Tax Planning for Mergers and Acquisitions Involving S Corporations

Mergers and acquisitions involving S corporations present unique tax planning challenges and opportunities. S corporations have pass-through taxation, meaning gains from a sale flow to individual shareholders who are taxed at their own rates. The structure of the deal—asset sale versus stock sale—has dramatically different tax outcomes. In an asset sale, the S corporation recognizes gain on each asset sold, which passes through to shareholders; built-in gains (BIG) tax may also apply if the S corporation was formerly a C corporation within the recognition period. Buyers prefer asset sales for the step-up in basis, reducing future depreciation and amortization taxes. Shareholders typically prefer stock sales to avoid double taxation concerns, but S corp shareholders may accept an asset sale structure when the tax outcome is similar due to pass-through treatment. Section 338(h)(10) elections allow a stock sale to be treated as an asset sale for tax purposes with buyer and seller agreement. Aurora Training Advantage's accounting webinars help tax advisors navigate these complex S corporation M&A scenarios.

A Section 338(h)(10) election is a joint tax election available when a buyer acquires at least 80% of an S corporation's stock. The election treats the transaction as if the S corporation sold all its assets at fair market value (an 'deemed asset sale') and then liquidated, even though the legal form is a stock purchase. This allows the buyer to receive a stepped-up basis in the acquired assets—improving future tax deductions through depreciation and amortization—without the legal complexity of an actual asset purchase. For the selling shareholders, gains are generally treated as a single sale event, potentially qualifying for long-term capital gain rates. The election is particularly advantageous when the S corporation has substantial depreciable assets, favorable goodwill allocations, or intangible assets with significant value. Key considerations include state tax treatment, the application of built-in gains tax for former C corporations, and the consent of all parties. Aurora Training Advantage's accounting webinars provide detailed guidance on 338(h)(10) mechanics for tax professionals advising clients on S corporation transactions.

Built-in gains (BIG) tax is a corporate-level tax that applies to S corporations that previously operated as C corporations and converted to S status. When the S corporation sells assets that were appreciated at the time of the S election, the gain attributable to the C corporation period is taxed at the highest corporate rate during the recognition period—generally ten years following the S election. In the context of mergers and acquisitions, BIG tax can significantly reduce the net proceeds from an asset sale or a 338(h)(10) election by imposing a corporate-level tax on recognized built-in gains. Buyers and sellers must identify assets with built-in gain, quantify the potential BIG tax liability, and incorporate it into deal pricing and structure negotiations. The recognition period and applicable rates should be confirmed under current law, as Congress has periodically modified them. In some cases, structuring the transaction as a stock sale avoids triggering BIG tax. Aurora Training Advantage's accounting webinars equip tax advisors with the frameworks to identify and mitigate built-in gains tax exposure in S corporation M&A transactions.

Shareholder basis is a critical element in S corporation M&A tax planning because it determines the character and taxability of proceeds received in a transaction. Each S corporation shareholder has an outside basis in their stock, adjusted annually for income, losses, distributions, and contributions. When the S corporation is sold—either as a stock sale or through a 338(h)(10) election—the taxable gain to each shareholder is the excess of proceeds received over their adjusted basis. Shareholders with low basis will recognize substantial gains; those with higher basis from prior undistributed income have lower tax exposure. Accumulated adjustments account (AAA) balances affect how distributions in connection with the sale are characterized. In transactions structured to trigger a deemed asset sale, shareholders must also consider the S corporation-level gain recognition and how it flows through. Pre-transaction planning—including electing S status timing, managing distributions, or making additional capital contributions—may optimize basis positions. Aurora Training Advantage's accounting webinars help practitioners understand basis mechanics in S corporation deal structures.

S corporation eligibility rules impose structural constraints that directly impact M&A deal design. S corporations may have no more than 100 shareholders; all shareholders must be U.S. citizens or resident aliens, estates, or certain qualifying trusts—partnerships, corporations, and nonresident aliens are ineligible. Only one class of stock is permitted, though differences in voting rights are allowed. In the context of acquisitions, a buyer seeking to acquire an S corporation through a stock purchase and maintain S election must ensure the post-acquisition ownership structure complies with all eligibility rules. If the acquirer is a corporation or foreign entity, the S election will terminate upon closing, converting the entity to a C corporation—with potentially significant tax consequences. Alternatively, the parties may structure the transaction as an asset purchase, allowing the buyer to place assets into a new or existing legal entity of their choosing. Understanding which eligibility rules apply to a specific transaction is a foundational step in S corporation M&A planning. Aurora Training Advantage's accounting webinars provide tax professionals with the eligibility and structuring analysis needed for S corporation deals.