FAQs about the Tax Basis Step Up
The tax basis step-up is the most valuable attribute available in mergers and acquisitions taxation and is the lynchpin to most tax structuring in the middle market. But it’s also complex, squishy, and potentially not worth anything at all. So…go figure. We’re going to outline some of the fundamental concepts inherent in tax basis planning, but as always, every situation is different and there’s no substitute for the advice of your Friendly Acta Tax Advisor.
What is tax basis?
Tax basis is an accounting mechanism designed to assist in calculating your gain or loss with respect to an investment. Every time you buy an asset, you take a “cost basis” in that asset – meaning that whatever you paid for it becomes your tax basis. Your tax basis in that asset is then adjusted upwards for additional cash investments you make in that asset (capital expenditures) and downwards for any wasting of the asset that Congress, in its infinite wisdom, has decided reflects a decline in value of the asset. When you sell the asset, you realize tax gain or loss based upon the difference between what you receive for that asset and your tax basis in the asset.
Example 1: Let’s say that in 2023, you purchase one of those hot dog rollers for your convenience store and you get a screaming deal – it normally sells for $150, but you get it for $100. You still only have a $100 cost basis in the hot dog roller, regardless of how much it’s worth. You then spend another $50 to have it installed and let’s assume that 100% of these expenditures must be capitalized into the equipment. That makes your basis in the equipment $150. Congress decreed that in 2023, such equipment qualifies for 80% “bonus depreciation” where you got to depreciate 80% of your basis immediately. That entitles you to a $120 deduction! Additionally, the remaining $30 of tax basis is eligible for another $9.60 of depreciation in 2023 with the remaining $20.40 to be depreciated over the next 4 years (we’re going to spare you a discussion of the nuances of the Modified Accelerated Cost Recovery System). That $129.60 of depreciation deductions reduce your tax basis in your hot dog roller to $20.40. If you sold the roller for $100, you would recognize $79.60 of gain.
What is a tax basis step-up?
The tax basis step-up is just the way tax advisors describe the cost basis you take in assets purchased in an M&A transaction.
Cool story. But if I always get a cost basis in whatever I purchase, why do I care about this?
Because what you purchase in the M&A context isn’t always depreciable and that’s where stuff gets weird. When you purchase depreciable assets, you take a cost basis in those assets and those assets can be depreciated or amortized, generating tax deductions. When you purchase stock (for tax purposes), however, you take a cost basis in the stock you purchase. Stock cannot be depreciated or amortized, and, more importantly, the corporation you just purchased cannot adjust its basis in its assets based on the purchase price.
Example 2a: Let’s say you purchase 100% of the tangible and intangible assets of a business for $100. You take a $100 basis in those assets. You’re required to allocate that basis among the assets in accordance with their relative value, so you allocate $10 to the tangible assets - net working capital and fixed assets - and the remaining $90 to intangible assets. The $90 allocated to intangible assets can be amortized on a straight-line basis over 15 years, resulting in $6 a year in amortization deductions for you.
Example 2b: Let’s say that instead of purchasing the assets, that business is held by a corporation and you purchase the stock of that corporation for $100. You take a $100 basis in the stock you purchase. However, the corporation that you have purchased maintains its historical basis in the assets of the business. So if, prior to the transaction, the corporation you purchased had $10 basis in its tangible assets – net working capital and fixed assets – but a $0 basis in its intangible assets, the corporation would continue, post-transaction, to have $10 basis in its tangible assets and $0 basis in its intangible assets.
The difference between Examples 2a and 2b are what people are talking about when they refer to a “tax basis step-up.”
Why do I care? In either situation, I have a $100 basis in the business I’m eventually going to sell.
Because in year 1, if the business generates $6 of taxable income prior to considering amortization deductions, the business in Example 2a is going to use $6 of amortization deductions to pay $0 of tax, while the business in Example 2b is going to pay tax on $6 of income. Assuming a 25% effective tax rate, that’s a cost of $1.50. And it’s going to happen every year for the next 15 years. That’s what we call marginal gains, baby!
Sure, but I’m going to have to recapture those deductions at ordinary income rates when I sell the business anyway, so that’s just a time value of money benefit.
That’s a pretty sophisticated observation from someone we just had to explain cost basis to. And it’s also both kind of true and kind of not true. If we assume that you purchase assets like in Example 2a and hold them through a pass-through investment, it’s true that the depreciation deductions will reduce your outside basis in your investment, thus resulting in additional gain if that investment is ever sold. It’s also true that additional gain will generally be “recaptured” at ordinary income rates. However, if you purchase assets and hold them through a pass-through investment, you get all of the benefits we described here, including the ability to resell that tax basis step-up to the next buyer. And you can’t get any of those benefits if you buy stock in a corporation.
Second, if you purchase assets and hold them through a C corporation for whatever reason (you’re a publicly traded company, you have significant foreign investors, you like to antagonize your Friendly Acta Tax Advisor), those deductions are never recaptured because you’re (generally) never selling assets – you’re selling stock. And your basis in your stock is never adjusted for deductions claimed at the corporate level. In this situation, your deductions from the tax basis step-up become permanent.
