Common Corporation Purchase Structures To Obtain Step-up in Tax Basis When Equity Is Purchased
by: Christopher Klug – Business Tax Attorney, Washington DC
Buyers of businesses conducted through C or S corporations typically prefer to purchase assets in order to receive a step-up in tax basis of the assets of the corporation to the assets fair market value. This will allow for additional depreciation on depreciable assets and less gain on the later sale of the assets. It may be difficult to structure transactions as pure asset transactions since the corporation may own certain assets, such as licenses or government contracts, which are subject to restrictions on transfer. It may also be desirable to transfer equity rather than the corporate assets to simplify the documentation needed to effectuate the transaction from a legal standpoint.
It is common for buyers to purchase a corporation’s equity and to make elections under either Internal Revenue Code (“IRC”) §338(h)(10) or 336(e) in order for the transaction to be taxed as a deemed asset purchase. Such election allows the buyer to achieve a step-up in tax basis of the assets held by the corporation. Through a F reorganization, the seller may have the opportunity for a tax free roll-over of their retained interest.
IRC § 338(h)(10) – Deemed Asset Sale
A purchase through IRC § 338(h)(10) is common in the merger and acquisition deals. The buyer and seller both need to make an IRC § 338(h)(10) election in a transaction structured as a stock purchase for legal purposes, the transaction is deemed to be treated as a sale of the corporation’s assets followed by a liquidation of the corporation for tax purposes. As a result of the election, the buyer will receive the desired step-up in the tax basis of the underlying purchased assets of the corporation.
The following is required to make an IRC § 338(h)(10) election:
- All shareholders must agree to the election;
- The target entity must be a corporation;
- The purchaser must buy at least 80 percent of the total voting power and value of the stock of the target entity over a 12-month period; and
- The purchaser must be a corporation.
The disadvantage of an IRC § 338(h)(10) election as to other potential structures is that the seller cannot achieve a tax-free rollover of any retained stock. This is due to the fact that if the election is made, the seller must recognize gain or loss on 100 percent of the assets of the corporation even if less than 100 percent of the corporation is sold. Also, the selling shareholders cannot retain more than 20 percent of the stock interest in the corporation.
IRC § 336(e) – Deemed Asset Sale
The final treasury regulations for an IRC § 336(e) election only became effective in 2013. An IRC § 336(e) election has the same general goal of converting a transaction that is structured as a stock sale for legal purposes as a deemed asset sale and subsequent liquidation for tax purposes.
The IRC § 336(e) election is procedurally similar to an IRC § 338(h)(10) election in that:
- The target entity must be a corporation; and
- The acquisition must be for at least 80 percent of the stock of the target in a 12-month period.
One key of the IRC § 336(e) election is that the purchaser is not limited to a corporation, the purchaser may be an individual, partnership, or limited liability company.
Similar to an IRC § 338(h)(10) election, under IRC § 336(e) the seller must recognize gain or loss on 100 percent of the built-in gain or loss of the corporation. This election also does not facilitate tax-free rollovers for the sellers. In addition, the seller cannot retain more than 20 percent of the stock of the corporation.
The IRC § 336(e) election is viewed as more flexible than the IRC § 338(h)(10) election and allows for more creative ways to achieve a desirable legal and tax result.
Sale of Membership Interests in an LLC after an F Reorganization
As more and more transactions desire tax-free equity rollovers, sellers seek structures that allow tax to be deferred on the equity that is not sold in a transaction, the retained interest. It is important for sellers to have a liquidity event prior to being taxed on the transaction.
Since IRC § 338(h)(10) and IRC § 336(e) do not allow the seller to defer taxation on their retained interest, sellers of S corporations can attempt to achieve this goal by converting the existing target S corporation into a single member LLC through an F reorganization prior to the sale and transferring the single member LLC interests to the buyer.
In order to achieve this desired structure for the transaction prior to the closing, a seller needs to take multiple steps, including those listed below:
- The selling S corporation’s (“Target”) current shareholders form a new corporation (“NewCorp”) that elects to be an S corporation for tax purposes.
- The shareholders of Target contribute all of their equity interests in Target to NewCorp in exchange for NewCorp equity in the same proportion to their current equity ownership in Target. After the transfer, Target is wholly-owned by NewCorp.
- A qualified subchapter S (“Qsub”) election is made for Target. After this election, Target is treated as a disregarded entity for US federal income tax purposes. As a result, its activities will be reported on NewCorp’s tax return.
- Following the Qsub election, the Target is converted to a single member limited liability company. Since a single member limited liability company is a disregarded entity for tax purposes, Target’s conversion from a Qsub to a limited liability company is not a taxable event. All activity of the limited liability company continues to be reported on the NewCorp’s tax return.
- Buyer purchases a percentage of the membership interest of the limited liability company from NewCorp. NewCorp retains a portion of the membership interests of the limited liability company, with the retained membership interests representing the portion which NewCorp wishes to rollover on a tax-deferred basis.
- The resulting structure is that buyer and NewCorp each own a portion of the limited liability company. The limited liability company will be taxed as a partnership.
The sale is treated as a deemed asset sale because the buyer is treated as purchasing a percentage of each asset of the limited liability company. This allows the buyer to receive a step-up in basis to extent of their purchase. NewCorp will defer gain on the interest that was not sold as part of the transaction.
Stock and asset transactions will continue to be prevalent in mergers and acquisitions, however, alternative structures can achieve more desirable results under certain circumstances. The above shows an alternative where the seller is not taxed on their retained interest while the buyer receives a step-up in tax basis to the extent of their purchase.
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