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.
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):
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.
Cons compared to an asset sale election tax treatment in general:
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 email@example.com or (301) 222-8220.
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.