brown and blue concrete building

 

What Is It?

Company Purchase of Stock at Shareholder's Death

A Section 303 stock redemption is a closely held business's purchase of its own stock at a shareholder's death, which (when specific requirements are met) is subject to capital gains tax treatment under Section 303 of the Internal Revenue Code. Congress enacted Section 303 specifically to help ease the liquidity problem faced by estates that consist largely of an interest in a closely held corporation. Stock redemptions under Section 303 must meet specific tests, so it is important that some advance planning is done with your estate or financial planner, tax advisor, and/or lawyer. In certain cases a Section 303 stock redemption can be used with stock of a publicly traded company. However, this discussion will focus on the closely held corporation.

Here's how it works: You are an owner of stock in a closely held corporation, and you die. Your estate sells part of your interest back to the corporation and receives cash. The amount of cash equal to your funeral and estate administrative costs (and federal and state death taxes, including any interest due) is eligible for capital gains tax treatment. Any additional amounts received through stock redemption would also be taxable, possibly at different rates.

Tip: Since the shares held by your estate will generally have a basis equal to the fair market value of the shares at the date of your death, little or no tax will generally result when a redemption of stock under Section 303 qualifies for capital gain treatment.

Transaction Could Be Part of an Entity Purchase Buy-Sell Agreement

The business entity might buy your ownership interest as specified under an entity purchase (stock redemption) buy-sell agreement. You do not need a formal agreement in place to sell your corporation stock under Section 303, but it is recommended that you do have one, especially if you are not a majority shareholder.

When Can It Be Used?

You Own a Corporation

You are an owner of stock in a closely held C corporation, S corporation, or family corporation. Section 303 stock redemptions can't be used with a corporation with only one stockholder or with a sole proprietorship for the same reasons an entity purchase buy-sell agreement can't be used--the corporation can't own itself, and the sole proprietorship is not a corporation.

Your Business Interest Represents a Substantial Portion of Your Estate

If your business interest is at least 35 percent of the value of your adjusted gross estate, you can use a Section 303 stock redemption. If you personally own interests in more than one corporation, you can combine the ownership percentages to reach the 35 percent minimum as long as you own 20 percent or more of the value of the stock of each corporation.

Tip: If the value of your interest in the corporation is currently less than 35 percent of your estate, you might want to consider making lifetime gifts of some of your other assets to allow you to meet the 35 percent rule.

Caution: Gifts made within three years of your death must be added back into the value of your estate for purposes of determining whether you satisfy the 35 percent rule.

Strengths

Lets Your Family Do Something You Couldn't Do--Redeem Part of Your Family Business Interest without the Redemption Being Considered a Dividend

With a Section 303 stock redemption, your estate can do something you generally could not do during your lifetime--it can sell a portion of your interest back to the corporation without it being considered a dividend for income tax purposes. This could be valuable to a family corporation, which is especially subject to scrutiny by the Internal Revenue Service. Normally, if you sold part of your stock back to a family corporation during your lifetime, the cash received would be considered a dividend.

Tip: In general, the American Taxpayer Relief Act of 2012 permanently extended the preferential income tax treatment of qualified dividends and capital gains. Capital gains and qualified dividends are generally taxed at 0% for taxpayers in the 10% and 15% tax brackets, and at 15% for taxpayers in the 25% to 35% tax brackets. However, dividends and capital gains are generally taxed at 20% for taxpayers in the 39.6% tax bracket. Also, as a result of the Affordable Care Act of 2010, an additional 3.8% Medicare tax applies to some or all of the net investment income for married filers whose modified adjusted gross income exceeds $250,000 and single filers whose modified adjusted gross income is above $200,000.

Tip: There remains a significant advantage in classifying a transaction as a sale or exchange rather than as a dividend distribution despite the fact that both types of transactions are subject to tax at long-term capital gains tax rates. That is, in the case of dividend treatment, part or all of the distribution is first treated as a dividend, any remaining distribution is then received tax-free to the extent of basis, and any distribution still remaining is taxed as capital gains. In the case of sale or exchange treatment, however, the shareholder pays tax only to the extent that the amount paid by the company exceeds his or her basis in the stock. If the sale or exchange of your shares occurs after your death, your shares will generally have a basis equal to the fair market value of the shares at the time of your death, and little or no tax may result. Thus, more may be subject to tax with dividend treatment than with sale or exchange treatment.

Even If Your Estate Doesn't Need the Money, It Can Still Use the Section 303 Stock Redemption

Even if your estate is highly liquid and doesn't need the cash for taxes, a partial redemption under Section 303 can still be used. The money does not actually have to be used to pay the estate taxes and expenses. As long as the amount does not exceed the total of all federal estate taxes and state death taxes, funeral costs, and administrative expenses, the partial redemption can qualify under Section 303.

Tip: The sale of the business interest must be made by whomever is obligated to pay the estate taxes and expenses, usually the family or estate.

Section 303 Stock Redemption Can Be Used Even If Estate Taxes Are Paid In Installments

Estate taxes attributable to a closely held business can be extended over a 14-year period in special situations. Under this estate tax installment plan, interest on the amount of federal estate tax is due over the first 4 years, with principal and interest paid over the next 10 years. A series of redemptions under Section 303 can be used to pay the taxes over the installment time period.

Coordinating the Section 303 stock redemption with the installment payment of estate taxes relieves the corporation of paying out the cash in a lump sum.

Section 303 Stock Redemption Can Be Used With Other Types of Buy-Sell Agreements

A Section 303 stock redemption can be used to supplement a cross purchase buy-sell agreement or as part of an overall entity purchase or stock redemption plan, especially in cases when the redemption would not otherwise qualify for capital gain treatment.

Protects Your Family Corporation from Forced Sale or Liquidation to Pay Estate Taxes and Settlement Costs--It Can Use Corporate Money Instead

If your business is a family corporation, you may not want it to be sold when you die. With a Section 303 stock redemption, your family can continue running the business after you die. The entire business would not have to be sold to pay for estate taxes. Your estate can sell just enough of your interest back to the corporation itself and use the corporation's money to cover your total funeral and estate administrative costs, federal estate taxes, and state death taxes, including any interest due.

Tip: The stock redemption must occur within 3 years and 90 days after your federal estate tax return is filed to qualify for Section 303 treatment.

Retirekit CTA

Attribution Rules Do Not Apply

Generally, attribution rules can eliminate favorable tax treatment of stock redemptions in a family corporation. The Section 303 stock redemption was designed to provide liquidity to the family corporation for the payment of estate taxes, state death taxes, and funeral and administrative costs. The attribution rules specifically do not apply to stock redemptions under Section 303.

Even If the Corporation Does Not Have the Cash, It Can Still Buy Back Part of Your Interest

If your corporation does not have cash available to buy part of your stock under a Section 303 stock redemption, your surviving spouse or adult child can loan the money to the corporation to fund the purchase of your interest. Future business earnings can be used to repay the lender in the form of corporate debt payments.

Tradeoffs

Amount of Stock That Can Be Redeemed Under Section 303 Is Limited

The amount of stock that can be redeemed without being treated as a dividend is limited to the total of your funeral and estate administrative costs, federal estate taxes, state death taxes, and any interest due.

Tip: If your estate chooses to redeem stock in excess of this limit, it should check out the requirements for a Section 302 stock redemption, which (when certain tests are met) may allow for sale or exchange treatment (subject to capital gains tax) on amounts in excess of the Section 303 limits.

Must Be Coordinated With Terms of Will and Other Estate and Tax Planning

The terms of your will might make redemption under the terms of Section 303 difficult or impossible. For this reason, it is important that you work with your attorney, or estate, tax, or financial planner. If your will is structured so that your heirs have no estate tax liability, then your heirs would not be able to use a Section 303 stock redemption to get cash from the business.

For example, if the business interest passes to your son by joint tenancy, and your will directs the executor to pay all final administration expenses and taxes from "the residue of the probate estate," the redemption of the business interest will not qualify under Section 303.

May Have Limited Usefulness to Surviving Spouse If Full Marital Deduction Used

For a tax-favorable redemption under Section 303 to be allowed, there must be a liability for federal estate tax. If you leave your property to your spouse, and the unlimited marital deduction is used, your estate is passed to your surviving spouse free of federal estate taxes. Because there would be no federal estate tax liability, a partial redemption of your shares under Section 303 tax treatment would not be possible.

Corporate Accumulations to Fund Redemption May Be Subject to Accumulated Earnings Tax

Funds accumulated before a shareholder's death to meet the expected need for a redemption might be subject to the accumulated earnings tax. If the Internal Revenue Service deems the accumulation of funds for a redemption as unreasonable, the corporation could be hit with a penalty tax. Check with your tax advisor if you are thinking about reserving corporate funds now for a future redemption under Section 303.

How to Do It

Things to Do Now

Decide What You Want to Happen to Your Share of the Business

You should consider all of your financial, tax, and estate planning goals.

You Might Want to Set Up a Buy-Sell Agreement

If you do not have a buy-sell agreement, you may want to create one. A buy-sell agreement is not required for a Section 303 stock redemption, but it can be set up now to ensure that the corporation will agree to buy your stock from your estate. The entity purchase buy-sell agreement is the form you would want to consider if you want the corporation to buy your stock at your death. Whoever has the authority to legally bind the business by contract needs to be part of the discussion so that the corporation will be obligated under the entity purchase agreement.

Make Sure the Corporation Is Able to Buy Your Stock

If you want your estate to be able to redeem your stock, you should check to see that the corporation is financially and legally able to buy your stock from you. This is especially important if you don't have a buy-sell agreement, because the corporation might not be prepared to make the purchase. Remember that state laws dictate that a corporation can only buy stock using surplus funds.

Meet With Your Tax Advisor

If you are planning to have your estate redeem your corporation stock, meet with your tax advisor to make sure your redemption qualifies under Section 303. If your estate does not qualify right now, action can be taken that may allow it to qualify in the future.

You will need help meeting the requirements.

Meet With Your Attorney If You Are Planning to Set Up a Buy-Sell Agreement

Setting up a buy-sell agreement can be very complex, because it involves legal and tax issues, so you should consult an attorney. Each party under the agreement should have his or her own attorney.

Things to Do Later

Periodically Review the Buy-Sell Agreement (If You Have One)

You and your buy-sell participants should review the agreement on a regular basis, perhaps yearly. You want to be sure that the agreement still meets your objectives, and that any required updates are conducted.

Caution: Failure to update an agreement when called for within the agreement could lead to problems.

Monitor Your Estate Assets

Although your corporate stock may make up 35 percent or more of your estate right now, it is important to monitor your estate assets to ensure that Section 303 qualification is maintained. It is possible that your corporate stock could become less than 35 percent of your adjusted gross estate due to any one or more of the following:

  • The value of the corporate stock could decline
  • Other assets in the estate could appreciate in value more than the corporate stock
  • Stock might be sold or given away

Tip: Remember to look at all assets when calculating gross estate value--including life insurance and jointly held property.

Tax Considerations

Income Tax

Normally No Capital Gain to Shareholder's Estate

When you die, your estate receives a new basis in your corporate stock equal to the fair market value (FMV) typically determined at the date of death. When the sale price is accepted as the FMV, there shouldn't be any capital gain or loss realized by your estate, upon redemption of your corporate stock.

Redemption of Shares Is Not a Tax-Deductible Event to Business

When a business redeems the shares of a shareholder, it is not an income tax-deductible expense of the business. When cash is distributed in exchange for the stock, the business recognizes no gain or loss on the transaction.

Gift and Estate Tax

Amount Estate Receives From Stock Redemption Sets Estate Tax Value

When your estate redeems your business interest, the amount received from the sale usually sets the value of the business interest that is included in the value of your estate.

Caution: If the price received is determined to be less than the fair market value (FMV), the estate will be taxed on the difference between the sale price it received and the FMV determined by the IRS. This means it is possible that the estate could be required to pay tax on value it did not (and never will) receive.

Questions & Answers

Do You Have to Have a Written Agreement in Place in Order for Your Family to Use a Section 303 Stock Redemption?

Your family or estate can redeem stock under the favored treatment of Section 303 without an advance agreement. If you are the majority shareholder of the corporation, your estate can use its influence as majority shareholder to see that the redemption is carried out. Even so, the absence of advance planning could still make it impossible to redeem your stock, as the funds may not be available, and/or local laws may prevent it.

However, if you are not the majority shareholder, you should enter into a Section 303 stock redemption agreement with the corporation in order that your plans for your share of the corporation are carried out as you intended. It would be unfortunate for your estate to encounter resistance or difficulty in redeeming your stock of the corporation under Section 303 because there was no formal agreement in place before your death.

 

 

This material was prepared by Broadridge Investor Communication Solutions, Inc., and does not necessarily represent the views of  The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867.

 

The Retirement Group is not affiliated with nor endorsed by fidelity.com, netbenefits.fidelity.com, hewitt.com, resources.hewitt.com, access.att.com, ING Retirement, AT&T, Qwest, Chevron, Hughes, Northrop Grumman, Raytheon, ExxonMobil, Glaxosmithkline, Merck, Pfizer, Verizon, Bank of America, Alcatel-Lucent or by your employer. We are an independent financial advisory group that focuses on transition planning and lump sum distribution. Please call our office at 800-900-5867 if you have additional questions or need help in the retirement planning process.

 

The Retirement Group is a Registered Investment Advisor not affiliated with FSC Securities and may be reached at www.theretirementgroup.com.



 

TRG Retirement Guide

Tags: Financial Planning, Lump Sum, Pension, Retirement Planning