Seller’s Continuing Ties to S Corp. Did Not Disqualify Redemption Treatment

Effectively navigating Sec. 302’s requirements can avoid recharacterizing a stock redemption from a capital transaction to a dividend. One business owner’s strategy, which involved a complete stock redemption, was challenged by the IRS (Hurst, 124 TC 2 (2004)). Fortunately, the Tax Court upheld the results of the taxpayer’s planning.

Background

Corporate distributions in redemption of stock may be characterized either as a sale (i.e., capital gain) or a dividend. In the case of a sale, the basis can be used against the sale proceeds, and gain could potentially be realized under the installment method. Sec. 302 provides three definitive safe harbor redemptions:

1. Substantially disproportionate to the shareholder (Sec. 302(b)(2));

2. That completely terminate the shareholder’s interest (Sec. 302(b)(3)); and

3. Of a noncorporate shareholder’s stock in a partial liquidation (Sec. 302(b)(4)).

If none of these safe harbors applies, Sec. 302(b)(1)’s vague standard might apply to redemptions not “essentially equivalent to a dividend.”

Lastly, Sec. 302(c)(2) allows Sec. 318(a)’s constructive stock ownership rules to be bypassed in determining whether shareholders completely terminated their interests under Sec. 302(b)(3). To bypass these rules when determining post-redemption stock ownership, Sec. 302(c)(2) requires redeemed shareholders to disassociate from the corporation as equity holders, officers, directors or employees, for 10 years following the redemption. However, the redeemed shareholder can be a creditor of the corporation. (This provision is supposed to facilitate seller-financed stock redemptions.) Regs. Sec. 1.302-4(d) defines a creditor for this purpose. It essentially provides that the claim cannot resemble a proprietary interest or be subordinate to general creditors’ claims, nor can principal or interest payments depend on corporate earnings.

Hurst

Richard Hurst (R) was the founder and sole shareholder of Hurst Mechanical, Inc. (HMI), a heating, ventilating and air conditioning (HVAC) business. He also owned, together with his wife Mary Ann (M), a much smaller HVAC company, RHI. HMI maintained headquarters in a building it leased from R and M. Both taxpayers were active employees of HMI.

In late 1996, as R was contemplating retirement, he received a bona fide offer to sell HMI to an HVAC consolidator. HMI’s key employees, which included R and M’s son, Todd Hurst (T), were convinced that their jobs would be eliminated if the company were sold. Thus, they put in a bid that matched the consolidator’s offer, to acquire HMI; choosing to keep the business in local hands, R accepted it.

HMI’s sale: The agreed-on offer was $2.5 million. HMI would purchase 90% of R’s HMI shares for a $2 million note. R sold his remaining shares to T (51%) and two key employees (the remaining 49%), for $250,000 in notes. R and M sold their RHI shares to HMI for a $250,000 note. Each note bore 8% interest and was payable quarterly over 15 years. HMI also signed a 15-year building lease with R and M, which included a purchase option. Lastly, HMI (1) entered into a 10-year employment agreement with M at a small salary and (2) gave R and M health insurance and M use of a company-owned vehicle.

Given that they were financing the sale, R and M required a rather complicated series of cross-default and -collateral provisions, essentially providing that default on any of the agreements (i.e., the promissory notes), the building lease or the employment contract would constitute a default on all of them. This would result in R reacquiring the HMI stock. Fortunately, the business prospered and the protective measures were never activated. R and M reported the redemptions as installment sales of long-term capital assets.

IRS’s Position

The IRS disagreed with R and M’s position; it recharacterized the stock dispositions as dividends and imposed a Sec. 6662 accuracy-related penalty. R and M’s position was straightforward: R retired and retained no interest in the company, other than as a creditor, landlord and husband of a nonshareholder employee. The IRS pursued a complex case, arguing that the total number of contractual obligations provided R a prohibited interest in the corporation, by giving him a financial stake in the company’s continued success. In rendering an opinion, the Tax Court analyzed each component of the redemption/buyout transaction.

Promissory notes: The notes called for fixed periodic payments of principal and interest that were not in any way tied to HMI’s financial performance. They were subordinate to HMI’s bank obligations, but not to any other creditors. The court referred to Dunn, 615 F2d 578 (2d Cir. 1980), aff’g 70 TC 715 (1978), in which the taxpayers prevailed because corporate obligations under a complete redemption did not (1) create a proprietary interest, (2) become subordinate to general creditors’ claims or (3) retain an interest other than that of a creditor.

Lease: The building lease called for fixed rent payments, not conditioned on HMI’s financial performance. The taxpayers pointed to Rev. Rul. 77-467, which held that an arm’s-length lease of property by a former shareholder is not a prohibited corporate interest within the meaning of Sec. 302(c)(2)(A)(i). The IRS pointed to a lease modification under which HMI surrendered its option to purchase the building from R and M. The court was unmoved, noting that the buyers did not gratuitously surrender the purchase option, but required in return a cut in the interest rate from 8% to 6% on their various promissory notes. The court characterized the modification to the lease as “a negotiation rather than a collusion.”

Employment: Next, the court took up M’s employment, to decide whether it was a prohibited interest. Important was the fact that M had not owned any HMI stock. Because she was not a “distributee” under Sec. 302(c)(2)(A)(i), her employment could not violate the ban on post-redemption employment.

However, the IRS argued that through M’s employment, R was able to command “an ongoing influence in HMI’s corporate affairs.” It further asserted that M’s employment was a “mere ruse” to allow her to benefit from continued health insurance, further noting that she drove the vehicle formerly driven by R during his employment. The court was not persuaded, noting that M’s compensation and fringe benefits were fixed and not subordinate to HMI’s general creditors. It also pointed out that she continued to perform the same clerical and administrative duties that she had been doing for many years. The court was satisfied that R had indeed retired from HMI, noting a lack of participation in any corporate activities, “not even a Christmas party or summer picnic.”

Conclusion

In a post-trial brief, the IRS asserted that R and M’s sale of RHI to HMI should be governed by Sec. 304. While the court rejected this as an inappropriate introduction of a new matter, the case was not a total rout for the IRS. The court agreed that the cost of M’s medical insurance paid by HMI was taxable to her, because HMI was an S corporation, and R and M continued to be viewed, however ironically, as a 2% shareholder under Sec. 1372(b), given Sec. 318 attribution. Thus, for 1997, M could deduct 40% of her health insurance premiums under Sec. 162(l)(1)(B). Currently, 100% of health insurance premiums are deductible by self-employed individuals, including partners and 2% S shareholders.

From Mark D. Puckett, CPA, MST, Memphis, TN