Chapter 6
Corporations:
Redemptions
and Liquidations
Corporations, Partnerships,
Estates & Trusts
© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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The Big Picture (slide 1 of 3)
• Christina Flores formed Orange Corporation 15 years ago
– She owns all 10,000 shares of Orange stock outstanding
– Stock basis of $400,000.
• Christina has been employed full-time with Orange since its
inception
– Handles all corporate management and strategy decisions.
– She receives an annual salary of $250,000.
• Within the next 5 to 7 years, Christina would like to retire and
transfer ownership to her two children, ages 24 & 22.
– The children have worked full-time with Orange over the last two
years.
– They have the capacity and willingness to take over the business after
their mother’s retirement.
The Big Picture (slide 2 of 3)
• Currently, the Orange stock is worth $6
million.
– Expected to be worth $8 million by Christina’s
retirement.
– The stock represents approximately 80% of
Christina’s net worth.
• Orange Corporation (E & P of $2 million)
generates strong positive cash flow
– Will require a significant investment in property,
plant, and equipment over the next several years.
The Big Picture (slide 3 of 3)
• The children are not expected to have the financial
wherewithal to purchase the Orange stock from their
mother at the time of her retirement.
– Christina would be receptive to taking notes in exchange
for her Orange stock.
• How could a stock redemption be used to assist
Christina in achieving her goal of transferring control
of Orange to the children upon her retirement?
• Read the chapter and formulate your response.
Effect of Redemption
(slide 1 of 3)
• If qualified as a redemption:
– Shareholder reports gain or loss on surrender of
stock
• Gain taxed at favorable capital gains rates (0%/15%)
• Shareholder reduces gain by basis in stock redeemed
• Capital gains may be offset by capital losses, if
available
Effect of Redemption
(slide 2 of 3)
• If transaction has appearance of a dividend,
redemption will not be qualified:
– For example, if shareholder owns 100% and
corporation buys ½ of stock for $X, shareholder
still owns 100%
Effect of Redemption
(slide 3 of 3)
• If not qualified as a redemption:
– Shareholder reports dividend income
• Individual shareholders may be taxed at 0%/15% rates
• But, redemption proceeds may not be offset by basis in
stock surrendered
• Cannot be offset by capital losses
– Corporate shareholders may prefer dividend
treatment because of the dividends received
deduction
Transactions Treated as Redemptions
(slide 1 of 3)
• The following types of distributions may be
treated as a redemption of stock rather than as
a dividend:
– Distributions not essentially equivalent to a
dividend (subjective test)
– Disproportionate distributions (mechanical rules)
Transactions Treated as Redemptions
(slide 2 of 3)
– Distributions in termination of shareholder’s
interest (mechanical rules)
– Partial liquidations of a corporation where
shareholder is not a corporation, and either
• (1) Distribution is not essentially equivalent to a
dividend, or
• (2) An active business is terminated
• (May be subjective (1) or mechanical (2))
Transactions Treated as Redemptions
(slide 3 of 3)
– Distributions to pay death taxes (limitation on
amount of allowed distribution is mechanical test)
• Stock attribution rules must be applied, so
distribution which appears to meet
requirements may not qualify
Stock Attribution
(slide 1 of 5)
• Qualified stock redemption must result in
substantial reduction in shareholder’s
ownership
– Stock ownership by certain related parties is
attributed back to shareholder whose stock is
redeemed
Stock Attribution
(slide 2 of 5)
• Attribution from family members
– Stock owned by spouse, children, grandchildren,
or parents attributed back to individual
Stock Attribution
(slide 3 of 5)
• Attribution from entity to owner:
– Partner: deemed owner of proportionate number
of shares owned by partnership
– Beneficiary or heir: deemed owner of
proportionate shares owned by entity
– 50% or more shareholder: deemed owner of
proportionate shares owned by corporation
Stock Attribution
(slide 4 of 5)
• Attribution from owner to entity
– Partnership: deemed owner of total shares owned
by partner
– Estate or trust: deemed owner of total shares
owned by heir or beneficiary
– Corporation: deemed owner of total shares owned
by 50% or more shareholder
Stock Attribution
(slide 5 of 5)
• Family attribution rules do not apply to
redemptions in complete termination of
shareholder’s interest
• Stock attribution rules do not apply to partial
liquidations or redemptions to pay death taxes
The Big Picture – Example 4
Stock Attribution Rules
• Return to the facts of The Big Picture on p. 6-2.
• Assume instead that Christina owns only 80%
of the stock in Orange Corp.
– The other 20% is owned by her two children.
• For purposes of the stock attribution rules,
Christina is treated as owning 100% of the
stock in Orange Corp.
– She owns 80% directly and, because of the family
attribution rules, 20% indirectly through her
children.
Not Essentially Equivalent
Redemptions (slide 1 of 3)
• Redemption qualifies for sale or exchange
treatment if “not essentially equivalent to a
dividend”
– Subjective test
– Provision was added to deal specifically with
redemptions of preferred stock
• Shareholders often have no control over when preferred
shares redeemed
• Also applies to common stock redemptions
Not Essentially Equivalent
Redemptions (slide 2 of 3)
• To qualify, redemption must result in a
meaningful reduction in shareholder’s interest
in redeeming corp.
• Stock attribution rules apply
• Indicators of a meaningful reduction include:
– A decrease in the redeeming shareholder’s voting
control
– Reduction in rights of redeeming shareholders to
• Share in corporate earnings, or
• Receive corporate assets upon liquidation
Not Essentially Equivalent
Redemptions (slide 3 of 3)
• If redemption fails to satisfy any of the
qualifying stock redemption rules
– Treated as ordinary dividend
– Basis in stock redeemed attaches to remaining
stock owned (directly or constructively)
Qualifying Disproportionate
Redemption (slide 1 of 4)
• Redemption qualifies as disproportionate
redemption if:
– Shareholder owns less than 80% of the interest
owned prior to redemption
– Shareholder owns less than 50% of the total
combined voting power in the corporation after the
redemption
Qualifying Disproportionate
Redemption (slide 2 of 4)
Qualifying Disproportionate
Redemption (slide 3 of 4)
Qualifying Disproportionate
Redemption (slide 4 of 4)
• Shareholder has 46 2/3% ownership
represented by 35 voting shares (60-25) of 75
(100-25) outstanding voting shares
• Redemption is qualified disproportionate
redemption because:
– Shareholder owns < 80% of the 60% owned prior
to redemption (80% × 60% = 48%), and
– Shareholder owns < 50% of total combined voting
power of corporation
Complete Termination Redemptions
• Termination of entire interest generally
qualifies for sale or exchange treatment
– Often will not qualify as disproportionate
redemption due to stock attribution rules
– Family attribution rules will not apply if:
• Former shareholder has no interest (other than as
creditor) for at least 10 years
• Agree to notify IRS of any disallowed interest within
10 year period
Redemptions in Partial Liquidation
(slide 1 of 3)
• Noncorporate shareholder gets sale or
exchange treatment for partial liquidation
including:
– Distribution not essentially equivalent to a
dividend
– Under a safe-harbor rule, distribution pursuant to
termination of an active business
Redemptions in Partial Liquidation
(slide 2 of 3)
• To qualify, distribution must be made within
taxable year plan is adopted or the succeeding
taxable year
• Not essentially equivalent test looks at effect
on corporation
– Requires genuine contraction of the business of the
corporation
• Difficult to apply due to lack of objective tests
• Advanced ruling from IRS should be obtained
Redemptions in Partial Liquidation
(slide 3 of 3)
• Under the safe-harbor rule, to meet the
complete termination of a business test, the
corporation must:
– Have two or more active trades or businesses that
have been in existence for at least five years
• Distribution must consist of the assets of a qualified
trade or business or the proceeds from the sale of such
assets
– Terminate one trade or business and continue a
remaining trade or business
The Big Picture – Example 14
Partial Liquidations (slide 1 of 3)
• Assume that Orange Corporation loses a major
customer and a severe drop in sales occurs.
• The corporation reduces its inventory
investment and has $600,000 of excess cash on
hand as a result.
• It distributes the excess cash to Christina in
redemption of 10% of her stock.
The Big Picture – Example 14
Partial Liquidations (slide 2 of 3)
• Since Christina’s ownership interest in Orange
remains unchanged (100%), the redemption
does not qualify as:
– A not essentially equivalent redemption,
– A disproportionate redemption, or
– A complete termination redemption.
The Big Picture – Example 14
Partial Liquidations (slide 3 of 3)
• Further, the reduction in inventory does not
qualify as a general contraction of Orange
Corporation’s business
• Thus, the distribution is not a partial
liquidation.
– Therefore, the $600,000 is dividend income to
Christina.
– The $40,000 basis in the stock redeemed (10% X
$400,000) attaches to the basis of Christina’s
remaining shares of Orange.
Redemptions to Pay Death Taxes
(slide 1 of 2)
• Allows sale or exchange treatment if value of
stock exceeds 35% of value of adjusted gross
estate
– Stock of 2 or more corps may be treated as stock
of single corp for 35% test if 20% or more of each
corp was owned by decedent
– Special treatment limited to sum of:
• Death Taxes
• Funeral and administration expenses
Redemptions to Pay Death Taxes
(slide 2 of 2)
• Basis of stock is stepped up to fair market
value on date of death (or alternate valuation
date)
– When redemption price equals stepped-up basis,
no tax consequences to estate
Effect of Redemption on Corporation
(slide 1 of 2)
• Gain or loss recognition
– If property other than cash used for redemption
• Corporation recognizes gain on distribution of
appreciated property
• Loss is not recognized
– Corporation should sell property, recognize loss, and use
proceeds from sale for redemption
Effect of Redemption on Corporation
(slide 2 of 2)
• Effect on Earnings and Profits
– E & P is reduced in a qualified stock redemption
by an amount not in excess of the ratable share of
E & P attributable to stock redeemed
• Corporate expenditures incurred in a stock
redemption are not deductible
– e.g., accounting, brokerage, legal and loan fees
Stock Redemptions—No Sale
or Exchange Treatment
• Redemptions not qualifying under previous
provisions
– Treated as dividend distribution to extent of
E&P
– Attempts by taxpayers to circumvent redemption
provisions led to rules covering:
• Preferred stock bailouts
• Sales of stock to related corporations
Effect of Preferred Stock Bailout
(slide 1 of 4)
• Preferred stock bailout involves:
– Corporate distribution of nontaxable (nonvoting)
preferred stock dividend on common stock
– Portion of basis in common stock is allocated to
preferred stock
– Shareholder then sells the preferred stock to third
party
• Effect is bailout of corporate profits as a capital gain
without reducing the shareholder’s percentage
ownership in the corporation
Effect of Preferred Stock Bailout
(slide 2 of 4)
• To minimize abuse potential, Code requires
this treatment:
– Shareholder has ordinary income (§306 taint) on
sale of preferred stock to third party
– Amount of ordinary income is FMV of preferred
stock on date received as distribution from
corporation
• Treated as a dividend for purposes of the 0%/15%
maximum tax on dividend income but has no effect on
the issuing corporation’s E & P
Effect of Preferred Stock Bailout
(slide 3 of 4)
• To minimize abuse potential, Code requires
this treatment (cont’d):
– No loss recognized on sale of “tainted” preferred
stock
– If stock is redeemed by corporation, proceeds
treated as a dividend to the extent of the
corporation’s E & P
Effect of Preferred Stock Bailout
(slide 4 of 4)
• §306 stock is stock which is not common stock:
– Received as a nontaxable stock dividend
– Received tax-free in a corporate reorganization (plus other
requirements), or
– Has a basis determined by reference to other §306 stock
• If a corporation has no E & P on the date of
distribution of a nontaxable preferred stock dividend,
the stock will not be § 306 stock
The Big Picture – Example 20
Preferred Stock Bailouts (slide 1 of 4)
• Return to the facts of The Big Picture on p. 6-2.
• Assume that on January 3, Orange Corp. (E & P of $2
million) declares and issues a nontaxable preferred
stock dividend of 1,000 shares to Christina.
• After the stock dividend, the fair market value of the
stock is:
– $540 per share of common stock,
– $600 per share of preferred stock.
• Two days later, Christina sells the 1,000 shares of
preferred stock to Emily, an unrelated party, for
$600,000.
The Big Picture – Example 20
Preferred Stock Bailouts (slide 2 of 4)
Section 306 produces the following results:
After the distribution and before the sale, the
preferred stock has a basis to Christina of
$40,000.
$600,000 value of preferred stock
$6 million value of preferred & common) X $400,000 original
basis
–At this time, the common stock has a new basis of
$360,000.
The Big Picture – Example 20
Preferred Stock Bailouts (slide 3 of 4)
Section 306 produces the following results (Cont’d):
• The sale of the preferred stock generates
$600,000 of ordinary income to Christina.
– This is the amount of dividend income Christina
would have recognized had cash been distributed
instead of preferred stock (i.e., the § 306 taint).
• The 15% maximum tax rate on dividend income is
applicable to the $600,000.
The Big Picture – Example 20
Preferred Stock Bailouts (slide 4 of 4)
Section 306 produces the following results (Cont’d):
• The $40,000 basis allocated to the preferred
stock is added back to the basis of the common
stock.
– Thus, the common stock basis is increased back to
$400,000.
• Orange Corporation’s E & P is unaffected by
either the stock dividend or its subsequent sale.
Redemption with Related Entities
(slide 1 of 2)
• When one corp acquires stock in another corp
from a shareholder and the shareholder
controls both corps (i.e., direct or indirect
ownership of at least 50%)
– §304 requires that the redemption result in a
reduction of ownership interest that would satisfy
one of the qualifying stock redemptions of § 302
(e.g., disproportionate redemption) or § 303
• If the redemption does not qualify under those rules, the
transaction is characterized as a dividend distribution
Redemption with Related Entities
(slide 2 of 2)
• When brother-sister corporations are involved
– Stock received by acquiring corp treated as a
capital contribution
• Corp’s basis in acquired stock is same as shareholder’s
basis
• Shareholder’s basis in acquiring corp is increased by
basis of stock surrendered
Corporation Division Under §355
• If one corp controls another corp
– Stock in subsidiary can be distributed to
shareholders tax free if requirements of §355 are
met
Liquidations—In General
• Corporation winds up affairs, pays debts, and
distributes remaining assets to shareholders
– Produces sale or exchange treatment to shareholder
– Liquidating corporation recognizes gains and
losses upon distribution of its assets, with certain
exceptions
Liquidations—Effect on Corporation
(slide 1 of 3)
• Gain or loss is recognized by corporation on
distribution in complete liquidation
– Loss may be disallowed or limited if:
• Property distributed to related parties
• Property distributed has built-in losses
• A subsidiary’s liquidating distribution to its parent corporation or to
its minority shareholders
– Property treated as if sold for FMV
– Result: Liquidating distribution subject to corporate level
tax (gain), and shareholder level tax (receipt of proceeds)
Liquidations—Effect on Corporation
(slide 2 of 3)
• Limitations on losses—Related Party
Situations
– Losses are disallowed on liquidating distributions
to related parties if:
• Distribution is not pro rata
– In pro rata distributions, each shareholder receives their share
of each asset
• Property distributed is disqualified property
– Disqualified property is property acquired by corp in a §351
transaction during the five-year period ending on date of
distribution
Liquidations—Effect on Corporation
(slide 3 of 3)
• Limitations on losses—Built-in Loss
Situations
– Losses are disallowed when property distributed
was acquired in a §351 transaction and principal
purpose was to cause recognition of loss by corp
on liquidation
– Purpose is presumed if transfer occurs within two
years of adopting liquidation plan
The Big Picture – Example 24
Antistuffing Rules (slide 1 of 2)
• Return to the facts of The Big Picture on p. 6-2.
• Assume that Christina transfers property to Orange
Corp. in exchange for additional stock.
– Property basis = $100,000, fair market value = $55,000.
– The exchange qualifies under § 351.
• Absent any exceptions, the general rule of carryover
basis would apply.
– Orange would take a carryover basis of $100,000 in the
property.
– Christina would take a $100,000 basis in the additional
stock.
The Big Picture – Example 24
Antistuffing Rules (slide 2 of 2)
• A sale or liquidating distribution of the
property by Orange Corp. would result in a
$45,000 loss.
– $55,000 (fair market value of property) - $100,000
(property basis).
• Similarly, a sale by Christina of the stock
acquired in the § 351 exchange would also
result in a $45,000 loss.
– $55,000 (fair market value of stock) - $100,000
(stock basis).
Distribution of Loss Property in
Liquidation
Liquidations—Effect on Shareholder
(slide 1 of 2)
• Gain or loss recognized on receipt of property
from liquidating corporation
– Amount = FMV of property received - basis in
stock
• Generally, capital gain or loss
– Basis in assets received in liquidating distribution
= FMV on date of distribution
Liquidations—Effect on Shareholder
(slide 2 of 2)
– Special rule for installment obligations
• Shareholder may defer gain recognition to point of
collection
• Corporation must recognize all gain on distribution
Liquidations: Parent-Subsidiary
Situations (slide 1 of 4)
• Parent corporation does not recognize gain or
loss on liquidation of subsidiary
– Also, subsidiary recognizes no gain or loss on
property distributions to its parent
Liquidations: Parent-Subsidiary
Situations (slide 2 of 4)
• To qualify:
– Parent must own at least 80% of voting stock and
value of subsidiary’s stock
– Subsidiary must distribute all property in complete
cancellation of all its stock within the taxable year
or within 3 years from close of tax year in which
first distribution occurred
– Subsidiary must be solvent
Liquidations: Parent-Subsidiary
Situations (slide 3 of 4)
• Liquidating distributions to minority
shareholders
– Subsidiary corporation treated same way as in
nonliquidating distribution
• Distributing corp recognizes gain but not loss
– Minority shareholders recognize gain or loss
• Amount = FMV of property received-basis in stock
Liquidations: Parent-Subsidiary
Situations (slide 4 of 4)
• Basis of property received by parent
– Has same basis as subsidiary’s basis (unless
election is made under §338)
• Parent’s basis in subsidiary’s stock disappears
• Parent acquires tax attributes of subsidiary
– e.g., NOLs, business credit carryovers, capital loss carryovers,
subsidiary’s E & P
• May result in some inequities
Election Under §338
(slide 1 of 4)
• Parent may elect to treat acquisition of stock in
acquired corp as a purchase of the acquired
corp.’s assets if:
– Election is made by fifteenth day of ninth month
following qualified stock purchase
• Qualified stock purchase occurs when corp acquires
stock representing at least 80% of voting power and
value within a 12-month period
• Must be acquired in taxable transaction
– Stock purchases by affiliated group members count
Election Under §338
(slide 2 of 4)
• Tax Consequences
– Parent corp has basis in subsidiary’s assets = basis
in subsidiary’s stock
• Subsidiary may, but need not, be liquidated
Election Under §338
(slide 3 of 4)
• Tax Consequences (cont’d)
– Subsidiary is deemed to have sold its assets for an
amount determined with reference to parent’s basis
in subsidiary’s stock, adjusted for liabilities of
subsidiary
Election Under §338
(slide 4 of 4)
• Tax Consequences (cont’d)
– Gain or loss is recognized by subsidiary
– Subsidiary is treated as a new corporation that
purchased all of its assets on the day after the
qualified stock purchase date
Refocus On The Big Picture (slide 1 of 4)
• With proper planning, a complete termination
redemption could be utilized to achieve Christina’s
objectives.
– In the years remaining before her retirement, Christina
should ensure that her children are actively involved in the
management and strategy decisions of Orange Corporation.
– Also, an ownership interest in Orange should be shifted to
each of the children so that they are in minority shareholder
positions by the time Christina retires.
• The children could purchase Orange shares from Christina or newly
issued shares from Orange.
Refocus On The Big Picture (slide 2 of 4)
• Alternatively, Christina could make gifts of Orange stock to
the children.
– This would eliminate the need for the children to raise capital for a
stock purchase and would produce favorable estate tax consequences.
• Upon Christina’s retirement, Orange would redeem her
remaining ownership interest
– The two children would be sole shareholders of Orange Corporation.
• Assuming that Christina satisfies the requirements of the
family attribution waiver, the transaction would qualify as a
complete termination redemption.
• Orange Corporation could issue notes to finance the stock
redemption.
– Christina could use the installment method to report her gain.
Refocus On The Big Picture (slide 3 of 4)
What If?
• What if Christina passes away before her
retirement date?
– A redemption to pay death taxes could be utilized
to redeem Orange stock from Christina’s estate, as
it appears that the requirements of § 303 would be
satisfied.
– However, a redemption would qualify under § 303
only to the extent of the estate’s death taxes and
funeral and administration expenses.
Refocus On The Big Picture (slide 4 of 4)
What If?
• A redemption of an amount greater than the
death taxes and funeral and administration
expenses probably would not qualify as a stock
redemption
– After the redemption to pay death taxes, the
estate’s remaining shares of Orange would be
distributed to the children, and they would control
100% of the outstanding shares of the corporation.
If you have any comments or suggestions concerning this
PowerPoint Presentation for South-Western Federal
Taxation, please contact:
Dr. Donald R. Trippeer, CPA
trippedr@oneonta.edu
SUNY Oneonta
© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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