 Hello and welcome to this session in which we will discuss the stock attribution rules section 318 of the IRS code Prior knowledge is essential for the session such as the knowledge of stock redemption. And what is stock redemption? Let's do real quick stock redemption is when you sell your shares back to the company Or when the company buys back the shares from the shareholder in the prior session We looked at stock redemption in details and for a stock redemption to be considered a sale It must result in a substantial decrease Substantial decrease in the shareholders interest in the company Now why do we have to determine whether it's a sale or an exchange? Because it makes a difference whether it's a sale slash exchange or dividend because it makes a difference to your taxable amount Well as a shareholder you would prefer that it's considered a sale or an exchange Why because when you make a sale you can deduct your basis It's gonna reduce your taxable income to figure out your capital gains or capital loss So one thing is you can deduct your basis. That's one. That's one benefit The second benefit if you have a capital loss You can deduct your capital loss against other capital gains and we discuss this in a prior session and we work several examples Corporate shareholder if you record if your corporation you would rather have The distribution treated as a dividend. Why? Because you have something called a dividend to receive deduction you include the income then you can deduct it So this is basically a quick review about stock redemption. Let's go back and look at quick example to see The big picture here. What what do we need to discuss? Let's assume? I own 60% of my company Farhat lectures my wife owns the remaining 40% I Sold all my shares back to my company. So I sold 60% of the shares back to the company Now my wife still owns 100% of the company now not still she still owns the 40% and the 40% becomes the only Shareholder and she owns 100% Now what happened to my ownership? My ownership went from 60 percent down to zero. Is this a substantial decrease? Well, that's not only substantial decrease. That's a complete Complete reduction of my shares Well in form it does in substance It does not in substance. I'm deemed to still own Farhat lectures I still own 100% through my wife. So this is what the stock attribution rules. So although I am out. I sold the shares I'm not really out. I'm Dean. I'm deemed an owner through my wife So who are these parties that makes you a deemed owner of the stock stock attribution rules? This is what we need to discuss in this session. Let's go ahead and get started before we proceed any further I have a public announcement about my company farhat lectures calm Farhat accounting lectures is a supplemental educational tool That's gonna help you with your CPA exam preparation as well as your accounting courses My CPA material is aligned with your CPA review course such as Becker Roger Wiley Gleam miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics My resources consist of Lectures multiple choice questions through false questions as well as exercises go ahead start your free trial today For the stock attribution rules You can be connected to the company through either family members like your wife We're gonna look at those rules a little bit more in details all through entity related Entity related relationship through a corporation or through a partnership Starting with the family. Well shares owned by immediate family members such as spouse children grandchildren Parents as well can be attributed at the taxpayer. Although you are out these individuals. They can bring you back in so you're not out really Not siblings or grandparents those that's okay. They own shares. You are not connected to them Let's take a look at an example Adam and Eve married couple each own 60 shares of Phoenix corporation To gather they own 100% of the company All the stock was purchased for 100,000. We're gonna assume 50,000 paid by Adam 50,000 paid by Eve now both Adam and Eve served as Directors of the corporation Now the corporation redeems buys back the 60 shares of Adam But he continued to serve as the on the board director of the corporation Okay, now this redemption is treated as dividend distribution assuming we have enough EMP because Adam still constructively Owns Eve's stock, which is 100% of the Phoenix stock now Adam's basis Of 50,000 is transferred to Eve's don't go away because remember Adams on the whatever the whatever the Sale happens to be let's assume the company gave Adam 300,000 this 300,000 becomes dividend So what happened to his basis that he paid? Well, his basis is transferred to his wife Now Eve's basis is 100,000, which is her 50,000 plus the 50,000 of Adams So the basis when she sells her shares the basis in the stock is 100,000 so bases don't disappear They got transferred to the person that still deemed you as the owner You could also be an owner through partnership attribution rules From partnership to partner for example a partner is considered to own stocks owned by the partnership To the extent the partners proportionate interest in the partnership. What does that mean? Let's assume if a partnership Owns 100% in a company company a and you own And a partner has and a partner has 25% in the partnership So the partnership owns 1,000 shares in company a you are 25% owner in this partnership You own 250 shares of company a or deemed to own them for this rule It could it could also occur from a partner to a partnership The other way around stock owned directly or indirectly by a partner is considered as owned by the partnership For example, if a partner owns 500 shares in a company The partnership is deemed to own those 500 shares It could also be transferred from partner to partner if a partner owns Stock directly or indirectly Any other partner who owns more than 50% of the partnership is deemed to own that stock as well For example of partner a owns 100 1000 shares in company a And partner b owns more than 50% of the partnership Partner b is considered to own those 100 1000 shares by partner a of company a You could also be connected through corporate attribution rules from corporation to shareholders and vice versa as well A shareholder is considered to own the stock Owned directly or indirectly by a corporation again in proportion to the share of the ownership in that corporation Example for example that the corporation owns 1000 shares of apple stock And shareholder a owns 10% of the corporation that shareholder is considered to own Deemed 100 shares of apple stock And conversely if the shareholder owns the stock the corporation is also considered to have owned that stock as well Now what are transactions that are treated as redemption? in other words What are some of the transactions that when the company buys back the shares from the shareholders? It's treated as a redemption It's treated as a sale where we have a sale minus the basis And that's what the shareholder want to get to the capital gain or capital loss Well the following are exceptions Distribution resulting in termination of shareholder interests Well, you just told me if I sell all my shares I might I might not I may not be out Well, we're going to look at specific rules. You may sell all your shares Even between a husband and wife and there's an exception where you can get out of it Then you are no longer deemed a shareholder would look at these rules Distribution for settling estate taxes. Well, the person dies Then we need to buy back their shares to pay for estate taxes. We'll look at that Distribution not fundamentally equivalent to a dividend and this is going to be evaluated by a subjective test This proportionate distribution. This is called the 8050 rule. That's also when it applies Now remember if the transaction not qualify as a stock redemption It's qualified as ordinary dividend assuming the company has EMP earnings and profit And remember if it's qualified as ordinary dividend the basis in the redeemed stock is allocated to the remaining stock owned Either directly or indirectly via the constructive ownership. So the basis don't go away. The basis are transferred. For example, they went from Adam to Eve because Eve is the person that kept Adam involved in this corporation. Let's take a look at exception one. Okay The complete termination is eligible for sale or exchange treatment Okay, but remember if you have a family due to the stock contribution It's often does not qualify at this proportionate redemption However, there's an exception family and attribution rules are not applicable if The former shareholder retain no interest except as a lender for a minimum of 10 years So you have to be out and you have to be out for 10 years. You can't go back and buy Any stocks now if you have a creditor relationship creditor means if you lend them money, that's fine, but you cannot be an owner Also, you have to send a letter to the IRS saying I am out for 10 years Also, you have to be out in terms of management consultancy advice You're no longer involved in the company except as a creditor if that's the case Then When I sell my shares, I'm not involved. My wife is still involved. That's fine. I'm out. I can treat the redemption as a sale Let's take a look at an example Thomas holds 60 percent in blue corporation The remaining shares are owned by his wife Amelia And 10 percent by Sophia a vital employee Blue corporation purchase all of the interest of thomas at its fair value What happened is a result what's left is Amelia and Sophia Amelia and Sophia remember Amelia owns 30 percent Sophia owned 10 percent now together they own the full 40 percent 30 out of 40 is 75 percent now Amelia 75 percent owner in Sophia 10 out of 40 is 25 percent owner so Amelia sell the major at 75 percent If the two requirements for the family attribution waivers are met If they are met the transaction would qualify as a complete termination and would result in a sale for thomas If the waiver are not satisfied Thomas will will deem to own the shares of his wife And the entire distribution will be taxed as dividend assuming we have enough EMP Let's take a look at this Continue with this example assuming that thomas qualify for the family attribution waiver In the year of redemption thomas will treat this transaction as a sale or an exchange however If he purchases Sophia start or get involved by any interest In the next seven years after the redemption what he has to do He has to tell the IRS I acquired a prohibited interest And as a result we have to go back to that transaction Where we redeem the shares and reclassify it as dividend So thomas must notify the IRS that that happened and he will owe additional taxes The second exception redemption to pay death taxes and other expenditure What does that mean? It means in case of death we need to The company needs to buy back the shares from the shareholder to give them some cash It could be considered a redemption This rule allow liquidity for an estate to pay taxes when it involved non publicly traded companies Usually this happens with small family business because they need money to pay the estate taxes So well if that's the case would allow you to redeem some of the stock the corporation to give you cash And it will be considered a redemption Sale or exchange treatment applies of the stock value Surpasses exceeds 35 percent of the adjusted value of the estate. What does that mean? What what happened when someone dies they look at the the fair market value of their estate? Look at everything from fair market value stocks bonds real estate boats airplanes, whatever they owned as long as 35 or more is tied up in stock Then we can liquidate and have it as a redemption if it's not 35 Then you can so the first thing these the stock value of the estate has to exceed 35 the stock This special treatment is restricted to the combined sum of death taxes funeral expenses at administrative cost So when you take out the money What's considered a redemption the amount that you use for death taxes funeral expenses and administrative cost anything else will be considered a dividend The basis of the stock is stepped up to the fair fair market value at the time of that all an alternate valuation date We'll talk about that later, but simply put Usually the redemption price will match the adjusted basis because in case of that the fair market the basis Equal to the fair market value Why because there's a step up basis So when you step up the basis and you sell the stock immediately the fair market value and the basis should be the same should be no tax implication Let's take a look at an example Victoria's adjusted gross estate is worth 30 million. So all her estate is worth 30 million That that taxes and the funeral cost expenses for the estate amounted to 2,880 The gross estate of the violet corporation valued at 11,200,000 So we have stocks in there and we have 11.2 million worth of stocks In this company and v company Well, let's take a look at the percentage if we take 11.2 million divided by 30 million So if we take 11.2 divided by 30 million, that's going to give us 37.33 percent We have enough stocks in the company to qualify for the redemption because it's more than 35 percent Victoria bought the stock eight years ago for 1.2 million. We really don't care Because what we're going to be using we're going to have a step up basis And the corporation redeemed 2,880,000 the needed amount for that taxes and for the funeral Okay As the value of the stock is exceeds 35 percent. We qualify for the 303 exception And what we do is we Liquidate the stock 2.8 million. We say the basis are 2.8 million. Therefore, there's no tax consequences third exception Not essentially equivalent dividend. This is where you have to argue that this exchange is essentially not dividend Okay It's basically it's a subjective determination This rule was specifically meant for the redemption of preferred stock but could apply to common stock as well So basically the preferred stock would say look I am buying you are buying back my shares, but I'm not really an owner. So it's really it's a purchase Common stockholder they started to argue look you're buying back my shares, but I'm losing a lot of control of the company I'm not I'm no longer in control. It should be considered a substantial reduction. Okay So the reduction must the redemption must lead to a substantial reduction meaningful reduction in the shareholder interest. Okay now What could be some indicators? What could you argue? You would argue that I'm no longer have a voting control I'm no longer in charge or you can say I am reducing my participation in corporate profit or liquidation Receive assets upon liquidation So let's take a look at this example. Again, this is a subjective measurement. Alex owned 75% of the common stock of phoenix After the redemption his ownership went from 75 to 65. Okay Alex still maintained voting control over phoenix. So for example, Alex cannot argue. This is a meaningful reduction Okay, consequently the the old the redemption the 10% redemption will be considered dividend assuming the company has sufficient earnings and profit How about if Alex goes from 75 to 40% Alex might try to argue. Look, I'm no longer in control I want this Transaction to be treated as a sale Just it's a subjective measurement The fourth exception is called the 8050 rule. It's a qualifying disproportionate redemption 8050 A redemption is seen as a disproportionate redemption if we have to we have to have two Conditions to be met The shareholder retained less than 80% of their previous interest post redemption So after the redemption he owns 80% less of his previous redemption not 80% of the company 80% less of his previous redemption and notice here and His shareholder total shareholder interest is less than 50%. So after the sale he owns less than 50% of the company And less than 80% of his previous Possession the best way to illustrate this with a number with numbers if shale holder owns 60 out of 100 So right now the shareholder owns 60% of the company This shareholder decided to redeem sell back 25 shares. What's left is for him is 35 now he owns 35 out of 75 simply put his his new structure of ownership is 35 out of 75 which is he owns now current ownership is 46.66 Which is less than 50% so the first The first condition is met. He owns less than 50% Does he less owns less than 80% of his previous position? Well, he owns 60% times 80% 48% He has to own less than 48% and 46.66 is less than 48% He met both conditions This transaction will be qualify as what as a redemption why he owns Overall less than 50% and he owned less than 80% of his previous ownership What's the effect on the corporation with the redemption if there's a gain or loss of property other than cash is used for redemption Corporation recognize the gain Not the loss. We already should know this rule. What should the company do under those circumstances sell the asset Sell the property recognize the loss use the proceeds to buy back the shares from the shareholders What is the effect on EMP? Corporate effect on EMP and a qualifying stock redemption means it's a sale Well, if it's a sale EMP is reduced by the sum not exceeding the proportional share of EMP attributed to the redeem stock Now you can reduce EMP, but it has to be in proportion to the ownership of the Person so if you reduce their ownership by 25 percent EMP is reduced by only 25 percent Bear in mind any corporate expenses related to the stock redemption Such as accounting brokerage legal loan fees are non deductible non deductible expenses Why because those are not expenditure needed to operate the business. This is not operating the business This is a finance. This is you're changing the ownership structure. This is a finance transaction. Therefore not operating expenses Therefore not deductible. You're going to reduce the equity. It's not deductible on the income statement not deductible for tax purposes ocean corporation Which currently has 200 shares of stock? In a qualifying stock redemption ocean corporation pays 300 000 to buy back 60 shares 60 out of 200 is this is a 30 percent redemption at the time of the redemption ocean paid in capital Has paid in capital of 200 000 and earnings and profit of 600 000 well EMP is reduced only by 180 Why 180 it's 30 percent reduction in the ownership 30 percent reduction in EMP This is what this is what this is what I just said earlier The remaining amount of the redemption reduces what the remaining reduces paid in capital reduced paid in capital We don't expenses not an expense not an expense. We just reduced paid in capital equity However, if 60 shares were redeemed for 100 000 instead The EMP would be reduced by 100 000, which is the exact amount paid by the corporation Not we don't we don't reduce it by 180 if we paid 100 our reduction is 100 000 So it's the lower you cannot go more than 30 percent But if you paid less well of the owner accepted less, that's fine Um, you will reduce EMP by less. What should you do now? You should go to far hat lectures look at additional mcqs true false additional lectures simulations that's going to help you understand stock redemption Stock attribution rules whether you are a CPA exam candidate Whether you are an enrolled agent or an accounting student invest in yourself. You need to know these topics. Good luck study hard And of course stay safe