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 tax returns.

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 their paper, "The Effect of Organizational Form on Acquisition Price," Merle Erickson, associate professor of accounting 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 C corporations.

"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. 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," says Erickson.

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. Erickson's 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. However, a step-up structure is typically less than optimal in the purchase of a C corporation," says Erickson. "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, Erickson estimates that an S corporation can fetch a tax-based purchase price premium that is 10 to 20 percent higher than a similar C corporation.

Differences in Purchase Price

To test the prediction that S corporations sell for a higher purchase price than C corporations, Erickson 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, Erickson 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, Erickson 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. He 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, Erickson 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."

Merle Erickson is associate professor of accounting at the University of Chicago Graduate School of Business. "The Effect of Organizational Form on Acquisition Price" serves as the basis for Chapter 15 in the second edition of Taxes and Business Strategy: A Planning Approach (Scholes, Wolfson, Erickson, Maydew and Shevlin. Prentice Hall, 2001).

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