Tax on Stock or Asset Sales

April 13, 2006

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If your business is organized as a corporation, you have a choice: you can either sell the stock in the corporation to the buyer, or you can have the corporation sell its assets to the buyer, leaving the corporate "shell" in your hands.

Tax aspects are the main reason that C corporation sellers usually prefer to sell their stock, while buyers prefer to buy the assets. With a C corporation asset sale, the seller will be taxed twice: the corporation will pay tax on any gains realized when the assets are sold, and then the shareholders will pay capital gains tax when the corporation is liquidated. In contrast, if you sell the stock, you'll pay capital gains tax on your profit from the sale, generally at the 20 percent long-term capital gains rate (15 percent starting May 6, 2003).

From the buyer's perspective, however, asset sales are usually preferable. In an asset sale, the buyer's basis for depreciation is the allocated purchase price of the transferred assets. In a stock sale, the basis of the stock shares is stepped up to the purchase price of the stock. However, the buyer takes over whatever basis the seller had in the assets. If the buyer had already depreciated some of the assets down to zero, the buyer can't claim any more depreciation deductions on them. Clearly, the buyer would much prefer the stepped-up basis of an asset sale.

One point to consider, when you negotiate the issue of a stock or asset sale with the buyer, is that your increased tax bill from an asset sale will usually be greater than the savings the buyer would get from such a sale. A stock sale usually results in the lowest total amount of tax being paid to the IRS, and the most money left in the hands of the parties. Theoretically at least, you should be able to take advantage of a stock sale by adjusting your purchase price to reflect the future tax burden to the buyer. Also, in a sale of stock, the IRS does permit the buyer to elect to have the transaction treated as a purchase of assets (i.e., buyer can get a step-up in basis for the assets), if the buyer pays tax on the difference between each asset's current basis and its fair market value in the year of the transfer.

Delaying the second tax. As explained above, if the seller is incorporated and sells assets, the transaction is normally taxed twice — once when the corporation sells the assets, and again when the corporation is liquidated. At the time of liquidation there will be capital gains tax imposed on the individual stockholders based on their proceeds from the liquidation, minus their basis in the stock. Sometimes this second tax can be deferred to the future, if the corporate "shell" is maintained rather than liquidated. In a family-owned corporation, the shell can become a holding company for family investments (for example, the proceeds of the sale can be held by the corporation and invested). As you can imagine, the IRS generally doesn't like this result, so in addition to the regular corporate income tax, the "shell" may have to pay personal holding company tax to the tune of 35 percent (i.e., the highest individual income tax rate in 2003 through 2010). You can generally avoid this result if the shell corporation pays out all its after-tax income as dividends.

Electing S corporation status. With an S corporation, there's generally just one tax to shareholders on either an asset or stock sale. If you're contemplating the sale of your business several years down the road, you may want to consider switching to an S corporation now. By doing so you can usually eliminate the double taxation on any appreciation after the date of the switch. If you go this route, be sure to get expert tax advice, and have an appraisal done at the time of the change.