Taking an S corporation public.

• Author: Schlather, Paul J.

As the stock market continues to be a valuable source of new funding for businesses, many S corporations have undergone initial public offerings (IPOs). These offerings raise many significant tax issues that need to be addressed on behalf of the S corporation and its shareholders. Among them are:

* Termination of S status caused by an IPO.

* Making distributions from the accumulated adjustments account (AAA).

* Disposition of unwanted corporate assets before an IPO.

* C corporation and shareholder estimated tax requirements.

* Reincorporating an S corporation before an IPO via an F reorganization, and meeting the continuity-of-interest test.

* Each case should be analyzed on its facts to determine whether not only these but also any other important tax factors must be considered.

Termination of S status

S status is terminated by the public offering; the entity ceases to be a qualified small business corporation. The termination of S status causes the corporation's tax year to be split into a short S year and a short C year, and its income to be prorated on a daily basis for the year (Sec. 1362(e)). The S corporation may avoid the proration of income by electing to close its books on the last day of the S year (Sec. 1362(e)(3)) if it obtains the consent of all who were shareholders during the S short year and all who are shareholders on the first day of the C year. In the public offering setting, the S corporation must obtain consent from all those who purchased shares in the public offering, which can be difficult and costly. Accordingly, it is generally beneficial to revoke the S election just prior to the offering's effective date. When more than 50% of the S corporation's stock is sold during the year, separate accounting between the S and C years is required. Legal counsel for the S corporation should be consulted as to the date subscribers became the legal owners of the shares, since subscription date and ownership date may differ under the state laws of the issuing corporation.

Distribution of AAA

The S shareholders who seek to sell less than 100% of their stock in the IPO may realize significant tax benefits from a distribution of AAA. S corporation distributions are tax free to the extent of the corporation's AAA and the shareholders' tax basis. Additionally, a distribution of AAA may reduce the capital gain recognized by the shareholders on the sale of their stock.

Example: X, the sole shareholder of an S corporation, has 10,000...