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Jeremy Wells: Many s corporations start as single owner companies. I work with a lot of S corporation owners, and most of the time we're dealing with sole proprietors who reach a point in profitability where having that little bit of reduction in self employment tax [00:00:30] makes sense. And for the most part, that's really the gist of the tax planning that goes into it. It's a single individual, usually operating as some sort of consultant or business coach, or maybe they have a small in-person operation going on. But really that's that's the extent of the structure of the business. But every now and then you have an S corporation that grows beyond [00:01:00] that either. It starts off as a partnership and there are multiple shareholders involved in it, or the individual owner reaches a point where they want to bring on an additional shareholder, maybe as an investor, maybe as a business partner, maybe they want to reward an employee for loyalty, get that employee involved in the ownership of the business. It might have some succession planning to do with it to make sure that there's [00:01:30] another owner involved that can maybe someday take the reins of the business for whatever reason. Every now and then, as corporations will grow beyond just that single member LLC that's elected s taxation when ownership changes in an S corporation, the tax consequences. In my experience, often surprise both the owners [00:02:00] of the business as well as the tax advisor.
Jeremy Wells: And when I'm the tax advisor, I'm often surprised too, because a lot of times, uh, the owners don't really understand that there are important tax implications of that decision to change the ownership of that's corporation. So sometimes I'm involved in that conversation early on. Sometimes I'm involved in that conversation later on, uh, later than I would like to be. But in general, [00:02:30] there are some important tax planning opportunities and some tax consequences that we need to be aware of whenever we have an ownership change in an S corporation. So in this episode, we're going to discuss S corporation stock sales and why they're usually a little more complicated than just deciding who needs a K one. In practice, knowing what to report and how to report that sale [00:03:00] or that exchange comes down usually to just two questions. And if you can answer these questions, then you'll be most, if not all the way to being able to correctly report that transaction first. Who or what bought the stock. And anytime we're dealing with an S corporation, it's important to know exactly what kind of individual or entity is going to be owning that stock. And then second, when for tax [00:03:30] purposes did ownership change and that specific date that the ownership changes can have some important implications for the tax treatment of that ownership change. In this episode, we're going to talk about identifying the tax consequences of an S corporation stock sale to a third party.
Jeremy Wells: So we're talking about someone who's not currently involved in the S corporation [00:04:00] coming into the S corporation. What would that look like? We're going to distinguish between sale and distribution treatment for stock redemptions. A redemption is a special kind of transaction that can occur. And the tax treatment of that transaction depends on some aspects of that transaction. We're going to understand the close the books elections that are available to s corporations [00:04:30] undergoing significant ownership changes. There are actually two elections, and they apply in different situations. And it's important to understand both of those elections when they apply and how the seller and buyer of that's corporation stock is going to interpret the election, as opposed to the default treatment Of the taxable income from that corporation during the year [00:05:00] of that change in ownership. And then finally, we're going to apply those rules to determine the correct reporting of ownership changes for the S corporation and for individual tax returns. If you can do these four things by the end of this episode or by the end of this course, then really you can handle a lot of relatively simple S corporation ownership changes. And for the most part, the S corporation ownership changes that I've seen have been fairly straightforward, [00:05:30] where they tend to get complicated and tend to get in trouble is when there's a lack of documentation, when there's a lack of communication, and when there's a lack of proactive, uh, planning, uh, ahead of the sale.
Jeremy Wells: That's when we tend to get into problematic territory. Often. It's not necessarily the tax advisors fault because we don't know until it's too late. If [00:06:00] the taxpayers if the shareholders don't tell us until later, however, some of what we're going to talk about is still going to be applicable, even though it might not be as easy to implement after the fact once that transaction is already done. But if you can be involved in the conversation leading up to that transaction happening, then there's going to be some important opportunities and important discussions to have with those outgoing and incoming shareholders. First [00:06:30] of all, I want to go back to that framework for understanding stock transactions in an S corporation. Like I said, there are two questions. The first one is who or what bought or acquired the stock. Already this is something that I see S Corporation shareholders tend to gloss over. So when S corporation stock changes hands, [00:07:00] then it's very important to understand what that transaction actually looked like. Where did the stock come from. Who acquired it and how? A lot of times when I've dealt with transfers of S Corporation stock, it's looked something like the current solo shareholder telling me I have an employee [00:07:30] and I'm wanting to or I already have sometimes, uh, given that, uh, employee some equity in the company. Okay.
Jeremy Wells: That situation is no different than if you decided that you have an investor coming in who wants to acquire some or all of your company stock. Now, the numbers might change. The tax treatment for either the [00:08:00] buyer or the seller might change. But in terms of the actual stock transfer and that part of the transaction really what matters is who or what bought the stock and how how did they acquire it. The reason I say who or what is, because we know that stock in general, the membership, the, the ownership of of any entity can be done by both [00:08:30] an individual or some sort of entity, right. That can be an actual human being that is actually buying that stock from another person. It could also be an entity. So it's important in that first question to be aware of situations with an S corporation, where it's very important to understand exactly who or what acquired that stock because of an ineligible [00:09:00] shareholder joins the S corporation, then it may result in an inadvertent termination of that's election. In fact, one way that this usually happens is with the death of an S Corporation shareholder. That can result in that shareholder's estate or a trust acquiring that stock. And in that [00:09:30] case, through no fault of that shareholder or anyone else. Uh, that's corporation might not be in a situation where it has an ineligible shareholder. And there are some avenues for relief for addressing that situation, but there are actually a lot of situations where tax court cases or IRS private letter rulings plrs result because there was an ineligible shareholder in an S corporation.
Jeremy Wells: Nobody [00:10:00] realized that. And now the corporation is in a situation where it has an inadvertent termination of. That's election because it has had an ineligible shareholder. So the first question we really need to make sure we're clear on whenever we have a transfer of S corporation stock to a new person or entity, is who exactly is that person or what exactly is that entity? Because we need to make sure it's an eligible shareholder. [00:10:30] That inadvertent termination of the election would result in a C corporation as of the date of the transfer of the stock. Usually there might be some post-termination transition period, but in general, we're dealing with a C corporation now, and that will probably present a very different tax situation for the remaining shareholders than what [00:11:00] they expected, what they thought they were getting into. So it's very important to understand the eligibility of any incoming shareholders when there is a transfer of S Corporation stock. If you haven't already, check out episode 14 on S election Terminations. In that episode, I go into the different ways that an selection can be terminated and what some of the consequences of that termination [00:11:30] are. And it's really important to understand that there are some avenues for relief in those cases of inadvertent termination.
Jeremy Wells: But generally they're not easy and they're definitely not free. Uh, whether that is paying an advisor to help with that, or having to pay fees to the IRS for a PLR or to go through the tax court. In general, that's a situation you're going to want to avoid. It might be possible, if you're involved in the conversation early enough [00:12:00] to prevent a situation from forming. If you can get the selling shareholder to recognize that they might be selling to an ineligible shareholder and prevent that transaction from happening. The second question is when for tax purposes, did ownership change? I'm going to talk more later about why that question in particular is important, especially [00:12:30] when we, as the tax advisor, are not involved in the details of the transaction ahead of time. It can get kind of murky as to when exactly that transaction happened. Often, in my experience, the conversation looks something like it's time to prepare the tax return. And at some point during the year, that transfer of stock happened. And so the existing shareholder [00:13:00] tells me as the tax return prepare. Oh yeah. Last year I gave someone some stock or I sold some stock to a new investor coming in. I need to know exactly who acquired that stock. And I need to know exactly when that stock changed hands. Well, uh, you know, it happened about this time is usually the kind of response I get back and we're reinventing [00:13:30] or rewriting history by the time that I get involved in that conversation.
Jeremy Wells: Ideally, these kinds of transactions are going to be written, uh, with details and they're going that writing is going to be the result of working with an attorney. Hopefully. Um, but again, this is if we're proactively involved in the transaction ahead of time doesn't necessarily always happen. But if it does, [00:14:00] then, uh, we're definitely going to be advising our clients who are involved in these kinds of transactions or are looking to get involved in a transaction like this, to be discussing them with an attorney, to make sure things are properly documented and properly handled. As far as making sure that what is in writing reflects what both sides, the buyer and the seller intend to happen with this transaction. If we are [00:14:30] talking about stock being sold to a third party by an existing shareholder, then for that shareholder, that is a capital transaction. Let's say that we have an individual who is the sole shareholder of an S corporation. And the way the transaction works is that individual is going to sell some or all of her stock [00:15:00] to a third party. And that third party is now going to be a shareholder in this S corporation for that shareholder. That is a capital transaction. S Corporation stock is a capital asset for the shareholder under IRC section 1221.
Jeremy Wells: Just like stock in any other corporation is a capital asset. Generally, when a shareholder sells stock to another party, then she's going to treat [00:15:30] it like a capital transaction. That means that that transaction is going to be covered by the general sale rules under IRC section 1001. We're going to look at whether there is gain or loss on that sale, and it's going to be measured using the shareholder's stock basis and looking at the holding period of that stock, long versus short term for that stock. And that shareholder [00:16:00] basis is going to be that same adjusted stock basis calculated under IRC section 1367. The buyer is going to take a cost basis in that purchase stock. That's going to be equal to the purchase price. And that is in accordance with IRC section 1012. Now with the sale of stock in an S corporation, [00:16:30] because this is a corporation, there is no adjustment for the inside basis for the corporation. The corporation itself is not a party to the transaction. This is something that I often see get confused with preparers that are working with s corporations who are also working with partnerships, or they're basing the way they think about S corporation taxation [00:17:00] from the perspective of partnerships. This is one of those situations where subchapter K for partnerships and subchapter S for S corporations are different sets of rules. There is a little bit of overlap, especially in terms of things like benefits paid to shareholders versus partners.
Jeremy Wells: There are some rules that are that overlap between subchapter K and subchapter S. But generally those are two [00:17:30] completely separate sets of rules. And when it comes to transactions of S corporation stock it's much closer to the way that subchapter C deals with C corporations than it is to the way subchapter K deals with partnerships. So when we're talking about stock transactions, we're generally going to look at this like stock transactions not like partnership [00:18:00] interest transactions. So when we're talking about S corporation shareholders transacting stock that is a person to person transaction generally. And that's going to be a capital transaction for the seller. And it's going to be a capital purchase purchase of a capital asset for the buyer. The corporation is generally not going to be [00:18:30] involved in that transaction. I'll talk about in a minute some ways that that transaction can be structured that the corporation would be involved. But if we're talking about a shareholder selling stock to another incoming shareholder, then that is a transaction that does not involve the corporation at all. There is no corporate level gain or loss. There's not going to be anything reported on the 1120 S, the S corporation's return, and there is [00:19:00] no change to the corporation's inside basis in its assets. Now, here I am using a term that is generally used with partnerships, not with corporations. But it's the same concept here.
Jeremy Wells: Inside basis refers to the corporation's basis in its own assets as opposed to outside basis, which refers to the shareholders basis in their stock. Now often with S corporations, we talk about stock basis and debt [00:19:30] basis. And with partnerships we talk about outside basis. Here I'm using the term similarly Because there needs to be a distinction between the stockholder's basis in his or her stock versus the corporation's basis in its assets. In general, the S Corporation's basis in its assets does not change whenever there are transactions involving [00:20:00] shareholder stock. If you haven't listened to the previous episode, that's episode 28. I cover S Corporation stock basis. In that episode, including how to calculate it, it's very important that we accurately track a shareholder's basis in an S corporation, even if we're dealing with a solo shareholder that, for as far as we know, has no intent [00:20:30] of selling the S Corporation, selling their stock in the S Corporation. You just never know. At some point, that shareholder might decide to sell some of his or her stock in that corporation. And at that point, that's going to be a capital transaction. And the way we're going to determine the gain or loss on that transaction is by knowing that shareholder's basis in that stock. [00:21:00] There might be other reasons that that shareholder disposes of the stock besides just selling it to a third party. But in general, we need to be accurately tracking that stock basis over time.
Jeremy Wells: And this is one of the biggest reasons why here is in case there is a transaction involving that shareholder stock. So be sure to listen to that episode, the previous episode 28, if you haven't listened to that already. But the key here is that whenever we have a shareholder selling stock to [00:21:30] a third party, an incoming shareholder, and assume For the rest of this episode that we're talking about eligible incoming shareholders. So we're not worrying about blown s elections at this point anymore in this episode. But if we have an existing shareholder selling to an incoming shareholder, that's a capital transaction between those two shareholders, the outgoing shareholder or the seller has a capital [00:22:00] gain or loss from that sale. The incoming shareholder now owns a capital asset. That stock in that corporation that is for that buyer's purposes is valued at his or her cost basis. And the corporation is not involved in that transaction. So there's nothing to calculate on the corporation's balance sheet. And there's nothing to calculate on the corporation's income tax return. The only difference [00:22:30] you might see is on the K one. There is on the K1A place to report the beginning and ending number of shares owned. So if a shareholder sells some shares to another shareholder, then you would see a change in the K one. But that's reported for that individual. It's not going to be reported anywhere on the actual 1120 S itself.
Jeremy Wells: Now back to this [00:23:00] concept of a stock redemption. This is a special kind of transaction that occurs when a shareholder sells stock back to the corporation. Or put another way, when the corporation buys back its own stock from a current shareholder, that transaction, called a redemption. Defaults to being a distribution [00:23:30] under IRC section 301, Now section 301 is part of subchapter C. Like I said earlier, subchapter C deals with C corporations. But actually subchapter S has within it language that says whenever there is a provision uh, or some sort of transaction, something occurs in an S corporation that isn't explicitly covered by subchapter S, then refer [00:24:00] to subchapter C. After all, S corporations are a type of corporation for federal tax purposes. Generally they're not. Uh, if it's an LLC, a limited liability company that has elected s generally for state law purposes, it's going to be an LLC. Whatever that state decides an LLC is. But for federal tax purposes, an S corporation is a special kind of corporation. And so if [00:24:30] subchapter S doesn't explicitly tell us what to do. Then we refer to subchapter C, and subchapter C tells us in section 301 that a stock redemption is treated as a distribution, unless it qualifies as a sale or exchange under IRC section 302. So what would the difference be? A distribution [00:25:00] under section 301 is a return of capital that is essentially a reduction in the shareholder's basis.
Jeremy Wells: And if that distribution exceeds the shareholder's basis, then the amount in excess is a capital gain to that shareholder as opposed to a sale, in which case now we're back into the world of section 1221, [00:25:30] where we're looking at a capital asset and we have some basis specifically in that asset, and then we have the proceeds from the sale or exchange of that asset. And so our gain or loss is just the net of the proceeds and the cost. With a distribution, there's never going to be a loss. We might be getting less than what [00:26:00] we had hoped for, but we're always just going to reduce basis by whatever the adjusted basis or the value of that distribution is. And so there's never going to be a loss on that transaction. Now under section 301, the payment is treated as a distribution for the redemption that's subject to S corporation rules under IRC section 1368. [00:26:30] That's going to tell us about how we handle distributions in an S corporation. If the distribution involves appreciated property, then it is possible that the corporation is going to recognize gain under IRC section 311. So if that redemption is a distribution, we do need to be careful if that redemption involves appreciated property. [00:27:00] Usually we think of distributions in terms of cash, especially with an S corporation. But that's not necessarily uh has to be. That doesn't necessarily have to be the case.
Jeremy Wells: It's entirely possible for an S corporation to distribute property to a shareholder. And that property may have actually appreciated in value. And in that case, we might have a gain at the corporate level. But if section 302 applies, in other words, if this redemption is actually treated as [00:27:30] a sale or exchange. Then the transaction is basically treated as a stock sale and there would be capital gain or loss. So the question then is when does section 302 apply? So there are actually four different distinct tests for whether the transaction whether the redemption is in fact a sale or exchange instead of a distribution. I'm going to gloss over that a bit here because it's [00:28:00] it's really out of scope for this episode. But if you have a transaction and you're not sure if it should be treated like a distribution or like a sale or exchange, then you should definitely look at section 302. And a way to simplify the thinking here that again, I admit, glosses over a bit of the detail here. But for the purposes of most S corporations that would have transactions like this, I I think it works, is [00:28:30] we can look at whether a redemption qualifies for exchange treatment depending on, uh, how we answer a few questions. So the first one is did the shareholder exit the corporation? In other words, was this a complete termination of that shareholders interest in the S corporation? Now if so, then the transaction probably meets the criteria under section 302 to be treated as [00:29:00] a sale or exchange.
Jeremy Wells: If not, then it might have just been a distribution under section 301, unless ownership meaningfully changed. Now I'll get into what I mean by that here in a minute. But if ownership meaningfully changed, then it's possible for the transaction to qualify as a sale or exchange under section 302 unless we [00:29:30] have any attribution issues. So there is a requirement that we take family or controlled entity attribution rules into account here. In other words, close family members are going to count as a single individual when it comes to determining whether there's been a significant change in ownership. Similarly, if I control an entity [00:30:00] and I exchange my stock with that entity, then I haven't really lost the control that I have based on that stock that I own. I still essentially control that stock. And so the transaction really doesn't change anything about my ability to ultimately control the corporation that that stock that that stock represents ownership of. So again, redemptions [00:30:30] generally default to section 301 distribution treatment. Unless the shareholder can demonstrate that the redemption qualifies as an exchange. So let me quickly go into what a little bit of what I'm glossing over here. So the detail and the nuance are all in IRC section 302 B, and that actually lists those four distinct tests and then gets into some detail about them.
Jeremy Wells: The second question is [00:31:00] effectively captures just one of the tests. It's the the not essentially equivalent to a dividend standard of paragraph one. So that second question that I posed, did ownership meaningfully decrease? That's essentially a somewhat simplified way of thinking about whether that transaction was not essentially equivalent to a dividend, [00:31:30] but in a transaction like, you know, what is described here, that would be the most meaningful test. So in the case of UC Davis, this is 397, US 301, 1970, the Supreme Court, the US Supreme Court said that a redemption must result in a meaningful reduction of the shareholders proportionate interest [00:32:00] in the corporation. Right. So if we do have a meaningful decrease and this is the this is the Supreme Court's own language here, if we have a meaningful reduction in the shareholders interest in the corporation, then we might have a transaction that qualifies for sale or exchange treatment under section 302. Again, there's a lot of nuance here. And so if you [00:32:30] have a transaction like this, be careful. Make sure you understand the criteria for qualifying under section 302 for sale transaction. And understand that the difference between 301 and 302, it's not elective. It's not trying to decide which one you want that transaction to be. It's judging the transaction based on the facts and circumstances, and determining whether that transaction results in a [00:33:00] meaningful decrease in the shareholders control, uh, interest in that corporation and therefore qualifies as a sale.
Jeremy Wells: Or if it doesn't, then that transaction has the default treatment as a distribution. Okay. Shifting gears here a little bit, that's that's looking at what kind of transaction we have. Now we need to focus on when does the transaction [00:33:30] occur and what effect does that have on the shareholders, both the seller and the buyer. In general, s corporations allocate items on a per day per share basis. When we're dealing with relatively simple S corporation one or maybe just a couple of owners and ownership doesn't change throughout the year. We don't really think [00:34:00] about this way of allocating income to those shareholders. But according to IRC section 1377, a one, technically what's happening is throughout the year, every single day A that's corporation is earning that companies net income [00:34:30] each individual day. So think about an S corporation that has a certain amount of net income for the entire year. And usually that's what we're thinking. We're thinking that annual total divvied up pro rata among the shareholders. Really what section 1377 A1 tells us happens is a little bit different. The S corporation actually earns that amount [00:35:00] of net income divided evenly across each day. So it's not the total amount for the year, but it's that amount divided by 365 or 366 in a leap year. And that amount per day is earned by the S Corporation.
Jeremy Wells: And then within each day we take that day's share of the annual net income, and we [00:35:30] allocate that based on the stock ownership on that particular day. So if you have two different shareholders that each own 50%, then on January 1st, they each split 5050. The total amount of annual income divided by 365. If it's not a leap year, and then on January 2nd, they do the same thing and the third they do [00:36:00] the same thing. And that's kind of a weird way of thinking about it, but that's actually what the tax code tells us is happening in an S corporation. That is the per day, per share allocation basis for an S corporation. Now again, if ownership stays the same throughout the year, then that doesn't really have any effect. When it has an effect is when ownership changes mid-year. Because now we have [00:36:30] to look at how much of that's corporation's income was earned up until the point to where we had that ownership change. And we have to look at how much each shareholder owned, owned, uh, and earned right on a day by day by day per share basis. So, for example, a new shareholder under [00:37:00] this approach would have income allocated from a period before he purchased the stock. Because think about it. I own 0% on the first day of the year, 0% the second day of the year. But at some point in that year, if I'm a new shareholder coming in mid-year to this S corporation at some point, I now have some percentage of that's corporation [00:37:30] stock.
Jeremy Wells: So I have 0% for all of the days of the year, up until the date that I now have some positive amount of stock in. That's corporation. And then I get allocated that amount of income from that point on. But that all gets averaged together because we take the annual income and we apply that evenly to every single day. And [00:38:00] then I get the average percentage of the stock that I've owned for the whole year. I take that percentage and allocate that annual income to myself and to all the other shareholders. So actually I get income allocated to me from a period during which I wasn't actually an owner and vice versa. An outgoing shareholder who has sold all of his or her stock would have income allocated to [00:38:30] her from the period after she sold that stock and left the company. Now, this could seem unfair if income is earned unevenly throughout the year. Imagine coming in mid-year into an S corporation when most of the income was actually earned in the first half of the year. That's going to increase the amount of income per day. But the period [00:39:00] during which I was actually a shareholder, there wasn't that much net income, which means there might not have been that much cash to distribute to myself.
Jeremy Wells: So that could throw off the relationship Between the economic reality of the corporation and what's being reported for tax purposes. So the very next paragraph in section 1377 A two gives us what's called [00:39:30] a close the books election, which is available upon a complete termination of a shareholder's interest in the corporation. So if an S Corporation shareholder terminates her interest during the tax year, then the corporation can elect to treat the tax year as two separate tax periods, with the first one ending on the date of the termination or the last day that that shareholder, uh, before that shareholder left the corporation. [00:40:00] So the terminating shareholder all affected shareholders and the corporation can agree to make this election. And it's an irrevocable election, but they can agree to make this election to treat the tax year as if it were two separate tax years. And so only the shareholders who are shareholders during that first part have the income up to that point of the year allocated [00:40:30] to them. And then whatever the ownership looks like after that date, has the rest of the year's income allocated to them for that period? Now, this is going to be most effective when you have a significant difference in the way that income was earned throughout the year. Now, I said affected shareholders. That includes the terminating shareholder along with any shareholders who received the stock from that terminating shareholder. [00:41:00] So if that terminating shareholder sells to just one other shareholder, then they're the only two affected shareholders.
Jeremy Wells: If that terminating shareholder sells stock back to the corporation. So this would be a redemption, then all of the shareholders of the corporation are considered affected shareholders. Now, note that this election only applies in the case of a complete disposition of a shareholders interest. So [00:41:30] any interest held as a creditor, employee, director or in any other non shareholder capacity, that doesn't count. We're not worried about that. You can have a terminating shareholder that stays on in some sort of advisory or employee capacity. Maybe even as a creditor still has some debts that the shareholder or that the corporation still owes to that former shareholder. But as long [00:42:00] as that shareholder has completely terminated their ownership interest in the corporation, then this election is available. The regulation associated with this section. That's regulation 1.13771 has a list of criteria for a statement that has to be attached to the tax return for that tax year. That makes the election. They're still just [00:42:30] going to be one tax return for the complete tax year. This is more of just a tax accounting election. It doesn't actually result in any short year tax returns that need to be filed. So it's not that the corporation is going to file two short year tax returns. It's still just files one tax return for the year. What this changes is how each shareholders at least each affected shareholders, uh income is going to be allocated on [00:43:00] their k-1's basically.
Jeremy Wells: It's also not going to change anything about the total income that the corporation reports on its return. That all stays the same. The only thing we're changing is how that income gets allocated across the shareholders. So the important thing to keep in mind here is that because the total amount of income is the same, we're just reallocating across shareholders. Some [00:43:30] shareholders will have more income reported to them. Other shareholders will have less income reported to them then they would have without making this election. So it's important to, uh, keep that in mind. There's also another election available for a qualifying disposition. So an S corporation can elect to treat the taxpayer similarly as two separate tax periods, with the first one ending [00:44:00] on the date of the disposition in case of a qualifying disposition. Remember, the election under 1377 A two was only for a terminating disposition here under regulation section 1.1681 G. We have instead an election that's available for a qualifying disposition. Now this can occur when any of the following happens. Either a shareholder disposes [00:44:30] of 20% or more of the corporation's outstanding stock. A shareholder redeems 20% or more of the corporation's outstanding stock, or the corporation issues stock equal to or greater than 25% of its outstanding stock to new shareholders in any 30 day period during the tax year.
Jeremy Wells: If any one of those is true, then you have a qualifying [00:45:00] disposition and the corporation is eligible to make this election under regulation. Section 1.1681 G Now, that's not available in case of a terminating disposition, because we have the election under section 1377 A two. So if a shareholder terminates their interest and completely leaves the corporation, that election has [00:45:30] to happen under 1377 A two. But if it's not a terminating disposition, but it is a qualifying disposition, then the corporation can make the election under 1.113681 G. All shareholders holding stock during the year have to consent to this election for a qualifying disposition, and like the other election, this one is irrevocable. So those are the two elections. And like I said earlier in [00:46:00] the episode, it's important to understand which one applies when if a shareholder terminates completely exits the S corporation. Then the election under section 1377 A two is available. If it's a qualifying disposition but not a terminating disposition, then this election under reg section 1.113681 G is available. So let's look at an example here to kind of walk through some of what we've talked [00:46:30] about at the beginning of the year. Let's assume that Jessica solely owns lighthouse LLC, which is an S corporation. Now assume that she sells half of her interest to Seth, who is an unrelated eligible shareholder. We're just going to assume that Seth joining this s corporation is fine. On July 1st, Seth is going to acquire half of Jessica's interest in lighthouse LLC.
Jeremy Wells: Jessica calculates capital [00:47:00] gain or loss depending on her stock basis and the proceeds she receives from Seth. So this is an example of a shareholder selling stock to another individual who's an eligible S corporation shareholder, but an unrelated individual. And that person is coming in and is now going to be a new shareholder of the corporation. Jessica is going to calculate capital gain or loss. Seth is going to have stock basis equal to his cost [00:47:30] for that stock. And the corporation itself does not have anything to report here. Right. Now, I do want to mention a caveat here that although an LLC is not a corporation under state law, if it makes an S election, it is treated as a corporation for federal tax purposes. I have had conversations. Some of them got a little heated for some reason, uh, that an S corporation can't have stock if it's [00:48:00] actually an LLC. Well, it doesn't for state law purposes. I get that an LLC doesn't have stock. It's not a corporation, it's an LLC. Usually we talk about membership units or membership percentages when it comes to LLCs, but for federal tax purposes, it is a corporation. It's an S corporation. So we have to talk about shareholders. We have to talk about stock. Now it's important to understand that with an S corporation we also have the one stock rule the the one [00:48:30] class of stock rule.
Jeremy Wells: Right. Uh but we do have stock for federal tax purposes. So even though the legal definition of equity for the entity at the state level is not defined in terms of stock, we do need to talk about stock for an S corporation in the federal tax level. Now with that caveat there and and set aside for a minute, let's assume lighthouse LLC instead of Jessica [00:49:00] selling her stock directly to Seth, let's assume that lighthouse LLC redeems half of Jessica's stock and issues new shares and sells them to Seth. Now, after the transaction, Jessica and Seth each own 50%. So instead of this being a third party sale, this is now a redemption. So let's look at whether this is a section 302 sale or exchange using our three [00:49:30] question framework. Right. So did the shareholder actually exit. Did Jessica exit. No she did not. Right. So that doesn't necessarily mean it's not a section 302 sale or exchange. It's just one of those four tests. We didn't meet it. Jessica didn't meet it in this case. Let's look at the second question from the framework. Did ownership meaningfully decrease? Jessica's ownership went from 100% to [00:50:00] 50%. That's a pretty significant decrease. Now, it's not an automatically qualifying decrease for what section 302 B calls a substantially disproportionate exchange. That's section 302. B two is the second test a substantially disproportionate transfer of stock that actually requires that the shareholder wind up with less than 50% ownership [00:50:30] after the redemption.
Jeremy Wells: If Jessica still owns exactly 50%, then it doesn't qualify as a substantially disproportionate redemption. However, the transaction still might qualify under IRC section 302 B one, which is that not essentially equivalent to a dividend test. And because Seth is unrelated to Jessica, we don't have any family or entity attribution rules at play [00:51:00] here. So in this case, we could say that the redemption likely qualifies as a sale under section 302 and not as a distribution under section 301. But again, it's important to work through the facts and circumstances of the sale. And if the transaction is documented in writing, that's going to make it a lot easier to do that. I've had situations where even though the transaction was already done technically, I've still asked [00:51:30] the shareholders to go back and get what actually happened in writing so that I'm not the one making decisions when it comes to preparing a tax return as to what actually happened, that they're guiding me through what they've agreed to in writing. Now, let's assume that Jessica owns 50% after the redemption. Say that she receives $120,000 for her shares and her stock basis before the redemption was one was $100,000 [00:52:00] And there are no C Corporation earnings and profits that we need to worry about, so we don't have to worry about any of that under section 301.
Jeremy Wells: Now if this is a sale under section 302, then Jessica receives $120,000. So that's her proceeds. She sold half of her stock. Her basis was $100,000, so half of her stock was worth $50,000 in terms of her stock basis. That means she has a $70,000 [00:52:30] capital gain, but she also has $50,000 in stock basis remaining. Now compare that to if this was a distribution under section 301, this would be a $120,000 distribution against $100,000 stock basis. That means she has $20,000 in excess distribution. So that's capital gain. But she has $0 basis remaining in the stock [00:53:00] in her 50% of the stock that she has in the S corporation. Now again, this is not elective. She doesn't get to choose which one, but she does need to make a decision as to whether this transaction is in fact a sale under 302, or whether it defaults to being a distribution under 301. And you can see even in a very simple situation here, that there's a pretty significant tax difference. And it's both an immediate difference in [00:53:30] terms of how much capital gain gets reported. But it's also a long term difference in terms of what her remaining stock basis is. So there are important considerations here and consequences of understanding exactly what kind of transaction this was. Now let's refresh here a bit. So Jessica sells half of her interest to Seth. According to the books. Right. Lighthouse's annual net income was $200,000, [00:54:00] and Seth comes into the company as a 50% shareholder on July 1st.
Jeremy Wells: But lighthouse is a seasonal business, so most of its income is in the fourth quarter. Its net income through June 30th was just $20,000, so the remaining $180,000 came in after Seth joined. Let's look at what happens with no election. Jessica is 100% owner for the first 181 days of the year through June [00:54:30] 30th, and she's a 50% owner for the remaining 184 days of the year. That means she actually owns stock for of. She actually owns about 74.8% of the stock in the company on average throughout the year. So if we think of it that way, then of that $200,000, $149,589 of that is applicable to Jessica. For Seth, it's exactly [00:55:00] the opposite. He's going to be considered owning 25.2% of the stock for the year on that per day per share basis. And so of the $200,000, the remaining $50,411 is applicable to him. But the corporation earned the overwhelming majority of its income while Seth was a shareholder. So it might make [00:55:30] sense to make an election to close the books as of Seth joining the corporation. Now, in this case, Jessica's disposition is partial. She doesn't completely terminate her interest in the business. So the corporation is not eligible to make the election under section 1377 A two. However, it does qualify under the criteria for that regulation. [00:56:00] Section 1.1681 G election, because she has definitely sold more than 20% of the total stock of the corporation.
Jeremy Wells: So that election means that for the first half of the year, January through the end of June, Jessica gets 100% of the income the corporation earned up to that point or $20,000. [00:56:30] Then she gets 50% of the income from July to the end of December. That's $90,000. So her total income from the corporation that's allocated to her with that election that closed the books election in place is now $110,000, as opposed to Thousand $589 without the election. And again, Seth is the opposite. [00:57:00] Seth is a 0% shareholder for the first half of the year, so he gets 0% of the income earned up to that point allocated to him. And then he gets 50% of the income earned after the end of June or starting in July allocated to him. So he also gets $90,000, half of $180,000 allocated to him for the second half of the year. So that means Seth's income for the year is $90,000, as [00:57:30] opposed to $50,411 that was allocated to him without the close the books election. So note that none of that changes the total income. It just changes who gets allocated more or less income. Now, there might be reasons that each shareholder, both the selling and the buying shareholder, want more or less income allocated to them. Seth is going to have to pay more taxes potentially if he has more [00:58:00] income allocated to him with the election.
Jeremy Wells: But if he is coming in with little or no basis in his stock, maybe that's not a bad thing. Maybe he wants more basis in his stock. And so having more income attributed to him if he's going to take more distributions, since more income occurred during the time that he was a shareholder, he might want more basis to offset those distributions. That's just one reason why an incoming shareholder [00:58:30] might want more income attributed. Of course, if the income were earned more in the first half as opposed to the second half of the year, it'd be the opposite situation for Seth, and he might not want the election. This is a really important point. Whether the close the books election is going to be made really needs to be agreed to as early as possible, and it definitely needs to be agreed to in writing. Preferably it should be part of the transaction documentation. [00:59:00] This is not necessarily something that you want to be discussing with the shareholders in the middle of trying to return, trying to prepare the tax return, and it's definitely not going to be an easy conversation once those shareholders start trying to calculate the numbers in their head and figure out the tax implications. This is really something that ideally should be discussed and determined ahead of time, not after the fact. Although even if they [00:59:30] haven't determined that until the time that you start preparing the return, it's still possible to make that election once you file the tax return, that's just not the ideal time to do it.
Jeremy Wells: Okay, let's look at some key takeaways from this episode. First of all, whenever s corporation ownership changes, you need to slow down and ask questions. Whether you're a shareholder or if you're preparing the tax return, it may involve. In fact, it probably will involve more than simply adding [01:00:00] or removing a K one. Again, looking at whether those elections make sense, looking at whether there's going to be any reporting of capital gain on the selling shareholders, individual tax return, whether basis has been accurately tracked and is correct. All of those considerations need to be taken into account. You definitely need to clarify who or what bought the stock and when. Clients may not distinguish between a redemption [01:00:30] uh, or a third party sale, but tax law does. And you need to also, if you're preparing the return and you need to be able to explain to the client whether that's the corporation or any of the shareholders, why that distinction matters. And then you can and absolutely should, in my opinion, insist on a clear written description of the transaction, even if that needs to be put in writing after the fact. It still needs to be written, [01:01:00] and it needs to be agreed to by all of the shareholders involved. This helps you as the tax advisor or if you're the shareholder, your tax advisor correctly report what actually happened, not just try to assume or guess what happened.
Jeremy Wells: And it ensures that everyone's clear on the tax implications. And as always, involving an attorney early as well as a tax advisor is always a good move in these kinds of situations. If [01:01:30] you found value in this episode, please let me know by liking and leaving a comment, either in your podcast application of choice or on YouTube. If you're looking for more on s corporations, there's actually a quite a few episodes. Now, we could put together a playlist that give you some good instruction on S corporations. So check out episode three on common issues I see that turn into problematic s corporations. Episode 14 is on terminating an s election. Episode 23 [01:02:00] is the opposite of making an s election and issues to look out for there. And then. Like I mentioned before, the previous episode 28 is on S corporation stock basis, as well as looking at the accumulated adjustments account and retained earnings, and how those three measures are all important but importantly, differ. For the next episode, we're going to look at asset sales and how they compare to stock sales and what that means for buyers and sellers, as well as yet another election or group of elections [01:02:30] that can be used to kind of get the best of both worlds of both the stock sale and an asset sale. So that's in the next episode. Thanks for listening.