Due Diligence Considerations When Selling a Business
When it comes to selling your business, you must consider the buyer’s perspective — not just your own — to get the deal done. Both sides will require certain due diligence procedures, which take time and patience to get through. Here’s what to expect, including some tax considerations.
Buyers Usually Prefer Asset Deals
A business sale can be structured in two general ways:
- As an asset purchase transaction, or
- As a purchase of your ownership interest, such as corporate stock, partnership interest or limited liability company (LLC) membership units.
Suppose you’ve used one of the following separate legal entities to conduct your business:
- Corporation,
- Partnership, or
- Multi-member limited liability company (LLC) that’s treated as a partnership for tax purposes.
There’s one big nontax reason that the buyer probably will prefer to arrange for an asset purchase transaction instead of purchasing your ownership interest. An asset purchase allows the buyer to avoid exposure to liabilities (both known and unknown) related to the business that you’re selling. If you’re able to sell your business by selling your ownership interest in your business entity, you can expect the buyer to insist on more extensive due diligence.
Important: If you’ve operated your business as a sole proprietorship or as a single-member LLC that’s treated as a sole proprietorship for tax purposes, you’re considered to personally own all the business’s assets. Therefore, for tax purposes, the sale of your company will be an asset sale by definition.
Seller’s Perspective: Allocating Sale Price for Asset Deal
When you sell a business by selling its assets, you’d prefer to maximize the amount of the sale price that’s allocated to assets that qualify for favorable long-term capital gains tax rates (Section 1231 gains), such as buildings and land that you’ve held for more than one year. Gains from selling depreciable personal property and amortizable intangibles will be treated as higher-taxed ordinary income to the extent of previously claimed depreciation and amortization deductions.
Additional gains will be taxed at the favorable long-term capital gain rates that apply to Sec. 1231 gains, if you’ve held the assets for more than one year. So, if the value of those assets is higher than their tax basis, selling them will result in gains, and part of those gains will be taxed at lower long-term gain rates. Allocating more of the sale price to those assets may make sense, especially if they’ve only been lightly depreciated or amortized.
As the seller, you would prefer to minimize the amount of the sale price that’s allocated to receivables, inventory and assets with short depreciable lives, such as furniture and fixtures, computer hardware and software. Most or all of the gains from selling those assets will be taxed at higher ordinary income rates.
There’s an important exception. If you sell the assets of a business that you’ve operated as a C corporation, Sec. 1231 gains from assets held for more than one year, short-term gains and ordinary income are all taxed at the same flat 21% corporate federal rate. Therefore, there’s generally no tax advantage to maximizing the amount of the sale price that’s allocated to assets that will be taxed at long-term capital gain rates.
Buyer’s Perspective: Allocating Purchase Price for Asset Deal
In an asset purchase deal, the buyer’s tax perspective is usually the opposite of yours. Buyers generally prefer to maximize the amount of the sale price that’s allocated to assets that can be written off quickly, such as receivables, inventory and assets with short depreciable lives, such as furniture and fixtures, computer gear and software. The buyer will prefer to minimize the amount of the sale price that’s allocated to assets that must be depreciated over long periods, such as commercial buildings (which are depreciated over 39 years). Land costs can’t be depreciated at all. The buyer must amortize purchase price amounts allocated to most intangible assets — such as customer lists, franchise rights, trademarks, goodwill and any noncompete agreement — over 15 years.
Asset purchase treatment automatically applies if you’ve operated your business as a sole proprietorship or as a single-member LLC that’s been treated as a sole proprietorship for tax purposes. In these situations, the business assets are considered to be owned by you personally for tax purposes, and the buyer is considered to purchase the assets directly from you.
On the buyer’s side, asset purchase treatment also applies if your business has been operated as a partnership or a multi-member LLC that’s been treated as a partnership for tax purposes. When the buyer becomes the sole owner of the business, there’s no longer any partnership for tax purposes because a partnership must have at least two owners. The same treatment applies for an LLC that’s been treated as a partnership for tax purposes. Therefore, the buyer treats the transaction as a purchase of the partnership or LLC’s assets.
Important: If you sell the assets of a business that you’ve operated as a C corporation, Sec. 1231 gains from assets held for more than one year, short-term gains and ordinary income are all taxed at the same flat 21% corporate federal rate. So, for you, there’s generally no tax advantage to a particular allocation of the sale price. You can agree to whatever the buyer wants with no tax harm done.
Corporate Stock Deal Treated as Asset Deal
Under a tax-law exception, you and the buyer can elect to treat a qualified purchase of your corporate stock as a purchase of your corporation’s assets by making a Sec. 338 election, a Sec. 338(h)(10) election or a Sec. 336(e) election. In this scenario, the sale price is allocated to the assets that your corporation is deemed to sell. The buyer will want to maximize the amount of the sale price that’s allocated to assets that can be written off quickly and assets with short depreciable lives.
The buyer will want to minimize the amount of the sale price that’s allocated to assets that must depreciated over long periods, such as commercial buildings, and land, which can’t be depreciated at all. Amounts allocated to most intangible assets must be amortized over 15 years.
Important: When you sell your corporate business with a straight stock sale, any gain on sale will be treated as lower-taxed long-term capital gain if you’ve owned the stock for more than one year. The buyer must capitalize the amount paid for your stock.
Primary Due Diligence Concerns for Sellers
As the seller, your main concerns are simply:
- Getting tax results that you can live with, and
- Taking steps to ensure than you’ll collect any deferred payments from the buyer.
However, the buyer has more due diligence concerns.
Buyer Concerns in Asset Deals
With an asset deal, the buyer will probably insist on compliance with so-called “bulk sale” laws. Various federal and state laws have been enacted to protect the interests of creditors and to ensure the collection of sales taxes when most or all of the assets of a business are transferred in a bulk sale to a new owner.
If the seller has conducted business using a separate legal entity, the entity might liquidate shortly after the asset sale by distributing the sales proceeds, along with anything else left on the books, to the owner(s). At that point, there’s nothing left for the entity’s creditors to pursue if they haven’t been paid. To prevent this outcome, credit protection laws require sellers to give creditors notice of asset sales.
Both the seller and the buyer of business assets in a bulk sale may have to notify state taxing authorities to ensure that applicable sales taxes are paid. The buyer may be required to withhold some of the purchase price until the amount of sales tax due has been determined. If applicable bulk sale laws aren’t complied with, creditors and sales tax collectors can “follow the assets” and make claims against the new owner. So, the buyer will be highly motivated to prevent that from happening by making sure bulk sale laws are followed.
In addition, with an asset purchase transaction, the buyer will probably insist on conducting a UCC filing search under the official name of the target business and all other names used by the target business (such as DBA names) and under the names of all principal owners and officers. A UCC search is intended to uncover security interests that have been granted for any assets that are being purchased. Examples include leases or loans secured by equipment that’s being purchased.
Buyer Due Diligence When Purchasing Ownership Interests
If you’re able to arrange to sell your ownership interest in the legal entity that you used to conduct your business, you can expect the buyer to be even more worried about avoiding exposure to liabilities connected with the acquired business. That’s because when a business is acquired by purchasing the ownership interest(s) of the business entity, the liabilities generally remain “inside” the acquired entity. So, the new owner effectively assumes the liabilities.
The buyer may decide to perform additional buyer due diligence procedures to uncover liabilities that may be undisclosed or understated on the balance sheet of the target business entity. These procedures might include:
Public records search. The buyer may want to inspect local court records to identify undisclosed liens or judgments against your business or the existence of current or past litigation against the business, its owners or its officers.
Review of tax returns. The buyer may want to review your business entity’s income, payroll, property, sales, use and excise tax returns for several years to identify any exposure to underpaid taxes due to aggressive tax positions.
Review of insurance policy loss payable endorsements. When insured assets are used as security for borrowings, it usually shows up as a loss payable endorsement on insurance policy declarations pages. The buyer may insist on examining these documents to uncover loss payable endorsements that direct the insurance company to pay all or part of the insurance proceeds to a lender if the insured asset is damaged or destroyed.
Depending on the nature of your business, the buyer may also want to take steps to identify the following types of liabilities and adverse facts:
- Liabilities under contractual arrangements, such as employment contracts, leases, maintenance agreements and warranties,
- Long-term contracts with major customers or suppliers with terms that are unprofitable or unfavorable to the buyer,
- Obligations under royalty or licensing agreements,
- Environmental liabilities, and
- Contingent liabilities due to patent or trademark infringement litigation, employee lawsuits or product liability lawsuits.
Expect to provide the buyer with a general representation that there are no undisclosed liabilities associated with your business entity or its assets. Don’t be offended. You would do the same if the roles were reversed.
Art of the Deal
Selling a business isn’t a do-it-yourself project. Reconciling the legal, financial and tax goals of you and your buyer requires specialized expertise and finesse. Get professional legal and tax advice before pulling the trigger on a deal. It will be money well-spent.
This article appeared in Walz Group’s April 13, 2022 issue of The Bottom Line e-newsletter.
