SECTION F-027B5 - CORPORATE DISTRIBUTIONS TO SHAREHOLDERS Table Of Contents Table Of Contents... -1- Corporate Distributions To Shareholders... -2- Nonliquidating, nondividend corporate distributions to shareholders... -2- Share redemption and share purchase agreements (funded and unfunded)... -8- Partial liquidations of corporations and the resulting distributions to shareholders.... -28- Complete liquidations of corporations and the resulting distributions to shareholders.... -30- Copyright 1986 Through 2007, Professor Jegen s Taxsite F-027B5-CorporateDistributions -1-
Corporate Distributions To Shareholders I. Nonliquidating, nondividend corporate distributions to shareholders. Generally, funds which are distributed by a C corporation, with respect of the corporation's stock, to be treated as dividends by the recipient. A. If a distribution is to be treated as a dividend to a shareholder, then the distribution will not be reduced by the shareholder s adjusted basis for the shareholder s stock and the entire distribution will be treated as ordinary income to the recipient/shareholder. 1. A C corporation generally would prefer to receive a dividend from another corporation, rather than to receive a capital gain distribution, because a C corporation generally is entitled to a 70% dividend received income tax deduction. See IRC section 243. 2. However, certain transactions involving corporate distributions do not produce dividends to the recipient/shareholders, for example, complete liquidations under IRC section 331 and partial liquidations under IRC section 302(b)(4) and redemptions under IRC section 302(b)(1)-(3) and IRC section 303. a. These IRC sections provide that the recipient/shareholders are to receive capital gain or loss treatment, generally, long term. (1) That is, a shareholder may offset the adjusted basis of the shareholder s shares against the distribution and the remaining amount of the distribution is to be treated as capital gain to the shareholder. b. Unlike a complete liquidation, these IRC sections allow shareholders to receive funds from a corporation without terminating the corporation's life. c. Unlike both a partial liquidation and a complete corporation, these IRC sections generally do not require any dynamic activity at the corporate level. (1) That is, under IRC section 302(b)(1)-(3) and IRC section 303, the corporation does not have to, for example, substantially terminate part of the corporation's business activities in order to qualify the distribution for capital gain treatment. 3. Thus, the most used IRC sections to qualify distributions to shareholders as capital gain and to allow shareholders to offset the adjusted basis of the stock against the distributions which the shareholders receive for redemptions of the shareholders' stock are IRC section 302(b)(1)-(3) and IRC section 303. a. As a general rule, these three IRC sections provide that if stock is redeemed from a shareholder, the transaction may be treated as an exchange for the stock, and thus, the shareholder may be entitled to capital gain or loss treatment, which gain or loss is determined after the offsetting, by the shareholder, of the shareholder's adjusted basis of the shareholder's stock against the corporate distribution which the shareholder receives upon a redemption of the shareholder's stock by the corporation. 4. If a corporation distributes appreciated property to a shareholder as part of an IRC section 302(b)(1)-(3) or IRC section 303 redemption, then the corporation must recognize the gain. a. But if a corporation distributes depreciated property to the shareholder as part of an IRC section 302(b)(1)-(3) or IRC section 303 redemption, then IRC section 311(a) operates to deny recognition of the loss to the corporation. B. The difficulty, then, is to walk a narrow line between the situation in which a corporate distribution is treated as capital gain or loss and the situation in which the corporation might be said to be doing nothing more than distributing the corporation's everyday earnings, in which latter case, the distribution is to be treated as a dividend to the shareholders. 1. For example, if a corporation redeems stock from a shareholder for $50,000 and the transaction qualifies for treatment under IRC section 302(b)(1)-(3) or IRC section 303 as a nonliquidating corporate distribution, then the shareholder may apply the shareholder's adjusted basis (of, for example, $40,000) in determining the shareholder's gain of $10,000. 2. However, if the transaction does not qualify under these latter redemptions and is, instead, treated as a dividend, then the total distribution of $50,000 is a dividend (ordinary income). a. Although the shareholder's adjusted basis does not reduce the amount of the Professor Jegen, 09/01/03 F-027B4-CorporateDistributions -2-
shareholder's gain, the adjusted basis of the stock redeemed is added to the basis of the shareholder's remaining stock or to the stock of a related person or entity if the shareholder has no remaining stock. C. In general, IRC section 302 is designed to provide the same treatment to shareholders, who receive distributions from nonliquidating corporation, as these shareholders would receive if the shareholders had sold their stock to strangers, rather than to the corporation. 1. In fact, IRC section 302 is the primary IRC section, concerning corporate distributions in redemption of stock, for removing funds from a corporation, with capital gain or loss treatment to the shareholders, once the corporation has been operating at a profit for several years. 2. There are the following three primary paragraphs under which an individual shareholder might qualify a nonliquidating (to the corporation) distribution in redemption of stock under IRC section 302. a. The redemption is not essentially equivalent to a dividend - - - IRC section 302(b)(1). b. The distribution is substantially disproportionate with respect to the shareholder- - - IRC section 302(b)(2). (1) A distribution is substantially disproportionate if: (a) The shareholder owns less then 50% of the total combined voting power of the corporation immediately after redemption, (b) Immediately after the redemption the ratio of voting stock owned by the shareholder to all the voting stock of the corporation is less than 80% of the same ratio immediately before the redemption, (c) Immediately after the redemption the ratio of common stock owned by the shareholder to all of the common stock of the corporation is less then 80% of the same ratio immediately before the redemption (if more than one class of common stock outstanding determination made by reference to fair market value). (2) A series of distributions are treated as a single redemption in testing for the disproportionality of the redemption. c. The redemption completely terminates the shareholder's interest in the corporation's stock - - - IRC section 302(b)(3). d. And for determining whether or not IRC section 302(a) applies to a particular corporate distribution, IRC section 302 states that the rules of attribution (the constructive rules of ownership) under IRC section 318 apply to determine stock ownership for the purposes of IRC section 302. 3. The simplest way, in theory, for a shareholder to meet the tests of IRC section 302 is to have the redemption come within the scope of IRC section 302(b)(3), specifically, to have a complete redemption of the shareholder's stock in the corporation. a. The theory here is that if a shareholder is willing to part with all of the shareholder's interest in a corporation, which the shareholder could do by selling the shareholder's stock to another person (and thereby, receive capital gain treatment), then the shareholder should be allowed to obtain capital gain treatment by selling the stock directly to the corporation. b. Further, this shareholder could retain the shareholder's position as an employee, director, or officer with the corporation as long as no other stock is attributable to the shareholder from another shareholder. 4. In order to have a complete redemption of the shareholder's stock under (b)(3), the shareholder must, at least, part with all of the shareholder's own stock in the corporation. a. Further, as stated above, IRC section 302(c)(1) provides that the rules of attribution of IRC section 318 apply to all of the subsections of IRC section 302(b). (1) IRC section 318 specifically states that the rules of attribution under IRC section 318 will only apply to another IRC section if the other IRC section specifically states that IRC section 318 will apply. Professor Jegen, 09/01/03 F-027B4-CorporateDistributions -3-
(a) And, IRC section 302(c) specifically states that the rules of attribution of IRC section 318 are to apply to IRC section 302. (2) Therefore, unless one or more of the constructive rules of ownership are waived, as provided in IRC section 302(c), a shareholder is considered to own some or all of the shares (of the redeeming corporation), which shares are owned, in fact, by another shareholder. (a) For example, under the family rules of attribution under IRC section 318(a)(1), a shareholder (or former shareholder) is considered to own stock (in the redeeming corporation) which stock is owned, in fact, by any of the following individuals: the shareholder's spouse; the shareholder's children; the shareholder's grandchildren; and, the shareholder's parents. i) However, IRC section 302(c) states that the family rules of attribution (of IRC section 318(a)(1)) may be waived for IRC section 302(b)(3) purposes, but only for the purposes of an IRC section 302(b)(3) redemption. a) However, there are several conditions which are provided in IRC section 302(c) with respect to obtaining such waiver. (b) Also, a shareholder (or former shareholder) is, in general, considered to own stock which is owned by: a partnership (in which the shareholder is a partner); an S corporation; a C corporation (in which the shareholder owns 50% or more of the corporation's stock); or, a trust or an estate of which the shareholder is a beneficiary. i) In these cases, the number of shares which a partner owns in a partnership which owns shares in the corporation which is redeeming shares is determined by using the percent of income interest which the partner has in the partnership. ii) And, the number of shares which a 50% shareholder owns in a corporation which owns shares in the corporation which is redeeming shares is determined by using the percentage of shares which the shareholder owns in the corporation which owns shares in the redeeming corporation. iii) And, the number of shares which a beneficiary owns in a trust which owns shares in the corporation which is redeeming shares is determined by the beneficiary s actuarial interest in the trust, determined at the time of the redemption. iv) And, the number of shares which a beneficiary owns in an estate which owns shares in the corporation which is redeeming shares is determined by the beneficiary s ownership percentage of the estate s net assets, determined at the time of the redemption. (c) Also, stock which is owned by or for partners, 50% shareholders, and beneficiaries, is, in general, considered to be owned in full by the partnership, corporation, trust, or estate, respectively. (d) Further, a shareholder (or former shareholder) who has an option (may be stock options, stock rights, stock warrants, or convertible debt) to acquire stock is considered to own the optioned stock. i) This includes an option which is not exercisable until after the lapse of a fixed period of time. Professor Jegen, 09/01/03 F-027B4-CorporateDistributions -4-
(3) For example, if John owns 60% of the common shares of Corporation A and Corporation A owns 1,000 shares of Corporation B. (a) Then, under the corporate attribution rule, John constructively owns 600 shares of Corporation B. (b) Further, Mary also constructively owns 600 common shares of Corporation B due to the family rule attribution. (4) In applying the partnership rule of attribution, the partner's interest in the income is used. (a) Therefore, if Paul has a 40% income interest in Partnership P which owns 1,000 shares of Corporation B, then Paul constructively owns 400 shares of Corporation B. (5) If Peter is a 10% beneficiary of an estate and the estate owns 1,000 shares of Corporation A, then Peter constructively owns 100 shares of Corporation A. b. Stock which is constructively owned by a person is considered as actually owned under IRC section 318(a)(5)(A). (1) However, exceptions are provided in IRC section 318(a)(5)(B) and (C) so that such stock is not to be reattributed to the same type of person or entity. (a) That is, if Sue and Peter each own 100 shares, then John constructively owns 200 shares. (b) However, the stock of Sue which is attributed to John is not reattributed to Peter. (c) And, there is no attribution of stock between siblings. c. Again, one important aspect of these rules of attribution is that if a former shareholder is considered to own stock due to these rules, then, the former shareholder might not be considered to have had a complete redemption of the shareholder's stock, and thus, the former shareholder might not be considered to meet the requirement of IRC section 302(b)(3). (1) However, there are two major exceptions to the application of the IRC section 318 rules of attribution to an IRC section 302(b)(3) redemption. (a) The first exception is that if stock is attributed to the shareholder, is due to the family rules of attribution, then the shareholder might be able to waive the family rules of attribution. See IRC section (b) 302(c)(2). The second exception is that: an entity (estate, trust, partnership, or corporation) may waive the estate, trust, partnership, or corporation rules of attribution when the stock has been further attributed to the entity through a related person. d. Note again. The family rules of attribution may be waived, but only for the purposes of IRC section 302(b)(3), and these rules may only be waived if the strict tests of IRC section 302(c)(2) are met. (1) In order to waive the family rules of attribution, the following tests must be met. (2) In reading these tests, notice that there are three separate ten-year periods referred to. (a) After the redemption, the former shareholder must have no interest in the corporation; i) The term "interest" includes: owning stock; being an employee, director, or officer of the corporation; and probably, being a consultant of the corporation. ii) The term "interest" does not include the situation in which the former shareholder is a creditor of the corporation. a) Thus, for example, a shareholder may have the shareholder's stock in the corporation redeemed Professor Jegen, 09/01/03 F-027B4-CorporateDistributions -5-
(b) (c) (d) and have the redemption proceeds paid on the installment basis to the shareholder and have the family rules of attribution waived so as to qualify the shareholder's redemption proceeds as capital gain or capital loss (with a basis offset). There must be a signed agreement; i) In order to have an effective waiver, the shareholder must also file an agreement with the shareholder's federal income tax return for the year in which the distribution occurs, which agreement states that the shareholder will notify the IRS if the shareholder acquires a prohibited interest in the corporate shares within ten years. There is a ten-year forward-looking test. i) The shareholder from whom the redemption is made must not acquire an "interest" within ten years following the redemption. a) However, an acquisition of stock in the corporation by devise or inheritance is not prohibited. ii) That is, IRC section 302(c)(2)(A) provides that the family rules of attribution does not apply to an IRC section 302(b)(3) redemption if the shareholder (from whom the redemption is made) has no interest in the corporation for ten years after the redemption. There is a ten-year backward-looking test. i) The shareholder must not have acquired any part of the redeemed stock within ten years before the redemption from a person whose stock would have been attributed to the shareholder. a) In general, this prevents, for example, a father from giving the father's stock to the father's child, and then, having the corporation redeem the child's stock. b) And, in general, this prevents, for example, a mother from giving the mother s stock to the mother s child, and then, having the corporation redeem the mother s stock. c) However, these latter two situations might not cause problems if the reason for the transfer of stock is not to avoid income tax. D. IRC section 303 provides that the distribution of property to a shareholder by a corporation in redemption of stock that are included in determining the gross estate of a decedent is treated as a distribution in full payment in exchange for the stock so redeemed. 1. The redemption of the decedent's stock is eligible for treatment under IRC section 303 only if the following three conditions are met. a. The value of the redeeming corporation stock included in the estate must exceed 35% of the decedent's adjusted gross estate. b. The redemption distribution must take place after the decedent's death or within the period of limitation provided in IRC section 6501(a) or within 90 days of the expiration of such period. c. The redemption must be from a shareholder who must bear the burden of death taxes and expenses. (1) That is, the shareholder s interest must be reduced by any payment of death taxes or funeral and administration expenses. See IRC section 303(b)(3). Professor Jegen, 09/01/03 F-027B4-CorporateDistributions -6-
d. The capital gain treatment under this type of redemption is limited to the amount of estate, inheritance, legacy, and succession taxes (and interest thereon) and the amount of funeral and administration expenses which are allowable allowable as deductions to the estate. 2. IRC section 303 may be utilized by a decedent's estate despite having failed under IRC section 302 because of the rules of constructive ownership of stock provided by IRC section 318. a. IRC section 303 may be particularly beneficial to a decedent's estate if the stock is devised to someone other than the decedent's spouse in order to provide liquidity for the estate. II. Questions for you to answer. A. See each course examination for course DN648 and course DN869. Professor Jegen, 09/01/03 F-027B4-CorporateDistributions -7-
III. Share redemption and share purchase agreements (funded and unfunded). Simply stated, a share redemption agreement is an agreement between or among a corporation and one or more other persons (generally, shareholders of the corporation) which states, among other things, that the corporation will purchase some or all of the corporation s shares from one or more of the corporation s shareholders upon the happening of one or more events. These agreements are generally imperative for general removal of a shareholder from a corporation or for the retirement or disability or death of a shareholder. A. Generally, in a share redemption plan, each shareholder agrees that upon the shareholder s death, the shareholder will sell the shareholder s stock to the corporation and the corporation agrees to purchase (redeem) the shareholder s shares. 1. Thus, a corporation is a necessary party to a share redemption agreement and will normally purchase and own life insurance on the lives of the shareholders to fund such plan. 2. The death of a shareholder may not always be the event triggering the implementation of the plan. a. Often a shareholder will agree that the shareholder s retirement or disability may also be the triggering event. 3. Unlike a share purchase agreement, a share redemption agreement must meet certain state law requirements with respect to the corporation s obligation to redeem the corporation s shares. a. State laws generally allow corporations to redeem the corporation s shares only to the extent of the corporation s surplus. (1) The purpose of this limitation is to protect creditors of the corporation and employees and minority shareholders of the corporation. (2) If this limitation were not imposed, then corporate assets could be siphoned off in a partial or complete redemption of the stock of controlling or favored shareholders. (3) As a result of this limitation, specific performance by a corporation under a share redemption agreement might be unenforceable if there is insufficient surplus to legally make the share redemption. (4) This requirement could be a problem if a redemption is triggered in a newly organized corporation which has had little time to accumulate earned surplus. (5) This problem can be minimized by the purchase of life insurance which may assure that in the event a shareholder dies, the full amount of the redemption price is available from the life insurance proceeds. B. Simply stated, a share purchase agreement is an agreement between or among two or more persons (generally, shareholders of a corporation) which states, among other things, that one or more of such persons will purchase some or all of the corporation s shares from one or more of such persons upon the happening of one or more events. 1. Generally, the corporation which has issued the shares is a party to a share purchase agreement only for the purpose of assuring that the terms of the agreement are followed, for example, that the shares will be properly transferred on the corporation s shareholder records, that dividends will be paid to the proper person, and that the proper person is allowed to vote the shares which are subject to the share purchase agreement. 2. A share purchase agreement generally involves an agreement between or among the shareholders to purchase or have the option to purchase the stock of a shareholder upon the occurrence of one or more of the following events: the death of a shareholder; the retirement of a shareholder; and/or the disability of a shareholder. 3. In a share purchase plan, each shareholder agrees to purchase a proportionate number of the terminating shareholder's stock. a. The number of shares to be purchased is determined by the number of shares owned by the purchasing shareholder relative to the stock issued, excluding those shares of the terminating shareholder. b. Assume that the outstanding common shares of a corporation are owned as follows. (1) Shareholder Stock Owned Professor Jegen, 09/01/03 F-027B4-CorporateDistributions -8-
John 20 Peter 40 Beverly 40 (2) If Beverly dies, then John would be obligated to purchase 1/3 (20/60) of Beverly s shares and Peter would be obligated to purchase 2/3's (40/60) of Beverly s shares. c. Generally, each shareholder will be required to consent, as part of the share purchase agreement, that upon the happening of a particular event, the shareholder will sell the shareholder s shares to the other shareholders. d. Generally, to ensure that the share purchase agreement is implement at, for example, the death of a shareholder, the purchase agreement will require that each shareholder must acquire specific amounts of life insurance proceeds which insure the lives of the other shareholders in proportion to the shareholder's obligation to purchase the other shareholders shares. (1) For example, if the triggering event is to be the death of a shareholder, then John will acquire and own life insurance policies on the lives of Peter and Beverly. Peter will acquire and own life insurance policies on the lives of John and Beverly. Beverly will acquire and own life insurance on the lives of John and Peter. 4. If the corporation is not required to redeem any of the corporation s shares, then there is no concern about the amount of the corporation s surplus. 5. A problem which exclusively arises in a share purchase agreement involves the ownership by the insured of the life insurance policy which is on the shareholder's own life. a. If the insured shareholder dies owning the life insurance policy, then the proceeds of the life insurance policy would be paid to the shareholder's estate. b. This would destroy the share purchase agreement because there would be no life insurance funds available for other shareholders to purchase the stock from the deceased shareholder's estate. c. When it was over, the decedent's estate would have both the stock and the proceeds from the life insurance policy. C. For a variety of reasons, the corporation and all or some of the shareholders of the corporation may use both a share redemption agreement and a share purchase agreement. 1. For example, the purchasing shareholder or shareholders might not be able to acquire sufficient funds for the purpose of purchasing all of the shares which are required to be purchased unless the corporation redeems some of the shares from the shareholder who is to be terminated. 2. Also, a redemption of some of a deceased shareholder s shares from a decedent s estate might cause the distribution to the estate to be a dividend due to the provisions of IRC section 302 and IRC section 318. a. The combination of both a share redemption agreement and a share purchase agreement might avoid this problem by providing as follows. (1) The corporation is required to redeem stock from the decedent's estate to the extent permitted by IRC section 303, which provides that distributions to redeem stock are not dividends to the extent that the corporate distribution does not exceed the amount of the estate s: funeral expenses, administration expenses; death taxes; and, interest on such death taxes. (2) The remaining stock is required to be purchased by the surviving shareholders. D. Thus, the significant difference between a share redemption agreement and a share purchase agreement is the difference between who is obligated to purchase the stock - - - the corporation or one or more shareholders. 1. However, there are many similarities and other differences between share redemption and share purchase agreements and there are many reasons why these types of agreements should be made and there are many provisions which these agreements might or should contain. Professor Jegen, 09/01/03 F-027B4-CorporateDistributions -9-
2. Like any other type of purchase/sell agreement, both of these agreements generally (at a minimum) describe who the parties are, what is to be sold, when the sale is to be effective, what is to be the purchase price, and when and how the purchase price is to be paid. 3. Because of the potentially long term nature of such agreements, such agreements often contain clauses requiring the funding of the purchase price, as well as provisions for securing performance of the agreement. 4. Generally, both of these of agreements may be enforced by a decree of specific performance. a. That is, a defaulting party may be ordered by a court to complete the purchase or sale, because an award of monetary damages to the injured party would not be adequate compensation for the nonperformance of such agreements, because, for example, no other comparable stock may be purchased. 5. Generally, both of these agreements are made with shareholders who are also employees of the corporation. a. Thus, these shareholders have a very significant interest with respect to who are shareholders of the corporations, because the shareholders of the corporation determine who will be the directors of the corporation and the directors of the corporation determine who will be the officers of the corporation, etc., etc. (1) These agreements can prevent an undesirable and/or an unskilled person from becoming a shareholder in the corporation. (2) These agreements can bring about a continuity of the business enterprise and a continuity of the business activities. (3) In the case of an S corporation, these agreements can eliminate the risk that the S corporation election will be terminated because an unqualified shareholder becomes the owner of shares of the corporation. (a) For example, such agreements can prevent a trustee, who might be a disqualified owner of S corporation stock, from owning stock in an S corporation or another type of shareholder (who does not want to consent to the continuation of the S election) from owning shares in the S corporation. b. Under both agreements, a shareholder knows that - - - when the triggering event (for example, the shareholder s disability or retirement or death) occurs - - - the shareholder or the shareholder s personal representative is to be paid (then or on installments) for the shareholder s shares and the corporation and/or purchaser knows the same thing and both of these persons can prepare for that event. (1) Thus, these agreements can be of particular help to a shareholder s personal representative if the shareholder becomes disabled or dies. c. These agreements can be particularly beneficial to minority shareholders who might find it difficult to dispose of a minority interest in the corporation. d. These agreements can be of significant help to shareholders who wish to have orderly estate plans. 6. A share purchase arrangement which is funded with life insurance eliminates a possible corporate alternative minimum tax, because the purchase funds are not paid to the corporation. 7. In the event of the death of a shareholder, the surviving shareholders' bases of their shares is increased. a. However, with respect to a share redemption agreement, there is no cost basis increase in the survivor's shares. 8. If a life insurance policy is used to fund a share redemption agreement, then the proceeds of a share redemption agreement will be subject to the creditors of the corporation. 9. If a life insurance policy is used to fund a share redemption, then only one life insurance policy is needed to purchase each shareholder s shares. a. However, if a share purchase agreement is used, then several life insurance policies generally must be purchased. E. There are several methods which may be used in order to establish the price which is to be paid for Professor Jegen, 09/01/03 F-027B4-CorporateDistributions -10-
stock through a share redemption agreement and/or through a share purchase agreement. 1. And, when selecting the method, there are several things which should be kept in mind in order to minimize later disputes among the shareholders and the corporation. 2. A definite price may be agreed upon at the time when the agreement is executed and/or a formula may used which allows for subsequent changes in the value of the business. 3. In any event, in establishing a price to be paid for stock, the shareholders should select the price or adopt a technique for determining the price which is supported by existing commercial practices. a. It is generally best to obtain a written appraisal from an independent evaluator. 4. If the business is of a type with respect to which there are well-established commercial practices for valuing the business, then the shareholders and the corporation should stay within the range of those practices. 5. Under certain conditions, these agreements can establish the estate tax value of the stock. a. Normally, the estate tax value of stock upon the death of a decedent is the fair market value of the stock at the date of the decedent s death or at the alternate valuation date. See IRC section 2032. Also, see IRC section 2032A. b. Further, the basis of such stock to the decedent s estate or to a beneficiary of the decedent at the death of the decedent is normally equal to the fair market value of the stock at the death of the decedent (or at the alternate valuation date). See IRC section 1014. c. However, in order to freeze the basis of the stock at a lower value (for estate tax and basis (income tax purposes)), a share redemption or share purchase agreement must: (1) Be in writing. (2) Legally obligate the estate to sell the stock. (3) Legally obligate the purchaser, the corporation or the surviving shareholders, to purchase the stock or at least have an option to purchase the stock from the decedent's estate. (4) Restrict the shareholder's right to sell the stock during the shareholder's life, such as by inserting a requirement that the other shareholders have a right of first refusal. (a) In other words, the shareholder may not be free to sell to anyone to whom the shareholder chooses during the shareholder's life for a price which is higher than the price which is set as the purchase price at the death of the shareholder. (5) Establish an equitable and fair method for establishing the value of the stock (looking at the corporation s history and reasonable prospects in the future). d. In addition, the agreement must follow the special valuation provisions of IRC section 2701, IRC section 2702, IRC section 2703, and IRC section 2704 prior to entering into a "price freezing" agreement. (1) For example, IRC section 2704 provides that, in general, the value of any property is to be determined without regard to - - - (a) Any option, agreement, or other right to acquire or use the property at a price which is less than the fair market value of the property (without regard to such option, agreement, or right), or (b) Any restriction on the right to sell or use such property. e. However, these restrictions do not apply for the purposes of valuing an option, agreement, right, or restriction which meets certain requirements. (1) Specifically, the value of the property may be determined with respect to an option, agreement, right, or restriction which is present if the option, agreement, right, or restriction - - - (a) (b) Is a bona fide business arrangement; Is an arrangement which is not a device to transfer such property to members of the decedent's family for less than full and adequate Professor Jegen, 09/01/03 F-027B4-CorporateDistributions -11-
consideration in money or money's worth; and, (c) Has terms which are comparable to similar arrangements entered into by persons in an arms' length transaction. f. The agreement should be reasonable, all things considered and looking backward and forward, as of the date of agreement. g. If the estate is not obligated to sell the stock, but is merely required to offer the stock to the corporation or surviving shareholders if the estate chooses to sell under a right of first refusal, then the plan price does not necessarily establish the value of the stock for estate tax purposes because the estate has the option to keep the stock. F. Obviously, the method of funding either of these agreements is of great importance to both the shareholders and to the corporation. 1. For example, if the triggering event is the death of the shareholder, then the funding device is generally life insurance. a. For example, the payment of life insurance premiums and the payment of life insurance proceeds can have a significant impact with respect to the regular tax and the alternative minimum tax to the corporation and have a significant impact with respect to the regular tax to the shareholders. (1) Just consider the impact of the transfer for value provisions of IRC section 101 with respect to a share purchase agreement which is funded with life insurance policies. G. Special considerations must be taken into account when the triggering event is the disability or retirement of a shareholder. 1. At a minimum, the agreement should clearly state the definitions of the terms disability and retirement. a. If disability insurance coverage is used as the funding vehicle for a disability triggering event, then the agreement should incorporate the terms of the disability insurance agreement into the share redemption or share purchase agreement so that there is no unintentional conflict between the two agreements. b. And, if there is to be a delay in making payments which are to be made through a disability insurance policy, the corporation or shareholders might consider making the disability payments themselves during the period of the delayed insurance disability payments. 2. While life insurance proceeds can be available at the death of a shareholder, the same amount of funds might not be available upon the disability or retirement of a shareholder. a. However, either agreement could be funded to some extent with a whole-life insurance policy which accumulates a cash value as premiums are paid. b. But it may be that the purchaser should be required to set aside funds in some type of trust arrangement in anticipation of a shareholder electing to retire and these funds would have to be after-tax dollars. c. In any event, as a practical matter, the purchaser may have to pay the required amount to the seller by installments. H. The principal IRC sections pertaining to share redemption agreements are IRC section 302(b)(1)-(3) and IRC section 303 and these IRC sections are discussed in detail above. However, a few concepts with respect to IRC section 302 should be repeated here. 1. As a general rule, redemptions which qualify under IRC section 302 allow the shareholder to treat the transaction as an exchange of property which will result in capital gain or loss to the shareholder if the stock given up by the shareholder is a capital asset, which the stock generally will be unless the shareholder is a dealer of securities. a. Thus, the shareholder is entitled to offset the shareholder s adjusted basis for the shareholder s redeemed shares against the corporate distribution and any resulting gain or loss would be capital gain or loss. 2. If the redemption distribution does not qualify as an exchange, then a distribution by a C corporation will be a dividend distribution to the shareholder to the extent that the corporation has current or accumulated earnings and profits, in which case, the entire Professor Jegen, 09/01/03 F-027B4-CorporateDistributions -12-
distribution will be ordinary income with no offset by the adjusted basis of the shareholder s redeemed shares. 3. Often, IRC section 302(b)(3) is involved whether or not the triggering event is the death, retirement, or disability of a shareholder. 4. IRC section 302(b)(3) provides that a corporate distribution to the retiring or disabled shareholder or to the estate of a deceased shareholder will be treated as capital gain or loss to be offset against the adjusted basis of the stock (instead of as a dividend which is ordinary income with no basis offset to the shareholder) while still allowing the corporation to continue business without the shareholder s involvement. a. However, a redemption under IRC section 302(b)(3) requires the corporate distribution in exchange for the shareholder's stock to completely terminate that shareholder's interest in the corporation. b. The IRC section 302(b)(3) is based on the theory that if a shareholder is willing to completely relinquish the shareholder s interest in the corporation (which the shareholder could do by selling the shareholder s stock to another person and thereby still receive capital gain or loss treatment), then the shareholder should be allowed to obtain capital gain treatment by selling the stock directly to the corporation. 5. However, one problem with respect to share redemptions is that the rules of attribution of IRC section 318 are applicable to IRC section 302 redemption transactions, unless the attribution rules of IRC section 318 can be waived. a. For example, the family rules of attribution may prevent the shareholder from having all of the shareholder s shares (which the shareholder owns actually and constructively) from being redeemed by the corporation. b. If a beneficiary of an estate of a deceased shareholder owns any stock of the corporation, then unless the shares of the beneficiary are also redeemed along with the shares owned by the estate, then the amount distributed by the corporation in redemption of the stock owned by the estate may be considered to be a distribution of a dividend under IRC section 302 by virtue of the attribution rules in IRC section 318(a). c. Often, if an IRC section 302 redemption of shares is made from a decedent s estate, the estate will not have any gain or loss, because the estate acquires a fair market value date of death basis under IRC section 1014 which basis is equal to the amount of the redemption distribution. d. However, if a closely held family corporation is involved, whose shareholders are related by blood or marriage or who are beneficiaries of the estate, then the redemption distribution may be treated under IRC section 302 and IRC section 318 as a dividend to the decedent s estate. (1) And, this could produce a catastrophic income tax result the estate, because the basis of the stock might not be able to be used to offset the redemption distribution. e. If a share redemption agreement does not involve closely related family shareholders, then it is not likely that IRC section 302 or IRC section 318 problems will be encountered. f. Further, because the rules of IRC section 302 and IRC section 318 apply only to a redemption by the corporation of the corporation s own stock, the IRC section 318 rules of attribution have no application to a share purchase agreement. (1) Therefore, a share purchase agreement between a parent and children would present no dividend problem even if the purchase of the shares of the parent were made by the children from the parent s estate. g. The failure to receive capital gain treatment under IRC section 302 is not totally disastrous. (1) The surviving shareholders, whose relationship with the decedent defeated the IRC section 302 redemption, might still be in control of the corporation. Professor Jegen, 09/01/03 F-027B4-CorporateDistributions -13-
(2) The decedent's basis in the stock is not destroyed, but the use of the basis is deferred until all earnings and profits are distributed as dividends. I. The effect on the shareholders through a share purchase agreement may differ from the effect on the corporation under a share redemption agreement. 1. Of course, the purchase price paid for the stock of a selling shareholder is not deductible for income tax purposes by the purchaser, whether or not the purchase is made by shareholders or the corporation, because the purchase or redemption is a capital expenditure and not the payment of an expense. 2. Under a share purchase agreement, the purchasing shareholders each receive a basis for their purchased stock which is equal to the cost of the stock. a. Thus, each purchasing shareholder obtains additional shares with a basis equal to the purchase price and all other stock previously owned by the shareholder retains their existing basis. 3. Under a share redemption agreement, there is no increase in the basis of stock to the remaining or surviving shareholders due to the stock redeemed by the corporation. a. Further, the stock redeemed by the corporation under a share redemption agreement does not cause the remaining or surviving shareholders increased proportionate interests in the corporation to be income taxed to the shareholders as a dividend, unless the shareholders have an obligation to purchase the stock which was satisfied by the corporation or unless the shareholders acquire the stock. b. Assume that John and Paul each own 50 common shares of Snappy Corporation, a C corporation, and that John and Paul each has an adjusted basis for their common shares of $10,000. Then, John dies and B, due to a share purchase agreement, purchases from John's executor John's 50 common shares for $60,000, which was 50% of the fair market value of Snappy Corporation at John s death and the adjusted basis of the estate s common shares. (1) At this point, if Paul wanted to liquidate Paul's interest in the corporation, Paul's cost basis for all of Paul s common shares would be $70,000 and Paul would receive value from the corporation of $120,000 and Paul would have capital gain of $50,000. c. Under a share redemption agreement, the result is different for the surviving shareholder. (1) At John's death, the corporation would use the life insurance proceeds to purchase the stock from John's estate for $60,000. (2) The value of the corporation after this transaction would be $120,000. (3) Paul would retain a basis of Paul s stock of $10,000 and if Paul liquidated the corporation, then Paul would have capital gain of $110,000. d. However, if the redemption is funded with life insurance, then with respect to an S corporation, when the S corporation receives the life insurance proceeds, the then shareholders (including the estate of the decedent shareholder) would have the bases of their shares increased, pro rata, by the receipt of the life insurance proceeds by the S corporation. J. Under either a share redemption agreement or a share purchase agreement, which is triggered by the death of a shareholder, if the corporation has certain passive activity losses, then the decedent shareholder's estate is permitted to deduct the suspended losses. 1. In the event of the death of a shareholder who has suspended passive activity losses or passive activity loss carryforwards from former years, the losses are deductible to a certain extent. 2. The passive loss is extinguished to the extent that the decedent shareholders' basis in the stock of the corporation is stepped up at death. 3. Any remaining passive activity loss is then fully deductible on the decedent's final income tax return under the rule for a fully taxable disposition. See IRC section 469(g)(2). 4. For example, if a shareholder dies owning stock in a corporation which stock is valued at the date of the decedent shareholder s death at $20,000 and if the shareholder has passive Professor Jegen, 09/01/03 F-027B4-CorporateDistributions -14-
activity losses which total $50,000 and are attributable to the stock, then the rules of IRC section 469 apply as follows. a. The decedent loses the benefit of $20,000 of the suspended passive activity loss which is extinguished because of the death basis of the stock. b. The remaining suspended passive activity loss of $30,000 is permitted as an income tax deduction on the decedent's final income tax return. 5. If possible, a shareholder, in a corporation which engages in passive activities, should attempt to maintain a relatively high adjusted basis in the shareholder's stock in order to avoid losing the benefit of any suspended passive activity losses at the shareholder s death. K. As indicated above, the method of funding both types of these agreements is of great importance to the shareholders and employees of a corporation, particularly, in the case of a closely held family corporation, because, in such a case, the shareholders are generally employees of the corporation. 1. For example, if the triggering event is the death of the shareholder, then the funding device is generally life insurance and there are significant income tax advantages to the corporation and the shareholders if life insurance is used to fund these agreements. 2. If life insurance is the funding vehicle, then a share redemption agreement has the virtue of being relatively simple to administer, because the corporation applies for, owns, and is the beneficiary of a life insurance policy on the life of each shareholder. 3. There are usually only as many policies as there are shareholders covered by the share redemption agreement. 4. A share redemption agreement provides an easy and reliable way for shareholders to determine whether or not life insurance premiums are being paid (and, if not, to do something about it) because there is just one owner of all the life insurance policies. 5. If the redemption is made by an S corporation and the redemption is funded with life insurance, then when the S corporation receives the life insurance proceeds, the then shareholders (including the estate of the decedent shareholder) will have the bases of their shares increased, pro rata, by the receipt of the life insurance proceeds by the S corporation. 6. A disadvantage of a share purchase agreement is the number of life insurance policies which are needed to fully fund the share purchase agreement. That is, this is a disadvantage to everyone but the life insurance company and the agent who is able to sell the life insurance policies. a. Each shareholder is required to carry life insurance policies on all the other shareholders and as the number of shareholders increases, the number of life insurance policies needed increases geometrically. b. For example, for two shareholders, two policies; three shareholders, six policies; 25 shareholders, 600 policies. c. The calculation is made by multiplying the number of shareholders times that number less one (N x (N-1)) to obtain the required number of insurance policies in a share purchase agreement. d. Although there is no limit on the number of shareholders who may utilize a share purchase agreement, any plan with more than five or six shareholders is cumbersome and probably should be avoided unless there are compelling reasons to the contrary. 7. Another possible drawback of a share purchase agreement is the practical problem of each shareholder's ability, or inability, to pay the premiums required on the shareholder's policies from year to year. a. Of course, the corporation could pay additional salary or dividends to a shareholder so that the shareholder could pay the premiums, but if this is undesirable, a solution might be to utilize term insurance for the funding. 8. Further, a share purchase agreement does not provide an easy way for a shareholder to confirm that the life insurance premiums are being paid by the other shareholders. a. Therefore, such shareholders must inquire of each other to confirm that the terms of the share purchase agreement are being complied with by all shareholders. (1) Generally, a share purchase agreement will require the life insurance Professor Jegen, 09/01/03 F-027B4-CorporateDistributions -15-