Tax Planning Shareholder Succession


Items to consider in planning a company buyback or a dividend

When a company repurchases its stock under §302 it is accounted for as a capital asset disposition and is viewed as a sale or exchange for tax purposes. The proceeds from the transaction offset the stock’s adjusted basis. The selling shareholder will recognize gain or loss in an amount equal to the difference between the amount received for the redeemed shares and the adjusted basis in such shares. Capital gain treatment may also be advantageous in that capital gains can be fully offset by capital losses and capital loss carry forwards.

Under the current tax regime long-term capital gains and qualified dividends have the same tax rate; a maximum of 23.8% comprised of 20% gain rate and net investment income tax of 3.8%. The “serendipity” of the same rates needs more analysis.

The distinction to make in considering sale treatment is the “power of basis” in the shares redeemed. Redemption treatment may be considerably more advantageous than dividend treatment, when basis is considered. Another tax planning point is that some dividends are not qualified dividends and may be taxed at the maximum ordinary income rate of 39.6%.

Not Essentially Equivalent to Dividends

There are a few ways corporate redemptions can be contemplated for tax planning. There are two tests in §302 that have been delineated in the Code and the Regulations, thus presenting no real problems of interpretation or application. 302(b) (2) Substantially disproportionate redemption of stock and 302(b) (3) Termination of shareholder’s interest have stringent requirements to qualify.

Sometimes tax planning needs to use the “Lower Road”, after discovering the fact, that for whatever reason a transaction does not qualify as under the two tests above; there is still another tax planning opportunity to make a stock redemption. The legal authority that guides how to affect this type of transaction is not as well described in the law, however it can be structured so that it is likely a transaction will qualify as a redemption under 302(b) (1) and not be equivalent to dividends.

The analytical standard that allows a taxpayer to qualify under 302(b) (1) is known as a “meaningful reduction.” This standard to will qualify under 302(b) (1) is similar to 302(b) (2) however the requirements are a little less stringent. Even though 302(b) (1) is less stringent, the regulations are not that concise, § 1.302-2(b) states “the facts and circumstances of each case.” Meeting well delineated numerical tests in 302(b) (2) and 302(b) (3) is a preferred method to make a transaction qualify as a redemption; rather than depending on the facts and circumstances.

The influential case concerning 302(b) (1) is United States v. Davis 397 U.S. 301 (1970). The Supreme Court established the requirement of a “meaningful reduction” as the requirement. A business purpose is not a requirement for a redemption to qualify under 302(b) (1). The opinion in this case states, “Regardless of business purpose, a redemption is always “essentially equivalent to a dividend” within the meaning of § 302(b) (1) if it does not change the shareholder’s proportionate interest in the corporation. Since taxpayer here (after application of the attribution rules) was the corporation’s sole shareholder both before and after the redemption, he did not qualify for capital gains treatment under that test.”1

A meaningful reduction concentrates on proportionate interest. “Rather, to qualify for preferred treatment under that section, a redemption must result in a meaningful reduction of the shareholder’s proportionate interest in the corporation.”2

The Service and the courts mostly focus on control to satisfy the standard of § 302(b) (1). The end product of this standard is a concentration on the percentage of ownership.

It is worth noting that there are several citations where percentage of ownership is not the main factor. In Wright v. U.S, 482 F2d 600, the taxpayer successfully argued that a redemption can still leave a shareholder in control. The Eighth Circuit ruled that a redemption which resulted in a reduction in voting power from 85% to 61.7% was meaningful where 66.67% of the voting power was needed to approve major corporate decisions.

A meaningful reduction was also accomplished when the redeemed shareholder was considered to own stock under §318 family attribution rules. In Rev Rul. 75-512 the shareholder had no power to control the corporation before or after the redemption, either alone or by acting in concert with other minority shareholders.

The meaningful reduction requirement is a more watered-down version of the same concept applicable to substantially disproportionate redemptions. Not Essentially Equivalent to Dividend is not a hot issue with the IRS right now however; the issue has been hotly contested in the past. In the event that a transaction needs to rely on § 302(b) (1) think beyond the basic percentage control.

Please contact the author for any tax planning questions. We appreciate this opportunity to help.

1. United States v. Davis 397 U.S. 301 (1970)

2. United States v. Davis 397 U.S. 301 (1970)