Petoskey Stone Quarry, Inc.(PSQ), a calendar year, accrual basis C Corporation, provides landscaping supplies to local builders in northern Michigan. PSQ has always been a family owned business and has a single class of voting common stock outstanding. The 500 outstanding shares are owned as follows:

..........................................................Number of shares

Nick Adams..................................................150

Amy Adams (Nick's sister)...........................150

Abigail Adams (Nick's daughter)................. 50

Charlie Adams (Nick's son)........................... 50

Sandler Adams (Nick's father)....................100

Total shares..................................................500

Nick Adams serves as President of PSQ, and his father Sandler serves as Chairman of the Board. Amy is the company's CFO, and Abigail and Charlie work as employees of the company. Sandler would like to retire and sell his shares back to the company. The fair market value of the shares is $500,000. Sandler's tax basis is $10,000.

The redemption is tentatively scheduled to take place on December 31 of this year. At the beginning of the year PSQ had accumulated earnings and profits of $2,500,000. The company projects current E&P of $200,000. The company intends to pay pro rata cash dividends of $300 per share to its shareholders on December 1 of this year.

a. Assume the redemption takes place as planned on December 31 and no elections are made by the shareholders.

1. What amount of dividend or capital gain will Sandler recognize as a result of the stock redemption?

2. How will the tax basis of Sandler's stock be allocated to the remaining shareholders?

b. What must Sandler and the other shareholders do to change the tax results you calculated in question a?

c. Compute PSQ's accumulated earnings and profits on January 1 of next year assuming the redemption is treated as an exchange.