In a continuation of our series on closely held business succession planning, our next few articles discuss the implications of buying or selling a closely held C-Corporation, S-Corporation, or Partnership/Limited Liability Company (LLC). These transactions will either be a purchase of the underlying assets of the entity or the stock or members’ interest of the entity. The tax implications for the buyers and sellers are generally in contradiction to each other as the buyer wants to use the purchase to create deductions through depreciation and amortization, while the seller wants to pay the least amount of federal and state tax as possible on the transactions. We will discuss the differences to the buyers and sellers for each of these types of transactions.
This article will focus on the tax implications on the purchase or sale of a C-Corporation. The use of the C-Corporation decreased dramatically when LLCs became more popular but have seen a small resurgence for some business owners in recent years, due to the fixed 21% tax rate that was enacted as part of the Tax Cuts and Jobs Act (TCJA) enacted in late 2017.
Buying and Selling C Corporation Assets
An asset transaction involves the transfer of the individual assets or group of assets of one business to another. In some cases, a newly formed entity is created by the buyer and in other cases an existing business will purchase the assets and absorb them into their current operations.
Many deals are structured on a cash-free, debt-free basis, meaning that any cash currently owned by the C corporation will remain with the owners but the sellers will also not assume any business debt that is not part of normal operations, such as accounts payable or other accrued business expenses. If any business liabilities are assumed by the buyer, these constitute an additional purchase price for the buyer and seller, resulting in additional gain for the seller and a higher basis in the assets and intangible for the buyer.
One of the most significant tax issues for the seller is the issue of double taxation that occurs when the assets are purchased. The gain on the sale of assets is taxed by both the federal government and states where the corporation has nexus. The remaining cash, after taxes are paid, is then distributed to the owner or owners who will have to pay federal and state tax on the dividend distribution. The double taxation can cause the tax on the transaction to be in excess of 50%. If the C-Corporation pays an effective 24.16% on the gain (21% federal tax and 3.16% state tax, net of federal benefit) and the owners pay 27.8% on the dividend (20% federal tax, 3.8% net investment income tax, and 4% state tax), then the marginal tax on the total transaction can exceed 45%. Planning can be done to help to mitigate some of the tax, but double taxation is always a significant concern when a C-Corporation is involved in a transaction.
For the buyer in this transaction, it is important to understand how the allocation of the purchase price will impact future deductions after the assets are purchased. The purchase of inventory results in an ordinary deduction as the inventory is sold. For the purchase of tangible assets, such as equipment, furniture, and fixtures, the expense is taken over time as allowed by tax law. The buyer may be able to take advantage of Internal Revenue Code Sections 179 or 168 depreciation, which allow for immediate or near-immediate expensing of assets. These code sections have limitations that change each year, but the implications must be considered by the buyer when they are purchasing the assets of a C-Corporation to understand their future tax deductions related to an asset purchase. The purchase of assets can include the purchase of goodwill or other intangible assets, such as location rights or customer lists that can be amortized over 15-years for tax purposes.
The purchase of assets is generally a better tax option for the buyer than the seller of assets held by a C-Corporation, due to the double taxation issue discussed above.
Buying and Selling C Corporation Stock
In contrast to the asset purchase, a stock purchase is generally more advantageous to the seller than to the buyer. The stock purchase is the transfer of the ownership interest of the legal entity from one owner(s) to another.
The seller of C-Corporation stock, will pay a capital gains rate on the sale of their stock which will generally qualify for the long-term rate of 20%. Depending on the seller’s level of involvement in the business, they may also be subject to the 3.8% net investment income tax in addition to the 20% capital gains tax. Also, depending on where the owner or owners live, they could be subject to state income tax on the gain on the sale. The gain on the sale is determined by taking the purchase price paid by the buyer less the owner’s basis in their shares of stock. For a C-Corporation shareholder, their basis is equal to the amount of money they have contributed to the corporation less any non-dividend distributions received from the corporation.
A seller may be allowed to exclude all or part of their gain on their stock if the C-Corporation qualifies for the gain exclusion under Internal Revenue Code Section 1202. While the nuances of the “1202 exclusion” are outside the scope of this article, in general terms an exclusion is available for gains on qualified small business stock (QSBS) that can allow for all or a larger portion of gain on the stock to be excluded from federal income tax. Understanding the nuances and benefits of Section 1202 is essential for investors and business owners seeking to optimize their tax strategies when contemplating the sale of their business.
The buyer of C-Corporation stock will inherit the assets and liabilities of the entity “as-is” with no step-up in basis for the underlying assets. The basis of the assets carries over at the historical tax basis, along with net operating losses, credit carryovers, and other tax attributes. The buyer may have limitations on how much of the purchased tax attributes they are able to use each year. Under Internal Revenue Code Section 382, which is outside this article’s scope, limitations can be placed on the ability of the acquiring company to use net operating losses, credits, and other tax attributes of the selling company. The purpose of Section 382 is to limit a profitable corporation’s ability to purchase losses generated by another entity through an acquisition. The implications of Section 382 should be understood and analyzed prior to closing a stock acquisition.
Finally, there is an election under Internal Revenue Code Section 338 that will allow the buyer and seller to agree on treating a stock transaction as an asset deal. As this article is an overview of the implications of these structures, the nuances of these elections are outside this article’s scope. However, this can be a negotiation point between buyer and seller to change the tax treatment of a transaction while keeping the overall structure in place.
Company A has agreed to purchase Company B for $500,000. Both companies want to understand the tax implications of both types of transactions. They have agreed to a purchase price allocation of $400,000 for the equipment and $100,000 for goodwill. The equipment of Company B has no tax basis due to prior depreciation taken. The shareholder of Company B has zero basis in the stock of the company.
The table below summarized the tax implications of this transaction:
*Note: The tax savings of depreciation and amortization will be received over time based on the tax law in effect at the time of the transactions. For 2023, the step-up on depreciation for most assets will be 80% in year one and the remaining over the useful life of the assets. For amortization on goodwill and intangibles, the deduction will be received over a fifteen-year period.
We can help
At Elliott Davis, our closely held business and transaction advisory services teams have years of experience working with customers to understand and execute the appropriate transaction structure whether they are buying or selling. We can work with you to understand the different options available, the tax implication of each, and help you determine the best path forward for you and your business.
The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change.