Make a Tax-Smart Redemption of C-Corporation StockShare
Closely-held C-corporation shareholders may have a number of reasons to dispose of their shares. Perhaps a stock comprises an inordinate portion of that individual’s net worth and divestiture would enable a greater diversification of investments. Perhaps the corporation runs a family business and the stockholder wishes to retire. Perhaps the stockholder has a need for liquidity. These are just a few reasons that might necessitate the disposal of the shares owned in a closely-held corporation. One method of disposal would be to have the corporation redeem the shares via a cash payout to the shareholder. What, then, are the tax consequences of the redemption and how can the shareholder structure the redemption most advantageously?
As a Dividend
Under the Internal Revenue Code (IRC) a stock redemption payment received by a C-corporation shareholder is generally treated as a taxable dividend from the corporation’s earnings and profits. Given the favorable tax rates currently applicable to “qualified” dividends (on stock held more than a year), this might be advantageous. Tax rates on qualified dividends remain at 15%, though higher-income taxpayers will pay a 20% rate. However, the additional “net investment income” tax of 3.8% could apply to dividend income for higher-income taxpayers (NIIT applies to taxpayers whose modified adjusted gross income exceeds $250,000 for joint returns and surviving spouses, $125,000 for separate returns, and $200,000 in all other cases). Still, tax on qualified dividend income remains less than the top marginal tax bracket for “ordinary” income, which is 39.6%.
As a Stock Sale
What if, however, a stock redemption payment received by a C-corporation shareholder could be treated as proceeds for the sale of the stock from the shareholder to the corporation, rather than a dividend? The sale treatment could make little or no difference, or a great difference, depending on the circumstances:
- The redemption payment should be a long-term capital gain depending on the shareholder’s tax basis. The amount of tax paid would be less than if taxed as a dividend. Long-term capital gains benefit from the same favorable tax rates that apply to qualified dividends (though they may be subject to the higher 20% rate and net investment income tax discussed above for higher-income taxpayers).
- If the shareholder has a substantial tax basis in the shares redeemed, however, sale treatment of the redemption payment may be considerably more advantageous than dividend treatment, as the taxable amount of the redemption payment in excess of the tax basis would be substantially reduced. In addition, there is an additional benefit since capital gains may be offset by current year’s capital losses and capital loss carryovers, resulting in reduction of the taxable gain on the redemption payment would be further reduced.
How, then, does one ensure that the redemption payment is treated as a stock sale under the IRC? As is customary in tax law, to obtain a favorable treatment certain criteria must be met. Practically speaking, if you are disposing of stock in a closely-held or “family” corporation as a sale (a “complete redemption”), you must be able to show that you have ostensibly separated yourself from the corporation and its activities. First, redeem all your stock and cease involvement in the business (some limited involvement may be allowed). And that may not be enough. If, due to “attribution” rules, you have retained constructive ownership of the corporation through shares owned by family members and/or entities you own or control, the favorable tax treatment is not allowed. This constructive ownership disqualifies the sale treatment!
Fortunately, the IRC provides the ability for the redeemed shareholder to waive (and cause to be disregarded for tax purposes of the redemption) the constructive ownership of shares through family members and related entities by attaching a statement to the shareholder’s tax return for the year of the redemption. Attribution rules can be waived if the following criteria are met:
- The redeemed shareholder does not have an interest in the corporation immediately after the redemption, other than as a creditor. Thus, the redeemed shareholder cannot be an officer, director or employee of the corporation.
- The redeemed shareholder does not acquire any interest (other than by bequest or inheritance) within 10 years from the date of the distribution.
- The redeemed shareholder agrees to notify the IRS of any acquisition of a prohibited interest within the 10-year period.
- None of the shareholder’s stock was acquired from a related person with a federal income tax avoidance purpose within the 10 years before the redemption.
Shareholders in closely-held “family” corporations may obtain sale treatment of a redemption of their stock, and avail themselves of both the favorable tax rates now applicable to long-term capital gains and utilize their tax basis in the shares (along with other capital losses) to reduce the taxable gain, by taking the right steps. Other considerations, however, will surely arise in a potential redemption of a shareholder – e.g., how is the stock valued and the redemption payout be calculated? What if the redemption payout was in the form of a debt instrument? What if the shareholder still wanted to provide services to the corporation? What if the shares were not redeemed but instead included in the shareholder’s estate? What if the shares were instead converted into preferred stock? Planning is paramount when considering redemption of shares – or any transfer of closely-held stock. If this is a consideration of yours, either now to possibly somewhere down the road, please contact us for additional information regarding planning opportunities.