When a shareholder of a closely held family corporation dies, the surviving shareholders have important decisions to make, including how to satisfy liquidity needs.
How to Cover Estate Expenses
The surviving shareholders may wish to keep the business in the family. However, there may be a shortage of liquid assets needed to satisfy bequests, pay estate expenses, and provide sufficient assets and income for a surviving spouse. These estate expenses may include:
• Funeral costs
• Probate and administration expenses, including filing fees
• Accounting fees to assist with tax filings
• Legal fees
• Debts of the decedent
• Personal income and excise taxes (federal and state)
• State and Federal estate taxes
• Federal, state and generation-skipping transfer taxes
• Specific cash bequests
• Living expenses of surviving family members
Selling Shares in the Business
As you can imagine, these expenses and overall liquidity needs can add up, leaving the surviving family members pondering how to pay and satisfy them without putting the business at risk. They may look to sell the decedent’s shares in the corporation to bring in liquid assets, or they may seek outside investment. However, that option raises concerns with introducing an outsider into the business. Conversely, if the decedent was a minority shareholder, his or her interests in the business may not even be very enticing to an outside investor. Yet, the costs could still be too much for the business or surviving family members to bear without sufficient liquidity to cover estate expenses.
Further, if the corporation redeems just that portion of the decedent’s shares sufficient to generate the required cash to pay estate expenses, the corporation’s distribution might be treated as a dividend – causing greater tax liabilities than if treated as a capital transaction. This is because, generally, when a corporation redeems its shares, the purchase price distribution is treated as a dividend to the shareholder unless it satisfies at least one of three applicable tests:
- The redemption is “not essentially equivalent to the dividend”; or
- The redemption is “substantially disproportionate”; or
- The redemption is a complete termination of the shareholder’s interest in the corporation.
Internal Revenue Code (“IRC”) Section 303 Stock Redemption
This is where IRC Section 303 stock redemption can help. In summary, it permits distributions in redemption of a deceased shareholder’s stock to be treated not as a dividend, but as a capital transaction, up to a certain amount and provided the estate qualifies.
Absent IRC Section 303, the above-described tests are rarely satisfied, and any income derived from the redemption is deemed dividend income and is fully taxable at ordinary income tax rates. IRC Section 303 addresses this obstacle by allowing a shareholder’s estate, or its heir(s), to sell enough shares of the closely held corporation sufficient to pay federal and state death taxes, the costs of probate and estate administration, and funeral expenses without treating the transaction as a dividend to the redeeming shareholder. With IRC Section 303, a distribution in partial redemption of the decedent’s shares is taxable only to the extent that the amount of the redemption exceeds the estate’s (or beneficiary’s(ies’)) basis in the shares.
Given that under IRC Section 1014 the basis in the shares is adjusted at death (stepped-up if there is an increase in their fair market value), little or no taxable capital gain should result, provided that the stock redemption takes place promptly following the death.
Qualifying Amount
The amount that qualifies for favorable characterization under IRC Section 303 is limited to the following sum:
- State and Federal estate taxes (and generation-skipping taxes); and
- The amount of funeral, probate, and administration expenses allowable as deductions to the estate under IRC Section 2053.
This qualifying limitation notwithstanding, it should be noted that the distribution amount received on the redemption need not be used to pay taxes or probate and administration expenses. These amounts are merely limitations determining the amount that qualifies for a favorable tax characterization under IRC Section 303 on the redemption.
Qualifying Estates
To be eligible for a IRC Section 303 share redemption, the value of the shares included in the decedent’s gross estate must exceed thirty-five (35%) percent of the value of the decedent’s adjusted gross estate. That said, for purposes of this requirement, shares in two (2) or more corporations can be treated as shares of a single corporation, provided the decedent owned twenty (20%) percent or more of the outstanding shares of each corporation.
Section 303 Filing Deadlines
A federal estate tax return must generally be filed no later than nine (9) months following the decedent’s date of death. An IRC Section 303 stock redemption must be carried out within three (3) years and 90 days from the date the estate tax return is due. In other words, within four (4) years of the date of death. However, the executor can file an extension for the federal estate tax return, which can extend the permissible redemption period if approved. Similarly, if IRC Section 6166 is elected for installment payments of the estate tax, the Section 303 period is extended until the due date of the last installment.
In the event of a partial redemption occurring more than four (4) years following the decedent’s death, the distribution is eligible for IRC Section 303 treatment only to the extent of the lesser of (i) the amount of taxes, funeral and administration expenses remaining unpaid at that time or (ii) the taxes and expenses that are actually paid within one year of the distribution.
Summary
An IRC Section 303 stock redemption can be used to provide the liquidity necessary to pay estate expenses without causing taxation at higher ordinary income tax rates. However, it is important to work with a tax professional and/or attorney who has experience with these transactions. You want to make the right decisions when it comes to something as important as your family business.
In our next article, we will continue with Part 2 of this article concerning IRC Section 303 stock redemptions. We will provide additional information concerning the qualification requirements and how it impacts tax deductions for qualified business interests.
If you have questions about IRC Section 303 redemptions or any other business planning, estate planning and estate tax planning issues, please contact me today.
