M&A Tax Structures for Closely Held Businesses
September 8, 2020
The buyer of a closely held business has strong reasons to purchase the target’s assets instead of stock. That way the buyer can pick and choose what assets to purchase and what liabilities to assume. Although successor liability may stick the buyer with some of the seller’s liabilities anyway.
But an asset acquisition won’t always work. A stock acquisition may be the only route to get some assets, such as valuable intellectual property licenses that can’t be transferred in an asset deal.
But what about a target’s highly appreciated real estate that the buyer does not want? That could present a problem to the target’s owner, even if his company is an S corporation, because getting the highly appreciated real estate out to the target owner could result in a large federal and often state income tax on the gain.
One taxpayer came up with a tax structure that solved this tax problem.
The proposed deal
The structure of the deal contemplated several steps. First, the target owner would form a holding company by transferring the S corporation target stock to the holding company in exchange for the holding company stock. The holding company would then make a QSub election for the target company.
This would then be followed by the target company’s distribution of the real estate to the holding company. Afterwards, the holding company would sell the target company stock to the buyer.
When the dust clears, the target owner would have cash from the buyer and stock in the holding company which would hold the real estate. The buyer would own the target stock with all of its assets except for the real estate.
The private letter ruling
The target asked the Internal Revenue Service to rule in advance that the only tax from the proposed transaction would on the gain from the sale of the non-real estate assets to the buyer. The Service agreed.
The IRS ruled that the target owner’s formation of the holding company by exchanging the owner’s target stock for holding company stock was not taxable because it was an “F” reorganization under Internal Revenue Code Section 368(a)(1)(F). Furthermore, the distribution of the real estate from the target company to the holding company was not taxable because the target company was a disregarded entity and so for tax purposes the real estate was already considered owned by the holding company. Finally, the Service ruled that the sale of the target stock to the buyer was treated for tax purposes as a sale of assets by the holding company because the target company was a disregard entity.
See Private Letter Ruling 201115016, Release Date: 4/15/2011 https://www.irs.gov/pub/irs-wd/1115016.pdf
In addition, since the buyer was buying assets for tax purposes it gets a step up in basis.
A private letter ruling can only be relied upon by this taxpayer. Another taxpayer can’t justify doing the same transaction with this private letter ruling. But this ruling is a good indication of how an IRS auditor would treat a similar transaction.
By John McCauley: I help people with M&A tax issues involving privately held companies.
Telephone: 714 273-6291
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