S Corporations: Cut- Off vs. Pro Rata Year End
Most taxpayers know that the tax code is very complicated and sometimes unfair but are unaware of the actual intricacies and potential pitfalls that await the unsuspecting. An example of one of these cases is if you own at least 20% of an S Corporation and dispose of 100% of your stock in a given year. This happens quite often and many likely don’t realize what occurs and the options available when this happens.
First, for those who are unaware, an S Corporation is an entity that, in general, flows 100% of its income, gain, or loss to its shareholders on a per share owned basis. The shareholders then pay the tax on their personal return and the amount of income reported to the shareholder by an S Corporation can normally be distributed tax free.
For a very simple example, consider an S Corporation that made $10,000 in year 1:
- This $10,000 is then reported to the shareholder and taxed on their personal return (Form 1040).
- The S Corp now has $10,000 of extra cash in its bank account.
- Since that $10,000 was/will be taxed at the shareholder level, the S Corporation can distribute the $10,000 to the shareholder and the shareholder will not pay tax on the $10,000 again (tax is paid in the year the S Corporation made the money, not if/when the money is sent to the shareholder).
So back to the point on hand, say you own 50% of a calendar year S Corporation and you decide to sell your shares as of 9/1/2016. You now do not own the business for the entire year; so how does the entity determine the portion of income or loss allocable to your ownership period? The IRS says the default method is to allocate the entire years’ worth of income (1/1-12/31/16 in our case) to each shareholder based on a per share per day concept. Basically, you take the number of days you owned the shares, which in our case is 244/365=67% of the year, and multiply that by all of the items of income and loss that the S Corporation generated during the year that is allocable to you (or 50% in our example).
Now after thinking about the mechanics laid out in the above paragraph, some of you may be thinking,
Why should someone have to report potential income or loss from a time when they did not own the stock?
Remember, the 67% mentioned above is based on the 1/1/2016 to 12/31/2016 income, not the income from 1/1/2016 to 9/1/16. So, if the corporation made $1,000,000 from 1/1-12/31/16, but from 1/1 to 9/1/16, the entity only made $300,000, you would be required to report and pay tax on $335,000 of income rather than what was actually earned during your ownership period of $150,000.
$1,000,000 income × 67% percent of time owned during the year × 50% ownership percentage = $335,000
$300,000 of income × 50% ownership = $150,000
For simplicity, assuming a flat 35% tax bracket that is an additional $64,750 in tax that will be owed for the 2016 tax year!
Many may now be thinking that is bad but could be worse because the company now has the allocable additional $185,000 in cash to distribute to you because it made the additional income.
$335,000 – $150,000 = $185,000
Here is where the problem lies. You are correct that the company now has the additional cash. But you are no longer a shareholder and therefore are not entitled to receive cash from the company. Therefore, you have to pay the additional $64,750 in tax but would not have received any cash to pay this off; thereby creating phantom tax income. This is pretty much the worst possible answer and can be catastrophic for the individual.
As an advanced aside topic, you would likely be able to take either a taxable loss, or reduce the gain, on the sale of the S Corporation stock if this happened. However, unless you have other capital gain transactions, the amount of capital loss on the sale of stock you can take to offset the S Corporation income is $3,000 per year. Therefore, in our example, you can end up with additional taxable S Corp income of $185,000 and an allowable capital loss of $3,000 for a net increase of $63,700 in tax.
$185,000 × 35% = $64,750 Tax Increase
$3,000 Allowable Capital Loss × 35% = $1,050 Tax Decrease
$64,750 Tax Increase – $1,050 Tax Decrease = $63,700 Net Increase
The other potential outcome is if the total gain on the sale of stock is reduced. The issue here is that in our example the S Corporation income is taxed at 35% while the reduction in capital gains would likely be taxed at 20%. This is because S Corporation income is taxed at ordinary rates while capital gains are taxed at a more favorable 20% for high income earners (you are generally only allowed to take $3,000 of capital loss against ordinary income each year). In this situation, the increase in tax for the additional S Corporation income is the $64,750 mentioned above. The reduction in tax for the smaller capital gain is only $37,000, for a net increase of $27,750. These are very bad answers and not something that anyone wants to hear from their accountant or have to tell a client.
$185,000 × 35% = $64,750 Tax Increase
$185,000 × 20% = $37,000 Tax Decrease
$64,750 Tax Increase – $37,000 Tax Decrease = $27,750
To summarize the above example, in effect, the new owner basically forced you to pay tax based on income that he receives the cash and gets the benefit from. Most would consider this to be an “up the creek without a paddle” situation.
So how do you prevent something like this from occurring? Luckily the IRS allows you to elect to use a method called the Cut Off Method. This is just what it sounds like – on the day that the stock is transferred, the books are closed and whatever income was earned up to that point is reported to you to pay tax on and any income/loss the company has after is all the responsibility of the new owners. In our example above, you would only be allocated and pay tax on the $150,000 of income vs the $335,000 of income if the pro rata method was used.
In order to use this method, the largest hurdle is all of the shareholders impacted by the election must agree to it. If they do not then you are stuck with the pro rata method. One important thing to note is that this election can be made after year end and only has to be made prior to the due date of the return. So the party who still owns the company has the knowledge of what is better for them and may force your hand into using the pro rata method if it is more beneficial. The likely easiest way to get around this is to make it a condition of you selling your shares. At this point, you have leverage whereas if you realize the mistake after the sale, the new owners may have little to zero incentive to agree to the cutoff method.
On the other hand, this can also potentially go well for the person selling the shares if the entity has a loss. This loss would be partially allocated to him and now he can reduce his income on his personal return by this amount. He then pays less tax because the taxable income is less. As an added bonus, he is not responsible for the cash that was spent to generate the loss, which could have come from loans or the other shareholder’s capital contributions. He also can keep any cash that was distributed to him during his ownership period.
There is another scenario where spouses each owned 50% of the business and upon divorce, the one spouse purchased all of the other spouses’ shares. The now 100% owner spouse generated huge gains by selling assets. These gains in turn were allocable to the other spouse because the former spouses’ lawyer never thought to get the cut off method agreed to in the divorce decree. The 100% owner thereby gave the former spouse a huge tax liability without providing them any cash to pay the bill.
The Kane Firm generally recommends all parties agree to the cut off method in the stock purchase agreement. It therefore is a condition of the sale and eliminates any uncertainty at the time of the sale of the amount of income (and thereby income tax) on the sale is known and can be taken into the price negotiation. Uncertainty and surprises are the last thing that anyone wants when considering a transaction.
For those that are interested, here is the location in the tax law to see when the cut off method may be used as well as any intricacies that may apply in your given situation: