Corporations & Shareholders
Rev. Rul. 75-447 addresses the tax treatment of two situations: an issuance of stock to a new shareholder followed by a redemption of stock from old shareholders, as well as the partial sale of stock by old shareholders to a new shareholder, followed by a redemption of some (but not all) of the remaining shares of the old shareholders. Typically, the tax consequences of a transaction in which property is distributed to a shareholder are determined under Sec. 301. Under Sec. 301, a distribution of property is treated as a dividend to the extent of the distributing corporation's current or accumulated earnings and profits (E&P). Any amount exceeding the corporation's E&P is treated as a reduction in the stock's adjusted tax basis. The remaining amount is treated as gain from a sale or exchange of property.
In Rev. Rul. 75-447, the IRS said that, regardless of the order of the steps, the redemption of shares (when combined with an issuance of stock or sale of stock by the shareholders) as part of an integrated plan should not be treated as a dividend to the shareholder, but rather should be treated as a sale or exchange under Sec. 302(b). Specifically, the ruling addresses whether the stock redemption (when combined with an issuance or partial disposition as part of an overall integrated plan) qualifies under Sec. 302(b)(2) as a "substantially disproportionate" redemption. However, as discussed below, this rule also applies in cases where a plan involves a redemption and an issuance or sale of stock that results in a termination of the old shareholder's interest in the corporation under Sec. 302(b)(3).
Zenz v. Quinlivan
Rev. Rul. 75-447 is based on Zenz v. Quinlivan, 213 F.2d 914 (6th Cir. 1954). In Zenz, the IRS argued that a redemption should be treated as a dividend; however, the Sixth Circuit disagreed, finding that the shareholder did not retain any ownership post-redemption, and therefore she was treated as if she had disposed of all of the interest as part of one transaction. Thus, the court held that the transaction qualified for Sec. 302(b)(3) treatment as a termination of the shareholder's interest. That the two transactions took place as part of one integrated plan was key to the Sixth Circuit's ruling. The order of the transactions does not have any effect on the treatment, as long as it results in a complete liquidation of the former shareholder's interest within a short period of time. The treatment of the stock redemption is determined by respecting the form of the transactions over their substance. These are commonly referred to as "Zenz transactions."
In most cases, the sale or exchange treatment of a stock redemption in a Zenz transaction should yield favorable results to the sellers by providing upfront basis recovery versus a distribution characterization where basis recovery occurs only after the exhaustion of all current and accumulated E&P. If the tax basis in the shares is significant, this result can have a large favorable effect on the amount of taxable income the seller recognizes.
This transaction also allows the buyer to purchase 100% of the interest in a target for partial consideration. Certain assets can be distributed to the seller as part of the transaction, while the seller receives consideration directly from the target. The purchase price is likely to be reduced by the amount of shares or assets redeemed by the former shareholder(s).
Example 1: Company X wants to buy Company Y for $500. Seller A (the sole shareholder of Y) wants to receive $2,000 for his 200 shares. Y has $1,500 available in cash. Y can redeem 150 of A's shares for $1,500. Immediately after the redemption, X buys A's remaining 50 shares for $500. At the end of the two transactions, X owns 100% of the shares in Y. Thus, X is able to purchase 100% of the shares of Y for $500, and A receives $2,000 for 100% ownership. Both transactions are treated as a sale or exchange, resulting in capital gain to A for the amount received in excess of his tax basis, assuming A held the stock as a capital asset.
...and the Bad
However, in some circumstances, this treatment can yield neutral or even unfavorable results to both parties in the transaction. For instance, if the shareholder redeeming the shares of the target is a corporation, the shareholder might prefer to receive dividend income that may qualify for a dividend-received deduction. Similarly, if the shareholder's tax basis in the shares redeemed is minimal or zero, the sale or exchange treatment of the transaction may not have a material effect on taxable income.
In addition, the buyer's basis in the target will be lower in a Zenz transaction than it would be if the buyer purchases all of the selling shareholder's stock.
Example 2: Assume the same facts as in Example 1. Company X now owns 100% of Company Y, which equals 50 shares. X takes a tax basis in those shares of $500. In contrast, if X bought all shares of Y without any redemptions, the total tax basis that X would hold in Y would have been $2,000. Thus, it is clear to see that the stock redemption resulted in wasted tax basis.
The Exit Strategy
Depending on its exit strategy, a buyer should be aware of these adverse effects on the tax basis of the shares purchased. The transaction in Example 2 might result in higher deferred gain, which will be triggered when X sells Y in the future.
Example 3: Assume the same facts as in Example 2. Three years after the Zenz transaction, Company X sells 100% of the stock of Company Y for $3,000. X recovers its tax basis of $500 in the stock of Y and recognizes gain of $2,500 on the sale. Alternatively, if X had bought all the shares of Y without a redemption of stock, X would have tax basis of $2,000 in Y's stock, which would result in capital gain of $1,000. Thus, the Zenz transactions would result in a higher gain to X upon sale of $1,500 (the redemption amount).
Conclusion: Buyer Beware
A buyer pays less in a Zenz transaction as the assets distributed in redemption are not included; however, future use of the target's cash or assets is lost to offset the economic benefit. The buyer is in the position of 100% ownership but has a deferred gain due to lost tax basis. If the buyer intends to sell the company in the future, then unanticipated gain potentially can be recognized. Accordingly, if the buyer plans on reselling the company, it may wish to negotiate a reduction in the purchase price to take into account the lower tax basis it will receive because of structuring the transaction as a Zenz transaction.
Private-equity buyers, especially, should be aware of these rules, as they likely intend to sell the company at a profit in the future. More strategic buyers, who intend to integrate the target's business and continue operations without any plans to sell the company in the future, might not be as adversely affected by the stock's lower tax basis.
As another alternative, the buyer may request to separate the transactions and treat them as not being part of an integrated plan. Because the seller potentially will pay more taxes in this scenario, the seller should carefully analyze the tax consequences of separating the transactions and negotiate a purchase price for its target company stock that reflects the additional tax it will have to pay.
Greg Fairbanks is a tax senior manager with Grant Thornton LLP in Washington.
For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.