Closely held corporations often have issues come up about succession planning and also about how to structure transactions in the most tax advantageous way possible.  Corporate redemption of a shareholders stock is always something to consider.

Hypothetical  - Bob and Jim created an oil and gas services company back in the 1970s as 50-50 owners.  That company has grown to be a big player and has been wildly successful.  The company has built up a large cash reserve.  Jim now wants to retire and spend his time sailing his boat in California.  Can he do a redemption?

A stock redemption lets you take cash out of a corporation in exchange for stock.  The advantage of structuring the redemption properly is that you are only taxed on the gain (redemption price less your stock basis).  This is just like selling the stock – but the company is the purchaser.

Like most things with taxes, redemptions are not simple.  But, there are two safe harbors to be aware of in planning a redemption so that you don’t run afoul with the IRS.  Those safe harbors are:

  1. The Substantially Disproportionate Redemption Test; and
  2. The Complete Termination of Interest Test

Substantially Disproportionate Redemptions.  For a redemption to qualify as substantially disproportionate (and not as a dividend) two elements must be satisfied:

  1.  Your interest after the redemption (in both all voting stock and all common stock) must be less than 80% of your interest before the redemption, and
  2. you must possess less than 50% of the voting power of all voting stock after the redemption.

In my hypothetical , this test is satisfied if, after the redemption, Jim’s interest is less than 40% (80% times 50%).  Jim’s will also possess less than 50% of the voting power. 

Beware, however, attribution rules apply that can make interests that family members or controlled entities own – constructively owned by you for purposes of the test. 

Complete Termination of Interest.   A redemption is also treated as giving rise to a sale, rather than a dividend, if it completely terminates your interest in the corporation.

In my hypothetical, were Jim to completely redeem his interest this test would be satisfied (assuming Bob is not related).

Note that the attributions rules still apply with this test, but there is an exception for family attribution if you don’t have any interest in the corporation as a shareholder, officer, director or employee after the redemption.