A Primer On Entity Selection For The Estate Planner

A Primer On Entity Selection For The Estate Planner


 by Jeffrey A. Galant and Andrew Wilson

        When helping theclient to select a business form, the estate planner must consider a great dealmore than how that decision will affect the transfer of the business on death.For a number of special provisions relating to closely held businesses, the formof the entity is not critical.  For example, the payment of estate taxesover 14 years applies to interests as proprietor, partner, and shareholder, andthe "qualified family-owned business interest" deduction does notdepend upon the type entity.  However, the choice must be compatiblewith the daily business operations, the degree to which the owner wishes tomaintain control of the business, as well as the transfer tax considerationsincluding transfers of business interests during life or at death, and whetherthe owner wants the business to continue in the family after his or herdeath.  The choice of entity can also have a significant impact onadministrative complexity, from a legal, financial, accounting, and organizationalperspective.  The income tax treatment of the business and the owner duringthe owner’s life should also be of primary concern.  Also, the choice ofentity will terminate the degree to which personal assets of the owner arevulnerable to claims.                                                                                   

        This article will look at several aspects of the various factorsthat should be considered when selecting the proper entity for a client’sbusiness, by explaining, in a skeletal way, the definition of several of themost popular and useful business entities, how they are formed, how theiroperations are taxed, how inter-vivos transfers of their equity or control canbe made, certain exit strategies, and the succession of the business upon theowner’s death.  The proper structure is the key to income taxplanning.  Choosing the appropriate entity within which to operate thebusiness is most important, not only for general business and legalconsiderations, but in order to maximize the business owner’s return in theevent the business issold.                                                                        

        The intricacies of entity selection lend themselves more to a treatise than anarticle.  In order to limit the discussion, a number of assumptions need tobe made.  First, the owner is a United States person; second, the businessis not a farm, and third, the business is located within the UnitedStates. 

SOLE PROPRIETORSHIP                                                                          A sole proprietorship occurs where an individual owns andoperates a business, that is, the business does not exist separately from theowner, and the individual owner accepts the risks of the business to the extentof all his or her assets, whether used in the business or used personally. The sole proprietorship is simplest from the viewpoint of ongoing accounting andreporting requirements.  Since the sole proprietorship is not a legallyunique entity, the business’ books and the owner’s books are the same. Therefore, business profits may be subject to the highest individual marginalfederal income tax rate of 39.6 percent.  A sole proprietor may also berequired to pay other taxes that apply (such as employment tax).  As thesole proprietorship is not an entity distinct from its owner, no formalities arerequired to operate assuch.          

        Aside from the lack of flexibility in operations and taxation, the soleproprietorship suffers from an undesirable trait, in that the assets of theowner, including those assets that are used in the business and those that arenot, are vulnerable to claims against the business by creditors, tort claimants,and the IRS.  See, however, the discussion of the limited liabilitycompany, infra.  Liability protection may be available to the soleproprietor, if the business is owned by a limited liability company of which theowner is the solemember.            

        Thesole proprietorship may be the least useful if the estate plan involves thetransfer of partial interests in the business during the owner’s life.  Bydefinition, partial transfers of interests in a sole proprietorship areimpossible.  Each asset disposed of during life is recognized on theowner’s individual return, and treated appropriately.  However, while acomplete discussion of entity changes is beyond the scope of this article, inmany cases a sole proprietorship may be converted into another entity, oftenwithout the imposition of tax on the conversion.                                          

        Termination of a proprietorship is easily achieved, as no formal documentationis required other than perhaps canceling certificates of doing business withlocal authorities.  The business ceases existence when the proprietor stopsdoing business.  Alternatively, the proprietor can sell the business, orgive it away.  The sale of a proprietorship is treated as a sale of eachindividual asset; gain or loss is recognized on each asset individually.  

        Upon the death of the proprietor, each asset of the business will become part ofthe business will become part of the gross estate of thedecedent.  Each asset, including the goodwill of the goingbusiness, receives a basis step-up to the value of the property on the date ofthe decedent’s death or the alternate valuation date, as the case may be.  The proprietorship ceases to exist, unless the assets aretransferred or deemed transferred, to a new entity.  The legatees may, ofcourse, continue to use the assets in the conduct of thebusiness.

GENERAL PARTNERSHIP                                                                            The Uniform Partnership Act of 1994 ("UPA") defines a partnershipas "an association of two or more persons to carry on as co-owners abusiness for profit."  For tax law purposes, a partnership includes"a syndicate, group, pool, joint venture or other unincorporatedorganization through or by means of which any business, financial operation, orventure is carried on, and which is not a corporation, trust, orestate."  From the point of view of liability protection, the generalpartnership offers little, if any, advantage over a sole proprietorship.  

        The organization of a partnership is generally a non-taxable event.  Thepartners contribute property to the partnership in exchange for interests in thepartnership.  A partner’s basis in his or her interest in the partnershipis the amount of money plus the adjusted basis of the property contributed. If the contributed property is subject to indebtedness or if liabilities of thepartner are assumed by the partnership, the basis of the contributing partner’sinterest is reduced by the portion of the indebtedness assumed by the otherpartners, since the partnership’s assumption of his indebtedness is treated as adistribution of money to the partner.  This may cause a taxable event tosuch partner.  The basis to the partnership of property so contributed isthe adjusted basis of the property in the hands of the contributor at the timeofcontribution.                                                                                     

        One ofthe primary advantages to the partnership form is the lack of formality requiredin its operation.  A general partnership can be formed on ahandshake.  There is no requirement in either state law or the tax code fora partnership to have a written agreement, but for planning purposes and otherobvious reasons such as proving the partnership’s existence, a writtenorganizational document is crucial.  The partnership agreement can definethe relationship between the partners in almost any way they would like. Most importantly, a partnership agreement can allocate each partner’sdistributive share of partnership income, gain, loss, deduction or credit. So long as  the allocation has substantial economic effect, the partnerscan allocate those items in any way theywish.               

        Whilethe definition of "substantial economic effect" occupies several pagesof the regulations, it is summarized in two parts.  "In order for anallocation to have economic effect, it must be consistent with the underlyingeconomic arrangement of the partners.  This means that in the event thereis an economic benefit or economic burden that corresponds to an allocation, thepartner to whom the allocation is made must receive such economic benefit orbear such economic burden."  Further,"the economic effect of an allocation is substantial if there is areasonable possibility that the allocation will affect substantially the dollaramounts to be received by the partners from the partnership, independent of taxconsequences."

        Apartnership as such is not subject to federal income tax; it is a pass throughentity.  Persons carrying on business as partners are liable for income taxonly in their separate or individual capacities.  The partnership computesits taxable income in the same manner as in the case of an individual, exceptthat the partnership accounts separately for certain items which may have adifferent effect on individual partners, depending upon the partner’s individualtax circumstances.  Also, several deductions are not allowed to thepartnership, most importantly the personal exemption, charitable contributions,and net operating losses.  Each partner accounts for his or herdistributive share of each item on their individual returns.  The itemsmaintain their tax character in the hands of the partner.  The adjustedbasis of each partner in the partnership is increased for his or her distributiveshare of income, and decreased for loses and nondeductible expenditures. This eliminates the double taxation inherent in corporations. Alternatively, a general partnership could elect to be taxed as a corporation,including, if it meets the requirements of subchapter S of the Internal RevenueCode of 1986, as amended ("the Code"), as an S corporation.

        Forfederal tax purposes (as opposed to state organizational purposes), thepartnership form may involve sophisticated reporting and accountingrequirements.  "Partnership characterization has numerous consequencesto the co-owners.  In addition to subjecting the co-owners to the reporting and filing requirements imposed onpartnerships, unexpected partnership characterization may result in adverse tax consequences."  The adverse consequences include penalties for failureto file partnership returns, and the disallowance of inappropriately claimedpartnership allocations.  

        Forestate planning purposes, partnerships provide an opportunity to legallyshift taxable income from parents to children, while the parents can maintaincontrol of the business.  This involves the gifting of partnershipinterests, and the corresponding distributive income allocations, withoutdistributing the right to participate too actively in the management of thepartnership.  A person will be recognized as a partner for purposes ofthe income tax provisions if he owns a capital interest in a partnership inwhich capital is a material income-producing factor.

        Unlikethe transfer of the evidence of ownership in corporations, the transfer ofpartnership interests can adversely effect the partnership itself.  Forfederal income tax purposes, an existing partnership is considered as continuingif it is not "terminated."  A partnership is consideredterminated only if "no part of any business, financial operation, orventure of the partnership continues to be carried on by any of its partners ina partnership," or if "within a 12-month period there is a sale orexchange of 50 percent or more of the total interest in partnership capital andprofits."

        Exceptas otherwise provided, upon the death of a partner, payments made in liquidationof his or her interests are considered a distributive share to the recipient ofpartnership income if the amount thereof is either determined with regard to theincome of the partnership, or is considered to be a guaranteed payment. The portion of the distributive share which is includable in the gross income ofa successor in interest of a deceased partner is considered income in respect ofa decedent under Code Sec. 691.  However to the extent such payments aredetermined to be made in exchange for the interest of the partner in partnershipproperty, the payments will be treated as a distribution by the partnership andnot as a distributive share or guaranteed payment.  The amount consideredto be a distribution shall not include amounts paid for unrealized receivablesor good will, if capital is not a material income-producing factor for thepartnership, and if the deceased partner was a general partner.  

LIMITED PARTNERSHIP                                                                               A "limited partnership" is a partnership formed by two or more personsunder state law that has one or more general partners and one or more limitedpartners.  The limited partnership may carry on any business that a generalpartnership may carry on.  The primary legal distinction between generalpartnerships and limited partnerships is that the liability of a limited partnerfor partnership obligations is limited to the amount of money or propertycontributed in exchange for a partnership interest, the amount of recourse debtof the partnership for which the limited partner could be held liable, and theobligation of the limited partner to contribute money or property to thepartnership in the future.  The income tax rules are generally the same asapply to general partnerships, and a limited partnership can elect to be taxedas a corporation, including as an S Corporation.  

        Inorder to form a limited partnership, a certificate of limited partnership mustbe executed and filed with the appropriate state office.  In addition toother requirements, the certificate must set forth the name and business addressof each general partner.  A general or limited partner may be anindividual, corporation, business trust, estate, trust, partnership,association, joint venture, or any other legal or commercial entity.  Thereis no requirement under the Revised Uniform Partnership Act (1985) ("RULPA")that any general partner be an individual.  

        Exceptas provided in the partnership agreement, a general partner of a limitedpartnership, has all the rights and powers, and is subject to all of therestrictions of a partner in a general partnership.  A general partner hasthe same risk of liability, both to other partners and to third parties as apartner of a general partnership.  The partnership agreement can, however,limit the liability of a general partner to the partnership and to the otherpartners.

        Alimited partner is not liable for the obligations of a limited partnershipunless he or she is also a general partner or, in addition to the exercise tohis or her rights and powers as a limited partner, he or she participates in thecontrol of the business.  However, a limited partner who knowingly permitshis or her name to be used in the name of the limited partnership, except if thename of the limited partnership contains the name of a general partner or thecorporate name of a corporate general partner, or the business of a limitedpartnership had been carried on under that name before the administration of thelimited partner, is liable to creditors who extend credit to the limitedpartnership without knowledge that the limited partner is not a generalpartner.  If the limited partner participates in the control of thebusiness, he or she is liable only to persons who transact business with thelimited partnership reasonably believing, based upon the limited partner’sconduct, that the limited partner is a general partner.

        Thismeans of course, that a limited partner loses his or her limited liability if heor she "participates in the control of the business."  There are,however, a number of ways in which a limited partner can be involved in theoperation of the limited partnership without "participating in the controlof the business."  For example, a limited partner is not deemed toparticipate in the control of the business solely by consulting with andadvising a general partner with respect to the business of the limitedpartnership, by being an officer, director, or shareholder of a general partnerthat is a corporation, or being a contractor for an agent or employee of thelimited partnership or of a general partner.  The law of the jurisdictionin which the partnership was organized must be carefully reviewed with respectto the extent to which the provisions of RULPA (1985) have been adopted andactually apply in the jurisdiction.  

        Unlesslimited by the partnership agreement, limited partnership interests areassignable in whole or in part.  An assignment does not dissolve thelimited partnership.  An assignment does not entitle the assignee to becomeor exercise any rights of a partner, but only entitles the assignee to receivethe distribution to which the assignor would have been entitled.  A commonestate planning technique involves the inter vivos transfer of limitedpartnership interests as gifts to family members.  The value of theinterest may be discounted as explained below.  

        If apartner dies or is adjudicated incompetent, the limited partnership does notdissolve and the partner’s legal representative may exercise all of thepartner’s rights for the purpose of settling his or her estate or administeringhis or her property.  


        Acorporation is "[a]n artificial person or legal entity created by or underthe authority of the laws of a state.  An association of persons created bystatute as a legal entity.  The corporation is distinct from theindividuals who comprise [it]."  The owners of the corporation, itsshareholders, enjoy limited liability.  

        As theproduct of state legislative fiat, the requirements for corporate formationvary.  A summary of typical requirements include:  


filing the corporate charter or Articles of Incorporation with the state; bullet

adopting written bylaws, or other document which controls corporate governance; bullet

adopting a shareholders agreement to govern the relationship among shareholders; bullet

electing a board of directors to oversee the corporation; and  bullet

holding an organizational meeting to elect or appoint officers to manage the daily operations of the corporation.

        Forminga corporation can be accomplished in a tax-free transaction.  No gain orloss is recognized if property is transferred to a corporation by one or morepersons solely in exchange for stock in such corporation and immediately afterthe exchange such person or persons are in control of the corporation. "Control" is defined as "the ownership of stock possessing atleast 80 percent of the total combined voting power of all classes of stockentitled to vote, and at least 80 percent of the total number of shares of allother classes of stock of the corporation."

        Theformation transaction will not always be entirely tax-free, however.  If,in addition to stock permitted to be received under Code Sec. 351(a), otherproperty or money is received, the recipient will be required to recognize anygain realized in the exchange, up to the amount of any money plus the fairmarket value of any other property received.  Stock issued for (1)services, (2) indebtedness of the transferee corporation which is not evidencedby a security, or (3) interest or indebtedness of the transferee corporationwhich accrued on or after the beginning of the transferor’s holding period forthe debt are not considered as issued in return for property.

        Ifstock received in exchange for a contribution to a control corporation is"non-qualified preferred stock," the nonrecognition rule of Code Sec.351(a) will not apply, and non-qualified preferred shares will be treated as"other property" for purposes of Code Sec. 351(b).  Non-qualifiedpreferred stock refers to certain preferred stock if (i) the holder has theright to require the issuer or a related person to redeem or purchase the stock,(ii) the issuer or a related person is required to redeem or purchase the stock,(iii) the issuer or a related person has the right to redeem or purchase thestock and, as of the issue date, it is more likely than not that such right willbe exercised, or (iv) the dividend rate on such stock varies in whole or in part(directly or indirectly) with reference to interest rates, commodity prices, orother similar indices.  Clauses (i), (ii), and (iii) apply only if theright or obligation may be exercised within the twenty-year period beginning onthe issue date of the stock and the right or obligation is not subject to acontingency which, as of the issue date, makes remote the likelihood of theredemption or purchase.  


        TheC Corporation, as defined in Code Sec. 1361(a)(2), is a legally unique entity,apart from its shareholders, which account for its own items of income, gains,losses, deductions and credits, files its own tax returns, and pays its owntaxes.  Corporate income is subject to taxation at the corporatelevel.  Corporate income is currently taxed at between 15 percent, fortaxable income of up to $50,000, to 35 percent, for taxable income over$10,000,000.  In addition, if corporate income is distributed to theshareholder, it can be taxed at the shareholder level.  This creates apotential for earnings by the corporation to be taxed at ordinary income ratestwice.  If the corporation does not distribute dividends, then the incomeearned by the corporation will be taxed to the shareholder as capital gain whenthe shareholder sells his or her shares.  The corporation cannot simplyaccumulate profits to avoid paying taxable dividends to shareholders, ascorporations are subject to tax (at 39.6 percent) on income which isunreasonably accumulated. 

        The equityinterest in corporations (the shares), whether C corporations or S corporations(see below), are readily transferable inter vivos.  When a shareholdertransfers stock to another person, there is generally no tax ramifications toeither the corporation, or to the shareholders who are not involved in thetransfer.  The donor does not recognize income upon a gift of shares, as agift is not a realization event.  When the shares are gifted, the doneetakes the property with the donor’s basis, plus the gift tax paid by the donor,if any. 

        In aplanning posture, the shares of a closely-held corporation can be discounted forgift tax purposes to reflect their lack of marketability and lack ofcontrol.  In such corporations, the shares can contain numerous types ofrestrictions on transfer, and such restrictions are commonly used as a mechanismto retain family control over the business.  Note, however, that any entitycan restrict the transferability of equity interest.  Whether suchrestrictions will be taken into account for gift tax purposes depends on theapplicability of certain valuation provisions in the Code. 


       An "SCorporation" is a small business corporation for which an election underCode Sec. 1362(a) is in effect.  Small business corporation eligible toelect S Corporation status means a domestic corporation which does (a) not havemore than 75 shareholders; (b) have a person who is not an individual as ashareholder (although an estate, certain trust, and certain exempt organizationsmay be shareholders); (c) have a nonresident alien as a shareholder; and (d)have more than one class of stock.  Thus, while the S Corporationeliminates the corporate double tax, the extra requirements for S Corporationstatus make the election impossible for many corporations. 

        Somecorporations, regardless of their adherence to the rules of Code Sec. 1361(b)(1)are ineligible to elect S status.  The include:  (a) financialinstitutions which use the reserve method of accounting for Code Sec. 585 baddebts; (b) insurance companies subject to tax under subchapter L;  (c)corporations to which a Code Sec. 936 election applies; or (d) a domesticinternational sales corporation ("DISC") or former DISC.

        Differencein voting rights among the shares of common stock are disregarded for purposesof the "one class of stock" requirement.  A corporation istreated as having only one class of stock if all outstanding shares conferidentical rights to distribution and liquidation proceeds.  "Thus, ifall shares of stock of an S Corporation have identical rights to distributionand liquidation proceeds, the Corporation may have voting and nonvoting commonstock, a class of stock that may vote only on certain issues, irrevocable proxyagreements, or groups of shares that differ with respect to rights to electmembers of the board of directors".

        Straightdebt is not treated as a second class of stock.  Straight debt is anywritten unconditional promise to pay on demand or on a specified date a sumcertain of money, if the interest rate and interest payment dates are notcontingent on profits, the borrowers discretion, or similar factors, there isnot convertibility (directly or indirectly) into stock, and the creditor is anindividual, an estate, a trust qualified to hold S corporation shares, or personactively and regularly engaged in the business of lending money. 

        An Scorporation is generally not subject to the corporate tax.  (An exceptionexists for those with built-in gain, or accumulated earnings and profits.) Indeed, the taxable income of an S corporation is computed in the same manner asin the case of an individual, except that the items of income which could affectthe tax liability of any shareholder are separately stated, certain deductionsare not allowed, organizational expenditures can be deducted, an the corporatepreference rules apply if the S corporation is a C corporation for any of thethree immediately preceding years.  The pro-rata share of the Scorporations items of income, loss, deduction, and credit are taken into accountby the shareholders.  The items maintain their tax character in the handsof the shareholder.  Income of the S corporation is recognized by theshareholders, regardless of whether or not a distribution is made. However, since the shareholders basis is increased by the amount of gain, doubletaxation is avoided. 

        In thisway, the taxation of the S corporation and its shareholders is very much likethat of a partnership.  However, the S corporation is not allowed toallocate tax items disproportionately to equity, as explained above, in the"one class of stock" discussion.  Furthermore, the C corporationrules apply to S corporations unless otherwise provided for in subchapter S, andexcept for those rules that are inconsistent with subchapter S.

        As the Scorporation status is solely a tax classification, the operations and state lawrequirements do not vary between S corporations and C corporations. Therefore, inter vivos transfers of S corporation shares are accomplished in thesame manner as transfers of C corporation shares.  However, the Scorporation shareholder requirements discussed above must still be met; atransfer that results in S corporation shares being held by an ineligibleshareholder will terminate the S election.  An S corporation may be apartnership in a partnership, a shareholder of a C corporation of a member of anLLC.  If the S corporation is the sole shareholder of the C corporation orthe sole member of the LLC, the S corporation can treat the C corporation as anunincorporated division by making the election to treat such corporation as aqualified subchapter S subsidiary.  In the case of the LLC wholly owned bythe S corporation, the LLC will be considered an unincorporated division of theS corporation as long as the election is not made to tax the LLC as acorporation.

        Trusts canbe utilized as estate planning tools for S corporations in the same way thatthey can be used for C corporation interests.  However, only certain typesof domestic trusts are permitted as shareholders of S corporation stock. These trusts are:  (1) a grantor trust (a trust all of which is treated asowned by an individual for purposes of the grantor trust rules of Secs. 671-679of the Code); (2) a trust which was a grantor trust immediately before thedeemed owner and which continues in existence after death, but only for atwo-year period beginning on the date of death; (3) a trust under a will, butonly for the two-year period beginning on the day on which the stock istransferred to it; (4) a trust created primarily to exercise the voting power ofstock transferred to it; and (5) an electing small business trust.

        A"qualified subchapter S" ("QSST") is treated as a grantortrust and is therefore an eligible shareholder of S corporation stock.  Toqualify as a QSST, the trust document must require that:  (i) during thelife of the current income beneficiary, there shall be only one incomebeneficiary of the trust; (ii) any corpus distributed during the life of thecurrent income beneficiary may be distributed only to such beneficiary; (iii)the income interest of the current income beneficiary in the trust shallterminate on the earlier of such beneficiary’s death or the termination of thetrust; and (iv) upon the termination of the trust during the life of the currentincome beneficiary, the trust shall distribute all of its assets to suchbeneficiary.  In addition, although the same need not be stated in thedocument, all of the income must be distributed currently to one individual whois a citizen or nonresident of the United States.  To elect QSST status,the beneficiary of the trust (or his or her legal representative) must electseparately with respect to each S corporation in which the trust holds stock,and such election is only revocable with the consent of the Secretary of theTreasury.

        An"electing small business trust" ("ESBT") is any trustif:  (1) such trust only has as a beneficiary an individual, estate, or anorganization described in 170(c)(2)-(5); (2) no interest in the trust wasacquired by purchase; and (3) the trustee so elects.  An ESBT is subject tospecial taxation rules, the most significant of which is that tax is imposed ata flat rate of 39.6 percent.  QSSTs, tax exempt trusts, and charitableremainder unitrusts are not eligible to elect ESBT status. 

        When aninterest in an S corporation is transferred, both the donor and the donee mustappropriately account for the tax attributes of the corporation.  Eachshareholder’s pro-rata share of any item for any taxable year is the sum of theamounts determined with respect to the shareholder by assigning an equal portionof such item to each day of the taxable year, an dividing that portion among theshares outstanding on such day.  There exists, however, the ability toclose the books on the transfer date and allocate the items of income anddeduction, etc., as they actually occurred, if all of the shareholdersconsent. 


        The LimitedLiability Company ("LLC") is a creature of state law that is neither apartnership nor a corporation, but contains elements of both.  An LLCoffers limited liability to members; like a corporate shareholder, the member’spersonal assets are not at risk, regardless of whether or not the member isactively involved in the mangement of the LLC. 

        Every stateof the District of Columbia now recognizes some form of Limited LiabilityCompany.  The formation of an LLC generally involves procedures similar toestablishing a corporation; articles of organization will be filed, and anoperating agreement signed by the members. 

        For taxreporting purposes, an LLC, like a partnership, offers substantial flexibility,in that the entity can choose its tax characterization.  An LLC with two ormore members can choose to be classified as a partnership or a corporation,including an S corporation.  An LLC with only one member can either beclassified as a corporation or can be disregarded for tax purposes.  Wherethe LLC is owned by a single individual, the business, although operated by anentity, will for tax purposes be treated as a sole proprietorship, unless anelection is made to be taxed as a corporation.  For legal (non-tax)purposes, if the business is owned by the LLC, the owner, even though he or sheis taxed as a sole proprietor, will likely be protected from the liabilities ofthe business.  An LLC which is solely owned by a corporation or partnershipwill be treated as an unincorporated division of such entity, again unless anelection is made to be taxed as a corporation.

        As an LLCtaxed as a partnership is a pass-through entity, income earned by the LLC mightbe taxed at the highest individual tax rate of 39.6 percent, assuming that themembers are individuals.  This tax is imposed whether or not thedistribution is made, which may leave the member with a tax bill and no cash onhand to pay it. 


        A majordisadvantage of the LLC as a business form is that the LLC is not a"corporation".  This means that an LLC, unless the election ismade to be taxed as a corporation, cannot participate in a tax free corporatereorganization.  There are basically three types of reorganizations thatare used in the acquisition or disposition of a business, although there aremany variations and permutations of such transactions, especially when theacquiring corporation (or buyer) uses a subsidiary to make theacquisition. 

        Justscratching the surface and without delving into the complexities that only yourattorneys, accountants and investment bankers need to suffer with, the threereorganization types are as follows:

        Type A –The target corporation merges into the acquiring corporation.  At leasthalf of the consideration payable to the target’s shareholders must consist ofthe stock (voting or non-voting) of the acquiring corporation.  Gain willbe recognized to the extent of the consideration other than the acquiringcorporation’s stock. 

        Type B –The target shareholders exchange at least 80 percent of their target stock forthe voting stock of the acquiring corporation.  The target shareholdersmust not receive any other consideration.  This transaction is generallyreferred to as the "stock-for-stock" reorganization. 

        Type C –Sometimes referred to as a "practical merger," this reorganizationrequires that the acquiring corporation obtain "substantially all of theproperties" of the target, in exchange for consideration at least 80percent of which consists of the voting stock of the acquiringcorporation.  Therefore, up to 20 percent of the consideration can be cashor other property.  Gain will be recognized to the extent of such otherconsideration. 

        Althoughthe rules to qualify are much stricter under the Type C than under the Type A(merger), from a non-tax legal point of view the Type C may be safer since theacquiring corporation need assume only those liabilities that it chooses. In the case of a merger, all liabilities are assumed by operation of law. The use of subsidiaries in merger transactions is possible if structuredcorrectly, in order to protect the acquiring corporation against liabilities.


        In the caseof a taxable sale or merger of the business, the entity of choice is either an Scorporation or an entity which is taxable as a partnership such as a LimitedPartnership or an LLC.

        Assume abusiness is sold for $10 million, all of which is attributable to inherentgoodwill.  The federal tax results to the seller are as follows: 

        Thus, thesale of a business operated as a C corporation will incur an overall tax (notincluding state and local taxes) of 48 percent, i.e., a double tax, whereas thepartnership or S corporation will incur a 20 percent tax, i.e., a singletax. 

        SinceAugust 1993, acquired goodwill is deductible for federal income tax purposesover a 15 year period.  Therefore, a buyer will obtain an immediate taxbenefit or a present value basis.  For example, discounted at 5.68 percent(a hypothetical 30-year Treasury bond) the buyer’s current benefit is equal toapproximately $2.3 million or 23 percent of the purchase price.  In effect,the buyer’s cost is only $7.7 million rather than $10 million.  Obviously,in pricing an acquisition an astute buyer will take such benefit in account whenmaking an offer.  An astute seller, i.e., a seller who is aware of thebuyer’s ability to amortize goodwill, may be able to negotiate a betterprice. 

        If theentity being sold is a partnership or S corporation the buyer can acquire theassets of the business including goodwill and obtain the tax benefit. 

        On theother hand, and this where the C corporation is at a severe disadvantage to thepartnership or S corporation, if the transaction is structured as a sale ofassets, the double tax will be incurred.  A buyer generally favorspurchasing assets since it can avoid unwanted liabilities.  On the otherhand, owners of a C corporation which is being sold generally try to structurethe transaction as a sale of stock rather than a sale of assets.  If thebuyer agrees to purchase the stock, the buyer, especially a financial buyer,will usually discount the price since it will not have the ability to amortizethe goodwill. 

        One of thegreatest benefits of the S corporation is the availability of the Code Sec.338(h)(10) election.  This election allows the buyer and the owner of the Scorporation to treat a sale of stock as if it is a sale of assets in effect, theelection allows the buyer to amortize goodwill.