Accounting Question

Look at the pdf.

Tax Memo D
Instructions:
The memo should not exceed two pages and students should use the tax memo template
provided. However, the answer should be a full 2 pages (double spaced, times new roman
12pt., 1-inch margins) Do not repeat the question in the answer. Each memo must include
an explanation of the relevant code sections, regs and/or other relevant controlling
authority such as case law. Don’t just cite the rules or cases, explain them and their
application to the specific facts in the questions.
Questions:
1. Threads Inc. wants to buy TicTak Corp. for $500. Purls (the sole shareholder of TicTak)
wants to receive $2,000 for his 200 shares. TicTak has $1,500 available in cash and can
redeem 150 of A’s shares for $1,500. Immediately after the redemption, Threads buys
Purl’s remaining 50 shares for $500. At the end of the two transactions, Threads owns
100% of the shares in TicTak. What is the tax treatment to Purl? Applying Zenz, what is
the buyer’s bass?
2. Assume the facts as in Question 1 except, if Threads bought all shares of TikTac without
any redemptions, would Thread’s basis in the stock be different?
3. If Thread is intending to resell the TicTak stock for $3000 after the acquisition, would
you advise Thread to acquire the stock in a Zenz transaction or without the redemption?
Why or why not?
Redemptions
and Partial
Liquidation
SALE OR EXCHANGE VS
DIVIDEND TREATMENT
STOCK REDEMPTIONS
SECTION 302 SAFE
HARBORS
BOOTSTRAP
ACQUISITIONS
What is a Redemption?
Definition: A nonliquidating distribution of cash or property in return for the
corporation’s own stock. Section 317(b).
A redemption alters the capital structure of a corporation by decreasing the
number of outstanding shares. If not pro ratra, the redemption may also alter
the relative ownership interests of the shareholders.
Different than other nonliquidating distributions that don’t alter capital
structure or the relationships between the shareholders and the corporation.
Tax Problem Under the Code:
Distinguishing Sale Redemptions from Distribution
Redemptions under Section 301
The key problem under the code is distinguishing when a redemption should be treated as a
Section 301 distribution or as the sale of stock to the corporation.
Why is this an important tax planning issue?
Individual shareholders prefer sale or exchange treatment because: (1) this allows a basis offset
against any gain that might not otherwise be available if treated as a section 301 distribution; (2) if
the stock has lost value, the shareholder can use the loss for tax purposes at the time of the
redemption; and, (3) while either transaction (sale or 301) allow the shareholder to apply favorable
capital gains rates, shareholders will not be able to use any loss from a distribution treated as a
dividend under Section 302. Remember qualified dividends allow net capital gains only for the
purpose of tax rate provisions in Section 1.
On the other hand, corporate shareholders may prefer to dividend treatment to take advantage of
the Section 243 dividends received deduction. Still, not much of an issue to corporate shareholders.
Tax Treatment to the Shareholder
If qualified as a redemption (Section 317):
◦ Shareholder reports gain or loss on surrender of stock
◦ Gain taxed at favorable capital gains rates (0 percent/15 percent /20 percent)
◦ Shareholder reduces gain by basis in stock redeemed
◦ Capital gains may be offset by capital losses, if available
If not qualified as a redemption (301 distribution):
◦ Shareholder reports dividend income
◦ Individual shareholders may be taxed at 0 percent /15 percent /20 percent rates
◦ But redemption proceeds may not be offset by basis in stock surrendered
◦ Cannot be offset by capital losses
Section 302 Roadmap:
The starting point for resolving the ambiguity
Section 302(b) provides “safe harbor” provisions so shareholders can be certain of sale or exchange
as opposed to dividend treatment. That is the whole purpose of the rule!
The 302 roadmap: 302(a) provides that if the transaction meets one of the four paragraphs under
302(b), the transaction will qualify for a sale or exchange. If not, Section 301 will apply to the
distribution.
302(b) qualifying sale transactions include:
◦ Distributions not essentially equivalent to a dividend (subjective test)
◦ Disproportionate distributions in terms of shareholder effect
◦ Distributions in termination of shareholder’s interest
◦ Partial liquidations of a corporation where shareholder is not a corporation, and either
◦ Distribution is not essentially equivalent to a dividend, or
◦ An active business is terminated
Section 302(b)(1):
The “Meaningful Reduction” Test
Under § 302(b)(1), a redemption qualifies for sale or exchange treatment if “not essentially equivalent to a
dividend”
◦ Subjective test
◦ Provision was added to deal specifically with redemptions of preferred stock
◦ Shareholders often have no control over when preferred shares are redeemed
◦ Also applies to common stock redemptions
To qualify, redemption must result in a meaningful reduction in shareholder’s interest in redeeming corporation
◦ Stock attribution rules apply
Indicators of a meaningful reduction include:
◦ A decrease in the redeeming shareholder’s voting control
◦ Reduction in rights of redeeming shareholders to
◦ Share in corporate earnings, or
◦ Receive corporate assets upon liquidation
Stock Attribution Rules Section 318
“Deemed or Constructive Ownership”
Rule under 302: Qualified stock redemption must result in substantial reduction in shareholder’s
ownership. However, stock owned by certain related parties is attributed back to shareholder whose
stock is redeemed under the “Deemed or Constructive Ownership” Rules:
Family: An individual is deemed to own the stock owned by his or her spouse, children, grandchildren,
and parents (not siblings or grandparents)
Partnership: A partner is deemed to own the stock owned by a partnership to the extent of the
partner’s proportionate interest in the partnership. Stock owned by a partner is deemed to be owned in
full by a partnership.
Corporation: Stock owned by a regular corporation is deemed to be owned proportionately by any
shareholder owning 50 percent or more of the corporation’s stock. Stock owned by a shareholder who
owns 50 percent or more of a regular corporation is deemed to be owned in full by the corporation.
Exceptions to Attribution Rules
Section 302(c)(2)
Family attribution rules can be waived for redemptions in complete
termination of shareholder’s interest
Stock attribution rules do not apply to partial liquidations or
redemptions to pay death taxes
Examples 302(b)(1):
Meaningful Reduction
Rev. Rul. 76-364
There are four shareholders in a corporation – A, B, C, and D. Shareholder A owns 27%,
while Shareholders B, C, and D each own 24.3%. The corporation redeems some of A’s stock,
reducing A’s share of the company to 22.7%, while increasing the proportionate control of
B,C, and D. This particular reduction was meaningful (and therefore warranted capital gains
treatment) because Shareholder A’s vote and value in the corporation declined.
Rev. Rul. 78-401
A 90% shareholder’s stake was reduced to 60% after a partial redemption. This is not a
meaningful reduction because the shareholder still maintains real control over the
corporation. While the reduction was significant, the shareholder did not relinquish control
of the corporation.
Section 302(b)(2):
Substantially Disproportionate Reduction
Two Part Test:
Redemption qualifies as disproportionate redemption if after the
distribution:
◦ Shareholder owns less than 80 percent of the interest owned prior
to redemption and
◦ Shareholder owns less than 50 percent of the total combined
voting power of all classes of stock entitled to vote
Example
Redemption is qualified
disproportionate redemption
because:
◦ Shareholder owns less than
80 percent of the 60 percent
owned prior to redemption
(80 percent × 60 percent = 48
percent), and
◦ Shareholder owns less than
50 percent of total combined
voting power of corporation
Rev. Rul. 75-447
Zenz Transaction
‍ dvice has been requested as to the Federal income tax consequences, in the situations described below, of the
A
redemption by a corporation of part of its stock.
Situation 1
Corporation X had outstanding 100 shares of voting common stock of which A and B each owned 50 shares. In
order to bring C into the business with an equal stock interest, and pursuant to an integrated plan, A and B
caused X to issue, at fair market value, 25 new shares of voting common stock to C. Immediately thereafter, as
part of the same plan, A and B caused X to redeem 25 shares of X voting common stock from each of them.
Neither A, B, nor C owned any stock of X indirectly under section 318 of the Internal Revenue Code of 1954.
Situation 2
Corporation X had outstanding 100 shares of voting common stock of which A and B each owned 50 shares. In
order to bring C into the business with an equal stock interest, and pursuant to an integrated plan, A and B each
sold 15 shares of X voting common stock to C at fair market value and then caused X to redeem five shares from
both A and B. Neither A, B, nor C owned any stock of X indirectly under section 318 of the Code.
Section 302(b)(2) of the Code states that section 302(a), which provides for treating a redemption of stock as a
distribution in part or full payment in exchange for the stock, will apply if the distribution is substantially
disproportionate with respect to the shareholder. Section 302(b)(2) provides, in part:
(2) SUBSTANTIALLY DISPROPORTIONATE REDEMPTION OF STOCK.– (A) IN GENERAL.–Subsection (a) shall apply if
the distribution is substantially disproportionate with respect to the shareholder.
Zenz v. Quinlan
Carl Zenz founded Carl Zenz & Associates Company, a closely held corporation. Zenz died, making his widow
the owner of all 108 issued shares of stock. The wife then decided to sell the business. A prospective buyer
purchased 47 shares of the wife’s stock and then used the E&P of the target company to redeem the
remaining 61 shares held by the wife. This is called a bootstrap acquisition or Zenz transaction because the
buyer is using the assets of the target corporation to redeem the stock of the seller. The buyer bootstraps the
purchase of the target by using the assets of the target to pay for the target.
The Government contended that the redemption was a dividend on the grounds that the result was the same
as if the steps had been reversed, that is, as if the stock had been redeemed first and the sale of stock to the
competitor had followed.
In Zenz v. Quinlivan, 213 F.2d 914 (6th Cir. 1954) the United States Court of Appeals rejected the
Government’s contention and held that the purchase of the stock by the corporation (when coupled with the
sale of stock to the competitor) was not a dividend to the selling shareholder and that the proceeds should be
treated as payment for the stock surrendered under the provisions of the Internal Revenue Code of 1939.
Was there a substantially disproportionate
reduction in Examples 1 and 2?
Rev. Rul.: In determining whether the “substantially disproportionate” provisions of
section 302(b)(2) of the Code have been satisfied in Situation 1 and in Situation 2, it is
proper to rely upon the holding in Zenz that the sequence in which the events (that is,
the redemption and sale) occur is irrelevant as long as both events are clearly part of
an overall plan. Therefore, in situations where the redemption is accompanied by an
issuance of new stock (as in Situation 1), or a sale of stock (as in Situation 2), and both
steps (the sale, or issuance, of stock, as the case may be, and the redemption) are
clearly part of an integrated plan to reduce a shareholder’s interest, effect will be
given only to the overall result for purposes of section 302(b)(2) and the sequence in
which the events occur will be disregarded.
The Computation
Rev. Rul:
Since the Zenz holding requires that effect be given only to the overall result and
proscribes the fragmenting of the whole transaction into its component parts,
the computation of the voting stock of the corporation owned by the
shareholder immediately before the redemption for purposes of section 302(b)
(2)(C)(ii) of the Code should be made before any part of the transaction occurs.
Likewise, the computation of the voting stock of the corporation owned by the
shareholder immediately after the redemption for purposes of section 302(b)(2)
(C)(i) should be made after the whole transaction is consummated. Making the
immediately before and the immediately after computations in this manner
properly reflects the extent to which the shareholder involved in each situation
actually reduces his stock holdings as a result of the whole transaction.
Conclusion
Rev. Rul.: Therefore, for purposes of the computations required by section
302(b)(2)(C) of the Code, A and B, in Situation 1, will each be viewed as having
owned 50 percent (50/100 shares) of X before the transaction and 331/2
percent (25/75 shares) immediately thereafter. In Situation 2, A and B will each
be viewed as having owned 50 percent (50/100 shares) of X before the
transaction and 331/3 percent (30/90 shares) immediately thereafter.
Furthermore, in each situation, the result would be the same if the redemption
had preceded the issuance, or sale, of stock.
Accordingly, in both Situations 1 and 2, the requirements of section 302(b)(2) of
the Code are satisfied.
Section 302(b)(3):
Complete Termination Redemption
Termination of entire interest generally qualifies for sale or exchange treatment. The complete
redemption need not take place in a single transaction, it can be done in a series of redemptions
as part of a “firm and fixed plan” to eliminate the stockholder from the corporations.
The shareholder cannot actually or constructively own stock of any kind, voting or nonvoting, or
common or preferred after the redemption. A Section 302 stock redemption can’t be used when
a corporation has only one stockholder because the corporation can’t own itself.
Caution: The attribution rules apply here, so a redemption might not qualify if family members or
beneficiaries of the shareholder’s estate are shareholders after the redemption.
Family attribution rules will not apply if:
◦ Former shareholder has no interest (other than as a creditor) for at least 10 years after the
redemption
◦ Former shareholder agrees to notify I R S within 30 days of any disallowed interest if acquired
in the 10-year post redemption period and retain all records
Zenz revisited
Zenz v. Quinlivan: The court held that the transaction qualified for Sec. 302(b)(3)
treatment as a termination of the shareholder’s interest because the two
transactions took place as part of one integrated plan. The order of the
transactions does not have any effect on the treatment, as long as it results in a
complete liquidation of the former shareholder’s interest within a short period
of time. This technique is also used in mergers and acquisitions. (week 6)
Planning Tool to Structure Complete Liquidation
Redemption/Buy Sell Agreement
A stock redemption buy/sell agreement is a contractual arrangement between the shareholders and the
corporation in which the corporation is obligated to redeem the shares of a deceased or disabled shareholder.
Upon the death or disability of a shareholder, that shareholder’s stock must be returned to the corporation for
payment according to the terms established in the buy/sell agreement. If the stock redemption agreement is
funded with life insurance or disability insurance, the corporation pays the premiums. Also, the corporation
owns the insurance policy and is the policy’s beneficiary.
Redemptions have complex tax implications and a high potential for adverse income tax consequences:
1.If the corporation pays more than the stock’s fair market value (FMV), the selling shareholder may have
received a gift from the remaining shareholders or compensation from the corporation.
2.If the corporation pays less than the stock’s FMV, the remaining shareholders may have received either a gift
or compensation (Rev. Rul. 58-614).
3.To qualify for sale or exchange treatment, the redemption must meet the applicable requirements. For
example, if the redemption agreement calls for a sale of less than 100% of the shareholder’s interest, the
complete termination or substantially disproportionate requirements of Sec. 302(b) may not be met, causing
the distribution to the shareholder to be taxed as a dividend.
Section 302(b)(4):
Partial Liquidations
To determine if a redemption qualifies for capital gain treatment under this test, the transaction must be
looked at from the perspective of the corporation, not that of the redeeming shareholder. And, this
section only applies to individual, noncorporate shareholders.
Partial liquidation is not defined in the code but has two requirements:
◦ The distribution “is not essentially equivalent to a dividend”(determined at the corporate not at
shareholder level)
◦ Both pursuant to a plan and made within the plan year or within the succeeding taxable year
Not essentially equivalent test looks at effect on corporation, so the test in the Davis case does not
apply. Instead, the test requires a genuine contraction of the business of the corporation.
◦ Difficult to apply due to lack of objective tests
◦ Advanced ruling from I R S should be obtained
Safe Harbor within the Safe Harbor
302(e)(2)
Specifically, there are two main requirements under section 302(b)(4). First, the distribution must be
made in partial liquidation of the corporation, which occurs if the distribution is not essentially
equivalent to a dividend. Again, the phrase “not essentially equivalent to a dividend” is distinct from
the standard, commonly known definition in section 302(b)(1) under the Davis test. Rather, it is defined
as follows for purposes of (b)(4):
•Safe Harbor: A distribution attributable to the corporation ceasing to conduct one qualifying trade or
business falls within a safe harbor definition of a partial liquidation if the corporation continues
conducting another qualifying trade or business. Section 302(e)(2): A “qualified trade or business” is a
business that was actively conducted for the 5-year period ending on the redemption date and that
was not acquired by the distributing corporation during that 5-year period in a gain or loss transaction.
•Corporate Contraction: A distribution resulting from a “genuine contraction” of the corporate business
—including a full or partial sale of the business—is also a partial liquidation. § 1.346-1(a). Determining
whether a corporate contraction has occurred involves several factors, including (a) the presence of a
business purpose, (b) the motivation for the distribution, (c) the amount of reduction in corporate
business activity, and (d) the past dividend policy. Rev. Rul. 74-296
Sale of part or all of a business
Companies may structure such transfers so that their shareholders are taxed at (lower) capital gains
rates and can offset the redemption amount by their stock basis rather than recovering earnings.
Example 1. X, a C corporation, is closely held by individual shareholders and has actively operated
two equally valued businesses for over 5 years: A and B. In Year 1, X sells business A for net proceeds
of $100. Thereafter, X continues to operate business B. X wishes to make a distribution of the
proceeds to all of its shareholders without altering their percentage ownership interests (i.e., pro
rata). X’s E&P is in excess of the $100 net proceeds.
Because X’s E&P exceeds its net proceeds from the sale of business A, the shareholders may prefer
that the distribution be taxed as a capital redemption rather than a dividend. Even if a dividend were
taxed at capital gains rates (as a “qualified dividend”), a capital redemption allows shareholders the
benefit of basis recovery. Thus, X should carry out a distribution of the $100 pro rata to its
shareholders pursuant to a formal plan of partial liquidation. The distribution must be made in Year 1
or Year 2.
Notably, X’s distribution is made in partial liquidation only to the extent of net proceeds from the sale
of business A. Any proceeds X uses to pay off liabilities or for investment in another active business
reduces the net proceeds available for a distribution in partial liquidation.
Section 302 Examples
Section 311 and 312(n)(7)
Tax Consequences to the Corporation on a Redemption
The redeeming corporation generally does not recognize gain or loss, unless it
distributes appreciated property. If appreciated property is distributed, gain to
the corporation will be recognized. 311(b) Losses from the distribution of
depreciated property will not be recognized. 311(a).
Redemptions that are treated as distributions under section 301 reduce E&P
dollar for dollar, but redemptions that are treated as sales affect E&P in a special
way. Section 312(n)(7) says redemptions shall not reduce the corporate E&P by
more than (1) the amount “properly chargeable to earnings and profits,” and (2)
the stock’s ratable share of the E&P. This provision caps the E&P reduction
following a redemption treated as a sale or exchange. For example, if the
corporation completely redeems a 50% shareholder, the redemption distribution
could not generate an E&P reduction greater than the 50% of earning and
profits attributable to the shares redeemed.
Example:
Looking at the “good and bad” tax consequences
Example 1: Company X wants to buy Company Y for $500. Seller A (the sole shareholder of Y)
wants to receive $2,000 for his 200 shares. Y has $1,500 available in cash. Y can redeem 150
of A’s shares for $1,500. Immediately after the redemption, X buys A’s remaining 50 shares for
$500. At the end of the two transactions, X owns 100% of the shares in Y. Thus, X is able to
purchase 100% of the shares of Y for $500, and A receives $2,000 for 100% ownership. Both
transactions are treated as a sale or exchange, resulting in capital gain to A for the amount
received in excess of his tax basis, assuming A held the stock as a capital asset.
In addition, the buyer’s basis in the target will be lower in a Zenz transaction than it would be if
the buyer purchases all of the selling shareholder’s stock.
Example 2: Assume the same facts as in Example 1. Company X now owns 100% of
Company Y, which equals 50 shares. X takes a tax basis in those shares of $500. In contrast,
if X bought all shares of Y without any redemptions, the total tax basis that X would hold
in Y would have been $2,000. Thus, it is clear to see that the stock redemption resulted in
wasted tax basis.
Cont’d
The transaction in Example 2 might result in higher deferred gain, which will be
triggered when X sells Y in the future.
Example 3: Assume the same facts as in Example 2. Three years after
the Zenz transaction, Company X sells 100% of the stock of Company Y for
$3,000. X recovers its tax basis of $500 in the stock of Y and recognizes gain of
$2,500 on the sale. Alternatively, if X had bought all the shares of Y without a
redemption of stock, X would have tax basis of $2,000 in Y’s stock, which would
result in capital gain of $1,000. Thus, the Zenz transactions would result in a
higher gain to X upon sale of $1,500 (the redemption amount).