Category: Corporations Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com As I understand it, two individuals, Taxpayer A and Taxpayer B, are 50-50 shareholders in an S corporation, ABC Company. The two shareholders agreed to contribute to the capital of ABC in equal amounts. Taxpayer B was able to put in his share; Taxpayer A was not. It has been understood between the shareholders that Taxpayer B was contributing on behalf of both, and there was a debt in favor of Taxpayer B in the amount of 50% of Taxpayer B's contributions. The parties want to put in place an agreement formalizing the existing indebtedness between Taxpayer B and Taxpayer A. Taxpayer B also wishes to increase his equity participation in the Company if Taxpayer A cannot come up with his share of capital. There is a proposal on the table to formalize the debt between Taxpayer B and Taxpayer A and to give Taxpayer B a security interest in Taxpayer A's existing stock. Under this plan, Taxpayer B would be able to foreclose on a portion of his security interest at several points in the future based on various defined benchmarks as to time and the amount of funds Taxpayer A has been able to contribute. The concern about the proposed plan is the tax consequences to Taxpayer A in the event that Taxpayer B exercises his rights under the security agreement. It is very well settled that transfer of property to creditors in satisfaction of debt is a deemed sale or exchange of the property. W.R. Taxpayer Aan, 114 F2d 217, 40-2 ustc ¶9635, (CA-2, 1940); and Peninsula Properties Co., 47 BTA 84 (Acq.). If the debt is nonrecourse (i.e., the creditor's only recourse is to the collateral, the entire amount of outstanding debt is treated as an amount realized from a sale or exchange of the collateral. See J.F. Tufts, 103 SCt 1826, 83-1 ustc ¶9328 (USSC, 1983). If the debt is recourse, the amount realized is the fair market value of the collateral at the time of the foreclosure. Any additional debt discharged is cancellation of debt income under Section 61(a)(12) and subject to potential exclusion under Section 108(a). J.S. Danenberg, 73 TC 370, Dec. 36,459. The question is whether there is a more tax-efficient way to structure this transaction and still meet the needs of those involved. Would it be possible to allow Taxpayer B to increase his ownership of ABC relative to Taxpayer A by increasing Taxpayer B's ownership in ABC with newly issued stock. This would dilute Taxpayer A's interest without creating a taxable event. Two possible methods come to mind: 1) issue a call option in favor of Taxpayer B; or 2) make the debt between Taxpayer B and ABC Company convertible into common stock. Since ABC Company is an S corporation, the two methodologies set forth above cause some concern about the second class of stock rules. Call Option As I envision this arrangement, there would be a series of option agreements that grant to Taxpayer B an option to purchase additional shares of common stock of ABC at their fair market value on the date of exercise based on how much capital Taxpayer A has been able to contribute to ABC as of that date. The amount of additional stock under each option agreement would be approximately commensurate with the dilution effect that would have occurred had Taxpayer A foreclosed on the corresponding portion of Taxpayer B's stock under the proposed agreement. The option would run for some reasonable period of time, perhaps 60 or 90 days. Presumably, Taxpayer B might choose to use a portion of his receivable from ABC as payment for the additional stock, although the agreement absolutely should not say so. The rules regarding stock options and the second class of stock issue are a little tricky. There is a facts as circumstances determination made at the time the options are issued AND at certain triggering points down the road. Accordingly, the options could be OK when issued but not OK based on certain subsequent events. Regulations Section 1.1361-1(l)(4). In general, options are treated as a second class of stock if they are substantially certain to be exercised and have a strike price substantially below the fair market value of the underlying stock A) on the date the option is issued, B) transferred to an ineligible shareholder, or C) materially modified. The regulations provide a safe harbor. If the strike price at the appropriate measuring point is at least 90% of the fair market value of the underlying stock, the option is not treated as a second class of stock. Regulation Section 1.1361-1(l)(4)(C). As I understand it, there is some realistic possibility that Taxpayer A will be able to perform on his capital contribution requirements. As a result, there is a substantial, real contingency that Taxpayer A may not even get the opportunity to exercise the options. Moreover, when and if that opportunity does arise, he will only have the ability to exercise at the fair market value of the stock at that time. From that standpoint alone, it seems that the options in question would not be reasonably certain to be exercised. Since the other trigger points involve transfer or modification of the option, I suggest taking further precautions as follows. Make the options explicitly non-transferrable without prior consent of ABC Company. In addition, I suggest something like the following be added to the language of the option agreement. Regarding Transfer of this Option Regarding Modification of this Option Agreement It is important that the shareholders resist the temptation to set the fair market value of ABC's stock by agreement at the outset. In order for this arrangement to work, the fair market value of the stock must be determined at the time of exercise. Reg. Sec. 1.1361-1(l)(4)(iii) provides that a call option does not have a strike price substantially below fair market value if the price at the time of exercise cannot, pursuant to the terms of the instrument, be substantially below the fair market value of the underlying stock at the time of exercise. It seems to me the option agreement should provide that the strike price is fair market value based on some methodology that produces a good faith, supportable estimate of fair market value. I advise strongly against determination of fair market value based on a simple formula, or book value, or some multiple of cash flow, or other such similar measures. I strongly advise that the option agreement contain an appraisal requirement. This is a very serious issue that warrants a serious level of concern and attention by the parties. In my opinion, only an appraisal evidences the appropriate level of seriousness and the appropriate level of good faith effort commensurate with the magnitude of the issue at hand. Convertible Debt |
