One of your clients is a small privately-held corporation with only three shareholders. The CFO of this small corporation calls you and says, “one of the shareholders (a 20% shareholder) would like to take out $500,000 in cash from the corporation to purchase a vacation home.” Current E&P of the corporation is $600,000 and accumulated E&P is a negative $200,000; however, the company has built a $900,000 cash account balance (a debit balance) so the corporation has the cash to provide to this shareholder. The CFO suggests an idea to you (not to the shareholder) in which the corporation will buy 500 shares from this shareholder for $1,000 per share when the market value per share is only $800 per share. The 20% shareholder paid $500 per share for this stock. If this is the only shareholder redeeming then this will NOT be considered a constructive dividend. What should you tell this CFO?
a. You may have a problem with the related party rules under Section 267.
b. The 20% shareholder will experience a capital gain of $300 per share and an ordinary gain of $200 per share.
c. The corporation will not be allowed to deduct the additional $200 above the market price of $800 on next year’s tax return.
d. None of the above are appropriate responses.