s corp

[Carlos]

Client is sole shareholder of s corp. He purchased the stock from another sole shareholder on 1/1/06. Part of the deal was for wip and outstanding invoices to be given to him. The income from the wip and the outstanding invoices was counted as income to the corp in 06. In 07 the corp paid off the previous shareholder. How would I account for the money the corp received but never kept?

[veritas]

Well

He should have given the selling shareholder more money for the stock. Who's advised your client on this goofy sales agreement?


Was there some type of written agreement?

[Bees Knees]

If the corporation was required to turn over income to the previous shareholder in addition to the stock purchase, you have what is known as a partial stock redemption.

For example, total purchase price of stock is $10,000, of which $6,000 is to be paid by the new shareholder directly to the selling shareholder, and $4,000 is to be paid to the seller by the corporation as it collects accounts receivable.

The new shareholder starts off with a basis of $6,000. The corporation then collects the $4,000 of accounts receivable, causing $4,000 to flow through to the new shareholder as income on the K-1 (assuming cash method of accounting). The new shareholder now has a stock basis of $10,000.

The corporation then redeems the rest of the seller’s stock and pays the seller $4,000. Since a stock redemption is not a deduction for the corporation, the new shareholder does not get a corresponding deduction flowing through on the K-1.

Thus, at the end of the day, the seller gets $10,000 cash and the buyer paid $10,000 ($6,000 out of pocket plus $4,000 from corporate profits) for a stock basis of $10,000.

No different than if the buyer simply pulled the full $10,000 out of his pocket at the time to purchase the stock.

[Carlos]

The stock was a specified amount. The prepaid items doesn't cause confusion as much as the work in progress and the outstanding invoices. Since the corp is on a cash basis, the previous 100% shareholder wanted these items to come to him as they came in. He did agree to wait until the current 100% shareholder paid back the loan for the stock. This put the income received in 06 (and included in gross receipts of scorp) to be paid back to previous shareholder in 07. This puts the flow through from the scorp to previous shareholder (who is willing and expecting to include this income on his personal return) without the current shareholder receiving any benefit. He paid the tax on the gross receipts last year, but isn't there some way to balance that with what he gave up this year?

[Bees Knees]

Like I said before, the new shareholder is acquiring part of the interest in the S corp with income earned by the S corp as it collects accounts receivable. The income flows through to the new shareholder, even though that money is used to pay off the old shareholder. The new shareholder pays tax on the income, which increases his stock basis. The older shareholder pays tax on the gain from receiving that income through the form of a stock redemption in exchange for his stock.

It is no different than if the new shareholder simply pulled the entire amount out of his pocket to pay off the older shareholder, and then retained all income from the S corp including the accounts receivable. Same result.