• No equitable tolling of statutory period of limitations for tax refund suits—In Davis v. U.S., 110 A.F.T.R.2d 2012-5027 (June 28, 2012), the executor of the estate of Anthony Walker Smith sued for a refund of income taxes the estate had previously paid. The district court for the Northern District of Mississippi dismissed the case for lack of subject matter jurisdiction, and the U.S. Court of Appeals for the Fifth Circuit affirmed.
The estate had paid income taxes that were owed as the result of Anthony’s ownership of a farm property. However, after the taxes were paid, Anthony’s father sued the estate, arguing that he had a life estate in the property. The Mississippi Court of Appeals affirmed the Chancery Court’s decision in favor of Anthony’s father. After the Mississippi Supreme Court denied certiorari, the executor filed an administrative claim for a refund, asserting that the estate had overpaid its income taxes under the mistaken belief that Anthony owned a fee simple interest in the property. The Internal Revenue Service disallowed the claim on the ground that it wasn’t timely filed under Internal Revenue Code Section 6511, because it hadn’t been filed within three years of the filing of the tax return or two years of the payment of the tax.
The Fifth Circuit upheld the district court’s dismissal of the suit, explaining that it was bound by the 1997 U.S. Supreme Court case, U.S. v. Brockamp, which held that courts couldn’t toll the statutory time limitations for filing tax refund claims under Section 6511 for non-statutory equitable reasons. The Fifth Circuit didn’t find the executor’s attempts to distinguish the estate’s predicament from the facts of Brockamp persuasive. It further noted that the executor could have filed a protective claim with the IRS to preserve the estate’s interest in the refund when the Chancery Court ruled in favor of Anthony’s father (even if it wasn’t sure if the Supreme Court would ultimately hear the case), which was before the statutory period ended. This case is a good reminder of the value of filing protective claims.
• Stock redemption following gift of shares qualifies for stock sale and capital gains treatment—In Private Letter Ruling 201228012 (July 13, 2012), a father owned all of the outstanding stock of a corporation, of which he was a director and president, and his two children were directors. The father wanted to retire and transfer management and control to his children. He proposed to give each of his children a certain number of shares of the company and to have the company redeem the rest of his shares. In exchange for the shares, the company would issue the father a 15-year promissory note; the redemption price was to be based on a third-party appraisal.
Under IRC Section 302(a), if there’s a complete redemption of all of the stock of a corporation owned by a shareholder under Section 302(b)(3), then the redemption is treated as a distribution in part or full payment in exchange for the stock. In determining whether a shareholder’s interest is terminated under Section 302(c), the attribution rules of IRC Section 318 may apply. This could cause other family members’ stock (such as the children’s stock in this case) to be attributed to the redeemed shareholder (the father), which could cause his interest in the corporation to be deemed not to have terminated (and, as a result, the redemption would be taxed as a dividend).
Generally, these attribution rules won’t apply if the redeemed shareholder: (1) immediately after the distribution, has no interest in the corporation (including an interest as an officer, director or employee) other than an interest as a creditor, (2) doesn’t acquire any such interest (other than stock acquired by bequest or inheritance) within 10 years from the date of such distribution, (3) files an agreement to notify the IRS of any acquisition of any such interest and retains the required records, and (4) hasn’t acquired shares or transferred shares to persons whose ownership would otherwise be attributable to him under the attribution rules of Section 318 (for example, family members) within a 10-year period ending on the date of redemption with the principal purposes of avoiding federal income tax. This last factor was a potential issue for the taxpayer, because he was giving shares in the company to his children prior to the redemption.
The taxpayers made many representations about the transaction, including that the promissory note wouldn’t be subordinated to the claims of general creditors; the redemption price wasn’t contingent on any future earnings or certain levels of working capital; no shares would revert to the father if the company were to default on the note; the father had no other interest in the company other than as a general creditor; none of the shares to be redeemed were acquired by the father from another family member within the previous 10 years; and the father would file the required agreement and information with the IRS.
The PLR held that the gifts to the children weren’t made for the principal purpose of avoiding federal income tax, so the attribution rules wouldn’t apply and the redemption would be a complete termination of the father’s interest in the corporation under Section 302(b)(3). Therefore, the amount distributed to the father would be treated as a distribution in full payment in exchange for the stock under Section 302(a).
As a result, since the transaction was characterized as a complete termination of the father’s interest in the company, the father would realize capital gains on the redemption, taking into account the basis of the redeemed shares, which could be reported using the installment method. Assuming that the redemption wasn’t performed to satisfy an obligation of either of the children to acquire the father’s stock in the company, the redemption wouldn’t cause any dividend income to be constructively received by the children.
This strategy allowed the father to sell his shares to the company and be paid from company assets, rather than force his children to purchase his shares directly, with the same capital gains treatment. While the rate applicable to capital gains may be equivalent to the rate applicable to dividends, treating the redemption as a sale allowed the taxpayer to recover his basis.