Structuring a redemption.

• Author: Ellentuck, Albert B.

FACTS: Basic Corporation is an S corporation that has been successful for several years. Basic once was a regular C corporation and has accumulated earnings and profits (AE&P) of $250,000. Distributions in past years have left the corporation with an accumulated adjustments account (AAA) balance of only $20,000. The two shareholders, Bert and Chuck, are not related. Of the corporation's 1,000 shares of outstanding voting common stock, Bert owns 600 and Chuck owns 400. Bert has a basis in his stock of $300,000, while Chuck has a basis in his stock of $200,000. The corporation has a current fair market value (FMV) of $1,000 ($1,000 per share).* Because Bert wants to pursue other business interests, the shareholders have decided to change their ownership percentages through a stock redemption. Bert wants additional cash, while Chuck wants an increase in his ownership (as he will be solely responsible for the corporation in the future). However, for various financial reasons, neither shareholder wants Basic to redeem all of Bert's stock.* The shareholders meet with the corporation's tax adviser to discuss their options. They intend to have Basic redeem 208 shares from Bert at its current FMV of $1,000 per share; this will reduce Bert's stock interest from 60% to 49% and increase Chuck's stock interest from 40% to 51%. Issue: Can the proposed redemption be structured to qualify for sale or exchange treatment?

Analysis

A redemption will be considered a sale or exchange subject to capital gain treatment if it is: 1. in partial liquidation of a corporation, 2. substantially disproportionate, 3. in complete termination of the shareholder's interest, 4. made to a deceased shareholder's estate or beneficiary and does not exceed the estate taxes and administration expenses, or 5. not essentially equivalent to a dividend.

The proposed redemption will not qualify as a partial liquidation of the corporation or a complete termination of Bert's interest. Further, both Chuck and Bert are alive and well, so the redemption will not be made for the shareholder's estate or beneficiary to pay estate taxes and administration expenses.

Additionally, the redemption cannot qualify as a substantially disproportionate distribution. One of the requirements for such a redemption is that the shareholder's percentage ownership of outstanding voting stock and outstanding common stock (whether voting or nonvoting) immediately after the redemption must be less than 80% of the...