One of the most dreaded replies coming from a professional services provider is, “it depends.” Unfortunately, that’s truly the case when the issue involves the most optimal tax structure for your transaction. This is because, like most things in life, there are many variables — tax and non-tax — that go into assessing whether a particular transaction structure “works.”
Non-tax considerations include whose perspective is at issue (buyer or seller); the type of business being bought or sold; and the type and amount of consideration a seller wants, or is willing to take.
A few, but not all, of the tax variables include the identity of the seller (the owner), whether an individual, C corporation or S corporation; value and portability of tax attributes held by the entity being sold (the target); length of the owner’s holding period; and tax rates in effect at the time of the transaction.
However, while every deal has unique attributes that vary in significance and number, there are some rules of thumb from which to operate. Below we offer tax structuring options and considerations for both corporate and non-corporate entities.
There are generally three M&A structures most commonly used by C corporations: equity sale, asset sale and a hybrid structure of both, i.e., legal equity sale/deemed asset sale for tax purposes only). Below offers pros and cons to each.
From an owner’s perspective, a sale of equity (versus assets) is the holy grail of transaction structures, particularly when there is opportunity to fully or partially defer gain. Assuming the owner will realize a gain, for tax purposes, the biggest draw is that it’s characterized as capital gain, and the fact that stock basis is used to lower the taxable portion of the gain. For non-tax reasons, often paramount is the fact that an equity sale necessarily involves the transfer of the target’s liabilities (known and unknown) to the buyer.
As if these weren’t reasons enough, Section 1202 of the tax code may allow from 50% to 100% of the otherwise taxable gain, subject to certain maximum thresholds, from the sale of certain C corporation stock to be exempt from a federal income tax perspective.
Given that this structure is often owner-favorable, it shouldn’t be surprising it generally yields equally unfavorable consequences for a buyer of equity. Legally, the buyer of equity is now on the hook for a target that may have been mismanaged or exposed to undue risk. Tax-wise, as a corollary to favorable tax consequences for the owner, your buyer takes carryover basis in the target’s assets (which often can be mostly or fully depreciated for tax purposes) and cannot recover any of its purchase price through tax amortization or depreciation deductions. Because of this dichotomy, buyers may be willing to offer a lower purchase price when purchasing equity where there is no potential for recovery of purchase price through tax deductions over time.
For some of the same reasons owners tend to favor equity transactions, buyers tend to favor asset deals. In an asset purchase, the buyer is simply acquiring the discrete assets of the target, not the actual company, which may have some undesirable traits and attributes. The primary tax motivation for asset purchases is the basis step-up the buyer receives. In an asset acquisition, the buyer’s purchase price, which is often much higher than the aggregate tax bases of the assets, is allocated among the purchased assets and may be recoverable through amortization and depreciation tax deductions. In this way, the buyer may more closely match its economic outlay with an investment return.
Although likely not as critical, another disadvantage of an asset structure will affect both the owner and buyer. An asset transaction involves the titling and conveyance of each individual asset, which is more administratively burdensome and thus can be more expensive than a sale of equity. Furthermore, assuming the target’s contracts and licenses are legally assignable, additional legal work will be required to actually assign those to the new buyer.
Finally, although dependent on the target’s tax classification, asset sales generally create an incremental tax burden for owners. If your entity is a C corporation, an additional layer of tax could be triggered when it distributes the sales proceeds — net of its tax liability on the sale — to you as the owner. In a pass-through entity, such as an S corporation, the incremental tax can result from the ordinary character of some of the disposed assets being subject to a higher tax rate than capital assets or equity, or potential differences in state income tax rates.
“F Reorgs,” Section 338(h)(10) and Section 336(e) elections are transactions used to conduct an equity sale for legal purposes and an asset sale for tax purposes. From a tax perspective, the buyer typically requests this structure for basis step-up reasons; from a legal perspective, this structure does not require transferring title to assets and contracts. As discussed above, this structure could come at a cost to an owner, either through two layers of tax or incrementally higher tax rates. Careful planning and evaluations of basis may ease this burden if a buyer can make an owner whole for these costs and still receive a net economic benefit due to the basis step-up received.
Note, however, that these types of transaction structures may be limited to certain types of buyers or owners. For example, the target in a Section 336(e) or 338(h)(10) transaction may only be an S corporation, or a C corporation at least 80% owned by another C Corporation.
If your business is a non-corporate entity, such as a partnership, the good news is that for a buyer, it may be easier to receive the coveted basis step-up. However, you will still need to analyze many of the same tax and non-tax considerations as corporations, including:
As with corporations, basic transaction structures for non-corporate entities include equity sale, asset sale and the hybrid legal equity sale/deemed asset sale for tax purposes only. However, there are often specific nuances to consider for non-corporate entities within these types of sales to achieve the desired result. For instance, buyers may be able to obtain a basis step-up in the target’s assets through a purchase of equity that would not be available — either because it requires pre-transaction restructuring on the target’s part or requires you and/or buyer to make certain elections — if your entity were a corporation. Consider this example: Purchasing 100% of partnership equity is equivalent to purchasing assets for tax purposes in the eyes of the buyer. If acquiring less than 100%, a common way to achieve the desired outcome is for the partnership target to make an election to step-up the basis in the assets of the partnership target — also known as a Section 754 Election.
When a buyer acquires some, but not all, of the interest in a partnership from existing owners, the partnership can make a Section 754 Election. This election allows the partnership to adjust the basis in the partnership assets with respect to the interest acquired by the buyer. Basis adjustments allocated to depreciable/amortizable property are treated as a newly purchased asset placed in service when the transfer occurs and can be depreciated/amortized. Basis adjustments allocated to non-depreciable/non-amortizable assets will be freed up when the partnership sells or disposes of the property. Although it may seem complicated that the step-up in basis only relates to the interest acquired by the buyer, this election is very commonly used to allow buyers to recover the purchase price paid in tax benefits over a period of years. Quite simply, the Section 754 Election is made on the partnership target’s timely filed income tax return.
When a buyer purchases 100% of the equity interest in a partnership, they will be deemed to have purchased the assets of the partnership for tax purposes. Therefore, assets of the target will be equal to the amount paid by the buyer for the equity interest. An owner of the selling partnership will need to bifurcate any gain on the sale to both capital gain taxed at favorable rates and ordinary gain taxed at higher rates. For the owners of a target partnership, there is often little or no difference between a sale of equity and sale of assets due to provisions in the tax code that may require the recharacterization of capital gains to ordinary income.
Although the information above has been focused on corporations and partnerships, it is important to note that if you are an owner selling a sole proprietorship, or entity disregarded as separate from you for income tax purposes, the buyer would be treated as purchasing a proportionate share of each asset held by the disregarded entity equal to the percentage of the equity the buyer acquired. Owners are also treated as selling a proportionate amount of each asset. As a result, the basis of the assets deemed acquired by the buyer would be equal to the amount paid by the buyer for the equity interest.
Whether your business is a corporate or non-corporate entity, finding the right structure is critical — you have choices, so take the time to consider them all with your advisers to find the right fit. A holistic approach is the key to determining the right transaction structure.
Contact Samantha Smudz, Robert Venables or a member of your service team to discuss this topic further.
Cohen & Co is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law with your professional advisers.