Discussion:S Corp: Liquidating a shareholder

Thanks in advance for any input.

Cr. Cash

Okay, thanks everyone for your help on this. The repurchase to treasury stock makes sense, but is there any additional adjustment for the stock being purchased at a price in excess of par? His purchase price of stock was $3,000 and it is being redeemed for $70,000. I have no idea how they determined the valuation for purchase because due to a writeoff the entity has a deficit retained earnings.

I will share that the one I did last year was a rat off a sinking ship scenario. CR was to term note payable. The entry pushed company into technical insolvency, corp legal counsel was not happy because it looked as if the company was being damaged to benefit a shareholder at the expense of the creditors. Of course this was not a problem that additional legal drafting could not solve. In the end all rats were at least technically sharing some risk.

My story obviously has nothing to do with 1120-S preparation. I think it does illustrate though that your clients should be consulting with you during the year and not handing you a stock re-purchase agreement on 3/25 cpataxmom. :)

Poring through my bible I note a couple of thingsbeyond the fact that Smktax is right:

The AAA adjustment is made at year end, after all current year activity is booked, although you can elect to split the year if >20% Shareholder is taken out. Also, "that the reduction of AAA does not consider the total amount of redemption proceeds. If the price paid for the stock exceeds the reduction in AAA, the remainder should be accounted for as T. Stock"

And I agree, I hate getting these suprises late in the game, but this is a new client we just picked up, so we were not consulted on the repurchase, though a CPA/Attorney apparantly drafted it. Sometimes you just gotta work with what your handed.

I would read the regs closely on this. My text indicates that in situations where the redemption would be less than the AAA reduction then the adjustment is limited to the amount paid for the stock.

My text = CCH S Corp taxation guide 2005 Robert Jamison, CPA PHD ISBN: 0-7355-4983-4

to capital gain or loss treatment where: (1) the redemption is not essentially equivalent to a dividend; (2) the redemption is substantially disproportionate with respect to the shareholder and immediately after the redemption the shareholder owns less than 50 percent of the total combined voting power of all classes of stock entitled to vote; (3) the shareholder’s interest is terminated; or (4) the redemption is of stock from an individual in partial liquidation (.10).

For purposes of (2) above, the distribution is substantially disproportionate if the ratio that the voting stock of the corporation owned by the shareholder immediately after the redemption bears to all of the voting stock of the corporation at that time is less than 80 percent of the ratio that the voting stock of the corporation owned by the shareholder immediately before the redemption bears to all of the voting stock of the corporation at that time. A distribution is treated as substantially disproportionate unless the shareholder’s ownership of the common stock of the corporation (whether voting or non-voting) after and before redemption also meets the 80 percent requirement of the preceding sentence.

Comment: Unlike a C corporation shareholder, an S corporation shareholder can generally receive the benefit of capital gain treatment without the benefit of the redemption rules. This is because a distribution to an S shareholder is generally treated as tax free to the extent of the AAA and the shareholder’s basis. Any excess is treated as capital gain from the sale or exchange of the S stock. The result is different, however, where the corporation has earnings and profits from C corporation years. In such cases, a capital gain redemption may be more favorable since it concurrently reduces accumulated earnings and profits independently of any adjustments made to the AAA.

For purposes of (3) above, a shareholder is permitted to retain non-stock interests in the corporation (e.g., such as that of a creditor). If the redeeming shareholder’s continuing interest is truly a debt interest rather than an equity interest, the retention of such an interest does not stand in the way of a complete termination of the shareholder’s interest. Further, if the constructive ownership rules applied, it would be virtually impossible for most closely held corporations to redeem their shares in transactions qualifying for exchange treatment. To alleviate this result, the Code Sec. 302(c)(2) provides special rules under which the family attribution rules can be waived in cases of complete terminations of interest. Practice Tip: While the seller of an S corporation may receive several different types of ongoing economic benefits from an S corporation company after the sale, this does not necessarily preclude the transaction from being taxed as a terminating redemption (i.e., having favorable tax treatment to the seller). In addition, cross-collateralization agreements (e.g., where payments are to be received over a period of time and are secured by the stock sold) do not necessarily mean that the seller has an interest in the stock sold other than an interest as a creditor.

If a redemption is treated as an exchange, the adjustment in the accumulated adjustments account (AAA) of an S corporation is an amount that bears the same ratio to the balance in the AAA as the number of shares redeemed bears to the number of shares of stock in the corporation immediately before the redemption.

Example: X is an S corporation equally owned by A, B, C, and D. The AAA is $50,000 when X redeems all of D’s shares. The AAA is reduced by $12,500. Although the reduction of the AAA takes place on the date of redemption, the amount of the AAA immediately before the redemption will not be known until the end of the year. This is because until the year closes, the increase or decrease in the AAA for the S corporation’s income or loss for the year is unknown. Where there are ordinary distributions during the year, the AAA is adjusted first for the ordinary distributions and then for the redemption distributions.

©2007 CCH. All Rights Reserved.

I am on the hook for a ton of money for invoices I signed personally for, can I go after him for abandament of the business?

Only if it's a child care center, and there was a legal adoption. Otherwise, you must play it by the book. First, call a special meeting of the Board. Woops, can't do that, there's not a quorum. See if there's something in the Bylaws that will allow you to seize control: Act of Terror, Declaration of War, etc. Otherwise, it looks pretty grim. If he stays gone for 7 years, you might be able to have him declared dead, then you can hunt down his widder and children, and sue them.

Overall, I'd see a lawyer, your lawyer. It sounds like your going to need one anyway to negotiate with all those creditors. P.S. I forgot to mention one more thing, if you can convince the government that you are too big to fail, you may qualify for a bailout.

SEE AN ATTORNEY!