Understanding the tax consequences of S corporation redemptions to a shareholder.

Author:Ellentuck, Albert B.
 
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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).

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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.

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