With respect to the sale of a business, the negotiated sales price is not the only determinant of the economic benefits to be ultimately realized by the seller.  The way the transaction is structured, specifically whether it is a stock sale or asset sale, can have material implications to the cash realized by the business owner. 

It probably goes without saying that that the optimal deal structure will vary for each proposed transaction and will depend on the specific circumstances of the buyer and seller.  Each business owner and buyer is unique and each will have their own tax situations and goals with respect to the business sale or purchase.  However, it is a general rule that stock sales are preferred by sellers, while asset purchases are preferred by buyers. 

A seller prefers a stock sale, especially for a C-corporation, because there is only one level of tax (which is imposed on the difference between the transaction price of the stock and the seller’s tax basis in the stock).  Additionally, if the seller has held the stock for more than 12 months, the gain will be taxed at the more favorable long-term capital gains tax rates.

The buyer, on the other hand, generally prefers an asset purchase for tax reasons, as well as to avoid any unknown corporate liabilities of the selling corporation.  If the cost of the assets to the purchaser is greater than the tax basis of the assets, there is a step-up in the tax basis of those assets.  The buyer fares better in the transaction, as the purchase price of furniture, fixtures or equipment can be deducted for tax purposes relatively quickly through depreciation expense.  The asset purchase also will often result in the creation of goodwill, which can be amortized for tax purposes over a 15-year period.  Unlike a stock purchase, the ability to depreciate and amortize these assets generates increased income tax deductions in the future, creating a lower tax liability.  This stepped-up basis can result in significant economic benefit to the purchaser, which may allow the buyer to pay a higher price. 

If the sale of the business is structured as an asset sale, one strategy that may be able to be used by the seller is to sell his or her personal goodwill as a separate asset.  In other words, the overall tax liability can be reduced if a portion of the sales proceeds are allocated directly to the shareholder, rather than the corporation.  In this manner, the seller avoids the double-taxation normally present on the sales of assets of a C-corporation (the double tax involves a tax on the gain on the sale of the asset and a second tax when the remaining proceeds are paid in dividends to the shareholders).  By allocating a portion of the sales price to be paid directly to the shareholder for personal goodwill, the selling shareholder pays only the tax on the realized gain on that asset.

Personal goodwill may be present depending on the circumstances with respect to the business and its owner, but certain factors may support the existence of personal goodwill.  These factors include that the owner should be directly involved in the operations of the business, the owner makes all of the day-to-day management decisions, and the owner is highly visible to the customers or clients of the business.  According to the June 2003 edition of the Tax Adviser, authors Darrell V. Arne and James R. Hamill provide a checklist for allocating a portion of the purchase price to personal goodwill.

Personal Goodwill Indicators:

• Small entrepreneurial business is highly dependent on the employee-owner’s personal skills and relationships;
• No pre-existing covenant not to compete and/or employment agreement between the selling company and the employee-owner;
• Personal service is an important feature in the company’s products or services;
• No significant capital investment in either tangible or identifiable intangible assets; and
• Only employee-owners own the company.

In the end, determining the structure of the deal is an integral part of the overall negotiating process, and the financial and tax advisors of both parties should be intimately involved throughout the process.  With each major revision of the transaction terms, these advisors should apprise their clients of the ultimate cash flow ramifications. When a transaction is structured properly, it can dramatically increase the economic benefits to the seller when it is all is said and done.

This information is general in nature and is not intended as tax advice.  Always have your tax preparer and/or other competent tax advisor(s) review your transaction for tax implications.