An S corporation does not pay federal corporate income tax. The S corporation passes its income, deductions and credits through to its shareholders, in proportion to their ownership interest in the S corporation. The shareholders then pay income tax on those tax attributes.
Most S corporations have a calendar taxable year. So, what happens if a S corporation shareholder sells his stock during the middle of the year?
Generally, the S corporations’ income, deductions and credits for the calendar year of sale is prorated. In other words, if the deal closed at the end of June, a 50% selling shareholder would receive 25% of the S corporation’s tax attributes because it owned ½ of the company for ½ of the year.
But what if the company had a loss as of the date of sale and the selling shareholder expected the company to end up with a substantial profit by year end? In that case, under the federal tax laws, the S corporation could close the books on the date of sale. There would be two taxable years. And the selling Shareholder would be allocated a share of the S corporation’s pre-sale loss.
However, for that to happen, all the shareholders, both pre and post-closing would have to consent to what is called an Internal Revenue Code or IRC section 1377 election. If the election is not made then the selling shareholder just takes his or her prorated share of the S corporation’s income, deductions and credits for the calendar year.
This case involved those facts. The selling shareholder sold his stock to the remaining shareholders at the end of the 2009 first quarter (March 31) pursuant to a stock purchase agreement. If the books were closed then, the selling shareholder would have been allocated a $31K loss from the S corporation.
After the closing, the selling shareholder requested that the other shareholders consent to closing the tax books as of March 31 by consenting to the S corporation making the IRC section 1377 election. Two of the buying shareholders refused.
At year end the selling shareholder was allocated $143K of prorated S corporation income for 2009.
The selling shareholder sued the two buying shareholders in an Illinois federal district court for $85K in federal and state income taxes it was required to pay, because the two buying shareholders did not consent to the section 1377 election. The selling shareholder based his suit on a boilerplate provision in the stock purchase agreement where the buying shareholders promised to “execute and deliver all … instruments and take all … actions as” the selling shareholder “may reasonably request … in order to effectuate the purposes of” the stock purchase agreement. In the trade this boilerplate provision is called a “further assurance” provision.
The buying shareholders asked the court to dismiss the lawsuit arguing that the further assurance provision does not obligate the buying shareholders to consent to closing the tax books of the S corporation at the end of the 2009 first quarter (consent to the IRC section 1377 election). The court would not dismiss the lawsuit saying that the selling shareholder’s argument was “plausible”; which was good enough for the court.
What does that mean? The selling shareholder’s get’s a chance to continue its lawsuit.
This case is referred to Manfre v. May, No. 1:18-cv-2184, United States District Court, N.D. Illinois, Eastern Division, (March 12, 2019)
It seems like a stretch that the further assurances provision obligates the buying shareholders to consent to the section 1377 election.
The lesson here is to have your tax adviser look at the deal before the parties have agreed to the key business terms in case there is an important tax provision that you want. That means before you sign a letter of intent; and of course, long before you sign a definitive acquisition agreement.
In this case, had you decided after consultation with your tax adviser that you wanted a section 1377 election; then make sure that the purchase agreement requires all shareholders to consent to an Internal Revenue Code section 1377 election.
By John McCauley: I help businesses minimize risk when buying or selling a company.
Telephone: 714 273-6291
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