This article was originally published online for the HVCAR Business Magazine.
Whether you’re selling a business, buying a business or merging two or more businesses, there are myriad tax and legal issues that need to be navigated, such as financing structure, purchase price allocation and fair trade laws.
Consulting tax and legal professionals early in the process is the best way to predict, address and resolve these issues in a smart and timely fashion. This is critical because many of the issues that arise during the merger and acquisition discussions can greatly impact the financial viability of the company long term.
When going into an acquisition or sale, you need to determine whether you are buying or selling assets or buying or selling stock. The difference between the two could have far-reaching economic impacts.
A typical asset transaction will have a greater benefit to the buyer. As the buyer of assets, you’re allowed to record the assets purchased on your books at the fair market value of what was paid, which should allow a higher tax deduction for depreciation or amortization of those particular assets.
As the seller of assets, you’re doing exactly that — selling assets. The IRS, however, looks at certain assets as “hot assets,” which may require the seller to recognize the sale of these assets at ordinary income rates rather than capital gains rates. Examples include cash basis accounts receivable, depreciation recapture and certain inventory items.
The allocation of purchase price is paramount to both the buyer and seller. The buyer will want to allocate as much of the purchase price short-lived assets as possible. Short-lived assets include items such as machinery, equipment, furniture and inventory.
Items such as goodwill, customer lists or non-compete agreements should be amortized over a 15-year period for tax purposes. The buyer should allocate the least amount of the purchase price to long-lived assets, such as buildings and land. Any land assets would not be eligible for depreciation at all.
Conversely, the seller will want to allocate as much of the purchase price to assets that will create capital gain treatment, such as goodwill, customer lists and non-compete agreements, as well as land and other assets with a fair market value greater than the original tax cost.
Because of the varying degrees of tax implications resulting from the transaction, the buyer and the seller will most likely have a difference of opinion when it comes to allocating the purchase price. Therefore, it would be beneficial to have a third party appraisal of what is being purchased to ensure less friction between the two sides of the table.
One of the biggest benefits to the buyer in the case of an asset purchase does not have a direct tax impact but can have a far-reaching economic impact. Under an asset purchase, the buyers do not assume would-be contingent liabilities related to the seller — the seller would have to report those liabilities themselves.
Now let’s take a quick look at another type of transaction that may occur. There is a looming matter that needs to be understood and doesn’t have a direct tax impact but can change the future of the buyer’s company forever.
The buyer of stock indirectly assumes all liabilities of the stock being purchased — this includes all recorded liabilities and all liabilities that were never recorded. Buying stock is much like buying real estate “as-is” — the house may look great from the outside, but the buyer should do his or her homework to see what else is potentially going on inside before the purchase.
Typically, the stock transaction is more beneficial to the seller because the seller will reap the benefit of a capital transaction — similar to the sale of a publically traded stock. If the seller happens to sell at a gain, that income will be picked up at capital gain rates rather than ordinary income rates.
There is one caveat: should the stock be sold at a loss, the tax loss from a capital transaction will currently be limited to an overall loss of $3,000 a year, and the remaining loss will be carried forward to future years. The loss on the sale of company stock can be used to offset other capital gains from other sources, but if this is the only capital transaction for the year, the tax benefit will not be as large as previously imagined.
Buyers need to be aware of purchasing stock. By buying the stock of the company, the company stays intact, and the buyer will not be able to increase the underlying assets to the fair market value.
In essence, the buyer is just taking the company over with the basis in the stock equivalent to the purchase price. The tax write-off of that basis (if any) occurs when the buyer sells the company.
Yet there are times when this type of transaction makes sense from the buyers perspective; one of which is when the transaction does not have room for negotiation and the seller will only sell as a stock transaction. As the buyer of stock,
it would be beneficial to request additional warranties or guarantees from the seller regarding contingent liabilities to cover some of the future “what-ifs.”
Many times, deals are motivated by the desire to join two or more businesses, with continued involvement from the management team and owners. This can be done via a tax-free merger.
A tax-free merger, in its simplest form, occurs when one company acquires a controlling interest in the other company in exchange for at least 80 percent of its stock. This can be accomplished in a few different ways. This first involves a new entity being created and both companies exchanging stock to the new parent company and/or holding company.
Under this method, the former shareholders’ tax basis in the stock they receive is equal to the tax basis of the stock they gave up, and they don’t report taxable gain until the new stock is sold. This can be beneficial if the shareholders of the acquired company are not planning to cash out in the near future.
There are myriad other types of mergers, and most serve a purpose of creating a larger and stronger unified company, but there are several questions that need to be answered when considering a merger:
- Are there states in which your old company has not filed in the past that you now have income tax nexus in, and will need to file an income tax return
- Are there personal property tax returns in new states and counties that will need to be filed?
- Will you need to register the new business in states that you used to do business under the old name?
- Will you need to file a final tax return for your “old” entity?
- Are there payroll matters that need to be addressed?
- Which relationships are you going to keep between the CPA, attorney, insurance division, IT department, HR and the like?
- Which tax attributes carry over to the new company?
- What is the legal status of the new company if the two companies that merge have a different legal and tax status?
Because the process of buying or selling a business can involve an extremely complex series of transactions, it’s important to solicit solid financial advice before signing an agreement. Doing so can set you up with a solid first step in your next business journey.
As a Director in the Tax Department of Ellin & Tucker with more than a decade of tax and financial planning expertise, Dan is one of the firm’s foremost advisors regarding tax-efficient investment strategies and financial tools designed to meet the needs of privately held business in a multitude of industries, as well as high net-worth individuals and their families. He can be reached at firstname.lastname@example.org.