Constructive Dividends, Redemptions, and Related Party Losses (Essay Sample)

Constructive Dividends, Redemptions, and Related Party Losses
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Constructive Dividends, Redemptions, and Related Party Losses
The tax research process basically comprises six key steps which are as follows: determine the facts; identify the issues; locate the authority; assess the authority; make conclusions and recommendations; and communicate those recommendations. Tax researchers need to approach the resolution of a tax problem in a manner that is structured so that the problem analysis would be exhaustive and the solution comprehensive.
Acceptance of the proposed adjustments
The fact and the situation in this case is that the taxpayer is presently getting a salary of $10 million that comprises a $5 million base salary in addition to 5% of gross receipts not to be greater than $5 million. The client should accept adjustments since his salary is unacceptable by the Internal Revenue Service basing on the 5% of gross recipes as a constructive dividend. The reasonableness of employee or shareholder compensation is usually a very controversial matter in the context of federal income taxation. The reason for this is basically that what is seen as reasonable compensation by an employee or shareholder is usually seen as being unreasonable by the Internal Revenue Service (IRS). Section 162 of the Internal Revenue Code specifies that for executive compensation to be deductible for federal income tax purposes, it has to be (i) reasonable in amount; and (ii) should be based upon the services rendered. In essence, the income tax-related compensation consequences related to unreasonable employee or shareholder compensation could be substantial.
Tax plan for future redemption
A stock redemption is basically understood as an acquisition by a business organization of its own shares in exchange for either property or cash, for the purpose of holding them as treasury stock or retiring the shares. Under Section 301 of the IRS, redemption is essentially treated as a distribution. As per Section 301(c) (1), a distribution is at first treated as a dividend to the extent of profits and earnings. If there is any remaining portion of a distribution, it is applied against and decreases basis of stock, and is ultimately treated as gain from the exchange or sale of property according to Section 301(3) and 301(c) (2). In essence, the IRS stipulates that redemption of stock by a company could be treated as a distribution in full or in part payment in exchange for the stock – that is, an exchange or a sale. The losses or gains to stockholders from such redemptions would be capital losses or gains, and not distributions pursuant to Section 301 – which are commonly dividends that are taxable as ordinary income.
In this case, a plan for future redemption of the client’s stock owned in the business that would not be taxed pursuant to Section 301 of the Internal Revenue Code entails treating the redemption as a dividend and not as an exchange. This is primarily because redemptions are not taxable as dividends; hence, the client’s stocks owned in the construction company would not be taxed. It is of note that in situations wherein an amount received in stock redemption is treated as a dividend instead of being treated as a sale, the shareholder needs to adjust the tax basis of the remaining stock. Although the redemption would not be recognized for taxation purposes, the only problem is that the shareholder will surrender shares in the redemption transaction. Since the construction company in this case redeemed 50 percent of the outstanding stock owned by the client and 50 percent of the stock owned by the son of the client, the redemption in this tax plan would treated as dividend payment. Therefore, the entire amount of stock redeemed owned by the client and the client’s son wou...