Play Meter
Issue: 1986 March 15 - Vol 12 Num 4 - Page 86
redeeming (selling back to the corporation) your non-
voting preferred stock to solve your financial problems.
Unless some strict tests are met reducing your voting
control in the corporation, the proceeds of the redemp-
tion will be taxed as ordinary income.
Suppose you and two other shareholders are foun-
ders of a closely held corporation. Each owns 18 percent
of the common stock. The rest of the stock is owned by
various members of your families and friends, none of
whom owns more than two percent. There is also a class
of nonvoting preferred stock owned in the same pro-
portion as the common stock. What would happen if you
redeemed your 18 percent of nonvoting preferred stock
to meet your cash needs? A tax disaster. Here's why.
The Internal Revenue Code awards you capital-gain
treatment for the profit on your sale of stock to the cor-
poration if the redemption meets one of three tests:
1. It terminates your interest in the corporation
completely.
2. It substantially reduces your voting power.
3. It is not essentially equivalent to a dividend.
The redemption of the nonvoting preferred stock
fails to meet test one or two. After the redemption, you
would still have an interest in the corporation and
unchanged voting power. Will test three do 'the trick?
No . Here's why.
I
A redemption is considered not essentially equiva-
lent to a dividend if it results in a meaningful reC!uction of
the shareholder's proportionate interest in the corpora-
tion. "What does that 'taxalese' mumbo-jumbo mean?''
you're probably asking. The courts have said that in
, determining whether a meaningful reduction takes place
. and c;;_apital-gain treatment is allowable in a redemption,
three elements should be considered. Those are a reduc-
. tion·+A- the shareholder's right to:
1. vote and exercise control over the corporation's
affairs;
2. participate in current earnings and accumulated
surplus of the corporation; and
3. share in the net assets of the corporation upon
liquidation.
In this case, the proposed redemption certainly
would reduce your percentage interest in the corpora-
tion's current earnings, accumulated surplus, and net
assets upon liquidation. But your voting interest
remained undiminished, and that sets the stage for a tax
disaster.
"Wait a minute," you protest, "I have only a minority
voting interest. That doesn't give me any right to direct
the corporation's affairs. I'm not even related to the other
two 18-percent shareholders. My voting interest
shouldn't even be considered." Logic is on your side. But
no dice, says the IRS.
Revenue Ruling 85-106, dealing with a similar' situa-
tion, holds that a redemption that does not reduce a
shareholder's ability to be part of a control group is not a
meaningful reduction in the shareholder's interest in the
corporation. Under these facts, your voting power could
be combined with that of the other two 18-percent share-
holders, enabling you to be part of a control group
directing the operations and financial affairs of the cor-
poration. Regardless of the reduction of your economic
interest in the corporation, your failure to reduce your
voting power means your interest in the corporation was
not meaningfully reduced, and that nixes capital-gain
treatment.
•
Expired tax breaks
may return
At the end of 1985 many tax breaks expired without
being renewed by Congress, which is preoccupied with
tax reform, the budget, and re-election. The House Ways
and Means Committee, however, will soon begin drafting
legislation to resurrect some of the expired proviSions.
Here is a list of some of the more popular old-friend
breaks being given a chance at new life:
1. The exclusion of up to $5,000 for employer-
provided educational assistance (employer pays
employee's tuition)
2. The 25-percent tax credit for incremental
research and development
3. The exclusion for benefits paid by an employer
under a pre-paid legal-services plan (employer pays for
employee's legal fees)
4. A host of residential and business energy credits
(only those provided for in the recent House-passed tax-
reform bill would be considered)
5. The targeted-jobs credit
6. The exclusion for van-pooling (employer pro-
vides transportation between employees' residences and
the workplace)
7. The expensing of costs for removing architec-
tural barriers to the handicapped
All of these provisions would have been extended
under a House bill passed late last year but rejected by
the Senate.
If Congress is true to form, the provisions that pass
will be made retroactive to January 1, 1986. For example,
the employer-provided tuition exclusion expired at the
end of 1984, but was resurrected in spring 1985 and made
retroactive to January 1, 1985.
•
/ruing L. Blackman is a CPA specializing in taxation and
closely held businesses. A partner in the firm of Black-
man, Kallick & Co., Ltd., he will consult with readers of
his column. Write him at 300 South Riverside Plaza,
Chicago, IL 60606, or call (312) 207-1040.
Advertising reaches
more buy~rs In Play Meter
I
84
PLAY METER. March 15, 1986
j
voting preferred stock to solve your financial problems.
Unless some strict tests are met reducing your voting
control in the corporation, the proceeds of the redemp-
tion will be taxed as ordinary income.
Suppose you and two other shareholders are foun-
ders of a closely held corporation. Each owns 18 percent
of the common stock. The rest of the stock is owned by
various members of your families and friends, none of
whom owns more than two percent. There is also a class
of nonvoting preferred stock owned in the same pro-
portion as the common stock. What would happen if you
redeemed your 18 percent of nonvoting preferred stock
to meet your cash needs? A tax disaster. Here's why.
The Internal Revenue Code awards you capital-gain
treatment for the profit on your sale of stock to the cor-
poration if the redemption meets one of three tests:
1. It terminates your interest in the corporation
completely.
2. It substantially reduces your voting power.
3. It is not essentially equivalent to a dividend.
The redemption of the nonvoting preferred stock
fails to meet test one or two. After the redemption, you
would still have an interest in the corporation and
unchanged voting power. Will test three do 'the trick?
No . Here's why.
I
A redemption is considered not essentially equiva-
lent to a dividend if it results in a meaningful reC!uction of
the shareholder's proportionate interest in the corpora-
tion. "What does that 'taxalese' mumbo-jumbo mean?''
you're probably asking. The courts have said that in
, determining whether a meaningful reduction takes place
. and c;;_apital-gain treatment is allowable in a redemption,
three elements should be considered. Those are a reduc-
. tion·+A- the shareholder's right to:
1. vote and exercise control over the corporation's
affairs;
2. participate in current earnings and accumulated
surplus of the corporation; and
3. share in the net assets of the corporation upon
liquidation.
In this case, the proposed redemption certainly
would reduce your percentage interest in the corpora-
tion's current earnings, accumulated surplus, and net
assets upon liquidation. But your voting interest
remained undiminished, and that sets the stage for a tax
disaster.
"Wait a minute," you protest, "I have only a minority
voting interest. That doesn't give me any right to direct
the corporation's affairs. I'm not even related to the other
two 18-percent shareholders. My voting interest
shouldn't even be considered." Logic is on your side. But
no dice, says the IRS.
Revenue Ruling 85-106, dealing with a similar' situa-
tion, holds that a redemption that does not reduce a
shareholder's ability to be part of a control group is not a
meaningful reduction in the shareholder's interest in the
corporation. Under these facts, your voting power could
be combined with that of the other two 18-percent share-
holders, enabling you to be part of a control group
directing the operations and financial affairs of the cor-
poration. Regardless of the reduction of your economic
interest in the corporation, your failure to reduce your
voting power means your interest in the corporation was
not meaningfully reduced, and that nixes capital-gain
treatment.
•
Expired tax breaks
may return
At the end of 1985 many tax breaks expired without
being renewed by Congress, which is preoccupied with
tax reform, the budget, and re-election. The House Ways
and Means Committee, however, will soon begin drafting
legislation to resurrect some of the expired proviSions.
Here is a list of some of the more popular old-friend
breaks being given a chance at new life:
1. The exclusion of up to $5,000 for employer-
provided educational assistance (employer pays
employee's tuition)
2. The 25-percent tax credit for incremental
research and development
3. The exclusion for benefits paid by an employer
under a pre-paid legal-services plan (employer pays for
employee's legal fees)
4. A host of residential and business energy credits
(only those provided for in the recent House-passed tax-
reform bill would be considered)
5. The targeted-jobs credit
6. The exclusion for van-pooling (employer pro-
vides transportation between employees' residences and
the workplace)
7. The expensing of costs for removing architec-
tural barriers to the handicapped
All of these provisions would have been extended
under a House bill passed late last year but rejected by
the Senate.
If Congress is true to form, the provisions that pass
will be made retroactive to January 1, 1986. For example,
the employer-provided tuition exclusion expired at the
end of 1984, but was resurrected in spring 1985 and made
retroactive to January 1, 1985.
•
/ruing L. Blackman is a CPA specializing in taxation and
closely held businesses. A partner in the firm of Black-
man, Kallick & Co., Ltd., he will consult with readers of
his column. Write him at 300 South Riverside Plaza,
Chicago, IL 60606, or call (312) 207-1040.
Advertising reaches
more buy~rs In Play Meter
I
84
PLAY METER. March 15, 1986
j
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