On your company’s growth journey, you may experience both organic and inorganic growth. Inorganic growth through acquisitions can present opportunities to quickly enter a market, overcome steep learning curves, or achieve larger scale. From Amazon’s acquisition of Whole Foods to CVS’s acquisition of Aetna, acquisitions happen frequently in capital markets. This article addresses specific issues companies face in taxable statutory mergers and stock acquisitions that meet the definition of a business combination for financial accounting purposes. The article also explains the advantages, disadvantages, and tax implications of each structure, including impacts of the Tax Cuts and Jobs Act (TCJA). For a more general overview of merger and acquisition (M&A) transactions, see M&A Buy Side vs. Sell Side or Acquisition Decision Making.
In the M&A environment, there are many methods of structuring an acquisition which can become quite complex. This article only addresses acquisitions that qualify as business combinations under the Accounting Standards Codification (ASC) 805. A business combination is “a transaction or other event in which an acquirer obtains control of one or more businesses” (ASC 805-10-20). We will assume throughout the article that the acquirer is purchasing 100% of the target firm through a lump-sum cash purchase for simplicity. The accounting treatment and tax implications can greatly differ from what is mentioned here depending on several factors, such as the type of consideration given, entity type of the acquirer and target firm, and percent of ownership acquired, among others.
Once you’ve determined if the transaction is a business combination, you can consider financial accounting implications. In a stock acquisition, although one of the entities owns the other, the two entities generally retain their separate legal existence. For example, Salesforce acquired Tableau in 2019 for 15.7 billion in an all-stock transaction, in which Tableau stock was exchanged for Salesforce stock. Salesforce and Tableau still operate as separate legal entities, but in a parent-subsidiary relationship. In contrast, a statutory merger results in one surviving company while the other company is legally dissolved. The transaction is often taxed as an asset acquisition of the target, with the target being subsequently dissolved. For example, many of the business combinations in 2007 – 2009 in the banking and financial services industry were statutory mergers, such as Bank of America purchasing LaSalle Bank and JPMorgan Chase purchasing Washington Mutual. In these statutory mergers, Bank of America and JPMorgan Chase each emerged as the sole surviving firm.
Lastly, the M&A structures discussed here will likely drive the purchase price of the target either up or down. For example, the buyer may pay more to structure the deal as an asset acquisition because of certain tax benefits. Alternatively, the target may agree on a lower purchase price to structure the deal as a stock acquisition because the target receives a lower tax burden. We will compare statutory mergers and stock acquisitions in more detail below.
A statutory merger is a business combination in which only one of the two combined firms remains a legal entity. The target firm must liquidate as a result of the transaction, and all known and unknown assets and liabilities of the target are assumed by the buyer. One downside of this structure is the buyer’s inability to acquire only desired assets and liabilities; acquiring all known and unknown liabilities may prove costly if the liabilities include contract claims, product liability claims, or employee lawsuits, for example.
In accordance with ASC 805, the buyer and seller must allocate the purchase price of the transaction to the acquired assets and liabilities at fair value (ASC 805-20-30-1). Determining the fair value of each acquired asset (or liability) can be a very expensive and complex process. Once the fair value is determined, generally accepted accounting principles (GAAP) requires the book basis of assets and liabilities to be stepped-up to the fair value. This change to fair value is called “Pushdown Accounting,” and is applicable for both statutory mergers and stock acquisitions.
Any excess of the purchase price over the net identifiable assets acquired is recorded as goodwill. For example, a typical buyer acquires Company XYZ for $5M. The sum of Company XYZ’s identifiable assets is $3M, so the buyer allocates $2M to goodwill. In the rare case of a bargain purchase where the fair value of the net identifiable assets is greater than the purchase price, a gain is recorded. A bargain purchase might occur when a seller is compelled to sell below fair value due to an economic event, company regulation, or legal order (ASC 805-30-25-3).
In addition to the step-up in book basis for financial accounting, a statutory merger also causes the tax basis in the net assets acquired to be stepped-up to their fair market value. This step-up for appreciated assets leads to higher initial tax depreciation and amortization expenses.1 These higher expenses generally lead to lower net income in post-acquisition periods and lower taxable income. For tax purposes in a statutory merger, the buyer amortizes any purchased goodwill on a straight-line basis over 15 years.2 In contrast, no tax deduction is allowed for goodwill in stock acquisitions, so taxable asset acquisitions are, in this sense, buyer friendly.
A stock acquisition—falling under the broader category of business combinations—occurs when the buyer acquires the target company by purchasing its stock. This can be done through peaceful negotiations with management or through a hostile takeover. The two entities retain their legal existence, but the buyer now owns the other as a subsidiary. After purchasing the target’s stock, the buyer gains control over the assets and liabilities of the target; however, because only ownership changes, the net assets don’t physically transfer to the buyer, they remain in the target company. For financial accounting purposes, all assets and liabilities are stepped-up to their fair value as described above for statutory mergers, since both are considered business combinations. Thus, the costly and complex process of valuing all identifiable assets and liabilities of the target is required for either method. However, for tax purposes, a stock acquisition does not cause a step-up in tax basis; the net assets keep their same basis since the target remains a separate legal entity.3 Certain tax elections are offered to treat a stock acquisition as an asset acquisition, but these will be discussed later in the article.
The advantage of a stock acquisition is the speed and relative simplicity of the transaction, and the fact that otherwise hard-to-purchase assets will easily fall under the buyer’s control. One disadvantage is the tax basis in acquired assets and liabilities remains unchanged, so the buyer may miss some tax benefits associated with higher depreciation and amortization deductions from appreciated assets. Another disadvantage is that any goodwill created in a stock acquisition is not tax-deductible. For these tax reasons, stock acquisitions are generally considered more seller-friendly and statutory mergers taxed as asset acquisitions are more buyer-friendly. All the differences between statutory mergers and stock acquisitions explained above are summarized in the table below.
|Statutory Merger Taxed as Asset Acquisition||100% Stock Acquisition|
|What is Acquired?||All known and unknown assets and liabilities||Complete ownership and control of the Target firm|
|Result on the Acquired Firm||Target must liquidate, thus ceasing to exist||Target remains a separate entity in parent-subsidiary relationship|
|GAAP Allocation of Purchase Price for Net Assets/Liabilities Acquired||Required, which can be costly and complex||Required, which can be costly and complex|
|Goodwill Tax Treatment||Amortized straight-line over 15 years for public and private companies||No tax deduction|
|Tax Basis in Net Assets Acquired||Stepped-up to fair market value of the asset or liability||Stays the same since target remains a separate entity|
|Income Tax Footnote Disclosure||Creates temporary book-tax difference leading to a deferred tax asset/liability||Creates permanent book-tax difference leading to a rate reconciliation item|
Detailed Tax Implications
The tax implications of an M&A transaction can affect the negotiated purchase price and whether the deal will ultimately go through. As mentioned in the overview, all examples below will assume the buyer purchases the target with cash in a taxable acquisition. Acquisitions may be tax-deferred under different circumstances, but we will not address these for simplicity.
Asset acquisitions are generally buyer-friendly in part because of the tax benefits the buyer receives. All appreciated assets the buyer purchases receive pushdown accounting and a step-up in book and tax basis, which generates higher current tax deductions. The following example illustrates a tax basis step-up for an asset:
Company B (Buyer) wants to purchase a business including a patent from Company S (Seller) on 01/01/19. Assume the purchase price equals the fair market value of the identifiable assets of the target. This patent has a fair value of $15 million and useful life of 20 years. If the transaction is structured as a statutory merger, the patent’s fair value can be amortized under IRC Section 197(a) over 15 years, just like goodwill. However, if the transaction is structured as a stock acquisition, the patent is not deductible, even though it is recorded under GAAP. Any goodwill created in a stock acquisition is not deductible. The table below illustrates this example:
|Statutory Merger||Stock Acquisition|
|Buyer’s tax basis in patent||$15 million||$0|
|2019 tax deduction||$1 million4||$0|
As shown above, Buyer benefits from an asset acquisition by receiving a $1 million tax deduction in 2019 because the basis in the patent was stepped-up to the fair market value. In our simple example, the tax implications of Buyer and Seller are quite clear; however, the tax effects depend on many factors, including the entity type of the seller, the type of assets in the transaction, tax elections made during the acquisition, tax deferral techniques, and type of consideration received.
In addition to the structure of the transaction, the target’s entity type also has important tax implications for the acquisition. When a statutory merger occurs and the target is a C-corporation, the target’s shareholders face two levels of taxation: one for the target’s gain or loss on the sale of net assets, and the second for capital gains recognized by shareholders when the target is subsequently liquidated. However, in a stock acquisition, the target’s shareholders only face one level of taxation at the shareholder level, even if the target is a C-corporation. This difference arises because the stock acquisition is with the target shareholders and not the target C-corporation itself, thus the target corporation doesn’t incur any tax liability. The following example illustrates the differences between a statutory merger and a stock acquisition when the seller is a C-corporation:
We will assume that Seller is a C-corporation, Bob is the owner and sole shareholder of Seller, Seller’s corporate tax rate is 21%, and Bob’s capital gains rate is 20%. Buyer purchases Seller for $30 million with cash in a taxable acquisition. In a statutory merger, Seller liquidates after being acquired, causing two levels of tax. The first tax is for Seller’s gain on the sale of its assets (assume Seller’s basis in the net assets is 10 million). The second level of tax occurs when Seller is liquidated and the proceeds are distributed to the sole shareholder, Bob. Contrastingly, in a stock acquisition, Bob only has one level of taxation. Assume Bob’s basis in his stock is $1 million. The tax impacts are highlighted below:
|Statutory Merger||Stock Acquisition|
|Seller’s Basis in Assets Sold||$10,000,000||NA|
|Seller’s Gain on Sale||$20,000,000||NA|
|C-Corp’s Tax (21%)||$(4,200,000)||NA|
|Bob’s Proceeds from Liquidation||$25,800,000||NA|
|Bob’s Basis in Stock||$1,000,000||$1,000,000|
|Bob’s Capital Gain||$24,800,000||$29,000,000|
|Bob’s Personal Tax (20%)||$(4,960,000)||$(5,800,000)|
|Total Tax Liability||$(9,160,000)||$(5,800,000)|
|Bob’s After-Tax Earnings||$20,840,000||$24,200,000|
If Seller was instead taxed as either an S-corporation or a partnership (with various legal forms), Seller would not experience double taxation in a statutory merger. Instead, the tax would flow through the company directly to Bob’s individual tax return.
Lastly, the entity type may influence how the purchase price is allocated, regardless of whether the transaction is a statutory merger or stock acquisition. If the target is a C-corporation, the corporation pays the taxes at the flat federal rate of 21% in the U.S. However, if the target is a flow-through entity, the tax rates depend on the shareholder and how the purchase price was allocated to the assets. The buyer and seller must independently report to the IRS the purchase price allocations used, and the IRS may inspect the reported forms to see if the buyer and seller used different allocations.5 Each party has a vested interest in how the purchase price is allocated to the assets since different allocations can result in different tax benefits to either party.6 Buyers prefer allocating the purchase price to assets with shorter depreciation periods and/or to assets that qualify for immediate bonus depreciation (e.g., equipment that depreciates over 7 years instead of intangible assets that amortize over 15 years). Sellers prefer allocating the purchase price to assets with a higher tax basis—which results in a lower taxable gain—and to capital assets7 rather than ordinary8 assets. This is because capital assets generate capital gains for a flow-through entity at a current maximum tax rate of 20%, and ordinary assets generate ordinary gains at a maximum tax rate of 37% as of 2020. Any excess of the purchase price over the net identifiable assets acquired is recorded as goodwill. Section 1060 of the Internal Revenue Code provides guidelines for the order in which the purchase price should be allocated to the assets in the transaction.
In an M&A transaction, certain tax elections may alter the tax impact of the transaction. A few notable tax elections include a Section 338(g) election or a Section 338(h)(10) election. Each optional tax election is described below with its corresponding requirements.
Section 338(g) Election
A Section 338(g) election allows a stock acquisition to be treated like an asset acquisition for tax purposes. This causes the transaction to have the same tax effects mentioned above for an asset acquisition, such as creating a basis step-up in the assets and double taxation. The major benefit is that all asset write-ups and recognized intangibles, including goodwill, become tax deductible. However, the election also results in two levels of tax at the corporate and shareholder level with an immediate gain recognized for stepping up the basis. Thus, the election only makes sense when the present value of future tax savings (created from the deductible depreciation and amortization expenses) exceeds the current tax cost of stepping up the tax basis.9 This election is advantageous if the target has net operating losses to offset the recognized gain, or if the target is a foreign corporation. Since foreign jurisdictions don’t recognize the 338(g) election, a foreign target allows the U.S. buyer to avoid recognizing the gain and to step-up the tax basis for free.
The following conditions (not comprehensive) apply to the Section 338(g) election:
- The buyer must be a C-corporation
- The target must be a C-corporation
- The buyer must purchase at least 80% of the target’s stock (voting and value)
- The buyer unilaterally makes the election
- The buyer bears the tax burden from the gain on the deemed sale of target’s assets
Section 338(h)(10) Election
A Section 338(g) election and Section 338(h)(10) election are quite similar. The major difference is that a Section 338(h)(10) election allows the buyer to avoid double taxation. The transaction is treated as though the target’s assets are sold while the target is part of the parent’s consolidated group, so the income is recorded on the consolidated group’s tax return. The seller bears the tax burden from the gain on deemed sale. These features cause the election to be a joint decision, meaning both the buyer and seller make the election. Thus, the election must be mutually beneficial to occur. This may apply when a parent company is selling a subsidiary’s stock. The stock sale is ignored, and the subsidiary is treated as if it sold its assets.
The seller must receive more after-tax cash from treating the acquisition as a deemed asset sale than as a stock sale to be beneficial. The buyer benefits from the step-up in tax basis and removal of the second level of taxation. Thus, if the buyer can compensate the seller for the incremental tax cost for less than the benefits the buyer will receive, then the election is advantageous for both companies. Unlike the 338(g) election, foreign targets are not eligible. A Section 338(h)(10) election is available only in limited circumstances, and the following conditions (not comprehensive) apply:
- The buyer must be a C-corporation
- The target must be 1) a U.S. subsidiary of an affiliate group of corporations or consolidated group, or 2) an S-corporation
- Both the buyer and seller jointly agree to make the election
Tax Cuts and Jobs Act
On December 22, 2017, the Tax Cuts and Jobs Act (TCJA) was signed into law. Two major provisions within the TCJA substantially affect M&A transactions: (1) the corporate tax rate was lowered from 35% to 21% and (2) companies can take 100% bonus depreciation on qualifying used property in addition to new property until December 31, 2022.
Before the TCJA went into effect, corporate tax rates were much higher than 21% and consequently, the effects of double taxation for C-corporations were much larger. When the TCJA lowered the tax rate, it decreased the severity of double taxation for C-corporations and made them relatively more attractive.
The benefits of bonus depreciation from the TCJA may increase participation in M&A activities. Bonus depreciation is a tax election that allows qualifying property to be depreciated immediately for tax purposes. This provision makes asset acquisitions (or stock sales with a Section 338(g) or Section 338(h)(10) election) more attractive to buyers because the higher basis of appreciated assets are immediately depreciated, resulting in a large tax benefit to the buyer. From a tax planning perspective, accelerating deductions (such as taking 100% bonus depreciation) will reduce tax liability in stable tax rate periods. This bonus depreciation does not apply to intangibles acquired, which follow the 197(a) amortization rules illustrated in the patent example above.10
Purchasing a business by acquiring its assets or stock includes different tax and nontax factors that you should consider before determining which structure is right for you. The purchase price is entirely negotiable, and how you structure the deal will likely drive the purchase price up or down. This article touches on some of the major considerations to be aware of when structuring your deal, including entity type, voluntary elections, and TCJA impacts for both asset and stock acquisitions.
- PwC: Pushdown Accounting Overview
- BKD – Private Company Reporting: Accounting for Goodwill pg. 4
- Macabus: Asset and Stock Deals “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.”
- $15 million / 15 years = $1 million per year
- Structuring Business Assets Purchases with Taxes in Mind
- Asset Allocation for Business Purchases – A Quick Primer for Buyers and Sellers
- A capital asset is any asset a company uses for investment purposes.
- An ordinary asset is any asset that a company uses in the ordinary course of business or is generated by the ordinary course of business.
- IRS Cost Segregation Audit Technique Guide – Chapter 6.8 – Bonus Depreciation Considerations