FEDERAL INCOME TAX CONSIDERATIONS IN ACQUISITIONS AND DISPOSITIONS OF S CORPORATIONS

Transcription

1 FEDERAL INCOME TAX CONSIDERATIONS IN ACQUISITIONS AND DISPOSITIONS OF S CORPORATIONS The University of Texas School of Law 60 th Annual Taxation Conference Timothy J. Devetski Lina G. Dimachkieh Vinson & Elkins L.L.P. December 5, 2012 Federal income tax classification A business entity, other than one formally designated a corporation under local law, generally may elect its treatment as a corporation or a partnership (or disregarded if it has only one owner) for federal tax purposes. Thus, an LLC or an LP may be treated as a corporation or a partnership (or disregarded), but a company with Inc. or Corp. in its name is per se treated as a corporation. S Corporation An S Corporation is simply a corporation (for federal tax purposes) that meets certain requirements (next slide) and for which a special federal tax election is made. 2 1

2 Requirements for S corporation status: Domestic corporation. Not an ineligible corporation (e.g., certain financial institutions, insurance companies). One class of stock no special allocations. Limited types of stockholders. Allowed: U.S. citizens and residents, certain trusts and estates. Not Allowed: Corporations, partnerships, and nonresident aliens. 3 Requirements for S corporation status (cont d): Limited number of stockholders. No more than 100 at any one time. Attribution rules generally do not apply; special rules treat certain family members as a single shareholder for purposes of this test. S corporation election. Required to be made within 75 days after either formation or first day of any year (or prior to such first day) and is effective either upon formation or as of such first day. All persons who are shareholders on the day of the election must consent to the election being made. Special qualification rules apply to S corporations that were formerly C corporations (any domestic corporation that is not an S corporation is referred to as a C corporation ). 4 2

3 In general terms, S corporations have a lot in common for federal income tax purposes with partnerships: Each is a pass-through, meaning that the owners of these entities, as opposed to the entities themselves, pay tax on the entity s operating income/gain from the disposition of assets. Each is generally subject to the same special rules applicable to pass-through entities (e.g., the passive loss and at risk rules apply to both partnerships and S corporations). Each is required to file an information return with the IRS and provide its owners with Schedules K-1 at the end of each year. 5 There are some important differences between S corporations and partnerships for federal income tax purposes: Partnerships are more flexible no limit on types of owners, number of owners, special allocations among owners (other than substantial economic effect requirements). S corporation shareholders are able to deduct losses only to the extent of their contributions or loans to the S corporation (by contrast, partners are allocated a share of debt incurred by their partnership; this provides them tax basis that they can use to support deductions in excess of contributed capital). A C corporation may elect to become an S corporation with limited tax consequences (although, in that case, the S corporation remains subject to a corporate-level built-in gain tax for 10 years) by contrast, the conversion of a C corporation to a partnership is treated as a liquidation (and is generally taxable). An S corporation remains a corporation for purposes of applying certain federal corporate tax principles (see next slide). 6 3

4 An S corporation remains a corporation: An S corporation may engage in a tax-free reorganization. By contrast, a partnership may not be a participant in a tax-free corporate reorganization (e.g., a partnership may not be the survivor in a tax-free corporate merger). A contribution of appreciated property to an S corporation is only tax-free to the contributor in the event the contributor (and others making contributions at the same time) owns at least 80 percent of the corporation. By contrast, any contribution to a partnership generally is tax-free to the contributor. Sales of S corporation stock generally give rise to capital gains. By contrast, Section 751 may require the seller of a partnership interest to recognize ordinary income and Section 1(h) may require the seller of a partnership interest to pay tax on Section 1250 gains. Purchases of S corporation stock do not result in a step-up in basis of the S corporation s assets (unless a Section 338 election is made, as discussed below). By contrast, a purchaser of a partnership interest may achieve an effective step-up in basis in its share of the partnership s assets if the partnership has a Section 754 election in place. Distributions of appreciated property by an S corporation to its owners generally are treated the same as a taxable sale of such assets. By contrast, a partnership generally may make tax-free distributions of appreciated property to its owners. 7 S Corporation Acquisitions and Dispositions 8 4

5 Taxable S Corporation Acquisition Structures Stock purchase (including reverse subsidiary merger) with Section 338(h)(10) election. Stock purchase (including reverse subsidiary merger) without Section 338(h)(10) election. Asset acquisition (including forward triangular merger and formation of joint venture). 9 Taxable S Corporation Acquisition Structures Stock Purchase with Section 338(h)(10) Election Advantages Step-up in basis of assets to purchaser. Disadvantages Ordinary income to sellers to the extent of hot assets. -- Appreciated inventory -- Accounts Receivable -- Depreciation Recapture Section 1374 tax for former C corporations with built-in gains. Not possible to roll over equity of sellers on tax deferred basis. 10 5