Planning for redemptions of S corporation stock using contingent payments.

• Author: Hendricks, Brent S.

When shareholders of an S corporation choose to part ways, they often do so by redeeming a departing shareholder's stock. This is often done under harmonious, friendly terms; in some cases, however, the split is less amicable and more distrustful. In those situations, the practitioner must balance two distinct objectives, each of which is critically important to both the shareholders' and the S corporation's wellbeing. On the one hand, the shareholders are motivated to effect a swift breakup, with each party determined to protect his own financial interests. On the other hand, the S corporation must take care to protect itself from IRS challenge, lest the transaction be characterized not as a stock redemption, but instead as an illusory second class of stock.

Example: Shareholders X and Y each own 50% of Q, an S corporation. For simplicity, assume X and Y are unrelated taxpayers under Sec. 318, for purposes of Sec. 302 (c). Because of financial misfortunes and differing visions of Q's future, the shareholders choose to part ways, with X leaving the business altogether. The enterprise value of Q is a point of contention. X proposes a garden-variety redemption, for a fixed purchase price, payable over a fixed term with adequate stated interest. X also insists on a provision where if, within the following two years, Q sells all its assets to a third party at a premium, X's purchase price will be ratcheted upward as if such premium existed at the date of X's redemption. If the transaction qualifies as a redemption (the transaction would be tested under Sec. 302 (b) and also through subchapter 5, as described later), X has shrewdly left Y to recognize gain on 100% of the asset sale, with Q paying nondeductible redemption proceeds to X. Note, however, that if Q also liquidates in the year of the asset sale, Y may generate a capital loss to offset the asset sale gain he disproportionately recognized.

The parties should determine whether such an arrangement constitutes a true redemption or whether it might instead be viewed as a recapitalization (Sec. 368 (a) (1) (E)). In a recapitalization, X is viewed as exchanging his existing Q shares for a different class of Q stock (the general consequences to X of which would be beyond the scope of this item). Such an E reorganization would have several tax consequences. First, it would likely terminate Q's S election, due to the creation of a second class of stock. (Regs. Sec. 1.1361-1 (1) requires an S...