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.