Question

The 200 shares of Long Corporation’s common stock are held as follows:

       Shareholder           # of Shares
       Matt               50
       Mark                60
       Jason               90

Matt purchased shares for $200 each on September 30, 2016. Assume Matt, who is Mark’s father, sells 40 of his shares to the Corporation for $12,000.

(1)   Will the sale qualify as a substantially disproportionate (or disproportionate) redemption?
In your answer, discuss the requirements for a substantially disproportionate redemption and show supporting computations.
(2)   Will the sale qualify as a redemption that is not essentially equivalent to a dividend? Provide an explanation for your conclusion.
(3)   Without prejudice to your answer in Parts (1) or (2), assume that the sale qualifies as a substantially disproportionate redemption. What will be the amount and nature of the income Matt must recognize (assume the sale took place on March 1, 2020, and that Long’s E&P for 2020 is $75,000).
(4)   What effect will the sale have on Long’s E&P balance?

Answer 1

Required 1

Redemption of shares qualifies for substantially disproportional redemption of stock if:

• Shareholder's entire interest in the corporation is terminated or
• After redemption the % of stock ownership is less than 80% of shareholder's holding before redemption and less than 50% of shares outstanding.

If a redemption of shares qualifies for substantially disproportional redemption, it shall qualify for sale or exchange treatment and gain or loss is recognized by the shareholder.

In the given case,

Before redemption Matt had 50 shares.

He redeemed 40 shares

So remaining shares after redemption = 10 (which less than 80% of Matt's holding before redemption and also which is less than 50% of the total shares outstanding)

Thus Matt's redemption would qualify for substantially disproportional redemption of stock

Required 2

In accordance with Section 302(b) (1) of the Internal Revenue Code of 1954, the commissioner of Internal Revenue had promoted a regulation in which only one transaction was given the benefit of treating it as not essentially equivalent to a dividend. The one transaction is - where a shareholder owns only non voting preferred stock (not section 306 stock) and half of that stock has been redeemed.

Thus the given case would not qualify for "not essentially equivalent to a dividend" benefit.

Required 3

If sale qualifies as a substantially disproportionate redemption, the sale is treated as normal sale or exchange transaction and is taxable in the hands of shareholder as capital gain/ loss.

Thus Matt's capital gain = $12,000 - 40 shares * $200 = $4,000

Required 4

Since the redemption is not treated as dividend and instead treated as sale of share, there would be no effect on Long's E & P balance.