Category: Sales & Exchanges; Corporations
Subject: Redemption
Title: Employee Buyout of Sole Shareholder
IRC Sections: 302
Filename: 1097.html
Date Produced: 4/97

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Background
The taxpayer, X, is the sole shareholder of J Corporation. X wishes to retire from the business. One of J's employees, TD, wants to acquire the equity position now owned by X. J has only one class of stock.

J Corporation was recapitalized. Its existing 100 outstanding shares of common stock were surrendered in exchange for 100 shares of newly-issued Class A Common stock. An additional new class of stock, Class B Common shares, was also authorized pursuant to the recapitalization. Both Class A and Class B shares are entitled to vote. Class A shares have two votes per share and Class B shares have only one vote per share. Class A shares are not entitled to receive dividends.

X determined that his existing J stock is worth $3 million. Pursuant to X's desire to retire from the business, the following agreement was reached.

On January 1, 1996 and on January 1 of each of the next nine years the following will occur:

X will transfer 10 shares of Class A common stock to Corporation J in exchange for a non-interest bearing note for $300,000 payable in 12 monthly installments of $25,000 each.

The stock acquired by Corporation J will be held as treasury stock and may not be voted. The stock so transferred will be held by X as additional security during the pendency of the agreement.

Corporation J is obligated under the agreement to purchase X's stock on an accelerated basis if corporate net profit exceeds a certain threshold.

The purchase price at which Corporation J will buy X's stock is fixed in the agreement; however, upward adjustments of the purchase price are possible based on the financial performance of Corporation J during the ten-year buyout period and based on the behavior of the Consumer Price Index.

Simultaneous to each annual purchase of Class A shares from X, 10 shares of Class B stock will be transferred to TD. With the exception of the first such transfer, this transaction will be treated as additional compensation to TD. The agreement appears to set the value of the Class B stock at $100 per share. However, the agreement contains conflicting valuation provisions based on differing circumstances under which the stock could be transferred.

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Discussion: After-Tax Dollars
As I understand it, TD has expressed some concern that J Corporation must use after-tax funds to purchase X's interest. That is true. It is also true that if X's interest is to be purchased, the buyer must use after-tax funds irrespective of the identity of the buyer (whether the buyer is J Corporation or TD, personally). I do not know of a workable way to redeem X's interest with pre-tax dollars.

Discussion: Existing Plan
The parties, X, J Corporation, and TD, intend for the above described transaction to be treated for tax purposes as a redemption of X's stock taxable to X at capital gains rates.

A distribution by a corporation in respect of its stock can be viewed either A) as a corporate distribution taxed to the shareholder as a dividend at ordinary income rates to the extent of current or accumulated earnings and profits of the distributing corporation; or B) as a sale or exchange of stock generally taxable to the shareholder at capital gains rates.

Internal Revenue Code Section 302 establishes four factual scenarios under which a corporate distribution can be treated as a sale or exchange of stock at the shareholder level. Two of the scenarios are potentially relevant to the proposal at hand.

1) Section 302(b)(3) provides sale or exchange treatment in the event a taxpayer's entire interest in the corporation is redeemed.

2) Section 302(b)(1) provides sale or exchange treatment if the distribution is not essentially equivalent to a dividend.

According to the conventional wisdom surrounding redemptions, the first scenario, Section 302(b)(3), is viewed as a "safe harbor": if the taxpayer terminates his entire interest, the transaction is treated as a sale or exchange rather than a dividend without any further inquiry. The second scenario is viewed as a provision of last resort. Since the phrase "essentially equivalent to a dividend" is not reliably defined anywhere, it is generally viewed as quite unpredictable to rely on Section 302(b)(1).

When we first discussed this plan, I stated that it is clear that Section 302(b)(3) does not apply to a prearranged series of redemptions which culminate in the termination of the shareholder's entire interest. I must soften that previous statement, at least somewhat. As part of my research in connection with creating a workable alternative to the existing proposal, I discovered some cases that suggest that it is possible to apply either Section 302(b)(1) or Section 302(b)(3) to a prearranged series of redemptions pursuant to a overall plan under which the taxpayer's entire interest in the corporation is ultimately terminated.

I must say that I am surprised and a little perplexed by these cases. Having dealt with the redemption area quite extensively, it has been my experience that most selling shareholders need essentially the same thing: the ability to "cash out" of the business at capital gains rates while maintaining enough control to make sure the business stays viable long enough to make the redemption payments. The serial redemption technique provides a significant opportunity for the selling shareholder to in large measure meet these needs. I am particularly perplexed that none of the well-respected commentators discuss these cases and the serial-redemption technique that is the heart of this proposal.

The author of BNA Tax Management Portfolio 767-1 on corporate redemptions suggests in passing (and without citing any of these cases that I found) that it may be possible to use a series of redemptions which culminate in the elimination of the shareholder's entire stock interest. Following is the entire passage.

In some situations, the stepping together of the separate steps of a large transaction can help the taxpayer qualify under Section 302(b)(3). For example, it may be possible to qualify under Section 302(b)(3) a series of annual redemptions of portions of a shareholder's stock where, pursuant to a plan, the series in the aggregate results in redemption of all of the shareholder's stock.

By far the most well-respected commentary source on corporate tax matters, Federal Income Taxation of Corporations and Shareholders by Bittker & Eustice says absolutely nothing on the subject.

The author of the corporate redemption portion of the CCH Federal Tax Service says the following in connection with use of a prearranged series of redemptions.

Comment: This evidentiary burden [proving that a pre-arranged plan exists] is obviously easier to carry if the entire series covers only a short period and has in fact already completely terminated the shareholder's interest. Nonetheless, at least theoretically, a series of redemptions could span a decade and still be treated for tax purposes as one integrated transaction resulting in complete termination.

Notwithstanding the oblique (or nonexistent) treatment of this subject by the various commentators, there really does appear to be a viable body of case law that sanctions serial redemptions. The question for our consideration is how far can that principle be taken?

The root of what I will call the serial redemption doctrine starts in 1951 with Carter Tiffany v. Commr., 16 TC 1441. In that case, there was considerable friction between various shareholders of the corporation. In December, 1943, the taxpayer, Mr. Tiffany, granted to one of his fellow shareholders, Mr. Gerrish, an option to purchase 300 of his approximately 3,500 shares. At the same time, he appointed Gerrish as his proxy with respect to the optioned shares, endorsed the shares in blank, and gave possession of the shares to Gerrish. A few weeks later, the corporation redeemed the taxpayer's remaining shares. The court held that the arrangement with Gerrish, even though termed an option, was intended and did in fact sever the taxpayer's beneficial interest in the 300 shares. The court held further that the so-called option arrangement with Gerrish was part of an overall plan to dispose of the taxpayer's entire interest in the corporation. Having found the existence of an overall plan for disposition of the taxpayer's entire stock interest, the court concluded that the redemption distribution was not essentially equivalent to a dividend under Section 115(g) of the Internal Revenue Code of 1939.

In Jackson Howell v. Commr., 26 TC 846 (1956), three commonly-owned, incorporated automobile dealerships were required by General Motors to eliminate minority interests held by a trust and holding company. These interests were redeemed by the corporations in a series of integrated steps consummated over a period of less than a year. Citing Tiffany and Zenz v. Quinlivan, 213 F. 2d 914, 45 AFTR 1672 (6 Cir., 1954), the court held that the redemptions were part of an integrated plan and were thus not essentially the equivalent of distribution of a dividend under Section 115(g) of the Internal Revenue Code of 1939.

In Zenz v. Quinlivan, the taxpayer as part of an integrated transaction sold a portion of her stock holdings and had the remainder thereof was redeemed by the issuing corporation. The court having found an integrated plan to dispose of her entire stock interest found the redemption transaction to be not essentially he equivalent of distribution of a dividend under Section 115(g) of the Internal Revenue Code of 1939.

In Lukens v. Commr., 246 F. 2d 403, 51 AFTR 877 (3rd Cir, 1957), 446 of the taxpayer's 547 shares were redeemed and the remaining shares were given away two years later. The court found that both transactions were part of an integrated plan for the taxpayer to remove himself from the business and to divest his entire stock holdings. The court cited the Zenz, Howell, and Tiffany decisions in support of its finding that the integrated series of transactions was not essentially the equivalent of distribution of a dividend under Section 115(g) of the Internal Revenue Code of 1939.

By the time of Lukens in the late 1950's, it seemed to be an accepted point that a series of integrated steps resulting in the complete termination of a shareholder's stock holdings would pass muster under the Internal Revenue Code of 1939 as a redemption rather than a dividend. The cases cited above, frankly, deal quite sparsely with the concept that a series of redemptions is an acceptable means of achieving total divestiture of one's stock holdings; rather, they focus on the factual issue of whether or not the prerequisite integrated plan existed.

The Internal Revenue Code of 1954 supplanted the confusing test of Section 115(g) of the 1939 Code with the more familiar safe harbor tests we have now: IRC Sections 302(b)(2) and 302(b)(3). The "not essentially equivalent to a dividend" test of Section 302(b)(1) is the remaining 1954 Code vestige of Section 115(g) of the 1939 Code.

It is clear that the serial redemption doctrine survived the transition from the 1939 code to the 1954 code. There is a similar body of cases under the 1954 Code citing the 1939 Code cases for the proposition that a series of redemptions in complete termination of a taxpayer's stock interest can be a valid redemption under either Section 302(b)(1) or 302(b)(3). Again, these cases focus principally on the factual determination of whether the various steps in question were part of an integrated plan. See, for example, Lettman v Commr, TC Memo 1982-511, 44 TCM 1050, ¶82,511 P-H TC Memo; Benjamin v Commr, 66 TC 1084 (1976), aff'd 592 F2d 1259 (5th Cir, 1979); Leleux v Commr, 54 TC 408 (1970); Bleily & Collishaw, Inc v Commr, 72 TC 751 (1979), aff'd in an unpublished opinion 647 F2d 169 (9th Cir 1981); Roebling v Commr, 77 TC 30 (1981); Paparo v. Comr., 71 TC 692 (1979); Peery S. Lewis v. Commr., 47 TC 129 (1966);

Having clearly established that a valid redemption can result from a serial redemption pursuant to an integrated plan culminating in the complete termination of a taxpayer's stock holdings, the relevant questions for the case before us are as follows.

1) Do we have an integrated plan?

2) How far can one push the concept of serial redemptions? How long can the series be stretched out and what relationship can the taxpayer have with the redeeming corporation during the pendency of the redemption plan?

As to the first question, it seems clear in my opinion that there is an integrated plan culminating in the complete termination of a taxpayer's stock holdings. I assume that the contract under which the redemptions are to take place is valid and absolutely binding under local law. If so, I think this eliminates any serious question about the existence of an integrated plan. The whole plan is laid out in a single, legally enforceable document. I cannot imagine a cleaner set of circumstances upon which to base our premise that an integrated plan exists for the elimination of X's entire stock interest in J Corporation.

The second question, or set or questions, is far more troublesome. The existing cases have very simple plans to redeem out a shareholder over a period of a few months up to as much as five years (Lewis). During the pendency of the redemption arrangement, the shareholder typically retained the right to vote any unsold shares and in some cases remained on as an officer and/or director. It is my view that the facts of the J Corporation matter are far beyond anything that has been litigated so far. Consider the following.

The redemption in question takes place over a period of nine years. The most we have in the existing cases is five years.

In the J Corporation matter, X retains control for about seven years of the nine years of the redemption period. I have seen nothing even remotely approaching that circumstance in the existing cases.

X effectively retains a right to participate somewhat in the growth and earnings of J Corporation by virtue of the various stock price adjustment provisions in the agreement.

I think it would be possible for the IRS to attack the existing situation by distinguishing it, based on the factors set forth above, from the line of cases on which we wish to rely. I think if this matter were challenged, there is a significant possibility that the IRS could convince a court that this transaction is both quantitatively and qualitatively different (and materially so) from the existing cases on which the taxpayer wishes to rely. Accordingly, I feel there is significant risk for the taxpayer in the current structure.

On the other hand, however, it seems clear to me that there is a valid filing position for treating the serial redemption as a redemption under either Section 302(b)(1) or Section 302(b)(2). After all, there is a long line of cases which sanction serial redemptions of taxpayer's entire interest. Further, it is clear that the separate redemption transactions are part of an overall plan to eliminate X's entire stock holdings. The risk comes down to whether a court would decide that the additional factors present in this case (the length of the payout period, participation in management, voting control, and participation in the earnings of the company) make this transaction into something more than a simple serial redemption.

On balance, I feel that if the existing transaction were scrutinized, there is a very significant chance that the taxpayer would ultimately lose. Both Sections 115(g) of the 1939 Code and Sections 302(b)(1) and 302(b)(3) of the current Code are based on the principle of significant reduction of the taxpayer's proprietary interest in the redeeming corporation. While it is true that the taxpayer's interest is ultimately terminated entirely, he holds onto it so strongly and for such a long period that I think a court might be sorely tempted to recharacterize this transaction as something other than a serial redemption.

Discussion: Alternative Structure
As discussed above, the current plan seems fairly risky in my opinion. What are the alternatives? The traditional answer is a simple installment redemption in which the taxpayer would sell all his shares in a single transaction in exchange for an installment note. Ideally, the taxpayer would take his installment note, retire from the business, and live happily ever after. Clearly, such a transaction would meet the entire termination of interest rules of Section 302(b)(3). Unfortunately, things are not that simple. I suspect that X would not be content to completely put the viability of his installment note in the hands of TD without any supervision or involvement from X. In addition, X needs security for the note. Finally, X would likely want to have a hand in the business in order to be sure that the business will produce enough cash to satisfy the terms of the note.

As far as security is concerned, X would likely demand a security interest in the redeemed stock until the note is satisfied. In addition, X would likely be inclined to retain some position as an officer or director of the company. Further, RJD would likely want to retain the right to hold the shares in escrow and retain voting rights to those shares until the note is paid off.

This is a fairly common scenario, and unfortunately there is a considerable amount of uncertainty here as well. Under Section 302(b)(3), it is only necessary to eliminate the shareholder's entire stock interest in the redeeming corporation. An interest as a creditor (and perhaps as an officer, director, employee, or consultant as well) is permitted without violation of Section 302(b)(3). (Note that if the waiver of family attribution under Section 302(c) is in play, which is not the case here, the redeemed shareholder cannot have any continuing interest in the redeeming corporation.) The whole premise under Section 302(b)(3) is the taxpayer's entire stock interest has been eliminated and substituted for a mere creditor's interest under the installment note. The problem is the arrangements for securing the note and the retention of voting rights and other control indicia can begin to look as if the taxpayer has a continuing proprietary interest in the redeeming corporation similar to the position enjoyed by a stockholder. If that is the case, then the safe harbor of Section 302(b)(3) is destroyed.

The IRS has taken the position that if it is possible for a taxpayer to reacquire redeemed stock under some sort of security agreement, the taxpayer has not terminated his entire stock interest. This is so, in the IRS's view, whether or not it is actually necessary for taxpayer to exercise his rights to reacquire stock under his security agreement. The official IRS position is indicated by a no-ruling policy for redemptions in which there is a possibility of reacquisition of the shares. See Section 3.01(16) of Rev. Proc. 96-3.

Fortunately, the IRS has been singularly unsuccessful in getting the courts to buy this argument. See Lisle v. Comr., 35 T.C.M. 627 (1976) (stock escrowed to secure payment); Lynch v. Comr., 83 T.C. 597 (1984), rev'd on other grounds, 801 F.2d 1176 (9th Cir. 1986) (note secured by pledge of remaining shareholder's stock); Mathis Est. v. Comr., 47 T.C. 248 (1966) acq., 1967-1 C.B. 2 (stock held in escrow); Hoffman v. Comr., 47 T.C. 218 (1966), aff'd per curiam, 391 F.2d 930 (5th Cir. 1968) (pledge of stock as security).

With respect to participation as an officer or director, Revenue Ruling 76-524 speaks directly and favorably to the issue. It holds that Sec. 302(b)(3) applies to a taxpayer who remained as president and chairman of the board after all his stock (as well as all the stock of parties related to the individual) was redeemed.

Depending on the exact facts of any installment purchase, I feel there could still be a significant level of risk. However, the level of risk is much lower and the degree of predictability of outcome is much higher with the installment purchase than with the serial redemption discussed above.

There are some obvious questions that need to be resolved should the parties wish to pursue restructuring this transaction as an installment redemption.

It would be necessary to provide an interest factor that is not present in the current arrangement. How would that change the economics of the deal and what would be its effect to the corporation and to X?

What to do about the 1/1/96 and 1/1/97 transactions that have already occurred pursuant to the existing arrangement? Would it be necessary to amend prior returns? If so, that of course increases the risk of scrutiny.

I stand ready to help you move forward with this matter should you desire additional assistance.