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Section 303 Stock Redemptions Legal Tax Angles: How to Save Taxes Without Going to Jail When a shareholder in a publicly held corporation dies, the value of his or her stock is part of the taxable estate. The estate can then sell the stock to convert it into cash. Because the value of the stock at the date of death (or the alternate valuation date) becomes the new basis (tax cost) for the stock (step-up-in-basis), there is no gain or loss to the estate. The transaction is treated as a sale or exchange and if there is any gain or loss when the stock is sold, it will usually be a capital gain or loss. Generally, if a publicly traded corporation were to redeem the stock of a shareholder, the redemption would be treated as a sale or exchange. However, if the shareholder and members of his or her family own more than 50% of the company, there are some complex rules which may treat the redemption of stock as a dividend. Tax code section 303 provides an exception to the dividend treatment even where the deceased stockholder owns all of the corporate stock. The amount paid by the corporation to the estate or heir of the decedent is treated as a sale or exchange rather than as a dividend. Since the stock has a new basis equal to it’s value at the date of death (or an alternate valuation date), the estate or the heir will have no gain or loss on disposition of the stock to the corporation. The corporation has no gain or loss in transactions involving its own stock. In most cases, the corporation won’t have the cash available at all times to redeem it’s stock from the estate or the heirs. The most common method of obtaining the funds to buy the stock is for the corporation to own life insurance on the life of the decedent. Upon the decedent’s death, the corporation receives a non-taxable distribution from the insurance company and uses that cash to purchase it’s own stock from the estate of the decedent. To qualify for this favored treatment, the value of the corporate stock must exceed 35% of the adjusted gross estate. This tactic is most suitable for families where a corporation represents a major asset of the family and where the surviving shareholders want to continue to operate the business. In many cases, the redemption may be part of a buy/sell agreement between shareholders of a closely held corporation or a family owned corporation. The primary benefit of this tax code section is to prevent a stock redemption from being treated as a fully taxable dividend from the corporation to the shareholder or the estate. If the corporation funds the redemption with life insurance, it will have to pay for the insurance with after tax (non deductible) corporate earnings. Until the Tax Relief Act of 1997, the corporation would most likely have to pay some alternative minimum taxes on the insurance proceeds when they were received. However, Section IV (B) of the Tax Relief Act of 1997 repeals the alternative minimum tax (after 1997) for corporations with average gross receipts of less than $5 million per year. For corporations with average gross receipts of more than $5 million a year, a portion of the life insurance proceeds may be subject to the alternative minimum tax. In a “worst case” situation, that tax could consume up to 15% of the insurance proceeds. (That would be an extreme circumstance.) Thus, to have the funds needed to redeem the stock of a shareholder, it may be necessary to buy insurance equal to 117% of the value of the stock - assuming a value is known by virtue of a buy/sell agreement or a recent appraisal. Generally, the estate (or the heir) whose stock is redeemed will not have a capital gain or loss because the price for the stock will be based on the value set in a buy/sell agreement which is also the value used for estate tax purposes. The estate tax value is used to determine the tax basis of the assets of the estate so that there is no capital gain or loss. The corporation will not have any gain or loss in transactions involving it’s own stock. Stock may not be redeemed under code section 303 for any shareholder who acquired the stock by gift or purchase from anyone other than the decedent. The amount of stock that is redeemed under tax code section 303 may not exceed the total of the estate and generation skipping transfer taxes, inheritance, legacy and succession taxes and any related interest, plus the amount of funeral and administration expenses. To the extent that the value of the stock is not set by a valid buy/sell agreement between unrelated parties, the value of the stock will be determined by normal valuation procedures and will be affected by the amount of any insurance proceeds that are to be paid to the corporation. Thus, the insurance that is used to provide the funds to redeem the stock may also have the effect of increasing the value of the stock by the face amount of the insurance over the cash value of the policy. The most effective use of this tax code provision requires the establishment of a buy/sell agreement to fix the value of the stock. The buy/sell agreement may not be the determining value for the stock if the corporation is closely held by members of the same family. In the case of family owned corporations, a valuation formula may be required that will approximate the real market value of the corporation to an unrelated buyer. Once a value has been established, the redemption can be funded with life insurance. The alternative is to gamble that the corporation will have sufficient assets to redeem the stock of the largest single shareholder at any time. The major concern would be that the IRS might find some grounds to argue that the redemption is not qualified under the provisions of section 303 and that the redemption is a fully taxable dividend to the estate or the heirs who have the stock. Vern Jacobs Copyright, 2003 |
Books and Services by Vern Jacobs
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