A buyer in an acquisition may reap tax savings through a deal structure involving tax basis step-up. Yet structuring options are numerous and complex. Comparing these options and their costs and benefits was part of a detailed Grant Thornton LLP webcast. This article presents an overview.
Potential benefits of tax basis step-up
Structuring options and what they entail
Provides a tax shield for the buyer to offset taxable income in future years
Allows a tax-efficient recovery of the purchase price
Potentially keeps past tax issues in the past
Can wipe out earnings and profits (E&P) of foreign targets, which makes it more tax-efficient to repatriate offshore profits
Avoids inside/outside basis complications
May make a future sale easier
A buyer may prefer to purchase some or all assets because it facilitates stepped-up basis while limiting liability assumption. Such a deal is also simple and easy to understand. In smaller deals, this is probably the most common structure used.
This structure is generally feasible only if the target is a pass-through entity. C corporations seldom sell assets without net operating losses (NOLs) sufficient enough to offset the gain. With a C corporation, an asset sale results in double taxation when sale proceeds are distributed to shareholders, either in liquidation or as a distribution.
On the downside, this type of sale brings into play business issues such as novation of contracts, government licenses and other “hard to transfer” assets.
Forward cash merger
This transaction leads to tax results that are similar to those of a straight asset sale and is sometimes employed when purchasing an entire business rather than certain assets. The target merges with and into the buyer or a merger subsidiary (with the acquiring entity surviving), and is taxed as if the target sold its assets for cash and liquidated. The buyer receives stepped-up basis of the assets purchased but does inherit the target’s tax history, as well as any nontax liabilities of the company.
This type of sale requires approval of target shareholders.
Purchase of single-member LLC interest
The purchase of some or all of a single-member limited liability company (LLC) is generally taxed as an asset purchase, resulting in a tax basis step-up for the buyer. There are a number of variations on this transaction, which is widely used. Variants of this transaction can also work for other types of disregarded entities, such as qualified subchapter S subsidiaries.
Private equity transactions often use some form of this approach, where the transaction is treated as a transfer of a portion of the LLC’s assets and liabilities to the buyer while the seller rolls over a portion of its investment. The seller’s “rollover” interest is treated as a contribution to a new partnership with the buyer. The buyer receives stepped-up basis of the assets purchased.
Tax implications to the seller include gain or loss on a deemed sale of a portion of each asset. The seller’s portion of retained assets roll over at their old basis, and the buyer gets depreciation/amortization deductions.
Caveat: If you are considering buying less than 100% of the target, make sure you examine Section 704(c), related to partnership formations in which any party contributes assets whose basis does not match value. Section 704(c) is a zero-sum game, so it may set the parties’ respective interests against each other.
Stock purchase with Section 338(g) election
In a stock purchase, Section 338(g) allows the purchaser to treat the transaction as an asset purchase, resulting in tax basis equal to fair market value (FMV) on the date of the acquisition. The result is achieved through a deemed asset sale of all the acquired corporation’s assets to a fictional alter ego. The target is treated as if it were two corporations: The old target is the seller of the assets, and the new target is the purchaser of the assets. The old target sells its assets for the aggregate deemed sales price to reflect the FMV. The new target purchases all its assets for the adjusted gross-up basis to reflect the price indirectly paid.
The buyer receives stepped-up basis in stock and assets, but also bears responsibility for any tax due on the target’s deemed asset sale, because it now owns the target’s stock. The target corporation recognizes gain on the deemed asset sale and owes any tax due. The selling shareholders pay tax only on any gain or loss from the stock sale. The target’s historic tax attributes, including E&P pools, are eliminated.
When drafting a stock purchase or merger agreement under this election, it’s important to make sure the buyer and seller contractually agree to the election and that the requirements for a “qualified stock purchase” (QSP) are met. The amount of stock must satisfy the Section 1504(a) control requirement, generally 80% voting and 80% value.
This election is much more common in foreign acquisitions and used only infrequently in domestic acquisitions due to double taxation. NOLs may make this more feasible in a domestic acquisition, but typically only if there will be a substantial Section 382 limitation on the target’s NOLs.
This election is commonly used when the target is either an S corporation or a subsidiary in a consolidated group. Both buyer and seller must agree to and jointly execute the election.
If an acquiring corporation purchases 80% control of a second corporation within a 12-month period (a QSP), the acquirer may treat the target as if it had purchased its own assets. If a Section 338(h)(10) election is made, the target is treated as a new corporation after the date it acquires 80% control, holding its assets with a stepped-up basis. The buyer receives FMV basis in each asset.
The target recognizes gain or loss on the deemed asset sale; its basis — in the hands of shareholders — is adjusted to reflect the gain. Its deemed liquidation may not result in double taxation, because in an S corporation context, the adjusted basis will reduce any gain, and in a consolidated return, the liquidation may be tax-free under Section 332. However, some gain may be recharacterized as ordinary income, and inside/outside basis differences will be triggered. There is no tax-free rollover for shareholders continuing in the new structure because a QSP requires a fully taxable sale. Parties often agree that the buyer will gross-up the purchase price for any incremental tax incurred by the seller as an incentive to make the election.
Section 336(e) election
This election garners similar treatment to a Section 338(h)(10) transaction, but without the requirement that the stock acquirer be a corporation. It also expands the opportunity to multiple purchasers and certain distribution transactions. The target is treated as two corporations: The old target is the seller of the assets, and the new target is the purchaser of the assets. The target recognizes gain or loss on the deemed asset sale. The buyer receives stepped-up basis in stock and assets. Under this arrangement, when all considerations are met, the old target’s tax attributes disappear.
This election is useful when the transaction is not a QSP — for example, there is no corporate purchaser, or no single party is buying 80%. The target must be a domestic subsidiary of a consolidated group on the acquisition date, a domestic subsidiary of an affiliated group or an S corporation. The target may unilaterally make the election, and if it does, the election is binding on the buyer as well. However, if the target is an S corporation, it and all its shareholders must enter into a binding agreement to make the election.
Because it’s a unilateral sell-side election, it is important that stock purchase agreements are clear about whether a Section 336(e) election can be made.
Another way a buyer can receive stepped-up basis in assets is through a Section 368(a)(1)(F) reorganization, which entails formation of a holding company and the transfer of a target to the holding company, followed by a conversion of the target company to a disregarded entity (such as a qualified subchapter S subsidiary or single member LLC). Once the F reorganization is complete, the new holding company can sell some or all of the target as discussed above.
A Section 754 election can work when a target is a partnership, or if it structures into one through a so-called “pre-formed” partnership transaction.
Get the deal right
Before a buyer opts for tax basis step-up, it has to investigate the pros and cons to be sure a transaction is the right one and worthwhile. There are legal consequences to be considered in addition to the tax issues, and finding the right fit for your deal depends entirely on the facts specific to your case. The details can get complicated fast, so it’s helpful to contact a tax professional.
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