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I formed a new S-Corp in February 2010. I was the sole stockholder

I formed a new S-Corp...
I formed a new S-Corp in February 2010. I was the sole stockholder and it was never a C-corp. In 2012, I sold 25% of the stock to an individual. In 2013, the same individual wants to purchase another 41% of stock and hold the shares in a partnership, which will terminate the S-election as an ineligible member. Is the termination of the S-election a taxable event and if so why? Is there any way for this to not be treated as a taxable event?

The business was a cash basis taxpayer and I want to hold my remaining 34% ownership in a partnership as well.
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Answered in 6 minutes by:
7/29/2013
Lane
Lane, JD, CFP, MBA, CRPS
Category: Tax
Satisfied Customers: 12,878
Experience: Law Degree, specialization in Tax Law and Corporate Law, CFP and MBA, Providing Financial & Tax advice since 1986
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NPVAdvisor :

Please Don't shoot the messenger here ....

NPVAdvisor :

But yes, a partnership is a non-qualifying shareholder

NPVAdvisor :

As to the WHY?: The limitations on who can be an S corp shareholder derive from the manner in which taxes are imposed on the corporation. The IRS permits shareholders of this type of entity to report what is called "flow-through" income and losses on their individual personal tax returns. Taxes are not assessed at the corporate level when an S corp election is made with the IRS.

NPVAdvisor :

If S corp shares are issued to a prohibited entity--another corporation, ( or a partnership)for example--the entire S corp election can be declared null and void by the IRS. In other words, the income of the entity will be taxed not only at the corporate level but in regard to individual shareholders as well. The double taxation an S corp is designed to avoid is enforced by the IRS

NPVAdvisor :

Here's an excellent article on the things that cause an involuntary termination of S-Corp election: http://smallbusiness.chron.com/events-cause-termination-s-corporation-64249.html

Customer:

I know the S election terminates, that was stated in the original question. The question was and is - "Is the termination a taxable event"? If so why is it taxable?

NPVAdvisor :

I said yes it is

NPVAdvisor :

Further, I said ....As to the WHY?: The limitations on who can be an S corp shareholder derive from the manner in which taxes are imposed on the corporation. The IRS permits shareholders of this type of entity to report what is called "flow-through" income and losses on their individual personal tax returns. Taxes are not assessed at the corporate level when an S corp election is made with the IRS.

NPVAdvisor :

Not only is it taxable ... as I have already told you............"-the entire S corp election can be declared null and void by the IRS. In other words, the income of the entity will be taxed not only at the corporate level but in regard to individual shareholders as well. "

NPVAdvisor :

You're trying to have you proverbial cak and eat it too

NPVAdvisor :

S corporations are required under Sec. 1361(b) to meet the following criteria to qualify as a small business corporation:



  • Be a domestic corporation.

  • Have only allowable shareholders: individuals, certain trusts, and estates. Partnerships, corporations, or nonresident alien shareholders cannot be shareholders.

  • Have no more than 100 shareholders.

  • Have one class of stock.

  • Not be an ineligible corporation, i.e., certain financial institutions, insurance companies, and domestic international sales corporations.

Customer:

Sir or mama, your telling me that the s-corp election ends. The question is "is the termination of the s-election a taxable event"? I know who can and cannot be members of an S-corp. If your missing the questions, you can call me. The question has nothing to do with the tax on the entity going forward, it's about the termination itself.

NPVAdvisor :

the income of the entity will be taxed not only at the corporate level but in regard to individual shareholders as well.

NPVAdvisor :

in the year of termination

NPVAdvisor :

that is the taxable event

NPVAdvisor :

the termination

Customer:

We are not communicating. So if I sell 40% of my stock to the partnership, do I calculate a gain or loss on 40% of the assets of the S-Corp? Do I calculate what 100% of the sale price would have been and use that as selling price and calculate a gain or loss based on the FMV of the assets?

NPVAdvisor :

It's not that simple

NPVAdvisor :

You essentially will be taxed twice

NPVAdvisor :

hang on a sec... I have an excellent example for you

Customer:

ok

NPVAdvisor :

Sorry, I lost ya there for a few... another expert locked on while I was looking ... Did't find the article which discussed it in Layman's terms, so I'll just give you IRS guidance... essentially you have to upon loss of status do a short year return wher part of the year you are taxes as a c_corp

NPVAdvisor :

See this:

NPVAdvisor :

The part of the S
termination year ending on the date before the
effective date of the termination is an 1120S
(S corporation) short tax year. The part of the
S termination year beginning on the first day
on which the termination is effective is an
1120 (C corporation) short tax year.

NPVAdvisor :

So, you don't really have the typical TRANSACTION based event, you have to allocate between an S-Corp and C-Corp taxation for that year

NPVAdvisor :

After the S termination year is divided into
an 1120S short year and an 1120 short year,
the separately stated items of income, loss,
credit, and deduction, and the amount of the
nonseparately stated income or loss must be
divided between the periods. There are two
methods that can be used to make this divi-
sion. They are:
1) A pro rata allocation, or
2) An allocation based on normal tax ac-
counting rules.

NPVAdvisor :

After the separately stated items and the
nonseparately stated income or loss are di-
vided, one set of amounts is used for the
1120S short year and the other set of amounts
is used for the 1120 short year.
The corporation will have to file two returns
to cover the S termination year. One covers
the 1120S short year and one covers the 1120
short year. The S termination year will count
only as one tax year for figuring carrybacks
and carryovers, even though two returns are
filed for the year.

NPVAdvisor :

The pro rata allocation cannot be made to
any item that results from a corporation’s elec-
tion to treat a stock purchase as an asset
purchase.
The pro rata allocation cannot be made if
50% or more of the corporation’s stock is sold
or exchanged during the S termination year.

NPVAdvisor :

See page 18 of IRS publication 589

NPVAdvisor :

Hope this helps

NPVAdvisor :

Here's the code: from http://www.law.cornell.edu/uscode/text/26/1362

NPVAdvisor :

(e) Treatment of S termination year


(1) In general
In the case of an S termination year, for purposes of this title—

(A) S short year
The portion of such year ending before the 1st day for which the termination is effective shall be treated as a short taxable year for which the corporation is an S corporation.


(B) C short year
The portion of such year beginning on such 1st day shall be treated as a short taxable year for which the corporation is a C corporation.


NPVAdvisor :

..

NPVAdvisor :

Essentially, (from a colleague here: "


There is a deemed "year end" at the time of termination. The assets are deemed to be sold and then contributed to the new corporation. So any gain or loss on the assets at the time of termination are reported, and the new entity gets to increase basis by the amount of gain that was taxed."

NPVAdvisor :

THe "event, " if you will, is the deemed year end and conversion to a C Corp

NPVAdvisor :

Hope this helps

Ask Your Own Tax Question

Be glad to drill down further here, and sorry for the data-dump, but wanted to get enough info to you that you could chew on it for a while and then ask follow-ups if need be.



Here's an excellent article we found, as well: http://taxhub.net/SCORP07_01_03.html



If this HAS helped, I would appreciate a feedback rating of 3 (OK) or better … That's the only way they will pay us here.

HOWEVER, if you need more on this, PLEASE COME BACK here, so you won't be charged for another question.
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Customer reply replied 4 years ago


I think the very last statement "the assets are deemed to be sold and contributed to the Corporation" is what I was trying to get to. Does it have to be a new Corporation? Can I file an 8832 election and be taxed as a partnership as well after the sale?


No, if you allow a partnership to be a shareholder that's a prohibited transaction, and a deemed sale.

See this: If any of the corporation's stock is acquired by a nonresident alien, a nonqualified trust, another corporation, a partnership, more than the permitted number of shareholders, or if more than one class of stock is issued, the corporation will cease to be a "small business corporation" under § 1361(b) (Reg. § 1.1362-2(b)).
Lane
Lane, JD, CFP, MBA, CRPS
Category: Tax
Satisfied Customers: 12,878
Experience: Law Degree, specialization in Tax Law and Corporate Law, CFP and MBA, Providing Financial & Tax advice since 1986
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Lane and 87 other Tax Specialists are ready to help you
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What I would look at doing is selling shares to the individual.

Also, you do have some options in terms of whether you do an asset sale or a stock sale.

But simply selling to a partnership is not the way to go.

Hope this has helped you start to think through it.
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Lane
Lane
Lane, JD, CFP, MBA, CRPS
Category: Tax
Satisfied Customers: 12,878
12,878 Satisfied Customers
Experience: Law Degree, specialization in Tax Law and Corporate Law, CFP and MBA, Providing Financial & Tax advice since 1986

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