Patrick Brown points out that many of us at Transact Capital have saved a deal from falling apart by using a special tax election which allows a buyer to purchase the stock of an S-Corp, and at the same time have it treated as an “asset purchase”. The article below summarizes the reason why this is beneficial and how to make the election.
If a C or S corporation is making a taxable acquisition of an S corporation, the preferred approach is often to buy the assets rather than all the stock.
The major benefits of this type of sale:
- The buyer avoids becoming legally responsible for the target corporation’s unknown or contingent liabilities.
- The acquiring corporation can “step up” the tax basis of the acquired assets to reflect the purchase price. This generates bigger post-purchase tax deductions and lower tax bills for the corporation.
But there’s a downside to a direct asset purchase: If there are a multitude of assets, the buyer must incur legal fees to transfer title to each of them.
In addition, if the target corporation has valuable non-transferable assets, such as favorable building leases, licenses and contracts, it can be difficult for the buyer to obtain legal ownership. And that can be a deal breaker.
But don’t walk away yet. The acquiring corporation can have its cake and eat it too by purchasing the target company’s shares and treating the entire acquisition as an asset purchase for federal tax purposes. Here’s the two-step plan:
Step 1 – The acquiring corporation buys all the target’s stock.
Step 2 – The buyer and the target S corporation then make a Section 338(h)(10) election. (A deadline must be met.) The deal is thus treated as an asset purchase deal, even though it is legally a simple stock purchase.
After the sale, the acquired S corporation continues to exist legally but the buyer owns all of its stock. So any unknown or contingent liabilities remain locked inside the target.
At the same time, the election allows the acquiring corporation to step up the tax basis of the target S corporation’s assets. If there are significant non-transferable assets, the buyer can effectively gain control over them because it owns all of the S corp’s stock.
The tax results for the target S corporation are the same as if it had sold its assets, paid its liabilities, and then liquidated. Gains from the deemed asset sales are passed through to the target’s shareholders.
While a Section 338(h)(10) election can benefit both the buyer and the seller, there are some issues to consider:
- Among conditions to be met to qualify for the election, the buying corporation must purchase at least 80 percent of the voting shares and at least 80 percent of all other stock within 12 months.
- If the asset sale results in ordinary income, the selling S corporation shareholder will generally pay higher income taxes and may want to negotiate a higher purchase price.
- There may be additional tax consequences if the target S corporation has been a C corporation within the last 10 years.
Important point: Because this strategy means the acquisition is treated as a direct asset purchase for tax purposes, the buyer generally needs a professional appraisal to allocate the purchase price to the specific assets to establish their initial tax basis. Consult with your tax adviser to help get the best tax outcome in business acquisitions.