Tax Planning Shareholder Succession
Items to consider when planning a repurchase of the company gold a dividend
When a company repurchases its shares under §302, it is accounted for as a capital asset disposition and is considered a sale or exchange for tax purposes. Proceeds from the transaction offset the adjusted basis of the shares. The selling shareholder will recognize a gain or loss for an amount equal to the difference between the amount received for the shares redeemed and the adjusted basis on those shares. Capital gains treatment may also be advantageous in that capital gains may be fully offset by capital losses and capital loss carryovers.
Under the current tax regime, long-term capital gains and qualified dividends are taxed at the same rate; a maximum of 23.8%, including the rate of profit of 20% and the tax on income from net investments of 3.8%. The “serendipity” of the same rates needs further analysis.
The distinction to be made when considering sale treatment is the “base power” in the redeemed shares. The redemption treatment can be considerably more advantageous than the dividend treatment, when the basis is considered. Another tax planning point is that some dividends are not qualified dividends and can be taxed at the maximum ordinary income rate of 39.6%.
Not essentially equivalent to dividends
There are a few ways corporate refunds can be looked at for tax planning. There are two tests in §302 that have been outlined in the Code and Regulations, so they present no real problems of interpretation or application. 302(b)(2) Substantially disproportionate redemption of shares and 302(b)(3) Termination of shareholder interest has strict requirements to qualify.
Sometimes tax planning needs to go the “lower road,” after discovering the fact that, for whatever reason, a transaction does not qualify under the above two tests; There is yet another tax planning opportunity to do a stock redemption. The statutory authority guiding how to affect this type of transaction is not as well described in the law, however, it can be structured so that a transaction is likely to qualify as a redemption under 302(b)(1) and not be equivalent to dividends.
The analytical standard that allows a taxpayer to qualify under 302(b)(1) is known as a “significant reduction.” This standard for qualifying under 302(b)(1) is similar to 302(b)(2), however the requirements are slightly less stringent. Although 302(b)(1) is less strict, the regulations are not as concise, § 1.302-2(b) sets forth “the facts and circumstances of each case.” Meeting the numerical tests well outlined in 302(b)(2) and 302(b)(3) is a preferred method of making a transaction qualify as redemption; instead of depending on the facts and circumstances.
The influential case related to 302(b)(1) is USA v. Davis 397 US 301 (1970). The Supreme Court established the requirement of a “significant reduction” as a requirement. A business purpose is not a requirement for a rescue to qualify under 302(b)(1). The opinion in this case states: “Regardless of business purpose, a redemption is always “essentially equivalent to a dividend” within the meaning of § 302(b)(1) if it does not change the interest of the shareholder proportional interest in the corporation. Since the taxpayer here (after application of the attribution rules) was the sole shareholder in the corporation both before and after the redemption, he did not qualify for capital gains treatment under that test.”1
A significant reduction is concentrated in the proportional interest. “Rather, to qualify for preferential treatment under that section, a redemption must result in a significant reduction of the shareholder’s proportionate interest in the corporation.”2
The Service and the courts are primarily focused on monitoring to satisfy the § 302(b)(1) standard. The end product of this standard is a concentration on ownership percentage.
It is worth noting that there are several quotes where percentage ownership is not the main factor. In Wright v. US, 482 F2d 600, the taxpayer successfully argued that a bailout can still leave a shareholder in control. The Eighth Circuit ruled that a redemption that resulted in a reduction in voting power from 85% to 61.7% was significant when 66.67% of the voting power was needed to pass major corporate decisions.
A significant reduction was also achieved when the redeemed shareholder was deemed to own shares under the §318 family attribution rules. In Rev Rul. 75-512, the shareholder had no power to control the corporation before or after the redemption, either alone or acting in concert with other minority shareholders.
The significant reduction requirement is more diluted version of the same concept applicable to substantially disproportionate reimbursements. However, not essentially equivalent to dividend is not a hot topic with the IRS at the moment; the subject has been much discussed in the past. In the event that a transaction must be based on § 302(b)(1), think beyond the basic percentage control.
Contact the author for any tax planning questions. We appreciate this opportunity to help.
1. United States v. Canada Davis 397 US 301 (1970)
2. United States v. Canada Davis 397 US 301 (1970)