We are in a time where more individuals are making the decision to become entrepreneurs and business owners via flow-through entity structures. One type of flow-through entity that owners can create is an S corporation, which is a corporation whose shareholders have elected to pass through corporate income, losses, deductions, and credits to their shareholders for federal tax purposes. One of the biggest benefits of this structure is the ability to avoid the double taxation that exists with a normal C corporation. While the purchasing of S corporations is commonplace, there may be hurdles to clear in structuring a deal. One of the initial decisions to be made will be whether you will buy the assets or stock of an S corporation, as there are various implications that can arise from your choice. Even if an asset sale is desired to receive a tax benefit from depreciation and amortization on stepped-up assets, a discussion with your tax advisors is necessary to determine whether special elections will be required to structure the purchase. Assuming that the ownership of S corporation shares is desired, specific buyers that are set up as C corporations, S corporations, or partnerships, need to understand that an S corporation has certain rules regarding who can actually own the stock. The following potential ownership restrictions should be considered before making a decision on how to structure your transaction.
When buying a business that is structured as an S corporation, a purchaser may initially plan on buying either 100% or a portion of the issued and outstanding shares of the corporation through one of their business entities. While this may have been the normal setup when a purchaser bought a partnership, limited liability company (“LLC”), or C corporation, an S corporation carries restrictions on who can actually own the shares. In order to retain an S corporation status, eligible shareholders can only be individuals that are U.S. citizens or resident aliens, certain exempt organizations, estates, certain trusts, and with the proper structuring, S corporations. Notably excluded from this list of eligible shareholders are entity structures such as C corporations and partnerships. This creates a hurdle for buyers that were planning on making a purchase through their C corporation or partnership.
If the deal is structured with a C corporation or partnership being the purchaser of shares, the S corporation will lose its “S” status and revert to a C corporation upon consummation of the transaction. This results in the removal of the flow-through aspect that may have been desired and now creates a taxable entity that is subject to the rules of double taxation. Preservation of the “S” status may necessitate individual owners of a C corporation or partnership to consider buying the stock directly to prevent the loss. While this is an available option, it may not be the optimal ownership structure. Fortunately there are options to restructure the target business prior to a purchase to avoid this scenario, though it comes with the burden of additional time and money in order to structure a deal.
One way to restructure the business as part of a deal would be to have the targeted S corporation form a new LLC that it owns 100% of the assets. This LLC would be a disregarded entity for federal tax purposes. The S corporation could subsequently transfer its assets down to the newly formed LLC. As a buyer, you would now be in a position to use your C corporation or partnership as the purchaser in the transaction. Instead of purchasing shares in an S corporation, you would now be purchasing an interest in a LLC. The actual restructuring will require additional administrative work as moving the business assets from one entity to another can create issues with assignment of existing contracts and agreements, transferring licenses and permits, and the receiving consent of existing lenders.
Alternatively, an “F reorganization” is another option to use your corporation or partnership as the purchaser in a transaction. An F reorganization is a mere change in identity, form, or place of organization of a corporation. In this scenario, the targeted S corporation would create a new S corporation and the existing shareholders would contribute all of the targeted S corporations stock in exchange for all the stock of the newly created S corporation. The newly created S corporation would now own 100% of the stock of the targeted S corporation. The new S corporation would make a special election to treat the 100% owned targeted S corporation as a qualified subchapter S subsidiary. This would make the targeted S corporation disregarded for federal tax purposes. The subsidiary would then make a formless conversion for state purposes to a LLC. This now puts a buyer in a position to purchase an interest in the originally targeted S corporation, which is now an LLC, and avoids the added work of transferring assets as mentioned in the previous scenario. A conversion to an LLC by the targeted S corporation may not be a simple task as the entity may not be organized in a state that permits formless conversions to LLC’s.
Another alternative is to make a Section 336(e) election, which treats the acquisition of an S corporation as a purchase of the underlying assets of the business for tax purposes. This election needs to satisfy the criteria of a qualified stock disposition, which requires at least 80% of the vote and value of S corporation stock to be sold, exchanged, or distributed in a transaction or series of transactions within a 12 month period to an unrelated party. The transaction would be treated as the sale of assets by the targeted S corporation, followed by a deemed liquidation of the target. As a buyer, you are treated as acquiring the assets for their fair market value, which will allow you to potentially step up the tax basis of the assets. Stepping up the value of the assets can bring tax benefits such as additional depreciation and amortization deductions. Additionally, with this type of election the buyer in the deal can take the form of a corporation, partnership, or individual. In either this scenario or the previous ones described above, the goal to have your C corporation or partnership be the purchaser in a deal can be accomplished, but does come with an added burden.
Buyers that are in the market for acquiring businesses such as an S corporation should be aware of the potential limitations and restrictions regarding ownership, as they can cause undue burdens in a proposed deal. The proposal of the transaction is one that should be properly planned with your lawyers and tax advisors to make sure you are properly positioned to purchase shares in an S corporation.