How do Taxes Play a Role in M&A Transactions?

Even though there have been less mergers and acquisitions in 2022, companies are still being bought and sold. If your business is thinking about an M&A transaction by merging with or buying another business, you should know how the deal will be taxed under current law.

M&A Transactions: Stocks vs. Assets

From a tax point of view, there are basically two ways to structure an M&A transaction:

1. Stock (or ownership interest). A buyer can buy a seller’s ownership interest directly if the target business is a C or S corporation, a partnership, or a limited liability company (LLC) that is treated as a partnership for tax purposes.

The current 21 percent federal income tax rate on corporations makes it a little more appealing to buy stock in a C corporation. The company will pay less tax and make more money after taxes than it would have done years ago. Also, when the assets are sold, any built-in gains from assets that have gone up in value will be taxed at a lower rate.

Federal tax rates for individuals are lower now than they were years ago. This may also make it more appealing to own shares in S corporations, partnerships, and LLCs. The income from these entities that is passed through to the buyer will also be taxed at lower rates on the buyer’s personal tax return.

Individual rate cuts, on the other hand, are set to end at the end of 2025. Depending on what happens in Washington, they could end sooner or last longer.

2. Assets. A buyer can also buy a business’s assets. This could happen if the buyer is only interested in certain assets or product lines. And it’s the only choice if the business you want to buy is a sole proprietorship or an LLC with one member that’s treated as a sole proprietorship for tax purposes.

Buying stock in a company can sometimes be treated as buying an asset by making a “Section 338 election.” Ask your tax advisor for details.

READ MORE: Buying or Selling a Business: How to Allocate Assets

What do buyers and sellers want in an M&A transaction?

Buyers usually prefer to buy assets instead of ownership interests for a number of reasons. Usually, a buyer’s main goal is to get enough cash flow from a business they buy to pay off any debt they took on to buy the business and get a good return on their investment. So, buyers want to limit their exposure to unknown and undisclosed liabilities and pay as little tax as possible after the deal closes.

A buyer can increase the tax basis of an asset to reflect its purchase price. This is called “stepping up.” When certain assets, like receivables and inventory, are sold or turned into cash, stepped-up basis lowers the amount of taxable gains. It also raises the deductions for depreciation and amortization for assets that qualify.

Sellers, on the other hand, tend to prefer stock sales for tax and other reasons. One of their main goals is to pay as little tax as possible on a sale. Most of the time, they can do this by selling their ownership interests in a business, such as corporate stock or partnership or LLC interests, as opposed to selling assets.

When a stock or other ownership interest is sold, the buyer usually takes on the seller’s obligations, and any gain from the sale is usually treated as a long-term capital gain, which is taxed less (assuming the ownership interest has been held for more than one year).

Keep in mind that other things, like employee benefits, can also cause tax issues that you didn’t expect when you buy or merge with a business.

READ MORE: Eligibility for Small Business Tax Benefits Expanded

Get help from a professional

Buying or selling a business could be the most important deal you make in your life, so it’s important to get tax advice from a professional while you’re negotiating an M&A transaction. It may be too late to get the best tax results after a deal is done. Get in touch with us to find out how to handle your situation best.

Originally posted 2.16.21. Updated 7.5.22 © 2022