Editor: Albert B. Ellentuck, Esq.
While an analysis of the tax consequences of a redemption to the shareholder usually begins with whether the transaction qualifies for sale or exchange treatment, another starting point is whether the S corporation has accumulated earnings and profits (AE&P). If the S corporation lacks AE&P (i.e., has always been an S corporation and has never acquired a C corporation with E&P via merger), dividend treatment cannot result from a redemption. Under the normal S corporation distribution rules, the redemption distribution is treated as a nontaxable return of capital to the extent of the adjusted basis of stock, followed by capital gain from the deemed disposition of stock (Sec. 1368(b); Rev. Rul. 95-14).
As illustrated by the following example, the tax consequences of a noncapital gain redemption to an S corporation shareholder can be more advantageous than capital gain treatment because the shareholder may be able to recover stock basis without any capital gain recognition.
Example: Assume that G is the senior shareholder of a small law firm that has always been an S corporation. G owns 60% of the stock, and her daughter, D, also an attorney, owns the other 40%. G is approaching retirement and would like the corporation to redeem her stock. G’s stock basis equals $100,000, and the fair market value (FMV) of her stock is $200,000.
Because G can potentially recover the first $100,000 tax free against her basis, her adviser structures the stock redemption in two steps. First, the corporation redeems half of her stock for $100,000. This redemption does not qualify for sale or exchange treatment, as it is not a complete redemption, nor is it substantially disproportionate (dropping G below 50% ownership) because of the family attribution rules. As a consequence, the $100,000 partial redemption in the first year is treated as a distribution and, under the S distribution rules, is a return of stock basis that is entirely tax free.
The following year, G sells her remaining shares and elects to waive family attribution to assure complete termination status. The sale is structured as an installment sale over a 10-year term. In this manner, G recovers her basis tax free against the initial payment of $100,000, and her capital gain on the transaction is deferred, to be recognized as the installment payments are received.
Applying New Taxes and Higher Tax Rates
The American Taxpayer Relief Act of 2012, P.L. 112-240 (ATRA), raised the top ordinary income tax rate to 39.6% (from 35%) for singles with taxable income above $400,000, married couples filing a joint return with taxable income above $450,000, and married individuals filing separate returns with taxable income above $225,000 (Sec. 1(i)). (After 2013, these taxable income amounts will be adjusted for inflation.) ATRA also increased the tax rate for long-term capital gains and qualified dividends to 20% for individuals subject to the 39.6% ordinary income tax rate. The tax rate for long-term capital gains and qualified dividends continues to be 15% for individuals with a marginal tax rate on ordinary income of 25% or greater whose taxable income falls below the levels for the new 39.6% regular tax rate, and 0% for individuals with a marginal tax rate on ordinary income of 10% or 15%.
The Health Care and Education Reconciliation Act of 2010, P.L. 111-152, authorized a new net investment income tax on higher-income individuals, starting in 2013. This net investment income tax applies to singles with modified adjusted gross income (MAGI, which is AGI for those not claiming the foreign earned income exclusion) above $200,000, married couples filing a joint return with MAGI above $250,000, and married individuals filing separate returns with MAGI above $125,000 (Sec. 1411(b)). Net investment income includes dividends, capital gains, and income from passive activities (among other types of qualifying income), less any expenses properly allocable to the income. (For more on the net investment income tax, see Williamson, “Planning for the ‘Parallel Universe’ of the Net Investment Income Tax.”)
According to Sec. 1411(c)(4), gain or loss from the disposition of an interest in an S corporation that conducts a trade or business in which the shareholder materially participates is subject to the net investment income tax only to the extent of the net gain that the shareholder would report if all of the S corporation’s nonbusiness property had been sold for its FMV immediately before the disposition. (This “deemed sale” rule adjusts the amount of gain or loss taken into account for net investment income tax purposes.) However, the deemed sale rule does not apply if the S corporation does not conduct a trade or business or the trade or business is a passive activity or a trade or business of trading in financial instruments or commodities for the redeemed shareholder because there would be no change in the net gain included in the shareholder’s net investment income under Sec. 1411(c)(1)(A)(iii) (Prop. Regs. Sec. 1.1411-7(a)(2); preamble to REG-130507-11).
Sec. 1411(c)(4), Prop. Regs. Sec. 1.1411-7(a), and the preamble to the proposed regulations are silent on whether an S corporation redemption is a “disposition of an interest in . . . [an] S corporation” under Sec. 1411(c)(4). Most practitioners would consider a redemption, no matter how effected, to be a disposition of the stock. On the other hand, it is possible that the deemed sale rule applies only to a redemption that qualifies for sale or exchange treatment under Sec. 302(b) or 303. Otherwise, the redemption is taxed as a distribution under Sec. 1368. In any event, Prop. Regs. Sec. 1.1411-1(a) states that: “Except as otherwise provided, all Internal Revenue Code provisions that apply . . . in determining taxable income . . . of a taxpayer also apply in determining the tax imposed by section 1411.”
Assuming the net investment income tax deemed sale rule can apply to an S corporation redemption that qualifies for sale or exchange treatment, the deemed sale rule will apply when the property is held in a trade or business not described in Sec. 1411(c)(2). This means that the deemed sale rule does not apply when (1) there is no trade or business, (2) the trade or business is a passive activity for the transferor (the redeemed shareholder), or (3) the S corporation is in the trade or business of trading in financial instruments or commodities. In these three circumstances, there would be no change in the amount of net gain included in the shareholder’s net investment income under the deemed sale rules. Furthermore, the net investment income tax does not apply if the redeemed shareholder’s MAGI in the year of the redemption does not exceed the thresholds previously listed (e.g., $200,000 for single filers).
Calculating Gain or Loss
When an S corporation redeems its stock in a transaction that qualifies as a sale or exchange, the shareholder’s realized and recognized gain or loss is governed by Sec. 1001. The shareholder’s adjusted stock basis is subtracted from the amount of cash and the FMV of other property received from the corporation. While the general rule is that stock basis is determined as of the end of the S corporation’s tax year, the basis of stock disposed of during the year is determined immediately before the disposition occurs (Regs. Sec. 1.1367-1(d)(1)). Therefore, stock basis is adjusted for current-year items of S corporation income, loss, etc., before determining gain or loss from the redemption.
Choosing the Method for Allocating Passthrough
The specific accounting method can be elected if the redeemed shareholder completely terminates his interest in the corporation, or there is a “qualifying disposition” of the stock as defined in Regs. Sec. 1.1368-1(g)(2). The method of allocation is important because it affects the amount of passthrough income, loss, etc., allocated to each person who owned stock during the year.
In many cases, use of either allocation method will result in the redeemed shareholder recognizing the same amount of income, since passthrough income increases the amount of the shareholder’s basis, which reduces the amount of gain recognized because of the redemption. However, the character of the recognized income (ordinary income vs. capital gain) may differ. Furthermore, if the redeemed shareholder recognizes capital losses in the year of redemption, or has a capital loss carryover, he or she will normally want to maximize the capital gain reported from the redemption. Because all affected shareholders must consent to the election in the case of a complete termination of a shareholder’s interest, and because all shareholders must consent to the election in the case of a qualifying disposition, the shareholders should consider addressing this issue in the shareholder or redemption agreement.
Characterizing the Gain or Loss
The character of gain or loss recognized by the redeemed shareholder depends on whether the stock is a capital asset in the redeemed shareholder’s hands and whether the redemption is treated as a sale or exchange. Capital gain status can be beneficial because of the maximum tax rate of 20% imposed on long-term capital gains. However, with dividends also taxed at a maximum 20% rate, structuring a redemption to qualify for capital gain status has diminished in importance. Nevertheless, there are still important reasons for qualifying the redemption for sale or exchange status. For example:
- Capital gains can be offset with capital losses, while dividends cannot be offset.
- Capital gain recognition can be deferred when an installment note is issued to the shareholder in a redemption that qualifies for sale or exchange treatment.
Considering the Potential Threat to the Corporation’s S Election
If the redemption occurs by the 15th day of the third month of the corporation’s tax year and the remaining shareholders own more than half of the outstanding stock, they can terminate the S election retroactive to the first day of the tax year (Sec. 1362(d)(1)). In addition, the remaining shareholders can change the corporation’s accounting method, resulting, for example, in passthrough income rather than an expected passthrough loss.
Using Suspended Passthrough Losses
In a complete redemption, suspended passthrough losses (losses not previously deducted because of basis limitations) remaining after the basis of the redeemed stock has been reduced to zero do not reduce gain, or increase loss, resulting from the redemption. (The result is the same whether the redemption qualifies as an exchange or is treated as a distribution.) When all of the shareholder’s stock is redeemed, the shareholder loses the ability to deduct any carryover losses. If less than all of the shareholder’s stock is redeemed, suspended passthrough losses are carried forward in full. Suspended losses are personal to the shareholder, not the shares owned, so a partial redemption would not result in a pro rata reduction of these losses (Regs. Sec. 1.1366-2(a)(5)).
Losses limited by the Sec. 465 at-risk rules are eligible for indefinite carryover (the same as losses suspended under the basis limitation rules). However, unlike the basis limitation rules, at-risk basis is increased for gain recognized on disposition of stock. Apparently, suspended losses arising from application of the at-risk rules can be claimed by the redeemed shareholder to the extent of gain recognized, if there is no basis limitation problem.
Losses limited by the Sec. 469 passive activity rules are also suspended at the shareholder level and carried forward indefinitely to offset future passive income. When a taxpayer disposes of an entire interest in a passive activity to an unrelated party in a fully taxable transaction, suspended passive losses (and any loss from disposition of the activity) can be deducted first against current net passive income and then against nonpassive income.
While a complete redemption seems to fall within this rule (since it is a taxable transaction), it is unclear when a redeemed shareholder would be prevented by the related-party rules from deducting suspended passive losses. In the authors’ opinion, any future regulations (Regs. Sec. 1.469-6 is reserved for this topic) will focus on who controls the corporation after the redemption, rather than whether the corporation is treated as a related party to the redeemed shareholder before the redemption.
This case study has been adapted from PPC’s Tax Planning Guide—S Corporations, 27th Edition, by Andrew R. Biebl, Gregory B. McKeen, George M. Carefoot, James A. Keller, and Kimberly Drechsel, published by Practitioners Publishing Co., Fort Worth, Texas, 2012 (800-323-8724; ppc.thomson.com).
Albert Ellentuck is of counsel with King & Nordlinger LLP in Arlington, Va.