Are you thinking about buying a business? How you structure the deal will affect the taxes owed by the buyer (you) and the seller (the other party).
The Tax Cuts and Jobs Act (TCJA) brought sweeping changes to the federal income tax rules for businesses, including some changes that affect the taxation of mergers and acquisitions. Here’s why many buyers are choosing to buy the assets of the target business rather than its ownership interests under current law, and why you may need to act fast to take advantage of breaks offered by the TCJA.
Asset Purchase Versus Stock Purchase
A potential buyer has two options for structuring the purchase of a target business that’s operated as a C or S corporation, a partnership, or a limited liability company (LLC) that’s treated as a partnership for tax purposes:
- Buy the assets of the business, or
- Buy ownership interests of the entity that owns the target business.
For simplicity, we use the term “stock” purchase to refer to purchases of ownership interests. But these interests can also include general or limited partnership interests or LLC membership interests. As a general rule, buyers prefer asset purchases versus stock purchases for financial and legal reasons. From a financial perspective, a buyer’s main objective is usually to maximize cash flow from the newly-acquired business to service any acquisition-related debt and provide an acceptable return on investment.
The buyer is allowed to “step up” the tax basis of asset purchases (unlike stock purchases) to reflect the purchase price. This setup results in bigger depreciation and amortization deductions for purchased depreciable and amortizable assets. Strategic asset purchase accounting also lowers taxable gains when other assets, such as receivables and inventory, are sold or converted into cash. Reduced tax bills increase post-acquisition cash flow.
From a legal perspective, asset purchases also minimize the buyer’s exposure to undisclosed and unknown liabilities of the acquired business. In contrast, when an acquisition is structured as a stock purchase, the business-related liabilities generally transfer to the buyer — even if they were unknown at the time the acquisition occurred.
TCJA Impact
When it comes to determining whether you should choose asset purchases versus stock purchases, there are several more TCJA aspects to consider. Several provisions of the TCJA make asset purchase accounting benefits even more attractive than under prior law, including:
Favorable first-year bonus depreciation deductions. Current tax law allows 100% first-year bonus depreciation for purchases of qualified assets between September 28, 2017, and December 31, 2022 (or December 31, 2023, for certain longer-lived assets and aircraft). Reduced bonus depreciation rates are scheduled to apply to purchases in 2023 through 2026 (or 2027 for certain longer-lived assets and aircraft). The bonus depreciation break is now allowed for both new and used qualified assets.
Favorable first-year Section 179 expense deductions. For tax years beginning in 2018 and beyond, the TCJA also permanently increased the maximum first-year Sec. 179 deduction to $1 million, subject to a $2.5 million phaseout limit. These amounts are adjusted annually for inflation. For tax years beginning in 2019, the maximum Sec. 179 deduction is $1.02 million and the phaseout limit is $2.55 million. For tax years beginning in 2020, the inflation-adjusted figures are $1.04 million and $2.59 million, respectively.
Lower individual tax rates. The TCJA’s reduced individual federal income tax rates for 2018 through 2025 benefit:
- Individual buyers of business assets,
- Buyers that will operate as pass-through entities with individual owners,
- Individual sellers of business assets, and
- Sellers that operate as pass-through entities with individual owners.
The last group listed above will benefit from lower individual tax rates to the extent that asset sale gains are treated as ordinary income (usually because of recapture provisions).
Reduced corporate federal income tax rate. Under current law, the corporate federal income tax rate has been permanently reduced to a flat 21% for tax years beginning in 2018 and beyond. This takes some of the sting out of the double taxation that can occur when a C corporation sells its assets — and may help convince sellers to agree to structure deals as asset purchases versus stock purchases.
Qualified business income (QBI) deduction. For 2018 through 2025, individuals, trusts, and estates can potentially claim the deduction for up to 20% of QBI from pass-through entities. These include:
- Sole proprietorships,
- Single-member LLCs treated as sole proprietorships for tax purposes,
- Partnerships,
- LLCs treated as partnerships for tax purposes, and
- S corporations.
The QBI deduction can reduce federal income tax bills for individuals, trusts, and estates that own pass-through entities that make business asset purchases (versus stock purchases, to which this does not apply). Lower taxes mean higher cash flow for buyers.
This deduction can also potentially benefit sellers of business assets that have been depreciated or amortized, because ordinary recapture income from selling these assets counts as QBI if the seller is an individual, trust, or estate that owns an interest in the selling pass-through entity. In contrast, capital gains from selling business ownership interests do not count as QBI.
In summary, you may benefit from increased QBI deductions and higher capital gains from selling asset purchases versus stock purchases.
Beware: The TCJA provision related to self-created intangibles makes business asset purchase deals less attractive. Effective for dispositions in 2018 and beyond, the TCJA stipulates that certain intangible assets can no longer be treated as lower-taxed capital gain assets. This unfavorable change applies to sales of inventions, models, and designs (whether or not patented), secret formulas, and processes that were:
- Created by the taxpayer, or
- Acquired from the creating taxpayer with the new owner’s basis determined by the creating taxpayer’s basis (such as after a contribution by the creating taxpayer to another taxable entity such as a corporation or partnership).
For deals that include self-created intangibles, asset deals might not be the right option. Be sure to consider this when analyzing your asset purchase accounting options with your CPA.
Allocating the Purchase Price
Federal income tax rules mandate the following four steps to allocate the total purchase price for assets that constitute a trade or business to the specific purchased assets:
- Allocate the price first — dollar for dollar — to cash and CDs and to the fair market value (FMV) of any government securities, other marketable securities, and foreign currency holdings included in the deal. These assets aren’t usually included in asset purchase deals, so this step is often unnecessary.
- Allocate the remaining amount to general business assets — such as receivables, inventory, furniture and fixtures, equipment, buildings, and land — that are included in the deal. Allocations in this step are made in proportion to each asset’s FMV, but they can’t exceed FMV.
- Allocate the remainder to identifiable intangible assets (other than goodwill). Examples include:
- Covenants not to compete,
- Technology and knowledge-based intangibles,
- Secret processes,
- Specialized software,
- Business systems,
- Customer lists,
- Favorable contracts,
- Workforce in place,
- Franchises,
- Copyrights, and
- Patents
These intangible assets are described in Section 197 of the Internal Revenue Code. Buyers can amortize the cost of purchased Sec.197 intangibles over 15 years. Allocations in this step are made in proportion to each asset’s FMV, but they can’t exceed FMV.
- Assign what’s left to goodwill. Goodwill often can’t be valued with any degree of precision. So, there’s no FMV cap on allocations to goodwill. Buyers also can amortize amounts allocated to purchased goodwill over 15 years.
The rules for amortizing goodwill and other intangible assets under U.S. Generally Accepted Accounting Principles (GAAP) differ from the federal income tax rules. Contact your tax advisors or asset purchase accountants for more information.
Important: Determining the FMV of business asset purchases versus stock purchases can be more of an art than a science, and usually requires the services of professional appraisers. Your tax advisor can help you find qualified outside appraisal experts who can provide supportable FMV determinations and purchase price allocations that deliver beneficial tax results to both buyers and sellers.
No Time Like the Present
Changes included in the TCJA add to the allure of asset purchase transactions. Under current law, some of these asset purchase accounting changes are permanent and some will expire in a few years.
But these taxpayer-friendly provisions could expire even sooner or be reversed, possibly even retroactively, depending on the results of the 2020 elections. So, if you’re contemplating a business asset purchase transaction, consider acting fast to secure your savings.
You can read more information on year-end tax planning for business owners here, as our transaction advisory services may be right for you. We are happy to assist you with any questions you may have, so please feel free to contact our asset purchase accountants and tax professionals today for more information.
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