Taking an S corporation public.
* 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 shares, with a tax basis of $20,000 and a market value of $120,000 ($12 per share). X seeks to offer shares to the public and receive $60,000 in exchange. The S corporation has $20,000 of AAA. X has two alternatives: 1. X could sell 5,000 shares (50%) at $12 per share and receive $60,000. As X's basis in the shares sold is $10,000, X would recognize $50,000 of capital gain. 2. X could receive a distribution from the S corporation of $20,000. The distribution would be tax free to X and would reduce X's basis to zero. Subsequently, X would sell 4,000 shares at $10 per share (i.e., the post-distribution value) for a total sales price of $40,000, which X would recognize as capital gain.
X would receive $60,000 under either alternative, but the distribution of AAA results in $10,000 less of capital gain. Note, however, that the first alternative leaves x with $10,000 of basis in the shares retained.
An S corporation may make distributions of AAA before or after the public offering. Sec. 1371(e) allows terminated S corporations to make distributions during the post-termination transition period (PTTP). Under Sec. 1377(b)(1), the PTTP is:
1. The period beginning on the day after the last day of the corporation's last tax year as an S corporation and ending on the later of (a) one year after the termination's effective date or (b) the due date of the return for the last year as an S corporation; or
2. The 120-day period beginning on the date of a determination that the corporation's S election had terminated in a previous year.
A determination is defined in Sec. 1377(b)(2) as a final court decision, closing agreement or agreement between the IRS and the corporation that the corporation failed to qualify as an S corporation.
Distributions of AAA typically may be made with cash, notes or property. However, distributions made during the PTTP may only be made in cash (Sec. 1371(e)). Also, the PTTP distributions may be made only to the extent of the corporation's AAA. Therefore, it is imperative to properly plan for PTTP distributions if sufficient cash is not available to distribute all of the corporation's AAA.
Disposition of unwanted corporate assets
Before a public offering, an S corporation may examine whether it holds assets unnecessary to its business operation or that it otherwise seeks to dispose of. By disposing of unwanted assets before the public offering, the corporation can avoid the double taxation that would apply if the asset dispositions occurred after termination of S status. However, the built-in gains tax consequences of Sec. 1374 should be considered. Additionally, the S corporation's AAA balance is increased by the amount of the gain, which increases the amount of distributions that can be made tax free to shareholders. The shareholders are taxed on the capital gain from the sale of the assets, but receive an increase in stock basis from which they may receive tax-free AAA distributions.
Estimated tax payments
Corporate Federal and state estimated tax payment requirements must be reviewed to assist the former S corporation in planning the timing of these payments. Many former multistate S corporations will be subject to state estimated tax payment rules that may not mirror the Federal payment dates or penalty avoidance thresholds.
PRE-IPO reincorporation--type F reorganization
Before offering their stock for sale to the public, many S corporations reincorporate in a state with laws favorable to publicly held corporations, such as Delaware. These reincorporations are typically accomplished by a type F reorganization (Sec. 368(a)(1)(F)), which is a mere change in identity, form or place of organization. An F reorganization does not terminate a corporation's S status (Rev. Rul. 64-250), and the surviving corporation is not required to make an S election (although a protective election may be advisable). If the reorganization has independent economic significance (see Dunlop & Associates, Inc., 47 TC 542 (1967)), the F reorganization may occur in conjunction with the IPO without substantial risk that the reorganization will fail due to a change in existing shareholders. Risk of the reorganization's failing is further reduced by reincorporating before the IPO is sure to take place. However, the reorganization must satisfy the continuity-of-interest test of Regs. Sec. 1.368-1(b) and (d).
In the F reorganization context, the continuity-of-interest test requires exact identity of shareholders before and after the transaction. In addition, the step-transaction doctrine may be applied if the IPO occurs a short time after the F reorganization. If the reorganization fails the continuity-of-interest test, the reorganization will be considered a taxable event.
From Paul J. Schlather, CPA, and Thomas P. Rudibaugh, CPA, Cleveland, Ohio, and P. Michael Baldasaro, CPA, New York, N.Y.
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|Author:||Baldasaro, P. Michael|
|Publication:||The Tax Adviser|
|Date:||Nov 1, 1995|
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