Chapter 6 - Redemptions

Question 1

Stock redemption

Answer 1

Under § 317(b), A corporation buys back its own stock from a specified shareholder. Typically, the corporation recognizes any realized gain on the noncash assets that it uses to effect a redemption, and the shareholder obtains a capital gain or loss upon receipt of the purchase price.

Question 2

Only a ___________ stock redemption is treated as a sale for tax purposes

Answer 2

qualifying

Question 3

Nonqualified stock redemptions…

Answer 3

are denied sale or exchange treatment because they are deemed to have the same effect as dividend distributions
Cannot be offset by capital losses

Question 4

What are common reasons why stock redemptions occur?

Answer 4

Publicly traded corporations often reacquire their shares in order to increase shareholder value.
For corporations where the stock is closely held, redemptions frequently occur to achieve shareholder objectives.
As a result of property settlements when a divorce occurs.
Buy-sell agreements between shareholders

Question 5

Why do noncorporate shareholders generally prefer to have a stock redemption treated as a sale or exchange rather than as a dividend distribution?

Answer 5

It results in both the tax-free recovery of the redeemed stock’s basis and the ability to offset any capital gain against capital losses

Question 6

What is the tax rate for long-term capital gains and qualified dividend income for individual taxpayers?

Answer 6

0, 15, or 20% depending on the taxpayer’s taxable income

Question 7

Why do most corporations prefer a nonqualifying stock redemption?

Answer 7

They receive more favorable tax treatment from a dividend distribution. Only a portion of dividend distribution is included in taxable income because of the dividends received deduction.

Question 8

Do corporations have a preferential tax rate on dividend and long-term capital gain income?

Answer 8

No

Question 9

When a qualifying stock redemption results in a loss to a shareholder rather than a gain, § 267 disallows loss recognition if…

Answer 9

the shareholder owns (directly or indirectly) more than 50 percent of the corporation’s stock.

Question 10

A shareholder’s basis in any property received in a stock redemption, qualifying or nonqualified, generally will be…

Answer 10

the property’s fair market value on the date of the redemption.

Question 11

When does the holding period of the property begin?

Answer 11

On the date of the redemption

Question 12

What are the five types of stock redemptions that qualify for sale or exchange treatment?

Answer 12

1. Distributions not essentially equivalent to a dividend
2. Distributions substantially disproportionate in terms of shareholder effect
3. Distributions in complete termination of a shareholder’s interest
4. Distributions to noncorporate shareholders in partial liquidation of a corporation
5. Distributions to pay a shareholder’s death taxes

Question 13

What are the requirements to qualify for “Not essentially equivalent to a dividend [§ 302(b)(1)]”?

Answer 13

Meaningful reduction in the shareholder’s voting interest. Reduction in the shareholder’s right to share in earnings or in assets upon liquidation also is considered.

Stock attribution rules apply.

Question 14

What are the requirements to qualify for “Substantially disproportionate [§ 302(b)(2)]”?

Answer 14

Shareholder’s interest in the corporation, after the redemption, must be less than 80% of interest before the redemption and less than 50% of the total combined voting power of all classes of stock entitled to vote.

Stock attribution rules apply.

Question 15

What are the requirements to qualify for “Complete termination [§ 302(b)(3)]”?

Answer 15

Entire stock ownership terminated.

In general, stock attribution rules apply. However, family attribution rules are waived when the former shareholder has no interest, other than as a creditor, in the corporation for at least 10 years after the redemption and files an agreement to notify the IRS within 30 days of any prohibited interest acquired during the 10-year period. Shareholder must retain all necessary records during the 10-year period.

Question 16

What are the requirements to qualify for “Partial liquidation [§ 302(b)(4)]”?

Answer 16

Not essentially equivalent to a dividend and both pursuant to a plan and made within the plan year or within the succeeding taxable year.

Genuine contraction of corporation’s business.

Termination of a business.
Corporation has two or more qualified trades or businesses.
Corporation terminates one qualified trade or business while continuing another qualified trade or business.

Distribution may be in form of cash or property.

Redemption may be pro rata.

Stock attribution rules do not apply.

Question 17

What are the requirements to qualify for “Redemption to pay death taxes [§ 303]”?

Answer 17

Value of the stock of one corporation in the gross estate exceeds 35% of the value of the adjusted gross estate. Decedent held at least 20% of the outstanding shares combined.

Redemption limited to the sum of death taxes and funeral and administration expenses.

Generally tax-free because the estate’s tax basis of stock is FMV on the date of the decedent’s death and the value is unchanged at redemption.

Stock attribution rules do not apply.

Question 18

Attribution

Answer 18

Under certain circumstances, the tax law applies attribution (constructive ownership) rules to assign to one taxpayer the ownership interest of another taxpayer.

Question 19

Under attribution rules, related parties are defined to include…

Answer 19

spouses, children, grandchildren, and parents

Question 20

When a redemption fails to satisfy any of the qualifying stock redemption rules, the basis of the redeemed shares…

Answer 20

does not disappear

Question 21

Meaningful Reduction Test

Answer 21

A decrease in the shareholder’s voting control. Used to determine whether a stock redemption qualifies for sale or exchange treatment.

Question 22

A redemption that does not qualify as a disproportionate redemption may still qualify as…

Answer 22

a not essentially equivalent redemption if it meets the meaningful reduction test

Question 23

Is the acquisition of stock in the corporation by bequest or inheritance a prohibited interest?

Answer 23

No

Question 24

What transactions has the IRS ruled will not satisfy the genuine contraction test?

Answer 24

Sale of investments
Sale of excess inventory

Question 25

A safe-harbor rule, the termination of a business test, will satisfy the “not essentially equivalent to a dividend” requirement. A distribution will qualify under the termination of a business test if all of the following conditions are met:

Answer 25

The corporation has two or more qualified trades or businesses. A qualified trade or business is any trade or business that (1) has been actively conducted for the five-year period ending on the date of the distribution and (2) was not acquired in a taxable transaction during that five-year period.

The distribution consists of the assets of a qualified trade or business or the proceeds from the sale of such assets.

The corporation is actively engaged in the conduct of a qualified trade or business immediately after the distribution.

Question 26

Distributions in redemption of stock, qualifying or not, are…

Answer 26

nonliquidating distributions

Question 27

Under § 311, corporations recognize…

Answer 27

gain on all nonliquidating distributions of appreciated property as if the property had been sold for its fair market value

Question 28

When distributed property is subject to a corporate liability and that liability is greater than the property’s fair market value…

Answer 28

the liability amount is used to determine the recognized gain.

Question 29

Are losses recognized on nonliquidating distributions of property?

Answer 29

No

Question 30

Why should a corporation avoid distributing a loss property (FMV less than basis) in a stock redemption?

Answer 30

Losses are not recognized

Question 31

In a qualifying stock redemption, the E & P of the distributing corporation is reduced by no more than…

Answer 31

the percentage of the corporation’s stock redeemed

Question 32

Code § 162(k) specifically denies a deduction for expenditures incurred in connection with a stock redemption, what are these expenditures?

Answer 32

Accounting, brokerage, legal, and loan fees

Question 33

Is interest from debt-financed redemptions deductible?

Answer 33

Yes

Question 34

What is a covered corporation?

Answer 34

any domestic corporation with stock traded on an established securities market

Question 35

For any covered corporation, the Inflation Reduction Act of 2022 includes a __% ____ tax that applies to the _____________ after December 31, 2022.

Answer 35

For any covered corporation, the Inflation Reduction Act of 2022 includes a 1% excise tax that applies to the fair market value of stock repurchases (redemptions) after December 31, 2022.

Question 36

There are several exceptions to the buyback tax; which stock repurchases are not subject to the tax?

Answer 36

1. Where the total value of the stock repurchased during the tax year does not exceed $1 million.
2. Where the repurchase is part of a reorganization and no gain or loss is recognized on the repurchase by shareholder by reason of the reorganization.
3. Where the stock repurchased is contributed to an employer-sponsored retirement plan, employee stock ownership plan (ESOP), or similar plan.

Question 37

The amount of repurchases subject to tax is reduced by the __________________, including the ________________________ during the tax year.

Answer 37

The amount of repurchases subject to tax is reduced by the value of any stock issued during the tax year, including the value of any stock issued (or provided) to employees of the corporation during the tax year.

Question 38

How are stock redemptions that do not fall within any of the qualifying stock redemption provisions treated?

Answer 38

As dividend distributions to the extent of the corporation’s E&P

Question 39

Preferred Stock Bailout

Answer 39

A process where a shareholder used the issuance and sale, or later redemption, of a preferred stock dividend to obtain long-term capital gains, without any loss of voting control over the corporation. In effect, the shareholder received corporate profits without suffering the consequences of dividend income treatment. This procedure led Congress to enact § 306, which, if applicable, converts the prior long-term capital gain on the sale or redemption of the tainted stock to dividend income.

Question 40

What is the reason for a preferred stock bailout?

Answer 40

Attempts to obtain the benefits of a qualifying stock redemption without the associated disadvantages. Attempt to obtain sale or exchange treatment.

Question 41

What are the tax consequences of a sale of § 306 stock to a third-party for a shareholder?

Answer 41

1. Shareholder has ordinary income (equal to FMV of preferred stock on the date of the stock dividend)
2. Ordinary income is treated as a dividend (preferential tax rate on dividend income)
3. No effect on the issuing corporation’s E&P
4. No loss recognized
5. Unrecovered basis in the preferred stock sold is added to the basis of the shareholder’s common stock

Question 42

“Section 306 stock” is stock other than common that…

Answer 42

(1) is received as a nontaxable stock dividend
(2) is received tax-free in a corporate reorganization or separation to the extent that either the effect of the transaction was substantially the same as the receipt of a stock dividend or the stock was received in exchange for § 306 stock, or
(3) has a basis determined by reference to the basis of § 306 stock

Question 43

What happens if a corporaton has no E&P on the date of distribution of a nontaxable preferred stock dividend?

Answer 43

The stock will not be a Section 306 stock