S Corp M&A: Three Options for Solving Income Tax Problems
The boom in M&A, or M&A, activity throughout 2021 and into 2022 has consequently led to more S corporations as target companies for M&A transactions. S corporation status is a popular option for small businesses, as it provides tax flexibility not available to C corporations. However, a buyer considering acquiring an S corporation should ensure that the entity was eligible for make its S corporation election and that the entity has continued to qualify for S corporation status throughout its history. If the IRS successfully challenges an entity’s S corporation status, the entity is automatically treated as a C corporation, which can result in significant unexpected federal income tax exposure. This article discusses three options for limiting this potential exposure to federal income tax: seller’s indemnities and receiverships, IRS private letter rulings, and tax assurance. As shown below, tax assurance, often combined with a private decision, is the most effective option for most taxpayers.
S Corporation General Requirements
With few exceptions, a corporation may be treated as an S corporation for US federal income tax purposes if it meets certain eligibility requirements and makes a valid election. To elect and retain S corporation status, the entity must be a domestic corporation; have only shareholders who are US citizens or residents; have less than 100 shareholders, taking into account certain grouping rules; have only shareholders who are individuals, certain trusts or tax-exempt entities; have a stock class; and not have excessive passive investment income. These requirements must be met at all times from the date of the S Corporation election; otherwise, the company’s S corporation status will be terminated.
A detailed analysis of the nuances associated with these requirements is beyond the scope of this article; however, it is safe to say that S corporations are historically problematic entities with strict rules. These rules create many foot faults that S corporations often inadvertently stumble upon, leading to potential termination. Failing to get a spousal election in community property states, invalidating the original election; make disproportionate distributions, resulting in a second class of shares; or involuntarily having an ineligible shareholder, often an unauthorized trust, are examples of common actions taken in the normal course of business by a corporation or its shareholders that may result in dissolution.
Tax risk of an inadvertent termination of an S corporation
Transactional and buy-side tax due diligence focuses on S corporation requirements and often reveals concerns about the qualification of an S corporation target.
An inadvertent termination can be catastrophic for a transaction. To the extent that a target’s historical S-Corporation status has been invalidated, the target reverts to a C-Corporation for U.S. federal income tax purposes, resulting in corporate income tax exposure. at the entity level for all tax years beginning after termination. Additionally, unless structured around it, the acquisition of a C corporation – as opposed to a planned S corporation – may result in a loss of basis.
To mitigate this entity-level unforeseen tax exposure and loss basis, parties to the agreement have three main options: seller indemnities/escrows, private letter rulings (PLRs), and tax assurance. Parties have, and often use, the ability to combine these options to best suit their needs.
Depending on the negotiating leverage, the traditional approach involves the buyer subjecting a seller to substantial indemnity or tying up the proceeds of the sale in an escrow to cover potential tax exposure. But if a seller holds the leverage, the buyer may be required to insure the tax exposure himself or, if he does not want to do so, to forfeit the transaction. All options are very inefficient, slow down the transaction process and lead to an undesirable outcome for part of the transaction.
Administrative relief and the PLR process
Under Section 1362(f) of the tax code, the IRS has the authority to reverse certain inadvertent terminations of an S corporation if: the entity has previously made a valid election to be an S corporation and that election has terminated, the IRS determines that the termination was inadvertent, the entity takes steps within a reasonable time to correct the condition that rendered the corporation ineligible to be an S corporation, and the entity and all shareholders during the term of termination agree to make any adjustments required by the IRS that are consistent with the entity’s treatment as an S corporation.
The adjudication process includes a brief, usually prepared by a law or accounting firm, which contains a factual summary, a request for ruling, a statement of law and analysis, and a statement of truth under penalty of perjury. Both preparing and filing the Ruling Request have their own distinct set of costs. While the IRS claims to adjudicate these requests in 60 to 90 days, the process is often much longer – the current time frame appears to be six to nine months. In the fast-paced world of mergers and acquisitions, the PLR timeline is often too long to wait for tax certainty before closing. Therefore, seeking a PLR is often used as a backstop for limited seller indemnity or escrow, or alongside a tax insurance policy.
In January, the IRS announced a new fast track PLR process which aims to reduce the decision time to 12 weeks. This new pilot process consists of a pre-ruling conference with the IRS, followed by the normal, albeit expedited, ruling request process. The IRS hopes this new program will streamline the time it takes to go from application to decision; however, the IRS has stated that it will not be available for requests for extensions of time to make elections or other requests for Heading 9100 relief, which are often needed to remedy the inadvertent termination of S corporation status. As a result, extending elections and other requests for 9100 relief may take significantly longer than the 12-week period offered under of the new program.
Tax assurance process
The most effective option is the use of tax insurance, often in combination with the above. Tax insurance policies are capable of covering known or discovered justifiable tax positions. These insurance policies transfer the risk of an unfavorable decision from a tax authority to an insurer or insurers and make the insured whole by providing coverage for the payment of tax, dispute costs, interest , penalties and, where applicable, an increase, if the proceeds of the insurance are taxable in the hands of the insured. In the transactional framework of the S corporation, this can provide buyers and sellers with certainty that facilitates the transaction process. Insurance of an identified S corporation may also limit, if not entirely eliminate, the need for agreement-specific escrows and/or seller indemnities.
Tax assurance for S corporations involves the buyer and/or seller of the S corporation, a tax assurance broker, and the insurer or insurers. One of the parties to the agreement brings the tax declaration to the insurance market through a broker. The broker presents the opportunity and aggregates the terms of the interested insurance markets. The parties then select their preferred insurer(s) and enter into a formal underwriting. During the underwriting process, the insurer or insurers will review all relevant documents associated with the underlying risk, comment on a possible PLR application and discuss with the parties about it, as well as negotiate an insurance policy tailored to the opportunity. This whole process usually takes a few weeks, but can be accomplished in a very expedited time frame – a few days – if the transaction requires it. Once underwriting is complete, the parties bind the coverage, transferring the risk to the insurer or insurers for a one-time payment typically ranging from 2% to 4% of the coverage obtained.
In certain circumstances, the insurer may require the taxpayer to request a decision under private signature in the context of taking out a tax insurance policy. However, the policy accepts the transfer of risk before the decision is received, thereby eliminating the worry associated with waiting for the IRS to rule on the application.
Since most M&A deals operate on much faster timelines for the IRS’ fast-track pilot program to have a meaningful effect, parties to the deal should continue to consider tax assurance as an option. to effectively reduce the risks associated with S corporations without disrupting or delaying their agreement.
This article does not necessarily reflect the views of the Bureau of National Affairs, Inc., publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Bryce R. Presentin is a tax underwriter at Euclid Transactional, where he is responsible for underwriting bespoke commercial insurance solutions for various tax matters.
Justin Pierce Berutich is Chief Tax Officer at Euclid Transactional, where he is responsible for leading Euclid’s tax assurance practice and developing tailored business solutions for various tax matters.
Jeff M. Lash is a tax underwriter at Euclid Transactional, where he is responsible for underwriting bespoke commercial insurance solutions for various tax matters.
Kyle Reiter is a senior partner at Euclid Transactional. Kyle works to support the underwriting group and directly supports the Head of Tax to help develop tax assurance solutions.
Lodge Sydney is a senior analyst at Euclid Transactional. Sydney analyzes the insurability of opportunities and facilitates the underwriting process by coordinating with partner brokers and external advisors.
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