Question

One of your clients is a small privately-held corporation with only three shareholders. The CFO of this small corporation calls you and says, “one of the shareholders (a 20% shareholder) would like to take out $500,000 in cash from the corporation to purchase a vacation home.” Current E&P of the corporation is $600,000 and accumulated E&P is a negative $200,000; however, the company has built a $900,000 cash account balance (a debit balance) so the corporation has the cash to provide to this shareholder. The CFO suggests an idea to you (not to the shareholder) in which the corporation will buy 500 shares from this shareholder for $1,000 per share when the market value per share is only $800 per share. The 20% shareholder paid $500 per share for this stock. If this is the only shareholder redeeming then this will NOT be considered a constructive dividend. What should you tell this CFO?
a. You may have a problem with the related party rules under Section 267.
b. The 20% shareholder will experience a capital gain of $300 per share and an ordinary gain of $200 per share.
c. The corporation will not be allowed to deduct the additional $200 above the market price of $800 on next year’s tax return.
d. None of the above are appropriate responses.

Answer 1

Option 1:Related party rules under section 267

1.shareholder who is holding 20% share in the corporation will be come under related party rules under section 267.

2.Stock owned, directly or indirectly, by or for a corporation, partnership, estate, or trust shall be considered as being owned proportionately by or for its shareholders, partners, or beneficiaries.

3.Provding loans to shareholders by the corporation which violated the rules of the section 267

4.Under tax laws transaction between related parties will be disallowed.

Option 2: capital gains

1.Shareholder purchases the shares from corporation for $500 @one share

2. Long-term capital gains are derived from investments that are held for more than one year & A short-term capital gain results from an asset owned for a year or less, which is taxed as though it were ordinary income

3. Short-term gains are taxed as regular income according to tax brackets up to 37%, as of 2020.

4.Long-term gains are subject to more-favorable rates of 0%, 15%, and 20%, also based on income.

5.now corporation wants to buy the shares @$1000 per share then shareholder will arises capital gains worth assumed It is short term capital gains $250000(500 shares *$500($1000selling price- $ 500 purchase price) even through market value per share $800.

Option 3:corporation not allowed additional amount $200 per share which is more than market price

1.Stock buybacks refer to the repurchasing of shares of stock by the company that issued them. A buyback occurs when the issuing company pays shareholders the market value per share and re-absorbs that portion of its ownership that was previously distributed among public and private investor.

2.If Corporation is not allowed to deduct $200 in tax return then Amount of $200*500 shares will be disallowed as per tax purposes. Profit will increase to that extent of $100000.

Option 4:none of the options is appropriate response

Conclusion: Corporation should purchase the share @$800 from the shareholder or else corporation will not provide the loan amount to shareholder.