The term “business divorce” refers to a dispute between feuding business partners that culminates in a change, transfer or relinquishment of a partner’s equity interest in the business. Not surprisingly, there are tax consequences that will result when one interest holder is bought-out or is otherwise required to assign his or her interests to finalize the “divorce.” Anyone who litigates in this arena must understand certain tax basics. This post specifically addresses the importance of understanding the tax methodologies that may apply in the event of a transfer of stock in a subchapter s corporation (“s-corp”) or membership interests in a limited liability company (“LLC”).
Although the effective date of the transfer of one party’s stock or LLC membership interests may seem like an afterthought, the date is actually crucial in determining each business owner’s share of profits and losses. The tax methodology that the parties adopt is equally important to each interest holder’s ultimate tax liability.
Generally, s-corps and LLCs are taxed as pass-through entities. This means that the company’s profits and losses “pass through” to the individual shareholders or members, and each reports his or her share of those profits or losses (as reflected on IRS Form K-1) on his or her individual tax return. Calculating each business owner’s share of profits or losses is often uncomplicated when it is done as of the end of the fiscal year.
Things become more complicated when one owner divests mid-year. Every company’s profits and losses are in flux from one month to the next. When a party relinquishes his or her stock or membership interest during the tax year, he or she will be allocated a share of the entity’s profits and losses based on the date of transfer. The ultimate calculation can be made by one of two methods: (1) the per share per day method; or (2) the interim closing of the books method.
With the per share per day method, the tax liability of the transferor is based on his or her share of the net income generated during the entire year, but prorated by the number of days of the year that transpired as of the transfer date. In other words, under this method one calculates the transferor’s share of taxable income as follows:
Taxable income = ((transferor’s share of entity’s end of year net income) x (number of days into year the transfer was deemed effective)) ÷ (365 days)
With the interim closing of the books method, the transferor is taxed based on his or her share of the company’s profits and losses as of the date of the transfer. In effect, when the interim closing of the books method is applied, the tax year is split in two and profits and losses are separately allocated to the pre-transfer and post-transfer periods.
Clearly, any party contemplating a transfer of his or her corporate interests would prefer to apply the methodology that results in a lower tax liability for him or her (and greater tax liability for the remaining interest holders). For example, if the business at issue is seasonal and tends to generate more income during the latter half of the year, it would better suit a transferor to apply the closing of the books method if the transfer is effectuated before the business’s expected uptick in revenue. On the flip side, the remaining interest holders would want to ensure that the outgoing partner is allocated his or her share of the net income generated during the business’s most profitable months.
With these competing interests at play, it is of paramount importance that the parties come to an agreement regarding the tax methodology to be used. If a methodology is not expressly agreed to, the default method under the Internal Revenue Code applies. To confuse things further, the applicable default method differs depending on whether the subject entity is a s-corp or a LLC. For s-corps, unless all interest holders expressly agree to adopt the interim closing of the books method, the per share per day method will apply. See 26 U.S.C. § 1377; see also 26 C.F.R. § 1.1377-1. Conversely, absent an agreement, the default method applying to LLC membership interest transfers is the interim closing of the books method. See 26 C.F.R. §1.706-4(a)(3)(iii).
In sum, it is critical for practitioners and business owners embroiled in business divorce disputes to understand these tax issues and account for them in formulating litigation and settlement strategies.