As we explained in our article on Choice of Entity, choosing the right structure for a business will impact the management, liabilities, how it gets sold and most importantly for this article, taxes. Unlike C corporations, S corporations are subject to a single layer of federal taxation. Conversely, a C corporation is taxed first as an entity at the corporate rate, and then individual shareholders are taxed at their respective individual income tax rates. You might hear your tax adviser talk about S corporations as “pass through entities,” which means that S corporations are not subject to federal corporate taxes at the entity level. Instead, the federal taxes are “passed on” to individual shareholders. Nonetheless, S corporation shareholders still enjoy limited liability. That is, the corporation, but not the shareholders, is liable for debt or other financial liabilities of the corporation.
So, if S corporations pay fewer federal taxes, why aren’t all corporations formed as S corporations? First of all, there are a number of states that levy entity level taxes on S corporations, thus diminishing the tax benefits of this type of incorporation. Moreover, if the corporation operates in many states, the administrative burden on the shareholders can be quite large as they figure out what type of, if any, tax returns they may need to file in states where they are not resident. The most likely reason, however, for many corporations not choosing to elect S corporation status is the host of requirements that must be met:
- Must be a domestic corporation;
- Has only the following shareholders:
- individuals, certain trusts and estates;
- Cannot be partnerships, corporations, or foreign shareholders;
- Has no more than 100 shareholders;
- Has only one class of stock;
- Cannot be an ineligible corporation – certain financial institutions, insurance companies, domestic international sales corporations.
Moreover, all shareholders must agree to file an election to become an S corporation (and some trusts will need to make additional special elections to be qualified as shareholders). If a business meets all of the requirements described above, it may file Form 2553 with the IRS to elect to become an S corporation.
While S corporations are entitled to a myriad of tax benefits, as they look for growth and capital injection, they may find it necessary to shred the S corporation status. For example, many private equity funds are organized as partnerships and look to preferred stock as their mode of investment. As a result, upon admission of such investors, the corporation will lose its S corporation status.
Mergers and Acquisitions Involving S corporations
As the company grows, the owners may look to exit by selling the business. Like C corporations, the sale may take the form of a sale of asset or a sale of stock. However, additional options are available in a transaction involving S corporations:
- Section 338(h)(10) election: this type of election is explained in more depth in our article: The Unicorn of M&A: 338(h)(10) Elections
- Stock Sale: the buyer acquires the shares from the S corporation’s shareholders. This may be advisable if the costs of an asset sale or a 338(h)(10) election outweigh the benefits of receiving a step up in cost basis. See our article on Asset Sales vs. Stock Sales to learn more.
- Asset Sale: the S corporation transfers individual assets and liabilities of the corporation to the buyer.The buyer benefits from a step up in the cost basis to the fair market value of the acquired assets (more on this in the Asset Sales vs. Stock Sales article)
- Section 336(e) Election: allows shareholders who dispose of 80% or more of their stock within a 12-month period to classify their sales as an asset sale rather than a stock sale.
- F reorganization: this structural reorganization is a wise choice when the target company, or seller, wants to become a disregarded entity (See our article on DRE’s) but is prevented from doing so for tax reasons. For a more in-depth discussion, read F reorganizations.
Participants in mergers and acquisitions involving S corporations should be aware of the potential tax consequences arising from the special rules around S corporations. In many instances, the sale of the S corporation will result in the entity losing its S corporation status because there are strict limitations on who can own an S corporation. Neither C corporations nor partnerships are allowed thereby ruling out pension fund investors or private equity investors in most situations. Making 336(e) or 338(h)(10) elections, or restructuring as a disregarded entity or through an F reorganization may be means to provide better tax consequences facing buyers and sellers in negotiations involving S corporations.
As well, because of the strict requirements that must be met for a company to qualify as an S corporation, potential buyers should conduct comprehensive tax due diligence to ensure the entity has properly qualified and operated in a manner to maintain its S corporation status. Pitfalls are abundant in this area. For example, in order to elect S corporation status, all shareholders must sign the election form and in community property states such as California, this means both spouses must sign. Failure to do so would mean an invalid S corporation. In that situation, the company would be liable to a corporate-level tax which may become a liability of the buyer depending on the manner in which the purchase is carried out.
For the above reasons, when planning an M&A transaction with S corporations, it is doubly important to engage competent tax advisers to give weight to the many tax considerations and guide the participants through the process.