Full expensing of stepped-up tax basis? It depends.
M&A deal structure should be examined
INSIGHT ARTICLE |
Many businesses appreciate the tax benefit resulting from the full expensing provision Congress enacted in 2017. The new expensing (or bonus deprecation) rule provides that the full purchase price of certain tangible depreciable property can be depreciated (i.e., can be expensed) for federal income tax purposes in the year the property is placed in service.
Full expensing can provide a valuable benefit, but whether it applies to a particular acquisition depends on the circumstances. Various requirements must be met. For example, the taxpayer claiming this bonus depreciation generally must either be the original user of an asset, or must have acquired an asset that it did not use previously in a taxable purchase.
Expensing stepped-up tax basis
A buyer making a taxable purchase of a seller’s assets often will take the assets with a tax basis higher than the seller’s pre-acquisition tax basis (a stepped-up basis). However, buyers and sellers should not assume that full expensing will be available for any and all stepped-up basis obtained in tangible assets as a result of a deal.
Whether a particular deal resulting in a stepped-up tangible asset tax basis will permit full expensing is clearer in some situations that others. Treasury and the IRS may determine or clarify in regulations (or other guidance) where full expensing is and isn’t available. In some situations, the answer appears reasonably clear without IRS guidance. Here are two examples.
Example 1 – purchase of LLC units from seller for cash
In our first example, T LLC has business assets with a fair market value (FMV) of $1000, including tangible assets with a FMV of $600. T LLC has tax basis of $0 in its assets and $0 of liabilities. T LLC is a limited liability company with 100 common equity units (units) outstanding. In 2018, buyer purchases 60 of the T LLC Units from seller for $600.
Prior to buyer’s purchase of units from seller, T LLC was treated as a disregarded entity for Federal income tax (Tax) purposes. After buyer’s purchase, T LLC will be treated as a new partnership for Tax purposes.
The Units purchase transaction is treated for Tax purposes as if these two steps had occurred:
- First, buyer purchased from seller a 60 percent interest in each of T LLC’s assets (the deemed purchased assets). Seller will recognize gain of $600 on its sale of the deemed purchased assets ($600 amount realized less $0 tax basis). This result is consistent with treating seller as the owner of the assets for Tax purposes prior to the transaction (recall that T LLC was a disregarded entity).
- Second, buyer contributed the deemed purchased assets to T LLC in exchange for a 60 percent partnership interest (buyer’s 60 T LLC units) and seller contributed the remaining 40 percent of T LLC’s assets to T LLC in exchange for a 40 percent partnership interest (seller’s 70 T LLC units). The deemed purchased asset will have a tax basis of $600, $360 of which is attributable to tangible assets.
An IRS revenue ruling provides this result. The ruling clearly describes the resulting asset purchase treatment. Because the $360 of tangible assets are deemed acquired by purchase, they would appear eligible for expensing if the other applicable requirements are met.
Example 2 – incorporation transaction with seller receiving cash
In our second example, the following facts remain the same: T LLC has business assets with a fair market value (FMV) of $1000, including tangible assets with a FMV of $600.T LLC has tax basis of $0 in its assets and $0 of liabilities. T LLC is a limited liability company with 100 units outstanding and a disregarded entity.
In 2018, seller contributes to a new corporation, T Inc., 100 percent of the T LLC units in exchange for 40 percent of T Inc.’s stock. Buyer pays T Inc. $600 for 60 percent of T Inc.’s stock, and T Inc. distributes the $600 to seller.
Like the transaction in Example 1, our Example 2 transaction is a partially taxable transaction. While this transaction generally qualifies for tax-free treatment under section 351, the $600 cash received by seller is taxable ‘boot.’ Seller will recognize gain with respect to a pro rata portion of the contributed T LLC assets. The gain will not exceed the $600 of boot received. Since the assets tax basis was $0, the entire $600 of boot is taxable to seller.
T Inc. will take the T LLC Assets with a $600 basis – i.e., seller’s basis of $0 plus the $600 amount of gain seller recognizes. The amount of this stepped-up basis attributable to the tangible assets will again be $360, as in Example 1. Unlike the tax treatment for Example 1, however, there is no deemed (or actual) purchase of the T LLC business assets in Example 2. As a result, it would appear that T Inc. cannot expense the stepped-up $360 in tangible asset basis.
Query whether changing the facts of Example 2 provides a different result. What if buyer contributes cash directly to T LLC in exchange for units and the cash is distributed to seller, followed by a contribution of T LLC to T Inc. (or by an election to treat T LLC as a corporation for Tax purposes). From a Tax perspective, this series of steps looks like first (1) a deemed sale of 60 percent of T LLC’s assets to buyer, followed by (2) an incorporation of T. The deemed sale aspect results in asset purchase treatment for tax purposes that would appear to leave the stepped-up $360 of tangible asset basis eligible for full expensing.
Not every transaction can be so easily changed to provide for an asset purchase treatment for Tax purposes. In addition, potential applicability of judicial doctrines such as step transaction and substance over form deserves consideration when planning any M&A transaction involving prearranged steps.
Other stepped-up basis issues
Additional questions regarding availability of immediate expensing arise in other M&A scenarios. These situations include asset tax basis resulting from a partnership’s section 734(b) or section 743(b) adjustments, remedial allocations of partnership items under section 704(c), and corporations applying the ‘section 338 approach’ to net unrealized built-in gain or loss calculations under section 382 pursuant to Notice 2003-65. Each of these scenarios has its own intricacies and technical rules, requiring a detailed analysis of the interplay of each to the requirements of immediate expensing. These analyses are beyond the scope of this article.
Deal participants should not assume full expensing will be available for any and all stepped-up tax basis obtained in tangible assets as a result of a deal. The specific transaction under consideration should be analyzed to determine whether and to what extent expensing is available. Buyers and sellers should consult their tax advisers when considering whether an acquisition will result in tangible asset expensing.
 For certain property acquired after September 27, 2017 and placed in service before January 1, 2023, full expensing may be available by means of a 100 percent bonus depreciation rate. The 100 percent rate is reduced by 20 percent each year beginning in 2023. section 168(k), as amended in 2017 by P.L. 115-97 (also known as the Tax Cuts and Jobs Act).
 See sections 168(k)(1), 168(k)(E)(2)(ii), and 179(d)(2). This Alert does not address other applicable requirements.
 i.e., T LLC was disregarded as an entity apart from its owner under Reg. § 301.7701-3.
 Rev. Rul. 99-5, Situation 2.
 section 351(b).
 Rev. Rul. 68-55.
 section 351(b)(1).
 section 362(a).
 See Rev. Rul. 99-5, Situation 2. See also section 707 (disguised sale rule applicable to certain distributions received from partnerships, potentially applicable here if T LLC is treated as a partnership for Tax purposes prior to the distribution of cash to seller).