As a general rule, most small business sales are conducted via an asset purchase agreement which transfers the assets of the company and leaves the liabilities with the seller unless specifically assumed by the buyer. Buyers generally prefer this method because they get the assets of the company, avoid the risk of unknown liabilities, and get tax advantages in that they can depreciate assets that were previously fully depreciated by the seller.
There are occasions, however, when a business transaction can more effectively be completed using a stock purchase agreement. For example, a business may be an S-corporation and may have long term government contracts which would not be transferred under an asset purchase agreement. If a substantial portion of revenue was related to those contracts, an asset sale would potentially disrupt the revenue stream. However, transferring the stock of the S-corporation leaves the revenue stream intact.
For a buyer, the stock transfer creates two unwanted issues: (1) the buyer will incur all of the company’s liabilities whether known or unknown, and (2) fully depreciated assets on the balance sheet remain fully depreciated. While the liability issue can sometimes be addressed by the use of insurance products, the depreciation issue can be addressed using various sections of the tax code.
There are two Internal Revenue Code (IRC) sections that will permit the sale of a business under a stock purchase agreement to be treated or deemed an asset sale. IRC section 338(h)(10) and IRC section 336(e). Under IRC 338(h)(10), the buyer must be another corporation; however, under IRC 336(e) the buyer can be an individual or other purchaser. IRC 336(e) is initiated by the seller when the seller files his or her tax returns. These two IRC sections treat the stock purchase as an asset sale and the buyer is able to benefit from depreciation deductions on future tax returns.
If you are a business owner contemplating the future sale of your business, contact us today. Engaging in pre-sale planning and seller’s due diligence will give you the flexibility to achieve both your financial and non-financial objectives when you ultimately transfer your business ownership interest.