Acquiring a business can be a strategic move to grow, diversify, or compete in the market. Acquisition also involves significant tax implications that can affect the value and structure of the deal. Therefore, it is crucial for buyers and sellers to understand the tax consequences of different types of acquisitions and plan accordingly. In Part 3 of PilieroMazza’s blog series “Focus on S Corporations,” we highlight key elements of an S Corp acquisition that buyers and sellers should address to improve tax outcomes and business continuity. Visit this link for Part 1 and this link for Part 2 in the blog series.
Important Tax Implications When Acquiring a Business
Frequently, clients come to us with a signed Letter of Intent (LOI) or an agreement in principle looking to move forward with a deal. Before signing an LOI, there are important tax issues that buyers and sellers need to understand when acquiring a business. Due to the complexity of these issues and their impact on the structure of the deal, both parties should consult with their attorney and tax professional early in the process.
Asset Acquisition vs. Equity Acquisition
The primary distinction between an asset acquisition versus an equity acquisition is the form of the purchase: either purchasing assets of the target (an asset deal) or the ownership equity of the target (a stock deal). The choice of acquisition type can also have significant tax implications for both parties.
In general, sellers prefer to sell their equity rather than their assets, as it can result in lower taxes and provide for a more streamlined business transition. Buyers of a stock sale can also enjoy other benefits such as having greater ease of continued business with current vendors, using the credit of the acquired business, and utilizing current employees. Disadvantages include, but are not limited to, legal liability for the corporation prior to closing and the buyer not being able to take a step up in basis on assets.
On the other hand, buyers generally prefer to buy assets rather than equity since it allows them to take a step up in basis in the assets they are acquiring and avoids inheriting any liabilities. Like a stock sale, there are also disadvantages that include, but are not limited to, paying sales or transfer taxes, establishing new licenses, transferring leases or other contracts, rehiring employees, and having no existing credit.
Special Considerations for S Corp Targets
As discussed in Part 1 of this series, if the target is an S Corp—an entity that is not subject to corporate-level tax—an asset sale may be more favorable than a stock sale for both parties. If a buyer wants to acquire an S Corp target, there are several options to consider, such as buying the stock directly from the shareholders, buying the assets from the corporation itself, or making a joint election with the seller to treat a stock purchase as an asset purchase for tax purposes.
S Corps must only have eligible shareholders (see Part 1). Therefore, the S Corp should ensure that any buyer in a stock transaction is an eligible shareholder or risk terminating S Corp status. Causes of termination of S Corp status and remedial action that can be taken to fix any violations were discussed in Part 2 of this series.
Each option has its own advantages and disadvantages depending on the facts and circumstances of the deal. For example, buying the stock directly from shareholders may be simpler and cheaper than buying assets from the corporation itself, but it may also result in lower tax deductions for the buyer and higher taxes for the seller. Therefore, it is important for buyers and sellers to evaluate each option carefully and consult with legal and tax professionals who can work together to help both sides choose the best option for their situation and needs.
Options for S Corp Acquisition
As referenced above, making a joint election with the seller may allow both parties to enjoy the benefits of an asset purchase without transferring any assets, but it may also require more coordination and cooperation between the parties and compliance with certain rules and conditions. Three of the most common methods for capturing these joint benefits include:
- A Sec. 338(h)(10) election is a special tax provision that allows a buyer and seller of a corporation to treat a stock purchase as an asset purchase for tax purposes. This election requires that the buyer is a corporation and that the seller is either an S Corp or a subsidiary of another corporation. A Sec. 338(h)(10) election can result in significant tax savings for both parties by allowing the buyer to step up the basis of the acquired assets and allowing the seller to avoid double taxation.
- A Sec. 336(e) election is another tax provision that allows certain taxpayers to treat the sale, exchange, or distribution of corporate stock as an asset sale. The benefit of an asset sale is that the basis of the target corporation’s assets is stepped up to fair market value. Unlike a Sec. 338(h)(10) election, a Sec. 336(e) election does not require the acquirer of the stock to be a corporation (or even a purchaser). This means individuals, partnerships, or other non-corporate entities that cannot benefit from a Sec. 338(h)(10) election may be able to qualify for a Sec. 336(e) election.
- A type F reorganization is a type of corporate restructuring that allows a single corporation to change its identity, form, or place of organization without incurring a tax bill. A type F reorganization may be useful for acquiring an S Corp target if the buyer wants to preserve the S Corp status of the target and avoid any adverse tax consequences. For instance, if the buyer is a corporation that is not eligible to own S Corp stock, the parties can agree to a type F reorganization as part of the transaction to avoid terminating the target’s S election.
These are simplified versions of complex provisions in the Internal Revenue Code. Strict compliance is necessary to ensure the tax treatment is respected by the IRS. Anyone considering a reorganization or election should consult their attorney and tax professional.
Takeaway
Every acquisition is unique and requires a customized approach that suits each party’s situation and needs. It is advisable to consult with experienced attorneys and tax professionals who can help you understand the tax implications of the deal and optimize your tax position.
Attorneys in PilieroMazza’s Corporate & Organizational Governance Team have successfully completed hundreds of M&A deals across various industries and regions and have the knowledge, skills, and resources to help you achieve your M&A goals. Please contact Abby Baker, Paul Tracy, or another member of the Group if you have any questions or need assistance.
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