When equity interests in a passthrough entity are sold, such transaction documents are often described as “partnership interest purchase agreements,” “membership interest purchase agreements” or “equity purchase agreements.” However, under U.S. federal income tax rules, a transaction that is legally structured as an equity purchase can sometimes be treated (in whole or in part) as an asset purchase—whether by default, election or sometimes as the result of post-closing actions.

Occasionally, this discrepancy is overlooked until just before closing, which can lead to headaches for deal lawyers, clients and tax professionals alike. This alert highlights the default recharacterizations of partnership and disregarded entity equity sales and why such tax treatment matters.

Default Recharacterization as an Asset Transaction for Tax Purposes

In partnership and disregarded entity settings, default federal tax classification rules under Revenue Rulings 99-5 and 99-6 can recharacterize an equity transaction to an asset transaction for tax purposes.

When a buyer acquires part or all of the equity of a single-member limited liability company (“SMLLC”) that is disregarded for federal income tax purposes, the buyer and seller are treated as acquiring and selling a proportionate share of each underlying asset from the company, respectively. The key takeaway here is that the purchase of an “LLC interest” in a disregarded entity is not respected simply as a purchase of equity for tax purposes. Instead, it is treated as a purchase and sale of assets for both the buyer and seller.

When a multi-member limited liability company that is treated as a partnership for federal income tax purposes becomes an SMLLC (taxed as a disregarded entity), sellers and buyers are subject to different tax treatment. For tax purposes, the sellers are treated as selling all of their equity, but the buyer is treated as purchasing the sellers’ share of the underlying assets. What looks like an equity transfer in the deal documents produces asset-purchase tax consequences to the buyer by default. This treatment occurs both when a current member purchases all of its fellow members’ equity interests or when a third party purchases all outstanding membership interests.

Why Tax Treatment Matters

Generally, the tax characterization of a transaction matters because it changes the economics and certain tax reporting obligations. Equity sales generally are favored by sellers because the sale of equity can more easily qualify for long-term capital gains tax rates (instead of ordinary income tax rates). Buyers, generally, seek to avoid equity sales because they receive carryover basis (instead of stepped-up basis), step into the shoes of the seller with regard to liabilities and require more extensive due diligence efforts.

From a tax perspective, asset sales are generally favored by buyers because they receive a stepped-up basis (based on purchase price), which generally allows for higher depreciation and amortization deductions over time. Further, buyers do not step into the shoes of the seller for purposes of all such liabilities (please note, certain tax liabilities, such as employment taxes and sales/use taxes, can still attach to the buyer). Sellers sometimes disfavor this transaction structure because the purchase price is allocated on a per-asset basis, and as a result, certain portions of the purchase price may be taxed as ordinary income instead of long-term capital gains.[1] Whereas the long-term capital gain tax rate is currently 20% (high earners may be subject to an additional 3.8% Net Investment Income Tax), the highest marginal tax rate for ordinary income on individuals is 37%. As such, individual sellers could pay higher taxes if the equity sale is treated as an asset sale for tax purposes.[2]

When the sale of a trade or business is treated as an asset sale for tax purposes, such transaction is generally reported on IRS Form 8594, and the buyer and seller should agree to certain allocations of the purchase price for purposes of this tax form. This agreement usually occurs prior to closing or post-closing pursuant to provisions in a purchase agreement. These allocations have a direct impact on certain deductions available to the buyer and the effective tax rate imposed on the seller. Although buyer and seller are not required to agree to purchase price allocations, inconsistency on IRS Form 8594 or other tax returns can increase IRS audit risk. As such, consistent reporting is highly advised.

Practical Takeaways

Understanding when an equity deal is taxed as an asset deal is not a technical footnote—it can lead to substantial tax savings or additional tax leakage depending on one’s perspective. As such, here are a few quick tips that can go a long way:

  1. Acknowledge the proper tax consequences in early iterations of an equity purchase agreement. This will ensure everyone is on the same page about proper tax consequences and next steps.
  2. Consult a tax professional to ensure compliance with certain purchase price allocation rules (if selling a trade or business, Section 1060 of the Internal Revenue Code of 1986, as amended) and to maximize your tax benefits when it comes to negotiating certain purchase price allocations.
  3. Include language in the Equity Purchase Agreement requiring the buyer and seller to agree to a purchase price allocation and file all returns consistent with such agreement. Further include language to bind both parties to certain purchase price allocations, as determined by an independent party (likely accounting firm), in the event the buyer and seller cannot agree to an allocation within a certain time period post-closing. This can limit IRS audit risk related to inconsistent tax positions.

Careful attention to these issues can help ensure that transaction documents align with their intended tax treatment and avoid costly surprises at or after closing.

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Hall Render blog posts and articles are intended for informational purposes only. For ethical reasons, Hall Render attorneys cannot—outside of an attorney-client relationship—answer specific questions that would be legal advice.

[1] As a common example, certain amounts allocated to previously depreciated assets may be subject to ordinary income tax rates due to depreciation recapture tax rules.
[2] The desired tax treatment generally reverses when the target is distressed and being sold at a loss. Further, there may be non-tax reasons why the buyer would prefer an equity purchase (i.e., ensure business continuity, simplify transfer of assets, and maintain hard-to transfer contracts, licenses, etc.). Such non-tax reasons generally lead the tax structuring in heavily regulated industries, such as healthcare, and must be explored early in a potential transaction.

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