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Redemption As an Estate Planning Technique

Two tips revealed.

November 15, 2007
by Fred Caspersen

As many CPAs are well aware, the most popular estate planning techniques involve the transfer of interests from one person to another — by outright gift or by sale, for example. We have our own lexicon of acronyms for these techniques — GRATs, QPRTs, SCINs, ILITs, IDGTs, etc. But if the object of your client’s bounty is an owner in their business enterprise, redemption of their interest in the business may be more tax efficient than either a gift or a sale.

Commonly Used Techniques Involving Business Enterprises

Of course, I am not going to discuss the details of these techniques for transferring an interest in a family business, and they are all worthy of consideration in every plan. But they all assume that the donor’s interest in the business is not going to change, other than by gift. And of course, redemptions have been a staple of transfer planning at death for decades. Futher, the special treatment of corporate redemptions at death (Internal Revenue Code Section 303) is a testament to the popularity of redemptions to meet the liquidity crises brought on by death.

Grantor Retained Annuity Trusts (GRATs) and Sales to Intentionally Defective Grantor Trusts (IDGTs) both work on two principles — the transfer of minority, illiquid interests in a closely held business enterprise. As you all know, a minority, illiquid interest in a closely held business enterprise is worth less, sometimes dramatically less, than a proportionate interest in the enterprise as a whole.

The Tax and Practical Uses of Redemptions

The C Corporation Redemption

Why, you might ask, would I want the company to redeem my stock, when ownership of my children’s shares is attributed to me (Code Section 318)? The redemption will be taxed as a dividend, no matter how many shares are redeemed. To which I say, “Exactly!” Dividends (at least for the time being) are taxed at 15 percent, just like capital gains. And the treatment at the corporate level is essentially the same as at the individual level: no deduction for the distribution, and so long as appreciated property is not being used to accomplish the redemption, there is no taxable gain to the corporation.

Here’s an example. A new client came to us whose business operated through a C corporation. Regular dividends were being paid to the shareholders, including both the senior generation, who owned about 65 percent of the company, and the client’s son, who was running the business and who owned the balance of the shares. The son had no need of the dividend income, as he could (within reasonable limits) adjust his deductible compensation to maintain his cash flow. So we advised the company to stop paying pro-rata dividends and instead to redeem shares from the parents every year with all of the cash previously used to pay dividends. Initially, there is not much movement in the senior generation ownership, but as their percentage interest declines, each annual redemption reduces their interest in the company by a larger and larger percentage. Since we started this plan a few years ago, the parents’ interests have been reduced to less than 20 percent, and they will be fully redeemed in another couple of years.

For example, assume there are 1,000 shares outstanding when we start, and the parents own 650 shares. Each share is worth $1,000. Instead of paying a $50,000 dividend to all shareholders, the full $50,000 is used to redeem 50 shares from the parents. The parents now own 600 out of 950 shares — a modest reduction in their percentage interest from 65 percent to 63 percent. But do the numbers for several years — if this program is continued for 12 years, the parents’ interest is down to 22 percent, with no change in what they were already doing anyway and with no taxable gifts. They can further reduce their interests with annual exclusion gifts of shares each year.

Year

Ownership

Shares Outstanding

Shares Redeemed

Percentage Ownership

1

650

1000

50

65%

2

600

950

50

63%

3

550

900

50

61%

4

500

850

50

59%

5

450

800

50

56%

6

400

750

50

53%

7

350

700

50

50%

8

300

650

50

46%

9

250

600

50

42%

10

200

550

50

36%

11

150

500

50

30%

12

100

450

50

22%

S Corporation Redemptions

S Corporations are especially susceptible to this technique because S corporation dividends are not taxable. That means that stock redemptions that are “essentially equivalent to a dividend” (Code Section 302) are free of tax to the redeemed shareholder. And that would be the case in this example (assume our prior case, but with an S corporation instead). Note, of course, that the son will be paying tax on an increasing percentage of the corporate income, but actual dividend distributions to pay the S corporation taxes will continue as before and the son will be receiving an increasing percentage of those dividends.

At some point, the son may want to redeem all of his parents’ remaining shares on a note. Assuming no Code Section 302(c)(2) election, the redemption is taxable on receipt of the note, which means there is no tax to the parents by reason of the redemption. And if the redemption occurs on December 30, the parents will pay the tax attributable to the redeemed shares for the 364 days that they owned them. The son will pay the income tax attributable to his shares for that year and 1/365 of the tax attributable to the redeemed shares. And looking forward, he will have to pay, in effect, the tax attributable to the cash used to make the payments on the note to his parents. But this means that only one tax is paid: on the corporate income. The redemption itself is tax-free.

Conclusion

Do not overlook the use of entity distributions to achieve a shift in equity ownership through a long-term plan for the redemption of interests.

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Fred Caspersen is a partner in Farella Braun + Martel’s Family Wealth Group. His practice focuses on the development and implementation of succession strategies for families and closely held businesses. For more information on selecting a guardian or other estate planning techniques please contact your Farella Braun + Martel Family Wealth attorney at (415) 954-4400.