[JSPERBER]

Julio is in the 35% tax bracket He acquired 1,000 shares of stock in Gray Corporation seven years ago at a cost of $250/share. In the current year, Julio received payment of $500,000 from Gray Corporation in exchange for 600 shares of his share in Gray. Gray has E & P of $1million. What tax liability would Julio incur on the $500,000 payment in each of the following.

a)The stock redemption qualifies for sale or exchange treatment.

b) The stock redemption does not qualify for sale or exchange treatment

c) How would your answer change to parts a and b if Julio were a corporate shareholder (in the 34% tax bracket) rather than an individual shareholder and the stock ownership in Gray Corporation represented 15% interest?

[tuanxn]

I'm not too fond of giving answers for homework, but I'll help you out 🙂

First.. let's consider what the main difference is between a redemption that is classified as a sale/exchange (a true redemption) and a redemption that doesn't qualify as a redemption.

1. When a redemption classifies as a sale/exchange then we can use the adjusted basis of the shares redeemed to offset the amount paid right? The resulting gain would then be capital gain (since it's a sale of stock, which is considered a capital asset). Since Julio is in the 35% normal tax bracket, what capital gain tax bracket would he be in?
You would apply this capital gain tax bracket to his gain on the redemption of the stock.

2. When a redemption DOESN'T qualify as a sale/exchange, what is it considered?
It's a dividend. Meaning we can't use the adjusted basis of the stock to offset the amount paid.
Since there is adequate E&P, ALL the amount paid will probably be a dividend…
Hmm, are there preferential tax rates for dividend payments to individual shareholders? I think so…

The main difference between 1 and 2 is that in 1, only the gain on the sale is taxed (since we can offset the amount paid with the adjusted basis of the stock) and in 2, we have to pay tax on the entire amount (since it's a dividend).
–>As you can see, you'd prefer proper redemption treatment as a shareholder so that you can offset your gain with the adjusted basis of the stock.

3. So this flips the entire scenario on its head. Why? The dividend received deduction is granted to corporations.
So as a corporation, you might actually want dividend treatment.
–>When you redo problem 1 as a corporation, just do the same process with a 34% tax rate. Why? Although the gain is still capital gain, corporations don't get preferential capital gain tax rates like individuals do.
–>When you redo problem 2 as a corporation, don't forget to reduce the dividend payment for the dividend received deduction (I'll let you figure out what that is for a 15% corporate shareholder). Subtract the DRD from the total dividend to get the dividend income that will be taxed. Remember that there are no preferential dividend tax rates for corporations either, so the remaining dividend income will be taxed at 34%.

Not sure if you're using WileyPlus or some other homework software, but once you get your answer, I'd be happy to check them for you.

Good luck!

[Author]

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