Corporate Strategies to Structure Stock Redemptions in Closely Held Corporations

By Lockwood, M. Jill; Fletcher, Leslie B. | The National Public Accountant, February 2001 | Go to article overview

Corporate Strategies to Structure Stock Redemptions in Closely Held Corporations


Lockwood, M. Jill, Fletcher, Leslie B., The National Public Accountant


How does a closely-held business provide capital for future growth and additional shareholders when the older shareholders retire or no longer remain active in the business? Attracting future shareholders poses a problem. As a practical matter, shares of a closely-held corporation can be sold only to the remaining shareholders or to the corporation itself because of: (1) the lack of marketability of such shares, and (2) the reluctance of outside parties to invest in small corporations--especially to acquire a minority interest.

Both the shareholders and the corporation must acknowledge this lack of marketability and decide, in the event of the death or retirement of a shareholder, who should purchase the shares--the remaining shareholders or the corporation. This decision should be made well in advance of the actual transaction.

CORPORATE PURCHASE OF THE SHARES

Capital Gains Treatment

In most cases, the shareholder wants the redemption to be treated as a sale. Gain is recognized only to the extent that the proceeds of the redemption exceed the shareholder's basis in the shares. If the shares are a capital asset, which is usually the case, the gain is taxed as a capital gain.

Corporate Redemptions

The most serious threat to capital gains treatment in the disposition of stock is having the corporation redeem the stock. Unless an exception applies under Internal Revenue Code (IRC) Section 302, the redemption transaction is usually treated as a dividend to the extent of the corporation's earnings and profits. Thus, the entire distribution to an individual may be subject to taxation at the highest individual tax rate of 39.6%. If the corporation has no earnings and profits at the time of the redemption, but does generate earnings by the end of the year, the redemption is likewise treated as a dividend. Furthermore, under Section 316(a) the shareholder is taxed to the extent of all earnings and profits, not just a pro rata share (Example 1). If the earnings and profits are not sufficient to cover the distribution, the basis of the shares being redeemed are reduced. The rest of the proceeds, if any, are usually capital gains (Example 2).

Example 1. Shareholder taxed to the extent of all earnings and profits

Ted has a 50 percent interest in a corporation. The corporation redeems part of his interest for $50,000. There are no earnings and profits at the time of the redemption, but by the end of the year, the corporation reports earnings of $60,000. If there are no other distributions, the entire $50,000 is a taxable dividend, not just $30,000 (50 percent of $60,000).

Example 2. Reduction of basis of redeemed shares

Assume the same facts as in Example 1, except that earnings and profits are only $10,000 and Ted has a $25,000 basis in his stock. The first $10,000 of the proceeds is a dividend. The next $25,000 is a non-taxable return of basis. The remaining $15,000 of the proceeds is taxed as a capital gain.

Avoiding Dividend Treatment

Dividend treatment on redemptions may be avoided in each of the following situations: (1) a disproportionate redemption, (2) a complete termination of interest, or (3) a redemption not essentially equivalent to a dividend. If dividend treatment is avoided, redemptions are treated and taxed as capital gains--the treatment preferred by the taxpayer/seller. Management should structure the redemption to satisfy one of these three exceptions to dividend treatment.

1. SUBSTANTIALLY DISPROPORTIONATE REDEMPTION. According to Section 302(b)(2), a distribution is substantially disproportionate when two criteria are met.

* The redemption must reduce the shareholder's voting interest below 80 percent of his or her interest before the redemption (Example 3).

* After the redemption, the shareholder must own less than 50 percent of the total combined voting power of the corporation (Example 4).

The rest of this article is only available to active members of Questia

Sign up now for a free, 1-day trial and receive full access to:

  • Questia's entire collection
  • Automatic bibliography creation
  • More helpful research tools like notes, citations, and highlights
  • Ad-free environment

Already a member? Log in now.

Notes for this article

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
One moment ...
Project items

Items saved from this article

This article has been saved
Highlights (0)
Some of your highlights are legacy items.

Highlights saved before July 30, 2012 will not be displayed on their respective source pages.

You can easily re-create the highlights by opening the book page or article, selecting the text, and clicking “Highlight.”

Citations (0)
Some of your citations are legacy items.

Any citation created before July 30, 2012 will labeled as a “Cited page.” New citations will be saved as cited passages, pages or articles.

We also added the ability to view new citations from your projects or the book or article where you created them.

Notes (0)
Bookmarks (0)

You have no saved items from this article

Project items include:
  • Saved book/article
  • Highlights
  • Quotes/citations
  • Notes
  • Bookmarks
Notes
Cite this article

Cited article

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

(Einhorn, 1992, p. 25)

(Einhorn 25)

1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited article

Corporate Strategies to Structure Stock Redemptions in Closely Held Corporations
Settings

Settings

Typeface
Text size Smaller Larger
Search within

Search within this article

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

Full screen

matching results for page

Cited passage

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn, 1992, p. 25).

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences."1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited passage

Welcome to the new Questia Reader

The Questia Reader has been updated to provide you with an even better online reading experience.  It is now 100% Responsive, which means you can read our books and articles on any sized device you wish.  All of your favorite tools like notes, highlights, and citations are still here, but the way you select text has been updated to be easier to use, especially on touchscreen devices.  Here's how:

1. Click or tap the first word you want to select.
2. Click or tap the last word you want to select.

OK, got it!

Thanks for trying Questia!

Please continue trying out our research tools, but please note, full functionality is available only to our active members.

Your work will be lost once you leave this Web page.

For full access in an ad-free environment, sign up now for a FREE, 1-day trial.

Already a member? Log in now.