A business combination can be effected as either an asset acquisition or a stock acquisition.
The acquirer buys some or all of the target's assets/liabilities directly from the seller. If all assets are acquired, the target is liquidated.
The acquirer buys the target's stock of from the selling shareholders.
Note that in a stock sale, the sellers are the target's shareholders (which may be a corporate entity). In an asset sale, the seller is a corporate entity. So, the type of acquisition will determine who pays taxes on the transaction and the amount of taxes to be paid based on the tax rate applicable to the seller.
Do not confuse the type of acquisition with the form of consideration. A buyer may use either cash or stock (or a combination thereof) as consideration in exchange for the assets or stock of the target.
In an asset sale, individually identified assets and liabilities of the seller are sold to the acquirer. The acquirer can choose ("cherry pick") which specific assets and liabilities it wants to purchase, avoiding unwanted assets and liabilities for which it does not want to assume responsibility. The asset purchase agreement between the buyer and seller will list or describe and assign values to each asset (or liability) to be acquired, including every asset from office supplies to goodwill. Determining the fair value of each asset (or liability) acquired can be mechanically complex and expensive; tedious valuations are costly and title transfer taxes must be paid on each asset transferred. Also, some assets, such as government contracts, may be difficult to transfer without the consent of business partners or regulators.
If the assets to be acquired are not held in a separate legal entity, they must be purchased in an asset sale, rather than a stock sale, unless they can be organized into a separate legal entity prior to sale. Subsidiaries of consolidated companies are often organized as separate legal entities, whereas operating divisions are usually not.
A major tax advantage to the acquirer of structuring a transaction as a taxable asset purchase is that the acquirer receives stepped-up tax basis in the target's net assets (assets minus liabilities). This means that the acquired net assets are written up (or down) from their carrying values on the seller's tax balance sheet to fair value (FV) on the acquirer's tax balance sheet. The higher resulting tax basis in the acquired net assets will minimize taxes on any gain on the future sale of those assets. Under U.S. tax law, goodwill and other intangibles acquired in a taxable asset purchase are required by the IRS to be amortized over 15 years, and this amortization is tax-deductible. Recall that goodwill is never amortized for accounting purposes but instead tested for impairment.
Buyer assumes a FV tax basis in the acquired net assets equal to the purchase price.
In a taxable asset sale, the seller pays tax on any gain on the sale of its assets. Of course, the seller won't agree to bear the tax burden of an asset sale while the acquirer enjoys the benefit of a tax step-up without some incentives. To induce the seller to agree to an asset purchase, the buyer will often pay a higher purchase price (relative to a stock acquisition) to the seller as compensation for the seller's tax liability.
In a stock purchase, all of the assets and liabilities of the seller are sold upon transfer of the seller's stock to the acquirer. As such, no tedious valuation of the seller's individual assets and liabilities is required and the transaction is mechanically simple. The acquirer does not receive a stepped-up tax basis in the acquired net assets but, rather, a carryover basis. Any goodwill created in a stock acquisition is not tax-deductible.
Buyer assumes the seller's existing tax basis in the acquired net assets.
However, if an Internal Revenue Code (IRC) Section 338 election is made by the acquirer (or jointly by the acquirer and seller), the stock sale is treated as an asset sale for tax purposes. A Section 338 election entitles the buyer to the coveted stepped-up tax basis and tax-deductible goodwill, but also triggers a taxable gain on the hypothetical asset sale. We will discuss Section 338 elections more in another lesson.
Although the buyer acquires all assets and liabilities in a stock purchase, it may contractually allocate unwanted liabilities to the seller by selling them back to the seller.
In the stock acquisition of a corporate subsidiary without a Section 338 election, the selling parent company may use the tax attributes (e.g. NOLs) of its other subsidiaries to offset its gain on the sale of target stock. However, the parent cannot use the tax attributes of the target subsidiary because they are lost to the buyer in the transaction and subject to limitation under Section 382.
Exhibit – Comparison of Taxable Asset and Stock Deals
|Asset Deal||Stock Deal (no §338 Election)|
|Assets / Liabilities||Acquirer can "cherry pick" wanted assets/liabilities, avoiding unwanted liabilities. However, some assets cannot be transferred easily without third party consents.||All liabilities transfer to the buyer by operation of law, wanted or not. However, the buyer can contractually allocate liabilities to the seller by selling them back.|
|Complexity / Cost||Complex and costly process that requires identification, valuation, and title transfer of individual assets.||Relatively inexpensive and easy to execute.|
|Taxes||If the target liquidates, then there are two levels of tax, at the corporate level and again at the shareholder level when the liquidation proceeds are distributed.||Only one level of tax–at the shareholder level.|
|Tax Basis||The buyer's basis in the acquired assets is stepped up to the purchase price (FV).||The buyer's basis in the acquired stock is stepped up to the purchase price (FV). The buyer assumes a carryover basis in the acquired assets.|
|Goodwill||Tax-deductible and amortized over 15 years for tax purposes under IRC Section 197.||Not tax-deductible.|
So far, we have focused on taxable acquisitions. We'll discuss non-taxable transactions in a subsequent topic. For now, realize that non-taxable deals do not involve tax basis step-ups.
Tax Basis Consequences of Deal Structuring
As we have seen, the buyer's tax basis in acquired assets and liabilities depends, in part, on whether the transaction is structured as an asset or a stock sale. However, the seller's assets and liabilities are always stepped up or down for accounting purposes on the buyer's books, regardless of the type of acquisition.
In deals structured as taxable asset purchases, the buyer records acquired assets at their stepped-up FVs on both its book and tax balance sheets. In stock acquisitions, however, the buyer receives a carryover tax basis and a stepped-up book basis in the acquired assets. Incremental post-transaction depreciation and amortization attributable to asset write-ups for book purposes—but not for tax purposes—in a stock acquisition result in lower taxable income for book purposes than for tax purposes. This incremental tax shield means the acquirer's book tax expense will be lower in future periods than the cash taxes actually due the IRS. A deferred tax liability (DTL) is recorded on the GAAP balance sheet to reflect the acquirer's higher cash tax liability (relative to GAAP tax expense).