Ken and Marilyn Hert started a business in 1972 in a C corporation form. Ken is 72 years old and Marilyn is 70.  The business struggled for many years but has now become very profitable. The Herts have two children, Fred, age 46, and Jessica, age 43. The children worked in the business while in high school and college but then pursued their own interests. Three years ago Ken and Marilyn became increasingly concerned about the ownership succession plan for the business. After discussing the issue with their kids, they decided to make a gift of 10% of the company to each of the children. So Ken now owns 40%, Marilyn 40%, Fred 10%, and Jessica 10%. The gifts were necessary to induce the kids to begin working in the business with the objective of eventually turning over ownership to the kids. 

In 2011 the corporation made an S election and has been an S corporation since that time. 

Ken and Marilyn are now comfortable with the idea of retiring and turning the business over to Fred and Jessica. They propose to redeem their shares so that the two children own 100% of the company.  The business is valued at $11.2 Million.  The corporation produces sufficient cash flow that Ken and Marilyn believe that their shares can be purchased over 12 years. They propose to sell 1/12 of their shares each year for the next 12 years. To permit sufficient cash flow to fund the share repurchase, and to allow Fred and Jessica to continue to receive a reasonable salary, Ken and Marilyn propose to continue to provide advice and occasional work to the company, but to receive no salary. They are also open to other suggestions. 

Corporate E&P is $860,000. The AAA is currently $1,150,000. Ken and Marilyn each have a tax basis in their shares of $400,000.

 

Required

Prepare a memo to Ken and Marilyn that addresses the tax consequences of a redemption of their shares. If you believe there are alternative structures, you should address those and explain the consequences of the alternatives identified. You should recommend a structure and make clear why this is your recommendation.