March 2, 2011
Firm News for March: Structuring a Partner Buyout as a Stock Redemption: Potential Tax Consequences Arising from the New Change of Ownership Rules
By: Jessica L. Conn, Esq.
Under the SOP 50 10 5(B), SBA permitted a change of ownership through a stock purchase by individuals, provided that the individuals and the entity being acquired were co-obligors on the loan. The SOP 50 10 5(C), which became effective October 1, 2010, changed this rule, and now only requires the business being acquired to be a borrower when financing a change of ownership through a stock transfer. No formal guidance has been provided by SBA with respect to the intent of this change. However, senior SBA officials have advised that this change means that a stock purchase by individuals can no longer be financed under the SBA loan program. A change of ownership via stock purchase is frequently utilized by shareholders that want to purchase the stock of another shareholder. In order to comply with SBA’s new regulations, a borrower may alternatively structure a partner buyout as a stock redemption, however, in doing so, both lenders and borrowers should be mindful of the potential tax consequences stemming from this structure change.
Let’s assume that Shareholder A and Shareholder B each own 50 shares of Company X stock. Shareholder B has entered into an agreement of sale to purchase Shareholder A’s 50 shares of Company X stock, and is currently seeking financing for the transaction. In order to comply with the new SBA regulations, Shareholder B assigns the purchase contract to Company X, thereby changing the structure of the deal from a stock purchase to a stock redemption. If Shareholder B had purchased Shareholder A’s stock, Shareholder A would recognize a gain on that sale. The gain would be taxed as a capital gain. Assuming Shareholder A held the stock for more than one year and is in an average tax bracket, this long-term capital gain would be taxed at a rate of 15% at the federal level. If the transaction is instead structured as a stock redemption, Corporation X would purchase Shareholder A’s 50 shares of stock. Depending on the circumstances, for Shareholder A, the stock redemption can either be taxed as an “exchange” (which would, like the example above, result in capital gains treatment) or as a “distribution” (which would result in ordinary income treatment). The tax rate for ordinary income varies, but for most, ordinary income is currently taxed at a rate of 25-35% at the federal level.
There are several different scenarios under which a stock redemption will be treated as an exchange. One such scenario is when the corporation redeems 100% of the seller’s stock in the corporation. Since SBA requires that 100% of a seller’s interest be purchased in order for the change of ownership to be eligible for financing, it may be relatively easy to meet the requirements for exchange treatment of the transaction. However, certain types of transactions may require additional professional guidance on the tax ramifications. One such transaction is intra-family transfers. Assume for a minute that Shareholder A is the father of Shareholder B. Under certain circumstances, Shareholder A may be treated by the IRS as indirectly owning the stock of Shareholder B. If the IRS so attributes Shareholder B’s stock to Shareholder A after the redemption has taken place, then the redemption may not be treated as an exchange, resulting in adverse tax consequences. Therefore, in this type of scenario, it is very important for a prospective borrower to seek guidance on structuring the transaction to ensure they meet the requirements to waive family attribution rules.
Another situation that can arise via a stock redemption deals with constructive dividends. Under Revenue Ruling 69-608, if the assignment of the contract takes place at a time when Shareholder B has a “primary and unconditional obligation” to purchase the stock of Shareholder A, satisfaction of the obligation by the corporation would result in a constructive distribution to Shareholder B. In other words, the IRS views the benefit gained by Shareholder B in no longer needing to meet the obligation set forth in the purchase agreement as taxable; and the constructive dividend is taxed at ordinary income rates. Each scenario must be assessed on a case by case basis, and it is best for a prospective borrower to discuss the purchase contract with a tax professional before assigning it to a corporation because there may be other methods of effectuating the transfer without incurring the constructive dividend tax.
It is possible to structure a stock redemption so that the tax consequences are similar to a stock purchase. However, it is imperative for a prospective borrower to consult with a tax professional before making structural changes to a transaction to get the best possible tax consequences for both the individuals and the corporation.
For more information regarding financing changes of ownership through stock transfers and the attendant tax consequences thereof, contact Jessica at email@example.com.
IRS Circular 230 Disclosure: This document was not intended or written to be used, and it cannot be used, for the purpose of avoiding federal, state or local tax penalties, or for promoting, marketing or recommending to another party any transaction or matter addressed herein.