The Internal Revenue Code uses four tests to make this distinction: To prevent gamesmanship among related parties, Congress has added another layer of rules that must be analyzed to determine if a distribution is a redemption.
These attribution rules provide that shares owned by a shareholder’s parents, children, and grandchildren (but not siblings) are considered to be owned by the shareholder. Similarly, shares held by corporations, trusts, and partnerships are deemed to be owned by their shareholders beneficiaries, and partners, and vice versa. As a result, shares held by these family members and entities are considered to be owned by the shareholder for purposes of determining whether the distribution qualifies as a redemption.
Note: For the sake of simplicity, dividends have been excluded from this example and we assume only one series of preferred shares.
From this example, you can clearly see how the different preference and participation terms can determine how the proceeds from exit are allocated.
If the venture is extremely successful, all shareholders will be substantially rewarded.