|
|
|
|
 |
|
Redeeming stock in the family business When co-owners are related to each other, a stock redemption can be very tricky When a succeeding generation takes over the family business, many issues dictate how the succession should be structured. Those issues also affect the amount of income and estate taxes paid to the federal government. An often used method involves the buyout of the predecessor using corporate assets in a redemption transaction. Sometimes the company needs to obtain financing to accomplish the buyout, and sometimes the buyout occurs over a period of years as the company earns enough money to make the payments. Attribution rules and the family business. One reason family businesses differ from other closely held businesses is that the Internal Revenue Code contains a never ending number of "attribution" rules that affect transactions among family members and the business entities they own or control. Attribution rules are important when structuring transactions, and you should carefully study them to assess their full effect. Ordinarily, when an asset is sold by one individual to another at a loss, the seller can deduct the resulting capital loss. If it is a passive activity, the sale may trigger the deductibility of suspended passive-activity losses. However, when a sale is to a family member or to an entity controlled by the seller or a family member of the seller, the loss will not be immediately usable. It is not until the asset is sold to someone outside of the family or to an entity not controlled by the family that the loss may be taken and passive activity losses used. Generally, when an individual sells a depreciable asset on the installment method, capital gain may be taken as income over the period of the installment note. However, where depreciable property is sold on the installment method between an individual and an entity which he or a family member controls, or between the individual and a related person, the rules change. The gain may be treated as ordinary income rather than capital gain and may be reportable all in the year of the sale rather than over the period of the note. Another pitfall awaits individuals who co-own an entity with other family members. Ordinarily, an accrual-basis business may accrue and deduct a salary earned in one year, as long as it is actually paid to the individual who performs the services within two-and-a-half months of the year-end. That is not true of salary payable to an individual who owns more than 50% of the stock of a C corporation or is any owner of an S corporation or partnership, nor is it true of a family member of that individual. The exception also applies to expenses that may be payable to the individual or his or her family members, and to an entity any of them controls if that entity is a cash-basis taxpayer. In those cases, the expenditure becomes deductible only when paid, not when accrued. Another set of rules applies for family partnerships and family-owned S corporations. Where more than one family member owns an interest in such a company, any family member who works in the business or provides capital for the business must be paid a fair salary or rate of return on capital before the remaining profits are divided up. That prevents the improper shifting of income to family members in low tax brackets. Know the rules. Family businesses are treated far differently from other closely held businesses. If you’re unaware of the rules affecting family members, you’re likely to stumble into a tax trap. However, creative things can still be done for family businesses, even with related-party rules. Know the rules that affect you before moving forward. Structuring redemption transactions. When dealing with a C corporation or certain S corporations, you must be extremely careful in structuring redemption transactions to avoid dividend treatment. (When a closely held corporation issues a dividend, only Uncle Sam wins.) In redemption transactions, retiring owners surrender their shares to the corporation in exchange for cash, property and/or notes. The redeeming shareholders try to get capital gain treatment on the transaction. Capital gain treatment is important for two reasons. First, capital gain is taxed at a substantially lower rate than ordinary income. Second, if individuals have basis in their stock, that basis off-sets the gain. If capital gain treatment is not accomplished, the redeemed shareholder may end up with dividend treatment on the proceeds, and a capital loss for the basis of the stock. The deduction limit on the capital loss is just $3,000 per year and can be used only to offset capital gains. This can impose a tremendous tax cost on the transaction. To get redemption treatment – and thus capital gain – on the transaction, the redeeming shareholder needs to actually give up substantive ownership in exchange for any cash or property received from the corporation. If there is no meaningful reduction in the ownership of the redeeming shareholder, the substance of the transaction will be a dividend. To determine whether the transaction is a dividend or a sale of stock, the Internal Revenue Code provides four rules, only three of which are pertinent. The transaction will be treated as a sale and not a dividend if any one of those three rules is satisfied:
Following the rules. Although these rules seem straightforward, they are difficult in a family situation because stock owned by family members of the redeeming shareholder may be treated as though it were owned by the redeeming shareholder. If a parent and his or her child are each 50% owners of a company, 100% of the stock ownership is attributed to each of them for the purposes of redemption. If either redeems his or her half of the stock, 100% ownership will still be attributed to him or her because of the family relationship. As a result, the transaction would likely fail the first two tests. Therefore, when family members want to be redeemed out of a corporation, they may have to rely entirely on the "complete redemption" safe harbor. In that instance, attribution also exists, but a family member may waive it under certain circumstances. If a family member redeems all of his or her shares and signs a waiver agreeing to have no interest in the corporation for at least 10 years (other than as a creditor), and if certain other tests are met, the transaction will probably be treated as a sale. Often the redeemed family member wants to remain part of the business. Sometimes that includes staying on the payroll, receiving medical coverage and coming in occasionally to greet customers and talk on the phone. That can be a problem. If a shareholder wants capital gain treatment on his or her redemption and signs a waiver of family attribution, the company may not provide a car or health insurance or employ him or her. Any continuing contact with the company will destroy the capital gain treatment. Posthumous redemption problems. Sometimes, predecessors decide to hold their stock until death, and the buy-sell agreement provides a redemption of the shares by the estate. That presents a new set of problems. The estate is deemed to own all of the stock owned by its beneficiaries. Thus, if a parent and child each owns 50% of the stock and the parent dies, a redemption of the shares from the estate while the child is still a beneficiary of the estate can cause the same dividend treatment instead of capital gain and loss. Worse, the estate’s basis in the stock will be stepped-up to fair market value as of the date of death. Thus, if the redemption is treated as a dividend, all the money received from the corporation will be treated as ordinary income to the extent the company has retained earnings, and the stepped-up basis in the stock will be considered a nearly useless capital loss. In the case of an S corporation that has always been an S corporation, a redemption transaction is less of a problem. Still, qualifying for a sale or exchange treatment may be important if the remaining shareholders would like to preserve a portion of the accumulated adjustments account. In that case, qualifying the redemption as a sale or exchange will be important. LLCs, partnerships exempt. Finally, it should be noted that limited liability companies taxed as partnerships, and partnerships themselves, generally do not have problems like those described above. However, regardless of the type of entity, you should always practice great care when buying out a family member. Seek competent professional advice before committing to any such transaction. 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. |
