In: Accounting
Flintstone Company is owned equally by Fred Stone and his sister
Wilma, each of whom hold 2,900 shares in the company. Wilma wants
to reduce her ownership in the company, and it was decided that the
company will redeem 630 of her shares for $26,600 per share on
December 31 of this year. Wilma’s income tax basis in each share is
$6,350. Flintstone has current E&P of $10,830,000 and
accumulated E&P of $50,070,000.
What is the amount and character (capital gain or dividend)
recognized by Wilma as a result of the stock redemption, assuming
only the “substantially disproportionate with respect to the
shareholder” test is applied?
What is Wilma’s income tax basis in the remaining 2,270 shares she
owns in the company?
Assuming the company did not make any dividend distributions this
year, by what amount does Flintstone reduce its E&P as a result
of the redemption?
Important Points of the Question
Flintstone Company:
Current E & P : $ 10.83 Million
Accumulated E & P : $50.07 Million
Shareholders Fred & Wilma 2900 Share each
Redemption Value 630 Shares of $26,600 each
Ans:
1. Substantially Disproportionate Test: If a redemption is not in complete termination of a shareholder's interest, it will still qualify for capital treatment if it is substantially disproportionate.
For a redemption to be treated as substantially disproportionate, the shareholder must own less than 50% of the total combined voting power of all classes of stock entitled to vote immediately after the redemption. The shareholder may own a majority of the stock (even 100%) before the redemption. After the redemption, though, the shareholder must own less than 50% of the total combined voting power.
The distribution is substantially disproportionate if, immediately after the redemption, the ratio of the redeemed shareholder's voting stock in the corporation in relation to the corporation's total voting stock has decreased by more than 20%.
Stated differently, the ratio of the shareholder's voting stock to the total voting stock must be measured both before and after the redemption, and the ratio between these two ratios must be less than 100:80.
In the Question Above Wilma's Share before redemption is 50%
After Redemption Wilma's Share is calculated as follows:
Total Share after Redemption 2,270+2,900=5,170
Wilmas Share = [(Wilma's Share after Redemption/Total Share After Redepmtion)*100 ]% = 43.91%
Substantial Redemption % = (80% of 50% =40%)
As the Share % after redemption is more than 40% it does not qualify substantial disproportionate redemption test.
Hence the Above case will be treated as Dividend.
2. Tax Basis: Tax basis is the current value of investment. As 630 shares of Wilma is redeemed the Tax basis will be based on the sale value of Shares. Hence the Tax Basis is $26,600 for 2270 shares. i.e., total Rs 60,382,000
3. E & P: Calculation of E & P
Accumulated E & P $ 50,070,000
Addition during the year: $ 10,830,000
Less Dividend: $ 16,758,000
Accumulated E & P 44,142,000
Reduction in E & P $ 5,928,000