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.
From a tax standpoint, the structuring of a transaction is achievable in two ways:
A buyer can directly purchase a seller’s ownership interest if the target business is operating as a:
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, individual federal tax rates are reduced 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, depending on future changes in Washington, they could be eliminated earlier or extended.
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, a corporate stock purchase can be treated as an asset purchase by making a “Section 338 election.” Ask your tax advisor for details.
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. Stepped-up basis lowers taxable gains when certain assets are sold or convert 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 acquiring, a business. One example includes employee benefits
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.