Tax & Business Insights

Hybrid Sales of Businesses – Bad Idea!

Volume 21 Issue 2 --  March/April 2009

Hybrids are sometimes good things. If you are concerned about gas mileage, a hybrid motor vehicle may be great. But if you are buying or selling a business, a hybrid may lead to disaster, at least from a tax standpoint.

What is a hybrid sale anyway? By definition a “hybrid” is the product of combining two very different things.

It is well known that there are basically two ways to sell businesses that are conducted through entities, like LLCs and corporations: a sale of assets or a sale of stock (or LLC ownership interests).

By the term “hybrid” sale of a business, we are referring to transactions that attempt to inconsistently mix elements of both a sale of stock and a sale of assets.

For example, we have seen purported asset sales where all of the payments for a corporation’s assets are made directly to the shareholders, as if it were a stock sale. And we have seen stock sales that purport to retain for the seller some of the corporation’s assets, as if the stock sale were an asset transaction.

Why would anyone do this, you might well ask? Most commonly, this is the result of poor planning and failing to keep in mind during the negotiating process exactly who is selling what?

Why are hybrid business sales usually so bad? There are at least two main consequences of hybrid business sales — uncertainty over the tax treatment and potentially adverse, unexpected results.

Suppose, as we saw in one case, a seller of stock retained the right to keep some of the corporation’s assets? For tax purposes, is this really a sale of stock or a sale of most of the corporation’s assets?  If the seller is looking for capital gains treatment on a stock sale, having the sale be treated by the IRS as an asset sale could be very disappointing.

Or consider a provision common in many asset sales agreements that employs the selling business owner as a consultant after the sale. Are the payments to the owner a payment for services or part of the purchase price for the asset sale? The IRS might well argue that the payments are part of the purchase price.

As suggested above, the first rule in conducting a business sale is to ask the question, who is selling what? In a stock sale, the seller is the individual shareholder or, in the case of an LLC, the seller is the individual LLC member. In an asset sale, the seller must be the corporate or LLC owner of the assets.

The question of “who is the seller” is a variation on the issue of who must report the gain or loss. In many of the hybrid transactions we have seen, it is extremely difficult to determine who must report what gain or loss.

With the identity of the seller clearly in mind, it is obvious that the payments for the sale must go to the seller, yet this is a concept frequently ignored.

We see many asset sales where little or none of the actual payment goes to the asset seller — the corporation or LLC — but directly to the individual owners. Conversely, we have seen some stock sale agreements where the buyer makes payments to, or assumes liabilities of, the corporation or the LLC rather than making payments to the actual seller. Such arrangements can lead to needlessly complex tax questions.

Cases where some of the business assets are owned outside of the business entity can be especially tricky. Suppose there is a sale of a veterinary practice conducted through an S corporation by a retiring veterinarian who also individually owned the real estate on which the building is located.

In reality, there are two separate transactions here — a sale of assets by the S corporation and a sale of real estate by the retiring veterinarian. There should be a separate sales price and separate payment provisions for each transaction.

Failure of the parties to keep in mind exactly who is selling what is often compounded by another problem that we discussed in a recent newsletter (Allocation of Business Sale Purchase Price, March/April 2008), where the sales agreement does not clearly allocate the purchase price among the items sold or the payees. In such situations, after the transaction closes, the buyer and the seller are often in a complete quandary as to how the transaction should be reported by both parties.

While it would be unreasonable, perhaps, to say that hybrid business sales transactions are never appropriate, any mixture of stock sales and asset sales must be very carefully thought out and clearly documented.

In the next two issues, we’ll look at suggestions for properly structuring business sales.

If you or a client have questions related to this topic, keep The Tax and Business Professionals in mind.

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