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.
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 Internal 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 taxation 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?