Q3 | Torys QuarterlySummer 2022

Key tax issues when buying a U.S. business

The U.S. market continues to be an attractive target for foreign businesses and investors. Due to the complexities of U.S. tax rules, the U.S. tax treatment of an acquisition can significantly impact the benefits received. Below we explore key tax issues to consider when acquiring a U.S. business.

Asset purchase

An asset purchase is often more advantageous for a buyer from a tax perspective than an equity purchase. In a taxable asset purchase, the buyer’s basis in the purchased assets is “stepped up” to the purchase price and allocated across the purchased assets. A higher tax basis in the purchased assets provides future tax benefits to the buyer, such as greater amortization and depreciation expenses.

In contrast, a taxable asset purchase may result in higher taxes for the seller than an equity purchase. The seller may recognize more gain, and depending on the nature of the assets and the seller, some or all of the seller’s gain may be treated as ordinary income taxed at a higher rate than capital gains. Thus, a seller may seek a higher purchase price for an asset purchase structure.

When negotiating an asset purchase, parties should agree on how to allocate the purchase price across the assets, consistent with general allocation principles in the U.S. tax rules.

Equity purchase

U.S. tax classification

Understanding the U.S. tax classification of the target is critical to understanding the tax impact of acquiring the target equity. In the United States, business entities may be classified as corporations, partnerships, or disregarded entities, and entities generally may choose their classification by filing a “check-the-box” election. For example, a U.S. LLC could be classified as a corporation, partnership, or disregarded entity, depending on whether the LLC has filed such an election and on the LLC’s members. Thus, knowing the target’s legal form is often insufficient information to determine the target’s U.S. tax classification, and a buyer will need to ask the seller for further information.

Buying a corporation
Types of corporations

An entity classified as a corporation for U.S. federal income tax purposes may be a “C corporation” or an “S corporation”. Unlike a C corporation, an S corporation is generally not subject to U.S. income tax at the entity level. Classification as an S corporation requires a validly filed election and compliance with various ownership and operational rules. If an S corporation fails to meet any of these requirements, the entity is instead treated as a C corporation subject to entity-level income tax. Thus, when acquiring an S corporation, a buyer should diligence the target’s compliance with the S corporation requirements to avoid inheriting unexpected tax liabilities.

Basis step-up

Unless an exception applies, the buyer of a U.S. corporation does not receive a basis step-up in the corporation’s assets. Instead, the buyer holds the stock with a basis equal to the purchase price, but the corporation continues to hold its assets with the same tax basis as before the transaction.

One common exception is an “338(h)(10) election”: If (a) the buyer is a corporation and (b) the target is either (x) an S corporation or (y) a member (but not the parent) of a consolidated or affiliated group, then the buyer and seller may jointly elect to treat the transaction as an asset purchase, solely for U.S. federal income tax purposes, such that the buyer receives a basis step-up in the target’s assets.

It is important to remember here that asset purchase treatment may result in higher taxes for the seller. When this election is made for an S corporation target, it is especially important for the buyer to be comfortable with the target’s S corporation status to ensure the election is valid.

Buying a partnership

When a buyer purchases interests in an entity classified as a partnership for U.S. federal income tax purposes, the buyer generally will receive a basis step-up on the buyer’s share of the partnership’s assets only if the partnership agrees to elect to do so (commonly referred to as a “754 election”).

A non-U.S. person is subject to U.S. tax on income effectively connected with a U.S. trade or business. To avoid this, most non-U.S. buyers generally form a U.S. corporation as the purchasing entity.

If a buyer purchases all the interests in a partnership, the buyer will be treated as purchasing the partnership’s assets rather than partnership interests, solely for U.S. federal income tax purposes. In such case, the buyer will receive a basis step-up in the partnership’s assets without any election, and the target will become disregarded from the buyer for U.S. federal income tax purposes.

Buying a disregarded entity

A buyer of a “disregarded entity” (such as a single-member LLC that has not elected to be classified as a corporation) is treated as purchasing the entity’s assets for U.S. federal income tax purposes. Accordingly, the buyer will receive a basis step-up in the target’s assets.

Structuring considerations for non-U.S. buyers

A non-U.S. person is subject to U.S. tax on income effectively connected with a U.S. trade or business and is required to file U.S. federal (and likely state and local) income tax returns. To avoid such obligations, most non-U.S. buyers generally form a U.S. corporation to be the purchasing entity.

Conclusion

Understanding U.S. tax rules is a critical component to efficiently structuring the acquisition of any U.S. business. While every transaction presents its own unique facts and circumstances, the U.S. tax treatment should always be carefully considered.


To discuss these issues, please contact the author(s).

This publication is a general discussion of certain legal and related developments and should not be relied upon as legal advice. If you require legal advice, we would be pleased to discuss the issues in this publication with you, in the context of your particular circumstances.

For permission to republish this or any other publication, contact Janelle Weed.

© 2022 by Torys LLP.

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