Shareholder Tax Treatment of S-Corporation Redemptions

There are many situations where a shareholder may want to eliminate or reduce ownership in an S-corporation. One may be the need for additional cash as a result of the economic downturn stemming from the COVID-19 shutdown.

If none of the other existing owners is interested in purchasing the shares, the shares can be sold back to the corporation. This is known as a “stock redemption for tax purposes.” The redemption can be treated as an exchange or a sale, with the resulting gain or loss treated as a capital gain or loss. Alternatively, the redemption transaction can be treated as a distribution. The tax treatment will depend on the facts and circumstances of each case.

The redemption is treated as a sale or exchange in the following scenarios:

• If the shareholder substantially reduces his/her interest.
• If there is termination of a shareholder interest.
• If the redemption is not equivalent to a dividend (a subjective test that occurs where there is no meaningful reduction in shareholder’s interest).
• If there is a partial liquidation.
• If the proceeds of the redemption are used to pay death taxes.

The shareholder would compute the gain or loss as to the difference between the amount distributed less the adjusted basis in the shares redeemed.

If none of the above scenarios applies, and the shareholder wishes to redeem a small percentage of ownership, then the redemption is treated as a distribution. The distribution will be treated as tax-free to the extent of the corporation’s accumulated adjustment account (AAA), then as a tax-free recovery of basis, with any remaining distribution in excess of AAA and basis, to be treated as a sale or exchange gain.

This assumes the S-Corporation does not have prior C-corporation earnings and profits. A distribution that originates from a redemption does not cause a disproportional distribution, so a there is no risk of violating S-corporation eligibility rules.

Again, each redemption depends on the facts and circumstances of the redeeming corporation and the shareholder.

Please contact your Marcum tax advisor with questions on your particular S-Corporation ownership situation.