The brand new world of S corporation reorganizations.

• Author: Karlinsky, Stewart S.
• Position: Internal Revenue Code Subchapter S

The Small Business Job Protection Act of 1996 liberalized the S corporation rules, enabling such corporations, for the first time, to have a C corporation subsidiary or a qualified subchapter S subsidiary. This, in turn, creates tremendous potential for S corporations to engage in reorganizations transactions to grow more rapidly, reduce state taxes or liability exposure or conduct business overseas more efficiently. This article explains some of the reorganization opportunities now available.

The Small Business Job Protection Act of 1996 (SBJPA) liberalized the criteria for qualifying as an S corporation. It allowed an S corporation to have up to 75 qualified shareholders and to own 80% or more of the stock of a C corporation or 100% of the stock of a qualified subchapter S subsidiary (QSSS).(1) However, only domestic corporations can elect S status and can have only one class of stock (albeit with different voting rights); further, corporations, partnerships and nonresident aliens still cannot be S shareholders.

The SBJPA provisions offer many tax planning opportunities for S corporations; for example, they can help an S corporation to restructure its activities to grow more rapidly, reduce state taxes or liability exposure or conduct business overseas more efficiently. Various tax-free and taxable restructuring and acquisition/disposition techniques are now available that will provide an advantage for S corporations vis-a-vis limited liability companies (LLCs) and partnerships. The Taxpayer Relief Act of 1997 (TRA '97) had little direct effect on S corporations, but the change in capital gains rates will influence the structuring of asset and stock acquisitions and dispositions.

This article will help the tax adviser put the additional options available to an S corporation in perspective; it will discuss the S corporation's role as either a buyer or seller in the context of a tax-free or taxable sale of assets or stock.

Liquidation or Merger

Often, a corporate liquidation (or its equivalent, a statutory cash merger)(2) can be a disastrous situation--if the target is a C corporation or an S subject to Sec. 1374 built-in gains (BIG) tax, the result is two gains and a step-up in basis of the acquired assets. However, if an S corporation target is not subject to BIG tax, the result may be more palatable: the target S corporation's shareholders recognize gain and the acquirer takes a stepped-up basis in the target's assets. After the SBJPA, an acquiring S corporation could use a reverse triangular cash merger(3) (discussed below) to acquire a target C corporation or squeeze out dissident shareholders and treat the transaction as a stock purchase, resulting in gain only at the shareholder level. If the acquirer wants a step-up in the basis of the assets, it can make a Sec. 338 election (discussed below).(4)

Liquidating S Corporation

A liquidating S corporation recognizes gain or loss on the distribution of assets to its shareholders, under Sec. 336(a). If Sec. 1374 does not apply, no corporate-level tax will be due. If the assets were sold to third parties and the proceeds distributed to the shareholders, the corporation again would not be taxable. Sec. 336(d)(1) and (2) might apply if the corporation incurs losses on the liquidation or sale; Sec. 267 does not apply to losses incurred in a liquidation.

When an S corporation liquidates, all of its tax attributes (including accumulated adjustments account (AAA), C corporation net operating losses (NOLs), suspended losses and adjusted earnings and profits (AE&P)) disappear. Thus, on the S corporation's final return, it is crucial to reflect all of the corporation's activities (including the short-period operating and investment income or loss, tax benefit rule income, write-offs of capitalized assets, organization costs, etc.).

When a corporation plans to liquidate, Form 966, Corporate Dissolution or Liquidation, should be filed, as well as appropriate Forms 1099-DIV, Statement for Recipients of Dividends and Distributions, and 1096, Annual Summary end transmittal of U.S. Information Returns. Because corporate status is a state right, the appropriate states should be notified of the planned dissolution and a plan of liquidation should be included in the minutes.

S Shareholders

Under Sec. 331, an S shareholder computes gain or loss on the corporation's liquidation by comparing his adjusted basis in his S stock to the net fair market value (FMV) of property received in the liquidation. If the shareholder has a loss, Sec. 267 does not limit its use. The shareholder's adjusted basis in his stock includes the corporation's gain or loss recognized on the liquidation, as well as any income or loss on the final S return. If the sale of assets to third parties and subsequent liquidation do not occur in the same year, a shareholder could get "whipsawed" by a capital gain in Year 1 and a capital loss in Year 2.

Under Sec. 334(a), the shareholder's basis in the property received is its FMV, unreduced by liabilities. Because of the step-up to FMV, the holding period in the shareholder's hands starts anew.

If, as part of the liquidation, the S corporation sells its assets on an installment basis to third parties, the shareholders step into the corporation's shoes and postpone their gain until payments on the notes are received, under Sec. 453(h)(1)(A). If the shareholder inherited the stock, the tax result may very be favorable: little or no gain and a step-up in basis of the assets.

Example 1: G dies owning 100% of the stock of M Corp., an S corporation, with an adjusted basis of $100,000 and an FMV of $1,000,000. M's basis and FMV of its assets are the same as that of G's stock. G's grandson, T, inherits the stock, but has no intention of continuing the business. M sells its assets to a third party at a $900,000 gain. T's stock basis will be $1,900,000. When he receives the $1,000,000 in sales proceeds, he will have a capital loss of $900,000 to offset against his passthrough gain. The net result is $1,000,000 cash, little tax liability to T and a step-up in the basis of M's assets for the acquirer.

Parent-Subsidiary Liquidation

If an S corporation (Parent) owns 80% or more of a C corporation (Subsidiary), a special rule applies. Sec. 337(a) allows Parent to liquidate Subsidiary without recognizing gain or loss on the distribution of property to Parent, whether in satisfaction of stock or debt. If Subsidiary sold property to third parties, gain or loss would be recognized. Under Sec. 336(d)(3), if Subsidiary were to distribute property in liquidation to its minority shareholders, gain (but not loss) would be recognized. These rules also apply if a third-tier subsidiary of an S corporation were to liquidate into a second-tier subsidiary or into a QSSS. If Parent lent Subsidiary funds and they are repaid with appreciated property, Subsidiary recognizes no gain or loss. However, if Subsidiary was a C corporation, Parent would now be subject to S corporate-level taxes (e.g., under Sec. 1374 or 1375).

According to Sec. 332(a), Parent does not recognize gain or loss on the receipt of property for Subsidiary's stock; instead, it takes a carryover basis in Subsidiary's assets and tax attributes, including AE&P, AAA, NOLs, accounting methods, etc., under Secs. 334(b) and 381(a)(1). Parent's basis in Subsidiary's stock disappears. If that stock basis (outside basis) is significantly higher than Subsidiary's basis in the assets (inside basis)...