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TEI EDUCATION FUND

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LECTURE ON INCORPORATIONS,DISTRIBUTIONS AND LIQUIDATIONS

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June 2000

Mark J. SilvermanSteptoe & Johnson LLP

Washington, D.C.

Copyright 2000, Mark J. Silverman, All Rights Reserved

TEI EDUCATION FUND

LECTURE ON INCORPORATIONS, DISTRIBUTIONSAND LIQUIDATIONS

TABLE OF CONTENTS

Page

I. BACKGROUND................................................................................................................. 1

A. Orientation to the Internal Revenue Code............................................................... 1

B. Orientation to Concept of Corporations and Taxes................................................. 2

C. Choice of Entity - Prior to the Issuance of the "Check-the-Box" Regulations ....... 4

D. The "Check-the-Box" Regulations.......................................................................... 5

E. Recent Tax Legislation Affecting Corporations ..................................................... 7

F. General Tax Concepts -- Realization v. Recognition............................................ 30

II. ORGANIZATION OF THE CORPORATION -- SECTION 351.................................... 31

A. Concepts Involved................................................................................................. 31

B. Section 351 -- In General ...................................................................................... 31

C. Related Statutes ..................................................................................................... 34

D. Section 351 -- Statutory Requirements ................................................................. 34

E. Administrative Requirement -- Business Purpose ................................................ 34

F. One or More Persons............................................................................................. 35

G. Transfer of "Property" ........................................................................................... 35

H. Solely..................................................................................................................... 37

I. In Exchange........................................................................................................... 37

J. For Stock ............................................................................................................... 37

K. Control................................................................................................................... 42

L. Immediately After the Exchange........................................................................... 45

M. Section 351(b) -- Transfers Not Solely for Stock ................................................. 47

N. Section 351(f) -- Exception for Section 311 Transfers ......................................... 50

O. Section 1032 -- No Gain or Loss Recognized to the Corporation on Receipt

of Property............................................................................................................ 50

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P. Section 358 -- Basis of Stock Received by Transferor-Shareholder..................... 50

Q. Section 362 -- Basis of Property to the Corporation ............................................. 52

R. Section 1223 -- Holding Period of Stock and Property......................................... 53

S. Section 357 -- Assumption of Liabilities by Corp. ............................................... 54

T. Contributions to Capital ........................................................................................ 59

U. Special Problems................................................................................................... 62

V. Disclosure Requirements and Ruling Requests .................................................... 70

III. DISTRIBUTIONS............................................................................................................. 72

A. Preliminary Concepts ............................................................................................ 72

B. Statutory Framework............................................................................................. 73

C. Types of Distributions........................................................................................... 73

IV. SECTION 301 -- TAX TREATMENT OF DISTRIBUTEE............................................ 73

A. Section 301(a) -- General Concepts ...................................................................... 73

B. Section 301(b) -- Amount Distributed .................................................................. 74

C. Section 301(c) -- Amount Taxable........................................................................ 75

D. Section 301(d) -- Basis of Property to Distributee................................................ 76

E. Section 301(e) – Special Earnings and Profits Rules............................................ 76

V. SECTION 316 -- WHAT IS A DIVIDEND ..................................................................... 76

A. Introduction ........................................................................................................... 76

B. Section 316(a) -- General Rule.............................................................................. 77

VI. SECTION 312 -- EARNINGS AND PROFITS ............................................................... 80

A. Introduction ........................................................................................................... 80

B. Concept of Earnings and Profits............................................................................ 81

C. Calculation of Earnings and Profits ...................................................................... 81

D. Effect of Distribution on Earnings and Profits...................................................... 84

VII. DISTRIBUTIONS OF PROPERTY IN KIND................................................................. 85

A. Introduction ........................................................................................................... 85

B. Old Section 311..................................................................................................... 85

C. New Section 311 ................................................................................................... 88

D. Earnings and Profits -- Effect of Distribution of Property. ................................... 89

VIII. CONSTRUCTIVE DISTRIBUTIONS ............................................................................. 90

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A. In General .............................................................................................................. 90

B. Examples of Constructive Dividends.................................................................... 91

C. Limits on Abuse of Distribution Transactions ...................................................... 93

IX. DISTRIBUTION OF CORPORATION'S OWN STOCK................................................ 95

A. In General .............................................................................................................. 95

B. Section 305............................................................................................................ 95

X. REDEMPTIONS............................................................................................................... 96

A. Definition .............................................................................................................. 96

B. Section 302............................................................................................................ 96

C. Legislative History ................................................................................................ 98

D. Ruling Requests..................................................................................................... 99

XI. SECTION 318 -- CONSTRUCTIVE OWNERSHIP OF STOCK ................................... 99

A. In General .............................................................................................................. 99

B. Family Attribution -- Section 318(a)(1) ................................................................ 99

C. Entity to Beneficiary Attribution......................................................................... 100

D. Beneficiary to Entity Attribution......................................................................... 102

E. Option Attribution............................................................................................... 104

F. Reattribution -- Constructive Ownership as Actual Ownership.......................... 105

XII. SECTION 302(b)(2) -- SUBSTANTIALLY DISPROPORTIONATE

REDEMPTIONS............................................................................................................. 107

A. In General ............................................................................................................ 107

B. Statutory Tests..................................................................................................... 107

C. Operating Rules................................................................................................... 108

XIII. SECTION 302(b)(3) -- TERMINATION OF SHAREHOLDER'S INTEREST............ 111

A. Statutory Requirements ....................................................................................... 111

B. Constructive Ownership Provisions .................................................................... 111

XIV. SECTION 302(b)(4) -- PARTIAL LIQUIDATIONS FOR NONCORPORATE

SHAREHOLDERS ......................................................................................................... 115

A. Partial Liquidations ............................................................................................. 115

B. Ruling Requests................................................................................................... 117

XV. SECTION 302(b)(1) -- NOT ESSENTIALLY EQUIVALENT TO A DIVIDEND...... 118

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A. Statutory Requirement......................................................................................... 118

B. United States v. Davis, 397 U.S. 301 (1970) ...................................................... 118

C. Meaningful Reduction -- Cases and Rulings After Davis................................... 119

D. Constructive Ownership Rules............................................................................ 121

XVI. REDEMPTIONS AND BOOTSTRAP ACQUISITIONS.............................................. 121

A. In General ............................................................................................................ 121

B. Seller Issues......................................................................................................... 122

C. Continuing Shareholder Issues............................................................................ 123

XVII. SECTION 304 -- REDEMPTIONS THROUGH RELATED CORPORATIONS......... 124

A. In General ............................................................................................................ 124

B. Section 304(a)(1) -- Brother-Sister Acquisitions ................................................ 125

C. Section 304 and Section 351 ............................................................................... 128

D. Section 304(a)(2) -- Parent-Subsidiary Acquisitions .......................................... 129

XVIII. SECTION 303 -- REDEMPTIONS TO PAY DEATH TAXES..................................... 130

A. Section 303(a) ..................................................................................................... 130

B. Limitations and Requirements ............................................................................ 130

C. Rev. Rul. 87-132 ................................................................................................. 130

XIX. EFFECT OF REDEMPTION ON THE CORPORATION............................................. 130

A. Recognition of Gain to the Corporation.............................................................. 130

B. Effect of a Redemption on the Corporation's Earnings and Profits .................... 131

C. Deductibility by Corporation of Stock Redemption Expenses ........................... 132

XX. LIQUIDATION OF THE CORPORATION .................................................................. 134

A. Concepts .............................................................................................................. 134

B. Liquidation Provisions ........................................................................................ 135

XXI. SECTION 331 -- COMPLETE LIQUIDATION (EFFECT ON SHAREHOLDERS)... 136

A. In General ............................................................................................................ 136

B. Statute.................................................................................................................. 136

C. Tax Consequences to Shareholder ...................................................................... 136

XXII. SECTION 332 -- COMPLETE LIQUIDATION OF CORPORATE SUBSIDIARY

(EFFECT ON CORPORATE SHAREHOLDER).......................................................... 146

A. Introduction ......................................................................................................... 146

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B. Requirements of Section 332 .............................................................................. 146

C. Avoid or Comply with Section 332..................................................................... 148

D. Effect of Section 332........................................................................................... 149

E. Method of Effectuating Liquidation Under State Law -- Dissolution v. Merger 150

F. Tax Consequences to Minority (20% or Less) Shareholders.............................. 150

G. Intercorporate Liabilities ..................................................................................... 150

H. Ruling Requests................................................................................................... 152

XXIII. SECTIONS 336 AND 337 -- DISTRIBUTION IN COMPLETE LIQUIDATION

(EFFECT ON CORPORATION).................................................................................... 152

A. Treatment of Liquidating Distributions -- Section 336....................................... 152

B. Section 337 -- Liquidating Distributions to an 80% Distributee......................... 155

TEI EDUCATION FUNDLECTURE ON INCORPORATIONS, DISTRIBUTIONS AND

LIQUIDATIONS

Mark J. Silverman

I. BACKGROUND

A. Orientation to the Internal Revenue Code

1. United States Code -- 50 Titles -- Title 26 is the Internal Revenue Code("IRC" or "Code")

2. Title 26 is divided into various subtitles and chapters -- 15 volumes inTitle 26

3. We are concerned with

a. Subtitle A -- "Income Taxes"

b. Chapter 1 -- "Normal Taxes and Surtaxes"

c. Subchapter C -- "Corporate distributions and adjustments"

4. Structure of Subchapter C

a. Part III -- organizations and reorganizations (sections 351-368)

b. Part I -- distributions (sections 301-318)

c. Part II -- liquidations (sections 331-346)

5. Section 7805

a. Section 7805(a) -- Treasury Secretary is authorized to issueregulations, revenue rulings and revenue procedures

b. Section 7805(b) -- amended as part of the Taxpayer Bill of Rights2 (“TBOR2”) in 1996 provides:

(1) In general, Treasury may not issue retroactive regulations --e.g., regulations shall not apply to any taxable periodending before the earliest of:

(a) the date the regulation is filed with the FederalRegister

(b) the date of any proposed or temporary regulations

(c) the date on which any notice substantiallydescribing the expected contents of the regulation isissued to the public

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(2) Exceptions, may issue retroactive regulations:

(a) within 18 months of enactment of statutoryprovision

(b) to prevent abuse

(c) to correct a procedural defect in a prior regulation

(d) if regulation relates to internal Treasury Departmentpolicies, practices, or procedures

(e) if given authority by Congress

(f) may allow taxpayer to elect to apply regulationretroactively

(3) Section 7805(f) -- must submit regulations to SmallBusiness Administration for comment on the impact of theregulation on small business

B. Orientation to Concept of Corporations and Taxes

1. Nature of a corporation

a. creature of state law -- created by state corporate law, not tax law

b. can hold property, transact business, sue and be sued

c. can act only through officers or employees

d. owned by shareholders (stockholders)

e. independent taxable entity -- can have taxable income or loss andcan do things that will affect tax position of its shareholders

2. Code definitions

a. "person" includes corporation -- section 7701(a)(1)

b. "individual" does not include corporation -- no express provision

c. "taxpayer" includes person and thus corporation --section 7701(a)(14)

d. "corporation" can include entities not technically corporations --section 7701(a)(3) and Treas. Reg. § 301.7701-2

3. Basic tax characteristics of corporations

a. Corporations taxed at different rates than individuals -- Followingthe Tax Reform Act of 1986 (“TRA 86”) and until 1993, corporatetax rates generally were higher than individual tax rates. However,following the Omnibus Budget Reconciliation Act of 1993

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(“OBRA 93”), the top individual rates are significantly higher thanthe top corporate rates

(1) individual tax rate structure

(a) for tax years beginning after 1992, income is taxedat five rates: 15%, 28%, 31%, 36% and 39.6%

(b) long-term capital gains generally are taxed at alower rate than ordinary income. The TaxpayerRelief Act of 1997 (“TRA 97”) lowered themaximum long-term capital gains rate to 20% (10%for individuals in the 15% tax bracket). TRA 97also lengthened the holding period long-term capitalgains from one year to 18 months. However, theInternal Revenue Service Restructuring and ReformAct of 1998 ("IRRA 98") changed the holdingperiod for long-term capital gains back to one year

(c) in 1990 an overall limit on itemized deductions wasadded and the deduction for personal exemptionsbecame subject to a "phaseout" for high-incometaxpayers

(2) corporate tax rate structure

(a) for taxable years beginning after 1992, income istaxed at four basic rates: 15%, 25%, 34% and 35%(there are also surtaxes of 3% and 5% for certainincome levels)

(b) Under the Omnibus Budget Reconciliation Act of1987 (“OBRA 87”), section 11(b) was amended sothat qualified personal service corporations are to betaxed at the maximum corporate rate

(c) the 28% alternative rate for corporate capital gainsno longer applies

b. Double-level tax

(1) income earned by "C" corporations (the typicalcorporation) generally is taxed twice -- once at thecorporate level and once at the shareholder level

(2) income earned by pass-thru entities such as partnershipsand "S" corporations is generally only taxed once at thepartner/shareholder level, except that

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(a) income from publicly traded partnerships that areclassified as corporations is treated as dividendincome -- see section 7704(a); and

(b) S corporations that sell certain built-in gain propertyor have “excess net passive income” may be subjectto tax at the corporate level -- see sections 1374 and1375

c. Cost of liquidating

(1) prior to TRA 86, a corporation in general could distributeor sell assets in connection with a liquidation on a tax-freebasis (subject to exceptions for certain recapture items) --even though a double-tax was imposed, combinedcorporate/shareholder tax was not too burdensome

(2) following TRA 86, a corporation generally will be taxed infull on liquidating distributions and sales

C. Choice of Entity - Prior to the Issuance of the "Check-the-Box" Regulations

1. Under the old entity classification rules, the Code distinguished betweenan entity taxable as a corporation and one taxable as a partnership basedon the substantive legal rights of the entity and its members -- see formerTreas. Reg. § 301.7701

2. As a result of the TRA 86, many taxpayers began to reconsider thetraditional corporate form of conducting business -- pass-thru entities suchas partnerships and S corporations could reduce tax liabilities

3. Congress added several Code sections that provided for taxation forentities which were looking to use a non-corporate form

a. OBRA 87 added new section 7704, which provides that a publiclytraded partnership will be treated as a corporation for taxable yearsbeginning after December 31, 1987 (or December 31, 1997, in thecase of an existing partnership provided it does not add asubstantial new line of business), unless at least 90% of its grossincome is passive type income -- regulations under section 7704were issued in November of 1995 see Treas. Reg. § 1.7704-1

b. OBRA 87 also added new section 1363(d) which requires therecapture of LIFO benefits in the case of S corporation elections byformer C corporations

4. The emergence of "Limited Liability Companies" (“LLCs”) -- a hybridform of business entity that offers both limited liability to all members anda system of representative management -- highlighted the problems with

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the old classification system. By careful planning, taxpayers could dictatewhether they were taxed as corporations or associations (partnerships)

D. The "Check-the-Box" Regulations

1. Generally

a. In January 1997, the Internal Revenue Service (“IRS” or“Service”) published "check-the-box" entity classificationregulations, Treas. Reg. § 301.7701-3, which greatly simplifiedentity classification

b. Under the regulations, a newly formed domestic entity with at leasttwo members is automatically classified as a partnership unless theentity elects to be taxed as a corporation

c. However, certain forms of entity are automatically classified ascorporations and may not elect partnership treatment -- theseinclude business entities incorporated under state statutes,insurance companies and certain other business entities

d. The default classification for entities with a single member is asole proprietorship (a non-tax entity which for corporate owners istreated as a division). Single member entities may elect to betaxed as corporations, but may not elect to be taxed as partnerships

e. For existing entities, unless the entity elects otherwise, it will havethe same classification as in effect before January 1, 1997.Existing entities generally may elect to change their classificationonce within any 60-month period. A conversion from corporate topartnership status or vice versa generally will have taxconsequences

f. The regulations are effective as of January 1, 1997

2. Analysis

a. Most likely few entities will elect to be taxed as corporations

b. The regulations will dramatically increase the utilization of singlemember LLCs

(1) Since under the regulations a single member LLC is taxedas a sole proprietorship (a single level of tax), but theindividual member receives limited liability, it seems likelythat single member LLCs will be used instead of Scorporations in many situations

(2) The regulations allow a corporation to organize singlemember LLCs that are accorded the same legal protectionsas subsidiaries, but which are taxed as divisions -- the

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treatment of these single member LLCs is similar to thetreatment of corporations that join in filing a consolidatedreturn -- the use of single member LLCs has the potentialof allowing corporations to reap the benefits of being aconsolidated group without having to file a consolidatedreturn

3. Treas. Reg. § 301.7701-3(g) describes the effect of an elective change inclassification

a. Deemed Treatment of Elective Changes

(1) Partnership to Association -- if an eligible entity classifiedas a partnership elects to be classified as an association, thefollowing is deemed to occur -- the partnership contributesall of its assets and liabilities to the association in exchangefor stock in the association, and immediately thereafter, thepartnership liquidates by distributing the stock of theassociation to its partners

(2) Association to Partnership -- if an eligible entity classifiedas an association elects to be classified as a partnership, thefollowing is deemed to occur -- the association distributesall of its assets and liabilities to its shareholders inliquidation of the association, and immediately thereafter,the shareholders contribute all of the distributed assets andliabilities to a newly formed partnership

(3) Association to Disregarded Entity -- if an eligible entityclassified as an association elects to be to be disregarded asan entity separate from its owner, the following is deemedto occur -- the association distributes all of its assets andliabilities to its single owner in liquidation of theassociation

(4) Disregarded Entity to Association -- if an eligible entitythat is disregarded as an entity separate from its ownerelects to be classified as an association, the following isdeemed to occur -- the owner of the eligible entitycontributes all of the assets and liabilities of the entity tothe association in exchange for stock of the association

b. Effect of Elective Changes -- the tax treatment of a change in theclassification of an entity for federal tax purposes is determinedunder all relevant provisions of the Code and general principles oftax law, including the step transaction doctrine

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c. Timing of Election

(1) in general -- any transaction that is deemed to occur as aresult of a change in classification under the regulation istreated as occurring immediately before the close of the daybefore the election is made

(2) coordination with section 338 election

(a) a purchasing corporation that makes a qualifiedstock purchase of an eligible entity taxed as acorporation may make an election under section338, and may also make as election to change theclassification of the target corporation

(b) if both elections are made, the deemed transactionsunder Treas. Reg. § 301.7701-3(g) are deemed tooccur immediately after the deemed asset purchaseby the new target corporation under section 338

E. Recent Tax Legislation Affecting CorporationsThe following section briefly describes the changes made in the area of corporatetaxation by the major tax acts since 1986

1. Tax Reform Act of 1986 (“TRA 86”)

a. rate inversion -- for the first time in history, the highest marginalrate of tax imposed on corporations (34%) exceeded the thenhighest marginal rate (28%) imposed on individuals

b. repeal of General Utilities -- sections 336 and 337 were rewrittento impose two levels of tax -- at the corporate and individual levels-- on the sale or distribution of corporate assets upon completeliquidation of the corporation

c. capital gains -- the lower capital gains tax rate was eliminated forcorporations

d. alternative corporate minimum tax -- an alternative minimum taxwas enacted

(1) taxpayers have to pay the greater of their regular taxliability or their tax liability computed under the minimumtax provisions

(2) the alternative minimum tax is imposed on a broader baseof income

(3) many deductions are eliminated under the alternativeminimum tax provisions

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e. dividends received deduction -- section 243 was amended toreduce the dividends received deduction from 85% to 80%, to keepthe maximum effective rate on dividends approximately the sameas before the reduction in corporate rates (6.8% under the new law)

f. greenmail payments -- TRA 86 added section 162(k) to deny adeduction for any amount paid by a corporation in connection witha redemption of its stock

g. extraordinary dividends -- TRA 86 revised the extraordinarydividend rules of section 1059 to provide that if a corporationreceives an extraordinary dividend on stock that it has not held formore than 2 years before the dividend announcement date, its basisin the stock will be reduced by the nontaxed portion of thedividend -- under previous law, an extraordinary dividend wastaxed only if the corporation disposed of the stock less than a yearafter it was acquired

h. section 382 -- limitation on net operating loss carryovers wherethere has been a change of ownership -- TRA 86 revised the rulesrelating to the limitation on the use of net operating losses to offsetincome after a corporation has undergone a change in ownership --in general, a corporation that has undergone an ownership changemay offset an amount of income equal to the value of the pre-change corporation multiplied by the long-term tax exempt rate

i. allocation of purchase price among assets -- TRA 86 added newsection 1060 to the Code requiring the seller and purchaser ofassets to allocate the consideration received for such assets inaccordance with section 338(b)(5)

j. sales between related parties -- TRA 86 broadened section1239(b)'s definition of related parties for purposes of sales ofdepreciable property -- this broadened definition also applies toinstallment sales

2. Omnibus Budget Reconciliation Act of 1987 (“OBRA 87”)

a. computation of earnings and profits for purposes of intercorporatedividends and stock basis adjustments

(1) section 1503(e) was added to require that for the purposesof determining gain or loss on the disposition of intragroupstock, a parent corporation's basis in the stock is to bedetermined by computing the earnings and profits of thesubsidiary without regard to sections 312(k), relating todepreciation, and 312(n), relating to adjustments toearnings and profits, in order to more accurately reflecteconomic gain and loss

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(2) in addition, earnings and profits do not include any CODincome excluded under section 108 to the extent that theamount so excluded did not reduce tax attributes other thanbasis

b. reduction of dividends received deduction for certain corporations-- OBRA 87 reduced the dividends received deduction from 80%to 70% for corporations owning less than 20% of the distributingcorporation's stock

c. elimination of mirror transactions

(1) OBRA 87 added section 337(c) to eliminate mirrortransactions -- under this provision, a subsidiary member ofa consolidated group will recognize gain upon its completeliquidation to the extent any of its shareholders own lessthan 80% of the liquidating subsidiary stock

(2) in addition, section 355 does not apply to any distributionby a corporation if control of the distributing corporationwas acquired by a corporate distributee during the five-yearperiod before the distribution

(3) furthermore, if the stock of one member of an affiliatedgroup is transferred to another member in a section 304(a)transaction, appropriate adjustments must be made to thebases of any intragroup stock and in the earnings andprofits of each member of the group

d. publicly traded partnerships treated as corporations -- section 7704was added to provide that a publicly traded partnership be treatedas a corporation for tax purposes, unless 90% or more of its grossincome consists of passive-type income

e. excise tax on greenmail -- section 5881 was added to impose a taxof 50% on any gain realized on the receipt of greenmail --greenmail is defined as any consideration from a corporation inconnection with the redemption of stock held by that shareholderfor less than two years, if the shareholder made or threatened apublic tender offer for stock in the corporation during that period

f. limitation on use of preacquisition losses to offset built-in gains --OBRA 87 provided that where a corporation with a net unrealizedbuilt-in gain became a member of an affiliated group, or its assetswere acquired in a tax-free reorganization, the built-in gain couldnot be offset by the acquiring group

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3. Technical and Miscellaneous Revenue Act of 1988 (“TAMRA 88”)

a. section 361 was revised to provide that no gain or loss isrecognized by a corporation that is a party to a reorganization if itreceives solely stock or securities of another corporation and toprovide that gain will be recognized by such corporation withrespect to the distribution of appreciated property

b. section 355(b)(2)(D) was revised to provide that a corporation isconsidered to be engaged in the active conduct of a trade orbusiness for purposes of section 355 if control of the corporationwas not acquired directly or indirectly either by any distributeecorporation or by any distributing corporation within the 5-yearperiod prior to the distribution

c. section 355(c) was added to provide that a corporation thatdistributes appreciated property in connection with a section 355transaction will recognize gain to the extent of the unrealizedappreciation under section 311(b)

d. section 351(f) was added to provide that if a corporation distributes"boot" in a section 351 transaction, the corporation recognizes gainunder section 311(b)

e. section 382(g)(4)(C) was added to provide that, for purposes ofdetermining when an ownership change occurs, any stock held bya 50% owner that is treated as becoming worthless during anytaxable year shall be treated as having been acquired on the firstday of the next taxable year

f. section 384 was revised to provide that if a corporation acquirescontrol of another corporation or acquires the corporation's assetsin an A, C or D reorganization, and either corporation has built-ingain, then income for any taxable year during the 5-year periodbeginning on the change date attributable to built-in gain of one ofthe corporations may not be offset by any preacquisition loss of theother corporation, unless the corporations were members of thesame controlled group at all times during the 5-year period endingon the acquisition date

g. section 386, containing miscellaneous corporate provisions, wasrepealed -- section 311(b)(3) was added to provide that if acorporation receives an interest in a partnership or trust as part of adistribution, the amount of gain recognized under section311(b)(1), relating to distributions of appreciated property, shall becomputed without regard to any loss attributable to propertycontributed to the partnership or trust for the principal purpose ofrecognizing such loss on the distribution

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a. section 1503(f) was added to provide that where a subsidiarydistributes dividends on any section 1504(a)(4) stock to anonmember of an affiliated group, no group loss item may reducethe income of the subsidiary for that taxable year and no groupcredit item may offset the tax imposed on the income of thesubsidiary

b. sections 163(e)(5) and 163(i) were added to provide that (i) nodeduction is allowed for original issue discount (“OID”) interest on"applicable high yield discount obligations" (“AHYDO”) untilsuch interest is actually paid and (ii) no deduction is allowed forOID interest to the extent the interest rate exceeds the applicablefederal rate (“AFR”) plus 5 percentage points

c. section 163(j) was added to disallow a deduction for interest paidto related parties exempt from U.S. tax on the interest received

d. section 351 was modified so that securities are now consideredboot, on which gain is recognized in a section 351 transaction

e. the threshold limitation for net unrealized built-in gains and lossesunder sections 382 and 384 was changed to the lesser of 15% ofthe fair market value (“FMV”) of the assets or $10 million -- thethreshold had previously been 25% of the FMV of the assets of thecorporation

f. section 1059 was revised to treat dividends with respect to certain"self-liquidating" preferred stock as extraordinary dividends, thusrequiring reduction in stock basis

g. section 1503(e)(4) was added to provide that a corporation may notreduce its excess loss account by reducing its basis in itsindebtedness of a subsidiary

h. section 385 was amended to allow the Treasury Department tocharacterize an instrument having significant debt and equitycharacteristics as part debt and part equity

i. section 6043(c) was added to require a corporation to file a reportwhen control of the corporation changes or when there is arecapitalization or other substantial change in the capital structureof the corporation

j. section 172 was modified to limit a corporation's ability to carryback net operating losses (“NOLs”) where the NOLs are created byinterest deductions allocable to certain corporate equity-reducingtransactions (“CERTs”), which include major stock acquisitionsand excess distributions

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a. section 355 was amended to more effectively eliminate mirrortransactions by the addition of section 355(d) to provide forrecognition of gain at the corporate level (1) if section 355otherwise applies, (2) if after the distribution, the shareholder holdsa 50% or greater interest in the distributing corporation, and (3)this interest was acquired by purchase within the preceding fiveyears

b. section 305(c) was modified to apply the economic accrual rulesapplicable to debt to preferred stock that is subject to mandatoryredemption, or is puttable at a premium

c. section 1060 was amended to provide that (1) a written agreementregarding the allocation of consideration to, or the fair marketvalue of, any assets in an asset acquisition will be binding on bothparties for tax purposes unless the parties are able to refute theallocation; (2) where a 10% owner of an entity transfers an interestin the entity and also enters into an employment or otheragreement with the transferee, the person and the transferee mustreport the transaction; (3) where a section 338(h)(10) election ismade, both the purchasing corporation and the selling consolidatedgroup must report the transaction as provided by regulations

d. the CERT rules (section 172(h)(3)) were modified to eliminate theexception for acquisitions of subsidiary stock

e. section 108(e)(11) was added and section 1275(a)(4) was repealed-- as a result, in a debt-for-debt exchange COD is measured bycomparing issue price of old debt to issue price of new debt


a. corporate tax rates -- top corporate tax rate was increased from34% to 35% for taxable income in excess of $10 million (thebenefit of the 34% tax rate was phased out for taxable incomesover $15 million) -- the new rates are retroactive to January 1,1993

b. business deductions for meals and entertainment expenses -- thededuction for meals and entertainment expenses was decreasedfrom 80% of the expense to 50% -- effective for taxable yearsbeginning after December 31, 1993

c. spousal travel expenses -- deductions for travel expenses of aspouse (or a dependent or other individual) accompanying a personon business travel are disallowed unless: (i) the spouse wasemployed by the person, (ii) the spouse's travel was for a bona fidebusiness purpose, and (iii) the spouse's expenses would otherwise

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be deductible -- these provisions apply for amounts paid orincurred after 1993

d. executive compensation -- for purposes of both regular tax andalternative minimum tax (“AMT”), the deduction for compensationpaid or accrued to a "covered employee" of a publicly heldcorporation is limited to $1 million per year -- "covered employee"includes the corporation's CEO and the four (or fewer) highestcompensated officers of the corporation whose compensation isrequired to be disclosed under SEC rules -- the $1 million cap isreduced by the amount of any excess parachute payments (asdefined in section 280G) -- compensation subject to the cap isbroadly defined -- applies to compensation that is otherwisedeductible by a corporation in a taxable year beginning on or afterJanuary 1, 1994 -- the following types of compensation are notsubject to the cap:

(1) remuneration payable on a commission basis;

(2) remuneration payable solely because an employee satisfiesone or more performance goals (provided certain outsidedirector and shareholder approval requirements are met);

(3) payments to a tax-qualified retirement plan (includingsalary reduction contributions);

(4) amounts that are excludable from an employee's grossincome (such as employer-provided health benefits, etc.);

(5) any remuneration payable under a written binding contractwhich was in effect on February 17, 1993, and which wasnot modified in any material respect before suchremuneration was paid

e. employer pension contribution deductions -- the amount ofcompensation that may be taken into account for purposes of anemployee's benefits and an employer's deductible contributionunder a qualified retirement plan was reduced from $235,840 to$150,000 -- this limit is indexed for inflation in $10,000increments -- the limitation is subject to special rules in the case ofgovernment plans and plans maintained pursuant to collectivebargaining agreements -- effective for benefits accruing in planyears beginning after 1993

f. lobbying expenses -- no deduction is permitted under section 162for any amount paid or incurred to influence Federal or statelegislation or to communicate with certain covered Federalexecutive branch officials in an attempt to influence the actions orpositions of such officials -- covered executive branch officials

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include the President, Vice President, individuals with Cabinet-level status and their immediate deputies, the two most senior-levelofficers of each agency within the Executive Office of thePresident, and any other officer or employee of the White HouseOffice of the Executive Office of the President -- the portion ofotherwise deductible membership dues in trade groups or otherorganizations that are used for lobbying are similarly disallowed --the disallowance applies to amounts paid or incurred after 1993

g. club dues -- no deduction is permitted for club dues for all types ofclubs, including business, social, luncheon, athletic, sporting,airline and hotel clubs -- effective for taxable years beginning afterDecember 31, 1993

h. intangibles -- 15-year amortization is required for certainintangible assets (including goodwill and going concern value) thatare acquired in connection with the conduct of a trade or business -- applies to transactions occurring after the date of enactment, withan election to apply the provision to transactions occurring afterJuly 25, 1991

i. nonresidential real property -- the recovery period for purposes ofdepreciation of nonresidential real property was increased from31.5 years to 39 years -- the new recovery period is for purposes ofregular tax, and has no effect on the recovery period for AMTpurposes (which remains 40 years) -- the change applies toproperty placed in service on or after May 13, 1993 (with transitionrelief for certain property placed in service before 1994)

j. AMT depreciation -- the depreciation component of the ACEadjustment was eliminated -- as a result, corporations computedepreciation for AMT purposes under the same rules applicable toindividuals (in the case of tangible personal property, for instance,depreciation is computed using a 150% DBM over the class life ofthe property)

k. debt cancellation rules -- the stock-for-debt exception was repealed-- thus, a corporation has COD income to the extent it transfersstock in satisfaction of its indebtedness and the FMV of thetransferred stock is less than the indebtedness -- a corporation in aTitle 11 case or an insolvent corporation can still exclude CODincome to the extent it reduces its tax attributes -- effective forstock transferred after December 31, 1994 in satisfaction of anyindebtedness (unless the transfer is in a Title 11 case filed on orbefore December 31, 1993)

l. earnings stripping rules -- prior to OBRA 93, the earnings strippingrules included a grandfather provision under which thedisallowance of a deduction for interest did not apply to interest on

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debt with a fixed term which was issued on or before July 10, 1989(or was issued after that date pursuant to a binding contract ineffect on that date) -- under OBRA 93, the grandfather provision isrevoked and such interest is subject to disallowance to the sameextent as other interest -- in addition, interest paid on a loan to anunrelated party is treated as interest paid to a related party if: (i) nogross-basis U.S. income tax is imposed on the interest; (ii) arelated person guaranteed the loan; and (iii) the related person iseither exempt from U.S. federal income tax or is a foreign person -- both provisions are effective for interest paid or accrued intaxable years beginning after December 31, 1993

m. inventories of securities dealers -- securities dealers are required tocompute taxable income by valuing their inventories of securitiesto market -- effective for taxable years ending on or after 1993 --transition rules permit any change in inventory value to beincluded in taxable income ratably over a 5-year period (a specialtransitional rule for LIFO inventories of floor specialists andmarket makers permits the adjustment to be included in incomeratably over a 15 year period)

n. research tax credit -- the research tax credit (which expired on June30, 1992) was extended from July 1, 1992 through June 30, 1995 --in addition, several technical changes were made relating tocomputation of the credit for start-up firms

o. section 936 credit -- starting in 1994 the credit was reduced to 60%of its current value, declining to 40% by 1998

p. other provisions -- various changes relating to estimated taxes,FUTA taxes, excise taxes, S&Ls, foreign taxes, tax procedure,withholding, information reporting, and personal income tax -- inaddition, there are several narrowly tailored tax benefit items:high-speed rail, "empowerment" zones, small business expensing,low-income housing credit, targeted jobs credit, "school-to-work"credit, and so on

7. Miscellaneous 1995 and 1996 Legislation

No comprehensive tax legislation was enacted during 1995 -- however, afew miscellaneous provisions were enacted during 1995 and early 1996

a. section 162(1) -- the deduction for health insurance costs of self-employed individuals was permanently extended; the percentage ofthe deduction was increased by legislation in 1997 and 1998, andwill reach 100% in 2003

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b. section 1031 -- section 1031 was amended to precludenonrecognition of gain on involuntary conversions when certainreplacement property is acquired from a related person

c. section 1071 -- the provision permitting nonrecognition of gain onsales to minority owned businesses to effect FCC policy wasrepealed

d. Line item veto -- the Line Item Veto Act allowed the presidentafter signing a bill into law to cancel in whole any dollar amount ofdiscretionary budget authority, any item of new direct spending, orany limited tax benefit -- the constitutionality of the provision waschallenged, and the Supreme Court held that the cancellationprocedures set forth in the Line Item Veto Act wereunconstitutional – see Clinton v. City of New York, 118 S. Ct.2091 (June 25, 1998)

e. Congressional review of guidance -- legislation was enacted whichrequires Congressional review of guidance issued by the IRS

8. The Small Business Job Protection Act of 1996

Of the four acts passed by Congress in the summer of 1996 that containedtax law changes, the majority of the provisions that affect corporatetaxpayers were contained in the Small Business Job Protection Act of1996 -- some of these provisions are described below

a. increase in small business expensing -- the amount of tangiblebusiness property that may be currently expensed under section179, rather than depreciated over time, will be increased from$17,500 to $25,000 -- this increase will be phased in over a seven-year period beginning in 1997

b. depreciation under the income forecast method -- the depreciationof certain property, such as films, television shows, books, patents,master sound recordings and video games, under the incomeforecast method was clarified

c. involuntary conversion rules for property damaged in a disaster --for purposes of the nonrecognition-of-gain rule regardinginvoluntarily converted property that is replaced similar property,any tangible property that is acquired and held for productive usein a business is treated as similar or related to business orinvestment property that was involuntarily converted as a result ofa Presidentially declared disaster

d. interest deduction for corporate-owned life insurance --corporations are denied a deduction for interest on any amount ofdebt incurred with respect to company-owned life insurance

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policies, annuities, or endowment contracts covering an officer oremployee or an individual who has a financial interest in thecompany -- an exception is provided for policies covering certainkey personnel where the total amount of debt is $50,000 or lessand the interest rate is under a set cap -- the denial of the deductionapplies to interest paid or accrued after October 13, 1995

e. financial asset securitization investment trusts -- a new entitycalled financial asset securitization investment trust (FASIT) wascreated to facilitate the securitization of revolving, nonmortgagedebt, such as credit card receivables, home equity loans, and carloans -- generally a FASIT is not subject to tax, but its income orloss will flow through to its owners -- the FASIT provisions aregenerally effective September 1, 1997

f. S corporation simplification -- many of the provisions of the SmallBusiness Job Protection Act of 1996 were aimed at simplifying thelaws pertaining to S corporations -- among other changes,provisions clarified which types of companies can be Scorporations and which types of entities may hold S corporationstock

9. The Taxpayer Relief Act of 1997 (“TRA 97”)

TRA 97 contained many provisions that affect the taxation of corporations-- some of the more significant provisions are discussed below

a. limitation on exception for investment companies under section351

(1) The definition of an "investment company" for purposes ofthe exception for such companies from the general rulesallowing tax-free contributions of property to corporationsand partnerships was expanded

(2) Under Treasury regulations, a contribution of property istreated as made to an investment company if:

(a) the contribution results in the diversification of thetransferor's interest, and

(b) the transferee is a regulated investment company("RIC"), real estate investment trust ("REIT"), orany corporation more than 80 percent of the assetsof which consist of readily marketable stocks orsecurities or interests in RICs or REITs that are heldfor investment

(3) The scope of assets that are counted toward the 80 percenttest was expanded to include:

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(a) stocks and securities (both readily marketable andnot readily marketable);

(b) money;

(c) equity interests in corporations (including evidencesof indebtedness, options, forward or futurecontracts, notional principal contracts, andderivatives);

(d) foreign currency;

(e) interests in RICs, REITs, common trust funds, andpublicly-traded partnerships;

(f) instruments convertible into equity interests;

(g) interests in precious metals (unless used by thetransferee in the active conduct of a trade orbusiness);

(h) and any other asset described in Treasuryregulations

(4) The provision is effective for transfers after June 8, 1997,with an exception for transfer made pursuant to certainbinding contracts in effect on June 8, 1997

b. treat certain preferred stock as "boot" for purposes of sections 351,354, 355, 356, and 368

(1) The provision added section 351(g) which treats certainpreferred stock ("nonqualified preferred stock") received inan otherwise tax-free incorporation or reorganizationtransaction as taxable "boot". Thus, when a taxpayerexchanges property for this nonqualified preferred stock ina transaction that otherwise qualifies as tax-free, gain butnot loss is recognized

(2) Preferred stock is defined as stock that is limited andpreferred as to dividends and that does not participate incorporate growth to any significant extent

(3) Nonqualified preferred stock is defined as preferred stockfor which:

(a) the holder has the right to require the issuer or arelated person to redeem or purchase the stock;

(b) the issuer or a related person is required to redeemor purchase the stock;

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(c) the issuer or a related person has the right to redeemor purchase the stock and, as or the issue date, it ismore likely than not that such right will beexercised; or

(d) the dividend rate for the stock varies in whole or inpart (directly or indirectly) with reference to interestrates, commodity prices, or other similar indices

(4) The rules related to redemption or purchase do not apply ifthe right or obligation cannot be exercised within 20 yearsof the date the right or obligation is issued or if the right orobligation is subject to a contingency which, as of the issuedate, makes the likelihood of purchase or redemptionremote

(5) The provision contains additional exceptions to this generalrule

(6) The provision generally is effective for transfers after June8, 1997

c. deny interest deduction on certain debt instruments

(1) TRA 97 enacted section 163(l) which denies interest andoriginal issue discount deductions on corporate instrumentsthat are payable in stock of the issuer or a related party,including instruments which are mandatorily (or at theoption of the issuer or a related party) payable orconvertible into such stock

(2) Interest and original issue discount deductions are alsodenied for instruments the payments on which are made byreference to the value of stock; or that are part of anarrangement designed to result in a payment of theinstrument with or by reference to such stock

(3) The provision is generally effective for instruments issuedafter June 8, 1997

d. require gain recognition for certain extraordinary dividends

(1) TRA 97 revised section 1059(a)(2) so that a corporateshareholder recognizes gain immediately with respect toany redemption treated as a dividend (in whole or in part)when the nontaxed portion of the dividend exceeds thebasis of the shares surrendered, if the redemption is treatedas a dividend due to options being counted as stockownership

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(2) In addition, the provision requires immediate gainrecognition whenever the basis of stock with respect towhich any extraordinary dividend was received is reducedbelow zero

(3) The provision generally is effective for distributions afterMay 3, 1995

e. require gain recognition on certain distributions of controlledcorporation stock (the anti-Morris Trust provision)

(1) Section 355(e) was added to the Code, it provides that thedistributing corporation in a section 355 transaction willrecognize gain if the distribution is part of a plan or seriesof related transactions pursuant to which a person (not thedistributee shareholder) acquires stock representing a 50percent or more interest in the distributing or controlledcorporations

(2) The gain is recognized immediately before the distribution,in the amount that the distributing corporation would haverecognized had the stock of the controlled corporation beensold for fair market value on the date of the distribution

(3) No adjustment to the basis of the stock or assets of eithercorporation is allowed by reason of the recognition of thegain

(4) No gain is recognized at the shareholder level

(5) There is a rebuttable presumption that any acquisitionoccurring two years before or two years after a section 355distribution is part of a plan including such distribution

(6) The distributing corporation in an intra-group spin-off willrecognize gain if such distribution is part of a plan thatwould trigger the above described tax

(7) The provision provides the Treasury Department withadditional authority to adjust the basis of stock in intra-group spin-off distributions

(8) For certain transfers of property to a corporation as part ofa spin-off after the date of enactment, the prior lawrequirement that shareholders of the contributingcorporation own 80 percent of the voting power and 80percent of each other class of stock after the distribution ismodified to a requirement of greater-than-50 percent of thevote and value of the stock

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(9) The provision is generally effective for distributions afterApril 16, 1997

f. reform the treatment of corporate stock transfers

(1) To the extent that a section 304 transaction is treated as adistribution under section 301, the transferor and theacquiring corporation are treated as if:

(a) the transferor had transferred the stock involved inthe transaction to the acquiring corporation inexchange for stock of the acquiring corporation in atransaction to which section 351(a) applies, and

(b) the acquiring corporation had then redeemed theshares it is treated as having issued

(2) In addition, section 1059 is amended so that, if the deemedredemption is treated as a dividend and the transferorclaims a dividends-received deduction, the dividend istreated as an extraordinary dividend in which only the basisof the transferred shares would be taken into account forpurposes of section 1059

(3) A special rule applies to transactions involving acquisitionsby foreign corporations

(4) Generally effective for distributions or acquisitions afterJune 8, 1997

g. modify holding period for dividends-received deduction

(1) A taxpayer is not entitled to a dividends-received deductionif the taxpayer's holding period for the dividend-payingstock is not satisfied over a period immediately before orimmediately after the taxpayer becomes entitled to receivethe dividend

(2) Applies to dividends received or accrued after September 5,1997 with a two-year grace period for certain stock ownedby a corporate shareholder that the taxpayer holds as part ofa hedge (or similar transaction) on June 8, 1997, andidentifies as such in its corporate records by September 5,1997

h. modify loss carryback and carryforward rules -- carrybacks ofNOLs are limited to two years and carryforwards are extended to20 years -- generally effective for NOL's arising in taxable yearsbeginning after August 5, 1997

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i. modify general business credit carryback and carryforward rules --carrybacks of unused general business credits are limited to oneyear and carryforwards are extended to 20 years -- generallyeffective for credits arising in taxable years beginning after August5, 1997

j. limit the use of hedging transactions

(1) TRA 97 enacted new section 1259. Section 1259 treatscertain transactions as constructive sales, thereby locking ingains on appreciated financial positions withoutimmediately recognizing the gain

(2) The term “appreciated financial position” generally meansany position with respect to any stock, debt instrument, orpartnership interest where there would be gain if suchposition is sold, assigned, or otherwise terminated at its fairmarket value

(3) A constructive sale is deemed to have occurred if thetaxpayer does any of the following:

(a) enters into a short sale of the same or substantiallyidentical property;

(b) enters into an offsetting notional principal contractwith respect to the same or substantially identicalproperty;

(c) enters into a future or forward contract to deliverthe same or substantially identical property;

(d) has entered into a short sale, an offsetting notionalprincipal contract and acquires the same property asthe underlying property for the position (acquires along position in the same property); or

(e) to the extent prescribed in regulations, enters intoother transactions having substantially the sameeffect as the four types of transactions listed above

(4) This provision is effective for constructive sales enteredinto after June 8, 1997

10. The Internal Revenue Service Restructuring and Reform Act of 1998(“IRRA 98”)

Although the main purpose of IRRA 98 was to reform the IRS, IRRA 98also contains several technical corrections to TRA 97. A few of the moresignificant provisions that affect corporations are discussed below

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a. certain preferred stock treated as boot

(1) the provision amends section 351(g) to clarify that section351(b) (providing that gain but not loss is recognized)applies to a transferor who transfers property in a section351 exchange and receives nonqualified preferred stock, ifand only if, the transferor also receives stock other thannonqualified preferred stock. Otherwise, the transferor istreated as if they had received solely "other property" ofany other type

(2) the provision applies to transactions after June 8, 1997

b. the "control immediately after" requirement

(1) the provision clarifies that in the case of certain divisivetransactions in which a corporation contributes assets to acontrolled corporation in a transaction that meets therequirements of section 355 (or so much of section 356 asrelates to section 355), solely for purposes of determiningthe tax treatment of the transfers of property to thecontrolled corporation by the distributing corporation, thefact that the shareholders of the distributing corporationdispose of part or all of the distributed stock shall not betaken into account for purposes of the control immediatelyafter requirement of section 351(a) and 368(a)(1)(D)

(2) the provision generally is effective for distributions afterApril 16, 1997

c. section 304 transactions involving foreign corporations -- theprovision provides that the Secretary shall issue regulations forsection 304 transactions in which the acquiring or the issuingcorporation is a foreign corporation. It is expected that theregulations will prevent double taxation and provide forappropriate adjustments to the basis of stock held by thecorporation treated as receiving the distribution

d. IRRA 98 amended section 1059(g)(1) to provide the IRS withregulatory authority to coordinate the basis adjustment rules ofSection 1059 and the consolidated return regulations. Accordingto the Senate Finance Committee Report concerning thislegislation, ”[i]t is expected that these rules generally wouldprovide that, except as provided in regulations to be issued ...section 1059 will not cause current gain recognition to the extentthat the consolidated return regulations require the creation orincrease of an excess loss account with respect to a distribution.”(S. Rep.No. 174, 105th Cong., 2nd Sess. 179 (1998))

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11. The Tax and Trade Relief Extension Act of 1998

The Tax and Trade Relief Extension Act of 1998 contains severaltechnical corrections to IRRA 98. The most significant provision thataffects corporations is discussed below

a. A provision of the Tax and Trade Relief Extension Act of 1998clarifies that for certain divisive transactions in which acorporation contributes assets to a controlled corporation and thendistributes the stock of the controlled corporation in a transactionthat meets the requirements of section 355, the fact that thecorporation whose stock was distributed issues additional stockshall not be taken into account

12. The Miscellaneous Trade and Technical Corrections Act of 1999 wassigned into law by President Clinton on June 25, 1999. The mostsignificant provision that affects corporations is discussed below

a. Section 357(d) was added to the Code. This section generallyeliminates the distinction between the assumption of a liability andtaking property subject to a liability. See Part II.S, infra. Section357(d) generally applies to transfers after October 18, 1998. Undersection 357(d)

(1) a recourse liability will be treated as assumed to the extentthat, based on all the facts and circumstances, the transferorhas agreed to, and is expected to, satisfy such liability (orportion thereof), whether or not the transferor has beenrelieved of such liability

(2) where property is transferred subject to a nonrecourseliability, unless the facts and circumstances indicateotherwise, the transferee would be treated as assuming aratable portion of the liability, based on the relative fairmarket values of all assets subject to such liability

13. The Ticket to Work and Work Incentives Improvement Act of 1999

The Ticket to Work and Work Incentives Improvement Act of 1999 wassigned into law by President Clinton on December 17, 1999. The mostsignificant provision that affects corporations is discussed below

a. Section 453(a)(2) was added to the Code. This section generallyrepeals the use of the installment method for accrual methodtaxpayers effective for sales or other dispositions entered into on orafter December 17, 1999

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14. On March 6, 2000, the Treasury Department released the Administration’sRevenue Proposals for fiscal year 2001. A few of the more significantproposals that would affect corporations are discussed below

a. treat corporations in an affiliated group as a single corporation

(1) the proposal would eliminate the “substantially all” test forsection 355 distributions, and instead, apply the activebusiness requirement on an affiliated group basis

(2) in applying the active business test to an affiliated group,each relevant affiliated group (immediately after thedistribution) must satisfy the requirement

(3) the relevant affiliated group for the distributing orcontrolled corporation would consist of the distributing orcontrolled corporation, respectively, as the common parentand all corporations affiliated with such common parentthrough stock ownership described in section 1504(a)(1)(B)(regardless of whether corporations are includiblecorporations under section 1504(b))

(4) an identical proposal was included in the Administration’sRevenue Proposals for fiscal year 2000

b. modify and clarify certain rules relating to debt-for-debt exchanges-- the proposal provides that for purposes of determining theamount of gain recognized to a securityholder in a reorganization(or a section 355 distribution), the excess of the fair market valueof the securities received over the fair market value of thesecurities surrendered would be treated as “other property”

c. corporate tax shelters

(1) the Administration proposed a comprehensive set ofprovisions to attack corporate tax shelters

(2) for purposes of these provisions, a corporate tax shelterwould include any entity, plan or arrangement (determinedbased on all facts and circumstances) in which a direct orindirect corporate participant attempts to obtain a "taxbenefit" in a "tax avoidance transaction"

(3) a tax benefit would include a reduction, exclusion,avoidance, or deferral of tax, or an increase in a refund, butwould not include a tax benefit clearly contemplated by theapplicable provision (taking into account the Congressionalpurpose for such provision and the interaction of suchprovision with other provisions of the Code)

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(4) a tax avoidance transaction would include (1) anytransaction in which the reasonably expected pre-tax profit(determined on a present value basis, after taking intoaccount foreign taxes as expenses and transaction costs) ofthe transaction is insignificant relative to the reasonablyexpected net tax benefits (i.e., tax benefits in excess of thetax liability arising from the transaction, determined on apresent value basis) of such transaction; and (2) in the caseof financing transactions, any transaction in which thepresent value of the tax benefits of the taxpayer to whomthe financing is provided are significantly in excess of thepresent value of pre-tax profit or return of the personproviding the financing

(5) if it is determined that an entity, plan or arrangement is acorporate tax shelter, the proposals would provide that,among other things, the Secretary may disallow adeduction, credit, exclusion, or other allowance obtained inthe transaction, deductions for certain tax advice would bedenied, an excise tax would be imposed on certain feesreceived in connection with the purchase andimplementation of the corporate tax shelter, an excise taxwould be imposed on certain rescission provisionsguaranteeing tax benefits, income from a corporate taxshelter involving tax-indifferent parties would be taxed, andthe substantial understatement penalty would be increasedfrom 20 to 40 percent

(6) a substantially identical proposal was included in theAdministration’s Revenue Proposals for fiscal year 2000

(7) the proposal is part of the Administration’s efforts to curbcorporate tax shelters. In February, 2000, the Serviceissued temporary and proposed regulations relating to taxshelters. See T.D. 8875, 8876, 8877 (Feb. 28, 2000). Seealso Notice 2000-15 (Mar. 20, 2000)

d. prevent duplication or acceleration of loss through assumption ofcertain liabilities

(1) under the proposal, if the basis of stock received by atransferor as part of a tax-free exchange with a controlledcorporation exceeds the fair market value of the stock, thenthe basis of the stock received would be reduced (but notbelow the fair market value) by the amount determined asof the date of the exchange) of any liability that (1) isassumed in exchange for such stock, and (2) did not

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otherwise reduce the transferor’s basis of the stock byreason of the assumption

(2) the proposal would be effective for transfers on or afterOctober 19, 1999

e. prohibit tax deferral on contributions of appreciated property toswap funds

(1) the proposal would add limited or preferred partnershipinterests to the list of assets that are taken into account indetermining whether a corporation (or partnership) is aninvestment company

(2) the proposal would require recognition on the transfer of anon-diversified portfolio of marketable securities to anycorporation (or partnership) that is either (1) registered asan investment company; (2) falls within the qualifiedpurchasers exception to the registration requirement; or (3)otherwise is marketed or sold to investors as providing ameans of tax-free diversification

f. conform control test for tax-free incorporations, distributions, andreorganizations

(1) the proposal would conform the control test for tax-freeincorporations, distributions, and reorganizations with thetest for determining whether corporations satisfy theownership test for affiliation

(2) thus, "control" would be defined as the ownership of atleast 80 percent of the total voting power and at least 80percent of the total value of a corporation's stock

(3) for this purpose, stock would not include certain preferredstock that meets the requirements of section 1504(a)(4)

(4) the proposal would be effective for transactions on or afterthe date of enactment

(5) an identical proposal was included in the Administration’sRevenue Proposals for Fiscal Year 2000

g. tax issuance of tracking stock

(1) the proposal would treat the receipt of tracking stock, in thehands of a shareholder, as a receipt of other property in thecase of (1) a distribution of a corporation’s tracking stockmade by such corporation with respect to its stock or (2)tracking stock received in exchange for other stock in the

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issuing corporation (either in a recapitalization or section1036 exchange)

(2) for this purpose, "tracking stock" would be defined as stockthat relates to, and tracks the economic performance of, lessthan all of the assets of the issuing corporation (includingthe stock of a subsidiary), and either

(a) the dividends are directly or indirectly determinedby reference to the value or performance of thetracked entity or assets, or

(b) the stock has liquidation rights directly or indirectlydetermined by reference to the tracked entity orassets

(3) the proposal would be effective for tracking stock issued onor after the date of enactment

(4) a substantially identical proposal was included in theAdministration’s Revenue Proposals for Fiscal Year 2000

h. require consistent treatment and provide basis allocation rules fortransfers of intangibles in certain nonrecognition transactions

(1) the proposal would provide that the transfer of an interest inintangible property constituting less than all of thesubstantial rights of the transferor in the property would betreated as a transfer of property for purposes of thenonrecognition provisions regarding transfers of property tocontrolled corporations or partnerships

(2) consistent reporting by the transferor and transferee wouldbe required

(3) in the case of a transfer of less than all of the substantialrights, the transferor would have to allocate the basis of theintangible between the retained rights and the transferredrights based upon respective fair market values

(4) the proposal would be effective for transfers on or after thedate of enactment

(5) an identical proposal was included in the Administration’sRevenue Proposals for Fiscal Year 2000

i. modify treatment of downstream mergers

(1) downstream mergers are mergers in which one corporation(the "target corporation") that holds stock of anothercorporation (the "acquiring corporation") transfers its assets

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(including acquiring corporation stock) to the acquiringcorporation, and the shareholders of the target corporationreceive stock of the acquiring corporation in exchange fortheir target corporation stock -- downstream transactionshave been held to qualify as tax-free reorganizations

(2) under the proposal, where a target corporation does notsatisfy the stock ownership requirements of section1504(a)(2) (generally, 80 percent or more of the vote andvalue) with respect to the acquiring corporation, and thetarget corporation combines with the acquiring corporationin a reorganization in which the acquiring corporation is thesurvivor, the target corporation must recognize gain, butnot loss, as if it distributed the acquiring corporation stockthat it held immediately prior to the reorganization

(3) as long as the other requirements for a reorganization aresatisfied, nonrecognition treatment will continue to apply toother assets transferred to the target corporation and thetarget corporation shareholders

(4) the proposal also would apply where a parent corporationowns less than 20 percent of the value of the stock of asubsidiary corporation and the subsidiary corporationcombines upstream with and into the parent corporation ora second subsidiary of the parent corporation. In suchcases, the parent corporation would recognize gain, but notloss, as if it sold its subsidiary corporation stockimmediately prior to the reorganization

(5) the proposal would apply to transactions that occur on orafter the date of enactment

(6) a similar proposal was included in the Administration’sRevenue Proposals for Fiscal Year 2000

j. clarify definition of nonqualified preferred stock -- the proposalwould clarify the definition of nonqualified preferred stock toensure that stock for which there is not a real and meaningfullikelihood of actually participating in the earnings and growth ofthe corporation is included in the definition

k. clarify rules for payment of estimated taxes for certain deemedasset sales -- substantial uncertainty arose as to whether eligibilityfor a section 338(h)(10) election exempts the seller from paymentof estimated taxes. The proposal would amend section 338(h)(13)to require that estimated taxes be paid based upon the deemed assetsale where there is an agreement between the buyer and the seller

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to make the section 338(h)(10) election, or upon the stock salewhere there is no such agreement

l. modify treatment of transfers to creditors in divisivereorganizations

(1) the proposal would limit the amount of money or otherproperty that a distributing corporation can distribute to itscreditors without gain recognition under section 361(b) tothe amount of the basis of assets contributed to a controlledcorporation in a divisive reorganization

(2) the proposal would also provide that acquisitivereorganizations under section 368(a)(1)(D) would no longerbe subject to the liabilities assumption rules of section357(c)

F. General Tax Concepts -- Realization v. Recognition

1. Amount realized -- usually the sum of money received plus the fair marketvalue of property received (section 1001(b)) -- if the property received issubject to nonrecourse indebtedness, then the fair market value of theproperty shall not be less than the amount of the nonrecourse indebtedness-- section 7701(g), added by the Deficit Reduction Act of 1984 (“DEFRA84”)

2. Realized vs. recognized gain -- vital distinction

a. realized -- transaction has occurred producing gain or loss, i.e.,value received is more or less than basis -- sections 1001(a) and1011

b. recognized -- the gain or loss so realized is currently taken intoaccount for tax computation purposes -- section 1001(c)

3. Realization doctrine

a. prohibits taxation of "unrealized" appreciation -- Eisner v.Macomber, 252 U.S. 189 (1920)

b. erosion of doctrine -- sections 305(b) (taxation of certain stockdividends) and 1256 (mark to market straddle provisions)

4. Many realized gains are not recognized for policy purposes

a. sections 1031-1045, dealing with various tax-free exchanges (e.g.,like-kind exchanges under section 1031)

b. numerous Subchapter C provisions

c. nonrecognition usually means deferral (i.e., gain will ultimately berecognized --achieved through basis computation), but in some

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cases it can amount to forgiveness (e.g., death prior to recognition -- fair market value ("FMV") basis)

II. ORGANIZATION OF THE CORPORATION -- SECTION 351

A. Concepts Involved

1. Assume

a. property owned by individuals or other persons (transferor)

b. is transferred to a corporation (transferee corporation) in exchangefor its stock

2. What are the tax consequences

a. to the transferor

b. to the transferee corporation

3. General rule of the Code – section 1001

a. section 1001(c) -- except as otherwise provided, gain must berecognized on a sale or exchange of property

b. section 1001(a) gain -- FMV of stock received less basis ofproperty exchanged

c. example --

A transfers assets: FMV $50,000basis $10,000

A receives stock: FMV $50,000

stock (FMV) $50,000less basis $10,000equals gain realized $40,000

4. Exception -- nonrecognition provision -- section 351

B. Section 351 -- In General

1. No gain or loss is recognized to the transferor or transferors if property istransferred to a corporation solely for stock and the transferor(s) are incontrol of the corporation immediately after the exchange

2. Background

a. enacted in 1921

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b. purpose -- end uncertainty and confusion in corporate formations(by reducing need to value assets transferred) and permit businessto operate in corporate form without paying tax for incorporation

c. theory -- transfer of property to corporation controlled byshareholders is merely a change in form of ownership -- assets heldindirectly through stock ownership (i.e., have not sold or disposedof assets) -- should be free from tax

d. see Portland Oil Co. v. Commissioner, 109 F.2d 479, 488 (1stCir.), cert. denied, 310 U.S. 650 (1940); G.D. Searle & Co., 88T.C. 252 (1987)

3. Statute much broader -- allows section 351 nonrecognition for a widerange of transactions

a. multiple transferors -- each transferor receives interest in others'assets

b. small business 1% and big corporation 99% -- change in ownershipfor small business

c. transfer assets to a newly formed corporation which is beginningbusiness

d. transfer assets of an ongoing sole proprietorship or partnership to anewly formed corporation

e. transfer additional assets to an ongoing corporation

4. Recent Changes

a. Under OBRA 87, if a publicly traded partnership is to be treated asa corporation, section 351 is deemed to apply -- new section7704(f)

b. OBRA 89

(1) amended section 351(a) (as well as (b), (d) and (e)(2)) bydeleting the words "or securities" after the term "stock" --under old section 351, transferor could receive stock andsecurities; under new section 351, a transferor who receivesback securities upon the transfer of property to a controlledcorporation does not continue an investment in thetransferred assets to the extent of the securities receivedand must recognize any gain as payments are received on`the securities, subject to the installment sales provisions

(2) reason for change -- Senate Finance Committee believedthat a transferor who receives securities does not continuean investment in the transferred assets to the extent of the

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securities received; therefore, it is more appropriate tocharacterize the transaction as a taxable sale, to the extentof the securities received, than as a tax-free exchange

c. TRA 97

(1) added section 351(g) -- excludes "nonqualified preferredstock" from the definition of "stock" for purposes of section351 (and sections 354, 355, 356 and 1036) -- nonqualifiedpreferred stock is defined as preferred stock that is limitedand preferred as to dividends and does not participate incorporate growth to any significant extent

(2) amended section 351(e)(1) -- expanded the definition of an"investment company" for purposes of the exception forsuch companies from the general rules allowing tax-freecontributions of property to corporations and partnerships.Under Treasury regulations, a contribution of property istreated as made to an investment company if (1) thecontribution results in the diversification of the transferor'sinterest and (2) the transferee is a RIC, REIT, or anycorporation more than 80 percent of the assets of whichconsist of readily marketable stocks or securities orinterests in RICs or REITs that are held for investment

the provision expands the scope of assets which arecounted toward the 80 percent test to include: stocks andsecurities (both readily marketable and not readilymarketable); money; equity interests in corporations(including evidences of indebtedness, options, forward orfuture contracts, notional principal contracts, andderivatives); foreign currency; interests in RICs, REITs,common trust funds, and publicly-traded partnerships;instruments convertible into equity interests; interests inprecious metals (unless used by the transferee in the activeconduct of a trade or business); and any other assetdescribed in Treasury regulations

d. IRRA 98

(1) certain preferred stock treated as boot -- the provisionamends section 351(g) to clarify that section 351(b)(providing that gain but not loss is recognized) applies to atransferor who transfers property in a section 351 exchangeand receives nonqualified preferred stock, if and only if, thetransferor also receives stock other than nonqualifiedpreferred stock. Otherwise, the transferor is treated as if

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they had received solely "other property" of any other type-- the provision applies to transactions after June 8, 1997

e. The Administration’s Revenue Proposals for Fiscal Year 2001contain a provision that would clarify the definition ofnonqualified preferred stock to ensure that stock for which there isnot a real and meaningful likelihood of actually participating in theearnings and growth of the corporation is included in the definition

C. Related Statutes

If section 351 applies (not elective -- if tests met it applies -- Gus Russell, Inc. v.Commissioner, 36 T.C. 965 (1961)), the following statutes apply --

1. Section 351 -- nonrecognition of gain or loss to the transferor

2. Section 1032 (not section 361) -- nonrecognition of gain or loss to thetransferee corporation

3. Section 358 -- basis of corporate stock received by the transferor generallyis basis of property transferred (substituted basis)

4. Section 362 -- basis of property to the corporation generally is basis ofproperty in the hands of the transferor (carryover basis)

5. Stock and assets take the same basis (substituted and carryover basis) --causes double tax on sale of stock and assets

D. Section 351 -- Statutory Requirements

1. One or more persons

2. Transfer property to a corporation

3. Solely in exchange for stock, and

4. The transferor(s) are in control of the corporation immediately after thetransfer

E. Administrative Requirement -- Business Purpose

1. TAM 8045001 -- a valid business purpose is necessary for a transaction toqualify under section 351; see also Estate of Kluener v. Commissioner,154 F.3d 630 (6th Cir. 1998) (The sole shareholder of a financiallytroubled corporation transferred property to the corporation. The propertywas then sold in the corporation’s name. The taxpayer intended the gainfrom the sale of the property to be offset by the corporation’s NOLs. TheCourt found that the transfer of the property to the corporation prior to itssale had no business purpose.)

2. May be used by IRS to attack tax avoidance transactions

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3. No express statutory authority, but one court has inferred a Congressionalintent to require a business purpose for section 351 transactions on thegrounds that section 351 is closely related to section 368, which requires avalid business purpose for reorganizations -- see Caruth v. United States,688 F. Supp. 1129 (N.D. Tex. 1987), aff'd, 865 F.2d 644 (5th Cir. 1989).The Service cited to Caruth approvingly in FSA 200001001 (Jul. 28,1999)

4. In the case of partnerships, similar limitations apply to capitalcontributions -- the IRS recently finalized regulations that would provide itwith authority to recast transactions structured to avoid tax -- see Treas.Reg. § 1.701-2

F. One or More Persons

1. Section 7701(a)(1) -- "person" is broader than "individual" -- coverscorporations, partnerships, estates, and trusts

2. Multiple persons may transfer property for stock

3. Transfers need not be simultaneous -- so long as all are pursuant to asingle plan (with orderly execution) and parties' rights are defined inadvance -- Treas. Reg. § 1.351-1(a)(1)

G. Transfer of "Property"

1. Not defined in the statute

a. section 317 defines property but it applies only to Part I ofSubchapter C (which does not include section 351)

b. property includes most assets -- it includes money -- Rev. Rul. 69-357, 1969-1 C.B. 101

c. nonexclusive license -- held to be property -- E. I. DuPont DeNemours & Co. v. United States, 471 F.2d 1211 (Ct. Cl. 1973)

d. corporate name and goodwill -- held to be property -- Rev. Rul. 79-288, 1979-2 C.B. 139

e. letter of intent relating to the financing of the construction of ahotel -- held to be property -- United States v. Stafford, 727 F.2d1043 (11th Cir. 1984)

2. Services are not property -- section 351(d)(1) -- example -- receive stockfor legal and accounting services

a. recipients of stock for services recognize income to the extent ofvalue of stock received -- James v. Commissioner, 53 T.C. 63(1969); cf. Hospital Corporation of America v. Commissioner, 81T.C. 520 (1983)

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b. persons who receive stock for services cannot be counted indetermining whether transferors of property are in control -- Treas.Reg. § 1.351-1(a)(1) -- discussed below

c. intangible rights created by personal services -- property orservices

(1) "know-how" including secret processes and formulas canqualify as property -- G.D. Searle & Co., 88 T.C. 252(1987) (patents, trademarks, copyrights, technical data,manufacturing know-how and contract rights constitute"property"); Rev. Proc. 69-19, 1969-2 C.B. 301, amplifiedby Rev. Proc. 74-36, 1974-2 C.B. 491; Rev. Rul. 64-56,1964-1 C.B. 133

(2) lease and loan commitments -- services create property

(3) the Administration’s Revenue Proposals for Fiscal Year2001 contain a provision that would provide that thetransfer of an interest in intangible property constitutingless than all of the substantial rights of the transferor in theproperty would be treated as a transfer of property forpurposes of section 351

(a) consistent reporting by the transferor and transfereewould be required

(b) in the case of a transfer of less than all of thesubstantial rights, the transferor would have toallocate the basis of the intangible between theretained rights and the transferred rights based uponrespective fair market values

(c) the proposal would be effective for transfers on orafter the date of enactment

3. Indebtedness of the transferee corporation (not evidenced by a security) isnot property -- section 351(d)(2) and (3)

a. Bankruptcy Tax Act of 1980 -- amended section 351 to treat thefollowing as "non-property" --

(1) debts of the transferee corporation not evidenced by asecurity

(2) interest on the transferee's debt accrued during thetransferor's holding period

b. persons who receive stock in exchange for unsecured debt of thetransferee corporation or accrued but unpaid interest will recognize

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gain or loss on the exchange -- cf. Rev. Rul. 77-81, 1977-1 C.B.97; PLR 8245010

c. purpose -- to tax a creditor who receives stock in exchange for debtunless the exchange qualifies under section 368(a)(1)(G) as abankruptcy reorganization

4. Transfer of property by a debtor corporation in a bankruptcy proceeding --section 351(e)(2) -- Bankruptcy Tax Act made section 351 inapplicable toa transfer of property by a debtor corporation in a bankruptcy proceedingwhere the stock received in the exchange is used to pay debts of thecorporation

H. Solely

Section 351(b) applies if the transferors receive property other than stock

I. In Exchange

1. Transfer entire interest in property or an interest which is continuous,perpetual and irrevocable -- E. I. DuPont De Nemours & Co., supra, 471F.2d 1211; Rev. Rul. 71-564, 1971-2 C.B. 179; Rev. Rul. 69-156, 1969-1C.B. 101; Rev. Rul. 64-56, 1964-1 C.B. 133

2. Transfer of a limited interest with retained economic ownership mayconstitute a license and not an exchange -- see also TAM 9215005

J. For Stock

1. "Stock" -- new section 351

a. no statutory definition

b. broad interpretation -- need not be voting stock

c. same meaning as in the reorganization area (sections 354 and 361et al.)

d. stock rights and warrants do not qualify

e. contingent right to acquire additional stock may qualify

f. wholly owned corporation need not issue new stock when itsowner transfers property to it -- section 351 does not require this"meaningless gesture" -- Lessinger v. Commissioner, 85 T.C. 824(1985), rev'd on other grounds, 872 F.2d 519 (2d Cir. 1989); seealso Scallen v. Commissioner, 54 T.C.M. 177 (1987), aff'd, 877F.2d 1364 (8th Cir. 1989)

g. section 351(g), added by TRA 97, excludes "nonqualifiedpreferred stock" from the definition of "stock" for purposes ofsection 351 (and sections 354, 355, 356, and 1036)

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(1) nonqualified preferred stock is defined as preferred stockthat is limited and preferred as to dividends and does notparticipate in corporate growth to any significant extent andfor which:

(a) the holder has the right to require the issuer or arelated person to redeem or purchase the stock;

(b) the issuer or a related person is required to redeemor purchase the stock;

(c) the issuer or a related person has the right to redeemor purchase the stock and, as or the issue date, it ismore likely than not that such right will beexercised; or

(d) the dividend rate for the stock varies in whole or inpart (directly or indirectly) with reference to interestrates, commodity prices, or other similar indices

(2) the rules related to redemption or purchase do not apply ifthe right or obligation cannot be exercised within 20 yearsof the date the right or obligation is issued or if the right orobligation is subject to a contingency which, as of the issuedate, makes the likelihood of purchase or redemptionremote

(3) the provision contains additional exceptions to this generalrule

(4) the provision generally is effective for transfers after June8, 1997

(5) the Administration’s Revenue Proposals for Fiscal Year2001 contain the provision that would clarify the definitionof nonqualified preferred stock to ensure that stock forwhich there is not a real and meaningful likelihood ofactually participating in the earnings and growth of thecorporation is included in the definition

h. IRRA 98 amended section 351(g) to clarify that section 351(b)(providing that gain but not loss is recognized) applies to atransferor who transfers property in a section 351 exchange andreceives nonqualified preferred stock, if and only if, the transferoralso receives stock other than nonqualified preferred stock.Otherwise, the transferor is treated as if they had received solely"other property" of any other type -- the provision applies totransactions after June 8, 1997

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(1) Example (1): A transfers appreciated property toCorporation X in exchange for “nonqualified preferredstock” within the meaning of section 351(g) --result:section 351(b) does not apply; A is deemed to have sold theproperty in a section 1001 transaction, the gain in theproperty is recognized

(2) Example (2): A transfers loss property to Corporation X inexchange for “nonqualified preferred stock” within themeaning of section 351(g) -- result: section 351(b) does notapply; A is deemed to have sold the property in a section1001 transaction, A recognizes a loss on the sale of theproperty

(3) Example (3): A transfers loss property to Corporation X inexchange for one share of common stock and “nonqualifiedpreferred stock” within the meaning of section 351(g) --result: section 351(b) applies because A receives commonstock as well as nonqualified preferred stock in the transfer-- such nonqualified preferred stock is “other property” forpurposes of section 351(b) -- therefore, under section351(b), the loss is not recognized

2. "Stock or Securities" -- old section 351 -- prior to OBRA 89, a transferorof property to a controlled corporation could receive securities, as well asstock, and the securities did not constitute boot

a. no statutory definition

b. refers to debt instruments having some degree of permanence, i.e.,not short-term notes -- cf. Lagerquist v. Commissioner, 53 T.C.M.530 (1987)

c. if maturity is more than ten years, the debt probably qualifies -- ifless than five years, it probably does not -- in between lies aquestionable area -- see Bradshaw v. United States, 683 F.2d 365(Ct. Cl. 1982)

d. if transfer property solely for securities (and own no stock of thecorporation), then will not qualify under section 351 -- Rev. Rul.73-472, 1973-2 C.B. 114

e. but if already own stock of the corporation and transfer propertyfor securities and stock or solely for securities, will qualify undersection 351 -- Rev. Rul. 73-473, 1973-2 C.B. 115

f. original issue discount -- transferor must recognize interest incomecurrently under OID rules (section 1272 et seq.) on debtinstruments received in a section 351 transaction if stated

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redemption price at maturity exceeds the issue price of suchinstruments

(1) stated redemption price at maturity --defined at section1273(a)(2)

(2) issue price -- defined at sections 1273(b) and 1274(a)

g. market discount -- section 1278(a)(2), added by DEFRA 84, wouldcause the transferor of property to recognize ordinary income tothe extent that the stated redemption price at maturity of the debtreceived exceeds the basis of property transferred

(1) TRA 86 (technical corrections) provides an exception fornewly issued debt -- section 1278(a)(1)(C)(i)

(2) exception may not apply if section 351 not met -- seesection 1278(a)(1)(C)(ii)

3. Classification of instrument as stock or debt

a. the use of debt offers a number of advantages from a planningperspective -- interest is deductible and thus the distribution ofincome is not subject to two levels of tax -- in the consolidatedgroup context, income generally is subject to only one level ofcorporate tax, however basis received in debt is not subject todisallowance under Treas. Reg. § 1.1502-20 -- thus, the taxpayerfrequently has an incentive to characterize its interest in acorporation as debt rather than equity -- see William T. Plumb, Jr.,The Federal Income Tax Significance of Corporate Debt: ACritical Analysis and a Proposal, 26 Tax L. Rev. 369 (1970)

b. factual issue -- IRS and courts refuse to accept the form of theinstrument in determining its character -- Segel v. Commissioner,89 T.C. 816 (1987); TAM 8735008

c. section 385 authorizes the IRS to issue regulations to determinewhether an interest in a corporation is to be treated as stock orindebtedness

(1) factors to consider:

• written unconditional promise to pay at demand orfixed date with fixed rate of interest

• subordination of debt

• convertibility of debt

• debt/equity ratio

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• proportionate holdings between stock and debt

(2) although the IRS has issued regulations in this area, theregulations were withdrawn. Rev. Rul. 83-98, 1983-2 C.B.40

(3) the IRS has issued a series of pronouncements indicatingthat it will closely scrutinize instruments which aredesigned to be treated as debt for federal income taxpurposes but as equity for regulatory, rating agency, orfinancial accounting purposes -- Notice 94-47, 1994-1C.B. 357; see also Notice 94-48, 1994-1 C.B. 357; Rev.Rul. 94-28, 1994-1 C.B. 86

d. under section 385(a), IRS is authorized to characterize an interestin a corporation that has "significant debt and equitycharacteristics" as part debt/part equity --

(1) debt instrument that provides for payments that aredependent to a significant extent on corporate performance,through equity kickers, contingent interest, etc.

(2) significant deferral of payment,

(3) subordination,

(4) interest rate sufficiently high to suggest a significant risk ofdefault

e. sections 163(e)(5) and 163(i) -- "applicable high yield discountobligations" -- authorize the IRS to treat certain debt as part debtand part equity

(1) exception -- C corporations not entitled to deduct"disqualified portion" of interest payment on certain debtinstruments -- remainder cannot be deducted until paid

(2) applicable to instruments with --

(a) maturity date more than 5 years from date of issue

(b) yield to maturity equals or exceeds applicablefederal rate (AFR) plus 5 points

(c) significant OID -- see sections 163(e)(5)(F) and163(i)(1)

f. section 385(c) provides rules that apply if an issuer characterizesan interest as debt or equity at the time of issuance --

(1) such characterization is binding on the issuer and allholders of the interest,

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(2) such characterization is not binding on the IRS, and

(3) a holder who treats such an interest in a mannerinconsistent with the issuer's characterization must makedisclosure to that effect on his return

g. TRA 97 enacted section 163(l) which denies interest and originalissue discount deductions on corporate instruments that are payablein stock of the issuer or a related party, including instrumentswhich are mandatorily (or at the option of the issuer or a relatedparty) payable or convertible into such stock. Interest and originalissue discount deductions are also denied for instruments thepayments on which are made by reference to the value of stock; orthat are part of an arrangement designed to result in a payment ofthe instrument with or by reference to such stock -- generallyeffective for instruments issued after June 8, 1997

4. Disproportionate transfers

a. stock need not be issued in proportion to FMV of propertytransferred -- Treas. Reg. § 1.351-1(b)(1); Weisbart v.Commissioner, 79 T.C. 521 (1982)

b. may result in gift or compensation to recipient -- section 351(g)(3)and (4)

c. gift tax liability or deduction to payor

K. Control

1. Transferor or transferors must be in control of the corporation

2. Control need not be obtained in this transaction -- can own stock fromprevious transactions

3. Defined in section 368(c): (a) 80% of total combined "voting power" of allstock "entitled to vote," and (b) 80% of the total number of shares of eachclass of nonvoting stock -- Rev. Rul. 59-259, 1959-2 C.B. 115

4. The Administration’s Revenue Proposals for Fiscal Year 2001 contain aprovision that would change the test for control under section 351. Underthe proposal, control would be defined as the ownership of at least 80% ofthe total voting power and at least 80% of the total value of a corporation’sstock

5. General rules

a. outstanding stock not authorized stock or treasury stock

b. beneficial ownership not mere legal title

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c. constructive ownership provisions do not apply -- see Yamamotov. Commissioner, 51 T.C.M. 1560 (1986), aff'd in part anddismissed in part without published opinion, 891 F.2d 297 (9th Cir.1989)

d. convertible stock or debentures and preferred stock havingcontingent voting rights -- not voting stock

e. little guidance in defining "voting power" or "voting stock"

(1) troublesome if multiple classes of stock withdisproportionate voting and equity rights

(2) other Code sections -- section 302(b)(2)(B);section 304(c)(1); section 332(b)(1); section 338(d)(3);section 368(a)(1)(B) and (C); section 1504(a)(2);section 1563(a)

6. Consolidated returns

a. the aggregate stock ownership rules of Treas. Reg. § 1.1502-34, inwhich all stock owned by members of an affiliated group that filesa consolidated return is taken into account, apply for the purpose ofdetermining whether a member satisfies the 80% rule of section351(a) -- Rev. Rul. 89-46, 1989-1 C.B. 272

(1) example

facts -- P has two wholly owned subsidiaries, X and Y, thatare members of an affiliated group that files a consolidatedreturn -- X transfers property to Y in exchange for stock ofY

result -- under Treas. Reg. § 1.1502-34, even though Xdoes not actually own an amount of stock constitutingcontrol of Y, X is considered for purposes of section 351(a)as in control of Y, by virtue of P's ownership -- therefore, Xsatisfies the control requirement of section 351(a)

7. Multiple transferors

a. can have more than one transferor and qualify under section 351 --provided transferors as a group have control

(1) existing shareholders who do not transfer property are nottransferors

(2) a person who receives stock for services only is not atransferor

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(3) a person who receives stock for indebtedness of thetransferee corporation (not evidenced by a security) is not atransferor

(4) if a person transfers property for stock and also receivesstock for services or indebtedness -- all of his stock iscounted in determining whether transferors have control --Treas. Reg. § 1.351-1(a)(2), ex. 3

(5) person who transfers stock or property to a subsidiary inexchange for parent's stock is not counted in determiningwhether group of transferors has control of parent -- Rev.Rul. 84-44, 1984-1 C.B. 105

(6) factual question whether transferor is part of control group-- Russell v. Commissioner, 832 F.2d 349 (6th Cir. 1987)

b. examples

(1) A owns 100% of the stock of X corporation, B transfersassets to X for 25% of the X stock -- section 351 does notapply because B is not in control -- B is taxed

(2) A, B, and C form X corporation, A and B transfer propertyfor 78% of the X stock, C performs services for 22% of thestock -- section 351 does not apply because persons whotransferred property are not in control -- A, B, and C aretaxed

(3) A and B receive 80% of the X stock for property and Creceives 20% of the stock for services -- section 351 appliesto A and B, but C is still taxed

(4) A and B receive 78% of the stock for property, C receives22% of the stock for property and services -- section 351applies regardless of the amount of property transferred byC (provided the property transferred by C is not only ofnominal value) and C is taxed to extent he receives stockfor services

(5) similar rules should apply if the shareholder exchangesproperty and transferee corporation indebtedness for stock

c. accommodation transferor -- transfer of minor amount of propertyso that the group of transferors have control -- will not berecognized

(1) A owns 100% of X corporation -- B transfers assets to Xfor 25% of stock -- section 351 does not apply because B isnot in control

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(2) same facts but A also transfers nominal amount of assetsfor one additional share of X stock; technically A and B areboth transferors and they are in control, but A will not berecognized as a transferor for purposes of section 351 --Kamborian v. Commissioner, 56 T.C. 847 (1971), aff'd,469 F.2d 219 (1st Cir. 1972)

(3) Rev. Proc. 77-37, 1977-2 C.B. 568 -- to qualify as atransferor a shareholder must convey property valued at10% of stock already owned (for advance ruling)

L. Immediately After the Exchange

1. Is there control if the shareholder disposes of part of the stock shortly afterreceiving it -- examples:

a. shareholder receives 100% of the stock and immediately sells 25%

b. shareholder receives 100% of the stock and gives 25% to his/herspouse

c. shareholder receives 100% of the stock and the corporation issuesadditional stock reducing the shareholder's interest to 75%

2. Step transaction doctrine -- momentary control is generally not sufficient

a. transferor agrees prior to transfer to dispose of sufficient stock tocause loss of control -- need not be binding commitment

b. the subsequent transfer is an integral part of the incorporation, i.e.,first transfer would not have happened without the second

c. authority

(1) McDonald's of Zion, Inc. v. Commissioner, 688 F.2d 520(7th Cir. 1982); Intermountain Lumber Co. v.Commissioner, 65 T.C. 1025 (1976); American BantamCar v. Commissioner, 11 T.C. 397 (1948)

(2) cf. National Bellas Hess, Inc. v. Commissioner, 20 T.C.636 (1953) (transferor's control "real and lasting," notmomentary formality, subsequent relinquishment not partof plan of reorganization or exchange)

(3) Rev. Rul. 79-70, 1979-1 C.B. 144 -- section 351 notapplicable because of required subsequent transfer

(4) Rev. Rul. 79-194, 1979-1 C.B. 145 (Situation 1) --transferor sells stock to another transferor -- section 351applies

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(5) TAM 8735009 -- section 351 applies to transfers by twocorporations notwithstanding right of one corporation topurchase stock initially acquired by second corporation

d. case law distinguishes commercial and non-commercial transfers

(1) transfer with prearranged sale of 25% of the stock --section 351 does not apply

(2) same facts but shareholder gives 25% of stock to spouse --section 351 applies (rationale: transferor had power toretain stock or to give it away) -- D'Angelo Associates, Inc.v. Commissioner, 70 T.C. 121 (1978)

e. Treas. Reg. § 1.351-1(a)(3) -- if a person acquires stock of acorporation from an underwriter in exchange for cash in a qualifiedunderwriting transaction, the person who acquires stock from theunderwriter is treated as transferring cash directly to thecorporation in exchange for stock of the corporation and theunderwriter is disregarded

(1) a qualified underwriting transaction is a transaction inwhich a corporation issues stock for cash in anunderwriting in which either the underwriter is an agent ofthe corporation or the underwriter's ownership of the stockis transitory

(2) this regulation supersedes Rev. Rul. 78-294, 1978-2 C.B.141 -- firm commitment underwriter treated as transferordespite transitory ownership

f. section 351(c) -- transferor corporation can distribute stock to itsshareholder without violating control; technical corrections to TRA97 and IRRA 98 clarify that for certain divisive transactions inwhich a corporation contributes assets to a controlled corporationand then distributes the stock of the controlled corporation in atransaction that meets the requirements of section 355, two factorsshall not be taken into account: (1) the fact that the shareholders ofthe distributing corporation dispose of part or all of the distributedstock; and (2) the fact that the corporation whose stock wasdistributed issues additional stock

g. Rev. Rul. 84-111, 1984-2 C.B. 88, describes consequences of threedifferent situations involving transfer of partnership assets andliabilities to a newly formed corporation (supersedes and revokesRev. Rul. 70-239, 1970-1 C.B. 74)

h. prearranged disposition through a reorganization will destroysection 351 application

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(1) example: A transfers assets to X corporation for all the Xstock -- Y corporation then acquires the X stock from A forY stock (B reorganization) -- section 351 does not apply

(2) West Coast Marketing Corp. v. Commissioner, 46 T.C. 32(1966) (incorporation followed by sale of stock treated as asale of assets); Rev. Rul. 80-221, 1980-2 C.B. 107; Rev.Rul. 70-140, 1970-1 C.B. 73

i. Where there is no prearranged disposition of stock and businesspurpose for incorporation exists, subsequent disposition of stock ina "B" reorganization will not destroy section 351 -- Weickel v.Commissioner, 51 T.C.M. 432 (1986); Vest v. Commissioner, 57T.C. 128 (1971)

j. Option to buy stock of transferee from transferor corporation aftersection 351 transaction does not violate control requirement -- PLR8735009

3. Successive transfers

a. A transfers assets to Y corporation in exchange for all the stock ofY, and Y immediately transfers the assets to Z corporation inexchange for all the Z stock

b. does section 351 apply to each exchange -- does A have "control"

c. Rev. Rul. 77-449, 1977-2 C.B. 110, treats each transfer as aseparate transaction --section 351 applies to each exchange

d. Rev. Rul. 83-34, 1983-1 C.B. 79, same facts as above except Aholds only 80% of the Y stock and Y holds only 80% of the Zstock --section 351 applies to each exchange -- see also Rev. Rul.83-156, 1983-2 C.B. 66

e. unclear whether result changes if Y receives only 50% of the Zstock and a third party (which also transfers property to Z) receivesthe other 50%

f. see PLR 9137003 -- successive transfers among related parties arein the nature of a business adjustment and do not have the effect ofthe taxpayer's "cashing in" of a gain

M. Section 351(b) -- Transfers Not Solely for Stock

1. Transfer of property in exchange for stock and other consideration -- cash,securities or other property (i.e., boot) -- "solely" requirement ofsection 351(a) is not met

2. Section 351(b) provides for limited recognition of gain

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a. realized gain (FMV of stock and boot received less basis ofproperty given up) is recognized to the extent of the value of theboot received

b. no loss recognized

3. Example


A receives: stock (FMV) $30,000cash $10,000other property (FMV) $10,000total $50,000

less basis $10,000equals realized gain $40,000

recognized gain (boot) $20,000

4. Character of gain (capital gain or ordinary income)

a. depends on character of property transferred

b. sections 291, 1239, 1245, 1250 apply if gain is recognized

c. section 47 -- must retain a "substantial interest" to avoidinvestment tax credit recapture -- Treas. Reg. § 1.47-3(f); Rev.Rul. 83-65, 1983-1 C.B. 10

d. under section 1239 gain recognized on a sale or exchange ofdepreciable property between "related parties" is taxed as ordinaryincome -- related party transactions include a sale or exchangefrom a parent corporation to its subsidiary or from a corporation toa commonly controlled partnership

5. Multiple assets -- amount and character of gain determined on anindividual asset basis -- Rev. Rul. 68-55, 1968-1 C.B. 140

example

A transfers Asset 1: FMV $45,000basis $25,000

Asset 2: FMV $5,000basis $25,000

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A receives stock: FMV $30,000boot: FMV $20,000

Total Asset 1 Asset 2FMV $50,000 $45,000 $5,000

(100%) (90%) (10%)

boot allocated to each asset: $20,000x 90%

$20,000x 10%

$18,000 $2,000

stock (FMV) $30,000 $27,000 $3,000plus boot (FMV) $20,000 $18,000 $2,000equals amount realized $50,000 $45,000 $5,000

minus basis $50,000 $25,000 $25,000equals gain realize - 0 - $20,000 ($20,000)

gain recognized $18,000 - 0 -

6. Multiple assets -- allocate aggregate basis of property among stock andsecurities received in exchange in proportion to the latter's fair marketvalue -- taxpayer may not designate specific property to be exchanged forparticular stock or securities -- Rev. Rul. 85-164, 1985-2 C.B. 117

7. Receipt of installment obligations

a. Installment note will constitute boot in a section 351 transaction --installment method can apply to defer gain. Prop. Treas. Reg.§ 1.453-1(f)(3) sets forth rules for the treatment of short terminstallment notes as boot

b. The installment method is not applicable to sales of inventory, orsales of depreciable property between a shareholder and a relatedparty -- sections 453(b)(2)(B) and 453(g)

c. example

B transfers property with a basis of $250,000 and fair market valueof $300,000 to newly formed corporation Y in exchange for all ofthe stock of Y (worth $200,000) and a $100,000 installmentobligation (bearing adequate interest) issued by Y. The installmentobligation is payable in full on the second anniversary of the dateof issue. The installment obligation is boot received by B in theexchange. However, the installment sale rules prevent B fromrecognizing gain immediately. Instead, B’s basis is first allocatedto the Y stock (but not in excess of the fair market value of the Y

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stock) and then to the installment obligation. Since the fair marketvalue of the Y stock is $200,000, B has a $50,000 basis in theinstallment obligation. If the $100,000 installment obligation ispaid in full on the second anniversary date, B will recognize gainof $50,000 at that time ($100,000 received less B’s $50,000 basisin the installment obligation) and Y at that time will increase thebasis at which it holds the property. See Prop. Treas. Reg. §1.453-1(f)(3), ex. 2

d. Section 453(a)(2, added by the Ticket to Work and WorkIncentives Improvement Act of 1999, provides that the installmentmethod cannot be used to report income from installment sales ifsuch income would be reported under an accrual method ofaccounting

N. Section 351(f) -- Exception for Section 311 Transfers

1. TAMRA 88 added section 351(f), effective for transfers occurring on orafter June 21, 1988

2. Where a corporation participates in a section 351 transaction which is notpart of a plan of reorganization, the corporation must recognize gain (ifany) on property which is transferred to a shareholder, pursuant tosection 311 (see Part VII, infra)

O. Section 1032 -- No Gain or Loss Recognized to the Corporation on Receipt ofProperty

1. Corporation recognizes no gain or loss on the receipt of property inexchange for its stock

2. Section 1032 applies whether or not section 351 applies -- i.e., even ifsection 351 is not applicable the corporation recognizes no gain

P. Section 358 -- Basis of Stock Received by Transferor-Shareholder

1. Concepts of basis

a. cost basis -- what you pay

b. substituted basis -- the basis of property received takes the basis ofthe property given up -- section 7701(a)(44)

c. carryover (or "transferred") basis -- the basis of the propertyreceived is equal to the basis of the property in the hands of thetransferor -- section 7701(a)(43)

2. Section 358 -- generally the basis of the stock received by the transferorequals the basis of the property given up (substituted basis)

a. reduced by money or other property received (i.e., boot)

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b. increased by gain recognized

3. Basis of money is face amount -- basis of other property is FMV

4. Example 1

A transfers Asset 1: FMV $50,000basis $10,000

A receives stock: FMV $30,000cash (FMV) $10,000other property (FMV) $10,000total FMV received $50,000less basis -$10,000equals gain realized $40,000

gains recognized (section 351(b)): $20,000basis of stock (section 358):

old basis $10,000less boot -$20,000plus gain recognized +$20,000equals $10,000

basis of boot (i.e., its FMV): $20,000

5. Example 2

B transfers assets: FMV $50,000basis $40,000

B receives stock (FMV) $30,000cash (FMV) $10,000other property (FMV) $10,000less basis -$40,000equal gain realized $10,000

gain recognized (section 351(b)) $10,000

basis of stock (section 358):old basis $40,000less boot - $20,000plus gain recognized +$10,000equals $30,000

basis of boot (i.e., its FMV): $20,000

6. If the transferor receives several classes of stock, the basis is allocatedamong the stock on a FMV basis -- Rev. Rul. 85-164, 1985-2 C.B. 117

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7. Section 358 and liabilities -- liabilities assumed by the corporation (forpurposes of determining basis) are treated as money received -- reduceshareholder's basis in the stock -- section 357 determines whether gain isrecognized on assumption of liabilities

Q. Section 362 -- Basis of Property to the Corporation

1. Property in hands of the corporation has the same basis as in the hands ofthe transferor (carryover basis) -- increased by gain recognized to thetransferor

2. Prior example:shareholder basis in property $10,000plus gain recognized $20,000basis to the corporation $30,000

3. It is unclear whether the transferee's payment of an assumed liabilityshould be capitalized or deducted -- see Holdcroft Transp. Co. v.Commissioner, 153 F.2d 323 (8th Cir. 1946) (capitalization); cf. Rev. Rul.80-198, 1980-2 C.B. 113 (deduction); PLR 7830010 (deduction); Rev.Rul. 95-74, 1995-2 C.B. 36 (1995) (deduction or capitalization asappropriate under the taxpayer’s method of accounting)

4. If section 351 does not apply, then the corporation takes a purchase basis -- FMV of assets -- section 1012; Treas. Reg. § 1.1032-1(d)

5. Zero basis problem -- parent corporation (P) transfers its stock to asubsidiary corporation (S) in exchange for S stock in a section 351transaction -- basis of P stock and basis of S stock are zero -- Rev. Rul. 74-503, 1974-2 C.B. 117

6. Zero basis relief -- Treas. Reg. § 1.1502-13(f)(6) provides some relieffrom the zero basis problem in the consolidated context -- if thedisposition qualifies for relief, the member is treated as having purchasedthe parent stock for its fair market value and therefore takes a basis equalto value -- however, relief is only available if --

a. the member acquires the P stock directly from the common parentas a contribution to capital

b. the member transfers the stock immediately to an unrelatednonmember as part of the plan

c. no nonmember receives a substituted basis in the stock

d. the stock is not exchanged for other parent stock

e. the parent corporation does not become, or ceases to be, thecommon parent as part of the disposition or plan

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f. the member is not a nonmember that becomes a member, or amember that becomes a nonmember, as part of the disposition orplan

7. On May 11, 2000, the Service published final regulations Treas. Reg. §1.1032-3, T.D. 8883, relating to the treatment of a disposition by acorporation of the stock of another corporation in a taxable transaction

a. If the regulations apply, the acquiring corporation does notrecognize gain or loss on the disposition of the issuingcorporation's stock. The transaction is treated as if, immediatelybefore the acquiring entity disposes of the stock of the issuingcorporation, the acquiring entity purchased the issuingcorporation’s stock from the issuing corporation for fair marketvalue with cash contributed to the acquiring entity by the issuingcorporation or an intermediate corporation or partnership

b. The regulations apply to issuing corporation stock options in thesame manner as it applies to issuing corporation stock

c. The regulations apply only if, pursuant to a plan to acquire moneyor other property, see Treas. Reg. 1.1032-3(c):

(1) The acquiring corporation acquires stock of the issuingcorporation directly or indirectly from the issuingcorporation in a transaction in which, but for this section,the basis of the stock of the issuing corporation in the handsof the acquiring corporation would be determined, in wholeor in part, with respect to the issuing corporation's basis inthe issuing corporation's stock under section 362(a) or 723;

(2) The acquiring corporation immediately transfers the stockof the issuing corporation to acquire money or otherproperty;

(3) No party receiving stock of the issuing corporation fromthe acquiring corporation receives a substituted basis in thestock of the issuing corporation within the meaning ofsection 7701(a)(42); and

(4) The issuing corporation stock is not exchanged for stock ofthe issuing corporation

d. The final regulations apply to transactions occurring on or afterMay 11, 2000

R. Section 1223 -- Holding Period of Stock and Property

1. Section 1223(1) -- the transferor's holding period of the stock receivedincludes the holding period of the property exchanged ("tack" holding

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periods) -- provided the property exchanged is a capital asset or asection 1231 asset -- Rev. Rul. 85-164, 1985-2 C.B. 117 transferor'sholding period of boot received -- does not include the holding period ofthe property exchanged -- section 1223(1) by its terms only applies toproperty which has the same basis in whole or in part as the propertyexchanged and section 358(a)(2) states that the basis of boot to thetransferor is its FMV

2. Section 1223(2) -- the holding period of the property in the hands of thecorporation includes the transferor's holding period -- whether or not theproperty exchanged is a capital asset or a section 1231 asset this ruleapplies even if the transferor receives boot -- section 1223(2) requires onlythat the transferee's basis in the property be the same in whole or in part asthe transferor's basis and under section 362(b) the basis of the property tothe corporation is the same as it would be in the transferor's hands,increased by any gain recognized by the transferor on the transfer

S. Section 357 -- Assumption of Liabilities by the Corporation (or PropertyTransferred "subject to" Liability)

1. Liability assumed or property taken subject to

a. assumption of liability -- transferee corporation becomes obligatedto pay debt whether or not transferor is relieved of liability

b. property subject to liability -- no personal liability to transfereecorporation -- liability secured only by asset -- unclear whethertransferor can retain liability and convey property -- see Jackson v.Commissioner, 708 F.2d 1402 (9th Cir. 1983); Rosen v.Commissioner, 62 T.C. 11 (1974), aff’d, 515 F.2d 507 (3d Cir.1975); Parsons v. Commissioner, 31 T.C.M. 290 (1972)

c. section 357(d), added by the Miscellaneous Trade and TechnicalCorrections act of 1999, eliminates the distinction between theassumption of a liability and the acquisition of an asset subject to aliability. Section 357(d) generally applies to transfers afterOctober 18, 1998. Under section 357(d)

(1) a recourse liability will be treated as assumed to the extentthat, based on all the facts and circumstances, the transferorhas agreed to, and is expected to, satisfy such liability (orportion thereof), whether or not the transferor has beenrelieved of such liability

(2) where property is transferred subject to a nonrecourseliability, unless the facts and circumstances indicateotherwise, the transferee would be treated as assuming aratable portion of the liability, based on the relative fairmarket values of all assets subject to such liability

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d. the Administration’s Revenue Proposals for Fiscal Year 2001contain a provision according to which, if the basis of the stockreceived by a transferor as part of a tax-free exchange with acontrolled corporation exceeds the fair market value of the stock,then the basis of the stock received would be reduced (but notbelow the fair market value) by the amount of any liability that (1)is assumed in exchange for such stock, and (2) did not otherwisereduce the transferor’s basis of the stock by reason of assumption

2. Section 357(a) -- general rule

a. the assumption of a liability of the transferor by the corporation isnot treated as money or other property (i.e., not boot) for purposesof determining gain (it is treated as money when determining basis-- section 358)

b. result -- liability generally does not cause recognition of gain to thetransferor

c. permits ongoing business to incorporate without fear of tax

d. immediate payment of liability by the corporation -- no gainrecognized, treated as an assumption and not a distribution of boot-- see Kniffen v. Commissioner, 39 T.C. 553 (1962); Rev. Rul. 74-477, 1974-2 C.B. 116 (payment or assumption of expensesincurred by the transferor in a section 351 transaction does notconstitute boot)

e. example


liabilities assumed $5,000

A receives stock (FMV) $45,000plus liabilities assumed $5,000equals amount realized $50,000

less basis $10,000equals gains realized $40,000

gains recognized - 0 -

basis of stock (section 358) --old basis $10,000less liability assumed - $5,000equals $5,000

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3. Section 357(b) -- exception to general rule -- no bona fide businesspurpose

a. if the principal purpose for the assumption of the liability was

(1) to avoid tax, or

(2) not a bona fide business purpose

then the entire amount of the liability is considered money,contrary to the general rule of section 357(a)

b. gain or loss is thus recognized pursuant to section 351(b)

c. example


business liabilities assumed $5,000personal liabilities assumed $5,000

A receives stock (FMV) $40,000plus liabilities assumed $10,000equals amount realized $50,000

less basis $10,000gain realized $40,000

section 357(b) gain recognized $10,000

d. if section 357(b) applies to one liability it applies to all liabilitiesassumed -- Treas. Reg. § 1.357-1(c)

e. section 357(b)(2) places the burden of proof on the taxpayer

f. generally applies to liabilities created shortly before incorporationand to personal liabilities of a shareholder not related to thebusiness

4. Section 357(c) -- exception to general rule when liabilities exceed basis ofassets

a. if the liabilities of the transferor assumed by the corporationexceed the basis of the assets transferred -- excess of liabilitiesover basis is treated as gain from sale of the assets

compare section 357(b) (all liabilities treated as boot -- recognizedonly if gain realized) with section 357(c) (excess liabilities treatedas if gain recognized on sale -- whether or not gain realized)

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b. example


liabilities assumed $30,000

A receives stock: FMV $20,000

liabilities assumed $30,000less basis $10,000

equals section 357(c) gain recognized $20,000

c. policy -- section 357(c) is required or gain would never be taxed --alternative is to use negative basis

d. character of gain -- capital gain or ordinary income depends onnature of property transferred -- if multiple assets, then allocategain among assets on FMV basis (similar to boot provision ofsection 351(b))

e. aggregate basis of all assets transferred compared to total liabilities-- Treas. Reg. § 1.357-2(a); PLR 8715003

f. two or more transferors -- section 357(c) applied to eachshareholder separately --Smith v. Commissioner, 84 T.C. 889(1985); Rev. Rul. 66-142, 1966-2 C.B. 66

g. section 357(c)(2)

(1) if both section 357(b) and section 357(c) apply, thensection 357(b) controls

(2) section 357(c) does not apply to a bankruptcyreorganization pursuant to section 368(a)(1)(G)

h. it has been held that a taxpayer does not recognize gain when heretains genuine personal liability for the excess amount ofliabilities over basis; in effect, the taxpayer's debt is not canceled --Lessinger v. Commissioner, 872 F.2d 519 (2d Cir. 1989), rev'g, 85T.C. 824 (1985); Jackson v. Commissioner, 708 F.2d 1402 (9thCir. 1983); but see Smith v. Commissioner, 84 T.C. 889 (1985),aff'd without published opinion, 805 F.2d 1073 (D.C. Cir. 1986)(357(c) gain determined where partnership interest subject toliability was contributed to corporation notwithstanding thatpartner retained personal liability thereon)

i. in a recent case, the Ninth Circuit concluded that section 357(c)was not triggered when a taxpayer transfers, in addition to property

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with liabilities in excess of basis, a promissory note in an amountexceeding the potential section 357(c) gain -- the court held thatthe taxpayer had a face value basis in the note, and therefore therewas no section 357(c) gain -- Peracchi v. Commissioner, 98-1 U.S.Tax Cas. (CCH) ¶50,374, 81 A.F.T.R.2d 1754 (9th Cir. 1998),rev’g 71 T.C.M. (CCH) 2830 (1996)

j. incorporating business with deductible liabilities

(1) Revenue Act of 1978 added section 357(c)(3) to cureproblem created on incorporation of cash basis business

(2) example -- incorporate professional partnership (doctors,lawyers, etc.) on cash basis

Assets Liabilitiescash $10,000 A/P $50,000A/R $100,000 equity $60,000

but A/R have no basis -- prior law would require thatshareholders recognize $40,000 of gain

(3) Numerous cases: Bongiovanni v. Commissioner, T.C.Memo. 1971-262, rev'd, 470 F.2d 921 (2nd Cir. 1972);Focht v. Commissioner, 68 T.C. 223 (1977); Thatcher v.Commissioner, 61 T.C. 28 (1973), rev'd in part and aff'd inpart, 533 F.2d 1114 (9th Cir. 1976)

(4) section 357(c)(3) (prior to Technical Corrections Act of1979) –

(a) if cash basis taxpayer

(b) exclude from liabilities accounts payable whichwould be deductible by transferor

Rev. Rul 80-199, 1980-2 C.B. 122, applies section357(c)(3) to pre-1978 years

(5) Section 358(d)(2) -- accounts payable are not treated as acash distribution and do not reduce shareholder's basis inthe stock

(6) Technical Corrections Act of 1979 amended section357(c)(3) as follows:

(a) all taxpayers (cash or accrual)

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(b) exclude all liabilities (not limited to accountspayable) which would be deductible by thetransferor

(7) Orr v. Commissioner, 78 T.C. 1059 (1982) -- customerdeposits transferred to a corporation in a section 351transaction constitute liabilities -- section 357(c)(3) doesnot apply because the deposits are not deductible when paid

(8) Rev. Rul. 95-74, 1995-2 C.B. 36 -- contingentenvironmental liabilities are not included in determiningwhether liabilities assumed exceed basis if contingentenvironmental liabilities had not yet been taken intoaccount, i.e., have not given rise to capital expenditure oreffected basis -- expands the scope of 357(c)(3) to excludenot only deductible liabilities, but some capitalexpenditures as well

T. Contributions to Capital

1. General concept -- transfer of property to a corporation without the receiptof stock

2. Section 118 makes contributions to capital nontaxable to the corporation --see PLR 8808004 (amounts received by a corporation for nonvoting stockare excludable from gross income because of the returnable nature of thepayment whether deemed debt or equity)

3. Section 362(a)(2) -- corporation's basis in the property is equal totransferor's basis (carryover)

4. Contributing shareholder normally increases his stock basis -- herecognizes no gain since he has not received any additional consideration -- see Commissioner v. Fink, 483 U.S. 89 (1987) (shareholder whovoluntarily surrenders portion of shares to the corporation, but who retainscontrol, does not sustain a deductible loss; shareholder has madecontribution to capital and must reallocate basis in surrendered shares toshares he retains)

5. Contribution by person not a shareholder -- basis to corporation governedby section 362(c)

see Rev. Rul. 93-16, 1993-1 C.B. 26 (federal improvement grants tocorporate owner of public airport constitute a non-shareholder contributionto capital under section 118); TAM 9238007 (payments by governmentalentity to a corporation to induce it to locate in a certain state constitute anon-shareholder contribution to capital under section 118)

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6. Debt forgiveness

a. Gross income includes income from discharge of indebtedness.Section 61(a)(12). See U.S. v. Kirby Lumber, 284 U.S. 1 (1931)(gain or saving realized by debtor upon reduction or cancellation ofits outstanding indebtedness for less than the amount due mayconstitute "income")

b. Section 108(a) -- gross income does not include income fromdischarge of indebtedness where it occurs in a Title 11 bankruptcyproceeding, or when, and to the extent, the taxpayer is insolvent

c. Section 108(b) -- taxpayer must reduce certain tax attributes tocompensate for the elimination of debt cancellation income undersection 108(a). These attributes include: net operating losses,business credits, capital losses, tax basis in assets, and foreign taxcredit carryovers. Ordering rules are described in section108(b)(4)

d. Section 108(e)(6) -- indebtedness contributed to capital

(1) debtor corporation acquires its own indebtedness from ashareholder as a contribution to capital

(2) the corporation is treated as having satisfied the debt withcash equal to the shareholders adjusted basis in the debt --the corporation will recognize income to the extent of thedifference between the face amount of the obligation andthe shareholder's basis in the debt

(3) example -- the corporation accrues and deducts salary owedto an employee; the employee, on the cash basis, does notinclude the salary in income and later cancels the debt --the corporation has income -- reverses Putoma Corp. v.Commissioner, 66 T.C. 652 (1976), aff'd, 601 F.2d 743 (5thCir. 1979)

e. 108(e)(4) -- acquisition of debt by related party

(1) debt acquired by a related party of the debtor corporation istreated as acquired by the debtor corporation

(2) if the related party acquires the debt at a discount, thedebtor corporation has income

(3) example -- parent corporation acquires subsidiary'soutstanding obligation from a third party at a discount -- thesubsidiary has income

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(4) similarly, if a holder of outstanding indebtedness becomesrelated to the debtor, or acquires the indebtedness inanticipation of becoming related to the debtor, the debtorhas income -- Treas. Reg. § 1.108-2(c)

f. 108(e)(8) -- indebtedness satisfied by corporation’s stock

if a debtor-corporation transfers stock to a creditor in satisfactionof a debt, the debtor shall be treated as having satisfied theindebtedness with an amount of money equal to the fair marketvalue of the stock

7. Repeal of stock for debt exception

a. the stock for debt exception -- under prior law, a corporation couldissue stock in exchange for its outstanding indebtedness withoutrealizing cancellation of indebtedness income

b. DEFRA 84 codified and restricted the stock for debt exception tocircumstances of bankruptcy or insolvency

c. OBRA 93 completely repealed the stock for debt exception forstock transfers occurring after December 31, 1994

(1) As of January 1, 1995, an exchange of stock for debt willbe treated as if the issuer satisfied its debt with an amountof money equal to the fair market value of the transferredstock, whether or not the issuer is insolvent

(2) A debtor who is insolvent (a prerequisite to qualifying forthe old stock for debt exception) will still be able toexclude the COD from income under section 108(a). Ineffect, therefore, the only result of the repeal of the stockfor debt exception will be to require attribute reduction forinsolvent debtors who satisfy their debt by issuing stock

8. Debt for debt exchanges

a. OBRA 90 added current section 108(e)(10) -- if a debtor issues adebt instrument in satisfaction of indebtedness, the debtor is treatedas having satisfied the indebtedness with an amount of moneyequal to the issue price of the debt instrument

b. thus, a corporation has income to the extent that the issue price ofthe debt extinguished exceeds the issue price of the new debtinstrument

c. the issue price of the debt instrument generally is determined undersections 1273 and 1274

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d. example

(1) facts -- a corporation issued for $1,000 a publicly tradedbond that provided for annual coupon payments based on amarket rate of interest -- some time later when the old bondis worth $600, the corporation exchanges the old bond for anew bond that has a stated redemption price at maturity of$750

(2) result: the new bond will have an issue price of $600 (thefair market value of the old bond) and deductible OID of$150 ($750 redemption price at maturity less $600 issueprice) and the corporation will have cancellation ofindebtedness of $400 ($1,000 adjusted issue price of the oldbond less $600 issue price of the new bond)

U. Special Problems

1. Corporation is a separate taxpayer -- the tax status of the corporation isboth integrated with and separated from the transferor

a. integrated aspects:

(1) carryover basis of assets -- section 362

(2) tacked holding periods of assets -- section 1223(1) and (2)

(3) section 351 does not cause depreciation recapture providedno boot is received -- Treas. Reg. § 1.1245-4(c)

(4) section 351 does not cause investment tax credit recaptureprovided: (1) no boot is received, (2) the transferor retainsa substantial interest in the assets, and (3) substantially allof the assets of the unincorporated business are transferredto the corporation -- Treas. Reg. § 1.47-3(f)(1); Rev. Rul.83-65, 1983-1 C.B. 10; see also Burwell v. Commissioner,56 T.C.M. 490 (1988); Loewen v. Commissioner, 76 T.C.90 (1981)

(5) a transfer of an installment obligation to a corporation isnot a disposition -- but see Rev. Rul. 73-423, 1973-2 C.B.161 (corporate transferee was obligor on note)

b. independent aspects -- corporation as separate taxpayer

(1) elect taxable year -- see new section 444, added by OBRA87, permitting partnerships, Subchapter S corporations, andpersonal service corporations to elect a taxable year otherthan the required taxable year

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(2) elect cash or accrual method for reporting income anddeductions, subject to the limitations of section 448

(3) select inventory method

(4) bad debt method

(5) method of depreciation

(6) elect installment reporting

(7) elect Subchapter S

(8) section 1033

(9) section 381 does not apply -- tax attributes do not carryover

(10) pay estimated taxes -- see OBRA 87, sections 10301(a)(which amends section 6655) (corporation's failure to payestimated income tax) and 10301(b) (relieving largecorporations from liability for certain estimated taxpenalties for 1987)

c. LIFO inventory

(1) corporation that transfers LIFO inventory to subsidiary insection 351 exchange must calculate basis of inventory on apro rata basis

(2) newly formed corporation that obtains LIFO inventory insection 351 exchange shall treat that inventory as itsopening inventory, with the same basis as that of thetransferor, under section 362(a)(1) -- Rev. Rul. 70-564,1970-2 C.B. 109; see also PLR 9215005 (transactiondetermined to be a purchase, not section 351 transaction, soRev. Rul. 70-564 does not apply)

(3) ongoing corporation using LIFO method that receivesLIFO inventory in a section 351 exchange must integratethe basis of the acquired inventory into its own LIFO layers-- Rev. Rul. 70-565, 1970-2 C.B. 110

2. Midstream transfers -- incorporation of an ongoing business

a. nature of the problem -- income earned but not yet reported;deduction claimed but valuable asset remains -- must transferorinclude income or recapture deduction

(1) accounts receivable not included in income

(2) accounts payable incurred but not deducted

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(3) work in process not yet sold

(4) costs of materials and supplies deducted but not used

(5) bad debt reserves previously deducted

b. section 351 may be subordinated to other judicial doctrines orstatutory provisions in order to tax transferor

(1) assignment of income

(2) tax benefit rule

(3) section 446 -- clear reflection of income

(4) section 482 -- allocate income between related taxpayers

c. assignment of income

(1) shareholder transfers claim for personal services oraccounts receivable to the corporation -- the shareholder istaxed on collection -- see O'Bryan v. Commissioner, 62T.C.M. 1347 (1991)

(2) Hempt Bros. Inc. v. United States, 354 F. Supp. 1172, aff'd,490 F.2d 1172 (3rd Cir. 1974) (accounts receivable of apartnership are transferred to a corporation; the court heldthat the corporation is taxed on collection of the receivable;assignment of income doctrine serves a limited role in asection 351 transaction) -- see also al-Hakim v.Commissioner, 53 T.C.M. 352 (1987)

(3) Rev. Rul. 80-198, 1980-2 C.B. 113 -- incorporation ofmedical practice and shareholder conveys accountsreceivable and accounts payable to the corporation inexchange for stock -- ruling holds that

(a) corporation (not shareholder) is taxed on accountsreceivable when collected

(b) corporation (not shareholder) deducts accountspayable when paid

(c) however, judicial doctrines may overridesection 351 if facts reflect tax avoidance purpose orto clearly reflect income

(4) Rev. Rul. 95-74, 1995-2 C.B. 36 (1995) -- a companytransferred its manufacturing business to a newly formedcorporation in exchange for all of the corporation’s stockand the corporation’s assumption of the manufacturing

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business’s liabilities (including contingent environmentalliabilities)-- the ruling holds that:

(a) the liabilities assumed by the newly formedcorporation were not liabilities for purposes ofsection 357(c)(1) and 358(d) because the liabilitieshad not yet been taken into account by the companyprior to the transfer

(b) the liabilities assumed by the newly formedcorporation are deductible as business expensesunder section 162 or are capital expenditures undersection 263, as appropriate, under the corporation’smethod of accounting

(5) PLR 8139073 -- applied the assignment of income doctrinewhere the transferor retained a portion of the assets

(6) Compare PLR 8213051 (transferee corporation permitted todeduct guaranteed payments (section 736(a)(2) payments)due retired partners) with David R. Webb Co. v.Commissioner, 77 T.C. 1134 (1981), aff'd, 708 F.2d 1254(7th Cir. 1983)

d. clear reflection of income

Palmer v. Commissioner, 267 F.2d 434 (9th Cir.) cert. denied, 361U.S. 821 (1959), taxpayer in construction business on completedcontract method incorporates shortly before payment received --court put taxpayer on percentage of completion method

e. tax benefit rule

(1) must accrual basis transferor include bad debt reservepreviously deducted when he incorporates

(a) United States v. Nash, 398 U.S. 1 (1970), no,transferor did not recover reserve for bad debts

(b) Rev. Rul. 78-280, 1978-2 C.B. 139, transferor'sbasis for stock equal to net value of receivables (i.e.,less reserves)

(2) transfer materials and supplies previously deducted andreceive value (i.e., stock) -- unclear whether transferor mustinclude the value of the stock in income -- see HillsboroNational Bank v. Commissioner, 460 U.S. 370 (1983) -- ina section 333 liquidation, the liquidating corporation mustinclude the value of cattle feed previously deducted -- not

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entirely clear how this decision affects section 351transactions

f. allocation of income between related taxpayers -- section 482

(1) Treas. Reg. § 1.482-1(f)(1)(iii) -- "If necessary to preventthe avoidance of taxes or to clearly reflect income, thedistrict director may make an allocation under section 482with respect to transactions that otherwise qualify fornonrecognition of gain or loss under applicable provisionsof the Internal Revenue Code (such as section 351) . . . ." --confers broad authority on Commissioner to allocateincome or deductions among commonly controlled entitieswhere lack of arms-length bargaining leads to a distortionof income

(2) Rooney v. United States, 305 F.2d 681 (9th Cir. 1962),taxpayer incorporated his farming business after deductingexpenses of planting crops but before harvest -- courtallocated all expenses to the corporation -- see also Eli Lilly& Co. v. Commissioner, 856 F.2d 855 (7th Cir. 1988);G.D. Searle & Co. v. Commissioner, 88 T.C. 252 (1987)

(3) section 482 may be applied in the context of professionalcorporations to allocate income from the corporation to theshareholder/employee -- this allocation reduces the incomesubject to contribution to the corporation's pension plan --see Foglesong v. Commissioner, 691 F.2d 848 (7th Cir.1982); Pacella v. Commissioner, 78 T.C. 604 (1982);Keller v. Commissioner, 77 T.C. 1014 (1981), aff'd, 723F.2d 58 (10th Cir. 1983)

(4) Perryman v. Commissioner, 55 T.C.M. 1588 (1988) --taxpayer in section 351 exchange transferred property tocorporation which sold property shortly thereafter --taxpayer held to have used corporation as mere conduit toreduce his tax liability -- gain attributed to taxpayer undersection 482

(5) section 269A -- personal service corporations used to avoidincome tax

3. Abuses of section 351

a. investment diversification (swap funds)

(1) transferors attempted to diversify portfolio in a section 351transfer -- shareholders transfer stock of publicly heldcorporations to closely held investment company

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(2) section 351(e)(1) -- no section 351 treatment on transfer ofproperty to investment company

(3) Treas. Reg. § 1.351-1(c) -- section 351 does not apply if --

(a) transfer results in diversification, and

(b) transferee is an investment company

(4) diversification -- two or more persons transfer nonidenticalassets to a corporation -- Treas. Reg. § 1.351-1(c)(5)

(a) includes transfers to a pre-existing corporationunless transferee's assets are identical to the assetstransferred

(b) does not prevent tax-free combinations of alreadydiversified portfolios -- transfers of assets will notbe treated as transfers that result in diversification ifeach transferor transfers a diversified portfolio ofassets that satisfy section 368(a)(F)(ii), as modified– see Treas. Reg. § 1.351-1(c)(6); see also PLR9328035 (Apr. 20, 1993)

(5) Treas. Reg. § 1.351-1(c)(1) -- investment company includesthe following:

(a) regulated investment company -- section 851

(b) real estate investment trust -- section 856

(c) corporation 80% of whose assets are held forinvestment and are stock or securities

(6) Rev. Rul. 88-32, 1988-1 C.B. 113 -- transfer of marketablestock by several transferors to newly formed corporation,which pursuant to a pre-existing plan sells the stock andpurchases other stock and securities, did not constitutetransfers to an "investment company" undersection 351(e)(1) -- thus, section 351 applies

(7) Rev. Rul. 87-9, 1987-1 C.B. 133 -- transfer of marketablestock by some transferors and cash by others in exchangefor stock of regulated investment company (89% and 11%,respectively) constituted transfers to investment company --section 351 did not apply -- instead, gain determined undersection 1001

(8) Treas. Reg. § 1.351-1(c)(1) -- expands definition ofinvestment company to include a corporation which is aninvestment company as defined in section 368(a)(2)(F) if

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one or more of the transferors also is an investmentcompany -- section 368(a)(2)(F) defines an investmentcompany as a corporation 50% of whose assets are stockand securities and 80% of whose assets are held forinvestment

(9) a TRA 97 provision expanded the scope of assets that arecounted toward the 80 percent test to include: stocks andsecurities (both readily marketable and not readilymarketable); money; equity interests in corporations(including evidences of indebtedness, options, forward orfuture contracts, notional principal contracts, andderivatives); foreign currency; interests in RICs, REITs,common trust funds, and publicly-traded partnerships;instruments convertible into equity interests; interests inprecious metals (unless used by the transferee in the activeconduct of a trade or business); and any other assetdescribed in Treasury regulations -- effective for transfersafter June 8, 1997, with an exception for transfers madepursuant to certain binding contracts in effect on June 8,1997

(10) the Administration’s Revenue Proposals for Fiscal Year2001 include provisions prohibiting tax deferral oncontributions of appreciated property to swap funds. Theproposals would add limited or preferred partnershipinterests to the list of assets that are taken into account indetermining whether a corporation (or partnership) is aninvestment company; and require recognition on thetransfer of a non-diversified portfolio of marketablesecurities to any corporation (or partnership) that is either(1) registered as an investment company, (2) falls withinthe qualified purchasers exception to the registrationrequirement, or (3) otherwise is marketed or sold toinvestors as providing a means of tax-free diversification

b. section 351 vs. sale

(1) shareholder attempts to avoid section 351: appreciated landis held as a capital asset by a shareholder, who sells theland to the corporation, takes back notes, and reportscapital gain -- the corporation subdivides and sells the landas an ordinary income asset and because the corporation'sbasis in the land is high, it has little income

(2) sell depreciable property to the corporation to increase thecorporation's depreciation deductions

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(3) IRS will often challenge and treat as section 351 transfer --see Burr Oaks Corp. v. Commissioner, 365 F.2d 24 (7thCir. 1964), cert. denied, 385 U.S. 1007 (1967); TAM9304002

(4) Bradshaw v. United States, 683 F.2d 365 (Ct. Cl. 1982)(transfers of real estate to corporations in exchange forassumption of debt held to constitute sales and notsection 351 transactions); see also Utley v. Commissioner,56 T.C.M. 885 (1988)

4. Section 351 and the reorganization provisions

a. section 351 transfer may also constitute "B" reorganization --shareholders of X corporation transfer an amount of X stocksufficient to constitute control to Y corporation in exchange for anamount of Y stock sufficient to constitute control of Y -- not clearwhich provision controls

b. section 351 transfer may also constitute "C" reorganization

(1) X corporation transfers all of its assets to Y corporation inexchange for an amount of Y stock sufficient to constitutecontrol

(2) DEFRA 84 requires that X corporation liquidate followingthe asset transfer -- section 368(a)(2)(G)

c. section 351 transfer may also constitute "D" reorganization -- Xcorporation transfers certain assets to Y in exchange for an amountof Y stock sufficient to constitute control, and X distributes the Ystock to its shareholders in a transaction qualifying under section355

d. section 351 can be used to avoid tougher requirements of thereorganization provisions

(1) to combat this use, the IRS requires a business purpose forsection 351 transactions -- TAM 8045001

(2) section 351 may apply to an acquisitive transaction(commonly referred to as the National Starch/Unilevertransaction -- PLR 7839060) even though the acquisitivetransaction does not qualify as a nontaxable reorganization-- Rev. Rul. 84-71, 1984-1 C.B. 106 (revoking Rev. Ruls.80-284, 1980-2 C.B. 117, and 80-285, 1980-2 C.B. 119)

(3) example

P wishes to acquire Target (T). Most of the T shareholders

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want to sell their stock to P for cash, but, A, who owns 14percent of T’s stock, insists on a tax-free transaction.

P transfers cash to a newly formed corporation (N) inexchange for voting common stock of N. A transfers its Tstock to N in exchange for N preferred stock. N forms awholly owned subsidiary S, by transferring cash to S inexchange for all of the S common stock. S is merged intoT. The shareholders of T, other than A, exchange their Tstock for cash. T becomes a wholly owned subsidiary of N.The IRS ruled that this transaction satisfies therequirements of section 351 -- Rev. Rul. 84-71, 1984-1C.B. 106

(4) Section 351(g), added by TRA 97, treats nonqualifiedpreferred stock as boot for purposes of section 351.Therefore, if the preferred stock received by X isnonqualified preferred stock, X’s exchange of T stock willbe fully taxable

5. Section 351 and Section 304

a. section 304 takes precedence over section 351 when both sections,by their terms, apply -- section 304(b)(3), amended by the DeficitReduction Act of 1984, section 712(l)

b. pre-DEFRA 84 -- see Gunther v. Commissioner, 92 T.C. 39(1989), aff'd, 909 F.2d 291 (7th Cir. 1990) (section 351 takesprecedence over section 304)

c. see discussion of section 304 at Part XVII, infra

V. Disclosure Requirements and Ruling Requests

1. Disclosure --

a. Treas. Reg. § 1.351-3 sets forth information to be filed with theIRS and records to be maintained in a section 351 transaction

b. requirements apply to both transferor and transferee corporation

2. Ruling requests

a. Rev. Proc. 2000-1, 2000-1 I.R.B. 4, sets forth procedures forissuing ruling letters

b. Rev. Proc. 83-59, 1983-2 C.B. 575, sets forth information to beincluded in a section 351 request for rulings

c. Rev. Proc. 2000-3, 2000-1 I.R.B. 103

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(1) section 3.01(22) -- IRS will not rule on whether section 351applies to an exchange of stock for stock in the formationof a holding company, and whether the taxpayer is subjectto the consequences of qualification under that section thatare adequately addressed by a statute, regulation, decisionof the Supreme Court, tax treaty, IRS ruling or otherauthority published in the I.R.B.

(a) in a change from the previous no-rule position, theService will rule on transfers of stock to acontrolled corporation where such transfers areundertaken prior to the distribution of the stock ofthe controlled corporation in a transactionqualifying under section 355

(b) in its discretion, the Service will also rule onsignificant subissues that must be resolved todetermine whether a transaction that is in the no-rule area qualified under section 351, provided thatsuch subissues are, in the view of the Service,significant and not adequately resolved by any otherauthority

(2) section 4.01(30) -- IRS ordinarily will not rule on the taxeffect of issuing evidences of indebtedness (notes, bonds,debentures) in a section 351 transaction and on the taxeffect of a transaction where section 351 treatment dependson debt/equity determination

(3) section 4.01(31) -- IRS ordinarily will not rule on whethersection 351 applies to a transfer of an interest in realproperty by a "cooperative housing corporation" to acorporation if the transferee engages in commercial activitywith respect to the real property interest transferred

(4) section 5.16 -- IRS will not rule (until study completed) onwhether section 351 applies to a transfer of widely-heldproperty (real estate, oil and gas interests) in exchange forstock if (a) the stock is issued in a form designed to make itreadily tradable or (b) the transfer was initiated by apromoter, broker, or investment house

d. Rev. Proc. 77-37, 1977-2 C.B. 568, sets forth rules for issuingruling letters when stock issued for property of relatively smallvalue

e. Rev. Proc. 85-22, 1985-1 C.B. 550, sets forth guidelines forcontingent stock and escrowed stock rulings

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III. DISTRIBUTIONS

A. Preliminary Concepts

1. Issue -- once corporation has been formed and is operating, how shouldtransfers ("distributions") of corporate property to shareholders withrespect to their stock be treated for tax purposes

2. Policy options

a. corporations and shareholders are separate taxpayers -- cannot use"flow-through" approach -- compare:

(1) parent-subsidiary relationship

(2) section 243 dividends received deduction

(a) note: OBRA 87 reduced the dividends receiveddeduction from 80% to 70% if the corporateshareholder owns less than 20% of the distributingcorporation's stock (determined by vote and value) -- section 243(a) and (c)

(3) consolidated returns

b. parameters of tax to shareholder

could make all distributions to shareholders ordinary income --rejected because may subject shareholder to tax on a return ofcapital

(1) limit ordinary income treatment to distributions thatrepresent corporate earnings -- adopted

(2) limit ordinary income to distributions from earnings earnedwhile shareholder held stock -- rejected

(a) shareholder buys stock of ongoing corporation andpurchase price reflects corporate earnings --distribution of preacquisition earnings taxed toshareholder

(b) United States v. Phellis, 257 U.S. 156 (1921)

c. integration proposals modify double tax concept

(1) flow-thru treatment

(2) deduction to corporation for dividends paid

(3) credit to shareholders for corporate tax paid

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B. Statutory Framework

1. Section 301 - tax treatment of distributee shareholder

2. Section 311 - tax treatment of distributing corporation

3. Section 312 - earnings and profits

4. Section 316 - definition of dividend

5. Section 317(a) - definition of property

C. Types of Distributions

1. Distribution of money

2. Distributions of property (other than money)

3. Distributions of the corporation's own obligations

4. Distributions of the corporation's own stock

5. Distributions in redemption of stock

IV. SECTION 301 -- TAX TREATMENT OF DISTRIBUTEE

A. Section 301(a) -- General Concepts

1. A "distribution" of "property" made by a corporation to a shareholder"with respect to its stock" shall be treated in the manner provided insection 301(c)

2. "Distribution" -- can be read as "payment"

a. actual distribution

b. constructive distribution

3. "Property" -- defined in section 317(a)

a. includes money, securities and any other property except stock inthe distributing corporation or rights to acquire such stock -- seeBhada v. Commissioner, 89 T.C. 959 (1987), aff'd, 892 F.2d 39(6th Cir. 1989) (defining "property" in section 304 context); PLR8748049 ("property" includes vouchers to purchase company'sproduct at discount)

b. section 305 governs distributions of stock

4. "With respect to its stock"

a. Treas. Reg. § 1.301-1(c) -- payment to shareholder in capacity asshareholder

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b. does not include

(1) compensation to shareholder/employee -- see Melvin v.Commissioner, 88 T.C. 63 (1987), aff'd on other grounds,894 F.2d 1072 (9th Cir. 1990) (personal use ofcorporation's cars was constructive dividend notcompensation)

(2) payment for property to shareholder/vendor -- see LittonIndustries, Inc. v. Commissioner, 89 T.C. 1086 (1987)(parent held to receive dividend and not proceeds from saleof subsidiary where dividend and sale were separatetransactions)

(3) rental payments to shareholder/lessor

(4) interest payments to shareholder/creditor

(5) royalty payments to shareholder/patent holder -- Belknap v.Commissioner, 57 T.C.M. 301 (1989) (reasonable royaltypayments not recharacterized as dividends)

B. Section 301(b) -- Amount Distributed

1. General rule -- section 301(b)(1)

a. amount of money, plus

b. fair market value of property received

2. TAMRA 88 retroactively repealed section 301(b)(1)(B), effective January1, 1987 -- under old section 301(b)(1)(B), the amount of a distribution fora corporate distributee was --

a. amount of money, plus

b. lesser of

(1) fair market value of property received, or

(2) basis of property received (in hands of distributingcorporation) plus gain recognized to distributingcorporation

3. TAMRA 88 also retroactively repealed section 301(b)(1)(C) and (D),effective January 1, 1987

a. special rules for distributions from a foreign corporation tocorporate shareholder

b. special rules for distributions to a foreign corporate shareholder

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4. Reduction for liabilities -- section 301(b)(2)

a. amount of distribution reduced by

(1) amount of liability assumed by shareholder, and

(2) amount of liability to which property is subject

b. liabilities cannot reduce distribution below zero

5. Fair market value of property distributed -- section 301(b)(3)

a. determined as of the date of distribution

b. whether or not the same date is used to include the distribution inthe shareholder's income -- Treas. Reg. § 1.301-1(b)

6. Distribution is taxable to shareholder

a. on receipt, or

b. when unqualifiedly made subject to his demand

(1) Treas. Reg. § 1.301-1(b)

(2) this determination is based on (1) the shareholder'sunrestricted legal right to demand payment at any time,(2) no agreement involving shareholders to defer payment,and (3) the ability of the corporation to fulfill the dividend -- see Moser v. Commissioner, 56 T.C.M. 1604 (1989);Bush Bros. & Co. v. Commissioner, 73 T.C. 424 (1979),aff'd, 668 F.2d 252 (6th Cir. 1982)

(3) constructive receipt doctrine -- Treas. Reg. § 1.451-1(a)and -2(a)

C. Section 301(c) -- Amount Taxable

1. Dividend -- section 301(c)(1) -- portion of distribution which is a dividendis included in income -- section 316 defines dividend

2. Return of capital -- section 301(c)(2) -- portion of distribution which is nota dividend shall reduce the shareholder's stock basis

3. Sale or exchange -- section 301(c)(3)(A) -- portion of distribution which isnot a dividend and which exceeds shareholder's stock basis shall be treatedas gain from the sale or exchange of property

a. note: after TRA 86, corporate capital gain income is taxed at thesame rate as ordinary income

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D. Section 301(d) -- Basis of Property to Distributee

1. Basis of property to distributee is fair market value of property

2. TAMRA 88 retroactively repealed section 301(d)(2), which provided thatbasis for a corporate distributee was the lesser of

a. fair market value of property, or

b. adjusted basis of property (in hands of distributing corporation)plus gain recognized by distributing corporation

E. Section 301(e) – Special Earnings and Profits Rules

1. DEFRA 84, OBRA 87, and TAMRA 88 added special rules to coverdistributions to corporate shareholders

2. Section 301(e) earnings and profits computed without regard tosection 312(k) (accelerated depreciation) and section 312(n) (economicgain or loss) for purposes of determining taxable income of corporateshareholders owning 20% or more of the stock of the distributingcorporation

3. TAMRA 88 retroactively repealed old section 301(e) which determinedthe holding period of property distributed to a corporate shareholder wheresection 311(b)(1) applied to the distribution (note that old section 301(e)erroneously stated section 311(d)) -- legislative history to TAMRA 88indicates that old section 301(e) was repealed as deadwood, since theholding period of distributed property begins on the date of distribution

V. SECTION 316 -- WHAT IS A DIVIDEND

A. Introduction

1. Dividend for Federal tax purposes does not necessarily correspond to statelaw definition of dividend

2. A distribution may be taxable as a dividend even though it impairscorporate capital

3. A distribution may be a dividend under state law and not a dividend forFederal tax purposes -- see Rev. Rul. 90-11, 1990-1 C.B. 10 (adoption of a"poison pill" plan does not constitute a distribution of stock or property bythe corporation to its shareholders, although under state law, adoption ofplan constituted a dividend; purpose of plan was to establish a mechanismby which corporation could in the future provide shareholders with rightsto purchase stock at substantially less than fair market value in response to"unsolicited" tender offers)

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4. TAM 8022010 -- X corporation distributes cash to partnership Z, its soleshareholder, which then distributes cash to its partners which included X --held: X is not taxed on the portion of its income received through Z

B. Section 316(a) -- General Rule

1. A dividend is a distribution of property out of:

a. earnings and profits accumulated after February 28, 1913 --accumulated earnings and profits

b. earnings and profits of the taxable year -- current earnings andprofits

2. Earnings and profits -- section 312

a. discussed in greater detail below

b. not the equivalent of earned surplus or retained earnings --accounting concepts

c. not the equivalent of taxable income

3. Accumulated earnings and profits reflect the financial success or failure ofthe corporation over its history -- if the corporation is profitable thedistribution is taxed as a dividend

4. Current earnings and profits

a. determined as of the close of the taxable year

b. without reduction for distributions made during the year

c. without regard to earnings and profits at the time of the distribution

(1) may have earnings and profits at the time of the distributionand no earnings and profits at the close of the year -- thedistribution is not taxed as a dividend

(2) may have a deficit at the time of the distribution andpositive earnings and profits at the close of the year --distribution is taxed as a dividend

5. Operating rules

a. every distribution is made out of earnings and profits to the extentavailable -- cannot earmark

b. a distribution is deemed to come first from current earnings andprofits and then the most recent accumulated earnings and profits(reverse chronological order) -- section 316(a); Treas. Reg.§ 1.316-2(a)

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c. a distribution covered by current earnings and profits is taxed as adividend even if the corporation has an accumulated deficit whichexceeds current earnings and profits --- i.e., do not net currentearnings and profits with accumulated deficit

d. if cash distributions exceed current earnings and profits thencurrent earnings and profits are prorated among each distribution --Treas. Reg. § 1.316-2(b)

(1) excess distributions are taxable as a dividend to extent ofaccumulated earnings and profits

(2) accumulated earnings and profits are not applied pro rata --determine accumulated earnings and profits available at thedate of distribution -- i.e., apply earnings and profits to firstdistribution and any excess carries to subsequentdistributions

(3) current deficit in earnings and profits prorated over year todetermine available accumulated earnings and profits atdate of distribution -- however, if can determine the datethe deficit is incurred, need not prorate current deficit

e. whether distribution is from current or accumulated earnings andprofits is relevant if

(1) stock ownership changes during the year

(2) the distributing corporation and the shareholders are ondifferent taxable years

f. if the corporation has no current or accumulated earnings andprofits the distribution cannot be a dividend

(1) section 301(c)(2) and (3) apply

(2) first reduce stock basis, to the extent the distributionexceeds the stock basis, the excess is gain

(a) unclear if recover aggregate basis on all shares or ifdetermine on a share-by-share basis

(b) if share-by-share basis applied, then non-dividenddistribution can trigger gain in some shares beforeall basis recovered -- see Johnson v. United States,435 F.2d 1257 (4th Cir. 1971); see also Anderson v.Commissioner, 92 T.C. 138, 145 n.5 (1989)

(3) section 301(c)(3) -- excess over basis is capital gain (ifstock is a capital asset)

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g. the taxpayer has the burden to establish that a corporatedistribution is a return of capital and that the corporation has nocurrent or accumulated earnings or profits -- see Estate of Foster v.Commissioner, 56 T.C.M. 163 (1988); Commissioner v. Delgado,55 T.C.M. 155 (1988)

6. Examples

a. on January 1, 1996, corporation X has accumulated earnings andprofits of $25,000; in 1996 X has $15,000 of current earnings andprofits -- X distributes $10,000 to its shareholders on July 15,1996 -- the distribution (which is covered by current earnings andprofits) is taxable as a dividend and the accumulated earnings andprofits at the end of 1996 are $30,000

b. assume the same facts as above, except X distributes $20,000 -- thedistribution is taxable as a dividend -- $15,000 out of currentearnings and profits and $5,000 out of accumulated earnings andprofits -- accumulated earnings and profits at the end of 1996 are$20,000

c. on January 1, 1996, corporation Y has an accumulated deficit of($15,000); in 1996 Y has current earnings and profits of $12,000and Y distributes $8,000 to its shareholders -- the distribution istaxable as a dividend despite the accumulated deficit -- Y'saccumulated deficit at the end of 1996 is reduced to ($11,000) --($15,000) plus $4,000 of undistributed current earnings and profits

d. if Y had waited until 1997 to make the distribution, the distributionwould not have been taxable as a dividend (assuming Y had nocurrent earnings and profits in 1997)

e. on January 1, 1996, corporation Z has $25,000 of accumulatedearnings and profits; in 1996 Z has current earnings and profits of$20,000 -- Z distributes $15,000 in March, June, September, andDecember -- current earnings and profits are allocated pro rata andthe balance of the distributions are covered by accumulatedearnings and profits in chronological order as shown --

Current Accumulated Total

Date Amount E&P E&P DividendMarch 15,000 5,000 10,000 15,000June 15,000 5,000 10,000 15,000September 15,000 5,000 5,000 10,000December 15,000 5,000 --- 5,000

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f. on January 1, 1996, corporation Z has $20,000 of accumulatedearnings and profits; in 1996 Z has a current deficit of ($16,000) --Z distributes $20,000 on July 1, 1996 -- the deficit is proratedunless it can be specifically allocated -- thus, as of July 1 availableearnings and profits are $12,000 ($20,000 less 1/2 of $16,000deficit) and $12,000 of the distribution is taxed as a dividend

7. Other operating rules

a. current earnings and profits are allocated first to distributions on"priority" classes of stock -- preferred stock absorbs earnings andprofits before common stock

(1) Rev. Rul. 69-440, 1969-2 C.B. 46

(2) unclear if same rule applies for accumulated earnings andprofits or if they are allocated based on date of distribution

b. distribution and redemptions

(1) current earnings and profits are allocated first todistributions then to section 302(a) redemptions -- seebelow

(2) accumulated earnings and profits are allocated todistributions and redemptions based on time of thetransaction

(3) see Rev. Rul. 79-376, 1979-2 C.B. 133; Rev. Rul. 74-338,1974-2 C.B. 101; Rev. Rul. 74-339, 1974-2 C.B. 102

VI. SECTION 312 -- EARNINGS AND PROFITS

A. Introduction

1. The term "earnings and profits" is not defined in the Code or regulations

a. section 312 specifies the effect of distributions on earnings andprofits

b. section 312 also sets forth certain special earnings and profits rules

2. Earnings and profits also has no counterpart in corporate law

3. Rev. Proc. 75-17, 1975-1 C.B. 677, sets forth guidelines for determiningearnings and profits

4. Effect on earnings and profits is a no ruling area -- Rev. Proc. 2000-3,section 3.01(21), 2000-1 I.R.B. 103

5. Statute of limitations is not applicable to earnings and profits -- keeppermanent records

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6. Generally do not need to know earnings and profits with precision --exceptions: sections 531, 902, 951, 1248

B. Concept of Earnings and Profits

1. Measurement of profit in broad economic terms

2. Stated differently, the corporation's ability to make a distribution

3. Earnings and profits are not equal to taxable income; also not equal tosurplus -- there is a relationship among all three

schedule M on tax return -- reconcile income and surplus

4. To determine earnings and profits, start with taxable income and makeadjustments

C. Calculation of Earnings and Profits -- Taxable Income Subject to Adjustments --Treas. Reg. § 1.312

1. Additions to taxable income (items excluded from taxable income must beadded back)

a. tax exempt municipal bond interest -- section 103

b. life insurance proceeds -- section 101; Rev. Rul. 54-230, 1954-1C.B. 114

c. cancellation of indebtedness income excluded under section 108,to the extent the taxpayer does not reduce basis in property undersection 1017 -- section 312(l)(1)

2. Deductions from taxable income not deductible for earnings and profits(deductions which do not represent actual expenses)

a. excess of percentage depletion over cost depletion

b. dividends-received deduction -- section 243

c. net operating loss deductions -- section 172

d. capital loss carryback and carryover -- section 1212

e. excess of accelerated depreciation over straight line --section 312(k)(1)

f. accelerated cost recovery system ("ACRS") -- must use newsection 168(g)(2) alternative depreciation system --section 312(k)(3)

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(1) Property Classification E&P Period

Personal property with 12 years no class life

nonresidential real property 40 years

residential rental property 40 years

all other property the class life

(2) section 168(i)(1) -- "class life" means class life undersection 167(m) as of January 1, 1986, as modified bysection 168(g)(3)

3. Items not deductible from taxable income can be deducted from earningsand profits (expenses which deplete cash available for distributions)

a. dividend distributions in prior years -- section 312(a)

b. federal income taxes

c. expenses incurred in earning tax exempt interest -- section 265

d. excess charitable contributions -- section 170(b)(2)

e. excessive compensation

f. life insurance premiums -- section 264

g. excess capital losses

h. nondeductible losses under section 267

i. lobbying expenses - section 162(e)

j. political contributions

k. unclear whether earnings and profits are reduced for nondeductibleexpenses under section 162(c) -- against public policy

l. section 964(a) -- earnings and profits are not decreased by foreignkickbacks -- cf. Rev. Rul. 77-442, 1977-2 C.B. 264

4. DEFRA 84 and TRA 86 added the following rules for computing earningsand profits to more accurately reflect "economic gains and losses":

a. increase earnings and profits on a distribution of property to theextent that the FMV of the property exceeds its adjusted basis --section 312(b)(1) -- see Rev. Rul 87-1, 1987-1 C.B. 132

b. capitalization of construction period carrying charges --section 312(n)(1)

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c. capitalization and amortization of intangible drilling costs --section 312(n)(2) -- OBRA 89 amended section 312(n)(2)(A)(ii) toallow deduction ratably over 60 month period beginning withmonth "in which amount was paid or incurred" instead of "inwhich the production from the well begins"

d. capitalization of deductions allowed under section 173 and 248 --section 312(n)(3)

e. increase earnings and profits to reflect changes in the LIFOrecapture amount -- section 312(n)(4) (as redesignated by TRA 86)

f. current reporting of gain from installment sales -- section 312(n)(5)(as redesignated by TRA 86)

g. must report long-term contracts on the percentage completion basis-- section 312(n)(6) (as redesignated by TRA 86)

h. in connection with redemptions, reduction of earnings and profitsonly to the extent of the redeemed stock's "ratable share" ofearnings and profits -- section 312(n)(7) (as redesignated by TRA86)

5. OBRA 87 added the following rules for determining adjustments to basisof intragroup stock when such stock is disposed of and results in gain orloss for purposes of section 1503 --

a. earnings and profits shall be determined as if section 312 wereapplied for the taxable year and all preceding consolidated yearswithout regard to section 312(k) and section 312(n) (reversesWoods Investment Co. v. Commissioner, 85 T.C. 274 (1985))

b. earnings and profits shall not include any amount excluded fromgross income under section 108 to the extent the amount excludedwas not applied to reduce tax attributes other than basis in property

c. the adjustments to basis are made solely to determine gain or losson disposition of intragroup stock and not to affect the earningsand profits for any other purpose, such as the character of thedistribution

d. the changes to section 1503 described in a. through c. supra aremade irrelevant by Treas. Reg. § 1.1502-32 which determines thebasis of intragroup stock by means of a hybrid measure of taxableincome (i.e., basis is no longer measured by reference to earningsand profits)

6. As noted above, OBRA 87 amended the present section 301(e) so thatearnings and profits are computed without regard to section 312(k)(accelerated depreciation) and section 312(n) (economic gain or loss) for

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purposes of determining taxable income of corporate shareholders owning20% or more of the stock of the distributing corporation

7. Tax accounting principles and earnings and profits

a. method of accounting used to determine taxable income is used tocalculate earnings and profits

(1) cash or accrual

(2) installment reporting

(3) inventory method

b. accounting for dividends -- generally reduce earnings and profitson date of payment, not date dividend declared -- Rev. Rul. 62-131, 1962-2 C.B. 94 -- however, different rules may apply toconsolidated dividends -- see Treas. Reg. § 1.1502 - 32(f)(2)

D. Effect of Distribution on Earnings and Profits -- Section 312(a) and Treas. Reg.§ 1.312-1

1. Distribution of property by corporation with respect to its stock reducesearnings and profits by

a. amount of money

b. principal amount of the debt obligations of the distributingcorporation

(1) if a corporation distributes its own discount obligation,earnings and profits are reduced by the issue price of theobligation

c. adjusted basis (or fair market value if higher) of other property

2. Earnings and profits are not reduced below zero by a distribution(although deficits in earnings and profits may result from operations)

3. Reduction in earnings and profits is the same whether the recipientshareholder is an individual or a corporation

4. Earnings and profits reduction rule applies regardless of how the recipientshareholder is taxed

5. Earnings and profits are increased by the excess of fair market value overthe adjusted basis of appreciated property distributed by the corporation(except for the corporation's obligations)

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VII. DISTRIBUTIONS OF PROPERTY IN KIND -- (EFFECT ON DISTRIBUTINGCORPORATION AND EARNINGS AND PROFITS)

A. Introduction

1. The tax consequences of a distribution of cash are easily determined

a. to the shareholder -- distribution is a dividend to the extent ofearnings and profits and the excess is a return of capital or capitalgain

b. to the corporation --

(1) the distributing corporation recognizes no gain or loss --section 311(a)

(2) earnings and profits are reduced to the extent of the cash

2. Property distributions are more difficult

a. does a distribution of appreciated property create income orearnings and profits to the distributing corporation

b. does a distribution of depreciated property produce a loss

c. how are earnings and profits affected

B. Distributing Corporation -- Effect of Distribution of Property -- Old Section 311

1. Background

a. Pre-1954 -- Treasury took the position that a corporationrecognized gain on a distribution of appreciated property

b. General Utilities & Operating Co. v. Helvering, 296 U.S. 200(1935), is generally held to stand for the proposition that adistribution of appreciated property does not result in gain (or loss)to the distributing corporation

c. old section 311(a) -- codification of General Utilities

d. TRA 86 repealed the General Utilities doctrine (subject to certaintransitional rules) -- general rule now is that gain (but not loss) isrecognized by the corporation on nonliquidating distributions ofproperty -- new section 311, added by TRA 86

(1) old section 311 is covered in Part VII.B.2., infra

(2) new section 311 is covered in Part VII.C, infra

2. Old section 311(a) -- a corporation generally did not recognize gain or losson a distribution of its stock or property -- exceptions:

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a. LIFO inventory -- corporation recognizes income equal to theLIFO reserve -- FIFO value less LIFO value of inventorydistributed (can use inventory method other than FIFO) --section 311(b)

b. liabilities exceed basis -- corporation recognizes gain equal to thedifference between the liability and the basis of the asset --section 311(c)

(1) liabilities are allocated on an asset-by-asset basis, not in theaggregate -- H&M Auto Electric, Inc. v. Commissioner, 92T.C. 1269, (1989) (bank note secured by property allocatedto the property that secures the note; unsecured liabilityallocated among all the properties distributed according tothe relative fair market values of the distributed assets);Rev. Rul. 80-283, 1980-2 C.B. 108

(2) liabilities considered include nonrecourse debt --section 7701(g)

(3) character of gain on the distribution is also determined onan asset-by-asset basis, by looking at the distributingcorporation -- H&M Auto Electric, supra

c. distribution of appreciated property -- corporation recognizes gainupon a nonliquidating distribution of appreciated property --section 311(d)(1)

(1) example

X corporation distributes property with a FMV of $10,000and a basis of $5,000 to its sole individual shareholder A --X recognizes $5,000 of gain on the distribution

(2) exceptions to section 311(d)(1)

(a) redemption from noncorporate shareholder inpartial liquidation -- section 311(d)(2)(A)(i)

(b) distribution to noncorporate shareholder of propertyused by corporation in active business (which is notsection 1221(1) or (4) property), which is adividend -- section 311(d)(2)(A)(ii)

(c) certain distributions of stock or obligations ofcontrolled corporations -- section 311(d)(2)(B) and(e)(2) -- see Esmark, Inc. v. Commissioner, 90 T.C.171 (1988) aff'd without published opinion, 886F.2d 1318 (7th Cir. 1989)

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(d) distributions to which section 303(a) apply --section 311(d)(2)(C)

(e) distributions to a private foundation in redemptionof certain stock -- section 311(d)(2)(D)

(f) redemption of regulated investment company stockupon demand of the shareholder --section 311(d)(2)(E)

d. installment obligations -- section 453B and section 311(a)

(1) corporation recognizes gain equal to FMV of obligationless its basis

(2) Rev. Rul. 74-337, 1974-2 C.B. 94

e. recapture of depreciation, depletion, and intangible drilling costs --sections 291, 1245, 1250, 1254

f. investment tax credit recapture -- section 47

g. other statutory provisions included in Treas. Reg. § 1.311-1(a)

h. distribution of property for which corporation previously claimed adeduction -- Commissioner v. First State Bank of Stratford, 168F.2d 1004 (5th Cir.), cert. denied, 335 U.S. 867 (1948)

i. corporation negotiates a sale of its property but distributes theproperty to its shareholder and the shareholder sells -- sale imputedto corporation -- Court Holding doctrine -- Treas. Reg. § 1.311-1(a)

(1) Rust Communications Group, Inc. v. United States, (U.S.Claims Ct. No. 604-87T, May 14, 1990) (summaryjudgment denied on company's partial liquidation followedby shareholders' asset sale because the trial court had toexamine motive, intent and conduct of the corporation tosee if transaction was indeed a genuine shareholder sale)

(2) see also Hines v. United States, 477 F.2d 1063 (5th Cir.1973); United States v. Lynch, 192 F.2d 718 (9th Cir.1951), cert. denied, 343 U.S. 934 (1957); Bush Bros. & Co.v. Commissioner, 73 T.C. 424 (1979), aff'd, 668 F.2d 252(6th Cir. 1982); but see Anderson v. Commissioner, 92T.C. 138 (1989) (sale not imputed to corporation)

j. assignment of income principles

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C. Distributing Corporation -- Effect of Distribution of Property -- New Section 311

1. Following TRA 86, general rule is that corporations must recognize gain(but not loss) on a distribution of property with respect to its stock -- newsection 311(a) and (b)

a. gain recognized as if corporation sold the property to a buyer at itsFMV -- new section 311(b)(1)

FMV determined as if the corporation had sold the property at thetime of the distribution, not determined by value of the property inthe hands of the shareholder -- Pope & Talbot v. Commissioner,104 T.C. 574 (1995), aff’d, 83 A.F.T.R.2d ¶ 99-319 (9th Cir. 1999)

cf. Rev. Rul. 87-96, 1987-2 C.B. 209 -- section 311(b) gain fromdistribution of appreciated stock of controlled foreign corporationtreated as a sale under section 1248(a) and deferred underconsolidated return regulations

b. FMV may not be less than any liability assumed by the shareholderor to which the property is subject -- new section 311(b)(2); cf.section 7701(g) (for all purposes of the Code, the fair market valueof property subject to nonrecourse debt will be treated as at leastequal to the amount of such debt)

c. TRA 86 repealed four out of five of the exceptions fornonrecognition treatment contained in old section 311(d)

(1) fifth exception -- old section 311(d)(2)(E), dealing with theredemption of regulated investment company stock upondemand of the shareholder, was moved to newsection 852(b)

(2) repeal intended to create parity between liquidating andnonliquidating distribution, i.e., gain recognition on bothtypes of distributions

2. New section 311(b) applies only to "distributions to which Subpart Aapplies"

a. Subpart A includes sections 301-307 (e.g., redemptions anddividend distributions)

b. distributions in complete liquidation covered by new sections 336-337

c. section 355 transactions and distributions occurring inreorganizations generally are not covered

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3. Section 311 applies only if corporation distributes property "with respectto its stock" -- distributions to shareholders in their capacity as creditor,employee, etc. are not covered by section 311 -- Former Treas. Reg.§ 1.311-1(e)(1)

4. New section 311(b), subject to transitional rules, applies to nonliquidatingdistributions made after December 31, 1986

5. TAMRA 88 provides that section 311 applies to section 351 exchangeswhich are not pursuant to a plan of reorganization (see new section 351(f))(effective on or after June 21, 1988) and to certain section 355 transactionswhich are not pursuant to a plan of reorganization (see newsection 355(c)), and that section 311 does not apply to distributions toshareholders pursuant to a plan of reorganization in accordance withsection 361(c)(1) (see new section 361(c)(4))

6. TAMRA 88 added new section 311(b)(3), providing that if a partnershipor trust interest is distributed, the IRS may issue regulations preventingany loss on property that was contributed to the partnership or trust fromreducing the amount of gain recognized on the distribution

7. TRA 86, as amended by TAMRA 88, provided in section 337(d) that theIRS could issue regulations to preclude avoidance of the repeal of theGeneral Utilities doctrine -- pursuant to this authority, the IRS has issuedregulations, Prop. Treas. Reg. § 1.337(d)-3, 57 Fed. Reg. 59,327 (1992),providing that section 311(b), rather than the general nonrecognition ruleof section 731(a), will be applicable whenever a partner receives adistribution of its own stock or stock of any member of the affiliated groupof which the partner is a member -- Notice 89-37, 1989-1 C.B. 679,modified by Notice 93-2, 1993-1 C.B. 292

D. Earnings and Profits -- Effect of Distribution of Property

1. Section 312(a) -- general rule is to decrease earnings and profits by thebasis of the property distributed

2. Section 312(b) -- appreciated property

a. if the FMV of distributed property exceeds its adjusted basis --earnings and profits are adjusted as follows –

(1) earnings and profits are increased by excess of FMV overadjusted basis -- section 312(b)(1)

(2) earnings and profits are decreased by the FMV of theproperty -- section 312(a)(3) and (b)(2)

b. definition -- adjusted basis is the property's adjusted basis forearnings and profits purposes

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c. example:

X corporation has $5,000 of earnings and profits -- X distributesproperty with a FMV of $10,000 and a basis of $5,000 to itsindividual sole shareholder A

(1) X recognizes $5,000 of gain on the distribution (newsection 311(b)) which creates an additional $5,000 ofearnings and profits (ignoring tax liability)

(2) earnings and profits are reduced by $10,000 -- the FMV ofthe property (section 312(b))

d. TAMRA 88 excludes from the meaning of property insection 312(b) any obligation of the corporation

3. Section 312(c) -- adjustments for liabilities

a. reduction in earnings and profits on a distribution is itself reducedfor liabilities assumed by the shareholder -- Treas. Reg. § 1.312-3

b. example:

corporation X distributes to its sole shareholder, individual A,property having an FMV of $5,000 and an adjusted basis forearnings and profits purposes of $3,000 -- A takes the propertysubject to a mortgage of $2,000

(1) X increases earnings and profits by $2,000 ($5,000 -$3,000)

(2) X reduces earnings and profits by $3,000 ($5,000 - $2,000)

VIII. CONSTRUCTIVE DISTRIBUTIONS

A. In General

1. Section 301 applies only if there is a distribution to a shareholder in hiscapacity as a shareholder

2. Section 301 may apply if a shareholder derives an economic benefit fromthe corporation even though not formally declared -- constructivedistribution -- see P.R. Farms, Inc. v. Commissioner, 820 F.2d 1084 (9thCir. 1987)

a. Treas. Reg. § 1.301-1(j), (l), and (n)

b. need not constitute a distribution for state law

c. can be made to only a few shareholders

d. applies most often to closely held corporations

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3. If the corporation has earnings and profits the distribution will be taxed asa dividend

B. Examples of Constructive Dividends

1. Corporate loan to shareholder -- no intent to repay -- Jacques v.Commissioner, 935 F.2d 104 (6th Cir. 1991) (taxable income and notloans where sole owner of professional corporation did not intend to repaycash withdrawals and made only small sporadic repayments); AltermanFoods, Inc. v. United States, 611 F.2d 866 (Ct. Cl. 1979); Sprague v.Commissioner, 56 T.C.M. 1511 (1989); Thielking v. Commissioner, 53T.C.M. 746 (1987); TAM 8749002; cf. McGee v. Commissioner, 62T.C.M. 1375 (1991) (withdrawals from closely held corporation bona fideloans, not dividends; loans recorded as such and repaid); In re: ClementBetpouey III, 82 AFTR2d ¶ 98-5373 (1998) (cash advances to soleshareholder held to be bona fide loans even though not evidenced by loanformalities, fact that shareholder was able to repay and made someattempts to repay were sufficient)

a. corporation assumes shareholder debt --dividend on payment --Rev. Rul. 77-360, 1977-2 C.B. 86

b. novation of debt -- dividend at time of transfer (not on payment) --Rev. Rul. 78-422, 1978-2 C.B. 129

c. corporation assumes corporate shareholder's debt -- dividend onassumption -- PLR 9133025

2. Corporate loan to shareholder -- no interest or below market interest --section 7872, added by DEFRA 84

a. term loans -- taxable dividend to shareholder equal to differencebetween the amount loaned and present value of all payments dueunder the terms of the loan

(1) present value determined using applicable federal rate(AFR) as the discount rate

(2) difference generates OID -- section 7872(b)(2)

(3) OID must be taken into income currently by corporationunder OID principles -- section 1272 et seq.

b. demand loans

(1) triggers annual dividend to shareholder equal to that year's"foregone interest"

(2) "foregone interest" -- difference between amount payableand amount that would have been payable if AFR had beencharged

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3. Shareholder loan to corporation -- debt treated as equity

a. section 385

b. payment on debt treated as dividend distribution on stock -- SeeWard v. Commissioner, 53 T.C.M. 685 (1987)

c. foregone interest on demand loan made by sole shareholder to acorporation is included in the shareholder's gross income asinterest -- McGinnis v. Commissioner, T.C. Memo 1993-45

4. Corporate payment for shareholder benefit

a. Old Colony Trust Co. v. Commissioner, 279 U.S. 716 (1929) --employee has income when his legal obligations are paid byemployer -- see also Hagaman v. Commissioner, 54 T.C.M. 992(1987)

b. was corporate expenditure incurred principally to benefit businessor shareholder

c. result -- disallow corporate deduction and treat as dividend toshareholder

d. examples:

(1) corporation owns and cares for boat used by shareholder --Security Associates Ins. Corp. v. Commissioner, 53 T.C.M.1239 (1987)

(2) corporation pays personal expenses of shareholder --Bennett v. Commissioner, 53 T.C.M. 403 (1987)

(3) personal use of cars, planes, etc.-- L&L Marine Service,Inc. v. Commissioner, 54 T.C.M. 312 (1987)

(4) corporation assumes shareholder's obligation to purchasedecedent's stock -- Ross v. Commissioner, 58 T.C.M. 1200(1990); Gerson v. Commissioner, 56 T.C.M. 1202 (1989)

(5) corporation pays shareholder's personal obligations --Sparks Farm, Inc. v. Commissioner, 56 T.C.M. 464 (1988)

e. cf. Gulf Oil Corp. v. Commissioner, 914 F.2d 396 (3d Cir. 1990) --payments in form of insurance premiums to captive insurancecompany are not constructive dividends

5. Bargain purchase or bargain use of corporate property

6. Excessive payment by corporation to shareholder for

a. purchase of shareholder property

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b. rental of shareholder property

c. compensation -- Rutter v. Commissioner, 853 F.2d 1267 (5th Cir.1988)

7. Advances between related corporations -- constructive dividend tocommon shareholder followed by a contribution to capital -- Stinnett'sPontiac Service, Inc. v. Commissioner, 730 F.2d 634 (11th Cir. 1984),aff'g, 44 T.C.M. 55 (1982); Morowitz v. United States, 15 Cl. Ct. 62(1988) (no business purpose for making payments); Scallen v.Commissioner, 54 T.C.M. 1177 (1987), aff'd, 877 F.2d 1364 (8th Cir.1989); cf. Schnallinger v. Commissioner, 52 T.C.M. 1311 (1987)(advances were bona fide loans)

8. Rev. Proc. 87-22, 1987-1 C.B. 718, provides checklist for request forruling under section 1001 so sale of stock by employee-shareholder toemployer's section 401(a) plan not treated as a dividend

9. Diverted corporate funds constitute constructive dividend to shareholder --Rescigno v. Commissioner, 62 T.C.M. 854 (1991); Delgado v.Commissioner, 55 T.C.M. 155 (1988); Truesdell v. Commissioner, 89T.C. 1280 (1987)

C. Limits on Abuse of Distribution Transactions

1. Section 246A may limit the dividends-received deduction where ashareholder invests in dividend-paying stocks with borrowed funds"directly attributable" to the investment --

a. to combat this perceived abuse the percentage of the otherwiseallowable dividends-received deduction (70% or 80%) is reduced -- however, the limitation does not apply to the 100% dividends-received deduction

b. H Enterprises Int'l Inc. v. Commissioner, 105 T.C. No. 6 (1995),held that section 246A may apply when one member of anaffiliated group is the borrower and another member is thepurchaser of portfolio stock -- whether the investment in portfoliostock by one member is directly attributable to borrowings by theother member is a question of fact

2. Section 1059 provides that if a corporation receives an extraordinarydividend on stock that it has not held for more than 2 years, its basis in thestock will be reduced (but not below zero) by the nontaxed portion of thedividend.

a. extraordinary dividends are defined as dividends on preferred stockthat exceed 5% of the taxpayer's adjusted basis in the stock withrespect to which the dividend is distributed and dividends on otherstock that exceed 10% of the taxpayer's adjusted basis in the stock

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b. dividends that have ex-dividend dates within an 85-day period aretreated as one dividend

c. if the aggregate of dividends that have ex-dividend dates within a365-day period exceed 20% of the taxpayer's adjusted basis in thestock, then such dividends are treated as extraordinary dividends

3. Courts will recharacterize a "dividend" paid by a subsidiary to a parentwhere it is used to reduce the parent's tax liability

a. Waterman Steamship Corporation v. Commissioner, 430 F.2d1185 (5th Cir. 1970) (dividend paid as a note by a subsidiary to itsparent is recharacterized as part of the purchase price of thesubsidiary by outside purchaser)

b. Basic Incorporated v. United States, 549 F.2d 740 (Ct. Cl. 1977)(first-tier subsidiary distributes the stock of a second-tiersubsidiary to the parent corporation prior to the sale by the parentof the stock of both subsidiaries -- the distribution wasdisregarded)

c. but see TSN Liquidating Corporation, Inc. v. United States, 624F.2d 1328 (5th Cir. 1980) (distribution of unwanted assets bysubsidiary to its parent prior to parent's sale of the subsidiary stockis treated as a dividend, not as part of the consideration receivedfrom the sale)

d. Litton Indus., Inc. v. Commissioner, 89 T.C. 1086 (1987) -- adividend was paid, in the form of a promissory note, at a timewhen a sale of the distributing corporation was contemplated, butprior to commencing negotiations -- because the dividend wasdeclared and paid prior to the time the parent corporation wascommitted to a sale of the target, the court held that the dividendhad significance independent of the sale and would be respected

e. it appears that the two factors which are considered in determiningwhether a pre-sale dividend will be respected as such are (i) timingof the dividend vis-a-vis the sale negotiations and (ii) the origin ofthe cash used to pay the dividend -- however, the IRS has recentlybeen reluctant to apply the binding commitment test in determiningwhether to integrate transactions -- see Rev. Rul. 96-30, 1996-1C.B. 36; Treas. Reg. § 1.351-1(c)(3) superseding Rev. Rul. 78-294,1978-2 C.B. 141

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IX. DISTRIBUTION OF CORPORATION'S OWN STOCK

A. In General

1. Section 317 -- stock of distributing corporation is not property -- seeBhada v. Commissioner, 89 T.C. 959 (1987), aff'd, 892 F.2d 39 (6th Cir.1989) (defining "property" in section 304 context)

2. Section 301 does not apply

3. Section 311(a) -- no gain or loss to corporation

B. Section 305

1. Section 305(a) -- distributions of corporation's stock to its shareholders("stock dividends") are generally nontaxable to the shareholder -- seeColonial Savings Ass'n and Subsidiaries v. Commissioner, 854 F.2d 1001(7th Cir. 1988), cert. denied, 489 U.S. 1090 (1989), acq., 1990-1 C.B. 1;see also First Federal Savings Bank of Elizabethtown v. United States, 90-1 U.S.T.C. d 50,218 (D. Ky); Rev. Rul. 87-132, 1987-1 C.B. 82 (issuanceof stock prior to section 303 redemption)

2. Section 305(b) -- exceptions

a. where shareholder can elect to receive stock or property -- see FirstFederal Savings Bank of Elizabethtown v. United States, supra, (noelection where distributor has discretion over whether to allowredemption); see also Western Federal Savings & Loan Ass'n v.Commissioner, 880 F.2d 1005 (8th Cir. 1989); Rev. Rul. 90-98,1990-2 C.B. 56

b. shift in proportionate interest -- Hagan v. Commissioner, 57T.C.M. 1489 (1989), aff'd, rev'd, and rem'd on other issues, 92-1U.S.T.C. d 50,030 (10th Cir. 1992) (disproportionate distributionof stock is not includible in income under section 305(b)(2) unlessaccompanied by receipt of property by other stockholders)

c. distribution of common and preferred stock on common stock

d. distributions on preferred stock and certain convertible preferredstock

e. constructive distributions -- see PLR 9835011 (capitalization of aforeign sub’s undistributed earnings through a cash distribution tothe U.S. shareholder’s temporary foreign bank account, followedby payment from the account back to the foreign sub, will be anontaxable stock distribution. No new subsidiary shares werecreated or distributed in the transaction) -- but see ColonialSavings Ass'n v. Commissioner, supra

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3. Section 305(c) provides that the Secretary will prescribe regulations todetermine under what circumstances certain transactions (such as a changein conversion ratio or redemption price or a difference betweenredemption price and issue price) that increase a shareholder'sproportionate interest in a corporation shall be considered a taxabledistribution under section 301

a. OBRA 90 amended section 305(c) to provide that regulations shallprovide that a redemption premium for stock redeemable at theoption of the stockholder shall be reasonable only if the amount ofsuch premium does not exceed the amount determined under theOID de minimis rule of section 1273(a)(3)

b. whenever a redemption premium is treated as a distribution, suchpremium will be taken into account under the OID rules of section1272(a)

c. regulations implementing revised section 305(c) were finalized atthe end of 1995 -- see TD 8643 (Dec. 20, 1995)

4. Section 312(d) -- nontaxable stock dividend does not reduce earnings andprofits

X. REDEMPTIONS

A. Definition

1. Section 317(b) -- a corporation's acquisition of its own stock from ashareholder in exchange for property (except the corporation's own stock)

2. State (corporate) law is irrelevant

3. Stock is treated as redeemed whether or not the stock is cancelled, retired,or held as Treasury stock

B. Section 302 -- Determines Whether a Redemption is an "Exchange" or a"Distribution”

1. Section 302 does not prescribe the tax consequences of a redemption -- itclassifies a redemption as an exchange or distribution -- other Codesections determine the tax consequences

2. Individuals prefer exchange -- corporations prefer distribution

3. Section 302(a)

a. a redemption is treated as an exchange if it is one of the four typesdescribed in section 302(b)

(1) section 302(b)(1) -- not essentially equivalent to a dividend

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(2) section 302(b)(2) -- substantially disproportionateredemption

(3) section 302(b)(3) -- complete termination of interest

(4) section 302(b)(4) -- partial liquidation

b. tax consequences to redeeming shareholder if redemptionconstitutes an exchange

(1) section 1001 -- sale or exchange and gain or loss isrecognized

(2) sections 1221 and 1223 -- long-term capital gain if capitalasset and stock held more than one year -- for redemptionsbetween July 29, 1997 and December 31, 1997, holdingperiod of more than 18 months required to be entitled tolower long-term capital gain tax rate. Stock redeemedduring this period that was held for more than a year, butless than 18 months, is entitled to a “mid-term” capital gaintax rate

(3) basis -- if shareholder receives property in exchange forstock -- basis of property equals its tax cost – FMV

4. Section 302(d)

a. if the redemption does not fit within the requirements ofsection 302(b), it is treated as a distribution -- section 301 controls

b. tax consequences to shareholder

(1) distribution is treated as a dividend to extent of earningsand profits

(2) distribution in excess of earnings and profits is a return ofcapital and capital gain

(3) basis -- if the shareholder continues to hold stock the basisof the stock redeemed is added to the basis of stockretained

(4) basis -- if the shareholder holds no stock after redemption(owns stock constructively) basis of stock added to basis ofshares held by related taxpayers -- Treas. Reg. § 1.302-2(c),ex. 2

5. Explanation of principle underpinning section 302 -- Clark v.Commissioner, 828 F.2d 221 (4th Cir. 1987), aff'd, 489 U.S. 726 (1989)(in section 368 reorganization context, boot distributed in section 356

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exchange treated as hypothetical redemption of acquiring corporation'sstock)

C. Legislative History

1. Pre-1954 Law -- Section 115(g)

a. "essentially equivalent to a dividend" language in Revenue Act of1921 (section 201(d)) -- after Eisner v. Macomber, 252 U.S. 189(1920) -- stock dividend taxed if distribution of stock followed byimmediate redemption -- equivalent to a dividend

b. statute amended to apply to any redemption if equivalent to adividend

(1) facts and circumstances

(2) pro rata redemption a dividend and non-pro rata redemptionan exchange

(3) exceptions to pro rata dividend rule --

(a) business purpose

(b) corporate contraction -- see section 346 prior toamendment by the Tax Equity and FiscalResponsibility Act of 1982 (TEFRA)

2. 1954 Code

a. section 302 enacted to provide certainty as to taxation ofredemptions and prevent "bail-out" of earnings at capital gain rates

b. House bill contained only section 302(b)(2) and (3)

c. Senate bill added section 302(b)(1) -- essentially equivalent to adividend -- to broaden statute and cover, for example, redemptionsof nonvoting preferred stock

d. result -- two safe harbor tests and subjective test of 1939 Code

e. section 318 -- constructive ownership provisions -- enacted in 1954Code

3. TEFRA --

a. added section 302(b)(4) partial liquidation for noncorporateshareholders

b. section 302(b)(4) replaces former section 346

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4. "Greenmail" -- section 5881, added by OBRA 87 and amended byTAMRA 88, imposes an excise tax equal to 50% of the gain or otherincome of any shareholder who receives greenmail -- see XIX.C.7

D. Ruling Requests

1. Rev. Proc. 86-18, 1986-1 C.B. 551 -- sets forth information to be includedin requests for rulings under sections 302 and 311

2. Rev. Proc. 2000-3, 2000-1 I.R.B. 103, sections 3.01(16)-(20) (areas inwhich rulings will not be issued under section 302), sections 4.01(21)-(23)(areas in which rulings will not ordinarily be issued under section 302),and section 5.13 (areas of section 302 under study in which rulings willnot be issued until resolved by the IRS)

XI. SECTION 318 -- CONSTRUCTIVE OWNERSHIP OF STOCK

A. In General

1. Section 318 applies only where expressly made applicable

2. Section 318(b)(1) and section 302(c)(1) apply section 318 to redemptions

3. Terms of section 318 often modified by other statutory provisions -- e.g.,sections 304(c)(3) and 382(l)(3)(A)

4. Many other constructive ownership provisions in the Code --sections 267(c), 425(d), 544, 1563(e)

5. Types of attribution

a. section 318(a)(1) -- family attribution -- from one family memberto another

b. section 318(a)(2) -- entity to beneficiary attribution -- fromcorporations, partnerships, trusts and estates to shareholders,partners and beneficiaries

c. section 318(a)(3) -- beneficiary to entity attribution -- fromshareholders, partners and beneficiaries to corporations,partnerships, trusts and estates

d. section 318(a)(4) -- option attribution

B. Family Attribution -- Section 318(a)(1)

1. Individual constructively owns any stock owned by:

a. spouse

b. children

c. grandchildren

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d. parents

2. No attribution among brothers and sisters

3. Section 318(a)(5)(B) -- attribution from one member of family to anotheris not reattributed to a third member

4. Example

a. facts -- X corporation has 100 shares of common stock outstanding-- husband (H) owns 25 shares, wife (W) owns 25, son (S) owns25, and grandson (GS) owns 25

b. result –

H - 100 sharesW - 100 sharesS - 100 sharesGS - 50 shares

C. Entity to Beneficiary Attribution -- Section 318(a)(2)

1. Partnership -- stock owned by partnership is constructively owned by itspartners

a. partners own in proportion to their interest in partnership

b. it is unclear how provision applies if profits interest and capitalinterest in partnership are held in different proportions

c. example

(1) facts -- partnership (P) owns 50 shares (50%) of Xcorporation stock -- A has a 25% interest in P

(2) result -- A constructively owns 12.5 shares of X stock (50 x25%)

2. Estate -- stock owned by an estate is constructively owned by itsbeneficiaries

a. beneficiaries own in proportion to their interest in the estate

b. beneficiary -- person entitled to receive property of a decedent bywill or intestacy -- Treas. Reg. § 1.318-3

c. beneficiary's interest must be a direct and present interest --remainderman not a beneficiary of an estate (compare trust rules)

d. cease to be a beneficiary when --

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(1) all property to which he is entitled has been distributed, and

(2) only a remote possibility that estate will retake property tosatisfy claims

e. example

(1) facts -- H and W each own 50 shares of X corporation stock-- H dies and the beneficiaries of his estate are H's brother(50%) and W (50%)

(2) result

B -- 25 shares (constructively)W -- 75 shares (50 shares actually

and 25 shares constructively)

3. Trust -- stock owned by a trust is constructively owned by its beneficiaries

a. section 401 employee trust is excluded from constructiveownership rules

b. beneficiaries own in proportion to their actuarial interests in thetrust

c. note -- estate attribution based on proportionate interest -- trustattribution based on actuarial interest

d. rule applies regardless of how small or remote interest is

(1) applies to remainder interest -- compare to estate

(2) compare attribution from beneficiary to trust -- 5% remoteinterest rules

e. actuarial interest depends in part on age

f. example

(1) facts -- trust A owns 100 shares (100%) of X corporationstock -- W holds a life estate (15% interest); S has a lifeestate after W's death (25% interest); GS has remainderinterest (60% interest)

(2) result --

attribution familyfrom trust attribution

W: 15 + 25 + 60 = 100S: 25 + 15 + 60 = 100GS: 60 + 25 = 85

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4. Corporation -- stock owned by the corporation is constructively owned byits shareholders

a. statute applies only if the shareholder owns 50% or more in valueof the corporation's stock

b. constructive ownership is based on proportionate value of stockowned by the shareholder

(1) number of shares irrelevant

(2) significant where multiple classes of stock outstanding

c. example

(1) facts -- H owns 70% in value of X corporation stock -- Xowns 100% of Y corporation stock

(2) result -- H constructively owns 70% of Y corporation

d. example

(1) facts -- H owns 30% of X corporation

(2) result -- H constructively owns zero stock of Y corporation

e. constructive ownership rules apply to determine if the shareholderowns 50% of the stock

f. example

(1) facts -- X corporation owns 80 shares (80%) of Ycorporation -- H owns 40 shares (40%) of X corporationand W owns 20 shares (20%) of X

(2) result -- H owns 60 shares (60%) of X (40 actually and 20constructively from W) -- thus H owns over 50% of XcorporationH -- 48% of Y corporation (60% of 80%)W -- 48% of Y corporation

D. Beneficiary to Entity Attribution -- Section 318(a)(3)

1. Partner -- stock owned by partner is constructively owned by partnership

a. all stock owned by partner is deemed owned by partnership --proportionate ownership in partnership is irrelevant

b. example

(1) facts -- A owns 50 shares (50%) of X corporation stock --A also is a 25% partner in partnership P

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(2) result -- P constructively owns 50 shares of X

2. Beneficiary -- stock owned by a beneficiary is constructively owned bythe estate

a. all stock owned by beneficiary is deemed owned by estate --interest in estate is irrelevant

b. example

(1) facts -- H owns 100 shares (100%) of X corporation stock -- H's brother (B) dies leaving one-half of his property to H -- H is thus a beneficiary of B's estate

(2) result -- B's estate constructively owns 100% of X

c. avoid attribution -- distribute property to beneficiary so no longerbeneficiary of estate

3. Beneficiary -- stock owned by a beneficiary is constructively owned bythe trust

a. all stock owned by beneficiary is deemed owned by trust

b. exception -- attribution rule does not apply if beneficiary's interestin trust is "remote and contingent"

(1) contingent -- not vested -- e.g., remainder interest

(2) remote -- 5% or less in value

c. example

(1) facts -- W owns 50 shares (50%) of X corporation stock --W is a life beneficiary of trust A

(2) result -- trust A constructively owns 50 shares of X

4. Shareholder -- stock owned by a shareholder is constructively owned bythe corporation

a. statute applies only if the shareholder owns 50% or more in valueof the corporation's stock

b. if 50% test met, all stock owned by the shareholder is deemedowned by the corporation

c. example

(1) facts -- H owns 50% of X corporation and 100% of Ycorporation

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(2) result -- X constructively owns 100% of Y and Yconstructively owns 50% of X

E. Option Attribution -- Section 318(a)(4)

1. Person with option to acquire stock is considered to own that stock -- i.e.,treated as if already exercised option

a. Rev. Rul. 89-64, 1989-1 C.B. 91 -- option which is exercisableonly after fixed period of time is an option for purposes of section318(a)(4); Rev. Rul. 68-601, 1968-2 C.B. 124, clarified ("at theelection of the shareholder" distinguishes unilateral right frombilateral contract)

2. Option to acquire an option to acquire stock -- treated as owning stock

3. Contingent options – unclear whether statute applies; compare T.D. 8149,1987-2 C.B. 85 (the option attribution rule under section 318(a)(4) ignoresany contingency relating to the exercise of the option) with Field ServiceAdvice 199915007 (December 21, 1998) (contingencies that removed theelection from the optionee’s unilateral control prevented attribution forsection 318(a)(4) purposes)

4. Options to acquire unissued stock -- law unclear

a. stock outstanding solely for person holding option

b. compare Northwestern Steel & Supply Co. v. Commissioner, 60T.C. 356 (1973) and Rev. Rul. 68-601, 1968-1 C.B. 124 withSorem v. Commissioner, 334 F.2d 275 (10th Cir. 1964) and HenryT. Patterson Trust v. United States, 729 F.2d 1089 (6th Cir. 1984)

5. If both option and family attribution apply, option attribution controls --section 318(a)(5)(D)

6. Example

a. facts -- A and B each own 50% of X corporation -- A has an optionto acquire 25% of B's stock in X

b. result -- A owns 75% of X (50% actual ownership and 25%constructive ownership)

7. Seagram/Dupont transaction

a. In April 1995, in order for Seagram to raise money to buy MCA,DuPont repurchased DuPont shares held by Seagram. Seagramturned back 156 million shares to DuPont in exchange for $8.3billion in cash and notes and $500 million in warrants to purchaseDuPont shares

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For tax purposes, the repurchase was carefully structured so that itwouldn't be a redemption under section 302(b), so that Seagramwould not be subject to a tax on capital gain. Instead, theredemption is treated, under section 302(d), as a distribution towhich section 301 applies. Because Seagram owned at least 20%of DuPont's outstanding stock, the dividend is eligible for the 80%dividends received deduction in section 243(c)

The key to dividend rather than exchange treatment is thatSeagram received warrants pertaining to the same number ofshares it surrendered in the redemption. Because Seagram istreated as owning stock on which it holds an option under section318(a)(4), Seagram did not experience a reduction in itsproportionate interest in DuPont

b. A provision in TRA 97 amended section 1059 to preventduplication of the Seagram/Dupont transaction

Under the provision, a corporate shareholder recognizes gainimmediately with respect to any redemption treated as a dividend(in whole or in part) when the nontaxed portion of the dividendexceeds the basis of the shares surrendered, if the redemption istreated as a dividend due to options being counted as stockownership -- in addition, the provision requires immediate gainrecognition wherever the basis of stock with respect to which anyextraordinary dividend was received is reduced below zero. Thereduction in basis of stock would be treated as occurring at thebeginning of the ex-dividend date of the extraordinary dividend towhich the reduction relates -- the provision is generally effectivefor distributions after May 3, 1995

F. Reattribution -- Constructive Ownership as Actual Ownership --Section 318(a)(5)

1. Section 318(a)(5)(A)

a. stock constructively owned by reason of section 318(a)(1), (2), (3)or (4) is considered actually owned for purposes of reapplyingattribution rules

b. example

(1) facts -- X corporation owns 100 shares of Y corporationand trust A owns 50 shares of X -- W has a 50% interest(actuarially) in trust A -- S (W's son) owns no stock of Xdirectly

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(2) result -- S constructively owns 25 shares of Y corporation(X owns 100% of Y; T owns 50% of what X owns; Wowns 50% of what T owns; S owns what W owns)

2. Limitations on reattribution

a. section 318(a)(5)(B) -- family reattribution

(1) stock constructively owned by family attribution is nottreated as actually owned to again apply family attribution

(2) example

(a) facts -- H owns 50 shares of X corporation -- S(son) and D (daughter) each own 25 shares of X

(b) result --

H -- 100 shares (50 actually; 25 constructivelythrough S; 25 constructively through D)

S -- 75 shares (25 actually; 50 constructivelythrough H)

D -- 75 shares (25 actually; 50 constructivelythrough H)

Note that H owns what S and D own, but hisconstructive ownership is not reattributed to eachchild

b. section 318(a)(5)(C) -- sideways attribution

(1) stock constructively owned by an entity from itsbeneficiary is not considered owned for purposes ofattribution from entity to other beneficiaries

(2) example

(a) facts -- A and B each own 50 shares of Xcorporation -- A owns 25 shares of Y corporation

(b) result -- X constructively owns 25 shares of Y heldby A -- B does not constructively own Y stockconstructively held by X

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XII. SECTION 302(b)(2) -- SUBSTANTIALLY DISPROPORTIONATE REDEMPTIONS

A. In General

1. A redemption is treated as a sale if the redemption is substantiallydisproportionate with respect to the redeeming shareholder

2. Treated as a sale because shareholder's interest in corporation issignificantly reduced

3. Safe harbor provision -- mechanical test applied

4. Commissioner v. Clark, 489 U.S. 726 (1989) -- dividend characterizationwas not appropriate for substantial cash payment made in connection withstock for stock exchange -- apply section 302(b)(2) mechanical test afterthe reorganization; see also Rev. Rul. 93-61, 1993-2 C.B. 118; Rev. Rul.93-62, 1993-2 C.B. 118

B. Statutory Tests

1. A redemption is substantially disproportionate if it meets three mechanicaltests

a. 50% test -- immediately after the redemption, shareholder ownsless than 50% of the total combined voting power of all classes ofstock entitled to vote -- section 302(b)(2)(B)

b. 80% voting stock test -- immediately after the redemptionshareholder owns a percentage of voting stock which is less than80% of his percentage of voting stock immediately before theredemption -- section 302(b)(2)(C)

c. 80% common stock test -- immediately after the redemptionshareholder owns a percentage of common stock (voting and non-voting) which is less than 80% of his percentage of common stockimmediately before the redemption -- section 302(b)(2)(C)

2. Example

a. facts -- A and B hold 60 shares and 40 shares respectively of Xcorporation common stock -- X corporation redeems 20 shares ofits stock held by A

b. result -- the threshold test is whether after the redemption A ownsless than 50% of the total combined voting power of all classes ofstock entitled to vote

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before after

A 60 = 60% 40 = 50%100 80

thus, A flunks the 50% test

3. Example

a. facts -- same as above, except X redeems 25 shares of stock

b. result -- this time, A passes the 50% test

before after

A 60 = 60% 35 = 46%100 75

in addition, A passes both 80% tests

% of voting stock after redemption = 46% = 77%% of voting stock before redemption 60%

% of common stock after redemption = 46% = 77%% of common stock before redemption 60%

4. If more than one class of common stock is outstanding, applysection 302(b)(2)(C) in an aggregate and not a class-by-class manner --Rev. Rul. 87-88, 1987-2 C.B. 81; Rev. Rul. 89-57, 1989-1 C.B. 90

C. Operating Rules

1. Section 318--constructive ownership

a. constructive ownership provisions apply to all three tests

b. example

facts -- H and W each own 50 shares (50%) of X stock -- Xredeems 25 shares of stock from H

result -- H owns 100% of X stock before and 100% after -- section302(b)(2) does not apply

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2. Multiple redemptions

a. statute applied on a shareholder by shareholder basis -- multipleredemptions look at each shareholder before and after entiretransaction

before redeem after 80% test

A 100 = 25%400

55 45 = 15%300

15 = 60%25

B 100 = 25%400

25 75 = 25%300

25 = 100%25

C 100 = 25%400

20 80 = 27%300

27 = 108%25

D 100 = 25%400

0 100 = 33%300

33 = 132%25

result --

All of the parties pass the 50% test (i.e., none of them owns 50%or more of the total combined voting power of all classes of stockentitled to vote)

However, A is the only shareholder that passes the 80% test. Afterall of the redemptions, A owns only 60% of the stock that it ownedbefore the redemptions. Therefore, the shareholders will treat theredemptions as follows:

A - sale (capital gain) B - dividend C - dividend

b. formal plan for series of redemptions not necessary -- consider twoor more redemptions together if they are causally related -- Rev.Rul. 85-14, 1985-1 C.B. 93

3. Redeem only non-voting stock -- section 302(b)(2) does not apply

4. Redemption of non-voting stock may qualify if also redeem voting stockand the voting stock redemption satisfies the section 302(b)(2) tests

a. Treas. Reg. § 1.302-3(a)

b. Rev. Rul. 77-237, 1977-2 C.B. 88

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c. Rev. Rul. 87-88, 1987-2 C.B. 81 -- section 302(b)(2)(C) applies tomultiple classes of common stock in aggregate, not class-by-classbasis

5. Redemption of voting preferred stock can qualify under section 302(b)(2)-- Rev. Rul. 81-41, 1981-1 C.B. 121

a. 50% test and 80% voting stock test met

b. shareholder owns no common stock

c. 80% of common stock test not applicable

6. Formula -- minimum number of shares redeemed to qualify under section302(b)(2)

a. formula

(1) X = NT 5T-4N

(2) X -- number of shares to be redeemed

(3) N -- number of shares shareholder owns before redemption

(4) T -- number of shares outstanding before the redemption

b. example

(1) facts -- X corporation has 100 shares of stock outstanding.A owns 60 shares

(2) result --

X = 60*100(5*100) – (4*60)

= 6000500-240

= 6000260

= 23.07 = 24

7. Redemptions that are designed to return a shareholder’s economicinvestment as dividends can be recharacterized as fast-pay arrangements.On Jan. 7, 2000, the Service issued final regulations relating to financingarrangements involving fast-pay stock. See T.D. 8853, 2000FED ¶47,015.Under the regulations, stock is fast-pay stock if it is structured so thatdividends paid by the corporation with respect to its stock areeconomically (in whole or in part) a return of the holder’s investment.The regulations provide that stock is not fast-pay stock solely because aredemption is treated as dividend by section 302 unless there is a principalpurpose of achieving the same economic and tax effect as a fast-payarrangement

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XIII. SECTION 302(b)(3) -- TERMINATION OF SHAREHOLDER'S INTEREST

A. Statutory Requirements

1. A redemption is treated as a sale if it is a redemption of all of the stockowned by the shareholder

a. generally effected by a single transfer of shares to the corporation

b. a series of redemptions may be treated as parts of a singleredemption provided they are executed pursuant to a fixed plan toterminate the shareholder's interest

Bleily & Collishaw, Inc. v. Commissioner, 72 T.C. 751 (1979),aff'd without published opinion, 647 F.2d 169 (9th Cir. 1981)

2. Retention of non-proprietary interest

a. statute requires that the shareholder terminate his proprietary(stock) interest -- shareholder may retain nonproprietary interest

(1) officer, director, employee -- Rev. Rul. 76-524, 1976-2C.B. 94

(2) lessor of property (fixed rental payments -- not contingenton earnings) -- see Rev. Rul. 77-467, 1977-2 C.B. 92 -- seealso Rev. Proc. 2000-3, section 3.01(18), 2000-1 I.R.B. 103(no ruling if rent is contingent on future earnings or lessor'sclaims are subordinate to general creditors)

(3) creditor -- notes issued in redemption of stock

(a) notes issued in redemption -- debt or equity --section 385

(b) reacquire stock on default -- stock held as security -- Rev. Proc. 2000-3, section 3.01(16) 2000-1 I.R.B.103 (nonruling area)

b. retention of non-proprietary interest is a problem if shareholdermust waive family attribution to achieve exchange treatment

B. Constructive Ownership Provisions

1. Constructive ownership provisions apply to determine if all theshareholder's stock is redeemed -- section 302(c)(1)

example

a. facts -- H and W each own 50 shares of X stock -- X redeems all ofthe stock held by H

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b. result -- section 302(b)(3) does not apply -- H constructively ownsthe stock held by W

2. Section 302(c)(2)(A) -- waiver of family attribution rules -- the familyattribution rules at section 318(a)(1) do not apply to a termination ofinterest (section 302(b)(3) redemption) if three requirements are met

a. redeeming shareholder retains no interest in the corporation otherthan an interest as a creditor

(1) statute expressly prohibits retention of officer, director oremployee interests -- section 302(c)(2)(A)(i)

(2) where shareholder retains interest not expressly prohibited,Tax Court applies a "facts and circumstances" test indetermining if prohibitive interest is retained -- interpretsstatute as prohibiting retained financial stake or control --see Estate of Lennard v. Commissioner, 61 T.C. 554(1974); Chertkof v. Commissioner 72 T.C. 1113 (1979),aff'd, 649 F.2d 264 (4th Cir. 1981); but see Seda v.Commissioner, 82 T.C. 484 (1984) (applied facts andcircumstances test even though employee interest retained);Cerone v. Commissioner, 87 T.C. 1 (1986)

(3) Seventh Circuit rejected "facts and circumstances" test --Lynch v. Commissioner, 801 F.2d 1176 (1986), rev'g, 83T.C. 597 (1984) -- all noncreditor interests are prohibited,including interest as an independent contractor

(4) retention of pension rights not a prohibited interest -- Rev.Rul. 84-135, 1984-2 C.B. 80

(5) cannot acquire interest in a successor corporation -- Treas.Reg. § 1.302-4(c)

(6) Treas. Reg. § 1.302-4(d) -- definition of creditor -- nosubordinated interests, no percentage of profits, etc.

b. redeeming shareholder does not acquire a prohibited interest within10 years from date of redemption distribution

(1) cannot acquire stock or any other prohibited interest incorporation

(2) acquisition by constructive ownership will violaterequirement -- H waives W's ownership and W later putsstock in partnership in which H is a partner

(3) can acquire stock by inheritance

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(4) under section 302(c)(2)(A), family attribution is waived indetermining whether there is an acquisition of a prohibitedinterest -- Rev. Rul. 88-55, 1988-2 C.B. 45; Rev. Rul. 71-562, 1971-2 C.B. 173

c. redeeming shareholder files an agreement pursuant to section302(c)(2)(A)(iii) to notify the IRS of a prohibited acquisitionwithin the 10-year period

(1) the agreement must be filed with the shareholder's returnfor the year of the redemption -- Treas. Reg. § 1.302-4(a)(1)

(2) District Director may grant an extension if there wasreasonable cause for failing to file and the extensionrequested is filed within reasonable time -- Treas. Reg.§ 1.302-4(a)(2)

(3) former shareholder did not violate section 302(c)(2)(A)(iii)agreement when section 304(a)(1) applied to subsequentsale of stock in a related corporation -- Rev. Rul. 88-55,1988-2 C.B. 45

3. Section 302(c)(2)(B) -- exception to waiver of attribution rules

a. waiver rules do not apply if within the 10-year period prior to theredemption the redeeming shareholder either

(1) acquired stock of the corporation from a related party, or

(2) transferred stock of the corporation to a related party

b. examples

(1) H owns 100 shares of X corporation stock -- H transfers 20shares to W as a gift and X redeems the stock from W

(2) H owns 100 shares of X corporation stock -- H transfers 80shares to W and X redeems 20 shares from H

c. exception to the exception -- may waive the attribution rules evenif acquire or convey stock within 10 years -- if the transfer was notdone principally to avoid tax

(1) Rev. Rul. 77-293, 1977-2 C.B. 91 -- gift from father to sonto permit son to take over business; son active in business -- not tax avoidance

(2) Rev. Rul. 85-19, 1985-1 C.B. 94 -- child inherited 80shares from deceased parent and was given 20 shares from

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parent; parent reacquired the 20 shares just beforeredemption of 80 shares -- not tax avoidance

(3) other rulings -- Rev. Rul. 79-67, 1979-1 C.B. 128; Rev.Rul. 77-293, 1977-2 C.B. 91; Rev. Rul. 77-455, 1977-2C.B. 93; Rev. Rul. 57-387, 1957-2 C.B. 225; Rev. Rul. 56-584, 1956-2 C.B. 179

4. Limitation on waiver of attribution rules

a. section 302(c)(2) provides that section 318(a)(1) will not apply to asection 302(b)(3) redemption if the requirements are satisfied

b. section 318(a)(1) applies only to family attribution rules -- entityattribution and option attribution cannot be waived

(1) example -- Estate (E) owns 50% of X corporation. W, abeneficiary of E, also owns 50% of X corporation. NeitherE nor W can waive the attribution rules -- section 318(a)(2)and (3) apply

(2) compare Rickey v. United States, 592 F.2d 1251 (5th Cir.1979) (estate can waive) with David Metzger Trust v.Commissioner, 76 T.C. 42 (1981), aff'd, 693 F.2d 459 (5thCir. 1982), cert. denied, 463 U.S. 1207 (1983) (no waiverby trust)

c. unclear who may waive family attribution

(1) IRS position (pre-TEFRA) -- only an individual may waivethe attribution provisions -- entities may not

(a) Rev. Rul. 59-233, 1959-2 C.B. 106; Rev. Rul. 72-472, 1972-2 C.B. 202

(b) example -- Estate (E) owns 50% of X corporation --W is the sole beneficiary of E; W's son S also owns50% of X -- thus, W owns stock of S by section318(a)(1) and E owns stock of W by section318(a)(3) -- IRS position was that E cannot waiveattribution between W and S

(2) court position -- entities may waive the family attributionprovisions

(a) Crawford v. Commissioner, 59 T.C. 830 (1973),acq., 1984-2 C.B. 1 -- estate can waive attribution

(b) Johnson Trust v. Commissioner, 71 T.C. 941(1979), acq., 1984-2 C.B. 1 -- trust can waiveattribution

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d. section 302(c)(2)(C), added by TEFRA, permits an entity to waivethe family attribution rules if the following requirements aresatisfied

(1) the redeeming entity and each related person hold nointerest in the corporation; agree not to acquire suchinterest for ten years; and file the required waivers

(2) the redeeming entity and each related person agree to bejointly and severally liable for tax which results from aprohibited acquisition

XIV. SECTION 302(b)(4) -- PARTIAL LIQUIDATIONS FOR NONCORPORATESHAREHOLDERS

A. Partial Liquidations

1. Section 302(b)(4) -- operative provision

a. a redemption of stock will qualify as a sale or exchange if:

(1) the stock redeemed is held by a noncorporate shareholder,and

(2) the redemption qualifies as a partial liquidation of theredeeming corporation

b. capital gain to redeeming shareholder

c. the provision is limited to redemptions of stock from noncorporateshareholders

(1) prior law permitted sale or exchange treatment regardlessof the type of shareholder

(2) reason for the statutory change -- U.S. Steel/Marathontransaction

d. Rev. Rul. 90-13, 1990-1 C.B. 65 (pro rata distribution bycorporation to its shareholders (individuals) qualifies as adistribution in redemption of stock in partial liquidation undersection 302(b)(4) and (e) even though the shareholders did notsurrender any of their shares)

2. Section 302(e) -- defines partial liquidation

a. section 302(e)(1) -- the distribution in redemption of stock is:(i) not essentially equivalent to a dividend (determined at thecorporate level), and (ii) pursuant to a plan which occurs in theyear the plan is adopted or in the next succeeding year

(1) "not essentially equivalent to a dividend"

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(a) identical to pre-TEFRA statute; pre-TEFRA lawthus continues to be relevant

(b) similar to section 302(b)(1) but tested at thecorporate level -- entitled to capital gain even if theredemption is on a pro rata basis

(c) "corporate contraction" concept -- adopted in pre-1954 case law Imler v. Commissioner, 11 T.C. 836(1948), acq., 1949-1 C.B. 2

(d) facts and circumstances test to determine if truetermination or reduction of business -- Mains v.United States, 508 F.2d 1251 (6th Cir. 1975)

(e) looks like dividend --

- earnings and profits- pro rata- continue business- potential to avoid dividends

-- not often applied

(f) examples of corporate contraction

(a) part of business destroyed by fire, insuranceproceeds distributed -- Treas. Reg. § 1.346-1(a)(2); Imler v. Commissioner, supra

(b) sale of part of business -- Rev. Rul. 75-223,1975-1 C.B. 109; Rev. Rul. 74-296, 1974-1C.B. 80; Rev. Rul. 71-250, 1971-1 C.B. 112

(g) no corporate contraction

(a) distribution of passive real estate -- Rev. Rul.76-526, 1976-2 C.B. 101

(b) distribution of cash reserved to replaceequipment -- Rev. Rul. 78-55, 1978-2 C.B. 88

(c) correct distribution of assets unrelated tocorporate contraction -- Rev. Rul. 79-275, 1979-2 C.B. 137

(d) sale of stock of subsidiary -- Rev. Rul. 79-184,1979-1 C.B. 143

(e) redemption pursuant to a plan in the year theplan is adopted or in the next succeeding year

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b. section 302(e)(2) -- a distribution which terminates one of two ormore businesses engaged in by the corporation (corporatecontraction concept with objective test)

(1) statutory tests

(a) the corporation sells or distributes the assets of a"qualified trade or business"

(b) the corporation continues to carry on a "qualifiedtrade or business"

(2) qualified trade or business -- a trade or business which wasactively conducted for five years on the date of thedistribution and was not acquired by the corporation withinthe five-year period in a taxable transaction

(a) purpose -- to permit capital gain if businesscontracts without requiring a factual inquiry of taxavoidance potential

(b) assets of business may be sold and cash distributedor assets can be distributed in kind

(c) section 355 definition of business applied -- Treas.Reg. § 1.355-3

(d) active business required to prevent avoidingdividend tax on investment type assets

(e) five-year requirement to prevent purchase of activebusiness shortly before redemption of stock

(3) See White's Ferry, Inc. v. Commissioner, 66 T.C.M. 1855(1993) -- ownership and management of real propertyconstituted a business activity, albeit a minor one, sodistribution of the property to shareholders in redemptionof stock resulted in a significant contraction in capital andbusiness activity; therefore, the distribution was adistribution in partial liquidation under section 302(e)

B. Ruling Requests

1. Rev. Proc. 81-42, 1981-2 C.B. 611, sets forth information to be includedin a section 346 request for rulings prior to the enactment of section302(b)(4)

2. It appears that this procedure continues to apply to partial liquidationsafter TEFRA -- see Rev. Proc. 86-18, section 4.02, 1986-1 C.B. 551

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3. Rev. Proc. 2000-3, section 4.01(22), 2000-1 I.R.B. 103 -- ordinarily noruling on whether distribution is a partial liquidation under section302(b)(4) unless it results in 20% or more reduction in: (1) gross revenue,(2) net FMV of assets, and (3) employees

4. Rev. Proc. 2000-3, section 4.01(23), 2000-1 I.R.B. 103 -- ordinarily noruling on the tax effect of the liquidation of a corporation preceded orfollowed by the reincorporation of all or part of the business and assetswhen more than a nominal amount of the stock (i.e., more than 20% invalue) of both the liquidating corporation and the transferee corporation isowned by the same shareholders; or when a liquidation is followed by thesale of the corporate assets by the shareholders to another corporation inwhich such shareholders own more than a nominal amount of the stock(i.e., more than 20% in value)

XV. SECTION 302(b)(1) -- NOT ESSENTIALLY EQUIVALENT TO A DIVIDEND

A. Statutory Requirement

1. A redemption is treated as a sale if the redemption is "not essentiallyequivalent to a dividend"

a. facts and circumstances

b. section 302(b)(5) -- failure of redemption to qualify under section302(b)(2), (3) or (4) is irrelevant

B. United States v. Davis, 397 U.S. 301 (1970)

1. Conclusions of Davis

a. redemption must result in a "meaningful reduction of shareholder'sproportionate interest in the corporation"

b. business purpose is irrelevant in applying section 302(b)(1)

c. redemption from sole shareholder cannot qualify as "notessentially equivalent to a dividend"

d. constructive ownership provisions apply to section 302(b)(1)redemptions

2. Unanswered questions of Davis

a. definition of "meaningful reduction"

b. what stock ownership characteristics are relevant in measuringinterest in corporation

c. whether tests are different for majority or minority shareholder,common or preferred shareholder, voting or nonvoting shareholder

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d. how voting power and economic interest interrelate

3. Dissent -- Davis writes section 302(b)(1) out of the Code

C. Meaningful Reduction -- Cases and Rulings After Davis

1. Stock ownership characteristics used to measure interest in corporation --Himmel v. Commissioner, 338 F.2d 815 (2d Cir. 1964); Rev. Rul. 75-502,1975-2 C.B. 111

a. right to vote and thereby exercise control

b. right to participate in current earnings and accumulated surplus

c. right to share in net assets on liquidation

2. Case law has extended Davis well beyond its facts to cover

a. common stock redemptions

b. redemptions involving multi-shareholder corporations

c. non-pro rata redemptions

3. Post-Davis case law adds little analysis -- quotes Davis and reachesconclusions

4. Redemption of voting stock -- majority interest

a. cases and rulings look exclusively at voting power

b. majority of cases and rulings have held reductions not to bemeaningful -- dividend

(1) 98.5% to 96.1% -- Jones v. United States, 72-1 U.S.T.C.9349 (D.N.J.)

(2) 98.2% to 88.6% -- Fehrs Finance Co. v. Commissioner, 58T.C. 174 (1972), aff'd, 487 F.2d 184 (8th Cir. 1973), cert.denied, 416 U.S. 938 (1974)

(3) 90% to 83% -- Niedermeyer v. Commissioner, 62 T.C. 280(1974), aff'd, 535 F.2d 500 (9th Cir. 1974), cert. denied,429 U.S. 1000 (1976)

(4) 98.50% to 98.05% -- Estate of Schneider v. Commissioner,88 T.C. 906 (1987), aff'd, 855 F.2d 435 (7th Cir. 1988)

(5) 100% to 81% -- Rev. Rul. 73-2, 1973-1 C.B. 171

(6) 90% to 60% -- Rev. Rul. 78-401, 1978-2 C.B. 127

(7) 60% to 55% -- Rev. Rul. 77-218, 1977-1 C.B. 81

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c. cases and rulings holding reduction meaningful

(1) 85% to 61.7% -- Wright v. United States, 482 F.2d 600 (8thCir. 1965)

(2) 80% to 63% -- Henry T. Patterson Trust v. United States,729 F.2d 1089 (6th Cir. 1984)

(3) 57% to 50% -- Rev. Rul. 75-502, 1975-2 C.B. 111

5. Redemptions of minority interests

a. issues to consider

(1) whether corporation is closely held or publicly traded

(2) whether stock redeemed is voting or non-voting, preferredor common

(3) how many classes of stock are outstanding and how manydoes shareholder hold

(4) whether minority interest is nominal or large enough toexercise effective control

b. very little case law -- recently IRS has been issuing favorablerulings -- IRS has determined that there has been a meaningfulreduction where ownership was reduced from:

(1) 11% to 9% -- Rev. Rul. 56-183, 1956-1 C.B. 161

(2) 30% to 24.3% -- Rev. Rul. 75-512, 1975-2 C.B. 112

(3) 27% to 22.27% -- Rev. Rul. 76-364, 1976-2 C.B. 91

(4) de minimis -- Rev. Rul. 76-385, 1976-2 C.B. 92

(5) .414% to .361% -- meaningful reduction -- TAM 8504009

(6) vote 1.72% to 1.56%, value 5.91% to 5.10% -- PLR9829008

6. Redemptions of preferred stock

a. characteristics of preferred different from common -- no vote,limited dividend and liquidation rights, does not participate ingrowth

b. redemption of preferred stock from shareholder holding onlypreferred stock always is a meaningful reduction -- Rev. Rul. 77-426, 1977-2 C.B. 87

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c. redemption of preferred stock can be a dividend -- depends onownership of other classes of stock

(1) example -- A holds 50% of the preferred stock and 100% ofthe common stock. Corporation redeems all of A'spreferred stock. Redemption is a dividend -- beforeredemption A's interest was 100% less 50% preferred stock-- after redemption his interest is the same

(2) redemption of preferred stock from majority shareholder --dividend

(3) redemption of preferred stock from minority shareholderwho has capacity to act with others as part of a controlgroup -- dividend -- Rev. Rul. 85-106, 1985-2 C.B. 116

(4) redemption of preferred stock from minority shareholder --may be sale

(a) PLR 7735031 -- 11.8% C.S.-- 100% P.S.

(b) PLR 7750041 -- 5.86% C.S.-- 100% P.S.

7. Redemptions of nonvoting common stock -- treat like preferred stock

D. Constructive Ownership Rules

1. Davis holds section 318 applies to section 302(b)(1)

a. section 302(c)(1) states that section 318 applies in determiningstock ownership for purposes of section 302

b. section 302(b)(1) does not refer to stock ownership

2. Family hostility -- can it make family attribution rules inapplicable

a. family hostility can overcome attribution rules -- Robin Haft Trustv. Commissioner, 510 F.2d 43 (1st Cir. 1975)

b. family hostility does not override attribution rules -- Cerone v.Commissioner, 87 T.C. 1 (1986); David Metzger Trust v.Commissioner, 76 T.C. 42 (1981), aff'd, 693 F.2d 459 (1982), cert.denied, 463 U.S. 1207 (1983); Rev. Rul. 80-26, 1980-1 C.B. 66

XVI. REDEMPTIONS AND BOOTSTRAP ACQUISITIONS

A. In General

1. Selling shareholder sells a portion of his stock to buyer and causescorporation to redeem the remainder -- tax consequences

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a. sell all stock to buyer -- section 1001 -- capital gain

b. redeem all stock -- section 302(b)(3)

2. Purpose

a. capital gain to seller

b. control of corporation to buyer

c. buyer uses corporate dollars (i.e., no double tax) to pay for stock

B. Seller Issues

1. Zenz v. Quinlivan, 213 F.2d 914 (6th Cir. 1954) -- taxpayer sells a portionof stock and has corporation redeem the remainder

a. pre-1954 Code case

b. holds transaction not essentially equivalent to a dividend --redemption which completely terminates interest

2. IRS has acquiesced in Zenz

a. Rev. Rul. 55-745, 1955-2 C.B. 223 -- sale and redemption ofshareholder's entire interest

b. Rev. Rul. 75-447, 1975-2 C.B. 113

(1) A and B each hold 50 shares of X stock -- X sells 25 sharesto C and simultaneously X redeems 25 shares each from Aand B

(2) A and B each hold 50 shares of X stock -- A and B eachsell 15 shares to C and simultaneously X redeems 5 sharesfrom A and B

c. Rev. Rul. 77-226, 1977-2 C.B. 90

(1) corporate shareholder buys stock and then has it redeemedpursuant to same plan -- reports redemption as a dividendin part to claim a dividends received deduction

(2) ruling concludes that Zenz controls

d. see also PLR 9148037

3. Sale and redemption need not occur simultaneously provided part of thesame plan

4. Step transaction doctrine may apply in characterizing transaction asredemption

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a. sale of stock by corporation to employees pursuant to stock bonusplan utilizing stock of majority shareholder recharacterized asredemption -- Estate of Schneider, 88 T.C. 906 (1987), aff'd, 855F.2d 435 (7th Cir. 1988)

b. TAM 8646002 -- step transaction doctrine not applied; firsttransaction is a redemption; second transaction is a "D"reorganization

c. Esmark, Inc. v. Commissioner, 90 T.C. 171 (1988), aff'd withoutpublished opinion, 886 F.2d 1318 (7th Cir. 1989) -- tender offerfollowed by redemption of stock acquired respected

5. Boot in section 356 exchange treated as redemption -- Commissioner v.Clark, 489 U.S. 726 (1989)

a. taxpayer exchanged his stock in a wholly owned corporation forless than one percent of the stock of a corporation in which he hadno prior interest and $3.25 million in boot

b. IRS argued that boot had the effect of a dividend distributionpursuant to section 356(a)(2) and that boot payment should betreated as hypothetical cash payment prior to reorganization andtaxed as ordinary income

c. held: boot payment treated as hypothetical redemption of stockafter the reorganization and taxed as capital gain. Payment waspart of integrated exchange; there would have been no cashpayment absent the exchange

6. shareholders who purchased property from corporation at bargain and onsame day sold all their stock in corporation to another shareholder couldnot recast the transaction as a redemption -- shareholders had constructivedividend equal to gain on bargain purchase and exchange treatment onsale of stock -- Durkin v. Commissioner, Dec. 48,644, 99 T.C. 651 (1992)

C. Continuing Shareholder Issues

1. Redemption of stock is a dividend to remaining shareholder only if thecorporation pays the primary and unconditional obligation of theremaining shareholder

a. Schroeder v. Commissioner, 831 F.2d 856 (9th Cir. 1987)(shareholder purchases stock with loan and has corporation redeemportion of purchased stock to pay off loan); Wall v. United States,164 F.2d 462 (4th Cir. 1947) (remaining shareholder purchasesstock but causes corporation to pay shareholder's note)

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b. if obligation to pay redeeming shareholder is the corporation's --no dividend -- Holsey v. Commissioner, 258 F.2d 865 (3d Cir.1958); Edenfield v. Commissioner, 19 T.C. 13 (1952)

(1) corporate obligation to buy stock

(2) shareholder guarantees corporate obligations

(3) shareholder conveys option to buy to corporation

c. Rev. Rul. 69-608, 1969-2 C.B. 42 -- sets forth seven examples

2. Section 305(c) -- periodic plan of redemption may result in constructivedividend to continuing shareholder

XVII. SECTION 304 -- REDEMPTIONS THROUGH RELATED CORPORATIONS

A. In General

1. Shareholder sells stock of one corporation to a purchasing corporation

a. section 302 does not apply

b. if sale to unrelated purchaser -- capital gain under section 1001

c. if sale to affiliated corporation, should transaction be treated as asale

(1) A owns stock of X and Y corporation; A sells part of Xstock to Y

(2) effect of transaction is a dividend

2. Section 304 treats a sale of stock by a shareholder to a related corporationas a redemption subject to section 302

3. Pre-1954 Code dealt only with parent-subsidiary relationships -- section115(g)(2)

4. Section 304 enacted in 1954 covers brother-sister and parent-subsidiarytransactions

5. A TRA 97 provision provides that if a section 304 transaction is treated asa dividend to which the dividend received deduction applies, the dividendis treated as an extraordinary dividend in which only the basis of thetransferred shares would be taken into account under section 1059

6. Treas. Reg. § 1.1502-80(b) provides that section 304 shall not apply to anyacquisition of stock of a corporation in an intercompany transaction or toany intercompany item from such transaction occurring on or after July24, 1991

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B. Section 304(a)(1) -- Brother-Sister Acquisitions

1. One or more persons in control of two corporations

a. 304(c) -- control is 50% of voting power or value

(1) the value test is applied, not class-by-class, but on the basisof the aggregate value of all classes of stock -- Rev. Rul.89-57, 1989-1 C.B. 90

b. section 318 applies with modifications

(1) de minimis rule -- constructive ownership is not applied ifshareholder owns less than 5% in value of the corporation'sstock; and

(2) a proportionate rule -- if shareholder owns less than 50% invalue of corporation's stock, then attribution to thecorporation is limited to the proportion of stock theshareholder owns. Sections 304(c)(3)(A) and (B)

(a) see Continental Bankers Life Insurance Company ofthe South v. Commissioner, 93 T.C. 52 (1989)(applying constructive ownership rules of section318(a) for purposes of control)

(b) See Rev. Rul. 91-5, 1991-1 C.B. 114

2. If shareholder sells stock of one corporation to the other, then treated asfollows

a. redemption of stock of acquiring corporation

b. section 302 standards applied to stock of issuing corporation --section 304(b)(1)

c. to the extent that the transaction is taxed as a distribution, section304(b)(2) characterizes the distribution as follows

(1) first as a deemed distribution by the acquiring corporationto the selling shareholder to the extent of the acquiringcorporation's earnings and profits,

(2) then as a deemed distribution by the issuing corporation tothe selling shareholder to the extent of the issuingcorporation's earnings and profits, and

(3) acquiring corporation considered to have received the stockas a contribution to capital

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d. to the extent that the transaction is treated as an exchange, section304(a) provides that the acquiring corporation will be treated aspurchasing the stock -- section 338 may apply

3. OBRA 87 added new section 304(b)(4) to provide that proper adjustmentsare to be made to (1) the adjusted basis of any intragroup stock and (2) theearnings and profits of any member of the affiliated group to the extentnecessary to carry out the purposes of section 304(a) -- however, thisamendment contained no specific rules "to carry out the purposes" ofsection 304 -- the IRS response was to issue regulations providing that inthe case of acquisitions of stock within consolidated groups, section 304would not apply -- see Treas. Reg. § 1.1502-80

4. Example

a. facts -- X and Y corporations each have 200 shares of commonstock outstanding; A and B each own 100 shares of X and Y -- Asells 30 shares of X to Y

b. result --

(1) determine if redemption is a sale or a section 301distribution by A's ownership of X before and afterredemption -- prior to transaction, A owned 100 shares ofX; after transaction, A owns 70 shares directly and 15shares constructively (Y owns 30 shares of X and A owns50% of Y)

50% testbefore after 80% tests

100 = 50% 85 = 42.5% 42.5% = 85%200 200 50%

thus, section 302(b)(2) does not apply (A flunks both 80%tests) and assume for this example that section 302(b)(1)does not apply

(2) section 301 distribution to A -- reduce earnings and profitsof Y and to the extent the distribution exceeds Y's earningsand profits, reduce earnings and profits of X

(3) basis of stock redeemed is added to A's basis in his Y stock-- basis of X stock to Y is equal to A's basis in the X stock

5. Example

a. facts -- same facts except A sells 50 shares of X stock to Y

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b. results -- prior to transaction, A owned 100 shares of X; aftertransaction, A owns 50 shares directly and 25 shares constructively(Y owns 50 shares of X and A owns 50% of Y)

(1) prior to transaction, A owned 100 shares of X; aftertransaction, A owns 50 shares directly and 25 sharesconstructively (Y owns 50 shares of X and A owns 50% ofY)

50% testbefore after 80% tests

100 = 50% 75 = 37.5% 37.5% = 75%200 200 50%

thus, section 302(b)(2) applies

(2) A recognizes capital gain -- selling price less basis of stock

(3) Y treated as acquiring X stock by purchase -- basis in Xstock is equal to Y's cost

6. Example

a. facts -- P owns all of the stock of X, and X owns all of the stock ofY and Z -- the group does not file a consolidated return -- X sells50% of its appreciated Y stock to Z in a section 304 transactionthat is treated as a dividend of the earnings and profits of Z to Xand a contribution of the stock of Y to the capital of Z

b. results -- prior to transaction, X owned 100% of Y; after thetransaction X owns 50% of Y directly and 50% constructively

(1) section 302(d) applies and the distribution is subject tosection 301 -- reduce earnings and profits of Z and to theextent the distribution exceeds Z's earnings and profits,reduce earnings and profits of Y

(2) the amount treated as a dividend is effectively not taxed asa result of the dividends-received deduction

(3) X's basis in the stock of Y it sold to Z is added to X's basisin its remaining Y stock -- the additional basis reduces X'sbuilt-in gain in the remaining Y stock -- arguably, however,adjustments must be made to the stock bases of themembers of the group to preclude the sale of Y stockwithout recognition of the built-in appreciation -- seesection 304(b)(4)

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C. Section 304 and Section 351

1. TEFRA and DEFRA 84 -- amended section 304 to clarify that section 304takes precedence over section 351

2. Pre-TEFRA example -- A owns all of the stock of two corporations (X andY); A transfers part of the stock of X to Y in exchange for additional Ystock and either securities or cash, in a transaction which qualifies forsection 351 treatment

3. If section 351 controlled, the securities are not taxed and the cash is taxedat capital gain rates; if section 304 controlled, the securities and cashwould constitute a dividend (up to Y's and X's earnings and profits)

4. Conflict in authority under old law

a. section 351 controls -- Gunther v. Commissioner, 92 T.C. 39(1989) (Tannenwald, J.) (separate opinion), aff'd, 909 F.2d 291(7th Cir. 1990); Haserot v. Commissioner, 46 T.C. 864 (1966),aff'd, 399 F.2d 828 (6th Cir. 1968);

b. section 304 controls -- Rose Ann Coates Trust v. Commissioner,480 F.2d 468 (9th Cir.), cert. denied, 414 U.S. 1045 (1973); Rev.Rul. 78-422, 1978-2 C.B. 129

5. TEFRA and DEFRA 84

a. section 304(b)(3)(A) -- section 304 overrides section 351 withrespect to the receipt of "property" as defined in section 317 (cash,securities, etc.); section 351 continues to apply to the receipt ofstock -- Bhada v. Commissioner, 89 T.C. 959 (1987), aff'd, 892F.2d 39 (6th Cir. 1989)

b. section 304(b)(3)(B) -- exception for acquisition indebtedness,limited to acquisitions from a person whose stock is notattributable to the person transferring the stock to the acquiringcorporation

(1) exception to the exception -- if the related personterminates his/her interest, does not acquire additionalinterest in either the issuing or the acquiring corporation for10 years, and files an agreement with IRS

c. section 304(b)(3)(C) -- special rules for formation of bank holdingcompanies -- assumption of acquisition indebtedness incident toformation of bank holding company not treated as distribution ofproperty

6. newly formed corporations before TEFRA and DEFRA 84 -- A owns allof the stock of X corporation; A forms new corporation Y and conveys X

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stock to Y in exchange for Y stock and cash (borrowed by Y from bank) --loan is later repaid by Y with dividend from X

a. IRS initially ruled that section 304 did not apply because A did notcontrol Y before the exchange -- i.e., section 351 transaction -- seeTreas. Reg. § 1.304-2(a); PLR 8008205; PLR 7947070

b. IRS subsequently reversed its position and would no longer issuesuch rulings -- however, even if section 304 applied, Y had noearnings and profits (because Y was a newly formed corporation)and the cash was treated as a return of capital or capital gain

c. Rev. Rul. 80-239, 1980-2 C.B. 103, holds that neither section 351nor section 304 applies -- cash distributed to A is a dividend fromX

7. newly formed corporations after TEFRA and DEFRA 84

a. section 304(c)(2) -- control determined by including stock receivedin the transaction

b. section 304(b)(2)(A) -- measure dividend to A by reference toearnings and profits of Y (acquiring corporation), up to the amountof the distribution; if distribution exceeds Y's earnings and profits,then combine with earnings and profits of X (issuing corporation)to measure A's dividend

D. Section 304(a)(2) -- Parent-Subsidiary Acquisitions

Shareholder sells stock of parent corporation to subsidiary --

1. treated as a redemption of stock by parent -- section 302 applied to stockof parent

2. operating rules if transaction taxed as dividend (sections 302(d) and 301) -

a. section 304(b)(2) provides that the dividend is first deemeddistributed by the acquiring corporation to the selling shareholderto the extent of acquiring corporation's earnings and profits; andthen deemed distributed by the issuing corporation to the extent ofthe issuing corporation's earnings and profits

b. earnings and profits of corporation deemed making the distributionare reduced accordingly -- H.R. Rep. No. 861, 98th Cong., 2d Sess.1223 (1984) -- see Caamano v. Commissioner, 879 F.2d 156 (5thCir. 1989); Bhada v. Commissioner, 89 T.C. 959 (1987), aff'd, 892F.2d 39 (6th Cir. 1989); GCM 39280 (June 22, 1990) (section304(a)(2) does not apply where shareholder exchanges stock ofparent corporation for stock of subsidiary; subsidiary's stock is notproperty under section 317(a))

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XVIII. SECTION 303 -- REDEMPTIONS TO PAY DEATH TAXES

A. Section 303(a)

1. Policy -- allows payment of death taxes without forcing liquidation or saleof business

2. Redemption of stock is treated as a sale to the extent the distribution doesnot exceed

a. estate, inheritance and transfer taxes, and

b. funeral and administrative expenses

3. Statute applies even if the redemption would otherwise be taxed as adividend -- e.g., estate owns 100% of stock and redeems 50%

4. Little or no gain on redemption -- stepped up fair market basis on death

B. Limitations and Requirements

1. Stock must be owned by decedent at date of death and includible in estate-- Rev. Rul. 84-76, 1984-1 C.B. 91

2. The value of the stock must be more than 35% of the value of the adjustedgross estate

C. Rev. Rul. 87-132, 1987-2 C.B. 82 -- section 303(a) applies to distribution of cashby corporation to an estate in redemption of stock that is newly issued tocorporation's shareholders as part of same transaction; stock issuance nontaxableunder e 305(a)

XIX. EFFECT OF REDEMPTION ON THE CORPORATION

A. Recognition of Gain to the Corporation as a Consequence of a Distribution inRespect of Its Stock

1. Section 311(a) generally provides that a corporation recognizes no gain orloss on the distribution of property with respect to its stock

2. However, as noted above at Part VII.C., supra, new section 311(b)provides that a corporation must recognize gain where it distributesappreciated property in redemption of stock

a. old section 311 may apply to "qualified corporations" during thetransition period

b. if old section 311 applies, gain will not be recognized if an oldsection 311(d)(2) exception applies (exceptions are noted supra atPart VII.B.2.c.ii) -- see Esmark, Inc. v. Commissioner, 90 T.C. 171(1988), aff'd without published opinion, 886 F.2d 1318 (7th Cir.1989)

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B. Effect of a Redemption on the Corporation's Earnings and Profits

1. The adjustment to earnings and profits to reflect a redemption isdetermined in part by the characterization of the redemption at theshareholder level

a. if the redemption is taxed as a dividend under section 301,corporate earnings and profits are decreased pursuant to section312(a) by the sum of the amount of money, the principal amount ofthe corporation's own obligations and the adjusted basis (or fairmarket value if higher (see below)) of any property distributed

b. if a redemption qualifies as a sale or exchange under sections302(a) or 303, then earnings and profits are reduced in proportionto the stock redeemed -- section 312(n)(7)

(1) earnings and profits are not allocated to preferred stockunless the stock is convertible or participating -- aredemption of preferred stock results in a reduction of thecorporation's capital account only

(2) priorities are taken into account in determining the amountof earnings and profits allocable to different classes ofstock

2. If the corporation distributes appreciated property, additional adjustmentsto earnings and profits are required, regardless of the characterization ofthe redemption at the shareholder level

a. earnings and profits are increased by the amount of appreciation --section 312(b)

b. earnings and profits are reduced by the fair market value of thedistributed property

c. these rules apparently apply even if an old section 311(d)(2)exception is available (i.e., no gain recognized)

3. Withholding Issues

a. Rev. Rul. 92-85, 1992-2 C.B. 69 -- if (1) a redemption is treated asa deemed dividend under section 304(a)(1), (2) the dividend isdeemed to be paid in whole or part by a domestic corporation to aforeign corporation, and (3) the dividend paid by the domesticcorporation is U.S. source income, then the domestic corporation issubject to the withholding rules of section 1442 -- similarly, aforeign corporation in the same position is also subject to thewithholding rules unless it can establish that the dividend is foreignsource income -- see also Rev. Rul. 92-86, 1992-2 C.B. 99 (foreign

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tax credit implications if domestic corporation is deemed to receivea dividend from a foreign corporation under section 304(a)(1))

C. Deductibility by Corporation of Stock Redemption Expenses

1. Prior to TRA 86, some corporate taxpayers took the position that expensesincurred to repurchase stock from corporate raiders ("greenmailpayments") could be deducted

2. TRA 86 clarifies that no deduction is allowed for amounts paid or incurredby a corporation in connection with a redemption of its stock -- section162(k)(1)

a. amounts included under section 162(k) include amounts paid torepurchase stock, fees incurred in connection with such repurchase(i.e., legal, accounting, appraisal, and brokerage fees), and anyother expenditures necessary or incidental to the repurchase. SeeH.R. Rep. No. 426, 99th Cong., 1st Sess., at 249; S. Rep. No. 313,99th Cong., 2d Sess, at 223

b. payments made under agreements to refrain from purchasing stock("standstill agreements") also covered, provided there is actualpurchase of all or part of payee's stock -- H.R. Rep. No. 841, 99thCong., 2d Sess. II-169 (1986)

c. does not cover payments in discharge of contractual obligations orother rights

(1) examples:

(a) payments in litigation settlement

(b) obligations under employment contracts

(2) IRS will scrutinize payments made in proximity to stockredemption

d. Interest payments to shareholder remain deductible -- section162(k)(2)(A)

(1) corporation acquires own stock in exchange for debtinstrument

(2) interest payments are deductible; principal payments arenot

e. investment banking fees and printing costs incurred in response tohostile offers are deductible even if merger eventually takes place -- such costs seek to preserve the status quo, not to produce futurebenefits, and are therefore deductible -- A.E. Staley Mfg. Co. v.

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Commissioner, 97-2 U.S.T.C. (CCH) ¶ 50,521 (1997), rev'g 105T.C. 166 (1995)

f. the cost of acquiring property with a useful life substantiallybeyond the taxable year is a capital expenditure -- INDOPCO, Inc.v. Commissioner, 503 U.S. 79 (1992)

g. section 5881, added by OBRA 87, imposes an excise tax on anyshareholder who receives greenmail equal to 50% of the gain orother income recognized by such shareholder with respect to thegreenmail

3. The Small Business Job Protection Act of 1996 made two significantchanges to section 162(k)

a. Section 162(k) was amended to include not just redemptionexpenses, but expenses incurred in any acquisition of previouslyoutstanding stock of the corporation or any related person

(1) thus, the section 162(k) rules now apply to transactionstreated as a reorganization, a dividend, a sale of stock, orany other transaction involving a corporation's acquisitionof its own stock. House Committee Report on the SmallBusiness Job Protection Act of 1996, at CCH ¶11,055

(2) the amendment applies to amounts paid or incurred afterSeptember 13, 1995

b. Section 162(k)(2)(A)(ii) was added, it provides that thedisallowance rules of section 162(k)(1) shall not apply to any"deduction for amounts which are properly allocable toindebtedness and amortized over the term of such indebtedness"

(1) thus, corporations are permitted to amortize costsattributable to obtaining debt financing for reacquiring itsown (or a related party's) stock, and deduct them over theterm of the loan

(2) this new exception applies to amounts paid or incurred afterFebruary 28, 1986

(3) prior to the legislative change to section 162(k) in the SmallBusiness Job Protection Act of 1996, there were divergentauthorities on the issue of whether or not costs incurred bya target in obtaining loans to purchase target stock wereamortizable over the term of the loan. These divergentauthorities lead to the enactment of new section162(k)(2)(A)(ii), and are described below

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4. Divergent Authorities Prior to Legislative Change

a. In In re Kroy, 27 F.3d 367 (9th Cir. 1994), the Ninth Circuit heldthat loan fees incurred in obtaining a loan for a leveraged buyout("LBO") could be amortized and deducted over the term of theloan -- the court reasoned that, although the term "in connectionwith the redemption of stock" is critical, the fees were incurred ascompensation for services rendered in a "separate andindependent" borrowing transaction, and not in a redemptiontransaction

b. In Fort Howard Corp. v. Commissioner, 103 T.C. 345 (1994), theTax Court disagreed with In re Kroy, and held that costs incurredin debt financing an LBO (other than interest costs) arenondeductible under section 162(k) (prior to its change in 1996), aswell as nonamortizable -- the court noted that there would be noreason to have an interest exception in section 162(k) if financingcosts were not related to redemptions

c. The amendment to section 162(k) included in the Small BusinessJob Protection Act of 1996 effectively overruled Fort Howard. Infact, the Tax Court has issued a new opinion in Fort Howard,ruling that the amendment does not preclude the taxpayer in FortHoward from deducting and amortizing its financing costs and feesover the term of the loan. Fort Howard Corp. v. Commissioner,107 T.C. No. 12 (1996)

XX. LIQUIDATION OF THE CORPORATION

A. Concepts

1. Conveyance by the corporation to its shareholders of property inretirement of stock because of:

a. cessation of corporate activities (complete liquidation)

b. distinguish from redemption

(1) also a transfer in retirement of stock

(2) does not involve termination of a business

2. In liquidation, corporate stock is cancelled and shareholders succeed toownership of the corporate assets

a. corporation may sell assets and distribute cash in liquidation

b. corporation may distribute assets in kind and shareholders may sellor retain and operate business as sole proprietorship or partnership

3. Complete liquidation not defined in Code

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a. Treas. Reg. § 1.332-2(c) -- status of liquidation exists whencorporation ceases to be an ongoing concern and its activities aremerely for winding up affairs and paying debts

b. Olmsted v. Commissioner, 48 T.C.M. 594 (1984) -- liquidation is aprocess, not an event -- test for status of liquidation: (1) a manifestintent to liquidate, (2) a continuing purpose to achieve liquidation,and (3) corporate activities oriented toward liquidation

(1) distribution not in liquidation where intent to liquidate notshown -- Griffith v. Commissioner, 56 T.C.M. 1263(1989); Estate of Foster v. Commissioner, 56 T.C.M. 163(1988); Householder v. Commissioner, 56 T.C.M. 829(1988)

4. Distinguish from dissolution

a. liquidation is a Federal tax term -- relates to movement of assetsout of corporation -- conceptually a distribution

b. dissolution is a state law term -- relates to end of corporateexistence under state law

c. a corporation which is completely liquidated may or may not bedissolved under state law

d. the retention of a nominal amount of assets for the sole purpose ofpreserving the liquidating corporation's name will not prevent thetransaction from qualifying as a complete liquidation. Rev. Rul.84-2, 1984-1 C.B. 92

5. Plan of liquidation

a. informal plan of liquidation may be okay -- i.e., simply distributeassets

b. advisable to adopt formal written plan

B. Liquidation Provisions

TRA 86 substantially revised the liquidation provisions of the Code

1. Section 331 -- complete liquidation -- taxable to shareholder

2. Section 332 -- liquidation of a subsidiary -- tax-free to shareholder

3. Section 336 -- effect of liquidation on liquidating corporation -- taxabletransactions

4. Section 337 -- distributions to controlling shareholder -- tax-free

5. Section 338 -- purchase of stock treated as taxable purchase of assets

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XXI. SECTION 331 -- COMPLETE LIQUIDATION (EFFECT ON SHAREHOLDERS)

A. In General

1. Enacted in the Revenue Act of 1924

2. General liquidation provision

3. Applies to all classes of shareholders -- individuals, corporations, trusts,partnerships, estates

4. Does not apply to distributions to shareholder/ creditor in status as creditor-- Braddock Land Co. v. Commissioner, 75 T.C. 324 (1980); see alsoStoecklin v. Commissioner, 54 T.C.M. 452 (1987), aff'd, 865 F.2d 1221(11th Cir. 1989) (distributee held equity interest, not interest as creditor oremployee)

B. Statute

1. Section 331(a) -- distribution treated as in full payment in exchange forstock

2. Section 331(b) -- section 301 not applicable, i.e., no dividendconsequences attach

C. Tax Consequences to Shareholder

1. Shareholder is deemed to have sold his stock to the corporation inexchange for assets received in the liquidation

2. The shareholder recognizes gain or loss to the extent of the differencebetween the FMV of the assets received and the shareholder's basis in hisstock -- section 1001

a. gain or loss is usually capital gain or loss (unless sections 341,1246, 1248, 1291, dealer situations, or Corn Products doctrineapply) -- section 1221

(1) Arkansas Best Corp. v. Commissioner, 485 U.S. 212(1988), significantly narrowed the scope of the CornProducts doctrine holding that (1) a taxpayer's motivationin purchasing an asset is irrelevant to the question whetherit is a "capital asset" under section 1221, (2) hedgingtransactions in Corn Products fell within the inventoryexception and (3) stock constitutes a capital asset

(2) see also Circle K Corp. v. U.S., 23 Cl. Ct. 161 (1991)(source-of-supply stock purchase may qualify as a hedgingtransaction if it is an integral part of the company'sinventory-purchase system)

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b. nature of capital gain or loss will depend on the holding period forthe stock and when the stock is deemed to have been sold

(1) due to recent changes to the Code, this determination ismore complicated than previously. IRRA 98 reinstated thelong-term capital gain tax rate holding period of more thanone year, the holding period had recently been lengthenedto more than 18 months by TRA 97

(2) for assets sold after January 1, 1998, or between May 7,1997, and July 28, 1997:

(a) short-term capital gain tax rates apply if the assetwas held for less than one year (maximum rate of39.6%)

(b) long-term capital gain tax rates apply for assets heldmore than one year (maximum rate of 20%)

(c) generally, for assets sold after December 31, 2000,a lower long-term rate will apply for assets held formore than 5 years (maximum rate of 18%)

(3) for assets sold after July 29, 1997 and before January 1,1998:


(b) the prior long-term capital gain tax rates (nowcalled a "mid-term rate") apply for assets held morethan one year, but not more than 18 months(maximum rate of 28%)

(c) long-term capital gain tax rates apply for assets heldmore than 18 months (maximum rate of 20%)

(4) For assets sold before May 7, 1997:


(b) long-term capital gain tax rates apply for assets heldmore than one year (maximum rate of 28%)

c. example -- A owns 10 shares of X corporation stock which hepurchased on January 1, 1985, for $10,000 (1,000 per share) -- onJuly 1, 1989, X is liquidated and distributes $30,000 in cash to A

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gain to A:

cash $30,000less basis -$10,000LTCG $20,000

d. amount and character of gain determined on a per share basis

(1) if acquire stock in one block simply determine gain or lossfor entire block

(2) if hold several blocks of stock, determine gain or loss foreach block --can have gain on some and loss on others andbecause of different holding periods can have short-termand long-term gains and losses

e. example

A owns 10 shares of X stock -- 5 shares acquired on January 1,1995 for 12,000, and 5 additional shares acquired on January 15,1997 for 17,000 – on January 1, 1998, X is liquidated and Areceives $30,000 for his stock ($3,000 per share)

1995 shares 1997 shares

5 x 3,000 = 15,000 5 x 3,000 = 5,000less basis -12,000 less basis -17,000LTCG 3,000 STCL (2,000)

f. section 346(a), added by TEFRA, provides that a distribution shallbe treated as a complete liquidation if the distribution is one of aseries of distributions in redemption of all of the stock of thecorporation

(1) similar to section 346(a)(1) prior to TEFRA

(2) recover basis first, then report gain --Rev. Rul. 68-348,1968-2 C.B. 141

(3) if the shareholder holds several blocks of stock -- allocateeach distribution to each block of stock and recover basisfirst and then gain for each block -- Rev. Rul. 85-48, 1985-1 C.B. 126

(4) the Installment Sales Revision Act of 1980 initially createdsome doubt regarding the continued availability of costrecovery reporting under Rev. Rul. 68-348, supra, for serialliquidating distributions

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(a) section 453 provides for ratable basis recovery oninstallment sales -- an installment sale is nowdefined as "any disposition of property where atleast 1 payment is to be received after the close ofthe taxable year"

(b) serial liquidating distribution made over two ormore years would appear to meet this definition andshould constitute an installment sale

(c) thus, ratable basis recovery under section 453 ratherthan cost recovery under Rev. Rul. 68-348, supra,would appear appropriate

(d) Section 453(a)(2), added by the Ticket to Work andWork Incentives Improvement Act of 1999,generally repeals the use of the installment methodfor accrual method taxpayers effective for sales orother dispositions entered into on or after December17, 1999

(5) notwithstanding the Installment Sales Revision Act, Rev.Rul. 85-48, supra, continues to authorize cost recoveryreporting

(6) example --

A owns 30 shares of X stock -- 10 shares acquired in 1985for $10,000 and 20 shares acquired in 1989 for $40,000. In1991, X distributes $45,000 to A as part of a plan ofliquidation. In 1992 X makes a final distribution to A of$135,000

First Distribution

1985 shares

10/30 x 45,000 = $15,000less basis - $10,000LTCG $5,000

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1989 shares

20/30 x 45,000 = $30,000less basis - $40,000result -- no gain

Final Distribution

1985 shares

10/30 x 135,000 = $45,000less basis - 0LTCG $45,000

1989 shares

20/30 x 135,000 = $90,000less basis - $10,000LTCG $80,000

3. Time of the liquidating distribution -- the shareholder is deemed to havereceived a distribution on the date it becomes payable, regardless of whenthe shareholder turns in the shares for the cash distribution -- Rev. Rul. 80-177, 1980-2 C.B. 109

a. application of constructive receipt doctrine -- Treas. Reg. § 1.451-1(a) and -2(a)

b. compare to old section 337 liquidation -- constructive receiptdoctrine did not apply -- Vern Realty, Inc. v. Commissioner, 58T.C. 1005 (1972), aff'd, 73-1 U.S.T.C. d 9455 (1st Cir.)

c. shareholder transfers shares after liquidation process began butprior to distribution -- who is taxed on distribution -- if liquidationis a "sure thing" at time of transfer, transferor is taxed -- compareJacobs v. United States, 390 F.2d 877 (6th Cir. 1968) and Rushingv. Commissioner, 52 T.C. 888 (1969), aff'd, 441 F.2d 593 (5th Cir.1971) with Dayton Hydraulic Co. v. United States, 592 F.2d 937(6th Cir.), cert. denied, 444 U.S. 831 (1979) and Jones v. UnitedStates, 531 F.2d 1343 (6th Cir. 1976)

4. Non-pro rata distribution -- treated as a pro rata distribution to eachshareholder followed by a payment from one shareholder to another --Rev. Rul. 79-10, 1979-1 C.B. 140; cf. Rev. Rul. 83-61, 1983-1 C.B. 78

5. In-kind liquidating distributions

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a. valuation

the amount realized on an in-kind distribution of assets inliquidation is the fair market value of the assets on the date of thedistribution

(1) ordinarily, the valuation of assets distributed in liquidationis readily accomplished through an appraisal or otherestimate

(2) valuation problems may be presented by the distribution ofcontingent claims, contract rights, goodwill, mineralinterests, and other intangible assets

b. "open" versus "closed" transaction treatment -- where the value ofsome or all of the assets received by the shareholder cannot beascertained with reasonable accuracy, shareholders have beenpermitted to keep the transaction "open" until collection -- in thiscase, recognition of gain is deferred until the cash or the value ofthe property received by the shareholder exceeds his basis in hisstock -- the shareholder is permitted to recover his basiscompletely before reporting any gain on the liquidation

(1) as a result, under the open transaction method, ashareholder could delay reporting gain, while amountscollected later in excess of basis will be taxed as capitalgain

(2) in a "closed transaction," by contrast, an asset must bevalued at liquidation and any amount collectedsubsequently in excess of the estimated value will receiveordinary income treatment

(3) example -- open vs. closed transaction -- A is the soleshareholder of X corporation and X is liquidated

A's stock basis $50,000

A receives cash: $10,000 equipment (FMV): $30,000

contingent claim:

face amount $50,000 FMV $30,000 ultimately collected $40,000

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open closedtransaction transaction

cash $10,000 $10,000equipment $30,000 $30,000claim $40,000 collect $30,000 FMV $80,000 $70,000

less basis $50,000 $50,000gain $30,000 $20,000

-- under the open transaction model, no gain is recognizeduntil collection -- until then, the amount received is lessthan basis

-- under the closed transaction model, there is an immediate20,000 capital gain upon liquidation -- upon collection, theremaining 10,000 of gain is picked up as ordinary income

c. availability of open transaction treatment

(1) open transaction treatment was approved by the SupremeCourt in Burnet v. Logan, 283 U.S. 404 (1931)

(2) the IRS vigorously opposes the use of the open transactionmethod -- see Rev. Rul. 58-402, 1958-2 C.B. 15, whichstates that only on "rare and extraordinary" circumstanceswill an asset's value be considered to be unascertainable;see also Temp. Treas. Reg. § 15 A.453-1(d)(2)(iii); Webbev. Commissioner, 54 T.C.M. 281 (1987), aff'd, 90-1U.S.T.C. d 50,254 (8th Cir.) (method disallowed becauseproperty had a readily ascertainable value and thuspayments were not contingent); cf. Cloward InstrumentCorporation v. Commissioner, 52 T.C.M. 34 (1986), aff'dwithout published opinion, 842 F.2d 1294 (9th Cir. 1988)(distribution of contract rights to future payments notsusceptible of valuation)

(3) the enactment of the Installment Sales Revision Act of1980 raises doubts about the survival of the opentransaction method

(a) the Senate Finance Committee Report states that thecost recovery method will not be available in thecase of sales for a fixed price -- for contingentpayment sales, the Committee Report adopts theIRS' view that reporting methods other than theinstallment method are available only in the "rare

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and extraordinary" case when the fair market valueof the purchaser's obligation cannot reasonably beascertained -- S. Rep. No. 1000, 96th Cong., 2dSess. 24 (1980)

(b) installment reporting is not available in the contextof a liquidation (except as noted in paragraph (c)below). In light of the legislative history's aversionto open transaction treatment, and the unavailabilityof installment reporting, the shareholder of aliquidating corporation may be forced to apply theclosed transaction doctrine

(c) exception -- if in section 331 liquidation

• shareholder receives installment obligation

• acquired by corporation from sale or exchangeduring 12-month period beginning on date thatthe plan of liquidation is adopted

• and corporation liquidates within 12-monthperiod

then receipt of payment on obligation is treatedas receipt of payment on stock -- notes acquiredon sale of inventory qualify only if sale is a bulksale -- sections 453(h)(1)(A) and (B) -- and saleis to one person in one transaction (amended byTAMRA 88)

6. Corporate liabilities assumed by shareholder

a. reduce gain recognized by shareholder -- Ford v. United States,311 F.2d 951 (Ct. Cl. 1963)

b. unknown, speculative or contingent liabilities -- do not reduce gain-- later payment by shareholder (as transferee) relates back to gain-- if capital gain on liquidation, then capital loss on contingentliability stemming from liquidation -- see Arrowsmith v.Commissioner, 344 U.S. 6 (1952); Rev. Rul. 78-25, 1978-1 C.B.270; TAM 8617001

7. Basis of assets to shareholder

a. section 334(a) -- basis of property received is its fair market valueat time of the distribution

b. appreciated inventory

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(1) prior to TRA 86, shareholder received step-up in basis atcapital gain rates

(2) after TRA 86, shareholder still receives step-up but capitalgains are taxed as ordinary income, subject to section 1(h)capping the tax on net capital gains at 28% for individuals

c. character of gain on subsequent sale of assets depends on characterof assets in shareholder's hands

8. Liquidation/reincorporation

a. pre-TRA 86 strategies

(1) shareholder liquidates the corporation, retains the cash andimmediately reincorporates the operating assets undersection 351

(2) the corporation sells the operating assets to a relatedcorporation under old section 337, liquidates and distributesthe cash to the shareholder

b. tax consequences -- if treated as a liquidation

(1) capital gain to the shareholder

(2) stepped-up basis for the operating assets

(3) tax attributes disappear

c. substance of the transaction -- withdraw cash and leave operatingassets in corporate solution, i.e., a dividend

d. liquidation envisions termination of the corporation as an operatingentity

e. IRS will challenge

(1) in effect simply a dividend -- Treas. Reg. § 1.301-1(l);Treas. Reg. § 1.331-1(c); Rev. Rul. 61-156, 1961-2 C.B. 62

(2) section 368(a)(1)(D) reorganization -- Smothers v. UnitedStates, 642 F.2d 894 (5th Cir. 1981); Rose v. United States,640 F.2d 1030 (9th Cir. 1981); Viereck v. United States,83-2 U.S.T.C. ¶ 9664 (Cl. Ct.)

(3) DEFRA 84 amended the control definition for acquisitiveD reorganizations -- Section 368(a)(2)(H) (as redesignatedby TRA 86) adopts the control definition of section 304(c)which uses a 50% control test and applies the section 318constructive ownership provisions

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(4) lack of complete liquidation -- Telephone AnsweringService, Co. v. Commissioner, 63 T.C. 423 (1974), aff'dwithout published opinion, 546 F.2d 423 (4th Cir. 1976),cert. denied, 431 U.S. 914 (1977)

(5) Rev. Proc. 2000-3, section 4.01(23), 2000-1 I.R.B. 103 --IRS will not ordinarily rule on the tax effect of a liquidationfollowed by a reincorporation if more than 20% of thestock of the liquidated corporation and the newly formedcorporation are owned by the same shareholders

f. TEFRA repealed the partial liquidation provisions of section 346and substituted new section 346(b) -- this provision grants the IRSbroad authority to prevent taxpayers from accomplishing theeconomic equivalent of a partial liquidation and may permit theIRS to deal more effectively with liquidation/ reincorporationissues

g. effect of TRA 86

(1) imposition of corporate level tax and elimination of capitalgain rates (except for capping of capital gain rate forindividuals at 28%) reduces the advantages of liquidation/reincorporation scheme

(2) liquidation or sale to related corporation forces corporationto pay tax on appreciation in operating assets (35%) andshareholder must pay tax as well (28%) on subsequentdistribution

(3) still marginally better than dividend -- corporation still pays35% tax on earnings, but shareholder must pay 39.6% (notcapital gains rate) on dividend -- however, in the case of acorporate shareholder which can use the dividends receiveddeduction, a dividend is superior to a liquidation/reincorporation

9. Disclosure requirements

a. 30 days after the plan of liquidation is adopted the corporationmust file Form 966 with the District Director along with the planof liquidation -- Treas. Reg. § 1.6043-1

b. failure to file the form will not invalidate the liquidation -- Rev.Rul. 65-80, 1965-1 C.B. 154

c. the corporation files Forms 1096 and 1099L on or before February28 of year following the year of distribution

d. shareholders must disclose liquidation on their return

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XXII. SECTION 332 -- COMPLETE LIQUIDATION OF CORPORATE SUBSIDIARY(EFFECT ON CORPORATE SHAREHOLDER)

A. Introduction

1. General rule -- under section 331, a liquidation is treated as a sale orexchange and gain must be recognized

2. Section 332(a) exception -- gain (or loss) realized but not recognized byparent corporation on liquidation of subsidiary

3. This type of transaction is in the nature of a reorganization -- combiningbusiness operations rather than terminating

4. History

a. enacted in Revenue Act of 1935

b. encourage simplification of corporate structure through tax freeliquidation of subsidiaries

B. Requirements of Section 332

1. Section 332(b)(1) -- requires that parent corporation ("P") own on the datethe plan of complete liquidation is adopted, and every day thereafter untilthe receipt of the property, stock meeting the requirements of section1504(a)(2):

a. 80% of the total voting power of subsidiary corporation's stock("S") and 80% of the total value of stock

b. general intent is that other parts of section 1504(a) apply includingsections 1504(a)(4) and (5) (other than section 1504(a)(5)(E)) --H.R. Rep. No. 426 99th Cong., 1st Sess. 894 (1986)

c. thus, in applying 80% vote/80% value test -- nonvoting,nonparticipating, nonconvertible, limited and preferred stock isexcluded -- section 1504(a)(4)

(1) see also Treas. Reg. § 1.1504-4 for regulations issued undersection 1504(a)(5)(A) and (B) that treat certain options asexercised, certain warrants as stock, and certain stock asnot stock -- according to Notice 87-63, 1987-2 C.B. 375,such regulations will not apply to liquidation plans adoptedunder section 332(b)(1) on or before the date theregulations were published in proposed form (i.e., March 2,1992) -- applies also to old sections 337 and 338(d)(3))

d. the aggregate stock ownership rules of Treas. Reg. § 1.1502-34, inwhich all stock owned by members of an affiliated group that filesa consolidated return is taken into account, apply for purposes of

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determining whether a member satisfies the 80% test of section332(b)(1) -- see also Rev. Rul. 89-46, 1989-1 C.B. 272

2. Section 332(b)(2) -- S, pursuant to a plan of liquidation which does notspecify the time for distribution, must distribute all of its assets incomplete liquidation in one taxable year, or

3. Section 332(b)(3) -- S, pursuant to a plan of liquidation, must distribute allof its assets in complete liquidation within three years from the close ofthe year the first distribution is made

4. S need not be formally dissolved pursuant to state law -- Rev. Rul. 84-2,1984-1 C.B. 92

5. P need not continue S's business following the liquidation -- Rev. Rul. 70-357, 1970-2 C.B. 79; but see Fairfield S.S. Corp. v. Commissioner, 157F.2d 321 (2d Cir.), cert. denied, 329 U.S. 774 (1946); TAM 8837003(circumstances evidenced an intent of S corporation to acquire Tcorporation's assets by purchasing T's stock to be followed by a liquidationunder section 332; because S's stock ownership of T was transitory and forthe end purpose of acquiring T's assets, T cannot be deemed to beaffiliated with S and parent corporation and may not join in theconsolidated return)

6. Redemption of all stock required

a. for section 332 to apply, P must receive a distribution with respectto "all its stock" -- sections 332(b)(2) and (3) -- if more than oneclass of stock held, then distribution must be made as to each class

b. Spaulding Bakeries, Inc. v. Commissioner, 252 F.2d 693 (2d Cir.1958), aff'g, 27 T.C. 684 (1957), nonacq. 1957-2 C.B. 8 --liquidation did not meet section 332 requirements wheredistribution made only with respect to nonvoting preferred stockand not common stock

(1) taxpayer could argue common stock should be ignoredwhere it has zero equity -- see Helvering v. AlabamaAsphaltic Limestone Co., 315 U.S. 179 (1942)

(2) alternatively, recapitalization prior to liquidation to convertinto one class of stock -- but see Rev. Rul. 68-602, 1968-2C.B. 135

c. Tax Court reaffirmed Spaulding principle -- H.K. Porter Co. v.Commissioner, 87 T.C. 689 (1986)

(1) subsidiary did not have sufficient assets to pay liquidationpreference on preferred stock

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(2) therefore, section 332 did not apply; no distribution incancellation of "all its [parent's] stock" -- i.e., the stock theparent owned in the subsidiary

7. Tax consequences to S if section 332 not met -- following TRA 86, if theliquidation does not qualify under section 332, the distributions will befully taxable to the liquidating corporation -- new sections 336 and 337

C. Avoid or Comply with Section 332

1. Avoid application of section 332

a. sell sufficient stock to reduce interest below 80% betweenadoption of plan and distribution

b. spread distributions out over more than three years

c. section 332 does not apply even if sole motive was to avoid thestatute -- Avco Manufacturing Corp. v. Commissioner, 25 T.C. 975(1956)

d. effort to avoid application unsuccessful -- Associated WholesaleGrocers, Inc. v. United States, 720 F. Supp. 887 (D. Kan. 1989),aff'd, 927 F.2d 1517 (10th Cir. 1991) -- step transaction doctrineapplied; sale of stock not bona fide -- section 332(a) applied todeny taxpayer capital loss treatment

e. if section 332 does not apply, subsidiary is taxed under section 336

2. Comply with section 332 -- acquire stock shortly before the plan isadopted

a. Rev. Rul. 75-521, 1975-2 C.B. 120 -- purchase stock from thirdparty to reach 80% -- section 332 applied because purchase ofshares occurred prior to plan of liquidation

b. Rev. Rul. 70-106, 1970-1 C.B. 70 -- redemption of minorityshareholder to increase P's interest to 80% -- section 332 does notapply because redemption was part of the plan of liquidation

(1) but see Madison Square Garden Corp. v. Commissioner, 58T.C. 619 (1972), aff'd in part and rev'd in part, 500 F.2d611 (2d Cir. 1974); George L. Riggs, Inc. v. Commissioner,64 T.C. 474 (1975)

(2) a similar issue exists in section 338 -- Temp. Treas. Reg. §1.338-3T(b)(5) provides that a redemption from anunrelated person is taken into account for purposes ofdetermining whether the percentage ownershiprequirements of section 338(d)(3) are satisfied

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D. Effect of Section 332

1. P recognizes no gain or loss

2. The basis of the assets in the hands of S carries over to P -- section334(b)(1) -- see also TAM 9003005 (basis of property not limited to FMVon date of distribution)

3. P's basis in S stock disappears

4. P succeeds to the tax attributes of S -- section 381 (net operating losses,capital loss carryovers, earnings and profits, etc.) -- note possibleapplication of section 269(b), enacted in DEFRA 84

a. but see Russell v. Commissioner, 832 F.2d 349 (6th Cir. 1987),which held that the parent corporation could not carryback anNOL of its subsidiary which liquidated pursuant to section 332 andold section 334(b)(2) because basis stepped up

b. see also section 384(a)(2), added by OBRA 87, which limits acorporation that acquires the assets of its subsidiary in a section332 liquidation from offsetting any built-in gain of the subsidiarywith any preacquisition loss of any other corporation unless at least50% of the stock (by vote and value) of the subsidiary was heldthroughout the 5-year period ending on the acquisition date by theacquiring corporation or members of its affiliated group

5. Examples Ex. 1 Ex. 2

P's basis in S stock 100,000 100,000S's basis in assets 40,000 135,000FMV of assets 75,000 125,000

Ex. 1FMV of assets 75,000less basis of stock 100,000realized loss (25,000)(not recognized)

P takes S's basis in assets = 40,000if P sells assets, will have 35,000 gain

Ex. 2FMV of assets 125,000less basis of stock 100,000realized gain 25,000(not recognized)

P takes S's basis in assets = 135,000

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if P sells assets, will have a (10,000) loss

E. Method of Effectuating Liquidation Under State Law -- Dissolution v. Merger

1. Dissolution

a. may require in-kind distribution of interest in assets to allshareholders

b. problems of conveyancing are substantial

(1) transfer title

(2) notify creditors

(3) publish in newspapers

c. if there are minority shareholders

(1) issue of division of property

(2) taxable transaction to minority shareholders

(3) distributing corporation realizes gain or loss with respect toproperty distributed to minority shareholders

2. Merger (S into P)

a. no distribution of assets required -- ownership of S assetsautomatically vests in P

b. minority shareholders of S receive stock of P in exchange forshares of S or, alternatively, they dissent and receive the cash valueof their shares

c. for tax purposes the transaction qualifies as a liquidation to P undersection 332 even though it is treated as a merger for state law --section 332(b) (last paragraph)

F. Tax Consequences to Minority (20% or Less) Shareholders

1. Section 332 only applies to P

2. Minority shareholders generally fit under section 331 -- recognize gain orloss

3. If combination of P and S consummated by merger, minority shareholdersmay receive P stock in a tax free transaction

G. Intercorporate Liabilities

1. S owes money to P

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a. if S is indebted to P, its assets will be used to pay off debt as wellas cancel stock in liquidation

b. pre-1954 -- S recognized gain if it used appreciated property tosatisfy liability

c. new section 337(b)(1) (replacing section 332(c)) -- S recognizes nogain or loss on payment of P debt in liquidation

d. new section 337(b)(1) does not protect P -- if P's basis in the debtis below its face P will recognize gain when paid by S (P buys Sbond from third party at a discount) -- Treas. Reg. § 1.332-7; butsee section 108(e)(4)

e. section 334(b)(1) -- basis of assets used to satisfy debt carry overfrom S to P

2. P owes money to S

a. note from P held by S and distributed to P in liquidation -- noincome to P, treated as a distribution of property under section 332-- Rev. Rul. 74-54, 1974-1 C.B. 76

3. S is insolvent -- liabilities exceed fair market value of assets

a. if S is insolvent, section 332 does not apply -- the distribution of itsassets to P is in partial satisfaction of debts and P receives nodistribution on its S stock

(1) Treas. Reg. § 1.332-2(b) -- section 332 applies only if Preceives at least partial payment for its stock

(2) see Inductotherm Industries, Inc. v. Commissioner, 48T.C.M. 167 (1984) (solvent because corporate shareholderadvances held to be equity; section 332 available);Continental Grain Co. v. Commissioner, 56 T.C.M. 900(1989) (fact that no debt instruments were drafted orreflected on books or tax returns did not preclude finding ofsubsidiary indebtedness)

b. since section 332 does not apply, attributes (including NOL) do notcarry over to P

c. P is entitled to a loss deduction to the extent of its basis in the Sstock

d. section 165(g) -- worthless security is generally a capital loss

e. section 165(g)(3) -- P may be entitled to an ordinary loss if

(1) P owns 80% of the S stock

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(2) over 90% of S gross receipts is not passive type income(rents, royalties, dividends, interest, etc.)

f. Rev. Rul. 68-602, 1968-2 C.B. 135 -- P cannot cancel its debt to Sin order to make S solvent and thereby fit into section 332

H. Ruling Requests

Rev. Proc. 90-52, 1990-2 C.B. 626 -- sets forth information to be included in asection 332 request for ruling

XXIII. SECTIONS 336 AND 337 -- DISTRIBUTION IN COMPLETE LIQUIDATION(EFFECT ON CORPORATION)

A. Treatment of Liquidating Distributions -- Section 336

1. General rule

a. corporation recognizes gain or loss on distribution as if it soldproperty at FMV to the distributee shareholder -- section 336(a)

b. FMV may not be less than amount of liability which shareholderassumes or to which property is subject -- section 336(b)

(1) nature of liability as recourse or nonrecourse is apparentlyirrelevant

(2) unclear how unsecured liability will be allocated todistributed property for purposes of computing gain tocorporation

2. Limitation on loss recognition -- section 336(d) -- TRA 86 drafters wereconcerned that the general loss recognition rule could be abused throughcontributions of built-in loss property -- three anti-abuse provisions wereadded:

a. distributions to related persons -- no loss may be recognized on adistribution to a "related person" unless the distribution is pro rataand property was not acquired within 5 years as contribution tocapital or in a section 351 transaction

(1) "related person" -- defined in section 267(b) -- includesshareholders owning 50% (by value) of corporation's stock

(2) loss can be disallowed even though there was no "built-inloss" at time of contribution

(3) unclear whether recipient shareholder may reduce gain (ifany) on a subsequent disposition to the extent of lossesdisallowed on the liquidation -- cf. section 267(d)

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b. contributions where prohibited purpose exists -- shareholdercontributes built-in loss property to corporation -- a principalpurpose is to recognize loss upon corporate sale or distribution --basis in corporation's hands must be reduced by amount of lossinherent at time of contribution

(1) any property acquired within 2 years in a section 351transaction or as a capital contribution -- presumed to havebeen transferred with the forbidden purpose

(2) period begins 2 years prior to adoption of the plan ofliquidation and continues thereafter -- section336(d)(2)(B)(ii)

(3) regulations may provide exceptions where:

• there is a "clear and substantial" relationship betweenthe contributed property and the conduct of acorporation's current or future business

• loss results from disposition of the assets of the trade orbusiness (or a line of business) and a "meaningfulrelationship" exists between the business and thecorporate form, i.e., the contributed business is notdisposed of immediately after the contribution

• the corporation acquires assets within its first two yearsof existence

c. loss limitation in section 332 liquidations -- section 336(d)(3) -- noloss may be recognized by the corporation with respect to anydistribution to minority shareholders in a section 332 liquidation --see section 337

3. Distributions or sales of subsidiary stock -- special election under section336(e)

a. under regulations to be issued, an election may be made to elect totreat a sale, distribution or exchange of stock in a "controlledcorporation" as a disposition of all of the assets of such controlledcorporation

(1) corporation is a "controlled corporation" if its parent owns80% of the voting power and 80% of the value of the stockin the corporation

(2) unclear whether some stock may be sold and somedistributed

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(3) election apparently not available until regulations areissued

b. section 336(e) -- no gain or loss on actual stock transfer

c. section 336(e) applies principles similar to section 338(h)(10)

(1) section 336(e) election is not tied to section 338 election bythe buyer as is section 338(h)(10)

(2) section 336(e) election may be made regardless of whethercontrolled corporation stock is "purchased" -- cf. section338(d)(3)

d. purpose of the election -- to avoid multiple taxation at corporatelevel on the same economic gain where appreciated stock istransferred without commensurate basis step-up in underlyingassets

example:

P owns all of the stock of S. P liquidates and distributes S stock toA, its sole shareholder. S later is liquidated by A. A triple tax maybe imposed as follows:

(1) P recognizes gain upon distribution of S stock to A

(2) A recognizes gain upon disposition of his P stock inliquidation of P

(3) S recognizes gain upon its subsequent liquidatingdistributions to A

e. it is unclear how the section 336(e) election will impact minorityshareholders

example:

individual B owns all of the stock of P. P owns 80% of the stockof S. P and S do not file consolidated returns. The other 20% of Sis owned by individual A. P distributes all of the S stock it owns(80%) to B and makes a section 336(e) election to treat thetransaction as an asset sale by S

(1) which entity will recognize the gain on the deemed assetsale, P or S?

(2) if the gain is taxed to P, A receives a windfall since he nowowns stock in S which has a stepped up basis in its assets

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(3) if the gain is taxed to S, A suffers a detriment because thetax liability imposed upon S will reduce the value of A'sstock in S

4. Exception to recognition rule

gain or loss under section 336 will not be recognized for distributionspursuant to a plan of reorganization -- section 336(c) -- see also section361(c)(4)

B. Section 337 -- Liquidating Distributions to an 80% Distributee

1. section 337(a) -- no gain or loss on liquidating distributions to an "80-percent distributee"

a. "80-percent distributee" is "only the corporation which meets the80-percent stock ownership requirements specified in section332(b)" -- section 337(c)

b. section 332(b) contains an 80% vote and value test. See PartXXII.B.1, supra

c. OBRA 87 amended section 337 to provide that the determinationwhether any corporation is an 80% distributee is made withoutregard to any consolidated return regulation

2. The distributee must meet the 80% ownership test on the date that the planis adopted and at all times thereafter until receipt of the property

3. The controlling corporate shareholder takes a carryover basis in thedistributed property -- section 334(b)(1)

4. Section 367(e)(2) provides that nonrecognition treatment under section337 is not available in the case of liquidations of controlled domesticsubsidiaries into foreign parent corporations -- see Notice 87-66, 1987-2C.B. 376 -- TAMRA 88 clarified that a non-liquidating transfer to aforeign corporation that would otherwise qualify as a tax-freereorganization is treated in the same manner -- this rule does not apply ifthe domestic transferor corporation is 80% controlled by five or fewerdomestic corporations (counting members of an affiliated group as onecorporation) -- see section 367(a)(5)

5. Distributions to minority shareholders in complete liquidation taxedgenerally as nonliquidating distributions -- gain but not loss is recognized

a. prevents the liquidating corporation from selectively recognizinglosses by distributing loss property to minority shareholders

b. rule applies only to extent that property is actually received byminority shareholders

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6. Gain or loss is recognized if the 80% distributee is a tax-exemptorganization (other than a section 521 cooperative) unless suchorganization uses such property in an unrelated trade or business and theincome is subject to tax under section 511(a) -- section 337(b)(2), asamended by TAMRA 88

7. OBRA 87 added section 337(c) to eliminate mirror transactions -- underthis provision, a subsidiary member of a consolidated group will recognizegain upon its complete liquidation to the extent any of its shareholdersown less than 80% of the liquidating subsidiary stock

8. Section 337(d) instructs the IRS to issue regulations to assure that thecongressional purpose in repealing the General Utilities doctrine is notcircumvented through the use of any provision of law or regulations orthrough the use of a RIC, REIT or tax-exempt entity. The legislativehistory also indicates that the IRS is expected to issue regulationspreventing the avoidance of the repeal of General Utilities throughcontributions of property with built-in loss to a corporation before itbecomes an S corporation

a. The IRS has issued regulations under section 337(d) thatimplement aspects of the repeal of the General Utilities doctrine bylimiting losses of consolidated groups with respect to the stock ofsubsidiaries for certain transitional periods

(1) Treas. Reg. § 1.337(d)-1 coordinates section 337(d) withthe consolidated return loss deferral rules

(2) Treas. Reg. § 1.337(d)-2 provides a transitional rule thatallows loss to the extent that the consolidated groupestablished that the loss is not attributable to therecognition of built-in gain

(3) Prop. Treas. Reg. § 1.337(d)-3 provides rules to preventtaxpayers from using a partnership to avoid section 337(d) -- see also Notice 89-37, 1989-1 C.B. 679

(4) Treas. Reg. § 1.337(d)-4 provides that generally, acorporation must recognize gain or loss when it transfers allor substantially all of its assets to a tax-exempt entity orconverts from a taxable corporation to a tax-exempt entity -- the regulations are effective as of January 28, 1999. SeeT.D. 8802

b. The IRS has issued temporary regulations under section 337(d) toprevent the avoidance of corporate level taxation of net built-ingain of corporate assets through RICs or REITs. See T.D. 8872,65 F.R. 5775-5777 (Feb. 7, 2000)

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(1) Temp. Treas. Reg. § 1.337(d)-5T(a)(3) requires acorporation that transfers its assets to a RIC or REIT in acarryover basis transaction to recognize gain as if it sold theassets at their fair market value and immediately liquidated

(2) Temp. Treas. Reg. § 1.337(d)-5T(b) permits the transfereeRIC or REIT, in lieu of the deemed corporate liquidation,to be subject to tax under section 1374. Net built-in loss,however, may not be recognized. Temp. Treas. Reg.§ 1.337(d)-5T(a)(4)

(3) the temporary regulations are effective retroactively as ofJune 9, 1987

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