Corporate Strategies to Structure Stock Redemptions in Closely Held Corporations

Article excerpt

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). …