Avoiding constructive dividends when a corporation purchases stock under a buy-sell agreement.

Facts

E-Z Corporation's outstanding voting common stock is owned equally by Elmer and Zeke, who are unrelated. The shareholders are considering executing a buysell agreement. Each shareholder wants to make certain that there will be a buyer for his stock if he wants to sell. Additionally, each wants to ensure that, should the other shareholder want to sell, he is given first opportunity to purchase the stock. Accordingly, Elmer and Zeke have proposed that the agreement provide that the stock of the shareholder wanting to sell must be purchased by the other shareholder.

They have asked their tax adviser to review the agreement before it is executed.

Issue

How should the buy-sell agreement be structured?

Analysis

According to the proposed terms of the buy-sell agreement, each shareholder is unconditionally obligated to purchase the stock of the other shareholder should he want to sell his stock. Often, however, the purchasing shareholder may not have the necessary funds, and may want the corporation to redeem the stock. If the agreement is structured as proposed and the corporation purchases the stock, the nonselling shareholder will have been relieved of an obligation. In effect, the corporation will have made the purchase on behalf of the nonselling shareholder. Thus, the transaction will be treated as if the corporation had made a constructive dividend to the nonselling shareholder, who then purchased the selling shareholder's stock.

Alternatively, the agreement could have either the nonselling shareholder or the corporation buy the selling shareholder's stock. The agreement might specify that the nonselling shareholder be given a right of first refusal before the stock could be purchased by the corporation. In that instance, if the corporation makes the purchase, the transfer would be treated as a redemption.

By effectively increasing their proportionate interests, a redemption benefits the nonselling shareholders. However, a redemption will not be considered a constructive dividend unless (1) the distribution satisfies a primary and unconditional obligation of the shareholder or (2) the redeemed shares are actually owned after the purchase by the remaining shareholders.

The proposed buy-sell agreement could be modified so that the selling shareholder's stock could be purchased by either the remaining shareholder or the corporation. The corporation would then be able to redeem the stock without creating a potential constructive dividend in case the nonselling shareholder did not have sufficient funds.

Alternatively, the agreement could be modified to allow the nonselling shareholder the option to purchase the stock or assign the purchase contract. An unconditional obligation will not exist if an agreement allows the shareholder the option to purchase the stock, assign the purchase contract or name another potential buyer. If a shareholder can assign or revise an agreement either before a certain event occurs or before the specified time is reached, purchasing the stock will no longer be considered an unconditional obligation.

Purchases of stock by a corporation could have other tax implications to the shareholders.

1. If the corporation purchases the stock for an amount in excess of its fair market value (FMV), the selling shareholder may be considered to have received either a gift or compensation from the remaining shareholders or compensation from the corporation.

2. If the stock is purchased by the corporation for less than FMV, the remaining shareholders may be considered to have received either a gift or compensation.

3. For the redemption to qualify for sale or exchange treatment, it must meet all of the requirements for such treatment. The potential for such treatment is complicated by the problems of valuing stock of a closely held corporation.

Conclusion

Elmer and Zeke should revise the buy-sell agreement to provide that the stock can be purchased by either the nonselling shareholder or the corporation. Thus, the stock purchase would no longer be an unconditional obligation, and would eliminate the potential for a constructive dividend.