What to Consider When Using Guideline Transaction Data

October 15, 2015 | Download PDF

Income taxes play a major role in the pricing and structure of transactions because income taxes can substantially reduce the seller’s net proceeds and/or lower the net cost of a purchased ownership interest.  Transactions are priced and structured to address these tax consequences.  This article addresses the impact of Federal income taxes on transaction prices and terms.[1]

Guideline transaction databases typically provide information about the selling price and terms of prior transactions of similar ownership interests.  Valuation analysts and business buyers/sellers can access these databases, and may choose to rely on them.  However, there is the risk that the transaction price or deal terms reported in the transaction databases have been materially affected by income tax consequences.  Such income tax consequences are impacted by (1) the entity form of the seller, and (2) the decision to buy/sell assets or equity.  Failing to properly consider the tax consequences of the entity form of the seller or the decision to buy/sell assets or equity may result in an improper valuation conclusion. 

The entity form of the seller affects whether the seller incurs one or two levels of taxation on the sale of business assets.  It also affects whether the gain on sale of certain assets is recognized as ordinary income or capital gains.  When assets are purchased, the buyer will realize a “step-up” in basis of the acquired assets.  When equity is purchased, absent an IRC 338 election, except for equity purchased from a partnership, limited liability company or sole proprietor, the buyer does not receive a “step-up” in basis.  The following Exhibit 1, which is discussed in more detail below, summarizes the income tax consequences to buyers and sellers of: (1) equity ownership interests in C corporations, S corporations, partnerships, limited liability companies, and sole proprietorships; and (2) assets of C corporations, S corporations, partnerships, limited liability companies, and sole proprietorships.

The following is a brief discussion of the tax consequences to seller and buyer under each of the scenarios presented in Exhibit 1.

Entity Form of Seller: C Corporation

The sale of assets by a C corporation results in the seller recognizing ordinary income (loss) on sale by the entity[2], and a second level of taxation at the shareholder level on receipt of the seller’s liquidating distribution.  On the other hand, if the C corporation sells equity, there is only one level of taxation – capital gain/loss at the shareholder level.  Accordingly, C corporation sellers have a financial disincentive to sell assets and a financial incentive to sell equity. 

From a buyer’s perspective, the incentives when purchasing a business from a C corporation are opposite that of the seller.  Buying assets will enable the buyer to “step-up” the cost basis of the purchased assets.  Thus, a buyer of C corporation assets could have a higher cost basis for depreciating fixed assets, and will be able to recognize goodwill and other intangible assets and then amortize such assets for tax reporting purposes.  The tax deduction benefit of increasing the tax basis of purchased assets could be very substantial.

When the equity of a C corporation is purchased, there is no step-up in basis of company-held assets (inside basis).  Rather, the purchaser has a higher basis in the stock purchased (outside basis).  The tax savings benefit related to the stepped-up outside basis is realized on the ultimate sale or disposition of the C corporation stock, which could be many years later.  Moreover, when purchasing the equity of the C corporation, all commitments and contingent liabilities of the company remain with the business and can potentially impact the buyer.     

Based on this discussion, it is generally to the seller’s disadvantage to sell assets and to the buyer’s advantage to purchase assets.  Nevertheless, many transactions involve the sale of assets.  The valuation analyst should consider the potential tax saving to the buyer and the tax cost to the seller when a C corporation’s assets are sold as the buyer’s tax savings may be built into the transaction price.  Failing to separately identify the tax savings component of a selling price when C corporation assets are sold could result in an overstatement of value.

Entity Form of Seller: S Corporation

S corporations are pass-through entities that, in general, pay no Federal income taxes at the entity level.  All of the S corporation’s taxable income and expenses pass-through to the S corporation’s shareholders, and the shareholders incur only one level of income taxes on S corporation taxable income. 

When an S corporation sells its asset to a buyer, the gain on sale of assets passes through to its shareholders as ordinary income/loss and/or capital gain/loss.  Unlike the sale of assets by a C corporation, the sale of assets by an S corporation only results in one level of taxation.[3] 

The buyer’s tax consequences are the same whether assets are purchased from a C or S corporation.  Similarly, the buyer’s tax consequences are the same whether equity is purchased from a C corporation or an S corporation.[4]

Based on this discussion, it is once again to the buyer’s advantage to purchase assets.  However, the disadvantage to the seller when assets are sold is much less as an S corporation than as a C corporation because there is only one level of taxation.  There remains a disadvantage to the S corporation seller with respect to selling assets versus selling equity because the sale of assets may result in a portion of the gain being realized as ordinary income whereas generally, no portion is recognized as ordinary income when equity is sold.  The valuation analyst should again consider the potential tax saving to the buyer and the tax cost to the seller when assets are sold as the selling price may include some amount for the buyer’s tax savings. 

Entity Form of Seller: Partnership, Limited Liability Company, or Sole Proprietorship

Partnerships, limited liability companies and sole proprietorships are all pass-through entities.  Unlike S corporations, the sale of equity by these pass-through entities are all treated as a sale of assets.  The seller recognizes ordinary income (loss) and/or capital gain (loss) from the sale of assets by partnerships, limited liability companies and sole proprietorships, and this income is only taxed once, at the owner level.

The buyer of assets or equity of partnerships, limited liability companies and sole proprietorships can achieve a step-up in basis of assets without any adverse tax consequence.  Accordingly, it makes no difference to either the buyer or seller if the sale of a business operating as a partnership, limited liability company or sole proprietorship is structured as a sale of assets or equity.

Examples

Now we’ll apply these concepts to several examples.  XYZ Company, LLC (taxed as a partnership), with an inside equity tax basis of $460 is sold for $1,285.  See Exhibit 2.  Based on the fair market value of the assets and liabilities, the seller realizes an ordinary loss of $25 on the sale of accounts receivable, an ordinary gain of $100 on the sale of inventory, and a capital gain of $750 on the sale of property & equipment ($300)[5] and goodwill ($450).  The buyer realizes a step-up in basis equal to the fair market value of the assets and liabilities acquired

 Now let’s consider the following questions:

1. If the transaction involved a sale of equity by a C corporation stockholder, would the negotiated selling price be greater or less than $1,285?[6] 

Based on Exhibit 1, we know that the C corporation equity buyer would not be able to realize an inside basis increase of $825.  Accordingly, the buyer of a C or S corporation equity interest would realize a substantially reduced tax benefit.  This would likely result in a lower offer by the buyer. 

The seller would receive capital gains treatment for one hundred percent (100%) of the gain on sale, instead of capital gains treatment on $750 (profit on sale of property, equipment and goodwill) and ordinary income treatment of $75 (profit [loss] on sale of accounts receivable and inventory).  Thus, the after-tax proceeds from sale of this ownership interest would be greater. 

This result would provide the seller with more flexibility to lower the selling price and still receive an acceptable after-tax return on sale.

2. If the transaction involved a sale of assets by a C corporation stockholder, would the negotiated selling price be greater than or less than $1,285? 

If the buyer purchased the assets of a C corporation, they would still be able to realize an inside basis increase of $825.  Accordingly, the buyer of the assets of a C corporation equity interest would still realize the same tax benefit that they would realize by purchasing the assets or equity of a partnership. 

The seller would be adversely affected.  The C corporation would realize an ordinary gain on sale of the difference between the tax basis and fair market value of all assets, and would then pay a second level of taxation on the liquidating dividend distribution.  Thus, the after-tax proceeds from a sale of assets would be substantially less. 

This result would require the seller to have an increased selling price to achieve the same after-tax return on sale.

Conclusion

Transaction databases include sales of assets and equity by C corporations, S corporations, partnerships, limited liability companies and sole proprietorships.  The sellers’ after-tax proceeds and the buyers’ after-tax cost in these transactions are substantially impacted by seller’s entity form (C corporation, S corporation, etc.) and whether assets or equity are sold.  Selling prices are often modified due to these factors.  Accordingly, the valuation analyst must take into consideration the tax savings component of each transaction’s selling price in order to avoid over or understating the pricing multiples inferred by the transactions. For these reasons, when using guideline transaction databases, it is imperative to sort the transactions to separately address the stock versus asset sales provided and to sort the transactions by entity type (C corporation versus S corporation versus LLC/Partnerships) in order to properly identify the distinction in the price multiples based on these tax consequences.

This article appeared in the September/October 2015 issue of The Value Examiner, published by the National Association of Certified Valuators and Analysts (NACVA).

About the Author

Eric J. Barr is the partner-in-charge of Marks Paneth LLP's Valuation Services group. He is the author of Valuing Pass-Through Entities (John Wiley & Sons, Inc., 2014). Mr. Barr has more than forty years of public accounting experience specializing in litigation support, consulting and traditional accounting and auditing services. Prior to joining Marks Paneth, Mr. Barr was a litigation and accounting partner in a national CPA firm.



[1]   This article does not address the impact of state, local and foreign jurisdiction income taxes on transaction pricing and terms.

[2]  A C corporation can recognize capital gains, and although taxed for Federal income tax purposes at the same rate as ordinary income, the C corporation can use available capital loss carryovers.

[3]  This analysis assumes that the S corporation is not subject to IRC 1374.

[4] This assumes that an IRC 338 election is not made.  This election treats a stock purchase as an asset purchase.

[5]  Assuming no depreciation is recaptured as ordinary income.

[6]  This discussion also applies to a sale of equity by an S corporation stockholder. 


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