Ownership transitions in closely held construction companies present a unique mix of opportunities and challenges, from multigenerational wealth continuity to balancing company culture and market competitiveness. Sellers must weigh economic value, tax implications, and legacy goals against various transition paths — each offering distinct outcomes.

This article focuses on internal transitions for S corporations, specifically where key employees are poised to take ownership. It also explores the three strategies of direct stock sales, new stock issuance, and F-reorganizations, detailing key steps, considerations, and tax impacts of each option.

For real-world context, BuildCo, Inc., a fictional typical mid-sized construction business with a single owner and annual revenues of $50-60 million, will be used to walk through these strategies with the goal of transitioning 20% ownership to two key employees.

Although the figures and structure are hypothetical, they mirror scenarios often encountered by closely held S corporations in the construction industry.

Stock Sale

Arguably, the most straightforward method to transition 20% ownership is for BuildCo’s sole owner 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. In this example, we’re ignoring any discounts for lack of control or lack of marketability as it’s 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 taxed at 20% — but will avoid the net investment income tax of 3.8%. If the sale occurs in a state that imposes an income tax, then state taxes may also be incurred.

Immediately after the transaction, the two minority shareholders will own 20% of the company and are entitled to a pro rata share of income and other pass-through items.

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 allocation 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 (Treasury Regulation Section 1.1368-1(g)¹).

Restrictions on S corporation stock ownership are also noteworthy. Specifically, there can be no more than 100 shareholders, all of whom 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 (Internal Revenue Code (IRC) Section 1361²).

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

The purchasing shareholders can also remain as company employees with no impact on 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, then the parties can agree to sell the shares in a manner 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 in electing the installment sale tax treatment and incurring the capital gains tax over the duration of the note.

If the sale is financed, then 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, then a financed sale could prove to be problematic.

Stock Issuance

Another potential option to transition 20% of BuildCo is to issue 25 new S corporation shares — 12.5 shares 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 the type of award — restricted stock awards, restricted stock units, nonqualified stock options, etc. — but for these purposes, 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 for 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 in federal income tax liability and a combined employee and employer Medicare payroll tax obligation of $58,000.

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.

BuildCo is also required to withhold federal income taxes on this transaction — a 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 for these individuals, which is 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, which would not be an S corporation, 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 corporation to a partnership coupled with the issuance of profit 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 the example with BuildCo, Inc., the first step to effectuate the F-reorganization is for BuildCo’s sole owner to legally form a new corporation in their desired state of domicile. Once the new entity HoldCo is formed, BuildCo’s owner contributes the stock of BuildCo to HoldCo in exchange for HoldCo stock.

HoldCo then files Form 8869, which turns BuildCo into a Qualified Subchapter S Subsidiary (QSUB) of HoldCo. At this point, HoldCo is a shell entity which only owns BuildCo, and BuildCo 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.³

Now that BuildCo, 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). Changing from one disregarded entity — in this case, changing from a QSUB to another disregarded entity, a single member LLC — is also free of federal income taxes.

Once the conversion to an LLC is complete, the LLC issues profit 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.