Our client, Theta, is managed jointly by three sisters (Amy, Beth, and Meg). Amy wants to either redeem or sell her shares depending on the tax implications on these options. She has written to us requesting a comparison of tax implications on the two options so that she can make a decision on whether to sell or redeem the shares.
Issues
The tax implication on the shares that Amy intents to dispose depends on two issues: First, whether Amy sells her shares to Beth and Meg (50 shares each) or to either Beth or Meg, and secondly, whether she redeems the shares under Theta Corporations which can redeem all of it.
Applicable Law
Section 1222 of the Internal Revenue Code (I.R.C), provides for taxation on certain types of gains in a different manner hence enhancing capital gain preference (Legal Information Institute, n.d.). This is in total disfavor of the common ordinary income. On the other hand, capital losses becomes a disadvantage when compared to ordinary losses since when it comes to making deductions, this is only done on capital gains (1211(a)). Under section 1001(a), if Amy sold the appreciated stock to Beth and/or Meg, the difference between the amount of her stock share and her basis constitutes the economic gain ($100,000-$40,000=$60,000). In this case, the sale can only be taxed on the amount realized by Amy over her basis. Under section 1221 of the code, what Amy is selling (stock) is categorized as capital asset hence any gain attained through this sale is referred to as a capital gain.
In a famous Supreme Court of the United States case, Eisner vs. Macomber, 252 U.S. 189 (1920), the court ruled in favor of Macomber by declaring that the income tax imposed on her dividends was unconstitutional. This was even when, in this case, the dividends represented the corporations accrued earnings though indirectly (“Eisner v. Macomber”, n.d).
Analysis
Issue 1: whether Amy sells her shares to Beth and Meg (50 shares each) or sells all her shares to either Beth or Meg- Under section 1001(a), if Amy sold the appreciated stock to Beth and/or Meg, the difference between the amount of her stock share and her basis constitutes the economic gain ($100,000-$40,000=$60,000). In this case, the sale can only be taxed on the amount realized by Amy over her basis. The amount realized over her basis in this case is $60,000 hence this is the amount to be taxed following the sale of her shares. Therefore, a 20% tax rate will be imposed on the $60,000 capital gain. In addition, under section 1221 of the code, what Amy is selling (stock) is categorized as capital asset hence any gain attained through this sale is referred to as a capital gain.
Issue 2: whether she redeems the shares under Theta Corporations which can redeem all of them- Two tax consequences can result if Theta Corporation redeems shares from Amy. It is worthy to note that, to the extent of earnings and profits, this redemption will be treated as a taxable income. The first tax implication (a taxable dividend treatment) prevents Theta from paying dividends as a stock redemption, taxable as a capital gain. For instance, Theta can redeem 10% of Amy’s share instead of paying cash dividend to her. In this case, Amy will continue to own all of her stock and will continue exercising her control over Theta Corporation. Therefore, this option would minimize tax burden on Amy and at the same time no reduction of her ownership interest of Theta will be expected. The second tax consequence (exchange treatment) requires Amy to pay a maximum of 20% tax rate on her net capital gain. Since Amy reports a $60,000 long-term gain ($100,000-$40,000), 20% of this gain would go to taxes. This option would have advantage over the taxable dividend treatment option if Amy had capital losses which have not been used. In addition, this option would permit Amy a tax free recovery of her investment in Theta. In contrast, the taxable dividend treatment option does not allow for a tax free recovery of investment. No attribution of stock occurs from either Beth or Meg to Amy because the family attribution rules do not apply to siblings (Internal Revenue Service, 2012). Under section 302 (b) (3), the redemption of Amy’s stock would result in a complete termination of her interest. In the case where Theta Corporation redeems Amy’s shares, a distribution of the remaining shares will be done to Beth and Meg, each controlling half of the stock hence making this a preferable option for the two sisters. At the same time, redemption of Amy’s shares will end up in a $50,000 reduction in earnings and profits of this Corporation as well as a general reduction of paid in capital amounting to $50,000.
Conclusion
The decision on whether Amy should sell or redeem her shares would depend on various factors. First is whether or not she wants to completely terminate her interest in Theta Corporation, Second is whether or not she decides to sell all her shares to Beth and Meg and thirdly whether she redeems all her shares with the Corporation or she just wants to redeem part of it (only a certain percentage). In the first instance, where she is ready to terminate all her interests in Theta Corporation under section 302 (b) (3), she may go ahead and redeem her shares but will be required to comply with a 20% maximum taxation rule on capital gains. Although this option results to a complete termination of Amy’s interest in Theta Corporation, it would be worthy to note that this option permits her to have a tax free recovery of her investments in Theta. In the second option where she decides to sell her shares to Beth and/or Meg, she would again be required to observe the 20% maximum taxation on capital gains. Finally, if she just wants to redeem part of the shares, she can go ahead and redeem a certain percentage, like 10% of her shares with Theta. This final option allows Amy to continue owning her shares and exercising control over Theta Corporation. If she decides on this final option, she will have various advantages including the minimization of tax burden on her and also there will be no reduction of her ownership interest of Theta Corporation. With these three available options, it is pretty clear that the final decision on whether to sell or redeem her shares would possibly come from Amy. The first and the second options are more or less the same when it comes to consequences on taxation. The final option however means that she will continue being part and parcel of the Corporation.
References
Eisner v. Macomber (n.d). Eisner v. Macomber. Web.
Internal Revenue Service (2012). Publication 542: Corporations. Web.
Legal Information Institute (n.d.).Internal Revenue Code. Web.