Tax & Business Insights

Buying a Business: Tips for the Unwary

Volume 7 Issue 1 -- January/February 1995

Buying a business? Too often not enough thought goes into exactly what you are buying. Let's say "Howard" has an incorporated garage that he started years ago as Howard & Sons, Inc. Now after twenty years of hard work and success, Howard wants to sell the business.

You, a mechanic in the area, want to show the world, and your old supervisor at the Ford dealership, that you know cars and can run your own garage business successfully.

The typical pattern in this situation is to have a discussion with Howard about how much the business is worth. There may even be extensive price negotiations before it is decided what you will pay.

Unfortunately, often little, if any, consideration is given to one of the most basic issues: Will you buy Howard's stock or the assets of the business?

Does it make any difference whether you buy Howard's stock or the assets of the business? The answer, emphatically, is YES.

If you buy Howard's stock here's what you may get, in addition to the assets of the business:

• Any lawsuits and other types of claims which could or may be filed against Howard & Sons, Inc. based on things that happened long before you bought the business.
• Potential Federal and State tax deficiencies which may come from a tax audit in the future and relate back to years before you purchased the stock.
• Hidden claims for back wages, OSHA audits, creditor's claims, and yet to be discovered mistakes for cars repaired.

When you buy "stock," all of the corporate attributes, history, and choices are delivered at your feet. As far as government agencies, creditors, and injured parties are concerned, Howard & Sons, Inc. is continuing on, even if you change the name after you purchase the stock.

In short, when you buy the stock of an incorporated business you get all the assets and any number of surprise packages that you might prefer to leave unopened in the attic. Unfortunately, when and if these packages are opened (by a tax audit for example) is beyond your control.

Asset Purchase

While the nature of these surprises will probably vary somewhat from business to business, fortunately there is a way to avoid these hidden claims: an "asset purchase." Why?

• In an asset purchase you buy only the assets you select, and not the hidden claims.
• When you buy the assets of Howard & Sons, Inc., you get only the items described in the bill of sale -- tools, trucks, inventory of parts, customer lists and the garage. (Generally, putting real estate in such corporations is a bad idea. This will be discussed in a future edition.)

Thus when you buy assets, you are generally free of hidden claims of creditors, former customers and government agencies. If you buy all of the assets of a business "in bulk" it is sometimes necessary to contact creditors and tell them whether you (the buyer) or the seller will pay outstanding bills.

Tax Benefits

When you purchase physical assets like tools, you qualify for a tax deduction called "depreciation." Usually assets are depreciated over their useful lives.

For example, if $10,000 is paid for a machine, you, as an "asset purchaser," would be able to depreciate the machine over its useful life, 10 years, and claim a deduction of $1,000 in each of the 10 succeeding years.

But if you had purchased Howard's stock, you could only deduct the depreciation Howard & Sons, Inc. could have claimed. If the machine was 15 years old and fully depreciated when you purchased the stock, then no more tax depreciation could be claimed.

Should I Ever Consider Buying Stock?

Occasionally, a business will own an asset or license that cannot be easily or lawfully purchased or obtained independently of the present corporate entity. Sometimes, there may be unused tax benefits that would be lost if the corporation goes out of business.

For example, let's say that the corporation has a valuable lease from the local airport authority. Perhaps the only way you can do business at that valuable location is to purchase the stock so that the corporation can continue operations there. Often such leases have special provisions limiting their transfer.

Where an important asset can only be obtained by buying the stock, then a stock purchase is the only alternative. In such situations, you should consider a variety of other protections, such as cash escrows and warranties, to insulate you from the consequences of unknown claims.

In the next newsletter we will look at this same problem from the Seller's perspective and consider other aspects of selling and buying a business.



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