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Tax trap on deceased shareholder's redemption.

Shareholder buy-sell agreements often contain provisions requiring the corporation to redeem a shareholder's interest on his death. It is intended that the redemption be treated as an "exchange" so the decedent's estate can use the stock's basis to reduce or eliminate any capital gains. However, if not properly planned, such redemptions may result in a dividend to the decedent's estate. This may occur if any of the estate's beneficiaries continue to hold the redeeming corporation's stock after the redemption.

Example: Corporation A is worth $1,000,000. A father, F, owns 80% of A and his two sons, X and Y, own 10% each. F's will leaves $600,000 in trust to X and Y, with the remainder of the estate going directly to his spouse. A is required to redeem F's 80% interest on his death. F dies.

A redeems F's 80% interest before X and Y's credit shelter trust is funded. Under Sec. 318(a)(3)(A) and (B), the stock owned by X and Y is considered owned by F's estate. Consequently, the estate will still be considered as owning 100% of A after the redemption. Since Sec. 302(c)(2)(C)(i)(I) prevents the estate from waiving beneficiary attribution, the redemption will not qualify as a complete termination of interest. This leaves the executor in the unenviable position of arguing that the redemption should be treated as an exchange because, as provided in Sec. 302(b)(1), it is "not essentially equivalent to a dividend." If the executor is unsuccessful with this argument, F's estate will recognize an $800,000 dividend.

The undesirable tax consequences in this example can be avoided if the credit shelter trust is fully funded before the redemption takes place and the estate, along with the surviving spouse, waives family attribution under Sec. 302(c)(2)(C). The trust (and consequently the two sons) will no longer be entitled to distributions from the estate and wwill cease to be beneficiaries. At this point, X and Y's stock ownership will no longer be attributed to the estate. Then, when A redeems the estate's 80% stock interest, the transaction will qualify for sale treatment under Sec. 302(b)(3). And, since the estate's basis in its A shares was stepped up to the date of death value, little or no gain or loss will result from the redemption. It must be emphasized that after the transfer of assets to the trust, the possibility that the estate could seek repayment of assets from the trust must be very remote. If such a possibility was likely, the IRs could argue that the estate-beneficiary relationship with X and Y remained intact and the estate would recognize a dividend on redemption of A's stock. Further, keep in mind that if A stock is used to fund the credit shelter trust, the same detrimental results will occur at the trust level.

These problems can be completely avoided if the redemption agreement is redrafted in the form of a cross-purchase agreement. This commonly used technique involves the purchase of stock between shareholders and avoids the attribution problems involved in a redemption. There are both advantages and disadvantages in adopting such an agreement, so each situation must be scrutinized to determine if the benefits outweigh any negative consequences.

The tax consequences of a corporate redemption agreement can be disastrous. However, problems can be avoided by proper planning in both drafting the agreements and administration of the estate. All such agreements should be reviewed to insure that the tax trap described is avoided.
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Author:Gunderson, Brian
Publication:The Tax Adviser
Date:Feb 1, 1992
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