Treating a Stock Purchase as an Asset Purchase for Tax Purposes
February 23, 2015 at 11:43 AM
When selling or buying a business think of the transaction structure as a three legged stool. The three legs are Price, Terms and Taxes. If any one of these “legs” are not well built your deal will collapse. Below is an excellent article about a tax strategy many sellers and buyers fail to consider. Thanks to our guest blogger Shaun Simma of Simma, Flottemesch & Orenstein.
As a matter of non-tax law, it is often preferable and less cumbersome to structure the sale of a business as a stock sale rather than as a sale of assets. Stock sales, however, do not allow purchasers to benefit from a “step up” in the basis of the acquired company’s assets. In such circumstances, parties to a transaction can utilize one of the few, genuine tax benefits of the tax code, an election under Section 338(h)(10), which permits taxpayers to achieve the tax benefits of an asset sale while structuring the transaction as a stock sale.
Benefits and risks of a section 338(h)(10) election. The U.S. Tax Code allows buyers and sellers of the stock of an S corporation to make a section 338(h)(10) election so that a qualified stock purchase will be treated as a deemed asset purchase for federal income tax purposes. A section 338(h)(10) election is a joint election that requires agreement between and among all of the selling shareholders and the prospective buyer. As a result of this election, a stock sale, for legal purposes will be treated as an asset sale for tax purposes, resulting in different tax consequences for both the buyer and seller. Selling shareholders need to understand these tax consequences. Importantly, a section 338(h)(10) election will adjust the tax basis of the S corporation’s assets in the hands of the buyer to fair market value. As a result, the buyer may enjoy incremental tax benefits, including amortization and depreciation of the assets’ purchase price for federal income tax purposes, along with resulting future tax deductions for the amount paid over the tax life of the acquired assets.
The deemed asset sale treatment may have negative tax consequences that selling shareholders need to consider. By agreeing to make a section 338(h)(10) election, selling shareholders may subject themselves to various federal and state taxes that a straight stock sale, one without a section 338(h)(10) election, would not generate.
Additionally, S corporations that sell assets within 10 years of converting from a C corporation are subject to built-in gains tax. The built-in gains tax imposes a corporate level tax on the portion of the gain that existed as of the C to S conversion date. Recent tax acts have provided for a temporary reduction in the 10 year built-in gains recognition period for certain sale transactions.
Some of the gains from a deemed asset sale may be taxed at ordinary rates. For example, purchase price allocated to fixed assets may result in ordinary gain due to depreciation recapture and gains associated with the difference between the fair market value of inventory and the tax basis may also be taxed at ordinary rates. On the other hand, assumption of certain liabilities might result in additional ordinary deductions to the S corporation today that were disallowed in prior years under the economic substance rules. It is important for selling shareholders to understand these tax implications, both for themselves and the buyer, before agreeing to make the election.
A straight stock sale may result in no state income taxes owed if the selling shareholders reside in states without an income tax, whereas a deemed asset sale may result in state taxes owed in the states where the S corporation operates.
Selling shareholders will want to understand both the costs associated with making a section 338(h)(10) election and the tax benefits in the hands of the buyer. It is possible that the tax benefits may substantially outweigh the costs. As a result, buyers may be willing to reimburse selling shareholders for any incremental costs incurred. Sellers who understand the potential benefits resulting from the step-up transaction may also be in a position to negotiate a higher purchase price by clearly articulating those benefits to potential buyers.
Early planning is another important consideration. S corporation shareholders should begin to weigh the benefits and risks of a section 338(h)(10) election at the earliest possible stages of a transaction, in most cases before a letter of intent is signed with a prospective buyer. The letter of intent often contains specific terms that address the transaction structure. Both sellers and the prospective buyer can save time, money, and resources by making an informed decision regarding the section 338(h)(10) election before the letter of intent is signed.