Converting Stock Sales to Assets Sales (and Back Again) S Corporation Committee ABA Section of Taxation May 12, 2017 Washington, D.C. Mary Beth Dolan, John S. Harper Bryan Cave, LLP Morrison & Foerster, LLP St. Louis, MO McLean, VA marybeth.dolan@bryancave.com JHarper@mofo.com Edward A. Waters Dean, Mead, Egerton, Bloodworth, Capouano & Bozarth, P.A. Orlando, FL EWaters@deanmead.com 1
There and Back Again – a Fantasy for Tax Lawyers* 1. Converting stock sales to asset sales and vice-versa (§§338(h)(10), 336(e), 453(h), and 453B(h)) 2. Incorrect technical corrections (diluted installment sale benefits under §453(h) for S corporations) 3. Regulations implementing §453(h) at the shareholder level (Treas. Regs. §1.453-11) 4. Self-help remedy for distortions in the operation of §453(h) (the 100% note solution) 5. Limits on self-help: Grossed-up ADSP on less than 100% stock sales and other income recognition 6. State tax treatment of deemed assets and stock sale gains for nonresident stockholders 7. Survey of some state approaches: • Virginia - Federal conformity, and sourcing of nonresidents’ income from deemed asset and stock sales • District of Columbia – S corporations taxed, but conformity in definition of taxable income • California – Acceleration of installment gains at corporate level only • New York – Pass-through gain and §453(h) installment gain sourced at entity level • Ohio – Sourcing stock gain based on entity level activities – constitutional limits? • New Hampshire – Disregard of basis increase or election to pay tax on or asset basis increase • Other states (audience participation) *There are no safe paths in this part of the world. Remember you are over the Edge of the Wild now, and in for all sorts of fun wherever you go.” J.R.R. Tolkien 2
Start here: Actual stock sale – § 338(h)(10) or § 336(e) Section 338(h)(10) Section 336(e) 80%+ purchased 80%+ disposed by by single buyer shareholders to any buyers Target stock Target stock Buyer 1 A B C C Buyer 2 B A Buyer 3 Target Target §338 requires a single corporate purchaser of Target stock (or consolidated group acquirer) of at least 80% of Target. §336(e) permits any number and type of purchasers to be parties to stock dispositions that cumulate to at least an 80% disposition of Target stock. 3 Overlap rule: §338(h)(10) takes priority if the transaction qualifies under both sections.
Deem this: Constructive asset sale via §338(h)(10) or §336(e) Buyer(s) A B C 80 10 10 1 Deemed assets sale Old New Target Target Deemed consideration, including Buyer notes Treated for federal income tax purposes as if the sale of Old Target assets to New Target had actually occurred. Old Target treated as having received from New Target the consideration actually issued by Buyer(s) to the stockholders. Flow-through asset sale gain for state income tax purposes is generally sourced based on Old Target nexus factors. 4
Deem this: Liquidating distribution via §338(h)(10) or §336(e) A B C 2 80 10 10 Deemed distribution in liquidation to shareholders, including any Buyer notes Old Target All consideration paid by Buyer, including installment notes, are treated as if distributed by Old Target to shareholders, including installment notes issued by Buyer(s). Old Target has no gain on actual or deemed distributions of “qualifying installment obligations” via §453B(h). Shareholders treat consideration received from Buyer as if received for stock of Old Target in redemption of Old Target stock, per §453(h). Shareholders’ stock gain is gain from the sale of intangible assets, generally treated as income sourced to each shareholder’s state of residence. 5
Or do it yourself: Direct or DRE asset sale DRE deemed asset sale Actual asset sale A B C A B C 2 Target 1 Consideration DRE interests distributed in 1 liquidation Target assets 2 Consideration Target DRE Buyer Consideration distributed in Consideration liquidation Actual or DRE asset sale is more flexible than §336(e) and §338(h)(10) qualification. 6
Back home again: Deeming a stock sale Section 453(h)(1)(A): If, in a liquidation to which section §331 applies, the shareholder receives (in exchange for the shareholder's stock) an installment obligation acquired [by the corporation] in respect of a sale or exchange by the corporation during the 12- month period beginning on the date a plan of complete liquidation is adopted and the liquidation is completed during such 12-month period, then, for purposes of this section, the receipt of payments under such obligation (but not the receipt of such obligation) by the shareholder shall be treated as the receipt of payment for the stock. Additional Rules • Receivables from sales of inventory – limited to bulk sales to one person in one transaction. • Obligations allocated to depreciable property sales – if issuer of the obligation is related to the shareholder who receives the obligation, the obligation is treated as a payment in the year of the sale. • Stock basis must be allocated among all payments received in all years – overriding the general rule of basis recovery first in a §331 liquidating distribution. 7
Living fossils: General Utilities found alive! Section 453B(h): If— (1) an installment obligation is distributed by an S corporation in a complete liquidation, and (2) receipt of the obligation is not treated as payment for the stock by reason of section 453(h)(1), then, except for purposes of any tax imposed by subchapter S, no gain or loss with respect to the distribution of the obligation shall be recognized by the distributing corporation. Under regulations prescribed by the Secretary, the character of the gain or loss to the shareholder shall be determined in accordance with the principles of section 1366(b). Importance of lineage through General Utilities and old §337: • General Utilities and Operating Co. – no corporate income on distribution of appreciated property to stockholders (Codified in 1954 Code §§337 and 311) • Court Holding Co. – sale negotiated by corporation before distribution taxable • Cumberland Public Service Corp. – asset sale by shareholders after distribution not taxable to corporation • Old §337 eliminated inquiry of who negotiated the sale (if within the 12-month liquidation requirement) • Form 966 – vestigial (useful to show time of adoption of the plan of liquidation) • Plan of liquidation deemed adopted when making §338(h)(10) election • Relevance to corporate level qualification for installment reporting on accounts receivable? 8 • Relevance to state law taxation of stock gain with source determined at corporate level?
§453(h) computations: Treas. Regs. §1.453-11 • A shareholder receiving an installment note from a liquidating S corporation maximizes gain deferral by maximizing the gross profit percentage. • Gross Profit Percentage = (Selling price – Adjusted shareholder tax basis) / Total Contract Price). This percentage is the amount of gain that is recognized on receipt of each installment payment. • Gross Profit Percentage will be 100% when stock basis is zero. • Minimizing corporate level gain (and increasing loss) increases gross profit percentage. Corporate- level gain (i) accelerates shareholder income on the pass-through and (ii) increases shareholder stock basis above zero. • Deductions at the corporate level may offset income that would otherwise pass through and increase shareholder basis. Such deductions (e.g. compensation deductions, including option settlement payments) may not pass through to the shareholder anyway after basis is reduced to zero. • Buyer’s assumption of liabilities in excess of asset basis triggers gain to the S corporation and corresponding pass-through of that gain and stock basis increase. • A wrap-around note that is retained by the selling S corporation and shareholder(s) does not trigger gain (for actual and DYI asset sales). • Debt assumed by a shareholder in liquidation increases the shareholder’s basis in the stock, but does not increase the amount received by the shareholder in liquidation. Treas. Reg. §1.453-11(a)(4). • Consider whether, in light of the repeal of the General Utilities doctrine, the assumption of deductible debt by a shareholder creates a deduction at the corporate level as if paid by the corporation. 9
§453B(h) – A botched 1988 “technical correction” Dilution of installment sale deferral under §453(h) caused by cash at closing 80% 10% each FMV $8,000 FMV $1,000 Basis $1,200 Basis $150 B A C 100% Target stock Buyer 10 $10,000 purchase price 10 50% cash at closing and 80 50% note payable in 2018 Assets Target FMV $10,000 Basis $1,500 Corporate level gain computations $10,000 Deemed sale proceeds (cash and notes delivered to A, B and C) ($1,500) Less asset basis $8,500 Gross profit 85% Corporate gross profit percentage [$8,500 / $10,000] $5,000 Corporate deemed cash payment received $4,250 Corporate gain on deemed cash payment [85% x $5,000] 10
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