Advantages of S-corporation taxation for aquisitions
by: Robert Hanson
There are far more US corporations that are classified a S Corps than C corps. And this makes sense. For year-to-year taxation, many advisors and taxpayers see the clear advantage of being taxed as an S-corp ( (although some of this may change thanks to the new low 21% tax rate available for C corps). But many wonder if it makes sense to switch to a C corp for a tax advantage in the case of pending acquisition. Yet such a move might not be warranted; in this article we will discuss some of the benefits of S corporation acquisitions.
The general difference between S Corps and C Corps
Suppose you have a C Corporation for your small business because you want to limit your liability, but you want to eliminate the corporate tax for the business. Electing pass-through S Corp. treatment for your C Corp. can make sense. Making the election would not eliminate your corporation as an entity, but instead have it serve as a conduit who tax attributes get passed through to you the shareholder, thus eliminating double taxation. Remember, the entity is formed under state law, not federal law, which is where the S election is made, so the corporate form should remain the same.
Considering an aquisition?
But what if you have another corporation who wants to buy your business? Does the S election change anything?
Yes. And no.
The purchase of the business can be structures either as an asset purchase or a stock purchase. If your buyer purchases the business assets directly, then the buyer will get the cost basis of the assets, and the target corporation (your business) will recognize gain or loss on the sale and the character of which will flow accordingly to the shareholders, who will adjust their stock basis. And the adjusted basis helps when your S Corp then distributes the cash proceeds of the asset sale to you the shareholders.
If the buyer purchases the business stock, you the shareholders will recognize gain or loss in the same way as when the buyer purchases the assets. This transaction takes into account both the pass-thru gain/loss from the sale of the assets and the gain or loss from the liquidating distribution of the cash proceeds.
The only difference is in the character of the gain or loss. It will either be gain or loss from disposition of assets or gain or loss from sale of stock. Both are capital transactions, though.
So if you are a shareholder, whether an asset or stock sale, the results are the same.
But the entity-level consequences matter, and are different depending on the one you pick.
A purchase of shares denies the purchasing company a new cost-basis in the assets, and instead he gets your original basis. A purchase of assets gives the purchasing company a new cost-basis. But sometimes purchasing stock may be more advantageous.
The IRS actually provides some relief in this area under regulation for section 338(h)(10). This section permits the shareholders of an S corporation to elect to treat the sale of their stock as the sale of the business assets. This came being quite advantageous to the purchasing corporation.
What about foreign S corps? Can utilizing a foreign S corp be advantageous?
In order to be considered a S corp, the corporation (or LLC) must be domestic. The solution however maybe some some sort of hybrid structure that involves a Domestic S corp.