Fund for structuring debt-financed investments in S Corporation enterprises to minimize ordinary income of S Corporation | Nutter McClennen & Fish LLP

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Partnerships are ineligible S corporation shareholders. Thus, a partnership cannot acquire shares of an S corporation without terminating that corporation’s S election.

However, a partnership can still invest in the business of an S corporation without terminating that corporation’s S election. Let’s say a partnership (fund) wants to invest in the business of an S corporation. To facilitate this investment, the shareholders of the S corporation (Opco) typically transfer their shares in the S corporation to a new corporation (Holdco) by Holdco stock exchange. Opco then converts to an LLC (Opco LLC).

Many articles deal with this reorganization and related tax issues. Little has been written about the tax issues that arise when the Fund finances its investment in Opco with debt financing. This review focuses on these issues.

Timing is everything

When Opco converts to Opco LLC, it is a single member LLC. It will become a tax partnership when another person acquires an interest in Opco LLC. This second person may be the Fund or another person. The transaction is completed when the Fund acquires an interest in Opco LLC. The tax consequences for the Fund and Holdco of this transaction may differ significantly depending on whether the Fund acquires its interest in Opco LLC where Opco LLC is a tax partnership or where Opco LLC is a single member LLC. The difference is amplified when the Fund finances its investment with debt.

When the Fund’s debt finances its investment in Opco, Opco LLC is the borrower. Opco is distributing the proceeds from the debt financing to Holdco to repurchase a portion of Holdco’s interest in Opco LLC. This distribution is the second step in a “disguised sale” transaction. In this back sale transaction, Holdco is treated as if it had sold the assets of Opco LLC for payment funded by the proceeds distributed from the debt financing. The amount of the payment depends on Holdco’s share of that debt according to the partnership’s debt allocation rules. These rules are outside the scope of this notice. Suffice it to say that Holdco is treated as selling assets of Opco, usually for a large gain.

As noted, the distribution of debt proceeds is the second stage of the disguised sale. The first stage occurs when Holdco is treated as a contribution of assets from Opco LLC to a tax partnership. This contribution occurs either when Opco LLC becomes a tax partnership or when Holdco contributes Opco LLC to an existing tax partnership.

The date of this first step is the date of the disguised sale. This is an important factor in determining Holdco’s tax consequences. If Holdco owns more than 50% of the capital or earnings of Opco LLC on that date, any gain to Holdco is ordinary income. For this reason, Holdco will want Opco LLC to become a tax partnership on the date it enters into all transactions with the Fund, including debt financing.

The fund, on the other hand, is incentivized to close with Holdco at least days after Opco LLC became a tax partnership. In this case, the deductions for depreciation and amortization financed by its investment can be assessed exclusively by the Fund. Otherwise, the Fund will share such deductions with Holdco, unless Opco LLC uses “corrective allocations” for deductions related to property contributed by Holdco.

Corrective allocations are a painful remedy for misallocating deductions. The corrective allocations require Holdco to prorate the gain that would otherwise be deferred until the sale of Opco. In addition, the income from these gains will be ordinary income and not a capital gain. For this reason, neither the Fund nor Holdco will want to use corrective allocations unless absolutely necessary.

Achieve a desired result

With proper planning and with the Fund’s cooperation, corrective allocations may not be necessary to ensure that the Fund achieves the deduction results it seeks. And Holdco can also avoid ordinary income on its hidden sale triggered by the distribution of debt proceeds. The key to achieving this outcome is structuring the transaction so that Holdco forms a partnership with an affiliate one day and several days later brings Opco’s assets to that partnership and enters into equity and debt transactions with Fund . It is possible, but complicated. However, the benefits for all parties involved may outweigh the complicated structure. If you have questions about structuring these types of transactions, our team can help you navigate this process.

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