Today we’ll discuss a proper stock redemption strategy. A corporate redemption of stock, a purchase of stock can be used to transition stock in the family business but as we will see, it is not a viable option for many. In our case study, the corporation would contract the purchase to redeem all of Steve and Betty’s stock in the corporation for a price equal to the fair market value of the stock. The corporation would pay the purchase price plus interest over a long period of time, as much as 15 years. Immediately following this redemption, this purchase, the only outstanding stock of the corporation would be the stock owned by Dave. So although Dave is not a party to the redemption, Dave would end up owning 100% of the outstanding stock of the company and would be in complete control.
The corporation would have a large debt that would then need to be paid off to Steve and Betty over time. This debt would be retired with corporate earnings. The interest and principles payments on the indebtedness would provide Steve and Betty with a steady stream of income during their retirement. If they die prior to a complete payout of the contract, the remaining amounts only on the contract would become part of their estate and together with their other assets would be allocated to their children in equal shares.
There’s a primary tax challenge with every corporate redemption. Is the character of the payments made by the corporation to the departing shareholders, the parents, will they be taxed as corporate dividends a bad thing? Or will they be considered true principle and interest payments made in exchange for stock? If the amounts paid are treated as stock consideration payments, the parents will be allowed to recover their basis in the transferred stock tax-free. The interest element of each payment will be deductible by the corporation and the gain element of each payment to the parents will be taxed as long-term capital gain. In nearly all cases the planning challenge is to structure the redemption to ensure that the payments qualify as consideration for stock, not as corporate dividends.
For the Wilson clan and just about all other family businesses, this tax objective will work only if it is a complete all or nothing goodbye for the parents. It requires one, that Steve and Betty sell all of their stock to the company in the transaction; two, that Steve and Betty have no further interest in the business other than that of a creditor; three, that Steve and Betty not acquire any interest in the business other than through inheritance during the 10 years following receipt of any payment made to them; four, that Steve and Betty, not have engaged in stock transactions with family members during the last 10 years with a principle purpose of avoiding income taxes; and five, that Steve and Betty sign and file with the secretary of treasury on appropriate agreement. If all of these conditions are met, and they often are, then the parents are able to treat the payments as consideration for their stock, not as dividends.
Usually, the most troubling condition is the requirement that the parents have no interest in the corporation other than that of a creditor following the redemption. In our case, neither Steve nor Betty could be an officer, director, an employee, a shareholder, or a consultant of the corporation following the redemption. This complete exit requirement is often an insurmountable hurl by a parent who is departing and turning over the reins with the hope that the payments will keep coming over a long term. Plus, there are other compelling disadvantages with the redemption approach that provide a strong incentive for many families to look for an alternative.
First, the principle payments made to Steve and Betty on the indebtedness will need to be funded by the corporation with after-tax dollars. This may create an intolerable cash burden for the corporation in redeeming the stock. It’s just too expensive tax-wise.
Second, even though large sums of after-tax dollars will be paid to the parents for their stock, Dave, the sole shareholder of the company, gets no increases in the tax basis of his stock. Because the corporation is purchasing the stock and making the payments, there is no basis impact at the shareholder level. So, any basis stock step-up benefit is lost forever.
Third, the amounts payable to Steve and Betty will terminate when the note is paid off. Now, given the size of the payout in this case, it is unlikely that this potential disadvantage will be a big deal. In many smaller situations, the parents may want and need a regular cash flow that will last as long as one of them or both of them is living.
Fourth, if the parents die before the contract is paid in full, the children who inherit the unpaid contract will continue to pay income taxes on their receipt of income and principle payments under the contract. There is no basis step-up for the children. The income tax burden survives the parent’s death.
Fifth, the company takes on a tremendous death burden in redeeming the stock. The company may not have the cash flow to foot such a huge bill and the associated tax burdens. At a minimum, the cash burden of the death may adversely impact Dave’s capacity to move the company forward and the secure financing that may be necessary to expand the business and accomplish his objectives long term. And add to this the fact that Betty and Steve are precluded from having any further involvement in the management and affairs of the company – the complete goodbye requirement that we previously discussed.
These disadvantages cause many companies to reject the redemption strategy and the plan design. They prefer a strategy that can be implemented on an incremental basis over time and that will allow the parents to have a continuing but reduced role in the business, which brings us to our third option – the cross purchase strategy.