-Use of S Corporations
One obvious gambit to eliminate tax at the corporate level is, in the appropriate instance, for the Target to be or convert from a taxpaying C Corporation to, an S Corporation, a so-called, pass-through entity  in that tax is not imposed on income at the entity (in this case the corporate) level.  Alternatively, Newco may be structured as an S Corporation going forward. The constraints on the structure of S Corporations are relatively rigid. Congress contemplated a limited exemption to the obligation to pay corporate tax, benefiting uncomplicated, modestly capitalized businesses-"small business corporations" in the language of the Code.  Thus, only one class of stock is allowed to an S Corporation,  a constraint that bites hard on some versions of Newco, since the organizers like to use preferred stock for a variety of reasons, including the facilitation of different types of equity financing. Common stock divided into series with varying voting rights is permissible (a result that could also be achieved through contractual arrangements)  but the inability to issue preference stock puts out of reach, among other things, the "eat ‘em all up" fiction which has blessed the tax-free issuance of cheap stock to the managers of Newco.  As indicated in the next section, the enactment of an alleged safe harbor for so-called "straight debt" in the Code, debt which will not constitute disguised senior equity for purposes of the "one class of stock" rule, plus the promulgation of workable new Regulations may increase the viability of S Corporations generally.
Only individual U.S. citizens or legal residents, certain estates, and certain kinds of trusts can be shareholders,  excluding quite prominently corporations and partnerships, which means that a corporation (or partnership) can hold an equity interest in an S Corporation only by taking certain rights to purchase stock-i.e., convertible debentures or debentures with warrants attached, conversion or warrant exercise occurring once the corporation has elected to terminate its S Corporation status.  (This gambit must be approached with caution since "debt" may be reclassified as equity by the IRS, thereby terminating the election in years in which it was thought to have been effective.) 
While an S Corporation is not subject to dollar-size limitations, in keeping with the notion that the exemption is designed for small, uncomplicated businesses, an S Corporation can have no more than one hundred shareholders  (counting a husband and wife as one).  While it can own subsidiary corporations, they would not be eligible for S status as they would have a corporate shareholder; however, a "QSUB" election may be made to effectively treat them as disregarded entities while owned by the S corporation.  The S Corporation can be used as a general partner of a limited partnership.
S Corporations are superior to partnerships in that an S Corporation does not "terminate" for tax purposes if 50% or more of the outstanding stock is transferred  and a reduction in corporate liabilities does not trigger a deemed distribution to the shareholders.  Moreover, S Corporations are eligible participants in tax-postponed reorganization plans.  One important point on which an S Corporation is inferior to a partnership involves the distribution of appreciated property, generally a tax-free event for partnerships but the occasion of a tax in respect of corporate level gain in the case of an S Corporation.  Also, a partnership is free to allocate income among its partners without being limited to one class of interest. An S Corporation succeeding to the business of a C Corporation may forfeit its status if more than 25% of its gross receipts for three consecutive years are "passive"  and the S Corporation has "earnings and profits" remaining from its years as a C Corporation. 
For a C Corporation owning appreciated assets, conversion to S Corporation status is seductively attractive. Congress, however, anticipated the maneuver by enacting §1374 of the Code, which imposes a tax upon "net recognized built-in" gains of a convert from C to S status if such gains are recognized during the ten-year period following the first day of the first taxable year for which the corporation is an S Corporation.  A C Corporation that reports gains from the sale of inventory on the LIFO basis faces an additional obstacle in converting, i.e., the imposition of tax on putative income or gain measured by the value of the inventory as at preceding year-end if FIFO had been the preferred method.  Moreover, by converting, the S Corporation "loses" its NOLs, because the losses (and the loss carryforwards) can only be used to offset corporate taxes, which are no longer payable. 
In structuring an LBO using an S Corporation as Newco, one objective is to allocate as much basis as possible to the shareholders so that basis can be recovered through losses or distributions in the nature of returns of capital, meaning in turn that loans from third parties to Newco should be funneled through the shareholders so as to maximize basis.  A third-party loan to the S Corporation guaranteed by the shareholder does not accomplish the same purpose unless the shareholder is prepared to prove that the lender was looking to the shareholder for repayment. 
If the Target is an S Corporation (and not subject to the §1374 "built-in gains" tax), the sponsors are presented with one of the rare opportunities, post-1986, to achieve a step-up in the basis of the assets at the cost of only one tax. If the Host purchases the Target's assets in a taxable transaction, then the desired result will occur [23.1] since the gain on the sale by the Target increases pro tanto the basis of the Target's shareholders in their Target shares, meaning no further gain or loss (or tax) in respect of the asset-level gain or loss when the Target liquidates.  A variety of problems may attend an asset sale, e.g., nontransferable assets and/or state taxes imposed on asset sales or on S Corporations. A substantially similar result may, however, be obtained if the sellers and acquirer agree to file a Code section 338(h)(10) election in respect of a stock sale of the S corporation target, with the effect of treating the transaction as an asset sale by the S corporation. 
[a]-S Corporation Regulations on "One Class of Stock"
Current Treasury Regulations in the Subchapter S area indicate that a corporation is treated as having only one class of stock if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds. Differences in voting rights among shares of stock of a corporation are disregarded in determining whether a corporation has more than one class of stock.  Furthermore, only stock that is outstanding is considered. Thus the existence of Treasury stock, or authorized but unissued stock of a different class, will not per se cause noncompliance with the single class of stock requirement. 
Many difficult issues arising under the one class of stock restriction arise in respect of instruments or rights that are not stock in form, but which may be treated as a stock or equity interest in the corporation. One relatively new area of potential concern arises from the application of the so-called "check the box" regulations. While rare, it is possible for a state law limited liability company (an "LLC") to be treated as a corporation for federal income tax purposes, by making the appropriate election. LLCs enjoy the flexibility of partnerships in structuring interests therein. Where an LLC that chooses to be taxed as a corporation nevertheless contains flexible allocation provisions, for example, different members may be regarded as having substantially different types of equity interests in the entity, or different classes of stock, making such an LLC unsuitable for an S election.
Another area of potential concern relates to potential classification of a debt interest as equity under applicable classification principles. The Subchapter S provisions of the Code include a safe harbor for so-called "straight" debt in §1361(c)(5), providing that a debt instrument which contains an unconditional promise to pay on demand or on a specified date a sum certain is not a second class of stock if the interest rate is not contingent on profits or other similar factors, the debt is not convertible, and the creditor is an individual or an estate or trust or an entity engaged in the lending business. Other safe harbors exist for certain small, unwritten short-term shareholder advances, and for proportionately held obligations of the same class that are owned solely by the owners of, and in the same proportion as, the outstanding stock of the corporation. 
Outside of the safe harbors, it is open to the IRS to challenge a debt as equity under traditional "debt vs. equity" analysis, with the risk that a debt, treated as equity, could constitute a second class of stock. Furthermore, there is no regulatory safe harbor protection of convertible debt, which by its nature has equity-like features. The current Regulations state that a convertible debt instrument will be considered a second class of stock if it either (i) is treated as equity under general debt vs. equity principles and used to contravene rights to distribution or liquidation proceeds, or to contravene the limitation on eligible shareholders; or (ii) embodies rights equivalent to those of a call option that is substantially certain to be exercised and has a conversion price that is substantially below the fair market value of the underlying stock on the date of issuance, transfer to an ineligible shareholder, or material modification. 
The Regulations confirm that shareholder buy/sell agreements will not generally result in two classes of stock.  The provisions regarding buy/sell agreements are generally benign unless the agreement is entered into in order to evade the one class of stock requirement or the price is so out of line (either above or below fair market value) that it looks like there is something fishy. And options and warrants are a second class of stock if reasonably certain to be exercised, unless issued to lenders or employees. 
The rules on options and warrants are in line with the fundamental thinking underlying the buy/sell agreements: If the options are not substantially in the money at the time granted, then (generally) a second class of stock has not been created. Options granted to lenders in connection with commercial loans are not, by specific exception, a second class of stock nor are options issued to employees if the option is not transferable and does not have a readily ascertainable market value (which few options do) at the time the option is granted.
-Newco, as a Partnership
Since a partnership, like an S Corporation, is a pass-through entity for tax purposes, there may be advantages to organizing Newco as a partnership. The most plausible scenario for "Newco as partnership" occurs in those selected instances when an asset sale is feasible, the Target transferring its profit generating properties to Newco Associates, L.P. In aid of the decision whether (or not) to employ a partnership, its distinctive features—generally favorable from a tax viewpoint—are summarized seriatim.
Thus, the first advantage is obvious—one tax is better than two. Secondly, corporations pay for limited liability in a number of ways: the application of alternative minimum tax income, the penalty tax on personal holding companies, the unreasonable accumulation of earnings penalty, the loss of NOLs upon an ownership change, and so forth. Generally, the Code provisions designed to penalize attempts to "bail out" earnings are not applicable—because there is no point—to partnerships.
In the restructuring context, corporations, but not partnerships, can participate in tax-postponed reorganizations under Subchapter C. On the other hand, migration from one form of organization to another is a one-way street: A partnership can organize a corporation and transfer its assets thereto without tax,  if the transaction qualifies pursuant to §351.  If a corporation wants to reorganize itself as a partnership, however, there is a double tax under the law; distributions of appreciated assets are taxed at the corporate level  and shareholders taxed on the liquidating distributions. And, in a partnership, the "inside" and "outside" basis adjustment rules obtain.
Thus, under §754, a partnership may elect to adjust the basis of partnership property  in order to take into account gains on the sale and/or redemption of partnership interests. Moreover, a partner's basis is stepped up by reason of the partnership incurring debt for which the partner is personally liable.  Upon the incurrence of inside debt by a corporation, there is no increase in outside basis nor does a sale of stock increase inside basis.
Further, election of the partnership structure allows greater flexibility in allocating items of income and loss among the partners.  The management and the investors may want to be able to arrange the split between them of calls on the company's future income (in the person of shares of capital stock or interests in partnership profits) without worrying about the consequences of that allocation as an immediate taxable event to either party.  In a partnership, interests in profits can be allocated and reallocated more or less as the parties agree, without regard to the respective contributions of capital. (The allocation must have "substantial economic effect," which means, in general, that a scheme directly keyed to the tax status of the partners is questionable.) 
On the other hand shareholders in corporations, including S Corporations, do not receive deemed distributions (thereby reducing basis or creating taxable income) upon a reduction in their share of the entity's liabilities, as is the case with partnerships.  Moreover, there is no constructive termination of a corporation if more than 50% of the stock is sold. 
Finally, the attraction to the partnership structure has grown with the advent of the LLC. An LLC with more than a single member provides partnership tax treatment with the corporate attribute of limited liability.
The complexity of the analysis, corporation versus partnership, is multiplied by the fact that there are issues other than federal income tax to take into account. Thus, a modest additional advantage of the partnership form stems front the fact that owner/managers, but not partners, are employees of a corporation, S or C, for unemployment and worker's compensation purposes. The ultimate decision on which form to use is based on the application of the benefits and the detriments of each type of entity to the particular situation and the personal preference (and priorities) of the persons involved.
 A pass-through entity entails immediate tax at the proprietor level, meaning that earnings may not be sequestered in the entity and "capitalized," i.e., later realized in a capital transaction. However, relatively low personal rates of tax combined with the effect of double taxation typically argue powerfully against sequestering earnings in a corporation with hopes of later "capitalizing" those earnings by selling stock or liquidating at an averaged rate.
 Other pass-through entities include partnerships (including limited liability companies), entities treated as disregarded entities, regulated investment companies, read estate investment trusts and real estate mortgage investment conduits.
 §1361(a)(1). The corporation must elect S Corporation status under §1362(a).
 §1361(c)(4). Prior to 1982, the issue of whether an agreement among shareholders dividing up the voting rights constituted two classes of stocks (thus, breaking S Corporation status) was often litigated. See, e.g., Paige v. United States, 590 F.2d 960 (9th Cir. 1978). The Service has ruled that rights to acquire stock do not constitute a separate class, Rev. Rul. 67-269, 1967-2 C.B. 298, nor do phantom stock plans, P.L.R. 8834085 (June 2, 1988), nor stock appreciation rights, P.L.R. 8828029 (April 14, 1988), nor employment arrangements which tie compensation to profits, P.L.R. 8506114 (Nov. 19, 1984), supplemented by P.L.R. 9011055 (Dec. 14, 1989). The new Regulations modify this analysis. If the option, etc., is substantially certain to be exercised because it is substantially in the money, it will be deemed exercised, unless subject to certain exceptions for options issued to lenders and compensatory options. Treas. Reg. §1.1361-1(c)(4)(iii). In calculating whether different series of common stock are in fact different classes, the important issue is whether each shareholder enjoys equal access to distributions and equal rights on liquidation. Treas. Reg. §1.1361-1(e)(i).
 Such a fiction is unlikely to be useful any more for other reasons, however, including more stringent valuation standards applicable to compensatory arrangements; see e.g. §409A and regulations thereunder. If preference stock cannot be used, a package of "straight debt" and common stock will qualify, assuming the debt is protected under the safe harbor in §1361(c)(5). Under the Regulations, the ratio of debt to equity is not an issue if the sale harbor requirements are met. Treas. Reg.§1. 1361-1(e)(5)(iv).
 §1361-(b)(1)(B), (C).
 Corporations and partnerships should also be able to own certain types of options. See Rev. Rul. 67-269, 1967-2 C.B. 298 (issuance of options does not give the holder an immediate stock ownership). The Regulations contain the notion that options and the like "substantially certain" to be exercised may be deemed a second class of stock. See Treas. Reg. §1.13611-1(l)(4)(iii).
 See generally, Haynsworth, Organizing a Small Business Entity, §3.02(d) (1986), on the question whether convertible debt will be construed as a second class of stock. The author concludes that it probably will not. The question of debt as a second class of stock is treated extensively in the Regulations.
 Compare, §708(b)(1)(B).
 Compare, §752(b).
 The S corporation provisions may be seen as an overlay on the regular rules for corporate taxation; an S corporation is still a corporation, and other corporate tax provisions will still apply, to the extent not inconsistent with the S corporation provisions.
 §§311 (b), 336(a). Essentially, the gain at the corporate level is recognized, and flows through to the shareholder to be taxed under the S corporation rules.
 "Earnings and profits" for this purpose are measured at the end of each of the three years; thus S Corporation status can be retained by distributing out all "earnings and profits". On the other hand, even if S status is not forfeited (e.g., during the three-year period), the S Corporation is subject to a penalty tax in each year it enjoys excess net passive income and "earnings and profits". §1375(a)(1). Section 1371 carries over the C Corporation rates to S Corporations except to the extent the Code provides specifically to the contrary.
 §1374. The tax is imposed on the lesser of the taxable income as conventionally determined assuming the corporation were a C Corporation and the hypothetical income if only built-in gains and losses were counted, §1374(d)(2), with carryovers of any untaxed excess to future years". Built-in gains, existing on conversion, lose their taint if unrecognized by the convert for ten years from the date of conversion. The Small Business Job Act of 2010 (P.L. 111-240) reduced the recognition period to seven years for taxable years beginning in 2009 and 2010 and to five years for taxable years beginning in 2011.
 The NOLs can be used to offset recognized built-in gains, §1374(b)(2); a similar rule should apply to passive income under §1375.
 Compare, Selfe v. United States, 778 F.2d 769 (11th Cir. 1985) (basis for guarantee if substance shows the shareholder was the true borrower) with Estate of Leavitt v. Commissioner, 875 F.2d 420 11th Cir. 1989).
[23.1] See, however, §197(f)(9), which denies a step-up with respect to certain intangibles if the assests were held or used by "related parties" prior to July 25, 1991.
 It is possible that the inside basis (the basis of the assets in the hands of the Target) is different from the outside basis (the basis of the shares in the hands of the shareholders). If the Target's asset basis is greater than the Target shareholder's stock basis, then the shareholders will have an additional gain on the liquidation (equal to the difference between the inside basis and the outside basis). Under the reverse scenario, the shareholders will have a capital loss on the liquidation. Because of the limitations on using capital losses, (e.g., individuals get no carrybacks, §1212(b)), tax planning encourages the asset sale and liquidation to occur in the same tax year.
 Treas. Reg. §1.1361-1(l)(1).
 Treas. Reg. §1.1361-1(l)(4)(ii)(B)(1), (2).
 Treas. Reg. §1.1361-1(l)(4)(iv).
 Id., §1.1361-1(1)(2)(iii).
 1d., §1.1361-1(1)(4)(iii).
 There are generally considered to be three ways in which a partnership can incorporate: (1) The partnership transfers its assets to Newco, takes back stock and distributes the same; (2) the partnership liquidates and the partners transfer assets to Newco; or (3) the partners transfer their partnership interests to Newco. There are tax differences dependent on which form is used, mostly focusing on tax basis. See Rev. Rul. 84-111, 1984-2 C.B. 88. A fourth method, pursuant to modern state merger statutes, would be to effect a state law merger of an entity taxed as a partnership directly into a corporation. However, other issues can arise. For example, in format 3, Newco may have in the year of transfer a partnership as a shareholder, meaning S Corporation status cannot be elected for that year Compare P.L.R. 8926016 (March 29, 1989) (momentary ownership of stock by the partnership disregarded and therefore not fatal to S election). The transformation of a partnership to a corporation, like any legal process, is not simple. There is always the possibility that certain prior deductions-federal investment tax credits or research and experimental deductions under §174-may be recaptured.
 See §§311(b), 337. A partnership can distribute appreciated property free of tax at the partnership or partner level unless the cash distributed exceeds the partner's basis, §731, or unless certain tax-avoidance rates apply, see §707.
 §§734, 743.
 This factor is especially significant when a partnership is compared to an S Corporation since an S Corporation may only issue one class of stock, which in turn prohibits special allocations among the shareholders. S Corporation shareholders share in income and loss strictly on a per day, per share basis. §1377(a)(1).
 If a partner as service provider is awarded a "carried interest" in profits, there should not be immediate tax, provided that the interest is considered a pure profits interest. See Rev. Proc. 93-27, 1993-2 C.B. 343. Proposed regulations current exist that would address the taxation of compensatory partnership interests, but which would not generally cause a different substantive tax treatment of pure profits interests granted in consideration of the performance of services. Beware, however, of legislative proposals that would tax income from carried interests as ordinary income.
 §712(b), the analog of §732(a), increases basis when a partner assumes a partnership's liability.
 §708(b)(1)(B) (partnership deemed terminated on the sale or exchange of 50% or more of the total interest in partnership capital or profits within twelve months).
Joseph W. Bartlett, Special Counsel, JBartlett@McCarter.com
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