Tax Basics for Structuring Your Next Deal
- Your position as a buyer or a seller determines how you examine your tax consequences.
- Whether pursuing equity or asset sales, there are tax election options to consider.
- Some tax elections come with complex requirements, so it’s important to have an understanding of the nuances and receive proper guidance when making decisions.
Need help structuring your next deal?
When buying or selling a business, one thing is certain: there will be tax consequences. Your deal’s tax structure can have long-lasting impacts, so it’s crucial to assess all options. Review the basics and important factors to consider when contemplating a transaction.
The difference between equity and asset sales
In simple terms, there are two ways a target business can be purchased: a buyer can acquire equity or assets. Typically, buyers prefer asset deals, as the buyer receives a step-up in the tax basis of the acquired assets, thus giving rise to valuable depreciation and amortization deductions over time.
Sellers, on the other hand, generally prefer equity deals, since asset sales can result in greater tax liability. This is particularly true for C corporations due to double taxation — they are taxed once at the entity level and again upon distribution to the shareholders.
Deemed asset sales bring additional options
In some cases, a sale can be treated as an equity sale for legal purposes while being treated as an asset sale for federal income tax purposes. There are a few ways to achieve this result.
Section 338(h)(10) election
This election recasts a stock purchase as an asset purchase. This option is available when a corporate buyer purchases at least 80% of the stock of an S corporation or a C corporation subsidiary in a consolidated group.
Accordingly, the buyer receives a step-up in the tax basis of the assets. Since the seller may be put in a worse tax position, this election could come at a cost. To cover these additional seller taxes, a buyer may pay a “tax gross-up” amount to the seller.
Section 336(e) elections
This is similar to the Section 338(h)(10) election in that it recasts a stock transaction as the sale of assets, with a notable distinction in the type of buyers that can be involved. Whereas the buyer must be a corporation to elect Section 338(h)(10) treatment, the buying entity may be a partnership or an individual when electing under Section 336(e). Therefore, noncorporate buyers could consider Section 336(e) when Section 338(h)(10) may not be an option.
LLCs and QSubs
Limited liability companies (LLCs) are hybrid tax entities that may be taxed in one of several ways. If the LLC has only one member, it may be treated as a disregarded entity, in which case its activity is reported on the tax return of the individual or entity that owns it. When an LLC is disregarded, the sale of its equity is treated as an asset sale, which can be useful in giving the buyer a basis step-up.
Similar asset treatment may also be available when a buyer purchases stock of a qualified subchapter S Subsidiary (QSub), which is an S corporation that is wholly owned by another S corporation. QSubs are treated like disregarded entities, similar to single-member LLCs.
Section 1202 stock
Consider Section 1202 as another powerful planning tool. It allows the exclusion of gain upon the sale of qualified small business (QSB) stock by a noncorporate shareholder (if held for more than five years). Among other requirements, a QSB is a C corporation that is engaged in an active business that has gross assets not exceeding $50 million at the time of the stock issuance. Section 1202 is vital in the venture capital setting, but can also be an effective strategy when buying into established companies.
There are a multitude of nuances and requirements under Section 1202, so investors should be well advised if considering it.
How we can help
CLA’s transaction tax team helps buyers and sellers across all industries shape the structure of their deals for federal and state tax purposes. Contact your CLA advisor to learn more about how our team can assist in your transaction.