Non-Pro Rata Rollover for S Corporations

In order to qualify as an S corporation, an entity must satisfy a number of requirements, including that the corporation may only have one class of stock that entitles each shareholder to identical economic rights.  One result of this “single class of stock” requirement is that each shareholder is allocated gain or loss of the S corporation based on their relative ownership of S corporation shares.  Unlike a partnership, where partners can be allocated different shares of partnership items, S corporation allocations must be pro rata based on share ownership.

Thus, where an S corporation sells assets, but defers a portion of the tax gain therefrom by rolling over some of those assets into equity of the buyer in a tax-deferred manner, whatever gain is recognized must be allocated pro rata to the S corporation shareholders, regardless of how they will share the proceeds of the transaction.

Example 1:  Seller, an S corporation, is owned equally by A and B.  Seller enters into an agreement to sell 100% of its assets to Buyer in exchange for $100 of total consideration, consisting of $80 of cash and $20 of equity of Buyer (issued in a tax-deferred manner); however, A wants to stay invested in the business, while B wants to exit entirely. As a result, they have agreed that A will retain 100% of the equity of Seller, which will hold the $20 of equity of Buyer, while B’s shares of Seller will be completely redeemed in exchange for $50 of cash.  Seller has $10 of basis in its assets.

At the S corporation level, the Transaction will result in $72 of gain to the Seller (total gain realized of $90 ($100 of amount realized, less basis of $10), but only $72 recognized gain due to 20% deferral). That gain will be allocated equally to A and B, $36 each.  

That $36 allocation to B will increase her basis (assume it was $5 pre transaction) to $41.  The distribution of $50 cash to B in redemption of its Seller shares will trigger additional gain to B of $9 ($50 distribution in excess of $41 basis results in $9 of gain for a total of $45 of gain to B).

At the end of the day, A and B will recognize a collective $81 of gain on $80 of cash received.  Further, Seller will have a $2 basis in the $20 worth of equity it continues to hold, potentially resulting in $18 of additional gain either during the life of the investment or at exit.  Ultimately, if/when Seller is dissolved, the negative tax ramifications will work themselves out but timing and character differences may result in material economic changes.

The easy solution to the non-pro rata rollover dilemma is to shift to a stock deal (for tax purposes) rather than an asset deal.  There, because the transaction is occurring at the shareholder level, each shareholder can experience their own tax consequences without being bound by the tax choices of the other shareholders. Shifting from an asset to a stock deal, however, can have adverse consequences on a buyer who sees significant value in a tax basis step-up and operating through a pass-through entity, so the easy solution may not be the best solution.

Another solution is simply to recognize 100% of the gain in the current transaction.  There’s the potential for that structure to be economically beneficial regardless of the non-pro rata rollover dilemma.   

There is also a more complex solution to the non-pro rata rollover dilemma, but you’ll need to contact your friendly Acta professional to find out whether your transaction is a fit for this potential solution.