As a tax planner, when a client approaches you about selling their S corporation, one of the first questions to ask is whether they are selling the stock or the assets of the business. What is the difference from a tax perspective? An asset sale requires you to allocate the assets into different classes, which then determines your tax liabilities or deductions. A stock sale, on the other hand, 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. A redemption can be used as a tax mitigation strategy depending on whether it qualifies as a sale or exchange or whether it would be characterized and taxed as a dividend. To delve into the distinctions, you can reference sections 301 and 302 of the Internal Revenue Code (IRC).
IRC §302 says that a “distribution in redemption of stock” is treated 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
If none of these four conditions are present, then the redemption would not be considered a sale or exchange. If the redemption is not a §302 distribution, it instead defaults to a §301 distribution, which is subject to the ordering rules laid out by IRC §1368. For qualifying companies, stock redeemed under §301 will be non-taxable as long as the distribution does not exceed the corporation’s accumulated adjustments account (AAA) balance. The AAA balance amounts to the undistributed net income of the S corporation.
So if your company has an AAA balance remaining after the redemption, your §301 distributions could be non-taxable. This points to a key tax strategy—to see if your stock redemption could qualify as a §301 distribution. Again, to qualify as a §301 distribution, your redemption simply cannot be a §302 distribution. Therefore, the goal is to fail one of the four §302 tests to potentially make your redemption eligible for tax exemption.
To break this down, let’s look at each of the four §302 tests one at a time:
First, if the redemption is a type of a dividend, it will fail the §302 test. You will want to seek more information on whether the company has a history of paying out shares of its profit according to a set formula or whether each partner receives the same amount and compare this to your current stock redemption agreement.
Secondly, the redemption will fail the §302 test if it is not substantially disproportionate. The redemption may be disproportionate if someone is leaving the company, but the other shareholders are not participating in the exchange.
Third, the redemption must not completely terminate the shareholder’s interests. To accomplish this, the seller needs to remain holding at least one share of stock. This is the trickiest §302 test to fail because the rules do not clarify how long you need to hold onto the share to ensure you have not “terminated” your shareholder’s interest. Is it a day, a year, or more than a year? Ultimately, from a tax perspective, the seller needs to maintain partial interest in order to have a qualifying §301 stock.
Lastly, to fail the §302 test, the redemption cannot result in partial liquidation of the redeeming corporation. 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. So for example, if you have a business partner who is going to take over your shares when you retire, you can set that up instead as a redemption and reissuance of shares to that partner.
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