Cross-purchase agreements.

A major problem affecting close corporations is the disposition of stock of a retiring or deceased partner-stockholder. Because of the close relationship of the stockholders, the introduction of a stranger is not usually permitted. In turn, the retiring stockholder normally wants a market for his shares, since one otherwise does not exist.

The problem is customarily solved by granting various options to the stockholders and the corporation. They may be of both the call and the put variety. The retiring (or deceased) stockholder must offer his stock to those remaining—or at least give them a right of first refusal. In turn, he is given the right to put the stock to those remaining, or to the corporation, at some agreed-upon price or formula.

These agreements take one of two forms. Either the corporation agrees to buy the stock—a redemption agreement—or the remaining stockholders agree to buy it—a cross-purchase agreement. Hybrid agreements that partake of both varieties are also used. The discussion that follows deals with the cross-purchase agreement.

Except for the constructive ownership problem discussed above, the act of entering into a cross-purchase agreement is usually without tax consequence.

If the stock is sold because of the retirement, as opposed to the death, of a stockholder, taxable gain or loss will be incurred. The profit or loss is the difference between the stockholder's basis in the stock and the consideration received for it.  A gain on the sale will always be recognized, regardless of the tax character of the purchaser. A loss, however, is not recognized if the purchaser is related to, or affiliated with, the seller. The relationship includes family members (brothers, sisters, spouse, ancestors, and lineal descendants) and trusts, partnerships, and corporations.

The gain or loss is short-term or long-term, depending on whether the stock has been held for more than one year.  A corporation can offset capital losses only to the extent of capital gains and an individual can deduct only $3000 of such losses in excess of his capital gains.  The tax on an individual's capital gains is capped at 28 percent.

If the purchase is made because of the death of the stockholder, the shares will have a basis equal to their value on the date of death.  A sale shortly thereafter by the estate will therefore not normally result in either gain or loss.

Under certain circumstances the rules set forth above are different. If the stock is Section 306 stock, a profit on the sale may be reclassified as ordinary in nature, not as capital gain. Section 306 stock usually arises when the corporation is recapitalized so that both common and preferred stock are outstanding.  If only the voting stock is redeemed and the Section 306 stock retained, (or vice-versa), the gain may be ordinary, rather than capital.

A similar result occurs if the corporation is classed as a collapsible corporation.  In general, a collapsible corporation is one that is liquidated or sold before it has earned the income for projects it has started. Gain on the sale of stock of a collapsible corporation is taxed as ordinary income.

Up to $50,000 of the loss on shares that are Section 1244 shares is ordinary in nature.  (For a married couple filing a joint return, the loss can reach $100,000.) Section 1244 stock is stock issued by a corporation that has capital of less than $1 million and earns less than 50 percent of its income from interest, dividends, and other passive income.

If the purchase price for the stock is payable over several years, the installment sale provisions of the Code will apply. (The seller may elect out of their application.)  Under these provisions, only the portion of each installment received that represents profit is reported as income. A seller who receives only nonnegotiable notes or only an obligation to pay has a second alternative. He may defer reporting income until his basis in the stock has been completely recovered.

The buyer's basis in the stock is his purchase price.