Introduction
Recently we’ve been writing a lot about valuing and exiting your business. Today we turn to what happens after you decide to sell your business and before signing the letter of intent. In the excitement of the process, one key hurdle is virtually lost until it is too late. The hurdle is that of the tax consequences at the various levels of government.
Generally, the tax consequences are as important as the selling price itself. What we frequently find is that the tax returns, both on the business and individual levels have not been seriously studied.
Within the course of our tenure at The Center, we have run into a situation where a broker brought a ready, willing, and able buyer to a seller of a laundromat. The seller and broker then viewed the tax consequences of the sale. The seller, upon realizing he would be upside down on the transaction due to the depreciation recapture, broker fees, recording fees, mortgage payoff, etc., the seller walked out of the deal. Not good and that is why we write today! We recommend that you get your tax consequences analyzed by a tax specialist well before making your exit.
When a corporate business is acquired, the transaction may be structured as a purchase of either the corporation’s assets or the shareholder’s stock. In a taxable transfer of a business generally the seller is concerned with the immediate tax burdens that result from the sale. The buyer is concerned with the future tax burdens associated with the acquisition of the new business. A dollar of current tax liability is more costly than a dollar of future tax liability because of the “time value of money.”
Consequences of Asset Acquisition to Buyer
When a corporation sells its assets, the character of the seller’s gains and losses is determined by the allocation of the purchase price among the transferred assets. The buyer’s basis in each of the assets it acquires is also established by the allocation of the purchase price among the assets purchased. The purchase price includes the price paid for the assets plus any liabilities assumed and acquisition expenses. The allocation of the basis is critical to the buyer since it can offset future income and reduce future taxes.
If the purchase price exceeds the fair value of the assets, the excess is known as goodwill. Goodwill is amortized over a fifteen-year period.
There are three basic benefits to the buyer of having an asset acquisition. First, the buyer can pick and choose which assets they want and leave behind such assets as obsolete inventory or those assets with liabilities attached. Second, because the buyer can eliminate certain liabilities, the transaction becomes less risky. Finally, as we mentioned earlier, the buyer will receive a stepped-up basis for appreciated fixed assets, which will allow them to depreciate and offset future income.
Consequences of a Stock Acquisition to Buyer
In a stock purchase, the buyer takes a cost basis in the stock equal to the purchase price. The assets and the corporation acquired become a wholly owned subsidiary. The problem here is the purchaser must take the same basis in the assets as they were with the seller as well as assume all of the selling company’s debt. This has discouraged many transactions from being set up this way when there are highly appreciated assets being transferred or a lot of debt involved.
Within our Tax Code, we have what is known as the “IRC section 338 election,” which allows the purchasing corporation to elect to treat the purchase of a target company’s stock as an acquisition of its assets, resulting in a step-up in basis, meaning the purchaser can increase the basis in the assets to reflect the purchase price paid rather than taking a carryover basis. In order to obtain this treatment, the buyer must purchase at least 80% of the seller’s stock and must make an election through filing proper IRS forms and pay the extra taxes.
A buyer that plans to make a IRC section 338 election normally will pay less for the target stock than for the target assets. When a IRC section 338 election is made, the selling company will recognize gain or loss on the deemed sale as if it were an actual sale of assets. The purchase price will be reduced by the amount the selling company will pay for taxes.
The decision to structure a purchase of a business as a stock or asset transfer many times will not be determined until negotiations with a seller have commenced. There are many variables that go into a decision; many stemming from the demands of the seller. Once again, Part 2 will be next month.
By: Roman Basi at the Center for Financial, Legal and Tax Planning for Transworld M&A Advisors