Corp Tax Outline

Corporate Tax OutlineSpring 2010

An overview of the Taxation of Corporations and Shareholders:

Forms of Business Organization

(1) Sole Proprietorships- Businesses operated and owned by a single individual(2) Corporations- fictitious legal entities that offer limited liability to their owners.(3) PartnershipsGeneral limited partnerships, LLP’s Joint ventures(4) LLC- provides limited liability for all its members

Conceptual Taxation Models

(1) Aggregate ConceptA business organization is viewed as an aggregation of its owners, each of whom holds a direct undivided interest in the assets and operations of the enterpriseEach of the owners takes into his account his or her respective share of income and expenses for tax purposes

(2) Entity ConceptCorporation is separate and distinct from its owners.Entity is taxed on its taxable income and transactions between owners and entity are taxable events“Double Tax”

(3) Hybrid ConceptOccurs with S corps and PartnershipsOrganization is separate entity for things such as filing of tax returnsAggregate passing through of income, and expenses to the owners, etc

Influential Policies

Double TaxRule: Corporation is taxed on its earnings and Shareholders are taxed when they receive dividends. Prior Rule: General Utilities Doctrine Distributions were non-taxable events. DT of C increases the cost of operating a business as a C Corp and often provides TP’s an incentive to choose a partnership or S corp. for business and investment activities

Rate Structure:In Past, Usually, min. individual tax rate has exceeded the corp. tax rate and gave incentive to operate as a C corp.Ex: 1980 and 1987 in class we saw that there was a big differenceCurrent Day: Not as clear because indiv. And corp. rates are approx. 35% and thus it is a fact and circumstance test.

Preferential Capital Gains Rates:TP are motivate to devise strategies to convert ord. income into capital gains, such as “bailing out” C corp. profits at capital gain rates

Non RecognitionCorp. and partnership transactions qualify for no recognition treatment b/c they are mere changes in form which result in continuity of investment.

Classification of Business Entities

Corporation DefinedDefined under §7701(a)(3)Associations, joint stock companies, and insurance companiesCertain unincorporated entities “associations” are treated as corporations for federal tax purposes

Pre-1997 RegulationsSix Characteristics of a “pure corporation”AssociatesAn objective to carry on a business and divide the profitsContinuity of LifeSH goes bankrupt or dies, no affect on corporationCentralization of ManagementBOD has power and responsibility of operating the business. Liability for debts limited to Corporate PropertySH not personally liableFree Transferability of interestSH can dispose of shares at anytime Ex: You own GM, and you can transfer your interest to someone else and that transferee will step into your shoes.So if there was an unincorporated entity, and it characteristics EXCEEDED any non corporate characteristic, it was a corporation for tax purposesState laws created LLC and now there was a blur b/t a corp. and unincorporated entityNew Regulations were proposed and “check the box” regulations were finalized in 1997.

Check The Box Regulations:Began in 1997

Reg §301.7701-2(b)(1)Corporation means a business entity organized under a federal or state statute or under a statute of federally recognized Indian Tribe, if the statute describes or refers to the entity as incorporated or as a corporation, body corporate or body politicReg §301.7001-3(a)A business entity that is not classified as a corporation can elect its classification for federal tax purposes.Does not apply to publicly traded entitiesPublicly traded partnerships will be taxed as a corp.§7704(b) Partnership whose interests are traded on an established securities market or are readily tradable on a secondary market.

No matter what, once you are publicly traded you are a corporation for tax purposes.Existing Entities:An entity in existence before 1997, generally retains the same classification that it had under the prior association regulationsException- Single owner entity that claims to be a partnershipElection under REG§301.7701-3(c)An entity wishes to change its classification must file an election, which is effective up to 75 days before or 12 months after it fileMust be:(1) Signed by each member of the entity, including prior members affected by retroactive elections OR(2) AN officer, manager or member authorized to make the election. Can not change for 60 months, unless Service p[permits the change and 50% of ownership interests are owned by persons who did not own any interests when the election was first made

Check the Box Hypos:See attached

FORMATION OF A CORPORATION

IRC:§351(a), (c), (d)(1), (d)(2)§358(a),(b)(1)§362§368§1032(a)§1223(1)§1221(2)§1245(b)(3)

Reg:§1.351-1(a)§1.351-1(b)§1.358-1(a)§1.358-2(b)(2)§1.362-1(a)§1.1032-1(a)(3)

A. Introduction:§1001(a)a TP who transfers property to a newly formed corp., in exchange for stock would recognize a gain or loss measured by the difference b/t FMV and AB. AR – AB = Gain (loss) Also, Corp may realize on issuance of stock for property.§351Allows no G or L to newly formed S or C Corps.§1032(a) provides that a corp., does not recognize a gain or loss when it receives money or property in exchange for stock. Rationale these transactions are mere changes in form of SH investments and thus non-taxable events.§351 preserves unrecognized gain or loss in the SH stock’s basis under §358 and in corp.’s basis in the transferred property under §362. Recognition of Gain or Loss (Transferor)§351 states:Certain transfer of property to a newly formed or preexisting controlled (80% owned) corporation are not taxable events. Unrecognized gain or loss is preserved through transferred and exchanged basis rulesBasically no gain or loss will be recognized if property is transferred and all elements are met. Normal §1001(a) Rule does not apply. Rationale Congress felt that a gain or loss should not be recognized because the transferor still has a financial interest in the property and still has control.

There is a continuity of proprietary interest. (continuing investment)Remember the gain is not forgiven, rather it is deferred until Transferor sells corp.’s stock.

B. Elements for Non-recognition under §351

(1) One or more persons (including individuals, corporations, partnerships, or other entities) must transfer property to a corporation

(a) PropertyCash, inventory, accounts receivable, patents and other intangibles such as goodwill and industrial know-howProperty does not include:Past, present or future services

(b) TransferAll substantial rights in the property must be transferredSo if you transfer a limited license element has not been met.

(2) The Property must be transferred solely in exchange for stock of the transferee corporation

(a) Solely in Exchange for StockMust be for stock, but does not include:Stock rights, warrants, or convertible debt securities”boot” (see below) Reg 1.351-1(a)(1)Exception: Nonqualified preferred stock Treated as other propertyboot rather than stock under §351(g)(1)§351(g) defines nonqualified preferred. Preferred stock (does not participate in corp., growth and limited to dividends) with any of the following debt-like characteristics(1) SH has the right to require the issuing corp., or related person (ex, families, etc) to redeem or purchase stock(2) Corp. issuer (or a related affiliate) is required to redeem or purchase stock(3) Issuer has the right to redeem or purchase the stock, and as of the issue date, it is more likely than not that such right will be exercise or(4) Stock’s dividend rate is variable- set by reference to mkt. interest reates, commodity prices or similar indiciesEven though boot for gain purposes, Under §351(g)- still stock for control test purposes.

(3) The transferors, as a group must be in control under §368(c)of the corp., immediately after the exchange. (a) Control

§368(c) defines control as:People transferring property must own at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of each class of nonvoting stock. Simultaneous exchanges:Reg §1.351-1(a)(1) Simultaneous exchanges are not required where the rights of the parties have been “previously defined” and the agreement proceeds with an “expedition consistent with orderly procedure”Example 1:A receives 50 shares of voting stock, B receives 50 share of nonvoting common stock, and C receives 50 shares of nonvoting preferred stock that is not nonqualified preferred stock. Control test is satisfied because the property transfers, as a group own at least 80% of class of stockExample 2:Now C, gets stock for services, so 100/150 is transferred and this is only 67% and thus not 80% and control has not been met. A and B must recognize gain and loss on their property.

Basis and Holding Period:

Shareholder’s Basis§351 Transferor’s basis in the stock received will equal his basis in the transferred property immediately prior to the exchange §358(a)(1).For more than 1 class of Stock aggregate basis is determined under §358(a)(1) as allocated among all classes of stock received in proportion to the FMV of each class §358(b), Reg §1.358-2(a)(2)§358 (FILL IN) used for determining adjusted Basis in Stock and Boot Received

2. Shareholder’s Holding Period§1223(1) TackingA transferor’s holding period for stock received in a §351 transaction in exchange for a capital or §1231 asset includes the holding period of transferred property.--> Tacking!Rule 2: Holding period of stock received in exchange for an ordinary income asset (inventory or services) begins on the date of exchange. No tacking for InventoryAccounts Receivable for sale of inventory or the providing of services is excluded Real property that is used in TP’s Trade of business or depreciable property held for 1 year or lessMoneyRationale If there was tack on for this type of property, a TP can always transfer stock for a preferential capital gain treatment (since stock is always a capital asset)…so it makes sense that there is no tack on.

Combination If stock is received in combination of capital asset and ordinary income assets, each share of stock takes a split holding period allocated in proportion to the FMV of the transferred asset. Rev Rul 85-164This says that when you have land and inventory (or another non tack on) you proportion the amount based on the FMVOnce you do the FMV by percentage, you take that percentage to get what will be capital gain and what would be ordinary income.

3. Corporations Basis and Holding Period in Transferred AssetsCorp’s basis is the same as the transferor’s basis. §362(a)§362(a) states that :If property was acquired on or after 6/22/1954, by a corp., in connection w/ a transaction to which §351 applies, then basis shall be the same it would be in the hands of the transferor increased in the amount of the gain recognized to the transferor (boot)Exception on 362(e)(2)If transferee’s aggregate Adjusted Basis of such property so transferred would exceed the FMV of such property immediately after such transaction then, notwithstanding (a) the transferee’s aggregate AB of the property so transferred shall note exceed the FMV of such property immediately after the transaction. Aggregate AB must exceed FMV of transferred propertyAllocation §362(e)(2)(b)Allocated amongst the property in proportion to its built in losses. Ex: 23AB and 20 FMV..so 3k difference reduce the basis by 3k in the property§1.351-1(a)(1)362(c)Now, since corp. has reduce the basis from 140k to 100, corporation and A can agree to elect A have the basis in stock be lower. Only one party can take the loss, not both. So can elect if Corp or SH should take the loss and if you pick SH, then SH doesn’t take the basis of the stock. Holding Period includes the transferor’s holding period, without regard to whether the property was a capital or §1231 asset in the transferor’s hands §1223(2)See parcel table below.

Hypo 1:A transfer land (§1231 asset) held long term with a basis of 10k and FMV of 60k, and inventory with a basis of 30k and a value of 40k, in exchange for 100 shares of Newco common stock with a FMV of 100k. Issue 1: Is this a §351 transaction?- Yes, on exam analyze all the properties and say that it isIssue 2: What is transferor’s basis in the stock?A’s basis is 40,000 because the rule under §358(a)(1) is the transferor’s basis in the stock received will equal his basis in the property immediately prior to the exchange.Here, transferor’s basis in the land is 10k, and in the inventory is 30k, so the total basis is 40k.Issue 3: What is A’s Holding Period?

A’s Holding period depends on whether it is a capital, 1231 asset or ordinary income.Here, the land is a 1231 asset and the inventory is ordinary income.Under Rev. Rul 85-164, there is a split holding period allocated in proportion to the FMV of the transferred asset.Total FMV of property is 60k land and 40k inventory so 100k, 60% is land and 40% is inventory.So for holding period, 60% of the time is of the land, and 40% of the stock is from the day of the exchange.Issue 4: Say that A sells stock the next day, what is his gain or loss on the stock?Gain AR- AB 100k- 40k= 60k60k*60%=36k (Land tack on so LTCG)60k*40%=24k(Ordinary Income so ST capital gain) Issue 5: Newco’s Basis and Holding PeriodNewco’s basis in land is 10k and 30k in the inventory under §362(a)Holding PeriodTacked under §1223(a)(2)

Hypo 2: Same facts as above, except now A receives 80 shares of Newco Common stock and 20 shares of Newco preferred stock. Remember combined basis in both was 40k so: As basis in both classes of stock is 40k and 80% is common, so 32k and 20% is preferred, so 8k. Holding Period Split Holding Period for each share of common and preferred stock60% tacked from land and 40% commencing on date of exchange.

Page 64 Problem:A, B, C, D, E form X Corporation to engage in a manufacturing business.X issues 100 shares of common stock.A transfers 25k for 25 sharesB transfers inventory with a value of 10k and a basis of 5k for 10 sharesC transfers unimproved land with a value of 20k and a basis of 25k for 20 sharesD transfers equipment with a basis of 5k and a value of 25k (prior depreciation was 20k) for 25 sharesE transfers 20k note for 20 shares. E received the note in exchange for land with a 2k basis he sold last year. The note is payable over a 5 year period beg. In two years at 4k per year plus market rate interestIssues:What are the tax consequences (G or L recognized) Does 351 apply?1. Yes2. Yes3. In control yes

Effect on Transferor:ABFMVAmount of sharesGain realizedGain RecognizedBasisHolding PeriodA-Cash---25k250025kNo Tack on- New Holding PeriodB-Inventory5k10k205k05kNo Tack on because does not fit categoriesC-Land25k20k20(5k)025kTack On! Capital assetD-Equipment5k25k25 shares20k05kTack onE- Note2k(amount paid)20k2018k02kOnly tack on if land is a capital improvement land. Key Things to rememember:Transferor takes basis. (find out rule if AB>FMV) For the equipment, the depreciation is normally a gain under §1245, but under §351 it will not be an actual realized gain!

(b)Effect on Corporation for sharesABFMVAmount of sharesGain realizedGain RecognizedBasisHolding PeriodA-Cash---25k2525k0N/ANo Tack on- New Holding PeriodB-Inventory5k10k2010k05kTack on!C-Land25k20k20(20k)020kTack On! Capital asset

(c)- Parcels

ABFMVBuilt in G/LAdjustmentRevised ABParcel 115k10k(5k)(3k)12kParcel 28k10k2k-8k23k20k(3k)What if there were two parcels with loss. must allocate loss based proportionally

Corporation will take the adjusted basis unless they make an election that SH is taking the adjusted basis.

(d) If there is an inherent gain and also a gain to the SH, both will be taxed. Double tax here! Rationale- else everyone would try to make it a capital gain and always escape ordinary gain.

CONTROL Immediately after the exchangeTransferor’s of property must have control of “NEWCO” immediately after the exchange.Issue when a transferor disposes of stock shortly after an incorporation exchange, §1.351-1(a)(1)page 1146 of code - immediately after exchange does not require simultaeneus transfer. Can be at different time and considered the same transaction - - does include time where rights of parties were previously defined and completed in a reasonable time frame. Case Law about two transfers that are interdependentBinding Agreements to Dispose of StockIf a SH disposes of stock received in exchange for property pursuant to a prearranged binding agreement entered into prior to an incorporation exchange, the control test is applied after the stock dispositionSo look at situation immediately after the transfer! A disposition of more than 20% of voting power or more than 20% of any class of nonvoting stock will cause a loss of control because the person ultimately acquiring the stock was not a transferor of property to NEWCO. Example:A transfers land with a basis of 10k and value of 60k in exchange for 60 shares of Newco (60%) and B transfers equipment with Basis and FMV of 40 for 40 shares (40%)Two months later, pursuant to a prearranged binding agreement B transfers all her Newco stock to C for 40k cash.Control test is applied after the transfer to C, since C was not a transfer or property to Newco, her ownership cannot be counted in testing for control, and A only owns 60% of NEWCO immediately after exchange and thus 80% is not satisfied.A must recognize a 50k gain on the transfer of land because this is not a §351 transaction IntermountainIntermountain Lumber Argued that trans was not a good 351 (bc it wanted higher basis to depreciate).IRS argued it was a good 351 trans. Bc lower depreciation deduction (taking shooks basis)Rule §351 – no gain or loss recognized if prop is transferred for stock IMMEDIATELY AFTER the exchange. Technically this happened but there was an agreement for Shook to sell 50% of stock (over time) to Wilson. Ct says control must include freedom of action – was contracted to sell 50% of stock. Only applies if there is a binding obligation. Court justifies this holding by – saying that 351 affects non-recognition of gain or loss that is only a change of form --- here there is more than a mere change of form. Prof says this is a bad decision - If prior to time you make transfer to a corporation, there is a pre-existing binding agreement where transferor will see so he loses control, not a good 351 transactionRJ This case does not further §351 policy for formation of corporation, rather it imposes an obligation.

Hypo: A owns property with a FMV of 100 and Basis of 10k and sells B an interest of 30%, so now A only has 70%, so B has a gain of 3k, and now B says A you get 100%, A has to recognize the 27k (30k - .3 * 10) = 27kA does not want this so A transfer biz to new corp called X. pursuant to agreement A agrees to transfer 30% of stock to B - thus this is not a good 351 (intermountain says this is not 351 but 1001)A would recognize a gain of 90K Heta go see RJ

Voluntary Donatives Dispositions of StockA voluntary disposition of stock (ex: gift) after an otherwise qualified §351, transfer will not cause the transaction to fail the control requirement.Result is same, if Newco issues the stock DIRECTLY to the transferee’s donee.Example Corporate TransferorsThe fact that a corporate transferor distpurtues part or all of the Nexco stock that it receives to its SH is not taken into account under 351(c)

Special Problems:Stock for Services§351(d)(1) stock issued for services is not considered as issued in return for property, and thus this is a taxable event! §351(d)(1) and Reg §1.351-1(a)(1)(i)Tax consequences of this transaction is determined under §61 and §83Problem: A person who receives stock solely in exchange for services may cause the other parties to the incorporation to recognize gain or loss. HYPO:TransferorTransferred AssetAdjusted BasisFMVStock ReceivedCLand20k50k50%SCashN/A10k10%ServicesN/A40k40%Here, this works as a good §351 transaction under §351(a) Because both C and S make up 100%, thus all stock received can be counted for purposes of 80% control requirement. Exception: Reg §1.351-1(a)(1)(ii)If the value of the property transferred is of relatively small value relative to the stock received for services and the primary purpose of the property transfer is to qualify the exchanges of other transferor for non-recognition, then CANNOT use for 80%RELATIVELY SMALL VALUE under Rev Proc. 77-37Property is not relatively small if it equals to or in excess of 10% of the FMV of stock already owned by the transferor. So Compare the other property to the services, and if the property is relatively small, probably won’t be §351 transaction

Hypo:A receives 70 Shares of CS (70k) in exchange for land (FMV-70k and basis-20k) and B receives 30 shares (FMV-30k) in exchange for 1k cash and services.A70% (property)

B 30%,B receives 1k cash, and 29k services, so the cash is of a relatively small in comparison to the services, (less than 10%) so not a §351 transaction, and both A and B recognize gain and loss, because A does not have more than 70%Hypo 2:Now, B receives 5 shares (5k) for 5k cash and 25 shares for 25k services.Here, cash is for 5k and it is 10% of 25k which is 2,500, so will be a 351 transaction, but B STILL RECOGNIZES a gain on the stock received for services So there is a gain of the 25k as ordinary income.

Page 73 Problem 1: CONTROL issueDoes the following qualify under §351?(a) A and B are unrelated individuals. A forms Newco, Inc. on Jan 2 of the current year by transferring property with a basis of 10k and value of 50k for all shares of Newco CS.On March 2, in an unrelated transactions, B transfers property with a basis of 1k and value of 10k for 10 shares Newco nonvoting preferred stock (this is not nonqualified preferred stock)AA’s transaction qualifies as a §351 transaction. A is control of more than 80% and thus he qualifies under §351He will not recognize a gain or loss and will be able to tack on.BB’s transaction is not a §351 transacton because he only has 10 shares of nonvoting preferred stock which is not 80%. No tack on and qualifies under §1032 so basis in property is FMV

(b) Same as (a) above, except the transfers by A and B were part of a single integrated plan.§368(c)- look at A and B collectively, and now they own 100% of voting and nonvoting so they both qualify under 351 this transactionA has same consequences as aboveB- B’s basis is 1k and corp takes basis of 1k. §1231- real estate with trade or business, so B can tack on if property is either a capital asset or 1231 property and the corp., can take the same basis

(c) Same as (b) above, except A transferred 25 of her 50 shares to her daughter as a gift on 3/5 (3 days after B’s transfer). What if A’s gift was on 1/5?A get shares on 1/5 and then transfers to daughter

Here, there is no change and A still has control – because intermountain says that there need be only a freedom of action with regard to the stock after completion of the initial transaction. Hypo- Say A received it as a binding contractual relatonNo §351- b/c under binding agreement there is no controlHere he was OBLIGATED to sell, 50% so not 80% and thus no control

(d) Same as (b) above, except that two months after B’s transfer, A sold 15 shares to E pursuant to a preexisting oral understanding w/o which Newco would not have been formed.Interdependent TestIf two transfers are interdependent they will be treated as part of the same transactionHere, 15 shares were sold, so now only 70% and requirement has not been made, so not a §351 transactions. What if A transfers services for stock (20%)A pays taxes as ordinary incomeB transfers property and retains 80% thus meets 351 testWhat if A transfers services for 30% stockA still pays ordinary income taxB does not retain 80% - 351 does not apply and must pay tax on the gains. What if C transfers ppty for 50% and S transfers ppty 10% and services 40%. (thus 60% of stock transferred for Does this qualify for 351 treatment? Yes both C and S both transfer property and retain 100% of stock ownership. (does not matter that services were used to transfer also.) However, Reg 1.351-1(a)(1)(ii) if property transferred for the stock is so small compared to stock transfer for the property and purpose is to create a 351 situation for another person.. then that person does not qualify as transferring property for the transaction. Rev proc 77-37 ( FMV of stock received >= 10 % FMV of stock received for services. Here S would be counted as a property transferor. 10% of 40% is 4 and 10 > than 4 thus transferred property. (this is a deminimus rule) Problem 2:Java has operated a chain of coffee houses as a sole proprietorship over the past three years and is now interested in expanding his horizons and limiting his liability.To do so, he wishes to incorporate, raise 150k of addl’t capital and hire, an experienced person to manage the business. He has located Venturer, who is willing to invest 150k cash and Manager, who has agreed to serve as chief operating officer if the terms are rightThe parties have decided to join forces and form Java Jyve, incJava will transfer assets with an AB of 50k and FMV of 200kVenturer will give 150k Cash, and M will enter into 5 year employment agreementJava wants control, V wants a guaranteed investment but wants to share in growth of business, mgr., wants to be fairly compensated (believes her services are worth 80k/year)

(a) J will get 200 shares and V will get 150 shares. M will get a salary of 40k/year and receive 150 shares. FMV of stock is 1k/share.

500 sharesJava wants >50% of stock, here he only gets 40% so it doesn’t satisfy Java’s goalsJ and V have 70% and not 80% so this is not a §351 transaction and will be taxed on gains. Managers share do not count because she gets services instead. So here J’s AB is 50 and FMV is 200, so he has a gain of 150, and Basis of 200k (FMV)VBasis of 150kManager ordinary income of 40k, and 150k of Shares

(b) same as (a), but M gets compensation of 80/year and will pay 150k for her stock. Qualifies as a §351, when she pays, because now it is cash and not services. Where as, V still does not own or have control Now mgr. gives a note this is still property (unlike services) but manager has to pay the note eventually and pay service

(c) same as(a) except M will pay 1k for her 150 shares and the incrop., documents specify she is getting shares in exchange for her cash contribution rather than for future serviceStock is worth 150k and so here FMV of stock is 1k and services is 149k, so here 1k is relatively small and under regulation not a §351 transaction. Here J and V, will not have 80% because cannot use it for these purposes.

(d) Same as (c) except M will pay 20k rather than 1kNow she pays 20k and 130k in services, so nowstock for property is are more than 10% of amount of services and this will be a §351 transaction. 10% of 130k = 13k 20k>13k manager pays ord income on 130k but Java is off the hook for the transaction.

Treatment of Boot

In GeneralIf a transferor receives property other than stock, e.g. cash, corporate debt, securities, nonqualified preferred stock or other property, boot, in a §351 transaction, §351(b) provides that the transferor’s realized gain is recognized to the extent of the cash and FMV of any other boot receivedNo Loss Rule Even if boot is received by transferor, no loss is recognized. §351(b)(2).Character of GainDetermined by reference to the character of the transferred asset to which the gain is attributable taking into account the depreciation recapture provision under §1245 and other applicable characterization rules under §1239Gain is triggered by the receipt of boot results in increases to the SH basis in the stock received and the Corp’s basis in the transferred property.Gain Rule Gain recognized on boot is limited to the gain realized (so it is the lesser of the boot received or the gain realized) If property transferred is capital then the recognized gain is capital.

If part capital part ordinary – then you bifurcate the transaction by capital and ord Step One:Determine the realized gain on the exchangeExample: A gives property with an AB of 70 and receives 80k stock and 20k cash.AR-AB 100k-70k30k Realized Gain, RECOGNIZE 20kRecognized Gain EXTENT OF CASH!!!!!!!!!!!!!!!!!!!!!!!!!!!§351(b) says gain recognized is to extent of cash AND FMV of boot, so here, the extent of it is 20klesser of boot received or realized gain of pproperty transferred. Example 2:A gets 60k cash and 40k stock and gives corp. land with FMV is 100k and 70k is AB. AR-AB 100k-70k30k, but here cash is 60k, but YOU CAN ONLY RECOGNIZE 30k, so here, Rule Recognize the lesser of the boot or realized gainRule: S351(b) NO LOSS IS RECOGNIZED ON BOOT!

Transferor’s Basis in StockFormula under §358(a)(1)Transferor’s Adj Basis in property Transferred(-) Amount of Cash and FMV of Boot (Debt and other non-stock property)(+) Gain Recognized by transferor = transferors AB in stock received More than one class of Newco StockAggregate basis determined above is allocated among the various classes in proportion to fmv of each class§358(b), §1.358-2(a)(2)So In example 1 basis is70k – 20k +20k70 K basis§358(a)(2) Boots basis is FMV

Corporation’s Basis§362(a)If the transferor recognizes gain b/c of the receipt of bootThe corp.’s basis in the property received is TRANSFEROR’s BASIS + ANY GAIN RECOGNIZED. Allocation of BootRule- When several assets are transferred in exchange for a combination of stock and boot, Boot is allocated among the transferred assets in proportion to their relative FMVRealized gain on transferred asset is recognized to the extent of the boot allocable to that asset, but no realized loss may be recognized under §351(b) Rev Rule 68-55Boot allocated to a loss asset will not cause gain or loss recognition.

Hypo 1:A transfers 50k cash in exchange for 50k stockB transfers a capital assets with Basis of 5k and a value of 30k and equipment with a basis of 5k and a value of 20k (10k is recapture under §1245) in exchange for 40k stock and 10k cashIssue 1: Where is the boot allocated for B?B has boot of 10k and it is allocated b/t capital asset and equipment in proportion to the FMV. Here, 30k is land and 20k is equipment, so 60% goes to land and 40% goes to equipmentSo 6k of Capital Gain on capital asset and 4k on ordinary income. Hypo 2:Same as Hypo 1, except that B’s basis in 30k capital asset is 40k rather than 5k.The 10k cash boot is still allocated 6k and 4k to the equipment. B recognizes 4k of ord. income on the equipment but may not recognize any loss, on the capital asset.

Installment Boot §453 A transferor who receives boot in the form of a newco debt instrument may be allowed to defer recognition of any §351 gain.Two Parts:(1) A §351(a) recognition exchange to the extent of the stock (“permitted property) received by the transferor and (2) a taxable installment sale to the extent of the boot receivedBasis of the transferred property is first allocated to the nonrecognition exchange and any remaining basis (“Excess basis”) is allocated to the installment sale. Installment MethodIf transferor defers any gain recognized under the §453 installment method, corp. may increase its basis under §362(a) only when that gain is recognized§1.453-1(f)(3)(ii)Handout Example:A transfers property (AB- 20k and FMV-60k) to X in a transaction under §351 and receives an exchange stock (FMV-10k), cash of 5k and a note of 45kStep 1: AB of transferred property to the stock up to the amount of the stock FMV

Here, the AB is 20k, and the FMV is 10k, so AB is 10kStep 2: Remaining amount. Is then allocated to the installment sales portionHere, it is 10k, so you end up applying the installment sales method:AR which si 5k cash and 45k note50kSubtraict AB allocated-10kNow there is a gain for 40kStep 3: Gross Profit %--> Gross Profit (Gain) / Total Sales Price 40k/50k 80%Gain on cash received is 4k (80% of 5k) and Gain on recognized payments of not is 36k (80*45k)Step 4: SH AB in stock:Elect as though there was no installment method and compute under §351AB of Transferred Property- FMV of Boot + gain RecognizedSo here 20k-50k (note+cash)+40k10k gainStep 5: Corp’s AB in property received:AB in the property is equal to the transferor’s AB, which is 20k, and increases AB when S recognizes gain.

Page 83 problem

A, B, and C form X corp., by transferring the following Assets, each of which has been held long-term

TransferorAssetABFMVAEquipment §1245 gain15k22kBInventory7k20kLand25k10kCLand20k50kIn exchange,A receives 15 shares of X common stock (value-15k) 2k cash and 100 shares of preferred stock with value of 5k)B receives 15 shares of X Common stock (15k) and 15k cashC receives 10 shares of X C.S (10k) 5k cash and X’s note for 35k payable in two years.A- not qualified preferred stock

(a) What are the tax consequences of the transfers to each SH and to X corp?Step 1 Is this a §351 TransactionYes, 100% and control, exchange property, just be aware of services and that they don’t count.

Step 2 AA is getting boot in this transaction. So here need to do formula:Gain Realized is AR- Ab, so here, 17k (15+2) – 15k2kHere 2k is recognized! - of ordinary income (due to recapture of depreciation) AB of property given is 15k less 2k(amount of cash) + 2k So here the AB is 15k. But you need to proportionate by the type of stock, because we have common and preferred.15k/20k is common and 5k/20k is preferred, so you have 75% of common 25% of preferred or 1$ 1,250 basis in common stock and $ 3,750 AB in preferred stock. Holding period = if held for more than one year its 1231 and tack on permitted. Holding period is based on the proportion received. Here 2/3 gets a new holding period 1/3 gets a tack on period. (p. 80)

Corp AB + Gain Recognized, so here it is 15k +2k, or 17k. Gain Realized 20k(k) Amount of stock given b/c it is the FMV of the stock- AB (which is 0 to corporation§1032, no G/L recognizedBoot Formula is AB + gain recognized. So 15+2 which is 17k.

Step 3 B has two properties, Land and Inventory. Note- When you have two properties, need to spit up by FMV, so in this case 2/3 goes to inventory and 1/3 goes to landBoot 15k 2/3 Inventory10k 1/3 Land 5k(1)Gain or Loss Realized on Boot (Inventory)

AR(20k)- AB(7k)13k Boot10k, so recognize ord. income on 10k. (gain is ordinary)(2) Gain or Loss Recognized on Boot (Land)AR (10k)- AB(25k) (15k) Loss No loss is recognized on boot! (2)- To get value of stock must do Aggregate Basis:AB in property 20k(-)FMV of boot (15k)(+) Gain recognized 10kBasis in stock is 15k(3) Effect on Corporation:(1) Realized Gain- 15k (fmv of stock)(2) Recog- 0(3) Basis in AssetsInventory: Basis + Recognized gain7k+10k- 17kLand: basis + Recognized gain on bootHere you have to do §362(e) adjustmentLand and Inventory have an AB of 20k and FMV of 30k, so need to adjust the AB of land by 10k so 25k-10k is 15.There was no recognized boot here.

C- Land of 20k AB with FMV of 50kC gets 10 shares with 10k FMV and 5k cash and 35k NoteStep 1 with Installment Method: Allocate basis in stock up to FMV = 10k to the 20k AB in landSo here AB of the stock is 10kStep 2: Remaining amountAllocate to installment sales portionAR40k (Note and FMV of boot received ( here, cash))AB allocated-10kGain is 30kGP% is 30/40 or 75%Gain Recognized in year 1:75% of cash received, or 5k is 3,75075% of note is 26,250=30kStep 3: Tax payer Basis in stock received is:AB in property( 20k(-) Boot----- 40k (Note +Cash)(+) Gain recog 30kBasis- 10k. CorpAB of 20k+ 3,750 cash. 23,750 and then increases AB when gain is recognized. 26250 + 23750 = 50k

Effect on TransferorsEffect on Transferee-Corp. G/LBasisHolding PeriodG/LBasis in AssetsHolding PeriodRealizedRecognizedReal.RecognizedA7k2k of Ordinary Income from BootCS- 11,250PS-3750Tack on b/c §123120k017kTack onB(2k)10k ord. income on inventory boot. 27kTack on1/3 for land (fmv)New 2/315k0Inv-17

Land-13kTack onC30k3,750 and 26,25010kTack on10k023,750Tack onASSUMPTION OF LIABILITIESIRC:§357(a)-(c)§358(d)§357(d) Skim

Regulation:§1.357-1§1.357-2§1.358-3

In General:§357 (a) Rule: If under §351 exchange, a company assumes a liability of the transferor SH, the assumption is not boot received by the transferor. Unless the assumption was for the purpose of avoiding gain – then total amount of liabilities is treated as boot (recognized gain).

§358(d) Transferor’s basis: Liability is treated as boot for purposes of determining transferor’s basis in the Newco stockSo only use liability in boot equation

Example:A transfers land with a basis of 30k and a FMV of 100k and subject to a 10k liability in exchange for Newco common stock worth 90k (mtg of 10). (1) What is A’s gain?0- because the transfer of liability under §357(a), is not boot received and no gain or loss is recognized.(2) what is A’s Basis in Newco Stock?Formula under §358(a)(1)Transferor’s Basis in property Transferred(-) Amount of Cash and FMV of Boot (Debt and other non-stock property)(+) Gain Recognized by transferor Applied to this formula:Basis20k -10k – 010k basis 10k basis, preserves 40k in land (60-20=40)

Determination of Amounts of Liabilities assumed:Recourse§357(d)(1)(A) A recourse liability is treated as having been assumed to the extent that, based on all the facts and circumstances, the transferee has agree and is expected to satisfy the liability , whether or not the transferor-SH has been relieve d of it. Non-Recourse§357(d)(1)(B) A nonrecourse liability is treated as having been assumed when an asset is transferred to Newco subject to the liability

S357(d)(2) But when more than one asset secures a nonrecourse liability, the amount of the liability treated as assumed must be reduced by the lesser or:(1) The amount of that portion of the liability which an owner of other assets not transferred to Newco and also subject to the liability has agreed to and is expected to satisfy; or(2) the FMV of the other assets to which the liability is subjectPurpose: Foreclose abusive result by preventing the liability from being counted more than once to make an upward adjustment under §362.

Exception 1Tax Avoidance Transactions§357(b) Assumption of liability is treated as boot if the TP’s principal purpose transferring the liability was the avoidance of federal income taxes or not a bona fide corporate business purposes. Reg §1.357-1(c) all the relieved liabilities, not just the abusive debts are treated as boot.TP has burden of proving the absence of an improper purposes by the clear preponderance of evidence§357(b)(2)Improper Tax Avoidance Ex: (1) company assumes personal debts, or (2) Encumbering personal property for personal ReasonsHypo:A transfers land with a basis of 20k, FMV of 60k and subject to a 10k liability in exchange for 50k stockA encumbered the land shortly before the transfer in order to raise funds to pay personal expenses here this is tax avoidance, and 10k boot under §351(b)As basis in stock is 20k-10k +10k20k

Exception 2Liabilities in Excess of Basis§357(c)(1)Sum of liabilities assumed in §351 transaction exceed the aggregate AB of the properties transferred by a particular transferor, the excess is treated as a gain from the sale or exchange of property. Applied sep. to each transfer or propertyPurpose: prevent a negative basis to stockRule: §357(c)(2)(A) if §357(b) and §357(c) both apply, then, §357(b) (tax avoidance) takes preferenceHypo:A transfers land with Basis of 30k, a FMV of 100k and subject to a 55k liability in exchange for stock worth 45k§357(a) A would have no gain, but basis in stock would be 30-55 and thus negative so §357(c)(1)A must recognize 25k gain (excess of liabilities over debt)A’s basis in the Newco stock is 30k (basis of land) - 55k (Debt relief) + 25k (gain recognized)- 0So if §357(c) applies, basis in stock will ALWAYS BE 0!

(cash basis based v. accruel based) cash- reports income when receives it and takes deduction when pays the expense.

A/R are greatest asset. And basis is zero.

If created corp would assume trade payables say 300 – thus would recognize a gain of 300 amount of boot including assumption of liability. This is not fair.

If given cash instead ot assuming liability taxed on the lesser of fmv or the amount of boot. Ie 300 gain. Would get offsetting deduction to when paid the trade payables and recognize no gain.

However bc of 357c assumed liability here is not treated as boot. Accruel -

Transferor Remains Liable to CreditorCase: Owen v. Commissioner:A transferor does not avoid §357(c) gain by remaining personally liable for debts encurmbering property transferred to Newco in a §351 transaction

Avoiding §357(c) by Transfer of NotePeracchi:Facts- P’s liabilities would have exceed basis, and he would have ord. income, so he decides to gives his note of 1.060m and now liabilities doe not exceed basisLiabilities of 1.550(-)AB .980= .570IRS says No you can’t do this b/c it is just a note and an IOU. – note has a basis of ZeroCourtTP had a basis equal to face value in his own note transferred to a wholly owned corporation b/c the note was a corporate asset subject to the claims of creditors in the event of a bankruptcy.Thus real and substantial increase in TP’s corporate investment.LIMITED to notes that have economic substance and have a FMV roughly equal to face value in his own note transferred to a wholly owned corporation b/c the note was a corporate asset subject to the claims of creditors in the event of a bankruptcy. RJ’s issue with case what is a “bona fide debt”It was a legitimate 351 transaction – he was a 100% owner of stock after the trans.

LessingerRule: A TP who transfers his own enforceable note to a controlled corp. in a §351 transaction may avoid recognizing gain under §357(c)Sine the corporation took the note with a basis equal to its face value; the TP should not be required to recognize any gain. Statute does not support this rationale.

Here IRS says that TP has 0 basis but this is an unsettled part of the law!

Character of §357(c) Gain§1.357-2(a)The character of gain is determined by allocating the gain among the transferred assets in proportion to their respective FMV§357(c) may be characterized by reference to an asset who has no built in gain

Hypo:A transfers inventory with a basis and FMV of 10k and a capital asset with a 25k liability with a basis of 5k and a FMV of 30k. Gain Recognized Basis of Assets 15k-25k (Liability)10k Gross asset value is 40k10/40 (25%) is inventory, and 75% is capital asset.So 25% is ordinary income (inventory) and 75% is capital gain even though A had no built in gain realized on inventory.

Excluded Liabilities:Liabilities assumed by Newco that have not yet bee taken into account by the transferor for tax purposes (either §162 or increasing the basis for property) are not treated as “liabilities” for purposes of determining gain recognized under §357(c)(1) or basis under §358. §357(c)(3) and §358 (d)(2)Example 1:A, a cash method TP, transfers 50k cash and 200k AR (0 basis) in exchange for 150k and Newco’s assumption of 100k of A’s AP which would have been deductible under §162(a) if paid by A§357(c)(1) A would recognize 50k gain (excess of 100k AP over 50k cash)§357(c)(3) AP are not treated as liabilities, A thus recognizes no gain.A’s basis in stock is 50k and it is not reduced by AP assumed by newco. Example 2:Newco is formed, B, an accrual basis TP, transfers contaminated land w/ associated contingent env. Liabilities in exchange for all of Newco’s stock. B neither deducted nor capitalized any amount with respect to liabilitiesThe liabilities assumed by Newco in the exchange are not liabilities under §357(c)(1) and §358(d) because NEVER DEDCUTED by B and they did not create or increase the basis of property prior to transfer

Limit on Basis Increase Attributable to Liability assumption

Page 102

A organized X corp by transferring the folliwng:Inventory AB- 20k and FMV-10kUnimproved Land- AB-20k and FMV-40k with a recourse debt of 30kX took land subject to liability and gave 20k of stock to A

(a) Assuming that §357(b), is not applicable how much gain does A recognize and what is A’s basis and holding period of the stock?AB is 40k (aggregate 20k + 20k) and Debt assumed is 30k. So here there is no excess No gain or loss is recognized when debt is assumed; it reduces the basis in stock receivedAB in stock received is:AB – 40k(-) FMV of boot- Debt- 30k

(+)gain recognized = here noneSo total is 10k basis. Inventory No tack on and it is 50/50 split. You get a tack on where a capital asset or 1231 asset. Inventory not included. So each share you get back there is a split holding period. Ie inventory – each share is 10k = so ten shares for inventoryLand – each share is 10k = so ten shares for landCorp takes - basis of property transferred. Ie 20k and 20k

(b) and (C) Now basis in land is only 5kNow the problem is that Debt exceeds the AB of the stock, so you need to recognize a gainLiability assumed is 30k and total AB of transfer is 25k, so gain recognized is 5kWhenever this happens basis is always 0, but do the math and:25k-30k+50Character of the 5k gain(4/5) 80% is capital gain and (1/5) 20% is ordinary gain §1.357-2(b).  Allocate the §357(c) gain between the transferred assets based on the relative fair market property values (without consideration of the debt).

(d) What is Corps’s Basis in the properties Received in (b)corp takes transferred basis plus any unrecognized gain.

5k(20% to inventory and 80% to land) so here 1k and 4k are added to the basisreg says - 21k (20k +1) for inventory, and 9k (5k + 4k) for landtax ct says 20k and 10k

(e) A could have avoided by:Giving cash of 5k to CorpPaying off some of the debtGiving another asset that would increase basis. Perachi case – can transferor provide a note of the amount (see perachi above)

Problem 2:B organized Y corp. and x-ferred bldg. with AB of 100k and FMV of 400k. Bldg. is subject to mtg. of 80k which was incurred two years ago for valid business reasons.B borrowed 10k for personal purposes with a secured loan on mortgage (this debt is taxable)Y corp will issue 310k of common stock to B and will take bldg. subject to mortgages. (a) What are the tax consequences to B on x-fer of bldg to Y corp.Step 1: Liability is 90k which is less than AB

(2) Is there a tax avoidance purpose so here yes the 10k, under regall liabilities will be treated as boot! AR here is 400k and AB is 100k so the lesser of 300k gain and boot is 90, so recognize gain of 90kBasis in stock is: 100k -90+90 100k Basis(b) What if B did not borrow 10k and instead Y borrowed 10k from a bank and gave B 310k of Y c.s., 10k cash and will take the bldg. subject to the 80k mortgageNow the 80k is not boot, but there is boot of 10k10k boot is recognized gainBasis- 100k -90+10 20k basis in stock (c) Is the difference justifiedIn A, it was tax avoidance so that is why it was treated as boot. (d) When might there be a leg. reason for corp to assume a property’s debt?Bona fide business purposes.

SPECIAL PROBLEMS

Incorporation of a Going Business

(1) Assignment of Income DoctrineAssignment of Income doctrine does not apply to a transfer to Newco of AR by a cash basis TP unless TP has a tax avoidance purposeHempt BrosEx A transfers the assets of her cash method sole proprietorship, including 0 basis AR, in exchange for Newco stockHere although A earned income, she is not taxed, Co., will have a 0 basis and get taxed when they get the incomeAccrual Basis Basis is equal to amount already included in income, and newco takes that same basis and recognizes no add’l income when it collects the receivables. Corp takes basis

(2) AP and Contingent LiabilitiesAP transferred to Newco by a cash basis TP or contingent liabilities for which the transferor has not received any tax benefit are not liabilities for §357(c)(1) PurposesIRS permits Newco to deduct the payable when they are paid I they would have been currently deductible by the transferor or to treat them as cap-ex as appropriate under Newco’s method of accounting.Accrual- take this into account when calculating §357 boot and AB of transferor.

(3) Tax Benefit RuleTB rule requires a TP who derives a tax benefit, such as a deduction, in one year to recognize income in a sub year on the occurrence of an event, such as a recovery of the amount deducted, that is inconsistent with the earlier deduction

Nash SC held that the tax benefit rule did not require an accrual basis TP to recognize income on the transfer of AR in a §351 transaction when the TP had previously deducted some of the AR as uncollectible by creating a bad debt reserveNo recovery because the TP received NEWCO stock equal to the value of the AR less previously deducted debt reserveNo longer important because- TP generally may not deduct bad debt reserves§351- override TB rule in situation where the TB can be preserved and later “recaptured” through a transferred basis.

Rev Rul-95-74

Page 112 Problem

Key Notes:General Rule of 357(c) Liabilities assumed (100k) – AB (60k) = 40k. However, AP is not a liability whose payment by transferor would have given rise to a deduction/is not a liability for §357(c) purposes (if architect paid them they would be deductible as a business expense). So never use AP to increase the basis. Thus liabilities assumed is 30k not 100k and thus basis is not > than liabilities assumed. AB = AB=(60) – liabilities (30K) – gain (0) = 30k What about the toxic liabilities. Rev Rule 95-74- Contingent liabilities whose payment have been deduct do not increase basis and not under §357(c) So: do not use AP or contingent liability to calculate boot and AB of Transferor.

(b) Tax of AR that hasn’t been paid yet and is transferred is tax to the receiving corporation(c) For contingent liabilities the rule is:Deductible by the corp., as a business expense under §162 or are capital expense under §263 as appropriate under S’s method of accounting determined as if S has owned the land for the period and in the same manner as it was owned by the P. Reasoning for 357 © TP would get an offsetting deduction from the AR and AP but this would not happen.

TP would not recognize gain for AP but

Adj basis in stock transferred to TP

AB in Transferred Prop = 60(-) FMV of boot = (30)(+) any gain recog= 0total = 30

Holding period = nature of assets being transferred AR are not cap or 1231Supplies are not cap asset or 1231

Thus there is a split holding period in each share of stock 120/200 = 60 % tack on 80/200 = 40% new period.

Basis for corp = no gain recognized so will take basis that TP transferred.

Peculiarities found in the problem - environmental contingent liabilities – in problem corp assumed those.To the extent those would be deductible (paid by the transferor) they would not be attributed to basis in 357(c).

the liabilities may be capitalized – part of the cost of the underlying capital asset (the land that is polutted)

95-74 Rev. Rul = see aboveShould tax benefit rule (recovery of money from previous deduction (ie supplies) from sale be applied to a 351 - NO

(b) Who pays the Receivables – from hempt bros case. See above. (c) Can AP once paid by Design be deducted as an expense – YES design can.(d) TP is trying to mismatch revenue and expense. – TP wants to deduct the expenses to reduce his tax And allocate all the income to the Corp. TP would have to incur the income.

What if TP was accruel

Assets = what would his basis in the assets be different. Here Liab asummed 70 (not 30: 357c exclusiont not applicapble here)AB of transferred prop 120

AB of transferred Prop 120(-) FMB of Boot 100 (70 + 30)(+ gain 0= 20k

CH 3 Capital Structure of a CORP.

(1) Sources of Corporate CapitalDebt and Equity create Capital Structure(A) Equity:Equity is contributed to a corp., in exchange for an ownership interest evidenced by shares of stockTypes Preferred, Common and Convertible(B) Debt:Evidence by a written unconditional obligation of the corp., to pay a specified amount on demand or on a certain date.

(2) Tax Advantages(A) DebtInterest Deduction

Principal tax advantage of debt is avoidance of the “double tax” on corporate profitsA corporation can deduct interest paid on its debt under §163, but not dividends – mitigated by consequences to lender. Repayment of PrincipalA tax free return of capital to the lender§1271 if amount repaid exceeds lender’s basis, excess is generally treated as a capital gainDefense against Accumulated Earnings Tax(B) Equity§351 Non-recognitionCharacter of Loss on WorthlessnessCorporate SHQualified Business stock

What happens when a shareholder loans to the company. Is repayment of the loan a dividend payment or loan repayment.?

1. Debt equity test – compare the debt of sh with SH equity 1:1. Or 9:1 lenders prefer to lend to the former. Because it signifies how much a biz can lose but pay its debts. The second number in the ratio is called the equity cushion. Amount that can be lost and pay the outstanding debt.

(3) Deciding Equity or DebtNote Courts use factors, but ultimate question is it ”risk capital” or strict debtor creditor relationship viewing the transaction as if it were w/ an o/s lender. (1) Form of the ObligationAn unconditional promise to payA specific TermA stated rate of interest payable in all eventsHybrid Instruments that have voting rights or make interest payments CONTINGENT on earning are likely to be treated as equity(2) ProportionalityDebt held by SH in the same proportion as their stock is subject to special scrutinyRationale SH have no economic incentive to act like creditors by setting or enforcing the terms of the purported debt. If co. fails would lose same amount as if it were a creditor or SHer. Only difference was a tax difference.

Ex. 3 SH abc raises suspicionStock Debt

A 300k 300kB 500k 500kC 200k 200k

As opposed to Stock Debt

A 300 1000B 500 0

C 200 0

Here the presumption that the debt of 1000 is valid.

(3) Debt/Equity RatioThis is the ration between corp.’s debt and equityHigh D/E is “thinly capitalized” and service will make debt equity on theory that purported debt is really at risk in the venture b/c no rational creditor would loan money to a thinly capitalized corp.,Debt CalculationDebt includes loans from SH. The ratio of SH debt to SH equity is sometimes called the “inside debt/equity” All long-term Liabilities is “o/s debt equity” including inside and outside creditors. Equity CalculationSH ownership interest in the corp.For exam, calculate based on AB and FMV§385 used AB, but current value is more accurateExcessive when:Inside 3:1 or lower is normally not excessiveOutside Debt equity ratio did not exceed 10:1 (proposed §385)

Problem: see shareholder debt problem sheet. P. 1554-157 1244 stock for small corps - if sell stock at a profit get cap gain if lose money can treat loss as ord deduction but limited to 50k (100k per married couple) per year. Character of Loss on Corporate Investment:

Stock and debt instruments are capital assets, any loss on their sale or exchange is a capital loss

Special Issues of Capital loss

(1) Loss on Worthlessness of debtSee if instrument is a security as defined under §165(g)(2) and if not, whether the debt is a business or non-business bad debtDebt Evidenced by Security:Security:Bonds, debentures, notes or other corporate debt instruments w/ interest coupons or in registered formA loss by a corporation of securities for an “affiliated corp.” is an ordinary loss!Affiliated Corp

Corp holder owns at least 80% of its voting power and value and more than 90% of its gross receipts are from sources other than passive investment income. §165(g)(3).Debt not Evidenced by Security:Losses on corp. debts not evidenced by a security are characterized by bad debt provisions in §166§166(a) losses from wholly or partially worthless business bad debts are ordinary.§166(d) Losses of non-corporate lenders from a wholly worthless non-business bad debt are treated as STCL.Losses from partially worthless non-business bad debts, are not deductible!! Business vs. Non-Business Bad Debts§166(d)(2)A non-business bad debt is a debt other than:(1) a debt created or acquired in connection w/ the Tp’s trade or business, or (2) a debt or loss from the worthlessness of which is incurred in TP’s Trade or business. SH-EmployeesIf a SH is an employee and loans money to a closely held corp., any resulting loss is treated as a non-business bad debt on the theory that the loan was made in TP’s capacity as an investorFor business bad debt deduction- TP must show that his dominate motivation or making the loan was related to his trade or businessUS v. Generes

(2) Loss on Worthlessness of EquityA loss incurred by a non-corporate SH on the sale of stock is treated as a capital loss, if the stock is a capital asset§165(g)(1) “If stock is security under §165(g)(2)”, a loss on the worthlessness of stock held as a capital asset is treated as a capital loss on the last day of the taxable year in which the loss is incurred.§1244 Stock§1244 stock is deductible as an ordinary lossQualifying SH§1244(a)- individual TP and partnerships who were original issues of §1244 are stock are eligibleDoes not include trusts, estates and corporate SH.§1.1244(a)-1(b)(2) Partners qualify only if they were partners when the partnership acquired the stock!Qualifying stockCS or PS that has been issued by a domestic corp. for money or property §1244(c)(1)§1.1244(c)-1(d)- Stock issued for services does not qualifySmall Business Corp StatusMust be a small corp.

Gross Receipts Test when Loss SustainedLimit on Amount of Ordinary LossReduction of Ordinary Loss

Chapter Four- Non-liquidating Distributions

(1) Distribution vs. DividendDistribution is any kind of payment by a corp. to its SH w/ respect to their stockDividend is a distribution out of current or accumulated Earnings &Profits of a corp. (what if it exceeds E and P – applied to the adjusted basis of the stock of the taxpayer)(what if it exceeds the AB of taxpayers stock – treated as capital gain from sale of the stock)Non-Liquidating ongoing corp.!

(2) Distributions under IRC

(a) Analysis:(1) Determine the amount of the distribution under §301(b)(2) How much of that is a dividend under §316(3) Specific tax treatment of those amounts provided in §301(c)

(b) Amount of DistributionsCannot be stock of the issuing corp! Cash received by SH + FMV (determined on date of distribution) of any other prop., received reduced by any liabilities assumed by the SH in connection w/ the distribution or liabilities to which the property is subject before and after the distribution§301(b)So:(1) Amount of Money received + FMV of other property(2) Reduction of Liabilities

(c)Amount of the Dividend§316(a)Distribution is a dividend to extent it is made out of E&P for taxable year in which the distribution is made or (2) E&P accumulated by corp. since 2/28/1913computed at the close of the yearthere is no reduction for distribution during the year.

The two basket approach

1. Current E P Basket 2 Acumulate E & P basket

Computed at close of Yr (accumulated basket can No reduction for distributions during the year negative but earnings during

the year are can be distributed despite being negative) if there is no E and P it is a reduction in the basis of the stock if that is exhausted then it is deemed a gain. (d) Tax Treatment of Distributions§61(a)(7) and §301(c)- Dividend is OI for SH§301(c)(1) First include distribution in GI(2) Reduce basis- §301(c)(2)(3) Excess is capital gain- §301(c)(3)

Example:E has 5k of E&P and no accumulated E&PX gives 12k cash to A who has an 8k of basis(1) 5k is income (still have 7k left)(2) 7k reduce basis, so now basis is 1

Earnings and ProfitsNot defined by statute - formed by case law.

Determining E&P§312- effect of various transactions on E&PE&P are determined by starting with TI and making Adjustments

E&P Formula:Taxable Income Starting Point(+) Items Excluded from taxable Income must be added backSuch as municipal bond interest, life insurance proceeds and fed tax refunds §1.312-6(b)(+) Add Back Certain Tax-Deductible Items§243 dividend received deductionRemember 70% and 80% deduction, gets added back in (happens because of subsidiary/parent relationship)§243 dividends rec’d deduction – a deduction where a company that pays dividend to another corp that ends up paying divident to ultimate shareholder. (the second co gets the deduction). (-) Subtract Non-Deductible ItemsFed tax paidCapital Loss Carryovers you can only deduct to extent of capital gain for tax purpose, so anything in excess should be used to reduce for E&PRemember Carryovers from prior years cannot be subtracted b/c you took it once in the prior year. (+/-) Timing Adjustments (such as depreciation)RJ said he probably won’t test on this.

Page 169 Problem see sheet.

Cash Distributions

Cash Distributions are dividends to the extent they are made out of current or accumulated E&P §316(a) and §1.316-2(a)

Current E&P Exceeds DistributionsCurrent E&P > Cash distributions, then distribution is a taxable dividendRemaining Current E&P is added to the accumulated E&P account§1.316-2(b)

Distributions Exceed Current E&P

Cash Distributions exceed current E&P, portion of each distribution that is treated as coming from current E&P is determined by a formula (§1.316-2(b))Formula Amount of Each Distribution x (Current E&P/Total Current Distributions)Remainder of each distribution is a dividend to the extent of the accumu. E&P available on the date of the distribution. If there is no Accuum. E&P. then it is a capital gain. Example:At beg of year, has Current E&P- 12k, Accum E&P-5kDistributes 10k on 4/1 and 10k on 10/2Formula Amount of Each Dis x Current E&P/Total Current Distribution10k x 12k/20k 6k is Amount of distribution that is dividend for each paymentApril 1 Payment:6k is dividend using formula, so you have 4k leftAt 4/1, you had 5k of accum. E&P, so here, all 4k is a dividend!Remember only 1k left of Accum. E&POctober 1:10k Dividend, 6k is Dividend based on Form.4k left, out of 4k, 1k can be used from Accum (see above)3k left, so 3k reduces SH basis in stock.

Accumulated E&P but Current DeficitEx:Beg of Year, has :12k- Accum E&P(10)k- Deficit for Current E&P20k- Cash Distributions (10k April 1, and 10k October 1)A’s Basis in stock is 40kIssue 1- A cannot show when deficit was incurredPro-rate deficit over the year, which is 10k/4, or 2.5 per Q in deterring the Accumulated E&P at date of distribution4/1 Accum., E&P is 12k-2.5k9.5kSo here, 9.5k is dividend and the 500 reduces basisOctober There is no accumulated E&P, so the entire amount is a reduction to basis.Year 2 Accumulated Earnings Deficit is- Issue 2: A can show when deficit occurred:10k deficit in 1Q o the year and broke even for 9 months, the deficit would eliminate 10k of the Accum E&P and only 2k would be a dividendPROBLEM p. 173

Ann owns 100% of Pelican co. Adj basis is 10k. A) Pelicans current E &P is 5k. Accumulated = 0 and distribution is 17,500.

Answer. Look to current E & P = 5k is a dividend. Then to Accumulated = 0 thus 12,500 reduces her basis – (10k). so there is 0 basis. And 2,500 left. This 2500 is capital gain.

B) 15k Accumulated deficit. 10k of current EP and distributes 10k. Answer. Look to current EP = 10k and thus there is a 10k dividend.

C) 10k accumulated EP. 4k current EP on July 1 sells ½ her stock to baker for 15k on April 1 distributes 10k and then on Oct 1 distributes 5k to ann and 5k to baker.

Total distributions for the year = 20k Answer: allocate the 4k among the distributions.

Amount of distribution X total current EP / Total distributions10k X 4k/20k = 2k5k X 4/20 =1k5K X 4/20 =1K

NOW accumulated distributions = allocate in chronological order.10k of accumulated e and p

thus 8k allocated to the first distributionremaining 2k allocated to the second distrubitions

10k of first distribution is dividend2k of second distribution to ann is dividend rest is cap gain (3k)2k of distribution to baker is dividend rest is cap gain (3k)

D) Rule 3 page 170 10k defict in E& P Find amount of accumulated earnings on date of distribution4/1 10k - (prorated loss = 2.5k) = 7.5k is dividend 2.k is return of capital. 10/1 5k – (prorated loss = 5k) = 5k and 5k is return of capital.

Property DistributionsConsequences to the Corp:(a) Background:General UtilitiesSC held that a corp. did not recognize a gain on a distribution of appreciated property to a SH even though the SH took a FMV basis in the distributed asset.§311(a) only applies to nonliquidating distribution of loss property§311(b) Applies to appreciated property

(b) Appreciated PropertyA corp. recognizes a gain on a nonliquidating distribution of appreciated property in an amount equal to the difference b/t the FMV of the property and its AB. §311(b)(1)Ex: X distributes Gain acre (FMV-30k and AB-10k) to its SH. (FMV –AB) A recognizes 20k on the distribution, and increases X’s current E&PTreatment of Liabilities:If distributed property is subject to a liability or if a SH assumes a liability of the distributing corp., in connection w/ the distribution, the FMV of the distributed property is treated as not less than the amount of liability. §311(b)(2) and §336(b)

(c) Loss Property§311(a)- Cannot recognize loss when AB >FMVEx:X distributes Lossacre (10k FMV, 30kAB) to its sole SH. X may not recognize its 20k loss. X should have sold Lossacre, recognized that 20k Loss (which would have reduced current E&P by 20k) and distributed the 10k cash proceeds to A

(d) Effect of Distributions on E&P§312(a)

(1) Generally under §312(a)Current E&P are determined as of the end of the taxable year w/o regard to distributions made during the yearAlthough a distribution may be a dividend “out of” current E&P, it does not reduce current E&P.To determine accumulated E&P at the beg. Of the follow year, accumulated E&P as of the beg of the year are increased by current E&P of the prior year, and then reduced by the amount of the distributionA distribution may not, create, a deficit in accumulated E&P

(2) Appreciated PropertyWhen corp distributes appreciated property:§312(b)(1)- (1) Increase current E&P by the gain recognized under §311(b)Accumulated E&P are reduced by the FMV of the distributed property §312(a)(3)(b)If SH assumes liabilities encumbering the distributed property or takes the property subject to liabilities, decrease in E&P resulting from the distribution is reduced by the amount of the liabilities. §312(c), Reg 1.312-3Liability relief increases E&P“The amount of any reductions in earnings and profits described in section 312 (a) or (b) shall be (a) reduced by the amount of any liability to which the property distributed was subject and by the amount of any other liability of the corporation assumed by the shareholder in connection with such distribution, and (b) increased by the amount of gain recognized to the corporation under section 311 (b), (c), or (d), or under section 341(f), 617(d), 1245(a), 1250(a), 1251(c), 1252(a), or 1254(a).”Example:X Corp., has 35k of accumulated E&P and 0 current E&P.X distributes Gainacre (FMV-50k, and AB-30k) to SH A who takes the property subject to a 10k mortgageX recognizes gain of 20k under §311(b) and increases CURRENt E&P.Distribution to SH is 40k (50k-10k)First take, 20k from Current and then 20k from Accumulated.

Accumulated E&P at 1/1 is:Accumulated – 35kPlus Current E&P- 20kMinus FMV of distribution- 50k Plus Mortgage Relief- 10k (3)Loss Property§312(a)(e)- Current E&P are not affected by a distribution of a loss property and the corp., reduces accumulated E&P by the AB of the distributed property.

(4) Corp’s Own ObligationsGeneral gain recognized in §311(b) does not apply to distributions of a corp’s own debt obligation§311(a) applies, and no G/L is recognized by the distributing corpEffects on E&P§312(a)(20A corp that distributes its own debt obligation reduces accumulated E&P by the principal amount of these obligations.A corp., distributes a debt obligation with a FMV that is less than its face amount, (b/c for example, the obligations have a stated interest rate that is below prevailing market rates), it reduces the Accumulated E&P by the “issue price” of the debt at the time of the distribution. So, if Corp gives principal note of 100k with FMV of 5k, reduce Accumulated E&P by 5k.

Consequences to SH – same as a cash distribution except for 301(d)§301(d)- Amount of property distribution is the FMV of the distributed property on the date of the distribution reduced by any liabilities to which the property is subject. Portion that is dividend is determined under the same rules applicable to cash distributions. P177 Problem

Constructive DividendsTransaction may not be labled as a dividend, but may be treated as constructive dividends if there is an economic benefit to the SH.Ex:Unreasonable compLow-interest loansBargain sale or bargain leasesPayment of SH personal expensesExcessive payment to SH for purchase of corp. propertyTransfers b/t commonly controlled corp. Case: D’Agostino No E&P and thus no dividend Appellants, who were owners of two corporations, were convicted of conspiracy to defraud the United States and tax evasion under HYPERLINK "https://www.lexis.com/research/buttonTFLink?_m=dd082851812427c9265b53bb4e20ceac&_xfercite=%3ccite%20cc%3d%22USA

%22%3e%3c%21%5bCDATA%5b145%20F.3d%2069%5d%5d%3e%3c%2fcite%3e&_butType=4&_butStat=0&_butNum=11&_butInline=1&_butinfo=18%20U.S.C.%20371&_fmtstr=BRIEF&docnum=1&_startdoc=1&wchp=dGLbVtb-zSkAW&_md5=34e0497aba54e4f176689643104dd752" µ18 U.S.C.S. 371§, ��HYPERLINK "https://www.lexis.com/research/buttonTFLink?_m=dd082851812427c9265b53bb4e20ceac&_xfercite=%3ccite%20cc%3d%22USA%22%3e%3c%21%5bCDATA%5b145%20F.3d%2069%5d%5d%3e%3c%2fcite%3e&_butType=4&_butStat=0&_butNum=12&_butInline=1&_butinfo=18%20U.S.C.%203551&_fmtstr=BRIEF&docnum=1&_startdoc=1&wchp=dGLbVtb-zSkAW&_md5=1efcbb4319c4d9579dec04aefe1a1724" µ3551§ as well as four counts of attempted tax evasion in violation of HYPERLINK "https://www.lexis.com/research/buttonTFLink?_m=dd082851812427c9265b53bb4e20ceac&_xfercite=%3ccite%20cc%3d%22USA%22%3e%3c%21%5bCDATA%5b145%20F.3d%2069%5d%5d%3e%3c%2fcite%3e&_butType=4&_butStat=0&_butNum=13&_butInline=1&_butinfo=26%20U.S.C.%207201&_fmtstr=BRIEF&docnum=1&_startdoc=1&wchp=dGLbVtb-zSkAW&_md5=d4d49062206bae352f0b268b1fc46208" µ26 U.S.C.S. 7201§ and �HYPERLINK "https://www.lexis.com/research/buttonTFLink?_m=dd082851812427c9265b53bb4e20ceac&_xfercite=%3ccite%20cc%3d%22USA%22%3e%3c%21%5bCDATA%5b145%20F.3d%2069%5d%5d%3e%3c%2fcite%3e&_butType=4&_butStat=0&_butNum=14&_butInline=1&_butinfo=18%20U.S.C.%202&_fmtstr=BRIEF&docnum=1&_startdoc=1&wchp=dGLbVtb-zSkAW&_md5=bcfb998700538ee7faaae76f70e9966d" µ18 U.S.C.S. 2§, ��HYPERLINK "https://www.lexis.com/research/buttonTFLink?_m=dd082851812427c9265b53bb4e20ceac&_xfercite=%3ccite%20cc%3d%22USA%22%3e%3c%21%5bCDATA%5b145%20F.3d%2069%5d%5d%3e%3c%2fcite%3e&_butType=4&_butStat=0&_butNum=15&_butInline=1&_butinfo=18%20U.S.C.%203551&_fmtstr=BRIEF&docnum=1&_startdoc=1&wchp=dGLbVtb-zSkAW&_md5=63a5c05b8f15fde8f70fdb1353aa0787" µ3551§. However, on appeal, the court reversed and remanded the convictions holding that the corporate funds, which appellants had diverted, were not taxable. The court further held that under the no earnings and profits, no income rule, because appellants’ corporation had not realized profits during the applicable tax years, the diverted funds were received as the repayment of a loan from appellants to the corporation.Case- Boulware: “intent of parties”The question was whether a 41istribute accused of criminal tax evasion could claim return-of-capital treatment without producing evidence that either he or the corporation intended a capital return when the distribution occurred. Language of HYPERLINK "https://www.lexis.com/research/buttonTFLink?_m=f41fc4a154533c6a456be3c235d57fdd&_xfercite=%3ccite%20cc%3d%22USA%22%3e%3c%21%5bCDATA%5b128%20S.%20Ct.%201168%5d%5d%3e%3c%2fcite%3e&_butType=4&_butStat=0&_butNum=12&_butInline=1&_butinfo=26%20U.S.C.%20301&_fmtstr=BRIEF&docnum=1&_startdoc=1&wchp=dGLbVtb-zSkAW&_md5=66589bc7a92ea822941ece7d7ed670b2" µ26 U.S.C.S. 301§ and ��HYPERLINK "https://www.lexis.com/research/buttonTFLink?

_m=f41fc4a154533c6a456be3c235d57fdd&_xfercite=%3ccite%20cc%3d%22USA%22%3e%3c%21%5bCDATA%5b128%20S.%20Ct.%201168%5d%5d%3e%3c%2fcite%3e&_butType=4&_butStat=0&_butNum=13&_butInline=1&_butinfo=26%20U.S.C.%20316&_fmtstr=BRIEF&docnum=1&_startdoc=1&wchp=dGLbVtb-zSkAW&_md5=7b8f9f1fcfcf7d4fc63d50e7fe7754ab" µ316(a)§, which stated that the tax consequences of a distribution by a corporation with respect to stock depended on whether the corporation had earnings and profits and the amount of the taxpayer’s basis for his stock. The lower court’s view also created a tax limbo or forced resort to an atextual stopgap as the interpretation created a disconnect between civil and criminal liability. In sum, HYPERLINK "https://www.lexis.com/research/buttonTFLink?_m=f41fc4a154533c6a456be3c235d57fdd&_xfercite=%3ccite%20cc%3d%22USA%22%3e%3c%21%5bCDATA%5b128%20S.%20Ct.%201168%5d%5d%3e%3c%2fcite%3e&_butType=4&_butStat=0&_butNum=14&_butInline=1&_butinfo=26%20U.S.C.%20301&_fmtstr=BRIEF&docnum=1&_startdoc=1&wchp=dGLbVtb-zSkAW&_md5=ef5d28af0c16eb3475cdd239ef99f3ef" µ 301§ and HYPERLINK ��"https://www.lexis.com/research/buttonTFLink?_m=f41fc4a154533c6a456be3c235d57fdd&_xfercite=%3ccite%20cc%3d%22USA%22%3e%3c%21%5bCDATA%5b128%20S.%20Ct.%201168%5d%5d%3e%3c%2fcite%3e&_butType=4&_butStat=0&_butNum=15&_butInline=1&_butinfo=26%20U.S.C.%20316&_fmtstr=BRIEF&docnum=1&_startdoc=1&wchp=dGLbVtb-zSkAW&_md5=eca9b3277b2a9d6ac135a4e6bcf126ef" µ316(a)§ governed the tax consequences of constructive distributions made by a corporation to a shareholder with respect to its stock. A defendant in a criminal tax case did not need to show a contemporaneous intent to treat diversions as returns of capital before relying on those sections to demonstrate no taxes were owed.

Case – Nicholls, Northy, Buse Co.

Smaill family co. purchased a yacht for the child non voting shareholder to use. The IRS tried to tax the father voting sh (a constructive dividend). Ct said – bc father was able to confer benefit to son thus he controlled the direction of the funds and thus should be taxed on the dividend. The amount of the dividend was the cost of the yacht. The corp held the title of the boat. Herbert was taxed on 75% of the daily rental rate.

Personal Benefit to SHCorporate payments of expenses (meals, travel, entertainment) that provide only an incidental benefit to the business and are primarily for the personal benefit of the SH or his family may be classified as constructive dividends. Ex: Nichols 75% personal use of corp., yacht was constructive dividend, to extent of 75% of yacht Fiar rental valueRev Ruling 69-630§482- authority to distribute, apportion, or allocate GI, deductions and credits among related org., trades or bus., if it is necessary in order to clearly reflect the income of such entites or to prevent the evasion of taxes

§482- bargain sail transaction b/t bro-sis corp that result in shifting of incomeAmount of allocation will be treated as a distribution of the controlling SH, with respect to the stock of the entity whose income is increased and as a capital contribution by the controlling SH, to the other entity involved gives rise to §482Issue- A owns 100% X and 100% Y. A caused X to sell its property to Y for less than arm’s length FMV price. Assume FMV for 100 sold for 80. X’s income was understated b/c avoidance of income.X will increase income to reflect arm’s length price of the property sold to YBasis of Y will reflect arm’s lentgth price. Amount of such increase will be treated as a distribution ot A< with respect to his stock of X and capital contribution by A to YThus X income increases by 20 (as though sold for FMV) and thus Y basis increase by 20 (paid FMV)To bring this inline with economic reality - the $20 is treated as distributed as Corp dist. (301 could be ) to A. and then A made a capital contribution of 20 to Y corp. increasing A’s basis in the Y corpUsing of Dividends in Bootstrap Sales see TSN Liquidating case. A parent corp., that is about to sell stock of a sub in a taxable transaction may attempt to convert capital gain on the sale to dividend income by causing the sub to make a large distribution shortly prior to the acquisitionSuccess depends on time of the distribution and source of the distributed moneyEx: X owns all the stock of T which has a value of 1mX’s basis in the stock is 200kT has ample E&P P wishes to purchase the StockIf X sells its T stock to P for 1m cash, X realizes 800k of gain taxable at 35kIf X causes T to distribute 800 to X and the entire amount is a dividend, X may deduct 100% under §243(a) and realizes no gain on the sale of the stock for 200kIf, after neg. began for the sale of T, the distribution were paid in the form of a T promissory note that was later paid off with funds supplied by P, it likely will be reclassified as a payment of the purchase price.If T distributed its own excess liqudi assets, dividend will likely not be reclassified even if the buyer infuses T with liquid assets shortly after the purchase. Caveat- Strategy may not be viable if X and T file a consolidated return of if distribution to X is extraordinary dividend under 1059.

TSN Liquidating See chart.TSN wanted to sell a sub CLIC to UNION MUTUAL UM did not want some small cap stock owned by CLIC – so prior to sale CLIC dividended out stock to TSN sold CLIC to UM and UM invested Bonds into CLICTSN claimed it was a dividend and claimed dividends received deduction of 85% - 1.IRS argued that it was part of the sales price.

Waterman Case disposition was a dividend- IRS said waterman was different from here, bc UM reinfused the CLIC with assets same as a beginning. Ct disagreed.

Facts of waterman – Waterman owned PA with a FMV of 3.5 Securities wanted to buy

Waterman wanted a 2.8 dividend ( a promissory note) Securities paid waterman 700k ( the AB in the stock owned by waterman) so there was not gain from the transaction.

Securities lent PA 2.8 million dollars and satisfied the note to waterman.

Ct said it was part of the purchase price. Securities was using Pan atlantic as a conduit to transfer cash to Waterman.

It differs from TSN bc in TSM the targets assets changed substantially. PA did not

Chapter 5- Redemptions and Partial Liquidations:

§302: Distribution in Redemption of StockIRC:§317(b)Regulations§1.302-5(a)§1.302-5(b)§1.302-5(c)

A. Introduction

(1) Redemption DefinedRedemption is a repurchase of a corporate security by its issuer.§317(b)A redemption is defined as an acquisition by a corporation of its stock from a SH in exchange for cash, debt securities or other property, whether or not the acquired stock is cancelled , retired or held as a treasury stock.Property§317(a)

(2) Overview of Tax ConsequencesConsequences to Distrubutee SHNeed to see if distribution is more like a (1) dividend or (2) Sale(1) Dividend if:Corp distributes money or property in exchange for its own stock and the distributee SH equity in the in the corp., is essentially unchanged.(2) Sale or exchange of stock if:Significantly, reduces SH equity interestConsequences to Distribution Corporation

(3) Tax Stakes To ShareholdersNoncorporate SH prefer exchangeCorporate SH prefer dividend treatment if 243 dividend deduction or consolidated return.

B. Constructive Ownership of Stock

§302(c)(1)§318§1.318-1(a), (b)§1.318-2§1.318-3(a), (b)§1.318-4

(1) Generally:

An individual or entity is treated as owning stock owned by certain related family members, corporations, partnerships, estates and trusts under the attribution rules in §318. (for §302 purposes) §302(e)(1)Rationale- related individuals and entities have a unity of economic interest.

(2) Family Attribution:§318(a)(1)An individual is treated as owning stock owned by her spouse, children (legally adopted), grandchildren and her parents, but not, siblings or in-laws. Grandchildren are not considered to own stock owned by their grandparents§318(a)(5)(B)- Stock constructively owned by one family member may not be reattributed to another family member. So can’t attribute from parent to child and then to child’s spouse. Example:X Corp’s 100 o/s shares are owned by H (10), his wife (20), their child (20), Wife’s Father(30) and Wife’s sister(20) SHActualConstructiveH- 1010%40% (W +C)W-2020%60% (H+C+WF_C-2020%30%(H+W)WF-3030%60% (C+WS+W)WS-2020%30% (WF only!)Total- 100100%

(3) Entity to Beneficiary Attribution

(a) From Partnership or EstatesStock owned by or for a partnership or estate is considered as owned by the partners or beneficiaries with present interests ex. Life estate in proportion to their beneficial interest. §318(a)(2)(A)Reg 1.318-3(a)- A person ceases to be a beneficiary of an estate when he receives all property to which he is entitled (ex. A specific bequest) and the possibility that the person must return the property to satisfy a claim is remote§1.318-3(a)

Ex 1- A, B and C are equal partners in ABC Partnership. The partnership owns 120 shares of X corp. stock. A,B, and C each are considered to own 40 shares of X.

Ex 2- D dies leaving a 50 k specific bequest to E, and his residuary estate to F. E is no longer a beneficiary for attribution purposes after she receives her bequest, but F remains a beneficiary until the estate is closed.

(b) Trusts§318(a)(2)(B)(i) Stock owned by a trust (not qualified employee retirement plan) is considered owned by its beneficiaries in proportion to their ACTUARIAL interests in the trust, however small or remote. §318(a)(2)(B)(ii)Stock owned by a grantor trust is considered as owned by the person who is taxable on the income of the trust

Example:Trust owns 100 shares of X corp. A is the income beneficiary of the trust and B is the remainder person. A and B’s actuarial interests are 60% and 40% collectively. So A owns 60 shares and B owns 40 shares of X corp.

(c) From Corporations§318(a)(3)(A)Stock owned by a corporation is considered as owned proportionately, (by reference to value) by the SH who owns, actually or constructively, 50% or more in value of the corporation’s stock. Ex:A owns 60% (by value) of the stock of X corp. X corp., owns 100 shares of Y corp. So, A is considered to own 60% or 60 shares of Y corp. Now say, A owned only 40%, A would not be considered, owning any shares of Y through X.If A owned 40% of X corp., actually and another 20% constructively (ex- through family member), A would be a 50% or more SH and thus would constructively own 60 shares of Y through X.

(4) Beneficiary (or Owner) to Entity Attribution

(a) To Partnerships or EstatesAll stock owned actually or constructively by partners or beneficiary of an estate is considered as owned by the partnership or estate §318(a)(3). Ex:A,B, and C are equal partners of the ABC general partnership. A owns 60 shares of X corp., actually and is considered owning 40 shares from his wife, W. So ABC is considered to own 100 shares of X corp., form A as well as any shares owned actually and constructively by B and C.

(b) To TrustsAll stock owned by a trust beneficiary is attributed to the trust unless the beneficiary’s interest is both remote and contingent. Remote 5% or less of the value of the trust property, assuming the trustee will exercise minimum discretion in favor of the beneficiary. §318(a)(3)(B)(i).§318(a)(3)(B)(i)- Grantor trusts are considered as owing stock owned by the grantor or other person taxable on the trusts income. Example:A is the income beneficiary of Trust. A owns 100 shares of X corp., all of which is considered owned by the trust. If A had only a contingent remainder which was 5% or less of trust property, none of A’s shares would be attributed to the trust

(c)To Corporations

All stock owned by a SH who actually and constructively owns 50% or more of a corp.’s stock is attributed to the corporation§318(a)(3)(C)Ex: A owns 60% (by value) of X corp. stock. A owns 100 shares of Y corp. X corp., is considered to own 100 shares of Y corp. from A.If A owned less than 50% of X, however, none of A’s shares in Y would be attributed to X.

(5) Option Attribution§318(a)(4) A person holding an option to acquire stock is considered as owning the stock. §318(a)(5)(E) If stock may be considered as owned by an individual under either family attribution or option attribution, Option attribution takes precedence. Permits reattribution of the optioned stock to another family member despite the no double family attribution rule. Example:H has an option to acquire 100 shares of X corp., stock owned by Child. H is considered to own Child’s 100 shares under the stock option attribution rules. H can reattribute these to other family member, but if he did not hold the option, he would still be considered as owning family attribution shares, but can not reattribute to other members.

(6)Other Operating Rules

(a) ReattributionStock constructively owned by a person under §318 is considered as actually owned for purposes of reattribution that stock to another person.Example:A and B (unrelated) each own 50 of the 100 o/s shares of X.X owns 100 shares of Y corp.A is 50% partner in the AC partnershipB is the sole beneficiary of TrustA and B each is considered as owning 50 shares of Y through .A’s shares of Y are reattributed to AC partnership and B’s shares are reattributed to the trustPartnership and Trust each is deemed to own 50 shares of X directly from A and B respectively.

(b) No Double Family AttributionStock constructively owned under family attribution rules of §318(a)(1) may not be reattributed to another family member under §318(a)(5)(B).Ex. Parent son and daughterSon owns 100 shares.Daughter does not constructively ownFather does.But daughter does not constructively own the fathers constructive share.

(c) Anti Sidewise AttributionStock owned by a beneficiary partner, or SH, that is attributed to an entity may not be rattributed from the entity to another beneficiary, partner or SH. §318(a)(5)(C)Example:A and B, unrelated, are equal partners in the AB general PartnershipA owns 100 shares of X corp stockPartnership is considered to won A’s 100 share of X corp under §318(a)(3)(A), but those shares may not be reattributed to B from the partnership under §318(a)(2)(A)

Problem page 213(1) Wham Corp has 100 shares of CS Outstanding. 25 are owned by G, 20 are owned by GF’s Daughter (Mother), 15 shares are owned by Mother’s Daughter, 10 Shares are owned by Mother’s adopted Son, and remaining 30 shares are owned by Gma’s estate of which mother is 50% beneficiary. Mother also has the option to purchase 5 of son’s shares. I: How much Wham stock to Grandfather, Mother’s daughter, and Grandma estate own after application of S318Analysis: Grandfather: Owns own shares 25 Mothers 20 Grand daughter 15 Grand son 10 Mothers beneficiary shares – (owns 50%) thus 15 Total 85 shares

Mothers daughter Own share 15 Mother 20 Mothers share of gm estate 15 Mothers option to purchase son shares 5 Total = 55

GM estate Own share 30 Attribution from mother (bc beneficiary) 20 + GF (25) + 15 + 10 = Total 100 = all the shares.

Mothers (2) All of the 100 Shares of X corp. are owned by a partnership, in which A,B,C,D are equal partners . W, A’s wife, owns all of the 100 shares of Y corp.(a) How many share, of X corp. are owned by A, W and M (W’s Mom)

A ownsOwn shares 25 (100 shares * .25)W ownsHer husbands shares 25 sharesM ownsNothing

(b) How many shares if any of X are owned by Y? Would Y constructively own any shares of X if W owned only 10% of YY ownsFlow from A to wife to Y. = 25 shares. If W owned 10%Flows from A to wife. But bc not 50% or more there is no flow to Y. = 0(c) How many shares, if any, of Y are owned by B,C,D, and X?Partnership =Wife owns 100 sharesA constructively owns 100 through family.All of those are attributed to PartnershipBCDWife owns 100A constructively owns 100Then go to PartnershipBut bc of anti sidewise – those don’t get attributed to BCDXWife owns 100A owns 100 constructivelyP owns bc a partnerThen it is attributed to X bc P is a beneficial owner of X. = 100.

C. Redemptions Tested at the SH levelRedemption in §302(b)(1)-(4) is treated as an exchange §302(a).Otherwise §301 applies (§302(d)) and it is a distribution - follows dividend rules(1) Substantially Disproportionate Redemptions§302(b)(2)§1.302-3

(1) Substantially Disproportionate RedemptionsA redemption that is described in §302(b)(1)-(4) is treated as an exchange. §302(a).Otherwise §301 applies and it is a distribution §302(d)

(a) Requirements for Exchange treatment§302(b)(2)- A distribution in redemption is treated as an exchange if it is “substantially disproportionate” with respect to the SH. There are Three requirements for substantially disproportionate:

(1) Immediately after the redemption, SH must own less than 50% of the total combined voting power of all classes of stock entitled to vote(2) Percentage of Voting Stock owned by the SH immediately after the redemption must be less than 80% of percentage of voting stock owned by that SH immediately before the redemptionNeed to do 80% of voting percentage before Ex: 60% x 80%(3) Percentage of C.S. owned by the SH immediate after the redemption must be less than 80% of the percentage of C.S owned immediately before the redemption. F there is more than one class of C.S. O/S, this test is applied in the aggregate by reference to FMV. Rev Rule 87-88.Example:A owns 60 out of the 100 shares of X Corp. (60%)X redeems 20 of A’s shares so that after redemption A owns 40 out of 80 shares still o/s (50%)Redemption is not substantially disproportionate b.c:A does not owe less than 50% of X’s voting powerThis focuses on a significant reduction of voting power. So if no voting shares are NOT redeemed , the redemption cannot qualify as a substantially disproportionate redemption

(b) Series of Redemptions:A redemption is not substantially disproportionate if it is made pursuant to a plan which has the purpose or effect of a series of redemption, that taken together, result in distributions that are not substantially disproportionate.§032(b)(2)(D) A plan exists if a series of redemptions are “casually related” even if they are not part of a joint plan or arrangements. RevRuling 85-14 – does not have to have an explicit agreement.

Problem page 217Y corp. has 100 shares of CS and 200 shares of nonvoting preferred stock o/s.A owns 80 shares of Y CS and 100 shares of PS. Cathy owns remaining 20 shares of Y CS and 100 shares of Y PS.A and C are not related. Does redemption satisfy the §302(b)(2) requirements?(a) 1/15, Y corp., redeems 75 of A’s PSThis does not qualify b/c it is not voting power. So dividend treatment under 301 would apply. (b) Y also redeems 60 shares of A’ CSAlice owns 80 shares so her percentage is 80%.Her new percentage is 20 shares are remaining so this is 20/40. So here this is 50%SO remember, you need to subtract from the total shares. So now the first step doesn’t work because it is NOT less than 50%.(c) Y also redeems 70 shares of A’ CSY now has 10/30, or 33 1/3%

First step is made because <50%<64%, (3) Now she owes 33 1/3 %, and this is exchange treatment. (d) What difference would it make in (c) above if on 12/1 of the same year, Y redeems 10 shares of C’s CS?Y redeems 10 shares of C’s CS A started with 80% voting power. 80/100A reduced by 70 and C reduced by 10 thus-20% and now it would be 10/20, so A has 50% voting power.(1) Need to see if there is a plan if we take into consideration Kathy’s redemption, this would not apply under the first prong! Alice would not reduce less than 50%(2) Was there a plan to defeat the requirements of §302(b)(2) What if Alice knew that Kathy would have 10 shares redeemed, and in anticipation she would be related b/c if one SH schedules a redemption to temporarily satisfy 302(b)(2) but with knowledge that voting interest would increase, that is a plan and thus, redemption would not satisfy 302(b)(2)(d).If she knew it would be temporary, this is a plan and thus this would be a dividend. Alice has <50% and it wouldn’t qualify.

(2) Z Corp has 100 shares of voting CS and 200 shares of nonvoting CS. Every share of ZCS has a FMV of 100. D owns 60 shares of Z voting CS, and 100 of Nonvoting CS..J owns all the remaining stock of Z40 Voting, and 100 Non voting. D and J are not related. If Z redeems 30 of Don’s voting CS (now Don will have 30)¸will redemption qualify under §302(b)(2) for exchange treatment?D- 60 Voting and 100 Nonvoting (60%)J- 40 Voting and 100 Non VotingCommon Stock- 100 and 200 Non VotingD- Before 60% or 48% or less or step (2)D- After 30/7042.9%Step 1 <50%Step 2 <48%Step 3 Common Stock FMV is 100 per shareCS Before 300 x 10030kDon owned 160 x10016k which is 16/3053.3 * .842 2/3 %Don After 130x10013k and CS after is 270 x 100k27k which is 48.1%This is not less than 42.3% so this step fails to qualify.

(2) Complete Termination of SH interest

In GeneralA redemption that completely terminates a SH actual and constructive interest in the corporation will be treated as an exchange under §302(b)(3).If a corp. distributes its debt obligations in exchange for the redeemed stock the SH may recover the stock if Corp defaults, and IRS may contend that SH has not terminated their equity interest.

(a) Waiver of Family Attribution§302(c)(2) A redemption that completely terminates a SH actual interest in a corporation will be treated as an exchange even if the SH (called the distributee in §302(c) constructively owns stock of a family member under §318(a)(1) provided following requirements for waiver of family attribution in §302(c)(2) are met(1) All Interests are Terminated§302(c)(2)(A)(i)Distributee may have no interest in the corporation as a SH, officer, director or employee, immediately after the distribution. Case: Lynch v. Commissioner:Parents wanted to turn co over to son. Corp sold 50 shares to son (16k was a gift)Corp redeemed stock in form of prop and a noteSon needed help .. father was kept as a consultant.9th Circuit Ct held that a TP who performs post-redemption services for the corp. as an independent contractor retains a prohibited interest.Father was only engaged for limited purpose and he did not have a financial interest in the corporation.Two Prong Analysis by tax court 1. Whether there is a significant financial stake or2. Did he retain control of the companyTax court held that F did not have a continuing interest in the corp., and no financial stake (500/month fee) thus waiver was satisfied.9th circuit/holdingCongress wanted to establish a bright line test. - see above.Hypo: What if you perform tax services, does this have an interest (under Lynch yes)Hypo: Father owns a filling station and trucks stop and get their tanks filled. Is this a continuing interest in the corporation so that it disqualifies a waiver of family attribution rules. Jensen says no, he thinks 9th circuit approach is not good. Employee vs. Independent K Employer has right to determine rights of employee and not the independent K. Independent K performs limited functions for the partnership.§1.302-4(d) the retention or acquisition of an interest as a creditor is permitted. A person is considered to be a creditor only if her rights are not greater or broader in scope than necessary for enforcement of the claim. (2) Ten-Year-Look Forward RuleThe distributee may not acquire any of the forbidden interests (other than stock acquired by bequest or inheritance) during the 10 year period beg. The date of the distribution in redemption. §302(c)(2)(A)(ii).§.1302-4(e) Distributee who remains a creditor of the corporation after a redemption is not considered as acquiring a prohibited interest by acquiring corporate assets to enforce her rights as a creditor, but an acquisition of stock is prohibited. (3),Procedural Requirement§302(c)(2)(A)(iii)- Distrubutee must attach a statement to her income tax return for the year of the redemption reciting that she has not acquired any prohibited interest since the distribution and agreeing to notify the service of any such acquisition w/in 30 days after it occurs during the 10 year-look forward period and to extend the SOL for assessing and collecting a tax with respect to the distribution on year after the notice

§1.302-4(a)(2)- IRS may grant extensions for filing the agreement if TP shows “reasonable cause” for a late filing. (4) Ten Year Look Back RuleEXCEPTION(1) Distributee must not have acquired any portion of the redeemed stock w/in the 10 year period preceding the distribution from a person who stock is attributable to the distrbutee under the family attribution rule in §318(a)(1)(2) At time of distribution, no person may own stock which is attributable to the distrbutee under the family attribution rules if that related family member acquired any stock in the corporation from the distribute within the 10-year-look-back period.DOES NOT APPLY IF:§302(c)(2)(B)- Acquisition or disposition by the distribute during the 10 year look back period was not principally motivated by a tax avoidance purpose. §1.302-4(g)- A gift of stock is not principally motivated by tax avoidance merely because the donees is in a lower income tax bracket. Example:Parent and child own 50 of the 100 o/s shares of X Corp. Parent, who wishes to retire and shift control of X to child, makes a gift of 20 shares to child and X corp. redeems parent’s other 30 shares, leaving child as the sole SH.Parent retains no other interest in X Corp.Here: Tax avoidance was not one of the principal purposes of the transfer to child, and the 10 year look back rule will not prevent the redemption form qualifying for waiver of family attribution under §302(c)Rev Rule 77-293.Page 235 Corp owned by J, daughter, and son. John owns 100, daughter 50 son 25A) before owns 100% after owns 100% redeems 50 shares. Would qualify as an exchange if waived the family attribution rules. B) if didn’t file agreement not to notify IRS – then not eligble for exchange treatmentC) what if shares contignent on R’s future profits ? this is some financial interest – regs say specifically that this is a prohibited interest (§1.302-4(d))D) R redeems 20 of alisons shares in year one; and remaining 30 shares on year two. Here could argue that this was part of a single transaction. – substance over form. Test - yr 2 redemption would have to be fixed and determined at the time of the initial transaction. E) randall remains a director – this is a prohibited interest F) R forms a subsidiary and Alison becomes an employee of the sub. – this is a prohibited interest (§1.302-4(c))G) son dies and leaves Alison shares. – here she regains interest within 10 years – this is allowed. (gain by bequest or inheritence)

B&B . created by betty and billy. Still own 120 shares

A) is it an exchange? Son received interest prior to redemption this would not qualify. But this is as valid business purpose. See 77-293

The note paid to parents for redemption lasts 20 year period. - a long term note – is more like equity – is more risky. However, Cts have allowed debt instruments to qualify. Agreement to restrict dividends and such other – Code says – can continue as a creditor – is it unusual to put a restriction No creditors often do this. The lease? Redeemed SH can enter into an arms length lease with co.

B) B creates a consulting firm. And wants to consult for B&B – lynch says no. there is no Ind Contracter relationship permitted. Tax ct; would use test; 1. Whether there is a significant financial stake or 2. Did he retain control of the company

3. Cinelab 100 shares outstanding. J owns 50 sister owns 30 estate of father owns 20. Sams widow is beneificiary (a) cinelab redeems estates 20 shares . – bella owns J and M shares and estate owns all shares. Before = actually own 20% const 80% After = actual non- const 100% - so there is a problem – a complete redemption can be waived where family attribution rule applied. See waiver by entity below. Estate must agree to have no interest in co. bc of 302©2© bella must also agree to all 3 provisions. (b) J and M have specific legatees and B has residuary Here bc J and M have attribution through beneficial ownership. The estate can only waive family attribution and not beneficial owner© J and M are residuary beneficiaries – here to solve the problem would typically pay J and M their interest but.. they are residuary benes and thus cant pay off. (d)20 shares owned by a trust providing income to bella and remainder to nancy. The trust can waive the attribution through family attribution. Nancy is a sibling and there is no family attribution concerns between siblings.

(b) Waiver of Family Attribution by Entities§302(c)(2)(C)- permits an entity to waive the family attribution rules. A waiver may be useful when a redemption terminates and entity’s actual ownership but the entity still owns stock that is attributed from one family member to another “related person” and is then reattributed to the entity.Only applies to waive family attribution under §318(a)(1)DOES NOT WAIVE direct beneficiary or owner under §318(a)(3)

(1) Entity defined§302(c)(2)(C)(ii)(I) partnership, estate, trust or corporation.

(2) Related Person Defined

A related person is any person to who ownership of stock in the corporation is (at the time of the distribution) attributable under the family attribution rules if the stock is further attributable to the entity. §302(c)(2)(C)(ii)(II)Ex 1: A and Estate each own 50 of the 100 outstanding shares of X corp. The sole beneficiary of Estate is A’s son, S. A’s shares are attributed to S under §318(a)(1) and are further attributable from S to Estate under §318(a)(3)S is a related person. If S actually owned 50 shares, he would not be a related person.

(3) Conditions for Entity WaiverAn entity may waive family attribution if (1) entity and each related person meet the usual requirement for waiver under §302(c) and (2) each related person agrees to be jointly and severally liable for any tax deficiency that may result if an interest is acquired in the 10 year look forward period. §302(c)(2)(C)(i).Example 2:Assume in Ex above that X corp., redeems Estate’s 50 shares. Estate has terminated its actual ownership in X but continues to own 50 shares from A through beneficiary S.Assuming no 10 year look back rule problems, Estate can waive family attribution and break the chain from A to S if Estate and S jointly agree not to acquire a prohibited interest for 10 ear and agree to notify IRS if an interest is so acquiredS also must agree to be jointly and severally liable for any tax deficiency If S actually owned 50 shares of X, S’s shares would be directly attributed to the Estate, and entity waiver rules would not allow Estate to terminate its interest under §302(b)(3).

(3) Redemption NOT essentially Equivalent to A dividend(a) The meaningful Reduction Standard If a redemption does not satisfy one of the specific §302 safe harbors, it still is treated as an exchange under §302(b)(1) if it is not “essentially equivalent to a dividend”US v. Davis:Redemption is not essentially equivalent to a dividend if it results in a “meaningful” reduction of the SH proportionate interest in the corporation.§1.302-2(b)- Dividend equivalence “depends upon the facts and circumstances of each case”§318 attribution rules fully apply, and a business purpose or lack of tax avoidance motive is irrelevant. See Role of § 302 (b) (1) After DavisExample:On the formation in Y1, X corp. issues 25 shares of common stock each to Father, Mother and their two children.In Year 3, for a valid business purposes, Father contributes 25k to X corp. in exchange for 100 shares of nonvoting preferred stock.In Year 5, X distributes 25k to Father in redemption of all his preferred stock.

Under the attribution rules, Father is considered to be a 100% SH before and after the redemption.The redemption of the P.S. is essentially equivalent to a dividend.

(b) Meaningful Reductions- Ex:IRS considers the three most significant SH rights to determine whether a reduction is meaningful: Rev Rule 81-289(1) Voting(2) Participation in current earning and corporate growth(3) Sharing in net assets on liquidationRev. Rule 85-106- If the redeemed SH has a voting interest, a reduction in voting power is a key factor, together w/ a potential to participate in a control group with other SH.(1) Partial Redemption of Nonvoting P.SIf a corp. redeems ½ of the nonvoting P.S of a SH who owns no other class of stock, the distribution ordinarily is not essential equal to a dividend §1.302-2(a)(2) Significant Loss of ControlRev Rule 75-502- A reduction of voting rights from 57% to 50% (with corresponding reductions in rights to earning and net assets on liquidation) has been ruled to be “meaningful” where the remaining shares are held by one unrelated SH. (3) Loss of Control in Concert with OthersA reduction of common stock ownership from 27% to 22% is meaningful where the remaining shares are owned by three unrelated SH b/c the redeemed SH lost the power to control the corp. in concert with one other SH. Rev Rule 76-364(4) Reduction of Ownership by Isolated Minority SHRev Rule 75-512- A reduction of C.S by a minority shareholder from 30% to 24.3% is meaningful.Even a very minimal reduction of a SH interest is meaningful if the SH exercises no control- ex: minims reduction resulting from a tender offer by a publicly traded corp.A pro-rata redemption of stock by a public company is not a meaningful reduction even if the SH has a small minority interest. Rev rule 81-289.

(5) Family DiscordHaft- Evidence of family discord may negate the presumption of the family attribution rules for purposes of §302(b)(1).IRS and other courts disagree, but Tax courts says family discord may be a relevant facts and circumstance test after family attribution rules have been applied

Problem page 247

(1)Z corp has 100 shares of C/S o/s owned by A (28 shares) B (25 shares), C (23) and D(24).Unless o/w indicated, assume no relation. Determine whether the redemption is not essentially equivalent to a dividend?(a) Z redeems 7 shares from A – A yes there is a meaningful control change – before he could ask only one person to form a majority. Now he has to ask two to form a majority. Make sure to consider majority by the reduced

(b) X redeem 5 shares from A and A and D are mom and daughter. Before comblinec control of 52% now 49.47% - this is a meaningful reduction(c) Z redeems 5 from A and A and B are mom and daughter A and B together still have a majority and not meaningful (d)Same as (c) except that A has not spoken to B since B married “o/s faith” . there are approaches. ... IRS does not care about family disputes. Other cases say.. if there is a slight reduction in interest then can consider all facts and circumstances.

(2) Y corp. has 100 shares of C/S and 100 shares of nonvoting preferred o/s stock. The p/s is not convertible into Y C/S and is not §306 stock. The Y common and P/s are owned by the following unrelated SHSHCommon SharesPreferred SharesA400B2055C2510D1515E020a) Y redeems 5 preferred shares from E this is redemption not equivalent to a dividend – no meaning ful control changeb) Y redeems all of its outstaning preferred stock. For E its an exchange. For the other sh’s – if sh can control corp with help of small number of other sh’s then IRS only focuses on power to control. Here bcd can control the corp by colluding with a – here it would not qualify as an exchange. (3) Indv. Owns 10 shares of CS with AB of 15k. 5 shares are redeemed in a transaction that is a dividend. What if 10 are redeemed which is properly classified as a dividend because §302(c)(2) waiver of family attribution is not available? A receives a dividend. Here the basis transferes from the 5 shares redeemed to the 5 shares that remain. Bc it is a dividend and will be paying tax on it as ordinary income. What if all ten shares are redeemed (thus no shares left) . it is still taxed as a dividend bc he was unable to waive the family attribution rules. The Basis passes to the shares that he is deemed to own by construction.

(4) Partial Liquidations

Occurs when a corp., significantly contracts its business and makes related distribution (of assets or their sale or insurance proceeds) to its SH in redemption of all or part of their stock.When distributions in redemption results from such a “corporate contraction” the transaction is more like a sale than a dividend.§302(b)(4)- exchange treatment for distributions in redemption of stocked held by noncorporate SH if the transaction is a “partial liquidation under 302(e) of the distributing corporation§302(b)(4) looks on the nature of the assets distributed and the corp’s reason for making the distribution. (other tests look to the effect of a redemption on the distribute SH)

(a) NONCORPORATE SH’s qualify§302(b)(4)- only noncorporate SH qualify for partial liquidation treatment.S Corps are treated as individuals for this purpose and qualify

§302(e)(5)- Stock held by a partnership, estate or trust is treated as if held proportionally by its partners or beneficiaries.

(b) Partial Liquidation Defined §302(e)(1)(1) Not essentially equivalent to a dividend ( definition not in the statutes)Determine at corporate level rather than a SH levelSatisfy the (a) corporate contraction doctrine – or (b) “termination of Business Safe Harbor”(2) distribution is pursuant to a “plan” (a simple corporate resolution wil suffice)(3) Distribution occurs w/in the taxable year in which the plan is adopted or the succeeding taxable year

Corporate Contraction Doctrine (amorphous and cannot be relied upon w/ assurance for planning)A distribution in partial liquidation is not essentially equivalent to a dividend if it result from a (permenant) contraction of the corporation’s business such as:(1) Involuntary EventsAfter a fire damages a manufacturer’s factory, co., distributes the insurance proceeds and contracts its business operations. Imler v. Comm’r and reg 1.346-1(2) Change in Nature of BusinessA corporation distributes working capital that is no longer needed b/c of a change in the scale of its operations(3) reserve for ExpansionA corporation no longer needs funds that had been accumulated for expansion/ Reg 1.346-1

Termination of Business Safe Harbor(1) Attributable to the termination of a “qualified trade or business” and(2) Corp continues to be engage in the conduct of another qualified trade or business §302(e)(2)(a) Qualified trade or Business§302(e)(3)Any trade or business conduct t/o the five year period ending on the date of the distribution and was not acquired (by the distributing corporation) in a taxable transaction during that five year period. §302(e)(3). Raw land held for investment or a securities portfolio is not an active trade or business §1.355-3(b)(2)(iv), which applies to similar active trade or business under 355.Ex: Corp acquires an active trade or business in a non-taxable acquisition/re-org., and in this situation so long the business is done by someone for five years, the distribution will satisfy

(b) Distribution of Assets or Proceeds of SaleThe terminated business must be operated directly by the distributing corporationMust be o assets of that business or the proceeds of sale of those assets

Sub stock or proceeds of sale of such stock NOT PARTIAL Rev Rule 79-184May qualify as a tax-free corporate reorganization under 355MergerStock for stockAlso c, d, types(c) Pro Rata RedemptionsUnder business safe harbor, no regard to whether the redemption is pro rata to the SH §302(e)(4)

(f) No Surrender of Stock RequiredActual surrender of shares is not required if it would be a “meaningless gesture” such as on a pro rata distribution.Each SH is deemed to have surrendered shares w/ the value equal to the amount of the distribution, and an appropriate portion of the SH stock basis is allocated to the shares deemed surrendered. Rev Rule 90-13Example:A, B and C each own 100 shares of X Corp., w/ a basis of 15k and a value of 100k. X corp. distributes 50k pro rata to each SH in transaction that qualifies as a partial liquidation but SH do not surrender any stock. Each SH is deemed to have surrendered 50 shares of X stock with a basis of 6k (.40*15) in exchange for the 40k distribution, so AR is 40 and AB is 6- so gain is 34k LTCG

Problem Page 253

A corp operates a book and cram division. A’s single class of c/s O/S are owned in equal shares by M, P (M’s wife) and I Corp. Neither M nor P own any stock in Iris. A also owns all of the stock of Beta Corp, a separately incorp., company which is engaged in the beta processing business, and it directly owns a diversified portfolio of securities(a) A has operated B and C for more than five years and it distrubtes the assets of Books to its 3 equal SH in redemption of 50 shares from each SH. Does result matter if there is no actual redemption of shares - can qualify or exchange treatment under the safe harbor provision under e2 a and b met. Does not apply to the corporation bc they cant qualify for exchange treatment here – here it is a distribution under 301. (b) A purchased Books three years ago for cash, if so why does that matter? What if A acquired books 3 years ago in a tax free re-org?bc it was purchased within 5 year period with cash (someone recognized gain or loss) if it acquired in a tax free organization – will get exchange treatment under the safe harbor as long as it operated for 5 years prior. (c) All assets of books were destroyed by fire and A distributes ½ of the insurance proceeds equally to its 3 SH in redemption of an appropriate number of shares of stock and retains the remaining proceeds to carry on its book publishing business on a somewhat smaller scale

won’t qualify under the safe harbor. (not distributing all the assets i.e. the insurance)Might qualify under imler if it is a permanent reduction of the business. (d) Same as (a) except A distributes assets of Books to Michael in redemption of all stockcan qualify as an exchange under the safe harbor. (e) Same as (a) except A distributes the assets of Books to Iris for all of A’s stocksdoes not qualify as a partial liquidation bc it was a corpmay qualify as a complete termination of interest. – and get exchange treatment(f) A distributes the securities portfolio to its 3 equal SH in redemption of 20 shares from each SH(g) A sells all of its Beta stock and distributes the proceed pro rata to SH in redemption of 20 shares from eachnot a partial liquidation – selling a subsidiary does not qualify under the safe harbor – beta is an investment and thus is not a qualified business and not ceasing to conduct a business. (h) Same as 9(g), except that A liquidates B and then distributes the assets of B’s business which has been operated more than 5 years. Will qualify under the safe harbor

D. Specific Tax Consequences of Redemptions

(1) Consequences to SH

(a) Exchange:If redemption is treated as an exchange, the distributee SH computes gain or loss as if the redeemed stock had been sold to an o/s.In case of losses- §267(a)(1)- disallows a deduction if the redeemed SH owns (directly/indirectly) more than 50% of the corp. stock.

(b) 301 DistrbutionDividends to extent of distributing corp’s E&P and reduction of Basis and capital gain to the extent of the balance of the distbrution

(c) Basis of Distributed Property§301 FMV on date of distribution. §301(d)Exchange FMV@

(d) Corp. SH§243 dividends received deduction

Effect of Redemption on E& P handout-See/attach

(2) Consequences to Distributing Corporation

(a) Recognition of Gain or Loss§311(a), (b)- Distribution corporation recognizes gain on a distribution of appreciated property in redemption of stock, but it may not recognize loss on the distribution of property that has declined in value. Does not matter if it is exchange or distribution to SH

(b) Effect on E&P

(1) Distribution of Appreciated PropertyDistributing corporation increases its current E&P by the gain recognized on distribution of appreciated property §312(b)If the basis for property for E&P purposes is different from its basis for taxable income purposes, the increase is the E&P gain, not the taxable gain.

(2) Reemption Treated as §301 DistrbutionIf redemption is treated as §301 distribution, the effect on E&P is the same as any ord., distribution.§312(a), (b)- Accumulated E&P are reduced by the amount of money, the FMV of any appreciated property distributed, the E&P AB of any loss property distributed and the principal amount of debt obligatons.

(3) Redemption Treated as ExchangeE&P are reduced in an amt., that may not exceed the ratable share of accumulate E&P attributable to the redeemed stock. §312(n)(7) (cant be reduced more than amount in dollars = percentage of the shares redeemed)E&P amount cannot exceed the distributionIf Corp has only one class of stock o/s, the E&P attributable to the redeemed stock are determined by multiplyingEx: X corp. has 1k shares of C.S. O/S (its only class), owned equally by A and B. X has 160k of accumulated E&P and no current E&P. X gives 100k in redemption of A’s 500 shares. Since the redeemed stock is 50% of the total number of shares (1k), X may reduce E&P by 80k (160 *.5). reason is the E&P is 160k, if E&P was 240, then can do the entire amount of the distribution.

Problem page 260X corp has 200 shares of C.S o/s. A and B each acquired 100 shares of X upon their issuance at a price of 1k per share, and they each have an AB of 100k in their X stock. Beg of Year- X has 100k of Accum. E&P abd ut gas 50k of E&P in the current yearI- tax consequences to X of the following alternative redemptions of A’s stock, assuming in each case that the redemption qualifies for exchange under §302(a)?(a) In redemption of A’s 100 shares, X distributes land(250k FMV, 200 AB) held as an investment(b) Same as (a) above, except X’s AB in the land is 300kYou would need to know the date of redemption. Adj acuum E and P from beging of year to date of redemption. Pro rate 100k for current year. Begin with 100k on 1/1 1/1 – 6/30 = 50k150k *.5 = 75k

(c) Stock Reacquisition ExpensesA corp may not currently deduct any expenses paid in connection w/ the reacquisition (including redemption) of its own stock ... ie greenmailThey are nondeductible, nonamortizable capital expenditure §162(k)(1)Disallowance deduction rule does not apply to the allocable costs of borrowing to finance a stock redemptionBorrowing costs may be amortized over the term of indebtedness §162(k)(2)(ii)Rationale: borrowing is separate from redemptionOther corporate payments such as payments to employees, etc., done with reacquisition rule are not subject to disallowance under §162(k).

Redemptions and Related Transactions

(1) BootstrappingZenz v. Quinlivan

If a redemption and sale are part of an integrated transaction to dispose of a SH entire interest in the corporation, the redemption will qualify as a complete termination under §302(b)(3) whether it occurs before or after the sale. SH use this to remove liquid assets from a corp and sell the remaining stock at a reduced price known as a bootstrapRev Rule 75-447A sale and redemption also may be combined to qualify the redemption as “substantially disproportionate” under §302(b)(2). Ex 1:A owns 100 o/s shares of X. The value of X is 100k including 20k in cash a nd 80k operating assetsX has 50k of E&_. B wishes to by X for 80k.X first distributes 20k to A in redemption of 20 shares. A sells remaining 80 for 80k to B.If the redemption and sale are part of an integrated plan, A is considered to have completely terminated interest in X and exchange under §302(b)(3)Ex 2:A and B are unrelated and each own 50 of X’s 100 o/s sharesC also unrelated wants to come in business, X issues 25 c/s to C and pursuant to the same plan redeems 25 shares of its stock from A and B. So now 25 each out of 75 ps/A and B’s interests are reduced from 50% to 33.5 and thus, this a substantially disproportionate under §302(b)(2)

(2) Redemptions pursuant to Buy-Sell Agreements

(a) Buy-Sell AgreementClosely-held corp., use buy-sell stock purchase agreements to provide for a continuity of business, to satisfy economic and tax goals when a SH dies or retires and to resolve SH disputes.Cross-purchaseDeparting SH or his estate sells the stock to the continuing SHEntity purchaseCorp., redeems the departing SH stockBuy/sell can be mandatory or optionalTypically, include other restrictions on the transfer of shares and provisions to determine the value of any stock purchased pursuant to the agreement.

(b) Constructive-DividendProblems arise when a continuing SH is personally and unconditionally obligated to purchase stock pursuant to a buy/sell agreement and that obligation is assumed by the corporation. SullivanA mere assignment to the corp of an option to purchase stock from another SH is not a constructive dividend, Holsey. Ex 1:

A and B, who are unrelated, own all 100 shares of XA and B agree upon the death of either SH, the survivor will be unconditionally obligated to purchase decedent’s X stock from his stateB dies, A causes the corp to assume his obligation and redeem the stock from B.Redemption is a constructive distributon to A Rev Rule 69-608Ex 2:Same as (1) but agreement provides that upon the death of either SH, X corp., has an option to purchase the decedent’s stock.If X chooses not to exercise the option, Survivng SH is obligated to purchase any redeemed shares.If B dies and X redeems all of B’s stock, the redemption is not constructive toA, because A was not primarily obligated to buy the stock. Rev Rule 69-608Ex 3:Now, agreement says either SH has an option to purchase stock of other b/c of certain events but is free to assign the options ot others.At B’s retirement, A ssigns his option to X corp., which redeems all of B’s stocks.Redemption is not constructive to A b/c A had no unconditional obligation to buy the stock Rev Rule 69-608Problem

Page 283 Problems:

(4) Charitable Contribution Followed by redemptionA SH of a closely held corp., may indirectly w/d earnings but avoide dividend treatement by contributing stock to charity and causing the corp., to redeem the stock from the charitable doness.Rule- A contribution of stock followed by a redemption shall be treated as a dividend to the donor only if the charitable doness is legally bound or can be compelled by the corp to surrender the shares for redemption. Rev Rule 78-197.

Redemption Through Related Corporations

Introduction

Policy§304 prevents a SH from selling stock of one corp to another related corp in order to w/d (bail out) earnings while treating the transaction as a sale rather than a dividend.§304 applies when one or more controlling SH sell stock of one corp., to another controlled corp (“brother-sister acquisition) or when any SH of a parent corp sells stock of the parent to a sub (parent-sub)§304 looks for dividend equivalency by applying §302 to determine if SH has sufficiently reduced his interest in the corp., whose stock has been transferredExampleA owns all stock of X and Y, each who have a lot of E&P.

If either corp were to redeem shares held by A, distribution would be a dividend.If A sells or part of her X stock to Y, the effect of the transaction is the same as a dividend b/c A has w/d funds from Y w/o reducing her 100% control of corp

§304 Definitions:

Property§304 applies only to acquisitions of stock in return for “property”“property- money securities, and other property but not stock, in the corporation making the acquisition.

Acquiring CorporationCorp that acquires stock form a SH of another related corp., in return for property

Issuing CorporationCorp whose stock has been transferred. Control(1) Ownership of stock possession at least 50% of the total combined voting power of all classes of stock entitled to vote, or¸ 50% of the total value of shares of all classes of stock §304(c)(1)§318 attribution applies. §304(c)(3)

Mode Analysis

(1) Does §304 applyMore than 50% of value

(2) Does the constructive dividend qualify under §302 as a redemption determine if its aCalculate amount of stock before in corporationCalculate amount of stock in corp (remember to multiply %)

(3) If does not come under §302, then it is §301, 1. and you need to determine amount and source of dividend by looking at (1) Acquiring corps E&P, and then (2) Issuing corp.’s E&P §304(b)(2) 2. and Acquring corp will take the transferors AB in the transferred stock 3. transferor increases his AB in the stock of the acquinring corp by his AB in the transferred stock..

ex. (treated as A transferring the stock to Acquiring co in a 351 trans. Getting stock back. A’s basis is the same as the basis in transferred asset; corps basis is the b transferred basis of the stock)

If the constructive redemption is an exchange:(where the before and after analysis provides or exchange treatment)

then A taxed under 1001 – if a gain its AR – AB = taxable gain = probably capital gain (or loss) Acquiring corp takes the cost basis in the stock acquired.

(2) Brother-Sister Acquisition

Constructive RedemptionIf one or more persons are in “control” of each of 2 corp nad sell stock of 1 corp to the other corp., in retrun for property, property is treated for purpose of §302 and §303 as a distributuion in redemption of the stock of the acquiring corp. §304(a)(1)§304(a)(1)- 2 or more unlreated SH who in the agg. Control each of the 2 corp., sell stock of one corp., to the other in related transaction even if no SH has control§304(a)(1)(B)

Tax Consequences:1) §301 DistributionIf under §301, look at E&P of acquiring corp., then E&P of issuing corp. §304(b)(2)

2) ExchangeSH recognizes a gain or loss measured by the difference b/t the AR and the AB in the transferred stockSH basis in the stock remains unchanged and acquiring corp takes a §1012 cost basis in the issuing corp’s stock §1.304-2(a)E&P reduction I limited by §312(n)(7) to an amount not in excess of redeemd stock’s ratable shares of E&P.Ex 1:Ex 1: A&B (unrelated) own 100 of the 200 shares of X corp and Y corp. respectivelyX has 70K E&P, and Y has 40k E&P.A sells 30 shares of X corp with AB of 10k to Y for 100kDoes this qualify under §304:(1) A owns at least 50% of all classes YES! So §304 applies(2) Before transfer A’s shares in issuing corp (X)- 50%(3) After transfer A’s shares in issuing corp (X)- 70+1585/200- 42.5(4) No change under §302 (need to analyze each, so comes under §301)(5) §301 dividend treatment, so it will be 10k coming out of Y (Acquiring corp.) E&P. (6)

(4) Relationship of §304 to Other Code Sections

(a) §351

§304(b)(3)(A)- §351 will not apply to any property received in a §304(a) distribution, except that §304 will not apply to any debt incurred or assumed in connecton with the acquisition of the transferred stock. §304(b)(3)(B)Ex (1)A owns 80/100 o/s shares of X corp. and Y corpBoth have E&)PThe remaining stock is owend by unrelated SHA sells 20 shares of X (AB-4k, value 15k) to U for 15 shares (15k) and 5k cashTransfer qualifies under §351 for the stock but §304 applies for the cashEx (2):Same as above, except A transfer 20 shares of X to Y for 15 shares and a liability incurred by A when he acquired XA recognizes now gain under §351 and §357, and §304 does not apply to Y’s assumption of liability.

Problem Page 299

(1) The Niedermeyer case is a good example of tax planning blunder. Illustrates the need for §304(a) Why did §304 apply to the sale by the TP of their AT&T common stock to Lents(b) Given that §304 applied, how do you test the redemption to determine if the TP have a dividend(c) Why were the TP unable to waive family attribution and qualify for “sale” treatment under §302(b)(3) – did not have complete termination of their interest. (d) How could they have avoided this unfortunate result - if they had donated the preferred shares before the transaction they could have waived the family attribtion rules and thus would not have cnstructively owned AT and T

TP argued that it was a dividend not equivalent to - saying there was family animosity - ct said should never consider family animosity - txct says that if there is any reduction in ownership then can considerTP argued that the PS was actually debt – this argument fails

TP can only integrate two tax transactions where there was a fixed and firm intent to complete the second transaction,

(2) - P. 299 Bail corp. and Out corp each have 100 share of Common stock O/S. Claude owns 80 share of Bail stock (AB of 40k or 500 per share) nad 60 shares of Out stock (AB of 9k or 150/share)Remaining B&O shares are owned by 1 individual who is not related to ClaudBail hs no current or Accumulated E&P.Out has no current and 5k of accumulated E&P

(a) Claude sells 20 of his out shares, in which he has 3k AB, to Bail for 4k – 304 governs because claude owns 50% of the control of each. - therefore it is a constructive redemption is it a 301 or is it an exchangedo a before or after analysis before – 60% before after – Actual 40 + constructive 16% (80% of 20%) = 56% ( does nt satisfy substantial (not less than 50%) not dividend equal and went from 60% to 56% thus its not an exchange4k dividend results = Accumulated E & P is reduced from 5k to 1k Claudes basis is increased by 3k in bail. And bails basis is 3k in the transferred shares.

(b) C sells all out to B for 12k – 304 applies as aboveit’s a constructive redemption – is it exchange treatmentdo a before after analysisBefore (A) 60% after (A) )0 and (C) is 48% Not a substantially disproportionate 80% of 60% = 48% > 46% and thus not disproportinateNot a complete terminationRedemption not essentially a dividend – yes – he had control and now it’s a minority. This it’s a meaningful reduction. – exchange treatment. Bails basis in 60 shares is 12k. Claudes is taxed under 1001 AR = 12k AB = 9k = gain of 3k =its cap gain and held for longer than one year its cap gain.

(c) Same as (a), except that C receives 3k and 1 share of Bail (FMV of 1k) for his 20 of out shares this would qualify under 351 and 304 – in these circumstances 304 governstransfer of prop in addition of stockreceive in exchange stock (d) same as (a) except that Clreceives one share and 3k in liability. 304 still governs. 304b3b situation not governed by 304 if liability incurred to acquire the stock. (see page 291-292)

immediately after must control (ie 80%) - tax consequences - got boot - tax the lesser of the realized gain (AR 4k – AB 3k = 1k) or the boot ( 3k) thus taxed on 1k its also capital gain. However – t304 says the boot requires treatment as dividend. (2) §304 still necessary

Chapter 6: Stock Dividends and §306 Stock

(1)Introduction(a) Types of Stock Distributions:Corp makes a stock distribution when it distributes its own stock to some or all of its SHStock distributions include:

Stock dividends and Stock splitsStock dividend may differ from a stock splitStock Split- increasing number of o/s shares of the same classStock Dividend- smaller and may be of another class of stock (ex- preferred)

(b)History of Taxation of Stock DistributionsEisner v. Macomber;Common on common stk dividend was not taxable b/c not gross income under 16th AmendmentCommon on preferred stock dividend was taxable b/c the SH received an interest different from her former stock holdings. Koshland v. HleveringTest Stock dividend is only table only if it increased a SH proportionate interest in the corporation.Strossberger v. commissioner – dividend of PS does not create ataxable event – see 305§305 is new rulePolicy of §305Stock dividend is not taxable if it does not increase a SH proportionate ownership interest in the corporation.If it does increase the interest or SH gets cash or property and other increase their proportionate interest, then taxable

(2) Nontaxable Stock Distributions(a) General Rule§305- stock distributions are not includible in GI unless an exception in §305(b) appliesEx of non-taxable dividends are “common on common and preferred on common” where no other classes of stock are o/s

(b) Allocation of Basis“new stock” is not taxable, the SH basis in the stock held prior to the distribution “old stock” is allocated b/t the old and new in proportion to the relative FMV of each on the date of the distribution. §307(a)Ex 1 A owns 100 of X c/s worth 12k or 120/share2 for 1 split gets another 100 CS sharesNot taxable, and A allocates his 12k basis b/t old and new shares, 12k/200 so $60/share basisEx 2A owns 100 shares of X, with basis of 12k (120/share)2 for 1 split A gets 25 shares with 25k (100/share)Value of A’s common stock after distribution is 75kA allocated 12k basis in the common b’/t common and preferred based on FMV. (75% common and 25% preferred)

(c) Holding Period of New Stock

Holding period of the old stock. §1223(5) ie you can tack.

(d) Consequences to Distributing CorporationDistributing corp., recognizes no gain or loss on nontaxable stock distribution (§311(a)(1)) and may not reduce E&P §312(d)(1)(B) ie no effect on e & p

(3) Taxable Stock DistributionsStock distributions in §305(b) are treated as distributions to which §301 applies and thus are dividends to the extent of the distributing corp. available E&P if it exceeds it reduces the basis of the stock once reduced to zero then it is capital gainAmount of the distribution is the FMV of the distributed stock. §1.305-1(b)(1)

(a) Election of Stock or Property§305(b)(1) If distribution , at ANY sh election is payable either in (1) stock of the dis. Corp, or (2) ccash or other property, the distribution is taxable to all SH regardless of wehter any SH exercises the election. SH who participate in stock reinvestment plans by acquiring stock in lieu of cash dividends are taxable under §305(b)(1) on the FMV of the stock received. Rev Rule 78-375ExX only has common stock o/s.X declares a cash dividend of 10/share or SH may elect to receive add’l C.S with a value of 10/share heldSH who elect to receive stock are treated as a §301 distribution of 10/share, even if all SH elect stock. Reg 1.305-2(a)(b) Disproportionate DistributionsIf result is that some SH receive cash or other property, while other increase their proportionate interest in the earnings or assets of the corp., those who increase their proportionate interest are taxed on the value of the increased interest. §305(b)(2)Cash and stock distributions can have a disproportionate effect even if they are not pursuant to a plan and are unrelated.If separated by more than 36 months, the are presumed to be beyond the reach of §305(b)(2) unless they are made pursuant to an integrated pan. Reg 1.305-3(b)(2), (4)Ex:X corp has 2 class of CS o/s.A and B and each class has equal rightX pays a 10/share on A stock dividend and a dividend on class B stock payable in additional shares of B stock with 10/shareTaxable- B SH increase their proportionate interest in earnings and assets of X while the Class A SH receive cash. Reg 1.305-3(e)Ex 2:X has 2 class of stock o/s- Common and PreferredX declares dividend on the Common payable in a add. Common stock and pays a cash dividend on the preferred stock.Cash dividend taxable, but common on common is not b/c does not increase the proportionate. Reg. 1.305-3(e)- Ex 2

Ex 3:Now, C.S dividend is shares of prereed. Now C.S proportionate has increased, dividend is taxable. If it was subordinate to all preferred stock, not taxable b/c no increase in proportionate interests of the common SH.Issuance of junior preferred stock does not give the common SH more than they had before the distribution. §1.305-3(e).

(c) Distributions of Common and Preferred stockIf a distribution has the result of some common SH receiving preferred stock, and other receiving common stock, all are taxable. §305(b)(3)Ex:X has Class A and Class B CSX declares a divdened on Class A stock payable in addl’t shares of Class and a dividend on Class B stock, payable in preferred stock.Both distributions are taxable. Reg. 1.305-4(b). (d) Distributions on preferred stockAll distributions on P.S are taxable except for an increase in the conversion ratio of convertible preferred stock that is made solely to take account of a stock dividend or split. §305(b)(4)Reg. 1.305-5(a)- PS is any stock which does not participate in corp., growth to any significant extent and has limited rights and privileges. Ex 1:X has two class of stock o.s. (1) common and non-convertible preferredX declares a dividend on both common and preferred, in each case payable in additional shares of the common.Distribution is taxable to the preferred but not the common. Ex 2:X has two class of stock o/s. one common and one preferredEach share of preferred is convertible into 2 share of common. X pay a dividend of one share of common stock for each common share held and doubles the conversion ration of preferred.Neither the C.S or doubling of conversion ratio is taxable. (e) Distributions of Convertible Preferred Stock§305(b)(5) A distribution of convertible P.S is taxable unless the P establishes to the satisfaction of the service that it will not have the result of a disproportionate distribution. §305(b)(5)Disproportionate right to convert must be exercised w/in a short period and it is likely that some SH will convert and others will not, taking into account factors such as the dividend rate and market conditionsIf right is exercised over many years, and the extent of conversion cannot be predicted, the corp., probably can establish that the distribution will not have a disproportionate effect. Reg 1.305-6(a)(2).ExX corp. has only 1 c/s o/s

Declares a dividend payable in the new issue of preferred stock convertible into common for a period of 20 years.If corp., can show that it is impossible to predict the extent to which the preferred will be conveterd, distribution is not taxable.If however, the prefreed was over a short period of time, and on the facts, it was likely that some SH would covert while others would sell their stock, the distribution is taxable, b/c it result in the receipt of case by some SH and an increase in the proportionate interest of others. Reg. 1.305-6(b). Ex (1), (2).

(g) Basis and Holding PeriodBasis to a SH who receives a taxable stk dividend is the FMV of the distributed stock. §301(d)Holding period of the stock commences as the date of the distribution. (h) Consequences to the Distribution Corp.,Distributing corp., recognizes no gain or loss on a taxable stock distribution/ §311(a)(1)Corp may reduce its E&P by t he FMV of the distributed stock. Reg 1.312-1(d)

(4) Distributions of Stock Rights(a) Rights DefinedRights are options to purchase shares from an issuing corp., at a fixed priced during a relatively short period of time. (b) Nontaxable RightsTaxed if it has one of the effects described in §305(b).

REDEMPTION AS A CONSTRUCTIVE DIVIDENDIn the case of a redemption – the commissioner has the authority to declare it a constructive cash dividend. – Ex. a owns 80 and b owns 20. A gets cash for 10 shares redeemed. B gets increased percentage of ownership - and thus a disproportionate distrubution – only under 301 and occur under a periodic redemption plan.

What if b gets additional shares to compensate – that’s ok

Problem Page 313 – see problems

Hilll is organized into two classes of stock Frank owns 100 shares of Class A and Fay and Joyce each own 50 shares of class B.

A) Pro rata share of non convertible PS – this is not taxable B) class b have option to take cash in lieu of distribution. – this is taxable 305b1 – this is true for those that elect to take cash and those that don’t and applies to all classes of stock.C) a pro rata distrubition on class a and cash on class b – this is taxable to all due to 305b2

D) class b is nonconvertible PS and Hill distributes class b stock to class A - 305b2 this is taxableE) same as d above hill distributes a class of PS that is Juniour to Class B

beforecurrent E and P = 100dividend ps = 20CS = 80---------------------------------

non taxable – f) assume on one class common outstanding. Issue – 10% debentures –convertible into common stock at 1 Cs:: $1000 debenture. hill makes annual interest payment and one month later distribute common on common stock dividend w/o adjusting the conversion ration of the debentures

the treatment of the convertible debenture is considered stock - 305(d)thus this is a disproportionate distribution under 305b2 bc frank gets a greater interest in the corp on distrubtion – if the conversion ratio changed to reflect this and keep her % interest in the biz the same.

g) same as f but the debentures are convertible preferred stock. Corp declares a one for one split on the CS and the preferred ratio is doubled. – this is non taxable – it’s a proportionate ratio

h) 305b3 - taxable. Class a get common and class b get preferred.

i) a gets 100 cs and b gets conv preffered over long term. -

if short term – some would convert and some would not convert – causing a disproportionate dist. – with long term --- there is no disproportionate dist.

2. a has 500sh b has 300sh c has 200sh

z corp has one class of CS – will 305c3 if there is a redemption plan for a shares.

Before is a 50%/30%20% Yr 1 After its 47.4%/31.6%/21.0%

Is it a redemption – exchange treatment – 302b1 as a redemption not equivalent to the dividend - he had veto power before now he doesn’t. this is not taxed under 301 and thus commissioner could not regard this a a constructive dividend.

Yr 2 – 44.4/33.3/22.0

This redemption is no longer meaningful. – and does not satisfy the 8% test. – 301 applies. And could treat it as a constructive stock dividend.

§306 STOCK

(1) Preferred Stock Bailout(a) BackgroundDevice used by SH before 1954 to w/d corporate earnings at LTCG rates.Profitable corp., would make a tax-free distribution of preferred stock to its common SH. SH would then sell preferred stock to an investor, reporting LTCG- corp would then repurchase the PS from the investor after a number of years.In computing the gain, a SH basis in the common was allocated to the preferred. Net effect was that SH received cash w/o reducing their prop., interest in the corp., the essence of a dividendChamberlin v. CommissionerRejected IRS saying this was taxable like a dividend and held that it was a good transaction.

(b) Overview of §306§306 stock stock with bailout potentionalSH must recognize ord. income rather than capital gain on sale, redemption or other disposition of stock.D/A under §305- SH may not offset her stock basis against the AR on a disposition of §306 stock. Exceptions for dispositions, such as complete terminations of a SH interest in the corp., that do not have bail out potential.

(2) Definition of §306 Stock(a) In GeneralPrincipal category of §306 stock is: Preferred stock distributed to a SH as a tax-free dividend under §305(a); Common stock is not included b/c it participates in corporate growth and thus lacks bail-out potential. §306(c)(1)(A)If stock has either a limited right to dividends or limited right to assets upon liquidations, it is not “common stock” for this purposes. Rev Rule 79-163Voting C.S that is subject to the issuing corp. right of first refusal at net book value is “common stock” Rev Rul. 76-386

(b) No E&P§306 does not include stock distributed by a corp w/ no current or accumulated E& P for the year of distribution.Test- whether no part of a tax-free stock distribution would have been a dividend if cash has been distributed instead of stock. §306(c)(2)If even a small part of a cash distribution would have been a dividend, then all the stock is §306 stock.Ex:X. corp, makes a tax-free distribution of preferred stock with a value of 25k to its common SH.X has no accumulated E&POn July 1, X has current E&P of 10k but at end of year, 1k E&P deficit.Preferred stock is not §306 stock b/c a distribution of cash in lieu of stock would have not been a dividend. If X had ended the year w/ S20 current E&P, all preferred stock would be §306 stock.

(c) Stock with Transferred or Substituted Basis§306 stock includes stock which has a transferred or exchanged basis determined by reference to the basis of §306 stock. §306(c)(1)(c)Ex includeStocks received as a giftStock received in exchange for §306 stock in a tax-free §351 transaction§306 taint is removed for death, b/c §1014, date of death basisDeath FMV so no 306 taint! Ex 1:Parent gives 100 shares of X corp to child of §306Stock remains §306 stock in child’s hand. If parent were to die and bequeath the stock to child, It would no longer be §306 stockEx 2:A transfers 100 shares of §306 p.s. to Y in exchange for 100 shares of Y corp. common stock that is tax-free under §351(a)X corp., preferred stock (§362(a) basis) and the Y corp. common stock (substituted basis determined by reference to the Y corp., under §358(a)) are each §306 stock.

(e) Certain Stock Acquired in a §351 ExchangePreferred stock acquired in a §351 exchange is §306 stock if the receipt of money instead of the stock would have been treated as a dividend to any extent. §306(c)(3).Ex:A is the sole common SH of X corp., with ample E&PA transfers her X common stock to a newly formed Y corp., in exchange for Y common and Preferred stock Y preferred stock will be §306 stock b/c a transfer of cash to A in lieu of the preferred stock would have been treated as a dividend under §304(a)(1)

(3) Dispositions of §306 Stock

(a) RedemptionsIf §306 stock is redeemed, the AR by the redeemed SH is treated as a distribution of property as to which §301 applies and this is taxable as a dividend to the extent of the corp.’s current or accumulated E&P at the time of the redemption. §306(a)(2)Balance, if any, of the AR is first treated as a reduction of basis and then if necessary as a capital gain under distribution rules of §301Example:X makes a tax-free distribution of preferred stock with a value of 20k to its common SH AX has 5k of E&P at time of distributionA’s allocable basis in the P.S(§306) is 10k2 years later, X redeems A’s preferred stock for 20k, at a time when X has 30k of E&PA continues to own 100% of common stock.Entire 20k AR on the redemption is a dividend.A’s basis in the preferred stock probably is added back to the basis of A’s common stock.If X had no E&P at the time of the redemption, entire 20k would be return of capital under §301©(2)A probably could reduce his basis in both the preferred and the common stock before recognizing any gain.

(b) Sales and Other DispositionsOn a sale or other disposition of §306 stock, the AR is first treated as Ordinary income to the extent of the stock’s ratable share of the amount that would have been a dividend at the time of the distribution if cash, rather than stock had been distributed.O.I is not considered a dividend, and thus corporate SH are not allowed a §243 dividends received deduction, and the corp., may not reduce its E&P. Reg 1.306-1(b)The balance, if any, of the the amount realized first reduces the basis of the §306 stock, and any excess is treated as a gain from the sale or excahgne fo the stokc. §306(a)(1)(B).No loss may be recognized on a disposition of §306 stock, but any unrecovered basis is allocated back to the stock w/ respect to which the §306 stock was distributed. §306(a)(1)(C) Reg 1.306-1(b)(2) Ex 2 and 3Ex 1X corp., makes a tax-free distribution of prefreed stock with a value of 20k to its sole common SH AX has 50k of E&P at the time of the distributionA’s allocatable basis in the preferred stock (§306) is 2kTwo years later, X has no E&P, A sells the §306 stock for 24kOf this amount, 20k is treated as ordinary income; this is the amount that would have been a taxable dividend if cash, rather than stock has been distributed at the time of the distribution.This the amount that would have been taxable if cash rather than stock has been distributed at time of distribution2k is a reduction of A’s basis in the P.S and 2k is treated as a gain from sale of stock Ex 2

Say X’s E&P was 8k, at time of distribution, A’s AR on sale of §306 is ordinary income the 2k is reduction of basis, and 14k is treated as a gain from sale of the stock. Ex 3Same as (1), except A sells the §306 stock for 21k. Of this amount, 20k is treated as ordinary income, and 1k is a reduction of A’s 2k basis in the preferred stock.No loss will be allowed.A may add the remaining 1k basis in the preferred back to his basis in the X common stock. Reg 1.306-1(b)(2) Example 2.

(c) Exempt DispositionsFour types of dispositions are exempted from the rule of §306(a) b/c they do not represent any opportunity for bail out.

(1) Complete Terminations and Partial LiquidationsDisposition of §306 stock in a transaction (other than a redemption) that terminates the SH entire stock interest in the corp is exempt if the SH does not transfer the stock to a §318 related person or entity. §306(b)(1)(A)(ii)§318 attribution rules apply. §306(b)(1)(A)(iii)Redemption of §306 stock that result in complete termination of the SH interest under §302(b)(3) or qualify as partial liquidation under §302(b)(4) are also exempt. §306(b)(1)(B)ExampleA owns 500 shares of X corp., common stock and 250 shares of X corp. preferred §306 stock. She owns no X stock constructively.A sells all of her common and preferred stock to an unrelated person.A’s sale of the preferred stock is not subject to §306(a) b/c she completely terminates her interest in the corporation. (2) Complete Liquidations§306(a) does not apply to a redemption of §306 stock in a complete liquidations. (3) Nonrecognition TransactionsDispositions that qualify for nonrecognition treatment, such as §351 transfers, contributions to capital and tax-free exchanges of stock under §1036 are exempt. §306(b)(3)Any stock received in a tax-free exchange, however, becomes §306 stock. §306(c)(1)(C).

4) Transactions Not in Avoidance of Tax§306(a) does not apply if the TP satisfies the service that either:(a)distribution and the subsequent disposition or redemption of §306 stock or(b)in the case of a prior or simultaneous disposition (or redemption) of the underlying stock with respect to §306 stock was issued, the disposition or redemption of the §306 stock was not made pursuant to a plan having federal tax avoidance as one of its principal purposes. §306(b)(4)§306(b)(4) relief is not automatically available, on dispositions of prefreed stock of wildely held corp.Case: Fire Oved:

The court in Fireoved held that the prior sale of a portion of the common did not exempt a corresponding portion of the preferred from § 306(a) treatment b/c the taxpayer had the same degree of control after the sale of the common stock as he did before. The court asserted that the evil § 306 was enacted to address was the ability of a shareholder to realize upon the accumulated E & P of the corporation (through the sale of preferred stock to a third party) without diminishing his control.Problem here veto powerSee – handout on 306 for step by step

P. 330 – Corp non convert non vote PS worth 1k to J and V each had basis of 2k prior to dist and avalue of 3k after. Corp. had E and P of 2k and Y3 E and P of 3k a) in yr 1: distribution of PS is tax free (no gain or loss (305a)) and have to reallocate basis after distribution from CS to CS and PS AB of PS= FMV of New / FMV of OLD * old basis 1k/ 3k +1k = ¼ * 2k = 500 basis in pf and 1500 basis in common. No tax consequences to arg. – no reduction of e and p b) V sells PS to Carl for 1k in year 3. There was 2k in E and P thus all 2k would be a cash dist (dividend). she received 1k. J received the other 1k: AR on sale is Ord Income. all 1k is taxed as OI – 15% dividend rate. Problem is she had a basis in the PS of 500; this disappears and flows back into the common. Thus the CS basis returns to 2000 (from 1500 after reallocation) c) same as B but V sells to carl for 1750 – the first 1k is treated as OI (as above). the next 500 reduces basis in the PS to zero. The rest (250) is capital gain.

d) same as b but there is no E and P at time of distribution. 306 is designed to prevent a bailout of E&P if there is no E&P there is no need to apply 306. This is not 306 stock then normal rules apply. its 1001 AR-AB 1000-500 = cap gain of 500.

e) if J gives to grandson. Generally - GS gets the transferred basis (still 306) sells stock to unrelated party. 306 does not apply in certain circumstances (see above) grandson does not have attribution interest—it’s a complete termination of interest. GS sold stock to unrelated party for 1000. Exceptions: 306b1 termination of sh interest not in redemption. This is treated as a sale AR –AB = 1000-500 = Cap gain of 500.

306 does not apply in death bequeaths – the stock loses its 306 status. There is a step up in basis to FMV at the time of death.

f) skip

g) see firoved handout – CS - before and after analysis before 50% after 33 1/3 % - is this substantially disproportionate. – 1. Must have less than 50% and voting power must be 80% of what it was before. Both satisfied. Thus is a substantially disproportionate stock.

Redemption of 306 exception (and wont apply) – complete termination of interest or partial liquidation. Does not occur here. Must argue that qualify under 306b4 see fireoved. In fireoved – he maintained his same level of control (veto power) here probably did not retain the same level of control after the redemption. Went from veto to no veto. – should be able to get exchange treatment.

Chapter 7 Complete Liquidations

(A) Complete Liquidation Defined

Corp distributes all of its assets (or proceeds of their sale) subject to any liabilities, to its SH in exchange for all their stockCorp then dissolves under state law.§1.332-2(c)- Corp. liquidates for tax purposes when it ceases to be a going concern and its activities are merely for the purpose of winding up its affairs, paying its debts and distribution any remaining balance to SHCorp sells to 3rd party assets to pay creditors and give cash to SH and to satisfy claims to creditors and SH.

(B) Complete Liquidation under §331

(1) Consequences to the SHRecognition of G/L

§331(a)- Amounts distributed to a SH in a complete liquidation are treated as in a full payment in exchange for the SH stock. Capital Gain or Loss AR – AB in stockAR-amount of money and the FMV of all other property received from the liquidating corporation – liabilities assumed by the SH or encumbering property. Remember it triggers 1001 = AR-AB = G/L ( cap gain or loss.

(2) Basis of Distributed Property§334(a)- SH basis on §331 is FMV of the property on the date of distribution, w/o reduction for any liabilities to which the property is subject.

(C) Consequences to the Corporation under §336

(1) Recognition of Gain or Loss§336(a)Corp., recognizes G or L (different from non liquidation dist) when it distributes property in a complete liquidation as if it had sold the property to the distrbutee for its FMV. G/L is determined seperatly on each asset. Exception to Loss Channel stuffing provisions

(2) Limits on Gain or LossS336(d) Limits the recognition of loss by distributing corp., in 3 situations(1) Distributions to Related Persons §336(d)(1)(B)No loss can be recognized to a §267 related person if the distribution is:Not pro rata or isDisqualified propertyRelated person§267(b)(2) SH owns directly or indirectly through attribution >50% in value of corp.’s o/s stock. Non Pro-rata§336(d)(1)(A)(i)- not distributed to the SH in the same proportion as their stock ownership in the corp. Disqualified Property:Any property acquired by the liquidating corp. in a §351 transaction or as a contribution to capital during the 5-year period ending on the date of distribution. §336(d)(1)(B)(2) Property Acquired for Tax Avoidance Purpose§336(d)(2)§336(d)(2) 2 years, and only to extent of built in loss. (look at old exam) If property distributed, sold or exchanged by corp., was acquired in a §351 transaction or as a contribution to cap as part of plan where principal purpose was to recognize a loss in connection w/ liquation.Can only disallow the loss that accrued before the corp., acquired property. Corp has to reduce its basis for determining the loss by the pre-contribution built in lossi.e- excess of the AB of the property when it was acquired over the FMV of the property at that time.

P. 349

a) Corp will recognize a gain of 300k. and a loss of 400k. no disqualified property distributed pro rata. And no distribution within 2 years ie net loss of 100k

b) this is not a pro rata distribution thus cant recognize the loss of 400k. thus there is a gain of 300k

c) gainacre gain is 300k loss acre loss of 400k = just net the gain and loss 336d1 and 2 don’t apply 1. Not related 2. After 5 years.

d) not subject to d2. Is it a distribution to related person that is disqualified. – is disqualified bc it is a contribution to capital within the 5 year property. Isqualifies the protion of the los distributed to the related person. Thus cant recognize the 240k loss distributed to ivan

recall - Exception on 362(e)(2)If transferee’s aggregate Adjusted Basis of such property so transferred would exceed the FMV of such property immediately after such transaction then, notwithstanding (a) the transferee’s aggregate AB of the property so transferred shall note exceed the FMV of such property immediately after the transaction. Aggregate AB must exceed FMV of transferred propertyAllocation §362(e)(2)(b)Allocated amongst the property in proportion to its built in losses. Ex: 23AB and 20 FMV..so 3k difference reduce the basis by 3k in the propertyE) 362 did not apply - 336d2 applies here bc transfer is within 2 years of liquidation - is an irrebutable presumption – unless there is a relationship to the business operations. Bc 336d2 applies - you squeeze out the built in loss of the property- thus you step down the basis from 800k to fmv at time the asset was transferred to corp. 300k gain of gain acre and a 300k loss of lossacre

What happens if 362(e) (2) did apply at the time property transferred to the corp. step it down at the time of the transfer – result is the same.

F) if 362 e2 applied –

Ivan contributed gainacre and 362e2 applied - trying to reduce the aggregate basis fro 900k aggregate to 800k aggregate. With respect to lossacre you reduce it to 700k reduce the aggregate basis to the aggregate fmv. property – thus cant recognize loss of DQ prop to related person – only recognize a loss of 60k by flo.

g) 362e2 applied to ivans contribution to x and 336d2 applied to lossacre bc there was a plan. - at time of contribution there was a step down from 700k to 400k then there is a distrubition to I and F – 336d2 applies. corp Cant recognize loss to distribution to Ivan. As to Flo bc 336d2 applies – corp

At time of transfer 362e2 applies corp would take basis fmv (reduce adj basis of the poperites by 100k to 800k – allocate to the loss property)distribution properties are disqualified - since we are distributing lossace must eliminate the built in loss (here 300k) 700k to 400k.

Redo of the last problem F) now assume that Ivan and Fow own 80/20 of X Ivan contributed Gainacre and Lossacre.Flo contributed 200k Lossacre is a 336d1 disqualified property362e2 applied to ivans contributions to X but 336d2 does not apply to the liquidation distrbution of lossacre because there ws no plan for X to recognize loss

LOOK TO EXPLANATIONS FOR AN ANSWER.

Subsidiary LiquidationViewed as a mere change in form – not a taxation event80% total value of all stock – and 80% of the total voting power (BOTH)§332 and §337 generally provide that neither the parent SH nor the liquidating corp recognize gain or loss on the receipt of property in complete liquidation of an 80% or more subsidiary. Parent takes the distributed assets with a transferred basis under 334b1Holding period also tacks on. Sub asset bases and other tax attributes transfer to the parent

Consequence to SH basis in Distributed Property§334(b)80% Parent- transferred basis and a tacked holding period in a §332. §334(a)treated as a normal liquidationdistributed to Minority SH Basis is FMVholding period begins on the date of distribution

Effect on Recipient Taxable Income No g/lDistribution to 80%- 80%§332 No gain or lossDistribution to Minority §331§331 No gain or loss

Effect on Corp’s Taxable Income80%-->§337(a)

If §332 applies, sub recognizes no gain or loss. Minority§336 included §336(d)(3) Can recognize Gain but not loss to a minority SH in a §332 Liquidation

a) S recognizes a gain on the distribution if inv. No gain recognized on Land to PP wont recognize gain – uses a transferred basis. I recognizes a gain in excess of its basis thus there is a gain of 800. Takes a basis of 1000k. S recognized gainon inventory of 900

b)S gets no loss recognized for distribution of equip to I . no gain or loss recognized to P P does not recognize a gain or loss and takes a transferred basis. I takes a basis of 1k in equipmentWhat could it do – sell the equipment and take the loss – if 336d2 applied however, reduce the basis of the equipment to 1000. (sold in connection with a liquidation).

TAX- FREE REORGANIZATION

Reorg occurs where corp acquires stock of another corp for its own stock

Target

P= Parent/Purchaser

T merges into P P survivesSH of T receive shares of P this is a tax free reorg 368.

This is tax free to the SH of T (351) Reason is that they have not cashed out – continued their investment SH take the same basis in the new shares that they had in the original stock Holding period tacks on.

If the SH receive anything other than stock – it is deemed as boot.Basis is the adj basis in the old T stock minus the FMV of the boot + the gain recognized. The gain recognized – is the lesser of the realized gain or the FMV of the boot

The trick is to determine what a tax free reorganization is 368a1

acquisitive reorganizations are set forth in 368a1a,b,c,(A) a statutory merger or consolidation;(B) STOCK FOR STOCK EXCHANGE - the acquisition by one corporation, in exchange solely for all or a part of its voting stock (or in exchange solely for all or a part of the voting stock of a corporation which is in control of the acquiring corporation), of stock of another corporation if, immediately after the acquisition, the acquiring

corporation has control of such other corporation (whether or not such acquiring corporation had control immediately before the acquisition);(C) STOCK FOR ASSETS - the acquisition by one corporation, in exchange solely for all or a part of its voting stock (or in exchange solely for all or a part of the voting stock of a corporation which is in control of the acquiring corporation), of substantially all of the properties of another corporation, but in determining whether the exchange is solely for stock the assumption by the acquiring corporation of a liability of the other shall be disregarded;

Control is defined in 368c - 80% of voting power and 80% of all other stock

CTs have added their own requirements to reorganizations SC held that a 99cash 1% stock – was not a valid transaction – this was not intended to be a reorganization – too much like a purchase of assets . – amount of consideration of stock must be stock 40% stock to boot ratio is ok. So 10% stock is not a reorganization. – not a continuity of interest.

Does there have to be historic continuity?

No. it doesn’t make a difference if a sufficient number of old sh receive stock.

100% of SH receive stock but pursuant to preexisting agreement that sale of new stock ocurred is this a reorg.

Judicial Requirements for a tax free Reorg

1. continuity of proprietary enterprise (Boot can be 60%)2. continuity of business enterprise IRS used to require that new biz conduct identical business as prior to reorg. Now that is not the case, just have to use the business assets3. business purpose. There must be a purpose.

(TYPE B) STOCK FOR STOCK ACQUISITIONS

Must be voting Stock Corp acquiring must become the controlling sh (80%) Cant have two transactions that constitute a single transaction – and one transaction has some boot.

(TYPE C) STOCK FOR ASSETS ACQUISITIONS

acquiring corp must get substantially all the assets of the target

what is substantially all? Gross assets – liabilities = net assets It is substantially all if 70% of gross assets AND 90% of net assets.

You can have some boot in a C reorg – up to 20% can include boots – includes assumed liabilities) Target must dissolve.

USE OF A DROP DOWN SUBSIDIARY 368a2d Can create a drop down subsidiary – if T ( P then P acquires all liablilites

If use a B or C can use parents stock

Forward triangular merger

P drops down S and S acquires T T dissolves.

Reverse triangular merger

P drops down S and T acquires S S dissolves