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Expecting a Step-Up on Your S Corporation Acquisition? Structure Carefully!
In the current economic climate, there is an increased focus on any opportunity to improve cash flow. For acquirers of Subchapter S corporations, this often means ensuring the availability of a step-up in the tax basis of the S corporation's assets. The challenge is that anyone who has acquired (or attempted to acquire) an S corporation knows that they have their complications. Taxand US discusses the alternatives available to ensure the buyer gets a step-up.
There are at least three ways to achieve a step-up in asset basis in connection with the purchase of an S corporation; a straight asset acquisition; the acquisition of the stock of the S corporation with a Section 338(h)(10) election; or the use of a limited liability company (LLC) structure.
Asset Purchase vs. Section 338(h)(10) Election
Typically, most buyers prefer to acquire assets, as this provides an opportunity to achieve a cost basis in tangible and intangible assets while not acquiring unwanted corporate liabilities. The struggle is that sellers typically prefer stock transactions where the entire gain on the sale of stock is treated as capital gain and it is not necessary to transfer and re-title each of the company's assets and/or licenses. As a result, for commercial reasons, it is often not feasible to acquire purely assets.
In situations where the purchase of assets is not practical (e.g., regulatory or license/title transfer issues, etc.), and the parties do not otherwise wish to do a forward cash merger, the parties may consider making a joint Section 338 election to treat the sale of at least 80 percent of the target S corporation's stock as a sale of assets. To qualify for a Section 338(h)(10) election on the purchase of S corporation stock, certain requirements must be met, including:
- The company must be a valid Subchapter S corporation.
- The company must be acquired by a corporation.
- The buyers must acquire at least 80 percent in vote and value of the stock.
- The buyers must acquire the stock in a "qualified stock purchase.
To make a valid Section 338 election, both the buyer and the seller must agree to the election. The deemed sale will likely result in some portion of the gain recognised by the S corporation shareholders being taxed as ordinary income, which is subject to a federal tax rate (35 percent) higher than the rate for capital gains (15 percent). A Section 338(h)(10) election could also result in additional state taxes being applicable to the selling shareholders if the assets are located in states with higher tax rates than the states in which the shareholders are domiciled. Also, the selling shareholders are taxed on 100 percent of the gain even if a portion of their stock is rolled over in the transaction. Typically, the purchaser agrees to increase the purchase price to gross-up the seller for the increased taxes that result from the Section 338 election. It is important to note that a corporate-level built-in-gains tax also may apply if the company was previously a C corporation or acquired assets from a C corporation in a tax-free transaction within 10 years of the proposed transaction.
Using an LLC to Achieve Tax Step-Up
As noted above, a valid Section 338(h)(10) election may not be practical in cases where there are concerns about the validity of the target's S corporation status, the seller plans to roll over more than 20 percent, or the buyer prefers not to use a corporate entity to acquire the target. Often, an LLC structure can be used to achieve a similar result for the buyer as making a Section 338(h)(10) election. Note that the use of an LLC structure will usually allow for a tax deferral on the rollover portion. However, there may still be more taxes payable by the seller relating to the portion of the business sold than in the case of a straight sale of the S corporation stock.
It should be noted that the above referenced LLC structures may not avoid the anti-churning rules of Section 197 if the business of the S corporation was in existence prior to August 1993 and the existing shareholders roll over more than 20 percent. The application of this rule would, in general, result in any portion of the step-up allocated to goodwill being non-amortisable for tax purposes. These rules can be avoided by limiting the historical shareholders' rollover into the acquiring entity to 20 percent.
In the case where anti-churning is an issue and there is expected to be greater than 20 percent rollover, the transaction should be structured as an "over-the-top" sale of partnership interests, so the step-up comes from a Section 754 election. Under these facts, the new LLC will need to have at least two partners and be formed some period prior to the closing of the transaction.
Buyers often assume that the step-up associated with the acquisition of an S corporation is something that happens as a matter of course. In fact, a number of issues that might arise could limit the availability of the step-up. For example, a failed election would eliminate the availability of the step-up. This is a very bad result where the step-up had been "paid for" (i.e., the purchaser compensated the seller for the incremental taxes associated with the election and/or included the benefit of the increased amortisation deductions in their model and/or purchase price).
There are a number of potential structural solutions. However, as noted above, many are form driven and need to be properly structured to achieve the desired result - that is, the availability of the step-up.
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