ARTICLE
19 April 2024

Tax Structuring For The Purchase/Sale Of An S Corporation Business

FF
Farrell Fritz, P.C.

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Farrell Fritz provides comprehensive legal expertise to businesses and individuals across the New York metropolitan area. The firm collaborates closely with clients to support business growth, resolve disputes, and manage wealth transitions. Inclusivity is central to its culture, fostering equality and diversity in professional development and client service. Farrell Fritz is committed to recruiting and promoting diverse talent, ensuring equitable opportunities within the firm. Additionally, the firm actively supports local communities through pro bono legal services, contributing positively to the region it serves.

Members of the baby-boomer gener­ation who have reached or passed retirement age continue to divest from their closely-held businesses as part of an overall wealth planning strategy.
United States Tax

Members of the baby-boomer gener­ation who have reached or passed retirement age continue to divest from their closely-held businesses as part of an overall wealth planning strategy. The resulting "middle market" of target companies contains, in particular, numerous entities that are organized as S corporations for tax pur­poses.1 Accordingly, buyers and sellers should be aware, and consider the use of an efficient tax planning tool in connection with the purchase and sale of an S corporation: the F reorganization. 2

F REORGANIZATION

Without getting lost in the minutia, an S corporation F reorganization is typically ac­complished through the following steps: (i) existing shareholders form a new corpora­tion ("NewCo"), and contribute their shares in the existing S corporation ("OldCo") to NewCo; and (ii) NewCo makes an election to treat OldCo as a qualified subchapter S sub­sidiary ("Qsub").3 A third step is often em­ployed whereby the Qsub is merged (or converts via state-law statute) into a limited liability company ("Target LLC").

All of these steps are generally treated as being tax-free; NewCo succeeds to OldCo's S corporation election; OldCo ( or Target LLC, as the case may be) retains its EIN, but is otherwise disregarded for income tax pur­poses. As discussed below, the resulting structure is attractive to buyers and provides flexibility to sellers.

M&A TRANSACTIONS

Generally speaking, in the context of M&A transactions, buyers and sellers each have certain tax- and non-tax goals. Some or all of these goals may be met, depending on the transaction's structure (e.g., whether stock or assets of the target company are bought/sold, and whether the seller retains some ownership, often in the form of rollover equity).4

With respect to the purchase and sale of S corporation businesses, buyers generally prefer to purchase assets, which (i) often re­sults in valuable tax depreciation and amor­tization deductions in the future;5 and (ii) helps insulate the buyer from certain historic tax exposures (such as those resulting from an invalid S corporation election). Sellers, on the other hand, often prefer an equity sale because it tends to provide for preferential capital gain treatment.6 Sellers also prefer tax-deferral on any rollover equity received as part of the deal.

By structuring a pre-sale S corporation F reorganization followed by an equity acqui­sition of the target business, buyer and seller may simultaneously accomplish several of their highest priority goals. For example, if structured correctly, the F reorganization:

  • Provides the buyer with a step-up in the tax basis of the target company's assets (i.e., for the portion of the business purchased, generally resulting in valuable tax deprecia­tion and amortization deductions)/ and in­sulates buyer from certain historic income tax liabilities of the target company;8
  • Provides the seller with the ability to ob­tain tax-deferred rollover equity without the limitations that are present with other acqui­sition structures;9
  • Avoids burdensome legal issues that generally arise in traditional asset sales (e.g. novation of contracts); and
  • Allows the target company to continue utilizing its EIN for employment/payroll tax purposes.

Thus, when discussing potential M&A transactions with clients, to the extent the target company is an S corporation, practi­tioners should keep the F reorganization in mind as a relatively simple, yet effective structuring tool.

This article provides a high-level explana­tion of a pre-sale F reorganization of an S corporation target company, including the re­organization's potential benefits to both buy­ers and sellers, and the steps to effectuate the transaction. Having said that, structur­ing this type of transaction takes technical expertise; careful planning is required to en­sure the F reorganization's steps are timed and executed properly, such that its intended results are respected. 

Published in The Suffolk Lawyer, Vol. 40 No.3 April 2024

1 Unlike C corporations, S corporations do not pay entity­level tax; rather, the company's income generally flows through to shareholders, resulting in a single layer of tax at the shareholder level. According to IRS statistics, since 1997, the S corporation is the most common type of corpo­ration utilized for closely held businesses. Even so, properly electing and retaining S corporation status takes a signifi­cant amount of planning and diligence, and contains traps for the unwary along the way.

2 See I.R.C. Section 368(a)(1 )(F). A full discussion of the re­quirements for effectuating an F reorganization is beyond the scope of this article.

3 See Rev. Rul. 2008-18. See also, PLR 200542013; PLR 200701017; PLR 200725012.

4 Rollover equity (that is, ownership in the buyer or its affili­ate) leaves the seller with "skin in the game" post-sale, which (i) motivates the seller to remain active in the com­pany and ensure a successful transition to new ownership; and (ii) allows the seller to enjoy additional gains in the fu­ture (i.e., upon sale of the hopefully-appreciated equity).

5 The mechanism that allows for this is colloquially referred to as a "step-up" in tax basis.

6 Indeed, to the extent the transaction takes the form of an asset sale that results in ordinary income and/or a higher tax bill, sellers may require a "gross-up" payment to equal­ize the difference vis-a-vis a stock sale.

7 The purchase generally should be treated as an asset pur­chase for federal income tax purposes, which may require buyer to make a gross-up payment. As is typically the case, however, the present value benefit of future tax deductions far outweighs the cost of the additional payment.

8 Nevertheless, tax due diligence of the target company generally is still warranted, particularly in respect of non-in­come (i.e., sales and use, employment/payroll, real and per­sonal property, etc.) tax matters.

9 For example, a joint Section 338(h)(10) election which, comparatively speaking, has strict requirements and signif­icant limitations. A full comparison of these structures is be­yond the scope of this article.

Originally published by The Suffolk Lawyer

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.

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