Question

5. Speed Corporation has current E&P of $200,000 and accumulated E&P of $100,000. It makes a distribution of land to its shareholder Bill. Bill’s stock basis is $600,000. The land was purchased by Speed two years ago for $400,000 and at the time of the distribution has FMV of $550,000.   Bill owns 75 shares, his sister owns 10 shares and the remaining 15 shares are owned by an unrelated party. (7 points)

1. What are the tax consequences to Speed and Bill if this is a non liquidating distribution?
2. What are the tax consequences to Speed and Bill if this is a liquidating distribution?
3. What are the tax consequences to Speed and Bill if this is a stock redemption and Speed redeems 40 of Bill’s shares in exchange for the land?
4. Which scenario (a, b, c) would you advise Speed and Bill to proceed with? Why?

Answer 1

a. If it is a non-liquidating distribution, it can have a variety of tax consequences for both Speed Corporation and Bill.

Corporate level tax consequences:

It depends on what type of distribution is made.

• If the distribution consists of cash then there is no gain or loss realized by the company and there is no tax effect.
• If the distribution consists of the company's property, the company realizes gain if the property's fair market value is more than the adjusted tax basis in the hands of the company. The capital gain or ordinary income will attract tax.

            

Shareholder level tax consequences:

At the shareholder's level, a variety of tax consequences can be there depending on the type of distribution:

• If the distribution consists of cash, it will be taxed as dividends.
• If the distribution consists of property, it will be taxed as capital gain or loss or reduction in stock basis.
• The capital gain for the shareholder is the fair market value of the non-liquidating asset.

The FMV of the land is $550,000

The adjusted tax basis in the hands of the company is the cost of the land minus the depreciation. As in the above question, there is no depreciation on land so the adjusted tax basis is $400,000 only, that is the cost of the land.

Capital Gain for Speed = $550,000 - $400,000

                                     = $150,000

Tax Paid By Speed = $150,000 * 15%

                               = $22,500

Capital Gain for Bill = FMV of the asset

                                  = $550,000

Tax Paid by Bill = $550,000 * 20%

                           = $110,000

b. If it is a liquidating distribution, the tax consequences for both Speed Corporation and Bill are:

Corporate level tax consequences:

The corporation is treated as selling the distributed assets for FMV to its shareholders with the resulting corporate-level tax consequences. If a company liquidates and distribution to the shareholders is made in kind then there is no gain or loss realized by the company. So, there are no taxes.

Shareholder level tax consequences:

If a company liquidates and distribution is made in cash or whether in kind there are tax consequences for shareholders.

Capital Gain for Speed = Shareholder's basis of the stock - FMV of the property

                                     = $600,000 - $550,000

                                     = $50,000

Tax Paid By Speed = $50,000 * 15%

                               = $7,500

Capital Gain/Loss for Bill = FMV of the property - Basis of land received

                                           = $550,000 - $600,000

                                           = ($50,000)

c. If this is a stock redemption, the speed corporation will exchange its shares for land from Bill.

In this case, Speed redeems 40 shares of Bill's shares in exchange for the land.

Tax consequences of stock redemption on shareholder:

• If the relative equity interest of a stockholder is the same: In this case, stock redemption is considered as a dividend payment.
• If the relative equity interest of a stockholder is significantly less after the redemption: In this case, it will be considered as a sale where there can be gain or loss.

In this case, the equity interest is significantly less after the redemption. So, this is a case of capital gain or loss.

Tax consequences of Stock-redemption on the company:

If the company exchanges property with the shareholder then it must recognize gain and not losses as per the fair value.

The tax consequences will depend on the treatment of stock redemption.

• If redemption is considered as a sale, then there is capital gain.
• If redemption is considered as a dividend, then the entire amount is subtracted from E&P.

In the above case, the redemption is considered as a sale.

Capital Gain for Speed = $550,000 - $400,000

                                     = $150,000

Tax Paid By Speed = $150,000 * 15%

                               = $22,500

Share Price per Share for Bill = Total value of shares held / Total number of shares held

                                               = $600,000 / 75

                                               = $8,000

Capital Gain for Bill = Fair value of land - Total value of shares redeemed of Bill

                                = $550,000 - (40 * 8000)

                                = $550,000 - $320,000

                                = $180,000

Tax Paid by Bill = $180,000 * 15%

                         = $27,000

d. The option C is the only option where both are gaining. Bill will only gain in option C with a low tax rate and Speed has lower tax in option B but there C is having losses hence, option C is better.