Day 1 December 1, 2011:

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1 BUSINESS PLANNING WITH S CORPS, PART 1 & PART 2 First Run Broadcast: December 1 & 2, :00 p.m. E.T./12:00 p.m. C.T./11:00 a.m. M.T./10:00 a.m. P.T. (60 minutes each day) Though LLCs have become the choice of entity for many new businesses, S Corporations are pervasive among existing closely held businesses. Their tax advantages and the legacy of doing business as an S Corp often outweigh considerations to convert them to LLCs. But S Corps present many challenges for attorneys advising these companies real and substantial capital structure restrictions that can limit operational flexibility, capital raising, and growth; limits on certain types of fringe benefits and compensation structures for owner-employees; and challenges in structuring mergers and sales. This program will provide you with a real world guide to effective planning with S Corps in business transactions, compensation structures, tax planning, mergers and sales, and much more. Day 1 December 1, 2011: Overview of planning opportunities and challenges of S Corps v. LLCs Finance issues capital raising, restrictions on shares, commercial borrowing Operational issues allocations and distributions Shareholder issues restrictions on transferability, stockholder agreements, tax planning Day 2 December 2, 2011: Equity compensation available plans and structures, and their deductibility Employee fringe benefit restrictions and workarounds Employment tax planning opportunities, including changes by the new federal health care law Planning for the merger or sale of an S Corp Speakers: C. Wells Hall, III, is a partner in the Charlotte, North Carolina office of Mayer Brown LLP, where he advises clients on the tax aspects of acquisitions, reorganizations, and restructuring of business entities, and private equity transactions. He also represents taxpayers before the Internal Revenue Service and the North Carolina Department of Revenue. Mr. Hall formerly served as chair of the S Corporation Committee of the ABA Tax Section. He is a Fellow of the American College of Tax Counsel and the American College of Trust and Estate Counsel. Mr. Hall received his B.A. from North Carolina State University and his J.D. from Duke University School of Law. Ziemowit T. Smulkowski is a partner in the Chicago office of Paul Hastings, LLP, where his concentrates his practice in federal income tax issues related to all aspects corporate and business transactions, including mergers and acquisitions, venture capital funds, real estate investments, and management compensation. His represents clients in the acquisition and disposition of closely held businesses, debt and equity investments in real estate joint ventures, commercial loan transactions, employee buyouts of businesses and more. He also represents clients in tax

2 controversy matters. Mr. Smulkowski received his B.A. from Loyola University in Chicago and his J.D. from Northwestern University School of Law.

3 VT Bar Association Continuing Legal Education Registration Form Please complete all of the requested information, print this application, and fax with credit info or mail it with payment to: Vermont Bar Association, PO Box 100, Montpelier, VT Fax: (802) PLEASE USE ONE REGISTRATION FORM PER PERSON. First Name Middle Initial Last Name Firm/Organization Address City State ZIP Code Phone # ( ) Fax # ( ) Address I will be attending: Business Planning With S Corps, Part 1 TELESEMINAR December 1, 2011 Early Registration Discount By 11/24/2011 Registrations Received After 11/24/2011 VBA Members: $70.00 Non VBA Members/Atty: $80.00 VBA Members: $80.00 Non-VBA Members/Atty: $90.00 NO REFUNDS AFTER November 24, 2011 PLEASE NOTE: Due to New Hampshire Bar regulations, teleseminars cannot be used for New Hampshire CLE credit PAYMENT METHOD: Check enclosed (made payable to Vermont Bar Association) Credit Card (American Express, Discover, MasterCard or VISA) Amount: Credit Card # Cardholder Exp. Date

4 VT Bar Association Continuing Legal Education Registration Form Please complete all of the requested information, print this application, and fax with credit info or mail it with payment to: Vermont Bar Association, PO Box 100, Montpelier, VT Fax: (802) PLEASE USE ONE REGISTRATION FORM PER PERSON. First Name Middle Initial Last Name Firm/Organization Address City State ZIP Code Phone # ( ) Fax # ( ) Address I will be attending: Business Planning With S Corps, Part 2 TELESEMINAR December 2, 2011 Early Registration Discount By 11/25/2011 Registrations Received After 11/25/2011 VBA Members: $70.00 Non VBA Members/Atty: $80.00 VBA Members: $80.00 Non-VBA Members/Atty: $90.00 NO REFUNDS AFTER November 25, 2011 PLEASE NOTE: Due to New Hampshire Bar regulations, teleseminars cannot be used for New Hampshire CLE credit PAYMENT METHOD: Check enclosed (made payable to Vermont Bar Association) Credit Card (American Express, Discover, MasterCard or VISA) Amount: Credit Card # Cardholder Exp. Date

5 PROFESSIONAL EDUCATION BROADCAST NETWORK Business Planning With S Corps C. Wells Hall, III Mayer Brown LLP Charlotte, North Carolina (o) (704) whall@mayerbrown.com

6 TABLE OF CONTENTS Page I. C Corporation or Pass Through Entity (S Corporation, Partnership, or LLC)?... 1 A. In General... 1 B. Advantages of Operating as a Pass-Through Entity One Level of Tax on Earnings with Increase in Owner Basis for Undistributed Earnings Avoidance of Double Tax Upon Sale or Liquidation of Business Pass-Through of Losses... 3 II. Tax Treatment of Transfers of Property and Liabilities to an S or C Corporation... 4 A. Non-Recognition of Gain and Loss Property Transfer Stock Control Immediately After the Exchange... 5 B. Shareholder s Basis in Stock... 5 C. Shareholder s Holding Period in Stock... 5 D. Corporation s Basis and Holding Period in Transferred Property... 6 E. Boot... 6 F. Liabilities... 6 G. Depreciation Recapture... 6 H. Transfers to Investment Companies... 7 III. Tax Treatment of Distributions from a Corporation to its Shareholders... 7 A. Tax Treatment of Distributions From a C Corporation Taxation of Qualifying Dividends Under the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGA-2003) Actual Distributions Constructive Distributions Dividends vs. Capital Gain Treatment Redemptions and Distributions Treated as Exchanges Tax Treatment of C Corporation on Distributions Distribution of Non-Cash Assets i-

7 TABLE OF CONTENTS (continued) Page B. Tax Treatment of Distribution from an S Corporation General Distribution Rules for S Corporations Without Earnings and Profits General Distribution Rules for S Corporations With Earnings and Profits Ordering of Adjustments to Basis AAA Bypass Election Allocations of Tax Items IV. Subchapter S Eligibility Requirements A. In General B. Single Class of Stock Requirement Differences in Voting Rights Non-conforming Distributions Stock Taken into Account Governing Provisions Routine Commercial Contractual Arrangements State Law Requirements for Payment and Withholding of Income Tax Distributions that Take Into Account Varying Interests Buy-Sell, Redemption and Other Stock Restriction Agreements Special Rule for Section 338(h)(10) Elections Use of options and warrants Use of convertible debt Short Term Unwritten Advances Proportionately Held Debt Straight Debt Use of Stock Appreciation Rights and Phantom Stock C. Use of Joint Venture to Avoid Single Class of Stock or Shareholder Eligibility Limitations D. Electing Small Business Trusts as Shareholders Taxation of ESBTs ii-

8 TABLE OF CONTENTS (continued) Page 2. Application of Subchapter J Purchase of S Corporation Stock Termination of ESBT Status Sale of S Corporation Stock by ESBT Distributions With Respect to S Stock Tax-Free Reorganizations E. Removal of Prohibition on Affiliation; Subsidiaries Permitted by SBJPA Prior to Ownership of C Subsidiary Permitted Repeal of Former Inactive Subsidiary Rule F. Qualified Subchapter S Subsidiary QSub as a Disregarded Entity Upon Effective Date of Election Ownership Through Disregarded Entities Debt, Options and Other Instruments, Arrangements Election of QSub Status Tax Treatment Of QSub Election Application to Newly Formed Subsidiaries F Reorganizations Timing of Deemed Liquidation Effect of QSub Election on S Corporation s Basis in Subsidiary Stock Acquisitions of S Corporations AAA and Suspended Losses Application of Built-In Gains Tax to QSub Elections Conversion of Consolidated Group into QSub Group Reorganizations Involving QSubs Termination of QSub Election V. Social Security and Medicare Tax Considerations of Entity Choice A. In General B. Employees and Partners Contrasted C. The Health Care and Education Reconciliation Act of iii-

9 TABLE OF CONTENTS (continued) Page 1. The New Medicare Tax on Investment Income The Definition of Net Investment Income Passive Activities Trading in Financial Instruments and Commodities Net Gain from Dispositions of Property D. Choice of Entity And Social Security Taxes Individuals and Sole Proprietorships Employment Tax Considerations for Disregarded Entities (Single Member LLCs and QSubs) Estates and Trusts General and Limited Partners, LLC Members LLCs Taxed as Partnerships The Definition of Limited Partner Under the 1994 Proposed Regulations The Definition of Limited Partner Under the 1997 Proposed Regulations The 1997 Congressional Moratorium The Thompson Case Medicare Tax on NII Passed-Through to Partners and LLC Members E. S Corporation Shareholders S Corporation Dividends Not Subject to SE Tax Dividends or Compensation? F. Recap: The Scope of the 3.8% Medicare Tax Under the 2010 Act G. Planning Opportunities and Strategies in the Current Environment Use S Corporation to Operate Closely-Held Business LLC Electing S Corporation Classification for Tax Purposes S Corporation as Member of LLC with Investors as Preferred Members Corporation as Manager of Manager-Managed LLC Limited Partnership With Sole S Corporation General Partner iv-

10 TABLE OF CONTENTS (continued) Page 6. Member Managed LLCs Should be Used Only When All Members Are Service Providers VI. Tax Free Mergers and Acquisitions Involving S Corporations A. General Characteristics B. The Alphabet Soup of Tax Free Reorganization Patterns C. Type A Reorganizations Application to S Corporations Impact on Subchapter S Status Impact on Acquired S Corporation D. Type B Reorganization In General S Corporation as the Acquiring Corporation S Corporation as the Acquired Corporation Tax Attributes E. Type C Reorganization In General S Corporation as Acquiring Corporation S Corporation as Target Corporation Momentary Affiliation Regulatory Repeal of Bausch & Lomb Doctrine; Prior Stock Ownership of Target Tax Attributes F. Triangular Reorganizations Forward Triangular Merger ( an (a)(2)(d) Reorganization ) Reverse Triangular Merger ( an (a)(2)(e) Reorganization ) G. Two Step Reorganizations King Enterprises H. Type D Reorganization Acquisitive Type D Reorganization Similarity to Type A Reorganization I. Divisive Type D Reorganization Business Purpose v-

11 TABLE OF CONTENTS (continued) Page 2. Allocation of Income or Loss in Year of Division Distributions Built-in Gains Tax /Section Tax Attributes J. Section 368(a)(1)(E) Reorganization K. Section 368(a)(1)(F) Reorganization L. Section 351 Transactions VII. Taxable Asset Acquisitions and Stock Purchases Treated as Asset Acquisitions A. The Acquiring S Corporation B. Taxable Merger C. Shareholder Basis in Assets Direct Asset Acquisition Regular Section 338 Election Section 338(h)(10) Election Section 338 (h)(10) Election Mechanics Allocation of Basis Among Purchased or Deemed Purchased Assets Purchase of Section 197 Intangibles D. The Selling S Corporation Allocation of Income Recharacterization Built-in Gains Tax per Section Deemed Asset Sale Treatment for Certain Qualified Stock Sales Allocation of Consideration for Multiple Asset Sales Where Target is a Corporate Parent Corporation (not an 80% or more corporate subsidiary of another corporation) Mitigation of Target Corporation s Tax Cost on Asset Sale By Presence of Favorable Tax Attributes Where Target Corporation Is An S Corporation Avoidance of Step-Transaction Doctrine Redemptions of Target Stock vi-

12 TABLE OF CONTENTS (continued) Page 11. Going Public/Section 338 Transaction Reverse Merger of Acquiring Corporation into Target Corporation Treated as Qualified Stock Purchase Forward Merger of Target into Acquiring Corporation Treated as Asset Sale E. Target Shareholders In General S Corporation: Allocation of Income in Year of Sale Impact of Installment Sales by S or C Corporation Targets Complete Liquidation of Target Corporation Downstream Merger Direct Asset Purchase and Liquidation Reverse Merger of Acquiring Corporation into Target Corporation Treated as Qualified Stock Purchase Forward Merger of Target into Acquiring Corporation Treated as Asset Sale Forward Triangular Merger Section 338(h)(10) Election: Target C Corporation Impact of State and Local Taxes Section 338(h)(10) Election: Target S Corporation F. Tax Consequences to the Shareholders Selling S Stock In General Income Allocation in Year of Acquisition Additional Tax Consequences to the Target S Corporation and its Shareholders Distributions vii-

13 BUSINESS PLANNING FOR S CORPS C. Wells Hall, III Mayer, Brown LLP Charlotte, North Carolina I. C Corporation or Pass Through Entity (S Corporation, Partnership, or LLC)? A. In General. The determination of whether to use a pass-through entity, such as an S corporation, a partnership, or a limited liability company, rather than a C Corporation to operate a business or investment activity, may depend on many considerations, including the stage of the life cycle of the business. 1. The pass-through entity may be advantageous during the startup phase when losses may be generated, since the losses may be passed through to the owners. 2. When the corporation must retain its earnings to fund growth and operation of the business, lower C corporation rates may be considered preferable to higher individual rates. 3. When the business entity becomes highly profitable and it is desirable to distribute earnings to the owners, pass-through entity status will generally be preferable. 4. When the owners desire to sell the business, the pass-through entity will be preferable because of the single level of tax incurred by the owner (generally at the capital gain rate) upon the sale of the business or its assets. Unfortunately, conversion from pass-through to non-pass-through status and back (i.e. S to C to S) during the different stages of the business life cycle may be cost-prohibitive and impractical. A taxable liquidation of a corporation to obtain partnership tax treatment (i.e., conversion of corporation to an LLC) will trigger multiple levels of tax. Conversion from C to S status may result in the triggering of the LIFO recapture tax imposed by section 1363(d) of the Internal Revenue Code of 1986, 1 imposition of the built-in gains tax under section 1374, the loss of NOL carryovers under section 1371(b), and the 5-year limitation on election after termination under section 1362(g). The tax on excess passive income under section 1375 and the less favorable distribution rules for S corporations with accumulated E&P may also come into play. 1 Unless otherwise specified, all section references are to the Internal Revenue Code of 1986, as amended (the Code ), and all Treas. Reg., Reg., or Regulation references are to the Treasury regulations promulgated thereunder. -1-

14 The decision as to what type of pass-through entity to use may depend upon business, state law and other non-tax considerations, as well as the extent to which the flexibility afforded to partnerships and LLCs (when compared to S corporations) is of any significance to the business owners. In some cases, a combination of entities may be necessary. In the event the current business is operated by a C corporation, the choice may be limited to that of a tax-free conversion from C to S as opposed to a taxable liquidation or other restructure of the operations in order to form a partnership or LLC for the benefits of a pass-through entity. B. Advantages of Operating as a Pass-Through Entity. There are a number of advantages of operating a business as a pass-through entity: 1. One Level of Tax on Earnings with Increase in Owner Basis for Undistributed Earnings. The earnings of a pass-through entity are generally subject to only one level of tax at the owner level. In contrast, the earnings of C corporations are subject to a level of tax at the corporate level as well as at the shareholder level, when earnings are distributed to the shareholders as dividends. Accordingly, the maximum combined corporate and individual marginal rate for earnings distributed to shareholders of a C corporation will be higher than the rate imposed on the owners of a pass-through entity. If earnings are not distributed currently, an S corporation shareholder s basis in S corporation stock or a partner s basis in a partnership interest 2 is increased by the shareholder s or partner s proportionate share of the undistributed income of the S corporation. As a result, future distributions will be treated as a return of capital (except to the extent attributable to the corporation s E&P when it was a C corporation). If earnings are continuously accumulated, the shareholder s or partner s basis will increase, resulting in less gain upon sale of the stock or liquidation of the business. In contrast, a C corporation shareholder s basis in stock is not increased by the earnings taxed at the corporate level with the result that all of the gain (sales proceeds less original basis) is subject to capital gains tax upon the sale of the stock. 2. Avoidance of Double Tax Upon Sale or Liquidation of Business. Except for the ten-year recognition period for the built in gains tax after conversion of a C corporation to S status, shareholders of an S corporation or partners of a partnership are effectively subject to only one level of tax upon the sale of the business and assets of the corporation or upon the liquidation of the corporation. This makes the S election particularly attractive for corporations that expect the value of the business to appreciate substantially or which will hold appreciating assets or property. 2 For reference purposes, members of an LLC classified as a partnership for tax purposes are sometimes referred to in this article as partners in a partnership, and a membership interest in an LLC is sometimes referred to as a partnership interest. It is further assumed, unless indicated otherwise, that an LLC will not elect to be classified as an association taxable as a corporation under Reg (c)(1)(i). -2-

15 C corporations and C corporation shareholders, on the other hand, are subject to a double tax on the sale of the corporation s assets or upon liquidation. If the gain is taxed at the corporate level at the rate of 35% and the net distribution is taxed at the shareholder level at a 15% rate, the effective (corporate and individual) marginal tax rate for such a sale or liquidation by a C corporation is 44.75%. Accordingly, the S corporation is generally superior to the C corporation if the scenario may involve the sale of a business that has appreciated substantially in value. When the corporation s business is not expected to appreciate substantially in value (for example, in the case of a personal service business where the business is dependent upon the personal involvement of the individual owners e.g., legal, accounting and many health care businesses), the shareholders may desire to hold property with the potential to appreciate in a separate pass-through entity (for example, a general or limited partnership or an LLC). The partnership or LLC may lease the real property to the C corporation and maintain the opportunity for a single level of tax upon the sale of the property Pass-Through of Losses. The net loss of a pass-through entity is passed-through and taken into account by the owners in proportion to their ownership. For example, an S corporation shareholder or partner in a partnership may use his pro rata share of losses to offset other income, subject to the following loss limitations: (a) (b) (c) The shareholder or partner must have sufficient basis in his S corporation stock or debt or partnership interest to deduct the pro rata share of the losses. The shareholder or partner must have sufficient amounts at-risk to deduct losses under the at-risk limitation rules of section 465, if applicable. The shareholder s or partner s pro rata share of losses may be subject to the passive activity loss limitation rules of section 469. On the other hand, losses of a C corporation do not pass-through to shareholders, but are allowable as deductions only against future taxable income of the C corporation under the NOL carryover rules of section 172. Accordingly, when it is anticipated that a start-up business will incur initial losses, and the shareholders have other income that could be offset by such losses, it may be advantageous for the business to be operated as a pass-through entity rather than a C corporation. 3 Sales taxes or gross receipt taxes may be imposed upon lease payments made by the C corporation to the partnership or LLC. If the property is expected to produce losses, deductibility of such losses may be limited by the basis limitations, the at-risk limitation rules, or the passive activity loss rules. Lease payments made by the C corporation to the partnership or LLC may be subject to scrutiny if not set at a fair market rental amount. -3-

16 II. Tax Treatment of Transfers of Property and Liabilities to an S or C Corporation A. Non-Recognition of Gain and Loss. Under general tax principles, when a taxpayer disposes of property, gain or loss is recognized, measured by the difference between the fair market value of what the taxpayer receives in the exchange and the basis in the disposed property. However, section 351 overrides such principles by providing that shareholders do not recognize gain or loss on certain transfers of property to a controlled corporation in exchange solely for stock. At the corporate level, section 1032(a) provides that the corporation does not recognize gain or loss when it receives money or other property in exchange for its stock. The rationale is that these transactions merely change the form of the shareholders investment and are, thus, not appropriate events for taxation. The specific requirements of section 351 are: (1) one or more persons must transfer property to a corporation; (2) the property must be transferred solely in exchange for stock of the corporation; and (3) the transferors, as a group, must be in control of the corporation immediately after the exchange. Each of these statutory elements is discussed below. 1. Property Property includes cash, accounts receivable, inventory, patents and such other intangibles as goodwill and industrial know-how. Property does not include services. 4 Thus, if the new corporation issues more than 20% of stock in return for past, present or future services rendered, the issuance will take the entire transaction (including issuances of stock to the other shareholders for property) out of the ambit of section 351, making the transaction taxable. However, if a person receives stock for both property and services, he is generally considered a transferor of property and may count all the stock he received for purposes of the control test (below), unless: (1) the value of the property transferred is relatively small compared to the value of the stock received for services, and (2) the primary purpose of the property transfer is to qualify the exchanges of other transferors for non-recognition. 5 The IRS does not consider property of relatively small value if its value equals 10% or more of the value of the stock received for services Transfer All substantial rights in the property must be transferred to the corporation. A limited license of property (e.g., non-exclusive license to use technology) does not satisfy the transfer requirement, and any stock received for the license is treated as royalty income. 3. Stock Only stock in the corporation may be issued under the section 351 non-recognition regime. Issuances of stock rights, warrants, and convertible debt securities are not included Section 351(d)(1); Reg (a)(1)(i). Reg (a)(1)(ii). Rev. Proc , C.B Reg (a)(1). -4-

17 4. Control -5- The transferors of the property to the corporation are considered in control of the corporation if they, as a group, own at least (A) 80% of the combined voting power of all classes of stock entitled to vote, and (B) 80% of each class of nonvoting stock. 8 It is permissible for some transferors to receive voting stock while others receive nonvoting stock. Nonsimultaneous transfers are also permitted so long as the rights of the transferors have been previously defined and the agreement proceeds with an expedition consistent with orderly procedure Immediately After the Exchange When a transferor disposes of his stock shortly after issuance by the corporation in exchange for his property, there is a risk that the transferors, as a group, will fail the 80% control test if it is determined that the test should be applied after the disposition. Specifically, where a transferor disposes of the stock pursuant to a prearranged binding agreement that he entered into prior to the section 351 exchange, the control test is applied after the disposition. In such a case, a disposition of either (A) more than 20% of voting stock or (B) 20% of any class of nonvoting stock will disqualify the entire transaction. 10 A disposition by gift will not cause a transaction to fail the immediately after test. 11 B. Shareholder s Basis in Stock If the transaction qualifies under section 351, the shareholder s basis in the stock received in exchange for property will equal: (A) the shareholder s basis in the property transferred to the corporation (determined immediately before the transfer), less (B) any of the shareholder s liabilities assumed by the corporation, less (C) cash and other non-stock property the shareholder received from the corporation ( boot ), increased by (D) any gain the shareholder recognized as a result of the boot (as discussed below). 12 If the shareholder received more than one class of stock, the foregoing basis is allocated among the classes of stock in proportion to the fair market value of each class. 13 C. Shareholder s Holding Period in Stock The shareholder s holding period in stock received in exchange for a capital asset or section 1231 property includes the holding period of the transferred property. 14 The holding period of stock received in exchange for an ordinary income asset (e.g., inventory or accounts receivable) begins on the date of the exchange. If stock is received for a combination of both Section 368(c). Reg (a)(1). See Intermountain Lumber Co. v. Commissioner, 65 T.C (1976). See Wilgard Realty Co. v. Commissioner, 127 F.2d 514 (2 nd Cir. 1942), cert. denied, 317 U.S. 655 (1942). Sections 358(a)(1); 358(d). Section 358(a)(1); Reg (a)(2). Section 1223(1).

18 capital and ordinary income property, each share of stock takes a split holding period, allocated in proportion to the fair market value of the transferred property. 15 D. Corporation s Basis and Holding Period in Transferred Property The corporation s basis in the transferred property is the same as the transferor s basis, increased by any gain the transferor recognized on account of boot. 16 The corporation s holding period includes the transferor s holding period, regardless of whether the transferred property was a capital asset or section 1231 property in the transferor s hands. 17 E. Boot If a shareholder received boot, the shareholder must recognize gain (but not loss) to the extent of the fair market value of the boot. 18 When several properties are transferred in exchange for a combination of stock and boot, the boot must be allocated among the transferred properties in proportion to the fair market values of each, and any boot allocated to a loss property will not cause a recognition of gain or loss. 19 If the corporation transfers an appreciated asset to a shareholder as boot, the corporation is required to recognize gain on the transfer as if it had distributed the asset in a section 311(b) transaction (shareholder distribution). 20 F. Liabilities If the corporation assumes a liability of the transferor or takes the transferred property subject to a liability in a section 351 exchange, the liability is generally not treated as boot to the shareholder. 21 However, the liability relief is boot if the liability was transferred to the corporation for the purpose of avoiding federal income tax. 22 In addition, if the liability relief exceeds the aggregate bases of the transferred properties by a particular transferor (i.e., debt in excess of basis), the excess is treated as gain from the sale or exchange of property. 23 G. Depreciation Recapture Section 351(a) also overrides the depreciation recapture provisions (except where the transferor must recognize gain as result of receipt of boot). The potential recapture gain is preserved in the transferee corporation s basis in the transferred property. 24 Also, a transferor who transfers an installment note to the corporation in a section 351 exchange is not required to Rev. Rul , C.B Section 362(a). Section 1223(2). Section 351(b). Rev. Rul , C.B Section 351(f). Section 357(a). Section 357(b). Section 357(c)(1). Sections 1245(b)(3); 1250(d)(3). -6-

19 recognize gain (if any) on the transfer. 25 The tax consequences of the installment note in the transferor s hands carry over to the transferee corporation. H. Transfers to Investment Companies Transfers to a corporation equivalent to an investment company as defined in section 351 do not qualify for non-recognition. The purpose of this rule is to prevent tax-free diversification by transferring appreciated portfolios of securities in exchange for stock of a newly formed investment company. 26 Generally, a contribution to a corporation will be considered to be made to an investment company if (a) the transfer results in diversification of the transferor s assets under a mechanical diversification test in the Code, and (b) more than 80% of the partnership s assets are stocks or securities held for investment. 27 III. Tax Treatment of Distributions from a Corporation to its Shareholders A. Tax Treatment of Distributions From a C Corporation 1. Taxation of Qualifying Dividends Under the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGA-2003) (a) After the amendments to the Code by JGA-2003 (effective January 1, 2003), the term qualifying dividend income means dividends received during the taxable year from domestic corporations and qualified foreign corporations received by a non-corporate taxpayer (i.e., a taxpayer whose capital gain income is subject to section 1(h). 28 The tax rate on qualifying dividends received by taxpayers between January 1, 2003 and December 31, 2008 is set at a maximum of 15% (5% for low income taxpayers). (b) Such term does not include: (1) Any dividend from a tax-exempt corporation. 29 (2) Any tax deductible dividend paid by a mutual savings bank. 30 (3) Any deductible dividend paid by a C corporation with respect to employer securities in a qualified plan that is paid to a plan participant Reg (c)(2). 26 Section 351(e); Reg (c). 27 Section 351(e)(1)(B) lists the following assets that are treated as stocks and securities (1) money (contrary to the Regulations which have not been updated); (2) stocks, options, forward or futures contracts, notional principal contracts and derivatives, (3) foreign currency, (4) interests in real estate investments trusts, common trust funds, regulated investment companies, publicly traded partnerships, (5) interests in precious metals, (6) interests in any entity if substantially all of its assets include the foregoing, and (7) any other assets specified in the Regulations. 28 Section 1(h)(11)(B)(i)(I) and (II). 29 See sections 501 and 521. Section 1(h)(11)(B)(ii)(I). 30 See section 591. Section 1(h)(11)(ii)(II). 31 See section 404(k). Section 1(h)(11)(B)(ii)(III). -7-

20 (4) Any dividend paid with respect to stock held by the shareholder for less than 60 days during the 120-day period beginning 60 days before and ending 60 days after the ex-dividend date. 32 (5) Any dividend paid by a RIC or REIT to the extent deductible in computing the table income of such entity. 33 (c) (d) If the taxpayer receives any dividends that constitute extraordinary dividends on stock under section 1059(c), any loss on the sale or exchange of such stock shall, to the extent of such dividends, be treated as long-term capital loss. Generally, an extraordinary dividend on preferred stock exceeds 5% of the shareholder s adjusted basis, and on common stock, 10% of the shareholder s stock basis. Qualifying dividend income shall not include any amount which the taxpayer takes into account as investment income under section 163(d)(4)(B). 2. Actual Distributions For purposes of Subchapter C, a distribution is any kind of payment (e.g., cash, stock in the corporation or other property) by a corporation to its shareholders in connection with their stock. A dividend is a distribution out of the corporation s current or accumulated earnings and profits ( E&P ). 3. Constructive Distributions In addition to outright distributions of cash and other property to its shareholders, a corporation may transfer cash or other property to (or make the same available for use by) one or more of its shareholders without characterizing the transfers as distributions. Such transactions may be reclassified as constructive distributions to the shareholders if the facts and circumstances surrounding such transactions give rise to a determination that the corporation was merely attempting to avoid the double tax by not formally labeling the transaction as a distribution. As with actual dividends, there must be either current or accumulated E&P in order for there to be a constructive dividend. Following are some examples of constructive distributions. (a) Unreasonable Compensation If the corporation pays a shareholder (or the shareholder s relative) who is also an employee of the corporation more than reasonable compensation, the excess is treated as a dividend with the consequence that the corporation may not deduct such excess as a business expense. The employee is required to include the full amount in his gross income in any case. Note that the failure of a closely-held corporation to pay dividends is a significant (but not Section 1(h)(11)(B)(iii). Section 1(h)(11)(D)(iii). -8-

21 conclusive) factor in determining whether compensation paid to a shareholder-employee is unreasonable. 34 (b) Bargain Sales/Leases To Shareholder If the corporation sells or leases property to a shareholder at below market rates, the fair market value of the property (or fair market rents) minus the amount paid by the shareholder constitutes constructive dividends. (c) Excessive Sales/Leases to Corporation On the flip side, where the corporation pays more than market rates to purchase or rent property from a shareholder, the excess amounts constitute constructive dividends. (d) Shareholder s Personal Expenses Corporate payments of expenses that provide only incidental or no benefits to the corporation may be reclassified as dividends. (e) Payment on Reclassified Debts If a shareholder s debt to the corporation is reclassified as equity, corporate payments of interest and principal on such debt are treated as dividends. (f) Corporate Low Interest Loans If the corporation lends money to a shareholder at below market interest rates, the foregone interest is treated as dividends to the shareholder (followed by a deemed payment of the same amount to the corporation as interest). 35 (g) Corporate Loans Without Payment Expectation If a corporate loan is made to a shareholder without an expectation of repayment, the entire amount (principal plus foregone interest) may constitute a constructive dividend. 4. Dividends vs. Capital Gain Treatment A three-prong test is applied in assessing the tax treatment of distributions determining the distribution amount, determining how much of the distributed amount constitutes a dividend, and ascertaining whether the remaining amount is a recovery of capital and/or capital gain. Under JGA-2003, the effective tax rate on qualifying dividends and long term capital gains is limited to 15 percent Rev. Rul. 79-8, C.B. 92. Section

22 (a) Amount of the Distribution The amount of the distribution is the amount of cash distributed to the shareholder. In the case of property other than cash, the distribution amount is the fair market value of the property reduced by any liability to which the property is subject. (b) Dividend Treatment The amount of the distribution is a dividend to the shareholder to the extent the corporation has sufficient current or accumulated E&P. 36 The approach is to look to current E&P as of the end of the year without reduction by distributions made during the year, and then, if necessary, to the most recent accumulated E&P. If current E&P as of the end of the year exceeds the amounts of distributions made during the year, all such distributions are dividends and any excess E&P is added to the accumulated E&P account. 37 On the other hand, if the distribution amounts exceed current E&P, the portion of each distribution that is treated as coming out of current E&P is determined as follows: (amount of each distribution) divided by (total distributions) and multiplied by (current E&P). Thereafter, the remainder of each distribution is a dividend to the extent of the accumulated E&P on the date of the distribution. If there are no current E&P (or if there is a deficit in the current E&P account), but the corporation has accumulated E&P as of the beginning of the year, the amount of a distribution constitutes a dividend to the extent of the accumulated E&P reduced by that portion of the current E&P deficit that is allocable to the period prior to distribution. Unless the deficit can be traced to a particular time of the year, it must be prorated on a daily basis to the date of the distribution. 38 If any portion of the distribution amount constitutes a dividend, the shareholder must include that portion in his gross income. 39 (c) Recovery of Capital The portion of a distribution amount that is not a dividend (because it exceeds both current and accumulated E&P) is treated as a recovery of the shareholder s capital that reduces his basis in the stock. (d) Gain Treatment Any portion of the distribution amount remaining after being treated as a dividend and/or capital recovery, is treated as a gain from a sale or exchange of the shareholder s stock Redemptions and Distributions Treated as Exchanges A shareholder receiving a distribution from the corporation may avoid dividend treatment altogether if the distribution is made in redemption of his stock whereby: (I) his equity interest in the corporation is significantly reduced (as discussed in (a), (b) or (c) below), or (II) there is a Section 316(a); Reg (a). Reg (b). Reg (b); Rev. Rul , 1974 C.B. 74. Sections 61(a)(7); 301(c)(1). Section 301(c)(3). -10-

23 meaningful contraction of the corporation s business activities (as discussed in (d) below). If the transaction qualifies under any of the following tests, it is treated as an exchange of stock for a corporate distribution and the shareholder may be entitled to capital treatment on all or part of the distribution amount. (a) Substantially Disproportionate Redemptions Under this test, a distribution in redemption is treated as an exchange if: (A) immediately after the redemption, the shareholder owns less than 50% of the total combined voting power of all classes of stock entitled to vote; (B) the percentage of voting stock owned by the shareholder immediately after the redemption is less than 80% of the percentage of voting stock owned by him immediately before the redemption; and (C) the percentage of common stock (whether or not voting) owned by the shareholder immediately after the redemption is less than 80% of the percentage of common stock he owned immediately before the redemption. 41 Notwithstanding a shareholder s meeting the foregoing requirements with respect to a distribution, exchange treatment is denied if such distribution is made pursuant to a plan having the purpose or effect of a series of distributions that, taken together, result in no significant reduction of the shareholder s equity interest in the corporation. 42 (b) Complete Termination of a Shareholder s Interest A redemption is treated as an exchange if it completely terminates the shareholder s actual and constructive stock interests in the corporation. 43 A complete termination of a shareholder s actual interest in the corporation will qualify for exchange treatment even if he constructively owns stock of a family member under the attribution rules, so long as all of the following requirements are met: (A) the shareholder has no interest in the corporation immediately after the redemption as a shareholder, director, officer, employee or independent contractor; (B) the shareholder does not acquire any of the forbidden interests (other than stock acquired by inheritance of bequest) during the 10-year period beginning on the date of the redemption; (C) the shareholder attaches a statement to his income tax return for the year of redemption stating that he has not acquired any forbidden interest since the redemption and that he agrees to notify the Service of any such acquisition during the 10-year period within 30 days after it occurs; (D) the shareholder did not acquire any portion of the redeemed stock within the 10-year period preceding the redemption from a person whose stock is attributable to him under the family attribution rules; and (E) at the time of the redemption no person owns stock that is attributable to the shareholder under the family attribution rules if that person acquired any stock from the shareholder within the 10-year look-back period. Note that requirements D and E need not be met if the acquisition or disposition by the shareholder during the 10-year look back period was not principally motivated by a tax avoidance purpose. 44 Under section 318(a)(1), a person is treated as owning constructively stock held directly by that person s (i) spouse (other than a spouse who is legally separated under a decree of divorce or separate maintenance), (ii) children, (iii) grandchildren, and (iv) parents Section 302(b)(2). Reg (a). Section 302(b)(3). Section 311(c)(2)(B). -11-

24 (c) Redemptions Not Essentially Equivalent to a Dividend A redemption is also accorded exchange treatment if facts and circumstances demonstrate that the redemption resulted in a meaningful reduction of the shareholder s proportionate interest in the corporation. 45 The family attribution rules also apply here. However, a business purpose or lack of tax avoidance motive in connection with the redemption is irrelevant under this test. The IRS has considered the following shareholder rights in determining whether there has been a meaningful reduction: (A) voting, (B) participation in current earnings and corporate growth, and (C) sharing in net assets on liquidation. 46 Using these factors, the IRS has found a meaningful reduction in the following situations: (1) A reduction of voting rights from 57% to 50%, where the remaining shares are held by one unrelated shareholder. 47 (2) A reduction of a minority shareholder s common stock holding from 30% to 24.3%. 48 (3) A reduction of common stock holding from 27% to 22%, where the remaining shares are owned by three unrelated shareholders (on the ground that the shareholder lost the power to control the corporation in concert with one of the other shareholders). 49 (d) Partial Liquidations When the corporation significantly contracts its business and makes a related distribution to its shareholders in redemption of all or part of their stock, the redemption qualifies for exchange treatment. Corporate shareholders do not qualify under this test. A distribution satisfies this test if: (A) it is made pursuant to a plan; (B) it occurs within the taxable year in which the plan is adopted or the succeeding taxable year; and (C) either the distribution is attributable to the termination of a qualified trade or business and immediately after the distribution, the corporation continues to engage in the conduct of another qualified trade or business, or the distribution results from a contraction of the corporation s business. 50 A qualified trade or business is any trade or business that the corporation actively and directly engaged in during the five-year period preceding the distribution date, so long as the corporation did not acquire such trade or business in a taxable transaction during the same five-year period. 6. Tax Treatment of C Corporation on Distributions (a) E&P Adjustments E&P accounts are maintained solely for purposes of characterizing distributions to shareholders of a C corporation. E&P are determined by starting with taxable income of the See U.S. v. Davis, 397 U.S. 301 (1970). Rev. Rul , C.B. 82. Rev. Rul , C.B Rev. Rul , C.B Rev. Rul , C.B. 91. Section 302(b)(4). -12-

25 corporation and making certain additions, subtractions and adjustments. A brief description of some of these adjustments follows: (1) Certain income items that are not taxable income are added back for purposes of calculating E&P. Examples include federal tax refunds, tax-exempt municipal bond interest and life insurance proceeds. 51 (2) Some tax-deductible items must also be added back to taxable income in calculating E&P. For example, if the corporation itself is a shareholder in another corporation and has taken the dividends received deduction under section 243, the deduction must be taken into account for E&P purposes. Another example is the add-back of carryover capital and net operating losses in the year the corporation deducts the losses. (3) Expenses that are not tax-deductible are subtracted from taxable income in determining E&P. Included in this category are federal income taxes paid, charitable contributions to the extent they exceeded the percentage limitations, and losses incurred by the corporation in a sale or exchange with a related person. (4) The full amount of gain realized under an installment sale must be included in E&P in the year of sale (even if the corporation is permitted to report the gain in installments when computing its taxable income). (5) In determining E&P, the corporation must use the straight line method of depreciation of its assets (even though it may use the accelerated cost recovery system in determining its taxable income). As a result of the foregoing, when the subject depreciable asset is sold or otherwise disposed, the amount of gain or loss that must be taken into consideration for E&P purposes needs to be calculated using the adjusted basis of the property that is determined under the straight line method. (6) Depreciation expense taken under section 179 for taxable income purposes must be amortized ratably over five years for E&P purposes. 7. Distribution of Non-Cash Assets. If the corporation distributes appreciated property to a shareholder, the corporation must recognize gain on the distribution in an amount equal to the property s fair market value less the corporation s basis in the property. 52 If the shareholder assumes or takes the property subject to a corporate liability, the fair market value of the property is treated as not less than the amount of the liability for purposes of determining the corporation s gain. 53 However, where the distributed property is the corporation s own debt obligations, no gain or loss is recognized by 51 Reg (b). 52 Section 311(b)(1). 53 Sections 311(b)(2); 336(b) (and the shareholder takes the property with a basis equal to its fair market value without any reduction for liabilities under section 310(d)). -13-

26 the corporation. 54 shareholders. 55 The corporation may not recognize any loss on a distribution of property to its B. Tax Treatment of Distribution from an S Corporation 1. General Distribution Rules for S Corporations Without Earnings and Profits. The same rules governing shareholders in C corporations under section 302 (and 303) also apply to distributions in redemption of stock of an S corporation, including the stock attribution rules in section Characterization of a distribution as a redemption under section 302(a) or as a distribution under section 1368(a) may make little difference to the redeeming shareholder because of the distribution rules governing S corporations having no earnings and profits. Distributions of cash or property made by an S corporation having no accumulated Subchapter C earnings and profits are received tax-free by shareholders to the extent of their basis in the S corporation stock. 57 To the extent distributions exceed basis, however, the excess is treated as gain from the sale or exchange of property. 58 Thus, unless the purchase price is to be paid over a period of years (where the shareholder will need exchange treatment to qualify for the installment sales rules), it essentially makes no difference to the redeeming shareholder whether the transaction is a redemption under section 302(a) or a distribution under section A separate block rule will apply to non-sale or exchange redemptions in mirroring the results under distributions to shareholders in C corporations General Distribution Rules for S Corporations With Earnings and Profits. This indifference as to whether a distribution is characterized as a section 302 redemption or a section 1368 distribution may also apply to S corporations having earnings and profits. Distributions made by S corporations having accumulated Subchapter C earnings and profits are subject to a 5-tier system of taxation. This system utilizes the corporation s accumulated adjustment account (AAA or Triple A ) in determining the taxability of distributions. AAA generally consists of the accumulated gross income of the S corporation less deductible expenses and prior distributions. The AAA is essentially a running total of the S corporation s income, losses, deductions and distributions. The 5-tier system of taxation may be summarized as follows: i. That portion of the distribution that does not exceed AAA is tax-free to the extent of the shareholder s stock basis; 60 ii. That portion of the distribution that does not exceed AAA, but that does exceed the shareholder s stock basis, is capital gain; Section 311(a). Id. See sections 1371(a)(1) and 318(a)(5)(E) (S corporation treated as a partnership for entity attribution rules). Section 1368(b)(1). Section 1368(b)(2). See Reg (c)(3) and (f). Sections 1368(c)(1) and 1368(b)(1). Sections 1368(c)(1) and 1368(b)(2). -14-

27 iii. iv. That portion of the distribution that exceeds AAA is a dividend to the extent of the S corporation s accumulated Subchapter C earnings and profits; 62 That portion of the distribution that exceeds AAA and the accumulated Subchapter C earnings and profits of the S corporation is tax-free to the extent of the shareholder s residual stock basis (the shareholder s adjusted basis in his or her S corporation stock less any reductions made in his or her stock basis for any first-tier distributions); 63 and v. That portion of the distribution that exceeds AAA, the accumulated Subchapter C earnings and profits of the S corporation, is tax-free to the extent of the shareholder s residual stock basis (the shareholder s adjusted basis in his or her S corporation stock less any reductions made in his or her stock basis for any first-tier distributions). 64 Thus, even if the redemption is not treated as an exchange, the same result will apply, e.g., return of capital to the extent of basis, gain from the sale of stock to the extent that the amount of the distribution exceeds basis, if the amount received by the shareholder is not in excess of the corporation s AAA as of the close of the taxable year and is allocated among all dividend distributions made during the same period. Where the distribution exceeds AAA as of the close of the taxable year, however, such excess will be a distribution of earnings and profits and taxed as a dividend. The dividend distribution will be allocated pro rata to all distributions made during the year. 3. Ordering of Adjustments to Basis. Before determining the tax treatment of distributions to S corporation shareholders, the basis of the distributee shareholder in his S corporation stock will be increased by items of S corporation income described in section 1367(a)(1), but will not be decreased by items of S corporation loss and deduction described in section 1367(a)(2) until after the tax treatment of the distribution has been determined. Additionally, section 1368(e) provides that in determining the corporation s AAA available to cover distributions made during the taxable year, the amount of AAA as of the close of the taxable year will be determined without regard to any net negative adjustment (the excess of reductions to AAA for the taxable year over increases to AAA for the taxable year). 4. AAA Bypass Election. Under section 1368(e)(3), an S corporation which has Subchapter C earnings and profits can make an election to change the ordinary distribution rules discussed above. If a section 1368(e)(3) election (which is referred to as a AAA bypass election ) is made, the distributions from the corporation to its shareholders will first be treated as coming out of the corporation s accumulated Subchapter C earnings and profits to the extent thereof, then out of the Sections 1368(c)(2) and 301. Sections 1368(c)(3) and 1368(b)(1). Sections 1368(c)(3) and 1368(b)(2). -15-

28 corporation s AAA. Because of the 15% tax rate now applicable to dividend distributions, in some situations it may make sense, in order to free up suspended losses and offset other ordinary income of the shareholder, for the corporation to make a section 1368(e)(3) election since such distributions will be taxed at the 15% tax rate and will not reduce the shareholders stock basis and, as such, allow losses that might otherwise be suspended to flow through and offset other ordinary income of the shareholder which would otherwise be subject to a maximum marginal income tax rate of 35%. (a) Example - No Section 1368(e)(3)Election. (1) Facts (Reg Example (5)): (2) Analysis: S is an S corporation with a single shareholder, B. As of 1/1/2005, S has accumulated E&P of $1,000 and AAA of $2,000. On 4/1/2005, S makes a $2,000 distribution to B. For 2005, S has $2,000 of income and $3,500 of deductions. As of 1/1/2005, B owned 100 shares of S stock with a basis of $20 in each share. S does not make an election under section 1368(e)(3) and Reg (f)(2). Under section 1368(e)(1)(C) and Reg (a)(5), in applying adjustments to AAA to determine the taxability of distributions, AAA is determined without regard to any net negative adjustment (excess of reductions in AAA (other than for distributions) over increases in AAA). For purposes of the distribution, the AAA of S is $2,000 ($2,000 + $2,000 (income) - $2,000 (loss (not to exceed the 2005 income)). Therefore, the $2,000 distribution to B is out of AAA. The AAA is further reduced by the remaining $1,500 loss to a negative ($1,500). For purposes of determining taxability of the distribution, B s beginning basis of $2,000 is increased by $2,000 income. 65 The $2,000 distribution reduces the basis of B s S stock to $2,000 ($2,000 + $2,000 - $2,000). The basis of B s S stock is further reduced by $2,000 of loss. The remaining $1,500 loss in excess of B s basis in his shares is suspended and will be treated as incurred by S in the succeeding taxable year with respect to B. 65 Section 1368(d). -16-

29 (3) Summary: The $2,000 distribution is not taxable to B. B has passthrough of $2,000 income and $2,000 loss. Additionally, B has $1,500 of suspended losses. (b) Example - Section 1368(e)(3)Election. (1) Facts (same as previous example except that S elects under section 1368(e)(3) and Reg (f)(2) to distribute E&P first). (2) Analysis: The $2,000 distribution by S is deemed to be made first out of accumulated E&P of $1,000 and is a dividend to B. 66 The remaining $1,000 distribution is made out of AAA and constitutes a tax-free return of basis. Under Reg (f): Beginning basis $2,000 Increase for income items 2,000 Decrease for distribution not includable in shareholder s income ($2,000 distribution - $1,000 portion treated as dividend) 1,000 Decrease for noncapital, nondeductible expense -0- Decrease for items of loss or deduction described in sections 1367(a)(2)(B) and (C) (but not in excess of basis) (3,000) Remaining Basis -0- The remaining $500 of loss in excess of B s basis in his shares of S stock is suspended and will be treated as incurred by S in the succeeding taxable year with respect to B. A section 1368(e)(3) election also might be helpful for an S corporation with Subchapter C earnings and profits which wishes to purge such earnings and profits to avoid the sting tax of section 1375 (which applies where the passive investment income of an S corporation having accumulated earnings and profits exceeds 25% of gross receipts) and the possible termination of S corporation 66 See Reg Example (7). -17-

30 (3) Summary: 5. Allocations of Tax Items. status under section 1362(d)(3) (which applies where passive investment income of an S corporation with accumulated earnings and profits exceeds 25% of gross receipts for three (3) consecutive years). B has $1,000 dividend income taxed at maximum rate of 15% under section 1(h). B has $2,000 of pass-through income and $3,000 of pass-through loss. Assuming B is taxed at a maximum marginal rate of 35% and loss items are fully deductible by B, he has a net savings of $200 [Excess of ($1,000 x.35) over ($1,000 x.15)]. Under sections 1366 and 1377(a)(1), the redeemed shareholder will be allocated his or her daily pro rata share of the S corporation s items of income, deduction, loss or credit for the year of the redemption. Where a shareholder completely terminates his or her stock interest, a hypothetical closing of the books rule for allocation purposes can be elected in accordance with section 1377(a)(2). i. The daily allocation rule of section 1377(a)(1) results in the redeemed shareholder of an S corporation being allocated an amount of the corporation s tax items even after the stock is sold. ii. Under section 1377(a)(2), where a shareholder in an S corporation completely terminates his or her stock interest in the corporation, the corporation and all of the affected shareholders may elect hypothetically to close the taxable year of the corporation as of the date of sale in allocating tax items. The affected shareholders are the shareholders whose interest ends and all shareholders to whom such shareholder transferred shares during the taxable year. 67 If a shareholder s interest in an S corporation is redeemed by the S corporation, all the shareholders during the taxable year of the redemption are affected shareholders. If section 1377(a)(2) applies, the pro rata shares of the affected shareholders are determined as if the corporation s taxable year consisted of two taxable years, the first of which ends on the date as of the termination of the shareholder s interest. 1. An S corporation that makes a terminating election for a taxable year must treat the taxable year as separate taxable years for purposes of allocating income (including tax-exempt income), loss, deduction and credit, making adjustments to the accumulated adjustments account, earnings and profits and basis under section 1367, and in determining the tax effect of a distribution to the S 67 Section 1377(a)(2)(B) and Reg (b)(2). -18-

31 corporation s shareholders under section This comprehensive treatment ensures that full effect is given to treating the taxable year as two separate taxable years, and is consistent with the basis and distribution regulations promulgated under sections 1367 and An S corporation making a terminating election under section 1377(a)(2) must assign items of income, loss, deduction and credit to each deemed separate taxable year using its normal method of accounting as determined under section 446(a). 2. A terminating election does not, however, affect the due date of the S corporation s tax return, nor does a terminating election under section 1377(a)(2) generally affect the taxable year in which a shareholder must take into account his pro rata share of the S corporation s items of income, loss, deduction and credit. If a terminating election is made by an S corporation that is a partner in a partnership, the election will be treated as a sale or exchange of the corporation s entire interest in the partnership for purposes of section 706(c), relating to closing the partnership taxable year, if the taxable year of the partnership ends after the shareholder s interest is terminated and within the full taxable year of the S corporation for which the terminating election is made. As such, any partnership income earned by an S corporation partner through the date that a shareholder completely terminates his interest in the S corporation will be allocated to the deemed taxable year ending on the date of the shareholder s disposition of his stock rather than to the deemed taxable year following the date of such disposition. 3. In the event that the termination of a shareholder s entire interest in an S corporation also constitutes a qualifying disposition within the meaning of Reg (g)(2) (as discussed below), the regulations provide that the election under Reg (g)(2) cannot be made by the S corporation. In other words, the section 1377(a)(2) allocation rules take precedence over the allocation rules set forth in Reg (g)(2) relating to qualifying dispositions. 4. Additionally, an S corporation may not make a terminating election under section 1377(a)(2) if the termination of the shareholder s interest occurs in a transaction which also results in a termination of the corporation s S election under section 1362(d). Rather, the rules of section 1362(e)(2) and (3) (see below) take precedence over the allocation rules of section 1377 and will determine the allocation of S corporation items where a corporation s S election has been terminated. Note that the allocation rules of sections 1362(e)(3) and 1377(a)(2) differ in one important respect. An election under section 1362(e)(3) closes the -19-

32 books on the day before the termination of S status, whereas a terminating election under section 1377(a)(2) closes the books on the day of the termination of the shareholder s entire interest in the S corporation. 5. A terminating election under section 1377(a)(2) can be made only if a shareholder s entire interest as a shareholder in the S corporation is terminated. A shareholder s entire interest in an S corporation is considered terminated on the occurrence of any event through which a shareholder s entire stock ownership in the S corporation ceases. The following are examples of events resulting in termination of a shareholder s entire interest in an S corporation: (A) (B) (C) A sale, exchange, or other disposition of all of the stock held by the shareholder; A gift under section 102(a) of all of the shareholder s stock; A spousal transfer under section 1041(a) of all of the shareholder s stock; (D) A redemption under section 317(b) of all of the shareholder s stock, regardless of whether the tax treatment of the redemption under section 302 is as a sale or exchange or as a dividend; and (E) (F) (G) The death of a shareholder. A shareholder s entire interest in an S corporation will not be considered as terminated, however, if the shareholder retains ownership of any stock that would result in the shareholder being treated as a shareholder of the corporation under section 1362(a)(2). In determining whether a shareholder s entire interest in an S corporation has been terminated, any options held by the shareholder (other than options that are treated as stock under Reg (1)(4)(iii)), and any interest held by the shareholder as a creditor, employee, director, or in any other non-shareholder capacity, will be disregarded. As such, a section 1377(a)(2) terminating election can be made when a shareholder sells all of his stock even though the shareholder remains an employee, officer and/or director of the S corporation. 6. The terminating election under section 1377(a)(2) is made by attaching a statement to the S corporation s timely filed original or -20-

33 amended return for the taxable year during which the shareholder s entire interest is terminated. A terminating election may be made on an amended return as well as on an original return, but a terminating election only can be made on a timely filed return, and not on a late return. Additionally, the regulations set forth the information that must be included in the election statement and provide that a single election statement may be filed by the S corporation for all terminating elections with respect to the taxable year. 7. All affected shareholders must consent to the terminating election The shareholders required to consent to the terminating election are the shareholders described under section 1362(a)(2) that must consent to a corporation s S election. For example, if stock of an S corporation is owned by a husband and wife as community property, both husband and wife must consent to the terminating election under section 1377(a)(2). If shares of stock of an S corporation are owned by a minor, the consent to the terminating election must be made by the minor (or by the legal representative of the minor); if shares of stock of an S corporation are owned by an estate, the consent of the estate must be made by an executor or administrator of the estate; and if a trust described under section 1361(c)(2)(A) owns shares of stock of an S corporation, the person treated as the shareholder under section 1361(b)(1) must consent to the terminating election. 9. In the event a terminating election is made with respect to a shareholder who terminates his entire interest in an S corporation, that shareholder will not, however, be required to consent to a terminating election made with respect to the subsequent termination of another shareholder s entire interest in the S corporation during the same taxable year. iii. If a sale of S corporation stock results in the termination of the corporation s S status, the taxable year of the termination is considered an S termination year as defined in section 1362(e)(4) and Reg (a). The S termination year is divided into two short taxable years, with Subchapter S governing the first short year (which ends on the day before the effective date of termination and is known as the S short year ) and with Subchapter C governing the balance of the year (the C short year ). While the corporation generally allocates its items of income, loss, deduction and credit between the two short years based on the number of days in each year, section 1362(e)(3) allows the corporation to elect to 68 See Footnote 65 supra and discussion in the related text. -21-

34 close its books on the day before the termination date, provided that all persons who own stock during the S short year and on the first day of the C short year consent to such election. 69 Also note that under section 1362(e)(6)(D), the books will close automatically if there is a sale or exchange of 50% or more of an S corporation s stock in an S termination year, and will also close with respect to any items resulting from the application of section 338. iv. If a shareholder disposes of 20% or more of the corporation s stock during a 30-day period, the corporation may also elect to close the books hypothetically as of the date of disposition, for purposes of allocating items of income and loss. 70 Moreover, the regulations provide that a redemption treated as an exchange under section 302(a) or section 303(a) of 20% or more of the outstanding stock of the corporation from a shareholder in one or more transactions over a 30-day period during the S year will constitute a qualifying disposition for which the hypothetical closing of the books election may be made. v. For dispositions of stock in an S corporation, Temporary Regulation T(e)(3) requires that the resulting gain or loss be allocated among the various activities of the S corporation as if the entity had sold all of its interests (assets) in such activities, including activities conducted by ownership of a pass-through entity such as a partnership, as of a prescribed valuation date, for purposes of applying the passive activity loss limitation rules. IV. Subchapter S Eligibility Requirements. A. In General. Since its enactment in 1958, the S corporation (originally known as an electing small business corporation) has been subject to ownership and structural limitations that have gradually been liberalized over time. Under current law, section 1361(b)(1) provides that an S corporation is: (i) a domestic corporation; (ii) which does not have more than 100 shareholders; (iii) does not have a shareholder who is not an individual (other than an estate, certain trusts or charitable or taxexempt organizations); (iv) does not have a nonresident alien as a shareholder; (v) does not have more than one class of stock which is issued and outstanding; and (vi) is not otherwise an ineligible corporation. Accordingly, an entity taxable as a partnership can not own stock in an S corporation. A regular or C corporation is not permitted to own stock in an S corporation. In 2004, Congress enacted a provision as part of the American Jobs Creation Act of 2004 (the 2004 Act ), section 1361(c)(1)(D), which provides that for purposes of the counting rules, members of a family will be treated as 1 shareholder. The term members of a family means a Section 1362(e)(3)(B) and Reg (b)(1). Reg (g)(2). -22-

35 common ancestor, any lineal descendant of such common ancestor, and any spouse or former spouse of such common ancestor or any such lineal descendant. The so-called common ancestor must not be more than 6 generations removed from the youngest generation of shareholders who would (but for this subparagraph) be members of the family. 71 B. Single Class of Stock Requirement Where an acquisition or disposition involves an S corporation, the eligibility requirements of section 1361(b) will be of primary importance since they can significantly restrict the structuring of the transaction. This will be particularly important where the acquiring corporation is an S corporation and wishes to continue to its S status after the acquisition. The Subchapter S rules prohibit the issuance of more than one class of stock, i.e., stock which has a preference on distributions during either the operational or liquidation phase. 72 A corporation is treated as having only one class of stock if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds. Differences in common stock voting rights are disregarded. 73 Shareholder covenants contained in buy-sell agreements generally will not result in a second class of stock. 74 This limitation has made it difficult for S corporations to raise funds and venture capital since many lenders seek hybrid forms of payment or kickers in addition to receipt of a pure interest stream of payments for the use of borrowed funds. A detailed discussion of the single class of stock requirements for S corporations is set forth below. 1. Differences in Voting Rights. Reg (1)(1) provides that differences in voting rights among shares of stock of the corporation will be disregarded in determining whether a corporation has more than one class of stock. Consequently, an S corporation may have voting and nonvoting common stock, a class of stock that may vote only on certain issues, irrevocable proxy agreements, or groups of shares that differ with respect to rights to elect members to the board of directors, as long as such shares confer identical rights to distribution and liquidation proceeds. 2. Non-conforming Distributions. The original proposed single class of stock regulations provided that even where all outstanding shares of stock conferred identical rights to distribution and liquidation proceeds, the corporation still would be treated as having more than one class of stock if the corporation made non-conforming distributions. Non-confirming distributions were defined as distributions which differed with respect to timing or amount as to each outstanding share of stock, with certain limited exceptions. Thus, under the original proposed regulations, excessive or 71 See Truskowski, AJCA Changes to Subchapter S Broaden the Availability of the S Election, 101 J. Tax n 327 (December 2004). Under the Gulf Opportunity Zone Act of 2005 (the 2005 Act ), an election is no longer required for a family to be treated as one shareholder, as originally required under the 2004 Act (b)-(1)(D). Treas. Regs (l)(2)(i)(differences in timing of distributions as a second class), (l)(2)(ii)(effect of state income tax withholding regimes) (c)(4). 74 See Reg (l)(2)(iv); Rev. Rul , C.B

36 inadequate compensation from an S corporation to a shareholder, shareholder loans, fringe benefits to shareholders, and other constructive distributions such as excessive rental payments between a shareholder and an S corporation could cause the inadvertent termination of an S corporation s election under the non-conforming distribution rule. Under the final single class of stock regulations, non-conforming distributions will not cause a corporation to be treated as having more than one class of stock, but such distributions (including actual, constructive or deemed distributions) that differ in timing or amount will be given the appropriate tax effect in accordance with the facts and circumstances. Thus, the Service has the power to recharacterize such distributions Stock Taken into Account. Under Reg (1)(3), in determining whether all outstanding shares of stock confer identical rights to distribution and liquidation proceeds, all outstanding shares of stock of a corporation are taken into account, except for: (i) restricted stock within the meaning of Reg (b)(3) with respect to which no section 83(b) election has been made; (ii) deferred compensation plans within the meaning of Reg (b)(4); and (iii) straight debt under Reg (b)(5) and -1(l)(5). 4. Governing Provisions. Reg (1)(2) provides that the determination of whether all outstanding shares of stock confer identical rights to distribution and liquidation proceeds is based upon the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds (the governing provisions ). Thus, with respect to an S corporation s outstanding shares of stock, only governing provisions can cause the corporation to be treated as having a second class of stock. 5. Routine Commercial Contractual Arrangements. Reg (1)(2) provides that routine commercial contractual arrangements, such as leases, employment agreements and loan agreements, will not be considered binding agreements relating to distribution and liquidation proceeds, and consequently will not be considered governing provisions, unless such agreements are entered into to circumvent the one class of stock requirement. 6. State Law Requirements for Payment and Withholding of Income Tax. Reg (1)(2)(ii) provides that state laws requiring a corporation to pay or withhold state income taxes on behalf of some or all of its shareholders will be disregarded in determining whether all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds if, when the constructive distributions resulting from the payment of such taxes by the corporation are taken into account, the outstanding shares otherwise confer identical rights to distribution and liquidation proceeds. Consequently, a difference in timing between constructive distributions attributable to withholding and payment 75 Reg (1)(2)(i). -24-

37 of taxes with respect to some of an S corporation s shareholders and actual distributions to other shareholders will not cause the corporation to be treated as having more than one class of stock. 7. Distributions that Take Into Account Varying Interests. Reg (1)(2)(iv) provides that an agreement will not be treated as affecting the shareholders rights to liquidation and distribution proceeds conferred by an S corporation s stock if the agreement merely provides that, as a result of a change in stock ownership, distributions in one taxable year will be made on the basis of the shareholders varying interests in the S corporation s income during the immediately preceding taxable year. If, however, such distributions are not made within a reasonable time after the close of the taxable year in which the varying interests occur, such distributions may be re-characterized depending upon the facts and circumstances, but still will not result in the corporation being treated as having a second class of stock. 8. Buy-Sell, Redemption and Other Stock Restriction Agreements. Reg (1)(2)(iii) sets forth rules regarding when buy-sell, redemption and other stock restriction agreements will be disregarded in making the determination as to whether a corporation s shares of stock confer identical rights to distribution and liquidation proceeds. (a) Agreements Triggered by Death, Divorce, Disability or Termination of Employment. A bona fide agreement to redeem or purchase stock at the time of death, divorce, disability or termination of employment will be disregarded in determining whether a corporation s shares of stock confer identical rights to distribution and liquidation proceeds. 76 (b) Non-Vested Stock. If stock that is substantially non-vested is treated as outstanding, the forfeiture provisions that cause the stock to be substantially non-vested will be disregarded. (c) Buy-Sell Agreements, Stock Restriction Agreements and Redemption Agreements. Buy-sell agreements among shareholders, agreements restricting the transferability of stock, and redemption agreements will be disregarded in determining whether a corporation s outstanding shares of stock confer identical distribution and liquidation rights unless (i) a principal purpose of the agreement is to circumvent the one class of stock requirement, and (ii) the agreement establishes a purchase price that, at the time the agreement is entered into, is significantly in excess of or below the fair market value of the stock. 76 Reg (1)(2)(iii)(B). -25-

38 (d) Determination of Value. Reg (1)(2)(iii) provides that a price established at book value or at a price between fair market value and book value will not be considered to establish a price significantly in excess of or below the fair market value of the stock. A determination of book value will be respected if the book value is determined in accordance with GAAP; or the book value is used for any substantial non-tax purpose. Additionally, the regulations provide that a good faith determination of fair market value will be respected unless it can be shown that the value was substantially in error and the determination of value was not performed with reasonable diligence. 9. Special Rule for Section 338(h)(10) Elections. Reg (1)(2)(v) provides that if the shareholders of an S corporation sell their stock in a transaction for which an election under section 338(h)(10) is made, the receipt of varying amounts per share by the shareholders will not cause the S corporation to have more than one class of stock, provided that the varying amounts are determined in arm s-length negotiations with the purchaser. This amendment is important because the amount a shareholder is paid per share of stock (and the timing of the payment) often will vary among the shareholders (for example, due to control premiums and minority discounts); this could create a second class of stock concern if the shareholders were viewed as receiving different amounts in the fictional liquidation of the S corporation resulting from the section 338(h)(10) election Use of options and warrants. Stock options or stock warrants are often important tools in structuring either a taxable or non-taxable acquisition. 78 Under the final regulations to section 1361, a call option, warrant or similar instrument will constitute a prohibited second class of stock if the option is substantially certain to be exercised by the holder or a potential transferee, and the option has a strike price substantially below the fair market value of the underlying stock on the date that the call option is issued, transferred by a person who is an eligible shareholder to a person who is not an eligible shareholder or materially modified. 79 (a) Not in the Money Safe Harbor. The regulations provide a safe harbor whereby a call option is not treated as a second class of stock if, on the date the call option is issued, transferred by a person who is an eligible shareholder to a person who is not an eligible shareholder, or materially modified, the strike price of the call option is at least 90 percent of the fair market value of the underlying stock on that date. The failure of an option to meet this safe harbor will not necessarily result in the option being treated as a second class of stock See also PLRs and Reg (l)(4). Regs (l)(4)(iii)(A), (l)(4)(iv)(B). -26-

39 (b) Option Issued to Commercial Lender. An additional exception is provided for options that are issued to a person that is actively and regularly engaged in the business of lending and issued in connection with a commercially reasonable loan to the corporation as described by the regulations. (c) Option Issued for Services. The regulations provide that a call option that is issued to an individual who is either an employee or an independent contractor in connection with the performance of services for the corporation or a related corporation (and that is not excessive by reference to the services performed) is not treated as a second class of stock under Subchapter S if the call option is not transferable under Reg (d) and the call option does not have a readily ascertainable fair market value as defined in Reg (b) at the time the option is issued. 11. Use of convertible debt. The regulations provide that convertible debt will be considered a second class of stock if: (i) it would be treated as a second class of equity under general tax principles, i.e., section 385, and (ii) it embodies rights equivalent to those of a call option that would be treated as a second class of stock under the portion of the regulations pertaining to options. In various instances involving an acquisition, particularly a non-taxable acquisition, the resolution of whether unretired debt, including convertible debt, of the target corporation will have substantial tax implications including (i) possible termination of S status; (ii) debt cancellation income under section 108; (iii) original issue discount issues; (iv) creation of market discount or bond issue premium; (v) dividend issues under section 305(5), and (vi) the existence of a taxable sale or exchange Short Term Unwritten Advances. Reg (l)(4)(ii)(B)(1) provides that unwritten advances by a shareholder that do not exceed $10,000 in the aggregate at any time during the year, which are treated as debt by the parties and are expected to be repaid within a reasonable time, are not treated as a second class of stock. 13. Proportionately Held Debt. Reg l(l)(4)(ii)(B)(2) provides that obligations of the same class owned proportionately by the shareholders are not treated as a second class of stock. An obligation held by the sole shareholder is always held proportionately to the outstanding stock. 80 See Reg ; Rev. Rul , CB 200 (change in interest rate or reduction in face material); Rev. Rul , CB 153 (same); Rev. Rul , CB 365 (postponement of maturity date not exchange); Rev. Rul , CB 222 (conversion of debt into stock of same debtor was tax-free); See also landmark Supreme Court s decision in Cottage Savings Association v. Comm r, 499 US 554 (1991) (swap of economically equivalent mortgage pools created deductible losses). -27-

40 14. Straight Debt. Section 1361(c)(5)(b) provides that certain debt, which qualifies as straight debt, will not result in a second class of stock despite its equity features or characteristics. The definition of straight debt requires, among other things, that the holder be an individual (other than a nonresident alien), or an estate or trust eligible to own S stock. If the holder were, for example, a financial institution, prior to 1997 it would not qualify under safe harbor debt. Under the straight debt safe harbor, indebtedness of an S corporation will not be treated as a second class of stock if it is (i) in writing; (ii) contains an unconditional promise to pay a sum certain in money on demand or at a specified date; (iii) does not bear interest contingent on corporate profits, the corporation s discretion or similar factors, (iv) is not convertible into stock and (v) is owned by a person who is eligible to be an S corporation shareholder. The regulations provide that the fact that an obligation is subordinated to other debt of the corporation does not prevent the obligation from qualifying as straight debt. The regulations further provide that where an obligation qualifies as straight debt it will lose its status under the safe harbor where (i) the obligation is materially modified so that it no longer satisfies the definition of straight debt; or (ii) is transferred to a third party who is not an eligible shareholder. Where an obligation of an S corporation satisfies the definition of straight debt it still may be treated as equity for other tax purposes. Thus, for example, where a straight debt obligation bears a rate of interest that is unreasonably high, an appropriate portion of the interest may be recharacterized and treated as a payment that is not interest. As a reform introduced by SBJPA, after 1996 a financial institution now qualifies for holding safe harbor debt provided such institution is actively engaged in the business of lending money. 81 This requirement should not be difficult to satisfy. Still, the non-convertibility requirement of safe harbor debt, as well as the restriction that interest payments not be contingent on profits, remain impediments for achieving transactional neutrality among pass through entities in this area. S corporations remain disadvantaged in this area. 15. Use of Stock Appreciation Rights and Phantom Stock. (a) Stock Appreciation Rights. A stock appreciation right (SAR), which is similar to a phantom stock arrangement, is basically a contractual right to receive cash, stock, or a combination of both, measured by the appreciation in a corporation s stock from the date of grant to the date of exercise. SARs allow the recipient, typically a corporate executive or a key employee, to participate in the future growth of the corporation without having to commit any resources or undertake any real economic risk. If properly structured, the SAR will not constitute a prohibited second class of stock under Subchapter S. (b) Phantom Stock Plans. A phantom stock plan works similarly to an SAR by rewarding the employee based on the performance of the employer s stock. In a phantom stock plan, however, the compensation is based on appreciation of units, the value of which are tied to the value of the employer s stock (c)(5)(iii). -28-

41 For example, the value of one unit at the date of grant can be 75% of the then current market value of one share of stock, or it may be tied to book value. As with the SAR, if properly structured, the phantom stock plan will not constitute a prohibited second class of stock under Subchapter S. C. Use of Joint Venture to Avoid Single Class of Stock or Shareholder Eligibility Limitations. Where the Subchapter S limitations concerning the one class of stock requirement or the shareholder eligibility limitations pose a formidable obstacle in structuring a business combination involving an S corporation, consideration should be given to the use of a joint venture. While the Service has backed off to a certain extent its concern that a joint venture involving an S corporation may not be used to end run the Subchapter S limitations, the outer limits of this liberal attitude have not been tested. 82 Section 707(a)(2)(A) applies to an allocation and distribution to a partner who has transferred property to a partnership if (1) the allocation and distribution are related to the property transfer and (2) the property transfer and the allocation and distribution, when viewed together, are properly characterized as a transaction occurring between the partnership and a partner acting other than in his capacity as a member of the partnership. The principal targets of this aspect of the provision are situations in which all or a portion of the purchase price of property is paid through partnership allocations in order to give other partners the practical equivalent of immediate deductions for payments of the purchase price. Section 707(a)(2)(B) provides that a partner s transfer of money or other property to a partnership is deemed made in a nonpartner capacity if (i) the partnership makes a related transfer of money or other property to the partner or another partner and (ii) the transfers of the partner and partnership, when viewed together, are properly characterized as a sale or exchange of property. This rule is intended to prevent the parties from characterizing a sale or exchange of property as a contribution to the partnership followed by a distribution from the partnership and thereby to defer or avoid tax on the transaction. 83 Reg (c) provides that if within a two-year period, a partner transfers property to a partnership and the partnership transfers money (or other consideration) to the partner (without regard to the order of the transfers), the transfers are presumed to be a sale of the property to the partnership unless the facts and circumstances clearly establish otherwise. Reg (b)(1) provides that, for purposes of the disguised sale rules, if a partner transfers property to a partnership, and the partnership incurs a liability and all or a portion of the proceeds of that liability are allocable under Reg T to a transfer of money or other consideration to the partner made within 90 days of incurring the liability, the transfer of money or other consideration to the partner is taken into account only to the extent that the amount of money or the fair market value of the other consideration transferred exceeds that partner s allocable share of the partnership liability See Rev. Rul , C.B. 198; Reg (d), Example 2. Compare Rev. Rul , C.B. and GCM (12/27/76); Application of Disguised Sales Provisions; 707(a)(2)(A). 83 Staff of Joint Comm. on Tax n, 98th Cong., 2d Sess., General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984 at 231 (Comm. Print 1984). 84 See Rubin, Here Comes the Kitchen Sink: IRS Throws Everything But at Two Partnership Tax Deferral Structures, PLI Tax Law and Practice, June,

42 D. Electing Small Business Trusts as Shareholders. After 1996, as part of the reforms to Subchapter S provided by the SBJPA, an accumulation (domestic) trust, referred to as an electing small business trust ( ESBT ) under section 1361, is permitted to own stock in an S corporation provided that the trustee of the trust files the appropriate election. Special rules are provided in determining the eligible beneficiaries of the ESBT. In contrast to a qualified Subchapter S trust which taxes the individual beneficiary on his or her share of the S corporation s income, the ESBT is treated as the taxpayer and is subject to federal income tax Taxation of ESBTs. Under the ESBT regime, the portion of the trust which consists of stock in one or more S corporations is treated as a separate trust for purposes of computing the income tax attributable to the S corporation stock held by the trust. The trust is taxed at the highest individual rate (currently 35 percent on ordinary income and generally 15 percent on net capital gain) on this portion of the trust s income. The taxable income attributable to this portion includes (i) the items of income, loss, or deduction allocated to it as an S corporation shareholder under the rules of Subchapter S, (ii) gain or loss from the sale of the S corporation stock, and (iii) to the extent provided in regulations, any state or local income taxes and administrative expenses of the trust properly allocable to the S corporation stock. Otherwise allowable capital losses are allowed only to the extent of capital gains. 2. Application of Subchapter J. Section 641(d)(1) provides that the portion of an ESBT that consists of stock in one or more S corporations ( S portion ) is taxed as a separate trust. Section 641(d)(2)(c) specifies that the only items of income, loss, deduction, or credit to be taken into account by the S portion ( S portion items ) are (i) the items required to be taken into account under section 1366; (ii) any gain or loss from the disposition of stock in an S corporation; and (iii) to the extent provided in regulations, State or local income taxes or administrative expenses to the extent allocable to items described in clauses (i) and (ii) section 641(d)(3) provides that the S portion items are excluded for purposes of determining the amount of tax on the portion of the trust that is not treated as a separate trust under section 641(d)(1) ( non-s portion ) and are excluded in determining the distributable net income (DNI) of the entire trust. Because the S portion items are not included in the computation of the ESBT s DNI, they are treated for purposes of determining the treatment of trust distributions in the same manner as any other item that does not enter into the DNI computation (e.g., capital gains and losses allocated to corpus). For example, for the tax year an ESBT has $40 of DNI from the non-s portion and $70 of net fiduciary accounting income from the S portion, if the ESBT makes a distribution of $100, the distribution includes $40 of DNI August, Huffaker and Agran, Clarifications Made by ESBT Final Regulations Demonstrate the Need for More Statutory Changes, Journal of Taxation, Aug See Notice

43 3. Purchase of S Corporation Stock. The final regulations provide that interest expenses paid by the trust on indebtedness incurred in connection with the purchase of S corporation stock must be allocated to the S portion of the ESBT. 87 When the regulations were finalized, such interest expenses are not deductible by the S portion because they are not administrative expenses. However, the 2007 Act provides that the interest paid or accrued on indebtedness to acquire S corporation stock is deductible in computing the taxable income of the S portion of an ESBT Termination of ESBT Status. The final regulations provide that except where an ESBT fails to meet the definitional requirements of an ESBT, a trustee must seek the consent of the Commissioner by obtaining a private letter ruling to revoke an ESBT election. Consent of the Commissioner is not required when the trust wishes to convert from an ESBT to a QSST, provided the trust meets all of the requirements to be a QSST and the trustee and the current income beneficiary of the trust sign the QSST election. Similar to the procedures for converting an ESBT to a QSST under Rev. Proc , the QSST must state at the top of the filing that it is a conversion of an ESBT to a QSST pursuant to Reg (m) of the regulations and include all information otherwise required for a QSST election under Reg (j)(6). A separate election must be made with respect to the stock of each S corporation held by the trust. Finally, to convert from an ESBT to a QSST under the automatic procedure, the trust must not have converted from a QSST to an ESBT within the 36 month period immediately preceding the effective date of the new QSST election. 89 As noted above, a trust that ceases to meet the ESBT requirements has its ESBT election terminated. The last day the trust is treated as an ESBT is the day before the day on which the trust fails to meet the definition of an ESBT. 90 The final regulations provide that a trust ceases to be an ESBT on the first day following the day the trust disposes of all of its S corporation stock. However, if the trust is using the installment method to report income from the sale or disposition of its stock in S corporation, the ESBT status continues until the day following the day the last installment payment is received by the trust, or the day the trust disposes of the installment obligation, if earlier. Under the special divestiture rule, if a potential current beneficiary is treated as an ineligible shareholder, or if an ineligible shareholder becomes a potential current beneficiary, the trust may dispose of all its S corporation stock within 60 days. The ineligible shareholder is not considered a potential current beneficiary during the 60 day period ending on the date of such disposition. 91 On the termination of the ESBT status, the loss carryovers or excess deductions referred to in section 642(h) are taken into account by the entire trust, subject to the usual rules on termination of the entire trust Reg (c)-1(d)(4)(ii). 641(c)(2)(C)(iv), as amended by 8236 of the 2007 Act. Reg (m)(7)(i)-(iv). Reg (m)(5)(i). Reg (m)(5)(iii), cross referencing paragraph (m)(4)(iii). -31-

44 5. Sale of S Corporation Stock by ESBT. Reg (c)-1(d)(3) requires that the resulting gain or loss from the sale of S corporation stock by an ESBT be reported by the S portion. As mentioned, capital losses are permitted only to the extent of capital gains. Consistent with the final regulations under section which treat gains on the sale of S corporation stock on the installment basis by a QSST as income of the trust, the final ESBT regulations permit the use of the installment method upon the sale or disposition of stock in an S corporation by an ESBT. The gain recognized under the installment method is taken into account by the S portion of the ESBT. 93 Although the trust no longer holds the S corporation stock, it continues to pay trust-level taxes on the gain as recognized under the installment method. The final regulations provide that the interest on the installment obligation from the sale or disposition of stock in an S corporation is included in the gross income of the non-s portion of the ESBT. 94 In effect, the final regulations keep the ESBT election alive with respect to the S portion as long as the installment payments are made upon the disposition of S corporation stock. On the other hand, the interest portion is carved out and allocated to the non-s portion, subject to the normal rules of Subchapter J. If all of the proceeds of the sale are distributed to beneficiaries, the interest amount would be passed out as a separately stated component of DNI. The capital gain portion, on the other hand, would be taxed at the trust level and then distributed tax-free to the beneficiary as a return of capital or non-taxable principal distribution of the trust. It would appear that the $5 million limitation rule of section 453A(c)(6) will apply to the S portion of an ESBT as a separate taxpayer. Where the ESBT has partial owners, presumably each partial owner will be treated as in receipt of a corresponding portion of the installment obligation. Presumably, the S portion also will bear the tax on gain from a disposition of an installment obligation or the burden of the interest charge on the tax from large deferred installment sale gains. 6. Distributions With Respect to S Stock. With respect to distributions from the S corporation, where dividend treatment results under section 1368(c)(2), Reg (c)-1(g)(2) provides that such amount is includable in the gross income of the non-s portion of the trust. Where gain results from a distribution in excess of stock basis, then such gain is allocable to the S portion of the trust. Presumably, this result will apply for a non-dividend-equivalent redemption of the trust s S stock in a particular corporation to the extent such proceeds are not characterized by reference to section 1368(c)(2) Tax-Free Reorganizations. Where the ESBT receives boot as part of a tax-free reorganization or spinoff of an S corporation, it would appear that a dividend-equivalent distribution described in section 356(a)(2) or (b) will be taxable to the non-s portion, while gain recognized under section Reg (j)(8). Reg (c)-1(d)(3)(ii). Reg (c)-1(g)(3). 302(a), 302(d). -32-

45 356(a)(1) presumably will be taxable to the S portion. Additional guidance should be issued in identifying and resolving these and other overlap issues involving ESBTs and distributions or exchanges described in Subchapter C that apply to S corporations and their shareholders. E. Removal of Prohibition on Affiliation; Subsidiaries Permitted by SBJPA. 1. Prior to Prior to the SBJPA, an S corporation had not been permitted to own stock in another S corporation, because the second corporation would have had another corporation as a shareholder. 96 A second limitation barred an S corporation from owning 80% or more of the voting and value of the issued and outstanding stock in a C corporation. 97 Still, section 1361(c)(6) provided that an inactive subsidiary, e.g., one which never has conducted business and merely reserves a corporate name in another state, is permitted. 98 Furthermore, the Service ruled that the momentary ownership of a subsidiary will not disqualify the parent corporation s S election. 99 Momentary affiliation may also be the first step in a tax-free division or split-up. The Tax Court has issued a warning on more than momentary affiliations despite the Service s more liberal attitude. 100 The rationale for prohibiting an S corporation from being a member of a consolidated or affiliated group presumably was to avoid complex intercompany transaction and distribution rules. This reasoning is unimpressive when one recognizes that tiered partnerships or LLCs or combinations of the two are common. These restrictions frequently complicated the structuring of acquisitions by S corporations because a S corporation that acquired all the stock of a target corporation had to immediately liquidate the target in order to avoid terminating its S election. In addition, if shareholders wanted to set up two distinct corporations for legal liability reasons and to have each benefit from flow through federal income tax treatment, they were forced to form multiple S corporations. Prior efforts to escape this limitation consisted of (i) issuing different classes of stock in the C corporation subsidiary in failing the definition of affiliation under section 1504 or (ii) simply issuing more than 20% of the C subsidiary stock (voting or value) to the individual shareholders of the S corporation parent since there is no attribution rule under section Ownership of C Subsidiary Permitted. Under the SBJPA, an S corporation may own stock in a C corporation subsidiary without causing the termination of the parent corporation s S election. The obvious advantage is the segregation of assets and liabilities from less risky operations from those subject to greater legal risk The SBJPA also added section 1504(b)(8), which excludes an S corporation from the affiliated group of corporations that may elect to file a consolidated federal income tax return 96 See 1361(b). 97 See 1504(b)(8). 98 But see May v. United States, 644 F.2d 578 (6th Cir. 1981), rev g 42 AFTR 2d 5328 (E.D. Ky. 1978); Coca Cola Bottling Company of Gallup v. U.S., 23 AFTR 2d 1763 (D.N.M. 1869), aff d on other grounds, 443 F.2d 1253 (10th Cir. 1971). 99 Rev. Rul , C.B. 312; Rev. Rul , C.B See Reg (b)(5)(ii)(election to treat subsidiary as not a member of group for that year). 100 Haley Brothers Constr. Corp. v. Comm r, 87 T.C. 498 (1996). -33-

46 under section Thus, if an S corporation owns all of the stock of S1, and S1 owns all of the stock of S2, S1 may elect to file a consolidated return with S2, assuming the other affiliated group requirements are met. 3. Repeal of Former Inactive Subsidiary Rule. As a result of the ability to own a (S or C corporation) subsidiary, the inactive subsidiary exception in section 1361(c)(6) has been repealed as no longer necessary. Furthermore, the issue of momentary affiliation is substantially reduced in its importance; the only issue being whether momentary affiliations incident to an acquisition or reorganization are to be ignored for federal income tax purposes. Thus, for example, an S corporation may acquire all the stock of a C corporation (and its lower tier subsidiaries) without having to liquidate immediately. Similarly, an S corporation that is purchased by another S corporation no longer will have to be liquidated immediately in order to preserve the application of the flow through rules with respect to its income and losses. Loss of either the purchaser s or the target s S corporation election could have resulted in built-in gains tax, passive investment income, and LIFO recapture tax 101 implications. Still, an S corporation may not file a consolidated return with one or more C subsidiaries, although a C subsidiary may be a member of an affiliated group. This would result in nonapplication of the deferred intercompany transaction rules, and dividends up to the parent S corporation will be taxable without benefit of a dividends received deduction. This excludes application of the inter-company transaction and investment basis rules among other things. Where the acquired C subsidiary is affiliated with other C corporations, it is still permitted to file a consolidated return with members of the affiliated group. Generally, dividends received from a C corporation which are from current or accumulated earnings and profits under applicable rules under Subchapter C, will constitute passive investment income for termination purposes under section 1362(d)(3) as well as for purposes of the entity termination rule under section Again, a dividends received deduction under section 243 is unavailable. Final regulations dealing with dividends received from affiliated C corporation subsidiaries by an S corporation parent were recently issued. 103 Where the S corporation parent owns at least 80% of the stock of a C corporation, subsidiary dividends which are attributable to earnings and profits of the subsidiary will not be treated as passive investment income provided such earnings are derived from the active conduct of a trade or business. The legislative history is silent on how the allocation or tracing of the subsidiary dividend to its active business operations is to be made. This problem will be especially pronounced where dividend distributions are from accumulated earnings and profits over a span of years. Application of the same rule will also be complex where the C subsidiary receives a dividend from a controlled affiliate. Where the distribution from the controlled C corporation constitutes gain (distribution in excess of earnings and profits and basis) presumably 101 See TAM , PLR revoking PLR August, Taxable Stock Acquisitions by S Corporations: Technical Advice Memorandum Permits Use of 332 and 338, 5 J. S. Corp. Tax n 203 (1994). 102 See 1375(b)(3), 1362(d)(3)(D). 103 See Reg

47 such gains will constitute passive investment income even if such distribution is from the conduct of active business operations. The passive income problem for S corporations is only faced where the S corporation parent itself has undistributed earnings and profits from prior C years. Dividends, even passive dividends, do not increase or create C year earnings and profits as provided in section 1371(c)(1). Final regulations issued by the Service address the question of tracing active earnings and profits in a C subsidiary or from a C affiliated group. 104 Under the regulations, earnings and profits of a C corporation derived from the active conduct of a trade or business are the earnings and profits of the corporation derived from activities that would not produce passive investment income under section 1362(d)(3) if the C corporation were an S corporation. A safe harbor is provided by which the corporation may determine the amount of the active earnings and profits by comparing the corporation s gross receipts derived from non-passive investment incomeproducing activities with the corporation s total gross receipts in the year the earnings and profits are produced. If less than 10 percent of the C corporation s earnings and profits for a taxable year are derived from activities that would produce passive investment income, all earnings and profits produced by the corporation during the taxable year are considered active earnings and profits. The regulations also provide that a C corporation may treat all earnings and profits accumulated by the corporation prior to the time an S corporation held stock meeting the requirements of section 1504(a)(2) as active earnings and profits in the same proportion as the C corporation s active earnings and profits for the three taxable years ending prior to the time when the S corporation acquired 80 percent of the C corporation bears to the C corporation s total earnings and profits for those three taxable years. Provisions also address the allocation of distributions from current or accumulated earnings and profits. 105 The final QSub regulations generally apply to taxable years that begin on or after January 20, 2000, but taxpayers may elect to apply the regulations in whole, but not in part, for taxable years beginning on or after January 1, F. Qualified Subchapter S Subsidiary. Section 1361(b)(3)(B) defines the term qualified subchapter S subsidiary ( QSub ) generally as any domestic corporation that is not an ineligible corporation if, (i) an S corporation holds 100 percent of the stock of the corporation, and (ii) that S corporation elects to treat the subsidiary as a QSub. An ineligible corporation includes a financial institution that uses the reserve method of accounting for bad debts; an insurance company subject to tax under Subchapter L; a possessions tax credit entity described in section 936 or a DISC or former DISC. Except as otherwise provided in regulations, a corporation for which a QSub election is made is not treated as a separate corporation, and all assets, liabilities, and items of income, deduction, and credit of the QSub are treated as assets, liabilities, and items of income, deduction and credit of the parent S corporation. 106 Thus, the QSub rule removes not only the controlled subsidiary Reg See Reg (b)(3). -35-

48 impediment, but also serves as an important exception to the prohibition on a corporation from owning stock in an S corporation QSub as a Disregarded Entity Upon Effective Date of Election. Once effective, the QSub election requires that the assets, liabilities, tax items, tax history, etc., of the QSub are treated as directly owned and realized by the S corporation parent for federal income tax purposes. All intercompany transactions presumably will be eliminated for federal tax purposes. 108 A similar rule is contained in section 856(i), permitting a REIT s ownership of a 100% subsidiary. As to the QSub, it would no longer add/subtract to its tax history, e.g., earnings and profits, AAA, etc., during the applicable period. There is a carryover of tax basis, which in turn triggers application of section 1374 with respect to transferred basis assets. 109 Where the subsidiary uses the LIFO method of inventory accounting, the making of the QSub election triggers the four year LIFO recapture rule. For state law purposes, the QSub is still recognized as a separate legal entity. 110 Final regulations to the QSub rules were issued on January 25, The final regulations generally apply to taxable years that begin on or after January 20, 2000; however, taxpayers previously could have elected to apply the regulations in whole, but not in part (aside from those sections with special dates of applicability), for taxable years beginning on or after January 1, 2000, provided the corporation and all affected taxpayers apply the regulations in a consistent manner. To make the election, the corporation and all affected taxpayers must file a return or an amended return that is consistent with these rules for the taxable year for which the election is made. The rules relating to the treatment of banks apply to all taxable years beginning after December 31, The provision relating to transitional relief from application of the step transaction doctrine applies to certain QSub elections effective on or before the end of calendar year Reg (c)(2), relating to automatic consent for an S or QSub election made for a corporation whose QSub election has terminated within the five-year period described in section 1361(b)(3)(D), applies to certain QSub elections effective after December 31, Ownership Through Disregarded Entities. A corporation may be a QSub even if all its stock is not actually owned by an S corporation, as long as all of its stock is treated as owned by an S corporation for federal income tax purposes. Therefore, an S corporation can make a QSub election for a subsidiary which it owns through other entities that are disregarded for federal income tax purposes. 107 Cummings and Starr, The Impact of the New S Corporation Revisions, 85 J Tax n 197 (October, 1996). Proposed Regulations to the QSub rules were published on April 22, Final regulations were issued on January 20, 2000 (65 FR 3843) 108 See S. Rept. No , 104th Cong., 2d Sess (1996) (d)(8). 110 See IRS Notice Reg FR Reg (a)(3)(iii). 113 See Reg (a)(5)(i). 114 Reg (i), relating to EINs, applies on or after January 20,

49 3. Debt, Options and Other Instruments, Arrangements. While the parent electing QSub must own all of the stock of the subsidiary, the question is whether there is any disguised equity floating around the QSub orbit through the issuance of debt, options or other arrangements held by third parties which would violate the QSub rules. 115 The Proposed Regulations did not provide any bright line rules or safe harbors. Instead, general federal tax principles are to be applied, including the safe harbors for options and straight debt instruments under Subchapter S. Instead, the amorphous set of 14 factors would be used to make this determination. 116 In response to criticism of the rule applying general tax principles for determining if the parent owns all of the QSub stock, the final regulations adopt the position that arrangements that are not considered to be stock under the one class of stock rules set forth in Reg (l) will be disregarded. Commentators recommended that, for purposes of determining whether a subsidiary is wholly owned by the parent S corporation, arrangements that are not considered to be stock under the one-class-of-stock rules of Reg (l) should be disregarded. The final regulations provide a straight debt safe harbor if the obligation would meet the requirements under Reg (l)(5). 117 The commentators noted that applying the principles of these regulations would provide certainty with respect to the subsidiary s eligibility to be a QSub and avoid difficult debt/equity determinations. Similar relief is provided for deemed exercise of an option under Reg An example of the use of straight debt to maintain QSub status is provided in Reg (d). 4. Election of QSub Status. Section 1361(b)(3) requires that an S corporation must file a QSub election for each applicable subsidiary otherwise the subsidiary will be treated as a C corporation. The election mechanics are set forth in Reg which generally follows the rules set forth in the proposed regulations including the provision that a QSub election may be made by the S corporation parent at any time during the taxable year. The election form, which is still to be prescribed by the IRS, must be signed by the appropriate officer of the corporation under section The election is filed with the Service center where the subsidiary filed its most recent tax return, or if a newly organized subsidiary, where the S corporation parent filed its most recent return. 119 The QSub election will be effective on the date specified on the election form or on the date the election form is filed if no date is specified. The effective date specified on the form cannot be more than two months and 15 days prior to the date of filing and cannot be more than 12 months after the date of filing. For this purpose, the definition of the term month found in Reg (a)(2)(ii)(C) applies. If an election form specifies an effective date more than two months and 15 days prior to the date on which the election form is filed, it will be effective two months and 15 days prior to the date it is filed. If an election form specifies an effective date 115 See Reg (l)(4)(ii)(B), (iii)(b), (iii)(c)(safe harbor rules for certain debt and option arrangements). 116 See Plumb, The Federal Income Tax Significance of Corporate Debt: A Critical Analysis and a Proposal, 26 Tax L. Rev. 369 (1971). 117 Reg (b)(2), -2(c). 118 See Reg (a)(2)(v). 119 Reg (a)(2). -37-

50 more than 12 months after the date on which the election is filed, it will be effective 12 months after the date it is filed. The final regulations further acknowledge that relief is available under the 9100 regulations for a late filing. 120 An S corporation may revoke a QSub election under section 1361 by filing the appropriate statement with the service center where the S corporation s most recent tax return was properly filed. The revocation of a QSub election, provided the QSub election has not otherwise terminated for eligibility reasons, is effective on the date specified on the revocation statement or on the date the revocation statement is filed if no date is specified. 121 The effective date specified on the revocation statement cannot be more than two months and 15 days prior to the date on which the revocation statement is filed and cannot be more than 12 months after the date on which the revocation statement is filed. If a revocation statement specifies an effective date more than two months and 15 days prior to the date on which the statement is filed, it will be effective two months and 15 days prior to the date it is filed. If a revocation statement specifies an effective date more than 12 months after the date on which the statement is filed, it will be effective 12 months after the date it is filed. Reg provides that an extension of time to make a QSub election may be available under the late election relief rule in Reg by filing a request with the National Office explaining the reason for the failure. 122 The final regulations acknowledge that 9100 relief is available for late QSub elections. 123 Rev. Proc contains relief provisions for late-filed QSub elections. The Revenue Procedure applies only to a corporation (i) for which a timely QSub election under section 1361(b)(3)(B) was not filed for the desired effective date, (ii) for which a QSub election is filed within 12 months of the date that an election for the desired effective date should have been filed, and (iii) for which the due date for the S corporation s tax return (excluding extensions) for the first taxable year for which the S corporation desired QSub status for the subsidiary has not passed. The procedural requirements for this relief is as follows. Within 12 months of the due date for filing a QSub election to be effective on the desired effective date (but in no event later than the due date for the S corporation s tax return (excluding extensions)) for the first taxable year of the S corporation for which the S corporation intended to treat the subsidiary as a QSub), the corporation must file with the applicable service center a completed QSub election. The QSub election must state at the top the form FILED PURSUANT TO REV. PROC Attached to the form must be a statement explaining the reason for the failure to file a QSub election within the time period required for the desired effective date. 125 Rev. Proc , 126 in superseding the earlier Rev. Proc , supra, provides for making a late QSub election within 2 years of its original due date by filing the form with the service center in the normal manner, but with a statement of reasonable cause attached. If the Reg (a)(6). Reg (b)(2). See PLRs , , (granting late filed QSub elections). Reg (a)(6) I.R.B. 27 See also Rev. Proc , I.R.B. 19, 97-40, I.R.B C.B

51 two-year period has passed, an S corporation may seek 9100 relief by filing a private letter ruling request with the National Office of the Service. 127 While an S corporation can obtain relief for a defective election under Subchapter S in section 1362(f), neither the QSub provision, nor the regulations had set forth a specific rule providing relief in this area. The proposed regulations indicated that the Service would allow for an inadvertent termination of QSub status. Example: A, the S corporation parent of B, inadvertently transfers one share of B stock to another person causing the QSub election to terminate. B is not eligible to have a QSub election in effect for the period during which the parent does not own 100 percent of its stock. If the QSub election terminates because of the inadvertent termination of the parent s S election, however, relief may be available under section 1362(f). A favorable determination under that section causes the subsidiary to continue to satisfy the requirements of section 1361(b)(3)(B)(ii) during the period when the parent is accorded relief for inadvertent termination of its S election. The final regulations do not include the provision relating to the inadvertent termination of a QSub election. Despite its refusal to provide relief, the Treasury indicated that the provision is not intended to suggest that relief under section 1362(f) is not available in appropriate circumstances. As a result of the amendment to section 1362(f) under the 2004 Act, relief is now provided for defective QSub elections provided there are adequate grounds for establishing relief. The 2005 Act provides that a QSub is a separate entity for purposes of making information returns, except to the extent otherwise provided by the Secretary. In other words, Treasury and the IRS have the authority to treat a QSub as a disregarded entity for purposes of information returns; the 2004 Act had mandated separate entity treatment for information return purposes. The final regulations confirm the rule set forth in the proposed regulations which provide that a QSub election can be effective at any time during its tax year as long as the QSub eligibility requirements are satisfied at the time that the election is made and for all periods for which the election is to be effective Tax Treatment Of QSub Election. Although the relevant statutory language does not specifically provide, the QSub election is treated as a deemed liquidation of a wholly owned subsidiary into its electing S corporation parent. 129 Under section 337, no gain or loss is generally recognized by the liquidating subsidiary. Similarly, no gain or loss is recognized by the parent. 130 In accordance with section 381, the S corporation parent will succeed to the QSub s entire tax history as well as the adjusted 127 Reg (a)(6). 128 Reg (a)(3); Reg (a)(2), -3(a)(3). 129 See Staff of the Joint Committee on Taxation, General Explanation of Tax Legislation Enacted by the 100 th Cong., supra

52 basis in its assets. Where the subsidiary has been a C corporation, the liquidation will cause the parent S corporation to become subject to the built-in gains tax under section 1374 with respect to the target s assets. If the target C corporation used the LIFO method of inventory accounting, the special recapture rule in section 1363(d) comes into play. Post-QSub election problems may also be attributable to inheriting the target s C earnings and profits. Obviously, such will have an impact on characterizing post-qsub election distributions by a parent S corporation to its shareholders. 131 Where there is a significant amount of passive investment income, the carryover of the target s earnings and profits may result in an entity level tax under section 1375 and/or eventually pose a termination risk under section 1362(d)(3). Although section 1361(b)(3) allows the IRS to issue regulations to make exceptions to the general rule disregarding a QSub s separate status for federal tax purposes, the proposed regulations provided only one exception for banks described in section 581. Final Reg (a)(3)(i) provides that for any QSub that is a bank, all of its assets, liabilities and items of income, deduction and credit, determined in accordance with the special bank rules, are treated as being the assets, liabilities, etc., of the S corporation parent. Debt instruments issued by a QSub to a shareholder of the S corporation-parent are also treated as debts of the parent under section 1366(d)(1)(B). This rule permits the flow through of losses up the S tier to the ultimate shareholder. However, it would appear that the at-risk rules apply at the shareholder level and require a determination of the extent to which each shareholder is at-risk with respect to the QSub s operations. There will also be instances where shareholders of the parent hold debt of both the parent S corporation and the QSub. The legislative history indicates that the Treasury may issue regulations regarding the order that the losses pass through. For states which have piggyback statutes which borrow from federal definitions of Subchapter S, it would appear that the QSub rules will be respected for state income tax purposes. Uncertainty is present however for those states which have separate definitions or modifiers, or, for states which do not recognize or otherwise tax S corporations, Section 332(b) requires that the parent must adopt a plan of liquidation when it owns 80% or more of the stock of the liquidating subsidiary. A QSub election is, by design, a constructive liquidation. Since the subsidiary will not liquidate under state law, the question arises as to whether the adoption of a plan of liquidation is necessary. The timing of the deemed liquidation may also affect its tax consequences. The deemed liquidation is effective at the close of the date prior to the QSub election is becoming effective. 132 For the conversion of a consolidated group (and its parent corporation), the S corporation/qsub election deemed liquidation of the QSubs will be deemed to occur in the last consolidated return year. This means that ELA will be eliminated. 133 Generally the ordering of the QSub elections is from the bottom up in order to avoid ELA recapture unless the election form designates a QSub election sequence. 134 For example, if (c). Reg (b)(1). Reg (b)(2)(i). Reg (b)(2). -40-

53 A, an S corporation, owns all of the stock of B and C, and B and C each own 50% of the stock of D, A should specify that the B and C liquidations occur first, in order to qualify the entire set of deemed liquidations. 135 Where the QSub election is made after the acquisition of a another corporation, the liquidation is deemed to occur immediately after the stock ownership requirement is met. 136 The deemed liquidation occurs immediately after the deemed asset purchase. 137 The regulations provide that, for purposes of satisfying the requirement of section 332(b) that the parent corporation own stock in the subsidiary meeting the requirements of section 1504(a)(2) on the date of adoption of the plan of liquidation of the subsidiary, the plan of liquidation is deemed adopted immediately before the deemed liquidation incident to a QSub election unless a formal plan of liquidation that contemplates the filing of the QSub election is adopted on an earlier date. 138 Still if as a result of the application of general tax principles the transactions that include the QSub election are treated as an asset acquisition, and as further subject to transitional relief, section 332 is not applicable and this rule has no relevance. 6. Application to Newly Formed Subsidiaries. Where an S corporation forms a subsidiary and makes a valid QSub election for the subsidiary effective as of the date of the formation of the subsidiary, no deemed liquidation should be treated as having occurred since the subsidiary will never have been a separate corporation. Example: X is an S corporation which operate retail and manufacturing division. In January, 2005, X contributes the retail operations, subject to liabilities, which liabilities exceed the adjusted basis of the retail assets, to a newly formed corporation Y in exchange for all of Y s stock and makes a QSub election effective as of the date of formation of Y. If section 332 applied, the liquidation would be taxable since Y is insolvent. Similarly, section 357(c) should not apply since there is no section 351 transaction. Reg (a)(2) applies step transaction analysis to ignore the deemed liquidation under sections 337 and 332 and treat the transaction simply as the formation of a newly organized subsidiary. 7. F Reorganizations. While the step transaction was adopted in the proposed and final regulations to the QSub rules, some argued that during the transition period where the step transaction is not applicable, per se, the formation of a new shell S corporation (Newco) by the shareholders of an existing S corporation in a mid year formation, qualify as a Type F reorganization if all of the other requirements of the section are met. As a Type F reorganization, the taxable year of the existing S corporation does not close. The preamble to the final regulations provides that during the extended transition period set forth in the final regulations, the Service will not challenge See Form Reg (b)(3)(i). Reg (b) and (d), Example 3. Reg (a)(2)(iii), (iv). -41-

54 taxpayers who, through use of the step transaction doctrine to an acquisition of stock followed by a QSub election, employ the tax treatment applicable to a Type F reorganization. In Ltr. Rul , the IRS ruled that an S corporation s merger into its wholly owned QSub constituted a tax-free reorganization under Section 368(a)(1)(F) without adversely affecting S corporation status. In the ruling, the S corporation and one of its two wholly owned QSubs desired to combine their assets and operations into a single corporation in order to take advantage of planned efficiencies and to reduce expenses and redundancies. Because certain legal agreements of the QSub prohibited the QSub from merging upstream into the S corporation, it was decided that the S corporation should merge downstream into the QSub. Citing Rev. Rul , 139 the IRS concluded that pursuant to the F reorganization, the S corporation election would continue in effect with respect to the surviving QSub following the merger. Additionally, citing Rev. Rul , 140 the IRS found that the status of the S corporation s other QSub would not terminate as a result of the F reorganization. Interestingly, the ruling does not address whether the surviving entity should continue to use the federal identification number previously used by the S corporation or the federal identification number of the QSub into which it was merged. In Rev. Rul , 141 the IRS ruled that where an S corporation merges into another corporation in a transaction qualifying as an F reorganization, the acquiring (surviving) corporation should use the employer identification number of the transferor corporation. However, more recently in Rev. Rul , 142 discussed further below, the IRS ruled that in the two situations presented in the ruling, which both qualified as F reorganizations within the meaning of Section 368(a)(1)(F), the newly formed corporations would be required to obtain new employer identification numbers and that the existing corporation which became a QSub would retain its same employer identification number. 8. Timing of Deemed Liquidation. (a) Where Parent Already Owns 100% of Subsidiary. Under Reg (b), rules are set forth for the date on which the deemed liquidation resulting from a QSub election occurs. Where the S corporation parent owns all of the subsidiary stock prior to the effective date of the QSub election, the proposed regulations provide that the deemed liquidation occurs at the close of the day prior to the effective date of the QSub election. This was the same rule previously contained in the proposed regulations. Thus, if a C corporation elects to be treated as an S corporation and makes a QSub election effective on the same date, the liquidation occurs immediately prior to the S election becomes effective, while the S electing parent is still a C corporation. This timing rule has significant implications for consolidated groups which convert to S corporation and QSub status CB CB CB CB

55 (b) Acquisitions by S Corporations of Stock of Target/QSub Election. A second rule pertains to acquisitions of target corporations, i.e., where an S corporation does not own all of the subsidiary s stock on the day before the QSub election is to be effective. In this situation, the regulations provide that the deemed liquidation occurs immediately after the time at which the S corporation s owns 100% of the subsidiary s stock. 143 (c) Qualified Stock Acquisitions Under Section 338. The QSub election is not effective for the target until the day after the acquisition date. The deemed liquidation resulting from the QSub election occurs immediately after the date of the deemed asset purchase by the new target corporation under section Where the S corporation makes an election under section 338 (without a section 338(h)(10) election) with respect to a target, the target must file a final or deemed sale return as a C corporation for the deemed sale Effect of QSub Election on S Corporation s Basis in Subsidiary Stock. Aside from the tax history issues generated by a deemed liquidation, perhaps the most immediate drawback to the QSub is the disappearing basis isssue. Suppose, for example, that an S corporation purchases all of the stock of a target C corporation (in a non-section 338 transaction) at a purchase price of $2,000x. Assume the target s basis in its assets is $500x. By purchasing all of the target s stock and making the QSub election (or, alternatively, by immediately liquidating the target into the purchaser), the parent s cost basis in the subsidiary stock, i.e., $2,000x, disappears. The only relevant basis to the parent is the adjusted basis of the subsidiary s assets. The $2,000x basis is not reinstated if there is a termination of the QSub election because the subsidiary is treated as a newly-formed corporation at that time under section 1361(b)(3)(C). Again, the inside versus outside value differential will present built-in gains tax problems to the purchaser with respect to the QSub s assets. The total net unrealized built-in gain is allocated on an asset-by-asset basis including goodwill and going concern value Acquisitions of S Corporations AAA and Suspended Losses. The Treasury Regulations acknowledge that the AAA of a target S corporation which is acquired in a tax-free reorganization or liquidation described in sections 337/332 will be inherited by the acquiring corporation. 147 Reg (c) further provides that suspended losses also carry over where one S corporation acquires the stock of another S corporation referencing Reg (c)(1). 143 Reg (b)(2) (h)(2). Reg (b)(2). 145 Reg T(a). Reg (d), Ex (b)(1), 1374(d)(8), 1374(d)(1). Treas. Regs (b), (a)(4)(except for purposes of 1361(b)(3)(B)(i) and Reg (a)(1), the stock of a QSub is disregarded for federal tax purposes). 147 Reg (d)(2). -43-

56 11. Application of Built-In Gains Tax to QSub Elections. Section 1374 imposes a corporate level tax on the built in gains of an S corporation after it has converted from C corporation status. The tax is imposed on net recognized built-in gains for the subsequent 10 year period following the effective date of a C to S conversion. Section 1374(d)(8) provides the section 1374 tax carries over with respect to an S corporation s receipt of transferred basis property from another C corporation or S corporation having an unexpired recognition period under section 1374 from a prior conversion event. Therefore, section 1374(d)(8) will apply with respect to the purchase of all of the stock of a target corporation and subsequent QSub election under the deemed liquidation rule. In such case, a separate determination of tax is made with respect to the assets acquired by each particular target corporation. Regulations under section 1374 provide that the tax attributes of the target, e.g., net operating loss and capital loss carryovers, may only be used against the target s subsequent recognized built-in gains. 148 Furthermore, section 1374 attributes acquired in one section 1374(d)(8) transaction may only be used to reduce the tax on the disposition of assets acquired in that transaction. This results in a Libson Shops type separate pooling approach. 12. Conversion of Consolidated Group into QSub Group. (a) In General. Where there is 100% ownership of each member of a consolidated group, and the shareholders of the parent C corporation are permissible shareholders, SBJPA makes it possible to convert the entire group to a Subchapter S regime. Still, section 1504(b) provides that an S corporation cannot be an includable corporation and cannot join in the filing of a consolidated return. Where the parent elects S status, the group will terminate. Where the parent does not elect to treat of any its subsidiaries as QSubs, excess loss accounts ( ELAs ) and deferred intercompany transactions will be triggered. Compare result where parent forms a single member LLC and causes each subsidiary to first merge upstream into the LLC. This transaction should qualify as a tax free liquidation under sections 337 and 332. A question which arises in converting from consolidated tax return model rules to a Subchapter S regime is to what extent are the consolidated groups intercompany accounts and ELAs affected. As to deferred or non-accelerated intercompany gain, since the benefits of consolidated reporting are affirmatively revoked in favor of a single tax system under Subchapter S, the Service may feel that it is appropriate to require a complete catch-up, i.e., triggering of deferred gain, on intercompany transactions upon a QSub conversion. On the other hand, the long-standing policy of a C to S conversion is that it is not a realization event for income tax purposes. Since there is a carryover of adjusted basis to the S corporation parent, there arguably is no need to impose a taxable event. As to deferred intercompany gain, under the regulations in effect for taxable years commencing prior to July 12, 1995, such gain generally was not recognized in a section 332 liquidation. The result is otherwise under the new (accelerated and matching) intercompany rules Reg (b). Reg (f)(1)(iii). -44-

57 As previously mentioned, such conversion would require application of the built-in gains tax, LIFO recapture and other C to S conversion issues. Prior to SBJPA, it would have been necessary to merge or liquidate all of the subsidiaries into the parent to effectuate a C to S conversion for the group. This may have produced an undesirable shift in economic and legal risk to the parent since all subsidiary debt would have to be effectively assumed. After SBJPA, the conversion to Subchapter S can be accomplished on a group wide basis without changing the group s operational structure under state law. (b) ELA. The consolidated return regulations provide that a parent must track its investment in each subsidiary. When the subsidiary s losses from operations exceed the parent s investment, such excess constitutes an excess loss account or ELA. Reg provides rules requiring, in certain instances, a member (X) of a consolidated group of corporations to include in income its ELA in the stock of another member (Y) of the group. An ELA reflects X s negative adjustments with respect to Y s stock to the extent the negative adjustments exceed X s basis in the stock. Most frequently this occurs as a result of the member funding its losses with third party borrowing. An ELA must be included in X s income if X is treated as disposing of Y s stock. 150 A merger or liquidation of X into an S corporation or an S election by X is treated as a disposition that triggers income recognition with respect to an ELA in Y stock. In contrast, X s income or gain in certain cases is subject to any nonrecognition or deferral rules applicable, including section 332. As a result, if Y liquidates into X in a transaction subject to section 332 (and the subsidiary is solvent), there is no income recognition with respect to an ELA in Y s stock. 151 This is based on the rationale that the nontaxable liquidation of a member the stock of which has the ELA eliminates the separate entity treatment of the stock of the subsidiary, since the tax basis of the stock is no longer relevant. (c) Impact of QSub Election on ELAs. Under the general timing rules of Reg (b)(1), if the common parent elects S status, the deemed liquidations of the subsidiary members of the consolidated group for which QSub elections are made (effective on the same date as the S election) occur as of the close of the day before the QSub elections are effective, while the S electing parent corporation is still a C corporation. As a result, there is no triggering of income with respect to ELAs in the stock of the subsidiary corporations if the liquidations qualify under section 332. Furthermore, the order of the deemed liquidations for a tiered group of corporations for which QSub elections are made (effective on the same date) is significant for ELA (and section 1374) purposes. Under the lowest to highest liquidations of tiered subsidiaries approach, the deemed liquidation of the common parent follows the deemed liquidation of its subsidiaries. Accordingly, there is no deconsolidation for purposes of Reg and no triggering of ELAs. In other circumstances, however, a top to bottom liquidation of a tiered group of subsidiaries may be preferable. Therefore, the final regulations allow the S corporation to specify the order of the deemed liquidations when QSub elections are made (effective on the same day) for a tiered 150 See Reg (b)(1). See also Reg (c)(2), (c). 151 See Reg (b)(2)(i). See also Textron, Inc. v. U.S., 561 F. 2d 1023 (1st Cir. 1977); Compare, Norman Scott, Inc. v. Comm r, 48 T.C. 598 (1967); Rev. Rul , C.B

58 group of subsidiaries. In default of an election, the deemed liquidations occur in succession on the effective date of the election, beginning with the lowest tier subsidiary. 152 Example: A, an S corporation, owns 100% of B and B owns 100% of C and C owns 100% of D. A QSub election is made for each subsidiary. If no order is set forth by election, the final regulations, under the default rule, treat the liquidations as occurring from the lowest tier, D to the highest A. Curiously, at the time that D is deemed to liquidate into C, C is a corporation (section 332 applies) which seems to ignore the effective date for each QSub election. Example: All the stock of B, an S corporation, is transferred to A, also an S corporation and a QSub election is made for B effective on the date of transfer. B is not treated as having a momentary (one day) C period because of its stock being held by an ineligible shareholder. The final regulations apply this rule even where A is a C corporation which makes an S election effective on the date of the acquisition. The deemed liquidation of B takes place at the start of the day the termination of its S election is effective. 153 (d) Deferred Intercompany Gains/Losses. Another important issue with respect to making an S election and/or QSub elections for members of a consolidated group is whether gains or income, from any deferred intercompany transactions between group members are taken into income and collapsed for the last consolidated return year. It is critical to distinguish the Old Intercompany Regulations, i.e., intercompany transactions which occurred in tax years beginning before July 12, 1995 from the New Intercompany Regulations, i.e., intercompany transactions which occurred in tax years beginning on or after July 12, Both sets of regulations provide that where the consolidated group terminates its election, gains and income from deferred intercompany transactions must be taken into account in the final consolidated return. 154 Both sets of rules provide that losses and deductions from such transactions remain deferred under section Under the Old Intercompany Regulations, deferred gain or income is not taken into account where the selling member is liquidated into the parent corporation in a section 332 liquidation. 156 Therefore, as with ELAs, gain and income from old intercompany transactions would not be taken into account where the buying and selling corporations are liquidated tax free into the common parent under section 332 prior to the group s ceasing to file consolidated returns. Query, does the deemed liquidation resulting from the QSub election occur before or after the termination of the consolidated group? The proposed regulations indicated that the deemed liquidation occurs before the consolidated group terminates. The final regulations confirm this result. Therefore the old DITS are not recaptured. Under the New Intercompany Regulations, gain or income must be included in income when the common parent becomes an S corporation. Although the new deferred intercompany Reg (b)(4). See also Reg (b). Reg (b)(3)(ii). Former Reg (f)(1)(iii); Reg (d)(1), (d)(3) Ex. 1(f). Former Reg (f)-2T(d)(1), Reg (f)-1T(c)(5), 1.267(f)-1(c)(1)(i). Former Reg (c)(6). -46-

59 regulations contain a similar exception to recognition of deferred gain or income when the consolidated group terminates by virtue of a section 332 liquidation up into the common parent, such exception applies so long as [the common parent] neither becomes a member of an affiliate group filing separate returns nor becomes a corporation described in section 1504(b). SBJPA amended section 1504(b) to include S corporations as part of the list of nonincludable corporations. Therefore, the new DITS presumably must be recaptured. There may also be a second round of taxation under section 1374 since there may be additional appreciation in the acquired assets. Thus, such gain will be subject to two immediate levels of gain when it is recognized. It may be advisable to sell off such assets prior to making the conversion, including a sale to another member of the group. 13. Reorganizations Involving QSubs. QSubs can be part of a tax-free reorganization, such as a section 368(a)(1)(A) merger or consolidation. 157 Provision is made that if a target S corporation that has a QSub merges into a disregarded entity, the termination of the QSub election followed by the deemed contribution of the former QSub s assets to a new C corporation immediately prior to the merger does not disqualify the merger under section 368(a)(1)(A). 158 These regulations generally apply to transactions occurring on or after January 23, As discussed further above, the Service and Treasury proposed regulations in January 2005 containing a revised definition of statutory merger or consolidation that allows transactions effected pursuant to the statutes of a foreign jurisdiction or of a United States possession to qualify as a statutory merger or consolidation. Simultaneously with the publication of the 2005 proposed regulations, the IRS and Treasury Department published a notice of proposed rulemaking proposing amendments to the regulations under sections 358, 367, and 884 to reflect that, under the 2005 proposed regulations, a transaction involving a foreign entity and a transaction effected pursuant to the laws of a foreign jurisdiction may qualify as a statutory merger or consolidation (the foreign regulations). The regulations were finalized in January, Termination of QSub Election. A QSub election may be terminated: (i) by revocation; (ii) by reason of the parent no longer being an S corporation; or (iii) by the subsidiary s failing to meet the QSub eligibility requirements. Where a QSub election is terminated due to a disqualifying event, Reg (a)(2) requires the S corporation to attach a statement to its return for the tax year in which the termination occurs, notifying the IRS that a QSub election terminated. This notification also must include the date of the termination and the names, addresses, and employer identification 157 Reg (b)(iv) ex See Reg (b)(1)(iii) Ex. 3 (providing that the deemed formation by the target S corporation of a C corporation subsidiary as a result of the termination of its subsidiary s QSub status is disregarded for federal income tax purposes; the target S corporation is viewed as transferring the assets of its subsidiary to the acquirer followed by the acquirer contributing those assets to a new C corporation subsidiary in exchange for stock); see also Reg (b)(3) Ex Reg (b)(1)(v) FR , I.R.B. 422, 2006 WL (F.R.) -47-

60 numbers of both the parent S corporation and the QSub. Reg (a)(3) provides, alternatively, that where a QSub election terminates because the S corporation becomes a member of a consolidated group (and no election under Section 338(g) is made), principles contained in Reg (b)(1)(ii)-(A)(2)(special rules for S corporations joining consolidated groups) apply. This regulation eliminates the one-day return problem by providing that an S corporation that is acquired by a consolidated group in a transaction other than a section 338 transfer, becomes a member of the consolidated group at the beginning of the day on which termination of its S election is effective. 161 (a) Effective Date of Termination. The final regulations provide that the effective date of a QSub termination is: (i) on the effective date contained in the revocation statement if a QSub election is revoked under Reg (b); (ii) at the close of the last day of the parent s last taxable year as an S corporation if the parent s S election terminates under Reg ; or (iii) at the close of the day on which a disqualification event occurs that results in the QSub not being described under section 1361(b)(3)(B). 162 Example: A terminates its S election effective on January 1, A wholly owned QSub B no longer qualifies as a QSub at the close of December 31, Example: A sells 1 share of its QSub B on December 10, B is no longer a QSub at the close of December 10, Example: A has a QSub election for B and C while B owns 100% of C. B transfers all of its C stock to A. No termination occurs since A is already treated as owning all of the C stock through B. Example: A, an S corporation owns 100% of B a QSub. Z, the common parent of a consolidated group purchases 80% of the stock of A on June 1, Z does not make a section 338 election. A s S election terminates its election as of the close of the preceding date, May 31, The QSub election for B is also terminated as of the close of May 31, Pursuant to Reg (b)(1)-(ii)(A)(2), A and B become members of Z s consolidated group as of the start of June 1, If instead of purchasing 80% of A, Z purchased 80% of B, A s QSub election terminates as of the close of June 1, 2006 and B becomes a member of the consolidated group at such time. 161 See, however, Rev. Rul , C.B. 189 which provides that (i) an election to treat a wholly owned subsidiary of an S corporation as a QSub, does not terminate solely because the S corporation engages in a transaction that qualifies as a reorganization under 368(a)(1)(F); (ii) an election to treat a subsidiary as a QSub terminates if the S corporation transfers 100 percent of the QSub stock (whether by sale or reorganization under 368(a)(1)(A), (C), or (D)), to another S corporation in a transaction that does not qualify as a reorganization under 368(a)(1)(F); and (iii) an entity classification election of an eligible entity, as described in Reg (b), does not terminate solely because the owner (whether by sale, reorganization under 368(a)(1)(A), (C), (D), or (F), or otherwise) transfers all of the membership interest in the eligible entity to another person. 162 Reg (a)(1),-5(a)(2)(information required to be filed upon failure to qualify as QSub). -48-

61 Under the final regulations, where a tier of QSubs have their elections terminated on the same day, the formation of any higher tier subsidiary is deemed to have occurred prior to the formation of a lower tier subsidiary, a so-called top to bottom approach. 163 (b) Effect of Termination of QSub Election. In the event of a termination of the QSub s election, the corporation is treated as a new corporation acquiring all of its assets (and assuming all of its liabilities) from the S corporation in exchange for stock of the new corporation immediately before the termination. 164 Without specifically providing that there is a deemed section 351 transaction, Reg (b)(1) provides that the tax treatment of this transaction or of a larger transaction that includes this transaction will be determined under the Code and general principles of tax law, including the step transaction doctrine. Prior to the 2007 Act, it was necessary to consider the control requirement (80% transferor group) in section 368(c) for the termination of a QSub election, for example upon the sale of some or all of the shares, as well as assessing the potential impact of section 357(c) as well as the other potential exceptions to tax free treatment. Under the 2007 Act, if a QSub election terminates because QSub stock is sold, the sale is treated as a sale of an undivided interest in the assets of the QSub followed by a deemed section 351 transfer of the assets to the new corporation by the purchaser (and the seller to the extent of unsold shares). 165 If a QSub election terminates because the S corporation distributes its QSub stock to some or all of its shareholders in a transaction which qualifies under section 368(a)(1)(D) and section 355, then the section 351 model will yield to the greater transaction (per step analysis). Reg (b)(2) provides that any loss or deduction disallowed under section 1366(d) with respect to a shareholder of the parent S corporation immediately before the distribution will be allocated between the parent S corporation and the former QSub with respect to each shareholder. The amount allocated to the parent S corporation will bear the same ratio to each item of disallowed loss or deduction as the value of the shareholder s stock in the parent S corporation bears to the total value of the shareholder s stock in both the parent S corporation and the former QSub, determined immediately after the distribution. A termination of QSub status may result through a revocation by the parent or a consequence of transferring a single share of subsidiary stock to a shareholder or third party. More specifically, section 1361(b)(3)(c) provides that a upon termination, the QSub is treated as a new corporation acquiring all of its assets and assuming all of its liabilities from the S corporation parent in exchange for its stock. The former QSub is prohibited from re-electing S status or QSub status for 5 years unless permission is received from the Service. 166 The final regulations provide some relief. For S and QSub election s effective after 1996, where a QSub election terminates, the corporation may, without obtaining IRS consent, make an S election or be subject to a new QSub election prior to the end of the five year waiting period provided: (i) immediately following the termination, the corporation (or its successor) is otherwise eligible to Reg (b)(1)(ii). 1361(b)(3)(C). 1361(b)(3)(C)(ii), added by 8234(a)(1)-(2)- of the 2007 Act. 1361(b)(3)(D). See Reg

62 make an S election or be subject to a QSub election, and (ii) the relevant election is made effective immediately following the termination of the QSub election. 167 Example: Assume X, an S corporation, owns 100% of Y, a QSub and distributes all of its Y stock to X shareholders. The distribution terminates the corporation s QSub election. 168 Assuming Y is otherwise eligible to elect S, Y s shareholders may elect S status without IRS consent within the 5 year period. The same result applies were X to instead sell 100% of its Y stock to an unrelated S corporation, Z, where Z intends to make a QSub election effective on the date of the acquisition. V. Social Security and Medicare Tax Considerations of Entity Choice A. In General. As part of the Federal Insurance Contributions Act ( FICA ), 169 a payroll tax is imposed on employees and employers up to a prescribed maximum amount of employee wages. This tax is comprised of two parts, the Old-Age, Survivor, and Disability Insurance (OASDI) portion and the Medicare Hospital Insurance (Medicare or HI) portion. The Medicare tax rate is 1.45% on both the employer and the employee, and the OASDI tax rate is 6.2% on both the employer and the employee. 170 The maximum wages subject to the OASDI tax rate for 2011 is $106,800. Each of the employer and employee must pay the Medicare tax on the total (uncapped) amount of wages equal to 1.45%. 171 Supplementing the payroll tax scheme for employers and employees, a separate selfemployment tax (the SE tax ) is imposed on net earnings from self-employment ( NESE ) for individuals classified as self- employed at the rate of 15.3% on the first $106,800 of such net earnings, and 2.9% (separately, the Medicare tax ) on amounts in excess of $106, Excluded from the definition of NESE are certain capital gains, rental income, interest and dividends. Because individuals are entitled to an above the line deduction equal to one-half of the SE tax paid under section 164(f), the effective tax rate for the SE tax is somewhat reduced Reg (c)(2). 168 See also 368(a)(1)(D), 355, Social Security Amendments of 1954, P.L Sections 3101(a),(b). 171 Section 3111(b). 172 Section 1402(a). 173 Assuming a top marginal income tax rate of 35%, the effective rates of self-employment taxes taking into account the deduction of one-half of the self-employment taxes are as follows: Marginal Rate Effective Rate on NESE $106,800 Effective Rate on NESE < $106,800 0% 2.9% 15.3 % 10% % % 15% % % 25% % % 28% % % 33% % % 35% % % -50-

63 The Revenue Reconciliation Act of 1993 ( RRA 93 ) 174 repealed the dollar limit on wages and self-employment income subject to the Medicare portion of the FICA tax as well as the self-employment tax. Thus, employers and employees are currently subject to the 1.45% HI tax on all wages, and self-employed individuals are subject to the 2.9% HI tax on all selfemployment income. B. Employees and Partners Contrasted. Bona fide partners are not treated as employees for purposes of federal employment taxes. 175 Thus, if an individual is a partner for federal tax purposes, that person will not be treated as an employee, regardless of the terminology used to describe the relationship. If, instead, an individual who provides services is not a partner for tax purposes, that individual may be considered to be either an employee or an independent contractor. It is important to note that the characterization of an individual as an employee for tax purposes will not necessarily be the same as his or her treatment under non-tax law. 176 The characterization of an individual as an employee or a partner will have an effect on both the individual and the partnership or other entity. Some of the consequences of the characterization are set forth below: 177 Item Employee Partner 1. Withholding The employer is obligated to withhold certain amounts from the payments to the employee. 178 Partners are not subject to withholding, but are required to pay estimated taxes. 179 Except in the case of foreign partners, P.L Rev. Rul , C.B For example, under Clackamas Gastroenterology Associates v. Wells, 71 USLW 4293, 123 S. Ct. 1673, 155 L.Ed2d 615 (2003) the Supreme Court set forth the following tests to determine whether a director/officer of a medical professional corporation would be an employee for the determination of whether the corporation had 15 or more employees for purposes of the Americans with Disabilities Act based on the EEOC Compliance Manual 605:0009: 1. Whether the organization can hire or fire the individual or set the rules and regulations of the individual s work 2. Whether and, if so, to what extent the organization supervises the individual s work 3. Whether the individual reports to someone higher in the organization 4. Whether and, if so, to what extent the individual is able to influence the organization 5. Whether the parties intended that the individual be an employee, as expressed in written agreements or contracts 6. Whether the individual shares in the profits, losses, and liabilities of the organization. 177 This chart and the annotations are reprinted in substantial part with the permission from the authors, Larry E. Ribstein and Robert R. Keatinge, Ribstein and Keatinge on Limited Liability Companies, (West, 2 nd Ed., June, 2011). 178 Section Section See also, Treas. Reg (c) ( For the purposes of other provisions of the internal revenue laws, guaranteed payments are regarded as a partner s distributive share of ordinary income. Thus, a partner who receives guaranteed payments for a period during which he is absent from work because of personal injuries or -51-

64 Item Employee Partner 2. Income and withholding on issuance of interest To the extent the value of the interest is included in the income of the employee, it will constitute wages and be subject to withholding. There are alternative treatments of the withholding amount. The value of the interest may be combined (1) with wages paid or to be paid within the same calendar year for the last preceding pay period, or (2) with wages for the current pay period Reporting form W-2 (employee), 1099(independent contractor) 4. Deduction of expenses by partner/ employee 5. Deductions for employer provided health insurance Expenses paid by an employee are unreimbursed business expenses which are subject to substantiation requirements, 183 and must be taken as an itemized deduction subject to the 2% AGI floor 184 and the phaseout of itemized deductions. 185 Payments of health insurance premiums are deductible to the employer 186 and not included in the income of the employee. the partnership is not obligated to withhold with respect to partners. 181 If the interest of a person already a partner is increased, the results are unclear. If the change is merely a change in the partner s share of profits, there is probably not a taxable event. On a change in a partner s share of capital (a capital shift ) the partner receiving an increase in capital will have income and, depending on the treatment of the services, will give rise to a deduction which will probably be allocated to the other partners in accordance with the amounts by which their capital accounts are reduced. In any case there should be no withholding. K-1 A partner who expends funds that are not reimbursed by the partnership, may be able to deduct those expenses as necessary and proper. Payments of health insurance premiums are deductible to the partner. 187 sickness is not entitled to exclude such payments from his gross income under section 105(d). Similarly, a partner who receives guaranteed payments is not regarded as an employee of the partnership for the purposes of withholding of tax at source, deferred compensation plans, etc. ). 180 Section Rev. Rul , C.B Treas. Reg (g)-1(a)(2). 183 Treas. Reg Section 67, Temp. Treas. Reg T(a)(i). 185 Section Section Section 162(i). -52-

65 Item Employee Partner 6. Personal use of entity property and other fringe benefits 7. Employment taxes 192 and selfemployment taxes 8. Workers compensation 9. Timing of income Employees are entitled to receive certain fringe benefits such as employer parking tax free. 188 A 2 percent shareholder in an S corporation is treated as a partner for purposes of the fringe benefit rules. 189 Except as provided in section 132, personal use of corporate property by an employee is taxable as wages. Wages are subject to employment taxes, while dividends are not. Thus, in an S corporation, the shareholders can, within certain limitations, allocate income between amounts subject to employment taxes and amounts that are excludible distributions to shareholders. 193 The income of independent contractor will constitute NESE (see next column). Employees normally must be covered by workers compensation, although some states allow employees who are officers, directors or own stock to elect not to be covered. All amounts paid to the employee or independent contractor are included in income at the time of payment. Partners, as self-employed persons, are treated as receiving guaranteed payments, not entitled to tax-favored fringe benefits 190 such as employer provided parking. Payments made on behalf of partners are treated as guaranteed payments to the recipient partners. 191 The tax treatment of the personal use of partnership property is unclear. A general partner s distributive share of ordinary income from a trade or business conducted by the partnership (other than dividends, interest, and real estate rentals) is NESE, and subject to self-employment taxes. 194 NESE does not include a limited partner s share of income or loss, except with respect to guaranteed payments for services 195 Partners are often not covered for purposes of workers compensation, although some states allow partners to elect to be covered if they so elect. Except with respect to guaranteed payments, which are included when paid to the partner, a partner includes his or her share of partnership income reflected on a partnership form K-1 as and when such income is recognized by the partnership (based on the partnership s method of accounting) regardless of when or if the income is distributed to the partner. In the 188 Section Section 1372(a)(2). 190 Section 132 (f)(5)(e) ( employee does not include persons who are self-employed). 191 Rev. Rul , C.B For 2011, each of the employer and the employee are subject to an employment tax of 6.2% on the first $106,800 of wages paid to the employee. Sections 3101(a), 3111(a). In addition, each of the employer and employee must pay a Medicare hospital tax on the total (uncapped) amount of wages equal to 1.45%. Sections 3101(b), 3111(b). 193 See Section V. D. Choice of Entity and Social Security Taxes, below. 194 Section 1402(a). 195 See Section V. D. Choice of Entity and Social Security Taxes, below. -53-

66 Item Employee Partner 10. Character of income 11. Unemployment insurance Income received by an employee or independent contractor will be ordinary income. Employers are liable for FUTA payments of 6.2% of wages 198 up to a total of $7,000 in wages. 199 C. The Health Care and Education Reconciliation Act of The New Medicare Tax on Investment Income. case of guaranteed payments, the payment is included in ordinary income in the year in which the payment is paid or accrued under the partnership s method of accounting. 196 Except with respect to guaranteed payments, which will be ordinary income, the character of a partner s distributive share of partnership income is determined at the partnership level, and the distributed share of income allocated to a partner has the same character in the partner s hands as in the hands of the partnership. 197 Partners are not subject to federal unemployment insurance requirements. The 2010 Health Care Act imposes a new Medicare tax on unearned income, including income passed-through to partners, members of LLCs taxed as partnerships, and S corporation shareholders. Specifically, section 1411(a)(1) imposes a 3.8% Medicare tax on the lesser of (a) net investment income ( NII ) or (b) the excess of modified adjusted gross income over $250,000 in the case of taxpayers filing a joint return and over $200,000 for other taxpayers. Under section 1411(c)(A)(i), NII includes gross income from interest, dividends, annuities, royalties, and rents other than such income which is derived in the ordinary course of a trade or business. Consequently, items of interest, dividends, annuities, royalties, and rents which pass through a partnership, LLC or S corporation to its partners, members or shareholders, will retain their character as NII and will be subject to the new 3.8% Medicare tax on NII. Additionally, the definition of NII includes: (1) any other gross income derived from a trade or business if such trade or business is a passive activity within the meaning of section 469, with respect to the taxpayer; and (2) any net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business that is not a passive activity under section 469 with respect to the taxpayer. The 2010 Health Care Act subjects investment income (rather than income derived from labor, as in the case of the SE tax), for the first time in the history of Social Security, to the Medicare tax. In addition, a partner, including a limited partner, LLC member and an S 196 Treas. Reg (c). 197 In some cases distributions of cash in redemption of a partner s interest in unrealized receivables and inventory will constitute ordinary income IRC Section Section 3306(b). -54-

67 corporation shareholder, will be subject to the new 3.8% Medicare tax on his or her distributive share of the operating income of the partnership, LLC or S corporation, as the case may be, if the activity generating such income is passive under section 469 with respect to such partner, LLC member or S corporation shareholder. The 2010 Health Care Act also increased the Medicare portion of the SE tax and the Medicare tax on wages by.9% (to 3.8%) on NESE and wages in excess of $250,000 in the case of taxpayers filing a joint return and more than $200,000 for other taxpayers. The new Medicare tax provisions are effective for tax years beginning after December 31, The Definition of Net Investment Income. The definition of NII includes interest, dividends, annuities, royalties and rents. 200 However, even these types of income are not subject to the new Medicare tax on NII if they are derived in the ordinary course of a trade or business, as long as that trade or business (i) does not constitute a passive activity with respect to the taxpayer, and (ii) does not constitute trading in financial instruments or commodities. Thus, presumably interest on customer receivables and interest derived in an active lending business should not be subject to the new Medicare tax. Moreover, royalties earned in the active conduct of a software business should be exempt. However, net interest generated on invested working capital will be subject to the tax. 201 NII does not include any distribution from a qualified retirement plan or individual retirement account. 202 There is a specific exclusion from NII of any item taken into account in determining SE income on which the SE tax is imposed under section 1401(b), therefore eliminating the risk that a taxpayer will be subject to Medicare tax on the same items of income under both tax schemes. 203 The statutory definition of NII, referring to trade or business and passive activity brings into relevance the line of cases that distinguishes between activities that constitute trade or business activities from those that are merely activities entered into for profit 204 as well as the regulations under section 469 dealing with the material participation standard. However, trade or business rental activities that are not excepted out under the special 750-hour/one-half services test for taxpayers in the real property business will generally still be subject to this new tax, because, as explained below, passive activity income is also treated as NII Section 1411(c)(1)(A)(i). 201 Section 1411(c)(1)(A)(i), (2). 202 Section 1411(c)(5), excluding from the definition of NII any distribution from a plan or arrangement described in sections 401(a), 403(a), 403(b), 408, 408A, or 457(b). 203 Section 1411(c)(6). 204 See, e.g., Whipple v. Comm r, 373 U.S. 193 (1963) (certain investment activities not a trade or business); McCullen v. Comm r, T.C. Memo (certain real estate activities not a trade or business); Moller v. United States, 553 F. Supp 1071 (Fed. Cl. 1982) (investment activities qualified as a trade or business); Higgins v. Comm r, 312 U.S. 212 (1941) (certain real estate activities qualified as a trade or business, while investment activities did not). 205 Section 469(c)(2),(7). Under this provision, a taxpayer who performs more than 750 hours of services in one or more real property trades or businesses, in which the taxpayer materially participates during a taxable year, and whose services constitute more than one-half of the personal services performed in such trades or businesses, is not -55-

68 3. Passive Activities. As mentioned above, the new Medicare tax on NII applies to net income from passive activities within the meaning of section 469 with respect to the taxpayer. 206 Under section 469, trade or business activities that are not rental activities or working interests in oil and gas properties are treated as passive activities unless the taxpayer materially participates in the activity. A taxpayer is not treated as materially participating in an activity unless his involvement in the operations of the activity is regular, continuous, and substantial. 207 The regulations under section 469 provide that a taxpayer materially participates in an activity if he or she meets one of seven tests during the taxable year: The taxpayer participates in the activity for more than 500 hours during the taxable year; 208 The taxpayer s participation in the activity for the taxable year constitutes substantially all of the participation in the activity (including individuals who are not owners of interests in the activity) for the taxable year; 209 The taxpayer participates in the activity fo more than 100 hours during the taxable year, and no other individual participates more; 210 The activity is a significant participation activity ( SPA ), where the taxpayer participates for more than 100 hours ( significant participation"), and the taxpayer s aggregate participation in multiple SPAs exceeds 500 hours. 211 The taxpayer materially participated in the activity in 5 of the last 10 taxable years; 212 The activity is a personal service activity (the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts or consulting, and any other trade or business in which capital is not a material income producing factor, and the taxpayer materially participated in the activity for any 3 taxable years (whether or not consecutive) preceding the taxable year, 213 and subject to the passive activity loss limitations on rental real estate activities. While such income or loss may be specially treated under the passive loss rules, the income may still be subject to the SE tax. 206 Section 1411(c)(1)(A)(ii), (B);(c)(2)(A). 207 Section 469(h)(1). 208 Treas. Reg T(a)(1). 209 Treas. Reg T(a)(2). 210 Treas. Reg T(a)(3). 211 Treas. Reg T(a)(4). 212 Treas. Reg T(a)(5). 213 Treas. Reg T(a)(6). -56-

69 Based on all the facts and circumstances, the taxpayer participated in the activity on a regular, continuous, and substantial basis during the year. 214 In the case of a married taxpayer, whether or not filing a joint return, participation by the taxpayer s spouse is treated as equivalent to participation by the taxpayer in determining material participation in each of the seven tests. 215 As a general rule, a limited partner is not considered to materially participate in activities of the limited partnership (with certain exceptions outlined below). If a taxpayer has multiple SPAs, but fails to meet the 500-hour test for combined significant participation activities, the income from the SPAs will be characterized as nonpassive and the losses will be characterized as passive. 216 The general rule for determining a partner's participation in partnership activities is that 217 any participation by the individual partner in any capacity is treated as participation. However, there are three exceptions to this general rule. Work Not Customarily Performed by an Owner. The first exception is for work not customarily performed by an owner. If the work performed by the partner is not of a type customarily done by an owner of the activity and one of the principal purposes of performing the work is to avoid the disallowance of losses under the PAL rules, the partner's work does not count as participation. 218 Participation as an Investor. The second exception excludes work done as an investor, unless the person is involved on a day-to-day basis in the activity's management or operations. Participation as an investor includes: (1) studying and reviewing financial statements or operational reports; (2) compiling or preparing summaries or analyses of the finances or operations of the activity for the investor's own use; and (3) monitoring the activity in a nonmanagerial capacity. 219 Thus, the normal work performed by an investor is excluded when determining whether the individual materially participates in the activity. Limited Partners. The third exception involves limited partners, who generally are not treated as materially participating. However, some exceptions apply. A limited partner is treated as materially participating if any of the following tests are satisfied: The limited partner participates in the activity for more than 500 hours during the year. The limited partner materially participated in the activity for any five of the 10 immediately preceding tax years. 214 Treas. Reg T(a)(7). 215 Section 469(h)(5); Treas. Reg T(f)(3). 216 Temp. Reg T(f). 217 Temp. Reg T(f)(1) 218 Temp. Reg T(f)(2) 219 Temp. Reg T(f)(2)(ii) -57-

70 The limited partner materially participated in a personal service activity for any three prior years. 220 The significant participation rules do not apply to limited partners. 221 Thus, income from a limited partnership activity automatically will be passive unless the limited partner meets one of the three exceptions listed immediately above. The threshold for establishing material participation based on all the facts and circumstances is high under section 469 and the legislative history. Regularity, continuity, and substantiality of involvement each impart a quantitative element. At the same time, the legislative history suggests that in the case of a farming activity, an individual who does not perform physical work, but who is treated as having self employment income with respect to the activity under section 1402, generally is treated as materially participating. 222 Until now, passive activity income was generally perceived to be a favorable tax classification because it, unlike non-passive trade or business income, could be offset by passive losses. 223 Thus, taxpayers have not taken steps to avoid this income classification, and in fact may have actively planned to qualify for it. The new Medicare tax may cause taxpayers to actually reverse course and actively avoid such classification. For example, an individual might be engaged in 10 separate activities, and actively participate in several of them for less than 500 hours per year (even though other individuals do participate in such activities). If each of these activities is treated as a separate activity, then those activities in which the taxpayer spends more than 100, but less than 500, hours per year (and which generate an overall net loss), along with those in which the taxpayer spends less than 100 hours per year, should be classified as passive activities generating passive activity income subject to the Medicare tax on NII. However, treating all of the activities in which the taxpayer participates as one single activity for passive activity purposes (satisfying material participation under the 500 hour test) could avoid the Medicare tax on NII on all of the income from the activities. 224 However, changes in the facts can alter this analysis considerably. For example, if one activity throws off a loss sufficient to avoid the tax on passive activity income if all taxpayer activities are aggregated together in such a manner that the outside passive activity loss would no longer be absorbed by the taxpayer s income from low participation activities, additional income tax may be payable. A careful analysis of the passive activity rules is important because the Service now requires all taxpayers who form new groups of activities or add new activities to existing groups 220 Temp. Reg T(e)(2) 221 Temp. Reg T(e) 222 Senate Report to Accompany H. R (The Tax Reform Act of 1986), S. Rep. No. 313, 99 th Cong., 2d Sess. (1986)( S. Rep. ) at Section 469(d)(1)(B). 224 Treas. Reg T(a)(1). -58-

71 to disclose how they are aggregating or segregating their activities under the passive activity loss rules. 225 These disclosure requirements apply for taxable years beginning after January 15, Incorporation of the passive activity rules into the new Medicare tax structure also creates a number of open issues. For example, the passive activity regulations provide that gross income from each significant participation activity equal to a ratable portion of the taxpayer s net passive income from such activity for the taxable year shall be treated as not from a passive activity if the taxpayer experiences net taxable income from such significant participation activities. 226 This suggests that in such cases, the income is not subject to the new Medicare tax on NII. 4. Trading in Financial Instruments and Commodities. The 2010 Health Care Act single out the trade or business of trading in financial instruments or commodities (as defined in section 475(e)(2)) for fully taxable treatment under the new Medicare tax on NII, regardless of whether a taxpayer materially participates in the trade or business. Although commodities are defined by reference to a specific Code Section, the term financial instruments will presumably have to be defined by regulation. The legislative history is not particularly helpful on this issue. However, the Code offers some indication that the term financial instrument may not be as broad as the term security. Treas. Reg (b)(3) defines financial instrument as a spot, forward, or future contract, an option, a notional principal contract, a debt instrument, or a similar instrument, or combination or series of financial instruments, but specifically excludes stock. Similarly, section 475(c)(2)(E) and Treas. Reg (a)(2)(iii) describe financial instruments in terms of what are commonly considered to be financial derivatives. On the other hand, section 731(c)(2)(C) defines financial instrument more broadly as including stocks and other equity investments, evidences of indebtedness, options, forward or futures contracts, notional principal contracts and derivatives. Another issue that this new statutory language raises is what exactly constitutes trading in financial instruments or commodities. Does the extensive case law relating to the treatment of dealers and traders come into play, perhaps with dealers and individual investors being spared this new tax on essentially all of their net income? This may be the correct result provided net income of the dealer or trader is classified as NESE subject to the SE tax. 5. Net Gain from Dispositions of Property. The final category that is required to be taken into account in determining NII for purposes of the new Medicare tax is net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business, unless that trade or business is either a passive activity with respect to the taxpayer or involves trading in financial instruments or commodities. 227 In general, this is a very broad category. It would, for example, cover gain from the disposition of non-business assets, such as houses, boats and airplanes, though excluded gain from the sale of a personal residence should 225 Rev. Proc Taxpayers who do not add new activities or alter their existing activity groups are effectively grandfathered in, and do not need to disclose their existing grouping decisions. 226 Treas. Reg T(f)(2). 227 Section 1411(c)(1)(A)(iii). -59-

72 not be taxable because it is not taken into account in computing taxable income. 228 Also, gain from the disposition of stock in a C corporation should be taxable under this provision (though not if excluded under section 1202). Significantly, property held in a trade or business is specifically excluded, as long as such trade or business does not fall within the disfavored passive activity/trading category. 229 There is also an exception for the disposition of interests in partnerships and S corporations (i.e., pass-through entities) engaged in an active trade or business (not involving trading in financial instruments or commodities), but only to the extent of the net gain which would be so taken into account by the transferor if all property of the partnership or S corporation were sold for fair market value immediately before the disposition of such interest. 230 The Technical Explanation concludes that [t]hus only net gain or loss attributable to property held by the entity which is not properly attributable to an active trade or business is taken into account. However, the language of the statute is not that clear. For example, if an S corporation shareholder s outside basis in his or her shares is less than the internal basis that the S corporation itself has in its assets, gain attributable to that difference would appear to be in excess of the net gain which would be so taken into account by the transferor if all of the property of the... S corporation were sold for fair market value. Similarly, if a majority shareholder sold his or her own stock at a premium, the gain attributable to that premium would appear to be in excess of such net gain which would be so taken into account by the transferor if all property of the corporation were sold for fair market value? These interpretational difficulties are compounded by the fact that this new Code Section provides that a rule similar to the exclusionary rule for gains quoted above shall also apply to losses from such dispositions. D. Choice of Entity And Social Security Taxes. 1. Individuals and Sole Proprietorships. Individuals earning income as sole proprietors (either as a sole proprietorship or a single member LLC which is treated as a disregarded entity under the Check-the-Box Regulations) from a trade or business are generally required to treat income from that trade or business as NESE. Business income of sole proprietors and owners of single member LLCs who materially participate in the business should be excluded from the definition of NII under section 1411(c)(2)(A), which includes income from a passive activity but not income from an activity in which the taxpayer materially participates. Similarly, net gains on the sale of the business or the 228 Section 121; JOINT COMMITTEE ON TAXATION, TECHNICAL EXPLANATION OF THE REVENUE PROVISIONS OF THE RECONCILIATION ACT OF 2010, AS AMENDED IN COMBINATION WITH THE PATIENT PROTECTION AND AFFORDABLE CARE ACT 135 n. 285 (Mar. 21, 2010) (hereinafter Technical Explanation ). 229 Section 1411(c)(1)(A)(iii). 230 Section 1411(c)(4). -60-

73 assets of the business in which the taxpayer materially participates should be excluded from NII. 231 On the other hand, business income of sole proprietors and owners of single member LLCs who do not materially participate in the business (that is, who are passive ) should be subject to the 3.8% Medicare tax on pass-through income since it constitutes income from a passive activity, within the definition of NII. Similarly, net gains on the sale of the business or the assets of the business in which the taxpayer does not materially participate should be NII and subject to the 3.8% Medicare tax.. 2. Employment Tax Considerations for Disregarded Entities (Single Member LLCs and QSubs). Notice provides that employment taxes and other employment tax obligations with respect to employees performing services for qualified subchapter S subsidiaries ( QSubs ) 233 and certain single member owned eligible entities ( disregarded entities ), 234 may be satisfied in one of two ways: (1) calculation and payment of all employment taxes and satisfaction of all other employment tax obligations with respect to employees performing services for the disregarded entity by its owner under the owner s name and employer identification number, or (2) separate calculation and payment of all employment taxes and satisfaction of all other employment tax obligations by the disregarded entity with respect to employees performing services for the disregarded entity by the disregarded entity, under its own name and employer identification number. The notice states that ultimate liability taxes remains with the owner of the disregarded entity, regardless of which alternative is chosen. Reg (c)(2)(iv), finalized in August 14, 2007 and effective for employment tax purposes on January 1, 2009, 235 provides that a disregarded entity, including a single member eligible entity and a QSub, is responsible for withholding employment taxes on wages paid to its employees and satisfying other employment tax obligations such as backup withholding, making timely deposits of taxes, filing returns, and providing wage statements to employees. In effect, the regulations eliminate disregarded entity status for purposes of federal employment taxes, imposing the reporting and payment obligation on the entity, and preclude the choice available under Notice 99-6 to report and pay employment taxes at the owner level or the disregarded entity level. An individual owner of a single-member LLC who is self-employed and subject to SE tax on his net earnings from self-employment with respect to the LLC s activities is not an employee of the LLC for employment tax purposes. The individual would be entitled to deduct trade or business expenses paid or incurred with respect to activities carried on through the LLC, 231 Section 1411(c)(1)(A)(iii)(NII includes net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business unless the trade or business is a passive activity with respect to the taxpayer) C.B Section 1361(b)(3)(B). 234 Treas. Reg through T.D

74 including the employer s share of employment taxes imposed under sections 3111 and 3301 on his Form 1040, Schedule C. 3. Estates and Trusts. For estates and trusts, the new Medicare tax on NII only applies to undistributed NII of the estate or trust that is subject to the highest tax bracket in section 1(e). 236 This would include income in excess of $11,350 for tax year To the extent of income derived from a business activity, the estate or trust is treated as materially participating if the executor or trustee, in his capacity as such, is so participating General and Limited Partners, LLC Members. A general partner of a partnership must include as NESE his distributive share of ordinary income of the partnership (other than the excluded interest, rent and dividends). On the other hand, section 1402(a)(13) excludes from NESE a limited partner s distributive share of partnership income (other than distributions that are guaranteed payments or compensation for services to the extent that those payments are established to be in the nature of remuneration for those services to the partnership). Accordingly, a general partner s distributive share of income from the partnership normally will be treated as NESE, while a limited partner s distributive share of income from the partnership normally will not be treated as NESE. The legislative history of Section 1402 makes clear that this exception for limited partners was intended to prevent passive investors, who do not perform services, from obtaining social security coverage or coverage under qualified retirement plans. The application of the SE tax with respect to a limited partner who also serves as a general partner in a partnership is less clear. Section 1402 s legislative history reflects an intent to apply these rules separately to limited partnership and general partnership interests, even if held by the same partner. The lack of legislative or regulatory clarity and the advent of LLCs where all members have limited liability has caused the application of the rules for limited partners and LLC members to be problematic. 5. LLCs Taxed as Partnerships. While multi-member LLCs (which do not elect to be treated as associations taxable as corporations) are treated as partnerships for tax purposes under the Check-the-Box Regulations, the application of the SE tax to LLC members is at best unclear. The question is whether members of LLCs taxed as partnerships would be treated as limited partners under section 1402(a)(13), so that their distributive share of LLC income and loss is exempt from SE tax. On its face, the language of section 1402(a)(13) would only exclude from NESE the distributive share of income of a limited partner of a partnership. Under such a literal reading, the distributive share of income of any other type or class of partner in the partnership would be 236 Section 1411(a)(2)(i). 237 See Rev. Proc (providing tax brackets for year 2011) 238 S. Report at 735; TAM In the case of a grantor trust, the determination of material participation is made at the grantor or deemed owner level. -62-

75 considered NESE. Rev. Rul , 239 held that the taxpayer s earnings from a working interest in an oil lease was NESE despite the fact that he had limited involvement in the organization. 6. The Definition of Limited Partner Under the 1994 Proposed Regulations. With the advent of LLC statutes in the early 1990 s and thereafter, the IRS attempted to address the SE tax issue with respect to members of LLCs through the promulgation of Prop. Reg (a)-18 (the 1994 Regulations ). Under the 1994 Regulations, a member of a member-managed LLC would have been treated as a limited partner for purposes of Section 1402(a)(13) if: (i) the member was not a manager of the LLC; (ii) the LLC could have been formed as a limited partnership (rather than as an LLC in the same jurisdiction); and (iii) the member could have qualified as a limited partner in that limited partnership under applicable law. Accordingly, for manager-managed LLCs, whether a non-manager member s share of the income of the LLC would be considered NESE turned on whether such member s interest could have been characterized as a limited partnership interest had the LLC been formed as a limited partnership. This factual determination often proved to be unworkable and depended on several factors, including the amount of the member s participation in the business operations, and the provisions of the LLC Act and Limited Partnership Act of the applicable state. 7. The Definition of Limited Partner Under the 1997 Proposed Regulations. The next attempt by the IRS to address the application of the SE tax to members of an LLC were the 1997 proposed regulations. (the 1997 Regulations ). Prop. Reg (h) defines a limited partner for purposes of the SE tax as an individual holding an interest in an entity classified as a federal tax partnership unless one of the following exceptions applies: Liability Test. The individual has personal liability for the debt of or claims against the partnership by reason of being a partner. For this purpose, an individual has personal liability if the creditor of the entity may seek satisfaction of all or any portion of the debts or claims against the entity from such individual. Authority Test. The individual has authority under the law of the jurisdiction in which the partnership is formed to contract on behalf of the partnership. 500 Hour Participation Test. The individual participates in the partnership s trade or business for more than 500 hours during the partnership s tax year. Additionally, the 1997 Regulations provide three exceptions to the general rule set forth in Prop. Treas. Reg (h), as follows: Persons Holding both General and Limited Partnership Interests. Under the first exception under the 1997 Regulations, an individual who holds more than one class of interest in a partnership and who is not a limited partner under the general definition, may still be treated as a limited partner with respect to a specific class of interest. This C.B

76 exception is satisfied if immediately after the individual acquires the class of interest: (1) persons who are limited partners under the general definition own a substantial continuing interest in the class of interest; and (2) the individual s rights and obligations with respect to that class of interest are identical to the rights and obligations of the specific class held by the partners of that class who satisfy the general definition of a limited partner. Whether the interests of the limited partners in the specific class under the general definition are substantial is determined based on all of the relevant facts and circumstances. There is a safe harbor under which 20% or greater ownership of the specific class is considered substantial. The 1997 Regulations define class of interest as an interest that grants the holder specific rights and obligations. A separate class exists if the holder s rights and obligations attributable to an interest are different from another holder s rights and obligations. The existence of a guaranteed payment to an individual for services rendered to the partnership is not a factor in determining the rights and obligations of a class of interest. Certain Limited Partners With More than 500 Hours of Participation. The second exception under the 1997 Regulations applies to an individual who holds only one class of interest. Under this exception, an individual who cannot meet the general definition of limited partner because he or she participates in the partnership s trade or business for more than 500 hours during the partnership s tax year is treated as a limited partner if: (1) persons who are limited partners under the general definition own a substantial continuing interest in the class of interest; and (2) an individual s rights and obligations with respect to that class of interest are identical to the rights and obligations of that specific class held by persons who satisfy the general definition of a limited partner. Service Partner in a Service Partnership. The third exception under the 1997 Regulations applies to a service partner in a service partnership and provides that regardless of whether the individual can satisfy the general definition of a limited partner under one of the above-described exceptions, that service partner may not be treated as a limited partner. A partnership is a service partnership if substantially all of its activities involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, or consulting. A service partner is a partner who provides services to or on behalf of the service partnership s trade or business unless that individual s services are de minimis. 8. The 1997 Congressional Moratorium. Immediately following the issuance of the 1997 Regulations, significant protests were made. As a result of this significant protest, Congress enacted Section 935 of the Taxpayer Relief Act of 1997, 240 which prohibited the issuance or effectiveness of temporary or final regulations with respect to the definition of a limited partner under section 1402(a)(13) prior to July Although the moratorium period has long since passed, no guidance on the definition of a limited partner for SE tax purposes under section 1402(a)(13) has been issued. 240 Pub. L. No

77 Accordingly, as a result of the moratorium, there is a dearth of authority with respect to the SE tax treatment of an LLC member s distributive share of an LLC s income. The only available guidance in existence are several private letter rulings that hold that a member is a partner and that a member s distributive share of partnership income is not excepted from NESE by Section 1402(a)(l3). 241 On January 14, 2010, Diana Miosi of the IRS reassured practitioners that they may rely on the proposed 1997 regulations in dealing with the application of the SE tax to limited liability companies. 242 In this regard, proposed regulations are considered substantial authority under Reg (d)(3)(iii) for purposes of avoiding penalties on substantial understatement of income tax under section 6662(d). 9. The Thompson Case. In Thompson v. U.S., 243 the United States Court of Federal Claims held that an LLC member could not be treated the same as a limited partner for purposes of meeting the material participation rules under the passive activity loss limitation rules of Section 469. In Action on Decision , 244 the IRS announced its acquiescence in result only in Thompson. In addition to Thompson, Garnett v. Comm r, 245 Gregg v. U.S., 246 and Newell v. Comm r, 247 have all ruled against the IRS s position that an interest in an LLC is a limited partnership interest under Reg T(e)(3)(i). The distinction between membership interests in limited liability companies and limited partnership interests in limited partnerships will be of even greater significance because the new Medicare tax on NII will apply to a partner s distributive share of the operating income of a partnership if the activity of the partnership producing the income is passive with respect to the partner under the passive activity loss limitation rules of section 469. The issue of whether the members of a multi-member LLC which is taxed as a partnership for federal income tax purposes are treated as general partners or limited partners for purposes of the SE tax continues to be unclear. Obviously, the IRS could use the same reasoning used against the IRS in the Thompson, Garnett, Newell and Gregg cases to reach the conclusion that a member s interest in the LLC is not equivalent to a limited partner s interest in a limited partnership for purposes of SE tax. This would result in members of an LLC being subject to the SE tax on their distributive share of the income of an LLC (with certain exceptions for interest, dividends, rent and capital gain) See Ltr. Ruls , and See Tax Notes Today, Jan. 15, F. Cl. 728 (2009). IRB, 5 (April 5, 2010). 132 TC 19 (2009). 186 F.Supp.2d 1123 (D. Or. 2000). TCM

78 However, as recently as January 14, 2010, a representative of the IRS reassured practitioners that they may rely on the proposed 1997 regulations in dealing with the application of the SE tax to limited liability companies Medicare Tax on NII Passed-Through to Partners and LLC Members. Income passed-through and distributions to partners and LLC members who materially participate in the business of the partnership or LLC should be excluded from the definition of NII under section 1411(c)(2)(A), which includes income from a passive activity but not income from an activity in which the taxpayer materially participates. Similarly, net gains on the sale or redemption of the partner s or member s interest in the partnership or LLC should be excluded from NII. NII includes net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business unless the trade or business is a passive activity with respect to the taxpayer. 249 On the other hand, partners and LLC members who do not materially participate in the business activities of the partnership or LLC (that is, who are passive ) should be subject to the 3.8% Medicare tax on pass-through income from a passive activity, within the definition of NII. Similarly, net gains on the sale or redemption of the shareholder s interest in the partnership or LLC should included in NII and subject to the 3.8% Medicare tax. E. S Corporation Shareholders. 1. S Corporation Dividends Not Subject to SE Tax. The IRS held in Rev. Rul that an S corporation s pass-through income does not constitute NESE to the shareholders for purposes of the SE tax, based on section 1402(a)(2) which specifically excludes from the definition of NESE dividends on shares of stock issued by a corporation. Consequently, neither a shareholder s distributive share of income passed through from the S corporation under section 1366 nor any S corporation distributions actually received by the shareholder from the S corporation constitute NESE subject to the SE tax. In Rev. Rul , 251 the IRS found that the taxable income of an S corporation included in its shareholders gross income is not income derived from a trade or business for purposes of computing the shareholders net operating losses arising from a trade or business under section 172(c). Similarly in Ltr. Rul , the IRS concluded that the income derived by a shareholderemployee from an S corporation did not constitute net earnings from self-employment for SE tax purposes and that such taxpayer was not eligible to adopt a qualified pension plan based on the income derived from his S corporation since such income did not constitute earned income. 248 See Tax Notes Today, Jan. 15, Section 1411(c)(1)(A)(iii) C.B C.B

79 Because wages paid to shareholder-employees of an S corporation are subject to Social Security taxes while S corporation distributions are not, it would appear that shareholderemployees have an opportunity for significant tax savings by withdrawing funds from the S corporation in the form of distributions rather than wages. Although the amount of funds available for distribution to an S corporation s shareholder-employees will increase as the wages paid to them decrease, all distributions made by the S corporation to its shareholders must be made in proportion to the number of shares held by such shareholders under section 1361(b)(1)(D). Thus, if an S corporation which has both shareholders who are employees and shareholders who are not employees adopts a tax strategy to reduce Social Security taxes by minimizing wages and maximizing distributions, the increase in the amount of distributions received by the shareholders who are employees will be less than the amount by which their wages were reduced (since distributions must also be made to the shareholders who are not employees). Additionally, it should be noted that a program that minimizes the amount of wages paid to shareholder-employees will increase: (1) purchase price formulas based on earnings; and (2) bonus formulas based on earnings. Decreasing the amount of wages paid to shareholderemployees of S corporations also will reduce the contribution base for contributions to the corporation s qualified plans. 2. Dividends or Compensation? In order for shareholder employees of an S corporation to avoid employment taxes by withdrawing funds as distributions rather than compensation, the distributions must not be characterized as wages for FICA purposes or as NESE for purpose of the SE tax. (a) The Rulings. In Rev. Rul , 252 two shareholders of an S corporation withdrew no salary from the corporation and arranged for the corporation to pay them dividends equal to the amount that they would have otherwise received as reasonable compensation for services performed. This arrangement was made for the express purpose of avoiding payment of federal employment taxes. Based on the expansive definition of wages for FICA and Federal Unemployment Tax Act ( FUTA ) purposes (which includes all remuneration for employment), the IRS found that the dividends paid to the shareholders constituted wages for FICA and FUTA purposes. Rev. Rul did not, however, address the issue of what constitutes reasonable compensation in the S corporation context since the ruling expressly stated that the dividends were received by the shareholder-employees in lieu of the reasonable compensation that would have otherwise been paid to them. Despite this shortcoming, Rev. Rul clearly indicates that the payment of no compensation will be unreasonable where shareholder-employees provide substantial services to the corporation. (b) The Cases CB 287, -67-

80 In Radtke v. United States, 253 the court recharacterized distributions made to the sole shareholder (an attorney) of an S corporation (a law firm) as wages subject to FICA and FUTA taxes, where the shareholder made all of his withdrawals from the S corporation in the form of S corporation distributions and received no salary from the S corporation during the tax year. The court relied on a broad definition of wages for FICA and FUTA purposes as all remuneration for employment, and concluded that the dividend payments were remuneration for services performed by the shareholder for the S corporation. Likewise, in Spicer Accounting, Incorporated v. United States 254, the court recharacterized dividend distributions made to a shareholder (an accountant) of an S corporation (an accounting firm) as wages subject to FICA and FUTA taxes where the shareholder received no salary during the tax year. Additionally, in Fred R. Esser, P.C. v. United States, 255 the court recharacterized amounts received by the sole shareholder, officer and director of a legal services S corporation, as wages subject to FICA and FUTA taxes, rather than as distributions. As in the Radtke and Spicer Accounting cases, the shareholder received no salary from the S corporation during the tax year. 256 In David E. Watson PC v. United States, 257 the Tax Court denied the taxpayer s Motion for Summary Judgment in connection with its claim for refund of employment taxes paid where the IRS recharacterized dividends paid by the S corporation to its sole shareholder as wages subject to employment taxes. During the years in issue, 2002 and 2003, David E. Watson, CPA ( Watson ), provided accounting services to a professional accounting firm operating as a partnership ( Accounting Partnership )and its clients as an employee of David E. Watson PC, an S corporation (the S Corporation ). The S Corporation was a 25% partner in Accounting Partnership. Watson received a salary of $24,000 from the S Corporation. The IRS made assessments against Watson after it determined that portions of the dividend distributions from the S Corporation to Watson should be recharacterized as wages subject to employment taxes. Specifically, the IRS contended that $130, out of a total of $203,651 of dividend distributions to Watson for 2002 should be recharacterized as wages subject to employment taxes, and that $175,470 out of a total of $203,651 of dividend distributions to Watson for 2003 should be recharacterized as wages subject to employment taxes. In his Motion for Summary Judgment, Watson argued that the intent of the S Corporation was controlling in determining the characterization of the payments from the S Corporation to Watson. Because the S Corporation clearly intended to pay Watson compensation of only $24,000 per year, Watson contended that any amounts distributed in excess of the $24,000 were properly classified as dividends. Citing Rev. Rul , and case authority, the court found that the intent of the S Corporation was not controlling in determining the character of the payments, but rather that the analysis turns on whether the payments at issue were made as remuneration for F.2d 1196 (CA-7, 1990) F.2d 80 (CA-9, 1990) F. Supp. 421 (D. Ariz. 1990). 256 See, also, Veterinary Surgical Consultants, P.C. v. Comm r, 117 TC 14 (2001), Van Camp and Brennion v. U.S., 251 F.3d 862 (CA-9, 2001), Old Raleigh Realty Corp. v. Comm r., TC Summ. Op AFTR 2d (S.D. Iowa 2010), -68-

81 services performed. Consequently, the court denied Watson s Motion for Summary Judgment because it found that there was a genuine issue of material fact as to whether the dividends paid to Watson by the S Corporation were remuneration for services performed subject to employment taxes. (c) Summary. The Watson case and others like it indicate that in abusive situations, such as where the shareholders of an S corporation make all withdrawals from the S corporation in the form of S corporation distributions and receive no salary from the S corporation during the tax year, the courts will recharacterize such distributions as wages subject to Social Security taxes. In non-abusive situations, however, the IRS may have difficulty in successfully asserting that distributions made by S corporations to shareholder-employees should be recharacterized as wages subject to Social Security taxes. In order for the IRS to recharacterize S corporation distributions as wages subject to Social Security taxes in non-abusive situations, the IRS would have to overcome: (i) the lack of express authority for its position (unlike the express authority granted to the IRS under section 1366(e) to recharacterize dividend distributions as wages in the family context); (ii) the reluctance of the courts to recharacterize distributions as wages; and (iii) the uncertainty surrounding the utilization of section 162(a)(1) by the IRS in the employment context to bring salaries up to a reasonable level. (d) Medicare Tax on Pass-Through Income of S Corporation Shareholders. Income passed-through and distributions to S corporation shareholders who materially participate in the business should be excluded from the definition of NII under section 1411(c)(2)(A), which includes income from a passive activity but not income from an activity in which the taxpayer materially participates. Similarly, net gains on the sale or redemption of the shareholder s interest in the S corporation should be excluded from NII. As noted above, NII includes net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business unless the trade or business is a passive activity with respect to the taxpayer. 258 On the other hand, shareholders who do not materially participate in the business activities of the S corporation (that is, who are passive ) should be subject to the 3.8% Medicare tax on pass- through income since it constitutes income from a passive activity, within the definition of NII. Similarly, net gains on the sale or redemption of the passive shareholder s interest in the S corporation should be included in NII and subject to the 3.8% Medicare tax. (e) All Eyes On the S Corporation SE Tax Loophole. The IRS, the Joint Committee on Taxation and the Department of Treasury have issued reports and notices addressing the use of S corporations as a means of avoiding the SE tax. On January 15, 2010, the United States Government Accountability Office ( GAO ) released a report entitled Tax Gap: Actions Needed to Address Noncompliance with S 258 Section 1411(c)(1)(A)(iii). -69-

82 Corporation Tax Rules (the GAO Report ). 259 The purported purpose of the study resulting in the GAO Report was to identify compliance challenges for S corporations and their shareholders and was based in part on a report prepared by the staff of the Joint Committee on Taxation and released on October 19, 2006, entitled Additional Options to Improve Tax Compliance. The GAO Report proposes to treat service partnerships, LLCs and S corporations the same for SE tax purposes, so that a partner s, member s or shareholder s distributive share of income from a service entity would be subject to the SE tax. The proposal would eliminate the choice of business form decision that results in substantially different tax liability for otherwise similar forms of business. Section 413 of the American Jobs and Closing Tax Loopholes Act of 2010, 260 passed by the House on May 28, 2010, would add new section 1402(m) to subject certain S corporation shareholders to the SE tax imposed under section 1402 on their distributive share of the income of an S corporation. Specifically, section 1402(m)(1)(a) provides that in the case of any disqualified S corporation, each shareholder of such disqualified S corporation who provides substantial services with respect to the professional service business referred to in section 1402(m)(1)(C) must take into account such shareholder s pro rata share of all items of income or loss described in section 1366 which are attributable to such business in determining the shareholder s net earnings from self-employment. A disqualified S corporation is defined in section 1402(m)(1)(C) as: any S corporation which is a partner in a partnership which is engaged in a professional service business if substantially all of the activities of such S corporation are performed in connection with such partnership; and any other S corporation which is engaged in a professional service business if the principal asset of such business is the reputation and skill of three or fewer employees. Section 1402(m)(3) defines the term professional service business as being any trade or business if substantially all of the activities of such trade or business involve providing services in the fields of health, law, lobbying, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, investment advice or management, or brokerage services. Except as otherwise provided by the Secretary, a shareholder s pro rata share of items of the S corporation subject to the SE tax will be increased by the pro rata share of such items of each member of such shareholder s family (within the meaning of Section 318(a)(1)) who does not provide substantial services with respect to such professional service business. Additionally, Section 1402(m)(2) provides that in the case of any partnership which is engaged in a professional service business, Section 1402(a)(13) -- which generally exempts limited partners from the SE tax -- shall not apply to any partner who provides substantial services with respect to such professional service business. 259 December 15, 2009, GAO H.R

83 On September 16, 2010, Senator Baucus introduced S. 3793, the Job Creation and Tax Cut Act of 2010, including provisions from the American Jobs and Closing Tax Loopholes Act of However, the proposal would not impose SE payroll taxes on the pass-through income of S corporation shareholders. The 2010 Lame Duck Congress did not deal with the S corporation payroll tax loophole. F. Recap: The Scope of the 3.8% Medicare Tax Under the 2010 Act. The imposition of the 3.8% Medicare tax on NII, including passive activity income, supplementing the Medicare tax already imposed on earned income, will impact many taxpayers after The application of the 3.8% Medicare tax after January 1, 2013 to earned income, including wages and net earnings from self-employment, and NII, including interest, dividends, annuities, royalties, rents, gains from disposition of property, and income from passive activities, may be summarized by the following Venn diagrams: This matrix suggests a strategy or choice of entity that would minimize the income subject to tax as NESE or in the alternative NII, and maximize the income exempt from the Medicare Tax as neither NESE nor NII. -71-

84 G. Planning Opportunities and Strategies in the Current Environment. Given the likelihood of future regulatory guidance and possible legislation with respect to the treatment of S corporation shareholders, general and limited partners and LLC members under the new Medicare tax, it may be that any reorganization or restructuring to provide tax benefits under the current regime have a short life span. On the other hand, it is important to ensure that SE taxes are properly reported and to anticipate the effect of the new Medicare tax on NII. Notwithstanding the lack of regulatory guidance and the status of the current law, certain planning opportunities and strategies have emerged under the current regime, some of which are summarized below. 1. Use S Corporation to Operate Closely-Held Business. It appears that the opportunity exists to avoid both the Medicare tax on earned income and (after 2012), the Medicare tax on NII for the owners actively involved in the business by operating the business through an S corporation (or an LLC electing to be taxed as a corporation and electing S treatment), provided reasonable salaries are paid to shareholder employees. Provided the compensation paid to the shareholder employees is reasonable, it may be difficult for the IRS to assert that distributions from the S corporations to shareholder employees should be characterized as additional wages subject to social security taxes. For the shareholder who materially participates in the business, only amounts paid as reasonable salary should be subject to the Medicare tax on wages, and all distributions should be (i) exempt from the SE tax by virtue of Rev. Rul and section 1401(a)(2), and (ii) excluded from the definition of NII by virtue of section 1411(c)(2)(A) which includes income from a passive activity but not income from an activity in which the taxpayer materially participates. Net gains on the sale or redemption of the shareholder s interest in the S corporation should similarly be excluded from NII (such gains are subject to the Medicare tax only if attributable to the disposition of property held in a trade or business which constitutes a passive activity with respect to the taxpayer). 261 Shareholders who do not materially participate in the business activities of the S corporation (that is, who are passive ) should be subject to the 3.8% Medicare tax on NII. Net gains from the disposition of stock by such passive shareholders would also be subject to the 3.8% Medicare tax. The current benefits and the 3.8% Medicare tax savings for shareholders should be weighed against the disadvantages of S corporation classification versus partnership classification, given the flexibility (and complexity) of the partnership tax regime. 2. LLC Electing S Corporation Classification for Tax Purposes. As an eligible entity, an LLC with only one class of economic interests and no preferred returns may elect S corporation classification by timely filing Form 2553 with the IRS. Provided 261 Section 1411(c)(1)(A)(iii). -72-

85 reasonable compensation is paid to the members providing services to the business, it may be difficult for the IRS to assert that distributions to members from an LLC classified as an S corporation for tax purposes should be characterized as additional wages subject to social security taxes. For the LLC member who materially participates in the business, only amounts paid as reasonable salary should be subject to the Medicare tax on wages and all distributions should be (i) exempt from the SE tax by virtue of Rev. Rul and section 1401(a)(2), and (ii) excluded from the definition of NII by virtue of section 1411(c)(2)(A) which includes income from a passive activity but not income from an activity in which the taxpayer materially participates. Net gains on the sale or redemption of the member s interest in the LLC classified as an S corporation should similarly be excluded from NII (such gains are subject to the Medicare tax only if attributable to the disposition of property held in a trade or business which constitutes a passive activity with respect to the taxpayer). 262 Members of the LLC classified as an S corporation who do not materially participate (that is, who are passive ) with respect to the business activities of the LLC should be subject to the 3.8% Medicare tax on NII. Net gains from the disposition of LLC interests by such passive LLC members would also be subject to the 3.8% Medicare tax. As in the case of the corporation electing S status, the 3.8% Medicare tax savings for members should be weighed against any disadvantages of S corporation classification versus partnership classification for the LLC. 3. S Corporation as Member of LLC with Investors as Preferred Members. Where the Subchapter S limitations concerning the one class of stock requirement or the shareholder eligibility limitations are a concern, an S corporation owned by the principals participating in the business may be a member of an LLC, with private equity or foreign investors not eligible to hold S corporation stock as preferred members of the LLC. 263 As noted above, for S corporation shareholders who materially participate in the business, only amounts paid as reasonable salary should be subject to the Medicare tax on wages, and all distributions should be (i) exempt from the SE tax by virtue of Rev. Rul and section 1401(a)(2), and (ii) excluded from the definition of NII under section 1411(c)(2)(A), which includes income from a passive activity but not income from an activity in which the taxpayer materially participates. Net gains on the sale or redemption of the shareholder s interest in the S corporation should similarly be excluded from NII (such gains are subject to the Medicare tax only if attributable to the disposition of property held in a trade or business which constitutes a passive activity with respect to the taxpayer). 264 S corporation shareholders and LLC members who do not materially participate in the business activities of the S corporation and the LLC (that is, who are passive ) should be subject to the 3.8% Medicare tax on NII. Net gains from the disposition of stock and LLC 262 Section 1411(c)(1)(A)(iii). 263 See Rev. Rul , C.B. 198; Reg (d), Example 2. Compare Rev. Rul , C.B. and GCM (12/27/76). 264 Section 1411(c)(1)(A)(iii). -73-

86 interests by such passive shareholders and LLC members would also be subject to the 3.8% Medicare tax. 4. Corporation as Manager of Manager-Managed LLC. By using a corporation as a manager, perhaps the sole manager, of a manager-managed LLC, only those members who materially participate in the business will be subject to SE tax under the 1997 proposed regulations. Only the corporate manager would have apparent authority to contract on behalf of the LLC. A member with only a capital investment in the LLC should be insulated from SE tax exposure. On the other hand, a member who materially participates in the business will still have exposure to the SE tax under the 1997 Proposed Regulations. The payment of a reasonable salary to the member as an officer and employee of the corporate manager, sourced from management fees from the LLC, or the payment of a reasonable guaranteed payment to the member for services provided may mitigate the SE tax exposure. However, the lack of guidance on whether an LLC member who is involved in the business of the LLC to the extent of material participation may be subject to the SE tax on his or her share of the non-passive income of the LLC may be of concern. Members of the LLC who materially participate in the business activity of the LLC (that is, who are not passive ) should not be subject to the 3.8% Medicare tax on NII. Similarly, net gains on the sale or redemption of the shareholder s interest in the S corporation or member s interest in the LLC should similarly be excluded from NII (such gains are subject to the Medicare tax only if attributable to the disposition of property held in a trade or business which constitutes a passive activity with respect to the taxpayer). 265 Members of the LLC who do not materially participate in the business activity of the LLC (that is, who are passive ) should be subject to the 3.8% Medicare tax on NII. Net gains from the disposition of LLC interests by such passive LLC members would also be subject to the 3.8% Medicare tax. 5. Limited Partnership With Sole S Corporation General Partner. Long prior to the check the box regulations, the limited partnership with a sole corporation general partner emerged as a favorite vehicle for promoters of real estate investments and tax shelter syndications. Pass-through treatment was obtained for all parties, and the owners of the S corporation general partner had complete control of the limited partnership, subject to rights and powers granted to the limited partners with respect to certain major decisions. While the tax treatment of this structure appears to be sound under current law, the possibility that a limited partner may materially participate in the business makes this structure no different from a manager-managed limited liability company with a sole corporate manager. As discussed above, there is a lack of guidance on whether an limited partner who is involved in the business of the limited partnership to the extent of material participation may be subject to the SE tax on his or her share of the non-passive income of the limited partnership may be of concern. As in the case of where a corporation is the manager of a manager-managed LLC, 265 Section 1411(c)(1)(A)(iii). -74-

87 the payment of a reasonable salary to the member as an officer and employee of the corporate manager, sourced from management fees from the LLC, or the payment of a reasonable guaranteed payment to the member for services may mitigate the SE tax exposure. However, the lack of guidance on whether a limited partner who is involved in the business of the limited partnership to the extent of material participation may be subject to the SE tax on his or her share of the non-passive income of the limited partnership may be of concern. On the other hand, net gains on the sale or redemption of the shareholder s interest in the S corporation or limited partnership interest in the limited partnership should be excluded from NII (such gains are subject to the Medicare tax only if attributable to the disposition of property held in a trade or business which constitutes a passive activity with respect to the taxpayer). 266 Limited partners who do not materially participate in the business activities of the limited partnership (that is, who are passive ) should be subject to the 3.8% Medicare tax on NII. Net gains from the disposition of limited partnership interests by such passive limited partners would also be subject to the 3.8% Medicare tax. 6. Member Managed LLCs Should be Used Only When All Members Are Service Providers. As a member in a member-managed LLC (or a member who is a manager of a managermanaged LLC), the member-manager has apparent authority to contract on behalf of the LLC, regardless of whether the taxpayer has personal liability or whether the taxpayer materially participates in the business of the LLC. Accordingly, a member-manager will be treated as a general partner under the 1997 Proposed Regulations and will likely be subject to the SE tax on all of the business income. In light of the Medicare tax considerations, member-managed LLCs should only be used where all members are actively involved in the business and expect to be subject to SE taxes on their distributive shares of the income of the business. Presumably, member-managers of an LLC will be treated as materially participating in the business activities of the LLC, and should not be subject to the 3.8% Medicare tax on NII. Similarly, net gains on the sale or redemption of the member-manager s interest in the LLC should be excluded from NII (such gains are subject to the Medicare tax only if attributable to the disposition of property held in a trade or business which constitutes a passive activity with respect to the taxpayer). 267 VI. Tax Free Mergers and Acquisitions Involving S Corporations. A. General Characteristics. One of the principle benefits of conducting business operations in corporate solution is that stock and equity interests in a corporation may be exchanged on a non-taxable basis between the parties to the transaction at both the corporate and shareholder levels. 268 In a tax-free 266 Section 1411(c)(1)(A)(iii). 267 Section 1411(c)(1)(A)(iii). 268 See, e.g., 354(a). -75-

88 reorganization, the acquiring corporation receives a carryover basis in the assets of the target corporation as well as the receipt of its tax history, subject to applicable limitations provided under Subchapter C or the consolidated return regulations. The shareholders of the target corporation continue to use their historical cost basis in their target stock with regard to their newly acquired stock ownership in the acquiring corporation. Of course, a reorganization may be partially taxable to the transferor corporation or the shareholders of the target, such as where cash or other property is received in addition to the stock or securities of the acquiring corporation. The reorganization must have business purpose, continuity of proprietary interest, a plan of reorganization and continuity of business enterprise. An S corporation is treated as a corporation for purposes of the tax-free reorganization provisions under Subchapter C. 269 Most typically, an S corporation may be a party to a tax-free merger or a divisive Type D reorganization. This is an advantage for S corporations over other pass thru entities since partnerships and LLCs may not exchange equity interests on a nontaxable basis. 270 Still there may be important differences in the consequences to the corporation and its shareholders where an S corporation is involved. The eligibility restrictions under Subchapter S significantly limit an S corporation s ability to serve as the acquiring corporation in a tax free reorganization. This is true for several reasons, including the one class of stock limitation. B. The Alphabet Soup of Tax Free Reorganization Patterns. 1. Statutory merger/consolidation. Type A. Section 368(a)(1)(A) Stock solely for voting stock. Type B. Section 368(a)(1)(B) 3. All or substantially all assets for voting stock. Type C. Section 368(a)(1)(C). 4. All or part of assets transferred to corporation controlled by transferor. Type D. Section 368(a)(1)(D) 5. Recapitalization. Type E. Section 368(a)(1)(E). 6. Place of Organization. Type F. Section 138(a)(1)(F). Mere Change in Form, Identity. 7. Bankruptcy Reorganization. Type G. Section 368(a)(1)(G). The transfer of assets to a corporation and the liquidation of a corporate subsidiary may also be tax-free under sections 351 and (a)(1). But see 708. See also 368(a)(2)(D), 368(a)(2)(E). -76-

89 C. Type A Reorganizations. 1. Application to S Corporations. In various favorable public and private letter rulings, the Service has permitted an S corporation to be a party to a reorganization which is a qualifying merger between two corporations under state law. 272 Although stock of a surviving S corporation which is transferred momentarily to an acquired corporation could be treated as resulting in an ineligible shareholder, this foot fault has been ignored by the Service in a Type A (as well as other types) of tax-free reorganizations. 273 Two other methods for effectuating Type A treatment but which are treated separately under section 368 are a forward triangular merger section 368(a)(2)(D) and a reverse triangular merger (section 368(a)(2)(E)), each having separate requirements. With the revisions in SBJPA permitting ownership of C subsidiaries, an S corporation can be an acquiring corporation in a forward/reverse triangular merger. Where a QSub is involved, the S corporation parent is treated as a party to the reorganization based on the tax nothing status of the QSub Impact on Subchapter S Status. (a) Acquiring S Corporation. The S election of an acquiring S corporation in a Type A reorganization will not terminate, per se, as a direct result of receiving the assets (and assuming the liabilities) of the merged or target corporation. 275 The question will be whether the shareholders of the target corporation are each eligible to own stock in the acquiring S corporation, whether the permitted number of shareholder requirement and the other ineligible shareholder rules will be triggered. In such instances, consideration should be given to taking out ineligible shareholders of the target with cash payments or notes without violating the continuity of interest requirements. 276 However, a proprietary interest in the target corporation is not preserved if, in connection with the potential reorganization, it is acquired by the issuing corporation for consideration other than stock of the 272 Rev. Rul , C.B. 283, Rev. Rul , C.B. 164; See GCM 39768, TAM (discussed above). 273 See West Shore Fuel, Inc. v. U.S., 598 F.2d 1236 (2d Cir. 1979). 274 Reg (b)(5). 275 Rev. Rul , C.B. 165 (the election and the taxable year of a small business corporation are not terminated where, in a statutory merger, it acquires the assets of another corporation that is not an electing small business corporation); Rev. Rul C.B See also Rev. Rul , (Part 1) C.B. 317 (merger of an S into a C corporation, per 368(a)(1)(A), does not terminate the electing small business corporation s election under 1372 with respect to its final taxable year ending on the date of the merger); Rev. Rul , C.B. 178 (statutory consolidation of two S corporations into a new S corporation does not terminate the elections of the corporations for their respective taxable years, which ended on the date of consolidation). See PLR briefly summarized in 4 Business Entities 52 (July/August 2001); 2001 (WL ). 276 Reg (b). Southwest Natural Gas Co. v. CIR, 189 F.2d 3332 (5th Cir.), cert. denied, 342 U.S. 860 (1951); John A. Nelson Co. v. Helvering, 296 U.S. 374 (1935). Compare Yoc Heating Corp., 61 T.C. 168, 1973); May B. Kass, 60 T.C. 218 (1973), aff d, by court order, 491 F.2d 749 (3d Cir. 1974). See Reg (e) for retention of a sufficient proprietary interest by the target shareholders (proprietary interest in the issuing is exchanged by the acquiring corporation for a direct interest in the target corporation enterprise, or it otherwise continues as a proprietary interest in the target corporation. -77-

90 issuing corporation, or the stock of the issuing corporation furnished in exchange for a proprietary interest in the target corporation in the potential reorganization is redeemed. All facts and circumstances must be considered in determining whether, in substance, a proprietary interest in the target corporation is preserved. For purposes of the continuity of interest requirement, a mere disposition of stock of the target corporation prior to a potential reorganization to persons not related to the target corporation or to persons not to the issuing corporation is disregarded and a mere disposition of stock of the issuing corporation received in a potential reorganization to persons not related to the issuing corporation is disregarded). Debt issued to target shareholders, although potentially taxable as boot, may also have to be tested as not constituting a disguised second class of stock. The debt could be drafted to qualify as qualified straight debt in order to preserve the S corporation s election. The issuance of stock in the corporation to shareholders of the target may give the target shareholders the power to revoke the corporation s S election, such as where the target shareholders receive more than 50% of the acquiring corporation s stock. 277 Where the election of an acquiring S corporation is terminated as a result of a Type A merger, it presumably will not be able to reelect S status for a succeeding period of 4 years after the year in which the terminating event took place unless early consent is received by the Service. 278 This rule applies to the corporation and any successor corporation. A successor corporation is defined as any corporation: (i) of which 50 percent or more of its stock is owned, directly or indirectly, by the same persons who, on the date of termination, owned 50 percent or more of the stock of the S corporation whose election was terminated, and (ii) which acquires a substantial portion of the assets of such small business corporation, or a substantial portion of the assets of which were assets of such small business corporation. 279 Generally, a corporation will not be a successor to a terminated S corporation unless there is both a continuity of shareholder interest of at least 50 percent and the new corporation acquires the assets of the S corporation or a substantial portion of the assets it holds are the former S corporation s assets. 280 Arguably, a C corporation which acquires the assets of an S corporation in a tax-free Type A reorganization should be able to make an S election without having a 5 year wait even if it meets the definition of a successor corporation since its S status was not terminated pursuant to section 1362(d), with the exception being whether the C corporation was already a former S corporation or successor to an S corporation and was in the five year waiting period. (b) S Corporation Acquired. Where an S corporation is a target corporation and is acquired or consolidated with a C corporation, its S status will end because the corporation ceases to exist and its taxable year will end on the date that it transfers its assets. 281 The Service has ruled that the termination of S (d)(1). 1362(g). Reg (b). See PLRs , , See also IRS INFO , 2002 WL (b)(1). -78-

91 status does not occur with respect to the corporation s final taxable year. 282 This means the S corporation will continue its S status through the last day of its existence. Where it is important to preserve the target corporation s S election, consideration should be given to structuring the acquisition as a reverse merger so that the target S corporation is the surviving corporation. Where an S corporation and its target form a new entity in a consolidation, the S corporation elections of both entities terminate as a practical matter but the Service views this as not resulting in a termination of either election. The new entity should be allowed to make a new S election without regard to the waiting period of section 1362(g) based on an outstanding ruling. 283 (c) Allocation of Income and Loss in Reorganization. (1) Acquiring S Corporation s Election Remains in Effect. If the acquiring corporation s S election does not terminate as a result of the merger, income will be allocated in the same manner as if the acquisition had not occurred, i.e., on a pershare/per-day basis. 284 Pre-acquisition income (loss) of the acquiring S corporation, A, may be shifted to the target T shareholders. Post-acquisition income (loss) attributable to T s assets may be shifted to A s shareholders. With respect to income generated by the acquired assets, only post-acquisition income would be included in A s income. 285 If a shareholder terminates his interest as a result of the merger, consideration should be given to closing the corporation s books as of the date of termination. 286 Reg (g)(2) provides that where there is a qualifying disposition of S stock, the corporation can elect to treat the tax year as if it consisted of separate taxable years with the first ending at the end of the day in which the qualifying disposition occurs. For this purpose, a qualifying disposition is (i) disposition of stock of 20% or more of the issued and outstanding stock of the corporation during any 30 day period during the corporation s tax year; (ii) a redemption treated as an exchange per sections 302(a) or 303 of 20% or more of the outstanding share of stock again within the applicable 30 day period; or (iii) the issuance of stock at least equal to 25% of the previously outstanding stock to one or more shareholders Rev. Rul , (Part 1) C.B. 317, 318; Rev. Rul , C.B. 177, Rev. Rul , C.B. 177; PLR ; PLR (a)(1) (b)(1) (a)(2). Reg Reg (b)(1) clarifies that the 1377(a)(2) election cannot be made where there is a termination of S status, i.e., 1362(e)(3) election could be made. See also Reg (b)(4)(options not constituting stock under Subchapter S regulations (Reg (l)) and other nonshareholder interests, such as a creditor, employee, director, are regarded in determining whether shareholder completely terminated his or her interest. c.f., Hightower v. Comm r, 2005 WL (unreported)(taxpayer who unsuccessfully opposed buyout of his shares in S corporation was required to include in his income distributive share of S corporation s income for year in which he received payment for his shares. Taxpayer was record owner of shares during year in question despite his diminished role in corporation as result of his poor relationship with other shareholder, and because taxpayer received through arbitrator s award payment compensating him for his increased federal income tax liability, he would receive windfall if he were not required to pay tax which was already paid to him as part of sale of his stock) See Reg (g)(2)(i). -79-

92 (2) Acquiring S Corporation s Election Terminates. If the acquiring corporation s S election does terminate such as result of being acquired or through a termination by revocation or three years of excess passive investment income, i.e., and an S termination year occurs, income is allocated on a per-share/per-day basis between the short S and short C years. 288 Accordingly, only the acquiring S corporation s pre-merger shareholders will be allocated its income or loss on a per-share/per-day basis. However, A s shareholders can elect to close the books on the date of termination. 289 The pro rata method, however, can not apply to a section 338 transaction involving a qualified acquisition of S stock. 290 If there is a 50 percent or more change in ownership of A in the S termination year, A is required to close it books unless the issuance of its stock in the reorganization is not considered a sale or exchange under section 1362(e)(6)(D). 291 Under section 1366(d), the excess of a shareholder s pro rata share of corporate loss and deductions over basis in stock and debt is carried over indefinitely, subject to other applicable limitations, including sections 465 and 469. The carryover of the excess loss retains its character through a pro rata rule contained in the regulations. 292 Thus, excess losses can be used, for example, in reporting gain from the sale of assets or deemed sale under section 338(h)(10) by a shareholder of a target S corporation. Stock and debt is carried forward to future years, where it is deductible to the extent of the shareholder s basis in those years. Suspended losses, with limited exception, are personal to the shareholder who was allocated the deductions and losses in the prior year(s). Where a shareholder retains a portion of his or her S stock, the excess losses will remain intact until the shareholder disposes all of the remaining shares. Where stock is transferred to a spouse per section 1041, however, the transferee succeeds to any carryover with respect to the transferred stock. 293 Where, for example, the acquiring S corporation s election terminates as part of an acquisition, its shareholders losses which were suspended under section 1366(d)(2) will be treated as incurred on the last day of the post-termination transition period. 294 The losses will be deductible to the extent of the shareholder s basis in the stock on such date. 295 However, if an S corporation acquires the assets of another S corporation in a transaction to which section 381(a)(2) applies, a post-termination transition period does not arise (e)(2) (e)(3); Reg (a)(5). 290 Reg (b)(3). 291 See, e.g., 354(a)(1) (relating to the target shareholder s exchange of stock or securities); See Reg (c)(terminating election by S corporation that is a partner (member) in a partnership (LLC taxable as a partnership) is treated as a sale or exchange of the corporation s entire interest in the partnership (LLC) for purposes of 706(c)). 292 Reg (a)(5) (d)(2)(B) (applicable for taxable years beginning after 2004) (d)(3). 295 See Reg (b)(tax free acquisition from S to a C corporation results in a post-termination transition period but only with respect to the shareholders of the target S corporation). 296 See Reg (d)(2) (for the treatment of the acquisition of the assets of an S corporation by another S corporation in a transaction to which 381(a)(2) applies). -80-

93 The special treatment under section 1371(e)(1) of distributions of money by a corporation with respect to its stock during the post-termination transition period is available only to those shareholders who were shareholders in the S corporation at the time of the termination. A post termination transition period can occur as a result of a reorganization but also simply by the filing of a revocation of S status or the occurrence of a terminating event, including an adverse determination as to S status. St. Charles Investment Company v. Commissioner 297 involved a closely held C corporation under section 469(j)(1). During years in which it engaged in real estate rental activities, it had PALs which were suspended and carried forward under section 469(b). St. Charles, in 1991, converted to S status and in accordance with section 469(g)(1)(A), claimed a deduction against gains from the sale of several rental properties after the conversion occurred. The Service disallowed the deduction for the suspended PALs per section 1371(b)(1) which prohibits S corporations from carrying forward PALs created in its C years to S years. The Tax Court agreed that section 1371(b)(1) prevailed over the PAL carryover rule. The Tenth Circuit, however, reversed the Tax Court and held that section 469(b) permits St. Charles to use its C year PALs to offset income in its post-conversion gains based on its finding that Congress did not expressly want section 469(b) to be preempted by section 1371(b)(1). 3. Impact on Acquired S Corporation. The taxable year of T will end as of the effective date of the reorganization. The merger will not, however, be viewed as having terminated the target corporation s S election and the election will remain in effect for all of its final tax year. Income or loss of T will pass through to its shareholders on a per-share/per-day basis. Although the target s shareholders will not face a potential shifting of income or loss to persons other than the pre-reorganization shareholders, the termination of the corporation s taxable year could create a bunching of income for the shareholders in the termination if the target s taxable year were not a calendar year. (a) Tax Attributes. (1) Net Operating Losses. The acquiring corporation will generally succeed to the tax attributes of the target corporation, T, under section 381. However, the acquiring S corporation will be precluded from using any net operating loss carryovers of the target in computing its taxable income as long as it continues to be an S corporation. 298 In addition, section 1371(b)(1) prevents any carryover between an S year and C year at the corporate level, although it is unclear whether section 1371(b)(1) applies only to attributes generated by the acquiring corporation itself or those inherited from a target corporation under section 381. An S corporation which is acquired generally will not have net operating or capital loss carryovers, although it could have such items from pre-subchapter S years or from other prior acquisitive transactions F.3d 773 (10th Cir. 2000), rev g 110 T.C. 46 (1998). 1363(b)(2), 703(a)(2)(D). -81-

94 (2) Built-in Gains Tax. In the case of the section 1374 built-in gains tax, section 1374(b)(2) provides that a net operating loss carryover arising from the taxable year for which the S corporation was a C corporation can be used to offset net recognized built-in gains. 299 If section 382 applies to the net operating loss carryforward on the first day of the recognition period, such limitation will continue to apply in limiting the utilization of the net operating loss carryforward in computing the section 1374 tax. 300 An S corporation s section 1374 tax attributes when it became an S corporation may only be used to reduce the tax imposed on the dispositions of such assets of the S corporation held at that time. The regulations require an acquiring S corporation to individually account for separate asset acquisitions for section 1374 purposes. Accordingly, an acquiring S corporation may only apply section 381 attributes of a target corporation when computing the built-in gains tax on such acquired corporation s assets and not against any built-in gain in other assets of the acquiring corporation. 301 (3) Earnings and Profits from C Years. If the target corporation is a C corporation with earnings and profits, T s earnings and profits will carry over to the S acquiring corporation under section 381. Accordingly, the S corporation may be subject to restrictions on passive investment income. 302 Moreover, postacquisition distributions will be tested for dividend status under section 1368(c) rather than section 1368(b). (4) LIFO Recapture. A transfer of a C corporation s LIFO inventory to an S corporation results in LIFO recapture under section 1363(d) even though the transaction is otherwise generally non-taxable to the transferor (C corporation). 303 (5) Distributions. i. Pre Merger. Pre-merger distributions generally should be governed by section Where the target is an S corporation and its election is terminated as a result of being acquired by a C corporation, pre-merger distributions of the target of AAA should be made. Otherwise, the AAA account will evaporate as a result of the reorganization unless the acquiring corporation is an S corporation on the date of the reorganization. Still, the regulations allow for a post-termination transition period distribution to the target shareholders of the now acquiring corporation in See Reg See also Reg for utilization of credit carryforwards. See Reg (b). See 1375 (sting tax) and 1362(d)(3)(termination of S election). Reg (a)(2). Cf. Rev. Rul , C.B

95 accordance with section 1371(e). 305 On the other hand, if the acquiring corporation provides the consideration for the distributions, the reorganization distributions rules should apply. ii. Distributions as Part of Tax-Free Reorganization. In the case of distributions made, pursuant to the plan of reorganization, it is unclear whether such distributions are governed by section 356 or section Under section 356, boot distributions could result in the recognition of gain by a shareholder of the target S corporation. Section 356 generally treats gain as a dividend if the exchange has the effect of the distribution of a dividend. 306 Alternatively, section 1368 generally would allow an S corporation to make a tax-free distribution to the extent of the target shareholder s basis in the corporation s stock or, if the corporation has earnings and profits, its accumulated adjustments account. iii. Post-merger Distributions. The tax treatment of post-merger distributions will depend on whether the surviving corporation retains its S corporation status, and the extent to which the target corporation s tax attributes such as accumulated adjustments account and earnings and profits carry over to the acquiring corporation. The distribution provisions of section 1368 will apply to a surviving S corporation s distributions to its shareholders, including former shareholders of target C and S corporations. AAA is maintained by the corporation and generally constitutes the post-1982 accumulated taxable income (less nondeductible expenses not chargeable to capital) related to the corporation most recent uninterrupted period as an S corporation. AAA becomes extremely relevant for distributions by an S corporation which was a former C corporation due to application of section 1368(c) for operating distributions, and for all types of S corporations in a post-termination transition period for distributions of AAA in money under section 1371(e). Section 1368(e)(1)(A) provides that AAA is adjusted in a manner similar to the basis adjustments under section 1367(a) with certain exceptions for tax exempt income and related expense, redemptions, federal income taxes and certain expenses. After AAA is adjusted for the year, then the tax impact to any distributions is assessed. 307 Where distributions exceed AAA, AAA is applied pro rata to the distributions made during the year. 308 Under a recent change in the law, distributions may be made from AAA to the extent of the ending AAA for the prior year where there is a net loss during the current year. 309 Redemptions are charged against AAA based on whether the redemption is treated as an exchange under sections 302(a) or 303(a) or a dividend equivalent redemption. Prior to the issuance of regulations under SSRA, and although not specifically identified under section 381(c), the Service has consistently ruled that an acquiring S corporation s and 305 See 1377(b)(1). 306 See Comm r v. Clark, 49 U.S. 726 (1989) (Supreme Court applied a post-reorganization redemption test in determining whether the payment of boot has the effect of a dividend ); Rev. Rul , I.R.B (d)(2). 308 Reg (b) (c)1)(C). -83-

96 target S corporation s AAA are combined after the merger. 310 Reg (d)(2), provides that in the case of a Type A merger, the acquiring corporation succeeds to and merges its AAA with the AAA of the target. Accordingly, the AAA of an acquiring S corporation following a Type A merger with a target S corporation will be the sum of the AAAs of the respective corporations immediately prior to the reorganization. 311 The regulations further provide for the carryover of a negative AAA account of the acquired corporation. 312 If the acquiring C corporation makes an S election effective for its tax year that includes the date of the reorganization, the AAA of the target S corporation carries over in that both corporations are S corporations at the time of the transaction but only for purposes of permitting shareholders of the target S corporation to receive qualifying distributions from AAA during the post-termination transition period. In a spin off transaction, the AAA of the distributing corporation is allocated in a manner similar to the method by which earnings and profits are allocated in such transaction under the regulations. D. Type B Reorganization. 1. In General. The requirements of a Type B reorganization are the most stringent for a tax-free reorganization. The consideration must be solely in exchange for voting stock or for the voting stock of its parent. An S corporation can be an acquiring corporation in a Type B reorganization followed by a QSub election without necessarily having the transaction recast into an asset purchase. 2. S Corporation as the Acquiring Corporation. If the S corporation is the acquiring corporation, it can immediately make a QSub election with respect to the purchased target which arguably recasts the transaction into a Type C reorganization S Corporation as the Acquired Corporation. Where an S corporation is acquired in a Type B reorganization, the target corporation s S status will terminate because of the presence of an ineligible corporate shareholder. 314 The taxable year is divided into two years, the first of which is subject to the rules applicable to Subchapter S. 315 The same rules apply with respect to the allocation of income and loss as with respect to a tax-free acquisition of assets. 310 See, e.g., PLR , and Reg (d)(2). 312 See Reg (d)(2). See also Reg (d)(3)(Type D reorganizations and AAA). But, see, PLR (negative AAA was required to be segregated from positive AAA in a reorganization and permitted the negative AAA to be used as an offset only with respect to post-reorganization positive AAA). 313 See Reg Ex stock) (d)(2)(B). See also 1362(e)-(6)(D)(automatic closing of books if an exchange of 50% or more of 1362(e)(1). See Versitron, Inc. v. U.S., 38 AFTR 2d 6119 (Ct. Cl. 1976); Rev. Rul , C.B

97 4. Tax Attributes. Unless the acquiring S corporation liquidates the target corporation, or is deemed to liquidate the target corporation by virtue of making a QSub election, the tax attributes of the target corporation will remain with the acquired subsidiary subject to the limitations of section Where a liquidation or deemed liquidation occurs, the transaction is recast into a Type C reorganization and the tax attributes of the acquired corporation are inherited by the acquiring corporation. E. Type C Reorganization. 1. In General. A Type C reorganization entails the issuance by an acquiring corporation of its voting stock to another corporation in exchange for substantially all of the assets of the acquired corporation. The acquiring corporation may also transfer a small amount of boot (cash or other property, and/or assumption of liabilities of the target) as long as 80 percent of the value of the assets of the target is acquired solely in exchange for voting stock. 316 The stock and other consideration, as well as any assets retained, must generally be distributed to the shareholders of the target corporation in complete liquidation unless the Services waives the requirement. 317 Based on the authority set forth in GCM 39768, S corporations may act as either acquiring corporations or target corporations in a Type C reorganization. For purposes of issuing private letter rulings, the Service requires that the substantially all requirement is satisfied if at least 70% of the gross assets of the target and 90% of its net assets are acquired. Cases have found that the substantially all test is satisfied where 86% and 71% of a corporation s assets were transferred. 318 On the other hand, a transfer of 68% has been held to be inadequate. 319 Like a B Reorganization, a C Reorganization permits only voting stock of the acquirer to be used as consideration, with two important exceptions. The first exception provides that the assumption of liabilities of the target by the acquirer will be disregarded for purposes of the solely for voting stock test. Section 368(a)(1)(C). If the buyer assumes target stock options in a C reorganization, it is treated as assuming a liability of the target. 320 This first exception is an important exception, since most ongoing businesses have liabilities that are assumed by the acquirer. The second exception to the solely for voting stock requirement provides that up to 20% of the total value of the consideration paid in a C Reorganization may be in the form of property other than voting stock. 321 However, if any such consideration is paid at all, then for purposes of determining whether the amount of boot exceeds 20% of the total consideration, (a)(2)(B) (a)(2)(G); Rev. Proc , C.B Commissioner v. First National Bank of Altoona, 104 F.2d 865 (3 rd Cir. 1939); Smith v. Commissioner, 34 B.T.A. 702 (1936). 319 Pillar Rock Packing Co. v. Commissioner, 90 F. 2d 949 (9 th Cir. 1937). 320 Rev. Rul , l968-2 C.B. 158; amplified by Rev. Rul , C.B Code section 368(a)(2)(B). -85-

98 the amount of liabilities assumed in connection with the transaction are counted (that is, the rule that excepts the assumption of liabilities from the definition of other consideration does not apply). Accordingly, the sum of the amount of liabilities assumed plus any other consideration paid must be below the 20% threshold in order for the transaction to qualify as a tax-free C Reorganization. Since the liabilities of an ongoing business may well exceed 20% of the total value of the assets of the business, and there exists a potential of unknown or contingent liabilities, the second exception cannot be relied upon except in rare cases. 2. S Corporation as Acquiring Corporation. Where an S corporation acts as an acquiring corporation in furtherance of a C reorganization, a risk exists that the corporation s S election will be terminated since the corporation will technically have a corporate shareholder in violation of section 1361(b)(1)(B). The issuance of voting shares by the acquiring S corporation to another corporation raises a basic concern that temporary ownership of some of the acquiring S corporation s stock by an ineligible shareholder (the target corporation) will terminate its S election. But in GCM 39768, the Service stated that an S corporation will not lose its S status merely because it has a momentary corporate shareholder while effectuating a reorganization, including a Type C reorganization. The same general rules described above with respect to Type A reorganizations will apply. Therefore, the allocation of the tax items will be per share per day and postreorganization income or loss will be allocated, in effect, to the shareholders of the target receiving shares of the acquiring S corporation s stock. However, where the acquiring S corporation loses its Subchapter S election as a result of the acquisition, income or loss for the pre-reorganization period will pass through to the shareholders of the acquiring corporation. In a transferred basis transaction, section 1374(d)(8) requires that the assets of the target C corporation or former C corporation are subject to the built-in gains tax in the hands of the acquiring corporation. Where the acquiring S corporation loses its S election as a result of the Type C reorganization, it is subject to the limitation under section 1362(g) in filing a re-election under Subchapter S. 3. S Corporation as Target Corporation. Since the Service s position is that an S corporation may engage in a Type C reorganization, the target S corporation does not forfeit its S election as a consequence, its existence merely terminates. This will result in an acceleration of income or loss attributable to the target S corporation s short taxable year Momentary Affiliation. In GCM 39768, the Service stated that an S corporation will not lose its S status merely because it has a momentary corporate shareholder while effectuating a reorganization, including a C reorganization. In the case of a target S corporation s ability to participate in a Type C (b)(1). -86-

99 reorganization, any concern regarding same was substantially reduced by the issuance of GCM The Service relied on Revenue Ruling , C.B. 262, evidencing its established policy that an S corporation can be acquired in a Type C reorganization without a termination of its S status. This will avoid a section 1362(g) five-year waiting period with respect to the acquiring corporation and will allow it to elect S status as soon as possible after the reorganization if it is not already an S corporation. 5. Regulatory Repeal of Bausch & Lomb Doctrine; Prior Stock Ownership of Target. Under the 1999 revisions to Reg (d)(4) pertaining to Type C reorganizations, the Bausch & Lomb doctrine impediment that prior ownership of a target would prevent tax reorganization in a subsequent acquisition of target stock was removed. More particularly, the regulations, as revised, provide that the prior ownership by the acquiring corporation of stock in a target corporation will not by itself prevent the solely for voting stock requirement contained in section 368(a)(1)(C) and Reg (d)(1), and (d)(2)(ii) to fail. Where the acquiring corporation has prior stock ownership in the target, the 20% boot rule limitation contained in Reg (d)(2)(ii) will be satisfied only if the sum of the money or other property that is distributed in pursuance of the plan of reorganization to the shareholders of the target corporation other than the acquiring corporation and to the creditors of the target corporation pursuant to section 361(b)(3), and all of the liabilities of the target corporation assumed by the acquiring corporation (including liabilities to which the properties of the target corporation are subject), does not exceed 20 percent of the value of all of the properties of the target corporation. Example. Old and Cold Prior Ownership of Target. P Corp. (P) owns 60% of Target (T) that P purchased several years ago in an unrelated transaction. The remaining 40% of T is owned by X Corp (X) which is unrelated to P. T has assets of $110x and liabilities of $10x. If (T) transfers its assets and liabilities to P for $30 of P voting stock and $10 cash which T distributes the P voting stock and cash to X (not also P of course) and liquidates. The example in the regulation states that the transaction meets the solely for voting stock requirement of Reg (d)(2)(ii) since the $10x cash and assumption of debt of $10x does not exceed 20% of the value of the assets of T (which is $110x). Under Bausch & Lomb, this transaction would have instead been treated as the liquidation of a 60% owned subsidiary which would be fully taxable to the corporation and the shareholders since sections 337 and 332 would not apply. This effectively removes the QSub problem that was faced under the regulations (after the transitional relief rule was eliminated). Reg (d)(4) applies to transactions occurring after December 31, 1999 unless pursuant to a prior written agreement that is binding prior to such date. Example. Integrated Steps Cause Failure to Qualify as a Type C Reorganization. The facts are the same as in Example 1 except that P purchased the 60 shares of T for $60x in cash in connection with the acquisition of T s assets. The transaction does not satisfy the solely for voting stock requirement of paragraph (d)(2)(ii) of this section because P is treated as having acquired all of the T assets for consideration consisting of $70x of cash, $10x of liability assumption and $30x of P voting stock, and the sum of $70x of cash and the assumption by P of $10x of liabilities exceeds 20% of the value of the properties of T. -87-

100 6. Tax Attributes. A Type C reorganization results in a carryover of the basis of the assets acquired from the target as well as the tax history and attributes of the subsidiary, including its earnings and profits account. Accordingly, an S corporation acquiring a target in a Type C reorganization may have passive investment income issues as well as falling into the three tier distribution system under section 1368(c)(3) if the target has C earnings and profits. A target C corporation presumably would be subject to the LIFO recapture rule were it acquired by a S corporation in a Type C reorganization. 323 The regulations divide the liability resulting on the LIFO recapture tax between the C corporation target and the acquiring S corporation. 324 F. Triangular Reorganizations 1. Forward Triangular Merger ( an (a)(2)(d) Reorganization ). The first variation of the triangular reorganizations is the forward triangular merger under section 368(a)(2)(D) and section 368(a)(1)(A). A forward triangular merger involves the merger of the target corporation into a subsidiary of the acquiring corporation, in which some or all of the consideration paid is in the form of stock of the corporation which is in control of the subsidiary. Forward triangular mergers are a popular form of reorganization and provide substantial flexibility with respect to the forms of permissible consideration and the mechanism for implementing the transaction under state law. A forward triangular merger requires that substantially all of the assets of the target corporation be acquired. On the other hand, section 368(a)(2)(D) does not impose special requirements on the types of consideration, except that only stock of the parent of the subsidiary may be used to count for continuity of interest purposes, and no stock of the controlled subsidiary may be part of the consideration. 2. Reverse Triangular Merger ( an (a)(2)(e) Reorganization ). In a reverse triangular merger, a subsidiary of the acquirer is merged into the target, in exchange for consideration consisting largely of stock of the parent of the merged subsidiary. Section 368(a)(2)(E) provides that the use of stock of the controlling corporation does not disqualify the transaction as a tax-free merger under section 368(a)(1)(A), provided that after the merger, the target holds substantially all of its assets and those of the merged subsidiary. While this requirement is phrased differently than the substantially all requirements of C reorganization and a forward triangular merger, which require an acquisition of substantially all of the assets of the target, the difference in language simply reflects the differences in the form of the transaction. The reverse triangular merger is appropriate where an objective is to have the target corporation remain in existence as the owner and operator of its business. A reverse triangular merger requires that the acquiring corporation must acquire control of the target in the transaction. Therefore, when the acquirer already owns sufficient stock of a target to break control in the hands of other shareholders (i.e., the acquirer holds more than 20% Reg (a)(2). Reg (b). -88-

101 of the stock of the target), it cannot acquire control in the transaction without first disposing of the stock. Note that this requirement is more stringent than the similar requirement for a B reorganization, which requires only that the acquirer be in control of the target after the transaction (therefore permitting a creeping acquisition to qualify). An amount of target stock which constitutes control must be acquired in exchange for voting stock of the acquirer. Shares of target stock in excess of the number of shares necessary to constitute control (80%) may be paid for with any form of consideration. For example, if a target has outstanding a single class of stock, and the acquirer wishes to acquire 100% of the target in a reverse triangular merger, at least 80% of the total consideration paid must be in the form of the acquirer s voting stock. G. Two Step Reorganizations King Enterprises SEC regulations make it attractive for an acquirer to make a stock-for-stock tender offer to acquire at least 50% of a target and then use a squeeze-out merger to acquire the balance of the target stock. Expedited review by the SEC is available in connection with a stock-for-stock tender offer. Provided the merger occurs as a part of the plan that includes the tender offer, the merger would also receive expedited review. Accordingly, SEC review would take substantially less time than if the acquirer had simply filed an S-4 for the merger without the preliminary tender offer. The Tax Court s opinion in J.E. Seagram Corp. v. Commissioner, 325 supports the treatment of the exchange offer and the squeeze-out forward triangular merger as a part of a single plan, as long as the parties are obligated to carry out the merger upon successful completion of the tender offer. In Rev. Rul , 326 the Service applied the step transaction doctrine to the acquisition of 51% of the target stock solely in exchange for voting stock of the acquiring corporation, followed by a reverse triangular merger under section 368(a)(2)(E)(ii) in which the remaining 49% of the target corporation s stock was acquired for a combination of voting stock of the acquiring corporation and cash. In the integrated transaction, 83.33% of the outstanding stock of the target was acquired solely for voting stock of the acquiring corporation, satisfying the requirements of a tax free reverse triangular merger under section 368(a)(2)(E). 327 H. Type D Reorganization. 1. Acquisitive Type D Reorganization. In an acquisitive (nondivisive) D reorganization, a corporation (transferor) transfers substantially all of its assets to another corporation (transferee) in exchange for stock of the transferee. 328 This stock, along with any other consideration received and all retained assets, is T.C. 75 (1995) See King Enterprises v. Commissioner, 189 Ct. Cl. 466 (1969), where the United States Court of Claims (predecessor to the United States Claims Court) applied the step transaction doctrine to treat a stock sale and later merger as a single transaction. King Enterprises was cited in Rev. Rul , 2001-I C.B and Rev. Rul , C.B. 321, applying the step transaction doctrine to integrate stock sales and subsequent mergers to effect tax free acquisitive reorganization C.B This issue did not arise in Seagram, since the forward triangular merger rules of section 368(a)(2)(D) do not require that control be acquired solely in exchange for voting stock (a)(1)(D). -89-

102 then distributed in complete liquidation to the shareholders of the transferor. 329 The shareholders must then be in control (50 percent of the voting power or 50 percent of the value test set forth in section 304(c), using modified section 318 attribution rules). The transfer of assets may be accomplished through either a statutory merger or C reorganization structure. In the latter instance, section 368(a)(2)(A) provides that where a Type C and Type D reorganization overlap, the transaction is controlled by section 368(a)(1)(D). Where the transfer is effectuated through a statutory merger or consolidation, the transaction may overlap with a type A reorganization. 330 There does not appear to be anything in Subchapter S which is inconsistent with permitting an S corporation to engage in a Type D reorganization. 331 Prior to SBJPA, section 1371(a)(2), which treated an S corporation as an individual in owning stock of another corporation, suggested that an S corporation could not technically engage in a Type D reorganization or section 355 transaction unless its ownership of the subsidiary was momentary. Still several revenue rulings and GCM provided authority for spin-off and split-off transactions by S corporations Similarity to Type A Reorganization. The tax consequences to an acquisitive Type D reorganization should have the same effects as a Type A, including the carryover of tax attributes in accordance with section 381. A critical exception is that in a Type D reorganization section 357(c) will trigger gain recognition to the transferor corporation where the aggregate amount of liabilities transferred are in excess of the aggregate adjusted basis of the assets transferred. 333 Such section 357(c) gain, in certain instances, could also fall within the built-in gains tax if the transferred assets were subject to section I. Divisive Type D Reorganization. In a divisive Type D reorganization only a part of the corporation s assets are transferred to another corporation which is controlled immediately thereafter by the transferor corporation and/or its shareholders. The shares of stock (or securities) of the controlled corporation are then distributed to the shareholders of the transferor corporation under sections 355 or 356. Control for this purpose is 80% of the voting power and of all other classes of stock of the corporation. While a divisive Type D reorganization can only occur in conjunction with a qualified distribution of stock or securities under section 355 or 356, a section 355 division can occur without a Type D reorganization, e.g., a distribution of subsidiary stock by a holding corporation owning several controlled subsidiaries (b)(1)(B). 330 See Rev. Rul , C.B (a)(1); GCM (12/1/88); PLR Rev. Rul , C.B. 270 (momentary affiliation in a Type D reorganization did not terminate S corporation status of a distributing corporation under 355); Rev. Rul , C.B. 312 (similar result in Kimbell-Diamond type acquisition/precursor to 338 involving momentary affiliation of 30 days or less). But see Haley Brothers Construction Corp., 87 T.C. 498 (1966). 333 See Rev. Rul , 1971 C.B. 114 ( 357(c) applicable in a Type D reorganization which also constituted a Type A reorganization). -90-

103 1. Business Purpose. If the transaction is to qualify as a tax-free reorganization, it must satisfy the business purpose test; it must have one or more real and substantial non-federal tax corporate business purpose. 334 Eligibility for an S election alone will not qualify as a requisite business purpose. 335 Reduction in non-federal taxes will not satisfy the business purpose if: (i) both federal and state taxes are reduced, and (ii) the federal tax reduction is greater than the reduction in any state taxes. 336 A distribution solely to make an S election to save state income or other taxes may be a valid business purpose. 337 Close scrutiny to business purpose is given by the Service. 338 To ensure a tax-free transaction, the shareholders will need to identify a business purposes other than Newco s S corporation election. When a valid non-tax corporate business purpose does exist, a subsequent S election by either the distributing corporation or controlled corporation may be viewed by the Service as tantamount to tax avoidance, possibly triggering the Service s no ruling policy. 339 This no ruling position will not apply, however, where the distributing corporation already has an S election in place, since an S election by the spun-off corporation merely represents a continuation of the distribution corporation s S status Allocation of Income or Loss in Year of Division. If the distributing corporation is an S corporation, the Type D reorganization and the divisive transaction under section 355 ordinarily will not terminate that status. Accordingly, the distributing S corporation s income or loss for its entire tax year will pass through to its shareholders under section In the case of a split-off transaction, a section 1377(a)(2) election to bifurcate the year will be available with respect to a shareholder s complete termination of his interest in the corporation as a result of the split-off. 3. Distributions. Generally, pre-divesture distributions should be governed by section 1368, although any distribution that bears a close connection in time or planning to the division may be analyzed by the Service under the boot rules of section 356. In the case distributions pursuant to the divisive reorganization, the application of section 356 to boot distributed in a section 355 transaction requires a different analysis from that applicable to boot distributed in other acquisitive reorganizations. In such cases, as required for section 1368 to apply, there would be a distribution made by an S corporation with respect to its stock. Moreover, in a pro-rata spinoff transaction, section 356(b) would apply to characterize the boot as a distribution to which section 301 applies. This section 301 characterization would necessarily implicate section 1368(a) treatment Reg (b)(1) and (2). See Reg (b)(2). Reg (b)(2) and (5) (Ex. 7). PLR Reg (b)(1). Rev. Proc , C.B See Rev. Proc. 92-3, I.R.B , 55. See, e.g., PLR ; PLR ; PLR

104 4. Built-in Gains Tax /Section The Service has consistently ruled that section 1374 will not apply to the spun-off corporation if it elects S status effective on the first day of its existence and the assets received from the distributing corporation would not have been subject to section 1374 in the hands of the distributing corporation. Accordingly, section 1374 should apply to the spun-off control corporation only to the extent that section 1374 would have applied to the distributing corporation. 341 A spun-off corporation that does not elect S status for its first year will face exposure to section 1374 upon its subsequent Subchapter S election. 5. Tax Attributes. In general, the section 381 attribute carryover rules do not apply to divisive reorganizations. However, Reg (d)(3) confirms that the accumulated adjustments account of the distributing corporation immediately before the divisive reorganization is to be allocated between the distributing and controlled corporation similar to the allocation of the earnings and profits of a distributing corporation under section 312(h). Under such rules, earnings and profits are generally allocated in proportion to the relative value of the assets transferred and retained by the distributing corporation. 342 J. Section 368(a)(1)(E) Reorganization. A Type E reorganization involves a recapitalization of a corporation and contemplates a reshuffling of the capital structure within the framework of an existing corporation. A tax free Type E reorganization involves the exchange of stock and/or securities of the issuing corporation. Rights issued to a party to a reorganization to acquire stock are treated as securities. 343 Notably, the continuity of business and continuity of interest requirement do not apply to Type E recapitalizations. 344 A Type E recapitalization may be the first step in a two step, two company Type A, B, C, D, F or G reorganization. 345 K. Section 368(a)(1)(F) Reorganization. A Type F reorganization occurs where there is a mere change in identity, form, or place of organization of one corporation, however effected. There are various overlap issues between a Type F and a Type A, Type C or Type D reorganization. For example, both a Type F and a Type A reorganization may occur when a corporation merges into a corporation newly created in another state by the same shareholders. 346 An application of an F reorganization would be where 341 See, e.g., PLR ; PLR ; PLR See Reg (a). 343 Reg (e). However, an exchange of solely securities, including warrants, for stock is not tax free. Reg (d), Ex Reg (b). Prop. Reg (b)(1) would further clarify that an exchange of net value is not required for a transaction to qualify as a Type E or F reorganization. 345 See Rev. Rul , C.B. 80 (E followed by B); Rev. Rul , C.B. 62. (E followed by F); Rev. Rul , C.B. 120 (E followed by A). The Service has also issued a number of private letter rulings involving E recapitalizations coupled with F reorganizations. 346 See Rev. Rul , CB 333 (Type F reorganization occurred when S corporation merged into new corporation set up by same shareholders in another state; corporation s S status did not terminate). -92-

105 an S corporation merges into a QSub. 347 A similar application would be where an S corporation transfers its assets to a newly organized corporation. If this is a Type F reorganization, the new corporation is simply a continuation of the old S corporation which has merged into Newco. 348 In Ltr. Rul , the IRS ruled that an S corporation s merger into its wholly owned QSub constituted a tax-free reorganization under Section 368(a)(1)(F) without adversely affecting S corporation status. In the ruling, the S corporation and one of its two wholly owned QSubs desired to combine their assets and operations into a single corporation in order to take advantage of planned efficiencies and to reduce expenses and redundancies. Because certain legal agreements of the QSub prohibited the QSub from merging upstream into the S corporation, it was decided that the S corporation should merge downstream into the QSub. Citing Rev. Rul , 349 the IRS concluded that pursuant to the F reorganization, the S corporation election would continue in effect with respect to the surviving QSub following the merger. Additionally, the IRS found that the status of the S corporation s other QSub would not terminate as a result of the F reorganization. In Rev. Rul , 350 the IRS ruled that in the two situations presented in the rulings, which both qualified as F reorganizations within the meaning of Section 368(a)(1)(F), the S election of the existing corporations did not terminate (and were carried over to the newly formed corporations), but that the newly formed corporations would be required to obtain new employer identification numbers. In situation 1 of the ruling, B, an individual, owned all of the stock of Y, an S corporation. In year 1, B forms Newco and contributes all of the Y stock to Newco, which meets the requirements for qualification as a small business corporation. Newco timely elects to treat Y as a qualified subchapter S subsidiary (QSub) effective immediately following the transaction. The ruling states that the transaction meets the requirements of an F reorganization under Section 368(a)(1)(F). In year 2, Newco sells 1% of the stock of Y to D, an unrelated party. In situation 2, C, an individual, owns all of the stock of Z, an S corporation. In year 1, Z forms Newco, which in turn forms Mergeco. Pursuant to a plan of reorganization, Mergeco merges with and into Z, with Z surviving and C receiving solely Newco stock in exchange for his stock of Z. Consequently, C owns 100% of Newco, which in turn owns 100% of Z. Newco meets the requirements for qualification as a small business corporation and timely elects to treat Z as a QSub effective immediately following the transaction. Again, the ruling expressly states that the transaction meets the requirements of an F reorganization. The ruling first cites Rev. Rul , 351 which provided that when an S corporation merges into a newly formed corporation in a transaction qualifying as a reorganization under Section 368(a)(1)(F) and the newly formed surviving corporation also meets the requirements of Reg (b)(3), Ex. 8. See PLR (Aug. 1, 1988) CB IRB C.B

106 an S corporation, the reorganization does not terminate the S election, and as such, the S election remains in effect for the new corporation (without the new corporation being required to file a new S election). The ruling then cites Rev. Rul , 352 in which the IRS concluded that where an S corporation merged into another corporation in a transaction qualifying as an F reorganization, the acquiring (surviving) corporation should use the employer identification number of the transferor corporation. Rev. Rul provides, however, that since the publication of Rev. Rul , the Code has been amended to provide the classification of certain wholly-owned subsidiaries of S corporations as QSubs and the regulations under Section 6109 have been amended to address the effect of QSub elections under Section Specifically, Reg (i)(1) provides that any entity that has a federal employer identification number will retain that employer identification number if a QSub election is made for the entity under Reg or if a QSub election that was in effect for the entity terminates under Reg Additionally, Reg (i)(2) provides that, except as otherwise provided in regulations or other published guidance, a QSub must use the parent S corporation s employer identification number. Additionally, for tax years beginning after December 31, 2004, Section 1361(b)(3)(E) was amended to provide that except to the extent provided by the IRS, QSubs are not disregarded for purposes of information returns. Further, QSubs are not disregarded for certain other purposes as provided in the regulations. For example, Reg (a)(7) provides that a QSub is treated as a separate corporation for purposes of employment tax and related employment requirements effective for wages paid on or after January 1, Because a QSub is treated as a separate corporation for certain federal tax purposes, the QSub must retain and use its employer identification number when it is treated as a separate corporation for federal tax purposes. Because of these recent changes, the IRS concluded that it would not be appropriate for the acquiring corporation in a reorganization under Section 368(a)(1)(F) to use the employer identification number of the transferor corporation that becomes a QSub. Thus, in situation 1, although Y s original S election will not terminate but will continue for Newco, Newco will be required to obtain a new employer identification number and Y will retain its employer identification number even though a QSub election is made for it and will be required to use its original employer identification number anytime Y is otherwise treated as a separate entity for federal tax purposes. Additionally, in year 2, when Newco sells 1% of the stock of Y to D, Y s QSub election will terminate under Section 1361(b)(3)(C) and Y will be required to use its original employer identification number following the termination of its QSub election. Likewise, in situation 2, Z s original S election will not terminate as a result of the F reorganization but will continue for Newco, and as such, Newco will not be required to file a new S election. Again, however, Newco will be required to obtain a new employer identification number and Z must retain its employer identification number even though a QSub election is made for Z and must use its original employer identification number any time it is otherwise treated as a separate entity for federal tax purposes or if its QSub election terminates C.B

107 Rev. Rul applies to F reorganizations occurring on or after January 1, For F reorganizations occurring on or after March 7, 2008 and before the effective date of the ruling, taxpayers may rely on Rev. Rul The ruling acknowledges that the IRS is aware that prior to the effective date of the ruling, S corporations have undergone F reorganizations in a manner similar to those described in situations 1 and 2 in which the acquiring corporation continued to use the transferor corporation s employer identification number consistent with Rev. Rul In those cases, the IRS provides that the acquiring corporation should continue to follow Rev. Rul and use the transferor corporation s employer identification number and that after the F reorganization, the transferor QSub should use the parent s employer identification number until such time as the QSub is otherwise treated as a separate corporation for federal tax purposes or until such time as the QSub terminates. At such time, the QSub must obtain a new employer identification number. The IRS also states in the ruling that for an F reorganization occurring prior to January 1, 2009, it may be prudent for the acquiring corporation to make a protective S election. Rev. Rul is consistent with a number of prior rulings issued by the IRS to the extent that the newly formed corporation making a QSub election for the existing (transferor) corporation is not required to make a new S election. On the other hand, Rev. Rul reverses the holdings in a number of prior rulings which provided that the newly formed corporation should use the employer identification number of the existing corporation (which becomes a QSub). 353 The ruling does state, however, that in situations not involving a QSub, such as the specific situation set forth in Rev. Rul involving the merger of one S corporation with and into another corporation that constitutes an F reorganization, the surviving corporation in those circumstances would use the employer identification of the transferor corporation. In EEC , dated October 9, 2009, the IRS issued guidance to a taxpayer providing that the taxpayer could rely on Rev. Rul In the advice, C owns all of the stock of Z, an S corporation with an existing employer identification number. In year 1, Z forms Newco, which in turn forms MergeCo. Pursuant to a plan of reorganization, MergeCo merged with and into Z with Z surviving and C receiving solely Newco stock in exchange for Z stock. Newco meets the requirements for qualification as a small business corporation and timely elects to treat Z as a QSub effective immediately following the transaction. The advice provides that the taxpayer may rely on the principles set forth in Rev. Rul , and consequently, Z s original S election will not terminate but will continue for Newco, but Newco will be required to obtain a new employer identification number and Z will retain its existing employer identification number even though a QSub election is made for it. Additionally, the IRS provided in the advice that Z would not file a final Form 1120S, but rather that Newco would report all of Z s and Newco s income on its Form 1120S See, e.g., Ltr. Ruls and , IRB

108 L. Section 351 Transactions. Under section 351, eligible shareholders may transfer property to a corporation in exchange for stock (and boot) of such corporation and immediately after the exchange, the transferor(s) must be in control of the corporation within the meaning of section 368(c). As the transferee corporation, an S corporation will qualify under section 351. No gain or loss will be recognized on the transfer of its stock per section Still, section 351 transfers are problematic for S corporations, not only for the control requirement under section 368(c) and liability in excess of basis issues, but in order to maintain eligibility. In particular, the one class of stock requirement places a straight jacket on the type of consideration that can be issued by an S corporation in exchange for its stock. Where an S corporation is a transferor in a section 351 transfer, the normal rules applicable to section 351 will apply. 355 VII. Taxable Asset Acquisitions and Stock Purchases Treated as Asset Acquisitions. A. The Acquiring S Corporation. Where an S corporation purchases the assets of another corporation or business entity, the tax impacts are substantially the same as with any other asset purchase. The acquiring corporation gets a cost basis in the acquired assets, which includes any liabilities which are assumed or to which the purchased assets are subject. Gain, including recapture gain is taxable to the selling entity in the year of sale, subject to potential application of the installment sales rules for qualifying deferred payment obligations of eligible sellers. The consideration paid for the assets is allocated in accordance with section 1060 and the regulations issued thereunder. Cost recovery deductions for tangible personal property and rules applicable to the amortization of purchased intangibles, including goodwill and going concern value, permit annual deductions for depreciation and amortization. 356 B. Taxable Merger. An asset sale may be effectuated through a forward taxable merger of the target into the purchasing corporation, which generally has the same tax consequences as a direct purchase of assets. C. Shareholder Basis in Assets. 1. Direct Asset Acquisition. Where the target s assets are purchased in a taxable transaction, the buyer s aggregate basis in the purchased assets will equal: (1) cash and value of property paid; and (2) liabilities assumed or taken subject to. 357 Interest, including OID, is not added to basis. Thus, the principal amount of any fixed payment obligations is included in basis even if the seller is reporting under 355 Prior to SBJPA, an S corporation could not own 80% or more of the stock (voting and value) of a subsidiary. For taxable years beginning after 1996, this limitation has been eliminated. 356 See 168, 197, 263 and the regulations thereunder

109 section 453. For contingent payments, generally basis is not established until the amount of the contingency is determined and resolved. 2. Regular Section 338 Election. In a deemed asset sale per section 338, section 338(b)(and the regulations thereunder) require that the new target s aggregate basis in the target s assets is equal to the sum of: (i) buyer s cost or basis in the qualified stock purchase gross-up to reflect shares retained by minority shareholders; (ii) the buyer s basis in any nonrecently purchased stock of the target; (iii) the liabilities of the target, including liability for taxes resulting from the deemed sale; and (iv) other adjustments required by the regulations. 3. Section 338(h)(10) Election. Where a deemed asset sale occurs pursuant to a section 338(h)(10) election, the new target s basis is based under the same rules as a regular section 338 election except: (i) basis of assets to new target does not include any liability for tax arising out of the deemed asset sale (i.e., since the consolidated group of the seller will be bearing the tax liability); and (ii) a basis step-up is made with respect to nonrecently purchased stock. 358 Query, as to (i), what if the buyer received payment from the target as to its tax liability on the deemed asset sale? 4. Section 338 (h)(10) Election Mechanics. The election is made (Form 8023) jointly by the purchasing corporation (or its common parent) or the common parent of a target subsidiary, affiliate of a nonconsolidated subsidiary or with respect to an S corporation, by unanimous consent of all S shareholders, regardless if some shareholders do not agree to sell their shares. 359 The section 338(h)(10) election must be made no later than the 15 th day of the 9 th month after the month in which the acquisition date occurs. 360 Once made the election is irrevocable. 361 Consistency rules are provided under the regulations Allocation of Basis Among Purchased or Deemed Purchased Assets. As mandated by section 1060, the residual method of valuation is required to allocate the purchase price in actual asset sales as well as deemed asset sales under section 338. See section 1060(c)(definition of applicable asset acquisition ). Sellers will tend to allocate to assets that produce long term capital gain, or, on the other hand, ordinary loss. As to purchased goodwill and similar items, section 197 eliminates the issues of whether an intangible s useful life can be estimated with reasonable accuracy and, if so, the length of that useful life; if an intangible is covered by section 197(a) its cost is amortized over 180 months, regardless of the period during which the intangible is expected to be useful in the business. In order to trigger application of section 1060, the acquisition must involve the purchase of any active trade or business (per 358 See Reg (b)-1(e)(3)(ii). 359 Reg (h)(10)-1(c)(2). 360 Reg (h)(10)-1(c)(3). See Rev. Proc , I.R.B (automatic extensions). Teas. Reg Reg (h)(10)-1(c)(3). 362 See Forms 8023, 8333, 8806, 1096 and 1099-CAP. See Temp. Reg T. -97-

110 section 355 definition) or any other group of assets where goodwill or going concern value could under any circumstances attach to such group. 363 Under section 1060, the allocation of the purchase price is to be made upon the following classes, in the following order: First: cash and general deposit accounts (including savings and checking accounts) ( Class I ); Second: actively traded personal property under section 1092(d)(1) (with some modifications), including publicly traded stock and U.S. government securities, as well as CDs and foreign currency ( Class II ); Third: accounts receivables, mortgages and credit card receivables from customers ( Class III ); Fourth: inventory, stock in trade and property held for sale to customers in the ordinary course of business ( Class IV ); Fifth: all assets other than Class I, II, III, IV, VI and VII assets, which would include property, plant and equipment ( Class V ); Sixth: Section 197 intangible assets, except goodwill and going concern value ( Class VI ), and Seventh: goodwill and going concern value (whether or not the goodwill or going concern value qualifies as a section 197 intangible) ( Class VII ). 6. Purchase of Section 197 Intangibles. Under section 197, amortization is permitted for acquisition or capitalized costs of certain intangible property, referred to as section 197 intangibles, that a taxpayer acquires and holds in connection with the conduct of a trade or business or activity engaged in for profit. (a) Definition of Section 197 Intangible. Section 197 intangibles include: (i) goodwill; (ii) going concern value; (iii) work-force in place; (iv) information base; (v) customer based intangibles; (vi) supplier based intangibles; (vii) licenses, permits or other governmental issued rights; (viii) covenants not to compete or similar agreements entered into in connection with any interest in a trade or business, i.e., liquor licenses, taxi medallions, airport rights, regulated transportation routes, and broadcasting licenses; and (ix) any franchise, trademark or trade name (except intangibles described in section 1253(d)(1)). Thus, for example, if the buyer pays a lump sum for the target s franchise, section 197 would provide for 15 year amortization instead of a contingent payout method described in section On the other hand, buyers who are not adverse to the seller s or other third party s control over the subject intangibles, generally will prefer the current deductibility of payments subject to section 1253, which produce ordinary income to the recipient. 363 Reg T(b)(2). -98-

111 (b) Use of Separate Company to Purchase Intangibles. As part of the acquisition, consider use of a holding company with the acquisition subsidiary acquiring the business assets and the holding company purchasing the licenses and similar intangibles which it then leases to its subsidiary. This planning strategy may avoid state income tax on the royalty payments. 364 (c) Consideration for Covenant Not to Compete. Prior to the introduction of section 197 in 1993, consideration paid for a covenant not to compete was generally deductible in level amounts over the term of the covenant period. However, under section 197, the period is 15 years even if the actual contract period is shorter. (d) Anti-churning Rules. Under special anti-churning rules in section 197, goodwill, going concern value, or any other section 197 intangible acquired after the enactment date (August 10, 1993, or July 25, 1991, where an election has been made) which would not have been amortizable prior to the enactment of section 197, are generally not treated as section 197 intangibles if they were held or used by the taxpayer (or a related person) before the effective date and in certain other situations. The definition of related person borrows from sections 267 and 707(b) and commonly controlled business definitions but using lower percentage of ownership thresholds. (e) Non-Section 197 Intangibles. Certain property is excluded from the definition of section 197, including interests in corporations or partnerships, futures and notional contracts, land, certain computer software, lease rights, rights under debt instruments, and sports franchises. (f) Information Reporting Requirements. 365 Buyers and sellers are not required to agree on asset allocations, but once an agreement is made, both buyer and seller (but not IRS) are bound. Report allocation on IRS Form (g) Allocation to Non-Corporate Assets. In trying to avoid double tax for an asset or deemed asset, sale of a corporation, note cases providing that non-corporate assets, include covenants not to compete from key shareholders, and, possibly, customer relationships or goodwill retained by shareholders are not corporate assets. 367 In Howard v. U.S., 368 the court denied the taxpayer s motion for a summary 364 See 446(b), See 1060(e). 366 See also Form 8023 ( 338 transactions). 367 See Martin Ice Cream Company v. Comm r, 110 T.C. 189 (1998)(in the absence of an employment agreement or covenant not to compete, client relationships and goodwill personal to shareholder are not assets of target corporation); Norwalk v. Comm r, T.C. Memo (1998) (presence of shareholder level goodwill on liquidation of accounting firm not included in amount realized) WL (E.D. Wash.) (July 30, 2010). -99-

112 judgment and granted the government s motion for summary judgment in finding that goodwill in connection with the sale of a dental practice was corporate goodwill rather than personal goodwill. Under the facts of Howard, the taxpayer incorporated his practice as the sole shareholder, officer and director in 1980, and also entered into an employment agreement and a covenant not to compete with the corporation. The covenant not to compete provided that for so long as the taxpayer held any stock and for a period of three years thereafter, he would not engage in any business which was competitive to that of the corporation within 50 miles of Spokane, Washington. In 2002, the taxpayer and his corporation sold the practice to another personal service corporation. In the Asset Purchase Agreement, the taxpayer was allocated $549,900 for his personal goodwill and $16,000 for consideration regarding a covenant not to compete with the acquiring personal service corporation. The selling corporation itself received $47,100 for its assets. Following an audit by the IRS, the IRS recharacterized the sale of goodwill as a corporate asset and treated the amount received by the taxpayer from the sale to the acquiring personal service corporation as a dividend from the selling professional service corporation to the taxpayer. The government argued that the goodwill was corporate goodwill versus personal goodwill for three main reasons. First, the goodwill at issue was a corporate asset because the taxpayer was an employee with the corporation and had a covenant not to compete with the corporation. Second, the corporation earned the income and correspondingly earned the goodwill. Third, attributing the goodwill to the taxpayer would not comport with the economic reality of the taxpayer s relationship with his personal service corporation. The government, citing Furrer v. Comm r, 369 Martin Ice Cream v. Comm r, 370 Norwalk v. Comm r, 371 and MacDonald v. Comm r, 372 found that the goodwill was an asset of the corporation and not of the taxpayer personally because of the contractual obligation of the taxpayer under the Employment Agreement to continue to work for and not to compete against his corporation. In granting summary judgment in favor of the government, the court found no merit in the taxpayer s argument that Washington state dissolution case law supported the proposition that professional goodwill is a community property right in dissolution cases, and as such, is of a personal nature. D. The Selling S Corporation. Where a selling S corporation never has had a C history, the impact of an asset sale is rather straightforward. The decision of whether it is more advantageous and to what extent the target should sell its assets or its stock will require consideration of four tax issues: (i) the comparison of inside (asset) basis versus outside (stock) basis; (ii) the character of gain differential between an inside sale versus an outside sale (long term capital gain); (iii) whether a corporate-level tax will be imposed because of the sale; and (iv) whether (and to what extent) the installment method of reporting is available. Where the target has been a qualified F.2d 1115 (9th Cir. 1977). 110 TC 189 (1998). TCM TC 720 (1944)

113 electing small business corporation for its entire history and has not acquired the assets of a C corporation within the past 10 years in an exchanged basis transaction, then the corporate level gain from an asset sale is, for federal (and most state) income tax purposes, passed through to the shareholders and results in a single level of tax. The amount realized is allocated among the basis of the individual assets in accordance with the residual method of valuation in accordance with section 1060 and section 338 regulations, to the extent applicable. Allocated gain or loss is characterized by reference to the nature of the corporation s purpose in holding the particular asset sold, e.g., depreciable real property used in a trade or business or section 1231 property, inventory, depreciation subject to recapture, or property held for investment, including corporate goodwill. Where the corporation has acquired assets in a C corporation in a tax-free reorganization within the past 10 years and/or otherwise converted to Subchapter S within the past 10 years (7 years in for sales of assets occurring in 2009 and 2010, and 5 years for sales occurring in 2011, discussed further below), then there is a special corporate level tax on the corporation s built-in gains (and losses) to the extent of such unrealized built-in gain (or loss) on the effective date of the conversion (exchange). Prior to the enactment of the American Recovery and Reinvestment Act of 2009 (the 2009 Recovery Act ), 373 the recognition period for built-in gains under section 1374 was generally defined as the 10-year period following the first day of the tax year for which the corporation was an S corporation. As a way to provide relief to small businesses faced with the need to dispose of assets to satisfy debts, the 2009 Recovery Act amended section 1374(d)(7) to reduce the recognition period from ten years to seven years for sales of assets occurring in 2009 and Section 1374(d)(7) provides that for the 2009 and 2010 taxable years, no tax shall be imposed on the net recognized built-in gain of an S corporation if the 7th taxable year in the recognition period preceded such taxable year. For property acquired from a C corporation in a carryover basis transaction, the recognition period is reduced to 7 years from the date the property is acquired, for sales occurring in 2009 and For example, if a taxpayer previously had elected to be treated as an S corporation, effective January 1, 2002, then the 7 th taxable year in the recognition period would be Therefore, the S corporation would be free to dispose of its assets in 2009 and 2010 without being subject to the built-in gains tax. If, instead, the taxpayer had elected to be treated as an S corporation, effective January 1, 2003, then the 7 th taxable year would be 2009, and the S corporation would only be able to dispose of its assets without being subject to the built-in gains tax in On the other hand, if an S corporation acquired a C corporation on February 1, 2002, followed by an immediate QSub election, the recognition period would begin on February 1, 2003 and the QSub assets could be sold free of the BIG tax after February 1, 2010 (7 years from the acquisition of the property in a carryover basis transaction) P.L (February ) See 1374(d)(7), as amended by the 2009 Recovery Act, (d)(8)(B)(i). Joint Committee on Tax n Report on P. L (February 17, 2009)

114 The Small Business Jobs and Credit Act of 2010 (the SBJA ) 376 further reduced the section 1374 recognition period to 5 years for sales occurring in Unless extended by legislation, the section 1374 recognition period will revert back to 10 years for the 2012 taxable year and subsequent years. 1. Allocation of Income. In the year of sale, the normal pro rata allocation rules under section 1377(a)(1) will generally continue to apply. Even in a taxable merger, the corporation will retain its S status through the close of the final S year, which will not constitute an S termination year. 377 The character and amount of the gain will generally be determined at the corporate level. The corresponding gain or loss is then passed through to the shareholders and increases or reduces outside basis in stock (and, in some instances, shareholder debt previously reduced for losses and other deductions). 2. Recharacterization. A controversial provision was inserted in the final regulations to section 1366 which permits the Service to recharacterize capital gain or section 1231 gain allocable to a dealer type shareholder with respect to such property Built-in Gains Tax per Section For the S corporation, gain from the sale of assets will result in the pass through of gain and loss to the shareholders in accordance with their proportionate stock interests. Alternative tax impacts are accounted for at the shareholder level. Where the corporation has converted to S status within the past 10 years (7 years for sales occurring in 2009 and 2010 and 5 years for sales occurring in 2011, as explained above), section 1374 may apply. Thus, an asset sale by an S corporation, with a prior C history, could result in a forced double tax to the extent of its recognized built-in gains. The section 1374 tax also applies to operating and liquidating distributions. Tax history is used in determining the taxable income or loss of the corporation in the year of sale. Where the corporation does not liquidate, then the seller may need to carefully consider the potential impacts of the accumulated earnings tax under section 531, or, alternatively, the personal holding company tax under section 541. There are also alternative minimum tax impacts as well. 4. Deemed Asset Sale Treatment for Certain Qualified Stock Sales. (a) Regular Section 338 Election. In order for an acquiring corporation to be eligible to make a section 338 election, it must satisfy the requirement of a qualified stock purchase, i.e., any transaction or series of transactions in which stock (per section 1504(a)(2), i.e., 80% or more voting and value) of 1 corporation is acquired by another corporation by purchase during the 12 month acquisition P.L , H.R. 5297, signed by President Obama on September 27, See Rev. Rul , C.B. 317; Rev. Rul , C.B Reg (b)(2)

115 period. 379 If target makes a section 338 election, then a stock sale by the target s shareholders will be deemed to have sold all of its assets, subject to liabilities, to a deemed newly formed corporation in a fully taxable transaction, which is then immediately followed by the deemed liquidation of the target. Unless the target has substantial net operating losses or capital loss carryovers, a regular section 338 liquidation is generally undesirable. 380 (b) Section 338(h)(10) Election. Section 338(h)(10) sets forth a somewhat advantageous method of converting a qualified purchase of 80% or more of the target stock sale into an asset sale on an elective basis. This election may only be made for a target that is a domestic corporation that before the sale of its stock, is a member of an affiliated group of corporations (whether or not the group files consolidated returns) or is an S corporation. Where a section 338(h)(10) election is made, the target corporation recognizes gain or loss as though it sold its assets on the acquisition date, but target shareholders generally recognize no gain or loss on selling target stock to the purchasing corporation. 381 If the gain inherent in the target shareholders stock is similar in amount to the gain inherent in the target s assets, section 338(h)(10) may provide a step-up in asset basis at a tax cost not significantly greater than would be incurred with no election. Regulations further provide for deemed asset sale treatment for shareholders of an S corporation target provided all shareholders of the target consent. 5. Allocation of Consideration for Multiple Asset Sales. The consideration received from the sale of a going concern must be itemized into separate sales of each asset. This allocation is performed in accordance with the residual method of allocation under section This allocation is critical not only in computing the amount of gain or loss and its character, but also in determining which part of the sale may qualify for installment sale reporting. This allocation is made on Form Where Target is a Corporate Parent Corporation (not an 80% or more corporate subsidiary of another corporation). A taxable asset sale, including deemed asset sale under section 338(g) or section 338(h)(10), is generally less desirable to the target, in comparison with a stock sale, because it would result in a double tax, first to the target on the sale of its assets and second to the target shareholders on the distribution of the after-tax proceeds. Deferred intercompany transactions are accelerated. 383 While the purchaser may want a step-up in basis for the price paid for goodwill and other assets having a tax basis less than fair market value on the seller s books, the 379 See 338(e), (f)(asset and stock consistency rules). 380 See 336(e)(regulations not promulgated yet)(permitting non-corporate purchaser to treat stock purchase as asset sale). 381 The S status of the target corporation remains in effect through the close of the acquisition date, including the time of the deemed asset sale and liquidation. Reg (h)(10)-1(d)(3). 382 See Bar-Deb Corp. v. U.S., 36 AFTR 2d (1975, Ct. Cl. Tr. Div)(failed allocation of installment obligation by seller); Johnson v. Comm r, 49 TC 324 (1968)(seller may not arbitrarily allocate payment received in year of sale); Monaghan v. Comm r, 40 TC 680 (1963)(consideration for inventory separated from sale of remaining assets for ISO). See Rev. Rul , CB 195, amplifying Rev. Rul , CB Reg (c)(2)

116 amortization and cost recovery allowances to the buyer will not mitigate the double tax cost to the seller. As to T subsidiaries, see section 338(h)(8). 384 However, it is important for a buyer to note that in a section 338(g) or section 338 (h)(10), the deemed New T remains liable for the tax liabilities of the old T (including the tax liability for the deemed sale tax consequences). For example, New T remains liable for the tax liabilities of members of any consolidated group that are attributable to taxable years in which those corporations and Old T joined in the same consolidated return Mitigation of Target Corporation s Tax Cost on Asset Sale By Presence of Favorable Tax Attributes. A taxable asset acquisition may lighten the impact of the double tax effect where the target has net operating loss and/or capital loss carryovers which can be used to reduce taxable income on the realized gain. Any unused losses disappear and may not be used by the target unless it continues to hold back income producing assets from being distributed to the shareholders. The tax attributes of the seller, including NOLs and CNOLs, are not portable Where Target Corporation Is An S Corporation. The decision of whether it is more advantageous and to what extent the target should sell its assets or its stock will require consideration of four tax issues: (i) the comparison of inside (asset) basis versus outside (stock) basis; (ii) the character of gain differential between an inside sale versus an outside sale (long term capital gain); (iii) whether a corporate-level tax will be imposed because of the sale; and (iv) whether (and to what extent) the installment method of reporting is available. Where the target has been a qualified electing small business corporation for its entire history and has not acquired the assets of a C corporation within the past 10 years (or the applicable recognition period under section 1374, if less), in a substituted or carryover basis transaction, then the corporate level gain from an asset sale is, for federal (and most state) income tax purposes, passed through to the shareholders and results in a single level of tax. The amount realized is allocated among the basis of the individual assets in accordance with the residual method of valuation in accordance with section 1060 and section 338 regulations, to the extent applicable. Allocated gain or loss is characterized by reference to the nature of the corporation s purpose in holding the particular asset sold, e.g., depreciable real property used in a trade or business or section 1231 property, inventory, depreciation subject to recapture, or property held for investment, including corporate goodwill. Where the corporation has acquired assets in a C corporation in a tax-free reorganization within the past 10 years (7 years in 2009 and 2010) and/or otherwise converted to Subchapter S during such period, there is a special corporate level tax on the corporation s built-in gains (and losses) to the extent of such unrealized built-in gain (or loss) on the effective date of the conversion (exchange). 9. Avoidance of Step-Transaction Doctrine. A fundamental, judicially-created, doctrine of Federal income taxation is the steptransaction doctrine which has been frequently applied in the corporate income tax area Reg (b)(4). See Treas. Regs (a), 1.338(h)(10)-1(d)(2). See 381(a)

117 Basically, the step transaction, which has several rules of construction or standards which the courts have each spared over with the Service, requires that in addition to the form of the transaction taken by the taxpayer, the IRS and the courts will look to the substance of the transaction in assessing its tax impacts. Therefore, where a planned or integrated series of steps are part of a single transaction, the steps will be collapsed in order to determine the type and consequences of the transaction. 387 Prior to the enactment of section 338, the long standing rule, which was the product of the step-transaction doctrine, was where a corporation purchased the stock of a target and immediately liquidated the target in order to acquire its assets, the transaction would be treated for tax purposes as an asset sale for both the buyer and the seller. This particular setting for application of the step transaction to recast a stock sale into an asset purchase, by application of section 334(b)(2), was known as the Kimbell-Diamond doctrine. 388 (a) Enactment of Section 338. The Kimbell-Diamond doctrine was strongly criticized by professional commentators as creating uncertainty and the prospect for possibly whipsawing an unsuspecting seller of stock into a double-tax asset sale. It was replaced in 1982 by section 338 although the use section 338 was reduced to a large extent by the 1986 repeal of the General Utilities doctrine. The (h)(10) election provision to section 338 apparently is the main route to section 338 unless a target has a substantial amount of loss carryovers. Under section 338(d)(3), a section 338 transaction requires that there be a qualified stock purchase, i.e., purchase of 80% or more of the target s stock within a testing period. Still, under step transaction principles a purchase of target stock solely for stock of the acquiring corporation in an apparent Type B reorganization could be recast into a Type C reorganization if the acquiring corporation immediately caused the target to be liquidated or otherwise liquidated the target in a planned (step transaction doctrine) sequence. (b) Step Transaction Doctrine Broken in Section 338(d)(3) Qualified Stock Purchase. In Rev. Rul , 389 the Service ruled that the step transaction doctrine does not apply to treat a QSP followed by the immediate liquidation of the target into the acquiring corporation as an asset purchase. The rationale for the Service s position was that section 338 overrode the Kimbell-Diamond doctrine. 390 In Rev. Rul , 391 the Service ruled that, under certain circumstances, such as the qualification for a statutory merger under section 368(a)(1)(A), step transaction principles apply to characterize the transaction prior to the determination of whether a QSP has been made. In such cases, Rev. Rul will not apply and there will be no QSP. 387 See Bowen, The End Result Test, 72 Taxes 722 (1994); Mintz & Kwall & Maynard, Dethroning King Enterprises, 58 Tax Law. 1 (2004); Plumb, Step Transactions in Corporate Reorganizations, 12 NYU Inst. on Fed. Tax n 247 (1954); Murray, Step Transactions, 24 U. Miami L. Rev. 60 (1969). 388 Kimbell-Diamond Milling Co. v. Comm r, 14 TC 74, aff d per curiam, 187 F.2d 718 (5th Cir.), cert. denied, 342 US 827 (1951) C.B See CCA (4/15/02). I.R.B

118 In July, 2003, Service issued final and temporary regulations that permit taxpayers to turn off the step transaction doctrine and to make a section 338(h)(10) election in certain multi-step transactions, as set forth in Rev. Rul The regulations are effective for stock acquisitions occurring on or after July 8, The notion is that where a section 338 election is made by the parties, then the transaction will be treated as a deemed asset sale and the step transaction doctrine will not apply even though the target corporation is immediately liquidated into the acquisition subsidiary or acquiring corporation. 393 If the section 338(h)(10) election is not made, Rev. Rul will continue to apply so as to recharacterize the transaction as a reorganization under section 368(a) Redemptions of Target Stock. Where the purchasing corporation (P) purchases less than 80% of the T stock and as part of the same transaction T redeems stock sufficient to increase P s holdings to more than 80%, the regulations provide that redemptions from unrelated persons of the PC will generally count towards the qualified stock purchase requirement; a question arises whether P has made a QSP Going Public/Section 338 Transaction. Although beyond the scope of this outline, it is possible, at least conceptually, to use a section 351 template to structure an asset purchase as part of an IPO transaction provided there is: (i) a binding commitment to have the target shareholders sell at least 80% of their stock; and (ii) the section 351 transaction has a unrelated party acquiring part of the stock prior to the IPO Reverse Merger of Acquiring Corporation into Target Corporation Treated as Qualified Stock Purchase. When the acquiring corporation (or a wholly owned subsidiary of the acquiring corporation) is merged into the target corporation (a reverse merger ) and the former shareholders of the target receive cash consideration, the transaction is treated as a qualified stock purchase eligible for treatment as a deemed asset sale under section 338(h)(10). 397 The gain from the deemed asset sale is passed through to the cashed out shareholders of the S corporation. 13. Forward Merger of Target into Acquiring Corporation Treated as Asset Sale. The same tax consequences resulting from a section 338(h)(10) election may be accomplished if the target company is acquired through a forward merger of the target into the acquiring corporation, where the selling shareholders receive cash and no stock (a cash 392 See Reg (c)(1)(i), (2) and Reg (h)(10) See Reg (h)(10)-1(c)(2). 394 Reg (h)(10)-1(e) Ex Reg (b)(5) (b)(5)(ii). 396 See Rev. Ruls , C.B. 144 and , 1 C.B Reg (b)(3)(iv), Ex. 1. See also 197(f)(9). See also PLR See Rev. Rul and 90-95, supra

119 merger ), in which event the transaction is treated as an asset sale. 398 Similarly, the forward cash merger of the target corporation into a LLC taxable as a partnership or disregarded as an entity separate from its sole owner is treated as a deemed asset sale, with the buyer obtaining a basis in the assets equal to the purchase price. The transaction is treated as if the assets were sold by the target and the proceeds distributed to the selling shareholders in a liquidating distribution. 399 E. Target Shareholders. 1. In General. Where the proceeds of an asset sale are distributed to the shareholders then the shareholder-distributees must report income (or loss) under the distribution rules contained in Subchapter C or such portion of Subchapter S, i.e., section 1368, which may apply. Thus, depending on the facts and circumstances, a distribution of sales proceeds will be treated as a dividend, a return of capital or capital gain. 400 Where the distribution of sales proceeds is accomplished by redemption of part of the stock of the target corporation, the shareholder level tax treatment may be a dividend equivalent or produce sale or exchange treatment in accordance with sections 302 and The acquisition could also be structured as a bootstrap redemption or Zenz redemption. 2. S Corporation: Allocation of Income in Year of Sale. Generally, the normal allocation of tax items per share per day will apply under section 1377(a)(1). The character of the gain or loss is determined at the corporate level. The tax items of gain or loss are passed through to the shareholders with gain increasing basis (or first restoring a previously reduced basis in debt) and loss reducing basis, including debt basis under section 1367(b). 3. Impact of Installment Sales by S or C Corporation Targets. Certain items of income realized under an installment sale are recognized in the year of sale, such as depreciation recapture and the amount of liabilities transferred in excess of adjusted basis. Certain assets, such as inventory, do not qualify for installment sale reporting. The portion of the sale allocable to depreciated assets is also outside of the scope of section 453 and is immediately recognized in the year of such. On the balance of qualifying gain under the installment sale obligation (ISO), gain may be deferred until the year(s) in which payments are received. (a) Exceptions to Installment Sale Treatment In General. Whether the seller corporation is an S (or C) corporation, a deferred payment taxable asset sale may trigger more immediate gain recognition than a stock sale would. First, under section 453(b)(2), installment method reporting is not available on the sale of inventory or dealer Rev. Rul. 69-6, C.B PLR (March 28, 2006) See also , See also 304 (redemptions of stock through related corporation)

120 dispositions. Second, under section 453(i), recapture income is recognized in the year of sale. Third, under section 453A, interest may be charged on nondealer installment sales (i.e., casual sales) of property used in a trade or business or held for the production of income if (i) the sales price exceeds $150,000, and (ii) the face amount of all such obligations held by the taxpayer for the taxable year exceeds $5 million. Fourth, a pledge of an installment obligation arising from such a sale may be treated as a payment. 402 (b) Distribution of ISO in Complete Liquidation. A shareholder that is a qualifying shareholder receiving an installment obligation in a complete liquidation (provided no election out is made) may treat the payments under the obligation instead of the obligation itself, as the consideration received in exchange for her stock. 403 In order to qualify for installment reporting, the installment obligation (IS0) must: (i) be acquired in respect to a sale or exchange of the target corporation s assets within 12 months after the corporation adopted a plan of complete liquidation; and (ii) the liquidation is completed within that 12-month period. 404 Exception is made for installment sales of depreciable property to certain related parties, recapture items, certain sales of inventory, and ISOs attributable to certain tax avoidance transactions. 405 The limitation on a shareholder s use of section 453 for reporting gain on complete liquidation for the portion attributable to inventory property is inapplicable (and therefore section 453 reporting is permitted) if a bulk sale requirement is met. 406 Under section 453B(h), a distribution by an S corporation of an ISO with respect to which the shareholder is entitled to report his stock gain on the installment method is not treated as a disposition of the obligation by the S corporation. Under section 453B(h), when a liquidating distribution includes an ISO and cash, the shareholder s stock basis must be apportioned between the ISO and cash (and any other property) distributed, in the manner appropriate to installment reporting, rather than the up front basis recovery otherwise contemplated under section Thus, the shareholder is allowed to report gain over the same period of years that it could have been reported if the nonrecognition rules for 12-month liquidations had not been repealed. This rule does not apply, however, with respect to the builtin gains tax or for purposes of determining the corporation s tax liability. Thus, except for purposes of determining the tax on certain built-in gains or on passive investment income, an S corporation-distributee shareholder is also permitted to defer the recognition of gain on the distribution of a qualifying ISO in complete liquidation. As a result, gain will be recognized and taxed to the shareholders only as payments are received. Whether the sale is effectuated by a stock sale with a section 338(h)(10) election, the same principles apply See 453A(d) (h). 404 See 453(h)(1)(A). Reg (a)(1). 405 See also Reg (c)(2). 406 Reg (c)(4)(i) (h)(2); 453B(h); Reg (a)(3), (d) requiring each shareholder to reasonably estimate the gain attributable to distributions received in each taxable year and the anticipated aggregate distributions. See also, Reg (h)(10)-1(e), Ex PLR (10/7/05) -108-

121 (c) Planning Considerations the One Day Note. Unfortunately, section 453(h) will accelerate the tax liability of the shareholders in many cases. Section 453(h), originally designed to apply to liquidating distribution from a C corporation, treats the distributed installment obligation as arising, not on the asset sale by the corporation, but rather on a sale of stock by the shareholders. Whether the liquidation of the corporation is accomplished in one year or two, the shareholder s tax basis in the stock must be apportioned between the installment note, any cash, and any property distributed by the corporation in the manner appropriate to installment reporting. This contrast with the front end basis recovery contemplated by section 331. As a result, the recovery of basis by the shareholder may not take place in an optimum manner. That is, less basis is allocable to any post-sale liquidating distribution of cash, therefore increasing gain recognition in the year of sale. 409 The adverse tax consequences to the selling shareholders of these basis recovery rules may be avoided if only installment obligations are distributed to the shareholders and no cash or property is distributed at closing. This may be accomplished by distributing any accumulated or surplus cash to the shareholders prior to the sale and liquidation, and selling the assets solely in exchange for installment notes, with no cash down payment at closing. The cash portion of the transaction can be payable a day or so later in satisfaction of the one day note. The stock basis allocation contemplated by section 453(h) does not come into play. The gross profit allocated to the notes is recognized ratably as the payments are received, based on the gross profit ratio, resulting in more deferral for the taxpayer. 410 The one day note can be backed up by a standby letter of credit or otherwise secured. Since the one day note strategy can be used to avoid gain recognition that would result if the S corporation is acquired with a combination of cash and an installment note, as opposed to only installment notes, the strategy may raise questions under the economic substance doctrine Complete Liquidation of Target Corporation. Where the target corporation completely liquidates as part of the acquisition, the general characterization rule at the shareholder level will be section 331, or as to a controlling corporate distributee, will qualify for nonrecognition under section Downstream Merger. As an alternative to liquidating the target corporation, the acquiring S corporation may merge downstream into the target, with the target surviving. 413 If the downstream merger is 409 See Reg (h)(10)-1(e), Ex For a further discussion of the one day note strategy, and possible legislative solutions involving the amendment of 453(h). see Levin & Ginsburg, Mergers, Acquisitions and Buyouts, , Wolters Kluwer Law & Business (September, 2011) 411 See Note Strategy Raises Economic Substance Concerns, Official Says 126 Tax Notes 768 (Nov. 15, 2010). Hall, The One Day Note Solution to the Section 453B(h) Tax Trap- Is it Viable under the Economic Substance Doctrine? Tax Assessments, Vol. 31, No 1, p. 8, published by the Tax Section of the NC Bar Association (September, 2011) 412 At the corporate level, for in-kind distributions in liquidation, see 336,

122 made immediately after the stock acquisition, the target conceivably would not be prevented from making an immediate S election due to the existence of a transitory corporate shareholder (assuming all other requirements under section 1362 are met). In addition, the acquiring S corporation s election presumably would not be terminated by the transitory affiliation with target. The target could then freely elect S corporation status without section 1362(g) applying. 414 If the acquiring S corporation s election terminates, section 1362(g) will prevent a subsequent election until the close of the prescribed five-year waiting period. This strategy also had potentially adverse tax consequences with respect to the built-in gains tax and LIFO recapture provisions 6. Direct Asset Purchase and Liquidation. In some instances there will be liabilities of the target, either contingent, or known or unknown, which were not assumed by the buyer. There may also be other assets that are retained to pay additional claims. In such cases, a liquidating trust may be required. In such instance, it is essential that the trust be treated as such for tax purposes and not be viewed as an association taxable as a corporation. 415 Generally, the corporation will recognize gain or loss on the distribution of property in liquidation. 416 Under section 336(d)(1), the corporation is not permitted to recognize loss on the distribution of assets to a related person if the distribution is non-pro rata or the distribution consists of disqualified property (i.e., assets acquired in a section 351 transaction or contribution to capital in the preceding 5 years). A second loss disallowance rule applies where a principal purpose of the transaction in which property was contributed to corporation in advance of liquidation was to recognize loss to offset corporate-level gain Reverse Merger of Acquiring Corporation into Target Corporation Treated as Qualified Stock Purchase. As noted above, when the acquiring corporation (or a wholly owned subsidiary of the acquiring corporation) is merged into the target corporation (a reverse merger ) and the former shareholders of the target receive cash consideration, the transaction is treated as a qualified stock purchase eligible for treatment as a deemed asset sale under section 338(h)(10), provide the purchaser is a corporation. 418 The gain from the asset sale is passed through to the cashed out shareholders of the S corporation. 8. Forward Merger of Target into Acquiring Corporation Treated as Asset Sale. The same tax consequences resulting from a section 338(h)(10) election may be accomplished if the target company is acquired through a forward merger of the target into the acquiring corporation, where the selling shareholders receive cash and no stock (a cash See Edwards Motor Transit Co., 64,317 P-H Memo T.C. (1964). See Rev. Rul , C.B See Reg., (d) Compare 311 for distributions of property not in liquidation. 336(d)(2). See Rev. Ruls and 90-95, supra

123 merger ), in which event the transaction is treated as an asset sale. 419 Similarly, the forward cash merger of the target corporation into a LLC taxable as a partnership or disregarded as an entity separate from its sole owner is treated as a deemed asset sale, with the buyer obtaining a basis in the assets equal to the purchase price. 420 The transaction is treated as if the assets were sold by the target and the proceeds distributed to the selling shareholders in a liquidating distribution. This may be a preferable method for acquiring the assets of a target subsidiary to avoid technical legal issues generated through the transfer of assets and assignment of leases, contract rights, licenses, etc. In certain instances, a forward merger may qualify as a non-taxable Type A or Type C reorganization. 9. Forward Triangular Merger. Same as forward merger but through use of a subsidiary, i.e., newly formed acquisition subsidiary. Where a portion of the consideration consists of stock or debt of the parent, the transaction may qualify for nonrecognition treatment. 421 Shareholders of the target corporation may be offered the option of receiving shares of the purchasing corporation (or parent) or cash. Continuity of interest guidelines need to be addressed, i.e., % of consideration in purchasing corporation stock. 10. Section 338(h)(10) Election: Target C Corporation. Where a C corporations is the seller of target subsidiary stock and both corporation are members of an affiliated group, the buyer and seller may consent to an (h)(10) election. In such instance the stock sale is treated as an asset sale followed by the (tax-free) complete liquidation of the target. The deemed sale occurs while the target is still a member of the affiliated (seller) group. In contrast, a regular section 338 election results in the deemed sale taking place after the target stock is sold and is included in a one-day short year return. 422 The benefits of the section 338(h)(10) election include the possible avoidance by the parent (seller) of liquidation gain per section 332. Target gain, i.e., on the deemed asset sale, can be sheltered by any favorable tax attributes of the rest of the consolidated group Impact of State and Local Taxes. Some (but not all) states will respect the section 338(h)(10) election. States also vary on the computation of consolidated tax liability or may deny consolidated reporting. 12. Section 338(h)(10) Election: Target S Corporation. Where S corporation shareholders are sellers of target S corporation stock, the corporation and all shareholders, as well as the purchasing corporation, may elect to treat the 419 Rev. Rul. 69-6, C.B PLR (March 28, 2006). 421 See 368(a)(1)(C), 368(a)(2)(D) (h)(9). 423 See PLR (parent s contribution of stock of two wholly-owned subsidiaries to a newly formed subsidiary (Newco) followed by parent s prearranged sale of Newco stock to a third party (acquiror) constituted a broken 351 transaction and a qualified stock purchase of Newco shares such that parent and acquiror could join in making a 338(h)(10) election)

124 stock sale as an asset sale for federal income tax purposes. This results in shareholder level gain or loss on the deemed liquidation. Note that the character of the gain may change significantly where the target has ordinary income assets, or recapture items and may be required to accelerate ordinary operating income in the year of the sale. There also is the gross up in the purchase price for liabilities assumed or taken subject to. Thus, in various instances, a straight up sale of stock for the equity value may produce a more favorable result to the seller shareholder(s). Regulations endorse the use of the installment sale method for section 338(h)(10) elections made by S corporation target shareholders. 424 F. Tax Consequences to the Shareholders Selling S Stock. 1. In General. The general rules applicable to reporting gain or loss from the sale of stock will apply, including, for cash method shareholders, the ability to use the installment sales provision. No gain or loss will be realized by the target corporation assuming a section 338 election is not made. 425 The computation of gain or loss is made after basis in stock and debt is allocated to the shareholders in accordance with section 1366 and the basis adjustments under section Where one or more of the target shareholders have suspended losses under section 1366(d)(2), such amounts may not be used to reduce gain or increase the loss on the sale of stock. However, such losses may be used where the target S corporation and its shareholders file a section 338(h)(10) election. Where 80% or more of the target S corporation s stock is acquired in a qualified purchase under section 338(d)(3), and an election is made by the purchasing corporation, the stock sale is also treated as a deemed asset sale and liquidation to the corporation. The selling shareholders still recognize capital gain or loss with respect to the sale of their stock. The section 338 gain is trapped in a one day C year on the date of the deemed liquidation. 426 The final S year return is made for the target corporation as of the date prior to the date of the deemed sale. 427 Final regulations issued in January, 1994 provide that when a corporation which acquires the stock of an S corporation (or a corporate subsidiary from an affiliated group), the purchasing corporation and the selling shareholders may jointly elect under section 338(h)(10) to treat such stock acquisition as an asset acquisition followed by a liquidation. 428 The S corporation will be treated as if, while still owned by its shareholders, to a new target corporation This permits the acquiring corporation to obtain a step up in basis in the target corporation s assets while generally facilitating a single level of tax to the target S corporation and its shareholders. The inside gain is passed through to the target shareholders based on the character of the assets to the corporation. This could create inside/outside basis issues resulting in substantial levels of ordinary income and the potential for a residual long term capital loss. Still, the deemed asset sale could result in a section 1374 event to the selling corporation which would compound the adverse tax impact of a deemed asset sale versus a stock sale Reg (h)(10)-1(d)(8). See 1222, 306, 341. Reg (e)(3). 1362(e)(6)(C). Reg (h)(10)-1(a)

125 Among the important issues in this area is the impact of the section 338(h)(10) election on non-selling shareholders since a qualified stock purchase only requires 80% (or more) of the S corporation s stock. Under the final regulations, each non-selling shareholder is taxed on his or her pro rata share of the deemed sale gain, which is a major trap for the unwary. 429 The proposed regulations make clearer that such is the result while at the same time providing that all shareholders are required to consent to the election to avoid minority shareholders from being forced to pay tax on a non-sale as to their stock position. On the other hand, this may give the minority shareholders additional bargaining power. 430 The final regulations apply generally to qualified acquisitions of target stock on or after January 20, A special retroactive (elective) rule was applicable to acquisitions on or after January 14, 1992 and before January 20, Where a target S corporation which has QSub elections in existence for certain subsidiaries, proposed regulations to section 338(h)(10) provide that the subsidiaries remain QSubs for purposes of assessing the deemed asset sale impacts on the S corporation parent and the shareholders of the target S corporation. Thus, the QSub status of the target S corporations will not terminate. No similar rule was provided under proposed regulations where the purchaser acquires the stock of the QSub instead of the stock of the parent S corporation. 2. Income Allocation in Year of Acquisition. The allocation of income, loss, deductions and credits in the year of acquisition will differ depending on whether the S election terminates. Where the acquiring corporation s S election is not terminated, income items are allocated under the per day/per share rule of section 1377(a)(1). Where the S election of the acquiring corporation is terminated as a result of the purchase of stock, items of income (loss) would be allocated under section 1362(e)(2) unless all relevant shareholders elect to close the books under section 1363(e)(3). If the target s S status terminates, it will have an S termination year consisting of a short S and a short C year. The target s income will be allocated between these two years on a closing-of-the-books basis assuming at least 50 percent of its stock has been acquired (otherwise, income will be allocated on a pershare/per-day basis) Additional Tax Consequences to the Target S Corporation and its Shareholders. If the acquisition constitutes an ownership change under section 382(g) and the target S corporation has built-in loss assets, the built-in loss limitations of section 382 could apply to restrict the amount of recognized losses (as well as depreciation or amortization deductions) of the acquired S corporation following the ownership change. 433 These loss limitations rules may or may not operate to restrict the amount of recognized losses (or depreciation deductions) attributable to built-in loss assets that could be taken into account by the shareholders of the target S corporation under section 1366(a). In the event section 382 does apply, and any amount 429 See Reg (h)(10)-1(d)(2). 430 Reg (h)(10)-1(b)(5). 431 Reg (i)-1(b). For a discussion of the proposed regulations see Collins, Harvey and Zywan, S Corporations in 338(h)(10) Transactions. Business Entities 6 (November/December 1999) (e)(6)(D). 433 See 382(a), 382(h); see also Temp. Reg T(f)(1)(i)

126 of such losses (or deductions) exceeds the section 382 limitation for any post-change of ownership year, it is not clear that this excess amount can be carried forward by the shareholders and utilized in a subsequent taxable year. 434 The target s taxable year may change if a consolidated return is filed with an acquiring corporation. The target shareholder s suspended losses under section 1366(d)(2) will be lost because they no longer would hold stock after the acquisition. 435 If the target s S election is terminated, re-election of S corporation status would be prohibited for the five-year period under section 1362(g) subject to applicable exception. 4. Distributions. (a) Post-Sale Distributions. The treatment of distributions by the acquiring S corporation after the acquisition depends on whether its S election terminates as a result of the acquisition. If the S election does not terminate, the distribution rules of section 1368 will apply. If the S election does terminate, the corporation may be able to make nontaxable cash distributions during the post-termination transition period to the extent of the AAA. After this period, the normal dividend distribution rules generally apply. 436 (b) Pre-Sale Distributions. A pre-sale distribution by the S corporation may result in a tax-free distribution to the selling shareholder. Under section 1368, the shareholder could cause the S corporation to distribute excess cash to the extent of the shareholder s basis in stock. The stock could then be sold on the installment basis for a reduced selling price. Each installment would carry a higher percentage of gain, but such gain would be deferred. This structure would allow the selling shareholder to receive immediate cash without gain recognition. 434 See I.R.C. 1371(b)(2), which provides that no carryforward, or carrybacks, arise at the corporate level for a taxable year for which a corporation is an S corporation. 435 Reg (a)(5). 436 See 1371(e)

127 M&A Transactions Involving S Corporations Ziemowit T. Smulkowski Paul Hastings LLP Confidential not for redistribution

128 Parties Objectives S corporation shareholders o Long-term capital gains tax on sale (35% vs. 15%) o Minimize state income tax on transaction o Defer recognition of gain on any roll-over equity (true if tax rates scheduled to increase?) o Preserve flow-through taxation on any roll-over equity (true if individual rates become higher than corporate rates?) o Maximize tax benefit from transaction expenses (banking fees, transaction fees, sales bonuses) o Control over preparation of S corporation tax return o Avoid exposure of sale proceeds to corporate liabilities Buyer o Step-up tax basis o Flow-through taxation? o Ability to deliver asset sale on exit? o Avoid exposure to historic corporate liabilities Paul Hastings LLP Confidential not for redistribution

129 Structuring Alternatives Sale of S corporation stock Sale of S corporation assets Sale of S corporation stock with a 338(h)(10) election (deemed asset sale transaction) Forward subsidiary cash merger of the S corporation (deemed asset sale transaction) Sale of a QSub (deemed asset sale transaction) Sale of a single member LLC (deemed asset sale transaction) Conversion of the S corporation into an LLC followed by sale of LLC interests (deemed asset sale transaction) Paul Hastings LLP Confidential not for redistribution 3

130 Structuring Alternatives Sale of S corporation stock A B Buyer S corporation Assets Paul Hastings LLP Confidential not for redistribution 4

131 Structuring Alternatives Sale of S corporation stock (continued) S corporation s shareholders perspective o Capital gain No look through for hot assets o State taxation based on residence of shareholder o Deferral of gain possible on roll-over equity if sale is part of a non-recognition transaction IRC 351 (contribution of S corporation shares to a corporation) IRC 721 (contribution of S corporation shares to a partnership) IRC 368 reorganization (exchange of S corporation shares/assets for stock of buyer corporation) o S corporation converts to a C corporation unless Buyer is an eligible shareholder (i.e., no flowthrough taxation) o Stub year of S corporation ends on the day before the Closing Date impact on deductibility of transaction expenses o Buyer (as owner of the S corporation) will control preparation of final S corporation tax return o Shareholders not exposed to corporate level liabilities o Each shareholder has to agree to sale (subject to drag along rights) A B Buyer S corporation Assets Paul Hastings LLP Confidential not for redistribution 5

132 Structuring Alternatives Sale of S corporation stock (continued) Buyer s perspective o No step-up in the tax basis of the assets Issue with cash basis accounts receivable o S corporation converts to a C corporation unless Buyer is an eligible shareholder (i.e., no flow-through taxation) o Not able to deliver asset sale on exit without double tax (unless S corporation status is preserved) o Historic liabilities follow corporation (subject to indemnification provisions in the purchase agreement) A B Buyer S corporation Assets Paul Hastings LLP Confidential not for redistribution 6

133 Structuring Alternatives Sale of S corporation assets A B Buyer S corporation Assets Paul Hastings LLP Confidential not for redistribution 7

134 Structuring Alternatives Sale of S corporation assets (continued) S corporation s shareholders perspective o Character of income based on assets of S corporation sold Accounts receivable of cash basis taxpayers (accounts payable) Depreciation recapture Inventory o State taxation based on S corporation nexus and apportionment and allocation rules o State entity level taxation possible (e.g., Illinois 1.5% personal property replacement tax) o Deferral of gain for roll-over equity available Impact of pro rata allocation rules on the ability to defer gain Roll-over equity needs to be retained in S corporation o Flow-through taxation on roll-over equity possible if buyer is a flow-through entity (i.e., partnership for income tax purposes or an S corporation) o S corporation taxable year does not end impact on deductibility of transaction expenses o Shareholders (as owners of S corporation) will continue to control preparation of S corporation tax return o Shareholders exposed to corporate level liabilities o Shareholders do not have to agree to sale (subject to corporate governance agreement) A B Buyer S corporation Assets Paul Hastings LLP Confidential not for redistribution 8

135 Structuring Alternatives Sale of S corporation assets (continued) Buyer s perspective o Step-up in the tax basis of the assets o Buyer can decide whether to structure acquisition vehicle to provide for flow-through taxation o Able to deliver asset sale on future exit without double tax if flowthrough taxation structure is put in place o Historic liabilities should remain with selling S corporation A B Buyer S corporation Assets Paul Hastings LLP Confidential not for redistribution 9

136 Structuring Alternatives Sale of S corporation stock with a 338(h)(10) election Same corporate form as stock sale Treated for tax purposes as if S corporation sold its assets and then liquidated A B Buyer S corporation Asset s Paul Hastings LLP Confidential not for redistribution 10

137 Structuring Alternatives Sale of S corporation stock with a 338(h)(10) election (continued) S corporation s shareholders perspective o Character of income based on assets of S corporation deemed sold Accounts receivable of cash basis taxpayers (accounts payable) Depreciation recapture Inventory o State taxation based on S corporation nexus and apportionment and allocation rules o State entity level taxation possible (e.g., Illinois 1.5% personal property replacement tax) o Deferral of gain for roll-over equity not available (338(h)(10) election results in a recognition of 100% of the gain) o S corporation converts to a C corporation unless Buyer is an S corporation (i.e., no flow-through taxation) o Stub year of S corporation ends on the Closing Date impact on deductibility of transaction expenses o Buyer (as owner of the S corporation) will control preparation of final S corporation tax return o Shareholders not exposed to corporate level liabilities o Each shareholder has to agree to sale (subject to drag along rights) & a 338(h)(10) election A B Buyer S corporation Assets Paul Hastings LLP Confidential not for redistribution

138 Structuring Alternatives Sale of S corporation stock with a 338(h)(10) election (continued) Buyer s perspective o Step-up in the tax basis of the assets o S corporation converts to a C corporation unless Buyer is an S corporation (Section 338(h)(10) election requires the Buyer to be a corporation) o Not able to deliver asset sale on future exit without double tax (unless Buyer is an S corporation) o Historic liabilities follow corporation (subject to indemnification provisions in the purchase agreement) o Risk of the 338(h)(10) election being invalid A B Buyer S corporation Assets Paul Hastings LLP Confidential not for redistribution 12

139 Forward subsidiary cash merger of the S corporation (deemed asset sale transaction) Similar corporate form to a stock sale Treated for tax purposes as if S corporation sold its assets and then liquidated (PLR ) A B S corporation Buyer Assets Paul Hastings LLP Confidential not for redistribution 13

140 Forward subsidiary cash merger of the S corporation (deemed asset sale transaction) (continued) S corporation s shareholders perspective o Character of income based on assets of S corporation deemed sold Accounts receivable of cash basis taxpayers (accounts payable) Depreciation recapture Inventory o State taxation based on S corporation nexus and apportionment and allocation rules o State entity level taxation possible (e.g., Illinois 1.5% personal property replacement tax) o Deferral of gain for roll-over equity not available o Flow-through taxation on roll-over equity possible if buyer is a flow-through entity (i.e., partnership for income tax purposes or an S corporation) o S corporation taxable year ends on the day of the transaction impact on deductibility of transaction expenses o Buyer will control preparation of S corporation tax return o Shareholders of S corporation not exposed to corporate level liabilities o All Shareholders do not have to agree to forward merger (subject to corporate governance agreement) A B S corporation Buyer Assets Paul Hastings LLP Confidential not for redistribution 14

141 Forward subsidiary cash merger of the S corporation (deemed asset sale transaction) (continued) Buyer s perspective o Step-up in the tax basis of the assets o Buyer can decide whether to structure acquisition vehicle to provide for flow-through taxation o Able to deliver asset sale on future exit without double tax if Buyer utilizes flow-through structure o Historic liabilities follow corporation (subject to indemnification provisions in the purchase agreement) o Risk of invalid S corporation election (versus risk of an invalid S corporation election in a 338(h)(10) transaction) A B S corporation Buyer Assets Paul Hastings LLP Confidential not for redistribution 15

142 Sale of a QSub/single member LLC (deemed asset sale transaction) Equity (stock or membership units) transaction for corporate law purposes Treated as a sale of assets for income tax purposes A B S corporation Buyer QSub LLC Assets Assets Paul Hastings LLP Confidential not for redistribution 16

143 Sale of a QSub/single member LLC (deemed asset sale transaction) (continued) S corporation s shareholders perspective o Character of income based on assets of S corporation deemed sold Accounts receivable of cash basis taxpayers (accounts payable) Depreciation recapture Inventory o State taxation based on S corporation nexus and apportionment and allocation rules o State entity level taxation possible (e.g., Illinois 1.5% personal property replacement tax) o Deferral of gain for roll-over equity available Impact of pro rata allocation rules on the ability to defer gain Roll-over equity needs to be retained in S corporation o Flow-through taxation on roll-over equity possible if Buyer is a flow-through entity (i.e., partnership for income tax purposes or an S corporation) o S corporation taxable year does not end impact on deductibility of transaction expenses o Shareholders (as owners of S corporation) will continue to control preparation of S corporation tax return o Shareholders not exposed to QSub/single member LLC liabilities (exposed to selling S corporation liabilities) o Shareholders do not have to agree to sale (subject to corporate governance agreement) A B S corporation Buyer QSub LLC Asset s Asset s Paul Hastings LLP Confidential not for redistribution 17

144 Sale of a QSub/single member LLC (deemed asset sale transaction) (continued) Buyer s perspective o Step-up in the tax basis of the assets o Buyer can decide whether to structure acquisition vehicle to provide for flow-through taxation o Able to deliver asset sale on future exit without double tax if flowthrough taxation structure is put in place o Buyer indirectly inherits liabilities of QSub/single member LLC but selling S corporation liabilities should remain with the S corporation A B S corporation Buyer QSub LLC Assets Assets Paul Hastings LLP Confidential not for redistribution

145 Sale of a QSub/single member LLC (deemed asset sale transaction) sale of less than 100% alternative (continued) Equity (stock or membership units) transaction for corporate law purposes Treated as a sale of assets for income tax purposes A B S corporation Buyer QSub LLC Assets Assets Paul Hastings LLP Confidential not for redistribution 19

146 Sale of a QSub/single member LLC (deemed asset sale transaction) sale of less than 100% alternative Equity (stock or membership units) transaction for corporate law purposes Treated as a sale of assets followed by a contribution of the assets by Buyer and Seller to a new entity (partnership or C corporation) for income tax purposes (Rev. Rul (Sale of Interest in LLC) and Treas. Reg (b)(3), Example 9 (Sale of Interest in QSub)). A B Buyer S corporation Buyer QSub LLC Assets Assets Paul Hastings LLP Confidential not for redistribution 20

147 Sale of a QSub/single member LLC (deemed asset sale transaction) sale of less than 100% alternative (continued) S corporation s shareholders perspective o Character of income based on assets of S corporation deemed sold Accounts receivable of cash basis taxpayers (accounts payable) Depreciation recapture Inventory o State taxation based on S corporation nexus and apportionment and allocation rules o State entity level taxation possible (e.g., Illinois 1.5% personal property replacement tax) o Deferral of gain for roll-over equity available Impact of pro rata allocation rules on the ability to defer gain Roll-over equity needs to be retained in S corporation o Flow-through taxation on roll-over equity possible if Buyer is a flow-through entity (i.e., partnership for income tax purposes or an S corporation) o S corporation taxable year does not end impact on deductibility of transaction expenses o Shareholders (as owners of S corporation) will continue to control preparation of S corporation tax return o Shareholders not exposed to QSub/single member LLC liabilities (exposed to selling S corporation liabilities) o Shareholders do not have to agree to sale (subject to corporate governance agreement) A B S corporation Buyer QSub LLC Assets Assets Paul Hastings LLP Confidential not for redistribution

148 Sale of a QSub/single member LLC (deemed asset sale transaction) sale of less than 100% alternative (continued) Buyer s perspective o Step-up in the tax basis of the assets o Buyer can decide whether to structure acquisition vehicle to provide for flow-through taxation o Able to deliver asset sale on future exit without double tax if flowthrough taxation structure is put in place o Buyer indirectly inherits liabilities of QSub/single member LLC but selling S corporation liabilities should remain with the S corporation A B S corporation Buyer QSub LLC Assets Assets Paul Hastings LLP Confidential not for redistribution 22

149 Sale of a single member LLC (deemed asset sale transaction) sale of less than 100% alternative (continued) Other uses for structure o Admission of non-qualified investors (e.g., entity investors) o Issuance of profits interests o Providing for non pro rata economics without creating a second class of stock issue o Providing for inclusion of liabilities in outside basis A B S corporation C LLC Assets Paul Hastings LLP Confidential not for redistribution

150 Conversion of the S corporation to an LLC (deemed asset sale transaction) Equity transaction for corporate law purposes Treated as a sale of assets for income tax purposes B A A B A B Oldco Inc. S corporation Newco Inc. S corporation Newco Inc. S corporation Assets Oldco Inc. QSub Oldco LLC Assets Assets Paul Hastings LLP Confidential not for redistribution 24

151 Conversion of the S corporation to an LLC (deemed asset sale transaction) (continued) S corporation shareholders form new corporation ( Newco Inc. ); S corporation shareholders contribute 100% of the shares of the S corporation ( Oldco Inc. ) to Newco Inc. Newco makes a QSub election for Oldco Inc. Newco is treated as a continuation of the S corporation that was previously Oldco Inc. and the transaction is treated as a 368(a)(1)(F) reorganization (Rev. Rul ) (Newco Inc. will need a new EIN). Oldco Inc. is converted into a limited liability company ( Oldco LLC ) (conversion statute, merger, etc.) Buyer buys 100% of the interests in Oldco LLC B A A B A B Oldco Inc. S corporation Newco Inc. S corporation Newco Inc. S corporation Assets Oldco Inc. QSub Oldco LLC Assets Assets Paul Hastings LLP Confidential not for redistribution

152 Conversion of the S corporation to an LLC (deemed asset sale transaction) (continued) S corporation s shareholders perspective o Character of income based on assets of S corporation deemed sold Accounts receivable of cash basis taxpayers (accounts payable) Depreciation recapture Inventory o State taxation based on S corporation nexus and apportionment and allocation rules o State entity level taxation possible (e.g., Illinois 1.5% personal property replacement tax) o Deferral of gain for roll-over equity available Impact of pro rata allocation rules on the ability to defer gain Roll-over equity needs to be retained in S corporation o Flow-through taxation on roll-over equity possible if Buyer is a flow-through entity (i.e., partnership for income tax purposes or an S corporation) o S corporation taxable year does not end impact on deductibility of transaction expenses o Shareholders (as owners of S corporation) will continue to control preparation of S corporation tax return o Shareholders not exposed to Oldco Inc. liabilities (but exposed to Newco Inc. liabilities) o Shareholders have to agree to conversion (merger alternative) but not to sale (subject to corporate governance) B A A B A B Oldco Inc. S corporation Newco Inc. S corporation Newco Inc. S corporation Assets Oldco Inc. QSub Oldco LLC Assets Assets Paul Hastings LLP Confidential not for redistribution

153 Conversion of the S corporation to an LLC (deemed asset sale transaction) (continued) Buyer s perspective o Step-up in the tax basis of the assets o Buyer can decide whether to structure acquisition vehicle to provide for flow-through taxation o Able to deliver asset sale on future exit without double tax if flowthrough taxation structure is put in place o Buyer indirectly inherits liabilities of Oldco Inc. but Newco Inc. liabilities should remain with the selling S corporation B A A B A B Oldco Inc. S corporation Newco Inc. S corporation Newco Inc. S corporation Assets Oldco Inc. QSub Oldco LLC Assets Assets Paul Hastings LLP Confidential not for redistribution

154 Conversion of the S corporation to an LLC (deemed asset sale transaction) sale of less than 100% alternative S corporation shareholders form new corporation ( Newco Inc. ); S corporation shareholders contribute 100% of the shares of the S corporation ( Oldco Inc. ) to Newco Inc. Newco makes a QSub election for Oldco Inc. Newco is treated as a continuation of the S corporation that was previously Oldco Inc. and the transaction is treated as a 368(a)(1)(F) reorganization (Rev. Rul ) (Newco Inc. will need a new EIN). Oldco Inc. is converted into a limited liability company ( Oldco LLC ) (conversion statute, merger, etc.) Buyer buys less than 100% of the interests in Oldco LLC B A A B A B Oldco Inc. S corporation Newco Inc. S corporation Newco Inc. S corporation Assets Oldco Inc. QSub Oldco LLC Assets Assets Paul Hastings LLP Confidential not for redistribution

155 Conversion of the S corporation to an LLC (deemed asset sale transaction) sale of less than 100% alternative (continued) S corporation shareholders form new corporation ( Newco Inc. ) S corporation shareholders contribute 100% of the shares of the S corporation ( Oldco Inc. ) to Newco Inc. Newco makes a QSub election for Oldco Inc. Newco is treated as a continuation of the S corporation that was previously Oldco Inc. and the transaction is treated as a 368(a)(1)(F) reorganization (Rev. Rul ) (Newco Inc. will need a new EIN). Oldco Inc. is converted into a limited liability company ( Oldco LLC ) (conversion statute, merger, etc.) Buyer buys less than 100% of the interests in Oldco LLC A B Newco Inc. S Corporation Buyer Oldco LLC Assets Paul Hastings LLP Confidential not for redistribution 29

156 Conversion of the S corporation to an LLC (deemed asset sale transaction) sale of less than 100% alternative (continued) Equity transaction for corporate law purposes Treated as a sale of assets followed by a contribution to a new partnership for income tax purposes (Rev. Rul. 99-5) A B A B A B Oldco Inc. S corporation Newco Inc. S corporation Newco Inc. S Corporation Buyer Assets Oldco Inc. QSub Assets Oldco LLC Assets Paul Hastings LLP Confidential not for redistribution 30

157 Conversion of the S corporation to an LLC (deemed asset sale transaction) sale of less than 100% alternative (continued) S corporation s shareholders perspective o Character of income based on assets of S corporation deemed sold Accounts receivable of cash basis taxpayers (accounts payable) Depreciation recapture o o o o o o o o Inventory State taxation based on S corporation nexus and apportionment and allocation rules State entity level taxation possible (e.g., Illinois 1.5% personal property replacement tax) Deferral of gain for roll-over equity available Impact of pro rata allocation rules on the ability to defer gain Roll-over equity needs to be retained in S corporation Flow-through taxation on roll-over equity possible even if Buyer is not a flow-through entity S corporation taxable year does not end impact on deductibility of transaction expenses Shareholders (as owners of S corporation) will continue to control preparation of S corporation tax return Shareholders not exposed to Oldco Inc. liabilities (exposed to Newco Inc. corporation liabilities) Shareholders have to agree to conversion (merger alternative) but not to sale (subject to corporate governance) A B A B A B Oldco Inc. S corporation Newco Inc. S corporation Newco Inc. S Corporation Buyer Assets Oldco Inc. QSub Assets Oldco LLC Assets Paul Hastings LLP Confidential not for redistribution 31

158 Conversion of the S corporation to an LLC (deemed asset sale transaction) sale of less than 100% alternative (continued) Buyer s perspective o Partial step-up in the tax basis of the assets (704(c) allocation issues) o Buyer can decide whether to structure acquisition vehicle to provide for flow-through taxation on Buyer s portion of the investment o Able to deliver asset sale on future exit without double tax if flowthrough taxation structure is put in place o Buyer indirectly inherits liabilities of Oldco Inc. but Newco Inc. liabilities should remain with the selling S corporation A B A B A B Oldco Inc. S corporation Newco Inc. S corporation Newco Inc. S Corporation Buyer Assets Oldco Inc. QSub Assets Oldco LLC Assets Paul Hastings LLP Confidential not for redistribution 32

159 Paul Hastings LLP Confidential not for redistribution 33

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