Elements to consider when planning a company buyback gold a dividend
When a company repurchases its shares under §302, it is accounted for as a disposal of capital assets and is considered a sale or exchange for tax purposes. Proceeds from the transaction offset the adjusted basis of the shares. The selling shareholder will recognize a gain or loss in an amount equal to the difference between the amount received for the redeemed shares and the adjusted basis on such shares. Capital gains treatment can also be advantageous in that capital gains can be fully offset by capital losses and capital loss rollovers.
Under the current tax regime, long-term capital gains and qualified dividends are taxed at the same rate; a maximum of 23.8%, including the rate of profit of 20% and the tax on net investment income of 3.8%. The “serendipity” of the same rates needs further analysis.
The distinction to be made when considering sale treatment is the “power of basis” in the redeemed shares. The redemption treatment can be considerably more advantageous than the dividend treatment, when the basis is considered. Another tax planning point is that some dividends are not qualified dividends and can be taxed at the maximum ordinary income rate of 39.6%.
Not essentially equivalent to dividends
There are a few ways that corporate refunds can be considered for tax planning. There are two tests in §302 that have been delineated in the Code and Regulations, so they do not present real problems of interpretation or application. 302(b)(2) Substantially disproportionate redemption of shares and 302(b)(3) Termination of shareholder interest has strict qualification requirements.
Sometimes tax planning needs to use the “lower path”, after discovering the fact that, for whatever reason, a transaction does not qualify under the two tests above; there is yet another tax planning opportunity to make a stock redemption. The legal authority guiding how to affect this type of transaction is not as well outlined in the law, however it can be structured so that a transaction is likely to qualify as a redemption under 302(b)(1) and not be equivalent to dividends.
The analytical standard that allows a taxpayer to qualify under 302(b)(1) is known as a “significant reduction.” This standard for qualifying under 302(b)(1) is similar to 302(b)(2), however, the requirements are slightly less stringent. Although 302(b)(1) is less strict, the regulations are not quite as concise, § 1.302-2(b) stating “the facts and circumstances of each case.” Meeting the well-delineated numerical tests in 302(b)(2) and 302(b)(3) is a preferred method of making a transaction qualify as a redemption; rather than relying on facts and circumstances.
The influential case related to 302(b)(1) is USA v. Davis 397 US 301 (1970). The Supreme Court established the requirement of a “significant reduction” as a requirement. A business purpose is not a requirement for a salvage to qualify under 302(b)(1). The opinion in this case states: “Regardless of the business purpose, a redemption is always “substantially equivalent to a dividend” within the meaning of § 302(b)(1) if the interest of the shareholder does not change. proportional interest in the corporation. Since the taxpayer here (after application of the attribution rules) was the sole shareholder of the corporation both before and after the bailout, he did not qualify for capital gains treatment under that test.”1
A significant reduction is concentrated in proportional interest. “Rather, to qualify for preferential treatment under that section, a redemption must result in a significant reduction of the shareholder’s proportionate interest in the corporation.”2
The Service and the courts are primarily focused on control to satisfy the § 302(b)(1) standard. The end product of this standard is a concentration in ownership percentage.
It’s worth noting that there are several quotes where percentage ownership is not the main factor. In Wright v. US, 482 F2d 600, the taxpayer successfully argued that a bailout can still leave one shareholder in control. The Eighth Circuit ruled that a redemption that resulted in a reduction of voting power from 85% to 61.7% was significant when 66.67% of voting power was needed to pass major corporate decisions.
A significant reduction was also achieved when the redeemed shareholder was deemed to own shares under the family attribution rules §318. In Rev Rul. 75-512, the shareholder had no power to control the corporation before or after redemption, either alone or acting in concert with other minority shareholders.
The significant reduction requirement is more diluted version of the same concept applicable to substantially disproportionate refunds. However, not being essentially dividend equivalent is not a hot topic with the IRS right now; the subject has been much discussed in the past. In the event that a transaction must be based on § 302(b)(1), think beyond the basic percentage check.
Contact the author with any tax planning questions. We appreciate this opportunity to help.
1. United States v. Davis 397 US 301 (1970)
2. United States v. Davis 397 US 301 (1970)