By Erin K. Tenner, Partner, Gray Duffy LLP
This is Part III in a five part series on dealership buy/sell basics. Part I examined the three different types of buy/sell agreements. Part II discussed the basics of one of those: Asset Purchase and Sale Agreements. This article will discuss Stock Sale and Purchase Agreements.
A Stock Sale and Purchase Agreement is different from an Asset Sale and Purchase Agreement in that it transfers an entire business, lock, stock and barrel, rather than just assets. When you buy the stock of a business you buy all of the cash, all of the receivables, all of the payables, as well as all of the assets you would purchase in an Asset Purchase and Sale Agreement.
You get all the liabilities too. Purchase agreements need to be drafted to include the right to examine all the liabilities. Liabilities purchased include many things that could be very expensive, so it is important to really know what the liabilities are before you buy capital stock. The purchase agreement also needs to protect you from things that should be disclosed, but aren’t, and from things that cannot be discovered through due diligence.
The most expensive areas of possible exposure when you are buying stock will vary depending on the circumstances. For example, if you are buying the stock of a C corporation you are going to become responsible for all corporate taxes, whether past due or current, as well as penalties and interest, even if not discovered until an audit after you are the owner. This includes income taxes, sales taxes, employment taxes, franchise taxes, and if the corporation owns real estate, real property taxes.
On the other hand, if you buy the stock of an S corporation, no income taxes are paid by the S Corporation. Rather, S corporations are pass through entities so the shareholders owe and pay the tax on corporate income. Income tax liability is therefore generally not a concern when buying an S corporation, with limited exceptions. Sales, employment and franchise taxes are still an issue.
But tax issues aren’t limited to just taxes that were not paid or will be due from conducting business. You also have to think about the tax consequences of the transaction itself. For example, because an S corporation is a pass through entity, its shareholders pay taxes on income even if it is not distributed to them.
This income on which tax has already been paid is recorded in an account called an AAA account or triple A account. When income is later distributed, it can be distributed tax free as long as there is a balance in the AAA account. Each distribution reduces the AAA account. When an owner sells capital stock the owner will want to make sure the purchase agreement allows them to take a distribution of AAA earnings before the sale so they can distribute the cash equal to the AAA account balance tax free rather than receiving payment for the same cash through the stock purchase agreement and having to pay capital gains tax on it.
The warranties and representations and conditions to the obligations of the buyer are the most important sections of a stock purchase agreement. These are the provisions that will dictate the rights and liabilities of the parties. For example, a condition to Seller’s obligations could be that the Seller shall have withdrawn all AAA earnings.
Several conditions typically provide for due diligence. The due diligence in a stock purchase agreement will need to be much more extensive than the due diligence for an asset purchase agreement. For example, in addition to just doing a Phase I and building inspection, the buyer is going to want to really understand how assets were accounted for on the financial statements.
The way assets were accounted for could significantly affect the purchase price and adjustments may be required to the purchase price under certain circumstances. For example, if the seller has an aged inventory of used vehicles and has not written them down each year, the value may be overstated on the financial statements.
Likewise, if journal entries have not been made then adjustments for depreciation on fixed assets may not be showing up on the financial statements. Whether adjustments are made may depend on accounts in which payments are being kept. Looking at the details behind the accounts will tell a buyer a lot about whether the dealership’s finances have been well managed.
These issues won’t matter as much in an asset purchase, because the buyer sets up its own set of books and records (although they may be important in determining purchase price of assets). In a stock purchase, on the other hand, it is very important to look at those details because the buyer is taking over the seller’s books and accounts, and could be held accountable later on by taxing authorities if they were handled improperly. Warranties and representations and indemnity provisions can provide a buyer some protection, but knowing what is going on up front is a much better approach than seeking damages or indemnification in a lawsuit later.