Magazine article The CPA Journal

Distributions in Redemption of Stock

Magazine article The CPA Journal

Distributions in Redemption of Stock

Article excerpt

Getting property out of a corporation is much easier than getting favorable tax treatment from the distributions of property. Understanding IRC Sec. 302(b) will possibly provide capital gain (exchange) treatment as opposed to ordinary income treatment for corporate distributions.

The key is to structure the distribution to be taxed as a redemption of corporate stock. A redemption results whether the corporate stock is canceled, retired, or held as treasury.

REDEMPTION TREATED AS EXCHANGE

There are four ways for a redemption to be taxed as an exchange.

NOT EQUIVALENT TO A DIVIDEND. One way is when a redemption is not equivalent to a dividend measured at the individual level. This takes place after the application of.the family attrihution rules and must result in a meaningful reduction in the shareholder's proportionate interest in the corporation. Items that define a meaningful reduction are the shareholder's ability to control the corporation, the shareholder's share of corporate earnings and the shareholder's rights upon liquidation after the distribution is made.

SUBSTANTIALLY DISPROPORTIONATE REDEMPTION. The second test measures a substantially disproportionate redemption of stock. For this condition to be met the shareholder must satisfy the following tests:

* The shareholder must own less than 50% of the combined voting power of all classes of stock entitled to vote, immediately after the redemption;

* The ratio of voting or nonvoting stock owned by the shareholder must be less than 80% of the shareholder's ownership of stock prior to the distribution; and

* There can not be a series of redemptions pursuant to a plan which results in distributions not substantially disproportionate to the shareholder.

TERMINATION OF SHAREHOLDER'S INTEREST. The third possibility is when there is a termination of a shareholder's interest. Exchange treatment will be granted when a redemption is for all of the stock of the corporation owned by a shareholder.

REDEMPTION FROM NON-CORPORATE SHAREHOLDER. The fourth possibility occurs when there is a redemption from a non-corporate shareholder in partial liquidation. This takes place when the redemption of stock is held by a shareholder who is not a corporation and occurs in partial liquidation of a distributing corporation. A distribution is made in partial liquidation if it is not essentially equivalent to a dividend, is pursuant to a plan, and takes place within one tax year from that in which the plan is adopted. A distribution is not considered equivalent to a corporate dividend, which is determined at the corporate level, if the following situations come into play.

* The distribution of property is attributed to the cessation of an active trade or business carried on for a period of five years preceding the date of redemption by the distributing corporation; and

* Immediately after the distribution, the distributing corporation is actively engaged in another trade or business that also has been carried on for at least five years before the date of redemption.

CONSTRUCTIVE OWNERSHIP OF STOCK

The attribution rules will apply in the determination of a shareholder's ownership. Termination of a shareholder's interest takes place when immediately after the distrihution the distributee relinquishes all interest in the corporation (including an interest as officer, director, or employee). A former shareholder can have an interest as a creditor, lessor or independent contractor.

The distributee may not acquire any such interest (other than stock acquired by bequest or inheritance) within 10 years from the date of such distribution, which includes interest in a subsidiary or a parent and the distributee must file an agreement to notify the IRS of any acquisition of any interest described above. …

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