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Tax Structures in Buying or Selling a Business

Nov. 17, 2021, 9:46 AM

Whether you are buying or selling your business, tax issues can complicate every deal. Finding a transaction structure that meets the needs of the buyer and the seller, achieving a step-up in tax basis, and determining whether and how net operating losses, carryforwards, and other tax attributes can be utilized are complex issues that need to be addressed.

Most transactions involving the buying and selling of a business can be organized into one of two categories: an asset sale or a stock sale. Structuring the transaction as an asset sale will have different tax ramifications than structuring the transaction as a stock sale, and both sides should appreciate and be mindful of the differences.

Asset Sale

In an asset sale, the buyer has the option to purchase all the assets and liabilities or specific assets—and assume certain liabilities—of a target corporation. This requires the buyer and seller to retitle/transfer all the acquired assets to the buyer.

After an asset sale, the seller retains ownership of the legal entity, which has cash from the sale, and excludes assets and liabilities that were not sold in the transaction.

The seller will also be required to provide a sufficient level of working capital to operate the business, which tends to be a negotiated item.

Pros and Cons in an Asset Sale

Buyers typically prefer asset sales because they can step up the basis in acquired assets—like equipment and goodwill—which provides a future tax benefit through higher depreciation expenses—like bonus depreciation—leading to higher after-tax cash flows to the purchaser. Due to the desire for higher after-tax cash flows, buyers may pay a higher purchase price.

Another reason that buyers generally prefer asset deals is because they can typically avoid certain liabilities that may not have been discovered during due diligence. It is also possible that a liability could surface later that couldn’t possibly have been known during due diligence—like lawsuits, for example.

While an asset sale may be good for the buyer, the seller may have adverse tax consequences. The adverse consequences are determined by whether the corporate seller is an S or a C corporation, the asset price allocation, and other facts and circumstances.

The primary drawback for a seller is that an asset sale can result in higher taxes, because a portion of the sale proceeds of the transaction will be considered ordinary income rather than capital gains. For this reason, sellers usually prefer a stock sale, at least from a tax perspective. However, if a seller’s company has a large goodwill component, then the tax differences may not be materially different.

Because each asset is assumed to be purchased separately, each will have its own tax rate depending on what type of asset it is. This often results in a mix of ordinary and capital gains income.

Stock Sale

In a stock purchase, the buyer purchases stock in a target company.

Pros and Cons in a Stock Sale

In most cases, the seller is motivated to structure the deal as a stock sale. However, if there are contracts or other assets that the corporation cannot easily transfer/retitle which are necessary, the buyer would be motivated to structure the deal as a stock sale.

There are many ways a buyer and seller can structure a stock deal, and the consequences to each can be very different. However, the most common are the following:

  • A sale where the buyer and seller make a section 338(g) election
  • A sale where the buyer and seller make a section 338(h)(10) election

Section 338(g) Election

A section 338(g) election allows a stock acquisition to be treated like an asset acquisition for tax purposes. This causes the transaction to have the same tax effects for an asset acquisition, such as creating a basis step-up in the assets and double taxation. The major benefit is that all assets step-up and recognized intangibles, including goodwill, become tax-deductible. However, the election also results in two levels of tax at the corporate and shareholder level, with an immediate gain recognized for stepping up the basis. The election only makes sense when the present value of future tax savings exceeds the current tax cost of stepping up the tax basis.

The following conditions apply to the section 338(g) election:

  • The buyer must be a C-corporation
  • The target must be a C-corporation
  • The buyer must purchase at least 80% of the target’s stock
  • The buyer unilaterally makes the election
  • The buyer bears the tax burden from the gain on the deemed sale of the target’s assets

338(H)(10) Election

A section 338(h)(10) election allows the buyer and seller to enter into a stock purchase agreement which generally does not require transfer or consent for the transfer of assets. However, the election states that the IRS will not recognize the transaction as a stock sale, but the IRS will treat it as if the buyer purchased the assets and liabilities of the target corporation.

This results in the same tax consequences as an asset sale as discussed above.

The seller may have a mix of capital and ordinary income and the buyer gets a stepped-up basis in the corporation’s assets. A section 338(h)(10) election could be an attractive option for a seller if they were an S-Corporation with a large goodwill component and certain contracts or leases that might be difficult to transfer.

The following conditions apply to the section 338(h)(10) election:

  • The buyer must be a C-corporation
  • The target must be
    • A U.S. subsidiary of an affiliate group of corporations or consolidated group, or
    • An S-corporation
  • Both the buyer and seller jointly agree to make the election

No matter which avenue or strategy you take in structuring your deal, keep in mind that buying and selling a business is a complicated matter, and you should consult with a tax expert beforehand.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Mark Gallegos, CPA, MST, is a tax partner on Porte Brown’s accounting and consulting services team in the Elgin, Ill., office. He has more than 20 years of experience. He spends a great deal of time advising, speaking, and writing about international tax, mergers & acquisitions, and credits and incentives. Gallegos has been entrenched in the intricacies of tax legislation and impending changes. Gallegos co-hosts a recurring webinar series on the topic and regularly speaks on tax legislation and other tax topics.

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To contact the reporter on this story: Kelly Phillips Erb in Washington at kerb@bloombergindustry.com

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