S corps. and Rev. Rul. 2008-18 F reorganizations

In this podcast episode, a collaboration between the JofA and the Tax Section Odyssey podcasts, Tony Nitti, CPA, partner—National Tax at EY, joins April Walker, CPA, CGMA, lead manager—Tax Practice & Ethics at AICPA & CIMA, from ENGAGE 2023.

The main topic of their discussion is Rev. Rul. 2008-18, delving into S corporation reorganizations.

Related resources

Rev. Rul. 2008-18 — Postulates two situations in which an S corporation becomes a qualified subchapter S subsidiary (QSub) of a newly formed corporation that will qualify as an F reorganization. The ruling also provides new guidance on the proper employer identification number (EIN) to be used by the entities in each situation.

Private equity and F reorganizations involving S corporations — The Tax Adviser, Sept. 1, 2020

6 reasons an S corporation wouldn’t need a PLR | Tax Section Odyssey —  Rev. Proc. 2022-19 provides procedures to allow S corporations and their shareholders to resolve frequently encountered issues without requesting a PLR.

What you’ll learn from this episode:

• How S corp. buyers can protect themselves against the risk of invalid S elections.
• An overview of Rev. Rul. 2008-18 and a hypothetical example of its applicability.
• A review of Rev. Proc. 2022-19 and fixes to invalid S elections.
• The extra step when an S corp. owns 100% of a qualified Subchapter S subsidiary.

Play the episode below or read the edited transcript:

To comment on this episode or to suggest an idea for another episode, contact Neil Amato at Neil.Amato@aicpa-cima.com.

Transcript

Neil Amato:

Welcome back to the Journal of Accountancy podcast. This is Neil Amato. Today’s episode is a special one, part of an ongoing collaboration with the AICPA Tax Section Odyssey podcast. The conversation you’ll hear is colleague April Walker speaking with Tony Nitti about S corps and Rev. Rul. 2008-18 F reorganizations.

April Walker: Hi, everyone, and welcome to this collaboration between the JofA podcast and the AICPA’s Tax Section Odyssey podcast. I’m April Walker, a lead manager from the Tax Section. On the AICPA’s Tax Section Odyssey podcast, we offer thought leadership on all things tax facing the profession.

Today I’m here with Tony Nitti. Tony is a partner at EY National Tax. He is a frequent guest of the show. I’m even more excited to be recording this today because we are recording together in person at ENGAGE. I asked Tony what he thought was important to talk about today. He brought up the topic that he is hearing a lot about, a lot of confusion about, a lot of misunderstandings about, and that is an F reorg. structure used in acquiring an S corporation in Rev. Rul. 2008-18.

First of all, for those who might be listening, who went like me, help, I need an overview of what you’re even, talking about, Tony. Talk to us about how this might apply, when it might apply, if you have clients who either might be the acquirer or the target. What are we talking about here?

Tony Nitti: First things first, yes, it’s good to be back together. It’s become a bit of an annual tradition.

Walker: It has.

Nitti: Then, just before I came in here, I was surprised to learn that there’s a trivia question where I was the first guest on an AICPA Town Hall. Is that right? I had no idea.

Walker: Yes.

Nitti: Everything from 2020–2022 is a blur. What we’re going to talk about today, when we call it either these F reorgs. or 2008-18 transactions, it is the most popular way in the current climate for someone to acquire an S corporation. We know that private equity is getting involved with acquiring everything, and so oftentimes it is private equity that wants to acquire an S corporation. Obviously, if they were to go out and acquire shares directly, the S election is going to terminate, and then you’ve got a C corp. on your hands, there’s whole bunch of other things going on. This has become the go-to transaction, and we’ll talk through it step-by-step from both the buyer and seller perspective.

But the reason I thought it was worth talking about today is just because something in the tax law has become very popular, does not mean that it’s necessarily well understood. We’ve experienced that sort of thing before, where the more you stop and actually think about this stuff, the more you go, why are we doing these steps that we’re doing? Or why is it a transaction that we use? And sometimes we just follow what everyone else is doing and don’t really think about what are we accomplishing, what are we not accomplishing, and other things. I just thought it would be fun to come in, talk for about 30 minutes or maybe less about what this transaction does, what it doesn’t do, when we want to consider it, when we don’t, that whole thing.

Walker: Sounds great.

Nitti: Let’s start with the hypothetical. It’s going to be the best way to explain all this. Let’s keep it simple. We’ve got private equity, set up as a partnership, and they would like to acquire the business operated by a current S corp. Here at AICPA ENGAGE, anybody that’s here on the tax side, they’ve got S corp. clients. A lot of times we will be the ones representing the seller. So it’s important to understand what this transaction holds for the seller, but there’s also going to be plenty of times where we represent a client that wants to buy an S corporation, so we’ve got to think about those buyer considerations as well.

Let’s just say we’ve got this private equity partnership that wants to buy this S corporation, 99 times out of 100 — and this is something I’ll talk about tomorrow in my M&A class — a buyer is going to want to buy assets. They’re going to want to buy assets because they’re going to want to get a stepped-up basis in those assets for depreciation and amortization purposes. But sometimes the buyer can’t buy assets. Because maybe those assets are not transferable, maybe for a particular business reason they need to acquire the legal interest in an entity, so that the EIN stays alive. You know how M&A works — like something’s going to force your hand.

From a buyer’s perspective here it’s how can I accomplish both of these things? How can I acquire the legal interest in this S corp. target, but yet get this stepped-up basis and the underlying assets? For years, the way we tried to accomplish that is by having the buyer and the selling shareholders of the S corporation jointly make an election under [Sec.] 338(h)(10) or, more recently, [Sec.] 336(e). That election was a magic bullet, but only for the buyer, and I’ll explain that. For the buyer, you make that election and for legal purposes, you’re treated as buying the stock because that’s what you bought. But for tax purposes, this fiction is created where the target S corporation is deemed to have sold all of its assets to a newly formed corporation owned by the buyer, and that gives them the step-up in basis and assets that they want. It’s win-win for the buyer.

It’s not win-win for the seller. The seller is giving something away because had they simply sold stock and not made a [338](h)(10) election, they get straight capital gains rates. But by making this election, they have to live with the deemed  consequences of the S corp. selling its assets, which means some of that gain may be converted to ordinary income if they have cash-basis receivables or inventory or whatever it may be. This really is more of a fix from a buyer perspective than anything else.

Now, there’s something in it for the seller in the sense that the buyer is going to have to pay them for that incremental tax cost. But that’s where we looked for a buyer to be able to get this best of both worlds — a step-up in basis, but keep the legal entity alive. It was always [338](h)(10), always 336(e). But there are limitations to those two types of transactions. For example, you have to acquire 80% of the stock of an S corp. to make an [338](h)(10) or 336(e) [election], and so if private equity only wants 50% of this business, that’s off the table.

Another thing is, let’s say you’re not going to buy all of it, but you are going to buy more than 80%. It’s not like the 10% interest that the shareholders of the target retain is going to be tax-free. The way a [338](h)(10) or 336(e) election works is, if private equity comes in and buys 90%, the other 10% is still treated as if they sold their interests as well. They still have to deal with the consequences of the asset gains. You can’t have any tax-free deferrals, there are limited types of entities that can be a purchaser in a [338](h)(10) [transaction[, and so private equity as a partnership cannot do it. It would have to set up a corporation. You get the idea. There’s a bunch of potential limitations there.

But the biggest limiting factor and really what’s caused this sea change in this transaction type is the fact that there are a limited type of targets in a [338](h)(10) [transaction]. One is a subsidiary in a consolidated group. One is a subsidiary in an affiliated group that could file a consolidated [return] but doesn’t, and the other is an S corporation. What you don’t hear in those three types of eligible targets is a standalone C corporation. What that means is if someone is looking to buy an S corporation and make a [338](h)(10) election or 336(e) election, they have to be sure that S election is valid. Because if it’s not valid, that’s not an S corp. you’re buying, it’s a C corp. If you buy the stock in a C corp., it’s a standalone C corp., and the [338](h)(10) or 336(e) election isn’t valid, either.

You just spent 30, 40, 50 million on something anticipating a step-up in basis in assets, and if it turns out that S election was invalid and you just bought C corp. stock, you don’t have that step-up in basis. There’s this disconnect, I feel sometimes, where 90% of the tax industry thinks that if somebody says they’re an S corp., they’re an S corp., but there’s not going to be any problems there. Then the other 20% works enough in due diligence or it’s just been around long enough to realize that there’s some real truth to this saying that permeates what I do, chairing sub S for EY, and it’s said in jest, but like I said, there’s some truth: You show me an S corp., I’ll show you an invalid S corp. If you do enough due diligence, there’s going to be things that arise that make you say, I don’t think this is valid or I’m worried that it’s not. The point is the second a buyer who’s looking to spend significant cash on a business realizes that there could be a skeleton in the closet for that S election, you don’t want to go forward with an (h)(10) or 336(e) because the risk is to you as the buyer. The risk is that you lose all of that step-up.

Walker: Does that tie back to our previous time we were together and ways to cure an S election?

Nitti: It does. You’re referencing Rev. Proc. 2022-19, which gives us an avenue in some respects to fix some of these problems that would cause an S election from being valid. But practically speaking, when the numbers are big enough and a buyer is looking to acquire a company, the second they get an inkling that something is wrong with that S election, even if you tell them it can be cured, they say, I want to pivot to something else to make sure I get what I came after. What I came after is the step-up. That’s where this transaction came into vogue. Because how else, if we’re not going to do an (h)(10), if we’re not going to do a 336(e), how else for example, can private equity go out and acquire some or all of the business of an S corp. while (1) keeping the legal entity alive and retaining the EIN; (2) getting a step-up in basis of the assets; (3) getting to continue to operate this business in flowthrough form — because that wasn’t available via an (h)(10) or something like that because it would become a corporation because it’d be owned by another corporation; (4) being able to offer potential tax-free rollover to some of the sellers. Like where else can you get all those things and not having to acquire 80%? It really was a wasteland of options until this Rev. Rul. 2008-18 came around and said, okay, there is a path forward here now to accomplish all of these things. Most importantly, is to still get our step-up as the buyer, even if this S election is invalid.

It’s not a complicated transaction at all. The reason I thought it was worth talking about today is that it’s amazing.  I’ve talked to some people who’ve done dozens of these but it’s almost just because it’s a formula they follow and they don’t actually understand what each step does or, maybe more importantly, doesn’t accomplish. It would work like this: You would say to the seller, hey, we’ve got concerns about your S selection being valid, so I’m not buying your stock because I’m the one that gets stuck holding the bag if I just bought a C corporation and not an S corporation. I paid you for the step-up and I didn’t get the step-up. I want you as the seller to undergo this pre-transaction restructuring. It’s all on the seller side and it’s not complicated at all.

Step 1, the sellers, and let’s just say you and I are 50/50 shareholders at this S corp. I always like using you in my examples. You and I are sellers of this S corporation. We form a brand new holding corporation and we transfer our 50/50 interests in what I’ll refer to now as the target S corporation into this new corporation. Then we immediately elect to treat that target as a qualified Subchapter S subsidiary or a QSub. When an election is made to treat a subsidiary of an S corp. as a QSub, it’s treated as having liquidated into its parent S corporation, and it’s just disregarded from any separate existence. Now, what you didn’t hear there, which you may be curious about, is I said we formed a new corporation, transferred an S corp. into it, made it QSub election for it. I didn’t say that new corporation was formed as an S corporation.

You can be, like, how are you making a QSub election when the parent is not yet an S? But what this Rev. Rul. 2008-18 tells us, it builds off earlier principles from Rev. Rul. 64-250 and says that the combination of those steps, the formation of a new corporation, transfer of an S corp. to that corporation, and then immediate QSub election for that former S corp., it all combines into what we call a tax-free reorganization under Sec. 368(a)(1)(f). What that means is it’s a big fat tax zero. Nothing happens.

Because nothing happened, that newco that we set up is just considered to be a continuation of the target. The reason we didn’t have to make an S election for it is because the S election of the target carried over to this newco. If you are certain that the S election of the target is valid, and if you are, we’re probably not doing this whole thing. But if you were certain, it’s funny you’ll find that there’s no requirement to file a new S election for the parent. Instead, when you make the QSub election on the [Form] 8869, [Qualified Subchapter S Subsidiary Election,] there’s actually a box that was added that says this QSub election is being made in accordance with a Rev. Rul. 2008-18 transaction, and that just notifies the IRS that the S election of this company now carries over to the new company.

If we stop right there, like, we haven’t really accomplished anything. We’ve got a new company, a newco, that’s an S corp. that owns a disregarded entity as a QSub. Now, if you’re worried that the S election was bad, and usually you are, you would probably make a protective new [Form] 2553[, Election by a Small Business Corporation,] filing for the newco. But what this does, and I just want to point this out now, is eventually this newco S corp. is going to be selling this business, selling this disregarded entity. What this doesn’t do, this transaction, and this is where a lot of confusion comes in, it doesn’t do anything to cure the bad S election.

If we think about it, if the company had been a bad S and sold its assets as a C corp., there would have been corporate level tax. Going through these steps doesn’t change that at all. Because if we form a new S and transfer the stock of what was a bad S to that new S and make a QSub election for it, effectively what we’ve just done is liquidate a C corp. into an S. Without getting too into the weeds here, when you do that, the S corp. just inherits what we call the built-in gains taint of that sub under Sec. 1374. When it turns around two or three days later, like it’s going to in this transaction, sells those assets, 1374 is going to kick in anyway and make the seller pay corporate level tax. It’s not doing anything to avoid a corporate level tax for these sellers, and I think people should definitely understand that this doesn’t fix a bad S election. You and I talked at great length about how you could fix a bad S election. This does not accomplish that. Because a bad S being contributed to a new S and made a QSub election for it simply means you liquidated a C into an S and you inherit all that built-in gains exposure.

If we stop there for a moment, we’re left with a structure where the S corp. owns 100% of a QSub, which is a disregarded entity. But these transactions are almost always going to have an extra step. That extra step is you’re then going to take that QSub and convert it under state law, typically, from a corporate entity to a single-member LLC. Once again, you’re just going from disregarded entity to disregarded entity. It’s meaningless. It doesn’t cause any tax consequences at all.

People have asked, why that? What’s the point there? The point there is, if you screwed up something in steps 1 and 2, so that your QSub election is not respected, we have the same problem we would have had originally when the buyer comes in, as you’re going to see in the next step, and purchases the interest in the disregarded entity, if we think we’re buying the stock of a QSub and it’s not really a QSub, we just bought the stock of a C corp. again. The only way to really purge that corporate past is to do this extra step and, after we’ve made the QSub election, convert that QSub under state law into a single-member LLC. Because now, when those steps are all complete, we have an S corporation holdco owning a single-member LLC.

Just to keep things simple, if private equity wants to come in and buy 100% of that single-member LLC, they get the best of both worlds. Because legally they’re buying the entity, so the EIN stays alive. But from a tax perspective, when you buy the 100% interests of a single-member LLC, you’re treated as purchasing each underlying asset of that LLC. So they’re going to get that step-up in basis. By flipping it from a QSub to a single-member LLC, all you’re really accomplishing is fully guaranteeing that even if everything else goes to hell, the buyer is going to get their step-up, which is what they’re paying me to do, if you represent the buyer.

There’s just been a lot of confusion about these steps and what they can accomplish and the order in which they have to be done. Order in this stuff matters. We have a [letter] ruling from 2017 — [IRS Letter Ruling] 201724013 — that says, OK, if we contribute the stock of this S corp. to the new S corp., and then the next day convert it to an LLC, but then a month later, retroactively file the QSub election to be effective on the day of contribution, that QSub election is actually invalid because at the time you filed it, even though it was going to be effective earlier, at the time you filed it, it wasn’t a corporate entity anymore. You’d already switched it over to an LLC.

There’s just these little nuances like that that are a pain in the butt. Then one of the things we at the AICPA asked the IRS to consider is maybe we don’t need the intermediate step of making the QSub election. Like why can’t we just contribute the S corp. to the newco and then immediately convert that sub into an LLC? The only reason right now we go through that intermediate step of making the QSub election is because that’s what Rev. Rul. 2008-18 says will allow you to retain the EIN. There’s enough there that worries us that we want to make sure we get the consequences the IRS says we get, so we follow it to every step, letter of the law. It just creates confusion. Sometimes it appears unnecessary.

What will happen is the buyer will come in, and, let’s just say for starters, they buy 100% of a single-member LLC interest. As we said, they’ll get a step-up. From the newco S corp. perspective we set up, they’re treated as selling each underlying asset of the single-member LLC. Just like with an (h)(10) [election] they will be treated as if they sold the assets. So there might be a mix of ordinary income, capital gain, and they should get compensated for that. As I mentioned to you before, if the S election truly were bad, then that corporate level tax may still be levied on the sale because you might have built-in gains issues. It’s not really a magic potion for the seller, it’s more for the buyer.

Now the nice thing for the seller, though, is let’s say private equity only wants to buy 80%. If private equity buys 80% of the single-member LLC interest, then we have a deemed partnership formation under [Rev. Rul.] 99-5 where private equity is treated as buying 80% of the assets. They get their step-up, they’re happy, and then private equity contributes their 80% up to a new partnership and the S corp. contributes the remaining 20% tax-free. There’s an option here for seller to get tax-free rollover equity that doesn’t exist in your typical (h)(10) or 336(e) [transaction].

There is something in it potentially for the seller. Particularly, like I said, if you’re going to retain some rollover equity, but the buyer still gets their step-up and everybody’s happy. There’s still some unanswered questions. I think one of the most interesting unanswered questions is, okay, wait a minute, you’re telling me we’re doing all this because we have concerns the target was a C corp. for the last few years? We know we might pay C corp.–level tax on the sale of the assets if the IRS comes knocking and finds out the S election was invalid, but what about the three open years where it should have been a C and instead it was an S, who is on the hook for that?

There’s really no wonderful answer because, remember, the buyer in this situation, private equity has acquired that legal entity. That legal entity changed from an S corp. to a QSub to a single-member LLC, but all along, it kept its own EIN. If the tax liability for those previous open years attaches to that EIN, there’s no guarantee the buyer is not potentially on the hook for that. That can make for some interesting negotiations, because if there’s significant exposure for those open years, the buyer is going to want to build that into any type of agreement that they make in terms of an indemnity or hold back or something to make sure that they’re not going to get called upon by the IRS to pay tax for the open years.

But what makes the debate fascinating is we went through this F reorg., and in an F reorg. we said that this new holdco S corporation is truly treated as a continuation of the oldest corporation. From a practical perspective, if you’re the IRS and you want to collect tax from prior open years, why would you necessarily go to the buyer when there’s still this historical entity alive with its historical shareholders, and you can say,  you’re the ones who pocketed all the cash from those years so we’re going to come looking for you? But that’s something that I have that conversation maybe five times a week with people that are negotiating deals. Who’s on the hook here for any corporate level taxes that weren’t paid? No one’s certain.

I would plan as if the buyer is because you got the EIN, you’ve got the legal entity. That’s it, that’s all there really is to it. That’s how it unfolds. But you can see why it’s so advantageous because you can still get the step-up for the buyer even when the S selection is bad. Whereas if you try to do that via an (h)(10) or 336(e) [election], you’re dead in the water and you just spent, who knows, it could be $200 or 300 million that you spent on a company and you paid for that step-up and then you don’t get it.

But there’s confusion that sticks around with all of this. You can imagine the tax return filings get pretty confusing because with an S corporation going through and F reorg. — when I say an F reorg. is treated as a tax nothing in the continuation, it truly is. Even though you might form your newco midway through the year, it’s treated as stepping in the shoes of oldco, so you still file a full year return; one return, and that return is going to show the activity of the target for the beginning part of the year, and then it’s going to have the activity for holdco for the last half of the year, which will include the sale of the target. Then if you’re not selling 100% of the target, but only say 80%, then you’re still going to get a K-1 from a new partnership now for the remaining 20%. People often get confused there as well, but it’s just become an unbelievably powerful and popular method for selling an S corporation. For every one 338(h)(10) election, I see 49 of these. I’m just, like, why not talk about this?

Walker: I’m glad you brought it up.

Nitti: It’s because, like I said, if you dig deep enough, every S corp. is going to cause you some concern. Every one is going to make you go, hey, there’s something here that makes me wonder if this is an S. It’s usually not just one thing. You reference why can’t we fix it with 2022-19? Sometimes you can fix one aspect — like the bad LLC operating agreement you and I talked about. But if there’s other things that are out there. Half of my job, April, is explaining to people, I don’t think this causes the S selection to terminate, but I’m not the one spending $100 million to buy the company, you are, and so if you’re worried about it, let’s get out of this (h)(10) [election] and let’s pivot to this F reorg. transaction that we just talked through.

Walker: There’s a couple of Tax Adviser articles that also go into some of this detail. If you maybe have to listen to this a couple of times to get some of the details.

Nitti: I’m also going to be teaching it tomorrow, although by the time they hear it …

Walker: You can listen to the replay. We will wrap up. Thank you so much, Tony.

Again, this is April Walker from the AICPA Tax Section. This community is your go-to source for technical guidance and resources designed especially for CPA tax practitioners like you in mind. This is a podcast from AICPA & CIMA together as the Association of International Certified Professional Accountants. You can find us wherever you listen to your podcasts. Please follow us so you don’t miss an episode. If you already follow us, thank you so much and please feel free to share with a like-minded friend. You can also find us at aicpa-cima.com/tax to check out our other Odyssey episodes, as well as get access to the resources mentioned during the episode. Thank you for listening.