Robert Smith owns 20% of the shares of Quarks Inc.,a Canadian qualified small business corporation.He purchased the shares from a previous shareholder for $50,000.The stated paid up capital of the shares is $10,000.Two other shareholders own equal portions of the remaining shares of Quarks.
Robert has decided to sell his shares,which have a market value of $120,000.The shares are to be sold either to the two other shareholders,or back to the corporate treasury.All three shareholders used all of their capital gains deductions earlier in the year.
Robert has employment income of $185,000,a capital gain in the amount of $50,000,and property income of $20,000 for the current year.
All three shareholders are in a 50% tax bracket.The marginal rate on dividends is 43%.The corporate tax rate for Quarks is 13%.
Required:

Question

Quizplus · Accepted Answer

The Answer is A)1)Sell to other shareholders:

Tax cost: $35,000 × 50% = $17,500
2)Sell back to the corporate treasury:

Tax cost: $110,000 × 43% = $47,300

Tax saving: $20,000 × 50% tax rate = $10,000 (Robert recognized a capital gain of $50,000 during the year,so will be able to use the capital loss from the sale.)
Total tax consequence: Tax cost of $47,300 less tax saving of $10,000 = $37,300
B)1)Cost to the other shareholders:
1x - .43x = $120,000
x = $210,526
1x - .13x = $210,526
x = $241,984 of pre-tax corporate income
2)Cost to the corporation:
1x - .13x = $120,000
x = $137,931 of pre-tax corporate income.
C)Robert would prefer to sell his shares to the other shareholders due to the lower tax cost for himself.The other shareholders would prefer that Robert sell his shares back to the corporate treasury as less business income would be required to buy his shares.
D)If Robert sells back to the corporate treasury,he will be able to recognize the $20,000 allowable capital loss against his $25,000 ($50,000 * .5)taxable capital gain.He would not otherwise be able to use the loss as his ability to convert the loss to an ABIL is not available due to the prior use of his entire capital gain deduction.

Robert Smith Owns 20% of the Shares of Quarks Inc