An S-Corp is a popular structure to use when setting up an entity for a small business. However, despite having many positive features, an S-Corp is a highly inflexible structure with many limitations. One such limitation is the way in which income or loss can be allocated to the shareholders.
How is income/loss allocated to shareholders of an S-Corp?
S-Corps use the “per share per day” method, which requires shareholders to take their ownership percentage on each day of the year and multiply it by that day’s share of the annual income. In other words, income is allocated using a “day-weighted average”.
A basic example…
Alex and Jamie are each 50% shareholders in Grateful Inc (a fictional company that manufactures Grateful Dead merchandise), each will be allocated 50% of Grateful’s income or loss for the given year.
Grateful’s Income: $100
Alex’s portion: $50
Jamie’s portion: $50
A more complicated example…
Alex and Jamie are still 50% shareholders in Grateful Inc, however, on June 30th, Jamie sold her 50% share in Grateful Inc to Alex. Now, the idea of “per share per day” becomes more important.
Grateful’s Income: $100
Alex’s portion:
50% of the income for 50% of the year (Jan – June) = 50% * $100 * 50% = $25
Plus: 100% of the income for 50% of the year (July – Dec) = 100% * $100 * 50% = $50
Total: $25 + $50 = $75
Jamie’s portion:
50% of the income for 50% of the year (Jan – June) = 50% * $100 * 50% = $25
Plus: 0% of the income for 50% of the year (July – Dec) = 0% * $100 * 50% = $0
Total: $25 + $0 = $25
Is this fair to Alex and Jamie?
That depends. If the business earns its income relatively equally over the course of the year, then “per share per day” is a fair and accurate method for allocating the income to the shareholders.
However, what if Grateful Inc doesn’t operate during the first 6 months of the year, and then they make all of their money when Dead and Company go on tour in the fall? When the year ends and the tax return is being prepared, is it still fair to allocate taxable income to Jamie even though she no longer owned the company as of July 1st? Jamie should not be required to pay tax on the income earned after she sold the company, since she will not see any of the benefit (e.g. distributions, more valuable shares) of that income.
What recourse does Jamie have? How else can Grateful’s income be allocated?
Grateful has the option to make a “closing of the books” election, which effectively splits Grateful’s tax year into two periods, with the first period ending on the date Jamie sells her shares to Alex. If this election is made, Grateful has two separate income statements for the year, which are then used to allocate the income to the shareholders.
Grateful’s income: $100
Grateful’s income earned from January to June: $0
Grateful’s income earned from July to December: $100
Alex’s portion:
50% of the income from the Jan – June period = 50% * $0 = $0
Plus: 100% of the income from the July – Dec period = 100% * $100 = $100
Total: $0 + $100 = $100
Jamie’s portion:
50% of the income from the Jan – June period = 50% * $0 = $0
Plus: 0% of the income from the July – Dec period = 0% * $100 = $0
Total: $0 + $0 = $0
Given that Jamie was no longer a shareholder in the company when Grateful earned all if its income for the year, this method more fairly (and more accurately) allocates Grateful’s taxable income to Alex, who enjoyed the full benefit of the income.
What does it take to make a “closing of the books” election?
Technically, not much. The company files a form with their tax return which needs to be signed by all of the shareholders.
In reality, it can be more complicated:
- Closing the books may require significant accounting work, so closing them twice in a single year can lead to more time spent by your accountant
- Shareholders don’t always part company on the best of terms, and in our example, Alex may not want to take on the additional $25 of taxable income that is allocated to him by this method, even if we know it is more fair
What can be done to avoid complications?
When forming an entity, require that all shareholders enter into a shareholder agreement. In this agreement, stipulate that, upon the termination of a shareholder’s interest, any shareholder can require that all other shareholders sign off on a “closing of the books” election. When the entity is formed, the shareholders will have no way of knowing whether this will help or hurt them, and it will lead to a fairer resolution at the time that a shareholder’s interest is terminated. If the entity has already been formed, draw up a separate contract or stipulate this requirement in the contract to terminate the shareholder’s interest.
Not sure how this applies to you? Have any questions? Let us know, we can help you assess your individual situation!