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AAA Redemptions

No, this is not a story about the first gospel band listed in your iPod music directory. It is about a class-act technique to create financial security for the senior generation while transferring a portion of the family business to the younger generation tax-free. While it requires that your business be structured as an S corporation, a redemption approach can make sense for family businesses structured as regular corporations.

The concept is simple. You simply have the S corporation redeem a minority share (i.e., less than 50%) of the stock from the older generation. The redemption price would reflect appropriate discounts for the lack of marketability and control inherent in the redeemed portion. It must not exceed either the S corporation's AAA account or your total basis in your shares. Basis typically is not a problem because undistributed S corporation earnings are added to it each year.

What is an AAA account? You ask. Actually, those of us in the biz call it a triple A account, not an AAA account. Well, it basically is taxable income that has been accumulated while the corporation is an S corporation. AAA stands for Accumulated Adjustments Account, aka AAA. If the corporation has not accumulated much income, you can prepare for the redemption by retaining earnings for a few years.

The redemption is treated as a dividend for income tax purposes and we all know that the true joy of an S corporation is that dividends are tax-free to the extent of AAA. Voila! You have redeemed part of your stock with what amounts to a preferential dividend to you. Financial security (and less cash to the kids), here you come!

Playing the Percentages

The trick is that the technique works better the more stock the younger generation owns at the time of the redemption. If you own 100% of the stock and redeem half, you still own 100%. So, if you own the lion's share of the stock, you will need to prepare for this technique by making stock gifts or using other wealth transfer techniques to increase the kids ownership interest.

Suppose your kids own 40 shares and you own 60 shares. You redeem 30 of your 60 shares. Your kids will own 40 out of the remaining 70 shares. Their interest increases from 40% to over 57%. Assuming that the redemption price is fair market value for the redeemed minority interest and that AAA and basis covers it, there is no income tax and no gift tax.

You probably sneer at the example because the redemption shifts voting control to the kids. If that is undesirable, you could recapitalize the corporation prior to the redemption. In my example, suppose the corporation converts 99% of the outstanding stock into nonvoting shares. Then redeem 30 of your nonvoting shares. You would have 60% of the vote both before and after the redemption even though your total percentage ownership goes down to about 43%.

C Corporations

Regular corporations also can redeem stock from the older generation, with the same effect of transferring ownership. Unfortunately, for most family businesses redemption will be treated as a taxable dividend. The entire redemption proceeds will be taxable, with no reduction for accumulated earnings or for the shareholder's basis in the redeemed stock.

Before you trash the thought, remember that dividends through 2008 are taxed at only 15%. That's a lot, but it may well be cheaper than:

  • Payroll taxes, if you use compensation to cover your retirement financial needs and
  • Gift and estate taxes on the transfer of the stock through more traditional means.

There you have it. A clever way to use the income tax rules to transfer ownership, potentially without any tax. That just might be music to your ears!

 

 

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