There are a couple of different structuring options for the acquisition of an S corporation. A buyer that is a corporation will consider making an election that will recharacterize a sale of S corporation stock as a sale of assets. This election creates a fiction of an asset sale that can provide a substantial tax benefit to the buyer. The buyer will receive an increase to fair market value in the tax basis of the S corporation assets. The election allows the buyer to qualify for additional tax savings due to tax deductions from a higher depreciable or amortizable basis in the assets. The seller must agree to make the election with the buyer. The election is made under a provision of the federal tax law in Section 338(h)(10) of the Internal Revenue Code (I.R.C.).
There can be a cost to the seller in the form of additional tax as a result of the election. The seller would pay tax at preferential capital gain tax rates if there is a sale of S corporation stock. The seller would pay tax on gain from a fictitious or deemed sale of the S corporation’s assets if the parties agree to make the election. If the S corporation is considered to sell all of its assets then this may result in some gain that is characterized as ordinary income instead of capital gain. Depending on the composition of the assets, the seller could be required to pay tax at higher ordinary income tax rates on some of the gain from a deemed asset sale. The seller’s cost of making the election is referred to as the incremental tax. This is the difference between the tax that the seller would pay at preferential capital gain tax rates on the gain from a straight stock sale and the total tax that the seller would pay on the deemed asset sale. There can be an incremental tax cost to the seller in terms of both federal tax and state level tax. This can occur particularly when the S corporation has a relatively low tax basis in its assets which may include a substantial amount of zero tax basis accounts receivable. The seller may not be inclined to make the election when its outside basis in the S corporation stock is proportionately greater than the inside basis in the S corporation’s assets. However, the seller may generally agree to make the election with the buyer if the agreement provides for a tax gross up to effectively make the seller whole. The purpose of the tax gross up is to minimize or eliminate the seller’s incremental tax cost from the election. The tax gross up will increase the seller’s purchase price consideration to effectively equalize the seller’s tax liability from an asset sale so that it is the same as a stock sale.
Due diligence is an important part of the acquisition process. It is also important to model the incremental tax cost to accurately quantify the negotiable tax gross up amount and cost or benefit to the parties from the utilization of certain transaction deductions. A diligent modeling process will calculate whether the present value of the buyer’s future tax savings from additional depreciation or amortization tax deductions is greater than the seller’s incremental tax cost to make the election.
An S corporation acquisition could be somewhat more complicated if there is a controlled foreign corporation subsidiary (CFC) in the structure. If the parties make the I.R.C. section 338(h)(10) election for the sale of the S corporation parent then the deemed asset sale includes the CFC stock. There are some critical planning considerations for the concurrent acquisition of a foreign target corporation. A buyer has the option to make a comparable election that will enable the increase to fair market value in the tax basis of the foreign target’s assets. Again, the theoretical value or benefit to the buyer is from additional tax deductions from depreciation or amortization of assets with a higher basis. In the context of a foreign corporation acquisition, the election is made under I.R.C. section 338(g). This election also results in the fiction of a deemed sale of the foreign target’s assets. The gain from the deemed asset sale may be characterized as either Subpart F income or global intangible low-taxed income (GILTI) depending on the type of assets. A U.S. shareholder is required to pay U.S. tax on certain types of undistributed income of a CFC that are classified as Subpart F income or GILTI. The U.S. shareholders of the S corporation are basically required to pay U.S. tax on the gain from the deemed sale of the foreign target assets with the election. However, the seller would be able to increase the basis in the CFC stock due to a Subpart F income or GILTI reporting requirement. The increase in stock basis can effectively mitigate the U.S. shareholder’s tax liability on the allocated gain from the sale of the foreign target. When the U.S. parent corporation is an S corporation and not a C corporation the gain on the sale of the foreign target could not be recharacterized as a nontaxable deemed dividend based on the 100% dividends received deduction.
While the I.R.C. section 338(g) election could provide a benefit to the buyer from a higher depreciable or amortizable asset basis, an associated cost is the potential reduction of foreign tax credits. This can occur because the asset basis and corresponding depreciation or amortization deductions would be lower for foreign tax purposes resulting in higher foreign tax liability on a higher amount of foreign source income. U.S. tax rules effectively limit foreign tax credits from a greater amount of foreign tax paid due to the difference in the CFC asset basis determined under U.S. and foreign tax principles.
Another caveat with the I.R.C. section 338(g) election is the possible creation of GILTI tested losses with higher depreciation and amortization deductions. GILTI tested losses can result in the loss of foreign tax credits to be utilized in the GILTI foreign tax credit limitation basket. Although, the higher tangible asset basis with the election can help decrease GILTI tested income that otherwise would be subject to U.S. tax. However, the benefit of the reduction for the 10% of the higher tangible asset basis would be lost in the GILTI calculation if the depreciation and amortization deductions create GILTI tested losses.
Another planning alternative is to file a U.S. federal Form 8832 check-the-box election to reclassify a wholly-owned CFC target as a foreign disregarded entity (DRE) for U.S. tax purposes. This results in a deemed liquidation of the CFC. The sale of the CFC target is then characterized as an asset sale. The seller would need to quantify and negotiate the incremental tax cost gross up cautiously with this technique. Both federal and state S corporation built-in gains tax could result from checking the box on a CFC immediately before a sale of the S corporation parent in an I.R.C. section 338(h)(10) transaction. In some circumstances, the check-the-box election may provide a benefit to the seller at the cost of the S corporation built in gains tax. There also could be a cost to the buyer because any future profit from the foreign DRE would not qualify for a 50% deduction like GILTI from a CFC. Again, careful analysis is necessary to quantify the cost and benefit to both the seller and buyer.
There are also other possible structures for the acquisition of an S corporation. A strategy referred to as an “F reorganization” provides a helpful advantage and benefit to allow the selling shareholders of the target to acquire rollover equity on a tax-deferred basis. This means that the target sellers will be able to exchange their ownership interests in the target to either continue to own an equity interest in the surviving company or otherwise acquire equity in the acquiring company.
Additionally, another comparable election is possible when the buyer of the S corporation is not a corporation eligible to make the I.R.C. section 338(h)(10) election. Non-corporate buyers such as individuals, partnerships, and other non-corporate taxpayers could acquire an S corporation with an election under I.R.C. section 336(e). This election essentially recharacterizes a stock sale as an asset sale based on a similar structure of fictitious transactions that occurs under I.R.C. section 338(h)(10).
Overall, it is important to model the tax consequences to the buyer and the seller in an S corporation acquisition transaction. It is helpful to consider and account for any additional complexity resulting from the S corporation’s ownership of foreign subsidiary corporations. Aronson’s integrated team of transaction advisory and international tax professionals can help quantify the U.S. tax savings benefit and incremental tax cost for both the buyer and seller. For more information, please contact Alison Dougherty.