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University of Massachusetts Amherst

Family Business Center

Accountant and Lawyer Agree: Know Your Objectives and Plan to Reach Them

by Shel Horowitz

Accountant Kris Houghton and attorney Scott Foster, from Family Business Center sponsors Meyers Brothers, P.C. and Bulkley, Richardson and Gelinas, LLP, did a joint presentation to the Family Business Center's March meeting, showing tax and legal consequences of distributions from a corporation&emdash;and showing how often a qualified professional can help you find a solution to accomplish your goal in the most tax effective way..

They outlined three scenarios where advance planning didn't quite meet up with the reality, leaving unforeseen issues to be resolved.

First, an S corporation that had previously been a C corporation distributes earnings for the first three quarters, but then loses a large lawsuit that wipes out its profits for the entire year. The lack of profits means that some or all of the quarterly distributions will be treated as taxable distributions from the earnings of the corporation while it was a C corporation. If the distributions were treated as salary, they would be deductible, but subject to withholding taxes.

If the withholding taxes are not acceptable, then Houghton and Foster recommend recasting the distributions as loans to shareholders, formalized with a note (complete with repayment terms and interest rate) to make sure that the distributed money isn't treated as salary or a dividend. The recipients of the distributions would be responsible for repayment of the notes at a later time.

Second situation: In the above company, one of two shareholders decides to retire. To finance the buyout, the other shareholder has to use distributions. This raises the same issues as in the first situation &emdash;and if the redemption price exceeds the corporation's equity, the corporation could be rendered insolvent&emdash;creating liability in the directors who authorized the distribution, as well as in the shareholder who received it.

Two ways out: a corporate note for the redemption price payable only to the extent that payments do not render the corporation insolvent or payable only to the extent of some portion of future earnings and profits.

The third situation: A C corporation with significant earnings and rental property holdings allows a new stockholder to buy a quarter-share just before electing S corporation status. The existing three owners give a price break because they expect the new buyer will receive future earnings. Just before converting to S corporation status, they need to distribute prior years' earnings&emdash;but they don't want to include the new owner.

A possible, but risky, solution is to compensate the existing owners for services performed for the corporation, and pay withholding taxes on the bonuses. However, the new shareholder could challenge the fairness of the compensation and claim that the distributions were actually dividends. If the new owner is successful, then he would be entitled to a share of the dividends, and the original three shareholders could be personally liable.

The moral of the story? Seek expert advice before undertaking any transactions involving the purchase or sale of your corporation's stock or making any distributions to shareholders. Most importantly, don't hesitate to allow your advisors to talk with each other so they can jointly reach the resolution with is of most benefit to you.

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