When businesses acting as the seller or purchaser are going through the acquisition process, there is likely to be discussion as to whether the acquisition will be structured as an asset purchase or a stock purchase. There are advantages and disadvantages to an asset purchase and a stock purchase for both the seller and purchaser. 

However, there may be a means to treat a stock purchase as an asset purchase and receive the best of both worlds. The article below has been prepared by a Denver tax attorney and Denver business attorney to discuss certain tax matters. Still, please always discuss your specific issues with your attorney and check for current laws and regulations that may have changed.

A Stock Purchase

A stock purchase is relatively simple as the seller or target corporation’s stock is purchased. The buyer obtains control of the target corporation’s assets with no other action by owning all of the stock. This being said, the buyer may also inherit liabilities of the target corporation as the business continues and is exposed to prior matters. An asset purchase transaction may be more complex in that the buyer is purchasing the assets and not the stock, thus requiring the transfer of title to each asset, which depending upon the facts and circumstances, could begin to amount to significant time and cost etc. Further, if the target corporation has special licenses and permits, these may not be transferable to the buyer and could create additional issues under an asset purchase.

An Asset Purchase

As it is good and bad with both structures, a buyer, from a tax perspective, will generally prefer an asset purchase because the buyer, after the asset purchase, can step up the basis in purchasing assets. Therefore, the asset’s stepped-up basis will lead to more significant depreciation to lessen taxable income and thus tax at the corporate or personal level. In comparison, when the stock is purchased, the buyer will receive a basis in the stock at the purchase amount. The realization of the tax benefit may not come until the buyer sells the stock using the basis in the stock to offset a capital gain. Thus, the buyer will likely not “realize” the tax benefit of the stock purchase until a later date than they would under an asset purchase agreement.

There is a means under Internal Revenue Code Section 338 for the buyer to make an election treating a qualifying stock purchase as an asset purchase for federal income tax purposes. Under 338, if the transaction qualifies and the election is made, the transaction is treated as if the buyer purchased the target corporation’s assets for the purchase price of the stock. Therefore, the buyer will receive a more advantageous step-up based on the assets.

Section 338 Election

The buyer acquires the seller’s stock at a discount in a stock acquisition transaction. Suppose the buyer makes a qualifying stock purchase within 60 days of the date of transfer. In that case, it must elect to treat the transaction as an asset acquisition for federal income tax purposes. This is known as a “step-up” election.

If the buyer makes a Sec. 338 election, it treats the transaction as a stock purchase for legal purposes. Hence, it continues to acquire the seller’s liabilities, including outstanding debt, shares of capital stock, and certain contingent obligations. However, the buyer does not acquire the seller’s assets. Instead, it steps up the basis of those assets to the purchase price paid for the stock. At the end of the period, the buyer reports the transaction as a sale of stock and recognizes ordinary income equal to the difference between the purchase price and the adjusted cost basis of the stock.

The buyer can choose to allocate the excess of the purchase price over the adjusted cost basis to goodwill. Goodwill represents the purchased excess over the adjusted cost basis of intangible assets such as customer relationships, brand recognition, and patents.

Making the 338 elections is a means to structure an acquisition as a stock sale, which may have benefits, but allow the buyer the tax advantage of an asset purchase agreement.  John McGuire, a Denver tax attorney and Denver business attorney at The McGuire Law Firm, has prepared this article.

The Direct Stock Purchase

The direct purchase of stock from the target shareholders may be the simplest structure and means by which to implement a stock acquisition.  Through a direct stock purchase, the acquirer will purchase stock of the target from the shareholders of the target for an agreed upon purchase price or consideration.  When the target is a closely held corporation, the acquirer can work out and negotiate the deal directly with the shareholders of the target corporation.  When the target corporation is a publicly held corporation, the acquirer could purchase stock via the open market, or produce a cash tender offer (or exchange offer) for the purchase of the target corporation’s stock.  A tender offer would be an offer to purchase shares of the corporation for cash, in comparison to an exchange offer, which is an offer to exchange stock, securities or other consideration.  Certain (and different) securities laws must be considered when weighing tender offers versus exchange offers.

Often one or both parties will wish for the transaction to be a tax-free exchange under the Internal Revenue Code.  It is important to note that for the exchange to be considered under Internal Revenue Code Section 368, a tax free exchange of stock would require the consideration paid to the target shareholders consist solely of the voting stock the acquiring corporation, or the parent of the acquiring corporation.  See IRC section 368(a)(1)(B) and related treasury regulations for more information regarding a tax-free exchange.

Reverse Triangular Merger (Indirect Stock Purchase)

 A direct stock purchase may not always be feasible to consummate an acquisition, especially if the target corporation is publicly held.  When publicly held, each shareholder must decide whether to sell their shares via the public market or via the tender or exchange offer.  The odds may be stacked such that one or a few number of shareholders do not wish to sell, or perhaps are even unaware of the offer to dispose of their shares. There is an approach that can legally require the shareholders to sell known as the reverse triangular merger.  The benefit of the reverse triangular merger is that conversion of the shares occurs via operation of law, and is binding on the target corporation’s shareholders.  Thus, the purchaser or acquirer can legally force and guarantee the acquisition of the shares.

The reverse triangular merger would work as follows: Purchasing, Inc. wants to acquire all of the shares of Targeted, Inc., which is publicly held.  Purchasing Inc. and Targeted, Inc. have agreed upon the consideration to be paid and the other terms and conditions.  Purchasing, Inc. would form Subsidiary, Inc. and Subsidiary, Inc. would be merged with Targeted, Inc., with Targeted, Inc. as the survivor.  Via operation of law, the stock of Subsidiary, Inc. is converted to stock of Targeted, Inc. and Purchasing, Inc. as the sole shareholder of Subsidiary, Inc. would receive all of the stock of Targeted, Inc.  The former shareholders of Targeted, Inc. would receive the agreed upon consideration.  Further, Purchasing, Inc. is now the sole shareholder of Targeted, Inc.

The above article has been prepared by John McGuire of The McGuire Law Firm.  John is a tax attorney and business attorney in Denver, Colorado and can be contacted at John@jmtaxlaw.com