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Course Goals: Understand and be able to apply to problems the fundamental

provisions of the US tax rules to C and S corporations and their shareholders:


Subchapters C (90%) and S (10%) of the Internal Revenue Code and accompanying Treasury
Regulations
IRS administrative guidance (revenue rulings, revenue procedures, notices, and PLRs)
Judicial decisions interpreting the Code and Regs, and especially the application of common
law and statutory substance-over-form principles.
Redemptions: Buying Back Shares
Distributions to shareholders
Ordinary distributions and Redemptions
Liquidating Distributions
Formation and ongoing transfers of property to controlled corporations
Redemptions involving related corporations
Distribution of stock or stock rights
Taxable sale of shares and assets
Non-taxable exchanges of shares and assets
Non-taxable exchanges of shares and assets (reorganizations
Tax-free division of corporate assets
Spin-offs, Split-ups, split-offs

EE can elect alternate tax status


EE with 2 or more members can elect to be taxed as LLC or S-Corp
PSH if two or more members and at least one member doesnt have limited liability
Association if all members have limited liability
DRE if single owner who does not have limited liability

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Liability determined under foreign law or organizational documents (-3(b)(2))

Effective date: date listed on Form 8832 or filling date, but not more than 75 days prior to filing
date or not more than 12 months after filing date
Relief for late filing: Rev. Proc. 2002-59: New entity can request relief for late filing if election
filed by return due date

Many companies switched to PHs for passover tax in 1986 because individual tax rates were
lower than the corporate tax rate.
What was the concern of Congress?
Under sec 7704, PTPs generally taxed as corporations 7704(a)
Publicly traded partnerships
Traded on established securities market
Readily tradeable on a secondary market (or sub. equivalent)
Various exceptions (safe harbors) 1.7704-1

Passive Income Exception:


PTP not taxed as Corp if more than 90% of gross income is qualifying income such as
Dividends, Interest, Gains from Stock and Bond Sales, Swap Income
Real Property Rents and Gains
Income from the production of natural resources (7704(c))
Interest derived from conduct of financial or insurance business excluded
QI exception does not apply to any PSH that would be subject to the 40 act if it were a
corporation

Using Branches? Like disregarded entities?


Disregarded entities can make lower subsidiaries corp. In China, but disregarded for US tax
purposes

S Corporations Eligibility:
1. Small Business Corp + Elections 1361 (a)(1)
2. Small Business Corp (1361(a)(1))
a. Domestic Corp
b. 100 or fewer SHs
c. All SHs must be individuals (or certain trusts)
d. No NRAs
e. 1 Class of Stock

Banks have S-Corps instead of partnerships because the Banking Act requires incorporation.
All members of a family (and their estates) treated as 1 single shareholder 1361(c)(A)
A common ancestor (up to 6 generations from the youngest generation of SHs) and any lineal
descendent and their spouses of the common ancestor.

S-Corps can come together to form a partnership


This allows you to escape the 100 shareholder limit while maintaining s-corp status

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S-Corporations:
Grantor Trust
Qualified Subchapter S Trust
Testamentary Trust
Voting Trust
Electing Small Business Trust

QSST: Treated as Grantor Trust, all income must be currently distributed to 1 US individual. So
other trusts are popular to accumulate income
Income interest terminates upon beneficiarys death

S Corp: ESBT
Permitted beneficiaries: Individuals, estates, or certain charitable organizations
Interest in ESBT cannot have been acquired by purchase
Must elect ESBT status
Potential Current Beneficiary: a person who is entitled to, or in the discretion of any person may
receive, a distribution from the principal or income of the trust. 1361(e)(1) and (2).
The ESBT is taxed at 39.6% on its accumulated share of the S Corps income, except for NCG
and QDI under section 1(h).

S-Corporations: Tax-Exempt Status


Pension trusts and charitable organization are permitted shareholders. 1361(c)(6).
Tax-exempts share of income of S Corp and any gain/loss from sale/exchange of S Corp
shares is treated as UBTI. 512
Malpractice alert
Partnerships cannot be SHs of an S Corp, even if all partners are individuals. Reg. 1.1361-1(f).
Nonresident individuals cannot be SHs of an S Corp. Be careful of community property law,
either state or foreign. Reg. 1.1361-1(g)(1)(i).
Corporations cannot be SHs of an S Corp. Reg. 1.1361-1(f).
IRAs and Roth IRAs cannot be SHs of an S Corp. Reg. 1.1361-1(g)(1)(vii).

An S-corp can own:


1. An Interest in a partnership
2. Shares of a C Corp or shares of another S Corp in limited circumstances
a. An S-Corp cannot be part of a consolidated return; whereby all income and losses of all
subsidiary companies gets dumped onto one tax return.

Qualified Sub. S Subsidiary (QSSS)


100% owned by S Corp
QSSS status elected
Result For tax purposes, the S Corp is disregarded and all assets, liabilities, income
deduction of the QSSS are treated as assets liabilities of the S Corp
Election of QSSS status treated as liquidation of subsidiary into its parent. Reg. 1.1361-4(a)(2)
(i). This is generally tax free under section 332.

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Termination by sale: treated as sale of undivided interest in assets and subsequent
contribution of assets (and assumption of liabilities) in a 351 transaction. 1361(b)(3).

S-Corp, only one class of stocks??

Paige v. US
Where contributions to new S Corp consisted of cash and property, waivable state law provision
mandating preferred dividends to cash SHs (annual cumulative equal to 5% of purchase price),
was 2nd class of stock, even though dividends paid pro rata
Why is this potentially a problem according to the Court?
Read Reg. 1.1361-1(l)(2)(vi), Ex. 1.

Overview: Plaintiff taxpayers assigned their rights to an exclusive license agreement in


exchange for corporation stock and became property shareholders. Eight other parties paid
cash and became cash shareholders. The corporation made a subchapter S election and
plaintiffs filed a joint tax return claiming their proportionate share of the corporation's income and
losses. Thereafter, the Commissioner of the Internal Revenue disallowed these claims and
assessed additional taxes. At issue on appeal was whether plaintiffs' corporation qualified for
the subchapter S election provided in 26 U.S.C.S. 1371(1954). The court held that the
corporation did not meet the requirements to qualify for subchapter S tax treatment because the
corporation had more than one class of stock.

Outcome: The court affirmed the judgment of the district court denying plaintiff's' claim for a tax
refund because the corporation failed to meet the requirements to qualify for subchapter S tax
treatment.

Default Classification for an LLC with 2+ members, partnership, treated as a pass


through
LLC with 1 member; disregarded entity
If you dont like classification you can check the box and elect an alternative
There can be onerous tax implications if you go from association corp or vice
versa
LLC is used by individuals
Publicly traded partnership; as a general rule, taxed as a corporation

What is an S-Corp: Taxed as a pass through with only one level of tax. But there are special
rules for C-Corps that have changed to S-Corps.

S-Corp= Small Business Corp + Election 1361(a)(1)


Small Business Corp 1361(a)(1)
Domestic Corp.
100 or fewer SHs
All SHs must be individuals (or certain trusts)
No NRAs
1 Class of Stock
But 10 S-Corps can operate as a partnership

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Grantor trust
Qualified Subchapter S Trust
Testamentary trusts (2 year limit from date of death)
Voting Trust

IRA cannot be S-Corp shareholder


Pension Trusts and Charitable Organizations are Permissible Shareholder
Tax exempt entitys shares can be taxed as other business income if operated as a business
QSSS a C-Corp if owned by an S-Corp?

Paige v. US: different classes of shares treated as C-corp. Provision needed to be removed
and then refiled as an S-Corp

S-Corporations: One Class of Stock


We want taxable income to follow economic income
Buy-Sell agreements allow pass through income to be taxed at a lower bracket, then can shares
can be bought to take already taxed earnings

Book Value= Accounting Value, roughly the value you paid for some share or interest, (not
current market value)

Obligation is treated as SCOS


1. Treated as equity under federal tax principles
2. A principal purpose of issuing the obligation is to circumvent the SCOS limitation; 1(I(4)(ii)(A))

Straight debt safe harbor


Does not provide for interest that is contingent on profits, borrowers discretion, payment of
dividends, etc
Is not convertible
Held by individual, estate, or trust described in section 1361(c)(2), 1361(c)(5); -1(I)(5)(i).

Stock Options; Second class of shares?


Strike price, the amount you have to pay per share to exercise option

S-Corporation's: S-Election
Drafting SH agreements; What should you watch out for?
S election remains in effect;
1. Unless revoked by SHs holding more than 50% of the shares Sec. 1362(d)(1)(A)
2. Unless terminated by S Corp ceasing to be a SBC 1362(d)(2)
3. Corp whose S election is terminated cannot elect S status for 5 years w/out IRS consent.
1362(g)
Timing
1. Election can be made at any time during the preceding TY or
2. Any time during the taxable year and on/before the 15th day of the 3rd month of the Tax
Year

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For (2), if the Corp doesnt meet the S-corp requirements i.e... if the business gains more than
100 shareholders, gains a business or nonresident alien shareholder, or enters into a prohibited
industry, it will lose its S-corp status. The other way the business may lose its status is if over
the past three tax years it derived more than 25 percent of its gross income from passive
investment income. Passive investment income is any income that is generated by an activity
that the business did not directly participate in. An example of passive investment income is
dividends.

Two Brother 50% each in S-Corp, option for 75% of book value to sell SHs 50%
Warrant versus agreement between shareholders
This might be ok as disregarded unless the principal purpose is to circumvent restrictions on
different classes of shares
This was designed to punish perhaps and keep SHs together, 75% of book value in punitive to
SH who wants to leave
But one brother has the first right to dissolve which could be a gift from the other brother
Agreements to purchase at death, divorce, or termination, typically disregarded to the extent
that it creates a separate class of shares

State Taxes like NY and Texas have disparities that need to be written into shareholder
agreements
You shouldnt get the same dollar amount in distributions after tax

For what year is the S-Corp status effective; the filling for S-Corp status is effective for the whole
year if filed by March 15th, after March 15th then it is only effective for the subsequent year

Taxation in the front of the chapter:


The basic rule; S-corp is pass through with one level of tax
An S-Corp is not subject to tax on its income

An S Corp computes its income in the same manner as in the case of an individual, except: the
S Corp isnt allowed a deduction for personal exemptions, foreign income taxes, charitable
contribution. 1363(b)
Why?
Any election affecting the computation of items of income/loss etc. is made by the S Corp?
1363(c). Why?

(2) Exception for contribution of non-capital gain property. If an S corporation is formed or


availed of by any shareholder or group of shareholders for a principal purpose of selling or
exchanging contributed property that in the hands of the shareholder or shareholders would not
have produced capital gain if sold or exchanged by the shareholder or shareholders, then the
gain on the sale or exchange of the property recognized by the corporation is not treated as a
capital gain.

Built in loss, property that is a capital loss. Capital Losses can be used to offset capital gains

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Turn S-Corp into a dealer to get built in loss to income tax
S-Corp and partnerships send you a K-1 from showing your share of gains and losses

S-Corps and taxable year:


Follows the S-Corp year, whichever year that ends is the taxable year for the SH.
You can arrange calendar to defer tax for almost a year

S Corp has outstanding 100 shares, owned 50-50 by A & B. A sells her shares to C on 4/1. S
Corp earns $100 for entire TY, $20 from Jan. until 4/1, and $80 from 4/1 to 12/31. How much
income from S Corp must A include? See 1377(a)(1) and (2). What if A sold 25 shares? See
Reg. 1.1368-1(g).
Default rule? In 1377(a)(1) per share, per day
Default rule is Pro rata
Vs. 2nd option: terminate year at point of sale

S-Corps shares are deemed under the default rule to be earned pro rata per day
For example, if you own 50% and sell halfway through the year; you would be eligible for 25% of
profits or losses
You're taxed on profits made after you leave. Unless you ask the company to closes the books
at the date of sale.
Character flows through, what is distributed has nothing to do with the total S-corp income,
Because it is a passthrough the character of all the items flows through to you
When the S-corp distributes property it is taxable
Assume that you are a dealer in property (art, land) and you contribute appreciated property to
an S Corp that is not a dealer, and the S Corp sells the property. Result? See Reg. 1.1366-
1(b)(2).
If the property had a Built In Loss, under what circumstances could it be beneficial to contribute
it to an S Corp? See Reg. 1.1366-1(b)(3). See 362(e)(2).
The rules for C Corps generally otherwise apply to S Corps, e.g., contributions, certain
distributions, acquisitions, and reorganizations. 1371(a).

S Corp has outstanding 100 shares, owned 50-50 by A & B. A sells her shares to C on 4/1. S
Corp earns $100 for entire TY, $20 from Jan. until 4/1, and $80 from 4/1 to 12/31. How much
income from S Corp must A include? See 1377(a)(1) and (2). What if A sold 25 shares? See
Reg. 1.1368-1(g).
If you closes the books you have certainty as to your tax liability
Basis is what you paid for you shares in the S-Corp
Regardless of whether you borrowed money to borrow share
Amount realized vs. adjusted basis
If you take out more than your basis, then its a taxable gain

S corporations, however, are intended to be subject to only a single level of taxation. Thus,
when an S corporation generates income, the corporation generally does not pay tax on that
income at the entity level (subject to the notable exceptions of Sections 1374 and 1375).
Instead, the income is divvied up among and allocated to the corporations shareholders, who
report the income and pay the corresponding tax on their individual returns.

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This is where the basis adjustment rules of Section 1366 come into play they act as the
mechanism to preserve the single level of taxation specific to S
SH increases basis:
Separately stated items of income
Nonseparately stated income

SH decreases basis (but not below zero):


Distributions
Nondeductible expense
Separately stated items of loss/deduction. 1367(a); Reg. 1.1367-1(f).
Increases first then losses allows you to maximize your losses

S Corporations: Loss Limitations


An S Corp can only take into account losses/deductions up to:
SHs Basis in his shares (determined after adjustments for income and distributions); and
SHs adjusted basis in any debt of the S-Corp to the SH
What if SH with suspended loss transfers shares
Debt and Basis?
Borrow yourself as SH and then contribute the money if you want to increase your basis
Bank would want collateral in shares and assurances from S-Corp
Bigger the basis, the more losses you can accrue due to loans

Uri v. Commissioner
The taxpayers claimed that their adjusted basis in the returns in question included a pro-rata
share of the amount of the corporate loan each had personally guaranteed resulting in their
claimed net business loss deduction. The taxpayers claimed that the loan was made on the
strength of their personal financial worth and was in substance a loan to them and a subsequent
contribution by them to corporate capital and that the amount of the guarantee should be part of
their pass-through loss limitation under I.R.C. 1374.
The court held that the guarantees could not be considered as part of their adjusted
bases in the corporation's stock. The court found that the taxpayer's basis in the
corporation's stock was limited to contributions of cash or other property, and that
personal guarantees were neither cash nor other property and could not be considered
as part of their adjusted basis.
The form of a taxpayer's transactions governed the tax ramifications of those transactions and
recharacterization of the transaction in pursuit of tax advantages was properly disallowed.
Taxpayers had to choose a form for transactions which accurately reflected the substance of the
transactions.
The decision of the tax court disallowing the taxpayer's enhanced loss deductions was affirmed.

You can borrow from a positive S-Corp and loan to a negative S-Corp
That is o.k. under IRS regulations
But it must be bona fide debt/loans at fair market value.
Basis must track increase and decrease in companies cash value
Whether it goes up or down

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S Corporations: Notice 2002-65:. Even if the gain and loss legs of the straddle are triggered in
separate taxable years, or if, at the time relevant for making such determination, the corporation in the
transaction has not elected under 1377(a)(2) to treat the S corporation's taxable year as though it
consisted of two separate taxable years

S-Corp: Distributions
For an S Corp with no earnings & profits (E&Ps):
Distribution first reduces basis of stocks
Amounts in excess of basis are treated as gain from the sale/exchange of property Sec. 1368(b)
Effect on SHs Basis 1367(a)(2)(A)
Priority Rule in the case of distributions and losses, (Why do we need such a rule?)
In S-Corps you want the compensation to be low, so you avoid the compensation tax

Problems from the reading:


K-1 tells you how you have to break down distributions

A owns 90% and sells her shares halfway through, 100,000, 300,000 the rest of the way
Close the book, or pro rate, per day.

Problem 2.2: Laura has $20 in net profits, Basis goes up by $20
Sec 1367 is the basis rule
If you dont include income, you pay one the increase in basis, you have to increase basis if the
income is tax exempt
Earn $20, then distributes basis goes up, then goes down
Rationale behind 1367(a)(2)(D)
The value goes out and if you go to sell it, individuals would pay less

26 USC 1367- Adjustments to basis of stock of shareholders etc


You can have 0 basis, but not negative; Negative basis carries over to the following tax year
(A)Reduction of basis
If for any taxable year the amounts specified in subparagraphs (B), (C), (D), and (E) of
subsection (a)(2) exceed the amount which reduces the shareholders basis to zero, such
excess shall be applied to reduce (but not below zero) the shareholders basis in any
indebtedness of the S corporation to the shareholder.
(B)Restoration of basis
If for any taxable year beginning after December 31, 1982, there is a reduction under
subparagraph (A) in the shareholders basis in the indebtedness of an S corporation to a
shareholder, any net increase (after the application of paragraphs (1) and (2) of subsection (a))
for any subsequent taxable year shall be applied to restore such reduction in basis before any of
it may be used to increase the shareholders basis in the stock of the S corporation.

Cancellation of Debt counts as taxable income


We restore debt first to reduce any possible tax consequences before we restore basis from
loss
Whats the rule on distributions generally?

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Distributions arent taxable until they are made in excess of basis
Assuming it was an S-Corp since inception
If it used to be a C-Corp we still keep an eye on previous earnings and tax them later

Problem: $10,000 for all shares of an S-Corp


Beginning Basis of $10,000
Distribution of 3k
Loss of 1K
New Basis of 6K
Next year loses 8K
New Basis is 0, suspended loss of 2K carries forward to the next year
Next year: 10K income
Distribution goes next, 10K
Basis goes back down to 0
2K loss carries over again

Fines are nondeductible


Bob owns S-Corp with friends, Bob wants to keep profits, friends want distributions
Tax distribution can be utilized to distribute just enough to pay shareholder tax liability

C-Corporations:
Basically either an LLC that has elected to be taxed as a C-Corp or a C-Corp itself
All corporations are treated as separate taxable entities, even if a wholly (100%) owned
subsidiary
The C corporation is considered a legal person created by the state. The IRS treats C
corporations as separate taxable entities that pay taxes based on net income each year.
Conversely, the IRS taxes the owners of the other major business structures, including S
corporations, general and limited partnerships, sole proprietorships and limited liability
companies (LLCs), individually at their specific personal tax rates.

Commissioner v. Bollinger:
Overview: Petitioner taxpayers built and operated several apartment buildings. In order to
obtain financing for the projects, petitioners formed corporations to be the nominal debtors on
the construction loans. The corporations also held title to the real estate. The apartment
complexes were actively managed by sole proprietorships and/or partnerships formed by
petitioners. The income and losses attributable to the complexes were reported on the
partnership tax returns and on petitioner's' individual returns. Respondent Commissioner of
Internal Revenue disallowed the loss deductions claimed by petitioners, taking the position that
the losses were those of the corporations. The tax court allowed the deductions, finding that the
corporations were acting as petitioner's agents and that the losses were therefore attributable to
the proprietorships and partnerships.
Outcome: The court affirmed the orders of the tax court, which allowed petitioner
taxpayers to claim deductions for losses generated by the construction and operation of
apartment complexes, because a true agency relationship existed between petitioners
and the corporations that held bare legal title to the complexes.
Today section 469 and Passthrough rules limit the ability to do this today. Corporate losses
were allowed to pass through
Agency relationship existed because individuals held all the risk and benefit.

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Principle is treated as the owner of the building
Agents should have bona fide separation, should be paid/compensated in some manner

National Carbide Corp. v. Commissioner


Petitioners were wholly owned subsidiaries of a parent corporation which utilized them as
operating companies in the manufacture and sale of products. They operated strictly in accord
with contracts with the parent which provided, inter alia, that the subsidiaries were employed as
agents of the parent, that the parent would furnish working capital, and that all profits in excess
of six percent on their capitalization (which was nominal) would be paid to the parent. Title to the
assets utilized by the subsidiaries was held by them, and advances by the parent of working
capital were shown on the books of the subsidiaries as accounts payable to the parent.

Held: for purposes of federal income and excess profits taxes for the year 1938, income earned
by the subsidiaries and paid over to the parent corporation was taxable to the subsidiaries, and
not only to the parent corporation. Pp. 336 U. S. 424-439.

A corporation formed or operated for business purposes must share the tax burden despite
substantial identity, in practical operation, with its owner. Complete ownership of the corporation,
and the control primarily dependent upon such ownership, are no longer of significance in
determining taxability. P. 336 U. S. 429.
But that basis has been repudiated by subsequent decisions of this Court. Moline
Properties, Inc. v. Commissioner, 319 U. S. 436; Burnet v. Commonwealth Improvement
Co., 287 U. S. 415. Pp. 336 U. S. 428-430.

Moline Properties and The Separate Nature of the Corporation


Moline Properties facts are straightforward. An individual who owned commercial real estate
placed a single building into a corporation and subsequently placed the corporate shares with a
voting trustee for the benefit of the mortgagee.
When the corporation sold the property three years later, the single shareholder attempted to
claim the sale as individual income rather than corporate income.
The court ruled against the taxpayer, writing this now famous conclusion:
The doctrine of corporate entity fills a useful purpose in business life. Whether the purpose be to
gain an advantage under the law of the state of incorporation or to avoid or to comply with the
demands of creditors or to serve the creator's personal or undisclosed convenience, so long as
that purpose is the equivalent of business activity or is followed by the carrying on of
business by the corporation, the corporation remains a separate taxable entity.

Other Facts:
35% flat rate on Personal Service Corporations Sec. 11(B)(2)
Capital Losses can be deducted only to an extent of capital gains, any excess can be carried
back 3 years and forward 5 years Sec 1211(a); Sec 1212 (a)(1)(c)
Dividends received Deduction: 70%, 80%, and 100% Sec. 243(a)-(c)
Charitable Deduction: 10% of TI Sec 170(B)(2)

C:Corporations
Corporate Alternative Minimum Tax
Regular tax liability
Or AMT tax liability
AMT: 20% [Alt. Min. Tac. Inc. (AMTI) - 40K - FTC]

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AMTI: Regular TI with Certain adjustments (Sec 56, 57, and 58)
AMTI increased by 75% of ACE in excess of AMTI (pre-Ace) Sec. 56 (g)(1)
Straight-Line Depreciation

Section 1561: Treats all corp. As that are members of a controlled group of corporations as
one for purposes of the income tax, AET, AMT, and Environmental Tax
Controlled group of corporations
Parent-Subsidiary
Brother-Sister 1563(a)
Excluded Corporations and Stock
Tax exempts
Foreign Corporations
Non-Voting Preferred Stock (Sec 1563(b) and (C)
Constructive ownership rules (Sec. 1563(e))
Foreign tax credits and other credits reduce average tax rate vs 35% marginal rate

Individuals:
Maximum rate on dividends: 23.8%.
Maximum rate on CGs: 23.8%.
20% rate on CGs and dividends kicks in when TI > 415,050 (or 466,950 for joint returns) 1(h)
(1)(D) and(11)
Note: Dividend rate applies to entire dividend; CGs rate applies only to gains and not to gross
receipts (TPs recover basis first)
3.8% rate on net investment income (divs, CGs) kicks in when AGI > 200,000 (individuals) or
250,000 (joint return). 1411.
Corporations:
CGs taxed at same rate as business income
Can deduct between 70% and 100% of dividends received from other corporations
Ex. 100 div minus 70 deduct = 30 TI; 30 * 35% = 10.5.

Section 1202:
Noncorporate taxpayers can exclude 100% of the gain from the S/E of qualified small business
stock (QSBS) acquired after 9/27/10 (50% or 75% if acquired before) and held for more than 5
years. 1202(a)(1) and (4).
For stock eligible for the 100% exclusion, there is no AMT add back in this case.
Limit: Greater of (1) $10mm per-issuer; or (2) 10 x adjusted basis of the issuer. 1202(b)(1).
QSBS is C corporation stock of a qualified small business (QSB) acquired at original issue in
exchange for $, property, or services
QSB: Aggregate gross assets dont exceed $50mm after issuance, and 80% of assets are used
in the conduct of 1 or more businesses other than health, law, banking, investing, farming,
operating a hotel, motel, holiday inn, or restaurant. 1202(d)(1)(B); 1202(e)(3): Qualified trade
or business including health, law, engineering, accounting
Section 1045, rollover small business

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Dividends
The defining feature of a C-Corp is double tax: taxed as an entity and taxed for dividends paid
out
Why cant you just form 5 companies and treat as 1? Sec. 1563, substance over form, C-
Corporation must be genuinely independent entity.
Dividend Received: The dividends-received deduction (or "DRD"), under U.S. federal income
tax law, is a tax deduction received by a corporation on the dividends it receives by other
corporations in which it has an ownership stake.

90% of all C-Corps are in $0-75,000 income range


Companies over 18.33 million income pay nearly 90% of all
corporate taxes

Individuals:
Maximum rate on dividends: 23.8%.
Maximum rate on CGs: 23.8%.
20% rate on CGs and dividends kicks in when TI >
415,050 (or 466,950 for joint returns) 1(h)(1)(D)
and(11)
Note: Dividend rate applies to entire dividend; CGs rate applies only to gains and not to gross
receipts (TPs recover basis first)
3.8% rate on net investment income (divs, CGs) kicks in when AGI > 200,000 (individuals) or
250,000 (joint return). 1411.
Corporations:
CGs taxed at same rate as business income
Can deduct between 70% and 100% of dividends received from other corporation
Ex. 100 div minus 70 deduct = 30 TI; 30 * 35% = 10.5.

Section 1202:
Non-corporate taxpayers can exclude 100% of the gain from the S/E of qualified small business
stock (QSBS) Acquired after 9/27/10 (50% or 75% if acquired before)
Section 1244
Up to 50K/yr 100K for those married on S/X of sec. 1244 stock is treated as ordinary loss; any
excess is treated as capital loss
Sec 1244 Stock
Stock issued for money or property (not services); and
For 5-yr period ending before the date of loss, the corporation derived more than 50% of its
aggregate gross receipts from non-passive sources (i.e., not dividends, interest, rents, and
royalties). 1244(c)(1).

C-Corps Continued

Small Business Corporation

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Aggregate money and other property received by the corporation for stock, contribution to
capital, and paid-in surplus does not exceed $1mm. 1244(c)(3)(A).

Avoiding Corporate Tax with Compensation:


What are the tax consequences to the corporation and shareholder when the corporation pays
salary to the shareholder?
See Sec. 162: Trade or Business Expenses

When is it beneficial for a corporation to pay a shareholder a salary vs. paying a dividend?
C-Corps: Avoiding Corporate Tax with Compensation
1. Services must be reasonable compensation under all circumstances
2. You cant just pay exorbitant fees while purchasing and asset to deduct part of the purchase
price. We compare to like enterprises using like services

Menard inc. v. Commissioner


Bonuses were paid in exact proportion to the officers shareholdings
Payments were made in lump sums rather than as the services were rendered
Formal dividend distributions were absent even as the company was expanding
Bonus systems were unstructured or lacked relation to services performed
The company consistently had negligible taxable corporate income
Bonus payments were made only to the officer-shareholders
In its review of the Tax Court opinion, the Seventh Circuit commented that the following factors,
often included in a multi-factor test, were semantic vapors, and wholly subjective:
Type and extent of the services rendered
Scarcity of qualified employees
Qualifications of the employee
Employees contributions to the business venture
Peculiar characteristics of the employers business
The Seventh Circuit commented on the long hours Mr. Menard worked as well as the size,
growth, and profitability of the company. Additionally, the Seventh Circuit commented that Mr.
Menards bonus program, which entitled him to receive 5.0% of the companys earnings before
income taxes, was neither excessive nor a scheme to avoid paying certain taxes because:
1. the company generated a return on equity in excess of its peers even after consideration of the
bonus
2. the bonus was conditional on the company generating income
3. the bonus was paid as a percentage of income
Dividends are generally paid as a specific dollar amount, with the intention that the investor
receives a more predictable cash flow. A bonus, like the one offered to Mr. Menard, was riskier
in nature and was offered to a manager to align his incentive to that of the firm, even if the
manager was also a shareholder. The Seventh Circuit additionally commented that for
compensation purposes, the shareholder-employee should be treated like all other employees.
As such, a shareholder-employee should be treated as two distinct individuals for tax purposes
(i.e., an independent investor and an employee), especially as it relates to compensation
structure. Effectively, the Seventh Circuit advocated an independent investor test in
assessing the reasonableness of owners compensation.
Meaning you look at the returns the investors get after the compensation
Menards company had higher rate of return than its competitors

C-Corporations: Avoiding Corporate Tax with Compensation

14
Non-qualified Stock Options (options without a readily ascertainable FMV)
Bargain Element (difference btwn exercise price and share value) is taxed upon exercise, *3
Reg. 1.83-7(a).
Corporation receives deduction in the same amount as employee inclusion when the employee
reports the income. Sec. 839(h)

Incentive Stock Options


Bargain element taxed when employee disposes of shares at capital gains rates
No deduction for corporation
Upon exercise, bargain element is AMT add back Sec. 56 (b)(3)
100k annual limit 421 and 422

Financial Accounting Treatment:


Recognized as expense (FMV) when granted. If not vested at grant, FMV recognized over the
vesting period.

Capital Structure:
Interest paid by a corporation on indebtedness is generally deductible by a corporation in
computing its taxable income. Sec. 163
Is leverage always beneficial to a firm?
Consider the profitability of firm
Is leverage always beneficial to a firm's shareholders
Taxation of dividends vs. taxation of interest
What are some of non-tax burdens of leverage
Covenants?
Debt holders can place conditions upon financial decisions affecting the corporation's
profitability and long term fiscal success

15
Corporations pay dividends out of post-tax accumulated profits called retained earnings.
Corporations cannot deduct dividends from their taxable income. The Internal Revenue Service
taxes dividends twice -- once at the corporate level and again when you receive them.
Limits on Interest:
Sec 385(a), Sec 385(b)
Regulating Debt vs. Equity

C Corporation's: Capital Structure


Proposed Section 385 Regulations (Apr. 18, 2016)
Timely documentation and Financial analysis for related party debt
Aim at preventing corporate inversions
Implement the authority to treat instrument as part debt and part stock
Debt instrument treated as stock:
Distribution of debt obligations to related party
Issuance of debt in exchange for affiliate stock
Debt Issued pursuant to internal asset reorganization
Wont apply if immediately after issuance of the debt, the issue price of debt instruments held by
expanded group <50mm
Corporate inversions like Pfizer go bye-bye
C Corporations: Earnings Accumulation
When is it beneficial for a C-Corp to retain and invest its earnings rather than paying them out?
Consider various combinations of the following parameters:
C Corp tax on earnings
SH tax on current and future distributions of earnings
SH tax on sale of shares
Investment opportunities of SHs and C Corps

16
If you and Corp are taxed at the same rate, theres no benefit to holding money in the
corporation

Accumulated Earnings Tax (AET)


Applies to corporation formed or availed of for the purpose of avoiding tax by permitting E&Ps to
accumulated instead of being distributed. 532(a).
If E&Ps accumulate beyond the reasonable need of the business, tax avoidance is presumed,
unless corporation can prove to the contrary by a preponderance of the evidence. 533(a).
20% corporate tax on accumulated taxable income (ATI). 531.
ATI= TI (with adjustments) - Dividends Paid accumulated earnings credit (AEC)

Adjustments:
Less: taxes, unlimited charitable contributions, capital losses
Plus: NOLs, DRD. 535(a) and (b)
AEC: amount in excess of E&Ps retained for reasonable needs of business
Minimum Credit: $250,000 ($150,000 for service corporations). 535(c).

Personal Holding Company:


Corporate entity set up to earn and hold business income so that owner can pay corporate
income tax rather than at the individual income tax
No Tax at Death because of the step up in basis
Capital grows and grows, pay corp tax, and then theres no capital gains tax when your heirs
sell the asset post-mortem
Undistributed Personal Holding Company Income
20% tax on Personal Holding Company income
If 60% of your AOGI (adjusted ordinary gross income) is personal holding company income,
then there is PHCI Tax

Substance over Form:


Gregory v. Helvering (1935)
Relevant Facts: A corporation wholly owned by a taxpayer transferred 1000 shares of stock in
another corporation held by it among its assets to a new corporation, which thereupon issued all
taxpayer. Within a few days, the new corporation was dissolved and was liquidated by the
distribution of the 1000 shares to the taxpayer, who immediately sold them for her individual
profit. No other business was transacted, or intended to be transacted, by the new
corporation.The Commissioner of Internal Revenue, being of opinion that the reorganization
attempted was without substance and must be disregarded, held that petitioner was liable for a
tax as though the United corporation had paid her a dividend consisting of the amount realized
from the sale of the Monitor shares.

Relevant Issues: Is a taxpayer bound to the economic substance of a transaction, where the
economic substance varies from its legal purpose?

The purpose of the section is plain enough, men engaged in enterprises ... might wish to
consolidate ... their holdings. ... But the underlying presupposition is plain that the readjustment
shall be undertaken for reasons germane to the conduct of the venture in hand.... To dodge the
shareholders' taxes is not one of the transactions contemplated as corporate reorganizations.

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Transaction was splitting Ms. Gregorys basis: A Liquidation by owner is a taxable event

Why does organization matter?


Theres less tax on the sale of shares because the basis reduces the capital gains on sale of
shares

SCOTUS HOLDS: Simply an operation having no business or corporate purpose-a mere


device which put on the form of a corporate reorganization as a disguise for concealing its
real character, and the sole object and accomplishment of which was the consummation of a
preconceived plan, not to reorganize a business or any part of a business, but to transfer a
parcel of corporate shares to the petitioner. No doubt, a new and valid corporation was created.
But that corporation was nothing more than a contrivance to the end last described. It was
brought into existence for no other purpose; it performed, as it was intended from the beginning
it should perform, no other function. When that limited function had been exercised, it
immediately was put to death.

When [the statute] speaks of a transfer of assets by one corporation to another, it means a transfer
made 'in pursuance of a plan of reorganization' [ . . . ] of corporate business; and not a transfer of
assets by one corporation to another in pursuance of a plan having no relation to the business of
either, as plainly is the case here.
In other words, there must be a business purpose to reorganization other than tax sheltering

The doctrine of substance over form is essentially that, for Federal tax purposes, a
taxpayer is bound by the economic substance of a transaction where the economic
substance varies from its legal form.

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Gregory pays ordinary dividend tax on the sale of Averill
What were the tax consequences of Gregory having this transaction treated as a
reorganization?

Substance over Form: UPS v. CIR (11th Cir. 2001)


In the other case, United Parcel Service of America, Inc. v. Commissioner, while the Eleventh Circuit overturned the
Tax Court's determination that a lack of a business purpose for using an offshore affiliate rendered the entire
transaction a sham, it remanded the case to the Tax Court for a determination whether the amount of taxable income
allocated by UPS to such affiliate was proper under all the facts and circumstances.

Overview
The taxpayer was a package shipper. It profited from assuming liability for loss of parcels up to
their declared value for customers who paid an "excess-value charge." In 1983 the taxpayer
restructured the claims process by (1) forming and capitalizing a foreign subsidiary; (2)
purchasing an insurance policy for customers' benefit, where the insurer assumed the risk of
loss; (3) paying premiums in the amount of excess-value charges collected from customers; and
(4) the subsidiary's entering into a reinsurance treaty with the insurer, in exchange for premiums
paid to the subsidiary equaling the excess-value payments.
For purposes of federal income taxation, a "business purpose" does not mean a reason for a
transaction that is free of tax considerations. Rather, a transaction of a going concern has a
"business purpose" as long as it figures in a bona fide, profit-seeking business. This
concept of "business purpose" is a necessary corollary to the venerable axiom that tax-planning
is permissible.

But its sophistication does not change the fact that there was a real business that served the
genuine need for customers to enjoy loss coverage and for UPS to lower its liability exposure.
Held: We therefore conclude that UPS's restructuring of its excess-value business had
both real economic effects and a business purpose, and it therefore under our precedent
had sufficient economic substance to merit respect in taxation. It follows that the tax
court improperly imposed penalties and enhanced interest on UPS for engaging in a
sham transaction.

19
Ordinary Distributions
Ordinary distribution of property Sec. 301
Dividend to the extent of accumulated or current earnings & profits (E & Ps)
Recovery of basis
Capital gain 301(c)
SH receives FMV basis in property received. 301(d)
Redemptions distributions. 302.
Liquidating distributions. 331 and 332.
Property includes various items; real estate, stock, cash..etc

E & Ps
Start w/taxable income
Add tax-free income, such as municipal bond interest, life insurance proceeds
Add certain deductions that reduce TI, e.g., DRD and NOL
Subtract certain disallowed losses, e.g. section 1211 CLs
Subtract certain nondeductible payments, e.g. Income Taxes
Subtract Distributions ($ face value of debt, adjusted basis of property)
Intuitive Notion: E & P = economic income (approximately)
Taxes?
Earnings & profits (E&P) is the measure of a corporations economic ability to pay dividends
to its shareholders. An up-to-date E&P calculation is important for many corporate
transactions, including determining whether a distribution to shareholders is a taxable
dividend.
Life Insurance proceeds?
Criminal fine for SEC violation?
Accelerated depreciation
Loss from wash sale?

20
Unsubstantiated entertainment expense?

Distributions Continued
Ordinary distribution of property Sec. 301
Redemption Distributions Sec. 302
Liquidating Distributions 331 and 332

Ordinary distributions:
Dividend to the extent of accumulated or current earnings and profits (E&Ps)
Recovery of Basis
Capital gain, Sec. 301(c)
SH receives fair market value basis in the property received
E & P s are are a running total of all profits youve retained
Accumulated earnings and profits is an accounting term applicable to stockholders of closely
held businesses. Accumulated earnings and profits are a company's net profits after deducting
distributions to the stockholders. This is calculated as of the beginning of the year.
Remember that property has multiple definitions; cash, securities, real property, anything except
stocks or warrants from the distributing company

E&PS
Start w.taxable income
Add tax-free income, such as municipal bond interest, life insurance proceeds
Add certain deductions that reduce TI, e.g. Section 1211 CLs
Subtract distributions ($, face value of debt, adjusted basis of property)
Note when appreciated assets are distributed, E&Ps increased by the amount of gain and
decreased by the amount of the distribution
Realized gain/losses affect E&Ps only to the extent they are recognized Sec. 312(a)

E&Ps: See problem 5.1


1. Intuitive notion E&P = Economic Income, taxes ultimately reduce E&PS
a. Taxes
b. Tax-exempt interest
c. Life insurance proceeds
d. Criminal fine for violation of securities law
e. Accelerated depreciation: reduces E&P and increases the likelihood distribution will be treated
as a dividend
f. Loss From wash sale: 30 days
g. Unsubstantiated entertainment expense, subtracted from losses

The IRS is still issuing Rulings on E&Ps more than 100 years after corporate tax was enacted

1. When you receive life insurance payout, how much can you exclude?
a. You can only exclude what you paid, premiums, but not interest if you borrowed?
b. When you borrow to buy stocks and bonds, you can deduct that interest, but only to the extent
you get income from the investment vehicles.
c. Premiums are deducted from E&Ps, so when it is paid out you pay for tax on the payout less the
initial price and premiums, but the premiums have already been removed from E&Ps so they
remain.

Sec 102(a)(2) In the case of a transfer for a valuable consideration, by assignment or otherwise,
of a life insurance contract or any interest therein, the amount excluded from gross income by

21
paragraph (1) shall not exceed an amount equal to the sum of the actual value of such
consideration and the premiums and other amounts subsequently paid by the transferee. The
preceding sentence shall not apply in the case of such a transfer

Mother of All E&P rulings: When current E&Ps are insufficient to cover distributions
Rev. Rul. 74-164
Dividend comes out of current or accumulated E&Ps

(a)General rule: For purposes of this subtitle, the term dividend means any distribution
of property made by a corporation to its shareholders
(1)
out of its earnings and profits accumulated after February 28, 1913, or
(2)
out of its earnings and profits of the taxable year (computed as of the close of the taxable
year without diminution by reason of any distributions made during the taxable year),
without regard to the amount of the earnings and profits at the time the distribution was
made.
Except as otherwise provided in this subtitle, every distribution is made out of earnings
and profits to the extent thereof, and from the most recently accumulated earnings and
profits. To the extent that any distribution is, under any provision of this subchapter,
treated as a distribution of property to which section 301 applies, such distribution shall
be treated as a distribution of property for purposes of this subsection.

Current year loss effects accumulated E&P


Default rule in the reg; Deficit in annual E&Ps is pro-rated

The tax code defines earnings and profits (E&P) as a company's ability to pay out
profits without returning paid-in capital. Current E&P is approximately equal to the
corporate taxable income minus the federal income tax assessed on it, which is then
subjected to the statutory adjustments listed in IRC 312.

If a corporation has profits, then they can pay dividends with those profits, and any
amount not paid out as dividends is retained by the corporation. Any amounts retained
by the corporation increases accumulated E&P, or retained earnings.

If the total dividend payment by the corporation exceeds its total E&P, then:

% of Dividend Paid Out of = Total Total E&P


E&P Distribution
Total
Distribution

% of Dividend Treated as a Nontaxable Return of Capital = 1 % of Dividend Paid


Out of E&P

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Suppose you had different classes of shares, preferred/common
E&Ps go first to the distributions for preferred and the common shares

Dividend
Ordinary dividends are taxed at the same rates as LTCGs:
0% (10% or 15% tax brackets)
15% (25-35% tax brackets, up to $415,050 of TI)
20% (39.6% tax bracket) Sec 1(h)(1)
Both are subject to the NII tax of 3.8% (AGI>$200,000)
Qualified dividends are dividends from a:
US Corporation
Foreign corporation if incorporated in a possession, tax treaty eligible, or publicly traded in the
US Sec 1(h)(11)(B) &

Liabilities and Different Blocks of Shares:


1. Corp. can distribute $ or other property, both of which are treated as dividends to the extent of
current or accumulated E&Ps Sec. 301 (a) and (c)
The FMV of property distributed is reduced (not below) by liabilities
Assumed by shareholder in connection with the distribution, and
To which the property is subject to both before and after the distribution

SH owns 2 shares of Corp X, one with a basis of $25 and the other with a basis of $100. Corp
X has E&Ps of $100 and distributes $100 per share (or $200 total).
-Share with basis of $25: $50 dividend: $25 ROC; and $25 CG
-Shares with basis of $100: $50 dividend; $50 ROC. Prop. Reg. 1.301-2

Dividend is capped by E&P


How would it change if it was not per share but total?
I.e. 2 shares with a combined basis of $125

Distributions: Corporate Shareholders


Payor Corporation
Declaration Date-Dividend Declared
Record Date-Date you must be Sh to receive dividend
Payment Date-
Trading Terminology:
Ex-dividend- Without dividend
Cum-Dividend- With dividend
Record Date: Day buyer becomes SH of record
Trade Date: Day trade is consummated
Settlement Date: How many days until record date, i.e. t + 3
Payment Date

Corporations can use the DRD to generate tax refunds in the absence of economic income
Example, Corp A, which has 100 of CG, purchases stock cum-dividend just prior to the ex-
dividend date for 1,000 that will pay a dividend of 100. On the ex-date, the stock is sold for 900,
generating a loss of 100.
Economic income: Buy stock for $1,000, sell for 900, receive 100 dividend + 0
Tax consequences
CG 100 (from sale of other property on which 35 of taxes are owned)

23
CL <100> (on sale of share)
Tax Div 30 (100 -70 DRD)
Tax Inc 30
Taxes 10.5 (35% * 30)
Tax Savings 24.5 (35 taxes on CGs saved 10.5 on dividends paid)

Ordinary Distributions:
Put Option
Call
Short Position
Long Positions
Leverage, borrowing to purchase

PROGRESSIVE CORPORATION V. UNITED STATES


(1) whether Progressive's simultaneous purchases of a stock and a put option on the same stock resulted
in a holding period of zero under 26 U.S.C. 246(c)(3) so that Progressive did not meet the 16-day
holding period prescribed in 26 U.S.C. 246(c)(1)(A) and thus failed to qualify for the "dividends
received" deduction otherwise allowed corporate taxpayers by 26 U.S.C. 243, and (2) whether
Progressive's purchase of a stock and the simultaneous, or nearly simultaneous, sale of deep-in-the-
money call options resulted in a holding period of zero under 26 U.S.C. 246(c)(3) so that Progressive
did not meet the 16-day holding period prescribed in 26 U.S.C. 246(c)(1)(A) and thus failed to qualify for
the dividends received deduction established by 26 U.S.C. 243.
The government contends that certain 1984 amendments to the statute, which do not apply
directly to the years in question here, show that Congress considered risk of loss a
prerequisite to the deduction. Progressive argues that the legislative history of the 1984
amendments is irrelevant to an earlier Congress' intent.

Progressive essentially had a Short position: but under 246..


Special rules. Section 246(c) requires that the holding periods determined thereunder
shall be appropriately reduced for any period that the taxpayer's stock holding is
offset by a corresponding short position resulting from an option to self, a contractual
obligation to sell, or a short
Thus, according to the district court, the holding period would be reduced only when the
corporate taxpayer was actually short the stock in question, i.e., when it did not own that stock.
If the taxpayer does not own the stock, however it will not receive any dividends which the
deduction at issue might apply. Thus, no corporation in a short position as defined by the district
court would ever receive a dividend in the first place. This makes nonsense out of the very idea
of a holding period ....For these reasons the District Court decision is reversed

Special Rules for Corporate Shareholders:


The DRD (Dividends Received Deduction) is generally only available for dividend paid by a US
corporation. 243(a)
Certain dividends from foreign corporations are eligible for the DRD:
Dividends from 10%-owned foreign corporations to the extent that the E&Ps were subject to the
US tax. Sec. 245(a)(1).
Dividends from a wholly owned foreign subsidiary, if all of the subsidiaries gross income was
effectively connected with a US trade/business 245(b)(2)
Dividends from foreign corp. That succeeds to E&Ps accumulated by a US corp. 243(e)

24
For 20% corporate shareholder E&Ps of the payor corporation have to be computed as if
sections 312(k) and (n) didnt apply; accelerated depreciation applies, installment sales rules
apply Sec. 301(e)

Ordinary Distributions: Dividend Stripping and Extraordinary Dividends


A Corporation that receives an extraordinary dividend that hasnt held the stock for more than 2
years before the dividend announcement date
Must reduce its basis in the shares by the non-taxed portion of the dividend
Must recognize gain if non-taxed portion exceeds the basis Sec 1059(a) and (b)
Extraordinary dividend
Dividend equals or exceeds 10% (5% for preferred stock dividends) of the recipients basis in
the shares. 1059(c)(1) and (2). SH can use FMV instead of AB. 1059(c)(4).
Can be distributions in kind as well. 1059(d)(2).
Qualifying dividends excluded (received from member of same affiliated group). 1059(e)(2).
Aggregation rules
All dividends received that have ex-dividend dates within 85 days
All dividends received within 1 year if dividend exceeds 20% of adjusted basis. 1059(c)(3).
Dividends from a corporation that the SH has owned since the paying corporations inception
are excluded. 1059(d)(6).
There is Dividend stripping with Debt-Financed Stock
DRD is limited to 70% or (80% from 20% owned Corp.) times
100% of the average indebtedness percentage
Debt-financed portfolio stock: Portfolio Stock subject to portfolio indebtedness, which is
indebtedness directly attributable to investment in the stock 246(c)(1), (2) and d(3)(A).
Rev. Rul. 88-66
Intercompany loans do not trigger 246

General Utilities Operating Co. v. Helvering


No tax at the corporate level
Shareholders receive a Dividend in the Amount of the FMV
GU avoids paying gains on Island shares by distributing them as Dividends
.... The intent of the directors of petitioner was to declare a dividend payable in Islands Edison
stock; their intent was expressed in that way in the resolution formally adopted; and the dividend
was paid in the way intended and declared. We so construe the transaction, and hold that the
declaration and payment of the dividend resulted in no taxable income."

The Commissioner asked the Circuit Court of Appeals, Fourth Circuit, to review the Board's
determination. He alleged: "The only question to be decided is whether the petitioner (taxpayer)
realized taxable income in declaring a dividend and paying it in stock of another company at an
agreed value per share, which value was in excess of the cost of the stock."

General GU Rule: No G/L recognized by the corporation on the current distribution of stock or
property. Section 311(a)
Special Rule for Appreciated Property (GU Repeal): Distributing corporation recognizes gain
(but not loss) on current distributions of appreciated property (other than obligations). Sec.
311(b).

25
Earnings and Profits (E&Ps):
1. E & Ps generally decreased by AB of distributed property. Sec. 312(a)(3)
2. If gain recognized under 311(b), E&Ps first increased by gain and then decreased by FMV of
property. Sec. 312(b).
3. If distributed property is subject to liabilities, E&Ps increased by liabilities assumed by
shareholder or to which the property is subject. Sec. 301(b)
1.Dividend is included in GI
2.Amount distributed in excess of current or accumulated E&Ps is return of
capital (basis reduced)
Any distribution in excess of 1 and 2 is treated as gain from the sale/exchange of
property (301(c))
a. Distribution of Corps Own Obligations:
b. No G/L recognized by corporation
c. Amount of distribution is FMV of obligation
d. E&Ps reduced by principal amount of obligation. 312(a)(2).

C-Corp S-Corp
Long term losses offset first the long term gains
You want to offset short term gains and carry over long term loss to other taxable years

The Primary Purpose of the DRD limitations:


Prevents Hedging
DRD creates tax favored income and an economic loss identical to gain that actually can give
you a tax refund
Starts with 100, dividend of 3, sell at 97. No economic change. Taxed 10% on $3, use the $3
loss to offset other capital gains and save a net of 20%
No substantially similar or related hedging related activity

The Purpose of the Extraordinary Dividend Rule:


An extraordinary dividend is generally any dividend equaling or exceeding five percent of the
corporation's basis in preferred stock or 10 percent of its basis in any other stock. For this
purpose, certain dividends received during a consecutive 85-day period (or within one year)
must be aggregated. A corporate shareholder's receipt of an extraordinary dividend is
analogous to a shareholder's receipt of a dividend from an S corporation. In each case, the goal
of the tax law is generally to prevent taxing at the shareholder level income that has previously
been taxed.

In addition, rather than requiring individuals who receive extraordinary dividends to reduce the
basis in their stock - a requirement tew shareholders would likely understand and comply
with - the law simply treats any resulting capital loss from sale of the stock on which the
extraordinary dividend is distributed as long-term rather than short-term. This treatment applies
regardless of the shareholder's holding period in the stock at the time of disposition, but is
limited to the amount of the extraordinary dividend treated as qualified dividend income.

26
DRD is only reduced by 70% of the dividend
$10 dividend, you can remove 7.
30 basis-7= 23 Basis
Sell for 20= 3 capital loss
Taxed for $3 of dividend
$3 capital loss can be carried over to offset capital gains

On February 25, corporation X purchases 1,000 shares of IBM stock for a total cost of
$100,000. X finances 60 percent of the acquisition by borrowing $60,000 from Local Bank.
Subsequently, IBM distributes a $2/share quarterly dividend to all shareholders of record as of
May 15, including X. (The prior dividend was distributed to holders of record as of February 15.)
Throughout the period, the full amount of X's debt remains outstanding. Determine the tax
consequences of the dividend to X.

DRD is .7 * .4= .28


Dividend is 2000-(2000*.28)= 1440
Taxed on $1,440 as Dividend for Ordinary Income

S-Corp, S earnings are reduced


If only S earnings reduced, no change in basis
After S earnings are exhausted or gone, then basis is reduced
Accumulated Adjusted Account

Redemptions
Treatment of a corporate redemption, a transaction very similar to an ordinary distribution. A
redemption, also sometimes called a "share buyback" or "share repurchase," is a distribution by
a corporation to a shareholder in exchange for some or all of the shareholder's stock in the
corporation.
Between 1999 and 2004, the amount of corporate earnings distributed by the companies
included in the S&P 500 stock index through share repurchases roughly equaled the amount
those companies distributed as dividends.
For closely held corporations (which may distribute few, if any, dividends), a share buyback
provides a practical way to overcome the liquidity problem resulting from the non marketability
of the corporation's shares. The buy back permits corporate assets to finance a change in the
ownership of the corporation
A sale or exchange allows a shareholder to recover their basis tax free
For those with a low basis it doesnt make a large difference
For those with a high basis they rather it be a sale or exchange so they can avoid 20% tax on
dividends
Corporations like to have dividends because the get the DRD
From the shareholder's perspective, the redemption looks similar to a sale of stock to a third
party or to the continuing shareholders of the corporation, either of which ordinarily results in
exchange treatment. The key is the shareholder's reduced interest in the corporation as a result
of each transaction; in the case of a complete redemption, the interest is terminated. On the
other hand, a redemption of only a portion of a sole shareholder's interest in a corporation is
generally treated for tax purposes like an ordinary distribution

27
Section 302
(a)General rule
If a corporation redeems its stock (within the meaning of section 317(b)), and if paragraph (1), (2), (3), (4), or (5)
of subsection (b) applies, such redemption shall be treated as a distribution in part or full payment in exchange
for the stock.
(b)Redemptions treated as exchanges
(1)Redemptions not equivalent to dividends
Subsection (a) shall apply if the redemption is not essentially equivalent to a dividend.
(2)Substantially disproportionate redemption of stock
(A)In general
Subsection (a) shall apply if the distribution is substantially disproportionate with respect to the
shareholder.
(B)Limitation
This paragraph shall not apply unless immediately after the redemption the shareholder owns less than 50 percent of
the total combined voting power of all classes of stock entitled to vote.
(C)Definitions For purposes of this paragraph, the distribution is substantially disproportionate if
(i) the ratio which the voting stock of the corporation owned by the shareholder immediately after the redemption
bears to all of the voting stock of the corporation at such time,
is less than 80 percent of
(ii) the ratio which the voting stock of the corporation owned by the shareholder immediately before the redemption
bears to all of the voting stock of the corporation at such time.
For purposes of this paragraph, no distribution shall be treated as substantially disproportionate unless the
shareholders ownership of the common stock of the corporation (whether voting or nonvoting) after and before
redemption also meets the 80 percent requirement of the preceding sentence. For purposes of the preceding
sentence, if there is more than one class of common stock, the determinations shall be made by reference to fair
market value.
(D)Series of redemptions
This paragraph shall not apply to any redemption made pursuant to a plan the purpose or effect of which is a series
of redemptions resulting in a distribution which (in the aggregate) is not substantially disproportionate with respect
to the shareholder.
(3)Termination of shareholders interest
Subsection (a) shall apply if the redemption is in complete redemption of all of the stock of the corporation owned
by the shareholder.
(4)Redemption from noncorporate shareholder in partial liquidation Subsection (a) shall apply to a distribution
if such distribution is
(A)in redemption of stock held by a shareholder who is not a corporation, and (B) in partial liquidation of
the distributing corporation.
(5)Redemptions by certain regulated investment companies Except to the extent provided in regulations
prescribed by the Secretary, subsection (a) shall apply to any distribution in redemption of stock of a publicly
offered regulated investment company (within the meaning of section 67(c)(2)(B)) if
(A)such redemption is upon the demand of the stockholder, and
(B)such company issues only stock which is redeemable upon the demand of the stockholder.

In deciding whether a redemption looks more like a sale of stock or an ordinary distribution to
the shareholder being redeemed, current law applies an extensive set of"constructive
ownership" rules to try to identify the true economic interest of the shareholder in the
corporation both before and after the transaction. These rules, which also apply for certain other
tax purposes (but only if specifically cross-referenced), treat a taxpayer as owning stock that is
actually owned by someone else if they have a sufficiently close relationship. Thus, the rules
represent a further effort to determine tax consequences based on substance rather than form.
Where there are several relationships among the shareholders that might justify attribution, it is
important to remember that any given shareholder cannot end up owning, directly and indirectly,
more than 100 percent of the corporation in question. Thus, a useful general approach is to

28
examine each shareholder separately and determine how much of the stock actually owned by
others is treated as owned by the shareholder in question.

Immediately after redemption, SH owns <50% of total combined voting power of all classes
entitled to vote
SH also must satisfy the requirement that their ownership of common stock (voting and
nonvoting) after and before redemption also satisfies the 80% requirement
Reduction is tested on an aggregate basis

Redemption: Substantially Disproportionate


Immediately after transaction, you must own less than 50% of total combined voting power over
the company
SHs ownership of common stock (voting and nonvoting) after and before before and must also
satisfies the 80% requirement (80% of previous holding)
Reduction is tested on an aggregate and not class-by-class basis. Rev. Rule 87-88.
Rev. Rul. 81-41
If you dont have any common stock, the requirement that you reduce common stock holdings is
waived by I.R.S. (Commissioner)

Redemptions: Rev. Rule. 85-14


After the dust settles A owns more than 50% of X, and As ownership was reduced from 72.18%
to 61.37%
You must be below 50% for the benefit of Substantially Disproportionate
When does the snapshot get take, satisfy in March, Dont in September
A knew B would retire, he structured his redemption for the purpose of meeting the Substantially
Disproportionate rule and then regaining a control interest after the retirement. IRD recognized
this and disallowed A from receiving benefit

Exemption to Family Attribution 302(c)(2)


(A) In the case of a distribution described in subsection (b)(3), section 318(a)(1) shall not apply if
(i) immediately after the distribution the distributee has no interest in the corporation (including an interest as
officer, director, or employee), other than an interest as a creditor, ii) the distributee does not acquire any such
interest (other than stock acquired by bequest or inheritance) within 10 years from the date of such distribution, and
(iii) the distributee, at such time and in such manner as the Secretary by regulations prescribes, files an
agreement to notify the Secretary

Lynch v. CIR
We hold that a taxpayer who provides post-redemption services, either as an employee or an
independent contractor, holds a prohibited interest in the corporation because he is not a
creditor. The legislative history of section 302 states that Congress intended to provide "definite
standards in order to provide certainty in specific instances.
... Taxpayers who wish to receive capital gains treatment upon the redemption of their
shares must completely sever all non-creditor interests in the corporation. We
hold that the taxpayer, as an independent contractor, held such a non-creditor interest,
and so cannot find shelter in the safe harbor of section 302( c)(2)(A)(i). Accordingly, the
family attribution rules of section 318 apply and the taxpayer fails to qualify for a
complete redemption under section 302(b)(3). The payments from the corporation in
redemption of the taxpayer's shares must be characterized as a dividend distribution
taxable as ordinary income under section 301. ...

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See 318(A)(ii) Family Attribution Rule

United States v. Davis:


[I]t was necessary that the attribution rules apply to 302(b )( 1) unless they were to be
effectively eliminated from consideration with regard to 302(b)(2) and (3) also. For if a
transaction failed to qualify under one of those sections solely because of the attribution rules, it
would according to taxpayer's argument nonetheless qualify under 302(b)(l). We cannot agree
that Congress intended so to nullify its explicit directive. We conclude, therefore, that the
attribution rules of 318(a) do apply; and, for the purposes of deciding whether a distribution is
"not essentially equivalent to a dividend" under 302(b)(l), taxpayer must be deemed the owner
of all 1,000 shares of the company's common stock. .. After application of the stock ownership
attribution rules, this case viewed most simply involves a sole stockholder who causes part of
his shares to be redeemed by the corporation. We conclude that such a redemption is always
"essentially equivalent to a dividend" within the meaning of that phrase in 302(b)(l)...
If a corporation distributes property as a simple dividend, the effect is to transfer the property
from the company to its shareholders without a change in the relative economic interests or
rights of the stockholders. Where a redemption has that same effect, it cannot be said to have
satisfied the "not essentially equivalent to a dividend" requirement of 302(b)(l).

Note: For example, after applying the constructive ownership of stock rules of section 318 of the
Code in Davis, the taxpayer owned all of the redeeming corporation's stock both before and
after the redemption with the result that the distribution was precisely pro rata and, thus,
essentially equivalent to a dividend .

Redemptions Partial Liquidations:


Partial Liquidations (302(e)):
Applies to noncorporate shareholders
Can be non pro-rata
Partial liquidation of corporation
Distribution not essentially equivalent to a dividend (determined at the corporate level)
Pursuant to a plan and occurs w/in the TY the plan is adopted or succeeding TY. 302(e)(1).
Distribution is attributable to corporations ceasing to conduct (or consists of the assets of) a
Qualified T/B; and immediately after distribution, distributing corporation is actively engaged in
Qualified T/B
Qualified T/B: actively conducted throughout 5-year period ending on date of redemption; and
not acquired in taxable transaction w/5 previous 5 years. 302(e)(3).
Corporate SH: any amount treated as dividend in a partial liquidation is an extraordinary
dividend. 1059(e)(1)(A)(i).
For ruling purposes, the distribution must result in at least a 20% reduction in gross revenues,
net fair market value of assets, and employees. Rev. Proc. 2008-3.

Finish Heinz Next Time: Skip the Divorce stuff

Grove v. CIR:
We are not so naive as to believe that tax considerations played no role in Grove's planning. But foresight
and planning do not transform a non-taxable event into one that is taxable. Were we to adopt the
Commissioner's view, we would be required to recast two actual transactions-- a gift by Grove to RPI and
a redemption from RPI by the Corporation-- into two completely fictional transactions-- a redemption from
Grove by the Corporation and a gift by Grove to RPI. Based upon the facts as found by the Tax Court, we

30
can discover no basis for elevating the Commissioner's 'form' over that employed by the taxpayer in good
faith. 'Useful as the step transaction doctrine may be in the interpretation of equivocal contracts and
ambiguous events, it cannot generate events which never took place just so an additional tax liability
might be asserted.

Life Income Fund Plan


Donate shares and donor retains life interest
RPI could freely transfer shares but Grove Corp retained right of first refusal at book value
RPI generally was redeemed one to two years after donation
The redemption proceeds were deposited in an account managed by Groves investment
adviser
The income from the account was paid to and reported by Grove
What did the IRS argue?
The Commissioner of Internal Revenue refused to approve these arrangements. Instead, he assessed
deficiencies in Grove's income taxes for the years 1963 and 1964, contending that Grove had employed
RPI as a tax-free conduit for withdrawing funds from the Corporation and that redemption payments by
the Corporation to RPI were in reality constructive dividend payments to Grove. Grove successfully
challenged the deficiency determinations in the Tax Court, and the Commissioner appealed. We affirm.

Zenz v. Quinlivan
The question as to whether the distribution in connection with the cancellation or the redemption
of said stock is essentially equivalent to the distribution of a taxable dividend under the Internal
Revenue Code and Treasury Regulation must depend upon the circumstances of each case.
The intent of the taxpayer was to bring about a complete liquidation of her holdings and to
become separated from all interest in the corporation, the conclusion is inevitable that the
distribution of the earnings and profits by the corporation in payment for stock was not made in
such manner as to make the distribution and cancellation or redemption equivalent to the
distribution of a taxable dividend ....

Common logic dictates that a fair basis of measuring income is not determined upon the
profits on hand in the year of liquidation but is properly attributable to each year in which
the profits were gained. We cannot concur with the legal proposition enunciated by the District
Court that a corporate distribution can be essentially equivalent to a taxable dividend even
though that distribution extinguishes the shareholder's interest in the corporation.

The Zenz transaction is commonly referred to as a bootstrap" acquisition because the purchase price is
financed in part by the assets of the corporation being acquired. A bootstrap acquisition has traditionally
been a favorite way to structure a buyout since it permits a withdrawal of E&P at a preferential long-term
capital gain rate. In other words, a plain vanilla stock redemption can be viewed as resulting in a bailout.
As illustrated by Zenz, under current law, the transaction drains out most, but not all, of the corporation's
E&P. See I.R.C. 312(n)(7).

Payment of Personal expenses by corporation is treated as taxable dividends


Payment of taxes
Payment of Rent
Constructive Dividend**

31
Sit. 1 & 2: SH-level buy-sell agreement btwn A & B assigned to X after departure and death of
B. X redeemed Bs shares.
In this case, A had a primary and unconditional obligation to perform his contract with B at the
time the contract was assigned to X. Therefore, the redemption by X ofits stock held by B will
result in a constructive distribution to A. ...

Sit 3: Trust owns shares of X terminates in 69. A purchases Bs interest in trust for 25x and
deferred payment of 20x in 66. In 69, X reimburses A for 25x and redeems Bs shares for 20x.
B did transfer all of his beneficial and equitable ownership of the X stock to A in exchange for an
immediate payment by A of 25x dollars and an unconditional promise to pay an additional 20x
dollars upon termination of the trust. The payment by X of 20x dollars to B and 25x dollars to A
in 1969 constituted a constructive distribution to A in the amount of 45x dollars ....

Sit 4: A agreed to purchase (or cause to be purchased) Bs shares. B was free to sell to 3rd
party. A causes X to redeem Bs shares when A had no obligation to purchase stock.
At the time of the redemption, B was free to sell his stock to A or to any other person, and A had
no unconditional obligation to purchase the stock and no fixed liability to pay for the stock.
Accordingly, the redemption by X did not result in a constructive distribution to A ....

Sit 5: Agreement btwn A & B provided that X would redeem their shares upon death, with either
shareholder being liable to satisfy the obligation if X didnt redeem.
In this case A was only secondarily liable under the agreement between A and B. Since A was
not primarily obligated to purchase the X stock from the estate of B, he received no constructive
distribution when X redeemed the stock.

Sit 6: A owns 100% of X. B agreed to purchase As shares, but PA permitted B to fully assign
purchase obligation to Corp. B assigned PA to Y, which purchased X shares. Y subsequently
merged into X.
Since A did not contemplate purchasing the X stock in his own name, he provided in the
contract that it could be assigned to a corporation prior to the closing date. A chose this latter
alternative and assigned the contract to Y. A was not personally subject to an unconditional
obligation to purchase the X stock from B ....

Sit 7: Original buy-sell agreement btwn A & B to repurchase upon death was rescinded; new
agreement provided that X would redeem.
At the time X agreed to purchase the stock pursuant to the terms of the new agreement, neither A nor B
had an unconditional obligation to purchase shares of X stock. The subsequent redemption of the stock
from the estate of either pursuant to the terms of the new agreement will not constitute a constructive
distribution to the surviving shareholder.

Redemption treated as sale/X


G/L (value minus AB of shares)
Any loss recognized may be limited by section 267 (50%-or-more owned corporation)
Basis Issues in the case of Ordinary Distributions
Basis probably reduced on a share-by-share basis (instead of aggregate basis). Prop. Reg.
1.302-2(a).

32
Basis Issues in the case of Redemption Treated as a Dividend
Where does the basis of the redeemed shares go?
Proper adjustment of basis of remaining stock will be made with respect to stock redeemed
Reg. 1.302-2(c).
If SH retains any other shares, basis goes to those shares. Reg. 1.302-2(c), Exs. 1 and 3.
If no other shares, basis transferred to shares of related person if those shares attributed to the
redeemed SH. Reg. 1.302-2(c), Ex. 2.

Redemptions: Notice 2001-45 (Basis Shifting Shelters)\


Corp X and unrelated Y each purchase 1,000X shares of Corp Z.
Corp Y is a tax-indifferent party (may be tax-exempt or foreign corporation)
Corp Y purchases from Corp X an Option to purchase from Corp X and Option to purchase 2,000X
shares of Corp Z Stock
Corp Z redeems Corp Ys share in a transaction that is treated as a dividend. Why? Hint: Option
attribution rules.
Corp Ys basis in the redeemed shares goes to Corp Xs shares of Corp Z under Reg. 1.302-2, Ex. 2.

H.J. Heinz Co. v. US (Fed Cl. 2007)


According to Goldman Sachs, Heinz's investment banker, the Note, including its conversion privilege, was
"reasonably valued" at $130.5 million when issued, or the same value as the shares bought back by
Heinz. The purchase by HCC and share buyback by Heinz occurred during a period in which Heinz was
regularly engaged in purchasing its own common stock on the open market for various corporate
purposes.
In May 1995, HCC sold its remaining 175,000 Heinz shares to AT&T for about $7 million in cash. Thus,
HCC's short-term investment in Heinz stock produced about a $6.5 million profit ($130.5 million note plus
$7 million cash less $131 million purchase price and transaction costs). In addition, during the period it
held the Heinz stock, HCC received about $1. 7 million in Heinz dividends and paid an unspecified
amount of borrowing costs.
Heinz actually increased following the redemption. See I.R.C. 318(a)(4). The taxpayer therefore claimed
that HCC's basis in the shares sold back to Heinz shifted over to HCC's remaining 175,000 shares in
Heinz. Thus, the sale of those shares to AT&T resulted in a $124 million capital loss ($7 million amount
realized less $131 million total basis). This loss was carried back to offset significant capital gains realized
by the group in 1992-94.]
But Intercompany dividends within the same consolidated group are tax exempt. Heinz and HCC
are the same corporate group, there is thus no dividend tax from one to the other.

Proposed Regulations:
Generally no reallocation of basis to either retained shares or shares held by another through
attribution rules
For redemptions treated as a dividend distribution, once there are no additional E&Ps, basis of
shares is reduced on a share-by-share basis. Thus, you can have gain on some shares but not
on others. Prop. Reg. 1.302-5(a)(1).
If some shares are retained after the redemption, the proposed regulations create a deemed
exchange (aka: recapitalization) of all of the shares owned immediately before the redemption
for all of the shares owned immediately after the redemption. The basis of the redeemed
shares is retained in the remaining shares under a tracing approach. Prop. Reg. 1.302-5(a)(2).
Basic idea: same result in this case and the case in which no shares are cancelled.
If no shares are retained after the redemption, under the proposed regulations, the
unrecovered basis of the redeemed shares (after taking into account the above adjustments) is
a deferred loss that can only be recognized when, for example, the redeemed SH would satisfy

33
sections 301(b)(1), (2), or (3), if the facts and circumstances existing at the end of such day
existed immediately after the redemption. Prop. Reg. 1.302-5(a)(3), (b)(4)(A).

Basis of the share you get back will have the same basis as the shares you gave

Transfers to Controlled Corporations: Section 351 Requirements


The Transfer of property to a corporation (new or existing) solely in exchange for stock is tax
free to both the corporation and transferor(s).
The Transferors must transferors must transfer property...solely in exchange for stock
The transferors must be in control of the corporation immediately after. Sec. 351(a)
Property: includes $, but not services, open account debt, or accrued interest

What is a Hedge Fund?


Pool of investors assets which is discretionarily managed by a manager which is typically the
sponsor of the fund
How did managers get so rich off of this?
2 and 20 rule
2%management fee
20% of yearly profits (sometimes in excess of a hurdle rate)- the carried interest
How is a hedge fund manager taxed?
Management fee Ordinary Income
Carried Interest Underlying character of the income flows through
If underlying portfolio has short term capital gains, then the Hedge Fund Manager earns short-
term capital gains
Characteristic of gain or loss flows through to the Manager
Vast majority is treated as short term capital gain which is NOT entitled to preferential capital
gains rates

What is an option?
An instrument which references and underlying financial instrument such as a stock. Offer the
buyers the right to buy (call) or sell (put) a security or other financial asset at an agreed-upon
price
Put Option vs. Call Option
Most options are settled with cash
Option is treated as a capital asset and entitled to long term capital gain or loss
This is how we turn short term gains into long-term gains
Option price/Premium
Reflects
Moneyness: Spread between underlying securities price and strike price (in or out of the money)
Time value: Distance between current date and expiration date

Basket Options Trade: The Trade


Hedge Fund entered into basket contract
The Contract was papered as an at the money call option on a basket of securities
Hedge Fund paid an option premium
Investment bank gave back the premiums, only charged the financing fees
It does not appear that the investment bank could ever lose money because they could
terminate if value dropped more than 10%

34
Govt argued the transaction meant that the Basket Option would always be exercised
The Cash Settlement Account calculation ensured the hedge fund was always going to exercise
its option in order to recoup at least a portion of its investment
What about the knock-out provision
The ability to alter the asset composition in reference basket is inconsistent with an option which
is a contract on a particular referenced asset open for a period of time.
Margin Call: Kevin Spacey
Ok so it probably wasnt an option? What was it then?
A Margin loan most likely

Transferors to Controlled Corporations: Section 351 Requirements


The transfer of property to a corporation (new or existing) solely in exchange for stock is tax free
to both the corporation and transferor(s) if the transferor(s) controls the corporation immediately
after the transfer.
If property other than stock is received, e.g., money, the transferor recognizes gain (but not loss)
to the extent of the value of the property (boot) received.
The transferor(s) and corporation take a carryover basis in the stock and property received,
increased by any gain recognized.
Note: One potential gain (at the SH level) now becomes two: one at the SH level and the other
at the corporate level. Welcome to the world of Sub C.
Transfers to Investment Companies dont qualify under section 351
Transfer results in diversification of transferor's interest, and
Transferee is:
oRIC
oREIT

Corp > 80% of value of assets (excluding $ and nonconvertible debt obligations) are held for
investment and are stock or securities (or interests in RICs or REITs). Reg. 1.351-1(c)(1).
Diversification: two or more persons transfer nonidentical assets. Reg. 1.351-1(c)(5).
Special rules for transfers of diversified portfolios. Reg. 1.351-1(c)(6).
This issue arose in William Cos v. Energy Transfer (Del, 2016).

Control 80%: Ownership must be direct and not by attribution (No Family Attribution)
To satisfy (b), transferor(s) must own 80% of the total shares of each class of non-voting stock.
Rev. Rul. 59-259.

For ruling purposes, the property transferred must at least be 10% of pre existing holdings in the
transferee
Transaction to wholly owned subsidiary of control owners of holding company are considered as
separate transactions for the purposes of 351 Rev Rul 77-449

How do we calculate the boot to realize this gain?


The general rule is that each asset transferred must be considered to have been separately
exchanged .... Thus, for purposes of making computations under section 351 (b) of the Code, it
is not proper to total the basis of the various assets transferred and to subtract this total from the
fair market value of the total consideration received in the exchange. Moreover, any treatment

35
other than an asset-by-asset approach would have the effect of allowing losses that are
specifically disallowed by section 351(b)(2) of the Code.

Asset 1: no recognition of loss (never recognize loss period)


Asset 2: recognize 3x short term of gain
Asset 3: 5x of gain (5x of ordinary income)

Evaluate on an asset by asset basis


Recognize gain, pay tax, basis adjusted accordingly

Securities and nonqualified preferred stock of the transferee. The "solely for stock" requirement
represents an additional condition to distinguish a qualifying section 351 transaction from a sale
of the transferred property in which the transferor must recognize gain or loss. The statute has
been amended to narrow the type of consideration that qualifies for nonrecognition treatment
under section 351. Formerly, a transfer of property in exchange for securities of the transferee
(generally, a long-term debt instrument) qualified for such treatment, but this is no longer
permitted. (The regulations have not been fully updated to reflect this change. See, e.g., Reg.
1.351-l(a)(l).) In addition, a transfer in exchange for "nonqualified preferred stock" ("NQPS") of
the transferee is generally taxed as if the transferor received boot, and not stock, on the theory
that such preferred stock represents a more secure form of investment than the property
transferred. See I.RC. 351(g)..

Nonqualified Preferred Stock (NQPS)


Limited and preferred as to dividends and does not participate in corporate growth to any
significant extent, and the NQPS is putable by holder, redeemable by issuer and more likely
than not to be redeemed, or the dividend rate varies with reference to interest rates, commodity
prices or similar indices. 351(g)(2) and (3).
These rules apply if the rights/obligations can be exercised w/in 20 years.
Section 351 doesnt apply to T who receives only NQPS--T will recognize G or L--but is still
treated as stock for purposes of section 351 control test
If transferor receives NQPS and other stock, NQPS treated as boot.

SH takes carryover basis in stock received. Sec. 358(a)(1)


If more than one class of stock received, basis allocated in proportion to FMV. Reg. 1.358-2(b)

36
Tacked holding period for capital or 1231 assets. 1223(1). Shares can have part LT and ST
holding period.
SH probably must allocate basis of transferred property to shares received on an aggregate
basis

What about properties with net-built in losses?


If property w/ a net built-in loss is transferred in a 351 transaction, the corporations aggregate
AB is limited to the FMV of the property. 362(e)(2)(A).

1.362(b): (1) In general. The purpose of section 362(e)(2) and this section is
to prevent the duplication of net loss in transfers to which section 351
applies, capital contributions, and paid-in surplus (each, a section 362(a)
transaction). See paragraph (g) of this section for definitions of terms used
in this section.

Massive assets were being transferred from Foreign Entities to US Companies, Foreign entities
didnt care about built in losses, they did not pay tax on sale of property or stock

Adjusted Basis FMV


GA 5k 10k

LA 12k 10k

Inv 2k 5k

GA LA Inv

40% 40% 20%

2k 2k 1k

Gain from boot 2k 0 1k

5k (2k) 3k

The Transferee Corp. takes a carry-over basis in the property increased by any gain recognized
by the transferor

Jones: Basis of 19 Loss of (5) Gain of 3


Adjusted Basis of 17k at the end
For ruling purposes: must contribute 10% of assets to count as a transferor under rule 351

Transfers to Controlled Corporation

37
Commissioner v. Fink
Facts: The Finks received no consideration for the surrendered shares, and no other
shareholder surrendered any stock. On their 1976 and 1977 joint federal income tax returns, the
Finks claimed ordinary loss deductions totaling $389,040, the full amount of their adjusted basis
in the surrendered shares. The Commissioner of Internal Revenue disallowed the deductions as
a contribution to the corporation's capital.
In contrast, when a shareholder surrenders shares of the corporation's own stock, the
corporation's net worth is unchanged. This is because the corporation cannot itself exercise the
right to vote, receive dividends, or receive a share of assets in the event of liquidation .. . . A
shareholder who surrenders a portion of his shares to the corporation has parted with an asset
but that alone does not entitle him to deduction.
Reallocation of basis is consistent with the general principle that "payments
made by a stockholder of a corporation for the purpose of protecting his interest
therein must be regarded as [an] additional cost of his stock,"
We conclude only a controlling shareholder's voluntary surrender of shares, like
contributions of other forms of property to the corporation are not an occasion for
recognition of gain or loss ....

Transfers to Controlled Corporations: Assumption of Liabilities


Assumption of liability is generally NOT treated as boot. 357(a).
Assumption of liability is treated as boot if:
Tax avoidance/non-bona fide business purposes; or
Sum of liabilities assumed exceeds the total adjusted bases of property transferred. 357(b) and
(c).
Section 357(c) applies regardless whether any gain is realized upon transfer of property
Liabilities in excess of basis -not treated as boot if they would give rise to a deduction. 357(c)
(3).
This is intended to permit the tax-free incorporation of a cash basis taxpayer who transfers
payables that are greater than the AB of the transferred property.
The assumption of a liability (except for a liability that would give rise to a deduction) is treated
as money received by transferor for purposes of determining the transferors basis in the
stock received (thus requiring a reduction in the basis of the shares received). 358(d).

Assumption of Liability is treated as Money received in a transaction


For Example
Property worth 100 FMV, Basis of 50, Liability of 10
Sells for 90, with assumption of liability for 10
Gain is 50
40 cash, 10 in assumption of liability, 50 total gain

But remember, Basis can never be less than zero


If assumption of liability exceeds basis, then it is treated as boot
Not treated as boot if liability would give rise to a deduction
Payables being rolled over into corporation would be deductions that would otherwise be
recognized as gains

Section 357(c)(l) provides a second exception to the general rule of 357(a).

38
Section 357(c)(l) provides that if the sum of the liabilities the transferee corporation assumes
and takes property subject to exceeds the total of the adjusted basis of the property the
transferor transfers to the corporation pursuant to the exchange, then the excess shall be
considered as gain from the sale or exchange of the property. For purposes of applying the
exception in 357(c)(l), 357(c)(3)(A) provides that a liability the payment of which would give
rise to a deduction ... is excluded. This special rule does not apply, however, to any liability to
the extent that the incurrence of the liability resulted in the creation of, or an increase in, the
basis of any property. Section 357(c)(3)(B).

Transferees Basis is increased by any gain

In Rev. Rul. 80-198, 1980-2 C.B. 113, an individual transferred all of the assets and liabilities of
a sole proprietorship, which included accounts payable and accounts receivable, to a new
corporation in exchange for all of its stock. The revenue ruling holds, subject to certain
limitations, that the transfer qualifies as an exchange within the meaning of 351(a) and that the
transferee corporation will report in its income the accounts receivable as collected and will be
allowed deductions under 162 for the payments it makes to satisfy the accounts payable. In
reaching these holdings, the revenue ruling makes reference to the specific congressional intent
of 351(a) to facilitate the incorporation of an ongoing business by making the incorporation tax
free. The ruling states that this intent would be equally frustrated if either the transferor were
taxed on the transfer of the accounts receivable or the transferee were not allowed a deduction
for payment of the accounts payable.

Payables are NOT counted for liabilities in excess of basis that would allow them to be treated
as boot

Problem 7-2:
(a) Absent 357.. Kind of confusing
(b) What are the tax consequences under current law? What is the rationale for the result? What
is the role of section 358(d)? What happens to the gain that would be recognized by A but for
section 357(a)? Basis of 50, Property Mortg. 20, FMV is 100. Transfer to Corp get stock worth
$80, 100% Control
Basis in new shares; 50 if no liability; since liabilities are not in excess of basis, they are not
treated as boot, New Basis is 30.
358 Calculation, 50-20=30 basis, no gain recognized until stock is sold

(c) Same as (b), except that the amount of the mortgage is $60 and X issues only $40 stock to
A. What is the rationale for this result?
FMV of stock received is 40
10 of gain recognized per 357(c)
Resulting 0 Basis in 40 FMV stock (typically 0 basis when liability exceeds basis)
358(a)(B)(ii), sold stock 1 second later, 40 of gain

(d) Same as (c), except that in the same transaction, A transferred Whiteacre (fair market value
$20 and basis $10) to X in exchange for an additional $20 of X stock. See Reg. 1.357-2(a).

(e) Same as (c), except that the amount of the mortgage is $40 and X also assumes $20 of A's
accounts payables. A, a cash-basis taxpayer, had incurred the liabilities in the ordinary course of
business in exchange for certain services provided to A. What is the rationale for this result?
What happens to the gain that would be recognized by A but for

39
section 357(a)?

(f) Same as (e), except that A was an accrual-basis taxpayer.

(g) Ms. B purchased Whiteacre for $30,000 cash five years ago. It is now worth $100,000 and
she still owns it outright. B would like to incorporate Whiteacre in her wholly-owned corporation,
Landco, and B is also in need of $20,000 cash. In lieu of transferring Whiteacre to Landco for
$80 000 of additional Landco stock and $20,000 cash, B decides on the following plan: First, B
goes to Local Bank and borrows $20,000 cash, pledging Whiteacre as collateral. Second, B
transfers Whiteacre to Landco in exchange for $80,000 of Landco stock and Landco' s
assumption of the liability. Finally, Landco pays off the debt to Local Bank. What are the tax
consequences of this transaction? How would your answer change if the amount of cash
needed by B and transferred to her in the manner indicated was $40,000 and not $20,000?
Tax Avoidance Purposes

Payables that give rise to deductions do not reduce basis because the deduction will be
available once paid.

Property; 50 adjusted basis, 40 mortg., 100 fmv, Payable of 20, in exchange for control stock
worth 40.
New Basis is 10; No gain recognized
30 gain upon sale of new stock at FMV
358(d)(2): You DO NOT have to reduce basis for accounts payable
Accrual Basis (see E) you do reduce basis, pay gain on the amount liability exceeds basis

357(c)(3)
Rev Rule 95-74
The present case is analogous to the situation in Rev. Rul. 80-198. For business reasons, P transferred in
a 351 exchange substantially all of the assets and liabilities associated with the Manufacturing Business
to S, in exchange for all of its stock, and P intends to remain in control of S. The costs S incurs to
remediate the land would have been deductible in part and capitalized in part had P continued the
Manufacturing Business and incurred those costs to remediate the land.
HOLDINGS
(1) The liabilities assumed by Sin the 351 exchange described above are not liabilities for purposes of
357(c)(l) and 358(d) because the liabilities had not yet been taken into account by P prior to the transfer
(and therefore had neither given rise to deductions for P nor resulted in the creation of, or increase in,
basis in any property of P).
(2) The liabilities assumed by S in the 351 exchange described above are deductible by S as business
expenses under 162 or are capital expenditures 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 P).

Bail Corporation and Out Corporation each have 100 shares of common stock outstanding. Claude owns
80 shares of Bail stock (with a basis of $40,000, or $500 per share) and 60 shares of Out stock (with a
basis of $9,000, or $150 per share.) The remaining Bail and Out shares are owned by one individual who
is not related to Claude. Bail has no current or accumulated earnings and profits. Out has no current and
$5,000 of accumulated earnings and profits. Determine the tax consequences to the various parties in
each of the following alternative transactions:
(a) Claude sells 20 of his Out shares, in which he has a $3,000 adjusted basis, to Bail for $4,000.
304(a)(1), Claude is in Control of B & O because it is 50% or more

40
Stock for Cash here
Is this a redemption to which 301a dividend rule apply; sale or distribution?
O is issuing, B is acquiring
Substantially equivalent (must be below 50%) look through 40 directly and 16% in directly, Complete
Termination (NO), Disproportionate Distrb. (doesnt below 80%),
Treated as a Dividend for both; look through
There are 5k E&P for both so the 4K cash is entirely a dividend
The statute treats this as a redemption of the acquiring, carryover basis is taken by B, Basis goes back to
O
(b) Claude sells all of his Out shares to Bail for $12,000.
E & P Limitation
Look Through? Before C owned 60%, Now C owns 48% constructively, but it is below 50% so S/X
Is Property to be treated as redemption of the acquiring?
Recognize a $3,000 Gain
(c) Same as (a), above, except that Claude receives $3,000 and one share of Bail stock (fair market value
$1,000) for his 20 Out shares.
1k B Share, 3K cash
Breaks 304A because the share is not property, 351 v. 304; 304 trumps
351 applies to stock, 304 applies to cash
If 351 applies the 3K would be treated as Boot and 1K treated as gain
3K is recognized under 304 and treated as dividend (enough E&P between to companies)
(d) Same as (a), above, except that Claude receives one share of Bail stock (fair market value$1,000)
and Bail takes the 20 Out shares subject to a $3,000 liability that Claude incurred to buy the 20 shares of
Out stock.
351 transaction assumption of liability is treated as money received, but 351 doesnt apply

Transfers to Controlled Corporations: Assumption of Liabilities and Rev Rul. 95-74


Any Liabilities Assumed in excess of Basis is treated as gain and the basis is adjusted down to
zero
Otherwise Assumption of Liability is treated as cash and reduce the basis
Unless the Liability is a business deduction that has not yet been taken

Coltec on Appeal Federal Circuit The Federal Circuit (Judges Bryson, Gajarsa and Dyk)
reversed the opinion of the Court of Federal Claims and held that the taxpayer was not entitled
to a capital loss because the assumption of the contingent liabilities in exchange for the note
lacked economic substance.
The Federal Circuit upheld the technical analysis of the Court of Federal Claims.
The court concluded that section 357(c)(3) applies because payment of the liability would give
rise to a deduction. The court stated that the governments interpretation that the liabilities must
be transferred with the underlying business was plainly inconsistent with the statute.
The court concluded that if a liability was excluded by section 357(c)(3), then section 357(b)(1)
was not relevant. The court reasoned that the exception in section 358(d)(2) for liabilities
excluded under section 357(c)(3) does not contain any reference to section 357(b), nor does
section 357(b) contain any reference to the basis provisions in section 358.

(5) principles of economic substance. 1. The law does not permit the taxpayer to reap tax
benefits from a transaction that lacks economic reality; 2. It is the taxpayer that has the burden
of proving economic substance; 3. The economic substance of a transaction must be viewed

41
objectively rather than subjectively; 4. The transaction to be analyzed is the one that gave rise
to the alleged tax benefit; 5. Arrangements with subsidiaries that do not affect the economic
interest of independent third parties deserve particularly close scrutiny

Corporation could not give its own note because Corporations do not get any basis in their own
note
These are c(3) contingent liabilities so Basis does not need to be reduced
357 (b)(1) doesnt apply to c(3) liabilities, only c(1)

Contingent Liabilities and Basis: Sections 358(h) 357(d)


If the basis of the stock received is greater than its FMV, the basis is reduced by liabilities
assumed that are not taken into account under section 358(d), e.g., contingent liabilities such as
environmental liabilities.

The basis reduction rule doesnt apply if the T/B with which the liability is associated or
substantially all of the assets with which the liability is associated is transferred to the person
assuming the liability. 358(h)(2)(A).
Section 357 applies to liabilities that are assumed.

Recourse liability assumed if transferee agrees to satisfy liability whether the transferor has
been relieved of the liability.

(real-estate) Non-recourse liability: is treated as assumed if assets subject to liability is


transferred, but if there are non-transferred assets subject to the same liability, the liability is
reduced by the lesser of:
other amount that the owner of the non-transferred assets has agreed to satisfy, or
other FMV of the non-transferred assets. 357(a)(1) and (d)(1).

Corporate Transferees basis limited:

to FMV by reason of gain recognized under section 357; or

if gain recognized by foreign person on transfer of property subject to NR liability that is secured by non-
transferred assets, gain recognized is determined as if transferee assumed only a ratable shares of the
NR liability (FMV of transferred and non-transferred properties. 362(d)(1) and (2).

Redemptions Through Related Corporations: Section 304 and Brother-Sister Acquisitions


Acquiring Company vs. Issuing Company
Sale or Exchange vs Redemption? (Under section 304)
But related-party sale
If we respect the form it is then a sale or exchange
If it is not taxed as dividend, E&P can be removed from Y without being taxed
Basis tells you how much you are taxed, dividend is entirely taxed, sale or exchange is taxed in
excess of basis, in Dividend you get DRD tax break

304 Constructive Ownership


Property is everything except shares of the acquiring company
I.e. does not apply to stock of the company making distribution

42
Section 304(a)(1) potentially applies if one or more persons are in control of each of two
corporations and in return for property, one of the corporations acquires stock of the other
corporation from the person(s) in control.

Control:
50% of total combined voting power of all classes of stock entitled to vote, or
50% of total value of shares of all classes of stock.
If the corporation has more than 1 class of stock, voting power is tested on an aggregate basis.
Rev. Rul. 89-57.
If Corp A controlled and owns 50% of vote or value of Corp B, then Corp B is
controlled. 304(c)(1).

318 attribution rules apply to determine control, but with modifications:


Corporation-to-SH (SH owns what Corp owns) attribution threshold lowered from 50% to 5%;
and
SH-to-Corporation (Corp owns what SH owns) attribution threshold lowered from 50% to 5%,
but if share ownership is between 5% and 50%, the Corporation only owns a proportionate
amount of the SHs shares. 304(c)(3)(A) and (B).

A Redemption is either a sale or exchange or a dividend

If the redemption is treated as an ordinary distribution (not a S/X), then the transaction is recast
as follows:
(1) Transferor (seller) is treated as if it transferred the stock acquired by the acquiring
corporation to the acquiring corporation in exchange for stock of the acquiring
corporation in a section 351 transaction, and

(2) Acquiring corporation had redeemed the stock it is treated as issuing in such
transaction. 304(a)(1).
If 304(a)(1) applies, the deemed redemption in section 304(a)(1) still has to be tested under
section 302 to determine if the deemed redemption is treated as a current distribution (dividend
to the extent of E&Ps) or a sale/exchange.
The redemption analysis is determined by reference to the stock ownership of the the
issuing [acquired] corporation. 304(b)(1).

The section 318 attribution rules apply, but are (again!) modified:
Corporation-to-SH attribution threshold (50%) is disregarded;
SH-to-Corporation attribution threshold (50%) is disregarded. 304(b)(1).
If the redemption is treated as an ordinary distribution, it will be treated as a dividend to the
extent of the E&Ps of first acquiring and then issuing. 304(b)(2).

Does 304(a) Apply?


Is A in Control of Both X and Y? See Section 318.
Does Y acquire stock of X in exchange for Property?

43
Is the redemption an ordinary distribution or sale/X?
Are there any of the tests in 302(b) met?
Complete termination
Not Essentially Equivalent
Substantially Disproportionate
Partial Liquidation

What happens to Basis in a 304 transaction?


If no shares of acquiring are owned, the SH may have a loss that is deferred until the inclusion
date, Prop. Reg. 1.302-5(a)(3), or the basis may be lost. . Rev. Rul. 70-496.
It may be possible to allocate the basis of the redeemed shares to shares of issuing. Rev. Ru.
71-563.
If the redemption proceeds exceed the E&Ps of acquiring and issuing, the basis of all shares of
acquiring are reduced pro-rata. Prop. Reg. 1.301-2(a), Ex. If the redemption proceeds exceed
the basis of any of the acquiring shares, the SH will have gain.

Parent-Sub:
Hook Stock
Sub owns half of the parent and vice versa
In testing whether the redemption is a S/X or an ordinary distribution, the tests under section
302(b) are applied to the stock of issuing. 304(b)(1).
The same modifications of the section 318 rules discussed above apply in determining the SHs
ownership of issuing before and after.

Almost all Brother-sister is a Parent-Sub as well.


Overlap with 351
SH transfers shares of wholly-owned brother corp to wholly-owned sister corp in exchange for
(1) 100 and (2) Shares of sister corp
SH borrows against brother shares and transfers brother share subject of the liability of sister
corp
If acquiring assume liabilities generally treated as property for purposes of section 304, but
doesnt apply to acquisition indebtedness

Bhada, 304 doesnt apply to the shares but it does apply to the exchange of cash for US shares

Inversions are not recognized is foreign corporations is 60% or more owned by US shareholders

304 is used a lot in foreign transaction because foreigner states treat as S?X and US treats it as
dividend with Foreign Tax Credits

Class: 10/26/16

Wrapping up Redemptions through related Corporations


Acquiring Corporation
Acquiring takes a carryover basis in the shares of the issuing Sec. 362(a)
If the transaction is treated as S/Ex, Shareholder will recognize capital gain/loss

44
Parent-Subsidiary Acquisitions
Attribution Rules can be difficult in both large and closely held companies

Stock Distributions: Section 305


Exception: Distributions in lieu of money under the section
If you receive stock pro rata as dividend your share is the same as it was before
305 treats this as a constructive receipt of dividend when one class of shareholders position
changes
If any shareholder can elect (either before or after declaration of the distribution) to receive
stock or property, the distribution is taxable in its entirety to all shareholders Sec. 305(b)(1)
Rev. Rule. 83-68
6% Stock Dividend to FHLB Members of FHLB of City R
Each Member advised that it could tender excess shares for redemption, and at least one of the
banks could have tendered all of its shares.
All redemption requests honored in full
DRIPs: SH elects to participate in DRIP whereby cash dividends are payable in additional
shares that are purchased at 95% of FMV. Under Rev. Rule 76-53, SH had section 301
Distribution to the extent of the FMV of the stock received

1. Example Rev. Rul. 80-154: Corp declares dividend that is required to be made in cash but
utilized to cover a share, no cash or shares were actually distributed, but Corps capital was
increased
a. Corp distributes stock dividends to all SHs and grants 1 SH the option to receive $. SH opts for
stock instead of money, Result?

All Common at first, some get common stock as dividend, others get preferred, this changes
proportional interests and should be taxed

The interest in the corporation of the common shareholders remains subordinate to that of the
preferred shareholders, whose interest is unchanged by the distribution. Therefore, the
distribution of common stock is excluded from income under section 305(a). Reg. l.305-3(e)
(ex. 2). If, however, the preferred shareholders receive cash and the common shareholders
receive a pro rata distribution of the preferred stock, the distribution changes the relative
interests of the shareholders, since the holders of common stock now share in the preference
formerly held exclusively by the holders of preferred stock. Thus, the distribution of preferred
stock is treated as a distribution of property under section 301. Reg. l.305-3(e) (ex. 3).
Note, if this rule applies then all SHs are taxed on the receipt of their stock even the SHs whose
interest is reduced
Dividends of Convertible preferred are taxable if it is reasonable to anticipate based on the
dividend rate, redemptions provisions, and conversion price, that some SHs will convert and
others will not. Reg. 1.305-4(b), Ex. 2.

45
Section 305(b)(2): Disproportionate Distributions
Result of (1) Receipt of property by some shareholders and (2) an increase in the proportionate
interest or E&Ps of the corporation. Sec. 305(b)(2)

A distribution of property in an Isolated redemption is treated as an ordinary distribution under


section 301 Reg. 1.305-3(b)(3)

Next week focus on 9-1, 9-2, and 9-3 for next Mondays Class

Stock Distributions and Preferred Stock Bailouts


Distribution has the result of:
(1) receipt of Prd Stk by some CS SHs; and (2) receipt of CS by other CS SHs. 305(b)(3).
Why is this a concern?
Note: if this rule applies, all SHs are taxed on the receipt of their stock, even the SHs whose
interests are reduced!
Ex: Distributions of convertible preferred on CS are taxable if it is reasonable to anticipate based
on the dividend rate, redemptions provisions, and conversion price, that some SHs will convert
and others will not. Reg. 1.305-4(b), Ex. 2.

What is the problem with convertible preferred shares?


These are preferred shares you can convert to common stock
You would convert these once the common stock value exceeds the value of the preferred
Preferred Stock generally has a higher dividend rate

All stock distributions on preferred stocks are taxable regardless of whether there is a
disproportionate distribution

Exceptions: Increase in conversion ratio of convertible prd stock to take into account a stock
dividend/split with respect to the stock into which the prd is convertible.
Ex: Corp T has outstanding cumulative prd stock with dividends in arrears and an issue price of
100. It recapitalizes with prd stock on a 1.2 : 1 basis (the 20% difference being the dividend
arrearage). The prd SH are deemed to receive a 20 distribution on each share under 305(b)(4).
Reg. 1.305-5(d), Ex. 1.
Redemption premiums can be treated as additional distributions. 305(c)(3).

**If there is ever a distribution of common stock to preferred SHs, then it is taxable

Section 305(b)(2): Disproportionate Distributions


Distribution has the result of: (1) receipt of property by some SHs; and (2) an increase in the
proportionate interest of other SHs in assets or E7Ps of the Corp.

Redeeming a single SH could potentially be taxable as a distribution of increased value of


Shares in the hands of remaining SHs

46
Share buybacks are done by almost every company
Back in the day, Capital gains for stock buybacks, ordinary income for dividends
When someone gets cash and others get nothing, this increases value of remaining shares.
Isolated redemptions are

In addition, a distribution of property incident to an isolated redemption of stock (for example,


pursuant to a tender offer) will not cause section 305(b)(2) to apply even though the redemption
distribution is treated as a distribution of property to which section 301, 871(a)(1)(A), 881(a)(1),
or 356(a)(2) applies.

Rev. Rul. 78-90


Corp Z has 1 class of 6,000 CS outstanding, all of which is owned by 24 SHs.
Corp Z adopts annual redemption plan to redeem up to 40 shares
Each SH can (but is not obligated to) submit for redemption up to 2/3 of 1%; any unused
percentage rolls over to the other redeeming SHs for a total of up to 40 shares.
In 76, 8 SHs participate, and because of the attribution rules, all of the redemptions are treated
as ordinary distributions.
Why do the non-redeeming SHs have a deemed distribution? See 305(c) and Reg. 1.305-
7(a)(2).
What if the redemption werent part of a plan? See Reg. 1.305-3(b)(3); (e), Ex. 10.
If it werent part of a plan it would be ok.

305(b)(2) of the Code provides that section 301 will apply to a distribution by a corporation of its
stock if the distribution, or a series of distributions that includes the distribution, has the result of
the receipt of property by some shareholders, and increases in the proportionate interests of
other shareholders in the assets or earnings and profits of the corporation.

Increases in conversion ratios can treat SHs as receiving a constructive stock distribution.
Ex: Class B is convertible into class A on a 1:1 basis. The conversion ratio is adjusted to 1.05
: 1, and Corp pays cash dividend on class A shares. Class B is treated as receiving a
constructive stock dividend of 5%. Reg. 1.305-3(e). Ex. 6.

Problem 9-1: Determine the federal income tax consequences of the following transactions. In
each case, assume that the corporation making the distribution has only a single class of
common stock outstanding both before and after the distribution.

(a) Corporation X declares a distribution of two additional shares of common stock (worth $10
each on the date of the distribution) for each share of common stock held, except that, at the
option of the shareholder the shareholder is entitled to receive one share of common stock plus
$9 cash for each share held. See Reg. 1.305- 2(b) (ex. 1).
Would your answer change if you knew that X were a public corporation? . .
One share is not taxable
The second share is taxable
But which amount is taxable, $10 or $9?

47
(b) In a given year, public corporation Y declares four quarterly distributions, each equal to
$5/share. Each distribution is payable at the option of the shareholder in any combination of
cash or Y common stock. However the maximum amount of cash that may be distributed in any
distribution is equal to 20 percent of the total amount of the distribution. If shareholders in the
aggregate elect to receive 20 percent or less of the total quarterly distribution in cash, then each
shareholder is distributed the amount of cash or Y stock elected. If shareholders in the
aggregate elect to receive more than 20 percent of the total quarterly distribution in cash, then
the amount of cash distributed is reduced pro rata from the amount elected so that the total
cash distribution exactly equals 20 percent of the total quarterly distribution. For example, if
each shareholder elects to receive the entire amount of a quarterly distribution in cash, then
each shareholder is distributed $1/share in cash and $4/share in Y stock for that quarter.

(i) Suppose that the shareholder notice of each distribution is accompanied by information
provided by "reputable tax counsel" that no matter what the shareholder elects, the entire
distribution will be taxable to the shareholder as a dividend. Does this fact affect your analysis of
the tax consequences of the distributions?
If everyone elects cash, the amount is capped by the 20% limit
Some shareholder could get all cash
So they are all taxable

(ii) Suppose that no shareholder is given a choice of receiving cash in lieu of stock in any of the
distributions described in (b). Instead, three of the quarterly distributions are payable only in Y
stock and one quarterly distribution is payable only in cash. Do the tax consequences of this
alternate arrangement shed any light on how the distributions described in (b) should be taxed?
Stock option, not taxable. Cash option, yes taxable
25% in cash, in stock
25% taxable, 75% is not taxable because it is in stock without alternate option

REIT: (i) is helpful because you can get 100% dividend and only kick out 25% of cash
preserving AUM for management fees

Problem 9-2: Determine the federal income tax consequences of the following transactions
involving corporation Z.
(a) Z has both common and nonconvertible preferred stock outstanding. Z makes pro
rata distributions of cash to the preferred stockholders and shares of a new class of
preferred stock to the common
A. Distributions of Stock or Stock Rights of the Distributing Corporation 335 stockholders. The
rights provided by the new class of preferred stock are subordinate in all respects to those of the
original class of preferred stock. See Reg. 1.305-3(e) (ex. 3).
Under 305(b)(1) cash is always taxable
New Preferred Stock dont change interest of common or preferred shareholders

(b) Same as (a), except that in lieu of the distributions described, Z distributes pro rata
nonconvertible preferred stock to both its common and preferred stockholders.
Taxable under 305 because it is a disproportionate distribution

48
The Common SHs interest grows at the expense of the preferred SHs

(c) Z has outstanding a single class of common stock and some debentures convertible into the
stock under a fixed formula. During the year, Z pays interest on the debentures and distributes
common stock pro rata to the holders of the common stock. See Reg. 1.305-3(e) (ex. 4).
The interest is taxable (cash)
The stock interest of convertible changes unless proportion under conversion adjusts
proportionately
Common Stock distribution is taxable

(d) Z has outstanding class A and class B common stock. Class A shares are convertible into
class B shares on a 1:1 basis. However, the conversion ratio adjusts to increase the number of
class B shares obtainable by a class A shareholder for each class A share in order to take into
account any distribution of cash to the class B shareholders. In a given year, Z makes a pro rata
distribution of cash to the class B shareholders and the conversion ratio is adjusted to take into
account the cash distribution. See Reg. 1.305-3(e) (ex. 7) and -7(b)(l).
Not taxable if you adjust for stock
But it is taxable if you adjust the ratio in response to cash distribution
This is a taxable event as a deemed distribution

Review Problem 9-3: This problem requires you to apply sections 301 and 302, as well as
section 305. Unrelated individuals Alston and Bragan own 50 percent each (30 shares apiece)
of Dodge Corporation. Each shareholder has a $1,200 total basis in his' stock. Dodge is worth
$6,000 (each share worth $100) and has sufficient E&P to cover any of the following proposed
distributions. The parties would like to shift two-thirds control of the corporation to Bragan, with
Alston retaining the remaining one-third interest. Determine the tax consequences of the
following alternate methods of accomplishing this goal. Which produces the most favorable tax
consequences? The least favorable?

(a) Dodge distributes $1,500 cash to Alston in redemption of 15 of his shares. Following the
redemption, Alston still owns 15 shares of Dodge, which represent a one-third interest in the
corporation, and Bragan still owns the other 30 shares, which represent the remaining two-thirds
interest.

(b) Dodge distributes a total of$1,500 cash pro rata to Alston a~d Bragan,
$750 to each. Following the distribution, Bragan uses his $750 to purchase 10 of Alston's
shares, worth $75 per share following the distribution. After the purchase, Alston owns 20
shares of Dodge, representing a one-third interest, and Bragan owns the other 40 shares,
representing a two-thirds interest. .

(c) Alston sells 10 of his shares to Bragan for $1,000. Following the stock sale, Dodge
distributes a total of $1,500 cash pro rata to the shareholders: two-thirds, or $1,000, to Bragan
(which exactly reimburses and one-third, or $500, to Alston. Following the sale and distribution,
Alston and Bragan have one-third and two-thirds interests in Dodge, respectively.

49
(d) Dodge distributes $1,500 cash to Alston and an equal amount, in the form of 30 additional
shares, to Bragan. (After both distributions are taken into account, the 30 additional shares
would be worth $1,500, one-third of $4,500.) After the distributions, Alston owns 30 shares
(a one-third interest) and Bragan owns 60 shares (a two-thirds interest).

Taxable Corporate Acquisitions and Liquidations:

Corporate acquisitions are carried out in several different ways. In a corporate asset sale, one
corporation (commonly referred to as the target corporation) transfers its assets to another
corporation (commonly referred to as the acquiring or purchasing corporation) after which the
target may be completely liquidated. In a corporate stock sale, the target's shareholders transfer
their target stock to an acquiring corporation and the target may be subsequently liquidated into
the acquiring corporation. A third pattern, sometimes known as a shareholder asset sale,
reverses the order of the steps of a corporate asset sale. In this transaction, the target's
shareholders first completely liquidate the target, receive a distribution of its assets, and then
transfer those assets to the acquiring corporation. Acquisitions also take place as a result of a
merger.

Over the years, one major objective of the corporate tax law has been to provide identical tax
consequences to an acquisition no matter how it is carried out.

Problem 10-1: P Corporation has owned all of the stock of S corporation for over five years. P's
basis in its S stock is $1,000, and S's aggregate basis in its assets (worth $3,000) is $400. P
and S do not file a consolidated return. Determine the federal income tax consequences to P in
the event S is completely liquidated and distributes all of its assets to P. Following the
liquidation, what happens to the pre-transaction built-in gain in S's assets? To the pre-
transaction built-in gain in the S stock held by P? Explain the rationale for these results.

Liquidation
Formal plan not essential; Dissolution not essential; and Filing of Form 966 not a condition of
liquidation; Must demonstrate: Manifest intention to liquidate
Shareholder(s)
Recognize capital gain/loss equal to the difference in the AR and their AB in Target stock.
331(a).
oAR= FMV of property minus share of liabilities (including corporate tax)
Section 301 does not apply to liquidating distributions. 331(b).
Take a FMV basis in any property received. 334(a).
G/L computed on a share-by-share basis (not aggregate basis). Reg. 1.331-1(e).
Example: SH has 2 blocks of shares consisting of 10 and 20 shares. Each distribution is
allocated 1/3 and 2/3 to each block.
If series of distributions, basis recovered first before any gain recognized (Rev. Rul. 85-48), but
no loss is recognized until the final distribution made. Ethel M. Schmidt v. CIR.
Section 267 does not apply to losses realized on corporate liquidation. 267(a)(1).
E&Ps (and other tax attributes, e.g., NOLs, FTCs) of liquidating corporation disappear.
Compare sale of target stock.

Tax Lawyers See these as asset acquisitions, corporate lawyers see these as mergers

50
Target Survives in a reverse triangular merger because it has assets that are not easily
transferred or transferable

A merger, FOR TAX PURPOSES, is treated as an asset acquisition


Reverse Triangular Merger: Target Survives, it has non-transferable assets that you want\
Forward Triangular Merger: Acquirer survives

If the Target survives it is treated as a stock acquisition


In a pure asset sale, nothing happens at the shareholder level
Unless asset sale followed by liquidation of (or redemption or dividend from) Target
Liquidation
Formal plan not essential; dissolution not essential; and filing of Form 966 not a condition of
liquidation
Must demonstrate: manifest intention to liquidate
Shareholders
Recognize capital gain/loss equal to the difference in the AR and their AB target stock. Sec.
331(a).
AR=FMV of Property minus share of liabilities (including corporate tax)
Section 301 does not apply to liquidating distributions. 331(b)
Take a FMV basis (not reduced by liabilities) in any property received. Sec. 334(a).
G/L computed on a share by share basis (not aggregate basis). Reg. 1.331-1(e).
Example: SH has 2 blocks of shares consisting of 10 and 20 shares. Each Distribution is
allocated and to each block.
If series of distributions, basis recovered first before any gain recognized (rev. Rul. 85-48), but
no loss is recognized until the final distribution made. Ethel M. Schmidt v. CIR.
Section 267 does not apply to losses realized on Corporate Liquidation
E&Ps (and other tax attributes, e.g. NOLs, FTCs) of Liquidating corporation disappears.
Compare sale of target stock.

Liquidation to Parent Corporation (Parent Sub Liquidation): Shareholder Level Effects


Corporate shareholder does not recognize gain or loss in a P-S liquidation (section 332
liquidation). 332(a).
P owns = or > 80% vote and value (1504(a)(2)) and either:
There is a complete redemption or cancellation of all of Ss stock, and S transfers all property
within the taxable year, or
The distribution is one of a series of distributions in accordance with a plan of liquidation
completed within 3 years. 332(b).
If P doesnt receive any property, i.e., S is insolvent, 332 doesnt apply, but section 165(g) may.
Reg. 1.332-2(b).
Rev. Rul. 2003-125 (in election to treat C as DRE where Cs liabilities exceed the FMV of its
assets, including intangible assets, SH entitled to worthless security deduction under 165(g)(3);
section 332 doesnt apply).
Why were sections 332(c) and (d) enacted?

Asset sale followed by Liquidation to Parent Corporation (Parent-Sub. Liquid.):


Parent-level Effects
No G/L generally recognized by Parent under section 332.

51
P can recognize G/L on the satisfaction of sub Debt (e.g., P buys S bonds for 80 and receives
100 [face] upon liquidation of S). Reg. 1.332-7.
P generally gets a carryover basis (COB) in the property received. 334(b).
P inherits Subs E&Ps and other tax attributes (NOLs, CLCOs, FTCs). 381.
But see 334(b)(1)(B)
Parents basis (and any BIL or BIG) in subsidiary stock disappears.
Inside BIG/BIL is retained; Outside BIG/BIL disappears
Minority SHs: Section 332 doesnt apply; instead sections 331 and 1001(c) apply.

Asset sale followed by Corporate Liquidation (not Parent-Subsidiary): Corporate-Level


Effects
Corporation recognizes gain/loss as if property sold to distributee at its FMV. 336(a). Compare
311(b).
Potential OI and CL mismatch
No loss recognized if the property is distributed to a related person (see 267) and either:
Distribution is not pro rata (based on stock ownership), or
Property is disqualified property.
Disqualified Property: Property acquired by liquidating corporation w/in last 5 years in a 351
transaction or contribution to capital. 336(d)(1). Why?
If the AB > FMV of property (BIL property) when it was acquired by a corporation in a 351
transaction, capital contribution, and part of a tax avoidance plan, in determining gain/loss upon
a distribution or sale by the liquidating corporation of the property, the AB is reduced to the FMV
at the time of acquisition. 336(d)(2).
2-year presumption. 336(d)(2)(B)(ii).
E&Ps (and other tax attributes) dont survive but may be relevant in computing AMT in the year
of liquidation or in the case of foreign liquidations. Also, E&Ps increased (decreased) by gain
(loss) recognized by liquidating corporation.
Deemed liquidation: tax-free transfers of substantially all of a corporations assets to a tax-
exempt entity treated as deemed sale. 337(d); Reg. 1.337(d)-4.

In sum, in a non-parent/sub there is gain on both, in Parent/Sub there is carryover basis and no
gain on either end

Basis is 50, FMV is 100, Liability 120. FMV under 336 cannot be less than than liability, so gain
would be 70.

337 says No gain or loss recognized to the liquidating corporation to the 80-percent distributee
of any property in a complete liquidation to which section 332 applies

Pre--54 54-86 Post 86

Corp didnt recognized General Utilities (35) General Utilities repealed.


BIG/BIL in ordinary 311(b) (gain but not loss
distribution. General recognized on distribution of
Utilities (35) BIG property).
Assets have FMV in hands of
SHs.

52
Gain from sale of assets No gain/loss for sales by G/L recognized to SH in non-
distributed in liquidation corporation w/in 1 year of P-S liquidations. Sections
attributed to corporation. liquidation. Old section 337 331 and 332.
Court Holding (45). Assets have FMV in hands of
SHs. Section 334(a).
G/L recognized by subsidiary.
Section 336.

Gain from sale of assets No gain/loss for corporate No gain/loss for corporate
distributed in liquidation not liquidations. Old section liquidations at either the
attributed to corporation; tax- 336 corporate or SH level.
free under General Utilities. Sections 332 and 337.
Cumberland Public (50). Carryover basis in assets.
Section 334(b).

Sale of of 80% of T shares to Post 82: Qualified stock


P followed by liquidation of T purchases treated as asset
by P treated as asset acquisition. Section 338.
purchase. Section 334(b) Both selling SH and T
(2). generally recognize G/L.

If you buy stock, you get carry over basis. If you buy assets you get a costs basis.
This is good for depreciation, you want an inflated basis

GL. Riggs, Inc. v. CIR


Must be over 80% for initiating formal liquidation process

P acquires Ts assets in Taxable Acquisition


Q: Why does P generally want a SUB in T assets
Q: Whats Ts Basis in GW and self created software prior to Ts sale of its assets?
P does not directly assume any of Ts unwanted liabilities (maybe)
Use P sub (or even DRE) to segregate liabilities

Taxable Transfer of Assets: Allocation of Purchase Price


Seller computes G/L on each asset sold
Buyer must allocate purchase price to each asset purchased for purposes of determining future
depreciation, deductions, income, gain, and loss
But then Allocation of Purchase Price to Assets: Section 1060
If Ts assets constitute a trade/business, and Ps basis in the assets is determined by reference
to Ps purchase price, the Purchase price is allocated to Ts assets under the rules of section
1060 and Reg. 1.338-6. These rules apply to stock purchases accompanied by a sec. 338(g)
election

The permissible amortization of goodwill and going concern value means that, in theory, all
intangibles covered by section 197 could be included within the "residual" class of assets under
section 1060. The regulations, however, continue to treat goodwill and going concern value as

53
the only assets within the residual class, thus avoiding the need to determine the fair market
value of those assets separately.
Goodwill and intangibles are now depreciable for 15 years

338(g) Election
If the corporation acquiring the stock of the target makes a section 338(g) election, then the
consequences are identical to those of a corporate asset sale (followed by a liquidation) or a
shareholder asset sale: the target shareholders recognize gain or loss on sale of their stock,
and the target corporation recognizes gain or loss (and obtains a fair market value basis in its
assets) upon the deemed sale and repurchase of its assets.

Taxable Corporate Acquisitions:


Carryover Basis
Deferred Tax by preserving the Basis in Corporate Level
Taxed upon distribution
Parent takes a carry-over basis

Asset sale followed by Corporate Liquidation (not parent-sub): Corporate-Level Effects


Corporation recognizes gain/loss as if property sold to distributee at its FMV. 336(a). Compare
311(b).
Potential OI and CL mismatch
No loss recognized if the property is distributed to a related person (see 267) and either:
Distribution is not pro rata (based on stock ownership), or
Property is disqualified property.
Disqualified Property: Property acquired by liquidating corporation w/in last 5 years in a 351
transaction or contribution to capital. 336(d)(1). Why?
If the AB > FMV of property (BIL property) when it was acquired by a corporation in a 351
transaction, capital contribution, and part of a tax avoidance plan, in determining gain/loss upon
a distribution or sale by the liquidating corporation of the property, the AB is reduced to the FMV
at the time of acquisition. 336(d)(2).
2-year presumption. 336(d)(2)(B)(ii).
E&Ps (and other tax attributes) dont survive but may be relevant in computing AMT in the year
of liquidation or in the case of foreign liquidations. Also, E&Ps increased (decreased) by gain
(loss) recognized by liquidating corporation.
Deemed liquidation: tax-free transfers of substantially all of a corporations assets to a tax-
exempt entity treated as deemed sale. 337(d); Reg. 1.337(d)-4.

Asset Sale and Liquidation to Parent (Parent-Sub. Liquid): Subsidiary Level Effects
No G/L recognized on property distributed to 80% Corp. distributee. 337(a).
Doesnt apply if P tax-exempt, e.g., foreign parent. 337(b)(2).
Sub Debt to Parent: no G/L on distribution of property to P in satisfaction of indebtedness.
337(b)(1).
Distributions to Minority SHs:
Gains recognized. 336.
Losses not recognized. 336(d)(3).

P Acquires Ts Assets in Taxable Acquisition:

54
P get SUB in T assets
What does P generally want a SUB in T assets?
Whats Ts Basis in GW and self-created software prior to Ts sale of its assets?
P does not directly assume any Ts unwanted liabilities (maybe)
Use P subsidiary (or even DRE) to segregate any liabilities in merger
P does not inherit any of Ts tax attributes, e.g. NOLs, CLCOs, FTCs, or E&Ps
Asset Transfers may generate local transfer taxes, may raise issues under debt covenants;
some lenders may be concerned with Ps assumptions of Ts liabilities

Taxable Transfer of Assets: Allocation of Purchase Price:


Danielson Rule, Section 1060
If Ts assets constitute a trade/business, and Ps basis in the assets is determined by reference
to Ps purchase price, the purchase price is allocated to Ts assets under the rules of section
1060 and Reg. 1.338-6. These rules also apply to stock purchases accompanied by a 338(g)
election. AND All things including goodwill and going concern value can be depreciated over 15
years
P acquires Ts Stock in Taxable Acquisition
P takes SUB in T shares
Ts assets have COB
T retains its tax attributes
If Ts assets have BIG, Ts post-acquisition E&Ps will be higher than they would have been if Ts
assets had been purchased because of lower depreciation

Section 338 Background:


Under old 334(b)(2), Ps taxable purchase of 80% or more of Ts stock within 12 months was
treated as a purchase of Ts assets if T was liquidated within two years of the stock purchase.
Under old 337, T generally didnt recognize G/L on the deemed sale of its assets.
Current 338 was enacted in 1982. Among other things, it eliminated the requirement that T
liquidate. Thus, as an alternative to a taxable asset acquisition, if corporation P purchases the
stock of T in a taxable transaction, P can make an election under 338(g), in which case old T
will be treated as having sold all of its assets for their FMV to new T.
After the repeal of GU in 86, because a 338(g) election generally entails two levels of tax
selling shareholder and corporateit is rarely efficient to make it in the domestic setting.
When it is not desirable to make a 338(g) election? When can it be desirable to make a 338(g)
election?
When the new FMV is much higher for depreciable assets, then you can receive assets with a
stepped up basis and a higher annual deduction

Qualified Stock Purchase: P must acquire by purchase at least 80% of the vote and value of
P during a 12-month period. Certain preferred stock is ignored. 338(d)(3). This permits P and
T (if P and T are US corporations) to file a consolidated return.
Purchase: P must have SUB in the T stock; the T stock cant be acquired in an exchange under
351, 354-356; and the T stock cant be acquired from a related (under 318) person. 338(h)
(3).
T is treated as selling its assets for their aggregate deemed sales price (ADSP)(amount paid
for the stock), which is generally the price paid to purchase the T stock plus T liabilities,
including tax liabilities.

55
ADSP = G + L + Tax Rate *(ADSP Basis), where G is the grossed up amount realized on the
sale to P on Ps recently purchased stock and L, Ts non-tax liabilities. Reg. 1.338-4(g), Ex. 1.

Section 338(h)(10)
338(h)(10) Election: if T is a sub. in a consolidated group (or an affiliated group that doesnt file
a consolidated return), a joint election can be made to treat T as if it sold all of its assets for their
FMV, and then transferred the consideration to Ts old parent in a deemed liquidation.
Result: G/L recognized by T but no G/L is recognized by the selling parent.
Step up in basis with only one level of tax
338(g) generally not advisable while 338(h)(10) is but is not allowed for foreigners
Section 336(e)
336(e) authorizes the issuance of regulations permitting the unilateral election to treat the sale
of stock of an 80-80 (V&V) company as the sale of assets of the sold company and no gain
recognized on the sale of the stock.
22 years after the enactment of 336(e), proposed regulations were issued in 2008 and
finalized in 2013.
Principles of 338(h)(10) employed
336(e) not applicable to QSP
Can apply to S Corps, but does not apply if either T or seller is a foreign corporation

Seller must meet the 80% V&V test and must sell, exchange, or distribute all such stock
meeting the V&V test; possible to retain some stock
Available even if purchaser is not a corporation, i.e., purchaser can be individual or PSH
Losses can be recognized but only up to the gains recognized.

Example: X company BA; fmv of 100k, Adjusted Basis of 20k GE: 100 FMV, Adjusted Basis
150k
What are the tax consequences?
Net Gain of 30K
We distribute to SHs, each SH had basis of 20
Corporation distributes property, SHs pay tax based on their adjusted basis to determine
gain/loss for individual shareholders
Tax at Corporate level?

Assumption of liability 10-2 (c)


Liability is 120k, but shareholder gets FMV

(d) Same as (a), except t~at at the time of the liquidation, X has only one shareholder,
corporation M, and M receives both Blackacre and the GE stock in the liquidation.
332(a) no gain or loss by a complete distribution of property between Parent-Sub, instead
theres carryover basis

(g) Same as (a), except that at the time of the liquidation, corporation M owns 60 percent ofX,
and individuals Band C (who are unrelated to each other and to M) own 20 percent each.

56
Assume that, in addition to Blackacre and the GE stock, X has $50,000 cash. In the liquidation,
X distributes the stock plus $50,000 to M and divides Blackacre evenly between B and C.
Not a parent sub, so corporation pays tax on the gain for each. SH gets a Cost basis?

362(e), two gains are ok, only one loss. Corporation steps down the basis or the SH has the
ability to step down their basis in the shares.

Reorganizations: Overview
Tax Issues
G/L to T on Transfer of Assets
G/L to P on transfer P stock and other consideration
Ps Basis in T Assets
G/L to T on Transfer of T stock for P Stock
Basis of T Shareholders in P Stock and other consideration
What happens to tax attributes?

Does it qualify as Reorg? What kind of consideration is given?


Realization:
Exchange of Property differing materially in Kind. Regs sec 1.1001-1(a)
Realized G/L generally must be recognized. Sec. 1001(c).
Recognition Exceptions: 267, 351, 1031, 1036, 1091, 1092, and 354-368

What is a reorganization?
New Corporation that holds assets received is a continuation of the old stock/securities
surrendered
F Reorgs, Compare Marr v. US (1925) and Weiss v. Stern (1924)
The purpose of the reorganization provisions of the code is to except from the general rule
certain specifically described exchanges incident to such readjustments of corporate structures
made in one of the particular ways specified in the code as are required by business exigencies
only a readjustment of continuing interest in property under modified corporate forms.

Definition of Reorganization:
Statutory requirements- Regs. 368(a)(1)
Asset acquisitions (A, C, & D reorganizations and triangular variations)
Stock acquisitions (B reorganization)
Recapitalization (E reorganization)
Change in Identity, Place of Organization (F reorganization)

Reorganization is a term of art for corp readjustments that fall into one of these three categories (all
defined in 368 note: NO LIKE-KIND EXCHANGE STANDARD IN 368):
(1) Acquisitive reorganizations
Transactions in which the acquiring corp acquires the assets or stock of another. Includes statutory
mergers or consolidations (A reorgs), acquisitions of the target stock for voting stock in the acquirer (B

57
reorgs), acquisitions of assets of the target for voting stock of acquirer (C reorgs or practical mergers
due to their similarity to statutory mergers), and other, more complicated transactions.
(2) Divisive reorganizations (also 355)
Reorgs that result in the division of one corp into two or more separate entities. Usually preceded by a
D reorg.
(3) Non Acquisitive, non divisive reorganizations
Adjustments to the structure of a single, continuing corp. Includes recapitalizations (E reorgs), changes
in identity, form, or place of incorporation (F reorgs), certain transfers of virtually all of the assets from
one corp to another, and then liquidation of the transferor (non divisive D reorgs), and transfers of one
corp.s assets to another corp pursuant to a bankruptcy reorg plan (G reorgs).
To qualify as reorg, judicial doctrines have also been developed to enforce the rationale for
nonrecognition. Principally:
(1) Continuity of proprietary interest,
(2) Continuity of business enterprise, and
(3) Business purpose.

Common Law/Regulatory Requirements:


Continuity of Proprietary Interest. Reg 1.368-1(e)
Continuity of Business Enterprise. Reg 1.368-1(d)
Business purpose and plan of reorganization. Reg. 1.368-2(g) (for example you want to be in
Delaware Court)

Helvering v. Gregory, no business purpose, reorg not recognized


In reorgs the issuing corp. Refers to the acquiring corporation
A substantial part of the value of the proprietary interest in the target be preserved...by
receiving a proprietary interest in the [acquiring] corporation Reg. 1.368-1(e)(1)(i)
Two Issues
1. Nature of consideration received; and
2. Proportion of (1) that consists of PI acquiring.

Regulations permit stock consideration as low as 40%, 1-368-1(e)(2)(v), Ex. 1.


Ruling Standards: Stock of acquiring must represent > 50% of consideration. Rev. Proc 77-37

Continuity of Interest:
Step-transaction doctrine. As illustrated by Kass and Seagram, reorganization cases frequently
require application of the step-transaction doctrine. Because the conditions for reorganization
status vary with the taxpayer's acquisition pattern, there is a premium placed on identifying
which pattern actually transpired, and the step-transaction doctrine is often invoked to make that
determination. Three common formulations of the step-transaction doctrine are the "binding
commitment," "mutual interdependence," and "end result" tests.

a. Continuity by historic target shareholders

Kass 413 (Tax Court 1973)


Kass was a minority shareholder in ACRA, which was an acquisition target of TRACK. TRACK made a
tender offer and gained substantial control of ACRA, after which the remaining ACRA shareholders were
offered a 1-for-1 stock swap for TRACK stock, after which ACRA would be liquidated into TRACK. Kass

58
took the swap offer and claimed nonrecognition on a reorg basis. IRS and court disagreed, saying that
the swap was part of an integrated transaction to acquire ACRA, and not a reorganization. Therefore,
shareholders must be viewed as a whole in determining whether or not there is a substantial property
interest in the acquirer, and Kass did not have sufficient continuity of interest in TRACK. This last step
was in substance a subsidiary liquidation, and the minority shareholders are in harms way.

Seagram Corp. 417 (Tax Court 1994)


The difference between this and Kass is that DuPont and Conoco had a contractual two step merger
obligation; ACRA and TRACK didnt (although the acquisition and liquidation were part of an integrated
plan). Seagram made a hostile bid for Conoco and purchased 32% of the outstanding shares. Conoco
entered into a friendly two step merger agreement with DuPont and completed the first step. In the initial
round of offers, only 22% of the Conoco shareholders didnt bail out and take cash from either DuPont or
Seagram. Seagram conceded and tendered their 32% to DuPont in exchange for DuPont stock and
claimed it as a $500M loss because of the inflated tender price they paid for the it stock during their offer.
IRS balked, saying that it was part of a 368 reorg and required nonrecognition. Seagram said that they
didnt have continuity of interest, but the court said that they stepped into the shoes of the long term
shareholders when they made their tender offer for Conoco.

Why? Competing Seagram offer treated as a historic target shareholder. Basically, since there was no
acquisition, Seagram becomes like any other shareholder. When targets are announced, traditional SHs
tend to bail out before the tender offer can be completed, taking advantage of inflated target prices to
avoid the possible failure of the usually conditional offers. When tender offers succeed, the majority of
the target shareholders tendering to the acquirer tend to be new shareholders that bought at the inflated
price.

When do you take the snapshot?


The Court takes the snapshot when Dupont pays 54% of the Tender offer in Dupont Stock
Seagrams could recognize loss if they sell Dupont stock, but they want to hold and therefore
they cannot recognize loss
CEO wanted to be a SH of a combined Dupont-Conoco Company, which they remained. The
Court also said that it would be difficult to trace these continuity of proprietary interests in high
volume public companies. The court doesnt want to go back to every single historical
shareholder

Continuity of Interest: Regs. 1.368-1(e)(1), (2), and (8)


a mere disposition of stock of the target corporation prior to a potential reorganization to
persons not relatedto the target corporation or to persons not related to the issuing
corporation is disregarded and a mere disposition of stock of the issuing corporation received in
a potential reorganization to persons not related (as defined in paragraph (e)(4) of this section)
to the issuing corporation is disregarded.
A proprietary interest in the target corporation is not preserved if, in connection with a potential
reorganization, a person related to the issuing corporation acquires, for consideration other than
stock of the issuing corporation, either a proprietary interest in the target corporation or stock of
the issuing corporation that was furnished in exchange for a proprietary interest in the target
corporation.

Sale of Issuing stock to unrelated person after merger disregarded. Ex. 1

59
Sale of Target before merger disregarded. Ex. 1
Redemption of Acquiring stock received in merger destroys COI. Ex. 4
T SH sells P stock received in merger to B, and P redeems B: COI not satisfied. Ex. 5
P owns 70% of T old-and-cold. T merges into P and non-P SHs receive cash. COI satisfied
because Ps interest in T is exchanged for direct interest in T assets. Ex. 7
Pre-acquisition redemption by T of one of its SHs doesnt destroy COI. Ex. 9

Continuity of Business Enterprise


Continuity of business enterprise (COBE)
Bentsen v. Phinney 433 (S.D.TX. 1961)
Reorg doesnt require the company which continues to exist to be in the same line of business.
IRS would like it to be that either you continue the historic business of the acquired company, or
that if not, you at least use the historical assets of the acquired company. See Reg 1.368-1(d)
for this assertion making it to regulation form.

Problems 438
1. Assume Acquirer and Target are incorporated in a state with merger and incorporation laws
that OK anything approved by a majority of the voting shareholders. Do the following qualify as
A reorgs?
(a) T merges into A in an all cash merger. T transfers all assets to A and is dissolved, with all T
SHs receiving cash for their stock.
Yes, its a statutory merger. But it violates the continuity of interest test because of the cash out
of Ts SHs.
(b) Same as (a), except that T SHs receive non voting preferred A stock instead of cash.
Good A reorg because stock creates continuity of interest.

requires that Peither continue Ts historic business or use a significant portion of Ts


historic business assets in a business. Reg. 1.368-1(d)(1).
Historic business (conducted most recently, but not acquired as part of plan of reorganization;
sale of assets and purchase of portfolio of stocks is not historical business (Example 3))
T lines of business (P must continue a significant line of business; 1/3 test, Example 1)
Use of assets (must use a significant portion of Ts historic assets; can be used by members of
Ps qualified group; use of backup source of supply acceptable (Example 2))
Use of sales proceeds (T sells all assets for cash & notes, which are acquired by Puse of sale
proceeds not sufficient (Example 4))
Disposal of assets (disposal of all of Ts assets by P violates COBE (Example 5))
T assets/businesses held by other members of Acquiring qualified group

the term reorganization means (A) a statutory merger or consolidation 368(a)(1)(A).


a statutory merger or consolidation is a transaction effected pursuant to the statute or statutes
necessary to effect the merger or consolidation, in which transaction, as a result of the operation
of such statute or statutes, the following events occur simultaneously at the effective time of the
transaction

60
(A) All of the assets and liabilities of each member of one or more combining units [an entity
treated as a C Corp and each disregarded entity whose assets it owns] (each a transferor unit)
become the assets and liabilities of one or more members of one another combining unit (the
transferee unit); and
(B) The combining entity of each transferor unit ceases its separate legal existence for all
purposes . Reg. 1.368-2(b)(1)(ii).

Asset Acquisitions: A Reorganizations


Mergers and LLCs (Reg. 1.368-2(b)(1)(iii), Examples)
Merger of T corporation into disregarded entity in exchange for stock of owner. Ex. 2.
Triangular merger of Target into a disregarded entity. Example 4
Merger of Target into disregarded entity owned by a partnership. Example 5
Merger of disregarded entity into a corporation. Example 6
Merger of Target into a disregarded entity in exchange for interest in the disregarded entity.
Example 7.

Post-Reorganization Transfers:
A transaction otherwise qualifying under paragraph (1)(A), (1)(B), or (1)(C) shall not be
disqualified by reason of the fact that part or all of the assets or stock which were acquired in
the transaction are transferred to a corporation controlled by the corporation acquiring such
assets or stock. 368(a)(2)(C).
Regulations expand this rule to include transfers to Ps qualified group. Reg. 1.368-2(k).
Mergers under foreign law can qualify as A reorgs. Reg. 1.368-2(b)(1)(iii), Ex. 13.

Non Divisive Reorganizations

Continuity of Interest:
In J.E. Seagram Corp. v. Commissioner,12 Tax Court held that the continuity of interest
requirement was satisfied, because DuPont acquired Conoco for 54% stock and 46% cash. The
Tax Court concluded that Seagram "stepped into the shoes" of 32% of the Conoco
shareholders. Accordingly, Seagram's recent purchase of stock did not destroy the COI
requirement.13

Its too difficult to trace all historical shareholder in a public corporation, Seagram was treated as
a historical SH

Continuity of Business Enterprise:


Requires that P either continue Ts historic business or use a significant portion of Ts historic
business assets in a business. Reg. 1.368-1(d)(1).

Reorganization: A Reorganization (statutory merger)


the term reorganization means (A) a statutory merger or consolidation 368(a)(1)(A).
a statutory merger or consolidation is a transaction effected pursuant to the statute or statutes
necessary to effect the merger or consolidation, in which transaction, as a result of the operation
of such statute or statutes, the following events occur simultaneously at the effective time of the
transaction See Regs

61
Problem 11-1:
(a) How would Kass and Seagram be decided under the current
regulations?
(b) Suppose that in Seagram, following its exchange of Conoco stock for DuPont stock,
Seagram had subsequently sold its DuPont stock on the market for cash. If the current
regulations had been applicable, would that additional step have affected COI? Would it have
made a difference if the sale by Seagram were pursuant to a binding agreement
entered into prior to the exchange with DuPont?
Binding agreement to sell after reorganization does not destroy step-transaction recognition of
the reorg
(c) Answer the same questions as in (b) under the alternative assumptions that (i) Seagram's
DuPont stock is subsequently redeemed by DuPont for cash rather than sold on the market, or
(ii) DuPont subsequently redeems for cash the stock purchased from Seagram on the market.
This destroys reorg because corporate cash of acquirer is used to redeem shares rather than a
3rd party as discussed in (b)

Rev. Rule 2000-5


Compliance with a corporate law merger statute does not by itself qualify a transaction as a
reorganization .... In addition to satisfying the requirements of business purpose, continuity of
business enterprise and continuity of interest, in order to qualify as a reorganization under
368(a)(l)(A), a transaction effectuated under a corporate law merger statute must have the
result that one corporation acquires the assets of the target corporation by operation of
the corporate law merger statute and the target corporation ceases to exist.
Texas State statutory law does not guarantee reorg recognition if the elements of the merger
arent consistent with elements off the code in 368(a)(I)(A)

Mergers and LLCs (Reg. 1.368-2(b)(1)(iii), Examples)

Forward triangular Mergers


368(a)(2)(D)
Acquisition of substantially all of the assets of a corporation in exchange for stock of a
corporation in control of the acquirer.
No stock of acquirer can be used: The merger would have qualified as a A reorg had the
merger been made into parent
Although no stock of the acquiring corporation can be used in the transaction, there is no
prohibition (other than the continuity of interest requirement) against using other property, such
as cash or securities, of either the acquiring corporation or the parent or both. In addition, the
controlling corporation may assume liabilities of the acquired corporation without disqualifying
the transaction under section 368(a)(2(D), and for purposes of section 357(a) the controlling
corporation is considered a party to the exchange. Reg. 1.368-2(b)(2).
Post-merger liquidation into Parent treated as asset acquisition by Parent. Rev. rul. 72-405.
Then is is just treated as merger between X and P
It may be merger under other provisions

Good Consideration vs. Bad Consideration

62
1. Non voting preferred stock issues by controllers
a. Its ok for 368(a)(2)(D)
2. Bond issued by acquirer
a. Its fine, qualifies as boot, can't be more than 40% in order to maintain continuity of interest

Permissible consideration. What is the effect on reorganization status of the following


consideration provided in a forward triangular merger? For purposes of this question, the
"acquiring corporation" is the corporation surviving the merger and the "controlling corporation"
is a corporation m control of the acquiring corporation.
a. Nonvoting preferred stock issued by the controlling corporation;
b. A 30-year bond issued by the controlling corporation; .
c. Cash paid by either the controlling or acquiring corporation; ..
d. The assumption of certain target liabilities by the controlling or acquiring
corporation; . .
e. Nonvoting common stock or voting preferred stock issued by the acquiring
corporation; . . .
f. A 20-year bond or six-month note issued by the acquiring corporation;
g. A 15-year debenture issued by the acquiring corporation that is convertible
into voting common stock of that corporation.
This is bad because under 368(a)(2)(D) because you cant have any of the acquiring stock as a
part of the transaction, would be better if it was controlling company shares that the debenture
was convertible too

Asset Acquisitions: C Reorganizations:


Sections 368(a)(1)(C) and (2)(B)
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. 368(a)(1)
(C).

Boot Relaxation Rule: Acquirer must acquire solely for voting stock property of the other
corporation having a fair market value which is at least 80 percent of the fair market value of all
of the property of the other corporation
Liabilities assumed by the acquiring corporation are treated as money paid. 368(a)(2)(B).
Liquidation Requirement: Target has to distribute the stock, securities, and other property
received. 368(a)(2)(G).

Under a special rule, up to 20% of the consideration for Target's assets can be property other
than Acquiring (or Parent) voting stock, but for purposes of this rule, the assumption of Target's
liabilities is treated as the receipt by Target of other property. In most cases, therefore, the
effective limitation on property other than voting stock is far less than 20%.
Target must ordinarily liquidate.
Acquiring can contribute the acquired Target assets to a subsidiary controlled by Acquiring.
-$1 of bad consideration destroys a C organization

C Reorganizations and Substantially All


What is ''substantially all"? There is no statutory definition of "substantially all." As explained in
Rev. Rul. 88-48, the purpose of the "substantially all" test is to prevent divisive transactions from
qualifying as "C" reorganizations. Thus, a failure to transfer some part of the target's business

63
assets is more likely to violate this requirement than the retention of a small amount of cash or
liquid assets in order to satisfy remaining target creditors. For advance ruling purposes,
"substantially all" means at least 90 percent of the value of the net assets and at least 70
percent of the value of the gross assets of a corporation immediately prior to transaction. Rev.
Proc. 77-37, 1977-2 C.B. 568, 569.
Unwanted assets. The tax law is very formalistic

Bausch & Lomb Optical Co. v. Commissioner


In other words, that Bausch & Lomb parted with 21,161 shares of its own voting stock, plus
9923 114 shares of its Riggs stock, for the transfer to it of all of the Riggs assets. Bausch &
Lomb contends, however, that a "reorganization" was effected under [section 368(a)(l)(C)J and
that it is therefore entitled to tax-free treatment. Bausch & Lomb concedes that to qualify as a
"C" reorganization, it could not furnish any additional consideration over and above its own
stock.
Moreover, Bausch & Lomb admits, as the correspondence and minutes of pertinent meetings
plainly show, that the acquisition of the Riggs assets and the dissolution of Riggs were both part
of the same plan.
The argument runs to the effect that, if the two steps are viewed apart from one another, a "C"
reorganization is effected. Petitioner contends that, even if a qualification according to the literal
terms of [section 368(a)(1)(C)] is not found, the amalgamation was in substance a
"reorganization" because it has the attributes of one, including "continuity of interest" and
business purpose.
the "business purpose" of dividing the liquidation into two steps lends no support to Bausch &
Lomb's contention that in substance and actuality a reorganization was achieved. Congress has
defined in [section 368(a)(1)(C)J how a reorganization thereunder may be effected, and the only
question for us to decide, on this phase of the case, is whether the necessary requirements
have been truly fulfilled.
We merely hold that the attempt to thwart taxation in this case by carrying out the liquidation
process in two steps instead of one fell short of meeting the requirements of a C reorganization.

NewCo cannot be immediately liquidated


To qualify as a nontaxable reorganization under Sec. 368(a)(1)(C), an acquiring corporation
must acquire substantially all of the properties of a target in exchange solely for its voting stock
(or solely for voting stock of its parent). The solely-for-voting-stock requirement is relaxed by
Sec. 368(a)(2)(B), which provides that the use of money or other property will not prevent an
exchange from qualifying as a C reorganization if at least 80% of the value of the target's
property is acquired for voting stock. This "boot relaxation" rule allows up to 20% of the target's
assets to be acquired for cash or other property. Because liabilities assumed by (or taken
subject to) the acquiring corporation are treated as cash paid for the property, however, solely
voting stock must be used any time the target's liabilities exceed 20% of its assets' fair market
value (FMV).
The IRS ruled that the transaction failed to qualify as a tax-free C reorganization. Only
21% of the target's assets were acquired with the acquiring corporation's stock; the
remaining 79% were acquired as a liquidating dividend of the previously held stock in the
target.

64
Regs have since changed
Problem 11-2

Reorganizations Continued:
Tax-free M&A transactions are considered "reorganizations" and are similar to taxable deals
except that in reorganizations the acquirer uses its stock as a significant portion of the
consideration paid to the seller rather than cash or debt. Four conditions must be met to qualify
a transaction for tax-free treatment under Internal Revenue Code (IRC) Section 368:
k Continuity of ownership interest At least 50% of the consideration is acquirer stock
(although transactions with as little as 40% stock consideration have qualified for tax-free
treatment).
k Continuity of business enterprise The acquirer must either continue the target's historical
business or use a significant portion of the target's assets in an existing business for 2 years
after the transaction.
k Valid business purpose The transaction must serve a valid business purpose beyond tax
avoidance.
k Step-transaction doctrine The transaction cannot be part of a larger plan that, taken in its
entirety, would constitute a taxable acquisition.
Reorganizations, while not generally taxable at the entity level, are not completely tax-free to the
selling shareholders. A reorganization is immediately taxable to the target's shareholders to the
extent they receive non-qualifying consideration, or "boot". Also, tax on acquirer stock received
by target shareholders as consideration is deferred rather than avoided altogether.

Stock-for-Assets Acquisition ("C" Reorganization)

In a "C" reorganization, the acquirer


exchanges its voting common and/or preferred stock for "substantially all" of the target's assets.
The target liquidates and transfers the acquirer shares and any remaining assets to its
shareholders. Consideration paid in cash or securities other than voting common or preferred
stock (boot) cannot exceed 20% of the FV of the target's pre-transaction assets. Any liabilities
assumed by the acquirer count toward the 20% boot limit when cash or other non-qualifying
consideration is paid.
The acquirer is highly exposed to any assumed liabilities unless a subsidiary is used to
shield that exposure as in other structures. Moreover, like taxable asset acquisitions, the "C"
reorganization can be mechanically complex, costly, and time consuming. Hence, "C"
reorganizations are rare.
FOR RULINGS PURPOSES

65
Substantially all requires a transfer of assets representing at least 90% of the fair market value
of the nets assets and at least 70% of the FMV of the gross assets held by the corporation
immediately prior to the transfer.
All payments to dissenters and all redemptions and distributions (except for regular, normal
distributions) made by the corporation immediately preceding the transfer and which are part of
the plan of reorganization will be considered as assets held by the corporation immediately prior
to the transfer. Rev. Proc. 77-37.

Problem 11-2
Problem 11-2: T Corporation has $1,100x gross assets and $1,000x liabilities outstanding. P
Corporation would like to acquire T for P voting stock in a "C" reorganization. Which of the
following transactions is most likely to qualify as a reorganization? Why?
(a) T transfers $100x assets to P for P voting stock, and T retains the remaining $1,000x assets
to pay off its creditors.
a) What kind of reorg? COPI: What % of consideration was stock? Remember, the
notes will be boot.
(b) T transfers $1,100x assets to P in exchange for $1 OOx P voting stock and P's assumption
of all of T's liabilities. See Reg. 1.368-2(d)(1).
As discussed in class, if the total consideration satisfies COPI, does it matter how it is
divided among the SHs? See Rev. Rul. 66-224. Again, COPI: What % of total
consideration is stock?

(c) T uses $1,000x of its assets to pay off its creditors, and then T transfers its remaining $100x
assets to P for P voting stock.
When do you generally determine COPI? Reg. 1.368-1T(e)(2)(i)
(d) T transfers $1,100x assets to P for $100x P voting stock and $1,000x cash, and T then uses
the cash to pay off its creditors.
COPI: do sales to 3rd parties matter? Reg. 1.368-1(e)(1)(i), -1(e)(6) Example 1(i)
Per se bad because more cash that voting stock exchanged
(e) T transfers $1,100 x assets to P for $1,100x P voting stock, and T pays off its creditors with
$1,000x of the P stock. See IRC. 368(a)(2)(G)(i), 361(c)(1) and (3).
It T liquidated the stock and paid of SHs, no problem
P stock paying of creditors is ok as long as its pursuant to a plan of liquidation
Creditors can destroy reorg if they get redeemed by P rather than on the market
(f) T transfers $1,100x assets to P for $1,100x P voting stock, T sells $1,000x of the stock for
$1,000x cash, and T then uses the cash to pay off its creditors. See IRC. 358(a)(1).
Not substantially all when T sells

Problem 11-3: T Corporation has $650x operating assets, $250x investment assets, $100x
cash, and liabilities of$350x. Determine which of the following transactions involving the
acquisition of T's assets by P Corporation would constitute a reorganization. GP is a corporation
that controls P. Assume in each case that the "distribution" requirement is met.
(a) P acquires all of T's operating assets for P voting stock worth $650x
.
(b) Same as (a) except that the consideration consists of P voting stock

66
worth $50x and GP voting stock worth $600x.
You cant mix and match parent or sub stock. This is no good, you must use one or the other
(c) P acquires all of T's assets in exchange for P voting stock worth $600x, P nonvoting stock
worth $50x, and P's assumption of all of T's liabilities.
Assumption of liability counts as boot, for C reorgs, nonvoting stock counts as boot, 400x boot
600x Voting stock, boot is more than 20%
(d) Same as (c) except that all of the P stock is voting stock.
Assumption of liability doesnt count as boot when you have all voting stock, so 350k liability
doesnt count as boot, voting stock is then 100% and it is good
(e) P acquires all of T's assets in exchange for GP voting stock worth $650x and the assumption
(partly by P and partly by GP) of all of T's liabilities.
Boot relaxation rule doesnt apply, because acquirer and parent split assumption of liability: The
acquisition would qualify under (c)(1) if not for the fact that GP is assuming some of the liability

B Reorganization: Chapman v. CIR

B Reorganization: First, "the acquisition" of another's stock must be "solely for ... voting stock."
Second, the acquiring corporation must have control over the other corporation immediately
after the acquisition.

67
The single issue raised on this appeal is whether "the acquisition" in this case complied with the
requirement that it be "solely for ... voting stock." It is well settled that the "solely" requirement is
mandatory; if any part of "the acquisition" includes a form of consideration other than voting
stock, the transaction will not qualify as a (B) reorganization. See Helvering v. Southwest
Consolidated Corp., 315 U.S. 194, 198 (1942) ("'Solely' leaves no leeway. Voting stock plus
some other consideration does not meet the statutory requirement."). The precise issue before
us is thus how broadly to read the term "acquisition." The Internal Revenue Service argues
that "the acquisition ... of stock of another corporation" must be understood to
encompass the 1968-69 cash purchases as well as the 1970 exchange offer.

Whatever talismanic quality may have attached to the acquisition of control under previous
versions of the Code ... is altogether absent from the version we must apply to this case. In our
view, the statute should be read to mean that the related transactions that constitute "the
acquisition," whatever percentage of stock they may represent, must meet both the "solely for
voting stock" and the "control immediately after" requirements of Section 368(a)(l)(B).
Control is 80% of the Vote and 80% of all the other shares
Only consideration in B reorg is voting stock

B Reorganization:
1. Debentures of acquiring for debentures of target doesnt violate solely voting stock 98-10
2. Stock options of acquiring for stock options of target ok rev rul 70-269
3. Non-voting stock requirement not violated if consideration doesnt come from acquiring (or
related parties)
a. Cash payments to dissenting SHs ok if made by target. Rev. Rul. 68-285
4. Stock acquisition followed by liquidation constitutes an asset acquisition instead of a stock
acquisition Rev. Rul. 67-274

Reverse Triangular Mergers: Section 368(a)(2)(E)


In a reverse triangular merger, a subsidiary ("Sub") of the acquiring corporation ("Acquiring")
merges into the target corporation ("Target"). Acquiring's Sub stock is converted into Target
stock and the former Target shareholders receive the merger consideration in exchange for their
Target stock. This form of acquisition is often desirable for regulatory or contractual reasons
when it is important that no transfer of Target assets take place.
Transaction otherwise qualifying as a merger shall not be disqualified by reason that a corp.
which before the merger was in control of the merged corporation is used in the transaction if...
(i) after the transaction, the corporation surviving the merger [T] holds substantially all of its
properties and of the properties of the merged corporation [S] (other than stock of the controlling
corporation [P] distributed in the transaction); and
(ii) in the transaction, former shareholders of the surviving corporation [T] exchanged, for an
amount of voting stock of the controlling corporation [P], an amount of stock in the surviving
corporation [T] which constitutes control of such corporation.

Problem 11-5: Analyze the following transactions to determine whether they qualify as
reorganizations pursuant to section 368(a)(l)(A) and (2)(E)

68
(a) T Corporation has a single class of common stock and a single class of non-voting preferred
stock outstanding. As part of a plan for p Corporation to acquire T, T distributes cash to its
preferred stockholders complete redemption of their T stock. P then forms S, a new wholly-
owned subsidiary, and capitalizes it with voting stock of P. S merges into T, with T surviving, and
in the merger, the holders of the. T common stock surrender all of their stock in exchange for
the P voting stock formerly held by S. The surrendered T stock is cancelled and the stock of S
held by P becomes T stock by operation of law. As a result of the transaction, P owns all of the
stock of T the former common stockholders of T own voting stock of P, and the former preferred
stockholders of T are cashed out.

(b) Same as (a), except that the cash used to redeem the nonvoting preferred stock originates
with P and is transferred by S to the T preferred stockholders as part of the merger.

(c) Same as (a), except that the nonvoting preferred stock of T is owned by P prior to the
transaction. In the merger ofS into T, with T surviving, the common stockholders of T surrender
all of their stock solely for P voting stock.

(d) Same as (c), except that P acquired the nonvoting preferred stock of T 18 months prior to
the merger, 20 percent for cash and 80 percent for P voting stock.

(e) Same as (a), except that following the merger, but as part of the overall plan, T issues a new
class of nonvoting preferred stock (with more favorable terms than the former class of such
stock) to unrelated corporation Q for cash.
The issue here is control, if integrated then you dont have sufficient control

Rev Rul 2008-25: T has 150 of assets and 50 of liabilities. P has net assets of 410. P forms X
to acquire all the stock of T in a merger of X into T (reverse triangular merger). The T
shareholder receives 10 cash and 90 voting stocks. Good reorg?

However, ... a direct acquisition by P of T's assets in this case does not qualify as a
reorganization under 368(a). P's acquisition of T's assets is not a reorganization described in
368(a)(l)(C) because the consideration exchanged is not solely P voting stock and the
requirements of 368(a)(2)(B) are not satisfied. Section 368(a)(2)(B) would treat P as acquiring
40 percent of T's assets for consideration other than P voting stock (liabilities assumed of 50x
dollars, plus lOx dollars cash). Additionally, the transaction is not a reorganization under
368(a)(l)(A) because T did not merge into P. Accordingly, the overall transaction is not a
reorganization under 368(a).

Reorganization: D Reorgs
Divisive Reorganizations
Form Subsidiary to place class of assets
Distribute S stock to P SHs
P SHs now fully own P and S as separate corporations

69
a transfer by a corporation of all or a part of its assets to another corporation if immediately after
the transfer the transferor, or one or more of its shareholders (including persons who were
shareholders immediately before the transfer), or any combination thereof, is in control of the
corporation to which the assets are transferred; but only if, in pursuance of the plan, stock or
securities of the corporation to which the assets are transferred are distributed in a transaction
which qualifies under section 354, 355, or 356. 368(a)(1)(D).
To qualify as a D reorg
(A) the corporation to which the assets are transferred acquires substantially all of the assets of
the transferor of such assets; and
(B) the stock, securities, and other properties received by such transferor, as well as the other
properties of such transferor, are distributed in pursuance of the plan of reorganization. 354(b).
No stock has to actually be issued if the same person(s) own, directly or indirectly, all of the
stock of the transferor and transferee. Reg. 1.368-2(l)(2)(i).
If the value of the assets > consideration received, the transferee is deemed to issue its stock
in an amount equal to the excess and the stock is deemed distributed by the transferor.
If the value of assets = consideration receive, the transferee is deemed to issue a nominal
share of stock that is deemed distributed by the transferor. Reg. 1.368-2(l)(2)(i).

Individual A owns all of the stock of T and X corps. T sells all of its assets to X for cash and
liquidates. Reg. 1.368-2(l)(3), Ex. 1. What if A is a Corp? See Problem 11-7.

Type D . There are two kinds of Type D reorganizations: Acquisitive and Divisive.
a. Acquisitive Reorganization: The target absorbs the acquiring (sometimes called the minnow
swallowing the whale).
(1) Unlike other reorganizations, the target transfers a controlling interest in its stock for the
assets of acquiring. Thus, it is acquiring that is transferring assets rather than target. The target
stock received by acquiring must be distributed to its shareholders in a transaction qualifying
under one of the following Code sections: 354, 355, or 356.
(2) For acquisitive D reorganizations, 354 requires that substantially all of the property of the
acquiring corporation be transferred to the target corporation for control of the target.

(a) Control is owning at least 50% of total voting stock or 50% of total value of all stock classes.
No ownership attribution is permitted in determining whether the control test is met. See
368(a)(2)(H), which refers to the control requirements found in 304(c).
(b) All stock and property received from the target as well as property retained by the acquiring
corporation (i.e., not transferred to the target) must be distributed to its shareholders. The
acquiring corporation then terminates.

(3) If an acquisitive Type D could also qualify as a Type C, the Code provides that the
reorganization will be treated as a Type D. This ensures that distribution of stock and securities
will comply with 354 or 355.
b. Divisive Reorganization: Division of a corporation into two or more

E Reorganization

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Bazley v. CIR (1947): Exchange of stock for stock and debentures not a reorganization-
debentures treated as dividend
E Reorg:
1. Bonds for Stock
2. Preferred stock for common stock
3. Common Stock for Preferred Stock 1-368-2

(1) Stock for stock. This includes common stock for common, preferred stock for preferred,
common for preferred, and preferred for common. However, the preferred for common may
qualify as 306 stock.

(2) Bonds for bonds. If the principal amount of the bonds received is greater than the principal
amount of the bonds relinquished, the excess amount will be taxable as boot.
(3) Bonds for stock. To the extent that stock is received for interest in arrears, the
recapitalization is not tax free.
b. Stock for bonds does not qualify.

Type F
Type F reorganizations are a mere change in identity, form, or place of organization. a.
Although the reorganization is limited to a single corporation, this limitation does not preclude
the use of more than one corporation in the restructuring. For example, an operating corporation
in New York creates a new corporation in Delaware, transfers all of its assets to the new
corporation, and then liquidates. This reincorporation in a new state is a Type F reorganization.

b. Changing from a Subchapter S to a Subchapter C (regular) corporation or visa versa


qualifies as a Type F reorganization.
c. When a corporation changes its name, this is technically a Type F reorganization.
d. If a reorganization can qualify as a Type A, C, or D as well as a Type F reorganization, it is
treated as a Type F.

Rev. Rul. 96-29


Sit. 1: Q, a state A corp with nonvoting prd and common, merges into R, a state Y corp (aka
Delaware), and does an IPO and redeems the nonvoting prd.
Sit. 2: W, a state M corp, enters into merger agreement whereby Z (target) merges into Y, a sub.
of W with Z SHs receiving W shares. Immediately thereafter W merges into N, a new corp
organized in state R (Delaware). W SH (CS & PrdS) exchange their W shares for R shares.

Reorganization: Overview of the Tax Consequences


368(a)(1)
Target SHs
Exchange: 354/356
Basis 358(a)
Acquiror
1032
362(b)

71
381(a)
Target T/{ Exchange
361(a)/(b)
T Liquidation
361(c)
Target Consequences:
T does not recognize any G/L on the receipt of stock or securities of Parent or Sub. 361(a).
If boot is received, T doesnt recognize gain if it distributes the boot either to its SHs or creditors.
361(b)(1)(A) and (3).
T has a COB in the stock or securities received. 358(a)(1).
T has a FMV in the boot. 358(a)(2), (f).
T doesnt recognize G/L when it distributes qualified propertystock and securities of P, S or
T. 361(c)(1).
T recognizes G if it distributes property other than qualified property, e.g., T assets that werent
transferred in the reorganization. 361(c)(2)(a).

P and S Consequences
No G/L to P or S on issuance of their stock for T assets or stock. 1032(a).
What if S transfers P stock in the reorg, e.g., triangular merger, does section 1032 (a) apply?
Under 1032 regulations, P stock provided by P or S to T/T SHs is treated as a disposition by P
of P stock in exchange for T assets or T stock. Reg. 1.1032-2(b).
S doesnt recognize G/L on exchange of P stock if S receives the P stock pursuant to the plan
of reorganization. Reg. 1.1032-2(c).

S has a COB in the T assets or T stock. 362(b).


If Ts assets have a net BIL and T wasnt subject to US tax, the basis of the assets will be their
FMV. 362(e)(2).

P increases basis in S stock by the net insides basis (


basis less liabilities) of T assets (or stock).
In essence, transaction treated as if P acquired the T assets (or stock) and then dropped them
down into S. Reg. 1.358-6(c)(1).
Ts tax attributes (E&Ps, NOLs, FTCs) survive in the hands of the corporation that directly
acquires Ts assets. 381(a) and (b); Reg. 1.381(a)-1(b)(2)(i). This rule applies even if the
assets are transferred.

Target Shareholders and Security Holders


T stockholder (or security holder) doesnt recognize G/L upon the receipt of P or S stock (or
securities). 354(a).
Receipt of P or S securities by T SH is boot. 354(a)(2)(A)(ii).
If T SH receives only securities, the FMV of the securities is a distribution and not boot. 356(a)
(1).
T security holder can receive either P or S securities or stock.
If the principal amount of the security received is greater than the principal amount of the
security surrendered, the FMV of the excess is boot. 354(a)(2)(A)(i); 356(d)(2)(B).

72
Boot: If section 354 applies, exchanging SH (or security holder) must recognize gain to the
extent of . 354(b).
Dividend within Gain: If boot is received in a reorg has the effect of a dividend, the gain
recognized is treated as a dividend. 354(b)(2).
Dividend Test: Treat acquiring corp as having issued only stock to shareholder and then
acquiring redeems stock for boot. CIR v. Clark (1998). See 302(b).
Under current law, does it matter for individual SHs?
For corporations? 1059(e)(1)(B).
Allocation of boot: if no allocation is made, the boot is allocated pro rata based on FMV of
stock/security surrendered. Reg. 1.356-1(b).
TP receives a COB in nonrecognition property received, reduced by boot (including $) and
increased by gain (including any dividend-within-gain). 358(a)(1).
TP receives a FMV basis in any boot(a)(2).

The focus presumably of section 356(a)(2) -


The Court concluded that the Wright test was more consistent with the language and history of
the statute. In general, a taxpayer is less likely to receive a dividend under the Wright test than
the Shimberg test. If the acquiring corporation is widely held and more than 20 percent of the
consideration received by the taxpayer is boot, such boot will generally not be a dividend under
the section 302 tests. Although neither a "C" nor an "A" reorganization by reason of section
368(a)(2)(E) permits boot consideration in excess of 20 percent of the value of the target
corporation, that limitation is applied in the aggregate and not on a shareholder-by-shareholder
basis. Thus, a given target shareholder in either of those reorganizations, as well as in an" A"
reorganization and one qualifying under section 368(a)(2)(D), may generally receive enough
boot to avoid dividend characterization.

Problem 11-8: T Corporation is owned equally by individuals A ( 100 shares) and B (100
shares). A's basis in the T stock is $10 and B's basis is $50. T owns a single asset worth $100,
with a basis of $30, and subject to a $10 liability. Pursuant to a valid business purpose, T
transfers the asset to S Corporation in exchange for S voting stock ($80), cash ($10), and S's
assumption of the liability. As part of the plan, T liquidates and distributes pro rata to A and B (in
exchange for their T shares) the S stock and cash received from S. Assume that the S stock is
not nonqualified preferred stock and there is a plan of reorganization.

(a) Determine the tax consequences of this transaction to all parties.


It is a tax exempt C reorg. Why?
T has no G/L, per Sec 361. No G/L on receipt of voting stock
T basis 30-10-10= 10 basis in the new shares per section 358
S basis (has COB in T assets) = 30 basis per 362(b)
Ts tax attributes= S
T SHs A and B: Sec. 354, A has $5 gain from boot, B has unrecognized loss (so no loss)
Whether A and B have dividend depends on the other SHs
As basis starts at 10, recognizes 5 gain, subtracts 5 boot= 10 basis again at end
B basis starts at 50; recognizes 5 gain, subtracts 5 boot= 45 basis at end
(b) Same as (a), except that the stock exchanged by S is voting stock of P

73
Corporation provided by P in the transaction, and P controls S. Thus, in the exchange between
T and S, S transfers P voting stock worth $80 (provided by P in the transaction), $10 cash
(provided by S), and S assumes the liability.

(c) Same as (b), except that T's asset is subject to a $60 liability. In the
transaction, S exchanges P voting stock (worth $40) and assumes the
liability, but pays no cash.
(d) Same as (a), except that the T shares owned by A and B are all owned by a single
shareholder, C, in two blocks of equal value. C has a $50 basis in one block and a $10 basis in
the other. To minimize the amount of gain recognized in the transaction, how should C allocate
the consideration received in exchange for C's shares in T?

Divisive Reorganizations: Spin-offs, Split-offs, and Split-ups


Rockefeller v. Us (1921)
The distribution, whatever its effect upon the aggregate interests of the mass of stockholders,
constituted in the case of each individual a gain in the form of actual exchangeable assets
transferred to him from the oil company for his separate use in partial realization of his former
indivisible and contingent interest in the corporate surplus. It was in substance and effect, not
merely in form, a dividend of profits by the corporation, and individual income to the
stockholder ....

I. Overview of Section 355 Transactions Section 355 provides that when certain judicial and statutory
requirements are satisfied, a corporation can be divided into two or more separate corporations on a tax-
free basis. The rationale is that a corporate division is merely a change in the form of business which
continues to be owned and operated by the same shareholders. II. Types of Corporate Divisions

A. Spin-Offs A "spin-off' is a pro-rata distribution of a subsidiary corporation to its existing


shareholders. A spin-off resembles a dividend in kind. The stock of a subsidiary corporation is
distributed pro-rata to the shareholders of the parent without any surrender of stock by them. If
the spin-off fails to qualify under Section 355, the parent corporation would be taxed under
Section 311 on the appreciation (if any) in the value of the subsidiary stock that is distributed
and the shareholders would be taxable under Section 301 on the receipt of the stock as a
dividend.

B. Split-Off A "split-off' is a non pro-rata distribution of stock by the parent corporation of a


subsidiary corporation to some of its shareholders in exchange for their stock in the parent.
Example: A and B are two equal shareholders of the parent corporation. The business is divided
and one part of the business is transferred to a newly formed subsidiary followed by the parent
distributing the subsidiary stock to A in redemption for all of his stock in the parent corporation. A
split-off resembles a redemption. If the split-off fails to qualify under Section 355, the parent
corporation would be taxed under Section 311 on the fair market value (in excess of basis) of
the subsidiary stock distributed in redemption of the shareholder's stock in the parent; and the
shareholder receiving the subsidiary stock would be taxed under Section 302 on the redemption
of his stock in the parent.

C. Split-Ups A "split-up" is when the parent corporation divides the business and transfers it to
two new subsidiary corporations which are then distributed non pro-rata to all of the
shareholders in exchange for their stock in the parent corporation. A split-up resembles a

74
complete liquidation of the parent corporation. After a split-up, the shareholders own stock
interests (either pro-rata or non pro-rata) in the two new corporations and the distributing
corporation ceases to exist. If the split-up fails to qualify under Section 355, the parent
corporation would be taxed under Section 336 on the distribution of the subsidiaries as if it had
sold the subsidiaries at fair market value, and the shareholders would be taxed under Section
331 on the receipt of the stock.

D. Divisive Reorganizations In many cases, the subsidiaries do not exist at the time the parent
corporation wishes to separate its business. However, a divisive transaction can be done on a
tax free basis using a corporate reorganization under Section 368(a)(s)(D), which allows the
parent corporation to form a subsidiary to which the parent transfers part or all of its business as
the first step in a plan to distribute the subsidiary's stock to shareholders. For example: A Type D
Reorganization in a "split off' would involve the transfer of part of the parent corporation's
business to a controlled subsidiary corporation in exchange for its stock and securities followed
by a distribution of that stock (and securities) to certain shareholders of the parent corporation.
Handling the transaction as a D reorganization can accomplish any of the tax free divisions
described in Paragraphs A, B or C above. As in all types of tax free reorganizations, the judicial
requirements of "business purpose", "continuity of business enterprise" and "continuity of
interest" must also be met to satisfy the requirements of Section 355 whether or not
accomplished through aD Reorganization.

Divisive Reorganizations: Sections 355 and 368(a)(1)(D)


If the assets to be spun off are not in a separate subsidiary, the initial transfer is a divisive D
Reorganization under section 368(a)(1)(D)
In a non-divisive D reorg, the transferee corporation must acquire substantially all of the assets
of the transferor. Sec. 354 (b)(1)(A)
To Qualify as a divisive D reorg, the requirements of section 355 must be satisfied
If the assets to be spun off are already in a separate subsidiary, the rules of section 355 apply to
determine the tax consequences to the distributee(s) and distributing corporation.

Step Transaction doctrine:


Binding Commitment
End Result Test- IRS didnt accept this in Gordon
Mutual Interdependence Test
Distribution of stock rights are now treated as securities with no principal amount. Reg. 1.355-
1(c).

Hot Stock
Stock acquired within 5 yrs of its acquisition in a taxable transaction is treated as boot (but is
treated as stock for purposes of the distribution test). 355(a)(3)(B).
Whats the rationale for this limitation?
Note: Regs basically limit this rule to situations in which control (under 368(c)) is distributed but
the distributee doesnt own 80% of the V&V under 1504(a)(2).

355(a)(1)(B): Device
(B) the transaction was not used principally as a device for the distribution of the earnings and
profits of the distributing corporation or the controlled corporation or both355(a)(1)(B).

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Device Factors:
Pro rata distribution- Is it a disguised dividend?
Subsequent sale of stock of distribution or controlled
Existence of assets not used in a T/B that satisfies section 355(b), e.g., cash and other liquid
assets- this Yahoo, if distributing or control of a lot of non-business assets
Business of either distributing or controlled is a secondary business that continues to be
secondary after the separation and can sold w/out affecting the business of the other
corporation- Can accumulate a lot of earning outside the corporate structure of parent
Secondary business: business whose principal function is to serve the business of the other
corporation. Reg. 1.355-2(d)(2).

Non-device Factors:
Corporate business purposes
Distributing is publicly traded and widely held
Distribution to Corporate shareholders entitled to a DRD. Reg. 1.355-2(d)(3).
Quasi non-device Factors
Neither distributing or controlled has any current, accumulated, or potential E&Ps (any property
with BIG!)
Distribution would be a section 302(a) transaction (S/X). Reg. 1.355-2(d)(5)- Complete
Redemption
Rev. Rul. 64-102

Rev. Rul. 2003-38


The web site's operation does draw to a significant extent on D's existing experience and know
how, and the web site's success will depend in large measure on the goodwill associated with D
and the D name. Accordingly, the creation by D of the Internet web site does not constitute the
acquisition of a new or different business under l.355- 3(b )(3)(ii). Instead, it is an expansion of
D's retail shoe store business. Therefore, each of D and C is engaged in the active conduct of a
five-year active trade or business immediately after the distribution. ...

Passive Activities:
Holding investment stock, securities, land, or other property; No good (not active trade or
business)
Leasing, but only if the owner performs significant services with respect to the operation and
management of the property. Reg. 1.355-3(b)(2)(iv).

Business Purpose and Continuity of Interest: Reg. 1.355-2(c)


Section 355 requires that one or more persons who, directly or indirectly, were the owners of the
enterprise prior to the distribution or exchange own, in the aggregate, an amount of stock
establishing a continuity of interest in each of the modified corporate forms in which the
enterprise is conducted after the separation. Reg. 1.355-2(c)(1).

Business Purpose

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Corporate Business Purpose: A real and substantial non-Federal taxation purpose germane to
the business of the distributing, controlled, or affiliated group to which the distributing
corporation belong.

Distributees tax Consequences: Of a Good 355


1. No G/L to distributee on receipt of stock/securities
a. SH can receive shares tax-free but receipt of securities is boot
b. Security holder can receive shares tax-free but receipt of securities is boot
c. Security holder can receive shares or securities.
d. NQPS can be received if NQPS surrendered. 355(a)(1)(A), (a)(3)(A).
2. Receipt of boot is taxed as an ordinary distribution (dividend) under sec. 301 if no stock or
securities is surrendered (spin-off). 356(b).
a. If stock/securities surrendered (split-up and split-off) and boot is received, gain is recognized to
the extent of the boot. 356(a)(1).
b. Character-> Effect of the Distribution of a Dividend to the extent of E&Ps
c. Dividend Testing: Assume boot received is in redemption of distributees stock in distributing just
prior to the exchange of stock/sec for the boot. Rev. Rul. 93-62.
Example
Basis: COB (prior to the transaction), increased by gain, and decreased by boot. 358(a)(1).
Basis then allocated between nonrecognition property (e.g., shares) and retained
interest (e.g. shares) in distributing based on FMV. This allocation is required even if no
shares are given up (spin-off). 358(b) and (c).
Flexibility in allocating boot. Reg. 1.358-2(a)(2)(i), (iv).

Disproportionate Redemption; must be at least 20% reduction


Section 355: Control and Distribution of Control
For the distributee to avoid gain/income on the distribution of the stock/securities of the
controlled corporation, the distributing corporation
Must control the controlled corporation
Distribute all of the stock and securities of the controlled corporation (or an amount of stock and
securities of the controlled corporation (or an amount of stock and securities constituting
control). Sec. 355(a)(1)(A) and (D)

1. Step transaction Doctrine


a. Binding Commitment
b. End Result Test
c. Mutual Interdependence Test

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Distribution of stock rights are now treated as securities with no principal amount. Reg. 1.355-
1(c)

Hot Stock
Stock acquired within 5 yrs of its acquisition in a taxable transaction is treated as boot (but is
treated as stock for purposes of the distribution test) 355(a)(3)(B)
Whats the rationale for this limitation?
Note: Regs basically limit this rule to situations in which control (under 368(c)) is distributed but
the distributee doesnt own 80% of the V&V under 1504(a)(2).

The Device Test: 355(a)(1)(B)


(B) the transaction was not used principally as a device for the distribution of the earnings and
profits of the distributing corporation or the controlled corporation or both355(a)(1)(B).
Device Factors:
Pro rata distribution
Subsequent sale of stock of distribution or controlled
Existence of assets not used in a T/B that satisfies section 355(b), e.g., cash and other liquid
assets
Business of either distributing or controlled is a secondary business that continues to be
secondary after the separation and can sold w/out affecting the business of the other
corporation.
Secondary business: business whose principal function is to serve the business of the other
corporation. Reg. 1.355-2(d)(2).
Non-device Factors:
Corporate business purposes
Distributing is publicly traded and widely held
Distribution to Corporate shareholders entitled to a DRD. Reg. 1.355-2(d)(3).

Quasi non-device Factors


Neither distributing or controlled has any current, accumulated, or potential E&Ps (any property
with BIG!)
Distribution would be a section 302(a) transaction (S/X). Reg. 1.355-2(d)(5) See Rev. Rul. 64-
102

Active Trade or Business:


Both distributing & controlled must be engaged immediately after the distribution in the AT/B, or
distributing holds only stock/sec in the controlled corporation, which is engaged in the AT/B.
355(b)(1).
The AT/B cant have been acquired in a taxable transaction w/in the last 5 years, or control of a
corporation conducting the AT/B wasnt acquired in a taxable transaction w/in the last 5 yrs.
355(b)(2)(C) and (D).
For purposes of the AT/B test, all members of a separate affiliated group are treated as one
corporation. 355(b)(3)(A).

Passive activities:
Holding for investment stock, securities, land, or other property;

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Leasing, but only if the owner performs significant services with respect to the operation and
management of the property. Reg. 1.355-3(b)(2)(iv).

COI: Section 355 requires that one or more persons who, directly or indirectly, were the owners
of the enterprise prior to the distribution or exchange own, in the aggregate, an amount of stock
establishing a continuity of interest in each of the modified corporate forms in which the
enterprise is conducted after the separation. Reg. 1.355-2(c)(1).

Business Purpose
Corporate Business Purpose: A real and substantial non-Federal taxation purpose germane to
the business of the distributing, controlled, or affiliated group to which the distributing
corporation belong.

Proposed Regs:
Not Evidence of a Device: If the non business asset percentage of both distributing and
controlled is less than 20%, or the difference between the non business asset percentage of
distributing and controlled is less than 10%. (ratio of business asset to non-business asset)
Per Se Device:

Rev. Rul. 93-62, 1993-2 C.B. 118. For


example, suppose in a qualifying
section 355 transaction, (1) a taxpayer
surrenders her entire 40 percent
interest in the distributing corporation
for controlled corporation stock (worth
$200x) plus $200x cash, (2) all other stock in the distributing corporation is heId by unrelated
persons, and (3) no other distributions are made. The dividend equivalence of the taxpayer's
gain is determined by assuming that half of her stock in the distributing. corporation is redeemed
for $200x cash prior to the exchange of stock for stock. Since this redemption qualifies under
section 302(b)(2) (it reduces the taxpayer's interest in the distributing corporation from 40 to 25
percent, a greater than 20 percent reduction), the boot is taxable under section 302(a) and not
section 301. As discussed in chapter eleven, any dividend to the taxpayer is limited by the
amount of gain realized by the taxpayer in the exchange.

Basis is allocated based on FMV, split between control and distributing parties

Section 355(d)
355 and the Potential of avoidance of GU Repeal:
Assume P owns S with BIG at both P level and S level
Sale of S stock by P
Sale of assets by S and liquidation into P

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Liquidation of S into P
Sale of S stock with 338(h)(10) election (or 336(e))
Acquisition of P stock by new SH and distribution of S stock to New SH in a 355 transaction.

Section 355(d) aims to limit the tax-free distribution of stock/sec of controlled if the divisive reorg
is part of an acquisition (sale of Distributing assets w/out corporate-level tax).
These rules affect only distributing and not distributing shareholders.
Example: A, B, & C buy stock of T. After 2 years, T spins off its 3 businesses to each SH. Does
section 355(b)(2)(D) prevent this?

If someone comes in and buys stock for cash, they now have FMV basis, what happens to
earlier gain from 355(d) transaction? It could be gone forever
355(d) causes distributing company to be taxed

Distributing must recognize Gain in the case of a disqualified distribution. 355(d)(1).


Disqualified Distribution is any distribution if immediately after the distribution:
Any person holds at least 50% of the stock (V or V) of either distributing or controlled
attributable to certain (mostly) taxable purchases w/in 5 years of the distribution.
Disqualified stock
Any stock of distributing acquired by purchase w/in 5 years, and
Any stock of controlled: (1) acquired by purchase w/in 5 years; or (2) received in distribution to
the extent attributable to distributions on stock of distributing acquired w/in 5 years. 355(d)(2)
and (3).

Tax Consequences of Distributing: 355(e)


Distributing must recognize Gain if the distribution is part of a plan by which 1 or more persons
acquire directly or indirectly stock representing a 50% or greater interest [by Vote or Value] in
either distribution or controlled. 355(e)(2).
Plan Presumption: 1 or more persons acquire stock representing 50% or greater in distributing
or controlled during the 4-yr period beginning 2 years before the distribution.
In the case of an acquisition (other than involving a public offering) after a distribution, the
distribution and the acquisition can be part of a plan only if there was an agreement,
understanding, arrangement, or substantial negotiations regarding the acquisition or a similar
acquisition at some time during the two-year period ending on the date of the distribution. Reg.
1.355-7(b)(2).
Asset Acquisition: Merger or other asset acquisition (A, B, or D reorg) of distributing or
controlled treated as acquisition of the shares of the corporation whose assets were acquired.

What is a 'Reverse Morris Trust'


A reverse Morris trust is a tax-optimization strategy in which a company wishing to spin off and
subsequently sell assets to an interested party can do so while avoiding taxes on any gains
from such asset disposal. A reverse Morris trust is a form of organization that allows an entity to
combine a subsidiary that was spun off with a strategic merger or combination with another
company free of taxes, provided that all legal requirements for spin-off are met. To form a

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reverse Morris trust, a parent company must first spin off a subsidiary or other unwanted asset
into a separate company, which is then merged or combined with a firm that is interested in
acquiring the asset.

Acq. SHs must own less than 50% of V or V of the spin-off

Tax Consequences to Distributing: 355(g)


Section 355 doesnt apply to any distribution if, immediately after the distribution:
either distributing or controlled is a disqualified investment corporation, and
Any person holds a 50%-or-greater interest [by V or V] in disqualified investment corporation
and the person didnt hold such an interest immediately before the distribution. 355(g)(1)
Disqualified investment corporation
Any distributing or controlled is the FMV of the investments assets equals or exceeds 66.6% of
assets of the corporation.
Invest Assets: cash, stock, PSH interest, debt, option, forward, futures, FX. 355(g)(2)(A) and
(B).

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