2016-Issue 20—At first glance, acquiring an S corporation is a seemingly innocuous event; after all, S corporations are “flow-through” entities that generally are not subject to income taxes. Instead, income, losses, deductions and credits all flow through to the shareholders and are reported on the shareholders’ respective federal income tax returns. While in theory, any audit adjustments made to pre-close periods should affect only the S corporation’s shareholders, in reality, the failure to qualify as an S corporation may have nightmarish implications for the buyer.
If a corporation inadvertently terminates its S election, it will be treated as a C corporation beginning on the date of termination. This means the target will now have a corporate tax liability, including interest and penalties, for all years in which it failed to qualify as an S corporation. Needless to say, the amount of back taxes owed can be astronomical for targets where the S election was never valid to begin with. And to add insult to injury, one of the upsides of acquiring S corporation targets — namely, the ability to make a Section 338(h)(10) or Section 336(e) election to step up the basis of the target’s assets to fair market value — is unavailable if the S election is invalid. Given the magnitude of the potential tax liability a buyer may inherit, buyers must perform federal diligence on S corporations to avoid unwanted tax implications.
As is the case with all tax diligence, the goal is to examine where the potential for assessment by the IRS exists. In the case of an S corporation target, this means focusing on whether the target made a valid S election and whether the target satisfied the S corporation requirements at all times. In this edition of Tax Advisor Weekly, we explore some of the common federal income tax diligence areas for S corporations.
S Corporation Election
The first step is to ensure that the S election was properly made in the first place. Reviewing the target’s Form 2553, Election by a Small Business Corporation, to determine whether the target obtained the requisite shareholder consents is a good place to start. This is an area rampant with foot faults. The rules require all shareholders of the target at the time of the S election to consent to making the election by signing Form 2553. In community property states (i.e., Alaska (opt-in), Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin) where property is generally viewed as being equally owned by each spouse regardless of how the property is titled or which spouse actually acquired the property, consent must be obtained from both spouses, even if only one spouse is a shareholder. There are certain exceptions, such as if there is a pre- or post-nuptial agreement providing for separate ownership of the corporation's stock, but in general, it is necessary to understand the following: (i) who were the shareholders at the time of the election; (ii) were they married when the election was made; and (iii) if so, did they reside in a community property state. Often, finding the answers to these questions requires probing and uncomfortable inquiries, but they are all for a good cause.
Sometimes, a buyer may take comfort if the target can produce a copy of the IRS acceptance letter confirming the IRS’s acceptance of the S election. However, the letter alone may not suffice if the election was not properly executed since the IRS generally does not scrutinize whether such elections are valid at the time they are made.
Assuming the election was valid, the next step is to ensure that the target did not have more than 100 shareholders at any particular time. In 2004, the IRS amended the rules to be more taxpayer-friendly by treating all members of a family and their estates as one shareholder. For purposes of the shareholder limit test, the term “members of a family” means the common ancestor, any lineal descendant of the common ancestor, and any spouse or former spouse of either the common ancestor or any such lineal descendant. Therefore, an S corporation can theoretically have 100 family shareholders comprised of many hundreds of individuals without violating the shareholder limit.
Of all the rules governing S corporations, the shareholder limit requirement is arguably the least likely to be an issue.
In general, S corporation stock may be held only by United States citizens or resident alien individuals (as determined for federal income tax purposes), estates and certain trusts. When conducting tax due diligence, the target’s capitalization table generally provides a glimpse into the ownership structure, and a more detailed discussion is necessary to address current and historical shareholders to determine who holds shares in the target, and to confirm that all shareholders are permissible shareholders as outlined below.
U.S. Resident Alien Individuals
Individual shareholders of the target must either be United States citizens or resident aliens who reside in the United States. A resident alien individual who lives outside the United States but retains a “green card” to periodically return to the United States is generally also a permissible shareholder. Similar to obtaining the requisite consents to make an S election, the rules become more complex when community property laws come into play. In Ward v. United States, 661 F.2d 226 (Ct. Cl. 1981), the court held that the nonresident alien spouse of a United States citizen who was a shareholder in a corporation is also considered a shareholder in such corporation because the marriage was governed by the community property rules of Mexico. As a result, the spouse was an ineligible shareholder (because she was a nonresident alien) who precluded the corporation from electing S corporation status.
Estates, including a decedent’s estate and the estate of an individual in bankruptcy under Title 11, are eligible S corporation shareholders. A trap for the unwary is that a decedent’s estate cannot remain in existence indefinitely. Once the period of time required by the administrator or executor of an estate to perform the ordinary duties of administration is over, the estate will be considered terminated. In Old Virginia Brick Co. v. Commissioner, 367 F.2d 276 (4th Cir. 1966), the court ruled that the taxpayer was not eligible to make an S election because one of its shareholders was more properly characterized as a trust, rather than an estate, since the executors had long since concluded their duties as executors.
There are a number of different trusts that are permissible shareholders of an S corporation. The rules governing the types of eligible trusts often look to the real character of the organization and can be quite strict and complex. In general, grantor trusts and trusts that meet certain requirements and make an election to be classified as either qualified Subchapter S trusts or electing small business trusts are permissible S corporation shareholders. In diligence, the trust agreements should be requested to determine whether the trust was an eligible S corporation shareholder.
Single Class of Stock
Finally, although a target’s articles of incorporation may authorize it to issue different classes of stock, tax diligence should uncover whether the target has had only one class of stock outstanding at all times (said another way, the corporation has never issued a second class of stock). A corporation is treated as having only one class of stock if all of the outstanding shares confer identical rights to distribution and liquidation proceeds, regardless of their differences in voting rights. In other words, the target may have different classes of common stock with different voting rights (e.g., voting and non-voting) without violating the single class of stock requirement.
Generally, the target’s corporate charter, bylaws or other governing agreements are reviewed to determine the rights of the stockholders. However, there can be instances where a target may have inadvertently created a second class of stock through the normal course of its operations. In general, the rules governing the single class of stock requirement are fairly lenient; the S corporation shareholders generally need to be found to be intentionally circumventing the rules for an arrangement to be deemed to create a second class of stock.
Relief for Late, Missing and Invalid S Elections
If you have suddenly realized that Form 2553 was not filed, or was improperly filed, for the S corporation and are now reaching for your Bayer® aspirin, take a deep breath and continue reading — you may just be in luck. The IRS has the power to grant relief for late, missing or invalid S corporation elections by retroactively treating the corporation as an S corporation for all years in which the S election was intended to apply. There are two avenues available for requesting relief from the IRS: (i) “automatic” relief under Revenue Procedure 2013-30, and (ii) private letter rulings issued pursuant to Treasury Regulation Section 301.9100-3 (commonly known as “9100 relief”).
Generally, taxpayers first look to file for automatic relief under Rev. Proc. 2013-30 because the IRS grants relief under a set of simplified rules without requiring payment of a user fee. This form of relief is only available provided all of the following requirements are met:
- The corporation intended to be classified as an S corporation and only failed to qualify as an S corporation solely because the election was late;
- The corporation has reasonable cause for its failure to make a timely election;
- The corporation and all of its shareholders have reported their income in a manner consistent with how income should have been reported assuming the S election was in place; and
- Less than three years and 75 days have passed since the intended effective date of the S election (with certain exceptions).
If the corporation does not qualify for relief under Rev. Proc. 2013-30, it may seek relief by requesting a private letter ruling. This often requires the taxpayer to pay a substantial user fee and wait for a period of time before receiving a response from the IRS. Generally, to request 9100 relief, the taxpayer must demonstrate that the circumstances barring the election from taking effect were “inadvertent” and that the taxpayer acted in good faith (i.e., the taxpayer took steps to correct the invalid election and/or inadvertent termination within a reasonable period of time after discovery, and the corporation and its shareholders agree to make certain income adjustments as required by the IRS in order to be consistent with the treatment of the corporation as an S corporation).
In the context of a transaction, the buyer and seller often do not have enough time to wait for the IRS to rule on the matter. Fortunately, there are additional ways to structure around the aquisition of the S corporation so that the buyer could still receive a step-up but need not rely on the validity of the S corporation election. There is an excellent Tax Advisor Weekly article from September 2011 titled “Expecting a Step-Up on Your S Corporation Acquisition? Structure Carefully!” that discusses these structuring options in detail.
Conversion from a C Corporation to an S Corporation
Besides meeting the S corporation requirements, another area of focus in tax diligence is to determine whether the S corporation was previously a C corporation. The concern is targets that were previously C corporations may be subject to an entity-level tax under certain circumstances (in addition to historical income taxes). Below is a brief discussion of one of the most common S corporation entity-level taxes seen when performing diligence.
Built-in Gains Tax
In situations where a C corporation sells all of its assets and liquidates, gain or loss is recognized by the corporation on its federal income tax return. On the other hand, when a C corporation elects to be classified as an S corporation for federal income tax purposes, there are no immediate tax consequences. Since S corporations do not pay any federal income taxes, some clever taxpayers decided that their C corporations could elect to be classified as S corporations and then immediately sell all of their assets, effectively bypassing the corporate income tax that is imposed on liquidations. To combat this, Congress enacted Section 1374, which provides for an entity-level tax, called the built-in gains tax, to be imposed on S corporations that were formerly C corporations (or S corporations that acquire assets from a C corporation in a nontaxable transaction).
Under Section 1374, if, at the date of conversion from a C corporation to an S corporation (or the date that the S corporation acquires the assets of a C corporation in a nontaxable transaction), the company had built-in gains in its assets (i.e., the fair market value of the assets at the time of conversion is greater than the corresponding tax basis), and such assets are subsequently sold during the “recognition period” post-conversion, then the company would be subject to the entity-level built-in gains tax at ordinary corporate income tax rates, in addition to the tax imposed on its shareholders. This recognition period was shortened to five years beginning in 2011 as a result of the Small Business Jobs Act of 2010. Previously, it was ten years for tax years beginning before 2009, and seven years for tax years beginning in 2009 and 2010. Section 1374 is intended to put the corporation in the same place from a federal income tax perspective as if it had sold its built-in gain assets without ever having made the S corporation election.
Ideally, a valuation would have been performed at the time of the conversion to quantify any built-in gain. In the event a valuation was not performed, additional steps are needed to assess whether there is an exposure. If there are built-in gains, the buyer and seller can negotiate for the purchase agreement to stipulate that the built-in gains be borne by one of the parties through indemnity or an escrow; however, there are also ways to structure the acquisition such that the buyer would not inherit the built-in gains tax liability.
Beware of target S corporations using the cash receipts and disbursement method of accounting. To the extent a buyer is not allowed to use the cash basis method of accounting, (i.e., more than $10 million in annual gross receipts, the buyer is a C corporation, etc.), and a Section 338(h)(10) or 336(e) election will not be made, a change in accounting method will be required. The change in accounting method from cash to accrual may result in additional income that would be recognized in the post-closing period. By identifying the issue and quantifying the potential additional income, the buyer and seller can negotiate who will bear the tax on the additional income; one way to manage this issue is to treat the additional income tax liability as a debt-like item in the purchase agreement.
Opportunities Upon Exit
Typically buyers prefer to acquire a company’s assets because it provides an opportunity for a step-up in the tax basis while not acquiring unwanted corporate liabilities. However, sellers typically prefer stock transactions whereby the entire gain on the sale is treated as capital gain. Therefore, one of major appeals of acquiring an S corporation target is the ability to make a Section 338(h)(10) or Section 336(e) election to characterize the stock sale as a hypothetical asset sale for tax purposes. By making a Section 338(h)(10) or Section 336(e) election, the buyer will receive a step-up in the basis of the target’s assets equal to fair market value, thereby potentially creating depreciation and amortization deductions to shield future taxable income. However, by making this joint election, the seller is deemed to have sold its assets for an amount equal to the deemed sale price and thus will frequently require that they be made whole for any incremental tax payment required as a result of the hypothetical asset sale. To make the seller whole, the purchaser can “gross up” the seller by increasing the purchase price to accommodate for the incremental tax that the seller must suffer as a result of making the election.
As mentioned above, there may be opportunities to structure the transaction in such a way that the buyer may receive a step-up in the assets without relying on the S election or providing the sellers with a gross-up. For a discussion of these structuring options, see the Tax Advisor Weekly article referenced above.
Alvarez & Marsal Taxand Says:
Given the myriad of ways in which an S corporation can lose its favorable tax status, resulting in not only the loss of future amortization deductions but also a potential tax liability at the S corporation level that the buyer may inherit (quite the double whammy), buyers must say “yes!” to federal income tax diligence for S corporation targets.
Patrick A. Hoehne
Managing Director, San Francisco
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Senior Director, Chicago
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Shelley Song and Melissa Buich contributed to this article.
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The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.
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