As the economy picks up and there is a renewed interest in the sale and acquisition of business interests, buyers and sellers should consider the tax rules regarding sales of S corporation shares.
Some of the most misunderstood transactions involve the sale and transfer of interests in entities taxable as an S corporation. The rules regarding the taxability of S corporations are often rigid and transactions involving transfers of S corporation interests can produce some harsh results.
“As most people are aware, S corporations are ‘flow-through’ entities,” says Walter M. McGrail, JD, CPA, a senior manager at Cendrowski Selecky PC. “S corporation shareholders, not the S corporations, are subject to income tax on S corporation earnings. S corporations also provide a shelter from self-employment tax, as an S corporation shareholder’s allocable share of the S corporation’s earnings are exempt from self-employment taxes.”
Smart Business spoke with McGrail about ways to mitigate S corporation taxation issues.
How rigid are S corporation rules?
Of all the flow-through entities, the rules regarding S corporations are the least flexible. Each shareholder must generally be allocated income on the same basis as every other shareholder, on a per-share per-day basis, regardless of when the distributable cash was generated. Also, to qualify as an S corporation, each shareholder must receive the same distributions, regardless of when the cash was generated from S corporation earnings. However, there is no requirement for an S corporation to distribute its earnings. The combination of these rules has historically resulted in some unanticipated results.
How are transfers of S corporation shares affected by these rules?
While many examples of the pitfalls of transferring S corporation shares exist, transfers can have the same result: a shareholder is allocated income and does not receive a distribution commensurate with the income allocated. For example, S corporation shareholders sell their interest to a third party or have their shares redeemed by the S corporation. The shareholder negotiates the sale price or, in the case of redemption, the sale price may be in accordance with the terms of an existing buy-sell agreement. The S corporation has a history of distributing cash to at least cover the tax liability associated with the allocated earnings. Former shareholders receive their Schedule K-1 reporting a large share of earnings and discover that policy and obligation are two different things. The corporation does not have any obligation to distribute and the former shareholders failed to account for this when negotiating the sale price. This happens even when the selling shareholder receives counsel, but not necessarily tax counsel.
There is another way in which shareholders can get surprised when receiving their schedule K-1 for the year that they sell shares. Perhaps selling shareholders were sophisticated enough to determine a fair price for their shares, which takes into account the taxable income to be allocated on their final S corporation Schedule K-1. But if the S corporation has significant earnings after the sale date of their shares, the selling shareholders’ Schedule K-1 may include such post sale date earnings. If the earnings after the date of sale are disproportionately higher from the pre-sale period, such a shareholder will find himself or herself surprised. They will receive a Schedule K-1 that reports earnings far in excess of what they anticipated or for which they receive cash. Similarly, shareholders paying what they believe to be fair market value may think they have paid the selling shareholder for the tax associated with earnings prior to their acquisition, only to discover on their Schedule K-1 that they are picking up a share of earnings from before they became shareholders. Further, they may find the S corporation has already distributed the earnings attributable to this period prior to the sale date.
Are there remedies to avoid unintended results?
First, make sure that whomever you use to assist with the sale or purchase has a working knowledge of the taxation of S corporations and their shareholders, as there are some things you can do to avoid surprises. The S corporation rules permit an exception to the per-share-per-day rule for transfers and redemptions, which results in the termination of a shareholder’s interest. If properly elected, the S corporation can ‘cut off’ its books and records as of the share transfer date and allocate items among shareholders before and after the sale date. While this typically eliminates surprises, it may require analysis of the income allocated between such pre- and post-transfer dates to ensure that the cut-off is properly made. For example, if the acquiring shareholder has control of the books and records, there is an incentive to defer deductions to the post-sale date or to accelerate income into the pre-sale period.
Secondly, an S corporation is permitted to distribute amounts to former shareholders after the effective date of the transfers. Consideration should be given to post-termination distributions at the time of the share transfer. Likewise, selling shareholders should consider the income to be reported on their final Schedule K-1 in negotiating a fair price.
When acquiring S corporation shares, perform due diligence to find out whether buy-sell agreements apply and, if so, whether they include provisions to handle the tax allocations on a transfer of shares. Likewise, investigate the contractual obligations of the S corporation to distribute earnings or to make post-transfer distributions and not on its historical practices.
With sales of S corporation shares, the old adage of forewarned is forearmed is all too true.
WALTER M. MCGRAIL, JD, CPA, is a senior manager at Cendrowski Selecky PC. Reach him at (248) 540-5760 or email@example.com, or visit www.cendsel.com.