If your fund or portfolio company is considering acquiring a pass-through entity this year, such as an S Corporation, advance planning can be the key to help minimize purchase price adjustments due to a seller’s tax burden. In particular, recently created state elections for pass-through entities have had a surprising reach, in some cases changing the general dichotomy in the structuring goals of S Corporation sellers and buyers.
In general, S Corporation owners selling their business want to sell equity so they can pay tax at more favorable capital gain rates. However, buyers typically want to structure transactions in a way that allows them to recover the purchase price in depreciation and amortization benefits, often resulting in a portion of the sellers’ gain to be taxed at higher rates. This difference in goals can create strains in purchase price negotiations, and, in some cases, even delay the timing on closing a transaction.
The pass-through entity tax (PTET) election, often paired with a pre-transaction “F” reorganization, can help bridge the gap between buyer and seller, and can potentially eliminate any “make-whole” payments that could be required to solidify the coveted step-up in tax basis and tax goodwill buyers desire.
One of the most impactful provisions of the Tax Cuts and Jobs Act of 2017 created a limitation of $10,000 on deductions of state income taxes an individual can claim on their federal income tax return. Since that time, numerous states have created PTET elections. A PTET allows these entities to pay income tax at the entity level, resulting in a federal deduction of more than $10,000 in state income taxes paid by the businesses they own.
Often, the largest tax bill a seller has is in the year they sell their business. For example, the sale of equity in an S Corporation for $20 million of gain could create a federal and state tax bill of well over $5 million. Without a PTET election in place for a state that charges income tax of 4%, the seller may be losing out on almost $800,000 in federal tax deductions. Those deductions could be enough to make an asset sale more beneficial than an equity sale. For buyers, this could mean the elimination of “gross-up” payments to make a seller whole for selling assets.
It is also imperative to know that PTETs will vary by state — including timing, single or multiple year options, credit amount on seller’s individual income tax return, and even when the seller can deduct the taxes paid. For instance, some states require elections be completed early in a tax year. Sellers and buyers should consider the PTET election as early as possible in the tax structuring phase of a transaction, putting pen to paper to determine whether it could help eliminate any purchase price adjustments down the road. Regardless of the particulars in a seller’s state, timing and structuring the transaction specifically as an asset sale for tax purposes, versus equity, will be critical factors to success.
In order for a taxpayer to take advantage of the PTET in the year of a transaction, first the deal must be structured as a sale at the entity level rather than a sale of equity. Completing an “F” reorganization prior to a transaction can work well with the PTET.
An “F” reorganization has almost become the norm when acquiring or selling an S Corporation, and for good reason. In this context, the reorganization creates a new holding corporation above an operating company. As the operating company becomes disregarded for federal income tax purposes, a purchase/sale of all the equity in a disregarded entity is treated as a sale and purchase of assets. This allows deal makers who plan ahead to make sellers aware of the potentially beneficial PTET election and eliminate any gross-up payments that would otherwise be required to make sellers whole when selling assets. Potential tax benefits also allow:
While the M&A market continues to ebb and flow, if you plan to transact with pass-through entities, the best advice is to be aware of the tax opportunities available in your deal before going down the path of paying additional purchase price. Planning ahead could significantly impact your success.
Contact Samantha Smudz at ssmudz@cohenco.com 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.