installment sale deal).
The seller’s other main objective is minimizing the tax hit from the sale.
As a general rule, the best way for sellers to avoid liabilities and minimize the tax hit is to sell their ownership interest in the business (corporate stock, or partnership or LLC interest) as opposed to selling the assets of the business. That way, the seller generally sends the liabilities along with the ownership interest and treats any gain on sale as lower-taxed long-term capital gain (assuming the seller held ownership interest for more than one year).
But if you are selling a partnership interest, the tax code might treat some or all of the gain as higher-taxed ordinary income. As a general rule, the gain from selling a partnership interest is treated as capital gain per IRC Section 741. But Section 751 of the code stipulates that gain from selling a partnership interest is treated as higher-tax ordinary income to the extent of certain partnership assets such as zero-basis receivables. Therefore, some part of the gain from selling a partnership interest is likely to be treated as higher-taxed ordinary income rather than lower-taxed long-term capital gain.
Finding Common Ground
At first blush, it might seem like the interests of the buyer (you) and the seller (the other guy) are so opposed that no deal could be reached. Not true!
While neither party is likely to get everything desired, the two sides can usually get close enough to Nirvana to reach a purchase/sale agreement—with some give and take.
Option #1 Offer a higher price to complete the asset sale. You as the buyer are rightly concerned about avoiding business-related liabilities, and therefore you want to do an asset purchase deal. The seller is rightly concerned about the higher tax hit that would result from an asset sale, so perhaps a somewhat higher purchase price can convince the seller to do the asset deal.
Also, you and the seller may be able to conclude an asset deal by agreeing to allocate the purchase price to specific assets in a manner that reduces the seller’s tax hit to an acceptable level without unduly harming your desire to step up the tax basis of shorter-lived assets such as receivables and depreciable personal property. The federal income tax rules for allocating purchase/sale price in asset purchase/sale transactions are found in IRC Section 1060 and related IRS guidance. See also IRS Form 8594 (Asset Acquisition Statement Under Section 1060) and the instructions to that form, which do a pretty good job of explaining the rules.
Option #2 Accept a lower price to complete the stock sale. Alternatively, the seller could insist on a stock sale that would result in lower-taxed long-term capital gain for him or her but agree to accept a somewhat lower price to partially compensate you for the inability to step up the basis of the purchased assets.
To alleviate your rightful concerns about exposure to unknown or contingent liabilities, the seller in a stock sale deal could agree to indemnify you against certain specified contingent liabilities (for example, the possibility of underpaid corporate income taxes in tax years that could still be audited by the IRS).
If the Target Business Is a Sole Proprietorship or Single-Member LLC
When the seller operates a business as a sole proprietorship or as a single-member LLC that is treated as a sole proprietorship for tax purposes, the federal tax code treats any purchase of the business automatically as an asset purchase.
The tax code ignores the existence of a sole proprietorship or a single-member LLC. This means that the tax law deems the seller as an individual to directly own all the business assets, so you have no ownership interest to buy.
Here are the two tax law steps for you to follow when you buy the assets of a business:
- Allocate the total purchase price to the specific assets that you purchased. The amount you allocate to each asset becomes the tax basis of the asset. The basis determines your taxable gain or loss when your business later sells the asset or converts it to cash.
- Tell the IRS what you did by reporting how you allocated the total purchase price to specific assets on Form 8594 (Asset Acquisition Statement Under Section 1060).
With an asset purchase from a sole proprietorship or single-member LLC, the most important tax-saving opportunity revolves around how you allocate the total purchase price to specific assets. As the buyer, you generally want to allocate more of the price to assets that will generate higher-taxed ordinary income when converted to cash (such as purchased receivables and inventory), and assets that can be depreciated over relatively short periods (such as furniture and fixtures, equipment, and vehicles).
You want to allocate less to assets that must be amortized or depreciated over relatively long periods (such as buildings and intangibles) and assets that must be permanently capitalized for tax purposes (such as land).