The passing of the 2017 tax reform, the “Tax Cuts and Jobs Act,” will certainly intensify the pressure for maximum consideration deals that require leverage financing to make the numbers work. So, if you want a maximum deal, you might not be able to fully cash-out.
There are three possibilities for an S Corporation target to roll-over equity participation on a tax-deferred basis. To dispel myths and remove often misunderstood tax concepts, all asset sales transaction arrangement consummated pursuant to a Sec 338(h)(10) or Sec 336 (e) tax election regime is fully taxable, regardless of any stock rollover features. The rationale behind this is that for income tax reporting purposes you are selling 100% of the targets net asset plus assumed liabilities, followed by a deemed liquidation of the net assets sale proceeds received in cancellation of the target ownership participation. Therefore under this transaction arrangement, the stock roll-over feature would be ignored and become fully taxable.
The prospective buyer party is indifferent about the stepped-up basis tax benefit. Under this scenario, the selling shareholder representative negotiating the deal should consider introducing a two stepped transaction arrangement involving an incorporation transaction pursuant to Sec 351, followed by an acquisitive reverse cash merger. The selling S Corporation shareholder would contribute the earmarked stock rolled-over portion on a tax-deferred basis into a newly formed C corporation. The prospective buyer party, as part of the same incorporation transaction arrangement, would contribute cash and other assets, if applicable. This will be collectively referred hereafter as “Step 1”. Now, this type of rolled-over/sales transaction arrangement generally involves multiple selling shareholders. Typically, at least one of the shareholders is not fully cashing out and will be a key player of the new management team. In Step 2, as part of the contemplated acquisitive transaction arrangement to be consummated through a reverse cash merger involving the newly formed corporation created per Step 1, all the remaining shareholders of the selling target will receive taxable consideration ( i.e., will receive cash, contingent payable, etc.) in exchange for all its remaining stock, or stock that that was not rolled over. The taxable consideration received would be fully taxable as a stock sale with no stepped-up basis to the acquiring buyer party.
The prospective buyer party is sensitive to a step-up basis tax benefit. Under this scenario, the selling shareholder representative should consider undergoing an F reorganization arrangement pursuant to Rev. Rul. 2008-18. All the shareholders will contribute the entire S Corporation stock ownership to a newly formed corporation and elect QSub status for the contributed corporation, with a subsequent entity form conversion to an LLC form through a formless state conversion statute. The S election of the contributed target entity would automatically be transferred over to the newly formed corporation, thus allowing the newly created S Corporation holding company to sell a partial interest in the LLC ownership investment and retain the unsold portion that would economically equate to a tax roll-over transaction arrangement. In this instance, the buyer party would benefit from this transaction arrangement because it would receive a stepped-up basis adjustment for the partnership interest acquired and any appreciation attributable to the underlying intangible assets acquired would be amortized over 15 years.
The prospective buyer party involves a private equity that desires a step-up basis tax benefit treatment, but would not want to be partial LLC owner with the seller party. Additionally, assume that the underlying facts and circumstances support the spin-off a new operational platform to be organized by the buyer party as part of the overall contemplated acquisitive transaction. Under this set of facts and circumstances, the selling shareholder representative should explore conducting an F reorganization as discussed in scenario 2 and converting the target to a 100% owned LLC that would be accounted as a disregarded entity for tax reporting purposes. Furthermore, as part of an overall integrated stepped transaction arrangement that includes the consummation of the merger transaction with the seller party, the buyer party can organize a holding company structure that would directly own the intragroup spin-off business. This would either be through a wholly owned subsidiary and/or single member LLC. Finally, the newly created holding company would form a transitory LLC to accommodate the contemplated merger transaction with the seller party.
To effect the contemplated overall merger transaction, the seller party would merge its target LLC into the transitory LLC organized by the buyer, with the target LLC surviving the merger. This merger transaction would constitute a tax-deferred Sec 351 incorporation transfer arrangement between the seller and buyer party since it involves two disregarded LLCs. There is an exception to this if the seller party receives taxable boot consideration. Taxable boots are generally applicable to any cash received, assuming liabilities previously expensed for tax purposes by the buyer party, recourse debt assumed, and other merger consideration payable in the form of cash or cash equivalent to the seller party. The sales and exchange treatment of the taxable boot component under Sec 351 tax provisions mechanically would resemble an asset sale tax treatment format, with certain anomalies involving excess liabilities assumed. Generally, the taxable gain recognized by the seller party would create a step-up basis tax benefit recovery treatment to the buyer party and any gain attributable to intangibles assets would be recovered through amortization over 15 years. In respect to this scenario arrangement, there are certain restrictions and limitations and possible negative ramifications affecting intragroup spin-off transactions that need to be addressed.
Lastly, critical with respect to analyzing all the aforementioned scenarios is to fully integrate all the tax ramifications and planning opportunities stemming from the passing of the 2017 Tax Cuts and Job Acts. This includes provisions affecting tax rates structure, accrual basis accounting method timing provisions and conformity rules with GAAP reporting, technical termination rules involving the sale of a partnership interest, and the character tax treatment of asset sale gain recognition involving certain self-created intangibles assets for taxable years beginning after December 31, 2017. For more information, please visit my tax blog, “M&A Shop Talk – Tax Reform Act -Private Company Related Tax Developments.”
Please note that this blog has been purposely written at a high level and intentionally omits many critical integrated steps that are necessary to properly affect the tax scenarios results described. For more information regarding these planning opportunities, please contact our tax advisors at 301.231.6200.