Seven years ago, Eleanor transferred property she had used in her sole proprietorship to Blue Corporation for 2,000 shares of Blue Corporation in a transaction that qualified under § 351. The assets had a tax basis to her of $400,000 and a fair market value of $700,000 on the date of the transfer. In the current year, Blue Corporation (E & P of $1 million) redeems 600 shares from Eleanor for $260,000 in a transaction that qualifies for sale or exchange treatment. With respect to the redemption, Eleanor will have a:
A) $140,000 dividend.
B) $260,000 dividend.
C) $140,000 capital gain.
D) $260,000 capital gain.
E) None of the above.

Question

Quizplus · Accepted Answer

When Blue Corporation redeem shares from Eleanor, the shareholder needs to recognize either dividend income or capital gain. The amount of dividend income recognized is limited to the amount received in excess of the shareholder's basis in the stock. In this case, the basis in the 600 redeemed shares is calculated as:
($400,000 / 2,000 shares) x 600 shares = $150,000
Since the amount received ($260,000) is greater than the basis ($150,000), Eleanor must recognize a capital gain of $110,000 ($260,000 - $150,000). However, this is not the total gain on the stock, because the stock received in the original transfer had a fair market value of $700,000, and only $300,000 of that value has been recognized in the redemption. Therefore, the remaining gain of $200,000 ($700,000 - $500,000) will not be recognized until Eleanor sells or redeems her remaining shares of Blue Corporation stock.

Seven Years Ago, Eleanor Transferred Property She Had Used in Her