The Big Picture (slide 1 of 3) Christina Flores formed Orange Corporation 15 years ago –She owns all 10,000 shares of Orange stock outstanding –Stock basis of $400,000. Christina has been employed full-time with Orange since its inception –Handles all corporate management and strategy decisions. –She receives an annual salary of $250,000. Within the next 5 to 7 years, Christina would like to retire and transfer ownership to her two children, ages 24 & 22. –The children have worked full-time with Orange over the last two years. –They have the capacity and willingness to take over the business after their mother’s retirement.
The Big Picture (slide 2 of 3) Currently, the Orange stock is worth $6 million. –Expected to be worth $8 million by Christina’s retirement. –The stock represents approximately 80% of Christina’s net worth. Orange Corporation (E & P of $2 million) generates strong positive cash flow –Will require a significant investment in property, plant, and equipment over the next several years.
The Big Picture (slide 3 of 3) The children are not expected to have the financial wherewithal to purchase the Orange stock from their mother at the time of her retirement. –Christina would be receptive to taking notes in exchange for her Orange stock. How could a stock redemption be used to assist Christina in achieving her goal of transferring control of Orange to the children upon her retirement? Read the chapter and formulate your response.
Effect of Redemption (slide 1 of 3) If qualified as a redemption: –Shareholder reports gain or loss on surrender of stock Gain taxed at favorable capital gains rates (0%/15%) Shareholder reduces gain by basis in stock redeemed Capital gains may be offset by capital losses, if available
Effect of Redemption (slide 2 of 3) If transaction has appearance of a dividend, redemption will not be qualified: –For example, if shareholder owns 100% and corporation buys ½ of stock for $X, shareholder still owns 100%
Effect of Redemption (slide 3 of 3) If not qualified as a redemption: –Shareholder reports dividend income Individual shareholders may be taxed at 0%/15% rates But, redemption proceeds may not be offset by basis in stock surrendered Cannot be offset by capital losses –Corporate shareholders may prefer dividend treatment because of the dividends received deduction
The Big Picture – Example 1 Sale of Stock Return to the facts of The Big Picture on p Assume Christina sells 2,000 shares of Orange Corp. stock to a third party for $1.2 million. –If the transaction is treated as a sale or exchange (return of the owner’s investment), Christina has a long-term capital gain of $1,120,000 $1.2 million (amount realized) – $80,000 (stock basis).
The Big Picture – Example 2 Redemption Treated as D ividend Distribution Return to the facts of The Big Picture on p Assume that Orange Corp. redeems 2,000 of its shares from Christina for $1.2 million. –If treated as a dividend distribution (return from the owner’s investment), Christina has $1.2 million of dividend income. –After the redemption, Christina continues to own 100% of the Orange shares outstanding (8,000 shares ÷ 8,000 shares).
Transactions Treated as Redemptions (slide 1 of 3) The following types of distributions may be treated as a redemption of stock rather than as a dividend: –Distributions not essentially equivalent to a dividend (subjective test) –Disproportionate distributions (mechanical rules)
Transactions Treated as Redemptions (slide 2 of 3) –Distributions in termination of shareholder’s interest (mechanical rules) –Partial liquidations of a corporation where shareholder is not a corporation, and either (1) Distribution is not essentially equivalent to a dividend, or (2) An active business is terminated (May be subjective (1) or mechanical (2))
Transactions Treated as Redemptions (slide 3 of 3) –Distributions to pay death taxes (limitation on amount of allowed distribution is mechanical test) Stock attribution rules must be applied, so distribution which appears to meet requirements may not qualify
Stock Attribution (slide 1 of 3) Qualified stock redemption must result in substantial reduction in shareholder’s ownership –Stock ownership by certain related parties is attributed back to shareholder whose stock is redeemed
Stock Attribution (slide 2 of 3)
Stock Attribution (slide 3 of 3) Family attribution rules can be waived for redemptions in complete termination of shareholder’s interest Stock attribution rules do not apply to partial liquidations or redemptions to pay death taxes
The Big Picture – Example 6 Stock Attribution Rules Return to the facts of The Big Picture on p Assume instead that Christina owns only 80% of the stock in Orange Corp. –The other 20% is owned by her two children. For purposes of the stock attribution rules, Christina is treated as owning 100% of the stock in Orange Corp. –She owns 80% directly and, because of the family attribution rules, 20% indirectly through her children.
Not Essentially Equivalent Redemptions (slide 1 of 3) Redemption qualifies for sale or exchange treatment if “not essentially equivalent to a dividend” –Subjective test –Provision was added to deal specifically with redemptions of preferred stock Shareholders often have no control over when preferred shares redeemed Also applies to common stock redemptions
Not Essentially Equivalent Redemptions (slide 2 of 3) To qualify, redemption must result in a meaningful reduction in shareholder’s interest in redeeming corp. Stock attribution rules apply Indicators of a meaningful reduction include: –A decrease in the redeeming shareholder’s voting control –Reduction in rights of redeeming shareholders to Share in corporate earnings, or Receive corporate assets upon liquidation
Not Essentially Equivalent Redemptions (slide 3 of 3) If redemption fails to satisfy any of the qualifying stock redemption rules –Treated as ordinary dividend –Basis in stock redeemed attaches to remaining stock owned (directly or constructively)
Qualifying Disproportionate Redemption (slide 1 of 4) Redemption qualifies as disproportionate redemption if: –Shareholder owns less than 80% of the interest owned prior to redemption –Shareholder owns less than 50% of the total combined voting power in the corporation after the redemption
Qualifying Disproportionate Redemption (slide 2 of 4)
Qualifying Disproportionate Redemption (slide 3 of 4)
Qualifying Disproportionate Redemption (slide 4 of 4) Shareholder has 46 2/3% ownership represented by 35 voting shares (60-25) of 75 (100-25) outstanding voting shares Redemption is qualified disproportionate redemption because: –Shareholder owns < 80% of the 60% owned prior to redemption (80% × 60% = 48%), and –Shareholder owns < 50% of total combined voting power of corporation
Complete Termination Redemptions Termination of entire interest generally qualifies for sale or exchange treatment –Often will not qualify as disproportionate redemption due to stock attribution rules –Family attribution rules will not apply if: Former shareholder has no interest (other than as creditor) for at least 10 years Agree to notify IRS of any disallowed interest within 10 year period
Redemptions in Partial Liquidation (slide 1 of 3) Noncorporate shareholder gets sale or exchange treatment for partial liquidation including: –Distribution not essentially equivalent to a dividend –Under a safe-harbor rule, distribution pursuant to termination of an active business
Redemptions in Partial Liquidation (slide 2 of 3) To qualify, distribution must be made within taxable year plan is adopted or the succeeding taxable year Not essentially equivalent test looks at effect on corporation –Requires genuine contraction of the business of the corporation Difficult to apply due to lack of objective tests Advanced ruling from IRS should be obtained
Redemptions in Partial Liquidation (slide 3 of 3) Under the safe-harbor rule, to meet the complete termination of a business test, the corporation must: –Have two or more active trades or businesses that have been in existence for at least five years Distribution must consist of the assets of a qualified trade or business or the proceeds from the sale of such assets –Terminate one trade or business and continue a remaining trade or business
The Big Picture – Example 16 Partial Liquidations (slide 1 of 3) Assume that Orange Corporation loses a major customer and a severe drop in sales occurs. The corporation reduces its inventory investment and has $600,000 of excess cash on hand as a result. It distributes the excess cash to Christina in redemption of 10% of her stock.
The Big Picture – Example 16 Partial Liquidations (slide 2 of 3) Since Christina’s ownership interest in Orange remains unchanged (100%), the redemption does not qualify as: –A not essentially equivalent redemption, –A disproportionate redemption, or –A complete termination redemption.
The Big Picture – Example 16 Partial Liquidations (slide 3 of 3) Further, the reduction in inventory does not qualify as a general contraction of Orange Corporation’s business Thus, the distribution is not a partial liquidation. –Therefore, the $600,000 is dividend income to Christina. – The $40,000 basis in the stock redeemed (10% X $400,000) attaches to the basis of Christina’s remaining shares of Orange.
Redemptions to Pay Death Taxes (slide 1 of 2) Allows sale or exchange treatment if value of stock exceeds 35% of value of adjusted gross estate –Stock of 2 or more corps may be treated as stock of single corp for 35% test if 20% or more of each corp was owned by decedent –Special treatment limited to sum of: Death Taxes Funeral and administration expenses
Redemptions to Pay Death Taxes (slide 2 of 2) Basis of stock is stepped up to fair market value on date of death (or alternate valuation date) –When redemption price equals stepped-up basis, no tax consequences to estate
Effect of Redemption on Corporation (slide 1 of 2) Gain or loss recognition –If property other than cash used for redemption Corporation recognizes gain on distribution of appreciated property Loss is not recognized –Corporation should sell property, recognize loss, and use proceeds from sale for redemption
Effect of Redemption on Corporation (slide 2 of 2) Effect on Earnings and Profits –E & P is reduced in a qualified stock redemption by an amount not in excess of the ratable share of E & P attributable to stock redeemed Corporate expenditures incurred in a stock redemption are not deductible –e.g., accounting, brokerage, legal and loan fees
Stock Redemptions—No Sale or Exchange Treatment Redemptions not qualifying under previous provisions –Treated as dividend distribution to extent of E & P –Attempts by taxpayers to circumvent redemption provisions led to rules covering: Preferred stock bailouts Sales of stock to related corporations
Effect of Preferred Stock Bailout (slide 1 of 4) Preferred stock bailout involves: –Corporate distribution of nontaxable (nonvoting) preferred stock dividend on common stock –Portion of basis in common stock is allocated to preferred stock –Shareholder then sells the preferred stock to third party Effect is bailout of corporate profits as a capital gain without reducing the shareholder’s percentage ownership in the corporation
Effect of Preferred Stock Bailout (slide 2 of 4) To minimize abuse potential, Code requires this treatment: –Shareholder has ordinary income (§306 taint) on sale of preferred stock to third party –Amount of ordinary income is FMV of preferred stock on date received as distribution from corporation Treated as a dividend for purposes of the 0%/15% maximum tax on dividend income but has no effect on the issuing corporation’s E & P
Effect of Preferred Stock Bailout (slide 3 of 4) To minimize abuse potential, Code requires this treatment (cont’d): –No loss recognized on sale of “tainted” preferred stock –If stock is redeemed by corporation, proceeds treated as a dividend to the extent of the corporation’s E & P
Effect of Preferred Stock Bailout (slide 4 of 4) §306 stock is stock which is not common stock: –Received as a nontaxable stock dividend –Received tax-free in a corporate reorganization (plus other requirements), or –Has a basis determined by reference to other §306 stock If a corporation has no E & P on the date of distribution of a nontaxable preferred stock dividend, the stock will not be § 306 stock
The Big Picture – Example 22 Preferred Stock Bailouts (slide 1 of 4) Return to the facts of The Big Picture on p Assume that on January 3, Orange Corp. (E & P of $2 million) declares and issues a nontaxable preferred stock dividend of 1,000 shares to Christina. After the stock dividend, the fair market value of the stock is: –$540 per share of common stock, –$600 per share of preferred stock. Two days later, Christina sells the 1,000 shares of preferred stock to Emily, an unrelated party, for $600,000.
The Big Picture – Example 22 Preferred Stock Bailouts (slide 2 of 4) Section 306 produces the following results: After the distribution and before the sale, the preferred stock has a basis to Christina of $40,000. $600,000 value of preferred stock $6 million value of preferred & common) X $400,000 original basis –At this time, the common stock has a new basis of $360,000.
The Big Picture – Example 22 Preferred Stock Bailouts (slide 3 of 4) Section 306 produces the following results (Cont’d): The sale of the preferred stock generates $600,000 of ordinary income to Christina. –This is the amount of dividend income Christina would have recognized had cash been distributed instead of preferred stock (i.e., the § 306 taint). The 15% maximum tax rate on dividend income is applicable to the $600,000.
The Big Picture – Example 22 Preferred Stock Bailouts (slide 4 of 4) Section 306 produces the following results (Cont’d): The $40,000 basis allocated to the preferred stock is added back to the basis of the common stock. –Thus, the common stock basis is increased back to $400,000. Orange Corporation’s E & P is unaffected by either the stock dividend or its subsequent sale.
Redemption with Related Entities (slide 1 of 2) When one corp acquires stock in another corp from a shareholder and the shareholder controls both corps (i.e., direct or indirect ownership of at least 50%) –§304 requires that the redemption result in a reduction of ownership interest that would satisfy one of the qualifying stock redemptions of § 302 (e.g., disproportionate redemption) or § 303 If the redemption does not qualify under those rules, the transaction is characterized as a dividend distribution
Redemption with Related Entities (slide 2 of 2) When brother-sister corporations are involved –Stock received by acquiring corp treated as a capital contribution Corp’s basis in acquired stock is same as shareholder’s basis Shareholder’s basis in acquiring corp is increased by basis of stock surrendered
Corporation Division Under §355 If one corp controls another corp –Stock in subsidiary can be distributed to shareholders tax free if requirements of §355 are met
Liquidations—In General Corporation winds up affairs, pays debts, and distributes remaining assets to shareholders –Produces sale or exchange treatment to shareholder –Liquidating corporation recognizes gains and losses upon distribution of its assets, with certain exceptions
Liquidations—Effect on Corporation (slide 1 of 3) Gain or loss is recognized by corporation on distribution in complete liquidation –Loss may be disallowed or limited if: Property distributed to related parties Property distributed has built-in losses A subsidiary’s liquidating distribution to its parent corporation or to its minority shareholders –Property treated as if sold for FMV –Result: Liquidating distribution subject to corporate level tax (gain), and shareholder level tax (receipt of proceeds)
Liquidations—Effect on Corporation (slide 2 of 3) Limitations on losses—Related Party Situations –Losses are disallowed on liquidating distributions to related parties if: Distribution is not pro rata –In pro rata distributions, each shareholder receives their share of each asset Property distributed is disqualified property –Disqualified property is property acquired by corp in a §351 transaction during the five-year period ending on date of distribution
Liquidations—Effect on Corporation (slide 3 of 3) Limitations on losses—Built-in Loss Situations –Losses are disallowed when property distributed was acquired in a §351 transaction and principal purpose was to cause recognition of loss by corp on liquidation –Purpose is presumed if transfer occurs within two years of adopting liquidation plan
The Big Picture – Example 26 Antistuffing Rules (slide 1 of 2) Return to the facts of The Big Picture on p Assume that Christina transfers property to Orange Corp. in exchange for additional stock. –Property basis = $100,000, fair market value = $55,000. –The exchange qualifies under § 351. Absent any exceptions, the general rule of carryover basis would apply. –Orange would take a carryover basis of $100,000 in the property. –Christina would take a $100,000 basis in the additional stock.
The Big Picture – Example 26 Antistuffing Rules (slide 2 of 2) A sale or liquidating distribution of the property by Orange Corp. would result in a $45,000 loss. –$55,000 (fair market value of property) - $100,000 (property basis). Similarly, a sale by Christina of the stock acquired in the § 351 exchange would also result in a $45,000 loss. –$55,000 (fair market value of stock) - $100,000 (stock basis).
Distribution of Loss Property in Liquidation
Liquidations—Effect on Shareholder (slide 1 of 2) Gain or loss recognized on receipt of property from liquidating corporation –Amount = FMV of property received - basis in stock Generally, capital gain or loss –Basis in assets received in liquidating distribution = FMV on date of distribution
Liquidations—Effect on Shareholder (slide 2 of 2) –Special rule for installment obligations Shareholder may defer gain recognition to point of collection Corporation must recognize all gain on distribution
Liquidations: Parent-Subsidiary Situations (slide 1 of 4) Parent corporation does not recognize gain or loss on liquidation of subsidiary –Also, subsidiary recognizes no gain or loss on property distributions to its parent
Liquidations: Parent-Subsidiary Situations (slide 2 of 4) To qualify: –Parent must own at least 80% of voting stock and value of subsidiary’s stock –Subsidiary must distribute all property in complete cancellation of all its stock within the taxable year or within 3 years from close of tax year in which first distribution occurred –Subsidiary must be solvent
Liquidations: Parent-Subsidiary Situations (slide 3 of 4) Liquidating distributions to minority shareholders –Subsidiary corporation treated same way as in nonliquidating distribution Distributing corp recognizes gain but not loss –Minority shareholders recognize gain or loss Amount = FMV of property received-basis in stock
Liquidations: Parent-Subsidiary Situations (slide 4 of 4) Basis of property received by parent –Has same basis as subsidiary’s basis (unless election is made under §338) Parent’s basis in subsidiary’s stock disappears Parent acquires tax attributes of subsidiary –e.g., NOLs, business credit carryovers, capital loss carryovers, subsidiary’s E & P May result in some inequities
Election Under §338 (slide 1 of 4) Parent may elect to treat acquisition of stock in acquired corp as a purchase of the acquired corp.’s assets if: –Election is made by fifteenth day of ninth month following qualified stock purchase Qualified stock purchase occurs when corp acquires stock representing at least 80% of voting power and value within a 12-month period Must be acquired in taxable transaction –Stock purchases by affiliated group members count
Election Under §338 (slide 2 of 4) Tax Consequences –Parent corp has basis in subsidiary’s assets = basis in subsidiary’s stock Subsidiary may, but need not, be liquidated
Election Under §338 (slide 3 of 4) Tax Consequences (cont’d) –Subsidiary is deemed to have sold its assets for an amount determined with reference to parent’s basis in subsidiary’s stock, adjusted for liabilities of subsidiary
Election Under §338 (slide 4 of 4) Tax Consequences (cont’d) –Gain or loss is recognized by subsidiary –Subsidiary is treated as a new corporation that purchased all of its assets on the day after the qualified stock purchase date
Refocus On The Big Picture (slide 1 of 4) With proper planning, a complete termination redemption could be utilized to achieve Christina’s objectives. –In the years remaining before her retirement, Christina should ensure that her children are actively involved in the management and strategy decisions of Orange Corporation. –Also, an ownership interest in Orange should be shifted to each of the children so that they are in minority shareholder positions by the time Christina retires. The children could purchase Orange shares from Christina or newly issued shares from Orange.
Refocus On The Big Picture (slide 2 of 4) Alternatively, Christina could make gifts of Orange stock to the children. –This would eliminate the need for the children to raise capital for a stock purchase and would produce favorable estate tax consequences. Upon Christina’s retirement, Orange would redeem her remaining ownership interest –The two children would be sole shareholders of Orange Corporation. Assuming that Christina satisfies the requirements of the family attribution waiver, the transaction would qualify as a complete termination redemption. Orange Corporation could issue notes to finance the stock redemption. –Christina could use the installment method to report her gain.
Refocus On The Big Picture (slide 3 of 4) What If? What if Christina passes away before her retirement date? –A redemption to pay death taxes could be utilized to redeem Orange stock from Christina’s estate, as it appears that the requirements of § 303 would be satisfied. –However, a redemption would qualify under § 303 only to the extent of the estate’s death taxes and funeral and administration expenses.
Refocus On The Big Picture (slide 4 of 4) What If? A redemption of an amount greater than the death taxes and funeral and administration expenses probably would not qualify as a stock redemption –After the redemption to pay death taxes, the estate’s remaining shares of Orange would be distributed to the children, and they would control 100% of the outstanding shares of the corporation.