A business can be sold through an entity sale or an assets sale. The traditional way is through an entity sale, which involves selling all ownership interest in the business. If your business is a public corporation, then you would conduct an entity sale simply by selling shares of stock to your company. But if you sell your business with an asset sale, you are selling only the assets (tangible and intangible). Although stock could be considered as tangible asset, an assets sale typically involves the physical inventory, fixed assets, plus intangible assets such as trademarks and brands. The ownership equity of the business would still belong to you.
The type of business you have will sometimes determine which type of sale you conduct. For example, if your business entity is classified as a sole proprietorship, then you are only allowed to have an asset sale. After all, sole proprietorships have the owner as the entity so there is no equity to transfer to a buyer through any other type of sale. On the other hand, if your business entity is classified as a limited liability company, corporation, or partnership, then you can choose between an asset sale and an entity sale. The seller and buyer will usually decide together on the sale type in this scenario.
Related: How to Sell a Sole Proprietorship
There are several factors which will determine whether you conduct an entity sale or assets sale, aside from the buyer’s own preferences. For starters, does the business have any outstanding debts or liabilities? Have you figured out what the tax consequences would be if you conducted an assets sale versus an entity sale? For example, if you own a C Corporation and you conduct an assets sale, then you will likely be subjected to double taxation. It would be better in this situation to conduct an entity sale with the company’s employees because this would grant the most tax savings benefits. So, ask an accountant or tax professional to help you determine which sale type will give you the best tax benefits too.
Of course, the buyer’s preferences may go against your own preferences. Unless your company’s brand is truly established and already making lots of money, a buyer will likely only want to purchase your assets and not the business entity. As a seller, you might not like this idea because you’re trying to get out of the business altogether and don’t want to still be stuck running the company. Furthermore, you’ll have fewer tax consequences with an entity sale and you’ll make more money. The outcome of this depends on the specifics of the situation, like the profitability of the business and how badly you as the seller want to close the deal.
Role of Outstanding Liabilities
If a business currently faces outstanding liabilities, then those liabilities are the responsibility of the business entity. The liabilities are not attached to the current owner or the assets of the company. This means that if you were to sell your business through an entity sale while the outstanding liabilities have not been settled yet, then your buyer will have to deal with those liabilities after they obtain ownership of the company. However, if you were only selling the business through an assets sale, then you would not be passing those outstanding liabilities to the buyer. This is why buyers typically prefer asset sales because they don’t have to worry about those liabilities.
There are different types of taxes that could apply to the sale of your business. You need to understand what these taxes are and what their rates are. If you fail to plan for these taxes before the sale of your business, then your total sales price could be affected. Either that or the value of your business will diminish and possibly make the buyer want to walk away from the deal. To avoid these situations, study the tax rates of all applicable taxes carefully. Not all of them will apply to every sale but pay attention to the ones that will affect your sale and then act accordingly.
The basic income tax rate goes up to 39.6%, depending on how much income you earn. Then you have to worry about the corporate income tax rate if your company is a separate entity. This rate could fall between 15% and 35%. As for the sale of assets, a capital gains tax will be imposed. Unless you’ve owned the assets for less than a year, you will face a long-term tax rate for captain gains which will be between 0% and 15%. The capital gains long-term tax rate is actually less than the short-term tax rate. Finally, there is a 25% real estate depreciation recapture tax rate if you sell depreciated property and earned income from it.
Capital and Noncapital Assets
The capital gains tax applies to the sale of capital assets. The definition of capital assets are properties which are intended to be used for over a year and are not the company’s primary income source. These are assets which could assist the company in its operations, though. The most common examples include real estate, equipment, fixtures, furniture, and intangible or intellectual property. Certain capital assets can depreciate which means you can write off the depreciated value as an expense and claim a deduction on your tax return.
There are a few ways that a business can depreciate their assets. The most common way is the "straight-line approach" which involves claiming the same dollar amount of depreciation on every annual tax return until the anticipated lifespan of the asset is used up. Another way is to use the accelerated approach, which involves claiming a greater depreciation expense early on and then not being able to claim as much depreciation in later years. The useful lifespan of intangible personal property is set at 15 years under the law. Other depreciated assets can have a useful lifespan of 3 years, 5 years, 7 years, 10 years, 20 years, or 25 years.
Whether you use the straight-line approach or the accelerated approach, the total value of the asset will be written off as an expense by the end of its useful lifespan. With that being said, these depreciating assets can still have value to them. This means if you sell the assets for more than their worth after you’ve already written off the depreciation value, then you will have to pay a recapture tax on the total value of the assets. The only times when you won’t have to pay a recapture tax is if the assets do not depreciate and you’ve held them for under one year. Also, if you sold the asset for its book value or less than its book value, then you don’t have to pay the tax.
If you have any capital losses after selling your capital assets, then you can subtract the amount of money you lost from your regular income. The only stipulation is that you cannot subtract more than $3,000 in capital losses from your income per year. This means if your capital loss is $6,000 this year, then you can only subtract $3,000 from your income. Married couples who file separate tax returns can only claim $1,500 each in capital losses.
As for the sale of noncapital assets, these will be taxed as ordinary income rather than as capital assets. Some examples of noncapital assets include inventory, accounts receivable, promissory notes and business property which has been own for under one year. If you lose money from the sale of noncapital assets, then your loss falls under an ordinary loss as well.
How Entity Form Plays a Role
When we talk about entity sales, there are two forms of entities that you need to familiarize yourself with. If the entity is "pass-through", it means that it pays no income tax. Instead, the tax obligation gets passed onto the shareholders and all others who hold an interest in the company. They don’t pay any corporate income tax, but they do pay personal income tax that is based on the amount of business income they received. For example, a sole proprietorship or single-member limited liability company has its tax burden passed right onto the owner and not the company. You can also have this entity with partnerships and S-corporations as well.
The second type of entity is a taxable entity. The tax burden of a taxable entity does not get passed onto the shareholders only. There is double taxation with this entity which means the company is subjected to paying corporate income tax and the shareholders are subjected to paying their own personal income taxes based on the amount of corporate profits that were distributed to them. The tax rate for the shareholders will usually be around 15%, which is based on the dividends tax rate.
When you sell your business through an asset sale, the process is similar for taxable entities. If your business is a taxable entity with no pass-through, then the money made from the asset sale will be taxed twice. The company will have to pay corporate income on the net proceeds of the asset sale while the shareholders will have to pay taxes based on the individual proceeds they each received from it. Again, the latter is based on the dividends tax rate.
As for pass-through entities of an asset sale, the portion of the proceeds that each shareholder is paid will be subjected to their own personal income tax rate. Plus, these proceeds get subtracted from the total selling price of the assets. There is no corporate income tax to pay on the total selling price either. That is why more shareholders of a pass-through entity want to sell assets together as a collection.
Now you might wonder why a company would ever want double taxation from an entity sale. Well, it could be beneficial if the company paid their employees annually as a form of employee compensation rather than income. They could also invest their annual proceeds into the company and earn lots of tax savings as a result. But if that same business taxed entity were to perform an asset sale, it would not get any of these benefits and it would still be subjected to double taxation. In this case, the entity sale would obviously be the better option.
Types of Companies and Their Sales
Sole Proprietorships & Single Member LLC
A single member limited liability company and sole proprietorship are two types of business entities which can only conduct an asset sale. After all, these businesses are nothing more than a series of assets managed by one owner. When you sell these assets, the proceeds from the sale will only be taxed on the owner’s personal income tax return. There is no corporate tax return that gets filed with these two entities.
However, unless the sale of your assets is part of your company’s normal business practices, you will be subjected to the capital gains tax rate and not the personal income tax rate. If you sell assets which you’ve held for longer than one year, then it is a long-term capital gain. The tax rate for this is usually 15%. Assuming there was no depreciation, the most common long-term capital gains would be from selling assets like equipment and inventory. But if there was depreciation previously declared on those assets, then the sale will be subjected to the recapture tax.
Multi-Member LLC & Partnerships
If you have a limited liability company with multiple members or a partnership, then you can have either an asset sale or an entity sale. With the latter, the percentage of ownership interest that each member has in the company is considered to be a capital asset if it was held for over 1 year. When an entity sale is conducted in this case, the proceeds that each member gets is based on their percentage of ownership in the company. The tax rate of long-term capital gains then gets imposed which is usually 15%. If the ownership interest was held for under 1 year, then a regular income tax rate is applied.
When you conduct an asset sale with a multi-member LLC or partnership, there are no taxes imposed on the entity. The distribution of the proceeds of an asset sale is just like the distribution of an entity sale, since the ownership interest of each member in an entity sale is already treated as a capital asset. The only real difference is how the sales price is distributed since there are different types of assets with varying values.
As for corporations, this is where the sales get a little more complex. A corporate entity sale is when you sell the equity of your company. The IRS will treat the equity like a capital asset if it was held by the owner for more than one year. For example, if you’ve held shares of a corporation for over one year and then sell them, you must pay a long-term capital gains tax on the proceeds. But if you’ve held the shares for under one year, then you pay the personal income tax rate on the proceeds.
If a corporate entity sale causes you to lose money, then it can either be declared as a regular loss and/or a capital loss on your tax return. A regular loss would be what decreases your taxable income. For example, if your business earned $50,000 this year but had a net loss of $20,000, then your taxable income would only be $30,000. You would also have a lower tax rate because your income falls into a lower tax bracket.
In most cases, though, the losses from an entity sale are considered capital losses because the IRS treats equity like a capital asset. But there is an exception for some shareholders of small businesses. Tax Code Section 1244 allows these shareholders to claim up to $50,000 in losses as a regular loss. If you’re filing a joint return, then you can claim up to $100,000 in losses as a regular loss.
There are a few stipulations to qualify for this:
- The shareholder must have purchased the stock first and from a small business corporation. That corporation must have given property or cash in return.
- Up to 50% of all the company’s gross income over a 5-year period can be due to passive income.
- The seller must have received the stock as an individual entity from a U.S. based company.
- A corporation selling Section 1244 based stock cannot have received over $1 million for it.
Now, if any of these stipulations are not met, then all losses from the entity sale will be considered a capital loss. This means you would only be able to deduct $3,000 from your regular income. If you are married or file a joint income tax return, then you can each deduct $1,500 from your regular income.
S Corporations vs. C Corporations
In asset sales, the tax rate will depend on whether you have a C corporation or S corporation. Since the latter is considered to be a pass-through business entity, an asset sale with an S corporation will not mean double taxation. It just means that each individual interest holder of the company will pay either long-term capital gains taxes or personal income taxes on the percentage of the proceeds they received.
The only thing you must worry about with S corporations is state taxes. Depending on which state you live in, there could be a state law which imposes double taxation on asset sales. This means you would pay double taxes to the state government rather than the federal government. To make matters worse, if you changed a previous C corporation to an S corporation over the last 10 years, then you could have to pay a built-in gains tax. This tax rate is usually the higher end of the corporate tax rate, which is around 39%. The government does this to discourage C corporations from abusing the tax laws by converting to an S corporation just to pay fewer taxes.
C corporations are taxable entities rather than pass-through entities. This means asset sales result in double taxation at the federal level. If you sold mostly noncapital assets, then only the regular income tax rate would apply to the company. All individual shareholders would have to pay the dividends tax rate on the proceeds they received. Again, this rate is about 15%.
Coding Tax with Section 1042
The Tax Code Section 1042 gives business owners that sell equity to their employees the ability to decrease their taxable proceeds amount. If you own a C corporation and you want to avoid double taxation through an asset sale, then an entity sale with your employees can help you avoid this. This gives C corporation owners a greater incentive to have an entity sale if they are selling it to their employees. That way, there are fewer taxable proceeds afterward.
If you want to qualify for this benefit, then you must take the proceeds you received from the entity sale and reinvest them into what is called a "qualified replacement property". The amount you reinvest must be the exact amount you received from the sale. These replacement properties could be bonds, stocks, securities, and promissory notes that belong to active corporations which are based in the United States. You can reinvest in preferred stock as well, but you must be able to convert the preferred stock into common stock and the price has to be reasonable.
A C corporation is the only type of business entity that will be approved for Section 1042. If your business is a different type of entity, like an S corporation, then you still have a chance to benefit from Section 1042 if you were to convert the S corporation into a C corporation. It isn’t too hard for an S corporation to take away their "S-Corp" status that was originally chosen and then elect a new status like "C-Corp" status. Once the conversion is complete, the shareholders can use the tax deferral mentioned in Section 1042 if they sold their equity to an employee stock ownership plan. After five years from the date of the entity sale, the shareholders can choose to become an S corporation again if that’s what they want.
Of course, it may not always be the best choice to convert your S-corporation into a C-corporation. It all depends on whether the shares you own have a high basis, which refers to the stock’s original value. If you have an S-corporation and own stock with a high basis, then it wouldn’t be a good idea for your company to revoke its S-Corp status just to get the tax deferral. There is a technical process involved in figuring out the basis of the shares that are owned by the shareholders of an S-corporation. It all depends on how the stock was acquired by them. You must also learn about the tax code and the numerous provisions in it. Finally, you need to be able to research company records.
If you want a general estimate of the basis, just look at the shareholder’s original contribution. If you obtained your shares in the company from simply creating the corporation, then your contribution would be the property and cash you have given to it. On the other hand, if you purchased your shares in the company, then your contribution is the amount of money that you paid for the stock. Once you have figured the contribution out, the basis will either increase or decrease, depending on whether you receive proceeds from the company’s income or a loss from it.
With all the complexity involved with calculating the stock basis in S-corporations, many shareholders find it better to just become a C-corporation and benefit from the tax deferment of Section 1042. As for ownership interests that are partnerships or non-corporate, the IRS could regard the holding period of these interests as fulfilling the 3-year requirement of Section 1042 after their interests get switched over to corporate stock.
Allocating the Selling Price in an Asset Sale - How It Works
Companies that use asset sales must allocate the total price of the sale throughout 7 categories. The IRS created these categories for calculating the final tax rate. The way you allocate the sales price will make a huge impact on what your tax rate is going to be.
Related: How to Price a Business for Sale
Here are the 7 categories that you will use for allocation:
- Cash & assets that are like cash.
- Securities, such as foreign currency, marketable securities, marketable stocks, government securities, and share certificates.
- Accounts receivables and all instruments relating to debt.
- Tangible property, such as furniture, buildings, land, fixtures, and equipment.
- Intangible property, such as intellectual property, client lists, permits, licenses, etc.
- Goodwill Value
If you want to benefit yourself as the seller, then the sales price should be allocated more toward intangible capital assets and real estate. For tangible capital assets that can depreciate as well as noncapital assets, don’t allocate the sales price so much toward these assets. Noncapital assets are things like inventory and any other property that depreciates.
Why is this the case? Well, when you allocate the sales price toward assets that depreciate, then you may get taxed at your regular income tax rate and not at the capital gains tax rate. Just remember that sellers like yourself will never benefit if the allocated sales price is directed toward depreciating tangible capital assets or noncapital assets. You will almost always be paying the regular income tax rate if you do. Furthermore, if you allocate the sales price toward tangible assets which have already depreciated, then you will be burdened with paying the recapture tax based on the individual income tax rate that is applicable. As a result, you will face more tax liability as a seller.
In less than 7 years, businesses can typically write off most of their depreciating capital assets. These assets are usually depreciated completely or partially within that time. When allocating the sales price toward them, a huge portion of the price gets taxed at the regular income tax rate of the seller. If the business is a C-corporation, then it will be the corporate tax rate of the proceeds. It could also be another entity which chose to be taxed the same as a C-corporation. If your business is being taxed as a pass-through entity, then the personal income tax rate of the shareholders will apply toward the proceeds.
As a seller, you are allocating the sales price the most toward intangible capital assets and real estate. That way, the tax rate for long-term capital gains will apply. In order to make this happen, you must allocate the most you can toward all capital assets that do not depreciate and that you’ve held for more than one year. Also, you need to maximize the allocation amount to go toward all other assets that are intangible and will likely not depreciate so quickly, if at all. In Section 179 of the tax code, there is a list of intangible assets that can depreciate. However, it will take a minimum of 15 years for these intangible assets to depreciate completely. But, more than likely, the asset still won’t be fully depreciated after that much time has passed. Therefore, as long as the price amount allocated to these intangible assets is not higher than their book value, then the long-term capital gains tax rate will only apply to the proceeds. In regard to real estate, when you allocate the highest amount of the proceeds that you can toward it, you can make sure this amount has the recapture tax rate of 25% imposed on it. This rate is usually less than the corporate income tax rate or even the regular income tax rate.
As you can imagine, the buyer’s interest will be served differently than the seller’s interest from the sale. This means the allocation is going to be different. Since the seller makes money off the sale, they are the ones who must worry about paying taxes. Obviously, buyers won’t be making any money off the sale because they are the ones paying. So, the buyer doesn’t need to concern themselves with the tax rates of the sale or anything like that.
Of course, a seller will always try to limit the amount of taxes that they’ll have to pay from the sale. That is why sellers like to allocate the price toward intangible assets and other assets which take a long time to depreciate, if at all. For buyers to benefit, the opposite is true. The buyer will want the proceeds allocated toward all tangible assets and capital assets that will depreciate quickly. Why do buyers like this? The reason is that it helps them with their taxable basis in the future.
The proceeds which allocate to capital assets become the buyer’s taxable basis of the future. They’ll be able to completely write off what these assets are worth within the given timeframe. When the depreciation timeframe has a shorter window, the tax burden for the buyer decreases. As for inventory, even though it isn’t technically a capital asset that depreciates, it is an asset which is considered to be "short-term". This means it can quickly be written off by the buyer, so they can decrease their future tax burden.