There are two options for selling a business: an asset sale and an entity sale. In an asset sale, the buyer purchases the tangible and intangible assets while the entity’s owners retain equity, whereas, in an entity sale, the buyer acquires the entity along with all its assets. The key takeaways include considering outstanding liabilities, tax implications, and the type of assets involved when making the decision between the two sale approaches.
Understanding Asset Sale and Entity Sale Options
Businesses can be sold and their assets transferred, either through an asset sale or an entity sale.
- Asset sale: the entity sells its tangible and intangible assets to the buyer, while the entity’s owners retain equity in the entity.
- Entity sale: the seller transfers his or her equity to the buyer, who acquires the entity with all of its assets.
Determining whether to go for an asset sale or an entity sale is a decision influenced by various factors, and a key player in this game is what the buyer is comfortable with. These pivotal considerations weigh heavily on both the buyer’s and the seller’s choices. It’s a delicate dance where understanding what the buyer is willing to accept becomes a significant factor shaping the decision-making process for both parties involved. These are two crucial factors that will weigh on both the buyer’s and seller’s choices:
- Outstanding liabilities: The existence of outstanding liabilities. Outstanding liabilities refer to any debts, legal obligations, or contracts that the business has.
- Method of sale: Different tax consequences like the disparate tax effects that would result from the sale of assets when compared with the sale of the business entity.
Factors Influencing the Choice of Sale Method
1. Outstanding Liabilities
As a general rule, when a business is sold, any outstanding debts, contracts, and legal obligations of the business usually stay with the business itself, not the assets being sold. So, if someone buys the business, they also take on these existing liabilities.
These liabilities include:
- Debts – Being liable to pay back loans
- Legal Obligations – Being liable for lawsuits related to things the business did prior to being purchased
- Contractual Obligations – Being obligated to fulfill contracts entered into by the business. And being liable if those contracts are breached.
Exception – Successor Liability
However, there is an exception called successor liability that applies in some states, but only for manufacturing businesses. In these cases, if someone buys a manufacturing business and continues producing similar products, they may be held responsible for any legal claims arising from the seller’s manufacturing practices. Nevertheless, because outstanding liabilities stick with the business entity, buyers are usually less likely to choose an entity sale when there are existing liabilities.
On the other hand, in most cases, if the buyer decides to purchase the business through an asset sale, they can acquire the assets without taking on the outstanding liabilities. This means they can buy the assets “free and clear” of any existing debts and obligations.
2. Method of Sale
When a business owner decides to sell their business, they need to consider the different tax rates that could apply. These tax rates can have a big impact on the type of sale the owner should choose (either selling the assets or the entire business) and may even affect the final price and overall value of the business.
There are several tax rates that might be relevant in this situation.
- Ordinary income tax rates, which can go up to 39.6%.
- Corporate income tax rates that range from 15% to 35%.
- Long-term capital gains tax is another factor, with rates varying from 0% to 15%.
- Real estate recapture tax rate of 25% for assets that haven’t been depreciated rapidly.
Which tax rate applies depends on various factors:
- Type of sale (asset or entity).
- The specific terms of the sale.
- Whether the business’s capital assets have been written off.
- The entities involved.
- The business’s income.
- The seller’s current and future personal income.
2. Tax Status
Tax implications become particularly important if the seller’s business is a C Corporation (cooperatives that use Subchapter C tax status) since selling the assets could lead to double taxation. However, if the business is transitioning from being investor-owned or closely held to being employee-owned, there is an incentive to sell the business’s equity to the employees. This is because Section 1042 of the Tax Code offers significant tax benefits to eligible companies that transfer equity to their employees.
In summary, sellers must carefully assess the different tax rates and circumstances to make informed decisions about the type of sale that will minimize tax burdens and maximize benefits.
Navigating Tax Considerations in Business Sales
In considering the sale of a business, it’s essential to understand the tax implications related to capital assets, capital losses, and depreciation recapture:
- Capital Assets: These include equipment, real estate, goodwill, and certain types of intellectual property. The depreciation of capital assets over their useful life affects their book value and potential tax implications upon sale. Different depreciation methods, such as straight-line or accelerated depreciation, can impact the tax treatment of these assets.
- “Write Off”: When a business acquires a Section 1231 capital asset, it is allowed to gradually reduce its value over time through depreciation. This process, commonly known as “writing off,” involves recording the asset’s depreciation as an expense on the company balance sheet. There are different ways to calculate depreciation:
- The “straight-line method” allows a business to evenly distribute the depreciation expense over time, deducting the same amount each year.
- The “accelerated method”, is where more is deducted in the early years of owning the asset.
- Regardless of the depreciation method chosen, at the end of the asset’s anticipated useful life, its value will have been fully written off, resulting in a book value of zero. However, this does not mean the asset has no value, as it can still be sold for a certain price (refer to the Depreciation Recapture section below).
- Lastly, if a business sells a capital asset after holding it for over a year, and the asset is either not eligible for depreciation or has not been depreciated, all proceeds resulting from its sale will be taxed at the long-term capital gains rate (which is typically 15%).
- “Write Off”: When a business acquires a Section 1231 capital asset, it is allowed to gradually reduce its value over time through depreciation. This process, commonly known as “writing off,” involves recording the asset’s depreciation as an expense on the company balance sheet. There are different ways to calculate depreciation:
- Depreciation Recapture: means that if you sell an asset for more money than what it’s worth on your books (book value), the IRS can tax that extra amount. This usually applies to certain types of assets called Section 1231 assets, except for real estate which has its own rules. So, if you’ve been deducting depreciation on an asset and you sell it for a higher price, the IRS may want to tax that additional money you made from the sale.
- Capital Losses: When the sale of capital assets leads to a net capital loss, sellers may deduct the loss from their ordinary income up to a certain limit per year. This provision allows for tax benefits when capital losses occur.
- Non-capital Assets: Non-capital assets are assets the IRS does not categorize as capital assets. Non-capital assets include: inventory, promissory notes given to the business, accounts receivable and real estate or other depreciable trade or business property held for less than a year. Proceeds from the sale of non-capital assets are treated as ordinary income or loss.
Finding the Right Fit for Your Business
In conclusion, the choice between an asset sale and an entity sale depends on several factors, including buyer preferences. Where the business is a sole proprietorship, the sale by default will be a sale of assets, because there is no entity apart from the owner. Where the entity is a partnership, LLC, or corporation, the buyer and seller will generally have some choice over how the business should be sold.
Unfortunately, tax and liability considerations often pit sellers and buyers against one another. For tax purposes, as described above, typically the seller would prefer to transfer equity, while the buyer would prefer to buy a pool of assets. Moreover, where both parties have agreed to an asset sale, the parties’ interests often conflict as to how the sales price should be allocated across assets.
In the cooperative context, these concerns may be less pronounced, especially where the seller intends to stay on as a worker-owner, employee, or consultant.
Asset Sales
Asset sales are often favorable for buyers as they allow them to acquire assets free of outstanding liabilities. However, the doctrine of successor liability may impose certain obligations in specific situations.
Entity Sale
On the other hand, entity sales involve the transfer of equity and come with the responsibility for the business’s liabilities. Understanding the tax implications is crucial, as it can significantly impact the transaction structure and tax burden for both the buyer and seller. Ultimately, consulting with legal and tax professionals can help business owners make informed decisions and choose the most suitable sale method based on their specific circumstances.
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