Why Business Entity Matters When Structuring an M&A Deal

Taxes may not be the most exciting part of an M&A deal, but if you fail to consider how taxes will affect the final price, you may be in for an unpleasant surprise at closing. Depending on whether your — or your prospective acquisition’s — business is a C or an S corporation, either an asset or a stock sale may be more beneficial from a tax standpoint. 

Stock Deals for C corps

In an asset transaction, owners sell all or most of their company’s assets to a buyer and then liquidate the company stock and what few assets and liabilities remain in the business. In a stock transaction, owners sell the company stock — including all of their business’s assets and liabilities. Stock deals are almost always preferable for C corporation transactions. Sellers pay tax on net capital gains from the stock only.

On the other hand, C corporations sold in asset deals are subject to double taxation. First the corporation pays taxes on gains from the sale of the assets, and then shareholders pay taxes on the after-tax amounts distributed to them by the company. Paying tax on the gain can be detrimental to sellers that have considerably depreciated those assets in their business. So this tax impact must be addressed during deal negotiations.

Buyers may opt to assign the highest market values to acquired assets (known as a step-up in the tax basis) via a Section 338 election. Generally, this results in tax benefits for buyers with an increased depreciation schedule and greater cash flow.

Greater Flexibility for S corps

There are fewer tax differences between a stock and an asset sale for S corp owners. This is because S corps are considered conduit or flow-though entities by the IRS — meaning there’s no federal tax on corporate profits. Instead, company profits from an asset sale flow through directly to stockholders’ individual tax returns.

Therefore, double taxation generally doesn’t apply unless the S corp has recently converted from a C corp status. In that case, 10 years must elapse before an S corp can be sold in an asset sale and treated as such for tax purposes. If the sale takes place before the 10-year anniversary, double taxation is triggered by an asset sale.

The benefit to both buyers and sellers in an S corp transaction is the option to deem a stock sale as an asset sale under a Sec. 338(h)(10) joint election. Treating an S corp transaction as an asset sale produces the same depreciation cash flow benefits as electing a C corp transaction as an asset sale. S corps, however, don’t experience the same tax costs as C corp transactions because gains and losses from the step-up flow through to shareholders. 

This reduced tax burden normally makes an asset sale of an S corp the optimal transaction structure for buyers. Also, because of the beneficial depreciation schedule for the buyer, the seller may be able to negotiate a higher sale price. 

Many Considerations

Taxes are important when structuring an M&A transaction, but they are only one of many considerations. So before you prepare to go to battle for a tax-efficient deal, discuss other priorities — such as final price and postdeal plans — with your M&A advisor to help ensure the transaction as a whole will meet your needs.