Asset Sale or Stock Sale

Brent O’Mara works with business owners and multigenerational families, and that work often reaches past the portfolio into tax strategy, business succession and how a business sale is structured, which is where a common belief about selling a company meets the tax code. The belief is a reasonable one. A company is a single thing, so selling it ought to be a single transaction with a single price and a single tax bill. The difficulty is that the law sees two different objects where the owner sees one. The IRS explains that selling a business usually does not mean selling one asset; instead all the assets of the business are sold, and each is treated as sold separately when gain or loss is worked out.² A corporation, by contrast, is owned through its shares, and an interest in a corporation is represented by stock certificates, which when sold usually produce capital gain or loss.² Those two passages from the same IRS page describe the two shapes a sale can take: an asset sale, in which the buyer acquires the things the company owns, and a stock sale, in which the buyer acquires the company itself.

What changes hands in each form

In an asset sale the seller’s entity keeps its legal existence and hands over its contents. A columnist at Inc. who advises chief executives describes the mechanics from the buyer’s side: the buyer creates a new corporate entity that acquires all the assets needed to operate the business going forward, including employment contracts, intellectual property, machinery and long term leases, and even the name and brand transfer over.³ The same column explains why buyers often prefer this route. Buying the stock of a company means buying everything inside it, including liabilities that may be unknown on the day of purchase and may have been created years earlier; a purchase agreement can try to assign such liabilities to the seller, but it is hard to identify every risk in advance.³

Figure

The two forms side by side

	Asset sale	Stock sale
What the buyer acquires	Each asset of the business, treated as sold separately	The shares, which represent the owner's interest in the corporation
How the seller is taxed	Asset by asset, capital gain on capital assets and ordinary income on inventory	Capital gain, since an interest in a corporation is a capital asset
Where the price goes	Allocated asset by asset under the residual method	A single price for the shares

In a stock sale the entity itself changes owners, with its contracts, its history and its obligations intact. For the seller this is simpler, and the IRS page cited above supplies the tax reason it is often preferred: an interest in a corporation is a capital asset, so the proceeds of selling it are generally capital gain.² A New York Times small business column from 2011 put the contrast plainly for owners weighing offers that year. If a deal is structured as a stock sale, the entire transaction is taxed at the capital gains rate for the year of the sale, while in an asset sale the seller wants as much of the price as possible classified as goodwill, because the IRS taxes goodwill at the capital gains rate, usually much lower than the seller’s ordinary income rate.⁵ The column was written against a capital gains rate of 15 percent that was due to expire at the end of 2012, which is a reminder that the structure question is always answered against the tax law of a particular year.⁵

Professional practices show how settled the preference can become within one industry. The Journal of Accountancy reported in 2015, from a broker’s experience negotiating hundreds of accounting practice sales, that for most accounting practices a sale is structured as an asset sale rather than a stock sale, and that the buyer typically buys the practice’s fixed assets and intangible assets rather than the seller’s future labor.⁶ The same article warns that some buyers propose deferred compensation arrangements that recharacterize part of the price as payroll or contract labor, which gives the buyer a current deduction but turns what could have been capital gain into ordinary income for the seller, with payroll taxes added.⁶

Figure

How accounting practice sales were paid

of the price received by the seller at closing in most bank financed deals

70 to 80 percent

owed to the seller on a note after closing

20 to 30 percent

How the price is allocated and taxed

Once a sale is an asset sale, the law requires the price to be split across the assets, and it specifies the method. The IRS page on selling a business states that both the buyer and the seller must use the residual method to allocate the consideration to each business asset transferred, which determines the gain or loss on each asset, how much of the price is for goodwill and other intangibles, and the buyer’s basis in what it bought.² The mechanics live in the instructions for Form 8594, which both parties must file with their income tax returns when a group of assets making up a trade or business changes hands and the buyer’s basis depends only on the amount paid.¹ The form sorts assets into seven classes, from cash in Class I through traded securities, receivables, inventory and the physical plant of the business, to the section 197 intangibles of Class VI and, in Class VII, goodwill and going concern value.¹ The price is reduced first by the cash, then allocated to each class in order up to fair market value, and whatever is left lands in Class VII, which is why the method has its name.¹

Figure

The seven asset classes of Form 8594

1. 01
   Class ICash and general deposit accounts
2. 02
   Class IIActively traded personal property, such as government securities and publicly traded stock
3. 03
   Class IIIAssets marked to market each year and debt instruments, including accounts receivable
4. 04
   Class IVInventory and other property held for sale to customers
5. 05
   Class VEverything not in another class, which in practice means furniture, fixtures, buildings, land, vehicles and equipment
6. 06
   Class VISection 197 intangibles other than goodwill, such as workforce in place, customer relationships, licenses and trade names
7. 07
   Class VIIGoodwill and going concern value, which receive whatever is left

The allocation matters because each class carries its own tax character. The IRS page explains that capital assets produce capital gain or loss, that real property and depreciable property used in the business and held longer than a year fall under section 1231, and that inventory produces ordinary income or loss.² Form 8594 also requires a supplemental filing whenever the price later rises or falls, for instance because a contingent payment comes due, with the change allocated back through the classes in a set order.¹ How that contingent money is arranged is its own subject, covered under earnouts and seller financing.

The structure also shapes how and when the seller is paid. A second Inc. article, written for sellers by an online marketplace for business listings, sets out the payment approaches that accompany either structure: all cash at closing, which can push a seller into a higher bracket because every dollar arrives in one tax year; third party loans; a seller financed note that spreads proceeds over several years; earnout payments tied to how the business does afterward; and, when the buyer is a corporation, payment in the buyer’s own stock, which may carry restrictions on when it can be sold.⁴ The Journal of Accountancy’s broker reports that most of the deals his group negotiated used bank financing that let the seller receive 70 to 80 percent of the price at closing, with a note for the balance.⁶ Such terms belong to business succession planning when the successor is an outside buyer, and they interact with any buy sell agreement already in force.

The choice between the two forms is rarely the end of the matter. What comes next is the allocation schedule, which both parties must agree and file; the financing, which determines how much of the agreed price actually arrives and when; and the tax return for the year of sale, which is where the structure finally expresses itself in numbers. Which form suits a given business turns on its entity type, its mix of assets and the buyer’s own plans, so the decision rests on individual circumstances, the kind of judgment that calls for qualified professionals in tax, law and finance. Behind the individual deal sits a larger pattern: a generation of owners is approaching the point of sale at the same time, and the number of businesses that will change hands by one form or the other is the subject of the wave of retiring business owners.