› Forums › Support Library › EPT – Estate Planning Tools › Substantially Disproportionate Redemptions
Kathleen ReynoldsKeymasterOctober 15, 2022 at 3:38 pmPost count: 428
Calculates the number of shares that a corporation must redeem (buy back) in order for a redemption from a shareholder to qualify as a substantially disproportionate redemption. Substantially disproportionate redemptions are entitled to “sale or exchange” gains treatment. The calculation checks the “proper number to redeem” calculation by comparing the post-redemption ration with the pre-redemption ratio.
All distributions from a corporation to a shareholder with respect to its stock are considered dividends to the extent of earnings and profits. Dividends are taxed at ordinary income rates. This policy applies even if the recipient shareholder gives up stock in the transaction.
Some distributions, however, are deemed “amounts received in exchange” for the stock, rather than dividends. In this case, the seller pays tax only on the difference between the “amount realized” and the “adjusted basis.”
To qualify as an exchange, the transaction must satisfy the requirements of one of several tests (see Code Sections 302 and 303). One of these is the “substantially disproportionate” test. Under this test, the transaction is considered an exchange if the distribution from the corporation is substantially disproportionate with respect to the selling shareholder. A redemption is substantially disproportionate if it meets the following three criteria:
- After the redemption, the shareholder must own less than half of the total combined voting power of all classes of outstanding stock entitled to vote.
- After the redemption, the shareholder’s percentage of total outstanding voting stock must be less than 80% of his pre-redemption ratio.
- The shareholder’s post-redemption percentage ownership of outstanding common stock (voting or non-voting) must be less than 80% of his pre-redemption ownership.
A substantially disproportionate transaction is illustrated in the following example. Prior to redemption, a stockholder owns 30 out of the 100 shares of voting common stock outstanding (the only class of outstanding stock). His pre-redemption ratio is 30/100 (30%). Seven other shareholders hold 10 shares each. If the corporation buys back 10 of the stockholder’s 30 shares, but does not redeem shares from any other stockholder, the shareholder’s after-redemption ratio is 20/90 (22.2%). This is less than 50% of the outstanding stock and less than 80% of his pre-redemption ratio (80% of 30% is 24%); therefore the redemption is substantially disproportionate.
If one of the other stockholders is someone whose stock is attributed to the stockholder (such as a child, wife, etc.) under constructive ownership (attribution) rules, the redemption of his shares does not qualify as substantially disproportionate. The disqualification occurs because the stockholder owns his own 20 shares, plus the 10 shares attributed to him. His after-redemption percentage would be 30/90 (33.3%), which is more than 80 percent of his pre-redemption percentage (40/100, 40%).
- Shares Actually Owned Enter the pre-redemption shares that were actually owned.
- Shares Constructively Owned Enter the pre-redemption shares that were constructively owned.
- Total Shares Outstanding Enter the pre-redemption total number of shares (actual and constructive) that were outstanding.
- Shares Actually Owned Enter the post-redemption shares that are actually owned.
- Shares Constructively Owned Enter the post-redemption shares that are constructively owned.
- Total Shares Outstanding Enter the post-redemption total number of shares (actual and constructively) that are outstanding.
The Summary Tab shows the number of shares that are owned pre and post redemption. It also displays the shareholder’s pre-redemption and post-redemption ratios. Additionally, 80% of the pre-redemption ratio is calculated and displayed. This value is an essential factor in determining if the transaction qualifies as substantially disproportionate, as the post-redemption ratio must be less than 80% of the pre-redemption ratio.
The Redemption Tab shows the number of shares that must be redeemed (bought back) by a corporation in order for the redemption from a shareholder to qualify as “substantially disproportionate.” The shareholder must also own less than 50% of the total combined voting power in the corporation.
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