Tax trap on deceased shareholder's redemption.

• Author: Spletter, Richard

Shareholder buy-sell agreements often contain provisions requiring the corporation to redeem a shareholder's interest on his death. It is intended that the redemption be treated as an "exchange" so the decedent's estate can use the stock's basis to reduce or eliminate any capital gains. However, if not properly planned, such redemptions may result in a dividend to the decedent's estate. This may occur if any of the estate's beneficiaries continue to hold the redeeming corporation's stock after the redemption.

Example: Corporation A is worth $1,000,000. A father, F, owns 80% of A and his two sons, X and Y, own 10% each. F's will leaves $600,000 in trust to X and Y, with the remainder of the estate going directly to his spouse. A is required to redeem F's 80% interest on his death. F dies.

A redeems F's 80% interest before X and Y's credit shelter trust is funded. Under Sec. 318(a)(3)(A) and (B), the stock owned by X and Y is considered owned by F's estate. Consequently, the estate will still be considered as owning 100% of A after the redemption. Since Sec. 302(c)(2)(C)(i)(I) prevents the estate from waiving beneficiary attribution, the redemption will not qualify as a complete termination of interest. This leaves the executor in the unenviable position of arguing that the redemption should be treated as an exchange because, as provided in Sec. 302(b)(1), it is "not essentially equivalent to a dividend." If the executor is unsuccessful with this argument, F's estate will recognize an $800,000 dividend.

The undesirable tax consequences in this example can be avoided if the credit shelter trust is fully funded before the redemption takes place and the estate, along with the surviving spouse, waives family attribution under Sec. 302(c)(2)(C). The trust (and consequently the two sons) will no longer be entitled to distributions from the estate and wwill...