Despite merger and acquisition (M&A) activities being lower in 2022, reports suggest that businesses are still successfully sold. If you're considering an M&A with another company, it’s essential that you know the tax implications of your transaction under current law.
M&A Transactions: Stocks vs. Assets
From a tax perspective, merger and acquisition transaction structures can take one of two forms:
1. Buyers could opt to purchase business assets. This scenario usually takes place when buyers only want to purchase specific product lines or assets. If the targeted company is a sole proprietorship or single-member LLC treated as a sole proprietor for tax reasons, this could be the only option for an M&A transaction.
2. Buyers purchase a seller's stock or ownership interest. This often takes place if their business operates as one of the following:
- LLC treated as a partnership for tax purposes
Currently, the corporate federal income tax rate is at 21%, creating a more favorable environment for purchasing stock of C-corporations. This is because corporations have fewer tax obligations and more after-tax revenue than ever before. Also, consider that these companies have lower tax rates for their built-in gains from corporate asset appreciation when selling.
Current law puts individual federal tax rates even lower than they were a few years ago, which may grow ownership interest in LLCs, S-Corps, and partnerships. This is possible thanks to the lower tax rate buyers can enjoy on their personal returns for the pass-through income these entities generate. Keep in mind that these individual rate cuts are due to sunset at the end of 2025, though they could be extended or ended earlier, depending on changes coming from Washington in the future.
Special Note: There are some situations where purchasing corporate stock could be viewed as an asset purchase if a "Section 338 election" is taken. Talk to your tax advisor to get more details.
What Buyers and Sellers Want in M&A Transactions
Why do buyers prefer asset purchases over ownership interest? For a couple of good reasons.
Typically, a buyer wants their acquired businesses to generate enough cash flow to pay off any incurred debt and make a decent ROI. So, it makes sense that buyers want to limit their exposure to any unknown (and undisclosed) liabilities. They also keep their tax liability at a minimum once the deal is finalized.
Buyers have the option of increasing, or stepping up, an acquired asset’s tax basis to reflect the price paid. Doing this lowers taxable gains whenever assets involving inventory or receivables are converted to cash or sold. This also boosts depreciation and deductions for amortizations of qualifying assets.
On the other hand, some sellers pursue stock sales for reasons that have to do with taxation and interest liabilities. A primary objective for stock buyers is to reduce the tax expense related to the M&A transaction. This is usually done through selling their business ownership interest (LLC, partnership, or corporate stock interests) and not business assets.
When selling ownership interests or stocks, the associated liabilities are often transferred to the buyer, and any gains get classified as a lower-taxed long-term capital gain. But this is based on the assumption that the ownership interest has existed for more than a year.
Still, unexpected tax issues can arise when buying or selling a business, such as those caused by employee benefits. You’ll want to follow the latest IRS reporting guidelines closely. Getting the right professional guidance in these situations is always wise.
Work with an M&A Advisor
In business, acquiring a new company can be one of the most important decisions you'll ever make. This is why you need professional tax advice during the negotiation process. Waiting to take this step until after you finalize the deal could be too late to maximize your tax results. Reach out to our office today to learn more about how to best proceed with your M&A transaction.