Tag Archives: s corporation

M&A Shop Talk VII

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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.

  • The qualifying C corporation target must be a domestic corporation organized under state law and actively engaged in a trade or business. For more information on how an LLC can convert and complete an ESOP leverage transaction, and take advantage of the Section 1042 deferral strategy, visit this previous blog post.
  • The sales transaction must be a stock ownership sale transaction with no stepped-up tax election treatment under Section 338 and/or Section 336.
  • The buyer party must be a qualified sponsored ESOP plan. For general background information regarding what constitutes a qualified ESOP plan, including intricacies regarding how to carry out a leverage buyout, please visit the National Center for Employee Ownership (NCEO).
  • The minimum stock ownership sold must represent at least 30% of all voting shares including preferred with voting rights or all stock ownership value except pure preferred non-voting shares of the selling target.
  • The selling shareholder or shareholders if more than one, must all be qualifying individuals with a minimum holding ownership period of three years (i.e., measured at the date of sale).
  • The replacement property rules under Section 1042 must be satisfied within a 15 month prescribed period, commencing 3 months before the date that the sale of the qualified securities occurs, which ends 12 months after the date of such sale.
  • The replacement property generally consists of common and/or preferred stock, bond debenture obligation, etc., as defined by IRC Section 165(g) (2) issued by the qualifying C corporation target.

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  jrodriguez@aronsonllc.com.

 

 

 

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M&A Shop Talk

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What is the most efficient tax structure to recruit and retain top talent, and set your business model apart from the competition?

The partnership reporting form (i.e., including an LLC owned by at least two members under the default classification rules) is generally the most flexible and accommodating tax operating structure to attract and incentivize top-performing talent.

Keep in mind that the check-the-box classification regulations are intended to be taxpayer friendly. That being said, you can always start your business in a partnership model and subsequently convert (i.e. make the check-the-box election) if it makes business sense to a corporation. This conversion process is usually accomplished on a tax-free basis unless you have negative capital account recapture issues created by recourse debt financing and/or non-qualified recourse financing applicable to certain real estate business activities. As part of the conversion process, any negative capital account balance previously created must be restored to a zero balance upon conversion.

Now, unlike the corporate reporting form that has some flexibility provisions regarding the start-up stage and early business life cycle, under partnership taxation principles pursuant to IRS Section 704(b) provisions, a partnership can typically implement a re-evaluation agreement (i.e., book-up economic agreement) without a ton of constraints. This concept is nothing more than an economic arrangement incorporated into the partnership and/or LLC operating agreement via amendment that clearly defines who is financially entitled to what pre- and post-evaluation. This tax planning technique is typically conducted on a tax-free basis because there is no shifting of pre-existing wealth involved. Additionally, it provides tax ownership structure participation to the recipient key employee to be taxed at the preferential, federal long-term capital gain rate of 20% upon a future exit strategy as long as the one-year ownership holding period is over.

Here is an example demonstrating how to apply the above concept. Let’s say that you own and operate a very profitable business structured as an S corporation and would like to award equity participation and future appreciation to a key employee.

Solution: undergo an F re-organization under Section 368(a)(1)(F)and convert your current S corporation to an LLC operational form for tax reporting purposes pursuant to IRS Revenue Ruling 2008-18 to be owned by a newly formed S corporation holding company that you will still have 100% ownership and control over. Next, issue the desired ownership % in the newly created LLC structure to the key employee in conjunction with a re-evaluation agreement, which would stand for the proposition that all equity appreciation generated through the re-evaluation date will belong to you, and moving forward you are willing to share “X” profits and appreciation based on the agreed allocation percentage.

For more information on the tax benefits of F re-organization, please visit our recent blog posts on the topic here.

Please note that the described partnership re-evaluation planning technique has many variations and application possibilities. To learn how this technique can help grow your current business model and boost employee morale, please feel to call me at (301) 222-8220 or email me at jrodrigiuez@aronsollc.com.

 

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M&A Shop Talk III

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Have you heard of a horizontal, double dummy technique to achieve a partial asset sale tax treatment with stepped-up basis adjustment? A method that also accommodates a tax-deferred equity rolled-over feature?

Generally, this tax planning technique is more common in the context of a public company business combination scenario; however, it has some limited applicability in private M&A transaction planning considerations. The transaction arrangement uses a combination of tax-free reorganization doctrine provisions under IRC Section 368, along with incorporation tax rules pursuant to IRC Section 351 involving multiple entities to achieve the acquisition of a target entity with stepped up-basis tax treatment to the buyer party.

To keep things simple, if the overall transaction arrangement is properly structured and meets certain statutory provisions including valid business purposes, ownership control absolute minimum rule requirements, and continuity of interest test that are beyond the scope of this blog; the stock equity rolled-over component (i.e. received under the Section 351 incorporation exchange) is generally tax deferred. The cash consideration portion received (i.e. referred to as boot) is fully taxable. The character of the taxable boot is calculated based on the purchase price allocation. Thus the portion of the taxable boot consideration allocated to hot assets (i.e., unrecognized cash basis items including appreciated, non-long-term capital gain assets) are generally taxed as ordinary income. Liabilities assumed as part of the overall deal arrangement are generally not taxable, provided it does not exceed the aggregate tax basis of the underlying assets being transferred. Accrued, unpaid liabilities assumed and not previously deducted for tax purposes are generally not included in the excess tax calculation.

Now, as a general rule of thumb with some intricacies not mentioned in this blog, the major pros and cons from a tax benefit perspective in the context of private M&A deals are as follows:

Pros over asset purchase election tax treatment under Section 338(h)(10) or Section 336(e):

  • Can achieve partial equity rolled-over deferral
  • No tax election filing protocol is required to be agreed to beforehand in order to effect an asset purchase treatment
  • Less of a burden regarding tax compliance since there is no purchase price allocation filing requirement with the IRS. Please note the parties involved are still required to file certain disclosure requirements with tax return filings and keep certain permanent records.

Pros over sale of partial LLC interest including conversion of target to an LLC pursuant to an F reorganization, which involve an S corporation target as described in this previously written blog from April 4, 2016.

  • Eliminate pass-through taxation treatment involving a partial sale of LLC. This would typically be the case with institutional investors who are interested in the investment return without the administrative burden involving pass-through entities.

Cons compared to an asset sale election tax treatment in general:

  • No flexibility with the handling of unpaid, accrued vacation. The purchaser will be the only party that can deduct the accrued, unpaid vacation assumed
  • In the case of accrual basis target, there is no flexibility with the handling of deferred revenue tax items being deferred under Rev. Proc. 2004-34. All such deferred revenue will be completely recognized in full with no exception unlike the sale of less than 50% of LLC interest.

Stay tuned for the next M&A shop talk. We’ll discuss the handling of deferred revenue items involving asset sale transaction arrangement. 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 jrodriguez@aronsonllc.com or (301) 222-8220.

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M&A Tax Shop Talk – “F reorganization” Part II

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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 jrodriguez@aronsonllc.com or (301) 222-8220.

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M&A Tax Shop Talk – “F reorganization”

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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:

  • Permits partial equity rolled-over on a tax deferral basis that cannot be achieved under an asset sale tax election reporting structure transaction under Sec 338(h)(10), and/or Sec 336(e) with no permitted tax deferral rolled-over flexibility. Please note that under certain unique sets of facts and circumstances, there is an alternative planning opportunity to achieve somewhat comparable tax results to both the seller and buyer parties using Sec 351. We will cover this alternate structure in a future blog. 
  • Facilitates the handling of deferred compensation items to be assumed by HoldCo and administer, and satisfied from the collection of future indemnity hold-back and earn-out payout, etc.

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 jrodriguez@aronsonllc.com or (301) 222-8220.

 

 

                             

 

 

 

 

 

 

 

 

 

 

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