S Corporation Exit Strategies
By Scott M. Cheslowitz
In planning for the time when a shareholder of a subchapter S corporation leaves the company, a key consideration is the establishment of a buy-out agreement. Buy-out structures can be developed in many ways in order to achieve the desired result, which is predicated by both parties’ specific needs. Simple buy-out agreements lack the potential tax advantages of more carefully structured agreements. Two possible alternatives are the purchase of stock by one shareholder from another shareholder, and the redemption of stock by the corporation.
Determining both the shareholder’s debt basis and stock basis in the S corporation is of paramount importance. Debt basis is usually established by a direct loan to the company from the shareholder, but there is precedent for indirect loans stemming from intercompany transfers between commonly controlled entities (see Culnen, TC Memo 2000-139). Indirect loans are a risky proposition for establishing basis, however, and simply mirroring a particular fact pattern will not guarantee automatic acceptance of the argument for indirect loan basis.
Once the loan to the company has been established, reductions take place through payments against principal, forgiveness of indebtedness, or a reduction in stock basis to zero through excess loss and deduction items which flow through to the shareholder. The basis of indebtedness may then be reduced, but not below zero, by the same categories specified in IRC sections 1367(a)(2),(B), (C), (D), and (E). Subsequent profits restore debt basis before stock basis is restored [IRC section 1367(b)(2)(B)].
Example. The separate basis rule under Treasury Regulations section 1.1367-1 requires an adjustment to S corporation stock for income and loss items on a per share, per day basis. To illustrate, assume the following fact pattern:
Shareholder Z owns two shares of stock in an S corporation. Only 10 shares of stock are issued and outstanding as of December 31, 2000. The basis in the two shares is $20. On October 1, 2001, shareholder Z purchases one share of stock with a basis of $15 from another shareholder. In 2001, the company suffers a loss of $150. The loss would be allocated as follows: $30 to the first two shares and $3.78 to the share purchased on October 1, 2001 [($150 ¥ 365/365) ¥ 2/10, and ($150 ¥ 92/365) ¥ 1/10]. Based on the allocable loss calculations, there is a $10 excess basis reduction on the first two shares and a net $11.22 adjusted basis on the share purchased later. Spillover of the excess deduction of the first two shares against the remaining basis of the one share of stock is allowed.
This illustrates some of the administrative issues involved in not using a block approach to allocate items of income and deduction amongst the shareholders. One advantage is that the rules allow for selective disposition of shares sold, meaning that the shares with the highest basis are sold first.
Debt basis in situations where there is multiple indebtedness requires a shareholder to allocate losses in excess of stock basis proportionately. Assume the following fact pattern: Shareholder Z holds four notes of an S corporation; the first note is for $1,000 and the second, third, and fourth notes are each for $5,000. The first note is paid off during the year, while the other three notes are paid down each by $1,000. The company has a $6,000 loss in excess of stock basis; each of the three remaining notes absorb a reduction in basis of $2,000, which now leaves a remaining $2,000 in basis for each note.
Stock basis should not be confused with the equity reported in the financial statements. When an individual purchases shares of stock from another individual, or when shares of stock are gifted from one person to another, no entries are made to the corporate books. Gifted stock can present an interesting twist with regard to a capital loss scenario. If the seller has a capital loss, he must use the lower of the donor’s cost basis or fair market value of the stock as of the date of the gift. Pursuant to IRC section 1015, the basis is the same as it would be in the hands of the donor, except if such basis is greater than the fair market value of the property at the time of the gift; then the basis is the fair market value.
Under IRC section 317(b), a redemption has taken place when a shareholder receives corporate property in exchange for her corporate stock. A redemption distribution is generally afforded capital gain (or loss) treatment. The general parameters for what constitutes a redemption distribution under IRC sections 302 and 303 include the termination of an entire interest in the corporation, a substantial reduction in the shareholder interest as it relates to the other shareholders, a partial liquidation, or the use of the proceeds from the redemption to pay death taxes. Under the family attribution rules of IRC section 318, constructive ownership of stock should be taken into consideration when determining whether the transaction would qualify for capital gain treatment. Having a constructive ownership of stock vis-à-vis IRC section 318 as it relates to IRC section 302 can negate capital gain treatment and create an amount considered to be a dividend under IRC section 301. It should also be noted that a distribution of appreciated property under IRC section 311(b) may result in a gain on the sale of property, which flows through to all shareholders of the S corporation.
To illustrate some points, assume the following fact pattern: An S corporation has two equal shareholders, A and B. The accumulated adjustment account (AAA) has a balance of $100,000 and the capital stock account has a balance of $10,000, with no additional paid-in capital. Shareholder B is having his shares of stock redeemed by the corporation. He has an outside basis of $40,000 resulting from stock gifts and purchases of stock from other shareholders. A cursory look at the balance sheet might suggest that if B were to receive $55,000 there would be no gain or loss, because 50% of the stock equals $5,000 and half of the AAA balance would be $50,000, but he has a basis of only $40,000. Accordingly, if $55,000 were the selling price, B would have a $15,000 capital gain on the redemption of the shares of stock. The corporation reduces the AAA and capital stock, and any prior earnings and profits accounts proportionately to the percentage of total shares redeemed. This article and scenario do not consider the potential state tax consequences, which, depending upon the state, can also present some interesting tax pitfalls.
Outside basis can be used to flush out ordinary distributions should the S corporation’s AAA be large enough. Assume the following fact pattern: An S corporation has shareholders’ equity consisting of capital stock of $1,000, additional paid-in capital of $500, AAA of $100,000, and retained earnings of $100,000. The S corporation is owned equally by shareholders A and B. On January 1, 2001, the S coporation redeems the shares of B, which has the following effect on the equity section: capital stock is now $500, additional paid-in capital is $250, AAA is $50,000, and retained earnings is $50,000. Although the numbers for the shareholders’ equity section reflect a 50% reduction, the amounts with reference to A have not changed at all.
Redemptions resulting in a capital gain are generally governed by IRC sections 302 and 303. Noncapital gain redemptions require an analysis under IRC section 1368. If there are no accumulated earnings and profits, a noncapital gain redemption will produce the same results as a capital gain redemption. If there are accumulated earnings and profits, the excess is taxed under IRC section 1368 as an ordinary dividend to the extent of earnings and profits. The distinction between a capital gain redemption and a noncapital gain redemption is quite important.
A shareholder transaction with another shareholder occurs outside, separate, and apart from the corporation. The basis issue is very important in determining if there is a capital gain or loss. Outside basis must be determined and compared to the sales proceeds and any costs associated with the transaction in order to determine gain or loss. The shareholder must track her own basis, as the corporate books cannot always adequately reflect 100% of the stock basis. If the AAA is relatively large, an individual may want to take advantage of that large balance and get cash out tax free via ordinary distributions
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