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4

Corporate Distributions:
Stock Redemptions and
Partial Liquidations
Solutions to Problem Materials

DISCUSSION QUESTIONS
4-1

a.
b.

c.

The term redemption is used to describe the sale or exchange by the shareholder of his or her stock
back to the corporation. [See p. 4-2 and 317(b).]
Redemptions are generally used as a financing technique. The shareholder, desiring cash for some
reason, extracts the cash out of the corporation by selling some of his or her stock to the corporation.
If the redemption qualifies as a sale, the cash is obtained at the cost of a capital gains tax. This
technique is particularly useful when the shareholder is the estate of the decedent. A planned
redemption provides the estate with the liquidity needed to pay any death taxes and other expenses
related to death. Also, a corporation may redeem its stock to fund stock options, to improve its
financial ratios, or to avoid a takeover attempt.
Redemptions play an important role in so-called bootstrap acquisitions. In this situation, a cashpoor buyer approaches the shareholder who desires to sell the company. If the corporation has cash
and other liquid assets unnecessary for operations, the corporation could distribute such items to
the current shareholder and effectively reduce the value of the corporate stock and, concomitantly, the
price the buyer must pay. In effect, the buyer has financed part of the purchase price through the
corporation. (See pp. 4-2 and 4-3.)
Redemption transactions are not always afforded sale or exchange treatment but in some cases are
treated as dividends. This result occurs because, notwithstanding the surrender of stock by the
shareholder, the shareholders proportionate interest in the corporation has not been meaningfully
reduced. In such case, the effect of the distribution is a dividend and hence is treated as such. (See
Example 1 and pp. 4-3 and 4-4.)
Note that for noncorporate shareholders sale treatment is usually far more desirable than dividend
treatment for the following reasons.


Sale treatment enables the shareholder to recover the basis in the stock surrendered. The effect is
to reduce the taxpayers gain or increase any loss. For example, consider a taxpayer who receives a
distribution of $11,000 in redemption of stock with a basis of $10,000. If the transaction is treated
as a dividend, the taxpayer must report dividend income equal to the entire amount of the
distribution, $11,000. On the other hand, if the transaction qualifies for sale treatment, the
taxpayer is allowed to recover the stock basis of $10,000, producing taxable income of only $1,000.
 Sale treatment generally allows the taxpayer to characterize any income realized as long-term
capital gain. Historically, capital gains have received far more favorable treatment than
dividend income. For example, prior to 1986, only 40 percent of a noncorporate taxpayers
long-term capital gain was subject to tax, making the distinction between dividend and sale
treatment quite significant. To illustrate, assume that in 1986 a taxpayer received a distribution
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4-1

4-2

Chapter 4

Corporate Distributions: Stock Redemptions and Partial Liquidations

of $11,000 in redemption of stock with a basis of only $1,000. Assuming the distribution
qualified for sale treatment, the taxpayer would be taxed on only $4,000 of the gain rather than
$11,000 had the distribution been treated as a dividend. Today, this advantage is not what it
once was. Currently (2013), the maximum tax rate that applies to long-term capital gains is
20 percent (14 percent if the stock is qualified small business stock) while dividend income is
taxed at the same rate.
 Sale treatment is also preferable if the redemption is carried out in installments. For example,
assume that a corporation redeems a taxpayers stock with a $100,000 note that is payable
annually in ten equal installments. If the redemption is treated as a dividend, the taxpayer must
report the entire $100,000 as a dividend in the year the note is received. In contrast, if the
transaction qualifies for sale treatment, any gain may be deferred until the taxpayer receives
payments on the note.
The distinction between sale and dividend treatment can be significant in several other
situations. For example, taxpayers who have capital losses may seek capital gains to absorb
such losses. Corporate shareholders are also concerned with the distinction since they prefer
dividend treatment because of the dividends-received deduction to which they are entitled if the
distribution is considered a dividend. In addition, use of the installment sales rules is available
only with sale treatment.
4-2

The tax consequences cannot be determined from the information given. The effect of the redemption on
Ts interest cannot be determined for certain since the total number of shares outstanding is not given. Note
that it is clear that Ts number of shares has dropped far below 80 percent of what he had before; however,
it is Ts percentage interest that must drop by 20 percent, and this can be determined only in light of the
total number of shares outstanding before and after the redemption. Note that Ts redemption cannot be
considered in isolation but must take into account shares that were redeemed from other shareholders at the
same time. For example, if the same percentage of shares was redeemed from all other shareholders as was
redeemed from T, the redemption would not affect Ts interest.
a. If the redemption transaction is treated as a sale, T recognizes $55,000 capital gain [$60,000  (50 
$100 $5,000)]. Ts basis in his remaining stock would be $2,000 (20  $100).
b. If the redemption transaction is treated as a dividend, the entire $60,000 distribution is treated as a
dividend since there is adequate E&P. Note that it is not the $55,000 net gain that is treated as a
dividend but the entire $60,000 distribution. When the redemption is treated as a dividend, the basis of
the shares surrendered is added to the basis of the remaining shares. Thus Ts basis would continue to
be $7,000 in total but his per share basis would increase to $350 ($7,000  20).
(See Example 9 and p. 4-11.)

4-3

Under the Supreme Court test in Maclin P. Davis [70-1 USTC {9289 (USSC,1970)], the redemption
distribution is not essentially equivalent to a dividend when there has been a meaningful reduction in the
shareholders interest. Consequently, pro rata distributions typically do not qualify since the shareholders
interest is not reduced. In determining whether a reduction of this type occurs, the critical factor to be
considered is the effect of the redemption on the shareholders right to vote and exercise control over the
corporation. The fact that there is a valid business purpose for the redemption is irrelevant. In determining
the shareholders measure of influence over the corporation, relationships between the shareholders must be
taken into account using the constructive ownership rules of 318. (See p. 4-10.)
The meaningful reduction test is seldom relied upon to secure sale treatment because of its vague scope.
Alternatively, Congress has provided two safe harbors: the substantially disproportionate test and the
complete termination of interest rule. Under the substantially disproportionate test, the shareholders
percentage interest must drop below 50 percent and below 80 percent of that percentage that was owned
prior to the redemption. Under the complete termination of interest test, the shareholders interest must be
entirely eliminated. In this regard, the shareholder is entitled to waive the family attribution rules under
certain circumstances. [See pp. 4-10 and 4-12, and 302(b)(2) and (b)(3).]

4-4

a.

The redemption provisions are designed to allow sale treatment only when the interest of the
shareholder has been meaningfully reduced. In order to determine this, the influence that one family
member has over another family member or the influence that an individual has over an entity that
owns stock in the redeeming corporation must be considered. In addition, the constructive ownership
rules assume that related parties work together for their own best interests. The constructive ownership
rules are designed to take these relationships between shareholders into account. (See Exhibit 4.1,
Example 2, pp. 4-4, and 4-17, and 318.)

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Solutions to Problem Materials

4-5

Family attribution: An individual is deemed to own the shares of his or her family (e.g., a father
owns the shares owned by his son). Note, however, that reattribution is not permitted. Thus a
father does not own the shares of his sons wife, despite the fact that the son is deemed to own his
wifes shares. [See Example 6 and p. 4-7 and 318(a)(1).]
2. Entity to owner attribution: An owner is generally deemed to own proportionately any stock held
by an entity in which an interest is held (e.g., a partner with a 60% interest in a partnership owns
60% of whatever the partnership owns). [See Example 7 and p. 4-8 and 318(a)(2).]
3. Owner to entity attribution: An entity is deemed to own whatever its owners own (e.g., a
partnership with a 60% partner owns 100% of what the partner owns). In the case of corporations,
the corporation is only considered to own stock held by shareholders who own directly of
indirectly 50 percent or more of the corporation. [See Example 8 and p. 4-9 and 318(a)(3).]

b.

1.

c.

Although the rules are to be applied in all redemptions, family attribution may be waived when the
shareholders direct interest in the corporation is completely terminated, assuming certain requirements
are satisfied. [See pp. 4-12 and 4-13, and 302(c)(2).]

a.

If the redemption qualifies under 303, sale treatment is afforded the transaction, notwithstanding the
fact that the distribution would have been a dividend under 302. This treatment is particularly
favorable because the basis of the stock of the shareholder is often equal to the sales price of the stock
since it has been stepped up due to the decedents death. As a result, little or no gain is recognized on
the redemption. Thus the same result is achieved as in a sale to a third party. (See pp. 4-16 and 4-17.)
Section 303 only applies when the stock that is redeemed represents greater than 35 percent of the
decedents adjusted gross estate. In applying this test, stocks in which the decedent held at least
20 percent and which are included in the estate may be aggregated. (See p. 4-16 and 303.)
The benefits of 303 have shrunk somewhat over the years due to limitations on the amount that
qualifies. The qualifying amount is restricted to the sum of death taxes (Federal and state) and funeral
and administrative expenses. Since the Tax Reform Act of 1976 and the introduction of the unified
credit, fewer and fewer estates are subject to death taxes. As a general rule, only estates greater than
$5,25 0,000 (2013 ) will be subject to federal estate tax. Consequently, the amount that qualifies for 303
treatment is shrinking as well. (See p. 4-16.)

b.

c.

4-6

4-3

a.

b.

Although the phrase is identical to that contained in 302(b)(1), the determination for partial
liquidations is to be made at the corporate level rather than at the shareholder level. In effect, this means
that in a partial liquidation there must be a genuine contraction of the corporations business, while for
other redemptions there must be a meaningful reduction in the shareholders interest. (See p. 4-13.)
Under the safe harbor tests, the distribution must be attributable to either the corporations ceasing to
conduct a qualified business or consist of the assets of a qualified business. In addition, the
corporation must continue to operate a qualified business. To meet the qualified business test, the
activities must constitute a business that was actively conducted for five years prior to the distribution
and was not acquired in a taxable transaction during such period. These requirements were designed to
keep a corporation from investing its liquid assets in property desired by the shareholder and
subsequently distributing them, with the result that the distribution would be treated as one in partial
liquidation qualifying for capital gain treatment. [See p. 4-14, and 302(e)(3).]

4-7

Under 302 the distributing corporation must recognize gain, but not loss, on the distribution of property.
This rule applies to all distributions of property except those in complete liquidation. Consequently, with
respect to recognition of gain or loss, the rules are the same whether the distribution is a dividend, a normal
redemption, a redemption to pay death taxes, or a partial liquidation. (See p. 4-18 and 311.)

4-8

a.
b.

If the redemption is treated as a dividend, E&P is reduced by the amount of money distributed, i.e., $70,000.
If the redemption is treated as a sale, the redeemed stocks proportionate share of E&P is eliminated,
but it is not to exceed the amount of the actual distribution. In this case, 60 percent, or $60,000, of the
corporations E&P is eliminated. Note that this amount does not exceed the $70,000 actually
distributed. [See Example 23, p. 4-18, and 312(n)(7).]

4-9

a.

Without any special rules, the general redemption provisions could be circumvented. For example, a
shareholder who controls a related corporation could sell stock in one corporation to the other and not
fall within the scope of 302. Since the effect of such a sale is virtually equivalent to a redemption by
the acquiring corporation of its own stock, 304 was enacted to test the sale under the redemption
rules of 302.

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4-4

Chapter 4

b.

c.

4-10

a.

b.

c.

Corporate Distributions: Stock Redemptions and Partial Liquidations

Unfortunately, this provision catches many taxpayers unaware. For example, consider a father who
owns corporation A and his two sons who own corporation B. Father has decided to retire from the
business shortly, so he sells some of his stock to B corporation. Although the father has no direct
interest in B, he is considered as owning it through his sons, and, consequently, the rules of 304 cause
the sale to be treated as a dividend. (See Examples 24 and 25 and pp. 4-20 through 4-25.)
The ownership tests of 302 are applied to the selling shareholders interest in the issuing corporation
(i.e., his or her interest in the corporation represented by the stock he or she sold). This rule applies in
both a brother-sister and parent-subsidiary situation. (See pp. 4-21 and 4-23.)
False. The E&P of the two corporations is not combined when determining the amount of the
distribution that is a dividend. The distribution is deemed to come out of the E&P of the acquiring
corporation first, undiminished by any deficits of the issuing corporation, and then out of the issuing
corporations E&P, undiminished by any deficits of the acquiring corporation. Prior to changes by the
Deficit Reduction Act of 1984, the E&P of the two corporations was effectively netted; this is no longer
the case. (See pp. 4-21 and 4-22.)
Prior to the enactment of 306, shareholders would have their corporation make nontaxable preferred
stock dividends, and sell the stock received to an accommodating third party who would subsequently
redeem the stock. With these transactions, the shareholder effectively converted dividends into capital
gain. (See p. 4-25.)
Section 306 attaches the so-called 306 taint to the stock received as a nontaxable dividend (other than
common on common), and, on a subsequent sale, the shareholder must recognize ordinary income or
dividend income, depending on whether the sale was to an outsider or a redemption. (See p. 4-27 and
p. 4-32.)
In a sale to a third party, the amount of ordinary income is measured by the E&P at the date the
nontaxable stock dividend was paid. In contrast, in a redemption, the amount of the dividend is
determined in light of the corporations E&P at the time of the redemption. Thus, redemption
treatment could cause the shareholder to have more ordinary income (i.e., dividend) than otherwise
would arise had the corporation actually distributed cash at the time of the stock dividend. (See
pp. 4-27 through 4-28.)

PROBLEMS
4-11

a.

As determined below, the redemption is considered substantially disproportionate under the tests of
302(b), and the redemption is therefore treated as a sale. D reports a capital gain of $360,000,
computed as follows:
Amount realized
Less: adjusted basis (400 shares  $100/share)
Gain realized

b.

$400,000
(40,000)
$360,000

Ownership

Preredemption

Postredemption

Direct
Indirect
Total owned

600
0
600

200
0
200

Percentage owned

60% (600/1,000)

33% (200/600)

To be substantially disproportionate, Ds percentage ownership in the corporation after the redemption


must fall below 50 percent and 48 percent (80%  60% preredemption ownership percentage). Because
Ds percentage fell to 33 percent, it meets both of these tests. Consequently, the redemption qualifies
for sale treatment under the substantially disproportionate test of 302(b)(2). Ds basis in his
remaining 200 shares is still the same, $20,000 (200  $100). (See Example 10 and pp. 4-10 and 4-11.)
D will report dividend income of $200,000. As determined below, the redemption does not qualify for
sale treatment under any of the 302(b) tests. Therefore, the entire amount of the distribution is
considered a dividend to the extent of the corporations earnings and profits. Note that the entire
$200,000 distribution is considered a dividend. The dividend is not the portion in excess of the basis of
the shares surrendered, $180,000 ($200,000  $20,000). Because the distribution is treated as a
dividend, the $20,000 (200  $100/share) basis of the shares surrendered is added to the basis of the

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Solutions to Problem Materials

4-5

remaining 400 shares. Thus, Ds basis for his shares is $60,000. Although his total basis has remained
the same ($60,000), his per-share basis has increased from $100 per share to $150 per share ($60,000/
400). (See Example 9 and pp. 4-10 and 4-11.)
Ownership

Direct
Indirect
Total owned
Percentage owned

Postredemption

600
0
600

400
0
400

60% (600/1,000)

50% (400/800)

To be substantially disproportionate, Ds percentage ownership in the corporation after the redemption


must fall below 50 percent and 48 percent (80%  60% preredemption ownership percentage). Because
Ds percentage ownership fell only to 50 percent, he fails to meet either test and, consequently, does not
qualify for sale treatment under the substantially disproportionate test of 302(b)(2).

11-

4-12

Preredemption

a.

The redemption qualifies for sale treatment under the complete termination of interest test of 302(b)(3).
Note that the redemption would not qualify for sale treatment under the substantially disproportionate
test of 302(b)(2), as shown below.

Ownership

Preredemption

Postredemption

Direct
Indirect through his wife
Total owned

200
600
800

0
600
600

80% (800/1,000)

75% (600/800)

Percentage owned

To be substantially disproportionate, Hs percentage ownership in the corporation after the redemption


must fall below 50 percent and 64 percent (80%  80% preredemption ownership percentage). Because
Hs percentage ownership fell only to 75 percent, it meets neither of these tests and, therefore, does not
qualify for sale treatment under the substantially disproportionate test of 302(b)(1). (See Example 9 and
pp. 4-10 and 4-11.)
Note that H fails the substantially disproportionate test because he is treated as owning his wifes
600 shares under the constructive ownership rules of 318. However, 302(c)(2) allows H to waive the
family attribution rules if the following tests are met:
1. His direct interest is completely terminated;
2. He retains no interest except as a creditor;
3. He does not acquire any interest in the corporation for at least 10 years from the date of the
redemption; and
4. He signs an agreement with the IRS indicating that he will notify the Service if a prohibited
interest is acquired within the 10-year period.

b.

c.

In this case, H satisfies all of these tests (i.e., his direct interest is completely terminated and the only
interest he retains is as a creditor through the note receivable received as part of the redemption).
Because he is allowed to waive the family attribution rules, there is a complete termination of his
interest, and the redemption qualifies for sale treatment under 302(b)(3). (See Example 12 and p. 4-12.)
The redemption qualifies for sale treatment under the substantially disproportionate test of 302(b)(2)
and the complete termination of interest test of 302(b)(3). Note that E qualifies without having to
waive the family attribution rules. Only if he seeks to waive these rules is it necessary for him to
terminate his employment (i.e., so he does not have a prohibited interest). Consequently, his continued
employment with the company is not a factor. (See p. 4-12.)
The redemption continues to qualify for sale treatment. Under 302(b)(3), G cannot acquire a
prohibited interest for 10 years from the date of the redemption. The inheritance of his sons shares is
not prohibited. (See p. 4-12.)

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4-6

4-13

Chapter 4

Corporate Distributions: Stock Redemptions and Partial Liquidations

Mr. B must recognize dividend income of $150,000. Under 302, a redemption is granted exchange
treatment if it is not essentially equivalent to a dividend, substantially disproportionate, or a complete
termination of the shareholders interest. In making this determination, the constructive ownership rules of
318 must be taken into account. In this case, B is deemed to own the stock of his wife and that of his son.
Bs Ownership

Preredemption

Postredemption

Direct
Indirect:
through his wife
through his son
Total shares owned

60

30

30
10
100

30
10
70

100% (100/100)

100% (70/70)

Percentage owned

In order for the redemption to be considered substantially disproportionate, Bs ownership after the
redemption
must be less than 50 percent and less than 80 percent of what it was prior to the redemption. In
11this case, Bs ownership has not changed and, consequently, the redemption is treated as a dividend. Note
that the amount of the dividend is $150,000, unreduced by the $30,000 basis of the stock surrendered. The
basis of the stock surrendered is added to the basis of the remaining stock. (See Exhibit 4.1, Examples 6 and
9, and pp. 4-7 and 4-11.)
4-14

Under the family attribution rules of 318(a)(1), an individual owns the stock of the following persons:
parents, spouse, children, and grandchildren. An individual does not own the stock of siblings,
grandparents, or in-laws. (See Exhibit 4.1, Example 6, and p. 4-7.)
a. Yes
b. Yes
c. No
d. No
e. Yes
f. No
g. No
h. No

4-15

L, an individual, owns 46 shares of the stock of C Corporation, as computed below.


Ownership

Shares

Direct
Indirect:
Partnership A (10%  20)
Partnership B (60%  20)
Corporation X (not 50%)
Corporation Y (60%  20)
Total

20
2
12

12
46

Under the entity-to-owner attribution rules of 318(a)(2), stock owned by a partnership is deemed to be
owned proportionately by its partners. As a result, L owns his proportionate share of what Partnership A
and Partnership B own. On the other hand, stock owned by a corporation is deemed to be owned
proportionately only by shareholders owning at least 50 percent of the corporations stock. Consequently,
L owns his proportionate share of what Y owns since he owns 60 percent of the Y stock but none of what
X owns since he owns only 10 percent of X. (See Exhibit 4.11, Example 7, and pp. 4-8 and 4-9.)
4-16

Under the entity-to-owner attribution rules of 318(a)(2), stock owned by an entity is generally attributable
to its owners proportionately. However, under 318(a)(2)(C), stock owned by a corporation is deemed to
be owned proportionately only by shareholders owning at least 50 percent of the corporations stock.
a. Under the entity-to-owner attribution rules of 318(a)(2), stock owned by a partnership is deemed to
be owned proportionately by its partners. Therefore, A owns 63 percent (70%  90%) of C
Corporation while B owns 27 percent (30%  90%). (See Example 7 and p. 4-8.)

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Solutions to Problem Materials

b.

4-7

Under 318(a)(2)(C), stock owned by a corporation is deemed to be owned proportionately only by


shareholders owning at least 50 percent of the corporations stock. Consequently, A owns his
proportionate share of what A&B owns, 63 percent (70%  90%), since he owns 70 percent of
the A&B stock. B owns none of what A&B owns since he owns only 30 percent. (See Example 7 and
p. 4-8.)

4-17

Under the owner-to-entity attribution rules of 318(a)(3), stock owned by those having an interest in an
entity is generally attributed in full to the entity. Stock owned by a partner is considered as owned by the
partnership. Stock owned by a shareholder is attributed to the corporation only if the shareholder owns
either directly or indirectly at least 50 percent of the corporation.
a. Partnership X owns all 100 shares of D corporation, 40 directly and all 60 shares of the stock owned
by J. Note that the stock of J is not attributed to the entity proportionately. (See Example 8 and p. 4-9.)
b
Corporation X owns 40 shares of D Corporation, all of which are owned directly. The corporation is
not treated as owning any of Js shares since Js 20 percent ownership does not meet the 50 percent
threshold. (See Example 8 and p. 4-9.).
c. Corporation X owns all 100 shares of D Corporation, 40 directly and all 60 shares of the stock owned
by J because in this case he owns 80 percent of Xs stock, which meets the 50 percent threshold. Note
that the stock of J is not attributed to the entity proportionately. (See Example 8 and p. 4-9.)

4-18

This problem involves, in part, application of the rules concerning reattribution contained in 318(a)(5).
These rules are not discussed in the text except with respect to reattribution from one family member to
another. As a general rule, stock attributed to a person or an entity under the general constructive
ownership rules is treated as actually owned by such person or entity and may therefore be attributed again
from that person or entity to yet another person or entity [ 318(a)(5)(A)]. However, 318(a)(5) imposes
certain restrictions on reattribution. These special rules are summarized below.
1. Stock constructively owned by an individual because of the family attribution rules [ 318(a)(1)] cannot
be reattributed to another individual [ 318(a)(5)(B)]. In the language of the Code, an (a)(1) cannot be
followed by an (a)(1). Nevertheless, such stock may be reattributed to an entity (e.g., a partnership,
corporation, or trust) under the owner-to-entity attribution rules. In effect, the Code allows an (a)(1)
to be followed by an (a)(3).
2. Stock constructively owned by an entity because of the owner-to-entity attribution rules of 318(a)(3)
cannot be reattributed to another owner under 318(a)(2). Thus, an (a)(3) cannot be followed by an
(a)(2).
3. Stock constructively owned by an owner because of the entity-to-owner attribution rules [ 318(a)(2)]
may be reattributed to another entity under 318(a)(3). Thus an (a)(2) can be followed by an (a)(3).
Prohibited reattributions:
Stock Actually Owned by

Attributed to

Reattribution to

Family member

Family member (a)(1)

Not another family member (a)(1)

Partner, shareholder,
beneficiary

An entity (a)(3)

Not another partner, shareholder


or beneficiary (a)(2)

The ownership interests for each of Ms shareholders is summarized below, followed by determination
of each shareholders interest. (The constructive ownership rules are discussed on pp. 4-7 through
4-9.)

Ownership: Direct and Indirect

B
D
F
H
J
L
N

D
Bs Wife

F
Bs Brother

H
Ds Mother

J
Corporation

L
Partnership

N
Bs Kids Trust

Total

300
568

692
686
628

190
190

190

80

80

70

70

66

72

48

110
120

130

130

130

758
828
128
390
802
886
758

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4-8

Chapter 4

Corporate Distributions: Stock Redemptions and Partial Liquidations

Shareholder B

Direct ownership
Indirect ownership through
D, his wife

300
190

J, 60% owned corporation

66

L, 60% owned partnership

72

H, his wifes mother

N, trust for kids

Total

Family attribution [ 318(a)(1)]; a husband owns the


stock of his wife
60%  110 66; entity to owner: corporation to 50%
shareholder [ 318(a)(2)(C)]
60%  120 72; entity to owner: partnership to partner
[ 318(a)(2)(A)]
No family reattribution [ 318(a)(5)(B)]; although B
generally owns what his wife owns, stock constructively
owned by his wife under the family attribution rules is not
treated as actually owned for purposes of reattributing it to
another family member
Shares owned by the trust are attributed to Ds and Bs
kids under the entity-to-owner attribution rules
[ 318(a)(2)(B)]; such shares are treated as actually
owned for purposes of reattribution [ 318(a)(5)(A)];
shares attributed from an entity (trust) to an owner (kids)
under 318(a)(2) may be reattributed from the owner
(kids) to a family member; there is no prohibition under
318(a)(5)

130

758

Shareholder D, Bs Wife

Direct ownership
Indirect ownership through
B, her husband
Bs direct ownership
Bs indirect ownership
J, Bs 60% owned corporation

L, Bs 60% owned partnership


Total through B
N, trust for her kids

190

300

Family attribution [ 318(a)(1)]; a wife owns the


stock of her husband
60%  110 66; Js stock owned by B by virtue
of the entity-to-owner rules of 318(a)(2)(C)
is treated as actually owned for purposes of
reattribution [ 318(a)(5)(A)]; thus Js stock may
be reattributed from B to a family member; there
is no prohibition under 318(a)(5)
60%  120 72; same explanation as above

66

72
438
130

H, her mother
Total

70
828

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Shares owned by the trust are attributed to Ds


and Bs kids under the entity-to-owner attribution
rules [ 318(a)(2)(B)]; such shares are treated
as actually owned for purposes of reattribution
[ 318(a)(5)(A)]; shares attributed from an entity
(trust) to an owner (kids) under 318 (a)(2)
may be reattributed from the owner to a family
member; there is no prohibition under 318(a)(5)
Family attribution [ 318(a)(1)]; a daughter owns
the stock of her mother

Solutions to Problem Materials

4-9

Shareholder F, Bs Brother

Direct ownership
Indirect ownership through
J, Fs 40% owned corporation

80

L, Fs 40% owned corporation

48

Total

128

No attribution unless the shareholder owns at least


50% of a corporation [ 318(a)(2)(C)]
40%  120; entity to owner; partnership to partner
[ 318(a)(2)(A)]
Although B is Fs brother, there is no family
attribution since brothers are not related; further,
there is no attribution of Bs shares to J then to
F; 318(a)(5)(C) prohibits reattribution from a
partnership to its partners

Shareholder H, Ds Mother

Direct ownership
Indirect ownership through
D, her daughter
Direct
Indirect
Through B, Ds husband

70

190

Family attribution [ 318(a)(1)]; a mother owns the


stock of her daughter

No family reattribution [ 318(a)(5)(B)]; the stock


that D constructively owns through her husband is
not reattributed to Ds mother

Total through D
N, trust for Ds and Bs kids,
Hs grandchildren

190
130

Total

390

Shares owned by the trust are attributed to Ds and


Bs kids under the entity-to-owner attribution rules
[ 318(a)(2)(B)]; such shares are treated as actually
owned for purposes of reattribution [ 318(a)(5)(A)];
shares attributed from an entity (trust) to an owner
(kids) under 318(a)(2) may be reattributed from the
owner to a family member; there is no prohibition
under 318(a)(5); under the family attribution rules, H
owns what her grandchildren own.

Shareholder J, a Corporation

Direct ownership
Indirect ownership through
B, a 60% shareholder
Bs direct interest
Bs indirect interest
D, his wife

L, 60% owned partnership

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110
Owner-to-entity attribution in full if shareholder, B,
owns at least 50% of the corporation [ 318(a)(3)]
300
190

72

Shares owned by virtue of the family attribution rules


[ 318(a)(1)] may be reattributed to an entity under
318(a)(3); 318(a)(5) does not prohibit
60%  120 72; shares owned by virtue of the
entity, L, to owner, B, attribution rules [ 318(a)(2)]
may be reattributed to an entity, J, under 318(a)(3);
318(a)(5) does not prohibit

4-10

Chapter 4

Corporate Distributions: Stock Redemptions and Partial Liquidations

N, trust for kids

130

Total through B
F, a 40% shareholder

Shares owned by the trust are attributed to Ds and Bs


kids under the entity-to-owner attribution rules
[ 318(a)(2)(B)]; such shares are treated as actually
owned for purposes of reattribution [ 318(a)(5)(A)];
shares attributed from an entity to an owner under
318(a)(2) may be reattributed from the owner (kids) to
a family member (B); these can be reattributed to an
entity under 318(a)(3); no prohibition under 318(a)(5)
692

Total

Owner-to-entity attribution occurs only if the shareholder owns at least 50% [ 318(a)(2)(C)]

802

Shareholder L, a Partnership

Direct ownership
Indirect ownership through
B, a 60% shareholder

120

Bs direct interest
Bs indirect interest
D, his wife

300

N, trust for kids

J, a 60% owned corporation

Owner-to-entity attribution under 318(a)(3)(C):


partner to partnership in full

190

Shares owned by virtue of the family attribution rules


[ 318(a)(1)] may be reattributed to an entity under
318(a)(3); 318(a)(5) does not prohibit
Shares owned by trust are attributed to Ds and Bs
kids under the entity-to-owner attribution rules
[ 318(a)(2)(B)]; such shares are treated as actually
owned for purposes of reattribution [ 318(a)(5)(A)];
shares attributed from an entity to an owner under
318(a)(2) may be reattributed from the owner to a
family member; these can be reattributed to an entity
under 318(a)(3); no prohibition under 318(a)(5)
Shares owned by virtue of the entity, J, to owner, B,
attribution rules may be reattributed to an entity
under 318(a)(3); 318(a)(5) does not prohibit

130

66

Total through B
F, a 40% partner
Fs direct interest

686
80

Total

Owner-to-entity attribution [ 318(a)(3)(C)]; partner


to partnership in full

886

Shareholder N, a Trust

Direct ownership
Indirect ownership through
B and D

130

Bs direct interest

300

Ds direct interest

190

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Under the family attribution rules, Ds and Bs kids


own constructively what D and B owns; these shares
may be reattributed to the trust [ 318(a)(3)]; no
prohibition of reattribution [ 318(a)(5)]
Shares owned by virtue of the family attribution rules
[ 318(a)(1)] may be reattributed
Shares owned by virtue of the family attribution rules
[ 318(a)(1)] may be reattributed

Solutions to Problem Materials

Bs indirect interest
J, 60% owned corporation

66

L, 60% owned partnership

72

Total through B and D

628

Total

758

4-11

60%  110 66; entity to owner: corporation to


50% shareholder [ 318(a)(2)(C)]
60%  120 72; entity to owner: partnership to
partner [ 318(a)(2)(A)]
to an entity; 318(a)(5) does not prohibit
Kids do not own what their grandmother owns; thus
these shares do not flow to the trust

Although the question asks only for the shareholders ownership after the redemption, the solutions also
discuss the tax consequences of the planned redemptions.
a. No. A owns whatever his spouse owns. Thus, the exchange does not qualify unless A waives the family
attribution rules, which he is entitled to do. The effect of the redemption is shown below.

4-19

As Ownership

Direct
Indirect
Through B (50%  100)
Total owned
Percentage owned

Preredemption

Postredemption

100

100

100

200

100

100% (200/200)

100% (100/100)

(See Examples 6 and 11, and pp. 4-7, and 4-10.)


11-

b.

c.

No. Same as (a). Under the prevailing view, family hostility will not prevent the application of the
constructive ownership rules when evaluating a redemption under the meaningful reduction test of
302(b)(1). (See p. 4-10.) A research case (4-36) at the end of this chapter deals with this problem.
No. A owns proportionately whatever his 50 percent owned corporation owns. As a result, he owns
50 percent of Zs stock after the redemption. Since his ownership does not fall below 50 percent, the
redemption is not substantially disproportionate. (See Examples 7 and 11, and pp. 4-8, 4-9, and 4-11.)
As Ownership

Preredemption

Postredemption

Direct
Indirect
Through B (50%  100)
Total owned

100

50

50

150

50

75% (150/200)

50% (50/100)

Percentage owned

11d.

Yes. None of Bs stock is attributed to A since A owns less than 50 percent of B. Thus, As interest is
completely terminated. (See Examples 7 and 11, and pp. 4-8, 4-9, and 4-11.)
As Ownership

Direct
Indirect
Through B (none)
Total owned
Percentage owned

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Preredemption

Postredemption

100

100

50% (100/200)

0%

4-12

Chapter 4

Corporate Distributions: Stock Redemptions and Partial Liquidations

11e.

No. As a corporation, A owns whatever its 50 percent shareholders own in full. Thus, A still owns
100 percent of the stock after the redemption. Since A owns at least 50 percent after the redemption,
the redemption is not substantially disproportionate. (See Examples 8 and 11, and pp. 4-9 and 4-12.)
As Ownership

Preredemption

Direct
Indirect
Through B (100%  100)
Total owned

100

100

100

200

100

100% (200/200)

100% (100/100)

Percentage owned
11- f.

Postredemption

Yes. Although the stock of B is attributable to R, As son, it is not reattributed to A; to do so would


extend the definition of family. Thus, As interest is completely terminated. (See Examples 8 and 11,
and pp. 4-9 and 4-11.)
As Ownership

Direct
Indirect
Through B (none)
Total owned
Percentage owned

Preredemption

Postredemption

100

100

50% (100/200)

0%

11g.

A, as a trust, is considered as owning whatever its beneficiary owns in full. For this purpose, the stock
of B is attributed to his son and then reattributed to the trust. Consequently, the trust is deemed to
own 100 shares, or 100 percent of the stock after the redemption, due to the constructive ownership
rules as shown below. Thus, the distribution is treated as a dividend. Note: Since the distribution is in
complete termination of As interest, the trust may waive the family attribution rules only if the trust
and the beneficiary from which the stock is attributed to the trust, Bs son, has an interest after the
redemption. Since Bs shares are not redeemed, no waiver is available. (See Example 13 and p. 4-13.)
As Ownership

Preredemption

Direct
Indirect
Through B (100%)
Total owned
Percentage owned

114-20

a.

Postredemption

100

100

100

200

100

100% (200/200)

100%

Buck reports capital gain of $41,400 [$46,000  (23  $200)]. Under 302, the redemption will be
treated as a sale since it is substantially disproportionate as shown below.
Preredemption

Directly
Indirectly thru wife
Total owned

40
10
50

Percentage owned

50% (50/100)

23
 2
25

Postredemption

17
8
25
37% (25/67)

To be treated as substantially disproportionate, Bucks percentage ownership after the redemption


must be less than 50 percent and less than 80 percent of what it was before the redemption, or
40 percent (80%  50%). Since his ownership falls to 37 percent, both of these tests are met. Note that
in determining his postredemption percentage ownership, the denominator of the fraction reflects the
redemption of all 33 shares. The basis of his remaining shares is $3,400 ($200  17). (See pp. 4-7 and
4-10.)
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Solutions to Problem Materials

b.

4-13

John will report a dividend of $8,000 ($2,000  4). The distribution is treated as a dividend since the
redemption is not substantially disproportionate, as shown below.
Preredemption

Directly
Indirectly thru wife
Total owned

45
5
50

Percentage owned

50% (50/100)

4
4
8

Postredemption

41
1
42
63% (42/67)

To be treated as substantially disproportionate, Johns percentage ownership after the redemption


must be: (1) less than 50 percent and (2) less than 80 percent of what it was before the redemption, or
40 percent (80%  50%). Since his ownership actually increases to 63 percent, the distribution does not
qualify for sales treatment. The basis of his stock will remain the same, $9,000. (See pp. 4-7 and 4-10.)
4-21

C recognizes a gain of $65,000 ($75,000  $10,000) as if it had sold the distributed property. None of the
$10,000 loss realized on the equipment is recognized. Under 311, a corporation that distributes property
must recognize gain but not loss. Note that the loss is lost forever because the shareholders basis will be the
value of the property, $30,000. (See Example 21 and p. 4-18.)

4-22

a.

Under 311(b), the corporation must recognize gain on the distribution of appreciated property
regardless of whether the redemption is treated as a sale or a dividend. Therefore, D must recognize a
gain of $40,000 ($100,000  $60,000). Assuming the distribution qualifies as a dividend, the corporation
increases its E&P by the $40,000 gain recognized and reduces E&P by the fair market value of the
property distributed, $100,000. This results in a net reduction of E&P of $60,000, as summarized below.
(See Examples 21 and 23, and p. 4-18.)
Gain on the distribution
Fair market value of property distributed
Net decrease in E&P

b.

$ 40,000
(100,000)
$ (60,000)

The corporations E&P after the exchange would be $20,000 ($80,000  $60,000).
When the redemption is treated as a sale, the distributing corporation must recognize gain on the
distribution of the property, which in turn increases E&P. However, the corporation reduces E&P by
the percentage of the value of the stock redeemed, $24,000 [(2,000/10,000  ($80,000 $40,000). Note,
however, that this amount cannot exceed the amount of the distribution. In this case, the amount of the
distribution is $100,000; thus the reduction is $24,000. The net effect on the corporations E&P is
summarized below. (See Example 23, and pp. 4-18 and 4-19.)
Gain on the distribution
Reduction for distribution
Net increase in E&P

$ 40,000
(24,000)
$ 16,000

The corporations E&P after the exchange would be $96,000 ($80,000 $16,000).
4-23

a.

1. H reports a $15,000 dividend. The $15,000 is dividend income since the redemption is not
substantially disproportionate, as shown below.

Ownership

Preredemption

Postredemption

Direct
Indirect
Through PAC (80%  20)
Total owned

40

20

16

16

56

36

56% (56/100)

45% (36/80)

Percentage owned

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4-14

Chapter 4

b.

Corporate Distributions: Stock Redemptions and Partial Liquidations

To be substantially disproportionate, Hs percentage ownership after the redemption must fall


below 50 percent and 44.8 percent (80%  56%). Since Hs percentage ownership fell only to
45 percent, the redemption is not substantially disproportionate and thus must be treated as a
dividend.
Although Hs number of shares after the redemption of 36 is less than 80 percent of the number
of shares that he owned before the redemption (80%  56 shares 44.8 shares), the substantially
disproportionate test focuses on the change in the shareholders percentage ownership and not the
change in shares. It is interesting to note that the Committee Reports that originally accompanied
the enactment of 302 made this same error! (See Example 11 and pp. 4-8 through 4-12.)
2. Hs total basis of $5,000 is unchanged; however, his per share basis increases from $125/share
($5,000/40) to $250/share ($5,000/20). (See Example 3 and p. 4-5.)
3. CELs taxable income is unaffected. (See p. 4-18.)
4. Since the distribution is treated as a dividend, CEL reduces its E&P by the amount of the
distribution, $15,000. (See p. 4-18.)
1. As determined below, H is entitled to sale treatment since the redemption is substantially
disproportionate. Thus, H reports a capital gain of $12,500, determined as follows.
Amount realized
Adjusted basis (20 shares  $125/share)
Gain realized and recognized

$15,000
(2,500)
$12,500

Ownership tests:
Ownership

Preredemption

Postredemption

Direct
Indirect
Through PAC (none*)
Total owned

40

20

40

20

40% (40/100)

25% (20/80)

Percentage owned

*None of PACs stock is attributable to H since H does not own 50 percent or


more of PAC.

c.

d.

e.

4-24

To be substantially disproportionate, Hs percentage ownership after the redemption must fall


below 50 percent and 32 percent (80%  40%). Since Hs percentage ownership fell to 25 percent,
the redemption is substantially disproportionate and, thus, treated as a sale. (See Examples 8 and
9, and pp. 4-10 and 4-11.)
2. Hs basis in his remaining 20 shares is $2,500, or $125/share. (See Example 3 and p. 4-5.)
3. There is no effect on CELs taxable income. (See p. 4-18.)
4. Since the redemption is treated as a sale, CEL must reduce E&P in the same proportion as the
proportion of stock redeemed but not to exceed the amount of the distribution. Thus, the
reduction is $15,000, the lesser of the distribution, $15,000, or $20,000 [$100,000  (20/100)]. (See
Example 23 and p. 4-18.)
Since all of Fs stock is attributable to S, a redemption of any number of Ss shares will not be treated
as substantially disproportionate. However, S may waive the family attribution if all of his shares are
redeemed, he quits his job, and files the proper agreement with the IRS. Under 302(c)(2), S may not
retain any interest in the corporation except as a creditor, he cannot acquire any interest in the
corporation for at least 10 years except by inheritance, and he must file an agreement to notify the
Service if he should acquire the prohibited interest. (See Example 12 and p. 4-12.)
CEL must recognize a $20,000 gain [$50,000  ($40,000  $10,000)]. When appreciated property is
distributed in redemption of stock, the appreciation element must be recognized as gain. (See Example
21 and p. 4-18.)
The distributing corporation does not recognize the built-in loss of $25,000 ($50,000 value  $75,000
basis). Under 311, gain, but not loss, is recognized. (See Example 21 and p. 4-18.)

In order to satisfy the safe harbor requirements of 302(e)(2) and obtain partial liquidation treatment, the
distribution must consist of the assets of or be attributable to the cessation of a qualified business. In

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Solutions to Problem Materials

4-15

addition, the corporation must retain a qualified business, which it continues to operate immediately after
the exchange. An activity is a qualified business if it satisfies the following conditions:




It consists of active and substantial management operational functions;


It has been conducted for five years prior to the distribution; and
It was not acquired in a taxable transaction in the last five years preceding the distribution. (See
p. 4-14.)

1. Tavern. The tavern is a qualified business since its activities constitute a business, it has been conducted
for five years (since 1999), and it was not acquired in a taxable transaction in the past five years
(acquired in 1999). To qualify for partial liquidation treatment, however, HPI must retain another
business that is a qualified business. In this case, HPI would continue a qualified business since, as
discussed below, the sporting goods store also is a qualified business. (See pp. 4-13 and 4-14.)
2. Sporting goods store. The sporting goods store would be considered an active business. Although
acquired within the five-year period preceding the distribution, the acquisition was not taxable but
rather tax-free under 351. The acquisition was tax-free because immediately after the transfer of the
business, B owned 80 percent of the shares outstanding (400/500) of HPI. The business is also
considered as having been operated for the past five years because it has been operated since 1990.
Note that it is not necessary that HPI, the distributing corporation, operate the business for five years
prior to the distribution. It is sufficient that anyone operated it for such period. Since HPI would
continue to operate the tavern, which is also a qualified business, the sporting goods store could be
distributed in partial liquidation and meet the safe harbor tests. (See Example 16 and p. 4-15.)
3. The apartment is not a qualified business since it does not constitute a business (rental operations
generally are not considered businesses unless substantial services are rendered in connection with the
rental) and it was acquired in a taxable transaction within the preceding five years (purchased three
years ago). (See Example 15 and pp. 4-14 and 4-15.)
(See Examples 14 through 16 and pp. 4-14 and 4-15.)
4-25

a.

b.

4-26

a.

C reports capital gain of $28,000 [$30,000  ($100  20 shares redeemed)]. Under the partial
liquidation rules, a distribution to a noncorporate shareholder that qualifies as a partial liquidation is
treated as a sale. [See Example 17, p. 4-15, and 302(b)(4).]
Since C is a corporation, the partial liquidation rules do not apply. Thus, the treatment of the
distribution is governed by the normal redemption provisions of 302. In this case, Cs ownership is
unchanged after the redemption (100% and 80/80 or 100% after). Thus, the redemption is treated as a
dividend. Dividend treatment is favorable, however, since the corporation is entitled to a dividendreceived deduction of $30,000 (100%  $30,000). In addition, because the stock redemption is part of a
partial liquidation within the meaning of 302(e), 1059(e) requires that the dividend be treated as an
extraordinary dividend. As a result, the corporation is still entitled to the dividend-received deduction
but must reduce the basis of its stock by the nontaxed portion of the dividend, in this case $30,000.
Since the $30,000 reduction exceeds the corporations $10,000 basis in its stock, the corporation also
must report a $20,000 capital gain ($30,000  $10,000). (See Examples 4 and 5 and pp. 4-6 and 4-15.)
Q reports an $11,000 long-term capital gain as determined below.
Amount realized
 Adjusted basis (10  $400/share)
Gain realized

b.

c.

$15,000
(4,000)
$11,000

Distributions to a noncorporate shareholder in partial liquidation qualify for capital gain treatment.
(See Example 17 and p. 4-15.)
$13,000 [$15,000  ($8,000  $6,000)] $7,000 1231 gain and $6,000 1245 gain. The corporation
must recognize gain recognized on the distribution of appreciated property in partial liquidation. [See
Example 22, p. 4-18, and 311(b).]
Since TUV is a corporation, the partial liquidation rules do not apply. Thus, the treatment of the
distribution is governed by the normal redemption provisions of 302. In this case, TUVs ownership
drops to 16.6 percent (15/90), which is less than 50 percent and is also less than 80 percent of what it
was before20 percent (80%  25%). Thus, the distribution is substantially disproportionate and

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4-16

Chapter 4

Corporate Distributions: Stock Redemptions and Partial Liquidations

treated as a sale, resulting in an $11,000 ($15,000  $4,000 basis) long-term capital gain to TUV. This
sale treatment is unfavorable since the corporate shareholder would prefer dividend treatment because
of the 70 percent dividends-received deduction. Since the distribution is not a dividend, the
extraordinary dividend rules do not apply. (See Example 17 and p. 4-15.)
4-27

a.

J reports $10,000 long-term capital gain as determined below.




b.

4-28

a.

Amount realized
Adjusted basis (10  $500/share)
Gain realized

$10,000
(5,000)
$ 5,000

Distributions to a noncorporate shareholder in partial liquidation qualify for sale treatment. (See
Example 17 and p. 4-15.)
L reports $6,000 long-term capital gain as determined below and has a basis in the land of $15,000, its
fair market value.


d.

$20,000
(10,000)
$10,000

Distributions to a noncorporate shareholder in partial liquidation qualify for sale treatment. Basis in
cash is $20,000. (See Example 17 and p. 4-15.)
K reports $5,000 long-term capital gain as determined below and has a basis in the warehouse of
$10,000, its fair market value.


c.

Amount realized
Adjusted basis (20  $500/share)
Gain realized

Amount realized
Adjusted basis (15  $600/share)
Gain realized

$15,000
(9,000)
$ 6,000

Distributions to a noncorporate shareholder in partial liquidation qualify for sale treatment. The facts
indicate that one should assume that this is a partial liquidation. (See Example 17 and p. 4-15.)
Under 311(b), CRS must recognize gain, but not loss, on the distribution of property. Therefore,
CRS recognizes a gain on the distribution of the warehouse of $6,000 [$10,000 value  ($7,000 cost 
$3,000 depreciation $4,000 basis)], $600 of ordinary income under 291 ($3,000  20%), and $5,400 of
1231 gain. CRS does not recognize any of the built-in loss of $10,000 ($15,000 value  $25,000 basis) on
the distribution of the land. Note that the shareholders basis would be fair market value in the land, and,
consequently, this loss is lost. (See Example 22 and p. 4-18.)
Only a redemption of XYZ stock qualifies. In order for a redemption of stock to qualify under 303,
the stocks value by itself must exceed 35 percent of the adjusted gross estate. Alternatively, the
aggregate value of stocks of which the decedent owned 20 percent must exceed 35 percent of the
adjusted gross estate. The adjusted gross estate is computed as follows.



Gross estate
Funeral and administrative expenses
Debts
Adjusted gross estate

$2,000,000
(60,000)
(240,000)
$1,700,000

35%
$ 595,000

Since the $100,000 value of ABC stock does not exceed $595,000 or 35 percent of the adjusted gross
estate, redemption of such stock does not qualify under 303. Moreover, its value cannot be
aggregated with that of XYZ since Ks estate included only a 10 percent interest in XYZ. XYZ stock
does qualify since its $800,000 value exceeds $595,000.

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Solutions to Problem Materials

b.

4-17

The redemption receives sale treatment under 303, and, thus, the estate recognizes no gain or loss as
determined below.


Amount realized
Adjusted basis (1,000  $800,000/10,000)
Gain realized and recognized

$80,000
(80,000)
$
0

Note that the basis of the XYZ stock is its fair market value at the date of death, $800,000.
c.

$70,000. The maximum amount of stock that can be redeemed under 303 is limited to the sum of
funeral and administrative expenses and death taxes.
Funeral and administrative expenses
Death taxes (federal and state)

$ 60,000
90,000
$150,000
(80,000)
$ 70,000

Prior redemptions

(See Examples 18-20 and pp. 4-16 through 4-17.)


4-29

a.

T reports a dividend of $20,000. The sale of the ISC stock is governed by 304 concerning redemptions
through related corporations. Section 304 applies since T owns at least 50 percent of two corporations.
As a result, the sale is treated as a redemption by ACC of its own stock. The ownership tests of 302
are applied to Ts ownership in the issuing corporation ISC as follows.
Ownership tests:
Ownership

Preredemption

Postredemption

Direct
Indirect
Through ACC (80%  30)
Total owned

50

20

50

44

50% (50/100)

44% (44/100)

Percentage owned

b.
c.
d.
e.

To be substantially disproportionate, Ts percentage ownership after the redemption must fall below
50 percent and 40 percent (80%  50%). Since Ts percentage ownership fell to only 44 percent, the
redemption is not substantially disproportionate and is treated as a dividend to the extent of ACCs
$15,000 E&P first and the remaining $5,000 from ISCs E&P. (See Example 26 and p. 4-21.)
Basis in the remaining ISC shares remains the same, $2,000 ($100  20).
T increases her basis in her ACC stock by the basis of the ISC stock surrendered, $3,000 (30  $100/
share), to $7,000.
ACCs basis in the ISC stock acquired is $3,000, the same as the ISC stock in the hands of T. (See
Example 26 and pp. 4-21 through 4-23.)
a. T reports a capital gain of $17,000 ($20,000  $3,000). The redemption is governed by 304
concerning redemptions through related corporations. Section 304 applies since T owns at least
50 percent of two corporations and the brother-sister rules operate. As a result, the sale is treated
as a redemption by ACC of its own stock. The ownership tests of 302 are applied to Ts
ownership in the issuing corporation ISC as follows.
Ownership tests:
Ownership
Direct
Indirect
Through ACC (60%  30)
Total owned

Preredemption
50

Postredemption
20

50

18

Percentage owned

50% (50/100)

38% (38/100)

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38

4-18

Chapter 4

b.
c.
d.
4-30

a.

Corporate Distributions: Stock Redemptions and Partial Liquidations

To be substantially disproportionate, Hs percentage ownership after the redemption must fall below
50 percent and 40 percent (80%  50%). Since Hs percentage ownership fell to 38 percent, the
redemption is substantially disproportionate and is treated as a sale. (See Example 28 and p. 4-23.)
Ts basis in the remaining ISC shares remains the same, $2,000 ($100  20 shares remaining).
Ts basis in his ACC shares is unchanged, $4,000.
ACCs basis in the ISC shares acquired is their cost, $20,000. (See Example 28 and p. 4-23.)
T reports a capital gain of $36,000. The redemption is governed by 304 concerning redemptions
through related corporations. Since T sold the stock of P to a subsidiary that it controls, the parentsubsidiary rules of 304 operate. As a result, the sale is treated as a redemption by P of its own stock.
The ownership tests of 302 are applied to Ts ownership in the issuing corporation, P, as follows.
Ownership tests:
Ownership

Direct
Indirect
Through P (40*/200  90%  80 shares)
Total owned
Percentage owned

Preredemption

Postredemption

120

40*

120

14

60% (120/200)

27% (54/200)

54

*120  80 40 shares.
Note that the stock is still attributed to the shareholder even though he owns less than 50 percent. The
50 percent test is not applicable under 304 when applying 318. [See p. 4-28 and 304(b)(1).]
To be substantially disproportionate, Ts percentage ownership after the redemption must fall
below 50 percent and 48 percent (80%  60%). Since Ts percentage ownership fell to 27 percent, the
redemption is substantially disproportionate and is treated as a sale.
Amount realized
 Adjusted basis (80  $50/share)
Gain realized and recognized

$40,000
(4,000)
$36,000

(See Example 29 and p. 4-23.)


b.
c.
d.

Ts basis in her remaining shares of P is the same, $2,000 ($50  40 shares).


Ss basis in the shares acquired is $40,000.
1. T reports a dividend of $40,000. The redemption is governed by 304 concerning redemptions
through related corporations. Since T sold the stock of P to a subsidiary, which it controls, the
parent-subsidiary rules of 304 operate. As a result, the sale is treated as a redemption by P of its
own stock. The ownership tests of 302 are applied to Ts ownership in the issuing corporation P
as follows.
Ownership tests:
Ownership

Direct
Indirect
Through P (100/200  90%  20)
Total owned
Percentage owned

2.

Preredemption

Postredemption

120

100

0
120

9
109

60% (120/200)

54.5% (109/200)

To be substantially disproportionate, Ts percentage ownership after the redemption must fall below
50 percent and 48 percent (80%  60%). Since Ts percentage ownership fell only to 54.5 percent, the
redemption is not substantially disproportionate and must be treated as a dividend.
Ts basis in her remaining shares of P is increased by the basis of the stock surrendered, or $1,000
(20 shares  $50 per share). Thus, the basis of the remaining 100 shares is $60 per share ($6,000/100).

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Solutions to Problem Materials

3.

4-19

Ss basis in the shares acquired is its cost of $40,000.

(See Example 29 and p. 4-23.)


4-31

a.

Under 306, T reports $40,000 as ordinary income, which is the amount that would have been a
dividend had cash been distributed in lieu of stock. In addition, the basis of Ts common stock is
increased by $6,000, as determined below.


b.

4-32

a.
b.

c.

d.

e.
f.

Amount realized
Ordinary income
E&P at date of stock distribution
Return of capital
Adjusted basis in preferred stock
Unrecovered basis added to common stock

$ 42,000
(40,000)
$ 2,000
(8,000)
$ (6,000)

Note that no loss is recognized and the income is ordinary income and not dividend income. Also,
WIC is not permitted to reduce E&P by the $40,000 treated by T as a dividend because the
corporation did not actually make a dividend distribution. [See Example 37, p. 4-27, and 306(a)(1).]
T reports dividend income of $42,000, and the $8,000 basis of the preferred stock redeemed is added to
the common on which the preferred stock was distributed. When 306 stock is redeemed, the amount
realized is treated as dividend income to the extent of E&P, $65,000, as of the date of the redemption,
not as of the date distributed, which was $40,000. In this case, WIC reduces it E&P by the $42,000
dividend distribution, resulting in an E&P balance of $23,000 ($65,000  $42,000). [See Example 38,
p. 4-28, and 306(a)(2).]
Section 306 does not apply since there was a deficit in E&P at the date the stock was distributed. [See
Example 35, p. 4-27, and 306(c)(2).]
Section 306 does not apply since the common stock received is not 306 stock by definition. Section
306 stock includes stock other than common stock, which is distributed with respect to common as a
nontaxable stock dividend. [See p. 4-26 and 306(c)(1)(A).]
Section 306 applies. Section 306 stock includes stock received in a corporate reorganization when the
effect of the transaction was essentially the same as the receipt of a stock dividend and the corporation
has current or accumulated E&P. [See Example 33, p. 4-26, and 306(c)(1)(B).]
Section 306 does not apply. The 306 taint does not carry over to the heir of 306 stock since the basis
of such stock is not a carryover basis but rather is the stocks fair market value at death. [See Example
34 and p. 4-26 and 306(c)(1)(C).]
Section 306 applies. The taint carries over to the nephew because the stocks basis carries over. [See
Example 34 and p. 4-26 and 306(c)(1)(C).]
Section 306 applies. The shareholder is not treated as having completely terminated her interest because
she has sold the stock to someone, her father in this case, whose stock she would be considered as
owning under the constructive ownership rules of 318. [See 306(b)(1)(A)(iii).]

TAX RESEARCH PROBLEMS


Solutions to the Tax Research Problems (4-334-37) are contained in the Instructors Resource Guide and Test Bank
for 2014 .

All materials are copyright Pratt & Kulsrud and Van-Griner, LLC

All materials are copyright Pratt & Kulsrud and Van-Griner, LLC

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