I received a query from a family-owned company and one of its shareholders. I’ll call them Lady Godiva Accessories (LGA) and Lola. LGA wants advice on the tax-right way to handle its planned redemption of all of Lola’s shares.
Simply put, LGA and Lola, soon to become a bought-out shareholder, are concerned about the tax consequences of the redemption. Does the Internal Revenue Code contain a provision that, as Lola wants, allows her to use the lower rates for long-term capital gains to calculate the taxes that kick in on the redemption? Or will the IRS insist Lola use the higher rates for dividends?
Will Lola get what Lola wants? I respond that it depends on whether the IRS treats her as the owner of the LGA shares still owned by other family members.
What happens in the event the IRS concludes that it should treat buyouts as partial? The agency forbids preferential capital-gains treatment for the stock sales.
But all is not lost, as I remind Lola and as I point her in the direction of Internal Revenue Code Section 302. This easily overlooked provision carves out an important exception crafted specifically to benefit Lola and other individuals who hold shares in family-owned companies.
The exception authorizes the IRS not to apply the family-attribution rules to any family members whose actually-owned shares are completely redeemed. Would that it were that simple, as I explain to her.
The exception applies only if Lola and those individuals agree to comply with a series of requirements. What the IRS insists that Lola must do is explained in exquisite detail in Section 302(c).
The section’s first stipulation: Immediately after the redemption, Lola has no personal financial interest in LGA, other than as a creditor.
The second one: Lola no longer serves as a director, an officer or an employee of LGA.
The third one: Lola doesn’t acquire any prohibited interest in LGA (other than by bequest or inheritance) or position in LGA for a ten-year period. The period runs from the date the redemption takes place.
During that entire period, Section 302 authorizes a suspension of the usual statute of limitations (for most returns, three years from a 1040’s due date) on an audit of Lola’s return for the year of redemption. Section 302 empowers the IRS to scrutinize that return.
The fourth one: Lola didn’t acquire any of the redeemed stock from close family members within ten years prior to the redemption, and she didn’t transfer any stock to them within that ten-year period. There’s an exception for acquisitions and transfers that aren’t principally motivated by tax avoidance.
The fifth and final technicality: Lola submits a timely 1040 for the year of redemption. Her 1040 is accompanied by a separate statement. In it, Lola states that she hasn’t acquired any new interest in LGA (except by inheritance) and that she’ll notify the IRS within 30 days after she acquires any new interest.
My recitation of mind-numbing technicalities causes Lola to turn ashen, though her color comes back when I offer some good news: Fret not is how I counsel individuals whose holdings include shares in family-owned companies and want to sell out either immediately or on installment pay-out deals and take no further interest in the companies, other than as creditors. Generally, they’ll have little trouble satisfying the requirements imposed by Section 302(c).
I will devote my next column to two court decisions, one by the Tax Court and the other by the Ninth Circuit Court of Appeals. The decisions differ on how strictly courts should interpret Code Section 302(c)’s requirement that Lola not serve as a director, an officer or an employee of LGA.
Does Lola violate the cease-to-serve stipulation when, say, LGA wants to retain her expertise and they enter into a consulting agreement? Stay tuned.
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...