Tax-Deferred Disposition of a Former Partnership Business via a Type B Stock Swap

Editor:
Albert B. Ellentuck, Esq.
Of Counsel
King and Nordlinger, L.L.P.
Arlington, VA

Editor's note: This case study has been adapted from "PPC Tax Planning Guide—S Corporations," 13th Edition, by Andrew R. Biebl and Gregory B. McKeen, published by Practitioners Publishing Company, Fort Worth, Tex., 1999.

Facts: Joe and Frank Pessimist are 50% partners in a highly profitable small business. Although they presently have a competitive advantage in terms of quality and "trade secrets" over their major publicly traded competitors, they believe their position to be relatively short-term. One of these has approached them, expressing an interest in purchasing their business. For cashflow and current-ratio purposes, the potential buyer has indicated that the corporation would be willing to pay a high price if the Pessimists would accept the company's publicly traded stock instead of cash or debt instruments. Both partners expect their income to drop in future years. They would like to accept the stock offer but are reluctant to enter into any arrangement that generates a current tax burden. Also, they expect the value of the stock of the acquiring corporation to rise significantly in the years ahead, and would prefer to dispose of that stock gradually in future years. Issue: How might an S corporation be used to assist Joe and Frank in the sale of their business?

Analysis

One major advantage of an S corporation when compared to a partnership is its ability to use the tax-free reorganization provisions of subchapter C. These provisions apply to S corporations, unless otherwise expressly provided by the Code or inconsistent with subchapter S. If Joe and Frank swap their partnership interests for publicly traded stock, they will have a fully taxable sale at the current time. (The transaction would not qualify as a tax-free incorporation under Sec. 351, because Joe and Frank together would not be in control of the publicly traded corporation immediately after the exchange.) The tax costs of this sale would likely require a disposition of some of the shares to generate cash to cover the tax liabilities.

Joe and Frank's tax adviser recommends that they work toward a tax-deferred, stock-for-stock swap by first accomplishing a Sec. 351 tax-free incorporation of their partnership. In considering this recommendation to incorporate, the adviser examines the partnership's pre-incorporation tax-basis balance sheet to test for the existence of either excess liabilities or liabilities unrelated to the business. To the extent that liabilities transferred to the corporation exceed the bases of the assets transferred, gain recognition will occur. This potential pitfall is quite common in converting partnerships to a corporate structure. Also, to the extent any liabilities unrelated to the partnership's business are transferred to the corporation, all liabilities conveyed will be considered to give rise to taxable boot to the incorporators.

To avoid the possibility of double taxation, the tax adviser recommends an S election. As the negotiations for the sale of the business proceed, the company will operate as an S corporation. If the negotiations fail, the conversion from partnership to S status will not have significantly changed the income tax structure of Frank and Joe's business. Conversely, if S status were not initially elected and the acquisition failed, Joe and Frank would be trapped into potential double taxation on any future sale, because the prior C status would cause the corporation to be subject to the Sec. 1374 built-in gains tax.

When the purchase agreement is finalized, the tax adviser recommends that it be structured as a B reorganization (a stock-for-stock exchange). In a B reorganization, one corporation, solely in exchange for its voting stock, acquires the stock of another corporation and immediately thereafter has control of the acquired corporation. No boot can be paid to Joe and Frank; they must receive only stock of the acquiring company. Unlike an A or C reorganization, in a B reorganization, the acquired corporation is not liquidated. It continues to exist as a subsidiary after the acquisition transaction.

The S status of Joe and Frank's corporation terminates as of the date of the stock exchange, as an S corporation cannot retain its eligibility when it has a corporate shareholder. This causes the filing of a short-period S return and passthrough of income or loss to Joe and Frank as of the termination date. However, the resulting tax consequences presumably would be similar if Joe and Frank had retained their partnership to the point of sale.

If properly structured and carefully executed, the stock exchange will not be taxable to the Pessimists until they eventually sell the acquiring corporation's publicly traded stock. Their adjusted tax basis in the former partnership carries over to their newly formed corporate stock, and then to the publicly traded stock received in the stock-for-stock exchange. Frank and Joe now each have the flexibility to sell shares of stock of the publicly traded company gradually during future years to fit their individual income tax and cashflow objectives.

In addition, if the publicly traded stock produces sufficient retirement income via its dividends, Joe and Frank might consider holding the shares through their eventual estates. This would accomplish a basis step-up under Sec. 1014 and allow their estates or heirs to sell the stock without gain recognition.

The overriding benefit is that Joe and Frank may succeed in deferring income taxation by structuring a B reorganization. There are, however, potential detriments to be considered. When an S corporation is acquired in a B reorganization, the decrease in the proportionate stock ownership of the former S corporation's shareholders could cause business credit recapture under the normal stock disposition rules. Another potential detriment is the loss of Sec. 1244 ordinary loss treatment in the event the stock is subsequently sold at a loss or becomes worthless; ordinary loss treatment is not available to a partner to whom the stock is distributed by the partnership. This problem can be overcome if the incorporation of the partnership is structured so that the partners (and not the partnership) are the incorporators.

Conclusion

One of the benefits of the corporate format is the potential to successfully use the reorganization statutes. The tax adviser has devised a plan by which the former partners have aligned their business in a way that allows a tax-transferred stock reorganization. By incorporating, electing S status and undergoing a B reorganization, Joe and Frank can dispose of publicly traded stock gradually during retirement years and achieve a deferral of the tax consequences.