© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Corporations, Partnerships, Estates & Trusts 1 Chapter 6 Corporations: Redemptions and Liquidations

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 2 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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 3 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%

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 4 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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 5 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)

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 6 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))

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 7 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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 8 Stock Attribution (slide 1 of 5) 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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 9 Stock Attribution (slide 2 of 5) Attribution from family members –Stock owned by spouse, children, grandchildren, or parents attributed back to individual

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10 Stock Attribution (slide 3 of 5) Attribution from entity to owner: –Partner: deemed owner of proportionate number of shares owned by partnership –Beneficiary or heir: deemed owner of proportionate shares owned by entity –50% or more shareholder: deemed owner of proportionate shares owned by corporation

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 11 Stock Attribution (slide 4 of 5) Attribution from owner to entity –Partnership: deemed owner of total shares owned by partner –Estate or trust: deemed owner of total shares owned by heir or beneficiary –Corporation: deemed owner of total shares owned by 50% or more shareholder

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 12 Stock Attribution (slide 5 of 5) Family attribution rules do not apply to redemptions in complete termination of shareholder’s interest Stock attribution rules do not apply to partial liquidations or redemptions to pay death taxes

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 13 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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 14 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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 15 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)

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 16 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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 17 Qualifying Disproportionate Redemption (slide 2 of 4)

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 18 Qualifying Disproportionate Redemption (slide 3 of 4)

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 19 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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 20 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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 21 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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 22 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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 23 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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 24 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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 25 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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 26 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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 27 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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 28 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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 29 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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 30 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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 31 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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 32 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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 33 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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 34 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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 35 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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 36 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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 37 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)

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 38 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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 39 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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 40 Distribution of Loss Property in Liquidation

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 41 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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 42 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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 43 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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 44 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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 45 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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 46 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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 47 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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 48 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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 49 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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 50 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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 51 If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA SUNY Oneonta