Question

What is meant by the term "arm’s length," and how do you see it as important in tax planning? In what ways can a stock redemption be classified? In a stock redemption, would corporate and noncorporate shareholders have the same preference for tax treatment? Explain your response.

Answer 1

Answer:-

Meanings of "arm's length" :

• The arm's length principle (ALP) is the condition or the fact that the parties to a transactions are independent and on equal footing.
• Such a transactions is known as"arm's length transaction". It is used specifically in correct contract law to arrange an equitable agreement that will stand up to legal security, even though the parties may have shared interests (eg: employer-employee) or are too closely related to be seen as completely independent (eg: the parties have familial ties).

A transactions in which the buyers and sellers of a product act independently and have no relationships to each other. The concept of an arm's length transaction is to ensure that both parties in the deal are acting in their own self interest and are not subject to any pressure or suress from the other party.

Importance in Tax Planning:

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1.) Redemptions:

a.) Corporation non liquidatory distributions to shareholders are typically treated as divend income. However, distributions that qualify aas a stock redemption are treated the share holders to a third party. Thus, capital gain treatment normally results.

b.) Corporation shareholders prefer nonqualified stock redemption (i.e dividend treatment).

2.) Liquidations:

a.) In a complete liquidation , the company corporation may recognize gains and losses on the distributation of its property to its shareholders. The gain/losses are determined in the same manner as if the property was sold to a third party.

b.) Shareholders recognize gains/losses on the receipt of distribution determined by the difference between the fair market value of property and cash received and their basis in their stock.

c.) The liquidation of a subsidiary by the parent corporation generally does not create recognized gains or losses except for minority interest shareholders.

3.) Shareholders of liquidating corporations receive sale or exchange treatment; thus, the difference between fair market value of all properties received and the stock basis is a capital gain or losses.

4.) Corporations generally recognize both gains and losses, on liquadating distributions thus, perserving the dauble taxation inherent in operating a business as a C corporation some major exceptions apply.

Stock Redemptions- Sale or exchange Treatment

Non corporate shareholder prefers stock redemptions to qualify for sale treatment.

a.)Shareholders can offset their amount realized by the basis of the stock redemption.

b.)Any gain remaining after offsetting capital losses is taxed at the applicable capital gain rates (long-term as currently 0% or 15%).

Corporate shareholders prefer nonqualified stock redemption (dividend treatment).

a.) with dividends, corporate shareholders receive the dividendes received deduction.

b.) Qualified stock redemptions production capital gains are taxable at corporations highest marginal rate.

There is no special capital gains rates of corporations.

Redemptions resulting in a less may be disallowed under the related party rules ({207)