Avoiding the 25% Passive Gross Receipts Problem by Using a Stock Redemption to Remove Excess Investments

Editor:
Albert B. Ellentuck, Esq.
Of Counsel
King and Nordlinger, L.L.P.
Potomac, MD

Editors note: This case study has been adapted from PPC Tax Planning GuideS Corporations, 17th Edition, by Andrew R. Biebl, Gregory B. McKeen and George M. Carefoot, published by Practitioners Publishing Company, Ft. Worth, TX, 2003 ((800) 323-8724; www.ppcnet.com).

Facts: Jack Excesso Corp. has been operating a highly successful manufacturing business that produces a unique automotive equipment item. This product has a limited market life. The company now finds the sales of this product dropping, primarily because the major automobile manufacturers now include a similar item as original equipment on new vehicles. Excesso anticipated the limited life span of its primary product and invested its profits from this product while developing new ones.

The corporation was originally a regular C corporation and has substantial accumulated earnings and profits (AE&P). The corporation elected S status 12 years ago and now files as a calendar-year S corporation.

Excessos stock is held equally by five family members (father, mother and three children). Each shareholder has a $100,000 stock basis. The father and two of the children are active in the business; the mother and one child have been passive investors since making their initial investment a number of years ago.

Excesso is advised by its tax adviser that it faces a risk of excessive passive receipts. As sales have declined, the corporations investment income is projected to exceed 25% of gross receipts for the tax year. Excessos accumulated adjustments account (AAA) is zero, because it distributed all current net income following its conversion to S status. Issue: How might a stock redemption be structured to eliminate the tax on excess net passive income (ENPI)?

Analysis

An S corporation faces a corporate-level tax at the top corporate rate (currently 35%) on its ENPI. An S corporation is subject to this tax if it meets two criteria:

1. The entity has AE&P as of the close of its current S tax year.

2. More than 25% of the corporations gross receipts are from passive investment income (PII).

According to Sec. 1375(b)(1)(A), the corporations NPI subject to the top corporate tax rate is determined by the ratio of PII in excess of 25% of gross receipts divided by PII for the tax year. The corporation can avoid this tax if it maintains a ratio of passive receipts to gross receipts of 25% or less. As a further strategy, the ENPI subject to tax is limited to the corporations current-year taxable income; if the corporation has no taxable income for the current year, the passive income tax is not applicable, according to Sec. 1375(b)(1)(B).

ENPI carries a significant additional risk, in that it may eventually cause termination of S status. When an entity has both AE&P and more than 25% passive gross receipts for three consecutive years, S status terminates as of the first day of the fourth year, under Sec. 1362(d)(3).

The tax adviser first determines whether it is feasible to restructure Excessos investments to minimize current income recognition from passive sources. The definition of tax-exempt interest income includes passive gross receipts. However, the earnings of other investments that do not produce current receipts or income recognition would avoid the passive tax. The tax adviser also determines if Excesso could use its excess funds in the new product line in the near future. If these strategies are not feasible, distributing the invested funds to shareholders would be an option. Because Excesso has AE&P but no AAA, any distribution in excess of the current years addition to the AAA is treated as a dividend to the extent of AE&P (a dividend distribution produces no tax-free basis offset until all AE&P has been recognized as dividend income).

Rather than have the shareholders absorb a large dividend to remove the excess investments, the tax adviser suggests that Excesso consider the redemption of one or more shareholders. For example, it might be feasible to completely redeem the stock of the mother and the child who are inactive in the business, thereby distributing a major portion of the investments producing the excess passive receipts. Characterization as a complete redemption allows the redeemed shareholders to fully use their stock basis to recover a portion of the corporate distribution as a tax-free return of investment. In addition, the remaining shareholders will benefit by the deemed reduction of AE&P that occurs as a result of a redemption, under Secs. 1371(c)(2) and 312(n)(7). If the two shareholders are redeemed, the corporate AE&P is reduced by 40%, with no adverse result to the redeemed shareholders. Also, a similar rule under Sec. 1368(e)(1)(B) and Regs. Sec. 1.1368-2(d)(1) requires proportionate reduction of any AAA existing immediately before a redemption.

To qualify such a redeeming distribution for exchange treatment (to allow basis offset by a terminating shareholder), a shareholder needs to redeem all of his or her stock. Further, because the Sec. 318 family attribution rules deem a terminating family shareholder to indirectly own the stock of certain remaining family members (including the shareholders spouse, child and parents), the redeemed shareholder must execute a waiver of family attribution agreement for the redemption to be a complete termination of each shareholders interest. Among other criteria, this waiver requires that the departing shareholders have no involvement as directors, employees or officers for the 10-year period following the redemption.

Conclusion

The tax adviser has shown how a stock redemption can extract assets creating an excess passive gross receipts problem for an S corporation. Further, the redemption results in a proportionate reduction in AE&P, which will benefit the remaining shareholders. If other family members are shareholders, care must be taken to properly execute an agreement to accomplish the waiver of family attribution to allow a complete termination of the shareholders interest.

Variation

The facts are the same as above, except that Excesso remained as a C corporation. The S corporation excess passive gross receipts tax is not a threat, but the accumulated earnings (AE) and personal holding company (PHC) taxes are. The AE tax becomes an issue when AE&P exceeds $250,000 ($150,000 for certain personal service corporations) and the corporation has excess funds that could be deemed accumulated beyond the reasonable needs of the business, under Secs. 533(a) and 535(c)(2). The PHC tax will apply if more than 50% of the outstanding stocks value is owned (directly or indirectly) by or for no more than five individuals at any time during the last half of the year, and at least 60% of the corporations adjusted ordinary gross income is passive PHC income, under Sec. 542(a). The AE and PHC tax rates are 15% for 2003.

A stock redemption may assist in avoiding the risk of both of these penalty taxes, by removing portfolio assets and investments. Such excess liquid or invested funds are often indicative of an unreasonable accumulation for purposes of the AE tax and often cause excess PHC receipts (interest and dividend income) in the case of the PHC tax. If the primary threat is the AE tax, the tax adviser might recommend an installment payout of the redeemed shareholders, with use of a strong interest rate on the debt obligation to further diminish corporate funds.