Explore a case study where a stock seller filed a lawsuit against buyers due to a breach of stock purchase agreement. Learn about the significance of Section 1377 election and clear communication in M&A transactions.
July 27, 2020
Introduction:
When selling the stock of an S corporation business in the middle of the year, a crucial tax concern involves allocating the year’s income and expenses. An S corporation transfers its income and expenses to the business owners, who report them on their personal tax returns. There are two ways to handle this division: either based on ownership interest for the year or through an Internal Revenue Code Section 1377 election. The latter option involves closing the books on the date of the stock sale.
The Scenario:
In this case, a Chicago-based air and ocean freight forwarding company was involved. The seller, who owned 25% of the company’s stock, sold his stock to other shareholders on March 31, 2009. The company incurred a $125K loss in the first quarter of that year.
The Dispute:
Following the sale, the seller requested the buyers’ consent for a Section 1377 election, aiming to report a $31K loss on his personal tax return. However, the buyers declined the request. That was because the company performed well for the rest of the year and generated profits, resulting in an allocation of $143K in company income to the seller.
Legal Action:
The seller filed a lawsuit against the buyers in a Chicago federal district court, alleging a breach of the stock purchase agreement. The seller argued that the buyers were obligated to consent to the Section 1377 election due to a “Further Assurances” provision in the agreement. This clause required both parties to take the necessary actions to fulfill the agreement’s objectives.
Court’s Decision:
The buyers requested the court to dismiss the lawsuit, contending that the stock purchase agreement did not mandate their consent to the Section 1377 election. However, the court rejected this argument, stating that the “Further Assurances” provision could be reasonably interpreted to require accommodating such requests. Thus, the seller can present its case in a trial.
This case is referred to as Manfre v. May, No. 1:18-cv-2184, United States District Court, N.D. Illinois, Eastern Division, (March 12, 2019)
Conclusion:
This case highlights the importance of clear communication in agreements. To avoid complications, parties involved in such transactions should explicitly address key matters like the Section 1377 election rather than relying solely on standard contract language.
By John McCauley: I help manage the tax risks associated with buying or selling a business.
Email: jmccauley@mk-law.com
Profile: http://www.martindale.com/John-B-McCauley/176725-lawyer.htm
Telephone: 714 273-6291
Check out my book: Buying Assets of a Small Business: Problems Taken From Recent Legal Battles
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