After a challenging year, you may have questions about your small business, especially If you are considering a merger or acquisition. At Tom Dunn, we can help you understand the tax implications of making a move in 2021, whether that be buying or selling a business.
Two Ways to Buy or Sell Under Current Tax Law
Merger and acquisition activity in many industries slowed during 2020 due to COVID-19. But analysts expect it to improve in 2021 as the country comes out of the pandemic. Under current tax law, a transaction can basically be structured in two ways:
(1) Stock or Ownership Interest
A buyer can directly purchase a seller’s ownership interest if the target business is operated as a C or S corporation, a partnership, or a limited liability company (LLC) that’s treated as a partnership for tax purposes.
The current 21% corporate federal income tax rate makes buying the stock of a C corporation somewhat more attractive. Why? First of all, the corporation will pay less tax and generate more after-tax income. Plus, any built-in gains from appreciated corporate assets will be taxed at a lower rate when they’re eventually sold.
The current law’s reduced individual federal tax rates have also made ownership interests in S corporations, partnerships and LLCs more attractive. The passed-through income from these entities is also taxed at lower rates on a buyer’s personal tax return. However, current individual rate cuts are scheduled to expire at the end of 2025, and, depending on actions taken in Washington, they could be eliminated earlier. Keep in mind that that tax rate on corporations may increase over the next couple of years.
A buyer can also purchase the assets of a business. This may happen if a buyer only wants specific assets or product lines. And it’s the only option if the target business is a sole proprietorship or a single-member LLC that’s treated as a sole proprietorship for tax purposes.
What do Buyers Prefer?
For several reasons, buyers usually prefer to buy assets rather than ownership interests. In general, a buyer’s primary goal is to generate enough cash flow from an acquired business to pay any acquisition debt and provide an acceptable return on the investment. Therefore, buyers are concerned about limiting exposure to undisclosed and unknown liabilities and minimizing taxes after a transaction closes.
Another thing to keep in mind is this: a buyer can step up (increase) the tax basis of purchased assets to reflect the purchase price. Stepped-up basis lowers taxable gains when certain assets, such as receivables and inventory, are sold or converted into cash. It also increases depreciation and amortization deductions for qualifying assets.
What do Sellers Prefer?
In general, sellers prefer stock sales for tax and nontax reasons. One of their objectives is to minimize the tax bill from a sale. That can usually be achieved by selling their ownership interests in a business (corporate stock or partnership or LLC interests) as opposed to selling assets.
With a sale of stock or other ownership interest, liabilities generally transfer to the buyer and any gain on sale is generally treated as lower-taxed long-term capital gain (assuming the ownership interest has been held for more than one year).
Contact Tom Dunn for Professional Tax Advice
Be aware that other issues, such as employee benefits, can also cause tax issues in M&A transactions. Buying or selling a business may be the largest transaction you’ll ever make, so it’s important to seek professional assistance before you proceed. After a transaction is complete, it may be too late to get the best tax results.
If you have questions about your specific situation, call us as soon as you can. We’ll be happy to go over any tax implications with you with an expert tax accountant.