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Examining stock redemption rules

Aug 1, 1996 12:00 AM

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In privately held printing companies, buying out major shareholders always presents challenges. How will it be accomplished? How will it impact the selling shareholder, corporation and remaining shareholders?

Stock redemption, a common method of cashing out shareholders, occurs when firms buy the shares. Frequently, this is the most viable option since remaining shareholders lack the personal funds to purchase a large interest in the business--the organization is the entity with the money.

In stock redemption transactions, firms purchase shares from stockholders and shareholders no longer own those shares. Then, the remaining shareholders' interests increase proportionally.

The best way to illustrate the effects of stock redemption is to look at a sample transaction for a $2 million firm. The business has three shareholders: Smith (40 percent), Jones (40 percent) and Brown (20 percent). Smith wishes to retire, so the firm will redeem his shares. As with most closely held companies, the organization does not have the cash to buy 40 percent of its own stock, and pays for the stock with a 10-year note at eight percent interest.

Jones and Brown own the same number of shares, but since the number of shares outstanding has been reduced by 40 percent, their interests increase to 67 percent and 33 percent, respectively. Prior to the redemption, no shareholder had a majority position, but now Jones has a two-thirds majority.

Using notes allows corporations to fund redemption obligations out of future income and cash flow, and annual principal and interest payments are $119,224. The interest portion of notes is a tax-deductible expense to companies, however the principal must be paid with after-tax dollars.

One factor often ignored in analyzing stock redemption's effect on business is how it changes balance sheets. The firm where Smith is employed has a net worth or owner's equity account of $2 million, and the shares will be repurchased at a value equal to the book value or owner's equity per share. Therefore, Smith's interest will be purchased for $800,000 (40 percent of $2 million), and the shares become treasury shares, which offset the owner's equity on balance sheets (see chart).

Since personal tax rates are high, it is important for sellers to receive capital gains treatment on stock sales. Many people mistakenly assume that all stock redemptions qualify as capital gains. Specific rules under Section 302 of the Internal Revenue Code must be met in order to qualify for capital gains treatment when corporations are purchasers; otherwise, transactions are treated as dividends and taxed at ordinary income rates.

One of the following three requirements must be met for transactions to qualify: total termination of interest (shareholder sells all shares); after the sale, shareholders own less than 80 percent of what they owed before; the transaction is not substantially equivalent to a dividend.

In the company scenario stated above, the transaction qualifies because Smith is selling his entire interest. If he met the requirements of the second provision, he would need to sell enough shares to reduce his interest below 32 percent (80 percent of 40 percent). The third situation is ambiguous and subjective, and, consequently, it is prudent to meet the rules outlined in one of the other two safe harbors.

The aforementioned rules apply in non-family situations, but what if all three shareholders were related? In this situation, a different set of requirements is involved, and the principle of attribution applies.

The rules of attribution state that shares owned by sons are deemed to be owned by fathers and vice versa, and the same is true for mothers' shares. Thus, if shares owned by fathers are redeemed, due to attribution, the family still is deemed to own 100 percent of the stock and transactions are treated as dividends and taxed at ordinary income rates. Attribution rules apply to shares owned by parents, children, grandchildren or any of their spouses.

Is there a situation that allows a redemption to qualify for capital gains treatment in a family ownership arrangement? The answer is yes. In the above example, if a father sold all his shares and agreed not to be an officer, shareholder director or employee of the company for a 10-year period, the IRS has ruled the transaction will qualify as a capital gain.

Stock redemptions can be an effective, efficient method for buying shareholder stock. Also, understanding the rules for receiving capital gains treatment is crucial for minimizing taxes on the transaction. As in all stock transactions, it is important to seek the advice of competent legal and tax counsel before proceeding.