CPA firm M&A tax issues

Consolidation of CPA firms continues to advance at a steady pace. Advisers and consultants often play a key role in locating acquisition or merger targets, facilitating discussions and negotiations, and designing deal terms and conditions. In many CPA firm consolidations, the legal entity and tax issue complexities rest with the CPA firm parties to handle. Further, legal counsel may not have in–house tax personnel to assist with the tax structure and may assume that because the parties to the transaction are CPA firms, they have the tax issues under control. In many cases, the deal progresses, and the terms are negotiated absent proper attention to any tax pitfalls or tax efficiencies in the legal entity structure.

Many CPA acquisitions involve purchasing a practice for cash from a retiring partner. Typically, the retiring partner would remain employed for a year or two to aid in the transition and to secure the existing client base. In other cases where the partners (or sole owner) may be younger and want to continue working in a larger practice environment or where finding talent is problematic, the acquisition consideration may be equity in the acquirer where the target partners (or sole owner) become owners of the acquirer.

This article discusses some of the possible entity deal structures for CPA mergers and acquisitions (M&As) and their potential tax issues (and, to a large extent, those more broadly applicable to M&As of other types of businesses). The recent trend of private–equity investments in public accounting firms creates the need for alternative legal entity structures to comply with state–law requirements. Due to the differences in state–law requirements and their consequential legal entity structure requirements, structuring for private–equity investment is beyond the scope of this article, which discusses only federal tax law.

For consistency, this article uses the following nomenclature, word construction, and assumptions:

• “Combination” can broadly refer to either an asset acquisition or a merger.
• A limited liability company (LLC) will be identified as a multimember LLC (MMLLC) or a single-member LLC (SMLLC), depending upon the structure discussed.
• In this article, MMLLCs and limited liability partnerships (LLPs) are classified as partnerships for tax purposes. This article assumes that no entity-classification election was made to treat these entities as corporations.
• An SMLLC is classified as a disregarded entity for tax purposes. This article assumes that no entity-classification election was made to treat an SMLLC as a corporation.
• Corporations will be specifically referred to as either S corporations or C corporations as the structure requires.
• A merger of firms is not necessarily a “merger of equals.” A merger may also connote an acquisition of a target firm.

Contingent asset acquisitions

Many CPA firm acquisitions are promoted as “mergers” rather than “acquisitions” to quell client concerns over continuity of the practice. Many CPA firm acquisitions are true asset acquisitions of a going concern where the existing owner or owners are retirement–minded and lack internal succession. The assets acquired typically are both tangible and intangible, with intangible assets comprising the bulk of the assets acquired. Intangible assets principally include the client base and goodwill. In addition, the parties typically enter into some form of a covenant–not–to–compete agreement, either a standard geographic/time covenant or an anti–solicitation covenant, or both. In an asset acquisition, the selling entity would remain in the hands of the target owners and would likely be liquidated at some future date.

The terms of each deal are unique to each situation. Nevertheless, in many asset acquisitions where the owners are retirement–minded, the assets (essentially, the intangible client base or goodwill) are purchased with a minimal down payment on a contingent basis for a price that is dependent upon future collected billings. For example, the purchase price may be structured to require 20% of collected billings for five years to be paid to the target seller. This would equate to 100% of one year’s gross receipts or “1 × revenue.” In a contingent installment sale, there is symmetrical risk for both the acquirer and the acquired. An exodus of clients post–acquisition could be detrimental to both sides.

In the example above, for tax purposes, this type of transaction is considered a contingent installment sale. It is contingent because the ultimate selling price is not known until the five–year term has elapsed. Contingent installment sales have special reporting requirements for both the acquired entity (target) and the acquiring entity (acquirer). The target must determine the tax year of any gain recognition.¹ The acquirer must determine the tax year of acquisition for the assets acquired as well as the amount and timing of depreciation and amortization deductions. Both the target and the acquirer have information–reporting requirements to report the allocation of the assets acquired on either Form 8594, Asset Acquisition Statement Under Section 1060, or Form 8883, Asset Acquisition Statement Under Section 338. Inconsistencies in reporting between the target and acquirer could result in IRS scrutiny.

Assets acquired in an “applicable asset acquisition,” i.e., assets that constitute a trade or business for which the basis is determined by reference to the consideration paid for the assets, are subject to the special allocation rules of Sec. 1060.² Acquired assets in an applicable asset acquisition are allocated using the residual method as prescribed in the regulations governing deemed asset acquisitions under Sec. 338 and, in particular, Sec. 338(b)(5) and the regulations thereunder.³ Under the residual method, assets are allocated pursuant to their fair market value (FMV) among seven classes of assets (Classes I through VI, with any residual allocated to goodwill, Class VII).⁴

Whether or not a written promissory note has been executed in a contingent installment sale,⁵ the contingent consideration is considered an installment obligation. The target must report the sale transaction using the installment–sale method or elect out of installment–sale reporting.⁶ General principles of taxation apply to determine whether the assets sold result in capital gain or ordinary income, including any imputed interest.⁷ Nevertheless, the target must report any ordinary recapture income in the year of disposition.⁸ Recapture income includes any ordinary income under Secs. 1245, 1250, and 751 (as it relates to Sec. 1245 or 1250).⁹

The contingent–payment regulations provide detailed rules “to be applied in allocating the taxpayer’s basis (including selling expenses except for selling expenses of dealers in real estate) to payments received and to be received in a contingent payment sale.”¹⁰ The regulations set forth guidance for contingent–payment sales in which a maximum selling price is determinable, for sales in which a maximum selling price is not determinable but the payment term is defined, and sales in which neither a maximum selling price nor a payment term is defined.¹¹ In addition, the regulations permit taxpayers in appropriate situations to recover basis under an income–forecast computation.¹²

In transactions where the maximum selling price is determinable (for example, the purchase–and–sale agreement provides for payment of 20% of collected billings over five years with a maximum cap on the contingent consideration), the regulations provide that in calculating the gross profit¹³ for installment sale reporting, the specified maximum selling price is used, assuming all contingencies in the agreement are satisfied.¹⁴ The initial maximum selling price will be used to determine the gross profit ratio (gross profit divided by the contract price¹⁵) in all years unless the maximum selling price is reduced by the terms of the agreement, amendment to the agreement, application of a payment recharacterization rule (dealing with recomputed interest where there is a contractual arrangement that treats part of the selling price as an interest payment),¹⁶ or by a subsequent event such as the obligor’s bankruptcy.¹⁷ In such a reduction situation, the gross profit ratio is reduced in the tax year of the event causing the reduction and in subsequent years.

In transactions where the maximum selling price is not determinable but the term is fixed (which would likely be the case in many CPA firm asset acquisitions), the target’s tax basis (including any selling expenses) is allocated in equal annual amounts over the term of the payments to be received under the agreement.¹⁸ If no payments are received in any tax year, or if the payment received (not including any interest) is less than the tax basis, no loss is allowed, unless it is the last payment year or the obligation is deemed to be worthless.¹⁹ In a tax year when no loss is allowed, “the unrecovered portion of basis allocated to the taxable year shall be carried forward to the next succeeding taxable year.”²⁰

In transactions where there is neither a maximum selling price nor a fixed term for payments, the regulations question whether there was actually a sale or whether the payments resemble some other economic arrangement, such as rent or royalty income.²¹ If a sale does realistically exist, the regulations provide that basis is recovered ratably over 15 years beginning with the year of sale.²² If no payments are received in any tax year, or if the payment received (not including any interest) is less than the tax basis, no loss is allowed unless the obligation is deemed to be worthless.²³ “[I]nstead the excess basis shall be reallocated in level amounts over the balance of the 15 year term. Any basis not recovered at the end of the 15th year shall be carried forward to the next succeeding year, and to the extent unrecovered thereafter shall be carried forward from year to year until all basis has been recovered or the future payment obligation is determined to be worthless.”²⁴

The target can choose to hold the unrecovered contingent installment obligation to full term or distribute the contingent installment obligation to its owners. A distribution of an installment obligation is considered a disposition of the installment obligation subject to potential accelerated gain recognition, depending upon the type of distributor entity. In the case of a C corporation liquidating distribution of an installment obligation, the distribution of the installment obligation is a disposition resulting in corporate–level gain recognition to the extent of the difference between the amount realized and the basis of the installment obligation.²⁵ With respect to the shareholders of the corporation, in general,²⁶ the shareholder may treat the receipt of payments under the installment obligation as payment for its stock (rather than the installment obligation) provided that (1) the distribution of the installment obligation is pursuant to Sec. 331;²⁷ (2) the liquidating corporation acquired the installment obligation in respect of a sale or exchange during the 12–month period beginning on the date a plan of complete liquidation is adopted; and (3) the liquidation is completed during such 12–month period. Essentially, the shareholder may use the installment method with respect to the Sec. 331 gain for the payments received under the installment obligation (unless the shareholder elects out of the installment–sale method).²⁸

There is a special exception to corporate–level gain for S corporations upon a liquidating distribution of an installment obligation. Provided that the requirements discussed above under Sec. 453(h)(1) are satisfied, there is no gain recognition at the S corporation level upon the liquidating distribution of the installment obligation to the shareholders.²⁹ This exception does not apply to any built–in gains tax under Sec. 1374 or to the passive investment income tax under Sec. 1375.³⁰ Further, provided the requirements of Sec. 453(h)(1) are satisfied, the S shareholders may avail themselves of the installment method of reporting their Sec. 331 gain with respect to the installment obligation.

With respect to partnerships, a distribution of the installment obligation to a partner under Sec. 731 should not result in recognition of gain at the partnership level.³¹ This general rule for nonrecognition does not apply to distributions pursuant to Secs. 704(c)(1)(B), 736, 737, and 751(b).³²

In a contingent installment sale, the acquirer is faced with determining the timing of capitalizing and depreciating or amortizing contingent payments made to the target. In general, the cost of property acquired in exchange for a debt instrument is equal to the issue price of the debt instrument as determined under Secs. 1273 and 1274 and the regulations thereunder, whichever applies.³³ The regulations under Sec. 1274³⁴ provide that if a debt instrument provides for one or more contingent payments, the issue price is the lesser of (1) the noncontingent principal payments and (2) the sum of the present values of the noncontingent principal payments.³⁵ This means that only the noncontingent payments create tax basis; contingent payments create basis only in the tax year when they are actually paid or become fixed.³⁶

In many cases, contingent payments will be allocated to the acquired intangible assets, i.e., goodwill and client base. These intangibles are Sec. 197 intangibles amortizable ratably over a 15–year period beginning with the month of acquisition.³⁷ With respect to the treatment of contingent amounts, amounts that are included in tax basis during the 15–year period are amortized ratably over the remainder of the 15–year period.³⁸ Contingent amounts that are included in tax basis after the expiration of the 15–year period are immediately amortized in full.³⁹

Partnership combinations

Regulations provide guidance where partnerships⁴⁰ consolidate or merge into one partnership.⁴¹ For simplicity, this article and the following example assume that the partnership merger transaction only includes two partnerships. In addition, consideration for the target owners will only include equity of the acquirer and will not include any cash.

In the case of a merger or consolidation of two or more partnerships, the continuing partnership is the partnership whose members own more than 50% of the capital and profits of the resulting partnership.⁴² In the case where partners own interests in both partnerships (pre–merger) and both partnerships can be considered the continuing partnership under the 50% threshold discussed above, the partnership credited with the greatest FMV of assets (net of liabilities) in the resulting partnership is considered the continuing partnership.⁴³ The tax year of the terminated partnership will close under the provisions of Sec. 706(c), and it will file its final return for a tax year ending on the date of termination.⁴⁴ The regulations provide for two alternate structures or forms, “assets–over” and “assets–up.”⁴⁵

Assets-over

Unless the form of the transaction specifically comports to the assets–up form, the transaction will be governed by the assets–over form.⁴⁶ In other words, assets–over is the default form. For example, under this default rule, a contribution of all the partners’ interests in Partnership A to Partnership B in exchange for interests in Partnership B, with Partnership A being immediately liquidated into Partnership B, is treated as an assets–over form.⁴⁷

Example: The acquirer CPA firm, Firm A, is an MMLLC that will acquire another CPA firm, Firm B, that is also an MMLLC. Both are classified as partnerships for tax purposes. Firm A will acquire all of Firm B’s assets, both tangible and intangible, and assume all liabilities. The consideration for the acquisition will be LLC membership interests in Firm A. Firm B will merge into Firm A under state law. Firm A will be the surviving partnership; Firm B’s legal existence will be terminated.

Under the assets–over form, the partnership that is considered terminated contributes all of its assets and liabilities to the resulting partnership in exchange for an interest in the resulting partnership.⁴⁸ This exchange should not result in any gain or loss.⁴⁹ The terminated partnership is considered to distribute the interests in the resulting partnership to its partners in liquidation of the terminated partnership.⁵⁰ Assuming no cash is distributed, the distribution of the partnership (membership) interest in liquidation should also not result in any gain or loss to the distributee partners or the liquidating partnership.⁵¹ Tax basis in the distributed resulting partnership interests to the distributee partners should be equal to their adjusted tax basis in the liquidating partnership.⁵² The tax basis in the assets contributed by the terminating partnership should also carry over to the resulting partnership.⁵³

Assets-up

Partnerships could also be combined using an assets–up form, where partnership assets are distributed “up” to the partners with a subsequent contribution of those assets to the acquiring or resulting partnership. Provided that the partnership that is considered terminated distributes all of its assets to its partners, the transitory or momentary ownership of the assets by the partners will be disregarded, and therefore, the concept of partnership continuation will be respected.⁵⁴ Specifically, under this assets–up form, the partnership that is to be terminated must actually distribute all of its assets to its partners (in a manner that the partners are treated as the owners of the assets under state law) in liquidation of the partners’ interests.⁵⁵ Immediately thereafter, the partners must contribute the distributed assets to the resulting partnership.⁵⁶ To qualify as an assets–up transaction, the transaction must follow the form described above. Otherwise, it will be governed by the assets–over form.

There are certain disadvantages to the assets–up form that make it less advantageous than the assets–over form. Using the assets–up form, there is the added legal cost and complexity of effecting actual distributions of assets and assumption of liabilities, including retitling of certain assets such as automobiles and real estate; paying transfer taxes such as real estate conveyance taxes; obtaining any consents pursuant to existing contracts; and dealing with creditors regarding assumption of debt, which could result in accelerating the balance due. In addition, distributions of partnership assets in the assets–up form could trigger partner–level gain where cash distributed may exceed a partner’s tax basis in their interest, including a reduction in liabilities treated as a cash distribution.⁵⁷ Further, tax basis of the distributed partnership assets may change when in the hands of the partner under the assets–up form. A change in basis may occur because the tax basis of assets distributed to partners in liquidation of a partner’s interest is equal to the adjusted basis of the partner’s interest in the partnership, reduced by any cash distributed in the same transaction.⁵⁸

Corporate and SMLLC/MMLLC combinations

CPA firm acquisitions involving only equity consideration can present some difficult tax issues where (1) the acquirer is a corporation, either a C or S corporation, and the target is an SMLLC (or sole proprietorship) or an MMLLC (or general partnership); or (2) the acquirer is an SMLLC (or sole proprietorship) or an MMLLC (or general partnership) and the target is a corporation, either a C or S corporation. Some of the difficulty lies in the need to cross–reference Subchapter C (corporations) and Subchapter K (partnerships), unlike pure partnership combinations that are only affected by Subchapter K. Each of these acquisition types is examined next.

Corporate acquirer, SMLLC or MMLLC target

A corporation (C or S) may acquire the sole membership interest of an SMLLC or the membership interests of an MMLLC (no check–the–box election to be classified as a corporation) or may directly acquire the assets of the SMLLC or MMLLC. With respect to an SMLLC, for federal tax purposes, the transaction is treated as acquiring the assets of the SMLLC because the SMLLC is a disregarded entity.⁵⁹ A merger under state law of an MMLLC into a corporation, with the corporation as the survivor, is treated as a transfer of assets by the MMLLC to the corporation for tax purposes. The corporate nontaxable reorganization provisions of Subchapter C do not apply to a corporate/partnership merger under state law. Further, with respect to an MMLLC, the form of the transaction (including the merger of an MMLLC into a corporation) will be respected whether it is an exchange of the entity’s assets or an exchange of the members’ membership interest for equity in the corporation because the MMLLC is not disregarded for tax purposes.⁶⁰ The danger in the corporate acquisition of an SMLLC (or sole proprietorship) or MMLLC (or LLP, or partnership) is that the exchange transaction, i.e., assets for stock, must satisfy Sec. 351⁶¹ to receive nonrecognition treatment for the target or target owners.

No gain or loss is recognized to the transferor if property is transferred to a corporation solely in exchange for stock, provided that the transferor or transferors are in control of the corporation immediately after the exchange.⁶² Control is defined as ownership of stock possessing at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all other classes of the corporation’s stock.⁶³

Consequently, unless the target transferor(s) acquires control of the acquirer (the “minnow swallowing the whale”), the gain or loss will be recognized to the transferors. The transfer of assets by the target (including a transfer of the sole membership of an SMLLC) or the transfer of MMLLC membership interests by the members can result in gain (or loss) to the transferor(s) measured by the difference between the FMV of the property transferred and the adjusted tax basis. With respect to the transfer of goodwill or client base, these assets generally have zero tax basis unless these intangibles were previously purchased in a taxable transaction (any amortization previously deducted could result in ordinary income⁶⁴). Consequently, the exchange of intangibles can result in potentially significant gain recognition to the transferor(s) without the receipt of cash to pay the resulting tax. In a gain recognition situation, the acquirer will receive FMV as tax basis for the acquired assets. In this case, it may be advisable to negotiate a tax–sharing agreement with respect to the tax benefit of the amortization deductions inuring to the acquirer.

SMLLC or MMLLC acquirer, corporate target

Structuring an acquisition of corporate assets by an SMLLC or MMLLC in exchange for LLC equity can create its own set of difficulties. The good news is that no gain or loss is recognized to any partner or partnership for a contribution of property in exchange for an interest in the partnership.⁶⁵ Therefore, a corporate target that contributes assets in exchange for a partnership interest (including a membership interest) to a partnership (or an SMLLC that becomes a partnership upon the contribution and exchange) should not recognize gain or loss. The acquiring partnership would succeed to the corporation’s tax basis in the assets, i.e., carryover basis.⁶⁶ With one caveat, this nonrecognition rule should also apply to the contribution of a shareholder’s stock in the corporation to the partnership in exchange for a partnership interest, resulting in the creation of a corporate subsidiary of the partnership. The caveat is that the contribution of stock of an S corporation would terminate the S election because a partnership is not an eligible shareholder of an S corporation.⁶⁷

A transfer of assets by a corporation to a partnership in exchange for an interest in the partnership would result in the corporation’s becoming a partner in the partnership. Under state law in many jurisdictions, only licensed CPAs (or a limited number of non–CPAs) can be partners in a CPA firm. As a result, the corporation would need to divest itself of the partnership interest by either making a current distribution of the interest or a liquidating distribution. State law should be consulted on whether a momentary corporate ownership of a CPA firm partnership interest is permissible.

In either a corporate current distribution or a liquidating distribution, a distribution of appreciated property to a shareholder results in gain recognition at the corporate level as if the property were sold to the shareholder(s).⁶⁸ Therefore, the distribution of the partnership interest (membership interest) to the shareholders of the corporation would result in corporate–level gain recognition. For S corporation distributions of appreciated property, the gain passes through to the shareholders and increases their stock basis. The S corporation could also be subject to the built–in gains tax if the distribution was made during the five–year recognition period.⁶⁹ For C corporations, the distribution would constitute a taxable dividend or taxable liquidating distribution to the shareholders, creating a potential double–taxation situation.⁷⁰

If the corporate target merges into an SMLLC or an MMLLC under state law, the merger is not governed by the nontaxable reorganization provisions of Sec. 368 located in Subchapter C.⁷¹ For Subchapter C to be invoked, both the acquirer and the target must be corporations (either a C or S corporation). In such a corporation merger into an LLC, the corporation transfers all assets and liabilities to the acquirer and is terminated under state law. The LLC acquirer is the survivor. In exchange for corporate net assets, the corporate shareholders receive membership interests in the LLC. In the case of a merger of a corporation into an SMLLC, the SMLLC would then convert to an MMLLC.

For federal tax purposes, a state–law merger of a corporation (either a C or an S corporation) into an LLC resembles the assets–over form discussed above. The merger is treated as a transfer of corporate assets to the LLC (and an assumption of liabilities by the LLC) in exchange for membership interests in the LLC. The membership interests are then deemed distributed to the corporate shareholders in complete liquidation of the corporation.⁷² No gain or loss should be recognized to the corporation upon the transfer of assets to the LLC.⁷³ Tax basis of the assets in the hands of the LLC is carryover basis.⁷⁴ Gain or loss will be recognized to the corporation upon the deemed distribution of membership LLC interests as though the corporation sold the membership interests at FMV to the shareholders.⁷⁵ The shareholders will recognize gain or loss upon receipt of the deemed liquidating distribution in exchange for their stock.⁷⁶ Note that the assets–over approach for a merger of a corporation into an LLC that is not owned prior to the merger by the corporation is in contrast to the assets–up form for a corporation that changes its classification to an LLC under the entity–classification regulations. Under the entity–classification regulations, if a corporation elects to be classified as a partnership (or MMLLC), the corporation is treated as distributing all of its assets and liabilities to its shareholders in liquidation of the corporation, and immediately thereafter, the shareholders are treated as if they contributed all of the distributed assets and liabilities to a newly formed partnership.⁷⁷ Under the entity–classification regulations, if a corporation elects to be classified as a disregarded entity (SMLLC), the corporation is treated as distributing all of its assets and liabilities to its single owner in liquidation of the corporation.⁷⁸

Corporate combinations

An acquisition transaction that involves both a corporate acquirer and corporate target where the consideration is substantially stock in the acquirer can result in nonrecognition of gain or loss under the corporate reorganization provisions in Subchapter C of the Code. The reorganization provisions apply to S corporations as well as C corporations.⁷⁹ Nonrecognition is not guaranteed. A failure to meet the technical requirements of Sec. 368 and the regulations thereunder will result in a taxable sale to the target and/or the target shareholders.

The transaction must meet the requirements of one of the nontaxable reorganizations permitted in Sec. 368. Three common structures are: an “A” reorganization (statutory merger under state law);⁸⁰ a “B” reorganization (stock exchange);⁸¹ and a “C” reorganization (exchange of the acquirer’s voting stocks for the target’s assets).⁸² Each of these reorganizations has its own requirements, including the percentage of stock required as consideration, the amount of cash or other property given as consideration, whether voting stock is required to be used as consideration, the amount of assets that must be transferred to the acquiring corporation, and others. A complete discussion of the reorganization provisions is beyond the scope of this article.

The F reorganization

A structure for the acquisition of an S corporation that has become popular in recent years is the so–called “F reorganization” acquisition structure.⁸³ It is worth a mention in this article, even though it may be a difficult structure for CPA firm acquisitions due to state–law restrictions of non–CPA owners discussed below.

The F reorganization acquisition is useful to preserve S corporation status for the target when there could potentially be an ineligible shareholder of the S corporation. Under the F reorganization (as described in Situation 1 of Rev. Rul. 2008–18), the shareholders of the S corporation contribute their stock to a new corporation so that the new corporation owns all the stock of the S corporation. This contribution of stock is followed by a qualified Subchapter S subsidiary (QSub) election⁸⁴ for the old S corporation, resulting in the old S corporation becoming a disregarded entity. The old S corporation’s S election does not terminate but continues for the new parent corporation.⁸⁵

The QSub then converts to an LLC under state law, which should be a nontaxable transaction (i.e., disregarded to disregarded). The acquirer then makes a nontaxable cash contribution to the LLC, converting the SMLLC to an MMLLC. The MMLLC would have two partners, the S corporation, owned by the original S corporation owners, and the acquirer entity. This structure would create a partially owned subsidiary (now a partnership) of the acquirer. The clients remain in the original entity, now in the form of an MMLLC.

Unfortunately, this structure could violate state restrictions of nonlicensed CPAs (in this case, the S corporation and the acquirer entity) having an ownership interest in a CPA firm. Some states allow some percentage of ownership by nonlicensed CPAs.

Planning for tax issues

This article is meant to highlight a few of the common structures and tax complexities encountered in a typical CPA acquisition; there certainly may be others. Consolidation of CPA firms does not appear to be slowing down. Structuring the transaction from a tax perspective should not be left to the end of the negotiation process. The tax issues could be as complex, and possibly as contentious, as the nontax deal terms. Too often, the parties assume the other has considered all the tax ramifications.

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Footnotes

¹Installment sales are reported on Form 6252, Installment Sale Income.

²Sec. 1060(c).

³Sec. 1060(a); Regs. Sec. 1.1060-1(c)(2), citing Regs. Secs. 1.338-6 and 1.338-7.

⁴Regs. Sec. 1.338-6(b). A complete discussion of Sec. 1060 and allocation is beyond the scope of this article.

⁵The regulations under Regs. Sec. 15a.453-1(c) refer to contingent installment sales as “contingent payment sales.”

⁶Regs. Sec. 15a.453-1(c)(1). See Sec. 453(d) for electing out of installment-sale reporting. For electing out of contingent-payment sales, see Regs. Sec. 15a.453-1(d)(2)(iii) for valuing the contingent-payment obligation. “The fair market value of a contingent payment obligation may be ascertained from, and in no event shall be considered to be less than, the fair market value of the property sold (less the amount of any other consideration received in the sale)” (Regs. Sec. 15a.453-1(d)(2)(iii)).

⁷Generally, capital gain or loss treatment results from the sale of goodwill or client base. Ordinary income results from a payment for a covenant not to compete. In addition, in the absence of stated interest, the rules for reporting imputed interest under Secs. 483, 1274, and 1275 should generally apply. See Regs. Sec. 1.1274-2(c) for rules pertaining to whether a debt instrument provides for adequate stated interest.

⁸Sec. 453(i)(1)(A).

⁹Sec. 453(i)(2).

¹⁰Regs. Sec. 15a.453-1(c)(1). A complete discussion of the installment contingent payment regulations are beyond the scope of this article. Only general principles will be presented. See Regs. Sec. 15.a453-1(c) for further details and examples.

¹¹Id.

¹²Id.

¹³Gross profit equals selling price less the adjusted basis as defined in Sec. 1011 (including its regulations) (Regs. Sec. 15a.453-1(b)(2)(v)).

¹⁴Regs. Sec. 15a.453-1(c)(2)(i).

¹⁵Regs. Sec. 15a.453-1(b)(2)(i). Contract price “means the total contract price equal to selling price reduced by that portion of any qualifying indebtedness (as defined in [Regs. Sec. 15a.453-1(b)(2)(iv)]), assumed or taken subject to by the buyer, which does not exceed the seller’s basis in the property” (Regs. Sec. 15a.453-1(b)(2)(iii). “The term ‘selling price’ means the gross selling price without reduction to reflect any existing mortgage or other encumbrance on the property (whether assumed or taken subject to by the buyer) and, for installment sales in taxable years ending after October 19, 1980, without reduction to reflect any selling expenses. Neither interest, whether stated or unstated, nor original issue discount is considered to be a part of the selling price” (Regs. Sec. 15a.453-1(b)(2)(ii)).

¹⁶See Regs. Sec. 15a.453-1(c)(2)(ii) for further details concerning the payment-recharacterization rule.

¹⁷Regs. Sec. 15a.453-1(c)(2)(i).

¹⁸Regs. Sec. 15a.453-1(c)(3)(i).

¹⁹Id.

²⁰Id.

²¹Regs. Sec. 15a.453-1(c)(4).

²²Id.

²³Id.

²⁴Id.

²⁵Sec. 453B(a). This section also applies to a nonliquidating distribution.

²⁶There are other detailed rules in Sec. 453(h) that are not discussed in this article, e.g., related-party rules, liquidating subsidiaries, etc.

²⁷Sec. 331, Gain or Loss to Shareholder in Corporate Liquidations, provides rules for a distribution received by a shareholder in exchange for stock in a complete liquidation. Further, for Sec. 453(h) to apply, the shareholders’ stock must not be publicly traded. See Sec. 453(k)(2).

²⁸Sec. 453(h)(1)(A).

²⁹Sec. 453B(h).

³⁰Id.

³¹Prop. Regs. Sec. 1.453B-1(c)(1)(i)(C). Presumably, this exception agrees with the aggregate approach to partnership taxation. Sec. 731 provides rules regarding gains or losses on partnership distributions.

³²Id. These sections override nonrecognition for certain types of “mixing bowl” transactions, payments to a retiring or deceased partner’s successor’s interest, and disproportionate distributions of “hot assets” (ordinary-income assets).

³³Regs. Sec. 1.1012-1(g).

³⁴ Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property.

³⁵Regs. Sec. 1.1274-2(g). See also Regs. Sec. 1.1275-4(c)(4) for characterization of principal and interest for contingent-payment debt instruments.

³⁶For purposes of determining the adjusted grossed-up basis under Sec. 338(b) and Regs. Sec. 1.338-5, this rule should equally apply to a deemed asset acquisition under Sec. 338, including an acquisition election under Sec. 338(h)(10). Sec. 338 applies to elections to treat stock transactions as deemed asset acquisitions.

³⁷Secs. 197(a) and (c).

³⁸Regs. Sec. 1.197-2(f)(2)(i).

³⁹Regs. Sec. 1.197-2(f)(2)(ii).

⁴⁰Partnerships include general partnerships, MMLLCs, and LLPs.

⁴¹Regs. Sec. 1.708-1(c).

⁴²Sec. 708(b)(2)(A); Regs. Sec. 1.708-1(c)(1).

⁴³Regs. Sec. 1.708-1(c).

⁴⁴Regs. Sec. 1.708-1(c)(2).

⁴⁵Regs. Sec. 1.708-1(c)(3).

⁴⁶Regs. Sec. 1.708-1(c)(3)(i).

⁴⁷Regs. Sec. 1.708-1(c)(5), Example (4).

⁴⁸Regs. Sec. 1.708-1(c)(3)(i).

⁴⁹See Sec. 721(a). See also Sec. 722 for the tax basis of the interest acquired by the terminating partnership.

⁵⁰Regs. Sec. 1.708-1(c)(3)(i).

⁵¹See Sec. 731. Whether the mixing-bowl statutes under Secs. 704(c)(1)(B) and 737 apply is beyond the scope of this article.

⁵²See Sec. 732(b).

⁵³See Sec. 723.

⁵⁴Regs. Sec. 1.708-1(c)(3)(ii).

⁵⁵Id.

⁵⁶Id.

⁵⁷See Secs. 731(a)(1) and 752(b). Gain may also be recognized under the mixing-bowl provisions of Secs. 704(c)(1)(B) and 737.

⁵⁸Sec. 732(b). For an excellent in-depth discussion of the assets-up form, see Bloomberg Tax Research, Portfolio 718, Disposition of Partnership Interests or Partnership Business; Partnership Termination, Section IV.C., “Structural Changes.”

⁵⁹Regs. Sec. 301.7701-3(b)(1)(ii).

⁶⁰Regs. Sec. 301.7701-3(b)(1)(i).

⁶¹Transfer to Corporation Controlled by Transferor.

⁶²Sec. 351(a).

⁶³Sec. 368(c).

⁶⁴See Sec. 197(f)(7), treating them as depreciable property.

⁶⁵Sec. 721(a). This general rule does not apply in the case of a partnership treated as an investment company (defined in Sec. 351) (Sec. 721(b)).

⁶⁶Sec. 723.

⁶⁷See Sec. 1361(b)(1).

⁶⁸See Sec. 311(b) for current distributions and Sec. 336(a) for liquidating distributions.

⁶⁹Sec. 1374.

⁷⁰Sec. 301 for current distributions; Sec. 331 for liquidating distributions.

⁷¹Regs. Sec. 1.368-2(b)(1)(iii), Example (5).

⁷²IRS Letter Ruling 200214016.

⁷³Sec. 721(a).

⁷⁴Sec. 723.

⁷⁵Sec. 336. For S corporations, the gain or loss passes through to the shareholders. Further, for S corporations, the built-in gains tax of Sec. 1374 may also apply.

⁷⁶Sec. 331.

⁷⁷Regs. Sec. 301.7701-3(g)(1)(ii).

⁷⁸Regs. Sec. 301.7701-3(g)(1)(iii).

⁷⁹“Except as otherwise provided in this title, and except to the extent inconsistent with this subchapter, subchapter C shall apply to an S corporation and its shareholders” (Sec. 1371(a)).

⁸⁰Sec. 368(a)(1)(A).

⁸¹Sec. 368(a)(1)(B).

⁸²Sec. 368(a)(1)(C).

⁸³An F reorganization is described in Sec. 368(a)(1)(F) as “a mere change in identity, form, or place of organization.” It is discussed in Rev. Rul. 2008-18. See also Joshi, “Private Equity and F Reorganizations Involving S Corporations,” 51 The Tax Adviser 566 (September 2020).

⁸⁴See Sec. 1361(b)(3).

⁸⁵Rev. Rul. 64-250 and Rev. Rul. 2008-18. See also Form 8869, Qualified Subchapter S Subsidiary Election, Part II, Question 14.

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Contributors

Paul N. Iannone, CPA, J.D., MST, and Danny A. Pannese, CPA/ABV/CFF, CSEP, MST, are both associate professors in the Jack Welch College of Business and Technology at Sacred Heart University in Fairfield, Conn. Iannone also is a retired practicing tax attorney. For more information about this article, contact thetaxadviser@aicpa.org.

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