Question

Foxrun Company has three equal shareholders, Thomas, Kimberly, and Jennifer. Kimberly and Jennifer are Thomas’s daughters. On September 2 Foxrun redeemed all of Thomas’s stock in return for $250,000. Thomas had acquired the stock six years ago for $190,000. Foxrun’s current E&P was $325,000. Thomas would like to minimize his federal income tax liability. Explain the alternative available to him and how they would impact his taxable income.

Answer 1

Redemption of stock:

When corporation buys stock from its shareholders in exchange for cash or property then the transaction is redemption of stock. But the transaction can be treated as sale or exchange, or dividend payment.

For the distribution to be treated as sale or exchange, the shareholder after redemption must hold less than 50% of the outstanding stock, his proportionate interest in outstanding stock must be less than 80% of what it was prior to the redemption, the eighty percent test is made using the fair market value if there are more than one class of stock.

Constructive ownership:

A shareholder is deemed to own shares of another person for the purposes of determining ownership interest. A shareholder is deemed to own the shares held by his spouse, children including legally adapted, grandchildren, and parents. He is deemed to own stock owned by a partnership, estate, and a corporation (if more than fifty percent of stock is owned directly or indirectly) in proportion to his shareholding.

In the given case even after redemption of stock he is indirectly controlling the corporation through his daughters. Distribution may be taxable as dividend.

To avoid dividend taxation and to receive capital gain on sale treatment he should not participate in the management or affairs of the company and he should not be associated with the company in any manner.

By doing so he will be only required to pay capital gain tax on capital gains of = $250,000 - $190,000 = $60,000

If he choses dividend taxation then his taxable income increases by $250,000.

Capital gain treatment increases taxable income only by $60,000.

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