Practical tax planning for sec. 303 stock redemptions.

• Author: Howard, John W.

Sec. 303, which permits redemptions of stock owned by estates or beneficiaries to receive capital gain, rather than dividend, treatment, is much more liberal a provision than it initially appears. Sec. 303 actually allows an infusion of cash into an estate or to a beneficiary and therefore offers a number of planning opportunities. These opportunities and the basic workings of Sec. 303 are addressed in this article's many examples.

When should a taxpayer take advantage of the benefits provided by Sec. 303? Sec. 303, distributions in redemption of stock to pay death taxes, allows an estate that owns stock or beneficiaries who inherit stock to redeem shares with minimal (if any) income tax ramifications; such a transaction may be necessary to generate cash to pay certain death taxes and estate expenses. The underlying purpose of Sec. 303 is to help mitigate the potential cash-flow shortage often associated with estates comprised largely of stock in a closely held or family owned business.(1)

Example 1: D's estate consists of $100,000 cash and $750,000 of I corporation stock, while death taxes and estate expenses are $250,000. D's executor can use Sec. 303 to have the I stock redeemed to generate the cash necessary to meet the estate's dosing expenses without significant adverse income tax consequences. In most cases, the cash generated by such a redemption, although limited to the total death taxes and funeral and administration expenses, need not be spent in actual payment of such items.

Sec. 303 grants a redemption sale or exchange treatment; thus, any recognized gain or loss is capital rather than ordinary.(2) In addition, under Sec. 1014, because most assets owned by a shareholder at death receive a step up (or step down) in basis to fair market value (FMV),(3) the redemption will frequently result in no gain or loss to the owner.

Example 2: The facts are the same as in Example 1. If $250,000 of I stock is redeemed shortly after D's death at its FMV, the estate realizes no gain or loss ($250,000 amount realized-$250,000 adjusted basis).(4)

Individuals often seek to have a stock redemption receive sale or exchange treatment, a preference arising from the basis offset and applicability of the capital gains rate. If an estate owns stock that is not redeemed, it will ultimately be held by the beneficiaries; any subsequent stock redemption not qualifying under Sec. 303 could produce (relatively harsher) dividend treatment. Assuming the beneficiaries could benefit from the receipt of cash, the better result is for the estate to redeem the stock under Sec. 303 (even if the cash is not needed) and distribute it to the beneficiaries. Alternatively, in certain cases, a beneficiary could redeem stock under Sec. 303 after receiving it from the estate. Thus, even though Sec. 303 is designed to help meet an estate's cash-flow needs, the estate need not actually require additional cash for Sec. 303 to be available. Indeed, because of the beneficial results, it can be argued that Sec. 303 should be used even if additional cash is not required in closing the estate.

Although Sec. 303 offers a very attractive way for an estate or beneficiaries to receive desired cash with little or no negative income tax effects, three major conditions must be met for Sec. 303 to apply. This article discusses these conditions(5) and considers some important tax planning aspects.

Sec. 303 Requirements

For an estate or beneficiary to use Sec. 303, three conditions must be met:

1. The qualifying redemption cannot exceed the total of certain taxes and expenses incurred by the estate in the normal course of closing its affairs and distributing its assets to the beneficiaries (Sec. 303(a)).

2. The value of the stock subject to the redemption owned by the estate must exceed 35% of the adjusted gross estate (AGE) (Sec. 303(b)(2)(A)).

3. The redemption must occur within one of three specific time frames (Sec. 303(b)(1)).

Dollar Limit

Under Sec. 303(a), a qualifying redemption cannot exceed the total of certain death taxes and funeral and administration expenses deductible under Sec. 2053(6) As mentioned earlier, the redemption proceeds do not have to be used to pay such taxes and expenses, but instead can be distributed to the beneficiaries. While Sec. 303 is designed to mitigate cash-flow constraints typically characteristic of estates holding large blocks of closely held stock, the estate is not required to show that it otherwise could not meet its cash-flow requirements.

According to Sec. 303(a)(1), "taxes" include any estate, inheritance, legacy and succession taxes paid or to be paid by the estate net of any appropriate credits or discounts. Interest costs are also included to the extent collected as a part of the taxes. Under Regs. Secs. 20.2053-2 and -3, the funeral and administration expenses permitted to be deducted under Sec. 2053 encompass reasonable funeral expenses, executor's commissions, attorney's fees and other miscellaneous expenses (including court costs, accountant's and appraiser's fees and other expenses related to disposition of the estate's assets). Redemption proceeds exceeding the qualifying taxes and funeral and administration expenses are taxed under Sec. 302.(7)

Example 3: Q's AGE includes stock in corporation X with an FMV of $200,000; estate taxes are $100,000 and funeral and administration expenses are $50,000. The maximum redemption qualifying under Sec.303 is $150,000 ($100,000 + $50,000). If the remaining $50,000 of stock is also redeemed, the proceeds are taxed under Sec.302.(8)

Ownership Requirements

Under Sec. 303(b)(2)(A), the value of the stock subject to redemption owned by the estate must exceed 35% of the AGE: the gross estate less the sum of the amounts allowable as a deduction under Sec. 2053 or 2054.

Example 4: Z's AGE is 51,000,000 and includes stock in corporation M valued at $400,000. Because the value of the M stock is 40% of the AGE ($400,000 $1,000,000), qualifying amounts of M stock may be redeemed under Sec. 303.

Sec. 303(b)(2)(B) provides that if the gross estate includes stock in two or more...