Avoiding locked-in installment gain on a predeath stock redemption.

• Author: Ellentuck, Albert B.

Facts: Marshall Basket Co.'s outstanding stock is held by 11 members of the same family (heirs and relatives of the deceased founder, Jonas Marshall). The oldest shareholder is Jerry Marshall, Jonas' brother. Jerry, who is single, is advanced in years and has just been diagnosed with a terminal illness. Jerry's will leaves his estate to his five children and their families, none of whom are Marshall Basket shareholders. Jerry and the present shareholders agree it would be better for the corporation to redeem his stock before death, rather than extend the ownership to his diverse group of heirs.

Jerry's stock basis is approximately $20,000; the stock's fair market value (FMV) is approximately $500,000. The shareholders ask their tax adviser about their plan to have Jerry redeem his shares now for $50,000 down, with the corporation paying the $450,000 balance via a 10-year installment note. Issue: Is a stock redemption funded by an installment note the best way to retain corporate ownership within the existing shareholder group?

Analysis

The tax adviser explains that Jerry's lifetime stock redemption would qualify for sale or exchange treatment, as it would be a complete termination of his interest. Further, it appears that Jerry would not be required to enter into a 10-year waiver of family attribution, because none of his immediate family members are shareholders. Presumably, Jerry has nieces and nephews who are shareholders (the children of his brother who founded the corporation), but the family attribution rules do not attribute stock ownership other than from a spouse, children, grandchildren and parents.

While on the surface, a lifetime stock redemption appears to satisfy Jerry's and the other shareholders' objectives, the tax adviser notes that it presents a significant ongoing tax cost to Jerry's heirs. By redeeming his stock now, Jerry will be setting up a long-term installment obligation with $450,000 of principal remaining to be paid. Because his basis in the stock was only $20,000 (i.e., 4% of the total redemption price), there is a 96% gross profit ratio (GPR) on the note receivable.

If Jerry dies during the note's 10-year term, his heirs will inherit it without a basis step-up. Under Sec. 691 (a) (4), an installment obligation inherited from a decedent passes to the heirs with the same GPR, despite the note's FMV being included in the estate. As the heirs collect the future annual principal payments from the corporation, they...