Question

In a transaction that qualifies as a stock redemption, John receives $10,000 in exchange for all his shares in Delco Corp, At the time of stock redemption transaction, John's tax basis in the shares was $6,500. Also at the time of the transaction, Delco Corp had -0- current or accumulated earnings and profits. What is the amount and nature of any gain or loss recognized by John pursuant to the transaction? A. Dividend Income: $10,000 B. Capital gain income: $3,500 C. Nontaxable return on investment: $10,000 D. Dividend income: $3,500

Answer 1

Solution:

As per provisions, The tax consequences of the stock redemption depend on whether the relative equity interest of a stockholder is the same or significantly less after the redemption. If a stockholder's equity interest relative to other stockholders in the corporation remains the same, then the stock redemption is treated as a dividend payment (deemed dividend redemption) in so far as it can be paid out of earnings and profit (E&P).

If the stock redemption significantly decreases the stockholder's equity stake in the corporation, then the stock redemption is treated as a capital sale, in which a stockholder will either have a capital gain or loss, just as if the stock was sold on the market.

In the given question john Receive $10,000 against all of his shares in Delco Corp, therefore it results in decrease in equity stake in corporation thus treated as capital sale.

Amount of capital gain = $10,000 - $6,500 = $3,500