Low interest rates and other factors have caused global merger and acquisition (M&A) activity to reach new highs in 2021, according to Refinitiv, a provider of financial data. It reports that 2021 is set to be the biggest in M&A history, with the United States accounting for $2.14 trillion worth of transactions already this year. If you’re considering buying or selling a business — or you’re in the process of an M&A transaction — it’s important that both parties report it to the IRS and state agencies in the same way. Otherwise, you may increase your chances of being audited.

If a sale involves business assets (as opposed to stock or ownership interests), the buyer and the seller must generally report to the IRS the purchase price allocations that both use. This is done by attaching IRS Form 8594, “Asset Acquisition Statement,” to each of their respective federal income tax returns for the tax year that includes the transaction. 

Here’s what must be reported

If you buy business assets in an M&A transaction, you must allocate the total purchase price to the specific assets that are acquired. The amount allocated to each asset then becomes its initial tax basis. For depreciable and amortizable assets, the initial tax basis of each asset determines the depreciation and amortization deductions for that asset after the acquisition. Depreciable and amortizable assets include:

  • Equipment,
  • Buildings and improvements,
  • Software,
  • Furniture, fixtures and
  • Intangibles (including customer lists, licenses, patents, copyrights and goodwill). 

In addition to reporting the items above, you must also disclose on Form 8594 whether the parties entered into a noncompete agreement, management contract or similar agreement, as well as the monetary consideration paid under it.

What the IRS might examine

The IRS may inspect the forms that are filed to see if the buyer and the seller use different allocations. If the tax agency finds that different allocations are used, auditors may dig deeper and the examination could expand beyond the transaction. So, it’s best to ensure that both parties use the same allocations. Consider including this requirement in your asset purchase agreement at the time of the sale.

The tax implications of buying or selling a business are complex. Price allocations are important because they affect future tax benefits. Both the buyer and the seller need to report them to the IRS in an identical way to avoid unwanted attention. To lock in the best results after an acquisition, consult with us before finalizing any transaction.

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Merger and acquisition activity has been brisk in recent years. If your business is considering merging with or acquiring another business, it’s important to understand how the transaction will be taxed under current law.

Stocks vs. assets

From a tax standpoint, 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 now-permanent 21% corporate federal income tax rate under the Tax Cuts and Jobs Act (TCJA) makes buying the stock of a C corporation somewhat more attractive. Reasons: 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 TCJA’s reduced individual federal tax rates may also make ownership interests in S corporations, partnerships and LLCs more attractive. Reason: The passed-through income from these entities also will be taxed at lower rates on a buyer’s personal tax return. However, the TCJA’s individual rate cuts are scheduled to expire at the end of 2025, and, depending on future changes in Washington, they could be eliminated earlier or extended.

2. Assets. 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.

Note: In some circumstances, a corporate stock purchase can be treated as an asset purchase by making a “Section 338 election.” Ask your tax advisor for details.

Buyer vs. seller preferences 

For several reasons, buyers usually prefer to purchase assets rather than ownership interests. Generally, a buyer’s main objective 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 the deal closes.

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.

Meanwhile, sellers generally prefer stock sales for tax and nontax reasons. One of their main 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 business 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).

Keep in mind that other issues, such as employee benefits, can also cause unexpected tax issues when merging with, or acquiring, a business.

Professional advice is critical

Buying or selling a business may be the most important transaction you make during your lifetime, so it’s important to seek professional tax advice as you negotiate. After a deal is done, it may be too late to get the best tax results. Contact us for the best way to proceed in your situation. 205-345-9898 or info@covenantcpa.com.

© 2019 CovenantCPA