Q: What are the benefits and negative effects faced by a C corporation vs. an S corporation when buying or selling a business?
A: One of the main issues here centers on the tax ramifications to a seller and the potential value gap this can cause between a buyer and seller during negotiations. As a first step in elucidating these tax issues, let me explain the difference between the two primary deal structures for purchasing a business: an asset purchase of a business and a stock purchase of a business.
In an asset purchase, the buyer purchases certain assets of a company. Either the buyer can purchase everything on the balance sheet-plus intangibles, such as the name of the firm, customer lists and contracts-or he or she can purchase selected assets and leave some of the assets (usually nonoperational) in the company. Either way, the proceeds from the sale are paid to the company in exchange for the specified assets, and the purchased assets are placed into the buying entity. In a stock purchase, on the other hand, the buyer purchases the stock of the corporation and assumes ownership of the existing entity.
When buying small and midsized businesses, buyers typically prefer to purchase the assets rather than the stock for a few primary reasons. By purchasing the assets of a business, the buyer can, in principle, avoid the assumption of certain liabilities that may be tied to the corporate entity (for example, past tax and employee liabilities and product liabilities). In addition, by purchasing the assets of a business, a buyer can "mark up" the value of certain assets, such as machinery and equipment, to fair market values. This allows the buyer a tax shelter, because he or she can then re-depreciate that same equipment and shelter some of the new company's taxable income.
If the selling entity is a sub-S corporation, there is one level of corporate tax-at the shareholders' level. The profits for the company flow through to the individual shareholders' personal tax returns. On that note, whether the sale of the business is structured as an asset or a stock sale, the taxes associated with the sale proceeds primarily fall to the shareholders' personal taxation level.
Similarly, when the sale of a C corporation is structured as a stock sale, the shareholders will generally pay personal capital gains taxes based on the value of the stock over their basis. However, when it's structured as an asset sale, this may create a double-taxation situation. The proceeds of such a sale are paid to the corporate entity, which then pays corporate capital gains taxes on the consideration from the sale that is in excess of the book value of the assets sold. In addition, when the proceeds from the sale are distributed to the shareholders, the shareholders would pay taxes on the distribution at the personal level as well. In essence, the sale proceeds are double-taxed at the corporate, then the shareholder, level. This additional level of tax creates the value gap: Buyers prefer to structure a sale as an asset purchase, but the seller of a C corporation would obviously prefer the sale of stock.
As long as parties on both sides of the transaction are flexible, alternative structures do exist. There may be a way to bridge the value gap created by tax regulations by allocating a portion of the purchase price to other types of structures, such as a noncompete agreement or consulting agreements. Other alternatives include the utilization of other tax rules, such as the 338-H10 election or the implementation of a tax-free reorganization.
Overall, alternatives should be considered based on the specific needs and circumstances of the selling entity and shareholders. You are well-advised to retain the services of a financial advisor who is familiar with merger and acquisition (M&A) tax codes; he or she can provide you with the best possible guidance during the complicated M&A process.
Loraine MacDonald is director of advisory services at USBX, an investment banking firm specializing in the mergers and acquisitions of small to midsized businesses. She has been involved in the valuation and sale of privately-held businesses for over ten years. She can be reached at email@example.com at (310) 315-6700.
The opinions expressed in this column are those of the author, not of Entrepreneur.com. All answers are intended to be general in nature, without regard to specific geographical areas or circumstances, and should only be relied upon after consulting an appropriate expert, such as an attorney or accountant.