Why Flow-Through Entities Are Worth More Than C Corporations

It is one of the great fundamentals of our income tax system that businesses that are organized and taxed as C corporations for income tax purposes are subject to two levels of tax.  That is to say, both current earnings and realized appreciation are taxed first at the corporate level and a second time when the earnings or appreciation are distributed to the stockholders. 

A purchaser’s preferred acquisition structure for both tax and non-tax reasons is generally an asset sale.  In the case of the sale of assets of a C corporation, the presence of this double level of tax makes an asset sale highly tax inefficient.  Thus, being organized as a C corporation for tax purposes can prevent the selling stockholders from obtaining the premium that a purchaser is generally willing to pay for an acquisition of assets.

Fortunately, many entities have either elected to be taxed for income tax purposes as S corporations or are taxed as partnerships under the “Check-the-Box” regulations. 

For S corporations, a simple tax election known as a 338(h)(10) election can often be made in connection with the sale of the stock of an entity taxed as an S corporation that can significantly enhance the value of the S corporation target to a corporate purchaser.  This enhanced value should be something which can then be captured by the selling stockholders in the price negotiation. 

Premium Value for an Asset Purchase

The value of the tax benefit to the purchaser of an asset purchase may be as much as 20 to 25 percent of the premium paid for a business.  The premium, for these purposes, is measured by the excess of the purchase price over the target’s tax basis in its assets.

For example: 

• Assume a $100 million purchase price for a business which has a $25 million tax basis in its assets (an implied $75 million premium).
• Further assume an 8 percent discount rate and a 40 percent effective tax rate for the purchaser.
• Finally, assume, as is often the case, that the entire premium is allocable to the goodwill and going concern value of the business (and therefore amortized over a fifteen-year period). 

On these assumptions, the present value of the amortization deductions (i.e., the present value of the increased cash flow resulting from the lower income taxes) would be approximately $17 million.

Under classic economic theory, these tax benefits should enable a seller to obtain significant additional purchase consideration for the sale of the business in an asset transaction over that which would be payable in a stock transaction.[1]

Thus, an asset purchase is an optional tax structure to maximize value.

When an Asset Sale is Not Viable

But what if an asset purchase is not available because of business limitations?

Sale of Partnership Interests

Under Rev. Rul. 99-6, where 100% of the interests in an entity taxed as a partnership are acquired, the purchaser is treated as having acquired the assets of the entity in a taxable asset purchase.[2]  This is the optimal result for tax purposes for the acquiror.

Impact of the 338(h)(10) Election on a Stock Sale

When the acquisition of an S corporation cannot be structured as an asset sale for commercial or business reasons, it is generally structured as a stock sale for state law purposes.  This taxable stock purchase may take the form of a “cash out triangular merger” for a variety of reasons, most notably dealing with numerous small or potentially recalcitrant selling shareholders. 

Where the purchaser in a taxable stock purchase of an S corporation is a corporation, the parties can make an income tax election, often with minimal incremental income tax cost to the selling stockholders, that will treat the stock purchase for U.S. federal and most state income tax purposes as an asset purchase.  This can provide a valuable economic benefit to the purchaser.

The election in question is a 338(h)(10) election and is made, not surprisingly, pursuant to Section 338(h)(10) of the Internal Revenue Code.  It is made jointly by the purchaser and all of the stockholders of the target corporation. 

The deemed fiction for income tax purposes of a 338(h)(10) election  is that while still owned by the selling stockholders, the target is treated as though it sold all of its assets to a new corporation (acquired by the purchaser) and then liquidated, distributing the sale proceeds to the selling stockholders.  As a result, the purchaser acquires the target business with a full fair market value tax basis in the assets.  This “basis step up” gives rise to enhanced depreciation and amortization deductions that are valuable to the purchaser.

Potential Qualification Traps for the 338(h)(10) Election

To make a 338(h)(10) election, 80 percent or more of the target corporation’s stock must be acquired in a 12-month period by a corporation in a “purchase.”  “Purchase” for this purpose excludes tax-free and partially tax-free transactions.  Thus, if a seller receives any rollover equity in the transaction, it will be necessary to structure the transaction so that the rollover equity is taxed to the selling stockholders when received.[3]  Likewise, non-corporate purchasers cannot make a 338(h)(10) election.

Benefits Outweigh Costs

Assuming the acquisition target has always been an S corporation, or has been an S corporation for more than ten years, the tax resulting benefit to the purchaser often comes at little cost to the selling shareholders. 

A point that is often not fully appreciated is that the stockholders of an S corporation target will recognize the same aggregate amount of gain or loss irrespective of whether the acquisition of the business is structured as a stock sale or a stock sale with a Section 338(h)(10) election.  This results because the selling stockholders’ stock basis in their target stock is increased by any gain recognized on the deemed asset sale and this increased tax basis reduces the gain to the seller(s) upon the deemed liquidation of the S corporation target. 

The potential incremental costs to the selling stockholders in a 338(h)(10) setting thus arise because

(i)         the gain on certain assets may be taxed at ordinary income rates rather than the favorable capital gains rate that otherwise would have applied to the stock gain, and

(ii)        the state income tax cost to the selling stockholders may be higher (although it may be lower in some cases). 

In most cases, these incremental costs are modest and may be acceptable to the selling stockholders. 

Even if the selling stockholders are not willing to bear these incremental costs, the benefit of the section 338(h)(10) election to the purchaser is usually significant enough such that the purchaser may be willing to make the selling stockholders whole for any incremental increased income taxes resulting from the election with a tax “gross-up” provision.

Medicare Tax

Beginning in 2013, for selling owners who are active in the business (or who are deemed active in the business), S corporation status or partnership status provides another important tax benefit. 

As part of the Healthcare Act, Section 1411 of the Internal Revenue Code imposes a 3.8 percent tax on “net investment income.”  For owners who are active in the business of the S corporation or of the partnership, and are thus able to avoid their ownership being characterized as an interest in a passive activity, this 3.8 percent tax does not apply to any gain on sale. 

For owners who are not active in the business and whose interest is characterized as a passive activity, however, the 3.8 percent tax will apply to the resulting gain.  The result occurs regardless of whether a Section 338(h)(10) election is made in connection with the acquisition of an S corporation. 

By contrast, capital gain on the sale of C corporation stock will generally be treated as investment income for purposes of Section 1411.  As a result, the 3.8 percent tax could be applicable on sales of stock in a C corporation by an individual, even if the selling stockholder is otherwise active in the C corporation’s business.

Purchaser Preference

In the context of purchase of an entity taxed as a partnership, the purchaser succeeds to any liabilities, including potential state tax liabilities as general liabilities.  So, even though the tax result of a purchase of an entity taxed as a partnership is the same as a purchase of assets, purchasers will generally prefer to do an asset acquisition rather than an entity acquisition.

Similarly, although the purchaser is treated as acquiring a new corporation for income tax purposes with a clean slate of tax attributes and a fair market value tax basis in its assets if the section 338(h)(10) election is made, this does not change the fact that the purchaser acquires the historic state law target entity (as opposed to assets of the target).  The acquiror will thus be saddled with liabilities related to taxes and other hidden liabilities of the target.  Well informed purchasers will seek to have the selling stockholders to indemnify the purchaser from such losses pursuant to the acquisition agreement. 

Conclusion

For the reasons noted above, purchasers will always continue to prefer an actual asset purchase where possible for non-tax reasons. 

Nevertheless, if -- as is often the case -- an asset sale is commercially not practical, in a partnership setting, a purchaser will still obtain a basis step-up in the context of the purchase of 100% of the entity equity interests.   As a result the assets of the business should have a premium value in the context of an acquisition.

Similarly, in the S corporation setting, the a corporate purchaser should still be able to realize the same tax benefits in the acquisition of the stock of an S corporation as in an asset purchase by using a Section 338(h)(10) election. 

Thus, under classic economic theory, an entity taxed as a flow-through will generally have greater value because of the significant tax benefits and that can be afforded the purchaser than for an entity that is not taxed as a flow-through.