Revenue Ruling 82-12: Shareholder Payment Tax Treatment

Revenue Ruling 82-12 is guidance from the Internal Revenue Service (IRS) that addresses the tax treatment of payments a professional corporation makes to a shareholder who is leaving the practice. This situation arises when a shareholder retires or dies, where payments are made to their estate. The ruling’s function is to provide a framework for classifying these payments, which determines how the funds are taxed for both the individual and the corporation. The guidance recognizes that a single payment can represent compensation for multiple things, such as the value of the departing shareholder’s ownership stake and their rights to future income or other claims.

Differentiating Payment Types

Revenue Ruling 82-12 separates payments into two fundamental categories: those made in exchange for the shareholder’s stock and those made for other specified claims. The payment for stock is conceptually straightforward, representing the purchase of the shareholder’s equity interest in the corporation. This portion of the payment typically covers the value of the corporation’s tangible assets and may also include a value for the corporation’s goodwill if the governing agreements explicitly treat it as a salable corporate asset.

Payments for other claims are distinct from the stock purchase and cover a different set of rights. This category often includes arrangements for deferred compensation, a share of the corporation’s undistributed profits earned up to the departure date, or payment for the value of unbilled work or accounts receivable. For example, a payment for a retiring accountant’s share of the firm’s computers is a payment for stock, while a payment for their portion of fees from a recently completed but not-yet-billed audit is for other claims.

The proper allocation between these categories is not arbitrary and is subject to IRS scrutiny. The substance of the transaction, rather than its mere form, dictates the classification. A corporation cannot simply label a payment to achieve a more favorable tax outcome if the underlying facts do not support it.

The Role of the Buy-Sell Agreement

The buy-sell agreement, sometimes called a redemption agreement, is the central document the IRS examines to understand the intent behind payments to a departing shareholder. This legally binding contract outlines the terms for the transfer of stock upon a triggering event like retirement or death. Its language and structure carry significant weight in determining how payments will be classified for tax purposes.

Within the agreement, the most important provisions are those that explicitly allocate the total payment among different components. A detailed agreement will break down the total buyout price, assigning specific values to the stock being redeemed and to any other rights being settled. This allocation provides clear evidence of the parties’ intentions and is often respected by the IRS, provided it is based on economic reality.

The treatment of goodwill is a particularly noteworthy aspect of the buy-sell agreement. The agreement should clarify whether goodwill is considered an asset of the corporation, in which case a payment for it is part of the stock sale, or if it is being treated as a separate payment to the individual. If the agreement is silent or ambiguous on these allocations, the IRS may make its own determination based on the facts and circumstances, which could alter the expected tax outcomes.

Shareholders in professional corporations should understand how their buy-sell agreement addresses payment allocations, goodwill, and other potential claims. The agreement serves as the primary piece of evidence in supporting the tax treatment of the transaction. Its clarity and specificity can prevent future disagreements with tax authorities.

Tax Consequences of Payments

Payments for Stock

For the departing shareholder or their estate, a payment for stock results in a capital gain or loss. The gain or loss is calculated by subtracting the shareholder’s basis in the stock from the amount received for it. If the stock was held for more than one year, the gain is a long-term capital gain, taxed at preferential rates compared to ordinary income.

From the corporation’s perspective, payments made to redeem its own stock are not tax-deductible. These payments are treated as a capital transaction that reduces the corporation’s equity. This creates a tension, as the corporation often prefers to maximize deductible payments while the shareholder may prefer capital gains treatment.

Payments for Other Rights

Payments allocated to other claims, such as deferred compensation, a covenant not to compete, or a share of accounts receivable, are treated differently. For the recipient, these payments are considered ordinary income, not capital gain. This means they are taxed at the individual’s standard marginal income tax rates, which are typically higher than long-term capital gains rates. The income is reported as miscellaneous income or compensation, depending on the specific nature of the payment.

Conversely, these payments are generally deductible by the corporation as ordinary and necessary business expenses. For example, a payment for a covenant not to compete is amortized and deducted over a 15-year period, while payments for deferred compensation or accounts receivable are typically deductible in the year they are paid. This allows the corporation to reduce its taxable income, resulting in a lower tax liability.

Reporting the Transaction

Once payments are classified, the transaction must be reported correctly to the IRS. The specific forms used depend on how the payments were categorized. This procedural step ensures that both the payer and the recipient are compliant and that their reporting is consistent, reducing the likelihood of an audit.

For payments treated as ordinary income, the reporting depends on the nature of the payment. If the payment is for services rendered, which includes deferred compensation, the corporation issues a Form 1099-NEC. For other types of ordinary income payments, a Form 1099-MISC may be used. The recipient reports this income on their Form 1040, U.S. Individual Income Tax Return.

The portion of the payment allocated to the sale of stock is reported differently. The shareholder must report the sale on Form 8949, Sales and Other Dispositions of Capital Assets, which then flows to Schedule D (Form 1040). The corporation does not typically issue a Form 1099 for a simple stock redemption, but the shareholder is responsible for tracking their stock basis and calculating the resulting capital gain or loss.