Accounting 6073
Fall, 2010

Lesson 6A--Stock Redemptions and Partial Liquidations (In General) 

I.  Background and General Concepts

What we are dealing with here is trying to establish a line distinguishing
corporate distributions (made in exchange for transfer of the
corporation's own stock back to the corporation) treated
as sales (which produce capital gain treatment) from those that are treated
as dividends (taxed at C.G. rates, but not allowing for recovery of any basis) to the shareholder surrendering the stock.

	A.  Introductory Comments

		1.  Transactions where shareholder "sells" and corporation ends up
			with its own stock can be arranged on a continuum.

			a.  On one end are cases where, for example, the shareholder
				of preferred stock sells the stock thru a broker and 
				the buyer happens to be the corporation, who is 
				accumulating its own shares in a buy back program.
				Such a transaction clearly should produce CG treatment.

			b.  On the other end are cases where a 100% shareholder of 
				a closely held corp. sells 30% of his shares back to the 
				corporation. He still owns 100% of the stock after the 
				transaction, and his interest in the corporation's assets,
				profits and his degree of control are unaffected.  Such
				a transaction appears much more like an extraction of
				corporate e&p than a sale.

		2.  Old (pre 1954 rule) was that transactions like this were assumed to be
			sales (entitled to CG treatment) unless "essentially equivalent to 
			the distribution of a taxable dividend."

3.  However, the courts eventually reversed the starting assumption, so that it was assumed that any pro rata redemption was equivalent to a taxable dividend.  Thus taxpayers had the burden of showing that such transaction was "not essentially equivalent to a dividend." 

			a. This was a hazardous course for taxpayers because it usually
				 entailed an inquiry into all of the relevant facts and
				 circumstances...

			b.  However, there were exceptions for "corporate
				contraction" and "legitimate shrinkage of the 
				corporation's business"

		4.  During this time courts continued to treat "non pro rata" redemptions
			as sales eligible for CG treatment.

	B.  Current Law

		1.  Introduction
	
			a.  lawmakers sought to preserve the non-pro rata concept
				and "legitimate shrinkage" concept in current law.

			b.  specifically, IRC 302(a) provides that a redemption of 
				stock "shall be treated as a distribution in part or in 
				full payment in exchange for the stock" if the 
				transaction fits into one of the following 4 categories:

				i. a redemption that is not essentially equivalent to a 
					dividend (NEED) 302 (b)(1).

				ii. substantially disproportionate redemptions 302 (b)(2)

				iii. redemption of all shareholder's stock 302(b)(3)	

				iv. a "partial liquidation" (non corporate shareholder
					only) 302 (b)(4)

			c.  a redemption not falling into one of these four categories
				defaults into section 301, and is therefore treated as 
				a dividend to extent of corporation's e&p.

			d.  note that while exchange treatment is almost always more
				desirable for non-corporate shareholders, for corporate
				shareholders, dividend treatment may be preferable.

			e.  of the four categories of redemptions qualifying for exchange 
				treament, categories 2 and 3 are most important for
				tax planning.  If carefully complied with, these sections
				will ensure that a transaction will qualify for CG treatment.

			f. If a taxpayer cannot bring a transaction within category 2 or 3,
				it must attempt to navigate category 1, a treacherous route
				requiring lots more reliance on judicial doctrine & rulings.

			g.  category 4 comes into play only if the redeeming corp. is 
				carrying on two or more "qualified trades or businesses"
				as defined--less important.

		2.  Definition of Redemption:

a.	Defined in 317 IRC:
i.	"a corporation's acquisition of stock 
				from its shareholder in exchange for 'property'
				regardless of whether such stock is cancelled,
				 retired or held as treasury stock."  

				ii.  Note the definition says nothing about whether a 
				redemption of shares is treated as a dividend or a sale.
			
			b.  comments on the definition
				i.  presupposes proper classification as stock--doesn't
					apply to debt.

				ii.  property includes money or anything else except
					stock or stock rights in acquiring corp.

				iii.  if s/h receives nothing of value for its stock, 
					no redemption has occurred.

				iv.  doesn't apply to transactions with shareholders
					not in their capacity as shareholders or to 
					portion of a unified transaction that fits 
					that definition (e.g. in conjunction with 
					a severance agreement that might produce
					compensation expense to corp).

		3.  No ruling area:  Because the IRS is concerned in redemption 
			transactions as to whether a meaningful reduction of the owner's 
			interest in the corp. has occurred, it will not issue rulings in
			the following scenarios:

				a.  redemption for corporate debt with the stock
					held as security, where there is a possibility
					that the stock will revert to the seller.

				b.  redemption for a corporate obligation to pay
					some amount based on future earnings or a 
					similar contingency.

				c.  redemption followed by corporate use of shareholder
					property and paying therefor an amount based
					on corporate earnings or subordinate to genl.
					creditors.

				d.  redemption for payments over a period in excess of 
					15 years.

II.  Constructive Ownership of Stock (In general)

	A.  The constructive ownership rules attribute stock owned by one person to
		 another on the basis of various relationships. 

	B.   These rules are expressly made applicable to redemptions.

	C.  Stock deemed owned by "attribution" is considered as actually owned
		(don't confuse this with stock "indirectly owned" which refers to 
		stock held thru an agent).

	D.  Attribution rules operate to increase, but not to decrease stock ownership
		(see e.g. p. 9-14).

	E.  Types of attribution

		1.  Family attribution
		2.  from entity to beneficiary, and from beneficiary to entity
		3.  from entity to beneficiary to family, and from family to
			beneficiary to entity.
		4.  Option attribution.

	F.  We will look at this in more detail below.

III.  Substantially Disproportionate Redemptions (IRC 302(b)(2))

	These redemptions are accorded sale treatment because they sufficiently change
	the shareholders' relative interest in the assets, earning capacity and control
	of the corporation.

	A.  To qualify, must meet 3 requirements 

		1.  Immediately after redemption, shareholder must own less than 50%
			of the total combined voting power of all classes of stock
			entitled to vote.

		2.  Shareholder's percentage of total outstanding voting stock immediately
			after the redemption must be less than 80% of his percentage
			of voting stock immediately before the redemption.

		3.  Shareholder's percentage of outstanding common stock (voting or 
			non voting) after the redemption must be less than 80% of 
			the shareholder's percentage of ownership before the redemption.

	B.  Constructive ownership rules of 318 apply, and these materially reduce
		feasibility of such redemptions by closely held family corporations.

	C.  The 50% and 80% tests--see example on p. 9-24

	D.  Step transaction doctrine and redemptions
		
		1.  can both cause and prevent the application of  302(b)(2).  
	
		2.  "integrated" transactions will be aggregated

		3.  Statute expressly provides that it is inapplicable to redemptions
			under a plan that contemplates a "series of redemptions"
			that in the aggregate, are not substantially disproportionate
			with respect to the shareholder in question.

IV.  Redemptions Not Essentially Equivalent to a Dividend (302(b)(1))	

	A.  In General
		1.  This subsection provides another route to sale treatment for
			 transactions that fail to qualify under 302 (b) 2, 3, or 4.

		 2.    However, standards for applying are vague--avoid except
			 as last resort.

		 3.  U.S. v Davis:  
			a.  neither absence of tax avoidance motive nor presence
				of business purpose protects against dividend
				 treatment.	

			b.  constructive ownership rules apply

		4.  Principles from regulations
			a.  if only one class of stock-pro rata redemption is a dividend
			b.  if more than one class, complete redemption of one class
				is a dividend if all classes held in same proportion.

			c.  only e.g. in regs of qualifying transaction under 302 (b)(1)
				is a redemption of 50% of non voting preferred stock
				of a shareholder who holds no other stock in corp.

			d.  all facts and circumstances (including integrated sales, 
				redemptions and issuances of stock) will be 
				considered in applying this provision.

	B.  Dividend Equivalence:  The "Meaningful Reduction" Test

		1.  Under this rule, a pro rata distribution, or one that doesn't change
			a shareholder's proportionate equity interest in the corp.
			in a significant way (attribution rules apply)
			will be treated as a dividend.

		2.  When is a reduction in interest meaningful?--Two views:  

			a.  Himmel v. CIR 338 F.2d 815 (C.A. 2, 1964)  analyzes the 
				relevant interests that stock in a corporation embodies:

				i.  interest in control of the corp. (thru voting)
				ii.  interest in earnings of the corp.
				iii.  interest of the corporate assets (on liquidation)

			Himmel said that for a redemption to be NEED, shareholder's
			proportionate interest in one or more of these must drop
			to some extent.

b.  IRS view--rejects Himmel--it says that where redeemed shareholder has a voting interest, reduction in that interest is a "key" factor (maybe a "super factor") in determining whether there has been a meaningful reduction.

			C.  Meaningful Reduction:  Some Specific Situations

		1.  Redeemed shareholder holds only nonvoting stock:
			
			a.  thru a quirk in the law, these kind of redemptions don't 
qualify under 302 b 2.   But probably easier to fit under 302 b 1 because there	is no "super factor" issue as noted above.

			b.  regs. say that reduction of 50% interest of nonvoting
				stock where shareholder holds no other stock
				qualifies under 302 b 1.  Regs. 1.302-2(a)

			c.  a 1977 ruling indicates that redemption of a smaller amount
of nonvoting stock would also qualify under 302 b 1.  RR 77-426.

		2.   Redeemed shareholder holds both voting and non voting stock, and 
			only non voting stock is redeemed.
		
			a.  IRS would say dividend treatment here, unless redeemed
				shareholder's voting power is small.

			b.  But courts have continued to follow Himmel approach
				of considering factors other than voting power.

		3.  Redemption of voting stock

			a.  6th and 8th circuit have held that where shareholder's voting
				interest drops below "super control" ( some states 
				have this in their corporate law), shareholder
				gets sale treatment.  However, IRS disagrees unless
				control drops below 50%.

			b.  If s/h control drops below 50% and
				i.  only one other unrelated shareholder:  SALE

				ii.  if remaining ownership widely dispersed so that
					shareholder still has de-facto control, then
					maybe a dividend, but unclear.

			c.  If s/h percentage of ownership drops from one level below
				50% to another, hard to categorize.
			
				i.  key issue is whether there is a loss of conjunctive 
					control.

				ii.  where a minority shareholder has no potential to
					participate in control -even a trivial degree
					of voting power reduction will probably
					result in sale treatment.

			d.  redemptions by public companies--virtually always treated
				as sales, unless, because of responses of other shareholders
				a given shareholder's voting control happens to remain the
				same or increase.

V.  Shareholder Gain or Loss on 302 (b) Redemption:

	A.  In general
		1.  If corporation obligated to pay a dividend at time of redemption,
			proceeds first applied to discharge dividend obligations.

		2.  If qualifies under 302b (or 303 or 304), treated as sale under
			1001 IRC. 

		3.  Shareholder may select the shares to be redeemed if he bought
			his shares at different times and/or different prices.

		4.  If shareholder receives more (or less) than the shares are worth,
			excess (deficit) may respesent gift or compensation paid 
			to him by (paid by him to) other shareholders.

	B.   Basis of property received in redemption does not carry over from
		corporation.  Under general rule, basis of received property
		is its cost, thus equal to fmv of stock redeemed.

VI.  Treatment of Redemptions treated as 301 Distributions (The disappearing basis
		problem)

	A.  Section 301 distributions
		1.  General rules apply, i.e. dividend to extent of E&P etc.
		2.  If corporate shareholder, entitled to DRD, but can be subject
			to 1059, resulting in reduction of basis of remaining
			stock.

	B.  Basis of redeemed stock (the disappearing basis problem):
		1.  If redemption treated as a dividend, the proceeds are taxable
			in full as dividend.

		2.  What happens to basis of that stock?  Regs. have long provided
			that "appropriate adjustment" will be made to basis
			of remaining stock.

		3.  This means that basis of remaining shares will be increased for
			basis of redeemed stock that produced no benefit.

		4.  If shareholder holds no more stock, regs sanction a transfer
			of that basis to related taxpayer whose shares are 
			attributed to the redeemed shareholder.

			a.  ordianrily, this outcome is reasonable
			b.  but can add insult to injury if basis transferee is 
				not on good terms (especially in case of forced
				redemptions).

		5.  Basis in property received in a redemption treated as a 301 
			distribuiton is the fmv of such property.

VII.  More on the Constructive Ownership (Attribution) Rules

	A.  Family Attribution

		1.  Under 318 (a)(1):  an individual is deemed to own stock owned by his
			spouse, children, grandchildren and parents.

		2.  Note that this attribution is lineal only--n/a to brothers/sisters
		3.  No reattribution here
		4.  Apply without regard to family hostility
		5.  See e.g. p. 9-15.

	B.  Entity-to-Beneficiary (outbound) attribution

		1.  Under 318 (a)(2):  stock owned "directly or indirectly" by partnerships
			estates, trusts and corporations is attributed to the beneficial
			owners in proportion to their ownership interests.

		2.  Special rules
			a.  stock owned by a corporation is attributed pro rata
				only to those shareholders (if any) who own 50%
				 or more by value of the corporation's stock

			b. stock attributed from a beneficiary to an entity (see below)
				is not reattributed out from entity to beneficiary.

	C.  Beneficiary-to-Entity (inbound) attribution

		1.  Under 318(a)(3):  stock owned "directly or indirectly" by partners,
			beneficiaries and shareholders generally is attributed IN FULL
			to the partnership, estate, trust or corporation.

		2.  Special Rules:  
			a.  if the entity is a corporation, only stock owned by a shareholder
				owning 50% or more of the value of its stock is
				attributed to the corporation.

			b.  stock attributed from a partner, beneficiary or shareholder to
				an entity is not reattributed out to other partners, 
				beneficiaries or shareholders of the same entity.

	D.  Option Attribution

		1.  Under 318 (a)(4):  a person who has an option to acquire stock is
			deemed to own the optioned stock.

		2.  Special Rules:
			a.  if options are contingent, prevents attribution
			b.  where both option attribution and family attribution
				rules apply, option attribution takes precedence.
			c.  therefore, reattribution of optioned stock to other
				members of option holder's family is permitted.
			d.  If a partnership, estate, trust or corp holds
				option on stock owned by beneficial owners, 
				that stock can be reattributed out to other
				beneficiaries of the entity.

	E.  Application Rules for attribution
		1.  Corporation is never deemed to own its own stock by attribution
		2.  Stock is not counted more than once.
		3.  Stock is attributed in such a way as to maximize ownership.

	F.  See the series of examples on pp 9-20 and 9-21.  There is no substitute for 
		working through examples to learn this difficult concept.