When you purchase shares of a company, you are acquiring all of liabilities of the company. This includes current, future, unrecorded and tax liabilities. If you acquire a company which has unreported income – i.e. cash sales in a retail store, the company’s sales may be understated. The owner did not remit the sales tax which they collected and did not pay income tax on the revenue. The expenses are reported in the financial statement and the gross profit may be lower than normal because revenue is missing. When the owner is trying to sell the business, they want to include the cash sales in normalize earnings. How do you prove the cash sales that the owner claims he has? Be wary, you cannot substantiate this and owners may tell buyers that the cash component is far greater than it really is to increase the normalized profits and selling price of the company.
In my example above, if the government does an audit 2 years after you acquired the business and says that there was unreported income and now you as the new owner is subject to taxes and penalties, you must pay this amount. Your purchase and sale agreement may have an indemnity from the old owner to cover this liability but you must pay first, then try to collect. Do you know where the old owner is? You may have to sue the old owner to recover the amount paid to the government but if you go to court, you will incur additional costs and possibly take years to get a judgement. Then you have to collect on the judgement. If the old owner has no assets, you have now incurred many additional costs over and above the tax liability.
If the old owner gives a VTB – vendor take back financing, you now have a hold back in case of an audit. In Canada, for businesses without international cross border transactions, the tax returns become statued barred after 3 years after the date of the notice of assessment. This means that CRA cannot open up and audit the statued barred years unless they believe that there is a fraud or you filed documents which were misleading.
All of the assets of the company go to the new owner of the business if they buy shares of the business. If there is a building in the company and the building was purchased 50 years ago, the fair market value of the building may be far greater than the net book value (the accounting value) per the financial statements. You may pay for the appreciation in the price of the shares. If you purchase shares of a business, you cannot amortize or deduct the purchase price.
If you purchased assets of the business, you will allocate the fair market value of each asset. For example, if the building had a net book value of $100,000 but fair market value of $500,000, you would allocate $500,000 to the building and be able to depreciate the building for tax purposes if you purchased the assets. If you paid $500,000 for the shares of the business, you do not get any tax deduction.