by Bob Rywick
If a corporation redeems its stock from a shareholder, the gross proceeds paid (unreduced by the shareholder’s basis in the shares) is treated as a dividend to the shareholder unless the redemption qualifies under Internal Revenue Code §302(b):
● As not essentially equivalent to a dividend; or,
● As a substantially disproportionate redemption of stock; or,
● As a complete redemption of all the stock of the corporation owned by the shareholder.
It’s usually difficult for the estate of a decedent to meet one of the above tests since, under the constructive ownership rules of IRC §318, the estate is treated as owning stock owned directly or indirectly by a beneficiary of the estate.
However, even if none of the above-listed requirements are met, the redemption of shares included in a decedent’s estate may qualify for capital gains treatment as payment in exchange for stock under IRC §303 instead of as a dividend if:
● Certain ownership requirements (see below) are met; and,
● The redemption proceeds do not exceed the amount of death taxes payable plus certain funeral and estate administration expenses.
If the redemption is treated as an exchange rather than as a dividend, only the gain will be includible in the income of the estate. Since the basis of the redeemed shares was stepped up to fair market value on the date of death (or the alternate valuation date, if applicable), there is likely to be little or no gain.
Observation: Both long-term capital gains from the sale or exchange of corporate stock and qualified dividends now are taxed at a maximum rate of 15 percent. Accordingly, the main benefit of having a redemption distribution taxed as an exchange, not a dividend, is that only the gain will be taxed.
Example 1: Your client’s mother died owning stock in Mercury-Venus Inc. Her estate needs $1 million to pay estate taxes and administration expenses. Assume the estate is in a 25 percent tax bracket before any distributions are taken into account. If Mercury-Venus distributes $1 million to the estate in redemption of stock, and the distribution is taxed as a dividend, the estate will have to pay federal income taxes of $150,000 as a result of the distribution.
On the other hand, if the redemption distribution is a payment in exchange for stock under IRC §303, the estate will only have to pay tax to the extent that the amount distributed exceeds the basis of the redeemed shares. Thus, if the amount distributed equals that basis, no tax will be owed as a result of the redemption.
Treating a redemption
as a capital gain
For a death taxes redemption to qualify for capital gains treatment as payment in exchange for stock, the following requirements must be met:
1. The redeemed stock must be included in the estate. Exchange treatment is available only for redemptions of stock included in a decedent’s estate or that is the subject of a generation-skipping transfer. As long as the other requirements are satisfied, exchange treatment is available whether the stock is redeemed directly from the estate or, alternatively, from a person who received it as heir or legatee.
However, if a will provides that a particular person is to receive a cash bequest and, in satisfaction of that claim, she receives stock instead, a redemption of that stock does not qualify as a death taxes redemption that is eligible for capital gains treatment.
Suppose a taxpayer receives stock that was included in an estate, and that stock is exchanged for other stock in a substituted-basis transaction (i.e., the taxpayer’s basis in the new stock is determined by reference to his basis in the old stock). In that case, the redemption of the new stock can qualify for capital gains treatment.
Example 2: Your client’s father dies and leaves his stock in Valamon Corp. to your client. Soon after his death, the stock in Valamon is exchanged for stock of Belabeck Corp. in a tax-free merger. Since your client’s basis in the Belabeck stock is determined by reference to his basis in the Valamon stock, a redemption of Belabeck stock will qualify for capital gains treatment if the other requirements are met.
2. The total value of all the stock of the redeeming corporation included in the estate must be more than 35 percent of the gross estate less deductible taxes, expenses, debt and losses.
However, if the estate includes stock of two or more corporations, in each of which at least 20 percent (by value) of the outstanding stock is included in the estate, the stock of each is aggregated in applying the 35 percent test.
Observation: If stock in a single corporation satisfies the 35 percent test, exchange treatment can be available regardless of how large a percentage of the stock is included in the estate. On the other hand, if it is necessary to rely on the aggregation rule, only stock of 20-percent-owned corporations is taken into account.
Example 3: At the time your client’s sister died, she owned 200,000 shares of Cordono Corp., a public corporation. The stock was worth $5 million at the date of death, and there were 400 million shares outstanding. The gross value of your client’s sister’s estate (less deductible taxes, expenses, debt and losses) was $10 million. Even though she owned only 0.05 percent of the outstanding shares of Cordono, the value of her interest was more than 35 percent of her gross estate. Accordingly, if Cordono redeems some of those shares from her estate, as long as the other requirements are satisfied, the redemption distribution will be eligible for capital gains treatment.
Example 4: The same facts apply as in Example 3, except that the gross value of your client’s sister’s estate (less deductible taxes, etc.) was $20 million, the value of the gross estate, reduced by deductible taxes, expenses, indebtedness and losses. Accordingly, capital gains treatment will not be available if Cordono redeems some of the shares from the estate, since the more-than-35-percent test is not satisfied. Your client’s sister’s estate’s interest in Cordono cannot be aggregated with stock of any other company in applying the more-than-35-percent test, since the estate does not own stock with 20 percent or more of the value of all of the stock of Cordono.
Observation: A death taxes redemption will be available only if a sufficient part of the estate consists of stock of a single corporation, or of more than one closely held corporation.
3. There are limitations on the amount that can qualify for capital gains treatment. The amount received as a death taxes redemption distribution qualifies for capital gains treatment only to the extent that it does not exceed the sum of:
● The estate, inheritance, legacy and succession taxes (including interest) that are imposed because of the decedent’s death; and,
● Funeral and administration expenses that are deductible for estate tax purposes.
Note, however, that redemption proceeds do not actually have to be used to pay those taxes and expenses.
4. A redemption will qualify for capital gains treatment as a death taxes redemption only to the extent that the estate (or other person from whom the stock is redeemed) bears the economic burden of the death taxes or funeral or administrative expenses. Where there is more than one heir or legatee, the issue of whose share is affected by the payment of the taxes and expenses is usually determined under local law, and may be controllable by will.
5. Capital gains treatment for a death taxes redemption generally is available only for amounts paid within three years and 90 days of the decedent’s death. An exception applies where a bona fide Tax Court petition is timely filed with respect to a deficiency in estate tax. In that case, payments made up to 60 days after the Tax Court decision becomes final can qualify.
A second exception applies where the estate is eligible to elect, and actually elects, to pay estate tax in installments under IRC §6166. If that election is made, capital gains treatment can be available for payments made within the time for making installment payments.
If the corporation redeems its stock in exchange for an installment note, the date of the redemption, and not the date of payment on the note, will be taken into account in determining whether the timing rules have been satisfied.
Bob Rywick is an executive editor at RIA, in New York, and an estate planning attorney.
