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Shareholder Redemption Traps: All Gains Are Not Equal-Part 1

Inevitably, there may come a day when it is necessary for your company to buy back (redeem) some of its shares. Perhaps your sibling will want money to start her own business or your parent decides to retire and cash in his chips.

Shareholder agreements typically specify the terms by which family members can or must transfer their stock. Some provisions may force shares to be sold back to the corporation if they are transferred to “prohibited parties” (i.e., ex-spouses and creditors). Others may give shareholders the option to redeem part or all of their shares. In fact, prearranged terms to allow dissatisfied or cash-needy owners to redeem all or part of their shares can be the ultimate relief valve to avoid major family discord.

Unfortunately, a couple of obscure income tax traps can create major migraines for both the redeeming and non-redeeming shareholders. And, the traps can exist when the company buys back stock even if there is no written shareholder agreement.

Ordinary income or capital gain?

Suppose you want to sell part of your stock to get funds to buy that nice house. Shouldn’t your tax be the same regardless of whether you sell stock back to the corporation, to a family member or to some unrelated person? Most people would expect a maximum 20% capital gains tax regardless of who buys their stock. Unfortunately, a sale to the corporation typically will be taxed as a dividend at ordinary income rates as high as 39.6%.

Why? Suppose you and I each own 50 shares, representing 100% of our corporation’s stock. Instead of paying ourselves a $10,000 dividend subject to ordinary income tax rates, we each redeem 10 of our shares for $10,000. We would like to treat the redemption as a sale taxed as a capital gain. However, if you think about it, turning in the 10 shares was meaningless because we each own half of the outstanding stock both before and after the redemption. The relative percentage ownership, not the number of shares, is what’s important. Decades ago, Congress discovered this gambit. So, the law would treat our redemption as a dividend. IRS collects a higher tax rate. Plus, we cannot reduce the proceeds by the basis in our stock. That basis simply “floats” over and adds to the basis in our remaining 40 shares.

Qualifying for capital gain

A redemption is treated as a sale if it is “substantially disproportionate,” which requires:

  • the shareholder to own less than half the voting stock after the redemption; and
  • the shareholder’s percentage of both voting and nonvoting stock to be reduced by more than 20%.

Alternatively, a complete redemption of all of a person’s shares can qualify as a sale.

Unfortunately, both alternatives are complicated for family owned businesses because of another set of arcane rules called “family attribution.” These rules treat you as owning stock that is actually owned by your spouse, children, grandchildren and parents. Your stock ownership may not go down enough to meet the percentage tests, or your stock will not be considered redeemed in its entirety, because you are deemed to own these relatives’ stock holdings.

Redeeming All Your Stock

One way out of the quagmire is for you to redeem all of your stock and “waive” the ownership attribution rules. However, Congress extracts a huge pound of flesh for this privilege. Specifically, you must:

  • Have no interest in the corporation immediately after the redemption other than as a creditor, meaning that you may not own stock or serve as a director, officer or employee;
  • Not acquire any interest (other than by gift or inheritance) within 10 years after the redemption; and
  • File an agreement with the IRS and meet some additional technical requirements.

Obviously, this exception has limited application, but it does work when a shareholder wants out “for good.”

It’s one thing for a redeeming shareholder to pay ordinary income tax on the redemption proceeds. However, in my opening paragraph, I said that redemptions can create major headaches for non-redeeming shareholders. Tune in next month to hear how even non-redeeming shareholders can be stung with an unexpected tax.

 

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