No, this post is not “Part II” to last week’s piece on the tax consequences of a stock redemption. That being said, it describes an interesting redemption-related ruling that was recently issued by the IRS. The ruling considered a redemption plan proposed to be adopted by a closely-held business. The context for the plan is one that is very common.
Corp was an S corporation. As such, it had only one class of stock outstanding, with all of its shares having identical voting, distribution and liquidation rights. Corp’s stock was owned equally between Shareholder A and A’s family and Shareholder B and B’s family.
Corp amended its articles of incorporation in order to create non-voting common stock.
It then declared and issued a dividend of “X” number of shares of non-voting common stock per each share of Corp’s outstanding voting common stock.
Corp next proposed to adopt a stock redemption plan (“Redemption Plan”). The Redemption Plan was voluntary, meaning that a shareholder could, at his or her discretion, decide to offer his or her shares to Corp for redemption on an annual basis. The amount that could be redeemed, however, was capped at a specific cash limit.
Although not stated in the ruling, the purpose for the arrangement was to offer shareholders an opportunity to monetize their non-marketable, closely-held shares (by creating a “market” for them), while at the same time not putting the business in a cash crunch.
The Redemption Plan provided that any shareholder who desired to have his or her Corp stock redeemed had to have his or her non-voting and voting shares redeemed in the ratio of “Y” (non-voting) to “Z” (voting), unless Corp’s board of directors, in its discretion, approved the stock redemption in a different ratio.
This redemption ratio was intended to ensure that the voting power and economic ownership in Corp remained approximately equal between Shareholder A and A’s family and Shareholder B and B’s family. It was also intended to prevent an individual shareholder from owning a disproportionate amount of voting versus nonvoting common stock.
Corp represented to the IRS that, under the Redemption Plan, the redemption price for the stock would be the appraised value of the voting and nonvoting common stock (determined on a minority basis) as shown on the most recent independent appraisal. However, if no independent appraisal had been made within a certain time frame of the redemption, then Corp’s board of directors could determine the value, in good faith, based upon the methodology used by the independent appraisal.
Corp represented that the Redemption Plan was not designed or intended to circumvent or otherwise violate the second class of stock rule. Corp also represented that the Redemption Plan did not establish a purchase price for the stock that, at the time the agreement was entered into, was significantly in excess of or below the fair market value of the stock.
A small business, or “S” corporation, means a domestic corporation that, among other things, does not have more than one class of stock.
IRS Regulations provide that a corporation that has more than one class of stock does not qualify as a small business corporation. In general, a corporation is treated as having only one class of stock if all of the outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds. Differences in voting rights among shares of stock of a corporation are disregarded in determining whether a corporation has more than one class of stock.
These Regulations further provide that buy-sell agreements among shareholders, agreements restricting the transferability of stock, and redemption agreements are disregarded in determining whether a corporation’s outstanding shares of stock confer identical distribution and liquidation rights, unless: (1) a principal purpose of the agreement is to circumvent the one class of stock requirement, and (2) the agreement establishes a purchase price that, at the time the agreement is entered into, is significantly in excess of or below the fair market value of the stock.
Agreements that provide for the purchase or redemption of stock at book value, or at a price between fair market value and book value, are not considered to establish a price that is significantly in excess of, or below, the fair market value of the stock and, thus, are disregarded in determining whether the outstanding shares of stock confer identical rights. For purposes of this rule, a good faith determination of fair market value will be respected unless it can be shown that the value was substantially in error and the determination of the value was not performed with reasonable diligence.
Based on the foregoing, the IRS concluded that the Redemption Plan would be disregarded in determining whether the outstanding shares of Corp stock conferred identical distribution and liquidation rights. Thus, the Redemption Plan would not cause Corp to be treated as having a second class of stock.
So what’s the big deal? Nothing really. The ruling reminds us, however, that there are many possibilities available to the closely-held business for creating a “liquidity market” for its owners. It also demonstrates that, with proper planning, it may be possible to accomplish important business goals, such as preserving the “balance of power” between two families (or shareholders) without necessarily sacrificing tax efficiencies. You just need to think it through.
Part II of the stock redemption series will appear next week.