Tax Considerations in M&A Transactions

Posted by Dave Richards, Managing Partner on May 18, 2023 2:00:05 PM
Dave Richards, Managing Partner
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Despite merger and acquisition activity being down in early 2023, there are still many companies being bought and sold. If your business is considering merging with or acquiring another business, it’s important to understand how the transaction might be taxed under current tax laws.

Are you selling Stock or Assets?

From a tax standpoint, a transaction is generally structured in one of two ways:

1. Stock Purchase (or ownership interest purchase).
A buyer can directly purchase a seller’s ownership interest if the target business is operated as a C or S corporation, a partnership, or a limited liability company (LLC) that’s treated as a partnership for tax purposes.

The current 21% corporate federal income tax rate can sometimes make buying the stock of a C corporation somewhat more attractive. The corporation will pay less tax and generate more after-tax income than it would have years ago. Plus, any built-in gains from appreciated corporate assets will be taxed at a lower rate when they’re eventually sold.

Under current law, individual federal tax rates are lower than previous years, and may also make ownership interests in S corporations, partnerships and LLCs the most attractive. The pass-through income from these entities also will be taxed at lower rates on a buyer’s personal tax return. However, individual rate cuts are scheduled to expire at the end of 2025, and depending on future legislative changes, they could be eliminated earlier or extended.

2. Asset Purchase.
A buyer can also purchase the assets of a business. This can occur if a buyer wants the entire business or if they only want specific assets or product lines too. And it’s the only option if the target business is a sole proprietorship or a single-member LLC that’s treated as a sole proprietorship for tax purposes.

Note: In certain circumstances, a corporate stock purchase can be treated as an asset purchase by making an Internal Revenue Code Section 338 election. There are other ways to convert otherwise stock purchases to asset purchases for tax purposes as well – however, these are beyond the scope of this blog post. Please ask your tax advisor for more details.

What buyers and sellers want 

Many buyers prefer to purchase assets rather than ownership interests in the business. Generally, a buyer’s main objective is to generate enough cash flow from an acquired business to pay any acquisition debt and provide an acceptable return on the investment. Therefore, buyers are concerned about limiting exposure to undisclosed and unknown liabilities and minimizing taxes after the deal closes.

A buyer can step up (increase) the tax basis of purchased assets to reflect the purchase price. This is not the case in a traditional stock purchase. Stepped-up basis lowers taxable gains when certain assets, such as receivables and inventory, are sold or converted into cash. It also increases depreciation and amortization deductions for qualifying assets such as fixed assets and intangible assets like goodwill.

Meanwhile, sellers generally prefer stock sales for tax and nontax reasons. One of their main objectives is to minimize the tax bill from a sale. That can usually be achieved by selling their ownership interests in a business as opposed to selling business assets. Certain rules apply to the sale of non-corporate ownership interests (partnership and/or LLC interests) that can make a portion of the gain ordinary for tax purposes. A case-by-case analysis is needed, as there are too many considerations to summarize here.

With a sale of stock or other ownership interest, liabilities generally transfer to the buyer and any gain on sale is generally treated as lower-taxed long-term capital gain (assuming the ownership interest has been held for more than one year).

Get professional advice

Buying or selling a business may be the most important transaction you make during your lifetime, so it’s important to seek professional tax advice as you negotiate. After a deal is done, it is likely too late to get the best tax results. If you have questions about the buying and selling process please leave a comment below, or feel free to contact me directly.

Topics: Transaction Advisory, Business Advisory