Redeeming corporate stock to take advantage of 1991's lower rates.by Horvitz, Jerome S.
TRA 86 made significant changes to the tax law. One major change was the shift from the preferential treatment of net long-term capital gains, i.e., long-term capital gains in excess of long-term capital losses. Prior to 1987, a taxpayer could exclude 60% of net long-term capital gains from taxation. For 1987, this exclusion was repealed. As a transition rule, net long-term capital gains for 1987 were taxed at a maximum rate of 28%. This was accomplished by an alternative computation on Schedule D.
Beginning in 1988 and continuing through 1990, a taxpayer's net long- term capital gain received no special tax treatment. During this period, the IRC continued the mechanical calculation for determining a net long- term capital gain. However, the designation as a net long-term capital gain bore no particular tax significance and it was taxed as ordinary income.
For 1991, RRA 90 provides that the maximum rate applied to a net capital gain is 28%. A net capital gain is the excess of net long-term capital gain over net short-term capital loss (if any) for the year. RRA 90 eliminates the 5% rate adjustment (i.e., the "bubble") enacted by TRA 86, phase-out of the use of the 15% bracket and exemptions for certain high-income taxpayers. RRA 90 provides for the same 15% and 28% rate brackets provided by TRA 86, but adds a permanent and explicit top marginal rate of 31% that generally applies to taxable income above the bubble thresholds. This new 31% bracket will not apply to net capital gains. Thus, for the first time since 1987, a taxpayer may have an incentive to recognize net capital gains because they would benefit from a 3% rate preference. Compared to the tax treatment that would have occurred in 1990, the preferential rate differential might be viewed as 5% as shown in Example 1.
Example 1: The taxpayers are married and file a joint tax return. They had AGI of $90,000 in 1990. The taxpayers were considering a transaction that would have resulted in a $40,000 net capital gain in 1990. The $90,000 of AGI placed the taxpayers in the 5% bubble range for 1990. If the $40,000 net capital gain had been recognized in 1990, it would have been taxed at a marginal rate of 33%. Given the same facts in 1991, the taxpayers would be in the 31% marginal bracket. However, if the $40,000 net capital gain is recognized, it will be taxed at the maximum rate of 28%, a 5% differential between 1990 and 1991.
In computing the tax liability applicable to a net capital gain, there are three steps that must be followed. 1. Apply the regular rates to the greater of:
a. Taxable income less the net capital
b. The amount of taxable income taxed
at a rate below 28%. 2. Apply the 28% rate to taxable income in excess of the taxable income utilized in step (1). 3. Total the results in steps (1) and (2).
In Example 2, the reader should note that RRA 90 provides that for married individuals filing jointly, taxable income not over $34,000 is taxed at 15%, taxable income over $34,000 but not over $82,150 is taxed at 28%, and taxable income over $82,150 is taxed at 31%.
Example 2: In 1991, the married taxpayers file a joint tax return. They have salary income of $30,000, a net capital gain of $120,000, exemptions of $4,300, and $8,700 in deductible medical expenses. Thus, their taxable income for the year is $137,000 ($30,000 + $120,000 - $4,300 - $8,700). Their tax is computed as follows: 1. The greater of:
a. 15% of ($137,000 - $120,000) = $2,550; or
b. 15% of $34,000 = $5,100.
The greater of A or B = $5,100
2. 28% of ($137,000 - $34,000) = 28,840 3. Total of steps (1) and (2) = $33,940
If not for the preferential treatment of the net capital gain, the tax liability would have been $35,586 rounded as follows: (15% x $34,000) + 28% ($82,150 - $34,000) + 31% ($137,000 - $82,150) = $35,586, a resultant tax savings of $1,646, ($35,586 - $33,940).
Taxpayers, particularly those of closely held companies, may have foregone stock redemptions until preferential treatment was available for net capital gains. For taxpayers in that situation, the time may be right to seize the opportunity provided by RRA 90 for tax year 1991. If the stock redemption is to qualify as a long-term capital gain rather than a dividend, the taxpayer must adhere to the rules of Sec. 302.
According to Sec. 302(a), a redemption of stock is a distribution in exchange for stock if the conditions of Sec. 302(b) are satisfied and conditions are:
1. Sec. 302(b)(1) - redemptions not equivalent to dividends;
2. Sec. 302(b)(2) - substantially disproportionate redemptions of stock:
3. Sec. 302(b)(3) - termination of a shareholder's interest; and
4. Sec. 302(b)(4) - redemption of a noncorporate shareholder in partial liquidation.
Sec. 318(a), which relates to the constructive ownership of stock, applies to all redemptions under Sec. 302, except that in under Sec. 302, except that in a termination of a shareholder's interest there are limitations placed on Sec. 318. This exception will be discussed later. Finally, if a distribution fails the previously mentioned conditions of Sec. 302, the distribution under Sec. 301 and dividend income may be triggered.
Redemption not Equivalent to a Dividend
If a redemption fails to meet the conditions of Secs. 302(b)(2), (b)(3) and (b)(4) it does not mean that Sec. 302(b)(1) is inapplicable. Also, the fact that a corporation has no earnings and profits at the time of distribution has no bearing on whether Sec. 302(b)(1) applies. Thus, if a shareholder owns all of the stock of a corporation and the corporation redeems part of the shareholder's stock at a time when there are no earnings and profits, the distribution is treated as a distribution pursuant to Sec. 302(d).
The question of whether a redemption is not essentially equivalent to a dividend depends on the facts and circumstances of each case. However, it has been held that a meaningful reduction of a shareholder's proportionate interest qualifies as not being essentially equivalent to a dividend. For example, a loss of voting control has been held to be a meaningful reduction. If a corporation has only one class of stock outstanding and there is a pro rata redemption, the regulations state that the distribution will come under Sec. 301. Also, it should not be forgotten that the constructive ownership rules of Sec. 318 apply. So, if there are related shareholders, a redemption of stock of one of the shareholders may not be a meaningful reduction. Consequently, Sec. 301 would apply. Finally, when an amount is received in a redemption of stock and it is treated as a dividend under Sec. 301, an adjustment of the basis to the remaining stock must be made.
Example 3: H and W, husband and wife, each own half the stock of Corporation X. All of the stock was purchased by H for $100,000 in 1980. In 1985 H gave one half of the stock to W. In 1991 all of the stock of H is redeemed for $150,000. The redemption would not satisfy Sec. 302(b)(1) because of the constructive ownership rules, and it would be considered a dividend distribution. After the redemption, H's $50,000 basis would attach to W's basis giving W a basis of $100,000 in her stock.
Substantially Disproportionate Redemptions
Sec. 302(b)(2) provides for capital gain treatment in the redemption of stock if:
1. Immediately after the redemption the shareholder owns less than 50% of the total combined voting power of all classes of stock entitled to vote; and
2. If the ratio of the voting stock after the redemption is less than 80% of the voting stock owned before the redemption.
In applying these tests, the constructive ownership rules of Sec. 318 apply. These tests are applicable to each shareholder individually. Also, Sec. 302(b)(2)(D) provides that a redemption will not trigger capital gain treatment where the redemption is made pursuant to a plan, the purpose of which is to make a series of redemptions which in the aggregate are not substantially disproportionate. Finally, Sec. 302(b)(2) only applies to voting stock or to a redemption of both voting stock and preferred stock if there is a simultaneous redemption of both.
Example 4: Corporation X has outstanding 400 shares of common stock of which A, B, C, and D each own 100 shares or 25%. The corporation redeems 55 shares from A, 25 shares from B, and 20 shares from C. For the tests to apply, the shareholder must own less than 20% (80% x 25%) of the 300 shares then outstanding. After the redemption A owns 15%, B owns 25%, and C owns 26 2/3%. In this example, only A will have capital gain treatment. B and C will have dividend income. However, if the shareholders had been related under Sec. 318, shareholder A would have recognized dividend income.
Termination of Shareholder Interest
Sec. 302(b)(3) triggers capital gain treatment if there is a redemption of all the stock of a shareholder. Sec. 302(c) requires that the constructive ownership rules of Sec. 318 must apply to a complete termination.
The constructive ownership rules are waived if:
1. Immediately after the distribution the shareholder is not an officer, director, or employee and has no other interest than that of a creditor.
2. The shareholder does not acquire one of these interests within 10 years of the distribution, except by bequest or inheritance; and
3. The shareholder must attach to the tax return a signed statement that the shareholder has not acquired any interest in the corporation other than by bequest or inheritance. The shareholder must agree that notice will be sent to the district director if an acquisition of a prohibitive interest occurs within 10 years.
A shareholder is considered a creditor where his or her rights are not subordinated to the claims of general creditors. If the payments or interest on debt are pegged to earnings of the corporation, then the shareholder is not considered a creditor. The fact that the shareholder collects on a note by acquiring assets of the corporation does not create a prohibitive interest. Finally, if the shareholder receives stock from related party, within the meaning of Sec. 318, within 10 years of the date of the redemption, a complete termination will not have occurred, unless there is no tax avoidance motive. However, according to the regulations, where the stock was gifted to the shareholder by a family member and there is a subsequent redemption in complete termination of all that stock, no tax avoidance motive is present even if the shareholder is in a lower tax bracket.
Redemption in Partial Liquidation
Sec. 302(b)(4) affords capital gain treatment upon redemption of stock in partial liquidation of a corporation. Sec. 302(e) defines a partial liquidation as:
1. The distribution is not essentially equivalent to a dividend as determined at the corporate level; and
2. The distribution is pursuant to a plan and occurs within one year after the year the plan is adopted.
For Sec. 302(b)(4) to apply there must be a genuine contraction of the business. This is a subjective test, and the authors recommend that the taxpayer get a ruling from IRS. Sec. 302(e)(2)(B) states that the business must remain active after the redemption and be a qualified trade or business. Sec. 302(e)(3) defines a "qualified trade or business" as one that was active for five years up to the date of redemption.
If the business in question was acquired by the redeeming corporation within the five-year period, it cannot be sold and have the sale proceeds used to redeem its stock. Thus, the five-year requirement helps prevent the bail-out of corporate earnings at favorable capital gains rates.
Example 5: X Corporation, a wholesale grocery business, acquires a freight-hauling concern. Three years later, the freight-hauling company distributes its assets to shareholders in redemption of their stock. In this example, there is a violation of Sec. 302(e)(3) because the hauling business had not been held for five years. Consequently, the redeeming shareholders do not qualify for capital gain treatment under Sec. 302(b)(4).
Where the taxpayer is considering a stock redemption that qualifies as a capital gain, 1991 may be the year to engage in the redemption. The 3% preferential treatment may be enticement enough to proceed with the redemption. However, Congress may be forthcoming with an even greater incentive. At the time this article was being written, Congress was considering a maximum rate of 15% on net capital gains. Taxpayers and advisors may wish to watch this issue carefully. If the 15% rate does not materialize, the question of the reduction in future years must be considered.
RRA 90 added some provisions that will potentially make the redemption decision more complex. Specifically, where AGI exceeds specified thresholds ($150,000 on joint returns) each personal and dependency exemption is phased out by 2% for each $2,500 or fraction thereof of AGI in excess of the threshold amounts.
Example 6: The taxpayers in Example 2 have a net capital gain due to a qualified stock redemption of $145,000 instead of $120,000. This changes their AGI to $175,000 ($30,000 salary + $145,000 net capital gain) from $150,000 ($30,000 salary + $120,000 net capital gain, Example 2). The couple is now subject to the exemption phase-out. In Example 2, they were not subject to this phase-out and the full $4,300 was allowed. However, with AGI of $175,000, their allowable exemptions become $3,440. This is computed as $4,300 less $860 ($4,300 times 20% phase-out percentage). The phase-out percentage is computed a follows:
AGI - Threhold Amount =
$175,000 - $150,000 = $25,000
$25,000 (Excess Amount)/$2,500 =
10 x 2% = 20%
An additional caveat is necessary where the net capital gain increases AGI above a different threshold - $100,000, for all taxpayers except married filing separately where the threshold is $50,000. Where this occurs, certain itemized deductions are reduced by 3% for AGI in excess of the threshold amount. The 3% reduction applies after any other applicable limitations, i.e., the 2% floor on miscellaneous itemized deductions. The 3% reduction may eliminate a maximum of 80% of the deductions that are reduced by this provision.
For purpose of this provision, itemized deductions are divided into two categories, one subject to the 3% reduction and one not subject to the 3% reduction. The category subject to the reduction includes state and local income taxes, real estate and qualifying property taxes, interest other than investment interest, contributions, moving expenses and miscellaneous itemized deductions, including those subject to the 2% floor and those not subject to the 2% floor. The itemized deductions, not subject to the 3% reduction, include medical expenses, investment interest (limited to net investment income), gambling losses to the extent of gambling gains, and casualty and theft losses.
Example 7: In example 2, the couple's itemized deductions ($8,700) were exclusively medical expenses above the 7 1/2% AGI threshold. If these, instead, had been $8,700 state and local income taxes, the $8,700 itemized deductions would have been reduced to $7,200 (8,700 - $1,500). The computation would be as follows: AGI: $150,000 ($30,000 salary + $120,000 net capital gain) Less: (100,000) Threshold Excess: $50,000 x 3% = $1,500 Potential Reduction Maximum Reduction: 80% of $8,700 = $6,960. Of course, this would alter taxable income in Example 2 and the subsequent tax calculations.
WHERE TO GO FROM HERE
In utilizing the rules under Sec. 302, the distribution which is not essentially equivalent to a dividend according to Subsec. 302(b)(1) should be the path of last resort. This test is subjective and is applied on a case-by-case basis.
If a redemption is considered, the safe harbors of Secs. 302(b)(2) and 302(b)(3) should have priority over 302(b)(1). However, with these two redemptions taxpayers should be concerned about the constructive ownership rules of Sec. 318. Taxpayers may wish to consider having a two-step transaction whereby the related party shareholderr sells his shares to an unrelated party with a redemption happening thereafter. The redemption should be spaced from the earlier sale to prevent IRS from collapsing the transaction into a single-step or having the sale to the unrelated party classified as "straw-transaction."
The constructive ownership rules can be waived if the shareholder does not acquire an "interest" in the corporation for 10 years. Since the shareholder cannot be employed by the company during this time, it might be plausible to have the shareholder classified as an independent consultant or independent contractor, if needed. If this route is chosen, the corporation cannot withhold taxes nor should the shareholder have access to employee benefits, such as retirement and health plans.
In the situation where the shareholder is a corporation, it might be better to have a redemption that triggers a dividend rather than a capital gain because of the dividend-received deduction under Sec. 243. This route may be even more attractive where the corporation redeeming the stock has little or no earnings and profits at the time of redemption.
Where a shareholder has passed away, capital gain treatment can be achieved under Sec. 303. The corporation can redeem stock directly from an estate of a deceased shareholder. This course of action may be required because usually the other shareholders do not have the where- with-all to purchase the stock.
Finally, where a corporation is offered for sale, the corporation can finance its acquisition by redeeming its own stock. This can be accomplished by the corporation redeeming some or all of its shares of stock from the existing shareholders. Where the redemption is properly structured, the shareholders will receive capital gain treatment.
Randall K. Serrett is an Assistant Professor at Fort Lewis College, Durango, Colorado.
Jerome S. Horvitz is an Associate Professor at University of Houston, Houston, Texas.
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