In these uncertain economic times, 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 (and the corresponding depreciation/amortization deductions). The challenge is that anyone who has acquired (or attempted to acquire) an S corporation knows that they have their complications. In a previous edition of , we discussed some of the hidden traps encountered when acquiring an S corporation. Once the decision is made to move forward with the acquisition of the target S corporation, the question becomes one of structuring. If you are hoping to achieve a step-up in tax basis of the S corporation’s assets, close attention must be paid to the structuring of the transaction. In this issue, we discuss 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:
(1) A straight asset acquisition;
(2) The acquisition of the stock of the S corporation with a Section 338(h)(10) election; or
(3) 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 recognized 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. (Note: The American Recovery and Reinvestment Act of 2009 reduced the recognition period for the built-in gains tax to seven years for 2009 and 2010, and the Small Business Jobs Act of 2010 similarly reduced the recognition period to five years for 2011.)
Given that making a valid Section 338(h)(10) election requires that certain conditions be met, it is not always easily achieved. If a buyer is concerned about meeting the requirements to make a Section 338(h)(10) election, consideration should be given to an LLC structure as an alternate means to achieve a step-up.
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.
For example, the assets of the target can be contributed to a newly formed LLC, and the acquirer can then buy shares in the new LLC (which does not need to be 80 percent or more, as with the Section 338(h)(10) requirement) from the target.
In an “LLC drop-down” structure, the IRS has ruled the purchase by the acquirer of 80 percent of the LLC units previously held by a single member is treated for tax purposes as if acquirer bought 80 percent of each asset and assumed 80 percent of the liabilities of the business. Then it assumes the acquirer and the target formed a new LLC and contributed their assets and liabilities in proportion to their ownership in exchange for LLC membership units. Under this situation, the LLC transaction triggers only 80 percent of the gain and the 20 percent rollover is tax deferred.
Example: Rev. Rul. 99-5: After Acquirer Has Bought LLC Units
• Target shareholder transfers all of Target’s stock (“Old S”) to a newly formed S corporation holding company (“New S”) in exchange for all of the stock of New S.
• New S makes an election for Old S to be taxed as a qualified Subchapter S subsidiary.
• New S creates a wholly owned LLC, into which it merges Old S.
• 80 percent of interests of LLC are sold to purchaser.
Example: Drop-Down LLC Structure
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-amortizable 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.
Example: Over-the-Top Sale of LLC Interest
In this transaction, the acquisition is a purchase of a partnership interest from the target. As mentioned, to ensure the step-up, a valid Section 754 election must be in place. The over-the-top purchase will result in the acquirer’s proportionate share of the inside basis of the partnership’s assets being stepped-up to reflect the purchase price paid and entitle the purchaser to tax deductions and amortization of goodwill reflective of such stepped-up inside basis.
Alvarez & Marsal Taxand Says:
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 Section 338(h)(10) 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 amortization 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.
Jamie Rimmer, Director, contributed to this article.
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