November 21, 2018
Do you have too much of your net worth tied up in your family C corporation? Consider bailing out some or all of that hard-earned wealth with a stock redemption. Here’s an explanation of why the federal income tax results for stock redemptions are far better today than in the past when much higher tax rates applied to dividend income.
A redemption occurs when you sell back some or all of your shares to the corporation. In other words, you get cash from the family corporation in exchange for turning in some or all of your stock.
The general rule for a stock redemption payment received by a C corporation shareholder is the payment is treated as a taxable dividend to the extent of the corporation’s earnings and profits (similar to the financial accounting concept of retained earnings). However, the Tax Code provides exceptions to this general rule. If one of the exceptions applies, your redemption payment is treated as proceeds from selling the redeemed shares.
Dividend Versus Stock Sale Treatment. The tax rates on long-term capital gains and dividends remain 15% for most individuals. However, the maximum rate for higher-income folks increases to 20% (up from 15%). This change only affects singles with taxable income above $425,800, married joint-filing couples with income above $479,000, heads of households with income above $452,400 and married individuals who file separate returns with income above $239,500.
Short-term capital gains are taxed at your ordinary income tax rate of 10, 12, 22, 24, 32, 35 or 37%. This applies to investments held for one year or less.
In your case, the tax-law distinction between dividend treatment and stock sale treatment may or may not be important. Why? When dividend treatment applies, you generally receive no offset for your basis in the redeemed shares. In other words, the entire redemption payment counts as taxable income.
In contrast, when stock sale treatment applies, you generally recognize a long-term capital gain equal to the excess of the redemption payment over the tax basis of the redeemed shares. So only part of the redemption payment is taxable.
Another benefit: You can offset capital gain from a stock sale with capital losses from other sources. However, you can only offset up to $3,000 of dividend income with capital losses ($1,500 if you are married and file separately).
Bottom Line: When you have significant basis in your family C corporation stock or significant capital losses, you want to structure your redemption transaction as a stock sale — if possible.
Generally, the easiest way to ensure stock sale treatment is to sell all of your stock back to the corporation in a complete redemption. For a complete redemption to qualify as a stock sale, you cannot constructively own any shares after the redemption. Unfortunately, a provision in the Tax Code (Section 318) stipulates that any stock owned by your spouse, parents, children or grandchildren is constructively owned by you (for tax purposes only). You may also constructively own stock held by certain related entities in which you have an ownership interest, such as a corporation or partnership.
Here’s a potential snag: If you constructively own any shares after the redemption, your redemption payment will be treated as a dividend to the extent of the corporation’s earnings and profits. Stock sale treatment is generally more advantageous. However, that’s not allowed when you are considered to constructively own stock held by members of your family or certain related entities such as corporations or partnerships in which you own an interest. This is a problem!
Fortunately, there may be a way to save the day. You can include a special statement with your federal income tax return for the year your complete redemption takes place. This allows you to ignore any constructive stock ownership due to ownership by family members. In turn, that means you can treat your complete redemption transaction as a stock sale and thereby reap much better tax results. This assumes you have no other constructive ownership of stock, such as via a related corporation or partnership. (Source: Treasury Regulation 1.302-4)