More and more individuals are becoming business owners, which has increased the purchasing of S-corporations. One of the biggest benefits of an S-corporation is the ability to avoid the double taxation that exists with a typical C-corporation, since shareholders report income and losses on individual tax returns, and pay taxes based on their respective tax rates. While purchasing an S-corporation is becoming more commonplace, there may be hurdles to clear in structuring a deal.
Before making the purchase, you will need to decide whether you will buy the assets or the stock of an S-corporation, as there are various implications that can arise from your choice. Even if you prefer an asset sale in order to receive a tax benefit from depreciation and amortization on stepped-up assets, a discussion with your tax adviser is necessary to determine whether special elections will be required to structure the purchase. Those who wish to own shares of an of S-corporation need to understand that if they are set up as a C-corporation, S-corporation or partnership, buying an S-corporation has certain rules regarding who can actually own the stock. Before deciding on how to structure your transaction, consider the following ownership restrictions:
Can my business entity own shares in an S-corporation?
When buying a business structured as an S-corporation, a purchaser may initially plan to buy either 100% or a portion of the issued and outstanding shares of the corporation through one of their business entities. While this may have been the normal setup when a purchaser bought a partnership, limited liability company (“LLC”), or C-corporation, an S-corporation carries restrictions on who can actually own the shares. In order to retain the S-corporation status, eligible shareholders can only be individuals that are U.S. citizens or resident aliens, certain exempt organizations, estates, certain trusts and properly structured S-corporations. Notably excluded from this list of eligible shareholders are entity structures such as C-corporations and partnerships. This creates a hurdle for buyers who planned to make a purchase through their C-corporation or partnership.
If a C-corporation or partnership is the purchaser of shares, the S-corporation will lose its “S” status and revert to a C-corporation upon consummation of the transaction. This results in the removal of the flow-through aspect and creates a taxable entity that is subject to the rules of double taxation. To preserve the “S” status, individual owners of a C-corporation or partnership could consider buying the stock directly to prevent the loss. While this is an available option, it may not be the optimal ownership structure. Fortunately, there are options to restructure the target business prior to a purchase to avoid this scenario, though it comes with the burden of additional time and money.
Can we restructure the business to transfer the S-corporation assets?
One way to restructure the business as part of a deal would be to have the targeted S-corporation form a new LLC that it owns 100% of the assets. This LLC would be a disregarded entity for federal tax purposes. The S-corporation could subsequently transfer its assets down to the newly formed LLC. As a buyer, you would now be in a position to use your C-corporation or partnership as the purchaser in the transaction. Instead of purchasing shares in an S-corporation, you would now be purchasing an interest in an LLC. The actual restructuring will require additional administrative work as moving the business assets from one entity to another can create issues with assignment of existing contracts and agreements, transferring licenses and permits, and receiving consent of existing lenders.
Alternatively, an “F reorganization” is another option to use your corporation or partnership as the purchaser in a transaction. An F reorganization is a mere change in identity, form or place of organization of a corporation. In this scenario, the targeted S-corporation would create a new S-corporation and the existing shareholders would contribute all of the targeted S-corporation’s stock in exchange for the stock of the newly created S-corporation. The newly created S-corporation would now own 100% of the stock of the targeted S-corporation, and can make an election to treat the targeted S-corporation as a qualified subchapter S subsidiary, making it disregarded for federal tax purposes.
There are additional scenarios, which add layers of complexity to the purchase of an S-corporation, and buyers should be aware of the potential limitations and restrictions regarding ownership, as they can cause undue burdens in a proposed deal. It is best to consult with your attorney and tax adviser to make sure you are properly positioned for a transaction.
To learn more about purchasing an S-corporation, restrictions of ownership, and other issues regarding corporate tax structures, you can contact the author, Branden Greene, directly at email@example.com. Citrin Cooperman is a full service CPA firm, currently ranked among the Top 25 in the United States. We have been serving New Jersey business owners since 1979, providing tax, audit, and business advisory services to help clients grow a successful and profitable business.