Comet Company is owned equally by Pat and his sister Pam, each of whom holds 100 shares in the company. Comet redeems 50 of Pam's shares on December 31 of the current year, 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 of the current year. What are the tax consequences to Comet because of the stock redemption?

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BlackTom AI · Accepted Answer

First, let’s restate the question and the available choices to be sure we’re examining the same scenario. 
Question: Comet Company is equally owned by Pat and Pam (each 100 shares). Comet redeems 50 of Pam’s shares on Dec 31 for $1,000 per share in a transaction Pam treats as an exchange for tax purposes. Comet has total E&P of $160,000 on Dec 31. What are the tax consequences to Comet because of the stock redemption? 
Answer options:
- A: No reduction in E&P because of the exchange.
- B: A reduction of $50,000 in E&P because of the exchange.
- C: A reduction of $40,000 in E&P because of the exchange.
- D: A reduction of $80,000 in E&P because of the exchange.

Option A: No reduction in E&P because of the exchange. 
Consider the general rule: a stock redemption treated as an exchange (under Sec. 302) may reduce E&P to the extent that the distribution is treated as a payment from the corporation’s earnings and profits. If the redemption were strictly an exchange with no distribution treated, one might think there is no E&P effect. However, in practice, stock redemptions that are treated as exchanges for tax purposes typically reduce E&P to the extent of the “distribution” element embedded in the redemption. Since Pam receives $50,000 (50 shares × $1,000) in the redemption, the transaction is effectively a cash distribution from E&P to Pam under the exchange treatment. Therefore, option A would be incorrect because there is normally some E&P reduction associated with the redemption treated as an exchange.

Option B: A reduction of $50,000 in E&P because of the exchange. 
This option uses the full $50,000 of the redemption proceeds as the reduction in E&P. While it captures the idea that E&P is affected by the redemption, the precise reduction may be limited by ownership tests and the portion of the distribution that is considered an exchange versus a dividend. In many exam scenarios, not the entire redemption amount is treated as an E&P reduction when the redemption is a partial return of capital to a stockholder and the exchange provisions apply in a more nuanced way. Without applying those nuance factors (e.g., the extent of the exchange treatment under Sec. 302 and the ownership/percentage rules), this option risks overstatement. Hence, this is not the typical correct E&P reduction figure in this specific setup.

Option C: A reduction of $40,000 in E&P because of the exchange. 
Here, the analysis suggests that only $40,000 of the $50,000 redemption price reduces E&P. The reduction level can reflect the portion of the redemption that is considered an exchange of stock for property from E&P rather than a pure return of capital or a dividend. The disagreement between $50,000 and $40,000 hinges on how the IRS code sections treat partial exchanges and the effect on E&P given the post-redemption ownership structure. In many tax problem contexts, the reduction is calculated to align with the portion that constitutes an exchange and to reflect any limitations imposed by the interplay of ownership percentages after redemption. This option aligns with a nuanced application where not the entire redemption price reduces E&P.

Option D: A reduction of $80,000 in E&P because of the exchange. 
This option implies that the entire $50,000 redemption amount plus an additional $30,000 (to total $80,000) reduces E&P, which would be inconsistent with the given numbers and the typical mechanics of E&P reductions for stock redemptions. There is no basis in the stated facts for an $80,000 E&P reduction, since the redemption amount itself is $50,000. Therefore, this option is not correct.

To compare the options more clearly: Option A ignores the typical E&P impact of an exchange-style redemption; Option B uses the full redemption amount as the E&P reduction without considering the exchange-specific limitations; Option D introduces an amount not supported by the stated transaction data; Option C offers a partial reduction ($40,000) that reflects the nuanced view that not all of the redemption proceeds reduce E&P when the redemption is treated as an exchange under the tax rules and considering the ownership structure after redemption. The setup most commonly supports a partial reduction rather than the full $50,000 in E&P.

Putting it together, the redemption generates an E&P reduction that is not simply the entire amount. The question’s framing and typical tax exam conventions point toward a $40,000 reduction in E&P as the correct consequence for Comet, under the exchange treatment in this partial redemption scenario.

Summary of why the other options diverge: 
- A is incorrect because there is generally some E&P impact when a redemption is treated as an exchange. 
- B is incorrect as it assumes the full $50,000 reduces E&P without applying the nuanced exchange limitation. 
- D is incorrect since $80,000 exceeds the actual redemption amount and lacks support in the facts. 
- C is correct in reflecting a partial reduction consistent with the exchange treatment and ownership dynamics described.

SU25-BL-BUS-A329-2695 Quiz 19

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