What Is It?
Before delving into the specifics of a Section 303 Stock Redemption, we believe it is beneficial to first explain what it is.
Company Purchase of Stock at Shareholder's Death
A Section 303 stock redemption is the purchase by a closely held corporation of its own stock upon the death of a shareholder, which (when certain conditions are met) is subject to capital gains tax treatment under Section 303 of the Internal Revenue Code. Congress enacted Section 303 in order to alleviate the liquidity problem encountered by estates whose primary asset is a closely held corporation interest. Stock redemptions under Section 303 must satisfy specific requirements, so it is essential to consult with your estate or financial planner, tax advisor, and/or attorney in advance. In certain circumstances, a Section 303 stock redemption may be utilized with publicly traded company stock. However, the focus of this discussion will be on closely held corporations.
Here's how it works: You are a shareholder in a closely held company, and you pass away. Your estate receives cash after selling a portion of your interest back to the corporation. The cash quantity equal to your funeral and estate administration expenses (and federal and state death taxes, including any interest due) is subject to capital gains taxation. Any additional amounts received through the redemption of shares would be subject to taxation, potentially at varying rates.
Since the shares held by your estate will generally have a basis equal to the fair market value of the shares at the date of your death, a redemption of stock under Section 303 that qualifies for capital gain treatment will generally result in little or no tax.
According to a recent study published by Retirement Researcher, implementing a Section 303 stock redemption in conjunction with a well-structured buy-sell agreement can provide significant benefits for Fortune 500 employees and retirees. Not only does this strategy offer liquidity for estates primarily consisting of closely held corporation interests, but it also allows retirees to transfer their ownership stake in a tax-efficient manner. By establishing a buy-sell agreement, Fortune 500 employees can ensure that their shares will be purchased by the corporation upon their death, protecting the continuity of the family business and providing financial security for their loved ones.
Transaction Could Be Part of an Entity Purchase Buy-Sell Agreement
We like to recommend entity buy-sell agreements to Fortune 500 employees and retirees to facilitate section 303 stock redemptions. The business entity may acquire your ownership stake in accordance with the terms of a buy-sell agreement governing entity purchases (stock redemptions). Under Section 303, you are not required to have a formal agreement in place to sell your corporation's stock, but it is highly recommended, particularly if you are not the majority shareholder.
When Can It Be Used?
Many of our Fortune 500 clients inquire about the circumstances under which section 303 stock redemptions are pertinent.
You Own a Corporation
You own stock in a C corporation, S corporation, or family corporation. Section 303 stock redemptions cannot be utilized by a corporation with a single stockholder or a sole proprietorship for the same reasons that an entity purchase buy-sell agreement cannot be utilized: the corporation cannot own itself, and the sole proprietorship is not a corporation.
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Your Business Interest Represents a Substantial Portion of Your Estate
Section 303 stock redemptions may be utilized if your business interest comprises at least 35% of your gross estate value as adjusted. If you personally own interests in more than one corporation, you can combine ownership percentages to reach the minimum ownership requirement of 35 percent as long as you own at least 20 percent of the value of the stock of each corporation.
If the value of your corporation interest is currently less than 35 percent of your estate, you may wish to contemplate making lifetime gifts of some of your other assets in order to comply with the 35 percent rule.
Caution: Gifts made within three years of your mortality must be added back to your estate's value in order to determine if you meet the 35 percent rule.
Strengths
Lets Your Family Do Something You Couldn't Do--Redeem Part of Your Family Business Interest without the Redemption Being Considered a Dividend
Employees and retirees of Fortune 500 are eligible for favorable tax treatment on stock redemptions upon death. With a Section 303 stock redemption, your estate can do something you could not normally do during your lifetime: it can sell a portion of your interest back to the corporation without it being deemed a taxable dividend. This could be advantageous for a family-owned business, which is especially susceptible to IRS scrutiny. Typically, if you sold a portion of your stock back to a family business during your lifespan, the money you received would be considered a dividend.
In general, the American Taxpayer Relief Act of 2012 extended the favorable income tax treatment of qualified dividends and capital gains in perpetuity. In general, capital gains and qualified dividends are taxed at 0% for taxpayers in the 10% and 15% tax brackets, and 15% for those in the 25% to 35% tax brackets. However, the tax rate on dividends and capital gains for taxpayers in the 39.6% tax bracket is typically 20%. In addition, the Patient Protection and Affordable Care Act of 2010 imposes an additional 3.8% Medicare tax on some or all of the net investment income of married filers whose modified adjusted gross income exceeds $250,000 and single filers whose modified adjusted gross income exceeds $200,000, depending on the amount of net investment income.
Despite the fact that both types of transactions are subject to taxes at long-term capital gains tax rates, there is still a significant advantage to classifying a transaction as a sale or exchange rather than a dividend distribution. In other words, in the case of dividend treatment, a portion or the entirety of the distribution is initially treated as a dividend, any remaining distribution is then received tax-free up to the amount of the basis, and any remaining distribution is taxed as capital gains. In the case of sale or exchange treatment, the shareholder only pays tax to the extent that the amount paid by the company exceeds his or her stock's basis. If the sale or exchange of your shares occurs after your death, your shares will generally have a basis equal to the shares' fair market value at the time of your death, and there may be little or no tax liability. Thus, there may be a greater tax liability associated with dividend treatment than sale or exchange treatment.
Even if your estate is not in need of cash, it can still utilize the Section 303 Stock Redemption.
We remind our clients that a 303 stock redemption is not an all-or-nothing proposition. A partial redemption under Section 303 may be utilized even if the estate is extremely liquid and does not need the cash for taxes. The funds are not required to be used to cover estate taxes and expenses. Section 303 allows partial redemptions as long as the amount does not exceed the sum of all federal estate taxes and state death taxes, funerary costs, and administrative expenses.
Whoever is responsible for paying the estate taxes and expenses must sell the business interest, typically the family or estate.
Section 303 Stock Redemption Can Be Used Even If Estate Taxes Are Paid In Installments
Numerous clients from Fortune 500 have elected to pay their estate taxes in installments. Section 303 stock redemption is still applicable in this situation. In exceptional circumstances, estate taxes attributable to a closely held business can be extended over a 14-year period. Under this estate tax installment plan, interest on the federal estate tax amount is due over the course of the first four years, followed by principal and interest payments over the course of the next ten years. A series of redemptions pursuant to Section 303 may be used to pay taxes in installments.
By coordinating the Section 303 stock redemption with the installment payment of estate taxes, the corporation is spared from making a lump-sum distribution of cash.
Section 303 Stock Redemption Can Be Used With Other Types of Buy-Sell Agreements
A Section 303 stock redemption can be used to supplement a cross-purchase buy-sell agreement or as part of a larger entity purchase or stock redemption plan, particularly in situations where the redemption would not otherwise qualify for capital gain treatment.
Protects Your Family Corporation from Being Forcibly Sold or Liquidated to Pay Estate Taxes and Settling Expenses - It Can Use Corporate Funds Instead
If your company is a family enterprise, you may not want it to be sold upon your passing. With a Section 303 stock redemption, your family can continue to operate the business in the event of your passing. To pay estate taxes, it would not be necessary to sell the complete business. Your estate can sell just enough of your interest back to the corporation to satisfy your total funeral and estate administrative expenses, federal estate taxes, and state death taxes, including any interest due, using the corporation's funds.
To qualify for Section 303 treatment, the stock redemption must occur within 3 years and 90 days of filing your federal estate tax return.
Attribution Rules Do Not Apply
Generally speaking, attribution rules can eradicate the favorable tax treatment of stock redemptions in a family-owned business. The purpose of the Section 303 stock redemption was to provide liquidity to the family-owned business for the payment of estate taxes, state death taxes, and administrative expenses. The attribution standards expressly do not apply to Section 303 stock redemptions.
Even if the company lacks cash, it can still buy back a portion of your interest.
If your corporation does not have enough cash on hand to purchase a portion of your shares in a Section 303 stock redemption, your surviving spouse or adult child can loan the corporation the money to finance the purchase. Future business profits can be used to repay the lender through corporate debt payments.
Tradeoffs
While While a section 303 stock redemption can be a powerful instrument, we would like to remind Fortune 500 employees and retirees of the restrictions that apply.
There is a limit on the number of shares that can be redeemed under Section 303.
The maximum quantity of stock that can be redeemed without being considered a dividend is equal to the sum of your funeral and estate administration expenses, federal estate taxes, state death taxes, and any interest due.
If your estate wishes to redeem shares in excess of this limit, it should investigate the requirements for a Section 302 stock redemption, which (when certain conditions are met) may permit sale or exchange treatment (subject to capital gains tax) on amounts in excess of the Section 303 limits.
Must Be Coordinated With Terms of Will and Other Estate and Tax Planning
In our experience working with the estates of a number of Fortune 500 clients, we have discovered that executing a section 303 stock redemption is frequently complicated due to other estate administration factors. It is possible that the provisions of your will make redemption under Section 303 difficult or impossible. It is crucial that you consult with an attorney, estate, tax, or financial planner for this reason. If your will is written so that your successors have no estate tax liability, they cannot use a Section 303 stock redemption to receive cash from the business.
For instance, if the business interest passes to your son via joint tenancy and your will instructs the executor to pay all final administration expenses and taxes from "the residue of the probate estate," the redemption of the business interest will not qualify under Section 303.
May Have Limited Usefulness to Surviving Spouse If Full Marital Deduction Used
For a tax-favored redemption under Section 303 to be permitted, there must be a federal estate tax liability. If you bequeath your property to your spouse and take advantage of the unlimited marital deduction, your estate passes to your surviving spouse tax-free. Due to the absence of a federal estate tax liability, a partial redemption of your shares under Section 303 would be impossible.
Corporate Accumulations to Fund Redemption May Be Subject to Accumulated Earnings Tax
Potentially subject to the accumulated earnings tax are funds accumulated prior to the shareholder's death to satisfy the anticipated need for a redemption. If the Internal Revenue Service deems the accumulation of funds for a redemption to be unreasonable, a penalty tax may be imposed on the corporation. If you are contemplating reserving corporate funds for a future redemption under Section 303, you should consult your tax advisor.
How to Do It
How to initiate the process is one of the most frequent inquiries we receive from Fortune 500 clients regarding this type of stock redemption.
Things to Do Now
The following are some suggestions we provide to our Fortune 500 clients to help them initiate their section 303 stock redemption.
Decide What You Want to Happen to Your Share of the Business
You should carefully consider your financial, tax, and estate planning objectives.
You Might Want to Set Up a Buy-Sell Agreement
Based on our extensive experience with Fortune 500 clients and retirees, buy-sell agreements have proven to be extremely useful in facilitating section 303 stock redemptions. If you lack a buy-sell agreement, you may wish to draft one. A buy-sell agreement is not required for a Section 303 stock redemption, but it can be established now to ensure the corporation will consent to purchase your stock from your estate. Consider the entity purchase buy-sell agreement if you want the corporation to purchase your shares upon your passing. In order for the corporation to be legally bound by the entity purchase agreement, whoever has the authority to commit the business by contract must participate in the discussion.
Make Sure the Corporation Is Able to Buy Your Stock
If you want your estate to be able to redeem your stock, you should confirm that the corporation has the financial and legal means to purchase your shares. This is especially crucial in the absence of a buy-sell agreement, as the corporation may not be able to make the purchase. Keep in mind that state laws stipulate that a corporation can only purchase stock with excess funds.
Meet With Your Tax Advisor
We urge all Fortune 500 employees and retirees to meet with a tax professional in order to make sure that your redemption qualifies under section 303. If your estate does not qualify right now, action can be taken that may allow it to 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
Creating a buy-sell agreement can be extremely complicated due to legal and tax issues; therefore, you should consult an attorney. Each party to the contract should have their own attorney. From our experience working with Fortune 500 employees and retirees, we know that dedicated professional assistance is incredibly valuable for these types of tasks.
Things to Do Later
While the steps listed above are things we suggest Fortune 500 employees and retirees to take care of immediately, there are some steps that must be completed down the line.
Periodically Review the Buy-Sell Agreement (If You Have One)
We urge all employees and retirees of Fortune 500 who have a concluded buy-sell agreement to review its contents on a regular basis, perhaps annually. You want to ensure that the agreement still suits your needs and that any necessary revisions are made.
Caution: failing to update an agreement as stipulated in the agreement could result in complications.
Monitor Your Estate Assets
Even if your corporate stock comprises at least 35 percent of your estate at the moment, it is essential to monitor your estate assets to ensure that Section 303 eligibility is maintained. It is possible for your corporate stock to fall below 35 percent of your adjusted gross estate if any of the following occur:
Consider all assets when calculating the aggregate value of the estate, including life insurance and jointly held property.
Tax Considerations
Income Tax
Normally Typically, there is no capital gain to the shareholder's estate.
Your estate receives a new basis for your corporate stock equal to the fair market value (FMV) typically determined on the date of your demise. When the sale price is accepted as the FMV, no capital gain or loss should be realized by your estate upon redemption of your corporate stock if the sale price is accepted as the FMV.
Redemption of Shares Is Not a Business Tax Deductible Event
Redeeming a shareholder's shares does not qualify as a tax-deductible business expense. When cash is distributed in exchange for stock, the business does not record a gain or loss.
Gift and Estate Tax
Many of our Fortune 500 clients have inquired about the role of gift and estate tax in the section 303 stock redemption procedure.
Estate Tax Value Is Determined By Amount Received From Stock Redemption
When your estate redeems your business interest, the amount received from the transaction typically determines the value of the business interest that is included in your estate's value.
Caution: If the price received is less than the fair market value (FMV), the estate will be taxed on the difference between the price received and the FMV as determined by the IRS. This means that the estate may be required to pay tax on value it did not receive and will never receive.
Questions & Answers
Do you need a written agreement for your family to utilize the Section 303 Stock Redemption?
Without an advance agreement, your family or estate can redeem stock under the favorable provisions of Section 303. If you are the corporation's dominant shareholder, your estate can use its influence to ensure that the redemption occurs. In the absence of forethought, it may be impossible to redeem your stock, as the funds may not be available and/or local regulations may prohibit it.
Nevertheless, if you are not the majority shareholder, you should enter into a Section 303 stock redemption agreement with the corporation to ensure that your intentions for your share of the corporation are carried out. It would be regrettable for your estate to encounter resistance or difficulty in redeeming your stock under Section 303 if there was no formal agreement in place prior to your passing.
Conclusion
Imagine you've spent years nurturing a beautiful garden, carefully cultivating rare and valuable flowers. As you approach retirement, you want to ensure the garden continues to flourish and your loved ones can enjoy its beauty. In order to protect your precious flowers, you decide to create a special agreement with a professional gardener. This agreement ensures that upon your departure, the gardener will purchase a portion of your garden, providing financial support for your family while allowing the rest of the garden to thrive. This agreement acts as a safety net, preserving your legacy and ensuring the next generation can enjoy the fruits of your labor. Just like this gardening analogy, a Section 303 Stock Redemption Buy-Sell Agreement can safeguard your family business, allowing you to pass on your hard-earned success to your loved ones and ensuring the continuation of your entrepreneurial legacy.
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.
The Retirement Group is not affiliated with nor endorsed by fidelity.com, netbenefits.fidelity.com, hewitt.com, resources.hewitt.com, access.att.com, ING Retirement, AT&T, Qwest, Chevron, Hughes, Northrop Grumman, Raytheon, ExxonMobil, Glaxosmithkline, Merck, Pfizer, Verizon, Bank of America, Alcatel-Lucent or by your employer. We are an independent financial advisory group that focuses on transition planning and lump sum distribution. Please call our office at 800-900-5867 if you have additional questions or need help in the retirement planning process.
The Retirement Group is a Registered Investment Advisor not affiliated with FSC Securities and may be reached at www.theretirementgroup.com.
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