Merger and acquisition (M&A) activity in several sectors is bouncing back in 2024 after a lull in 2023. This trend will likely continue following a ½ percentage-point decrease in the federal funds rate by the Federal Reserve rate in September 2024. The Fed has also suggested it could lower the rate further in the coming months if economic conditions warrant further easing. Fed funds rate decreases typically spur M&A activity by reducing the cost of capital for buyers.

If you’re purchasing a business, there’s more than financing costs to consider. It’s also crucial to aim for the best possible after-tax outcomes. There are generally two ways to structure a deal if the business operates as a corporation, partnership or limited liability company (LLC): You can buy either the assets of the business or the seller’s ownership interest. Here’s a closer look at these two alternatives to help you decide what’s right for your situation.

1. Asset Sales

Under the first option, the buyer acquires most of the seller’s assets and assumes all liabilities associated with those assets. The selling entity continues to legally exist after the sale and retains any unwanted assets and liabilities.

There are many upsides for buyers that choose this deal structure. They can select exactly which assets they want to buy and avoid taking on any liabilities that might be particularly burdensome, such as employee pension plans. But certain assets — such as licenses or permits — might not be transferable with an asset sale. Buyers also have greater flexibility to step up appreciation of acquired assets and enjoy higher tax deductions with asset sales than stock sales.

From a tax perspective, assets sales can be costly for sellers, because their proceeds are likely to be taxed as ordinary income, rather than lower-tax long-term capital gains. Depending on the legal structure of the selling entity, asset sales may also result in double taxation for the seller — first at the business level and again when proceeds are distributed to owners. (However, tax on distributions may be deferred in certain situations by having the corporation hold and invest the sale proceeds.)

Important: The Tax Cuts and Jobs Act includes a provision that requires sellers to pay ordinary income tax rates on sales of certain self-created intangible assets after 2017. This change makes asset sales even less appealing to sellers with significant intangibles.

Sellers often factor the adverse tax effects of a proposed asset sale into deal prices. As a result, buyers may have to pay premiums or make other concessions to entice sellers to structure deals as asset sales.

Note: Asset sales are the only option for sellers that operate as sole proprietorships or single-member LLCs for tax purposes.

2. Stock Sales

The second option (available only when the seller is a corporation, partnership or LLC) is to buy a controlling majority (if not all) of the seller’s ownership interests. Essentially, the buyer becomes the owner of all the selling entity’s assets and liabilities.

This setup can benefit buyers because the seller continues running operations, simplifying the post-deal transition process. The buyer also retains the rights to all contracts, intellectual property and assets, as well as the seller’s tax benefits, such as net operating loss carryforwards. Stock sales also don’t require buyers to pay bulk and sales taxes. But the buyer in a stock sale generally assumes the seller’s tax basis in the business’s assets. That means assets that have been fully (or mostly) depreciated provide no (or little) tax benefit. (However, workarounds allow certain pass-through entities to step up asset basis.) In addition, taking on the seller’s liabilities — including any legal obligations and dissenting shareholder issues — can be problematic for buyers after the deal closes.

Sellers typically prefer stock purchases. Why? They’re less likely to disrupt daily business operations, and the proceeds of these sales generally are taxed at lower long-term capital gains rates. But stock sales typically take more time to complete, so sellers looking to cash out quickly may prefer asset sales.

Ready, Set, Buy

The markets are primed for increased M&A volume over the next year. But it’s important to weigh a purchase’s tax and legal consequences before negotiating the deal terms. We can help you determine how to structure your business purchase to achieve the most advantageous outcome.