S-Corp Sale of Sharholder Interest - Odd

[JohnH]

I have (or had) an S-Corp client which fell apart last year. There were 2 shareholders owning 50% each. Shareholder A presented a buyout offer to Shareholder B to purchase his entire ownership for $20K via a cashiers check. The offer alluded to a non-compete agreement the be decided upon later, but didn't specifically one out.

About a week later, Shareholder A deposited $10K to the corp account and a $10K check was written to Shareholder B from the corporation account, with the notation "1/2 buyout". This was done with the consent of Shareholder A.

A week later, a $5K check was written to Shareholder B with the notation "1/4 buyout. This was also done with the consent of Shareholder A.

Then 2 weeks later, Shareholder B went into the office very early, wrote himself a $5K check, and left his stock certificate on the desk. The stock certificate was endorsed back to the corp, not to Shareholder A. This was all done without the consent of Shareholder A, as he didn't know about it until he arrived at the office that morning.

(Nobody is telling me very much about motivation, but I'm pretty sure that Shareholder B handled things in this way to avoid signing the non-compete agreement)

Shareholder A now has the main thing he originally wanted (100% ownership of the corp) and although he's upset over how it went down at the end, he's generally fine with the outcome. So I'm thinking through this, and even though the form of the transaction was different than the original agreement, the substance is close to the same.

The only thing that bugs me is whether the distributions to Shareholder B prior to the date he signed over the stock certificate constituted an unequal distribution and would be a disqualifying event invalidating the S-corp election as of that date. If the original agreement had called for this sort of buyout plan it probably wouldn't matter, but since there was no agreement between the corp and Shareholder B, I'm wondering if this could be a problem. If anyone has any thoughts on this, especially if you think I'm torturing the facts, I'd like to hear.

Isn't it wonderful how clients do these things without asking any questions?

[DaveO]

I worked for a company years ago when something like this was done. If Shareholder "A" wants to buy out Shareholder "B" he should do it with his own money.

If it's done with the corporations money then it's a distribution for the benefit of Shareholder "A" and taxable to him. Did "A" loan the corporation the money?

[BHoffman]

I have (or had) an S-Corp client which fell apart last year. There were 2 shareholders owning 50% each. Shareholder A presented a buyout offer to Shareholder B to purchase his entire ownership for $20K via a cashiers check. The offer alluded to a non-compete agreement the be decided upon later, but didn't specifically one out.

About a week later, Shareholder A deposited $10K to the corp account and a $10K check was written to Shareholder B from the corporation account, with the notation "1/2 buyout". This was done with the consent of Shareholder A.

A week later, a $5K check was written to Shareholder B with the notation "1/4 buyout. This was also done with the consent of Shareholder A.

Then 2 weeks later, Shareholder B went into the office very early, wrote himself a $5K check, and left his stock certificate on the desk. The stock certificate was endorsed back to the corp, not to Shareholder A. This was all done without the consent of Shareholder A, as he didn't know about it until he arrived at the office that morning.

(Nobody is telling me very much about motivation, but I'm pretty sure that Shareholder B handled things in this way to avoid signing the non-compete agreement)

Shareholder A now has the main thing he originally wanted (100% ownership of the corp) and although he's upset over how it went down at the end, he's generally fine with the outcome. So I'm thinking through this, and even though the form of the transaction was different than the original agreement, the substance is close to the same.

The only thing that bugs me is whether the distributions to Shareholder B prior to the date he signed over the stock certificate constituted an unequal distribution and would be a disqualifying event invalidating the S-corp election as of that date. If the original agreement had called for this sort of buyout plan it probably wouldn't matter, but since there was no agreement between the corp and Shareholder B, I'm wondering if this could be a problem. If anyone has any thoughts on this, especially if you think I'm torturing the facts, I'd like to hear.

Isn't it wonderful how clients do these things without asking any questions?

Hi John - If Shareholder A was buying Shareholder B's stock, then why did they involve the Corp checking account? Wouldn't A just have paid B directly if he was buying B's stock? This seems to have been treated as though the Corp bought treasury stock from B.

This could probably be fixed by calling the first $10k a loan TO the corp from Shareholder A , with A being paid back by writing the check to B.

The other two $5k disbursements to B would then be a loan FROM the corp to A.

Unless they did intend for this to be a treasury stock transaction.

[JohnH]

I don't think they knew what they were doing, and why call me when all they wanted to do was COMPLETELY RESTRUCTURE OWNERSHIP! After all, I might charge them for a little advice. As you can see, I'm more than a little perturbed at ther behavior.

At this point I think what actually happened was that the corp simply bought all of B's stock, which went back in as treasury stock, and A is now the 100% owner. But of course that isn't what they wrote down on that silly piece of paper they drew up. I should put the entire thing up here for laughs - it's one of the best examples of hillbilly tax planning ever devised. Lots of "whereas", "wherefore", "party of the first part", and other semi-legalese (although I've never heard of a "mediated divestiture" or a "Divestiture of Corporate Partnership" before). I swear I'm not making this up.

Anyhow, my basic approach is just to treat it as a sale of stock to the corp on the date the certificate was signed over and treat the two prior payments as advance deposits against that final event. I can then allocate profits between them as of that date and be done with it.

But what keeps bugging me is whether they inadvertently terminated the s-corp with those first two distributions since they came from the corp. It won't make a whole lot of difference for 2008 since there wasn't much activity in the aftermath of all this, but the corp may actually be a "C" corp as of Mid-Nov of 2008.

[BHoffman]

I don't think they knew what they were doing, and why call me when all they wanted to do was COMPLETELY RESTRUCTURE OWNERSHIP! After all, I might charge them for a little advice. As you can see, I'm more than a little perturbed at ther behavior.

At this point I think what actually happened was that the corp simply bought all of B's stock, which went back in as treasury stock, and A is now the 100% owner. But of course that isn't what they wrote down on that silly piece of paper they drew up. I should put the entire thing up here for laughs - it's one of the best examples of hillbilly tax planning ever devised. Lots of "whereas", "wherefore", "party of the first part", and other semi-legalese (although I've never heard of a "mediated divestiture" or a "Divestiture of Corporate Partnership" before). I swear I'm not making this up.

Anyhow, my basic approach is just to treat it as a sale of stock to the corp on the date the certificate was signed over and treat the two prior payments as advance deposits against that final event. I can then allocate profits between them as of that date and be done with it.

But what keeps bugging me is whether they inadvertently terminated the s-corp with those first two distributions since they came from the corp. It won't make a whole lot of difference for 2008 since there wasn't much activity in the aftermath of all this, but the corp may actually be a "C" corp as of Mid-Nov of 2008.

Were the payments received by B distributions or were they payments for the treasury stock?

[JohnH]

The first $10K was agreed by both A & B to be a payment toward the $20K buyout. Same for the $5K second payment. But the third & final payment of $5 was done by B without A's advance knowledge. It was intended by B to be the final payment against the $20 K. So as far as B is concerned, the $20K was payment for the treasury stock (although neither A nor B knew what treasury stock was until I pointed it out to them after they gave me the documentation and I saw that the stock was signed over to the corp).

In retrospect, A is fine with the transaction since his intent all along was to buy out B for a total of $20K. Except of course for the small matter of A having offered to pay the $20K directly to B, and then deciding to funnel half the money through the corp. Neither one of them can tell me how they came up with that brilliant idea part way into the transaction.

So neither A or B is unhappy with the final result, but they did it without any real agreement, and they both "more or less" got what they were after. They just didn't document it at the outset in the manner that it actually happened.

[ChEAr$]

It doesn't have to be termed

"treasury stock". Treasury stock exists when the corporation buys it's own stock but
keeps it outstanding.

The intent in your case, John, I think was for the corporation to redeem the stock, thus
cancelling the shares upon payment therefore. therefore, where 1000 shares were
formerly issued, there will be only 500 outstanding now.

Have remaining stockholder get the resolution of the board of director(s) prepared and
duly signed by both as having occurred at the last board meeting.

After all, they DID have a board meeting when they agreed to disagree!

[JohnH]

Harlan: That sounds like a good way to resolve the matter. I like the way you cut to the main issue, especially on these S-Corp matters. All they need to do is document the meeting and everything else falls into place.