Distributions not Essentially Equivalent to a Dividend: Stock Redemptions and Partial

Liquidations

Overview--Redemptions vs. Dividends

Stock Redemption Defined

A stock redemption is a purchase by a corporation of its own stock from an existing shareholder. Like a dividend distribution, a stock redemption may involve the distribution of cash, property or both to a shareholder. But a legitimate redemption differs from a dividend both in motivation and effect.

Unlike a dividend, which is a distribution of corporate earnings to a shareholder, a stock redemption represents the liquidation of all or a portion of the shareholder's actual investment in the corporation. Thus, a stock redemption represents a return of the shareholder's capital investment in the corporation, rather than a return on that investment.

The two transactions result from differing incentives: a dividend is a form of compensation to the shareholder for continuing her/his investment in the corporation whereas a stock redemption represents an actual reduction in the shareholder's investment in the corporation. As a result, their effects on the shareholder also differ. Although some portion of a redemption payment may consist of the shareholder's interest in accumulated earnings, the redemption typically reduces her interest in the corporation, and thus her interest in future earnings. A dividend distribution, in contrast, does not affect the shareholder's continuing interest in the corporation and thus does not alter her interest in future earnings.

Example 1: Corporation X is owned by three shareholders, A, B, and C. Assume that last year, X had undistributed earnings and profits (E&P) of $120,000, and distributed $25,000 to each shareholder as a dividend. The distribution reduces X's E&P to $45,000 ($120,000 - $75,000 dividend), but does not reduce any of the shareholders' interests in the corporation. A, B and C each continue to own one-third of Corporation X's stock.

This year, the company had current earnings and profits of $60,000, increasing its total E&P to $105,000. In October, A decided to retire from Corporation X. In order to liquidate A's interest in Corporation X, the company purchased all of A's shares for $135,000. This price reflected the $100,000 value of A's initial investment in the company, plus her $35,000 share of the company's undistributed E&P (one-third of $105,000). Although a portion of the distribution is comprised of A's share of corporate earnings, the distribution is treated as a redemption because it reduces A's continuing interest in the corporation from 33 percent to zero.

General Consequences to Shareholders

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A legitimate, or qualified, stock redemption is treated as a sale by the shareholder of her stock back to the corporation. Under current law, structuring a transaction as a stock redemption rather than a dividend may reduce the tax liability associated with the transaction for individual shareholders. Because the transaction is treated as a sale of part or all of the shareholder’s shares, the amount received will be offset by the basis of the shares received. In contrast, a dividend distribution is generally fully taxable, depending on the level of corporate earnings and profits. As a result, stock redemptions often trigger a smaller amount of taxable income than do dividend distributions.

Example 2: Gene owns 250 shares of stock in X-Ray Incorporated. His tax basis in the X-Ray stock is $250,000. He is in the 35 percent tax bracket. This year, Gene sold 125 of his X-Ray shares back to X-Ray in a qualified stock redemption transaction. The purchase price for the shares was $400,000. Gene must recognize a $275,000 gain on the redemption transaction ($400,000 received - $125,000 basis in the shares surrendered). Although Gene is in the 35 percent tax bracket, his tax on the gain from this transaction will be only $42,250 ($275,000 capital gain x 15 percent capital gains tax rate). Note that had the $400,000 distribution received from X-Ray been treated as a dividend, Gene's tax liability would have been $60,000 ($400,000 x 15 percent dividend tax rate). Thus, by treating the payment as a sale of Gene's stock back to X-Ray, he saves $17,750 in taxes.

Note that the maximum tax rate on dividends has been equivalent to that on capital gains only since 2003. Beginning in 2011, the maximum tax rate on dividends is scheduled to revert to 39.6%, while that on capital gains would revert to 20%. If the preferential tax rates on dividends and capital gains are not extended, the tax advantages associated with structuring distributions as a stock redemption rather than as a dividend will be increased significantly.

Unlike individual shareholders, corporate shareholders often prefer dividend treatment over treatment as a qualified stock redemption. There are two reasons for this preference. First, the 15 percent maximum tax rate on capital gains does not apply to corporate taxpayers, only to individuals. Thus, there is no tax preference for capital gains. In contrast, however, corporations receive special treatment for dividend income. Under §243, corporations are entitled to claim a dividends received deduction, substantially reducing the tax burden on dividend income.

Example 3: Assume the same facts as in Example 2, except that Y Corporation, rather than Gene, exchanges X-Ray stock for $400,000 cash. Further assume that Y Corporation is in the 35 percent tax bracket, and owns 60 percent of the outstanding shares of X-Ray Incorporated. Its basis in the X-Ray stock exchanged is $125,000 as in Example 2. If the transaction is a qualified redemption, treated as a sale of Y's X-Ray stock for $400,000, Y will recognize a $275,000 taxable gain on the redemption, increasing its tax liability by $96,250 ($275,000 x 35 percent). If, on the other hand, the $400,000 payment is treated as a dividend distribution, Y's tax liability on the distribution will be substantially less. After deducting the 80 percent dividends received deduction, Y's taxable dividend income will be only $80,000. At 35 percent, Y's tax liability on the distribution will be only $28,000. Thus, treatment as a dividend rather than a qualified stock redemption reduces Y's tax liability by $68,250.

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It is clear from these examples that individual and corporate shareholders have different incentives for structuring distributions as dividends versus qualified stock redemptions. For that reason, most stock redemption transactions take place between individual shareholders and relatively small or closely-held corporations. In these settings, it is often difficult to distinguish between dividend distributions and true stock redemptions, particularly given the incentives for individual shareholders to structure corporate distributions as stock redemptions. The primary focus of the tax law in this area is on preventing closely-held corporations from "disguising" dividend distributions as stock redemptions.

Example 4: Brad owns 5,000 shares in Hoosier Corporation. His tax basis in the Hoosier stock is $50 per share, or $250,000. Hoosier's E&P is $1,500,000. This year, Brad, who is in the 39.6 percent tax bracket, received a $300,000 distribution from Hoosier.

If the distribution is treated as a dividend, Brad's associated tax liability will be $45,000 ($300,000 X 15 percent). If the transaction is treated as a stock redemption of half his shares, however, Brad will recognize a $175,000 capital gain ($300,000 less the $125,000 tax basis of half his shares) rather than a $300,000 dividend. His tax on the gain will be $26,250 ($175,000 X 15 percent). The tax savings associated with treatment as a stock redemption will be $18,750.

Qualified Stock Redemptions: Requirements for TreatmentAs A Sale of Stock

Redemption Must Reduce Shareholder's Interest in the Corporation

In order to be accorded sale treatment for tax purposes, the shareholder must be able to show that the payment received from the corporation was not "essentially equivalent to a dividend." Conceptually, the primary difference between a dividend (a return on capital) and a stock redemption (a return of capital) is that the latter reduces the shareholder's capital investment in the company, and thereby reduces her interest in the company's future operations. Thus, dividend equivalency, or the lack thereof, for tax purposes is based on the effect the distribution has on the shareholder's continuing interest in the company. In order to be treated as a qualified stock redemption, the distribution must result in a "meaningful reduction of the shareholder's proportionate interest in the corporation.” If the distribution does not reduce the shareholder's continuing proportionate interest in the corporation, for tax purposes it will be treated as a dividend.

Example 5: Shelly Parker owns 1,000 shares of stock in Parker Companies. There are no other shareholders. Shelly's basis in her Parker shares is $100,000. Parker Companies has E&P of $250,000. This year, Shelly sold 100 shares of Parker stock back to the company for $75,000. Although the transaction was structured as a sale of stock, it did not affect Shelly's continuing interest in Parker Companies. Prior to the sale, Shelly owned 1,000 shares of Parker stock, representing 100 percent of the shares outstanding. After the "sale," she owned 900 shares, still representing 100 percent of the company's outstanding stock. Thus, for tax purposes, the form of the

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transaction will be disregarded and the $75,000 payment to Shelly will be treated as a dividend distribution under Section 301.

Section 318: Determining the Shareholder's Interest in the Corporation

In determining the shareholder's interest in the corporation before and after a stock redemption, §302(c) requires that the attribution rules of §318 be applied. Under §318, a shareholder is considered to own shares held by certain other, related shareholders. That is, under §318, the shareholder is considered the "constructive" owner of shares held by related shareholders in addition to those shares the shareholder holds directly. The shareholder is also considered to own any shares which may be purchased in the future if the shareholder currently holds an option on those shares.

Example 6: Becky owns 200 of the 1,000 outstanding shares of Western Corp. In addition to her 200 shares, Becky owns an option entitling her to purchase an additional 800 shares of Western stock over the next 5 years. No other shareholders have a similar option. Under Section 318, Becky's interest in Western is determined as if the options were exercised. If the options were exercised, Becky would own 1,000 shares of Western, and Western's outstanding shares would be increased by 800, to 1,800 shares. Becky is thus deemed to own 55.5 percent of Western's stock (1,000 shares ÷ 1,800 shares outstanding).

Family Attribution

In addition to acceleration of a shareholder's option rights, Section 318 attributes ownership between related individuals, between individuals and certain related entities, and from individuals to certain related entities. Under §318(a)(1), individual shareholders are deemed to constructively own all the shares owned, directly or indirectly, by their spouses, children, grandchildren, or parents. No ownership is attributed from any other relative (e.g., brothers, sisters, grandparents, etc.).

Example 7: A owns 100 shares of stock in X Corporation. Of the remaining 900 shares of X Corporation stock outstanding, 300 are owned by A's mother, 300 by A's maternal grandmother, and 100 by each of A's three brothers and sisters. Under Section 318, A is deemed the constructive owner of the 300 shares held by her mother, in addition to the 100 shares A owns directly, giving her a 40 percent actual and constructive interest in the corporation (400 shares actual and constructive ownership ) 1,000 shares outstanding). A's mother, in contrast, is deemed the actual and constructive owner of 100 percent of X Corporation's stock. In addition to the 300 shares owned directly by the mother, she is the constructive owner of the shares held by A (100 shares), A's three brothers and sisters (300 shares), and A's maternal grandmother (300 shares). Note that the same is true for A's maternal grandmother, who is deemed the constructive owner of the shares held by A's mother (300 shares) and the shares held by A and her three brothers and sisters (400 shares total). Thus, both A's mother and her grandmother are

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deemed to own, directly and indirectly, 100 percent of the outstanding stock of X Corporation.

Attribution from Entities

Under §318(a)(2), a taxpayer is also deemed the constructive owner of a proportionate share of stock owned, directly or indirectly, by a partnership in which (s)he is a partner, a trust or estate in which (s)he is a beneficiary, and stock owned by a corporation in which (s)he owns 50 percent or more of the outstanding stock. Note that attribution from a partnership, trust, or estate is required regardless of the taxpayer's proportionate interest in the entity, whereas attribution from a corporation is required only if (s)he owns at least 50 percent of such corporation's stock. Also note that attribution from these entities is proportionate: the shareholder is deemed to own only that portion of stock held by the entity which corresponds to his/her percentage of ownership or other interest in the entity.

Example 8: The outstanding stock of J Corporation is owned by the following shareholders:

Shareholder Shares Owned

Ernie 350Ricky 250Zelna 150RQ, Inc. 200QLR Partnership 300QLR,Inc. 250

Total shares outstanding 1,500

Ernie, Ricky and Zelna are unrelated individuals. Ricky owns 50 percent of the outstanding stock of RQ, Inc., a one-third interest in QLR Partnership, and one-third of the outstanding stock of QLR, Inc. Neither Ernie nor Zelna own any interest in these entities. Under Section 318(a)(2), Ricky is deemed to own 100 (50 percent) of the J Corporation shares held by RQ, Inc., and 100 (one-third) of the shares in J held by QLR Partnership, in addition to the 250 shares Ricky owns directly. Although Ricky is also a shareholder in QLR, Inc., no attribution of ownership in J from this corporation is required because Ricky owns only one-third of its stock. Thus, for purposes of Section 302, Ricky is deemed to own 450 of the 1,500 outstanding shares of J Corporation.

Attribution to Entities

The rules for attribution to entities are similar to those for attribution from entities, except that attribution is full rather than proportionate. A partnership, trust or estate is deemed the constructive owner of all the shares of stock held by a partner, or beneficiary, regardless of the partner's or beneficiary's interest in the partnership, trust, or estate. A corporation is deemed to own all the shares of stock in another corporation held by any shareholder holding at least a 50 percent interest in such corporation. Note that the attribution rules also apply in determining whether an individual is a 50 percent shareholder in the corporation.

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Example 9: The outstanding stock of R Corporation is owned by the following shareholders:

Albert Jones 500 sharesRhonda Jones 500 sharesEleanor Polk 500 sharesPolk-Jones, Inc. 500 shares

Total shares outstanding 2,000 shares

Albert and Rhonda are married. Both are unrelated to Eleanor Polk. Additionally, Albert, Rhonda and Eleanor each own one-third of the stock of Polk-Jones, Inc. Because Albert and Rhonda are married, they are each deemed to own two-thirds of Polk-Jones, Inc. (their own one-third interests, plus the one-third interest of their spouse). Thus, under Section 318, each is deemed to own two-thirds of the R Corporation stock owned by Polk-Jones, giving each a total direct and indirect interest in R Corporation of 1,333 shares. Likewise, Polk-Jones is deemed the constructive owner of all 1,000 shares of R Corporation stock owned by Albert and Rhonda, giving it a total direct and indirect interest in R Corporation of 1,500 shares. No attribution is required between Eleanor and Polk-Jones, Inc. because Eleanor owns less than 50 percent of the stock in Polk-Jones.

Multiple Attribution

As noted above, Section 318 generally attributes ownership of stock held directly or indirectly by a shareholder to all persons or entities deemed related to that shareholder. There are, however, limits on the extent to which the statute requires stock which is deemed to be constructively owned by a shareholder to be "reattributed" to another, related party. Section 318(a)(5) establishes certain operating rules under which two types of multiple attribution are specifically prohibited. The first provides that stock which is attributed to an individual from a member or members of her family cannot then be reattributed, through her, to another member of the family.

EXAMPLE 10: Martin Corporation is a family-owned company, owned by the following shareholders:

Janice Johnson 200 sharesRalph Johnson 100 sharesApril Martin 500 sharesDenise Martin 200 sharesTotal shares outstanding 1,000 shares

Janice and Ralph are married. April is Janice's mother and Denise is Janice's sister. Under Section 318 Janice is deemed to constructively own all the stock owned by her spouse (Ralph), her parents (April) and her children (not applicable here). She is not deemed to own the stock owned by her sister (Denise). Similarly, April is deemed to own the stock owned by her children (Janice and Denise), but not by her son-in-law (Ralph) because he is not her child. Under Section 318, April is not deemed the owner of the stock held by Ralph even though that stock is attributed to Janice. Section 318(a)(5)

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prohibits the reattribution of Ralph's stock from Janice to April. Similarly, Janice is not deemed to own the stock held by Denise, even though such stock is deemed constructively owned by April. Section 318(a)(5) prohibits the reattribution of Denise's stock through April to Janice.

Section 318(a)(5) also prohibits multiple attribution through entities. Specifically, stock the ownership of which is attributed to an entity from one of its owners cannot be reattributed from the entity to another of its owners.

Example 11: Jane and Bob are each 50 percent beneficiaries of the JB family trust, established by their grandfather several years ago. Jane also owns 100 shares of the family corporation. Under Section 318(a)(3), the estate is deemed the constructive owner of Jane's 100 shares. Although Bob is considered the constructive owner of half of the stock owned by the trust, constructive ownership of Jane's shares cannot be reattributed to Bob through the trust under Section 318(a)(2).

Note, however, that there is no prohibition against multiple attribution of stock from one entity through an owner or beneficiary of such entity to another entity in which such owner also owns an interest.

Example 12: A owns 100 percent of the outstanding stock of Corporations X and Y. Corporation X owns 100 percent of the stock of Corporation Z. Under §318(a)(2), A is deemed the constructive owner of 100 percent of Corporation X's stock in Corporation Z (because A owns 100 percent of Corporation X). Under §318(a)(3), A's indirect ownership of Z stock is also reattributed to Corporation Y. Thus, Corporation Y is also deemed to own 100 percent of the stock of Corporation Z.

Example 13: The outstanding stock of Johnson Corporation is owned by the following shareholders:

Jill Smith 100 sharesSmith-Jones, Inc. 500 sharesCoggins, Smith, Becker Partnership 600 sharesErnie Jones 300 sharesTotal shares outstanding 1,500 shares

Jill owns half the stock of Smith-Jones, Inc. In addition, she is a one-third partner in the Coggins, Smith, Becker Partnership. Ernie Jones, who is no relation to Jill, owns the other fifty percent of stock in Smith-Jones, Inc. He has no interest in the partnership.

As a one-third partner in the Coggins, Smith, Becker partnership, Jill is deemed the constructive owner of 200 of its 600 shares in Johnson Corporation. As a fifty-percent shareholder in Smith-Jones, Inc., she is deemed the constructive owner of 250 of the 500 shares in Johnson Corporation which Smith-Jones owns directly. Although Smith-Jones is also the constructive owner of Ernie Jones' 300 Johnson shares, these shares cannot be reattributed to Jill. Thus, Jill is deemed the actual and constructive owner of 550 shares of Johnson stock (100 shares owned directly, plus 200 shares attributed from Coggins, Smith, Becker, plus 250 shares attributed from Smith-Jones, Inc.).

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Statutory Safe Harbors of Section 302

Section 302(b)(2)--Substantially Disproportionate Redemptions

Section 302 provides three "safe harbors" which, if satisfied by the taxpayer, will assure that a redemption qualifies for treatment as a sale of stock. Note that if the taxpayer does not satisfy one of these safe harbor provisions, the transaction may still qualify for sale treatment, but it will be much more difficult. Outside the safe harbor provisions, the taxpayer must show that the transaction satisfies the more vague "not essentially equivalent to a dividend" standard discussed later in this chapter.

Under the first safe harbor provided by Section 302, a distribution will be treated as a redemption (rather than a dividend) if it is "substantially disproportionate." A distribution will be considered substantially disproportionate only if all of the following are true:

the shareholder must own less than 50 percent of the total combined voting power of all corporate stock immediately after the distribution;

the redemption must reduce the shareholder's interest in the corporation's voting stock by more than 20 percent; and

the redemption must reduce the shareholder's interest in the corporation's common stock (voting and nonvoting) by more than 20 percent.

The first requirement assures that the taxpayer does not have control of the corporation after the redemption. No matter how many shares are redeemed, if the shareholder retains control of the corporation after the redemption, the transaction will not be considered substantially different from a dividend.

Example 14: John owns 800 of the 1,000 outstanding shares of voting stock in Lite Corporation. In July, Lite Corporation redeemed 200 of John's shares for $150,000. No shares of any other shareholder were redeemed. Lite Corporation's E&P at the date of the redemption was $500,000. Even though John surrendered 200 of his shares in Lite Corporation, the redemption did not dilute John's control of the company: he still retains 75 percent (600 of the remaining 800 outstanding shares) of the voting stock of Lite. Thus, the distribution will not qualify as a substantially disproportionate redemption and John must treat the $150,000 payment as a dividend.

Note that in determining the effect of the distribution on the shareholder's interest in the corporation, the taxpayer must take into account the reduction in total shares outstanding. Thus, to satisfy the requirements that the distribution reduce the taxpayer's interest in the corporation's voting and other common stock by more than 20 percent, the corporation must redeem much more than 20 percent of the taxpayer's pre-redemption holdings.

Example 15: Arlene owns 1,000 of the 2,500 outstanding shares of common stock in Zero, Inc. There are no other classes of stock outstanding. In December, Zero redeemed 250 of Arlene's shares for $250,000. Immediately after the redemption, Arlene owns 750 of the remaining 2,250 shares of Zero

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stock outstanding. Since this is less than 50 percent, the distribution satisfies the first requirement of §302(b)(1): she does not have control of Zero. Taking into account the reduction in Zero's outstanding shares, however, the distribution does not satisfy the requirement that Arlene's interest be reduced by more than 20 percent. Her interest in Zero prior to the redemption was 40 percent (1,000 shares ÷ 2,500 shares outstanding). To satisfy the second and third requirements for treatment as a substantially disproportionate redemption, however, her interest must after the redemption must be less than 32 percent (40% x 80%). Her interest after the redemption is 33 percent (750 remaining shares ÷ 2,250 shares outstanding). Thus, the redemption will not qualify for treatment as a substantially disproportionate redemption.

Finally, note that the attribution rules of §318 must be applied in determining whether the requirements of §302(b)(1) are satisfied.

Example 16: The outstanding stock of Caster Oil, Inc. is owned in the following ratios by the following shareholders:

Shares Owned

Paul Caster 500 sharesSara Caster 500 sharesBobbi Martin 250 sharesJudy Louise 250 sharesTotal shares outstanding 1,500 shares

Paul and Sara are husband and wife. Bobbi is Paul's sister. Judy is unrelated to Paul. In August, Caster Oil, Inc. redeemed 300 of Paul's shares for $900,000. Applying Section 318, prior to the redemption Paul is deemed the constructive owner of Sara's stock, giving him a total direct and indirect interest in the corporation of 66.67 percent (1,000 shares owned ÷ 1,500 shares outstanding). After the redemption, he is deemed the owner of his remaining 200 shares, plus the 500 shares owned by his wife, Sara, giving him a total direct and indirect interest in the corporation of 58.33 percent (700 shares owned ÷ 1,200 shares outstanding). Thus, the distribution will not qualify as a substantially disproportionate redemption. It will likely be treated as a dividend.

Section 302(b)(3)--Complete Termination of a Shareholder's Interest

General Framework. The second safe harbor applies when the redemption completely terminates the shareholder's interest in the corporation. For this purpose, the family attribution rules (but not the entity attribution rules) are waived. In order to qualify, the following requirements must be satisfied:

after the redemption, the shareholder must retain no interest in the corporation (including an interest as an officer, director or employee) other than as a creditor; and

the shareholder must agree not to acquire any prohibited interest (other than by bequest or inheritance) in the corporation for ten years following the redemption.

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The shareholder's agreement not to acquire a prohibited interest for ten years after the redemption must be filed with her tax return for the year of the redemption. The agreement must state that the shareholder will notify the IRS if a prohibited interest is acquired within the ten-year period. Moreover, filing the agreement extends the statute of limitations for assessment of tax for such return, so that if a prohibited interest is acquired before expiration of the ten-year period, the shareholder must file an amended return for the year of the redemption recharacterizing the distribution as a dividend.

Example 16: The stock of Carpenter Brothers, Inc. is owned by the following shareholders:

Karl 400 sharesKaren 400 sharesLisa 200 sharesJohn 1,000 sharesTotal shares outstanding 2,000 shares

Karen is Karl's wife. Lisa is his granddaughter, and John is his father. Accordingly, under Section 318, Karl is deemed the actual and constructive owner of 100 percent of the stock in Carpenter Brothers, Inc. In May, the company redeemed all 400 shares of stock owned directly by Karl. Assuming Karl does not maintain a prohibited relationship with the corporation, the family attribution rules will be waived, and the redemption will be treated as a sale of his stock back to the corporation.

Waiver of Family Attribution Rules. Note that the family attribution rules are waived only if the shareholder does not retain or acquire a prohibited interest in the company after the redemption. In the above example, for instance, if Karl remained a director of the company, or even an employee, the family attribution rules would not be waived, and the distribution would not qualify for redemption (sale) treatment. Karl could, however, retain a relationship with the corporation as a bondholder or other creditor without affecting the tax treatment of the stock redemption.

As indicated above, only the family attribution rules, and not the entity attribution rules, are waived. Moreover, the family attribution rules are waived only for purposes of determining whether the redemption constitutes a complete termination of the shareholder's interest in the corporation. If the transaction does not satisfy the requirements for treatment as a complete termination, the family attribution rules will be applied to determine whether the redemption is substantially disproportionate.

Example 17: Nordane, Inc. is owned by the following shareholders:

Jill Price 1,500 sharesEddie Price 250 sharesSusan Price 250 sharesPrice family trust 1,000 sharesTotal shares outstanding 3,000 shares

Jill Price inherited her 1,500 shares from her parents several years ago. At that time, the elderly Prices also established the Price family trust. Jill and her two children, Eddie and Susan, are equal beneficiaries of the trust. In April this

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year, Jill decided to retire and turn control of the corporation over to Eddie and Susan. Pursuant to this plan, Nordane redeemed all 1,500 of Jill's shares for a price of $1.5 million. Jill retained her interest in the family trust. As a result, although the family attribution rules are waived, the redemption does not qualify as a complete termination of Jill's interest in Nordane. Under Section 318, she is still deemed to own one-third of the shares held by the trust in which she is a one-third beneficiary. The transaction also fails to qualify for treatment as a substantially disproportionate redemption. For this purpose, the family attribution rules are not waived and Jill is deemed the constructive owner of 100 percent of Nordane's stock, even after the redemption [333 shares attributed from the family trust, plus 583 shares each from Eddie and Susan (250 shares owned directly plus 333 shares attributed from the trust)].

Exceptions for Certain Tax-motivated Transactions

The family attribution rules are not waived in certain circumstances involving a transfer of stock between the distributee-shareholder and a related party within the ten-year period preceding the redemption. For this purpose, the waiver is nullified if:

any portion of the stock being redeemed was acquired from a related party (as defined in Section 318) within the ten-year period ending on the date of the redemption; or

the distributee-shareholder transferred stock in the redeeming corporation to a related party within ten years of the date on which the corporation redeemed the shareholder's remaining stock.

These provisions are intended to prevent shareholders from using pre-redemption stock transfers to convert a transaction which is in substance a dividend distribution into a qualified stock redemption. Accordingly, the limitations only apply if a principal purpose of the pre-redemption transfer was to avoid federal income tax.

Example 18: In 2000, Harriet inherited all 1,000 shares of stock in her family's corporation. In January this year, she gave 900 shares to her husband, Roy. Three months later, the corporation redeemed Harriet's remaining 100 shares for $1 million. The obvious purpose for the pre-redemption transfer of 900 shares to Roy was to allow Harriet to structure the subsequent distribution as a complete termination of her remaining interest. By transferring the 900 shares to her husband, Harriet ensured that she would retain an interest in the company after redemption. Accordingly, the waiver of the family attribution rules in this case is nullified, and the redemption does not qualify as a complete termination of her interest in the corporation. Moreover, since 100 percent ownership of the company is attributed to Harriet from Roy after the redemption, the transaction also will not qualify as a substantially disproportionate redemption. The $1 million distribution to Harriet will be taxed as a dividend to the extent of the corporation's E&P.

Example 19: Rogers Feed, Inc. is owned by the following shareholders:

Bill Rogers 750 sharesLarry Rogers 150 shares

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Terri Rogers 150 sharesRogers Family Trust 450 sharesTotal shares outstanding 1,500 shares

Larry and Terri are brother and sister. Bill is their father. In addition to the stock each owns directly, Larry and Terri are each 50 percent beneficiaries of the Rogers Family Trust. Larry would like to have the corporation redeem his shares. Due to his interest in the trust, however, the redemption would not completely terminate his interest. Such a stock redemption also would not qualify as a substantially disproportionate distribution since for that purpose he will be attributed ownership of stock from both his father and the trust. Accordingly, a redemption of Larry's interest will not qualify for sale treatment. To avoid the attribution rules, Larry transferred ownership of his 150 shares in the corporation to his wife, Cindy. Since she is not a beneficiary of the Rogers Family Trust, ownership of its stock can only be attributed to her through Larry. Since the family attribution rules are waived in a complete termination of the shareholder's interest, redemption by the corporation of all 150 shares transferred to Cindy would ordinarily qualify for treatment as a sale. However, in this case, the family attribution rules are not waived, because the principal purpose for Larry's transfer of the shares to Cindy was to obtain preferential tax treatment for the subsequent redemption.

Section 302(b)(4)—Partial Liquidations

The third statutory safe harbor applies to individual shareholders receiving a redemption in partial liquidation of the redeeming corporation. To qualify as a partial liquidation, the distribution must result from a "genuine contraction" of the corporation's business activities, must be made under a written plan providing for partial liquidation of the corporation, and must be made in the year such plan is adopted or within the succeeding year.

It is not always clear what constitutes a genuine contraction of a corporation's business activities. For example, the regulations under Section 346 state that a distribution of insurance proceeds from a fire which destroyed part of a corporation's business might qualify as a partial liquidation, whereas distribution of funds accumulated in a reserve for an expansion program which has been abandoned will not qualify1.

To alleviate this uncertainty, §302(e)(2) provides a safe harbor under which certain redemption distributions will be guaranteed treatment as partial liquidations (and thus qualify for sale treatment). Under the safe harbor, a distribution will qualify as a partial liquidation if the following requirements are satisfied:

the distribution is attributable to the cessation of, or consists of the assets of, a qualified trade or business; and

1 Reg. Sec. 1.346-1. Note that the requirements for treatment as a partial liquidation are found in the regulations under Section 346, which defines corporate liquidations, while the regulations dealing with the requirements for treatment as a substantially disproportionate distribution or a complete termination of the shareholder's interest are provided under Section 302..

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immediately after the redemption, the corporation continues to be actively engaged in the conduct of another qualified trade or business.

For this purpose, a qualified trade or business is defined as one which:

has been actively conducted (though not necessarily by the redeeming corporation) for a period of at least 5 years prior to the redemption; and

was not acquired in a taxable or partially taxable transaction by the redeeming corporation within the preceding five years.

These requirements ensure that a taxpayer cannot cause a controlled corporation to invest its E&P in a targeted business before distributing it to her in order to avoid treatment of the distribution as a dividend.

Example 20: Sharon owns 100 percent of the stock of Reynolds Corporation. Reynolds has earnings and profits of $1,000,000. This year, Sharon decided to buy an apartment complex near the local university. In order to buy the complex, which is listed for sale at $485,000, Sharon plans to use corporate funds. She does not, however, want title to the apartment complex to be held in the corporation's name. She also does not want to withdraw corporate funds to purchase the complex because any distribution to her will be taxable as a dividend. Instead, she decides to have the corporation purchase the apartment complex and subsequently distribute it to her in partial liquidation of the corporation's business activities. Under Section 302(e), this scheme will not work. Operation of the apartment complex does not constitute the active conduct of a trade or business. Moreover, even if operation of the complex did constitute an active trade or business, the complex was purchased by the corporation in a fully taxable transaction within five years of its distribution to Sharon.

Example 21: Wilson Manufacturing Co. is wholly-owned by Fred Wilson. Prior to this year, the company was involved in two lines of business. In its plant in Des Moines, Idaho, Wilson manufactured tractor parts. In a separate plant in Texas, the company manufactured feed supplements for the cattle industry. This year, Fred decided that the company should concentrate its efforts on the manufacture of tractor parts. To this end, Wilson Manufacturing sold its feed supplement operations to a competitor. About half of the proceeds from the sale were invested in an expansion project at the tractor parts plant. The remainder of the proceeds was distributed to Fred in redemption of 10 percent of his Wilson stock. Both the tractor and the feed operations have been conducted by Wilson for more than five years prior to the sale of the feed supplement business. The distribution to Fred will be treated as a partial liquidation eligible for treatment as a sale.

Note that a distribution in partial liquidation is treated as a qualified redemption only by individual shareholders. A distribution to a corporate shareholder in partial liquidation of the distributing corporation will be treated as a dividend distribution2.

2 Sec. 302(b)(4)(A)..

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Example 22: S, Inc. is owned 60 percent by Jill Gray and 40 percent by Blue Corporation. This year, S sold one of its 2 lines of business and distributed the proceeds to Jill Gray and Blue Corporation in redemption of a portion of their shares in S. Assuming that both of S's lines of business were qualified businesses, the distribution to Jill will be treated by her as received from the sale of part of her S stock back to S. The distribution to Blue Corporation, on the other hand, will be treated by Blue as a dividend distribution even though Blue is surrendering a portion of its stock in exchange for the distribution. Blue will be able to shelter 80 percent of this distribution from taxation by using the dividends received deduction.

Redemptions Outside the Safe Harbors--The Dividend Equivalency Standard

A stock redemption does not necessarily have to satisfy the requirements of any of the above safe harbor provisions to qualify for sale treatment. Under Section 302(b)(1), a redemption will be treated as a sale of stock so long as it is "not essentially equivalent to a dividend." The safe harbors described in the preceding sections identify three types of redemptions which will be deemed to satisfy this requirement. Where a stock redemption does not satisfy the provisions of any of the safe harbors, treatment as a sale vs. dividend will depend on the facts and circumstances particular to the redemption transaction.

The standard to be applied in determining whether the redemption qualifies for sale treatment is whether it results in a "meaningful reduction" in the shareholder's interest in the corporation after application of the constructive ownership rules of Section 3183.

The underlying premise of the Section 318 attribution rules is that related parties will act in accordance with common objectives so that it does not matter which of the related shareholders actually owns the stock. In cases involving family disharmony, where members of a family are hostile to one another, this premise may be unfounded. Nevertheless, the Fifth Circuit has ruled that the Section 318 attribution rules are applied mechanically, regardless of the hostility between family members. In David Metzger Trust et al. vs. Commissioner, CA-5, 82-2 USTC ¶9718, 693 F2d 459, affirming 76 TC 42, Dec. 37,614, the court noted the difficulty faced by courts and the IRS in determining the "pattern, intensity and predicted duration of a family fight," and refused to waive the family attribution rules even in the face of family discord. Given the difficulty of analyzing the relationships among family members, the court praised the "fixity" of the family attribution rules as a strength rather than a weakness. This decision, though inconsistent with an earlier ruling of the First Circuit,4 has subsequently been adopted by the Tax Court5 and the IRS.6

The Internal Revenue Service has indicated that the following factors should be considered in determining whether a redemption results in a meaningful reduction in the shareholder's interest:

3 U.S. vs. Maclin P. Davis 20 AFTR 2d 5515, 09/15/19674 Robin Haft Trust v. Commissioner, CA-1, 75-1 USTC &9209, 510 F2d 43, vacating and remanding 61 TC 398, Dec. 32,400.5 See M.N. Cerone v. Commissioner, 87 TC 1, Dec. 43,144.6 See Revenue Ruling 80-26, 1980-1 CB 66.

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whether the redemption affects the shareholder's "ability to control" the corporation;

whether the redemption affects the shareholder's future interest in the corporation's earnings; and

whether the distribution affects the shareholder's rights upon liquidation of the corporation.7

The first factor is consistent with the requirements for qualification as a substantially disproportionate redemption, suggesting that no redemption which leaves the recipient shareholder in control of the redeeming corporation will be deemed to substantially reduce the shareholder's interest in the corporation. Thus, for example, where a corporation redeems shares held by its sole shareholder, the redemption will always be treated as a dividend (unless the redemption results from a qualified partial liquidation).

It is possible, however, for a redemption to qualify for sale treatment where it prevents the recipient-shareholder from acting in concert with another shareholder to control the corporation. Moreover, the redemption may qualify for sale treatment even if it would not satisfy the provisions of the substantially disproportionate redemptions safe harbor (because it does not result in more than a 20 percent decrease in the shareholder's interest in the corporation).

Example 23: J Corp is owned by 4 shareholders as indicated below:

A 280 sharesB 240 sharesC 240 sharesD 240 sharesTotal shares outstanding 1,000 shares

None of the four shareholders, all individuals, are related. Although none individually possesses enough shares to control the corporation, A can act in concert with any other shareholder to exert control (A's 270 shares, when combined with any other shareholder's 240 shares, results in 52 percent control). Thus, A can control the corporation merely by convincing one other shareholder to side with her.

Early this year, A needed money. J Corp redeemed 50 of her 280 shares for $250,000 cash. The redemption will not qualify as a substantially disproportionate redemption because A's interest in J Corp is not reduced by more than 20 percent. (A's interest would have to be reduced to less than 22.4 percent--80% x 28%--to qualify). However, the redemption eliminates A's ability to act in concert with any other single shareholder to control the corporation. After the redemption, A will have to convince at least two of the remaining three shareholders to side with her in order to exert control over J Corp. Thus, the redemption significantly reduces A's "ability to control" J Corp, and should be treated as a sale of her stock back to J, rather than as a dividend.

7 Revenue Ruling 75-502, 1975-2 CB 111.15

Note that in order to avoid dividend equivalence, the redemption itself must cause a diminution in the shareholder's ability to control the corporation. In the above example, if A had owned only 240 shares of J stock before the redemption, any group of two shareholders (A and B, A and C, or A and D) would have had insufficient voting power to control the corporation. The votes of at least three shareholders would be necessary to exceed 50 percent control. Accordingly, any redemption of A's stock likely would have to satisfy one of the safe harbors to be treated as a stock sale.

The other two factors indicated by the Service (relating to the redemption's impact on the shareholder's future interest in corporate profits or corporate assets) are most likely to arise in cases involving the redemption of preferred stock. Since preferred shares generally do not entitle their holder to vote on corporate management issues, redemption of preferred shares generally will not affect the shareholder's ability to control the corporation. Nonetheless, if the redemption of preferred shares significantly affects the shareholder's future interest in corporate profits and/or assets, the redemption will qualify for sale treatment.

Example 24: J and D each own 50 percent of R Corporation's outstanding common stock. In addition, J owns 200 shares of R Corporation preferred stock, giving her a preferential interest in R Corporation's income and assets upon liquidation. J and D are not related. D has no preferred shares. This year, R Corporation redeemed all of J's preferred shares for $200,000. Although the redemption does not affect J's interest in the voting stock of R Corporation, it may still qualify for sale treatment if it substantially alters her interest in R's income and assets. This determination, in turn, would depend on the relative magnitude of the preferred stock rights when compared to the rights to income and assets accorded common shareholders.

A factor which is not considered in determining whether a stock redemption is essentially different from a dividend is the business motive for the redemption. Thus, if a redemption does not qualify for sale treatment under one of the safe harbors (substantially disproportionate redemption, complete termination of shareholder's interest, or partial liquidation), and does not affect her control of the corporation, nor her interest in corporate income or assets, it will be treated as a dividend distribution even if motivated by a sound business purpose.

The Supreme Court has ruled that the existence of a valid business purpose for a stock redemption has no bearing on the tax treatment accorded the transaction. In Maclin P. Davis v. Commissioner (ibid), the taxpayer was the largest shareholder in a family-owned corporation. All the other shares in the corporation were owned by the taxpayer's spouse and his children. In order to satisfy certain working capital requirements necessary to receive a loan, Mr. Davis purchased 1,000 shares of preferred stock. It was understood that the preferred stock would be redeemed by the corporation as soon as the loan was repaid. Upon repayment of the loan, the preferred stock was redeemed. Applying the constructive ownership rules, Mr. Davis was deemed the constructive owner of all the company's stock both before and after the redemption. Accordingly, the Supreme Court ruled that the redemption was properly taxable as a dividend, even though it was motivated by a legitimate business purpose rather than for reasons of tax avoidance.

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Example 25: The outstanding stock of Tico, Inc. is owned by the following shareholders:

Shares Owned Tax BasisMarty 1,000 shares $150,000Sherry 750 shares $115,000Terry 750 shares $115,000MST, Inc. 500 shares $ 75,000

Marty and Sherry are married. Terry is Marty's brother. In addition to their shares in Tico, Marty, Sherry and Terry each own one-third of the shares of MST, Inc. This year, Tico redeemed all of Sherry's Tico stock for $200,000. Tico's E&P at the date of the redemption was $750,000.

Prior to the redemption, Sherry is deemed the constructive owner of Marty's stock, both in Tico Corporation and MST, Inc. As a result, she is deemed a controlling shareholder (two-thirds stock ownership) of MST, Inc. and is attributed two-thirds or 367 shares, of MST's stock in Tico. Accordingly, the redemption does not qualify as a complete termination of Sherry's interest in Tico, even though the family attribution rules are waived for purposes of this determination. The redemption also fails to qualify as a substantially disproportionate redemption. Prior to the redemption, Sherry is deemed the constructive owner of all 1,000 shares of stock owned by Marty, and 367 shares owned by MST, Inc., in addition to her own 750 shares, giving her a total interest of 2,119 shares, or 70.57 percent (2,117 ÷ 3,000). After the redemption, she will be deemed the constructive owner of 1,367 shares (1,000 from Marty, plus 367 from MST). However, there are now only 2,250 shares outstanding, so that Sherry's interest leaves her in control of Tico (1,367 shares ÷ 2,250 shares outstanding = 60.75 percent). Accordingly, the redemption fails to satisfy the requirements for treatment as a substantially disproportionate redemption. The redemption also fails to reduce Sherry's ability to control the corporation. Thus, it is essentially equivalent to a dividend.

Section 303: Redemptions to Pay Death Taxes

Stock Must Constitute Significant Portion of Estate

Certain redemptions to pay death taxes are treated as sales of stock regardless of their effect on the shareholders' relative interests in the corporation. Under Section 303, if stock in a closely held corporation comprises a significant portion of a decedent's estate, a redemption by the corporation of stock held by the estate or its beneficiaries may be treated as a sale. In enacting Section 303, Congress acknowledged that corporate funds may be necessary in these cases to pay the estate tax. Section 303 applies when the value of stock included in the decedent's gross estate exceeds 35 percent of the net value of the estate after allowances for funeral and administrative expenses, certain losses, and other claims against the estate.

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Where the decedent owned stock in two or more corporations, all blocks constituting at least a 20 percent interest in a particular corporation are aggregated for purposes of determining compliance with the 35 percent threshold.

Example 26: A died this year, leaving behind an estate with a net value of $2.5 million. Included in A's estate were shares of stock in the following corporations:

Shares Value of Corporation Shares Owned Outstanding A's Interest

X Corp 10,000 30,000 $250,000Y Corp 50,000 100,000 $500,000Z Corp 1,000 20,000 $200,000Total Value $950,000

For purposes of determining whether Section 303 applies, the estate can aggregate A's shares in Corporations X and Y, in which A owned 33 percent and 50 percent respectively. Corporation Z, in which A owned only a 5 percent block, is disregarded. Since the X and Y stock together constitute only 30 percent of the net value of A's estate ($750,000 ) $2,500,000), Section 303 will not apply. The tax treatment of any redemptions of X or Y stock will therefore depend on whether the redemption satisfies one of the safe harbors of Section 302, or is otherwise not essentially equivalent to a dividend.

Qualified Redemption Limited to Taxes and Funeral Expenses

Where Section 303 does apply, sale treatment extends only to that portion of the redemption the proceeds of which do not exceed the aggregate of all federal and state estate and inheritance taxes, plus funeral and administrative expenses incurred by the estate. Moreover, because the purpose of Section 303 is to allow the estate (or beneficiaries) to use corporate funds to pay the estate tax liability, the redemption must occur within 90 days after the expiration of the period for assessing the federal estate tax in order for Section 303 to apply.8

Example 27: W died this year, leaving a net estate valued at $5 million. Included in this amount was a block of stock in a family-owned corporation with a gross value of $4 million. Estate and inheritance taxes (federal and state) totaled $2,450,000. Funeral and administrative expenses totaled $150,000. Shortly after W's death, the family corporation redeemed 75 percent of the stock held by the estate for $3 million. Under Section 303, $2.6 million of the redemption proceeds are treated as proceeds from a sale of the stock to pay death taxes (the total of the estate and inheritance taxes, funeral and administrative expenses). The remaining $400,000 of the redemption proceeds will be treated as dividend income unless the redemption can be shown to have meaningfully reduced the estate's interest in the corporation. (Remember that any stock owned by the beneficiaries will be attributed to the estate for purposes of this determination).

Consequences to the Shareholder8 Sec. 303(b)(1). Note that this period can be extended if the estate petitions the Tax Court for resolution of a disagreement with the IRS, or elects to pay the estate tax liability in installments.

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Although the purpose of Section 303 is to allow the estate, or the beneficiaries, to use corporate funds to help pay the taxes and/or funeral and administrative expenses incurred as a result of the decedent's death, the statute does not require that any of the redemption proceeds actually be used for that purpose. Even where the estate has sufficient liquidity to pay all necessary expenses, it is often beneficial to redeem stock under Section 303. The benefit derives from the step-up in the basis of the estate assets allowed under Section 1014. Since estate assets are stepped up to their fair market value as of the decedent's date of death (or an alternate valuation date six months later if applicable), a stock redemption under Section 303 is generally a nontaxable transaction to the shareholder (the estate or beneficiary). Accordingly, in many cases, it is beneficial to redeem as much stock as allowable under Section 303 even if the proceeds are not needed to pay taxes or other estate expenses.

Example 28: H died this year, leaving a $2 million net estate. Included in the net estate are 1,000 shares of a family-owned corporation valued at $1 million. The balance of the estate consists of $750,000 in life insurance proceeds and $250,000 in other assets. Under §1014, the estate will take a basis in the family stock equal to its $1 million value. Assume estate taxes and funeral and administrative expenses total $800,000. A redemption of 80 percent of the family corporation stock will be treated as a sale of such stock back to the corporation under Section 303, even though the redemption proceeds are not necessary to pay the taxes and other expenses. Moreover, since the basis of the stock to the estate will be equal to its $800,000 value (only 80 percent of the stock is being redeemed), no gain or loss will be recognized for income tax purposes as a result of the redemption.

Example 29: Estelle owned 100 percent of the stock of E Inc. when she died. The value of Estelle's E stock was $2.2 million. Her net estate (after funeral and administrative expenses) was valued at $4 million. The estate tax liability on her estate was $1,900,000. Funeral and administrative expenses totaled $250,000. During the administration of the estate, E Inc. redeemed half the shares held by the estate for $1,100,000. Of this amount, $700,000 was used to pay the estate tax liability. The remainder was invested in U.S. Treasury bonds. E, Inc. had E&P at the date of the redemption of $1,200,000.

Under Section 303, the redemption of stock held by the estate, or beneficiaries thereof, will be a qualified redemption regardless of its effect on the shareholder's interest in the corporation. To qualify, the decedent's stock in the redeeming corporation must constitute at least 35 percent of the net value of the estate after payment of funeral and administrative expenses, and the redemption must occur within 6 months of the due date for payment of the estate tax liability. Although Section 303 applies only to the extent the redemption proceeds do not exceed the sum of the estate tax liability, funeral and administrative expenses, it does not require that the redemption proceeds be used to pay these expenses. Here, the value of the E stock constitutes 55 percent of the value of the net estate ($2.2 million ÷ $4 million). The redemption proceeds do not exceed the estate tax liability. Thus, the redemption qualifies for sale treatment under Section 303. Since the tax basis of the estate's E shares equals their value at the date of Estelle's death ($1.1 million), no gain is recognized on the redemption.

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Tax Consequences of Corporate Redemptions

Individual Shareholders

As noted previously, a qualified redemption is treated by individual shareholders as a sale of their stock back to the corporation. Accordingly, they recognize capital gain or loss equal to the excess of the redemption proceeds over their basis in the redeemed shares. Their basis in remaining stock is reduced by the basis allocable to the redeemed shares.

Example 29: Ralph owned 1,200 shares in RM, Incorporated. His basis in his RM stock was $125,000. This year, RM redeemed 40 percent of Ralph's stock for $150,000 in a qualified redemption under §302(b)(2) (substantially disproportionate redemption). Ralph's basis in the redeemed shares was $50,000. He must recognize a capital gain of $100,000 ($150,000 redemption proceeds less $50,000 basis in redeemed shares). Note that the maximum tax rate on this gain is 15 percent. Ralph's basis in his remaining RM shares will be $75,000 ($125,000 less $50,000 basis in redeemed shares).

If the stock redemption does not qualify for treatment as a sale, the shareholder must recognize dividend income to the extent of her share of corporate E&P. The shareholder's basis in remaining shares in this case is increased by the basis allocated to the surrendered shares. The result in most cases is that the shareholder's total stock basis remains unchanged. However, if the distribution exceeds corporate E&P, so that a portion is treated as a return of capital, the shareholder's total stock basis will be reduced by the return of capital. In either case, the shareholder's per share basis in the remaining shares will generally increase.

Example 30: V owns all 1,000 shares of the stock of Vero Corp. V's basis in her Vero shares is $150,000. Vero's E&P is $105,000. This year, Vero redeemed 500 of V's shares for $125,000. The redemption was not the result of a partial liquidation. Moreover, since V is the sole shareholder of Vero, the redemption did not affect her interest in the company. She must recognize $105,000 of dividend income (limited to corporate E&P). The remaining $20,000 of the distribution is a nontaxable return of capital, reducing her basis in her stock to $130,000 ($150,000 original basis less $20,000 return of capital). This basis is allocated among her remaining shares, leaving her with a basis, per share of stock, of $260 ($130,000 total stock basis ÷ 500 remaining shares).9

Corporate Shareholders

The consequences to corporate shareholders of a qualified redemption are generally the same as those for individual shareholders, except that there is no cap on the tax rate applied to corporate capital gains. Recall, however, that a redemption in partial liquidation of the redeeming corporation is not treated as a sale of stock by corporate shareholders.10

9 Note that when a shareholder surrenders all her stock in a nonqualified redemption, her stock basis is allocated to the basis of stock held by others whose shares are attributable to the distributee-shareholder under Section 318. See Reg. Sec. 1.302-2(c).10 Sec. 302(b)(3).

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Instead, corporate shareholders treat redemptions in partial liquidation as dividend distributions eligible for the dividends received deduction.

Under §1059(e), these dividends must be treated by corporate shareholders as extraordinary dividends. Accordingly, corporate shareholders must reduce their bases in remaining shares by the dividends-received deduction taken with respect to the redemption.

Example 31: X Corporation owns 50 percent of the stock (10,000 shares) of GX, Incorporated. GX has E&P of $600,000. X's basis in its GX stock is $400,000. This year, GX redeemed 2,000 of the shares held by X for $200,000 in a qualified partial liquidation under Section 302(b)(3). Although the redemption qualifies as a partial liquidation, as a corporate taxpayer, X treats the $200,000 distribution as a dividend. As a 50 percent shareholder in GX, X is entitled to a dividends received deduction equal to 80 percent of the amount received, or $160,000. Under Section 1059(e), X must reduce its basis in the GX stock by a like amount. Accordingly, X's basis in its remaining GX shares is $240,000 ($400,000 less $160,000 dividends received deduction).

Consequences to the Redeeming Corporation

Distributions in redemption of corporate stock are not subject to special treatment for the redeeming corporation. Under §311, if the corporation distributes property in redemption of its stock, the redeeming corporation must recognize gain, but not loss, as if the property had been sold at fair market value. Gain must be recognized whether the distribution is treated as a qualified redemption or as a dividend. Corporate E&P must be adjusted to reflect the gain.

Corporate E&P is also adjusted to reflect the distribution. If the distribution is not treated as a sale or exchange (i.e., is not a qualified redemption), corporate E&P must be reduced by the portion of the distribution treated as a dividend. If the distribution qualifies for sale treatment, the distributing corporation's E&P is reduced by the lesser of:

the fair market value of the distributed property (including cash); or

the portion of the corporation's E&P attributable to the redeemed shares (the ratio of the fair market value of the redeemed shares divided by the total fair market value of the corporation's outstanding stock).11

Example 32: Jones Corporation has 100,000 shares of stock outstanding. Its E&P is $750,000. This year, it distributed property worth $125,000 (basis $70,000) and $75,000 cash to its shareholders in redemption of 20 percent of their stock. The redemption qualified as a partial liquidation. Jones has no corporate shareholders. The distribution affects Jones in two ways. First, it must recognize a $55,000 gain on distribution of the property ($125,000 value less $70,000 basis). The gain increases Jones' E&P to $805,000. Next, it must reduce E&P by the lesser of the fair market value of the distributed property, including cash ($200,000 total value) or the portion of the E&P attributable to the redeemed shares (20 percent). In this case, the portion of E&P attributable to the redeemed shares, $161,000, is less than the fair market value of the

11 Sec. 312(n)(7).21

distributed property, so Jones' E&P is reduced to $644,000 ($805,000 - $161,000) after the redemption.

Example 33: Jacob and Helen Finch, brother and sister, each own 50 percent (1,000 shares) of the stock of Finchmasters Corp. This year, Finchmasters redeemed 400 of Jacob's shares, in a qualified redemption, in exchange for land valued at $300,000 (basis $175,000). The corporation's E&P prior to the redemption was $350,000.

Finchmasters must recognize a $125,000 gain on distribution of the property as if it had been sold for $300,000. This gain increases the corporation's E&P to $475,000. This balance must then be reduced to reflect the redemption. Finchmasters' E&P is reduced by the lesser of the amount of the distribution ($300,000), or the amount attributable to the redeemed shares. The redemption involved 20 percent of the company's stock (400 shares ÷ 2,000 shares outstanding). Twenty percent of Finchmasters' $475,000 E&P balance is $95,000. Thus, Finchmasters' post-redemption E&P is $380,000.

Anti-Abuse Provisions

Section 306--Preferred Stock Bailouts

Section 306 was implemented to discourage the use of certain preferred stock transactions designed to allow shareholders to withdraw corporate E&P without reducing their interests in the corporation. The specific transaction targeted by Section 306 involves the issuance by a corporation of preferred stock as a tax-free stock dividend, followed by a sale or redemption by the shareholder of the preferred stock received.

Example 34: J is the sole shareholder of Jenkins Corporation. Jenkins has E&P of $500,000. J's basis in Jenkins stock is $130,000. The fair market value of the Jenkins stock is $1,000,000. On August 1 this year, Jenkins distributed nonvoting preferred stock worth $250,000 to J as a nontaxable stock dividend. J recognizes no gain on the distribution and allocates one-fifth of his common stock basis, or $26,000, to the preferred shares ($250,000 ÷ ($1,000,000 + $250,000)). J subsequently sold the preferred stock to his sister, K, for its $250,000 value. Shortly thereafter, Jenkins Corporation redeemed the preferred shares held by K for $250,000. Since K's basis in the preferred shares was $250,000, she recognizes no gain on the redemption. Combining the three transactions, the net effect is a transfer by Jenkins Corporation of $250,000 to J (through K). Both before and after the distribution, J owned 100 percent of Jenkins' voting stock. Section 306 requires that the consequences of this transaction, and others like it, be determined by reference to the combined net effect of the three transfers, rather than viewing each transfer as a separate transaction.

Sale of Section 306 Stock

Section 306 generally applies when a shareholder sells preferred stock received as a nontaxable stock dividend, or when the corporation issuing such preferred stock

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subsequently redeems it.12 When the shareholder sells these "tainted" shares of preferred stock (hereafter referred to as Section 306 stock), the proceeds from the sale will be taxable as ordinary income, but only to the extent of the dividend income which would have been recognized by the shareholder had the corporation distributed cash to the seller-shareholder rather than Section 306 stock.13 Thus, the seller will recognize ordinary income equal to the lesser of the amount realized from the sale of the Section 306 stock, or the issuing corporation's E&P at the date on which the Section 306 stock was distributed to the shareholder.

Example 33: Consider the facts in Example 32 above. J's sale of the preferred stock to K for $250,000 will trigger $250,000 of ordinary income to J. His basis in the preferred stock will be reassigned to his common shares, leaving him with a basis in the common shares of $130,000, the same as before the distribution of the preferred stock dividend. Note that had J sold the preferred shares to K for $600,000, his ordinary income under Section 306 would have been limited to $500,000, Jenkins Corporation's E&P at the date of the preferred stock dividend to J.

Although the selling shareholder recognizes ordinary income in the same amount as if a cash distribution had been received in lieu of the preferred stock dividend, the sale by such shareholder of the preferred shares is not treated as a dividend by the corporation. The corporation's E&P balance is not affected. If, however, the corporation subsequently redeems the preferred stock from the buyer, E&P is reduced at that time by the portion attributable to the redeemed shares. Recall from part E.3, however, that the reduction in E&P cannot exceed the fair market value of the property, including cash, distributed in redemption of the preferred shares.

Example 34: Again consider the facts from Example 28. Shortly after K purchased the preferred stock from J for $250,000, the corporation redeemed K's newly acquired preferred shares for the same price. Recall that the value of the preferred stock was $250,000, and that the total value of all the Jenkins stock outstanding was $1,250,000 ($1,000,000 common stock, plus the $250,000 in preferred). The redemption of K's preferred stock (which completely terminates K's interest in the corporation) is a redemption of one-fifth of Jenkins' stock (by value). Its E&P must therefore be reduced by the lesser of 20 percent (one-fifth) or $250,000 (the redemption price). Assuming that Jenkins E&P immediately prior to the redemption of K's preferred stock remained $500,000, the redemption will reduce Jenkins' E&P to $400,000.

Redemption of Section 306 Stock

An alternative to selling the Section 306 stock to a third party is for the issuing corporation to subsequently redeem the preferred shares from the distributee-shareholder (J in the above Example). In this case, Section 306 treats the redemption of the tainted stock as a distribution that is essentially equivalent to a dividend (i.e., a nonqualified redemption).14 As a dividend, the redemption of Section 306 stock, unlike the sale of such stock to a third party, will cause a reduction in the redeeming corporation's E&P.

12 Section 306 also applies to the sale or redemption of stock received in exchange for "tainted" shares of preferred stock. See Sec. 306(c) for a list of specific types of stock to which the statute applies.13 Sec. 306(a)(1).14 Sec. 306(a)(2).

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Example 35: The stock of McAlex Incorporated is owned equally by unrelated individuals A and B. This year, when the company's E&P was $375,000, McAlex distributed 500 shares of nonvoting preferred stock to each shareholder as a nontaxable stock dividend. A took a basis in her preferred stock of $50,000. The preferred stock was valued at $175,000. On December 31, McAlex redeemed all of A's preferred shares for $175,000 cash. None of B's preferred shares were redeemed at that time. Nonetheless, regardless of the effect of the redemption on A's interest in the corporation's future profits, or in its assets, the payment to A will be treated as a dividend distribution under Section 306. A will recognize $175,000 dividend income and McAlex will reduce its E&P by $175,000. A's basis in the preferred shares redeemed by McAlex will be added to her basis in her remaining common stock.

Exceptions--Transactions to which Section 306 will not apply

Under §306(b), the provisions of §306 do not apply to the sale or redemption of Section 306 stock in the following situations:

the sale or redemption completely terminates the shareholder's interest in the corporation;

the redemption of Section 306 stock is the result of a qualified partial liquidation as described in Section 302(b)(4);

the shareholder exchanges Section 306 stock for other stock in a nontaxable transaction (typically associated with tax-free corporate reorganizations); or

the sale or redemption of Section 306 stock was not motivated by tax avoidance purposes.

Note that a sale (as opposed to a redemption) which completely terminates a shareholder's interest in the corporation is exempted from Section 306 only if the buyer is not a related party to the seller as defined in Section 318. Note also that where the shareholder exchanges Section 306 stock for other stock in a nontaxable exchange, although Section 306 is not triggered, the replacement stock becomes Section 306 stock.

Example 36: Kerry owns 25 percent of the outstanding stock of KC, Inc. The remaining 75 percent of KC shares are owned by Kerry's parents and grandparents. Last year, KC distributed 100 shares of preferred stock to Kerry as a nontaxable stock dividend. At the date of the distribution, KC's E&P totaled $650,000. Kerry took a basis in the preferred stock of $15,000. This year, KC redeemed all of Kerry's preferred stock (received in the prior as a stock dividend) for $75,000. If none of Kerry's common stock in the corporation is redeemed, the transaction will be treated as a $75,000 dividend. On the other hand, if KC also redeemed all of Kerry's common stock, in addition to her preferred shares, Section 306 will not apply and the transaction will be treated as a qualified redemption (i.e., a sale of Kerry's stock back to KC) in its entirety.

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Example 37: Assume in Example 36 above that rather than having KC redeem all her stock, Kerry sold her entire interest (including her common shares) to her father for $250,000. Of this amount, $75,000 was received for her preferred shares and $175,000 for her common shares. As noted in Example 32, Kerry's basis in the preferred stock was $15,000. Assume her basis in the common stock was $35,000. Although the sale completely terminates Kerry's interest in KC, the buyer is a related party under Section 318. Accordingly, Section 306 is not waived, and Kerry must recognize $75,000 ordinary income on the sale (the sales price of the preferred stock). Her basis in the preferred is added back to her basis in the common shares, increasing that basis to $50,000. Thus, the sale of the common stock triggers a $125,000 capital gain. KC's E&P balance is not affected by the sale.

Section 304--Redemptions Using Related Corporations

Similar rules apply when a taxpayer sells stock in a controlled corporation to a related corporation. Under Section 304, the structure of the transaction is disregarded, and the tax consequences are determined by reference to the underlying economic substance. There are two types of related corporation transfers governed by Section 304: Brother-Sister redemptions, and Parent-Subsidiary redemptions.

Brother-Sister Redemptions

In a brother-sister redemption, the taxpayer sells stock in one controlled corporation to another corporation also controlled by the taxpayer. Although neither entity owns stock in the other, they are related by virtue of being controlled by the same shareholder or group of shareholders.

Example 38: Jim owns 100 percent of the stock of both B Corporation and S Corporation. Jim's basis in his B stock (500 shares) is $100,000. His basis in his S stock (100 shares) is $150,000. B has E&P of $250,000. S has E&P of $300,000. On June 1, Jim sold 40 percent of his B shares (200 shares) to S for $225,000. His basis in the B shares sold was $40,000. Although the transaction is structured as a sale of stock, Jim's interest in B Corporation is not affected by the stock transfer. As the sole shareholder of S Corporation, Jim still controls the B shares held by S. Thus, just as before the transfer, Jim owns 100 percent of the stock of B. As a result, Section 304 disregards the structure of the transaction and prohibits Jim from treating the transfer as a sale.

Under Section 304, the sale of stock in one controlled corporation to another controlled corporation (a brother-sister redemption) is treated as a two-step transaction:

First, the purchasing corporation is deemed to have issued new shares of its own stock to the shareholder in exchange for stock in the related corporation;

Second, the purchasing corporation is treated as if it immediately redeemed the newly issued shares for a cash payment equal to the purchase price.

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Example 39: Reconsider Example 38. Jim's transfer of 200 shares of B stock to S Corporation will be treated as occurring in a two-step transaction. First, Jim will be deemed to have contributed the B stock to S in exchange for additional S shares. Since Jim's basis in the B stock was $40,000, the contribution increases his basis in his S stock by $40,000. S takes a $40,000 basis in the B stock received (rather than $225,000, the amount "paid" for such stock). S is then treated as if it immediately redeemed the newly issued shares for $225,000. Since Jim owns 100 percent of S's outstanding stock both before and after the redemption, the $225,000 payment to Jim will be treated as a dividend, paid from S's E&P.15 S's E&P is reduced to $75,000 ($300,000 beginning balance less $225,000 dividend). Jim's basis in his S stock remains at $190,000 ($150,000 original basis plus $40,000 basis acquired on deemed contribution to S). His basis in his B stock is $60,000 ($100,000 original basis less $40,000 transferred to S).

Parent-Subsidiary Redemptions

The second type of related corporation transfer covered by Section 304 is the Parent-Subsidiary redemption. In a parent-subsidiary redemption, the taxpayer sells stock in a controlled corporation (the Parent) to a subsidiary of the same corporation. Since the taxpayer controls the parent, and the parent controls the subsidiary, the sale generally has no meaningful effect on the taxpayer's interest in the Parent.

Example 40: Paula owns 100 percent of the stock of P Corporation (1,000 shares). P owns 100 percent of the stock of S Corporation (500 shares). Paula's basis in her P stock is $100,000. P's basis in its S stock is $150,000. P has E&P of $325,000 and S has E&P of $175,000. On June 1, Paula sold 20 percent of her P stock (200 shares) to Corporation S for $200,000. Although this transaction is structured as a sale of stock, Paula's interest in Corporation P is not affected by the stock transfer. Indeed, since P owns 100 percent of the stock of Corporation S, the transaction is not economically distinguishable from a sale of Paula's P stock back to P (i.e., a redemption by P of its own stock). Accordingly, under Section 304, Paula must apply the rules of Section 302 (stock redemptions) to determine the tax consequences of this transaction.

Consistent with the economic substance of such transactions, Section 304 treats the sale of stock in a Parent Corporation to a subsidiary of the Parent as a redemption by the Parent of its own stock from the seller-shareholder.

Example 41: Consider the facts of Example 40. Paula's sale of P stock to S is treated as a redemption by P of its own stock. Since Paula owns 100 percent of the stock of P both before and after the transaction, the redemption is not essentially different from a dividend. Accordingly, Paula must recognize $200,000 of dividend income. Corporation P must reduce its E&P to $125,000 ($325,000 beginning balance less $200,000 dividend). Since the so-called "sale" of P Corporation stock is disregarded, Paula's basis in the 200 shares of

15 Note that under Section 304(b)(2), if the payment to Jim exceeded S's E&P, it would then be deemed to come from B's E&P. The net result is that Jim recognizes dividend income to the extent the payment from S does not exceed the combined E&P of S and B Corporations.

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Corporation P stock transferred is re-allocated to her remaining P shares. Paula's basis in her remaining 800 P shares is $100,000 (increasing her per-share basis in the remaining P stock to $12.50 per share).

Example 42: Arthur Johnson owns all 10,000 shares of the outstanding stock of Z Corporation. His basis in his Z stock is $125,000. Last year, Z distributed 1,000 shares of preferred stock to Arthur as a nontaxable stock dividend. Z's E&P at the date of the stock dividend was $95,000. Arthur took a basis in the preferred shares of $50,000 (reducing his basis in his common shares to $75,000). In January, Arthur sold the preferred shares to a business associate for $115,000. In April, Z redeemed the shares from the buyer for $120,000. Z's E&P at the date of the redemption was $145,000.

Section 306(a)(1), which applies to the sale of Section 306 stock to a third party, provides that the proceeds of the sale will be taxed to the seller as ordinary income to the extent the seller would have recognized dividend income had a cash distribution been received at the date of the preferred stock dividend. Here, Z Corporation's E&P at the date of the dividend was $95,000. Thus, Arthur must recognize $95,000 dividend income. Note that the remaining $20,000 of the sales proceeds will be treated as a nontaxable return of capital. Arthur's basis in his common shares after the sale will be $105,000 ($75,000 + $50,000 allocable to the preferred stock, less $20,000 return of capital).

Assume that the preferred stock constitutes 40 percent of the total value of Z Corporation's outstanding stock. The sale of the preferred stock by Arthur, although generating a large amount of ordinary income to him, will not affect Z's E&P. Upon redemption of the preferred stock held by the buyer, however, Z must reduce its E&P by the lesser of the amount of the distribution ($120,000) or the portion of E&P attributable to the redeemed shares (40 percent). Here, 40 percent of the E&P balance is only $58,000 ($145,000 X 40 percent). Thus, Z must reduce its E&P to $87,000 ($145,000 - $58,000).

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