Is your business considering an M&A transaction and wondering how it will affect your taxes?
Although merger and acquisition (M&A) activity has been down in 2022, companies are still being bought and sold. It’s important to understand how the transaction will be taxed under current law. Here are some tips.
Stocks vs. Assets
From a tax standpoint, a transaction is structured in two ways:
- Stock (or ownership interest). A buyer can directly purchase a seller’s ownership interest if the target business is operated as a C or S corporation. This can also happen if the business is a partnership, or a limited liability company (LLC) that’s treated 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. The corporation will pay less tax and generate more after-tax income than it would have years ago. The built-in gains from the appreciated corporate assets are taxed at a lower rate, and this occurs when they are 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. The passed-through income from these entities will be taxed at lower rates on a buyer’s personal tax return. However, individual rate cuts are scheduled to expire at the end of 2025. Depending on future changes in Washington, they could be eliminated earlier or extended.
- Assets. A buyer can also purchase the assets of a business. This may happen if a buyer only wants specific assets or product lines. 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 cases, a corporate stock purchase can be treated as an asset purchase by making a “Section 338 election.”
What buyers 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 from an acquired business to pay any acquisition debt and provide an acceptable return on the investment. Therefore, buyers are concerned about limiting exposure to undisclosed and unknown liabilities and minimizing taxes after the deal closes.
A buyer can increase the tax basis of purchased assets to reflect the purchase price. Increased basis lowers taxable gains when certain assets, such as receivables and inventory, are sold or converted into cash. It also increases depreciation and amortization deductions for qualifying assets.
What sellers want
Meanwhile, sellers generally prefer stock sales for tax and nontax reasons. One of their main objectives is to minimize the tax bill from a sale. Ownership interests can be sold 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. Any gain on sale is usually treated as lower-taxed long-term capital gain. This assumes ownership interest has been held for more than one year.
Keep in mind issues such as employee benefits. This can also cause unexpected tax issues when merging with, or acquiring, a business.
Get professional advice
Buying or selling a business through mergers and acquisitions is an important decision. Be sure to seek professional tax advice as you negotiate. Contact us for the best way to proceed in your situation.
If you have questions about taxes on M&A transactions, contact our CPAs here!