Hurst v. Comm'r
124 T.C. No. 2, 124 T.C. 16, 2005 U.S. Tax Ct. LEXIS 2 (2005)
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Rule of Law:
A former shareholder does not retain a prohibited proprietary interest in a corporation following a complete stock redemption under IRC § 302(b)(3) merely by holding multiple, cross-collateralized financial arrangements with the corporation, such as promissory notes, a long-term lease, and a spouse's employment contract, provided these arrangements are commercially reasonable and payments are not contingent on the corporation's future earnings.
Facts:
- Richard and Mary Ann Hurst owned Hurst Mechanical, Inc. (HMI), a successful HVAC company, as well as a smaller company, RHI, and the building that HMI occupied.
- In 1997, the Hursts decided to retire and sell their businesses to three key employees, one of whom was their son, Todd Hurst.
- The transaction was structured as a seller-financed buyout payable over 15 years.
- Richard Hurst sold 90% of his HMI stock to HMI itself (a redemption) in exchange for a $2 million promissory note, and the remaining 10% to the new owners for separate notes.
- The Hursts also sold RHI to HMI for a $250,000 note.
- Simultaneously, the Hursts entered into a new 15-year lease agreement to continue renting their building to HMI.
- Mary Ann Hurst signed a 10-year employment contract with HMI to perform administrative tasks in exchange for a modest salary and benefits, including health insurance.
- All agreements—the promissory notes, the building lease, and the employment contract—contained cross-default provisions, allowing Richard Hurst to reclaim the HMI stock if the new owners defaulted on any single obligation.
Procedural Posture:
- Richard and Mary Ann Hurst reported the disposition of their HMI and RHI stock on their 1997 tax return as installment sales qualifying for long-term capital gains treatment.
- The Commissioner of Internal Revenue audited the return and issued a notice of deficiency, recharacterizing the payments as dividends and immediately recognized capital gains.
- The Commissioner determined a total tax deficiency of $538,114 and imposed an accuracy-related penalty of $107,622.80.
- The Hursts, as petitioners, filed a petition in the United States Tax Court to challenge the Commissioner's determination.
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Issue:
Does a former shareholder retain a prohibited 'interest other than as a creditor' under IRC § 302(c)(2)(A), thereby disqualifying a stock redemption from complete termination treatment, when the transaction involves multiple, cross-collateralized agreements including long-term promissory notes for the stock, a 15-year property lease to the corporation, and a 10-year employment contract for the shareholder's spouse?
Opinions:
Majority - Holmes, Judge
No. A former shareholder does not retain a prohibited interest when the collection of financial ties to the corporation are consistent with a creditor's interest. The court analyzed each of the Hursts' continuing connections to HMI—the promissory notes, the building lease, and Mrs. Hurst's employment—and found that none of them constituted a prohibited interest. The payments under these agreements were fixed, were not subordinated to general creditors, and were not contingent on HMI's profitability. The court viewed the cross-default provisions not as a mechanism for retaining control, but as a legitimate and common security arrangement for a creditor financing a high-value transaction with very little money down. Taken together, these arrangements protected the Hursts' legitimate financial interests as creditors and did not give them a continuing proprietary stake or control over HMI's management.
Analysis:
This case provides significant guidance on structuring buyouts of closely-held family businesses to achieve capital gains treatment under IRC § 302(b)(3). The court's decision affirms that a seller can finance the sale and retain multiple, commercially reasonable financial ties to the company without automatically voiding 'complete termination' status. It signals a pragmatic, substance-over-form approach, focusing on whether the arrangements give the seller a 'financial stake' tied to profits versus a protected creditor's interest. This precedent offers a degree of certainty to taxpayers and practitioners designing seller-financed redemptions with complex security arrangements.
