It is important to consider various risk factors when acquiring a business. Some important considerations include federal and state tax implications, assumption of the target’s company’s liabilities, business continuity and integration, stockholder approval requirements, and more. When acquiring an S corporation, it is especially important to evaluate the target’s past and future S corporation qualification and consider how to best structure a transaction to reduce this significant risk.
Overview of S Corporations
An S corporation is a type of corporation that allows business owners to avoid double taxation. Unlike a C corporation, an S corporation does not pay federal income tax at the corporate level. Instead, its income, losses, deductions, and credits pass through to its shareholders, who report them on their personal tax returns. To qualify, the business must meet certain requirements set by the Internal Revenue Service, including having no more than 100 shareholders and only one class of stock.
Practical Consideration of Acquiring Stock
If a prospective buyer intends on purchasing all of a target’s outstanding stock directly from its stockholders, such stockholders would need to provide unanimous approval of the transaction. If the target has many stockholders or such stockholders are not aligned, this could be a significant hurdle or merely impractical. To account for this, transactions may be structured as a statutory merger, which requires, among other things, only a majority vote of the target company’s stockholders.
Risk of a Straight Stock Purchase
When acquiring stock in an S corporation, a significant risk is that a buyer could indirectly assume responsibility for all of the target’s potential liabilities to third parties, including unknown liabilities. Importantly, the assumption of liabilities to third parties includes the assumption of tax liability to the Internal Revenue Service and other applicable state and local taxing authorities. If a target’s S election has been invalidated and such target S corporation is no longer a pass-through entity as of the date of such invalidity, an unwary buyer could expose itself to the target’s tax liability for unpaid income taxes in prior years since the target would have been subject to taxation at both the corporate and stockholder levels as of the date it failed to qualify as a S corporation.
A buyer would also inherit the target’s existing depreciation schedules of its assets in a stock acquisition. This is generally unfavorable to a buyer because it may only depreciate the assets based on the existing depreciation schedule of the target, which could be significantly lower than the fair market value the buyer paid for the target’s equity. This results in less depreciation expense in contrast to an asset sale and, therefore, higher taxes after closing than if the buyer acquired the target’s assets. In an asset sale, for tax purposes, the buyer’s cost basis would have been written up to fair market value of the assets thus allowing the buyer an increased depreciation expense and lower taxes after closing. Although a prospective buyer could, in some circumstances, elect to structure the transaction as a stock purchase recharacterized for federal income tax purposes as an asset purchase, which would solve for such adverse tax implications, the legal implications such as assumption of liabilities would remain the same. In the event such target’s S election is deemed invalid, the election to recharacterize the transaction for federal income tax purposes would similarly be deemed invalid and the acquisition would be taxed as an acquisition of stock, not assets. Therefore, even when a buyer conducts significant due diligence, acquiring the stock of an S corporation still presents a risk of assuming an unanticipated tax liability that may prove difficult to recoup under an indemnity claim.
Reducing Risk with an F Reorganization
A common approach to sidestep many of these issues is to use a multi-step, tax-free restructuring of the target prior to closing called an F reorganization. An F reorg, as it is commonly referred to as, is the creation of a disregarded seller partnership entity to hold the to be acquired assets of the target business. This helps to avoid the risks presented by acquiring a target with an invalid S election while also keeping the structure of the transaction as an acquisition of equity.
However, rather than acquiring stock in the existing S corporation, an F reorg would allow the buyer to acquire the equity of a newly formed limited liability company, which, after the F reorg, would then hold the target’s assets.
Although more complex than acquiring stock in the target S corporation, having the target undergo an F reorg prior to closing avoids reliance on a valid S election. Consequently, the buyer would avoid assuming unanticipated tax liability and gain a stepped-up tax basis in the target’s assets since the acquisition of equity of a disregarded entity would be characterized as an asset sale for federal tax purposes. Moreover, if the buyer and seller intend to include equity as part of the purchase, an F reorg can permit the seller to obtain rollover equity on a tax deferred basis.
While engaging in an F reorg is a time sensitive and complicated multi-step process, when done correctly, it can be an effective tool to help the parties get to a successful closing.
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