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Stock Redemption for Ownership Transfer in Orange Corporation

Explore how a stock redemption can assist Christina in transferring control of Orange Corporation to her children upon her retirement.

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Stock Redemption for Ownership Transfer in Orange Corporation

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  1. Chapter 6 Corporations: Redemptions and Liquidations

  2. The Big Picture (slide 1 of 3) Christina Flores formed Orange Corporation 15 years ago She owns all 10,000 shares of Orange stock outstanding Stock basis of $400,000. Christina has been employed full-time with Orange since its inception Handles all corporate management and strategy decisions. She receives an annual salary of $250,000. Within the next 5 to 7 years, Christina would like to retire and transfer ownership to her two children, ages 24 & 22. The children have worked full-time with Orange over the last two years. They have the capacity and willingness to take over the business after their mother’s retirement.

  3. The Big Picture (slide 2 of 3) Currently, the Orange stock is worth $6 million. Expected to be worth $8 million by Christina’s retirement. The stock represents approximately 80% of Christina’s net worth. Orange Corporation (E & P of $2 million) generates strong positive cash flow Will require a significant investment in property, plant, and equipment over the next several years.

  4. The Big Picture (slide 3 of 3) The children are not expected to have the financial wherewithal to purchase the Orange stock from their mother at the time of her retirement. Christina would be receptive to taking notes in exchange for her Orange stock. How could a stock redemption be used to assist Christina in achieving her goal of transferring control of Orange to the children upon her retirement? Read the chapter and formulate your response.

  5. 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

  6. 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%

  7. 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

  8. 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)

  9. 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))

  10. 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

  11. 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

  12. Stock Attribution (slide 2 of 5) • Attribution from family members • Stock owned by spouse, children, grandchildren, or parents attributed back to individual

  13. 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

  14. 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

  15. 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

  16. The Big Picture – Example 4Stock Attribution Rules Return to the facts of The Big Picture on p. 6-2. Assume instead that Christina owns only 80% of the stock in Orange Corp. The other 20% is owned by her two children. For purposes of the stock attribution rules, Christina is treated as owning 100% of the stock in Orange Corp. She owns 80% directly and, because of the family attribution rules, 20% indirectly through her children.

  17. 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

  18. 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 • Indicators of a meaningful reduction include: • A decrease in the redeeming shareholder’s voting control • Reduction in rights of redeeming shareholders to • Share in corporate earnings, or • Receive corporate assets upon liquidation

  19. Not Essentially Equivalent Redemptions (slide 3 of 3) • If redemption fails to satisfy any of the qualifying stock redemption rules • Treated as ordinary dividend • Basis in stock redeemed attaches to remaining stock owned (directly or constructively)

  20. 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

  21. Qualifying Disproportionate Redemption (slide 2 of 4)

  22. Qualifying Disproportionate Redemption (slide 3 of 4)

  23. 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

  24. 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

  25. 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

  26. 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

  27. 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

  28. The Big Picture – Example 14Partial Liquidations (slide 1 of 3) Assume that Orange Corporation loses a major customer and a severe drop in sales occurs. The corporation reduces its inventory investment and has $600,000 of excess cash on hand as a result. It distributes the excess cash to Christina in redemption of 10% of her stock.

  29. The Big Picture – Example 14Partial Liquidations (slide 2 of 3) Since Christina’s ownership interest in Orange remains unchanged (100%), the redemption does not qualify as: A not essentially equivalent redemption, A disproportionate redemption, or A complete termination redemption.

  30. The Big Picture – Example 14Partial Liquidations (slide 3 of 3) Further, the reduction in inventory does not qualify as a general contraction of Orange Corporation’s business Thus, the distribution is not a partial liquidation. Therefore, the $600,000 is dividend income to Christina. The $40,000 basis in the stock redeemed (10% X $400,000) attaches to the basis of Christina’s remaining shares of Orange.

  31. 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

  32. 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

  33. 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

  34. 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

  35. 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

  36. 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

  37. 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

  38. 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

  39. 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

  40. The Big Picture – Example 20Preferred Stock Bailouts (slide 1 of 4) Return to the facts of The Big Picture on p. 6-2. Assume that on January 3, Orange Corp. (E & P of $2 million) declares and issues a nontaxable preferred stock dividend of 1,000 shares to Christina. After the stock dividend, the fair market value of the stock is: $540 per share of common stock, $600 per share of preferred stock. Two days later, Christina sells the 1,000 shares of preferred stock to Emily, an unrelated party, for $600,000.

  41. The Big Picture – Example 20Preferred Stock Bailouts (slide 2 of 4) Section 306 produces the following results: After the distribution and before the sale, the preferred stock has a basis to Christina of $40,000. $600,000 value of preferred stock $6 million value of preferred & common) X $400,000 original basis At this time, the common stock has a new basis of $360,000.

  42. The Big Picture – Example 20Preferred Stock Bailouts (slide 3 of 4) Section 306 produces the following results (Cont’d): The sale of the preferred stock generates $600,000 of ordinary income to Christina. This is the amount of dividend income Christina would have recognized had cash been distributed instead of preferred stock (i.e., the § 306 taint). The 15% maximum tax rate on dividend income is applicable to the $600,000.

  43. The Big Picture – Example 20Preferred Stock Bailouts (slide 4 of 4) Section 306 produces the following results (Cont’d): The $40,000 basis allocated to the preferred stock is added back to the basis of the common stock. Thus, the common stock basis is increased back to $400,000. Orange Corporation’s E & P is unaffected by either the stock dividend or its subsequent sale.

  44. 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

  45. 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

  46. 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

  47. 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

  48. 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)

  49. 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

  50. 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

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