“Sale or Exchange” or “Distribution”
There are two ways that a Subchapter S corporation shareholder can dispose of his stock in the company: sell it to another person or sell it back to the company. The latter transaction, known as a stock redemption for tax purposes, is often the more common method of disposition in the S corporation context. Section 302 of the Internal Revenue Code (IRC) governs a corporation’s stock redemptions. This section considers a redemption to be either a “sale or exchange” or a “distribution,” and, depending on the form applied to the transaction, it will have different tax consequences to the taxpayer as well as the company.
Under IRC Section 302, for a redemption to be treated as a “sale or exchange,” the transaction must meet at least one of the following three tests: (1) the transaction must result in a complete redemption of all of the S corporation stock owned by the selling shareholder (the “complete redemption test”); (2) immediately after the redemption, the selling shareholder must own less than 50% of the total voting power of the company and the percentage of the company’s voting stock owned by the selling shareholder immediately after the redemption must be less than 80% of the company’s total voting stock owned by the shareholder immediately prior to the redemption (the “substantially disproportionate test”); or (3) the redemption is not essentially equivalent to a dividend (the “not essentially equivalent to a dividend test”). For purposes of these three tests, ownership will include the shareholder’s direct, indirect and constructive ownership of the company’s stock. Constructive ownership is determined based on the “attribution rules” discussed below. In general, if a selling shareholder transfers 100% of his stock to the company, he will meet one of these tests unless he is deemed to own shares of company stock under the “attribution rules” described below. The “not essentially equivalent to a dividend” test is based on all facts and circumstances surrounding the redemption. In general, to meet this test the shareholder must be able to demonstrate a “meaningful reduction” in his proportionate ownership of the company based on all facts and circumstances. The Internal Revenue Service has indicated in published rulings that a minority shareholder whose relative interest in the company is minimal (i.e., less than 1%) and who exercises no control with respect to the corporate affairs would generally be considered to have a meaningful reduction upon his sale of some of his shares back to the company.
If the selling shareholder meets at least one of the tests under IRC Section 302, the disposition of his stock will be treated as a “sale or exchange,” and the taxpayer will report the sale just as if it were a sale to a third-party individual. In that case, the selling shareholder will recognize gain or loss in an amount equal to the difference between the amount received for his redeemed shares and his tax basis in such shares. This gain or loss will be capital gain or loss provided that the shareholder had held these shares as a capital asset.
If, on the other hand, a selling shareholder does not meet the tests noted above, the redemption price paid by the company will be treated as if a distribution was made to the shareholder. If the company is a C corporation, the distribution will be taxed as a dividend to the shareholder to the extent of the company’s undistributed earnings and profits. However, this may not be the case with a Subchapter S corporation. The taxability of an S corporation distribution depends on several factors. Moreover, the transaction could be tax-free to the shareholder.
For an S corporation that was formerly a C corporation, if the corporation has accumulated earnings and profits (E&P) from its prior C corporation years, the taxability of a distribution paid on the redemption of a shareholder’s stock will depend on the amount that the company has in its Accumulated Adjustments Account (AAA) and the adjusted tax basis of the selling shareholder. The AAA is the accumulated but undistributed net profits from the years the company has been an S corporation. A distribution to a selling shareholder of an S corporation will be tax-free to the shareholder to the extent that the amount of the distribution does not exceed either the shareholder’s tax basis or the amount of the company’s AAA. If the distribution to the selling shareholder exceeds the shareholder’s tax basis but not the company’s AAA, then the excess is treated as a capital gain from the sale of the stock to the extent of the AAA. If the distribution to the selling shareholder exceeds the company’s AAA, the excess is taxed as a regular dividend to the extent of E&P from prior C corporation years. Most dividends (as opposed to distributions) paid by an S corporation will be treated as “qualifying dividends” subject to the current maximum federal income tax rate of 15%. To the extent the distribution exceeds the amount of the company’s E&P from prior C corporation years, then the excess will be treated first as a tax-free return of any remaining portion of the shareholder’s tax basis in his stock and then as capital gain. If the S corporation has no undistributed E&P from prior C corporation years, then the distribution will be treated first as a tax-free return of the selling shareholder’s tax basis and then as capital gain.
For purposes of determining whether a selling shareholder meets one of the tests set forth in IRC Section 302, a selling shareholder will be deemed to “constructively” own company shares under the attribution rules of IRC Section 318. In general, the attribution rules treat a shareholder as owning: (a) shares of stock owned by certain relatives, related corporations, partnerships, estates or trusts, and (b) shares of stock the shareholder has an option to acquire. When the attribution rules apply, a selling shareholder may be “deemed” to own shares actually held by another shareholder who is a lineal descendant, even if the selling shareholder owns no shares in his own right. If a shareholder would have met the complete redemption test except for attribution from a family member, then the shareholder can waive that family attribution and qualify the transaction as a complete redemption if all of the following requirements are met:
- immediately after the redemption, the selling shareholder has no interest in the company (including as a director, officer or employee), other than as a creditor;
- the selling shareholder does not acquire any such interest (other than stock acquired by bequest or inheritance) within 10 years of the redemption;
- the selling shareholder files an agreement to notify the Internal Revenue Service (IRS) of any acquisition described in item 2 above and retains records as may be required by the IRS (i.e., copies of income tax returns and any other records indicating fully the amount of tax that would have been payable had the redemption been treated as a dividend);
- if the selling shareholder acquires such an interest in the company (other than by bequest or inheritance) within 10 years from the redemption, then the statute of limitations to assess a deficiency ends one year after the shareholder notifies the IRS of the acquisition;
- the selling shareholder did not make any tax avoidance dispositions of any stock in the company in the 10 years before redemption to a person who still owns the stock at the time of distribution and whose ownership is attributable to the selling shareholder; and
- the selling shareholder did not make any tax avoidance acquisitions of any part of the redeemed stock in the 10 years before the redemption from a person whose ownership of the stock would be attributable to the selling shareholder.
In order for the above waiver to be effective, the selling shareholder must file the agreement to notify the IRS of any acquisition within 10 years of the redemption as part of the shareholder’s return for the year of the distribution, unless the shareholder can show reasonable cause why this could not be done. In such case, the shareholder may be granted an extension of time to file the waiver and requisite agreement. Sale Versus Distribution
If a redemption is made by a C corporation, the selling shareholder generally prefers the “sale or exchange” tax treatment noted above. If the redemption is treated as a “distribution” in such case, none of the redemption price is allowed to be offset by the shareholder’s basis in his stock.
In the S corporation context, however, this is not always the case. See the example below.
Peter owns 40% of the S corporation’s 1,000 shares of outstanding common stock, or a total of 400 shares of the company’s common stock, which he has owned for several years. His basis in those shares is $4,000,000, or $10,000 a share. The company has no other shares outstanding and has no accumulated earnings and profits. Peter is not an officer, director or employee of the company and has no relatives who have any interest in the company. Peter sells 100 shares of his company common stock back to the company for $1,500,000, or $15,000 a share.
After the redemption, Peter will own 30% of the 900 shares of remaining company stock outstanding, so he meets the substantially disproportionate test of IRC Section 302. Peter meets the first part of this test because he owns less than 50% of the voting stock after the redemption, and he meets the second part of this test because, after the redemption, he will hold less than 80% of the stock he held before the redemption. (Peter owned 400 shares before the redemption and 300 shares after; 80% of 400 shares is 320 shares.)
The redemption would, therefore, be treated as a “sale or exchange,” and Peter would realize a capital gain in the transaction. Peter’s adjusted basis of $10,000 per share or $1,000,000 in the aggregate in the stock that he sold back to the company would result in a long-term capital gain to Peter of $500,000, which at today’s capital gains rate would be taxed at the long-term capital gains rate (currently 15%) as he had held the redeemed shares for more than one year.
If, however, the company had redeemed only 50 of Peter’s 400 shares for $15,000 a share, he would not have met the substantially disproportionate test because his ownership of company voting stock would not have been reduced by 20% over his prior ownership. Peter may argue that the reduction should be treated as a “meaningful reduction” in his ownership, but if he was active in the company, this could be a difficult argument. If Peter is unable to convince the IRS that the reduction from being a 40% to a 30% owner is a meaningful reduction, then he may be deemed to have received a “distribution.” As the company did not have any accumulated earnings and profits, Peter would compare the $750,000 distribution paid to him for his shares to his $4,000,000 basis in the stock, and all of the $750,000 paid to him in the redemption would be tax-free. Peter’s basis in the remaining shares would now only be $3,250,000.
Redemption Using a Note
If the S corporation gives the shareholder a note for part of the purchase price it pays for the shares it is redeeming, this could have a distinct impact on the tax treatment of the transaction. If the redemption is taxed as a “sale or exchange,” the selling shareholder can defer reporting the gain on the sale until the sales proceeds are received.
If, on the other hand, the redemption is treated as a “distribution,” the shareholder cannot defer the realization of the consideration for tax purposes. Rather, the shareholder will report the cash and the fair market value of the note received as a current year distribution. The fair market value of the note typically will equal its face amount, assuming it bears a reasonable interest rate and there is no reasonable basis for questioning the likelihood of repayment.
It should be noted that the company’s interest expense on the note used to redeem the shares may not necessarily be deductible as an ordinary expense. The treatment of the interest payments for tax purposes will depend on the types of assets held by the S corporation.
Effect of Redemption on AAA
The S corporation rules require that an S corporation reduce its AAA by the percentage of stock redeemed. Thus, if 10% of the company’s stock is purchased by the company, the AAA should be reduced by 10% (through line 5, Other Adjustments). Companies often fail to make this adjustment, which results in an overstatement of the AAA balance. Because S corporation distributions must come out of the AAA to be tax-free, if the AAA is overstated, in an audit, this could come back to harm the S corporation, particularly if the company has paid significant distributions that could be recast as taxable dividends.
Another adjustment that is often missed is the adjustment to the company’s E&P for stock redemptions. Under Section 312(n)(7) of the IRC, like the AAA, E&P should also be reduced by the percentage of stock redeemed. Failure to reduce E&P results in an overstated balance in the company’s prior C corporation’s earnings, with the potential of subjecting future distributions by the company to taxation when they should not be.
In conclusion, whenever an S corporation is considering a purchase of its shares from a shareholder, it is important to be mindful of the redemption rules in the IRC to determine how the transaction should be treated for tax purposes by the selling shareholder and the resulting impact on the S corporation.