Tax & Sports Update

S Corporation - When Should You Keep the S Corporation Alive After an Asset Sale?

Posted by Joseph B. Darby III on Apr 16, 2015 2:36:00 PM

dollarsign.jpgThe Situation

In contrast to the situation discussed in another blog post where, immediately after an asset sale, the S corporation's inside tax basis is greater than the shareholders outside tax basis, an entirely different tax strategy may make sense if the tax basis relationship is reversed — i.e., when the inside tax basis is higher than the outside tax basis.

In particular, following an asset sale where the inside tax basis of an S corporation exceeds the outside tax basis, it may make sense to distribute out an amount of cash and property equal to the outside basis, but then consider keeping the S corporation alive and retaining am anount equal to the tax-basis differential.

Example

Assume the S corporation was a C corporation for many years before electing S status in 1986, and therefore has inside tax basis that is $7 million higher than outside tax basis, due to the fact that during its C corporation period it accumulated $7 million of E&P that was held and reinvested at the corporate level.

On a sale of the S corporation assets for $50 million, the founder is interested in keeping that last $7 million in the corporation to do something else. The founder may be intrigued by the following strategy: sell the company assets, distributing all the $50 million of cash proceeds except for the last $7 million. At that point in time the outside tax  basis of all shareholders is reduced to zero by the distribution of $43 million in cash, and so, if the S corporation distributed the last $7 million of cash proceeds, the shareholders would have a capital gain transaction, and would pay what is, in substance, a “second” level of tax on the total transaction.

On the other hand, if the last $7 million is retained at the S corporation level, the shareholders will have zero outside tax basis and $7 million of cash inside the company, and the founder might choose to buy a new company or engage in some new business or investment activity.

A Zero-Interest Loan from the Government – That May Also Be Forgiven

This transaction is the equivalent of an interest-free loan from the federal and state governments of the tax amount that would otherwise be collected on $7 million of LTCG, which is approximately 30%, or about $2.1 million. By keeping the S corporation alive and retaining the last $7 million in cash proceeds, the S corporation (and by proxy its shareholders) can instead borrow this amount interest-free and use it indefinitely.

Moreover, on the passing of the founder, there would be a step up in outside tax basis under Code § 1014 to fair market value, and so, on a subsequent liquidation of the S corporation by the estate or the heirs, the successor(s) would probably never have to repay that interest-free loan because the outside tax basis would equal the value of the assets held in the S corporation at the date of the founder’s death. In effect, the founder can borrow the $2.1 million interest-free for the rest of his life, and on death the debt is forgiven.  [Note:  If the dollar amounts are large, the trade-off between including the S corporation stock in the estate of the founder (subject to estate tax), versus the “free pass” on income taxation provided under Code § 1014, can be interesting and complicated, so this strategy is more likely to be of interest to “small” or “medium” sized transactions.]

Cautionary Additional Thoughts

Be aware that because the S corporation in the above example has substantial prior E&P from C corporation years, it will likely be subject to the twin whammy of Code §§ 1362(d)(3) and 1375.  The former is a much larger concern than the latter, because the former can cause the S corporation to lose its S status if more than 25% of S corporation income is from passive sources for three consecutive tax years.

The good news: There are investment strategies that can reduce or obviate these Code §§ 1362(d)(3) and 1375 problems, but the single best way to avoid it is for the S corporation to go on and engage in the next business activity.  Good luck!! With a $2.1 million interest-free loan, you are off to a great start.

Topics: Tax Law, Partnership Tax, S Corporation

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Sullivan's Tax & Sports Update provides timely updates and cutting-edge commentary on all issues affecting U.S. taxation, and, of course, an always humorous take on sports! Edited by Joseph B. Darby III, a partner in Sullivan's Tax Department.

The material on this site is for general information only and is not legal advice. No liability is accepted for any loss or damage which may result from reliance on it. Always consult a qualified lawyer about a specific legal problem.

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