Tuesday, July 31, 2012

Father’s Transfer of Business to Children Through Gifts of Stock Followed by Redemption of Father’s Shares is Approved by IRS.

PrivateLetter Ruling 201228012 - The IRS issued a private letter ruling allowing a father to transfer his corporate business to his two children through the use of gifts and stock redemption. This transaction results in favorable tax consequences to the father, his children and the corporation.

The facts of this ruling are: A father owns all of the outstanding stock of a C corporation which has earnings and profits. The father is a director and president of the corporation and his two children are also directors of the corporation.
The father wants to retire and cede management and control of the corporation to his two children. In order to accomplish this, he devises a plan to gift some of his shares of stock in the corporation to each of his two children and then immediately thereafter have the corporation redeem his remaining shares of stock for cash and a promissory note for the total redemption price, as determined by a third-party appraisal. The promissory note is payable by the corporation over a period of time in monthly installments of principal and interest at the applicable federal rate.
The father made the following representations to the IRS:
  • The promissory note will not be subordinated to the claims of general creditors of the corporation.
  • The stock redemption price is not contingent on future earnings of the corporation, nor is it contingent on working capital being maintained at a certain level.
  • In the event of a default on the promissory note, no shares of the corporation will revert to or be received by the father or any entity related to him, nor will the father or any entity related to him be permitted to purchase the stock at public or private sale.
  • No shareholder of the corporation has been or will be obligated to purchase any of father’s shares of stock to be redeemed.
  • The redemption is related to the gifts of shares to the children.
  • None of the shares to be redeemed was acquired by father within the 10-year period from a family member whose stock would be attributed to father under the family stock attribution rules.
  • After the redemption, father will not have any interest in the corporation (including an interest as officer, director or employee), other than an interest as a creditor.
  • Father will execute and file the agreement and information required to be filed with the IRS.
  • Father will not hold any obligation of the corporation except for the promissory note.
  • Father will not enter into any contract or agreement, or have any other business relationship with the corporation.
  • The stock redeemed from father is not Section 306 stock. 
Based on this information, the IRS issued the following rulings:
  • The proposed gifts of shares by the father to his children do not have as one of their principal purposes the avoidance of federal income tax.
  • Provided that father files the required agreement with the IRS, referenced above, in accordance with the Tax Regulations and assuming that the conditions stated in the Tax Code (which were included in the representations made by father to IRS) are satisfied, the stock redemption will qualify as a complete termination of father’s interest in the corporation and will be treated as a sale of father’s stock to the corporation. This would result in gain recognition by father measured by the difference between the stock redemption price and the father’s tax basis in the shares redeemed. Such gain will be capital gain provided that the stock is a capital asset to father.
  • Father may report the gain on the redemption of his stock using the installment method of accounting.
  • The corporation will not recognize gain or loss on the distribution of the promissory note in redemption of father’s stock.
  • Provided that the stock redemption is not performed in satisfaction of a primary and unconditional obligation of either of father’s two children to acquire the stock of the corporation held by father, the redemption will not cause any dividend income to be constructively received by the children.
  • The interest paid by the corporation on the promissory note is deductible, subject to any applicable restrictions.
  • There is no imputed interest with respect to the promissory note.
While the above-referenced ruling is not binding authority, it is encouraging to note that the IRS did not treat the father’s gifts of his shares to his children immediately prior to the stock redemption transaction as having tax avoidance as one of its principal purposes. Otherwise, the stock redemption would not have qualified as a sale of father’s stock in the corporation and, instead, would have been taxed as a dividend to father to the extent of the corporation’s earnings and profits, without reduction for his basis in the stock.
The IRS viewed the father’s gifts of his shares to his children as part of an integrated plan to facilitate the father’s retirement from the business and allow him to cede management and control of the corporation to his children which the IRS apparently agreed was undertaken for proper business purpose.
Although this transaction could have been structured as a stock sale and achieved capital gain treatment, structuring this transaction as a stock redemption allows the corporation’s earnings and profits to be used to fund the stock redemption payments to father without creating any taxable dividends to the father or to the children.

If you desire to Transfer Your Business to your Children, contact the Tax Lawyers at Marini & Associates, P.A. for a FREE Tax Consultation at www.TaxAid.us or www.TaxLaw.ms or Toll Free at 888-8TaxAid (888 882-9243).

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