Chapter 5 - Redemptions and Partial
Liquidations
The sale of corporate stock
ordinarily produces a capital gains/loss event.
What tax impact arises when a
“redemption” transaction occurs (i.e., a stock sale to the issuing corporation
of its own stock)?
If a stock redemption occurs
is this transaction:
1) a property sale (§1001
realization event), or
2) a dividend distribution (i.e.,
E&P sourced)?
Income Tax Treatment of a Redemption to
Shareholder
Options for federal income tax
classification of the stock redemption transaction:
1) Stock sale (with a tax basis
recovery); consider the time value of the tax funds.
2) Dividend equivalency (& no
basis offset).
What is the relevance of the 2003
tax legislation (15% capital gains and 15% dividend tax rate)? Tax basis
recovery in gains situation?
Code §302(a) - Exchange Treatment for
Shareholders
1) §302(b)(1) - the distribution is not
“essentially equivalent to a dividend”.
2) §302(b)(2) - the “substantially
disproportionate” redemption exception.
3) §302(b)(3) - complete termination of the
shareholder’s interest in the corporation.
4) §302(b)(4) – stock redemption occurs
after a partial liquidation (measured by reference to events at the corporate
level).
Basis Allocation Issues
p.195
When a stock redemption is treated
as a dividend distribution: what happens to the tax basis of the disappeared
shares?
1) Allocation to the shareholder’s
remaining shares.
2) If all shares are sold
(but dividend treatment occurs because of §318) – basis allocation to related
parties.
Prop. Regs.: deferred loss to
selling shareholder.
Stock Redemptions &
Corporate Level Treatment
1) §311 gain recognition occurs upon a
corporate distribution of appreciated property in a stock redemption
transaction, but no loss recognition is permitted.
2) What effect on the distributor
corporation’s E&P account when appreciated or depreciated property is
distributed in a redemption transaction?
Business Objectives for Stock
Redemptions p.198
1) Enable the shift of corporate
control (e.g., to younger generation members in a closely-held corp).
2) Buy out of the share interest
of a disgruntled or deceased shareholder.
3) Stock buyback program for a
publicly held corporation, e.g., to reduce the equity base.
Constructive Ownership of Stock - Code §318
Rules
What is the function of the “constructive
ownership” or “attribution of ownership” rules? Assumption: commonality of
ownership causes parties to coordinate tax planning for their joint investment
interests.
Example: Father owns 50% of shares and
Daughter owns 50% of shares and Father redeems all his shares - treatment of
the Father as a continuing stock owner? Possibly.
Constructive Ownership of Stock - Code §318
Rules
1) §318(a)(1). Family deemed ownership
attribution – to spouse, children, grandchildren and parents. Not to siblings
and not to a grandchild from GP.
2) §318(a)(2). From an entity to
an individual owner/beneficiary -
a) Partnership or estate to the
partner or the beneficiary on a proportionate basis.
b) Trust to the beneficiaries.
c) Corporation to some (50%)
shareholders.
Constructive Ownership of Stock - Code §318,
cont.
3) §318(a)(3). From owner to
the entity:
a) Stock owned by partners or by
beneficiaries of an estate or trust is considered as owned by the partnership
or the estate.
b) Stock owned by a 50 percent or more
shareholder is attributed to the corporation.
4) §318(a)(4). An option to acquire stock
is equivalent to the ownership of that stock (even if seriously “underwater”?).
Constructive Ownership of Stock – Operating
Rules
1) No family reattribution.
2) No “sidewise” attribution – e.g.,
attribution
(a) from one partner to the partnership and
(b) then to another partner.
3) S corporations are treated as
partnerships and
S corporation shareholders are treated as
partners.
Problem 1 p.200
Family Attribution
Wham Corp has 100 common shares
outstanding.
GF Mother Daughter
Son GM’s Estate
25 20 15
10 30
Mother as (i) a 50% GM estate
beneficiary, and (ii) holding an option for 5 of son's 10 shares.
Problem 1, p.200
Grandfather’s stock
Grandfather - total share interest is 85.
a) 25 directly.
b) 20 from mother to GF -
§318(a)(1)(A)(ii).
c) 15 from daughter (granddaughter), and
10 from son (grandson).
§318(a)(1)(A)(ii ).
d) 15 from GM's estate. §318(a)(2)(A) -
from GM’s
estate to mother & then from mother to
GF - §318(a)(1)(A)(ii). Reattribution is permitted here. §318(a)(5)(A).
Problem 1, p.200
(Grand) Daughter’s stock
Mother's daughter’s shares - total
is 55.
a) 15 directly.
b) 0 shares from son - no sibling
attribution.
c) 25 shares from mother - i) 20 shares
directly; & ii) 5 (only) shares owned through mother's option. §§318(a)(4)
& 318(a)(5)(D). No double attribution for other 5 shares.
d)15 sh. (thru Mom) from GM's estate.
318(a)(2)(A)
e) GF to (grand) daughter – no & not
thru Mom.
Problem 1, p.200
GM’s Estate’s stock owned
Grandmother's estate - 100 shares owned.
a) 30 shares owned directly.
b) 20 shares owned by mother - since Mom is
an estate beneficiary. §318(a)(3)(A).
c) 50 shares owned through Mother by GF
(25), daughter(15) & son(10). §318(a)(1)(A) & §318(a)(3)(A). Reattribution
to entity does apply.
Problem 2 p.200
M – (W's W- (A's wife) A B C
D mother) owns
(unrelated)
equal
partners
Partnership
100 shares
owns 100 being shares
being
100% of 100%
of
Yancy Corp
Xerxes Corp
Problem 2(a), p.200
Number of Xerxes shares owned by:
1) A - 25 shares are owned by attribution
from the partnership. §318(a)(2)(A).
2) W- 25 owned by A & attributed to W -
through family attribution. §318(a)(1)(A)(i).
3) M - W's mother - does not own any
shares in Xerxes. Shares attributed to W from A are not reattributed
under the family attribution rules. §318(a)(5)(B).
Problem 2(b), p.200
Shares of Xerxes owned by Yancy:
1) Premise: stock owned by a 50 percent or
greater shareholder of a corporation is attributed to the corporation -
§318(a)(3)(C).
2) Yancy owns constructively 25 shares
owned by W: (a) Partnership to A; (b) then, A to W; (c) then,
W to Yancy - since W owns 50 percent or more of Yancy (i.e., W can
instruct Yancy).
Problem 2(c), p.200
Shares of Yancy owned by Partnership, B, C,
D & Xerxes:
1) Partnership - constructively owns the
100 shares in Yancy; W's 100 shares are attributed to A & A's 100 shares
are reattributed to ptnshp.
2) B, C, & D do not own any
Yancy shares. No “sidewise reattribution” to another partner.
3) Xerxes owns the 100 shares
constructively owned by the Partnership.
Substantially P.200
Disproportionate Redemp.
§302(b)(2). Requirements to qualify:
1) Own less than 50 % of the total
combined voting power of the voting stock. §302(b)(2)(B).
2) Percentage of voting stock owned
after this redemption is less than 80% of the total voting % owned before the
redemption. §302(b)(2)(C).
3) Percentage of ownership of all common
stock is less than 80 percent of the prior % of the total common stock owned.
§302(b)(2)(C).
§302(b)(2) Issues p.202
1) How are “voting rights” defined for
this purpose? Must be current availability of voting rights, i.e., not
rights available only (e.g.) on a dividends payment default.
2) How can nonvoting stock be redeemed
under §302(b)(2) (since no reduction in the “vote”)?
Only by “piggybacking” on a qualifying
redemption of voting stock (per Reg. §1.302-3(a)) .
Rev. Rul. 85-14 p.202
Multiple Stock Redemptions
B indicated to A, the majority shareholder,
B’s intention to terminate status as shareholder.
A redeemed & (temporarily) A then owned
less than 50% of the total corp. shares.
B then redeemed one week later & A went
back above the 50 percent ownership level.
Issue: Should these two transactions be
integrated concerning the tax treatment to A? Answer - yes. See §302(b)(2)(D).
Problem 1 (Y Corp) p.204
§302(b)(2) Eligibility
Alice
Cathy Totals
80 common 20
common 100
100 nonvoting 100
nonvoting 200
___preferred
preferred______________
•
Redeem
A’s 75 preferred shares.
No qualified – Reg. §1.302-3(a).
No reduction in voting shares.
Problem 1 (Y Corp) p.204
§302(b)(2) Eligibility
Alice
Cathy Totals
80 common 20
common 100
100 nonvoting 100
nonvoting 200
___preferred
preferred______________
b) Also redeem 60 of Alice’s common shares.
Not qualifying – Alice owns before: 80/100
Alice owns after: 20/40 – not owning less
than 50 percent of the stock after.
Problem 1 (Y Corp) p.204
§302(b)(2) Eligibility
Alice
Cathy Totals
80 common 20 common
100
100 nonvoting 100
nonvoting 200
___preferred
preferred______________
c) Also redeem 70 of Alice’s common shares.
Yes, qualifies. After redemption Alice
owns 10/30 or 1/3 of voting power.
Also, 1/3rd is less than 80% of
80% of vote before.
Also, redemption of preferred piggybacks
voting.
Problem 1 (Y Corp) p.204
§302(b)(2) Eligibility
Alice
Cathy Totals
80 common 20
common 100
100 nonvoting 100
nonvoting 200
___preferred
preferred______________
d) Also redeem 10 of Cathy’s common later.
Application of step-transaction doctrine?
Is Cathy’s redemption part of a coordinated
plan?
See §302(b)(2)(D) & Reg.§ 1.302-3(a) –
use all “facts & circumstances” to determine whether a plan exists. Use
Code § or tax common law.
Problem 2, Z Corp.,
Voting & Nonvoting p.205
Don Jerry Total
60 voting 40
voting 100
common common
100 nonvoting 100 nonvoting 200
common common
300
Z redeems only 30 of Don’s voting common.
Question: §302(b)(2) qualification?
1) 60/100 voting to 30/70 = 42.9% (less
than 48%).
2) 160/300 total to 130/270 – not
sufficient.
Complete Termination —Code
§302(b)(3) P.205
The redemption will qualify as an exchange
transaction if the redemption is “in complete redemption of all of the
stock of the corporation owned by the shareholder.”
This is obviously more than a “significant
reduction”.
Query: How measure “complete redemption”
status to enable capital transaction treatment?
Is a Waiver of Family Attribution
Available?
Code §302(c)(1) & (2).
Attribution of ownership rules can preclude
a complete termination occurring, unless the ownership attribution rules
are made inapplicable.
§302(c)(2) permits waiver of the family
attribution rules, but no waiver of the entity or option
ownership attribution rules.
Code §302(c) Limitations on Waiving
Attribution Rule
1) Can have no continuing interest as an officer,
director, or employee; cf., concern about an “independent contractor.”
2) Ten year look forward rule.
§302(c)(2)(A).
3) Ten year look back rule.
§302(c)(2)(B).
No acquisition of stock by a relative or
from a relative within the prior ten years - unless income tax
avoidance not one of the principal purposes for that
acquisition.
Lynch case p.206
Attribution Cut-off? §302(c)(2)
Facts: Total redemption of the father's
stock after the sale of some shares to the son.
Consulting agreement for the father - as an
“independent contractor” (not as an employee).
Tax Court held the post-redemption
arrangement was not a prohibited interest.
9th Circuit: Consulting arrangement is
a prohibited interest, even when independent contractor status for the
seller.
Rev. Rul. 59-119 p.213
Board of Directors Status
Facts: Stock sale made on an installment
basis and the shares were retained by an escrow agent.
Redeeming shareholder retained the right to
designate his lawyer (nominee) to be on the corporation’s board - to protect
the former shareholder's creditor interest.
Held: Having one’s lawyer (an agent) on the
Board violates the requirement in Code §302(c)(2)(A)(i). Observer status is
OK.
Rev Rul. 77-293 p.215
§302(c)(2)(B)(ii)
Facts: Father transfers stock to son by
gift and, thereafter, corporation redeems all the father's remaining shares.
Son then actively manages the corporation’s business.
Issue: Was the pre-redemption disposition
for a principal income tax avoidance purpose? No.
Concept: Must be an objective to withdraw
at capital gains rates when coupled with continued control or an economic
interest in the corp.
Limitations on the Retained Interest
p.217
1) Cannot be a custodian under TUTMA or be
a voting trustee.
2) Reacquisition of stock (or only
interest as an executor) only as a result of an inheritance or bequest is
permitted.
3) Deferred payment redemptions are
permitted, subject to certain limitations.
4) Leasing property to the corporation on
an arm's length basis is acceptable.
Waiver of Attribution of Ownership by Entities
P. 220. §302(c)(2)(A) & (B) only
permit the waiver of family attribution rules.
What if the redeemed shareholder is a trust
or estate that completely terminates its actual interest in the
corporation (but is attributed constructive ownership from another, e.g., a
beneficiary)?
§302(c)(2)(C) permits the waiver by the trust
and its beneficiaries (if both are redeeming).
Problem 1 p.221
Complete Redemptions?
John Alison Chuck
(parent) (daughter) (grandson)
100 shares 50
shares 25 shares
Randall
Corp
Problem 2 p.222
Estate Planning Structure
B&B Windshield Wiper Corporation.
Betty & Billy, husband & wife, own
150 shares common stock of corporation.
Billy & Betty lease the plant to
corporation.
Transfer of corp. control to Junior to
occur.
(1) Gift of shares - §302(c)(2)(B)(ii)
transfer to Junior within ten year period. For an income tax avoidance
(principal) purpose?
Problem 2, continued
(2) Credit redemption of remaining shares.
20 year term not satisfying IRS ruling
standards because of the length of the term.
Securitization of the creditor position by
the corporate assets is permitted.
Escrow arrangements are acceptable if not
actually reacquiring the shares upon a payment default.
Problem 2, continued
3(a) Continued leasing
of the plant:
Can lease if on an arm's length basis.
FMV purchase option - also acceptable.
3(b) Consulting
arrangement - a noncreditor interest which constitutes a prohibited interest
under §302(c)(2)(A)(i)? Yes?
Cannot have "financial stake" in
enterprise. What result here? Lynch vs. U.S. Tax Court.
Problem 3(a)
Cinelab p.223
John Mary
(sister) Estate of Sam (father)
Bella (mother) as the
estate beneficiary
50 30
20
shares shares shares
Redemption of the Estate’s 20 shares
-
Is a Code §302(c)(2) waiver of
constructive ownership rules available?
Problem 3(b)
Cinelab p.236
John Mary
(sister) Estate of Sam (father)
Bella (mother) as resid.
bene. of the estate
50 30 20
shares shares shares
Estate of Sam:
(i) John & Mary are specific legatees;
&
(ii) Bella is the residuary beneficiary.
Problem 3(c)
Cinelab p.236
John Mary
(sister) Estate of Sam (father)
50 30 20
shares shares shares
John & Mary are residuary
beneficiaries of the estate. Any possible cutoff of the attribution of
ownership rules? John & Mary cannot terminate their estate
beneficiary status here. Estate owns all stock.
Problem 3(d) & (e)
Cinelab p.236
John Mary (sister) Estate of
Sam (father)
50 30 20
shares
shares shares Trust for
Bella and
Nancy (sister)
(d) Shares of the trust are redeemed. Is a
waiver acceptable to eliminate attribution?
(e) Nancy subsequently acquires shares.
Impact of the ten year “look forward” rule?
§302(b)(1) - Not Essentially Equivalent to
a Dividend
Davis case
p.223
Taxpayer Wife Son
Daughter
250 250
250 250
common common common common
& preferred
Taxpayer’s preferred stock was redeemed.
“Meaningful reduction” requirement
was not satisfied since no reduction in his vote %.
.
Rev. Rul. 85-106 p.229
Voting Power Controls
Trust owned nonvoting common &
preferred stock.
Redemption of only nonvoting preferred
stock. No redemption of any common stock.
18 percent of voting stock owned both
before and after by Trust beneficiary.
Reduction in voting power as the key
factor.
Shareholder still participating in same
voting blocks.
Held: Not a “meaningful reduction”
&
§302(b)(1) requirements are not satisfied.
Rev. Rul. 75-502
note case p.232
X Corporation
Estate A B
(& A as bene.)
250 shares 750
shares 750 shares
Estate owns A's shares through
§318(a)(3)(A) attribution. Estate’s shares were redeemed. The estate went from
57% to 50% for its constructive ownership in the corporation.
A meaningful reduction resulted for
the estate.
Rev Rul. 75-512
note case p.232
Corp. redeemed all 75 shares owned by the
trust.
Prior to redemption the trust owned 300
shares directly and indirectly (or 30 percent). Decreased ownership from 30
percent to 24.3 percent (225 shares owned by C, D & E).
Not eligible for (i) complete redemption or
(ii) substantially disproportionate; but, held:
Not essentially equivalent to a dividend.
Why? Reduction of the impact of trust’s voting rights?
Limited Participation
Situations p.232-3
1) Redemption of nonvoting
preferred stock – not essentially equivalent to a dividend.
2) Redemption of a minor interest
in a public corporation, i.e., a “stock buy-back program.” No meaningful
reduction – but no impact on corporate management.
3) Relevance of
“super-majority” rules? E.g., no longer a capacity to quash a merger
transaction, but authority to control vote on officers and dividends. When
relevant?
Relevance of Family Discord
p. 233
Is family discord relevant in determining
the applicability/non-applicability of the
§318(a)(1) family attribution rules in the
stock redemption context? No.
Question: How demonstrate this
intra-family hostility (i.e., the “family fight”) to the satisfaction of the
IRS?
No “complete termination” treatment
(§302(b)(3)) because of continuing employment relationship.
Problem 1 p. 235
Meaningful Reduction?
A B
C D
28 25 23
24
shares shares shares shares
Z
Corporation
100 total shares
Effect of various redemptions by A?
Problem 2, p.235
Common & Preferred
Shareholder Common Preferred
Shares
Shares
A 40
0
B 20 55
C 25 10
D 15 15
E
0 20
Problem 3 p.236
Treatment of Tax Basis
(1) Five of 15 shares are redeemed in a
transaction treated as a dividend.
The remaining shares have a basis of
$15,000.
Reg. §1.302-2(c), Examples 1 & 3.
(2) Mystery of the disappearing basis -
where all shares redeemed but dividend treatment occurs. Stock basis is
transferred to those parties whose shares are attributed to the shareholder;
Reg. §1.302-2(c), Example 2.
Partial Liquidations
Corporate Level Testing
Code §302(b)(4) - redemption treatment for
partial liquidations (if non-corporate status of shareholder).
Redemption treatment is available to the
shareholder, but the eligibility is dependent upon corporate level events
rather than upon shareholder level events.
Need a genuine contraction of a corporation's
business to enable a distribution eligible for redemption/sale or exchange
treatment.
Code §302(e)(2) Safe Harbor
p.237
1) (a) Termination of a “qualified
trade or business,” and
(b) the continuation of
another “qualified trade or business.”
2) Five year prior active conduct
for each business to be “qualified.”
3) No acquisition of these
businesses within the prior five year period where gain has been recognized
upon acquisition.
Rev. Rul. 79-184 p.238
Stock vs. Assets Disposition
Sale of the stock of a subsidiary
& the distribution of the proceeds held not to be a distribution in
partial liquidation of corp.
Not a corporate business contraction, but
the sale of an investment (rather than a sale of one of several directly
held businesses).
Cf., upstream corporate liquidation of the
subsidiary into the parent and the relevance of Code §381 (re: tax attribute
carryovers).
Problem p.240
Partial Liquidation?
Michael Pamela Iris
Corp.
(M's
wife)
ALPHA
Books Cram Beta, Inc.
Securities
(division) (division) (100%
sub) portfolio
Consequences to the Distributing
Corporation
1. Distributions by Corporation of
Appreciated Property in Redemption.
§311(b) applies to nonliquidating distributions.
Gain to be recognized to corp. on distribution.
2. Effect on Earnings and Profits.
See §312(n)(7) requiring the ratable
reduction of E&P when a redemption occurs, subject to a limit as to the
actual distribution amount.
Rev. Rul. 74-338 p.243
E&P Determination
What pro-rata share of E&P is
attributable to redeemed shares (when CG treatment)?
Consider both: (1) current E&P and
accumulated E&P; and (2) current dividend distributions and redemption
distributions.
Ordering rules: Dividend distributions
first, pro rata; then, redemption distributions in chronological order
(proportionate allocation).
Problem p.246
Stock Redemption
Facts: 200 shares at price of
$1,000 per share.
Each shareholder has 100 shares
& $100,000 basis
for each of two shareholders.
$100,000 accumulated
e&p and $100,000 current
e&p.
Redemption of A's shares - X
distributes cash. 1/2
of corporation’s shares are
redeemed; cf., dividend
treatment. Redemption distribution
is mid-year.
Here: July 1 redemption; E&P
then is 100 acc.
E&P & 50% of current e&p
= 150,000 e&p times
50% shareholder = 75,000 charge to
E&P.
Stock Redemption Expenses
§162(k)
All expenditures incurred by a corporation
in purchasing stock are non-deductible, non-amortizable capital
expenditures.
“Greenmail” payments must be
capitalized.
Cf., Woodward case re required
capitalization of legal costs incurred in litigation by dissenters.
Note §162(k)(2)(A)(ii) re amortization of loan
costs over the period of the loan (funded to pay greenmail costs). Loan is
a separate transaction.
Bootstrap Acquisitions
(Rev Rul. 75-447) P.249
Zenz v. Quinlivan - Sale of stock to
a third party; three weeks later redemption of the balance of
outstanding shares.
Assertion by IRS that this was equivalent
to a dividend distribution - even though the shareholder's entire remaining
share interest was terminated by the stock redemption.
Held: not a bootstrap dividend
distribution; rather, capital gains transaction treatment.
Rev. Rul. 75-447 p.249
Integrated Transactions
Situation One:
Corporation X shares equally owned by A and
B (50 each).
(1) 25 new shares issued to C by
Corporation X, and (2) A & B then each redeemed 25 shares.
A & B owned 50% before new
shares and 33 1/3% after the stock redemption.
Requirements of §302(b)(2) are
satisfied.
Rev. Rul. 75-447 p.249
Sale & Redemption Option
Situation Two:
(1) Sale of shares to C by A & B, and
(2) Redemption of part of the remaining
shares held by A & B.
A & B held 50% before and 33 1/3% after
the transaction.
Held: §302(b)(2) applies when
measuring before and after these several transactions.
Problem p.251
Redemption Occurs First
Strap is the sole shareholder of Target.
Target value is $500,000 and Target has
$100,000 cash.
Strap redeems $100,000 of Target shares and
Strap sells remaining Target shares to Boot.
Is step transaction treatment applicable to
enable the redemption to be part of a sale or exchange/gain recognition
transaction?
Buy-Sell Agreement
p.251
Objectives of the buy-sell arrangement:
1) Preserve the limited ownership group.
2) Fix value/binding price required during
lifetime; is a right of first refusal acceptable?
3) Possibly fix value for federal estate
tax purposes.
4) Liquidity for the selling shareholder -
assurance that his successors are not in a minority/non-controlling shareholder
position after death of that shareholder.
Types of Buy-Sell Arrangements
1) Cross-purchase: a capital gains
event;
but, if a sale after death, limited capital
gain since tax basis for shares is stepped up (down?) (§1014, in 2011
& thereafter) to
FMV of stock at death.
2) Entity purchase: redemption
treatment and possible dividend risks.
3) Combination transaction: Zenz
situation analysis should be applicable to enable CG status.
Types of Restrictions on Stock Transfers
1) Lifetime: a) right of first refusal
& b) matching a bona fide offer from a potential outside purchaser.
2) Death - mandatory sale/purchase??
Consider effect of the mandatory nature of
a purchase requirement (as of date of death), if
(i) shares are to be purchased by the
remaining shareholder, and (ii) the corporation assumes that
shareholder’s obligation.
Valuation Approaches for the Buy-Sell
Agreement
1) Agreed price, with a “kick-out”
clause if no valuation occurs within a specified period.
2) Book value; or a “multiple” of
book value?
But, mark to market (rather than book) for
certain (e.g. investment) assets held by the corporation?
3) Independent appraisal of the
shares.
4) Apply a “multiple” times: (a)
earnings; or (b) cash flow?
Terms of Payment for the Shares Sold
Cash
Deferred payments:
1) installment reporting for income
tax?
2) what risk to stock redemption tax
treatment?
3) security arrangements: (a) escrow
of the redeemed stock - but cannot get the stock back; (b) assets pledged;
or, (c) letter of credit or an indemnity policy.
4) negative covenants in the loan
agreement.
Life Insurance Tax & Related
Considerations
Life insurance acquired to satisfy
liquidity needs.
Each shareholder’s life is insured by the others.
A) Cross-purchase agreement - other
shareholder(s) acquire life insurance.
B) Entity purchase - insurance proceeds
flow into the corporation and at death the value of the corporation
(&E&P) is increased by the difference between (1) book value and (2)
face value of the life insurance policy.
Transfer Tax §2703
Considerations p.253
Value to be determined for transfer tax
purposes without regard to:
1) Any option, agreement or other right to
acquire property at a price less than FMV.
2) Any restriction on the right to sell/use
property.
§2703(b) provides an exception for an
arrangement which has terms "comparable to similar arrangements entered
into by persons in an arm's length transaction."
Constructive Dividend Issues in a Redemption
Revenue Ruling 69-608, p.254.
Basic question: does the corporation
assume a binding obligation of the remaining shareholder
when agreeing to purchase shares?
If so, a constructive dividend transaction
will be treated as occurring, with the dividend distribution being made to the remaining
shareholder(s).
Problem p.257
Buy-Sell Tax Issues
A, B & C each own 1/3 of Y corporation.
A cross purchase agreement is in
place.
(a) Sale by B of 1/2/ of shares to each of
A & C:
Proceeds to B equal B’s stepped-up basis
(b) Redemption by B results in a complete
termination (§302(b)(3) – unrelated parties) and distribution equals B’s
stepped-up basis.
continued
Problem p.257
Buy-Sell Tax Issues
A, B & C each own 1/3 of Y corporation.
(c) A & C to buy B’s stock over ten
years, but obligation assigned to X corp:
If gain to B on the redemption installment
sale reporting would be available (but no gain here).
But, for A & C, primary obligation
assumed by X corp. and constructive distribution to them occurs when X corp.
makes installment payments.
continued
Problem p.257
Buy-Sell Tax Issues
A, B & C each own 1/3 of Y corporation.
(d) A & C have options to buy B’s stock
when B retires, but X corp actually buys.
B has no gain since sale for basis.
No constructive dividend to A & C since
options were not primary and unconditional obligations.
continued
Problem p.257
Buy-Sell Tax Issues
A, B & C each own 1/3 of X corporation.
A cross purchase agreement is in
place.
X Corp. purchased life insurance on the
lives of the shareholders and paid the premiums on this life insurance.
X Corp. is the owner of the policies and is
also the beneficiary under these policies.
B dies and X Corp. uses the proceeds to
redeem B's stock. continued
Problem p.257
Treatment to X Corp.
1) Are the premiums deductible by X
Corp.?
No, §264(a)(1).
2) At death the tax-free insurance
proceeds are received by X Corp. §101(a)(1).
3) The excess of the insurance proceeds
over the aggregate premiums is included in the X Corp E&P upon collection
of the proceeds.
continued
Problem - Treatment to Shareholders
A&C p.257
A&C as the remaining shareholders.
1) No constructive dividends upon the
insurance premium payments by X Corp. (i.e., prior to the death
of B).
2) A & C do have constructive dividend
distribution treatment upon the stock redemption because of the binding
obligations of A & C to purchase B's estate’s shares.
Divorce Redemptions p.258 Who Has Redeemed?
Arnes v. United States He and she each
owned 50 percent of Corp. Divorce agreement for redemption of her 50 percent
interest. Installment sale reporting.
In refund litigation she asserts
transaction really is a stock transfer to husband and she is protected from
gain recognition because of §1041.
Issue: Does this constitute a transfer to
a third party by ex-wife? No, really a transfer to husband,
& no gain to be recognized by her.
Treatment of Nontransferor
Spouse p. 262
If the departing ex-spouse
does not engage in a stock redemption transaction with the corporation, what is
the treatment to the ex-spouse who remains as the shareholder in the
corporation?
Treatment of the remaining
shareholder spouse as (1) receiving a constructive dividend, and
(2) transferring the proceeds to
the ex-spouse –
since tax-paid cash is
received by the departing
spouse?
What Divorce Tax Planning in this
Context? P.262
Get her (departing shareholder) to
redeem and obtain LT capital gains treatment (at 15%) after her income tax
basis recovery for the shares?
Or, does he redeem from the
corporation to get cash to pay her and (as the remaining shareholder) he has
15% dividend treatment on his stock redemption (since he is not eligible for
sale or exchange treatment)?
Ultimate question: Does he have
primary or secondary liability for this payment to her?
Divorce Redemptions,
Final Regulations p.264
The conflict: “Primary and unconditional
obligation” vs. §1041 (carryover
basis).
Option One: Dividend tax to the nontransferor
if a primary and unconditional obligation exists on him.
Option Two: Tax to the transferor spouse
if no such obligation - capital gain treatment – no §1041.
Option Three: Choose which spouse is to be
taxable - enabling negotiation in their divorce deal;
But, deal must be in writing. And, timely.
Divorce Redemptions,
Problem p.266
How structure H’s buy-out of W?
(a) H buys W’s stock: Incident to
divorce and no gain to W.
(b) Corp. to redeem: Arnes case – no gain
to W since her stock transfer to Corp. on behalf of H.
(c) How structure? (1) Avoid constructive
dividend treatment and (2) reduce E&P.
Or, H gets current tax basis for shares
purchased.
Use the “special rule” to get best after
tax results.
Charitable Contribution & Redemption
Transaction
Grove v. Commissioner p.266
Facts: Grove donated to
charity shares of closely-held stock & retained a life interest.
The charity signed the buy-sell agreement.
Shares were redeemed by the issuing
corporation 2-3 years after the charitable contribution.
Held: No agreement made
for the charitable donee to redeem shares. Therefore, stock gifts and
no dividend distribution treatment to the donor.
Sequel to the Grove case
p.273
Rev. Rul. 78-197 – dividend
treatment only if the charity is legally obligated to surrender shares
for redemption.
But, are most charities obligated to
sell illiquid shares as quickly as possible – and do trustees/directors violate
fiduciary responsibilities if not doing so?
Note alternative (now required)
charitable gift techniques, e.g., CRAT & CRUT, to get the charitable
contributions income tax deduction.
Problem p.274
Charitable Gift of Shares
Redemption & cash contribution vs.
charitable bailout (i.e., charitable deduction for FMV of stock and no dividend
income).
a) Distribution to P in redemption of
1,000 shares of stock and then the contribution of $100,000 cash to charity.
Result: (1) $100,000 taxable dividend
distribution and (2) deduction of $100,000 for the cash charitable
contribution. continued
Problem, cont. p.274
b) Contribution of shares to
charity and subsequent redemption of charity's shares. No legal obligation to
surrender the shares for redemption. Oral understanding is not a legal
obligation. Not a constructive dividend.
No legal obligation to redeem.
c) Pattern of conduct for charitable gifts
and redemptions. Still not a problem (pursuant to the Grove decision).
Redemptions Through Related Corporations
p.275
Brother-sister acquisitions - §304(a)(1).
A (individual or
corp.) owns
X Corp
& Y Corp
Facts: A sells X stock to Y Corp. for
cash; the cash comes from Y Corp. to A.
Transaction is treated as a distribution in
redemption of Y stock - rather than as a sale or exchange of stock of X
corp. “Control” of each of the two corporations must exist.
Parent-Subsidiary Acquisitions
§304(a)(2)
Facts: A - shareholder
P
- parent
S
- subsidiary
Stock of P is sold by A to S. Must be
satisfaction of a 50 percent control test.
Treated for “dividend equivalency” purposes
as a distribution in redemption of P's stock. Next question: Are any Code
§302(b) redemption tests satisfied in this transaction?
§304(a)(1) - Collateral Income Tax
Effects p.276
If ordinary dividend treatment for
tax purposes:
1) A §351 contribution to the
acquiring corporation.
2) The acquiring corp. receives a
transferred basis for the stock received.
3) E&P of the acquiring
corporation is reduced when the dividend treatment occurs.
If an “exchange” occurs (§302(a)) - then a
cost basis for the shares received.
§304(a)(2) - Collateral Income Tax Effects
If ordinary dividend treatment for
tax purposes:
1) Basis shifting from the
contributed parent’s stock to the remaining parent stock held by the
shareholder.
2) Reduce the sub’s E&P to the
extent of dividend treatment; then, reduce the parent’s E&P.
If an “exchange” (§302(a)) occurs
then: (a) recovery of basis, and (b) capital gain for the parent stock sale.
Niedermeyer v. Comm.
§304(a)(1) p.279
Bernard, Jr. Bernard(F) Ed
Linus Thomas
& Walter & Tessie(M)
67.91% 22.58%
67%
AT&T
Lents Industries
Bernard & Tessie sold their AT&T
common to Lents & retained their AT&T pref. stock.
Issue: Does the sale of AT&T common
produce capital gain treatment to Bernard & Tessie? No.
Taxpayer’s arguments in Niedemeyer case
1) Bad blood and no attribution
rules are applicable. Rejected. P.280.
2) Not essentially equivalent to a
dividend?
But, no
“meaningful reduction” of % interest.
- 90.49%
reduced to 82.96 %. P.282.
3) Terminated interest &
§302(b)(3) is applicable – but, only after the preferred is redeemed.
Filed a §302(b)(3) agreement,
but two years late.
& no de
minimis rule is applicable.
4) Preferred stock as debt, not
stock? No, rejected.
Problem 1 p.286
Re: Niedermeyer case
(a) Why did §304(a) apply?
§304(a)(1) – (1) the sale of controlled
shares to a related corporation & (2) combined with the application of
attribution of ownership rules.
(b) Testing of the redemption (under
§302(b)) to determine dividend status:
§304(a)(1) - testing by reference to stock
ownership in AT&T, i.e., the issuing corporation.
Problem 1, cont., p.286
Re: Niedermeyer case
1(c) Why unable to waive the
family attribution rules? (1) No complete termination of the actual
interest in AT&T when the sale of the AT&T stock to Lents occurred (or
part of a total sale plan) & (2) no established intent to donate the
preferred stock.
1(d) How avoid this result?
Qualify for §302(b)(3) - if the AT&T preferred disposition were part of the
overall disposition plan; have a written plan; then similar to the Zenz v.
Quinlivan decision.
Problem 2 p.286
Partial Sale of Shares of Out
Claude
owns 80%
owns 60%
Bail Corp. (buyer)
Out Corp.
$40,000 basis $9,000
basis
(80 shares @ $500) (60 shares @
$150)
(Bail - no e&p) (Out -
$5,000 acc. e&p)
(a) Claude sells 20 of his Out shares to
Bail for $4,000 (basis is $3,000, i.e., 1/3 of $9,000)).
Problem 2(a) p.287
1) Constructive redemption of Bail
stock.
2) Test the redemption % of Out
stock
(from 60% to 56%, 40% directly +
16% indirect)
3) Deemed transfer of Out stock to
Bail.
4) Basis increase ($3000) to Claude
for Bail stock.
5) $4,000 dividend (qualified) to
Claude & E&P
$4,000 reduction. No §302(b)
redemption.
6) $3,000 basis to Bail for Out
stock - §362(a)(2).
Problem 2(b) p.287
Sale of All Shares of Out
Claude sells his 60 Out shares to Bail for
12x. Treated as a redemption of Bail stock tested under §302 with reference to
the Out stock.
Before Claude owned 60% of Out.
After redemption he owns 48% of Out by
attribution through Bail (80% of 60 shares; §318(a)(2)(C)). Treat as under
§302(b)(1) (yes?) or §302(b)(2) (no, since reduction to exactly
80%)?
Gain to Claude: 12x less 9x basis = 3x
(CG?)
E&P reduction (to Bail?) - §312(n)(7).
Problem 2(c) p.287
Stock of Purchaser Received
Same as (a) above, except that Claude
receives $3,000 and one share of Bail stock for his 20 Out shares. Claude's
argument - this is a §351 transaction (§368(c) control exists), and
Bail stock is received (& boot = $4x received less 3x basis =1x gain).
But, cf., §351(b) (boot) vs. §304(b)(3)(A)
(noting that §351 is not applicable).
This redemption then produces a $3,000
dividend.
Problem 2(d) p.287
Assumed Liability
Same as (a) above, except that Claude
receives one share of Bail stock (fmv- $1,000) & Bail takes 20 Out shares
subject to a $3,000 liability that Claude incurred to buy the 20 shares of
Out stock.
Special rule applicable - §304(b)(3)(B) -
assuming the stock was not acquired from a related person (under
§304(b)(3)(B)(iii)).
§357 applies and no gain recognized on
transfer.
Basis in Bail stock is 0 (3x less the 3x
boot), per §358(d).
Redemptions to Pay Death
Taxes p.287
Code §303(a) enables cash availability to
pay “death taxes” with no dividend effect.
Under §1014 the basis of stock is
stepped-up at death to its FMV. Therefore, the income tax choices on the
post-death stock redemption are:
1) zero capital
gain
vs.
2) ordinary dividend
distribution.
Section 303 Eligibility
Requirements p.287-8
1) Value of the redeemed stock must be
included in determining the decedent's gross estate.
2) Substantial portion of decedent's estate
- 35% of the gross estate (less certain expenses). §303(b)(2).
3) Timing of the redemption: within 90
days after expiration of the 3 year S/L. §303(b)(1)(A).
4) Eligible shareholders - where the
interest of the beneficiary is reduced directly by a liability for death
taxes (e.g., residuary estate). §303(b)(3).
Problem p.289
§303 – Estate Tax Impact
Gross estate $6,000,000
Expenses 300,000
Net estate 5,700,000 x
35%=1.995 mil.
Estate includes:
X corp. stock - 600,000 of 4.2 mil. total X
corp. fmv.
(Wife also owns 600,000 of X corp. stock).
Y corp. stock - 1.2mil. of 4.8 mil. total Y
corp. fmv.
Issue re qualification under §303.
Problem, continued
p.289
1) Qualification for the §303(b)(2)(B)
test (yes):
20% plus of X stock and Y stock counted for
this 35% test (when including the wife’s stock in the X stock computation). 2.4
mil. of 9.0 = 20%+
2) Qualification for §303(b)(2)(A)
test (no):
Wife’s stock is not counted for this
purpose.
Estate’s stock: 600x plus 1,200x equals
1,800x which is less than 1,995x (35% of 5.7 mil).