#11711 - Redemptions And Partial Liquidation - Corporate Tax (Duke Zelenak)

Section 302(d): redemption treated as dividend unless subsections of 302(b) apply (then treated as sale, capital gain).

Section 302: redemption treated as sale (SH therefore recognizes capital gain or loss) if:

1. 302(b)(1)-(3): a sufficient reduction in the SH’s ownership interest in the corporation to justify treating the redemption as an exchange, or

2. 302(b)(4): on a corporate level, distribution that qualifies as a “partial liquidation” under 302(e) is treated as exchange

3. 302(b)(5): redemption by mutual fund or real estate investment trust generally will be treated as an exchange

Exchange (or sale)/ Dividend - Consequences

1. If a redemption is treated as sale, the basis of the redeemed stock is taken into account in determining the SH’s gain or loss

2. If a redemption is treated as a dividend, basis shift to the SH’s other retained share.

13-3

302(b)(2): substantially disproportionate redemption safe harbor: if a SH’s reduction in voting stock as a result of a redemption satisfies three mechanical requirements, the redemption will be treated as sale: (example: A owns 70 out of a total of 100 outstanding, A redeems 50)

1. Immediately after the redemption, the SH must own (actually and constructively) less than 50% of the total combined voting power of all classes of stock entitled to vote

   1. (70-50)/(100-50)<50%

2. The % of total outstanding voting stock owned by the shareholder immediately after the redemption must be less than 80% of the percentage of total voting stock owned by the SH immediately before the redemption, and

   1. (70-50)/(100-50)<80%*70%

3. The SH’s percentage ownership of common stock (voting or not voting) after the redemption also must be less than 80% of the percentage of common stock owned before the redemption.

Step transaction:

1. 302(b)(2)(D) requires the application of step transaction principles in the case of a “plan the purpose or effect of which is a series of redemptions resulting in a distribution which (in the aggregate) is not substantially disproportionate”

2. Rev. Rul. 85-14 indicates that a plan can exist solely in mind, without agreement

3. Does this only apply to the 80% test?

   1. Yes: the language of 302(b)(2)(D) suggests that it only applies for the purpose of the “substantially disproportionate” test.

      1. Also the 302(b)(2)(D) preempts the common law step transaction doctrine, so common law step transaction should not apply to the 50% test.

   2. No: it also applies to the 50% test. Even if the language of 302(b)(2)(D) suggests it only applies to the 80% test, we can use the common law step transaction doctrine with respect to the 50% test.

Example:

1. A and B each own 50% of X, how can A and B satisfy the three tests?

2. First, can sell any share to have <50% of total voting power

3. Second, must satisfy the 80% test, must go under 80%*50%=40%

   1. Magic number x: sell at least x shares (must round up)

   2. a = # of shares owned by A; b= total # shares outstanding; looking for X such that

      1. (a-x)/(b-x)<80%*a/b, then x>ab(5b-4a)

Problem p204: Y has 200 preferred non-voting stock, 100 voting shares. A owns: 80 voting, 100 preferred; C owns: 20 voting, 100 preferred

1. Y redeems 75 of A’s preferred share.

   1. No treatment of sale because no voting power share redeemed. And has 80% of voting power

2. Same as (a) above, except Y also redeems 60 shares of A’s voting stock

   1. No treatment of sale because must get below 50%, now she has exactly 20/(20+20)=50%

3. Same as (a) above, except Y also redeems 70 shares of A’s voting stock

   1. 10/30< 50%

   2. For the 80% test, you should go below 80%*80%=64% of total voting power after the sale, and 10/30<64%

4. Same as (c), later in the year, Y redeems 10 shares of C.

   1. Consequences for A?

      1. step transaction principles apply to the two 80% test, treated as part of the same plan as the A’s redemption

      2. step transaction does not apply to the 50% test.

      3. For the 50% test, do not take into account of C’s later redemption, 10/(10+20)<50%

      4. For the 80% test, take into account of C’s later redemption

         1. A still goes below 64%: 10/(100-70-10)=50%

   2. Consequences for C?

      1. Now A has 10 shares, C has 20 shares 10 shares

      2. For the 50% test, 10/(10+10)=50% does not satisfy the 50% test

Section 318, four categories of attribution rules

1. 318(a)(1) Family attribution: an individual is considered as owning stock owned by his spouse, children, grandchildren and parents.

   1. Siblings and in-laws are not part of family for this purpose

   2. No attribution from a grandparent to a grandchild.

2. 318(a)(2) Entity to beneficiary attribution: stock owned by a partnership or estate is considered as owned by the partners or beneficiaries in proportion to their beneficial interests.

3. 318(a)(3) Beneficiary to entity attribution: stock owned by partners or beneficiaries of an estate is considered as owned by the partnership or estate.

4. 318(a)(4) Option attribution: a person holding an option to acquire stock is considered as owning that stock.

Operating rules of Section 318(a)(5)

1. Allows chain attribution: parent to child to child’s trust

   1. No double family attribution: no attribution from parent to child to child’s spouse

   2. No sidewise attribution: stock attributed to an entity from a partner, cannot be reattributed from that entity to another partner.

2. Option attribution takes precedence over family attribution where both apply.

3. S corporation treated as a partnership for section 318 purposes.

Example

1. Parent and Child each own 50 shares, P redeems 50 shares, after the redemption, P is deemed to constructively own C’s 50 shares, 50/50=100% fails the 50% test

Problem p200

1. Grandfather 25%; Mother 20%; Daughter 15%; Son 10%; Grandmother’s estate 30%, of which Mother has a 50% interest; mother has option to buy 5% of son’s shares

2. GF: 85%

   1. 25% GF actually owns

   2. 20 M; 318(a)(1)

   3. 15 D; 318(a)(1)

   4. 10 S; 318(a)(1)

   5. 15% GM estate motherGF

3. D: 55

   1. 15 D

   2. 20 M

   3. 5% S optionMD

   4. 15 GM estateMD

4. GM estate 100

   1. 20 M

   2. 30 Estate

   3. 25 GF Mother GM estate

   4. 15 D MotherGM estate

   5. 10 S MotherGM estate

Problem p200: X 100% owned by P, P owned by each A, B, C, and D. A’s wife W owns 100% of Y, M is W’s mother.

1. A: 25%; W 25%; M 0

2. X owned by Y: 25%; W must own more than 50% of Y to be able to attribute shares to Y, so 0

3. X or P owns 100%; B, C, D: 0 because of sideway attribution

Step 1: waiver of family attribution is only available if immediately after the distribution the redeemed SH retains no interest in the corporation (other than as a creditor).

1. Must eliminate all actual stock ownership

2. And eliminate all non-family 318 attribution

3. Get rid of interests as an officer, director or employee.

4. Creditor interest okay

Step 2: ten year look forward, 302(c)(2)(A)

1. SH may not retain or acquire (other than by bequest or inheritance) any of the forbidden interests in the corporation other than an interest as a creditor.

2. Tax court, it is possible to remain an officer without violating this

   1. You work as an uncompensated labor

   2. You can have a fixed salary and the salary is small

Step 3: ten year look back 302(c)(2)(B)

1. Tax avoidance is not one of the principal purposes of the transfer this step satisfied

   1. A retirement type of setup

2. Tax avoidance is one of the principal purposes of the transfer, then family attribution may not be waived if during the 10 preceding years:

   1. The redeemed SH acquired any of the redeemed stock from a Section 318 relative; or

   2. Any such close relative acquired stock from the redeemed SH.

Entity can waive the family attribution rules if those through whom ownership is attributed to the entity join in the waiver

1. Thus, a trust and its beneficiaries may waive family attribution to the beneficiaries if, after redemption, neither the trust nor the beneficiaries hold an interest in the corporation, do not acquire such an interest within the 10 year period, and join in the agreement to notify IRS of any acquisition.

Problem 3(a), p223: C, 100 shares outstanding; S 50; D30; Estate of F 20, beneficiary M.

1. C redeems 20 shares of estate, now neither the trust nor the beneficiaries hold an interest, no family attribution to the entity.

Meaningful reduction standard:

1. Effect of the redemption on the redeemed shareholder’s voting power

2. Rights to participate in current and future corporate earnings

3. Rights to share in net assets on liquidation

4. Effect of the redemption upon the SH’s control of corporate affairs (302 regulations)

Examples of meaningful reduction from Revenue Rulings

1. For pro rata distribution that does not change the % of shares of SH, it is not meaningful reduction

2. Dominant voting right non dominant voting right: 5750

3. SH with only preferred nonvoting stock and redemption is not pro rata

4. SH owning a tiny portion of a publicly holding company can always be treated as exchange if not pro rata

Family discord: 302(b)(1) can sometimes be used to ignore attribution when there is evidence of family discord between the redeemed SH and related continuing SH.

1. Step 1: apply attribution rule

2. Step 2: whether there has been a reduction in the SAH’s proportionate interest in the corporation. Family discord can be an evidence for showing inability to get control after redemption

Problem 1 p235: Z 100 outstanding shares, A-28; B-25; C-23; D-24

1. Z redeems 7...