In today’s economy, news of mergers, spin-offs or reorganizations can energize businesses and financial markets. Small businesses can also take advantage of these techniques to merge with a complementary company, spin-off a high-flying division or reorganize their capital structure.
Smart Business spoke with David L. Musser, a partner with Nichols Cauley & Associates LLC, about how S corporations can grow their business through mergers, acquisitions or reorganizations and assess the best tax strategy to achieve this.
How does this tax treatment work for businesses?
The reorganization provisions of the Internal Revenue Code, which are primarily located in the IRC Sections 354, 355 and 368, allow a variety of tax-free transactions in the form of combinations, divisions and recapitalizations. The tax-free treatment of these types of transactions is based on the theory that the corporation has essentially continued its old business within the corporate structure, without distributing boot or assets to the shareholders, despite the various implementing sales and exchanges.
Stated another way, the tax-free reorganization provisions of the Code are intended to recognize that in some cases there simply has not been a sufficient change in the economic circumstances of the corporation and its shareholders to justify the imposition of an income tax.
How can corporations realize tax-free transactions under the Internal Revenue Code?
The Code’s definitions are concerned with the form of the transaction rather than its substance. Accordingly, form plays an important role in achieving the desired tax result. This does not mean the economic consequences of a transaction can or should be ignored. Tests such as ‘business purpose,’ ‘continuity of shareholder interest,’ ‘continuity of business enterprise,’ and the ‘step-transaction’ doctrine can be applied to disqualify what otherwise seemingly qualifies, under the technical requirements of the Code, as a tax-free reorganization.
If the transaction meets the requirements for a tax-free reorganization, the property, stock and securities passing between corporations involved in the transaction and the stock and securities passing to shareholders of the corporations can be received without recognition of gain or loss. The price to be paid for tax-free (tax-deferred) treatment of reorganization exchanges is in the basis carryover and adjustment rules.
What other factors should a corporation consider when pursuing a tax-free reorganization/recapitalization?
A tax-free reorganization is only one way to acquire the assets or stock of another corporation. A major difference between a tax-free and taxable transaction is that stock of the acquiring corporation is the principal if not sole consideration that can be conveyed in a tax-free reorganization.
Some factors should be considered when deciding whether an S corporation should purchase the stock or assets of a target corporation, or combine with the target via a tax-free reorganization.
- The effect on the S election of the acquiring corporation
- Restrictions on what can be purchased
- Consideration conveyed to the target
- The effect of the target’s existence
- Recognition of gain or loss
- Basis and holding period
Corporations should also consider the following when determining whether to pursue a stock purchase, asset purchase or reorganization:
- Target shareholders often prefer stock sales due to capital gain and installment sales treatment. It may be difficult or impossible if regulatory approval is required. A stock sale avoids the reporting requirements that apply to asset sales (IRS Form 8594).
- S corporations may prefer an asset purchase because it allows new basis for depreciation and eliminates exposure to pre-purchase claims against the target. Paperwork needed to document the transfer of the assets can be burdensome. As with stock sales, regulatory approval may be required.
- In reorganization, the S corporation generally succeeds to the target’s earnings and profits, which can lead to liability for the tax on excess new passive income and termination of the S election after three years. S corporations may also be exposed to built-in gains tax for appreciation assets obtained from the target that are sold within 10 years.
- A method even exists to buy stock but, under IRC 338(h)(10), elect to treat it as an asset purchase.
Are there other options for corporations to limit their tax burden?
Corporations should also consider the introduction of qualified Subchapter S subsidiaries (QSubs). A QSub is a corporation 100 percent owned by an S corporation that has made a valid QSub election for that subsidiary. In addition to being 100 percent owned by an S corporation, a QSub must be a domestic corporation that otherwise meets the basic requirements to be an S corporation.
A QSub is technically neither a C corporation nor an S corporation. Instead, a QSub is not treated as a separate corporation for federal tax purposes (although it is still treated as a separate corporation for other purposes). A QSub’s assets, liabilities, and items of income, deduction and credit are treated as owned by the parent S corporation.
Whether acquiring a company or reorganizing, these tax techniques are highly complex, so it is imperative that you seek a tax professional before proceeding.
David L. Musser, CPA, CIA, CFP, is a partner with Nichols Cauley & Associates LLC. Reach him at email@example.com or (404) 214-1301.