Much has been written regarding the limitations of the S corporation, especially the requirement that it have only one class of stock, and the prohibition against its having nonresident aliens, partnerships, or other corporations as shareholders. The fact remains, however, that there are thousands of S corporations in existence, out of which many closely held businesses operate.
For these businesses, the satisfaction of these requirements – i.e., living within these limitations and the attendant “lost opportunities”[i] – is the cost of securing and maintaining the corporation’s status as a pass-through entity[ii] for tax purposes.
There is one point in the life of the business, however – perhaps the most inopportune time – at which a corporation’s failure to satisfy these requirements or, stated somewhat differently, its inability to demonstrate that it has satisfied them, may cost its shareholders dearly. I am referring to the sale of the business and, in particular, the sale of all of its issued and outstanding stock.
I wish I could say that it is rarely the case for an S corporation that is in the midst of negotiating the sale of its business to discover that it may have lost its “S” status by virtue of having, for example, two outstanding classes of stock, but that would be inaccurate, as illustrated by a recent IRS letter ruling.[iii]
Before delving into the ruling, it may be helpful to review the “one class of stock” requirement and the tax consequences of a sale of an S corporation’s stock.
One Class of Stock
Under the Code, a corporation that has more than one class of stock does not qualify as a “small business corporation.”[iv]
A corporation is treated as having only one class of stock if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds.[v]
Differences in voting rights among shares of stock are disregarded in determining whether a corporation has more than one class of stock.[vi] Thus, if all outstanding shares of stock of an S corporation have identical rights to distribution and liquidation proceeds, the corporation may have voting and nonvoting stock.
In general, the determination of whether all outstanding shares of stock confer identical rights to distribution and liquidation proceeds is made based on the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds.[vii]
If a corporation qualifies as a small business corporation,[viii] and if its shareholders elect to treat the corporation as an S corporation for tax purposes[ix], then the corporation’s items of income, gain, deduction, loss, or credit will flow through to its shareholders, based on their respective pro rata shares, and will be taken into account in determining each shareholder’s income tax liability.[x]
The S corporation, itself, will not be subject to federal income tax.[xi]
Thus, the gain from the sale of the assets of an S corporation – or from the deemed sale of its assets (see below) – will be included in the gross income of its shareholders for purposes of determining their individual income tax liability. What’s more, the character of any item of gain (as ordinary or capital gain) that is included in a shareholder’s pro rata is determined as if such item were realized directly from the source from which realized by the corporation, or incurred in the same manner as incurred by the corporation.[xii]
A Stock Sale . . . ?
At this point, some may be wondering why the purchaser of an S corporation’s business would be acquiring the corporation’s stock instead of its assets.[xiii]
After all, in a stock deal, the buyer necessarily acquires all of the assets of the target S corporation,[xiv] both the assets that are necessary to the operation of the business, as well as those that aren’t. The buyer also takes subject to all of the target S corporation’s liabilities, both known and unknown, absolute or contingent,[xv] whether or not related to the operation of the business, including any liability for taxes owing by the target corporation.[xvi]
The buyer of stock also loses the opportunity, generally speaking, to step-up the basis of the assets acquired from the S corporation to their fair market value – the buyer’s cost for acquiring the assets[xvii] – and to expense, depreciate or amortize such cost, as the case may be, and to thereby recover their investment (i.e., the purchase price) faster than in the case of a purchase of stock.[xviii]
That being said, there are circumstances in which either the purchaser, or the shareholders of the target S corporation, may favor a stock deal.
For example, the S corporation may hold unassignable licenses or permits, or there may be contracts or other agreements, the separate transfer of which may require consents that will be difficult or too time-consuming to obtain.[xix]
A stock deal may also be easier to effectuate where the target S corporation’s assets are so numerous or extensive that it would be difficult or costly to transfer them separately. The purchase of the target’s tock would ensure the buyer of acquiring all of the necessary business assets owned or used by the corporation.
It may be that the purchaser wants to keep the corporation intact – as a going concern – perhaps after determining that the business has few liabilities,[xx] while also recognizing that is has great potential as is; only the management of the business needs to change.
Finally, the shareholders of the target S corporation will usually prefer a stock deal because it ensures them that their gain from the sale of the stock will be treated as long term capital gain for tax purposes.[xxi] If the purchaser wants the business badly enough, they will accede to the shareholders’ request.[xxii] It comes down to a question of leverage and risk allocation.
. . . And A Basis Step-Up?
Fortunately for the buyer, its decision to acquire the stock of a target S corporation does not always mean that the buyer must forfeit the ability to depreciate or amortize the purchase price. Even in the case of a stock deal, it may still be possible for the buyer to acquire a cost basis for the target S corporation’s assets, provided the selling shareholders agree to make one of two elections, depending upon the tax status of the buyer.[xxiii]
Thus, if the buyer is a single corporation, the buyer and each shareholder of the target S corporation may jointly elect to ignore the stock sale and to treat the transaction, instead, as a sale of assets by the target S corporation to a subsidiary of the buyer corporation, followed by the liquidation of the S corporation.[xxiv]
If the buyer is not a single corporation – for example, a partnership, an individual, or more than one person – then the shareholders of the target S corporation may be able to elect (without the consent of the buyer, but certainly at its insistence) to treat the stock sale as a sale of assets, as described above.[xxv]
It is unlikely that the shareholders of the target S corporation would make either of these elections unless they were asked to do so by the buyer. In that case, it is still unlikely that the shareholders would consent to the election unless they were compensated for any additional tax (including any deficiency) imposed upon them as a result of treating the transaction as a sale of assets – which may generate some ordinary income,[xxvi] or even corporate-level gain if the sale occurs during the corporation’s “recognition period”[xxvii] – followed by a liquidation of the target corporation (which may, itself, generate additional capital gain).[xxviii]
This compensation often takes the form of a “gross-up” in the purchase price for the target S corporation’s stock, such that the shareholders’ after-tax proceeds of a stock sale for which an election is made will be equal in amount to their after-tax proceeds of a stock sale without an election.[xxix]
Significantly, neither of these elections is available where the target is a stand-alone C corporation. Thus, it is imperative that the target corporation’s “S” election be intact at the time of the stock sale.
Which brings us to the letter ruling referenced above.
A Failed “S” Election?
Corp was a C corporation. Its board of directors amended Corp’s articles of incorporation to divide its common stock into shares of class A stock and shares of class B stock. The class A shares retained voting power and the class B shares held no voting power. The class A and class B shares otherwise conferred identical rights to distribution and liquidation proceeds.
The board subsequently amended Corp’s articles for a second time, to change the liquidation rights of the corporation’s stock. After this amendment, the class A and class B shares were entitled to receive equal shares of any assets of Corp in liquidation until a specified amount had been paid to each share. Upon reaching this amount in liquidation proceeds per share, the class B shares were entitled to receive the balance of any remaining assets of the corporation.
Corp later filed an election[xxx] to be taxed as an S corporation for tax purposes. At that time, Corp had only two shareholders.
Somehow unbeknownst to Corp, the election was ineffective because Corp’s two classes of stock prevented it from qualifying as a small business corporation. Corp claimed that its tax advisors were unaware of this amendment.
In addition, according to Corp, at the time this election was filed, its board of directors was either unaware or had forgotten that the distribution and liquidation rights had been changed, and differed for class A and class B shares, as a result of the second amendment to Corp’s articles of incorporation.
Corp indicated that its legal counsel discovered the second amendment,[xxxi] which created two classes of stock, in connection with due diligence performed by counsel in connection with the proposed sale of Corp’s stock by its two shareholders (the “Transaction”).
Upon learning of this issue, Corp’s board amended Corp’s articles prior to the Transaction to reconstitute the class A and class B shares into a single class of stock, with identical rights to distribution and liquidation proceeds, in order to rectify the ineffectiveness of Corp’s S corporation election.
Corp also asked that the IRS recognize the corporation’s status as an S corporation, effective retroactively as of the date requested by its original election.
In support of its request, Corp represented that it and its shareholders filed their respective tax returns consistent with Corp being an S corporation since the time of the failed election.
On the basis of the foregoing facts, the IRS concluded that Corp’s S corporation election was ineffective when made, as a result of the second class of stock that was created by the second amendment to Corp’s articles.
However, the IRS also determined that the circumstances resulting in the ineffectiveness of Corp’s election were inadvertent,[xxxii] and were not motivated by tax avoidance or retroactive tax planning.
The IRS also found that, no later than a reasonable period of time after discovery of the circumstances resulting in the ineffective election, steps were taken so that Corp qualified as a small business corporation.
Thus, the IRS decided to respect the “S” election,[xxxiii] provided that Corp, and each person who was a shareholder of Corp at any time since the date of the election, agreed to make any adjustments to their tax returns – consistent with the treatment of Corp as an S corporation – that may be required by the IRS with respect to the period beginning with what would have been the effective date of the election, through the date of the Transaction.
Corp and its shareholders were fortunate that the failed election was discovered prior to the consummation of the Transaction. It appears that they had sufficient time before the Transaction to request relief from the IRS, as reflected in the ruling described above.[xxxiv] It also appears that they had an understanding buyer; one that was willing to wait for them to put their tax situation in order.
What if events had unfolded differently?
For one thing, the buyer could have walked away from the deal. There are always other buyers, right? Or are there?
Perhaps the purchase price offered by this buyer was the highest that Corp and its shareholders had received. Or perhaps this buyer was the only one who had agreed to pay a gross-up to Corp’s shareholders in connection with an election to treat the stock sale as a sale of assets. Moreover, this buyer may have been the only one that agreed to pay the entire purchase price at closing, in cash, whereas other suitors had included a promissory note or an earn-out, each payable over a number of years, as part of their consideration for Corp’s stock. Or maybe this buyer had agreed to keep the business at its present location, and to lease such location from the former shareholders of Corp, who happened to own the property in a separate business entity, whereas other potential buyers had planned to consolidate Corp’s business into one of their other locations.
You get the picture.
Another “What If:” The SPA
What if the Transaction had closed without either side being aware of the failed “S” election, and what if the buyer had discovered the failure on its own after the sale? Worse yet, what if the IRS had audited Corp’s returns for the periods ending on or prior to the Transaction?
In the typical stock purchase agreement, the buyer asks that the sellers and the target S corporation make certain representations as to their stock ownership and as to the business and legal condition of the corporation. As in the case of other representations, these play a due diligence function in that the seller’s willingness to make a certain representation, or to schedule an exception to the representation, will disclose facts that are important to the buyer.
The representations also afford the buyer the opportunity to walk away from a deal where the closing occurs some period after the SPA has been executed by the parties.[xxxv] The sellers will state that their representations were accurate on the execution date, and will continue to be accurate through the closing. To the extent there is a “material” change in the accuracy of a particular representation, or if the buyer discovers that a representation is incorrect, then the buyer may call off the deal.
Finally, if the buyer suffers an economic loss after the closing that is attributable to an inaccurate representation, the buyer make seek to be indemnified by the sellers on account of the breached representation. The fact that the buyer had been given the opportunity to examine the target corporation’s records and documents prior to the sale will not provide a defense for the sellers.[xxxvi]
In the case of a target S corporation, the buyer may ask for the following representations and covenants (among many others) from the corporation and its shareholders: that the target S corporation has been a validly electing S corporation at all times, and will continue as such through the closing; that the corporation is not liable for the built-in gains tax; that they will not revoke the corporation’s “S” election, or take any action, or allow any action to be taken, that would result in the termination of such election (other than the sale to the buyer); and, at buyer’s option, that they will make an election to treat the stock sale as an asset sale for tax purposes.
Fast forward. The stock sale is completed and the target corporation is now a subsidiary of the buyer. The buyer subsequently learns that the target’s “S” election was either ineffective or had been lost prior to the closing of the stock sale. The buyer realizes that its newly acquired subsidiary was, in fact, a C corporation during the period preceding its acquisition.
As a result, the new subsidiary is liable for corporate-level income taxes for tax periods ending on or before the date of its acquisition by the buyer.
What’s more, the buyer and/or sellers’ election to treat the stock sale as a sale of assets was also ineffective. Consequently, the buyer did not obtain a recoverable basis step-up for the assets of its new subsidiary.
In addition, the buyer’s gross-up payment to the former shareholders of the target corporation need not have been made.
In short, the immediate economic result to the buyer from its purchase of the target corporation’s stock is substantially different from what it had planned, bargained for, and expected.
The buyer looks to the sellers to indemnify it for these economic losses. The buyer may be able to “recover” part of this loss from any portion of the purchase price that it had withheld, whether in the form of a promissory note, an escrow arrangement, or otherwise. The buyer may also have to seek recovery directly from the sellers.
In short, the economic result for the sellers is substantially different from what they had planned, bargained for, and expected.
Ease Their Pain
If the shareholders of an S corporation were honest with themselves, this is the point at which they wish they had listened to the very simple and straightforward counsel of their tax and corporate advisers.[xxxvii]
Among the nuggets of advice most often ignored by shareholders are the following:
- Enter into a shareholders’ agreement that includes transfer restrictions, as well as other safeguards, for preserving the corporation’s “S” status, including the buyout of shares where necessary;
- Require shareholders to share their estate plans (on a confidential basis) with the corporation’s counsel, so as to avoid any surprise transfers of their shares at their demise (like a transfer to a nonresident alien);
- Require shareholders to cooperate in restoring the corporation’s “S” election in the event it is inadvertently lost;
- Do not amend any corporate organizational or governing documents, and do not enter into any commercial agreements with shareholders, without first seeking tax counsel’s advice;
- Do not issue any convertible debt instruments without first seeking counsel’s advice;
- Do not issue equity-based compensation without first seeking counsel’s advice;
- Keep meticulous and contemporaneous records of any and all stock transfers;
- Provide for a drag-along right by which a majority shareholder may compel a minority shareholder to join in the sale of the corporation’s stock; and
- Require minority shareholders to join in making an election, at the option of the majority owner, to treat a stock sale as a sale of assets.
Granted, some of these are more easily attainable than others; for example, a minority shareholder may resist some of these suggestions.
One truth that cannot be disputed, however, is the following: a business owner should start to prepare for the sale of their business as soon as they go into business; they should act accordingly throughout the life of the business; getting the business “ready” for a sale is not something that they can adequately address just prior to the sale.
[i] For example, the infusion of equity from an investment partnership, or from an investor who wants a preferred return in exchange for their capital contribution, perhaps in the form of convertible preferred stock.
[ii] An entity that is not, itself, taxable, but the income, loss, etc., of which passes through to its owners.
[iii] PLR 201935010.
[iv] IRC Sec. 1361(b)(1)(D).
The term “S corporation” means, with respect to any taxable year, a small business corporation for which an election under Sec. 1362(a) is in effect for such year.
IRC Sec. 1361(b)(1) defines a “small business corporation” as a domestic corporation which is not an “ineligible” corporation and which does not (A) have more than 100 shareholders, (B) have as a shareholder a person (other than an estate, a trust described in Sec. 1361(c)(2), or an organization described in Sec. 1361(c)(6)) who is not an individual, (C) have a nonresident alien as a shareholder, and (D) have more than one class of stock. Sec. 1362(a)(1) provides that a small business corporation may elect to be an S corporation.
[v] Reg. Sec. 1.1361-1(l).
[vi] IRC Sec. 1361(c)(4).
[vii] Reg. Sec. 1.1361-1(l)(2). It should be noted that other arrangements may be treated as creating a second class of stock if a principal purpose thereof is to circumvent the one class of stock requirement.
[viii] IRC Sec. 1361(b).
[ix] IRC Sec. 1362.
[x] IRC Sec. 1366. These amounts will be reflected on the Schedule K-1 issued by the S corporation to each of its shareholders.
[xi] IRC Sec. 1363. There are exceptions; for example, where the built-in gain rule applies. IRC Sec. 1374.
[xii] IRC Sec. 1366(b).
[xiii] We’ll consider only a couple of the factors that favor an asset deal over a stock deal. There are others, including, for example: the target corporation’s ability to sell its assets to the buyer even in the face of opposition from some minority shareholders (though the sale may trigger dissenter’s rights); and the buyer’s ability to select which assets it wants to acquire, and which liabilities it will assume.
Speaking of recalcitrant shareholders, this is where the absence of a shareholders’ agreement with a drag-along provision may be felt keenly.
[xiv] Indirectly; in a sense, the buyer steps into the shoes of the selling shareholders.
[xv] Sellers in a stock deal are always asked to represent to the buyer that the corporation has no liabilities, obligations or commitments of any nature whatsoever, asserted or unasserted, known or unknown, absolute or contingent, accrued or unaccrued, matured or unmatured or otherwise, except (a) those which are adequately reflected or reserved against in the balance sheet [as of a specified date], and (b) those which have been incurred in the ordinary course of business consistent with past practice since the [date of the balance sheet] and which are not, individually or in the aggregate, material in amount.
[xvi] Because of this exposure, a stock deal will require more due diligence, which means the expenditure of more time and fees by both the buyer and the seller(s).
It will likely also require the buyer’s holdback or escrowing of a greater portion of the purchase price for a greater period of time.
With respect to the corporation’s tax liabilities, the parties will have to agree as to the preparation of returns, and the payment of any amounts owing, for tax periods ending on or before the closing date, or which begin before the closing and end some time after the closing date.
A related issue will be a more extensive indemnity agreement by the selling shareholders to indemnify the buyer for any losses suffered by the buyer as a result of a breach of a representation by the sellers regarding the state or condition of the target corporation and its business.
[xvii] IRC Sec. 1060 and Sec. 1012. In general, Sec. 1060 requires that the purchase price for the acquisition of the business be allocated among its assets.
[xviii] The cost of which is generally recovered only upon the subsequent sale of the stock or the liquidation of the corporation. IRC Sec. 168(k), Sec. 167, and Sec. 197. The Tax Cuts and Jobs Act (P.L. 115-97) extended the bonus depreciation deduction by allowing a buyer to expense the cost of certain “used” tangible personal assets.
[xix] Note, however, that many contracts include change-in-control provisions pursuant to which the “assignment” of the contract requires the consent of a party where the ownership of the “assigning” party (i.e., the target corporation) changes, as in the case of a stock deal. A large part of the due diligence process involves reviewing the target’s contracts and determining whether such consents are required,
[xx] Or liabilities that are manageable.
[xxi] Where there are too many shareholders with whom to negotiate, or where there are some shareholders who do not want to sell their shares, the stock deal may be structured as a reverse subsidiary merger. The result of such a merger is that the target corporation becomes a subsidiary of the acquiring corporation. For tax purposes, the transaction is treated as a purchase and sale of stock. See, e.g., Rev. Rul. 90-95.
[xxii] IRC Sec. 1221 and Sec. 1222. An individual’s gain from the sale of stock in a corporation (“S” or “C”) is taxed as capital gain; if the gain is long-term, a federal income tax rate of 20-percent will be applied; the same holds true for trusts and estates. IRC Sec. 1(h).
This should be compared to the sale of partnership interests. Although generally treated as the sale of a capital asset, the gain will be treated as ordinary income to the extent the purchase price for the interest is attributable to so-called “hot assets.” IRC Sec. 741 and Sec. 751.
If the selling shareholder did not materially participate in the business of the corporation, the federal surtax of 3.8-percent of net investment income will also apply to the gain. IRC Sec. 1411.
[xxiii] Congress recognized that there are circumstances in which the buyer has a bona fide business (non-tax) reason to acquire the stock of a target corporation. In some such cases, Congress decided it would be improper for the buyer to give up its ability to recover its purchase price for tax purposes; i.e., to have to choose between good business decision and a tax benefit. The result was the elections discussed below.
[xxiv] IRC Sec. 338(h)(10); Reg. Sec. 1.338(h)(10)-1.
[xxv] IRC Sec. 336(e); Reg. Sec. 1.336-1 through -5. It should be noted, if the buyer of the target’s stock does not want the sellers to make a Sec. 336(e) election, it should include a prohibition of such an election in the stock purchase agreement; specifically, a covenant not to make the election.
[xxvi] You’ll recall that the character of the gain – for example, ordinary income from the sale of receivables, or depreciation recapture from the sale of machinery – passes through to the target S corporation’s shareholders. The maximum federal tax rate for ordinary income included in the gross income of an individual is 37-percent.
[xxvii] IRC Sec. 1374.
[xxviii] IRC Sec. 331; Sec. 1371.
[xxix] The gross-up amount paid by the buyer will end up being allocated to the target’s goodwill and going concern value, and will be amortizable over 15 years under IRC Sec. 197.
[xxx] IRS Form 2553.
[xxxi] Presumably, counsel did not prepare or file the second amendment.
[xxxii] Within the meaning of IRC Sec. 1362(f).
[xxxiii] Assuming that Corp met all of the other requirements for status as a small business corporation.
[xxxiv] Or perhaps they asked for expedited handling.
[xxxv] As opposed to signing and closing on the same day.
[xxxvi] Query whether the sellers’ and the target’s attorneys have done their own diligence.
[xxxvii] “You can pay us now to fix the problem, and avoid bigger issues down the road,” they said, “or you can ignore us now, and pay a lot more to someone else down the road.”
About the Author:
Lou Vlahos practices tax law and has extensive experience in corporate, individual and partnership income taxation, and in estate and gift taxation, including tax planning, ruling requests, and tax controversy.
Lou counsels not-for-profit corporations in connection with reorganizations. He has advised cultural institutions, hospitals and other nonprofit organizations on their tax-exempt status, corporate restructuring, the creation and operation of supporting organizations (including fundraising entities), the structuring and acceptance of charitable gifts (including charitable trusts), compensation and other excess benefit issues, deferred compensation arrangements, and the taxation of unrelated business income.