Key Takeaways

  • An S corp stock redemption involves the corporation repurchasing shares from a shareholder, which can occur for retirement, succession planning, or shareholder exit.
  • Tax treatment depends on whether the redemption qualifies as a sale or exchange under IRC §302 or is treated as a dividend, impacting capital gains vs. ordinary income tax rates.
  • Shareholder basis, accumulated earnings, and the corporation’s history as a C corp influence the tax outcome.
  • Redemption agreements often outline triggering events (e.g., death, disability, retirement) and funding methods, including life insurance.
  • Proper structuring of the agreement can prevent disputes, ensure fair valuation, and provide liquidity without disrupting the business.

S corp stock redemption refers to the process of disposing of your shares in an S Corporation.

Redemption of S corporation Stock

You can sell all or part of your stock either to the company or to someone else. Most shareholders prefer selling it back to the company. Tax liability on stock redemption varies depending upon whether it amounts to sale or distribution.

According to the Internal Revenue Code (IRC), it's treated as a sale or exchange, if it satisfies at least one of the following conditions:

  • You are selling all of your S corporation shares, or
  • The sale reduces your voting power to less than 50 percent, and your voting power after redemption is less than 80 percent of the voting power you had before redemption, or
  • The redemption does not amount to a dividend

Common Triggers and Structuring of Stock Redemption Agreements

Stock redemption agreements serve as binding contracts between the corporation and its shareholders, setting terms for when and how the company will repurchase shares. Common triggering events include:

  • Retirement – Allowing a shareholder to exit while receiving fair market value for their interest.
  • Death – Providing liquidity to the estate of a deceased shareholder and facilitating smooth ownership transfer.
  • Disability – Ensuring a fair buyout if a shareholder can no longer participate in the business.
  • Voluntary Withdrawal – Offering an orderly exit strategy for shareholders wishing to sell their interest.

A well-drafted agreement will specify:

  • Valuation method (e.g., agreed formula, independent appraisal).
  • Funding mechanism (cash reserves, loan, installment payments, life insurance proceeds).
  • Payment terms to balance fairness with the corporation’s financial stability.

This structure minimizes conflicts, maintains operational control, and ensures continuity for the remaining owners.

Tax Consequences of S Corporation Redemptions to a Shareholder

Another point to consider for analyzing tax implications is whether the company has accumulated profits. If there are no accumulated profits, meaning that the company has been an S corporation right from the beginning and has never taken over a C corporation with accumulated profits, the redemption cannot be considered as a dividend payment.

In a deemed disposition, the adjusted original cost of the stock is non-taxable and treated as a return of capital. A non-capital gain redemption is usually more beneficial from a taxation point of view since you can recover the original cost without having to pay any capital gain tax.

If an S corporation has accumulated profits from its initial C corporation years, taxation on the redemption distribution depends upon the balance in its Accumulated Adjustments Account (AAA). The Accumulated Adjustments Account contains the undistributed net profits for the period after the company converted into an S corporation.

You need not pay taxes on a redemption distribution to the extent that it does not exceed your tax basis or the balance in the Accumulated Adjustments Account of the company. If you are selling stocks in an S corporation, after holding them for more than a year, you are liable to pay capital gains tax on it.

Sale or Exchange vs. Dividend Treatment Under IRC §302

For a redemption to receive favorable sale or exchange treatment (capital gains), it must meet one of the tests under IRC §302:

  1. Complete termination of shareholder interest – All stock owned, directly or indirectly, is sold back to the corporation.
  2. Substantially disproportionate redemption – Voting power after redemption is less than 80% of pre-redemption voting power, and total ownership falls below 50%.
  3. Not essentially equivalent to a dividend – Determined based on facts and circumstances, usually involving a meaningful reduction in ownership.

If none of these conditions are met, the IRS may classify the redemption as a dividend, taxed at ordinary dividend rates to the extent of the corporation’s earnings and profits. For S corporations with no C corp earnings and profits, the risk of dividend treatment is reduced.

Basis Issues

  • Debt basis requires a direct loan from shareholders. You can also prove it on the basis of indirect loans between commonly held companies, but it would be risky and difficult to establish.
  • Once you establish a loan to the corporation, you need to make adjustments for principal payments, indebtedness forgiveness, and other deductible items.
  • In case of multiple indebtedness, you must proportionately allocate the losses over and above the stock basis.
  • Stock basis is different from equity reported in the company's financial statements.
  • When an individual stockholder sells or gifts shares of his stock to someone else, it's not entered in the company books.
  • For calculating capital loss arising from the sale of gifted stock, the seller must use the donor's cost basis or the stock's fair market value, whichever is lower.

Impact of Basis on Redemption Tax Liability

The shareholder’s basis in S corp stock plays a crucial role in determining the taxable portion of a redemption. Key considerations include:

  • Recovery of basis first – Amounts received up to the shareholder’s basis are generally tax-free as a return of capital.
  • Excess over basis – Taxed as capital gain if sale or exchange treatment applies.
  • Debt basis adjustments – If the shareholder lent money to the corporation, loan repayments can also affect gain recognition.
  • Inherited stock – Basis is stepped up to fair market value at the shareholder’s death, potentially reducing gain upon redemption.

Death, Taxes, and Repurchases

  • Redemption agreements often include provisions for stock transfer in case of any of an owner's death. Companies usually agree to buy back the shares in such cases.
  • When a corporation buys back shares due to a shareholder's exit, it is liable to pay capital gains tax on the accumulated earnings.
  • When the sale is done due to a shareholder's death, death taxes are collected from the proceeds of the sale and the ex-shareholder's estate.
  • In order to facilitate the buyback, an S corporation buys a life insurance policy for its shareholders. When any of the shareholders die, the company buys back the holdings with the amount it receives from the insurance company.
  • When the share buyback price in the agreement is set to be equal in value with the base estate tax of the stock, there is zero gain during the buyback.

Role of Life Insurance in Funding Redemptions

Many S corp redemption agreements are funded with corporate-owned life insurance on shareholders. Upon a shareholder’s death, the death benefit provides immediate liquidity for the buyout, avoiding disruption to cash flow. Advantages include:

  • Ensuring the corporation has tax-free funds to purchase the deceased shareholder’s stock.
  • Avoiding the need for debt financing or asset liquidation.
  • Providing certainty to both the business and the shareholder’s estate regarding payout timing and amount.

However, the corporation must structure the policy ownership correctly to avoid unintended tax consequences, and the agreement should specify how proceeds will be applied.

Short Tax Year Election

  • Buying back stock from a life insurance claim causes a problem since the interest of the deceased owner can't exceed the fair market value of the stock.
  • The Internal Revenue Code increases a shareholder's basis so that it's equal to the fair market value upon his death.
  • If the company is paying taxes on a cash basis, it can file a short tax year, which allows it to carry out redemption with the insurance proceeds even before filing an insurance claim.

Frequently Asked Questions

  1. What is the main difference between a stock redemption and a stock sale to another person?
    A stock redemption is when the corporation buys back the shares, while a stock sale transfers ownership to another shareholder or outside party.
  2. How is stock redemption taxed in an S corp?
    It depends on whether it qualifies as a sale or exchange (capital gains) or is treated as a dividend (ordinary income), based on IRC §302 tests.
  3. Can an S corp use life insurance to fund redemptions?
    Yes. Corporate-owned life insurance is a common tool for funding buyouts after a shareholder’s death.
  4. What happens if the shareholder’s basis is higher than the redemption amount?
    The redemption proceeds are generally tax-free up to the basis, with no capital gain recognized.
  5. Does a redemption affect the S corp’s remaining shareholders?
    Yes. It can change ownership percentages, voting power, and potentially influence control and profit allocations.

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