Question: Is there a “tax attractiveness” difference with respect to an acquisition if the company being sold is a corporation or an LLC?
Answer: From an acquisition tax attractiveness perspective, while sale of a regular C corporation (as compared to an LLC that elects treatment as a partnership for tax purposes) would generally be considered to be tax detrimental as compared to sale of an LLC, an S corporation may be able to provide certain LLC-type tax benefits. For example, an acquirer of at least 80% of the S corporation’s stock (with an accompanying Internal Revenue Code (IRC) Section 338(h)(10) election, which election is required to be made jointly by buyer and seller in order to be effective) or an acquirer of the S corporation’s assets, can obtain a “purchase price” tax basis in the S corporation assets similar to acquisition of assets or membership interests from an LLC. This enables the acquirer to claim additional depreciation/amortization deductions, as well to use any additional non-depreciated/amortized tax basis, to reduce/offset future taxable income or gain as would occur with an LLC. With the sale of an S corporation or an LLC the selling shareholders/members recognize only a single level of tax in such acquisition, and they may be eligible to pay tax at the preferential long-term capital gains tax rate. The foregoing would not be available for an acquirer of less than 80% of the S corporation’s stock (e.g., the selling shareholders retain more than 20% of the S corporation’s stock). In addition, even when the acquirer acquires at least 80%, but less than all, of the selling shareholders S corporation stock (with the selling shareholders retaining the un-acquired stock), the “tax basis step-up” in the acquired S corporation’s assets that would result from the making of a Section 338(h)(10) election would come at a tax cost to the selling shareholders (e.g., there would be a deemed taxable sale of 100% of the S corporation’s assets even though the selling shareholders sell less than all of their S corporation stock). Finally, in all likelihood, the selling shareholders’ retained shares will lose the benefit of S corporation status, with the result that the investment in the retained S corporation shares will “convert” for tax purposes into an investment in a regular C corporation.
By comparison, the acquirer of a C corporation could only obtain a “purchase price”/“stepped up” tax basis in the C corporation’s assets at a tax cost to the selling shareholders of two levels of income tax – a corporate-level income tax and a shareholder-level income tax (which would be recognized at such time that the C corporation distributes, or is deemed to distribute, its after-corporate income tax sale proceeds to the shareholders). This tax cost could be significantly reduced if the C corporation (and its stock) qualifies for the benefits of IRC Section 1202 (partial exclusion for gain from certain small business stock, with the amount of such reduction further depending on when the qualified small business stock is acquired—with the exclusion being 100% if the qualified stock is acquired before the end of 2010).
Finally, if a C corporation (but not an LLC that is treated as a partnership for tax purposes) were to incur debt any portion of which is written off as part of the sale transaction, any resulting “cancellation of indebtedness” income would not flow-through and be taxed to the shareholders. However, in the case of an S corporation or an LLC that is treated as a partnership for tax purposes, the members of the LLC or the S corporation shareholders would be required to report, and pay tax on, such income (in the absence of an otherwise applicable exemption or exception).
Peter Rothberg
Question provided by Caroline Byrne, founder of Know It All Neighbor.
Answer provided by Peter Rothberg – (website, LinkedIn Twitter), Partner at Duane Morris, Ultra Light Startups sponsor and counsel.
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