Guaranteed Compensation

[veritas]

I was mistaken. A sale between related parties should be no problem. I was thinking of a stock redemption which would be a problem. My bad

[Bees Knees]

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)

1. What you have here is a non-compete agreement in the form of a salary. The S corporation is going to continue to pay Dad for 10 years for his consulting services and his agreement not to start up a new company across the street.

Nothing wrong with that. It is done all the time. The IRS will like it because Dad has ordinary income to report, not capital gain income…Plus they get FICA tax out of the corp.

The son should like it because he gets an expense deduction for the salary, as opposed to tying up tons of money in the basis of stock.

Dad seems to like the deal, so why make waves, even though he will be paying ordinary income tax rather than capital gains tax on the sale of most of his stock. Maybe he doesn’t care.

2. Daughter recognizes entire gain in year of sale because she received all the proceeds from the sale in the year of sale. No installment method here.

[OldJack]

Bees Knees.. you have completely ignored Code Sec. 318(a)(1)(A), constructive ownership rules regarding capital gains for daughter. Yes.. excess of basis is all taxable to daughter as a ordinary dividend on 1040 Sch-B when if not redemption it would be Sch-D.

[Bees Knees]

Bees Knees.. you have completely ignored Code Sec. 318(a)(1)(A), constructive ownership rules.

What does that have to do with non-competes? Are you saying you can't sell your business to a related party with a Non-compete agreement?

[OldJack]

What does that have to do with non-competes? Are you saying you can't sell your business to a related party with a Non-compete agreement?

The IRS will look at the fair-market-value of the corporation and in all likelihood the IRS will reclassify a substantial non-compete amount to a family member as part of the sales price. The question begs to be answered... would a dad sell and compete against his own son causing failure of his sons business?

[Bees Knees]

Why would the IRS do that if that meant converting ordinary income to capital gain?

Net tax to IRS would be less.

[OldJack]

Why would the IRS do that if that meant converting ordinary income to capital gain?

Net tax to IRS would be less.

Simple... the old bird in the hand is worth 2 in the bush! The IRS wants their money on the full value sale.... today! Dad may not take the salary tomorrow because the business may not be in business. The IRS has always taxed on a year by year without regard to what may happen next year.

[Bees Knees]

Problem is, to get all the tax on the sale up front, you have to claim part of the sales proceeds are ordinary income. If it is a capital gain for a stock sale, as you wish it to be, that means it is an installment sale and the gain has to be reported over the 10 year term of the sale.

You can’t have it both ways. If you insist it is all a sale, then you have to deal with the favorable capital gain rules.

I understand the point that this really is a sale. The problem is, Dad isn’t trying to get away with anything. He is trying to pay MORE tax.

The attribution rules of Section 318 are used by IRS to prevent taxpayers from structuring stock redemptions in a way where the seller receives capital gain treatment on the redemption of his stock. The IRS and courts generally rule that the taxpayer must treat the income as ordinary dividend income rather than capital gain income. Treating it as dividend income means the C corporation would receive no deduction for the payment. But we are talking about an S corporation, not a C corporation. So treating it as a dividend would simply put it back into the capital gain issue of S distributions in excess of basis.

The only way the IRS can get the transaction treated as ordinary income under the Section 318 attribution rules is to say it is a wage for a non-compete agreement. That would then recharacterize the capital gain tax rate treatment into ordinary income.

But wait….that IS what Dad wants. So what’s your point?

[Bees Knees]

I noticed you edited your earlier post to clarify you were talking about the daughter.

Regardless, section 318 also would not apply because daughter is selling her entire interest, not trying to redeem a portion of her stock. Capital gain treatment can apply if entire interest is redeemed or sold.

Again, dividends are only an issue when you have a C corporation, not an S corporation. The C corporation dividend issue under Section 318 is meant to prevent family members from converting C corp E&P into capital gains.

Not applicable here.

[OldJack]

I noticed you edited your earlier post to clarify you were talking about the daughter.

Regardless, section 318 also would not apply because daughter is selling her entire interest, not trying to redeem a portion of her stock. Capital gain treatment can apply if entire interest is redeemed or sold.

Again, dividends are only an issue when you have a C corporation, not an S corporation. The C corporation dividend issue under Section 318 is meant to prevent family members from converting C corp E&P into capital gains.

Not applicable here.

I don't believe the code §318 mention any difference in C-corp stock verses S-corp stock. Daughter is deemed to constructively own her dads stock with regards to redemption. True, I mentioned she may fall into an except to the rule. 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. The possibility of Code 318 can easily be avoided by selling to son/brother rather than the corporation.

True, this is a S-corp, but you are not recognizing the IRS bargain sale reclassification as the sale price of redemption is valued at fair-market-value of the corporation (not father's valuation or a minority discounted valuation) with property appreciation in excess of AAA account, thus ordinary dividend income potential rather than capital gains.

[Bees Knees]

I don't believe the code §318 mention any difference in C-corp stock verses S-corp stock. Daughter is deemed to constructively own her dads stock with regards to redemption. True, I mentioned she may fall into an except to the rule. 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. The possibility of Code 318 can easily be avoided by selling to son/brother rather than the corporation.

Don't you think going from a 20% ownership interest to a zero % ownership is a "meaningful reduction in the redeemed shareholder's proportionate interest?"

If so, Section 318 does not apply, and my original statement was correct.

True, this is a S-corp, but you are not recognizing the IRS bargain sale reclassification as the sale price of redemption is valued at fair-market-value of the corporation (not father's valuation or a minority discounted valuation) with property appreciation in excess of AAA account, thus ordinary dividend income potential rather than capital gains.

Dividend treatment does not apply if there is no E&P from a C corp. The original post makes no mention of C corp E&P. Thus, the IRS has nothing to reclassify as a "dividend." Appreciation in excess of AAA with no E&P is pure and simple capital gain. That is the only thing the daughter can get, unless she agrees to a non-compete agreement like Dad and receives a wage.

[Snaggletooth]

Original Post

I appreciate the banter between you two experts, as it gives me numerous perspectives into the issue.

If it makes any difference, the original post may or may not have made the following facts clear:

1. Corporation has always been a Sub S since inception.

2. Fair market value is in fact $2 million. Daughter's share is $400,000, and
that is the payment corporation will make for Treasury Stock.

Does this constitute enough of an arms length transaction to avoid treatment as a dividend or capital gain at ordinary income rates?

[Bees Knees]

The daughter gets capital gain tax rate treatment. No funny business going on on that end.

The only issue that looks goofy is Dad getting most of his money in the form of a wage.

When IRS re-characterizes a sale of stock transaction under related party rules, it is always done to stop someone from taking E&P out of the corporation as a capital gain.

That can't apply here because there is no E&P, and Dad already wants most of his share paid out as ordinary income in the form of a W-2 wage.

[OldJack]

Don't you think going from a 20% ownership interest to a zero % ownership is a "meaningful reduction in the redeemed shareholder's proportionate interest?"

If so, Section 318 does not apply, and my original statement was correct.

As usual its facts and circumstances that have to be determined to apply or not apply code §318.

An individual is considered as owning stock owned, directly or indirectly, by his spouse (unless divorced or legally separated), children (including adopted children), grandchildren and parents. [code §318(a)(1)].

Therefore, under the constructive ownership rules:
1) Dad is considered owner of shares owned by son and daughter.
2) Son is considered as owner of his and dads shares.
3) Daughter is considered as owner of hers and dads shares.

Before dad sells out dad owns 100% (his+son+dau) and a "redemption" of son or daughter means a constructive dividend/ordinary income if dad still owns 100% (his, sons) after the redemption and therefore there is no "meaningful reduction in the redeemed shareholder's (dads) proportionate interest?"

Daughter is considered owning 80% (dads 60%+her 20%) and a redemption of 20% share is not a complete redemption. Daughter would therefore have a constructive dividend/ordinary income rather than a capital gain unless she meets an exception. In all likelihood she meets an exception under Reg §1.302-2(b), especially as it relates to complete redemption of a low percentage minority shareholder.

But you say dad sold to son before daughter redemption and therefore does not own shares attributed to daughter. An IRS position could be that dad selling and daughter selling is all one transaction and as such dad was redeeming daughters stock and as such it was only a partial redemption before dad selling to son.

Truth is the IRS will probably not audit or question the whole transaction or cause any problem, however, why not have daughter sell to son instead of the corporation and then daughter gets capital gains and there is no concern.

Dividend treatment does not apply if there is no E&P from a C corp. The original post makes no mention of C corp E&P. Thus, the IRS has nothing to reclassify as a "dividend." Appreciation in excess of AAA with no E&P is pure and simple capital gain. That is the only thing the daughter can get, unless she agrees to a non-compete agreement like Dad and receives a wage.

A dividend is a distribution of property by a corporation to its shareholders with respect to its stock, out of accumulated or current earnings and profits. A dividend needn't be proportionate and needn't be formally declared. "Property" includes money, securities and any other property (except the corporation's own stock or rights to that stock). "Property" also includes any economic benefit the corporation gives its shareholders, in whatever form (Reg §1.317-1).

I agree that S-corp appreciation on liquidation or sale of stock (which FMV=Appreciation) is capital gain EXCEPT in a partial redemption it is a taxable dividend/ordinary income as though the S-corp and shareholder had recognized ordinary income before the partial redemption. In other words if the appreciated business property had been sold by the S-corp the shareholder would have ordinary 4797 gain income and then on liquidation the cash redeemed would be at capital gains v. basis for the shares owned. Without this redemption rule, what might be S-corp ordinary income would be converted to capital gains.

As an example without code §318 and redemption rules, a 100% shareholder of an S-corp could redeem one share of stock in exchange for appreciated equipment (at FMV) with the S-corp not recognizing gain as a sale or purchase of treasury stock does not recognize taxable gain for a corporation [Code§1032(a); Reg.§1.1032-1]. The shareholder recognizing capital gains and turns around and sell the equipment at capital gains rates (basically no gain) bypassing the S-corp recognizing ordinary gain on form 4797.

[Roland Slugg]

A few thoughts

Some random thoughts that occurred to me as I read this thread:

1) The $120k per year for 10-years plan ignores interest. The PV of those payments, assuming a 6% interest rate, is only $883k ... a discount of more than 25% from the stated FMV of $1.2MM.

2) Contrary to someone's post above, the related taxpayer rule of Code §318(a)(1)(A) does not apply if there is a complete termination of a shareholder's interest. See Code §302(c)(2)

3) The $120k per year compensation scheme is terrible, IMO. There would be payroll taxes on those payments, and they would be significant; this would convert capital gain into ordinary income; and at the end of ten years, Dad would still own his 60% of the shares!

4) The plan involving increasing the Son's salary by $120k per year is almost as bad ... perhaps worse. Some of that additional salary might be subject to payroll taxes, and all of it would be subject to income taxes. After taxes the Son would have nowhere near the $120k he would need to pay Dad his annual payments.

5) Why is Dad against gifting some or all his shares to Son? Is there some downside to using his unified Estate/Gift credit? Does he need the income?

6) Is Dad up in years? Any chance of a death (or worse) in the year 2010? (That's going to be one macabre year unless the currently scheduled repeal/revival is changed! It reminds me of that great dialog, spoken by Jeremy Irons, in the 1990 film about Claus von Bülow, "Reversal of Fortune." Q: What does a man give his wife who has everything? A: An insulin injection. Q: And what do you call a fear of insulin? A: "Claus"-traphobia.)

I have a strong bias against clients ... including other people's clients ... who move their deck chairs around in ways that create no significant economic changes, but only trigger a big tax liability in the process. Somebody needs to ask Dad to focus on his objectives ... then address those! If he truly wants to sell out, and get $1.2MM for his shares (with or without interest thereon), I would recommend having the corporation redeem them. No payroll taxes ... 100% capital gain.

As others have pointed out, Dad would have to cut all ties with the corp, except as a creditor.