Many industries have seen an increase in merger and acquisition activity in recent years. Is there potential for your business to merge with or acquire another?
If so, you’ll need to understand the potential tax implications of that decision.
Assets vs. stocks
These transactions can be structured in two ways for taxes:
1. Stock (or ownership interest) sale
If the target business is operated as a C or S corporation, a partnership, or a limited liability company (LLC) treated as a partnership, the buyer may directly purchase a seller’s ownership interest.
Purchasing stock from a C-corp is a particularly attractive option because the 21% corporate federal income tax rate under the Tax Cuts and Jobs Act (TCJA) is now permanent.
The corporation will generate more after-tax income and pay less tax overall. Additionally, any built-in gains from appreciated corporate assets will be taxed at a lower rate should you eventually decide to sell them in the future.
Ownership interests in S corporations, partnerships, and LLCs are also made more attractive by the TCJA’s reduced individual federal tax rates. On the buyer’s personal tax return, the passed-through income from these entities also will be taxed at lower rates.
Keep in mind that the TCJA’s individual rate cuts are scheduled to expire at the end of 2025. Depending on future changes in Washington, only time will tell if they’ll be eliminated earlier or extended.
Note: In some circumstances, a corporate stock purchase can be treated as an asset purchase by making a “Section 338 election.” Ask us if this would be beneficial in your situation.
2. Asset sale
A buyer may also purchase assets of a business. For example, a buyer may only be interested in certain assets or product lines. If the target business is a sole proprietorship or single-member LLC treated as a sole proprietorship for tax purposes, an asset sale is the only option.
Buyer vs. seller preferences
Buyers often prefer to purchase assets instead of ownership interests for many reasons. Typically, the buyer’s primary goal is to generate enough cash flow from an acquired business to cover the debt of acquiring it, as well as provide a pleasing return on the investment (ROI).
As such, buyers are reasonably concerned about minimizing exposure to undisclosed and unknown liabilities and achieving favorable tax rates after the deal closes.
One option is for the buyer to step up (increase) the tax basis of purchased assets to reflect the purchase price. This can lower taxable gains for certain assets, like inventory and receivables when they’re sold or converted into cash. It can also increase amortization deductions and depreciation deductions for some qualifying assets.
In contrast, many sellers prefer stock sales for both tax and nontax reasons. They strive to minimize the tax bill from a sale. This can often be achieved by selling their ownership interests in a business (corporate stock or partnership or LLC interests) as opposed to selling business assets.
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).
Of course, it’s worth bearing in mind that areas, like employee benefits, can cause unanticipated tax conundrums when acquiring or merging with another business.
Pursuing professional advice is crucial for both buyers and sellers.
Questions? Smolin can help.
For many people, selling or buying a business is the largest and most important financial transaction they’ll make in a lifetime. That’s why it’s essential to seek professional tax advice as you negotiate this situation. Once the deal is done, it could be too late to achieve a favorable tax result.
If you’re considering merging with another business or acquiring a new asset, contact the knowledgeable staff at Smolin to discuss the most favorable way to proceed.