S-Corp sale - Shareholder options paid over 3 years

First of all, I doubt there’s any NIIT on this transaction. So use 20% and not 23.8%. Second of all, this will come down to the ordinary vs. LTCG tax rate differential.

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.

I think of the difference as whether the compensation deduction resulted from a transfer of equity (i.e., a noncash deduction) or resulted from a transfer of an asset, such as cash. The result of the equity expansion is that the real SHHs report $31.5M LTCG.

I think of the difference as whether the compensation deduction resulted from a transfer of equity (i.e., a noncash deduction) or resulted from a transfer of an asset, such as cash.

Nope. Doesn’t matter. The difference is because of a timing issue. Had he exercised, they wouldn’t have ascribed any additional value to the stock because of the contingency. That is, they would have valued the stock at the cash that was received for it. They would have valued the stock at cash received plus $0. No deduction would have been triggered under Sec 83, other than for the cash piece. If you had an option cancellation payment instead, wherein a contingent note is the consideration, they would have ascribed (and actually did ascribe) a value of $0 to that consideration. So the consideration for the option cancellation is the cash plus $0. Same as if there had been an actual exericse.

The fact that the real shareholders effectively will be adding the cancellation payment to their stock basis (they’re really taking a capital loss for that cancellation payment) as opposed to taking an ordinary pass-thru deduction for it, isn’t because we’re dealing with an option cancellation payment instead of an exercise. It’s because the consideration won’t be furnished until later.

I'm fascinated by this discussion and wondering why we seem to be talking past each other.

I suggest for purposes of resolving the issues between us that we begin by simplifying the facts by treating it as a $35M cash sale. If we're on the same page with an all cash deal, we can then discuss the significance of the contingent note.

Please pardon my density, but I got confused as I tried to follow you. Are you saying with an all cash deal we end up with $35M or $31.5M LTCG for the original SHHs? If $35M, then we have a disagreement as to the significance of the noncash deduction. If $31.5M, then we can change the facts and discuss the correct treatment of the contingency -- which I suspect means we'll end up respectfully disagreeing as to whether the note should be considered as property with a FMV for 83 purposes. (I don't think there is any scenario where 83 is not applicable.)

I suggest for purposes of resolving the issues between us that we begin by simplifying the facts by treating it as a $35M cash sale.

Yes, we’ve been doing that for recent analysis purposes. We’ve been looking at the ramification from a $35m all cash deal. And specifically, looking at a $35m all cash deal wherein we create 2 scenarios: (1) option is exercised prior to closing wherein the 10% equity value received (value of unrestricted stock received upon exercise) is $3.5m vs (2) no exercise, and instead, a $3.5m option cancellation payment. Such an analysis of these 2 scenarios is being done to your point (theory) about how there is a difference between (1) an exercise and (2) a cancellation payment. One nuance to these 2 scenarios is the per-share/per-day concept. If we have an exercise, we have a new shareholder. And then we have allocations to him of income and loss.

You have to run the numbers, factoring in (1) LTCG and the allocation thereof (2) the $3.5m compensation deduction and the allocation thereof (3) shareholder basis and (4) cash distributions pursuant to the (h)(10) liquidation construct.

Here's the exercise scenario. Let’s assume all shareholders have a $0 outside stock basis prior to the transaction. I’m just making that assumption because I don’t what the pre-transaction balance sheet looks like and I don’t know what each shareholder’s pre-transaction stock basis actually is. But I do realize these shareholders likely have outside stock basis. That would imply the corp likely has other assets that will be distributed in liquidation.

Exercise
If we exercise, we have a $3.5m ordinary compensation deduction. Then we have $35m inside LTCG. And then we’ll have $35m of cash distributions under the (h)(10) construct. Let’s assume the real shareholders have a LTCG allocation of $35m (100%, because the per-share, per-day concept, let’s say, would cause very little to be allocated to the new shareholder that just acquired his shares via option exercise). The real shareholders get a collective distribution of $31.5m. Their stock basis now sits at $3.5m. Their 100% share of the $3.5m loss pass-thru is $3.5m. It is all deductible because they have sufficient stock basis to absorb it. The new 10% shareholder has $0 of pass-thru LTCG. His basis remains at $3.5m [$0 LTCG allocation plus $3.5m basis from the exercise]. He gets a distribution of $3.5m because he is an actual shareholder. His basis is now $0. His share of the $3.5m loss pass-thru is 0%, or $0. His ending stock basis is $0.

In summary: Original shareholders have $35m LTCG and a $3.5m ordinary loss deduction, which they can deduct. Option shareholder has $0 LTCG and $0 ordinary loss.

Option Cancellation Payment
If there is no exercise and there’s an option cancellation payment instead, we have $35m of pass-thru LTCG. Since there was no exercise, the option holder never becomes a shareholder. Thus, all $35k LTCG passes through to the pre-existing shareholders. Then there’s an option cancellation payment of $3.5m made by Sold Co to the option holder. That creates a $3.5m entity level deduction that passes through to the pre-existing shareholders. There’s $31.5m of cash left, all of which gets distributed to the pre-existing shareholders. In the end, the pre-existing shareholders have $35k of LTCG and a $3.5m ordinary loss deduction. That net is $31.5m. And they get a $31.5m distribution, resulting in $0 ending outside stock basis.

Results are identical to the exercise scenario. No difference if we have an exercise or a cancellation payment. (However, if there’s an exercise, the option holder becomes a shareholder, and hence, could get allocations of LTCG and ordinary loss. That could be detrimental to the pre-existing shareholders and is one reason why the cancellation payment route is often taken).

All in all, your theory is off-base. You propose that there is some difference stemming from a non-cash deduction associated with an exercise (when compared to an option cancellation payment). That’s a fallacy. That non-cash deduction will be followed up with a cash payment, rendering it not non-cash. All in all, you’re making high level, general statements without doing the mathematical work to prove your theory.

Let's try not to criticize each other's thinking. I respect your opinion, but don't understand it. I suppose I get lost as the assumed fact patterns change.

Please correct me if I am wrong, but I think we each end up with a $3.5M ordinary deduction and agree that in both fact patterns that entire deduction should pass through to the original SHHs. If so, the immediate difference between us is that you end up with $35M of total LTCG and I end up with $31.5M of total LTCG. Correct?

When I attempt to understand the source of the difference, I see you mentioned the per day thing. That did not occur to me as a factor. So here's how I see that entering the picture =>

In the exercise scenario I see $35M of sale proceeds split 31.5 and 3.5 with no gain to the service provider. You seem to be saying the $35M is allocated to the original SHHs because of the per day thing. If so, then I see that as generating $35M LTCG to the original SHHs and a $3.5M STCL to the service provider (or even perhaps an ordinary abandonment deduction, which seems quite a stretch...)

I don't see any way the original SHHs get a capital loss if they deduct the $3.5M. Please explain how that could happen.

Let's try not to criticize each other's thinking.

Why not? I’m not criticizing you…

If so, the immediate difference between us is that you end up with $35M of total LTCG and I end up with $31.5M of total LTCG. Correct?

The proof put forth in Post #105 is a straight-up comparison (involving an all cash sale) between an exercise and a cash cancellation payment. That proof tells us there is no difference. That fact will not be upset if both scenarios are symmetrically changed so as to insert a contingent note (or contingent notes) such that the transaction is not all cash. Now, if you insert asymmetry into the equation, you could of course get a difference. For example, if you analyze the exercise scenario and argue that the stock value received upon exercise is the cash received plus $3.5m [such that there is a $3.5m deduction to be had], but then analyze the option cancellation side and value the contingent option cancellation obligation at $0 [such that there is no deduction to be had], that is asymetrical. You get a different result because asymmetry has been improperly applied to the 2 scenarios, not because of exercise vs. cancellation payment. It’s because of apples to oranges.

Bear in mind that Post #105 compares an exercise to a cash cancellation payment. Neither is OP’s scenario. OP’s scenario involves a delayed option cancellation payment. Thus, the proper comparison there, as Wiles will tell you, is that scenario (the delayed option cancellation payment scenario) vs. a scenario wherein a deduction can be immediately taken. That analysis was done in Post #101. We end up with a difference there, which stems exclusively from the fact that a delayed option cancellation payment causes the pre-existing shareholders, in the end, to take the $3.5m deduction as a capital loss (satisfication of an assumed obligation) instead of as an ordinary loss (pass-thru deduction from a cash option cancellation payment that did not occur prior to liquidation). Thus, they have a $35m LTCG and a $3.5m capital loss…as opposed to…a $35m LTCG and a $3.5m ordinary loss.

An option exercise would not have changed this result. And that’s because on an exercise, as stated, the value of the stock would be cash + $0, not cash plus $3.5m. Your idea is that an exercise would have produced a $3.5m non-cash deduction. My point is that if this is the value for valuing the stock, then valuing the note at $3.5m and staying with an option cancellation would get you to the same place. In other words, your idea that a non-cash transfer of equity (i.e. an exercise) is somehow better than an option cancellation payment involving $3.5m of “property” consideration. That’s inaccurate. If you change the value for exercise purposes, you need to do the same in the scenario that you’re comparing the exercise to. And if you don’t, you will get a difference. But that difference is because you’ve inserted asymmetry into the equation: You’re using one value for the stock value upon exercise, but another value for the property consideration associated with an option cancellation payment.

So, that’s that. We all recognize that we could salvage this situation by just deeming the $3.5m contingent note as being “property” for Sec 83 purposes. But you have a lot of problems with that, as has been previously explained. That tags the service provider with a $1.295m tax bill that he will have to pay without the receipt of cash beforehand. It also puts him in the uneviable position of having a $3.5m basis in his contingent note wherein his collections might end up being much less. What will the existing shareholders say to him, “Hey option holder, we’re gonna tag you with $3.5m of ordinary income immediately. Please forward $1.295m to Sold Co asap so we can cover your withholdings. And by the way, we as shareholders won’t be recognizing any gain on ‘our’ contingent note until the buyer pays us.” We’ve already gone through all of that

Exercise: Before 90 shares. After 100 shares. $3.5M noncash income to new SHH and matching deduction for 90. New SHH has $3.5M stock basis. $35M is received by all (100) SHHs (338(h)(10). S allocation is $35M to 90 (per day rule). (Assume no assets on dissolution.)
Result: 90 has $3.5M ordinary loss, net $31.5M LTCG and $31.5M cash. 10 has $3.5 OI and $3.5M cash.

Disregard last post. I missed the basis reduction for the deduction.

Don't offset LTCG by the ordinary deduction. Instead reduce basis by the deduction, so the deduction remains to offset other income.

In a nutshell, here's what I think the correct answer is:

Exercise: Before 90 shares. After 100 shares. $3.5M noncash income to new SHH and matching deduction for 90, reducing basis by $3.5M. New SHH has $3.5M OI and $3.5M stock basis. $35M is received by all SHHs $31.5M and $3.5M (338(h)(10). S allocation is $35M LTCG to 90 (per day rule). (Assume no assets on dissolution.)
Result: 90 has $3.5M deduction (to offset other income), $35M LTCG ($31.5M cash received plus the $3.5M basis reduction.) New SHH has $3.5 OI, no gain and $3.5M cash.

Option Cancellation Payment:
Facts: Before 90 shares, after 90 shares. $35M received by 90. 90 contribute $3.5M to Target. Target pays $3.5M to service provider. 90 get $3.5M deduction and offsetting basis reduction. 90 get $35M LTCG (per day rule). No assets on dissolution.
Results: 90 get $3.5M deduction (to offset other income), $35M LTCG, and $31.5M cash. Service provider gets $3.5M OI and $3.5M cash.

WE WERE BOTH WRONG.

S allocation is $35M to 90 (per day rule)
Result: 90 has $3.5M ordinary loss, net $31.5M LTCG and $31.5M cash.

Those statements are contradictory. The top part is right, the bottom part isn’t. I already did the Exercise math, under “Exercise,” in Post #105.
Per Your Post #109, regarding the Exercise:

Result: 90 has $3.5M deduction (to offset other income), $35M LTCG ($31.5M cash received plus the $3.5M basis reduction.) New SHH has $3.5 OI, no gain and $3.5M cash.

That is the same thing I said in Post #105 under “Exercise.”

Per your Post #109, regarding the Option Cancellation Payment:

Results: 90 get $3.5M deduction (to offset other income), $35M LTCG, and $31.5M cash. Service provider gets $3.5M OI and $3.5M cash.

That is the same thing I said in Post #105 under “Option Cancellation Payment.”

WE WERE BOTH WRONG.

No, you were wrong. You are just now concluding what I already concluded in Post #105, which again, involves 2 scenarios (exercise vs. option cancellation payment) associated with an all cash deal. My further conclusion was that the 2 scenarios produce identical results. One correction, though, as to your Post #109 regarding the Option Cancellation Payment scenario: 90 does not contribute $3.5m to Target. That $35m of cash is already in Sold Co if this was a straight asset sale. And if we’re talking about an (h)(10) scenario, that cash is deemed to be inside Sold Co by virtue of the $35m being the ADSP.

Now, if we jump to OP’s case, which is the option cancellation scenario, the $3.5m obligation to the option holder isn’t on Sold Co’s Balance Sheet. It was distributed out to the pre-existing shareholders, who assumed it as an obligation. When they pay it, with the funds they get from the contingent note they received (i.e., the asset, the buyer’s note that was distributed to them) they get a $3.5m capital loss deduction. They end up with a $35m LTCG and a $3.5m capital loss deduction. The net is $31.5m LTCG. No ordinary deduction. Compare and contrast that to the above 2 scenarios that involve $35m LTCG and a $3.5m ordinary loss deduction. The pre-existing shareholders lose (if I would even use that word) to the tune of $3.5m x 17%, or $595k…which we (or at least Wiles and I) already knew. That is the whole subject of this thread. And my recent point, contrary to yours, is that this isn’t a function of Exercise vs. Option Cancellation Payment. It is a function of a delayed payment.

For our instant purposes I request that you please stay with the assumed facts in our recent posts (i.e., all cash.)

On reflection I agreed that I was incorrect in saying there was a difference.

I criticized your description because you used an ordinary deduction to offset LTCG. You did not respond to that criticism.

And if I understand your last post, now you're saying there was no deduction, but rather a LTCL. To get there you say a contractual obligation was transferred without there ever being a tax consequence to the transferor. That sounds very weird to me. I'm not buying it.

I request that you respond to my criticism and tell me what particular statement in #109 is incorrect. I might learn something.

I criticized your description because you used an ordinary deduction to offset LTCG.

No, I didn’t. If there’s a $3.5m ordinary deduction that’s allowable (i.e. sufficient stock basis), there’s a $3.5m ordinary deduction that’s allowable. Then you run each shareholder’s share of that deduction through their 1040. For basis purposes, there’s a set of ordering rules. Assuming we have a naked $3.5m ordinary loss, it would go like this: $35m LTCG basis increase, minus $31.5m distribution basis decrease, minus $3.5m ordinary loss basis decrease, equals ending basis of $0. That’s not saying the ordinary loss offsets the LTCG, if that’s what you’re implying. That’s just a basis calculation, where $1 of ordinary income is the same as $1 of LTCG.

I request that you respond to my criticism and tell me what particular statement in #109 is incorrect.

First, when you said we were both wrong. I wasn’t wrong. You end up concluding something I already concluded and then you say I was wrong. Go figure. And second, your idea about 90 contributing capital to Target, which I already addressed.

And if I understand your last post, now you're saying there was no deduction, but rather a LTCL.

I’m not now saying that, I said it (and so did Wiles) all along. That is the thrust of this entire thread. They cancelled the guy’s option and said, “We’ll pay you later.” That obligation gets moved out of Sold Co and onto the shoulders of the pre-existing shareholders. Buyer didn’t assume that obligation. Pre-existing shareholders get a $35m LTCG and a $3.5m capital loss. Net $31.5m LTCG. They don’t get $35m LTCG and a $3.5m ordinary loss. That would have been better for them because of the tax rate arbitrage. We’ve beaten it to death.

I continue to be confused by your words. You wrote:

"... the $3.5m obligation to the option holder isn’t on Sold Co’s Balance Sheet. It was distributed out to the pre-existing shareholders, who assumed it as an obligation. ... They end up with a $35m LTCG and a $3.5m capital loss deduction. The net is $31.5m LTCG. No ordinary deduction. ... They cancelled the guy’s option and said, “We’ll pay you later.” That obligation gets moved out of Sold Co and onto the shoulders of the pre-existing shareholders. ,,, Net $31.5m LTCG. They don’t get $35m LTCG and a $3.5m ordinary loss."

While confusing, it is nevertheless obvious that we disagree as to whether there is a remaining deduction when the dust settles. That was the criticism I made. In my description the deduction was never used to offset any income. In yours it disappears into a reduction in LTCG.

I don't follow your description of obligation shifting. And even if the 90 transferred 9 shares, the target would get the $3.5M deduction.

So again, I ask you to specifically address the particular sentences in #109 that you disagree with. (My sense is that your responses have been to declare that I am incorrect and then restate your position.)

While confusing

It’s not confusing. Sold Co agree to pay consideration to the guy for his option. But Sold Co went away in a liquidation. So the shareholders of Sold Co assumed that obligation, which was just a mere promise to pay.

So again, I ask you to specifically address the particular sentences in #109 that you disagree with.

Why are you asking again? Here’s what I said in Post #112:

First, when you said we were both wrong. I wasn’t wrong. You end up concluding something I already concluded and then you say I was wrong. Go figure. And second, your idea about 90 contributing capital to Target, which I already addressed.

Did you not say, in Post #109, that we were both wrong? Yes, you did. I take issue with that incorrect assertion. Did you not talk about a capital contribution in Post #109? Yes, you did. I take issue with that too.

In yours it disappears into a reduction in LTCG.

It doesn’t disappear and I didn’t say that it did. That’s just you not paying attention. It is taken as a capital loss, which has the effect of reducing LTCG. The Rev Rul was cited in Post #101.

I don't follow your description of obligation shifting.

I wouldn’t expect you too. You’ve been lost pretty much the whole time.

This is my first experience with chatting. I quickly got addicted and went overboard. The negative reactions have caused me to apologize and stop chatting. I'll be happy to respond to a private message.