Section 303 Stock Redemption: Post-Mortem Planning

In order to qualify for the Section 303 preferential tax treatment, the following requirements must be satisfied.

Your estate must pass a 35 percent test

The stock you plan to redeem generally must be included in your gross estate, and the value of the stock must exceed 35 percent of your gross estate less debts and administration expenses. If you own interests in more than one business, you can combine the ownership percentages to reach the 35 percent minimum as long as the value of your interest in each business is 20 percent or more of the value of your gross estate less debts and expenses.

Tip: If the value of your interest in the business is currently less than 35 percent of your estate, you might want to consider making lifetime gifts of some of your assets, but not any part of the business interest, to allow you to meet the 35 percent rule.

Caution: Section 2035 requires that all gifts made within three years of your death must be added back into the value of your estate for calculation of the 35 percent rule.

The redemption distribution must be made on time

Generally, the redemption distribution must occur after your death and within three years and 90 days after the estate tax return (Federal Form 706) is filed (or due, if filed early).

The redeemed shareholder must bear the burden of the expenses and taxes

The sale of the business interest must be made by whoever is obligated to pay the expenses and estate taxes, usually the executor or administrator.

What are the advantages?

Gets preferential tax treatment

Depending upon the circumstances of a stock redemption, proceeds received from the redemption may be classified as a sale or exchange of the seller’s interest (subject to capital gains tax) or as a dividend distribution. Transactions classified as sales or exchanges generally benefit from more favorable tax treatment than transactions classified as dividend distributions. Qualifying Section 303 redemptions are treated as sales or exchanges subject to capital gains tax.

For tax years beginning on or after January 1, 2003, qualifying dividends paid to individual shareholders from domestic corporations (and qualified foreign corporations) are taxed at capital gains tax rates. For tax years beginning prior to January 1, 2003, however, dividends were taxed at ordinary income tax rates. This generally resulted in significantly more tax due for redemptions that were treated as dividends.

Even with qualified dividends taxed at capital gains rates, there remains an advantage in classifying a transaction as a sale or exchange rather than as a dividend distribution, despite the fact that both types of transactions will be subject to tax at capital gains tax rates. That is, in the case of dividend treatment, the entire amount paid to the shareholder is subject to tax. In the case of sale or exchange treatment, however, the shareholder pays tax only to the extent that the amount paid by the company exceeds his or her basis in the stock.

Tip: If the sale or exchange of your shares occurs after your death, your shares will generally have a basis equal to the fair market value of the shares at the time of your death, and little or no tax may result.

Provides liquidity to your estate without having to sell the business

If your business is a family corporation, you may not want it to be sold when you die. With a Section 303 stock redemption, your family can continue running the business after you die. The entire business would not have to be sold to pay estate taxes. Your estate can sell just enough of your interest back to the corporation itself and use the corporation’s money to cover your total funeral and estate administrative costs, federal estate taxes, and state death taxes, including any interest due.

Can be used even if your estate doesn’t need the money

Even if your estate is highly liquid and doesn’t need the cash for taxes, a partial redemption under Section 303 can still be used. The money does not actually have to be used to pay the estate taxes and expenses. As long as the amount does not exceed the total of all federal and state death taxes, funeral costs, and administrative expenses, the partial redemption can qualify under Section 303.

Caution: The sale of the business interest must be made by whoever is obligated to pay the expenses and estate taxes, usually the executor or administrator.

Can be used even if estate taxes are paid in installments

Payment of estate taxes attributable to a closely held business can be extended over a 15-year period in special situations. Under the Section 6166 installment plan, the tax payment may be deferred for 4 years (interest only is payable) and then the unpaid tax must be paid, together with interest, over and up to a 10-year period. A series of redemptions under Section 303 can be used to pay the taxes over the installment time period. Coordinating the Section 303 stock redemption with the installment payment of estate taxes relieves the corporation of paying out the cash in a lump sum.

Can be used with other types of buy-sell agreements

A Section 303 stock redemption can be used to supplement a cross purchase buy-sell agreement or as part of an overall entity purchase or stock redemption plan, especially in cases when the redemption would not otherwise qualify for capital gains tax treatment.

Attribution rules do not apply

Generally, attribution rules can eliminate favorable tax treatment of stock redemptions in a family corporation. The Section 303 stock redemption was designed to provide liquidity to the family corporation for the payment of estate taxes, state death taxes, and funeral and administrative costs, and the attribution rules specifically do not apply to stock redemptions under Section 303.

Even if the corporation does not have the cash, it can still buy back part of your interest

If your corporation does not have the cash to buy part of your stock under a Section 303 stock redemption, your surviving spouse or adult child can loan the money to the corporation to fund the purchase of your interest. Future business earnings can be used to repay the lender in the form of corporate debt payments. For more on this, see the discussion Reverse Section 303 Stock Redemption.

Are there any tradeoffs?

Amount of stock that can be redeemed is limited

The amount of stock that can be redeemed without being treated as a dividend is limited to the total of your funeral and estate administrative costs, federal estate taxes, state death taxes, and any interest due. If your estate chooses to redeem stock in excess of this limit, the excess proceeds will generally be treated as ordinary dividends.

Must be coordinated with terms of will and other estate and tax planning

The terms of your will might make redemption under the terms of Section 303 difficult or impossible. If your will is structured so that your beneficiaries have no estate tax liability, then your beneficiaries would not be able to use a Section 303 stock redemption to get cash from the business. For example, if the business interest passes to your son by joint tenancy, and your will directs the executor to pay all final administration expenses and taxes from the residue of the probate estate, the redemption of the business interest will not qualify under Section 303.

How is a Section 303 stock redemption reported?

The Section 303 stock redemption transaction is reported on Federal Form 1041. In addition, the stock must be listed on line 6, part 2 of Schedule D.