Exit Dreams and Tax Nightmares: The Lurking Threats behind your S Corporation

A few years ago, we advised a group of professional services sellers in connection with a dream of an acquisition event: $100 million+ exit as a platform company to a well-known private equity group within the professional services space. The deal promised not only a healthy cash payment of $50-60mm at closing, but potentially, future riches from the sale of the owners’ rollover equity once the business achieved another exit at an even higher valuation.

Unbeknownst to them, years before, their tax advisor had made the grave mistake to counsel them that it was acceptable to issue some of their equity to LLC entities owned by them and certain employee investors. What appears as a harmless reorganization had a catastrophic consequence: the buyer averred that the operating company had a serious tax issue and in lieu of simply walking away from the deal, they insisted on a ~$10mm purchase price reduction. My firm was a new advisor to this client and although we proposed every possible solution to give fair protections to the buyer and avoid the reduction, the buyer wouldn’t budge. The deal closed after our sellers accepted that reduction and a litany of other protections for the buyer.

What had our sellers done that was so egregious? Their operating company was an S corporation, and S corporations generally can only be owned by individuals, estates, certain trusts, or certain other exempt organizations, but not an LLC. At the moment our sellers had issued their operating company equity to an LLC, their S election was terminated and their company had become a C corporation.

That fact created a number of different problems for the sellers. Firstly, it meant that for all prior years after the mistake, they should have been filing and paying their taxes as a C corporation and not an S corporation. C corporations are subject to double-taxation: they are taxed on their earnings and distributions made to shareholders are also subject to tax. The sellers needed to amend some prior year tax returns and potentially pay some additional tax, penalties, and interest. The double-tax scenario also upended the private equity sponsor’s projections of future cash flows from the operating company – this is what primarily drove the purchase price reduction. There was also a wider world of tax rules applicable to C corporations that the sellers hadn’t thought to comply with, under the assumption they were operating as an S corporation: requirements to use accrual (rather than cash basis) accounting methodologies, requirements around “golden parachute” bonus payments to executives in M&A transactions, and other requirements.

Thankfully, the deal closed and the sellers and their company are thriving alongside their new private equity partner. However, on reflecting on their transaction, I realized that many of my other proserv firm clients also have S corps and almost always have some tax issue created by their S election. Right now, there are thousands of LLCs (putatively) taxed as S corporations that have defaulted their S elections because they have adopted operating agreements built for LLCs taxed as partnerships rather than S corps – a simple but extremely common mistake. So many of the potential areas for foot faults arise from completely arcane legal and tax issues. Had a shareholder with a spouse in a community property state and that spouse did not sign the original S election tax form? It’s probably invalid. One of your shareholders transferred his stock to his IRA? That transfer may have terminated the S election. This is a minefield.

So what can Proserv firms interested in becoming an S corp or currently operating as an S corp learn from the above parable?

1. This area of tax law is too complex to be navigated by the average business owner. You really must have an experienced tax advisor and lawyer to guide you.
2. Even a seemingly competent tax advisor can make a mistake in this area. A tax advisor with S corp experience can spot a lawyer’s mistake and vice versa; be sure to involve your subject-matter experts on relevant items and all your experts on major decisions.
3. In exit transactions, the tax treatment given to your company deeply impacts its value, both for you and your buyer. Uncertainty about tax treatment leads to uncertainty about your exit.

Are you sure you made a valid S election (and that it’s still valid)? My team would be happy to help you get certainty and connect you with the tax advisors that will help you stay certain. Don’t wait until your dream exit meets up with a tax nightmare.