M&A Tax Shop Talk – “F reorganization” Part II

May 11, 2016

Still thinking about selling your business? Do you have the proper techniques and structures in place?

Generally, one of the most powerful planning techniques to structure a tax efficient sales transaction of your business is the installment sale reporting method under IRC Section 453. However, there are some complexities and inherit limitations that requires an experienced M&A tax planning professional to work around in the context of an S corporation target.

Installment sale reporting doctrine generally supports the proposition that there will not be a tax on the portion of the selling proceeds that you have not constructively received regardless of your overall tax method of accounting. However, keep in mind that the term constructive receipt is very broad and it includes deemed consideration constructively received (i.e., assumed liabilities by the buyer party) and it excludes any portion of the purchase price allocated to hot assets that do not qualify for installment sale treatment.

Under the current rules and regulations, there are tremendous planning opportunities when combining installment sale reporting in the context of an F reorganization. However, if this powerful combination of techniques is not fully understood and properly coordinated, it can yield unintended, devastating tax ramifications to you.

For example, under current law, the S corporation target has the ability to distribute the collection of its outstanding installment sale obligation to its selling shareholders without triggering any taxable gain at the entity level. The selling shareholders will be able to step into the shoes of the S corporation and report the remaining, outstanding installment sale obligation as collected. This planning tax provision is generally referred to as the “H Rule” and is not available unless the installment sale obligation stems from a sales transaction, transacted after the S corporation has adopted a plan of liquidation under the 12 months rule pursuant to Section 331.

Now in the context of an S corporation selling target that is undergoing an F reorganization and converting to an LLC status prior to completing the contemplated sales transaction, the described H Rule provision is not appropriate if it involves an equity rolled-over portion consideration. In this particular circumstance, because the selling S corporation will not be liquidated within 12 months after completing the sales transaction, the H rule is not applicable and the distribution of the installment sale obligation to any selling shareholder would constitute an immediate taxable event.

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