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Distributions in redemption of S stock from estate of deceased shareholder.

Corporate redemptions of S stock from the estate of a deceased shareholder may cause unexpected results due to the distribution ordering rules for S corporations.

Example: Corporation A is an S corporation and is on a calendar year-end. During A's tax year, shareholder X, who owns 60% of A, dies. A has a self-funded redemption agreement that is triggered on the death of a shareholder. The formula price to be paid for X's stock under the redemption agreement is $1,200,000, which, it is assumed, is the stock's fair market value [FMV] for estate tax purposes. The remaining shareholders of A are Y, who is X's son and owns 20% of A, and Z, who is X's spouse and owns the remaining 20% of A. Y and Z are beneficiaries of X's estate. X's estate is such that it will not be subject to death taxes. The redemption price is paid in the year X dies and is the only distribution made by A during the year. At the end of the calendar year in which X died, A's accumulated adjustment account (AAA) had a balance of $1,000,000.A had accumulated earnings and profits (AE&P) of $450,000 from the years it operated as a C corporation.

Under Sec. 318(a)(3)(a), X's estate is deemed to own Y and Z's stock. Therefore, the redemption will not qualify for sale or exchange treatment under Sec. 302(b). In addition, X's estate cannot waive attribution of stock ownership from Y and Z under Sec. 302(c)(2)(c) because Y and Z continue to have an ownership interest in A.

Because the redemption does not qualify for sale or exchange treatment, the redemption payment will be treated as a dividend distribution. Since A is an S corporation, the character of the distribution will be determined under Sec. 1368.

Under Sec. 1368, if an S corporation has AE&P, the distribution order is: 1. A nontaxable return of capital to the extent of AAA (to the extent there is AAA but no stock basis remaining, there is capital gain). 2. A taxable dividend to the extent of AE&P. 3. A nontaxable reduction of stock basis. 4. Capital gain from the deemed disposition of stock.

Therefore, under Sec. 1368, the $1.2 million redemption distribution to X's estate would be characterized as a $1 million nontaxable distribution out of AAA and a $200,000 taxable dividend.

Thus, the $1.2 million redemption distribution has reduced A's AAA to zero, limiting the ability of Y and Z to receive tax-free distributions. In addition, $200,000 of the basis step-up in X's stock does not provide a current benefit.

Considering the need to pay income taxes on the S earnings for the year of death, only the estate may have the necessary cash. Depending on earnings in the following year, A may have to pay taxable dividends or make loans) to its shareholders to assist them in paying their income taxes.

A could make an election under Sec. 1368(e)(3) to distribute its AE&P before distributing AAA. If such an election is made, the $1.2 million redemption distribution would be characterized as a $450,000 taxable dividend and a $750,000 nontaxable distribution out of AAA.

While preserving $250,000 of the AAA, the election would not provide a current benefit for $450,000 of the stock's step-up in basis and would increase the estate's taxable dividend income by $250,000.

Note that the characterization of the redemption distribution would be even more complicated if other distributions had been made during the year. In general, if total annual distributions are in excess of the ending AAA balance, a portion of each distribution would be deemed to be out of AAA based on the size of each distribution. The remaining portion of each distribution deemed to be out of AE&P would be determined by the chronological order of the distributions.

Funding the redemption with insurance would not alleviate the problem; the life insurance proceeds paid to A would be tax-exempt income and, as such, would not increase AAA. Rather, the proceeds would increase the other adjustments account, which is distributed out after AE&P. The payment of the redemption through a series of distributions may spread out the effect of the distributions on the AAA.

In the event an estate is subject to death taxes or has funeral or administrative expenses, Sec. 303 may treat a portion of the redemption distribution as payment in exchange for the stock so redeemed.

The above problem would not exist if the S corporation did not have any AE&P. Under Sec. 1368 the distribution would be tax free to the extent of stock basis and capital gain for the excess. Since the decedent's stock would get a step-up in basis at death to its FMV, all of the redemption distributions should be a tax-free return of basis (assuming the redemption price equalled the date of death value).

S corporations with corporate redemption agreements triggered on death should review these agreements and make sure they will not have any unanticipated tax effects to the estate of a deceased shareholder or the remaining shareholders because of the ordering rules for S distributions and the stock attribution rules.

From Eugene R. Schramka, f.d., CPA, Madison, Wisc.
COPYRIGHT 1993 American Institute of CPA's
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Copyright 1993, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Author:Schramka, Eugene R.
Publication:The Tax Adviser
Date:Feb 1, 1993
Words:895
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