It is well established that a properly structured transaction may result in significant benefits for the acquirer (purchaser) of an interest in a trade or business (target), and that such benefits may additionally serve to benefit a target's seller (seller). (1) One significant tax benefit that results from certain acquisitions is a tax basis step-up. Although an acquisition of corporate stock generally does not result in a tax basis step-up, an asset purchase can result in a tax basis step-up. Tax law provides the purchaser with a variety of methods to obtain a tax basis step-up in the target's underlying assets. This article discusses various tax forms that enable a purchaser to obtain a tax basis step-up. If one method of obtaining a tax basis step-up is precluded by the facts of a deal, another method may nonetheless be available. Thus, familiarity with the acquisition forms that enable a tax basis step-up is an essential aspect of acquisition planning. The article assumes that the purchaser is buying a target's interests directly from seller in a cross-purchase (rather than, say, acquiring such interests directly from the target pursuant to an equity issuance).
The Benefits of a Tax Basis Step-Up
Where available, the tax basis stepup is a significant benefit sought by tax savvy acquirers. Generally, with respect to the tax basis of the target's underlying assets, a purchase results in one of two situations: a) The tax basis is carried over from before the target's acquisition; or b) the tax basis in the target's underlying assets is adjusted to reflect the purchase price (when the purchase price exceeds the historical tax basis, this results in a tax basis step-up--this fact pattern is assumed for the course of the discussion). Depreciation and amortization deductions are only available to the extent of an asset's adjusted tax basis, (2) and any step-up in an asset's tax basis results in additional depreciation or amortization deductions going forward. Furthermore, the subsequent sale of an asset that has been stepped-up will result in less taxable gain. (3)
Indeed, a purchaser may realize significant economic benefit as a result of a tax basis step-up, and a seller may in turn have additional leverage in negotiating the purchase price or other terms of a transaction. Given this, tax planning for an acquisition should be sensitive to whether such transaction will result in a tax basis step-up, as well as alternative techniques available in order to obtain such step-up.
Stock Acquisitions and Asset Acquisitions
While a purchaser is generally incentivized to engage in an asset acquisition in order to avoid acquiring unwanted liabilities of a target, as well as to obtain a tax basis step-up, (4) a seller is typically incentivized to engage in a stock sale. From a liability perspective, a stock sale results in the seller being able to have "clean hands" with respect to the target, as generally all of the liabilities within a target would be transferred to the purchaser. (5) Additionally, if a target is taxed as a C corporation, the sale of the target's assets results in taxable gain at the corporate level, and potentially again upon the distribution of sale proceeds to the corporation's shareholders as a dividend6 (whereas the sale of a target stock would result in only one layer of taxation). As a result, the purchaser and seller often have adverse interests when choosing between a stock and asset purchase. Fortunately, tax law provides for alternative planning techniques that result in a stepped-up tax basis for the purchaser, with decreased disincentives to the seller. As the below discussion indicates, the tax law is nuanced; as such, counsel is well-advised to pay close attention to the various forms available to obtain a tax basis step-up.
Acquisition of Interests in a Single-Member LLC
Absent an election to the contrary, a single-member limited liability company (LLC) is disregarded for federal income tax purposes. (7) Accordingly, the purchase of all of the interests in a disregarded single-member LLC is treated as the purchase of the LLC's underlying assets. Therefore, if the target is a single member LLC, the purchaser's acquisition of all of the target's interests will result in the purchaser obtaining cost-basis in the target's assets.
The purchase of less than all of the outstanding membership interests of a single-member LLC is addressed in Situation 1 of Revenue Ruling 99-5. (8) In this fact pattern, a purchaser buys membership interests in an LLC directly from its single member in exchange for cash consideration. The purchase is treated as if the single member sold a...