Asset Sale or Share Sale: Which Seller Approach Should You Use?

Pros and Cons of Share and Asset Purchase Agreements

Shares or assets? Whether you’re a buyer or seller, an LLC or a corporation ( C Corporation or S Corporation), liability and tax advantages determine if a share sale or an asset sale is a better fit.

How should a seller decide between an asset sale or a share sale? There are four different ways to structure a stock acquisition:

1. The direct purchase of the stock from the selling shareholder owners, either for cash or for stock of the buyer.
2. Direct merger of the acquirer and the target.
3. A forward triangular merger whereby the target merges into a newly created subsidiary of the acquirer.
4. A reverse triangular merger whereby the acquirer’s subsidiary merges into the target in return for the stock of the target.

In contrast, there is one ‘asset acquisition’ method by which the acquiring company purchases the assets of the target company.

Analyze the differences between purchase agreement terms:

• Liability protection afforded by asset sale
• Important exceptions to ‘free and clear’ assets
• Ability to step up basis for tax depreciation purposes

Liability and Asset Protection Afforded by Asset Sale

In an asset purchase agreement, the buyer can assume specific liabilities and exclude those the buyer does not want to assume. For example, a buyer might specify that it will not assume a particular bank debt owed by the target company.  Also, a buyer might specifically state that it will not assume certain outside contracts that the seller is obligated to perform. For example, a buyer might specifically decline to assume a seller’s contractual obligation to repair parts shipped to customers.

In a properly structured asset purchase agreement, the buyer can insulate itself from unknown and contingent liabilities not identified in the agreement.

Examples include:

• Delinquent taxes of seller accounts payable owed to trade creditors
• Claims by former employees
• Lawsuits, whether existing or not yet filed

In addition, when it comes to an asset purchase agreement, one can specifically itemize and identify all assets in question, such as raw materials, specific copyrights, logos, business names, and trade secrets. Specifically, transfer those from the seller to the buyer by a bill of sale.

Exceptions to ‘Free and Clear’ Assets

There are important exceptions to the general rule that an asset buyer takes title to assets ‘free and clear’ of claims by the seller’s creditors. Liens, or claims to an asset(s) until a debt is paid, are different. A buyer generally cannot take title to assets free and clear of liens. Therefore, an adequately represented buyer performs a ‘lien and judgment’ search to determine if the assets being sold are lien-encumbered.

In most cases, regardless of whether the transaction is structured to sell shares or assets, the buyer may, via negotiations, be required to assume some known liabilities of the seller. However, in a share sale without specific delineation of liabilities, the buyer automatically acquires the seller’s liabilities by operation of law.

When a purchaser buys assets in an asset transaction, there is no automatic assumption of liabilities. But there are important exceptions.  Generally, an asset sale requires a conscious effort by both parties to choose which liabilities the seller will transfer to the buyer and which the seller will retain.

A seller should expect to make fewer representations and warranties in a definitive agreement for the sale/purchase of assets than in a share sale. For example, in an asset transaction, the seller need not make representations as to

• Capital structure
• Identity of shareholders
• Number of shares issued and outstanding
• Number of shares authorized
• Share options
• Warrants outstanding

On the other hand, it is perfectly reasonable for a purchaser to want to confirm that the company’s equity owners have appropriately authorized the sale.

Step-Up Basis for Tax Depreciation Purposes

One compelling factor driving a buyer to select an asset acquisition structure, as opposed to a share acquisition structure, is the buyer’s ability to ‘step-up’ the basis of the acquired assets for tax depreciation purposes.

In an asset acquisition, the depreciated basis of assets is ‘stepped up’ to the purchase price of the assets, meaning the buyer gets a higher basis for depreciation. This reduces the buyer’s income tax, which increases its cash flow. The purchase price in an asset acquisition can be allocated to assets with a shorter (i.e., faster) depreciation life. Those assets may include machinery and equipment with a three to five-year lifespan. Note that the tax code treats a share sale like an asset sale. Both parties must file a Section 333(h) election under the Internal Revenue Code.

Tax Code Differences for C Corporations and S Corporations

Whether the company is a C Corporation or an S Corporation also determines tax advantages in asset and share sales.

For sellers of a C Corporation, when assets are sold in an asset sale, the corporation must pay a tax on the gain it realizes. After distributing proceeds to shareholders, the corporation pays a second tax.

By contrast, in the case of a C Corporation stock sale, if the shareholders sell their stock to the purchaser, thereby transferring ownership of the corporation, the sellers only pay capital gains tax on the profit they received. Thus, the corporation avoids the consequences of double taxation in an asset sale of a C Corporation.

Tax Code Differences — S Corporation

However, for an S Corporation, it generally makes no difference whether the seller sells their stock or the S Corporation sells its assets to the buyer. In either case, there would usually be no double taxation. The shareholders pay tax at their personal individual income tax rates. However, an asset sale can produce ordinary income and differences in exposure to state tax liabilities.

Obtaining Third-Party Consents — Non-Assignment Clauses in Existing Contracts

In an asset transaction, the buyer may face the problem of getting third-party consent. For example, if the seller leases real estate from a third-party landlord, the lease may contain a non-assignment clause. Therefore, the seller cannot transfer the lease to the new buyer without the landlord’s consent. This is typically not the case in a share purchase agreement. Since the lessee remains the same, there is no assignment of leases involved. However, some leases deem transfers of company ownership, or changes of control, as an attempt to assign the lease, thereby requiring prior consent.

There may be non-assignment clauses if the seller has material or supply purchase contracts with third parties. That necessitates contacting each third party for consent to assign those contracts to the buyer. Similarly, intellectual property licenses from third parties may contain non-assignment clauses. Again, contact the licensors for permission to assume the license. This is particularly important when the seller corporation has government contracts.

Defense Department contracts or other government contracts may contain non-assignment clauses. The seller may have to obtain assignment consent by navigating the bureaucracy. When the seller owns certain registered patents or trademarks, the purchase and sale agreement must specifically assign those patents and trademarks to the buyer. Assignments must be filed with the US Patent and Trademark Office before the buyer acquires the assets.

In contrast to an asset sale, obtaining any of the above third-party consents in a share sale is not necessary. Therefore, the process is more efficient with less uncertainty. In a share transaction, it may be required to obtain third-party consent. That happens where the original documents (i.e., original leases, IP licenses, material contracts, government contracts, and similar contracts) contain a ‘change of control’ provision.

Whether you decide to go with an asset sale or a share sale, it is incredibly important that you choose the best route for your business. Choosing an asset sale or a share sale, depending on the nature of the sale, can have large effects on your tax liability, asset value, and overall state of your business.

We think you’ll also like:

1. Planning and Staging a Company for Transition
2. How to Conduct Due Diligence Before Buying a Business
3. Steps for Protecting Business Sale Confidentiality

[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can view at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. Digital Assets as Collateral: UCC Article 12
2. Keys to a Successful Sales Process
3. How to Prepare for Sale

This article was originally published on September 12, 2019 and updated on October 6, 2022.]

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