How Do Taxes Factor Into An M&A Transaction?

Mergers and acquisitions have been decreasing in 2022, according to various reports. However, there are still companies being bought and sold. Is your business is considering merging with or purchasing another business? If so, it’s important to understand taxing of the transaction under current law.

Stocks vs. Assets

From a tax standpoint, the structuring of a transaction is achievable in two ways:

1. Stock (or Ownership Interest)

A buyer can directly purchase a seller’s ownership interest if the target business is operating as a:

  • C or S corporation.
  • Partnership.
  • Limited liability company (LLC) that’s set-up as a partnership for tax purposes.

The current 21% corporate federal income tax rate makes buying the stock of a C corporation somewhat more attractive. Reasons: The corporation will pay less tax and generate more after-tax income than it would have years ago. Plus, any built-in gains from appreciated corporate assets will be taxed at a lower rate when they’re eventually sold.

Under current law, there is a reduction in individual federal tax rates from years ago and may also make ownership interests in S corporations, partnerships and LLCs more attractive. Reason: The passed-through income from these entities also will be taxed at lower rates on a buyer’s personal tax return. However, individual rate cuts are going to expire at the end of 2025. Additionally, there will either be an elimination or extension of these rate cute, depending on future changes in Washington.

2. Assets

A buyer can also purchase the assets of a business. This may happen if a buyer only wants specific assets or product lines. And it’s the only option if the target business is a sole proprietorship or a single-member LLC that’s treated as a sole proprietorship for tax purposes.

Note: In some circumstances, you can treat a corporate stock purchase as an asset purchase by making a “Section 338 election.” Ask your tax advisor for details.

What Buyers and Sellers Want

For several reasons, buyers usually prefer to purchase assets rather than ownership interests. Generally, a buyer’s main objective is to generate enough cash flow after purchasing a business to pay any acquisition debt and provide an acceptable return on the investment. Therefore, buyers are concerned about limiting exposure towards undisclosed and unknown liabilities and minimizing taxes after the deal closes.

A buyer can step up (increase) the tax basis from purchasing assets to reflect the purchase price. A “Step-up” basis lowers taxable gains when a business sells certain assets or converts them into cash. Examples include receivables and inventory. It also increases depreciation and amortization deductions for qualifying assets.

Meanwhile, sellers prefer stock sales for tax and non-tax reasons. One of their main goals is to minimize the tax bill from a sale. This is usually achievable by selling their ownership interests in a business (corporate stock or partnership or LLC interests) versus selling business assets.

With a sale of stock or other ownership interest, liabilities usually transfer to the buyer. Additionally, the treatment of any gain on sale is generally a tax of a lower and long-term capital gain. This is assuming that the ownership interest has been for more than one year.

Keep in mind that other issues can also cause unexpected tax issues when merging with, or purchasing, a business. One example includes employee benefits

Get Professional Advice

Buying or selling a business may be the most important transaction you make during your lifetime. As such, it’s important to seek professional tax advice as you negotiate. After completing a deal, it may be too late to get the best tax results. Contact our accounting firm for the best way to proceed in your situation.