Structuring Minority Interest Acquisitions With a Step-Up in Basis: Sec. 1239 and Beyond

By Nick Gruidl, CPA, MBT, Washington, D.C., and Corey Wittersheim, CPA, MSA, McLean, Va.

Editor: Mindy Tyson Weber, CPA, M.Tax.

Corporations & Shareholders

In many private-equity M&A transactions, the private-equity firm invests in a noncontrolling interest in the target entity (T). Where the private-equity investment funds payments to pretransaction shareholders, the shareholders generally realize gain upon receipt of these payments. In addition, if structured properly, the transaction often provides a step-up in asset basis to either T or the private-equity firm that provides tax benefits in the form of future tax deductions. However, the failure to properly structure a transaction can result in ordinary income, as opposed to capital gain, to the pretransaction T shareholders due to the related-party traps of Secs. 1239 and 707. The recent decision in Fish, T.C. Memo. 2013-270, is a reminder of these traps and the importance of properly structuring a minority investment.


Sec. 1239(a) provides that “in the case of a sale or exchange of property, directly or indirectly, between related persons, any gain recognized to the transferor shall be treated as ordinary income if such property is, in the hands of the transferee, of a character that is subject to the allowance for depreciation provided in section 167.” Under Sec. 197(f)(7), any amortizable Sec. 197 intangible is subject to the allowance under Sec. 167. Furthermore, according to Regs. Sec. 1.197-2(g)(8), “an amortizable section 197 intangible is section 1245 property and section 1239 applies to any gain recognized upon its sale or exchange between related persons (as defined in section 1239(b)).” Therefore, Sec. 1239 applies to the sale of intangibles, whether or not amortizable in the hands of the transferor before the sale (e.g., self-created intangibles and goodwill).

Sec. 1239(b)(1) defines a related party as a person and all entities controlled by that person. The Sec. 1239(c)(1) definition of controlled entities looks to a greater-than-50%-value test for corporations and a greater-than-50%-capital-or-profits-interest test for partnerships and includes any entity related to the person under Sec. 267(b)(3), (10), (11), or (12). In addition, Sec. 1239(c)(2) applies the Sec. 267(c) constructive-ownership rules.

Similarly, for partnerships, Sec. 707(b)(2) treats gains recognized on the sale of property that would otherwise be considered capital under Sec. 1221 as ordinary if the sale occurs between related partnerships or a partnership and a related person. Like Sec. 1239, Sec. 707(b) applies a greater-than-50%-capital-or-profits-interest test.


The facts surrounding the transaction in Fish mirror those of many noncontrolling acquisitions of an S corporation. Due to the single level of taxation on S corporations, a private-equity firm or strategic acquirer is generally able to structure the acquisition of a noncontrolling interest in an S corporation’s business to receive a step-up in basis at the same time. However, the step-up in basis does not result from a Sec. 336(e) or Sec. 338(h)(10) election. Rather, the step-up occurs through an acquisition of a proportionate amount of the underlying assets of the business. However, a proportionate acquisition of assets is often a very difficult and expensive proposition with significant business ramifications.

To achieve the desired tax results in the Fish acquisition, the target (T), an S corporation, was contributed to a newly created S corporation (Newco) that immediately made a qualified subchapter S subsidiary (QSSS) election for T in a transaction qualifying as a Sec. 368(a)(1)(F) reorganization. On an unrelated note, the court described the transaction as both (1) a Sec. 368(a)(1)(F) reorganization and (2) a Sec. 351 transfer followed by a Sec. 332 liquidation. This contradicts existing step-transaction guidance that would characterize the Fish transaction as simply a Sec. 368(a)(1)(F) reorganization, with no Sec. 351 and Sec. 332 transactions (see Rev. Rul. 2008-18 and Regs. Sec. 1.1361-4(a)(2), Example (3). Following the F reorganization, T issued preferred stock to the new private-equity investors, which terminated T’s QSSS election. The result was a deemed Sec. 351 transfer by Newco and the private-equity investors to newly created T1, a C corporation. Because Newco received a cash distribution funded in whole or in part by the private-equity funds, the transaction represented a Sec. 351 transfer with “boot.” Thus, Newco recognized gain, and T1 increased the basis in the assets acquired by an amount equal to the gain recognized. The acquired assets consisted primarily of intangible assets self-created by T in growing the company. The 2005 return Newco filed reported $9.6 million in dividend distributions received as long-term capital gain. Because Newco was an S corporation, the $9.6 million flowed through to the shareholder’s personal return, where it was again reported as long-term capital gain. (As a side note, the antichurning provisions of Sec. 197(f)(9) did not appear to be an issue in the case.)

Upon the termination of the QSSS election, the issue arose whether Newco and T were related parties. In light of Sec. 267(b)(3), the question became whether Newco owned more than 50% of the total combined voting power of all classes of T stock entitled to vote or more than 50% of the total value of shares of all classes of T stock. Whether the taxpayer structured the transaction with the intent to avoid Sec. 1239 or was unaware of the related-party trap is something that may never be known. The court held that Newco and T were related for purposes of Sec. 1239 and the gain was ordinary.

Why This Structure, and What Are the Alternatives?

As this item discusses below, changes to the statutory rules surrounding QSSS acquisitions have minimized the need to structure transactions as the parties did in Fish; however, the case is a good reminder of the pitfalls of Sec. 1239 when structuring using disregarded entities.

So, how else could they have structured the transaction? Obviously, the shareholders of T could have simply sold a portion of their shares to the private-equity investors without the pretransaction F reorganization, but that would not have provided a step-up in basis in T’s assets. Furthermore, at the time the transaction took place, a sale of more than 20% of T’s stock (as a QSSS) to the private-equity investors would have resulted in a fully taxable exchange of T’s assets due to a failure to satisfy the Sec. 351 control requirement. Thus, that was not a feasible option (see Regs. Sec. 1.1361-5(b)(3), Example (1) (despite the statute change discussed below, this example remains in the regulations)). From purely a tax perspective, T could have structured the transaction as a proportionate asset sale to the private-equity investors followed by the transfer to a newly created entity; however, that likely would have been administratively difficult. Neither of these would appear to be viable solutions, leaving the parties with the transaction that they structured.

Statutory Change Provides Relief, but Not Completely

In 2007, as part of the Small Business and Work Opportunity Tax Act of 2007, P.L. 110-28, Sec. 1361 was amended to add Sec. 1361(b)(3)(C)(ii), which reversed the order of transactions deemed to occur in the sale of QSSS stock, as applied in Regs. Sec. 1.1361-5(b)(3). Under current law, the sale of QSSS stock is deemed to represent a sale of an undivided interest in a proportionate amount of the assets, followed by a Sec. 351 transfer by the resulting shareholders to a newly created corporation (Sec. 1361(b)(3)(C)(ii)). As a result, a sale of more than 20% of a QSSS will not result in a failed Sec. 351 transaction because the transfers are deemed to occur after the acquisition, and all post-transaction owners are treated as transferors.

If this change in the statute had been in effect at the time of the transaction at issue in Fish, perhaps the parties would have structured the transaction differently by still using the pretransaction F reorganization, but having Newco sell shares of T (as a QSSS) directly to the private-equity investors, followed by a recapitalization into a preferred and common structure if deemed appropriate. It appears such a transaction would provide the step-up in basis while also avoiding Sec. 1239, as the sale would have occurred between Newco and the private-equity investors, not between Newco and a related entity.

However, when structuring such a transaction, traps for the unwary remain. A common element in a majority of transactions, whether control or noncontrol acquisitions, is the use of leverage. How would leverage impact the 2007 “fix” to the QSSS acquisition?

Example: Assume T, a QSSS, has a fair market value of $200 million. Newco (T’s S corporation parent) and PE have negotiated a transaction to allow Newco to cash out a portion of T ’s value while retaining control of the business. The transaction is funded through an equal combination of $65 million of new debt incurred by T and $65 million in private equity. Following the transaction, Newco owns approximately 52% of T, and PE owns approximately 48% of T. As a result, a portion of the acquisition remains a Sec. 351 transfer with “boot,” and any gain on the boot occurs in a transaction between Newco and T. Further, Newco and T are related under Sec. 1239, and the gain on the Sec. 351 transfer is taxed at ordinary income rates. As a result, the transaction does not fully avoid the Sec. 1239 trap, and the result in Fish would still occur.

To avoid the result in the example, T and PE might suggest that T borrow the funds from a bank and distribute those funds to Newco before the PE acquisition to avoid the Sec. 351 with “boot” problem. However, potentially significant problems could arise under that scenario. First, there is the question of whether the borrowing could be separated from the acquisition by PE. In other words, would the creditor have been willing to loan the funds and would T have borrowed the funds, if it were not for the transaction as a whole? If not, successfully arguing that the loan is simply a liability assumed by new T in a Sec. 351 transaction would be difficult. Second, Sec. 357(b) may apply to treat the entire amount of the debt assumed as boot if it is determined that the assumption of the liability either lacked a bona fide business purpose or occurred with the intent to avoid federal income tax.

Additional Disguised-Sale Concerns

As has been seen over the last decade or more, partnerships and limited liability companies taxed as partnerships are just as likely to be used in either private-equity or strategic acquisitions. Noncontrol transactions in the partnership context must navigate the disguised-sale rules of Sec. 707(b)(2), which provide an additional pitfall similar to that of Sec. 1239. Sec. 707(b)(2) requires that gains on the sale or exchange of property that is other than a capital asset (as defined in Sec. 1221) in the hands of the transferee be treated as ordinary gain if the sale or exchange occurs “between a partnership and a person owning, directly or indirectly, more than 50 percent of the capital interest, or profits interest, in such partnership, or between two partnerships in which the same persons own, directly or indirectly, more than 50 percent of the capital interests or profits interests.”

In a partnership acquisition, the way in which the transaction is structured is equally as important as in a corporate transaction. In many situations, where PE acquires an interest in a business, the business assets are transferred to a newly created entity as a part of the investment. Where PE transfers cash to a newly created LLC taxed as a partnership (NewLLC) for an interest in NewLLC and the cash is then transferred to the other transferor (T, in this case), the transaction may represent a disguised sale under Regs. Sec. 1.197-2(k), Example (17), as opposed to an acquisition of a proportionate amount of the assets by PE followed by Sec. 721 transfers under Rev. Rul. 99-5. Therefore, when structuring a noncontrolling acquisition, it is important to structure the sale as a sale of an interest in NewLLC “across the top” from T to PE.


When analyzing the tax implications of a noncontrolling investment/acquisition, opportunities often exist to achieve a partial step-up in basis. This step-up frequently represents a significant tax shield and valuable future tax asset that most private-equity firms are intent on acquiring. In most cases involving flowthrough entities (e.g., S corporations and partnerships), that step-up does not come at an additional tax cost to the historic owners. However, as was seen in Fish, the application of Sec. 1239 may result in unintended consequences, even with the 2007 changes to the QSSS acquisition rules. As with so many M&A issues, the specific facts of a transaction are critical, and special care should be taken to fully analyze all aspects of an M&A transaction for tax traps and opportunities.


Mindy Tyson Weber is a senior director, Washington National Tax, for McGladrey LLP.

For additional information about these items, contact Ms. Weber at 404-373-9605 or

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

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