IRS Revenue Ruling 83-54: Shareholder Payments
IRS Rev. Rul. 83-54 clarifies why certain shareholder payments are treated as distributions of income, not a stock sale, altering tax outcomes for both parties.
An Internal Revenue Service (IRS) Revenue Ruling is an official interpretation of the tax code, applying the law to a specific set of factual circumstances. Revenue Ruling 83-54 specifically addresses payments made by a professional service corporation to a former shareholder or their estate. It clarifies the tax nature of these payments.
The Core Principle of the Ruling
The central concept of Revenue Ruling 83-54 is the recharacterization of certain payments. When a professional corporation makes payments to a retired shareholder or their estate, these are not always treated as a purchase of the shareholder’s stock. Instead, the ruling stipulates that such payments can be considered a distribution of the corporation’s income. This interpretation is based on the idea that in many professional service firms, a departing shareholder is receiving their share of future income or accounts receivable that were not yet collected.
The IRS’s reasoning distinguishes these payments from a typical stock sale. In a professional service corporation, such as a medical or law practice, the value is often tied to ongoing services and client relationships rather than tangible assets or formally recognized goodwill. This prevents the payments from being classified as capital gains, which often have a more favorable tax treatment for the recipient.
Determining Applicability
The payment must originate from a professional service corporation, a business entity common in fields like accounting, law, medicine, and engineering. The recipient of the funds must be a shareholder who has retired from the practice or the estate of a shareholder who has passed away.
A primary factor is how the payment amount is determined. The ruling applies when the payment is not based on the fair market value of the corporation’s tangible assets. Instead, the amount is linked to the shareholder’s past compensation or their proportional share of the firm’s accounts receivable or work-in-progress. The shareholder or redemption agreement is an important document, as its terms often define whether the payments are for the purchase of stock or represent a share of future income.
Tax Treatment and Reporting
When Revenue Ruling 83-54 applies, the tax consequences are specific for both the paying corporation and the recipient. For the former shareholder or their estate, the payments received are treated as ordinary income. This means the amounts must be reported on their tax return and are subject to regular income tax rates, rather than the potentially lower capital gains rates.
From the corporation’s perspective, these payments are generally considered a deductible business expense. Because the payments are classified as a distribution of income to the former shareholder, the corporation can subtract these amounts from its own taxable income.