The key is to structure the distribution to be taxed as a redemption of corporate stock. A redemption results whether the corporate stock is canceled, retired, or held as treasury.

Redemptions Treated as

Exchanges

There are four ways for a redemption to be taxed as an exchange.

Not Equivalent to a Dividend One way is when a redemption is not equivalent to a dividend measured at the individual level. This takes place after the application of the family attribution rules and must result in a meaningful reduction in the shareholder's proportionate interest in the corporation. Items that define a meaningful reduction are the shareholder's ability to control the corporation, the shareholder's share of corporate earnings and the shareholder's rights upon liquidation after the distribution is made.

Substantially Disproportionate Redemption. The second test measures a substantially disproportionate redemption of stock. For this condition to be met the shareholder must satisfy the following tests:

* The shareholder must own less than 50% of the combined voting power of all classes of stock entitled to vote, immediately after the redemption;

* The ratio of voting or nonvoting stock owned by the shareholder must be less than 80% of the shareholder's ownership of stock prior to the distribution; and

* There can not be a series of redemptions pursuant to a plan which results in distributions not substantially disproportionate to the shareholder.

Termination of Shareholder's Interest. The third possibility is when there is a termination of a shareholder's interest. Exchange treatment will be granted when a redemption is for all of the stock of the corporation owned by a shareholder.

Redemption from Non-Corporate Shareholder. The fourth possibility occurs when there is a redemption from a non-corporate shareholder in partial liquidation. This takes place when the redemption of stock is held by a shareholder who is not a corporation and occurs in partial liquidation of a distributing corporation. A distribution is made in partial liquidation if it is not essentially equivalent to a dividend, is pursuant to a plan, and takes place within one tax year from that in which the plan is adopted. A distribution is not considered equivalent to a corporate dividend, which is determined at the corporate level, if the following situations come into play.

* The distribution of property is attributed to the cessation of an active trade or business carried on for a period of five years preceding the date of redemption by the distributing corporation; and

* Immediately after the distribution, the distributing corporation is actively engaged in another trade or business that also has been carried on for at least five years before the date of redemption.

Constructive Ownership of Stock

The attribution rules will apply in the determination of a shareholder's ownership. Termination of a shareholder's interest takes place when immediately after the distribution the distributee relinquishes all interest in the corporation (including an interest as officer, director, or employee). A former shareholder can have an interest as a creditor, lessor or independent contractor.

The distributee may not acquire any such interest (other than stock acquired by bequest or inheritance) within 10 years from the date of such distribution, which includes interest in a subsidiary or a parent and the distributee must file an agreement to notify the IRS of any acquisition of any interest described above. This is required to waive the family attribution rules.

Acquisition of an interest, within 10 years from the date of distributions will cause an assessment for additional taxes and interest and will trigger the attribution rules under the IRC.

When considering the attribution rules family estrangement or hostility is not taken into account, as the basic premise is that family will usually act in concert to benefit each other.

Under the constructive ownership of stock rules, individuals are considered owners of stock owned by parents, children, a spouse, and grandchildren. Attribution rules also apply when stock is owned by a partnership or an S corporation based on the partner or S corporate shareholder's pro rata interest in that entity. Stock owned by an estate or trust is attributed proportionately to the beneficiaries except in the case of a grantor trust where the grantor retains the attribution of the stock. In the case of a shareholder with a 50% or more interest in a C corporation the stock ownership is distributed proportionately to that shareholder.

There will be no attribution between in-laws, siblings, aunts, uncles, or nieces and nephews.

Working with the Code

Table 1 illustrates the interplay with the family attribution rules and a substantially disproportionate distribution.

Based on the result, the distribution is only substantially disproportionate to shareholder A, who has an ownership reduction of 80% or less of his original interest. Eighty percent of 25% is 20% and his final ownership is 20%.

If shareholder A is the only shareholder of corporate shareholder C, the distribution is not considered substantially disproportionate as the total ownership attributed to shareholder A is (1,350 - 3,000) or 45%, which is greater than 80% of 50% (the original ownership) or 40%, the desired after redemption ownership to satisfy as a substantially disproportionate distribution.

If a redemption of stock is not substantially disproportionate and therefore treated as a dividend, a proper adjustment of the remaining stock basis will be made.

For example: A, an individual, purchased all the stock of X corporation for $1,000,000 and the corporation redeems half the stock for 1,000,100. if the distribution were determined to be a dividend, no reduction in basis is made, and the basis of the remaining stock to shareholder A" would be $1,000,000. If the stock of the corporation was later sold, there would very likely be a capital loss.

In the situation where a husband gives half of his stock to his wife and receives subsequently a reclassification of a redemption of stock as a dividend, the wife's basis is increased by what was the husband's basis in his shares of stock which was considered redeemed.

Because the consequences are so severe, owners of privately-owned businesses seeking to withdraw a portion of their equity must proceed with great caution. Their advisors may wish to recheck or consult with another practitioner to assure that all factors have been considered and the calculations have been accurately made. There is no margin of error when it comes to corporate distributions.

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