Every owner of a closely-held corporation has certain property rights, arising from his or her status as an owner, that have economic value to the owner.  At the inception of the business, the owner may count among these rights the ability to share in the profits generated by the business, whether in the form of compensation or distributions.  Taking a longer-term perspective, the owners may contemplate the ultimate sale of the business to a third party, at which point each owner would share in the sale or liquidation proceeds.

 As so often happens, however, the ownership of a closely-held corporation does not remain static.  Sometimes, an owner will leave of his or her own volition; at other times, the owner will be “asked” to leave.  In either case, the business relationship is formally terminated upon the former owner’s disposition of his or her equity interest in the business.

 Although several factors may be considered in determining the “purchase price” for this interest (including the shareholder’s agreement, if any), when the parties ultimately do arrive at a price, this price inevitably will reflect a pre-tax economic result.  The after-tax and true economic result will usually depend upon both the corporation’s tax status and the structure of the disposition.  Nevertheless, it is often the case that insufficient thought is given to this structure, and thus to the tax treatment of the disposition; consequently, the economic cost of the transaction becomes more expensive than it otherwise could have been.

 In disposing of his or her equity in a closely-held corporation, an owner has two basic choices:  a sale to some or all of the other owners (a cross-purchase) or a sale to the business itself (a redemption of the shares of stock).  In some cases, these two structures may be combined.  In others, additional elements may be added to the structural and economic mix.


A shareholder departing from either a C corporation or an S corporation may sell his or her shares of stock to some or all of the other shareholders.  He or she will realize gain equal to the amount paid for the shares over his or her adjusted basis in the shares.  (Thus, if the seller had inherited the shares with a basis step-up, it is possible that little or no gain may be realized.)  Provided the selling shareholder has held the shares for more than 12 months, the gain recognized will be treated as long-term capital gain.  (Inherited property is deemed to satisfy the long-term holding period.)

 In general, the selling shareholder will recognize, and be taxed on, the gain realized on the sale when he or she receives cash or other property in exchange for his or her shares.

 A shareholder who receives a term-note from the buyer(s), providing for payments after the year of the sale, will recognize a pro rata portion of the gain realized as payments are made on the note.  The gain may thus be deferred under installment method reporting.  If the note bears interest, the receipt of the interest will be taxed as ordinary income.  If the note does not provide for interest, the IRS will impute interest, thereby converting some of the principal payments (otherwise capital gain) into interest (ordinary income). 

 It should be noted that installment reporting is not always available to the selling shareholder (as where the note received is a demand note).  Additionally, even where such reporting is available, certain actions on the part of the seller may accelerate recognition of the otherwise deferred gain (for example, by pledging the note to secure a debt).  Moreover, where the installment obligation exceeds $5 million, a special interest charge will be imposed by the IRS, for the life of the note, which will effectively negate the tax benefit of installment reporting


Instead of selling his or her shares to the other shareholders, the corporation itself may buy back the departing owner’s shares.  In the case of most closely-held businesses that are not family-owned, the redemption of all of the seller’s shares should be treated as a sale of the stock, with the seller realizing gain equal to the purchase price for the shares over the seller’s adjusted basis for the shares. The gain recognized should be treated as capital gain (though a special rule applies to the redemption of preferred stock, which may result in some dividend treatment).  If the corporation issues an installment note in consideration for the shares, gain recognition may be deferred under the installment method.

 In the case of a C corporation, these results may change significantly if the redeeming corporation is owned, at least in part, by persons that are “related” to the seller. A redemption in which the seller’s ownership in the corporation is completely terminated is typically treated as a sale. If the seller’s interest  is treated as not having been completely terminated, however, the corporation’s payment may be treated as a dividend distribution to the extent of the corporation’s earning and profits.  In that case, the entire distribution amount may be taxed to the seller; it is not reduced first by the seller’s basis in the redeemed shares.  Moreover, since the redemption is not treated as a sale or exchange for tax purposes, any note distributed by the corporation to the seller is likewise treated as a dividend distribution, in an amount equal to the fair market value of such note; there is no installment reporting.  Thus, the results are less favorable than exchange treatment.

 Attribution Rules

In distinguishing between a sale-redemption and a dividend-redemption, certain attribution rules must be considered.  Under these rules, a selling shareholder disposing of all of his or her shares is nevertheless deemed to own the shares that are actually owned by another, “related” shareholder.  By virtue of this attribution of ownership, the selling shareholder will have failed to terminate his or her interest in the corporation and, so, may be subject to dividend treatment.  However, where the related person is a family member, it may be possible for the redeemed shareholder to “waive” the family attribution rule, provided he or she satisfies certain conditions; for example, immediately after the redemption, the former shareholder cannot be an officer, director or employee of the corporation, though he or she may be a creditor of the corporation.  If these conditions cannot be satisfied (for example, a redeemed parent wants to remain on the board of directors), then waiver of family attribution is not available.

 S Corps

Where the corporation is an S corporation, the tax consequences to the departing shareholder from the sale of her stock in a cross-purchase is the same as described above.  As in the case of a C corporation, the complete redemption of a departing shareholder’s stock is taxable as either a distribution or as a sale, depending upon the application of the ownership attribution rules.  If the S corporation was previously a C corporation with earnings and profits (or if it had acquired a C corporation in a tax-free reorganization), some portion of the redemption proceeds will be taxable as a dividend, as described above, if the redemption fails to qualify as a sale or exchange.  However, if the S corporation has no earnings and profits from a C corporation, the redemption proceeds will be treated first as a tax-free return of stock basis; and then as gain from the sale of the stock, even where the redemption fails to be treated as a sale or exchange.  Thus, in the case of a corporation that has always been an S corporation, the distinction between a dividend-type and a sale-type redemption may be less important. 

Anything Else?

The foregoing is not to say that the only two buyout choices are a cross-purchase or a redemption.  In fact, the two structures may be combined such that the remaining shareholders will purchase some of the departing shareholder’s shares while the corporation redeems the balance.  The tax analysis is the same as set forth above.  However, the tax analysis of a shareholder-buyout is not limited to the actual sale transaction. There are a number of other economic and tax considerations, some of which will be the subject of our next post.