Buy-sell agreements: constructive dividend dangers lurk; how to structure an agreement to avoid adverse tax consequences.

One of the more pernicious threats faced by closely held corporation shareholders is the prospect of "constructive" distributions, taxed as ordinary dividend income to the extent of available earnings and profits, for transactions in which the shareholder benefits from a corporate action. In this connection, buy-sell agreements have proven to be a source of revenue for the Internal Revenue Service when the agreement is not properly structured.

USE OF BUY-SELL AGREEMENTS

Typically, to facilitate an orderly transfer of ownership, closely held corporation owners structure buy-sell agreements to enable a departing shareholder to dispose of his or her stock efficiently. Remaining shareholder(s) also have a stake in this process because failure to plan for this eventuality could lead to a situation in which the departing shareholder's stock winds up in disruptive or unfriendly hands. A buy-sell agreement can be structured in a variety of ways; it can involve either a purchase by remaining shareholder(s) or a corporate-level acquisition.

The selling shareholder's tax consequences are well known and generally devoid of controversy. In a sale to other shareholder(s), capital gain or loss consequences naturally follow. In a corporate redemption, the transaction is normally treated as an exchange under Interal Revenue Code section 302(b)(3), which covers transactions in which the redeemed shareholder's proprietary interest in the corporation is completely terminated. Similarly, under the doctrine of Zenz v. Quinlivan, section 302(b)(3) also applies to a part sale, part redemption transaction if, as is typical, the steps are part of an integrated plan; in these cases, the step-transaction doctrine treats the steps as a unit for purposes of determining eligibility for section 302(b)(3) treatment.

In a redemption, applying section 302(b)(3) can be complicated by stock attributed to the redeeming shareholder under the constructive ownership rules. A taxpayer is deemed to own a portion of the shares actually (but not constructively) owned by entities such as trusts, estates, partnerships and corporations of which the taxpayer is beneficiary, partner or shareholder, respectively. In these instances, additional planning is necessary to gain the benefits of section 302(b)(3).

In IRS revenue ruling 71-211, for example, a taxpayer redeemed all shares actually owned but, under IRC section 318(a)(2)(B), was considered to own a portion of the shares owned by a trust of which he was beneficiary. The ruling says the redemption would be governed by section 302(b)(3) only if the taxpayer concurrently renounced his beneficial interest in the trust and such renunciation, under local law, was (1) effective to achieve a divestiture of his trust interest and (2) "valid and binding."

ATTRIBUTION RULES 

IRC section 318(a)(1) provides a broad set of family attribution rules. A taxpayer is deemed to own stock actually (and in some cases constructively) owned by a spouse, children, grandchildren or parents. However, section 302(c)(2) permits a waiver of the family attribution rules if the taxpayer.

* Possesses no interest (except as a creditor but including an interest as an officer, director or employee) in the corporation immediately after the redemption.

* Does not acquire such an interest, other than stock acquired through bequest or inheritance, during the 10-year period beginning on the redemption date.

* Files an agreement to notify the IRS of any acquisition of interest within the 10-year look-forward period.

The central issue is the nature of an "interest" in the corporation. Predictably, the IRS takes an expansive view in defining what constitutes an interest. Its central position, that performance of any service on behalf of the corporation (whether as an employee or as an independent contractor) constitutes a prohibited interest, was recently affirmed in Lynch v. Commissioner. Moreover, according to IRC regulations section 1.302-4(e), a creditor interest, although generally permitted, will be tainted if creditor rights are greater than necessary to enforce a claim or are subordinate to the claims of general creditors.

Certain relationships are permitted. These include

* An interest as a lessor, provided lease payments are neither dependent on earnings nor subordinate to the claims of general creditors.

* Being named a trustee of a trust, or executor of an estate, holding voting stock of the redeeming corporation, provided such interest (the right to vote the stock) arises from the terms of a decedent's will. Because section 302(c)(2)(A)(ii) permits acquisition of a complete stock interest--by reason of death--it is reasonable to conclude acquisition of this even smaller interest, under identical circumstances, would not violate the statutory purpose.

* A right to receive pension payments, under an unfunded, preredemption, written agreement, if the payments are neither subordinate to general creditor claims nor dependent on corporate earnings. Moreover, a funded arrangement with the same provisions also has been sanctioned.

* A vendor relationship (approved in IRS private letter ruling 8208164), provided the products are supplied on a job-by-job basis

ROBERT WILLENS, CPA, is senior vice-president of Lehman Brothers, New York City. He is a member of the American Institute of CPAs and the New York State Society of CPAs. at prices comparable to those charged unrelated third parties.

Although the law defining prohibited interests is still evolving--particularly on the significance of rendering postredemption services--the selling shareholder normally can qualify for section 302(b)(3) exchange treatment even if stock is outstanding after the redemption attributable to him or her.

REMAINING SHAREHOLDERS:

PITFALLS AND OPPORTUNITIES

Buy-sell agreements commonly provide that upon a shareholder's death or termination of employment, the departing shareholder will sell and remaining shareholder(s) will buy his or her interest in the company. If the responsibilities of remaining shareholder(s) are performed by the corporation, the redemption is treated as a constructive dividend distribution.

The prerequisite for distribution treatment is the fact the corporation's undertaking satisfies a "primary" and "unconditional" obligation of remaining shareholder(s). Thus, with a typical buy-sell agreement, distribution treatment is appropriate because the triggering event--death or termination of employment--transforms the remaining shareholder's obligation into an unconditional one.

Remaining shareholder(s) who face having the redemption taxed to them as a dividend often attempt, belatedly, to avoid this treatment by contending they were merely acting as the corporation's agent, so the transaction is simply a redemption of stock the remaining shareholder(s) were not obligated to acquire. This assertion, however, is difficult to sustain.

In Skyline Memorial Gardens, Inc., the Tax Court concluded it is only proper for remaining shareholder(s) to be treated as the corporation's agent when a mutual agreement exists; if the seller insists on an intrashareholder transaction, a later redemption (pursuant to the buyer's intent) is not sufficient to invoke agency treatment.

A virtually identical decision, using strikingly similar reasoning, was reached by the Eighth Circuit Court of Appeals in Schroeder v. Commissioner. Accordingly, if all parties envision and contemporaneously express their intent to accomplish a redemption, a shareholder-level purchase will not be taxed as a redemption of the seller's shares under an agency theory.

This rule was illustrated in IRS private letter ruling 8813034. After numerous meetings with the IRS, a company was permitted to redeem 50% of a shareholder's stock. However, if the company reflected the redemption liability on its books, the transaction would constitute an act of default on its bank credit agreement. Accordingly, the remaining shareholder formally agreed to purchase the stock on the corporation's behalf until the latter's banking relationship improved. In this case, the IRS acknowledged the remaining shareholder was the corporation's agent, so the eventual redemption was not regarded as discharging the remaining shareholder's primary purchase obligation. The ruling shows--by virtue of its unique facts--the futility of attempting to avoid constructive dividend treatment with an agency argument.

PROPERLY STRUCTURING

A BUY-SELL AGREEMENT

There are numerous cases in which a remaining shareholder's involvement in a buy-sell agreement, ultimately effected through a redemption, is sufficiently tenuous to avoid constructive dividend treatment. In IRS revenue ruling 69-608, a buy-sell agreement provided that if a shareholder desired to sell stock, the remaining shareholder would purchase the shares, or "cause them to be purchased." The remaining shareholder exercised his right to cause the corporation to purchase the stock but no constructive dividend was found; the existence of alternative methods of discharging the purchase obligation meant the remaining shareholder's obligation could not be regarded as unconditional.

Recent case law expands this doctrine. In Bunney v. Commissioner, an executed purchase agreement defined the purchaser as the principal shareholder "or his assigns." The stock was, in fact, redeemed by the corporation. The Tax Court rejected the IRS's attempt to impose a constructive dividend. By defining the purchaser as the principal shareholder or his assigns, it is possible to avoid constructive dividend treatment in the same way if, as in revenue ruling 69-608, the contract obligated the shareholders to either purchase the shares or cause them to be purchased. Similarly, in Buchholz Mortuaries, Inc. v. Commissioner, Mr. B offered to purchase the stock of corporation M. Shareholders who wished to sell signed a letter accepting the offer of Mr. B "or his assigns."

Corporation M accepted assignment of the offer of tender and the resulting payment obligation. As in Bunney, the Tax Court rejected the IRS's constructive dividend argument. The phrase "or his assigns" was given controlling significance; it created merely an alternative obligation that, in turn, meant Mr. B never was burdened by the type of unconditional obligation that triggers a constructive dividend.

Closely related to the alternative-obligation line of cases is the situation in which the agreement provides from the beginning for a corporate-level purchase but, if the corporation is unable or unwilling to perform, for a purchase by remaining shareholder(s). If the stock is actually redeemed, revenue ruling 69-608 says no constructive distribution arises; the remaining shareholder is only secondarily liable, thus the primary obligation necessary for a constructive distribution does not exist.

In a related pronouncement, IRS private letter ruling 9110029 addresses a situation not previously considered in case law. In the ruling, Mr. A entered into a contract with his coshareholder to acquire the right to purchase, on the latter's death, the stock owned by the estate.

Shortly after the coshareholder's death, Mr. A assigned his purchase right to the corporation, which redeemed the estate's stock. Although the ruling is uncomfortably vague on this point, it appears the redemption should not result in constructive dividend treatment for Mr. A. The ruling says the redemption should not be viewed as performed in satisfaction of Mr. A's primary and unconditional obligation to acquire the stock. Mr. A, in effect, simply purchased a call option on the decedent's shares and, by definition, an option (provided it is not exercised before assignment) does not create mutual obligations that might invoke constructive dividends.

REVISING A DEFECTIVE AGREEMENT

For taxpayers who find their present agreements run afoul of the principles outlined above, it's not too late to make changes. Revenue ruling 69-608 says canceling an intrashareholder buy-sell agreement and replacing it with an agreement naming the corporation as the ultimate purchaser of the stock do not give rise to a deemed distribution because the restructuring took place when the shareholder's obligation was not yet unconditional. The obligation was, at the time of the revision, still voluntary. This revision rule is not limitless; Gerson v. Commissioner illustrates how a failure to adhere to it can create tax liabilities.

In Gerson, the shareholders executed a buy-sell agreement activated at death. The continuing shareholder and the decedent's estate executed a settlement letter providing for a purchase by the former of the latter's stock. The executor initially declined, but eventually was ordered, to comply with the letter. Ultimately, the estate's shares were redeemed. The continuing shareholder argued there had been a change in the original agreement--due to the executor's failure to comply--and thus the subsequent agreement was unrelated to the obligation under the original agreement.

The court disagreed. On death, obligations to buy and sell were created and everything that took place thereafter was directly related to these obligations. The redemption, therefore, was merely the final step in the participants' efforts to resolve their obligations under the original agreement. Accordingly, it discharged the continuing shareholder's primary purchase obligation and dividend treatment ensued. This case bolsters the idea that agreements can be revised but confirms such revision must occur before the confirms such revision event converts the executory responsibility into an unconditional one.

NEED FOR BUY-SELL AGREEMENTS

The need for buy-sell agreements in virtually every closely held corporate situation is apparent. It is equally clear improperly structured arrangements can lead to substantial tax liabilities when the corporation discharges a shareholder's purchase obligation. Tax counsel can perform a valuable service by guiding taxpayers in drafting new agreements or taking the steps necessary to cure defective pacts.