Insights and Frequently Overlooked Items Arising From Purchase Price Allocations in an Asset Purchase

Many more acquisitions of businesses occur in the form of asset purchases, as opposed to stock purchases. This structure presents many opportunities and pitfalls when it comes time to allocate the purchase price for the assets over the various types of assets acquired in the acquisition. This article focuses on some of the often overlooked allocation opportunities and the hidden tax liabilities that are important to understand when a deal is being negotiated and priced. Many times, if these issues are not addressed prior to closing, the opportunities are lost.

Many corporate buyers prefer purchasing the assets (as opposed to stock) of a corporation for several reasons, including the sense that the buyer may have more control over which of the target's assets it acquires directly and the ability to exclude pre-acquisition liabilities that may attach to the corporate entity. Another important reason for engaging in an asset purchase is for the income tax benefits that may arise from obtaining a cost basis and the associated increased depreciation and amortization for years going forward. Unlike buyers, corporate sellers may generally prefer stock sales so that they can be relieved of certain liabilities associated with the unwanted line of business (including those not readily identifiable or valued at the time of the transaction) and incur only one level of tax at the shareholder level. Section 338 of the Code provides some relief to reconcile these divergent motivations by allowing taxpayers that enter into a stock sale to file an election to treat a stock sale transaction as an asset sale for tax purposes.

Section 338 provides several choices for buyers and sellers in determining how they want to be taxed in a purchase situation. For example, a basic Section 338(a) election is made by the buyer only and results in stock sale treatment to the seller. The buyer will be responsible for any income tax due as a result of the "deemed sale" of all of "old target's" assets to "new target." The buyer will then receive a step-up in the tax basis of the target company's assets. For domestic purchases, this is not a favored approach because of the tax cost on the transaction date.

A more typical use of Section 338, is the Section 338(h)(10) election. This election is made jointly by both the buyer and the seller and can only be applied to a target corporation that is either an "S" corporation for federal income tax purposes, or a target corporation whose stock is held by a controlling (80%) shareholder. If a Section 338(h)(10) election is made, the target corporation is treated as having sold all of its assets at the close of the acquisition date at fair market value in a single transaction, and a new target corporation is deemed to purchase all the assets on the day after the acquisition date. Once the buyer and seller agree to file the election, the seller will...