S corporation redemptions: Navigating Secs. 302 and 301

By Devin Tenney, J.D., Milwaukee, and James Malczewski, CPA, Appleton, Wis.

Editor: Mark Heroux, J.D.

Fueled by the law known as the Tax Cuts and Jobs Act of 2017 (TCJA), P.L. 115-97, and a market of retiring Baby Boomers looking to divest ownership interests, the marketplace recently experienced a wealth of transactions. Among this crowd are S corporations engaging in shareholder redemptions — with some also contemplating a subsequent conversion to a C corporation to take advantage of the preferable C corporation tax rates.

Among clients' chief concerns is whether a redemption qualifies as a sale or exchange, or instead must be characterized and taxed as a dividend — and the resulting tax consequences. This discussion sheds light on these questions with a high-level overview of the applications of Secs. 302 and 301 to S corporation redemptions.

Redemption under Sec. 302

Pursuant to Sec. 302, a distribution in redemption of stock is treated as a sale or exchange if the redemption:

1. Is not essentially equivalent to a dividend;

2. Is substantially disproportionate;

3. Completely terminates the shareholder's interest; or

4. Is in partial liquidation of the redeeming corporation.

Not essentially equivalent to a dividend: This is a largely subjective standard applied on a case-by-case basis, looking at the relevant facts and circumstances. Due to the uncertainty surrounding the application of this standard, it is best relied on only if the other three mechanical exceptions are not met.

Substantially disproportionate: A redemption is substantially disproportionate if: (1) The shareholder's interest in the outstanding common stock of the redeeming company post-redemption is less than 80% of the shareholder's interest before the redemption (the 80% test must be met for both common voting, and common voting and nonvoting combined); and (2) immediately after the redemption, the shareholder owns less than 50% of the total combined voting power of all classes of stock entitled to vote.

Example 1: Star, an S corporation, has 1,000 shares of outstanding voting common stock. Shareholders A, B, C, D, and E are unrelated parties (no attribution under Sec. 318), and each owns 200 shares. Star redeems 150 shares from A, 75 shares from B, and 25 shares from C (for a total of 250 redeemed shares — or 25% of the total outstanding stock). Following the redemption, there are 750 outstanding shares, with A owning 50, B owning 125, C owning 175, and D and E each owning 200. A's redemption will qualify as being substantially disproportionate, as her post-redemption ownership is less than 80% of her pre-redemption ownership. (A's post-redemption ownership of 6.67% (50 ÷ 750) is less than 80% of her pre-redemption 20% ownership (20% × 80% = 16%), and her post-redemption ownership is less than 50% of the corporation's voting shares.) However, B's and C's redemptions do not meet the substantially disproportionate test, with B's post-redemption ownership share of 16.67% exceeding the 16% threshold, and C's ownership share increasing to 23%.

Constructive ownership: With closely held corporations, the application of constructive ownership under Sec. 318 is a common hurdle that prevents a shareholder from qualifying for the mechanical tests provided in Sec. 302 and is usually experienced through family attribution — either directly or through trusts (although attribution also applies to other entities). Family attribution applies to lineal descendants, where an individual is considered as owning the stock owned, directly or indirectly, by or for his or her spouse, children, grandchildren, and parents. While beyond the scope of this discussion, when ownership interests are held in trusts, one needs to determine what trust ownership will be attributed to which beneficiaries.

Example 2: Assume the same facts as Example 1, except A is the daughter of D. In determining whether A's redemption was substantially disproportionate, her father's ownership will be attributed to her. Consequently, A's pre-redemption ownership percentage is deemed to be 40% (her 200 shares plus her father's 200 shares). For A's redemption to qualify as being substantially disproportionate, her ownership would need to decrease below 32%. However, her post-redemption ownership under Sec. 318 is 33.3% (250 ÷ 750) and, therefore, does not meet the qualifying threshold.

Reattribution: It is important to note that ownership attributed to an individual from an entity can then be reattributed to that family member's lineal descendants.

Example 3: Assume the same facts as Example 2, except E is a trust from which D is attributed the 200 shares owned by E. In determining whether A's redemption was substantially disproportionate, her father's ownership, which will be attributed to her, is 400 shares. Consequently, A's pre-redemption ownership percentage is deemed to be 60% (her 200 shares plus her father's 400 shares). For A's redemption to qualify as being substantially disproportionate, her ownership would need to decrease below 48%. However, her post-redemption ownership under Sec. 318 remains at 60% (450 ÷ 750) and, therefore, does not meet the qualifying threshold.

Waiver of family attribution: An individual or entity shareholder may waive the Sec. 318(a)(1) family attribution rules — serving to disregard their application — to a redemption made under Sec. 302(b)(3). The waiver applies only to distributions completely terminating the shareholder's interest if the redeemed shareholder:

  • Does not have a prohibited interest in the distributing corporation immediately after the distribution;
  • Does not acquire any prohibited interest (i.e., by means other than by bequest or inheritance) within 10 years following the distribution;
  • Agrees to notify the IRS if the shareholder acquires any prohibited interest within the 10 years after redemption;
  • Agrees to retain certain records; and
  • Did not make certain tax-avoidance acquisitions or dispositions of the company's stock in the 10 years before the redemption.

    Example 4: Assume the same facts as Example 2, except A's ownership interest was fully redeemed, she has no plans of acquiring any interest in Star within the next 10 years, and she did not engage in transfers of Star stock with a principal purpose of tax avoidance. By attaching a statement pursuant to Sec. 302(c)(2)(A)(iii) to her timely filed federal income tax return for the year of the redemption, A will be permitted to disregard the family attribution portion of the constructive ownership rules. Therefore, A would not be attributed her father's 200 shares.

Redemptions as a Sec. 302 sale or exchange versus a Sec. 301 distribution

If a redemption of S corporation stock fails to meet the requirements of Sec. 302, it is taxed under the mechanics of Secs. 301 and 1368. Given the comparative tax rates on capital gains and qualified dividends, it is easy to question what impact, if any, a failure to meet the requirements of Sec. 302 has on a redemption of C corporation stock. However, in the S corporation environment, shareholders may find more tax advantages from Sec. 301, as discussed below.

Tax consequence of a sale or exchange under Sec. 302: If a redemption qualifies as a sale or exchange under Sec. 302, the amount of the redemption proceeds in excess of the shareholder's basis in the redeemed stock will be taxed as a capital gain. Keep in mind that the balance of the corporation's accumulated adjustments account (AAA) and earnings and profits (E&P), if any, will be affected, with AAA being reduced in an amount equal to the ratable share of the corporation's AAA (whether negative or positive) attributable to the redeemed stock as of the date of the redemption and E&P reduced by the amount of the ratable share of E&P attributable to the redeemed stock— reducing the remaining amount of E&P, which could affect future distributions.

Tax consequence of a distribution under Sec. 301If an S corporation redemption does not qualify as a sale or exchange under Sec. 302, it instead defaults to a Sec. 301 distribution, subject to the ordering rules of Sec. 1368, which provide that the recipient shareholder must treat the redemption in the following sequence:

1. Nontaxable to the extent of the corporation's AAA balance (note that this is the corporation's total AAA balance and not the redeemed shareholder's ratable share);

2. A taxable dividend to the extent of the S corporation's accumulated E&P;

3. A nontaxable reduction in any remaining shareholder stock basis; and

4. Taxable as a capital gain distribution.

Shareholders of S corporations with significant AAA may benefit considerably due to the Sec. 1368 ordering rules (although potentially at the cost of future shareholders, who will have less AAA to work with). Redeeming shareholders with sufficient stock basis could find that a substantial portion, or all, of their redemption proceeds would not be subject to tax as a result of the redemption.

One class of stock: One area of confusion and concern among clients is whether a redemption made under Sec. 301 is considered a disproportionate distribution in violation of the identical-distribution rules under Regs. Sec. 1.1361-1(l)(1). A redemption that fails to qualify under Sec. 302 is generally not considered a disproportionate distribution that creates a second class of stock in violation of the S corporation eligibility rules (so long as the redemption agreement was not entered into to circumvent the single-class-of-stock requirement) (Regs. Sec. 1.1361-1(l)(2)(iii); see also IRS Letter Rulings 9810020 and 9404020). Therefore, a redemption made under Sec. 301 will generally not terminate an S election.

Redemptions that qualify under Sec. 302 are generally treated as sales or exchanges and are not distributions. Therefore, qualified redemptions under Sec. 302 generally do not create a second class of stock and do not terminate an S election. The potential exception involves a redemption that fails to reflect the fair market value of the redeemed shares.

Planning opportunity

The TCJA may tempt certain family businesses to revoke their S status in favor of the lower flat tax rate of 21% on C corporation income. Interesting fact patterns may include family businesses in need of succession planning.

Evaluating a conversion to a C corporation is a complex analysis that should not be made lightly and most often favors retaining S status. However, a desire for a tax-efficient redemption of a senior generation's S corporation stock could generate some interesting analyses.

For family business S corporations that have reasons to consider a C corporation conversion and wish to retire the senior generation's stock, it might be worthwhile to strategize on pairing these two objectives. The family may evaluate using AAA to make redemptions before converting to a C corporation. Perhaps the redemption is made with an installment obligation payable to the redeemed shareholder over time (while the business is a C corporation). Doing so will provide the redeemed shareholder with a tax-efficient income stream for multiple years and permit the corporation to use the additional annual tax savings realized from the C corporation status to help meet the annual installment payments.

Analyzing a potential C corporation conversion is a complex and weighty matter in any circumstance. An even more complex and intriguing analysis includes a preconversion shareholder redemption that fails the sale-or-exchange treatment under Sec. 302. Understanding the implications and interplay of Secs. 301, 302, 318, and 1368 is essential in any such analysis. As such, clients are strongly encouraged to consult a tax adviser in considering this matter.

EditorNotes

Mark Heroux, J.D., is a principal with the National Tax Services Group at Baker Tilly Virchow Krause LLP in Chicago.

For additional information about these items, contact Mr. Heroux at 312-729-8005 or mark.heroux@bakertilly.com.

Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP.

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