Knowing the structure of a transaction you are involved in is key to optimizing the composition of a deal. If you enter a proposed transaction thinking you understand the offer, you may be blindsided by various structures that may affect your net cash position. A critical aspect of a transaction is understanding the structure and what it means for you as a buyer or seller. Clients often believe that they agree to accept a stock transaction only to find out that the transaction will include an election that may affect their tax bill. A 338(H)(10) election is one of the more popular tax elections, but there are others.
Typically, a buyer will seek an asset purchase while a seller will seek a stock purchase. The primary factors for preferring one structure over another are legal and tax consequences. An asset purchase allows the buyer to leave behind liabilities and enables the buyer to have a step-up basis in the assets, accelerating depreciation and reducing taxable income. On the other hand, a seller often prefers a stock purchase because of the favorable capital gains rates. Of course, there are other considerations when it comes to structuring a transaction, such as a contract assignment, but your advisors can help advise you on your specific situation.
338(H)(10) tax election in use
When a 338(H)(10) election is in use, the transaction remains a stock purchase for all legal purposes, but the transaction is taxed as an asset purchase, allowing the buyer to benefit from the steppe-up basis of the previously depreciated assets in the business. Sometimes this structure doesn’t affect a seller’s tax position, but if the business has a significant amount of accumulated depreciation on its balance sheet, the seller might have a larger tax bill than expected.
As part of a transaction involving a 338(H)(10) tax election, the buyer and seller will agree to a “purchase price allocation” in which portions of the purchase price are attributed to specific assets (or asset classes) of the business on mutually agreeable terms. To the extent the purchase price exceeds the agreed value of the assets, that excess is booked by the buyer as goodwill. While the election will not typically change the tax bill on the portion of the purchase price allocated to goodwill, it will subject the seller to a depreciation recapture tax on the amounts by which the purchase price allocated to the assets exceeds the book value of those assets. Meanwhile, the buyer will take the business with a higher tax basis on the assets.
This higher basis will allow the company to “re-” depreciate the assets. The resulting tax shield on that extra depreciation in years going forward makes the business more valuable to the buyer at the time of the deal. Buyers, however, rarely offer to share that added value with the seller.
Buyers sometimes will not bring up the expectation that the transaction will have an election until the purchase agreement. This delay may give a seller heartburn, so getting in front of the issue can help ensure a smooth transaction. In addition, there are options, such as true-ups, to protect a seller from being left with an avoidable tax bill while the buyer pockets the added value directly derived from that tax paid by the seller.
338(H)(10) elections are limited to a seller being a US corporate subsidiary of a partner company or an S-Corp. The buyer and all shareholders much make the election. The election can not be made unilaterally. The transaction remains a stock purchase for legal purposes and does not limit a buyer’s exposure to unknown liabilities associated with the acquisition. The buyer must be a corporation and acquire at least 80% of the seller’s stock.
If you are unsure about the structure of the transaction that you are considering proposing or that you are considering accepting, consult a professional tax advisor to better understand your options. Tax treatment of business sales must be addressed on a case by case basis and the tax code is an ever-changing. Therefore, a tax advisor specifically experienced in the code provisions relating solely to the sale of a business is strongly encouraged.
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Benchmark International’s global offices provide business owners in the middle market and lower middle market with creative, value-maximizing solutions for growing and exiting their businesses. To date, Benchmark International has handled engagements in excess of $8.25B across various industries worldwide. With decades of global M&A experience, Benchmark International’s deal teams, working from 14 offices across the world, have assisted thousands of owners with achieving their personal objectives and ensuring the continued growth of their businesses.