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How to Design a Stock Sale that is Palatable to a Buyer

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How to Design a Stock Sale that is Palatable to a Buyer

In this series of articles, which has covered the double tax that confronts sellers of C-corporation assets, we met Brent James, a fictional owner who has decided to sell the assets of his C corporation in three‑plus years despite the tax consequences.

Today, let’s assume that Brent either can’t convert his corporation to S status or insists on selling now, before an S election can take effect.

We don’t need to know Brent’s exact reasons for his insistence, but we do know that owners cite numerous reasons to forge ahead with immediate sales:

  • They may need to sell immediately or soon for health reasons.
  • The offer on the table will not be repeated.
  • The company may be in a declining industry.
  • The owner may have died and the business will die as well without a quick sale.

In this article, we discuss how to design a stock sale that is palatable to a buyer.

Strategy 1: Reduce a Buyer’s Liability Exposure
 

To offset the risk of purchasing the business, buyers generally insist on a substantial reduction to the purchase price. One alternative to substantially reducing the purchase price is to reduce the buyer’s risk associated with a stock purchase. Brent could agree to do one of the following:

  • Indemnify the buyer with respect to specific company liabilities.
  • Place part of the purchase price in escrow for a set time period after the sale to deal with possible recognized or unknown liabilities existing at the time of sale.

A second alternative to slashing the purchase price is to sell to an industry buyer who is well aware of, but undeterred by, the liability risks inherent in Brent’s company.

A third alternative is to sell Brent’s stock to an ESOP.

Strategy 2: Accentuate the Positives
 

You can argue that it is in a buyer’s best interest to purchase stock if the company fulfills one or more of the following criteria:

  • Possesses a large number of copyrights, patents, or other forms of intellectual property that are difficult to assign.
  • Has a large number of governmental contracts that may be difficult to assign.
  • Has only one or two primary customers. (We recently worked on a transaction in which both the seller and buyer agreed that if the buyer purchased stock rather than assets, one customer would be less likely to change its relationship with the company.)

Strategy 3: Let Personal Goodwill Tackle the Loss of Tax Benefits
 

For many buyers, the principal objection to a purchase of stock is the loss of tax benefits available via an asset sale. Some of those buyers may be more inclined to accept a stock sale if a significant part of the purchase price is allocated to personal goodwill. (See Personal Goodwill.)

In Brent’s service company, the assets were almost entirely attributable to goodwill, specifically, as personal goodwill. This classification implies beneficial consequences, even in a stock sale.

If a buyer is willing to accept the liability risks inherent in acquiring stock rather than assets (for the reasons described above) yet is insistent on receiving the tax benefits of an asset sale, it’s time to revisit the concept of personal goodwill. If a significant part of that goodwill is characterized as personal goodwill, the new owner can amortize it. If that’s the case, the purchase is structured so that the new owner buys the stock and acquires the owner’s personal goodwill. A business appraiser will value the goodwill and allocate an appropriate portion to personal goodwill.

The tax benefit of using goodwill does not affect the seller: Brent pays only a capital-gains tax, whether his company sells stock or personal goodwill. Rather, this structure benefits the buyer, who can amortize a significant part of the purchase price.

The Bottom Line
 

When Exit Planning Advisors are given a sow’s ear and take several risk-reducing steps, describe the benefits of a stock sale to a buyer, and establish personal goodwill, they may create a close-enough version of a silk purse to entice a qualified buyer to purchase stock rather than assets. We say “close enough” because C-corporation owners may still have to accept purchase-price reduction when selling stock. However, this purse makes a sale possible, and owners can yield enough after-tax proceeds to enable them to exit their businesses on their terms.

In the next article, we’ll talk about post-sale planning concepts that reduce the double-tax consequence. Specifically, we’ll address the following question: Once a C corporation has sold its assets, what can be done to reduce the net tax consequences for your client?

A Note to Exit Planning Advisors
 

The purpose of this series is to expose the breadth of information that Exit Planning Advisors should have available when relatively “narrow” issues arise (e.g., the sale of C-corporation assets). Our role as Exit Planning Advisors is to inform owners about the many tax, legal, and other technical issues outside of our particular areas of expertise, not decide how to tackle these issues for them. Our role is to make owners and their other advisors aware of the design options and tools necessary to create exits that achieve our clients’ goals of leaving their businesses on their terms (turning their sows’ ears into silk purses).

This laser focus on an owner’s terms or goals may mean that the design an owner chooses is not necessarily the one that results in the lowest tax. Instead, it may be the design that achieves an exit goal that is more important to a particular owner. For example, an owner may choose the design that achieves the fastest exit or perhaps provides a blend of speed and tax efficiency. The ultimate decision lies with owners once you have provided the information necessary to make their decision an informed one. That is precisely what Exit Planners do. 

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