Question

Describe the stock redemptions that qualify for sale or exchange treatment.

Please include reference.

Answer 1

A stock redemption is an acquisition by a corporation of its own shares in exchange for cash or property, for the purpose of either retiring the shares or holding them as treasury stock. Common reasons for redemptions include: An obligation under a buy-sell agreement to purchase stock of any shareholder who offers it for sale;

To be able to provide stock for employees exercising stock options;

to go private by redeeming all shares traded publicly, thereby restricting ownership to private investors;

to gain a bargain if the corporation feels that the shares are trading below their intrinsic value;

to increase the market price of the stock;

to eliminate dissident minority shareholders;

to pay estate taxes;

to prevent a takeover of the company, or

to retire preferred stock so as to eliminate the dividend payments.

The tax consequences of the stock redemption depend on whether the relative equity interest of a stockholder is the same or significantly less after the redemption. If a stockholder's equity interest relative to other stockholders in the corporation remains the same, then the stock redemption is treated as a dividend payment (deemed dividend redemption) in so far as it can be paid out of earnings and profit (E&P).

To qualify for sale or exchange treatment, a stock redemption generally must result in a substantial reduction in a shareholder’s ownership interest in the corporation. In the absence of this reduction in ownership interest, the redemption proceeds are taxed as dividend income. In determining whether a stock redemption has sufficiently reduced a shareholder’s interest, the stock owned by certain related parties is attributed to the redeeming shareholder.1 Thus, the stock attribution rules must be considered along with the stock redemption provisions. Under these rules, related parties are defined to include the following family members: spouses, children, grandchildren, and parents. Attribution also takes place from and to partnerships, estates, trusts, and corporations (50 percent or more ownership required in the case of regular corporations). Exhibit 5–1 summarizes the stock attribution rules.

A stock redemption that terminates a shareholder’s entire stock ownership in a corporation will qualify for sale or exchange treatment under § 302(b)(3). The attribution rules generally apply in determining whether the shareholder’s stock ownership has been completely terminated. However, the family attribution rules do not apply to a complete termination redemption if the following conditions are met:

The former shareholder has no interest, other than that of a creditor, in the corporation for at least 10 years after the redemption (including an interest as an officer, director, or employee).

The former shareholder files an agreement to notify the IRS of any prohibited interest acquired within the 10-year period and to retain all necessary records pertaining to the redemption during this time period.

A corporate liquidation exists when a corporation ceases to be a going concern. The corporation continues solely to wind up affairs, pay debts, and distribute any remaining assets to its shareholders. Legal dissolution under state law is not required for a liquidation to be complete for tax purposes. A liquidation can exist even if the corporation retains a nominal amount of assets to pay remaining debts and preserve legal status.

A stock redemption qualifies for sale or exchange treatment under § 302(b)(2) as a disproportionate redemption if the following conditions are met:

The distribution is substantially disproportionate. To be substantially disproportionate, the shareholder must own, after the distribution, less than 80 percent of the interest owned in the corporation before the redemption. For example, if a shareholder owns a 60 percent interest in a corporation that redeems part of the stock, the redemption is substantially disproportionate only if the shareholder’s ownership interest after the redemption is less than 48 percent (80 percent of 60 percent).

The shareholder owns, after the distribution, less than 50 percent of the total combined voting power of all classes of stock entitled to vote.