Goodwill is the difference between the market value of your business and the current value of its hard assets.
If you own a midstreet company ($1M-$25M in revenue), you might sell using an asset sale, a stock sale, or another creative structure.
Generally, as you go up in purchase price and the harder it is to transfer your assets, it becomes more likely to sell the stock of a business (see graphic below).
This article is not intended as tax or legal advice. When considering an acquisition or sale and for tax planning purposes, I recommend buyers and sellers of businesses to consult with the appropriate professionals, including accountants and attorneys. Work with a quality CPA to determine your net worth after you sell your company.
Definition of an Asset Sale
In an asset sale, you (the seller) retain possession of the legal entity used to operate your business, and the buyer purchases the individual assets of your company.
Asset sales usually do not include cash, and you will retain long-term liabilities on your company’s balance sheet. Accounts Payable and Accounts Receivable usually stay on your old Company’s balance sheet but can be transferred to the seller through language in the Asset Purchase Agreement.
In the final purchase agreement, the company's assets are broken out through an allocation of the purchase price into several buckets, including:
- Non-Competition Agreement
- Real Estate (if applicable)
Depending on your company's industry and specific features of your company, the individual or company purchasing the assets of your business might spell out specific items in their purchase agreement, such as customer lists, contracts, or patents.
You'll pay taxes on each “bucket,” according to IRS guidelines. A common sticking point we see during negotiations between buyers and sellers is how goodwill vs. equipment are allocated in the purchase price.
For tax minimization, as a seller, you will likely want to allocate a greater value to goodwill than to equipment, since goodwill is taxed at the capital gains rate, while equipment is taxed at your higher income tax rate.
The buyer will want the opposite, since they can benefit from greater depreciation as described in the next section.
After the sale, you will also be charged normal income tax rates on the gain of your company’s assets, instead of their depreciated or book value. This is what is known as depreciation recapture.
If you have a C-Corporation, you could be exposed to double taxation on the sale of your business. Your corporation could be taxed when you sell its assets to the buyer and taxed again when the proceeds of the sale are distributed.
Even if you change your entity to an S-Corporation, it could take 10 years from the time your company made the change to negate the double taxation effects (see IRS Sec. 1374).
The Buyer’s Perspective
By purchasing your business through an asset sale, a buyer achieves a “step-up” in basis of the company’s assets, allowing them to benefit from greater tax depreciation.
In addition to tax advantages, a buyer will likely not want to inherit your debts, liability for litigation, contract disputes, etc.
The buyer and their counsel will draft the initial transaction documents, but first you and the buyer must agree on what kind of sale to execute – asset or stock. The document that defines the structure of an asset sale is known as the Asset Purchase Agreement.
One of the downsides to an asset sale for everyone involved in the transaction is that certain assets can be difficult to transfer, such as contracts without assignability clauses or consent from a landlord.
Leverage the advice of a quality business broker, a transaction CPA, and an attorney to consider the buyer's perspective. Often, there is a way to achieve both your goals as the seller and those of the buyer through creative dealmaking.
How a deal is structured has a major impact on you (the seller) and the buyer.
Other factors beyond the scope of this article can also determine what structure you might use.
Before it is time to enter into a purchase agreement with a prospective buyer, you should seek advice from professionals with mergers and acquisitions experience.
That way, you can arrive at closing confident in your understanding of the taxes and liabilities that you will be responsible for after the sale.
If you have questions, comments, or feedback, email me at firstname.lastname@example.org.