M&A Shop Talk: Tax Planning Using One-Day Note Concept Application

An S corporation selling shareholder should always evaluate whether the “one-day note” obligation planning concept will achieve federal and state tax optimization objectives of an asset sale transaction arrangement. There are some exceptions to applying this concept due to business reasons or overriding tax regimes, beyond the scope of this blog.

The current tax provisions of the one-day note tax calculation require that the pre-liquidation calculated tax basis of an S corporation selling target, following the consummation of an asset sale transaction, should be allocated between the cash and non-cash liquidation components respectively. Accordingly, the selling shareholders will immediately recognize the cash liquidation proceeds less allocated S corporation tax basis. Any remaining tax basis allocated to the deferred income items will be recognized proportionally as the deferred income items are collected.

The described mandatory allocation mechanism will generally create an acceleration of gain recognition tax effect. This is because a substantial portion of the pre-liquidating stock tax basis calculated, including the gain recognition from the deemed asset sale prior to liquidation, will be allocated to the deferred income item. Such allocated stock basis will not be recognized until the deferred income items are eventually collected. In extreme situations, the non-collection of deferred income items can create an unused capital loss whipsaw tax effect that is beyond the scope of this blog. Therefore, the proper application of the one-day note planning concept will mechanically reduce the pre-liquidation tax basis allocated to the deferred income items and safeguard against the described negative tax implications.

From a state tax minimization perspective, many state taxing jurisdictions currently conform to federal law income tax statutes regarding installment sale reporting rules. This includes the non-taxable treatment and distribution of a deferred note receivable obligation stemming from an asset sale or liquidation scenario. The one-day note planning concept will generally minimize, or in some case totally mitigate, all non-resident income tax burdens incurred by a bona fide residents and selling shareholders living in a  no state tax jurisdiction, such as Florida, Texas, and Washington. This concept would also be applicable to certain selling shareholders who would be subject to double taxation because of non-conformity S Corporation pass-through tax treatment, such as the District of Columbia with respect to Virginia residents. This is because the District of Columbia franchise tax is not considered a creditable income tax under Virginia income tax statute.

Please note that the one-day note tax planning concept will only mechanically work pursuant to an approved and adopted plan of liquidation that is beyond the scope of this blog or pursuant to a Sec 338(h) (10) or Sec 336(e) tax election.

Contact Aprio to learn more about the one-day note concept application and how it may apply to your business.