Planning For Taxable Acquisitions of S CORPORATIONS

A relatively common characteristic of theacquisition of a closely-held business is tohave all or certain of the sellers retain orreceive equity positions in the business,which are often colloquially referred to inthe market by bankers and deal lawyers as“rollover equity.” This practice is particularlyprevalent in acquisitions of S corporations.

4 BUSINESS ENTITIES July/August 2016

S CORPORATION SALES

KNOW YOUR “

Planning For Taxable Acquisitions of S CORPORATIONS

Involving Equity Rollover for Sellers

C

BUSINESS ENTITIES 5

“ROLL”

When an S corporation sale with rollover equity for the sellers isimplemented, the transaction’s structural elements will affect

the parties’ tax treatment, as well as their interests in the continuing target business.

CASEY S. AUGUST AND PAUL A. GORDON

S corporation targets by definition mustbe closely-held corporations, and inpractice they are often controlled andoperated by the founding principals.In order to successfully transition own-ership of the S corporation target tothe new buyer, founding principal andmanagement sellers are often requiredby buyers to continue to work for thetarget after the sale transaction. Thiscommon paradigm makes post-trans-action seller equity retention or acqui-sition structures, including use ofrollover equity, a common commercialtool of S corporation target buyers toalign seller and buyer objectives forsuccessful financial performance afterthe S corporation’s purchase. Of course, the tax treatment of the saleand rollover transaction will depend onthe form of the transaction actuallyimplemented, which is often dictated bythe tax objectives and profiles of the sell-ing and buying parties. This articleaddresses certain tax and other com-mercial aspects of taxable S corporationacquisitions involving rollover equity forthe sellers, in order to provide a generalframework for thinking about associat-ed tax structuring issues for these typesof transactions.

Tax Structuring Issues for EquityRollover TransactionsAs a preliminary matter, the nature ofthe S corporation eligibility rules affectsthe possible forms that may be adopt-ed to implement a sale with rolloverequity.1 An S corporation is an eligible“small business corporation” that makesan election pursuant to Section 1362 tobe subject to the tax regime of Sub-chapter S of the Internal Revenue Code,which generally subjects S corporationearnings to a single level of tax at theshareholder level (rather than a C cor-poration’s separate levels of tax at theentity and shareholder levels).2Amongthe various initial and continuing S cor-poration eligibility requirements, an Scorporation must be a domestic entityclassified as a corporation and may onlyhave a single class of stock, all of theshares of which must be held by notmore than 100 shareholders, each of

whom fits within a category of eligibleshareholders.3To be an eligible shareholder, the

shareholder must be either an individual(not including a nonresident alien), adecedent’s estate, estate of an individualin bankruptcy, certain trusts, certain tax-exempt organizations, or a qualifyingESOP. A single-member LLC that is dis-regarded for tax purposes may hold Scorporation stock if its member is an eli-gible shareholder. Single class of stockdeterminations under the S corporationeligibility rules are generally based onthe shareholders’ relative rights to com-pany economics (both operating distri-butions and liquidating proceeds); and,consequently, S corporations cannot issuean economically preferred class of stock.4Additionally, S corporation-issued finan-cial instruments not expressly labeled asstock (such as promissory notes or war-rants) may nonetheless be treated as animpermissible second class of stock.5By operation of these eligibility

requirements, a valid S corporation oftenreflects a closely held operating compa-ny controlled by its founders. This S cor-poration organizational and operationalstructure often proves to be a prime can-didate for having sellers remain benefi-cial equity holders in their existingbusiness, through a rollover equity struc-ture, following an acquisition by an unre-lated third party.

Commercial Reasons. Sellers and buy-ers each have their own set of commer-cial reasons for using rollover equitystructures for S corporation sale trans-actions. Buyers (particularly financialbuyers such as private equity funds) maydesire to use rollover equity structures asa means of retaining and incentivizing thesellers for continuing service to the busi-ness on a longstanding and more con-crete basis than a short time horizonearnout or employment contract. Sellersmay prefer the greater return associatedwith an equity position in the ongoingbusiness, particularly as compared to acapped return associated with sellertransaction financing (for example, aninterest-based return as a creditor ratherthan a true entrepreneurial stake in theongoing company). Moreover, theretained equity position associated witha rollover may be combined with othercommercial arrangements like a put orcall option for the sale or redemption of

the rollover equity that could replicateearnout type arrangements.6 A rolloverequity component can also assist inbridging a deal pricing gap in seller andbuyer valuations of the business beingsold. As with all business tax planning, the

commercial objectives of the constituentparties and their tax profiles typicallydrive the tax form of the transactionimplemented. S corporation sale rollovertransactions are no different and the taxform of the transaction implementedmost often depends on a set of tax pro-file and commercial objectives of the par-ties, including those addressed below.

Asset vs. Stock Sale Tax Treatment.From the buyer’s perspective, the issue ofwhether the transaction will be treated asan asset sale for tax purposes pertains towhether there will be a stepup in the basisof the target’s assets caused by the pur-chase. This asset basis stepup providesbuyers with the ability to effectivelyamortize their purchase price for tax pur-poses through tax deductions to offsetfuture company taxable income (or,potentially, other income of the buyer).Assuming a majority of the sold busi-ness’s value is attributable to amortizable“Section 197 intangibles” (such as goingconcern value and goodwill), the pur-chase price will largely be amortizableas deductions recognized over a 15-yearperiod. Facing this amortization sched-ule, strategic buyers with a longer holdtime horizon often place a greater valuepremium on a basis stepup associatedwith an asset sale than financial buyerswith an anticipated shorter hold timehorizon (except to the extent the shorthold financial buyers anticipate a saleprice premium for the stepped up basisor a structural ability to provide a furtherstepped up basis for buyers on an exittransaction). In general, the relative seller cost of an

S corporation asset sale (as opposed to astock sale) compared to the significant taxbenefit associated with a buyer’s assetbasis stepup can economically supportasset sale tax treatment, where a C cor-poration business asset sale could not besupported. This is due to the generalflow-through tax structure for S corpo-ration earnings, which can allow forshareholders to receive the proceeds fromthe corporation’s sale of its assets withonly a single imposition of tax. Specifi-

6 BUSINESS ENTITIES July/August 2016 S CORPORATION SALES

CASEY S. AUGUST is an associate, and PAUL A. GOR-DON is a partner, in the Philadelphia, Pennsylvania,office of Morgan, Lewis & Bockius LLP.

cally, the gain or loss attributable to thetaxable portion of the actual or deemedasset sale transaction flows through fromthe selling S corporation to its share-holders.7Any gain passed through to theshareholders increases their “outside”basis in their S corporation shares, whichis available to allow for the proceeds fromthe asset sale to be distributed to theshareholders without the imposition ofadditional tax.8 An S corporation assetsale structure, however, does have thepotential to produce additional tax coststo the selling shareholders when com-pared to a stock sale structure. As a baseline for measuring against

asset sale treatment, a taxable sale of Scorporation stock produces gain for theseller measured by the difference betweenthe seller’s basis in the sold stock and theconsideration received, which is generallysubject to tax at preferential long-termcapital gains rates if the stock was held formore than one year.9 For a disposition ofan S corporation taxable as an asset sale,by contrast, the character of gain on theS corporation’s sale of its assets flowingthrough to its shareholders will corre-spond to the nature of the S corpora-tion’s assets sold.10 This means that theselling shareholders may recognize ordi-nary income attributable to certain typesof assets held by the S corporation,including cash method accounts receiv-able, appreciated inventory, and depre-ciation recapture on equipment.11

Additionally, an S corporation targetwith a C corporation history (includingto the extent assets held by the S corpo-ration had been held in a C corporationpredecessor or transferor and received

in a tax-deferred exchange) may be sub-ject to entity-level corporate tax in respectof an asset sale transaction as Section1374 “built-in gains” tax.12 An S corpo-ration shareholder also may have an “out-side” basis in its stock that exceeds the Scorporation’s corresponding “inside” basisin its assets, thereby creating additionalgain from the sale of assets from suchshareholder’s perspective. S corporationshareholders who purchased their S cor-poration stock after formation from anexisting shareholder often have this out-side-inside basis disparity.13 Althoughbeyond the scope of this article, theremay be additional state and local taximpact of an S corporation asset sale.Finally, an asset sale transaction involv-ing installment note consideration mayhave an unintended detrimental impacton expected tax deferral associated withthe seller’s use of the installment methodof accounting on an actual or deemedliquidation of the S corporation.14

These possible additional seller taxcosts associated with an asset sale mustbe carefully reviewed to inform whetheran asset sale structure is economicallyviable and establish the basis for nego-tiating a purchase price increase or oth-er commercial accommodation. Partiesto a transaction will often performextensive modeling in order to quanti-fy these additional costs to sellers andresulting tax benefits to a buyer. Thismodeling may form the basis of com-puting any negotiated gross-up paymentto the sel lers for addit ional taxesimposed for an asset sale structure ascompared to a stock sale structure. Thatbeing said, it is typically the case for an

S corporation target with no C corpo-ration tax status or successor asset his-tory that the tax benefits to a buyer ofan asset sale structure will significantlyexceed the associated increased tax costsof the sellers. Thus, astute sellers of Scorporations and their advisors oftenfocus on the tax benefit to a buyer of anasset sale structure rather than the taxcosts to sellers in negotiating a purchaseprice premium for such a structure. A buyer should also be mindful that

a properly structured asset sale transac-tion may not provide it with the full pur-chase price amortization benefits itanticipates. For instance, for equityrollover structures with the sellers hold-ing more than 20% of the sold businessdirectly or indirectly through an affili-ate, buyers must consider the potentialoperation of the intangible asset “anti-churning” rules of Section 197(f)(9).Additionally, for situations involving aseller receiving partnership interestrollover equity on a pre-tax (that is, tax-deferred) basis, a buyer may not receiveamortization benefits commensurate withthe full purchase price depending on theSection 704(c) method adopted withrespect to a Section 704(b) book account-tax account disparity created by the trans-action. These concepts are furtherdiscussed below.

Receipt of Rollover Equity On a Pre-or Post-Tax Basis. Sellers may receiverollover equity on a tax-deferred or“pre-tax” basis, meaning that they willonly pay tax on the portion of the con-sideration received in the transactionas non-rollover equity consideration.Alternatively, sellers may receive rollover

BUSINESS ENTITIES 7S CORPORATION SALES July/August 2016

Buyers may use rollover equity structuresas a means of incentivizing continuingconcrete service to the business.

equity on a “post-tax” basis, whichmeans that they pay tax with respect tothe sale of 100% of the company, includ-ing the portion of the company con-sidered sold for the rollover equity. Ingeneral, a post-tax equity rollover dealsignifies that sellers are effectivelyputting new equity into the entity issu-ing the rollover equity. Assuming thesellers are in a taxable gain position withrespect to their sale of the S corporationbusiness, the sellers would recognize“phantom” taxable gain on a post-taxrollover attributable to the value of therollover equity, albeit they likely willhave cash proceeds from the non-rollover equity piece of the transactionto pay this additional tax. As discussedbelow, the ability to implement a “pre-tax” or “post-tax” rollover structure isnot formally an elective one and requirescareful attention to the form and sub-stance of a transaction.

Whether Post-Transaction BusinessOperations Will Be Taxed on Flow-Through Basis. If the post-acquisitiontarget business is operated as an S cor-poration or partnership (or disregardedentity with an S corporation or partner-ship parent), the target business opera-tions will continue to be subject to asingle level of tax imposed on its ownerson a flow-through basis, as reported tothe owners on Schedules K-1. If the post-acquisition target business is insteadtaxed as a C corporation, future compa-ny earnings will become subject to twolevels of tax, one at the corporate entitylevel on earnings and another at theshareholder level on distributions. A buyer may require that a C corpo-

ration rollover equity structure be imple-mented for a variety of reasons.

Investment funds or other financial buy-ers with foreign or institutional investorsmay require a post-acquisition C corpo-ration structure to avoid effectively con-nected income (ECI) or unrelatedbusiness taxable income (UBTI) issuesfor their investors.15Additionally, a strate-gic buyer will most often be a C corpo-ration (such as would be required if thebuyer’s stock is publicly traded) and bedeeply motivated to avoid minority own-ership of its subsidiaries for a variety ofcommercial, accounting, and legal rea-sons. Although some strategic buyersprefer an identical tax profile for the tar-get (for example, so that the target canjoin the buyer’s consolidated group), theseissues can be overcome with LLC sub-sidiary structures, which would not lim-it tax consolidation based on thepercentage of rollover equity owned bythe target sellers.16A C corporation buy-er and target operating structure maynot provide much (if any) tax leakagefor the shareholder level of tax on dis-tributions from the buyer’s perspective,depending on the percentage of targetstock the buyer holds.17

Of course, the rollover sellers will notbe able to maintain their pre-sale flow-through tax treatment for the target busi-ness if it becomes operated as a Ccorporation. These rollover sellers hold-ing C corporation stock following thesale transaction will economically bearthe burden of a second level of tax oncompany earnings distributed to themas taxable dividends out of earnings andprofits in addition to the tax imposed atthe C corporation level. While detri-mental from an effective tax rate on earn-ings management perspective, rolloversellers may actually prefer this structure

for certain practical reasons. First, therollover sellers will not be burdened withthe extra reporting and administrativeburdens associated with continuing asminority members in a tax flow-throughentity. That is, because the direct resultsof company operations would no longerbe reported on their individual taxreturns, the rollover sellers would not beaffected, from a direct tax standpoint, bytarget company cash flow decisions thatthey likely no longer control as minori-ty owners (such as negotiating for andpolicing company tax distributions). Thisstructure would also reduce tax admin-istration and compliance burdens asso-ciated with receiving and reporting thetax operations of the company reportedto them on Schedules K-1 and similarstate and local tax forms. Thus, if the buyers anticipate ex-

panding the operations of the targetinto new states and locales, operating ina C corporation structure could signif-icantly reduce the tax compliance bur-den for the company itself as well as forthe rollover sellers. Additionally, rolloversellers may have an exit objective overthe short or medium term horizon.These rollover sellers may prefer thatthe company retain rather than dis-tribute company earnings with the goalthat they benefit from the appreciationin company value on a deferred basisupon the eventual sale of rollover stockat capital gains rates.

Post-Acquisition S Corporation Eli-gibility. For S corporation businessesintended to be operated as tax flow-through entities after the acquisition, theform of the acquisition may depend onthe continuing ability of the target tomaintain its valid S corporation election


1 By contrast, rollover equity sales of target enti-ties classified as partnerships, such as multi-member LLCs not making a check-the-box elec-tion to be classified as a corporation, do notexhibit some of the complexities associatedwith the S corporation rollover mattersdescribed in this article. Many of these S corpo-ration-specific complexities stem from the for-mal S corporation election and the Section338(h)(10) and 336(e) election eligibility rules.

2 Section 1366. 3 Section 1361(b). 4 Reg. 1.1361-1(l)(1). 5 Reg. 1.1361-1(l)(4). 6 Note, however, that such equity purchase rights

can raise concerns over whether sellers aretruly equity owners with respect to theirrollover equity for tax purposes depending on

the terms of such purchase rights and other rel-evant facts and circumstances.

7 Section 1366. 8 Sections 1367, 1368. 9 Sections 1001, 1221, 1222. 10 Section 1366(b). 11 Cf. Reg. 1.751-1. 12 Recently, Congress permanently shortened the

built-in gains tax “recognition period” to five yearspursuant to the Protecting Americans from TaxHikes (PATH) Act of 2015. The “recognition peri-od” had previously been ten years, subject toshortened periods for tax years beginning after2008.

13 This more factual scenario for S corporationsis less common when compared to partner-ships given the absence of a partnership taxa-tion Section 754 election analogue underSubchapter S.

14 See Eustice, Kuntz, and Bogdanski, FederalIncome Taxation of S Corporations ¶ 13.04[7][a][ii](Thomson Reuters/Tax & Accounting, 5th ed.,2015).

15 In these situations, however, it may be possible toretain flow-through tax treatment for the rolloversellers while implementing an ECI/UBTI C corpo-ration “blocker” structure for the buyer, includingby adopting the drop-down LLC structuredescribed below. However, these structures cre-ate structural conflicts of interests between buy-ers and sellers on exit planning and certain opera-tional issues and often result in the negotiation ofelaborate covenants to realign interests, leadingmany buyers to reject pursuing such structures.

16 Some strategic buyers in special industriesemploy “Up C” structures where the sub-sidiary tax partnership is used as a commonacquisition tool (e.g., UPREIT structures), butthis is a more prevalent paradigm for tax part-

or obtain qualified Subchapter S sub-sidiary (QSub) status through the sale.The tax profile of the buyer, the form ofthe acquisition financing, and the post-sale capital structure of the company allaffect this issue. In particular, any financ-ing obtained at the target level to fundthe purchase (such as under a leveragedbuy-out structure) may impact the abil-ity of the target corporation to retain itsS corporation or obtain QSub statusunder the S corporation eligibility rulesthat can consider financial instrumentslabeled as debt as an impermissible sec-ond class of stock.

Historical S Corporation Election Con-cerns. Issues concerning the validity ofthe target’s historical S corporation sta-tus have the potential to affect deal pric-ing and the form of the transactionultimately implemented. An invalid Scorporation election can cause a host ofcomplexities for the acquisition associatedwith two sets of risks for buyers. The firstpertains to all transactions, regardless of

form, that the buyer could bear risk forthe target’s historical unpaid corporatelevel taxes after the closing indirectly asthe owners of the target corporation ordirectly as a transferee of all of the cor-poration’s business assets imposed underthe tax laws18 or state law (for example,under a bulk sales or fraudulent con-veyance statute). The second pertains tothe risk that a buyer may not receive anasset basis stepup under a Section338(h)(10)/336(e) election structure,which election is predicated on a valid Scorporation target. In response, the par-ties may implement one of a set of struc-tural solutions to mitigate this risk to thebuyer’s desired asset sale tax treatment,including an outright sale of the target’sassets, as well as a drop-down LLC struc-ture or a pre-sale LLC conversion struc-ture described below.

Stock Purchase TransactionsFor situations in which the partiesagree that there will be no inside basisstep up in the target company’s assetsfor the buyer, the transaction will beimplemented as a stock purchase fortax purposes. A stock purchase for taxpurposes may take the transactionalform of an outright purchase of sharesof target stock, a “reverse” merger of asubsidiary of the buyer with and intothe target corporation, or in the formof one of these transactions coupledwith a redemption.19

Where rollover equity takes theform of the seller’s retention of stockin the sold S corporation, the sellerdoes not recognize gain or loss attrib-

utable to the stock. For rollover equi-ty in the form of the buyer’s or itsaffiliate’s equity, whether the sellerreceives this equity on a pre-tax orpost-tax basis generally depends onwhether this portion of the acquisitiontransaction qualifies as a nontaxablecapital contribution exchange underSection 351 (for corporation rolloverequity) or Section 721 (for partner-ship rollover equity). The tax rulesprovide greater flexibility for taxdeferral on partnership rollover equi-ty under Section 721 due to therebeing no analogue to the post-trans-action “control” requirement underSection 351 for corporations.20 Thus,while pre-tax rollover transactionswith partnership equity may involveexist ing partnerships,21 a pre-taxrollover with a corporation buyer typ-ically requires the formation of a newcorporation to issue the rollover equi-ty so that the rollover sellers could beconsidered members of a Section 351control group with the ultimate buy-er. Conversely, implementing a post-tax structure for the recipient ofcorporate stock rollover equity mere-ly requires that the rollover equityexchange not qualify as a Section 351exchange (or a Section 368 reorgani-zation), which generally can be con-trolled by the form given the rigidrequirements of these tax rules. Apost-tax equity rollover structureusing tax partnership equity, howev-er, is a much harder result to achievein a tax efficient manner given thatSection 721 is both much more expan-sive than Section 351 or 368 for sell-


nership targets for a variety of tax reasons out-side the scope of this article.

17 Earnings distributions from a subsidiary to itsSection 1504 “affiliated” corporate parent general-ly is not subject to a tax at the shareholder levelwhether by operation of the Reg. 1.1502-13 and1.1502-32 rules if the affiliates join in filing a con-solidated income tax return, or the Section243(a)(3) 100% dividend received deduction rulesfor affiliates reporting on a separate entity basis. Anonaffiliated parent corporation may receive aSection 243(a)(1) 70% dividends-received deduc-tion for subsidiary corporation distributions to ittaxed as Section 301 dividends.

18 See, e.g., Reg. 1.338-1(b)(3)(i) (new target result-ing from a Section 338 election liable for old tar-get’s federal income tax liabilities).

19 See Zenz v. Quinlivan, 213 F.2d 914, 45 AFTR1672(CA-6, 1954); Rev. Rul. 90-95, 1990-2 CB 67.

Astute sellers often focus on the tax benefitto a buyer of an asset sale structure.

ers and much narrower than Section1032 for corporate issuers. For the target business’s post-sale

operations, flow-through tax treatmentis only available when there are eligibleS corporation shareholder buyers or Scorporation buyers. For buyers that areeligible to hold S corporation stock (andany company leverage used to financethe deal does not risk being treated as animpermissible second class of stock),22

the buying and selling shareholders cancontinue to operate the target as an Scorporation. An S corporation buyermay also maintain flow-through taxtreatment for the acquired business if itobtains all of the target stock (so thatrollover equity is issued at the buyer

entity level), and the buyer makes aQSub election for the target effective onthe date of the acquisition.23

Stock acquisitions by non-S corpo-ration entities are not eligible for apost-acquisition flow-through taxstructure for the acquired business andresult in the target corporation becom-ing classified as a C corporation. Thisresults in a bifurcation of the target’stax year, with a short S corporationyear ending on the day before the saleand a short C corporation year begin-ning on the day of the sale.24 Target Scorporations joining a buyer’s consol-idated group as a result of the trans-action do so at the beginning of theday of the sale.25

Asset Purchase TransactionsS corporation sales treated as asset salesfor tax purposes that provide buyerswith an asset basis stepup may be imple-mented in a variety of ways. To reflectthe structure of an actual sale of assets,the S corporation may simply sell all ora portion of its assets or the S corpo-ration may merge with and into anacquiring entity as a “forward merg-er.”26 Nontax considerations, however,often make an outright sale of a targetcompany’s assets more challenging froman implementation perspective as com-pared to a stock sale. For example, thetarget may have contract assignment orregulatory consent issues that coulddelay and even impede an asset sale.


20 Section 351(a) requires that “one or more per-sons” participating in the contribution exchangebe in “control” of the corporation immediatelyafter the exchange. The one or more personsconstituting a “control group” are not required toparticipate in the property for stock exchangesimultaneously, but the regulations indicate that“the rights of the parties [be] previously definedand the execution of the agreement proceedwith an expedition consistent with orderly proce-dure.” Reg. 1.351-1(a)(1). “Control,” for purposesof Section 351, means the ownership of stockpossessing at least 80% of: (1) the total com-bined voting power of all classes of stock enti-tled to vote; and (2) the total number of sharesof all other classes of stock of the corporation.

21 See Section 707(a)(2)(B). 22 Given the dire consequences associated with

an invalid S corporation election, taxpayersgenerally rely on qualification for the “straightdebt” safe harbor of Section 1361(c)(5) to miti-gate risk that company issued debt constitutes

an impermissible second class of stock underthe S corporation rules. Among other require-ments, the straight debt safe harbor requiresthat the lender may only be a person eligible tohold S corporation stock or a person that isactively and regularly engaged in the businessof lending money (e.g., a bank).

23 See Reg. 1.1361-4(a)(2)(ii), Example 1. This QSubelection for the target should be treated as a non-taxable subsidiary liquidation into the buyer S cor-poration under Sections 332 and 337.

24 Sections 1362(d)(2), (e)(1). 25 This special exception to the “end of the day

rule” negates the need to file a one-day C cor-poration return for the target. See Reg. 1.1502-76(b)(1)(ii)(A)(2).

26 See Rev. Rul. 69-6, 1969-1 CB 104. 27 An S corporation’s distribution of equity in an enti-

ty to its shareholders triggers any unrecognizedgain inherent in the equity value pursuant toSection 311(b) (for operating distributions) orSection 336(a) (for liquidating distributions).

28 Reg. 1.197-2(h)(6). 29 Of note, a purchase of S corporation stock sub-

ject to a Section 338/336(e) election generallycleanses a Section 197(f)(9) anti-churning taintfor the sold business intangibles in the hands ofthe deemed “new corporation” acquiror in thetransaction. Regs. 1.197-2(h)(8), -2(k), Example23. However, this rule does not apply to theextent the persons subject to the anti-churningtaint (here, the rollover sellers) are considered“related” to the new corporation. Thus, a situa-tion with the sellers receiving more than 20%rollover equity in the buyer or its affiliates hasthe potential to create an anti-churning problemby operation of the constructive ownershiprules incorporated under the anti-churning rulesfor testing relatedness.

30 Although Congress authorized an electionunder Section 336(e) for deemed asset saletreatment in 1986, the IRS did not promulgatefinal regulations authorizing taxpayers to makeSection 336(e) elections unti l 2013. See

Thankfully, Congress has providedtaxpayers with methods to deem a saleof stock of a corporation to be a saleof the corporation’s assets solely fortax purposes via elections filed underSections 338 and 336(e). Another alter-native for implementing an asset saletax structure in the form of an equitysale involves a “drop-down LLC” pre-sale restructuring to have the transac-tion take the form of an S corporationholding company selling equity in adisregarded entity subsidiary that holdsthe target business assets. Further, theparties could execute a pre-sale LLCconversion of the target company toeffect an equity sale treated as an assetsale for tax purposes.

The parties may implement the cor-porate stock or tax partnership equityrollover consideration in the transactionon a pre- or post-tax basis as describedabove under the stock purchase para-digm, as well as under the additionalmethods described below. However, onlya post-tax rollover equity structure maybe employed when the selling S corpo-ration will distribute (or be deemed todistribute) the rollover equity to its share-holders.27 The post-sale operations ofthe target S corporation business may beoperated in a flow-through tax structureor in a C corporation structure, depend-ing on the tax classification of the buyerand any affiliate issuing rollover equity. Additionally, buyers should remain

aware of potential limitations on theirability to enjoy full purchase priceamortization benefits associated withthe asset sale basis stepup. The Section197(f)(9) anti-churning rules can pro-vide such a limitation for situationsinvolving a rollover equity componentthat provides the sellers with a 20%direct or indirect equity interest in thesold business. These rules apply if aperson “related” to the purchaser of anotherwise amortizable Section 197intangible (or to the post-purchase userof the intangible) held or used the intan-gible prior to 8/10/1993. Generally, aperson owning a direct or indirect 20%or greater interest in a corporation’sstock (by value) or a partnership’s cap-ital or profits is treated as related to thecorporation or partnership for the pur-poses of the anti-churning rules.28 Thus,if the target S corporation holds intan-gibles subject to the anti-churning rules,the intangibles may similarly beunamortizable in the hands of the buy-er depending on the relative size ofrollover equity provided to sellers.29

Deemed Asset Sale—Section338(h)(10)/336(e) Election. Section 338includes two deemed asset sale electionsfor stock sales made to a corporationbuyer, one under Section 338(h)(10) forsales of S corporation stock and stock ofan affiliated subsidiary (under an 80%vote and value test) and another underSection 338(g) for other qualifying stocksales. An election under Section 336(e)provides asset sale treatment similar to aSection 338(h)(10) election for situa-tions involving a transferee that is not acorporation.30

A Section 338(g) election for targetcorporations that are not S corporationsor affiliated subsidiaries results in twolevels of taxes—one at the target corpo-ration level attributable to the deemedsale of all of its assets to a “new” targetcorporation and one at the shareholderlevel attributable to the actual sale of thetarget stock.31As for all asset sale struc-tures involving two levels of tax, a Section338(g) election rarely makes economicsense because the amortization benefitsof the asset basis stepup for the buyersgenerally do not outweigh the addition-al tax cost associated with the imposi-tion of a separate corporate level of taxon the sale.32 By contrast, the deal eco-nomics often can support Section338(h)(10) or Section 336(e) electionsfor S corporation and affiliated subsidiarytargets. These elections deem the existingtarget entity to sell all of its assets and lia-bilities to a “new” target corporation withthe existing target corporation liquidat-ing immediately after the sale, generallyresulting in a single level of tax (subjectto any Section 1374 “built-in gains” tax).33

Although there must be a qualifying pur-chase or disposition of only 80% of thetarget corporation’s stock to be eligible fora Section 338(h)(10) or Section 336(e)election as described below, this electionproduces a fully taxable transaction forall of the pre-transaction shareholdersunder a deemed sale of all of the target’sassets, even for any nonselling share-holders.34 The tax rules accordinglyrequire all of the target corporation’sshareholders to consent to the filing ofeither of these elections.35

In order for a purchase to be eligiblefor a Section 338 or 336(e) election, itmust be considered part of a Section338 “qualified stock purchase” (QSP) orSection 336(e) “qualified stock disposi-tion” (QSD). The QSP and QSD require-ments generally mirror each other and,at a high level, necessitate that targetstock meeting the requirements of Sec-tion 1504(a)(2) (80% of vote and valuetest) be acquired/disposed of within a12-month period. Although superficial-ly simple, this test can prove to be a trapfor the unwary given that only certainacquisitions or dispositions of target stockmay be taken into account for purposesof a QSP/QSD test.36 In particular, theterms “purchase” and “disposition” forpurposes of these rules do not refer to


August, “Final Section 336(e) Regs. OfferTaxpayers Flexible Benefits,” 15 BET 14(September/ October 2013).

31 Section 338(a); Reg. 1.338-1(a)(1). 32 In practice, Section 338(g) elections are gener-

ally only contemplated for targets with signifi-cant usable net operating losses to shelter theentity-level gain triggered by the election or forforeign corporations that are not subject toU.S. taxation (i.e., foreign corporations notengaged in a U.S. trade or business).

33 Regs. 1.336-2(b), 1.338(h)(10)-1(d). 34 Regs. 1.336-2(b)(1)(iii)(A), 1.338(h)(10)-1(d)(5)(i). 35 Regs. 1.336-2(h)(3)(i), 1.338(h)(10)-1(c)(3). 36 For more detailed discussion of these

QSP/QSD qualification issues, see Rizzi,“QSPs and Other Formalities,” 38 J. Corp.Tax’n 14 (September/October 2011), andGeracimos, “Target Shareholder’s InvestmentMay Jeopardize 338 Election in LBO Transactions,”35 J. Corp. Tax’n 5 (September/October 2008).

stock acquired/disposed of if (1) the basisof the stock in the hands of the acquiroris determined in whole or in part by ref-erence to the basis in the hands of thetransferor, (2) the stock is acquired in anexchange to which Section 351 appliesor “is acquired in any other transactiondescribed in regulations in which thetransferor does not recognize the entireamount of the gain or loss realized inthe transaction” or (3) the stock is trans-ferred to a “related” person.37

These QSP/QSD requirements posea challenge for implementing rolloverequity for Section 338(h)(10)/336(e) elec-tion transactions. Initially, a pre-taxrollover transaction should not be avail-able for sellers in this transaction giventhat a Section 338(h)(10)/336(e) elec-tion transaction triggers gain for evennonselling target shareholders. More cru-cial to the validity of the structure itself,however, the rollover equity has thepotential to invalidate the Section338(h)(10)/336(e) election if it could beconsidered to involve a Section 351 orSection 721 transaction.

Specifically, using buyer stock or part-nership equity as rollover equity that isexchanged in a Section 351 or Section721 transaction could invalidate theintended QSP/QSD because it couldcause the entire transaction to be con-sidered to be subject to Section 351 or721, transactions explicitly excepted fromQSP/QSD treatment.38A possible struc-tural solution to this technical problemin a C corporation rollover equity struc-ture could involve having the buyer’s par-ent corporation issue the rollover equityin order to prevent Section 351 treat-ment at the acquiring entity level.39 Fortax partnership rollover equity, this struc-ture is not generally feasible because thereis no analogue to the Reg. 1.1032-3 rulesfor tax partnership equity considerationas compared to corporate equity con-sideration from the issuer perspsective.Moreover, rollover equity has the poten-tial to invalidate an otherwise good QSPor QSD to the extent it causes the rolloversellers to be considered “related” to thebuyer for Section 338/336(e) purposes.40

Given these challenges associated with

issuing seller rollover equity in a Section338(h)(10)/ 336(e) election stock sale,these structures are generally not usedfor S corporation sales with rollover equi-ty, as further described below.

Drop-Down LLC Structure. While aSection 338(h)(10)/336(e) electionstructure has the appeal of creating anasset sale that is accomplished in theform of a stock sale, there may be struc-tural or commercial impediments toadopting this form. First, Section338(h)(10)/336(e) election eligibilitydepends on the target being a valid Scorporation. Consequently, buyers areoften wary of entering into a Section338(h)(10)/336(e) election acquisitionwhen their diligence shows uncertain-ty with the validity of the target’s S cor-poration election. Also, a Section338(h)(10)/336(e) election may not beavailable due to the inability of the par-ties to implement a valid QSP or QSD,including due to the complexities asso-ciated with a rollover equity structure.Further, the parties may desire that theS corporation seller remain in existence


37 Section 338(h)(3)(A); Reg. 1.336-1(b)(5)(i). Thegovernment has not promulgated regulationsaddressing the quoted language.

38 See Chudy and Reddy, 788-3rd T.M. (BNA),Stock Purchases Treated as Asset Acquisitions—Section 338 § VI.C.5.; Rizzi, note 36, supra.

39 See Rev. Rul. 84-44, 1984-1 CB 105 (ruling thata merger of a target corporation into a sub-sidiary of an acquiring corporation with the tar-get shareholders receiving acquiring corpora-tion stock was not potentially characterized aSection 351 exchange because the sharehold-ers did not transfer any property to the acquir-ing corporation in exchange for their stock).

40 A structure using tax partnership rollover equi-ty in particular has the propensity to cause arelatedness problem for an intended QSP or

QSD under the modified Section 318(a) stockownership attribution rules applied under theSection 338/336(e) rules.

41 See Rev. Rul. 2008-18, 2008-1 CB 674. 42 Given its status as a “tax nothing,” the QSub

historical operating entity may itself be sold tothe buyer in a transaction treated as an assetsale. However, the parties generally will desirefor the QSub to become an LLC classified as adisregarded entity prior to the sale as amethod to mitigate historical S corporation riskto the buyer’s asset stepup and/or to allow fora post-sale flow-through tax structure for thepurchased business as a partnership or disre-garded entity rather than a C corporation.

43 Although a structure involving the historicaloperating entity becoming a disregarded entity

(rather than a Qsub) was not at issue in Rev.Rul. 2008-18, the IRS has ruled that this trans-action may nonetheless qualify as an F reorga-nization. See PLR 201314003.

44 Rev. Rul. 99-5, 1999-1 CB 434, Situation 1. 45 Regulations confirm the validity of using S cor-

poration LLC subsidiary investment structuresas a means to mitigate S corporation ineligibleshareholder and second class of stock risks.See Reg. 1.701-2(d), Example 2.

46 Reg. 1.197-2(g)(4), (h)(12)(vii). 47 The remedial allocation election also generally

accelerates property contributor goodwill gainand converts it from capital gain on an exittransaction into ordinary income.

48 Regs. 1.197-2(g)(3), (h)(12)(v)(A).

The ability to implement a “pre-tax” or “post-tax”rollover structure requires careful attention to the

form and substance of a transaction.

and/or retain certain unwanted assets,an impossibility under the deemed saleand liquidation of a Section 338(h)(10)/336(e) election. A seller may also desireto receive its rollover equity consider-ation on a pre-tax basis, which shouldbe unavailable in a Section 338(h)(10)/336(e) election transaction. Finally, theparties may desire to maintain a flow-through tax structure for the rolloversellers while implementing a non-flow-through C corporation structure for thebuyer, or to maintain a 100% flow-through tax structure following anacquisition involving ineligible share-holder buyers or target company-issuedfinancial instruments that raise S cor-poration second class of stock concerns,in each case in a manner that would bepractically difficult or impossible toimplement under a Section 338(h)(10)/336(e) election transaction. A commonly employed structural

solution to achieve these objectiveswhile retaining the flexibility associ-ated with the sale of equity treated asan asset sale for tax purposes is for theparties to implement a “drop-downLLC” structure. Under this structure,the parties effect the transaction as asale by an S corporation parent of anLLC disregarded entity subsidiary thatholds the business assets and liabili-ties to be transferred to the buyer. Thedrop-down LLC structure thus requiresthe sellers and the S corporation toundergo a pre-sale restructuring. Inits most simple iteration, this restruc-turing involves the S corporation trans-ferring its business assets and liabilitiesdesired to be sold to a newly formedsubsidiary LLC in exchange for all ofthe LLC’s membership interests. Sellers desiring to avoid implemen-

tation issues associated with an outrightasset transfer (for example, contractassignment consent issues) can achievethe same result through a Section368(a)(1)(F) “F reorganization” struc-ture. This involves the sellers forming anew S corporation holding company,transferring the existing S corporation’sstock to the new S corporation and, effec-tive immediately after this transfer, hav-ing the existing S corporation becomeclassified as a disregarded entity for taxpurposes.41 How the existing S corpo-ration is organized under state law dic-tates how this last step is accomplished.

If the S corporation is a state law corpo-ration, the entity will make a QSub elec-tion and then take steps to change itsstate law form to an LLC.42 If the histor-ical S corporation is organized as an LLC,the entity may file a check-the-box elec-tion on a Form 8832 to become classifiedas a disregarded entity.43

Upon completion of this preliminaryrestructuring, the S corporation parent,which is treated as the same entity as thepre-restructuring S corporation (asidefrom its new EIN in the case of an F reor-ganization structure), owns 100% of theequity in the subsidiary LLC disregard-ed entity that holds the business assetsand liabilities desired to be transferred tothe buyer. Then, the S corporation par-ent sells a portion or all of its LLC mem-bership interest equity to the buyer. Asale of all of the LLC membership inter-est equity is treated as the S corporation’ssale of all of the assets held by the LLC. For a sale of less than all of the LLC

membership interest equity (with theretained membership interest servingas rollover equity), the parties treat thistransaction as the buyer’s acquisition ofan undivided proportionate interest ineach of the LLC’s assets and liabilitiesdirectly from the seller S corporation,and, immediately thereafter, as a con-tribution by the buyer and the S corpo-ration seller of their respective interestsin these assets and liabilities to the LLCentity in exchange for their respectivemembership interests in the LLC, whichis now classified as a partnership for taxpurposes.44 Thus, a sale of less than allof the S corporation’s equity in the dis-regarded entity LLC target provides apre-tax rollover transaction for the Scorporation shareholders and also per-mits them to maintain a flow-throughtax structure for their continuing inter-est in the business through their inter-est in the operat ing company taxpartnership and the S corporation hold-ing company.45

While the drop-down LLC structureitself fits the asset sale paradigm with afull basis stepup with respect to the buy-er’s purchased interest in the businessassets, it may not provide a buyer with fullpurchase price amortization deductionbenefits. This is due to the operation ofthe partnership tax rules under Section704(c) (specifically, potential operation ofthe Section 704(c) “ceiling rule”), and

potentially due to the Section 197(f)(9)intangible “anti-churning” rules. Whilean in-depth discussion of these issues isbeyond the scope of this article, the buy-er can obtain full purchase price amor-tization benefits and avoid theselimitations if the LLC tax partnershipadopts the Section 704(c) remedial allo-cation method with respect to the pur-chase transaction.46 However, adoptionof this method is generally considered azero sum game for buyers and sellersbecause the sellers are consequently allo-cated notional amounts of ordinaryincome from the LLC as phantomincome (absent any associated LLC taxdistributions) corresponding to theamortization deductions allocated to thebuyer.47 This issue can understandablybecome contentious in negotiating thepurchase and LLC operating agreementdocuments in a transaction. For transactions in which this Sec-

tion 704(c) remedial allocation methodissue becomes a sticking point, partiesmay attempt to provide buyers with fullpurchase price amortization benefitswithout the phantom income pickup tosellers by having the target become clas-sified as a partnership prior to the trans-action. This would be accomplished byadmitting a second member in the targetLLC prior to the sale to the buyer. In thisway, the transaction would be structuredas a partnership equity purchase and thebuyer could receive full purchase priceamortization benefits through Section743(b) adjustments reported on itsSchedule K-1 and not Section 704(b)allocations with no impact on the seller.48

This structure, however, is not withoutrisk so that the parties should take appro-priate measures to support the validity ofthe pre-sale partnership classification ofthe target.

Pre-Sale LLC Conversion Structure.A similar method for implementing anasset sale for tax purposes that is con-sidered an equity sale for corporate lawpurposes is to convert the target S cor-poration into an LLC classified as a part-nership or disregarded entity effectiveprior to the sale transaction. This statelaw entity and tax classification conver-sion may be implemented pursuant to aso-called “formless conversion” from acorporation to an LLC in states that per-mit such an action, such as Delaware,California, and (Continued on page 47)


(Continued from page 13) Pennsylvania,or pursuant to a merger of the corpora-tion into a newly formed LLC.49 Theconversion will trigger all of the poten-tial asset level gain for the sellers as ataxable liquidation under Section336(a).50 The subsequent sale of some orall of the LLC equity would then pre-sumably not result in additional taxablegain to the sellers beyond their initial Scorporation liquidation gain. For thebuyer, its purchase of LLC equity wouldbe treated as a purchase of assets or taxpartnership equity, which provides theintended asset basis stepup (assuming aSection 754 election is made in the case

of a tax partnership equity purchasetransaction). The tax features of this structure for

the parties are identical to those featuresunder an actual asset sale paradigmdescribed above. Thus, S corporationbuyers and sellers opting for this type ofequity sale structure rather than an actu-al asset sale or forward merger asset salestructure generally have nontax com-mercial reasons for doing so (for exam-ple, contract assignment issues or otherissues associated with the target businessnot operating under the same EIN). Of course, sellers will not want to

undergo an LLC conversion prema-turely without assurance that the dealwill close due to the taxable gain trig-

gered by this deemed liquidation. Tomitigate this transaction implementa-tion tax risk, sellers often wait to causethe target S corporation to undergo theLLC conversion until the actual clos-ing. Parties following this commonly-employed path rely on the principles ofRev. Rul. 2004-59,51 which treats a part-nership to corporation formless con-version in the same manner as if this taxclassification change had occurred pur-suant to a check-the-box election. Treat-ing the converse situation involved in anLLC conversion (corporation to part-nership/disregarded entity tax classifi-cation change) in a similar manner,52

the check-the-box election rules requirethat the election is effective as of thebeginning of the election date so thatthe deemed taxable liquidation occursas of the end of the day prior to theelection date.53 This rule that triggersthe taxable liquidation on the day pri-or to the election effectively permitsthe sellers to implement the pre-saleLLC conversion structure at the sametime they actually close the sale trans-action. An alternate method for achiev-ing the same result that does not relyon Rev. Rul. 2004-59 would be for theLLC conversion to occur on the dayprior to the scheduled closing with theparties waiting until (or after) the clos-ing to determine whether or not acheck-the-box election should be made(effective as of the conversion).54 Thatis, an election via Form 8832 for thetarget LLC to be classified as a corpo-ration would be filed only in the eventthat the deal fails to close.55

ConclusionThe form of how an S corporation salewith rollover equity for the sellers isimplemented has a great impact on theparties’ tax treatment of the transaction,as well as their interests in the continu-ing target business. Thus, failure to con-sider all of the structural tax elements ofa transaction has the potential to pro-vide the parties with a tax result thatdiverges from their expectations. Well-advised buyers and sellers engaging in Scorporation sales with a rollover equitycomponent therefore should take par-ticular care to ensure that the parties’commercial deal is effectively carried outin the tax structure of the transaction. �


49 If the S corporation target entity is already orga-nized as an LLC under state law and has notmade a check-the-box election in the prior fiveyears (not including any initial elective tax classifi-cation upon formation), this structure may beimplemented by submitting a check-the-box elec-tion for the target to be classified as a disregardedentity or partnership (a “check and sell” structure).

50 See Reg. 301.7701-3(g)(1)(ii); CCA 200848036. 51 2004-1 CB 1050. 52 Given this factual distinction, Rev. Rul. 2004-59

technically does not apply to an LLC conversionstructure. However, practitioners generally believethat the same reasoning underlying Rev. Rul.2004-59 should similarly support check-the-box

election treatment for an LLC conversion. Partiesdesiring to mitigate risk on this issue may adoptthe alternative LLC conversion method detailed inthe text.

53 Reg. 301.7701-3(g)(3)(i). 54 A check-the-box election may be made effective

up to 75 days prior to the election filing date. Reg.301.7701-3(c)(1)(iii).

55 In this situation, an additional S corporationelection should not be necessary for the contin-uing LLC successor of the existing S corpora-tion operating company, although the LLCmembers may opt to file a protective election ifso desired. See Rev. Rul. 64-250, 1964-2 CB333; PLR 200622025; PLR 9636007.

S Corporation Sales

Documents

Planning For Taxable Acquisitions of S CORPORATIONS