Written with contributions from Curtis Kim, Frances Ellington and Arun Dubey
Even if a buyer and seller have agreed in principal to a transaction, there are still often many considerations that still need to be worked about before a deal is finalized.
One of those items is the structure of the transaction. A purchase of stock is often more commercially feasible than a purchase of the underlying assets, though there may be legal or tax reasons for the parties to pursue an asset transaction.
Additionally, when the transaction involves an S corporation, the parties have an opportunity to engage in stock transactions for legal purposes, but a deemed asset purchase for tax purposes.
This blog will highlight:
- The tax benefits for a buyer engaging in an asset acquisition (whether actual or deemed) as compared to a stock acquisition
- The increased tax cost to sellers in an asset transaction
- How recently enacted pass-through entity taxes have changed the way such costs are calculated (and therefore how many of these transactions are negotiated)
EXAMINING TAXES ON BOTH SIDES OF A TRANSACTION
Generally, an acquisition of stock does not present the opportunity for a buyer to receive a step-up in the asset basis of the acquired company’s underlying assets; rather, the buyer receives a carryover basis in the assets, stepping into the seller’s shoes and depreciating the assets over their remaining useful life.
However, in certain situations, the buyer may treat the stock acquisition as a deemed asset acquisition for tax purposes, or the buyer may simply acquire assets. This allows the buyer to receive a step-up in the basis of the acquired assets to fair market value.
Furthermore, Internal Revenue Code Section 168(k) — as added by the Tax Cuts and Jobs Act (TCJA) — allows the buyer to fully depreciate qualified property in the year of acquisition; non-qualified property still receives the step-up in asset basis, but it is depreciated over a reset useful life as opposed to taking the full amount of depreciation year one. To the extent that the purchase price is greater than the fair market value of tangible assets, generally, the buyer should also receive tax basis in an amortizable intangible asset, which may be amortized over 15 years.
Depending on the size of the transaction/asset profile of the acquired company, these depreciation and amortization deductions may provide a significant tax shield for the buyer. On the other hand, the seller often has an increased tax burden (generally due to ordinary income items on the federal side and entity-level taxes on the state side). This is where the concept of a gross-up payment comes in. A gross-up payment is an additional payment made to the seller that compensates the seller for additional federal, state, local or non-U.S. taxes that may result from treating the transaction as an asset purchase for stock purposes.
Historically, sellers have generally been willing to accommodate the buyer receiving a step-up. Because of the gross-up payment, they end up in the same position from an after-tax cash perspective.
2017 TAX CUTS AND JOBS ACT AND THE STATE TAX WORKAROUND
Under the TCJA, the itemized deduction for state and local taxes (SALT) is limited to $10,000 (or $5,000 in the case of a married person filing separately).
With IRS Notice 2020-75, the IRS clarified that state and local income taxes imposed on and paid by a partnership or S corporation on its income are allowed as a deduction by the partnership or S corporation in computing its non-separately stated taxable income or loss for the taxable year of payment. Therefore, such payments are not subject to the SALT deduction limit discussed above.
As we have outlined in previous posts, many states (including California) began implementing a new entity-level tax on partnerships and S corporations as a workaround for the SALT limitation. To date, 22 states (see the map below from AICPA) have enacted these new pass-through entity (PTE) level taxes, while three more states have pending legislation on the topic. With the exception of Connecticut, these PTE taxes are elective.
When calculating a gross-up payment, the effect of such PTE taxes should be taken into account. Since the PTE taxes may not be subject to the SALT deduction limit in many states, sellers should receive a higher deduction on federal taxes for PTE taxes that are passed through to them. As such, the gross-up may be drastically decreased or in some cases fully eliminated. Since the gross-up is often agreed to as part of the purchase agreement (i.e., prior to taxes being due), buyers who do not properly account for the benefit of the PTE tax may be putting an additional purchase price in the sellers’ pockets by paying above what incremental taxes are owed.
Consider this hypothetical illustration:
- The acquired company is an S corporation doing 100 percent of its business in California with no tax basis in its assets and all of its built-in gains are attributable to intangibles
- The acquired company’s current shareholders are all California residents
- Purchase Price: $10 million
In this simplistic fact-pattern, a gross-up payment formulated by the parties may be 1.5 percent, which is the California franchise tax on the S corporation’s income of $10 million plus taxes on the gross-up amount. However, with the state tax workaround, upon a sale of assets, there may be an opportunity to pay up to $930,000 in California personal income taxes at the entity level, thereby getting a federal deduction. Even if the $930,000 deduction reduces capital gain only, it may be approximately $186,000 in federal tax savings, which might not have been available had the sellers sold the stock for tax purposes. As such, in some cases, sellers may be more inclined to sell assets.
On Feb. 9, 2022, Governor Newsom signed Senate Bill 113. The bill includes, but is not limited to, the following significant tax-friendly changes:
- Taxpayers can use the PTE Elective Tax credit to offset the state’s tentative minimum tax for tax years beginning on or after 2021
- Pass-through entities that have partnerships as one of their owners and taxpayers that own a share of the business through a disregarded entity, such as a single-member limited liability company, may elect into the California PTE Elective Tax beginning in tax year 2021
- The bill removes the AB 85 California net operating loss (NOL) and tax credit limitations for the 2022 tax year, one year earlier than originally enacted
Click here to learn more about California’s new PTET rules and other changes that are effectuated in SB 113.
The concept of gross-up payments and how they should be calculated are all dependent upon business negotiations. However, the party with knowledge of how the transaction structure will impact the tax consequences for both parties will be able to make informed decisions.
GHJ’s Transaction Tax Team has significant experience modeling the gross-up and can assist clients on both the buy-side and sell-side of transactions to ensure that they are getting tax-efficient results when it comes to gross-up payments.