S corporations are widely used throughout the country, primarily by privately held businesses. As there has been an increase in merger-and-acquisition (M&A) activity in recent years, there has also been a disproportionately large number of S corporations selling as they become part of larger investment groups. A few typical structures are used when buying S corporations, depending on the desired result. Certain buyers may want to maintain flowthrough status but are not eligible to be S corporation shareholders, while others may want to own a C corporation as a result. However, one issue that continually arises is the desire for certain shareholders to roll a portion of their equity into the buyer, while other shareholders do not roll any equity. This item discusses some ways to effectuate this and the corresponding tax implications. This item does not address the family attribution rules.

 

The first thing to note is that there are no perfect solutions for this situation, and the rolling shareholder will be adversely affected primarily through the timing of gain recognition and cash. For the examples below, it is assumed that there is one S corporation that is owned equally by two shareholders. Shareholder A intends to roll over his entire interest into the buyer, while Shareholder B intends to sell her entire interest. The transaction structure with the buyer is simple: all cash, with no earnouts or seller notes. Additionally, the S corporation does not have any unrecognized built-in gain or residual earnings and profits from any time previously structured as a C corporation.

When the desire is for the target to maintain flowthrough status, one of the typical structures in the M&A space is performing an F reorganization under Sec. 368(a)(1)(F). In this structure, a new S corporation holding company is formed by the owners of the target S corporation, and the owners’ target stock is transferred to this new S corporation. The target S corporation is converted to a disregarded entity or an LLC taxed as a partnership. Then, the new S corporation sells a portion of the target (which is now a disregarded entity or partnership). This sale is a deemed asset sale for tax purposes under Rev. Rul. 99-5 or the sale of a partnership interest. The portion not sold is considered a rollover interest. Some buyers may prefer to purchase a partnership interest in order to receive the Sec. 743 deductions rather than purchasing a disregarded entity and negotiating such tax items as how depreciation will be allocated between the parties. That issue, however, is outside the scope of this discussion.

The gain from the sale is then allocated to the shareholders based on their ownership percentage of the new S corporation. However, in the examples discussed here, Shareholder B wants to exit the investment entirely and not roll any equity, which means that the cash proceeds should not be distributed pro rata. In these situations, the sellers have a couple of options, none of which get the shareholders to where they would be if they were selling a partnership or C corporation interest.

They could adjust the ownership immediately prior to the transaction or immediately after the transaction. Either way, this would be treated as a separate transaction from the acquisition of the target by the buyer.