Introduction
S corporations, or S-corps, are one of the most popular entity choices for businesses. In contemplating the sale of an S-corp, it is important to plan how the transaction is structured from a tax perspective (ideally before an LOI is signed), both to maximize the gain on the sale and avoid pitfalls that can result in liabilities for the selling shareholders.
For corporate purposes, businesses are generally formed as limited liability companies, partnerships, or corporations. For tax purposes, however, entities are taxed as corporations, partnerships, or disregarded entities.[1] Corporations[2] are taxed as either a C corporation or an S corporation. C corporations are taxed at the corporate level and again at the shareholder level.[3] S corporations are corporations that, for federal tax purposes, elect to pass corporate income, losses, deductions, and credits through to their shareholders and are only taxed at the shareholder level.[4]
To qualify as an S corporation, the corporation must meet the requirements of Section 1361,[5] which provides that the corporation not have more than 100 shareholders, not have non-individual shareholders (with the exception of certain types of trusts, estates, and tax-exempt organizations), not have a nonresident alien as a shareholder, not have more than one class of stock, and not be an ineligible corporation (as defined in the Code).[6]
When sellers begin to explore the sale of their business, tax considerations are important to discuss at the outset so that the seller and buyer are on the same page – no one wants to attempt to renegotiate the terms of a deal in the middle of a transaction. For tax purposes, acquisitions of companies are categorized as either an asset purchase or stock purchase. In general, owners prefer to sell their stock (as opposed to the company’s assets) for a few reasons. First, a stock sale results in capital gain to the shareholders because their stock is a capital asset.[7] In an asset sale, however, noncorporate sellers (including S-corp shareholders) recognize ordinary income or capital gain, depending on the type of asset sold. Second, unlike in an asset sale, a stock sale may not require the seller to transfer company assets and licenses or obtain third party consents.
On the other hand, buyers usually want to engage in an asset sale to obtain a step-up in basis of the purchased assets. In a stock acquisition, the buyer gets a carryover basis in the acquired corporation’s assets, without any basis step-up. In an asset purchase, however, the buyer takes a cost basis in the assets, including in the target corporation’s goodwill (which otherwise will generally have a zero basis), and allows the buyer to take higher depreciation deductions to reduce the buyer’s annual tax liability.[8] Unless otherwise agreed, the buyer also does not assume corporate liabilities in an asset sale.
Sellers who agree to engage in an asset sale should negotiate with the buyer to be compensated for the additional tax that the seller may incur for engaging in an asset sale.
There are two additional ways for a buyer to obtain a basis step-up in the seller’s assets. The first is a 338(h)(10) election under Section 338 and the second is an F reorganization pursuant to Section 368(a)(1)(F) and consistent with Revenue Ruling 2008-18.[9]
Making the 338(h)(10) Election
A buyer and seller will sometimes make a 338(h)(10) election, which treats an acquisition of a corporation’s stock as a sale of assets for federal income tax purposes, but a sale of stock for legal purposes.[10] The sale is treated as if buyer and seller engaged in a regular asset sale for income tax purposes (so the buyer obtains a step-up in the tax basis of the assets), yet the seller does not need to re-title each asset.[11] Seller does not have capital gain on the sale of stock. Instead the parties must allocate the sales price among the assets based on each asset’s fair market value.[12] The price paid in excess of the fair market value of the tangible assets of the business is allocated to business intangibles and then to goodwill.[13]
The 338(h)(10) election is only available if a “qualified stock purchase” is made.[14] A “qualified stock purchase” is defined as any transaction (or series of transactions) in which a corporation purchases at least 80% of the stock (both voting and value) from a member of a consolidated group(as defined in 1.1502-1) or from shareholders of a S corporation during a 12 month period.[15] If during diligence it is revealed that the target corporation in fact failed to qualify as an S corporation, the 338 election will be invalid.[16] If the Section 338(h)(10) election is invalid, the transaction will be treated as a straight stock sale and buyer will not receive a basis step-up in the target’s assets.
A section 338(h)(10) election is made jointly by the purchaser and seller on Form 8023.[17] S corporation shareholders who do not sell their stock must also consent to the election. The election must be made not later than the 15th day of the 9th month beginning after the month in which the acquisition date occurs.[18]
If the target failed to qualify as an S corporation (thereby becoming a C corporation), an election can be made to treat the sale of the corporation’s stock as an asset sale under Section 336(e). The election can be made if target is owned by a parent corporation that sells at least 80% of target’s stock.[19] A 336(e) election closely resembles a 338(h)(10) election, but the purchaser does not have to be a corporation.[20] Note that a transaction that qualifies under both 336(e) and 338(h)(10) will be treated as 338(h)(10) transaction.[21]
Consequences of a 338(h)(10) Election
Under the Regulations, the target corporation is treated as making a deemed sale of its assets and liquidating following the deemed asset sale.[22] The transaction is treated as a taxable acquisition of 100% of the target’s assets for income tax purposes.[23] This means that the stock cannot be acquired in a tax free transaction or reorganization (such as a transfer to a controlled corporation, merger or spinoff) or a transaction where the seller does not recognize the entire amount of gain or loss realized on the transaction.[24]
Issues with a 338(h)(10) Election
While the 338 election can be a useful way for a buyer to achieve a basis step-up without burdening the seller to retitle and transfer assets, the following disadvantages of the election should be considered:
- The rules under Section 338 require all S corporation shareholders (whether or not they sell their stock) to pay tax on all of the target’s assets, even if selling less than 100% of the target.[25] This effectively eliminates any structuring of a deal on a tax-deferred basis (i.e. where seller only pays tax on the consideration attributable to non-rollover equity). Sellers need to be aware that they will pay tax on all of the target company’s assets regardless of the percentage of assets sold.
- The election presents an issue for rollover transactions where the seller rolls over more than 20% of its equity on a pre-tax basis in a Section 721 or Section 351 transaction (in which seller receives equity in buyer, buyer’s parent, a holding company that holds target, or another form of equity). Rolling over more than 20% of equity will invalidate the 338(h)(10) election because it will not meet the “purchase” requirement under Section 338.[26]
- If the target company’s S corporation election turns out to be invalid (which happens frequently due to the ease with which S corporation status can be voided), the 338(h)(10) election will be invalid, thereby eliminating any advantage provided by the election.[27] Note that the seller will also be in breach of its representations and warranties under the purchase agreement.
F-Reorganization
An alternative to a 338(h)(10) election is an F reorganization, or F reorg., which allows sellers to avoid the potential issues that come with a 338 election. In an F reorg., the seller recognizes gain only with respect to the assets that it is deemed to have sold, allows the seller to roll over equity on a pre-tax basis, and avoids some of the risk that the target may have not properly qualified as an S-corp (thereby invalidating a Section 338(h)(10) election).
Engaging in an F-Reorganization
The first step in an F reorg. is to engage in a tax free reorganization of the S-corp.[28] Shareholders of the target S-corp (“T”) form a new corporation (“Holdco”) and transfer their shares in T to Holdco in exchange for Holdco shares. As a result of the transaction, T shareholders own all shares of Holdco, which in turn owns all shares of T, making T a fully owned subsidiary of Holdco. Holdco then elects to treat T as a Qualified Subchapter S Subsidiary (“QSub”) by making the election on form 8869. For federal tax purposes, T, as a QSub, becomes a disregarded entity and all assets and liabilities of T are treated as part of Holdco.[29] Note that the QSub election made by T also suffices as the S-corp election for Holdco.[30] After T becomes a QSub of Holdco, T converts into a limited liability company (“LLC”) under state law in a nontaxable transaction by converting from one disregarded entity to another.[31] Holdco will need to obtain its own EIN, but T retains its old EIN after the conversion.[32] Once the conversion to an LLC is complete, the shareholders of Holdco can sell some or all of the LLC interests of T; the sale is treated as an asset sale for tax purposes, thereby resulting in a step up in basis for the purchaser.[33] The seller recognizes gain from the deemed sale of each asset of T. If less than 100% of the LLC interests are sold to the buyer, the transaction is treated as the purchase of a proportionate interest in each of the LLC assets, followed by a contribution of the respective interests to a partnership in exchange for ownership interests in the partnership, resulting in a stepped up basis in the assets for buyer.[34] In this scenario, T is no longer a QSub and is converted to a partnership for tax purposes.[35]
Note that a straight conversion of the existing S corporation target from an S-corp to an LLC should not be done because it is treated as a taxable liquidation of the S corporation (i.e. a deemed sale of its assets) resulting in a fully taxable event to the shareholders.[36]
Alternatively, the S-corp could form a new LLC, contribute all its business assets and liabilities to the new LLC in exchange for the LLC interests, and sell the LLC interests to the buyer. However, the transfer of assets might require third party consents; the F reorg. achieves the same result without any potential assignment issues, and even preserves the historical EIN of the S-corp.
Advantages of an F-Reorganization
The F-reorganization is an effective way to avoid the issues that arise with a 338(h)(10) election:
- If the acquisition is for less than 100% of the target, the S-corp shareholders will only recognize gain on the portion of the LLC sold by the S-corp parent. Any portion of the LLC interests rolled over will be tax-deferred. Rollover transactions are perfectly suitable in a F reorg. and do not present the issues that come with a 338(h)(10) election.
- The converted LLC retains its old EIN number and is essentially the same entity for legal purposes. This can be useful for a target in a regulated industry (such as healthcare, food services, manufacturing, etc.) by possibly avoiding the need to reapply for new permits and licenses.
- An F reorg. can be useful for planning purposes under Section 1202 (Qualified Small Business Stock, or QSBS), which allows shareholders of a C corporation to exclude from their taxable income the greater of ten million dollars or ten times the adjusted basis of their stock upon a sale.[37] One requirement is that the stock must be stock of a C corporation, not an S corporation.[38] S corporation shareholders who want to qualify under 1202 can perform an F reorg. and contribute the LLC interests of their operating company to a newly formed C corporation in a tax free exchange under 351. The S corporation (which owns the C corporation which owns the LLC) is now an eligible shareholder of QSBS and will qualify for favorable treatment under Section 1202.[39]
Footnotes
[1] Reg. §301.7701-2. Entities may also be taxed as cooperatives or as tax-exempt organizations if the statutory requirements are met.
[2] For purposes of this article, a corporation includes a limited liability company (LLC) that has elected to be taxed as a corporation.
[3] IRC §11(a).
[4] IRC §1363. For state tax purposes, treatment of S corporation status varies – certain states either conform with the federal treatment or conform with certain limitations and adjustments, while others do not recognize the S election at all and tax S corporations as regular corporations. In particular, California imposes an entity level tax of the greater of $800 or 1.5% of net income.
[5] Section references are to the Internal Revenue Code of 1986, as amended.
[6] See IRC §1361 (for example, an insurance company or certain financial institutions). In addition, Form 2553 must be filed to make the S corporation election.
[7] See IRC §1221(a).
[8] See IRC §1012(a) and §167.
[9] A 338(g) election also obtains a basis step-up, but results in two layers of tax and is not generally used for domestic transactions.
[10] IRC 338(a).
[11] Reg. 1.338(h)(10)-1(d)(9).
[12] In accordance with the allocation provisions set forth in IRC 1060 and Reg. 1.338-6 and 1.338-7.
[13] Reg. 1.338-6(b)(vi) and (vii).
[14] IRC 338(a).
[15] IRC 338(d)(3) and Reg. 1.338(h)(10)-1(c). For the purposes of this article, we assume that target is a standalone S-corp.
[16] Reg. 1.338(h)(10)-1(c)(5). However, the transaction may still qualify under Section 336(e). See below.
[17] Reg. 1.338(h)(10)-1(c)(3). Form 8883 also needs to be filed. If an F reorg is done, form 8594 will need to be filed.
[18] Reg. 1.338(h)(10)-1(c)(3).
[19] Reg. 1.336-2(a). The election is made unilaterally by seller and target. See Reg. 1.336-2(h).
[20] Reg. 1.336-1(b)(2). See Reg. 1.336-1 – Reg. 1.336-5 for the mechanics of making the 336(e) election and what qualifies as a “qualified disposition” under 336.
[21] Reg. 1.336-1(b)(6)(ii)(A).
[22] See Reg. 1.338(h)(10)-1 for the tax aspects of the deemed asset sale and liquidation.
[23] A deemed asset sale under Section 338 does not give rise to California sales tax. Cal. Code of Regs. 1595(a)(6).
[24] IRC 338(h)(3). See below for rollover transactions.
[25] Reg. 1.338(h)(10)-1(d)(5).
[26] IRC 338(h)(3)(A)(ii). Beware of situations where the acquiror appears to “purchase” at least 80% of target’s stock (and target rolls over 20% or less of its stock in a 351 transaction), but the acquiror in fact does (or might be deemed to) “purchase” less than 80% of target’s stock, thereby invalidating a 338, 338(h)(10), or 336(e) election. This most commonly occurs where purchaser is a newly formed corporation and target rolls over 20% (or less) of its shares. See Ginsburg, Levin & Rocap, Mergers, Acquisitions, and Buyouts, § 4.06.1.2.2 (relating to redemption of stock held by target’s shareholders and recharacterizing a 351 transaction and cash sale as a single 351 exchange with boot).
[27] See footnote 16.
[28] In accordance with Rev. Rul. 2008-18.
[29] IRC 1361(b)(3).
[30] Rev. Rul. 2008-18. Obviously, Holdco must meet all the requirements of an S-corp. In many cases, the parties will file Form 2553 to treat Holdco as an S corporation as a “belt and suspenders” step.
[31] Upon conversion, T is no longer treated as a QSub per 1361(b)(3). The conversion has no tax consequences; see Reg. 1.1361-5(b)(3), example 2, where the merger of two disregarded entities owned by the same entity is a disregarded transaction for tax purposes because the assets continue to be held by the same entity. The same should apply when one disregarded entity converts to another. The QSub can also merge with a newly formed LLC subsidiary of Holdco to achieve the same result.
[32] Rev. Rul. 2008-18.
[33] Rev. Rul. 99-5; Reg. 1.1361-5(b)(3), example 2.
[34] Rev. Rul. 99-5; see also Rev. Rul. 99-6.
[35] Id. Although not required, a Section 754 election is often required by the Buyer.
[36] IRC 336(a).
[37] IRC 1202(b). See Section 1202 for the requirements to qualify for QSBS.
[38] IRC 1202(c).
[39] The S corporation shares do not qualify as QSBS. The new shares of the C corporation issued after the reorganization qualify as QSBS to begin the 5 year holding period.
