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2009_Solutions__004

2009_Solutions__004 - H Chapter Four H CORPORATE...

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H Chapter Four H CORPORATE DISTRIBUTIONS: STOCK REDEMPTIONS AND PARTIAL LIQUIDATIONS SOLUTIONS TO PROBLEM MATERIALS DISCUSSION QUESTIONS 4-1 a. The term redemption is used to describe the sale or exchange by the shareholder of his or her stock back to the corporation. [See p. 4-3 and § 317(b).] b. Redemptions are generally used as a financing technique. The shareholder, desiring cash for some reason, extracts the cash out of the corporation by selling some of his or her stock to the corporation. If the redemption qualifies as a sale, the cash is obtained at the cost of a capital gains tax. This technique is particularly useful when the shareholder is the estate of the decedent. A planned redemption provides the estate with the liquidity needed to pay any death taxes and other expenses related to death. Also, a corporation may redeem its stock to fund stock options, to improve its financial ratios, or to avoid a takeover attempt. Redemptions play an important role in so-called bootstrap acquisitions. In this situation, a cash- poor buyer approaches the shareholder who desires to sell the company. If the corporation has cash and other liquid assets unnecessary for operations, the corporation could distribute such items to the current shareholder and effectively reduce the value of the corporate stock and, concomitantly, the price the buyer must pay. In effect, the buyer has financed part of the purchase price through the corporation. (See pp. 4-2 and 4-3.) c. Redemption transactions are not always afforded sale or exchange treatment but in some cases are treated as dividends. This result occurs because, notwithstanding the surrender of stock by the shareholder, the shareholder’s proportionate interest in the corporation has not been meaningfully reduced. In such case, the effect of the distribution is a dividend and hence is treated as such. (See pp. 4-3 and 4-4.) Note that for noncorporate shareholders sale treatment is usually far more desirable than dividend treatment for the following reasons. ± Sale treatment enables the shareholder to recover the basis in the stock surrendered. The effect is to reduce the taxpayer’s gain or increase any loss. For example, consider a taxpayer who receives a distribution of $11,000 in redemption of stock with a basis of $10,000. If the transaction is treated as a dividend, the taxpayer must report dividend income equal to the entire amount of the distribution, $11,000. On the other hand, if the transaction qualifies for sale treatment, the taxpayer is allowed to recover the stock basis of $10,000, producing taxable income of only $1,000. ± Sale treatment generally allows the taxpayer to characterize any income realized as long-term capital gain. Historically, capital gains have received far more favorable treatment than dividend income. For example, prior to 1986, only 40 percent of a noncorporate taxpayer’s long-term capital gain was subject to tax, making the distinction between dividend and sale treatment quite significant. To illustrate, assume that in 1986 a taxpayer received a distribution of $11,000 in redemption of stock with a basis of only $1,000. Assuming the
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