Tax Law Insights

In a recent private letter ruling, PLR 201405005, the IRS validated a succession plan implemented by a Subchapter S corporation to transition share ownership from retiring co-owners to certain key employees. An S corporation is a small business corporation which has made an election to be taxed under Subchapter S of the Internal Revenue Code and which, among other things, may not have more than one class of stock.

Specifically, the IRS concluded that profit on a redemption of the owners' shares by the company for notes will:

1. be taxed to them as capital gain reportable on the installment method,

2. the company will have no gain on the redemption and may deduct interest paid to the retiring shareholders on the notes, and

3. the notes will be considered "straight debt" and not a prohibited second class of stock.

The structure of the proposed transaction was as follows:

(i) First, the corporation would redeem all of its outstanding shares from the selling shareholders in exchange for promissory notes with a face amount determined by a third-party appraisal.

(ii) Second, immediately after the redemption, the corporation would reissue a certain number of its shares (subject to transfer restrictions and service-related risks of forfeiture) to the key employees. The remaining shares would be held in treasury for issuance to future employees. After the proposed transaction, the only outstanding shares of Corporation stock would be common stock owned by the key employees.

The notes require semiannual payments of principal and interest over a period of years starting in Year 1. The notes provide for a fixed interest rate that will exceed the mid-term applicable Federal rate (compounded semiannually) in effect as of the day on which the notes are issued, and their interest rate and payment dates will not be contingent on the corporation's profits, discretion, the payment of dividends with respect to the corporation's common stock, or similar factors. The notes also will not be convertible (directly or indirectly) into stock or any other equity interest of corporation.

After the transaction, the shareholders will remain connected to the corporation as employees and directors and would continue to be the members of the LLC that rented space to the corporation.

Redemption

If a stock redemption does not qualify under Code Sec. 302(a), it will be treated as a distribution to which Code Sec. 301 applies. A distribution qualifies under Code Sec. 302(a) if it not essentially equivalent to a dividend, is a substantially disproportionate redemption, is a complete redemption, or is a redemption in partial liquidation of a noncorporate shareholder.

The IRS held that the redemption would constitute a complete termination of the Shareholders' interest in the Corporation, and the Shareholders would thus realize gain on the difference between the redemption price and their adjusted basis in their shares. Provided that the stock was a capital asset in the hands of the Shareholders, that gain would be capital gain. The Corporation would not recognize any gain or loss on its acquisition of the shares, under Code Section 311(a).

Straight Debt

Straight debt, under Section 1361(c)(5)(B) of the Code, is not treated as a second class of stock. Straight debt is a written unconditional obligation, whether or not contained in a formal note, to pay a sum certain on demand, or on a specified due date. The obligation may not provide for an interest rate or payment dates that are contingent on profits, the borrower's discretion, the payment of dividends on the corporation's common stock, or similar factors. In addition, to be straight debt, an obligation may not be convertible (directly or indirectly) into stock or any other equity interest of the S corporation and must be held by an individual (other than a nonresident alien), an estate, a trust that is eligible to be an S corporation shareholder, or entities that are actively and regularly engaged in the business of lending money.

Based on the facts presented, including that the notes were not convertible and their repayment was not contingent on the performance of the corporation, the IRS held that the notes constituted straight debt of the corporation and not a second class of stock in the hands of the selling shareholders, and that interest on the notes was deductible by the corporation.

Installment Method

Code Sec. 453 provides that income from an installment sale is taken into account under the installment method, that is, a portion of the total gross profit from an installment sale is included in income in each year in which the seller receives payment. An installment sale is a disposition of property where at least one payment is to be received after the close of the tax year in which the disposition occurs. Based on the facts presented, including that the notes bear appropriate interest, are not payable on demand, and are not marketable securities as defined by Section 453(f)(2), the IRS determined that the Shareholders were eligible to report their gain attributable to the notes in the years received, on the installment method.