The boom in mergers and acquisitions, or M&A, activity throughout 2021 and into 2022 has correspondingly led to more S corporations as target companies of M&A transactions. S corporation status is a popular option for small business corporations because it offers tax flexibility not available to C corporations. However, a buyer that is considering acquiring an S corporation must ensure that the entity was eligible to make its S corporation election, and that the entity continued to qualify for S corporation status throughout its history. If the IRS successfully challenges an entity’s S corporation status, the entity is automatically treated as a C corporation, which may give rise to significant unexpected federal income tax exposure. This article discusses three options to limit this potential federal income tax exposure: seller indemnities and escrows, IRS private letter rulings, and tax insurance. As discussed below, tax insurance, often in combination with a private letter ruling, is the most efficient option for most taxpayers.
General S Corporation Requirements
With certain exceptions, a corporation may be treated as an S corporation for U.S. federal income tax purposes if it satisfies certain eligibility requirements and makes a valid election. To elect and maintain S corporation status, the entity must be a domestic corporation; only have shareholders that are U.S. citizens or residents; have fewer than 100 shareholders, taking into account certain aggregation rules; only have shareholders that are individuals, certain trusts, or tax-exempt entities; have one class of stock; and not have excessive passive investment income. These requirements must be met at all times from the date of the S corporation election; otherwise, the company’s S corporation status will be terminated.
A detailed analysis of the nuances associated with these requirements is beyond the scope of this article; however, it is safe to state that S corporations are historically problematic entities with stringent rules. These rules create numerous foot-faults that S corporations often inadvertently trip over, leading to potential termination. Not obtaining a spousal election in community property states, invalidating the initial election; making disproportionate distributions, resulting in a second class of stock; or unintentionally having an ineligible shareholder, often a non-permitted trust, are examples of common ordinary course actions taken by a corporation or its shareholders that may lead to termination.
Tax Risk of an Inadvertent S Corporation Termination
Transactional, buyside tax due diligence focuses on the S corporation requirements and often uncovers concerns with the qualification of an S corporation target.
An inadvertent termination can be catastrophic to a transaction. To the extent the historical S corporation status of a target was invalidated, the target reverts to being classified as a C corporation for U.S. federal income tax purposes, resulting in entity-level corporate income tax exposure for all open tax years post-termination. Additionally, unless structured around, the acquisition of a C corporation—as opposed to an intended S corporation—can result in a loss of basis step-up.
To mitigate this unanticipated entity-level tax exposure and lost basis, deal parties have three main options: seller indemnities/escrows, private letter rulings (PLRs), and tax insurance. The parties have, and often utilize, the ability to mix and match these options to best fit their needs.
Seller Indemnities/Escrows
Dependent on negotiating leverage, the traditional approach involves the buyer subjecting a seller to a large indemnity or tying up sales proceeds in an escrow to cover the potential tax exposure. But if a seller holds the leverage, the buyer may be required to self-insure the tax exposure or, if unwilling to do so, walk away from the deal. All options are highly inefficient, slow the deal process, and result in an undesirable outcome for one side of the transaction.
Administrative Relief and PLR Process
Under Section 1362(f) of the tax code, the IRS has the authority to reverse certain inadvertent S corporation terminations if: the entity previously made a valid election to be an S corporation and that election terminated, the IRS determines that the termination was inadvertent, the entity takes steps within a reasonable period to correct the condition that rendered the corporation ineligible to be an S corporation, and the entity and all shareholders during the period of the termination agree to make any adjustments the IRS requires that are consistent with the treatment of the entity as an S corporation.
The ruling process includes a filing, usually written by a law or accounting firm, that contains a factual summary, ruling request, statement of law and analysis, and a declaration of truth under penalties of perjury. The preparation and filing of the ruling request both come with their own set of distinct costs. While the IRS claims to rule on these requests in 60 to 90 days, the process is often much longer—the current timeline appears to be six to nine months. In the fast-paced world of M&A, the PLR timing is often too long to wait for tax certainty before closing. As a result, seeking a PLR is often used as a backstop to a limited seller indemnity or escrow, or side-by-side with a tax insurance policy.
In January, the IRS announced a new fast track PLR process that aims to reduce the ruling timeline to 12 weeks. This new pilot process consists of a pre-ruling conference with the IRS, followed by the normal, albeit accelerated, ruling request process. The IRS is hoping that this new program will streamline the period it takes to get from request to ruling; however, the IRS has stated it will not be available for requests for extensions of time to make elections or other applications of Section 9100 relief, which are often required to remedy inadvertent termination of S corporation status. As a result, election extension and other 9100 relief applications may take significantly longer than the 12-week timeline proposed under the new program.
Tax Insurance Process
The most efficient option is the utilization of tax insurance, often in combination with the above. Tax insurance policies are capable of covering known or discovered, supportable tax positions. These insurance policies shift the risk of an adverse ruling by a tax authority to an insurer or insurers and make the insured whole by providing coverage for the payment of tax, contest costs, interest, penalties, and—if applicable—a gross-up, should the insurance proceeds be taxable in the hands of the insured. In the transactional S corporation setting, this can provide buyers and sellers with certainty that smooths the deal process. Insuring an identified S corporation concern can also limit, or potentially entirely remove, the need for agreement-specific escrows and/or seller indemnities.
Tax insurance for S corporation concerns involves the buyer and/or seller of the S corporation, a tax insurance broker, and the insurer or insurers. One of the deal parties brings the tax submission to the insurance market via a broker. The broker presents the opportunity and aggregates terms from the interested insurance markets. The parties then select their preferred insurer or insurers and enter formal underwriting. During the underwriting process, the insurer or insurers will review all the relevant documents associated with the underlying risk, comment on a potential PLR request, and speak with the parties about the matter, as well as negotiate a bespoke insurance policy tailored to the opportunity. This entire process usually takes a few weeks to complete but can be accomplished on a very accelerated timeline—a matter of days—if the transaction requires. Once underwriting is complete, the parties bind coverage, shifting the risk to the insurer or insurers for a onetime payment generally ranging from 2% to 4% of the coverage obtained.
In certain circumstances, the insurer may require the taxpayer to seek a private letter ruling in connection with the procurement of a tax insurance policy. However, the policy accepts the risk transfer before the ruling is received, eliminating the concern associated with waiting for the IRS to rule on the request.
Conclusions
Since most M&A deals operate on much faster timelines for the IRS’s fast-track pilot program to have any meaningful affect, deal parties should continue to consider tax insurance as an option to efficiently de-risk S corporation concerns without disrupting or delaying their deal.
This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Author Information
Bryce R. Pressentin is a tax underwriter at Euclid Transactional, where he is responsible for underwriting bespoke, commercial insurance solutions to diverse tax matters.
Justin Pierce Berutich is head of tax at Euclid Transactional, where he is responsible for leading Euclid’s tax insurance practice and developing bespoke, commercial solutions to diverse tax matters.
Jeff M. Lash is a tax underwriter at Euclid Transactional, where he is responsible for underwriting bespoke, commercial insurance solutions to diverse tax matters.
Kyle Reiter is a senior associate at Euclid Transactional. Kyle works to support the underwriting group and directly supports the head of tax to help develop tax insurance solutions.
Sydney Lodge is a senior analyst at Euclid Transactional. Sydney analyzes the insurability of opportunities and facilitates the underwriting process by coordinating with broker partners and outside advisers.
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