Avoiding Locked-In Installment Gain on a Predeath Stock Redemption

Editor:
Albert B. Ellentuck, Esq.
Of Counsel
King & Nordlinger, L.L.P.
Arlington, VA

Editors note: This case study has been adapted from PPC Tax Planning GuideClosely Held Corporations, 16th Edition, by Albert L. Grasso, Joan Wilson Gray, R. Barry Johnson, Lewis A. Siegel, Richard L. Burris, James A. Keller, Gary W. Brown and James J. Mogelnicki, published by Practitioners Publishing Company, Fort Worth, TX, 2003 ((800) 323-8724; www.ppcnet.com ).

Facts: Marshall Basket Co.s outstanding stock is held by 11 members of the same family (heirs and relatives of the deceased founder, Jonas Marshall). The oldest shareholder is Jerry Marshall, Jonas brother. Jerry, who is single, is advanced in years and has just been diagnosed with a terminal illness. Jerrys will leaves his estate to his five children and their families, none of whom are Marshall Basket shareholders. Jerry and the present shareholders agree it would be better for the corporation to redeem his stock before death, rather than extend the ownership to his diverse group of heirs.

Jerrys stock basis is approximately $20,000; the stocks fair market value (FMV) is approximately $500,000. The shareholders ask their tax adviser about their plan to have Jerry redeem his shares now for $50,000 down, with the corporation paying the $450,000 balance via a 10-year installment note. Issue: Is a stock redemption funded by an installment note the best way to retain corporate ownership within the existing shareholder group?

Analysis

The tax adviser explains that Jerrys lifetime stock redemption would qualify for sale or exchange treatment, as it would be a complete termination of his interest. Further, it appears that Jerry would not be required to enter into a 10-year waiver of family attribution, because none of his immediate family members are shareholders. Presumably, Jerry has nieces and nephews who are shareholders (the children of his brother who founded the corporation), but the family attribution rules do not attribute stock ownership other than from a spouse, children, grandchildren and parents.

While on the surface, a lifetime stock redemption appears to satisfy Jerrys and the other shareholders objectives, the tax adviser notes that it presents a significant ongoing tax cost to Jerrys heirs. By redeeming his stock now, Jerry will be setting up a long-term installment obligation with $450,000 of principal remaining to be paid. Because his basis in the stock was only $20,000 (i.e., 4% of the total redemption price), there is a 96% gross profit ratio (GPR) on the note receivable.

If Jerry dies during the notes 10-year term, his heirs will inherit it without a basis step-up. Under Sec. 691(a)(4), an installment obligation inherited from a decedent passes to the heirs with the same GPR, despite the notes FMV being included in the estate. As the heirs collect the future annual principal payments from the corporation, they would be required to report the same GPR Jerry reported. If the receivables FMV triggers estate tax to Jerrys estate, the heirs would be allowed an itemized deduction for the estate tax attributable to this income in respect of a decedent; see Sec. 691(c)(1). However, the estate tax deduction would only partially offset the gain the heirs will report.

Note: The Jobs and Growth Tax Relief Reconciliation Act of 2001 repealed the Federal estate tax for decedents who die after 2009.

The high tax cost of the redemption plan becomes particularly evident when compared to the alternative of deferring the redemption until after Jerrys death. Stock that passes through an estate receives a fresh basis equal to the stocks FMV at the date of death (DOD) (or the alternate valuation date, if elected). By deferring the redemption until the stock is in Jerrys estate, the entire $480,000 of appreciation would avoid income taxation on redemption.

For decedents dying after 2009, the rules that allowed for a basis step-up to the FMV of property acquired from a decedent are replaced with modified carryover-basis rules. Under the new rules, the basis of property inherited from a decedent will be his or her adjusted basis or the propertys FMV on the DOD, whichever is less; see Sec. 1022(a)(2)(B). However, estates can increase basis (but not above FMV on the DOD) by up to $1.3 million on certain appreciated assets; an additional $3 million increase in basis will be available for outright transfers or qualified terminable interest property transferred to a surviving spouse, under Sec. 1022(b)(1), (c)(1) and (d)(1). Although the estate tax and the basis step-up rule are scheduled to be repealed beginning in 2010, a new Congress may block the repeal before it occurs. Tax advisers should monitor this area for future developments.

The danger in deferring the redemption into Jerrys estate is that his executor and heirs may be unwilling to have Marshall Basket redeem the stock. To ensure that the corporation can acquire this stock via a redemption, the tax adviser suggests that the shareholdersincluding Jerrycurrently establish a buy-sell or shareholder sale agreement that obligates the deceased shareholders estate to offer to sell the stock to the corporation at the agreement price. In addition, the agreement should require that the corporation purchase the stock at the agreed-on price.

Without these requirements, a ready market is not established for the stocks value. An agreement that contains merely an option to purchase or a right of first refusal to meet any third-party offer does not create liquidity for the decedents estate or beneficiaries.

Also, it is extremely important that the buy-sell agreement meet the requirements to establish the estate tax value of Jerrys stock in Marshall Basket. When a buy-sell agreement does not meet such requirements, the estate may be forced to sell the stock for the amount specified in the buy-sell agreement, which may be less than the stocks estate tax value; thus, estate tax may be paid on value the estate never realized. (For more information on buy-sell agreements, see Jackson III and Mahoney, Buy-Sell AgreementsAn Invaluable Tool (Parts I and II), TTA, April 2003 and May 2003.)

Conclusion

A stock redemption that occurs shortly before the redeemed shareholders death represents a tax trap if it includes a long-term installment obligation. Once an installment obligation is created, the gain is permanently locked in and continues to be reportable by the heirs or beneficiaries who might inherit the note. To avoid this result, Jerry and Marshall Basket should defer the redemption until after his death, by providing a buy-sell agreement that obligates the estate to offer (and the corporation to purchase) the stock at the agreement price.