IRS discusses possible prohibited transactions of redeemed shareholder.

• Author: Fiore, Nicholas J.

Individual A was the sole shareholder of Corp. X from its inception. On a specified date, X redeemed 90% of A's stock with a note, to be paid in installments over a 15-year period, secured by a pledge of the redeemed stock. A resigned as a director, officer and employee of X as of that date. Also on that date, A sold 51% of the remaining X stock to his son, S, and the other 49% to two unrelated X employees, for 15-year installment notes with provisions (including a pledge) similar to the redemption note.

At the same time, X entered into a new lease of its business premises from A, and a new employment agreement with A's spouse B. (The lease provides for arm's-length lease payments.) It is unclear whether the employment contract provides excessive compensation for the services provided. X had leased the same property from A and employed B before the redemption.

A had spousal benefits in B's health insurance plan provided by X. X prepared A and B's joint Federal income tax return. X also provided a pickup truck for B's use, but it was used primarily by A.

In addition, under the stock-pledge agreement, the redeemed X stock is pledged to A as security for his installment note. The agreement assigns the dividend and voting rights on the pledged stock to the pledgor (not A), as long as there is no default on the note. The agreement provides that, if there is a default on the note, A might elect, subject to state law Y, to foreclose on the pledged stock by causing it to be sold at a public or private sale at a price that A might determine. A may purchase all or part of the pledged shares at the sale. Under Y, A may not obtain more than the unpaid balance on the note plus reasonable related expenses; any surplus over that amount must be accounted for to the debtor. It also appears that, under Y, a debtor is responsible for any deficiency after the sale of collateral.

The installment notes provide that, if X breaches either the employment agreement or the lease, the remaining principal on the note would become immediately due and payable. Not paying the full amount due may trigger the default provisions of the stock-pledge agreement.

Notwithstanding the agreements among A, X and the unrelated individuals, there is some question as to whether the stock was actually registered in the names of the new shareholders (as is contemplated by the agreements) and a sale actually occurred, or whether the parties' rights vis-a-vis the stock are simply...