Tax Structuring for the Purchase/Sale of an S Corporation Business

Members of the baby-boomer gener­ation who have reached or passed retirement age continue to divest from their closely-held businesses as part of an overall wealth planning strategy. The resulting “middle market” of target companies contains, in particular, numerous entities that are organized as S corporations for tax pur­poses. Accordingly, buyers and sellers should be aware, and consider the use of an efficient tax planning tool in connection with the purchase and sale of an S corporation: the F reorganization.

F REORGANIZATION

Without getting lost in the minutia, an S corporation F reorganization is typically ac­complished through the following steps: (i) existing shareholders form a new corpora­tion (”NewCo”) and contribute their shares in the existing S corporation (”OldCo”) to NewCo; and (ii) NewCo makes an election to treat OldCo as a qualified subchapter S sub­sidiary (”Qsub”). A third step is often em­ployed whereby the Qsub is merged (or converts via state-law statute) into a limited liability company (”Target LLC”).

All of these steps are generally treated as being tax-free; NewCo succeeds to OldCo’s S corporation election; OldCo (or Target LLC, as the case may be) retains its EIN, but is otherwise disregarded for income tax pur­poses. As discussed below, the resulting structure is attractive to buyers and provides flexibility to sellers.

M&A TRANSACTIONS

Generally speaking, in the context of M&A transactions, buyers and sellers each have certain tax- and non-tax goals. Some or all of these goals may be met, depending on the transaction’s structure (e.g., whether stock or assets of the target company are bought/sold, and whether the seller retains some ownership, often in the form of rollover equity).

With respect to the purchase and sale of S corporation businesses, buyers generally prefer to purchase assets, which (i) often re­sults in valuable tax depreciation and amor­tization deductions in the future; and (ii) helps insulate the buyer from certain historic tax exposures (such as those resulting from an invalid S corporation election). Sellers, on the other hand, often prefer an equity sale because it tends to provide for preferential capital gain treatment. Sellers also prefer tax-deferral on any rollover equity received as part of the deal.

By structuring a pre-sale S corporation F reorganization followed by an equity acqui­sition of the target business, buyer and seller may simultaneously accomplish several of their highest priority goals. For example, if structured correctly, the F reorganization:

• Provides the buyer with a step-up in the tax basis of the target company’s assets (i.e., for the portion of the business purchased, generally resulting in valuable tax deprecia­tion and amortization deductions)/ and in­sulates buyer from certain historic income tax liabilities of the target company;
• Provides the seller with the ability to ob­tain tax-deferred rollover equity without the limitations that are present with other acqui­sition structures;
• Avoids burdensome legal issues that generally arise in traditional asset sales (e.g. novation of contracts); and
• Allows the target company to continue utilizing its EIN for employment/payroll tax purposes.

Thus, when discussing potential M&A transactions with clients, to the extent the target company is an S corporation, practi­tioners should keep the F reorganization in mind as a relatively simple, yet effective structuring tool.

This article provides a high-level explana­tion of a pre-sale F reorganization of an S corporation target company, including the re­organization’s potential benefits to both buy­ers and sellers, and the steps to effectuate the transaction. Having said that, structur­ing this type of transaction takes technical expertise; careful planning is required to en­sure the F reorganization’s steps are timed and executed properly, such that its intended results are respected. 

Adam Margulies is at Farrell Fritz, P.C. and provides domes­tic and international transactional tax advice to clients within the private wealth, insurance, banking, and asset manage­ment sectors. Adam is a member of the Nassau County Bar Association and the American Bar Association and can be reached at amargulies@farrellfritz.com.

Published in The Suffolk Lawyer, Vol. 40 No.3 April 2024

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1 Unlike C corporations, S corporations do not pay entity-­level tax; rather, the company’s income generally flows through to shareholders, resulting in a single layer of tax at the shareholder level. According to IRS statistics, since 1997, the S corporation is the most common type of corpo­ration utilized for closely held businesses. Even so, properly electing and retaining S corporation status takes a signifi­cant amount of planning and diligence and contains traps for the unwary along the way.

2 See I.R.C. Section 368(a)(1 )(F). A full discussion of the re­quirements for effectuating an F reorganization is beyond the scope of this article.

3 See Rev. Rul. 2008-18. See also, PLR 200542013; PLR 200701017; PLR 200725012.

4 Rollover equity (that is, ownership in the buyer or its affili­ate) leaves the seller with “skin in the game” post-sale, which (i) motivates the seller to remain active in the com­pany and ensure a successful transition to new ownership; and (ii) allows the seller to enjoy additional gains in the fu­ture (i.e., upon sale of the hopefully-appreciated equity).

5 The mechanism that allows for this is colloquially referred to as a “step-up” in tax basis.

6 Indeed, to the extent the transaction takes the form of an asset sale that results in ordinary income and/or a higher tax bill, sellers may require a “gross-up” payment to equal­ize the difference vis-a-vis a stock sale.

7 The purchase generally should be treated as an asset pur­chase for federal income tax purposes, which may require buyer to make a gross-up payment. As is typically the case, however, the present value benefit of future tax deductions far outweighs the cost of the additional payment.

8 Nevertheless, tax due diligence of the target company generally is still warranted, particularly in respect of non-in­come (i.e., sales and use, employment/payroll, real and per­sonal property, etc.) tax matters.

9 For example, a joint Section 338(h)(10) election which, comparatively speaking, has strict requirements and signif­icant limitations. A full comparison of these structures is be­yond the scope of this article.