Consider the tax treatment of stock redemptions in family businesses
Waiver of family attribution is critical if capital gain is desired
INSIGHT ARTICLE |
Senior shareholders of closely held family businesses who are approaching retirement regularly seek to pass ownership down to the next generation. Family-owned corporations often are structured with a parent as the majority shareholder and an adult child as the minority shareholder. To help fund retirement, assume a parent seeks cash for 100 percent of his or her shares with the intent that his or her child (now as sole shareholder) will take over corporate ownership. A common strategy involves the corporation redeeming all the shares from the parent for cash or a note to prevent the child from having to individually finance a direct stock purchase. Since the parent will no longer own any shares of the corporation, the redemption seems to qualify as a capital transaction to the parent under section 302(b)(3)—the parent has terminated his or her interest in the corporation. However, unless the parent waives family attribution (see section 318(a)(1)(ii)), the redemption is generally treated as a corporate distribution rather than as an exchange qualifying for capital gain treatment. Waiving family attribution is the exception to the general rule provided under section 318(a) that instructs that a parent will be considered to own any stock owned by his or her children. While straightforward, waiving family attribution is subject to several restrictions, including the stringent separation requirements discussed below. Taxpayers must understand how the separation requirements are applied in order to properly structure the redemption as an exchange qualifying for capital gain treatment.
Background—redemptions under section 302
A corporate distribution in redemption of stock is treated as (1) a distribution in part or full payment in exchange for the stock1 (capital transaction), or (2) as a distribution subject to section 301.2 If the latter treatment applies, the distribution is taxed as a dividend to the extent of earnings and profits (E&P),3 the portion of the distribution in excess of E&P is applied to the redeemed shareholder's stock basis,4 and any remaining distribution in excess of the shareholder's stock basis is then treated as a sale or exchange of property.5
As referenced above, some corporate redemptions are treated as exchanges rather than dividend distributions.6 One such redemption is a complete redemption of all stock of the corporation owned by the redeeming shareholder.7 However, exchange treatment is generally not available for a complete redemption when the redeeming shareholder has family members who will continue to own stock in the corporation subsequent to the redemption. Section 318(a) provides that, generally, stock owned by one family member is "deemed" to be owned by other family members (constructive ownership). Thus, if a parent and a child both own stock in a corporation and the parent redeems all of his or her stock, the parent will normally be deemed to own the stock owned by the child after the redemption, causing the parent to not have a complete termination of his or her stock interest. Proper tax planning, however, can produce the desired result of having the redemption treated as an exchange taxed as a capital gain. If the parent effectively waives family attribution, the parent will no longer be deemed to own stock owned by the child, and thus, the parent will have terminated his or her interest in the corporation.
Redeemed shareholder must possess "no interest" following the redemption
A waiver of the family attribution rules is only allowed where the redeeming family member possesses no interest in the corporation (other than as a creditor) following the redemption. In this regard, interest extends beyond simply an interest as a shareholder. Specifically, the statute states that the parent may not have a disqualifying interest as an "officer, director or employee"; however, an interest as a creditor (i.e., if the corporation funds the redemption with a note) is not disqualifying.8
The definition of "no interest" has been the subject of several court cases and IRS rulings. Clearly, holding a title of officer, director or employee is problematic, as these positions are directly prohibited in the statute. But gray areas exist. For instance, can the redeemed shareholder provide services as an independent contractor? Can the redeemed shareholder be covered by the corporate medical insurance plan? Can he or she drive a corporate car or have an office at the corporate headquarters? Obviously, this list could go on and on. While the IRS has consistently taken the position that the "no interest" requirement must be strictly interpreted because the Code instructs that the redeemed shareholder must have no interest other than that of a creditor, for many years the courts appeared willing to address each case based on its own set of facts. However, the most recent court decision that addressed this issue concluded it was a mistake for the courts to sort through a myriad of fact patterns and agreed with the IRS. To wit, the redeemed shareholder could have no interest in the corporation other than as a creditor if the family attribution waiver was to be valid.9
Consequently, taxpayers need be aware that providing services to, holding titles with, or maintaining other relationships with the redeeming corporation post-redemption can play havoc on the intended tax consequence of claiming no interest, above and beyond simply redeeming 100 percent of their corporate stock. While some courts may continue to address the facts in each case, redeeming taxpayers who need to waive family attribution in order to receive exchange treatment proceed at their own risk if they maintain any interest other than as a creditor.
Tax consequences—redemption as a distribution versus exchange
Long-term capital gains and dividends are currently taxed at 20 percent and also subject to the 3.8 percent net investment income tax for the highest earners. However, a redemption treated as a distribution generally will have significantly different tax consequences when compared to a redemption treated as an exchange. The differences include: (i) how the redemption will impact the corporation's E&P, (ii) how much of the redemption will be taxable and (iii) what adjustments may be needed to any remaining stock basis.
First, a redemption will have different effects on corporate E&P depending on how it is treated. A redemption treated as a distribution is taxable as a dividend to the extent of E&P,10 but a redemption treated as an exchange reduces E&P by the amount properly chargeable to the redeemed shareholder's ratable share of E&P.11 As a result, the treatment of the redemption will impact the amount of E&P remaining for future corporate distributions.
Second, a redemption treated as an exchange is taxable only when the amount realized exceeds the redeemed shareholder's historic stock basis. Conversely, a distribution treated as a dividend will be taxable to the extent of E&P, with no basis recovery until the E&P is depleted. The amount of the distribution that is not a dividend (the amount in excess of E&P) is applied against and reduces the redeemed shareholder's basis until no basis remains,12 in which case the remaining distribution amount is treated as a gain from an exchange.13 Thus, even though the tax rates on dividends and capital gains are the same, differences in the treatment of the redemption will result in different tax consequences because the taxable amount will presumably be different, with exchanges taxed only to the extent of gain and distributions taxed to the extent of E&P.
Third, a redemption treated as a distribution will require adjustments to the basis of the corporation's stock held by the remaining related family shareholders with respect to the stock redeemed.14 The basis of the redeemed stock is not lost permanently but, rather, reallocated to the related family shareholders. As a result, the redeemed shareholder's stock basis will be allocated to the remaining shares that are constructively owned through the family attribution rules, but any current-period benefit from that basis is deferred. Therefore, in the redemption discussed earlier, if the parent failed to effectively waive family attribution and the redemption proceeds were therefore taxed as a dividend, the basis that the parent had in the shares surrendered would transfer to and become part of the child's basis in his or her shares.
Family-owned corporations may find that structuring a redemption for exchange treatment is a tax-efficient way to transfer corporate ownership to the family's next generation while also providing a source of retirement funding for the redeeming shareholder(s). For the redemption to receive exchange treatment, the family attribution waiver rules must be satisfied by the redeeming shareholder(s), including a surrender of all interests in the corporation for at least 10 years. It is not uncommon for a former shareholder to want to stay involved with a business, especially if that business is family owned. Thus, taxpayers must understand the limitations involved when planning to redeem stock from a corporation involving family.
Waiver of the family attribution rules is highly complex and involves significant planning. This article addresses one of the more common issues that normally arises in doing a redemption in a family corporation, but severing all interests in the corporation as discussed above is only one element of successfully waiving family attribution. Taxpayers should consult with their tax advisors when planning or executing a corporate redemption to insure the transaction's intended tax consequences will be upheld if challenged by the IRS.1 Section 302(a).
2 Section 302(d).
3 Section 301(c)(1).
4 Section 301(c)(2).
5 Section 301(c)(3).
6 Section 302(b).
7 Section 302(b)(3).
8 Section 302(c)(2)(A)(i).
9 Lynch v. Commissioner, 801 F.2d 1176 (1986).
10 Section 301(c)(1).
11 Section 312(n)(7).
12 Section 301(c)(2).
13 Section 301(c)(3).
14 Reg. section 1.302-2(c).