According to some industry surveys, well over 90% of business sales are “asset” sales as opposed to “stock” sales. More times than not, this is driven by specific tax objectives of the buyer. It has major tax implications for the seller that are – more times that not – bad.

In a recent series of articles, we discussed how a business seller’s tax strategy often depends on who the buyer is. In one installment, we noted situations when – given who the buyer is – the seller would want her or his business to be treated as a “C” corporation for tax purposes. What would initial seem like “tax death” turned out to be a tax-reducing strategy. These situations are the exception.

In that same series, we also discussed how “what is being sold” affects the business seller’s tax strategy. In this article, we will focus on when “what is being sold” might negate tension between the buyer’s preference for an “asset” sale and the seller’s preference for a “stock” sale. Before getting into specifics, let’s be clear that the discussions below deal with a business that is already treated as a “C” corporation for tax purposes. We are not talking about taking a business that a not already treated as a “C” corporation for tax purposes and converting into one. We’re trying to get out of a pickle, not get into one.

Back in 1944, an individual conducted business as an insurance broker via a corporation of which he and his wife were the sole owners. The couple dissolved the corporation and distributed the corporation’s assets – including the corporation’s goodwill – to themselves. The IRS argued that the distributed goodwill should be taxed as any other distribution. But, the Tax Court held that the goodwill was really due to the personal ability and relationships of the husband himself. As such, the goodwill was that of the person and not the corporation.

In 1998, the Tax Court considered a similar set of circumstances; this time involving an ice cream distributor. It affirmed its decision from a half-century earlier. “This Court has long recognized that personal relationships of a shareholder-employee are not corporate assets when the employee has no employment contract with the corporation. Those personal assets are entirely distinct from the intangible corporate asset of corporate goodwill.” Later that same year, the Tax Court again affirmed its position in another case. Finally, in 2002, the IRS conceded the issue in a Technical Advice Memorandum.

Here’s what it boils down to. If your company is taxed as a “C” corporation, is owned only by you and/or your spouse, and the company’s goodwill stems from your personal ability and relationships, that goodwill is not an asset of the company . . . it is yours as an individual. Thus, you would sell that goodwill as an asset of your own and not as an asset of your “C” corporation. When doing this, formality must be followed. The corporation sells its tangible assets and you personally sell your goodwill. Two separate transactions. Your personal sale of your goodwill is reported on Schedule D of your personal income tax return. Yes, the corporation will be taxed on gain realized on all other assets. And, yes, when the corporation subsequently distributes cash proceeds to you, it will be a dividend taxable to you. But, you will avoid the double-taxation on your personal goodwill. For most service businesses, it will be your personal goodwill that is the bulk of the firm’s value.

Now, let’s take the ice cream case a step further. The personal relationships with the suppliers and the customers were those of the owner as an individual. The only other meaningful asset of the “C” corporation is inventory. (For those who “drop ship,” you can disregard this part of the discussion.) A business can’t depreciate inventory. As such, there is no meaningful difference to the buyer or the seller between a “stock” sale and an “asset” sale. There’s no reset of depreciable basis for the buyer.

As for the seller, consider the instance when inventory is sold as an asset to the buyer. The “C” corporation has no profit on the sale and the proceeds are distributed to the seller as a dividend. There is only one level of tax to the seller. Alternatively, if we have a “stock” sale for the same price as the asset sale, there is also only one level of tax to the seller. Truly, the buyer and seller end up in the same spot either way.

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