Stock Redemptions: An Improved Tool
By: THOMAS W. GARTON
The redemption of corporate stock is a useful transaction tool that can be employed for various purposes in a corporation’s life cycle. For instance, repurchasing shares of stock is one way to reduce the number of shareholders or to eliminate an unwanted shareholder. Many banks and bank holding companies use this tool to “clean up” their shareholder roster to eliminate disqualifying shareholders in preparation for making an S election. It is also a customary element of corporate ownership succession plans. Most shareholder buy-sell agreements provide for mechanisms which utilize the redemption as one of the tools for effecting ownership changes upon occurrence of specified triggering events. Redemptions provide a source of liquidity and an assured market for shares held by employees or directors.
Redemptions require only director authorization, except that directors may not authorize a distribution (including a redemption) if to do so renders the corporation unable to pay its debts in the ordinary course of business. Further, a director who votes for (or refrains from voting against) an illegal dividend can be held personally liable for the amount of the illegal distribution. All Minnesota corporations are governed by Minnesota Statutes, Chapter 302A, and regulated financial institutions must also obtain appropriate regulatory approvals in authorizing a redemption. Directors must also assure that the redemption is at a fair price that does not disadvantage other continuing shareholders.
The income tax treatment of a redemption should be considered carefully. If the standards of Internal Revenue Code Section 302 are met, a shareholder selling his shares back to the corporation will be taxed as if he had sold his stock (capital gains treatment on the excess of sale price over tax basis). If, however, the Section 302 numerical test is not met, the redemption payment to the shareholder will be treated as a dividend. The Section 302 test is an arithmetic formulation intended to accord dividend treatment where the shareholder either directly or indirectly (through family members or related entities) retains a significant interest in the redeeming corporation.
Before the recent reduction to 15% of the tax rate applicable to dividend income, the failure of an intended redemption to meet the Section 302 test was a very costly mistake, at least in the case of a corporation which had not made an S election. Rather than being subject to the low capital gains rate on the excess of sale price over basis, the entire amount of the payment was taxed as a dividend at ordinary income rates. But now, with capital gains and dividends taxed at the same rate, failing the Section 302 test is not nearly so costly. The only difference between redemption and dividend treatment is that in the case of dividend treatment, the shareholder’s basis in the redeemed stock does not get deducted from the amount recognized. That basis is not lost forever, however. It shifts over to the shareholder’s other retained shares (or those of the related persons whose ownership caused the failure of the test) and can be used later against a subsequent disposition of the retained shares.
In the case of an S Corporation, there are situations where a shareholder may want intentionally to fail the Section 302 test in a redemption transaction. If the test were to be met, the S shareholder would recognize capital gain on the excess of the distribution over the basis of the shares redeemed. If the test is not met, and the distribution is treated as a dividend, it is altogether possible for the entire distribution to be received tax free by the shareholder. Under Subchapter S, for a corporation which has no C Corporation earnings and profits, dividends are deemed to come first out of the corporation’s Accumulated Adjustments Account (“AAA”). AAA is the aggregate of all previously taxed but undistributed S Corporation income. If the shareholder has sufficient basis in his shares, the full amount of the distribution, to the extent of AAA, will be tax free. The shareholder’s basis in his retained stock will be reduced by the amount of the distribution. This treatment applies regardless of how much of the AAA represents income previously taxed to the redeeming shareholder. That is, this treatment is not limited to the redeeming shareholder’s share of AAA.
Redemptions can advance numerous purposes or goals. Redemptions can also present an attractive tax planning opportunity for S Corporations. Furthermore, since the reduction of the tax rate on dividends, even in C Corporations the treatment of a redemption as a dividend is not a particularly painful result.