Lesson 6.3.1 Qualifying Stock Redemptions I: Concepts

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From the course by University of Illinois at Urbana-Champaign

Taxation of Business Entities I: Corporations

18 ratings

University of Illinois at Urbana-Champaign

Taxation of Business Entities I: Corporations

18 ratings

Course 3 of 5 in the Specialization U.S. Federal Taxation

This course provides an introduction to the U.S. federal income taxation of corporations and their shareholders. The course focuses on the relevant provisions of Subchapter C of the Internal Revenue Code, as well as related Treasury Regulations and judicial opinions, governing corporate formation, operations, distributions, and liquidation. Practical in-class study problems facilitate self-discovery of technical tax knowledge along with the development of a variety of professional skills and attitudes.

From the lesson

Module 6: Corporate Redemptions and Partial Liquidations

In this module, you will explore redemptions and partial liquidations, which is when shareholders sell stock back to the issuing corporation in exchange for cash. You will learn about the five types of qualified redemptions, which are applied after you have considered stock attribution rules. Finally, you will analyze how these redemptions are treated by both the shareholders and the corporation.

Lesson 6.3.1 Qualifying Stock Redemptions I: Concepts2:49

Lesson 6.3.2 Qualifying Stock Redemptions I: Applications6:16

Meet the Instructors

Michael P Donohoe, PhD, CPA
Associate Professor of Accountancy and PwC Faculty Fellow
Department of Accountancy, Gies College of Business

[MUSIC]

You previously learned that section 302 Distributions and

Redemption of Stock stipulates that if stock is redeemed at a specified manner,

it qualifies for sale or exchange tax treatment.

In particular subsection b outlines five types of qualifying redemptions.

This lesson examines section 302(b)(1) and

(2), which considers stock redemptions not equivalent to dividends and

disproportionate redemptions, respectively.

After reviewing the concepts, you'll apply them to Sunchaser Shakery.

Section 302(b)(1) states that sale or exchange tax treatment shall

apply if the redemption is not essentially equivalent to a dividend.

This rule is a continuation of the dividend equivalency rule,

under prior law mentioned earlier.

Despite its lack of objectivity, it remains in the code for redemptions of

preferred stock which shareholders typically have no control over.

Although largely based on subjective facts and circumstances,

the courts have provided some guidance over time.

For instance, the US Supreme Court held that a stock redemption is not essentially

equivalent to a dividend, only when the shareholder's interest in the corporation

has been meaningfully reduced.

Other case laws suggest that a meaningful reduction is best defined

as a decrease in the shareholder's voting control.

But reductions in the right to share in corporate earnings or

to receive corporate assets upon liquidation might also be sufficient.

The second type of

qualifying stock redemption is a disproportionate redemption.

In particular, code section 302(b)(2) states that a sale or

exchange treatment shall apply if a redemption is substantially

disproportionate with respect to the shareholder which involves two conditions.

First, after the redemption, the shareholder owns

less than 80% of the interest owned in the corporation before the redemption.

Notice that this is not referring to total ownership interest, but

less than 80% of the original ownership in the corporation.

Second, after the redemption, the shareholder owns less than 50% of

the total combined voting power of all classes of stock entitled to vote.

Recall that the stock attribution rules in section 318 apply when evaluating

ownership interest before and after the redemption.

Keep in mind that the qualifying redemptions outlined in section 302(b)

are separately applied.

Thus, if a particular redemption does not qualify as a disproportionate redemption

under (b)(2), it could still qualify as not essentially equivalent redemption

under (b)(1) if the meaningful reduction test is satisfied.

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