Impact of S corp. verification in M&A transactions

Impact of S corp. verification in M&A transactions

The merger-and-acquisition market for private companies has been very active. The activity should remain high as aging Baby Boomers look to retirement, many of them business owners for whom selling a closely held business is a key part of their financial plan.

A great majority of private businesses are structured as S corporations, which are pass-through entities. The taxable income of the corporation is generally not taxed to the corporation but rather is passed out to the shareholders, who pay the tax on their individual income tax returns. In Sec. 338(h)(10) transactions, the gain from the deemed asset sale is passed out to the selling shareholders, and the buyer receives a basis step-up in the corporate assets. In most cases, the buyer will reimburse the selling shareholders for the difference in the tax cost caused by a portion of the gain’s being taxed as ordinary income in the deemed asset sale (i.e., depreciation recapture income, cash-basis receivables, inventory gains, etc.).

One of the key concerns for buyers entering into a Sec. 338(h)(10) transaction is that they must be assured that the sellers have a valid S election. If the S election turns out to be invalid, the buyer would have bought a C corporation that has to pay the tax on the deemed asset sale at the corporate level. Plus, C corporation taxes may be due for prior years. As part of their due diligence, buyers should verify the seller’s S election is valid by examining any existing shareholder agreement. If one does exist, the buyer wants to be sure that it does not cause the corporation to have a second class of stock, which would invalidate the S election under Sec. 1361(b)(1)(D).

Shareholders and their advisers should be prepared to verify the validity of the S election when the decision is made to begin marketing the company for sale. Efforts should be made upfront to provide the necessary documentation to substantiate the entity’s S status, or consideration should be given to alternatives to making a Sec. 338(h)(10) election. Too often, the validity of the S election comes up very late in the due-diligence process and can derail a deal.

If you are planning to sell your business as part of your retirement planning or financial strategy, let’s discuss the process and make sure your company is strategically positioned to your tax and profit advantage.

DeHoek & Company, PLLC 
In part from AICPA