Everyone understands that if you own equity in a so-called “pass through entity” (i.e. stock in a corporation taxed as an S corporation, a partnership interest, or membership interests in a limited liability company taxed as a partnership or S corporation), the entity does not pay taxes on recognized profits.  Instead, profits and losses pass through to the equity holders, who report their share of gain or loss on their individual income tax returns.  An allocation of income, however, does not necessarily translate into a corresponding cash distribution to pay the tax due with respect to the allocation.  Typically, a limited liability company’s operating agreement, a partnership’s partnership agreement, or a corporation’s stockholders’ agreement should require the entity to make tax distributions to the equity holders in sufficient amounts to cover their respective tax liabilities (a “Minimum Tax Distribution”).  Often times, however, such agreements do not address the issue, and more importantly for this article, we have seen many stock and membership interest purchase agreements that ignore the issue as well—usually to the detriment of the Seller, who forgets that by the time a tax distribution is to be made, he is no longer a stockholder or member, and therefore not entitled to the distribution he might have expected. 

Without a corresponding Minimum Tax Distribution, the equity holder receives only “phantom income” and has to pay the corresponding tax obligation.  The cash to pay the tax must be obtained from another source.  Were you to sell your interest in a pass-through entity, you would of course receive the agreed purchase price.  However, you will also receive an allocation of income or loss for the period of time during the tax year that you were a member, stockholder or partner.  Unless the agreement provides for a Minimum Tax Distribution to cover income that will be allocated to you for the period of time that you owned your interest or shares of stock, the net, after-tax amount that you receive on your sale may be materially affected.    On the other hand, the remaining members or stockholders of the entity receive a substantial windfall in such a situation, since they will allocate a portion of the company’s profits to the departing member or stockholder, yet retain the cash that would otherwise have been distributed to the former equity holder. 

When a stockholder of a Subchapter S corporation sells his entire interest in the corporation, the transaction qualifies for a book closing election for the purpose of allocating the corporation’s items of income or loss among the stockholders.  This requires all of the stockholders to agree to the election.  With a book closing, the amount of income or loss that flows down to the stockholders is calculated as of the effective date of the closing.  The entity is treated as if it has two separate tax years, and income or loss that accrues after the closing is not included in the seller’s allocation.  Without a closing of the books, the seller would instead receive a daily pro rata allocation of the entire year’s income or loss, based on the number of days during the year that the seller was a stockholder and the percentage of stock held on those days.  Without a book closing, transactions that occur after the closing will be included in the seller’s allocations and can create unexpected consequences.  Whether or not the seller benefits from such an arrangement depends on the nature and size of the transactions occurring after the closing.  Thus, utilizing a book closing election and preserving the right to review the final tax return will provide greater certainty to a seller.  For partnerships and limited liability companies taxed as partnerships, unless the parties agree to use the proration method, there is a book closing with respect to the seller only. 

Problems can arise for parties to a transaction when they fail to adequately address timing issues with respect to income and expense recognition.  For example, if the company is a cash basis tax payer, income is not recognized until it is collected, and expenses are deducted when they are paid.  Consequently, accounts receivable collected after the closing on the purchase of a minority stockholder’s shares (after an election for a book closing had been made) represented income allocated entirely to the post closing period, although the corresponding expenses may have been deducted prior to the closing.  Thus, by using a book closing, the Seller may shift the taxes on the income that would have been allocated to him, had the company used the accrual method of accounting, to the remaining stockholders.  On the other hand if the company were to delay paying certain expenses until after the closing, the remaining stockholders can reduce their own post-closing income, and thereby inflate the pre-closing income allocable to the seller. 

In another example of bad timing, a selling member received a substantial bonus after the closing for work done prior to the closing.  To his surprise, the deduction for the bonus was properly allocated entirely to the remaining members of the company, thereby substantially increasing the pre-closing profit, and thus the amount of tax allocated to the seller.  The seller, in effect, paid a double tax on that portion of the bonus equal to the seller’s ownership share of the company. 

A similar issue arose in another transaction where the effective date of the transaction was stated to be a date that was prior to the date of the actual closing.  In that instance, all of the payments made to the Seller at the closing were excluded from the tax year that closed as of the effective date of the sale, thereby inflating the income allocated to the pre-closing period, and giving the remaining equity holders a windfall in the form of additional deductions in the tax year that commenced immediately after the effective date of the closing. 

The moral of these stories is the same:  be very careful about tax allocations and timing of payment issues when selling an interest in a pass-through entity.   Mistakes can be very costly.