Tax inversions have been much in the news lately. What is reported in the popular press is a trend to reincorporating a US company abroad for lower effective rates of tax on non-US source income. In the middle market, such tax inversions are rare, but there is another kind of corporate tax inversion of relevance to middle market companies and their advisors.
Consider that you have an S corporation client who wants to bring an investor into ownership. Do you bring the investor directly into the corporation? The investor may be an entity that is not eligible to own the stock of an S corporation. Or the negotiated deal with the investor may create a second class of stock that would result in loss of the S election.
Consider, also, a key employee who is to be given an ownership stake in an S corporation. The intended deal with the company (that the key employee participates in future growth in value only) is probably not compatible with the no second class of stock rule.
So you might consider a conversion of the corporation into an LLC, or a drop down of the corporation’s assets to an LLC, and then bring the investor into the LLC. See my recent posting on Subchapter S corporations: Not So Much.
The conversion probably triggers an unacceptable “toll charge” in the form of tax on the deemed liquidation of the corporation (indeed even for an S corporation).
You may like the drop down idea instead, but alas the client has no interest in shifting payroll from the corporation to the LLC, obtaining consent to an assignment of the facilities lease from the corporation to the LLC, obtaining lender consent, obtaining consent from major customers and suppliers, etc. Clearly there are administrative burdens to what appears to be a simple drop down of operating assets into an LLC in preparation for bringing the investor or employee into the LLC.
But consider this “inversion” technique:
1. Shareholders of the existing corporation form a new corporate holding company above the existing corporation.
2. The new corporate parent makes an S election.
3. The old corporation by election becomes a Q-sub of the new corporate parent.
4. The old corporation then converts into an LLC (in some states the conversion occurs by way of merger of the Q-sub into the LLC).
5. The investor or employee is then admitted into the LLC (which was the old corporation). This creates a tax partnership, and the S corporation problems involving the new investor or employee have been managed.
A little complicated, but really not. Go through these steps again.
Notice, now, that from a commercial perspective, all of the operating assets, contracts and legal relationships remain in the old corporation (which eventually converted into an LLC). No assets are transferred. Consents from landlords, lenders and major customers may not have to be obtained (although documents should still be reviewed to be certain of that). This inversion technique avoids most (albeit not all) of the administrative burdens associated with the drop down of corporate assets into the LLC.
Notice, also, that because the conversion of the subsidiary corporation to LLC occurred at a time when the corporation was a Q-sub of another company (the new corporate parent), the conversion is from one disregarded entity (Q-sub) to another disregarded entity (single member LLC).
This is yet another example of how to use disregarded entities creatively to advantage, to bridge the gap between a tax objective (accommodating an investor not eligible to own S corporation stock or an employee on terms that would result in a second class of stock) with the client’s commercial objective of minimizing change.