Tax Structuring (Part 2)
Home Newsletter Articles About Contact
Tax Structuring (Part 2)
In my last post, we began addressing deal structuring from a tax perspective. In particular, we looked at two scenarios where an equity acquisition may be treated as an asset acquisition for tax purposes.
But what if neither scenario applies to your deal?
You may still have options. Specifically, making an election under Section 338(h)(10) or Section 336(e) of the Internal Revenue Code may get you to the same result.
What is a Section 338(h)(10) election?
An election under Section 338(h)(10) is available when the buyer is a corporation and will acquire the stock of a target corporation in a qualified stock purchase.
A qualified stock purchase is one in which the buyer acquires at least 80 percent of the total voting power and value of the stock of the target.
The buyer and the seller must jointly elect to treat the stock acquisition as an asset acquisition for tax purposes.
But how does it all work?
From a tax perspective, if the parties make an election under Section 338(h)(10), the taxing authorities waive their hands and conjure two target corporations, old and new. The old target is treated as selling its assets and discharging its liabilities; the new target is deemed to have acquired those assets and assumed those liabilities. The new target is left with a stepped-up basis in the assets (which is what the buyer normally wants).
When the hand waiving stops, the old target is deemed to liquidate. The seller receives a tax-free distribution of the proceeds. The buyer is left owning the stock of the new target (complete with the stepped up basis in the assets).
What issues are there with a Section 338(h)(10) election?
The seller takes the tax hit at the entity level rather than the stockholder level (as would be the case in a straightforward stock acquisition). The seller may therefore suffer a worse tax outcome if the seller’s basis in the stock exceeds the target company’s basis in its assets.
Additionally, a Section 338(h)(10) election is available in a narrow range of circumstances. The buyer must be a corporation and must generally acquire the stock from a selling corporation—which rarely happens in the self-funded searcher space.
There is an exception: If the target company is an S corporation, the corporate buyer may acquire the stock from the S corporation’s stockholders.
Acquiring stock from an S corporation’s stockholders is far more common.
How does a Section 336(e) election work?
An election under Section 336(e) is available when the buyer is an individual and will acquire the stock of a target corporation in a qualified stock purchase.
A Section 336(e) election is only available if a Section 338(h)(10) election is unavailable.
The seller and the target corporation must elect to treat the stock acquisition as an asset acquisition.
Section 336(e) works in the same way as Section 338(h)(10). However, it expands the categories of deals that can be included. Individual (rather than just corporate) buyers can benefit from a Section 336(e) election.
As with a Section 338(h)(10) election, the buyer must generally acquire the stock from a selling corporation. The same exception applies, however: If the target company is an S corporation, the corporate buyer may acquire the stock from the S corporation’s stockholders.
Again, as with a Section 338(h)(10) election, the seller may suffer a worse tax outcome.
Can an LLC buyer benefit from a Section 336(e) election?
Yes, if the buyer is a single-member LLC taxed as a disregarded entity. Remember, the taxing authorities look through a disregarded entity. For income tax purposes, that LLC is an individual.
As a result, Section 336(e) elections are more common than Section 338(h)(10) elections in the self-funded searcher space. Corporate buyers are less common; buyers are usually individuals or single-member LLCs taxed as disregarded entities.
How should I negotiate the above tax elections with the seller?
You need the seller’s cooperation to make a Section 338(h)(10) election or a Section 336(e) election. But as explained above, the seller may suffer a worse tax outcome.
Like most things, it’s a negotiation.
If possible, signal your intent to make a tax election in the Letter of Intent (LOI). Remember, asset acquisitions are the norm in SMB M&A. By purchasing the equity, you’re doing the seller a favor by taking on more liabilities. Treating the deal as an asset acquisition for tax purposes is, arguably, fair recompense for that added risk.
If the seller pushes back, crunch the numbers. How much will you save in tax? Can you split the benefit with the seller by increasing the purchase price?
It can be a win-win.
What else should I consider?
Are you purchasing a large amount of fixed assets or mostly goodwill?
A deep dive into depreciation and amortization schedules is beyond the scope of this post (and, candidly, my expertise). But be aware of the following:
Goodwill is amortized over 15 years, using the straight-line method (evenly spread).
Fixed asset are usually depreciated over five to seven years, using the 200% declining-balance method (accelerated).
As a result—and as a general rule—if you are purchasing a company with significant fixed assets, the benefit of treating the deal as an asset acquisition for tax purposes is greater. In contrast, if you are purchasing a company consisting of mostly goodwill (which may be the case when purchasing, for example, an online business), the benefit is reduced.
Why? Increased depreciation and amortization deductions reduce taxable income, leading to lower tax payments. Being able to claim accelerated depreciation deductions will result in meaningful tax savings in the years immediately following your transaction.
Beware: General rules do not always hold true.
Generally, buyers are better off for tax purposes when buying assets. But elections under Section 338(h)(10) and Section 336(e) can result in adverse tax consequences for buyers too.
If a target company’s basis in its assets exceeds their fair market value, an asset acquisition could result in a reduced basis, leaving the buyer in a worse position for income tax purposes.
This scenario is most likely to occur in an economic downturn. Of course, economic downturns may also present the best buying conditions for the adventurous.
Consult with a tax specialist before finalizing the structure of any deal, as you may be leaving money on the table or walking into avoidable losses.
What language should I include in my letter of intent?
For those interested in pursuing a Section 338(h)(10) or Section 336(e) election, the relevant section of your LOI could include language as simple as the following:
Buyer and Seller will cooperate to make a tax election to treat the Transaction as though Buyer were purchasing substantially all of the assets of the Company.
If you already know you want to make, for example, a Section 336(e) election, you can revise the language to be more specific. But if there is any doubt (because, for instance, the identity of the buyer is still under discussion), be general rather than specific.