Fernway DiarySM

Jul 06, 2021

Mergers and acquisitions effectively ground to a halt in early 2020 due to the COVID-19 pandemic. However, M&A activity has since rebounded in a big way, with no signs of slowing down. In fact, Morgan Stanley predicts that affordable access to capital, economic recovery, and corporate interest in global expansion will drive M&A activity — especially cross-border deal-making — in 2021.

If you are considering buying or selling a business in the coming year, it is important to understand the tax implications.

Two Ways to Structure a Deal

Currently, organizations have two options for structuring transactions, each with its own tax benefits.

1. Stock or ownership interest purchase. A buyer can purchase the seller’s ownership interest in the company if the target is structured as a corporation, partnership or LLC.
2. Asset purchase. A buyer can purchase the assets of the business, such as equipment, fixtures, receivables, intellectual property, customer lists, website/domain, goodwill, trade names, inventory, etc. The seller retains ownership of the legal entity.

Like other agreement terms, what may be good for the seller is not always in the best interest for the buyer, or vice versa.

Structuring a Transaction from the Buyer’s Viewpoint

For buyers, the goal from a tax perspective is primarily to minimize tax implications after the deal closes.

Purchasing the stock of a C corporation can be attractive to the buyer because the corporate federal income tax rate is currently at 21{d61ad4666dda706b731686a225909392f074403d16c1288901cab8f2cf34ab1f}. Purchasing ownership interest in an S corporation, partnership or LLC can also be advantageous because the Section 199 pass-through deduction allows income from S corporations, partnerships and LLCs to be taxed at a low rate on the owner’s individual tax return.

A buyer may also favor purchasing stock or ownership interest in a company if the target has net operating loss (NOL) carry forwards. The Coronavirus Aid, Relief, and Economic Security (CARES) Act allows losses generated in 2018, 2019 and 2020 to be carried back for up to five years, so the buyer may be able to carry back losses generated after the transaction’s closing to pre-closing tax years and claim refunds of taxes paid during those years. The buyer can also waive the carryback option and elect to carry forward NOLs indefinitely to future years.

However, depending on the terms of the stock purchase, the buyer may require seller approval to amend the target company’s pre-closing tax returns. Therefore, if NOLs are a key factor in the transaction, the buyer and seller may need to come to an agreement on how NOLs will be utilized.

There can also be downsides to a stock purchase for the buyer. The buyer of stock generally inherits the target company’s basis in its assets (and liabilities). Separately, if the target company has already taken significant depreciation and amortization deductions on those assets, there may be little or no basis for the buyer to write off.

Alternatively, if the target company has highly appreciated assets, an asset purchase might be more attractive since the buyer receives stepped-up basis in those assets to align with the transaction purchase price. This lowers the buyer’s taxable gains when inventory is eventually sold, receivables are converted into cash, or capitalized assets are depreciated or amortized.

Structuring a Transaction from the Seller’s Viewpoint

For sellers, the main concern is minimizing tax on any realized gains. For this reason, sellers often prefer a stock sale for tax purposes. Stock sales are generally treated as long-term capital gains (assuming the seller has held their interest for more than one year) and taxed at a top rate of 20{d61ad4666dda706b731686a225909392f074403d16c1288901cab8f2cf34ab1f}, plus an additional 3.8{d61ad4666dda706b731686a225909392f074403d16c1288901cab8f2cf34ab1f} Net Investment Income Tax (NIIT) may be applicable.

On the other hand, asset sales usually generate a combination of ordinary income (currently taxed at a top rate of 37{d61ad4666dda706b731686a225909392f074403d16c1288901cab8f2cf34ab1f}, plus NIIT) and capital gains, depending on how the deal allocates purchase price among various business assets.

Tax Changes on the Horizon

Tax considerations for buyers and sellers could change drastically in the near future. President Joe Biden and several members of Congress have proposed increasing the corporate tax rate, increasing long-term capital gains rates for high-income taxpayers, and increasing the top individual income tax rate. In addition, the pass-through deduction is scheduled to expire at the end of 2025.

Right now, it remains unclear precisely when and how new tax rates and policies will come into effect as negotiations are underway in Congress, but many private equity firms and owner-operators are prioritizing deals now to take advantage of current tax rates.

Conclusion

Buying or selling businesses are a complex transaction with income tax considerations being just one factor when assessing potential tax implications.

Obtaining professional advice will help structure the deal in a tax-advantaged way, ensure alignment with your objectives, navigate potential changes in tax law, and minimize the overall tax exposure when buying or selling a business.

For more information, please contact your US tax advisory team at youradvisor@fernwaysolutions.com or visit us at www.fernwaysolutions.com.

Disclaimer:
The above content is intended to support the marketing of professional services and should not be construed as written tax advice directed at the particular facts and circumstances of any person. If you are interested in the topics presented herein, we encourage you to contact us or an independent tax professional to discuss their potential application to your particular tax situation. To the extent this content may be considered to contain written tax advice, any written advice contained in, forwarded with or attached to this content is not intended to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code. Changes in tax laws or other factors could affect, on a prospective or retroactive basis, the information contained herein; Fernway Solutions assumes no obligation to inform the reader of any such changes.