Issues to Consider When Merging Two S Corporations or Other Closely-Held Entities

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January, 2003 Hot Topics - Part 1 of a 2-part series

		Issues to Consider When Merging Two S Corporations or Other Closely-Held Entities

Scenario:		Tom and Mary want to combine their subchapter S corporations, Acme Corporation and Beta Corporation, respectively, and work together as owners of a new entity. Beta Corporation is owned 90% by Tom and 10% by Sally. Tom suggests a merger, but Mary, who owns the larger company, wants to remain in charge of business operations after the transaction. Following are some of the issues that Tom and Mary should consider.
HOW SHOULD TOM AND MARY COMBINE THEIR BUSINESSES? Merge The Companies:		Since Tom and Mary each have a corporation, they can merge (become one) on a tax-free basis. With a merger, either Acme or Beta corporation will become the surviving entity while the other corporation will "disappear" into it. An advantage of the merger is that it is relatively straightforward, one entity remains and the other disappears. A disadvantage is the disappearing corporation no longer operates as an independent entity and its goodwill (name recognition, business operations, telephone numbers, advertisements) will disappear into the surviving entity. Issues dealing with employees and outstanding liabilities and potential creditor claims also become the responsibility of the surviving entity. Also, Sally, as a 10% shareholder in Beta corporation could have dissenter's rights under state law if she objects to the merger, although in this case, Sally will not object.
Create a Parent Corporation with Acme and Beta Corporations as subsidiaries:		Tom and Mary could transfer their stock in both Acme and Beta Corporations to a newly formed corporation (called "Parent"), in exchange for stock in Parent. In general, this can be accomplished on a tax-free basis under IRC Sec. 351. Parent Corporation can be an S corporation which owns Acme and Beta corporations. Acme and Beta corporations must meet the requirements of a qualified sub-chapter S subsidiary¹, which should not be an issue in this case. Tom can transfer his stock in Acme corporation to Parent in exchange for Parent stock and Mary does the same with her Beta corporation stock. Since Beta is the larger corporation, Tom and Mary agree that Mary should own 60% of Parent and Tom and Sally would then receive the 40% balance of the issued and outstanding stock. Under this scenario, Acme and Beta retain their independent entity status, which means that each continues in business with its individual employees and liabilities remaining within each independent entity. Also, if Tom and Mary decide that their business venture is not working, each can receive their former company as part of a dissolution or buyout. Note: The shareholders of Parents must timely consent to the S Corporation elections and if they live in a community property state, their spouses must consent as well.
Create a Limited Liability Company (LLC) which owns both Acme Corporation and Beta Corporation:		Tom and Mary could create an LLC that owns the corporations, generally on a tax-free basis, however, the corporations would no longer qualify as S corporations; an adverse tax consequence that, in many instances, would preclude using an LLC as a parent.
OTHER TAX ISSUES: Stock Options for Employees:		Tom and Mary will provide an employee stock option plan for their employees. IRS has ruled that such a plan will not violate the S corporation's one class of stock rule. Because shareholders, including employee/shareholders, take into income their pro-rata share of corporae earnings, Tom and Mary want the stock options to "vest" over a 4-year period. If Tom and Mary issue Incentive Stock Options (IRC Sec. 422), there could be hidden tax traps caused by the Alternative Minimum Tax ("AMT") when the employee exercises the options, especially when the stock price rises greatly in value during the vesting period.²
Forming a Separate LLC to Hold and License Mary's Intellectual Property:		Mary wants to separate out the intellectual property (her tradename and copyrighted materials, trade secrets and know-how) created by her prior to the formation of Parent. She wants to continue to own her IP. Mary should consider forming an LLC to hold her IP and then licensing it to Parent in return for royalties. There are several reasons for Mary to form a separate entity to hold her IP. (1). The LLC may be owned by a combination of the following members: Mary; a trust for Mary's parents and children; and, possibly, her IRA. This allows income to be received directly by persons whom Mary would otherwise support with after-tax dollars. If her IRA owns a significant portion of the LLC, the income received by the IRA is not currently taxed.³ If the IP is subsequently sold for a large capital gain, the proceeds will be divided among the members and Mary's share will be limited to her interest in the LLC. This reduces Mary's estate for estate-tax purposes. Also, Mary's interest in the LLC will be entitled to valuation discounts should she die owning the LLC interest.⁴ (2). The royalty income is not subject to employment taxes. Unlike earnings from an S corporation, which, if characterized as income from personal services is subject to employment taxes, the royalty income is not personal service income and, therefore, not subject to employment taxes. (3). If Parent is successfully sued by a creditor or goes out of business, Mary's IP is not an asset of Parent. Parent merely has a licensing agreement which, if properly drafted, could be terminated by the LLC. The LLC could then enter into a new licensing agreement with another entity. ⁵
Form an LLC with Tom to Purchase a Building:		Mary wants to take advantage of the depressed real estate market where Parent will operate and would like to purchase a building and lease it to Parent. Mary and Tom decide to become equal members of an LLC which will purchase a building and lease it to Parent. Reasons to acquire a building and place it into an LLC include: (1). Rents paid by Parent are not self-employment income to Tom or Mary. Future appreciation in the building will benefit Tom and Mary directly. Each can engage in estate planning by transferring membership interest to family members or trusts. Minority discount rules for valuing each member's interest in the LLC for gift and estate-tax purposes will produce a lower valuation. (2). The building is not an asset of Parent, thus, if Parent is successfully sued, the building will not be subject to the claims of Parent's creditors. -------------------Footnotes----------------------- 1 A "Q-sub" is a domestic corporation that qualifies as an S corporation and is 100% owned by an S corporation parent. A Q-Sub is a disregarded entity: all of its income, losses and assets flow through to the parent. A corporation must elect Q-Sub status. 2 See my article on ISOs Meet the AMT: Employees Ambushed by the Tax Code regarding the problems of an ISO issued by an S corporation which is later acquired by a public company. Also, see my Tax Prophet section on Stock Options in general. 3 If Mary has a Roth IRA as a member of the LLC, the income conceivably will never be taxed to her, provided she receives it after age 59 ½. 4 See generally my Tax Prophet section on Estate Planning. 5 See generally, my Tax Prophet section on Asset Protection.

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