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Shareholder Redemption Traps: All Gains Are Not Equal-Part 2

Last month, I explained how a partial redemption of a family member’s stock typically is taxed as ordinary dividend income, not capital gain. To add insult to injury, the income can’t be reduced by the cost basis in the stock. What could be worse? Well, could the law tax the non-redeeming shareholders, too? Shocking though it may seem, a little understood and often overlooked law can do exactly that!

Stock Split? Tax-Free

The culprit is Infernal Revenue Code Section 305. (Yes, for the first time in a long time I put a citation in this column. Yawn. Sorry.) It starts out friendly enough by saying that a corporation’s distribution of stock to its shareholders is not taxable income to them. That is why an Internet company can do a two-for-one stock split every few months, doubling the number of shares owned by each shareholder. After the flurry of new stock certificates is distributed, everyone owns exactly the same percentage of the company as they did before the split.

Bottom line: No tax because nothing really changed other than a few trees were killed. No shareholder got cash and everyone kept the same relative percentage ownership.

Cash or Stock - Taxable

Let’s suppose we change the facts a little bit. Instead of distributing additional stock certificates proportionally to each shareholder, the Internet company offers the shareholders a choice: a $10 dividend per share payable in cash or in additional shares. Obviously, the shareholders taking cash are taxed on the dividend.

What about the ones who take stock? Section 305 starts to turn nasty. It taxes the stock-takers on the value of the stock they receive in lieu of the cash dividend. In a way, that’s fair. They could have opted to take cash, pay tax, and then turn around and buy additional shares.

Section 305 just treats them like they took that more circuitous route. Section 305 says that shareholders receiving stock are taxed if the distribution (or a series of distributions) has the effect of some shareholders receiving cash and other shareholders receiving an increase in their proportionate interests in the corporation.

Bottom line: The ones who take additional stock now own a higher percentage of the company than the ones who take cash. Some get cash and some get stock. Everyone gets taxed.

Redemption of Shares

Change the facts again. Suppose that the company redeems some shareholders’ stock for cash. Because there are fewer shares outstanding, the shareholders who did not redeem wind up owning a larger percentage of the company. Isn’t that the same end result as the “cash or stock” deal above?

In fact, it is. Some shareholders received cash in exchange for shares. Although the others did not actually receive additional stock certificates, their ownership percentage increased due to fewer shares outstanding.

That is the core of the problem. When the dust settles, issuing new shares to Shareholder A and cash to Shareholder B is the same as taking shares away from Shareholder B in exchange for cash. Either way, Shareholder A’s percentage interest in the corporation increases and B gets cash.

The regulations say that an “isolated” redemption will not trigger Section 305's wrath. Unfortunately, they stop short of guidance in defining what is isolated and what is not. Advisors tend to be very comfortable with the redemption of a single shareholder. But, when another shareholder seeks to redeem some stock, even within a few years of the first, they get nervous. Your lawyer and accountant will break into a sweat when a third one wants to cash in some chips within a few-year time period.

Family Business Impact

From a non-tax standpoint, family businesses are well advised to create a shareholder agreement that allows shareholders to cash-in stock when they desire (subject to the business’ capital needs). Why? It’s not wise to hold unwilling owners hostage. They can create major problems. Unfortunately, Uncle Sam disagrees because, if more than one exercise their rights, it could cause unexpected txation to those who remain behind.

Unfortunately, there’s no real solution other than discouraging the need for frequent redemptions. Perhaps shareholders’ cash requirements can be handled in other ways. From a financial planning standpoint, cashing in shares is not a very sensible way to handle normal living expenses anyway.

Now that I think of it, maybe Uncle Sam is on to something. Perhaps the moral to the story is that it is in the best interests of those who want to keep their stock to do what’s necessary to keep the others happily on board. Enough said?.

 

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