This article discusses how shareholders can use Section 303 to avoid dividend treatment on a partial redemption and receive money from the corporation tax free.

 

Congress created Section 303 out of concern that small businesses could be forced to liquidate just to pay death taxes and related expenses. 

 

Typically, distributions for partial redemptions of closely held stock are taxable as ordinary dividends unless the redemption falls within certain categories outlined by the Code.  Subject to certain conditions, Section 303 allows exchange treatment for partial redemptions of a decedent's stock.  Because decedent's stock receives a step-up in basis at death, little or no income tax cost is incurred on the redemption. The requirements to qualify for Section 303 treatment are listed below.

 

The value of stock redeemed must be included in the decedent's gross estate for estate tax purposes. 

 

The value for federal estate tax purposes of the corporation's stock that is included in decedent's estate must exceed 35% of the decedent's adjusted gross estate.  Adjusted gross estate is defined as the gross estate, including transfers made within three years of death (less deductions allowable for funeral expenses, administration expenses, debts, taxes and losses).

 

In certain cases, the stock of two or more corporations may be combined to meet the 35% test.

 

The value of the stock that can be redeemed and receive favorable tax treatment cannot exceed the sum of all death taxes (including any interest), plus funeral and administrative expenses.

 

A 303 redemption is allowed only to the extent that the burden of paying death taxes and funeral and administrative costs fall, directly or indirectly, on the stock to be redeemed.  Thus, decedents will must be coordinated with a potential redemption.

 

The redemption must take place after decedent's death and, in most cases, within 3 years and 90 days of filing the estate tax return.  If estate tax deferral is elected under Section 6166, the redemption can be made within the time permitted for estate tax installments.

 

Lifetime planning is needed to be certain the redemption will qualify under Section 303.  Estate documents and gifting programs should be coordinated with a potential Section 303 redemption.

 

The corporation also needs sufficient cash to take advantage of Section 303.  Accumulating sufficient cash is difficult because accumulations to fund a Section 303 redemption are subject to the Accumulated Earnings Tax until after the death of the shareholder.  Life insurance on major shareholders, owned by the corporation or an irrevocable trust, can provide the needed liquidity.

 

Section 303 presents a unique opportunity to take money out of a C corporation at little or no tax cost.  Planning is needed in order to take advantage of the opportunity, however.