Comet Company is owned equally by Pat and his sister Pam,each of whom hold 100 shares in the company.Pam wants to reduce her ownership in the company,and it was decided that the company will redeem 50 of her shares for $1,000 per share on December 31,year 1.Pam's income tax basis in each share is $500.Comet has total E&P of $250,000.What are the tax consequences to Pam as a result of the stock redemption?
A)$25,000 capital gain and a tax basis in each of her remaining shares of $500.
B)$25,000 capital gain and a tax basis in each of her remaining shares of $100.
C)$50,000 dividend and a tax basis in each of her remaining shares of $100.
D)$50,000 dividend and a tax basis in each of her remaining shares of $50.

Question

Quizplus · Accepted Answer

When a shareholder sells or redeems shares in a company, the first step is to determine the amount of gain or loss. In this case, Pam's income tax basis in the 50 shares being redeemed is $500 per share. Therefore, she will realize a capital gain of $500 per share ($1,000 redemption price minus $500 basis). Since 50 shares are being redeemed, the total capital gain will be $25,000.

The next step is to determine the character of the gain. Since Comet has E&P of $250,000, the first $25,000 of the redemption amount will be treated as a return of capital, which reduces Pam's basis in her remaining shares. The remaining $25,000 will be treated as a capital gain.

Therefore, Pam will have a $25,000 capital gain and a tax basis in each of her remaining shares of $500 ($1,000 original basis minus $500 reduction from the return of capital). Choice A is the correct answer.

Comet Company Is Owned Equally by Pat and His Sister