C11-Chp-06-1A-Redemptions-2011

7/30/2019 C11-Chp-06-1A-Redemptions-2011

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Chapter 6A.

CorporateRedemptions

Howard Godfrey, Ph.D., CPAProfessor of Accounting

Edited February 3, 2010Copyright 2010


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The student should be able to:

1. Distinguish between a stockredemption treated as a sale andone treated as a dividend.

2. Explain the tax treatment forpreferred stock bailouts.

3. Determine when Sec. 304 applies toa stock sale and its consequences.


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Distinguish betweena stock redemptiontreated as a saleand onetreated as a dividend.


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Stock Redemptions.

A stock redemption is defined as the

acquisition by a corporation of its ownstock in exchange for property (Sec.317(b)).

The property exchanged can bemoney, securities or any otherproperty that the corporation wants to

use to acquire the stock.The acquired stock may be canceled,retired or held as treasury stock.


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Effect of Redemption on Shareholder -1

When a shareholder's stock is

redeemed by a corporation, thetransaction will either be treated as asale or exchange, or as a dividend.

The reason is that some redemptionsclosely resemble a sale or exchange to

a third party, while others areessentially equivalent to a dividend.


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Effect of Redemption on Shareholder.-2

A redemption qualifies for sale or exchange

treatment if it satisfies any one of the fiveconditions listed on the slides that follow.

Under current law the capital gains rateapplies to both dividends and capital gains.

With exchange treatment, basis of stock issubtracted to get gain, whereas a dividendtreatment applies to 100% of the proceeds,

Corporate shareholders may preferdividend treatment in order to claim a70%, 80%, or 100% dividends-receiveddeduction.


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Corporation redeems stock - buys it back

Individuals often prefer exchange treatment,

(sale of stock) over dividend treatment.A bought 1,000 shares Big Corp. for $80,000.

A sells the stock to Big Corp. for $100,000.

Tax Impact on A Dividend ExchangeAmt. Received for Stock 100,000$ 100,000$

Less: Cost of Stock

Dividend incomeCapital gain or loss

What if Corp. has no Earnings and Profits?


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Corporation redeems stock - buys it back

Individuals often prefer exchange treatment,

(sale of stock) over dividend treatment.A bought 1,000 shares Big Corp. for $80,000.

A sells the stock to Big Corp. for $100,000.

Tax Impact on A Dividend ExchangeAmt. Received for Stock 100,000$ 100,000$

Less: Cost of Stock (80,000)

Dividend income 100,000$Capital gain or loss 20,000$

What if Corp. has no Earnings and Profits?


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Exchange treatment-multiple benefitsFirst, you get to subtract your cost from the

proceeds. This reduces your incomeand may even produce a loss on thetransaction.

Second, the gain is capital gain, which ishas traditionally been subject to a lowertop tax rate (But 2003 Act reduced tax rateon dividend income).

Third, the capital gain may be offset by

unused capital losses.A redemption gets dividend treatment,unless it meets specific criteria.


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Substantially Disproportionate Redemptions.

If a stock redemption qualifies as substantiallydisproportionate under Sec. 302(b)(2), it qualifies

as a sale (Sec. 302(b)(2)). A redemption issubstantially disproportionate if:

1. After the redemption, the shareholder ownsless than 50% of the total combined voting power

of all classes of voting stock;2. After the redemption, the shareholder ownsless than 80% of his percentage ownership ofvoting stock before the redemption; and

3. After the redemption, the shareholder ownsless than 80% of his percentage ownership ofcommon stock (voting or nonvoting) before theredemption.


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Shares 7,000 Shares 3,000

Cost/share $100 Cost/share $100

FMV/ share $300 FMV/ share $300

Total Value $2,100,000 Total Value $900,000

Redeem 3,000 shares from Jones at $300/share.Does Jones have dividend or capital gain?

What if 5,000 are redeemed from Jones at $300?

Local Cor orationOwned by Jones & Smith (not related)

Jones Owns: Smith Owns:


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Before After

Jones 7,000 4,000Smith 3,000 3,000

Total 10,000 7,000

Jones % 70% 57%Does Jones meet 80% test?

Does Jones meet 50% test?

Shares

Local Corp. Redemption

See Previous Slide


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Selling Price

Per share $300No. of Shares 3,000

Total Price $900,000

Dividend Income $900,000


See Previous Slide


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Before After

Jones 7,000 2,000Smith 3,000 3,000

Total 10,000 5,000

Jones % 70% 40%Does Jones meet 80% test?

Does Jones meet 50% test?

Shares


See Previous Slide


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Selling PricePer share $300

No. of Shares 5,000

Total Price $1,500,000

Cost $100

Shares 5,000Total Cost $500,000

Gain $1,000,000


See Previous Slide


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Complete Termination of theShareholder's Interest.

A redemption qualifies as a sale if itsatisfies the requirements for acomplete termination under Sec.

302(b)(3). If a shareholder's interest ina corporation is completelyterminated, the family attribution rules

of Sec. 318(a)(1) may be waived andother family members may continue toown the stock.


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In order to waive the family attribution rules, thefollowing requirements must be met:

1. Shareholder must not retain any interest in the

corp. after the redemption except as a creditor.2. Shareholder must not acquire any such interest

(other than by bequest or inheritance) for atleast ten years from the date of the redemption.

3. Shareholder must file a written agreement thatthe IRS will be notified if any prohibited interestis acquired. The written agreement allows theIRS to assess additional taxes for the year of

the distribution if the prohibited interest isacquired, even if the basic three-year statute oflimitations has run.


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Waiver of family attribution rules not permitted if:1. Part or all of the stock redeemed was acquired

within the past 10 years from a person whose

stock ownership would be attributable (at thetime of the distribution) to the distributee underSec. 318.

2. Any person who owns (at the time of thedistribution) stock of the redeeming corporation

the ownership of which is attributable to thedistributee under Sec. 318 and such personacquired any stock in the redeemingcorporation, directly or indirectly, from thedistributee within the 10-year period ending onthe distribution date.

These prohibitions do not apply if the distributeecan show that the acquisition or disposition ofthe stock did not have a tax avoidance purpose.


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Redemptions Not Essentially Equivalent to Dividend.Section 302(b)(1) provides that a stockredemption is treated as a sale if it is not

essentially equivalent to a dividend. TheSupreme Court's decision in Maclin P. Davisprovides us with some criteria to follow. TheSupreme Court held that (1) business purpose isirrelevant in determining whether a redemption is

essentially equivalent to a dividend, (2) the Sec.318 attribution rules must be used to determinedividend equivalency, and (3) a redemption ofpart of a sole shareholder's stock is alwaysessentially equivalent to a dividend. There mustbe a "meaningful reduction" in the shareholder'sproportionate interest in the corporation aftertaking into account the constructive ownershiprules of Sec. 318(a) to qualify under Sec.

302(b)(1).


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Partial Liquidations.

A partial liquidation occurs when a corp.

discontinues one line of business,distributes those assets to theshareholders, and continues in at least oneother line of business. Under Sec.

302(b)(4), a redemption also qualifies as apartial liquidation if the distribution is notessentially equivalent to a dividend. Ineither case, the distribution must be madewithin the tax year in which the plan ofpartial liquidation is adopted or within thesucceeding year.


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Determination Made at Corporate Level.

The determination that adistribution is not essentiallyequivalent to a dividend is

made at the corporate level.The distribution must result in

a bona fide contraction of thecorporation's business.


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Safe Harbor Rule.Distribution qualifies as a partial liquidation

if:a. The distribution is attributable to thedistributing corporation's ceasing toconduct a qualifying trade or business, or

consists of the assets of a qualifying tradeor business.

b. Immediately after the distribution, the

distributing corporation is engaged in theactive conduct of at least one qualifyingtrade or business.


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Effect of Partial Liquid. on Shareholders.

A distribution qualifying as a partial

liquidation is treated as a sale of stock for anoncorporate shareholder. For a corporateshareholder, the same transaction is

treated as a dividend unless the transactionqualifies for sale treatment under one of theother Sec. 302(b) provisions. Dividendtreatment may be preferred by a corporate

shareholder in order to take advantage ofthe 70%, 80%, or 100% dividends-receiveddeduction.


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Redemptions to Pay Death Taxes. -1

If corporate stock ris a substantial portion of a decedent'sgross estate, a redemption of the stock by the estate or its

beneficiary may qualify for sale treatment. Under, Section303 a redemption of stock that was included in thedecedent's gross estate is treated as a sale of stock by theshareholder if the following conditions are met:

1. The value of the redeeming corporation's stockincluded in the decedent's gross estate is more than 35%of the value of the adjusted gross estate.

2. The maximum amount of the redemption distribution

that can qualify for sale treatment is the sum of all federaland state estate and inheritance taxes, plus any interestdue on those taxes, and all funeral and administrativeexpenses that are allowable as deductions on the federalestate tax return.


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Redemptions to Pay Death Taxes. -23. Section 303 applies to the redemption

distribution only to the extent that the recipient

shareholder's interest in the estate is reducedby the payment of death taxes and funeral andadministrative expenses.

4. Redemption must take place within 90 days

after the expiration of the statute of limitationsfor the assessment of the federal estate tax.

5. The stock of two or more corporations can beaggregated in order to satisfy the 35%

requirement, provided 20% or more of the valueof each corporation's outstanding stock isincluded in the gross estate.


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Effect of Redemptions on Distributing Corp.

1. Corporate Gain or Loss on PropertyDistributions.

The rules for the recognition of gain or loss by acorporation that distributes property inredemption of its stock are:

a. The corporation recognizes gain when itdistributes appreciated property in redemption ofits stock as if it had sold the property immediatelybefore the redemption. The character of the gaindepends on the character of the distributed

property.b. The corporation does not recognize any lossrealized when it distributes property that hasdeclined in value.


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2. Effect of Redemptions on E&P.

If appreciated property is distributed, the gain(net of taxes) is included in the E&P account.

If the redemption is treated as a dividend by theshareholder, the corporation must reduce E&P bythe amount of money, the principal amount of anyobligation, and the FMV of any other property

distributed.If the redemption qualifies as a sale, current andaccumulated E&P balances are reduced by theportion of E&P attributable to the redeemed

stock, but not by more than the actual redemptiondistribution amount. The remainder of thedistribution reduces the corporation's paid-incapital account.


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Shares owned b Don 1,000

Don's total basis in stock $2,000Balance of CCor E&P $5,000CCor redeems 500shares of stock for: $3,500

What does Don Report?

a. $2,500 dividend income.b. $2,500 ca ital ain.c. $3,500 dividend income.d. $3,500 ca ital ain.

Don is sole owner of CCor .


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Shares owned by Don 1,000Don's total basis in stock $2,000

Balance of CCorp E&P $5,000

CCorp redeems 500

shares of stock for: $3,500

What does Don Report?

c. 3 500 dividend income.

Don is sole owner of CCorp.


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Balance in E & P $100,000

No. of Shares owned by Karen 2,000No. of Shares owned by Bob 2,000

Basis of each share $20

FMV of each share $30Big redeems 1,000 shares from each

shareholder. Big pays $30 for each

share. What does Karen Report?

c. $ - 0 d. $10,000 Capital gain

b. $ 30,000 Capital gain.a. $ 30,000 Dividend income.

Karen & Bob own 100% of Bi Co.


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Balance in E & P $100,000

No. of Shares owned by Karen 2,000

No. of Shares owned by Bob 2,000

Basis of each share $20

FMV of each share $30

Big redeems 1,000 shares from each

shareholder. Big pays $30 for eachshare. What does Karen Report?

a. $ 30,000 Dividend income.

Karen & Bob own 100% of Big Co.


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Stock Redemption in Divorce-1

Big Manufacturing Company

Company Assets -FMV $5,000,000

Company Debt $3,000,000

Company Stock - FMV $2,000,000There are 2,000 shares outstanding.

Each share of stock is worth $1,000.

Corporation was built with retained

earnings & has large cash reserves.


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Stock Redemption in Divorce-2

Husband owns all stock of company.

Husband's stock basis: $300 per share.Husband's stock FMV: $1,000 per share.

In the divorce, Wife wants $1,000,000.

They are considering the following:

Husband has the corporation redeem

1,000 of his shares for $1,000,000.

Husband gives $1,000,000 to Wife.

Husband gives 1,000 shares to wife.

Corp. redeems her stock for $1,000,000.

Does the choice make a difference?


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Explain the taxtreatment for

preferred stockbailouts.


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Preferred Stock Bailouts.

The rules for stock redemptions were

added to the IRC to permit sale treatmentfor stock redemptions under certainspecific circumstances and to requiredividend treatment in all other situations.

In most cases, taxpayers prefer saletreatment. Consequently taxpayers havedevised methods to circumvent Congress's

intent. One such method, devised prior toenactment of the IRC of 1954, is known asthe preferred stock bailout.

S 306 S k D fi d S 306 k i


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Sec. 306 Stock Defined. Sec. 306 stock is:1. Stock (other than common stock issued with

respect to common stock), which is received as anontaxable stock dividend.

2. Stock (other than common stock) received in a tax-free corporate reorg. or division if the effect of thetransaction was substantially the same as thereceipt of a stock dividend, or if the stock was

received in exchange for Sec. 306 stock.3. Stock with basis determined by reference to thebasis of Sec. 306 stock. One example of thiscategory of Sec. 306 stock is stock received as agift.

4. Stock (other than common stock) acquired in anexchange to which Sec. 351 applies if the receipt ofmoney (in lieu of the stock) would have beentreated as a dividend.


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Preferred stock issued by a corporationwith no current or accumulated E&P is notSec. 306 stock.

B. Dispositions of Sec. 306 Stock. If ashareholder sells or otherwise disposes ofSec. 306 stock, the amount realized is

treated as ordinary income to the extent itwould have been treated as a dividend atthe time of the distribution if money hadbeen distributed rather than stock. The

2003 Act takes much of the sting out of thistreatment by taxing dividends at amaximum rate of 15%.


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Redemptions of Sec. 306 Stock.

If Sec. 306 stock is redeemed by theissuing corporation, the amountrealized is a dividend to the extent of

E&P in the year of redemption.Any amount received in excess of E&Pis first a recovery of basis and then

gain from sale or exchange of thestock.


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Exceptions to Sec. 306 Treatment.

Sec. 306 does not apply in these situations:

1. A shareholder sells all of his or hercommon and preferred stock in acorporation, thus completely terminating

his or her interest in the corporation.2. The corporation redeems all of the

shareholder's common and preferred

stock, completely terminating theshareholder's interest in the corporation.


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Big Corporation - Slide 1 of 2Mr. Smart owns all of the 1,000 shares of Big. Corp.

Big Corp. has invested capital of $100,000

and retained earnings of $500,000.

Big Corp. pays Mr. Smart a stock dividend

of 100 shares of 8%, $100 par preferredPreferred stock has a market value of $100.

Smart allocates basis of $60 to each preferred share.

Later Mr. Smart sells all of the preferredto a neighbor for $125 per share.

What is the tax impact of these transactions?


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Dividend Capital When recognized?Income Gain When Smart :

a. $10,000 $0 receives preferred stk

b. $6,000 $0 sells preferred stock

c. $10,000 $0 sells preferred stock

d. $6,000 $2,500 sells preferred stock

Big Corporation - Slide 2 of 2


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Determine when

Sec. 304 appliesto a stock sale and

its consequences.

St k R d ti B R l t d C ti


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Stock Redemptions By Related Corporations.

A. Brother-Sister Corporations.

Brother-sister corporations occur whereone or more shareholders are in control ofeach of two corporations and a parent-subsidiary relationship is not present.

Control means ownership of at least 50% ofthe voting power, or 50% of the total valueof all stock of the corporation. If acontrolling shareholder sells stock of onecorporation to the other corporation inexchange for property, the exchange isrecast as a redemption.

If th d ti d t lif l


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If the redemption does not qualify as a sale,it is treated as a dividend made first by theacquiring corporation to the extent of its

E&P, and then by the issuing corporation tothe extent of its E&P.

The shareholder's basis in the issuing

corporation's stock that was sold is addedto his or her basis for the acquiringcorporation's stock.

The acquiring corporation takes the samebasis in the issuing corporation's sharesthat the shareholder had.


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If the redemption qualifies as

a sale, the shareholder'srecognized gain or loss isthe difference between theamount received from theacquiring corporation and

the shareholder's basis inthe surrendered shares.

Parent Subsidiary Corporations


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Parent-Subsidiary Corporations.

If a shareholder sells stock in a parent corp. to asub. of the parent, the exchange is treated as aredemption of part or all of the shareholder'sstock in the parent. For this purpose, a parent-sub relationship exists if one corp owns at least50% of the voting power or 50% of the value of allstock in the subsidiary.

If the redemption is not a sale, it is treated as adividend from the sub. to the extent of its E&Pand then from the parent to the extent of its E&P.As in the case of Sec. 306, dividend treatmentresults in the gain being taxed at a maximum rateof 15%. The shareholder's basis in his or herremaining parent corporation stock is increasedby his or her basis in the stock transferred to thesubsidiary.

A idi U bl C ti


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Avoiding Unreasonable Compensation.Corporations can avoid the double taxationproblem associated with a constructive

dividend by entering into a hedgeagreement with a shareholder-employee,which obligates the shareholder to repay

any portion of the salary that is disallowedby the IRS as a deduction. Theshareholder-employee deducts the amountof the repayment under Sec. 162 in the year

the repayment is made, provided that alegal obligation exists under state law tomake the payment.

Bootstrap Acquisition


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Bootstrap Acquisition.A prospective buyer who wants to acquire acorp. may not have sufficient cash to make

the purchase. Corporate funds may beused to make part of the purchase.This can be accomplished by having theseller sell part of his stock to the purchaser

and having the corporation redeem theremainder of the seller's stock.Such an arrangement is called a bootstrapacquisition. Care must be taken to structurethe transaction so that a constructivedividend does not occur when thecorporation redeems some of the stock.

Ti i f Di t ib ti


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Timing of Distribution.

If distributions can betimed to be made whenthe corporation has littleor no E&P,the distributions are

treated as a return ofcapital.

C li & P d l C id ti


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Compliance & Procedural Considerations.

A corporation that makes a nondividend

distribution to its shareholders must fileForm 5452 (Corporate Report ofNondividend Distributions).

In order to waive the family attributionrules, a statement must be attached to thefirst return filed by the shareholder in theyear of redemption stating that he will

notify the IRS if any prohibited interest isacquired within the ten-year periodfollowing redemption. Sec. 302(b)(3).


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