Pros and Cons / Share Sale or Asset Sale of a Business?

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There are two ways of structuring the sale of a business:

1. Share sale; and

2. Asset sale.

Share Sale - The Shareholder(s) is the Seller. In a share sale, the Company and its on-going business are valued and the buyer purchases all by purchasing the Shares of Capital Stock of the Corporation. The Buyer assumes ownership of the Corporation itself. Following the sale, the Corporation continues to operate the ongoing business concern, and to hold ownership of the tangible and intangible assets and to retain responsibilities for the liabilities, but all under new corporate ownership; new shareholders.

Asset Sale - In an Asset sale, the company, corporation, partnership or individual(s) is the Seller. In the United States and Canada, whenever capital gain exemption is not at issue, the sale of a small business is most commonly structured as an asset sale. Thus the tangible and intangible assets of the company are valued and sold as a whole, intact, as an ongoing concern. Such assets (and sometimes liabilities) are usually deposited into a new corporation owned by the buyer. The new corporation will assume the name (generally) and goodwill, and will continue the business activity of the selling entity, but all as a new and independent legal entity from the seller.

In a Share transaction, the purchaser acquires all of the outstanding shares of the business and, in so doing, acquires ALL of the assets and liabilities of that business. Historically, this has been the preferred method of “selling a business” in Canada because of more favorable tax treatment for the seller. However, it is not necessarily the preferred method of “buying a business” and, due to recent tax rulings, may not be the only way for the seller to achieve favorable tax treatment.

A fundamental consideration in preparation for, and structuring of the sale offering, will be the question as to whether the offering will be structured as an Assets sale or as a Share sale. And, fundamental to that question are the questions: Is your business incorporated? Is the seller eligible for capital gains tax exemption on the sales proceeds? Does the current share structure maximize on that tax exemption?

In Canada, the Share sale is generally advantageous to sellers who have not previously utilized their once-in-a-lifetime federal capital gains tax exemption. An Asset sale is generally more attractive to a buyer (in both the US and Canada) because it often provides the buyer with an opportunity to restructure asset values, also for tax advantage.

Share Transaction - Pros

Capital Gains Exemption - Profits made through the sale of shares in a business are treated as capital gains for purpose of taxation. If the business is a Canadian Controlled Private Corporation (CCPC) and has been held for a period of at least two years, each shareholder of such a business is entitled to up to a one-time $500,000 capital gains exemption. That is, each selling shareholder may be eligible to receive a $500,000 profit from the sale of the business tax-free (this should be discussed with a qualified tax accountant).

For larger business for which the sale price is likely to exceed $500,000, it is crucial that ownership be shared with multiple family members as each shareholder is entitled to the exemption.

Note however, that even though the transaction involves the sale of shares, the value of the transaction is still attributed to the various assets of the business. (If the selling price of the business exceeds the book value of the assets of the business, the excess is attributed to “goodwill” or the intangible “going concern” value of the business.)

Also note that certain assets do not qualify for the capital gains exemption and the proceeds from their sale (including recapture of depreciation) must be treated as regular income in the hands of the seller:

•Real estate, including buildings and property;
•Assets that are not used at least 90% in the operation of the business.

Loss carry-forwards – These remain with the business and, in a share sale, are therefore available to the new owners to reduce future earnings for income tax purposes.

Simplicity – The purchaser acquires the entire business – lock, stock and barrel. There is no need to negotiate which assets are or are not included, nor to set up and administer procedures for dealing with adjustments after the sale.

Share Transaction - Cons

Risk of hidden liabilities - In a share sale, the purchaser acquires ALL assets and liabilities, including hidden liabilities of which the buyer, and even the seller, may not be aware.

If and when such liabilities emerge following a share transaction, the new owner(s) are fully liable. Here are a few examples of such potential hidden liabilities:

•Re-assessment by the Workers Compensation Board regarding insufficient past payments;
•Former employees suing for various reasons;
•Claims by customers for product warrant and related issues.

Share Transaction - Summary

Because of the unknown potential risk of hidden liabilities inherent in a share sale, buyers always prefer to structure the purchase of a business as an asset transaction. However, the $500,000 per shareholder capital gains exemption plus the fact that the liabilities, included in the transaction which offset the value of the assets, means that the selling price for the business is usually lower than an asset sale. The reduced selling price plus the potential benefit of loss carry-forwards may provide sufficient incentive to the buyer to overcome the risk of hidden liabilities.

However, as you will see below, recent tax rulings indicate that there may be other ways for the seller to receive favorable tax treatment on the sale of a business. To the extent that these rulings apply to a particular situation, the benefits of a share transaction may disappear, thereby making the Asset sale the preferred approach.

Asset Transaction

In an Asset sale, the purchaser acquires only certain specified assets and business interests of the business. The seller retains ownership of the business entity, including all liabilities, loss carry-forwards and any assets that were not explicitly acquired by the purchaser.

Other than the possibility of a reduced selling price made possible by the uniquely Canadian Capital Gains Exemption, the asset sale is generally the preferred method of buying a business.

Under the Bulk Sales Act, which applies when a buyer acquires substantially all of the assets of a business, the seller must provide a certified list of trade payables and other liabilities, which remain the responsibility of the seller. A certified list of Accounts Receivable is also provided, which is remitted to the seller if and when the amounts are collected by the new owner.

Generally, a business will sell for considerably more than the book value of the assets being acquired. When the selling price exceeds the current book value of those assets, the seller of the assets (i.e., the business entity that is being retained by the seller) must treat the proceeds from the sale as business income, which is taxed at normal business tax rates and taxed again as personal income in the hands of the original business owner.

Asset Transaction Pros

Favorable Asset Allocation – Allocation of a substantial portion of the selling price to a non-compete clause is beneficial to both the seller and the buyer. For the seller, it means that the proceeds are non-taxable; to the purchaser, the value of that asset can be amortized (deducted as an expense for tax purposes) over the term of the non-compete clause – generally one to three years.

To be allowable, however, the value allocated to the non-compete clause must be reasonable and defensible. For example, it must reasonably reflect the seller’s loss of income that could otherwise be earned.

Minimization of Buyer Risk – Because the buyer is acquiring only certain specified assets and few in any specified liabilities, the buyer is relieved of any risk of hidden liabilities.

Asset Transaction Cons

Complexity – An asset sale is more involved as it requires buyer and seller to negotiate exactly which assets are to be included in the sale and to put in place and monitor procedures for dealing with adjustment after the sale. For example, the seller typically retains ownership of the Accounts Receivable, even though collection of those accounts generally rests with the new owners. The seller needs assurance that the outstanding amounts will be collected and remitted by the new owner. Similarly, the seller retains ownership of trade payables. The new owner needs assurance that trade payables will be settled in a timely and appropriate manner so as not to impede ongoing business transactions with those suppliers.

Risk to the Seller – Because the seller remains responsible for any hidden liabilities, the risk to the seller is greater with an Asset sale than in a Share sale.

Asset Transaction - Summary

Overall, an asset-based sale of a business is more favorable to the buyer and less favorable to the seller because it places more of the risk of hidden liabilities on the seller. In addition, without the recent (and perhaps temporary) tax relief provided by the tax-exempt status of a non-competition clause, an asset-based sale will typically result in a substantial tax liability to the seller that would not apply in a share-based transaction.

The seller is responsible for all warranties provided to its customers, unless the warranties are treated as part of the purchase.

Summary

With the sale of a small business, the question often determining Asset sale or Share sale is, what are the tax advantages to the seller and the buyer, to structuring the sale one way or the other? A typical question for the Canadian owner is, will the sale proceeds qualify for capital gains tax exemption?