Business

Shareholder succession tax planning

Items to consider when planning a buyback of the company gold a dividend

When a company repurchases its shares under §302, it is accounted for as a capital asset disposal and is considered a sale or exchange for tax purposes. The proceeds from the transaction offset the adjusted basis of the shares. The selling shareholder will recognize a gain or loss in an amount equal to the difference between the amount received for the redeemed shares and the adjusted basis of said shares. The capital gains treatment can also be advantageous in the sense that capital gains can be fully offset by capital losses and carried over capital losses.

Under the current tax regime, long-term capital gains and qualified dividends have the same tax rate; a maximum of 23.8% composed of a profit rate of 20% and a tax on net investment income of 3.8%. The “chance” of the same rates needs further analysis.

The distinction to make when considering the 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 may be taxed at the maximum ordinary income rate of 39.6%.

It is not essentially equivalent to dividends

There are a few ways that corporate refunds can be viewed for tax planning. There are two tests in §302 that have been outlined in the Code and Regulations, so they do not present real problems of interpretation or application. 302 (b) (2) Substantially disproportionate repayment of shares and 302 (b) (3) Shareholder interest termination has strict qualifying requirements.

Sometimes tax planning needs to use the “Lower Path”, after discovering the fact that, for whatever reason, a transaction does not meet the requirements of the previous two tests; there is yet another tax planning opportunity to make a stock redemption. The legal authority that guides 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 low redemption. 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) states “the facts and circumstances of each case.” Meeting well-delineated numerical tests in 302 (b) (2) and 302 (b) (3) is a preferred method of qualifying a transaction as a redemption; rather than relying on facts and circumstances.

The influential case concerning 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 an exchange to qualify under 302 (b) (1). The opinion in this case states, “Regardless of the business purpose, a redemption is always” essentially equivalent to a dividend “within the meaning of section 302 (b) (1) if it does not change the proportional interest in the corporation. Since the taxpayer here (after the application of the attribution rules) was the sole shareholder of the corporation both before and after the bailout, he did not qualify for capital gains treatment under that test “1.

A significant reduction is concentrated on the interest provided. “Rather, to qualify for preferential treatment under that section, a redemption must result in a significant reduction in the shareholder’s proportionate interest in the corporation.” two

The Service and the courts primarily focus on control to satisfy the standard of § 302 (b) (1). The end product of this standard is a concentration on the percentage of ownership.

It is worth noting that there are several quotes where the percentage of ownership is not the main factor. On Wright v. US, 482 F2d 600, the taxpayer successfully argued that a redemption can still leave one 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 reimbursed 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 rescue, either alone or acting in concert with other minority shareholders.

The requirement for significant reduction is more diluted version of the same concept applicable to substantially disproportionate refunds. However, it is not essentially equivalent to dividend. It is not a hot topic with the IRS; the subject has been much discussed in the past. In the event that a transaction needs to be based on § 302 (b) (1) think beyond basic percentage control.

Contact the author if you have questions about tax planning. We appreciate this opportunity to help.

1. United States v. Davis 397 United States 301 (1970)

2. United States v. Davis 397 United States 301 (1970)

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