Legal Issues and Tax Implications When Acquiring an S-Corporation

Acquiring an S-Corporation is a significant event for both buyers and sellers, and it’s not as simple as just signing on the dotted line. The process is filled with legal and tax considerations that can have long lasting effects on both parties; a process that is unique to S-Corporations. If you’re contemplating such a transaction, it’s crucial to understand not just the basics, but also the issues that can arise. Let’s walk through what you need to know, from the structure of the deal to the nitty gritty of tax elections and the potential pitfalls that can trip up even experienced business owners.

The S-Corporation: What Makes It Unique?

First, let’s clarify what an S-Corporation is and why its acquisition is so different from acquiring a C-Corporation or an LLC. An S-Corporation is a special type of corporation that’s designed to avoid the double taxation that plagues C-Corporations. Instead of the company paying income tax, the profits and losses “pass through” to the shareholders, who report them on their personal tax returns. In regards to LLCs, it allows owners to avoid additional self- employment taxes when paying themselves a "reasonable salary." This setup is great for small business owners, but it comes with strict eligibility rules: you can’t have more than 100 shareholders, you’re limited to one class of stock, and only certain types of entities (generally individuals, certain trusts, and estates) can be shareholders. Nonresident aliens, partnerships, and most corporations are out.

These rules are not just technicalities, they’re central to the S-Corporation’s tax status. If you violate them, even accidentally, you can trigger a termination of S status, which means the IRS will start treating the company as a C-Corporation, bringing double taxation into play. That’s why, when you’re acquiring an S-Corporation, step one is always to verify that the S election is valid and has been maintained properly.

Two Paths: Asset Purchase vs. Stock Purchase

When it comes to acquiring an S-Corporation, you generally have two options: you can buy the company’s assets, or you can buy its stock. Each approach has its own set of legal and tax consequences, and the choice you make will have a big impact on the outcome of the deal.

Asset Purchases: In an asset purchase, the buyer picks and chooses which assets and liabilities to acquire. This is often the preferred route for buyers, especially if the company has liabilities or potential legal issues they’d rather not inherit. The big tax advantage here is that the buyer gets to “step up” the basis of the acquired assets to their current fair market value. This means bigger depreciation and amortization deductions in the future, which can translate into significant tax savings.

But for the seller, an asset sale can be less attractive. The company will recognize gain or loss on each asset sold, and if the assets have appreciated, this can mean a large tax bill, sometimes at ordinary income rates if there’s depreciation recapture involved. After the sale, the S-Corporation distributes the proceeds to its shareholders, who may face a second layer of tax.

Stock Purchases: On the flip side, a stock purchase is usually simpler from a legal perspective. The buyer acquires the shares of the S-Corporation, taking control of the company as a whole. Contracts, licenses, and permits typically remain in place, and there’s less risk of missing some hidden liability. For the seller, a stock sale is generally more tax efficient, as the gain is usually taxed at favorable capital gains rates, and there’s no second layer of tax at the corporate level.

However, the buyer doesn’t get a step-up in the basis of the company’s assets. They’re stuck with the historical basis, which limits their future depreciation deductions. This can be a major sticking point in negotiations.

Bridging the Gap: Section 338(h)(10) and 336(e) Elections

Here’s where things get interesting. To give buyers the best of both worlds-the legal simplicity of a stock purchase and the tax benefits of an asset purchase-Congress created special elections under the tax code.

Section 338(h)(10) Election: If the buyer is a corporation and acquires at least 80% of the S-Corporation’s stock in a single transaction, both parties can jointly elect under Section 338(h)(10) to treat the sale as if the S-Corporation sold all its assets and then liquidated. For tax purposes, it’s as if the buyer bought the assets directly, so they get the step-up in basis. Legally, though, it’s still a stock purchase, so contracts and licenses stay put.

This election is a powerful tool, but it comes with strings attached. Both the buyer and seller must agree to it, and the seller faces the same tax consequences as in an asset sale-potentially higher taxes due to depreciation recapture and the built-in gains tax if the S-Corporation was once a C-Corporation (see IRC §1374). Also, the election must be made on a timely filed tax return, or the opportunity is lost. For more on this, check out our article on the Section 338(h)(10) Election.

Section 336(e) Election: If the buyer isn’t a corporation-say, an individual or a partnership-Section 338(h)(10) isn’t available. But Section 336(e) offers a similar path. Here, the seller can elect to treat a qualifying stock sale as a deemed asset sale for tax purposes. This election is less common and comes with more restrictions, but it can be a valuable option in the right circumstances. Fore more on Section 336(e) Elections, check out our article.

F Reorganizations: Sometimes, buyers and sellers use what’s called an “F reorganization” (IRC §368(a)(1)(F)) to restructure the S-Corporation before the sale. This can help preserve S status, facilitate a tax-free rollover of equity, or set the stage for a 338(h)(10) election. F reorganizations are complex, but they’re a key tool in the M&A planner’s toolkit. For more on the F Reorganization process, check out our article.

Legal Issues: S Status, Due Diligence, and Indemnification

The legal side of acquiring an S-Corporation is just as critical as the tax side. The first order of business is always confirming that the S election is valid and has never been inadvertently terminated. This means reviewing shareholder records, checking for ineligible shareholders, and making sure there’s only one class of stock. Even a small misstep (like issuing preferred stock or transferring shares to a partnership) can blow up the S status and turn the company into a C-Corporation overnight.

Due Diligence: Due diligence is your best defense against unpleasant surprises. Buyers should scrutinize everything: tax returns, corporate records, contracts, employment agreements, intellectual property, pending litigation, and environmental issues. Special attention should be paid to any potential “landmines” that could terminate S status or trigger unexpected tax liabilities.

Indemnification and Escrow: Because of these risks, most purchase agreements include robust indemnification provisions. Sellers may be required to set aside a portion of the purchase price in escrow to cover any post-closing surprises, such as unpaid taxes or breaches of representations. The specifics of these provisions can be a major point of negotiation.

Rollover Equity: In some deals, sellers receive a portion of the purchase price as equity in the acquiring company. This “rollover equity” can complicate the tax picture, especially if it’s not structured carefully. If the rollover results in the S-Corporation having an ineligible shareholder, S status could be lost. And if the rollover isn’t structured as a tax-free exchange, the seller could face immediate gain recognition.

Tax Implications for Buyers: The Step-Up and Beyond

From the buyer’s perspective, the biggest tax issue is whether they get a step-up in the basis of the acquired assets. With a straight stock purchase, they don’t. The assets keep their old basis, which means lower depreciation deductions and potentially higher taxable income down the road. With an asset purchase, or a stock purchase with a 338(h)(10) or 336(e) election, the buyer gets to step up the basis to fair market value. This can mean substantial tax savings over time.

But it’s not just about the step-up. Buyers also need to think about how the purchase price is allocated among the assets. Under IRC §1060, the price must be allocated based on the fair market value of each asset class, which affects future depreciation and the calculation of gain or loss if the assets are later sold.

Another key issue is making sure the acquisition doesn’t inadvertently terminate S status. If the buyer is an ineligible shareholder, or if the structure of the deal creates a second class of stock, the S election could be lost, and the company could become subject to double taxation as a C-Corporation.

Tax Implications for Sellers: Gain Character, Built-In Gains, and State Taxes

For sellers, the main concern is the character of the gain recognized on the sale. In a stock sale, the gain is usually a long-term capital gain, taxed at favorable rates. In an asset sale (or a deemed asset sale via 338(h)(10) or 336(e)), the gain is calculated asset by asset. Gains on inventory and receivables are ordinary income, while gains on capital assets and goodwill are capital gains. Depreciation recapture can also convert what would otherwise be capital gain into ordinary income.

If the S-Corporation was previously a C-Corporation, the built-in gains tax (IRC §1374) comes into play. If appreciated assets are sold within five years of the S election, the company must pay corporate-level tax on the built-in gain, which can be a nasty surprise.

Don’t forget about state taxes, either. Not all states recognize S-Corporation status, and some impose their own taxes on S-Corporations or treat asset sales differently from federal law. This can add another layer of complexity to the transaction.

Capital Gains Surprises and Other Tax Triggers

S-Corporations can trigger capital gains taxes in several unexpected ways. For example, if an LLC that owns appreciated property elects S-Corporation status, the IRS may treat the property as sold at fair market value, resulting in immediate taxable gain.

Similarly, if a new shareholder contributes appreciated property to the S-Corporation, that can also trigger taxable gain. And if the S-Corporation distributes appreciated property to its shareholders, that’s a taxable event-unlike in a partnership, where such distributions are generally tax-free.

Common Pitfalls and How to Avoid Them

The most common mistake in S-Corporation acquisitions is failing to protect the S election. Transfers to ineligible shareholders, issuing a second class of stock, or failing to follow the rules can all result in termination of S status and the loss of pass-through taxation.

Another frequent pitfall is inadequate due diligence. If the buyer doesn’t uncover hidden liabilities, tax exposures, or S status issues before closing, they may be stuck with them after the fact. Similarly, failing to make a timely Section 338(h)(10) or 336(e) election can result in the loss of valuable tax benefits.

Finally, state and local tax issues are often overlooked. Buyers and sellers need to analyze the state tax consequences of the transaction, as these can differ significantly from federal law.

Strategic Advice for Buyers and Sellers

For Buyers: If you want the tax benefits of an asset purchase but the legal simplicity of a stock purchase, push for a 338(h)(10) or 336(e) election if eligible. Make sure the acquisition doesn’t jeopardize S status, and negotiate strong indemnities and escrows to protect against post-closing surprises.

For Sellers: Understand the tax impact of the deal structure, especially if the company owns appreciated assets or was previously a C-Corporation. Plan for capital gains and recapture taxes, and consider the effect of the built-in gains tax. If you’re rolling over equity, make sure it’s structured to avoid immediate gain recognition and S status problems.

Acquiring an S-Corporation is a complex process that requires careful planning and attention to detail. The structure of the deal, the use of special tax elections, and the preservation of S status all have major implications for both buyers and sellers. Thorough due diligence, expert tax advice, and well-crafted legal documents are essential to avoid costly mistakes and maximize the value of the transaction.

Frequently Asked Questions

Can non-corporate buyers make a Section 338(h)(10) election? No, only corporate buyers can make a Section 338(h)(10) election. Non-corporate buyers may be able to use Section 336(e), but this comes with its own set of requirements and limitations.

What happens if S-Corporation status is lost during an acquisition? If S status is lost, the company becomes a C-Corporation and is subject to double taxation. This can dramatically change the economics of the deal.

Are there special considerations for S-Corporations with appreciated assets?Absolutely. Asset sales or deemed asset sales can trigger capital gains and recapture taxes, and if the company was previously a C-Corporation, the built-in gains tax can apply.

How is the purchase price allocated in S-Corporation acquisitions? In asset or deemed asset sales, the purchase price is allocated among the assets based on fair market value, which affects future depreciation and gain/loss calculations.

Do state tax laws always follow federal S-Corporation rules? No. State tax treatment can differ significantly, so it’s important to analyze the state tax consequences of the transaction.

If you’re considering buying or selling an S-Corporation, don’t go it alone. Work with experienced legal and tax advisors who understand the intricacies of these transactions. The right guidance can help you avoid pitfalls and make the most of the opportunities an S-Corporation acquisition can offer.

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Howard Law is a business, regulatory and M&A law firm in the greater Charlotte, North Carolina area, with additional services in M&A advisory and business brokerage. Howard Law is a law firm based in the greater Charlotte, North Carolina area focused on business law, corporate law, regulatory law, mergers & acquisitions, M&A advisor and business brokerage. Handling all business matters from incorporation to acquisition as well as a comprehensive understanding in assisting through mergers and acquisition. The choice of a lawyer is an important decision and should not be based solely on advertisements. The information on this website is for general and informational purposes only and should not be interpreted to indicate a certain result will occur in your specific legal situation. Information on this website is not legal advice and does not create an attorney-client relationship. You should consult an attorney for advice regarding your individual situation. Contacting us does not create an attorney-client relationship. Please do not send any confidential information to us until such time as an attorney-client relationship has been established.