The last few posts have focused upon the “tax-free” contribution of property to a partnership. Today, we’re “doing a 180,” as they say (whoever “they” are), and considering how the acquisition of assets may be structured so as to provide the buyer with a cost, or “stepped-up,” basis in those assets. It sounds simple enough, but there will be times when a buyer (especially a partnership) may inadvertently stumble into a partially tax-free transaction – as where part of the consideration paid consists of equity in the buyer – thereby losing the benefit of a full basis step-up for the assets being acquired.
For example, I recently came across a situation in which the buyer-LLC was treated as a partnership for tax purposes. The buyer offered to acquire most of the target corporation’s assets (with zero basis in the hands of the target) in exchange for cash and a minority membership interest in the LLC (both payable at closing). I learned that the buyer intended to take the target assets with a full step-up in basis, and believed that this structure would accomplish this goal. What a surprise when it learned that the target’s transfer of its assets for cash plus equity would be treated for tax purposes as two transactions: (i) an acquisition of some target assets in exchange for equity in the buyer-LLC, which would be treated as a tax-free exchange, with the buyer taking those assets with zero basis, and (ii) an acquisition of the other target assets for cash, with the buyer taking those assets with a basis step-up.
As we have stated on many occasions, the buyer’s preference will almost always be to acquire the assets of the target company, rather than its stock. There are two primary reasons for this preference:
- First, the buyer does not want to take subject to, or assume, all of the liabilities of the target company (which will necessarily be the case with an acquisition of all of the issued and outstanding shares of the target stock); and
Second, the buyer wants to acquire a step-up in basis for the target assets (equal to the purchase price for the assets) that it may then amortize or depreciate, as the case may be, thereby allowing the buyer to recover its cost for the assets on a current basis, and thus making the transaction economically less expensive for the buyer.
Use of Buyer’s Equity
Of course, the seller will prefer to defer the recognition and taxation of any gain to be realized on the transfer of assets to the buyer.
This deferral may be achieved in one of two ways:
- the buyer agrees to pay at least part of the purchase price after the tax year in which the sale occurs (an installment obligation, or an “IO”), or
- the buyer issues equity to the seller.
The former is still part of a taxable transaction for tax purposes, but it defers the seller’s tax liability to the year(s) in which principal payments are made under the installment obligation (though the sale of some assets does not qualify for installment reporting, and the deferred gain may be accelerated under certain circumstances); the latter is generally not a taxable event.
I say “generally” because there are exceptions, depending upon the buyer’s status for tax purposes and upon how the acquisition is structured. For example, if the buyer is a corporation, it may issue shares to the target in exchange for the target’s assets without jeopardizing its acquiring the target assets with a full step-up in basis equal to the fair market value of the equity and other consideration transferred by the buyer, provided these shares represent less than 80% of the total voting power or value of the corporation’s equity (i.e., less than “control”).
Similarly, where both the target and the buyer are corporations, and the target merges with and into the buyer, with the buyer surviving, the buyer may issue shares of its stock, plus other property and/or cash, as merger consideration without jeopardizing its acquiring the target assets with a full step-up in basis, provided the equity represents less than 40% of the total consideration transferred.
On the other hand, if the buyer is an LLC that is either disregarded or treated as a partnership for tax purposes, its issuance of even a minority equity interest in exchange for any assets of the target will result in its taking such assets with the same basis that they had in the hands of the target – not stepped-up to the value of the consideration paid.
Straight Asset Sale
The simplest structure for ensuring the buyer receives a full basis step-up in the acquired assets is for the buyer to transfer cash, an installment obligation or other deferred payments (such as an earn-out), and/or other property to the target company in exchange for its assets. The consideration may also include those target liabilities that the buyer may agree to assume (such as trade payables). A corporate buyer may even transfer its own stock as consideration, provided the amount transferred does not give the seller control of the buyer immediately after the transfer.
The buyer will thereby acquire the assets with a holding period that begins with the acquisition, and with a basis equal to the total consideration paid, including the face amount of any IO issued by the buyer (assuming the IO bears adequate interest).
Although the buyer may acquire the assets directly, it may prefer to shelter its existing assets and business from any liabilities that may arise out of the acquired assets.
For that reason, the buyer may first form a wholly-owned subsidiary corporation or LLC that will be funded by the buyer and that will act as the acquisition vehicle for the target assets. The wholly-owned LLC will generally be disregarded for tax purposes. Where the buyer is an S-corporation, it may elect to treat the new subsidiary corporation as a “qualified subchapter S subsidiary” (or “Q-sub”) that will also be disregarded for tax purposes. Either way, the tax consequences arising from the ownership and operation of the acquired target business will be reflected on the parent company’s tax return.
Sec. 338(h)(10) Election for Stock Purchase
It may be that the assets of the target corporation include assets the direct acquisition of which may be difficult to effectuate through a conventional purchase and sale (e.g., a license). In that case, the buyer may have to purchase the issued and outstanding shares of the target’s stock. How, then, can the buyer obtain a basis step-up for the target’s assets?
In general, provided: (i) the buyer is a corporation, (ii) the buyer acquires at least 80% of such stock, (iii) the target is an S-corporation, or a member of an affiliated or consolidated group of corporations, and (iv) the target’s shareholders consent (including, in the case of an S-corporation target, any non-selling shareholders), then the stock sale will be ignored, and the buyer will be treated, for tax purposes, as having acquired the target’s assets with a basis step-up equal to the amount of consideration paid by the buyer plus the amount of the target’s liabilities.
Section 336(e) Election for Stock Purchase
Where an election under Sec. 338(h)(10) of the Code is not available – for example, because the buyer is not itself a corporation – the buyer may want to consider an election under Sec. 336(e) of the Code.
The results of a Sec. 336(e) election are generally the same as those of a Sec. 338(h)(10) election in that the target, the stock of which was acquired by the buyer, is treated as having sold its assets to the buyer.
This election, however, may only be made by the seller’s shareholders – it is not an election that is made jointly with the buyer. In the case of an S-corporation target, all of its shareholders must enter into a binding agreement to make the election, and a “Sec. 336(e) election statement” must be attached to the S-corporation’s tax return for the year of the sale.
The buyer that finds itself in these circumstances will want to “require” the S-corporation’s shareholders to make the Sec. 336(e) election. Of course, it may have to pay a premium in terms of increased purchase price for the stock being acquired in order to induce them to consent.
Purchase of Membership Interests
If the target is an LLC that is either treated as a partnership or disregarded for tax purposes, the buyer’s acquisition of all of the LLC’s outstanding membership interests will be treated as a purchase of all of the LLC’s assets and the “assumption” of its liabilities. Thus, the buyer will take the assets with a stepped-up basis.
Where the LLC is treated as a partnership, it may be that some of its members do not want to sell their membership interests (and nothing in their operating agreement compels them to do so). In that case, the buyer will not be treated as having acquired the LLC’s assets for tax purposes.
However, if the LLC has already made an election (that remains in effect) under Section 754 of the Code, or if the LLC makes such an election for the taxable year in which the sale of the membership interests occurs, then the buyer will receive a special basis adjustment with respect to the LLC’s underlying assets. This adjustment will be treated as a “new asset” that is being placed in service beginning with the buyer’s acquisition of the membership interests. Moreover, any depreciation or amortization deductions attributable to these “new” assets will be specially allocated to the buyer and not to the holdover members of the LLC. On a later sale of any of these “new” assets, the amount the gain therefrom that is otherwise allocated to the buyer will be reduced by the amount of any remaining (i.e., not-yet-depreciated/amortized) adjustment for that asset.
It may be that the assets of the target corporation are such that their direct acquisition through a conventional purchase and sale may be difficult to effectuate. In that case, the buyer may want to consider a merger of the target with and into the buyer, with the buyer surviving the merger. Provided the consideration does not include equity in the buyer (or, in the case of a corporate buyer, includes only a relatively small amount of equity), the transaction will be treated for tax purposes as an acquisition of the target’s assets (followed by the liquidation of the target) for which the buyer will receive the desired stepped-up basis.
As in the case of a straight asset sale, the buyer may prefer to keep its existing business assets separate from those being acquired from the target by first creating a wholly-owned subsidiary corporation or LLC that will be funded by the buyer and that will act as the acquisition vehicle for the merger; the target will merge into this subsidiary and, in exchange, the target’s shareholders will receive the taxable merger consideration.
Purchase Subsidiary Equity
In some situations it may be easier to acquire the target business by acquiring the target’s equity from its owners. Of course, this will also result in the buyer’s acquiring all of the target assets and assuming all of the target liabilities (including both assets and liabilities that the buyer does not want to take).
This need not be the buyer’s only choice, however; instead, the target may transfer the desired assets and the assumed liabilities into a newly-formed LLC, while retaining the unwanted assets and liabilities. The buyer may then acquire the target’s entire membership interest in the LLC. For tax purposes, this acquisition will be treated as a purchase of the LLC’s assets, thereby giving the buyer the desired basis step-up.
Where the target assets cannot be easily transferred, the better approach may be to keep the target intact and to remove the unwanted assets. The target owners may contribute their equity in the target to a new holding company in exchange for all of the equity in the holding company. The holding company thereby becomes the sole owner of the target.
Following this step, if the target is an LLC, it will be treated as a disregarded entity for tax purposes. If the target is an S-corporation, the holding company and the target may elect to be treated as an S-corporation and a Q-sub, respectively. If the target is a C-corporation, it may be merged into a newly-formed LLC that is also entirely owned by the holding company (though it should be noted that this merger will be treated as a taxable sale of its assets by the C-corporation target). The “conversion” of the target into a disregarded unity for tax purposes will enable the target to then transfer to its parent holding company those assets and liabilities that the buyer does not want to take. The buyer may then acquire the target equity from the holding company in a transaction that, for tax purposes, will be treated as a purchase of the target assets with a stepped-up basis.
Consider the Options
The foregoing discussion highlights a number of methods by which a buyer may acquire a target’s assets with a step-up in basis. One approach may be better than another, depending upon the facts and circumstances and upon the nature of the target, its business, its assets, and its owners. In some cases, it may be possible to combine methods as part of a “single” acquisition.
What the buyer must realize is that there are choices – it is not limited to only one method by which to acquire a target’s assets with a basis step-up. One of these approaches, or a combination thereof, may not only secure a depreciable/amortizable basis increase for the buyer, it may also accommodate other business goals.