Entrepreneurs are often advised to organize their new business as a corporation due to certain perceived advantages. Chief among the perceived advantages is that the corporate form primes the company for an eventual public offering, a tax-free acquisition by a public company, or an investment by a venture capital firm.[1] However, commencing a business as a flow-through entity (e.g., S corporation or LLC treated as a partnership for federal income tax purposes) does not necessarily preclude these exit strategies. Furthermore, a business established as a flow-through may be sold for a higher purchase price in a taxable acquisition of the business, as discussed further below. Founders choosing C corporation status may be leaving money on the table in an eventual exit as compared to keeping their company in a flow-through structure.

A study conducted in 2007[2] concluded that purchase price multiples are generally higher when targets are flow-through entities (S corporations) than in a matched sample of C corporation targets. The study found that the average tax benefits in S corporation acquisitions equals approximately 12 to 17 percent of the deal value, translating to a tax-derived purchase price premium for sellers of S corporations over sellers of similar C corporations in the range of 10 to 20 percent of the deal value.[3] The purchase price premium associated with S corporation acquisitions is attributable to the buyer’s ability to obtain a step-up in the tax basis of the S corporation’s assets via a section 338(h)(10) election.[4] This step-up is generally unavailable when purchasing a stand-alone C corporation. The step-up in the tax basis of assets is valuable to the buyer because it leads to greater cash flows as a result of larger depreciation and amortization deductions and reduced gains on a subsequent sale of the assets.

A similar result occurs when an LLC (treated as a partnership for federal income tax purposes) is acquired. The acquisition of the LLC interests is generally treated for federal income tax purposes as a taxable acquisition of the LLC’s assets with respect to the buyer.[5]/ Like the acquisition of an S corporation, the buyer of the LLC interests receives a step-up in the basis of the LLC’s assets equal to the purchase price.

The following example illustrates why buyers may be willing to pay a premium to acquire a flow-through entity. Assume that Taylor and Katy formed a business (the “Company”). Taylor and Katy each contributed intellectual property to the Company with $0 tax basis. Five years later, a corporation (the “Buyer”) acquired all of the equity of the Company.

If the Company was organized as a C corporation and the Buyer paid $100X to acquire all of Taylor and Katy’s stock of the Company, Taylor and Katy would recognize $100X of capital gain from the sale of stock of the Company, pay $27.8X in tax, and pocket after-tax proceeds of $72.2X.[6]/

In contrast, if the Company had been organized as an LLC, the Buyer may have been willing to pay a purchase price premium to Taylor and Katy because the Buyer would have obtained a step-up in the basis of the Company’s assets from $0 to the purchase price of $100X. Assuming the Buyer would have paid $115X (i.e., a 15% premium) to acquire all of Taylor and Katy’s LLC interests in the Company, Taylor and Katy would have recognized approximately $115X of gain, paid tax of approximately $31.97X, and pocketed after-tax proceeds of approximately $83.03X, assuming the gain from the sale of the LLC interests was entirely capital.

The reason that the Buyer may have been willing to pay a premium to acquire the Company if it was an LLC is because of the potential value to the Buyer of a stepped-up basis in the Company’s assets. Assuming the sole assets of the Company were intangibles (e.g., software, patents, goodwill), stepping-up the basis in the assets to $115X would allow the Buyer to recover its purchase price over 15 years through amortization deductions of approximately $7.67X per year. The value of an income tax deduction of $7.67X is approximately $3.07X assuming a 40% tax rate. Over 15 years, the Buyer would receive an aggregate tax benefit of approximately $46X.[7]/ In contrast, if the Company was a C corporation, the Buyer receives no tax benefit from the basis of the Company.

Accordingly, entrepreneurs should consider the potential for a premium upon a sale of their business when choosing an entity. While every transaction is different, the potential tax benefits that may accrue to a buyer of a flow-through entity may result in a larger purchase price upon exit.

[1] See, e.g., Daniel S. Goldberg, Choice of Entity for a Venture Capital Start-Up:  The Myth of Incorporation, 55 Tax Lawyer 923 (2002).

[2] Merle M. Erickson & Shiing-wu Wang, Tax Benefits as a Source of Merger Premiums In Acquisitions of Private Corporations, 82 The Acct. Rev. 359 (2007).

[3] Id. at 385.

[4] The study found that in the typical acquisition of a C corporation a step-up tax structure (i.e., via a direct acquisition of the C corporation’s assets or a stock acquisition followed by a section 338(g) election) is not viable because the tax costs of the step-up generally outweigh the tax benefits of the step-up. Id. at 360, 367.

[5] See Rev. Rul. 99-6, 1991-1 C.B. 432.

[6] The example assumes a combined tax rate of 27.8% consisting of (i) 20% long-term capital gain rate, (ii) 3.8% net investment income tax, and (iii) 4% state tax rate.

[7] Buyers will generally apply a discount rate to determine the present value of a stream of tax deductions to account for the time value of money. Using an 11% discount rate, the present value of the tax benefits is approximately $22X.

(Visited 639 times, 1 visits today)