S Corp Stock Redemption: Everything You Need to Know
S corp stock redemption refers to the process of disposing of your shares in an S Corporation.3 min read
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
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 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.
- 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 stock holder 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.
Death, Taxes, and Repurchases
- Redemption agreements often include provisions for stock transfer in case 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 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.
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 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.
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