Section 303 Redemption
Section 303 of the Internal Revenue Code recognizes that unique estate liquidity problems can arise in the estates of deceased shareholders of family corporations: - The need to sell off part of the business to generate cash for estate needs
- The possibility that outsiders might join the business as a result of such a sale
- Potential treatment of a stock redemption as taxable dividend income under tax law.
Under Section 303, when a business is a closely held corporation, a deceased shareholder's estate or heirs may sell to the corporation enough stock to pay federal and state death taxes, costs of estate administration, and funeral expenses without treating the transaction as a dividend to the redeeming shareholder. Section 303 permits heirs to get cash out of the corporation for liquidity needs with minimal or no income tax consequences. Any gain arising from a Section 303 redemption is taxed favorably as a long-term capital gain. Capital gains can be offset by the shareholder's basis in the stock, including the stepped-up basis at death (allowed through 2009 under current law), but dividend income cannot be offset. Under Section 303, a partial redemption of stock after a shareholder dies may be treated as the sale of an asset eligible for long-term capital gains treatment if four tests are met: - The stock must be included in the decedent's gross estate, but may be held by a surviving joint tenant as well as by the executor.
- The stock's value must exceed 35% of the adjusted gross estate.
- The stock must be held by a person whose interest in the estate would be reduced by the payment of estate costs.
- The redemption must occur within four years of the deceased shareholder's death.
Section 303 limits the maximum amount of stock that may be redeemed to the sum of: - State and federal death taxes
- Costs of estate administration
- Funeral expenses
- If more than one heir wants to redeem stock, a "first-come, first-served" rule applies. Once the maximum is reached, Section 303 is no longer available to any heir.
Because a small corporation may not have enough cash to redeem a deceased shareholder's stock, life insurance can be used to fund a Section 303 redemption. The corporation owns a life insurance policy on the shareholder's life and is the beneficiary of the policy. When the shareholder dies, the corporation uses the policy proceeds to purchase stock from the deceased shareholder's heirs or estate. Death proceeds are usually federal income tax free. However, corporate-owned life insurance may subject a C corporation to the alternative minimum tax unless the business qualifies as a "small business corporation" exempt from that tax. Other uses for life insurance in a family business include: - Ensuring adequate income for the deceased owner's spouse or family
- Equalizing inheritances between children of the deceased owner
- Providing adequate estate liquidity
Advantages of a Section 303 stock redemption funded by life insurance include: - Ownership may remain in the family in a family-owned corporation.
- Heirs are assured of funds to help pay estate settlement costs.
- Corporate dollars can be used to make a tax-favored partial redemption.
- Income taxes on the sale can be minimized or eliminated.
- Since there is no requirement that a Section 303 redemption may occur only if the estate needs cash to pay final expenses, the redemption may be made even if other cash is available.
Like any stock redemption, Section 303 alters the ownership percentages of surviving shareholders. For example: Tom, Dick and Harry own 40%, 40% and 20%, respectively, of their small corporation. Dick dies and half of his stock (20%) is redeemed. The ownership percentages now shift to: - Tom 50% (increased by 10%)
- Dick's heirs 25% (remaining 20% is increased by 5%)
- Harry 25% (increased by 5%)
Whereas Dick's interest was formerly twice as great as Harry's, because of the redemption of half of Dick's stock, Harry's interest is now equal to the interest of Dick's heirs. | 
