Stockholder loan S corp

[JON]

Multiple stockholders the one with loans to the corporation is willing to transfer all to equity. The other shareholders have requested it. There will not be a change in ownership and most of loans have been used up with loss reductions. Seems to me there are some critical issues you are supposed watch out for. What are they??????? How do we do it???

Is there any differences if it is a single stockholder???]]

Thanks.

[Bees Knees]

2 classes of stock issue

Yeah there is a critical issue here. You have to be careful not to create two classes of stock. If you transfer a loan to equity, you also have to increase his or her distributive share of profits. You can’t just dump it into capital and say it increases his basis so it will come out in the end when things are liquidated. S corps must distribute profits in proportion to a shareholder’s share of equity in the corporation.

This wouldn’t matter with a single shareholder since he or she would still own the same 100% interest in the business before and after the loan to equity transfer.

[JON]

Very little value

Are we sure Bees. Very little value in the Corp-the one other shareholder wants to do it and get a third in(stockholder) employee for very little if anything. they want to give new on encouragement to give it a try for a while. If there was true value being added would have to be a problem. If original wants to keep everyone around he believes he should do it. The consequences of not keeping one and getting a new one does not look good.

The original has some big loans to the corp-alone that could be a second class of stock.

[Bees Knees]

Yes I am sure. The value in the corp at the moment is irrelevant. It has to do with the cost of capital stock.

For example, lets assume you have 4 shareholders, each putting $2,500 in 10 years ago in capital stock to start up this S corp. That means each shareholder owns 25% of the stock and receives 25% of the distributive share of profits and losses on the K-1.

Now lets assume over the years, the S corp doesn’t do so hot. So the shareholders put extra to keep it going calling them loans. These are not equal because loans don’t have to be equal. Say shareholder #1 loans an extra $2,000 over the years, shareholder #2 loans an extra $3,000 over the years, shareholder #3 loans $2,200, and shareholder #4 loans $2,800. Each shareholder utilizes their loan basis to deduct losses so that none of their loans are left. They are still on the books because the corp didn’t have the funds to pay them back, but that’s OK because the shareholders decide to just call it even and say let’s apply the unpaid loans to equity. After all, each shareholder got a tax benefit for the loans by using them to deduct pass through losses. Right?

Wrong. Shareholder #1 now has total capital stock contributions of $4,500, shareholder #2 has capital stock contributions of $5,500, shareholder #3 has total capital stock contributions of $4,700, and shareholder #4 has capital stock contributions of $5,300. That’s a 22.5% share of equity, 27.5% share of equity, 23.5% share of equity, and 26.5% share of equity respectively. Not 25% each. It is irrelevant that these unequal shares of equity are all in a corp that has zero value because it is bankrupt. The fact is, even if just a $100 profit is distributed anytime in the future and you distribute $25 to each shareholder, that is an uneven distribution meaning each shareholder’s share of stock has unequal rights to distributions.

That is the primary reason for S corps losing their S status under the more than one class of stock issue. Of course if you were to re-allocate each shareholder’s distributive share of profits and losses, then that would be OK. But I assume the shareholders did not agree to re-allocate their ownership interests accordingly, since they no longer view those loans as having any current value.

[JON]

Stock loans no value

Stockholders are not related. The third one coming in will probably be issued stock for nothing to get a work commitment out of him, how can it be a second class of stock when no rights are obtained by reclassifing it. Values of stock go up and down monthly, yearly... If 10% ownership was $10,000 10 years ago- $100,000 pay be the price today or $.50 may be the price today. If they said for 1 share he will retire the debt would that make a difference??? Corp with the loan there has a negative value. Without the loan it probably has 0 value or a little one way or the other. If the employee is not convinced to stay with some ownership it has gone negative immediately. How can it be a second class of stock when you have received no rights??. Capital accounts and ownership percentages do not have to be the same...

[Bees Knees]

OK, I will concede the point that ownership percentage and capital accounts do not have to be identical. But only in the case where new stock is issued for the value of the debt retired. If you do not issue new stock when loans are re-classified as equity, then you are creating two classes of stock. Why would someone pay money for zero value in stock? They wouldn’t. So putting more capital in for zero stock is not the answer. If someone is retiring debt in exchange for equity, then that debt has to increase the shareholder’s ownership percentage accordingly, or else you are creating a second class of stock.

[JON]

To keep the Corp going

He wants to retain the current other stockholder and bring a new stockholder in who is currently an employee... He is not doing anything he does not want to do. I do not see two classes of stock here at all. If there was some benefit to the value of the corp I would guess there is gift problem or compensation issue with the one coming in..

He has a choice of keepin the two running the locations or ending up liquidating and since he as the only availale resources putting money in to cover loans of corp. He could go after the other shareholder, but already knows how much he could get...

I do think there are certain corporate issues in handling of it to insurew it is not considered repayment of debt-basis has been used for loses.

[Bees Knees]

He is not doing anything he does not want to do.

What he wants is irrelevant.

If there was some benefit to the value of the corp I would guess there is gift problem or compensation issue with the one coming in..

If there is no benefit to the value of the corp, then why transfer the loans to equity? If they are worthless, then there is no need to transfer them, is there?

since he as the only availale resources putting money in to cover loans of corp.

Fine, let him put more money in as loans, if he is the only one who can keep it going. But if he wants to convert those loans to equity, he better increase his proportionate share of ownership accordingly.

Go back and re-read the two classes of stock issue. Tell me what you think a second class of stock means? If you can dump money into a corp without receiving an increased share of distributions, and that's not a second class of stock, then how do you create a second class of stock?

[Lance Emerson]

In talking about a second class of stock, and the situations where a loan is a second class of stock, Treasury Regulation 1.1361-1(l)(5) talks about a "straight debt safe harbor." One of the safe harbors is that [the debt] "...is not convertible (directly or indirectly) into stock or any other equity interest of the corporation..."

Debt forgiveness is treated the same as if there is a cash payment made, so you can't say there's no value created.

There's going to have to be income recognized somewhere if that debt is converted.

[JON]

What is the difference between debt and equity???!!!

There is a big difference between debt and equity. Would you rather be join a compnay as a stockholder with $100,000 in equity and no debt or the same one with $10 equity and $99,910 in debt. The interest has to be paid or deemed paid on a yearly basis. All that means is cash out or have the debt grow. That is the reason debt in this case and most I know of is not as good as equity. There is a BIG Benefit to transfer the debt to equity-lock in the third stockholder.

The original lender/stockholder believes to keep the second stockholder and get the third this would accomplish the goal. My reference was this seems very much an arms length transaction with no one getting anything out of line. Write off of debt just creates income at the corporation level-with adverse tax effects to the two stockholders.

This debt was never convertable. Original it was needed because of some bad times-slowly looks like breakeven could happen with keeping the employee who they want to offer stock to. The breakeven is without stockholder debt and related interest. If business would have been as anticipated the debt would have been paid back with interest, but now they have to adapted to the truth of the business. Two classes of stock to me is when debt was given convertable terms or control on mangement can be obtained because of the debt. That is debt is considered a second class of stock. Here we are getting rid of debt and not atrributing any increase in management or control. If I have the problem it because OF the current debt-that will go away without any ownership increase.

Appreciate the info, but my problem was the mechanics. PPC S Corporations shows some information and related Code sections. Definitely easier with one stockholder, but such is not the case. Thanks...

[Bees Knees]

Two classes of stock to me is when debt was given convertable terms or control on mangement can be obtained because of the debt. That is debt is considered a second class of stock. Here we are getting rid of debt and not atrributing any increase in management or control.

I am sorry, but I respectfully disagree. You are converting debt to equity because there isn’t any money to pay the debt back. Fine, that is OK to do. Nothing wrong with that. But why not increase his ownership percentage accordingly? Would an outside lender just agree to contribute the uncollectible debt to equity and walk away without receiving any ownership interest? Maybe, but then that would be called forgiveness of debt, taxable to the one who's debt is forgiven.