Selecting property to be distributed to minimize a corporation's recognition of gain.

Facts

John, Rex, Mike and Bill own 2,500 shares each of Jacorp, a real estate development company. John does not agree with the business goals of the other three shareholders and wants the corporation to redeem his stock for $60,000.

The corporation cannot afford to redeem the stock for cash because its cash reserve must be used to service real estate debt. However, the shareholders agree that Jacorp can distribute a tract of land to John.

The schedule at right illustrates the corporation's assets.

John does not care which tract of land he receives, because he plans to sell the land immediately. The other shareholders feel that the tracts will appreciate at about the same rate. Thus, they are willing to distribute any of the tracts. However, they do want to avoid corporate income tax on the transaction.

Issue

How can the redemption be structured without resulting in Jacorp's recognition of gain?

Analysis

If a corporation distributes property (other than the corporation's own obligations) that has a fair market value (FMV) in excess of its adjusted basis to a shareholder, the corporation must recognize gain as if the property had been sold at its FMV. No losses may be recognized on distributions of property to shareholders. If the property is subject to or secured by any liabilities, the FMV of the property is treated as not less than the amount of the liability. As a result, gain is recognized on distributions of property secured by liabilities in excess of basis.

Although Jacorp does not own property secured by liabilities in excess of basis, it does own appreciated property (tracts #1 and #2). Distribution of the appreciated property causes the corporation to recognize gain as if it had sold the property at FMV to the shareholder. The gain is computed on an asset-by-asset basis. Note that the IRS's position is that gain is also computed on an asset-by-asset basis when properties secured by liabilities in excess of basis are transferred to the shareholders.

If Jacorp distributes tract #1 or tract #2 to John in redemption of his stock, the corporation must recognize a $50,000 gain. However, if the corporation distributes tract #3, it will not recognize gain on the transaction.

Conclusion

Jacorp can avoid gain recognition on the redemption by carefully selecting the property to be distributed. In this situation, Jacorp can distribute $5,000 in cash and tract #3 (with a net equity of $55,000) in redemption of John's stock without recognizing gain. If the corporation distributes either tract #1 or tract #2, Jacorp must recognize taxable gain of $50,000. Therefore, the tax adviser should recommend that Jacorp distribute $5,000 in cash and tract #3 to John. This provides John with the $60,000 ($5,000 cash + $55,000 net equity in tract #3) he wants in exchange for his stock.

It must be must kept in mind that if the shareholder assumes debt in excess of the basis of the property distributed, the corporation recognizes gain whether the property is appreciated or not. Thus, care must be taken in selecting the property to be distributed.

Editor's note: This case study has been adapted from PPC Tax Planning Guide-Closely Held Corporations, 7th Edition, by Albert L. Grasso, R. Barry Johnson, Linda Ketter, Lewis A. Siegel, Joan Wilson Gray, Elizabeth DiTommaso and James D. Eversole, published by Practitioners Publishing Company, Fort Worth, Tex., 1994.