PROBLEM 3 Bedrock Inc. is owned equally by Barney Rubble and his wife Betty, eac

Question

PROBLEM 3 Bedrock Inc. is owned equally by Barney Rubble and his wife Betty, each of whom hold 1,000 shares in the company. Betty wants to reduce her ownership in the company, and it was decided that the company will redeem 500 of her shares for $25,000 per share on December 31 of this year. Betty’s income tax basis in each share is $5,000. Bedrock has current E&P of $10,000,000 and accumulated E&P of $50,000,000. a) What is the amount and character (capital gain or dividend) recognized by Betty as a result of the stock redemption, assuming only the “substantially disproportionate with respect to the shareholder” test is applied? b) Given your answer to part (a), what is Betty’s income tax basis in the remaining 500 shares she owns in the company? c) Assuming the company did not make any dividend distributions this year, by what amount does Bedrock reduce its E&P as a result of the redemption? d) Can Betty argue that the redemption is “not essentially equivalent to a dividend” and should be treated as an exchange?

Explanation / Answer

a) What is the amount and character (capital gain or dividend) recognized by Betty as a result of the stock redemption, assuming only the “substantially disproportionate with respect to the shareholder” test is applied?

Solution: Betty want to reduce her ownership in Bedrock inc. from 50% to 33.33% (i.e, 500 / 1,500). However under family attribution rules, she is deemed to own the 1,000 shares owned by her husband, Barney.
Her stock ownership before the exchange is still 100% (1,500/1,500).
betty fails the sustainability disproportionate test to treat the redumption as an exchange.
As, a result Betty recognizes a dividend of $12,500,000 ( $25,000 * 500 shares).

b) Given your answer to part (a), what is Betty’s income tax basis in the remaining 500 shares she owns in the company?

Solution: Betty’s income tax basis in her remaining shares is $5,000,000.Betty adds back the“unused” tax basis of the 500 shares redeemed ($2,500,000) to the basis of herremaining 500 shares ($2,500,000).

c) Assuming the company did not make any dividend distributions this year, by what amount does Bedrock reduce its E&P as a result of the redemption?

Solution: Bedrock reduces its accumulated E&P by the cash distributed ($12,500,000).

d) Can Betty argue that the redemption is “not essentially equivalent to a dividend” and should be treated as an exchange?

Solution: No.The attribution rules apply to this test as well as the other stock ownership tests.

As a result, Betty is treated as owning 100% of the Bedrock stock before and after the reduction.

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