Now, let’s look at the tax implications of a stock deal from the buyer’s perspective. If the buyer pays $100 for all of the stock of the seller’s company, the buyer inherits the assets at their current book value. Recall that in our example the current book value of the seller’s assets is $50. If our buyer depreciates the assets over five years, the deduction per year is $10. Therefore, in the first year the buyer will pay taxes on $90 ($100 earnings before taxes minus $10 of deducted depreciation). At a 40% effective tax rate, the buyer’s tax bill is $36, which means the buyer who acquires this company by purchasing its stock only nets $64 for the first year ($100 earnings before taxes minus $36 in taxes = $64). Also, at some point in the future the buyer will sell the purchased assets. If the assets are carried on the buyer’s books at very low book rates because they’ve been heavily depreciated, the buyer will pay a significant amount of taxes upon selling the assets (the difference between the price for which they’re sold and their then current book value).
The seller, on the other hand, usually prefers a stock deal over an asset deal. In a stock sale, the seller usually pays capital gains tax rates on the sale of the stock. Capital gains tax rates are lower than ordinary income tax rates. So, if the seller originally bought all the stock of its company for $50 (or its “basis” in its stock is otherwise $50) and now sells all that stock for $100, it will pay capital gains tax on $50 ($100 sale price minus $50 basis in the stock = $50 of net gain). If the capital gains tax rate is 15% (as it is in 2014), the seller will pay $7.50 of taxes ($50 of net gain multiplied by 15%).
Sticking with our same example but looking at the seller’s side of an asset deal, the seller who holds assets valued on its books at $50, will realize the same $50 gain on the sale of those assets for $100 as if it did a stock deal. However, the $50 gain will now be taxed at ordinary income rates. If our seller has a 40% effective tax rate, the tax will be $20. Quite a difference from the $7.50 the seller owed in taxes in a stock deal.
The tax treatment of mergers is a complex area of law and finance. Mergers may often be accomplished as “tax-free reorganizations.” Tax-free is a bit of a misnomer, however. The IRS always collects its taxes, it’s just a matter of when. In a tax-free reorganization, the taxes are deferred to the future. Certain requirements apply depending on the type of reorganization being undertaken. By way of example, in a Type-A reorganization, the acquirer uses its stock to purchase the stock of the selling company. The acquirer must purchase at least 80% of the voting stock of the seller and certain IRS tests must be satisfied to ensure that the acquirer actually continues to operate the seller’s business post-closing and that there is a valid business purpose for the reorganization. There are other types of reorganizations – B to G, actually, giving rise to the term “Alphabet Reorganizations” to describe these types of transactions.
Again, disclaimer, disclaimer, disclaimer – I’ve really simplified the deal structure analysis here to make the broad points. And, there are exceptions galore. For example, a buyer with significant net operating losses that are carried forward into the current tax year is not concerned with the amount of depreciation write-off the purchased assets provide because that buyer has no earnings left in which to apply the depreciation write-off. Also, there is something called a 338(h)(10) election, which allows the parties to agree to treat a stock sale like an asset sale for purposes of its tax treatment. Certain restrictions apply to 338(h)(10) elections. In the same vein, there are certain types of stock purchases that may qualify as “tax-free organizations” although those and the specifics of the 338(h)(10) election are way outside the scope of this article.
Author: Brett Cenkus
Brett Cenkus is a business attorney with 18+ years experience based in Austin, Texas. He has worked with a variety of businesses and has clients throughout Texas as well as many technology clients throughout the United States. Brett is a Harvard Law graduate with a sharply seasoned mind and an entrepreneurial heart. As a founder of 6 companies himself, he is especially passionate about helping startups succeed. In 2016 Brett was named the winner in the Individual category for RecognizeGood’s Ethics in Business & Community Award. He offers businesses solutions that are in sync with their culture, goals and values. You can learn more about Brett by visiting the About page on this website.