Corporate Redemptions and Liquidations PDF

1 STUDY UNIT SIXTEEN CORPORATE REDEMPTIONS AND LIQUIDATIONS 16.1 Redemptions.......................................................... 1 16.2 Complete Liquidation......................................................

1 STUDY UNIT SIXTEEN CORPORATE REDEMPTIONS AND LIQUIDATIONS 16.1 Redemptions.......................................................... 1 16.2 Complete Liquidation................................................... 5 16.3 Partial Liquidation...................................................... 8 A stock redemption occurs when a corporation acquires its stock from its shareholders in return for cash or property. Whether the redemption is treated as a sale, an exchange, or a dividend depends on numerous factors. 1) For instance, if the distribution is considered a partial liquidation under Sec. 302, noncorporate shareholders will receive sale or exchange treatment. 2) In contrast, at some point in the life of a corporation, it may be determined that the corporation should be liquidated. If so, the corporation’s shareholders will surrender all of their stock in the corporation and receive their pro rata shares of any remaining assets after all creditors are paid. 16.1 REDEMPTIONS Stock is redeemed when a corporation acquires its own stock from a shareholder in exchange for property. The stock may be canceled, retired, or held as treasury stock. A shareholder is required to treat the amount realized on redemption (not in liquidation) as either a distribution (a corporate dividend) or a sale of the stock redeemed. 1. Redemptions of stock by a corporation are treated as dividends unless certain conditions are met. If any of the following conditions are met, the exchange is treated as a sale, and the gains or losses are capital gains and losses. a. The redemption is not essentially equivalent to a dividend. b. The redemption is substantially disproportionate. c. The distribution is in complete redemption of all of a shareholder’s stock in the corporation. d. The distribution is to a noncorporate shareholder in partial liquidation. e. The distribution is received by an estate. Corporation 2. A corporation recognizes gain realized on a distribution a. As if the property distributed were sold at FMV to the distributee immediately prior to the distribution b. Even if stock is redeemed by the distribution 3. A corporation recognizes ordinary income on the distribution of depreciated property to the extent of depreciation or amount realized, whichever is less. 4. No recognition of loss realized is allowed the corporation, unless the redemption is a. In complete liquidation of the corporation or b. Of stock held by an estate (to pay death taxes). Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 2 SU 16: Corporate Redemptions and Liquidations Shareholder 5. A shareholder treats a nonqualifying redemption in the same manner as a regular distribution. The amount is a dividend to the extent of earnings and profits (E&P). a. Any unrecovered basis in the redeemed stock is added to the shareholder’s basis in stock retained. b. A distribution that redeems all of a shareholder’s shares is treated as a sale irrespective of earnings and profits. EXAMPLE 16-1 Shareholder Treatment -- Nonqualifying Redemption of Stock Since 2017, Paige has owned all 1,010 outstanding shares of E and E Corporation’s stock. Paige’s basis for the stock is $10,100. In 2023, E and E has earnings and profits of $110,000. The corporation redeemed 450 shares of Paige’s stock for $98,000 in 2023. Because Paige owns 100% of the stock before and after the redemption, the transaction is a dividend to the extent that E and E has earnings and profits. Because the distribution ($98,000) is less than earnings and profits ($110,000), the entire amount is taxable as a dividend. NOTE: Do not confuse this with noncorporate shareholder treatment of a partial liquidation. (Details of partial liquidation requirements are covered in Subunit 16.3.) 6. The expenses incurred in connection with any reacquisition by a corporation of its own stock or the stock of a related person (50% relationship test) are not deductible. a. An exception exists for any cost allocable to an indebtedness and amortized over the life of the indebtedness (e.g., financial advisory costs). Sale Treatment 7. The shareholder treats qualifying redemptions as if the shares redeemed were sold to a third party. a. Gain or loss recognized is any difference between the adjusted basis (AB) of the shares and the fair market value (FMV) of property received. b. Character of gain or loss depends on the nature of the stock in the shareholder’s hands. c. Basis in distributed property is its FMV. d. Holding period for the property starts the day after the redemption exchange. e. This treatment applies only to redemptions that 1) Terminate a shareholder’s interest 2) Are substantially disproportionate between shareholders 3) Are not essentially equivalent to a dividend 4) Are received by an estate 5) Are from a shareholder, other than a corporation, in partial liquidation f. Treatment of a redemption as a sale is determined separately for each shareholder. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 16: Corporate Redemptions and Liquidations 3 Not Essentially Equivalent 8. Not essentially equivalent to a dividend means that there is a meaningful reduction in the shareholder’s proportionate interest in the corporation. a. Reduction in voting power is generally required for a redemption. 1) Shareholders in control of a corporation must generally lose control to qualify as not essentially equivalent to a dividend. 2) Majority control (over 50%) reduction to deadlock (50%) has been determined sufficient. 3) Minimal reduction by a minority shareholder may be meaningful. b. Attribution can be used to determine essential equivalence. Substantially Disproportionate 9. Substantially disproportionate means that the amount received by shareholders is not in the same proportion as their stock holdings. a. It is tested by determining the shareholders’ applicable ownership percentages (including constructive ownerships) both before and after the redemption. b. A redemption is substantially disproportionate with respect to a shareholder if, immediately after the redemption, the shareholder owns 1) Less than 50% of the voting power of outstanding voting stock and 2) Less than 80% each of interest in a) The voting stock owned before the redemption and b) The common stock owned before the redemption. EXAMPLE 16-2 Substantially Disproportionate Redemption Carol, an individual shareholder, owns 275 shares of Allegiance Corporation. Allegiance has 1,000 shares of common stock outstanding and redeems 200 shares of common stock from its shareholders. The least number of Carol’s shares that will need to be redeemed in order for the redemption to be substantially disproportionate to Carol is determined as follows: Carol owned 27.5% of Allegiance Corporation before the redemption (275 shares ÷ 1,000 shares). Carol must reduce her interest to below 22% for the redemption to be substantially disproportionate (80% × 27.5%). Carol needs to own less than 176 shares after the redemption [22% × (1,000 shares – 200 shares)]. Thus, more than 99 shares (275 shares – 176 shares) need to be redeemed to reduce Carol’s interest below 22%. Accordingly, Carol needs to have a minimum of 100 shares redeemed for the redemption to be substantially disproportionate. Termination 10. Termination of a shareholder’s interest must be complete to qualify. a. All the stock owned by the shareholder in the corporation, actually and through family attribution, must be redeemed in the exchange for the property. b. The family attribution rules may be waived if the following three requirements are met: 1) The shareholder may not retain any interest (e.g., an employee, officer, director, or shareholder), except as a creditor, in the corporation. 2) The shareholder may not acquire an interest, except by bequest or inheritance, for 10 years. 3) A written agreement must be filed with the IRS stating that the IRS will be notified if a prohibited interest is acquired. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 4 SU 16: Corporate Redemptions and Liquidations Estate 11. An estate may treat a qualifying redemption (to pay death taxes) as a sale. a. Redeemed stock must be valued at more than 35% of the gross estate net of deductions allowed. 1) Deductions allowed are administration expenses, funeral expenses, claims against the estate (including death taxes), and unpaid mortgages. Constructive Ownership 12. The (redeemed) shareholder is treated as owning shares owned by certain related parties. The following ownership is considered to be constructively owned by the shareholder through related parties: a. Stock owned directly or indirectly by or for the shareholder’s spouse, children, grandchildren, or parents (excludes siblings and grandparents) EXAMPLE 16-3 Constructive Ownership A corporation has 100 shares outstanding. A husband, wife, child, and grandchild (the child’s child) each own 25 shares. The husband, wife, and child are each considered as owning 100 shares. The grandchild is considered as owning only 50 shares (25 shares of the grandchild + 25 shares of the child). b. Stock owned directly or indirectly by or for a partnership (or S corporation) in which the shareholder is a partner 1) The reverse also applies (i.e., partnership owns stock owned by a partner). c. Stock owned directly or indirectly by an estate or trust in which the shareholder is treated as a beneficiary or an owner d. Stock owned directly or indirectly by or for a corporation (other than an S corporation) in which the shareholder owns directly or indirectly at least 50% of the value of the stock e. Stock on which the shareholder holds an option to buy Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 16: Corporate Redemptions and Liquidations 5 16.2 COMPLETE LIQUIDATION Under a plan of complete liquidation, a corporation redeems all of its stock in a series of distributions. The distributions of assets to the shareholders are made from the remaining assets after all creditors have been paid first. Corporate Liquidation Figure 16-1 Visual Memory Aid: For candidates who are visual learners, the figure above and the description below can aid in recalling the order of distributions when a corporation is liquidated. If a corporation is liquidated, who is paid first? Secured creditors (“Loan Sharks”) in the picture are first in line, receiving either cash or assets. Unsecured creditors are paid second, and shareholders are paid last of all (notice the people holding shares behind the loan sharks). The image above is © Dugger Corcoran Illustrations, LLC. Reprinted with permission. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 6 SU 16: Corporate Redemptions and Liquidations Corporate Gains 1. A corporation recognizes any gain or loss realized on distributions in complete liquidation as if the property were sold at its FMV to the shareholder immediately before its distribution. a. Gain or loss is computed on an asset-by-asset basis. b. FMV of distributed property is treated as not less than related liabilities that the shareholder assumes or to which the property is subject. c. Character of amounts recognized depends on the nature of the asset in the hands of the distributing corporation, e.g., Secs. 1245 and 1250. EXAMPLE 16-4 Complete Liquidation -- Corporate Gains Under a plan of complete liquidation, Zaige Corporation distributed land having an adjusted basis to Zaige of $19,000 to its sole shareholder. The land was subject to a liability of $98,000, which the shareholder assumed for legitimate business purposes. The FMV of the land on the date of distribution was $71,000. Generally, the FMV of $71,000 would be used to determine any gain; however, because the liability relief of $98,000 is greater than the FMV, Zaige’s recognized gain is $79,000 ($98,000 liability relief – $19,000 AB). Corporate Losses 2. A corporation generally recognizes any losses realized on liquidating distributions. a. Certain realized losses are not recognized when the distributee shareholder is related to the corporation. 1) A more-than-50% shareholder, actually or constructively, is a typical related distributee. 2) Applicable distributions are of assets non-pro rata or acquired within 5 years by a contribution to capital or a Sec. 351 exchange. 3) Permanent disallowance results, even if the decline in value occurred postcontribution. b. Precontribution loss. The amount of a loss inherent on a contribution reduces loss recognized on distribution. 1) Applicable dispositions are of assets a liquidating corporation distributes, sells, or exchanges that were acquired by a contribution to capital or by a Sec. 351 exchange when its AB exceeded FMV for the principal purpose of recognizing the loss on liquidation. 2) The loss limit operates by requiring that basis for computing the amount of loss be reduced by loss inherent on contribution. c. Carryovers. Unused, unexpired NOLs; capital losses; and charitable contribution carryover amounts are lost. Shareholder Treatment 3. A shareholder treats amounts distributed in complete liquidation as realized in exchange for stock. a. Capital recovery to the extent of basis is permitted before recognizing gain or loss. b. Holding period will not include that of the liquidated corporation. c. Amounts realized include money and the FMV of other distributed property received. 1) Liabilities assumed or to which property is subject reduce the amount realized. 2) Allocation of amounts realized to each block of stock is required. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 16: Corporate Redemptions and Liquidations 7 EXAMPLE 16-5 Liquidating Distribution to Shareholder Consider a single liquidating distribution to Shareholder R on February 1, 2023, of $70 cash and a car (FMV = $25) subject to a liability of $15. R’s amount realized is $80 [$70 + ($25 – $15)]. Block Shares Acquired Basis Amount Realized Gain (Loss) Realized A 1 5/10 $10 $20 $10 B 3 10/16 $90 $60 $(30) d. When a series of liquidating distributions is made, the shareholder must use the cost recovery method for recognition of gain or loss. 1) Each payment received is first applied against the basis of the stock. 2) When basis is exceeded, a gain must be recognized. e. Character of recognized gain or loss depends on the nature of each block of the stock in the hands of the shareholder. EXAMPLE 16-6 Character of Recognized Gain or Loss If R, in Example 16-5, held the stock for investment, R would recognize LTCG on Block A and STCL on Block B. f. Basis in distributed property is its FMV but only after gain or loss on its receipt has been recognized. Reporting 4. A corporation must file an information return (Form 966, Corporate Dissolution or Liquidation) reporting adoption of a plan or resolution for its dissolution, or partial or complete liquidation, within 30 days of adoption. a. The IRS requires a corporation to file Form 1099-DIV for each calendar year it makes partial distribution(s) of $600 or more under a plan of complete liquidation. b. Expenses incurred in connection with the liquidation are deductible by the dissolved corporation. c. A corporation may file Form 4810 with the IRS requesting a prompt assessment of tax liability. If granted, this request limits the time for assessment to 18 months from the date the request was filed. 1) The period for assessing the tax will not be shortened if the taxpayer a) Filed a false return, b) Willfully attempted to evade tax, c) Did not file a return, or d) Omitted from gross income greater than 25% of the amount of gross income stated in the return. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 8 SU 16: Corporate Redemptions and Liquidations 16.3 PARTIAL LIQUIDATION A noncorporate shareholder treats a distribution as a sale to the extent it is (in redemption) in partial liquidation of the corporation. 1. The corporation making the distribution recognizes gain but not loss. 2. A corporation receiving a distribution in redemption for partial liquidation of another corporation treats the distribution as a dividend to the extent of E&P of the distributing corporation. a. The distributee corporation is eligible for the dividends-received deduction. 3. Partial liquidation refers to contraction of the corporation’s business. Focus is not on the shareholders but on genuine reduction in size of the corporation’s business. a. Partial liquidation must be pursuant to a plan, and the distribution must not be essentially equivalent to a dividend. The partial liquidation must be complete within either 1) The tax year of plan adoption or 2) The succeeding tax year. b. Pro rata distributions do not preclude partial liquidation sale treatment. Furthermore, shareholders are not required to surrender stock to the corporation. c. Safe harbor. Noncorporate shareholders apply partial liquidation sale treatment to distributions received if the following conditions are satisfied: 1) The corporation ceases conduct of a trade or business that it actively conducted for at least 5 years ending with the date of the distribution. a) The distribution must be attributable to the discontinued operations. 2) Immediately after the distribution, the corporation continues to conduct at least one active trade or business it has conducted for 5 years. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].