Using Corporate Stock Redemptions to Pay Estate Taxes

Many large estates subject to the estate tax have businesses. To make it easier to pay estate taxes, IRC §303 allows the purchase of a portion of the decedent shareholder stock by the corporation to be treated as a sale or exchange rather than as a dividend. The stock must be included in the decedent's gross estate and its value must comprise more than 35% of the gross estate minus deductions allowed under IRC §2053, including debts, taxes, and other estate expenses, and any losses under IRC §2054.

So, if the value of the gross estate = $25 million and estate + funeral costs = $1 million, then the value of the stock must at least exceed 35% × (25 million − $1 million) = $8,400,000.

Even someone other than the executor can sell stock to the corporation if that stock was included in the decedent's gross estate.

The stock redemption under the rules is more favorable because any redemption will only be subject to capital gains tax, but since the stock receives a stepped-up basis, no tax would be due from the redemption. On the other hand, if it is treated as a dividend, then it will be subject to ordinary income tax, regardless of a stepped-up basis.

The §303 stock redemption is limited to the total of all estate, inheritance, generation-skipping transfer, legacy, and succession taxes + any interest imposed because of the decedent's death + funeral and administrative expenses, even if they are not claimed as a deduction on the federal estate tax return (it may be claimed as deductions from estate income, instead). Any amounts exceeding the §303 limits will be taxed as a dividend to the seller, unless the tests of IRC §302 or §303 treating the sales as a capital gain are satisfied. The favorable tax treatment under §303 will only extend as far as the proceeds of the redemption are used to pay death taxes and/or administration expenses. IRC §302 has tests for the redemption of stock for purposes other than paying estate expenses.

Why Corporate Stock Redemptions Are Treated as Dividends Rather Than Sales

Why stock redemptions by a corporation are treated as dividends is to prevent abuse. For instance, suppose corporate stock redemptions were treated as sales rather than dividends. Under the current law, if you are the only owner of your corporation, then any dividends paid to you would be taxed as ordinary income. However, if you had your corporation redeem some of your shares, then you could receive that income as a capital gain, since you sold the shares to your corporation. Those shares become treasury stock of the corporation that has no voting rights. You still own the entire corporation and have total control over it, but if the tax code did not treat corporate stock redemptions as dividends, then, instead of receiving dividends, you can simply have your corporation redeem some of your stock periodically for a much more favorable tax treatment. Each of the remaining shares you own will be more valuable, since there would be fewer shares outstanding, so you may sell fewer shares to receive the same amount of money in the future. To replenish your shares, you can simply have your corporation issue you more stock that you can later resell back to the corporation or simply have the corporation issue a stock dividend, which increases your number of shares but is not taxable. This is why corporate stock redemptions are treated as dividends unless they satisfy the exceptions under §302 and §303. One exception under §302 is that the redemption will be treated as a capital gain or loss if you sell all your shares to the corporation. Note, that this default treatment only applies to corporate stock redemptions. If you sell your stock to someone else, then the sale will be treated as a sale of a capital asset that will qualify for capital gains treatment. Moreover, unlike §302 redemptions, §303 redemptions are exempt from the attribution rules that attribute the ownership of the stock to another party, who is usually a member of the shareholder’s family.

If the decedent owned more than 1 corporation, then the stocks of those corporations where the decedent owned at least 20% of the stock can be combined to meet the 35% threshold.

Any gifts made within 3 years of death minus the annual gift tax exclusion are brought back into the gross estate to determine if the 35% requirement is met. This rule prevents a moribund taxpayer from making gifts to qualify for the 35% rule.

Because an AB type bypass trust does not bear the expenses of the estate, it cannot qualify for the preferable tax treatment of the stock redemption. If the stock passes by joint tenancy to the surviving spouse, but the will directs the estate to pay all death taxes and expenses from the residue of the probate estate, then the redemption will not qualify, since the redemption proceeds were not used to pay estate expenses. Likewise, any stock received by a beneficiary because of a specific monetary bequest will not qualify as a §303 stock redemption.

If necessary, beneficiaries of the estate can lend money to the corporation to pay for the redemption. Life insurance is often used to pay for stock redemptions. Often, the corporation purchases life insurance on the key people owning the stock of the corporation. The corporation is both owner and beneficiary, and pays the premiums. If the stockholder is uninsurable, that a sinking fund can be used to accumulate enough funds to pay the taxes. When the stockholder dies, then the stock becomes part of the gross estate. The corporation receives the insurance proceeds, using it to pay for the stock. The estate then transfers the purchased stock to the corporation, then the estate uses the cash to pay federal and state death taxes and administrative and funeral expenses.

An irrevocable trust can also own the life insurance policy on the shareholder, who would then receive the proceeds when the shareholder died. Then the trust can loan the corporation the money to redeem the stock. This ensures that the insurance proceeds will not increase the value of the estate nor will it cause an alternative minimum tax for the corporation. Additionally, the proceeds will not cause an accumulated earnings tax, although this it is unlikely, since the money is being accumulated to pay estate taxes.

If desired, control of the corporation can be maintained by the beneficiaries of the estate if, while the shareholder was still alive, the stock issued a preferred stock dividend which can be redeemed under §303. A stock dividend of nonvoting stock can also be issued to accomplish the same objective.

To qualify for the capital gain treatment, the stock redemption proceeds must be received no later than:

But if a distribution is made more than 4 years after the decedent's death, then capital gain treatment only extends to the lesser of:

Tax Notes