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Sale of a Corporation

Sale of a Corporation

Shareholders in a sale of a Corporation have many options depending on the motivation of the parties. For example, minimizing tax paid through the transactions may not be synonymous with maximum proceeds, so true motivation of the parties matters. Shareholders have an option to sell to an acquiring corporation as a 1) taxable asset sale, 2) taxable stock sale, 3) taxable stock sale treated as an asset sale under IRC, or 4) as a non-taxable merger or consolidation, otherwise known as a reorganization. Straight stock sales provide the simplest form of sale for the seller, where shareholders are assured a single level of taxation at the most favorable long-term capital gains rates. This form of sale will be least appealing to the acquirer (A) because a stock purchase allows no recovery or amortization to A as an investment.

The law, however, allows a stock sale to be treated as an asset sale, which could provide the acquirer high incentive due to stepped up bases in the assets. The taxable stock form of sale and acquisition will require that both the target corporation (T), its shareholder sellers (SH), and acquirer (A) make a decision under the IRC whether or not to make a Section 338(h)(10) or a Section 336(e) election. If T is a C-Corporation as intended by regulatory application of Section 336, not a common parent, and is not a member of an affiliated group as defined by Section 1504, or as intended in regulatory application of Section 338, then a stock sale treated as an asset sale would require a Section 336(e) election. Section 336 election will provide the potentially large incentive to A for stepped up bases in assets. T could engage in a Section 336(e) election, which provides the benefit to SH of a single level of taxation like a straight stock sale, but may, however, expose SH to ordinary income due to the asset sale treatment of the sale under Section 1245 recapture requirements.

Worldview Consulting & Accounting, Inc. is an Oregon registered CPA accounting firm. William Burwell, MBA, CPA, CFF, CFE is a business consultant and financial forensic accounting services professional with over twenty years of high technology industry experience. Licensed in Oregon and Washington.

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Non Taxable Reorganization – Tax Free Mergers

Tax Free Mergers

receipts Shareholders (SH) of a corporation may have an option to enter into a non taxable reorganization with an acquirer (A).  A tax free merger is a “reorganization” under the tax code.  In such a deal, A would use its stock as a significant portion of the consideration paid to SH rather than cash or debt.  This requires SH taking equity, and thus risk in an investment stake in A. The buyer may prefer a merger.  Tax is effectively deferred under such a merger, except for cash or boot taken in the transaction.  In this case, A would be able to pay for a significant part of the acquisition price with its equity.  The motivation for such a deal may be that A cannot offer consideration other than equity.  A may have little cash, and may have trouble financing the acquisition with debt. Here, A and SH could pursue a non-taxable exchange of stock under a Section 368 statutory merger transaction.  Continuity and non-tax avoidance criteria must be met.  A and SH can pursue a reorganization such that A will be required to continue with target (T) business for a minimum of 2 years.

Tax Deferral

Taxes are only deferred, not avoided.  A will defer taxes on the asset acquisition of T.  SH will defer taxes until it sells its stock in A.  A will pay taxes on the amount of boot taken in the deal.  A will assume the tax structure of the assets of T, and take all carryover bases in those assets.  This could be an incentive or disincentive depending on the spread between the bases and the market values of those assets.  If and when A sells those assets it will realize taxable gain inherent in those assets.  Under Section 368, up to 60% of the aggregate deemed asset disposition price (ADADP) can be money or other property received by SH.

Risk

SH may, in such a deal, take on what could be an undue risk with equity in A, deferring taxes, and limit and defer cash flows for A.  If acquirer is a large solid firm, with a market for its shares, the risk to SH would be much lower.  If the stock received in the transaction is higher risk, that stock could become worthless in a worst case scenario.
Worldview Consulting & Accounting, Inc. is an Oregon registered CPA accounting firm.  William Burwell, MBA, CPA, CFF, CFE, is a certified public accountant,  forensic accountant, certified fraud examiner, and business consultant with over twenty years of high technology industry experience.  CPA licensed in Oregon and Massachusetts.

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Property Distribution to Related Party Shareholder

Let’s say a company, a C corporation, is to make a distribution to you as a shareholder. With proper purpose and execution within the tax code, this is fine, so we leave out the why. This is also a serious matter, so it should be transacted under the IRC correctly. If you are a major shareholder, or exert control over the corporation, then you are considered a related party shareholder. If you own the majority of shares in a small business and your business is to distribute equipment to you, an old truck for example, that is not fully depreciated on the books of the company, then it has a book value. Let’s say, for example, it has been depreciated down to a basis of $25,000. Let us also say that the truck is worth something in the market, hypothetically $40,000, the fair market value (FMV). If the basis is less than the FMV, then we say the property is “appreciated.” If the company also distributes cash to you in this example, let’s say $5000, then that must also be valued and cared for in the transaction.

In this case, we need to describe the character and amount of the gain or loss to both the corporation and you as the recipient of a dividend of both cash and appreciated property. Also in this case we need to define the character of the gain given the corporation has no earnings and profits (for a good explanation of E&P, I suggest the following link written by Kaiser at http://www.thetaxadviser.com/issues/2013/oct/kaiser-oct2013.html.)

Let’s move on with our simplified example with some tax code in effect at the time of writing this blog (tax code does change so you should check with your accountant in a real life example).

Section 311(a) states, in general, that except as provided in 311(b), no gain or loss will be recognized to a corporation in its distribution of its stock or of property. Section 311(b)(1)(A) and 311(b)(1)(B) also provide that when a corporation distributes appreciated property to a shareholder the disposition of the property will be as if the corporation sold it. It states in part, “then gain shall be recognized to the distributing corporation as if such property were sold to the distributee at its fair market value.” This means the difference between its FMV and its adjusted basis will be recognized as gain to the corporation.

Section 301(c)(1) states that the amount considered a dividend as defined in Section 316(a) shall be included in gross income. The amount not considered a dividend reduces the adjusted basis of the stock according to Section 301(c)(2). The amount not recognized as a dividend, and in excess of adjusted basis, shall be treated as a gain from sale of property per Section 301(c)(3).

Section 316(a)(1) and Section 316(a)(2) defines a dividend as “any distribution of property made by a corporation to its shareholders” out of current or accumulated earnings and profits.

In our hypothetical, the corporation made a current distribution of $5,000 cash and an appreciated truck worth $40,000, as defined in Section 311(b). Since this is a dividend distribution in relation to your stock holding in the corporation, the corporation must include the gain on the appreciated property as if it sold the property to you, and also must include in gross income per 301(c). This will be ordinary income as to the truck. Since the truck has a current FMV of $40,000, and it basis to the corporation is $25,000, the gain is $15,000, and it is ordinary income.

Per section 301(c) you must recognize the distribution, to him or her, first as dividend income if the corporation has any current or accumulated E&P.  The corporation has no E&P. Thus, there is no dividend income. Next you must reduce your basis in the corporation stock. Since your total dividend is $45,000 your potential gain is reduced by first reducing your basis in stock as a shareholder. If your basis in stock was, let’s say $20,000, then your gain is reduced from $40,000 potential to $25,000, due to reduction first of your $20,000 stock basis to $0. The balance per Section 301(c)(3) is, therefore, recognized as capital gain of $25,000.

The corporation recognizes an increase in ordinary income of $15,000 on the distribution of appreciated property. It recognizes no gain on the $5,000 cash because it is not appreciated property.

You recognize a capital gain equal to the $25,000 balance of your distribution after the total $45,000 is first reduced by your $20,000 basis in stock. There is no dividend income recognized before reduction of your stock basis because the corporation has no E&P current or accumulated.

Worldview Consulting & Accounting, Inc. is an Oregon registered CPA accounting firm. William Burwell, CPA, CFF, MBA, CPIM, is a business consultant and financial forensic accounting services professional with over twenty years of high technology industry experience. Licensed in Oregon and Massachusetts.

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Section 1245 Property Recaptured As Ordinary Income

A corporation may be subject to ordinary income and tax rates in an asset sale, or if in a contemplated taxable stock sale (treated as an asset sale) where a Section 336(e) or a Section 338(h)(10) election is made, shareholders (SH) are taxed on asset sales resulting in recapture for Section 1245 property.

For example, if a corporation in such a sale sold equipment for $300,000 that it held for two years, the equipment’s cost was $270,000, and accumulated depreciation was $60,000, and adjusted basis was $210,000, realized gain would be $90,000, $60,000 of that would be recaptured as ordinary income, and only $30,000 would be at favorable long term capital gains (LTCG) tax rates (Section 1231 property).
The issue is how a corporation must treat the realized gain on the sale of its assets, what kind of property is each asset under the law, and what is the character of the gain on sale of each asset. Section 1245 property is defined in Section 1245(a)(1)(3)(A) and Section 1245(a)(1)(3)(B) as any property subject to depreciation under Section 167, and is either personal property or other tangible property used “as an integral part of manufacturing, production, or extraction or of furnishing transportation, communications, electrical energy, gas, water, or sewage disposal services…”.

Section 167 allows depreciation deductions to be taken on property subject to wear and tear, if used in trade or business or used in production of income. Section 1245(a)(1) provides that if Section 1245 is sold, the amount by which the sales price exceeds the adjusted basis shall be treated as ordinary income. This means that all depreciation taken against the original basis shall be recovered as ordinary income.

If a corporation has Section 1245 property, much of which has been fully depreciated, then the equipment is Section 1245 property as defined by the IRC. The assets sold would be allocated part of the aggregate deemed asset disposition price (ADADP), thus the gains subject to recapture rules will be all previously taken depreciation represents to the difference between the ADADP and the adjusted basis (a very low basis, thus large potential gain). Under Section 1245 and Reg. Sec. 1-1245-1, the treatment of this gain shall be the recapture of all depreciation taken, with only the balance of gain taxed at the applicable and favorable capital gains tax rates.

Worldview Consulting & Accounting, Inc. is an Oregon registered CPA accounting firm. William Burwell, CPA, CFF, MBA, CPIM, is a business consultant and financial forensic accounting services professional with over twenty years of high technology industry experience. Licensed in Oregon and Massachusetts.

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Tax on Preferred Stock Received as a Dividend

Timing and Character of Tax on Preferred Stock Received as a Dividend

Worldview Consulting & Accounting, Inc., as a Portland CPA firm, provides tax advisory services to help its clients understand the code.  An issue that comes up is what to do when you receive preferred stock as a dividend.  When preferred stock is received in a stock dividend, you want to know the timing and character of tax, or what is the tax implication of receiving such a dividend.

The issue is whether preferred stock received as a stock dividend is taxable.  If so, whether it is taxable when received, sold, or redeemed, and how is the tax calculated.  The issue is also whether the difference between sales price and basis, or the earnings and profits of the corporation limits the gain recognized and taxed.

Section 305(a) provides that “gross income does not include the amount of any distribution of the stock of a corporation made by such corporation to its shareholders with respect to its stock.”  Section 305(b) then describes where 305(a) does not prevail, or cases that are considered exceptions to 305(a).  The first is per 305(b)(1), in cases of distributions made in lieu of money, for example where cash dividends are in arrears and the corporation distributes preferred stock in its stead.  Second, per 305(b)(2) disproportionate distributions are considered an exception, along with 305(b)(3), with distributions of common and preferred stock simultaneous to different shareholders, 305(b)(4), with distributions “in respect of preferred stock,” and 305(b)(5), with distributions of convertible preferred stock.  Section 305 also defines that if something is required to be included in “gross income” for the period, this means the income is ordinary.

Reg. Sec. 1.305-1(b) states as follows: “where a distribution of stock or rights to acquire stock of a corporation is treated as a distribution of property to which section 301 applies by reason of section 305(b), the amount of the distribution, in accordance with section 301(b) and §1.301-1, is the fair market value of such stock…”.

Section 306(a) provides that if a shareholder “sells or otherwise disposes of section 306 stock,” and the transaction is not a redemption, then the “amount realized shall be treated as ordinary income.”

Section 306(c)(1)(A) defines “Section 306 stock” to include stock “which was distributed to the shareholder selling or otherwise disposing of such stock if, by reason of section 305(a), any part of such distribution was not includable in the gross income of the shareholder.”  However, Section 306(c)(2) excludes from Section 306 where no earnings and profits exist.

Section 301(c)(1) states that the amount considered a dividend as defined in Section 316(a) shall be included in gross income.  The amount not a dividend reduces the adjusted basis of the stock according to Section 301(c)(2).  The amount not recognized as a dividend, and in excess of adjusted basis, shall be treated as a gain from sale of property per Section 301(c)(3).

Section 316(a)(1) and Section 316(a)(2) defines a dividend as “any distribution of property made by a corporation to its shareholders” out of current or accumulated earnings and profits.

Here, the facts for one client provided that the distribution is preferred stock, per 305(a), not in respect of preferred stock already owned, not in lieu of cash, and not to any other exception provided in Section 305(b) as immediately triggering inclusion in gross income.  Section 306 applies in this case where the stock is defined as Section 306 stock and is sold.  When sold, it is treated as a gain at full market value or proceeds of that stock sale, and per Section 306(c) and Section 316(a) is only taxable where it comes out of earnings and profits.  If there were no earnings and profits, it would be considered a redemption.

Thus, in this case, the preferred stock received without a known exception to 305(a), and is taxable when sold on full value of the sale, and limited to the amount of earnings and profits.

Worldview Consulting & Accounting, Inc. is an Oregon registered CPA accounting firm. William Burwell, CPA, CFF, MBA, CPIM, is a business consultant and financial forensic accounting services professional with over twenty years of high technology industry experience. Licensed in Oregon and Massachusetts.

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LLC Owned by S Corporation

Disregarded Entities Under 100% S Corporation Ownership

Worldview Consulting & Accounting, Inc., as a Portland CPA firm, provides tax advisory services to help its clients understand the tax code and intricacies of proper S corporation reporting.  For example, when a Small Business Corporation, otherwise known as an “S Corporation,” owns 100% of the stock in an LLC.  Presume the LLC has made no specific tax elections.

The issue, in this case, is how the Internal Revenue Service will treat the income, taxable or otherwise, coming from the LLC to its owners in the S Corporation.  The shareholders of the S Corporation will have earnings passed to them through the S Corporation and, therefore, the earnings coming to them from the wholly owned LLC need to be clarified.

Section 1361 defines S Corporation as a small business corporation, making a valid election per Section 1362(a) as to any tax year, and that has less than or equal to 100 shareholders, only one class of stock, and has no non-US-citizen owners.

1361(b)(3)(A) provides that a corporation where the S Corporation owns 100% of the stock of such corporation can be treated as a “qualified subchapter S subsidiary.”  Thus, per Section 1361(b), a “corporation which is a qualified subchapter S subsidiary shall not be treated as a separate corporation,” and “all assets, liabilities, and items of income, deduction, and credit of a qualified subchapter S subsidiary shall be treated as assets, liabilities, and such items (as the case may be) of the S Corporation.”

Under Reg. Sec. 301.7701-2(a), a business entity with two or more members is classified for federal tax purposes as either a corporation or partnership, and with only one member is classified as a corporation and is disregarded.  If it is a disregarded entity, then it is treated in the same manner as if a part of its owner.

Under Reg. Sec. 301.7701-2(b)(3), a corporation is also defined as a business entity organized under state law if that state jurisdiction describes such as a “joint-stock company.”

Under Reg. Sec. 301.7701-2(c)(1), a partnership exists if it has at least two members.  Under Reg. Sec. 301.7701-2(c)(2), a wholly owned business entity with only a single owner that is not a corporation is disregarded as an entity separate from its owner.

Here, we are given an LLC 100% owned by the S Corporation.  We can presume that the LLC is organized under a state statute since this is the only way such an entity is allowed for purposes of limited liability and is, thus, not per se a corporation under federal definitions.  We are also not told whether it is defined as a joint-stock company by the actual jurisdiction involved.  Given the fact that the LLC is a wholly owned business entity, if not a corporation, under Reg. Sec. 301.7701-2 it is “disregarded as an entity separate from its owner.”  Similarly, per Sections 1361 and 1362, the LLC could be a qualified subchapter S subsidiary of the S Corporation if elected to be as such by the S Corporation under Section 1363.

Since the subsidiary LLC will be disregarded as a separate entity for federal income tax purposes, all items of earnings and losses will be considered one and the same with the S Corporation as its owner.  This means the shareholders of the S Corporation will report the earnings and losses of the LLC as pass-through earnings and losses on their individual tax returns as reported by the S Corporation.

Thus, all of the LLC earnings and losses will be disregarded and considered one and the same with the S Corporation for tax purposes.

Worldview Consulting & Accounting, Inc. is an Oregon registered CPA accounting firm. William Burwell, MBA, CPA, CFF, CFE is a business consultant and financial forensic accounting services professional with over twenty years of high technology industry experience. Licensed in Oregon and Washington.

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