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Keep a close eye on dealing with S corporation

Jim HamillALBUQUERQUE, N.M. — I teach people to be tax advisers. I often tell them that being a parent is a good preparation for dealing with clients. There are many reasons for this, but today I’ll just deal with one.

Growing up, I was amazed at how many ways you could put someone’s eye out. I never actually saw an eye put out, but I do recall being told various activities that I was engaged in would “put someone’s eye out.”

Kids can find joy in just about anything. Adults, well-intentioned or otherwise, always throw a damper on that joy and often with the dire warning about the loss of an eye.

The most common business form in New Mexico is the S corporation. Clients seem to like it. It’s a corporation with only one level of tax. But if you’re not careful in dealing with your S corporation, you can, figuratively, put someone’s eye out.

S corporations must be eligible to make an election, must make a valid and timely election, and must operate in a way that is permitted by subchapter S. If the entity fails in any of these tasks it is a C corporation subject to two levels of tax. That’s like putting someone’s eye out.

So I always warn S corporation clients to be careful. Distributions must be made in proportion to stock ownership. Only certain types of shareholders can own stock. Trusts can own stock only if they meet certain requirements. Partnerships and corporations cannot be owners.

There can be only one class of stock. The provisions that govern share ownership cannot allow for differences other than in voting rights.

Shareholder loans should be well documented, and payments should be made on a prescribed schedule. If not, the debt may be treated as more like equity, and possibly a second class of stock.

The statute has a “safe harbor” for terms of debt instruments that should be followed. Debt structured under the safe harbor may be classified as equity, but it cannot be a disqualifying second class of stock.

So there are many ways to put someone’s eye out. But like children, clients think I am just exaggerating the risks. Even other tax advisers often think I am exaggerating.

Why is this? Well they say that they have never seen an eye put out. By this they mean they have not seen the IRS raise the issue of a disqualification of an S election. And they’re probably right.

Did I just admit to being an unnecessary worrier? No I did not. Because what even the tax advisers seem to miss is who is putting that eye out. It’s not the IRS. It’s someone else’s tax adviser.

The problems start if the shareholders want to sell their stock. The buyer’s tax adviser will conduct a “due diligence” review that includes a review of the i-dotting and t-crossing of the S corporation requirements.

If there is a concern, even a small one, that the corporation to be sold is not a qualified S corporation, the buyer’s tax adviser will raise an alarm. The IRS may be silent, but the tax adviser will warn that someone’s eye is about to be put out.

Like the worrisome parent, the adviser’s concerns are likely overstated. But the adviser must protect the client. And guard against a malpractice suit.

So the alarm bells must be heeded. And the result will likely be a complete restructure of the original deal. And it will not be easy and it will not be cheap.

Often the company to be sold is restructured as a subsidiary of a new corporation. And an election is made to treat the target entity as a qualified subchapter S subsidiary (QSub). This QSub is ignored for tax purposes.

Many times, the QSub is then merged into a new single-member LLC . This SMLLC is also ignored for tax purposes.

The buyer then purchases the SMLLC and is treated as if he purchased assets. No worries about the eligibility of the target S corporation. But a lot of fees and a lot of work have been squandered because someone, years earlier, didn’t believe that an eye could be put out. Be careful with your S corporation.

Jim Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at jimhamill@rhcocpa.com.

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