09 Oct 2013 Exit Strategies
1. Partnership Mergers.
a. Basic Merger Transaction. California law allows an LLC or partnership to merge with other business entities. See Cal. Corp. Code sections 15678 and 17550. A merger may be desirable as a state law matter to address state and local tax concerns, minority owner and third party consents, dissenter remedies, compliance with or avoidance of transfer restrictions under partnership or operating agreements, and the like.
b. Partnership Divisions. A partnership division differs from a merger in that less than all the assets of the transferor partnership are transferred to the transferee. There will be multiple partnerships resulting from a division, and may be more than one continuing partnership. A partnership resulting from a division is a continuation (carryover of tax attributes) of the prior partnership if it has at least two partners (no single member resulting partnerships) who held interests in the prior partnership before the division, whose interests together exceed 50% of the profits and capital of the prior partnership.
c. Tax Consequences. Code section 708 and the regulations thereunder describe the tax consequences of a merger or division of partnerships. For tax purposes, a partnership merger or division will be deemed to take one of two forms:
i. The partnership that does not continue (the terminating partnership) contributes its assets and liabilities to the resulting partnership in exchange for interests in the resulting partnership, and immediately thereafter, distributes interests in the resulting partnership to its partners in liquidation of the terminating partnership (Assets-Over Form).
ii. The terminating partnership liquidates by distributing its assets and liabilities to its partners who then contribute the assets and liabilities to the resulting partnership (Assets-Up Form).
The default for partnership mergers and divisions is the Assets-Over Form, so that if a transaction is not characterized under the Assets-Up Form, it will be characterized under the Assets-Over Form regardless of whether that form is followed. If the taxpayer deliberately uses either an “interests-over” (the ownership interests in the old entity are contributed to the new entity, and the old entity is then liquidated) approach or a statutory merger approach, the form of the transaction will be disregarded and it will be recast into an Assets-Over form for tax purposes.
iii. Redemptions are permitted in connection with mergers.
iv. Form controls if assets are actually titled in the name of the partners (e.g. assets up merger will be treated as such if assets are actually distributed).
d. Continuing and Terminating Partnerships. For tax purposes, the resulting partnership of a merger or division is considered a continuation of the partnership whose members own more than 50 percent of the capital and profits of the resulting partnership. The most valuable entity (greatest net assets) is deemed the survivor of a merger when more than one entity is deemed to continue under “greater than 50%” ownership test (members of merging partnership own more than 50% of capital and profits of resulting partnership). The resulting partnership takes an exchange basis in the distributed assets under section 732(b), and is subject to the preexisting elections made by the prior partnership. The continuing partnership inherits the historical tax attributes of the merging or dividing partnership.
e. Application of Anti-Mixing Bowl Rules. Under Section 704(c)(1)(B), if a partner contributes property to a partnership, and within 7 years the partnership distributes that property to another partner, the contributing partner recognizes gain or loss in an amount equal to the gain or loss the partner would have been allocated under Section 704(c)(1)(A) on a sale of the property by the partnership at its fair market value at the time of the contribution. Section 737 taxes a distributee partner up to the amount of his pre-contribution gain. In the case of an Assets Over Merger, a partnership’s transfer of all its assets followed by complete liquidation of partnership is not subject to sections 704(c)(1)(B) or 737. Subsequent distributions of the transferor’s properties by the transferee, however, trigger gain to same extent as if distributed by the transferor. Thisexception applies only to a merger involving a transfer of all the transferor partnership’s assets, and only applies to an Assets Over type merger (not an Assets Up type).
A Partnership’s section 721 transfer to another partnership of all section 704(c) property contributed by a partner, followed by a distribution of the transferee partnership’s interests in complete liquidation of the contributing partner’s interest, is not subject to section 737. This rule prevents gain from triggering under section 737 upon the distribution of transferee interests (but does not prevent gain under section 704(c)(1)(B)). Under a “subsequent distribution” rule, the prior period that 704(c) assets were held is included for purposes of the 7-year holding requirement. Also, a transferor’s reverse 704(c) gain is not triggered under section 737 upon a subsequent distribution of the transferor’s contributed property. Gain is triggered in an Assets Up division, except possibly for a pro rata division.
f. Cash Outs. If a partner in a transferor partnership receives cash in the merger, he or she is treated as selling that interest in an Assets Over merger if the merger agreement specifies that the transferee partnership is buying the interest, the consideration is specified, and the transferor consents to that characterization.
g. Liabilities. Partners in an Assets Over merger may net increases and decreases in their shares of pre and post merger debt for purposes of determining section 752 gain. A merger of a partnership with nonqualified liabilities (under Treas. Reg. Section 1.707-5) may result in a deemed sale.
2. Inter-Species Mergers.
a. Merger of Corporation into an LLC or partnership under a “cross-species” merger statute (e.g. Cal. Corp. Code sections 1113 and 17550 et seq.).
i. “Assets-over” model applied to inter species merger. PLR’s 9701029 9543017, but parties can structure transaction as assets up or interests over.
ii. Regardless of the form selected, the merger of a corporation into a partnership will not be a nonrecognition transaction.
b. Merger of an S corporation into an LLC or partnership. The built-in gain rules (if applicable) may result in a tax at the shareholder and corporate levels and the transaction may trigger S corporation passive investment income under Code section 1362. A conversion involving a sale of assets by an S corporation could also result in the recognition of corporate level income if the S corporation has C corporation earnings and profits (i.e. if the S corporation had at one time been a C corporation or if the S corporation was the surviving entity in a merger with a C corporation).
3. Mergers Involving Disregarded Entities. Section 368 provides general nonrecognition treatment for a statutory merger or consolidation effected pursuant to the corporation laws of the United States or a State or Territory or the District of Columbia. Under Treas. Reg. Section 301.7701-2(a), a one owner LLC or Qsub (Code section 1361(b)(3)(B)) may be disregarded as an entity separate from its owner for Federal tax purposes. Because a QSub is a corporation under state law, state merger laws generally permit them to merge with other corporations, and California law permits an LLC to merge with a corporation. Under 2003 final regulations, a corporation may merge under section 368 into a disregarded entity (wholly owned by a corporation) if the following events occur simultaneously at the effective time of the transaction: (1) all of the assets (other than those distributed in the transaction) and liabilities (except to the extent satisfied or discharged in the transaction) of the transferor become the assets and liabilities of the transferee (as a unit) and (2) the transferor ceases its separate legal existence. A merger of a disregarded entity into a corporation will not qualify as a statutory merger or consolidation under section 368(a)(1)(A) because all of the transferor unit’s assets may not be transferred to the transferee and the separate legal existence of the transferor (i.e. the corporate owner) does not terminate as a matter of law (but might qualify as a type C reorganization in the requirements are otherwise met).
4. S Corporation Section 338(h)(10) Election.
a. Generally. A Section 338 transaction is a purchase of stock that is treated as a sale of assets for income tax purposes. If an S corporation makes the 338(h)(10) election, the corporation is treated as having sold its assets (recognizing all its gain) and liquidated while owned by the sellers. Because the selling shareholder’s basis in the S corporation’s shares is increased under §1367 to reflect gain recognition on the deemed asset sale, the deemed post-sale liquidation generally will not give rise to additional tax, and the S corporation owners will disregard any gain from the sale of their S corporation stock. The effect of the election is that the seller will report the gain from the deemed sale of assets and the buyer will take a fair market value basis in the assets of the acquired entity.
b. Requirements. A 338(h)(10) election may be made for a domestic target S corporation if the purchasing corporation makes a qualified stock purchase of target stock from S corporation shareholders, and the purchasing company and the S corporation shareholders make a joint §338(h)(10) election on Form 8023 (Corporate Qualified Stock Purchases). Only a purchasing corporation (not an individual) is eligible to make a joint §338(h)(10) election with the seller, and only if it has purchased, in one or more transactions during the “12-month acquisition period,” at least 80% (by vote and value) of target’s stock. The §338(h)(10) election must be made not later than the 15th day of the 9th month beginning after the month that includes the acquisition date. If a §338 election (but not a §338(h)(10) election) is made for an S corporation, the S corporation must file a separate C corporate return that includes only the items resulting from the deemed sale, and a separate S corporation return for the short taxable year ending on the acquisition date but excluding the deemed sale. If an (h)(10) election is made, the S corporation will include the gain or loss from the deemed sale on a final return for its final taxable year ending at the close of the acquisition date. The final return will include both the results of the taxable year and the deemed sale gain or loss. As a deemed asset purchase, Form 8023 is to be filed with the District Director and is attached to the tax return of the buyer and the seller showing the allocation of purchase price among the classes of assets. In addition, any ancillary consulting, management, lease arrangements, covenants not to compete and other side agreements must be disclosed.
c. Calculation of Gain. The S Corporation is deemed to sell its assets for the aggregate deemed sale price (ADSP), which is the “grossed-up amount realized” (as defined below) on the sale of stock and the S Corporation’s liabilities. The ADSP is then allocated among the assets under the residual method to determine deemed sale gain. Since the S corporation recognizes gain or loss on the deemed sale of its assets, the 338 election may have the effect of recharacterizing the income/gain from capital gain on the sale of stock to ordinary income on the sale of the S corporation’s assets. In addition, if the S corporation has built-in gain (BIG) assets, the S corporation is liable for BIG tax arising out of the deemed asset sale. The “grossed-up amount realized” is (1) the value of the target stock purchased during the 12-month acquisition period (“recently purchased”); (2) divided by the percentage of target stock that is recently purchased; (3) less the selling costs incurred by the selling shareholders in connection with the sale of recently purchased stock
d. Adjusted Grossed-Up Basis (AGUB). The S corporation will be deemed to have purchased all the assets of the electing S corporation for (1) the grossed-up basis in the purchasing corporation’s recently purchased stock; (2) the purchasing corporation’s basis in nonrecently purchased target stock; and (3) the liabilities of the corporation. The AGUB is then allocated among the corporation’s assets using the residual method.
e. State Tax Issues. For state purposes, the (h)(10) election shifts gain to the corporate level, and may change the way in which the income is allocated or apportioned. Income derived from the sale of S corporation stock is generally allocated to the shareholder’s state of residence. If an (h)(10) election is made, however, the S corporation may be subject to an entity level tax on any income attributable to those states imposing such a tax, such as the 1.5% California franchise tax.
5. Technology and Operating Partnerships.
a. Section 174 and R&D Partnerships. Code section 174 allows a taxpayer to elect to deduct research and experimental expenditures incurred in connection with a trade or business or defer and amortize the expenses over a period selected by the taxpayer, which may not be shorter than 60 months. If expenditures of this type are neither deducted nor deferred and amortized, they are charged to capital and (1) deducted through depreciation over the estimated useful life of the asset generated by the expenditures; (2) offset against the sales price of the asset if it does not have a limited useful life; or (3) deducted as a loss if the asset is abandoned or the research project is a failure.
Section 174 expenses may be deducted by a taxpayer even when the research is carried on in his behalf by another person or organization. Treas. Reg. Section 1.174-2(a)(2). In addition, a taxpayer need not be conducting a trade or business at the time it incurs the research expenditure if it can demonstrate a ‘realistic prospect’ of subsequently entering its own business in connection with the fruits of the research, assuming that the research is successful. A taxpayer demonstrates such a prospect by manifesting both the objective intent to enter such a business and the capability of doing so. Courts and the IRS look to the following factors to distinguish between a passive investor and a taxpayer who had a realistic prospect of eventually engaging in a trade or business in connection with research and development expenditures: (1) the intent of the parties to the agreements; (2) the amount of capital retained by the taxpayer during the conduct of the research activity; (3) the exercise of control by the taxpayer over the person or entity performing the research; (4) the business activity of the taxpayer during the years in question; and (5) the experience of the taxpayer and others involved in the research. Case law indicates that a carefully structured R&D partnership should avoid granting exclusive license or marketing rights, or nominal price purchase options.
b. Capital Gains Treatment. Under Code section 1235, holders of patent rights may treat gains from the sale or exchange of all substantial rights to a patent as capital even if (i) the rights sold would otherwise be treated as inventory, (ii) the rights were held for less than one year, and (iii) the proceeds from the transfer are paid over time in a royalty-like stream. In order for partners to obtain the benefits of section 1235, the partners must qualify as “holders” and the sale must be to an unrelated partner (applying a 25% common ownership test). Each individual partner may qualify as a holder as to his share of a patent owned by the partnership if the individual is the inventor or acquired his interest in the patentable property from the individual creator(s). The Partnership must acquire its interest for consideration in money or money’s worth prior to actual reduction to practice (when it has been tested and operated successfully under operating conditions). Long-Term capital gain treatment may be available for transfers of patent rights under other sections of the Code when section 1235 does not apply, such as section 1221 (sale or exchange of a capital asset held for more than one year).
i. 80% Control. Under Code section 351, the exchanging shareholders must be in control (i.e. 80% ownership) of the transferee corporation immediately after the exchange. This require may impede the acquisition of assets in exchange for stock of an existing corporation.
ii. NQPS. The issuance of debt or nonqualified preferred stock by NewCo would be treated as boot. Nonqualified preferred stock is, subject to certain exceptions, any preferred stock if: (1) the holder has the right to require its redemption, (2) the issuer (or related person) is required to redeem, (3) the issuer has a right to redeem and it is more likely than not that the right will be exercised, or (4) the dividend rate on the stock varies with reference to interest rates or other indices. Code section 351(g). The economic terms of the preferred interest may require some revision to avoid a taxable result to the preferred shareholder.
iii. The Property Requirement. Stock must be issued in exchange for stock or property to qualify for section 351 treatment. “Property” includes patents, secret processes and formulae and other secret information subject to legal protection from unauthorized use. Courts have been more liberal in defining property rights than the IRS. A nonexclusive license may or may not be property. See E.I. Du Pont de Nemours and Company v. U.S., 471 F.2d 1211 (Ct. Cl. 1973) (non-exclusive license under a patent to manufacture, use and sell a particular product was property for §351 purposes even though the transferor kept certain rights in the patent).
iv. Subsequent sale or section 368 Transactions. An incorporation in anticipation of a section 368 merger with a corporation may be treated as a taxable sale under step transaction principles, since only a corporation (and not a partnership) can participate in a merger (as defined by Code section 368(a). Similar issues arise with respect to obtaining tax free incorporation treatment under Code section 351 if the NewCorp is to be disposed of immediately after the incorporation. See Rev. Rul. 54-96, 1954-1 C.B. 111; Rev. Rul. 70-140, 1970-1 C.B. 73 (incorporation followed by stock exchange).
6. Issues with Respect to Redeemed Partner or S Corporation Shareholder.
a. Allocation of S Corporation Income for Year of Buy Out. If a shareholder terminates his or her interest in an S Corporation during a taxable year, the taxable income of the shareholder is generally determined as a pro rata portion of the corporation’s income (or loss) during the entire year based on the number of days he or she was a shareholder during the year. The affected shareholders may agree to the closing of the books method. The “affected shareholders” are the shareholders whose interest terminated and all shareholders to whom such shareholder has transferred shares during the taxable year, or if the shareholder has transferred shares to the corporation, all shareholders during the taxable year. A buy sell or shareholders agreement may provide that the consent of less than all the affected shareholders is controlling. Partnerships may allocate income and loss for the change year using any reasonable method agreed to by the partners (hopefully in advance). See Treas. Reg. Section 1.706-1(c)(2)(ii).
b. Treatment of Payments to Withdrawing Partners. Under Code section 736(b)(3), a payment to a withdrawing partner for his or her share of good will and unrealized receivables is treated as a payment for the withdrawing partner’s share of the partnership’s assets, and not as a guaranteed payment or distributive share income. The remaining partners deduct or reduce their income for those payments and the withdrawing partner has ordinary income with respect to payments for his or her share of unrealized receivables. If capital is not a material income-producing factor for the partnership and the retiring partner was a general partner, the partnership can treat payments for good will as guaranteed payments or distributive shares of the partnership’s taxable income.
 “Code” refers to the Internal Revenue Code of 1986, as amended.
For additional information on legal issues, contact Roger Royse and see our blog.
For more information on mergers and acquisitions, and the tax aspects of purchases and sales of businesses, see RoyseLaw Mergers and Acquisitions, RoyseLaw Tax, Recent M&A Transactions, and blog posts at Royse University M&A, and Royse University Tax. Additional materials on mergers and acquisitions can be found at our blog posts at Franchise Tax Board Audits Sale of S Corp in 338(h)(10) Transaction, Corporate Reporting of Transactions Affecting Basis, M&A Trends and Qualified Small Business Stock. See M&A
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