iara owns 100% of the shares of Lion Corporation. Kiara's basis is $70,000 and the FMV of the shares is $200,000. Kiara is willing to sell all of the stock to Tia, but Tia is unwilling to pay more than $150,000 for the stock because the Corporation has excess cash balances. They have agreed that Kiara can withdraw $50,000 in cash from Lion before the stock sale. What tax issues should be

Question

considered with respect to Kiara and Tia's agreement?

What will be an ideal response?

Answer 1

• What is Lion's E&P balance immediately preceding the distribution?
• If $50,000 in cash is withdrawn from the business, will it be treated as a dividend to Kiara?
• Can the $50,000 withdrawn from the business be considered to have been received as part of Kiara's stock sale?
• Can the tax results for the transaction be improved if Kiara has some of her stock redeemed for the $50,000 cash?
• Are the tax consequences of the transaction different if the $50,000 is withdrawn from the business either before or as part of the stock sale?
• Can the $50,000 payment be classified as payment of back wages to Kiara? Would such an amount be deductible by the corporation?
• What is the amount and character of the gain recognized on Kiara's sale of the stock?

The primary issue is whether the $50,000 Kiara receives from Lion's is a dividend or is part of the amount she receives for her stock. If Lion redeems 25% of her stock for $50,000 in cash as part of the same transaction in which her remaining stock is sold to Tia for $150,000, quite likely she can treat the entire $200,000 as being received in exchange for her stock under the bootstrap redemption rules. In such case, she has a $130,000 ($200,000 - $70,000) capital gain.

However, if she receives $50,000 from Lion before entering into the sale agreement with Tia, she will have a $50,000 dividend and then an $80,000 ($150,000 - $70,000) capital gain on a later sale of her stock to Tia.

It is not likely that Lion can treat the $50,000 payment as additional compensation (e.g., a bonus or payment made because of lower-than-normal salary payments made in prior years) and then deduct the payment in computing its corporate tax liability. A possibility might be to treat the $50,000 payment as being paid to Kiara in exchange for a covenant not to compete for a certain period of time. Such payment generally is ordinary income for the recipient but is deductible by the payer over 15 years in accordance with Sec. 197.