Explore the tax intricacies of S corporation stock sales in this informative M&A legal blog. Understand the implications, including IRC section 1377 elections, through a real-life case study. Gain insights for your M&A transactions.
M&A Stories
March 27, 2019
Introduction:
In the world of M&A, understanding the tax implications of an S corporation stock sale is crucial. S corporations pass their financial attributes to shareholders, making it a matter of concern when a shareholder sells stock mid-year. Let’s dive into the details:
S Corporation Tax Basics:
1. S corporations don’t pay federal corporate income tax; instead, income, deductions, and credits pass through to shareholders based on their ownership.
2. Most S corporations follow a calendar taxable year.
Mid-Year Stock Sale:
1. If a shareholder sells stock mid-year (e.g., end of June), their portion of the S corporation’s tax attributes is prorated. For a 50% shareholder, it’s 25% for half of the year.
2, But what if the company expects substantial profit by year-end? In such cases, an Internal Revenue Code (IRC) section 1377 election is crucial.
3. This election allows the S corporation to close the books on the sale date, creating two taxable years and allocating pre-sale losses to the selling shareholder.
4. However, all shareholders must consent to the IRC section 1377 election for it to apply.
The Case:
In 2009, a selling shareholder sold stock at the end of the first quarter, potentially qualifying for a $31K loss allocation.
Post-closing, the selling shareholder requested the IRC section 1377 election, but two buying shareholders refused.
At year-end, the selling shareholder was allocated $143K of prorated S corporation income for 2009.
The Lawsuit:
The selling shareholder sued the two buying shareholders in an Illinois federal district court for $85K in federal and state income taxes due to the lack of consent for the IRC section 1377 election.
The suit was based on a “further assurance” provision in the stock purchase agreement, which obligated the buying shareholders to take actions as reasonably requested.
The court didn’t dismiss the lawsuit, deeming the selling shareholder’s argument “plausible.”
What It Means:
The outcome means the selling shareholder gets to continue the lawsuit.
However, it’s debatable whether the “further assurance” provision indeed obligates buying shareholders to consent to the IRC section 1377 election.
Takeaway:
Always involve a tax advisor early in the deal-making process, even before signing a letter of intent.
Ensure that the purchase agreement includes clear provisions about tax elections like IRC section 1377.
In the complex world of S corporation stock sales, attention to tax details is key. This case serves as a reminder of the importance of clarity in purchase agreements and early tax consultation.
Case Reference:
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)
By John McCauley: I help businesses minimize tax risk when buying or selling a company.
Email: jmccauley@mk-law.com
Profile: http://www.martindale.com/John-B-McCauley/176725-lawyer.htm
Telephone: 714 273-6291
Check out my book: Buying Assets of a Small Business: Problems Taken From Recent Legal Battles
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