Hello,

I am preparing a 2013 personal income tax return for a family member and I am looking for a little bit of guidance on a specific issue.

For simplicity sake, I will provide an example with approximations. Here are the facts:

October 2011 - Person is asked to join an S-Corp start up with a 10% ownership interest for $100K. The person has limited capital so the original $100K investment is made up of $10K in shareholder cash and $90K is loaned to the shareholder by the S-Corp with repayment terms over 5 years. Shareholder agrees and becomes 10% owner where approximately $80K in losses are passed through via K-1s over the next couple of years and are deducted on their personal income tax return.

July 2013 - Shareholder elects to sell their interest back to the S-Corp. Shareholder's Final K-1 reflects a $20K basis due to $80K in pass-through losses incurred over the previous 2 years. The shareholder agreement stipulates a buyout price of the original $100K (same as acquisition amount). Terms on separation agreement state that S-Corp forgives remaining $80K of loan and the other $20K is payable to the shareholder over 3 years. Shareholder receives approximately $5K in principal on the $20K note in 2013 as well as some interest reported on a 1099-INT.

Here is my understanding of how that needs to be treated on their income tax return:

Gain = $80K ($100K sales price less $20K basis)

Approximately $68K gain should be reported in 2013 (85% of principal is received in 2013; $80K loan forgiveness + $5K principal payments = 85/100)

Approximately $12K gain should be reported in subsequent years as remaining principal is received

Are my assumptions correct or am I missing something? My biggest concern revolves around the forgiveness of debt. It is my understanding that the loan forgiveness is constructively received in 2013 so it should be treated as a down payment. It is also my understanding that this transaction would also qualify for capital gains treatment and that none of the income would be ordinary in nature. The only tax documents received from the S-Corp were the final K-1 and a 1099-INT for the interest portion of the installment note. I also have the separation agreement which states the buyout terms exactly as I have indicated above.

Any help would be appreciated.

Edit: Please let me know if this is in the wrong thread since it actually relates to the shareholder of an S corporation. If so, I can delete and re-post elsewhere.