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1. Chapter 6 Corporations: Redemptions and Liquidations

2. Redemption A corporation�s acquisition of its own stock in exchange for corporate property. The property could be cash, securities of other corporations, or any other consideration the corporation wants to use. The corporation may cancel, retire, or retain the acquired stock. When might a redemption be desirable?

3. Redemption � These questions must be answered What is the amount & character of income, gain, or loss recognized? What is the shareholder�s basis in any property received? When does the holding period for the property begin? What is the shareholder�s basis in any stock still held after the redemption?

4. Redemption � These questions must be answered What is the amount & character of gain or loss that the corporation must recognized when it redeems the stock with noncash property? What is the effect on the corporation�s E & P?

5. Effect of Redemption If qualified as a redemption: Resembles a sale with capital gain treatment Shareholder reports gain or loss on surrender of stock Gain taxed at favorable capital gains rates (5%/15%) Shareholder reduces gain by basis in stock redeemed

6. Effect of Redemption If transaction has appearance of a dividend, redemption will not be qualified: For example, if shareholder owns 100% and corporation buys � of stock for $X, shareholder still owns 100% Effect would be similar where there is a pro rata redemption among all shareholders

7. Effect of Redemption If not qualified as a redemption: Shareholder reports dividend income (if adequate E & P) Individual shareholders may be taxed at 5%/15% rates But, redemption proceeds may not be offset by basis in stock surrendered All other rules relating to property distributions that were discussed in the last chapter apply Corporate shareholders may prefer dividend treatment because of the dividends received deduction

8. Transactions Treated as Redemptions The following types of distributions may be treated as a redemption of stock rather than as a dividend: Distributions not essentially equivalent to a dividend (subjective test) Disproportionate distributions (mechanical rules)

9. Transactions Treated as Redemptions Distributions in termination of shareholder�s interest (mechanical rules) Partial liquidations of a corporation where shareholder is not a corporation, and either (1) Distribution is not essentially equivalent to a dividend, or (2) An active business is terminated (May be subjective (1) or mechanical (2))

10. Transactions Treated as Redemptions Distributions to pay death taxes (limitation on amount of allowed distribution is mechanical test) Stock attribution rules must be applied, so distribution which appears to meet requirements may not qualify

11. Stock Attribution �318 Qualified stock redemption must result in substantial reduction in shareholder�s ownership Stock ownership by certain related parties is attributed back to shareholder whose stock is redeemed

12. Stock Attribution Attribution from family members Stock owned by spouse, children, grandchildren, or parents attributed back to individual

13. Example H & W are married and have one son, S. H, W, S, & W�s father, F, each own 25% of D Corp�s outstanding stock. Under the attribution rules, what would each own? (Stock that has been attributed to one family member, cannot be reattributed to another family member.)

14. Stock Attribution Attribution from entity to owner Partnership: stock owned by the partnership is owned proportionally by the partners Example: If partner owns a 30% interest in the Partnership, he/she owns 30% of the stock the partnership owns

15. Stock Attribution Attribution from entity to owner Estate or trust: Beneficiaries own a proportionate share of stock owned by the estate or trust.

16. Stock Attribution Attribution from entity to owner Corporation: Stock is owned proportionately only by shareholders owning either directly or indirectly at least 50% of stock.

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18. Stock Attribution Attribution from owner to entity Partnership: deemed owner of total shares owned by partner Estate or trust: deemed owner of total shares owned by heir or beneficiary Corporation: deemed owner of total shares owned by 50% or more shareholder In previous example, what result?

19. Stock Attribution Family attribution rules do not apply to redemptions in complete termination of shareholder�s interest Stock attribution rules do not apply to partial liquidations or redemptions to pay death taxes

20. Not Essentially Equivalent Redemptions Redemption qualifies for sale or exchange treatment if �not essentially equivalent to a dividend� Subjective test Provision was added to deal specifically with redemptions of preferred stock Shareholders often have no control over when preferred shares redeemed Also applies to common stock redemptions

21. Not Essentially Equivalent Redemptions To qualify, redemption must result in a meaningful reduction in shareholder�s interest in redeeming corp Stock attribution rules apply

22. Not Essentially Equivalent Redemptions If redemption is treated as ordinary dividend Basis in stock redeemed attaches to remaining stock owned (directly or constructively)

23. Not Essentially Equivalent Redemptions See U.S. v. Davis, 397 U.S. 301, 90 S.Ct. 1041,70-1 USTC �9289 (1970) �Meaningful reduction� is uncertain This is used as a last resort Critical factors appear to be shareholders� right to vote and exercise control of the corporation.

24. Qualifying Disproportionate Redemption Redemption qualifies as disproportionate redemption if: Shareholder owns less than 80% of the interest owned prior to redemption Shareholder owns less than 50% of the total combined voting power in the corporation after the redemption

25. Qualifying Disproportionate Redemption

26. Qualifying Disproportionate Redemption

27. Qualifying Disproportionate Redemption Shareholder has 46 2/3% ownership represented by 35 voting shares (60-25) of 75 (100-25) outstanding voting shares Redemption is qualified disproportionate redemption because: Shareholder owns < 80% of the 60% owned prior to redemption (80% � 60% = 48%), and Shareholder owns < 50% of total combined voting power of corporation

28. Complete Termination Redemptions Termination of entire interest generally qualifies for sale or exchange treatment Often will not qualify as disproportionate redemption due to stock attribution rules Family attribution rules will not apply if: Former shareholder has no interest (other than as creditor) for at least 10 years Agree to notify IRS of any disallowed interest within 10 year period

29. Complete Termination Redemptions Example: M & daughter, D, started a corporation 15 years ago. Each owned 50 shares out of 100 shares of stock outstanding. M wants to retire. D wants to continue but has insufficient funds to purchase the stock. Corp. redeems all 50 shares Would not qualify as disproportionate distribution since D deemed to own 100% of stock before & after But attribution rules do not apply to a complete redemption

30. Complete Termination Redemptions To waive the attribution rules, these conditions must be met: Shareholder cannot retain any interest in the corporation except creditor Shareholder cannot acquire an interest for at least 10 years after the redemption (except for an inheritance.) Shareholder must file an agreement stating will notify IRS if interest acquired See Lynch v. Com., 801 F.2d 1176, 58 AFTR 2d 86-5970, 86-2 USTC �9731 (9th Cir. 1986)

31. Redemptions in Partial Liquidation Noncorporate shareholder gets sale or exchange treatment for partial liquidation including: Distribution not essentially equivalent to a dividend Distribution pursuant to termination of an active business

32. Redemptions in Partial Liquidation To qualify, distribution must be made within taxable year plan is adopted or the succeeding taxable year Not essentially equivalent test looks at effect on corporation Requires genuine contraction of the business of the corporation Difficult to apply due to lack of objective tests Advanced ruling from IRS should be obtained

33. Redemptions in Partial Liquidation To meet the complete termination of a business test, the corporation must: Have two or more trade or businesses that have been in existence for at least five years, Terminate one trade or business and continue a remaining trade or business

34. Redemptions to Pay Death Taxes Allows sale or exchange treatment if value of stock exceeds 35% of value of adjusted gross estate Stock of 2 or more corps may be treated as stock of single corp for 35% test if 20% or more of each corp was owned by decedent Special treatment limited to sum of: Death Taxes Funeral and administration expenses

35. Redemptions to Pay Death Taxes Basis of stock is stepped up to fair market value on date of death (or alternate valuation date) When redemption price equals stepped-up basis, no tax consequences to estate

36. Effect of Redemption on Corporation Gain or loss recognition If property other than cash used for redemption Corporation recognizes gain on distribution of appreciated property Loss is not recognized Corporation should sell property, recognize loss, and use proceeds from sale for redemption If property is subject to a liability > FMV, corporation recognizes gain to the excess of the liability over the basis But if the liability does not >FMV, FMV is used

37. Effect of Redemption on Corporation Effect on Earnings and Profits If appreciated property is distributed, the gain increases E & P E & P is reduced in a qualified stock redemption by ratable share of E & P attributable to stock redeemed Corporate expenditures incurred in a stock redemption are not deductible e.g., accounting, brokerage, legal and loan fees

38. Stock Redemptions�No Sale or Exchange Treatment Redemptions not qualifying under previous provisions Treated as dividend distribution to extent of E & P Attempts by taxpayers to circumvent redemption provisions led to rules covering: Preferred stock bailouts Sales of stock to related corporations

39. Effect of Preferred Stock Bailout  Preferred stock bailout involves: Corporate distribution of nontaxable (nonvoting) preferred stock dividend on common stock, Portion of basis in common stock is allocated to preferred stock, Shareholder then sells the preferred stock to third party Effect is bailout of corporate profits as a capital gain

40. Effect of Preferred Stock Bailout  To minimize abuse potential, Code requires this treatment: Shareholder has ordinary income (�306 taint) on sale of preferred stock to third party Amount of ordinary income is FMV of preferred stock on date received as distribution from corporation (limited by E & P of company, but does not reduce entity E & P)

41. Effect of Preferred Stock Bailout  To minimize abuse potential, Code requires this treatment (cont�d): No loss recognized on sale of �tainted� preferred stock If stock is redeemed by corporation, proceeds treated as a dividend

42. Effect of Preferred Stock Bailout  �306 stock is stock which is not common stock: Received as a nontaxable stock dividend Received tax-free in a corporate reorganization (plus other requirements), or Has a basis determined by reference to other �306 stock

43. Redemption with Related Entities When one corp acquires stock in another corp from a shareholder and the shareholder controls both corps �304 requires that the redemption result in a reduction of ownership interest that would satisfy one of the qualifying stock redemptions of � 302 (e.g., disproportionate redemption) or � 303 If the redemption does not qualify under those rules, the transaction is characterized as a dividend distribution

44. Redemption with Related Entities When brother-sister corporations are involved Stock received by acquiring corp treated as a capital contribution Corp�s basis in acquired stock is same as shareholder�s basis Shareholder�s basis in acquiring corp is increased by basis of stock surrendered

45. Corporation Division Under �355 If one corp controls another corp Stock in subsidiary can be distributed to shareholders tax free if requirements of �355 are met

46. Liquidations�In General Corporation winds up affairs, pays debts, and distributes remaining assets to shareholders Produces sale or exchange treatment to shareholder �331 Liquidating corporation recognizes gains and losses upon distribution of its assets, with certain exceptions �336

47. Liquidations�Effect on Corporation Gain or loss is recognized by corporation on distribution in complete liquidation Loss may be disallowed or limited if: Property distributed to related parties Property distributed has built-in losses A subsidiary�s liquidating distribution to its parent corporation or to its minority shareholders Property treated as if sold for FMV Result: Liquidating distribution subject to corporate level tax (gain), and shareholder level tax (receipt of proceeds)

48. Liquidations�Effect on Corporation Limitations on losses�Related Party Situations Losses are disallowed on liquidating distributions to related parties if: Distribution is not pro rata In pro rata distributions, each shareholder receives their share of each asset Property distributed is disqualified property Disqualified property is property acquired by corp in a �351 transaction during the five-year period ending on date of distribution

49. Liquidations�Effect on Corporation Limitations on losses�Built-in Loss Situations Losses are disallowed when property distributed was acquired in a �351 transaction and principal purpose was to cause recognition of loss by corp on liquidation Purpose is presumed if transfer occurs within two years of adopting liquidation plan

50. Distribution of Loss Property in Liquidation

51. Liquidations�Effect on Shareholder Gain or loss recognized on receipt of property from liquidating corporation Amount = FMV of property received - basis in stock Generally, capital gain or loss Basis in assets received in liquidating distribution = FMV on date of distribution

52. Liquidations�Effect on Shareholder Special rule for installment obligations Shareholder may defer gain recognition to point of collection Corporation must recognize all gain on distribution

53. Liquidations: Parent-Subsidiary Situations Parent corporation does not recognize gain or loss on liquidation of subsidiary �332 Also, subsidiary recognizes no gain or loss on property distributions to its parent �337

54. Liquidations: Parent-Subsidiary Situations To qualify: Parent must own at least 80% of voting stock and value of subsidiary�s stock Subsidiary must distribute all property within three years from close of the tax year in which the first distribution occurred Subsidiary must be solvent

55. Liquidations: Parent-Subsidiary Situations Liquidating distributions to minority shareholders Treated same way as nonliquidating distribution Distributing corp recognizes gain but not loss Minority shareholders recognize gain or loss Amount=FMV of property received-basis in stock

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57. Liquidations: Parent-Subsidiary Situations Basis of property received by parent Has same basis as subsidiary�s basis (unless election is made under �338) Parent�s basis in subsidiary�s stock disappears Parent acquires tax attributes of subsidiary e.g., NOLs, business credit carryovers, capital loss carryovers, subsidiary�s E & P May result in some inequities

58. Election Under �338  Parent may elect to treat acquisition of stock in acquired corp as a purchase of the acquired corp.�s assets if: Election is made by fifteenth day of ninth month following qualified stock purchase Qualified stock purchase occurs when corp acquires stock representing at least 80% of voting power and value within a 12-month period Must be acquired in taxable transaction Stock purchases by affiliated group members count

59. Election Under �338 Tax Consequences Parent corp has basis in subsidiary�s assets = basis in subsidiary�s stock Subsidiary may, but need not, be liquidated

60. Election Under �338 Tax Consequences (cont�d) Subsidiary is deemed to have sold its assets for an amount determined with reference to parent�s basis in subsidiary�s stock, adjusted for liabilities of subsidiary

61. Election Under �338 Tax Consequences (cont�d) Gain or loss is recognized by subsidiary Subsidiary is treated as a new corporation that purchased all of its assets on the day after the qualified stock purchase date