By: Bob Cutolo, CPA
Corporate mergers and acquisitions are generally classified as either stock or asset deals, and the tax consequences for the buyer and seller vary accordingly.
During an asset sale, the buyer can purchase the entire inventory of assets and obligations of the target corporation or choose to buy only selected assets and liabilities. The seller retains the legal ownership of the corporation that is now funded with the sale proceeds but without the sold assets and liabilities. Certain seller liabilities or obligations not identified during due diligence won’t be a problem for the buyer in an asset sale.
Buyers usually prefer asset sales because they can “step up the basis in purchased assets, which offers a future tax benefit by increasing the buyer’s after-tax cash flows due to greater depreciation expenses. Buyers may purchase more because they want higher after-tax cash flows. Bonus depreciation applies to the purchased assets and is typically an 80% deduction in 2023 for purchased assets with a useful life of twenty years or less.
The main disadvantage of selling an asset is that the seller may have to pay more taxes as a result of the transaction since some of the sale profits will be treated as ordinary income rather than capital gains. Because of this, sellers typically favor a stock sale, at least from a tax perspective.
An election under Section 338(h)(10) of the Internal Revenue Code of 1986, as amended (IRC), treats a stock purchase as a deemed asset purchase for federal tax purposes. It remains a stock purchase for all other legal purposes, and the seller must be either a U.S. corporate subsidiary of a parent company or an S corporation. Buyers often prefer this election because they receive a tax basis in the acquired assets equal to their fair market value. Sellers generally prefer a stock deal without the election, and their agreeing to it is regularly predicated on a higher purchase price.
In a stock sale, a buyer acquires the outstanding shares directly from the shareholder of a C or S corporation. The buyer assumes full ownership of the business, including its assets and liabilities. Since share transactions are taxable as capital gains, the seller is subject to a lower rate on their taxable gain.. If the target is a C corporation subject to double taxation, the seller would benefit even more.
Unlike an asset sale, a taxable stock sale does not cause taxable income or loss to be recognized at the company level. The corporate double taxation issue is postponed and ultimately may be an issue for the buyer, even though the selling shareholders could recognize taxable gain on the sale of their shares.
Additionally, the buyer obtains control over the corporation’s tax attributes, including its net operating loss, capital loss, tax credit carryovers, and other built-in losses. However, under IRC Sections 382 and 383, these attributes may be significantly restricted following a change in corporate control. Conversely, the tax attributes of the selling corporation are still in the seller’s hands in an asset sale and can be used to reduce income and gains from the asset sale.
After a stock sale, sellers are typically released from most continuing obligations. However, a purchase agreement may transfer some of these obligations back to the seller. Critically, because there is no basis “step-up” to compensate for the increased depreciation expense, the buyer does not receive the same favorable tax treatment as they would in an asset purchase. Instead, the assets remain as they were in the past. Moreover, since all future and contingent liabilities are assumed (unless mitigated within the purchase agreement), buyers are likewise exposed to risk.
For further information, contact your MSPC Partner or Bob Cutolo, CPA.