Hello SMB Buyers!

Today I'm going to cover step-up basis, a critical part of most SMBA acquisition structures.

First, let's start with a definition: The step-up allows a buyers to adjust asset values to market prices, therefore increasing their tax basis.

Example: Let's say you're buying a business for $10 million, and the business owns $1 million worth of assets. If the previous owner bought those assets for $500k, what will be the buyer's cost basis?

Well, if you don't take the necessary steps to structure the deal with an equity step-up, then your cost basis in those assets will be the seller's basis, $500k.

This is bad for the buyer: You'll have lower depreciation expense each year, and therefore a higher tax liability. And you'll have a higher tax liability if you choose to sell any of those assets for a gain soon after the purchase of the business.

By default, buying a business typically means that your cost basis in all the assets is the same as the old owner's. Think about how a public company would be sold: Their books would remain the same for a new buyer. The cost basis for any assets owned by the business wouldn't change because someone else owns the business.

But when buying an SMB, the new owner should strongly prefer to step up to the higher basis.

How do you do that?

The most common method is an asset sale.

You can either buy a business in a stock sale or asset sale. In a stock sale, you're buying the outstanding shares of a company (like how one would buy a public company). But in an asset sale, you're buying the assets of the business: The physical assets, the brand, logo, customer list, etc.

Effectively, you're buying the business in either scenario. But both scenarios have different tax implications.

The asset sale allows you to step up to the higher basis of the assets.

I love this illustrative example from Eli Albrecht. Read his full post on this here.

You can see that the buyer's tax liability is much lower each year thanks to step-up basis.

Without a step-up basis, the buyer is basically paying taxes on the old owner's gains from those assets. If you're paying full market value for those assets, and also paying the old owner's tax liability on their gains, then you are paying extra for certain assets! Many buyers don't realize this until it's too late.

Of course, the seller may object to structuring the deal with the equity step-up. Their tax liability could jump significantly. To compensate, sometimes the deal will be structured to add in a "gross up", which is basically the buyer adding in a cash payment to compensate for some or all of the additional tax liability the seller will realize when the deal closes.

As always, if you have any questions on content in this newsletter, please feel free to reach out to me via email at matthias@pioneercap.com