Chapter C4
Corporate Nonliquidating Distributions
Discussion Questions
C4-1 Current E&P is computed on an annual basis by making adjustments to taxable income so
that it represents the corporation's economic ability to pay dividends out of the current year's
earnings. The specific adjustments required are outlined in Table C4-1. Accumulated E&P is the
sum of the current E&P (less distributions made out of current E&P) balances for all previous years
reduced by the sum of (1) all previous current E&P deficits and (2) any distributions that have been
made out of accumulated E&P. p. C4-3.
C4-2 Distributions are deemed to come first from current E&P and then from accumulated E&P.
Thus, if current E&P is positive, any distributions will be dividends to the extent of the current E&P
even if accumulated E&P is negative. Also, if E&P is insufficient to cover all distributions,
distributions are deemed to come pro rata from current E&P and then in chronological order from
accumulated E&P. pp. C4-7 and C4-8.
C4-3 a.
The distribution is a $100,000 dividend payable out of current E&P.
b.
$60,000 of the distribution is a dividend from current E&P. The remaining $40,000 is
a return of capital. $25,000 of the return of capital portion of the distribution reduces the
shareholder's basis in his stock to zero and the remaining $15,000 is a capital gain. The $50,000
accumulated E&P deficit remains.
c.
All $100,000 of the distribution is a return of capital. $25,000 of the distribution
reduces the shareholder's basis in his stock to zero and the remaining $75,000 is a capital gain. A
$120,000 ($60,000 + $60,000) accumulated E&P deficit remains.
d.
The distribution is a $100,000 dividend payable out of accumulated E&P. None of
the current E&P deficit reduces accumulated E&P since the distribution is made on January 1.
If the distribution is made on October 1, the answers to parts a through c are the same.
However, in part d, accumulated E&P as of October 1 is $40,000 ($100,000 beginning balance $60,000 current deficit as of October 1) so that the distribution is a $40,000 dividend and a $60,000
return of capital. Allocation of the current E & P deficit to the pre-October 1 period is accomplished
here simply by multiplying $80,000 times 9/12ths. (Alternatively, the actual number of days could
be used in which case the accumulated E&P deficit would be $59,836 ($80,000 x 273/365) in a non
leap-year tax year.) $25,000 of the return of capital reduces the shareholder's basis in his stock to
zero and the remaining $35,000 is a capital gain. pp. C4-7 through C4-9.
C4-1
C4-4 a.
The distribution amount is the FMV of all property received. If the shareholder
assumes or acquires a liability in connection with the distribution, it reduces the amount of the
distribution (but not below zero).
b.
The distribution amount is a dividend to the extent it is paid out of the current and
accumulated E&P of the corporation.
c.
The basis of any property received is its FMV. Any liability assumed or acquired by
the shareholder in connection with the distribution does not reduce the property's basis.
d.
The holding period for the property begins on the day after the distribution date. pp.
C4-9 and C4-10.
The answers would not change if they were made to a corporate shareholder since Sec. 301(c)
applies the same dividend rules to each type of shareholder.
C4-5 a.
b.
c.
d.
The tax-exempt interest is added to taxable income to compute current E&P.
The dividends-received deduction is added to taxable income.
The capital loss carryover is added to taxable income.
The federal income taxes are deducted from taxable income. p. C4-4.
C4-6 It is possible. Taxable income or loss must be adjusted to compute current E&P. If, for
example, Badger had $12,000 of tax-exempt income, or if it had a $12,000 positive adjustment for
depreciation, its current E&P could be $4,000 or more. In such case, the $2,500 distribution would
be taxed to shareholders as a dividend and a $1,500 accumulated E&P balance would remain. pp.
C4-7 and C4-8.
C4-7 It matters only if the corporation has a current E&P deficit and positive accumulated E&P. In
such case, the amount of the current E&P deficit accrued on the distribution date reduces the
accumulated E&P, and only the remainder is available for paying out dividends.
It also matters if there is more than one distribution made during the year, and there is
insufficient E&P for all distributions to be treated as dividends. In such case, current E&P is
allocated ratable to all distributions, but accumulated E&P is allocated on a FIFO basis to each
distribution. pp. C4-7 and C4-8.
C4-8 The corporation should sell the property to a third party and report a $40,000 loss ($120,000
FMV - $160,000 basis) and then distribute the proceeds to its shareholders. If the property is
distributed to the shareholders first, the loss cannot be recognized when determining taxable income
by either the corporation or its shareholders. If the property is distributed, the $160,000 adjusted
basis for the property reduces the distributing corporation's E&P and therefore the taxability of future
distributions. pp. C4-10 and C4-11.
C4-9 It makes no difference whether the property is distributed first and then sold or sold first and
the proceeds distributed to the shareholder. Either way the corporation must recognize a $40,000
gain ($160,000 FMV - $120,000 basis) on the disposition/distribution of the building and the
C4-2
shareholders have a $160,000 dividend. The shareholder's basis in the building is $160,000. pp. C410 and C4-11.
C4-10 A constructive dividend (or undeclared distribution) is an indirect payment made to a
shareholder without a formal declaration. Such dividends are most likely to arise in the context of a
closely held corporation. Examples of constructive dividends include excess compensation paid to a
shareholder-employee or excess lease payments made to a shareholder-lessor. pp. C4-12 through
C4-14.
C4-11 Stock dividends are generally nontaxable because they do not add anything to the property
that the shareholder already owns nor do they reduce the property of the corporation. As a general
rule, the distribution is taxable whenever a stock dividend changes or has the potential to change the
shareholder's proportionate interest in the distributing corporation. pp. C4-14 and C4-15.
C4-12 A distribution of stock rights is tax-free unless it changes, or has the potential to change, the
shareholder's proportionate interest in the distributing corporation. The same exceptions to tax-free
treatment apply to distributions of stock rights as apply to stock dividends. A distribution of stock
rights that is nontaxable to shareholders has no effect on the distributing corporation. The
shareholders need to allocate the basis of the underlying stock between the stock and the rights if the
FMV of the rights is at least 15% of the value of the underlying stock. If the FMV is less than 15%
of the value of the underlying stock, the basis allocation is elective. pp. C4-15 and C4-16.
C4-13 A stock redemption is defined as the acquisition by a corporation of its own stock. Some
reasons for a redemption are listed on pages C4-16 and C4-17. Some redemptions that substantially
change the shareholder's proportionate interest closely resemble a sale of stock to a third party and
are treated as a sale or exchange, while others that do not produce such a change are essentially
equivalent to a dividend and are taxed as a dividend. pp. C4-16 and C4-17.
C4-14 If the redemption is treated as a sale, Andrew has a $2,000 capital gain ($10,000 - $8,000). If
the redemption is not treated as a sale, Andrew has a $10,000 distribution that is a dividend to the
extent of Field Corporation's current and accumulated E&P. In the dividend case, Andrew's $8,000
basis in the redeemed stock is added to his basis in his remaining stock. pp. C4-17 and C4-18.
C4-15 A redemption is treated as a sale if it satisfies any of the following conditions:
·
The redemption is substantially disproportionate.
·
The redemption is a complete termination of the shareholder's interest.
·
The redemption is not essentially equivalent to a dividend.
·
The redemption is a partial liquidation of the distributing corporation in redemption
of part or all of a noncorporate shareholder's stock.
·
The redemption is made in order to pay death taxes.
p. C4-18.
C4-3
C4-16 Three out of the five exchange exceptions to the Sec. 302 redemption rules (see question C415) depend on the shareholder's stock ownership before and/or after the redemption. The basic
purpose for the attribution rules is to prevent shareholders from either taking advantage of these
favorable tax rules, or avoiding unfavorable tax rules, by having family members or related entities
own stock that the shareholder is not permitted to own. There are four types of attribution rules:
family attribution, attribution from entities, attribution to entities, and option attribution. These rules
are described on pages C4-19 through C4-21.
C4-17 No. The assets will have been acquired by Ace Corporation in a taxable transaction within
the past five years and partial liquidation treatment will not be available (unless Ace Corporation is
willing to retain the assets and operate the business for at least five years prior to the partial
liquidation). pp. C4-25 through C4-27.
C4-18 A Section 303 redemption is a redemption to pay death taxes and is treated as a sale by the
estate or by the beneficiary of the estate who inherits the stock. The estate or beneficiary's basis in
the stock redeemed is the stock's FMV on the date of death (or alternate valuation date). Since the
stock is redeemed sometime soon after the date of death, the stock's value at the time of redemption
is likely to be close the stock's basis. Therefore, the beneficiary or estate generally has little or no
gain or loss to recognize on the redemption if it qualifies as a sale under Sec. 303. p. C4-26 through
C4-28.
C4-19 A corporation must recognize gain when it distributes appreciated property in redemption of
its stock. It does not recognize any loss when it distributes property that has declined in value. Any
gain recognized (net of taxes) increases the distributing corporation's E&P. Like with an ordinary
dividend, the gain that increases the E&P balance may be different from the amount that increases
taxable income. The E&P account is also reduced. The amount of the reduction depends on whether
the redemption is treated as a sale or exchange or as a dividend distribution. If the redemption is
treated as a sale or exchange, the corporation must reduce its E&P by the portion of the current and
accumulated E&P balances that are attributable to the redeemed stock. That is, E&P is reduced by a
percentage that equals the fraction of the outstanding stock that is redeemed. The remainder of the
distribution reduces the capital account. If the redemption does not qualify for sale or exchange
treatment, the corporation must reduce its E&P as it does for any other nonliquidating distribution
that does not involve a stock redemption. p. C4-28.
C4-20 A preferred stock bailout is the name given to a plan devised by shareholders to use preferred
stock to withdraw earnings from a corporation as a capital gain rather than as a dividend. The
specific steps of the plan are described on page C4-29. Section 306 was enacted to prevent the
scheme from working by denying capital gain treatment to certain sales or exchanges and
distributions. It operates by causing certain preferred stock held by a distributee to be tainted. When
the tainted (or Sec. 306) stock is sold or redeemed, part or all of the gain or income that is recognized
is ordinary income or dividend income rather than capital gain. pp. C4-30 and C4-31.
C4-4
C4-21 Section 304 requires that a sale of stock of one controlled corporation (Plum Corporation) to
a second controlled corporation (Cherry Corporation) be treated as a contribution to the capital of the
purchasing corporation and a stock redemption of part of the purchasing corporation's stock. If the
redemption is substantially disproportionate or meets any of the other exceptions of Secs. 302(b) or
303 that permit exchange treatment, it is treated as a sale by Bill. Otherwise it is treated as a
dividend distribution to Bill. In this case, Bill owns 100% of the Plum stock before the redemption
and 96% after the redemption (80 shares directly + [80% x 20 shares] indirectly through Cherry).
Therefore, the sale fails to qualify under any of the sale or exchange exceptions and is treated as a
dividend under Sec. 302. pp. C4-31 through C4-34.
C4-22 A determination that part of the compensation paid an owner-employee is unreasonable in
amount means that the corporation loses its tax deduction for that portion of the payment. Generally
the unreasonable compensation is taxed as a dividend to the owner-employee. The double taxation
associated with dividend treatment can be avoided by having the owner-employee enter into a hedge
agreement to repay any salary amounts that are determined to be unreasonable in amount. The
shareholder is taxed on the salary payment in the year in which the compensation is received, and
claims a deduction in the year the excess amount is repaid to the corporation. The large number of S
corporation elections that have been made following the enactment of the 1986 Tax Act means that
the question of reasonable compensation should be less important in the future as all of the S
corporation's income, whether distributed or not, will be passed through and taxed to the owneremployee. It remains to be seen whether or not this remains the case after the 1993 Tax Act now that
the top two individual tax rates have risen above the top corporate tax rate. pp. C4-12 through C414, C4-34 and C4-35.
C4-23 A bootstrap acquisition is an arrangement whereby a seller sells part of his stock to a
purchaser and has the corporation redeem the remainder of his stock. The advantage of this
arrangement is that the purchaser needs less cash to make the purchase. The consequence to the
seller is the same as though he had sold all of his stock to the purchaser because the redemption
qualifies for sale treatment as long as the sale and redemption are all part of an integrated plan to
terminate the seller's entire interest. pp. C4-35 and C4-36.
Issue Identification Questions
C4-24 ·
·
Since the two cash distributions exceed E&P, what portion of each distribution
comes out E&P?
What portion of each shareholder's distribution is a return of capital?
·
What portion of the return of capital distribution(s) reduces the basis of the
shareholder's stock?
·
What portion of each shareholder's return of capital distribution is a capital
gain?
·
Is the capital gain that is recognized long-term or short-term?
C4-5
The issue is to what extent Marsha's distribution is a dividend. Dye Corporation has $12,000
of current and accumulated E&P so only $12,000 can be a dividend to either Barbara or Marsha.
Current E&P is allocated ratably to Barbara and Marsha ($4,000 each) and accumulated E&P is
allocated on a first-in, first-out basis so the remaining $4,000 of E&P is allocated to Marsha.
Therefore, Marsha has an $8,000 dividend and a $2,000 return of capital. Barbara has a $4,000
dividend and a $6,000 return of capital. Any amount received by Marsha or Barbara after recovering
their stock basis is a capital gain. The return of capital distribution reduces the basis of Marsha's
stock investment and will cause a corresponding increase (decrease) in the capital gain (capital loss)
reported on her sale of the Dye stock to Barbara. pp. C4-3 through C4-9.
C4-25 ·
·
·
·
·
What reasons might cause the sale price to be $125,000 below the apparent
prevailing market price?
What gain or loss does Spring Harbor recognize on the sale?
What is Spring Harbor Corporation's E&P balance?
Do the related party sale rules apply to the sale?
If the $125,000 shortfall is a dividend,
·
What gain or loss does Spring Harbor recognize on the distribution?
·
What is the shareholder's gross income?
·
What is the shareholder's basis for the land?
·
What is the shareholder's holding period for the land?
·
What is the distributing corporation's gain or loss on the distribution?
·
What effect does the distribution have on the distributing corporation's E&P?
One issue is whether a $25,000 loss can be recognized on the Spring Harbor's sale of the land
to Neil for $275,000 ($275,000 sale price - $300,000 adjusted basis). It appears that Sec. 267 will
prevent the recognition of the loss since Neil and Spring Harbor Corporation are related parties under
Sec. 267(b). An additional issue is whether there has been a constructive dividend to Neil. If similar
land has recently sold for $400,000, it appears that the sale price should have been $400,000 instead
of $275,000. The $125,000 difference between the actual sales price and the price paid for similar
land should then be considered a constructive dividend. Classifying the difference as a constructive
dividend causes Spring Harbor to recognize a $100,000 ($400,000 - $300,000) capital gain on the
deemed land sale that occurs under Sec. 311(b) when appreciated property is distributed. It will also
trigger a $34,000 ($100,000 x 0.34) income tax liability that will reduce E&P. Neil will take a
$400,000 basis in the land. The distribution will reduce E&P by $125,000. pp. C4-9 through C4-14.
C4-26 ·
·
What is Penny's stock ownership before and after the redemption?
·
Are any shares attributed to Penny from her mother?
·
Can Penny elect to waive the family stock attribution rules?
What is the amount and character of Penny's gain or income on the stock
redemption?
·
What is Penney's basis on the 30 shares of stock she received as a gift from
her mother?
·
If the transaction is a dividend, what happens to Penny's basis in her stock?
C4-6
·
·
·
·
What is Penny's mother's basis for her stock after the redemption (i.e., is any
of Penny's remaining basis transferred to her mother?)
Does the corporation recognize any gain on the repurchase of the shares?
What is its basis for the shares repurchased?
What effect does the redemption have on Price Corporation's E&P?
The issue is whether the redemption should be treated as a sale or a dividend. Penny is
deemed to own the shares owned by her mother. Therefore, she is deemed to have owned 70 shares
before the redemption (70/100 = 70% of the Price stock) and 40 shares after the redemption (40/70 =
57% of the Price stock) after the redemption. Thus, the redemption is not substantially
disproportionate under Sec. 302(b)(2).
The second issue is whether Penny can sign a waiver to have the family attribution rules
waived under Sec. 302(b)(3). The problem is that she received her shares as a gift from her mother.
If Penny can show that tax avoidance was not the principal purpose for the gift of the Price stock, she
can sign a waiver and the redemption will be treated as a sale. In such case, she has a $19,000
($35,000 - $16,000) LTCG. E&P will be reduced by 30% of the current and accumulated E&P, or
$30,000 (0.30 x $100,000). If a waiver of the family attribution rules is not possible, Penny will
most likely have a $35,000 dividend. It is not likely that the Sec. 302(b)(1) "not essentially
equivalent to a dividend" rules will apply since Penny still maintains a majority stock ownership
position in Price following the redemption. If the transaction is a dividend, her basis for all 30 shares
will be reallocated to her mother since she is the individual whose stock ownership prevented the
redemption from receiving capital gain treatment. E&P will be reduced by the $35,000 that was
distributed to Penny. The corporation's basis for the redeemed shares is not important since no gain
or loss is recognized when new or treasury stock is issued. (Sec. 1032). pp. C4-16 through C4-23.
C4-27 ·
·
·
What is Gumby's Pizza's E&P balance immediately preceding the distribution?
If $50,000 in cash is withdrawn from the business, will it be treated as a dividend to
George?
·
Can the $50,000 that is withdrawn from the business be considered to have
been received as part of George's stock sale?
·
Can the tax results for the transaction be improved if George has some of his
stock redeemed for the $50,000 cash?
·
Are the tax consequences of the transaction different if the $50,000 is
withdrawn from the business either before or as part of the stock sale?
·
Can the $50,000 payment be classified as payment of back wages to George?
Would such an amount be deductible by the corporation?
What is the amount and character of the gain recognized on George's sale of the
stock?
The primary issue is whether the $50,000 George receives from Gumby's Pizza is a dividend
or is part of the amount he receives for his stock. If 25% of his stock is redeemed by Gumby's for
$50,000 in cash as part of the same transaction in which his remaining stock is sold to Mary for
$150,000, quite likely he can treat the entire $200,000 as being received in exchange for his stock
C4-7
under the bootstrap redemption rules. In such case, he has a $130,000 ($200,000 - $70,000) capital
gain.
However, if he receives $50,000 from Gumby's before entering into the sale agreement with
Mary, he will have a $50,000 dividend and then an $80,000 ($150,000 - $70,000) capital gain on a
later sale of his stock to Mary.
It is not likely that Gumby can treat the $50,000 payment as additional compensation (e.g., a
bonus or payment made because of lower-than-normal salary payments made in prior years) and then
deduct the payment in computing its corporate tax liability. A possibility might be to treat the
$50,000 payment as being paid to George in exchange for a covenant not to compete for a certain
period of time. Such payment is generally ordinary income for the recipient, but is deductible by the
payer over a period of 15 years in accordance with Code Sec. 197. pp. C4-3 through C4-9, C4-35
and C4-36.
Problems
C4-28 a.
Gross profit from operations
Dividends
Interest
Net capital gain ($8,000 - $1,200)
Gross income
Minus: Administrative expenses
Bad debt expense
Depreciation
$250,000
20,000
10,000
6,800
$286,800
$110,000
5,000
86,000
Charitable contribution [lesser of $8,000
or 0.10 x ($85,800 - $40,000)]
( 4,580)
$ 81,220
Dividends-received deduction
(0.80 x $20,000)
NOL deduction
Taxable income
b.
(201,000)
$ 85,800
( 16,000)
( 40,000)
$ 25,220
Earnings and profits:
Taxable income
Plus: Municipal bond interest
$
Life insurance proceeds
Excess depreciation
($86,000 - $42,000)
NOL carryover
Dividends-received deduction
C4-8
$ 25,220
12,000
100,000
44,000
40,000
16,000
212,000
Minus: Excess charitable contribution
($8,000 - $4,580)
Penalties
Taxes ($25,220 x 0.15)
Current earnings and profits
$
3,420
450
3,783
$229,567
( 7,653)
pp. C4-3 through C4-7.
C4-29 Taxable income
Plus: Dividends received deduction
(0.70 x $80,000)
NOL carryover deducted
Excess depreciation
Minus: Long-term capital loss
Fines and penalties
Federal income taxes
($500,000 x 0.34)
Current earnings and profits
$500,000
40,000
170,000
$ 56,000
30,000
126,000
$ 80,000
6,000
(256,000)
$370,000
pp. C4-3 through C4-7.
C4-30 Beginning of 1996:
affect E&P.)
Beginning of 1997:
Beginning of 1998:
Beginning of 1999:
($10,000) (The $2,000 distribution is a return of capital and does not
($6,000) [($10,000) + ($8,000 - $4,000)]
($11,000) [($6,000) + ($5,000)]
$2,000 [($11,000) + ($18,000 - $5,000)]
p. C4-3.
C4-31 a.
$60,000 dividend to Edna.
b.
$25,000 is a dividend to Edna. $25,000 is a return of capital which reduces Edna's
basis to zero; the excess $10,000 is taxable as a capital gain.
c.
Yellow's accumulated E&P as of March 1 (of a non-leap year) is $65,000 - [($36,500
 365) x 59] = $59,100. Therefore, $59,100 is taxable as a dividend. $900 is a return of capital
which reduces Edna's stock basis to $24,100.
d.
$25,000 is a return of capital which reduces Edna's basis to zero; the excess $35,000
is taxable as a capital gain. pp. C4-7 through C4-9.
C4-9
C4-32 a.
Indiv.
Charles
Donald
Total
Date
Amount
3/1
9/1
$ 60,000
90,000
$150,000
Current
E&P
Accumulated
E&P
$16,000
24,000
$40,000
$30,000
-0$30,000
Dividend
$46,000
24,000
$70,000
Return of
Capital
$14,000
66,000
$80,000
Thus, Charles has $46,000 of dividend income and a $14,000 return of capital which reduces his
basis for the Pearl stock from $80,000 to $66,000. The basis reduction, of course, increases Charles's
capital gain on the sale to $59,000 [$125,000 - ($80,000 - $14,000)]. Donald has a $24,000 dividend
and a $66,000 return of capital which reduces his stock basis at year-end from $125,000 to $59,000.
b.
Indiv.
Charles
Donald
Total
Date
Amount
3/1
9/1
$ 60,000
90,000
$150,000
Current
E&P
Accumulated
E&P
$ 40,000
60,000
$100,000
$ -0-0$ -0-
Dividend
$ 40,000
60,000
$100,000
Return of
Capital
$20,000
30,000
$50,000
The return of capital distributions reduce Charles' basis in his Pearl stock from $80,000 to $60,000
and Donald's basis from $125,000 to $95,000. This basis reduction, of course, increases Charles's
capital gain on the sale to $65,000 [$125,000 - ($80,000 - $20,000)].
c.
Indiv.
Charles
Donald
Total
a
Date
Amount
3/1
9/1
$ 60,000
90,000
$150,000
Current
E&P
Accumulated
E&P
$ -0-0$ -0-
$60,000a
35,700b
$95,700
59 x ($36,500) = ($5,900) E&P deficit for 1/1-2/28.
365
Acc. E&P on 3/1 = $120,000 - $5,900 = $114,100 available.
b
243 x ($36,500) = ($24,300) E&P deficit for 1/1-8/31.
365
C4-10
Dividend
$60,000
35,700
$95,700
Return of
Capital
$ -054,300
$54,300
Acc. E&P on 9/1 = $120,000 - $24,300 - $60,000 = $35,700
Charles reports a $45,000 capital gain ($125,000 - $80,000) on the stock sale since the distribution
does not affect the basis for his stock. The return of capital distribution reduces Donald's basis in his
stock from $125,000 to $70,700 ($125,000 - $54,300). pp. C4-7 through C4-9.
C4-33 a.
Barbara receives a taxable dividend of $52,000 ($60,000 - $8,000).
b.
Barbara's basis for the land is $60,000, its FMV.
c.
Ruby Corporation recognizes a $30,000 [($52,000 net FMV + $8,000 release from
liability) - $30,000] capital gain on the distribution.
d.
Ruby Corporation's E&P is increased by the $30,000 gain and decreased by the
$52,000 ($60,000 FMV - $8,000 mortgage) net amount of the distribution plus the $10,200 (0.34 x
$30,000) of federal income taxes imposed on the gain, or a net reduction of $32,200. pp. C4-9
through C4-11.
C4-34 a.
The $20,000 cash received by Arlene is taxable as a dividend. The FMV of the land
is deemed to be at least equal to the mortgage assumed by Arlene. Therefore, Arlene has received a
property distribution of -0- ($60,000 FMV - $60,000 liability assumed).
b.
Arlene's basis for the land is apparently $60,000, the property's FMV under Sec.
311(b). Two alternatives exist for the basis amount. One approach is that the basis of the land is
$50,000, or the property's actual FMV. Proponents of this approach argue that Sec. 311(b)(1) applies
only for gain recognition purposes. The other approach is that the land's basis is $60,000 or the FMV
determined under Sec. 311(b)(1). Some practitioners lean towards the $60,000 amount, although the
IRS has not taken an official position in either the Treasury Regulations or a revenue ruling. BNA
Portfolio 59 [footnote 307] refers to the property's actual FMV as being its basis citing Code
Sections 1012 and 301(d).
c.
Stowe Corporation must recognize a $45,000 ($60,000 FMV - $15,000 basis) capital
gain on the distribution.
d.
Stowe Corporation's E&P is increased by the $45,000 gain and reduced by the zero
($60,000 - $60,000) net amount of the property distribution resulting in a net increase of $45,000.
This increase is offset by $15,300 (0.34 x $45,000) of federal income taxes imposed on the gain and
the $20,000 cash distribution for a net increase of $9,700 [$45,000 -($15,300 + $20,000)]. pp. C4-9
through C4-11.
C4-35 a.
Calvin has a dividend of $170,000 ($250,000 FMV - $80,000 mortgage assumed),
since Quick has E&P in excess of the amount distributed.
b.
Calvin's basis for the building is $250,000.
c.
Quick Corporation must recognize a gain of $100,000 ($250,000 FMV - $150,000
adjusted basis) for taxable income purposes. Because the building was used in Quick's business,
$6,000 ($30,000 x 0.20) of the gain is ordinary income that is recaptured under Sec. 291. The
remaining $94,000 ($100,000 - $6,000) is Sec. 1231 gain.
d.
Quick Corporation's E&P is increased by the $90,000 gain recognized for E&P
purposes and reduced by the $170,000 net amount of the distribution plus $34,000 (0.34 x $100,000)
C4-11
in federal income taxes on the $100,000 gain recognized for taxable income purposes, thereby
resulting in a net decrease of $114,000. pp. C4-9 through C4-11.
C4-36 a.
Susan has $200,000 of dividend income and a $200,000 basis in the land. Zeta
Corporation recognizes a $75,000 Sec. 1231 gain. Zeta Corporation's E&P is increased by $75,000
and reduced by the land's $200,000 FMV plus the $25,500 ($75,000 x 0.34) of federal income taxes
imposed on the gain.
b.
Susan has $60,000 ($200,000 - $140,000) of dividend income and a $200,000 basis in
the land. Zeta Corporation recognizes a $75,000 Sec. 1231 gain. Zeta Corporation's E&P is
increased by $75,000 and reduced by the land's $60,000 ($200,000 - $140,000) net FMV plus the
$25,500 ($75,000 x 0.34) of federal income taxes imposed on the gain.
c.
Susan has $25,000 of dividend income and a basis of $25,000 in the inventory. Zeta
Corporation recognizes $7,000 of ordinary income. Zeta Corporation's E&P is increased by $7,000
and reduced by the inventory's $25,000 FMV plus the $2,380 ($7,000 x 0.34) of federal income taxes
imposed on the gain.
d.
Susan has $450,000 of dividend income and a basis of $450,000 in the building. Zeta
Corporation recognizes a $300,000 ($450,000 - $150,000) gain for taxable income purposes of
which $15,000 ($75,000 x 0.20) is ordinary income under Sec. 291 and $285,000 ($300,000 $15,000) is Sec. 1231 gain. For E&P purposes, the basis of the building is $165,000 ($225,000 $60,000). The recognized gain for E&P purposes is $285,000 ($450,000 - $165,000). Zeta
Corporation's E&P is increased by $285,000 and reduced by the building's $450,000 FMV plus the
$102,000 ($300,000 x 0.34) of federal income taxes imposed on the gain.
e.
Susan has $8,000 of dividend income and an $8,000 basis in the automobile. Zeta
Corporation recognizes $2,240 of ordinary gain ($8,000 - $5,760) for taxable income purposes. For
E&P purposes, the basis of the automobile is $6,800 ($12,000 - $5,200). The recognized gain for
E&P purposes is $1,200 ($8,000 - $6,800). Zeta Corporation's E&P is increased by $1,200 and
reduced by the automobile's $8,000 FMV plus the $762 ($2,240 x 0.34) of federal income taxes
imposed on the gain.
f.
Susan has $35,000 of dividend income and a $35,000 basis in the obligation. Zeta
Corporation recognizes a $10,500 Sec. 1231 gain on the distribution from sale of property in a prior
year (the character of the gain depends on the character of the property sold when the obligation was
received). Zeta Corporation's E&P is reduced by the obligation's $35,000 FMV plus the $3,570
($10,500 x 0.34) of federal income taxes imposed on the gain. E&P is not increased by the gain on
the installment obligation because E&P was increased by the entire gain in the year of sale. pp. C4-9
through C4-11.
C4-37 a.
$220,000 ($500,000 paid - $280,000 reasonable compensation) would be
nondeductible to the corporation and be a constructive dividend to Wilma.
b.
$400,000 would likely be a dividend to Harry.
c.
The net FMV of the property that was sold is $290,000 ($350,000 - $60,000). Since
Wilma paid only $150,000, she has a constructive dividend of $140,000 ($290,000 - $150,000).
King Corporation must recognize a total gain of $260,000 ($350,000 FMV - $90,000 basis) on the
sale of a portion of the building and the distribution of the remainder of the building.
d.
Harry has a constructive dividend of $15,000 per year. King's rent expense is reduced
C4-12
by $15,000.
C4-13
e.
Wilma has a constructive dividend of $65,000 ($250,000 - $185,000). King's basis in
the land is reduced from $250,000 to $185,000.
f.
Harry and Wilma have a constructive dividend of $8,000. King's deductions for its
airplane use are reduced by $8,000. pp. C4-12 through C4-14.
C4-38 a.
The $200,000 in disallowed salary and bonuses will be nondeductible for Forward
Corporation and taxable as a dividend to Alvin.
b.
The repayment will be deductible by Alvin. The dividend income and deduction
items would represent offsetting amounts reported in the year in which the initial "salary" payment
was made and the year of repayment, respectively. The hedge agreement prevents the monies from
being paid to Alvin out of after-tax dollars. pp. C4-12, C4-13, C4-34 and C4-35.
C4-39 a.
The stock dividend is nontaxable under Sec. 305(a).
b.
Robert's basis in each share is $909.09 ($100,000  110 shares). His gain on the sale
is computed as follows:
Amount received on sale
$7,000.00
Minus: Basis of 5 shares (5 x $909.09)
(4,545.45)
Recognized gain
$2,454.55
c.
Robert's basis in his remaining shares is $909.09 each. Basis for the shares is
$95,454.55 ($100,000 - $4,545.45). Robert's holding period for all shares begins in 1992 when he
acquired the original 100 shares. pp. C4-14 and C4-15.
C4-40 a.
Tillie recognizes no income when she receives the preferred stock. Tillie's basis in
her common and preferred stock is:
Basis for 100 preferred shares:
$100,000 x $ 10,000 = $ 5,263.16
$190,000
Basis for 1,000 common shares:
$100,000 x $180,000 = $94,736.84
$190,000
b.
Tillie must recognize a long-term capital gain of $2,368.42 ($5,000 - $2,631.58) on
the sale of one-half of the preferred stock.
c.
Tillie's basis in her common stock is $94,736.84. Tillie's basis in her remaining
preferred stock is $2,631.58. Her holding period begins in 1994 when she purchased the common
stock. pp. C4-14 and C4-15.
C4-41 a.
No income is recognized when the rights are received.
b.
Since the value of the rights ($15) is more than 15% of the value of the underlying
stock ($75), the basis of the stock must be allocated to the stock and the right. Jim's basis in his
stock is: $10,000 x ($75/$90) = $8,333.33 ($41.67/share). Jim's basis in his rights is $10,000 x
($15/$90) = $1,666.67 ($8.33/right). Jim recognizes a long-term capital gain of $1,166.67 ($2,000 $833.33) when the 100 rights are sold.
C4-14
c.
No gain is recognized when the rights are exercised. Their basis is added to the basis
of the stock purchased with the rights ($6,000 + $833.33 = $6,833.33).
d.
Jim recognizes a gain of $700 [(60 x $80) - (60 x $68.33)] on the stock sale. The gain
is a short-term capital gain since the holding period commences on the September 10 exercise date.
e.
Jim's basis in his remaining shares is: Jim's original 200 shares: $8,333.33 ($10,000 $1,666.67). Jim's 40 remaining shares purchased with the rights: $2,733.33 (40 shares x $68.33).
pp. C4-15 and C4-16.
C4-42 George's stock will be attributed to: a, his wife; b, his father; e, his daughter; and g, his
grandfather. pp. C4-19 through C4-21.
C4-43 Lara owns:
60 shares directly,
10 shares through LMN Partnership (0.20 x 50 shares)
70 shares through LST Partnership (0.70 x 100 shares)
-0- shares through Lemon Corporation
54 shares through Lime Corporation (0.60 x 90 shares)
for a total deemed shareholding of 194 shares. pp. C4-19 through C4-21.
C4-44 Since Paul still owns 100% of Presto Corporation's stock, the redemption is treated as a
dividend under Sec. 301. Paul has a $30,000 dividend to be taxed as ordinary income. His $2,500
($10,000 x 25/100) basis in the redeemed shares is added to his $7,500 ($10,000 - $2,500) basis in
his remaining 75 shares so that his basis in the remaining 75 shares is $10,000. Presto Corporation's
E&P is reduced by the amount distributed, or $30,000.
pp. C4-19 through C4-21, C4-28, and C4-29.
C4-45 a.
Ann owns 25% of the Moore stock before the redemption and 10% (30  300) after
the redemption. Therefore Ann treats the redemption as a sale of stock under Sec. 302(b)(2) and
must recognize a long-term capital gain of $29,400 [70 x ($600 - $180)]. Ann's remaining 30 shares
have a basis of $180 per share.
Beth owns 25% of the Moore stock before the redemption and 26-2/3% (80  300) after the
redemption. Therefore Beth treats the redemption as a dividend distribution and must recognize
dividend income of $12,000 (20 shares x $600). Beth's remaining 80 shares have a total basis of
$18,000 (100 shares x $180 each), or $225 per share.
Carol owns 25% of the Moore stock before the redemption and 30% (90  300) after the redemption.
Therefore Carol treats the redemption as a dividend distribution and must recognize dividend
income of $6,000 (10 shares x $600). Carol's remaining 90 shares have a total basis of $18,000 (100
shares x $180 each), or $200 per share.
b.
Ann is considered to own 50% of the Moore stock (200  400) before the redemption
and 40% (120  300) after the redemption. Therefore Ann might have to treat the redemption
distribution as a dividend. (It is no longer substantially disproportionate since the post-redemption
C4-15
ownership interest for Ann is exactly 80% of her pre-redemption ownership interest.) If so, Ann
must recognize dividend income of $42,000 (70 shares x $600). Ann's remaining 30 shares have a
total basis of $18,000, or $600 per share. Carol is also considered to own 50% before the redemption
and 40% after the redemption and will be considered to have a dividend. Thus, the tax consequences
for Beth and Carol do not change from part a. If the distribution is instead considered to be not
essentially equivalent to a dividend under Sec. 302(b)(1), Ann and Carol will each report the
transaction as a sale or exchange. The tax consequences to Ann will not change from part a. Carol
will recognize a $4,200 long-term capital gain [($600 - $180) x 10]. Carol's basis in her remaining
shares is $180 per share. pp. C4-16 through C4-24.
C4-46 The redemption is treated as a sale of stock by Amy, Beth, and Carla. Each recognizes a
$15,000 ($20,000 - $5,000) capital gain on their shares that were redeemed. All these shareholders
have a $1,000 per share basis for their remaining shares. Delta Corporation has a $20,000 dividend
since it does not experience a change in its stock ownership percentage and the redemption does not
qualify for exchange treatment under Sec. 302(b)(4). Delta's basis in its remaining 20 shares is
$25,000, or $1,250 per share. Delta is entitled to an 80% dividends-received deduction for the
distribution. pp. C4-24 through C4-26.
C4-47 a.
A redemption of stock held by either John's estate or John, Jr. will qualify as a sale
under Sec. 303. The value of the stock in the gross estate ($1,500,000) is more than 35% of the
adjusted gross estate [$787,500 = 0.35 x ($2,500,000 - $250,000)]. John, Jr. is eligible for Sec. 303
treatment since he is responsible for all of the taxes and expenses of the estate. The maximum
qualified redemption under Sec. 303 is $600,000 ($250,000 + $350,000). A redemption of stock
held by John's wife will not qualify under Sec. 303 since it is not included in the gross estate.
b.
The redemption qualifies under Sec. 303. However, only $600,000 (150 shares x
$4,000 per share) qualifies for sale treatment under Sec. 303. The estate will report a $37,500 capital
gain [$600,000 - ($1,500,000 x 150/400)] on this part of the redemption. The remaining $200,000 of
the redemption proceeds is taxed as a dividend to the estate. pp. C4-26 through C4-28.
C4-48 a.
White's E&P is reduced by 30%, the percentage of stock that was redeemed. Thus, it
is reduced by $24,000 (0.30 x $80,000). The remaining $6,000 of the distribution comes from the
capital account.
b.
White's E&P is reduced by $30,000. pp. C4-29 and C4-30.
C4-49 a.
This is a complete termination of interest. Alan recognizes a gain of $40,000
($100,000 - $60,000 basis). Barbara and Dave each retain a basis of $60,000 in their remaining
shares. Time's E&P is reduced by $80,000 (100/300 shares x $240,000).
b.
If Barbara is Alan's mother, Alan is considered to own 200/300 =
66 2/3% before the redemption and 100/200 = 50% after the redemption. This is not a substantially
disproportionate redemption. Therefore, the redemption is treated as a dividend of $100,000 to Alan.
Barbara's basis in her shares is increased by Alan's basis in the 100 shares surrendered, so her basis
is $120,000 ($60,000 + $60,000). Dave's basis remains at $60,000. Time's E&P is reduced by
$100,000, the amount of the dividend to Alan. The distribution might be considered to be not
C4-16
essentially equivalent to a dividend. There is some uncertainty about its qualification since it does
not meet the usual requirements of going from a controlling position to a minority position or from
one minority position to another minority position. See part c, however, for another option.
c.
If Alan signs an agreement not to obtain any interest in Time for ten years, the family
attribution rules can be waived. Therefore the redemption is treated as a sale and Alan recognizes a
$40,000 gain. Barbara and Dave each retain a $60,000 basis in their remaining shares. Time's E&P
is reduced by $80,000 [(100/300) x $240,000]. pp. C4-16 through C4-24.
C4-50 a.
Before redemption: 30 + 7.5 = 37.5 shares (37.5%)
After redemption: 5 + 7.5 = 12.5 shares (16.67%)
The redemption is treated as a sale since it is substantially disproportionate. Bea has a capital gain of
$25,000 ($30,000 - $5,000). Excel Corporation's E&P is reduced by $25,000 (0.25 x $100,000).
b.
Before redemption: 30 + 7.5 = 37.5 shares (37.5%)
After redemption: 20 + 7.5 = 27.5 shares (30.55%).
Generally this redemption is treated as a dividend of $12,000 to Bea since the 80% test is not met
(0.80 x 37.5% = 30.00%). Alternatively, sale or exchange treatment may be available under Sec.
302(b)(1) since Bea goes from one minority position to another. If so, a $10,000 ($12,000 - $2,000)
long-term capital gain is recognized. If the transaction is a dividend, Excel Corporation's E&P is
reduced by $12,000 (amount distributed). If it is a sale, E&P is reduced by $10,000 (0.10 x
$100,000).
c.
Before redemption: 25 + 15 = 40 shares (40%)
After redemption: 15 shares (20%)
The redemption is treated as a sale since it is substantially disproportionate. Carl must recognize a
$26,000 ($30,000 - $4,000) capital gain. Excel Corporation has a $25,000 (0.25 x $100,000)
reduction in its E&P. This redemption also qualifies as a complete termination if the family
attribution rules are waived.
d.
The redemption qualifies as a sale. Carl's estate must recognize a $2,000 gain
($30,000 minus $28,000 FMV of the Excel stock on the date of Carl's death). Excel Corporation
again has a $25,000 reduction in its E&P?
e.
Before redemption: 20 shares (out of 100) (20%)
After redemption: -0- shares (out of 80) (0%)
The redemption is either a complete termination or substantially disproportionate. (No stock is
attributed from Tetra Corporation to Andrew since Andrew owns less than 50% of the Tetra stock.)
Andrew must recognize a $21,000 ($24,000 - $3,000) capital gain. Excel Corporation must
recognize an $18,000 gain on the distribution of the land. Its E&P is increased by $18,000 minus the
$6,120 ($18,000 x 0.34) of federal income taxes attributable to the gain. The reduction for the
distribution is the lesser of (1) 20% of the E&P balance [$22,376 = 0.20 x ($100,000 + $18,000 $6,120)], or (2) the amount of the redemption distribution [$24,000]. pp. C4-16 through C4-29.
C4-51 a.
Beth has ordinary income to the extent of the issuing corporation's E&P at the time
the Sec. 306 stock was issued. The remainder is a return of capital or capital gain.
b.
All amounts received are a return of capital or capital gain under the general rules of
Sec. 301.
C4-17
c.
Ruth has dividend income up to Zero's E&P at the end of the year in which the
redemption occurs under the regular Sec. 301 dividend rules. The remainder, if any, is a return of
capital or capital gain.
d.
There is no tax at the time of the gift, but the stock retains its Sec. 306 taint in the
hands of the donee, Barry.
e.
Since Ed completely terminates his interest in Zero Corporation, the redemption is
treated as a sale and Sec. 306 does not apply.
f.
Section 306 does not apply to inherited stock. pp. C4-29 through C4-31.
C4-52 a.
is:
The preferred stock is Sec. 306 stock. Fran's basis in the preferred and common stock
Preferred:
$150,000 x $ 60,000 = $20,000
$450,000
Common:
$300,000 x $ 60,000 = $40,000
$450,000
When the preferred stock is sold, $100,000 (the E&P at the time the stock was distributed) is
ordinary income to Fran, $20,000 is a return of capital, and $80,000 is a capital gain. There is no
adjustment to Star Corporation's E&P.
b.
$100,000 is ordinary income, $10,000 is a return of basis. Fran's remaining $10,000
basis is added to her basis in the common stock so that it is $50,000 ($40,000 + $10,000). There is
no adjustment to Star Corporation's E&P.
c.
Under the Sec. 301 rules, $75,000 is a dividend (up to the amount of E&P in the year
of the redemption); Fran's $20,000 basis in the preferred shares is recovered tax-free; and the
remaining $105,000 of the distribution is a capital gain. Star Corporation's E&P is reduced by
$75,000. pp. C4-29 through C4-31.
C4-53 a.
The sale is recast as a redemption of Razzle stock that was issued as a result of Bob's
capital contribution of the Dazzle stock to Razzle. The Sec. 302 stock ownership is tested by
looking at Bob's ownership of the Dazzle stock.
·
Bob's ownership of Dazzle stock before the redemption: 60% of Dazzle stock.
·
Bob's ownership after the redemption: 30 shares directly and 80% x 30 shares
indirectly = 54 shares = 54% of Dazzle stock.
The redemption is treated as a $50,000 dividend to Bob since the combined E&P of Dazzle and
Razzle Corporations is $65,000 ($25,000 + $40,000).
b.
Bob's basis in his remaining Dazzle stock is $6,000 (30/60 x $12,000). Bob's basis in
his Razzle stock is increased to $14,000 by his $6,000 basis in the redeemed Razzle stock.
c.
Razzle's E&P is reduced by the first $40,000 of the distribution and Dazzle's E&P is
reduced by the remaining $10,000 ($50,000 - $40,000) of the distribution.
d.
Razzle's basis in its Dazzle shares is $6,000, the same as Bob's pre-sale basis.
e.
If Bob owned only 50% of the Razzle stock before the sale, Bob owns 60% of the
Dazzle stock before and 45% after the sale [30 shares + (50% x 30 shares)] so the redemption is
C4-18
treated as a sale under Sec. 302(b)(2). Bob has a capital gain of $44,000 ($50,000 - $6,000 basis).
pp. C4-31 through C4-33.
C4-54 a.
The sale is recast as a redemption. Since Jane still owns more than 50% of Parent
after the redemption, [100 shares directly and 20 (50% x 80% x 50) shares indirectly out of 200
outstanding shares], or 60% of Parent's stock. The $40,000 is taxed as a dividend to Jane.
b.
Jane's basis in her remaining 100 shares of Parent stock is $15,000.
c.
Subsidiary Corporation's E&P is reduced to $20,000 ($60,000 - $40,000).
d.
Subsidiary Corporation's basis in the Parent shares is $40,000.
e.
The recast redemption is substantially disproportionate {75% before the redemption
and 70 [50 + 20 (25% x 80% x 100)] shares, or 35%, after the redemption}. Therefore, Jane has a
capital gain of $70,000 [$80,000 - (100/150 x $15,000)]. pp. C4-31 through C4-34.
C4-55 a.
Jana will recognize $450,000 ($750,000 - $300,000) of capital gain on her sale of 75
shares of Stone Corporation stock to Michael. She will recognize an additional $150,000 ($250,000
- $100,000) of capital gain on the redemption of her remaining shares by Stone. Michael will have a
basis in his stock of $750,000, the amount paid for the 75 shares that were purchased. Stone
Corporation will not recognize any gain or loss on the redemption if the redemption is for cash. If
Stone uses property to redeem Jana's stock, it will have to recognize gain (but not loss) on the
property used as though the property was sold. Since the redemption of one-fourth of the Stone
stock is treated as a sale, the corporation's E&P will be reduced by $150,000 which is one-fourth of
the available E&P.
b.
The results are the same even though the redemption takes place before the sale. As
long as the redemption and sale are all part of one transaction, the redemption will qualify as a sale.
pp. C4-35 and C4-36.
Case Study Problems
C4-56 (See Instructor's Guide)
C4-57 (See Instructor's Guide)
Tax Research Problems
C4-58 (See Instructor's Guide)
C4-59 (See Instructor's Guide)
C4-60 (See Instructor's Guide)
C4-61 (See Instructor's Guide)
C4-19