As part of the tax planning process, business owners looking to sell their S corporation first need to establish whether they are selling the stock or the assets of the business. What is the difference from a tax perspective? An asset sale will involve assigning each business asset to an asset “class,” which then determines your tax liabilities or deductions. A stock sale only involves selling shares of the S corporation—this typically results in long-term capital gains and comes with unique opportunities for seeking tax advantages.
When stock is involved, the second question to ask is whether we are dealing with a stock redemption, which occurs when the company itself buys the stock back from the shareholder. Stock redemptions can come with a tax advantage—the main factor is whether the redemption is considered a sale or exchange or whether it is considered a dividend. To understand the difference, we will need to compare two sections in the Internal Revenue Code (IRC): §302 and §301, which cover distributions in redemption of stock and distributions of property, respectively.
Section 302 of the tax code says that a “distribution in redemption of stock” is considered (and taxed as) a sale or exchange when one of these four situations is true:
- The redemption is not essentially equivalent to a dividend
- The redemption is substantially disproportionate
- The redemption completely terminates the shareholder’s interest, or
- The redemption is in partial liquidation of the redeeming corporation
Before looking more closely at each of these four tests, let’s establish why they are important. If a redemption fails one of these four tests, it would not be considered a §302 distribution and would automatically default to being treated as a §301 distribution instead. This is where the tax strategy comes into play—for qualifying companies, §301 distributions can be tax-exempt as long as the amount does not exceed the corporation’s AAA (accumulated adjustments account) balance. The AAA balance is the undistributed net income of the S corporation.
Now, the tax code lays out a number of rules that will affect whether a company can qualify for this exemption (as explained in IRC § 1368). Most taxpayers will want to consult a Certified Tax Planner to determine if they could be eligible for this tax strategy, but the key takeaway is that a significant tax benefit is available for §301 distributions. Again, to qualify as a §301 distribution, your redemption simply cannot be a §302 distribution. Therefore, if you can fail one of the four § 302 tests, your redemption may be eligible for tax exemption.
To review, let’s look at each of the four §302 tests again:
First, if the redemption is a type of a dividend, it will fail the §302 test. A Certified Tax Planner can help you determine whether this is the case by looking at the company’s history of paying out shares of its profit and compare this to your current stock redemption agreement.
Secondly, the redemption will fail the §302 test if it is not substantially disproportionate. An imbalance might occur if someone is leaving the company, but the other shareholders are not participating.
Third, the redemption must not completely terminate the shareholder’s interests. To fail this test, the seller needs to remain holding at least one share of stock. This is the trickiest test to fail because the rules do not clarify how long you need to hold onto the share to maintain your interest in the company. Is it a day, a year, or more than a year? From a tax perspective, the seller needs to maintain partial interest in order to have a qualifying §301 stock.
Lastly, the redemption cannot result in a partial liquidation—-in other words, the S corporation cannot be operating on a plan to recollect stock in order to liquidate the whole company. One way to guard against this when selling your business is to first set up a redemption of stock for yourself. Again, you will want to hold onto at least one share. Then, by doing the redemption prior to the sale of your business, that redemption could qualify as a §301 distribution and be non-taxable. So for example, if you have a business partner who is going to take over your shares when you retire, you could possibly treat that as a redemption of shares and follow the steps above to maximize your tax benefits.
To fully assess your tax planning options for an S corporation or other stock sale, reach out to Certified Tax Planner today!