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June 2005 Getting around stock redemption restrictions The Tax Code contains strict, but not insurmountable, rules regarding stock redemption transactions between related parties When it becomes time for the senior generation of shareholders in a closely held corporation to sell stock to younger successors, the transaction is often structured as a stock redemption. The corporation buys the stock of the retiring shareholders, causing those shares to be canceled, and the remaining stock, already held by the successors, becomes the controlling ownership. This form of buyout can be mutually advantageous, as the selling shareholder can receive capital gain treatment and deferred installment reporting, while the buyer finds it efficient to use the corporate earnings, rather than personal resources, to fund the buyout. Also, the interest is a deductible expense. However, the Tax Code contains strict rules – with harsh consequences – regarding stock redemption transactions in which the selling shareholder and remaining shareholder are related to each other. Because of concerns that the departing shareholder might actually be retaining indirect control of the corporation, the tax rules require that this person may have no involvement in the corporation as an officer, director or employee for a 10-year period following the redemption. The lack of employee status can be a major drawback, as it typically means denial of such employee benefits as family medical insurance coverage. Getting around the rule. A recent Tax Court case illustrates how it is possible to endure these restrictions and still accomplish objectives that are part of most family business sales. In the Hurst case (124 TC 2 [2004]), Dad was the sole shareholder. At retirement, he sold 10% of the stock personally to a group of three employees, with his son acquiring the majority of those shares. The other 90% of his stock was sold to the corporation on a long-term installment note. The corporation signed Mom to a 10-year employment contract that obligated the company to provide her with health insurance. Dad also signed a new 15-year agreement for the real estate that he leased to the corporation. The IRS disallowed the corporation’s agreements with Mom and Dad, prompting a lawsuit. The Tax Court found that neither the retention of lease income by the redeemed shareholder (i.e., Dad) nor the employment of Mom by the corporation constituted a prohibited relationship. Mrs. Hurst was not a shareholder prior to her husband’s sale of the stock, and her compensation and health insurance benefit represented a reasonable payment for her services to the corporation. (Note: This case originated in a separate property state. Had it occurred in a community property state such as Arizona, Mrs. Hurst may have been presumed, depending on the facts surrounding the Hursts’ marriage, to own an undivided 50% interest in the corporation’s stock.) The fact that the lease and employment agreement were cross-collateralized with the corporate stock note did not taint the arrangement. As a result, Dad was allowed to use the installment method and report the gain at capital gain rates. Planning tip. If your family business operates as an S corporation, it is often more efficient to have the next generation of shareholders personally acquire the retiring party’s stock rather than use a stock redemption. This avoids the 10-year rule requiring the departing shareholder to be uninvolved with the corporation. If a transition of your family business is on the horizon, we can help you structure a tax efficient succession plan. Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market. |