A version of this article was originally published in CFMA Building Profits Magazine.

Transitioning ownership in closely held construction companies offers opportunities and challenges ranging from multigenerational wealth transfers to measuring impacts on company culture and market competitiveness.

A seller’s considerations can include issues such as economic value, tax impacts and owner legacy. Based on the current ownership’s goals, market conditions, and existing structure, these transitions typically follow one of the four following paths for a full or partial transition, each with highly different considerations and outcomes.

• External sale or a combination, such as sale to strategic buyer, private equity, family office, etc.
• Internal transition to key employees
• Employee stock ownership plans
• Family gifting

This article is an overview of three different internal options for construction companies taxed as subchapter S corporations with key employees ready to transition into ownership roles.

These options include:

• Stock sale from existing owners
• New issuance of corporate stock
• F-reorganization followed by issuing new profits interests

The article outlines specific steps, considerations, and advantages and disadvantages for an F-reorganization.

We’ll use AMH Construction, Inc., as our example company. Key information for AMH Construction, Inc.:

• General contractor with 60 employees
• Annual revenues of $50–$60 million
• Legal structure of corporation taxed as S corp
• Enterprise value $10 million
• One owner—an individual
• 500 shares authorized; 100 shares outstanding
• Goal to transfer 20% of the company to two key employees—10% each

Stock Sale

Arguably, the most straight forward method for AMH Construction’s sole owner to transition 20% ownership is to sell 20 shares directly to the two new shareholders.

At an enterprise value of $10 million, the parties agreed to a $2 million purchase price for the shares. We’re ignoring any discounts for lack of control or lack of marketability for this example as beyond the scope of this article.

In this structure, the seller will realize a taxable transaction on the 20% share disposition. Assuming the seller has a $400,000 tax basis in the corporate shares, a $1.6 million gain will be incurred—$2 million purchase price less $400,000 in tax basis.

Assuming the selling shareholder is in the top marginal tax bracket, has held the shares for several years and is also a material participant in the construction company the sale will produce $320,000 in federal tax—long term capital gains at 20%—but will avoid the net investment income tax of 3.8%. If the sale occurred in a state that imposes an income tax, state taxes may also be incurred.

Immediately after the transaction, the two minority shareholders now own 20% of the company and are entitled to a pro-rata share of income and distributions.

It’s important to note that taxable income will be allocated on a per share per day basis, meaning that the entire year’s taxable income is calculated and then allocated to each shareholder based on the number of shares held weighted by the number of days held.

Without proper planning, the mechanics of per share per day can surprise the shareholders if there is significant taxable income or loss prior to the stock sale without similar taxable results after the transaction. In certain qualifying transactions the company can make a tax election to divide the tax year into two periods, pre- and post-transaction, and allocate each period’s income to its respective shareholders in proportion to actual percentages owned—as opposed to the entire year’s income allocated on a per share per day basis. See Treasury Regulation Section 1.1368-1(g) for more information.

Restrictions on S corp stock ownership are also noteworthy. Specifically, there can be no more than 100 shareholders, all of which are eligible shareholders. Eligible shareholders include individuals, certain trusts, and estates and the corporation can only have one class of stock; they can have voting and nonvoting shares but generally all economic rights must be equivalent on a per share basis. See Internal Revenue Code (IRC) Section 1361.

Failure to maintain eligible ownership may cause an inadvertent termination of the company’s S corp election.

The purchasing shareholders can also remain as company employees with no impact to their employment agreements. The company and new owners should evaluate the impacts to any fringe benefits these employees are still receiving as some modifications may be required to adhere to plan requirements.

If the purchasing shareholders do not have excess liquidity to fund the purchase, the parties can agree to sell the shares where the seller finances the transaction by carrying a note receivable from the purchasers. The note must contain an appropriate interest rate, security, and payment terms to be respected by the IRS. A financed sale also facilitates the seller to elect the installment sale tax treatment and incur the capital gains tax over the duration of the note.

If the sale is financed, careful cash flow modeling should be prepared prior to executing the transaction considering the ultimate liquidity to pay principal and interest will be generated from company operations. The purchasers should model their ability to service the debt via company distributions or payroll while maintaining their ability to pay their tax obligations on their pro-rata share of the company’s taxable income.

If the business has cash needs that preclude it from making additional distributions in excess of tax distributions, a financed sale could prove to be problematic.

Stock Issuance

Another potential option to transition 20% of AMH Construction is to issue 25 new S corp shares—12.5 to each new shareholder. That is, 25 shares held divided by 125 shares outstanding equals 20%.

There are several considerations around issuing stock that are beyond the scope of this article such as type of award—restricted stock awards, restricted stock units, nonqualified stock options, etc. This article will assume that the shares issued are stock awards with no prescribed vesting period.

Under this structure, the stock awards will be considered taxable compensation. Assuming a $2 million value to 20% of the company, ignoring any discount potential, the stock award’s fair market value will be included in the key employees’ W2s and subject to federal income taxes, payroll taxes, and required withholdings. State income tax impacts should also be evaluated.

Assuming the recipient individuals are in the highest marginal federal income tax bracket (37%), the receipt of $2 million in value will create an aggregate $740,000 federal income tax liability and a combined employee and employer $58,000 Medicare payroll tax obligation.

This often creates an immediate cash flow crunch considering the new owners have a $740,000 tax obligation and received no cash in the transaction.

AMH Construction also has the requirement to withhold federal income taxes on this transaction—22% flat withholding rate—which causes a $440,000 cash outflow in addition to the $58,000 in Medicare taxes. The federal income tax withholdings made by the company on behalf of the recipient shareholders creates additional taxable income to these individuals which are subject to additional withholdings.

Considering the issued stock was taxed as compensation to the recipients, the company receives a corresponding compensation deduction. Once the transaction is complete, the original owner’s stock holdings are diluted to 80%, with only tax deductions received as the economic benefit. This ownership dilution in exchange for a tax deduction coupled with the cash strain to pay taxes, typically makes this option unattractive beyond fractional ownership issued in conjunction with a key employee’s compensation plan.

Issuing stock can be more attractive in a publicly traded entity where the recipient can immediately liquidate shares to generate cash to pay their tax obligation or in circumstances where fractional share ownership is awarded as a bonus.

F-Reorganization Restructure—Profits Interests

A third transaction structure has become an increasingly popular option to facilitate partial ownership transitions.

This option includes restructuring the construction company from an S corp to a partnership coupled with the issuance of profits units.

This option has very specific steps that must occur in a certain order and should be executed under the close supervision of competent legal and tax counsel to avoid potential missteps.

In our example with AMH Construction, Inc., the first step to effectuate the F-reorganization is for AMH Construction’s sole owner to legally form a new corporation in their desired state of domicile. Once the new entity HoldCo is formed, AMH Construction’s owner contributes the stock of AMH Construction to HoldCo in exchange for HoldCo stock. HoldCo then files Form 8869 which turns AMH Construction, Inc., into a Qualified Subchapter S Subsidiary (QSUB) of HoldCo. At this point, HoldCo is a shell entity which only owns AMH Construction, Inc., and AMH Construction, Inc., is a legal entity recognized in its state of incorporation but has become a disregarded entity for federal income tax purposes with the filing of a QSUB election.

These steps, if done properly, are a federal tax-free reorganization under IRC Section 368(a)(1)(F) and considered a mere change in corporate identity. The F in Section 368(a)(1)(F) is where the reorganization gets its name as the F-reorganization.

Now that AMH Construction, Inc., is a disregarded entity for federal income tax purposes, the next step in the reorganization is to legally convert from a corporation to a limited liability company (LLC). This step— changing from one disregarded entity, a QSUB, to another disregarded entity, a single member limited liability company—is also free of federal income taxes.

Once the conversion to an LLC is complete, the LLC issues profits units to the two new minority owners. Once the LLC has multiple members, namely HoldCo plus two profit unit holders, the LLC is no longer a federally disregarded entity and will be taxed as a partnership for federal income tax purposes.

F-Reorganization Impacts

There are several impacts and considerations needed when adopting this structure.

Company Valuation and Hurdle

In our example, AMH Construction LLC was valued at $10 million. For partnership tax accounting purposes, its balance sheet is restated to fair market value and the HoldCo’s capital account in the partnership is adjusted to $10 million. The capital accounts of the two new owners are left at zero value.

The valuation of the capital accounts is an important concept for this structure to remain a federally tax-free reorganization. For the receipt of profits units to be tax-free to the new owner, they must have no liquidation value at the issue date. This is accomplished by setting the participation threshold, or hurdle, at the company’s current fair market value or higher.

For example, if the hurdle is $10 million and the company was sold in a fair market value transaction immediately after the profits units’ issuance, the new owners are not entitled to any liquidating distribution on the company sale. Once the value of the company exceeds $10 million, the new owners are entitled to 20% of the profits and appreciation past the hurdle.

It’s a common practice to engage a certified business appraiser or valuation specialist to assist in valuing the business. An independent valuation can help the parties agree to the company’s value and will assist in the event of an IRS examination if the value of the profits units is scrutinized.

Profit Allocation and Distributions

Entities taxed as partnerships are afforded great flexibility in how they structure their operating agreements. The process for profit allocations and corresponding cash distributions must be agreed upon and drafted with the assistance of qualified legal counsel and tax advisors. These allocations can be straight forward or complex depending on the desired economic arrangement between the partners.

Employee Identification Number

AMH Construction LLC will retain the same federal employee identification number it has as a corporation. This is very convenient for administrative purposes.

Compensation of Profit Units Holders

Now that our two key employees of AMH Construction LLC are now owners, they are considered partners in a partnership and are no longer eligible to be classified as employees. This has several key impacts to how they are compensated. First, they no longer receive wages that are reported on a Form W-2. Their salary component is now considered a guaranteed payment and reported to them on a partnership schedule K1. Second, the company no longer withholds federal income taxes or payroll taxes.

The responsibility to remit taxes falls on the partner who now must send quarterly estimates to the IRS. Prior to ownership as a partner, payroll taxes were shared 50% by the employer and 50% by the employee. Now as partners, the profit units’ holders are responsible for 100% of the payroll taxes now reported on their 1040 Schedule, SE. Considering the responsibility for payroll taxes shifted, it is common for the entity to gross up the partners guaranteed payments by an appropriate amount to leave the new partners cash flow neutral to this change. State and local tax considerations should also be evaluated to ensure proper reporting and taxation.

Note that these changes are for the new minority owners. The prior owner of AMH Construction and now sole owner of HoldCo, can remain as an employee of AMH Construction LLC and receive a W2. Only direct partners in a partnership are precluded from employee status. AMH Construction LLC’s original owner has indirect ownership which facilitates ongoing employment status.

Fringe Benefits

Partners can still participate in their company sponsored health plans and 401(k) plans but should consult with the plan administrators and tax advisers to ensure proper compliance and taxation.

Other Considerations

AMH Construction LLC should review key contracts, customer service agreements, vendor agreements, leases, and loan agreements in addition to informing its bank and surety well ahead of the transaction. Often these agreements have notice or notice and consent provisions for ownership or control changes. Violation of these provisions can trigger immediate payment clauses in loan agreements or cancel customer or vendor agreements creating the need to renegotiate future terms.

As one can see, there are several options, each with differing economic outcomes, that S corp construction companies can pursue to effectuate a partial internal ownership transition. Construction companies considering an internal ownership transition should consult with their attorney and CPA to weigh the different options.

Once the desired option is selected, careful planning and a detailed checklist should be created—again under the supervision of legal counsel and the company’s CPA—to avoid any potential missteps during execution.

We’re Here to Help

To learn more about an F-reorganization and the potential tax opportunities, contact your Moss Adams professional.

Additional Resources

• Construction Practice