Corporations & Shareholders
The disregarded entity (DE) has created numerous opportunities for well-advised taxpayers to accomplish transactions that may not have previously been feasible. DEs include a variety of entities, the most common of which are the single-member limited liability company (SMLLC) and the qualified subchapter S subsidiary (QSub). Other DEs include qualified real estate investment trust subsidiaries, certain grantor trusts, and other creations of the Code. This article focuses on SMLLCs and QSubs.
Much of the power of the DE in income tax planning stems from the fact that the legal acquisition of an interest in a DE is taxed with respect to the underlying assets and not as an acquisition of a membership interest—that is, as an acquisition of a corresponding share of the assets and liabilities of the entity, followed by a contribution to a new separately regarded entity (whether taxed as a partnership, corporation, DE, or something else). See Rev. Rul. 99-5 regarding transfers of SMLLC interests and Sec. 1361(b)(3)(C)(ii) regarding transfers of QSub shares. This tax fiction allows buyers to receive a step-up in their share of the inside basis of the acquired company’s assets without a hard asset purchase.
Example 1: A Corp. owns 100% of T LLC, a disregarded entity. B Corp. purchases 90% of the interests of T from A in exchange for cash. For federal income tax purposes, the transaction is taxed as if B has acquired 90% of T’s assets and liabilities directly from A. B and A are then deemed to contribute their respective shares of T’s assets and liabilities to a separately regarded entity. Barring an election to have T taxed as a corporation, the parties are considered to have contributed their respective shares of T’s assets and liabilities to a newly formed tax partnership. B contributes full-basis assets (i.e., their tax basis equals their fair market value), while A’s 10% retained assets roll over at their old basis in the hands of the new tax partnership.
On the deemed sale of 90% of T’s assets, A will recognize gain or loss as if it had sold those assets directly to B in exchange for cash and assumption of 90% of T’s liabilities. Some of that gain may be capital gain or Sec. 1231 gain, depending on the property involved.
Without the use of a DE, this transaction would be impractical and expensive, resulting in a host of administrative, tax, and legal nuisances. For example, an actual sale of 90% of T ’s assets to B would result in the parties each having a joint interest in those assets and joint liability on certain liabilities. Sales and transfer taxes might be triggered. Legal titles would have to be transferred and perfected. If the parties decided to carry on the business in a new entity, both parties would have to transfer their respective interests to a new entity. All these headaches and costs potentially can be avoided through the judicious use of a DE. (Note that even when a Sec. 338(h)(10) election for nonrecognition of gain is available following a qualified stock purchase, 100% of the gain is still taxed immediately, rather than the 90% shown here.)
What to do with a business that is not already in a DE? One option is to contribute all the assets of the target business into a new DE, but many of the same nuisances above may follow this asset contribution. However, another potential transaction is available: a Sec. 368(a)(1)(F) reorganization (F reorganization), which effectively allows the target corporation to convert itself into a DE without triggering any tax liability, thus setting up the base transaction described above.
One possible F reorganization is illustrated in the following example.
Example 2: ABC Corp. is a stand-alone C corporation. ABC wants to sell 100% of its business to B, a private equity buyer, in exchange for cash. The parties prefer a stock acquisition to avoid transfer taxes and other legal problems involved in an asset sale, but ABC is willing to sell assets for tax purposes. B would like to get a step-up in the basis of ABC’s assets to provide tax deductions in future years. ABC’s shareholders therefore form H, a holding company, and contribute their shares of ABC to H. ABC then immediately converts to an LLC under the relevant state formless conversion statute. The end result is that ABC’s former shareholders now own H in exactly the same percentages as they owned ABC, and H owns 100% of ABC LLC (a DE). This is generally a valid F reorganization (Rev. Rul. 64-250; Rev. Rul. 2008-18).
H can now sell ABC LLC to B in exchange for cash. B takes full basis in the assets acquired from H; H recognizes gain or loss as if it had sold all of old ABC’s assets. H now has the remaining after-tax cash from the C corporation, which can be invested as it sees fit (or ultimately distributed to the shareholders).
While this particular example is certainly unlikely by itself, given the double-tax impact to the seller, it inspires a number of derivative transactions that can accommodate a variety of needs. Significantly, this transaction allows a buyer and a seller to replicate many of the overall tax effects of a Sec. 338(h)(10) transaction while providing workarounds to the restrictions of that section.
Sec. 338(h)(10) generally allows a buyer and a seller to treat a stock purchase as an asset purchase, subject to a number of statutory and regulatory limitations, most notably:
- The buyer must be a corporation;
- The buyer must acquire at least 80% of the target;
- The target must be a subsidiary in a consolidated group or an S corporation; and
- The seller must pay tax on 100% of the gain built into the target, even if it sells less than 100% of the target.
The F reorganization transaction described in Example 2 provides some alternatives to each of these restrictions:
- Buyer must be a corporation: In the example, B can be any type of entity. If B purchases an interest in a DE, it will be treated for income tax purposes as if B had acquired a proportionate share of the DE’s assets and liabilities. Because B can be any type of entity, this allows a prospective buyer to be taxed as a flowthrough LLC, a sole proprietorship, or any other type of tax entity. This is of particular interest to a private equity buyer that wishes to keep flowthrough treatment in an acquisition of an S corporation: Because B may be taxed as a partnership, the portfolio company will not qualify to be taxed as an S corporation (due to a disqualifying shareholder), so the only way to get flowthrough treatment is by using a tax partnership or LLC.
- Buyer must acquire at least 80% of the target: In the example, B can acquire any amount of interests in the DE. It can acquire 100% or 1%, but in either case it receives full basis in the assets acquired. If the assets are deemed to be contributed to a new, separately regarded partnership or corporation, B’s full basis in those assets will carry over to the new entity, while ABC’s retained assets will come in with carryover tax basis. (The parties should consider the impact of Secs. 751 (unrealized receivables and inventory items) and 704(c) versus Sec. 351, discussed below. Also note the potential impact of the Sec. 197 antichurning rules, Sec. 1239 gain recharacterization rules, and numerous other provisions. This transaction is not a cure for all tax ills.)
- Target must be a subsidiary in a consolidated group or an S corporation: In Example 2, ABC Corp. is a stand-alone C corporation that converts itself into a DE without triggering any immediate tax liability as a result. Once the conversion is complete, any buyer can acquire ABC LLC and will be taxed as noted above. (The opportunity this presents to the prospective buyer of an S corporation is discussed below.)
- Seller must pay tax on 100% of the gain built into the target, even if it sells less than 100% of the target: In our example, H sells 100% of ABC LLC to B. However, there is no requirement that H sell that much, and if H instead chooses to sell, for example, 70% of ABC, H will pay tax on the 70% sold and roll over the remaining 30% on a tax-deferred basis. (Contrast this result with a Sec. 338(h)(10) transaction, which is available only if at least 80% of T is acquired and still requires that 100% of the gain be taxed immediately.)
This final point is a key consideration in many private equity deals and is one of the most significant benefits of this transaction. Many private equity buyers wish to have the seller and/or management continue as minority owners in the business. Without the use of a DE, it would be impossible to get a basis step-up for the assets purchased without an actual asset sale or some other legal transfer of assets (such as a disguised sale to a partnership or a Sec. 351 with boot transaction). The F reorganization transaction allows the parties to effect an asset sale for income tax purposes without a hard asset transfer that would raise the problems discussed above.
Tax planning with this transaction provides for many different structuring alternatives:
- If the target is an S corporation, this transaction can be used to manage built-in gain (BIG) tax (see Sec. 1374). Again, with a Sec. 338(h)(10) election, 100% of any BIG tax liability will be triggered on the sale, even if less than 100% of the target is sold. With the F reorganization transaction, only the proportion of the assets deemed sold would attract immediate BIG tax. The remaining BIG would be deferred until a later transaction and possibly avoided completely if that later transaction occurred outside the BIG tax window. Alternatively, some or all BIG assets could be distributed up to the new holding company and retained by the seller without triggering any taxes.
- If the target is an S corporation whose total net unrealized BIG is in dispute, this transaction allows the buyer to avoid any BIG tax risk by avoiding taking ownership of the S corporation that sells its assets.
- If the target is an S corporation whose S election may not be valid, this transaction creates a way for the buyer to avoid all the potential ramifications of that problem by effectively leaving the issue with the seller. The buyer acquires the LLC interest (and thus the target’s assets) directly from the selling corporation. If the target’s S corporation election is invalid, that would not affect the status of the asset sale. Nor would the buyer be subject to any old C corporation taxes that might be assessed by a taxing authority, as the seller retains control over the selling corporation. (If the newly formed corporation retained by the seller is a valid S corporation, the historic status of the DE (whether an SMLLC or a QSub) is still relevant. If the old S corporation election is determined to be invalid, the DE conversion will result in a new BIG tax period, and the sale of interests in the DE may cause BIG tax for the selling corporation. Again, this is the seller’s problem.)
- This transaction allows an S corporation seller to roll over its interest on a tax-deferred basis while also allowing it to hold that interest as a flowthrough entity. For example, if the target is converted to an LLC, both the buyer and the rollover interests are generally deemed to have contributed their relative shares of the target’s assets to a tax partnership. The S corporation seller ends up owning an interest in a partnership, which allows it to continue to hold its investment with only one level of tax. Any investor that does not wish to hold its interest in a flowthrough can insert a blocker C corporation with generally benign consequences.
- In many circumstances, it is important for the target to retain its employer identification number (EIN) due to vendor relationships, long-term contracts, etc. This transaction allows the parties to accomplish the income tax benefits of an asset sale without losing the target’s EIN, as the EIN remains with the target (see Rev. Rul. 2008-18).
As with any transaction, there are some traps for the unwary:
- The parties need to carefully consider whether the DE should be a corporation or an LLC. This is not only a tax consideration; the attorneys will likely have an opinion of which entity provides better legal protection to the parties. In addition, state law may require some businesses to be organized in a certain way.
- If the proposed sale is for less than 100% of the target, the DE eventually will be taxed as a partnership or a corporation. If any of the parties wish to have flowthrough status, the DE should likely be an LLC, since S corporation status likely is not available following a private equity buyout.
- If the parties decide to carry on their ongoing business in a partnership, they will need to plan for the impact of the various partnership tax rules, particularly Sec. 704(c) regarding contributed property. They will also need to determine whether a Sec. 754 election (adjustment to basis of partnership property) is appropriate or necessary.
- If the parties wish to continue their business as a corporation, they need to consider the impact of Secs. 351 and 357(c). Sec. 351 has some basis allocation rules that do not mirror the Sec. 1060 rules, and Sec. 357(c) is a significant issue when the target has liabilities in excess of its basis, since it provides that the excess is considered gain.
- Sec. 1239 should be carefully considered in sales between related persons, as it might cause an otherwise capital gain to be taxed as ordinary income in certain situations.
- Sec. 197’s antichurning rules should also be considered in situations where the seller retains 20% or more of the target.
- State taxes should be analyzed carefully. For example, any state that does not conform to the current Internal Revenue Code may produce some unexpected results. In addition, DEs are not always disregarded for state tax purposes.
- The parties should consider whether any step-transaction issues are present. Generally an F reorganization is respected as its own step in a larger restructuring (Rev. Rul. 96-29), but the parties should analyze the entirety of the transaction.
- Finally, as with any transaction, the parties should assess whether new Sec. 7701(o) (the economic substance doctrine) might apply.
The IRS recently issued Letter Ruling 201115016, which validates a variation on the transaction discussed in this item. In the ruling, the F reorganization was set up to allow the seller to retain certain unwanted assets, while also allowing the buyer to buy 100% of a QSub and get a basis step-up.
Michael Koppel is with Gray, Gray & Gray, LLP, in Westwood, MA.
Unless otherwise noted, contributors are members of or associated with CPAmerica International.