Redeeming closely held stock.

When a corporation redeems its own shares, the selling shareholder must report either capital gains or dividend income; IRC section 302 decides the type of income to report. Under IRC section 318(a) a taxpayer is deemed to own the stock owned by family members. Consequently most redemptions by closely held corporations are treated as dividends, but there is an important exception in cases of complete redemption of the shareholder's interest. The Tax Court recently considered how this exception works.

Richard Hurst owned all the stock of Hurst Mechanical Inc. (HMI). He and his wife Mary also owned all the stock of RHI, a sister corporation. In 1997, when Richard decided to retire, he and his wife sold all the P, HI stock to HMI. HMI redeemed 90% of the stock owned by Richard, and he sold the remainder of his HMI stock to three individuals, one of whom was his son. Richard received installment notes in payment for the stock. The Hursts continued to lease the building housing HMI and RHI to the two corporations, and Mary continued as an employee of HMI, receiving a salary and fringe benefits. As the Hursts believed Richard had completely terminated his ownership, they reported the sales of their stock as long-term capital gains. IlLS objected to this treatment.

Result. For the taxpayers. Normally, in determining the tax results of a stock redemption, taxpayers are considered to own all the stock they own directly and all the stock they own by attribution, including stock owned by their children. There is an exception: Taxpayers who completely terminate their interest and have no relationship with the corporation other than that of a creditor can waive the family attribution rules. The IRS argued that the notes Richard received, the building lease and the wife's employment violated the no-relationship test.

The note Richard received for the redemption of the HMI stock had a principal amount of $2 million. The note he received from the sale of the P,_HI stock to HMI was $250,000. Both notes were payable in 60 quarterly installments with 8% interest. A default on either note or on Mary's employment contract would have been considered a default on both notes and would have allowed Richard to reclaim the stock that was pledged as collateral. The notes were subordinated to HMI's bank obligations.

The IRS claimed the provisions in the installment notes created a relationship greater than a normal debtor/ creditor relationship permitted by section 302(c)(2). The Tax Court concluded, however, that the Hursts' use of the stock as collateral was acceptable. Likewise, the provision that a default on either note would be treated as a default on both notes was acceptable because this provision was a reasonable condition and the note payments were independent of the financial performance of the corporation. Therefore the notes were true debt and did not violate the requirements for the attribution waiver.

The IRS then argued the building lease was a prohibited interest. The court viewed the lease as a separate transaction designed to guarantee income to the Hursts while reducing the cash-flow issues of the corporation. Therefore, it was not a financial stake in the corporation and so the transaction was acceptable.

The IRS' last argument was that Mary's employment contract violated the no-interest rule. The court pointed out that the employment contract was reasonable, it was not subordinate to other creditors and it was not based on the corporation's performance. It was, therefore, not a prohibited interest.

The IRS's letter ruling policy is that stock may not be security for a debt and that no subordination is permitted. The court's decision in this case means the service's ruling policy is overly restrictive. The decision also reaffirms a taxpayer may lease real property to a corporation after a redemption and the employment of a taxpayer's spouse can exist without violating attribution-waiver requirements.

In its reply brief the IRS argued that the sale of RHI stock to HMI was a redemption taxable as a dividend because of the sections 304 and 302 overlap (sale of the stock to a sister corporation). The Tax Court did not hear this argument, which came after all evidence was admitted. For the court to fully explore this argument, new evidence would have been needed. Had the court addressed the issue, it would have clarified section 302 rules as they apply to sales of stock to controlled corporations.

* Richard Hurst v. Commissioner, 124 TC no. 2.

Tax Time Total

The IRS handled 224.4 million tax returns for fiscal year 2004.

Source: www.irs.gov, April 2005.

Uncle Sam Needs More Hands

Last year the IRS pursued only 18% of cases that used known abusive devices designed to hide income, leaving an estimated $447 million in taxes uncollected.

Source: IRS Oversight Board FY2004 Budget/Special Report, www.irsoversightboard.treas.gov, 2004.

Give and Take

Uncle Sam returned about 15% of fiscal year 2003 taxes in the
form of taxpayer refunds.

                      Gross
                  collections         Refunds
Type of return   (in millions)   (in millions)

Individual            $987,209        $223,317
income tax
Employment          695,976 *            4,445
taxes
Corporate              194,146          65,332
income tax
Excise taxes            52,771           2,026
Estate and              22,827             944
gift taxes
Total               $1,952,929        $296,064

* Excludes self-employment tax

included in individual income tax.

Source: IRS, www.irs.gov.

Prepared by Edward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy. University of Alabama, Tuscaloosa.