Let’s take a deeper dive into the tax issues associated with stock sales and asset sales in the context of an owner selling their business.

Stock vs Asset Sales – What is the breakdown?

Based on an analysis of marketplace transactions by Mariner Capital Advisors, approximately 30% of all transactions were stock sales. However, this figure varies significantly by company size, with larger transactions having a greater likelihood of being stock sales. It’s important to note that the choice between stock and asset sales can depend on various factors such as the type of business, tax implications, and potential liabilities. Therefore, these percentages can fluctuate over time and across different industries. The key takeaway is that the vast majority of transactions are asset sales.

Why do External Buyers strongly prefer Asset Sales vs Stock Sales?

Buyers, including private equity firms, often prefer asset purchases in certain situations for several reasons:

  • Reduced Risk: Unknown liabilities, such as legal or environmental obligations, can be a significant concern. Asset purchases can reduce the risk to buyers by limiting their exposure to potential legal and financial liabilities that may be associated with the target company. This can provide a greater degree of protection and peace of mind.
  • Step-Up in Basis: In an asset purchase, the buyer can often step up the tax basis of the acquired assets to their fair market value. This can result in potential tax advantages, such as higher depreciation deductions, which can lead to lower future tax liabilities for the buyer.

  • Greater Flexibility: Asset purchases offer flexibility in terms of which assets to acquire. Buyers can cherry-pick the most valuable assets that align with their strategic objectives while leaving behind any assets they do not need.

  • Easier Financing: Asset purchases may be more attractive to lenders as they typically involve fewer uncertainties and potential liabilities compared to stock purchases. This can make it easier for buyers to secure financing for the transaction.

  • Simplified Due Diligence: In asset purchases, due diligence may be more straightforward and focused on specific assets and liabilities, making the process potentially quicker and less complex than stock purchases.

  • Clearer Ownership Structure: Asset purchases result in a clear transfer of ownership for specific assets. This can simplify the ownership structure and legal entity of the acquiring company.

A $10 Million Company Sale as an Asset Sale vs Stock Sale

Let’s consider a company worth $10 million. Here’s an example of how the net proceeds and tax cost might look in a stock sale versus an asset sale.

Stock Sale:

  • Purchase Price: $10,000,000
  • Basis (original investment in the stock): $3,000,000
  • Gain on Stock Sale (Purchase Price – Basis): $7,000,000
  • Capital Gains Tax Rate (Estimated Federal & State Combined): 30%
  • Capital Gain Taxes on Stock Sale (Gain on Stock Sale * Capital Gains Tax Rate): $2,100,000
  • After-tax Stock Proceeds (Purchase Price – Capital Gain Taxes on Stock Sale): $7,900,000

Asset Sale:

  • Gain on Sale of Assets: $5,000,000
  • Ordinary Tax Rate (Estimated Federal & State Combined): 45%
  • Ordinary Taxes on Asset Sale (Gain on Sale of Assets * Ordinary Tax Rate): $2,250,000
  • After-Tax Asset Sale Proceeds/Dividend Payment: $7,750,000
  • Capital Gains Tax Rate (Estimated Federal & State Combined): 30%
  • Capital Gains Taxes on Dividend Payment (After-Tax Asset Sale Proceeds/Dividend Payment * Capital Gains Tax Rate): $2,325,000
  • After-Tax Asset Sale Proceeds: $5,425,000

In this example, the seller would receive more net proceeds from a stock sale compared to an asset sale due to the lower capital gains tax rate. However, the actual tax implications can vary based on numerous factors including the specific tax situation of the seller and buyer. This example illustrates just how important the structure of a business sale are to the seller.

Why are ESOP Sales Tax Advantaged for Sellers?

Employee Stock Ownership Plan (ESOP) sales can be tax-advantaged for sellers due to several key factors:

  • Capital Gains vs Ordinary Income: As we saw in the example above, a stock sale can yield much higher proceeds to a selling owner than an asset sale. An ESOP is a stock transaction!
  • Capital Gains Tax Deferral: One of the significant tax advantages of selling to an ESOP is the potential for capital gains tax deferral. When a business owner sells their shares to the ESOP, they can often defer the immediate recognition of capital gains taxes on the proceeds from the sale. This allows sellers to reinvest the sale proceeds and potentially grow their wealth over time.

  • Section 1042 Rollover: Section 1042 of the Internal Revenue Code provides a tax benefit for business owners selling qualified securities to an ESOP. Under this provision, if the seller reinvests the proceeds from the ESOP sale in qualified replacement property (typically stocks of domestic operating corporations), they can defer capital gains taxes indefinitely. This can result in substantial tax savings for sellers.

  • Tax-Advantaged Exit Planning: ESOPs offer business owners a structured and tax-advantaged exit planning strategy. Sellers can gradually sell their ownership stake over time, managing the timing of their tax liability and potentially reducing the overall tax burden.

  • Potential Tax Exemptions: In some cases, if certain conditions are met, sellers may be eligible for partial or complete exemptions from capital gains taxes on ESOP sales. These exemptions are designed to encourage and reward business owners for promoting employee ownership.

It’s important to note that the specific tax advantages of ESOP sales can vary based on individual circumstances, the structure of the ESOP transaction, and applicable tax laws. Want to learn more about ESOPs and how they work? Check out our ESOP University