I devote one of my recent columns to a query from a woman I call Lola. She’s an entrepreneur and owns shares in a family-owned company. Lola plans to retire. When that happens, the company is going to redeem all of her shares.
Tax-savvy Lola asks a straightforward question: Whether there’s some provision in the Internal Revenue Code that allows her to side step the higher rates for dividends and use the lower rates for long-term capital gains to calculate her tax tab on the redemption? I direct her to Code Section 302.
It’s possible for the redemption to qualify for capital gains treatment. For that to happen, as I explain in my earlier column, Lola must comply with a series of post-redemption requirements that are spelled out in Section 302.
The stipulation that most concerns Lola: Section 302(c) (2) (A) (i). It specifies that she ceases to serve as a director, an officer or an employee of her company.
Nyet problemy, says Lola. She’ll have no further interest in it and will have little trouble complying with Section 302’s other conditions.
I’m devoting this column to a subsequent query about Section 302 from another woman. I’ll call her Hester.
Like Lola, Hester is a soon-to-become retiree and the owner of shares in a family business. Hester, too, understandably wants her removal of money from the company to be taxed at favorable capital gains rates. Unlike Lola, Hester still wants to play some role as an adviser to the company.
Hester’s question cuts to the chase: Suppose the company wants to retain her expertise. They enter into a consulting agreement.
Will doing so trigger an IRS claim that Hester violates the ceases-to-serve requirement? Therefore, according to the IRS, she forfeits capital gains treatment for the redemption of her stock and it should be treated as a dividend.
How, Hester asks, do the courts read Section 302? I refer her to two decisions. While one is helpful, it’s trumped by another that isn’t.
I ask her to time travel with me back to 1986. That’s when the Ninth Circuit Court of Appeals, a tribunal one rung below the Supreme Court, was asked to resolve a similar dispute. It involved an owner of shares in a family enterprise, who cut a deal for a consulting arrangement.
The Ninth Circuit sided with the IRS; there can be no two opinions, the court concluded, that the clear language of the ceases-to-serve provision requires dividend treatment for the redemption of the owner’s shares. (Lynch v. Commissioner, 801F2d 1176)
The Ninth Circuit’s pro-IRS decision reversed a pro-taxpayer decision in 1984 by the Tax Court, Lynch v. Commissioner, 83 T.C. 597. The Tax Court approved capital gains treatment for the redemption.
Additional articles: A reminder for accountants who would welcome advice on how to alert clients to tactics that trim taxes for this year and even give a head start for next year: Delve into the archive of my articles (more than 300 and counting).
Attorney and author Julian Block is frequently quoted in the New York Times, Wall Street Journal, and the Washington Post. He has been cited as “a leading tax professional” (New York Times), an “accomplished writer on taxes...