Key Employee

Technical topics regarding tax preparation.
#1
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Looking at an S-corporation stock sale agreement. Client owns 100% of the stock. In the agreement, he sells only 70% to buyer for $50k. Per the agreement, seller also “grants” the other 30% of stock he owns to Key Employee.

I said, “This sounds like a taxable event…fiction is, you contributed capital to the corp and then the corp made a compensatory wage payment to the Key Employee, etc., etc.” You know, Section 83 stuff. So now there’s 2 shareholders and only one of them, my client, sold his stock. In terms of the amount of the deemed wage, it would be [($50k/70%) - $50k = $21,429]. So enterprise value would be $71,429 and 30% of that is the $21,429.

Client says, “Well, I was going to receive $50k no matter how much I sold – 70% or 100%. That was my agreement with the buyer. So as far as I’m concerned, it was really the buyer that “compensated” the key employee. It was really the buyer that wanted the Key Employee to stick around. We just wrote the agreement the way we did, with me granting 30% of my shares to the Key Employee, to make it easy.
 

#2
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Agree with your fiction. It's not a sale, exchange, or gift to employee.

Jeff-Ohio wrote:We just wrote the agreement the way we did, with me granting 30% of my shares to the Key Employee...


But without any professional guidance before finalizing the transaction, it would appear.

Jeff-Ohio wrote:to make it easy.


I find it easier to to my own dental work too. However, "easy" doesn't result in 'best', 'effective', or even 'adequate'.
~Captcook
 

#3
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But without any professional guidance before finalizing the transaction, it would appear.

That’s what’s strange. Our firm prepares the corporate return, but not the shareholder’s 1040. The attorney that drafted the agreement should have known better. We’ve worked with that attorney on other matters and the agreement language came as a big surprise. We were told that the shareholder was selling all of his stock. It wasn’t relayed to us that he was selling all of this stock, but only after he “gifted” 30% of it to the Key Employee.

I find it easier to do my own dental work too.


Maybe not a great analogy there. The dental results aren’t subject to interpretation. Hopefully in my case, there is some subjectivity.
 

#4
Nilodop  
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Have the lawyer write a clarifying amendment to the original agreement, and get all parties to sign it. The agreement would "clarify" that they actually did what the last paragraph of OP says they intended. To the extent the paperwork (stock transfer, e.g.) is different, agreement should say it was done as agent for buyer.
 

#5
supdat  
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I think the value of the shares transferred to the employee is a compensation deduction for the S corporation, and the taxable income of the S corporation is allocated based on per share per day unless closing of the books is elected. Assuming closing of the books is elected, the question would be whether client or buyer gets the benefit of the deduction. I think the sales agreement would govern as to whether the buyer or seller should get the benefit of the deduction for the transfer of the shares to the employee.
 

#6
jon  
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The stockholder transferred the shares not the corporation. where is that attorney? A REDO!
 

#7
Nilodop  
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The stockholder transferred the shares not the corporation. where is that attorney? A REDO!. But no, there's a deemed capital contribution and transfer of the shares by the corp. That's what OP's saying in second paragraph of OP. The reference is section 83(h).
 

#8
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The attorney that drafted the agreement should have known better.


I just learned this was not the seller attorney’s work. Seller (client) had his attorney, the good one that our firm has a history with, draft the agreement. Buyer forwarded it to her attorney and lo and behold, we have a new agreement, as prepared by buyer’s attorney, that seller client just went along with, like a dumba**.

There’s even a typo in the agreement…
 

#9
Pitch78  
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dont forget minority and lack of marketability discounts for the stock.
 

#10
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Pitch78 wrote:dont forget minority and lack of marketability discounts for the stock.

Good point. We were talking about that late last night. It seems to me that if $50k is the benchmark (i.e. if 70% of the stock is worth $50k…then 30% is worth $21,429)…the lack of marketability is already imbedded in the $50k, since that was the price negotiated between unrelated parties, with respect to this unmarketable, privately held stock. But, the $50k is also associated with a majority interest (i.e. control). So it seems to me we could lob off x% of the $21,429 to account for minority interest…and that’s it.

This is a really weird situation.

Individual sells stock, as previously described. There are two new owners of the stock: the 70% cash buyer and the 30% key employee. These two people proceeded to wind down the bank account and then they formed Newco [a partnership] and basically operated the newly acquire business out of Newco, even though what they acquired was S-corporation stock.
 

#11
Pitch78  
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Either the buyer was paying $50k for a controlling interest, which makes the 30% worth less than $21,429, as you state, or as your client stated, it was $50k for the whole thing, which makes the 30% interest worth less than $15k.

Discounts can get pretty large.
 

#12
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What a flashback!! Years ago, decades ago, and I can't remember how many, I got trapped into having to explain IRC Section 83(h) and its repercussions to a lawyer, one of those mature, educated, credentialed, intelligent, experienced, ego-driven, sometimes deaf, professional business advisors, some of whom may occasionally refuse to acknowledge the existence [or maybe just the value] of **double-entry accounting**. Wow!!

Section 83(h) is marvelous. It creates a deduction for an entity that is neither the transferor nor the transferee of something valuable. Is it possible that Section 83(h) is unique, in that it is the only place in the tax code where that happens? I mean, just finding the word "transfer" used in the tax code is quite surprising, I realize now, many decades later.

8-) :cry: ;) 8-)
 

#13
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Thanks, Pitch. I think where we’re ending up is here: We’re going with the language in the agreement as written. This means we’ll use an enterprise value of $71,429 (70% of which is the $50k). Starting point for Key Employee’s income inclusion would be the $21,429. We plan on lobbing off 25% as a minority interest discount. This would make the EE’s income inclusion $16,072. Corp would get a deduction for that, which we’ll allocate entirely to the selling shareholder under Sec 1377(a)(2). We’ll also get the Key Employee’s consent as to the 1377(a)(2) election, which shouldn’t be a problem. We already have the consent of the selling shareholder and the cash buyer shareholder. The corporation will issue a 1099 to the Key Employee, which is the best we can do at this point without a lot of hassles.

Then there is the liquidation to deal with…as stated, the cash buyer (primarily) and the Key Employee basically shut down this corporation they just acquired and started operating as a newly formed LLC (taxed as a partnership). I think this is a taxable liquidation involving a corporation with value. In computing inside value as to the S-corp liquidation, we plan on using the $71,429 (no discounts available on the inside). This will produce entity level gain, that will pass thru exclusively to the new 70% shareholder and the 30% Key Employee, as per the (a)(2) election.

My client, who no longer owns the S-corp, is spear-heading all of this, including the handling of the 1120S. He is worried that since his name and address are attached to this corporation, something might come back to bite him if things aren’t done right….although he could say: “I’m not the owner anymore. You new owners figure it out and just send me my K1.” But he doesn’t want to leave the 30% guy, who is also a friend of his, and a young kid, in the lurch. I should add that the 30% guy is in charge of everything at this point. The 70% cash buyer fell ill and is on her deathbed. When she fell ill, she transferred her 70% equity to the Key Employee, which the Key Employee apparently accepted.

I did advise my client to think hard about his role in all of this. It might be in his best interests to just tell the Key Employee, “Just give me my K1” and leave it at that. Even though the Key Employee has authority to sign the 1120S and make decisions surrounding it, I wonder how the heirs of the 70% owner will feel when they get a K1 with a big gain on it from the liquidation. They won’t be happy and they might be looking to place the blame on someone. In addition, my client doesn’t want to leave this mess to the young Key Employee to figure out on his own.

I also told my client that the 2018 Form 1120S doesn’t have to marked “final.” Even though a Newco was formed, one might argue that Oldco wasn’t liquidated, and Newco is just using the Oldco assets on a rent-free (or royalty-free basis). I doubt the IRS would see it that way, however. One issue with keeping Newco alive is that my client can’t get comfort around this entity still hanging out there, with his name still attached to it, when the thing could be shut down and a final return filed.

I think my client’s IRS concerns are unwarranted. Overall, I think he’s worried because this sale happened in 2018 and he was the 100% owner on the last tax return filed (and an owner for part of 2018). IRS has his name, address, etc. Things have not been transitioned over to the new owners such that client is off the radar. So he somehow thinks the IRS will connect things back to him. From a legal standpont, it’s not making much sense to me. I don’t think he has any responsibility here, in terms of the 2018 Form 1120S filing, even though he was a shareholder for part of the year. But it’s been a while since I’ve researched the issue. I don’t think the IRS can deem a former shareholder as responsible for filing the return, but I could be wrong. But at the same time, I understand where he’s coming from in terms of not wanting to leave the the Key Employee in the lurch. Even if client can deflect the IRS, they’ll be coming for the Key Employee next. And client doesn’t want that either.

But no, there's a deemed capital contribution and transfer of the shares by the corp.

A deemed capital contribution of what – cash? If so, that means the selling shareholder would have a stock basis increase for the amount of compensation recognized by Key Employee (and deducted by the corp), right?
 

#14
Nilodop  
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A deemed capital contribution of what – cash?. No, of 30% of the stock.
 

#15
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No, of 30% of the stock.

Hmmm…How would that work? Let’s say he has $10k basis in his stock. He contributes 30% of his stock. His basis initially goes down by $3k to $7k. But then, he should get basis credit for the $3k capital contribution. So his basis remains at $10k. Is that right?

But that stock was worth $21,429, but call it $16,072 after the minority interest discount. There will be a compensation deduction hitting the books for the $16,072, all of which gets allocated to my client. Assume that’s the only transaction inside the corporation for the year. Are you saying my client won’t be able to deduct all of the $16,072 pass thru loss because he lacks stock basis? He’s short on basis by $6,072.

Or, are you saying he will able to deduct the loss, but only because he has personal gain of $6,072. In effect, he satisfied an “obligation” worth $16,072 with appreciated property; property that had a basis of $10k. While the net effect to the shareholder is neutral, that wouldn’t make sense on a couple of grounds. First, I don’t know why we’d add the personal gain to his stock basis. And second, it is the corporation that is deemed to satisfy the obligation. But from the corporation’s standpoint, it can’t have gain because of Sec 1032, right?

So, is it like this: After shareholder transfers 30% of his stock to the corporation, the corporation is deemed to pay $16,027 in cash compensation to the Key Employee…who is deemed to contribute that cash back to the corporation in exchange for his shares, thus giving the Key Employee a $16,027 basis in his stock?
 

#16
Nilodop  
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Hmmm…How would that work? Let’s say he has $10k basis in his stock. He contributes 30% of his stock. His basis initially goes down by $3k to $7k. But then, he should get basis credit for the $3k capital contribution. So his basis remains at $10k. Is that right?
. His basis would stay at $10k on the reasoning that his (deemed) capital contribution of 30% of his shares was, by itself, meaningless, because he owned 100% of the shares before and after said contribution. And according to RR 80-76, that would even be true if he were only a majority (as opposed to 100%) shareholder.
 

#17
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His basis would stay at $10k on the reasoning that his (deemed) capital contribution of 30% of his shares was, by itself, meaningless, because he owned 100% of the shares before and after said contribution.

What?!? So you’re saying my guy doesn’t even get a loss deduction for the basis of the shares he transferred?? And I’m also hearing that he has no gain either, which is good, but odd, since he transferred appreciated property.

And how is it that the corporation gets a deduction here? The corporation didn’t *really* transfer anything of value to the Key Employee, the sole shareholder did. It is such that the sole shareholder’s actions have decidedly determined that the “compensation” is ordinary and necessary as to the corporation? Or, is that a loaded question…because we don’t need the compensation to be ordinary and necessary, strictly speaking - we get to Sec 162 by going to Sec 83(h) first?
 

#18
Nilodop  
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What is this, a CPE course or what?

So, is it like this: After shareholder transfers 30% of his stock to the corporation, the corporation is deemed to pay $16,027 in cash compensation to the Key Employee…who is deemed to contribute that cash back to the corporation in exchange for his shares, thus giving the Key Employee a $16,027 basis in his stock?. That's pretty close, IMO. But there is no deemed cash in or out. It's compensation in the form of property.

What?!? So you’re saying my guy doesn’t even get a loss deduction for the basis of the shares he transferred??. Yup, I sure am. Instead, he gets to keep the basis, as discussed a coupla posts back.

And I’m also hearing that he has no gain either, which is good, but odd, since he transferred appreciated property.. Not so odd. He made a capital contribution, not a sale or exchange.

And how is it that the corporation gets a deduction here? The corporation didn’t *really* transfer anything of value to the Key Employee, the sole shareholder did.. But as I suspect you know, the regs. (based of course on the law) deem that the corporation "paid" the compensation by the fiction of deeming that it, not the shareholder, transferred the shares.

It is such that the sole shareholder’s actions have decidedly determined that the “compensation” is ordinary and necessary as to the corporation? Or, is that a loaded question…because we don’t need the compensation to be ordinary and necessary, strictly speaking - we get to Sec 162 by going to Sec 83(h) first?. We do get to 162 via 83(h) but we also do need to determine that the compensation was ordinary and necessary, and not, for instance, a capital expenditure or even (since we don't know for sure whether the key guy is a relative) a gift, in which latter case I think section 83 would not even be invoked.

Especially where, as here, the shareholder is 100% owner pre-deal, I look at it as really a different way of saying that what "really" happened is simply an issuance of shares to key guy by the corporation as compensation.

Why do I have the feeling you are headed somewhere novel with this?
 

#19
Nilodop  
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Just to cover all the bases, even the remotely, unlikely, hardly a chance ones as to applicability, are you thinking an issue with section 351?
 

#20
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What is this, a CPE course or what?

Yes, be sure to report your response time the the PA Accountancy Board.

It's compensation in the form of property.

Are you saying the Key Employee gets no basis for his stock?

Yup, I sure am. Instead, he gets to keep the basis, as discussed a coupla posts back.

And what he gave 100% of his stock to the Key Employee?

Just to cover all the bases, even the remotely, unlikely, hardly a chance ones as to applicability, are you thinking an issue with section 351?


No.
 

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