During the course of the year, we encounter a number of shareholder disputes. Sometimes we represent a minority shareholder; sometimes we represent the corporation or the majority shareholders. shareholderlit-300x263

Regardless of who the players are, the resolution of the dispute will involve some economic deal. The economic deal, in turn, will depend in no small part upon the tax consequences.

Today’s post will review some of the tax considerations that are unique to S corporations – in particular, those that may result from the loss of the corporation’s “S” status.

 S Corps

Most folks are aware of the requirements for an S corporation, including the limitation on who may be a shareholder.  Generally speaking, only the following persons may hold shares of stock in an S corporation:

Shareholders’ Agreement

Well-advised shareholders and their S corporations will have entered into agreements by which the shareholders are prohibited from transferring, and the corporation is prohibited from issuing, shares of stock to ineligible persons.

Not all shareholders, however, are well-advised.  In many situations, the shareholders are unable to agree on all of the terms of a proposed shareholder agreement – it becomes an “all-or-nothing” proposition – and, so, they fail to adopt any of them, including restrictions on the transferability of the corporation’s stock.

In other situations, they simply refuse to spend the time and money on preparing an agreement, relying instead upon their “relationships” with one another.

Disgruntled Shareholder

This state of affairs provides a potential weapon to a disgruntled taxpayer, as he or she may then be free to cause the corporation to lose its “S” status by the transfer of just one of his or her shares.

Sounds simple, right?   Not necessarily.

Give Up Rights

The shareholder must first resign him- or herself to a transfer of some or all of his or her equity in the corporation. This includes the transfer of any economic rights that the transferred shares may eventually realize (as, for example, on the sale of the S corporation’s business), as well as any voting rights (which may, in some circumstances, carry a potential swing vote).

Such transfer may be done by way of a gift to a related person, which may be subject to gift tax, or by way of a sale to a related person, which may be subject to income tax.

(Note that we are assuming related persons as transferees – after all, why would an unrelated person agree to step into a closely-held corporation as a minority shareholder and why, under the circumstances, would the transferor give up all potential influence over the shares?)

Trigger Event(s), Goals

In most cases, the impetus for the disqualifying disposition is the shareholder’s inability to control or benefit from his or her economic investment in the corporation.

The shareholder is a minority shareholder, is likely not an officer with decision-making authority, and may not even be an employee.

In contrast, the “insider” shareholders who control the corporation are directors and officers, and are being paid a salary.

There is no shareholders’ agreement and, so, there are no mandatory corporate distributions to the shareholders to at least enable them to pay their tax liabilities arising from the flow-through to them of their pro rata share of S corporation income, let alone realize an economic return on their investment.  This forces the shareholder to use his or her other assets to pay the income tax liability.

In these circumstances, there is no mechanism by which a shareholder can force the redemption or cross-purchase of some or all of his or her shares.  Again, in the case of a closely-held corporation, the only real market for its shares is among the other shareholders.

The foregoing scenarios typically do not arise in a vacuum.  They are likely coupled with other disagreements (family, personal, etc.) between the disgruntled minority shareholder on the one hand, and one or more controlling shareholders on the other.

“Revoking” the S- Election: Immediate Consequences

The minority shareholder eventually reaches the point at which he or she feels that there is no choice but to “attack” (or threaten to attack) the other shareholders.

An easy way to do this is to destroy the corporation’s “S” status.

By causing the corporation to become a C corporation, he or she will cause the corporation’s income and gains to be subject to two levels of tax, once at the corporate level, and a second when the after-tax corporate profit or gain is distributed to the shareholders (including the disgruntled shareholder).

This may not matter much where the corporation pays out significant (but “reasonable”) compensation to the controlling shareholders, where the corporation is not in the habit of making dividend distributions anyway, or where the corporation is not planning to sell its business.

On the other hand, cutting off the flow-through of S corporation income to the minority shareholder, and the resulting income tax liability and economic loss,  can be a significant benefit.

However, this benefit must be weighed against the potential exposure to the minority shareholder arising from the rules applicable to  the allocation of any corporate income or gain realized for the year in which the election is lost.  Specifically, the remaining shareholders could cause large taxable events later in the year, a portion of which will be allocated to the S-corp. portion of the year, thereby impacting the minority shareholder for that part of the year.  This may leave the minority shareholder with an even larger tax bill (closing the books is not an available option without the consent of the other shareholders).

Asset Sale

Where the corporation may be contemplating a sale of its business in the foreseeable future, the loss of its “S” election is likely going to have a significant impact.

In contast to an “S” corporation seller, a “C” corporation seller will be subject to a corporate level tax on its taxable income and gains. With zero-to-low basis assets like goodwill and going-concern value, this means a significant reduction in the net proceeds from the sale that may then be distributed to the shareholders.

Depending on the nature of the business, it may be possible to structure a sale in a way that avoids some of these adverse consequences.  Some examples include:  a stock sale, a sale of personal goodwill, or a compensation agreement with the key shareholder-officer—anything that bypasses the C corporation level.

The corporation’s distribution to its shareholders will be subject to federal tax at a 20% capital gain tax rate, plus a 3.8% surtax on net investment income. The latter may have been avoided in the case of an S corporation, at least as to its materially participating shareholders.

The loss of the S election will also deprive the corporation and some of its potential buyers of the ability to make a § 338 (h)(10) election or a § 336(e) election, to treat a stock sale as an asset sale and corporate liquidation. This may impact the sales price for a stock sale since it will restrict the buyer’s ability to recover its investment.

Other S-Corp. Tax Consequences

The shareholders may lose the benefit both of any suspended S corporation losses and any undistributed AAA.

If the election is lost, there is a five-year period before “S” status may be elected again.  Moreover, this second election would require the consent of the disaffected shareholder, assuming he or she is still around.

Finally, on the “re-election” of S status, the corporation’s assets would start a new built-in gain recognition period.

“Cutting Your Nose, . . .”

Of course, the disgruntled shareholder will be hurting him- or herself by causing the loss of the S election.  There are times however, where “rational” behavior is not to be expected; viewed differently, the course taken may actually be rational under the circumstances – the shareholder is using the potential loss of S status and the consequences therefrom as leverage in his or her negotiations with the corporation and the other shareholders.

Stay tuned for Part II, tomorrow, for what happens once the decision to “break” the election has been made.