Redemptions (Portfolio 767)

Tax Management Portfolio, Redemptions, No. 767-3rd, discusses the tax effects of a stock redemption both to the redeeming corporation and the redeemed shareholder and analyzes the categories of §302. In addition to discussing the applicable rules and tax consequences, this Portfolio emphasizes practical problems and planning techniques.

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Tax Management Portfolio, Redemptions, No. 767-3rd, discusses the tax effects of a stock redemption both to the redeeming corporation and the redeemed shareholder and analyzes the categories of §302. In addition to discussing the applicable rules and tax consequences, this Portfolio emphasizes practical problems and planning techniques.
A redemption is a transfer by a shareholder of some or all of his stock to the issuing corporation in return for cash or other property. Section 302 contains the basic tax rules governing redemptions of stock by shareholders.
Section 302 authorizes “exchange” treatment to a recipient of a redemption distribution if: (1) its effect is not essentially equivalent to a dividend; (2) the exchange is “substantially disproportionate;” (3) the shareholder's interest in the corporation is completely terminated; or (4) it is a distribution in redemption of the stock of a noncorporate shareholder in a partial liquidation. If a redemption fails to satisfy any of these tests, the distribution is treated as a §301 distribution.
Section 311 addresses the effect on the issuing corporation of a distribution of property (other than cash or obligations of the issuing corporation), while §312 addresses the effect on the issuing corporation's earnings and profits.
In addition to analyzing the definitional elements and the effects of redemptions, this Portfolio briefly explains the application of the constructive ownership rules of §318 to redemptions.

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Joseph M. Doloboff, J.D. (cum laude), Harvard Law School; B.A., University of North Carolina (Phi Beta Kappa); member, California, District of Columbia and Virginia State Bar; formerly Acting Deputy Tax Legislative Counsel, Department of the Treasury.

George C. Koutouras, LL.M., Georgetown University Law Center; J.D., University of Detroit School of Law; B.S.A., University of Michigan; bar membership, Michigan and Illinois; formerly Attorney/Advisor to Special Trial Judge Stanley J. Goldberg, United States Tax Court.

Bill Ling, CPA; MS in Taxation, Baruch College, The City University of New York; B.S.B.A., American University; member, American Institute for Certified Public Accountants; member, California Society of Certified Public Accountants.


Detailed Analysis

I. Introduction

Introductory Material

A. The Basic Statutory Scheme

B. The Tax Dilemma

C. The Stakes - Sale or Exchange vs. Distribution

1. Individuals

2. Corporations

D. Uses of Redemptions

1. Private Corporations

2. Public Corporations

E. Nontax Restrictions

1. In General

2. Effect of Nontax Restrictions on Federal Tax Consequences

F. Ruling Requests

1. When a Ruling Should Be Sought

2. Procedure for Requesting a Ruling

3. “No Ruling’’ Areas

II. History

III. Definition of a Redemption

Introductory Material

A. In General

1. Timing

2. ‘‘Sale’’ vs. ‘‘Redemption’’

3. Termination of Proprietary Interest of Redeemed Shares

a. The Lisle Case

b. Other Cases and Rulings

4. Repurchase of Option Stock

a. Qualified Stock Options

b. Restricted Stock or Other Property: Section 83

5. Conversion of Convertible Preferred Stock

6. Dealings with Shareholder in Nonshareholder Capacity

a. In General

b. Cross Redemptions

7. Rescission Transactions

a. Annulling a Prior Tax-Free Reorganization

b. Return of Contingent Stock Issued in a Tax-Free Reorganization

c. Reversing a Redemption

8. Reduction in Par Value of Stock

B. Exchange

1. In General

2. Special Cases

a. Theft of Corporate Assets

b. Questions of Fact

(1) Life Insurance Policy

(2) Covenant Not to Compete

(3) “Death Benefit”

(4) Employment and Consulting Agreements

(5) Settlement of Lawsuit

(6) Repayment of Debt

(7) Noncompete Covenants

C. ‘‘Property’’

1. Distributing Company's Own Stock

2. Debt Obligations

3. Stock Rights

4. Assumption of Liability

5. No Consideration

6. Release of Contract Claims

7. Reduction in Shareholder's Debt to Corporation

8. Other Cases

a. Life Insurance Policy

b. Other Agreements

c. Fractional Interest

D. “Stock’’

1. In General

a. Association Taxable as Corporation

b. Interest in Stock Purchase Agreement

c. Warrants and Convertible Debentures

2. Debt-Equity Distinction

3. Determining Outstanding Stock

4. Investment Units of Interest in Mutual Fund

E. ‘‘Shareholder’’

1. Constructive Ownership Rules

2. Voting Trust

3. Community Property

4. Publicly Held Corporations

5. Grantor Trust

6. Testamentary Trust

7. Other Cases

IV. Tax Consequences of a Redemption

Introductory Material

A. Consequences of Exchange Treatment

1. To the Shareholder

a. Computing Gain or Loss

(1) Receipt of More Than Fair Market Value of Stock

(2) Receipt of Less Than Fair Market Value of Stock

b. Basis in Redeemed Stock

c. Basis in Distributed Property

d. Installment Payouts

e. Special Situations

(1) Accrued Dividends on Preferred Stock

(2) Section 306 Stock

(3) Collapsible Corporations

(4) Controlled Foreign Corporation

(5) Tax-Exempt Entities

(6) Noninvestment Purposes

f. Recognition of Loss

(1) Section 267

(2) Nonstatutory Principles

(3) Corporate Note Received: When Loss Realized

2. To the Corporation

a. Recognition of Gain

(1) In General

(2) Exceptions

(a) Debt Obligations of Distributing Corporation

(b) Section 355 Transactions

(c) Reorganizations

b. Basis in Stock Redeemed

c. Effect on Earnings and Profits

(1) Use of Cash or Notes

(2) Use of Property

d. Deductibility of Corporate Payments and Expenses

(1) Judicial Background

(2) The 1986 TRA Enactment of § 162(k)

(3) Amendments to § 162(k) by The Small Business Job Protection Act of 1996

B. Consequences of § 301 Treatment

1. To the Shareholder

a. Rules of § 301

b. Effect of No E & P

c. Amount of Distribution

(1) In General

(2) Corporate Obligation

d. Basis Rules

(1) The Property Received

(2) Disappearing Basis Problem

e. Corporate Shareholders

2. To the Corporation

3. Effect on Earnings and Profits

a. In General

b. Ordinary Dividends, Redemptions Treated as § 301 Distributions, and Redemptions Qualifying Under § 302(a) During the Same Year

V. Section 302(b)(3) - Complete Termination of Shareholder's Interest

A. In General

B. Installment Payout Redemptions

1. In General

2. Debt vs. Equity

3. Private Ruling Policy

a. Reacquisition of Stock

b. Contingent Redemption Price

c. Redemption Followed by Use of Shareholder's Property

d. Fifteen Year Limit on Payments

C. Waiving Family Attribution

1. Introduction

a. Waiver of Family Attribution by Entities

b. Family Attribution Waived for Purposes of § 302(b)(3) Only

c. Continued Interest Not Prohibited if Family Attribution Is Not Involved

2. Community Property

3. ‘‘Interest’’

a. In General

(1) Employee, Officer or Director

(2) Independent Contractor

(a) In General

(b) Tax Court Decisions

(c) Ninth Circuit's Rejection of the Financial Stake or Control Standard

(3) Voting Trustee

(4) Other Relationships

b. Creditor Status

c. Warrants or Convertible Debentures Received in the Distribution

4. Ban on Acquiring Interest for 10 Years

a. Other Corporations

b. Later-Acquired Interests

c. Acquiring Stock Through Bequest or Inheritance; Becoming an Executor or Co-Trustee

d. Effect of Attribution Rules on Reacquisitions of Interest

(1) Family Attribution

(2) Nonfamily Attribution

5. Transfers of Stock During Prior 10 Years

a. Two Different Situations

b. Transfer to Distributee

c. Transfer by Distributee

d. Simultaneous Redemption from Transferee

(1) Limited Scope of the Rule

(2) Transferred Stock Must Be Redeemed

e. Escape Hatch if No Tax Avoidance Purpose

(1) Generally

(2) Rulings

(a) In General

(b) Early Revenue Rulings

(c) 1977-1979 Revenue Rulings

(d) Rev. Rul. 85-19

6. Written Agreement; Statute of Limitations; Record Keeping

a. In General

b. Distributee Dies

c. Agreement Not Timely Filed

(1) Current Regulations

(2) Former Regulations

(a) In General

(b) The Fehrs Case

d. Section 302(b)(5)

e. Section 304(a)(1) Redemption

VI. Section 302(b)(2) - Substantially Disproportionate Redemptions

A. In General

B. Reduction in Percentage Interest in Voting Stock

1. The Basic Test

a. Outstanding Stock

b. Incorrect Application of the Test

c. Minority Interests

d. Test Applied on Shareholder-by-Shareholder Basis

2. Mathematical Formulas

3. Public Company Redemption Offers: Conditional Tenders

C. Reduction in Percentage Interest in Common Stock

1. Only Voting Preferred Owned

2. Planning

D. Less Than 50% Voting Power

E. Nonvoting Stock - Free Ride for Preferred Under Certain Conditions

F. Attribution Rules

1. Generally

2. Use of Attribution Rules to Qualify a Redemption Under § 302(b)(2)

G. What Is Voting Stock and Related Matters

1. Voting Stock

2. Stock Entitled to Vote

3. Total Combined Voting Power

4. Common Stock

H. Related Transactions Under a Plan

VII. Section 302(b)(1) - Not Essentially Equivalent to a Dividend

A. Introduction

B. Legislative History

1. The Sale Analogy

2. 1954 Code

C. Meaningful Reduction Test

1. U.S. v. Davis

a. In General

b. Further Dissenting Views of the Supreme Court

2. “Meaningful Reduction in Proportionate Interest”

a. Proportionate Interest

b. Interest of Officer, Employee, Etc.

c. “Reduction”

d. Meaningful

e. Business Purpose

3. Classes of Stock Covered by § 302(b)(1)

D. Redemption That Fails § 302(b)(2) or § 302(b)(3)

E. Applying § 302(b)(1) Shareholder-by-Shareholder

1. In General

2. The Pro Rata Concept

F. Single Class of Voting Common Outstanding

1. Overview

a. Factual Inquiry

b. What is Meaningful?

(1) Resemblance to Sale to Outsider

(2) Voting Power

2. 100% Shareholder

a. Authorities Since Davis: Summary

b. Discussion

3. Majority Shareholder

a. Authorities Since Davis: Summary

b. Retention or Loss of Control

(1) Pre-Davis Authorities

(2) Reduction to Exactly 50%

(3) Loss of Control While Retaining Over 50% of Stock

(4) The Wright Case

(5) Rev. Rul. 78-401

(6) Other Developments

c. Nonvoting Common Stock

d. Special Problems Under § 304(a)(1)

4. Minority Shareholder

a. Authorities Since Davis: Summary

b. Relation to Control

(1) Pre-Davis Authorities

(2) Control Group

(3) Publicly Held Companies

c. Negative Control

d. Summary

G. Redemption of Preferred Stock

1. In General

a. The “Hypothetical Dividend” Concept

b. Equity Recoupment Theory

2. Redemption of Some or All of the Preferred from Shareholder Who Owns No Common

3. Redemption of Preferred from Owner of All the Common

4. Redemption of Preferred from Owner of Over 50% of Common

5. Redemption of Preferred from Owner of Preferred and a Minority of Common

a. In General

(1) Control Realities

(2) Preferred Held in Proportion to Ownership of Common

b. Other Pre-Davis Authorities

6. Redemption of Preferred from Owner of 50% of Common

H. Redemption of Common from Owner of Common and Preferred

1. Redemption of Common from Owner of Preferred and a Majority of Common

2. Redemption of Common from Owner of Preferred and a Minority of Common

I. Disregarding Attribution Rules in Hostility Situations

1. Basic Problem

2. Qualifying Under § 302(b)(1) Even with Attribution

3. The Davis Decision and Its Progeny

a. Before the Haft Trust Decision

b. The Haft Trust Decision

c. Rev. Rul. 80-26

d. Other Developments

4. Other Aspects of the “Hostility” Concept

a. Nonfamily Discord

b. Must Discord Affect Redeemed Shareholder Directly?

c. Factors Other Than Hostility

d. Burden of Proof

VIII. Partial Liquidation: § 302(b)(4) and § 302(e)

A. In General

B. History

C. The Requirements

1. Introduction

2. Redemption of Stock

3. Plan of Liquidation

4. Distribution Occurs Within the Year the Plan Is Adopted or Within the Succeeding Tax Year

5. Not Essentially Equivalent to a Dividend

a. In General

b. The Safe Harbor - Termination of a Qualified Trade or Business

D. Private Rulings

IX. Constructive Stock Ownership: § 318

Introductory Material

A. Basic Relationships

1. Family Attribution

2. Attribution from Partnerships, Estates, and Trusts

3. Attribution from a Corporation

4. Attribution to a Partnership or Estate

5. Attribution to a Trust

6. Attribution to a Corporation

7. Option Attribution

B. Option Attribution

1. Computing Ownership in Light of Options

2. Cross-Purchase Agreements

3. “Entity” Buyout Agreements

4. Stock Warrants

a. Bailout Potential?

b. Use by Publicly Held Companies

X. Bootstrap Acquisitions and Related Topics

A. Introduction

B. Seller Redeems in Connection with Disposition of Shares

1. Straight Sale

2. “B” Reorganization

3. Reverse Cash Merger

4. Recapitalization

5. Retention of Interest by Distributee

C. Dividend Strip by Seller

D. Buyer Redeems or Strips Dividend After Sale

E. Transactions Treated as Redemptions

1. LBO Structures

2. Reverse Stock Split

XI. Other Special Issues

A. Substance vs. Form

1. In General

2. Redemption or Joint Venture

3. Exchange of Shareholders’ Interests

4. Distributing and Redeeming Subsidiary Stock

5. Sale vs. Redemption

6. May Department Stores Transaction

7. General Step Transaction Principles

B. Redemptions in Connection with Reorganizations

C. Section 304

D. Section 305

E. Section 303

F. Section 306

G. Greenmail Payments

H. Reporting Requirements

1. Reporting Requirements Under § 6043(a)

2. Reporting Requirements Under § 6043(c)

3. Reporting Requirements Under § 302

a. Reporting Requirements of the Shareholder Whose Stock Is Redeemed

b. Reporting Requirements in Redemptions That Terminate a Shareholder's Interest; Waiver of Family Attribution Rules by Individuals

4. Reporting Requirements Under § 6045B


Working Papers

Table of Worksheets

Worksheet 1 Overview of § 302(b)(2) Disproportionate Redemption Formulas

Worksheet 2 Section 302(b)(2) Redemption from a More Than 62.5% Shareholder Where There Is One Class of Voting Common Stock

Worksheet 3 Section 302(b)(2) Redemption from a 62.5% or Less Shareholder Where There Is One Class of Voting Common Stock

Worksheet 4 Section 302(b)(2) Redemptions From Two or More 62.5% or Less Shareholders Where There Is One Class of Voting Common Stock

Worksheet 5 Disproportionate Redemption Under § 302(b)(2) - More Than One Class of Common Stock - Fair Market Value Test

Worksheet 6 Rev. Proc. 86-18, 1986-1 C.B. 551

Worksheet 7 Facts and Circumstances Statement Regarding Redemption

Worksheet 8 Statement by Redeemed Shareholder Under § 302(c)(2)(A)(iii) to Avoid Family Attribution Rules

Worksheet 9 Redeemed Shareholder's Notice of an Acquisition of a Prohibited Interest



Statutes and Regulations:

Legislative History:

Treasury Rulings: