Guaranteed Compensation

[Snaggletoof]

Dad has highly successful Sub S Corp. Dad owns 60%, and Son owns 20%, both of whom have worked uninterruptedly for the company since it was founded.

Dad is now to the point in his life where he wants to go fishing 2-3 days a week. He wants to sell his 60% to his son. FMV of the corporation is $2MM, meaning the son needs to somehow pay $1,200,000 for his share.

Dad does not want son to be burdened with debt service, so instead of "selling", he believes son should put Dad on guaranteed salary of $120,000 for ten years. Actual value of Dad's services to the corporation after fishing is around $35,000 annually.

Can Dad and son pull this off?

[veritas]

Maybe When will dad's stock go to son?

[OldJack]

Anything dad (60%) and son (20%) wants to do has a potential problem as there must be another 20% shareholder that is going to complain.

Sure... son can purchase dad's shares of stock on a 10 year installment sale basis and increase son's salary with an employment contract in order for son to make the payments. Dad then has mostly capital gain and interest income each year and no say about how the corp is run. This gives son 80% immediate ownership.

Sure... the S-corp can redeem dad's "entire" 60% shares on the installment sale basis. This leaves the son with 50% ownership along with whoever owned the unidentified 20%. If the redemption is less than full ownership the distribution in excess of the AAA is taxed as a taxable dividend.

Sure... dad can gift the shares at fair market value to son. Works without estate tax if dad's estate is under the limit at death, however, the gift value is considered a part of dad's gross estate for estate tax.

In addition dad can still have a consulting agreement for around $35,000 per year.

[Unregistered-I tried]

Selling what assets

or stock.... Assets normally a lot higher. Net worth of company-established by what measure. Would be crazy not to do some combination of salary and stock buyout. There are implicit interest rates involved. Corporation can buy back some stock, but be careful-old rule on complete liquidation of stock and can not be anything but a creditor, not employee, to qualify as a stock sale. Gifting some stock shares with nice discounts could also work...

[rosieea]

...

Dad does not want son to be burdened with debt service, so instead of "selling", he believes son should put Dad on guaranteed salary of $120,000 for ten years. Actual value of Dad's services to the corporation after fishing is around $35,000 annually.

Can Dad and son pull this off?

If you're asking if a salary that high passes muster with the IRS, I'd say there's no problem with an S Corp. If it were a C Corp, there could be a problem with a salary viewed as unreasonably high. But if the Corporation is paying for the stock with excess wages, the Corporation will own the stock (Treasury Stock), no? How does the son get ownership? Instead, is Dad going to gift the stock to the son? Could be gift tax implications with that.

[Snaggletoof]

Clarity

Dad wants no complications raised by gift reducing his unified deduction. Dad owns substantially more holdings than the just the corporation - probably $7-$8 MM in real estate alone.

Parties intend for this to be a transfer of stock. In TN, standard 1000 share of stock exist, Dad and wife hold 600 shares. Daughter holds another 20% and this will have to be dealt with separately from any arrangement described in this thread.

One of the factors not discussed was that this proposed deal pays Dad $120,000/yr salary for 10 years, but that has a discounted value of only $814,000 at 8%. If this were a classic GAAP question about recognizing a liability, only $814,000 would be recognized and $386,000 in income amortized over the 10 year period. But compensation doesn't work that way, I suppose.

[veritas]

Anything dad (60%) and son (20%) wants to do has a potential problem as there must be another 20% shareholder that is going to complain.

Sure... son can purchase dad's shares of stock on a 10 year installment sale basis and increase son's salary with an employment contract in order for son to make the payments. Dad then has mostly capital gain and interest income each year and no say about how the corp is run. This gives son 80% immediate ownership.

Sure... the S-corp can redeem dad's "entire" 60% shares on the installment sale basis. This leaves the son with 50% ownership along with whoever owned the unidentified 20%. If the redemption is less than full ownership the distribution in excess of the AAA is taxed as a taxable dividend.

Sure... dad can gift the shares at fair market value to son. Works without estate tax if dad's estate is under the limit at death, however, the gift value is considered a part of dad's gross estate for estate tax.

In addition dad can still have a consulting agreement for around $35,000 per year.

If their is an installment sale and the father wants to report sale under favorable capital gains he can no longer have anything to do with the corporation. He can perform no services. If not sale of stock will be ordinairy income.

[OldJack]

Paying dad a salary has no discount value only ordinary income. What is it you don't like about a pay raise for son with dad selling shares to son as mention in my previous post? Son immediately owns shares and dad gets capital gain and interest. It is still confusing that 60%+20% does not add to 100% outstanding stock ownership? You don't count treasury shares or stock that is not issued.

[OldJack]

If their is an installment sale and the father wants to report sale under favorable capital gains he can no longer have anything to do with the corporation. He can perform no services. If not sale of stock will be ordinairy income.

There is no reason anyone (including dad without shares of stock) can't be an employee or a consultant for a corp. That is up to management of the corporation.

You only have a problem with capital gains when a "partial redemption" is by the corp. A partial redemption is not treated as sale but treated as a taxable dividend. The sale discussed here is to an individual (son or son-in-law) and not a purchase of shares as a redemption by the corp. Therefore redemption rules do not apply and there is no change to anything on the corp books.

[Snaggletooth]

Specific Questions

Before this thread rides off into oblivion, let me reduce the above situation to a couple of questions. Some of them have been answered, but in format dejeure.

1. Dad "sells" his 60% share of a $2MM valued S corp to his son. Terms of sale are:
$200,000 cash in year of sale (Dad's basis is $150,000). Then $100,000 guaranteed salary for 10 years. Guaranteed salary ceases in the event of death.

Question: What recognition of gain must be reported by Dad in the year of sale?

2. Daughter owns 20% share of same company. S corp buys back her 20% as Treasury Stock for $400,000. Daughter's basis in S corp at time of sale is only $15,000. Daughter received entire proceeds in the year of the sale.

Question: What recognition of gain must be reported by Daughter in the year of sale? (Note: GAAP does not recognize profit on transactions between a corporation and its shareholder)

[Unregistered-yes I was]

Gain

on sale of stock is all in year one. $200,000 - $150,000. Salary is salary. Now if you word the agreement that you are selling your stock for $200,000 down and a salary for ten years even though you are not going to work-if audited IRS would probably say that is not salary but a stock buy, maybe even dividend to the son who ends up with the stock and payment to Dad by him.

[OldJack]

1. Dad "sells" his 60% share of a $2MM valued S corp to his son. Terms of sale are:
$200,000 cash in year of sale (Dad's basis is $150,000). Then $100,000 guaranteed salary for 10 years. Guaranteed salary ceases in the event of death.

Question: What recognition of gain must be reported by Dad in the year of sale?

1040 Installment sale form 6252 results in 2 million less $150,000 = $1,850,000 LTCG = 92.5% gross profit percent. Each payment would have 92.5% LTCG plus interest on the note. Salary, if any, would be recognized as earned and in year of cash paid. This is not considered a redemption (subject to attribution rules) as the sale is direct to an individual (son) and proceeds are NOT coming from the corporation. Also dad is liquidating his complete interest in the corporation.

Note that a 10 year "employment contract" with a related party (son's company) would probably be determined as unreasonable and possibility cause the whole deal to be considered on audit as a "shame" with the dad having the full gain ($1,850,000) reported as a partial redemption of stock (he is considered to own son's shares at time of his sale) in the current year, which would not give him the LTCG on the sale. However, if there was no contract (verbal or written) dad could probably do some work for the company at a reasonable pay without it being questioned.

Note RIA handbook, paragraph 3528 : A redemption on the installment basis can qualify as a complete redemption if the corporation and the shareholder are bound by a purchase agreement to complete the redemption by a certain date and for a maximum price.

Reg.§1.302-2(b) states that a redemption isn't essentially equivalent to a dividend if it results in a meaningful reduction in the redeemed shareholder's proportionate interest in the distributing corporation without regard to how it affects the distributing corporation.

2. Daughter owns 20% share of same company. S corp buys back her 20% as Treasury Stock for $400,000. Daughter's basis in S corp at time of sale is only $15,000. Daughter received entire proceeds in the year of the sale.
Question: What recognition of gain must be reported by Daughter in the year of sale? (Note: GAAP does not recognize profit on transactions between a corporation and its shareholder)

Not only GAAP but Tax accounting also does not recognize profit/gain at the corporate level on redemption of stock to treasury stock.

Daughters sale is a redemption of stock by the corporation and as such the following code applies:

In general
An individual shall be considered as owning the stock owned,
directly or indirectly, by or for -
(i) his spouse (other than a spouse who is legally
separated from the individual under a decree of divorce or
separate maintenance), and
(ii) his children, grandchildren, and parents.

Normally you would expect that Daughter's 1040 sale would be LTCG of $385,000 reported on 1040 Sch-D as it is a complete redemption of daughters ownership. However, due to the constructive ownership rules (see above quote) she is deemed to also own her father's 60% (and son's %) and thus her redemption is only a partial redemption and subject to ordinary income reported on form 4797. There are certain exceptions depending upon facts and circumstances (stock might be sec. 306, daughter might be daughter-in-law, redemption not essentially a dividend Reg.§1.302-2(b)) that might keep this from being a partial redemption subject to ordinary income.

[veritas]

I'll repeat

If their is an installment sale and the father wants to report sale under favorable capital gains he can no longer have anything to do with the corporation. He can perform no services. If not sale of stock will be ordinairy income.

[OldJack]

If their is an installment sale and the father wants to report sale under favorable capital gains he can no longer have anything to do with the corporation. He can perform no services. If not sale of stock will be ordinairy income.

I would appreciate a reference or documented example for your position on an installment sale so that I could better understand.

[veritas]

I was hoping you would remember. It's been a ling time since I read this. I'll see what I can do.