Federal Income Tax 2 – Discussion W3

Redeeming the stock of a major shareholder in a closely held or family-owned business
has advantages and disadvantages. The amount that the major shareholder receives will be a
distribution in section 301. The redemption will be an advantage as it will be treated as a capital
gain for the company. The redemption will be in section 301 as the major shareholder no longer
has shared with the corporation. The strategy is an advantage as redeeming all the shares from
the major shareholder in the form of cash or a note will prevent the other family members from
having to individually finance the purchase of direct stock.
However, the redemption will be a disadvantage if the family member fails to waiver the
family attribution. In such a situation, the redemption will be treated as a corporate distribution
instead of an exchange. Thus, the redemption will be a loss as it will not qualify for the capital
gain treatment. According to the constructive ownership rule of section 318, waiving the
attribution of the family is the only exception if a parent decided to terminate his or her contract
with the corporation.
Since the parent will be assumed to be owning any of the shares owned by the children,
redeeming will a disadvantage in such a situation. One of the tax effects of redeeming
corporations is a reduction in the corporate’s earnings and profits. The decrease in the earnings
of the corporation will depend on the tax effect the redeeming has on the shareholders. Also, the
taxable income of individuals in the corporation will adversely increase. For the redemption to
get the exchange treatment, the family attribution rule must apply where all the interests should
be surrendered for a period of at least ten years.