Question

Z-Sisters Corporation has one class of voting common stock, of which 1,000 shares are issued and outstanding. The shares are owned as follows:

Shares

Lourdes Vick	400
Anita Vick (Lourdes’s daughter)	200
Liz Vick (Lourdes’s daughter)	200
Cat Labrillazo (unrelated)	200
Total	1000

Z-Sisters Corporation has current E&P of $300,000 for this year and accumulated E&P at January 1 of this year of $500,000.

During this year, the corporation made the following distributions to its shareholders:

03/31: Paid a dividend of $10/share to each shareholder ($10,000 in total).

06/30: Redeemed 200 shares of Lourdes’s stock for $200,000. Lourdes’s basis in the 200 shares redeemed was $100,000.

09/30: Redeemed 60 shares of Cat’s stock for $60,000. His basis in the 60 shares was $36,000.

12/31: Paid a dividend of $10/share to each shareholder ($7,400 in total).

Determine the tax status of each distribution made this year. (Hint: First, consider if the redemptions are treated as dividend distributions or exchanges.)

Compute the corporation’s accumulated E&P at January 1 of next year.

Lourdes is considering retirement and would like to have the corporation redeem all of her shares for $100,000 plus a 10-year note with a fair market value of $300,000.

What must Lourdes do or consider if she wants to ensure that the redemption will be treated as an exchange?

Could Lourdes still act as a consultant to the company?

Z-Sisters Corporation must pay attorney’s fees of $5,000 to facilitate the stock redemptions. Is this fee deductible?

Answer 1

Part A

	Treatment		Amount
	Dividend	distribution on 3/31	10000
Lourdes	dividend	distribution on 6/30	200000
Cat	capital gain	distribution on 9/30	24000
	Dividend	distribution on 12/31	7400

The $10,000 distribution on 3/31 is a dividend because CE&P of $300,000 exceeds total dividends distributed i.e. $10,000 during the year.

Lourdes Vick is deemed to own 800 of the 1,000 (80%) shares of Z-Sisters Corporation (400 directly and 200 each from Anita Vick and Liz Vick) before the redemption. After the redemption Lourdes is deemed to own 600 of the 800 (75%) remaining shares of Z-Sisters Corporation (200 directly and 200 each from Anita and Liz). Lourdes fails the stock ownership tests because he still owns more than 50% of the stock. Therefore, the entire $200,000 received by Lourdes is treated as a dividend.

Cat owns 200 of the remaining 800 (25%) shares of Z-Sisters Corporation stock before the redemption. After the redemption, Cat owns 140 of the 740 (18.9%) remaining shares of Z-Sisters Corporation stock. In this way, Cat meets both the 50% and 80% tests of §302(b)(2) i.e. (18.9% is less than 50%and is less than {80% * 25%} = 20%). Cat treats the redemption as an exchange and reports a capital gain of $24,000 ($60,000 - $36,000).

The $7,400 distribution on 31/12 is a dividend because CE&P of $300,000 exceeds total dividends distributed during the year.

Part B

Current E&P................................ $ 300,000

Less: Dividends PAID..................... (217,400)

Undistributed Current E&P................ $82,600

× 9 / 12.................................................. 0.75

Undistributed Current E&P at 9/30...... $61,950

Current E&P in 4th quarter....................... 20,650 (82600-61950)

Accumulated E&P at 1/01................... ... 500,000

Total accumulated E&P at 9/30.............$ 582,600

Reduce accumulated E&P by the lesser of:$60,000, or 60/800 × $582,600 = $43,695....................................(43,695)

Accumulated E&P at 01/01 of next year ......538905

Part C 1

Lourdes Vick must execute a family attribution waiver and a “triple i agreement” with the IRS in which she agrees not to acquire a “prohibited interest” within the next 10 years. If she does acquire such an interest, she must so inform the IRS or the statute of limitations on the tax return that reports the redemption will begin to run. A creditor is not a prohibited interest.

Part C 2

No. The IRS and courts have held that serving as a consultant is considered to be a prohibited interest. The Tax Court adopted a de minimis rule with respect to how much the former shareholder is paid. The 9th Circuit overruled the Tax Court in Lynch and held that no de minimis rule should be applied.

Part D

Mostly, §162(k) disallows a deduction for expenses incurred “in connection with” a stock redemption. However, Congress enacted §162(k)(2)(A)(i) in 1996 to allow deductions for expenses related to indebtedness incurred to repurchase stock. If the payment was to facilitate a debt offering to repurchase the stock, the expense would be deductible.