Article

Converting S-Corps to C-Corps to Achieve Tax Deferral Under Section 1042

August 10, 2016

This article discusses potential planning opportunities (and limitations) when a taxpayer attempts to convert an existing S-corp into a C-corp prior to sale of such corporation to an employee stock ownership plan (“ESOP”) in order to achieve the benefit of tax deferral under Section 1042 of the Internal Revenue Code. [1]  It provides a high-level overview of Section 1042 and discusses US federal income tax considerations for converting a C-corp to S-corp status after a purchase by an ESOP and converting from S-corp status to a C-corp before a purchase by an ESOP.  

Overview

An eligible shareholder can generally elect to defer capital gains when he or she sells stock of a C-corp to an ESOP under the rules of Section 1042.  Section 1042 generally allows eligible shareholders to elect to defer capital gains tax on eligible stock sold to an ESOP if the proceeds of the sale are reinvested in qualified replacement property (“QRP”).  Taxes will not be owed until the taxpayer has a disposition of the QRP.

To be eligible for tax deferral under Section 1042, the following requirements must be satisfied.

  • The shareholder must be an individual, a trust, an underwriter selling securities, or a partnership.
  • The corporation must be taxed as a C-corp for US federal income tax purposes.
  • The stock of the corporation must be held by the shareholder for at least 3 years prior to the sale of the stock to the ESOP.  
  • The stock of the corporation must be sold to an ESOP sponsored by the “C-corp” and after the sale, the ESOP must own at least 30% of the issued and outstanding stock of the corporation.
  • The selling shareholder must reinvest transaction proceeds into QRP either 3 months prior to the sale or within 12 months after the sale. QRP generally includes the common stock, preferred stock, bonds, and convertible bonds of “operating companies” incorporated in the US.  [2]
  • The selling shareholder must make an election, and other filing requirements must be satisfied. 

Converting to S-Corp Status after Purchase by ESOP

Following an ESOP’s purchase of the C-corp stock, there are significant incentives to convert the ESOP-owned C-corp into an S-corp.  As a tax exempt shareholder, an ESOP is not subject to US federal income tax on profits attributable to the shares of the S-corp stock owned by the ESOP.  If the corporation remains a C-corp after the purchase, it will be subject to a corporate level tax.  The decision and ability to convert the C-corp into an S-corp will depend upon a number of operational issues, the tax attributes of the corporation and certain requirements that must be satisfied for S-corp status.  

Converting an S-Corp to C-Corp Status before Purchase by EOSP

If a taxpayer owns stock in an S-corp, he or she may want to convert the S-corp into an C-corp prior to the sale of stock to the ESOP to achieve the benefit of tax deferral under Section 1042.  However, it is problematic if there is a desire to convert the C-corp back into an S-corp after the ESOP purchases the stock to avoid a corporate level tax.  Converting back to a S-corp will be problematic because if an S-corp election is previously revoked or terminated, the C-corp is generally not eligible to reelect S-corp status for 5 years unless it receives consent from the IRS.[3]

It is doubtful that the IRS would ever give an ESOP consent to change the corporation back to an S-corp before the 5-year waiting period expires. For example, in PLR 199952072, the shareholders of an S-corp consented to revoke S-corp status and then sold the C-corp stock to an ESOP in a tax deferred sale under Section 1042. Thereafter, the ESOP requested a waiver from the IRS to reelect S-corp status before the 5-year waiting period expired. The Service denied the request despite the fact that the ESOP was a new shareholder who did not consent to the revocation of the S-corp election.  The Service stated that to allow a company to terminate its S-corp election, immediately have its shareholders engage in a Section 1042 transaction, and then subsequently have an ESOP reelect S-corp stats before the expiration of the 5-year waiting period would contravene applicable statutes and be contrary to congressional intent. Accordingly, the conversion of an S-corp into an C-corp prior to the sale of stock to the ESOP will cause the entity to remain as a C-corp for a 5-year waiting period.

Section 351 Exchange followed by Sale.  One could try to get around the 5-year waiting period by having the shareholders of the S-corp make a contribution of the existing S-corp stock to a newly formed C-corp followed by the sale of stock of the C-corp to the ESOP.  The ESOP could then make an election to convert the C-corp into an S-corp.  As a newly formed C-corp, the 5-year waiting period would not be imposed on such entity. However, for this transaction to work, the selling shareholder would need to take the position that the contribution of S-corp stock to the C-corporation is a tax-free exchange under Section 351. The IRS would likely challenge the taxpayer’s position and tax the contribution of the S-corp to the C–corp on the theory that a plan or intention to sell the C-corp stock to the ESOP existed on the date of the contribution.  This is especially true if the sale takes place within a short period of time following the contribution.

F Reorganization followed by Sale.  A selling shareholder could also attempt to get around the 5-year waiting period by merging the existing S-corp with and into a newly formed C-corp followed by the sale of the stock of the C-corp to the ESOP.  The merger could potentially qualify as tax-free F reorganization under Section 368(a)(1)(F) if there is a non-tax business purpose for the merger and certain other requirements are satisfied. However, pursuant to Treas. Reg. Sec. 1.1362-5(b), the new C-corp will likely be treated as a “successor corporation” for purposes of the 5-year waiting period.  The term “successor corporation” means any corporation:

1)      50% or more of the stock of which is owned, directly or indirectly, by the same persons who on the date of termination owned 50% or more of the stock of the small business corporation with respect to which the election was terminated; and

2)      which acquires a substantial portion of the assets of such small business corporation or a substantial portion of the assets of which were assets of such small business corporation.

If the merger qualifies as an F reorganization, the target corporation is not terminated as a result of the merger, but is instead treated as a mere continuation of the existing corporation. Moreover, the tax year of a target does not end as a result of the F reorganization.[4] Hence, the S-corp status of the target corporation would terminate before its final taxable year because the corporation still exists albeit as C-corp after the merger.  In such case, the 5-year waiting period would carryover over to the new C-corp because the new C-corp is a successor corporation.  

A or C Reorganization followed by Sale.  If the selling shareholder owns two existing S-corps, the S-corps could merge with and into a newly formed C-corp followed by the sale the stock of the C-corp to the ESOP.  Because there are two S-corp, such mergers could potentially qualify as tax-free A reorganizations under Section 368(a)(1)(A) or tax-free C reorganizations under Section 368(a)(1)(C). To qualify, there must be a non-tax business purpose for the mergers and certain other requirements must be satisfied.

In contrast to an F reorganization, if the merger qualifies as an A or C asset reorganization, the acquiring C-corp should not be treated as a “successor corporation” under Treas. Reg. Sec. 1.1362-5(b). Pursuant to Rev. Rul. 70-232 and PLR 200218017, an A reorganization of a target S-corp into a C-corp terminates the target S-corp’s taxable year, and the target S-corp remains an S-corp throughout its entire taxable year.  Thus, an acquiring C-corp in an A or C reorganization should not be treated as a “successor corporation” under Treas. Reg. Sec. 1.1362-5(b) and the ESOP should be able to convert the C-corp into a S-corp immediately following its purchase of S-corp stock.

Holding Period RequirementAs discussed above, one requirement of Section 1042 is that the stock of the corporation must be held by the shareholder for at least 3 years prior to the sale of the stock to the ESOP.  In the context of a tax-free asset reorganization, there is favorable authority which provides that the holding period of acquiring C-corp includes the holding period of the predecessor S-corp.[5] Accordingly, a newly formed C-corp could potentially be used as the acquiring corporation in an A or C asset reorganization.

Conclusion

As this article demonstrates, it is difficult, but not impossible, for a taxpayer to achieve the benefit of tax deferral under Section 1042 if the taxpayer owns shares of an existing an S-corp.  If the S-corp itself is converted to a C-corp prior to the sale of stock to an ESOP, the selling shareholder can achieve the tax deferral benefit under Section 1042. However, the C-corp will be restricted from converting back to an S-corp for a period of 5 years.  Planning ideas that involve the contribution of existing S-corp stock to a C-corp in a Section 351 exchange or an F reorganization of existing S-corp into a C-corp are problematic to the taxpayer or the ESOP.  There may be a planning opportunity if multiple S-corps can be merged with and into a C-corp in a transaction that qualifies as an A or C asset reorganization prior to the sale of C-corp stock to the ESOP.  If the transaction qualifies as an A or C asset reorganization, the ESOP should be able to convert the C-corp back into an S-corp immediately following its purchase of the C-corp.  

While this planning opportunity may appear relatively straightforward, there are a number of important things to consider from both an operational and tax perspective before the implementation of any planning.   

If you have any questions regarding this topic please contact John Buckun at 312-476-7515 or David Solomon at 312-476-7526.

Information in this article is not intended as legal or tax advice to any person. All readers must rely on their own legal and tax advisors. Tax law is also subject to change and the IRS may not agree with the conclusions reached in this article.

 

Footnotes:

[1] Unless otherwise indicated, all “Section” references are to the Internal Revenue Code of 1986, as amended (the “Code”).  In addition, all references to “Treas. Reg. Sec. are references to treasury regulations promulgated under the Code (collectively, the “Regulations”).  All references to the “IRS” are references to the Internal Revenue Service.

[2] To qualify, 50 percent of the operating company’s assets must be used in active conduct of a trade or business, and no more than 25% of the operating company’s gross receipts can come from passive sources. 

[3] Section 1362(g).

[4] Treas. Reg. Sec. 1.381(b)-1(a)(2).

[5] See PLR 200003014 (note that this ruling involved an F reorganization of a single corporation). 

 

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