Tax consequences of M&A transactions vary considerably depending on the structure of the deal and the flexibility of the parties.
One of the key questions buyers and sellers face in every M&A transaction is the related tax implications.
Tax implications are based on how the transaction is structured; for example, a stock/equity transaction has different tax implications than an asset transaction. Without proper consideration, there can be unintended consequences and unexpected costs. This article explores the differences between stock and asset transactions and underscores the need for careful consideration when determining which route to take.
Stock transactions
A stock sale takes place between the buyer and the target company’s shareholders. It does not involve the sale of assets, and the target company remains in existence and intact after the transaction. In a C corporation or S corporation context, the target company does not generally recognize any gain or loss from the sale of its stock. Instead, the shareholders recognize gain or loss on the difference between the selling price and their basis in the stock/equity interests.
A stock transaction is often highly desirable for the selling shareholders because it results in one layer of taxation (by the shareholders) and avoids double taxation that occurs with asset sales by C corporations. Furthermore, the character of the gain recognized is generally long-term capital gain, which is taxed at favorable rates under the current system. Buyers may also find a stock sale to be favorable if there are significant tax attributes within the corporation that the buyer can utilize or if the buyer needs to keep the legal entity in existence (for example, customer contractual obligations, union contracts, and the like).
Buyers may be deterred from a stock sale due to potentially undesirable tax outcomes because the tax basis of the target company’s business assets do not get adjusted to fair market value. Rather, the buyer acquires the target company with the historical tax basis of its assets. As such, the buyer does not get the benefit of additional depreciation and amortization tax deductions on the appreciated value of the assets. Instead, the target company’s depreciation methods and lives continue undisturbed.
Additionally, a buyer of stock generally inherits the target company’s undisclosed liabilities and uncertain tax positions. Thus, the buyer could be liable for additional taxes as a result of an IRS or state agency audit where the target company is a C corporation (most potential liabilities of a valid S corporation generally flows through to the shareholders). Typically, a buyer negotiates representations, warranties, indemnifications, and perhaps escrows, in the stock purchase agreement to protect itself against potential undisclosed tax and nontax liabilities. However, any protections negotiated in the stock purchase agreement are only as good as the buyer’s ability to enforce them.
For target companies taxed as a partnership (including limited liability companies), the selling members need to consider if the company has any “hot assets” as defined under Internal Revenue Code (IRC) Section 751. “Hot assets” could be allocated to the selling members which change the characterization from capital gain to ordinary income and subject to tax at the partner’s marginal tax rate.
In addition, the IRS treats the sale of 100 percent of the equity interests in an entity taxed as a partnership as a sale of partnership interests to the sellers (generally capital gain treatment with the exception of “hot assets”) and a purchase of assets to the buyer. This treatment potentially affords both buyers and sellers the best of both worlds.
An important consideration of a stock transaction is whether an election should be made by the buyer and the sellers to treat the transaction as an asset sale. This election can be made under IRC Sections 338, 336, and 754, depending upon the type of entity involved and if other criteria are met. A more detailed discussion is beyond the scope of this article.
Asset transactions
When a buyer acquires the target company’s assets, the transaction occurs between the buyer and the target company. Accordingly, the consideration is paid to the target company for its business assets and liabilities. The target company can liquidate, dissolve, or otherwise cease to exist, such that the proceeds are distributed to the equity owners after the transaction is completed, or can choose to remain in existence.
The target company recognizes gain or loss on the difference between the sales price allocated to the assets (generally negotiated by the parties in the asset purchase agreement) and the tax basis of the assets on an asset-by-asset basis. When determining the sales price of an asset transaction, a commonly overlooked issue is correctly calculating the sales price, which also includes any transaction costs incurred by the buyer to facilitate the transaction and the target company’s liabilities assumed by the buyer.
Buyers may want to pursue an asset transaction when there is significant potential of undisclosed tax or nontax liabilities that the buyer does not want to assume. Also, asset transactions generally have a built-in tax benefit to the buyer when the target company has a low tax basis in its assets and the buyer wants to achieve a step-up in the basis to fair market value (which increases the amount of future tax deductions as described above).
Some common tax pitfalls of an asset transaction typically fall to the sellers. Mainly, the sellers can be subject to double taxation or depreciation recapture. Double taxation occurs in asset sales of C corporations because one level of tax is assessed to the target company on the gain from the sale of its assets, and another level of tax is assessed to the shareholders on the distribution of the net proceeds. Double taxation also occurs with an S corporation if it was previously a C corporation, had built-in gains at the time of conversion, and the conversion occurred within five years of the transaction date. Otherwise, S corporations and partnerships are generally not subject to double taxation.
Gain from the sale of assets attributable to prior depreciation deductions must be recaptured and taxed as ordinary income. Therefore, unforeseen tax consequences can result to a target company that is fixed asset-intensive and has taken advantage of bonus depreciation or fixed asset expensing under IRC Sections 168 or 179, respectively.
Tax attributes
Tax attributes are an important consideration for both the buyer and sellers, as they can be a contributing factor in how the transaction is structured. A buyer needs to carefully evaluate situations in which a C corporation target company has tax attributes that provide future benefit, such as net operating loss and/or tax credit carryforwards.
In a stock transaction, these attributes generally carry over to the buyer for potential utilization in future years. However, if the stock acquisition results in a change of ownership greater than 50 percentage points during a three-year period, the tax attributes should be further evaluated to determine if there is any limitation to the buyer under IRC Sections 382 or 383 that could limit the buyer’s ability to utilize the attributes. The target company’s tax attributes can also be subject to prior limitations in situations where it used its equity to raise capital.
Tax attributes do not carry over to the buyer in an asset transaction. Sellers need to carefully review situations where the target company has significant tax attributes and an asset sale is pursued. The target company can utilize these tax attributes to offset any gains recognized as a result of the transaction (giving considerations to limitations due to prior ownership changes).
Because a stock transaction oftentimes results in an ownership change, it may advantage the sellers to structure the transaction as an asset deal rather than a stock deal. The parties commonly model the tax consequences of both transactions and pursue the most favorable tax structure.
How we can help
This information is a starting point for determining the transaction tax implications of an M&A deal. There are a variety of other considerations, including the rollover of a seller’s equity, deductibility of transaction costs, and state and local tax issues, just to name a few. Buyers and sellers should consider buy-side or sell-side due diligence to help determine the deal structure.
Due diligence can help you ascertain the need for (and level of) representations, warranties, indemnification provisions, and whether escrows and holdbacks are necessary in the purchase agreement. Wherever you are in the negotiation process, consider the guidance of an experienced M&A tax professional to help ease the anxiety associated with M&A transactions.