As brokers and appraisers of closely-held and family-owned businesses, we work with a lot of S-Corporations. When S-Corp shares transfer subject to a buy-sell agreement, the valuation date, trigger date and transaction date rarely fall conveniently at the end of a year. That’s no problem for valuation experts. We can determine value as of any date. But what’s the fairest way to allocate taxable income among S-Corporation shareholders in a year in which ownership changes?
The answer, according to Santa Rosa California-based CPA Dan Prince, is to allocate income among the S-Corporation’s shareholders on a per-share basis in the pre-change period and in the post-change period as if the books were closed on the date of the ownership change. The shareholders agree to make what’s called a “Closing of the Books” election.
Let’s look at a simple example.
Greg and Matt each own 50% of an S-Corp’s shares at the beginning of the year, and on September 30 they both sell 1/3 of their shares to Bud, at which point they each own 1/3 of the shares outstanding. As part of their purchase and sale agreement, they agree to make a closing-of-the-books election. Assume the Corp has pre-change income of $200,000 and post change income of $100,000, for a total of $300,000 for the year.
Under the Closing of the Books method, the allocation of the year’s income is calculated as follows:
- Greg: 50% x $200,000 + 33.333% x $100,000 = $133,333.
- Matt: 50% x $200,000 + 33.333% x $100,000 = $133,333.
- Bud: 33.333% x $100,000 = $33,333.
The Closing of the Books method is in contrast to the general rule where annual income is simply prorated on a per share per day owned in the change year. Under this general “proration method”, here’s the income allocation calculation:
- Greg: $300,000 x (50% x 3/4 + 33.333% x 1/4) = $137,500.
- Matt: $300,000 x (50% x 3/4 + 33.333% x 1/4) = $137,500.
- Bud: $300,000 x 33.333% x 1/4 = $25,000.
In practice there’s more to this, but you get the idea.
Business valuation plays an important role in a buy-in, buy-out, buy-sell, redemption, MBO, ESOP or other equity transactions in privately-held businesses. When you transfer stock or LLC interests during a tax year, Exit Strategies Group can provide a business valuation but we are not CPA’s. Be sure to consult with your CPA and business attorney for tax and legal advice.
Al Statz is founder and President of Exit Strategies Group, Inc., a business valuation and M&A brokerage firm with offices in California and Portland, Oregon. For further information on this subject or to discuss a valuation or M&A question or need, confidentially, contact Al at 707-781-8580 or firstname.lastname@example.org.