S corporations are pass through entities, but lack the flexibility of partnerships. When more than 20% of the stock of an S corporation is sold, the issue arises as to how to account for income to the shareholders during the year. The default rule is to wait until the the end of the year, determine income for the year and then allocate it on a per day basis. For example, if shareholder A owns 50% of the S corporation and sells all of his stock on October 1 to shareholder B and the S corporation has $100 of income, shareholder A will be allocated $75 of income. But what if all $100 of income is earned after October 1? Poor shareholder A will be allocated $75 of income, but will have no right to receive any of it since he wasn’t a shareholder when it was earned. This creates a phantom income problem for shareholder A.
What is the solution for shareholder A? Well if all shareholders agree the S corporation can elect to use the cut off method. The cut off method creates two separate tax years-one to the date of sale and one after. The cut off method can be elected anytime before the tax return is filed. However, there will usually be a winner and a loser here. In this case shareholder B would be disadvantaged to agree to the cut off method. Therefore, it is recommended that shareholder A require the cut off method to mandated in the stock purchase agreement.