Comet Company is owned equally by Pat and his sister Pam, each of whom hold 100 shares in the company. Comet redeems 50 of Pam's shares on December 31, 20X3, for$1,000 per share in a transaction that Pam treats as an exchange for tax purposes. Comet has total E&P of $160,000 on December 31, 20X3. What are the tax consequences to Comet because of the stock redemption?

Question

Quizplus · Accepted Answer

When a shareholder makes an exchange of stock for money in a redemption, the transaction must be treated as a distribution to the extent it is a dividend. The amount of the dividend is determined under the general rules of §301(c). 
Pam is redeeming 50 of her 100 shares, so the distribution is treated as if she had received a dividend on the 50 shares, and the remaining 50 shares remain outstanding. The amount of the dividend is based on the company's current and accumulated E&P. 
In this case, the company has $160,000 of E&P, but only half of that is attributable to Pam's shares, since her sister owns the other half of the company. Thus, there is $80,000 of E&P for Pam's shares, and the distribution on the 50 shares is $1,000 per share, or $50,000. 
Therefore, the dividend is the lesser of $50,000 (the cash distributed) and $80,000 (the E&P attributable to Pam's shares), so the dividend is $50,000. As a result, there is a reduction of $40,000 ($80,000 - $50,000) in E&P because of the exchange. The correct answer is therefore (C).

Comet Company Is Owned Equally by Pat and His Sister