The day after the end of tax season, we received a call from a Forum attendee to consult on the redemption of a 50% shareholder in an equally owned S corporation, and we wanted to pass on a couple of items of interest. While we generally do not invite S corporations to Sunday dinner, taxpayers are often faced with the tax-related repercussions of having chosen the S corporation format, and this was one of those circumstances. In turns out that the S corporation was formed 2-1/2 years ago, and the continuing shareholder had lent $950k of funds to the S corporation to avoid a change in shareholder ownership that would have occurred had he contributed funds to the S corporation without a matching infusion by the other 50% shareholder. The acquisition price was going to be $750,000, and a non-compete/non-solicitation provision was part of the acquisition price.
Unfortunately, a major downside of S status is that in the S corporation arena there is no concept of “basis adjustments,” which would provide a basis step-up in the S corporation’s underlying assets, such as exists in the partnership arena. We raised the concept of an allocation of purchase price to the departing shareholder’s personal goodwill; however, there wasn’t any. We then inquired about the possibility of a deferred compensation plan, but the continuing shareholder nixed that idea, indicating that the seller would not acquiesce to the consequent ordinary income recognition. We landed on pushing for as large an allocation as possible to the non-compete/non-solicitation provisions (which provisions generally require an allocation of purchase price to support a claim for damages, if the provisions were breached – a litigation topic beyond the scope of this e-mail blast), so as to at least garner some amortization deductions (and a corresponding amount of ordinary income recognition for the departing shareholder). Oh, well.
Next on the table was whether to use existing corporate funds (which were present) for a redemption or for a distribution of funds to the continuing shareholder to effectuate a cross-purchase. We explained that neither structure had an impact on the net stock basis of the continuing shareholder, i.e., (1) a redemption did not impact the stock basis of the continuing shareholder, and (2) a distribution to fund a purchase of the stock by the continuing shareholder ended up with no net impact on the continuing shareholder’s stock basis (because the reduction of stock basis caused by the distribution would be matched by the increase in basis resulting from the purchase price for the acquired stock). (Where there is C e&p, a redemption can be beneficial because it generally results in a reduction of C e&p, but there was no C e&p).
In addition, we explained that the existence of the corporate-level debt was detrimental from a §199A standpoint, because the payment of interest, which is not QBI for §199A purposes, reduces the S corporation income, which is QBI. Moreover, the payment of interest reduces the S corporation income that is eligible for PTE tax payment purposes. As a result of there no longer being any shareholders after the acquisition transaction other than the lending/continuing shareholder, there no longer was any need for the $950k previously infused into the S corporation by the continuing shareholder to be structured as debt. So, we landed on a redemption of the shares of the departing shareholder by the S corporation followed by the lending/continuing shareholder contributing his debt to capital. (The corporation was not organized or operating in a state where increased stated capital caused an increase in franchise taxes.)
A story for another day is what likely will be step two: a recapitalization of the corporation into voting and non-voting stock, followed by a “non-taxable” sale of non-voting stock to an irrevocable grantor trust for the benefit of the continuing shareholder’s descendants.
The above is a common occurrence for the Forum faculty – a call for assistance from a prior seminar attendee, which sometimes makes its way into an exhibit that may be discussed at either a Forum or Fundamentals program. Both of the programs are open for registration, including our two spring programs, which will be presented on May 17-19 and June 23-25. There are numerous choices of virtual and in-person programs in the fall and early winter. Please visit our Fundamentals of Flow-Through® or Tax Planning Forum® pages and for schedules and program content.