Prepping to Sell Your S Corp? Read This First – and Consider Becoming an LLC

By Dan Baucum, Attorney/Shareholder

The current business environment is ripe with mergers and acquisitions, and many of the companies being sold are S Corporations. Why? S Corps are popular choices for closely held businesses because S Corp shareholders pay taxes only on their proportionate share of profits – and no corporate level tax. However, S Corps have significant ownership limitations that, if violated, turns the S Corp into a taxpaying C Corp. Because of this, S Corps are not ideal acquisition targets for many purchasers…but LLCs are.

The Downside of Selling a S Corp

Buyers purchasing a business want to acquire all the business assets efficiently and with a “stepped-up” depreciable basis. Buying stock in an S Corp is efficient. But buying S Corp stock does not afford the buyer a stepped-up basis in its assets. Alternatively, a buyer could purchase the assets directly from the S Corp and achieve the depreciable “stepped-up” basis in the acquired property. But this is inefficient at best, and a buyer runs the risk of having to incur additional legal fees and other costs to ensure it is acquiring all the company’s assets, like franchise agreements, leases, employment contracts, and intellectual property.

Why Transforming to an LLC is Advantageous

If the business were owned by an LLC instead of an S Corp, the buyer’s purchase of equity in the LLC would result in an efficient acquisition of all the business property and a depreciable stepped-up tax basis in the business assets. Not only that, but the S Corp ineligible shareholder rules do not apply to LLCs.

Fortunately, there is a way to transform an S corporation into an LLC without triggering federal taxes on the transformation. To do so, requires three steps:

  1. The S Corp shareholders create a new S Corp that will act as the Holding Company for the Target S Corp operating the business and exchange their stock in Target for stock in the new Holding Company on a tax-free basis. The shareholders will then own 100% of the stock in Holding Company in the same proportion as they owned their stock in Target and Holding Company will own 100% of Target.
  2. Holding Company and Target will elect for Target to be treated as a “qualified subchapter S subsidiary,” which is disregarded for federal tax purposes.
  3. Target will convert under state law into an LLC and elect to convert on a tax-free basis into an LLC for federal tax purposes.

After that, the buyer purchases the LLC’s equity from Holding Company in an efficient sale.  Also, ineligible S Corp shareholders can acquire the LLC without fear of purchasing an S Corp that becomes a C Corp, because the S Corp no longer exists after conversion to an LLC.

For tax purposes, the buyer will be treated as if it purchased Target’s business assets from the Holding Company, giving the buyer a depreciable “stepped-up” tax basis. The original S Corp shareholders – who are now the shareholders of the holding company – will pay tax as if they sold the business assets through the holding company even though they sold the LLC’s equity.

The bottom line: S Corps are not ideal acquisition targets for many purchases, but LLCs are. So if you’re considering a sale, also consider that there are smart, efficient ways to transform S Corps into LLCs and increase buyer appetite.