Closely held corporations and stock redemption.

Many times an entrepreneur persuades a family member to invest in a company. Other times the owners disagree and one will be bought out. If a corporation buys out an owner or the family member who invested, the selling owner or family member may not receive capital gain treatment on the proceeds.

Too often, owners of stock in closely held corporations are surprised when a redemption of stock (a repurchase by the corporation) becomes fully taxable as ordinary dividend income rather than as long-term capital gain -- at a federal rate of up to 39.6% instead of the maximum 20% rate that usually applies to long-term gains on stock. The entire amount can be taxed even if the shareholder economically takes a loss! This sorry state of affairs depends on whether the redemption is treated as a "sale or exchange" or as a distribution" for income tax purposes.

As explained below, sometimes prior planning can avoid an adverse tax result. First, some definitions, then some basic rules, and finally an example.

"Sale or exchange" -- If the redemption is treated as a "sale or exchange" for tax purposes, then the shareholder will recognize capital gain or loss equal to the difference between the sale price and the cost basis in the stock.

"Distribution" -- If the redemption is treated as a distribution, the amount received on redemption will be treated as ordinary dividend income up to the amount of the corporation's current or accumulated earnings and profits, with no offset for tax basis.

A distribution is a dividend up to the corporation's entire current and accumulated earnings and profits (not just the redeemed shareholder's pro rata share) for the entire year -- including the period after the stock is repurchased. Only redemption proceeds above total current and accumulated earnings and profits are offset with basis in the stock. Any excess over basis results in capital gain instead of ordinary dividend income.

Obviously, a shareholder usually benefits more from a stock redemption treated as a sale or exchange instead of as a distribution. There are generally three ways to accomplish being considered a sale or exchange:

Complete termination -- the corporation repurchases all the stock actually or "constructively" owned by the shareholder.

A shareholder constructively owns stock that is actually or constructively owned by the shareholder's spouse, children, grandchildren and parents. A shareholder also constructively owns a proportionate share of stock owned by a corporation at least 50% in value of which is held by the shareholder or owned by partnership of which the shareholder is a member or a trust of which the shareholder is a beneficiary. In addition, a shareholder constructively owns stock the shareholder can acquire by exercise of an option -- but stock subject to other persons' options is not considered to be outstanding in calculating percentage ownership. Other constructive ownership and special rules apply that are not discussed in this article.

Substantially disproportionate redemption -- the corporation repurchases enough stock so that immediately afterward the shareholder owns less than 50% of the total combined voting power and the shareholder's percentage of both voting stock and common stock is reduced to less than 80% of the shareholder's percentage of voting stock and common stock immediately before the redemption. All these percentage tests also are applied based on stock owned actually or "constructively" by the shareholder.

This category also depends on "constructive" ownership of stock, as well as actual ownership of stock on the part of a selling shareholder.

Not essentially equivalent to a dividend -- the redemption is considered not to be "essentially equivalent to a dividend" taking into account both actual and "constructive" ownership of stock.

This can be extremely difficult to prove in the context of a closely held corporation and therefore is not considered further here.

An Example to Consider

Case Study: Redemption of family member stock Child owns all 98 shares of Corporation common stock. Parents invest in nonvoting "true blue" preferred stock (preferred with a coupon return and liquidation preference, but no equity participation). The preferred can be redeemed by Corporation. This scenario can result in tax disaster -- redemption of the preferred could be treated entirely as dividends to Parents!

Waiver of family attribution -- if a child owns all remaining stock, the parents are considered to be 100% shareholders even after a redemption of all the parents' stock. However, in this particular case, fortunately there is a relatively easy answer if Parents will no longer be involved with Corporation. The parents can avoid constructive ownership by filing with the IRS an agreement for "waiver of family attribution" of ownership. For 10 years after redemption, the parents must not hold an interest in the corporation other than as a creditor -- that is, not as a shareholder, officer, director, employee or consultant.

But now assume that Parents will remain involved with Corporation. Perhaps Parents own some common stock they wish to retain, or possibly they are directors or advisors employed by the company. Are there any solutions here?

Use of option and community property attribution rules. Assume that Child is married and all the stock is community property. Parents own no common stock but will remain as directors and employees, so family attribution cannot be waived.

Corporation issues two shares of common stock to third party employees as an incentive for performance. Add to the mix an option for Parents to purchase all 98 shares of Child's stock. The option expires if Parents do not exercise it before Parents' preferred stock is redeemed.

For sake of discussion, assume that all these transactions are on commercially reasonable terms and entered into for valid, independent business purposes.

Redemption of all preferred in this new fact pattern can qualify as a "substantially disproportionate" redemption. The reason is the Parents do not "constructively" own the community property interest of Child's spouse, nor do Parents own the stock held by third party employees. Before the redemption, Parents "own" all 98% of Child's stock because of their option to purchase. After redemption and expiration of the option, Parents "own" just 49% -- Child's community property interest. Thus, Parents satisfy the 50% and 80% percentage requirements for a "substantially disproportionate" redemption. The sale or exchange test is passed. Note: If Parents own some common stock in addition to preferred, the calculations of stock ownership become more complicated.

As this example demonstrates, advance planning can help avoid severely adverse tax results. Owners of closely held corporations should consult their tax advisors before proceeding with such transactions.

John Bonn is a partner in the Tax Practice Group at Sheppard, Mullin, Richter & Hampton LLP. He can be reached in Los Angeles at 213-617-4160 or at [e-mail].