Issues to Consider When Merging Two S Corporations or Other Closely-Held Entities
A. Control [an error occurred while processing this directive] Mary wants control of the business plan and culture of the business, including advertisement and promotion, but she wants Tom to be in charge of the "back-office" operations, dealing with computers and phone systems, accounting and payroll issues. Mary wants to own 60% of Parent, but is concerned that Tom and Sally will outvote Mary on critical issues. With a corporation, Mary's 60% should insure her control. Corporate voting is based on the number of shares held, not on the number of shareholders. For instance, if Mary owned 50.01% of the voting shares, and 20 other shareholders held the remaining 49.99% of the voting shares, Mary would have control over the corporation even though she is only one of 21 shareholders. Mary, Tom and Sally should have a written shareholder's agreement stating that Mary will be President and CEO with exclusive authority regarding business operations, except for tasks specifically delegated to Tom.
B. Compensation [an error occurred while processing this directive] Mary wants 60% of income and profits from the sale of Parent and Tom and Sally agree. Because Parent is an S corporation, shareholders take into income their pro-rata share of the income and profits of the corporation in proportion to their percentage of stock owned. Thus, for Mary to receive 60% of the income and profits of Parent, she must own 60% of the stock.
Unlike an LLC, an S corporation cannot make special allocations of income and losses1 - income and expenses are shared in proportion to stock owned. An S corporation is allowed just one class of common stock2 and cannot alter shareholder rights regarding distributions; otherwise, IRS will argue the corporation has a second class of stock which will disqualify the company from S corporation status.
Potential Trap: An S corporation shareholder takes into income his or her pro-rata share of the corporation's earnings, whether or not those earnings are actually distributed to the shareholder. Therefore, the shareholder could be taxed on corporate earnings never actually received by the shareholder! In this situation, Tom, as the minority shareholder, will want a provision permitting him to receive a corporate income distribution roughly equal to his tax liability.
Also, there have been cases where an S corporation's officers were not reporting income and "skimming" the income into their own pockets. When IRS audited the corporation, it claimed additional corporate income was taxable to all shareholders, even though some of them never knew about the illegal activity!
THE LESSON: Be careful when using an S corporation3 because you could be liable for income you never actually receive.
Tom and Mary can adjust compensation by paying salaries to themselves. For instance, if they agree that each should receive approximately 50% of the income, but Mary wants to own 60% of the stock, they can pay Tom a higher salary to equalize the overall income paid to each. Salary payments raise payroll tax issues, but with an S corporation, adjusting income through salaries is usually the exclusive mechanism available to alter the strict pro-rata distribution rules pertaining to stock.
Mary believes that if either she or Tom increases Parent's gross receipts by landing a large new client, they should receive a commission, and Tom and Sally agree. Mary suggests the commission should be on a sliding scale: 10% of the gross receipts for the first 12 months, then 5% for the next 12 months and 2.5% for the following 12 months. The sales commission can be treated as additional salary compensation without violating the one class of stock rule.
C. Shareholder Buy-Sell Agreements [an error occurred while processing this directive] Although stock in a corporation is freely transferable, closely-held corporations often use shareholder buy-sell agreements to restrict the rights of the parties regarding the sale or transfer of their stock. Usually, a selling shareholder must give the other shareholders a "first right of refusal" to purchase the stock on the same terms and conditions as those offered to a independent third party buyer.
With an S corporation, the shareholders want to be sure that only those who are eligible to own S corporation stock, U.S. individual taxpayers and certain qualified S corporation trusts ("QSST")4, become shareholders and that transfers to an ineligible S corporation shareholder (usually an entity, individual foreign taxpayer or trust which is not a QSST) are void.
Tom and Mary may want to provide that during the first two years of operation, if there is a disagreement, then each will receive a pro-rata share of earnings and the subsidiary they owned prior to the formation of Parent. Thereafter, if one wants to leave the business, the other will have the right to purchase the departing shareholder's interest at the fair market value of that person's stock, usually determined by formula.
One formula that can be adapted as needed is the 3-year average of Parent's: Three times the total "earnings before income, taxes, depreciation and amortization" (EBITDA) for each accounting year; and three times the annual gross revenues for each accounting year.
FOR EXAMPLE: If in year one EBITDA is $1,000 and gross revenues are $2,000 (average $1,500); year two EBITDA is $5,000 and gross revenues is $7,500 (average $6,250) and in year three EBITDA is $10,000 and gross revenues is $15,000 (average $12,500). The average for all three years is $6,750 ($20,250/3) and three times the average is $20,250. Thus the company's FMV would be valued at $20,250 and Mary's 60% interest would be $12,150.
If the remaining shareholders agree to purchase the departing shareholder's stock, the purchase is usually made in equal monthly payments with interest, over a 3 to 5 year period (as negotiated by the parties).
Life Insurance: [an error occurred while processing this directive] The shareholders' agreement may contain life insurance provisions to fund the purchase of a shareholder's stock upon death.5 That way, the remaining shareholder can continue the business without interference of the deceased shareholder's heirs or estate, and the deceased shareholder will receive fair market value for the shares held in Parent.
Also, if an irrevocable trust is used to purchase the life insurance, acquire the stock of the deceased shareholder, and then distribute the stock is distributed to a properly-structured QSST or series of QSSTs, the stock held in the QSST would avoid estate tax on the death of the remaining shareholders.
Key-Person Insurance [an error occurred while processing this directive] In addition, Parent may want to purchase "key-person" insurance to keep Public's business operations going when a shareholder dies, since the remaining shareholder will probably need to hire an employee to replace the departed shareholder's contribution to the company as an employee.
Footnotes [an error occurred while processing this directive] 1 For instance, with an LLC which is taxed as a partnership, Tom and Mary could own the entity 50/50, but agree that Mary receives 60% of the income (subject to the special allocation rules of IRC Sec. 704). An S corporation does not have this flexibility.
2 The common stock, however, may be divided into voting and non-voting, as long as each share has identical rights to distributions, income and losses, with the same rights on liquidation of the company.
3 The same issue arises in the LLC or partnership context since both those entities are considered flow-thoughs, meaning the entity does not pay a separate federal tax but owners are taxed on income, whether or not the income is distributed to them.
4 Generally a grantor trust (the grantor is taxed on the income), with one beneficiary (an individual U.S. taxpayer), where distributions are made on a current basis. See IRC Sec. 1361(d)(1) for other requirements.
5 The shareholders may want to purchase disability insurance as well. That way, a disabled person will be bought out with the insurance and realize the value of the stock, and the remaining owner can use the departing owner's shares to acquire a new owner as a replacement.
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| © 1995-2004 Robert L. Sommers, attorney-at-law, all rights reserved. This article and internet site provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet® is a registered trademark of Robert L. Sommers. |
