When pursuing an acquisition, companies often face a critical decision between an asset purchase and a stock acquisition. Each option presents its own set of benefits and challenges, but there is a strategy that allows buyers to leverage the advantages of both.
Stock Acquisition
Acquiring a target company’s stock is typically a straightforward process. By purchasing the stock, the buyer gains control of the target’s assets without the need for individual transfers or hassle, as ownership is obtained through the corporation’s stock. This can streamline the acquisition process, saving both time and money. Under this structure, the buyer is assuming ownership of all the target’s assets and liabilities, including potential liabilities from past actions of the target.
Asset Purchase
However, with a taxable asset purchase, both companies can decide which assets and liabilities should be exchanged. While this can allow more flexibility in structure than a stock purchase, it also requires the legal title of each asset to be transferred directly to the buyer. This can be a complex and expensive process, especially if the target company owns a large number of assets. Moreover, certain valuable assets—such as key leases, licenses, or contracts—may not be transferable, which could complicate the deal.
From a tax perspective, a direct asset purchase often provides more favorable outcomes for the buyer. This method allows the buyer to step up the tax basis of the target’s appreciated assets to the purchase price, offering two significant tax advantages:
- Reduced income recognition when collecting receivables or selling inventory.
- Increased depreciation and amortization deductions on the cost of appreciated assets, including real estate, equipment, and intangibles.
The Best of Both Worlds: 338 Elections
The decision between an asset purchase and a stock acquisition often comes down to whether the buyer prioritizes the tax benefits of an asset purchase or the simplicity and speed of a stock acquisition.
There is, however, a way to combine the benefits of both asset and stock acquisitions. A corporation can elect to treat certain qualifying stock purchases as an asset purchase for federal income tax purposes. Under Section 338 of the Internal Revenue Code, this election allows the IRS to treat the transaction as if the buyer acquired the target’s assets directly, based on the stock purchase price. This election enables the buyer to benefit from the stepped-up tax basis typically associated with an asset purchase, without the legal complexities of transferring each asset.
For state law purposes, the transaction is still considered a stock purchase, and the target corporation continues to exist as a legal entity after the sale. The Section 338 election only alters the tax implications of the transaction.
To accurately allocate the purchase price to the specific assets and establish their initial tax basis, an appraisal is often necessary. Working closely with a tax professional and appraiser will help ensure the best possible tax outcome for the buyer.
Types of Section 338 Elections
There are two primary types of Section 338 elections:
- Regular Section 338 Election: This election is available when a buyer acquires 80% or more of the target corporation’s stock. However, a regular Section 338 election is often not recommended due to the potential for double taxation—once at the corporate level for the deemed asset sale, and again at the shareholder level for the stock sale. This election is typically used if the target has unused net operating losses or capital losses, as these can be applied to offset the income and gains from the deemed asset sale.
- Special 338(h)(10) Election: This election is designed for situations where the target is an S corporation or a C corporation whose stock is owned by another corporation. It allows the transaction to be treated as an asset sale for tax purposes, avoiding double taxation by disregarding the stock sale. This election cannot be made if individuals own the C corporation’s stock. Additionally, foreign targets are not eligible for the 338(h)(10) election but are eligible for the regular 338 election.
Steps to Make a Section 338(h)(10) Election
The Section 338(h)(10) election process involves three key steps:
- The buyer acquires at least 80% of the target’s stock in a qualified stock purchase, whether the target is a C corporation or an S corporation.
- The buyer and the target agree to make the special election, effectively treating the transaction as an asset purchase for federal tax purposes. Any Section 338 election must be made by the fifteenth day of the ninth month after the month in which 80% control of the target is acquired (within 8.5 months).
- The buyer then enjoys the benefits of the stepped-up tax basis during tax filing.
Why Make a Special Election?
- To obtain a stepped-up tax basis for appreciated assets.
- To avoid double taxation, as preferred by the seller.
- To circumvent the complexities and costs associated with transferring legal ownership of assets.
- To acquire valuable non-transferable assets that would be difficult to obtain in a direct asset purchase.
Post-Election Considerations
After the election is made, the buyer owns the stock, and the target remains a legal entity. However, the buyer needs to be aware that any unknown or contingent liabilities remain within the target corporation. With a stock acquisition, the buyer typically assumes responsibility for these liabilities, making thorough due diligence essential to avoid unexpected issues.
Take the Next Step with ML&R
Understanding the nuances of asset acquisition and stock purchases is crucial to making the right decision for your business. If you’re considering a merger or acquisition, ML&R is here to help. Contact us today to see how we can assist in your next business transaction.
