S Corporation Return

  • Thread starter Stuart O. Bronstein
  • Start date

S

Stuart O. Bronstein

I had a call from a client that you will have some thought
about (if there is a God in the heavens!)

My client (let's call him Joe) went into partnership with a
guy (let's call him Ray), and bought a business from Ray's
mother that had been run by Ray's recently deceased father.
An S corporation was set up to buy the business.

The business was ok, but due to some undisclosed problems in
Ray's background, the business was, in Joe's opinion, not
able to achieve it's aims. Frankly, Ray was just as happy
to see Joe go, so they agreed that Ray would buy Joe's
stock.

When the tax return came, the corporation is attributing to
Joe about three times as much (income and profit on sale of
the stock) as he actually got from the corporation last
year. I didn't ask him if Ray had misinformed him about the
status of the business while negotiating his buyout.

Needless to say, if he has to pay tax on so much income that
he never received, he won't end up with much if any at the
end of the day.

I think Ray is trying to take advantage of Joe, and lower
his own taxable income at Joe's expense.

Any ideas?

Thanks.

Stu
 
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M

MTW

Stuart O. Bronstein said:
When the tax return came, the corporation is attributing to
Joe about three times as much (income and profit on sale of
the stock) as he actually got from the corporation last
year. I didn't ask him if Ray had misinformed him about the
status of the business while negotiating his buyout.
There are two ways that income can be allocated to a
departing shareholder. One is a "pro rata" share of annual
income based on the number of days during the year that Joe
was a shareholder. The other is the "interim closing of the
books" method where actual income is measured through the
date of departure. It might be helpful to find out what
method was used in your case. I don't know offhand WHO gets
to choose the method, but presumably it could have been a
point of negotiation at the time of the buyout.
Needless to say, if he has to pay tax on so much income that
he never received, he won't end up with much if any at the
end of the day.
Note that the income never received will nevertheless
increase Joe's "basis." He'll be able to write that off
against the proceeds from the sale of his stock. However,
due to differing tax rates for ordinary and capital gain
income, this won't necessarily work out to a direct "push."

MTW
 
H

Harlan Lunsford

Stuart said:
I had a call from a client that you will have some thought
about (if there is a God in the heavens!)

My client (let's call him Joe) went into partnership with a
guy (let's call him Ray), and bought a business from Ray's
mother that had been run by Ray's recently deceased father.
An S corporation was set up to buy the business.

The business was ok, but due to some undisclosed problems in
Ray's background, the business was, in Joe's opinion, not
able to achieve it's aims. Frankly, Ray was just as happy
to see Joe go, so they agreed that Ray would buy Joe's
stock.

When the tax return came, the corporation is attributing to
Joe about three times as much (income and profit on sale of
the stock) as he actually got from the corporation last
year. I didn't ask him if Ray had misinformed him about the
status of the business while negotiating his buyout.

Needless to say, if he has to pay tax on so much income that
he never received, he won't end up with much if any at the
end of the day.

I think Ray is trying to take advantage of Joe, and lower
his own taxable income at Joe's expense.

Any ideas?
I trust Joe's 1040 is on extension by this time? (grin

You say "partnership" and of course I understand what you
mean, as in percentages of ownership of the S corp.

From what you say I get the impression Joe was dissatisfied
with operations and decided to cash in his chips so to
speak. However, after that the business recovered nicely
and became even more profitable, and in preparing the 1120S,
allocation was made to each shareholder on the number of
days each held the stock.

Joe should of course demand to see the books. Then hire an
attorney AND a CPA to audit the books. Then decide whether
or not to sue the pants off Ray. well, you know what I
mean.

Cheer$$$$$,
Harlan Lunsford, EA n LA
 
E

Ed Zollars, CPA

MTW said:
I don't know offhand WHO gets
to choose the method, but presumably it could have been a
point of negotiation at the time of the buyout.
The closing of the books can only be done if all parties
that are involved consent to the election. Since someone
will clearly be worse off by consenting to that election, I
tell clients if they want it done that way they need a
provision in the sales agreement requiring all parties to
sign off on the consent to closing of the books election.
 
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B

Bruce E. Cobern

MTW said:
There are two ways that income can be allocated to a
departing shareholder. One is a "pro rata" share of annual
income based on the number of days during the year that Joe
was a shareholder. The other is the "interim closing of the
books" method where actual income is measured through the
date of departure. It might be helpful to find out what
method was used in your case. I don't know offhand WHO gets
to choose the method, but presumably it could have been a
point of negotiation at the time of the buyout.
The default method is to allocate the income per share per
day, using the total income for the year. Thus, IF the
business became profitable after Joe sold, he would still be
taxed on a portion of those profits, even though the price
he negotiated was based on the lousy results up until that
time. As Mike said, the profits would increase his basis and
reduce his gain or increase his loss on the sale. (I'm
confused about the initial comment that the S corp return
reported income to Joe from the sale of the stock, since
this transaction should be occurring outside the
corporation, unless he didn't sell to Ray, but had the
corporation redeem his stock.)

The option to close the books at the termination of a
shareholder's interest can only be used with the consent of
every shareholder of the corporation during the year. So,
both Joe and Ray would have had to agree, in writing, to
allocate the income this way.

First Joe must get a copy of the 1120S and determine how the
income was allocated. Then he can see if he has any
recourse depending on what method was used, and whether he
agreed to an interim closing of the books (if that method
was used).
 

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