Tax Considerations in M&A
This guide provides a general overview of tax considerations in M&A. Tax laws are complex and constantly changing. Always consult qualified tax advisors for specific situations. This is not tax advice.
Tax considerations often drive deal structure more than any other factor. A well-structured transaction can save millions in taxes, while poor tax planning can destroy value for both parties. This guide covers the key tax implications in M&A.
The Two Fundamental Tax Questions
For the Seller
"How do I minimize taxes on the gain?"
• Capital gains vs. ordinary income?
• Immediate taxation vs. deferral?
• Federal + state tax rates?
For the Buyer
"How do I maximize future tax deductions?"
• Step-up in asset basis?
• Deductible goodwill / amortization?
• Future tax savings from deductions?
Asset Purchase vs. Stock Purchase: Tax Implications
| Factor | Asset Purchase | Stock Purchase |
|---|---|---|
| Buyer: Step-Up in Basis | YES Can depreciate/amortize assets at FMV |
NO Inherit seller's tax basis (usually low) |
| Buyer: Goodwill Deductibility | YES Amortize over 15 years (Section 197) |
NO Not deductible (unless 338(h)(10)) |
| Seller: Tax Treatment | WORSE Ordinary income + capital gains |
BETTER All capital gains (lower rate) |
| Seller Entity Type | Matters less - recapture rules apply | C-Corp: one level tax S-Corp/LLC: pass-through |
| Net Tax Impact | Buyer Wins Gets valuable step-up |
Seller Wins Lower tax rate |
Understanding Step-Up in Basis
What is a Step-Up and Why Does it Matter?
The Concept:
When a buyer acquires assets, they establish a new tax basis equal to the purchase price. This "steps up" the basis from the seller's usually-low historical cost to current fair market value.
The Value:
Higher basis = more depreciation/amortization = lower taxable income = tax savings
Example:
Asset Purchase at $100M:
- Equipment allocation: $20M → Depreciate over 5-7 years
- Customer relationships: $15M → Amortize over 15 years
- Goodwill: $65M → Amortize over 15 years
Annual tax deduction: ~$6.7M
Annual tax savings (@ 25% rate): ~$1.7M
PV of tax savings (10 years): ~$10-12M
This is REAL VALUE to the buyer!
Seller Tax Implications by Entity Type
C-Corporation Seller
Stock Sale (Preferred by Seller):
Purchase Price: $100M
Seller's Stock Basis: $5M
Gain: $95M
Federal tax (20% long-term cap gains): $19M
State tax (varies, ~5%): $4.75M
Net Medicare tax (3.8%): $3.6M
Total Tax: ~$27.4M (27.4%)
Net to Seller: $72.6M
Asset Sale (Worse for C-Corp):
Two levels of tax:
1. Corporate level: Tax on asset gains
2. Shareholder level: Tax on distribution
Effective rate: 35-50% (state dependent)
Much worse than stock sale!
C-Corps almost always prefer stock sales
S-Corporation / LLC Seller (Pass-Through)
Stock Sale:
Purchase Price: $100M
Seller's Basis: $10M
Gain: $90M
Tax rate: 20% + 3.8% + state (varies)
Total: ~29-33%
Net to Seller: $67-71M
Asset Sale (with 338(h)(10) Election):
Can elect to treat stock sale as asset sale for tax purposes
- Seller: Still pays tax (same as asset sale)
- Buyer: GETS STEP-UP IN BASIS!
This is the "best of both worlds" structure
Commonly negotiated: Buyer pays seller for tax cost
Example Negotiation:
Asset sale causes $5M extra tax to seller vs. stock sale
Buyer values step-up at $10M (PV of future tax savings)
Solution: Buyer pays $3M additional to seller
- Seller net: Same as stock sale
- Buyer net: Still saves $7M vs. stock purchase
- Win-win!
The 338(h)(10) Election - Magic for S-Corps
The Best Structure for S-Corp / LLC Sales
What is it?
A tax election that treats a stock purchase AS IF it were an asset purchase for tax purposes.
How it Works:
- Transaction is legally a stock purchase
- But for tax purposes, treated as asset purchase
- Seller pays tax as if assets sold (higher tax)
- Buyer gets step-up in asset basis (valuable tax benefit)
When to Use:
- Target is S-Corporation or LLC
- Buyer wants step-up in basis
- Parties negotiate to share tax benefit
The Math:
Without 338(h)(10):
Seller net: $71M (stock sale, lower tax)
Buyer NPV: $88M (no step-up)
With 338(h)(10):
Seller gross: $100M
Seller tax: $33M (asset sale, higher tax)
Seller net: $67M
Buyer gross: ($100M)
Buyer step-up value: +$12M
Buyer net: ($88M)
Seller loses: $4M
Buyer gains: $12M
Negotiation: Buyer pays additional $2-4M to seller
Final: Both parties better off!
Capital Gains vs. Ordinary Income
📈 Capital Gains (Better)
Rate: 0%, 15%, or 20% (based on income)
Plus: 3.8% net investment income tax
Plus: State taxes (varies)
Total: 23.8% - 33% typically
📉 Ordinary Income (Worse)
Rate: Up to 37% federal top rate
Plus: 3.8% net investment income tax
Plus: State taxes (varies)
Total: 40.8% - 50%+ depending on state
Asset Sale Allocation Example:
Total Purchase Price: $100M
Allocation:
- Inventory: $5M → Ordinary income to seller
- Equipment: $20M → Depreciation recapture (§1245/1250)
• Amount above depreciated basis: Ordinary income
• Amount above original cost: Capital gains
- Real Estate: $15M → Depreciation recapture + capital gains
- Customer Lists: $10M → Capital gains
- Goodwill: $50M → Capital gains
Seller's tax varies based on recapture vs. capital gains portions
Tax-Free Reorganizations
Deferring Taxes Through Stock-for-Stock Exchanges
The Opportunity:
Under IRC Section 368, certain merger structures allow seller shareholders to defer taxation if they receive buyer's stock instead of cash.
Requirements (Simplified):
- Continuity of Interest: Seller shareholders must receive substantial stock (typically >40% stock consideration)
- Continuity of Business: Buyer must continue target's business or use target's assets in a business
- Business Purpose: Must have valid business purpose beyond tax avoidance
Types of Tax-Free Reorgs:
- Type A: Statutory merger
- Type B: Stock-for-stock
- Type C: Stock-for-assets
The Benefit:
Example:
Seller receives $100M in buyer stock (no cash)
Seller's basis: $10M
Gain: $90M
Tax if taxable: $27M immediately
Tax if tax-free reorg: $0 now (deferred until sell buyer stock)
Seller can time recognition by selling buyer stock over time
The Trade-Off:
- Seller takes buyer's stock risk
- Buyer doesn't get step-up in basis
- More complex structuring requirements
Key Tax Considerations
1. Depreciation Recapture
Section 1245: Equipment depreciation recapture (ordinary income)
Section 1250: Real estate depreciation recapture (often 25% rate)
Impact: Asset sales trigger recapture, increasing seller's ordinary income tax
Example:
Equipment original cost: $10M
Accumulated depreciation: $8M
Book value: $2M
Sale price: $12M
Recapture (§1245): $8M taxed as ordinary income (~40%)
Gain above original cost: $2M taxed as capital gain (20%)
Without recapture awareness, seller underestimates tax!
2. State and Local Taxes
Don't forget state taxes - they can add 5-13% depending on location!
Considerations:
- State income tax rates (0% in TX, FL, WA vs. 13.3% in CA)
- Domicile of seller (where they pay tax)
- Source of income rules (where business is located)
- Potential for double taxation (multiple states)
Asset Purchase State Tax Issues:
- Sales tax on asset purchases in some states
- Transfer taxes on real estate
- Can add 1-3% to deal cost in some jurisdictions
3. Net Operating Losses (NOLs)
Buyer Consideration: Can you use target's NOLs post-acquisition?
Section 382 Limitations:
- Stock purchase with >50% ownership change limits NOL usage
- Annual limitation = Value × IRS rate (~5-6%)
- Can significantly reduce NOL value
Example:
Target has $20M in NOLs
Purchase price: $50M
Section 382 limitation: $50M × 5% = $2.5M/year
Can only use $2.5M of NOLs per year (not all $20M immediately)
Takes 8 years to fully utilize
PV of NOLs much lower than face value
Planning: Sometimes structure deals to preserve NOLs
4. Purchase Price Allocation (IRC Section 1060)
Requirement: In asset sales, buyer and seller must agree on allocation of purchase price among assets
IRS Class System (allocated in order):
- Class I: Cash and cash equivalents
- Class II: Marketable securities
- Class III: Accounts receivable
- Class IV: Inventory
- Class V: Fixed assets (equipment, real estate)
- Class VI: Intangibles (customer lists, patents)
- Class VII: Goodwill and going concern value
Why It Matters:
- Determines depreciation/amortization for buyer
- Determines ordinary income vs. capital gain for seller
- Buyer and seller may have conflicting preferences
- Must file Form 8594 with IRS
Negotiation:
- Buyer wants more in Class V-VII (depreciable/amortizable)
- Seller wants more in Class VII (capital gains)
- Often negotiate compromise allocation as part of deal
International Tax Considerations
🌍 Cross-Border M&A
Withholding Taxes: Non-resident sellers may face withholding (10-30%)
Transfer Pricing: Must use arm's-length pricing for intercompany transactions
Tax Treaties: May reduce withholding rates
CFC Rules: Controlled Foreign Corporation complexity
💼 Inversion Transactions
Concept: Redomicile to lower-tax jurisdiction
Anti-Inversion Rules: IRC § 7874 restricts inversions
Requirements: Substantial business activity in new country
Planning: Complex, requires expert advice
Tax-Efficient Deal Structures
Structure 1: S-Corp with 338(h)(10)
Best for: Domestic S-Corporation or LLC sellers
Benefits:
- Buyer gets step-up (future tax savings)
- Seller gets single level of tax
- Negotiate sharing of benefit
Process:
1. Structure as stock purchase legally
2. File 338(h)(10) election (joint election)
3. Buyer grosses up price to compensate seller for higher tax
4. Both parties win vs. alternatives
Structure 2: Tax-Free Reorganization (Type A Merger)
Best for: Seller wants tax deferral, buyer can issue stock
Benefits:
- Seller defers tax until sells buyer stock
- Can structure with some cash (tax-able) and stock (tax-free)
- Buyer issues stock (preserves cash)
Requirements:
- Minimum 40% stock consideration (often 50%+ safer)
- Continuity of business
- Valid business purpose
Trade-offs:
- Buyer dilutes existing shareholders
- No step-up in basis for buyer
- More complex structuring
Structure 3: Installment Sale
Best for: Seller wants to spread tax liability
Benefits:
- Seller recognizes gain as payments received
- Spreads tax over multiple years
- Can help stay in lower brackets
Structure:
- $20M at close
- $10M/year for 5 years (seller note)
Taxes:
- Pay tax on gain proportionally as received
- Interest income taxed as ordinary income
Risks:
- Seller has buyer credit risk
- IRS rules on minimum interest rates (AFR)
Common Tax Mistakes
❌ Not Involving Tax Advisors Early
Most common and costliest mistake. Tax structure should be determined before LOI, not during definitive agreement negotiation.
Fix: Engage tax counsel/CPAs during initial structuring discussions
❌ Ignoring Step-Up Value
Buyers often don't properly value the step-up in basis, missing opportunity to offer higher price.
Fix: Model NPV of future tax savings from step-up. Often worth 10-15% of purchase price.
❌ Not Negotiating Purchase Price Allocation
Buyer and seller have different preferences for allocation. Failure to address leads to IRS disputes.
Fix: Negotiate and document allocation as part of definitive agreement (exhibit to purchase agreement).
Best Practices
1. Early Tax Planning
Engage tax advisors before LOI. Structure drives economics.
2. Model the Tax Impact
Build spreadsheets showing after-tax proceeds to seller and NPV of tax benefits to buyer under different structures.
3. Negotiate Tax Allocation
If buyer gets tax benefit (step-up), consider sharing some value with seller through higher purchase price.
4. Document Everything
Clear allocation schedules, tax elections, and agreements to avoid disputes and IRS challenges.
5. Consider Combined Optimization
Sometimes the optimal structure isn't best for either party alone, but maximizes joint after-tax value.
6. State Tax Matters
Don't forget state taxes - can add 5-13% and vary by structure.
7. International Requires Specialists
Cross-border deals require international tax specialists. Don't attempt without expert help.
8. Tax Law Changes
Tax laws change frequently. Ensure advice is current (TCJA 2017 changed many rules, future changes possible).
References
Last updated: Wed Jan 29 2025 19:00:00 GMT-0500 (Eastern Standard Time)