Chapter 6
Corporations: Redemptions
and Liquidations
Corporations, Partnerships,
Estates & Trusts
Copyright ©2010 Cengage Learning
Corporations, Partnerships, Estates & Trusts
C6 - 1
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
Corporations, Partnerships, Estates & Trusts
C6 - 2
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%
Corporations, Partnerships, Estates & Trusts
C6 - 3
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
Corporations, Partnerships, Estates & Trusts
C6 - 4
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)
Corporations, Partnerships, Estates & Trusts
C6 - 5
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))
Corporations, Partnerships, Estates & Trusts
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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
Corporations, Partnerships, Estates & Trusts
C6 - 7
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
Corporations, Partnerships, Estates & Trusts
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Stock Attribution (slide 2 of 5)
• Attribution from family members
– Stock owned by spouse, children,
grandchildren, or parents attributed back to
individual
Corporations, Partnerships, Estates & Trusts
C6 - 9
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
Corporations, Partnerships, Estates & Trusts
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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
Corporations, Partnerships, Estates & Trusts
C6 - 11
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
Corporations, Partnerships, Estates & Trusts
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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
Corporations, Partnerships, Estates & Trusts
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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
Corporations, Partnerships, Estates & Trusts
C6 - 14
Not Essentially Equivalent
Redemptions (slide 3 of 3)
• If redemption is treated as ordinary dividend
– Basis in stock redeemed attaches to remaining
stock owned (directly or constructively)
Corporations, Partnerships, Estates & Trusts
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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
Corporations, Partnerships, Estates & Trusts
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Qualifying Disproportionate
Redemption (slide 2 of 4)
Corporations, Partnerships, Estates & Trusts
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Qualifying Disproportionate
Redemption (slide 3 of 4)
Corporations, Partnerships, Estates & Trusts
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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
Corporations, Partnerships, Estates & Trusts
C6 - 19
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
Corporations, Partnerships, Estates & Trusts
C6 - 20
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
Corporations, Partnerships, Estates & Trusts
C6 - 21
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
Corporations, Partnerships, Estates & Trusts
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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
Corporations, Partnerships, Estates & Trusts
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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
Corporations, Partnerships, Estates & Trusts
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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
Corporations, Partnerships, Estates & Trusts
C6 - 25
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
Corporations, Partnerships, Estates & Trusts
C6 - 26
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
Corporations, Partnerships, Estates & Trusts
C6 - 27
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
Corporations, Partnerships, Estates & Trusts
C6 - 28
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
Corporations, Partnerships, Estates & Trusts
C6 - 29
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
Corporations, Partnerships, Estates & Trusts
C6 - 30
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
Corporations, Partnerships, Estates & Trusts
C6 - 31
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
Corporations, Partnerships, Estates & Trusts
C6 - 32
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
Corporations, Partnerships, Estates & Trusts
C6 - 33
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
Corporations, Partnerships, Estates & Trusts
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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
Corporations, Partnerships, Estates & Trusts
C6 - 35
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
Corporations, Partnerships, Estates & Trusts
C6 - 36
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)
Corporations, Partnerships, Estates & Trusts
C6 - 37
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
Corporations, Partnerships, Estates & Trusts
C6 - 38
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
Corporations, Partnerships, Estates & Trusts
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Distribution of Loss Property in Liquidation
Corporations, Partnerships, Estates & Trusts
C6 - 40
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
Corporations, Partnerships, Estates & Trusts
C6 - 41
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
Corporations, Partnerships, Estates & Trusts
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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
Corporations, Partnerships, Estates & Trusts
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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
Corporations, Partnerships, Estates & Trusts
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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
Corporations, Partnerships, Estates & Trusts
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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
Corporations, Partnerships, Estates & Trusts
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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
Corporations, Partnerships, Estates & Trusts
C6 - 47
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
Corporations, Partnerships, Estates & Trusts
C6 - 48
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
Corporations, Partnerships, Estates & Trusts
C6 - 49
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
Corporations, Partnerships, Estates & Trusts
C6 - 50
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
Corporations, Partnerships, Estates & Trusts
C6 - 51