Asset and Stock Differences – Part 2
By: Doug Copple
Chief Financial Officer, CPA, CVA
 In the last issue of the InSight, we pointed out many of the advantages and disadvantages of both an asset sale and a stock sale. In this edition, we continue with this topic by focusing on items to consider regarding asset and stock sales when an extended buy-in and partnership-like arrangement occurs.
Generally, with a 100% sale of an orthodontic practice, the buyer prefers an asset sale for the reasons noted in the previous article. The decision as to whether to structure the purchase of a partial ownership interest as a stock sale or asset sale can be more complicated and should be analyzed by both the buyer and seller. With the purchase of a partial ownership interest, the buyer purchases a percentage of the seller’s practice (for example, a buyer purchases a 50% interest) either immediately or over a period of years (i.e. a buy-in rather than a 100% buy-out). The buyer and seller then work as partners for an extended period of time, and the buyer or a third party generally purchases the seller’s remaining ownership interest in the future.
The purpose of this article is not to address the various strategies and intricacies of extended buy-ins and partnership arrangements, because the possibilities of how they can be structured regarding repayment methods, income allocation models, compensation arrangements and buy/sell arrangements vary significantly depending on each doctor’s specific circumstances and goals. This article only discusses issues or strategies of what to consider when trying to determine whether the buy-in should be structured as a sale of the seller’s corporate stock or a sale of the corporate assets.
We begin with an overview of the ways both an asset transaction and stock transaction would generally be structured under a buy-in and partnership arrangement. We will then examine the advantages and disadvantages of both.
Sale of Corporate Stock
With a stock sale, the buyer simply purchases 50% of the outstanding stock of the corporation from the seller. The buyer generally does not form a new seller’scorporation, although such a structure is possible. Both doctors work and are compensated as employees of the co-owned corporation (whether a C-corporation or S-corporation).
Sale of Assets
Since the buyer is not purchasing stock of the seller’s existing corporation, the purchasing doctor creates a new operating entity (we will assume a corporation herein) to purchase 50% of the corporate assets owned by the seller’s corporation. Such purchase can be for specifically identified individual assets of the seller’s corporation, or it can be an undivided 50% interest in all such assets. The buyer’s corporation may also purchase 50% of the seller’s personal goodwill directly from the seller. Now there are two corporations – the seller’s corporation and the buyer’s newly created corporation. A third entity, usually a partnership or LLC (referred to as “Partnership” within this article), is also created that is owned 50% by seller’s corporation and 50% by buyer’s corporation. This new Partnership employs and pays the staff and the doctors, collects fees, pays expenses, and distributes remaining profits to the buyer’s and seller’s corporations based on pre-defined allocation parameters. It also leases the assets owned by the seller’s and buyer’s corporations for the operation of the practice, paying rent to those two corporations. This structure requires three entities and three tax returns (seller’s corporation, buyer’s corporation and the Partnership). Certain expenses, such as personal and discretionary expenses of the buyer and seller, may be recognized within and paid from each of the doctors’ corporations rather than through the Partnership or LLC.
Asset Sale – Advantages and Disadvantages
The advantages of an asset transaction with a long-term buy-in are similar to those noted in last quarter’s newsletter, including: (1) protection from seller’s liabilities and (2) stepped-up basis of assets purchased, which allows the buyer to write-off or depreciate the purchase price. Additionally, the buyer’s corporation can amortize any personal goodwill purchased from the seller.
The disadvantages of an asset sale in the purchase and sale of a partial ownership interest most likely became apparent when reading the previous paragraphs. These include the creation of at least two new entities, and their multiple and complex documents and agreements that must be created to ensure the entities function properly with one another. This creates additional administrative and accounting burdens and expenses because there are three entities and three tax returns, as well as K-1s with respect to the Partnership. In addition, many of the operational and accounting functions must be transferred from the seller’s corporation to the new Partnership. It also requires obtaining new insurance provider numbers, insurance contracts, leases, and maintenance and vendor contracts, etc., for the Partnership (or they must be assigned/transferred from the seller’s corporation to the Partnership). In addition, the employment of the staff is transferred from the seller’s corporation to the Partnership, which may require setting up new payroll records and altering or creating new retirement plans. Expenses (and, in certain circumstances, revenues) must be properly tracked to ensure they are recognized in the correct entity. Additionally, challenges to the deal structure will arise if the assets of the seller’s corporation are subject to financing liens. If such liens will not be paid in full at the closing of the transaction between the buyer and the seller, then the seller must either obtain a lien release from its lender with respect to the assets being purchased by the buyer’s corporation (which is particularly difficult if the buyer is purchasing an undivided 50% interest in all of the assets), or the buyer must purchase the assets still encumbered by the seller’s liens. In the latter case, if the seller’s loan documents contain a ‘due on sale’ clause, the sale of the assets by the seller’s corporation to the buyer’s corporation might trigger an automatic acceleration of the seller’s loan.
Stock Sale – Advantages and Disadvantages
The disadvantages to stock sales are similar to those outlined in the previous newsletter, which include the buyer’s inability to deduct or write-off (through amortization or depreciation) the purchase price and the assumption of known and unknown liabilities by the buyer.
The advantages, however, to a stock sale are primarily the simplicity and efficiencies in the transfer of ownership. No new entities are created (generally speaking) and there is no need to create or transfer insurance, maintenance, lease or other service contracts or employees. Though there can be many discontinuities with an asset sale, a stock sale is seamless and creates fewer disruptions for the staff and doctors.
In addition, the payment terms of the purchase can often be structured such that much of the purchase price can be repaid in a tax efficient manner to the buyer. The purchase obligation can generally be broken down into two components. The buyer initially will pay a percentage of the total purchase price to purchase the corporate stock. The value and purchase price of the stock generally equals the net tangible value of the corporation, which equals the corporation’s assets minus its liabilities. This portion of the purchase price is generally less than 40% of the total purchase price. The remaining purchase price can be repaid to the seller through a shift in income from the buyer to the seller over a period of time while the two doctors work as partners. This repayment method allows the buyer to repay the purchase obligation with pre-tax dollars. With this arrangement, the seller generally finances this portion of the purchase price, and he/she will pay taxes at ordinary income rates on the additional income (versus capital gains rates with the sale of stock or personal goodwill). Therefore, adjustments may need to be made to the amount of the income shift to ensure the tax effects and benefits to both the buyer and seller are fair and equitable.
Many potential purchasers may have been advised in the past not to purchase the stock of the seller’s corporation because it is too risky and the tax ramifications to the buyer are detrimental. As a result, many buyers request that the buy-in be structured as an asset sale before fully understanding the various issues. A stock sale, however, is often the simplest method of structuring an extended buy-in with a two or more doctor practice. Many of the disadvantages are mitigated if the repayment terms are structured properly, there is limited risk of liability exposure in the seller’s corporation and/or if proper indemnifications are included in the agreements.
Each buy-in arrangement is different. All circumstances need to be analyzed and the financial outcomes of both scenarios considered. In certain situations, the seller and/or buyer and their respective advisors may request either an asset or stock transaction for specific reasons other than the primary issues noted within this article, which is completely legitimate; however, either option should be seriously considered before simply concluding that an asset sale is the safest and only means of having another orthodontist buy into and become a partner in the seller’s orthodontic practice. The efficiencies and simplicity of a stock transaction must be considered when the tax detriments can be offset and the risk of liability exposure mitigated.
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