A sure sign of an equitable deal is when the buyer and seller have both made sacrifices to get the deal done. Structuring deal terms often places buyers and sellers in competing tax positions. What, if any, of these considerations should deal stakeholders be cognizant of while reviewing a letter of intent or purchase agreement?

The buyer’s point of view is usually easiest to understand. Generally speaking, buyers come into a deal looking for ways to amortize (i.e., deduct for tax purposes) the purchase price as efficiently as possible. Buyers achieve this result by structuring a deal as a combination asset acquisition (asset deal) and continuing employment agreements for key personnel. Sellers, on the other hand, will more often want to structure a “stock deal.” As we peel back the layers of the onion on each, it will become obvious why the parties are often at odds.

Asset Deal

The tax treatment of an “asset deal” is straight-forward. Buyers allocate the purchase price to the various classes of assets acquired according to their FMV. The buyer thus gets a basis in the assets acquired that is stepped up to the allocated FMV.

But wait, there’s more. An asset deal is just that: a deal to acquire assets, not liabilities. Buyers are notorious for not wanting to acquire a seller’s liabilities or for wanting to select which of those liabilities they will assume. Nor does the buyer have to purchase 100% of the seller assets. To the extent the purchase price is allocated to amortizable goodwill, the seller amortizes the goodwill over 15 years under IRC Section 179.

At this point you may be thinking, “Slow down big guy…what is ‘goodwill?’ It sounds like something I want to acquire because it can be deducted over 15 years and my accountant tells me deductions, unlike fried food, are good for me!”

IRS Revenue Ruling 59-60 provides the following description: "Goodwill is based upon earning capacity. The presence of goodwill and its value, therefore, rests upon the excess of net earnings over and above a fair return on the net tangible assets. While the element of goodwill may be based primarily on earnings, such factors as the prestige and renown of the business, the ownership of a trade or brand name, and a record of successful operation over a prolonged period in a particular locality, also may furnish support for the inclusion of intangible value.”

Put in plain language, goodwill is an asset representing the future economic benefits arising from other assets acquired in a transaction. Another way to think of goodwill is the amount remaining after its possible to value tangible assets acquired and still have purchase price left over.

Amortization of goodwill is thus the main reason buyers look to asset acquisitions. An asset deal allows the purchaser to select which assets it will purchase. So, an asset deal is good for buyers.

But what happens to the seller in an asset deal? When making allocations of purchase price among classes of assets (including goodwill), there is a pesky rule that requires buyers and sellers to agree to such allocations. There is actually an IRS form (of course there is) where the allocation of purchase price among assets is reported by the buyer and the seller. The IRS loves consistency, and these two forms will, in most cases, match one another.

Sounds good, but what’s the downside for the seller? Suppose the seller is a C corporation. An asset sale results in corporate tax paid on the asset sale and then tax paid on dividends distributed to shareholders. In the tax business, this is referred to as double taxation and it is no good.

If the seller is an LLC or an S-corporation (both so called “flow-thru” entities), the gain on the sale of the assets is characterized according to the type of property being sold. Depending on the type of assets, this treatment can result in ordinary income recognition to the seller. Ordinary income also is not good for the seller.

Stock Deal

Stock deals are beloved by sellers and despised by buyers for the same reasons buyers and sellers are on opposite sides of the fence on an asset deal—namely, a stock deal is generally more favorable to a seller. As the word implies, a stock deal involves the transfers of the stock or shares (i.e., ownership interests) of a company. When the shares are sold, the buyer is purchasing the entire enterprise, including its liabilities. This is usually a fly in the ointment for buyers as they rarely will look to acquire known and unknown liabilities. Moreover, absent any other considerations, the buyer does not receive a stepped up basis in the assets of the enterprise and loses the ability to amortize purchased goodwill.

From the seller’s perspective, a stock deal is generally favorable. By selling their ownership interests in the entire enterprise, sellers may achieve more favorable capital gain treatment on the transaction. And, in the case of a C corporation, shareholders avoid the imposition of the dreaded double taxation.

Reconciliation

With two sides standing to benefit from different deal structures, how can there be equitable reconciliation? That’s the part where both sides are feeling not so good about the deal. Without employing advanced planning techniques (foreshadowing), there is generally movement on the purchase price to compensate the tax disadvantaged party. This results in more or less consideration from the buyer, the carrot of an employment agreement, or other consideration.

Are there advanced planning techniques available to help bridge the gap between buyer and seller? Personal goodwill, deemed asset acquisitions and drop down transactions to do just that.

At the end of the day, deals get finalized because both parties have enough incentives to close. Buyers and sellers can benefit from understanding what’s motivating the parties on the other side of the fence.