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 tax basis offset).

What is the relevance of the 2013 tax legislation

(20% capital gains and 20% dividend tax rate)?

Cf., tax basis recovery in the gains transaction.

Code §302(a) - Exchange Treatment to 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) – the stock redemption occurs after a partial liquidation (measured by reference to events at the corporate level).

Tax 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 shareholder’s remaining shares.

2) If all shares are sold (but dividend treatment occurs because of §318) – basis allocation to related parties.

Prop. Regs. (p. 196-7): deferred loss to selling

shareholder; deferral until redemption transaction

qualification.

Stock Redemptions &
Corporate Level Treatment

1) §311 (p. 197) - 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? §312(b) re E&P increase.

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 (and increase earnings per shares, etc.).

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.

Consider the impact of the Windsor case (DOMA illegal) and Rev. Rul. 2013-17 recognizing same sex marriages. What impact if filing a refund claim based on same sex marital status for earlier year when a stock redemption transaction occurred - §318(a)(1) then applicable?

Constructive Ownership of Stock - Code §318 Rules

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 (e.g., child to mother to

father).

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 is (i) a 50% GM estate beneficiary, and (ii) holds 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) – (a) from GM’s estate to mother & (b) 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 an entity does apply.

Problem 2 p.200

M – W- (A's wife) A B C D (W’s owns (unrelated)

Mother) equal partners in 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:

Premise (re W to Yancy): stock owned by a 50 percent or greater shareholder of a corporation is attributed to the corporation - §318(a)(3)(C).

Result: 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 (e.g., preferred stock).

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). Transactions causally related.

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____________

a) Redeem A’s 75 preferred shares.

Not 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 under §302(b)(2). After redemption Alice owns 10/30 or 1/3 of voting power.

Also, 1/3^rd is less than 80% of 80% of vote before.

& redemption of preferred piggybacks voting stock.

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 com. 40 voting com. 100

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 (53.3%) total to 130/270 – not sufficient.

(needs 80% of 53.3% = 42.66%; here 48.1%)

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 for tax purposes? Consider attribution of ownership.

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 (1) waiver of the family attribution rules, but (2) 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 is 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 exists 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 shareholders).

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’s beneficiary.

Reduction in voting power as the key factor.

Shareholder still participating in same voting blocks.

Held: Not a “meaningful reduction” & the

§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 (only owned) – 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 the 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? Assuming no “complete termination” treatment (§302(b)(3)) because of a 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
for partial liquidation 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 the 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.

(1/3) (M's wife)(1/3) (1/3)

ALPHA

Books Cram Beta, Inc. Securities

(division) (division) (100% sub) portfolio

Problem p.240
Partial Liquidation?

(a) Michael & Pamela – exchange treatment under

§302(b)(4) & 302(e)(2). Iris not eligible (as corp) & §301 distribution (under §302(d)) & subject to §1059 (extraordinary dividend – basis reduced for nontaxed portion of dividend).

(b) Not satisfying §302(e)(2) for individuals because of time limit? But, eligible under §302(e)(1)?

Tacking when tax-free reorg – if business conducted for five years.

Problem p.240
Partial Liquidation?

(c) Fire & ½ insurance proceeds distributed. Not qualifying under §302(e)(2) (not ceasing business), but §302(e)(1) – not essentially equivalent to a dividend? Sufficient corporate contraction?

(d) Books assets distributed to Michael. (1) partial liquidation under §302(b)(4) (and no family attribution rules apply); and, (2) §302(b)(1) – since Michael’s interest goes from 66 2/3^rd to 50% (with attribution of ownership); Rev. Rul. 75-502.

Problem p.240
Partial Liquidation?

(e) Assets of Books to Iris (corp) to redeem all its Alpha stock. §302(b)(3) complete termination of Iris’s interest in Alpha.

(f) Distribution of securities portfolio: not a qualified corporate contraction. All the shareholders have a §301 (dividend) distribution.

Problem p.240
Partial Liquidation?

(g) Alpha sells Beta stock and pro-rata distribution of the proceeds. Sale of sub’s stock not a qualifying partial liquidation. Rev. Rul. 79-184. Therefore, §301 distribution.

(h) Alpha liquidates Beta and Alpha distributes the Beta assets. Qualifying partial liquidation distribution under §302(b)(4). Later discussion: this is a tax-free liquidation under §332.

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. Cf., §301 distribution.

Rev. Rul. 74-338 p.243
E&P Determination

What pro-rata share of E&P is attributable to redeemed shares (when cap gain 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 (spouse & children) are not in a minority/non-controlling shareholder position after the 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 the tax basis for shares is stepped up (down?) (§1014, in 2011 & thereafter) to FMV of the 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. Rev. Rul. 69-608, p.254

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 corporation’s 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 of shares is 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 the 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, the primary obligation is 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 the sale was for tax basis.

No constructive dividend to A & C since the options were not primary and unconditional obligations assumed by the corp.

continued

Problem p.257
Buy-Sell Tax Issues

A, B & C each own 1/3 of X corporation.

(e) 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. B has cap gain (but no gain due to basis step-up) continued

Problem (e) cont. p.257
Treatment to X Corp.

1) Are the premiums deductible by X Corp.?

No, §264(a)(1).

2) At death the insurance proceeds are received tax-free 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 the collection of the proceeds.

continued

Problem - Treatment to Shareholders A&C p.257

(e) cont.

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 the redemption of her 50 percent interest (required by franchisor). Installment sale reporting.

In refund litigation she asserts the 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 the 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 & sourced from the corporation?

What Divorce Tax Planning in this Context? P.262

Get her (departing shareholder) to redeem and obtain LT capital gains treatment (at 20%) 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 20% dividend treatment on his stock redemption (since he is not eligible for “sale or exchange” treatment)?

Ultimate question: Does he have (1) primary or (2) 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 (at book value) by the issuing corporation 1-2 years after 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 when only a remainder to charity.

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?

Considering the Collateral Income Tax Effects

1) Dividend treatment or redemption treatment.

2) How test for dividend treatment?

3) If dividend, where is distribution sourced from (a) first and (b) second?

4) What is the tax basis for stock acquired to the purchasing corporation (cost or transferred)? & a basis reduction for the deemed distribution?

5) What is the reduction of the E&P account?

§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% com.+pref. 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.

§304(a)(1) applies (constructive ownership rules).

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 by Clause 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).