It is all too common that businesses and individuals must deal with unforeseen, adverse tax consequences as a result of transactions that were executed without performing an adequate level of due diligence and without dedicating the necessary amount of time and resources to planning. Unfortunately, in some situations these negative tax consequences are permanent and can have a lasting effect.
While tax consequences should certainly not be the only factor considered when contemplating a transaction, it is critical to understand the tax implications early in the process to ensure that it is structured in the most tax-efficient manner. This will also help ensure that any compliance obligations resulting from the deal are completed and filed within the required timeframe (i.e., elections, statements, etc.).
In many cases, investing the proper amount of time and resources upfront into tax planning can yield a net cash-flow benefit in the form of income tax savings. When reviewing the structure of contemplated transactions, the slightest nuances can yield vastly different tax consequences to the parties involved. A simple example is the direct acquisition of a business, as there are generally two methods for doing so:
- The buyer can purchase the underlying assets of the business from the seller.
- The buyer can purchase the stock/equity of the business from the seller.
From a tax perspective, the two scenarios would have vastly different consequences to both the buyer and seller. Under the first scenario, known as an “asset” acquisition, the buyer receives tax basis in the acquired assets equal to the total purchase price paid (e.g., purchase price plus assumed liabilities), therefore stepping up the tax basis of the acquired assets to Fair Market Value (FMV). The total purchase price is allocated amongst the acquired assets with the excess being allocated to intangibles and goodwill, which become amortizable over 15 years. This effectively provides the buyer the ability to recover its purchase price and realize a cash tax benefit via the tax deductions. From the seller’s perspective, the treatment varies between corporations and individuals, depending on the tax profiles as tax rates differ with individuals receiving a preferential capital gains rate, while a corporation might have tax attributes available to shield or reduce its tax liability. Other factors to be considered in asset acquisitions include the transferability of the assets (i.e., any legal restrictions), as well as transfer taxes, which can be a surprise to some as state rules vary widely.
Under the second scenario, known as a “stock” acquisition, the buyer does not receive a stepped-up tax basis in underlying assets to FMV but rather a carryover basis in the assets. Further, if the acquired business has tax attributes, their utilization could become subject to limitation. From the seller’s perspective, the sale should result in capital gains treatment, and, as discussed above, the tax profiles impact the consequences.
To further complicate things, there are certain elections available, each with their own specific requirements that would treat stock acquisitions as asset acquisitions, which is beyond the scope of this article.
The proper upfront tax planning can help facilitate a transaction that makes sense for all parties involved. The U.S. has one of the most complex tax regimes in the world, and the slightest change in facts or circumstances can yield a completely different tax result. Until Congress can find a way to streamline the tax rules, it is important to be proactive in reviewing the tax implications of a deal structure to avoid surprises.
Christopher Phelan is a Senior Manager at CBIZ MHM in New York. Christopher can be reached at firstname.lastname@example.org.