Question

Megahurtz Enterprises, Inc. (“Inc.”) is a closely-held C corporation formed 20 years ago by Adam and Bea Hurtz, who are husband and wife, and Bea’s wealthy uncle, C.D. Rom, to develop and manufacture multimedia entertainment products for personal computers. Inc. has 10,000 shares of common stock and 1,000 shares of nonvoting preferred stock outstanding. At Inc.’s formation, each of the founding shareholders contributed cash in exchange for Inc. common stock, which was the only class outstanding at the time. About ten years ago, when Inc. needed more paid-in-capital, Adam Hurtz and C.D. Rom made additional cash contributions in exchange for 1,000 shares of nonvoting preferred stock. Inc. has been a very profitable company and had $4 million of accumulated earnings and profits as of the beginning of the current year. Inc. also has substantial cash on hand and is in a position to borrow additional cash if necessary to finance a stock repurchase.

Five years ago, Adam and Bea began making gifts of some of their Inc. common stock to their son, Dan, and to a trust for the benefit of Dan’s two children. Dan’s wife, Hilary, serves as Trustee of the trust. Dan Hurtz has been active in the family business for several years and is currently serving as vice-president.

C.D. Rom died last month, and his substantial Inc. holdings are now held by his estate, the co-executors of which are Bea Hurtz and Local Bank. C.D.’s will bequeathed $200,000 cash (2%of his estate) to Bea and the residue to his children.

As of the beginning of the current year, Inc.’s common and preferred shares were held as follows:

Common Stockholders Shs. Adjusted Basis F.M.V.

C.D. Rom Estate 8,000 $8,000,000 $8,000,000

Adam Hurtz 800 80,000   800,000

Bea Hurtz 800 80,000 800,000

Dan Hurtz 300 30,000 300,000

Children’s Trust 100 10,000 100,000

Total 10,000 $8,200,000 $10,000,000

Preferred Stockholders

C.D. Rom Estate 500 50,000 50,000

Adam Hurtz 500 50,000 50,000

Total 1,000   $100,000 $100,000

Inc. is considering a redemption of all of its preferred stock. In addition, Adam and Bea are contemplating retirement and ultimately wish to shift ownership of Inc. to Dan and his family, and the Rom Estate wishes to diversify its holdings. Evaluate the tax consequences of the following alternative proposals to meet some or all of these goals:

A) Inc. redeems 6,000 of the Rom Estate’s common stock for $6 million cash and all of the Estate’s preferred stock for $50,000 cash

B) Inc. redeems Bea’s 800 common shares for $800,000 cash but Bea continues to serve as an Inc. director.

C) Same as (b), above, except that six months after the redemption of Bea’s stock, Inc. also redeems 4,200 shares from the Estate for $4.2 million

D) Inc. only redeems its preferred stock, distributing $50,000 to each preferred shareholder

Answer 1

A)

If the stock price when it is sold was higher compared to original price paid for it, then they will be considered as capital gains for which a company has to pay Tax according to the IFRS standards.

But here in this case it is evident that Inc has been redeeming its shares at a lower price than the value at which they were at the beginning of the year. Here it is redeeming both the common stock and preferred stock at a lower price in other words for losses. We will combine all the capital gains and losses before assessing the Tax returns. The proceeds from the equity and preferred stock will be combined and can be used for offsetting future or current capital gains and if we have more losses we can use them as deductions in Tax returns as subjected to the respective Tax rates.