Find out why it’s important to understand the tax implications associated with the acquisition of a private company.

Many private companies were formed years ago using what was known as a Subchapter S election, which refers to the optional treatment of an otherwise taxable C corporation as (generally) a passthrough entity. These structures can survive generational transfers through proper estate and gift planning and are found on the market today as historic owners decide to dispose of the business and move to their next stage of life.

Often, the seller’s advisors initially suggest (or insist) on their client selling shares, which is pretty simple from a transactional standpoint that results in long-term capital gain income. Under current law, long-term capital gain income is taxed at a maximum rate of between 20% and 23.8%, plus applicable state income taxes. However, if the buyer is organized as a C corporation (irrespective of whether it is owned privately or an SEC registrant), a share purchase alone has a hidden tax cost in that without remediation steps that are a part of the acquisition agreement, the buyer’s purchase price is not reflected in its new carrying value of the assets; rather, it inherits the seller’s historic tax basis in the assets at the time of closing. These (usually) lower tax basis amounts are only available to offset limited future earnings vs. an allocation based upon current fair market value, including tax amortizable goodwill.

READ MORE: New Mexico Non-Resident Pass-Through Withholding & Composite Return Election

Further, U.S. GAAP accounting requires that the future cost of this lack of tax basis (i.e., a “step-up”) from cost recovery attributed to non-goodwill assets be measured and recorded as additional consideration given (which is undiscounted) at closing, effectively increasing the book purchase price paid. If the goodwill portion is impaired in the future, it is charged to earnings, but no tax benefit is afforded as no tax basis in the goodwill resulted from the acquisition from the lost step-up.

Next Steps: A Measurable Solution

A solution to be considered early in the acquisition process is to measure the additional (incremental) income tax from the (deemed) sale of ordinary income items (minimized with effective valuation planning) along with incremental state income tax due, if any. This amount can be then tax-protected to compensate the seller for the tax-on-tax cost of this acquisition pattern and set out in the acquisition agreement.

The benefit to the buyer is measured in a with/without calculation that shows the excess present value of the incremental tax shield (meaning, future cost recovery dollars offsetting ordinary income on tax returns) over the grossed-up incremental purchase price.

This exercise involves the following Opportune service lines (depending on the industry of the target):

• Tax
• Complex Financial Reporting (via quality of earnings)
• Valuation, and perhaps
• Opportune Partners LLC

Contact us today to see how our experienced tax advisory professionals can help you navigate the nuances of the tax code when considering a purchase of a private company.

About The Authors

Lynn Loden is a Managing Director in charge of Transaction Services and Tax Advisory for Opportune LLP. He has over 40 years of corporate tax and accounting experience with Big Five public accounting and similar professional services firms. Before joining Opportune, Lynn served clients in both relationship and specialty roles ultimately as a partner at Arthur Andersen and Deloitte, and as a Managing Director at Alvarez & Marsal. He has advised both public and private companies and private equity investors in the oil and gas, oilfield service, public utility, and service industries. Lynn has significant experience in mergers and acquisitions, roll-ups, spin-offs, IPOs, special purpose acquisition corporations (SPACs), regulated investment companies (RICs), lease and project finance, and troubled debt restructurings and bankruptcies. His assignments include engagement and transactional responsibility for tax planning, reporting and compliance matters, accounting for income taxes, leases, transactional due diligence, representation before the Internal Revenue Service (IRS) national office for ruling requests, valuation engagements, and expert testimony before bankruptcy and other courts. A graduate of the University of Mississippi, he holds active CPA licenses in the states of Texas and Mississippi, along with FINRA series 79 and 63 licenses.

Bill Schulz is a Manager with the Tax Advisory practice at Opportune LLP in Houston. He is adept in partnership and corporate compliance at both the federal and state level and business controversy consulting. Before joining Opportune, Bill was a Senior Tax Associate with PricewaterhouseCoopers (PwC) where he prepared and reviewed complex returns at the corporate and partnership level, performed a thorough analysis of client state apportionment calculations, examined company organizational structures, and strategized how to lower clients’ taxable footprint and conducted research and analysis of multiple state tax controversial issues and interpreted laws according to the facts of the client. Bill graduated from The University of Iowa with a BBA in Accounting and Finance.