Avoiding locked-in installment gains on predeath stock redemptions.Facts: Weaver Basket Co. (WBC WBC white blood cell; see leukocyte.
white blood cell
n stands for white
cell. ), a closely held S corporation, was formerly a C corporation. The stock is held by 12 members of the same family (heirs and relatives of Jonas Weaver, the deceased founder). * The oldest shareholder is Jed Weaver, Jonas' brother. Jed is single, aged and has just been diagnosed with a terminal illness. * Jed's will leaves his estate to his five children and their families, none of whom are WBC shareholders. Jed and the present shareholders agree that WBC should redeem his stock rather than extend the ownership to his diverse group of heirs. * Jed's basis in his WBC stock is $20,000; the fair market value (FMV FMV - full-motion video ) is about $500,000. * The shareholders ask their tax adviser about the feasibility of having Jed redeem his shares now, receiving $50,000 down, with WBC paying the $450,000 balance via a 10-year installment note. * WBC's accumulated adjustments account is $100,000 and its accumulated earnings and profits are $700,000. Issue: Is a stock redemption funded by an installment note the best way to retain corporate ownership within the existing shareholder group? What are the tax traps and planning alternatives?
The tax adviser explains that a lifetime WBC stock redemption by Jed would qualify for sale or exchange treatment under Sec. 302(b)(3) as a complete termination of his entire interest. Further, Jed would not be required to enter into the 10-year waiver of family attribution, because none of his immediate family members are WBC stockholders. Presumably pre·sum·a·ble
That can be presumed or taken for granted; reasonable as a supposition: presumable causes of the disaster. , Jed's nieces and nephews (Jonas's children) are shareholders, but the Secs. 302(c) and 318(a)(1) family attribution rules Attribution Rules
A set of rules created by Canada Customs and Revenue Agency (CCRA) that prevents investors from transferring assets between family members with the intention of avoiding taxes. do not attribute stock ownership other than from a spouse, children, grandchildren and parents.
However, such a redemption presents a significant ongoing tax cost to Jed's heirs. A stock redemption now will create a long-term installment obligation with $450,000 of principal remaining to be paid. Because Jed's stock basis is only $20,000 (i.e., 4% of the total redemption price Redemption price
See: Call price
1. The price at which an open-end investment company will buy back its shares from the owners. In most cases, the redemption price is the net asset value per share.
2. ), the WBC note has a 96% gross profit ratio (GPR (Ground Penetrating Radar) A UWB-based technology that locates objects buried underground. It is used to locate buried lines, storage tanks, pipes and conduits as well as to determine the structural integrity of the ground underneath a road or runway. ).
If Jed dies during the note's 10-year term, his heirs will inherit it as a note receivable note receivable
A debt due from borrowers and evidenced by a written promise of payment. Note receivable, an entry on the asset side of many corporate balance sheets, indicates the dollar amount of loans due to be repaid by borrowers. without a basis step-up. Under Sec. 691(a)(4), an inherited installment obligation passes to heirs with the same GPR, despite the fact that the receivable's FMV is included in the decedent's estate. As the heirs collect the future annual principal payments from WBC, they would be required to report the same GPR that Jed reported. If the receivable's FMV triggers estate tax to Jed's estate, the heirs would be allowed an itemized deduction Itemized Deduction
A deduction from a taxpayer's taxable adjusted gross income that is made up of deductions for money spent on certain goods and services throughout the year. for the estate tax attributable to this income in respect of a decedent An individual who has died. The term literally means "one who is dying," but it is commonly used in the law to denote one who has died, particularly someone who has recently passed away. , under Sec. 691(c)(1). However, the estate tax deduction Tax deduction
An expense that a taxpayer is allowed to deduct from taxable income.
See deduction. would only partially offset the gain the heirs report.
The high tax cost of this redemption plan becomes particularly evident when compared to the alternative--deferring the redemption until after Jed's death. Stock passed through an estate takes a basis under Sec. 1014(a) equal to the date-of-death FMV. By deferring the redemption until after Jed's death, the entire $480,000 of appreciation in Jed's WBC stock would avoid income taxation on redemption.
The danger in deferring the redemption into Jed's estate is that his executor and heirs may be unwilling to have WBC redeem their stock. To ensure that WBC can acquire this stock via a redemption, the tax adviser suggests that the shareholders (including Jed) currently establish a buy-sell or shareholder sale agreement allowing WBC to purchase the stock from a deceased shareholder's estate. Alternatively, Jed could grant an option to WBC allowing it to acquire his shares within a stated period of time after his death.
A stock redemption that occurs shortly before the death of a redeemed shareholder is a tax trap if it includes a long-term installment obligation. Once an installment obligation is created, the gain is permanently locked in and continues to be reportable by the heirs or beneficiaries inheriting the corporate installment note. To avoid this result, Jed and WBC should defer the redemption until after Jed's death, by providing a way for the shares to be purchased from his estate.
Editor's note: This case study has been adapted from "PPC See Pocket PC, PowerPC and pay-per-click.
PPC - PowerPC Tax Planning Tax planning
Devising strategies throughout the year in order to minimize tax liability, for example, by choosing a tax filing status that is most beneficial to the taxpayer. Guide--S Corporation," 16th Edition, by Andrew R. Biebl and Gregory B. McKeen, published by Practitioners Publishing Company, Fort Worth, Tex., 2002 ((800) 323-8724; www.ppcnet.com).
Albert B. Ellentuck, Esq. Of Counsel King and Nordlinger, L.L.P. Arlington,VA