Partially Taxable Asset Acquisitions from S Corporations

Editors: Mindy Tyson Cozewith, CPA, M.Tax., and Sean Fox, MPA

S Corporations

In private equity and venture capital transactions, selling shareholders of an S corporation commonly seek a partially tax-deferred rollover of equity. While these transactions may take various forms, this item describes the differing results between a transaction accomplished through a Sec. 351 transfer and one structured as part sale/part contribution.

Acquisition of Target QSub

When Target is an existing or a newly created qualified subchapter S subsidiary (QSub) of an S corporation and the Buyer acquires less than 100% of the stock in Target, the Buyer is treated as acquiring a proportionate interest in each asset and assuming a proportionate amount of each liability, determined based on the percentage of Newco stock sold (Sec. 1361(b)(3)(C)). Both the Buyer and the selling S corporation are then treated as contributing their shares of the assets and liabilities of QSub to a newly created C corporation (Newco) in Sec. 351 transfers (Sec. 1361(b)(3)(C)). Therefore, the basis of the property held by each transferor must be ascertained to determine the basis of the assets held by Newco. Secs. 1001 and 1060 generally govern Buyer’s basis in the acquired assets.

Under Sec. 1001, the gain or loss on the asset sale is calculated by comparing the amount realized from the sale with the adjusted basis in the assets. Regs. Sec. 1.1001-2(a)(1) provides that the amount realized from a sale or other disposition of property generally includes the amount of liabilities from which the transferor is discharged as a result of the sale or disposition. Thus, any liabilities of the Target assumed by the Buyer will be treated as additional consideration.

Where the acquisition represents an applicable asset acquisition as defined in Sec. 1060, the purchase consideration is allocated using the residual method provided under Regs. Secs. 1.338-6 and 1.338-7 (Sec. 1060(a) read with Regs. Sec. 1.1060-1(c)(2)). The residual method allocates the purchase price among seven asset classes, starting with the most liquid assets (with cash as class I) and moving on to assets with lesser liquidity (with goodwill and going-concern value as class VII). The purchase price allocated to an asset (other than a class VII asset) cannot exceed the fair market value (FMV) of that asset (Regs. Sec. 1.338-6(c)).

Example 1. Part sale/part contribution: S Corporation owns Target (T), a QSub that owns the following assets with a combined FMV of $400: Asset A with an FMV of $100 and basis of $20; Asset B with an FMV of $100 and basis of $80; Asset C with an FMV of $100 and basis of $50; and self-created goodwill with an FMV of $100 and basis of $0. T also has an ordinary course trade liability of $100. Buyer acquires 75% of T for cash consideration of $225.

As discussed above, the acquisition of 75% of T’s stock is treated as an acquisition of 75% of each asset in exchange for cash consideration and assumption of 75% of each liability for a total purchase price of $300, followed by Sec. 351 transfers by S Corporation and Buyer to Newco (Sec. 1361(b)(3)(C)). Assuming the transaction qualifies as an applicable asset acquisition, the total consideration is allocated among the assets under the residual method. Thus, total consideration of $75 each is allocated to assets A, B, and C, and the remaining $75 of consideration is allocated to class VII intangibles (goodwill and going-concern value).

As a result, Newco receives a step-up in the basis of assets A, B, and C, and creates amortizable Sec. 197 goodwill. T’s gain recognized on the sale of 75% of the assets equals $187.50 (the difference between the amount realized of $300 and 75% of the basis in the assets transferred). Newco’s basis in the assets equals $337.50, which is the sum of Buyer’s stepped-up basis in 75% of the assets ($300) and T’s carryover basis in the remaining 25% of assets ($37.50).

Sec. 351 Transfer with Boot

Sec. 351 provides for nonrecognition treatment on the transfer of property to a corporation in exchange for stock of the corporation if, after the exchange, the transferors are in control of the corporation. If a transferor receives cash or other property (boot) in addition to Newco stock in exchange for the transfer of the assets, the transferor recognizes gain (but not loss), realized on the exchange of property to the extent of the amount of money plus the FMV of any other property received by Newco (Sec. 351(b)). Newco’s basis in property received in a Sec. 351 transaction is equal to the transferor’s basis in the property transferred, increased by any gain recognized by the transferor (Sec. 362(a)).

With respect to the assumption of liabilities by Newco, Secs. 357(a) and (b) provide that the assumption of liabilities is generally not treated as boot to the transferor, unless the principal purpose of the assumption is to avoid federal income taxes. However, assumption of such liabilities is taken into account in determining the amount realized on the transfer (Regs. Sec. 1.357-1(b), Example).

In instances where liabilities assumed exceed the adjusted tax basis of the property transferred, Sec. 357(c) treats the excess as gain on the sale or exchange of the transferred assets. In determining gain, any liabilities the payment of which would give rise to a deduction (e.g., accounts payable for a cash-basis taxpayer) are excluded when determining the amount of liabilities assumed (Sec. 357(c)(3)).

When a transferor transfers multiple properties (e.g., an entire business) in exchange for stock and boot, the FMV of each category of consideration received is separately allocated to the transferred assets in proportion to the relative FMVs of the transferred assets (see Rev. Rul. 68-55, amplified by Rev. Rul. 85-164).

Example 2. Sec. 351 with boot: Assume the same facts as Example 1. T transfers the $400 in assets and a $100 ordinary course liability to Newco (a newly formed corporation) in a qualifying Sec. 351 transaction in exchange for $225 cash and $75 of Newco stock. The total amount realized by T upon the transfer of assets is $400 ($225 cash plus $75 of Newco stock plus $100 assumption of liabilities).

As the FMV of each of the assets A, B, C, and goodwill is equal, boot is allocated equally to each asset ($56.25 each). Gain realized on assets A, B, C, and goodwill is $80, $20, $50, and $100, respectively (with a total realized gain of $250). Gain is recognized to the extent of the lower of gain realized and boot received. Therefore, gain recognized on the transfers of assets A, B, C, and goodwill is $56.25, $20, $50, and $56.25 respectively. Total gain recognized by T is $182.50, as compared with $187.50 in Example 1. Newco’s basis in the assets is $332.50, which is equal to the sum of T’s basis in the assets transferred ($150) plus gain recognized by T ($182.50), as compared with $337.50 in Example 1.

Under the fact patterns of Examples 1 and 2, Sec. 1060 results in higher gain recognition by T and higher basis for the C corporation in the acquired assets compared with a Sec. 351 transaction. However, Examples 3 and 4 below show that the results may vary with slightly different facts.

Example 3. Part sale/part contribution: Assume the same facts as Example 1 except that the Buyer instead acquires a 60% interest in T (QSub) for cash consideration of $180. Under Sec. 1060, the total purchase consideration is $240 ($180 of cash consideration and $60 of assumed liabilities). T’s recognized gain is $150 (the difference between the amount realized of $240 and 60% of the $150 asset basis). Newco’s (T, formerly a QSub) basis in the acquired assets equals $300, which is the sum of Buyer’s stepped-up basis in 60% ($240) and T’s carryover basis in the remaining 40% ($60).

Example 4. Sec. 351 with boot: Assume the same facts as Example 2, except that assets and liabilities are transferred to Newco in a qualifying Sec. 351 transaction in exchange for $180 cash and $120 of Newco stock. Total gain recognized by T is $155, as compared with $150 in Example 3. Newco’s basis in the assets is $305, which is equal to the sum of T’s basis in the assets transferred ($150) plus gain recognized by T ($155), as compared with $300 in Example 3.

Conclusion

When structuring an asset acquisition with seller equity rollover, it is critical to consider the impact that the transaction structure may have on both the rollover and the asset step-up. The transaction type that best serves a taxpayer depends on a variety of facts, such as the intent to maximize either step-up or tax deferral, the mix of consideration, the individual and aggregate basis in the assets transferred, and the liabilities assumed in the transaction. As with most transactional tax issues, careful consideration of these questions at the outset of a transaction will provide the most clarity and flexibility to all affected parties.

EditorNotes

Mindy Tyson Cozewith is a director, Washington National Tax in Atlanta, and Sean Fox is a director, Washington National Tax in Washington, DC, for McGladrey & Pullen LLP.

For additional information about these items, contact Ms. Cozewith at (404) 751-9089 or mindy.cozewith@mcgladrey.com.

Unless otherwise noted, contributors are members of or associated with McGladrey & Pullen LLP.