Section 302 Stock Redemption Buy-Sell Agreement

What Is It?

Company Purchase of Shareholder Stock During Lifetime or At Death

A Section 302 stock redemption is a corporation's purchase of its own stock which, when specific requirements are met, is subject to favorable tax treatment under Section 302 of the Internal Revenue Code. A stock redemption qualifying under Section 302 can occur during your lifetime or at your death. When used after your death, a Section 302 stock redemption can provide your estate with liquidity for taxes and expenses. A Section 302 redemption can be used during your lifetime to dispose of some or all of the business interest.

Here's how it works: You are a shareholder of a closely held corporation. You sell all or part of your interest to the corporation itself. If the sale of your shares meets certain specific criteria (which will be explained later), the sale will qualify for favorable tax treatment.

Tip: The favorable tax treatment mentioned above and explained below refers to the fact that a qualifying redemption under Internal Revenue Code Section 302 is treated as a taxable sale or exchange, allowing the shareholder to pay taxes on the capital gain at capital gains tax rates. A stock redemption that doesn't qualify under Section 302 for sale or exchange treatment is treated as a dividend distribution.

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 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 an advantage to classifying the 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 dividends, 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 a sale or exchange, however, the shareholder pays tax only to the extent that the amount paid by the company exceeds his or her basis in the stock. Thus, more may be subject to tax with dividend treatment than with sale or exchange treatment.

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

Although not a requirement, stock redemptions that qualify under Section 302 are often prearranged using an entity purchase buy-sell agreement (also referred to as a stock purchase agreement). With such an agreement, the business entity would be obligated to buy your ownership interest at the occurrence of some specified triggering event.

When Can It Be Used?

You Own a Corporation with One or More Other Owners

You are a shareholder of a business organized as a C corporation or S corporation. If your business is a family corporation, you may be able to structure a redemption that qualifies under Section 302, but it could be difficult. A Section 302 stock redemption can't be used when a corporation has only one stockholder because the corporation can't own itself. A Section 302 stock redemption can't be used with a sole proprietorship because the sole proprietorship is not organized as a corporation.

Strengths

Lifetime Redemption Can Qualify For Favored Tax Treatment

The sale of your stock to the business could be taxed in one of two ways. Sometimes favorable tax treatment on the sale of your business stock is available only after your death. Generally, when a company (other than an S corporation) redeems the stock of a shareholder, it is treated as a dividend. The (generally) more favorable tax treatment occurs when the redemption of your stock is treated as a sale or exchange, subject to capital gains tax. If a sale of corporate stock meets the tests for a Section 302 stock redemption, you can receive this favorable tax treatment on a sale of your stock during your lifetime.

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 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 an advantage to classifying the 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 dividends, 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 a sale or exchange, however, the shareholder pays tax only to the extent that the amount paid by the company exceeds his or her basis in the stock. Thus, more may be subject to tax with dividend treatment than with sale or exchange treatment.

Stock Sale at Death May Qualify for Additional Favored Tax Treatment

If the sale of your interest in the corporation occurs after your death, and your estate is subject to estate tax, the stock redemption might qualify for favorable tax treatment as a Section 303 stock redemption. Stock redemptions under Section 302 can be coordinated with Section 303 redemptions to receive the maximum allowable tax benefit.

Tradeoffs

Favorable Treatment of Stock Redemption May Not Apply to Family Corporation

If shareholders are related to each other (including spouse, parents of either spouse, and their children and their spouses, and any natural objects of the transferor's bounty), and the business is a corporation, the attribution rules of Internal Revenue Code Section 318 must be considered. The attribution rules can affect the tax treatment of a shareholder's stock redemption, and could make it impossible for a redemption to qualify under Section 302. In a family corporation, the sale of stock to the business under a stock redemption plan usually results in dividend treatment to the redeeming shareholder.

Local Laws Could Prevent Corporate Redemption

In all states, corporate law allows a corporation to buy its own shares only from surplus funds. The specifics of the laws vary by state, but generally the rule is that a corporation must have funds in excess of the minimum capital requirement to redeem stock.

Tip: If a corporation does not have funds in excess of the minimum capital requirement imposed under state corporate law, it may still be possible to structure a stock redemption buy-sell agreement. The corporation may be able to increase its capital through: (1) a revaluation of assets or (2) shareholder contributions. It may also be possible to fund the buy-sell agreement with life insurance.

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. Think about what you want to happen to your business during your lifetime and after your death.

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 302 stock redemption; the corporation may agree to buy your interest without an agreement. A buy-sell agreement, however, can be set up now to ensure that the corporation will agree (and be obligated) to buy your stock at some future time.

The entity purchase buy-sell agreement is the form you would want to consider if you want the business to buy your stock at your death or at another triggering event. If you have co-owners who will be part of the agreement, you will need to talk with them about it. Whoever has the authority to enter the corporation itself into legally binding contracts 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 to redeem your stock now, or you think you might want to do so later, 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 corporate stock redeemed, meet with your tax advisor to make sure your redemption qualifies under Section 302. There are four possible paths to favorable capital gains tax treatment under Section 302. Your stock redemption only needs to qualify under one of them. The following summary will give you an idea of the requirements.

Qualify Under One of the Section 302 Tests

•  Redemption not essentially equivalent to a dividend--This one is tough. The redemption must constitute a meaningful reduction of your interest in the corporation. This test is subjective and involves questions of fact. If the IRS challenges capital gain treatment, each redemption is analyzed individually.

Tip: If you want to apply capital gain treatment to the redemption under this test, you should consult with a tax attorney.

•  Redemption is substantially disproportionate to the shareholder--A substantially disproportionate redemption will automatically qualify under Section 302. To qualify for this test, the redemption must reduce the shares held by certain minimum percentages.

Technical Note: To be considered both 'substantial' and 'disproportionate' the redemption must meet three mathematical tests:

1. Immediately following the redemption, the shareholder must own stock with less than 50 percent of the total voting power of the corporation.
2. After the redemption, the shareholder's percentage ownership of voting stock must be less than 80 percent of that shareholder's ownership percentage of voting stock before the redemption.
3. After the redemption, the shareholder's percentage ownership of common stock must be less than 80 percent of that shareholder's ownership percentage of common stock before the redemption.

Note: The tests in 2 and 3 compare the ratio of stock ownership to the total outstanding stock of the corporation, not the shareholder's original holdings.

Caution: The attribution rules apply here, so your redemption might not qualify if family members or beneficiaries of your estate are shareholders after the redemption.

Example(s): You and Barney each own 500 shares of the 1,000 outstanding voting common shares of Gorp Corp. You and Barney are not related. Gorp Corp. has no other classes of stock outstanding. You would like to redeem 200 shares of your stock and you want to know if the redemption will qualify for capital gain treatment under the substantially disproportionate test. Before your redemption, the ownership of Gorp Corp. looks like this:

Example(s): After the redemption of your 200 shares, you will own 300 of the 800 outstanding voting common shares (the 200 you have sold are no longer considered outstanding). The ownership looks like this:

Example(s): Your new ownership percentage is less than 50 percent, so it meets the first test.

Example(s): Before the redemption, you owned 50 percent of Gorp Corp. Eighty percent of your original 50 percent is 40 percent, so 40 percent ownership of the total outstanding stock is the threshold for the next test. After your redemption, you own 37.5 percent of Gorp Corp. (as shown), so your ownership is below the 40 percent maximum threshold. Your redemption meets the 80 percent test for both voting and common stock since Gorp Corp. has only one class of stock outstanding. Your redemption qualifies for capital gain treatment under the 'substantially disproportionate' test of Section 302.

•  Redemption is a complete termination of interest in corporation -- If your redemption is a complete redemption, meaning that all of your stock is redeemed, including all voting, nonvoting, preferred, and common stock held by you, the redemption will qualify for capital gain treatment under Section 302.

Caution: The attribution rules apply here, so your redemption might not qualify if family members or beneficiaries of your estate are shareholders after the redemption.

•  Redemption is a partial liquidation of the corporation -- To determine if a redemption qualifies for capital gain treatment under this test, the transaction must be looked at from the perspective of the corporation, not that of the redeeming shareholder.

You will need expert guidance to see if your redemption qualifies under this test.

Things to Do Later

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

You and your buy-sell participants should review the buy-sell 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.

Tax Considerations

Income Tax

Redemption of Shares Is Not Tax Deductible for the Corporation

When a corporation 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.

Redemption Qualifying Under Section 302 Avoids Dividend Treatment

Generally, when a company (other than an S corporation) redeems the stock of a shareholder, it is treated as a dividend. An exception to this treatment may occur if your redemption meets the qualifications of Section 302. In this situation, the redemption is treated as a sale or exchange.

Caution: If your family members (by blood or marriage) are also shareholders, the favorable tax treatment can be complicated or even eliminated by the attribution (constructive ownership) rules.

Stock Sold By Estate Receives Step-Up in Basis

Stock held by your estate receives a new basis equal to the fair market value (FMV) typically determined at the date of death. If your estate redeems from your estate stock held by you at death under an entity purchase buy-sell agreement, and the sale price is accepted as the FMV, there shouldn't be any capital gain or loss realized by your estate.

Remaining Shareholders Do Not Receive Increase in Basis

When the corporation buys out the interest of an owner, the remaining owners do not receive an increase in basis for income tax purposes. This means that if you are a remaining owner, and you sell your interest in the business during your lifetime, you will realize a larger capital gain.

Example(s): You and your two co-owners, Dick and Jane, originally invested $100,000 each in the business (original value $300,000). The FMV of the business is now $600,000.

Example(s): Dick dies. The company buys back Dick's interest and pays Dick's estate $200,000, representing the FMV of his interest in the business. Now, you and Jane each own half of the business valued at $600,000 ($300,000 each). Because there is no step-up in basis to the remaining shareholders, your basis is still the original $100,000 you paid for your interest.

Example(s): If you sell your interest during your lifetime, you would recognize a taxable capital gain of $200,000.

Gift and Estate Tax

Your Stock Is Included In the Gross Estate Value

When you die, the value of your stock is included in the value of your estate. This generally should be equal to the redemption proceeds.

Caution: If the price received is determined to be less than the fair market value (FMV), the estate will be taxed on 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 an Entity Purchase Buy-Sell Agreement in Place to Qualify for a Section 302 Redemption?

The tax laws allow you to redeem stock under the favored treatment of Section 302 without a buy-sell agreement. However, without a legally binding agreement in place, the corporation is not obligated to redeem your stock. If you are the majority shareholder of the business, you can probably use your voting power to see that your 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.

Tip: If you think you might want to redeem corporate stock during your lifetime, or you want to be sure that your estate can sell your stock to the corporation after your death, consider putting an entity purchase buy-sell agreement in place now to protect yourself and your estate.

Can Your Stock Redemption Qualify for Favorable Tax Treatment Under Section 302 and Section 303?

To qualify for favorable tax treatment under Internal Revenue Code Section 303, the redemption must occur after your death. If your estate is subject to estate taxes, state death taxes, and funeral and administration expenses, a stock redemption up to the total of these liabilities may qualify under Section 303. More than one shareholder might qualify for a Section 303 redemption if your will leaves stock to two or more people who are responsible for estate taxes.

Refer to the discussion of the Section 303 Stock Redemption for more information. Your estate's redemption of your stock may also qualify under Section 302. It is important for your estate to coordinate the stock redemption to take advantage of the benefits of both Section 302 and 303, and not waste redemptions qualifying under one section by applying them to another. Consult a tax advisor to maximize the benefit you derive from Sections 302 and 303.

What Happens If the Existing Agreement Calls for Periodic Updating and It Isn't Done?

If the agreement requires an update, the failure to do the updating could have serious consequences. For example, if the agreement calls for a revaluation of the business at specified intervals and the revaluation is not calculated, the value set under the agreement may be lower than the taxable value set by the IRS. If you die, your estate will be bound under the agreement to sell your shares at the agreement price. The taxable value assigned by the IRS may be higher, subjecting your estate to taxation on value it will not receive (assuming there is an estate tax). In addition to the potential tax consequence, the failure to update the agreement when called for in the terms could affect the ability of the agreement to stand up if challenged in court.

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.

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

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