Rolling over shares upon S corporation’s acquisition

Editor: Mark Heroux, J.D.

S corporations are widely used throughout the country, primarily by privately held businesses. As there has been an increase in merger-and-acquisition (M&A) activity in recent years, there has also been a disproportionately large number of S corporations selling as they become part of larger investment groups. A few typical structures are used when buying S corporations, depending on the desired result. Certain buyers may want to maintain flowthrough status but are not eligible to be S corporation shareholders, while others may want to own a C corporation as a result. However, one issue that continually arises is the desire for certain shareholders to roll a portion of their equity into the buyer, while other shareholders do not roll any equity. This item discusses some ways to effectuate this and the corresponding tax implications. This item does not address the family attribution rules.

The first thing to note is that there are no perfect solutions for this situation, and the rolling shareholder will be adversely affected primarily through the timing of gain recognition and cash. For the examples below, it is assumed that there is one S corporation that is owned equally by two shareholders. Shareholder A intends to roll over his entire interest into the buyer, while Shareholder B intends to sell her entire interest. The transaction structure with the buyer is simple: all cash, with no earnouts or seller notes. Additionally, the S corporation does not have any unrecognized built-in gain or residual earnings and profits from any time previously structured as a C corporation.

When the desire is for the target to maintain flowthrough status, one of the typical structures in the M&A space is performing an F reorganization under Sec. 368(a)(1)(F). In this structure, a new S corporation holding company is formed by the owners of the target S corporation, and the owners’ target stock is transferred to this new S corporation. The target S corporation is converted to a disregarded entity or an LLC taxed as a partnership. Then, the new S corporation sells a portion of the target (which is now a disregarded entity or partnership). This sale is a deemed asset sale for tax purposes under Rev. Rul. 99-5 or the sale of a partnership interest. The portion not sold is considered a rollover interest. Some buyers may prefer to purchase a partnership interest in order to receive the Sec. 743 deductions rather than purchasing a disregarded entity and negotiating such tax items as how depreciation will be allocated between the parties. That issue, however, is outside the scope of this discussion.

The gain from the sale is then allocated to the shareholders based on their ownership percentage of the new S corporation. However, in the examples discussed here, Shareholder B wants to exit the investment entirely and not roll any equity, which means that the cash proceeds should not be distributed pro rata. In these situations, the sellers have a couple of options, none of which get the shareholders to where they would be if they were selling a partnership or C corporation interest.

They could adjust the ownership immediately prior to the transaction or immediately after the transaction. Either way, this would be treated as a separate transaction from the acquisition of the target by the buyer.

Pre-transaction ownership adjustment

Prior to the transaction, the shareholders could adjust ownership through one shareholder buying the other out, or they could distribute the equity of the target (which is now a disregarded entity). If Shareholder A buys out Shareholder B, then both shareholders will have a taxable event. Shareholder B will be taxed on the gain associated with the sale to Shareholder A. Shareholder A will step up his basis in his stock in an amount equal to the price paid B and will be taxed when he sells 50% of the target to the buyer, as the intent is to roll his initial ownership. Shareholder A will receive the benefit of the stepped-up basis when he finally exits the investment, which results in a timing issue. This does not impact the basis of the underlying assets. It should be noted that this would effectively shift all Sec. 1245 recapture to Shareholder A (of course, the purchase price Shareholder A pays Shareholder B could be adjusted to compensate for this impact).

Alternatively, the new S corporation could distribute a portion of the target to Shareholder A in a redemption under Sec. 302. This would trigger a Sec. 311(b) gain within the new S corporation, which would be split between the shareholders. However, it would also allow Shareholder A, rather than the S corporation, to now own 50% of a partnership directly (the disregarded entity would automatically convert to a partnership), with a stepped-up basis. This could also potentially trigger a taxable event for both shareholders. Shareholder A could have taxable income if the basis of the assets distributed exceeds the basis of the stock; however, Shareholder A may not take a loss on this redemption.

Once the transaction happens, Shareholder A may contribute his interest in the target to the buyer under Sec. 721 if the buyer is a partnership. If the buyer is a C corporation, then the contribution would be subject to tax unless it qualifies under Sec. 351 as a tax-free contribution. Of course, Shareholder A could also simply hold his interest as a direct partner in the target. Note that Shareholder A’s otherwise tax-free rollover is taxed pursuant to Sec. 311(b) when distributed, which results in a timing issue for Shareholder A similar to that created in the first pre-transaction ownership adjustment option.

Post-transaction ownership adjustment

If the shareholders adjust the ownership after the transaction, the same two options still exist — one shareholder buying out the other or a distribution of property in redemption of Shareholder B. Once the sale transaction happens, the gain from the sale of 50% of the target will be split equally between the two shareholders regardless of what happens after the transaction. However, cash will shift from Shareholder A to Shareholder B either through Shareholder A’s purchase of Shareholder B’s stock or the new S corporation redeeming Shareholder B’s interest entirely for cash. This creates a timing issue for Shareholder A where gain is recognized but a portion of the associated cash goes to Shareholder B.

The alternative to a redemption or one shareholder buying out the other is a straight stock sale. In the straight stock sale, the buyer purchases the stock from the S corporation shareholders in the percentages they want to sell. Shareholder B would sell 100% of her stock and would report the gain on her tax return. Shareholder A would simply hold his stock or contribute his stock to the buyer in exchange for stock in the buyer. Depending on the buyer’s legal structure, this could convert the target to a C corporation. Additionally, the buyer would not receive a step-up in the underlying assets without a valid election to the contrary (Secs. 338(h)(10), 336(e), etc.).

Ultimately, practitioners need to be aware of nonprorated S corporation rollovers and understand the unexpected tax consequences. Modeling to help quantify the impact could identify the adverse tax effect to the rolling shareholder; however, there will be a tax effect for each shareholder. Utilizing Secs. 301, 302, 311, 351, and 721, advisers can determine which method is best for selling shareholders.

Editor Notes

Mark Heroux, J.D., is a tax principal in the Tax Advocacy and Controversy Services practice at Baker Tilly US, LLP in Chicago. Contributors are members of or associated with Baker Tilly US, LLP. For additional information about these items, contact Mr. Heroux at mark.heroux@bakertilly.com.