S corporations: a few buy-sell issues to consider
NOTE: The following article is from the collection of articles in our Automobile Dealership Buy/Sell Newsletters. The newsletter deals with the complex area of buying and selling automobile dealerships. Some of the material may not be up to date because of changes in the law from the date shown at the end of the article. This article is not to be taken as legal, accounting, tax, or other advice. You should consult your own professionals for such advice and for any updating of the information provided.
Income/Loss Flowthrough to Shareholders
The formation of a small business corporation or S corporation can be very beneficial to a car dealer as it allows for passthrough of income and loss to the shareholders, thereby avoiding corporate double taxation and allowing for tax-free distributions. Unfortunately, due to the nature of the tax law, these advantages can become problems and areas of concern when stock is sold.
Generally, passthrough items of income and loss from an S corporation are allocated on a per-share, per-day basis. Each shareholder’s portion is calculated by allocating the passthrough items for the entire tax year equally to each day of the year and then by allocating that amount pro rata among the shares of stock owned by the shareholder on each day of the year. This allocation is more complex when an ownership change occurs.
If an ownership change does occur, the specific accounting method, also known as the “cut-off of books” method, may be used if certain conditions apply. An S corporation can elect under IRC Section 1377 to allocate passthrough items based on specific accounting when a shareholder disposes of his entire interest in the S corporation. Under this code section, a timely filed election can be made to treat the tax year as if it consisted of two tax years. The first tax year is deemed to end on the date that the shareholder terminated his/her interest in the S corporation, and the second tax year ends on the last day of the normal tax year. The specific accounting election divides the tax year into two periods for the purpose of allocating pass-through items to the shareholders and as such, takes into consideration the actual transactions of the business before and after the sale of stock in lieu of the per-share per-day basis which is the default method. The tax year is not terminated and therefore only one tax return is required to be filed. This election is irrevocable.
The affected shareholders must agree to make this election. The shareholders that disposed of their shares and the shareholders that acquired those shares must all consent to use the specific accounting method. If the shareholder transfers his/her shares to the S corporation (e.g., stock redemption) then all shareholders must consent to the election. This election is made by attaching a statement to a timely filed tax return for the year the stock disposition took place. The fact that the decision of which method to use, either the per-share, per-day method or the specific accounting method can be made after the end of the tax year provides principles with a financial planning opportunity. Calculations can be performed to determine which method is more preferable and beneficial for the shareholders. The seller may prefer to negotiate to have this election made prior to the closing of the sale if potential disputes could arise with the buyer/remaining shareholders after the end of the taxable year.
Example: Assume that shareholder A owns 25% of the outstanding stock in the S corporation and that shareholder B owns the remaining 75% of the outstanding stock. Shareholder B sells all his stock to a new Shareholder C on June 30th. Under the per-share, per-day method (the default provision) the income for the entire year ($40,000) is allocated as follows:
Shareholder A (25% x $40,000) $10,000
Shareholder B (75% x $40,000 x ½) $15,000
Shareholder C (75% x $40,000 x ½)$15,000
Now assume that the S corporation and the shareholders elect to use the specific accounting method. Under this method the income/loss is allocated as follows:
|1/1 -6/30||7/1 -12/31||Total|
|Shareholder A (25%)||$ (1,000)||$11,000||$10,000|
|Shareholder B (75% x $4,000)||$ (3,000)||———||$ (3,000)|
|Shareholder C (75% x $44,000)||———||$33,000||$33,000|
As you can see Shareholder A is allocated the same amount of income under each of the two methods, but the two methods allocate amounts of income and loss notably different between the two shareholders involved in the stock sale. This can be especially true if certain months of the business are historically higher or lower than the average monthly profit or loss.
Keep in mind that S corporation distributions are generally only allowed to S corporation shareholders. Once an individual shareholder disposes of their interest in the stock, a distribution from the corporation cannot be made to an individual who is not a shareholder. This does not preclude income or loss to be allocated to an existing shareholder as is the case in the above example on the default provision of per-share, per-day allocation. In effect, without the specific accounting election, shareholder B (selling shareholder) will be paying taxes on $15,000 allocated S corporation income even though up to the day the stock was sold, he/she would have suffered a loss of $3,000 based on the actual activity of the business through the date of sale. Again, the reality is that absent specific mention of the election to use specific accounting method within the buy/sell, the seller is potentially exposed to adverse tax consequences later on if the dealership performs better after the seller leaves. Potentially, taxable income could be allocated to the exiting shareholder without the corresponding right to take an S distribution to pay the tax.
Accumulated Adjustments Account
What about those S distributions if the corporation had experienced losses prior to the sale, to the point that the AAA (accumulated adjustments account) or “S corporation retained earnings” was in a negative position? In essence, the AAA is a corporate level special tax item and is not associated to particular stockholders, but merely the stockholders of record at any given point in time. A common maneuver for a selling shareholder in a successful business with a healthy, positive AAA, is to have the corporation declare distributions concurrent with or immediately prior to the close of the sale of stock. In effect, this wipes the slate clean so to speak, by distributing to the shareholders what they have been taxed on in the past on a flowthrough basis. In some instances, as in a family transfer, it may be beneficial to leave the undistributed S corporation earnings in the corporation which will allow the new shareholders (family members) access to tax-free S distributions in order to help fund their buy/sell cash flow obligations.
But what happens if the AAA is negative? Remember, it is a corporate level account that remains with the corporation after the selling shareholder leaves. The buying shareholder who has bought into an S corporation with a negative or deficit AAA has, for all practical purposes, started out their shareholder experience in a complicated tax hole. The new shareholder must pay tax on his/her future allocated income up to the point where the income has restored the AAA balance to zero without the availability to receive S distributions to pay for the taxes on the income! S corporation distributions are only allowed to the extent that a positive AAA exists, as a result of income flowing through the corporation to the shareholders. If a distribution is made while the AAA is in a negative position, the corporation could inadvertently cause a taxable dividend to be made to the shareholders to the extent there are C corporation retained earnings from the years prior to electing S corporation status. These unfortunate consequences can be avoided with proper planning and consultation with a tax professional.
Strong consideration should be made to structuring a potential sale as an asset sale so that the negative AAA does not impact the new business owner/shareholder. In a situation where a family is planning a business transition to a younger generation, and it is beneficial to keep the current S corporation around, then possibly a tiered reorganization should be explored.
This article is intended to alert readers to some potential traps and opportunities regarding S corporation tax treatment in a dealership stock buy/sell situation. Readers should consult with their qualified tax professional regarding the specific issues before contemplating a buy/sell.
This article was written in 1999.