Revenue Ruling 87-50: Taxing Shareholder Payments

The federal income tax treatment of payments from a professional service corporation (PSC) to a retiring or deceased shareholder’s estate raises a key question. Are the payments for the shareholder’s stock, or are they for a claim on the corporation’s future income? This distinction determines how both the corporation and the recipient are taxed. The tax code clarifies when payments should be treated as a stock sale versus a distribution of income, based on the substance of the shareholder agreement.

Differentiating Payments for Stock from Other Payments

When a corporation buys back its own stock, the transaction is known as a stock redemption. If the redemption significantly reduces a shareholder’s ownership, it is treated as a sale of a capital asset. For the shareholder, this means the difference between the payment received and their cost basis in the stock is taxed as a capital gain or loss. For the corporation, these payments are not deductible business expenses; they are a capital transaction.

This treatment contrasts sharply with payments that represent a share of the corporation’s earnings. This can include payments for a claim on unrealized receivables or for the value of work in progress. Such payments are a distribution of corporate income. From a tax perspective, these distributions are often deductible by the corporation as a business expense, which lowers its taxable income. For the recipient, these payments are taxed as ordinary income.

The distinction hinges on what the payment is actually for, which is determined by the language in the shareholder or employment agreement. If an agreement specifies that a payment is for the redemption of stock and the amount is based on a clear valuation of that stock, it points toward a capital transaction. Conversely, if payments are linked to the corporation’s past or future revenues or are designated as compensation for past services, they are more likely to be treated as income distributions. The IRS emphasizes that the substance of the transaction, as dictated by the governing agreements, is paramount.

Common Payment Structures

The tax treatment of a shareholder buyout is best illustrated through common scenarios. In one situation, a shareholder agreement may stipulate that upon retirement or death, the corporation will redeem the shareholder’s stock for its net book value. If the agreement makes no provision for any additional payments related to accounts receivable or work in progress, the payment is identified as being for the purchase of the stock. The transaction is treated as a stock redemption because the payment amount is tied directly to the value of the shares as defined in the agreement.

A different scenario presents an agreement where the payments are structured differently. For instance, an employment contract might provide that a retiring shareholder is entitled to receive payments that are not linked to the stock’s value but are instead based on a percentage of the corporation’s future collections from clients the shareholder serviced. The agreement might even state that these payments are in exchange for the shareholder’s rights to the firm’s unrealized receivables. Here, the payments are not for the stock but are a continuation of the professional’s earnings.

These contrasting examples highlight the importance of the underlying legal agreements. The labels used are less important than the economic reality of the payments. A payment labeled as a “buyout” could be treated as ordinary income if it’s calculated based on future earnings. Conversely, a payment might be part of a capital transaction even if it’s paid out over several years. The key is whether the payment’s origin is the stock itself or a right to a portion of the corporation’s income stream.

Tax Consequences for the Corporation and Shareholder

This dual treatment creates a natural tension. A corporation typically prefers to have payments be deductible, which pushes toward classifying them as income distributions. A departing shareholder, on the other hand, usually prefers the lower tax rates associated with capital gains treatment. The IRS closely scrutinizes these arrangements to prevent corporations from improperly deducting payments that are, in substance, non-deductible stock buybacks. Ultimately, the controlling factor is the specific terms laid out in the corporate agreements that define the nature and purpose of the payments.