If you are a former C corporation with an S election older than five calendar years (i.e., your business has been an S corporation since 1/1/2008) and are currently subject to built-in-gains (BIG) tax implications, there might be immediate relief in 2013 to permanently avoid BIG tax ramifications without IRS scrutiny.
General background information: The BIG tax regime is an S corporation, entity level tax calculated at the highest C corporation federal income tax rate (currently 35%) by some states (i.e., depending on the state taxing jurisdiction) and is imposed on the taxable recognition of net unrealized built-in gains (NUBIG) within the S corporation recognition period, which, unless modified by law, generally stands for the first 10 taxable years (full calendar years) of an electing S corporation. The calculated BIG tax is limited each reporting year within the S corporation recognition period to the calculated taxable income of the electing S corporation as a C corporation. Realized but unrecognized former NUBIG becomes a carried over tax item and is accounted as incurred for purposes of the BIG tax calculation in the subsequent year of the S corporation recognition period.
The NUBIG is comprised of all the C corporation deferred income tax items that include the taxable disposition of appreciated assets as further explained below within the S corporation prescribed recognition period. Depending on the state tax ramifications beyond the scope of this blog, the double taxation regime (i.e., combined S corporation and stockholder level tax on the same pass-through taxable income) could be as much as 70% in some cases. The NUBIG is measured at the S election conversion date and generally stems from either:
Note: The NUBIG items described above do not comprise an all- inclusive list.
The good news is that, thanks to Congress, the recognition period has been temporarily reduced from ten to five calendar years for 2013. Therefore, it is strongly recommended that any S corporation with an S election conversion, effective date of on or before January 1, 2008, should consider accelerating taxable income into 2013 and taking full advantage of the five-year reduced recognition period.
In the context of contemplated Sec 338(h) (10) or Sec 336(e) sales transactions involving a target S corporation with a BIG tax profile, you will need to run the numbers to get the full picture, but it might make sense to induce the seller party to accelerate the contemplated transaction into 2013 by reducing the asking price (i.e., sharing the tax savings).
If you would like more information regarding this topic or have any specific questions or concerns, please call your Aronson tax advisor or contact Jorge L. Rodriguez, CPA, Tax Director, at 301.222.8220.
Determining the most optimal tax structure to operate your current business enterprise depends on many factors such as the current life cycle of your business model, outside investor requirements, licensing issues, tax matters, financial constraints, bankruptcy considerations, and your exit strategy.
If asked to rank the importance of the listed factors, your exit strategy and tax matters should be considered in conjunction with each other and should be at the top of the list unless there are financial investor pre-requisite requirements. Generally, the correct analysis of these two factors tend to alleviate much of the inherit tension stemming from the other cited factors.
For example, if you are a successful technology company or government contractor, your exit strategy will most likely entail a sale of your business to a private equity investment group or perhaps to a public company. To sweeten the pot and maximize your after tax consideration, the ability to consummate a deemed asset sale treatment election for tax reporting purposes would be critical.
Purely from a seller party tax perspective, as a target, you ideally want to be operating as a pass-through entity (i.e., partnership or an S corporation) with no tainted assets subject to built-in gains tax implications (e.g., subject to potential double taxation) prior to consummating an asset sale transaction. However, this perfect world scenario might not be available to you because of evolving facts and circumstances and/or factors beyond your control such as previous ownership composition or perhaps financing structure involving third party investors requiring preferred equity participation.
Supposing that your future target corporation currently operates as a standalone C corporation or as a subsidiary of a consolidated tax filing group, should you consider restructuring to achieve pass-through tax status? The answer might be “no” because the most likely scenario for your particular exit strategy planning might simply be to sell the target corporation to a private equity investment group or a large public company and agree to make a Sec 338(h)(10) or Sec 336(e) election to account for the stock sales transaction as a deemed asset sale for tax reporting purposes (that would be generally tax favorable to the purchaser because of stepped-up and amortization of intangibles over 15 years). Note that, under the current regulation construct provisions, you can generally restructure without negative tax implications a standalone C corporation into a consolidated group filing tax structure in order to qualify for Sec 338(h)(10) and/or Sec 336(e) election provisions prior to consummating a qualified sales stock transaction.
Now, suppose you started a government contracting business a couple of years ago and you received tax advice that it would be beneficial for you to operate your business model as a C corporation because of the partial gain exclusion provisions under Sec 1202 available to a qualifying C corporation, small business stock upon future sale (i.e., provided the stock was originally issued to you and it was held for more than 5 years). Depending on your exit strategy timetable, economic climate and trends, market niche (including the current positioning of your business), technological advantage, and other factors beyond your control, the suggested tax structure might be quite ideal for you. However, a taxpayer’s ability to retain the use of a favorable accounting method that is generally available to large pass-through entities engaged in providing services (i.e., business model for which material and supplies is not a significant producing income items), such as cash basis, should be also be heavily factored into the overall decision making process. (See previous article: “Exploring Cash Basis for a Competitive Edge”)
If you would like to explore your tax operating structure options with regards to your particular set of facts and circumstances, please contact your Aronson LLC tax advisor or Jorge Rodriguez, CPA, Tax Director, at 301.222.8220.
In an acquisition scenario where an S Corporation is the target, it is common for the S Corporation’s shareholders and the qualified acquiring entity (the purchaser must be a corporation and/or members collectively of an affiliated group of corporations acquiring 80% of the underlying stock ownership of the target measured in terms of voting shares and fair market value within a 12-months prescribed period) to agree to making a joint election under Sec 338(h)(10). Under the Sec 338(h)(10) tax regime, the stock acquisition transaction is entirely disregarded by the selling shareholders and instead, the transaction is reported as a deemed asset sale by the target followed by its deemed liquidation (i.e., the remaining selling price considerations are deemed distributed to the selling S Corporation’s shareholders in exchange for the cancellation of ownership in the target’s stock and the S Corporation status is terminated). Accordingly, throughout the described deemed asset sale/ liquidation construct provision, the target’s S Corporation status remains in effect, and any gains or losses recognized on the deemed sale passes through to the shareholders (and their stock bases are adjusted for purposes of determining gain or loss on the deemed liquidation). Please be aware that the deemed asset sale tax construct provision described above might be subject to certain S Corporation-level tax implications such as built-in gain tax, which is beyond the scope of this article.
It is important to keep in mind that public companies typically will not pay a premium for participating in a Sec 338(h)(10) election. Public companies are driven by future earnings and the tax deduction might be alluring, but it generally does not drive the price of the majority of deals. In a private equity scenario, you might be able to negotiate part of the benefit. For purposes of this article, we will limit our discussion exclusively to an S Corporation target scenario and assume that the purchasing party is only willing to make you whole on the deal, meaning that the buyer is only willing to compensate you for the additional tax bite that you would pay on the ordinary portion of the deemed asset sale under a Sec 338(h)(10) tax regime.
Complicating and clouding the calculation and negotiation process is the newly enacted 20% top long-term capital gain rate, and 3.8% Medicare tax provisions applicable to certain passive shareholders with modified adjusted gross-income in excess of $250,000, as well as unique factors such as:
Negotiation consideration: As a purchaser, agreeing to reimburse for the 3.8% Medicare tax should generally be disregarded because it has nothing to do with the ordinary taxation of certain hot assets. However, agreeing to reimburse the 3.8% Medicare tax or part thereof might come into play as an inducement with regards to meeting the 80% ownership requirements, etc. Also, be fully aware that the list of overall factors above is not all-inclusive and is beyond the scope of this blog.
Under an ordinary S Corporation deal (i.e., the target S Corporation is non-leveraged, all the third party debt obligation will be paid at settlement, etc. ), the additional tax to be incurred from making a joint Sec 338(h)(10) election) should generally range from between 1.4% to 3% of the total overall maximum expected consideration. Another shortcut used to estimate the incremental tax bite is to simply multiply the calculated taxable portion of the target’s current net working capital at closing plus assumed nondeductible liabilities by the buyer times a factor ranging between approximately 16% to 17.4% (i.e., the incremental tax rate differential between the top long-term capital gain of 20% versus the ordinary rate of 39.6% adjusted for state tax benefit prepayment using DC, MD and VA income tax rates).
The aforementioned shortcut calculation approach should only be used as a working tool to estimate a preliminary sum to be agreed on in principle, but will need to be proven prior to closing by performing a formal calculation process. Furthermore, the percentage range being applied assumes that the current tax regime structure will not change in the future because of legislative action by Congress and/or court case rulings and that the entire purchase price allocation to be allocated to the intangible asset classes (including contract rights and goodwill) will be effectively taxed at the preferential long-term capital gains rate not to exceed 20%.
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.
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.