When buying or selling a business, the existence of a target company that is taxed as a subchapter S corporation (an “S Corporation”) can be advantageous for all parties to a transaction.  The acquisition of an S Corporation, however, presents unique tax considerations that are vital for both buyers and sellers to understand. Accordingly, when an S Corporation acquisition is being contemplated, it is important to understand the benefits and drawbacks, and  related complexities involved with such an acquisition.

Taxation of S Corporations                                                                                                                                                     

S Corporations generally avoid the double taxation otherwise imposed on C Corporations.  Instead of being taxed at the corporate level, items of income, gains, deductions, and losses typically flow through directly to the shareholders.  There are, however, various exceptions to this flow-through treatment. For instance, if an S Corporation was previously taxed as a C Corporation within the prior five years, any gains realized on a sale (or deemed sale) of the S Corporation’s assets, which were held while the S Corporation was a C Corporation, are subject to entity-level tax at the applicable corporate rate. Additionally, certain states and localities impose entity-level taxes on an S Corporation’s income (e.g., California), or do not recognize a federal S corporation election, and thus tax the entity as though it were a C Corporation (e.g., New Hampshire, Tennessee, the District of Columbia, New York City). An understanding of the various nuances and exceptions is crucial for any acquisition involving an S Corporation.

S Corporation Election and Eligibility

Under Subchapter S of the U.S. Internal Revenue Code of 1986, as amended (the “Code”), an eligible corporation may make an election to become an S Corporation (an “S Election”). In order to qualify as an S Corporation, a corporation (including an LLC electing to be taxed as a corporation) must meet the following five requirements:

1. Is domestic (i.e., a U.S. entity);
2. Has no more than 100 shareholders;
3. All shareholders are “eligible S Corporation shareholders” (e.g., U.S. individuals, estates, certain trusts);
4. Has only one class of stock (i.e., no differences in distribution or liquidation rights among the shareholders, however, voting and non-voting stock is permissible); and
5. Is not an “ineligible corporation” (i.e., a bank or thrift institution, an insurance company, or a current or former domestic international sales corporation).
   

A valid S Election remains effective until revoked or until the S Corporation ceases to meet the above requirements.

Common Due Diligence Issues

In light of the myriad of requirements, the acquisition of an S Corporation requires meticulous due diligence to validate eligibility and avoid costly surprises, especially because the buyer inherits the associated risk of S Corporation invalidity. Common issues include: (1) errors in the S Election process, such as the S Election not having been signed by all shareholders at the time it was made, a missing 385C letter from the IRS accepting the S Election, or failure to file separate state S corporation elections where applicable; (2) ineligible shareholders, such as having more than 100 shareholders, certain foreign or trust shareholders, or corporate/partnership shareholders; and (3) the existence or creation of an impermissible second class of stock, including stock with non-equal distribution or liquidation rights, actually making disproportionate distributions (other than slight timing differences), “unreasonable” compensation, non-arm’s-length transactions with certain related parties, and instances where “profits interests” or “change of control” rights to sale proceeds are granted to employees, vendors, and/or other nonshareholders.

Acquisition Structures

If any S Corporation is to be acquired, there are multiple ways to structure an S Corporation acquisition, each of which involve unique tax considerations. These commonly include asset acquisitions, stock acquisitions, “F” reorganizations under Section 368(a)(1)(F) of the Code (an “F Reorganization”), and stock acquisitions for which an election is made under Section 338(h)(10) of the Code (a “Section 338(h)(10) Election”).

A. Asset Acquisitions

In order to avoid any risk of an invalid S Election, a buyer can purchase the assets of a target, rather than its stock. Another positive in an asset acquisition is that the buyer receives a stepped-up cost tax basis in the assets acquired; however, for various corporate reasons, an asset acquisition will often times not be feasible or desirable.

B. Stock Acquisitions

Stock acquisitions, on the other hand, typically result in the buyer bearing all risk of a potentially invalid S Election. The buyer receives a cost tax basis in the shares of the target; however, the inside tax basis of the assets of the target is not stepped up and is instead carried over. For this reason, a stock acquisition is often less tax-efficient for buyers and more desirable for sellers due to any gain generally being fully taxed at preferential long-term capital gains rates.

C. F Reorganizations

Although adding a bit more complexity compared to the other acquisition structures, an F Reorganization avoids reliance on a valid S Election (unlike a Section 338(h)(10) Election) and may be beneficial to both buyer and seller by providing the buyer with a stepped-up tax basis, while allowing the target to continue in existence, and permit the seller to obtain a tax-deferred equity rollover. This acquisition structure is most often used when a buyer has concerns about a target’s qualification as an S Corporation, or there is a seller rollover contemplated in the acquisition. Consideration should be given to potentially applicable state taxes; in the case where there is a non-pro rata rollover, potential equalization issues should be addressed by the seller. Although outside the scope of this article, alternative structures are required for S Corporations that have “anti-churning” considerations.                                                                                                                                                                                                                                                                   The steps involved in an F Reorganization are typically as follows. The seller shareholders form a new corporation (“NewCo”), which generally makes a “protective” S Election. The target’s shares are subsequently contributed to NewCo and NewCo elects (on IRS Form 8869) to be treated as a qualified S Corporation subsidiary, which is disregarded as separate from its owner for U.S. federal income tax purposes. Pursuant to Revenue Ruling 2008-18, NewCo succeeds to the target’s original S Election, and thus a new S Election is not required (although protective elections are advisable). Following the F Reorganization, if the target is not already an LLC, it can either converted to an LLC or, if unavailable under state law, form a new LLC that is then merged into the target. The newly formed LLC must be disregarded as separate from its owner for U.S. federal income tax purposes, either by default classification, or by making a check-the-box election (on IRS Form 8832). Lastly, the buyer would acquire all, or some of, the membership interests of the target from NewCo.                                                                                                                                                                                                                                                                   For U.S. federal income tax, and for most state income tax purposes, the buyer’s purchase of all of the membership interests in the LLC is generally treated as an asset acquisition. Any built-in gain in the target’s assets flows through to NewCo’s shareholders as a result of the deemed sale, increasing its outside tax basis. The parties generally negotiate and agree on a purchase price allocation amongst the relevant classes of assets, which determines the amount of ordinary versus capital gain recognized by NewCo’s shareholders. The shareholders of NewCo will often require a tax “gross-up” to be compensated for any increased tax cost associated with buyer’s step-up in tax basis, and the seller often will request that the buyer pay the costs associated with the F Reorganization. Lastly, as a deemed asset acquisition, a buyer does not acquire any of the target’s tax attributes.

D. Stock Acquisition with Section 338(h)(10) Election

The more traditional S Corporation acquisition structure compared to an F Reorganization is a stock acquisition with a Section 338(h)(10) Election. A stock acquisition with a Section 338(h)(10) Election requires the buyer to purchase at least 80% of the shares of the target in exchange for cash, note(s), and/or other property (a “Qualified Stock Purchase” or “QSP”). The Section 338(h)(10) Election must be made jointly by both buyer and seller (on IRS Form 8023) by the 15th day of the 9th month after the acquisition date and has the effect of the target being treated as selling all its assets to the buyer, followed by the deemed liquidation of target. A purchase price allocation must be made, for which the parties must prepare an IRS Form 8883, to be attached to the tax return on which the transaction is reported. For a valid Section 338(h)(10) Election transaction, a target’s S Election must be valid and this requires pre-transaction diligence to be thorough and complete. Other notable considerations when making a Section 338(h)(10) Election include: (i) approval being needed by all of target’s shareholders, (ii) buyer needing to be a C Corporation, (iii) seller being unable obtain a tax-free equity rollover, (iv) the bilateral requirement of a Section 338(h)(10) Election often causing a buyer to agree to “gross-up” the purchase price to account for incremental tax to seller (as compared to a straight stock acquisition), and (v) accounting for certain state taxes that may be applicable.      

A Section 338(h)(10) Election results in the target recognizing gain or loss on the deemed asset sale, with any gain generally being characterized as a capital gain, except for gain attributable to accounts receivable, inventory, and depreciation/amortization recapture (with such ordinary income typically driving any tax gross-up paid by buyer to seller). From the buyer’s perspective, a cost tax basis is achieved in the target shares and assets (which can be a “step-up” if the aggregate purchase price exceeds the target’s pre-closing tax balance sheet); however, the target’s tax attributes do not carry over. Additionally, the target’s S Election terminates as a result of the transaction, thus becoming a C Corporation in the hands of the buyer and, if applicable, resulting in the need to be reported in consolidation with buyer’s other subsidiaries.

Note, to the extent an earn-out or other deferred purchase price arrangement is contemplated, additional consideration should be given to potentially adverse impacts of a Section 338(h)(10) election, such as accelerated gain recognition. The use of a “one-day note” can potentially mitigate such adverse impacts but should be discussed by the parties early in the transaction as its implementation can create significant legal and corporate hurdles.

Other Considerations

Because of  the 2017 Tax Cuts and Jobs Act’s imposition of a limitation on individuals’ state and local tax deduction, most states have enacted Pass-Through Entity Tax (PTET) regimes, which aim to ease the burden of this limitation, generally by shifting state tax liability to the business entity level. Where potentially applicable, careful consideration should be given to PTET elections, as they can significantly impact the tax treatment of asset and stock sales and alter the tax implications for both buyers and sellers in S Corporation acquisitions.

Conclusion

Acquiring an S Corporation is a complex process laden with tax implications, an understanding of which is essential for any successful tax planning involving an S corporation acquisition.  From ensuring the validity of the S Corporation election, to choosing the appropriate acquisition structure, and valuing the impact of a tax basis step-up, every aspect should be carefully considered.

Thomas Mitchell, Esq. and Brian Krastev, Esq., are respectively senior associate and associate attorneys at Hodgson Russ LLP. Tom and Brian counsel businesses, individuals, and nonprofit organizations on U.S. federal income tax and international tax-related matters. They advise clients on all aspects of U.S. federal income tax and international tax, including acquisitions, planning, compliance, and controversy work.