Business combinations can occur in the form of asset acquisitions or stock acquisitions. From a buyer's perspective, there are many tax advantages to structuring a business combination transaction as an asset acquisition. Conversely, from a seller's perspective, the tax advantages are greater when the transaction is structured as a stock acquisition. For the potentially substantial tax benefits, buyers will frequently pay a premium to structure a business acquisition transaction as an asset acquisition. Another way to structure a business combination transaction is as a hybrid between an asset acquisition and a stock acquisition, through a qualified stock purchase with a Sec. 338 election.
In a stock acquisition transaction, if the acquisition is a qualified stock purchase and an election is made under Sec. 338, the stock acquisition is treated as an asset acquisition for tax purposes. Under this scenario, the buyer will have the privilege of a step-up in basis of the seller's assets. At the closing of the transaction, the seller's assets will be revalued and stepped up to fair market value (FMV) on the buyer's balance sheet, which will closely reflect the purchase price. The buyer allocates any amount of the purchase price that exceeds the FMV of the asset acquired to goodwill on its balance sheet.
Under the Sec. 338 election, the parties treat the transaction as a stock sale for legal purposes, so the buyer will still acquire the seller's liabilities and stock, in addition to its assets. The asset sale generates taxable gain to the seller. Often, the parties will structure the transaction so that the buyer bears the burden of paying tax on the gain. The gain will be an adjustment on Schedule M-1 of the corporate return, since it is a tax-only item under the election. To make a Sec. 338 election, the buyer must execute a qualified stock purchase, which is a transaction or series of transactions in which a buyer purchases at least 80% of the total voting power and value of the seller's stock within 12 consecutive months after the initial purchase of the stock (Sec. 338(d)(3)).
Under an asset acquisition, the foremost tax benefit to the buyer is the step-up in basis of the assets acquired. Should the buyer sell the acquired assets in the future, it will recognize less gain, and thus its tax liability will be lower, since the assets will have been revalued up to their FMV.
A second tax benefit to the buyer of a step-up in basis of the assets acquired is its ability to take a depreciation expense on the revalued assets. The depreciation expense will be deductible on the buyer's tax return, which will decrease its tax liability.
The third major tax benefit to the buyer in an asset acquisition comes into play when the purchase price of the assets acquired is greater than the FMV and thus creates goodwill. Under Sec. 197, the buyer can amortize goodwill and deduct it over 15 years. This produces a substantial tax benefit to buyers in many asset acquisitions.
In stock acquisitions, sellers will typically enjoy paying less tax, in contrast to asset acquisitions. In an asset acquisition, assuming the selling company liquidates, the seller will be taxed twice—once at the corporate level when the assets are sold and once at the shareholder level when the company is liquidated. In a stock acquisition, the seller pays tax only at the shareholder level.
Transaction Within Qualified Stock Purchase
The IRS recently issued Letter Ruling 201622012 regarding a specific type of transaction pursuant to a qualified stock purchase under Sec. 338. The ruling indicates that when a buyer is conducting an asset acquisition and furnishes an asset sale note in exchange for the purchase of the seller's assets, and the seller later cancels the note, it would be treated as a distribution in proposed liquidation, as opposed to a sale of property to an acquisition subsidiary. Consider the following example to illustrate the letter ruling:
Example: Company A is the buyer and is a C corporation that is a parent in an affiliated group of companies that files a consolidated tax return. Company B is a C corporation and is a 100%-owned subsidiary of Company A. Company X is a stand-alone C corporation and the seller. Company A would like to acquire Company X and make a Sec. 338 election to receive the step-up in basis of the assets acquired. Company A makes an initial offer to acquire 100% of the outstanding shares of stock of Company X. Once the terms of the transaction are agreed upon, Company B will purchase shares of Company X at the price per share in the agreement. Note that Company B will not acquire 100% of the shares in one transaction but will continually purchase shares until the transaction falls within the "asset sale range."
Once Company B purchases enough of Company X stock to fall within the asset sale range, the proposed liquidation will begin. The asset sale by Company X, followed by the dissolution of the company, is referred to as the proposed liquidation. At this point, Company X will initiate the sale of its assets to Company B. In return, Company B will provide an asset sale note to Company X. Subsequent to the asset sale, Company X will make liquidating distributions that are composed of the cancellation of the asset sale note and cash received from the sale of its stock. The cash distribution from the sale of stock will be administered to the Company X minority shareholders. Note that Company B has already acquired a controlling portion of Company X stock by this point but not 100% of the stock.
In the letter ruling, the IRS ruled that the scenario described in the example above is considered a distribution in proposed liquidation, as opposed to a sale of property to an acquisition subsidiary. This transaction also satisfies the conditions to be a qualified stock purchase.
In business acquisitions, there is often a substantial tax benefit to buyers to structure the transaction as an asset acquisition, due to the amortization of goodwill and depreciation on the FMV of the asset acquired. Making a Sec. 338 election is one way to achieve these tax benefits for a buyer. Sellers prefer to structure business acquisition transactions as stock sales because they incur only one level of tax, as opposed to two levels in an asset sale. A Sec. 338 election can provide benefits to both parties, but the transaction must be carefully structured so that it satisfies the conditions to be a qualified stock purchase.
Mark Cook is the lead tax partner with SingerLewak LLP in Irvine, Calif.
For additional information about these items, contact Mr. Cook at 949-261-8600 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with SingerLewak LLP.