Overview Corporate Stock Redemptions

Distributions in Redemption of Stock and Partial Liquidations: Synopsis A dividend results in ordinary income to the extent of earnings and profits, whereas a sale or exchange can result in the more preferential capital gain treatment. A sale or exchange typically occurs when a shareholders sells stock to a third party. A transfer of the shares back to the corporation also qualifies as a sale or exchange and is known as a "redemption." Consequently, many corporations, especially closely held corporations, will seek to engineer a redemption that is the functional equivalent of a dividend (payout of earnings and profits with no practical loss in voting power or control. Code !ec. "#$ addresses this planning opportunity by specifying the circumstances that will result in dividend income and those that, with proper planning, can result in capital gain or exchange treatment. Capital gain vs. ordinary income A shareholder%s transfer of shares to another person for full value is usually considered a sale. A transfer of the same shares for the same price back to the issuing corporation, however, is not necessarily a sale, but could be a redemption ( Code !ec. "#& or a liquidating distribution ( Code !ec. "&' . (istorically, the underlying concern of Congress has been to limit the capital gain benefits associated with a sale to a distribution which is "not essentially equivalent to a dividend." )or example, the sole shareholder of a closely*held corporation could easily forego annual dividends and "sell" a portion of his holdings back to the corporation for an amount equivalent to the accumulated earnings and profits. +n substance, this is nothing more than the functional equivalent of a dividend, earnings have been distributed with no change in ownership, control or voting power. -oncorporate shareholders may prefer capital gain treatment to dividend treatment if the corporation has earnings and profits. +f the redemption payments are treated as a dividend, the entire amount paid will be taxable to the noncorporate shareholder if it does not exceed the earnings and profits of the corporation. (owever, if the redemption is treated as an exchange of stock, the amount received will generate capital gain (regardless of the corporation%s earnings and profits only to the extent that it exceeds the shareholder%s basis in the stock. Capital gain treatment may also be advantageous in that capital gain can be fully offset by capital loss. .rdinary income is limited to the extent that it can be offset by capital loss. -oncorporate taxpayers may offset capital losses dollar*for*dollar against up to /",### of ordinary income (0"#,"1$.#2 . Corporate shareholders may prefer dividend treatment to sale or exchange treatment because of the 3#*percent dividends*received deduction (2## percent for dividends received from a small business investment company or for qualifying dividends described in Code !ec. $&"(b (2 and 4# percent for corporations that own less than $# percent of the distributing corporation available to corporations (see 02",#54.#2 . All corporate capital gains, whether long*term or short*term, are taxed at the corporation%s regular tax rate, which can be as high as "5 percent. Redemption defined A stock redemption occurs when a corporation reacquires its stock in exchange for property, whether or not the stock is canceled, retired, or held as treasury stock. 6he term "property" means any property, including money, securities, and indebtedness to the corporation except stock or rights to acquire stock in the corporation making the distribution.

6he redemption of stock by a corporation can be treated as an exchange, rather than a dividend, if one of four tests is met (see 025,""#.#$" . 6hese tests are described more fully below. Redemption treated as exc ange A redemption of stock by a corporation can be treated as a distribution in part or full payment in exchange for the stock ( i.e., a sale or exchange and gains or losses to stockholders from such redemptions will be capital gains or losses, rather than distributions under Code !ec. "#2 (which are usually dividends taxable as ordinary income , if any one of the following applies, (2 the redemption is not essentially equivalent to a dividend ( Code !ec. "#$(b (2 ( 025,""#.#$& 7 ($ the redemption is substantially disproportionate with respect to the shareholder%s actual or constructive holdings ( Code !ec. "#$(b ($ ( 025,""#.#$5 7 (" the redemption terminates the shareholder%s entire interest in the corporation Code !ec. "#$(b (" ( 025,""#.#$' 7 or (& the redemption is of stock held by a noncorporate shareholder and is made in partial liquidation of the redeeming corporation Code !ec. "#$(b (& ( 025,""#.#$4 . Redemption treated as a dividend !! "d#ustment to basis of remaining stock +n any case in which an amount received in redemption of stock is treated as a dividend rather than a sale, the shareholder must ad8ust the tax basis of the remaining stock ( 9eg. :2."#$*$(c . 6he problem arises because the shareholder has surrendered shares in the redemption transaction even though the redemption was not recogni;ed for tax purposes. )or example, if a sole stockholder holds 2,### shares of stock which cost him /2## a share, or /2##,###, and half the stock is redeemed for /25#,###, which constitutes a dividend (there being at least /25#,### in available earnings and profits , the basis of the remaining 5## shares is still /2##,###, or /$## a share. 6he same result would apply if a husband and wife together own all the stock, the wife%s having been acquired by gift from her husband. +f all the husband%s shares are redeemed in a transaction amounting to a dividend in the amount of the entire proceeds of the redemption, the basis of the wife%s shares after the redemption is the entire basis of both husband%s and wife%s shares before the redemption ( 9eg. :2."#$*$(c , Example 2

Qualified Redemptions --Code Sec. 302

Redemptions $ot %ssentially %quivalent to a Dividend & Code Sec. '()*b+*,+ 6o be "not essentially equivalent to a dividend" the redemption, after application of the constructive ownership rules, must result in a meaningful reduction of the shareholder%s proportionate interest in the corporation ( M.P. Davis, !Ct, 4#*2 <!6C 01$31, at 025,""#.2"25 . 6his vague standard makes the determination dependent upon the facts and circumstances, and does not easily lend itself to clear guidelines. )or example, a minority shareholder in a large publicly*held corporation received a dividend distribution where his proportionate interest in the corporation prior to a tender offer by the corporation for its own stock was exactly the same as after such offer was accepted and the stock redeemed, even though only about 2# percent of

shareholders tendered a portion of their stock to the corporation ( 9ev. 9ul. 32*$31, at 025,""#.2"25 . 6he redemption of a portion of a sole shareholder%s stock will always result in the transaction being classified as a distribution that is sub8ect to the dividend rules of Code !ec. "#2. 6he same is generally true when the redemption is pro rata, particularly if there is only one class of stock. )actors to be considered in determining whether a reduction in a shareholder%s proportionate interest in a corporation results in a meaningful reduction include the shareholder%s ability to control the corporation, any retained right to a share of the corporation%s earnings, and retained rights upon liquidation of the corporation ( 9ev. 9ul. 45*5#$, at 025,""#.2"12 and M.G. Roebling, =ec. "3,#"1, at 025,""#.25"5 . According to the +9!, a reduction from 1# percent to '# percent was not a meaningful reduction because the redeeming shareholder still had control of the corporation ( 9ev. 9ul. 43*&#2, at 025,""#.2"12 . (owever, the <.!. !upreme Court has held that where a taxpayer%s interest in the surviving corporation of a reorgani;ation was reduced $1 percent by a cash distribution and the taxpayer held less than 5# percent of the voting stock after the reorgani;ation, there was a meaningful reduction in the taxpayer%s proportionate interest in the corporation ( D.E. Clark, 31*2 <!6C 01$"#, at 025,""#.2'"" . A meaningful reduction in ownership often results from a redemption that fails to qualify either as a complete termination of a shareholder%s interest or as a substantially disproportionate redemption. !ee, 025,""#.#$5 and 025,""#.#$'. !ome examples are, (2 A redemption resulted in a reduction in the taxpayer%s stock ownership from $4 percent to $$ percent, leaving him with slightly more than 3# percent of the stock he formerly held before the redemption but preventing him from exercising control over the corporation even if he acted in concert with any one of the other three shareholders (all of whom were unrelated to the taxpayer . ($ A redemption resulted in a reduction in the taxpayer%s stock ownership from 54 percent to 5# percent, but left control of the corporation%s stock equally divided between the taxpayer and an unrelated individual ( 9ev. 9ul. 45*5#$, at 025,""#.2"12 and M.G. Roebling, =ec. "3,#"1, at 025,""#.25"5 . (" A redemption left a minor shareholder owning 1'.4 percent of the stock he previously held (due to the operation of the attribution rules but represented only a fraction of the corporation%s total stock (several hundred out of $3 million ( 9ev. 9ul. 4'*"35, at 025,""#.2"1& . >oreover, partial redemptions of nonvoting stock may qualify as redemptions that are not essentially equivalent to a dividend ( Roebling, 025,""#.25"5 . )or example, redemption of nonvoting, nonconvertible, nonparticipating preferred stock that is not "section "#' stock" and that is owned by a person who does not own any common stock is not equivalent to a dividend ( 9ev. 9ul. 44*&$', as clarified by 9ev. 9ul. 32*&2, at 025,""#.25"5 . +n addition, redemptions of fractional shares may qualify as redemptions entitled to be treated as a sale or exchange. )or example, redemptions that result in the payment of cash for fractional shares are not treated as potential dividend distributions where the cash is not a separately bargained*for consideration but is paid by the corporation to avoid having fractional shares ( 9ev. 9ul. 4&*"', at 025,""#.2"#5 . 6he stock attribution rules of Code !ec. "23 apply in determining whether a redemption is essentially equivalent to a dividend (M.P. Davis, !Ct, 4#*2 <!6C 01$31, at 025,""#.2"25 . Consequently, for many closely held family corporations, the attribution rules will often prevent a

redemption from qualifying as not essentially equivalent to a dividend ( 9ev. 9ul. 55*525, at 025,""#.2"13 . (owever, a dispute exists as to whether the stock attribution rules can be mitigated by proof of antagonism between related parties (see 025,""#.#$&3 . Code Sec. '()*b+*,+: "ttribution rules in family disputes +n its 214# decision in M.P. Davis ( 4#*2 <!6C 01$31, at 025,""#.2"25 , the <.!. !upreme Court held, (2 that the attribution rules of Code !ec. "23 apply in testing whether a stock redemption is "essentially equivalent to a dividend" under Code !ec. "#$(b (2 , and ($ that, in determining dividend equivalence, the "business purpose" for the redemption is irrelevant. 6he test is simply whether there has been a "meaningful reduction in the shareholder%s proportionate interest", with the reduction being considered after applying the attribution rules. 6he Davis case by no means answered all of the difficult questions that arise under Code !ec. "#$, and some commentators have argued that the decision might leave room for ignoring the attribution rules in situations of family disharmony. 6he basic thought underlying the !ec. "23 attribution rules is that the parties among whom the ownership of stock is attributed will act in concert and for the benefit of each other. 6his assumption, however, is arguably inappropriate in cases where the parties are at sword%s point. +n its pre* Davis decision in A.H. S !ier Estate ( =ec. $&,425, at 025,""#.2"11 , the 6ax Court refused to find dividend equivalence where "#? of the stock of an estate was redeemed, but where **by virtue of the attribution rules **the proportionate interest of the estate was reduced only from '"."#? to 5'.32? (leaving the estate with control and with a post*distribution proportionate interest that was 31.4&? of its pre*distribution proportionate interest . A ma8or reason for the decision was the existence of a serious disagreement between the executor of the estate and the stockholders whose stock was deemed to be owned by the estate under the attribution rules. !ee also annotations at 025,""#.2"$7 H.C. Parker, =ec. $&,425, at 025,""#.2"11. Although the 6ax Court ( Robin Ha"t #r!st, 45*2 <!6C 01$#1, at 025,""#.2"11 has taken the position that the family dispute rationale of S !ier is inconsistent with Davis, the Court of Appeals for the )irst Circuit, on appeal, ruled that family hostility can mitigate the constructive ownership rules in determining whether a stock redemption is essentially equivalent to a dividend, since hostility can in fact result in a meaningful reduction of a shareholder%s interest in a corporation. 6he case was remanded for determination of the effect of family discord on redemption of the stock of four trusts that benefited a principal shareholder%s children. !ee 025,""#.2"11. (+n reviewing Davis, the 6ax Court, in Robin Ha"t #r!st, read that decision as attempting to bring a measure of certainty to a highly confused area. +t then noted that much of this certainty would be lost if the courts were to undertake the task of inquiring into the existence of intra*family hostility, whether it was serious, and whether it would actually or probably impair the ability of one member of the family to influence the conduct of other members. 6he +9! views the attribution rules under Code !ec. "23 as requiring mechanical application and, except for certain taxpayers who may have relied on its subsequently withdrawn acquiescence in S !ier, will not follow the )irst Circuit%s decision in Ha"t ( 9ev. 9ul. 3#*$', at 025,""#.2"11 . 6he 6ax Court reiterated its position regarding the application of attribution*of*stock*ownership rules to redemptions caused by family hostility in Davi$ Met%ger #r!st ( 3$*$ <!6C 01423, at 025,""#.2"11 which aligns the 6ax Court squarely with the +9!%s position that family hostility does not prevent the application of the stock attribution rules. As a practical matter, family hostility will be a factor in determining dividend equivalency only where a shareholder unrelated to the redeeming shareholder is involved. @ecause the unrelated shareholder%s stock will not be attributed to the redeeming shareholder, a reduction of the redeeming shareholder%s

proportionate interest may be possible. +n both the 6ax Court%s and the +9!%s views, only at this point may family hostility become a factor, and then only in determining whether the reduction was meaningful (caused a loss of control over the corporation . !ee 9ev. 9ul. 45*5#$, at 025,""#.2"12. Code Sec. '()*b+*)+: Substantially disproportionate distributions A distribution of earnings and profits (dividend is typically made pro*rata among the shareholders and, thus, conforms to their relative ownership interests. +f the distribution is substantially disproportionate, the redemption is treated as a sale or exchange, with any gain treated as capital gain, and with no danger of any portion of the gain being taxed as ordinary dividend income to the shareholder whose stock is redeemed. As to whether other shareholders may be deemed to have received a constructive dividend, see 025,""#.2'", 025,""#.5# and 025,""#.5". Substantially disproportionate defined A non*pro*rata distribution may qualify as an exchange, provided the following mechanical tests are met immediately after the redemption, (2 the stockholder owns less than 5# percent of the total combined voting power of all classes of stock immediately after the redemption, ($ the ratio of his holdings of voting stock immediately after the redemption to all the voting stock in the corporation at that time is less than 3# percent of the ratio which the voting stock he owned immediately before the redemption bore to the entire voting stock in the corporation at that time, and (" the stockholder%s ownership of common stock (whether voting or nonvoting after and before redemption also meets the 3# percent test. 6hese tests will be applied to each stockholder individually, regardless of the effect of the distribution on the other stockholders. )urther, the redemption must not be pursuant to a plan the purpose of which is a series of redemptions which result in the aggregate in a distribution which is not substantially disproportionate. Ahere events are clearly part of an overall, integrated plan to reduce a shareholder%s interest in a corporation, the sequence of events will be disregarded **effect being given only to the overall result **in determining whether a distribution is substantially disproportionate in a plan calling for a stock redemption accompanied either by an issuance of new stock or by a shareholder%s sale of stock ( 9ev. 9ul. 45*&&4, 025,""#.'4 . Bery often, competing shareholders may redeem their shares for independent reasons in separate transactions. -onetheless, the two redemptions can be considered in the aggregate (pursuant to Code !ec. "#$ (b ($ (= where one shareholder%s redemption is undertaken with knowledge of the impending redemption of the second shareholder, even though there is no agreement between the two. !ee annotations at 025,""#.'4. 6he constructive ownership rules (see Code !ec. "23 apply when making a determination as to whether a redemption is substantially disproportionate. Example 1: C corporation has one class of stock, voting common, 2## shares of which are outstanding immediately before a redemption. !mith owns 4# shares, Dones owns $5 shares and 6aylor owns 5 shares. 6he shareholders are not related. C redeems 5# shares of !mith%s stock, ' shares of Dones% stock and & shares of 6aylor%s stock for a total of '# shares redeemed.

+n order to determine whether the redemption is substantially disproportionate with respect to any of the aforementioned shareholders, the following chart may be used, Before Redemption Shares Shareholders Owned Total % Smith ............. 70 100 70 Jones ............ 25 100 25 Taylor ........... 5 100 5 After Redemption Shares Owned Total % 20 40 50.0 19 40 47.5 1 40 2.5

Aith respect to !mith, the redemption is not substantially disproportionate because, although his current holdings ratio (5#? is less than 3#? of his previous holdings (4#? 3#? E 5'? , his stock ownership after redemption is exactly 5#? of all of the outstanding voting stock, but the law requires his stock ownership to be less than 5#? in order for the redemption to qualify as substantially disproportionate with respect to him (such a redemption may, however, qualify as a distribution not essentially equivalent to a dividend . Aith respect to Dones, the redemption is not substantially disproportionate either. Although he owns only &4.5? of all outstanding voting stock after redemption, his holdings ratio after the redemption is greater than his holdings ratio before the redemption (&4.5? v. $5? . Aith respect to 6aylor, the redemption would qualify as substantially disproportionate. (er percentage of ownership in the corporation is well below 5#? after the redemption ($.5? and her holdings ratio after the redemption ($.5? is less than 3#? of her holdings ratio before the redemption (5? 3#? E &? . Example 2: Assuming the same facts as in the immediately preceding example, with the exception that !mith is related to 6aylor, the redemption of four shares of 6aylor%s stock does not qualify as substantially disproportionate. 6aylor is treated as owning the shares owned by !mith both before and after redemption. Consequently, although 6aylor%s holdings ratio immediately after the redemption ( $2F&#or 5$.5? is less than 3#? of her holdings ratio before the redemption ( 45F2## 3#? E '#? , she is treated as owning 5$.5? of all of the voting stock after the redemption.

Code Sec. '()*b+*'+: Redemptions in complete termination of a s are older-s interest As a result of the operation of the attribution rules of Code !ec. "23, a shareholder in a family* owned, closely*held corporation may find it difficult to successfully effect a substantially disproportionate distribution. 6hus, Code !ec. "#$(b (" provides that a redemption in &omplete redemption of the shareholder%s stock in the corporation will be treated as an exchange. +f in complete redemption, then no part of the distribution is taxable as a dividend. +f not, further tests must be met in order to determine whether a dividend may be involved. Application of the constructive ownership rules in Code !ec. "23 can disqualify a sale of all shares actually owned by the shareholder. .ermination of Stock older/s 0nterest !!Code Sec. '()*b+*'+: 1aiver of family attribution rules As mentioned above, shareholders in a family*owned business may find it difficult to effect a substantially disproportionate distribution and thereby avail themselves of sale or exchange treatment. 9elief from this result is available, however, through waiver of the family attribution

rules by the distributee under certain conditions. Aaiver is permitted if, immediately after the redemption, the distributee has no interest in the corporation (e.g., as an officer, director, or employee other than as a creditor, acquires no such interest for 2# years after the redemption, and files an agreement with the +9! that the distributee will notify it of any interest acquired during the 2#*year period. 6he +9! has clarified the requirements for filing the agreement with respect to tax years beginning on or after >ay "#, $##'. 6he agreement must be in the form of a statement that has this title, "!6A6G>G-6 H<9!<A-6 6. !GC6+.- "#$(c ($ (A (iii @I J+-!G96 -A>G A-= 6ACHAIG9 +=G-6+)+CA6+.- -<>@G9 (+) A-I .) 6ACHAIG9 .9 9GKA6G= HG9!.-, A! 6(G CA!G >AI @GL, A =+!69+@<6GG (.9 9GKA6G= HG9!.- .) J+-!G96 -A>G A-= G>HK.IG9 +=G-6+)+CA6+.- -<>@G9 (+) A-I .) =+!69+@<6+-M C.9H.9A6+.-L". 6he statement must be included on or with the distributee%s first tax return for the tax year in which the distribution occurs. +f the distributee is a controlled foreign corporation ( Code !ec. 154 , each <nited !tates shareholder ( Code !ec. 152(b must include the statement on or with its tax return ( 9eg. :2."#$*&(a . 6he statement must include a representation that, (2 6he distributee (or related person has not acquired , other than by bequest or inheritance, any interest in the corporation (as described in section "#$(c ($ (A (i since the distribution7 and ($ 6he distributee (or related person will notify the +nternal 9evenue !ervice of any acquisition, other than by bequest or inheritance, of such an interest in the corporation within "# days after the acquisition, if the acquisition occurs within 2# years from the date of the distribution. 6he requirements for the form of agreement as described above are effective for tax years beginning on or after >ay "#, $##'. 6axpayers may also follow this procedure with respect to an original income tax return, and any amended return that is filed on or before the due date (including extensions of the original return, where a timely filing occurs on or after >ay "#, $##' ( 9eg. :2."#$*&(h . +f, during the 2#*year period, the shareholder and unrelated persons organi;e a new corporation that acquires a division of the redeeming corporation, this would not be sufficient reason to require the shareholder to notify the +9! ( 9ev. 9ul. 4'*&1', at 025,""#.2""" . An "interest in a corporation" for determining whether a waiver of attribution agreement is ineffective ( Code !ec. "#$(c ($ (A , thereby preventing termination of a stockholder%s entire interest under Code !ec. "#$(b (" , is different from the interest that must be terminated in order for the stock redemption rules to apply (and the stock dividend rules not to apply . A Code !ec. "#$(b (" "interest" is outright andFor constructive stock ownership and includes a beneficial interest. !ee 025,""#.4# and 025,""#.4#'. 6hus, a former shareholder is treated as having retained an "interest in the corporation" by being (2 a voting trustee of a trust that holds the remaining corporate stock for the benefit of the shareholder%s children ( 9ev. 9ul. 42*&$' at 025,""#.2"&2 and ($ the custodian of stock held under the <niform Mift to >inors Act ( 9ev. 9ul. 32*$"" at 025,""#.2"&2 . .n the other hand, a former shareholder can be a lessor of a building that is rented by the corporation without possessing an "interest" ( 9ev. 9ul. 44*&'4, at 025,""#.2&$' . 6he +9! maintains that performance of services under a long*term contract to perform consultant and advisory services for a corporation is an "interest in the corporation" for waiver purposes (

9ev. 9ul. 4#*2#& at 025,""#.2"$1 . (owever, the 6ax Court has held that an employment relationship did not constitute an "interest" where, (2 6he former shareholder was employed as an independent contractor, performing services of the same nature, extent and quality as would be provided to any other employer7 ($ .perating policy was set by the corporation, i.e., the former shareholder was implementing, not making, policy decisions7 (" 6he former shareholder%s employment was terminable at will by the corporation7 and (& 6he remuneration of the former shareholder was not keyed to profits, but was reasonable compensation for the services actually performed ( M. 'ennar$ Est. =ec. "$,&"&, at 025,""#.2"$1 . Conversely, the 6ax Court has found that a former shareholder retained an interest in the redeeming corporation from a management contract with another corporation through which he was able to exercise sufficient control over the redeeming corporation ( (. C)ertko", 32*2 <!6C 01&'$, at 025,""#.2"$3 . 6he 6ax Court ( '.*. Se$a, =ec. &2,#'4, at 025,""#.2""" has held that a family member who continues to work for a closely held family corporation after it has redeemed all of his stock has an interest in that corporation that undermines the waiver of constructive ownership provisions as applied to the redemption. A "prohibited interest" had previously been defined by the 6ax Court as a financial stake in or managerial control of a corporation (as in C)ertko" . Se$a adopts a more literal, stricter interpretation of this term. 6hus, a family corporation shareholder may now run a greater risk that a complete redemption of his shares will not be classified as an exchange and that the redemption proceeds will not qualify for capital gain treatment where, after the redemption, he continues in an advisory capacity in order to aid family members in running the corporation. .ermination of Stock older/s 0nterest !!Code Sec. '()*b+*'+: Constructive o2ners ip -ot only must the shareholder be divested of all interest in the corporation, but no stock in the corporation may be held by such related interests as a partnership related to a partner (and vice versa , an estate related to a beneficiary and vice versa, a trust related to its beneficiaries (not including a remote contingent interest , a beneficiary related to a trust, a trust related to its grantor as substantial owner of the trust corpus, or a corporation related to its controlling (5#*percent or more ownership stockholder. -or may the stockholder have an option to acquire stock in the corporation. 6hus, in 9ev. 9ul. 5'*2#", at 025,""#.2"$3, an estate%s interest was not regarded as terminated, even though all its stock was redeemed, where a beneficiary continued to hold shares in the corporation. )or a detailed discussion of the constructive stock ownership rules, see 025,1#'.#2 et seq. .ermination of Stock older/s 0nterest !!Code Sec. '()*b+*'+: 1aiver by entities <nder the stock attribution rules of Code !ec. "23, stock attributed to an individual because it is owned by a member of his family may be reattributed to an estate or trust of which the individual is a beneficiary, to a partnership in which he is a member, or to a corporation in which he is a stockholder.

Example 3: Dim !mith is the beneficiary of a trust that owns corporate stock, all of which is being redeemed. Although !mith owns no stock in the corporation, his son Dohn does own stock in the corporation that is not being redeemed. Consequently, since !mith is considered to own the stock of Dohn, the trust, in turn, is deemed to own the stock actually owned by Dohn. An entity to which stock is reattributed (either a trust, an estate, a partnership, or a corporation may waive the family attribution rule, provided that it is also waived by the person through whom the stock is attributed to the entity (e.g., Dim !mith in the above example . @oth an entity and an individual must meet the waiver requirements (see 025,""#.2""2 and agree to be 8ointly and severally liable for additional tax if stock in the redeeming corporation is acquired by either within the 2#*year period ( Code !ec. "#$(c ($ (C (ii . An entity may not waive any attribution rules other than the family attribution rules. Ahere the beneficiary of a trust is considered to be its owner under Code !ec. '42 through Code !ec. '43, a redemption of the trust%s stock is considered to be a redemption of the beneficiary%s stock ( 9ev. 9ul. 4$*&42, at 025,""#.2"$' . <nder such circumstances, waiver of family attribution by the trust would presumably not be required7 waiver by the beneficiary would seem to be sufficient, since a reacquisition by the trust would be considered a reacquisition by the beneficiary. +n cases where an individual dies after having his stock redeemed but before he makes an effective waiver of family attribution, the executor of his estate is permitted to execute the waiver. Partially Liquidating Distributions !!Code Sec. '()*b+*3+: Distributions in partial liquidation to noncorporate s are olders A distribution by a corporation to a non&orporate shareholder in redemption of that shareholder%s stock will qualify the redemption for sale or exchange treatment if it is made in partial liquidation of the corporation. A distribution is made in partial liquidation if it is not essentially equivalent to a dividend (determined at the corporate rather than the shareholder level , is pursuant to a plan, and occurs within the tax year in which the plan is adopted or within the succeeding tax year ( Code !ec. "#$(e . +f a distribution qualifies as being in partial liquidation, it need not satisfy any of the requirements relating to disproportionate distributions, distributions in complete termination of the shareholder%s interest or lack of shareholder*level dividend equivalency. A distribution will be considered not to be the equivalent of a dividend, as determined at the corporate level, if the following conditions are met, (2 6he distribution must be attributable to the cessation by the distributing corporation of the conduct of a trade or business that was actively carried on, for a period of five years preceding the date of redemption, by the corporation or by a predecessor from whom the business was acquired in a transaction in which no gain or loss was recogni;ed. (owever, the distribution may take the form of the proceeds from the sale of the discontinued assets of the business, of the current assets of that business, or a combination of assets and sale proceeds. ($ +mmediately after the distribution, the distributing corporation must be actively engaged in conducting another trade or business that also had been carried on for at least five years before the date of redemption by the corporation or by a predecessor from whom it was acquired in a nonrecognition transaction. 6he distribution of a reserve that is not needed for expansion of a business is not a partial liquidation ( 9eg. :2."&'*2 . !imilarly, where a corporation has accumulated a substantial amount of earnings, but, because of a decline in the demand for its products, distributes cash reali;ed

from the sale of portfolio bonds and excess inventories in redemption of a part of its stock, the distribution is not a partial liquidation ( 9ev. 9ul. '#*"$$, at 025,4#&.&$' . Also, in case of a condemnation that does not reduce business, if the corporation continues to operate for a considerable time at the same pace as maintained before the condemnation, the proceeds distributed in redemption of the corporation%s stock are not considered to have been distributed in a partial liquidation ( 9ev. 9ul. '4*2', at 02',"'2.21"" . .n the other hand, a partial liquidation will not be upset merely because the right to receive payments on a note (rather than the note itself given by the purchaser of part of the corporation%s business was distributed to the shareholders ( 9ev. 9ul. 44*2'', at 02',"'2.$"$5 . +n determining whether a distributee is a noncorporate shareholder, stock owned by a partnership, estate or trust will be treated as if held proportionately by its partners or beneficiaries. 6hus, for example, if a distribution in partial liquidation is made to a partnership in which a corporation and an individual each has a 5#*percent interest in the capital and profits of the partnership, only 5# percent of the distribution will qualify as received in exchange for stock.

S are older Reporting Requirements 9eporting requirements for tax years beginning on or after >ay "#, $##' have been clarified. A significant holder that transfers stock to the issuing corporation in exchange for property from the corporation must furnish a statement to the +9! if the transaction is an exchange that is not taxable as a dividend. 6he statement must be included on or with the tax return for the tax year in which the exchange occurs. A significant holder is a person who, immediately before the exchange, owned at least the threshold amount of stock as measured by vote or value. )or publicly traded stock, the threshold amount is 5 percent of the total outstanding stock of the issuing corporation. )or stock that is not publicly traded, the threshold amount is 2 percent of the total outstanding stock of the issuing corporation. +f the significant holder is a controlled foreign corporation ( Code !ec. 154 , each <nited !tates shareholder ( Code !ec. 152(b is required to file a statement. !tock is "publicly traded" if it is listed on a national securities exchange that is registered under section ' of the !ecurities Gxchange Act of 21"&. !tock is also "publicly traded" if it is listed on an interdealer quotation system sponsored by a national securities association that is registered under section 25A of the !ecurities Gxchange Act of 21"&. 6he "issuing corporation" means the corporation that issued the shares of stock that are transferred in the exchange. 6he statement must have this title, "!6A6G>G-6 H<9!<A-6 6. : 2."#$*$(b ($ @I J+-!G96 -A>G A-= 6ACHAIG9 +=G-6+)+CA6+.- -<>@G9 (+) A-I .) 6ACHAIG9L, A !+M-+)+CA-6 (.K=G9 .) 6(G !6.CN .) J+-!G96 -A>G A-= G>HK.IG9 +=G-6+)+CA6+.- -<>@G9 (+) A-I .) +!!<+-M C.9H.9A6+.-L." 6he following information must be included in the statement, 6he fair market value and basis of the stock transferred by the significant holder to the issuing corporation7 and A description of the property received by the significant holder from the issuing corporation. )or the purposes of this statement, the taxpayer%s good faith estimate of fair market value will be accepted. 6he taxpayer%s estimate of basis will be accepted by the +9! if, (a the basis is not relevant to the determination of taxable income for that tax year, and (b the taxpayer cannot

precisely determine basis ( 6.=. 1$'& (>ay "#, $##' . 6his reporting requirement applies to tax years beginning on or after >ay "#, $##'. (owever, taxpayers may use this procedure with respect to an original )ederal income tax return, and any amended return that is filed on or before the due date (including extensions of the original return, where a timely filing occurs on or after >ay "#, $##' ( 9eg. :2."#$*$(d . 6he statement described above is not used if the transaction is a corporate liquidation. 6he reporting requirements for a corporate liquidation are given in 9eg. :2.""2*2. )or tax returns filed before >ay "#, $##', the shareholder was required to report the "facts and circumstances" of the exchange on the tax return (9eg. :2."#$*$(b , prior to amendment by 6.=. 1$'& (>ay "#, $##' and 6.=. 1"$1 (Dune 2&, $##4 . 6he new rule clarifies what must be included in the report ( 9eg. :2."#$*$(b ($ . **CC(.

Corporate Liquidations
Synopsis ! effect of liquidations on s are olders A complete liquidating distribution is treated as a payment in exchange for stock ( Code !ec. ""2(a . Menerally, therefore, the redemption of stock by a dissolving corporation results in a capital gain or loss to the shareholders. 6here need not be a formal surrender of stock by the shareholders or cancellation of the stock by the corporation. +f the distribution is in complete liquidation, it is treated as received in exchange for the stock. 6his applies to the entire liquidating distribution, even though part of it may consist of corporate earnings which, had they been distributed in a transaction other than in liquidation, might be ordinary dividend income. 6herefore, stockholders may be sub8ect to a lower tax liability if they allow corporate profits to accumulate until liquidation, instead of distributing them currently. (owever, the possible application to the corporation of the accumulated earnings tax ( 0$",##&.#2 must be considered. Menerally, when Code !ec. ""2 applies to a corporate liquidation, the rules of Code !ec. "#2 do not apply ( Code !ec. ""2(b . Code !ec. "#2 usually must be considered when shareholders receive corporate distributions (see 025,"#5.#2 et seq. . (owever, a liquidation followed by a transfer to another corporation of all or part of the assets of the liquidating corporation may be treated as a dividend distribution or as a transaction in which no loss is recogni;ed and gain is recogni;ed only to the extent of "other property" (see 02',##&.#$57 9eg. :2.""2*2(c . +n addition, Code !ec. 2$&' and Code !ec. 2$&3 provide that the gain recogni;ed by shareholders, resulting from Code !ec. ""2 liquidating distributions on stock of a controlled foreign corporation or a foreign investment company, may be treated as ordinary income rather than capital gain (see 0"#,1$2.#2 et seq. and 0"#,1'3.#2 et seq. . -o gain or loss is recogni;ed upon the receipt by a parent corporation of property distributed in complete liquidation of its 3#*percent owned subsidiary corporation (see 02',#5$.#2 et seq. . (owever, special rules apply if the subsidiary liquidation involves a foreign subsidiary or parent (see 02',''4.#2 et seq. . S are older/s gain or loss A stockholder%s gain or loss is the difference between the cost or other basis of the stock and the fair market value ()>B of the property, or interest in property, received in liquidation of such stock. +t makes no difference whether cash or property or both are distributed. +f property is received, its fair market value is also used as the basis for determining gain or loss upon the subsequent sale of such property ( Code !ec. ""&7 02',25$.#2 et seq. . Main is recogni;ed when the combined value of the money and the fair market value of assets received by the shareholder

in the distribution exceeds the shareholder%s basis in the stock. +f a corporation distributes its assets in complete liquidation in installments, and it is not known what the total proceeds will be, the stockholder should not report any part of the installments as income until the amounts received exceed the basis in the stock. (owever, when contracts or claims to receive indefinite amounts are acquired as a distribution, the +9! generally requires valuation of such contracts or claims except in rare and extraordinary cases. !ee 9ev. 9ul. 53*&#$, at 0$1,$$5.25". A distribution that is made as a single step in a series of distributions in complete liquidation should be applied against the total basis of all the shareholder%s stock, even though only some of the shares are surrendered ( +.M. ,!inn, =ec. 1542 (Acq. , at 02',##&.2'" . Cal&!lating gain on installment obligations. !hareholders who receive an installment obligation in a corporate liquidation use the installment method to calculate any gain on the liquidation unless the shareholder elects out of the installment method pursuant to Code !ec. &5"(d . Oualifying shareholders would treat the receipt of payments under the obligation, not the receipt of the obligation itself, as payment for their stock. 6hus, gain with respect to such payments would be reported on the installment method as payments are received ( Code !ec. &5"(h 7 9eg. :2.&5"* 22(a (2 7 0$2,&42.#&27 0$2,&42.#&& . Menerally, in order for the installment method to be used for an installment obligation received in a corporate liquidation three requirements must be met, (2 Code !ec. ""2 must be applicable to the liquidation, ($ the installment obligation must result from a sale or exchange by the corporation within the 2$*month period after the date the plan of complete liquidation was adopted, and (" the liquidation must be &omplete$ within the 2$*month period after the date the plan of complete liquidation was adopted ( Code !ec. &5"(h . )or more discussion of a shareholder%s treatment of installment obligations distributed to him in liquidation, see 0$2,&42.#&2 et seq. Ahere there is a sale of all corporate assets, followed by investment of the sale proceeds for a period of time preceding a distribution to shareholders in complete liquidation, the corporation may inadvertently become a personal holding company. +f it does, the portion of the distribution that represents the personal holding company income may be taxed as ordinary income ( A.S. -eiss, =C .hio, 45*$ <!6C 015"3, at 02',##&.244 . Disproportionate li !i$ation $istrib!tions. Ahere shareholders receive a distribution in complete liquidation that is disproportionate to their share holdings (a non*pro rata distribution , the shareholders will still be considered for tax purposes as having received a pro rata distribution. Ahere shareholders receive less than their share, the excess of their pro rata share over the amount actually received is treated as if it had been used in a separate transaction to make gifts, pay compensation, satisfy obligations of any kind, or accomplish other goals, depending on the particular facts and circumstances. Ahere shareholders receive more than their share, the excess is treated as a payment attributable to those shareholders who received less ( 9ev. 9ul. 41*2#7 02',##&.2&4 . %ffect of Liquidations on S are olders: Partial liquidations A distribution that is one of a series of distributions in complete liquidation pursuant to a plan of liquidation is classified as one made in &omplete liquidation. 6he distribution is treated as received in exchange for stock, and any resulting gain qualifies for capital gain treatment ( 9eg. :2.""2(a 7 Code !ec. "&' . A distribution made as a part of the contraction of the business of a corporation is not treated as a liquidating distribution in exchange for stock if it is made to a &orporate shareholder of the liquidating corporation. 6hus, a distribution of assets in redemption of stock by a corporation that is not in the process of complete liquidation is treated as a taxable exchange by the corporation

and as a nonliquidating distribution (generally taxable as a dividend by the corporate shareholders. )urthermore, any amount treated as a dividend by the recipient corporation will usually result in a reduction of the corporate shareholder%s basis in the stock of the partially liquidating corporation ( 0"#,#$2.#2 et seq. . =istributions to non&orporate shareholders made in connection with a contraction of the business are classified as redemptions qualifying for sale or exchange treatment under Code !ec. "#$ (see 025,""#.#2 et seq. . %ffect of Liquidations on S are olders: Distribution sub#ect to liabilities +f, as a condition to receiving a liquidation distribution, the shareholder agrees to pay a liability of the liquidating corporation, the liability is taken into account in determining the amount of gain. +f the existence of the liability and its amount are known at the time of the distribution, the amount received is reduced by the shareholder%s portion of the amount of the liability which he agrees to pay, even though it is paid in a year subsequent to the distribution. +f an ad8ustment is not made at the time that the distribution is received, the return which reflects the distribution should be amended ( 02',##&.$#1 . Hayment of the liability in a later tax year does not 8ustify deduction of the liability on the return for that year. Complete Liquidation of Subsidiary: Synopsis ! complete liquidation of subsidiary Although stockholders generally must recogni;e gain or loss on liquidation of the corporation, this is not the case when the stockholder is an 3#? corporate parent of the liquidating corporation ( 02',#5$.#$2 . 6he nonrecognition of gain or loss on a subsidiary liquidation results in deferral of gain or loss through the mechanism of carried over basis of the subsidiary%s distributed assets ( 02',#5$.#$5 . )or the nonrecognition rules to apply, the subsidiary liquidation must be completed either within the tax year ( 02',#5$.#" , or within three years under a plan of liquidation ( 02',#5$.#"" . =istributions of earnings in outbound liquidations of <.!. holding companies may trigger dividend income for the foreign parent company under certain circumstances ( 02',#5$.#$4 . !hareholders other than a qualifying 3#? corporate parent recogni;e gain on the liquidation ( 02',#5$.#"5 . )or recordkeeping and filing requirements, see 02',#5$.#45. Complete Liquidation of Subsidiary: 4inority recogni5es gain or loss +t is only the parent corporation which benefits from the nonrecognition of gain or loss provisions on complete liquidation of a subsidiary ( 9eg. :2.""$*5 . =ue to the 3#? stock ownership requirement for the parent, as much as $#? of the stock might be owned by minority interests, who also share in the liquidation. 6he minority shareholders are required to recogni;e gain or loss on the liquidation distributions, under the rules described at 02',##&.#2. 6asis of Property Received in Liquidation: Synopsis ! basis of property received in liquidation +f property is received in a distribution in complete liquidation and gain or loss is recogni;ed on re&eipt of the property, the basis of the property in the hands of the person receiving it is the fair market value of the property at the time of the distribution. Menerally, if a liquidating corporation distributes property to its noncorporate shareholders or to a corporation that owns less than 3# percent of the liquidating corporation%s stock, the recipient will recogni;e gain or loss upon receipt of the property ( 02',##&.#2 . +n this situation, the recipient%s basis in the property will generally be the property%s fair market value. +f an 3#*percent owner*parent corporation receives a distribution of property from a liquidating subsidiary corporation, its basis in the property received will generally be the same as the ad8usted basis of the property in the hands of the liquidating subsidiary corporation. (owever, if the $istrib!ting s!bsi$iary &orporation recogni;es gain on the distribution of property to its 3#* percent owner*parent corporation in a liquidation described in Code !ec. ""$ or Code !ec. ""4(b (2 , the distributee%s basis is the fair market value of the property. Although a liquidating

subsidiary will generally not recogni;e gain upon the distribution of property to its 3#*percent owner*parent corporation, the subsidiary will recogni;e gain upon certain distributions to a tax* exempt corporation ( 02',$$4.#2 . 6asis of Property Received in Liquidation: Corporate parent/s basis in subsidiary liquidation property Ahen a parent liquidates a subsidiary, the parent corporation%s basis in the property received is the same as the liquidating subsidiary%s basis in the property (i.e., the parent has a carryover basis in the property unless the subsidiary recogni;es gain from the transfer. !pecial rules apply where the subsidiary possesses built*in loss property which will subsequently be sold by the parent. 6hose rules are beyond the scope of this course.