Buying & Selling a Business: Tax Considerations

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Lisa LaSaracina's presentation from the 2/15/13 Boardroom Series on M & A: Tax Considerations. Presented by Fiondella, Milone & LaSaracina in New Haven, CT.
Visit www.cvg.org/boardroom-series for more information on this and other events.

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  • b. For tax years beginning after 2012, the top rate for capital gains and dividends will permanently rise to 20% (up from 15%) for taxpayers with taxable incomes exceeding $450,000 for joint filers and surviving spouses; $425,000 for heads of household; $400,000 for single filers; and $225,000 for married taxpayers filing separately. c. Liabilities - Although existing liabilities will usually reduce the selling price, selling (or redeeming) stock rather than selling assets protects the business owner from unasserted or unrecorded liabilities that may exist at the time of sale.
  • However, some or all of the gain may be taxed at the higher ordinary income rate, so that the seller's tax on an asset sale may still exceed the tax on selling the stock or partnership interests.
  • 3rd bullet - No step-up is available when stock is acquired, unless a Section 338 election is made. (Likewise, a basis step-up is available when a partnership interest is acquired, if a Section 754 election is in effect.)
  • To the extent the seller finances a portion of the sale, some of the gain may be deferred under the installment reporting method
  • When a stock ownership change of more than 50 percentage points occurs among the 5% or greater shareholders in a loss corporation, the Section 382-384 rules likely will limit the postchange use of the loss corporation's tax attributes.
  • Asset purchases are more common when the business is an S corporation, partnership, or LLC taxed as a partnership.
  • The character of the gain or loss on the sale of each asset (e.g.capital or ordinary) depends on the character of the asset sold. After winding up any other business and paying tax on the asset sale, the business entity is often liquidated. If the business is a C corporation, this results in double tax to the owner, since he or she is taxed on the liquidation proceeds.
  • However, an S corporation owner's tax on an asset sale does not always equal the tax on a stock sale. Depending on the business assets, the difference can be significant. Although the gain on an asset sale increases the owner's basis, the character of the owner's income passed through from the S corporation depends on assets sold. If the asset sale results in a large amount of ordinary (e.g., recapture) income, selling stock will result in less tax for the shareholder.After winding up any other business and paying tax on the asset sale, the business entity is often liquidated. If the business is a C corporation, this results in double tax to the owner, since he or she is taxed on the liquidation proceeds.
  • Under the residual allocationmethod, all assets are divided into seven classes (i.e. Cash, Receivables, PP&E, Inventory, and Intangibles). Both the buyer and the seller must allocate the purchase/sales price amount.
  • Other factors:The target has nondepreciable built-in loss property (basis exceeds FMV) and has depreciable built-in gain property (FMV exceeds basis). The loss on the deemed sale of the built-in loss property may offset the gain on the deemed sale of the built-in gain property to minimize the tax liability resulting from the Section 338 election. After the election, the depreciable property has been stepped up in basis, resulting in greater depreciation deductions in the future. The selling shareholders will recognize a loss on the sale of their stock in the target (that will be at least partially deductible in the year of the sale), and that allows the purchasing corporation to bargain for a lower price for the target stock that partially offsets the target's tax liability from the deemed sale of its assets.
  • Note that the seller's stock sale is ignored for tax purposes. For legal and GAAP accounting purposes, the sale is still deemed a stock sale.
  • These liabilities are contained within the target corporation, which continues its legal existence, but they can still diminish the value of the buyer's investment. In contrast, a direct asset purchase generally means the buyer is responsible only for those liabilities expressly assumed or secured by the purchased assets (which can include tax liabilities for sales and use tax, payroll tax, and property tax that attach to the assets acquired).
  • Sale of outside interest is sources to state of selling SH residency. Sale of assets sourced under each states sourcing and apportionment rules
  • c. However, sellers are usually only willing to indemnify against a specific liability (e.g., underpaid federal income tax for all open years). Thus, indemnification is usually not effective against a liability that is discovered after the sale. Also, indemnification is only effective to the extent the seller has assets available to repay the buyer. Id. The negotiating point here is how long the funds will remain escrowed.
  • In effect, when the interests are sold, it’s as if the partnership distributed all the partnership assets to the partners in complete liquidation of the partnership, and the partners then sold the business assets to the buyer. The result is no different than if the partnership sold the assets directly and distributed the sales proceeds to the partners.
  • IRC Sec. 751recharacterizes gain on the sale of a partnership interest as ordinary income to the extent the partnership owned assets that would generate ordinary income if sold. (Although only gain attributable to unrealized receivables and inventory is reclassified, those terms are defined broadly enough to include most assets that would generate ordinary income if sold.) Thus, as far as taxes are concerned, a seller would often have no strong preference for an asset versus an entity sale.
  • Buying & Selling a Business: Tax Considerations

    1. 1. Buying and Selling a Business– Tax Considerations– Presented by:  Lisa LaSaracina, Partner, Tax  Alex Morgan, Partner, Tax
    2. 2. Introduction  Buying or selling a business is a complex transaction. There are many tax variables to consider, such as: – Structure of transaction (i.e. asset sale versus a stock sale) – Goals of both Buyer and Seller – Types of entities involved as buyer and seller (corporations, partnerships, LLCs, individuals, etc.)2
    3. 3. Structure of Transaction  An existing business can be acquired in two basic ways: – The purchaser can buy 1. the Assets of the business; or 2. the Stock/Ownership Interests (i.e. the stock of a corporation, a membership interest in an LLC, etc.).3
    4. 4. Critical factors in determining transactions structure A. Amount of tax paid by the seller. B. Assumption of the business liabilities, including those not yet identified. C. Purchasers ability to step up the basis of business assets (generating a tax benefit when the assets are sold, depreciated, or amortized). D. Ability to obtain tax related benefits, such as NOL carryovers. E. Purchasers ability to use intangibles, such as customer lists, contracts, or know-how.4
    5. 5. What the Seller Wants  Sellers main concerns when a business is sold are minimizing tax on any realized gain and being insulated from the business’s liabilities5
    6. 6. What the Seller Wants  If the business is a C corporation, the seller often has a strong preference for selling stock rather than assets because— a. Avoidance of potential double taxation which could occur with asset sale; b. The sellers gain is almost always capital gain, qualifying for preferential tax rate (currently 15% for 2012/13); and c. Liabilities (both known and unknown) associated with the company remain with the stock6
    7. 7. What the Seller Wants  If the business is a partnership, LLC, or S corporation: – The negative tax consequences of selling assets (rather than the entity) are usually less severe, since the gain on asset sale is passed through to the owners resulting in a single layer of tax.7
    8. 8. What the Buyer Wants – Generally, buyers prefer to acquire assets rather than stock.  Acquiring assets protects the buyer from assuming the sellers liabilities (especially contingent or unknown liabilities) which is what happens when stock is purchased.  An asset purchase also allows the buyer to acquire only the assets it wants.  An asset purchase allows the purchaser to step up the basis of the acquired assets to FMV.8
    9. 9. Finding Common Ground  While it may seem that the interests of buyer and seller are always opposed, the desire to complete the transaction usually provides motivation to strike a deal that satisfies everyone.9
    10. 10. Finding Common Ground  Several options are available for finding common ground… a. The seller could sell assets and demand a higher selling price. b. The seller could sell stock and accept a lower sales price. c. The seller could indemnify the buyer with respect to certain liabilities. d. The seller could agree to escrow a certain amount of funds to cover future liabilities.10
    11. 11. Taxable Stock Purchase  Direct Purchase - P purchases Ts stock directly from its shareholders for cash and/or notes  Reverse Subsidiary Merger - If T has too many shareholders for P to deal with individually or T anticipates some shareholders will be recalcitrant, P can achieve the same results as a direct purchase by completing a Reverse Subsidiary Merger.11
    12. 12. Taxable Stock Purchase  Reverse Subsidiary Merger 1. Buyer forms new, transitory Subsidiary which is then merged into the Target, with Target as the surviving corp.; 2. Target S/Hs receive cash and/or notes; 3. Buyer receives Target stock; 4. Target becomes wholly owned subsidiary of Buyer12
    13. 13. Taxable Stock Purchase EXAMPLE 1  P forms transitory S and merges S into T in a state-law merger in which Ts shareholders receive from P $100 cash for each T share and those previously outstanding T shares are cancelled. In the merger, Ps stock in S is exchanged for newly issued T shares.  Transitory S is ignored for tax purposes, and the transaction is treated as if P had directly purchased each previously outstanding T share for $100 cash.13
    14. 14. Taxable Stock Purchase Seller’s Tax Consequences  The seller realizes capital gain or loss equal to the difference between the sales proceeds and tax basis in the stock.  Assuming the stock was owned for over 12 months, any gain would be taxed at favorable long-term capital gain rates (i.e. 15% under current law.)14
    15. 15. Taxable Stock Purchase Buyer’s Tax Consequences  Buyer obtains basis equal to its purchase price.  Basis is not recovered until stock is sold or liquidated.  No adjustment is made to the basis of the assets in the corporation (i.e. carryover basis).15
    16. 16. Taxable Stock Purchase Buyer’s Tax Consequences (cont.)  The corporations tax attributes (i.e. NOL, capital loss, and credit carryforwards) remain with the buyer and are available to offset income generated after the sale. – However, IRC Sec. 382 may limit the use of these attributes after an ownership change16
    17. 17. Taxable Stock Purchase Purchasing Stock with a Sec. 338 Election  When a buyer purchases stock, a Sec. 338 election treats the purchaser as if assets were purchased for tax purposes.  Why would a Buyer want a §338 election? – The Buyer is purchasing stock but would like a step-up in the basis of the Target’s assets.17
    18. 18. Purchasing Stock with a Sec. 338 Election  2 types of Sec. 338 elections – Section 338(g) (“Regular” Sec. 338 Election) – Section 338(h)(10) Election18
    19. 19. Purchasing Stock with a Sec. 338 Election  For either election: – The Purchaser must be a corporation. – During a 12 month period, the purchasing corporation must purchase 80% or more of the vote and value of the Target stock.  If elected, the selling shareholders are treated as selling stock, while the acquired corporation is treated as if it sold its assets to the purchaser.19
    20. 20. Regular Sec. 338 Election 1. Ts selling shareholders are treated for tax purposes as having sold their T stock to P. 2. T is treated as having sold all of its assets at FMV to a new corporation (“New T”). 3. Old T recognizes and is taxed on the full gain and loss on the deemed sale of its assets. – Thus, it is advantageous to make a Code §338 election for T only in certain limited circumstances (i.e., T has a large NOL). 4. New T is treated as purchasing old Ts assets. 5. New T generally takes a basis for old Ts assets equal to the price P paid for Ts stock. 6. Old Ts tax attributes (i.e. NOL and tax credit C/Fs) disappear.20
    21. 21. Regular Sec. 338 Election  Potential Double Taxation – Because of the potential tax liability at the target corporation level (resulting from the deemed sale of the targets assets) and the potential additional tax liability at the selling shareholder level, a regular Section 338 election generally makes sense only in limited circumstances.21
    22. 22. Regular Sec. 338 Election  When this election makes sense: – Target has unused NOL, capital loss, or tax credit carryovers that will offset the gains and tax recognized as a result of the election; – The use of target tax attributes after the stock purchase will be limited by IRC Secs. 382-384 if a Section 338 election is not made; – Target holds depreciable property (basis exceeds FMV) such that sale generates loss that can be carried back to an income year22
    23. 23. Section 338(h)(10) Election  An IRC Sec. 338(h)(10) election is a special election that can be made when: 1. The target corporation is a member of a consolidated return group or; 2. When the stock of an S corporation is purchased by another corporation.23
    24. 24. Section 338(h)(10) Election  The effect of this election is to treat the acquired corporation as if it sold all its assets and then distributed the proceeds to its shareholders in complete liquidation.  The corporation is taxed on the deemed sale of its assets, but double taxation is avoided because the target is deemed to be liquidated into its parent corporation tax-free under IRC Sec. 332.24
    25. 25. Section 338(h)(10) Election  The purchaser takes a stepped-up basis in the assets. However, unlike the “regular” Section 338 election, the purchaser is often not liable for any tax on gain from the target corporations deemed asset sale.25
    26. 26. Advantages of Sec. 338 Elections over Direct Asset Purchases  A direct asset purchase of the targets assets followed by a liquidation of the target through distributing the sales proceeds to its shareholders may achieve approximately the same tax results as a Sec. 338 election.  However…26
    27. 27. Advantages of Sec. 338 Elections over Direct Asset Purchases 1. The target may have many assets, making the transfers of title after a direct asset acquisition expensive and time-consuming. 2. A Sec. 338 election, with the resulting step-up in the basis of corporate assets, can be made after acquiring 80% of the targets stock. Thus, in effect, 100% of the assets can be stepped up by buying only 80% of the targets stock.27
    28. 28. Section 338 Elections  Caution: Note that a disadvantage of either type of Section 338 election is that the underlying transaction is still treated as a stock purchase for legal purposes. Therefore, the target corporations liabilities, including any unknown, undisclosed, or contingent liabilities, remain intact.28
    29. 29. Taxable Asset Purchase  Although a purchaser often would prefer to purchase business assets for reasons discussed earlier (e.g., limited liability exposure, basis step-up to FMV, ability to purchase only desired assets, and the opportunity to renegotiate or terminate existing unfavorable contracts), the tax cost to the seller is often prohibitive.29
    30. 30. Taxable Asset Purchase  In certain situations, however, an asset purchase may be the appropriate structure for a C corporation.  For example, if the selling corporation has NOLs to offset the gain on the asset sale, or the purchasers step-up will be allocated to assets that are sold or depreciated very quickly (so that the purchaser is willing to increase the purchase price by an amount equal or almost equal to the sellers tax cost).30
    31. 31. Taxable Asset Purchase Seller’s Tax Consequences  The selling entity allocates the sales price to each asset sold using the residual method described in IRC Sec. 1060.  Potential double taxation resulting from 1) Sale of Assets and 2) Liquidating Distribution31
    32. 32. Taxable Asset Purchase Seller’s Tax Consequences (cont.)  If the business is an S corporation, the gain on the asset sale is generally taxed only once, since the gain increases the owners basis in the entity (reducing any tax on a future liquidating distribution).32
    33. 33. Taxable Asset Purchase Purchaser’s Tax Consequences  Buyers purchase price is allocated to all the acquired assets using the residual method described in IRC Sec. 1060.  Any purchase price in excess of the acquired assets FMV is allocated to goodwill and amortized over 15 years.  Buyer is not entitled to any of the acquired entitys tax attributes (e.g., NOL, credit carryforwards, etc.).33
    34. 34. Selling or Buying Partnership Interests vs. Assets  When the business is operated as a partnership, there is little tax difference between selling assets and selling an interest in the partnership – This is because when partnership interests are sold, the sale triggers a liquidation of the partnership assets into the hands of the buyer.34
    35. 35. Selling or Buying Partnership Interests vs. Assets  In either case, gains or losses are passed through to the partners where they retain their character as capital or ordinary. *** No Double Taxation35
    36. 36. Q & A Session…36

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