GCD. Tax Update. Gardner Carton & Douglas. Acquisition Overview: The Target Company is an S-Corp - So, What s the Difference?

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1 GCD Gardner Carton & Douglas Tax Update July 2004 Issue Executive Overview This article highlights some of the key tax considerations to take into account if you are considering purchasing the stock of an S-Corp. Because of the favorable tax treatment available to certain shareholders of closely held businesses that operate in this form, they are more and more common. As a result, Purchasers will find that they will routinely need to address the unique tax issues associated with acquiring these types of corporations. To receive future editions, please complete and return the form on the last page. Inside This Issue Update: IRS Releases Final Version of Schedule M-3 Application of Section 280G: When the Employer Is Undergoing a Plan of Reorganization in Bankruptcy Acquisition Overview: The Target Company is an S-Corp - So, What s the Difference? By Jeffrey M. Friedman, Esq. Because of favorable changes in the tax law, many companies have chosen to organize as an S-Corporation ( S-Corp ). As a result, Corporate Purchasers need to understand the complexities of S-Corp s more and more. Generally, an S-Corp is a corporation with certain restrictions on who may be a shareholder, what kind of stock may be issued and outstanding, and provides for flow-through treatment of income and expenses that are similar to a partnership. 1 As a result of the difference in structure and tax treatment of both the corporation and its shareholders, a Purchaser will necessarily want to tailor its tax due diligence and planning to take these differences into account. Thus, aside from the general considerations and planning that apply to a stock purchase transaction, there are special considerations that a purchaser should take into account when acquiring the stock of an S-Corp. This article identifies and analyzes a few of the issues a purchaser should account for in a stock purchase of an S-Corp and provides a short information checklist at the end. While not intended to be a comprehensive list, we highlight some of the more significant tax matters that should be evaluated when the Target company is an S-Corp. S-Election Status Although it may seem obvious, the Purchaser should inquire into the validity of the Target s S-Corp status. This may be confirmed by requesting a copy of the Target s Form 2553, Election by a Small Business Corporation, including copies of consents of the shareholders if they are separate from the election form. Additionally, the Purchaser should request a list of the Target s shareholders, the number of shares owned (by class and series) since inception, and confirm that the shareholders are eligible shareholders (i.e., does not have shareholders other than individuals, estates, or certain trusts and no nonresident alien shareholders). All S-Corp eligibility requirements must be met on the day the election is filed and on each day of the year for which the election takes effect. When the S-Corp no continues on page 2

2 2 Gardner Carton & Douglas LLP Acquisition Overview continued from page 1 longer qualifies, it ceases to be an S-Corp. Accordingly, in the initial diligence process, inquiries should be made as to whether any prior transactions have involved an ineligible shareholder such as a C corporation. The existence of an ineligible shareholder could have the effect of terminating the S election in a prior year and as a result, corporate taxes may be due. Built-In Gains If Target has not been recognized as an S-Corp since its inception, Purchaser should request appraisals or valuations, if any, of the Target S-Corp and its assets relating to the conversion to S-Corp status. Most importantly, the Purchaser should identify and request the calculation of the unrealized built-in gains of the assets at the conversion date, including certain deferred income producing assets. The built-in gains tax imposes a corporate level tax on the built-in gain recognized by the former C corporation during the first 10 years after the S-Corp status begins. 2 Therefore, the S-Corp would be subject to a tax if it were to dispose of an asset with a builtin gain. In effect, the Purchaser would have acquired a builtin tax liability. Alternatively, if the S-Corp has never operated as a C corporation, the built-in gains tax does not apply. Treatment of Pass-Through Items and Closing the Books The Purchaser and Target shareholders may want to address, in the stock purchase agreement, whether or not the S-Corp status will continue after the date of acquisition. In effect, the Purchaser and Seller identify how to allocate the pass-through items of income, loss, deduction, and credit for the S-Corp s year. Generally, such items are prorated between the Purchaser and Seller based on the number of days each owns the stock. 3 If the S election is to be continued, the Purchaser and Seller may consider closing the books on the acquisition date. If the Target shareholders sell all of the S-Corp stock during the corporation s tax year and if all affected shareholders (all terminating shareholders and their transferees) consent, the S-Corp s tax year can be split into two short tax years. The first short tax year ends on the date the seller s interest in the S-Corp is terminated. 4 The affected shareholders show their consent by attaching a statement to Form 1120S for the tax year during which the shareholder s entire interest was terminated. As a result of the election, the pass-through items will be allocated between the two short tax years according to the books. Alternatively, if there is a sale or exchange of 50% or more of the stock during the year of termination, the IRC provides that the pro rata allocation cannot apply and the books of the corporation will close automatically. 5 As a result, when an S-Corp is acquired and its S-Corp status is terminated, at least two short years will result. It will have an S-Corp short year which ends on the day before the date of termination of the election. It will then have a C corporation short year which begins on the date of termination. Accumulated Adjustments Account As part of the due diligence process, the Purchaser typically requests Target s federal income tax returns, Forms 1120S, for the last three fiscal years (or open periods, if longer), including forms, other attachments, disclosures, and amended returns for the same periods. Schedule M-2 on Form 1120S shows the balance of the accumulated adjustments account ( AAA ). This amount generally reflects the accumulated undistributed net income of the corporation. It is important to identify the value of the AAA because the treatment of a distribution from the S-Corp depends on the balance of the AAA at the end of the tax year in which the distribution was made. Before computing the tax for distributions of accumulated earnings and profits (if any), the AAA generally enables S-Corps to make tax-free distributions to shareholders of income that has been earned and taxed, but that has not been distributed. As was the case with the treatment of pass-through items, the Purchaser and Seller may elect to terminate the tax year for purposes of determining the taxability of distributions for the tax year. When the election is made, the tax year consists of separate years for purposes of allocating items of income and loss as well as for making adjustments to AAA, basis and earnings and profits. 338(h)(10) Election One benefit of operating as an S-Corp is that individual shareholders can participate in a Section 338(h)(10) election, which generally provides a benefit to a Purchaser through the stepup in basis of the Target s assets. Without the S-Corp status, a corporation owned by individuals does not qualify as a

3 Tax Update 3 potential participant in a Section 388(h)(10) election. If no election is made in a stock purchase of an S-Corp, the basis of the assets to the corporation after the sale generally remains the same as it was prior to the stock sale. Alternatively, when a Purchaser acquires at least 80% of the stock of an S-Corp in a qualified stock purchase and a 338(h)(10) election is made, 6 the transaction is treated as if the sale of stock is a purchase of the Target S-Corp assets, followed by a distribution of the proceeds in liquidation to its shareholders. As a result of the deemed sale, Purchaser will be entitled to the stepped-up basis in the assets. The amount of the purchase price exceeding the value of the hard assets is generally allocated to goodwill. Accordingly, the Purchases may be able to benefit from greater depreciation deductions associated with the goodwill component of the purchase in future years. The deemed sale results in gain being recognized by the S-Corp on any appreciation in the assets of Target. The gain ultimately passes through and is recognized by its shareholders. As a result of the asset sale, the seller may be subject to more tax. Furthermore, a portion of the seller s gain may be characterized as ordinary income rather than capital gain depending on the type of assets held by the Target. As a result, the Purchaser and the S-Corp shareholders usually agree to adjust the purchase price to take the increased tax cost from the sale into account. When a 338(h)(10) election is made, Form 8023-A must be filed by the Purchaser and Target S-Corp shareholders. The election must be made by all of the Target shareholders including any shareholders who do not sell their stock. S-Corp Acquisition Checklist: S-Corp Considerations Request a copy of Form 2553, Election by a Small Business Corporation. Inquire whether S-Corp has ever had its corporate charter suspended. Inquire whether S-Corp was ever a C corporation within the last ten (10) years. If so, request a list of the built-in gain assets at the conversion date. Confirm the types of stock the S-Corp has issued. Inquire who are the shareholders of the S-Corp and confirm that they are eligible shareholders (i.e., (i) 75 or fewer shareholders; (ii) only individuals, estates, or certain trusts; (iii) no nonresident alien individuals). Inquire whether S-Corp has had passive income within the last three (3) years. If the S-Corp has accumulated earnings and profits and passive income in excess of 25% of gross receipts for three consecutive tax years, the S-Corp status may terminate. Identify any loans between the S-Corp and any of its shareholders. Inquire as to the amount of the AAA account. Inquire whether the S-Corp has any qualified subchapter S subsidiaries or other affiliates. GCD s Perspective As discussed, there are several key differences in structuring an acquisition where the Target company is an S-Corp as opposed to a C corporation for federal income tax purposes. Because these types of entities are much more common, a company that is targeting closely held businesses for acquisition should become familiar with some of the key tax issues that may trigger tax liabilities unique to these types of entities prior to entering into negotiations on price and structure. Therefore, it is advisable that a federal income tax professional be a key participant on the transaction team. Endnotes 1 Section 1361 of the Internal Revenue Code ( IRC ), and the Treasury Regulations thereunder, provide definitions and requirements for electing and qualifying as an S-Corp for federal income tax purposes. Numerous court cases and IRS rulings and other guidance also interpret these provisions. Thus, a complete analysis of the applicable authorities should be undertaken prior to making any conclusions about a corporation s status as an S-Corp, or the tax issues arising from elections or business operations under these rules. 2 See IRC Sec See IRC Sec. 1377(a)(1).

4 4 Gardner Carton & Douglas LLP 4 See IRC Sec. 1377(a)(2); Treas (b). 5 See IRC Sec. 1362(e)(6)(D). 6 See Treas. Reg. Sec (h)(10)-1. Update: IRS Releases Final Version of Schedule M-3 By Todd B. Reinstein, Esq., CPA The Treasury Department and Internal Revenue Service ( IRS ) released the final version of Schedule M-3, Net Income (Loss) Reconciliation for Corporations with Total Assets of $10 Million or More, for reporting annual bookto-tax reconciliations on July 7, The new schedule replaces the current M-1 schedule by requiring taxpayers to submit a significant amount of detail beyond the general white paper disclosure that has been the procedure for many years. The M-3 must be filed by a corporation required to file a Form 1120 and whose assets are equal or exceed $10 million at the end of the corporation s year. The new schedule is effective for any taxable year ending on or after December 31, The new schedule has been combined and reformatted somewhat from the draft released in January (discussed in our February newsletter). Part I lists certain questions about the corporation s financial statements and reconciles worldwide financial statement net income (or loss) to the amount reported as net book income in the tax return. Parts II and III are consolidating schedules that require corporate taxpayers to separately report over 70 items of income and expense in reconciling net income (or loss) and identify each as either a temporary or permanent difference. The IRS has stated in a list of frequently asked questions that a corporation is required to complete only Part I and certain columns of Parts II and III for the corporation s transition year (the first taxable year the corporation is required to file Schedule M-3). The IRS also clarified in the list of frequently asked questions that Part I of Schedule M-3 must be completed once to report the consolidated information and activity for the entire U.S. consolidated tax group. However, Parts II and III of Schedule M-3 must be completed separately by each member of the U.S. consolidated tax group to reflect each member s own activity. Along with the release of the final Schedule M-3, the IRS simultaneously issued Revenue Procedure which provides streamlined procedures to satisfy a taxpayer s disclosure obligations for reportable transactions with a significant book-tax difference. The Rev. Proc. states that a corporation s filing of Schedule M-3 with the corporation s timely-filed original tax return for the taxable year is deemed to satisfy the disclosure requirements of the Treasury Regulations with respect to reportable transactions with a significant book-tax difference for that taxable year. As a result, a portion of the overlap between Form 8886, Reportable Transaction Disclosure Statement, and Schedule M-3 has been eliminated when the reportable transaction is for certain book-tax differences only. If the transaction is classified as a reportable transaction for other reasons (e.g., Section 165 losses), taxpayers still need to complete Form GCD s Perspective The purpose of the new schedule is to increase the transparency of corporate tax filings and requires more taxpayer disclosure and a significant understanding of the book-tax differences in reporting corporate events that must be taken into account in a corporate taxpayer s federal income tax return. Thus, corporate taxpayers and their advisors will need to plan to spend more time analyzing how corporate transactions will be reflected on their tax returns. Application of Section 280G: When the Employer Is Undergoing a Plan of Reorganization in Bankruptcy Introduction By Francisca N. Mordi, Esq. On July 19, 2004, the IRS issued Rev. Rul that addresses the application of the golden parachute payment rules under Section 280G in a bankruptcy context. The IRS described four factual situations involving payments made to executives of companies in the process of undergoing a plan

5 Tax Update of reorganization in Bankruptcy. The IRS evaluated whether or not payments made to an executive in connection with a change in control of a corporation in a bankruptcy context would be exempt from the parachute payment rules because of the application of an exception found in IRC Section 280G(b)(5)(ii). 1 Overview of IRC Section 280G In the early 1980s, it became common for company executives to enter into individual agreements to establish severance provisions that would be applicable in the event of a change in ownership or control of the company. Pursuant to these provisions, if an event qualifying as a change in ownership or control occurred, the executive would receive payment substantially exceeding his or her base compensation from the company. Such payments, now known as golden parachute payments, came to the attention of Congress because of a perceived conflict of interest that might be created in a situation where senior management s interests are so divorced from those of the other shareholders that such executives may be encouraged to favor a proposed hostile take over that may not be in the best interests of the other shareholders. This resulted in the enactment of Section 280G in 1984, in order to discourage excessive payments to executives of a corporation in connection with an acquisition of that corporation. Under Section 280G, a company that makes excess parachute payments to an executive is not allowed a deduction for the excess parachute payments, and under Section 4999, the recipient is subject to a nondeductible 20% excise tax on the excess parachute payment. Section 280G and the applicable Treasury Regulations provide that, if (i) it is determined that a change in ownership or control occurred, and (ii) in connection with such change in ownership or control, payments in the nature of compensation are made to an executive, and (iii) the payment equals or exceeds an amount equal to three times the executive s base amount, the payment will be deemed a parachute payment that is subject to the application of penalties, if excessive, under Sections 280G and A change in ownership or control event generally is deemed to occur if: Any one person (or persons acting as a group) acquires ownership of stock of the corporation that represents more than 50% of the total fair market value or total voting power of the stock of such corporation; During a specified 12-month period, either (1) any one person (or persons acting as a group) acquires ownership of the corporation s stock representing 20% or more of the total voting power of the stock of such corporation; or (2) a majority of the members of the corporation s board of directors is replaced by directors whose appointment or election is not endorsed by a majority of the members of the corporation s board prior to the date of the appointment or election; 2 or During a specified 12-month period, any one person (or persons acting as a group) acquires assets from the corporation that have a total gross fair market value equal to or more than one-third of the total gross fair market value of all of the assets of the corporation prior to the date of acquisition. Notwithstanding the foregoing general rules for determining whether a payment is a parachute payment for purposes of Section 280G, under Section 280G(b)(5)(ii), certain payments that otherwise qualify as parachute payments will not be so considered, and thus, exempted from the application of the parachute payment rules, if the following conditions are satisfied: Prior to the change in ownership or control event, the corporation s stock was not readily tradeable on an established securities market; and Pursuant to adequate disclosure of material facts and information regarding the payment, such payment was authorized by a vote of persons who owned more than 75% of the voting power of all outstanding stock of the corporation prior to the change in ownership or control. Rev. Rul In Rev. Rul , the IRS provides four fact situations in the bankruptcy context, the first two of which address the rules relating to when a change in ownership or control would be presumed to have occurred, and the other two discussing the applicability of the Section 208G(b)(5)(ii) exception. 5

6 6 Gardner Carton & Douglas LLP In the first situation, Corporation, whose common stock was widely held and actively traded on the New York Stock Exchange, filed a voluntary bankruptcy petition. Its unsecured creditors and shareholders were represented by two different committees that entered into negotiations with Corporation. Pursuant to an approved plan of reorganization, Corporation s common stock was canceled, and new shares were authorized and issued, 75% to the unsecured creditors, and 25% to the equity holders. The 75% shares were distributed to the unsecured creditors in proportion to their claim, and no single unsecured creditor received 20% or more of the shares. The IRS noted that creditors usually had no control over the receipt of stock in a bankruptcy situation. In this situation, there was no indication that the creditors wanted Corporation s stock, and thus, did not act together in any way to influence Corporation s filing of bankruptcy. Furthermore, the receipt of Corporation s stock was pursuant to the bankruptcy courtapproved plan of reorganization, based on negotiations conducted by committees appointed under the Bankruptcy Code to represent the creditors. Thus, the creditors did not act as a group to acquire control of Corporation. Therefore, despite the receipt of 75% of Corporation stock by one group of creditors, the IRS ruled that, under these circumstances, a change in ownership or control did not occur because the creditors did not act as a group to acquire ownership of 75% of Corporation s outstanding stock. In the second situation, with facts that are substantially the same as the first, except that pursuant to the plan of reorganization, Corporation s single largest creditor received 25% of the new shares, the IRS ruled that a change in effective control was presumed to have occurred because one creditor acquired more than 20% of Corporation s outstanding shares within a 12-month period. This presumption could be rebutted by a showing that such creditor would not control the management of Corporation. In the third situation, Corp. B, whose common stock was widely held and actively traded on the New York Stock Exchange, filed a voluntary bankruptcy petition. Thereafter, its stock was delisted from the New York Stock Exchange, and was no longer tradeable either on any established securities market, or any other market (including an over-the-counter market). A few months later, Corp. C proposed to purchase more than 75% of Corp. B s assets, which, if approved by the bankruptcy court, would result in a change of ownership or control event, thereby triggering certain payments to X, an executive of Corp. B, pursuant to an agreement between X and Corp. B. X made a request to the Bankruptcy Court under the Bankruptcy Code, seeking authorization for Corp. B to make the payments to X as actual administrative expenses that are necessary for preserving the bankruptcy estate. After a hearing, the Bankruptcy Court authorized the requests for the sale of Corp. B s assets and the payments from Corp. B to X. The IRS ruled that the payments to X, even though made to an executive in connection with a change in ownership or control event, were not parachute payments because the exception under Section 280G(b)(5)(ii) applied. First, prior to the court-approved change in control event, Corp. B s stock had been delisted from an established securities market, and thus, was no longer readily tradeable on such market. In fact, the stock was not traded on any market prior to this event. Second, the Bankruptcy Court s authorization and approval of the payments satisfied the statutory requirement of shareholder approval in a bankruptcy context. In the fourth situation, with substantially similar facts as the third, except that after Corp. B filed its bankruptcy petition, its stock was delisted from the New York Stock Exchange, but was tradeable on an over-the counter market, the IRS ruled that the payments to X were not parachute payments because the exception under Section 280G(b)(5)(ii) applied. First, prior to the court-approved change in ownership or control event, Corp. B s stock was delisted from an established securities market, and, thus, was not readily tradeable on such market. Although the stock was still tradeable on an over-the-counter market, the IRS stated that the trading of stock of a corporation that is a debtor in a bankruptcy case is impaired, and thus, the stock will not be considered readily tradeable for purposes of the exception. Furthermore, as in situation 3, the Bankruptcy Court s approval and authorization of the payments to X satisfied the shareholder approval requirement of Section 280G(b)(5)(ii) in a bankruptcy context. GCD s Perspective The golden parachute rules were enacted to discourage excessive payments to key personnel in order to protect the shareholders. However, where a company is a debtor in a case that is under the Bankruptcy Code, the company is subject to the bankruptcy rules administered under such Code, and, thus, there is oversight by the Bankruptcy

7 Tax Update 7 Court. As a result, the rules are somewhat different from the general rules for corporations that are not in bankruptcy. To avoid the numerous pitfalls that exist in this area, it is very important that corporations obtain the assistance of counsel prior to, during, or even after an event that may qualify as a change in control that may have occurred in order to: (i) review and structure benefit plans, compensation plans, employment and severance agreements, and other agreements that may trigger the application of the Section 280G and Section 4999 penalties; (ii) identify the value of comparable employment and severance plans at similar companies within the same industry and region to ensure competitiveness; and (iii) determine who could be deemed a disqualified person for purposes of Section 280G, in addition to performing the complex calculations associated with Section 280G. Endnotes 1 All Section references are to the Internal Revenue Code of 1986, as amended, unless otherwise noted. 2 A presumption that a change in ownership or control has occurred under any of these circumstances may be rebutted by showing that the acquisition of stock or replacement of the board does not in any way transfer the power to control from any one person (or group) to another person (or group). To learn how Gardner Carton & Douglas Corporate Tax Group can assist you, please contact Homeira Ghorbani, Director of Tax Service Business Development, at or send an to hghorbani@gcd.com. If you have any questions about the implications of these topics, please contact any member of our Corporate Tax Group. Annette M. Ahlers aahlers@gcd.com Dennis J. Carlin dcarlin@gcd.com Glenn E. Ferencz gferencz@gcd.com Jeffrey M. Friedman jfriedman@gcd.com Kristin B. Jones kjones@gcd.com Karen B. McAfee kmcafee@gcd.com Francisca N. Mordi fmordi@gcd.com Kathleen M. Nilles knilles@gcd.com Todd B. Reinstein treinstein@gcd.com T.J. Sullivan tsullivan@gcd.com Please Return This Form by , Facsimile or Mail to: Gardner Carton & Douglas LLP 1301 K Street, N.W. Suite 900, East Tower Washington, D.C (202) Telephone (202) Facsimile hghorbani@gcd.com Attn: Homeira Ghorbani Name Title Company Address Phone Fax Corporate Tax Attorneys To Receive Future Issues To add a name to our mailing list or to correct or update information, please complete and return the form below. This client memorandum is not intended as legal advice, which may often turn on specific facts. Readers should seek specific legal advice before acting with regard to the subjects mentioned here. Gardner Carton & Douglas LLP Chicago, Ilinois Washington, D.C Milwaukee, WI Albany, NY Promotional Material