Using Stock Redemptions to Create Liquidity for C Corporation Owners
Shareholders of closely-held C Corporations often find themselves in a tax dilemma when it comes to creating liquidity from their investment. Generally, the shareholder is compensated for work performed (Ordinary income to the shareholder) or for risk taken and paid in the form of dividends. Compensating a shareholder has many tax considerations that are not covered in this post. For dividends, the issue is double taxation whereby the corporation is not allowed to deduct the dividend from taxable income and the shareholder is taxed on the dividend received. By limiting the deduction of the dividend at the corporate level and taxing the recipients of the dividend, any dividends paid are subject to taxation at the corporate and individual levels. This double taxation can push the combined effective federal tax rate to over 60%. Based on this, you can see why S Corporation status has become the standard for small to medium size businesses. However, there are many small to medium size C Corporations that continue to exist today.
Stock redemptions can be structured in a manner that lets shareholders take cash out of the corporation while minimizing the tax cost. While dividends are taxable to non-corporate taxpayers at capital gains rates, the advantage of property structuring a stock redemption is that shareholders are only taxed on the “gain,” i.e., you are not taxed on the portion of the cash attributable to your basis in the redeemed stock. The safest two approaches to structure a redemption are Substantially Disproportionate Redemptions and Complete Termination of Interests, as described below. If the redemption cannot be structured as describe below, it may be taxable as a dividend, defeating the purpose of the stock redemption.
The substantially disproportionate redemption and the complete termination of interest tests are designed to provide safe-harbors for redemptions where the shareholder who receives cash from the corporation has a meaningful decrease in his or her stock ownership in the corporation.
Substantially Disproportionate Redemptions
To qualify as substantially disproportionate redemption,
The shareholder’s interest after the redemption (in both all voting stock and all common stock) must be less than 80% of their interest before the redemption, and
the shareholder must possess less than 50% of the voting power of all voting stock after the redemption.
Thus, if a shareholder owned 50% of the only class of stock of the corporation before the redemption, the test is satisfied if their interest is less than 40% (80% times 50%) after the redemption,.
Keep in mind that when computing the ownership percentages, you must take into account the reduction in total share outstanding after the contemplated redemption.
Also, the attribution rules discussed below apply and should be evaluated before structuring a stock redemption.
Complete Termination of Interest
If the redemption completely terminates your interest in the corporation it treated as giving rise to a sale, rather than a dividend. The requirements for a complete termination can be satisfied by a waiver of family attribution, as described below, however, other attribution rules are not waived.
Attribution rules apply when determining how much stock is owned before and after a redemption. These attribution rules treat a shareholder as owning shares owned by certain family members as well as entities in which the shareholder has an interest. Thus, even when a shareholder’s actual ownership is sufficiently reduced by a redemption to qualify under one of the safe-harbor tests, the redemption may fail to qualify if shares owned by other persons or entities are attributed to the shareholder.
A shareholder is treated as owning shares held by his spouse, parents, children, and grandchildren, but not those held by siblings nor grandparents.
However, in applying the complete termination of interest test, family attribution do not apply if immediately after the redemption the shareholder does not have any interest in the corporation as a shareholder, officer, director or employee. The redeeming shareholder can retain an interest solely as a creditor. The redeeming shareholder must also not acquire such an interest within ten years of the redemption (other than by bequest or inheritance).
Keep in mind that if redeeming shareholders must notify the IRS if they acquire shares within the ten year window by bequest or inheritance. Also, if the redeeming shareholder transferred shares to family members within ten years of redemption, the IRS may challenge the validity of the redemption on the basis of tax avoidance. In these situations, make sure that you document and support the business reason for the transfers such as retirement or overall plan to transfer the business to family members.
Shareholders are treated as owning shares owned by a partnership, S corporation, trust, or estate, in proportion to his or her interest in the entity. Stock is also attributed through a regular (“C”) corporation if 50% or more of its stock is owned directly or indirectly by (or for) the shareholder.
A person who owns an option to acquire stock (or a series of options) is treated as owning the stock.
Stock owned by reason of applying one attribution rule may, under certain circumstances, be treated as actually owned for purposes of applying another attribution rule.
Non-deductibility of Expenses
Corporations cannot deduct any amount paid or incurred in connection with the reacquisition of its stock or the stock of any related person. This includes transactions treated as redemptions. However, interest and other fees on debt incurred to finance the redemption are deductible.
Stock redemptions can be a tax effective way for shareholders to liquidate a portion or complete interests in a C Corporation.
Partial redemptions must take attribution rules into account and be structured to satisfy the Substantially Disproportionate Redemptions rules.
Complete Terminations of Interests are in effect a sale of the shareholder’s stock and also must consider the attribution rules as well as other restrictions that may be reviewed by the IRS.
Before executing a stock redemption, consult with a qualified tax professional to structure the transaction properly and avoid issues.