Avoiding locked-in installment gain on a predeath stock redemption.
Jerry's stock basis is approximately $20,000; the stock's fair market value (FMV) is approximately $500,000. The shareholders ask their tax adviser about their plan to have Jerry redeem his shares now for $50,000 down, with the corporation paying the $450,000 balance via a 10-year installment note. Issue: Is a stock redemption funded by an installment note the best way to retain corporate ownership within the existing shareholder group?
The tax adviser explains that Jerry's lifetime stock redemption would qualify for sale or exchange treatment, as it would be a complete termination of his interest. Further, it appears that Jerry would not be required to enter into a 10-year waiver of family attribution, because none of his immediate family members are shareholders. Presumably, Jerry has nieces and nephews who are shareholders (the children of his brother who founded the corporation), but the family attribution rules do not attribute stock ownership other than from a spouse, children, grandchildren and parents.
While on the surface, a lifetime stock redemption appears to satisfy Jerry's and the other shareholders' objectives, the tax adviser notes that it presents a significant ongoing tax cost to Jerry's heirs. By redeeming his stock now, Jerry will be setting up a long-term installment obligation with $450,000 of principal remaining to be paid. Because his basis in the stock was only $20,000 (i.e., 4% of the total redemption price), there is a 96% gross profit ratio (GPR) on the note receivable.
If Jerry dies during the note's 10-year term, his heirs will inherit it without a basis step-up. Under Sec. 691 (a) (4), an installment obligation inherited from a decedent passes to the heirs with the same GPR, despite the note's FMV being included in the estate. As the heirs collect the future annual principal payments from the corporation, they would be required to report the same GPR Jerry reported. If the receivable's FMV triggers estate tax to Jerry's estate, the heirs would be allowed an itemized deduction for the estate tax attributable to this income in respect of a decedent; see Sec. 691 (c)(1). However, the estate tax deduction would only partially offset the gain the heirs will report.
Note: The Jobs and Growth Tax Relief Reconciliation Act of 2001 repealed the Federal estate tax for decedents who die after 2009.
The high tax cost of the redemption plan becomes particularly evident when compared to the alternative of deferring the redemption until after Jerry's death. Stock that passes through an estate receives a flesh basis equal to the stock's FMV at the date of death (DOD) (or the alternate valuation date, if elected). By deferring the redemption until the stock is in Jerry's estate, the entire $480,000 of appreciation would avoid income taxation on redemption.
For decedents dying after 2009, the rules that allowed for a basis step-up to the FMV of property acquired from a decedent are replaced with modified carryover-basis rules. Under the new rules, the basis of property inherited from a decedent will be his or her adjusted basis or the property's FMV on the DOD, whichever is less; see Sec. 1022(a)(2)(B). However, estates can increase basis (but not above FMV on the DOD) by up to $1.3 million on certain appreciated assets; an additional $3 million increase in basis will be available for outright transfers or qualified terminable interest property transferred to a surviving spouse, under Sec. 1022(b)(1), (c)(1) and (d)(1). Although the estate tax and the basis step up rule are scheduled to be repealed beginning in 2010, a new Congress may block the repeal before it occurs. Tax advisers should monitor this area for future developments.
The danger in deferring the redemption into Jerry's estate is that his executor and heirs may be unwilling to have Marshall Basket redeem the stock. To ensure that the corporation can acquire this stock via a redemption, the tax adviser suggests that the shareholders--including Jerry--currently establish a buy-sell or shareholder sale agreement that obligates the deceased shareholder's estate to offer to sell the stock to the corporation at the agreement price. In addition, the agreement should require that the corporation purchase the stock at the agreed-on price.
Without these requirements, a ready market is nut established for the stock's value. An agreement that contains merely an option to purchase or a right of first refusal to meet any third-party offer does not create liquidity for the decedent's estate or beneficiaries. Also, it is extremely important that the buy-sell agreement meet the requirements to establish the estate tax value of Jerry's stock in Marshall Basket. When a buy-sell agreement does not meet such requirements, the estate may be forced to sell the stock for the amount specified in the buy-sell agreement, which may be less than the stock's estate tax value; thus, estate tax may be paid on value the estate never realized. (Fur more information on buy-sell agreements, see Jackson III and Mahoney, "Buy-Sell Agreements--An Invaluable Tool (Parts I and II)" TTA, April 2003, p. 200, and May 2003, p. 284.)
A stock redemption that occurs shortly before the redeemed shareholder's death represents a tax trap if it includes a long-term installment obligation. Once an installment obligation is created, the gain is permanently locked ha and continues to be reportable by the heirs or beneficiaries who might inherit the note. To avoid this result, Jerry and Marshall Basket should defer the redemption until after his death, by providing a buy-sell agreement that obligates the estate to offer (and the corporation to purchase) the stock at the agreement price.
Editor's note: This case study has been adapted from PPC Tax Planning Guide--Closely Held Corporations, 16th Edition, by Albert L. Grasso, Joan Wilson Gray, R. Barry Johnson, Lewis A. Siegel, Richard L. Burris, James A. Keller, Gary W. Brown and James J. Mogelnicki, published by Practitioners Publishing Company, Fort Worth, TX, 2003 ((800) 323-8724; www.ppcnet.com).
Editor: Albert B. Ellentuck, Esq. Of Counsel King & Nordlinger, L.L.P. Arlington, VA
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|Author:||Ellentuck, Albert B.|
|Publication:||The Tax Adviser|
|Date:||May 1, 2004|
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