Hurst v. Commissioner

United States Tax Court · 2005 · Corporations

Corporationsstock redemptionfamily attributionS corporation fringe benefitssection 302(b)(3)section 302(c)(2)section 304section 318

Facts

In 1997, Richard Hurst caused HMI to redeem 90 percent of his HMI stock for a 15-year note and sold his remaining HMI shares to his son Todd Hurst and two key employees for additional 15-year notes. At the same closing, HMI bought the Hursts' RHI stock for a note, leased the Hursts' headquarters building on fixed rent, and entered into a 10-year employment contract with Mary Ann Hurst providing a small salary and fringe benefits including health insurance. All notes, the lease, and the employment contract had cross-default and cross-collateralization provisions secured by the transferred stock. After the transaction, Mr. Hurst did not participate in HMI's corporate affairs, while Mrs. Hurst remained an employee and received health insurance through HMI.

Issue

Did Richard Hurst retain a prohibited interest in HMI so that the HMI redemption failed to qualify as a complete termination redemption under section 302(b)(3) despite the cross-default, lease, and employment arrangements? Could the Commissioner defeat sale treatment of the RHI stock transfer by invoking section 304 for the first time in posttrial briefing? Was Mrs. Hurst a 2-percent shareholder whose HMI-paid health insurance premiums were includible in income?

Rule

A redemption qualifies as a complete termination redemption under section 302(b)(3) when, after waiver of family attribution under section 302(c)(2), the former shareholder retains no interest other than an interest as a creditor. Fixed obligations not contingent on the corporation's earnings or financial performance, including secured notes, an arm's-length fixed-rent lease, and related cross-default protections, do not create a prohibited proprietary interest when they merely protect the seller as creditor. A theory first raised after trial is a new matter if it would reasonably have changed the evidence offered. Under section 1372, an S corporation employee who owns, actually or constructively under section 318, more than 2 percent of the stock on any day during the year must include employer-paid health insurance premiums in income, subject to the section 162(l) deduction then allowed.

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One of 10 multiple-choice questions for this case. Pick an answer to see why.

In Columbus, Ohio, Elena Morris redeemed all of her shares in Rivergate Controls, Inc. for a 12-year promissory note. The note required fixed quarterly principal and interest payments, was secured by the redeemed shares, and Elena stopped attending meetings, giving advice, or otherwise participating in the company after closing.

If Elena timely waives family attribution and the IRS argues that her security interest in the redeemed shares is a prohibited retained interest, what is the strongest answer?

Explanation. Under the majority opinion, a former shareholder may retain an interest as a creditor without losing section 302(b)(3) treatment after a valid section 302(c)(2) waiver. Fixed promissory notes secured by redeemed stock do not create a prohibited proprietary interest when they merely protect payment of the debt. The key points are that the payments are fixed and not tied to corporate earnings or performance, and the seller does not continue to participate in management.