Question

Problem 19-57 (LO. 8, 9)

Broadbill Corporation (E & P of $650,000) has 1,000 shares of common stock outstanding. The shares are owned by the following individuals: Tammy, 300 shares; Yvette, 400 shares; and Jeremy, 300 shares. Each of the shareholders paid $50 per share for the Broadbill stock four years ago. In the current year, Broadbill Corporation distributes $75,000 to Tammy in redemption of 150 of her shares. Determine the tax consequences of the redemption to Tammy and to Broadbill under the following independent circumstances.

a. If Tammy and Jeremy are grandmother and grandson:

The transaction does not qualify for sale or exchange treatment.

Tammy will recognize dividend income of $ 75,000 (correct).

Broadbill Corporation's E & P is reduced by $ ______?? .

b. If the three shareholders are siblings:

The transaction does qualify for sale or exchange treatment.

Tammy will recognize a long-term capital gain of $ ______?? .

Broadbill Corporation's E & P is reduced by $ 75,000 (correct) as a result of the distribution.

Answer 1

Requirement a)

Broadbill Corporation’s E & P is reduced by $75,000

Tammy's ownership interest in the corporation after redemption:

=(( 300 - 150 + 300)/(300 - 150 + 400 + 300)) *100

=52.9%

Even after redemption Tammy continues to hold 52.9% ownership interest in Broadbill corporation. Therefore it not a qualified stock redemption and $75,000 is recognized as dividend income. The entire amount of dividend distribution can be reduced from E&P if stock redemption is done by way of dividend payment. As a result Broadbill Corporation’s E & P is reduced by $75,000

Requirement b)

Tammy will recognize long term capital gain of $67,500

Rules of Section 318 are not applicable in this case as the stock is owned by siblings .

Tammy's ownership interest after redemption :

=[(300 - 150)/(300 - 150 + 400 + 300)] x 100

=17.6%

Post redemption ownership interest of 17.6% satisfies the 80% test ie, 17.6% < 80%x 300/1,000 (pre-redemption ownership)

Hence the redemption will be considered as substantially disproportionate and will qualify for sale or exchange treatement.

As a result, long term capital gain recognized by Tammy will be :

=75,000 - 7,500 (basis)

=$67,500

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