Chapter 6A.

Corporate Redemptions

Howard Godfrey, Ph.D., CPA Professor of Accounting

Edited February 3, 2010 Copyright 2010 1

The student should be able to: 1. Distinguish between a stock redemption treated as a sale and one treated as a dividend. 2. Explain the tax treatment for preferred stock bailouts. 3. Determine when Sec. 304 applies to a stock sale and its consequences.

Distinguish between a stock redemption treated as a sale and one treated as a dividend.

Stock Redemptions.

A stock redemption is defined as the acquisition by a corporation of its own stock in exchange for property (Sec. 317(b)). The property exchanged can be money, securities or any other property that the corporation wants to use to acquire the stock. The acquired stock may be canceled, retired or held as treasury stock. 4

Effect of Redemption on Shareholder -1 When a shareholder's stock is redeemed by a corporation, the transaction will either be treated as a sale or exchange, or as a dividend. The reason is that some redemptions closely resemble a sale or exchange to a third party, while others are essentially equivalent to a dividend. 5

Effect of Redemption on Shareholder.-2 A redemption qualifies for sale or exchange treatment if it satisfies any one of the five conditions listed on the slides that follow. Under current law the capital gains rate applies to both dividends and capital gains. With exchange treatment, basis of stock is subtracted to get gain, whereas a dividend treatment applies to 100% of the proceeds, Corporate shareholders may prefer dividend treatment in order to claim a 70%, 80%, or 100% dividends-received deduction.

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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 Amt. Received for Stock Less: Cost of Stock Dividend income Capital gain or loss Dividend $ 100,000 Exchange $ 100,000 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 Amt. Received for Stock Less: Cost of Stock Dividend income Capital gain or loss Dividend $ 100,000 $ 100,000 Exchange $ 100,000 (80,000) $ 20,000 What if Corp. has no Earnings and Profits?

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Exchange treatment-multiple benefits First, you get to subtract your cost from the proceeds. This reduces your “income” and may even produce a loss on the transaction. Second, the gain is capital gain, which is has traditionally been subject to a lower top tax rate (But 2003 Act reduced tax rate on dividend income). Third, the capital gain may be offset by unused capital losses. A redemption gets dividend treatment, unless it meets specific criteria. 9

Substantially Disproportionate Redemptions . If a stock redemption qualifies as substantially disproportionate under Sec. 302(b)(2), it qualifies as a sale (Sec. 302(b)(2)). A redemption is substantially disproportionate if: 1.

After the redemption, the shareholder owns less than 50% of the total combined voting power of all classes of voting stock; 2.

After the redemption, the shareholder owns less than 80% of his percentage ownership of voting stock before the redemption; and 3.

After the redemption, the shareholder owns less than 80% of his percentage ownership of common stock (voting or nonvoting) before the redemption.

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Local Corporation

Owned by Jones & Smith (not related) Jones Owns: Smith Owns: Shares Cost/share FMV/ share 7,000 Shares $100 Cost/share $300 FMV/ share 3,000 $100 $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?

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Local Corp. Redemption See Previous Slide Shares Before After Jones Smith Total Jones % 7,000 3,000 10,000 70% 4,000 3,000 7,000 57% Does Jones meet 80% test?

Does Jones meet 50% test?

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Local Corp. Redemption See Previous Slide Selling Price Per share No. of Shares $300 3,000 Total Price $900,000 Dividend Income $900,000

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Local Corp. Redemption See Previous Slide Shares Before After Jones Smith Total 7,000 3,000 10,000 2,000 3,000 5,000 Jones % 70% 40% Does Jones meet 80% test?

Does Jones meet 50% test?

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Local Corp. Redemption See Previous Slide Selling Price Per share No. of Shares Total Price Cost Shares $100 5,000 $300 5,000 $1,500,000 Total Cost Gain $500,000 $1,000,000 15

Complete Termination of the Shareholder's Interest.

A redemption qualifies as a sale if it satisfies the requirements for a complete termination under Sec. 302(b)(3). If a shareholder's interest in a corporation is completely terminated, the family attribution rules of Sec. 318(a)(1) may be waived and other family members may continue to own the stock.

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In order to waive the family attribution rules, the following 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 at least ten years from the date of the redemption.

3. Shareholder must file a written agreement that the IRS will be notified if any prohibited interest is acquired. The written agreement allows the IRS to assess additional taxes for the year of the distribution if the prohibited interest is acquired, even if the basic three-year statute of limitations has run. 17

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 the time of the distribution) to the distributee under Sec. 318.

2. Any person who owns (at the time of the distribution) stock of the redeeming corporation the ownership of which is attributable to the distributee under Sec. 318 and such person acquired any stock in the redeeming corporation, directly or indirectly, from the distributee within the 10-year period ending on the distribution date.

These prohibitions do not apply if the distributee can show that the acquisition or disposition of the 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 stock redemption is treated as a sale if it is not essentially equivalent to a dividend. The Supreme Court's decision in Maclin P. Davis provides us with some criteria to follow. The Supreme Court held that (1) business purpose is irrelevant in determining whether a redemption is essentially equivalent to a dividend, (2) the Sec. 318 attribution rules must be used to determine dividend equivalency, and (3) a redemption of part of a sole shareholder's stock is always essentially equivalent to a dividend. There must be a "meaningful reduction" in the shareholder's proportionate interest in the corporation after taking into account the constructive ownership rules of Sec. 318(a) to qualify under Sec. 302(b)(1). 19

Partial Liquidations.

A partial liquidation occurs when a corp. discontinues one line of business, distributes those assets to the shareholders, and continues in at least one other line of business. Under Sec. 302(b)(4), a redemption also qualifies as a partial liquidation if the distribution is not essentially equivalent to a dividend. In either case, the distribution must be made within the tax year in which the plan of partial liquidation is adopted or within the succeeding year.

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Determination Made at Corporate Level.

The determination that a distribution is not essentially equivalent to a dividend is made at the corporate level. The distribution must result in a bona fide contraction of the corporation's business.

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Safe Harbor Rule.

Distribution qualifies as a partial liquidation if: a.

The distribution is attributable to the distributing corporation's ceasing to conduct a qualifying trade or business, or consists of the assets of a qualifying trade or business.

b.

Immediately after the distribution, the distributing corporation is engaged in the active conduct of at least one qualifying trade 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 a noncorporate shareholder. For a corporate shareholder, the same transaction is treated as a dividend unless the transaction qualifies for sale treatment under one of the other Sec. 302(b) provisions. Dividend treatment may be preferred by a corporate shareholder in order to take advantage of the 70%, 80%, or 100% dividends-received deduction. 23

Redemptions to Pay Death Taxes. -1 If corporate stock ris a substantial portion of a decedent's gross estate, a redemption of the stock by the estate or its beneficiary may qualify for sale treatment. Under, Section 303 a redemption of stock that was included in the decedent's gross estate is treated as a sale of stock by the shareholder if the following conditions are met: 1. The value of the redeeming corporation's stock included 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 federal and state estate and inheritance taxes, plus any interest due on those taxes, and all funeral and administrative expenses that are allowable as deductions on the federal estate tax return.

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Redemptions to Pay Death Taxes. -2 3. Section 303 applies to the redemption distribution only to the extent that the recipient shareholder's interest in the estate is reduced by the payment of death taxes and funeral and administrative expenses.

4. Redemption must take place within 90 days after the expiration of the statute of limitations for the assessment of the federal estate tax. 5. The stock of two or more corporations can be aggregated in order to satisfy the 35% requirement, provided 20% or more of the value of each corporation's outstanding stock is included in the gross estate. 25

Effect of Redemptions on Distributing Corp.

1. Corporate Gain or Loss on Property Distributions.

The rules for the recognition of gain or loss by a corporation that distributes property in redemption of its stock are: a.

The corporation recognizes gain when it distributes appreciated property in redemption of its stock as if it had sold the property immediately before the redemption. The character of the gain depends on the character of the distributed property.

b.

The corporation does not recognize any loss realized when it distributes property that has declined 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 the shareholder, the corporation must reduce E&P by the amount of money, the principal amount of any obligation, and the FMV of any other property distributed. If the redemption qualifies as a sale, current and accumulated E&P balances are reduced by the portion of E&P attributable to the redeemed stock, but not by more than the actual redemption distribution amount. The remainder of the distribution reduces the corporation's paid-in capital account. 27

Don is sole owner of CCorp.

Shares owned by Don 1,000 Don's total basis in stock Balance of CCorp E&P CCorp redeems 500 shares of stock for: What does Don Report?

a. $2,500 dividend income. b. $2,500 capital gain.

c. $3,500 dividend income. d. $3,500 capital gain. $2,000 $5,000 $3,500 28

Don is sole owner of CCorp.

Shares owned by Don 1,000 Don's total basis in stock Balance of CCorp E&P CCorp redeems 500 shares of stock for: What does Don Report?

$2,000 $5,000 $3,500 c. $3,500 dividend income.

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Karen & Bob own 100% of Big Co.

Balance in E & P $100,000 No. of Shares owned by Karen 2,000 No. of Shares owned by Bob Basis of each share FMV of each share 2,000 $20 $30 Big redeems 1,000 shares from each shareholder. Big pays $30 for each share. What does Karen Report?

a. $ 30,000 Dividend income. b. $ 30,000 Capital gain. c. $ - 0 – d. $10,000 Capital gain 30

Karen & Bob own 100% of Big Co.

Balance in E & P $100,000 No. of Shares owned by Karen No. of Shares owned by Bob Basis of each share FMV of each share 2,000 2,000 $20 $30 Big redeems 1,000 shares from each shareholder. Big pays $30 for each share. What does Karen Report?

a. $ 30,000 Dividend income. 31

Stock Redemption in Divorce-1

Big Manufacturing Company Company Assets -FMV $5,000,000 Company Debt Company Stock - FMV $3,000,000 $2,000,000 There are 2,000 shares outstanding.

Each share of stock is worth $1,000.

Corporation was built with retained earnings & has large cash reserves. 32

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? 33

Explain the tax treatment for preferred stock bailouts.

Preferred Stock Bailouts. The rules for stock redemptions were added to the IRC to permit sale treatment for stock redemptions under certain specific circumstances and to require dividend treatment in all other situations. In most cases, taxpayers prefer sale treatment. Consequently taxpayers have devised methods to circumvent Congress's intent. One such method, devised prior to enactment of the IRC of 1954, is known as the preferred stock bailout.

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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 a nontaxable stock dividend.

2. Stock (other than common stock) received in a tax free corporate reorg. or division if the effect of the transaction was substantially the same as the receipt of a stock dividend, or if the stock was received in exchange for Sec. 306 stock.

3. Stock with basis determined by reference to the basis of Sec. 306 stock. One example of this category of Sec. 306 stock is stock received as a gift.

4. Stock (other than common stock) acquired in an exchange to which Sec. 351 applies if the receipt of money (in lieu of the stock) would have been treated as a dividend.

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Preferred stock issued by a corporation with no current or accumulated E&P is not Sec. 306 stock.

B. Dispositions of Sec. 306 Stock. If a shareholder sells or otherwise disposes of Sec. 306 stock, the amount realized is treated as ordinary income to the extent it would have been treated as a dividend at the time of the distribution if money had been distributed rather than stock. The 2003 Act takes much of the sting out of this treatment by taxing dividends at a maximum rate of 15%.

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Redemptions of Sec. 306 Stock.

If Sec. 306 stock is redeemed by the issuing corporation, the amount realized is a dividend to the extent of E&P in the year of redemption. Any amount received in excess of E&P is first a recovery of basis and then gain from sale or exchange of the stock. 38

Exceptions to Sec. 306 Treatment. Sec. 306 does not apply in these situations: 1. A shareholder sells all of his or her common and preferred stock in a corporation, 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 the shareholder's interest in the corporation.

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Big Corporation - Slide 1 of 2

Mr. 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 preferred Preferred stock has a market value of $100. Smart allocates basis of $60 to each preferred share. Later Mr. Smart sells all of the preferred to a neighbor for $125 per share. What is the tax impact of these transactions?

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b.

c.

d.

a.

Big Corporation - Slide 2 of 2

Dividend Income Capital When recognized?

Gain When Smart : $10,000 $0 receives preferred stk $6,000 $10,000 $6,000 $0 $0 sells preferred stock sells preferred stock $2,500 sells preferred stock 41

Determine when Sec. 304 applies to a stock sale and its consequences.

Stock Redemptions By Related Corporations.

A. Brother-Sister Corporations. Brother-sister corporations occur where one or more shareholders are in control of each of two corporations and a parent subsidiary relationship is not present. Control means ownership of at least 50% of the voting power, or 50% of the total value of all stock of the corporation. If a controlling shareholder sells stock of one corporation to the other corporation in exchange for property, the exchange is recast as a redemption.

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If the redemption does not qualify as a sale, it is treated as a dividend made first by the acquiring corporation to the extent of its E&P, and then by the issuing corporation to the extent of its E&P. The shareholder's basis in the issuing corporation's stock that was sold is added to his or her basis for the acquiring corporation's stock. The acquiring corporation takes the same basis in the issuing corporation's shares that the shareholder had. 44

If the redemption qualifies as a sale, the shareholder's recognized gain or loss is the difference between the amount received from the acquiring corporation and the shareholder's basis in the surrendered shares.

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Parent-Subsidiary Corporations.

If a shareholder sells stock in a parent corp. to a sub. of the parent, the exchange is treated as a redemption of part or all of the shareholder's stock in the parent. For this purpose, a parent sub relationship exists if one corp owns at least 50% of the voting power or 50% of the value of all stock in the subsidiary. If the redemption is not a sale, it is treated as a dividend from the sub. to the extent of its E&P and then from the parent to the extent of its E&P. As in the case of Sec. 306, dividend treatment results in the gain being taxed at a maximum rate of 15%. The shareholder's basis in his or her remaining parent corporation stock is increased by his or her basis in the stock transferred to the subsidiary. 46

Avoiding Unreasonable Compensation.

Corporations can avoid the double taxation problem associated with a constructive dividend by entering into a hedge agreement with a shareholder-employee, which obligates the shareholder to repay any portion of the salary that is disallowed by the IRS as a deduction. The shareholder-employee deducts the amount of the repayment under Sec. 162 in the year the repayment is made, provided that a legal obligation exists under state law to make the payment. 47

Bootstrap Acquisition.

A prospective buyer who wants to acquire a corp. may not have sufficient cash to make the purchase. Corporate funds may be used to make part of the purchase. This can be accomplished by having the seller sell part of his stock to the purchaser and having the corporation redeem the remainder of the seller's stock. Such an arrangement is called a bootstrap acquisition. Care must be taken to structure the transaction so that a constructive dividend does not occur when the corporation redeems some of the stock. 48

Timing of Distribution.

If distributions can be timed to be made when the corporation has little or no E&P, the distributions are treated as a return of capital.

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Compliance & Procedural Considerations.

A corporation that makes a nondividend distribution to its shareholders must file Form 5452 (Corporate Report of Nondividend Distributions).

In order to waive the family attribution rules, a statement must be attached to the first return filed by the shareholder in the year of redemption stating that he will notify the IRS if any prohibited interest is acquired within the ten-year period following redemption. Sec. 302(b)(3). 50

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