S Corporations are one of the most popular operating vehicles for small business in the United States. Whether legally structured as a corporation or LLC under state law, qualified businesses electing S-Corp tax status are able to reap many associated financial benefits, such as the realization of pass-through income taxation while also having the ability to treat owners as employees of the business and pay them a reasonable salary.
When it comes time to sell, however, many of our clients have found that S-Corp status can be somewhat of a nuisance in the acquisition process, both from a legal and tax perspective. There are many strategies and best practices S-Corp owners can observe, both during the business life cycle and at an exit or liquidity event, to minimize risk and ensure a smooth closing.
Respect the “S”
Among other things, to maintain valid and effective status as a subchapter S corporation, the company must not have (or be deemed to have) more than 100 shareholders, must be owned only by U.S. citizen or permanent-resident individuals and certain qualified trusts, and must have only one class of stock or LLC interests.
Buyer due diligence often reveals seemingly miniscule violations that may have inadvertently terminated the S election, resulting in potential imposition of C-Corp tax and a large, unexpected liability. S-Corp owners should take proactive steps to ensure the S election remains intact, such as:
- Confirm Form 2553 was filed with the appropriate IRS service center and that you have evidence of certified mailing or other delivery
- Adopt policies restricting transfer of ownership to qualified S-Corp equity holders
- Make sure your governing documents (e.g., articles, bylaws, shareholders’ agreement, LLC operating agreement, etc.) do not contain provisions that create or imply a second class of stock
Choosing a Deal Structure
One of the first decisions made in any acquisition process is whether the Buyer will acquire the equity interests of the target company (i.e., a “stock sale”) or all or certain of the company’s assets (i.e., an “asset sale”) (less common structures like mergers and consolidations are a topic for another day).
While Buyers tend to prefer assets sales because they allow the Buyer to realize a step-up in tax basis while picking and choosing assets to buy and limiting assumed liabilities, certain factors associated with the deal can make such transactions more costly, time-intensive and/or logistically burdensome, such as:
- the nature of the target company’s business
- required contractual and governmental consents (which are often not otherwise triggered by a change of equity control)
- notice or filing requirements triggered upon sales of material assets
- permit and license restrictions
- personnel and employee benefit continuity concerns
- business integration logistics
Sellers typically prefer a stock sale because they can often realize 100% long-term capital gains rather than ordinary income tax liability on certain assets, without retaining liabilities associated with the target company. But given the ownership restrictions discussed above, S-Corp status alone can initially present a roadblock to closing.
In situations where an asset sale is either impractical or not contemplated, there are various strategies the parties can employ in order to facilitate a step-up in tax basis and/or a direct purchase of S-Corp equity by a larger company, private equity firm, or other buyer that would otherwise be unqualified to hold ownership of an S-Corp.
The “F Reorg” Explained
“We’ve been presented with an LOI for the purchase of our company, and it says we need to complete an ‘F Reorganization’ before the closing – what does that mean?”
Simply put, an “F Reorganization” (or “F Reorg”) is a creative tax-free reorganization strategy under Section 368(a)(1)(F) of the Internal Revenue Code that can potentially benefit a buyer in a stock sale transaction in at least two ways, if completed properly – (1) it permits an entity buyer to acquire the stock or equity of an S-Corp without inadvertently terminating the subchapter S status of the target company (thus avoiding reversion to C-Corp “double” taxation), and (2) the buyer can obtain asset sale tax treatment (i.e., a “step-up” in tax basis in the target company’s assets), without the need for additional complex tax filings.
While the intricate underlying tax code requirements and various other utilities of F Reorganizations are beyond the scope of this article, in the context of a sale of a small to mid-sized business which is taxed as an S-Corp, buyers asking for an F Reorg generally expect the Seller to take the following steps prior to closing:
Step 1: Selling shareholders form a new holding company and file a valid S-Corp election for the holding company. This new entity will become the “seller” in the stock purchase transaction.
Step 2: Selling shareholders contribute all shares of stock in the target company to the new holding company in exchange for stock of the holding company. Importantly, the new shares must be owned in the same proportion as the contributed shares were owned in the target company.
Step 3: The holding company makes a valid election to treat the target company as a qualified subchapter S subsidiary (i.e., a “Q Sub”) of the holding company. The Q Sub election, if made properly, ensures the target company is a disregarded entity for tax purposes at closing.
Step 4: (If the target company is not already an LLC) Selling shareholders cause the target company to be converted into an LLC via a filing with the state of its incorporation. Buyers want this so that the target keeps its disregarded entity status after the closing.
While F Reorgs can often be mutually beneficial to buyers and sellers, they are not always necessarily the best strategy, and the attendant circumstances must be evaluated by legal and tax professionals to confirm whether the benefits outweigh the costs.
Whenever a step-up in tax basis is sought in a stock purchase transaction – whether via an F Reorg or pursuant to another tax election (such as a 338(h)(10) election) – the selling shareholders should be concerned with the associated increase in taxes imposed on the sale of equity. As a result of the step-up in tax basis, the portions of the purchase price allocated to certain of the target company’s assets (such as cash, inventory, accounts receivable, etc.) will be taxed at ordinary income rates rather than treated as long-term capital gains.
Again, this mirrors an asset sale for tax purposes, but depending on the circumstances, the increase in taxes could be a game changer. Depending on the relative benefit the buyer may realize from the step-up in tax basis and the landscape of the negotiations, a buyer may be willing to “gross up” the sellers by adding cash to the purchase price intended to cover these excess tax liabilities.
If you are an S-Corp owner considering the sale of your business or a buyer evaluating whether to acquire an interest in an established S-Corp, careful evaluation of the legal and tax compliance considerations discussed here should be a top priority. If you have questions on positioning your S-Corp for an exit event or otherwise need assistance with a potential acquisition, please contact Zack Andrews at (703) 284-7283 or firstname.lastname@example.org.
This article is for informational purposes only and does not contain or convey legal or tax advice. Consult an attorney and a tax professional. Any views or opinions expressed herein are those of the authors and are not necessarily the views of the firm or any client of the firm.