This item presents a potential opportunity to minimize the tax impact of a distribution by a closely held corporation that is not made out of the corporation's earnings and profits (E&P). In general, Sec. 301 provides that corporate distributions are treated as (1) dividends to the extent of the corporation's current or accumulated E&P; (2) return of capital to the extent of the shareholder's tax basis in the shares; and (3) gain from the sale or exchange of the shares to the extent that it exceeds the shareholder's adjusted basis in the shares. The application of this provision is fairly straightforward where a shareholder owns a single block of shares. However, if a shareholder owns multiple blocks of shares with differing tax bases, the application of Sec. 301 is more complex. The following example illustrates this complexity.
Example: Corporation A makes a distribution of $200 and has $0 of E&P. The fair market value of the stock is $1 per share, and it is owned 100% by B with the following tax bases: 100 shares with zero basis in block 1; 100 shares with a $100 basis in block 2; and 200 shares with a $400 basis in block 3.
Tax treatment of a regular distribution
Prop. Regs. Sec. 1.301-2(a), issued in 2009 (REG-143686-07), provides that corporate distributions are treated as proportionally made with respect to each share of stock and that Sec. 301 is applied on a per-share basis. While this regulation will not become effective until it is issued in final form, it follows the decision in Johnson, 435 F.2d 1257 (4th Cir. 1971), which established precedent for the recovery of tax basis in a Sec. 301 distribution.
Applying this to the above example, B cannot offset the $200 distribution against his $500 aggregate basis in the shares. Instead B is treated as receiving $50 with respect to block 1, $50 with respect to block 2, and $100 with respect to block 3. This would result in capital gain of $50 (since block 1 has zero basis) and a reduction of basis in block 2 from $100 to $50 and a reduction in basis for block 3 from $400 to $300.
Share redemption vs. regular distribution
What if, instead of making a $200 regular distribution, Corporation A redeems B's block 3 shares for $200? Since B would continue to own 100% of Corporation A following the redemption, Sec. 302(d) would apply, and the redemption would be treated as a distribution to which Sec. 301 applies (and not as a sale or exchange of the block 3 shares). As Corporation A has no E&P, under Sec. 301(c), the proceeds are first applied to reduce B's stock basis, and any excess is treated as gain from the sale or exchange of shares. Once again, the issue is how to apply B's stock basis in this scenario.
A June 2006 report by the New York State Bar Association Tax Section (Report on Basis Recovery in a Dividend Equivalent Redemption, Rep't No. 1112 (June 13, 2006)) identified five alternative methods for recovering basis in a Sec. 302(d) stock redemption. The application of each method, using the above example, is described below.
All-shares method: This method is adopted in Prop. Regs. Sec. 1.302-5 issued in 2009; however, as the provision will not become effective until adopted in final form, it is not currently binding on taxpayers. First, in the above example, the amount distributed is allocated proportionally among all of the shares (similar to the approach in the Johnson case), resulting in $50 of gain on the block 1 shares, a $50 reduction of basis in the block 2 shares, and a $100 reduction of basis in the block 3 shares. Since the block 3 shares have been redeemed, the remaining $300 of tax basis in those shares is proportionally allocated $150 to the block 1 shares (resulting in a final basis of $150) and $150 to the block 2 shares (resulting in a final basis of $200).
Nonredeemed-shares method: This method is based on the legislative history of Sec. 1059 (requiring a reduction of stock basis for the nontaxed portion of an extraordinary dividend). Under this method, the basis of the redeemed shares is first allocated proportionally to the nonredeemed shares, and then the amount distributed is allocated proportionally among all of the nonredeemed shares. Applying this method to the example, the $400 basis in the block 3 shares is proportionally allocated $200 to the block 1 shares (resulting in a tax basis of $200) and $200 to the block 2 shares (resulting in a tax basis of $300). The $200 of redemption proceeds is then allocated $100 to the block 1 shares (resulting in $0 gain and a reduction in basis from $200 to $100) and $100 to the block 2 shares (resulting in $0 gain and a reduction in basis from $300 to $200).
Redeemed-shares method: Under this method, only basis in the redeemed shares can be applied to offset the distribution amount. Applying this method to the example, by opting to redeem the block 3 shares, B can offset the $200 distribution against the $400 basis in the block 3 shares, resulting in no gain recognition and $200 of remaining basis to be reallocated between the block 1 and block 2 shares. B's block 1 basis would increase from $0 to $100, and the block 2 basis would increase from $100 to $200.
Recapitalization method: Under this method, Corporation A is first treated as recapitalizing its shares from 400 shares to 200 shares, and the basis in B's three blocks is preserved. B is then treated as receiving $50 for his block 1 shares, resulting in $50 of gain; $50 for his block 2 shares, reducing his basis in block 2 from $100 to $50; and $100 for his block 3 shares, reducing his basis in block 3 from $400 to $300. This method is similar to the all-shares method and results in a similar amount of gain recognition.
Aggregate-basis method: Under this method, the aggregate tax basis of both the redeemed and nonredeemed shares would be available to offset the redemption proceeds before any gain would be recognized. The remaining aggregate basis would then be proportionally reallocated to the nonredeemed shares. In the example, B's aggregate basis of $500 would be reduced to $300 and would be allocated $150 each to block 1 and block 2.
Several routes to a tax-efficient redemption
Pending the issuance of final regulations under Sec. 302, shareholders of closely held corporations have the opportunity to redeem high-basis shares in a tax-efficient manner by adopting one of the alternative approaches to recovering tax basis. As illustrated in the example above, adopting the nonredeemed-shares, redeemed-shares, or aggregate-basis method should generally result in no gain recognition, while the all-shares or recapitalization method would result in some recognition of gain. While there is no certainty that the IRS will accept any of the favorable approaches, they provide taxpayers with an opportunity to structure a tax-efficient redemption.
Kevin Anderson is a partner, National Tax Office, with BDO USA LLP in Washington.
For additional information about these items, contact Mr. Anderson at 202-644-5413 or email@example.com.
Unless otherwise noted, contributors are members of or associated with BDO USA LLP.