Reverse Section 303 Stock Redemption
What is a reverse Section 303 stock redemption?
A reverse Section 303 stock redemption is a form of stock redemption, meaning the company buys back its own stock from a shareholder. The reverse Section 303 stock redemption can provide your family or your estate with cash equal to your funeral and estate administrative costs, and federal and state death taxes, including any interest due. This can be accomplished using funds from outside the corporation, thus preserving corporate cash levels at the time of redemption, allowing for installment payments for the redemption, and providing a tax deduction for the interest portion of the payments. A reverse Section 303 stock redemption must meet the same criteria as a regular Section 303 Stock Redemption. In fact, in all respects, it is a Section 303 stock redemption... with a twist.
Section 303 stock redemption requirement recap
First, let's recap the Section 303 stock redemption to show how it and a reverse Section 303 stock redemption are the same. To see the full discussion, go to Transfer Your Business Interest with a Section 303 Stock Redemption. Specifically, the prerequisites are that you own a corporation, the stock redemption occurs after your death, and your business interest represents at least 35 percent of your adjusted gross estate.
Why you might want a Section 303 or a reverse Section 303 stock redemption
Valuable for family corporation
The Section 303 stock redemption and the reverse Section 303 stock redemption can be very valuable if your business is a family corporation. Under these two types of redemption, the Internal Revenue Service allows your family to get money from your business interest without the funds being subject to treatment as a dividend for income tax.
Can be used even if money not needed for estate expenses
Even if your estate doesn't need the money, it can still use the Section 303 or reverse Section 303 stock redemption to get cash from the business. The amount of the stock redeemed cannot exceed the total of your funeral and estate administrative costs, and federal and state death taxes, including any interest due, although the money doesn't actually have to be used for these expenses.
Can be used even if estate taxes paid in installments
The Section 303 and reverse Section 303 forms of stock redemption can be used even if your estate taxes are paid in installments, and can be used with other types of buy-sell agreements.
Attribution rules do not apply
The attribution rules, which generally eliminate any favorable tax treatment for stock redemptions in a family corporation, do not apply to stock redemptions qualifying under Section 303 of the Internal Revenue Code. Section 303 was specifically enacted to help provide liquidity to the family-owned corporation for estate expenses.
The not-so-cool things you have to put up with to get the good stuff
Must be coordinated with terms of will and other estate and tax planning
The terms of your will might make redemption under the terms of Section 303 difficult or impossible. For this reason, it is important that you work with your attorney, or estate, tax, or financial planner. If your will is structured so that your heirs have no estate tax liability, then your heirs would not be able to use a Section 303 stock redemption to get cash from the business.
For example, if the corporate stock passes to your son by joint tenancy, and your will directs the executor to pay all final administration expenses and taxes from the residue of the probate estate, the redemption of the corporate stock will not qualify under Section 303.
May have limited usefulness to surviving spouse if full marital deduction used
For a tax-favorable redemption under Section 303 to be allowed, there must be a liability for federal estate tax. If you leave your property to your spouse and the unlimited marital deduction is used, your estate is passed to your surviving spouse free of federal estate taxes. Because there would be no federal estate tax liability, a partial redemption of your shares under Section 303 would not be allowed.
How does it work?--Funding the reverse Section 303 redemption
Stock redemption doesn't require corporate funds
The key to the reverse Section 303 stock redemption is that it doesn't use corporate money. This is where the reverse part of the name comes in--the corporation is buying its stock back without using its own money, and you are getting money from the corporation that you helped to provide. There are several ways to provide the cash to be used in the reverse Section 303 stock redemption, which gets money from outside the corporation, which is then loaned to the corporation.
Can use life insurance policy payable outside corporation
A relative (for instance, your son or daughter) could buy a life insurance policy on your life. Your son or daughter would be the owner and beneficiary of the life insurance policy. When you die, the beneficiary would receive the death benefit from the insurance policy (income-tax free) and loan the money to the corporation for the purchase of your stock. The corporation would make loan payments with interest to the lender.
Can use life insurance trust
During your lifetime, you might set up a life insurance trust, which would buy a policy insuring your life. The trust would own the life insurance policy, pay the premiums, and be the named beneficiary. When you die, the life insurance trust as the beneficiary would receive the policy proceeds free of income tax. The trust would then loan the money to the corporation. The corporation would use the money to buy some of your stock from your family or estate. The corporation would make loan payments with interest to the trust.
Can use loan to corporation
You don't need a trust or a life insurance policy to set up the funding for the reverse Section 303 stock redemption. Anyone who has the cash can loan it to the corporation for the partial redemption of your stock. The lender would then receive payments for principal and interest from the corporation.
What makes the reverse Section 303 stock redemption different?
Even if the corporation doesn't have the cash, it can still buy back part of your business interest
If your corporation does not have cash available to buy part of your stock under a Section 303 stock redemption, you can still sell back part of your stock. The corporation can borrow money from somewhere else to make the purchase (which we will discuss shortly).
Allows your heirs to keep control of family corporation and receive income stream
Your family can retain control of the corporation and receive the benefit of the income stream from the repayment of the loan. The loan principal payments would be untaxed, while the interest would be considered taxable income.
The corporation is not exposed to the alternative minimum tax (AMT) when life insurance is used
Under a regular Section 303 stock redemption funded with life insurance, the death benefit proceeds are generally payable to the corporation. The proceeds could expose the corporation to the alternative minimum tax (AMT). When life insurance funding is used with a reverse Section 303 stock redemption, the death benefit proceeds are paid to a party outside the corporation, so there is no increase in corporate exposure to the AMT. For more information, see Fund Your Buy-Sell Agreement with Life Insurance and Alternative Minimum Tax and Your Insurance Funded Buy-Sell Agreement.
Creates tax-deductible way for corporation to redeem your stock
The reverse Section 303 stock redemption allows the corporation to pay for your partial stock redemption in a manner that is partly tax deductible. While this benefits the corporation and not you directly, if your corporation is a family corporation, you might care about this benefit for your family. Generally when a business redeems the shares of a shareholder, it is not an income tax-deductible expense of the business. When the reverse Section 303 stock redemption is used, a loan is created on the books of the corporation. The company doesn't have to shell out the cash for your partial redemption, and the interest payments on the loan are tax deductible.
Transactions not subject to state laws governing corporate stock redemption
In all states, corporate law allows a corporation to buy its own shares only under certain conditions. One of these conditions is that stock purchases must come from surplus cash. To complicate things, corporations are subject to the accumulated earnings tax on excess cash. Thereverse Section 303 stock redemption avoids the corporate stock redemption rules because no corporate money is involved.
How can you set up a reverse Section 303 stock redemption?
If you think the reverse Section 303 stock redemption sounds like a good idea, you might want to do the same legwork required for the Section 303 Stock Redemption. To recap:
Things to Do Now
Decide what you want to happen to your share of the business
You should consider all of your financial, tax, and estate planning goals. Think about the questions in the Buy-Sell Planning Questionnaire.
You might want to set up a buy-sell agreement
If you do not have a buy-sell agreement, you may want to create one. A buy-sell agreement is notrequired for a Section 303 or a reverse Section 303 stock redemption, but it can be set up now to ensure that the corporation will buy your stock from your estate.
Make sure the corporation is able to buy your stock
If you want your estate to be able to redeem your stock, you should check to see that the corporation is financially and legally able to buy your stock from you. This is especially important if you don't have a buy-sell agreement, because the corporation might not be prepared to make the purchase. Remember that state laws dictate that a corporation can only buy stock using surplus funds.
Meet with your tax advisor (make sure your redemption qualifies under Section 303)
If your estate does not qualify for a Section 303 stock redemption right now, action can be taken to see that it does qualify in the future. You will need help meeting the requirements.
Meet with your attorney if you are planning to set up a buy-sell agreement
Setting up a buy-sell agreement can be very complex, because it involves legal and tax issues, so you should consult an attorney. Each party under the agreement should have his or her own attorney.
Set up the funding--there are three possibilities:
- If you want to use life insurance to fund the reverse Section 303 stock redemption, you should apply for the policy now.
- If you want to use a trust to own the policy, you will need to see your attorney and establish the trust. In this case, the insurance policy would be bought by the trust. The trust might receive cash from you or your family so that it can make the payments on the policy.
- If you expect that your family will have enough cash available in savings accounts, mutual funds, or other accessible sources (like in the mattress), then cash may be a suitable method for funding the reverse Section 303 stock redemption.
Tip: If you choose insurance to fund the reverse Section 303 stock redemption, you might want to have the policy owned and payable to either your children or a trust. This way, the value of the policy can be kept out of your taxable estate.
Things to Do Later
Monitor your estate assets (to ensure that Section 303 qualification is maintained)
This step is really important. Even though your interest might exceed 35 percent of the value of your adjusted gross estate now, changes in the value of the business or the value of your other assets could throw the percentage off. Your tax advisor or estate or financial planner can help you keep an eye on this.
This material was prepared by Broadridge Investor Communication Solutions, Inc., and does not necessarily represent the views of The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867.
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