Partially taxable asset acquisitions from S corporations.

• Author: Gruidl, Nick

In private equity and venture capital transactions, selling shareholders of an S corporation commonly seek a partially tax-deferred rollover of equity. While these transactions may take various forms, this item describes the differing results between a transaction accomplished through a Sec. 351 transfer and one structured as part sale/part contribution.

Acquisition of target QSub

When Target is an existing or a newly created qualified subchapter S subsidiary (QSub) of an S corporation and the Buyer acquires less than 100% of the stock in Target, the Buyer is treated as acquiring a proportionate interest in each asset and assuming a proportionate amount of each liability, determined based on the percentage of Newco stock sold (Sec. 1361(b)(3)(C)). Both the Buyer and the selling S corporation are then treated as contributing their shares of the assets and liabilities of QSub to a newly created C corporation (Newco) in Sec. 351 transfers (Sec. 1361(b)(3)(C)). Therefore, the basis of the property held by each transferor must be ascertained to determine the basis of the assets held by Newco. Secs. 1001 and 1060 generally govern Buyer's basis in the acquired assets.

Under Sec. 1001, the gain or loss on the asset sale is calculated by comparing the amount realized from the sale with the adjusted basis in the assets. Regs. Sec. 1.1001-2(a)(l) provides that the amount realized from a sale or other disposition of property generally includes the amount of liabilities from which the transferor is discharged as a result of the sale or disposition. Thus, any liabilities of the Target assumed by the Buyer will be treated as additional consideration.

Where the acquisition represents an applicable asset acquisition as defined in Sec. 1060, the purchase consideration is allocated using the residual method provided under Regs. Sees. 1.338-6 and 1.338-7 (Sec. 1060(a) read with Regs. Sec. 1.1060-l(c)(2)). The residual method allocates the purchase price among seven asset classes, starting with the most liquid assets (with cash as class I) and moving on to assets with lesser liquidity (with goodwill and going-concern value as class VII). The purchase price allocated to an asset (other than a class VII asset) cannot exceed the fair market value (FMV) of that asset (Regs. Sec. 1.338-6(c)).

Example 1. Part sale/part contribution: S Corporation owns Target (T), a QSub that owns the following assets with a combined FMV of $400: Asset A with an FMV of $100 and basis...