Before you rush into an M&A, know the tax traps

As per Deloitte’s “The State of the Deal: M&A trends 2020” report, U.S. companies held $1.55 trillion in cash at the end of 2019, with M&A being the top intended use for those funds. 

Are you a business owner looking to grow your business by acquiring other businesses?  Or are you open to the idea of being acquired? Before rushing into a deal, there are many tax traps laid upon the path for which you should be ready.

Tax Free Reorganizations of Corporations.  

When the transaction involves corporations, the shareholders should consider whether they can structure the transaction as a tax-free reorganization.  The Internal Revenue Code provides that certain types of reorganizations of corporations will result in no gain or loss being recognized if certain protocols are followed.  These types of tax-free reorganizations include the following:

  • Statutory mergers.
  • Acquisition by one corporation, in exchange solely for all or a part of its voting stock, of stock of another corporation if, immediately after the acquisition, the acquiring corporation has control of such other corporation.
  • Acquisition by one corporation, in exchange solely for all or a part of its voting stock, of substantially all of the properties of another corporation.
  • A transfer by a corporation of all or part of its assets to another corporation if immediately after the transfer the transferor, or one or more of its shareholders, or any combination thereof, is in control of the corporation to which the assets are transferred.

Beware of the built-in gains tax

When you have a buyer interested in your business, it is common for the buyer to negotiate that the transaction take the form of an asset purchase rather than a stock purchase.  By structuring it this way, the buyer is reducing its risk that it may inadvertently be assuming the liabilities of the seller. However, if the selling corporation is an S corporation, the shareholders of the S corporation must be aware of the built-in gains tax.

This built-in gains tax applies when a corporation started as a C corporation, converted to an S corporation, and sells any assets that have unrecognized gains within five years after the conversion.  The tax rate applied is the highest marginal corporate tax rate, which is currently 21%.  

For example, assume that ABC Corporation began operations as a C corporation and bought property worth $700,000.  Further assume that ABC Corporation converts to an S corporation when that same property is worth $1,000,000. If ABC Corporation sells that property to a buyer within five years after electing to be taxed as an S corporation, then ABC Corporation will be responsible for a built-in gains tax of $63,000.  Assuming that the capital gains tax rate for the shareholders of ABC Corporation is 15%, the shareholders will then pay a capital gain tax of $35,550. Thus, the total federal tax paid on the sale would be $98,550. If the built-in gains tax had not applied, the total federal tax paid on the sale would be $45,000.

If the shareholders of ABC Corporation had waited until the five-year period expired, they could have saved $53,550 in federal taxes.

Ensure that the sales agreement addresses IRS Form 8594.

When assets of a corporation are sold, the buyers and sellers must allocate the purchase price among several classes of assets.  The seller will want to allocate more of the purchase price to assets that have a higher cost basis. The buyer will want to allocate more of the purchase price to assets that can be depreciated or assets that the buyer intends to sell shortly for a premium.  The IRS is very interested in how the purchase price is allocated, because it will impact the amount of gain or loss that the seller must report, and it will also impact the gain or loss that the buyer reports when such assets are sold in the future.

The IRS developed Form 8594 for buyers and sellers to disclose how the purchase price is allocated among different classes of assets.  The parties will be subject to penalties if they do not file Form 8594 for the year in which the sale takes place. The parties are not required to file consistent forms, but they should both be prepared for an audit if they file forms with inconsistent allocations of the purchase price.  Therefore, before a buyer and seller sign on the dotted line, they should ensure that they include the allocation of the purchase price as part of their negotiations.

There are many other tax traps for business owners looking to buy or sell, but this article provides a sample of some of the more common issues.  Before entering into any agreements, business owners should consult with their legal and tax advisors to review these types of issues.

Attorney R. Nicholas “Nick” Nanovic helps individuals and businesses understand their potential tax liabilities with the IRS and Pennsylvania Department of Revenue. He advises business entities on how to properly structure corporations, S corporations, LLCs, and partnerships.

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