The most recent M&A Shop Talk highlighted the major tax advantages of completing a leveraged ESOP buyout transaction as an exit strategy for S corporation structured small businesses with no liquidity except its workforce. Now, we’ll cover a parallel discussion in the context of a C corporation target.
Currently, IRC Section 1042 tax provisions allow owners with at least 30% ownership stake in a qualifying C corporation selling target to complete a leveraged ESOP transaction, and invest their entire net cash proceeds received from the transaction into a qualifying replacement property (QRP). Thereby deferring 100% of the underling gain until such QRP is subsequently liquidated. In order to carry out this exit strategy, the following criteria must be met.
In addition to the described IRC Section 1042 gain deferral provision, qualifying C corporation businesses can also take advantages of the following favorable tax provisions that are not available under an S corporation transaction format as discussed here.
First tax provision, dividend distributions received by the ESOP constitute an additional pension contribution fully deductible to arrive at the regular corporate taxable income. This is not deductible from the alternative minimum tax calculation by the qualifying C corporation target. Accordingly, this contribution is subject to the normal 25% aggregate employee compensation limitation and overall pension contribution ceiling limitation per eligible ESOP employee participant under IRC Section 415.
Second, the cash contribution portion used by the ESOP to satisfy the interest expense portion with respect to the leverage buyout loan is generally not subject to the aforementioned overall 25% aggregate employee compensation limitation. Further, it is not counted as an employer contribution for purposes of the aforementioned IRC Section 415 tax provisions provided that less than 1/3 of the current year employer contributions are credited to highly-compensated employees.
If you are a small business and your workforce is your most valuable asset, the described leverage buyout sales transaction via an ESOP might be the ideal exit strategy for you. If you have any questions or need additional information, please contact Jorge Rodriguez at 301-222-8220 or firstname.lastname@example.org.
Are you considering converting your C corporation to an S corporation?
If so, being aware of the built-in gains tax that may be assessed to your corporation is essential. With the proper planning, such as timing the sale of the built-in gain assets, you can escape paying the dreaded built-in gains tax.
What is built-in gains tax? Generally, an S corporation is not subject to tax. However, when a C corporation is converted to an S corporation status, the highest corporate tax rate (currently 35%), is imposed on the net built-in gains of the corporation, which is the excess of the fair market value of assets over the adjusted basis of assets. The built-in gains tax is only applied for assets that were in existence at the time of conversion and turned into cash or sold during the “recognition period,” which was normally a 10-year period. The good news is that on December 18, 2015, President Obama signed the “Protecting Americans from Tax Hikes” (PATH) Act, which retroactively and permanently extends, among other provisions, the 5-year built-in gains tax recognition period instead of the 10-year period.
For example, a C corporation was converted to an S corporation status on January 1, 2015. On the date of the conversion, it had assets with a fair market value of $3 million and adjusted basis of $2 million. The corporation’s net unrealized built-in gain would be $1 million. If the corporation had taxable income of $1.5 million and sold the built-in gain assets in 2017, the corporation would be subject to the built-in gains tax of $350,000 ($1 million X 35%). However, if the built-in gain assets were sold in 2020, the built-in gains tax would be a non-issue (zero built-in gain tax) since the fifth year of the recognition period ends on December 31, 2019.
Of course, there are other tax planning strategies to escape the built-in gains tax, such as selling accounts receivables before converting to an S corporation status, recognizing built-in losses in years when built-in gains are recognized, and so on. Before you make a decision to convert your C corporation to an S corporation status, you need to look closely at the real effect of the built-in gains tax and plan accordingly. By doing so, you may be able to reduce or escape paying the built-in gains tax that means a real tax savings for you.
For more information, please contact your Aronson tax advisor or Tonny Tani at 301.231.6200.
The U.S. federal tax system provides for the direct foreign tax credit and the indirect foreign tax credit. U.S. taxpayers may claim the direct foreign tax credit as a dollar-for-dollar offset against their U.S. federal income tax liability. The credit is claimed for foreign taxes paid directly by the U.S. taxpayer on foreign source income earned outside the United States. The direct foreign tax credit can be claimed by a U.S. individual or corporation that pays foreign tax on foreign source income from activities engaged in directly in a foreign country. The direct foreign tax credit is also available forforeign taxes paid by a foreign branch or a foreign partnership owned by a U.S. taxpayer. For U.S. partnerships or S corporations, the foreign taxes paid will pass through to the partners or shareholders who will claim the foreign tax credit on their respective federal tax return.
The indirect foreign tax credit is referred to as the deemed paid credit. Only a U.S. Subchapter C corporation that owns 10% of a foreign corporation may claim the indirect foreign tax credit for foreign taxes paid on earnings that are actually distributed as a dividend. However, there is a special rule which allows a U.S. parent corporation to claim the indirect foreign tax credit for foreign tax paid on undistributed earnings of a foreign corporation that are subject to U.S. federal taxation as a deemed dividend.
The foreign tax credit is subject to a limitation, which is calculated as the amount of the foreign tax paid or accrued multiplied times the amount of foreign source taxable income divided by worldwide taxable income. Foreign taxes that are greater than the limitation for the tax year can be carried back one year and forward 10 years. The limitation applies to separate baskets of income, including passive income and general limitation income. In determining foreign source taxable income for purposes of the limitation, it is necessary to allocate and apportion expenses to each class of income.
It is important to be aware of overall foreign loss rules which recharacterize foreign source income as U.S. source income for purposes of the foreign tax credit limitation in years after the U.S. taxpayer has utilized a foreign loss as a deduction to offset U.S. taxable income. An example of this is where a U.S. individual owns an interest in a hybrid foreign partnership and utilizes losses from the foreign partnership as a deduction to offset U.S. taxable income. In a subsequent year, when the hybrid foreign partnership pays foreign tax on positive net income, the U.S. partner is required to recapture the prior year foreign loss and recharacterize the foreign source income as U.S. source income in calculating the foreign tax credit limitation. A similar rule exists for an overall domestic loss that is utilized as a deduction to offset the U.S. taxpayer’s foreign source income. The overall domestic loss is recaptured when U.S. source income is earned in a subsequent year and it is recharacterized as foreign source income.
When negotiating your next business acquisition or sales transaction, don’t be so quick to dismiss an election under Section 336(e) that might be ideal in your particular circumstances. Regulations were recently issued that provide finality, as well as some long awaited perks.
Enacted as part of the 1986 Tax Reform Act, the Sec 336(e) regime election was intended as a relief provision that would help certain corporate entity taxpayers that were negatively impacted due to the repeal of the General Utilities doctrine and were not eligible to qualify for deemed asset sale tax treatment under a Sec 338(h)(10).
As originally constructed, the Sec 336(e) election basically stated that, under regulation to be prescribed by the Secretary, a corporation that owned at least 80% of the voting shares and value of another corporation, could sell, exchange or distribute all of its ownership in such corporation and be eligible to make an election to treat such sale, exchange, or distribution as a disposition of all of the assets of such corporation, and no gain or loss would be recognized on such sale, exchange, or distribution of such stock. The Sec 336(e) election provision, as originally enacted, was a mere promise awaiting interpretation from the Treasury. Furthermore, there were many unanswered questions, including:
All of these questions have now been addressed with the issuance of the final regulation covering qualified stock dispositions transacted on or after May 15, 2013.
Ideal Scenarios for a Potential Sec 336(e) Election
The election under Sec 336(e) should be considered under the following scenarios:
Under all the above scenarios, a present value tax calculation analysis should be performed to quantify:
Depending on buyer’s internal rate of borrowing/raising capital and other business factors beyond the scope of this blog post, the buyer might be willing to partially or fully reimburse the seller for making the election.
In summary, if you do not qualify for Sec 338(h)(10) joint election filing, which is always controlling, a Sec 336(e) election might be appropriate for you in your next business acquisition or contemplated sales transaction.
Through the end of 2013, investors other than corporations can exclude 100% of the gain on its sale of qualified small business stock (QSBS) from its income, for stock acquired on or after September 28, 2010 and on or before December 31, 2013.
There are several criteria to meet the QSBS designation, two of which are:
Entity choice must be weighed carefully. Choosing to be a C corporation just to get QSBS status may not necessarily work out as planned. Many corporate dispositions are treated as asset sales for tax purposes (even though they may be a stock sale for legal purposes) because this usually results in the most favorable outcome for the buyer. The gain exclusion on QSBS is on just that – the stock. An asset sale is fully taxable to the C corporation and then again to the shareholder as the earnings are passed through as dividends or liquidating distribution.
If you are contemplating starting a business or selling a business that may be a QSBS, please contact your Aronson tax advisor or a member of the Aronson Tax Services Group at 301.231.6200 to discuss strategies that may be right for you.