Asset deals, stock deals and tax

Key takeaways

• In a stock deal the entity changes owner and keeps all its liabilities and contracts; in an asset deal the buyer chooses what it takes, but contracts, permits and employees must be transferred and consents obtained.
• An asset purchase gives the buyer a tax basis equal to the price, and the step up in goodwill and other intangibles is amortised over 15 years under Section 197; the tax shield has real present value.
• In the Kestrel example a $300m step up is worth $5.0m of tax a year for 15 years, $38.0m in present value at 10 percent, about half its undiscounted $75m.
• C corporation sellers usually insist on a stock sale because an asset sale is taxed twice; for an S corporation the extra cost is small and can be covered by a gross up, so 338(h)(10) elections and F reorganisations are common.
• A gross up must itself be grossed up, because the seller pays tax on it: G = incremental tax / (1 - seller tax rate).

What transfers in each structure

In a stock purchase nothing moves except the shares. The company keeps its contracts, permits, employees, bank accounts and its full history, including liabilities nobody has discovered yet: past tax exposures, product claims, environmental contamination, wage and hour claims. The buyer protects itself with diligence, representations, indemnities, escrow and, increasingly in US sponsor deals, representation and warranty insurance. Contracts usually continue, although many contain change of control clauses that let the counterparty terminate or renegotiate when ownership changes.

In an asset purchase the buyer lists what it takes and which liabilities it assumes. Unassumed liabilities stay with the seller, which is the main legal attraction. The cost is mechanical: each contract must be assigned, and many require the counterparty's consent; permits and licences may need to be reissued; employees are terminated and rehired; real estate is conveyed by deed; and title to each asset must be documented. Some liabilities follow the assets regardless, under successor liability doctrines, environmental law and certain employee benefit and tax rules.

Mergers sit between the two. In a reverse triangular merger, the standard structure for buying a public company or a private company with many shareholders, a buyer subsidiary merges into the target, the target survives as a subsidiary, and shareholders receive the consideration. Legally it works like a stock purchase, and it avoids needing every shareholder to sign.

The basis step up and its value

Tax basis is the amount a taxpayer can recover tax free through depreciation, amortisation or a later sale. A company that has run for years usually has a tax basis in its assets far below what a buyer will pay, because its valuable assets (customer relationships, brands, know how, workforce) were built internally and never recorded at cost. Buying the stock leaves that low inside basis in place. Buying the assets resets basis to the purchase price, allocated across asset classes under Section 1060 using the residual method, with whatever is left over landing in goodwill.

The step up creates deductions. Under Section 197, acquired goodwill and most other intangibles are amortised straight line over 15 years. Equipment and other tangible property can be depreciated faster, sometimes immediately under bonus depreciation rules that have changed several times, which makes the portion of a step up allocated to them more valuable. Each dollar of deduction saves tax at the buyer's marginal rate, and the stream of savings, the amortisation tax shield, is valued like any other cash flow.

The value of the shield depends on the buyer actually having taxable income to shelter, on the tax rate, and on the discount rate. Because the savings arrive over 15 years, a large share of the nominal value is lost to discounting.

Why sellers usually prefer stock sales

A C corporation is taxed on its own income, and its shareholders are taxed again when profits are distributed. If a C corporation sells its assets, the corporation pays tax on the gain over its inside basis, and the shareholders pay tax again when the after tax proceeds are distributed to them in liquidation. If the shareholders sell their stock instead, there is only one tax, at the shareholder level, on the gain over their stock basis. The buyer of stock gets no step up, but the seller's tax saving usually dwarfs the step up's value.

Pass through entities change the picture. An S corporation, or an LLC taxed as a partnership, has only one level of tax: gain on an asset sale flows through to the owners. An asset sale still costs them somewhat more than a stock sale, because part of the gain may be recaptured as ordinary income (prior depreciation on equipment, for example) and state taxes can differ, but the gap is small. That gap is what a gross up pays for. For a partnership, a buyer of the interests can obtain a step up in its share of the inside basis through a Section 754 election, without an asset sale at all.

Section 338(h)(10) and the F reorganisation

Tax law lets the parties buy stock for legal purposes and treat the purchase as an asset purchase for tax. Under a Section 338(h)(10) election, made jointly by buyer and seller, a qualified stock purchase of at least 80 percent of a target's stock by a corporate buyer is treated as if the target sold its assets and then liquidated. It is available when the target is an S corporation or a subsidiary in a consolidated group of corporations. The buyer gets the step up and keeps the simplicity of a stock deal: contracts and permits stay in the entity. Section 336(e) offers similar treatment in some cases where the buyer is not a corporation.

Sponsors buying S corporations increasingly prefer an F reorganisation. Before the sale, the shareholders form a new S corporation, contribute the target's stock to it, elect to treat the target as a qualified subsidiary and convert it into a single member LLC, which is disregarded for tax. The buyer then purchases the LLC interests, which for tax is a purchase of assets with a full step up. The approach avoids a key risk of the 338(h)(10) route, an S election that turns out to have been invalid, works for non corporate buyers, and makes a tax deferred seller rollover easier to arrange.

Both routes reach the same economic point: the buyer gets the step up and the seller pays tax as if it sold assets. Whether that is worth doing depends on comparing the buyer's step up value with the seller's incremental tax, which is what the gross up settles.

Negotiating the gross up

When the buyer wants asset treatment and the seller would pay more tax as a result, the buyer can compensate the seller with a gross up: an increase in the price equal to the seller's incremental tax. The trap is that the gross up is itself part of the price and is taxed. To leave the seller whole after tax, the payment must be grossed up again, which is why the formula divides by one minus the seller's tax rate.

The negotiation turns on the numbers being modelled by both sides. The buyer caps the gross up at a fraction of its own step up value and wants the calculation done on agreed assumptions, not on the seller's eventual return. The seller wants the gross up computed on its actual position, including state taxes and ordinary income recapture, and wants it to adjust if the price adjusts. Purchase price allocation, which determines how much gain is ordinary income, is usually agreed in the purchase agreement for the same reason.