WHILE AN ANALYSIS OF THE TAX consequences of a redemption to the shareholder usually begins with whether the transaction qualifies for sale or exchange treatment, another starting point is whether the S corporation has accumulated earnings and profits (AE&P). If the S corporation lacks AE&P (i.e., has always been an S corporation and has never acquired a C corporation with E&P via merger), dividend treatment cannot result from a redemption. Under the normal S corporation distribution rules, the redemption distribution is treated as a nontaxable return of capital to the extent of the adjusted basis of stock, followed by capital gain from the deemed disposition of stock (Sec. 1368(b); Rev. Rul. 95-14).
As illustrated by the following example, the tax consequences of a noncapital gain redemption to an S corporation shareholder can be more advantageous than capital gain treatment because the shareholder may be able to recover stock basis without any capital gain recognition.
Example: Assume that C is the senior shareholder of a small law firm that has always been an S corporation. G owns 60% of the stock, and her daughter, D, also an attorney, owns the other 40%. G is approaching retirement and would like the corporation to redeem her stock. G's stock basis equals $100,000, and the fair market value (FMV) of her stock is $200,000. Because G can potentially recover the first $100,000 tax free against her basis, her adviser structures the stock redemption in two steps. First, the corporation redeems half of her stock for $100,000. This redemption does not qualify for sale or exchange treatment, as it is not a complete redemption, nor is it substantially disproportionate (dropping G below 50% ownership) because of the family attribution rules. As a consequence, the $100,000 partial redemption in the first year is treated as a distribution and, under the S distribution rules, is a return of stock basis that is entirely tax free.
The following year, G sells her remaining shares and elects to waive family attribution to assure complete termination status. The sale is structured as an installment sale over a 10-year term. In this manner, G recovers her basis tax free against the initial payment of $100,000, and her capital gain on the transaction is deferred, to be recognized as the installment payments are received.
Applying New Taxes and Higher Tax Rates
The American Taxpayer Relief Act of 2012, P.L. 112-240 (ATRA), raised the top ordinary income tax rate to 39.6% (from 35%) for singles with taxable income above $400,000, married couples filing a joint return with taxable income above $450,000, and married individuals...