Question

Petoskey Stone Quarry Inc. (PSQ), a calendar-year, accrual-method C corporation, provides landscaping supplies to local builders in northern Michigan. PSQ has always been a family-owned business and has a single class of voting common stock outstanding. The 500 outstanding shares are owned as follows: Number of shares 150 150 50 Nick Adams Amy Adams (Nick's sister) Abigail Adams (Nick's daughter) Charlie Adams (Nick's son) Sandler Adams (Nick's father) Total shares 50 100 500 Nick Adams serves as president of PSQ, and his father Sandler serves as chairman of the board. Amy is the company's CFO, and Abigail and Charlie work as employees of the company. Sandler would like to retire and sell his shares back to the company. The fair market value of the shares is $490,000. Sandler's tax basis is $14,500. The redemption is tentatively scheduled to take place on December 31 of this year. At the beginning of the year, PSQ had accumulated earnings and profits of $2,950,000. The company projects current E&P of $255,000. The company intends to pay pro rata cash dividends of $345 per share to its shareholders on December 1 of this year. Required: a. Assume the redemption takes place as planned on December 31 and no elections are made by the shareholders. 1. What amount of dividend or capital gain will Sandler recognize as a result of the stock redemption? 2. How will the tax basis of Sandler's stock be allocated to the remaining shareholders? b. If Sandler files a proper election to waive the family attribution rules, what is the amount of his gain? c. Compute PSQ's accumulated earnings and profits on January 1 of next year, assuming the redemption is treated as an exchange.

Answer 1

a)

1) Sandler will receive a dividend to the tune of $490,000. Under the family attribution rules, Sandler is deemed to own the shares of the stock of his son Nick (150) and of his grandchildren Abigail (50) and Charlie (50). He is not deemed to own any of Amy's stock. Prior to redemption, Sandler owns a 70% share (350/500). After the redemption, assuming he does not waive the family attribution rules, Sandler is deemed to own a 62.5% share (250/400). The company has ample E&P to absorb the distribution to Sandler on December 31 and distribution of $172,500 (500 * $345) on December 1.

2) Sandler's unused tax basis in his stock of $10,000 will be allocated to Nick, Abigail, and Charlie on a pro-rata basis as they caused him to fail the exchange test.

b) If Sandler files a proper election to waive the family attribution rules, then he will have a capital gain of $475,500 ($490,000 - $14,500) because it will be treated as a complete termination of his interest in PSQ.

c) Calculation of PSQ's accumulated Earnings & Profits as on January 1 :

Current Earning & Profits $255,000

Less: Dividend paid on December 1 ($172,500)

Earning & Profits on December 31 after dividend $82,500

Add : Accumulated Earning & Profits at the beginning of $2,950,000

Total Earning & Profits as on December 31 $3,032,500

Less: Lesser of cash distributed ($490,000)

($490,000 or 20% of $3,032,500 whichever is lower)

Accumulated Earning & Profit as on January 1 $2,542,500