S-Corp sale - Shareholder options paid over 3 years

S-Corp shareholders sell their stock and agree to a 338(h)(10) election.

The S-Corp has issued non-qualified options to one of its shareholders. The value of these options will be picked up as wages by that shareholder.

The purchase will be paid over 3 years and it includes contingencies for years 2 & 3.

That shareholder's option value (with the same contingencies) will also be paid out over those 3 years.

Does the shareholder recognize the entire value in Year 1 as wages? They have essentially received a promissory note in exchange for their options.

Does the shareholder recognize the entire value in Year 1 as wages?

Shareholder should recognize the earn out payments as received in years 2 and 3.

Greiner involves similar facts. Roberts & Holland have a good write up on the case here: https://www.robertsandholland.com/siteF ... ation_(DEK)_(00347026).pdf
Cite to the case is: Greiner v. United States, 122 Fed. Cl. 139 (2015), aff'd, 651 F. App'x 1000 (Fed. Cir. 2016)

The argument would go:
1. Treas. Reg. § 1.83-7(a) -- If the option is sold or otherwise disposed of in an arm's length transaction, sections 83(a) and 83(b) apply to the transfer of money or other property received in the same manner as sections 83(a) and 83(b) would have applied to the transfer of property pursuant to an exercise of the option.
2. Treas. Reg. § 1.83-3(e) -- the term “property” includes real and personal property other than either money or an unfunded and unsecured promise to pay money or property in the future.
3. Under Greiner, taxpayer can apply open transaction or presumably installment method to the receipt of the installment note/earn out obligation.

Thank you. Excellent citation.

The link to the article did not work for me, but I did review the case in my Checkpoint subscription.

Can you please confirm my understanding? It is not the unknown nature of the earnout that allows the open transaction method. It's the receipt of an unfunded & unsecured note.

In other words, if the option payout was a fixed amount, would the shareholder have had to recognize the entire amount in Year 1?

If we have something that isn’t property for Sec 83 purposes, then I think that would lead us to Reg. Sec. 1.61-2(d)(4) and -2(d)(6)(i). And we can talk about that when you get to it, namely the part about FMV.

And by the way, I think the fact that these are stock options isn’t relevant. This sure sounds to me like a buyout of those options. That is, we pretend the options were exercised, add those shares to the cap table, and the value you’re describing is really the value associated with those options being actual shares. Not sure if we have a strike price. And I use the word “pretend,” but it might be that this situation would be viewed as an effective exercise. I also wonder about who will get the deduction.

I also wonder about who will get the deduction.

This is a good related question, too.

I am on the outside of this transaction as I only prepare the tax return for the shareholder and not the S-Corp.

What I have heard is going to happen is the S-Corp final tax return (Year 1) is going to ignore all aspects of Year 2 & 3 of the sale transaction as it relates to these options. And the buyer will be deducting the Year 2 & 3 option payout as wages and issuing W-2's.

This feels wrong because this is an asset sale. The buyer is buying assets but will now be deducting a portion as wages. Also, the seller is not reporting the full asset sales price on the tax return. The Form 8883 Asset Allocation totals will not tie to the gross sales price found on the tax return.

If the wage deduction belongs to the seller, then the seller shareholders as a group are now reporting more ordinary income than they should be. Overall income will be the same as they will be reporting less capital gain income. But how do you claim a wage deduction in Year 2 & 3 when the S-Corp has been liquidated?

I’ve noted that you’ve had several posts about this transaction. You have Sec 404 issues with these situations. If were dealing with a pass-thru entity and high individual tax rates, it is advisable to have Oldco make these option buyouts (plus phantom/SAR stuff) in cash before the transaction closes. Oldco gets the ordinary deduction and you have an arbitrage in tax rates (Ord vs LTCG). I mentioned that in another Post. In any case, that didn’t happen. So now we find ourselves in a bit of a pickle.

This pickle is this: You think it’s all taxable in Year1 (it sounds like). If you show it on the guy’s 1040 in Year1 (on Line 1), you have a bit of an issue when W2’s arrive in future years. A related issue is valuation. That’s just Part 1. And then you have an issue as to the deduction and the timing thereof. And related to all of this is the effect on purchase price.

This is a different transaction than my many recent F-reorg posts.
It's also not the same transaction as this discussion: Sale of business & phantom shares - ordinary deduction?. For that one, all options were paid off immediately.

No reorg here. S-Corp sold. Started as a stock sale, then switched to an asset sale via the 338(h)(10). For this one, I am only doing the shareholder's 1040. But I did receive a copy of the S-Corp tax return with the K-1.

This pickle is this: You think it’s all taxable in Year1 (it sounds like). If you show it on the guy’s 1040 in Year1 (on Line 1), you have a bit of an issue when W2’s arrive in future years.

Yes. I do think it is likely taxable in Year 1. But the W-2 from Sold Co only shows the current year proceeds on the options and the tax return for Sold Co is only claiming this deduction. If it's all taxable to the shareholder in Year 1, then Sold Co should claim the same as a deduction. The shareholder owned 60% of Sold Co, thus would be getting a 60% ordinary income offset.

But if it is not taxable in Year 1, and the buyer claims as it's wages, then the shareholder is still not getting their 60% ordinary income offset. They will, by way of accounting for the installment sale, be getting a 60% capital gain income offset.

But the W-2 from Sold Co only shows the current year proceeds on the options and the tax return for Sold Co is only claiming this deduction.

Maybe other CPA’s position is that the contingent nature of Years2 and 3 makes the FMV $0 in Year1 as to that piece. And then maybe they’ll follow this sentence in the Reg:

As payments are received on such a note, there shall be included in income that portion of each payment which represents the proportionate part of the discount originally taken on the entire note.

And I don’t know buyer’s intended treatment of the Year2 and Year3 payments (capitalize vs deduct).

I think you are over-thinking this. If the grant of the option was taxable, the option is an asset with a basis and a holding period and its installment sale should be reported as such. If the grant was not taxed, then its disposition triggers section 83 earned income in an amount equal to the FMV of the note. The company gets a matching deduction when and to the extent the grant was taxable.

I think you are over-thinking this. If the grant of the option was taxable, the option is an asset with a basis and a holding period and its installment sale should be reported as such. If the grant was not taxed, its disposition triggers section 83 earned income in an amount equal to the FMV of the note. The company gets a matching deduction when and to the extent the grant was taxable.

Are you saying there is no company deduction at disposition when the employee picks it up as wages?

The timing of the deduction mirrors the timing of the earned income. If the grant were taxed, the owner would have earned income and the option would be an asset with a holding period. The business sale would result in an installment sale of that capital asset. But I presume the grant of the option was not taxed. I think of that as if the option was not granted at all. Consider what happens to the unrecognized option is extinguished as part of the sale of the business. The option holder now has an installment note and not the unrecognized option. In that situation the installment note was received for services, generating the matching compensation deduction.

The company gets a matching deduction when and to the extent the grant was taxable.

Which Company? Seems there might be two tranches here: The up front FMV – whatever that is – because it’s speculative. And then the payout of the contingency as per the cited Reg. There’s also a question as to capitalization, and impact on purchase price, is there not? It also seems that what we might conclude to be the proper treatment might not align with what buyer proposes to do.

I'm simply saying section 83 is a timing provision. Once the section 83 income is recognized, the deduction is taken by the service recipient, not the buyer (See 83(h)), and the option becomes a capital asset with a new holding period. It is valued at FMV at that time. The sale of the option is then treated like the sale of any other asset with a contingency. I don't see that 338(h)(10) changes the analysis, but the section 83 analysis may change the deal.

and the option becomes a capital asset with a new holding period.
Once the section 83 income is recognized

Confusing. Why would 83 income be recognized? I can think of two reasons: The option is (deemed) exercised and stock is issued or the option is bought out. If option is bought out, I wonder who bought it out.

In any case, if the option is deemed exercised, there’s no more option, so I don’t follow “the option becomes a capital asset with a new holding period.” So, this can’t be right. Further, no mention has been made of a formal exercise.

If the option is bought out by the buyer, seems this might be a transaction independent of the “main” transaction. In that case, I suppose buyer would own the option (but I’d also think buyer would cancel it – I mean, why would the buyer own 100% of the stock and then care about an option to acquire more?). So, in this instance, I kinda follow “the option becomes a capital asset with a new holding period.” But I would also think the buyer would somehow have to capitalize the purchase of the option into the basis of the acquired assets, but maybe not, if it’s an independent transaction. But then we wonder what happens to the buyer’s basis in that “capital asset with a new holding period.” From a deduction standpoint, with respect to the Sec 83 issue, if buyer buys out the option, seller would get the deduction.

If the option is bought out by the seller, the option would, for all practical purposes, cease to exist. So I don’t follow the comment “the option becomes a capital asset with a new holding period.” From a deduction standpoint, seller would get the deduction. But this scenario doesn’t make sense. Sounds like the “Note” flows to optioned shareholder, although that isn’t entirely clear.

So, of these scenarios, the one that makes the most sense to me is “buyer buys out the option,” but I could be wrong.

And don’t forget about this:

But how do you claim a wage deduction in Year 2 & 3 when the S-Corp has been liquidated?

Again, you're over-thinking this. Employee received the option for services. Assuming it was not taxed when issued, it will be taxed as compensation when it becomes transferrable. And the service recipient takes the matching deduction.

Again, you're over-thinking this. Employee received the option for services. Assuming it was not taxed when issued, it will be taxed as compensation when it becomes transferrable. And the service recipient takes the matching deduction.

Yeah, it really is that simple. The service recipient, that liquidated 2-years ago, will somehow take the deduction…

Hi, Wiles,
I look at the option as a capital asset once its issuance becomes a taxable event. Its holding period begins at that time. The FMV of the option at the time of the taxable event is the measure of income, deduction and basis. The later sale was an installment sale with contingencies.

Hi, Jeff-Ohio,
Sounds like you may be able to argue the income was triggered upon dissolution, which presumably was when FMV (and deduction) was small. That would start the holding period. But I'm confused because I thought the facts were as Wiles described in the initial post.

But I'm confused because I thought the facts were as Wiles described in the initial post.

The facts are as Wiles stated them. Income inclusion on options will happen in Year1, Year2 and Year3. See Post #5.

gatortaxguy,

You do agree that Sold Co does not claim a wage deduction until the shareholder reports the wage income. Correct?

Do you also agree that, due to the contingencies, the option holder does not report the ordinary income (wages) for the Year 2 & Year 3 portion until it's received in Years 2 & 3?

Sold Co liquidated after the sale in Year 1. Do you see the pickle?

Perhaps the solution would have been to create Sold Co Successor Inc and transfer the entire installment sale with the option payout obligation to the new entity. I am not even sure if this is possible. Maybe, in hindsight, an F reorg drop down would have set this up better.

I am just a passenger on this tax trip and I do not like that my client is trading his ordinary income deductions for less capital gain income.