12-1

Contributions to Corporations in Exchange for Stock

Section 351 No gain/loss recognized on transfers of

property to corporation in exchange solely for stock if immediately after transaction the transferors are in controlProperty does not include servicesSolely generally means only common stock

is received (no ‘boot’)Control means ownership of 80% of voting

power and value of all classes of outstanding stock

12-2

Impact of Boot on Section 351 Exchange

Boot includes cash or other property received by shareholder as part of Section 351 exchange Recipients of boot recognize gain (but

not loss) equal to the lesser of the gain realized or the FMV of the boot received

Tax basis of boot equals its FMV

12-3

Tax Basis and Section 351 Exchanges

Shareholders basis in stock received equals: Adjusted tax basis of assets transferred Less FMV of boot received Plus gain recognized

Corporations basis in assets received equals: Adjusted basis to contributing

shareholder Plus gain recognized by contributing

shareholder on exchange

12-4

Corporate Tax Consequencesof Receipt of Contributed Property

No gain or loss recognized by corporation on receipt of property in exchange for its stockNo gain recognized by corporation on receipt of property contributed by nonshareholder Example: contribution of land by municipality

to encourage business development Zero tax basis to corporation in such property If contribution is cash, tax basis of property

purchased with the cash is reduced

12-5

Corporate Capital Structure – Debt versus Equity

From issuing corporation’s perspective, debt is tax advantaged relative to equity Interest payments are deductible Dividend payments are not

From investor’s perspective Interest and dividend receipts are

taxable as ordinary income (Post-2003 Act, dividends taxed at 15%)

Sales of appreciated securities produce capital gains/losses

12-6

Debt versus Equity – Clientele Effects

Who are the natural clientele investors for corporate shares paying dividends? Other corporate investors – DRD

Who are the natural clientele investors for corporate shares that do not pay dividends? Individual investors – lower capital gains

rates

How will the before-tax rate of return on debt (which is tax-disfavored for the investor) compare to the before-tax rate of return on stock?

12-7

Corporate Distributions

Dividend: distribution by a corporation to its shareholders to the extent made out of earnings and profits (E&P) Taxed to shareholders as ordinary income

Distributions in excess of E&P are first considered a return of capital, reducing shareholder tax basisDistributions exceeding E&P and shareholder tax basis are taxed as capital gains

12-8

Earnings & Profits

Concept: measure of a corporation’s ability to pay its shareholders a return on their investmentEnding E&P equals Beginning E&P Plus current E&P Minus current deficit E&P Minus dividend distributions out of E&P

12-9

E&P continued

Annual calculation of current E&P: Current taxable income Less federal income tax and other

expenses not deducted in calculating taxable income but that reduce dividend-paying ability

Plus items of income not included in taxable income but that increase dividend-paying ability

E&P is general assumed to be earned ratably throughout the year

12-10

Distribution Ordering Rules

If current E&P is positive Distributions are treated as dividends to

the extent of current E&P Distributions in excess of current E&P

are dividends to the extent of beginning accumulated E&P

If current E&P is negative, subtract from beginning accumulated E&P Distributions are dividends to extent

above sum is positive

12-11

Dividends-Received Deduction

DRD available only to corporate shareholders receiving qualified dividends (generally from taxable domestic corporations)Amount of DRD depends on ownership share If ownership <20%, DRD = 70% If ownership >20%, <80%, DRD = 80% If ownership > 80%, DRD = 100%

12-12

Corporate Distributions of Non-cash Property

Shareholder recognizes dividend income equal to FMV of property received, and takes a tax basis equal to FMV Distributions of appreciated property

Corporation recognizes gain equal to excess of FMV over tax basis of property

FMV of distributed property reduces E&P Distributions of depreciated property

Corporation cannot recognize loss on excess of property’s tax basis over FMV

Adjusted basis of distributed property reduces E&P

12-13

Stock Dividends

Non-taxable stock dividends Proportionate distribution with no potential

for differential impact on any owner’s share of outstanding stock

No dividend income recognized, no impact on corporate E&P

Taxable stock dividends Disproportionate distribution of stock Dividend income recognized equal to FMV of

stock received, corporate E&P reduced by FMV

12-14

Stock Redemptions

Some possible motivations for redeeming stock: Stock needed for ESOP contributions Stock needed for option plans Belief that stock is under-valued,

management attempting to signal this belief to the market

Possibly more favorable tax treatment to redeeming shareholders than achieved if corporation simply pays a dividend

12-15

Example: After-Tax Cash Flow from Dividends

Tony owns 10% of the stock of X Corporation and receives a dividend of $10,000 If Tony’s marginal tax rate on dividend

income is 15%, calculate the tax due on his dividend income, and his after-tax cash flow

How would your answer change if the shareholder were Tony Inc. a corporation with a 35% marginal tax rate?

12-16

Example: Sale of Stock

Tony sells stock for $10,000. The stock was purchased two years ago for $2,000. Calculate Tony’s tax liability and after-tax

cash flow from the stock sale. How would your answer change if the

shareholder were Tony Inc.? On an after-tax cash flow basis, would Tony

(Tony Inc.) prefer a dividend or stock sale? What important economic difference between

these transactions affects this comparison?

12-17

Example: Dividend versus Sale Extended

Suppose that Tony owns 100% of the stock of X Corporation. If Tony sells 10% of his stock to an

unrelated third party, has his economic interest in the corporation changed substantively?

If X Corporation redeems 10% of Tony’s stock, has his economic interest in the corporation changed substantively? Is this transaction economically different

from a dividend?

12-18

Stock Redemptions: Dividend versus Sale Treatment

Qualifying redemptions are treated as a sale of stock. Otherwise, amounts received in redemption are taxed as dividends. Qualifying stock redemptions:

Distributions not essentially equivalent to a dividend

Substantially disproportionate distributions Distributions in complete termination of a

shareholder’s interest

12-19

Types of Stock Redemptions

Distributions ‘not essentially equivalent’ to a dividend Subjective determination, requires a

‘meaningful reduction’ in shareholder’s interest Decrease in voting control important factor to courts

Substantially disproportionate distributions after redemption, shareholder must own less

than 80% of interest owned prior to redemption after redemption shareholder must own < 50%

of combined voting power of the corporation

Redemptions in complete liquidation of shareholder’s interest

12-20

Shareholder Tax Consequences of Redemptions

If redemption qualifies in one of the above categories: Treated as sale of stock for tax

purposes Loss realized on redemption not deductible

if shareholder owns, directly or indirectly, 50% or more of the stock of the corporation prior to the redemption

12-21

Tax Consequences to Redeeming Corporation

If redemption funded with cash, no gain or loss recognized by redeeming corporationIf redemption funded with property other than cash Gain recognized if property’s FMV >

adjusted tax basis Loss not recognized if FMV < adjusted

tax basis

Redemption also reduces E&P

12-22

Example: Redemption versus Dividend

At the beginning of the year, Lance owned 1,000 shares Camelot Corporation with a total tax basis of $20,000. The corporation had 2,500 shares outstanding. If the corporation redeems 500 of Lance’s

shares for $100,000, is the redemption treated as a sale or as a dividend, and what are the resulting tax consequences?

What if the corporation had 1,500 shares outstanding prior to the redemption?

12-23

Corporate Liquidations

Tax consequences depend on ownership: Liquidation of controlled subsidiary into

parent corporation Liquidation of corporation not

considered a controlled subsidiary

General rule: tax treatment of liquidations maintains the double taxation inherent in the corporate tax system

12-24

Liquidations continued

Liquidation of corporation not a controlled sub Tax consequences to corporation:

Treated as if all assets sold on date of liquidation General rule: resulting gains and losses

included in taxable income for final tax return Tax consequences to shareholders:

Treated as sale of stock, with FMV of liquidating distribution as amount realized

Tax basis of assets received = FMV

12-25

Liquidation of Controlled Sub

Parent recognizes no gain or loss on receipt of property in liquidation of controlled sub Carryover basis in property received

Subsidiary recognizes no gain or loss on distributions of property to controlling parentIf sub < 100% owned, distributions to minority owners treated like non-liquidating redemptions Sub recognizes gain (not loss) on property

distributed Shareholders taxed on sale of shares