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Let's now apply the concepts of qualifying stock redemptions in
Section 301 (b)(1) and (2) to Sunchaser Shakery.
Nicholas owns 65 percent of the common stock of Sunchaser Shakery Corporation.
Assume his ownership interest drops to 55 percent following a stock redemption.
In part A, we want to know does this redemption qualify as
a not essentially equivalent redemption under Section 302 (b)(1)?
So in part A, to determine whether this is
a non-essentially equivalent redemption under Section 302 (b)(1),
we have to apply a very broad facts and circumstances based tests.
Which means it's highly subjective.
But to do that, you learned in the concepts discussion that we're
looking for a meaningful reduction in interest.
Again, this is highly subjective,
and many courts argue that is defined as a decrease in voting control.
So in this case, this particular redemption is probably not
qualified under 302 (b)(1).
Why? Because Nicholas continues to have dominant voting rights after the redemption.
In other words, his interest remains greater than 50 percent.
In fact, it's 55 percent.
So the distribution would be treated as essentially equivalent to a dividend,
which would make the entire amount taxable as a dividend,
to the extent of corporate E&P.
In part B, it says,
"What if his ownership interest drops to 40 percent?"
Well, in this case,
it may actually qualify under
(b)(1) because he does in fact realize a reduction in voting rights.
A right to participate in E&P,
and essentially the right to share in net assets upon liquidation.
Sunchaser Shakery Corporation has 100 shares of stock outstanding.
Nicholas owns 70 shares,
and unrelated parties own 30 shares.
What percentage of Sunchaser must Nicholas own after a redemption for it to
qualify as a disproportionate redemption under Section 302 (b)(2)?
Well, if you recall from the concepts discussion,
there are two conditions that must apply to qualify under 302 (b)(2).
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Note that this is the interest owned beforehand,
not an ownership percentage.
And condition two, after the redemption,
the shareholder owns less than 50 percent of
the total combined voting power.
So before the redemption,
we're told that he owned 70 percent.
So in other words,
after the redemption is complete,
he has to own less than 80 percent of that amount or 56 percent.
To meet condition one,
and to meet condition two,
his ownership has to be less than 50 percent though.
Therefore, to satisfy both conditions,
he must own less than 50 percent after redemption to qualify under Section 302 (b)(2).
Nicholas, Emily, and Michael are
unrelated individuals who own all of the stock in Sunchaser Shakery Corporation,
which has E&P of $1.2 million.
Nicholas owns 1,500 shares,
Emily owns 300 shares,
and Michael owns 200 shares.
Assume Sunchaser redeems 900 of Nicolas' shares for $705,000 with a basis of $300,000.
And we want to know what are the tax effects of the redemption for Nicholas.
So let's begin by looking at Nicholas' ownership interest after the redemption.
So Nicholas has 1,500 shares beforehand,
and he's have 900 shares that are being redeemed.
There are 2,000 shares outstanding before the redemption,
and again, 900 shares are being redeemed.
So after the redemption,
Nicholas has a 54.6 percent ownership interest in the corporation.
As such, the redemption does not qualify as
a disproportionate redemption under
302 (b)(2) because his ownership interest exceeds 50 percent.
But we also learned about (b)(1) already,
which is whether it's essentially equivalent to a dividend,
but here, Nicholas still has control.
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That is his ownership interest is greater than 50 percent
thus 302 (b)(1) does not apply either.
So (b)(2) is out, (b)(1) is out.
Since these two qualifying redemptions do not apply,
then the entire distribution is treated as
a taxable dividend to the extent of corporate E&P.
And we're told there's $1.2 million of E&P on hand,
and the distribution itself is $705,000.
Thus Nicholas is going to have $705,000 of dividend income.
Michael P Donohoe, PhD, CPAAssociate Professor of Accountancy and PwC Faculty Fellow
