C and S Corporations for Estate Planners: IRC Section 303 Stock Redemptions After Death

Balancing double-tax rules with the liquidity needs of the estate

This is the fifth installment of C and S corporations for estate planners.

For the prior article in this series, click here.

For the first article in this series and a series index, click here.

Table of Contents

1. Intro

2. 303 Redemptions in General

3. Limitations

4. Value and Ownership Requirements

5. Aggregation Rules

6. Time and Post-Mortem Transfer Limitations

7. Special Considerations for Marital Trusts

8. Application of Proceeds

9. Conclusion

Intro

Previously, we left off with a discussion of the differing tax treatment of a redemption of C or S corporation stock.  Generally, for both a C and S corporation, we must determine whether a redemption is granted sale or exchange treatment under IRC Section 302.  If so, in most cases there is capital gain on each share redeemed.  But, redemption requires application of the family attribution rules under IRC Section 318, which can prevent a redemption that complies in isolation with IRC Section 302(b) from complying after considering shares constructively owned by the redeemed shareholder from family members, estates, trusts, or other entities. 

The outcome of failing IRC Section 302 is dividend treatment under IRC Section 301.  This generally means ordinary income treatment on redemption proceeds from a C corporation (to the extent of current and accumulated earnings and profits), plus possible net investment income tax as we will later discuss, before being granted sale or exchange treatment.  This is a big deal in estate planning when dealing with stepped-up basis stock at the death of a shareholder, because the stepped-up basis can become partially or fully taxable on redemption.  And, as I will mention below with the pending Connelly decision, this could disproportionately affect situations involving corporate-owned life insurance. 

For an S corporation, however, we aggregate basis across all S corporation shares in a noncomplying redemption to first give tax-free return of basis before creating sale or exchange treatment under IRC Section 1368.   In an S corporation with an operating history as a C corporation, this tax-free redemption is limited to the lesser of such aggregated basis or the accumulated adjustments account (AAA) of the S corporation.  Then, we have sale or exchange treatment if basis is less than the AAA.  Then, once AAA is exhausted, C corporation E&P that accumulated before the S election is distributed – according dividend treatment as ordinary income – before we get back to sale or exchange treatment. 

When we left off, however, I introduced one exception that could benefit estates or other shareholders with stepped-up basis stock – the IRC Section 303 redemption.  Without further adieu, let’s dig in. 

303 Redemptions in General

In broad terms, IRC Section 303 grants sale or exchange treatment on a redemption of stock that is included in a decedent’s gross estate for estate tax purposes.  Due to the step-up in basis for such stock (by virtue of gross estate inclusion under IRC Section 1014(b)(9)), there should be no taxable gain so long as the redemption price does not exceed the federal estate tax value of the stock.  The outcome is avoiding the family attribution rules, which could otherwise recharacterize such a redemption as a taxable dividend on the stepped-up basis under IRC Sections 301 and 302. 

While this seems great in theory, there are several hoops we must jump through in order to achieve this tax treatment.  Keep in mind that if any of these requirements are not met, however, we still have IRC Section 302 as a backup. 

Limitations