Seller's continuing ties to S corp. did not disqualify redemption treatment.

• Author: Puckett, Mark D.

Effectively navigating Sec. 302's requirements can avoid recharacterizing a stock redemption from a capital transaction to a dividend. One business owner's strategy, which involved a complete stock redemption, was challenged by the IRS (Hurst, 124TC 2 (2004)). Fortunately, the Tax Court upheld the results of the taxpayer's planning.

Background

Corporate distributions in redemption of stock may be characterized either as a sale (i.e., capital gain) or a dividend. In the case of a sale, the basis can be used against the sale proceeds, and gain could potentially be realized under the installment method. Sec. 302 provides three definitive safe harbor redemptions:

1. Substantially disproportionate to the shareholder (Sec. 302(b)(2));

2. That completely terminate the shareholder's interest (Sec. 302(b)(3)); and

3. Of a noncorporate shareholder's stock in a partial liquidation (Sec. 302 (b)(4)).

If none of these safe harbors applies, Sec. 302(b)(1)'s vague standard might apply to redemptions not "essentially equivalent to a dividend."

Lastly, Sec. 302(c)(2) allows Sec. 318(a)'s constructive stock ownership rules to be bypassed in determining whether shareholders completely terminated their interests under Sec. 302(b)(3). To bypass these rules when determining post-redemption stock ownership, Sec. 302(c)(2) requires redeemed shareholders to disassociate from the corporation as equity holders, officers, directors or employees, for 10 years following the redemption. However, the redeemed shareholder can be a creditor of the corporation. (This provision is supposed to facilitate seller-financed stock redemptions.) Regs. Sec. 1.302-4(d) defines a creditor for this purpose. It essentially provides that the claim cannot resemble a proprietary interest or be subordinate to general creditors' claims, nor can principal or interest payments depend on corporate earnings.

Hurst

Richard Hurst (R) was the founder and sole shareholder of Hurst Mechanical, Inc. (HMI), a heating, ventilating and air conditioning (HVAC) business. He also owned, together with his wife Mary Ann (M), a much smaller HVAC company, RHI. HMI maintained headquarters in a building it leased from R and M. Both taxpayers were active employees of HMI.

In late 1996, as R was contemplating retirement, he received a bona fide offer to sell HMI to an HVAC consolidator. HMI's key employees, which included R and M's son, Todd Hurst (T), were convinced that their jobs would be eliminated if the company...