September 1998 Issue



By Joel Steinberg, CPA, American Express Tax and Business Services of New York Inc.

A subchapter S corporation that completes an initial public offering (IPO) or that is acquired by a public company will generally terminate its S corporation election. This is because to qualify for S corporation status, a corporation can have no more than 75 shareholders (35 shareholders for tax years beginning before 1997), and the income tax regulations place restrictions on what constitutes eligible shareholders. An S corporation also cannot have more than one class of stock issued and outstanding. The financial statement implications of a change in tax status occurring when a company goes public or is acquired by a public company becomes an important consideration. In the case of an acquisition, the provisions will be applicable to the separate financial statements of the acquired company included in an SEC filing. The provisions are also applicable to a corporation that was formerly a partnership or a limited liability company (LLC).

Stockholders' Equity. Retained earnings or accumulated deficit of an S corporation may include undistributed earnings and losses. SEC Staff Accounting Bulletin (SAB) Topic 4.B states that undistributed earnings and losses of an S corporation should be reclassified to additional paid-in capital rather than included in retained earnings. Since the income and losses of an S corporation pass through to the shareholders, it is considered as if the accumulated undistributed earnings were distributed to the shareholders and then contributed back to the corporation.

Deferred Income Taxes. FASB No. 109, paragraph 28 states that when an entity's tax status changes from nontaxable to taxable, a deferred income tax asset or liability should be recognized for temporary differences at the date that the nontaxable entity becomes taxable. The effect of recognizing the deferred tax asset or liability should be included in income from continuing operations. Upon termination of the S corporation election, the bases of the corporation's assets and liabilities may be different than their tax bases. The recognition of deferred tax assets or liabilities could have a significant impact on the earnings and earnings per share of the period when the change occurs.

Paragraph 28 also states that an election for a voluntary change in tax status is recognized on the approval date, or on the filing date if approval is not necessary. Accordingly, the change in status might occur after the date of the financial statements. In such a case, the impact of the change should be disclosed as a subsequent event in accordance with AU Section 560.05. If the impact of the change is significant, consideration should be given to presenting a pro forma balance sheet giving effect to the change as if it had occurred on the balance sheet date.

Provision for Income Taxes

SAB Topic 1.B.2, Pro Forma Financial Statements and Earnings Per Share, addresses the disclosure that should be made if the historical financial statements of a registrant are not indicative of the ongoing entity. The bulletin states that the registration statement should include pro forma income statements that reflect the impact of terminated or revised cost sharing agreements and other significant changes. The pro forma information should be presented for the most recent year and interim period only.

If a company's tax status changes upon going public or upon being acquired by a public company, the application of this provision would be required. If the company was formerly an S corporation, partnership, LLC, or other tax exempt entity, pro forma income taxes and earnings per share should be presented on the face of the historical income statement. The presentation should show the results of operations and earnings per share as if the company was a taxable entity during the reporting period.

The Division of Corporation Finance Accounting Disclosure Rules and Practices Training Manual, 1996 Edition, states that, if the necessary adjustments include more than adjustments for income taxes, the pro forma presentation should be limited to the latest year and interim period. If the adjustments include only income taxes, a pro forma presentation for all periods presented is encouraged but not required.

Distributions to Shareholders. Subchapter S corporations or other nontaxable entities might pay distributions to promoter/owners when an IPO becomes effective. Such distributions might be necessary to enable the shareholders to pay income taxes due on their share of the corporation's income. Such distributions would constitute a change in capitalization at the effectiveness of an IPO and would require a pro forma balance sheet presentation. The pro forma balance sheet should reflect the subsequent distribution as if it had occurred at the balance sheet date. Additionally, if the payments are to be made from the proceeds of the offering, pro forma earnings per share should be presented for the latest year and interim period only. The pro forma earnings per share should be computed by adding to the weighted average shares outstanding the number of shares whose proceeds would be necessary to pay the distribution.

This is based on SAB Topic 1.B.3, which states that dividends declared by a subsidiary subsequent to the balance sheet date either be given retroactive effect in the balance sheet with appropriate footnote disclosure, or be reflected in a pro forma balance sheet. In addition, when the dividends are to be paid from the proceeds of an offering, the SEC staff has required pro forma earnings per share data (for the latest year and interim period only) giving effect to the number of shares whose proceeds are to be used to pay the dividend. *

Gary Illiano, CPA
Grant Thornton LLP

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