Our last post examined what are commonly thought of as the most “direct” income tax consequences arising from a the buy-out of a departing shareholder by way of a cross-purchase or redemption of his or her shares. However, there are a number of other tax consequences to be considered that are no less direct, and that may be equally significant.

 The Other Shareholders

In many closely-held corporations, the remaining shareholders may be contractually obligated, under the terms of a shareholders agreement, to buy the shares of a departing shareholder. In many (if not most) cases, the funding for this cross-purchase arrangement will come from the corporation, for example, by way of loans made or dividends paid to the acquiring shareholders. Oftentimes, these shareholders will simply cause the corporation to purchase the shares from the departing shareholder, without thought as to their own tax consequences. Where the other shareholders are primarily obligated to purchase the shares themselves, the corporation’s satisfaction of that obligation, by redeeming those shares, may result in the deemed payment of a taxable dividend to the other shareholders—a constructive cash distribution.

Constructive Stock Dividend

The remaining shareholders may also realize a form of constructive stock dividend, taxable to them as a cash dividend, where the departing shareholder’s shares are not redeemed all at once but, rather, over a period of years.  In that case, if the redemption of the departing shareholder is treated as a dividend (for example, because the attribution rules prevent a complete termination of his or her interest), the remaining shareholders, by virtue of the relative increase in their equity interests over that same period, may be treated as having received a dividend distribution.

A Gift?

In a family-controlled corporation, a cross-purchase or redemption of stock for an amount other than fair market value may be construed by the IRS as a taxable gift.  For example, if a parent is redeemed for a below-market price, the remaining shareholders may be treated as having received a taxable gift from the departing parent for which gift tax may be imposed, unless it can be shown that the redemption was a bona fide, arm’s length transaction, and free of donative intent (for example, it was negotiated to settle a family dispute).  Conversely, an excessive purchase price may reflect a gift to the departing shareholder from the other shareholders in the context of a family corporation.

 S Corp. Considerations

In addition to the tax consequences that arise directly from the sale of a taxpayer’s shares in an S corporation, there are a number of ancillary considerations, for example, the allocation of S corporation income to the shareholder for the year of the sale (and the possible closure of the corporation’s books as of the sale date), the determination of his or her stock basis through that date, his or her right to “tax distributions” for the preceding tax year, the seller’s right to participate in the tax audit of S corporation tax periods preceding and including the year of sale, and the impact of any adjustments resulting therefrom. These and other factors have real economic consequences to the departing S corporation shareholder and should be addressed before the purchase of his or her shares.

 The Corporation

Generally speaking, from the perspective of the corporation, the redemption of the departing shareholder should not have any adverse tax consequences, though there are some important exceptions.


Where the resulting change in stock ownership is significant enough (an “ownership change”), it will trigger certain limitations on the corporation’s ability to use its net operating losses to offset its taxable income.  In that case, it may possible for the corporation’s carryforward period for such losses to expire before the losses have been fully utilized.

In-Kind Distributions

When the corporation buys back the shares of the departing shareholder, the corporation will not realize any gain unless it distributes appreciated property to the shareholder in consideration for the shares.  In that case, the corporation will be treated as having sold the distributed property.  Depending upon whether or not the corporation may be characterized as a “controlled entity” with respect to the shareholder (either before or after the transaction), and if the property is depreciable in the hands of the  former shareholder, the gain realized may be ordinary or capital in nature.  If the corporation is an S corporation, the gain will pass through, and be taxed, to all of the shareholders, including the seller.


Where the redeeming corporation is an S corporation, a redemption of the shares of a departing shareholder will reduce a proportionate amount of the corporation’s accumulated adjustments account (“AAA”) where the redemption is treated as an exchange (as opposed to a “dividend” distribution) (see Part I). Because the AAA is a corporate account, its reduction will limit the S corporation’s ability to make future distributions to shareholders that will not carry out any C corporation earnings and profits taxable as dividends.

Amortizable Payments?

In addition to the consideration paid to the departing shareholder for his stock, the corporation may pay an additional amount in exchange for the former shareholder’s promise not to compete against the corporation.  This amount will usually be reflected in a separate agreement.  Provided the amount paid for the non-compete is reasonable, it may be amortized by the corporation over 15 years; to the extent it is unreasonable, it may be recharacterized by the IRS as additional purchase price for the stock and, so, would not be amortizable.  Unless it is so recharacterized, the non-complete payment will be taxed as ordinary income to the shareholder.

If the departing shareholder (for example, the parent in a family-owned corporation) enters into a consulting arrangement with the redeeming corporation, the amount paid to him thereunder will be taxable as ordinary income (compensation for services).  If the amount paid is reasonable, it may be deducted by the corporation.  If it is excessive, the excess may be recharacterized by the IRS as payment for a non-complete, amortizable by the corporation over 15 years (not currently deductible).

 Charitable Planning?

In some cases, the departing shareholder may have charitable inclinations and will seek to secure a charitable contribution deduction for the full value of the stock he or she is about to sell, while at the same time avoiding the recognition of the gain to be realized from such sale. These goals may be incompatible where the charity sells the stock shortly after the contribution pursuant to a prearranged plan (under which the charity either is legally bound, or can be forced, to surrender the shares for redemption). In that case, the donor-shareholder will be treated as having sold the stock for cash (thereby recognizing taxable gain), and then contributing the proceeds to the charity (generating a deduction the tax benefit from which may be limited).

IRD and Basis Step-Up

It is often the case that the impetus for the buyout of a shareholder is the latter’s deteriorating health. The timing of such a buyout can have significant consequences for the selling shareholder’s family. For example, if the shareholder were to pass away prior to the execution of a definitive purchase and sale agreement, the fair market value of the deceased shareholder’s shares would be included in his or her gross estate and would receive a step-up in basis.  As a result of such basis increase, the subsequent sale of the decedent’s shares (whether by way of a cross-purchase or by way of a redemption that is treated as an exchange) should not generate any taxable gain.

On the other hand, if the purchase and sale agreement was finalized, but the sale was not completed, prior to the decedent’s death, then the decedent’s estate would not be entitled to a basis step-up in his or her shares. In this scenario, the shares would represent income in respect of a decedent – with the decedent having effectively exchanged his or her  stock ownership for the sales proceeds to be received – and, so, the gain inherent in the shares would be recognized and taxed.

 Planning Ahead

The foregoing discussion highlights some of the many tax considerations that are attendant to the buy-out of a shareholder from a closely-held corporation.  There are others. The manner in which each of these is addressed can have a significant impact on the net economic benefit of the buy-out transaction.  It is imperative that they be planned for prior to the sale.

An especially important factor to be considered is the valuation of a deceased shareholder’s shares and how it may be impacted by the buyout of those shares. This item will be the topic of another post.