Accounting 6073
Fall, 2010

Lesson 6B--Termination of Interest, Partial Liquidations, Related Matters 

I.  Termination of Shareholder's Entire Interest 302 (b)(3) IRC

	A.  Introductory Comments

		1.  Under 302(b)(3)--redemptions are treated as sales if they are
			"in complete redemption of all the stock of the corp.
			owned by the shareholder."

		2.  Principal purpose of this provision is to provide an escape route:
			a.  302(b)(2) difficult to satisfy in closely held corp. where
				family attribution operates to treat one shareholder
				as owning stock held by others in the family.

			b.  302(b)(3) is an escape route because it provides that 
				family attribution rules can be waived in certain
				circumstances.  This is a key advantage.

		3.  This provision applies where shareholder terminates its proprietary
			interest in the corp.  

			a.  this doesn't preclude the possibility of the former shareholder
				having a continuing interest in another capacity (say as 
				a creditor)  BUT:

			b.  IRS reluctant to approve credit redemptions where there
				is a possibility that the stock may revert on default. AND

			c.  courts reluctant to approve redemptions where the debt 
				instrument given in exchange for stock looks like equity.

		Thus, the former shareholder must really be just a creditor in these cases.

	B.  Waiver of Family Attribution

		1.  In general--waiver permitted if shareholder meets three requirements

			a.  retains no interest in the corp. (proprietary interest or
				interest as officer, director or employee)

			b.  doesn't acquire such a tainted interest (except by
				bequest or inheritance) w/in 10 years AND

			c.  shareholder agrees to inform IRS of the acquisition of any
				forbidden interest w/in the 10 year period.

Acquiring an interest in a parent, subsidiary or successor corp. is equally tainted.

		2.  Note:  while waiver of family attribution rules is possible under
			this provision, the waiver of entity-beneficiary or option 
			attribution rules is not.

		3.  Theory--while complete termination of s/h interest should be treated
			as a sale, in a closely held family corp., it is likely that such 
			interest will not really be terminated.  However, if s/h is 
			willing to truly forego any interest in the corp. for 10 years, 
			then waiver of family attribution and sale treatment seem 
			appropriate. 
		 
		4.  Waiver by Entities--entities may waive the family attribution rules as
			applied to the stock that the entity's partner, beneficiary or 
			shareholder owns constructively by attribution from members
			of his/her family.  This is true provided:

a.  entity and each related person satisfies the normal requirements for a waiver (set out above) AND

			b.  each related person must agree to be liable along with the 
				entity for any related deficiencies.

			c.  see example p 9-31.

		5.  Tainted post-redemption interest in the corp.

			a.  as defined in statute, includes "interest" as officer, director or
				employee, but excludes interest as a creditor.

			b.  IRS takes strict view of this--thus, performing services, or
				holding position as officer or director, with or without
				compensation is a tainted relationship, in IRS view.

			c.  some courts have upheld IRS view, others have not.
			d.  also, some authority that relationship as an independent
				contractor is not tainted.

			e.  interest as creditor not fatal, but if debt has equity features, 
				interest may become tainted e.g.
				--if debt is subordinate to other debt
				--if repayment based on earnings or other contingency
				--if enforcement of rights results in the acquisition of a 
					forbidden interest.
		
II.  Effect of Redemptions on Corporation's Earnings and Profits

	A.  In General--Redemptions affect E&P in 2 ways:

		1.  If distribution consists of appreciated property, interim e&p 
			is created.  E&P is increased for gain recognized by
			corp.

		2.  Whether or not distribution consists of appreciated property,
			e&p is reduced.  Amount of reduction depends on 
			whether distribution treated as proceeds from the 
			sale of stock under 302, or as a dividend under 301.

	NOTE:  This can create problems, since characterization of the transaction by
			shareholders (who may or may not be known to the corp.) can 
			have an effect on the corp.'s e&p.  This effect may not finally
			be determined until years later, or on examination of the 
			returns of the individuals involved.

	B.  Increase to earnings and profits--amount of increase is of course, the excess
		of fmv of property distributed over the adjusted basis of the property.
		This increase, as noted above is accompanied by a decrease to reflect
		federal tax due on the corp.'s gain.

	C.  Decrease to earnings and profits:

		1.  Redemptions treated as a dividend:  treated same as any other 
			dividend  that is, e&p reduced by:

			a.  amount of money
			b.  principal amount of obligations
			c.  adjusted basis of property or
			d.  FMV of appreciated property.

		2.  Redemptions treated as sales--

			a.  IRC 312 (n)(7) limits the reduction in e&p to stock's
				"ratable share" of all corp.'s e&p.

			b.  reduction in e&p follows the same rules otherwise

c. reduction to e&p may not exceed amount distributed (see note below)

			d.  if fmv of distribution exceeds stock's ratable share of corp's 
				e&p, excess over ratable share ceiling is charged to
				corp's capital account.		

 Note:  It is not clear what happens when stock is redeemed in exchange for depreciated property.  Statute appears to allow e&p to be reduced by the basis of the property distributed when such basis exceeds the property’s fmv.  However, committee reports accompanying statute (312(n)(7) IRC) appear to limit reduction to fmv in such cases.  Note that this interpretation would place the methodology at odds with the methodology used when the distribution is treated as a dividend.  In that case, the reduction to e&p would be equal to the higher adjusted basis of the distributed property.  See p. 9-109, fn 479.