Business Transfers: The Tax Considerations

Are you thinking about buying or selling a business? If the business in question is incorporated, the buyer and the seller must decide whether they will transfer the business' assets or the stock. Tax considerations often drive this decision.

Buyers Prefer To Buy Assets

Suppose a business owner has manufacturing equipment purchased in 1989 for $10,000 with a seven-year life for tax purposes. When the business is sold in 2001, the equipment is already fully depreciated.

If the business owner sells the business in the form of stock, the equipment's zero basis carries over to the buyer, who won't be able to take any more depreciation deductions on the asset. But, if the sale of the business is structured as an asset sale, the equipment can be booked at the cost the parties allocate to it, and the buyer can depreciate the equipment over another seven years. Consequently, business buyers generally prefer to buy assets rather than stock so that they can "step up" the basis of depreciable assets.

Another reason why most buyers prefer asset deals is that they don't want the selling business' potential liabilities: IRS inquiries about back taxes, age-old contract disputes, and problems arising from employee benefit plans put in place before they took over the business. If the buyer purchases assets, these problems remain the original owner's responsibility.

Sellers Prefer To Sell Stock

For an S corporation, the proceeds from an asset sale flow through the corporation to the individual. The S corporation long-term capital gains from the asset sale are taxed on the shareholders individual tax return at long-term capital tax rates. However, amounts allocated to noncompete agreements and gains allocated to inventory, accounts receivable, and property held for one year or less are taxed as ordinary income.

In the case of a C corporation, the business seller may pay taxes twice — a capital gains tax on the sale of the assets (at the same rate as for ordinary income) and an individual income tax on any corporate distributions received by the stockholders. Now that maximum long-term capital gains rates have dropped to 20% (and certain qualifying small business stock may be taxed at an even lower effective rate), more owners of incorporated businesses are motivated to sell their stock instead of the assets in their businesses.

What To Do?

Using Section 338 of the tax code, a business buyer can purchase qualified stock and get a step-up in the basis of the assets.

A "qualified stock purchase" is a purchase of at least 80% of a corporation's stock (by voting power and total value) within a 12-month period. With a Section 338 election, the purchased corporation is treated as having sold its assets for the amount of the buyer's basis in the stock, adjusting for the corporation's liabilities. This approach can benefit both buyers and sellers.

Because the transfer of a business involves so many complexities, it makes sense to seek an independent evaluation of the opportunities and pitfalls inherent in your situation. Talk to one of our tax professionals when you are contemplating a business transfer.