Thanks to the Tax Cuts and Jobs Act (TCJA), many businesses in Maine and beyond will pay less federal income taxes in 2018 and going forward. Some of these will spend their tax savings to merge with or acquire another business. Before jumping on the M&A bandwagon, you do need to understand how such transactions will be taxed under the new tax law.
Stock vs. Asset Purchase
There are two basic ways a deal can be structured from a tax perspective:
1. Stock (or ownership interest) purchase. Commonly referred to as a “stock sale,” a buyer can directly purchase the seller’s ownership interest. This requires the target business to be operated as a C or S corporation, a partnership, or a limited liability company (LLC) which is treated as a partnership for tax purposes. Some sales may involve partner or member units.
Under the TCJA, the now permanent flat 21% corporate federal income tax rate makes buying C corporation stock somewhat more attractive for two reasons. First, since the corporation will pay less tax, it will, therefore, generate more after-tax income. Second, any built-in gains from appreciated corporate assets will be taxed at a lower rate when they’re eventually sold. A higher purchase price may be justified by these considerations when structuring the deal as a stock purchase.
Theoretically, the TCJA’s reduced individual federal tax rates may also allow for higher purchase prices for ownership interests in S corporations, partnerships and LLCs treated as partnerships for tax purposes. Why? The passed-through income from these entities also will be taxed at lower rates on the buyer’s personal tax returns. But the TCJA’s individual rate cuts are scheduled to end at the end of 2025, and they could be eliminated even earlier, depending on Congressional changes.
2. Asset purchase. A buyer can purchase just the assets of the business. This may be the situation if the buyer selects specific assets or particular product lines. It’s the only option if the target business is a sole proprietorship or a single-member LLC (SMLLC) treated as a sole proprietorship for tax purposes.
The existence of a sole proprietorship or an SMLLC treated as a sole proprietorship is ignored under federal income tax rules. Instead, the seller, as an individual taxpayer, is considered to directly own all the business assets. Thus, there’s no ownership interest to buy.
Important: In some specific circumstances, a corporate stock purchase may be treated as an asset purchase by making a Section 338 election. Ask your tax advisor for details.
Buyers and sellers of businesses generally have differing financial and tax objectives. The TCJA doesn’t change these basic objectives, but it may change how best to achieve them.
Typically, buyers prefer asset purchases. A primary objective of a buyer is often to generate sufficient cash flow from the new acquisition to service any related debt and provide an acceptable return on the investment. Thus, buyers are focused on limiting exposure to undisclosed and unknown liabilities and minimizing taxes after the deal closes.
For legal reasons, buyers often prefer to purchase business assets instead of ownership interests. A straight asset purchase transaction usually protects a buyer from exposure to undisclosed, unknown, and contingent liabilities.
On the other hand, when an acquisition is structured as the purchase of an ownership interest, the business-related liabilities tend to transfer to the buyer — even if they weren’t known at closing.
For tax reasons, buyers also prefer asset purchases. That’s because a buyer can step up (increase) the tax basis of purchased assets to reflect the purchase price.
Stepped-up basis reduces taxable gains when certain assets, such as receivables and inventory, are sold or converted into cash. It also increases depreciation and amortization deductions for qualifying assets. Expanded first-year depreciation deductions under the TCJA make asset purchases even more attractive, potentially warranting higher prices if the deal is structured appropriately.
In comparison, when corporate stock is purchased, the tax basis of the corporation’s assets generally cannot be stepped up unless the transaction is treated as an asset purchase by making a Sec. 338 election.
Important: When an ownership interest in a partnership or LLC treated as a partnership for tax purposes is purchased, the buyer may be able to step up the basis of his or her share of the assets. Consult your tax advisor for details.
Stock sales are generally preferred by sellers. A seller has two main nontax objectives:
• Safeguarding against business-related liabilities after the sale, and
• Collecting the complete sales price if the seller provides financing.
A seller may provide financing through an installment sale or an earnout provision (where a portion of the purchase price is paid over time or paid only if the business achieves specific financial benchmarks in the future).
Of course, the seller’s other main objective is minimizing the tax hit from the sale. This can usually be achieved by selling their ownership interest in the business (corporate stock or partnership or LLC interest) versus selling the business assets.
With a sale of stock or other ownership interest, liabilities generally transfer to the buyer and any gain on sale is generally treated as lower-taxed long-term capital gain (assuming the ownership interest has been held for more than one year).
Important: Some, or all, of the gain from selling a partnership interest (including an interest in an LLC treated as a partnership for tax purposes) may be treated as higher-taxed ordinary income. Consult your tax advisor for details.
During the sale negotiation, the buyer and seller both need to give and take, depending on their top priorities. For instance, a buyer may want to structure the deal as an asset purchase. Agreeing on a higher purchase price, combined with an earnout provision, may persuade the seller to agree to an asset sale, which arrives with a higher tax bill than a stock sale.
A seller might instead insist on a stock sale that would end with a lower-taxed long-term capital gain. In exchange, the buyer might be willing to pay a lower purchase price to partially compensate for their inability to step up the basis of the corporation’s assets. The seller might also agree to indemnify the buyer against certain specified contingent liabilities (such as underpaid corporate income taxes in tax years that could still be audited by the IRS).
Purchase Price Allocations
Another aspect to consider in asset purchase deals — including those corporate stock sales that are treated as asset sales under a Sec. 338 election — is how the final purchase price is allocated to specific assets. The amount allocated to each asset becomes the buyer’s initial tax basis in the asset for depreciation or amortization purposes. It also acts as the sales price for the seller’s taxable gain or loss on each asset.
Generally, buyers will want to allocate more of the purchase price to:
• Assets that will generate higher-taxed ordinary income when converted into cash, such as purchased receivables and inventory, and
• Assets that can be depreciated in the first year under the expanded bonus depreciation and Sec. 179 deduction breaks.
Buyers prefer to allocate less to assets that must be amortized or depreciated over relatively long periods (such as buildings and intangibles) and assets that must be permanently capitalized for tax purposes (such as land).
On the seller’s side, most want to allocate more of the purchase price to assets that will generate low-taxed long-term capital gains, such as intangibles, buildings, and land. Tax-smart negotiations can result in allocations that satisfy both sides.
Buying or selling a business may be the most important transaction of your lifetime, so it’s critical to seek professional tax advice as you negotiate the deal. After the deal is done, it may be too late to get the best tax results. Contact Filler & Associates today.