Buy-sell agreements: constructive dividend dangers lurk; how to structure an agreement to avoid adverse tax consequences.

Author:Willens, Robert

One of the more pernicious threats faced by closely held corporation shareholders is the prospect of "constructive" distributions, taxed as ordinary dividend income to the extent of available earnings and profits, for transactions in which the shareholder benefits from a corporate action. In this connection, buy-sell agreements have proven to be a source of revenue for the Internal Revenue Service when the agreement is not properly structured.

USE OF BUY-SELL AGREEMENTS

Typically, to facilitate an orderly transfer of ownership, closely held corporation owners structure buy-sell agreements to enable a departing shareholder to dispose of his or her stock efficiently. Remaining shareholder(s) also have a stake in this process because failure to plan for this eventuality could lead to a situation in which the departing shareholder's stock winds up in disruptive or unfriendly hands. A buy-sell agreement can be structured in a variety of ways; it can involve either a purchase by remaining shareholder(s) or a corporate-level acquisition.

The selling shareholder's tax consequences are well known and generally devoid of controversy. In a sale to other shareholder(s), capital gain or loss consequences naturally follow. In a corporate redemption, the transaction is normally treated as an exchange under Interal Revenue Code section 302(b)(3), which covers transactions in which the redeemed shareholder's proprietary interest in the corporation is completely terminated. Similarly, under the doctrine of Zenz v. Quinlivan, section 302(b)(3) also applies to a part sale, part redemption transaction if, as is typical, the steps are part of an integrated plan; in these cases, the step-transaction doctrine treats the steps as a unit for purposes of determining eligibility for section 302(b)(3) treatment.

In a redemption, applying section 302(b)(3) can be complicated by stock attributed to the redeeming shareholder under the constructive ownership rules. A taxpayer is deemed to own a portion of the shares actually (but not constructively) owned by entities such as trusts, estates, partnerships and corporations of which the taxpayer is beneficiary, partner or shareholder, respectively. In these instances, additional planning is necessary to gain the benefits of section 302(b)(3).

In IRS revenue ruling 71-211, for example, a taxpayer redeemed all shares actually owned but, under IRC section 318(a)(2)(B), was considered to own a portion of the shares owned by a trust of which he was beneficiary. The ruling says the redemption would be governed by section 302(b)(3) only if the taxpayer concurrently renounced his beneficial interest in the trust and such renunciation, under local law, was (1) effective to achieve a divestiture of his trust interest and (2) "valid and binding."

ATTRIBUTION RULES

IRC section 318(a)(1) provides a broad set of family attribution rules. A taxpayer is deemed to own stock actually (and in some cases constructively) owned by a spouse, children...

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