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In: Finance

William Smith, Sr., was the founder of Smith Enterprises, Inc. He owns 60% of the stock...

William Smith, Sr., was the founder of Smith Enterprises, Inc. He owns 60% of the stock of Smith Enterprises (60,000 shares of 100,000 shares outstanding, stock basis $100 per share). The value of the stock was recently determined to be about $500 per share. Over the years, William, Sr., has done a very good job of getting his sons and daughters (and even grandchildren) involved in the business, and the other 40% of the Smith Enterprises stock is owned by is two daughters, his son and his granddaughter. William, Sr., has reached the point in his life where he is ready to retire from the family business that he founded. He has done a sufficiently good job of training up the younger generation in the management of the business that he feels able to completely withdraw from the business.

In a few concise, coherent sentences, advise William, Sr., of what steps he needs to take to assure that the tax consequences of the redemption of all of his stock in Smith Enterprises will be treated as a sale of stock (long-term capital gain/loss), rather than as distribution (dividend income). If William, Sr., cannot understand your advise, he will fire you and you will lose a $600,000-per-year client, so make sure that your advise is both correct and coherently presented.

Solutions

Expert Solution

To qualify for sale or exchange treatment, a stock redemption generally must result in a substantial reduction in a shareholder’s ownership interest in the corporation. In the absence of this reduction in ownership interest, the redemption proceeds are taxed as dividend income. In determining whether a stock redemption has sufficiently reduced a shareholder’s interest, the stock owned by certain related parties is attributed to the redeeming shareholder. Thus, the stock attribution rules must be considered along with the stock redemption provisions. Under these rules, related parties are defined to include the following family members: spouses, children, grandchildren, and parents. Attribution also takes place from and to partnerships, estates, trusts, and corporations (50 percent or more ownership required in the case of regular corporations). Exhibit 5–1 summarizes the stock rules.

A stock redemption that terminates a shareholder’s entire stock ownership in a corporation will qualify for sale or exchange treatment under § 302(b)(3). The attribution rules generally apply in determining whether the shareholder’s stock ownership has been completely terminated. However, the family attribution rules do not apply to a complete termination redemption if the following conditions are met:

  • The former shareholder has no interest, other than that of a creditor, in the corporation for at least 10 years after the redemption (including an interest as an officer, director, or employee).
  • The former shareholder files an agreement to notify the IRS of any prohibited interest acquired within the 10-year period and to retain all necessary records pertaining to the redemption during this time period.

Under § 302(b)(3), a redemption is treated as a sale or exchange if it completely terminates the shareholder’s interest in the corporation. If all of the stock actually owned by the redeeming shareholder is redeemed and immediately after the redemption the shareholder has no interest in the corporation (other than as a creditor), the family attribution rules of § 318 will be waived. Section 302(c) provides all the requirements for waiving family attribution.

Section 318 provides that in applying the stock ownership tests for redemptions, the shareholder is treated as not only owning the shares that he or she actually owns, but also those shares of certain related parties. The following related parties compose the attribution rules: l Family Members: An individual is considered as owning the stock owned by a spouse, children, grandchildren, and parents. l Entity to Owner Attribution: Stock owned either directly or indirectly (constructively) by an entity is considered to be owned proportionally by those having an interest in the entity. l Owner to Entity Attribution: Stock owned by those having an interest in an entity is attributed in full to that entity. l Special qualifying rules exist under each of these separate attribution rules. 8. The effect of a redemption on a distributing corporation’s taxable income is determined under § 311. After the 1986 Tax Reform Act, these rules are exactly the same as those discussed in Chapter 3 pertaining to the effect of a dividend distribution. In other words, the corporation must recognize its gains but not its losses on a distribution of property

Therefore , William Smith should follow above provisions for treating redemption of stock as sale of shares.


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