Wednesday, July 15, 2020
A major issue for farm and ranch families that have at least one child or other heir that is interested in taking over the business after the senior generation either retires or dies, is how to transition the business to that next generation of managers/operators.
For farming and ranching operations that operate in a corporate structure, one way to transition the business is by means of a corporate stock redemption. What are the pros and cons of a corporate redemption? How does it actually work mechanically?
Corporate stock redemptions – it’s the topic of today’s post.
“Retiring” the Senior Generation
Compared to a sole proprietor farming operation, the tax “hit” to a retiring owner can often be much less in the corporate structure. When a sole proprietor retires and assets are sold, the tax consequences can be harsh. Grain and livestock in inventory and depreciable property (other than 20-year general purpose farm buildings) are subject to ordinary income tax treatment upon sale. In addition, any I.R.C. §1245 depreciation recapture is not eligible for the installment method of reporting. However, the sale of corporate stock by a retiring owner is taxed at capital gain rates that are lower than the ordinary income tax rates. That’s the case whether the stock is sold directly to the buyer or by means of a stock redemption. In addition, the installment method of reporting the income is available allowing for income tax deferral.
On the other end of the transaction, the next generation that is acquiring an ownership interest in the farming entity also has tax implications. When assets are purchased directly from a sole proprietor farmer or when a partnership interest is acquired with a basis-step up election in place, enhanced tax deductions are available. In addition, any basis that can be allocated to depreciable property results in deferred deductions. On the other hand, the seller recognizes depreciation recapture that must be recognized at the time of sale. See I.R.C. §1245.
One advantage of a stock redemption over a direct sale (at least to the buyer) is that a stock redemption can be used to fund the acquisition of stock with corporate earnings that are taxed at a 21 percent rate under current law.
The primary advantage of a corporate stock redemption is that it can remove post-tax wealth that has built up inside the corporation at a 21 percent rate. The same is true for future wealth built up if the payout occurs by virtue of installment reporting. In addition, interest expense is deductible inside the corporation if, for example, a member of the next generation individually buys the stock Likewise, there is no additional payroll tax burden that would otherwise occur if a person in the subsequent generation withdrew funds from corporate earnings to acquire stock from the senior generation.
With a corporate stock redemption, there is no increase in stock basis in the hands of the acquiring next generation. That’s the case even though the seller (senior generation) could have a large gain to report on the transaction.
The redemption of the senior shareholder’s stock must be a complete redemption to achieve capital gain tax treatment. The redeemed shareholder’s interest in the corporation must be completely extinguished. If it is, the proceeds received by the retiring shareholder, as indicated above, are treated as capital gain. That’s the case even if the corporation has earnings and profits what would otherwise be taxed as ordinary income if they were distributed to the retiring shareholder. I.R.C. §302(a). A complete redemption also eliminates characterization of the redemption as a dividend that would be taxed at ordinary income tax rates up to the amount of the earnings and profits of the corporation.
A complete redemption is also required for the transaction to be eligible for installment reporting. I.R.C. §302(b)(3). To accomplish a complete redemption, the senior shareholder must agree to have no involvement in the corporation for 10 years following the transaction. That means the former senior shareholder can’t be a consultant or an employee or a director during that time-span. No salaries or director fees for 10 years! However, it is permissible for the corporation to continue to employ the redeemed shareholder’s spouse and provide fringes via a lease of real estate to the corporation (and collateralization agreements) if the arrangement is structured to ensure payment on the installment note involving the redeemed stock, the employment contract for the spouse and the lease. That is especially true if the collateralization agreements are entered into in an arms’-length transaction and is comparable to arrangements involving unrelated parties. See, e.g., Hurst v. Comr., 124 T.C. 16 (2005). But, it is important that the redeemed shareholder not be determined to be involved in the business via the spouse.
As for being a consultant to the corporation, the U.S. Tax Court held in 1984 that consulting services could be provided by the redeemed shareholder occasionally and medical insurance benefits could continue without the redemption being taxed as a dividend. Lynch v. Comr., 83 T.C. 597 (1984). But, the IRS doesn’t like consulting arrangements involving a redeemed shareholder. See Rev. Rul. 70-104, 1970-1 C.B. 66. In addition, an ongoing consulting arrangement is not permissible. Lynch v. Comr., 801 F.2d 1176 (9th Cir.1986).
If a prohibited interest is acquired within the 10-year post transaction timeframe, the redeemed shareholder must notify the IRS. Indeed, the redeemed shareholder must attach an agreement to the tax return saying that such notification will be made. I.R.C. §302(c)(2).
If the rules for a complete redemption are violated, stock basis won’t offset gain and installment sale treatment is not available.
How is a complete stock redemption accomplished? The rules governing a complete stock redemption are set forth in I.R.C. §302(b)(3). As noted above, the senior generation shareholder must surrender all of his stock either all at once or in exchange for an installment note that is payable over time. After the redemption, if the remaining shareholders are related (in accordance with family attribution rules) to the shareholder that is being bought out, the redeemed shareholder can’t have any interest in the corporation for 10 years except for an interest acquired by bequest or inheritance. An exception from this rule, however, allows the redeemed shareholder to be a landlord or a creditor. See, e.g, Priv. Ltr. Rul. 8551014 (Sept. 19, 1985).
A redemption can also occur in the context of an I.R.C. §1041 transaction (such as incident to a divorce or otherwise between spouses). Prop. Treas. Reg. §1.1041-2.
Prior Family Transfers
Another potential “snag” in the planning process is that an “anti-abuse” rule says that capital gain treatment is not available if there have been family transfers of stock within 10 years before the redemption. I.R.C. §302(c)(2)(B). Family attribution rules of I.R.C. §318 apply to define family members in this context. The rule seems to disallow gifts to family members. However, if tax avoidance wasn’t one of the principal purposes of the transfer, then the transfer is permissible. Basically, it comes down to whether the taxpayer can prove a non-tax purpose for the transfer and that avoiding tax was not a principal purpose. Thus, if the prior transfer involved, for example, a parent that owned all of the corporate stock of a family farming or ranching corporation and gifted stock to a child that was being groomed as the successor as part of the parent’s estate and succession plan, a complete stock redemption would still be available and treated favorably from a tax standpoint. See Rev. Rul. 77-293, 1977-2 C.B. 91.
A stock redemption can be part of a business succession transition plan for farming and ranching corporations. But, planning for it is a necessity to ensure that the redemption achieves the anticipated benefits.