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Structuring a redemption.

FACTS: Basic Corporation is an S corporation that has been successful for several years. Basic once was a regular C corporation and has accumulated earnings and profits (AE&P) of $250,000. Distributions in past years have left the corporation with an accumulated adjustments account (AAA) balance of only $20,000. The two shareholders, Bert and Chuck, are not related. Of the corporation's 1,000 shares of outstanding voting common stock, Bert owns 600 and Chuck owns 400. Bert has a basis in his stock of $300,000, while Chuck has a basis in his stock of $200,000. The corporation has a current fair market value (FMV) of $1,000 ($1,000 per share).* Because Bert wants to pursue other business interests, the shareholders have decided to change their ownership percentages through a stock redemption. Bert wants additional cash, while Chuck wants an increase in his ownership (as he will be solely responsible for the corporation in the future). However, for various financial reasons, neither shareholder wants Basic to redeem all of Bert's stock.* The shareholders meet with the corporation's tax adviser to discuss their options. They intend to have Basic redeem 208 shares from Bert at its current FMV of $1,000 per share; this will reduce Bert's stock interest from 60% to 49% and increase Chuck's stock interest from 40% to 51%. Issue: Can the proposed redemption be structured to qualify for sale or exchange treatment?

Analysis

A redemption will be considered a sale or exchange subject to capital gain treatment if it is: 1. in partial liquidation of a corporation, 2. substantially disproportionate, 3. in complete termination of the shareholder's interest, 4. made to a deceased shareholder's estate or beneficiary and does not exceed the estate taxes and administration expenses, or 5. not essentially equivalent to a dividend.

The proposed redemption will not qualify as a partial liquidation of the corporation or a complete termination of Bert's interest. Further, both Chuck and Bert are alive and well, so the redemption will not be made for the shareholder's estate or beneficiary to pay estate taxes and administration expenses.

Additionally, the redemption cannot qualify as a substantially disproportionate distribution. One of the requirements for such a redemption is that the shareholder's percentage ownership of outstanding voting stock and outstanding common stock (whether voting or nonvoting) immediately after the redemption must be less than 80% of the percentage of such stock owned by the shareholder immediately before the redemption. In this case, Bert's stock, ownership immediately after the redemption will be 82% of his ownership immediately before the redemption (49%/60%).

Thus, unless it can be established that the distribution is not essentially equivalent to a dividend, Bert will recognize $188,000 of ordinary income (the first $20,000 will be tax free from AAA, but the remainder will come from AE&P). However, if the redemption qualifies as being not essentially equivalent to a dividend, it will be treated as a sale or exchange, and Bert will recognize a capital gain of $104,000 ($500 gain per share X 208 shares).

No statutory tests exist to verify whether a distribution is not essentially equivalent to a dividend. Each case must be decided on its own facts and circumstances. Generally, dividend treatment arises when a corporate distribution to a shareholder does not result in a significant change in the shareholder's ownership. Thus, for the distribution to be not essentially equivalent to a dividend, it must result in a meaningful reduction in the shareholder's interest. In determining whether a meaningful reduction has occurred, the tax adviser should look to the change in the shareholder's right to: 1. participate in the corporation's E&P, 2. share in net assets on liquidation, and 3. vote (if the stock held by the shareholder is voting stock).

The IRS has ruled that a meaningful reduction in a shareholder's interest occurred when that interest was reduced: 1. from 57% to 50%, 2. from 30% to 24.3%, and 3. from 47.61% to 31.4%.

At the same time, the Service has ruled that a reduction in a shareholder's interest from 90% to 60% was not meaningful when the shareholder retained day-to-day control after the redemption. Note: Although the Code is unclear on the effect of the stock attribution rules, both the IRS and the Supreme Court have determined that the Sec. 318(a) constructive ownership (stock attribution) rules apply. Thus, if Bert and Chuck were related, Chuck's ownership would have to be considered in determining whether there has been a meaningful reduction in Bert's interest. Although some uncertainty exists as to the effect of family disharmony on the attribution rules, the Service has taken the position that family conflict has no effect on these rules. The courts have sometimes agreed with the IRS's position and sometimes disagreed.

Conclusion

The redemption of Bert's stock by Basic will not qualify as a sale or exchange under Sec. 302 or 303. However, Bert can report capital gain instead of ordinary income because the proposed redemption will result in a meaningful reduction of his interest in Basic. Because Bert now owns less than 50% of the stock, he no longer has a majority interest and must abide by Chuck's decisions. Additionally, Bert has given up a portion of his right to participate in Basic's E&P and a portion of his right to share in the assets on liquidation. While it appears that the redemption should qualify as a distribution that is not essentially equivalent to a dividend, Bert should still be aware of the possibility of IRS challenge.

Variation

Assume that Basic will redeem 300 shares from Bert. This will reduce his stock interest from 60% to 43%, and increase Chuck's stock interest from 40% to 57%. Under these changed facts, does the proposed redemption for sale or exchange treatment as a substantially disproportionate redemption? The redemption will be substantially disproportionate if the following three tests are met: 1. Bert must own, immediately after the redemption, less than 80% of the outstanding voting stock he owned immediately before the redemption. 2. Bert must own, immediately after the redemption, less than 80% of the percentage of the outstanding common stock (voting and nonvoting) he owned immediately before the redemption. 3. Bert must own, immediately after the redemption, less than 50% of the total combined voting power of all outstanding voting stock.

Stock constructively owned by Bert under the Sec. 318(a) attribution rules must be considered in these tests. The substantially disproportionate tests apply to a redemption of voting stock or of both voting stock and other stock; however, they do not apply to the redemption of solely nonvoting stock. If more than one shareholder is redeemed, the determination as to whether the tests are met is made separately for each shareholder.

In applying the first two rules, the tax adviser determines that Bert needs to own less than 48% (80% X 60%) of the outstanding stock after the redemption (because only voting common stock is outstanding, the first and second tests are identical). If Basic redeems 300 shares from Bert, there will 700 total outstanding shares, and Bert will own 43% of the outstanding stock. Thus, the first and second tests will be met. The redemption also meets the third test because Bert's percentage ownership of all voting stock after the redemption is less than 50%.

However, the IRS may consider any reacquisitions of stock in determining whether the mechanical 80% and 50% tests are met. This possibility is extremely important if Basic redeems Bert's stock with a corporate note. If the corporation defaults on the note, Bert might have to reacquire the stock, which could possibly jeopardize the prior exchange treatment. Similarly, the Service may consider a subsequent redemption in determining whether a previous redemption qualifies as substantially disproportionate. This is particularly important if there are indications (not present in this situation) that the shareholders are considering further redemptions.

In addition, when the ownership percentages otherwise prevent qualification as a substantially disproportionate redemption, a sale or purchase of stock between shareholders may enable the distribution to qualify as a substantially disproportionate redemption. If the redemption and sale are part of the same overall plan, the redemption should qualify for exchange treatment.

Finally, the tax adviser may want to remind the shareholders that Bert's redemption does not provide additional stock basis for Chuck, because Chuck has incurred no costs in the redemption.
COPYRIGHT 1997 American Institute of CPA's
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Copyright 1997, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Author:Ellentuck, Albert B.
Publication:The Tax Adviser
Date:Aug 1, 1997
Words:1405
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