Option A – Sale of assets

Following is an analysis of the different requirements and effects of choosing to structure the sale of Company as a sale of assets. The analysis includes a numerical exemplification of the said effects.

I. Approval requirements
In a sale of business such as the present one, vote requirements are essential before any further analysis can be done.
In particular, as far as the seller is concerned – in the present case Company – both the approval of the board and of the shareholders are required.
Complete information about the composition of the board is not yet available to us, though it can be expected that at least some of the five (5) sole shareholders are part of it. Even though the owners of Company themselves have asked for advice on potential sale structures, their final consent cannot be given for granted since their interest in selling today cannot yet be interpreted as a firm decision to do so tomorrow.
Taking a closer look to the buyer entity, instead, it not sure whether approval by its board will be required as it depends on whether or not the present transaction can be defined as a material one from its perspective. Though, even in the event the transaction should not be a material one for the acquirer, it would still be advisable to get the board’s approval.
The acquirer shareholders will not be asked to express their vote on the matter, unless the transaction will fundamentally change the nature of their initial investment.
While the default rule, in terms of votes required to consider the voted issue approved, is majority, it could be the case – for either or both the corporations involved – that the voting requirement has been changed internally in the articles of incorporation. Thus, the articles should be carefully read also in light of this.

II. Liabilities distribution
Differently from other types of transactions, in an asset sale, the acquirer will only assume those liabilities that chooses to – some restrictions apply in this case as it is not a sale of just some assets but rather of the entire business.
In fact, in the event should want to continue running the business acquired through the asset sale, the continuity of enterprise doctrine would come into play. This doctrine provides that it is not possible for the acquirer to avoid all the liabilities that it would have otherwise taken just by labeling a merger as an asset sale. In such cases, for successor liability issues only, the transaction will be treated as if it was a merger.
In addition to this, California also applies the product line exception, but this does not seem to apply to the present transaction, as the seller is interested in selling the complete business rather than part of it.
Even though this does not seem necessary from the available information, if it would make the buyer feel more confortable in making the transaction, it could decide to create a shell corporation as a vehicle for the purchase of the seller’s assets for the purpose of shielding itself from future liabilities.

III. Contracts with third parties
It is important to consider that the Company does not own the land where its primary manufacturing facility is located. Instead, it has a lease contract (the “Lease”) with a third party.
Of course, the buyer will most certainly assume the Lease given its centrality for the business and its operation. In particular, the Lease is a long-term lease agreement that still has a considerable amount of time remaining on the term – specifically fifty (50) years.
The concern regarding such lease contract is that it contains a “non-assignment” clause. This provision entails that written approval of the landlord is required in for the Lease to be assigned to the buyer.
For this reason, it is advisable to first investigate whether the landlord would agree to such an assignment or not. This investigation, of course, cannot be done before a potential buyer is actually identified and negotiations start. This is so as its identity, credentials, and business history can affect the decision of the landlord.
The alternative solution to investigating the willingness of the third party to the Lease to agree to the assignment is to foresee a cost of $75,000. In fact, the landlord agrees to consent to the assignment of the Lease in exchange for such amount of money. While this would avoid investigations and negotiations with the landlord, it would have an effect of the purchase price of the assets. In fact, negotiations on the matter would be required between the Company and the potential buyer; in particular, it is foreseeable that the buyer will try to avoid any of such cost and let the Company bear it all or, in case it agrees to share it, it will certainly ask for a lower purchase price – in the amount of, or at least part of, $75,000.

IV. Appraisal rights
Appraisal rights in the sale of assets of Company, as it has been proposed (complete liquidation for cash) would not be available to the shareholders.
For what concerns the buyer, instead, where the transaction would represent a fundamental change in its shareholders investment, appraisal rights would be available for the shareholders.
In the present case, no such rights seem to be available to neither corporations’ shareholders, thus related costs are improbable. This ultimately reflects itself in the purchase price the Company can ask.

V. Tax related issues
For purposes of organization the tax concerns related to the transaction will be analyzed hereunder by first focusing on State sale taxes, then on property taxes, and lastly on income taxes.

V.I. State sale tax
State sale taxes are to be considered only in the occasion of option A (sale of assets) given the very nature of the transaction.
Only tangible assets are subject to this taxation as opposed to intangible assets (such as but not limited to goodwill – which in the present case is present – patents and trademarks, which the Company may own too but about which we do not have any information yet).
Even though California provides an exemption for occasional sales, this exemption is narrower than it could appear to be. In fact, the “occasional sale of tangible personal property” exemption has a limited scope in that an “occasional sale” is defined as all of the following:

(a) A sale of property not held or used by a seller in the course of activities for which he or she is required to hold a seller's permit or permits or would be required to hold a seller's permit or permits if the activities were conducted in this state, provided that the sale is not one of a series of sales sufficient in number, scope, and character to constitute an activity for which he or she is required to hold a seller's permit or would be required to hold a seller's permit if the activity were conducted in this state.
(b) Any transfer of all or substantially all the property held or used by a person in the course of those activities when after the transfer the real or ultimate ownership of the property is substantially similar to that which existed before the transfer. For the purposes of this section, stockholders, bondholders, partners, or other persons holding an ownership interest in a corporation or other entity are regarded as having the "real or ultimate ownership" of the property of the corporation or other entity.
(c) A sale of property, other than hay, by a producer of hay, provided that the sale is not one of a series of sales sufficient in number, scope, or character to constitute an activity for which the producer would be required to hold a seller's permit if the producer were not also selling hay.

In the present case, the transaction should nonetheless qualify for the exemption, as the Company is not required to have a resale permit but on a manufacture license. However, it is necessary to understand whether or not the Company falls within the definition of “seller” for the purposes of the occasional sale exemption.
An important factor in determining such element seems to be – as it can be noted from the following two precedents – the qualification of the seller as a retailer or as a wholesaler. * A manufacturer who had made sales for resale but no retail sales and whose product was not suitable for retail sale was not a "seller" and the sale of the manufacturers business assets was, therefore, an occasional sale. * A manufacturer who makes no retail sales but whose product is suitable for retail sale is a "seller" and sale of the manufacturers business assets was not an occasional sale.
Also, time limits should be controlled in the event the Company has previously made similar sales.
Following the understanding of the Company’s status and its previous transactions, further research should follow regarding the specific assets subject of the sale since exemptions to the “occasional sale” exemption could exist for the single assets.
In any event, should there be any state sale tax, this is a liability the burden of which is sustained by the purchaser/acquiring corporation.
Lastly, successor liability sometime applies to unpaid state taxes too. From the information available it is not known whether the Company has any deficiencies towards the State Treasury or not, but should it be the case then, for the purchaser to avoid any such liability, “shall withhold sufficient of the purchase price to cover such amount until the former owner produces a receipt from the board showing that it has been paid or a certificate stating that no amount is due.”

V.II Property tax

Property tax applies to real and personal property, with due limitations and exceptions. As for now, we are aware that Company does not own the land on which its primary factory is located but we do not know if it owns other real property. While as for personal property, even though we do not know have specific information, it can be foreseen that Company owns machineries, equipment, supplies, and other personal taxable properties.
A direct consequence of a sale of assets is that title in each asset sold will be transferred from the Company to the buyer, from which it follows that the property will be revalued at the present fair market value for tax purposes. In particular, the buyer will acquire a new basis (on which it will be taxed) equal to the purchase price. For this reason, the process of allocating the purchase price to each single or group of assets is an important step, both for the acquirer and the seller.
An important feature that follows from a sale of assets for tax purposes it that the acquirer will also be able to start a new depreciation period for the assets it has bought.

V.III. Income tax

Before analyzing the income tax consequences of the two potential transactions (sale of assets and sale of stock) it is necessary to understand whether or not the reorganization of Company will be a taxable or non-taxable transaction. To understand this it shall be determined whether the shareholders (of the Company) will take meaningful cash out of the transaction.
From the information available it follows that, in the event option A will be the desired structure, the reorganization will be taxable. For what concerns option B, instead, more information is needed. In particular, if consideration for their stock will be cash then the transaction, as in option A, will be taxable; while, if consideration consists of anything but cash (e.g. equity) the transaction would not be taxable – the former shareholder will eventually be taxed only if and when he or she will sell the acquired equity or other consideration received. In sum, what is being taxed is the liquidity obtained from the transaction.
Option A
Since the Company is a C-corporation taxation will occur on two levels: 1) Company, and 2) shareholders. Following is an approximation of the tax effects on both levels. * Level 1 – the Company
To assess the taxes owed by the Company the figure from which to depart is the inside basis (Bi) of the Company in its assets, which we are told to be $10 million.
The inside basis is important to determine what the taxable amount (Ta) on which the tax rate (r) will be applied to. In particular, where P is the purchase price, the taxable amount will be:
P-Bi=Ta

The taxable amount can be also described as the profit brought by the transaction over the inside basis.
It is important to remember that, even though P is an aggregate sum (as it reflects the total amount), the Company will have to allocate (just as the buyer) that lump sum to each single or group of assets being sold (to this end, the buyer and the Company will have to either file a single – if they agree - or two separate forms – if they do not reach an agreement – to the IRS indicating the specific allocation). As a consequence, taxes will be calculated on the single assets and not on the total purchase price amount.
This means that:
1nTc=v1∙r+v2∙r+(vn∙r)
where Tc is the total amount of corporate tax, v is the value of each asset, and r is the tax rate applicable to the Company.

* Level 2 – the shareholders
Just as the Company has its basis in its assets (inside basis) the shareholders too have a basis on the assets (outside basis). Such a basis serves the same purpose of the inside basis: determine tax liability amount of the shareholders.
In our case the shareholders are also the founders of Company thus, their basis is equal to their initial contribution, which is potentially the same for all them given that they all own an equal share of Company (20%). Their individual outside basis is $10 million.

The purchase price is not equal to the amount of money that will be available for distribution to the shareholders rather it is the excess resulting after (first level of taxation occurs before distribution). In particular,

P-TcP-Bi=amount availabe for distribution

where Tc is the amount of corporate tax (first level) and Bi the internal basis of the Company in its assets. Thus,
TiP-[TcP-Bi)-Bo=individual tax liability

where Bo is the inside basis of the shareholders.

VI – Numerical exemplification of the effects of Option A (sale of assets)
It should be remembered that option A will most likely require a cost in the amount of $75,000 for the transfer of the Lease.
It is important to be noted that the exemplification assumes a purchase price of $25 million and allocation of said price to goodwill in the amount of $7 million.

Purchase Price | $25,000,000 | | Inside Basis | | $10,000,000 | | Allocation of price | | | Tangible assets | $18,000,000 | | Goodwill | | $7,000,000 | | | | | | Corporate Tax Effects | | | Taxable amount | $15,000,000 | | Tax rate 40% | 0.4 | | Tax liability | | $6,000,000 | | | | | | Shareholders Tax Effect | | | Amount for distribution | $19,000,000 | | Individual interest 20% | 0.2 | | Individual taxable amount | $3,800,000 | | Tax rate 25% | 0.25 | | Tax liability | | $950,000 | | Net gain | | $2,850,000 | | | | | |
As a result, the individual shareholders’ net return of the investment for the shareholders is 11.4% (Purchase price/Net gain).

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