Still thinking about selling your business? Do you have the proper techniques and structures in place? I’ll discuss the ins and outs in this week’s M&A Shop Talk.
Generally, one of the most powerful planning techniques to structure a tax efficient sales transaction of your business is the installment sale reporting method under IRC Section 453. However, there are some complexities and inherit limitations that requires an experienced M&A tax planning professional to work around in the context of an S corporation target.
This blog discusses in general broad terms the complexity of installment sale reporting in the context of an F reorganization involving the sale of an S corporation target. For background information on the benefits of an F reorganization involving an S corporation selling target, please visit my previous blog on M&A Shop Talk from Monday, March 28.
Installment sale reporting doctrine generally supports the proposition that there will not be a tax on the portion of the selling proceeds that you have not constructively received regardless of your overall tax method of accounting. However, keep in mind that the term constructive receipt is very broad and it includes deemed consideration constructively received (i.e., assumed liabilities by the buyer party) and it excludes any portion of the purchase price allocated to hot assets that do not qualify for installment sale treatment.
Under the current rules and regulations, there are tremendous planning opportunities when combining installment sale reporting in the context of an F reorganization. However, if this powerful combination of techniques is not fully understood and properly coordinated, it can yield unintended, devastating tax ramifications to you.
For example, under current law, the S corporation target has the ability to distribute the collection of its outstanding installment sale obligation to its selling shareholders without triggering any taxable gain at the entity level. The selling shareholders will be able to step into the shoes of the S corporation and report the remaining, outstanding installment sale obligation as collected. This planning tax provision is generally referred to as the “H Rule” and is not available unless the installment sale obligation stems from a sales transaction, transacted after the S corporation has adopted a plan of liquidation under the 12 months rule pursuant to Section 331.
Now in the context of an S corporation selling target that is undergoing an F reorganization and converting to an LLC status prior to completing the contemplated sales transaction, the described H Rule provision is not appropriate if it involves an equity rolled-over portion consideration. In this particular circumstance, because the selling S corporation will not be liquidated within 12 months after completing the sales transaction, the H rule is not applicable and the distribution of the installment sale obligation to any selling shareholder would constitute an immediate taxable event.
Stay tuned for the next M&A shop talk when will cover the use of Section 351 to achieve stepped-up basis tax treatment to the buyer party. In the meantime, please feel free to schedule a consultation with Jorge Rodriguez, CPA. Jorge is a Tax Director and part of Aronson’s Financial Advisory Services Group. Jorge can be reached by email at firstname.lastname@example.org or (301) 222-8220.
The “F reorganization” has become the tax planning structuring technique of choice in today’s middle market M&A world. So, what does it mean to you as a seller?
First, F reorganization is only applicable in the context of corporations not LLCs. Second, in the middle market M&A world, which is still controlled by S corporation’s seller target, it means legally converting your existing S corporation to an LLC before selling.
The basic conversion process should be tax-free and it generally consists of the following sequence of steps:
Step 1: Form a new corporation hereafter referred to as “HoldCo”.
Step 2: All the S corporation shareholders (with no exception) will contribute 100% of its ownership to HoldCo. Need to apply for a separate employer identification number (EIN).
Step 3: Pursuant to IRS Revenue Ruling 2008-18, the old S election of the S corporation will automatically revert to HoldCo.
Step 4: Effective the same date as Step 2, convert the S corporation to a Qualified Subchapter S corporation (QSub) by filing IRS Form 8869 within 75 days. Entity will retain old EIN.
Step 5: Convert the QSub still a legal entity for state tax purposes, to an LLC via a formless conversion. Entity will retain old EIN.
In some cases, there may be additional steps required beyond the scope of this blog. For example, if the S corporation is not organized under a state that permits formless conversion process to LLC form. Further, any S corporation that is subject to unrecognized Net Unrealized Built-in Gains (NUBIG) tax under IRC Sec 1374, will not be triggered upon such conversion process but it will become the legal responsibility of the newly formed Hold Co.
The two major tax benefits to the seller are as follows:
The major tax benefit to the buyer is to achieve a stepped-up basis transaction that can be amortized over 15 years with absolute minimum tax exposure. The buyer via the transaction described has legally transferred all income tax-related exposure to the HoldCo shareholders.
Now, the major drawback of the F reorganization with respect to a partial tax deferral transaction as described above, is the elimination of the 12 months favorable liquidation rule provisions in the context of installment sale obligation scenario. Stay tuned for the next M&A shop talk when we will cover this important topic. In the meantime, please feel to schedule a free consultation with Jorge Rodriguez, CPA. Jorge is a Tax Director and part of Aronson’s Financial Advisory Services Group. Jorge can be reached by email at email@example.com or (301) 222-8220.
There are many tax reasons why a small business organized as a limited liability company (LLC) chooses to operate as a flow-through partnership or disregarded entity taxed as a Schedule C filer on Form 1040. What happens, however, if you have successfully operated your business as an LLC, but have reached a point in your personal life that you want to achieve maximum liquidity and are willing to share continued success and the potential upside with your employees? Your exit strategy options may be very limited because you are a small business with a limited pool of viable potential buyers, if any. This is a common scenario among successful, small government contractors that primarily depend on size standards for new contract awards, including re-competes and renewals, making them an unattractive target candidate to larger organizations (i.e., because of contract novation and re-compete constraints).
When you peel back the layers of the onion, so to speak, what generally makes an organization an attractive target? Who knows your business best (i.e., real insider information)? Who is the best candidate to acquire your business? In today’s tight credit market, you will not be able to secure 100% third party financing and will need to partially self-finance the sale transaction and take the junior lien position to third party lenders.
In consideration of all of these important questions, an owner should strongly consider the possibility of selling its business to its employees, including the existing management team. As an inducement to the selling party, the issuance of warrants with an upside (regarding future appreciation rights upon a future sale event) can be attached to the subordinated debt financing. The terms and conditions, however, must be properly structured in order to avoid second class of stock successful determination upon IRS examination, which would entirely and/or severely eliminate all the favorable tax effects of selling to an Employer Stock Ownership Plan (ESOP).
With the proper tax planning, your existing business (organized as an LLC and currently taxed as a partnership or disregarded entity) can be converted to a corporation to successfully consummate a potential future sale to your ESOP in a tax efficient manner. Under the current tax system, an LLC organized under state law and taxed as a partnership or disregarded entity as discussed above cannot participate in or sponsor an ESOP. Moreover, an S Corporation owned 100% by an ESOP stockholder is generally not subject to federal and state income taxes (other than, potentially, built-in gains tax at the S Corporation entity level) upon its conversion from an LLC to S Corporation. Some tax professional describe an S Corporation that is 100% owned by an ESOP as a tax shield (i.e., the ESOP is a tax-exempt entity not subject to federal including most state and local income taxes with respect to pass-through S Corporation taxable income).
There are two basic ways to convert an LLC to a corporation. One way, if applicable under state law, is for the LLC to undergo a formless conversion process and convert to a corporation. Alternatively, if the LLC qualifies (i.e., the LLC did not change its default tax classification within the last 60 months), it can file a federal election (IRS Form 8832), under the check-the-box provisions, to be classified as a corporation for federal and most state taxing provisions. Please note that there are exceptions to the 60-month limitation classification change rule. This latter option requires an additional step to change the legal form of the LLC to a corporation under state law via F reorganization (the LLC will be merged into a newly-formed a corporation with the corporation being the surviving entity). The check-the-box election option gives you more flexibility since the conversion paperwork election can be filed with the IRS on or before 75 days after the targeted effective date of the conversion.
The next step, after the conversion to a corporation, would be for the corporation to elect Subchapter S tax treatment election, which can be effective the same date as the conversion date. Under the check-the-box election, you can use IRS Form 2553 to convert to an association and elect Subchapter S. Furthermore, similar to IRS Form 8832 discussed above, IRS Form 2553 paperwork can be filed with the IRS on or before 75 days after the effective S election date.
In addition to the tax planning required to minimize and mitigate the triggering of built-in gains upon conversion to an S Corporation as mentioned above, there are many other hidden tax traps that should be considered and addressed in advance when incorporating an LLC. This includes any pre-binding buy-sell agreements or other step transaction doctrines that, under certain circumstances beyond the scope of this blog, could entirely negate the tax-free status generally associated with an incorporation of a partnership and make the entire transaction a taxable sale. In addition, because of the conversion mechanics, the converting entity faces complex accounting method matters that require special handling, including the potential filing of a non-automatic accounting method change application and the review and approval of the IRS national office within certain statutory due dates.
Please note that the tax planning option described above might only be ideal for an owner looking for maximum liquidity versus deferral and diversification. Also, stay tuned for future blogs regarding other ESOP sale transactions, including transactions involving a C Corporation and Sec 1042 deferral exchange election treatment, or a combination of sale transactions involving first stage (Sec 1042 deferral) and second stage (electing Subchapter S tax treatment and selling the rest of the ownership). For more information on ESOPs, please visit the website for The National Center for Employee Ownership (NCEO).
Ready to negotiate the sale of your business? First you should sit down with your tax advisor to gain a general understanding of the major tax considerations and constraints that should be evaluated. Partnerships, LLCs, C Corps, and S Corps all have various entity-specific tax consequences that should be evaluated before making any decisions.
The decision analysis process, however, is now more complicated because the top long-term capital gain rate was raised to 20% versus 15%, and there is an additional 3.8% Medicare tax applicable to certain passive investors. In the case of LLC sale transactions, your choices are limited and the transaction will generally be accounted for tax reporting purposes as an asset sale. In the case of a corporation, depending on whether the entity is an S Corporation or you are selling one of the subsidiaries within a consolidated group, it can qualify as a deemed asset sale under Sec 338(h)(10). If the entity is a C Corporation owned 80% by an affiliated group, it can also qualify for deemed asset sale provisions under Sec 338(g) election provisions.
Note: Please be aware that the tax return mechanics and reporting provisions under Sec 338(h) (10) versus Sec 338(g) are very different and need to be fully reviewed and analyzed before reaching any conclusion. Also, this blog does not discuss an election available under Sec 336(e) that might be more advantageous, for example, where an 80% or greater owned target subsidiary (i.e., must be a domestic entity) being acquired has high basis assets or has large unused net operating losses. (An article regarding the tax benefits of a Sec 336(e) election, including a general discussion on the recently passed final regulations which have relaxed certain provisions, will be forthcoming.)
Some of the factors that should be considered when weighing pros and cons of various taxing regimes are as follows:
Issues Unique to an LLC Taxed as a Partnership
Issues Unique to S Corporations
Issues Unique to C Corporations
Other Tax Considerations Applicable to All
Understanding the major tax provisions and hidden tax traps applicable to your particular situation is a critical first step in an effective negotiation process. If you are interested in a pre-sale analysis and review of your specific tax situation, please contact your Aronson LLC tax advisor or Tax Director, Jorge L. Rodriguez, CPA at 301.222.8220.