Stock Redemptions

Although dividends are taxable to noncorporate taxpayers at capital gains rates, the advantage of structuring the redemption properly is that you 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 approaches for doing this are to structure a redemption that satisfies either the “substantially disproportionate redemption” test or the “complete termination of interest” test, as described below. In contrast, if you do not satisfy either of these tests, everything you receive (without subtracting your basis in the stock that is redeemed) may (depending on whether the redemption otherwise qualifies as not “substantially equivalent to a dividend”) be taxable as a dividend (at capital gains rates).

The purpose behind the substantially disproportionate redemption and the complete termination of interest tests is 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. For a redemption to qualify as substantially disproportionate: (1) your interest after the redemption (in both all voting stock and all common stock) must be less than 80% of your interest before the redemption and (2) you must possess less than 50% of the voting power of all voting stock after the redemption. Thus, if you owned 50% of the only class of stock of the corporation before the redemption, the test is satisfied if, after the redemption, your interest is less than 40% (80% times 50%). (Note that the arithmetic can be tricky. If, for example, you started out with 50 of 100 shares of the corporation's only class of stock and twelve shares (24%) were redeemed, your interest would not be reduced below 80% of the original 50% interest, as required, because the number of shares outstanding would also be reduced, so that you would own 38 of 88 shares, or 43% of the outstanding shares.)

Even if a redemption reduces your interest below 80% of your pre-redemption interest (the first part of the test), you won't satisfy the second part of the test unless your voting stock is reduced to less than 50%. Thus, for example, if you owned 70% of the corporation's one class of stock and a redemption reduced your interest to 55% (i.e., less than 80% of the original interest) you still wouldn't satisfy the second (less than 50% of voting power) test.

In applying the tests for a substantially disproportionate redemption, attribution rules discussed below apply.

Complete Termination of Interest. A redemption is also treated as giving rise to a sale, rather than a dividend, if it completely terminates your interest in the corporation. Although at first blush this appears to be a more difficult test to satisfy than the substantially disproportionate redemption test, 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.)

The attribution rules. In determining how much stock is owned before and after a redemption, “attribution” rules apply. These treat a shareholder as owning shares owned by certain family members as well as entities in which the shareholder has an interest. Thus, even if your actual ownership is sufficiently reduced by a redemption to qualify under one of the safe-harbor tests, you may fail to qualify if shares owned by other persons or entities are attributed to you.

1. Family attribution. A shareholder is treated as owning shares held by his spouse, parents, children, and grandchildren. Note that neither siblings nor grandparents are on this list.

However, in applying the complete termination of interest test (but not the substantially disproportionate test) family attribution won't apply if immediately after the redemption you don't have any interest in the corporation as a shareholder, officer, director or employee. (You can, however, retain an interest solely as a creditor.) You must also not acquire such an interest within ten years of the redemption (other than by bequest or inheritance). In addition, you must agree to notify IRS if you acquire an interest, certain records must be kept, and a special limitations period applies. Also, if you have transferred stock to family members from whom the stock is attributable to you (e.g., to children) within ten years of the redemption, the attribution rules will not be eliminated if income tax avoidance was a principal purpose of the transfer. (IRS has generally ruled that the tax avoidance rule does not apply where the transfer relates to a shareholder's plan to retire and turn the business over to family members.)

2. Entity attribution. A shareholder is treated as owning shares owned by a partnership, S corporation, trust, or estate, in proportion to his 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.

3. Options. A person who owns an option to acquire stock (or a series of options) is treated as owning the stock.

4. Other rules. 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.

Nondeductibility of expenses. Keep in mind that no deduction is allowed to the corporation for 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.