Many business owners prefer to organize their business as an S corporation because it serves as a good middle ground between commercial and tax objectives — limited liability and a single level of taxation. However, S Corporation status is extremely fragile when compared to other business entities. A single ineligible shareholder or an improperly drafted operating agreement can “bust” the election, classifying the company as a C Corporation in the eyes of the Internal Revenue Service (“IRS”), subjecting the shareholders to “double taxation.”
If you are a buyer and the target’s S Corporation status is unclear, you risk inheriting any tax liabilities imposed on the target. Sophisticated buyers should consider structuring these deals to protect their investment and ensure a stepped-up tax basis (which allows for higher future depreciation deductions).
1. The Direct Asset Purchase
The simplest way to bypass issues with an S Corporation’s status is to buy the company’s assets (equipment, inventory, goodwill, etc.) directly from the corporation rather than buying the company’s stock.
- Why Buyers May Prefer It: You get a “step-up” in the tax basis of the assets generally equal to the purchase price, regardless of whether the S corporation’s status is valid.
- Downsides: If the S corporation status is defective, the corporation—not just the shareholders—owes tax on the sale. This “double tax” can reduce the cash otherwise available for the sellers and, in some cases, lead tax collectors to look toward the buyer as a “successor” for unpaid tax bills of the corporation. Every contract, title, permit etc. may need to be individually transferred to the buyer
2. The Taxable Forward Merger
In this structure, the target company merges into the buyer (or a subsidiary of the buyer). Legally, the target no longer exists, and the shareholders receive the cash proceeds of the sale.
- Tax Treatment: The IRS views this as if the target sold its assets and then distributed the proceeds of the sale to the target’s shareholders in liquidation of the business.
- Downsides: Similar to a direct asset sale, if the S corporation’s status is invalid, the “final” tax bill at the corporate level could be much higher than anticipated. This could potentially place the buyer on the hook for the target’s unpaid taxes. Note that in this structure, the target ceases to exist by operation of law, and the buyer may inherit any liabilities of the target automatically.
3. The “F” Reorganization and “QSub” Drop
If you want to buy the entire company (for example, to keep contracts or licenses in place) but are worried about tax “skeletons” of the target, the “F” reorganization can be a powerful tool. In an “F” Reorganization, one corporation takes on the tax “identity” of another corporation, including any historic tax liabilities.
The Mechanics:
- The sellers contribute their target stock to a new holding company (NewCo).
- This NewCo makes an election for target to be treated as a Qualified Subchapter S Subsidiary (QSub).
- The target is converted into a limited liability company.
- The buyer purchases all of the interests in target from NewCo.
The Result: For tax purposes, this transaction is treated as an asset sale. NewCo takes over target’s S corporation status and all other tax attributes of the target. The buyer gets a basis step-up in the target’s assets, and the target’s historic tax risk should stay with the sellers and NewCo.
4. Contractual Protections
Sophisticated buyers don’t just rely on structure; they allocate any unknown tax risk through contractual provisions in the sale contract.
- Tax Indemnities: Buyers negotiate specific clauses where the sellers are contractually obligated to pay any taxes resulting from a “busted” S Corporation status that would otherwise be borne by the buyer.
- Escrows: Where you are worried about collecting on a tax indemnity (i.e., a seller’s creditworthiness), a portion of the purchase price can be set aside in a separate account for ideally 3 years (the typical audit window) to ensure funds are available in the event of an IRS audit.
- Tax Insurance: It is common in the private equity space (and increasingly common in strategic deals) for parties to purchase Representations and Warranty Insurance (RWI) to cover the transaction risk, including tax risk. Note that Insurers will push to exclude S corporation risk from the policy, especially where issues with the S corporation’s tax status are discovered in due diligence.
Disclaimer: This article is for informational purposes only and does not constitute legal or tax advice. Every business situation is unique; please consult with your own tax professional.