Selling Your S Corporation Is It Now Or Never?
Merger & Acquisition ServicesM&A InsightsSelling yourS corporationIs it now or never?With improving corporate confidence, increasing politicalcertainty, and strengthened balance sheets, conditionsappear to be ripe for increased merger and acquisition(M&A) activity in 2013. After a few years of stockpilingcash to guard against economic challenges, someexecutives are starting to loosen their purse strings andconsider strategic investments, including acquisitions,which can help them achieve their growth objectives.As a result, this could be an opportune time forS corporation owners who are contemplating selling theirbusinesses. However, the timing and tax structure of thesale transaction could significantly influence the valuederived by owners and other shareholders of the company.A quickly changing tax landscapeTax law changes that passed at the end of 2010 and 2012have had an impact on S corporation shareholders andtheir business decisions. For one, as a result of the PatientProtection and Affordable Care Act of 2010, beginning in2013 certain net investment income may be subject to anadditional 3.8% net investment income tax. Additionally,as a result of the American Taxpayer Relief Act of 2012,the highest marginal ordinary and capital gains rates haveincreased effective on January 1, 2013 to 39.6% and20% compared to the reduced rates of 35% and15%,respectively.Another important change authorized by the 2012 tax actis an extension of the reduced built-in gains recognitionperiod from 10 years for certain sales during calendaryears 2012 and 2013. Absent any additional tax lawchanges, the recognition period for built-in gains tax willrevert back to 10 years after 2013, which may make itmore advantageous, from a tax perspective, to completethe sale of an S corporation before December 31, 2013.Several S corporation disposition alternatives are availablethat shareholders should consider when planning for thesale of the S corporation. Alternatives include a “deemedasset sale” — technically known as a section 338(h)(10)1election — the sale of personal goodwill, a “direct asset”transaction, and a “direct stock transaction without asection 338(h)(10) election.”Which transaction is in a shareholder’s best interest? Areall shareholders treated the same? What are possibledeadlines for executing transactions? And what are thepotential consequences of waiting too long?S corporation owners should carefully evaluate theseoptions to understand their potential impact on theeconomics of the transaction, tax results, and theirindividual financial objectives. Critical to this effort is theability to compare the various options available so thatthe potential tax impacts and other implications can beanalyzed.Unless otherwise indicated, all “section” references are to theInternal Revenue Code of 1986, as amended (the “Code”), and all“Treas. Reg §” references are to the Treasury Regulations promulgatedunder the Code, all as in effect on the date of this publication.1M&A Insights — Selling your S corporation: Is it now or never? 1
Benefits and risks of a section 338(h)(10) electionThe U.S. Tax Code allows buyers and sellers of the stockof an S corporation to make a section 338(h)(10) electionso that a qualified stock purchase will be treated as adeemed asset purchase2 for federal income tax purposes.A section 338(h)(10) election is a joint election thatrequires agreement between and among all of the sellingshareholders and the prospective buyer. As a result of thiselection, a stock sale, for legal purposes will be treatedas an asset sale for tax purposes, resulting in differenttax consequences for both the buyer and seller. Sellingshareholders need to understand these tax consequences.Importantly, a section 338(h)(10) election will adjust thetax basis of the S corporation’s assets in the hands ofthe buyer to fair market value. As a result, the buyer mayenjoy incremental tax benefits, including amortizationand depreciation of the assets’ purchase price for federalincome tax purposes, along with resulting future taxdeductions — for the amount paid — over the tax life ofthe acquired assets.The deemed asset sale treatment may have negative taxconsequences that selling shareholders need to consider.By agreeing to make a section 338(h)(10) election, sellingshareholders may subject themselves to various federaland state taxes that a straight stock sale — one without asection 338(h)(10) election — would not generate. Additionally, S corporations that sell assets within10 years of converting from a C corporation aresubject to built-in gains tax. The built-in gains taximposes a corporate level tax on the portion of thegain that existed as of the C to S conversion date.Recent tax acts have provided for a temporary reductionin the 10 year built-in gains recognition period forcertain sale transactions. Currently, if at least five full taxyears of the recognition period have elapsed prior to thefirst day of the 2012 or 2013 calendar year, then salesof assets by the S Corporation are not subject to built-ingains tax. Some of the gains from a deemed asset sale may betaxed at ordinary rates. For example, purchase priceallocated to fixed assets may result in ordinary gain dueto depreciation recapture and gains associated with thedifference between the fair market value of inventoryand the tax basis may also be taxed at ordinary rates.On the other hand, assumption of certain liabilitiesmight result in additional ordinary deductions to theS corporation today that were disallowed in prior yearsunder the economic substance rules. It is importantfor selling shareholders to understand these taximplications, both for themselves and the buyer, beforeagreeing to make the election. A straight stock sale may result in no state income taxesowed if the selling shareholders reside in states withoutan income tax, whereas a deemed asset sale may resultin state taxes owed in the states where theS corporation operates.Selling shareholders will want to understand both the costsassociated with making a section 338(h)(10) election andthe tax benefits in the hands of the buyer. It is possiblethat the tax benefits may substantially outweigh the costs.As a result, buyers may be willing to reimburse sellingshareholders for any incremental costs incurred. Sellerswho understand the potential benefits resulting from thestep-up transaction may also be in a position to negotiate ahigher purchase price by clearly articulating those benefitsto potential buyers.Early planning is another important consideration.S corporation shareholders should begin to weigh thebenefits and risks of a section 338(h)(10) election at theearliest possible stages of a transaction, in most casesbefore a letter of intent is signed with a prospective buyer.The letter of intent often contains specific terms thataddress the transaction structure. Both sellers and theprospective buyer can save time, money, and resources bymaking an informed decision regarding the section338(h)(10) election before the letter of intent is signed.Generally the acquisition of 80% or more of the stock of a corporationin a 12-month period.2M&A Insights — Selling your S corporation: Is it now or never? 2
Alternatives to a deemed asset saleWith so many complex issues to consider, a section338(h)(10) election can be a complex transaction that maynot be appropriate for all S corporation sellers or buyers.For deal participants that are not positioned to make thesection 338(h)(10) election — or simply prefer not to —other options include: The sale of personal goodwill allows the buyer(s)of the S corporation to receive tax benefits withoutnegatively impacting the seller’s tax position. In this typeof transaction, the portion of an S corporation’s assetvalue that can be attributed to the “personal goodwill”of the company’s owners or executives is allocated andsegregated from the total asset value. The proceeds ofthat goodwill are reported as a gain to the shareholderto whom the goodwill relates and are treated aslong-term capital gains. For S corporations withbuilt-in gains, shifting purchase price to a shareholder’spersonal goodwill may limit the double taxation thatresults from the built-in gains tax. The buyer benefitsbecause it can deduct the purchase price associatedwith personal goodwill over 15 years. Again, manyfactors influence whether or not personal goodwillactually exists and how much asset value can beallocated to a selling shareholder’s personal goodwill,so it helps the shareholders of the S Corporation tocompare various scenarios and understand the potentialconsequences of the transaction. A direct asset transaction involves the transfer ofthe S corporation’s assets to the buyer. From a taxperspective, this type of transaction is usually moreadvantageous for the buyer than the seller because,similar to a section 338(h)(10) transaction, the buyer willreceive a step-up in the tax basis of the acquired assets,but unlike a section 338(h)(10) transaction, historicalincome tax risks associated with the business, includingbuilt-in gains taxes, will remain with the sellingshareholders. As such, it is important for the seller tounderstand all the implications of the transaction (see“Scenario analysis — the foundation of an informeddecision”) and use that knowledge to negotiateeither favorable terms or an alternate approach tothe deal. Straight asset purchases, however, may becomplicated by non-tax factors, such as the need toobtain consent to transfer certain assets — for example,contracts. These non-tax factors need to be evaluated inconnection with the tax objectives of the parties. The transactions noted above, including a stocksale with a section 338(h)(10) election, can also becompleted pursuant to installment sale rules. Aninstallment sale involves disposition of property at again, where at least one payment is to be receivedafter the tax year in which the sale occurs. This option,under section 453, offers the advantage to the sellerof receiving payments over time and only including inincome each year the part of the gain received thatyear. There are many details associated with this type oftransaction that should be considered, including rulesfor how to treat losses, inventory, securities, and intereston the installment amounts. In light of the potentialtax rate changes referenced above, selling shareholdersshould consider whether installment sale treatmentmakes sense for their transaction. A stock transaction without a section 338(h)(10)election may be an appropriate alternative when thecosts associated with a deemed asset sale clearlyoutweigh the tax benefits associated with a step-uptransaction. It will be important for buyers and sellers tounderstand the potential costs and benefits — or lackthereof — of a straight stock transaction.M&A Insights — Selling your S corporation: Is it now or never? 3
Scenario analysis — the foundation of an informed decisionScenario analysis is essential to helping S corporation owners and shareholders make informed decisions about which type ofdisposition structure provides the greater value. An effective scenario analysis clearly outlines the costs and benefits of eachapproach and provides insights into the potential consequences of the decision based on a variety of factors, including:Built-in gains taxOwners of an S corporation need to consider inadvance the impact of built-in gains tax associatedwith their transaction. Built-in gains are amounts ofunrecognized appreciation that existed when theS election was first made that are subject tocorporate-level taxation. Among the issues associatedwith built-in gains are: A company’s built-in gain may not be static overtime, so planning opportunities may be missed ifthis calculation isn’t considered. It is important to understand and apply properaccounting and valuation principles to documentthe effects of changes to the built-in gains taxlaw and to calculate the amount of the tax. If acompany does not have a built-in gain calculationfrom the date of the S election, this analysis mayrequire the use of financial information availableas of the date of the election and market trendsto estimate the amount of the company’s existingbuilt-in gain.State taxesWhere the shareholders of an S corporation live andwhere the company has operations can significantlyimpact state taxes consequences for both thecompany and its shareholders. For example: Whether the state in which a shareholder lives hasan income tax — for instance, Florida, Nevada, orTexas do not — can impact the decision of howto structure the deal, especially if the corporationitself has operations in other states. Certain states also have entity-level taxes forS corporations. In such states, the decision aboutwhether to undertake a stock or asset sale cansignificantly impact capital gains taxes paid by theS corporation, both at the federal and state level. Different states, of course, have very different taxrates for the same types of taxes. It’s important tofactor these various rates in to the overall picture sothe S corporation shareholders fully understand theirtax exposure when the sale transaction is executed. The American Taxpayer Relief Act of 2012 loweredthe recognition period for S corporations from 10to five years, for certain sales during the 2012 and2013 tax years. Therefore, owners who want totake advantage of the reduced window need totake action in 2013.M&A Insights — Selling your S corporation: Is it now or never? 4
Purchase price allocationScenario analysis can help both seller and buyerunderstand the implications of purchase priceallocation under various deal structures, including: Potential tax benefits the buyer could obtainthough a section 338(h)(10) election or straightasset deal, including the timing of those benefits. Whether purchase price can be allocated toshorter-lived assets, such as inventory or machineryand equipment, which may result in a quickerrecovery of tax benefits in a step-up transaction. The impact that the S corporation’s contingentliabilities, such as warranty claims, pendinglawsuits and deferred revenue, may have on thedeal economics for the seller and the buyer. It willbe important to consider the tax implications ofseller contingent liabilities as well as subsequentpayment of those liabilities by the buyer.Buyer’s tax benefitsAnother important calculation is the netpresent value of the buyer’s tax benefits from asection 338(h)(10) election based upon receiving astep-up for tax purposes. As noted above, a section338(h)(10) election will result in a step-up in the taxbasis of the acquired assets to fair market value (i.e.purchase price). The buyer may realize tax benefitsof the step-up in years one through 15 followingthe transaction. For example, the buyer may benefitfrom increased depreciation deductions over the taxlife of the acquired fixed assets or from amortizationdeductions related to the portion of purchase pricethat is allocated to goodwill. By taking the timeto project the buyer’s tax benefits resulting from asection 338(h)(10) election, sellers are likely to be ina better position to make informed decisionsregarding the transaction, including but not limitedto the right deal structure and purchase price. How potential benefits to the buyer can befactored into the deal equation for the benefit ofthe seller in terms of the overall deal valuation. In all of these areas — from built-in gains taxes to buyer’s tax benefits — the scenario analysis tools andtechnique are important. However, equally relevant is the experience of the people utilizing those tools. Specificknowledge of finance, valuation, estate planning, tax law, and tax accounting are important if deal participantsare to understand the many intricacies and nuances of the transaction.Look before you leapWith the M&A environment heating up and tax laws that continue to change, S corporation owners who are consideringthe sale of their business should carefully weigh the tax implications of a potential transaction. Because the structure ofthe deal has such a potentially big impact on rewards for the sellers and buyers, both parties can benefit from thoroughscenario analysis. Scenario analysis that incorporates a variety of disciplines and considerations can help make the sale of anS corporation tax efficient and clearly identify areas of deal value for the owners, both immediately and in the long term.M&A Insights — Selling your S corporation: Is it now or never? 5
Please visit the online M&A library, which showcases current thinking about mergers, acquisitions, anddivestitures. If you’re looking for guidance on how to tackle the toughest issues in M&A today, we thinkyou’ll find this a great place to start.Visit us at www.deloitte.com/us/malibraryTo receive a free subscription of the latest M&A-related thoughtware, newsletters, and events, visit us athttp://www.deloitte.com/us/masubscribeRyan SteczSenior ManagerDeloitte Tax LLP 1 312 486 4087rstecz@deloitte.comKyle WoitelPartnerDeloitte Tax LLP 1 312 486 3499kwoitel@deloitte.comMichael StibichPartnerDeloitte Tax LLP 1 312 486 9839mstibich@deloitte.comLindsay WietfeldManagerDeloitte Tax LLP 1 312 486 9388lwietfeld@deloitte.comAbout the publicationThis guidance contains general information only and Deloitte is not, by means of this guidance, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This guidance is also not intended to be an all inclusive listing of the considerations. Thisguidance is not a substitute for such professional advice or services and should not be viewed as being provided in lieu of consultations. Readersshould seek specific advice before taking any action with respect to matters discussed herein. Any discussion of U.S. Federal tax law contained in thisarticle was not intended or written to be used, and it cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed onthe taxpayer under U.S. Federal tax law. Deloitte shall not be responsible for any loss sustained by any person who relies on this guidance.About DeloitteDeloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee, and its network of member firms,each of which is a legally separate and independent entity. Please see www.deloitte.com/about for a detailed description of the legal structure ofDeloitte Touche Tohmatsu Limited and its member firms. Please see www.deloitte.com/us/about for a detailed description of the legal structure ofDeloitte LLP and its subsidiaries. Certain services may not be available to attest clients under the rules and regulations of public accounting.Copyright 2013 Deloitte Development LLC. All rights reserved.Member of Deloitte Touche Tohmatsu Limited
M&A Insights — Selling your S corporation: Is it now or never? 3 Alternatives to a deemed asset sale With so many complex issues to consider, a section 338(h)(10) election can be a complex transaction that may not be appropriate for all S corporation sellers or buyers. For deal participants that are not positioned to make the
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