Question

22. Corporation Z is owned entirely by two individuals, C and D. C owns 60 shares of Z common stock bought in one transaction for $1,200. D owns 40 shares of Z common stock with a basis of $60 per share. The stock's fair market value is $40 per share. Z's E&P is $1,000. C sells 60 shares to Z for $1,800.

D sells 10 shares back to Z for $400.

a. The redemption will be treated as a dividend.

b. The redemption will be treated as a sale under 302(b)(2), substantially disproportionate disposition.

c. It is impossible to tell how the redemption will be treated.

d. The redemption will likely be treated as a sale under 302(b)(1), not essentially equivalent to a dividend.

e. None of the above.

Answer 1

In order to treat any exchange of shares as sale or exchange, such a transaction of sale of stock to corporation must result in a major fall in ownership stake in the company. If that does not happen than such buy back of shres/ stock results in Dividend. While analysing whether stock redemption has reduced stockholder’s interest shares owned by mentioned related parties are also attributed to the share-holding of shareholder.

A buy back transaction which eliminates a shareholder’s entire ownership in the company will qualify for treatment under 302(b)(3).

As mentioned the attribution of related parties’ shareholding generally apply in determining whether the shareholder’s stock ownership has been completely terminated but the attribution of shares of family do not apply to a complete termination redemption if:

1. Redempted shareholder has no interest in the company for a minimum of 10 years after the redemption
2. Redempted shareholder notifies the revenue services for any prohibited interest acquired within that tenure and retains all necessary records relating to the redemption during this time period.

Buy back of shares redemption is treated as sale or exchange treatment as per 302(b)(2) as disproportionate redemption if;:

1. The buy-back is substantially disproportionate i.e. the shareholder must own not more than 80 percent of ownership shares in corporation before buy back. Like if shareholder has a 80 percent interest in a corporation which buys back part of the stock, it is substantially disproportionate only if the ownership interest after the buy-back is less than 64 percent i.e. 80 percent of 80 percent.
2. The shareholder holds, less than 50 percent of aggregate combined voting power of all classes of voting stock.

As per 302(b)(1), a buy back qualifies for such treatment if the same is “not essentially equivalent to a dividend.” This represents a continuation of dividend equivalency rule.

Thus considering the above discussion it can be said that the “The redemption will likely be treated as a sale under 302(b)(1), not essentially equivalent to a dividend” as the same does not fall within the purview of disproportionate holding or dividend.