As a general rule, businesses that are organized as state law corporations are subject to a double level of tax—that is, earnings and realized appreciation are taxed once at the corporate level and a second time when the earnings or appreciation are distributed to the stockholders. This double level of tax generally precludes the stockholders from structuring a sale of the business as an asset sale—which happens to be the purchaser's preferred acquisition structure. Importantly for the selling stockholders, it prevents them from obtaining the premium (as described below) that a purchaser is generally willing to pay for assets as compared to a stock purchase. Fortunately, many family enterprises that are organized as state law corporations qualify (and, importantly, have elected to be taxed for income tax purposes) as S corporations. There are 4.5 million S corporations in the United States, according to the S Corporation Association, and many of them are large, mature businesses that are prime acquisition targets. A simple tax election that is made in connection with the sale of the stock of an S corporation significantly enhances the value of an S corporation target, and such value should be captured by the selling stockholders.
Value of the Premium
The value of the tax benefit to the purchaser of an asset purchase may be as much as 20 to 25 percent of the premium paid for the business (i.e., the premium is measured by the excess of the purchase price over the target's tax basis in its assets). For example, assume a $100 million purchase price for a business which has a $25 million tax basis in its assets (an implied $75 million premium). Further assume an 8 percent discount rate and a 40 percent effective tax rate for the purchaser. Finally, assume as is often the case that the entire premium is allocated to the goodwill and going concern value of the business (which assets are amortized over a fifteen-year period). The present value of the amortization deductions (i.e., the present value of the increased cash flow resulting from the lower income taxes) would be approximately $17 million. Thus, the tax benefits enable a seller to obtain significant additional purchase price for a business. Although different parties may suggest a different discount rate or a different period over which the benefits will be realized (e.g., a financial purchaser that intends to flip the business in five years may only fully value the deductions for a five-year period).
Impact of the Election on a Stock Sale
When the acquisition of an S corporation cannot be structured as an asset sale for commercial or business reasons and is structured as a stock sale for state law purposes—generally a selling stockholders' desired structure—the parties can make an income tax election, often with minimal incremental income tax cost to the selling stockholders, that will treat the stock purchase for U.S. federal and most state income tax purposes as an asset purchase providing a valuable economic benefit to the purchaser. The election is made pursuant to section 338(h)(10) of the Internal Revenue Code and is jointly made by the purchaser and all of the stockholders of the target corporation. The deemed fiction for income tax purposes is that while still owned by the selling stockholders, the target sold all of its assets to a new corporation (acquired by the purchaser) and then liquidated, distributing the sale proceeds to the selling stockholders. As a result, the purchaser acquires the target business with a full fair market value tax basis in the assets which gives rise to the valuable depreciation and amortization deductions.
Potential Qualification Traps for the Election
To make the election, 80 percent or more of the target corporation's stock must be acquired in a 12-month period by "purchase." "Purchase," for this purpose, excludes tax-free and partially tax-free transactions. If a seller receives any rollover equity in the transaction, it will be necessary to structure the transaction so that the rollover equity is taxed to the selling stockholders when received. Although certainly a cost for the selling stockholders, the failure to provide a step-up in basis in the assets of the target that can be amortized for tax purposes often may have an even larger negative impact on the price the selling stockholders can command.
For deals structured as asset purchases for tax purposes such as stock sales with a section 338(h)(10) election, the purchaser usually has bargained for the tax benefits that accompany such a transaction – namely, the ability to tax-effect the purchase price by amortizing the premium paid for the assets. However, if the target business was in existence on or before August 10, 1993, and before or after the transaction, the seller or a related party owns greater than 20 percent of the equity of the purchaser (an even lower percentage if the acquirer or its parent is a partnership), the purchaser's ability to amortize this premium may be denied. A failure to address these "anti-churning" rules can result in a significant – and perhaps needless – reduction in the purchaser's after-tax cash flow for which the purchaser may have an indemnification claim.
Benefits Outweigh Costs
Assuming the acquisition target has been an S corporation for a number of years, the benefit to the purchaser often comes at little cost to the seller(s). A key point that is often not fully appreciated is that the stockholders of an S corporation target will recognize the same aggregate amount of gain or loss whether the acquisition of the business is structured as a stock sale or a stock sale with a section 338(h)(10) election. This results because the selling stockholders' stock basis in their target stock is increased by any gain recognized on the deemed asset sale and this increased tax basis reduces the gain to the seller(s) upon the deemed liquidation of the S corporation target.
The potential incremental costs to the selling stockholders arise because (i) the gain on certain assets may be taxed at ordinary income rates rather than the favorable capital gains rate that otherwise would have applied to the stock gain and (ii) the state income tax cost to the selling stockholders may be higher (although it may be lower in some cases). In most cases, these incremental costs are very manageable. Even if the selling stockholders are not willing to bear these incremental costs, the benefit of the section 338(h)(10) election to the purchaser is usually significant enough that the purchaser is willing to make the selling stockholders whole for any incremental increased income taxes resulting from the election.
For selling stockholders who are active in the business (or deemed active in the business), the S corporation status provides another important tax benefit. As part of the Healthcare Act, section 1411 of the Internal Revenue Code imposes a 3.8 percent tax on investment income. For stockholders active in the business, this 3.8 percent tax does not apply to any gain on sale; however, for stockholders who are not active in the business, the 3.8 percent tax will apply to the gain. These results occur regardless of whether or not a section 338(h)(10) election is made in connection with the stock purchase. On the other hand, capital gain on the sale of C corporation stock is generally not treated as investment income for purposes of section 1411 and the 3.8 percent will not be imposed even if the selling stockholder is active in the C corporation's business.
Although the purchaser is treated as acquiring a new corporation for income tax purposes with a clean slate of tax attributes and a fair market value tax basis in its assets if the section 338(h)(10) election is made, this does not change the fact that the purchaser acquires the historic state law target entity. Losses related to taxes and other hidden liabilities of the target will be borne by the purchaser if the selling stockholders do not ultimately satisfy such liabilities or fulfill their indemnity obligation to the purchaser for any payments made by the purchaser in connection with such losses (assuming the purchase and sale agreement has a standard indemnification provision). In other words, when possible, the purchaser will still very much prefer an actual asset purchase. Nevertheless, if—as often is the case—an asset sale is commercially not practical, the seller can realize the same tax benefits as an asset purchase with a section 338(h)(10) election.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.