Tax Redemption and Attribution Rules

When a family-owned corporation[1] purchases shares from a shareholder (a “redemption“), the shareholder and the corporation frequently assume, perhaps without much thought, that the sale will qualify for capital gain treatment. In fact, because of the application of certain federal tax redemption and attribution rules, the sale could instead be treated as a dividend, which may result in substantially worse economic consequences for the selling shareholder.

The most significant consequence of dividend treatment relates to the potential difference in the tax rates applicable to dividends and long-term capital gains. Long-term capital gain recognized by an individual on the sale of stock held for more than one year is currently taxed at a 15 percent federal rate. This tax rate is scheduled to increase to 20 percent starting in 2013. While dividends received by individuals also are currently taxed at the 15 percent capital gain rate, the tax rate on dividends is scheduled to revert back to the tax rate on ordinary income, which is a maximum rate of 39.6 percent, beginning in 2013. Accordingly, in the absence of legislative changes, dividends received by individuals will be subject to a 20 percent higher federal tax than long-term capital gains beginning in 2013. In addition to dividend income being taxed at a higher rate, shareholders are also unable to report dividend income on the installment method if payments are made to the shareholder over time and may not offset dividend income with the tax basis in their stock.

Historically, the significant differences in tax treatment of dividends and capital gains has motivated some taxpayers to attempt to structure corporate distributions as share redemptions rather than as dividends. The federal tax code curtails this strategy by treating some redemptions as dividends rather than sales of stock.

Determination of Sale vs. Dividend Treatment. In general, for a redemption to be treated as a sale rather than as a dividend for tax purposes, it must result in a meaningful reduction in the selling shareholder’s interest as a shareholder. Many redemption transactions are designed to qualify for one of two “safe harbors” that will provide certainty that the redemption will be treated as a sale qualifying for capital gain treatment. The first safe harbor is a substantially disproportionate redemption, which occurs when the selling shareholder reduces his interest in the corporation’s voting stock and common stock by more than 20 percent. The second “safe harbor” is a complete termination, in which a shareholder sells all of his stock in the corporation. If neither of these safe harbor tests is met, then the taxpayer can try to establish a meaningful reduction based on facts and circumstances, but even then it can be hard to assure that the IRS will agree with the characterization.

Attribution Rules. There is another step in the analysis to determine if one of the above tests is met, which is particularly relevant for family-owned corporations. In applying each of the tests, attribution rules apply, so that a shareholder is deemed to own stock held by his parents, children and grandchildren (but not his siblings) (“family attribution“). Additionally, shares held by corporations, trusts and partnerships are attributed to their shareholders, beneficiaries and partners, and vice versa (“entity attribution“). This means that shares owned by parents, children, grandchildren and certain entities must be counted as owned by a shareholder when determining whether there has been at least a 20 percent reduction in voting and common stock ownership, a complete termination of interest, or a meaningful reduction in shareholder interest under the facts and circumstances test.

An important exception to the attribution rules applies in connection with a complete termination. The family attribution rules may be waived in that case, provided that the selling shareholder is not a shareholder, officer, director or employee of the corporation for 10 years following the redemption. It is not possible to waive the entity attribution rules.

Conclusion. Family-owned corporations can redeem the shares of family members under many different circumstances, including in connection with recapitalizations or pursuant to shareholders agreements. The attribution of stock ownership must be taken into account when determining whether a stock redemption will be treated as a sale qualifying for capital gain treatment or a dividend taxed at potentially much higher ordinary income rates beginning in 2013.

NOTE: The application of the federal tax rules to redemptions, including the attribution rules, can be complicated and a tax advisor should be consulted.

Dori Brewer and Bryan Smith work with family-owned businesses on tax planning, corporate governance, mergers and acquisitions and more. They can be reached at (206) 359-8000 or at [email protected] or [email protected], respectively.

2012 Dori Brewer and Bryan Smith

[1] The focus of this article is on redemptions by corporations that are “C corporations,” rather than “S corporations.” Although the rules described in this article generally apply to S corporations, S corporations are subject to additional rules that can significantly affect (and complicate) the analysis, and dividend treatment for an S corporation is often preferred over redemption treatment.