June 26-July 2, 2018: Volume 34, Issue 1
By Roman Basi
The majority of my clients in the floor covering industry are classified as S corporations. The S corporation is an entity typically used by small businesses for its pass-through form of taxation, which is different from C corporations (i.e., Walmart, Apple, Microsoft, etc.) However, S and C corporations do share some similarities, primarily in the form of ownership and stock control that dictate the company model.
If you own stock in a corporation, you are an owner—and at some point owners may want to sell their stock in the company to “cash out.” In other situations, owners may be approached by another company looking to acquire it. When one company seeks to acquire another, or the company’s stock is being sold, it can create several questions concerning S corporations: (1) What happens if the shares are sold mid-tax year?; (2) What happens if the company holds an election to close the books?; or (3) How do you break up the income on taxes if a shareholder is bought out? Let’s take a closer look at each of these individually.
With 365 days in the calendar year, the likelihood of a shareholder being bought out or the company being sold mid-tax year as opposed to the end of year is high. One might ask how you allocate funds in a mid-year buyout or acquisition? Well, the general rule requires the funds to be split among shareholders pro rata on a per-share, per-day basis. For instance, a 50% owner of an S corporation bought out March 31 (end of first quarter) would be entitled to 12.5% of the yearly funds. The funds always follow whether a profit or a loss exists. This method is standard when the company chooses to forego change in its corporate structure at the time it’s acquired. Instead, the company chooses to close the books and make changes at the end of the tax year.
But there might be a better way. Another method to handle an S corporation shareholder buyout is to hold a special election deemed a “closing of the through form of taxation, which books.” This method allows a company to halt the profits or losses on a specific date to provide the subsequent income tonew shareholders in accordance with their ownership. Take the previous example where the owner of 50% of an S corporation is bought out March 31 and the company holds an election to close the books. All new owners vote a unanimous “yes” to close the books wherein the company’s accounting method ends the first quarter, then continues the second-through-fourth quarters separately for the new owners. The 50% previous owner would take his share of profit or loss for Jan. 1 through March 31, then take nothing during the following three quarters. The departed partner would not retain any subsequent taxation after the closing date. However, depending on the company’s margins at the time of the vote, the closing of the books method could create a benefit or detriment to the previous owner and new owners as far as personal income taxes are concerned. Thus, it’s wise to speak to a tax or accounting specialist to determine which method is better for your particular situation.
Another alternative is the “reasonable method.” Here, federal tax regulations will allow a partnership to allocate the taxes pro rata for departing partners, while also allowing the partnership to collect some profit for the rest of the year on income they may have contributed to. For instance, if a partner departs from its law firm but contributed to a case that will be settled six months later, the firm can opt to pay him or her from that profit and still have the new partnership structure remain the same.
Roman Basi, an attorney and CPA, is president of The Center for Financial, Legal & Tax Planning. An expert on closely held enterprises, he writes frequently on financial and legal matters impacting small businesses.