At present, using your numbers, we have:
Option holder with $3.5m of ordinary income.
The real shareholders have $31.5m of LTCG.
$3.5m + $31.5m = $35m of overall income.
For the real shareholders, $31.5m of LTCG x 20% equals $6.3m in federal tax.
Had there been an ordinary $3.5m deduction, we’d be looking at:
Option holder with $3.5m of ordinary income (no change).
The real shareholders have $35m of LTCG and an ordinary pass-thru deduction of $3.5m.
$3.5m + $35m - $3.5m = $35m of overall income (no change).
For the real shareholders, (1) $35m x 20% = $7m and (2) negative $3.5m x 37% (let’s say) = negative $1.295m. Combined, that’s $5.705m in federal tax.
The difference in federal tax ($6.3m vs $5.705m) is $595k. That $595k difference is 17% (the tax rate differential) times $3.5m. Again, it is the ordinary vs LTCG tax rate difference. This tax rate difference is the subject of this thread (see Posts #5 and #6, for example) and has been recognized as such throughout. You are just now getting up to speed.
Do you think they really did that?
It ”appears” that the above “problem” is indeed at play as an after-the-fact item. Remember, though, Wiles is just a 1040 preparer here. When it comes to these (h)(10) elections, there is usually a negotiation for a gross-up, given that the seller might be paying more taxes with an asset sale than a stock sale. This “problem” may very well have been addressed in those negotiations. That is, Wiles might go to the Sold Co shareholder(s) and say, “Hey, since Sold Co won’t get an ordinary deduction for the $3.5m, because Sold Co immediately liquidated, you shareholders will be paying $595k more in federal taxes.” But then the Sold Co shareholders might say, “Yeah, we already know that. We tried to negotiate a higher purchase price, but buyer balked.” Or, “Yeah, we already know that. The purchase price you see is already grossed up for the $595k to compensate us shareholders for the additional tax we’ll owe. And somebody pointed out that since we grossed things up, the gross-up itself will create more taxes for us, so we grossed-up the gross-up for that circularity.”
So, in short, I really don’t know (1) if this issue was identified before the transaction closed and if it was (2) what may have gone on with the related negotiation. And I’m still not sure if the buyer actually plans on claiming a deduction for the “wages paid.” We are only looking through Wiles’ lens here, meaning we are on the outside looking in.
Finally, and as a previously unaddressed technical matter, Wiles is assuming that the “current state of affairs” will indeed lead to $31.5m of straight LTCG for the real shareholders. Someone might say, “Why shouldn’t it be $35m of straight LTCG and then a $3.5m non-deductible unreimbursed expense for the $3.5m that will be paid to the option holder?” That, of course, would be terrible. But RR 72-137 tells us that the shareholders will get a capital loss for contingent obligation (payment to the option holder) they assumed upon liquidation.