Editor: Anthony S. Bakale, CPA
The merger-and-acquisition market for private companies has been very active. Activity should remain high as aging Baby Boomers look to retirement, many of them business owners for whom selling a closely held business is a key part of their financial plan.
Increasingly, these transactions have been structured as stock sales. Sellers have always preferred this form, as they receive capital gain treatment on the entire transaction. Buyers, on the other hand, have been reluctant to purchase stock, as they do not receive a basis step-up on the corporate assets. The growing popularity of Sec. 338(h)(10) elections to treat stock sales as asset sales for tax purposes has increased buyers' willingness to enter into stock purchases.
A great majority of private businesses are structured as S corporations, which are passthrough entities. The taxable income of the corporation is generally not taxed to the corporation but rather is passed out to the shareholders, who pay the tax on their individual income tax returns. In Sec. 338(h)(10) transactions, the gain from the deemed asset sale is passed out to the selling shareholders, and the buyer receives a basis step-up in the corporate assets. In most cases the buyer will reimburse the selling shareholders for the difference in the tax cost caused by a portion of the gain's being taxed as ordinary income in the deemed asset sale (i.e., depreciation recapture income, cash-basis receivables, inventory gains, etc.).
One of the key concerns for buyers entering into a Sec. 338(h)(10) transaction is that they must be assured that the sellers have a valid S election. If the S election turns out to be invalid, the buyer would have bought a C corporation that has to pay the tax on the deemed asset sale at the corporate level. Plus, C corporation taxes may be due for prior years. As part of their due diligence, buyers should verify the seller's S election is valid by examining any existing shareholder agreement. If one does exist, the buyer wants to be sure that it does not cause the corporation to have a second class of stock, which would invalidate the S election under Sec. 1361(b)(1)(D).
To evaluate shareholder agreements' impact on the one-class-of-stock requirement, buyers should look to Regs. Sec. 1.1361-1(l)(2)(iii)(A), which states that shareholder agreements are disregarded in determining whether shares of stock confer identical distribution and liquidations rights, unless:
- A principal purpose of the agreement is to circumvent the one-class-of-stock requirement; and
- The agreement establishes a purchase price that, at the time the agreement is entered into, is significantly in excess of or below the stock's fair market value (FMV).
The regulation section also provides a safe-harbor price range, stating that prices set at book value or between book value and FMV do not cause the agreement to establish a price that is significantly above or below the stock's FMV. Of particular relevance to sellers in a Sec. 338(h)(10) transaction, Regs. Sec. 1.1361-1(l)(2)(v) provides a special rule. If the shareholders of an S corporation sell their stock in a transaction for which an election is made under Sec. 338(h)(10), the receipt of varying amounts per share by the shareholders will not cause the S corporation to have more than one class of stock, provided the varying amounts are determined in arm's-length negotiations with the purchaser.
Thus, what would appear on the surface to create problematic non—pro rata values per share has been blessed by the regulation. The IRS has been willing to issue letter rulings on the impact of shareholder agreements on the one-class-of-stock requirement for S corporations. The vast majority of the rulings have been taxpayer-favorable. One such ruling, IRS Letter Ruling 9413023, addressed a shareholder agreement that set a price that included a minority discount. Using similar logic as Regs. Sec. 1.1361-1(l)(2)(v), the IRS stated in the ruling:
The facts reveal that the buy-sell agreement . . . established a purchase price of fair market value less a minority discount. When a purchase price is the result of arm's length business negotiations, the mere presence, or absence, of a minority discount does not cause an agreement to establish a purchase price that is significantly in excess of or below the fair market value of the stock. Therefore, the agreement will be disregarded in determining whether . . . shares of stock confer identical distribution and liquidation rights.
Given the authority and the favorable rulings by the IRS in this area, it would seem that most reasonable shareholder agreements that are entered into for valid business purposes would be disregarded in the analysis of whether a corporation has a second class of stock and, thus, should not cause heartburn for buyers in a Sec. 338(h)(10) transaction. However, in practice, the buyers often express concern about provisions in shareholder agreements and use those concerns to ask for an increase in the funds held in escrow to cover the potential tax exposure should the S election be invalidated and/or to restructure the transaction.
Why are buyers taking such a hard line on an issue that seems to have very little risk? If an S election has been in effect for a long time, it is difficult if not impossible to verify that it has been valid for all the years involved. This is especially true if there is a large number of shareholders, including trusts. Any misstep through the years could have caused the S election to be invalidated. If the sales price of the transaction is large, the buyer may not be willing to accept the risk, under any circumstances, that the S election will turn out to be invalid.
Given this fear, the shareholder agreement becomes an easy target for the buyer to create doubt about the S election's validity. The typical solution proposed by buyers is to have the seller enter into a tax-free F reorganization under Sec. 368(a)(1)(F). This is accomplished by forming a new corporation (Newco), which becomes the parent corporation of the existing S corporation. A QSub election is then filed, which terminates the existing S corporation for tax purposes. Newco is not required to file an S election under the F reorganization, but often the buyer insists that it do so as a precaution. The buyers then look to add funds to escrow to cover any corporate income tax that would be owed for open tax years should the S election be found to be invalid.
Other means are available to safeguard the buyer that put substantially all the risk of an invalid S election on the selling shareholders — such as conversion of the corporation to a limited liability company (LLC) immediately prior to closing. In this situation the target corporation is considered to have liquidated in a taxable transaction with the formation of the LLC. The corporate taint ends at that point, and the buyer purchases units of an LLC immediately after the conversion. Potential corporate tax liability should then fall upon the shareholders who received the corporation's assets in liquidation.
Shareholders and their advisers should be prepared to verify the validity of the S election when the decision is made to begin marketing the company for sale. Efforts should be made upfront to provide necessary documentation to substantiate the entity's S status, or consideration should be given to alternatives to making a Sec. 338(h)(10) election. Too often, the validity of the S election comes up very late in the due-diligence process and can derail a deal.
Anthony Bakale, CPA, is with Cohen & Company Ltd. in Cleveland.
For additional information about these items, contact Mr. Bakale at email@example.com.
Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.