M&A: Basic Tax Considerations for Taxable Asset and Stock Sales

Mergers and Acquisitions - Basic Tax Considerations for Taxable Asset and Stock Sales

Brianna N. Komppa

Jul 01, 2016

5 min read

Mergers and acquisitions of financial institutions increased steadily throughout 2014 and 2015, and it looks like the trend is continuing into 2016. An increasingly complex regulatory environment, the retirement of baby boomers, changing technology, and improvements in the overall economy have contributed to this trend. Whether your bank is considering an acquisition or a sale, there are some basic tax consequences that should be considered.

Tax Asset Sales

If the transaction is structured as an acquisition of assets, the seller will recognize gain or loss on an asset-by-asset basis. If the seller is a C corporation, tax will be paid at the corporate level and will be calculated using ordinary corporate tax rates (topping out at 35%) since the preferential tax rates related to capital gains are not used at the corporate level. The seller can use its tax attributes, such as net operating losses and capital loss carryforwards, to offset the gains, but any unused attributes are lost upon liquidation. Assuming the seller liquidates after the asset sale, double taxation will result since the shareholders will pay tax on the difference between their liquidating dividend and their basis in their C-corporation stock.

In the case of an S corporation, the gains on the sale of the assets will be passed through to the shareholders, retaining their ordinary or capital character. Each shareholder will then pay tax on their share of the gains at their respective tax rates, which allows for some of the gains to be taxed at the lower capital gains rates of 25% or 15%, rather than the top individual or trust tax rate of 39.6%. S-corporation shareholders will also recognize and pay tax on a capital gain on liquidation, equal to the difference between their liquidating distribution and their basis in their stock. However, the gains that were recognized on the sale of the assets increase the shareholders’ stock basis, reducing their gain on liquidation, effectively eliminating the double taxation problem (as long as the built-in gains tax does not apply). In addition, if an S-corporation shareholder is considered passive, meaning they do not meet one of the IRS tests for material participation in the business, the gains on the sale of the assets and on liquidation of their stock will be subject to the 3.8% net investment income tax.

From the buyer’s perspective, the purchase price is allocated to the assets as discussed below, and the allocations become the buyer’s tax basis in the assets purchased. The buyer often prefers an asset purchase from a tax perspective because the basis in the purchased assets is stepped up to fair market value (FMV), which yields greater depreciation and amortization deductions. Since only assets are being purchased, the tax attributes of the target corporation do not carry over to the buyer.

When an asset acquisition of an active trade or business occurs, IRS regulations require that the buyer and seller use the “residual method” to allocate the purchase price/sales price to the assets for purposes of determining the tax basis of the assets for the buyer and computing taxable gains for the seller. The residual method divides the assets into seven classes:

I. Cash
II. Actively traded personal property (U.S. securities, CDs, and currency)
III. Receivables and assets marked-to-market
IV. Inventory or stock-in-trade
V. Assets other than classes I-IV (including fixed assets)
VI. Intangibles other than goodwill and going concern value
VII. Goodwill and going concern value

The purchase price is then allocated first to Class I ($ for $) and to each succeeding asset class in ascending order to the extent of the FMV of the aggregate assets in each class. Any remaining amount is considered Class VII goodwill. Because the buyer and seller must both use this method for their allocation, negotiation and written agreements as to the FMV of each class is recommended. Both buyer and seller fill out Form 8594 on their respective tax returns showing the allocation.

Taxable Stock Sales

A seller often prefers to sell stock, rather than assets, because it avoids the double taxation problem. The sale of stock does not result in a taxable gain or loss at the corporate level. Stock in a corporation is a capital asset (unless the shareholder is considered a dealer in securities), so both C- and S-corporation shareholders will recognize a capital gain equal to the difference between the proceeds received and their basis in their stock. If the shareholders owned the stock for more than a year, the gain will be taxed at the long-term capital gains rate of 20%.

The buyer’s basis in the shares acquired will be equal to the purchase price it paid. GAAP requires push-down accounting for the assets inside the target corporation, meaning the purchase price will be allocated to all of the assets and the GAAP basis will reflect FMV. However, the tax basis of the underlying assets inside the corporation will not be stepped up to reflect the FMV of the purchase price, but instead will carry over at the existing amount. This results in lower depreciation and amortization deductions, as well as higher taxable gain on subsequent sale of the assets, since the buyer’s basis is lower than when assets are purchased. Because the buyer is purchasing the corporate entity, the tax attributes of the target are carried over. However, Section 382 of the Internal Revenue Code can severely limit the amount of net operating losses and built-in losses of the target that can be used year-to-year by the buyer. An analysis should typically be performed to determine how much of the tax attributes can actually be utilized by the buyer.

There are two elections under Section 338 of the Internal Revenue Code that can be made to treat a transaction as a stock sale for legal purposes and an asset sale for tax purposes, but both have immediate tax consequences. A 338(g) election assumes that the target sold its assets at FMV, rather than its stock. Once the buyer makes this election, the buyer (not the seller) pays the tax on the gains resulting from the deemed sale and is allowed to step up the basis of the assets inside the target corporation to FMV. The seller is not affected by this election. A 338(h)(10) election is made jointly by the buyer and seller and is only available for certain transactions. The acquisition must be for at least 80% of the target’s stock, and the target must be either an S corporation or a subsidiary that filed with a consolidated group. In this case, the stock sale is ignored for tax purposes, and both buyer and seller will be treated as though an asset sale occurred.

Note that if an S-corporation holding company sells the stock of its bank subsidiary, it will be treated as an asset sale for tax purposes. No Section 338(h)(10) election is required.

Summary

Because of the complexity of the tax ramifications of an acquisition or sale, it is very important to have a tax advisor to help analyze potential transactions during negotiations. Wipfli has a team of skilled professionals who would be happy to guide you through the process.