 Hello and welcome to the session in which we will discuss stock redemption. It's a fancy word for stock buyback This is what we learned in financial accounting and intermediate accounting the term in taxation is called stock redemption What is the big idea of stock redemption? Stock redemption is the process when the shareholder Sells back their stock back to the company now a stock buyback. It's one the corporation buys back the stock So it's the same transaction except here Assuming that the shareholder is selling the stock back to the company, but the shareholder here What we are assuming is controls the company so the shareholder makes the decision on behalf of the corporation Typically they will be the company would give them either cash or some other asset Let's start with a simple example to seed to look at the big picture Let's assume I invest at $10,000 in my company and issued 1,000 shares for four half lectures You know 20 years ago. So really my basis in the shares if I invest at 10,000 issued 1,000 shares It's $10 per share over the years four half lectures made a million dollars in earnings and profit Here's what happened now. I Redeemed I sold back 200 of my shares the four half lectures for 3000 remember when I started this business I Contributed $10,000 to the corporation. This is the corporation and the corporation gave me stock Of the company now what I did I said okay now and they gave me specifically we issued 1,000 shares what I did now I said, okay, you know what I'm going to sell back 200 of those stocks and I want you to give me back $3,000. That's what we did. So it's like the opposite of when the company was established So I redeemed those shares now if I redeemed those shares and this is truly a sale. Here's all that here's what would happen my Proceeds are $3,000 My cost basis is $2,000 Well, I have a profit of a thousand long-term capital gain I'm I will multiply this by long-term capital gain rate, which could be zero fifteen or twenty percent It's taxed as capital gain Now the IRS might question this the IRS might say, you know what this doesn't like this doesn't look Really like a sale this most likely this this this is likely a dividend now. Why why is the IRS concerned? It's a dividend and not a sale So let's talk about from a benefit motivational perspective as as as the owner of the company as far hat Would I rather treat this as a long-term capital gain or would I rather treat this as a dividend? Well, the dividend rate is also 0 15 and 20% assuming it's a qualified dividend. So the rate is the same What would be different? Well For one thing if it was dividend the full amount the 3,000 will be subject to this amount if it's a long-term capital gain. I can deduct my losses However, this is as an individual as a corporate shareholder We're gonna see later. You might prefer dividend and we'll see this in numbers again The IRS would always want you to treat this or they would prefer that you treat it as dividend Now, let's think about this for a moment. Let's think about this before we proceed any further What can I do as far hat? What can I do to keep treating this as long-term capital gain? Well, I can forever do what I can forever issue new stock dividend to myself In other words, you remember when you talked about stock dividend the company issue new stock dividend to the current shareholder I will take those stock dividend I will take those newly issued stock and exchange them for cash and I keep I can keep doing this and Treat those as long-term capital gain. You see where the problem could occur where the IRS would say hold on a second You're taking money out You're treating it as long-term capital gain, but it should be classified as a dividend now in this session We need to learn When is it classified as stock redemption indeed and when it's not? We're gonna look at the big picture. Let's go ahead and get started Before we proceed any further. I have a public announcement about my company far hat lectures comm Far hat 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 So stock redemption for a stock redemption to qualify for a sale treatment It must generally lead to a significant decrease and the term that they use Substantial reduction and the share in the shareholders ownership stake and the corporation. Let's go back to my example Let's go back to my example. I have a 1000 shares I Sold back 20 shares. I still own 980. Let's assume rather than 20. I sold back 800 of my shares. I still have 200 shares. Those 200 shares still represent 100% ownership So even if I sell 999 shares of the thousand selling back to the company, I'm still 100% owner So there's no substantial reduction in my ownership. Therefore, this doesn't look like a sale. This looks like a dividend Okay, and we're gonna learn later In another session. There's something called stock attribution rules So sometimes you might sell your shares, but you are still owner of the company You may not have you mean you may be out altogether, but indirectly you could still be an owner We'll talk about this in the next session, but this is the big picture here So as a short sold shareholder, you only have a sale if you have a complete Redemption simply put you're getting out and sometimes even when you get out through stock attribution rules You might still be an owner But the point I'm trying to make for for the IRS to consider my redemption as a sale I really have to get out. Okay. Now why redemption occurs? So why do companies buy back their shares? Well, if it's a publicly traded company There are many reasons but one reason is to bid the bid the price up To increase the price of the stock they buy it So therefore it increased the demand to reward the shareholder because the price goes up at reward the shareholder And this way you can you can reward them with no tax distribution in other words So why redemption occurs? Well for public companies, they want to bid the price up in other words They want to create more demand for their price. They want to reward the shareholder So when the price goes up, there are no tax consequences to the shareholders There are many reasons, but this is one of the reasons for closely held companies Which is private companies. Sometimes they buy the stock back when the shareholder passes away Or there's a divorce situation husband and wife. They own the same company. They're getting a divorce Well, you will sell back the stock to the company Agreement between shareholder and corporation Basically, there's five shareholders and they have an agreement if one leaves they cannot sell their shareholders to an outsider They would they have to sell it back to the company. There are many reasons the point is the company could always buy back the shares Redemption qualified as a sale or as an exchange. So remember you want to want the exchange to classify as a sale or an exchange If it's qualified Shareholders report gain and losses on the stock surrender Basically, you have a capital gain or a capital loss and you get taxed at either 0 15 or 20 percent capital gain long-term capital gain So the shareholder they reduce gains by the basis in the stock. So if you sold 10,000 Your basis are to you have a gain of 8,000 Now remember that capital gains my offset capital losses of available So if you have capital losses, let's assume you have stocks of other companies and you have losses losses of 8,000 Guess what the gains and the losses will offset each other and you're not responsible for any taxes So that's why capital gains are good because you can you can offset them and two reasons why they are good First you can use them against capital losses if you have capital gains and if you have capital losses You could use it against capital gain and the most importantly you could deduct your basis So you so the basis would reduce your proceeds if the transaction appears as a dividend Well, what does that mean? Means if the shareholder owns 100% and corporation buys half of the stock for whatever dollar amount The shareholders still own the stock. Therefore, it's classified as a dividend So if not classified as a redemption shareholder would report dividend you receive dividend dividend are taxed at 0 15 and 20 Well, hold on a second Capital gains are taxed at the same rate So why would I care whether it's a capital gain or dividend as I mentioned two reasons one? basis reduce the proceeds and we're gonna work an example and Net capital gain can offset capital losses week if you have gains and you have losses You can offset the gains with the losses or if you have losses and gains from other sources You can offset the gains with the losses, but redemption proceeds may not offset by basis in stock surrender So if you said it's a dividend, there's nothing you can do except tax You cannot offset capital losses now if you are a corporate shareholder not individual you might like to receive dividend Why because I'm sure you remember when we talked about dividend You have a dividend to receive deduction. So let's assume far hat lectures also owned by Google. Yeah, right But let's assume that's the case. Well, Google would prefer that when we take money out They would receive it as dividend Why because they would get a dividend received deduction and the best way to illustrate this is to look at an example Let's take a look at this example from an individual perspective Adam an individual in the 34% tax bracket purchase stock and far hat corporation Five years ago for 100,000 this year far hat corporation with an EMP of 1.5 million Redeems his shares for 200,000. So basically Adam purchased the shares five years ago Now Adam turns around and sold the shares back to the company for 200,000 and the company has plenty of earnings and profit If the redemption qualify for the sale Adam would realize a long-term capital gain of 100,000 200,000 Minus the basis his income tax liability will be 100,000 he would qualify under the 15% you know, 0 15 or 20 He's qualified under the 15% based on his tax bracket and he would be charged 15% which is $15,000 on the $100,000 now if you don't know the long-term capital gain 0 15 and 20% you want to go to that session and learn how do we taxed long-term capital gain? If the stock redemption is not considered a sale simply put it's considered a dividend Well, it's the whole amount the 200,000 is dividend times also 15% But that's going to give Adam a tax bill of 30,000 Adam can save $15,000 An income taxes if transaction qualify as a stock redemption Why because the tax bill is 15 as a dividend the tax bill is 30 Let's take a look at another it changed the scenario a little bit now Let's assume Adam carries a capital loss of 70,000 in the in the current tax here So when he made the sale he also have a capital loss if the transaction qualifies as a stock redemption Which want to show you the benefit of the capital gains when you have a capital loss Adam can offset his entire Capital loss against his long-term capital gain So all in all now his only gains is 30,000 and he will be taxed on that 30,000 times 15% And Adam tax bill now is down to 4500 Why because yes, he had a capital gains of 100,000 from the redemption of farhat stock But from another source he had a capital loss of 70,000 So his long-term capital gain long-term capital gain is only 30,000 times 15% It's even better. So notice the benefit of the treating the transaction as a long-term capital gain if that transaction does not qualify then It's 200,000 times 15% you cannot offset anything Also assuming he has no capital gains in the current year Adam would only be able to adopt 3,000 of the 70,000 Remember he had the 70,000 he can only offset 3,000 out of it because this is the limit by law Let's take a look when the Shearholder is a corporation now. Let's assume Adam is a calendar year calendar year C corporation And that the stocks represent 45 ownership in farhat corporation in the current year Adam has a corporate taxable income of a million dollar before the stock redemption So if the transaction qualify as a stock redemption, Adam will have a long-term capital gain of 100,000 times 21 corporate rate, which is 21,000 assuming this is a sale Let's assume Adam as a corporation Now we'll have to treat this transaction as a dividend if the 200,000 distribution is treated as a dividend Adam would receive a dividend receive deduction of 130,000 in other words 200,000 times 65 percent Dividend receive deduction or if you don't know what a dividend receive deduction you want to go there And learn about dividend receive deduction So of the 200,000 dollar in dividend dividend receive deduction Lower the dividend down to 70,000 now 70,000 we can live with that Now our tax bill is 14,700 Assuming Adam is a corporation. So notice Adam as a corporation would prefer to receive the dividend Adam as a shareholder will prefer to treat this as Long-term capital gain and I showed you in numbers the difference between the two What should you do now? You should go to farhat lectures Look at additional resources, especially mcqs through false additional Exercises that's going to help you understand this stock redemption concept, whether you are a CPA exam candidate enrolled agent or an accounting student Stock redemption is an important topic for the for your career. Good luck study hard. And of course stay safe