The sale of an S corporation with the filing of a 338(h)(10) election is a transaction structure with which most deal lawyers are reasonably comfortable. There is a hidden tax trap, however, that can arise when the purchase price includes delayed payments, principally earn-out payments of a significant (or unspecified) amount compared to the cash payments made at closing. In that situation, the sellers can find themselves paying tax on the cash portion of the purchase price more than once for the year of the sale. The following example illustrates the potential magnitude of this issue.
Example 1: A owns 100% of the stock of an S corporation, which he has agreed to sell to B for $80M in Year One, and an earn-out that pays out in Year 3 and Year 5. A and B expect that the earn-out will result in additional payments of between $10 million and $20 million, but they do not put a stated cap on the earn-out amount (a big coup for A). B insists that A consent to a 338(h)(10) election, which A agrees to do. A has a $0 basis in his S-corporation stock, and the S corporation has $0 of basis in its sole asset (goodwill).
A may expect that he will pay tax on his $80 million of gain in Year One and additional tax when his earn-out payments are received. He is mistaken. Instead, A will actually pay tax as if he had received $144 million in Year One. A will get a large capital loss in Year Five (unless the earn-payment equals or exceeds $64 million)—a wholly inadequate solution in most situations because that capital loss will only be recovered as A has offsetting capital gains from future transactions.
This result is not limited to situations where the earn-out is uncapped in amount. It can also occur as a result of an earn-out provision that has a stated maximum amount and even where an escrow agreement delays the payment of a portion of the purchase price. Generally, the magnitude of the issue is lesser in those situations, but depending on the amounts involved and the cash-management processes of the client, this issue is worth considering when structuring a deal.
What causes this problem?
The problem introduced above arises at the intersection between the rules regarding 338(h)(10) elections and those regarding installment sales under Internal Revenue Code section 453. The 338(h)(10) rules create a deemed asset sale by the company followed by a deemed liquidation of the company. Each of those steps is a taxable event. Normally, that does not create additional tax issues for S-corporation shareholders, because the corporate-level gain gives them additional basis in their shares. The installment sale rules create an issue, however, by requiring the shareholders to allocate that basis between the cash amounts received on the closing and the future payments that are to be received. The primary factor determining the magnitude of the tax issue created by this problem is how those basis-allocation rules apply. As seen above in Example 1, where an earn-out provision provides no maximum payout, the basis can be spread out significantly.
How can we structure around this?
Taxpayers can effectively plan around this problem in a variety of ways. A common fix is to have the buyer issue a short-term note (one or two days in duration) in lieu of paying cash at closing. By eliminating the cash payment on the closing date, buyers avoid the partial double taxation of that payment for technical tax reasons. (This is, of course, an easy solution to offer from a tax perspective. Commercial considerations may make this more difficult to accomplish.)
Another way to limit the impact of this issue is to put a cap on the earn-out payments. Depending on the facts and the magnitude of the potential earn-out payments, this method can alleviate a significant portion of the negative tax results from this type of transaction. The example below demonstrates this.
Example 2: Same facts as in Example 1, but A agrees to cap the earn-out payments at $20M. In this situation, A will report $80 million of gain from the deemed asset sale, and another $16 million on the deemed liquidation (both deemed transactions result from the filing of the 338(h)(10) election) in Year One. The total gain reported in Year One will thus be reduced from $144 million to $96 million, which results in a federal income tax due of $14.4 million rather than $21.6 million. If A ultimately receives earn-out payments of $20 million, he will only pay tax on $4 million of those payments, bringing his total gain to the $100 million that he received. (If A receives a lower earn-out payment, he will report a capital loss, as in Example 1.)
A third method to limit the impact of this issue is to have the shareholder elect out of the installment method. The result of that election is that the shareholder is required to take into his or her income for the year of the sale both the cash amount received and the fair market value of the right to future payments. Where those payments are highly uncertain, the fair market value of those rights may be low enough that it is advantageous to elect this option in lieu of using a short-term note to avoid the issue.
Obviously, this issue is complicated. The best time to address the issue is at the very beginning of negotiations, when the earn-out provision and cap (if any) are on the table. Consider consulting with your tax lawyer then, when this important issue can be addressed in the LOI.