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Structuring Fund Debt-Financed Investments in S Corporation Businesses to Minimize Ordinary Income to the S Corporation

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

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

Many articles discuss this reorganization and its related tax issues. Not much has been written about tax issues arising when Fund finances its Opco investment with debt financing. This advisory focuses on those 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 Opco LLC interest. That second person may be Fund or another person. The transaction is completed when Fund acquires an interest in Opco LLC. The tax consequences to both Fund and Holdco of this transaction can differ materially depending on whether Fund acquires its Opco LLC interest when Opco LLC is a tax partnership or when Opco LLC is a single member LLC. The difference is magnified when Fund finances its investment with debt.

When Fund debt finances its Opco investment, Opco LLC is the borrower. Opco distributes proceeds of the debt financing to Holdco to redeem some of Holdco’s interest in Opco LLC. That distribution is the second step in a “disguised sale” transaction. In this disguised sale transaction, Holdco is treated as if it sold Opco LLC assets for a payment funded by distributed proceeds of the debt financing. The amount of the payment depends on Holdco’s share of that debt under partnership debt allocation rules. Those rules are not in the scope of this advisory Suffice to say that Holdco is treated as selling Opco assets, usually for a sizable gain.

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

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

Fund, on the other hand, has an incentive to close with Holdco at least a few days after Opco LLC becomes tax partnership. In that case, depreciation and amortization deductions funded with its investment can be enjoyed exclusively by Fund. Otherwise, Fund will share those deductions with Holdco, unless Opco LLC uses “remedial allocations” for deductions related to Holdco’s contributed property. 

Remedial allocations are a painful remedy for deduction misallocations. Remedial allocations force Holdco to ratably recognize gain that would otherwise be deferred until Opco was sold. Further, the income from those gains will be ordinary income, not capital gain. For this reason, neither Fund nor Holdco will want to use remedial allocations unless absolutely necessary.

Achieving a Desired Outcome

With the right planning, and with Fund’s cooperation, remedial allocations may not be necessary to ensure that Fund get the deduction results it seeks. And Holdco can also avoid ordinary income on its disguised sale triggered by the debt proceeds distribution. The key to achieving this result is structuring the transaction so that Holdco forms a partnership with an affiliate one day and several days later contributes Opco assets to that partnership and closes equity and debt transactions with Fund. It’s possible, but complicated. However, the benefits to all concerned may be more than worth the complicated structure. If you have any questions about structuring these types of transactions, our team can help navigate this process.

This advisory was prepared by Nutter’s Tax Department. If you would like additional information, please contact your Nutter attorney at 617.439.2000.

This update is for information purposes only and should not be construed as legal advice on any specific facts or circumstances. Under the rules of the Supreme Judicial Court of Massachusetts, this material may be considered as advertising.

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