Whether a buyer expresses an interest in the purchase of your business or if you are considering going through any type of reorganization of the company structure, it is important to be aware of the common tax treatment and pitfalls related to your business’s entity structure. In this installment of our tax tips for mergers and acquisitions series, we focus on the basic tax issues for an S corporation that is undergoing a sale or reorganization.
An S corporation is a qualifying small business corporation that makes an election to be taxed under subchapter S of the Internal Revenue Code. The S corporation must pass through its income and loss items to its shareholders, who are individually taxed on their share of the company’s income or losses on their personal income tax returns. S corporations, therefore, are generally not subject to corporate-level tax. However, Subchapter S potentially imposes several corporate-level taxes in the event that the S corporation sells its assets and operated as a C corporation prior to making the S election.
Built-in gains include income or gains accrued by the corporation on the date that it converts to S status and recognized within the first five years of the entity operating as an S corporation. At the time of an asset sale, a built-in-gains tax may be assessed at the corporate level on the corporation's net recognized built-in gains, reduced by any built-in losses.
A passive investment income tax may also be assessed at the highest corporate income tax rate if the company has accumulated earnings and profits from a year that it operated as a C corporation and its passive investment income exceeds 25% of its gross receipts.
Additionally, depending on the activities of the business, S corporation sellers should be aware of the potential for recapture of certain tax benefits, including last-in-first-out (LIFO) inventory recapture and investment credit recapture.
As discussed in a previous article in our M&A tax series, the Internal Revenue Code provides various avenues for “tax-free” reorganizations. While the IRC tax-free reorganization rules for C corporations generally apply to S corporations, owners of S corporations should seek the guidance of an experienced tax advisor to confirm that the S status is not inadvertently terminated during the transaction. Careful consideration should also be given to the effect of any distributions made before, during, or after reorganization, and to the impact of any qualified subchapter S subsidiaries (QSubs).
There are many risks and opportunities to weigh when you begin considering the reorganization or sale of your S corp business. In an upcoming article, we will outline key tax issues for reorganizations or sales related to partnerships. When considering a transaction or restructuring, reach out to your P&N advisor for help navigating the complexities of this process.