There are various strategies to grow a business over a company’s life cycle. One option—purchasing another business—can be an effective means to achieve expansion into a new market or more rapid and less costly growth of existing business segments. Acquiring another business does present challenges and risk, however, and effective tax planning should be an integral component of the buying process.
Businesses are generally purchased either as an entity (stock or partnership interests) or as a group of assets. Entity purchases are more common for larger transactions, in large part due to the perceived higher costs and risks associated with the orderly transfer of ownership of all elements of a complex business enterprise. Asset purchases are more common for smaller transactions; in many cases, in response to a purchaser’s reluctance to assume undisclosed liabilities of the target business that may not be identified during due diligence.
Regardless of the type of purchase, here are four key tax considerations potential acquirers should consider:
Review historical financials and tax returns
An initial evaluation of a potential acquisition target should include a thorough review of financial statements and tax returns going back three to five years. The tax-related review process may begin with Federal tax filings. However, a comprehensive inspection of state and local income, franchise, employment, and sales tax filings should be conducted as well, particularly where activities are carried out in multiple states. An asset purchase aimed at avoiding undisclosed liabilities may not eliminate exposure for unpaid state and local taxes.
Understand what will happen with tax deductions
Tax deductions flowing to a buyer after a purchase are often an important component of the financing of acquisition costs. In the case of a corporate stock purchase, the buyer will inherit the company’s tax basis of assets existing at the time of purchase, unless the parties agree to make a special election to treat the stock purchase as an asset acquisition. If the corporation has a net operating loss or tax credit carryovers, these amounts may be available to offset income earned going forward. However, there can be limitations to this, which should be identified as part of due diligence. In the case of a partnership entity acquisition, a buyer will often be able to reestablish his or her allocation of tax basis in the underlying assets acquired. However, you should review applicable rules with your tax advisor.
Negotiate asset purchases to maximize tax deductions
In the case of an asset-based transaction, purchase consideration will often include both cash payments to be made to the seller, as well as some amount of seller liabilities that will be assumed (e.g., accounts payable). The buyer and seller will negotiate the allocation of total purchase consideration among the assets acquired. A buyer will typically seek to assign higher values to items which will produce short-term tax deductions. An example is fixed assets that will yield future depreciation deductions. Any residual amount remaining after all other identifiable assets have been assigned values will generally be allocated to goodwill, for which a buyer will receive future tax write-offs as well, albeit at a slower pace than fixed assets (15 years as opposed to 3 to 7 years for many fixed asset categories).
Consider covenants not to compete, consulting, and personal services arrangements
Covenants not to compete, as well as personal services arrangements entered into with sellers, can provide additional opportunities for buyers to generate future tax deductions. Covenant payments yield deductions similar to goodwill; i.e., a write-off taken over 15 years. Consulting and other personal services arrangements will generally yield tax deductions over a shorter time frame; i.e., as payments are made in connection with services rendered. Amounts assigned to such categories of payments are potentially subject to a higher level of scrutiny by taxing authorities and some care should be exercised in establishing the economic reasonableness of such amounts.