Buying a small business, especially a thriving one, is a tantalizing prospect. Once you’ve moved past your initial considerations and begin to make that idea a reality by starting negotiations with the seller, you’ll inevitably be faced with a choice:
Should you purchase the business entity or its assets?
What’s the difference between an asset and an entity sale?
For a business to operate successfully, it requires many different components. Equipment, trademarks, slogans, employees, a workspace, and many other pieces and intangibles particular to that business’ trade all serve to make the business what it is. So, how do you purchase all those things? Although different types of arrangements exist, the two typical options are to buy the business entity by purchasing all the corporation’s shares or all the limited liability company’s membership interest, or by arranging to buy the business’ assets.
When you buy the business entity, you are buying the corporation or limited liability company (LLC). What comes with the entity are all the contracts, debts, and anything else registered under the business’ name. You can arrange for the entity sale to include all the business’ assets as well.
When you purchase the assets, you are buying items like equipment, fixtures, property, and goodwill; but you will need to form your own business entity and enter into your own contracts, leases, and loans. Basically, the previous owner’s business will cease to exist and your new business will take over with all the assets of the old business.
How do most people buy a business?
The vast majority of individuals who are buying their first small business purchase the business’ assets. Simply buying the assets limits the buyer’s liability and can result in tax benefits. These main advantages are outlined below:
- Tax benefits: IRS guidelines allow a buyer to set the new company’s depreciable asset basis. For example, say part of your asset acquisition is equipment. Equipment depreciates faster than something like goodwill, and by assigning a higher value to the equipment (within reason), the buyer can lower their taxes in the first few years when cash flow will be more vital.
- Limiting liability: Hidden liability concerns are why buyers typically purchase assets and not the entity. When you buy an entity, you’re also buying the history of the company and whatever that may include (think: loans, liens and pending lawsuits). When you purchase assets, you don’t need to worry about inheriting debts, liens and lawsuits against the business entity because the business isn’t what you’re buying—you’re purchasing equipment, fixtures, property, and other intangibles like goodwill.
What’s wrong with buying the business entity?
Although many buyers worry about the possible liabilities associated with buying a business entity, there is nothing inherently wrong with purchasing the entity. And in some situations, it can be the right move. Below, you’ll find the potential advantages of buying the business entity:
- Patents and contracts: A company’s value may rest in its copyrights or patents, or if it has work contracts with the government or third-party businesses, it may be much simpler to purchase the entity than to try to renegotiate the contracts or takeover the patents and copyrights.
- Collections: If the business you are buying is owed money, it may be more difficult to collect on those outstanding invoices if you start a new business entity. Collecting those debts may be more hassle than they’re worth, but if not, this money could help sweeten the idea of purchasing the entity.
- Better purchase price: Sellers usually prefer entity sales. Along with the possible shift of liability to you—the buyer—the proceeds of the entity sale will be taxed at a lower capital gains rate. Knowing this, you will likely have more leverage when it comes to the selling price. If you can negotiate a price that makes any added liability worth it, buying the entity may be the right thing.
Limiting the liability of an entity sale
If you purchase a business entity, you’ll be given a piece of paper: either a stock certificate for all the stock in a corporation or a bill of sale for the membership of an LLC. These pieces of paper are essentially what make you the new owner of a company and all that comes with it, including any loans, employee disputes, or environmental concerns. Prior to taking ownership, however, you should track what the company owes and learn what kind of trouble might be lurking by performing some intense due diligence, as outlined below:
Perform a UCC search
Each state has a Uniform Commercial Code database online where you can search what creditors have filed against a debtor in that state. Be sure to do a UCC search in each state where the company has conducted business. Debtor information will be limited, but you should be able to get a sense of what outstanding debts are out there.
Federal, state, and county lien searches
To find out what kind of tax liens maybe affecting the business, especially if property is involved, you should run lien searches at the federal, state, and county levels. You can start by calling the IRS’ Tax Lien Department. You’ll need the business owner’s name and the Social Security Number. With the same information, contact the county clerk’s office in the county where the business is located. If you’re lucky, the county clerk will have a website where you can perform this search online. The clerk’s office may have access to federal and state liens, as well as local ones. If you want to continue searching, for a fee you can contact Experian or a similar service to run a background check on the business.
State tax authority
Even if you cannot find any liens against the business, it’s better to be safe. To make sure your investment is secure, you should call the state tax authority. Ask the state tax authority for a “letter of clearance” stating that the seller is current on all sales and use taxes. This letter may take a while, but can be worth the wait.
Sit down with the seller
Have the seller outline all of the outstanding debts he or she is aware of. Once these are outlined, you can have an attorney draft a warranty or indemnity stating if something outside of the known debts or loans arises, the seller will make good on them. For obvious reasons, the seller may be reluctant to sign such a document, but that may be an equally good reason for you not to buy the business.