Buying or Selling a Company? Consider Tax Implications of Asset vs. Equity Transaction

Value, like beauty, is largely in the eyes of the beholder. But when it comes to the value realized in a business transaction, the ultimate value can be influenced by the tax attributes of the deal.

While there are various methods to purchase a business, asset and equity deals are the most common. These methods of acquisition and sale can offer a wide range of pros and cons to the parties involved. Tax consequences can quickly turn a good deal into a poor one, but buyers and sellers alike can minimize their tax footprint through careful deal structuring.

The Difference Between an Asset and an Equity Purchase

In an asset purchase, the buyer acquires targeted assets and liabilities from the seller, also known as the target company. In some cases, the purchase takes the form of a direct asset purchase, where the acquirer selects specific assets and liabilities from the target. The buyer may only be interested in particular components, such as real property, inventory, equipment, existing contracts, and intellectual property. The terms of the deal will identify the components that the purchaser will acquire, while the seller retains anything not included. After the transaction, the target company can choose whether or not to remain in existence. Often, the target company will dissolve as a result of the sale (or sometime soon thereafter). Asset deals can be mechanically and logistically easier to execute, but it depends on the buyer’s flexibility and discretion. 

In an equity purchase, the buyer purchases the target company’s outstanding equity and generally receives a basis in the company equal to the amount paid. The target company generally remains intact after the transaction, as ownership is simply transferred to the buyer. A few variations of equity structured deals include purchase of LLC membership interest, purchase of corporate stock, redemptions, and reverse subsidiary mergers. Equity deals are often observed where larger companies are merging in smaller competitors. Investment companies, such as private equity groups, also typically structure deals via acquiring equity. Equity deals can offer more continuity and transfer supplementary value in the control of the target company to buyers in the form of retained brand recognition, customer continuity, and other benefits.

Tax Implications of an Equity Purchase

In a purchase of equity (from a legal perspective), tax treatment can vary widely depending on the underlying facts and circumstances. For example, a selling shareholder of subchapter C corporate stock will benefit from paying a single level of tax (at the individual level), and each shareholder’s holding period will determine whether the capital gain or loss will be treated as short-term or long-term. A member of an LLC selling membership interest is actually selling equity from a legal perspective, but from a tax perspective, the transaction may be deemed an asset sale.

Other sell-side tax implications include the following:

• In sale of subchapter C corporate stock, tax basis in assets and tax attributes generally remains unchanged (although utilization of tax attributes may be limited under IRC 382).
• Shareholders of the target company recognize gain or loss on the difference between the purchase price and their basis in the shares of the target. At the entity level, however, there is typically no recognition of taxable gain or loss.
• There could be potential application of the qualified small business stock gain exclusion (IRC 1202).

Buy-side tax implications of an equity deal include the following:

• Buyers are not able to select specific liabilities to acquire. Instead, the buyer automatically assumes any liabilities present at closing.
• Because the basis in the target company’s assets is not stepped up, the buyer is not able to recoup costs through tax deductions for depreciation and amortization.
• The buyer does, however, inherit the target company’s tax attributes, including net operating losses (NOLs) and tax credit carryforwards (although utilization of these tax attributes may be limited by IRC 382).
• The buyer also assumes the target’s undisclosed liabilities and uncertain tax positions.
• Various transaction and legal expenses associated with the acquisition are permanently capitalized into the equity basis and are not eligible to be amortized and deducted, although some exceptions may apply.

Tax Implications of an Asset Purchase

Buyers typically prefer structuring acquisitions as asset deals because they receive a step-up in the basis of the acquired assets, including allocating stepped-up tax basis to intangibles and goodwill. This stepped-up tax basis will generally allow for accelerated depreciation and amortization deductions, allowing buyers to recover the acquisition cost more quickly.

Other buy-side tax implications include the following:

• The buyer has the opportunity to exclude unwanted assets and liabilities.
• The buyer generally does not inherit exposure for pre-closing income taxes, any unassigned or undisclosed legal liabilities, and uncertain tax positions.
• Various transaction and legal expenses associated with the acquisition are generally eligible to be capitalized, and as a result, amortized and deducted over 15 years.
• On the downside, the acquirer also doesn’t receive the target’s tax attributes, such as NOLs and tax credit carryforwards.

Sell-side tax implications in an asset sale include the following:

• In sale of subchapter C corporate stock, shareholders are taxed on the proceeds twice — once at the company level and again at the shareholder level.
• The character of gain or loss recognized is determined on an asset-by-asset basis.
• Tax attributes remain with the target.

From a purely tax perspective, buyers tend to benefit from transactions structured as asset purchases, while pure stock purchases are most advantageous to sellers. However, sometimes parties seek to structure the deal so that it applies some of the benefits of each method. As mentioned above, there are various deal structures that result in treating the sale as an asset purchase for tax purposes and a stock purchase for legal purposes.

Protect Your Interests

Whether you’re involved in a transaction as a buyer or a seller, your ultimate goal is to maximize deal value while minimizing your tax encumbrance. From a seller’s perspective, understanding a buyer’s incentive to structure the deal methodology allows for optimizing the seller’s positioning and negotiating. Buyers should be aware of the implications of assuming liabilities (disclosed and undisclosed) and understand the value of an enterprise’s continuation.

To realize the full value of your transaction, bring your tax advisors to the table as early as possible. The sooner you address differences in position, the sooner you can come together on a workable solution.

Whether you're considering a sale or acquisition or have already signed a letter of intent, contact your CRI tax advisors. Wherever you are in the transaction life cycle, we can help.