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Avoiding locked-in installment gains on predeath stock redemptions.

Facts: Weaver Basket Co. (WBC), 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) 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, Jed's nieces and nephews (Jonas's children) are shareholders, but the Secs. 302(c) and 318(a)(1) family attribution rules 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), the WBC note has a 96% gross profit ratio (GPR).

If Jed dies during the note's 10-year term, his heirs will inherit it as a note receivable 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 for the estate tax attributable to this income in respect of a decedent, under Sec. 691(c)(1). However, the estate tax 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 Tax Planning 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;
Albert B. Ellentuck, Esq.
Of Counsel
King and Nordlinger, L.L.P.
COPYRIGHT 2002 American Institute of CPA's
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Author:Ellentuck, Albert B.
Publication:The Tax Adviser
Date:Dec 1, 2002
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