Avoiding locked-in installment gains on predeath stock redemptions.

• Author: Ellentuck, Albert B.

Facts: Weaver Basket Co. (WBC), a closely held S corporation, was formerly a C corporation. The stock is held by 12 members of the same family (heirs and relatives of Jonas Weaver, the deceased founder). * The oldest shareholder is Jed Weaver, Jonas' brother. Jed is single, aged and has just been diagnosed with a terminal illness. * Jed's will leaves his estate to his five children and their families, none of whom are WBC shareholders. Jed and the present shareholders agree that WBC should redeem his stock rather than extend the ownership to his diverse group of heirs. * Jed's basis in his WBC stock is $20,000; the fair market value (FMV) is about $500,000. * The shareholders ask their tax adviser about the feasibility of having Jed redeem his shares now, receiving $50,000 down, with WBC paying the $450,000 balance via a 10-year installment note. * WBC's accumulated adjustments account is $100,000 and its accumulated earnings and profits are $700,000. Issue: Is a stock redemption funded by an installment note the best way to retain corporate ownership within the existing shareholder group? What are the tax traps and planning alternatives?

Analysis

The tax adviser explains that a lifetime WBC stock redemption by Jed would qualify for sale or exchange treatment under Sec. 302(b)(3) as a complete termination of his entire interest. Further, Jed would not be required to enter into the 10-year waiver of family attribution, because none of his immediate family members are WBC stockholders. Presumably, Jed's nieces and nephews (Jonas's children) are shareholders, but the Secs. 302(c) and 318(a)(1) family attribution rules do not attribute stock ownership other than from a spouse, children, grandchildren and parents.

However, such a redemption presents a significant ongoing tax cost to Jed's heirs. A stock redemption now will create a long-term installment obligation with $450,000 of principal remaining to be paid. Because Jed's stock basis is only $20,000 (i.e., 4% of the total redemption price), the WBC note has a 96% gross profit ratio (GPR).

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