Chapter 5

Question 1

What section deals with stock redemptions to cover death taxes?

Answer 1

303

Question 2

What is the definition of redemption, and what section is it?

Answer 2

“…stock shall be treated as redeemed by a corporation if the corporation acquires its stock from a shareholder in exchange for property, whether or not the stock so acquired is cancelled, retired, or held as treasury stock.” (§317(b))

Question 3

What is the ‘bottom line’ of redemption?

Answer 3

In order for a shareholder to achieve “sale or exchange” treatment (instead of “dividend” treatment) in a redemption under §302, the shareholder must have a meaningful reduction in percentage of stock ownership!!

Question 4

What are the 4 tests of §302(a), and what does the section say?

Answer 4

Redemption of Stock
§302(a) provides that a redemption will be treated as a sale or exchange of stock if one of the four tests in §302(b) applies:

1. Not equivalent to a dividend
2. Substantially disproportionate
3. Termination of a shareholder’s interest, or
4. Partial liquidation (only applies to noncorporate shareholder)

With the exception of redemptions under §303 (redemptions to pay death taxes), all other redemptions are taxable as dividends under §301(a)

Question 5

What is the ‘substantially disproportionate’ test of 302(b)(2)?

Answer 5

Following the redemption, does the shareholder own less than 50% of the total combined voting power?

• If yes, go to next test.
• If no, it’s potentially a dividend under 301(a)

Test #2:

Following the redemption, does the shareholder own less than 80% of the voting power owned prior to the redemption?

• If yes, go to next test.
• If no, potentially a dividend.

Test #3:

Following the redemption, does the shareholder own less than 80% of the common stock(voting and non-voting) owned prior to the redemption?

• If yes, you have ‘sale or exchange treatment’
• If no, potentially a dividend.

Question 6

What section are the “attribution rules”, or “constructive ownership rules” in?

Answer 6

318

Question 7

What are the constructive ownership rules?

Answer 7

1. Family attribution – spouse, parent, child, grandchild (note that §318 does not include siblings as related persons)
2. Entity to owner attribution
   
   1. Partnerships – stock owned by a partnership is considered owned proportionately by the partners of the partnership
   2. Trusts – beneficiaries (or grantors if trust is a grantor trust) are deemed to own stock owned by the trust to the extent of their “interest” in the trust
   3. Corporations – shareholders who own 50% or more by value in the corporation are deemed to own stock owned by the corporation to the extent of their percentage ownership of the corporation’s value
3. Owner to entity attribution
   
   1. Partnerships – stock owned by a partner shall be considered as owned by the partnership
   2. Trusts – stock owned by a trust beneficiary or grantor shall be considered as owned by the trust
   3. Corporations – stock owned by a 50% or greater shareholder (by value) shall be considered as owned by the corporation

Question 8

What are the re-attribution rules?

Answer 8

Re-attribution:

1. General rule: stock owned indirectly through attribution by a person shall be considered as actually owned by such person
2. Exceptions:
   
   1. Family to Family Attribution: stock constructively owned by an individual by reason of the family attribution rules “shall not be considered as owned by him for purposes of again applying paragraph (1) [family attribution rules] in order to make another the constructive owner of such stock.” (§318(a)(5)(B))
   2. Entity to Entity Attribution: “stock constructively owned by a partnership, estate, trust, or corporation by reason of the application of paragraph (3) [owner to entity attribution] shall not be considered as owned by it for purposes of applying paragraph (2) [entity to owner attribution] in order to make another the constructive owner of such stock.” (§318(a)(5)(C))

Question 9

What are 3 issues of the termination of a shareholder’s interest?

Answer 9

1. §302(b)(3) provides “sale or exchange” treatment if redeeming shareholder has his/her/its entire corporate interest redeemed
2. Sounds simple but §318 attribution (constructive ownership) rules apply
3. Shareholder could have his/her/its entire interest redeemed (which sounds like a “sale or exchange”) but because of attribution, he/she/it will still be deemed as an owner violating the §302(b)(3) rule

Question 10

What are the 4 conditions for the family attribution waiver to apply, and what section is it?

Answer 10

Family Attribution Waiver Under §302(c)(2)(A)
Applies if:

1. Shareholder has no remaining “interest in the corporation”
2. Shareholder complies with 10-year “no interest” rule
   
   1. No longer an employee
   2. No longer a contract employee
   3. No longer a board member
   4. Can be a creditor
   5. Can be a lessor
3. Shareholder promises to disclose to the IRS if rule is violated. This is combined with an extended statute of limitations as it relates to the redemption.
4. Within the 10 years prior to the shareholder’s complete redemption, the shareholder did not transfer shares through sale or gift with the principal purpose of tax avoidance. Likewise, the shares redeemed were not transferred to the redeeming shareholder in a sale or gift where the principal purpose of such transfer was tax avoidance.

Question 11

What are the facts and issues of Lynch vs Commissioner?

Answer 11

1. Lynch owned 100% of W.M. Lynch Co. The company was incorporated on April 1, 1960
2. Lynch owned equipment used by the corporation. Such equipment was leased by Lynch to the corporation
3. On 12/17/75, Lynch sold 50 shares (out of a total of 2,350 shares) to his son of Lynch Co.
4. Lynch and his wife resigned as directors and officers of the corporation on the date of sale
5. On 12/31/75, the corporation redeemed all shares owned by Lynch (2,300 shares) for $17,900 in property and a note for $771,920.
6. The son became the sole shareholder at this point in time
7. On the date of the redemption, Lynch entered into a consulting contract with the corporation, in essence to support his son as the sole owner of the business. The life of the contract was five years.
8. The consulting contract provided for income of $500/month + travel, entertainment and automobile expenses
9. Lynch went to the office every day for one year; thereafter, the days in the office dwindled to one or two per week
10. Lynch continued to be covered by the corporation’s group medical insurance policy

Issue:
Given the waiver of family attribution, did Lynch meet the complete termination of interest under §302(b)(3)?

Holding:
No. The consulting contract gave Lynch a continuing interest in the corporation. As such, the waiver was meaningless (or of not effect)

Question 12

What are the facts and issues of the Davis case?

Answer 12

Facts:

1. In 1945, Davis, his wife and Bradley formed a corporation
2. Davis and his wife each owned 250 shares; Bradley owned 500 shares
3. Shortly after incorporation, due to a need for additional capital (in order to qualify for a loan), Davis made an additional equity investment in the corporation acquiring 1,000 shares of preferred stock
4. It was understood among the parties that once the loan was repaid, the 1,000 shares of preferred stock would be redeemed
5. In the interim, Davis bought all of Bradley’s shares and gifted them to his son and daughter
6. In 1963, after the loan was completely repaid, Davis’ preferred stock was redeemed for $25,000

Issue:
Was the redemption of Davis’ preferred stock “not essentially equivalent to a dividend” given that there was a valid business purpose from day one for the redemption and tax avoidance was not a factor in the decision to redeem the stock?

Holding:
Redemption does not meet the “not essentially equivalent to a dividend” test. As such, the redemption was treated as a dividend distribution

Lessons Learned:

1. The attribution rules of §318 apply to §302(b)(1) as well as §§ 302(b)(2) and 302(b)(3)
2. Any situation where the redeemed shareholder owns directly or indirectly 100% of the corporation both before and after the redemption will not qualify as “not essentially equivalent to a dividend” under §302(b)(1)
3. Business purpose is irrelevant for §302(b)(1)

Question 13

What are the facts and issues of Revenue Ruling 75-502?

Answer 13

Revenue Ruling 75-502
Facts:

1. X corporation had outstanding one class of stock consisting of 1,750 shares of common stock
2. An estate owned 250 shares and individual A (the sole beneficiary of the estate) owned an additional 750 shares. The remaining 750 shares were owned by an unrelated individual B
3. Through the attribution (owner to entity) rules, the estate was deemed to own all shares held by A. Thus the estate was deemed to own, directly and indirectly, 57% of X corporation stock
4. X redeemed for cash all of the stock held directly by the estate
5. As such, following the redemption, A owned 50% of the stock and B owned the remaining 50%
6. Before the redemption, the estate was deemed to own 57%. Following the redemption, the estate was deemed to own 50%

Issue:
Does the reduction from 57% to 50% constitute a meaningful reduction such that the estate’s redemption meets the “not essentially equivalent to a dividend” test under §302(b)(1)?

Holding:
Yes. At 57%, the estate is deemed to have control. At 50%, it no longer has absolute control. This is a meaningful reduction eliminating dividend treatment.

Question 14

What are the facts and issues of the Cerone case?

Answer 14

Mike Cerone and his son Mick owned and operated Stockade Café (a corporation) each owning 50% of the outstanding stock
Father and son had a volatile relationship frequently disagreeing on various issues effecting the success of the corporation
Finally, they decided one of the two of them had to go!
The father (Mike) decided that he could not run the business alone and therefore it was decided that the corporation would redeem all of his shares
After the redemption, Mike continued to work at the café for several years but he did not exercise any control over the corporation
Based on an argument that the attribution rules don’t apply in this case due to the hostility between him and his son, Mike treated the redemption as a sale or exchange (i.e., qualifying under either §302(b)(3) or §302(b)(1)) – he could have also argued that he meets the tests under §302(b)(2) if the attribution rules didn’t apply!!
Further, Mike argues that even if the attribution rules do apply, the redemption is “not essentially equivalent to a dividend”

Issue:
Do the attribution rules apply given the hostility between father and son?
Is the redemption “not essentially equivalent to a dividend”?

Holdings:
Hostility is not a factor in determining whether or not the attribution comes into play under §302
The redemption is treated as a dividend distribution
The only way that Mike could have achieved “sale or exchange” treatment would be for him to waive the family attribution and fall under §302(b)(3). Of course, he would not be able to continue on as an employee of the corporation.

Question 15

What are the elements and requirements of §303?

Answer 15

Redemptions to Pay Death Taxes (§303)

1. In order to minimize the risk that a business would have to be sold in order to pay the decedent’s estate tax, Congress passed §303 to provide “sale or exchange” treatment to the estate rather than “dividend” treatment. Note that due to the step-up in basis of the stock (under §1014) held by the estate, the estate should have little or no tax if the redemption is treated as a “sale or exchange”. Not so if §303 didn’t exist since the redemption could be treated as a “dividend”.
2. §303 overrules §302

Requirements of §303

1. More than 35% of the estate’s value must be due to the stock being redeemed
2. 20% or more test if multiple corporations are owned – eliminates the need for a “death bed merger”
3. Generally, redemption must occur within 15 months

Question 16

What are the effects of redemptions on the distributing corporation?

Answer 16

Effect of Redemptions on Distributing Corporation

1. These rules apply to corporations engaged in both §302 and §303 redemptions
2. §311(b) gain applies on built-in gain on the assets distributed
3. E&P is reduced on a pro-rata basis for any redemption
   
   1. If 20% of the corporation’s shares are redeemed, 20% of the E&P is deemed distributed

Question 17

What are the elements of 304?

Answer 17

The Mystery of §304
The redemption of a small number of shares (out of a larger holding of shares) will likely be treated as a dividend
The sale of these same shares to an unrelated party will likely generate capital gain treatment
What about the sale of shares by the shareholder to a related party? Will this be treated as a dividend or as a sale?

§304 Creates the Potential for Dividend Treatment
Two types of §304 transactions exist

1. Brother-Sister sales
2. Parent-Subsidiary sales

Question 18

How do brother-sister sales work under 304?

Answer 18

Brother-Sister Sales

1. Shareholder (or shareholders) of Issuer (I) sell shares to Acquiror (A) in exchange for cash or property
2. Shareholder(s) must be in control of both “I” and “A”
3. Control is defined as owning 50% or more by vote or value (§304(c))
4. For purpose of control, the attribution rules apply
5. In terms of the attribution rules, the 50% corporation-shareholder test is reduced to 5%

Question 19

What section provides sale or exchange treatment on a ‘partial liquidation’ for a noncorporate shareholder?

What section defines a partial liquidation and what does it say?

Answer 19

Partial Liquidation

1. §302(b)(4) provides sale or exchange treatment on a “partial liquidation” for a noncorporate shareholder
2. §302(e) defines a “partial liquidation”
   
   1. Not essentially equivalent to a dividend (tested at the corporate level rather than at the individual shareholder level)
   2. Distribution is part of a plan that occurs during the current or succeeding taxable year

Question 20

What is the section and requirements of ‘safe harbor’?

Answer 20

Requirements of the Safe Harbor:

1. Distribution is attributable to the corporation ceasing to conduct a trade or business (must meet the 5-year test)
2. Immediately after the distribution, the corporation is actively engaged in the conduct of a qualified trade or business (must meet the 5-year test)

Other Issues

1. The distribution can be pro-rata among the shareholders but it doesn’t have to be so
2. For a corporate shareholder, a “partial liquidation” is always treated as a dividend (not a bad thing for a corporation due to the dividend received deduction of §243)

Question 21

What are the facts and issues of the Imler case?

Answer 21

Facts:

1. Prior to 12/01/41, Imler Supply Co. (a corporation) was engaged in the business of retinning and soldering metals as well as renting excess space in buildings owned by the company
2. In its main building, Imler leased its top two floors (the 6th and 7th floors) to the Allegheny County Milk Exchange
3. On 12/01/41, a fire destroyed these two upper floors
4. The fire was insured and in 1942, Imler received insurance proceeds in the amount of $28k as a result of the fire
5. The cost to rebuild the two floors was estimated to be approximately $40k to $50k. Alternatively, a roof could be put on the 5th floor for approximately $15k
6. It was determined to place a roof on the 5th floor and to distribute $15k of excess cash to the shareholders
7. If it weren’t for the excess insurance proceeds, the corporation could not have paid the $15k in distribution to the shareholders
8. The corporation ceased to engage in the business of retinning and soldering metals due to lack of storage space. Likewise, the war made it difficult to make a profit in this business

Issue:
Did the distribution of $15k to the shareholders constitute a dividend taxable at ordinary rates or a partial liquidation taxable at capital gains rates (after reduction of a portion of the shareholders’ basis)?

Holding:
The distribution constitutes a partial liquidation