Tax Benefits in Acquisitions of Privately Held Corporations
The Way Companies are Organized for Tax Purposes Affects Their Selling Price in an Acquisition
Research by Merle Erickson
Anyone who forms a company has many choices regarding
how their business is organized for tax and legal purposes.
The tax code defines two common organizational forms: S corporations
and C corporations. Business owners choose between these forms
based on the organizational form's tax features, legal requirements,
and non-tax attributes.
"Conduit" or "pass-through" entities
include S corporations, partnerships, and limited liability
companies (LLCs). With conduit entities, there is no tax at
the entity level. Instead, all income or loss flows through
to shareholders, who report these earnings on their own income
For C corporations, also known as "regular" corporations,
there are two levels of taxes on income, one at the corporate
level and one on the individual level after distribution of
income to shareholders. Many large corporations, such as those
traded on the New York Stock Exchange, are C corporations,
while many privately held businesses operate as S corporations,
partnerships, or LLCs.
When a business is sold, the differences between conduit
entities (e.g., S corporations) and C corporations become
much more pronounced. In the paper "The Effect of Organizational
Form on Acquisition Price," Merle Erickson, an associate
professor at the University of Chicago Graduate School of
Business, and Shiing-wu Wang of the University of Southern
California's Leventhal School of Accounting show how and why
S corporations can be sold for a higher price than C corporations.
The authors examine the different acquisition tax structures
for these two organizational forms, comparing purchase prices
across sets of taxable stock acquisitions of S and C corporations.
According to their estimates, the tax benefits in S corporation
acquisitions can total approximately 12 to 17 percent of the
deal's value, and these benefits are often captured by target
company shareholders in the form of a higher purchase price.
These benefits are generally unavailable in acquisitions of
"Corporate tax textbooks usually list the ten things
that you should consider when deciding whether your business
should be an S or C corporation. However, these books don't
mention that you might want to pick an S corporation because
you can sell it for more," says Erickson.
Given that approximately 90 percent of successful new ventures
are acquired before becoming public companies, Erickson argues
that it is important to understand how organizational form
affects potential exit strategy cash flows and the resulting
wealth consequences for investors.
"Think about a situation where a C corporation will
sell for $100," says Erickson. "If it was an S corporation
instead, it could sell for $115. When the dollars are in millions,
the tax-related wealth effects of organizational form multiply
rather quickly for shareholders."
Structuring the Deal
An organization's form affects an acquisition's tax structure,
and the tax structure selected affects the acquisition price.
Acquisitions can be structured as taxable or tax-free, and
also as acquisitions of either a target company's stock or
assets. The study focuses on taxable transactions, where shareholders
of the target company sell their stock to the acquirer for
cash. The study identifies the optimal transaction tax structure
for S and C corporations and the purchase price associated
with this structure.
One particular provision of the tax code, known as a Section
338(h)(10) election, causes a stock sale of an S corporation
to be taxed as if it were an asset sale. This allows the acquiring
company to take a "stepped-up" tax basis in the
target's assets, which generates larger tax deductions, and
in turn increases acquirer cash flow.
For example, if an office building has a tax basis of $100,000,
depreciation deductions are derived from that amount. However,
if an acquirer buys the building for $1 million, the tax basis
is "stepped up" to $1 million, and the acquirer
can then take more depreciation from this larger basis, thereby
enjoying greater tax deductions and cash flow.
In the case of S corporation acquisitions, acquiring companies
can take advantage of the tax benefits of a basis step-up
with the Section 338(h)(10) election. However, the acquirer
must obtain the target shareholder's cooperation to make a
valid 338(h)(10) election. Therefore, companies acquiring
S corporations are typically willing to pay shareholders a
higher price for their cooperation in structuring a deal to
include the 338(h)(10) election. This type of election is
not available for C corporations. Therefore, for C corporations,
a taxable stock purchase without any special tax elections
is the most tax efficient way to structure the deal.
"An S corporation can be sold for more because a structure
that steps up the tax basis of the assets is optimal,"
says Erickson. "However, a step-up structure is typically
less than optimal in the purchase of a C corporation. Sellers
of S corporations can therefore ask for a higher price, and
acquirers are typically willing to pay a higher price to get
these tax benefits."
Taking into consideration these economic forces, the authors
estimate that an S corporation can fetch a tax-based purchase
price premium that is 10 to 20 percent higher than a similar
Differences in Purchase Price
To test the prediction that S corporations sell for a higher
purchase price than C corporations, the authors compared purchase
prices across 77 matched pairs of taxable stock acquisitions
of S and C corporations from 1994 to 2000. Since all sample
firms were privately held, the authors compared purchase price
multiples, (e.g., price to EBITDA [earnings before interest,
taxes, depreciation, and amortization]). As predicted, purchase
price multiples were higher for S corporations, supporting
the conclusion that they sell for a higher price than C corporations.
To measure the tax benefits created in these S corporation
acquisitions, the authors calculated the difference between
the purchase price and the estimated tax basis of the target
company's assets. This difference is an estimate of how much
the tax basis of the target's assets was stepped-up. They
also calculated the present value of the tax benefits for
the acquiring company.
For S corporations, the average value of tax benefits ranged
from $6.4 million to $9.1 million, which is equivalent to
12 to 17 percent of the deal's value. For the 77 S corporation
acquisitions in the study, estimates suggest that the total
value of the tax benefits in these deals is between $490 million
and $700 million.
The Advantages of S Corporations over C Corporations
During the study, the authors found several transactions
in which acquiring companies disclosed detailed information
regarding the tax benefits of using the Section 338(h)(10)
election in the acquisition of an S corporation. In one case,
Coca-Cola Enterprises (CCE) acquired Herb Coca-Cola, Inc.,
which was an S corporation pre-acquisition. CCE paid Herb
Coca-Cola's shareholders an extra $100 million to make the
Section 338(h)(10) election. Given that CCE valued the tax
benefits of the election at $145 million, CCE paid about 70
percent of the total tax benefits in the deal to Herb Coca-Cola's
shareholders in the form of a higher purchase price.
"Holding everything else constant, it's important to
consider these pricing effects when you are choosing the organizational
form for a new business," says Erickson. "Because
if you choose to be a C corporation instead of an S corporation
(or other conduit entity), you won't get the additional $100
million that Herb Coca-Cola extracted from Coke."