Redemptions and disappearing basis.

Under Sec. 302(b), a corporation's redemption of stock from a shareholder for property is treated as a sale or exchange if one of the following applies:

1. The redemption is not essentially equivalent to a dividend.

2. The distribution of property is substantially disproportionate with respect to the shareholder.

3. The redemption is in complete termination of the shareholder's interest.

4. The distribution is in redemption of a noncorporate shareholder and is in partial liquidation of the distributing corporation.

For all the above tests, the Sec. 318 stock attribution rules apply.

Tax Ramifications 

If a corporation purchases its stock back from a shareholder, and the transaction fits one of the above classifications, the shareholder will recognize gain or loss on the redemption under Sec. 1001. Thus, the shareholder will compare the fair market value of property and/or cash received to the basis in the redeemed shares. The corporation will recognize no gain or loss on the redemption, unless it has distributed appreciated property to the shareholder; see Sec. 311(b).

If a corporation purchases its stock back from a shareholder, and the transaction does not fit one of the listed circumstances, the distribution will be characterized as either a dividend, a return of capital or capital gain under Sec. 301. Under Secs. 301(c)(1) and 316(a), the distribution is a dividend up to the amount of the corporation's accumulated and current earnings and profits (E&P). According to Sec. 301(c)(2), if the distribution exceeds E&P, it is a return of capital up to the shareholder's basis in the redeemed stock. Finally, under Sec. 301(c)(3), if the distribution exceeds both E&P and the shareholder's basis, the excess distribution is capital gain.

Basis Disappearance

A problem that occurs when Sec. 301 applies to a dividend-equivalent redemption is "basis disappearance." As described above, if a corporation purchases its stock back flora a shareholder and Sec. 301 applies, the distribution can be characterized as a dividend, return of capital or capital gain. However, what happens to the basis of the shares actually redeemed by the corporation for the property received? Does it just "disappear" and produce no benefit to the shareholder? The IRS initially addressed the disappearing-basis issue in Sec. 302 regulations issued in 1955; see TD 6152 (12/2/55).

Example 1: Individual A purchased all 100 outstanding shares of X Corp. stock for $60. Two years later, X redeems 50 of A's shares for $100; its E&P exceeds $100. A has $100 dividend income (under Sec. 301(c)(1)) and $30 "disappearing basis" (50% of his original basis, because only half of his shares were redeemed). Under Regs. Sec. 1.302-2(c), Example (1), the basis of the shares redeemed are added to the basis of the shares A still retains. Thus, $30 is added to A's basis in his remaining 50 X shares (which already have a $30 basis); his new basis in those 50 shares is $60.

In the 1955 regulations, the IRS went on to clarify further the treatment of disappearing basis in redemptions involving related parties and the Sec. 318 attribution rules.

Example 2: The facts are the same as in Example 1, except that 50 shares of X stock were originally each acquired by A and B, A's spouse. Thus, A still receives $100 dividend income and there is $30 disappearing basis. Because A now owns no X shares directly, the disappearing basis cannot be added to A's remaining shares. Regs. Sec. 1.302-2(c), Example (2), provides that the $30 disappearing basis is added to B's basis in X stock, giving B a $60 total basis.

Prop. Regs.

In 2002, the IRS issued proposed regulations under Sec. 302 (REG-150313-01, 10/18/02) that provided significant differences in tax treatment in Examples 1 and 2 above. Under the proposed regulations, A would have a realized loss equal to the disappearing basis in the shares redeemed, but would not be able to recognize it until the earlier of the "final inclusion date" or the "accelerated loss inclusion date." The final inclusion date is a date after the distribution when the shareholder would first meet Sec. 302 for the corporation's purchase of stock from the shareholder. When this occurs, the shareholder can recognize the entire suspended loss connected with the disappearing basis. The accelerated loss inclusion date is a date after the distribution when the shareholder recognizes gain on the sale or exchange of part or all of his or her remaining shares in the corporation. The suspended loss created by the disappearing basis can be recognized only up to the amount of such gain.

Applying these rules to Example 1 above, A would still recognize $100 dividend income, but would also have a $30 realized loss (A's basis in the redeemed shares), which A could not recognize until the final inclusion date or accelerated loss inclusion date. The former would be triggered, for example, if X redeemed all of A's remaining shares; the latter would be triggered, for example, if A sold the remaining 50 shares to an unrelated third party for a $30 recognized gain. Both of these events would allow A to recognize a $30 capital loss.

In Example 2 above, A would still recognize $100 dividend income. However, A would also have a $30 realized loss that would not be recognized until, for example, X redeemed all of B's shares (final inclusion date) or B sold part or all of the shares to an unrelated third party at a gain (accelerated loss inclusion date).

Criticism: Citing various critical comments to its proposed disappearing-basis rules, the IRS withdrew the proposed regulations in Ann. 2006-30. The IRS said it would continue to study the disappearing-basis issue and would particularly welcome comments on whether a different approach is warranted for corporations filing consolidated returns. Also, the Service indicated that it was reconsidering whether, under a dividend-equivalent redemption, only the basis of the redeemed shares could be recovered under Sec. 301(c)(2) before applying Sec. 301(c)(3).

Conclusion

Stock redemptions require practitioners to focus not only on the nature of the property distributed, but also on the classification, basis and capital gain issues involved. The IRS has tried to improve the guidance already available through the issuance of new regulations; however, many tax professionals were not satisfied with the proposed treatment. Hopefully, the Service will ultimately adopt a reasonable solution that addresses the problems identified in the comments to the now-withdrawn regulations. Until then, the 1955 disappearing-basis rules still apply to dividend-equivalent redemptions.

FROM RORY J. MCKEAGUE, CPA, OAK BROOK, IL