A 50/50 shareholder in an S corporation comprised of several different entertainment businesses wanted a corporate divorce from his co-shareholder. The two shareholders had been involved in contentious litigation spanning several years, and had reached a tentative settlement. We were asked to double-check the terms of the tentative settlement from a tax point of view.

A Tax Disaster and Potential Windfall to the IRS

Under the settlement, certain corporate assets were to be transferred to one of the shareholders in exchange for all of his stock. The assets in question were worth more than $2.5 million. What’s wrong with this arrangement?  The answer is EVERYTHING.!!!

If the shareholders had proceeded along that course, there would have been two levels of taxation—one at the corporate level and one at the shareholder level. At the corporate level, if the $2.5 million in assets were directly distributed to the departing shareholder, it would have been treated as if the corporation had sold those assets, and the corporation would have realized a significant gain, which would have been allocated equally to the shareholders. 

As if that were not bad enough, at the shareholder level, the shareholder who got the $2.5 million of assets in exchange for his stock would have realized additional taxable gain.  And, to add tax insult to injury, had the deal gone forward there would not have been enough cash for the shareholders to even pay their taxes.

Reorganization:  Turning Lemons into Lemonade

A tax-free corporate reorganization offered a much better solution to this shareholder dispute. But, in order to legally comply with the tax requirements for corporate reorganization, the shareholders needed a legitimate business purpose for the reorganization  – in other words, a reorganization just to avoid tax is not enough.  Fortunately here, the resolution of a bitter shareholder dispute provided such a legitimate reason.

Here is how it worked:  the corporation dropped the assets that the departing shareholder wanted into a brand new corporation set up for that purpose. Then, under a written plan of reorganization, the departing shareholder exchanged his stock in the old corporation for 100% of the new corporation's stock.

When the dust settled one shareholder kept the old corporation and its remaining assets, while the other shareholder got the new corporation, which now owned the $2.5 million of assets that he wanted – and, the best part is that nobody paid any tax!  By structuring the settlement as a tax-free reorganization, taxes were avoided at both the corporate and shareholder levels. The feuding shareholders went their separate ways, with each owning a corporation holding the assets he wanted without either of then incurring a tax burden.  

 A True Win--Win

In this corporate divorce, after years of bitter litigation, everybody ended up happy with the tax consequences —a result that doesn’t happen all the time.

The moral of this story is that you should always seek tax advice before completing any significant transactions. Not all stories end as well as this one, but if the client hadn't asked, the results would have been disastrous. Unless you want to help pay down the national debt why overpay Uncle Sam?