Constructive Ownership: The Attribution Rules for Caterpillar Employees

What Is Constructive Ownership?

We receive this question all the time from Caterpillar Employees and Retirees. The tax system recognizes different types of ownership of business interests for taxation purposes: actual ownership and constructive ownership. You (or your estate) are treated for certain tax purposes as owning not only assets that you actually own, but also assets that you are deemed to own because such assets are owned by related or controlled individuals or entities.

For instance, the constructive ownership rules may cause you to be treated as owning shares in a family corporation that are actually owned by other family members. The application of the constructive ownership rules may adversely affect the tax treatment of a redemption of shares of a corporation.

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Why Does This Matter? (Because It Affects Your Tax Treatment)

We view constructive ownership as very important to all Caterpillar employees and retirees because it can drastically change your tax status. If you (or your estate) sell your entire actual interest in a corporation back to the corporation, the sale may not be considered a complete redemption of your interest in the corporation for taxation purposes if a family member or a beneficiary of your estate continues to own an interest in the business. A complete redemption may be subject to beneficial tax treatment. In the context of a family business organized as a corporation, the constructive ownership rules assume that for purposes of redemption, each family member constructively owns the stock owned directly or indirectly by other family members. The attribution rules make it difficult to arrange a transaction that will be treated for tax purposes as a complete redemption of your interest in a family-owned corporation.

Redemption of all of the shares you actually own might be considered only a partial redemption, and you might not receive tax treatment as favorable as a complete redemption.

What Do You Mean, Affect My Tax Treatment?

Depending upon the specific circumstances of a company stock redemption, the proceeds (payment) a shareholder receives from the redemption of his or her business interest may be classified as a sale or exchange of the seller's interest (subject to capital gains tax) or as a dividend distribution. Generally, the complete redemption of company stock (in cases other than a family business) is considered a sale or exchange, with any gain being taxed as a capital gain. A partial redemption, by comparison, may be considered a dividend distribution. This is a distinction that all Caterpillar employees and retirees should understand fully.

Tip:  In general, the American Taxpayer Relief Act of 2012 permanently extended the preferential income tax treatment of qualified dividends and capital gains. Capital gains and qualified dividends are generally taxed at 0% for taxpayers in the 10% and 15% tax brackets, and at 15% for taxpayers in the 25% to 35% tax brackets. However, capital gains are generally taxed at 20% for taxpayers in the 39.6% tax bracket. Also, as a result of the Affordable Care Act of 2010, an additional 3.8% Medicare tax applies to some or all of the net investment income for married filers whose modified adjusted gross income exceeds $250,000 and single filers whose modified adjusted gross income is above $200,000.

However, there remains an advantage in classifying a transaction as a sale or exchange rather than as a dividend distribution despite the fact that both types of transactions are subject to tax at long-term capital gains tax rates. That is, in the case of dividend treatment, part or all of the distribution is first treated as a dividend, any remaining distribution is then received tax-free to the extent of basis, and any distribution still remaining is taxed as capital gains. In the case of sale or exchange treatment, however, the shareholder pays tax only to the extent that the amount paid by the company exceeds his or her basis in the stock. Thus, more may be subject to tax with dividend treatment than with sale or exchange treatment.

Tip:  If the sale or exchange of your shares occurs after your death, your shares will generally have a basis equal to the fair market value of the shares at the time of your death, and little or no tax may result.

How Do Constructive Ownership Rules Operate?

We feel that it's also important to remind all Caterpillar employees and retirees exactly which constructive ownership rules will be applied and how they will be applied. There are several constructive ownership rules included in the Internal Revenue Code, but the rules that are relevant in the context of a redemption of shares are included in Section 318. These rules state that you are treated as owning not only your own direct holdings but also the stock holdings of certain related taxpayers. The constructive ownership rules apply to stock held by family members, entities such as corporations, trusts, estates and partnerships, and beneficiaries.

Let's assume that you own stock in a closely held family corporation. The following table shows the constructive ownership relationships that would apply to you and your estate through the attribution rules:

A stockholder is not deemed to own stock of brothers, sisters, or grandparents for purposes of the Section 318 constructive ownership rules.

The Family Attribution Rule In Action

The following tables illustrate how family attribution works, using a sample family corporation owned by the parents, Harry and Wilma, and their two sons. In the beginning, each family member owns an equal percentage of the business:

In addition to the actual ownership percentages, there is constructive ownership, based on the family attribution rule. Harry's actual and constructive ownership is shown below:

Harry sells his 25 percent interest back to Family Corporation. The actual ownership percentages look like this after the sale:

Harry expected the gain from the sale of his interest to be treated as a complete redemption, subject to tax at capital gains rates. Unfortunately, the tax system has a different view of the transaction. Under the family attribution rule, the transaction is viewed to have the following result:

Under the family attribution rule, Harry's redemption of his interest in the Family Corporation does not change his percentage of ownership. Harry is deemed to own all of the stock in the business due to attribution from his spouse and sons. Under the family attribution rule, the transaction is treated as a dividend rather than a capital gain. These rules are essential for all Caterpillar employees and retirees that have family businesses.

Tip:  In general, the American Taxpayer Relief Act of 2012 permanently extended the preferential income tax treatment of qualified dividends and capital gains. Capital gains and qualified dividends are generally taxed at 0% for taxpayers in the 10% and 15% tax brackets, and at 15% for taxpayers in the 25% to 35% tax brackets. However, capital gains are generally taxed at 20% for taxpayers in the 39.6% tax bracket. Also, as a result of the Affordable Care Act of 2010, an additional 3.8% Medicare tax applies to some or all of the net investment income for married filers whose modified adjusted gross income exceeds $250,000 and single filers whose modified adjusted gross income is above $200,000.

However, there remains an advantage in classifying a transaction as a sale or exchange rather than as a dividend distribution despite the fact that both types of transactions are subject to tax at long-term capital gains tax rates. That is, in the case of dividend treatment, part or all of the distribution is first treated as a dividend, any remaining distribution is then received tax-free to the extent of basis, and any distribution still remaining is taxed as capital gains. In the case of sale or exchange treatment, however, the shareholder pays tax only to the extent that the amount paid by the company exceeds his or her basis in the stock. Thus, more may be subject to tax with dividend treatment than with sale or exchange treatment.

Your Estate Must Play By The Rules, Too

When you die, your business interest passes to your estate. Your business interest is considered to be constructively owned by your estate. For tax purposes, the business interest is treated as if it is actually owned by the estate. Constructive ownership does not stop with your business interest, though. For taxation purposes, if a beneficiary of your estate also owns a portion of the business, the beneficiary's interest is considered constructively (indirectly) owned by your estate.

Example(s):  Let's say that you own 100 shares of the family business. Lou owns 50 shares of the business and is a beneficiary under your will. You die. The corporation redeems (buys back) your 100 shares in the business from your estate.

Example(s):  Even though your estate sold all of your actual ownership interest back to the business, it doesn't necessarily mean that your estate no longer owns an interest in the business. Because Lou is a beneficiary under your will, your estate is deemed to own his 50 shares of the business under the constructive ownership rules. After the redemption of your 100 shares, your estate is deemed to own Lou's interest because he is a beneficiary of your estate. Your estate's sale of your actual interest in the business would not be considered a complete redemption, because your estate is deemed to still own the 50 shares actually owned by Lou under estate/beneficiary attribution.

Avoiding Attribution of Stock Ownership Among Family Members

The family attribution rules can be waived if the redeeming shareholder meets the following conditions:

1. The shareholder holds no interest in the business other than that of a creditor immediately after the redemption. The shareholder cannot act as an officer, director, or employee.
2. The redeeming shareholder does not acquire any interest in the business (except by bequest or inheritance) for 10 years after the date of redemption.
3. The redeemed shareholder agrees to notify the IRS of any acquisition of a prohibited interest within the 10-year period.
4. None of the stock of the redeemed shareholder was acquired from any related person with the purpose of avoiding federal income tax in the 10 years before the redemption.
5. In the past 10 years, the redeemed shareholder has not disposed of stock for the purpose of income tax avoidance to a related person who still owns stock at the time of the redemption.

The application of the constructive ownership rules can be complex, and the results of poor tax planning can be expensive. It's in your best interest to consult a competent tax advisor when considering a redemption of stock from your family or closely held business.