When shareholders of an S corporation choose to part ways, they often do so by redeeming a departing shareholder’s stock. This is often done under harmonious, friendly terms; in some cases, however, the split is less amicable and more distrustful. In those situations, the practitioner must balance two distinct objectives, each of which is critically important to both the shareholders’ and the S corporation’s well-being. On the one hand, the shareholders are motivated to effect a swift breakup, with each party determined to protect his own financial interests. On the other hand, the S corporation must take care to protect itself from IRS challenge, lest the transaction be characterized not as a stock redemption, but instead as an illusory second class of stock.
Example: Shareholders X and Y each own 50% of Q, an S corporation. For simplicity, assume X and Y are unrelated taxpayers under Sec. 318, for purposes of Sec. 302(c). Because of financial misfortunes and differing visions of Q’s future, the shareholders choose to part ways, with X leaving the business altogether.
The enterprise value of Q is a point of contention. X proposes a garden-variety redemption, for a fixed purchase price, payable over a fixed term with adequate stated interest. X also insists on a provision where if, within the following two years, Q sells all its assets to a third party at a premium, X’s purchase price will be ratcheted upward as if such premium existed at the date of X’s redemption. If the transaction qualifies as a redemption (the transaction would be tested under Sec. 302(b) and also through subchapter S, as described later), X has shrewdly left Y to recognize gain on 100% of the asset sale, with Q paying nondeductible redemption proceeds to X. Note, however, that if Q also liquidates in the year of the asset sale, Y may generate a capital loss to offset the asset sale gain he disproportionately recognized.
The parties should determine whether such an arrangement constitutes a true redemption or whether it might instead be viewed as a recapitalization (Sec. 368(a)(1)(E)). In a recapitalization, X is viewed as exchanging his existing Q shares for a different class of Q stock (the general consequences to X of which would be beyond the scope of this item). Such an E reorganization would have several tax consequences. First, it would likely terminate Q’s S election, due to the creation of a second class of stock. (Regs. Sec. 1.1361-1(l) requires an S corporation to confer equal rights to all shares for distributions and liquidation proceeds.) Second, Q’s payments to X would be tested under Sec. 301, exposing X to dividend income instead of capital gains. Most important, if Q’s S election were indeed terminated, then a taxable asset sale by Q, followed by a liquidating distribution to its shareholders, would carry a substantially higher tax burden than the same transaction as an S corporation.
Fundamentally, the issue involves whether X has surrendered his equity stake and is now merely a creditor of the business, or whether the variability built into the redemption price suggests that X has retained his benefits and burdens of equity ownership. How does the IRS view such transactions? Not surprisingly, the answer is that it depends upon the facts and circumstances. The IRS has stated it will not issue rulings in certain redemption transactions, notably where the purchase price is based partly or entirely on future earnings of the corporation (or a similar contingency) (Rev. Proc. 2012-3). However, the IRS may issue rulings if the taxpayer seeks guidance on whether a redemption agreement will be treated as a second class of stock under Sec. 1361(b)(1)(D). In a recent letter ruling, the IRS assured a taxpayer that no second class of stock existed where a redemption price was adjusted if the S corporation engaged in “certain sales transactions” after the redemption (Letter Ruling 201218004).
In this letter ruling, the IRS analyzed the redemption agreement under Regs. Sec. 1.1361-1(l)(2)(iii), which provides that redemption agreements do not create a second-class-of-stock issue unless two conditions exist: (1) A principal purpose was to circumvent the single-class-of-stock requirement; and (2) the purchase price is significantly in excess of or below fair market value at the agreement date. If the contingent redemption price in the example above is meant to reconcile differing views of enterprise value, then the parties might argue, under this rule, that X’s agreement should not create a second class of stock. Surprisingly, in Letter Ruling 201218004, it appeared that simply representing to the IRS that neither of these two conditions existed helped the taxpayer receive a favorable ruling.
The parties would almost certainly be bound by their form in this transaction. Taxpayers have successfully argued redemption vs. sale treatment in fixed-plus-contingent-payment sales of property, and the courts have weighed the form the parties choose heavily. In Erickson, 56 T.C. 1112 (1971), a corporation redeeming a shareholder attempted to recast the transaction, post-closing, by bifurcating it into separate redemption and joint venture agreements. This treatment of the transaction was more favorable from a tax perspective to the remaining majority shareholder of the corporation.
The corporation’s rationale was that the redemption price was to be adjusted depending upon the profits from a specific construction contract and the redeemed shareholder played a significant managerial role in completing the construction contract that was the subject of the alleged joint venture. The court concluded that the transaction should be treated solely as a redemption, based on several factors, including the parties’ legal form, the agreement language, the parties’ representation by legal counsel, and the corporation’s internal accounting of the transaction.
Accordingly, the parties in the example should make every effort in the governing documents to clarify their intent that X is no longer considered a shareholder of Q. To that end, the parties should consider the following suggestions: (1) The term of the contingent payout should be as short as possible, minimizing the perception that X is along for the entrepreneurial ride; (2) if applicable, the parties should terminate X as an employee and remove him from the board of directors, to eliminate his prospective influence; (3) X should relinquish his shares and be barred from using the shares as collateral for any contingent payout; and (4) the redemption agreement should clearly state that the price is structured in this manner due to a disagreement between the parties on the enterprise’s fair market value.
Alan Wong is a senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York City.
For additional information about these items, contact Mr. Wong at 212-697-6900, ext. 986 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with DFK International/USA.