On Father’s Day, Morgan Bux celebrated with her dad Big Daddy Bux and asked him to team up with her to buy the fast-growing Green Earth Air Conditioning and Heating, LLC in Buda from the Green Earth retiring owner Gaia. Morgan suggested to Big Daddy that he invest her inheritance in Green Earth and work with her to grow the business as part of his own retirement and estate planning. Big Daddy’s tax and estate planning lawyers outlined a plan. Morgan’s business consultant recommended the formation of a Green Earth advisory team to support her after the purchase and developed a long-term plan for management growth and business expansion. To complete the purchase, should Morgan buy the assets or Gaia’s membership interest in the Green Earth limited liability company? Often buyers would rather purchase the company’s asset while sellers prefer to sell the stock / membership interest in the entire company. Why is that? What would Morgan and Big Daddy prefer?
A stock sale is the purchase of the owner’s shares in a corporation / membership interest in a limited liability company – including possible contingent legal liabilities and taxes. An asset sale is the purchase of individual assets and liabilities and cuts off any Green Earth legal and tax problems.
If it’s a stock purchase, the buyer takes legal title to the business entity – the transaction is simpler and more straightforward. Most contracts transfer automatically and seamlessly to the new owner. For the buyers Morgan and Big Daddy, it’s “what you see is what you get” for both assets and liabilities. Yet, to deal with any hidden liability fears, the parties will generally have contractual representations and warranties that obligate each of them to certain conduct and actions after the closing – generally enforceable by cash hold-backs of the final purchase payment which may also be sweetened by the promise of an additional purchase payment if the business performs exceptionally well.
Advantages of a Stock Purchase?
Because Morgan and Big Daddy are accepting the existing Green Earth entity – warts and all – no re-valuations or retitling of individual assets is required. The employees retain their current employment with the company and need not go through a process of being terminated from Green Earth and employed by a new entity that holds only the assets. A stock purchase also avoids the headache of dealing with certain assets which pose transfer challenges due to third party contract issues of assignability, legal ownership and third-party consents – such as intellectual property rights in patents and trademarks, licenses, leases and permits. The transfer of Green Earth’s membership interest presents an easy assumption by Morgan and Big Daddy to avoid the time consuming process of obtaining consents and refiling permit applications. However, it is to be noted that some contractual relationships have non-assignable licenses and permits that require the contracting third party’s specific consent to their assignment. Due diligence by Morgan and Big Daddy requires undertaking a close examination of all contracts executed by Green Earth to evaluate whether some contracts must be independently confirmed and, perhaps, approved or even renewed. Notably, some third party contracts may be more oppressive than advantageous – and in an asset purchase might be rescinded. That, alone might warrant a closer examination to recommend an asset purchase transaction over a stock / entity purchase.
Morgan and Big Daddy will realize few if any tax benefits, such as a “step-up” tax benefit. They get all the assets and liabilities – no handpicking. The only solution to dealing with toxic assets and unwanted liabilities would be separate contractual agreements, for example, for Gaia, the seller, to assume personal responsibility for them.
If it’s an asset sale, the buyer buys certain assets – equipment, licenses, goodwill, customer lists and inventory, and the seller retains legal title to the entity. The seller keeps the cash on hand, pays the non-trade debts, and delivers the business cash-free and debt-free to the buyer – except for the day-to-day cash needed to operate the business and its related vendor / trade expenses.
Advantages to the Buyer?
There can be some tax benefits by apportioning as much of the purchase price as possible to those assets that will depreciate the fastest. Section 167 of the Internal Revenue Code provides for a depreciation deduction of certain property from taxable gross income; therefore, the shorter the depreciation period, the sooner the buyer receives the tax benefit. Each type of asset to be acquired in the transaction must be analyzed individually to determine its priority to the buyer – which necessitates including a competent tax adviser on your team.
The most attractive category of assets is inventory and fixed goods. Because inventory assets can be expensed when sold in the ordinary course of the business – reducing the buyer’s taxable gross income from sales, Morgan and Big Daddy would like to apportion as large of a share of the purchase price as possible. Likewise, fixed goods (such as equipment) can be relatively quickly depreciated. Meanwhile, goodwill and any non-compete covenant are considered intangible assets and must be amortized (essentially depreciation for intangible assets) over time – generally over a 15-year period. However, there are critical restrictions to the purchase price allocation – Morgan and Gaia must agree to the allocation, and there is a limitation on the allocation of the entire price to one asset or any other blatant misappropriation effectuated purely for a tax benefit. As to the values of goodwill and the non-compete agreement, from the seller’s perspective goodwill is a capital asset and would therefore generate a more favorable capital gains tax for the seller than the non-compete agreement, which would be taxed as ordinary income at a higher rate. Finally, it is important to Morgan and Big Daddy, as the buyers, that they pay close attention to the allocation of the basis of each asset as it should equal their corresponding fair market values.
To get the employees, the seller is required to fire and the buyer must re-hire them – with all the imagined challenges and expenses that may well include employment contracts with key employees. Contracts – especially with customers and suppliers – may need to be renegotiated and/or renovated by the new owner. Some assets may need to be retitled. The tax-absorbing seller may require a higher sales price to get the cash at closing they want.
Tilting the Scales in Your Favor
Whether Morgan and Big Daddy elect to accept an asset sale or a stock sale, could it make a difference to the other family members? Of course it could.
Although Morgan and Big Daddy are prudently consulting with their lawyers, tax accountants, CPAs, business consultant and advisory team going forward, what if their purchase of Green Earth does not succeed? Like the father of the Prodigal Son, does Big Daddy risk giving Morgan her share of the inheritance only to have her fail and ask for more? What does Big Daddy’s wife (and Morgan’s mom) Angelica think? What about Morgan’s siblings? While perhaps more time consuming than a stock sale, does an asset sale – and its extermination of both known and unknown liabilities and risks – make more sense to the other family members? While management and business consultants are undoubtedly a great idea to help Morgan succeed, would it also make sense for Big Daddy and Angelica’s estate planning to consider and deal with the possibility that the Green Earth purchase could be a bad deal – not only for Morgan but perhaps also for Big Daddy and his Estate assets?