ELKINS_Corporate Tax I & II_Fall 2021
Table of Contents
NONLIQUIDATING DISTRIBUTIONS
2
EXTRAORDINARY DIVIDENDS
HOLDING PERIOD (INDIVIDUALS)
DISTRIBUTIONS OF PROPERTY
DISTRIBUTION OF SERVICES
3
7
13
15
STOCK DIVIDENDS
17
SECTION 306
24
REDEMPTIONS
30
INTRODUCTION; CONSTRUCTIVE OWNERSHIP
SUBSTANTIALLY DISPROPORTIONATE REDEMPTIONS
REDEMPTIONS NOT ESSENTIALLY EQUIVALENT TO A DIVIDEND
REDEMPTION THROUGH RELATED CORPORATIONS
30
33
46
58
COMPLETE LIQUIDATIONS
64
TRANSFER OF PROPERTY TO CORPORATION IN EXCHANGE FOR STOCK
73
INTRODUCTION AND REQUIREMENTS
BOOT; ASSUMPTION OF LIABILITIES
73
83
1
Nonliquidating Distributions
A.
B.
C.
D.
E.
F.
Dividends as Income; Dividend Received Deduction; Holding Period (corps)
(154-56; 180-82)
Classifying distrubutions by corp:
a. Taxable dividend,
b. Nontaxable return of capital
c. Gain from a sale of SH’s stock
Distributions in Many forms:
a. Corporation may distributre its own stock or debt olibations; redeem (repurchase)
stock from its SHs by distributing cash/property; or distribute its net assets iin
liquidation of entire business
Croproate and SH level tax treatment of nonliquidating distrubitons of cash or property –
i.e. dividends
§ 301
a. 301(c)(1) distributions that are “dividends” included in Gross Income
§ 316(a) – Dividend Defined:
a. Dividend is any distribution of property made by a corp to its SHs out of (1)
earnings and profits – “accumulated earnings and profits” OR (2) earnings and
profits of the current taxable year – “current earnings and profits”
i. Two irrebuttable presumptions: every distribution is deemed to be made
out of earnings and profits to the extent that they exist and is deemed to be
made from the most recently accumulated E/Ps
ii. Most dividends represent an increase in the SH’s wealth rather than a return
of capital – e.g., existence of accumulated E/Ps will cause a distribution to
be classified as a dividend even if those profits were earned before SH
acquired his stock.
DRD
a. Dividends received by noncorporate SHs are taxed at preferential long-term cap
gains trates
b. Distributions that aren’t dividends are first treated as recovery of the SH’s basis in
his stock, and any excess over basis is treated as gain from the sale or exchange of
the stock.
i. Distributions to member of consolidated group  100% DRD  receiving
corp reduces basis in stock by distribution amt (reg § 1.1502-13(f)(2)(ii)
1. [Distributions by S corps generally are tax-free to extent fo SH’s basis, and any
ecess is treated as gain from a sale of S corp stock (§ 1368(b))]
Testing for Dividend status:
c. Regs first look to current E/P, dx’d as of the close of the taxable year in which
distribution made – Thus a distribution out of current earnings and profits is
taxable dividend even if the corp has a historical deficit
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Dividends Received Deduction (DRD)
d. Code §§ 243(a)(1), (3), (c); 246(a)(1), (b)(1), (c); 246A; 1059(a)-(e)(1)
G. §243:
a. Most Corps = 50 % DRD
b. Small business investment  100%
c. Increased to 65 percent if the corp SH owns 20% or more (by vote and value) of
the distributing corp - § 243(c)
d. Increased to 100 percent for certain “qualifying” dividends if the payor and
recipient corps are members of same affiliated group – 243(a)(3)
Holding Period:
H. (why – b/c the DRD (dividend received deduction) may motivate corp SHs to convert
capital gain -taxable at 21% max corp rate – to tax sheltered dividend income – taxable at
a max rate of 10.5%)
I. (ex-dividend date is the first date tha a buyer of the stock w/ respect to which a dividend
has been declared is not entitled to receive the dividend)
J. § 246(c) – common stock – denies deduction unless stock held for more than 45 days
during the 91-day period beginning on the date which is 45 days before the stock goes exdividend - § 243(c)(1)(A)
K. § 246(c)(2) – preferred stock dividend – holding period is 90 days during the 181-day
period beginning on the date which is 90 days before the ex-dividend date
i. * 45 or 90-day period is tolled whenever the corp SH diminishes its risk of
loss with respect to the stock in any one of several specified manners –
consequently, a corp is not entitled to the dividends received deduction
unless it is willing to hold the stock and incur a genuine market risk for
the requisite period of time - §246(c)(4) & Reg § 1.246-5
Extraordinary Dividends
[Purpose: If dividend is extraordinarily large in relation to price of stock, a corp SH may incur a
minimal risk of loss even if it holds the stock for more than 45 days.]
§ 1059: corporate SH receiving an extraordinary dividend  reduce basis by amount of
“nontaxed” (i.e. deductible) portion of dividend IF corp not held stock more than two years
before the “dividend announcement date”
a. “Announcement date = the earliest date when the distributing corp declares,
announces or agrees to the amt or payment of the dividend.
b. Basis only reduced by “nontaxed” portion = total amt of div reduced by taxable
portion, i.e., the portion of div included in GI after DRD
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c. If nontaxed portion EXCEEDS AB, excess treated as gain from Sale/exchange of
property (in tax yr ED (extraordinary div) received)
Extraordinary Dividend if dividend received equals or exceeds threshold percentages 
o 5% of SH’s adjusted basis for most Preferred Stock and
o 10% of the AB if Common Stock, or any other stock
o
o
o
o
o
Dividends with ex-div dates within 85 consecutive days combined and treated as one
dividend - §1059(c)(3)(A)
Dividends in 365 consecutive days are extraordinary IF aggregate dividends exceed 20%
of AB – § 1059(c)(3)(B)
Distribution NOT extraordinary IF stock held for entire corp existence or predecessor
corp – § 1059(d)(6); (a)(1), (d)(5)
Alternate Test  TP may elect to dx the status of a dividend as extraordinary by
reference to the FMV (not AB) of stock as of day before the ex-dividend date – must
establish FMV to satisfaction of Commissioner.  beneficial if stock appreciated
substantially from time it was acquired.
A 301 dist. to CORP SH treated as ED if distribution is in redemption of stock which is:
a. (1) part of Partial Liquidation of redeeming corp – 302(e), OR
b. (2) non pro-rata as to all SHs
c. Doesn’t matter  Holding Period & Size of Dist
d. § 1059(e)(1)
Corporate SHs only – relief from multiple taxation via § 243 dividends received deduction
(DRD
1059(e) - Special Rules for Certain Distributions
o (e)(1) partial liquidations and certain redemptions:
o (A) in case of any reemption of stock –
 (i) which is part of partial liquidation,
 (ii) which is not pro rata to all SHs, OR
 (iii) which would not have been treated as a dividend if (I) any options had
not been taken into accound under 318(a)(4), or (II) 304(a) had not applied,
o THEN  any amt treated as div w/r/t above redemptions is treated as ED w/o
regard to holding period. RE (iii) above – only basis in stock redeemed taken into
account re ED.
o Distributions b/t an affiliated group that qualify 100 % DRD under are NOT treated as
extraordinary dividends – 1059(e)(2)
o “qualified preferred dividends” = which are defined as dividends payable w/ respect to
any share of stock which provides for fixed preferred dividends payable not less than
annually AND was not acquired with dividend in arrears
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a. Qualified preferred dividend is not treated as extraordinary dividend if the
dividends received by the SH during the period it owned the stock do not exceed
an annualized rate of 15% of the lower of (a) the SH’s adjusted basis OR (b) the
liquidation preference of the stock, AND the stock is held by the SH for over five
years.
i.
ii.
1059 not “bad arrangement,” works pretty well. ONLY applies in first two years b/c
(preacquisition earnings is problem)
To reduce tax liablity, makes sense to take money out . . . .
a. Should congress shut this “tax abusive” technique down? NO, nothing abusive
about this, simply self-help, getting to right result.
i. When is pulling out dividend before selling abusive?
1. If youre talking about PRE-ACQUISITION EARNINGS  creating
artificial loss. SO, key Q = whether earning distributed are preacquisition or post-acquisition earnings.
2. Pre = abusive; post = not abusive
ii. (if pull dividend out before selling, reducing your capital gains)
b. Commissioner: not going to view it as pull out dividend then sell; no distinction
against pre-acq vs. post-acq . . . treat them the same.
Bootstrap Sales
Dividends in Bootstrap Sales
Avoid pre-sale div treated as shame * pull out note before start talking to potential
company (to sell to); and make sure not in exchange of sell, i.e. dividend must be completely
separate from negotiations to sell company.
Purpose of Business Purpose Test re dividend = stop double-taxation; NOT to make corps act
more “business-like”
i. ** if can show pulled out dividend for business purpose, then court will
uphold form.
TSN Liquidating Corp.  pre-sale dist. of sub’s assets, b4 sub’s ultimate sale, treated as div;
NOT part of purchase price
F: TSN owned 90% subsidiary CLIC – CLIC had stock/notes for small public corps not
frequently traded; TSN wanted to sell CLIC sub to Union Mutual which didn’t want CLIC’s
small corp stocks/notes, so after Purchase Agmt signed but b4 closing CLIC declared dividend
in-kind. Closing next day. On tax return, TSN reported dividend and claimed 85% DRD w/r/t
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CLIC’s distribution. IRS – treated CLIC dist as part of sale so added CLIC’s stock dist. Price to
purchase price.
I: Whether pre-sale dist. of CLIC’s assets b4 CLIC’s sale treated as (1) dividend, or (2) part of
sale price?
H: TSN wins. The pre-sale distribution by CLIC to its SHs (TSN) of assets which Union
Mutual did NOT want, would not pay for and did not ultimately receive, is a dividend for tax
purposes, and not part of the purchase price of the capital stock of CLIC.
R:
o Transaction viewed as whole
o Agmt to distribute assets as div was part of purchase agmt & motivated specifically
by Buyer’s unwillingness to take/pay for assets distributed
o Business Purpose controls  bus purpose behind div explains div re Buyer did NOT
want assets and told TSN to take them before sale
o There is no evidence that there was any tax avoidance motivation by TSN.
b. Coffey – Ct said div, not sale  Smith Bros selling corp but certain assets hard to
value so agmt w/ buyers that Smith Bros will distribute those hard-to-value assets
to corp as div b4 ultimate sale (thus eliminating need to value those assets/stock)
i. Factors:
1. Purchase price consideration expressly excluded those assets
distributed as div
2. Buyers didn’t want those assets
3. Buyers negotiated with Smith Bros to exclude those assets
c. Waterman Steamship – Shame div; “substance over form”
i. Transaction form  (1) subs give Waterman note for $2M payable in 30
days as dividend, (2) 1hr after, Waterman agreed to sell subs stock for
$700k; (3) 30 mins later, after closing, Subs’ new board authorized sub to
borrow $2M from Buyer to pay-off $2M note to Waterman (which not yet
due).
ii. H: distribution part of purchase price; not dividend  CT treated div and
sale as one-transaction b/c note “was but one transitory step in a total, prearranged plan to sell stock.” Subs acted as “mere conduit” for pymt of
purchase price to Waterman (thus, subs didn’t actually declare or pay div)
iii. Factors:
1. Waterman rejected the original offer re straight sale  instead made
sale two-step transaction - Waterman wanted to sell subs for original
offer price but disguised $2M as div so there’ll be no taxable gain.
2. No intent to remove assets from subs b4 sale
3. Distribution financed by Buyer but paid thru subs to disguise div
4. Doesn’t matter that Pan-Atlantic issued its note to Waterman before
the closing agreement was signed, the “creation of a valid
indebtedness cannot change the true nature of the transaction”
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d. IRS also cited Basic: the assets distributed as a pre-sale dividend was promptly
transferred to the buyer while in this case the distributed assets were retained by
the target corp’s SHs.
e. PROF  Waterman’s argument should be: substance is not sale, it’s a distribution
and then a sale!  selling right to already accumulated earnings and then selling
the actual stock as well.
Presale dividend still viable (i.e. don’t have to reduce stock basis by div amt)  if the
selling parent corp has held the stock of a subsidiary for more than 2 years before div
announced AND parent & sub corps don’t file consolidated return.
 Problem of pre-sale div of unwanted assets when dist. requires reduction in basis (e.g.,
1059) b/c gain re div offset by subsequent sale of sub stock.
Holding Period (individuals)
Holding period:
(1) the common stock re dividend paid must have been held by the TP for more
than 60 days in the 121-day period beginning 60 days before the stock’s exdividend date
(2) Preferred stock – 91 days during the 181-day period beginning 90 days
before the ex-dividend date for preferred dividends - §1(h)(11)(B)(iii)
(3) (under exchange rules – ex-dividend date is typically three days before the
date on which SHs of record are entitled to receive a declared dividend
(4) (w/o holding period rule, TP could acquire stock shortly before becoming
entitled to a dividend, sell the stock at a cap loss that could offset short-term
cap gain OR up to $3,000 of ordinary income if the TP has no cap gains, but
still pay tax on the dividend at the preferential rate.)

Earnings and Profits
(1) Code: § 312(a), (c), (f)(1), (k)(1)-(3); 316(a); skim 312)n_
 1.312-6(a): E&Ps – in dx-ing amt of E/P due consideration given to facts and, while mere
bookkeeping entires inc/dec-ing surplus will not be conclusive, the amt of E/P in any case
will be dependent on the method of accounting employed in computing TI.
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o E.g., a corp keeping books and filing income returns under subchapter E on cash
receipts and disbursements basis my NOT use accrual basis in dx-ing E/P; a Corp
computing income on installment basis under 453 will compute E/P on installment
basis.
-6(b) – In computing Corp’s E/P, items included are income exempted by statue, income
not taxable by Fed Govt under Const., and all items includible in GI under § 61.
o Gains/losses within 1002 are brought into E/P at time and to the extent such
Gains/losses are recognized under 1002.
o Interest on bonds and other obligations, alto not taxable when received by Corp, is
taxable as other dividends when distributed to SHs in the form of divdends.
-6(d) – a loss sustatined for a year before the taxable year does NOT affect the T/P of the
taxable year.
1.312-7(b)(1) – Effect on E/P of gain/loss realized:
o The gain/loss realized increases/dec the E/P to the extent to which such gain/loss
was recognized in computing taxable income under law applicable to year in which
such sale/disposition made.
312(a) – Effect on E/P – Distribution of Property by a corp w/r/t its stock, the E/P of
corp will be decreased by the sum of –
o (1) the amt of money,
o (2) the principal amt of the obligations of such corp (if obligation has OID, the
aggregate issue price of obligation), and
o (3) the AB of other other property distributed
(c) – Adjustments for Liabilities – for adjustments to E/P under (a)-(b), adjustment
should be made for –
o (1) the amt of any lial bity to which the property distributed is subject, and
o (2) the amt of any liablity of the corp assumed by a SH in connection w/ the
distribution.
(f)(1) – Effect on E/P of G/L and of Receipt of Tax-Free Distributions –
o Gain or loss so realized shall increase or decrease the earnings and profits
to, but not beyond, the extent to which such a realized gain or loss was
recognized in computing taxable income under the law applicable to the year
in which such sale or disposition was made
o For purposes of this subsection, a loss with respect to which a deduction is
disallowed under section 1091 (relating to wash sales of stock or securities),
or the corresponding provision of prior law, shall not be deemed to be
recognized.
 (k) – Effect of Depreciation on Earnings and Profits
EARNINGS AND PROFITS – distribution is only dividend when taken from Corp’s E/P
b. Function of E/P: measuring device used to dx the extent to which a distribution is
made from a corp’s economic income as opposed to its taxable income or paid-in
capital.  meant to measure economic performance of corp.
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c. No statute of limitations on E/P issues
Corp’s Taxable Income (TI) must be adjusted to find correct E/P
 Traditional Approach - start w/ Corp’s Taxable Income and make below adjustments:
(1) items excluded from TI are added back to TI:
1. Items that represent true financial gain but are exempt from tax are
included in E/P (e.g., municipal bond interest, life insurance proceeds
and federal tax refunds and otherwise excludable discharge of
indebtedness income) unless coupled w/ basis reduction under §
1017))
(2) Items deducted in dx-ing TI are added back to TI:
1. Certain deductions and benefits allowed in computing taxable income
which do not reflect a real decrease in corporate wealth are not
permitted or are restricted in dx-ing E/P
2. a deductible item that involves no actual expenditure:
a. § 243 dividends received deduction
i. [The depletion allowance must be based on the corp’s
cost of a depletable asset even if the corp deducts
percentage depletion in computing taxable income]
(3) Certain Nondeductible items are SUBTRACTED
1. Some items not allowed as deductions in computing TI in fact
represent actual expenditures that diminish a corp’s capacity to pay
dividends. These items reduce E/P to pay div so added back!
2. federal income taxes (only cash method corp) paid during the year
subtracted from TI
3. losses and expenses disallowed under provisions such as § 265
(expenses allocable to tax-exempt income, § 267 (losses b/t related
TPs) and § 274 (travel and entertainment expenses) and charitable
contributions in excess of the ten percent corp limitation = ALL
SUBTRACTED from TI
4. Net Operating Losses and Capital Losses in excess of gains reduce
earnings and profits in the year they are incurred - may not be carried
back or forward in dx-ing E/P (to avoid double tax-benefit)
(4) Certain timing adjustments must be made:
1. [Variety of adjustments req’d to override timing rules that allow corps
to artificially defer income or accelerate deduction in computing
taxable income]
2. IF dist to 20% controlled Corp SH  312(n) adjustments don’t
apply  effect = reduct E/P only in dx-ing amt of div to major corp
SHs. (to prevent abuse of DRD)
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3. Corp can’t use generally applicable accelerated cost recovery
system (ACRS) of § 168 in dx-ing E/P –> Effect = corp inc TI by
excess of accelerated dep allowed
a. INSTEAD, the cost of depreciable property must be recovered
in computing E/P under the alternative depreciation system, RE
straight line method using specially prescribed and generally
longer recovery periods than ACRS.
i. Rule applies to property expensed under § 168(k)
ii. * The corp thus must increase its taxable income by the
excess accelerated deprecation allowed for tax purposes.
4. If corp elects to expense the cost of eligible property under § 179,
it must amortize that expense ratably over 5 years in dx-ing E/P
5. Realized gains that are deferred under Installment Sale Method
(453) OR by Completed Contract Method MUST be included in
E/P
a. Also, for E/P purposes, gains on the sale of inventory must be
reported under the first-in-first-out (FIFO) method rather than
the Last-in-first-out (LIFO) method.
Distributions of Cash
Code: §§ 301(a)-(c); 312(a); 312(a)
301 – Distributions of Property
o (a) a distribution of property (def 317(a)) made by a corp to SH w/r/t its stock is
treated provide in subsec (c).
o (b)(1) Amt Distributed – the amt of any distribution will be the amt of money
received plus the FMV of other property received
 (2) Reduction for Liabilities – the amt of any distribution shall be reducted
(not below 0) by –
 (A) amt of any liability of corp assumed by the SH in connection w/
distribution, AND
 (B) the amt of any liability to which the property received by the SH
is subject immediately before, and immediately after, the distribution.
o (c) Amount Taxable
 (1) Amt Constituting Dividend – that portion of distribution which is
dividend will be included in GI
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 (2) Amt Applied against Basis – that portion of the distribution which is not
a dividend will reduce stock’s basis.
 (3) Amt in Excess of Basis
 (A) portion of dist that isn’t a dividend, will be treated as gain from
sale/exchange of property IF non-div portion exceeds the AB of the
stock
 (B) Distributions out of Increase in Value accrued b4 1913 –
exempted from tax
1.301-1(a) – Rules Applicable re Dist. of Money and Other Property
o (a) General. Section 301 provides the general rule for treatment of distributions on or after June 22, 1954,
of property by a corporation to a shareholder with respect to its stock. The term property is defined in section
317(a). Such distributions, except as otherwise provided in this chapter, shall be treated as provided in section
301(c). Under section 301(c), distributions may be included in gross income, applied against and reduce
the adjusted basis of the stock, treated as gain from the sale or exchange of property, or (in the case of
certain distributions out of increase in value accrued before March 1, 1913) may be exempt from tax.
The amount of the distributions to which section 301 applies is determined in accordance with the provisions of
section 301(b). The basis of property received in a distribution to which section 301 applies is determined in
accordance with the provisions of section 301(d). Accordingly, except as otherwise provided in this chapter,
a distribution on or after June 22, 1954, of property by a corporation to a shareholder with respect to its stock shall
be included in gross income to the extent the amount distributed is considered a dividend under section 316
b. Amount of distribution is amount of money SH received. This amount is taxable as
a dividend to the extent of corp’s current E/P
c. Amts distributed in excess of available earnings and profits are first applied against
– and reduce – the basis of SH’s stock  if amt exceeds SH’s basis, amt
distributed treated as gain from the sale/exchange of stock. – 301(c)(2), (3)
d. For Corp – can reduce its E/P by the amount of money distributed – only if E/P
exists – 312(a)
(1) * i.e. a deficit in E/P can’t be created or increased by a distribution – must
have E/P to distribute cash to SHs
RULES re Insufficient Current E/P to Cover All Cash Dists.
* When there isn’t enough current E/P to cover all cash distributions during the year, E/P must
be allocated to the distribution in order to dx dividend status under following rules:
(2) First, current E/P – dx’d as of end of year – are prorated (allocated) among
the distributions via formula:
1. Current E/P allocated to distribution =
a. Amount of distribution X (Total current E/P / Total
distributions)
(3) Next, accumulated E/P are allocated chronologically to distributions – i.e. on
a first-come, first-served basis)
(4) If the corp has a current loss but has accumulated E/P from prior years, dx
the amount of accumulated E/P available on the date of distribution. Unless
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the loss can be earmarked to a particular period, the current deficit is
prorated to the date of the distribution. Reg 1.316-2(b)
1. i.e if distribution on 7/1 and $5,000 deficit in E/P for year, as of
distribution $2,500 is prorate to date of distribution.
RR 74-164
e. X corp and Y corp made distributions of $15,000 to SHs, no other
distributions that year. Distributions taxable under § 301(c)
f. Situation 1: a beginning of year, X corp had accumulated E/P of $40,000;
operating loss of $50,000; and current E/P of $5,000
(1) Entire distribution is dividend re § 316 - $5,000 of distribution of $15,000
was from current E/P and rest of $10,000 from accumulated E/P
g. Situation 2: At beginning of year, Y corp had deficit in E/P of $60,000; net
profits were $75,000 (from jan 1 thru June 30); current E/P of $5,000:
(1) b/c Y corp only had $5,000 current E/P and no accumulated E/P  only
$5,000 of Y’s distribution to Shs was a dividend re §316. Balance of
distribution - $10,000 – was NOT a dividend, and is applied against/reduced
adjusted basis of stock, and if exceeds adjusted basis of stock it is a gain
from sale/exchange of property
h. Situation 3: same facts as in situation 1 except that X had a deficit in current
E/P of $5,000:
(1) ** if deficit in current E/P, the taxable status of distributions is dependent
upon the amount of E/P accumulated and available at dates of distribution.
(2) ** Reg 1.316-2(b) – deficit in current E/P will be prorated (allocated) to the
dates of distribution.
(3) SO  Accumulated E/P $40,000 – [E/P current deficit from 1/1 to 7/1
($5,000) prorated to date of distribution on 7/1 (1/2 of $5,000)] 2,500 =
$37,500 total E/P avialble on 7/1  37,500 - $15,000 (distribution on 7/1) –
(E/P deficit from 7/1 to 12/31) 2,500 = $20,000 total accumulated E/P
balance on 12/31
i. Situation 4: same facts as in 1 except that X had deficit in current E/P of
$55,000:
(1) [Accumulated E/P 1/1] 40,000 – 27,500 [E/P for entire year (55,000) prorate
to date of distribution (1/2 of 55,00)] = 12,500 total E/P available on 7/1
(2) 12,500 [total E/P available on 7/1] – 12,500 [distribution on 7/1 that is
taxable as dividend out of 15,000] – 27,000 [e/P deficit from 7/1 tru 12/31]
= 27,500 total accumulated E/P balance on 12/31
(3) ** Note however, Under reg. § 1.316-2(b), if deficits were sustained in the
first half of 1971, the FULL deficit (not just half) would reduce the
accumulated E/P available to characterize the 7/1 distribution as dividend.
How Distribution Treated:
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 Dividend portion of Dist. (def 316) is included in SH’s GI;
 Non-Div portion of Dist. applied against/reduces stock basis;
 Portion that exceeds AB (and not from inc in value before 1913) treated as gain from
sale/exchange of property.
Dividend Defined
316(a): “dividend” means any distribution of property made by a corp to SHs out of
accumulated E/P OR out of current E/P w/o diminution by reason of any distribution made
during year, and without regard to the amount of E/P at the time the distribution was made
Return of Capital Distribution
** If distribution is not a dividend, § 301(c)(2) first requires a reduction of stock basis and, once
basis is zero, §301(c)(3) treats the remainder of distribution as gain from the sale of stock
(usually cap gain)
Multiple Tax Lots
If SH has multiple tax losts of stock, Q of whether the SH recovers his aggregate basis before
recognizing gain, or whether distribution must be allocated pro rata to each shore of stock is not
“crystal clear.”
1. IRS indicated that is continues to believe that under current law, the
results of a section 301 distribution should be based on the
consideration received by a SH in respect of each share of stock
Distributions of Property
[Profits form he sale of appreciated corporate property are taxed twice – first to the corp when it
sells the property and again to the SHs when the sales proceeds are distributed as dividends. ]
SH:
 If corp distributes appreciated property to SHs, the SHs receive a taxable dividend to the
extent the distribution is out of current or accumulated earnings and profits (E/P).
CORP:
A. Corp distributes appreciated property (not own obligations) in a nonliquidating
distribution  CORP recognizes gain equal to FMV of property over AB (i.e. FMV –
AB)
B. Loss Disallowed when distribution of property has declined in value – 311(a)(2)
C. Liability Assumed  then, FMV of property is not less than amt of liability
i. Applies when distributed property is subject to liability OR if SH assumes
liability in the distribution
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Effect on the distribution Corp’s Earnings and Profits
D. Code §312(a)(3), (b), (c), (f)(1); Reg §1.312-3
a. Gain recognized by the corporation on the distribution increases current earnings
and profits.
b. Following property distribution, the corp may reduce accumulated earnings and
profits under §312(a)(3) by the adjusted basis of the distributed property.
c. Distribution of Appreciated property, rule modified by §312(b)(2) - E/P reduction
rule in 312(a)(3) is applied by substituting the FMV of the property of its adjusted
basis.
i. Allows corp distributing appreciated property to make downward adjustment
to accumulated E/P in amt equal to FMV of property.
ii. ** SO, net result of these E/P adjustments – first re gain recognized on
distribution and second to effect of distribution itself – is the same as if the
corp had sold the property (increasing current earnings and profits by the
gain recognized) and then distributed cash equal to the FMV of the property
(decreasing accumulated E/P by that amount) .
d. §312© “proper adjustment” re liabilities assumed by SH or which property is
subject to.
i. Regulation §1.312-3  proper adjustment is a reduction in the §312(a)(3)
charge to earnings and profits for liabilities assumed or to which the
property is subject.
ii. * Thus, adjustment decreases the charge to earnings and profits and properly
reflects fact that relief from the liability is an economic benefit to the
distributing corp.
Distributions of a Corp’s own obligations
e. Gain recognition rule does not apply to distributions by a corp of its own debt
obligations
f. SH - both the amt of distribution and the SH’s basis = FMV of the obligation
g. CORP - Distributing Corp’s E/P are reduced by principal amt of obligation.
Consequences to the SHs
E. Code: §301(a)-(d)
a. Amt of distribution is the FMV of the distributed property, reduced by any
liabilities assumed by the SH or to which the property is subject (dx’d as of date of
distribution); that amt taxed under §301©
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Distribution of Services
IRC §§ 482, 7872(a), (b)(1), (c)(1)(C), (3); Reg. § 1.482-2(c)(1), (2)(i)
482 – Allocation of Income and Deductions among TPers
 In the case of any transfer (or license) of intangible property (within the meaning of section 367(d)(4)),
the income with respect to such transfer or license shall be commensurate with the income attributable to
the intangible. For purposes of this section, the Secretary shall require the valuation of transfers of
intangible property (including intangible property transferred with other property or services) on an
aggregate basis or the valuation of such a transfer on the basis of the realistic alternatives to such a
transfer, if the Secretary determines that such basis is the most reliable means of valuation of such
transfers.
7872 – Treatment of Loans w/ Below-Market Interest Rates
 (a) Treatment of Gift Loans and Demand Loans –
o (1)re below-market loan and is gift loan or demand loan, the forgone interest shall be treated as
(A) transferred from lender to borrower, and (B) retransferred by borrow to Lender as interest.
o (2) Time when Transfers Made: any forgone interest shall be treated as transferred and
retransferred on the last day of calendar year
 (b) Treatment of Other Below-Market Loans:
o (1) re below-mrkt loan (a)(1) doesn’t apply to, the lender shall be treated as having transferred on
the date the loan was made, and borrower treated as having received cash in amt equal to the
excess of
 (A) the amt loaned, over
 (B) the present value of all pymts which are req’d to be made under the terms of the loan.
 (c) (1)(C) – applies to Corporate-Shareholder Loans – any below-mrket loan directly or indirectly b/t a
corp and any SH of such corp
Nicholls, North, Buse Co.
a. F: Nicholls corp was owned by Herbert Resenhoeft, his wife and two sons. Herbert
previously owned two boats: pea picker I & II. Nicholls corp bought new yacht –
pea picker III – for 68,290 and Nicholls board approved purchase and provided
that any expenses for PERSONAL use of boat attributed to Herbert. Herbert was
charged 1,144 for personal use of boat for the year.
i. Service originally took position that Herbert was taxable on entire 68k
purchace price plus boat expenses, later argued that Herbert was only
taxable on a dividend equal to the fair rental value of Pea Picker III.
b. I: all regarding petitioner Herbert
i. Was there a constructive dividend
1. Yes – any expenditure made by a corp for the personal benefit of its
SHs, or the making available of corporate -owned assets/facilities to
SHs for their personal benefit, may result in the receipt of a
constructive dividend by SHs.
2. Here, evidence concludes that boat was used fro business purposes
25% and for personal purposes 75%  thus, the 75% personal use
was a constructive dividend (but to whom?)
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ii. May the use of the boat by Herbert’s son James, a SH of Nicholls corp, be
imputed to his father who was in control of the corp so that Herbert is the
recipient of the constructive dividend; and
1. Herbert def received a benefit when he was present on the boat while
it was used fro personal use. The fact that others were personally
benefiting doesn’t matter re Herbert b/c he enjoyed “in the friendships
and social activity.”
2. Can Herbert’s son’s personal use of boat be imputed to Herbert when
Herbert wasn’t present on boat during personal use? YES
a. Elements underlying taxation of assigned income to the
assignor = Helvering v. Horst  “the power to dispose of
income is the equivalent of ‘ownership’ of it and the exercise of
that power to procure the payment of income to another is the
enojoyment and hence the realization of the income by hime
who exercises it.”
b. Here, power was manifestly in Herbert’s power – Herbert
personally owned over 50% of all voting stock and was
president of Nicholls corp and on its board. It was Herbert’s dx
to acquire boat and his decision to allow the use of the boat by
his sons as they wished and w/o direct control over how they
used it (i.e., Herbert knew how the boat was being used by his
sons for personal enjoyment and he didn’t stop it)
c. Principle of assignemtn was applied to constributive dividends
in Byers v. Commissioner  Thus, since Herbert was in
complete control of the events, the fact that James primarily
used the boat for personal reasons or was a SH of the corp is
IRRELEVANT.  i.e. son’s use of boat imputed to Herbert.
iii. Is the dividend the purchase price of boat plus actual operating expenses OR
the fair rental value of the use of the boat?
1. Proper measure of dividend = fair rental value
a. Louis Greenspon – Ct held that continued corporate ownership
of farm equipment used by SH meant that the constructive
dividend to the SH was NOT the purchase price of the
equipment. (however, in cases where the amount of the
dividend was the acquisition cost, the SH either had clear
ownership OR title couldn’t be located so was presumptively
owned by SH)
2. Not acquisition cost b/c:
a. Here, since ownership continued to rest with Nicholls corp,
petitioner did NOT receive a constructive dividend equivalent
to cost of acquisition of boat.
3. Fair Rental Value:
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a. After considering all evidence, including rental value of similar
craft, Ct held that the full rental value of Pea Picker III was
$4,000, of which he already paid 1,144.72. Since Herbert
gained personal benefit and thus received a constribtive
dividend from his own use and the use of the crafty by his sons
equaling 75 percent of the rental value.
b. Thus, Herbert owes 75% of the rental value (4,000) = $3,000.
He already paid 1,144.72, thus Herbert must recognize income
of 1,855.
Stock Dividends
A. Stock dividend = a distribution of stock [or rights to acquire stock – 305(d)(1)] by a corp
to some/all of its SHs.
B. If distributed stock is of the same class of the SH’s underlying holdings, a stock dividend
is similar to “stock split.”
a. Only difference is stock dividend requires the corp to transfer an appropriate amt
from retained earnings to paid-in capital while a stock split usually increases the
number of outstanding shares w/o any adjustment to the corporate capital account.
b. Reverse stock split decreases the number of shares outstanding.
c. Dividend v split? – usually drawn by the rx of the number of shares distributed to
the previously outstanding shares
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i. (e.g. ?N?Y? stock Exchange says a distribution of less than 25% of shares
outstanding prior to the distribution is stock dividend. Larger distributions
(e.g. distributions of one share for each share held) is a stock split.
C. But, stock dividend doesn’t need to be of the same class of stock as SH’s existing stock.
(e.g. preferred stock can be distributed re common stock, and vice versa)
D. Objectives:
a. Dividend – public company pays small “common on common” stock dividends
instead of cash to give SHs sense of their corp earnings increasings, while
company gets to retain cash for business us.
b. Split – prompted by desire to increase the number of outstanding shares and thus
reduce the price per share in attempt to increase marketability (and market value)
of the stock by making stock more attrative to smaller investors.
c. However, see close corporation business objectives  stock distibutions frequently
are used to shift corporate control.
i. [recapitalization frequently used as alternative method for making
adjustment to the corp’s cap structure – may provide more favorable income
tax results]
ii. E.g., family wants to shift control of business to son. Doesn’t want o use fit
of common stock b/c wealth or gift tax liablity. SO, family distributes new
class of preferred stock to son. The preferred stock could be structured w/
dividend rights and a liquidation preference so that its value absorbs most of
the net worth of the comdpany, leaving the common stock w/ only nominal
value.  distribution of preferred stock to son will be tax-free (however the
preferred stock would be § 306 stock assuming corp has E/P - §305(a))
E. § 305
a. Governs tax consequences of stock distribution – provides that gross income does
not include a distribution of stock by a corp to its Shs w/ respect to its stock. –
however, exceptions in 305(b)
b. [e.g., (if tax-free distribution of preferred stock to son, and corp has ample E/P and
father retained his common stock, father could sell the preferred stock to Facilitator
for cash and, after a short tiem period, crop could redeem the preferred stock from
Facilitator for a share premium)  when dust settled, this series of transactions
had viturally the same economic effect as a cash distribution by corp to father –
father has cash in hand, corp’s treasury has been depleted, and father still owned
100% of the company. But tax consequences dramatically different  Rather than
being stuck w/ a taxable dividend, father wanted “sale” treatment on the
disposition of the preferred stock.
i. Sale treatment enabled father to recover his basis in the preferred stock
and to recognize a long-term cap gain to the extent the amount realized
on sale exceeded his basis.
ii. However, since Section 306 stock, § 306(a)(1) will characterize father’s
amount realized to sale to Facilitator as ordinary income.
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Taxation of Stock Dividends Under § 305
c. Towne v. Eisner (1918) – Sup Ct concluded that a stock dividend was not
“income” or “dividends” under Revenue Act of 1913.
i. Eisner v. CMacomber –Mrs. Mcaomber, a common SH of a corp w/ no other
class of stock outstanding, received a proportionate distribution of additional
common stock.
d. Proportionate interest test – a stock dividend was taxable if it increased a SH’s
proportionate interest in the corporation.
i. Helvering v. Sprouse – Sup CT dx’d that a pro rata distribution of nonvoting
common stock to a SH owning voting common stock was nontaxable b.c it
did not change the proportionate interests of the SHs
ii. Strassburger v. Commissioner – Ct held that a distribution of cumulative
nonvoting preferred stock to the corp’s sole SH was not taxable b/c “both
before and after the event he owned exactly the same interest in the net value
of the corp as before”
F. Senate F?inance Committee Report on Tax Reform Act of 1969
a. Proportionate interest test (stock dividend was taxable if it increased any SH’s
propeertionate interst in corp] eliminated in 1954
b. IRS reg 1969: brings into §305(b) a number of methods of achieving the effect of a
cash dividend so some SHs and a corresponding increase in the proportionate
interest of other SHs – result that SHs who receive increases in proportrionate
interest are treated as receiving taxable distribuitons:
c. Committee b elieves that dividends paid on preferred stock should be taxed
whether they are received in cahs or another form, such as stoc,, rts to receive
stock, or rights to receive an increased amount on redemption.
d. §305(b)(1) – a stock dividend is taxable if it is payable at the election of any SH in
property instead of stock.
e. 305(b)(2) – if there is a distribution or series of distributions of stock which has the
result of the receipt of cash or other property by some SHs and an increase in the
proportionate interests of other Shs in the assets or earnings and profits of the corp,
the SHs receiving stock are to be taxable.
i. E.g. if a corp has two classes of common stock, one paying regular cash
dividends and the other paying stock dividends (common or preferred) the
stock dividens are to be taxable.
f. But, if a corp has a single class of common stock and a class of preferred stock
which pays cash dividends and is not convertible, and it distributes a pro rata
common stock dividend w/ respect to its common stock, the stock distribution is
not taxable b/c the distribution does not have the result of increasing the
proportionate interests of any of the SHs.
g. In dx-ing whether there is a disproportionate distribution, any security convertible
into stock or any rt to acq stock is to be treated as outstanding stock.
i. E.g. if a corp has commong stock and convertible debentures outstanding,
and it pays interest on the debentures and stock dividends on the common
19
stock, there is a disproportionate distributin, and the sjtock dividends are to
be taxed under § 301.
ii. Also, in dx-ing if disproportionate distribution re SH, each class of stoc must
be considered separately.
h. 305(b)(3)- if a distribution or series of distributions has the result of the receipt of
preferred stock by some common SHs and the recdeipt of common by other
common Shs, all of the SHs aree taxable under 301 on the receipt of stock
i. 305(b)(4) – distributions of stock re preferred are taxable.
i. All distributions on preferred stock except increases in the conversion ratio
of convertible preferred stock made solely to take account of stock dividends
or stock splits w/ respct t othe stock into which its convertible stock is
convertible (???)
j. 305(b)(5) – a distribution of convertible preferred stock is table unless it is est to
the statifaction of Secretary that it will not have the result of a disproportionate
distribution.
i. E.g. if a corp makes a pro rate distribution on its common stock of prefrred
stock convertible into common at a price slightly higher than the market
price of the common stock on the date of distribution, and the period during
which the stock must be converted is 4 months, it is likely that a
distribgution would have result of disproportionate distribution.
ii. On other hand, if stock convertible for 20 yr period from date of issuance,
likelihood that substantially all of stock would be converted into common,
and there would be no change in the proportionate interest of the common
Shs.
k. ** 305(c) – a change in conversion ratio, redemption price, difference b/t
redemption price and issue price, a redemption treated as a §301 distribution, or
any transaction (including recapitalization) having similar effect on interest of any
SH is treated as a distribution w/ respect to each SH whose proportiote interest is
thereby increased.
i. Allows secretary to deal w/ transactions that have effect of distribution, but
in which stock is not actually distributed.
G. Revenue Ruling 78-60
a. Issue 1: Under § 302(a), whether the stock redemptions described below qualified
for exchange treatment?
b. Issue 2: whether under § 305(b)(2) and (c) the SHs who experienced increased in
their proportionate interests in the redeeming corp as a result of the stock
redemptions will be treated as having received distributions of property to which
§301 applies?
c. Redemption
i. Corp Z has only one class of stock outstanding; 24 SHs (all descendants of Z
corp founder). Z corp had 6,000 shares of common outstanding in 1975
when board adoped plan of annual redemption (means by which SHs can
sell stock).
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ii. Plan provides that Z will redeem up to 40 shares per year at price set by
directors. Each SH can redeem two-thirds of one percent (0.66%) of SH’s
stock each year.
iii. In 1976, Z corp redeemed 40 shares, 2/ 8 SHs participating in the
redemptions.
1. (after redemption, each SH owned less than 13% of corp before and
after redemption, and after redemption each SH’s actual and
constriuctive ownership was at least 97% of its ownership before
redemption).
d. Law Issue 1:
i. Section 302(a) – if a corp redeems its stock, and if § 302(b)(1), (2), or (3)
applies, the redemption will be treated as a distribution in part or full
payment in exchange for the stock.
1. (but see 302(d) – stock redemption treated as distribution of property
where 301 applies IF 302(a) doesn’t apply to a stock redemption!)
ii. Section 302(b)(1) – 302(a) will apply if the redemption is not essentially
equivalent to a dividend.
iii. Section 302(b)(2) – 302(a) will apply if redemption is substantially
disproportionate w/ respect to the SH unless the redemption is made
pursuant to a plan the purpose/effect of which, in the aggregate, is not
substantially disproportionate w/ respect to the SH.
iv. Section 302(b)(3) – 302(a) applies if all the stock of the corp owned by the
SH is redeemed.
v. Section 318(a) – rules of constructive stock ownership applied to subchapter
C.
vi. Section 302(c)(1) – constructive ownership rules of § 318(a) apply in dx-ing
the ownership of stock for purposes of § 302.
vii. Section 302(d) – a stock redemption to which § 302(a) does NOT apply will
be treated as a distribution of property to which 301 applies.
viii. 302(b)(1) – redemption “not essentially equivalent to a dividend”
1. 1.302-2(b) – Q of whether a distribution in redemption of stock is not
essentially equivalent to a dividend depends on facts and
circumstances.
2. US v. Davis – for a redemption to qualify as not essentially equivalent
to a dividend under 302(b)(1), the redemption must result in a
meaningful reduction of the SH’s proportionate interest in the corp.
The business purpose of the redemption is IRRELEVANT to this
determination and that the ownership attribution rules of 318(a) apply.
3. If SHs experienced reductions in their proportionate interests in Z
corp, the reductions must be “meaningful”  if “meaningful”
reduction, then SHs entitled to exchange treatment under 302(a).
21
e. H 1: none of the redemptions qualified for exchange treatment under 302(a) –
thus all redemptions must be treated as distributions of property to which 301
applies.
i. None of redemptions here qualify under 302(b)(3) b/c all of the SHs who
participated in the redemptions continue to own Z corp stock.
ii. None of redemptions qualify for 302(b)(2) b/c none of the SHs who
participated experienced a reduction in interest of more than 20%, as req’d
by 302(b)(2)(C).
iii. Thus, real first issue = whether the redemptions were “not essentially
equivalent to a dividend” within meaning of 302(b)(1)
1. Z corp SHs did experience reduction in their proportionate interests in
Z corp, but must dx if reductions were “meaningful” which depends
on facts and circumstances.
2. Here, None of the reductions in proportionate interest were
“meaningful” b./c the reductions were small and each SH had the
power to recover the lost interest by electing not to participate in the
redemption plan in later years.
a. (important fact is that the redemptions were not isolated
occurrences but were undertaken pursuant to an ongoing plan
for Z corp to redeem 40 shares of its tack each year)
f. Law Issue 2:
i. 305(b)(2) – 301 will apply to a distribution by a corp of its stock if the
distribution, or series of distributions that includes the distribution, has the
result of the receipt of property by some SHs, and increases in the
proportionate interests of other SHs in the assets or earnings and profits of
the corp.
ii. 305(c) – a redemption treated as a 301 distribution will be treated as a 301
distribution to any SH whose proportionate interest in the E/P or assets of
the corp is increased by the redemption.
iii. 1.305-7(a) – a redemption treated as a 301 distribution will generally be
treated as a distribution to which §§ 305(b)(2) and 301 apply IF the
proportionate interest of any SH in the E/P or assets of the corp is increased
by the redemption, and the distribution has the result described in §
305(b)(2).
iv. 1.305-3(b)(3):
1. For a distribution of property to meet the req’s of 305(b)(2), the
distribution must be made to a SH in the capacity as a SH and must be
a distribution to which 301 applies
2. A distribution of property incident to an isolated redemption will NOT
cause 305(b)(2) to apply even tho the redemption distribution is
treated as a 301 distribution.
v. 318(a) constructive stock ownership rules do NOT apply to Section 305.
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g. H 2: the 16 SHs of Z corp who did NOT participate in the redemption are
deemed to have received stock distributions to which 305(b)(2) and 301 apply.
i. 16 SHs who did NOT tender stock for redemption experienced increases in
their proportionate interests of the E/P and assets of Z corp as a result of the
redemptions
1. (we’re not taking into account constrictive stock ownership rules of
318)
ii. SHs B and X – who surrendered small amounts of their stock – also
experienced increases in their proportionate interests.
iii. The redemptions were not isolated but were undertaken pursuant to an
ongoing plan of annual stock redemptions.
iv. Finally, the redemptions are to be treated as distributions of property to
which section 301 applies.
H. NOTES:
I. Collateral Tax Consequences:
a. The collateral tax consequences off a stock distribution (e.g. basis, holding period,
and effect on E/P) depend on whether the distribution is taxable to SHs.
b. If distribution taxable . . .
i. Taxable distributions governed by rules in Section 301
ii. Amount of distribution = FMV of stock - 1.305-1(b)(1)
1. Applies to corporate SHs too 1.301-1(d)(1)(ii)
2. Noncorporate Shs, taxable stock dividends may be “qualified” and
eligible for the preferential rates under Section 1(h)(11)
iii. SH takes a FMV basis in the distributed stock, and his holding period runs
from the date of the distribution.
iv. Distributing corp recognizes no gain/loss under Section 311(a)(1), and it
may reduce its E/P by the FMV of the distributed stock. 1.312-1(d)
c. If stock distribution is NON-taxable . . .
i. Nontaxable under Section 305(a) . . . SH must allocate the basis in the stock
held prior to the distribution b/t the old and new stock in proportion to the
relative FMVs of each on the date of distribution (§307(a)), and the holding
period of the old shares may be tacked on in dx-ing the holding period of the
distributed stock. §1223(4).
ii. Distributing corp recognizes no gain/loss on the distribution, and it may
NOT reduce its E/P – 311(a)(1) & 312(d)(1)(B)
J. Stock Rights Distributions
a. § 305 also governs distributions of stock rights (warrants) – public companies issue
such rights to acquire add’l stock at a favorable price as a means of raising equity
capital.
b. Like stock dividends, rights distributions are NOT taxable UNLESS they come
within one of § 305(b) exceptions. 305(d)(1) – treats rights as “stock” for purposes
of § 305.
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c. Non-taxable rights distribution - § 307(a) requires an allocation of basis b/t the
underlying stock and the rights in proportion to their relative FMVs on the date of
distribution  but regs permit this allocation only if the rights are exercised or sold
(in which event the basis allocated to the rights is added to. The cost of the new
stock acquired). If the rights simply lapse, the SH recognizes no loss but the basis
returns to the underlying stock. Reg 1.307-1(a)
i. However, such an allocation is unnecessary in most cases b/c of § 307(b)’s
administrative convenience exception – which provides that the rights will
take zero basis if their FMV is less than 15 percent fo the value of the stock
w/ respect to which they were distributed.
d. TPers with time on hands (or incentive to make allocation) may elect to use the
allocation method prescribed in § 307(a). 307(b)(2).
e. Taxable rights distributions are treated as § 301 distributions; thus, their value (if
any) is a dividend to the extent of the distributing corp’s E/P.
Section 306
Section 306 Stock
A. General notes:
a. Section 306 aimed primarily at closely held companies. But, public companies not
automatically entitled to relief under the “no tax avoidance” exception in 306(b)(4)
– see C(c) below
b.
B. The Preferred Stock Bailout
a. Section 306 – provision in Subchapter C - not as useful/significant as long as
dividends and long-term cap gains of noncorporate TPs are taxed as same
preferential rates.
b. Reason for 306 – prevent preferred stock bailout
i. Preferred stock bailout was previously used by SHs to withdraw corporate
earnings at favorable cap gains rates. Classic transaction  profitable C
corp would make a tax-free distribution of preferred stock to common SHs,
who sold the preferred stock to investor and reported long-term cap gain on
the sale. The investor collected dividends on preferred stock and a few years
later the corp redeemed the preferred stock from investor.
1. Net effect = the recept of cash by SHs on the sale of the preferred
stock and, after the redemption from the investor, there would be no
reduction of SHs’ proportionate interest in the corp.
ii. Chamberlin v. Commissioner – 6th cir – buyer of preferred stock (the
investor) made bona fide investment, the preferred stock dividend was
legally paid, the subsequent redemption was a distribution to investor (not
24
common SHs), and thus the SHs’ gain on the sale of the preferred stock
should NOT be taxed as ordinary income.
c. Congress labeled preferred stock bailout as Section 306 Stock and required SH to
report ordinary income rather than cap gain when Section 306 stock is sold or
redeemed.
i. IF sale, the ordinary income amount is generally dx’d by the amt that would
have been a dividend at the time of the stock distribution if cash rather than
stock had been distributed.
ii. IF redemption, the ordinary income amount is dx’d at the time of the cash
distribution.
d. b/c dividends and long-term cap gains taxed at same low rate, only remaining tax
advantages to noncorporate SHs of a sale of stock rather than a dividend are
recovery of stock basis and, in special situations, the ability to offset cap gains (but
not qualified dividends) with cap losses.
The Operation of Section 306
e. 306 Stock Defined
i. 306(c)-(e); 1.306-3(a)-(c), (e)
ii. Category 1: Stock distributed to a SH as a tax-free stock dividend under §
305(a) – other than “common on common” – 306(c)(1)(A)
1. E.g. preferred stock distributed to common SHs by a corp w./ E/P.
2. (preferred stock is the primary vehicle for a bailout b/c it can be sold
w/o diminishing the Sh’s control or right to share in future corporate
growth.)
3. Common stock is EXCLUDED b/c it lacks bailout potential – i.e., it
may not be sold w/o diminishing the SH’s control and interest in corp
growth.
iii. Common Stock not defined but focus on whether a sale of stock would cause
a reduction of the SH’s equity position in corp.
1. Thus, fundamental inquiry is whether the stock has a realistic and
unrestricted opportunity to participate in the growth of corp equity.
2. If stock has EITHER a limited right to dividends OR limited right to
assets upon liquidation it is not “common” stock for § 306 purposes.
a. (but voting common stock that is subject to the issuing corp’s
first refusal right to purchase the stock at net book value
whenever a SH wishes to make a transfer IS common stock b/c,
upon a transfer, the SH will part with some/all his interest in the
future growth of the corp vis a vis other SHs)
iv. Section 306 stock does NOT include stock which would not have been
treated as a dividend at the time of distribution if cash had been distributed
instead of stock – 306(c)(2)
1. Reason – a tax-free stock dividend issued by a corp w/ no current or
accumulated E/P for yr of distribution has limited bailout potential – if
25
cash instead of stock had been distributed, the SH would not have
realized ordinary income whenever the distribution corp has no E/P.
v. Category 2: Section 306 stock includes stock w/ a transferred or substituted
basis – 306(c)(1)(C)
1. Encompasses stock received as a gift which takes a Section 1015
transferred basis, or stock received in exchange for Section 306 stock
in a tax-free Section 351 transaction
vi. Category 3: stock received in a tax-free corporate reorganization or division
when the effect of the transaction is substantially the same as the receipt of a
stock dividend or when the stock is received in exchange for Section 306
Stock.
1. E.g. preferred stock received by SHs of the target (acquired) corp in a
tax-free merger may be a prime candidate for Section 306
classification
vii. Category 4: 306(c)(3) characterizes the preferred stock of the Holding
Company (i.e. preferred stock acquired in a Section 351 exchange) as
Section 306 Stock IF the receipt of money instead of the stock would have
been treated as a dividend to any extent. Section 306(c)(3)(A) borrows rules
of § 304 – re redemptions thru the use of affiliated corps)  thus, in
example below, the Holding Co preferred would be Section 306 Stock if
Profitable corp has any current or accumulated E/P. This is b/c a cash
payment by Holding Co for the Profitable corp common stock would have
resulted in a dividend to SH under § 304(a)(1).
1. Prevent this  E.g. Sh holds common stock of Profitable corp. SH
organizes a Holding Company, exchanging SH’s Profitable common
stock for newly issued Holding corp’s common and preferred stock in
a tax-free Section 351 transaction. The Holding corp’s preferred stock
would NOT be Section 306 Stock b/c the Holding corp had no E/P at
time of incorporation. SH could now sell Holding corp’s preferred
stock to an institutional investor, recovering basis and realizing cap
gain, and the stock could later be redeemed by Profitable corp – all
w/o losing any of SH’s control or share in the growth or Profitable
corp.
2. ** We look to the E/P of the original corp (profitable corp) in x-ing
whether the receipt of cash would have been a dividend. – 306(c)(4)
a. (in testing for the effect of a dividend, the Section 318
attribution rules apply w/o regard to the 50% limitation in
318(a)(2)(C) and 318(a)(3)(C).
Disposition of Section 306 Stock
viii. 306(a); 1.306-1
26
ix. Tax consequences re dispositon of Section 306 stock depends on whether the
stock is SOLD OR REDEEMED.
1. SALE:
a. On a sale of Section 306 stock, the amt realized is treated as
dividend income to the extent of the stock’s “ratable share” of
the amount that would have been a dividend if the corp had
distributed cash in an amt equal to the FMV of the stock at the
time of distribution. – 306(a)(1)(A), (a)(1)(D).
b. Req’s SH to look back to time of distribution and dx extent that
cash distribution would have come from the corp’s current or
accumulated E/P at that time.
c. ** Tax consequences:
d. If gain  The balance, if any, of the amount realized is treated
as a reduction of the basis of the Section 306 stock, and any
excess is treated as gain from the sale or exchange of the stock.
– 306(a0(1)(B).
i. The ordinary income amount is treated as a dividend
received from the corporation to allow
NONCORPORATE SH only to qualify for the preferred
rates under Section 1(h), but . . .
ii. Not clear if CORPORATE SHs are eligible for the
Section 243 dividends received deduction (DRD), or
whether the copr is entitled to reduce its E/P when
Section 306 stock is sold. (** 306(a)(1)(D) “appears corp
SHs may not claim the DRD, and no E/P reduction
allowed on sale of Section 306 stock. . . until Treasury
‘specifies’.” – 1.312-1(d) – No E/P adjustments for
issuing corp upon Section 306 stock disposition unless
disposition is redemption).
e. If Loss  No loss recognized (if a/b exceeds amt realized) and
any unrecovered basis allocated back to stock (of corp that
issued Section 306 stock) – 306(a)(1)(C) – example 3 1.3061(b)(2).
2. REDEMPTION:
a. Whats actually happening here is a withdrawal of cash from
corp disguised as a SH who receives a nontaxable stock
dividend of Section 306 stoc that is later redeemed by the corp.
b. 306(a)(2)  the amount realized on redemption of 306 Stock is
treated as a Section 301 distribution – taxable as a dividend
(likely qualified dividend) to extent of current/accumulated E/P
in redemption yr. 306(a)(2).
27
c. Balance of distribution, if any, treated as reduction of basis and
then capital gain under rules applicable to nonliquidating
distributions – 301(c)(2), (3)
Dispositions Exempt from Section 306
x. Code 306(b) – 1.306-2
xi. 306(b)(1) provides that the punitive genera rule of Section 306(a) will not
apply to nonredemption dispositions if the SH completely terminates her
interest in corp and doesn’t sell stock to related person re 318 rules.
xii. 306(b)(1(B)) – redemptions of Section 306 stock that result in complete
termination of SH’s interests under 302(b)(3), OR qualify as a partial
liquidation under 302(b)(4), are also exempted from 306(a) harsh rule.
xiii. Other exempt dispositions:
1. Redemptions of 306 Stock in complete liquidation – 306(b)(2);
2. Dispositions that are treated as nonrecognition transactions – e.g. taxfree 351 transfers – or capital contributions or the like – 306(b)(3);
and,
3. Distributions coupled w/ subsequent dispositions or redemptions of
Section 306 stock if the TP satisfies to Service that either: (a) the
distributions and subsequent disposition or redemption was not made
pursuant to plan to avoid tax, OR (b) in case of a prior or
simultaneous disposition of underlying common stock, just the
disposition or redemption, was not part of plan re tax avoidance.
306(b)(4).
a. But public companies not automatically entitled to relief here.
Fireoved
f. I 1: whether one of the principal purposes of the transaction was the avoidance of
tax
g. I 2: does the prior sale of common stock exempt a subsequent sale of Section 306
(preferred) stock from 306(a) rules re ordinary income?
i. NO
h. F: P had 100 shares of common in company that was merged with other company
whose 2 founders each got 100 shares of common – 300 total – and P got additonal
~300 preferred shares (to preferred he already had from old co.) b/c P contributed
more assets to joint-merged corp. Year later, P redeemed 451 preferred shares for
47,355 and recorded long-term cap gain. Commissioner said proceeds from 451
preferred share redemption was ordinary income based on Section 306.
i. H: none of the stock is exempt.
i. Clear that P’s 535 preferred stock as stock dividend was Section 306 stock.
Also clear that 451 shares redemmed would require that any amount realized
by P to be taxed at ordinary income rather than long-term cap gain B/C
company had earnings to satisfy redemption.
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ii. Thus, Q = whether exceptions apply to Section 306 to permit P to report
gain as long-term cap gain.
iii. P’s argument – the transaction should fall within the exception 306(b)(4)(A)
– “if establish to satisfaction of Secretary that the distribution, and the
disposition/redemption, was NOT in pursuance of a plan w/ a principal
purpose of tax avoidance, then the 306(a) rule will NOT apply”
1. Thus, P argues that his sale of 24 common stock to satisfy partner’s
desire for more control was a business purpose and thus, given benfit
of 306(b)(4)(B) exception.
2. Also, the second redemption of preferred stock was for business
purpose too b/c used part of the proceeds to pay off a $20,000 loan
company made him.
iv. CT:
1. First, TP has burden of showing a lack of a tax avoidance purpose.
a. The fact that P needed $20,000 of proceeds to pay of loan
doesn’t meet this burden b/c the total proceeds from redemption
was $47k. Thus, although the 20k may not have been to avoid
taxes, ct finds no other purpose than tax avoidance re the
additional $27k. *b/c one of the principal purposes of the 451
pf share redemption was the avoidance of tax, P can’t take
advantage of 306(b)(4)(B0 exemption for ANY part of
redemption
2. * more important is that facts of this case is what congress didn’t want
(i.e. preferred stock bail-out)
a. * “when only a portion of the underlyiong common stock is
sold, and the TP retains essentially all the control he previously
had, unrealistic to contclude that Cohngress meant to give TP
the advantage of 306(b)(4)(B) when he ultimately sells his 306
Stock”
b. Here, while P did sell some of his common stock prior to his
disposition of 306 Stock, P retained as much control in the corp
after sale as he did before sale. Thus, congress didn’t intent for
sale of underlying common stock to exempt the gains from
disposition of 306 Stock from treatment as ordinary income.
29
Redemptions
Introduction; Constructive Ownership
(201-04; 250-51; 205-06)  problems (206-07)
I.
Effect on Earnings and Profits (p 250)
a. Code § 312(n)(7)
i. To dx the effect of a stock redemption on the distributing corp’s E&P
(earnings and profits) depdens on effect of redemption at SH level
b. If redemption treated as distribution – thus §301 applies – distributing corp adjusts
E&P same as in other nonliquidating distributions (i.e., earnings and profits are
decreased by the amount of cash and the principal amt of any obligations, and by
the greater of the adjusted basis or the FMV of any property distributed)
i. (Corp always recognizes gain and increases its current earnings and profits
on a distribution of appreciated property, and reduces current earnings and
profts by any taxes paid on that gain)
c. If redemption (inc partial liquidation) treated as exchange to SH, §312(n)(7) –
provides that the part of the distribution in redemption that is properly chargeable
to E&P must be an amt which does not exceed the ratable share of the corp’s
accumulated EP attributable to the redeemed stock.
i. Re §312(n)(7) – accumulated EP includes current EP at time of redemption
– but current EP are dx’d after they first have been applied to characterize as
dividends any § 301 distributions made during the year.
ii. (Congress expressed intention that EP never would be reduced by more than
the amt of the redemption.
d. E.g.
i. X corp has 1000 shares of common outstanding and A and B acquire 500
shares at issuance price of $20 per/share.
ii. X corp has $100,000 net assets (50k cash; 50k appreciated real property)
iii. X corp has $50,000 accumulated EP
iv. = if X distributes 50k to A in redemption of A’s 500 shares, §312(n)(7)
ratable share reduces X’s EP by $25,000 – ratable share of X’s 50k EP
attributable to A’s 50% stock ownership redeemed.
30
v. = remaining $25,000 of distribution to A charged to X’s capital account.
After redemption, X has $25,000 in accumulated EP.
e. IF: Multiple classes of stock outstanding:
i. If corp has multiple classes, then its EP should be allocated among the
different classes in dx-ing the amt of EP that is reduced by the redemption.
ii. *EP should NOT be allocated to non-convertible preferred stock which
doesn’t participate to any significant extent in corporate growth.
1. THUS, redemption of preferred stock should result in a reduction of
the capital account only, unless distribution includes dividend
arrearages which will reduce EP.
iii. [Priorities legally req’d b/t different classes should be taken into account in
allocating EP b/t classes]
Constructive Ownership of Stock – FAMILY ATTRIBUTION RULES
f. Code: § 302(c)(1) & § 318
g. Regulations: § 1.318-1(a)
31
When dx-ing stock ownership for purposes of § 302(b) tests for exchange treatment, an
individual TP or entity should be considered as owning stock owned by certain family members
and related entities under attribution rules in § 318; which is one of several sets of constructive
ownership rules in IRC and applies only when it is expressly made applicable by another
provision of the code
1. (§318(b) contains partial list of cross references to sections applying
Section 318)
2.
Four Categories:
1) Family Attribution: an individual is considered owning stock owned by spouse, children,
grandchildren and parents.
h. NOT Siblings and in-laws
i. NO attribution from grandparent  grandchild; BUT grandchild attributed to
grandparent is okay!
2) Entity to Beneficiary Attribution: [partnership to partners) stock owned by or for
partnership or estate is owned by the partners or beneficiaries in proportion to their
beneficial interests – 318(a)(2)(A).
o (no longer beneficiary if receive all property entitled to AND possibility that property
must be returned to satisfy claims is remote]
[Corp’s stock to SH] if 50% in value of corp stock: Stock owned by a corp is considered owned
proportionately by a SH who owns, directly or thru attribution rules, 50 percent or more in
value of that corp’s stock. 318(a)(2)(C)
3) Beneficiary to Entity Attribution: [partner to partnership; SH 50% to Corp] stock owned by
partners or beneficiaries of estate is owned by the partnership or estate. All stock owned by a 50
percent or more SH of a corp is attributed to the corp. 318(a)(3)(C).
4) Option Attribution: a person holding an option to acquire stock is considered as owning that
stock – 318(a)(4) (Options include warrants and convertible debentures)
“Operating rules” 318(a)(5) supplement above rules
j. Operating rules authorize chain attribution (e.g. parent to child to child’s trust)
k. NO double family attribution (e.g. no attribution from parent to child to child’s
spouse)
32
l. NO “sidewise” attribution (e.g. stock attributed to an entity from a
partner/SH/beneficiary can’t be reattributed from that entity to another
partner/SH/beneficiary)
m. Option attribution takes precedence over family attribution where both apply.
n. S corp is treated as partnership, and its SHs are partners  only for purposes of
attributing stock to and from the S corp, but NOT for dx-ing constructive
ownership of stock in the S corp. 318(a)(5)(E)
Substantially Disproportionate Redemptions
Redemptions tested at the SH level: Substantially disproportionate redemptions
a. Code: §302(b)(2) ; Regulations: 1.302-3
b. Virtue of Section 302(b)(2) is its certainty.
Substantially Disproportionate Redemption- 3 req’ments, if met treated as exchange:
IF SH’s reduction in voting stock b/c of redemption meets 3 mechanical reqs, redemption
treated as exchange – to qualify as “substantially disproportionate” redemption must meet
following:
1. Immediately after the redemption, SH must own (actually/constructively)
less than 50% of the total combined voting power of all classes of stock
entitled to vote
2. The percentage of total outstanding voting stock owned by the SH
immediately after the redemption must be less than 80% of the percentage
of total voting stock owned by the SH immediately before the redemption,
and;
i. Formula:
1. 𝒗𝒐𝒕𝒊𝒏𝒈 𝒔𝒉𝒂𝒓𝒆𝒔 𝒐𝒘𝒏𝒆𝒅 𝒂𝒇𝒕𝒆𝒓 𝒓𝒆𝒅𝒆𝒎𝒑𝒕𝒊𝒐𝒏 ÷
𝒕𝒐𝒕𝒂𝒍 𝒗𝒐𝒕𝒊𝒏𝒈 𝒔𝒉𝒂𝒓𝒆𝒔 𝒐𝒖𝒕𝒔𝒕𝒂𝒏𝒅𝒊𝒏𝒈 𝒂𝒇𝒕𝒆𝒓 𝒓𝒆𝒅𝒆𝒎𝒑𝒕𝒊𝒐𝒏
2. 𝑴𝒖𝒔𝒕 𝒃𝒆 𝒍𝒆𝒔𝒔 𝒕𝒉𝒂𝒏:
3. .80 X (voting shares owned before redemption
Total shares outstanding before redemption)
3. The SH’s percentage ownership of common stock (voting or nonvoting)
after the redemption also must be less than 80% of the percentage of
common stock owned before the redemption. If there is more than one
class of common stock, the 80% test is applied by reference to the FMV.
33
a. Redemption of solely nonvoting stock will NEVER satisfy
§302(b)(2) b/c no sufficient reduction in SH’s voting stock
interest.
b. BUT if redemption qualifies as “substantially disproportionate
under 302(b)(2), a simultaneous redemption of nonvoting
preferred stock will be treated as exchange (not 306 stock).
c. Service ruled that a redemption of voting preferred stock from a
SH owning NO common stock may qualify under 302(b)(2) even
tho SH can’t satisfy the 80% test re common stock
Revenue Ruling 85-14  look at two “redemptions” close in time together to dx if
redemptions, in aggregate, were not substantially disproportionate.
o Facts: A had majority control. B told A that B would be leaving which would have
required corp X to redeem B’s shares, but before B left, A caused corp X to adopt a
redemption plan to redeem part of A’s shares. After the redemption plan, A’s ownership
percentage dropped below 50% and A voting stock in X was less than 80% of its preredemption percentage. Thus, before B left, A’s redemption was in the “safe harbor”
exchange treatment under 302(b)(2)(B) & (C).
o However, after B left and X corp redeemed B’s stock, A’s ownership was above
50% and also didn’t meet the 80% requirement of 302(b)(2)(C).
o Issue: Should the “safe harbor” exchange treatment under 302(b)(2) be measured
immediately after one SH redeems or whether it should be measured after the 2nd SH
redeems soon after the first SH’s redemption?
o H: after 2nd SH redeems - qualification under 302(b)(2) of A’s redemption should NOT
be measured immediately after A’s redemption, but should be measured after B’s
redemption that followed soon after A’s redemption!
o Reasoning:
302(a) states that if a corp redeems its stock and one of para of subsection (b) applies, then such
redemption will be treated as a distribution in part/full payment in exchange for the stock.
[exchange treatment not dividend treatment]
302(b)(2) provides that a redemption will be treated as an EXCHANGE if the redemption is
substantially disproportionate with respect to the SH, but only applied if immediately after
the redemption the SH owns less than 50% of the total combined voting power of all classes of
stock entitled to vote AND the ratio of the SH voting stock immediately after redemption must
be less than 80% of SH’s voting stock before redemption. 302(b)(2)(C);
i. 302(b)(2)(D) – in dealing with a series of redemptions, 302(b)(2) is not
applicable to any redemption made pursuant to a plan the purpose or effect
of which is a series of redemptions resulting in a distribution which (in the
aggregate) is NOT substantially disproportionate with respect to the SH.
1. “Plan” [302(b)(2)(D)]: need be nothing more than a design by a single
redeemed SH to arrange a redemption as part of a sequence of events
34
that ultimately restores to such SH the control that was apparently
reduced in the redemption.
a. A plan does NOT depend upon an agreement b/t two SHs
2. “all the facts and circumstances” [Reg 1.302-3(a)]
HERE:
o While there was no joint plan/agreement b/t A and B, the redemption of A’s shares was
causally related to the redemption of B’s shares in that A saw an apparent opportunity to
secure exchange treatment under 302(b)(2) by temporarily yielding majority control over
Corp X.
o H: Thus, b/c 302(b)(2)(D) requires A and B’s redemptions to be considered in the
aggregate, and b/c A’s redemption does NOT meet the 50% limitation in 302(b)(2)(B)
NOR the 80% test of 302(b)(2)(C), the redemption of A’s shares was NOT
substantially disproportionate within the meaning of § 302(b)(2).
Complete Termination of a Shareholder’s Interest
Waiver of Family Attribution [§ 302(b)(2), (c); § 1.302-4]
- Safe harbor for substantially disproportionate redemption to
qualification thru waiver of family attribution rules
[Theory of the substantially disproportionate safe harbor is that exchange rather than dividend
treatment is appropriate when a distribution in redemption causes a sig reduction in the SH’s
interest in the corp’s voting stock. This policy applies doubly so in case of complete
termination of SH’s interest, which qualifies for exchange treatment under 301(b)(3).
However, issue for SHs of closely held family corp b/c even if all stock of SH redeemed, she
is still treated as owner of 100 % of her children’s shares.]
*No exception applies if “tax avoidance” was one of the principal purposes of the
otherwise tainted transfer  i.e., if even one of principal purposes of transfer was tax
avoidance, then whole transaction fails to fall into 302(a)’s preferred sale/exchange
treatment! (Lynch)
35
302(c)(2) – waiving the family attribution rules if certain conditions are met, thus easing way
for complete termination. Waiver Only applies to FAMILY attribution, [entity and
.
option attribution rules still apply!]
“Prohibited interest”: SH CANNOT retain “interest” in the corp (other than as creditor). Ban
includes interests as officer, director, or employee
“ten year look forward” rule – SH can’t retain/acquire (other than by bequest or inheritance)
any of the forbidden interests in the corp other than interest as
creditor. 302(c)(2)(A)
a. (SH must file tax form w/ return agreeing to notify Service of such acquisition
within 10 years, and retains records. SOL extended. 302(c)(2)(A))
“ten year look back” rule – family attribution rules may NOT be waived if during the ten
years preceding the redemption either:
(1) the redeemed SH acq’d any of the redeemed stock from a
Section 318 relative, OR
(2) any such close relative acq’d stock from the redeemed SH.
302(c)(2)(B)
a. RULE – Family Attribution Waiver Req’s – 302(c)(2)(A) – in the case of a
distribution described in (b)(3) – complete redemption – the family attribution
rules in 318(a)(1) shall NOT apply if:
i. (i) immediately after the distribution the distribute has NO interest in the
corp (e.g. officer, director, employee), other than an interest as a creditor;
ii. (ii) the distribute does not acquire any such interest (other than stock acq’d
by bequest/inheritance) within 10 years from date of such distribution, and
iii. (iii) the distribute files an agmt to notify the district director of Service of
any acquisition of any such prohibited interest in corp.
302(b)(3) – a SH is entitled to sale/exchange treatment if corp redeems ALL of SH’s stock.* In
order to dx whether there is complete redemption for purposes of Section 302(b)(3), family
attribution rules of 318(a) apply UNLESS 302(c)(2) req’s are satisfied.
Lynch v. Commissioner  family waiver not applicable b/c TP held prohibited interest in corp
after redemption  TP who provides “post-redemption” services (e.g., consulting) holds a
prohibited interest under 302(c)(2)(A)(i) in the corp b/c TP is MORE than merely a creditor.
Thus, payments in redemption of TP’s shares must be characterized as a dividend distribution
taxable as ordinary income under 301.
36
In Lynch, TP (redeemed SH) was completely redeemed of his stock supposedly under
302(b)(3), but b/c redeemed SH and remaining SH were related (father/son), and b/c family
attribution rules under 318(a) apply to 302(b)(2) transactions (and thus redeemed SH here
wouldn’t qualify b/c deemed to constructively own all of son’s stock (100% of corp)), UNLESS
family attribution rules waived pursuant to 302(c)(2). Here, no waiver of family attribution
rules re complete redemption under 302(b)(3) when, after redemption, TP has a “prohibited”
interest in corp under 302(c)(2)(A)(i) b/c of “consulting agreement” with corp ($500 per month
salary for 5 years & reimbursement for business travel & office in corp’s new building).
302(c)(2)’s waiver requirements are mechanically and strictly applied; redeemed SH can have
NO interest except as creditor! Here, interest more than creditor according to facts above.
b. employee vs individual contractor distinction doesn’t matter, nor does amount
of control nor salary  strictly applied, NO interest at all, except as creditor!
c. if redemption: long-term cap gains treatment
d. if dividend: ordinary income under 301
o F: TP sold shares to son and in same month, corp redeemed all of TP’s 2,300 stock for
~$18k in property and $770,000 promissory note. On date of redemption the TP entered
into a “consulting agreement” with corp – TP gets $500 per month for 5 years, plus
reimbursement for business travel, and a office in corp’s building.
o I: Whether the redemption of the TP’s stock is taxable as a dividend distribution (301 –
ordinary income) or as long-term cap gain under 302(a)? Main issue = whether the TP
working for the corp after redemption of all his stock was a “prohibited” interest in the
corp which cancelled the waiver of the family attribution rules in 302(b)(3)?
o Law:
a. 302(a) a corp distribution of property in redemption of a SH’s stock is treated as a
sale or exchange of stock (so long-term cap gain rates) if the redemption falls
within 1 of 4 categories in 302(b). if redemption not in any category, treated as
dividend distribution under 301 to extent of corp’s E/P
b. 302(b)(3) – a SH is entitled to sale/exchange treatment if corp redeems ALL of
SH’s stock.* In order to dx whether there is complete redemption for purposes of
Section 302(b)(3), family attribution rules of 318(a) apply UNLESS 302(c)(2)
req’s are satisfied.
i. Here, if family attribution rules apply, TP will be deemed to constructively
own all of son’s stock (i.e. 100% of corp) and thus, transaction would not
qualify as a complete redemption within 302(b)(3)’s meaning
c. RULE – Family Attribution Waiver Req’s – 302(c)(2)(A) – in the case of a
distribution described in (b)(3) – complete redemption – the family attribution
rules in 318(a)(1) shall NOT apply if:
i. (i) immediately after the distribution the distribute has NO interest in the
corp (e.g. officer, director, employee), other than an interest as a creditor;
ii. (ii) the distribute does not acquire any such interest (other than stock acq’d
by bequest/inheritance) within 10 years from date of such distribution, and
37
iii. (iii) the distribute files an agmt to notify the district director of Service of
any acquisition of any such prohibited interest in corp.
o H: A TP who provides post-redemption services, either as an employee or an
independent contractor, holds a prohibited interest by section 302(c)(2)(A)(i) in the
corp b/c he is MORE than merely a creditor. Thus, family attribution rules of 318
apply and the TP fails to qualify for a complete redemption under 302(b)(3). Thus,
the payments from corp in redemption of TP’s shares must be characterized as a
dividend distribution taxable as ordinary income under 301.
o R:
a. Purpose = certainty: Tax Court’s interpretation re individualized determination of whether a TP has a
retained financial stake or continued to control corp after redemption is inconsistent with Congress’ desire
to bring a measure of certainty to tax consequences of a corporate redemption.
i. “in lieu of a factual inquiry in every case, Section 302 is intended to prescribe specific conditions
from which the TP may ascertain whether a given redemption will qualify as a sale or be treated
as a dividend distribution” – H.R.Rep.No 1337
ii. Length of employment after redemption nor amount of annual salary is what
Congress meant to prohibit
iii. provides uncertainty – want to know if entitled to cap gains treatment at time
of redemption.
iv. Purpose: Congress’ goal was to ensure that TPs who transferred only
ostensible control or maintained a financial stake in the corp did not receive
the benefit of cap gains treatment.
1. ** Dx-ing the existence of control is particularly difficult in the
context of a family-held corp. the exercise of control often won’t be
obvious b/c parent influence child, and hence corporate dx-making, if
diff ways Ct’s rule here that the provision of services is a prohibited
interest eliminates need to make a speculative inquiry into whether the
parent still controls the corp after redemption.
b. Section 302(c)(2)(A)(i) operates mechanically: the TP must sever all but a
creditor’s interest to avoid the family attribution rules and thereby receive cap
gains treatment. “No where in the leg history of 302(c) does Congress intimate that
cts may use a flexible facts and circumstances test to dxx the existence of
managerial control or a financial stake.”  not facts and circumstances inquiry
rev ruling 77-467 –TP who leased real property to a corp after redemption only held
creditor’s interest under 302(c)(2)(A)(i)). I.e., leasing property to corp is not
a “prohibited interest” so waiver still applies.
- Service will permit a redeemed SH to lease property to corp at arms-length
basis, provided that the rental payments are NOT dependent on corp
earnings OR subordinated to the claims of the corp’s general creditors.
Revenue Ruling 59-119 – agency relationship- redemption agmt included board seat to
“monitor” redeemed-SH’s interest in corp until loan paid = prohibitied interst.
38
Agency rx (director) with redeemed SH violates conditions set out in 302(c)(2) and is a
proscribed post-redemption interest, therefore the redemption treated as distribution of property
under 301 (taxed as ordinary income). Here, TP’s stock redemption agmt with remaining SHs
stated that redeemed SH will appoint, indirectly through law firm representing SH, a member of
the firm to serve on the corp’s board of directors as long as the corp remained indebted to SH.
Here, the agreement which provided the redeemed SH appoint a nominee to serve on the corp’s
board ( thus creating a agency rx b/t the director and SH) violated the conditions prescribed in
302(c)(2)(A)(i), and thus, transaction doesn’t qualify for exchange treatment under 302(a).
c. F: Corp and SH’s stock redemption agreement states that the remaining SHs and
the instant SH will appoint, indirectly thru law firm rep-ing SH, a member of the
law firm to serve on the board of directors of the corp as long as the corp is
indebted to SH. (corp is indebted to SH b/c the redemption agmt states that the SH
will be paid substantial sum within 8 years for tendering his stock to firm now, and
payments will be made in quarter-annual installments). The sole purpose of
arrangement is to protect the SH as a creditor by dx-ing that the stock redemption
agmt’s conditions are being met rather than having to enter protracted litigation in
the future if the agmt is violated.
d. H: The agmt b/t the SH and corp – where SH’s nominee appointed to board –
violates the condition prescribed in 302(c)(2)(A)(i). Thus, in event of such agmt,
the redemption of the TP’s stock will be treated as a distribution of property under
301 (i.e., tax as ord. income)
i. the arrangement with the director – who is acting solely on behalf of the
TP’s interests – will make the director an agent of the TP (doesn’t matter
that the director’s salary will come from the corp, source of salary only one
factor re agency relationship). Such an appointment of an agent to the board
of directors is contrary to the condition prescribed in 302(c)(2) – it is
immaterial whether an interest in the corp is asserted directly or thru an
agent.
1. “limited” director re only duty will be to dx whether conditions in
stock redemption agmt are being observed is immaterial for 302(c)(2),
which makes no exception for such directors.
ii. Moreover, code doesn’t make exception for a director whose power is
limited b/c he is a minority member of the board.
o AVOID PROBLEM  if the TP/SH-er designates a rep of his law firm to attend the
director’s meetings solely for the purposes of dx-ing whether the provisions of the agmt
have been complied with, and not in the capacity of a director, officer, employee, or
advisor, then such action won’t impact a 302(c)(2) redemption.
Revenue Ruling 77-293 – a gift of stock to a related person and then a complete redemption of
remaining TP’s stock will be allowed - if family attribution waiver rules of 302(c)(2)(A) are met
– only if 302(c)(2)(B)(ii) is not applicable, and aforementioned section not applicable if the
disposition by the distributee of the stock gift did not have as one of its principal purposes the
39
avoidance of income tax. Here, the gift of X corp stock by TP was to son who is active and
knowledgeable in the affairs of the business of X corp and who intends to control and
manage the corp in the future. Thus, the gift of stock was intended solely for purpose of
enabling TP to retire while leaving business to son, therefore, avoidance of tax is NOT one
of principal purposes of the gift. Thus, 302(b)(3) will apply b/c waiver of family attribution
rules met and thus, the redemption is given exchange/sale treatment for purposes of
302(b)(3).
a. F: dad, TP, wants to retire from business and give ownership to his son, so TP
gives 60 shares of X corp stock to son as a gift, and not consideration for services.
TP then resigns and later X corp redeems TP’s remaining 60 shares in exchange
for property. Immediately after redemption, TP has NO interest in X corp. TP’s
gift of stock to B was for purpose of giving son complete ownership and control of
X corp. E/P of X exceeded the amount of distribution in redemption of TP’s stock.
b. H: dx-ing whether one of principal purposes of disposition of stock is tax
avoidance within 302(c)(2)(B) = facts and circumstances of particular situation.
Here, the gift of stock was intended solely for the purpose of enabling TP to retire
while leaving business to son. Thus, the tax avoidance is NOT deemed to have
been one of the principal purposes of the gift of stock from TP to son. Thus, if TP
files the agmt specified in 301(c)(2)(A)(iii), the X corp’s redemption of TP’s stock
qualifies as a termination of interest under 302(b)(3)
c. Law:
i. 302(b)(1) nor (b)(2) applies here b/c, thru constructive ownership rules of
318(a), TP owned 100 percent of X corp stock both before and after
redemption, thus there was no meaningful reduction (b)(1) or a substantially
disproportionate reduction (b)(2) of TP’s stock ownership
ii. 302(c)(2)(A) – for purposes of applying 302(b)(3), 318(a)(1) will NOT
apply if . . . (i), (ii), and (iii) conditions in 302(c)(2)(A) are met.
iii. ** However, 302(c)(2)(B)(ii) – “ten-year look back rule” - 302(c)(2)(A)
doesn’t apply when a person owns stock (at time of distribution) attributable
to distributee under 318(a) AND acquired stock from distributee within 10
years [ending on distribution date], UNLESS such stock so acquired from
distributee is redeemed in the same transaction.
1. ** BUT, 302(c)(2)(B)(ii) will not apply if the disposition by the
distributee did not have as one of its principal purposes the
avoidance of federal income tax.
iv. Purpose of 302(c)(2)(B) is NOT to prevent the reduction of cap gains thru
GIFTS of appreciated stock prior to the redemption of the remaining stock
of the transferor; purpose is to prevent a bailout of earnings at cap gains
rates while SH remains in control of stock thru transfer to related party.
v. Examples of tax avoidance within 302(c)(2)(B)
1. If a TP transfers stock of a corp to a spouse in contemplation of the
redemption of the remaining stock of the corp and terminates all direct
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interest in the corp in compliance w/ 302(c)(2)(A), but with the
intention of retaining effective control of the corp indirectly thru
spouse’s stock.
2. Transfer by a TP of part of the stock of a corp to spouse in
contemplation of the subsequent redemption of the transferred stock
from the spouse.
vi. Here, the gift of X corp stock by TP was to son who is active and
knowledgeable in the affairs of the business of X corp and who intends to
control and manage the corp in the future. Thus, the gift of stock was
intended solely for purpose of enabling TP to retire while leaving business to
son, therefore, avoidance of tax is NOT one of principal purposes of the
gift.
1. Doesn’t matter that an ancillary benefit to the transaction is the
reduction of cap gains tax payable by TP as a result of the gift of
appreciated stock prior to the redemption (not sufficient to conclude a
primary purpose is tax avoidance).
o Notes:
o Ten-year Look Forward Rule
i. While Lynch stated that any performances of services, w/ or w/o
compensation, constituted a forbidden corp interest, results are mixed in
other factual contexts arising under this rule.
ii. Service has ruled that a prohibited interest is obtained if the redeemed SH
becomes a custodian under the Uniform Gifts to Minors Act or a voting
trustee of corp stock during the restricted ten year period. BUT, if the SH
becomes executor of a deceased SH’s estate and can vote the stock held by
the estate, 302(c)(2) protection still available b/c stock acq’d by
bequest/inheritance.
iii. Rev Ruling 72-380 – Service ruled that it was reasonable to permit
“acquisition” by circumstances similar to SH reacquiring a direct stock
interest by bequest/inheritance  so, and executor can have right to vote
stock in an estate.
iv. Rev ruling 79-334 – appointment by will of a previously redeemed SH as a
trustee of a trust is okay. A redeemed SH may waive family attribution even
tho, as trustee, he can vote stock of the corp in which he once had an
interest.
Deferred Payment Redemptions
b. Courts and Service disagreed over what constitutes a complete termination of a
SH’s interest or the acquisition of a forbidden proprietary interest for purpose of
waiver of family attribution exception.
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o Service  to be considered a creditor, the rights of the redeemed SH must NOT be
greater than necessary to enforce the claim. An obligation may be treated as forbidden
proprietary if obligation is: (1) subordinated (lower) than claims of general creditors, (2)
if payments of principal depend on corporate earnings, OR (3) if the interest rate
fluctuates w/ the corp’s success.
i. Redeemed TP can still acquire corp property as a result of enforcement of
rights as creditor w/o running afoul of 302(c)(2), unless the redeemed SH
acquires stock in the corp, its parent or a subsidiary.
ii. (fn 41 on p 224 = defer gain on a credit redemption under installment
method)
o Courts: less rigid standards applied by courts to credit redemptions.
a. Dunn v. Commissioner – redemption agmt provided for postponement of principal
and interest payments on corporate notes given in payment for the SH’s stock if
such payments would violate financial reqs in the corp’s franchise agmt. Ct
concluded that the postponement provision did NOT require the notes to be
classified as equity or give the SH an interest in the corp other than as a creditor.
b. Estate of Lennard – CT found that a subordinated demand note, which was paid
approx. three months after issuance, did NOT represent a proprietary interest in the
corp.
o Service re granting favorable 302 rulings – specific guidelines
i. E.g., Service will not usually rule on tax consequences of a redemption of
stock for notes when the note payment period extends beyond 15 years.
ii. Also, Service will not issue ruling under 302(b) if: (1) the SH’s stock is held
in escrow or as security for payments on corporate notes given as
consideration for redeemed stock, OR (2) the consideration given to the SH
is entirely or partly contingent on either future corp earnings or maintenance
of level of corp working capital, or any other similar contingency
arrangement. (Service worried that the redeemed SH either may reacquire
stock in the corp or has retained a proprietary stock in its possible future
success.)
o Court re granting favorable 302 rulings – more lenient than IRS
i. Lisle v. Commissioner – Tax Ct found a 302(b)(3) complete termination
where the redeemed SHs were to be paid for their stock over 20 year period,
the SHs retained their voting rts re security agmt, the stock was held in
escrow and could be returned to SHs and SHs continued to serve as corp
directors and officers. Ct concluded that SHs were directors and officers
in name only and that, based on facts here, the security provisions were
consistent with finding that the transaction qualified as a complete
redemption.
Retention of Multiple Interests
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b. Issue arises b/c a SH of a closely held corp will retain several different types of
interests after redemption, SO, Q of whether, in dx-ing if the SH has retained a
prohibited financial stake, we look to each separate economic relationship, or the
totality of continuing interests?
Hurst v. Commissioner – In closely held corp, to determine whether a redeemed SH who retains
an interest holds a prohibited financial stake, CT looks at each separate economic interest and
must analyze each interest separately, not according to totality of continuing interests - Tax Ct
rejected Service’s argument that multiple interests taken together can constitute a prohibited
interest.
i. F: TPers were husband and wife who owned stock in two corps, each owned
stock in A corp, but only husband owned B corp stock. When retiring, they
first sold their A stock to B, B then redeemed 90% of husband’s B stock, and
he sold remaining 10% to son. Both redemption and sale were to be paid
over 15 years, and corp’s obligation secured by B’s stock. TPers continued
to own B’s corp headquarters, which they leased back to B; Wife continued
to be a B employee.
ii. I: whether the redemption of husband’s B stock qualified as a complete
termination under 302(b)(2) after application of the waiver of attribution
rules in 302(c)?
iii. H: Husband did NOT retain any prohibited interests by virtue of the
15-yr promissory notes (b/c not tied to the corp’s financial performance,
and using the stock as collateral was consistent w/ common practice),
the lease (b/c it had a fixed rent that was reasonable), and wife’s
employment agreement with B corp (b/c wife owned no B stock, her
compensation was not related to corp’s financial performance, and
there was no evidence that she was acting as a surrogate manager for
husband).
c. (Hurst good example of why, apart from basis recovery, characterization can still
matter under current rate regime. Redemptions of closely held stock in the typical
“family business” setting are frequently funded with installment notes. If
redemption is treated as dividend, there is immediate gain recognition; but if the
redemption is treated as an exchange under 302, then installment sale reporting
under § 453 available.)
Waiver of Attribution by Entities:
d. Issue – Can an entity waive family attribution or is the waiver opportunity only
limited to ind SHs, where the redeemed SH is a trust/estate that completely
terminates its actual interest in the corp but continues to own shares attributed to a
beneficiary from a related family member which then are reattributed from the
beneficiary to the entity?
i. (e.g., Father is sole beneficiary of Mother’s Estate – which owns 50 of 100
shares of X corp – the other 50 shares owned by Child. If X corp redeems
43
Estate’s 50 shares, Estate continues to constructively own Child’s 50 shares,
which are attributed from Child to Father and then reattributed from Father
to Estate.
e. H: Congress enacted special rule for waiver by entities, incorporating appropriate
safeguards to preclude the beneficiaries from reacquiring an interest. –
302(c)(2)(C) – Permits an entity to waive the family attribution rules if those
thru whom ownership is attributed to the entity (i.e., the father) join in the
waiver. Thus, a trust and its beneficiaries may waive family attribution to the
beneficiaries if, after the redemption, neither the trust nor the beneficiaries hold an
interest in the corp, do not acquire such interest within 10-year period, and join in
the agmt to notify the IRS of any acquisition. (Entity and beneficiaries are jointly
and severally liable if one of them acquires stock within 10-years.)
i. Under Act, only family attribution under 318(a)(1) may be waived by an
entity and its beneficiaries. The Waiver rules are NOT extended to waivers
of attribution to and from entities and their beneficiaries – 318(a)(2), (3).
1. The B & B Windshield Wiper Corporation (“B & B”) was organized ten years ago by
Betty and Billy, who are wife and husband. Betty and Billy formed B & B by
transferring cash and other property to the corporation in exchange for 150 shares of
the corporation’s common stock. Betty and Billy own B & B’s manufacturing plant
and lease the plant to the corporation for an annual rental fee. B & B has been very
successful and has a large amount of accumulated earning and profits.
a. Five years ago, Betty and Billy’s youngest Son, Junior, began working for B &
B as a clerk in the domestic subcompact wiper division. Junior’s managerial
talents were quickly recognized and he has risen rapidly in B & B’s corporate
structure. Today Junior is B & B’s Vice President in charge of operations and
has overall responsibility for production at B & B’s manufacturing plant.
44
b. Shortly after Junior came to B & B, his parents agreed that he would eventually
take over control and management of the company.
Betty and Billy have now decided that the time has come to retire. To implement
this decision, their accountant has suggested the following plan:
i. Betty and Billy will give 30 of their 150 B corp shares to Junior to
provide him with an ownership interest in the corporation.
ii. B corp redeem Betty and Billy’s remaining 120 shares for $50,000 plus a
$400,000 B & B note paying market rate interest. The note will be
payable monthly over a 20-year term and will be secured by an interest in
the corporation’s assets. Additionally, B & B will agree to restrict
dividend payments, limit new indebtedness, and refrain from taking
certain extraordinary corporate action (e.g., merger or liquidation) during
the term of the note.
iii. Betty and Billy will continue to lease the manufacturing plant to B & B
under a lease which has a rent escalation clause dependent upon the
consumer price index. They also grant B & B a five-year option to
purchase the plant at its appraised fair market value.
a) Will Betty and Billy’s redemption be classified as an exchange under Section 302(a)?
a. Code Sec. 302 only applies when a corporation redeems its stock. In this context a
redemption occurs when a company acquires some or all of its stock from
shareholders in exchange for property.To qualify for sale or exchange treatment, a
stock redemption generally must result in a substantial reduction in a shareholder’s
ownership interest in the corporation.The shareholder owns, after the distribution,
less than 50 percent of the total combined voting power of all classes of stock
entitled to vote,
b. in present case Betty & Billy out of their 150 B& B shares gave 30 B&B shares to
their youngest son Junior continuing to redeem 120 shares (ownership resulting in
more than 50% combined voting power and hence are NOT qualified as exchange
treatment under 302.
c. As per the leasing concept, lease of Plant can continue only if transaction is based
on ARM LENGTH BASIS ie transactions in which buyer and seller have no
relationship to each other, here there is ARM LENGTH TRANSACTION, hence
lease will be allowed to continue.
d. Betty and Billy will continue to hold the 20 year note as creditors.
i. IRS Collection Financial Standards are intended for use in calculating
repayment of delinquent taxes, in present case since the Credit Note length is
more than10 years , IRS ruling standard not applicable.
45
b) Suppose Betty establishes a management consulting firm after leaving B & B. What
would be the tax impact on the redemption if B & B hired Betty’s firm to perform an
analysis of its proposed entry into the Australian windshield wiper market?
a. under Section 302(c)(2)(A)(i)  Lastly B & B can not have financial stake in
enterprise, since according to verdict of Tax Court and Commissioner, Tax payer
who enters into management consultancy contracts after the redemption has a
prohibited interest.
Redemptions Not Essentially Equivalent to a Dividend
Redemptions Not Essentially Equivalent to a Dividend
A. Code 302(b)(1); Reg 1.302-2
US v Davis – redemption didn’t qualify as “not essentially equivalent to dividend” b/c 318(a)
attribution rules apply, so SH was in control of corp thru related party after redemption, thus
Note essentially Equivalent test re “meaningful reduction” failed.
B. F: Davis (TPer) organized a corp with Bradley, Bradley received 500 shares and Davis
and his wife each received 250 shares. Then TP made an additional contribution to corp,
purchasing 1,000 shares of preferred stock at $25 per share – purpose of purchasing add’l
shares was to increase corp’s working capital to qualify for a loan. The corp was to
redeem the preferred stock when the loan had been repaid. TP later bought all of
Bradley’s 500 shares and gave them to son and daughter. Years later, the loan was fully
repaid and the corp then redeemed TP’s preferred stock. TP considered the redemption as
a sale of his preferred stock to the company, not dividend (ordinary income), and thus
wanted cap gains transaction under 302 which would result in no tax since TP’s basis in
the stock equaled the amt he received for it.
a. Commissioner: redemption of TP’s stock was essentially equivalent to a dividend
and was thus taxable as ordinary income under §§ 301 and 316.
C. I: whether the $25,000 distribution by the corp to TP falls under 302’s exceptions to
certain distributions for redeemed stock – specifically, whether its legitimate business
motivation qualifies the distribution under 302(b)(1)?
D. H: Attribution rules re 318(a) apply in dx-ing “not essentially equivalent” under
302(b)(1); and redemption to meet test must result in a meaningful reduction of the SH’s
proportionate interest in the corp.
E. R:
a. 301 and 316 = tax treatment of distributions by a corp to its SHs; under those
provisions, a distribution is includable in a TP’s gross income as a dividend out of
E/P to the extent earnings exist.
b. 302 – distribution is treated as “payment in exchange for the stock,” thus
qualifying for cap gains rather than ordinary income treatment . . IF the conditions
contained in any one of the 4 paras in (b) are met.
46
c.
d.
e.
f.
g.
h.
i.
i. Not essentially equivalent to a dividend test
ii. TP’s voting strength is substantially diminished
iii. TP’s interest in the company is completely terminated
318 attribution rules DO apply in considering whether a distribution is essentially
equivalent to a dividend under 302(b)(1)
i. Thus, under the “not essentially equivalent to a dividend” test, TP is deemed
the owner of all 1,000 shares of the company’s common stock.
ii. (TP argued that attribution rules wouldn’t apply, thus, he would be
considered to own only 25% of the common stock and the distribution
would then qualify under 302(b)(1) b/c it was not pro rata or proportionate to
his stock interest)
[A sole SH who causes part of his shares to be redeemed by the corp – such
redemption is always “essentially equivalent to a dividend” within 302(b)(1)]
* app ct wrong in looking for a business purpose and considering it in dx-ing
whether the redemption was equivalent to a dividend. Rather, the business
purpose of a transaction is irrelevant in dx-ing dividend equivalence under
302(b)(1)
[if a corp distributes property as a simple dividend, the effect is to transfer the
property from the company to its SHs w/o a change in the relative economic
interests or rights of the SHs]
TEST ** to qualify for preferred treatment under 302(b)(1) – not essentially
equivalent to dividend – a redemption must result in a meaningful reduction
of the SH’s proportionate interest in the corp
Here,
i. TP was the sole SH of the corp both before and after the redemption, after
application of the attribution rules. Thus, there was NO meaningful
reduction for the redemption to be considered a redemption “not essentially
equivalent to a dividend” under 302(b)(1).
Dissent: the redemption was not essentially equivalent to a dividend b/c there was
a bona fide business purpose to the redemption re the redemption served as loan
repayment to TPer.
Revenue Ruling 85-106 – redemption that is “not essentially equivalent to dividend” must result
in a “meaningful reduction” of SH’s proportionate interest in the corp (318 attribution applies).
Most significant factor is SH’s right to vote and exercise control (includes control via “Control
Group” participation). HERE, T was not in minority SH position, isolated from corporate
management and control b/c redemption did NOT reduce Trust’s percentage of voting
power in X corp. Importantly, redemption didn’t change Trust’s ability to participate in
“control group” by acting in concert with SHs A or B.
j. I: Did the redemption of nonvoting preferred stock qualify as a redemption under
302(b)(1) – “not essentially equivalent to dividend” – when there was no
meaningful reduction in the percentage of voting and nonvoting common stock and
47
when the redeemed SH continued to have the opportunity to act in concert with
other SHs as a control group?
k. H: No, redemption doesn’t qualify as “not essentially equivalent dividend” under
302(b)(1)  Altho there was reduction of Trust’s economic interest in X corp,
such reduction was not large enough to result in meaningful reduction of
Trust’s interest. The absence of any reduction of T’s voting interest in X (thru
SH C) and Trust’s potential (thru SH C) for control group participation are
compelling factors here.
l. F: Corp X had 3 classes of stock outstanding – 100 voting common, 100 nonvoting
common, and 50 nonvoting preferred stock – held by 3 major SHs and some
minor. SH C held no nonvoting common or preferred directly, but was sole
remaining beneficiary of trust, T, which owned 18% of both the nonvoting
common and preferred. X corp redeemed six shares of preferred stock from Trust
for FMV. After redemption, Trust continued to hold 3 shares of preferred stock,
and 18% of nonvoting common. Via 318(a)(3)(B) attribution rules, Trust is
considered to own the voting common stock owned by its beneficiary C . . . thus
Trust owns 18 voting common, 18% nonvoting common, and 3 shares of preferred,
(C owns these shares via constructive ownership).
m. Law & Analysis:
i. 302(a) – if redemption falls within 302(b)(1) or (2) or (3) or (4), then
redemption treated as a distribution in part/full payment in exchange for
stock.
1. 302(b)(2) doesn’t apply b/c there was no reduction in T’s 18% vote
via voting common stock
2. 302(b)(3) doesn’t apply b/c no complete termination of interest.
ii. Thus, must dx if redemption is considered not essentially equivalent to a
dividend to qualify under 302(b)(1) – 1.302-2(b) determination is facts and
circumstances specific.
iii. TEST – “Meaningful Reduction”  Davis – Sup Ct held that in order to
qualify under 302(b)(1), a redemption must result in a meaningful reduction
of the SH’s proportionate interest in the corp, and 318 attribution rules
apply.
1. ** in dx-ing whether a reduction in interest is “meaningful,” the rights
inherent in a SH’s interest must be examined.
2. 3 elements of SH’s interest most significant: (1) the right to vote and
thereby exercise control; (2) the right to participate in current earnings
and accumulated surplus; and (3) the right to share in net assets on
liquidation.
iv. * When redeemed SH has a voting interest (directly or by attribution), a
reduction in voting power is a key factor in dx-ing the applicability of
302(b)(1)
1. HERE, as a result of 318(a)(3)(B) attribution rule, “it is significant
that” the redemption did not reduce Trust’s percentage of voting
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power in X. Doesn’t matter as much that Trust reduced its percentage
interest in current earnings, accumulated surplus, and net assets upon
liquidation, and reduced the FMV of its ownership in X corp.
v. Participation in “Control Group”
1. * Significant aspect of T’s failure to reduce voting power is the fact
that the redemption leaves unchanged T’s ability to participate in a
control group by acting in concert with SHs A and B. Tax Court
indicated significance for this factor of potential group control.
2. [rev rul 76-364  a reduction in voting interest was meaningful in
itself when it caused the redeemed SH to give up a potential for
control by acting in concert with one other SH]
3. Bloch v. US – in finding that the distributions were essentially
dividends, the ct noted that there was no change in the redeemed
SH’s potential for exercising control “by aligning himself w/ one
or more of the other SHs”
vi. While T not largest SH, T was not in minority SH position, isolated from
corporate management and control [b/c majority of redeeming corp’s
voting stock not held by single unrelated SH to redeeming trust, and b/c
redeemed SH’s total interest was NOT de minimis – rev ruling 76-385]
n. Since redemption doesn’t meet 302(b) tests, it is not a distribution in part/full
payment for stock under 302(a)  thus, under 302(d), the redemption is treated as
distribution of property under 301.
Meaningful Reduction Standard
o. In interpreting the “meaningful reduction” standard of Davis, the Service’s rulings
have considered the effect of the redemption on the redeemed SH’s voting power,
rights to participate in current/future corp earnings, and rights to share in net assets
on liquidation
p. IF SH has voting interest, the key factor in measuring dividend equivalencies
the reduction in the SH’s voting power as opposed to other important economic
rights.
q. Q of whether a reduction is “meaningful” is a question of fact, but some
guidelines:
i. 75-502 – SH’s reduction of voting common stock ownership from 57% to
50% was meaningful where the remaining stock was held by a single
unrelated SH. But a lesser reduction would NOT have qualified under
302(b)(1) b/c the SH would have continued to have “dominant voting rights”
r. Minority Shareholders
i. 75-512 – a reduction of common stock ownership from 30% to 24.3% was
meaningful b/c the redeemed SH experienced a reduction in three significant
rights: voting, earnings, and assets on liquidation.
ii. 76-264 – Reduction in common stock ownership from 27% to 22% was also
meaningful where the remaining shares were owned by three unrelated SHs
49
b/c the redeemed SH lost the ability to control the corp in concert with only
one other SH.
s. 302 also focuses on effect of the redemption on SH’s control of corporate
affairs
i. [Thus, a pro rata redemption of corp’s single class of stock doesn’t qualify
for exchange treatment, and the redemption of all of one class of stock also
fails if all outstanding classes of stock are held proportionately]
ii. BUT, any redemption of stock from a SH owning nonvoting preferred stock
meets test re “not essentially equivalent to a dividend” b/c the SH doesn’t
have control over whether the redemption occurs
1. [77-426 – a redemption of 5% of the outstanding preferred stock from
a SH owning all of the preferred stock (and only preferred stock)
qualified for exchange treatment under 302(b)(1)]
iii. A redemption of publicly traded common stock that reduces a SH’s interest
from .0001118% to .0001081% qualifies for exchange treatment b/c such
SH cannot exercise control over corporate affairs.
1. [but pro rata redemption of publicly traded corp will NOT satisfy “meaningful reduction”
standard even if the SH owns only small noncontrolling interest in the corp]
iv. **Redemptions by closely held companies of stock held by minority SHs
who reduce their percentage interests, even if the reduction is slight qualifies
for exchange treatment b/c SH can’t exercise control over corp affairs.
Extraordinary corp action vs. routine corp action:
 Redemption causes SH to lose control of “extraordinary” corp action (i.e., 2/3 maj needed to
approve merger/liquidation) but SH retains control of routine matter (i.e. only need simple maj.;
stock reduced to 60% voting control)?
v. Two different views by CTs v. Service:
1. CT – Wright v. US: 8th cir dx’d that such a redemption is “not
essentially equivalent to a dividend” b/c of the loss of two-thirds
control of the corp  i.e., yes to preferential exchange treatment
2. Service – [78-401]: more restrictive view – if extraordinary corp
action is not “imminent,” the retention of day-to-day control of corp
activities is a “predominant factor” and the redemption does not
result in a meaningful reduction in the SH’s interest. (unclear
Service’s position if a merger were contemplated).
Family Discord
t. Issue under 302(b)(1) whether 318(a)(1)’s family attribution rules would be
ignored when there is evidence of family discord b/t the redeemed SH and the
related continuing SHs?
i. Most courts and Service– attribution rules apply w/o regard to family
squabbles
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ii. [but see 1st cir – family discord might “negate the presumption” of the
attribution rules]
u. Cerone v. Commissioner Tax Court suggested that family discord may be
relevant in testing for dividend equivalence under 302(b)(1), AFTER the
attribution rules have been applied –
i. “family discord has a limited role in testing for dividend equivalence under
302(b)(1). Proper analysis is: first, the attribution rules are plainly applied.
Second, a determination is made whether there has been a reduction in the
SH’s proportionate interest in the corp. If not, the inquiry ends b/c, if there is
no change in the SH’s interest, dividend equivalency results. If there has
been a reduction, then all the facts and circumstances must be examined to
see if the reduction was meaningful under US v. Davis. AT this point, and
only then, family hostility becomes an appropriate factor for consideration.”
1. [see also Henry Patterson Trust v. US – reduction from 97% to 93%,
after applying attribution rules, is meaningful under Davis b/c of
family hostility]
Basis issue: Mystery of the Disappearing Basis
v. Issue: after redemption the SH no longer owns any stock in the redeemed class of
shares and the redemption treated as 301 distribution (b/c continues to own shares
in another class of corp’s stock or family’s stock attributed to SH but can’t get
waiver of family attribution rules), what happens to the basis of the redeemed
shares?
w. Regs permit any remaining basis in the redeemed shares to move to other classes
of stock SH owns. Assumption that the basis in the redeemed shares next move to
shares held by SH in different class of stock [1.302-2(c) ex 1 & 3]. Where SH
owns NO shares in the corp following redemption treated as 301 distribution, the
regs permit the basis to “levitate” and move to stock held by family members or
entities whose stock was attributed to the redeemed SH under 318.
i. Regs were proposed in 2009 but later withdrawn.
Problem on 243-44:
1. Z corporation has 100 shares of common stock outstanding, owned by A (28 shares), B (25
shares), C (23 shares) and D (24 shares.) Unless otherwise indicated, assume the shareholders
are not related. In each of the following alternative situations, determine whether the
redemption is not essentially equivalent to a dividend under § 302(b)(1):
a. Z redeems 7 shares from A
a. Prior to the redemption of that, A could control with any other single shareholder.
After the redemption, A own 21 of 93 shares and could no longer control with just
one. Good case for (b) (1).
b. Prior to redemption, A could take corporate action by acting with any other shareholder.
After redemption A will own 21 of the 93 outstanding shares. Thus 47 shares would allow
51
a shareholder to control and A would not be able to combine with any other shareholder to
have majority of Zs shares. That such a loss of control, together with the corresponding
decrease in interest in earnings and assets, is not essentially equivalent to a dividend.
b. Z redeems 5 shares from A, and A and D are mother and daughter.
a. Z redeems 5 shares from A; A and D are mother and daughter. Before with
attribution, A (including D) owned 52% (52 / 100). After, A (including D) own
49.4% (47 / 95). This loss of control probably enough to get under (b) (1) where
the balance of stock owned only by a few (no big dispersion).
b. Before the redemption, A owns 52% of Z's stock (28 directly and 24 by attribution under
section 318. After the redemption A owns 49.4% of the stock. Since the redemption brings
A’s ownership percentage under 50 it will qualify under section 302b.
c. Z redeems 5 shares from A, and A and B are mother and daughter.
a. Z redeems 5 shares from A; A and B mother and daughter. 53% before (53 / 100)
and 50.5% after (48 / 90), with attribution. No hope under (b) (1).
b. A owns 53 percent of Z before redemption and 50.5 percent after redemption, since A has
corporate control over Z the redemption will not qualify under section 302b.
d. Same as (c), above, except that A has not spoken to B since B married “outside her
faith.”
a. Issue: Does hostile family situation negate family attribution of 318?
b. IRS has said “no.” Rev. Rule 80-26. First Circuit once allowed, but most have
held no
c. Family hostility has no impact on the application of section 318, the section must apply.
However, even if section 318 is disregarded after redemption A owns 23 shares and can
control corporate action with only B, two shareholders who are not on speaking term
2. Y corporation has 100 shares of common stock and 100 shares of nonvoting preferred stock
outstanding. The preferred stock is not convertible into Y common stock and is not Section 306
stock (i.e., not stock treated specially in § 306 because of its tax avoidance potential). The Y
common and preferred stock are owned by the following unrelated shareholders:
Shareholder
A
Common
Shares
40
Preferred Shares
B
20
55
C
25
10
D
15
15
E
0
20
0
Will the following alternative redemptions qualify for exchange treatment under § 302(b)?
(a) Y redeems 5 preferred shares from E?
52
In the given case before redemption E's holding is 20% and after reduction E's holding is 15%.
15% is less than 80% of 20%. Condition 1 is satisfied and Preffered stock not bearing voting
right therefore condition 2 is not applicable. Such redemption qualifies for exchange treatment.
(b) Y redeems all of its outstanding preferred stock?
[Outline had different answer! ] A stock redemption that terminates a shareholder’s entire stock
ownership in a corporation will qualify for sale or exchange treatment under § 302(b)(3). Hence
this case also qualifiy for exchange treatment.
3. Suppose an individual shareholder owns ten shares of common stock of X Corporation
with a basis of $15,000. What happens to the shareholder’s basis if five shares are
redeemed in a transaction which is properly classified as a dividend?
Regs permit any remaining basis in the redeemed shares to move to other classes of stock SH
owns. Remaining 5 shares originally had $7500 basis (15k (basis for 10 shares) /2) now basis of
stock redeemed moves to remaining stock (the 5 shares) so 15000 basis in remaining 5 shares.
the basis of the remaining 5 shares of common stock of X Corporation will be its cost price ie.
$15000 / 2 = $7500 and the shareholder's continues hold its interest in the company.
What if all ten shares are redeemed in a transaction which is properly classified as a
dividend because a § 302(c)(2) waiver of family attribution is unavailable?
Where SH owns NO shares in the corp following redemption treated as 301 distribution, the
regs permit the basis to “levitate” and move to stock held by family members or entities whose
stock was attributed to the redeemed SH under 318.
If all ten shares are redeemed in a transaction which is properly classified as a dividend, then
there exists nil basis and the shareholder losses its voting right as the holding basis reduced
below 50% and his/her shareholder's interest is terminated.
Partial Liquidations
ONLY APPLIES TO NONCORPORATE SHs!!
[Distributing passive assets is NOT enough. (thus, a holding company cannot be partially
liquidated)] – re “significant contraction?
302(b)(4) provides exchange treatment for redemptions of stock held by
noncorporate SHs if the distribution qualifies as a “partial liquidation”
3 requirements:
53
302(e)(1), distribution is treated as in partial liquidation if it is pursuant to a plan,
occurs within the taxable year in which plan is adopted or the succeeding taxable
year, and is “not essentially equivalent to a dividend.”
For partial liq purposes, dividend equivalency (not same as in 302(b)(1)) is determined at the
corporate level, rather than SH level.
Genuine Contraction Rule:
Any redemption that results in a genuine contraction of the corp’s business may qualify for
exchange treatment as a partial liquidation if the distribution is made to a SH other than a C
corp. [unlike 302(b)(1) where a pro rata redemption could never escape dividend classification]
x. “Genuine Contraction” Standard:
i. E.g. if the entire floor of a factory is destroyed by fire, the insurance
proceeds received may be distributed pro rata to the SHs w/o the imposition
of a dividend tax, if the corp no longer continues its operations to the same
extent maintained by the destroyed facility.
ii. Voluntary bona fide contraction of corp business may also qualify as partial
liquidation
iii. ** Partial liquidation in any event – If a corp is engaged in two or more
active businesses which has been carried on for at least 5 years, it may
distribute the assets of either one of the businesses in kind, or the proceeds
of their sale.
Safe Harbor 302(e)(2):
iv. Partial liquidation status assured if the distribution consists of the assets of a
“qualified trade or business” OR is attributable to the termination of such a
trade or business, and immediately after the distribution the corp continues
to conduct another qualified T/B.
1. “Qualified T/B” = T/B must have been actively conducted thru-out the
five-year period ending on the date of the distribution and must not
have been acquired by the distributing corp in a taxable transaction
during that period.
2. The “active” T/B that corp continues to conduct must have a similar
five-year business history.  req meant to patrol against the
accumulation of earnings in the form of investment assets, such as real
estate or securities, followed by prompt bailout distributions
masquerading as corp contractions. (1.355-3(b) def of an active T/B)
v. ** If 302(e)(2) safe harbor NOT satisfied, Service will usually not rule that a
distribution qualifies as a partial liquidation UNLESS it results in a 20% or
greater reduction in gross revenue, net fair market value of assets, AND
employees of the corp
54
Treated as “constructive redemption of stock” – when SHs don’t surrender stock
Distribution may qualify as a partial liquidation even if the SHs do NOT actually surrender any
stock . . . if the other reqs of either the general corporate contraction doctrine or the 302(e)(2)
safe harbor is met, the transaction will be treated as a constructive redemption of stock.
F. * Distributions to Corporate SHs do NOT qualify for partial liquidation treatment even
if all the other statutory req’s met – 302(b)(4)
i. Dx-ing whether SH is corporate or noncorporate, stock held by a
parternship, estate, or trust is treated as if held proportionately by partners or
beneficiaries.
ii. S corp are treated as corporate SHs and do NOT qualify for exchange
treatment on a partial liquidation under 302(b)(4)
Corporation’s distribution in partial liq treated as “extraordinary dividend”
G. * To prevent abuse of dividends received deduction  Any amount treated as a dividend
to a corporate SH under 301 is an “extraordinary dividend” under Section 1059 IF it is a
distribution in redemption of stock which is part of a partial liquidation of the redeeming
corp, regardless of the SH’s holding period or the size of the distribution.
i. Corp’s basis: corp SH must reduce its basis in the stock of the redeeming
corporation by the portion of the dividend that was not taxed b/c of the
dividends received deduction.
ii. 1059(a), (b) – if the nontaxed portion of the dividend exceeds the SH’s basis
in the redeemed stock, the excess is treated as gain from a sale or exchange
of the stock.
b. ** IF pro rata distribution, then NOT Extrodinary dividend
Rev Ruling 79-184: No “corporate contraction” - distribution of proceeds to parent’s SHs from
sale of subsidiary’s STOCK (not assets) is NOT a “genuine contraction” to get partial
liquidation’s preferred treatment. Distribution of subsidiary’s stock, under these facts, by parent
corp is a corporate separation governed by 355, and is NOT a corporate contraction.
c. I: whether the SALE by a parent corporation of all the STOCK of a wholly owned
subsidiary and the distribution of the sales proceeds by the parent to its SHs
qualifies as a distribution in partial liquidation within 346(a)(2)?
d. H: the distribution by parent corp to its SHs of the proceeds of the sale of
subsidiary’s STOCK does NOT qualify as a distribution in partial liquidation
within 302(e)(1), and thus, the distribution will be treated as a 301 distribution
of property.
e. F: P corp owned all the single class of outstanding stock of S corp for many years,
during which each had been engaged in the active conduct of a trade or business.
Pursuant to a plan, P corp sold all the stock of S corp to unrelated party for cash
and distributed the proceeds of the sale pro rata to its SHs in redemption of part of
their P stock.
f. Law & Analysis:
55
i. 302(e)(1) – a distribution is treated as a partial liq of a corp if it is not
essentially equivalent to a dividend, is in redemption of a part of the stock of
the corp pursuant to a plan, and occurs within the taxable year when plan
adopted or within succeeding yr.
1. For purposes of 302(e), the business that is terminated or contracted
must be operated directly by the corp making the distribution, but
2. 74-223 – when a parent corp liquidates a wholly owned subsidiary
and distributes the subsidiary’s assets, or the proceeds from the sale of
those assets, to its SHs, the fact that the distributions were attributable
to assets used by the subsidiary rather than directly by the parent will
NOT prevent the distribution from qualifying as a “genuine
contraction of the corp business” to the parent within 1.346-1(a)(2).
a. [basis for holding is under 381 a parent corp that liquidates a
subsidiary under 332 inherits attributes of the liquidated sub so
that after the liquidation of the sub the parent is viewed as if it
had always operated the business of the liquidated sub]
3. ** However, when a parent corp distributes the stock of its
subsidiary, Section 381 does NOT apply to integrate the past business
results of the subsidiary with those of the parent. Thus, distribution by
the parent of the subsidiary’s STOCK doesn’t result in the parent corp
taking into account the past operations of the subsidiary –
a. thus, no comparison b/t a distribution of stock of a subsidiary
and a distribution of the liquidated sub’s assets.
ii. * A distribution of the stock of the sub under such circumstances is a
corporate separation, governed by Section 355, and NOT a corporate
contraction!
iii. 1.346-1(a)(2) – a distribution resulting from a genuine contraction of the
corp business is an example of a distribution that will qualify as a partial
liquidation under 302(e)(1)
iv. HERE,
1. Where P sells all the stock of its wholly owned subsidiary and
distributes the proceeds to its SHs, there is NO basis for attributing the
business activities of the subsidiary to the parent corp. It is well
established that a corp is a legal entity separate/distinct from its SHs.
2. Altho the assets of P are reduced by the distribution of the sale of the
stock proceeds, the sale by P of sub’s stock is NOT in and of itself
sufficient to affect a contraction of the business operations of parent
corp that 346(a)(2) contemplated. Rather, overall transaction “has the
economic significance of the sale of an investment and distribution of
the proceeds.”
3. 1.302-2(b) – all distributions in pro rata redemption of a part of the
stock of a corp generally will be treated as distributions under 301 if
the corp has only one class of stock outstanding.
56
H. Consequences to the Distributing Corporation:
a. Distribution of Appreciated Property in Redemption
i. Code § 311
ii. Demise of General Utilities doctrine – Congress acted b/c insurance
companies were redeeming large amts of their own stock by distributing
appreciated securities while avoiding recognition of gain at the corporate
level.
iii. Congress curtailed this abuse by req-ing a corp to recognize gain on a
distribution of appreciated property in a redemption as if the property had
been sold for its FMV.
1. But partial liquidations continued to qualify for nonrecognition at the
corporate level. Congress further narrowed the opportunity for
nonrecognition on nonliquidating distributions of appreciated property
in redemption via 311(b)
iv. 311(b)
1. Applies to non-liquidating distributions and partial liquidations too
2. Congress repealed all the remaining exceptions that had provided for
nonrecognition of gain to the distributing corp. as a result, a corp
distributing property in redemption of stock (inc partial liq)
always recognizes gain but does NOT recognize loss!
Substantially disproportionate?
A redemption is substantially disproportionate if it meets the following three criteria:
I.
II.
III.
After the redemption, the shareholder owns less than half of the total combined voting power of all classes of
outstanding stock entitled to vote.
After the redemption, the shareholder's percentage of total outstanding voting stock is less than 80% of preredemption ratio.
The shareholder's post-redemption percentage ownership of outstanding common stock (voting or nonvoting) is less than 80% of pre-redemption ownership.
57
Redemption Through Related Corporations
10/25
Code: § 304(a); (b)(1), (2), (3)(A) & (B); (c)
Regs: §§ 1.304-2(a), (c) Examples (1) & (3), -3(a).
o 304 is a statutory watchdog designed to prevent an end-run around §§ 301 & 302
a. Purpose = prevent controlling SHs from claiming basis recovery and capital gain
treatment on transactions that result in a “bailout” of corporate earnings w/o a
significant reduction in control.
b. (Davis case – redemption of either X or Y stock will result in a dividend and no
recovery of basis)
c. ** §304 ensures that a supposed sale that is actually a dividend is treated as a
dividend, requiring SH sales involving “brother-sister” and “parent-subsidiary”
corps to satisfy one of the tests in § 302 in order to qualify for cap gain status and
recovery of basis
o Brother-sister Acquisitions
a. 304(a)(1) applies when one or more persons who are in “control” of each of the
two corps transfer stock of one corp (issuing corp) to the other (acquiring corp) in
exchange for cash or other property (property doesn’t include stock of acquiring
corp)
b. * Control = at least 50% ownership of either the corp voting power OR of the total
value of all classes of stock.
i. §318 attribution rules apply in dx-ing control
ii. If corp has more than one class of stock, the value prong of the control test is
applied to the aggregate value of all classes of stock, not class-by-class. (i.e.
if SH owns 50% of the value of ALL corp’s stock, he has “control” even if
he owns less than 50% in a particular class)
c. Method to test “sale” for dividend equivalence
i. If 304(a)(1) applies, A selling X corp stock to Y corp for cash, A treated as
having received a distribution of cash in redemption of Y stock. Then the
redemption is tested under § 302(b) to dx whether A may treat the
transaction as an exchange.
ii. Dividend equivalence is dx’d by reference to A’s stock ownership of X corp
(issuing corp – company whose stock sold) before and after the transaction.
1. If Y’s purchase of X stock from A for cash is characterized as a
distribution to which § 301 applies (i.e., dividend/ord income), A
treated as having transferred X stock to Y in exchange for Y stock in a
tax-free §351(a) transaction, and then Y is treated as having redeemed
(from A) the Y stock that is hypothetically issued in the §351
exchange.
58
2. If distribution treated as exchange under § 302(a), Y is treated as
purchasing the stock of X.
iii. Ex. Since A owned 100% of X stock before the sale to Y, after the sale, A
still owns 100% of X stock directly and constructively b/c A owns Y corp.
Thus, b/c the sale doesn’t reduce A’s interest in X, it fails to satisfy any of §
302(b) tests for exchange treatments and is thus threated as a § 301
distribution from Y to A.
1. * §304(b)(2) req’s the distribution to be treated as a dividend received
by A from Y – to the extent of Y’s earnings and profits – and then
from X – to the extent of E/P. Thus, earnings and profits of both corps
are available to characterize the distribution to A as a dividend.
o Parent-Subsidiary Acquisitions:
a. § 304(a)(2) applicable when a controlled subsidiary acquires stock of its parent
from a SH of the parent in return for property.
b. Control test – parent subsidiary rx is defined by same 50% control test as in
304(c)(1).
c. If § 302 dividend equivalency – “property” used to make the acquisition is treated
as a distribution in redemption of the parent’s stock
i. If constructive redemption treated as exchange, selling SHs recognize
gain/loss under normal tax principles
d. If redemption fails to qualify as an exchange and is thus treated as a § 301
distribution, the amt and source of any dividend is first dx’d by reference to E/P of
the acquiring (subsidiary) corp and then, if necessary, by the E/P of the issuing
(parent) corp.
e. If transaction both a brother-sister and parent-sub acquisition, the parent-subsidiary
rules take precedence (304(a)(1)).
i. HOWEVER, b/c attribution rules transform most actual brother and sister
corps into a constructive parent/sub, the regulations provide that an actual
brother-sister rx takes precedence over a constructive parent-sub affiliation,
thus causing § 304(a)(1) to govern acquisitions by related non-subsidiary
corps (reg 1.304-2(c) example 1)
o Collateral Tax Consequences:
a. § 304(a)(1) brother-sister acquisition – treated as § 301 distribution (A deemed to
have transferred X stock to Y in exchange for Y stock in hypothetical § 351(a)
exchange, and Y is treated as having redeemed the Y stock it hypothetically issued
in that exchange.
i. * Y takes a transferred basis from A in the X stock under § 362, and A’s
basis in the Y stock is equal to A’s basis in the X stock.
b. If distribution = dividend  reduction in E/P follows ordering rules in § 304(b)(2)
– i.e. first reduce the acquiring corp’s (X corp’s) E/P to extent that they are source
of the dividend and then, if necessary, reduce the issuing corp’s (Y Corp’s) E/P.
c. IF §304(a)(1) applies and A’s sale of X crop stock is treated as EXCHANGE under
§ 302(a), Y is treated as having acq’d X stock by purchase and thus Y takes cost
59
basis under § 1012, and A’s original basis in Y stock remains unchanged.
(Thus, A’s basis in Y stock stays the same, i.e. basis in X stock)
d. In brother-sister acq where redemption treated as EXCHANGE  any reduction of
E/P is limited by § 312(n)(7) to an amt not in excess of the redeemed stock’s
ratable share of E/P
i. But which corp’s E/P?
1. 3 possibilities – acquiring corp’s (transaction treated as constructive
redemption of acqing corp stock and distributed property comes from
that entity); the issuing corp’s (redemption is trested by reference to
its stock); neither (transaction is simply a purchase, not a reduction of
either corp’s wealth), or both (pro rata?)
a. Usually, required reduction should be made first to acquiring
corp’s E/P and then, if necessary, to the issuing corp’s E/P
e. Parent-Sub acq –
i. if constructive redemption of parent’s stock is treated as DIVIDEND, selling
SH’s basis in the parent stock transferred to the subsidiary is added to the
basis in the SH’s remaining parent stock. Subsidiary takes a cost basis in the
parent stock that it acquires.  i.e. first reduce the acq’ing sub’s E/P to
extent they are source of dividend then move to reduce parent’s E/P
ii. if redemption treated as EXCHANGE, selling SH recovers his basis in
the transferred parent stock and recognizes cap gain/loss under normal
tax principles.
1. Again, § 312(n)(7) applies, but unclear which corp’s E/O are reduced,
leaving taxpayers to apply any reasonable approach.
Niedermeyer v. Commissioner
o F:
a. Taxpayers owned 22.58% common stock of American Timber and Trading Co
(ATT) and 125 of the 2,136 outstanding preferred stock. TP’s two sons owned
67.91% of common stock of ATT. Lents Industries was another corporation
controlled by the Niedermeyer family by TP’s other three sons who each owned 22
1/3 of Lents common stock. TP sold their ATT stock to Lents for $174,975 but
kept the 125 preferred shares which they contributed to a family foundation 3 ½
months after the common stock sale. On their 1966 tax return the TPs reported a
long-term cap gain of $168,321.58 for the ATT common stock sale to Lents.
b. Commissioner dx’d that the entire proceeds of the sale were taxable as ordinary
income b/c the transaction was covered by § 304(a) and was essentially equivalent
to a dividend.
o I: whether the TPs realized a cap gain or received a dividend on the sale of their ATT
common stock to Lents in 1966?
o H: Dividend
o R:
60
a. First need to dx if the sale was a redemption thru the use of a related corporation
under the provisions of § 304(a)(1), and if so, whether the distribution by Lents to
TP is treated as in exchange for the redeemed stock under §302(a) or as property
under §301.
b. 304(a)(1) – if one or more persons are in “control” of each of two corps and if one
of those corps acquires stock in the other corp from the person in control, then the
transaction is treated as a distribution in redemption for purposes of § 302.
i. 304(c)(1)  Control = the ownership of stock possessing at least 50% of the
total combined voting power of all classes of stock entitled to vote, or at
least 50% of total value of shares of all classes of stock.
ii. 304(c)(3) – constructive ownership of stock rules contained in § 318(a)
will apply for the purpose of dx-ing control (but 50% limitations will be
disregarded for dx-ing control)
c. CT: 304(a)(1) applies here b/c TPers and their sons collectively owned 4,346
common stock of the 4,803 outstanding, or 90.49% of ATT outstanding voting
sock was actually or constructively owned by TPers. TPers sons owned 48 of 72
shares of Lents or 67%. Thus the ownership of Lents is constructively attributable
to TPers. Thus, under 304(c)(1), TPers (individually or together) are said to be the
persons in control of both ATT and lents prior to the transaction.  Accordingly,
under § 304(a)(1) the transaction must be treated as a redemption.
d. TPers Argument:
i. Object to the applicability of § 302 b/c the attribution rules of §318(a)
shouldn’t apply b/c of the “bad blood” exception to the attribution rules,
citing Estate of Arthur Squier.
1. *** (when does bad blood actually come up – not essentially
equivalent dividend – meaningful reduction – then need to dx what is
really going on behind the scenes) bad blood doesn’t matter re
whether 304 applies – only comes in in 302 when dx-ing meaningful
reduction
2. CT: Squier case rationale not applicable to § 302(b)(1) in light of
Davis and b/c no evidence here to show that any cleavages (disputes)
between the TPers and their sons. (falling out was b/t sons only)
3. “control tests of §302(a)(1) and (c) requires attribution rules be
appliced in every case b/c that’s what Congress’ expressly indicated –
intended to remove uncertainties existing under prior law.
ii. Even tho the sale is treated as a distribution in redemption of Lents’ stock
under 304(a)(1), TP argues they are entitled to treat the distribution as in full
payment in exchange for their stock under § 302(a) and state that the
transaction meets the test of either § 302(b)(1) or 302(b)(3).
1. ** (302(b) determination made by reference to the issuing corp’s
stock (ATT stock))
2. (§302(b) states the conditions under which a redemption of stock will
be treated as an exchange. If none of those conditions are met, 302(d)
61
states that the distribution will then be treated as one where § 301
applies.)
3. 302(b)(1) – redemption be not essentially equivalent to a dividend –
to meet test of nondividend equivalency the redemption must, after
application of attribution rules, result in a “meaningful reduction of
the SH’s proportionate interest in the corp.”
a. Bona fide business purpose no longer relevant nor is any
bad blood b/t parties.
b. ** before the redemption TP owned 90.49% of outstanding
common of ATT and after, while TP actually owned no ATT
common, they constructively owned 82.95% of ATT common
via their sons, and 67% of Lents. THUS, there is no meaningful
reduction in ownership of ATT common from 90.49% to
92.96%.
iii. TPers assert they terminated their interest in ATT under § 302(b)(3)
1. (if test satisfied, the redemption treated as exchange if the redemption
is in complete redemption of all stock of corp owned by SHers)
2. If 302(c)(2) conditions satisfied, TPers exempted from application of
family attribution rules of 318(a)(1)
3. 302(b)(3) REQUIREMENTS: TPers must show they completely
terminated their stock interest in ATT – other than interest as creditor,
immediately after the distributin referred to in § 302(b)(3), AND
effect a proper agreement re waiver (302(c)(2)(A)(iii)
4. CT: requirement not met b/c TP retained 125 preferred stock in ATT
for 3 ½ months after the redemption of their ATT common stock.
5. ** TP then argue that the 125 preferred shares was not retention of an
interest other than as creditor b/c:
a. The preferred stock was actually debt
i. CT: don’t agree that preferred merely debt b/c, while
preferred had no rt to participate in management that
alone is not conclusive ---- furthermore, preferred here
had “equity flavor” b/c: no unconditional obligation ot
pay sum at fixed maturity date; timing of preferred
dividends was discretionary with directors; upon
liquidiation preffered would be paid “ from
money/property available for distribution to SHs” which
indication preferred was subordinated in priority to
general creditors; ATT amendment to articles of incorp
used terms dividends, preffered stock, and SHs re
preferred stock in question; and the preffered was created
during a reorganization by a transfer or earned surplus to
ATT’s capital account.
b. The de minimis rule should be applied (TP argues)
62
i. 302(b)(3) clearly requires no less than a complete
termination of all TP’s stock interest in corp
c. The relinquishment of their preferred was “immediately after:
the sale of their ATT common; and
i. The words “immediately after” must be given their
ordinary meaning and thus, December 28 cannot be
considered “immediately after” September 8th.
d. At time of ATT common stock, they intended to donate
preferred to charity before year’s end.
i. (TPers are esstentially saying that the sept 8th transafer
was but one step in a plan to terminate completely their
interest in ATT, the final step being their Dec 28
preferred stock contribution)
ii. Where redemptions were executed pursuant to a plan to
terminate one’s interest in a corp, it has been held that
dividend equivalency may be avoided where the ind
redemptions are components parts of a single sale or
exchange of an entire stock interest  where there is a
plan which is comprised of several steps, §302(b)(3) may
apply. HOWEVER, redemption must occur as part of
a plan which is firm and fixed and in which the steps
are clearly integrated
iii. HERE, evidence is too insubstantial to prove the
existence of a firm and fixed plan in which all steps are
clearly integrated.
1. Plan not in writing and no evidence of
communication of TP’s asserted donative intention
to charity or to anyone.
2. Citing Arthur McDonald – their plan was written
and was fixed as to its terms and apparently
binding.
e. H: TPers didn’t establish that the redemption should be treated as an exchange
under 302(a), therefore, the proceeds should be treated as a distribution of property
to which § 301 applies and as a dividend.
f. ** what should they have done  get rid of preferred shares at same time as
common or make a plan.
The Niedermeyer case is a good example of a tax planning blunder. It illustrates the need for
sensitivity to prvisions such as Section 304. In reading the case, make sure you can answer the
following questions
1 a). Why did Section 304 apply to the sale by the taxpayers of their AT&T common stock to Lents.
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1 b). Given that Section 304 applies, how do you test the “redemption” to determine if the
taxpayers have a dividend?
1 c). Why were the taxpayers unable to waive family attribution and qualify for “sale” treatment
under Section 302(b)(3)?
(a)-(c) Section 304 would apply because the taxpayers controlled both AT&T and Lents, and they sold the
stock to Lents in return for property. After the application of section 318 constructive ownership of stock,
they controlled both stocks. The taxpayers didn’t terminate their interest in the AT&T stock at the time of
the sale, so the taxpayers failed to qualify for the waiver of family attribution.
1 d). How could they have avoided this unfortunate result?
(d) The sale of AT&T stock to Lents qualifies under Section302(b)(3) and also with a waiver of family
attribution if the sale is after the disposition of the AT&T stock was part of a fixed plan to terminate the
shareholders interest in the stock.
3. Is Section 304 still necessary?
Yes, 304 necessary b/c designed tp prevent confusion re whether the redemption treated
under 301 or 302. Ensures controlling SHs don’t get exchange treatment without significant
reduction in control and ensures such result by requiring SH sales in brother-sister or parentsubsidiary coroprations fulfill one of the tests in 302.
As long as dividined and investment gains are taxed as same rate, less need for 304.
Complete Liquidations
A. Code treats liquidating distributions differently than non-liquidating distributions.
B. Code views complete liquidations as a sale.
a. As corp SH, not a good deal
C. Corp distributes all of its property to SHs, usually non-liquidating distribution –
considered a sale and realize gain but don’t recognize loss.
a. For complete liquidation – gain AND LOSS recognized
b. Why doesn’t code allow losses for non-liquidating distribution – b/c can “cherry
pick” gains and losses. But in complete liquidation, youre distributing everything
so that fear of picking “winners” and “losers; is not there (or minimized).
c. START MONDAY WITH EXCEPTIONS TO RULE …… page 339
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A. Codes doesn’t define complete liquidation but regs provide that liquidation status exists
for tax purposes “when the corp ceases to be a going concern and its activities are
merely for the puproe of winding up its affiars, paying its debts, and distributing
any remaining balance to its SHs”
a. Don’t need state law dissolution for liquidation
b. Still liquidation even if corp retains nominal assets to pay remaining debts and
preserve legal existence
B. Liquidations ofent are preceded by a sale of sub all of corp’s assets and distribution of the
sales proceeds to SHs in exchange for their stock. Alternatively, the buyer of a corp
business may acquire all the stock of the target company and either keep the old corp
alive or liquidate it.
a. *liquidation doesn’t have to involve a sale(s). The corp can simply distribute its
asets in kind to the SHs (who may sell assets or continue to operate business)
b. A parent copr may wish to rearrange its holding by liquidating or selling the stock
of a subsidiary.
C. Goals in a liquidation: SH vs. Corp
a. Corp level goals = avoid recognition of gain on a distribution or sale of assets
while providing the SHs (in liquidation) or purchaser (in acq) w/ a FMV basis in
the distributed or acquired assets.
b. SHs hoped to emerge from a complete liquidation or sale of profitable corp
business by realizing a cap gain on their stock and, on installment sale, by
deferring recognition of the gain until cash payments are received.
D. Complete Liquidations Under § 331:
E. 1. Consequences to Shareholders
i. Code = 331; 334(a); 346(a); 453(h)(1)(A)-(B)
ii. Regs = 1.331-1(a), (b), (e); 1.453-11(a)(1), 2(i), (3), -11(d)
b. Liquidations are treated as exchanges, thus, permitting SHs to avoid dividend sting
and are taxed at cap gains rates.
i. (congress concerned that the dividend threat was preventing the liquidation
of many corps b/c of the high tax cost re dividend treatment.
c. 331(a) – amounts received by a SH in complete liquidation are treated as full
payment in exchange for the SH’s stock. [b/c most SHs hold their stock as a capital
asset, they will recognize capital gain or loss in an amount equal to the difference
b/t (1) the money and FMV of property received and (2) the SH’s adjusted basis in
the stock surrendered]
d. 334(a) – the SH’s basis in property distributed by a corp in complete liquidation
that is taxable at the SH level will be the FMV of the property at the time of the
distribution.
e. Computation of SH’s gain/loss:
i. SH’s amount realized is the money and the FMV of all other property
received from liquidating corp.
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ii. If SH assumes corp liabilities or receives property subject to a liability in a
liquidating distribution, the amount realized is limited to the value of the
property received, net of liabilities.
1. Keeping w/ principles of Crane case, it is assumed that distribute SH
will pay the liabilities and he thus obtains a full FMV basis in the
property under 334(a)
iii. SHs who hold several blocks of stock w/ different bases and acquisition
dates must compute their gain/loss separately for each block rather than on
an aggregate basis1 . . . but this method only makes difference when some
shares are held long-term and others short-term . . . otherwise, tax
consequences are identical whether SH uses share-by-share or an aggregate
approach.
f. Timing issues
i. (liquidating corp usually can’t distribute all of its property at one time, or
within same taxable year)
ii. 346(a) – defines a complete liquidation to include a series of distributions
occurring over a period of time if they are all pursuant to a plan of complete
liquidation.
1. Cost Recovery Approach: SHs normally treat these “creeping
complete” liquidations as open transactions so they can defer
reporting gain until amounts received exceed their stock basis
a. The cost recovery approach has been okay’d by Service in the
liquidation context, even tho appears 453 forecloses such option
– Section 453 requires ratable basis recovery as payments are
received even in cases where the selling price can’t be readily
ascertained.
i. [since liquidating distriubtions are treated as payments in
exchange for SHs’ stock, Section 453 technically applies,
and thus, SHs wishing to defer their gain should be
required to use the installment method – allocating each
distribution b/t recovery of basis and taxable gain. But
TPers using Cost Recovery approach not likely to be
challenged by Service.
ii. [Installment sale reporting usually only needed when
corp distributes an installment obligation re 453(h).
Installment sale reporting NOT available if stock of the
liquidating corp is publicly traded. BUT, restriction
1
E.g. SH holds 60 shares of X corp stock long-term w/ $30,000 basis and another 40 shares short-term with
$50,000 basis. If SH receives $100,000 in complete liquidation of X corp, SH must allocate the amount realized
ratably b/t the two blocks as follows:
Long Term (60 shares)  $60,000 (A.R.) – (A.B) 30,000 = LTCG $30,000
Short Term (40 shares)  (A.R.) $40,000 – (A.B) 50,000 = STCL $10,000.
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doesn’t apply when a SH of a public company receives a
series of distributions straddling tow or more taxable
years.]
iii. 453(d) – permits a TP to “elect out” of installment sale
treatment. Re a liquidation, an “election out” requires the
SH to report his entire gain in the year of the first
distribution, except where the value of future
distributions is unascertainable.
iii. Issue re liquidating corp sells certain assets for installment obligations
and then distributes the obligations in complete liquidation
1. Here, SHs who receive the installment obligations may be able to
defer part of their 331(a) gain on the liquidation by using the
installment method of reporting under 453.
2. Installment sale reporting is accomplished by treating the SHs’ receipt
of payments on the distributed installment obligations as if they were
received in exchange for the SH’s stock.2
3. To qualify for installment sale reporting, the obligations must have
been acquired by the corp in a sale or exchange of property during the
12-month period - beginning on date a plan of complete liquidation is
adopted - and the liquidation must be completed within that 12-month
period.
4. Installment obligation arising from sale of inventory or other “dealer”
property by corp
a. Eligible for installment sale treatment in the hands of the
distributee SHs (i.e., SHs receiving obligation by corp) only if
the obligation resulted from a bulk sale – i.e. the sale was to one
person in one transaction and involves substantially all of the
property attributable to a T/B of the corp.
5. Installment sale reporting NOT available if the stock of the liquidating
corp is publicly traded3, or if the SH elects out of Section 453(d)
F. Notes:
a. Discussion re repeal of General Utilities doctrine re liquidations
i. Congress didn’t want the code to artificially encourage corp liquidations and
acquisitions – b/c the tax benefits of liquidating and nonliquidating
distribuitons were different, corps would liquidate appreciated assets and
transfer them to other corps. Congress also though Gen Utilties rule
§ 453(h)(1)(A) – a SH who receives liquidating distributions that include installment obligations in more than
one taxable year must reasonably estimate the gain attributable to distributions received in each taxable year
based on the best available info and allocate his stock basis pro rata over all payments to be received. When the
exact amount of gain is subsequently dx’d, any adjustment is made int eh taxably year in whih that
determination is made. Alternatively, the SH may file an amended return for the earlier year.
3
But if a non-publicly traded liquidating corp distributes an installment obligation arising from a corporatelevel sale of publicly traded stock, the obligation qualifies for installment sale reporting under 453(h).
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2
undermined the corp income tax b/c assets were generally permitted to leave
corporate solution and take a stepped-up basis in the hands of the transferee
w/o the imposition of s corp-level tax… thus the effect of rule was to grant a
permanent exemption from corp income tax.
G. Liquidating Distributions and Sales
i. 336(a) – requires a liquidating corp to recognize gain or loss on the
distribution of property in complete liquidation as if the property were sold
to the distributee at its FMV. [if the distributed property is subject to a
liability, the FMV of the property can’t be less than the amount of the
liability]
ii. Whenever a corp makes a liquidating distribution of appreciated property,
gain generally recognized at the corporate level and the distribution also
taxable event to the SHs.
1. Two exceptions - nonrecognition of gain/loss is preserved for: (1)
distributions in complete liquidation of a controlled – 80% subsidiary, and (2) distributions in certain tax-free reorganizations.
iii. A corp must recognize gain/loss on any sale of its assets pursuant to
complete liquidation plan [but see 338(h)(10) – a corp that sells or
distributes stock in an 80% or more subsidiary may elect under 336(e) to
treat the sale as a disposition of the subsidiary’s assets and ignore any
gain/loss on the sale or distribution of stock.
H. Limitations on Recognition of Loss
a. The sections governing complete liquidations (336(a)) and nonliquidating
distributions (311) differ in two major ways: (1) 336 allows the distributing corp to
recognize loss as well as gain; and (2) while 267 disallows losses on sales of
property by a corp to a “related” party (e.g. a controlling SH), 336 doesn’t disallow
them on liquidating distributions to related parties. BUT see two loss limitation
rules [336(d)] below:
b. 336(d) Loss Limitation Rules:
i. 1) Distributions to Related Persons: 336(d)(1) – no loss shall be recognized
by a liquidating corp on the distribution of property to a Section 267 related
person if either: (1) the distribution is not pro rata among the SHs, OR (2)
the distributed property was acquired by the liquidating corp in a Section
351 transaction or as a contribution to capital within the five-year period
ending on the date of the distribution.
1. b/c restrictions focus on the recipient of loss property, related persons
usually will be SHs who own directly, or thru 267 attribution rules,
more than 50% in value of the stock of the distributing corp –
267(b)(2), (c).
2. “not pro rata” among SHs – no def in statue nor leg history. Congress
likely intended to single out situations where a majority SH receives
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an interest in loss property that is disproportionate4 to his stock
interest in the corp.
I. Problem p 342 – only 1 (a)-(c):
All the outstanding stock of X corp is owned by Ivan (60 shares) and Flo (40 shares), who are
unrelated. X has no liabilities and the following assets: (1) Gainacre (A/B $100,000; FMV
$400,000); (2) Lossacre (AB $800,000; FMV $400,000); and (3) Cash (AB $200,000; FMV
$200,000). [Assume each property held for more than five years].
On Jan 1 of the current year, X adopted a plan of complete liquidation. What are tax
consequences to X on the distribution of its assets pursuant to the liquidation plan in each of the
lowing alternatives?
(a) X distributes each of its assets to Ivan and Flo as tenants-in-common in proportion to
their stock interests (i.e., Ivan takes 60% interest and Flo a 40% interest in each asset).
a. X corporation will realize a $400,000 loss on Lossacre and recognize $0 of it.
b. X distributes each of its assets to Ivan and Flo as TIC in proportion to their stock interests (i.e.
Ivan takes a 60% interest and Flo a 40% interest in each asset)? Under IRC §336(a) gain or loss
is recognized by a corporation upon liquidation of property as if it were sold. Therefore, X
recognizes a $300,000 capital gain and a $400,000 loss (netted to $100,000 loss). IRC §336(d)
does not apply because each asset is distributed pro rata and were held by more than 5 years
i.e. is not “disqualified property.”
1. Same as (a), except X distributes Lossacre and the cash to Ivan and Gainacre to Flo.
i. No change for the distribution of gainacre to Flo ($300,000 capital gain) §336(a). X may not
recognize the $400,000 loss on the distribution of lossacre to Ivan because under
§336(d)(1)(A), “no loss shall be recognized by a liquidating corporation on the distribution of
any property to a related person (within the meaning of IRC section 267) if:
1. such distribution is not pro rata. OR
2. such property is disqualified property.
1. Under 267(b)(2) a corporation is related to a shareholder if the
shareholder owns more than 50% in value of the outstanding stock. YES.
2. NON-Pro rata means anything that is not pro rata. Pro Rata means that
each shareholder received a portion of every property. YES – this is non pro
rata. Therefore, §336(d)(1) applies.
3. Disqualified Property – defined in 336(d)(1)(B) is property acquired by
the corporation within 5 years of the liquidation in an IRC §351 transaction.
NO this is not disqualified property because held for more than 5 years.
However, because the distribution is to a related party and is non pro rata,
§336(d)(1) will apply.
X Corporation does not recognize a loss on the distribution of lossacre to Ivan. Ivan will take the property
with an adjusted basis of $400,000 FMV IRC§334(a).
4
E.g. X corp has a net worth of $1,000 and is owned 75% by A and 25% by five unrelated SHs. X distributes
Loss-acre (value $750; basis $1,000) to A and $250 cash to the other SHs. Since Loss-acre was not distributed
to the SHs in proportion to their respective stock interests, the distribution is not pro rata and X may not
recognize its $250 loss.
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(b) Same as (b), except X distributes Gainacre and the cash to Ivan and Lossacre to Flo.
a. Same as (b) above, except X distributes Gainacre and the cash to Ivan and Lossacre to Flo? X
Corporation recognizes $3000,000 LTCG on the distribution of Gainacre to Ivan and Ivan will
take the property with a basis of $400,000 (FMV). X may take the $400,000 loss on the
distribution of Lossacre, because Flo is not a related person under IRC §267 and therefore
§336(d)(1)(A) does not apply. Flo will take Lossacre with a basis of $400,000 (FMV).
Liquidation of a Subsidiary:
Consequences to the Shareholders
A. Code §§ 332; 334(b)(1); 1223(2)
B. Regs: §§ 1.332-1, -2, -5
C. While nonrecognition treatment is NOT appropriate on an ordinary complete liquidation
b/c it would permit ind SHs to achieve a tax-free bailout, nonrecognition treatment is
appropriate in a complete liquidation when a parent corp liquidates a controlled
subsidiary. [since the assets of the subsidiary remain in corporate solution, the
liquidation is a mere change in form and should not be impeded by tax imposition]
D. 332 – a parent corp recognizes NO gain or loss on the receipt of property in complete
liquidation of an 80% or more subsidiary if certain conditions are met. If conditions met,
the parent takes the distributed assets with a transferred basis under 334(B)(1)5 and
inherits the subsidiary’s E/P and other tax attributes under 381(a)(1)6.
a. * to qualify under 332 – the subsidiary must distribute property to its parent in
complete cancellation or redemption of its stock pursuant to a plan of liquidation,
and the liquidation must meet two formal requirements – relating to control and
timing.
i. Control:
1. 332(b)(1) – parent must own at least 80% of the total voting power of
the stock of the subsidiary and 80% of the total value of all
outstanding stock of the subsidiary from the date of adoption of the
But see when liquidating subsidiary is a goreign corp – thus not subject to US tax re distributed property – and
distributee parent IS jubject to US tax (e.g. domestic corp), the distributee’s aggregate adjusted basis of the
distributed property, if it otherwise would exceed its FMV, must be limited to the lesser FMV – 334(b)(1)(B).
[purpose = prevent importation of tax losses into US tax system thru the liquidation of a foreign subsidiary]
6
The parent’s basis in the stock of a subsidiary is not taken into account in dx-ing the tax consequences of a
Section 332 liquidation and disappears from the scene. Creates possibility parent may be deprived of a loss on
its investment in the subsidiary even tho it must inherit a low carryover basis in its assets.
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5
plan of complete liquidation and at all times thereafter until the parent
receives the final distribution7.
2. Usually condition is no problem when subsidiary is wholly owned,
but any significant minority ownership creates a risk that the
transaction will run afoul of the control req. [e.g., parent sometimes
motivated to intentionally violate 80% tests in order to avoid 332 and
recognize a loss on its stock in sub]
ii. Timing:
1. Two timing alternatives of 332
2. “One-shot” liquidations qualify if the subsidiary distributes all of its
assets within one taxable year8 even if it is not the same year in
which the liquidation plan is adopted.
3. Distributions spanning more than one taxable year, the plan must
provide that the subsidiary will transfer all of its property within
three years after the close of the taxable year in which the first
distribution is made – 332(b)(3)
4. Failure to meet the deadline will cause the liquidation to be
retroactively disqualified.
b. Minority SHs:
i. Nonrecognition under 332 is ONLY granted to the controlling parent corp;
nonrecognition NOT available to minority SHs, who must dx their gain/loss
in normal manner under 331(a), unless liquidation also qualifies as a tax-free
reorganization – rare tho.
Consequences to the Liquidating Subsidiary
A. Code: §§ 336(d)(3); 337(a), (b)(1), (c)
B. Reg: 1.332-7
C. Distributions of Property.
a. Generally, a liquidating corp recognizes gain or loss on distributions of property in
a complete liquidation (336(a)) – however, major exception = 337
b. 337: a liquidating subsidiary does NOT recognize gain or loss on distributions
of property to its parent in a complete liquidation where 332 applies
i. “parent” = 80% distributee [337(a)] = a corp that meets the 80% stock
ownership reqs in 332(b) [337(c)]
ii. (nonrecognition makes sense here b/c the subsidiary’s tax attributes (inc
built-in gain or loss in assets) can be preserved in hand of parent)
Stock ownership reqs are derived from Section 1504(a)(2) – sets forth rules for dx-ing whether a corp is a
member of an “affiliated group” – most nonconvertible preferred stock is disregareed for purposes of stock
ownership req.
8
332(b)(@) the adoption by the SHs of the resolution authorizing the distributions in liquidation is considered
an adoption of a “plan” of liquidation even tho it may not specify the time for completeing the transfers.
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7
c. 334(b)(1): the parent takes a transferred basis in property received from a
subsidiary in a 332 liquidation
d. Depreciation recapture provisions do not override § 337 [1245(b)(3)] and recapture
potential continues to lurk in the distribued property thru the def of “recomputed
basis” in § 1245(a)(2) and “additional depreciation” in § 1250(b)(1), (3)
e. Liquidating subsidiary does NOT recognize gain or loss on the distribution of
installment obligations if 332 applies [453B(d)(1)], and the parent will take a
transferred basis in the oblgiations under 334(b)(1).
D. Distributions to Minority SHs.
a. Nonrecognition rule in 337(a) is limited to distributions of property by a liq
subsidiary to the “80-percent distributee”, i.e., the parent corporation.
b. Distributions to MINORITY SHs are teated the same as a distribution in a
nonliquidating redemption – thus, the distribution corp will recognize gain but
NOT loss
i. [recognition of gain appropriate b/c minority SHs do NOT inherit any builtin gain in the distributed property thru transferred basis b/c they take a FMV
basis under 334(a)]
c. 336(d)(3): no loss shall be recognized to a subsidiary on a distribution of
property to minority SHs in a 332 liquidation
i. [purpose = to prevent a controlled subsidiary from recognizing losses (but
not gains) by “bullet” distributions of loss property to minority SHs]
E. Transfer of Property to Satisfy Indebtedness of Subsidiary to Parent.
a. 337 only applies to liquidation DISTRIBUTIONS. If a subsidiary is indebted to its
parent, a transfer of property to satisfy debt normally taxable even rather than a
nontaxable distribution governed by 337(a), causing the subsidiary to recognize
gain or loss and the parent to take a FMV basis in the distributed property
i. BUT, b/c of the disparate treatment of distributions in complete liquidation
vs. transfers of property to satisfy debt may tempt a subsidiary to distribute
appreciated property as part of the liquidation while simultaneously using
loss property to extinguish sub’s debt to parent .. . 337(b)(1)
b. 337(b)(1): any transfer of property in satisfaction of a subsidiary’s debt to its
parent is treated as a distribution, subjecting the transfer to the general
nonrecognition rule of 337(a). Thus, Parent takes a transferred basis in the
distributed property [334(b)(1)].
F. Distributions to Tax-Exempt and Foreign Parents.
a. In both situations below where subsidiary recognizes gain or loss, the parent takes
a FMV basis in the distributed assets [334(b)(1)(A)]
b. Tax-Exempt: 337(b)(2): the general corporate-level nonrecognition rule for
liquidations of a subsidiary will NOT apply where the parent is a tax-exempt
organization. BUT, nonrecognition restored if the distributed property is used by
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the tax-exempt parent in an “unrelated trade or business”9 immediately after the
distribution.
c. Foreign Parent: Recognition of corporate-level gain in the case of a liquidating
distribution to a parent that is a foreign corp – regs permit nonrecognition if the
appreciation on the distributed property is NOT being removed from the US’s
taxing jurisdiction prior to recognition.
Transfer of Property to Corporation in Exchange for Stock
Introduction and Requirements
o Introduction to SECTION 351
a. Code §§ 351(a), (c), (d)(1)-(2); 358(a), (b)(1); 362(a), (e); 368(c); 1032(a);
1223(1), (2); 1245(b)(3).
b. Regs: §§ 1.351-1(a), (b); 1.358-1(a), -2(b)(2); 1.362-1(a); 1.1032-1(a), (d).
o Section 351 policy:
a. To start a business, a corp needs assets and normally acquires these assets – initial
“capital” of corp – by issuing shares of stock in exchange for cash or property or
by borrowing.
b. Stock for Cash: when a corp raises its equity capital by issuing stock solely for
cash, the tax consequces = the SH simply has made a cash purchase and takes a
cost basis in the shares acquired [1012].
c. Stock for Property: if corp issues stock for property other than cash, the exchange
would be a taxable event w/o a spcial provison of codew. The SH would recognize
gain or loss equal to the diference b/ t the FMV of the stock recievd and the AB of
the property transferred to corp.
d. ** To remove double taxed obstacles, Congress dx’d that routine incorporations
should be tax free to the SHs and the corp. h
e. SHAREHOLDER LEVEL– at SH level, Section 351(a) provides that no gain or
loss shall be recognized if property is transferred to a corp by one or more persons
solely in exchange for its stock if the transferor or transferors of property are in
“control” of the corp “immediately after the exchange”
i. 351 applies to both transfers to newly formed and preexisting corps,
provided that the transferors of property have “control” immediately after
the exchange.
Exempt organizations are taxable on income from “unrelated business” = a regularly carried on trade or
business activity that is not substantially related to the organization’s exempt purposes [511]. BUT, if the taxexempt parent later disposes of the property or ceases to use it in an unrelated T/B, any gain not recognized on
the earlier liquidation becomes taxable as unrelated business income [337(b)(2)(B)(ii)]
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9
f. CORPORATE LEVEL: 1032(A0 privides that a corp shall not recognize gain or
loss on receipt of money or other property in exchange for its stock (inc treasury
stock).
g. 351 policy is familiar to nonrecognition provisions – the transfer of
appreciated/depreciated property to a corp controlled by the transferor is viewed as
a mere change in the form of a SH’s investment.
i. 351 broad enough to embrace transfers of property by a group of previously
unrelated persons – provided that the specific statuory reqs are met:
h. However, 351(e)(1) – disallows nonrecognition in the case of a transfer of property
to an investment company – provision intended to stop a group of TPs from getting
a tax-free diversification of their investment portfolios thru an exchange w/ a
newly formed investment company.
o 351 Requirements to qualify for nonrecognition of gain or loss:
1) One or more persons (inc individuals, corps, partnerships and other entities)
must transfer “property” to the corporation;
2) Transfer must be solely in exchange for stock of the corp; and
3) The transferor or transferors, as a group, must be in “control of the corporation
“immediately after the exchange”
o “Control”
a. 368(c): Control is the ownership of stock possessing at least 80 percent of the total
combined voting power of all classes of stock entitled to vote AND at least 80
percent of the total number of shares of all other classes of stock of the corp.
o Shareholder Basis and Holding Period
a. BASIS
i. SH may realize gain/loss BUT does NOT currently recognize gain/loss! (b/c
351 exchange)
ii. 358(a)(1) – the basis of the stock (“nonrecognition property”) received in a
351 exchange shall be the same as the basis of the property transferred by
the SH to the corp – “an exchanged basis” [7701(a)(44)]
a. E.g., if A transfers property to Venture corp with a $10 basis
and a FMV of $100 for stock w/ value of $100 in a 351
transaction, A’s basis in the stock will be $10. The $90 gain
that went unrecognized on the exchange will be recognized
if/when A sells the stock
b. [but, if SH dies w/o selling the stock, his basis will be stepped
up (or down) to its FMV on the date of his death]
b. HOLDING PERIOD
i. 1223(1) where a transferor receives property with an exchanged basis, such
as stock in a 351 exchange, the holding period of that property is dx’d by
including the period during which he held the transferrd property if the
transferred property is a capital asset or a 1231 asset;
1. if property is not, the transferor’s holding period begins on the
date of the exchange.
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o Tax Consequences to Transferee Corporation
a. 1032 – a corp does not recognize gain or loss when it issues stock in exchange for
money or property
b. BASIS
i. 362(a) – “transferred basis” – i.e. the corp’s basis in any property received in
a 351 exchange is the same as the transferor’s basis
c. HOLDING PERIOD
i. 1223(2) – if property has a transferred (carryover) basis to the corp, the
transferor’s holding period will also carry over.
o Limitations on Transfer of Built-in Losses
a. If property with a net built-in LOSS is transferred to a corp in a 351 transaction or
as contribution to capital, the transferee corp’s aggregate adjusted basis of such
property is limited to the FMV of the transferred property (FMV at time
immediately after transfer) [362(e)(2)]
i. [this limitation is applied on a transferor-by-transferor basis, rather than to
an aggregated group of transferors]
b. * Transferred property has a “net built-in loss” when the aggregate adjusted basis
of the property exceeds its FMV.
i. Any gain recognized by a transferor that increases the transferee corp’s basis
in the transferred property is taken into account in dx-ing whether the
transferred property has a “net built-in loss” in the tranferee’s hands. [1.3624(h) ex 6.
c. If multiple properties are transferred in same transaction, some with built-in gains
and others with losses, the basis limitation only applies when there is a net built-in
loss.10
i. If more than one property with a built-in loss is transferred, the aggregate
reduction in basis is allocated among the properties in proportion to their
respective built-in losses immediately before the transaction [362(e)(2)(B)]
d. Alternatively, the SH and the corp may jointly elect to reduce the SH’s basis in the
stock that it receives to its FMV [362(e)(2)(C)].
i. The amount of basis reduction resulting from this election may NOT be
larger than what is necessary to eliminate the duplication of loss in the
transferred assets.
ii. Thus, the amount of any stock basis reduction equals the amount of asset
basis reduction that would have been required under 362(e)(2) if the election
had not been made … i.e. the transferee (corp’s) aggregate AB of such
property is limited to the FMV of the property immediately after the transfer.
362(e)(2)(A)(ii) – similar basis limitation rules apply to transactions where there is an “importation” of a net
built-in loss, such as a transfer of loss property to a domestic corp by a person not subject to US tax, or a taxexempt entity.
75
10
iii. If the election is made, the assets continue to have a build-in loss in the
hands of the transferee corp, but the loss will not be duplicated on the
disposition of the SH’s stock.
Requirements for Nonrecognition of Gain or Loss under 351
e. A tax-free exchange is easily accomplished if a group of individuals forms a corp
by transferring property solely in exchange for common stock.
o “Control” Immediately after the Exchange
a. 368(c) Control: (1) the ownership of at least 80% of the total combined voting
power of all classes of stock entitled to vote, AND (2) at least 80% of the total
number of shares of all other classes of stock.
i. Control must be obtained by one or more transferors of “property” who act
in concert under a single integrated plan.
1. Timing: Transfers don’t have to be simultaneous to still be part of
integrated plan  sufficient fi the rights of the parties are “previously
defined” and the agreement proceeds with an “expedition consistent
w/ orderly procedure”
a. No limit to # of transferors, and some may receive voting stock
while others receive nonvoting stock
2. Mutually interdependent steps: transfers must be mutually
interdependent steps in the formation and carrying on of business
a. [thus, possible for transfers to be separated by less than an hour
to be considered separately for purposes of control req-ment.
Vice versa with transfers years apart]
3. Immediately after: transferors of property must be in control
immediately after exchange. Momentary control not enough if the
holdings of the transferor group fall below the re’d 80% as a result of
dispositions of stock in a taxable transaction pursuant to binding agmt
or prearranged plan.
a. [BUT, a voluntary disposition of stock, esp in donative setting,
shouldn’t break control even if the original transferor of
property parts with shares minutes after incorporation
exchange]
ii. If corp issues more than one class of nonvoting stock, the Service
requires that the transfer group must own at least 80% of EACH
CLASS.
o Intermountain Lumber Co. v. Commissioner (tax ct- 1976)
a. F: Sawmill burned down that was owned by Shook. Shook made agreement w/
Wilson to replace burned down mill with bigger one and in return for financing,
Wilson will own half of new company. Shook transferred sawmill site to new corp
76
b.
c.
d.
e.
for 364 shares of new corp’s stock. In mins of first SH meeting, Shook informed
meeting that a separate agmt was being prepared where Shook was to sell one-half
of his stock to Wilson. On same day Shook transferred sawmill site, Shook and
Wilson entered into “an Agreement for Sale and Purchase of Stock” under which
Wilson was to purchase 182 shares from Shook’s stock, to be paid in installments,
As each principal payment was made, a proportionate number os shares were
transferred to Wilson . . . i.e., Wilson didn’t get all shares at once. A certificate for
all 182 shares was placed in escrow, which would be released periodically as
Wilson made payments. Shook also executed an irrevocable proxy granting Wilson
voting rights in the 182 shares.
i. Intermountain Lumber bought all outstanding stock of new corp, which
became a wholly owned sub of intermountain.
I: what basis in new corp’s assets did Intermountain take for purposes of
depreciation? Depends on if 351 transaction or a sale. If 351 transaction, need to
know if Shook owned the requisite percentage of stock immediately after the
exchange to control the corp as req’d for nontaxable treatment under 351.
i. ** If the transfer of assets by the incorporators in new corp was a tax-free
351 exchange, then new corp and Intermountain must depreciate assets of
new corp on incorporators’ basis (i.e., the lower basis that the incorporators
of new corp had). But if 351 inapplicable, and the transfer of assets to new
corp was treated as sale, Intermountain could base depreication on FMV of
those assets at the time of incorporation (which was higher than
incorporators’ cost and would, thus, provide larger depreciation deductions.
H: Shook did NOT own the requisite percentage of stock immediately after
the exchange to control the corp as req’d for nontaxble treatment under 351 .
. . b/c Shook gave up his legal rights to half of new corp in the same
transaction where he transferred property to new corp.
Arguments:
i. Intermountain: the transfer of S&W’s assets to new corp at the time of
incorporation by the primary incorporator was a taxable sale.
1. Assets that 351 inapplicable b/c Shook didn’t have requisite
percentage of stock necessary for “control” of new corp immediately
after the exchange. – b/c an agmt for sale required Shook, as part of
the incorporation transaction, to sell almost half of the new corp’s
shares to Wilson.
ii. Service: the agreement b/t Shook and Wilson did not deprive Shook of
ownership of the shares immediately after the exchange b/c the stock
purchase agmt merely gave Wilson an option to purchase the shares.
R:
i. First, Wilson was not a transferor of property, and thus not counted for
purposes of control under 351, b/c Wilson didn’t transfer any property to
new corp upon its initial formation. Thus, Wilson’s agmt to transfer cash fro
corporate stock isn’t part of the same transaction.
77
ii. Next, must dx if Shook alone onwed the requisite percentage of shares for
control
1. Facts and circumstances inquiry
iii. Who owns the stock?
1. “ownership” depends upon the obligations and freedom of action
of the transferee w/ respect to the stock when he acquired it from
the corp. [ownership attributes such as legal title, voting rights, and
possession of stock certificates are NOT conclusive]
2. Owner if no restrictions on what you can do with the shares – or if
you still have the legal right (b/c of option) to buy the shares. No
ownership if relinquished legal right to decide to keep shares.
3. If the transferee (Wilson) has irrevocably foregone or relinquished his
legal right to dx whether to keep the shares, then ownership is lacking.
HOWEVER, if there are no restrictions upon freedom of action at the
time he acquired the shares, then it doesn’t matter how soon thereafter
the transferee disposes of the stock or even if such disposition is
allowable by the preconceived plan that’s not a binding obligation.
iv. HERE:
v. Shook and Wilson intended to consummate a sale of the new corp stock,
that they never doubted that the sale would be completed, that the sale was
an integral part of the incorporation transaction, and that they considered
themselves to be coowners of new corp upon execution of the stock
purchase agmt.
vi. “forfeiture clause” doesn’t convert agmt to an option agmt
1. – which said that Wilson forfeited the fight to purchase a proportione
number of shares if timely principal payments were not made – such
clause didn’t covert the agreement into an option agreement
2. Moreover, the agreement for sale didn’t state that interest on the
remaining principal would stop if the principal payments weren’t
made
vii. Thus, Shook, as part of same transaction by which the shares were acquired,
had relinquished the legal right to determine whether to keep the 182 shares
to Wilson  Shook was under an obligation to transfer the stock as he
received Wilson’s principal payments. [agmt also stated that Wilson had the
right to prepay the principal and receive all 182 shares at any time in
advance]
viii. THUS, Shook did NOT own the requisite percentage of stock [within
368(c)’s meaning] immediately after the exchange to control the corp as
required for nontaxable treatment under 351.
1. More than ‘mere change in form: If the transferor sells his stock as
part of the same transaction as transferring property to corp, thus
taxable
78
2. ** In this case, the transferor agree to sell and did sell 50 percent of
stock to be received from new corp, placed the certificates in the
possession of an escrow agent, and granted a binding proxy to the
purchaser to vote the stock being sold. – “far more than a mere change
in form was effected”
o Note:
a. Rev Ruling 2003-51
i. Involved a plan by two corps, X and Y corp, to consolidate certain
businesses in a holding company structure. X transferred $40 of ASSETS to
a wholly owned sub, X sub, in exchange for X Sub stock. Pursuant to
preexisting agmt, X Corp transferred its X Sub stock to Y Sub, in exchange
for Y Sub stock. Y contributed $30 of CASH to Y Sub for Y Sub stock.
Finally, Y Sub transferred its own business assets and the $30 of cash from
Y to X Sub. So, X co and Y co owned 40% and 60%, respectively, of Y Sub,
and Y Sub owned 100% of X Sub.
ii. Issue = tax consequences of first transfer.
iii. H: First transer would have qualified for nonrecognition of gain under 351
on the first transfer, but also 351 treatment for X’s preexisting obligation to
also make the second transfer.
iv. * ruling distringuesh b/t prearranged dispositions of stock that are taxable
and those that are nontaxable:
1. NOT 351 - a transfer of property that is followed by a prearranged
sale of the stock received as a transfer is NOT a 351 transaction.
2. 351 Transaction - a transfer of property that is followed by a
nontaxable disposition of the stock received as a transfer is consistent
with 351 nontax treatment. Accordingly, the control req may be
satisfied in such a case, even if the stock received is transferred
pursuant to a binding commitment in place upon the transfer of the
property in exchange for the stock.
Transfers of “Property” and Services
Reg 1.351-1(a)(1), (2)
79
“Property” - Not defined in 351, but has been broadly construed to include: cash, capital assets,
inventory, accounts receivable, patents, and in certain circumstances, other intangible assets
such as nonexclusive licenses and industrial know-how.
Stock in exchange for Services:
o 351(d)(1) – if stock is issued for services rendered, not b/c of tranfer of property, then not
considered “transferor of property” so not considered part of control group.
o (e.g. promoter of enterprise or company lawyer)  If stock is compensation for
services, the tax consequences are dx’d by §§ 61 & 83.
b. Stock for Services = ordinary income, and may cause the other parties to the
incorporation to recognize gain/loss.
i. Pure service provider is NOT considered a transferor of property and may
NOT be counted as part of the control group for purposes of qualifying the
exchange under 351.
c. BUT, if person receives stock in exchange for BOTH property and services, ALL
that SH’s stock is counted toward the 80-percent control req.
i. [Issue when promoter and investor form new corp and Promoter, in
exchange for only his services, recievs 25% of new corp and Investor takes
rest in exchange for property. Investor, as the only transferor of property,
does not have control and thus must recognize gain UNLESS Promoter can
qualify as a transferor of property – easily achieved by the mere transfer of
$100 in cash. Rule below prevents this situation:]
d. De minimus Rule: If value of property tranfsered to corp is de minimis compared
to the stock received for services, then stock will not be treated as being issued for
property:
i. Rev Procedure 77-37 – property transferred “will NOT be considered to be
of relatively small value if the FMV of the property transferred is equal to,
or in excess of, 10% of the FMV of the stock already owned (or to be
received for services) by the transferor.
1. In Subchapter C, Stock will NOT be treated as having been issued for
property IF the primary purpose of the transfer is to qualify the
exchanges of the property transferors for nonrecognition AND IF the
stock issued to the nominal transferor is “of relatively small value” in
comparison to the value of the stock already owned or to be received
for services by the transferor – 1.351-1(a)(1)(ii)
“SOLELY for Stock”
e. [final req for nonrecognition is that the transfers of property be made “solely” in
exchange for “stock” of the controlled corp.]
f. “Stock” means an equity investment in the company = nonrecognition property
i. NOT stock rights or warrants.
ii. NOT Debt Securities
1. Any other form of non-security debt (e.g. short-term note)
80
“nonqualified preferred stock” – preferred stock that has debt-like characteristics is treated as
“boot” – not stock – for 351 purposes. 351(g)(2). Recognize gain, but not loss.*
o HOWEVER, TP allowed to recognize a LOSS if ONLY nonqualified preferred stock is
received in an exchange – 351(g)(1)(B).
o Effect of 351(g) is to treat debt-like preferred stock as boot, resulting in potential
recognition of gain to recipient under 351(b), BUT generally NOT loss.
o nonqualified preferred stock is boot for gain recognition purposes but stock for other
purposes.
iii. = preferred stock11 with any of the following: (1) SH has the right to require
the issuing corp or a “related person”12 to redeem or purchase the stock, (2)
the issuer or a related person is required to redeem or purchase the stock, (3)
the issuer or a related person has the right to redeem or purchase the stock
and, as of the issue date, it is more likely than not that such right will be
exercised, OR (4) the dividend rate on such stock varies in whole or in part
with reference to interest rates, commodity prices, or similar indices.
1. First three categories apply only if the right or obligation w/ respect to
the redemption or purchase of the stock may be exercised within the
20-year period beginning on the issue date of the stock, and such right
or obligation is not subject to a contingency which, as of the issue
date, makes remote the likelihood of the redemption or purchase. –
351(g)(2)(B)
g. De minimus Rule: If value of property tranfsered to corp is de minimis compared
to the stock received for services, then stock will not be treated as being issued for
property:
“preferred stock” is stock which is limited and preferred as to dividends and does not participate in corp
growth to any sig extent – 351(g)(3)(A)
12
Persons are “related” if they bear any of the relationships described in 267(b) or 707(b) – e.g., family
members, controlling SHs or partners, a corporate affiliate, etc.
81
11
i. Rev Procedure 77-37 – property transferred “will NOT be considered to be
of relatively small value if the FMV of the property transferred is equal to,
or in excess of, 10% of the FMV of the stock already owned (or to be
received for services) by the transferor.
h. In Subchapter C, Stock will NOT be treated as having been issued for property IF
the primary purpose of the transfer is to qualify the exchanges of the property
transferors for nonrecognition AND IF the stock issued to the nominal transferor
is “of relatively small value” in comparison to the value of the stock already owned
or to be received for services by the transferor – 1.351-1(a)(1)(ii)
A. Formation of a Corporation – Intro to Section 351
a. Code: §§ 351(a), (c), (d)(1)-(2); 358(a), (b)(1); 362(a), (e); 368(c); 1032(a);
1223(1), (2); 1245(b)(3)
b. Reg: §§ 1.351-1(a), (b); 1.358-1(a), -2(b)(2); 1.362-1(a); 1.1032-1(a), (d)
c.
B. Intentional Avoidance of Section 351
a. Section 351 applies whenever its requirements are met – Must apply, not elective.
i. Historically, TPers attempted to avoid 351 in order to recognize a loss
[recognition of losses in this manner on a sale b/t a controlling (more than
50%) SH and a corp would be limited by Section 267] or to step-up the basis
of an asset after recognizing a gain to increase the transferee corp’s cost
recovery decutions. When LTCG enjoy sig tax rate preference, TPs found it
advantageous to freeze apprecitation as cap gain on an asset that was about
to be converted into “ordinary income” property – e.g., land held for
investment that TP intended to subdivide.
b. (TPs attempted to avoid §351 in order to recognize a loss or to step-up the basis of
an asset after recognizing a gain to increase the transferee corp’s cost recovery
deductions – tax savins achieved by converting ordinary income into cap gain
outweighed the disadvantage of accelerating recognition of part of the gain)
i. But see § 1239 – gain on sales of property b/t related TPs (e.g., a corp and a
more-than-50% SH) as ordinary income if the property is depreciable in the
hands of the transferee.
Successful avoidance strategy:
o Break control after the exchange by a prearranged disposition of more than 20% of the
stock. (Intermountain Lumber case)
o Structure an incorporation transfer as a taxable “sale” rather than a tax-free § 351
exchange. Resolution of the “section 351 vs. sale” issue turns on facts in each case and
court’s inclination to reclassify what the TP labels “debt” into what the Service believes
to be “equity.”
82
o Sale strategy e.g., - Investor owns undeveloped land w/ adjusted basis of $50,000 and
FMV of 300k. Investor intends to subdivide land and sell home sites for a total of
$500,000. If he developed the land as an individual, Investor would recognize $450,000
of ordinary income. HOWEVER, if Investor sold land to a controlled corp for $300,000
of corporate installment obligations, Investor would recognize $250,000 of capital gain
on sale, the corp would take a $300,000 stepped-up basis in the land, so the remaining
$200,000 is only amt subject to ordinary income tax.
c. Bradshaw v. US – overruled by § 453(e)
i. TP transferred 40 acres of land in which he had basis of 8,500 to new corp in
exchange for $250,000 of unsecured corporate installment notes; corp’s only
other capital was $4,500 car transferred same day in exchange for common
stock.
H: Sale, not 351 exchange  CT treated transfer of land as sale and
permitted TP to report his gain on the installment method, rejecting
Service’s claim that the notes were really stock.
[§ 453(e), (f)(1) – the deferral of gain in Bradshaw is forclosed under new
laws  b/c SH and his wholly owned corp are “related parties,” a later sale
of the land by the corp will accelerate recognition of any gain that otherwise
would be deferred on the SH’s installment sale to the corp.]
d. But see Burr Oaks Corp v. Commissioner
i. Three TPs transferred land to a corp in exchange for two-year notes with
face value of $330,000; corp’s only equity capital was $4,500.
ii. H: 351 exchange, not a sale  CT held that the transfer was a nontaxable
Section 351 exchange rather than a sale b/c the notes were really preferred
stock – payment of notes was dependent on the profitability of an
undercapitalized corp.
Boot; Assumption of Liabilities
(70-75; 80-98)  problems 79(a), 98-99
Treatment of Boot
a. Code: §§ 351(b); 358(a), (b)(1) ; 362(a)
b. Regs: §§ 1.351-2(a); 1.358-1, -2; 1.362-1
A. Remember: If SH transfers property in a tax-free 351(a) transaction, the unrecognized
gain on the transfer will be preserved thru an exchanged basis in transferor’s stock [under
§ 358]and again thru a transferred basis in the corporation’s assets [under § 362].
a. If transferor received more than one class of stock, the transaction would’ve still
qualified under 351  Transferor req’d to allocate his aggregate exchanged basis
83
B.
C.
D.
E.
among the various classes of stock received in proportion to their relative FMVs
[1.358-2(b)(2)]
BUT what if transferor, motivated by the tax advantages of corp debt, capitalizes Venture
with the same $100 asset in exchange for common stock worth $80 and a corporate note
worth $20.
351(b) – if an exchange otherwise would have qualified under 351(a) but for the fact that
the transferor received other property or money in addition to stock, then the transferor’s
realized gain must be recognized to the extent of the cash plus the FMV of the other
property received.
a. i.e., 351(b) provides that any gain realized by a transferor on an otherwise qualified
351(a) exchange must be recognized ONLY to the extent of the boot received.
b. ** gain characterized by reference to the character of the assets transferred, taking
into account the impact of the recapture of depreciation provisions
i. [1245(b)(3) – characterizes the recognized gain on the transfer of
depreciable property to a corp as ordinary income if the transferor and
certain related parties own more than 50% of the value of the transferee
corp’s stock]
c. ** despite the boot, NO LOSS may be recognized under 351(b)13
[e.g., A receives $80 of stock and a $20 corporate note in exchange for his $100 asset
with a $10 basis.  351(b) will require A to recognize $20 of his $90 realized gain
IF SH recognizes some gain b/c of boot, not all of his realized gain must be accounted for
later . . . SH may increase his basis in the stock, securities and other property received by
an amount equal to the gain recognized on the transfer – 358(a)(1)(B)(ii)
a. This higher basis will result in less gain (or more loss) if and when the SH later
sells the property received from the corp.
SH’s BASIS** The SH’s basis in the “nonrecognition property” (i.e., the stock) received from
the corp thus equals the basis in the property transferred to the corp, decreased by the FMV of
any other property and the amount of cash received, and increased by the gain recognized on the
transfer. The Boot takes a FMV basis.
b. Assign the boot a FMV basis and allocate the remaining basis to the
nonrecognition property – 358(a)(2)
c. E.g., A received $80 of corp stock and a $20 note in exchange for his $100 asset w/
a basis of $10, his recognized gain would be $20 – FMV of the boot – and his basis
in the note would be $20 – note’s FMV. A’s basis in the stock dx as follows:
i. Basis of Asset Transferred
$10
ii. Less: FMV of Note Received ($20)
iii. Plus: Gain Recognized
$20
iv. = A’s BASIS in STOCK
$10
§ 267(a)(1) – disallowing losses on sales/exchanges b/t related TPs, including an individual and a corp more
than 50 % in value of which is owned by the individual (directly or attribution rules)
84
13
Corp’s BASIS** 362(a) – Corporate Level – the corp’s basis in the property received on a
351 exchange is the same as the transferor’s basis, increased by any gain recognized on the
exchange
d. E.g., A recognized $20 gain on the exchange b/c of boo, Venture corp’s basis in
the transferred asset would be $30  a $10 transferred basis in A’s hands plus $20
gain recognized
F. Rev Ruling 68-55
a. Corp Y was organized by X and A. A transferred $20x cash in exchange for $20
stock. X transferred three different assets and received in exchange $100x stock
AND $10 cash.
i. X’s assets:
ii. Asset 1 = Capital asset held more than 6 months; FMV $22x; AB 40x;
1. Gain/loss = (18x)
2. Character of gain/loss = Long-term cap loss
iii. Asset II = Capital asset held not more than 6 months; FMV 38x; AB 20x
1. Gain = 13x
2. Character of gain/loss = Short-term capital gain
iv. Asset III = Section 1245 property; FMV 55x; AB 25x
1. Gain = 30x
2. Character of gain/loss = Ordinary income
3. [1245(a)(1) – re 1245 property in Asset III, the depreciation subject to
recapture exceeds the amount of gain that would be recognized on a
sale at FMV. Therefore, all of such gain would be treated as ordinary
income under 1245(a)(1)]
b. Law:
i. Under 351(a), no gain or loss is recognized if property is transferred to a
corp solely in exchange for its stock and immediately after the exchange the
transferor is in control of the corp.
c. BOOT RULE: If 351(a) applies to an exchange but for the fact that there is
received, in addition to the property permitted to be received w./o recognition of
gain, other property or money, then under 351(b), gain (if any) to the recipient will
be recognized, but in an amount not in excess of the sum of such money and the
FMV of other property received, and NO LOSS will be recognized.
i. How to determine the amount of gain to be recognized under 351(b)?
1. Rule = Asset-by-asset Approach = each asset transferred must be
considered to have been separately exchanged.
2. Rev ruling 68-23: holds that there is no netting of gains and losses for
purposes of applying Sections 367 and 356(c).  thus, for dx-tion
under 351(b), not proper to total the bases of the various assets
transferred and to substract this total from the FMV of the totatl
consideration received in the exchange.
85
ii. How to allocate the cash and stock received to the amount realized as to
each asset transferred in the exchange [for purposes of 351(b)
computations]?
1. Asset-by-asset approach (for calculating amount of gain realized)
requires that the FMV of each category of consideration received must
be separately allocated to the transferred assets in proportion to the
relative FMVs of the transferred assets
a. [1.1245-4(c)(1) requires that for purposes of computing the
amount of gain to which 1245 applies, each category of
consideration received bmust be allocated to the properties
transferred in proportion to their relative FMVs]
iii. THUS, amt and character of the gain recognized in the exchange should be
computed as follows:
iv. Asset I – 351(b)(2) – the loss of 18x dollars realized is NOT recognized.
Any loss may not be used to offset the gains realized on the exchanges of
the other assets.
v. Asset II – 351(b)(1) – the gain of 13x dollars will be recognized as shortterm capital gain in the amount of 3x dollars – the amt of cash received
vi. Asset III – 351(b)(1) & 1245(b)(3) – the gain of 30x dollars will be
recognized as ordinary income in amount of 5x dollars – amt of cash
received
Total
FMV of asset $110x
transferred
Percent of total
FMV
FMV of Y stock $100x
received in
exchange
Cash received 10x
Amount realized $110x
Adjusted basis
Gain (loss)
realized
Asset I
$22x
Asset II
$33x
Asset III
$55x
20%
30%
50%
$20x
$30x
$50x
2x
3x
5x
$22x
40x
$33x
20x
$55x
25x
($18x)
$13x
$30x
d. X’s basis in Y stock:
i. exchanged basis ($40 form Asset I, plus $20 from Asset II, plus $25 from
Asset III = $85), increased by its total gain recognized on the transfer ($3 on
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Asset II, plus $5 on Asset III = $8) and decreased by the FMV of the boot
(including cash) received ($10) for a total basis of $83 ($85 + $8 -$10)
e. X’s holding period for the stock:
i. Each share could have a split holding period allocated in proporition to the
FMV of the transferred assets – rev rul 85-164
f. Y’s basis in the assets received:
i. Y’s basis in those assets will be their adjusted bases in X’s hands ($40 for
Asset I, plus $20 for Asset II, plus $25 for Asset III) increased by the gain
recognized to X ($0 on Asset I, plus $3 on Asset II, plus $5 on Asset III) for
a total of $93 ($40 + 20 + 25 + 3 + 5)
ii. Code/regs/rulings don’t explain how this basis is allocated among the assets
– but re underlying premise of 362, each separate asset is given its original
transferred basis and then increasing the basis by the amount of gain
recognized by the transferor on that asset
1. Y’s basis in Asset I = $40 (transferred basis) since no gain or loss was
recognized on that asset.
a. If Y sells Asset I for its $22 FMV, it when will recognized the
$18 loss realized but not recognized by the transferor.
2. Y’s basis in Asset II = $23 (transferred basis of $20 increased by the
$3 gain recognized on Asset II).
a. Thus, on the $13 of realized gain on Asset II, $3 already has
been recognized, so Y will recognized the $10 additional gain if
it sells that asset for its FMV of $33
3. Y’s basis in Asset III = $30 (transferred basis of $25, increased by $5
gain already recognized)
a. If Y sold the asset for its $55 FMV, Y will recognize the $25
additional realized gain that X did not recognize.
G. Assumption of Liabilities
a. Code §§ 357(a)-(c); 358(d)
b. Regs. §§ 1.357-1, -2; 1.358-3
c. [Generally, a TP who is relieved of a debt in comnnection with the disposition of
property must include ethe debt relief in the amt realized even if debt is
nonrecourse. – See US v. Hendler. However, if this reule applied to corp
87
formation, many incorps of a going business would become taxable events to the
extent of the liablities assumed, and the policy of 351 would be frustrated.
Congress responded w/ 357(a)]
i. US v. Hendler, interpreting corp reorganization provisions, the Court held
that the assumption and subsequent payment of the transferor’s liablities by
a transferee corp constituted boot to the transferor.
d. 357(a) – the assumption of a liability by a transferee corp in a 351 exchange
will neither constitute boot nor prevent the exchange from qualifying under
351.
i. Rather than trating the debt relif as boot, the code postpones the recognition
of any gain attributable to the transferred liabilities – see 358(d)
e. 358(d) – reduces the basis in the stock received in the exchange by treating the
relieved liabilities as “money received” by the transferor for purposes of dxing the SH’s basis.
f. 367’s Two Exceptions:
i. 357(b) – prevents abuse
1. [Purpose  357(b) designed to prevent TPs from transferring
personal obligations to a newly formed corp or from achieving a bail
out w/o boot by borrowing against property on the eve of
incorporation and then transferring the encumbered asset to the corp]
2. “tax avoidance” exception
3. * The assumption of a liability is treated as boot if the TP’s “principal
purpose” in transferring the liability was the avoidance of federal
income taxes OR was not a bona fide business purpose.
a. (factual dx-ation made after “taking into consideration the
nature of the liability and the circumstances in the light of
which the arrangement for the assumption or acquisition was
made.”
4. 357(b)(1) – in evaluating whether the business purpose is bona fide,
the regs require BOTH the transferor and the corp to demonstrate a
“corporate business reason” for the assumption of the liabilities when
they report a 351 transaction on their income tax returns.
a. If Improper purpose exists  all the relieved liabilities, not
just the evil debts, are treated as boot – 1.357-1(c)
5. 357(b)(2) – Burden of proof requirement (ignored by cts tho)
a. In “any suit” where the TP has the burden of proving the
absence of an improper purpose, that burden shall not be met
unless the TP “sustains such burden by the clear
preponderance of the evidence.”
ii. 357(c) – avoids the tax taboo of a negative basis – but see exception
357(c)(3)
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1. If the sum of the liabilities assumed by the corp exceed the aggregate
adjusted bases of the properties transferred by a particular transferor14,
the excess shall be considered as gain from the sale or exchange fo the
property.
2. Character of 357(c) Gain  dx’d by allocating the gain among the
transferred assets in proportion to their respective FMVs. [anomalous
approach b/c it requires an allocation of gain – for characterization
pruposes – to an asset with no realized gain]
3. e.g., A forms Venture corp by transferring a building w/ an AB of
$30, a FMV of $100, and an outstanding mortgage of $55. In
exchange, Venture corp issues common stock w/ a value of $45 and
takes the building subject to the $55 mortgage.
a. If 357(a) applies, w/o more, A would recognize no gain on the
exchange. But bais under 358 – it would be $30 (the basis of
the building) less $55 (the liability, treated as boot for basis
purposes under 358(d)), so basis = - $25 (i.e., minus $25). B/c
the Code hates negative basis – 357(c) avoids that taboo by
req’ing A to recognize $25 gain (the excess of the $55 liability
over this $30 AB). A’s basis then becomes Zero.
iii. 357(c)(3) – excludes from the term “liabilities,” for purpose of dx-ing the
excess of liabilities over basis, any obligation that would give rise to a
deduction if it had been paid by the transferor15 or which would be described
in Section 736(a)16.
1. These same types of obligations are also not treated as “liabilities” for
purposes of dx-ing the basis of the stock received by the transferor
under 358. 17
14
357(c) is applied on a transferor-by-transferor basis
Excepted from this exception are obligation which, when incurred, resulted in the creation of, or an increase
in, the basis of any property. E.g., obligations to pay for small tools purchased on credit. P buys $100 of tools
on credit w/ prosmise otpay two months later. One month later, P transfers the tools and the related obligation to
a new corp in 351 transaction. The obligation is treated as a “liability” for 357(c) pruposes – BUT the amt of
that liability is offset by P’s basis in the transferred tools ($100).
15
However, contingent liablities that have not yet given rise to a capital expenditure (and thus have not created or
increased basis)( are not included in dx-ing the amt of liabilities assumbed by the transferee.
16
736(a) applies to payments made to a retiring partner or to a deceased partner’s successor in interest in
liquidation of that partner’s interest in the pt-ship.
736(a) payments, like accounts payable of a cash basis TP, have the effect of reducing ross income when paid
and thus are appropriately excluded from “liabilities” for purposes of 357(c) and 358(d).
17
But see 358(h) – anti-abuse rule – generally provides that if, after the application of the 358 basis rule, the
transferor’s basis of stock received in a 351 transaction exceeds its FMV, that basis must be stepped down (but
not below FMV) by the amount of any liabilities not taken into account under 358(d) (e.g., “deductible” or
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g. E.g. Assets total = AB $150 ; FMV $550. Liabilities = accounts payable $400.
i. A incorporates business by transferring all the assets to Newco in exchange
for $150 of Newco stock and Newco’s assumption of the $400 accounts
payable. If the payables are “liabilities” for 357(c)(1) purposes, A
recognizes $250 gain (the excess of the $400 liabilities assumed by Newco
over the $150 aggregated AB of the assets transferred). A’s adjusted basis
in the Newco stock would be zero ($150 (basis in assets transferred by A)
minus $400 (liabilities assumed by Newco, treated as “money received” for
basis purposes) plus $250 (gain recognized by A.
ii. This result above is harsh b/c if A had retained the accounts payable liablity,
trnasffer all $550 of assets to Newco in exchange for $150 of stock AND
$400 cash, then A used the cash to pay-off the accounts payable  even tho
A woulrd recognize $400 gain under 351(b), that gain would be offset by the
$400 deduction A would receive on payment of the payable.
1. Alternatively A could have avoided any gain by simply retaining
sufficient assets to pay the deductible accounts payable.
iii. Issue resolved by amended 357(c) and 358(d) – which provide that
deductible obligations no longer jwould be considered “liablities” for these
limited purposes.
iv. If all else fails, a transferor can avoid recogning 357(c) gain by constributing
additional cash to the corp in an amount equal to the excess of assumed
liabilities over the aggregated AB of the other contributed assets.
v. However, Q of whether a cash poor transferor can eliminate the gain by
remaining personally liable on the assumed debts or by transferring a
personal note to corp for the 357(c) excess? – see Peracchi case
H. Peracchi v. Commissioner (1998)
a. F:
i. P needed to contribute additional capital to NAC, his closely-held corp to
comply w/ Nevada’s law for insurance companies. P contributed two parcels
of real estate. The parcels were encumbered w/ liablities which exceeded P’s
total basis in the property by ~$500,000. Under 357(c), contributing property
w/ liabilities in excess of basis can trigger immediate recognition of gin in
the amt of the excess. To avoid this recognition of gain, P also executed a
promissory note promising to pay NAC $1,060,000 over 10 years at 11%
interest.
ii. P argues that the note has a bais equal to its face amount, thereby making his
total basis in the property contiubtedf greater thatn the total liabilities. If P is
right, 357(c) will not apply and he will owe no immediate tax on the transfer
of property.
contingent liabilities that do not result in a basis reduction) and assumbed by another person as part of the
exchnbage.
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iii. IRS argues that (1) the note is not genuine indebtedness and should be
treated as an unenforceable gift; and (2) even if the note is genuine, it does
not increase P’s basis in the property.  i.e. claiming the note has a basis of
ZERO.
iv. IF P is right, he pays no immediate tax on the half a million dollars by which
the debts on the land he contributed exceed his basis in the land; if the IRS is
right, the note becomes irrelevant for tax purposes and P must recognieze an
immediate gain on the half million.
b. Law:
i. 351 – capital contribution is a “nonrecognition” event – SH can contribute
capital w/o recognizing gain on the exchange. As long as 351 req-ments met
(e.g., immediate control), then 351 applies. Doesn[‘t matter if the capital
contribution occurs at the time of incorporation or if – as here- the company
is already up and running.
ii. 358(a)– Gain Deferral
1. [general rule re bais = an asset’s basis is equal to its cost – 1012]
2. The SH must substitute the basis of that property for what would
otherwise be the cost basis of the stock, rather than take a basis equal
to the FMV of the property exchanged.
iii. 351(b) – Continutiy of Investment: Boot
1. [contintuity of investment is the cornerstone of nonrecognition under
351; nonrecognition assumes that a capital contribution amounts to
nothing more than a nominal change in the form of ownership’ in
substance the Sh’s investment in the property continues. ]
2. Exception to nonrecognition for 351 transactions = when TP receives
“boot” – money or property other than stock in the corp – in exchange
for property contirubted – 351(b)
a. Boot is recdognized as taxable income b/c it represents a partial
cashing out.
3. *HERE, P did NOT receive boot in return ofr property, but must
consider whether P has cashed out in some other way which would
warrant trating part of the transaction as taxable boot.
iv. 357(a) – Assumption of Liabilities
1. A SH engaging in a 351 transaction does NOT have to treat the
assumption of liablity as boot, even if the corp assumes his obligation
to pay
2. Basis does NOT disappear tho  the SH’s substite basis in the stock
received is decreased by the amount of the liablity assumed by the
corp – 358(d), (a)
a. [thus, the gain preserved since when SH sells stock, his taxable
gain will be difference b/t the (new lower) basis and the sale
price of the stock.
v. 357(c) – Negative Basis Problem
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1. Prfevents negative basis by forcing a SH to recognize gain to the
extent liablities exceed basis.
a. Thus, if a SH contributes a building w a basis of $50 and
liabilities of $90, he does NOT receve stock w/ a basis of minus
$40; Instead, SH takes a basis of zero and must recognize a $40
gain.
2. HERE, if the note has zero basis like IRS suggests, then P’s
contribution of two parcels of property to NAC in a 351 transaction
ran afoul of 357(C0 b/c the property P wanted to contribute had
liabilities in excess of basis, and P would have had to recognize gain
to the extent of the excess, or $566,807. (While P remained personally
liable on the debts encumbering the property transferred, NAC took
the property subject to the debts, which is enough to trigger gain
under the plain language of 357(c) – Owen v. commissioner))
vi. Can basis be boosted with a Promissory Note
1. P’s argument:
a. P maintains that the note has a bsis in his hands equal to its face
value. IF he’s right, we must add the basis of the note to the
basis of the real property. Taken together, the aggregate basis
then in the property contributed would exceed the aggregage
liabilities (w/ the note, the basis of the property contributed
would be $2,042,406 while the liablities would be $1,548,213)
b. Thus, under this theory, the aggregate liabilities no longer
exceed the aggregate basis, and section 357(c) no longer
triggers any gain.
2. IRS:
a. The note has a zero basis. If true, the note would not affect the
tax consequences of the transction and P’s ~$550,000 in gain
would be taxable immedialtely.
vii. Is note “unenforceable promise to pay himself (thus, basis of note $0) –
IRS – OR does note have basis equal to its face value (TP)?
1. IRS says that b/c TP incurred no cost in issuing their own note to this
controlled corp, the basis of the note is zero. Thus, P holds an
unenforceable promise to pay himself money, since the corp will not
collect on it unless he says so.
2. Key issue then  whether bankruptcy is significant enough a
contingency to confer substantial economic effect on this transaction.
a. If risk of bankruptcy is important enough to be recognized, P
should get basis in note: he will have increased his exposure to
the risks of the business – and thus his economic investment in
NAC – by $1,000,000 (value of note).
b. If bankruptcy remote that there’s no realistic possiblitiy it will
occur, ct can ignore the potential ecnomic effect of the note as
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speculative and treat it as merely an unenforceable promise to
contribute capital in the future.
3. HERE: P’s obligation on the note was conditioned on NAC’s
remaining solvent – i.e. P’s obligation represents a new and
substantial increase in P’s investment in the corporation.18
4. Code recognizes that economic exposure of the SH is the ultimate
measuring rod of a SH’s investment. Therefore, P is entitled to a stepup in basis to the extent he will be subjected to economic loss if the
underlying investment turns unprofitable
5. Another reason for support of P’s view is that the transaction could
have been structured a little differently and still given P a boost in
basis – e.g., if P borrowed $1 million from bank and contributed the
cash to NAC along w/ the properties. b/c cash has a bais equal to face
value, P would not have faced any 357(c) gain.
6. Experts  “357(c) can be avoided by a transfer of enough cash to
eliminate any excess of liablities over basis; and since a note given by
a solvent obligor in purchasing property is routinely traeated as the
equivalent of cash in dx-ing the basis of the property, it seems
reasonable to give it the same treatement in dx-ing the basis of the
property transferred in a 351 excahnge”
viii. THUS, we hold that P has a basis of $1,060,000 in the note he wrote to
NAC. The aggregate basis exceeds the liablities of the properties
transferred to NAC under 351, and P does NOT need to recognize any
357(c) gain.
ix. Was note “genuine indebtedness” or a “sham” for tax purposes?
1. Genuine indebtedness – Q is to look at the face of the note and
consider whether P’s legal obligation is illusory. It was not illusory so
note should be treated as genuine indebtedness!
a. 1) the note’s bona fides are adequate: P is creditworth and
likely to have the funds to pay the note.
b. 2) the value of the note is the face value, which IRS doesn’t
contest; NAC could borrow against the note to raise cash, and
c. 3) the note if fully traansferable and enforceable by 3rd parties,
e.g., hostile creditors.
x. Note is sham b/c executed simply to avoid taxes?
1. 357(a) does provide the opportunity for a bailout transaction – e.g. a
TP with unencumbered bulding wants to sell and takes out a
nonrecourse mortgage, pockets the proceeds, and then contributes the
18
CT confines their cholding to a cae such as this wehre the note is contributed to an operating business which
is subject to a non-trivial risk of bankruptcy or recerivership. NAC is not, fore example, a shell corp or a passive
investment company; P got int o this mess b/c NAC was in financial trouble and needed more assets to meet
Nevada’s min premium-to asset ratio for insurance companies.
93
property to a newly organized corp. The TP would have paritally
cashed out his economic investment in the property – by taking out a
nonrecourse mortgage, the economic risk of loss would be transferred
to the lender.
2. 357(b) prevents bailout re nonrecourse mortage transaction by req-ing
the recognition of gain if the transaction lacks a business purpose
3. HERE,
a. P’s capital contribution was NOT a bailout.
b. P contributed the building to NAC b/c the company needed
additional capital and the contribution of the note was part of
that transaction.
4. [bailout potential exists regardless of whether the TP contributes a
note along w/ the property; but section 357(b), NOT 357(c), is what
the Service must use to attack bailout transactions.
xi. Note a gift?
1. NO - The contribution of the note was no more a gift than the
contribution of $1 million in cash to the corp would have been; it does
not reflect the “detached and disinterested generosity” which
characterizes a gift for purposes of federal income taxation –
commissioner v. Duberstein
xii. THUS:
1. P is entitled to a step up in basis for the face value of the note, just as
if he contributed cash to the corp – 358
2. By increasing his personal exposure to the creditors of NAC, P has
increased his economic investment in the corp, and a corresponding
increase in basis is justified.
3. H: P has a basis of $1,060,000 in the note, its face value. As such, the
aggregate liablities of the property contributed to NAC do NOT
exceed its basis, and thus, P does not recognize any 357(c) gain.
c. [What happens if NAC does not go bankrupt, but merely writes off the note
instead?  P would then face discharge of indebtedness income of $1,060,000. P
would be in worse off position than when he started, since discharge of
indebtedness is normally treated as ordinary income. P, having increased his basis
in the stock of the corp by $1,060,000 would receive a capital loss to that extent.
But the shift in character of the income will work to the disadvantage of a TP]
d. [P owned all the voting sotck of NAC both before and after the exchange, so the
control req of 351 is satisfied. P received no boot (such as cash or securities) which
would qualify as “money or other property” and trigger recognition under 351(b)
alone]
i. P did not receive any stok in return for the property contributed, so it could
be argued that the exchange was not “solely in exchange for stock” as req’d
by 351. HOWEVER, Cts have consistently recognized that issueing stock in
this situation would be a meaningless gesture – b/c P is the sole SH of NAC,
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issuing additional stock would not affect his economic position relative to
other SHs – Jackson v. Commissioner]
I. Why didn’t TP just not transfer the liabilities . . maybe TP didn’t want to pay the note,
easier to be indebted to corp.
J. Avoid recognition – A pay off the debt. Write a note to the corporation. Agree transferee
remains liable vis a vis corporation, I will ultimately remain liable to the debt.
Acquisitive Reorganizations
Introduction; Non-Statutory Requirements
389-393; 396-412
o Initially, Sup Ct said that even minor changes in the corporate form (e.g., changing the
state of incorp) caused SHs to realize gain. However, Congress enacted nonrecognition
provision  § 351
o § 351 provides that no gain or loss would be recognized on the “reorganization, merger or
consolidation of a corporation” where a person received “in place of stock or securities
owned by him new stock or securities of no greater aggregate par face value.”
o Purpose – (same as broader policies of nonrecognition) IRS? Shouldn’t impede
diverse transactions b/c they are simply readjustments of a continuing interest in
property, albeit in modified form, and the new property received is “substantially a
continuation of the old investment still unliquidated.”
 i.e., provision allows businesses to make necessary adjustments and
provision removes a “source of grave uncertainty” in the law
o Congress clarified  nonrecognition really means deferral rather than total
forgiveness of gain or loss.
 Rev Act 1928 – rules for carryover and substituted bases in order to preserve
the unrecognized gain/loss for recognition at the time that the SH liquidated
investment.
o [NOT Sensible system]
o Functionally different transactions are lumped together and labelled
“reorganizations
o Economically equivalent acquisition methods are tested for reorganization status
under sharply different criteria that ofen place a great premium on the form chosen
by the parties
o Dx-ing tax consequences of a corp combination or readjustment requires an
application of both precise statutory provisions and judicially created “common
law” principles of uncertain scope.
o Analysis complicated by possibility of overlap b/t reorg provisions and other parts
of subchapter C.
95
Overview of Reorganizations
o Code 336(c); 354-56; 358; 361; 362(b); 368(a)(1), (b), (c); 381(a); 1032
o Regs 1.368-1(a)-(c)
o “reorganization” is usede to describe corporate combinations or readjustments that fall
into the following three broad categories: (1) Acquisitive reorganizations; (2) Divisive
reorganizations; (3) nonacquisitive, nondivisive reorganizations
o Acquisitive reorganization – transactions where one corp (i.e., acquiring corp) acquires
the assets or stock of another corp (i.e., acquired/target corp)
o Statutory mergers or consolidations (“A” reorganizations);
o Acquisitions of stock of the target for voting stock of the acquiring corp (“B
reorganiations);
o Acquisitions of assets of the target for voting stock of acquiring corp (“C” reorgs
or “practical mergers” ;
o Also includes other complex acquisition techniques involving the use of a
subsidiary or multiple steps
o Divisive reorganizations – result in the division of a single corp into two or more separate
entities and which often are preceded by a “D” reorganization
o Nonacquisitive, nondivisive reorganizations – involve adjustments to the corp structure
of a single, continuing corp enterprise.
o Residual category
o Includes recpaitalizations (“E” reorganizations;
o Changes in identity, form or place of incorporation (“F” reorganizations);
o Certain transfers of substantially all of the assets from one corp to another,
followed by a liquidation of the first corp (nondivisive “D” reorganization); and
o Transfers of a corp’s assets to another corp pursuant to a bankruptcy reorganization
plan (“G” reorganizations).
o COMMON LAW REQs
o To qualify as a reorganization, a transaction also must pass muster under
“common law” doctrines developed by the courts to reinforce the rationale for
nonrecognition.
o Principal judicial doctrines affecting acquisitive reorgs are: continuity of SH
proprietary interest, continuity of business enterprise and business purpose
o Continuity of interest doctrine – requires that a substantial part of the value of the
proprietary (i.e., equity) interests in the target corp must be preserved in the
reorganization thru an exchange of target stock or assets for stock in the acquiring corp –
1.368-1(e)(1)
o Continuity of interest doctrine incorporated into statutory definition of
“reorganization” for some transactions
 E.g., only permissible consideration in a B reorg is voting stock of the
acquiring corp - § 368(a)(1)(B)
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o Doctrine far more important if statute is imprecise  Type A reorgs, where Code
merely requires “statutory merger or consolidation: w/o any elaboration on the
permissible consideration – 368(a)(1)(A)
o THUS, continuity of interest questions primarily in connection w/ Type A reorgs
o Continuity of business enterprise doctrine – focuses on the continuing business
operations of the target. Req-ment incorporated in regs (1.368-1(d)) and also is
considered w/ “A” reorgs
o Generally, all these above req-ments must be satisfied for the transaction to qualify as an
acquisitive reorg – 1.368-1(b) & 2(g)
o To complicate matter, Service sometimes applies step transaction doctrine to corp
regorgs to convert what in form may be separate nontaxable steps into what in
substance is a taxable transaction, or vice versa – Rev Rul 79-250
o * IF statutory and judicial req-ments met, unlock “operative provisions” – sections of
code that provide for nonrecognition of gain or loss and that govern collateral matters like
treatment of liabilities, basis, holding period and carryover of tax attributes.
o E.g., §§ 354 & 356 grant total or partial nonrecognition of gain to SHs of the target
corp in an acquisitive reorganization
o § 358 provides a formula for dx-ing the substituted basis of the stock or securities
received by these SHs in a reorg.
o At corp level, § 361(a) provides for nonrecognition when a corp transfers its assets
in a reorg and distributes property in a liquidation pursuant to a reorg plan - §
336(c)
o § 357 ensures that the assumption of the target’s liabilities is NOT treated as boot
for this purpose
o § 1032 – acquiring corp is accorded nonrecognition w/ respect to stock used to
make the acquisition and takes a transferred basis in the target’s assets or stock
under § 362(b)
o § 381 – tax attributes of the target corp (e.g., earnigns and profits, and net
operating losses) generally carry-over to acquiring corp, subject to various
limitations to prevent abuse
o IF transation doesn’t qualify as reorg, these provisions do NOT apply and the tax
consequences of transaction muist be dx-d under other parts of Subchapter C
o E.g., an asset acquisition that fails as a type A or C reorg ordinarily would be
taxable transaction to the SHs under the rules considered in chap 7 & 8
o BUT, rare reorganization that fails
o Service no longer provides “comfort ruling” re whether transaction is proper reorg
o BUT, Service will rule on one or more “significant” issues re proposed reorg, but
won’t rule on transaction as a whole – rev procedure 2013-32
 “Significant” issue if it is “an issue of law the resolution of which is not
essentially free from doubt and that is germane to dx-ing the tax
consequences of the transaction – 2013-32 §4.01(1)-(3)
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o B/c service unwilling to issue ruling approving tax-free status of reorgs, Service’s
administrative guidelines on these issues are often tantamount to law in the area –
TPs who disagree w/ govt must proceed w/ a transaction at their substantial risk.
Continuity of Proprietary Interest: Quantity and Quality
o Southwest Natural Gas Co. v. Commissioner (1951 – 5th Cir)
 I: whether a merger of Gas corp w/ TP under Delaware law, was a sale or a
“reorganization under § 112(g) [predecessor of 368]? TP argued
reorganization, IRS said sale.
 Tax court held sale, not reorg  CT held that compliance with only
provisions of state law authorizing a merger does not make the
transaction a “reorganization: ‘within IRC; test of continuity of
interest was applicable; and that the transaction here did not meet this
test.
 H  the continuity of interest for the 59.2% of Gas corp common stock that
was exchanged for 16.4 % of acquiring corp’s stock represented less than
1% of the price TPs paid to acquire corp and THUS, NOT sufficient to find
continuity of interest to make transaction a reorganization
 Underlying purpose of 112 and 112(g)(1)(A) specifically = no income
tax applies to purely “paper profits/losses” where there is no
realization of gain/loss in the business sense, but merely recasting the
same interests in different form, and the tax is postponed to a future
date when tangible gain/loss is realized. Gilmore’s Estate
o Thus, a statutory merger does NOT ipso facto constitute a
“reorganization” under IRC. Roebling
 Bazley – while transaction satisfied the literal req’s of reorganization
under 112, transaction still failed to qualify as reorg b/c not within
purpose/intent of 112
o i.e., “terms expressed in statute are NOT to be given literal
interpretation but are to be considered and applied in
accordance w/ the purpose of § 112”
 THUS, “continuity of interest” test must be met before a statutory
merger can be held to be a “reorganization” within § 112(g)(1)(A)
o Facts and circumstances approach
o No precise formula, but . .
o Continuity of interest RULE  Must show: (1) that the
transferor corp or its SHs retained a substantial proprietary
stake in the enterprise represented by a material interest in the
affairs of the transferee corp, AND (2) that such retained
interest represents a substantial part of the value of the property
transferred.
 HERE,
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 Gas corp’s assets were acquired by TP in exchange for specified
amounts of stock, bonds, cash and assumption of debts. Total Gas
corp common shares = 18,875 - SHs offered Option A (59.2% of Gas
corp SH exercised this option – received 16.4 % of TP’s com on stock
plus $340,000 in mortgage bonds, which was assumed by TP in prior
merger, and $17,779 cash) or Option B ($30 cash per share or
$230,700 total – 7,700 SH took this option)
 ** Continuing property interest of gas corp SHs = the 16.4 % of
common stock rep’d by 111,850 shares having a market value of
$5,592, or 5 cents per share = less than 1 % of the consideration
paid by TPs for entire transaction, THUS, NOT sufficient
continuity of interest to be considered a reorganization
o Revenue Ruling 66-224
o F: X corp merged under state law into Y corp. X corp’s had 4 SHs (A,B,C,D) who
held 25% each.
 A & B  each received $50,000 cash for their X corp stock
 C & D  each received Y corp stock w/ value of $50,000 in exchange of
their X corp stock.
o H: continuity of interest of 1.368-1(b) satisfied b/c total price paid to
continuing SHs (C & D) was 50% of the consideration paid by X corp for
entire transaction.
o Continuity of interest also satisfied If the facts were same except corp Y paid each
SH $25,000 in cash and each SH received corp Y stock w/ value of $25,000 = b/c
total consideration paid to continuing SHs is 50% of entire purchase price of
transaction
 In dx-ing continuity of interest under 1.368-1(b), no other facts should be
taken into account, such as sales, redemptions, or other dispositions of stock,
prior to or subsequent to the exchange which were part of the plan of
reorganization.
o NOTE:
o Measuring continuity of interest.
 In evaluating CoI, it’s the overall continuity preserved in the transaction that
controls, NOT the continuity of any individual SH. [66-224 & 1.3681(e)(1)(i)].
 Nelson v. Helvering - Sup ct held that there was sufficient continuity of
interest where T SHs received 38% nonvoting preferred stock of the
acquiring corp and 62% cash
 But see early cases focused on both the quality of the consideration
received by the target’s SHs and the percentage of equity
consideration (relative to total consideration) received by those SHs as
group – e.g.,
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 Pinellas Ice & Cold Storage: Sup Ct, in applying continuity of interest
doctrine, held that a transaction literally satisfying the definition of a reorg
was still considered a taxable sale b/c the T SHs received only short-term
notes of the acquiring corp.
 RULE: ** All classes of stock, whether voting or nonvoting, provide the
requisite continuity – while any other consideration (cash, short-term notes,
bonds, assumption of liabilities) will FAIL to meet test
 Service will rule favorably on Type A reorganization if P uses at least
40% equity consideration in making acquisition (more permissive
than previous 50% benchmark set by Service) – 1.368-1(e)(@)(v) ex
1.
 “Percentage” is the proportion of equity consideration relative to total
consideration used by P to acquire T; NOT the percentage of P stock
owned by former T SHs after the P’s acquisition of T.
o NOT all T SHs defer recognition of gain –
 those receiving nonequity consideration must recognize gain, if any, likely
as ordinary income, to extent they receive boot. BUT, if entire transaction
fails to qualify as reorg, all parties – including T (i.e., not just those getting
nonequity consideration) – must recognize gain or loss.
 This principal not altered by § 356(e) – treats certain debt-like preferred
stock, defined in § 351(g) as “nonqualified preferred stock,” as other
property (i.e., boot – see qualified preferred stock below) for purposes of
recognition of gain or loss by T SHs in reorg.
 However, nonqualified preferred stock would continue to be treated
as equity under other provisions of code, e.g., § 351 and 368.
 [purpose re treating nonqualified preferred stock as boot for gain
recognition purposes was concern re acquisitive transactions where T
SHs received secure instrument labelled as “stock” - but had
characteristics of debt – in exchange for riskier equity investment – in
this circumstance, Congress believed appropriate to view the new
debt-like preferred stock as taxable consideration  b/c the T SH
was obtaining a more secure form of investment, as opposed to riskier
stock]
o Remote Continuity.
 RULE: regs provide that continuity is not broken by a transfer or successive
transfers of the acquired T stock or assets to lower-tier subsidiaries provided
that the transferor continues to “control” each transferee (using 80% tests in
§ 368(c)), AND the continuity of business enterprise requirement is
satisfied. [1.368-2(k)(1) & -1(d)(4)-(5)].
 “Remote continuity” doctrine  Previous continuity test required the
T stock or assets acquired in a reorg to be held directly by the corp
that issues its stock to T SHs.
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 Doctrine focused on the requisite link b/t the former T SHs and the T
business assets after the reorg.
 BUT, later amendments to code provided flexibility – e.g., permitted
“drop-down” transfers to subsidiaries of the acquiring corp [§
368(a)(2)(C)], OR allowing a controlled subsidiary to use its parent’s
stock as consideration in a merger [368(a)(2)(D)]. Also regs permit
successive transfers of T stock or assets among various members of an
affiliated group of corps, or, in some cases, to a controlled pt-ship.
[1.368-2(f), -2(k)(1), -2(k)(2) exs 1-3]
o When to measure continuity of interest.
 . . where merger agreement provides for “fixed” consideration – regs say
that the appropriate measuring date is the last business day before the first
date that the contract is a binding contract.” [1.358-1(e)(2)(i)]. i.e., the
“signing date rule.” – pro-taxpayer rule
o “binding K” is instrument enforceable under law against the
parties to it [1.368-1(e)(2)(ii)(A)].
 Will not prevent a K from being “binding” - the presence
of conditions outside the parties’ control (e.g., regulatory
approval req) OR insubstantial terms still need to be
negotiated OR customary conditions that still need to be
satisfied
o “fixed” consideration = if the K states the number of P stock
shares and the amt of nonstock consideration given to T’s SHs,
AND the K does NOT include contingent adjustments that
prevent T’s SHs from being subject to benefits/burdens of P
ownership as of the signing date [1.36801(e)(2)(iii)(A)].
 – e.g., when T SHs are entitled to receive add’l
consideration if the price of P stock declines by certain
amounts during time b/t signing and closing dates =
contingent adjustment
o [policy purpose of “signing date rule” is that, if K gives fixed
consideration, the T SHs are viewed as being subject to the
“economic fortunes” of P on the day K becomes binding –
1.368-1(e)(2)(i)]
 w/o this rule – a decline in the value of the acquiring
corp’s stock b/t the signing date and date of closing could
cause the transaction to fall below the continuity
threshold.
 . . . where consideration received in potential reorg is NOT “FIXED” –
continuity of interest is measured based on the value of the P stock as of “the
effective date” of the transaction – i.e. “closing date rule.” [77-37; 1.3681(e)(2)(v) ex 1]
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o Under this approach, a decline in the value of the P stock b/t the
signing and closing dates could cause a transaction to fail the
continuity of interest requirement.
 If either the signing or closing date rule applies, Services authorizes use of
three safe-harbor valuation methods using average trading prices over a
range of measuring periods if the P stock is traded on a national securities
exchange, all the parties treat the transaction consistently, and a binding
agmt specifies the measuring period and other details. [rev proc 2018-12].
Identifying the SHs who must maintain continuity of interest
a. [b/c SHs of target corp must receive a sufficient amout of stock of the acquiring
orp to satisfy the continuity of interest doctiren, it is necessary to identify which
target SHs count for purposeso f this requirement.
b. (historic SHs = SHs who held their T stock before P commenced its efforts to
aquire control of T in a reorganization.
c. JE Seagram corp: tax ct declined to measure contintuity of interest solely by
looking to the “historic” SHs of T. continuity of interest was satisfied b/c P-1
stepped into the shoes of the 30% T SH group who sold their stock to P-1 for cash.
i. F: Two corps, P-1 and P-2, wish to acquire T and each makes a tender offer.
By March 1, P-1 purchasess the stock of 30 T SHs for cash while P-2
purchases the stock of 45 T SHs for cash. Ultimate winner is P-2 which on
June 1 complete its acquisition by ac uiring all the T stock it didn’t already
own (55%, incluing P-1’s 30 shares and the 25 shares not tendered to either
suitor) for P-2 common stock, and then T mergers into P-2
ii. I: does merger of T into P-2 qualify as a Type a reorganization?
iii. H: Yes
1. Key qualification issue is whether SHs owning at least 40% of T stock
maintain sufficient continuity of interest by receiving P-2 common
stock in exchange for their T stock.
2. If continuity measured re T’s Jan 1 SHs (the “historic” SHs of T) the
acquisiton fails the test b/c 75 % of those SHs sold their T stock for
cash to P-1; HOWEVER, if continuity test based on T SHs on June 1,
then T SHs holding 55% of T will have received P-2 stock, and the
test will be met.
3. (P-1, the bidder, argued that the transaction did NOT qualify as a
reorg b/c he wanted to deduct a loss on its exchange of T stock for P
stock. IRS said transaction qualified as a Type A reorg)
d. 1.368-1(e)(1)(i) – a “mere disposition” of T stock prior to a potential
reorganization to buyers unrelated to T or P will be disregarded in applying the
continuity of interest doctrine.
i. 1.36801(e)(8) ex 1(ii) – fact pattern – assume T is owned 70% by B SH and
30% by C SH, and P wants to acquire T in tax-free merger. Previously P
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couldn’t get tax-free merger if B only wanted to cash out of T. But, under
regs . .
1. IF B can find an independent third party purchaser who is willing to
buy B’s T stock for cash and who eventually becomes a P SH after the
merger, each of the party’s business and tax objectives can be
satisfied. B’s sale for cash is taxable event to B, but C achieves
nonrecognition of gain on the exchange of C’s T stock for P stock in
the merger, and T does NOT recognize gain/loss on the transfer of its
assets to P
e. 1.368-1(e)(8) ex 5 – regs guard against situations where a T SH may indirectly
receive cash compensation from P
i. E.g., SH A owns 100% of T and, in merger, A receives P stock which A
sells to B, an unrelated buyer. Stop here, then transaction ok b/c meets
continuity of interest requirement. BUT, shortly thereafter, and in
connection w/ the merger, P redeems B’s stock for cash  continuity of
interest req NOT satisfied b/c, in substance, P acquire the T stock solely for
cash
ii. Ex. 9 – BUT, if T redeems the stock of one of its SHs for cash prior to the
acquisition, with no consideration coming from, the preacquisition
redemption does not affect continuity of interest, which is dx’d solely w/
reference to the remaining T SHs.
Post-Acquisition Continuity
f. [continuity of interest doctrine issue re length of time that the target SHs must hold
their stock in the acquiring corp]
g. Assume T merges into P in a tax-free reorganization in which the only
consideration is P stock, BUT SHs who hold 80% of the T stock are legally
committed at the time of the merger to sell their P stock to a 3rd party. Does
prearranged sale disqualify merger as Type A reorganization b/c continuity of
interest test is not met?
h.  Service has never required T’s SHs to maintain continuity of interest in P for
any particular time period after re-org, BUT in dx-ing if the Continuity of Interest
req has been satisfied:
i. Courts - disagreed over whether a pre-merger intent to sell (w/o any binding
commitment) would defeat continuity of interest
1. McDonalds – Tax ct treated a post-merger sale of P stock by former T
SHs as a separate transaction b/c the SHs were not contractually
bound to sell.
2. But see Penrod and seventh Circuit which found that a pre-merger
intent to sell was sufficient to invoke step transaction doctrine and
cause the merger to lack continuity of interest,
ii. IRS – subsequent dispositions of P stock received in a potential
reorganization by former T SHs generally will be disregarded in dx-ing
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whether the continuity of SH interest req is met, even if the dispositions were
pursuant to a preexisting binding contract [1.368-1(e)(1)(i)].
1. HOWEVER, if T SHs have sold their P stock for cash to P or a related
party (e.g., P subsidiary) before or after the acquisition, the continuity
of interest req may not be satisfied [1.368-1(e)(1)(ii), -1(c)(2)]
a. E.g., if P re-acquired stock that it issued in reorg from T SH in
exchange for cash, the re-acquisition IS considered in dx-ing if
the C-of-I req was satisfied.
b. BUT, sales of P stock by former T SHs to outsiders would be
ignored, even if the sales were pursuant to a binding
commitment entered into prior to the reorganization [1.3681(e)(8) ex (4)(i)]
i. Rev Ruling 99-59 – a sale of P stock on the open market by a former T SH
during the repurchase program (via a broker) will have same effect on
continuity of interest as a mere disposition to person unrelated to P, i.e., no
effect on C-of-I req of reorg.
i. H: continuity of interest is satisfied. There was not an understanding b/t the
T SH and P that the T SHs’ ownership of the P shares would be transitory,
Moreover, b/c of the mechanics of an open market repurchase, the
repurchase program does NOT favor participation by the former T SH.
Therefore, even if it could be established that P repurchased P shares from
former T SHs in the repurchase program, any such purchase would be
coincidental.
1. The merger and the stock repurchase together in substance would
NOT resemble a sale of T stock to P by the former T SHs and, thus,
the repurchase would not be treated as “in connection with” th e
merger.
ii. F: T merges into P , a corp w/ stock widely held and publicly and actively
traded. P has one class of common stock. In the merger, T SHs received 50%
common stock of P and 50% cash. (stop here and C-of-I req met). In effort
to prevent dilution resulting from issueance of P shares in merger, P’s
preexisting stock repurchase program modified to enable P to reacquire P
shares equal to number issued to T SHs in acquisition. The repurchases are
made following the merger, on the open market, thru a broker and for the
prevailing makret price. P’s intention to repurchase shares was announced
prior to T merger, bu repurchase program was not negotiated w/ T or T’s
SHs. No understanding b/t P and T SHs that T SHs’ ownership of P stock
would be transitory. b/c of mechanics of open market purchase, P doesn’t
know the identify of a seller of P stock, nor does a former T SH who
receives P stock in merger and then sells knows whether P is the buyer.
o Relationship of Continuity of Interest Doctrine to Taxable Acquisitions
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o Jx conflict is b/t the treatment of a “qualified stock purchase” – e.g., P’s purchase
of 80% or more to T stock – as defined in § 338 and an acquisitive reorganization
o § 1.338-3(d)(2)  Regs re tax consequences of the transfer of T’s assets to P or a
P affiliate following P’s qualified stock purchase where P does not make a section
338 election
 Regs provide that the T stock acquired by P in the qualified stock purchase
will count for continuity of interest purposes if T later transfers its assets to a
P subsidiary, enabling the second step of the transaction to qualify as a taxfree acquisitive reorganization.19. As a result, T does NOT recognize gain on
the transfer of its assets, which will take a transferred basis in P’s
subsidiary’s hands.
o Regs reversed holding in Yoc Heating – P bought 85% of T’s stock for cash and
notes and, as part of same transaction, T subsequently transferred its assets to S, a
newly formed P subsidiary, and then T dissolved. P received additional S stock in
exchange for its T stock, and the T minority SHs received cash in exchange for
their T stock.
 Tax CT held P’s purchase of T stock and subsequent T asset transfer to S
was an integrated transaction in which P acquired all of T’s assets for cash
and notes; THUS, there was insufficient continuity of interest to qualify the
asset transfer as a § 368 reorg b/c the historic SHs of T did not receive any P
stock. (only upside was S received a cost basis in the T assets rather than the
transferred basis if the acquisition had qualified as a reorg)
 Regs take position that the result in Yoc Heating is inconsistent w/ policy of
338 to preempt the subjective Kimbell-Diamond doctrine – which treated
P’s purchase of T stock for cash followed by a liquidation of T as a taxable
purchase of T’s assets.
o ** Regs also provide that the operative reorganization provisions applicable to
SHs of the target corp in an acquisitive reorganization do NOT apply to minority
SHS of T UNLESS The transfer of T assets is pursuant to a reorganization under
generally applicable tax rules w/o regard to the regs. – 1.388-3(d)(5), ex (v).
 E.g., P buys 85% of T stock for cash from SH A, but does NOT make a
section 338 election. The remaining 15% of T owned by Mrs. K. After sale,
as part of the same plan, T merges into S , a wholly-owned P subsidiary, and
Mrs. K receives P (or S) stock in exchange for her T stock.
 * Under regs, the continuity of interest requirement is NOT met in dx-ing
the tax consequences to Mrs. K, who thus recognizes gain/loss w/ respect to
the exchange of her T stock.
 Thus, transaction can qualify as a reorganization for some purposes (T’s
transfer of its assets) but not for others (Mrs. K’s exchange of her T stock).
o Continuity of Business Enterprise
Similarly, P is treated as a T SH for purposes of dx-ing whether, immediately after the transfer of T assets, a T SH is in “control” of
the corp to which the assets are transferred for purposes of § 368(a)(1)(D). - § 1.338-3(d)(3)
19
105
o Bentsen v. Phinney (1961)
 F: Rio Development Company was Texas corp engaged in land development
business along w/ two other corps. All three corps were controlled by
Bentsen family. Three corps transferred all their assets, subject to liabilities,
to a newly formed life insurance company. Three transferor corps then
liquidated, and their SHs became SHs of new insurance company.
 TPs reported a taxable gain and then took steps to file a refund,
claiming the transaction qualified as a reorganization.
 Service argued that NO corp reorganization under 368(a)(1) here b/c
there was not a continuity of business enterprise before and after the
reorganization; and that this is a prerequisite as set out in Treasury
Regs.
 I: was the corp transaction described in facts above a corporate
“reorganization” as defined in 368(a)(1), even tho Rio Development
Company engaged in the land development business before reorganization
but after, it became an Insurance Company engaged in the insurance
business?
 H: CT finds there was a continuity of business activity and thus, the TPs
have a right to a refund of the income taxes paid on the exchange of stock.
**To qualify as a “reorganization” under the applicable statutes, the new
corp does NOT have to engage in an identical or similar type of business.
All that is required is that there must be continuity of the business
activity.
 TP cited:
o Becher v. Commissioner – TP owned all the stock in a corp
engaged in the sponge rubber and canvass-product
manufacturing business. New corp engaged int eh business of
manufacturing upholstered furniture. Service took position that
there had been a reorganization and that a cash distribution to
SHs of the old corp was taxable boot. CT said the tax ct was
correct that a business purpose does NOT require an identity of
business before and after the reorganization.
o Pebble Spring Distilling – old corp had power to carry on both
a. whiskey distilling business and a real estate business, but it
engaged solely in the real estate business
o Morley Cypress Trust – [CT finds this most persuasive b/c
facts most similar to facts here]
 Old corp owned land held for timber and the land was
conveyed to a new corp engaged in the oil business.
 In Morely Cypress, the land was held for timber; here, it
was held for development. In Morley, land was conveyed
to a new oil corp for use in the oil business; here, land
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(plus proceeds from sale of land) was conveyed to a new
corp to furnish the means to capitalize a new insurance
business.
 Ct said continuity of business enterprice as used in Service’s regs does
NOT mean that the new corp must engage in either the same type of
business as the old or a similar business.
o No Ct has upheld the meaning of continutity of business
enterprise as the Regs interpret, thus can’t say Congress wanted
Reg’s meaning to stay same b/t code’s amendements b/c
Congress not apprised of the meaning the Service laid out in
their regs.
o Thus, CT not bound by any Treasury Reg since it is CT’s
province to dx whether the Regs means what the Govt contends
it means; and whether or not if it means what the Govt
contends, CT must dx if the reg is one that could appropriately
be promulgated under the appropriate sections of code.
o Revenue Ruling 81-25
 I: for a transaction to qualify as a reorganization under 368(a)(1), does the
continuity of business enterprise req-ment apply to the business or business
assets of the acquiring (transferee) corp prior to the reorganization?
 H: NO, in a § 368(a)(1) reorganization, the continuity of business enterprice
requirement does NOT apply to the business or business asset of the
transferee corp prior to the reorganization.
 § 1.368-1(b) states that in order for a reorg to qualify under §
368(a)(1), there must be continuity of the business enterpricse under
the modified corporate form. Rev. Rul 63-29 holds that the continuity
of business enterprice req-ment of 1.368-1(b) satisfied where a
transferee corp sold its assets and discontinued its business, then
acquired the assets of another corp in exchange for its voting stock,
and used the sales proceeds realized from the sale of its assets to
expand the business formerly conduced by the acquired corp. Rev
ruling now codified in 1.368-1(d) which looks ONLY to the
transferor’s historic business or historic business assets for dx-ing if
the continuity of business enterprise req-ment is satisfied.
 ** Continuity of business enterprise doctrine requires P either to
continue T’s historic business or to use a significant portion of T’s
historic business assets in a business – 1. 368-1(d)(1). Dx-ation based
on all facts and circumstances, applying the permissive regs.
o E.g., doctrine satisfied in the acquisitive reorg setting even if P
transfers the acquired T assets or stock to controlled P
subsidiaries, or in certain cases, even to a pt-ship that is
controlled by the P corp group. – 1.368-1(d)(4) & (5)
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o 1.368-1(d)(5) – Honbarrier v. Commissioner (2000) = rare case
in which transaction was found to FAIL the continuity of
business enterprise requirement – acquiring corp did not
continue the target’s historic business or use a significant
portion of its historic business assets in a business.
Mergers; Type “B” Reorganizations
394-96; 416-19 (433-34 1(a)-(g))
o Type A reorganization – statutory merger or consolidation
o “statutory” refers to a merger or consolidation pursuant to local law.
 Russell: regs provide that a transaction may qualify as a statutory” merger or
consolidation w/o requiring it to be effected under a domestic statute, thus
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permitted foreign corps to be parties to a Type a Reorganization. Reg 1.3682(b)(iii).
o Statutory merger – assets and liabilities of target corp are transferred to acquiring
corp w.o need for deeds or bills of sale, and taret dissolves by operation of law.
Consideration received by T’s SHs is specified in formal agmt of merger. SHs may
receive stock or debt instruments of the acquiring corp, cash or a combo of all
three.
o Consolidation – transfer of assets and liabilities of two corps to a newly created
entity followed by the dissolution of the transferor corps, and the SHs of the
transferors become SHs of the new entity by operation of law. E
 Either cololidation or statutory merger may require approval by simple
majority or two-thirds vote of the SHs of both corps, and under state corp
law dissenting SHs may be granted the right to sell their target stock at a
price dx’d in appraisal proceeding.
 (under Delaware law, dissenting target SHs have appraisal rights in
statutory mergers but not in asset acquisitions)
o “Divisive” Mergers.
o To be Type A reorg, merger must be acquisitive, NOT divisive transaction
o “Acquisitive” – result of transaction must be that one corp acquires the assets of
another (target) corp by operation of law, and the target must cease to exist
o “Divisive” transaction – a corp’s assets are divided among two or more corps
o Rev ruling 2000-5: a transaction in which T merged under state law into P,
transferring only some of its assets and liabilities, and T remained in existence, was
NOT a Type A reorg.
 Similarly, a transaction where T transferred some of its assets and liabilities
to each of two acquiring corps and then T dissolved, with each T SH
receiving stock in both acquiring corps, was NOT a Type A reorg.
 ** Even tho both transactions were called “mergers” under state law, they
were divisive rather than acquisitive b/c T’s assets were divided b/t two
corps, and T’s SHs wound up with sto0ck in two separate companies.
 (ruling serves as reminder that simple compliance w/ stte corp merger law
does not ensure that transaction will qualify as Type A reorg)
o Mergers involving disregarded entities.
o Service issued regs addressing mergers b/t corps and disregarded entites
o Two most typical transaction forms: (1) merger of a single-member LLC w/
corporate owner into an acquiring corp, and (2) the merger of a target corp into a
single-member LLC in exchange for stock of LLC’s corporate owner.
 **In both situations, the LLC is disregarded entity and thus is treated for tax
purposes as a division of its corporate owner unless it elects to be taxed as
separate corp.
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 First transaction doesn’t qualify as Type A reorg b/c corp owner’s assets and
liabilities are divided b/t corp owner of LLC and the acquiring corp as a
result of merger.
 HOWEVER, the second transaction – a merger of T into a single-member
LLC in exchange for stock of LLC’s corporate owner may qualify as a Type
A reorg if the other requirements are met (e.g., continuity of interest
doctrine) and the separate legal existence of T terminates. (consistent w
treatment of a disregarded entity as a division of its owner, its as it T merged
directly into P)
 (permitting statutory mergers into disregarded entities to qualify as Type A
reorganizations offers more flexibility by eliminating need for these
transactions to pass muster under the stricter req-ments applicable to Type C
stock-for-assets acquisitions
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