S Corps, Cash Flow and Shareholder Expectations
One of the most common and predictable frustrations we hear expressed by family business owners (especially new shareholders) is the curse of the S Corp. Here is how it works.
Howard, the founder, passes shares of his S Corp. to his two children Sheila and Rudy. He tells his children how hard he worked to give this gift, and they are truly appreciative. Little is said about tax implications. The business has a great year and produces $100,000 in income for each sibling, as stated in the K-1 that appears in the mail on March 5. It took that long to get the revised financial statements compiled for last year and for the company CPA to produce and send out the K-1s the tax form that details S Corp. earnings.
Wow, $100,000 is a lot of money for Sheila who earns $44,000 in her current job. She should be happy, but there is more to the story. Sheila's husband Dean, is a highly organized type of person who has been frustrated with his own tax preparation because he has been waiting on the tax forms from Howard's CPA. He has been pressing Shelia to get the information from her father. When she did ask Howard about the forms, he told her not to worry about it that it was a good year and it just takes time. Dean, meanwhile, just becomes more stressed as the weeks passed. Now it is March 5 and he just opened the mail. Realizing he owes taxes on $100,000 additional income raises his anxiety, especially since Shelia has never received a distribution check for her shares. His concern for their ability to pay taxes prompts him to again question Sheila, who again presses Howard, this time for information on how they are going to pay the tax check. From Howard's perspective, Sheila is overreacting. I already told her we had a great year, he thinks. It seems like she doesn't trust me! Frustrated, Howard says, We will cut the checks in plenty of time to pay the taxes stop worrying. No specific date is given to cut the checks. After all, they have never had a problem getting checks out in 22 years.
Back home at Sheila's, Dean is becoming increasingly fearful and distrustful. I've always turned in taxes by March 1, and now we don't even know if we are going to get the money to pay the taxes. Something isn't right here, He states out of fear and frustration. Sheila is caught between her husband and father, and each tick of the clock adds more stress. She thinks, I thought this stock was supposed to be a gift. It feels like a curse! Shelia now is feeling great anxiety over being an owner.
Sheila's brother Rudy is in a different conundrum. He waited until after the K-1 arrived to work on his taxes, and his accountant just informed him that his S Corp. earnings put his income in a higher tax bracket. Having asked Howard how these tax payments work, Rudy is not concerned about receiving enough income to pay the taxes on his company stock portion of his income, but he just found out that the amount of tax due will be much higher because his income tax rate is higher. The modest income that he and his wife earn collectively will be taxed more; evaporating what they had hoped would be a small but needed tax refund. Instead, they will need even more cash to settle up with Uncle Sam. He thinks, So where is the gift?
Both of these scenarios point to the surprises that rookie shareholders, and sometimes veteran shareholders find when dealing with S Corps. On paper, both Sheila and Rudy had a good year, but they feel like they are out of control or even worse manipulated.
Of course, as has happened every year, Howard cut checks on the week that taxes were due; it was enough to cover each child's earnings on their portion of the family business and all survived. But was all this tension necessary? After all, it raised issues of trust between family members.
We can't help but wonder how a shareholder orientation meeting, with spouses included, might have impacted the family. It could have provided the opportunity to have cash flow input discussions, clarify expectations, set up estimated timelines and establish who to call with questions.
New shareholders do have a lot to learn in any family business. Education and conversation can go a long way in boosting their learning curve.