TEI EDUCATION FUND
________________________________
LECTURE ON INCORPORATIONS,
DISTRIBUTIONS AND LIQUIDATIONS
________________________________
June 2000
Mark J. Silverman
Steptoe & Johnson LLP
Washington, D.C.
Copyright 2000, Mark J. Silverman, All Rights Reserved
TEI EDUCATION FUND
LECTURE ON INCORPORATIONS, DISTRIBUTIONS
AND LIQUIDATIONS
TABLE OF CONTENTS
Page
I.
II.
BACKGROUND................................................................................................................. 1
A.
Orientation to the Internal Revenue Code............................................................... 1
B.
Orientation to Concept of Corporations and Taxes................................................. 2
C.
Choice of Entity - Prior to the Issuance of the "Check-the-Box" Regulations ....... 4
D.
The "Check-the-Box" Regulations.......................................................................... 5
E.
Recent Tax Legislation Affecting Corporations ..................................................... 7
F.
General Tax Concepts -- Realization v. Recognition............................................ 30
ORGANIZATION OF THE CORPORATION -- SECTION 351.................................... 31
A.
Concepts Involved................................................................................................. 31
B.
Section 351 -- In General ...................................................................................... 31
C.
Related Statutes ..................................................................................................... 34
D.
Section 351 -- Statutory Requirements ................................................................. 34
E.
Administrative Requirement -- Business Purpose ................................................ 34
F.
One or More Persons............................................................................................. 35
G.
Transfer of "Property" ........................................................................................... 35
H.
Solely..................................................................................................................... 37
I.
In Exchange........................................................................................................... 37
J.
For Stock ............................................................................................................... 37
K.
Control................................................................................................................... 42
L.
Immediately After the Exchange........................................................................... 45
M.
Section 351(b) -- Transfers Not Solely for Stock ................................................. 47
N.
Section 351(f) -- Exception for Section 311 Transfers ......................................... 50
O.
Section 1032 -- No Gain or Loss Recognized to the Corporation on Receipt
of Property............................................................................................................ 50
- ii -
III.
IV.
V.
VI.
VII.
VIII.
P.
Section 358 -- Basis of Stock Received by Transferor-Shareholder..................... 50
Q.
Section 362 -- Basis of Property to the Corporation ............................................. 52
R.
Section 1223 -- Holding Period of Stock and Property......................................... 53
S.
Section 357 -- Assumption of Liabilities by Corp. ............................................... 54
T.
Contributions to Capital ........................................................................................ 59
U.
Special Problems ................................................................................................... 62
V.
Disclosure Requirements and Ruling Requests .................................................... 70
DISTRIBUTIONS............................................................................................................. 72
A.
Preliminary Concepts ............................................................................................ 72
B.
Statutory Framework............................................................................................. 73
C.
Types of Distributions........................................................................................... 73
SECTION 301 -- TAX TREATMENT OF DISTRIBUTEE ............................................ 73
A.
Section 301(a) -- General Concepts ...................................................................... 73
B.
Section 301(b) -- Amount Distributed .................................................................. 74
C.
Section 301(c) -- Amount Taxable........................................................................ 75
D.
Section 301(d) -- Basis of Property to Distributee................................................ 76
E.
Section 301(e) – Special Earnings and Profits Rules............................................ 76
SECTION 316 -- WHAT IS A DIVIDEND ..................................................................... 76
A.
Introduction ........................................................................................................... 76
B.
Section 316(a) -- General Rule.............................................................................. 77
SECTION 312 -- EARNINGS AND PROFITS ............................................................... 80
A.
Introduction ........................................................................................................... 80
B.
Concept of Earnings and Profits............................................................................ 81
C.
Calculation of Earnings and Profits ...................................................................... 81
D.
Effect of Distribution on Earnings and Profits...................................................... 84
DISTRIBUTIONS OF PROPERTY IN KIND................................................................. 85
A.
Introduction ........................................................................................................... 85
B.
Old Section 311..................................................................................................... 85
C.
New Section 311 ................................................................................................... 88
D.
Earnings and Profits -- Effect of Distribution of Property. ................................... 89
CONSTRUCTIVE DISTRIBUTIONS ............................................................................. 90
- iii -
IX.
X.
XI.
XII.
A.
In General.............................................................................................................. 90
B.
Examples of Constructive Dividends.................................................................... 91
C.
Limits on Abuse of Distribution Transactions ...................................................... 93
DISTRIBUTION OF CORPORATION'S OWN STOCK................................................ 95
A.
In General.............................................................................................................. 95
B.
Section 305............................................................................................................ 95
REDEMPTIONS............................................................................................................... 96
A.
Definition .............................................................................................................. 96
B.
Section 302............................................................................................................ 96
C.
Legislative History ................................................................................................ 98
D.
Ruling Requests..................................................................................................... 99
SECTION 318 -- CONSTRUCTIVE OWNERSHIP OF STOCK ................................... 99
A.
In General.............................................................................................................. 99
B.
Family Attribution -- Section 318(a)(1) ................................................................ 99
C.
Entity to Beneficiary Attribution......................................................................... 100
D.
Beneficiary to Entity Attribution......................................................................... 102
E.
Option Attribution ............................................................................................... 104
F.
Reattribution -- Constructive Ownership as Actual Ownership.......................... 105
SECTION 302(b)(2) -- SUBSTANTIALLY DISPROPORTIONATE
REDEMPTIONS............................................................................................................. 107
XIII.
A.
In General............................................................................................................ 107
B.
Statutory Tests..................................................................................................... 107
C.
Operating Rules................................................................................................... 108
SECTION 302(b)(3) -- TERMINATION OF SHAREHOLDER'S INTEREST............ 111
A.
Statutory Requirements ....................................................................................... 111
B.
Constructive Ownership Provisions .................................................................... 111
XIV. SECTION 302(b)(4) -- PARTIAL LIQUIDATIONS FOR NONCORPORATE
SHAREHOLDERS ......................................................................................................... 115
XV.
A.
Partial Liquidations ............................................................................................. 115
B.
Ruling Requests................................................................................................... 117
SECTION 302(b)(1) -- NOT ESSENTIALLY EQUIVALENT TO A DIVIDEND...... 118
- iv A.
Statutory Requirement......................................................................................... 118
B.
United States v. Davis, 397 U.S. 301 (1970) ...................................................... 118
C.
Meaningful Reduction -- Cases and Rulings After Davis................................... 119
D.
Constructive Ownership Rules............................................................................ 121
XVI. REDEMPTIONS AND BOOTSTRAP ACQUISITIONS.............................................. 121
A.
In General............................................................................................................ 121
B.
Seller Issues......................................................................................................... 122
C.
Continuing Shareholder Issues............................................................................ 123
XVII. SECTION 304 -- REDEMPTIONS THROUGH RELATED CORPORATIONS......... 124
A.
In General............................................................................................................ 124
B.
Section 304(a)(1) -- Brother-Sister Acquisitions ................................................ 125
C.
Section 304 and Section 351 ............................................................................... 128
D.
Section 304(a)(2) -- Parent-Subsidiary Acquisitions .......................................... 129
XVIII. SECTION 303 -- REDEMPTIONS TO PAY DEATH TAXES..................................... 130
A.
Section 303(a) ..................................................................................................... 130
B.
Limitations and Requirements ............................................................................ 130
C.
Rev. Rul. 87-132 ................................................................................................. 130
XIX. EFFECT OF REDEMPTION ON THE CORPORATION............................................. 130
XX.
A.
Recognition of Gain to the Corporation.............................................................. 130
B.
Effect of a Redemption on the Corporation's Earnings and Profits .................... 131
C.
Deductibility by Corporation of Stock Redemption Expenses ........................... 132
LIQUIDATION OF THE CORPORATION .................................................................. 134
A.
Concepts .............................................................................................................. 134
B.
Liquidation Provisions ........................................................................................ 135
XXI. SECTION 331 -- COMPLETE LIQUIDATION (EFFECT ON SHAREHOLDERS)... 136
A.
In General............................................................................................................ 136
B.
Statute.................................................................................................................. 136
C.
Tax Consequences to Shareholder ...................................................................... 136
XXII. SECTION 332 -- COMPLETE LIQUIDATION OF CORPORATE SUBSIDIARY
(EFFECT ON CORPORATE SHAREHOLDER).......................................................... 146
A.
Introduction ......................................................................................................... 146
-vB.
Requirements of Section 332 .............................................................................. 146
C.
Avoid or Comply with Section 332..................................................................... 148
D.
Effect of Section 332........................................................................................... 149
E.
Method of Effectuating Liquidation Under State Law -- Dissolution v. Merger 150
F.
Tax Consequences to Minority (20% or Less) Shareholders.............................. 150
G.
Intercorporate Liabilities ..................................................................................... 150
H.
Ruling Requests................................................................................................... 152
XXIII. SECTIONS 336 AND 337 -- DISTRIBUTION IN COMPLETE LIQUIDATION
(EFFECT ON CORPORATION).................................................................................... 152
A.
Treatment of Liquidating Distributions -- Section 336....................................... 152
B.
Section 337 -- Liquidating Distributions to an 80% Distributee......................... 155
TEI EDUCATION FUND
LECTURE ON INCORPORATIONS, DISTRIBUTIONS AND
LIQUIDATIONS
Mark J. Silverman
I.
BACKGROUND
A.
Orientation to the Internal Revenue Code
1.
United States Code -- 50 Titles -- Title 26 is the Internal Revenue Code
("IRC" or "Code")
2.
Title 26 is divided into various subtitles and chapters -- 15 volumes in
Title 26
3.
We are concerned with
4.
5.
a.
Subtitle A -- "Income Taxes"
b.
Chapter 1 -- "Normal Taxes and Surtaxes"
c.
Subchapter C -- "Corporate distributions and adjustments"
Structure of Subchapter C
a.
Part III -- organizations and reorganizations (sections 351-368)
b.
Part I -- distributions (sections 301-318)
c.
Part II -- liquidations (sections 331-346)
Section 7805
a.
Section 7805(a) -- Treasury Secretary is authorized to issue
regulations, revenue rulings and revenue procedures
b.
Section 7805(b) -- amended as part of the Taxpayer Bill of Rights
2 (“TBOR2”) in 1996 provides:
(1)
In general, Treasury may not issue retroactive regulations -e.g., regulations shall not apply to any taxable period
ending before the earliest of:
(a)
the date the regulation is filed with the Federal
Register
(b)
the date of any proposed or temporary regulations
(c)
the date on which any notice substantially
describing the expected contents of the regulation is
issued to the public
-2(2)
(3)
B.
Exceptions, may issue retroactive regulations:
(a)
within 18 months of enactment of statutory
provision
(b)
to prevent abuse
(c)
to correct a procedural defect in a prior regulation
(d)
if regulation relates to internal Treasury Department
policies, practices, or procedures
(e)
if given authority by Congress
(f)
may allow taxpayer to elect to apply regulation
retroactively
Section 7805(f) -- must submit regulations to Small
Business Administration for comment on the impact of the
regulation on small business
Orientation to Concept of Corporations and Taxes
1.
2.
3.
Nature of a corporation
a.
creature of state law -- created by state corporate law, not tax law
b.
can hold property, transact business, sue and be sued
c.
can act only through officers or employees
d.
owned by shareholders (stockholders)
e.
independent taxable entity -- can have taxable income or loss and
can do things that will affect tax position of its shareholders
Code definitions
a.
"person" includes corporation -- section 7701(a)(1)
b.
"individual" does not include corporation -- no express provision
c.
"taxpayer" includes person and thus corporation -section 7701(a)(14)
d.
"corporation" can include entities not technically corporations -section 7701(a)(3) and Treas. Reg. § 301.7701-2
Basic tax characteristics of corporations
a.
Corporations taxed at different rates than individuals -- Following
the Tax Reform Act of 1986 (“TRA 86”) and until 1993, corporate
tax rates generally were higher than individual tax rates. However,
following the Omnibus Budget Reconciliation Act of 1993
-3(“OBRA 93”), the top individual rates are significantly higher than
the top corporate rates
(1)
(2)
b.
individual tax rate structure
(a)
for tax years beginning after 1992, income is taxed
at five rates: 15%, 28%, 31%, 36% and 39.6%
(b)
long-term capital gains generally are taxed at a
lower rate than ordinary income. The Taxpayer
Relief Act of 1997 (“TRA 97”) lowered the
maximum long-term capital gains rate to 20% (10%
for individuals in the 15% tax bracket). TRA 97
also lengthened the holding period long-term capital
gains from one year to 18 months. However, the
Internal Revenue Service Restructuring and Reform
Act of 1998 ("IRRA 98") changed the holding
period for long-term capital gains back to one year
(c)
in 1990 an overall limit on itemized deductions was
added and the deduction for personal exemptions
became subject to a "phaseout" for high-income
taxpayers
corporate tax rate structure
(a)
for taxable years beginning after 1992, income is
taxed at four basic rates: 15%, 25%, 34% and 35%
(there are also surtaxes of 3% and 5% for certain
income levels)
(b)
Under the Omnibus Budget Reconciliation Act of
1987 (“OBRA 87”), section 11(b) was amended so
that qualified personal service corporations are to be
taxed at the maximum corporate rate
(c)
the 28% alternative rate for corporate capital gains
no longer applies
Double-level tax
(1)
income earned by "C" corporations (the typical
corporation) generally is taxed twice -- once at the
corporate level and once at the shareholder level
(2)
income earned by pass-thru entities such as partnerships
and "S" corporations is generally only taxed once at the
partner/shareholder level, except that
-4-
c.
C.
(a)
income from publicly traded partnerships that are
classified as corporations is treated as dividend
income -- see section 7704(a); and
(b)
S corporations that sell certain built-in gain property
or have “excess net passive income” may be subject
to tax at the corporate level -- see sections 1374 and
1375
Cost of liquidating
(1)
prior to TRA 86, a corporation in general could distribute
or sell assets in connection with a liquidation on a tax-free
basis (subject to exceptions for certain recapture items) -even though a double-tax was imposed, combined
corporate/shareholder tax was not too burdensome
(2)
following TRA 86, a corporation generally will be taxed in
full on liquidating distributions and sales
Choice of Entity - Prior to the Issuance of the "Check-the-Box" Regulations
1.
Under the old entity classification rules, the Code distinguished between
an entity taxable as a corporation and one taxable as a partnership based
on the substantive legal rights of the entity and its members -- see former
Treas. Reg. § 301.7701
2.
As a result of the TRA 86, many taxpayers began to reconsider the
traditional corporate form of conducting business -- pass-thru entities such
as partnerships and S corporations could reduce tax liabilities
3.
Congress added several Code sections that provided for taxation for
entities which were looking to use a non-corporate form
4.
a.
OBRA 87 added new section 7704, which provides that a publicly
traded partnership will be treated as a corporation for taxable years
beginning after December 31, 1987 (or December 31, 1997, in the
case of an existing partnership provided it does not add a
substantial new line of business), unless at least 90% of its gross
income is passive type income -- regulations under section 7704
were issued in November of 1995 see Treas. Reg. § 1.7704-1
b.
OBRA 87 also added new section 1363(d) which requires the
recapture of LIFO benefits in the case of S corporation elections by
former C corporations
The emergence of "Limited Liability Companies" (“LLCs”) -- a hybrid
form of business entity that offers both limited liability to all members and
a system of representative management -- highlighted the problems with
-5the old classification system. By careful planning, taxpayers could dictate
whether they were taxed as corporations or associations (partnerships)
D.
The "Check-the-Box" Regulations
1.
2.
Generally
a.
In January 1997, the Internal Revenue Service (“IRS” or
“Service”) published "check-the-box" entity classification
regulations, Treas. Reg. § 301.7701-3, which greatly simplified
entity classification
b.
Under the regulations, a newly formed domestic entity with at least
two members is automatically classified as a partnership unless the
entity elects to be taxed as a corporation
c.
However, certain forms of entity are automatically classified as
corporations and may not elect partnership treatment -- these
include business entities incorporated under state statutes,
insurance companies and certain other business entities
d.
The default classification for entities with a single member is a
sole proprietorship (a non-tax entity which for corporate owners is
treated as a division). Single member entities may elect to be
taxed as corporations, but may not elect to be taxed as partnerships
e.
For existing entities, unless the entity elects otherwise, it will have
the same classification as in effect before January 1, 1997.
Existing entities generally may elect to change their classification
once within any 60-month period. A conversion from corporate to
partnership status or vice versa generally will have tax
consequences
f.
The regulations are effective as of January 1, 1997
Analysis
a.
Most likely few entities will elect to be taxed as corporations
b.
The regulations will dramatically increase the utilization of single
member LLCs
(1)
Since under the regulations a single member LLC is taxed
as a sole proprietorship (a single level of tax), but the
individual member receives limited liability, it seems likely
that single member LLCs will be used instead of S
corporations in many situations
(2)
The regulations allow a corporation to organize single
member LLCs that are accorded the same legal protections
as subsidiaries, but which are taxed as divisions -- the
-6treatment of these single member LLCs is similar to the
treatment of corporations that join in filing a consolidated
return -- the use of single member LLCs has the potential
of allowing corporations to reap the benefits of being a
consolidated group without having to file a consolidated
return
3.
Treas. Reg. § 301.7701-3(g) describes the effect of an elective change in
classification
a.
b.
Deemed Treatment of Elective Changes
(1)
Partnership to Association -- if an eligible entity classified
as a partnership elects to be classified as an association, the
following is deemed to occur -- the partnership contributes
all of its assets and liabilities to the association in exchange
for stock in the association, and immediately thereafter, the
partnership liquidates by distributing the stock of the
association to its partners
(2)
Association to Partnership -- if an eligible entity classified
as an association elects to be classified as a partnership, the
following is deemed to occur -- the association distributes
all of its assets and liabilities to its shareholders in
liquidation of the association, and immediately thereafter,
the shareholders contribute all of the distributed assets and
liabilities to a newly formed partnership
(3)
Association to Disregarded Entity -- if an eligible entity
classified as an association elects to be to be disregarded as
an entity separate from its owner, the following is deemed
to occur -- the association distributes all of its assets and
liabilities to its single owner in liquidation of the
association
(4)
Disregarded Entity to Association -- if an eligible entity
that is disregarded as an entity separate from its owner
elects to be classified as an association, the following is
deemed to occur -- the owner of the eligible entity
contributes all of the assets and liabilities of the entity to
the association in exchange for stock of the association
Effect of Elective Changes -- the tax treatment of a change in the
classification of an entity for federal tax purposes is determined
under all relevant provisions of the Code and general principles of
tax law, including the step transaction doctrine
-7-
c.
E.
Timing of Election
(1)
in general -- any transaction that is deemed to occur as a
result of a change in classification under the regulation is
treated as occurring immediately before the close of the day
before the election is made
(2)
coordination with section 338 election
(a)
a purchasing corporation that makes a qualified
stock purchase of an eligible entity taxed as a
corporation may make an election under section
338, and may also make as election to change the
classification of the target corporation
(b)
if both elections are made, the deemed transactions
under Treas. Reg. § 301.7701-3(g) are deemed to
occur immediately after the deemed asset purchase
by the new target corporation under section 338
Recent Tax Legislation Affecting Corporations
The following section briefly describes the changes made in the area of corporate
taxation by the major tax acts since 1986
1.
Tax Reform Act of 1986 (“TRA 86”)
a.
rate inversion -- for the first time in history, the highest marginal
rate of tax imposed on corporations (34%) exceeded the then
highest marginal rate (28%) imposed on individuals
b.
repeal of General Utilities -- sections 336 and 337 were rewritten
to impose two levels of tax -- at the corporate and individual levels
-- on the sale or distribution of corporate assets upon complete
liquidation of the corporation
c.
capital gains -- the lower capital gains tax rate was eliminated for
corporations
d.
alternative corporate minimum tax -- an alternative minimum tax
was enacted
(1)
taxpayers have to pay the greater of their regular tax
liability or their tax liability computed under the minimum
tax provisions
(2)
the alternative minimum tax is imposed on a broader base
of income
(3)
many deductions are eliminated under the alternative
minimum tax provisions
-8-
2.
e.
dividends received deduction -- section 243 was amended to
reduce the dividends received deduction from 85% to 80%, to keep
the maximum effective rate on dividends approximately the same
as before the reduction in corporate rates (6.8% under the new law)
f.
greenmail payments -- TRA 86 added section 162(k) to deny a
deduction for any amount paid by a corporation in connection with
a redemption of its stock
g.
extraordinary dividends -- TRA 86 revised the extraordinary
dividend rules of section 1059 to provide that if a corporation
receives an extraordinary dividend on stock that it has not held for
more than 2 years before the dividend announcement date, its basis
in the stock will be reduced by the nontaxed portion of the
dividend -- under previous law, an extraordinary dividend was
taxed only if the corporation disposed of the stock less than a year
after it was acquired
h.
section 382 -- limitation on net operating loss carryovers where
there has been a change of ownership -- TRA 86 revised the rules
relating to the limitation on the use of net operating losses to offset
income after a corporation has undergone a change in ownership -in general, a corporation that has undergone an ownership change
may offset an amount of income equal to the value of the prechange corporation multiplied by the long-term tax exempt rate
i.
allocation of purchase price among assets -- TRA 86 added new
section 1060 to the Code requiring the seller and purchaser of
assets to allocate the consideration received for such assets in
accordance with section 338(b)(5)
j.
sales between related parties -- TRA 86 broadened section
1239(b)'s definition of related parties for purposes of sales of
depreciable property -- this broadened definition also applies to
installment sales
Omnibus Budget Reconciliation Act of 1987 (“OBRA 87”)
a.
computation of earnings and profits for purposes of intercorporate
dividends and stock basis adjustments
(1)
section 1503(e) was added to require that for the purposes
of determining gain or loss on the disposition of intragroup
stock, a parent corporation's basis in the stock is to be
determined by computing the earnings and profits of the
subsidiary without regard to sections 312(k), relating to
depreciation, and 312(n), relating to adjustments to
earnings and profits, in order to more accurately reflect
economic gain and loss
-9(2)
in addition, earnings and profits do not include any COD
income excluded under section 108 to the extent that the
amount so excluded did not reduce tax attributes other than
basis
b.
reduction of dividends received deduction for certain corporations
-- OBRA 87 reduced the dividends received deduction from 80%
to 70% for corporations owning less than 20% of the distributing
corporation's stock
c.
elimination of mirror transactions
(1)
OBRA 87 added section 337(c) to eliminate mirror
transactions -- under this provision, a subsidiary member of
a consolidated group will recognize gain upon its complete
liquidation to the extent any of its shareholders own less
than 80% of the liquidating subsidiary stock
(2)
in addition, section 355 does not apply to any distribution
by a corporation if control of the distributing corporation
was acquired by a corporate distributee during the five-year
period before the distribution
(3)
furthermore, if the stock of one member of an affiliated
group is transferred to another member in a section 304(a)
transaction, appropriate adjustments must be made to the
bases of any intragroup stock and in the earnings and
profits of each member of the group
d.
publicly traded partnerships treated as corporations -- section 7704
was added to provide that a publicly traded partnership be treated
as a corporation for tax purposes, unless 90% or more of its gross
income consists of passive-type income
e.
excise tax on greenmail -- section 5881 was added to impose a tax
of 50% on any gain realized on the receipt of greenmail -greenmail is defined as any consideration from a corporation in
connection with the redemption of stock held by that shareholder
for less than two years, if the shareholder made or threatened a
public tender offer for stock in the corporation during that period
f.
limitation on use of preacquisition losses to offset built-in gains -OBRA 87 provided that where a corporation with a net unrealized
built-in gain became a member of an affiliated group, or its assets
were acquired in a tax-free reorganization, the built-in gain could
not be offset by the acquiring group
- 10 -
3.
Technical and Miscellaneous Revenue Act of 1988 (“TAMRA 88”)
a.
section 361 was revised to provide that no gain or loss is
recognized by a corporation that is a party to a reorganization if it
receives solely stock or securities of another corporation and to
provide that gain will be recognized by such corporation with
respect to the distribution of appreciated property
b.
section 355(b)(2)(D) was revised to provide that a corporation is
considered to be engaged in the active conduct of a trade or
business for purposes of section 355 if control of the corporation
was not acquired directly or indirectly either by any distributee
corporation or by any distributing corporation within the 5-year
period prior to the distribution
c.
section 355(c) was added to provide that a corporation that
distributes appreciated property in connection with a section 355
transaction will recognize gain to the extent of the unrealized
appreciation under section 311(b)
d.
section 351(f) was added to provide that if a corporation distributes
"boot" in a section 351 transaction, the corporation recognizes gain
under section 311(b)
e.
section 382(g)(4)(C) was added to provide that, for purposes of
determining when an ownership change occurs, any stock held by
a 50% owner that is treated as becoming worthless during any
taxable year shall be treated as having been acquired on the first
day of the next taxable year
f.
section 384 was revised to provide that if a corporation acquires
control of another corporation or acquires the corporation's assets
in an A, C or D reorganization, and either corporation has built-in
gain, then income for any taxable year during the 5-year period
beginning on the change date attributable to built-in gain of one of
the corporations may not be offset by any preacquisition loss of the
other corporation, unless the corporations were members of the
same controlled group at all times during the 5-year period ending
on the acquisition date
g.
section 386, containing miscellaneous corporate provisions, was
repealed -- section 311(b)(3) was added to provide that if a
corporation receives an interest in a partnership or trust as part of a
distribution, the amount of gain recognized under section
311(b)(1), relating to distributions of appreciated property, shall be
computed without regard to any loss attributable to property
contributed to the partnership or trust for the principal purpose of
recognizing such loss on the distribution
- 11 4.
Omnibus Budget Reconciliation Act of 1989 (“OBRA 89”)
a.
section 1503(f) was added to provide that where a subsidiary
distributes dividends on any section 1504(a)(4) stock to a
nonmember of an affiliated group, no group loss item may reduce
the income of the subsidiary for that taxable year and no group
credit item may offset the tax imposed on the income of the
subsidiary
b.
sections 163(e)(5) and 163(i) were added to provide that (i) no
deduction is allowed for original issue discount (“OID”) interest on
"applicable high yield discount obligations" (“AHYDO”) until
such interest is actually paid and (ii) no deduction is allowed for
OID interest to the extent the interest rate exceeds the applicable
federal rate (“AFR”) plus 5 percentage points
c.
section 163(j) was added to disallow a deduction for interest paid
to related parties exempt from U.S. tax on the interest received
d.
section 351 was modified so that securities are now considered
boot, on which gain is recognized in a section 351 transaction
e.
the threshold limitation for net unrealized built-in gains and losses
under sections 382 and 384 was changed to the lesser of 15% of
the fair market value (“FMV”) of the assets or $10 million -- the
threshold had previously been 25% of the FMV of the assets of the
corporation
f.
section 1059 was revised to treat dividends with respect to certain
"self-liquidating" preferred stock as extraordinary dividends, thus
requiring reduction in stock basis
g.
section 1503(e)(4) was added to provide that a corporation may not
reduce its excess loss account by reducing its basis in its
indebtedness of a subsidiary
h.
section 385 was amended to allow the Treasury Department to
characterize an instrument having significant debt and equity
characteristics as part debt and part equity
i.
section 6043(c) was added to require a corporation to file a report
when control of the corporation changes or when there is a
recapitalization or other substantial change in the capital structure
of the corporation
j.
section 172 was modified to limit a corporation's ability to carry
back net operating losses (“NOLs”) where the NOLs are created by
interest deductions allocable to certain corporate equity-reducing
transactions (“CERTs”), which include major stock acquisitions
and excess distributions
- 12 5.
6.
Omnibus Budget Reconciliation Act of 1990 (“OBRA 90”)
a.
section 355 was amended to more effectively eliminate mirror
transactions by the addition of section 355(d) to provide for
recognition of gain at the corporate level (1) if section 355
otherwise applies, (2) if after the distribution, the shareholder holds
a 50% or greater interest in the distributing corporation, and (3)
this interest was acquired by purchase within the preceding five
years
b.
section 305(c) was modified to apply the economic accrual rules
applicable to debt to preferred stock that is subject to mandatory
redemption, or is puttable at a premium
c.
section 1060 was amended to provide that (1) a written agreement
regarding the allocation of consideration to, or the fair market
value of, any assets in an asset acquisition will be binding on both
parties for tax purposes unless the parties are able to refute the
allocation; (2) where a 10% owner of an entity transfers an interest
in the entity and also enters into an employment or other
agreement with the transferee, the person and the transferee must
report the transaction; (3) where a section 338(h)(10) election is
made, both the purchasing corporation and the selling consolidated
group must report the transaction as provided by regulations
d.
the CERT rules (section 172(h)(3)) were modified to eliminate the
exception for acquisitions of subsidiary stock
e.
section 108(e)(11) was added and section 1275(a)(4) was repealed
-- as a result, in a debt-for-debt exchange COD is measured by
comparing issue price of old debt to issue price of new debt
Omnibus Budget Reconciliation Act of 1993 (“OBRA 93”)
a.
corporate tax rates -- top corporate tax rate was increased from
34% to 35% for taxable income in excess of $10 million (the
benefit of the 34% tax rate was phased out for taxable incomes
over $15 million) -- the new rates are retroactive to January 1,
1993
b.
business deductions for meals and entertainment expenses -- the
deduction for meals and entertainment expenses was decreased
from 80% of the expense to 50% -- effective for taxable years
beginning after December 31, 1993
c.
spousal travel expenses -- deductions for travel expenses of a
spouse (or a dependent or other individual) accompanying a person
on business travel are disallowed unless: (i) the spouse was
employed by the person, (ii) the spouse's travel was for a bona fide
business purpose, and (iii) the spouse's expenses would otherwise
- 13 be deductible -- these provisions apply for amounts paid or
incurred after 1993
d.
executive compensation -- for purposes of both regular tax and
alternative minimum tax (“AMT”), the deduction for compensation
paid or accrued to a "covered employee" of a publicly held
corporation is limited to $1 million per year -- "covered employee"
includes the corporation's CEO and the four (or fewer) highest
compensated officers of the corporation whose compensation is
required to be disclosed under SEC rules -- the $1 million cap is
reduced by the amount of any excess parachute payments (as
defined in section 280G) -- compensation subject to the cap is
broadly defined -- applies to compensation that is otherwise
deductible by a corporation in a taxable year beginning on or after
January 1, 1994 -- the following types of compensation are not
subject to the cap:
(1)
remuneration payable on a commission basis;
(2)
remuneration payable solely because an employee satisfies
one or more performance goals (provided certain outside
director and shareholder approval requirements are met);
(3)
payments to a tax-qualified retirement plan (including
salary reduction contributions);
(4)
amounts that are excludable from an employee's gross
income (such as employer-provided health benefits, etc.);
(5)
any remuneration payable under a written binding contract
which was in effect on February 17, 1993, and which was
not modified in any material respect before such
remuneration was paid
e.
employer pension contribution deductions -- the amount of
compensation that may be taken into account for purposes of an
employee's benefits and an employer's deductible contribution
under a qualified retirement plan was reduced from $235,840 to
$150,000 -- this limit is indexed for inflation in $10,000
increments -- the limitation is subject to special rules in the case of
government plans and plans maintained pursuant to collective
bargaining agreements -- effective for benefits accruing in plan
years beginning after 1993
f.
lobbying expenses -- no deduction is permitted under section 162
for any amount paid or incurred to influence Federal or state
legislation or to communicate with certain covered Federal
executive branch officials in an attempt to influence the actions or
positions of such officials -- covered executive branch officials
- 14 include the President, Vice President, individuals with Cabinetlevel status and their immediate deputies, the two most senior-level
officers of each agency within the Executive Office of the
President, and any other officer or employee of the White House
Office of the Executive Office of the President -- the portion of
otherwise deductible membership dues in trade groups or other
organizations that are used for lobbying are similarly disallowed -the disallowance applies to amounts paid or incurred after 1993
g.
club dues -- no deduction is permitted for club dues for all types of
clubs, including business, social, luncheon, athletic, sporting,
airline and hotel clubs -- effective for taxable years beginning after
December 31, 1993
h.
intangibles -- 15-year amortization is required for certain
intangible assets (including goodwill and going concern value) that
are acquired in connection with the conduct of a trade or business - applies to transactions occurring after the date of enactment, with
an election to apply the provision to transactions occurring after
July 25, 1991
i.
nonresidential real property -- the recovery period for purposes of
depreciation of nonresidential real property was increased from
31.5 years to 39 years -- the new recovery period is for purposes of
regular tax, and has no effect on the recovery period for AMT
purposes (which remains 40 years) -- the change applies to
property placed in service on or after May 13, 1993 (with transition
relief for certain property placed in service before 1994)
j.
AMT depreciation -- the depreciation component of the ACE
adjustment was eliminated -- as a result, corporations compute
depreciation for AMT purposes under the same rules applicable to
individuals (in the case of tangible personal property, for instance,
depreciation is computed using a 150% DBM over the class life of
the property)
k.
debt cancellation rules -- the stock-for-debt exception was repealed
-- thus, a corporation has COD income to the extent it transfers
stock in satisfaction of its indebtedness and the FMV of the
transferred stock is less than the indebtedness -- a corporation in a
Title 11 case or an insolvent corporation can still exclude COD
income to the extent it reduces its tax attributes -- effective for
stock transferred after December 31, 1994 in satisfaction of any
indebtedness (unless the transfer is in a Title 11 case filed on or
before December 31, 1993)
l.
earnings stripping rules -- prior to OBRA 93, the earnings stripping
rules included a grandfather provision under which the
disallowance of a deduction for interest did not apply to interest on
- 15 debt with a fixed term which was issued on or before July 10, 1989
(or was issued after that date pursuant to a binding contract in
effect on that date) -- under OBRA 93, the grandfather provision is
revoked and such interest is subject to disallowance to the same
extent as other interest -- in addition, interest paid on a loan to an
unrelated party is treated as interest paid to a related party if: (i) no
gross-basis U.S. income tax is imposed on the interest; (ii) a
related person guaranteed the loan; and (iii) the related person is
either exempt from U.S. federal income tax or is a foreign person - both provisions are effective for interest paid or accrued in
taxable years beginning after December 31, 1993
7.
m.
inventories of securities dealers -- securities dealers are required to
compute taxable income by valuing their inventories of securities
to market -- effective for taxable years ending on or after 1993 -transition rules permit any change in inventory value to be
included in taxable income ratably over a 5-year period (a special
transitional rule for LIFO inventories of floor specialists and
market makers permits the adjustment to be included in income
ratably over a 15 year period)
n.
research tax credit -- the research tax credit (which expired on June
30, 1992) was extended from July 1, 1992 through June 30, 1995 -in addition, several technical changes were made relating to
computation of the credit for start-up firms
o.
section 936 credit -- starting in 1994 the credit was reduced to 60%
of its current value, declining to 40% by 1998
p.
other provisions -- various changes relating to estimated taxes,
FUTA taxes, excise taxes, S&Ls, foreign taxes, tax procedure,
withholding, information reporting, and personal income tax -- in
addition, there are several narrowly tailored tax benefit items:
high-speed rail, "empowerment" zones, small business expensing,
low-income housing credit, targeted jobs credit, "school-to-work"
credit, and so on
Miscellaneous 1995 and 1996 Legislation
No comprehensive tax legislation was enacted during 1995 -- however, a
few miscellaneous provisions were enacted during 1995 and early 1996
a.
section 162(1) -- the deduction for health insurance costs of selfemployed individuals was permanently extended; the percentage of
the deduction was increased by legislation in 1997 and 1998, and
will reach 100% in 2003
- 16 -
8.
b.
section 1031 -- section 1031 was amended to preclude
nonrecognition of gain on involuntary conversions when certain
replacement property is acquired from a related person
c.
section 1071 -- the provision permitting nonrecognition of gain on
sales to minority owned businesses to effect FCC policy was
repealed
d.
Line item veto -- the Line Item Veto Act allowed the president
after signing a bill into law to cancel in whole any dollar amount of
discretionary budget authority, any item of new direct spending, or
any limited tax benefit -- the constitutionality of the provision was
challenged, and the Supreme Court held that the cancellation
procedures set forth in the Line Item Veto Act were
unconstitutional – see Clinton v. City of New York, 118 S. Ct.
2091 (June 25, 1998)
e.
Congressional review of guidance -- legislation was enacted which
requires Congressional review of guidance issued by the IRS
The Small Business Job Protection Act of 1996
Of the four acts passed by Congress in the summer of 1996 that contained
tax law changes, the majority of the provisions that affect corporate
taxpayers were contained in the Small Business Job Protection Act of
1996 -- some of these provisions are described below
a.
increase in small business expensing -- the amount of tangible
business property that may be currently expensed under section
179, rather than depreciated over time, will be increased from
$17,500 to $25,000 -- this increase will be phased in over a sevenyear period beginning in 1997
b.
depreciation under the income forecast method -- the depreciation
of certain property, such as films, television shows, books, patents,
master sound recordings and video games, under the income
forecast method was clarified
c.
involuntary conversion rules for property damaged in a disaster -for purposes of the nonrecognition-of-gain rule regarding
involuntarily converted property that is replaced similar property,
any tangible property that is acquired and held for productive use
in a business is treated as similar or related to business or
investment property that was involuntarily converted as a result of
a Presidentially declared disaster
d.
interest deduction for corporate-owned life insurance -corporations are denied a deduction for interest on any amount of
debt incurred with respect to company-owned life insurance
- 17 policies, annuities, or endowment contracts covering an officer or
employee or an individual who has a financial interest in the
company -- an exception is provided for policies covering certain
key personnel where the total amount of debt is $50,000 or less
and the interest rate is under a set cap -- the denial of the deduction
applies to interest paid or accrued after October 13, 1995
9.
e.
financial asset securitization investment trusts -- a new entity
called financial asset securitization investment trust (FASIT) was
created to facilitate the securitization of revolving, nonmortgage
debt, such as credit card receivables, home equity loans, and car
loans -- generally a FASIT is not subject to tax, but its income or
loss will flow through to its owners -- the FASIT provisions are
generally effective September 1, 1997
f.
S corporation simplification -- many of the provisions of the Small
Business Job Protection Act of 1996 were aimed at simplifying the
laws pertaining to S corporations -- among other changes,
provisions clarified which types of companies can be S
corporations and which types of entities may hold S corporation
stock
The Taxpayer Relief Act of 1997 (“TRA 97”)
TRA 97 contained many provisions that affect the taxation of corporations
-- some of the more significant provisions are discussed below
a.
limitation on exception for investment companies under section
351
(1)
The definition of an "investment company" for purposes of
the exception for such companies from the general rules
allowing tax-free contributions of property to corporations
and partnerships was expanded
(2)
Under Treasury regulations, a contribution of property is
treated as made to an investment company if:
(3)
(a)
the contribution results in the diversification of the
transferor's interest, and
(b)
the transferee is a regulated investment company
("RIC"), real estate investment trust ("REIT"), or
any corporation more than 80 percent of the assets
of which consist of readily marketable stocks or
securities or interests in RICs or REITs that are held
for investment
The scope of assets that are counted toward the 80 percent
test was expanded to include:
- 18 -
(4)
b.
(a)
stocks and securities (both readily marketable and
not readily marketable);
(b)
money;
(c)
equity interests in corporations (including evidences
of indebtedness, options, forward or future
contracts, notional principal contracts, and
derivatives);
(d)
foreign currency;
(e)
interests in RICs, REITs, common trust funds, and
publicly-traded partnerships;
(f)
instruments convertible into equity interests;
(g)
interests in precious metals (unless used by the
transferee in the active conduct of a trade or
business);
(h)
and any other asset described in Treasury
regulations
The provision is effective for transfers after June 8, 1997,
with an exception for transfer made pursuant to certain
binding contracts in effect on June 8, 1997
treat certain preferred stock as "boot" for purposes of sections 351,
354, 355, 356, and 368
(1)
The provision added section 351(g) which treats certain
preferred stock ("nonqualified preferred stock") received in
an otherwise tax-free incorporation or reorganization
transaction as taxable "boot". Thus, when a taxpayer
exchanges property for this nonqualified preferred stock in
a transaction that otherwise qualifies as tax-free, gain but
not loss is recognized
(2)
Preferred stock is defined as stock that is limited and
preferred as to dividends and that does not participate in
corporate growth to any significant extent
(3)
Nonqualified preferred stock is defined as preferred stock
for which:
(a)
the holder has the right to require the issuer or a
related person to redeem or purchase the stock;
(b)
the issuer or a related person is required to redeem
or purchase the stock;
- 19 -
c.
d.
(c)
the issuer or a related person has the right to redeem
or purchase the stock and, as or the issue date, it is
more likely than not that such right will be
exercised; or
(d)
the dividend rate for the stock varies in whole or in
part (directly or indirectly) with reference to interest
rates, commodity prices, or other similar indices
(4)
The rules related to redemption or purchase do not apply if
the right or obligation cannot be exercised within 20 years
of the date the right or obligation is issued or if the right or
obligation is subject to a contingency which, as of the issue
date, makes the likelihood of purchase or redemption
remote
(5)
The provision contains additional exceptions to this general
rule
(6)
The provision generally is effective for transfers after June
8, 1997
deny interest deduction on certain debt instruments
(1)
TRA 97 enacted section 163(l) which denies interest and
original issue discount deductions on corporate instruments
that are payable in stock of the issuer or a related party,
including instruments which are mandatorily (or at the
option of the issuer or a related party) payable or
convertible into such stock
(2)
Interest and original issue discount deductions are also
denied for instruments the payments on which are made by
reference to the value of stock; or that are part of an
arrangement designed to result in a payment of the
instrument with or by reference to such stock
(3)
The provision is generally effective for instruments issued
after June 8, 1997
require gain recognition for certain extraordinary dividends
(1)
TRA 97 revised section 1059(a)(2) so that a corporate
shareholder recognizes gain immediately with respect to
any redemption treated as a dividend (in whole or in part)
when the nontaxed portion of the dividend exceeds the
basis of the shares surrendered, if the redemption is treated
as a dividend due to options being counted as stock
ownership
- 20 -
e.
(2)
In addition, the provision requires immediate gain
recognition whenever the basis of stock with respect to
which any extraordinary dividend was received is reduced
below zero
(3)
The provision generally is effective for distributions after
May 3, 1995
require gain recognition on certain distributions of controlled
corporation stock (the anti-Morris Trust provision)
(1)
Section 355(e) was added to the Code, it provides that the
distributing corporation in a section 355 transaction will
recognize gain if the distribution is part of a plan or series
of related transactions pursuant to which a person (not the
distributee shareholder) acquires stock representing a 50
percent or more interest in the distributing or controlled
corporations
(2)
The gain is recognized immediately before the distribution,
in the amount that the distributing corporation would have
recognized had the stock of the controlled corporation been
sold for fair market value on the date of the distribution
(3)
No adjustment to the basis of the stock or assets of either
corporation is allowed by reason of the recognition of the
gain
(4)
No gain is recognized at the shareholder level
(5)
There is a rebuttable presumption that any acquisition
occurring two years before or two years after a section 355
distribution is part of a plan including such distribution
(6)
The distributing corporation in an intra-group spin-off will
recognize gain if such distribution is part of a plan that
would trigger the above described tax
(7)
The provision provides the Treasury Department with
additional authority to adjust the basis of stock in intragroup spin-off distributions
(8)
For certain transfers of property to a corporation as part of
a spin-off after the date of enactment, the prior law
requirement that shareholders of the contributing
corporation own 80 percent of the voting power and 80
percent of each other class of stock after the distribution is
modified to a requirement of greater-than-50 percent of the
vote and value of the stock
- 21 (9)
f.
reform the treatment of corporate stock transfers
(1)
g.
h.
The provision is generally effective for distributions after
April 16, 1997
To the extent that a section 304 transaction is treated as a
distribution under section 301, the transferor and the
acquiring corporation are treated as if:
(a)
the transferor had transferred the stock involved in
the transaction to the acquiring corporation in
exchange for stock of the acquiring corporation in a
transaction to which section 351(a) applies, and
(b)
the acquiring corporation had then redeemed the
shares it is treated as having issued
(2)
In addition, section 1059 is amended so that, if the deemed
redemption is treated as a dividend and the transferor
claims a dividends-received deduction, the dividend is
treated as an extraordinary dividend in which only the basis
of the transferred shares would be taken into account for
purposes of section 1059
(3)
A special rule applies to transactions involving acquisitions
by foreign corporations
(4)
Generally effective for distributions or acquisitions after
June 8, 1997
modify holding period for dividends-received deduction
(1)
A taxpayer is not entitled to a dividends-received deduction
if the taxpayer's holding period for the dividend-paying
stock is not satisfied over a period immediately before or
immediately after the taxpayer becomes entitled to receive
the dividend
(2)
Applies to dividends received or accrued after September 5,
1997 with a two-year grace period for certain stock owned
by a corporate shareholder that the taxpayer holds as part of
a hedge (or similar transaction) on June 8, 1997, and
identifies as such in its corporate records by September 5,
1997
modify loss carryback and carryforward rules -- carrybacks of
NOLs are limited to two years and carryforwards are extended to
20 years -- generally effective for NOL's arising in taxable years
beginning after August 5, 1997
- 22 i.
modify general business credit carryback and carryforward rules -carrybacks of unused general business credits are limited to one
year and carryforwards are extended to 20 years -- generally
effective for credits arising in taxable years beginning after August
5, 1997
j.
limit the use of hedging transactions
(1)
TRA 97 enacted new section 1259. Section 1259 treats
certain transactions as constructive sales, thereby locking in
gains on appreciated financial positions without
immediately recognizing the gain
(2)
The term “appreciated financial position” generally means
any position with respect to any stock, debt instrument, or
partnership interest where there would be gain if such
position is sold, assigned, or otherwise terminated at its fair
market value
(3)
A constructive sale is deemed to have occurred if the
taxpayer does any of the following:
(4)
10.
(a)
enters into a short sale of the same or substantially
identical property;
(b)
enters into an offsetting notional principal contract
with respect to the same or substantially identical
property;
(c)
enters into a future or forward contract to deliver
the same or substantially identical property;
(d)
has entered into a short sale, an offsetting notional
principal contract and acquires the same property as
the underlying property for the position (acquires a
long position in the same property); or
(e)
to the extent prescribed in regulations, enters into
other transactions having substantially the same
effect as the four types of transactions listed above
This provision is effective for constructive sales entered
into after June 8, 1997
The Internal Revenue Service Restructuring and Reform Act of 1998
(“IRRA 98”)
Although the main purpose of IRRA 98 was to reform the IRS, IRRA 98
also contains several technical corrections to TRA 97. A few of the more
significant provisions that affect corporations are discussed below
- 23 a.
b.
certain preferred stock treated as boot
(1)
the provision amends section 351(g) to clarify that section
351(b) (providing that gain but not loss is recognized)
applies to a transferor who transfers property in a section
351 exchange and receives nonqualified preferred stock, if
and only if, the transferor also receives stock other than
nonqualified preferred stock. Otherwise, the transferor is
treated as if they had received solely "other property" of
any other type
(2)
the provision applies to transactions after June 8, 1997
the "control immediately after" requirement
(1)
the provision clarifies that in the case of certain divisive
transactions in which a corporation contributes assets to a
controlled corporation in a transaction that meets the
requirements of section 355 (or so much of section 356 as
relates to section 355), solely for purposes of determining
the tax treatment of the transfers of property to the
controlled corporation by the distributing corporation, the
fact that the shareholders of the distributing corporation
dispose of part or all of the distributed stock shall not be
taken into account for purposes of the control immediately
after requirement of section 351(a) and 368(a)(1)(D)
(2)
the provision generally is effective for distributions after
April 16, 1997
c.
section 304 transactions involving foreign corporations -- the
provision provides that the Secretary shall issue regulations for
section 304 transactions in which the acquiring or the issuing
corporation is a foreign corporation. It is expected that the
regulations will prevent double taxation and provide for
appropriate adjustments to the basis of stock held by the
corporation treated as receiving the distribution
d.
IRRA 98 amended section 1059(g)(1) to provide the IRS with
regulatory authority to coordinate the basis adjustment rules of
Section 1059 and the consolidated return regulations. According
to the Senate Finance Committee Report concerning this
legislation, ”[i]t is expected that these rules generally would
provide that, except as provided in regulations to be issued ...
section 1059 will not cause current gain recognition to the extent
that the consolidated return regulations require the creation or
increase of an excess loss account with respect to a distribution.”
(S. Rep.No. 174, 105th Cong., 2nd Sess. 179 (1998))
- 24 11.
The Tax and Trade Relief Extension Act of 1998
The Tax and Trade Relief Extension Act of 1998 contains several
technical corrections to IRRA 98. The most significant provision that
affects corporations is discussed below
a.
12.
The Miscellaneous Trade and Technical Corrections Act of 1999 was
signed into law by President Clinton on June 25, 1999. The most
significant provision that affects corporations is discussed below
a.
13.
A provision of the Tax and Trade Relief Extension Act of 1998
clarifies that for certain divisive transactions in which a
corporation contributes assets to a controlled corporation and then
distributes the stock of the controlled corporation in a transaction
that meets the requirements of section 355, the fact that the
corporation whose stock was distributed issues additional stock
shall not be taken into account
Section 357(d) was added to the Code. This section generally
eliminates the distinction between the assumption of a liability and
taking property subject to a liability. See Part II.S, infra. Section
357(d) generally applies to transfers after October 18, 1998. Under
section 357(d)
(1)
a recourse liability will be treated as assumed to the extent
that, based on all the facts and circumstances, the transferor
has agreed to, and is expected to, satisfy such liability (or
portion thereof), whether or not the transferor has been
relieved of such liability
(2)
where property is transferred subject to a nonrecourse
liability, unless the facts and circumstances indicate
otherwise, the transferee would be treated as assuming a
ratable portion of the liability, based on the relative fair
market values of all assets subject to such liability
The Ticket to Work and Work Incentives Improvement Act of 1999
The Ticket to Work and Work Incentives Improvement Act of 1999 was
signed into law by President Clinton on December 17, 1999. The most
significant provision that affects corporations is discussed below
a.
Section 453(a)(2) was added to the Code. This section generally
repeals the use of the installment method for accrual method
taxpayers effective for sales or other dispositions entered into on or
after December 17, 1999
- 25 14.
On March 6, 2000, the Treasury Department released the Administration’s
Revenue Proposals for fiscal year 2001. A few of the more significant
proposals that would affect corporations are discussed below
a.
treat corporations in an affiliated group as a single corporation
(1)
the proposal would eliminate the “substantially all” test for
section 355 distributions, and instead, apply the active
business requirement on an affiliated group basis
(2)
in applying the active business test to an affiliated group,
each relevant affiliated group (immediately after the
distribution) must satisfy the requirement
(3)
the relevant affiliated group for the distributing or
controlled corporation would consist of the distributing or
controlled corporation, respectively, as the common parent
and all corporations affiliated with such common parent
through stock ownership described in section 1504(a)(1)(B)
(regardless of whether corporations are includible
corporations under section 1504(b))
(4)
an identical proposal was included in the Administration’s
Revenue Proposals for fiscal year 2000
b.
modify and clarify certain rules relating to debt-for-debt exchanges
-- the proposal provides that for purposes of determining the
amount of gain recognized to a securityholder in a reorganization
(or a section 355 distribution), the excess of the fair market value
of the securities received over the fair market value of the
securities surrendered would be treated as “other property”
c.
corporate tax shelters
(1)
the Administration proposed a comprehensive set of
provisions to attack corporate tax shelters
(2)
for purposes of these provisions, a corporate tax shelter
would include any entity, plan or arrangement (determined
based on all facts and circumstances) in which a direct or
indirect corporate participant attempts to obtain a "tax
benefit" in a "tax avoidance transaction"
(3)
a tax benefit would include a reduction, exclusion,
avoidance, or deferral of tax, or an increase in a refund, but
would not include a tax benefit clearly contemplated by the
applicable provision (taking into account the Congressional
purpose for such provision and the interaction of such
provision with other provisions of the Code)
- 26 -
d.
(4)
a tax avoidance transaction would include (1) any
transaction in which the reasonably expected pre-tax profit
(determined on a present value basis, after taking into
account foreign taxes as expenses and transaction costs) of
the transaction is insignificant relative to the reasonably
expected net tax benefits (i.e., tax benefits in excess of the
tax liability arising from the transaction, determined on a
present value basis) of such transaction; and (2) in the case
of financing transactions, any transaction in which the
present value of the tax benefits of the taxpayer to whom
the financing is provided are significantly in excess of the
present value of pre-tax profit or return of the person
providing the financing
(5)
if it is determined that an entity, plan or arrangement is a
corporate tax shelter, the proposals would provide that,
among other things, the Secretary may disallow a
deduction, credit, exclusion, or other allowance obtained in
the transaction, deductions for certain tax advice would be
denied, an excise tax would be imposed on certain fees
received in connection with the purchase and
implementation of the corporate tax shelter, an excise tax
would be imposed on certain rescission provisions
guaranteeing tax benefits, income from a corporate tax
shelter involving tax-indifferent parties would be taxed, and
the substantial understatement penalty would be increased
from 20 to 40 percent
(6)
a substantially identical proposal was included in the
Administration’s Revenue Proposals for fiscal year 2000
(7)
the proposal is part of the Administration’s efforts to curb
corporate tax shelters. In February, 2000, the Service
issued temporary and proposed regulations relating to tax
shelters. See T.D. 8875, 8876, 8877 (Feb. 28, 2000). See
also Notice 2000-15 (Mar. 20, 2000)
prevent duplication or acceleration of loss through assumption of
certain liabilities
(1)
under the proposal, if the basis of stock received by a
transferor as part of a tax-free exchange with a controlled
corporation exceeds the fair market value of the stock, then
the basis of the stock received would be reduced (but not
below the fair market value) by the amount determined as
of the date of the exchange) of any liability that (1) is
assumed in exchange for such stock, and (2) did not
- 27 otherwise reduce the transferor’s basis of the stock by
reason of the assumption
(2)
e.
f.
g.
the proposal would be effective for transfers on or after
October 19, 1999
prohibit tax deferral on contributions of appreciated property to
swap funds
(1)
the proposal would add limited or preferred partnership
interests to the list of assets that are taken into account in
determining whether a corporation (or partnership) is an
investment company
(2)
the proposal would require recognition on the transfer of a
non-diversified portfolio of marketable securities to any
corporation (or partnership) that is either (1) registered as
an investment company; (2) falls within the qualified
purchasers exception to the registration requirement; or (3)
otherwise is marketed or sold to investors as providing a
means of tax-free diversification
conform control test for tax-free incorporations, distributions, and
reorganizations
(1)
the proposal would conform the control test for tax-free
incorporations, distributions, and reorganizations with the
test for determining whether corporations satisfy the
ownership test for affiliation
(2)
thus, "control" would be defined as the ownership of at
least 80 percent of the total voting power and at least 80
percent of the total value of a corporation's stock
(3)
for this purpose, stock would not include certain preferred
stock that meets the requirements of section 1504(a)(4)
(4)
the proposal would be effective for transactions on or after
the date of enactment
(5)
an identical proposal was included in the Administration’s
Revenue Proposals for Fiscal Year 2000
tax issuance of tracking stock
(1)
the proposal would treat the receipt of tracking stock, in the
hands of a shareholder, as a receipt of other property in the
case of (1) a distribution of a corporation’s tracking stock
made by such corporation with respect to its stock or (2)
tracking stock received in exchange for other stock in the
- 28 issuing corporation (either in a recapitalization or section
1036 exchange)
(2)
h.
i.
for this purpose, "tracking stock" would be defined as stock
that relates to, and tracks the economic performance of, less
than all of the assets of the issuing corporation (including
the stock of a subsidiary), and either
(a)
the dividends are directly or indirectly determined
by reference to the value or performance of the
tracked entity or assets, or
(b)
the stock has liquidation rights directly or indirectly
determined by reference to the tracked entity or
assets
(3)
the proposal would be effective for tracking stock issued on
or after the date of enactment
(4)
a substantially identical proposal was included in the
Administration’s Revenue Proposals for Fiscal Year 2000
require consistent treatment and provide basis allocation rules for
transfers of intangibles in certain nonrecognition transactions
(1)
the proposal would provide that the transfer of an interest in
intangible property constituting less than all of the
substantial rights of the transferor in the property would be
treated as a transfer of property for purposes of the
nonrecognition provisions regarding transfers of property to
controlled corporations or partnerships
(2)
consistent reporting by the transferor and transferee would
be required
(3)
in the case of a transfer of less than all of the substantial
rights, the transferor would have to allocate the basis of the
intangible between the retained rights and the transferred
rights based upon respective fair market values
(4)
the proposal would be effective for transfers on or after the
date of enactment
(5)
an identical proposal was included in the Administration’s
Revenue Proposals for Fiscal Year 2000
modify treatment of downstream mergers
(1)
downstream mergers are mergers in which one corporation
(the "target corporation") that holds stock of another
corporation (the "acquiring corporation") transfers its assets
- 29 (including acquiring corporation stock) to the acquiring
corporation, and the shareholders of the target corporation
receive stock of the acquiring corporation in exchange for
their target corporation stock -- downstream transactions
have been held to qualify as tax-free reorganizations
(2)
under the proposal, where a target corporation does not
satisfy the stock ownership requirements of section
1504(a)(2) (generally, 80 percent or more of the vote and
value) with respect to the acquiring corporation, and the
target corporation combines with the acquiring corporation
in a reorganization in which the acquiring corporation is the
survivor, the target corporation must recognize gain, but
not loss, as if it distributed the acquiring corporation stock
that it held immediately prior to the reorganization
(3)
as long as the other requirements for a reorganization are
satisfied, nonrecognition treatment will continue to apply to
other assets transferred to the target corporation and the
target corporation shareholders
(4)
the proposal also would apply where a parent corporation
owns less than 20 percent of the value of the stock of a
subsidiary corporation and the subsidiary corporation
combines upstream with and into the parent corporation or
a second subsidiary of the parent corporation. In such
cases, the parent corporation would recognize gain, but not
loss, as if it sold its subsidiary corporation stock
immediately prior to the reorganization
(5)
the proposal would apply to transactions that occur on or
after the date of enactment
(6)
a similar proposal was included in the Administration’s
Revenue Proposals for Fiscal Year 2000
j.
clarify definition of nonqualified preferred stock -- the proposal
would clarify the definition of nonqualified preferred stock to
ensure that stock for which there is not a real and meaningful
likelihood of actually participating in the earnings and growth of
the corporation is included in the definition
k.
clarify rules for payment of estimated taxes for certain deemed
asset sales -- substantial uncertainty arose as to whether eligibility
for a section 338(h)(10) election exempts the seller from payment
of estimated taxes. The proposal would amend section 338(h)(13)
to require that estimated taxes be paid based upon the deemed asset
sale where there is an agreement between the buyer and the seller
- 30 to make the section 338(h)(10) election, or upon the stock sale
where there is no such agreement
l.
F.
modify treatment of transfers to creditors in divisive
reorganizations
(1)
the proposal would limit the amount of money or other
property that a distributing corporation can distribute to its
creditors without gain recognition under section 361(b) to
the amount of the basis of assets contributed to a controlled
corporation in a divisive reorganization
(2)
the proposal would also provide that acquisitive
reorganizations under section 368(a)(1)(D) would no longer
be subject to the liabilities assumption rules of section
357(c)
General Tax Concepts -- Realization v. Recognition
1.
Amount realized -- usually the sum of money received plus the fair market
value of property received (section 1001(b)) -- if the property received is
subject to nonrecourse indebtedness, then the fair market value of the
property shall not be less than the amount of the nonrecourse indebtedness
-- section 7701(g), added by the Deficit Reduction Act of 1984 (“DEFRA
84”)
2.
Realized vs. recognized gain -- vital distinction
3.
4.
a.
realized -- transaction has occurred producing gain or loss, i.e.,
value received is more or less than basis -- sections 1001(a) and
1011
b.
recognized -- the gain or loss so realized is currently taken into
account for tax computation purposes -- section 1001(c)
Realization doctrine
a.
prohibits taxation of "unrealized" appreciation -- Eisner v.
Macomber, 252 U.S. 189 (1920)
b.
erosion of doctrine -- sections 305(b) (taxation of certain stock
dividends) and 1256 (mark to market straddle provisions)
Many realized gains are not recognized for policy purposes
a.
sections 1031-1045, dealing with various tax-free exchanges (e.g.,
like-kind exchanges under section 1031)
b.
numerous Subchapter C provisions
c.
nonrecognition usually means deferral (i.e., gain will ultimately be
recognized --achieved through basis computation), but in some
- 31 cases it can amount to forgiveness (e.g., death prior to recognition - fair market value ("FMV") basis)
II.
ORGANIZATION OF THE CORPORATION -- SECTION 351
A.
Concepts Involved
1.
2.
3.
Assume
a.
property owned by individuals or other persons (transferor)
b.
is transferred to a corporation (transferee corporation) in exchange
for its stock
What are the tax consequences
a.
to the transferor
b.
to the transferee corporation
General rule of the Code – section 1001
a.
section 1001(c) -- except as otherwise provided, gain must be
recognized on a sale or exchange of property
b.
section 1001(a) gain -- FMV of stock received less basis of
property exchanged
c.
example -A transfers assets:
FMV
basis
$50,000
$10,000
A receives stock:
FMV
$50,000
stock (FMV)
less basis
equals gain realized
4.
B.
$50,000
$10,000
$40,000
Exception -- nonrecognition provision -- section 351
Section 351 -- In General
1.
No gain or loss is recognized to the transferor or transferors if property is
transferred to a corporation solely for stock and the transferor(s) are in
control of the corporation immediately after the exchange
2.
Background
a.
enacted in 1921
- 32 -
3.
4.
b.
purpose -- end uncertainty and confusion in corporate formations
(by reducing need to value assets transferred) and permit business
to operate in corporate form without paying tax for incorporation
c.
theory -- transfer of property to corporation controlled by
shareholders is merely a change in form of ownership -- assets held
indirectly through stock ownership (i.e., have not sold or disposed
of assets) -- should be free from tax
d.
see Portland Oil Co. v. Commissioner, 109 F.2d 479, 488 (1st
Cir.), cert. denied, 310 U.S. 650 (1940); G.D. Searle & Co., 88
T.C. 252 (1987)
Statute much broader -- allows section 351 nonrecognition for a wide
range of transactions
a.
multiple transferors -- each transferor receives interest in others'
assets
b.
small business 1% and big corporation 99% -- change in ownership
for small business
c.
transfer assets to a newly formed corporation which is beginning
business
d.
transfer assets of an ongoing sole proprietorship or partnership to a
newly formed corporation
e.
transfer additional assets to an ongoing corporation
Recent Changes
a.
Under OBRA 87, if a publicly traded partnership is to be treated as
a corporation, section 351 is deemed to apply -- new section
7704(f)
b.
OBRA 89
(1)
amended section 351(a) (as well as (b), (d) and (e)(2)) by
deleting the words "or securities" after the term "stock" -under old section 351, transferor could receive stock and
securities; under new section 351, a transferor who receives
back securities upon the transfer of property to a controlled
corporation does not continue an investment in the
transferred assets to the extent of the securities received
and must recognize any gain as payments are received on`
the securities, subject to the installment sales provisions
(2)
reason for change -- Senate Finance Committee believed
that a transferor who receives securities does not continue
an investment in the transferred assets to the extent of the
- 33 securities received; therefore, it is more appropriate to
characterize the transaction as a taxable sale, to the extent
of the securities received, than as a tax-free exchange
c.
TRA 97
(1)
added section 351(g) -- excludes "nonqualified preferred
stock" from the definition of "stock" for purposes of section
351 (and sections 354, 355, 356 and 1036) -- nonqualified
preferred stock is defined as preferred stock that is limited
and preferred as to dividends and does not participate in
corporate growth to any significant extent
(2)
amended section 351(e)(1) -- expanded the definition of an
"investment company" for purposes of the exception for
such companies from the general rules allowing tax-free
contributions of property to corporations and partnerships.
Under Treasury regulations, a contribution of property is
treated as made to an investment company if (1) the
contribution results in the diversification of the transferor's
interest and (2) the transferee is a RIC, REIT, or any
corporation more than 80 percent of the assets of which
consist of readily marketable stocks or securities or
interests in RICs or REITs that are held for investment
the provision expands the scope of assets which are
counted toward the 80 percent test to include: stocks and
securities (both readily marketable and not readily
marketable); money; equity interests in corporations
(including evidences of indebtedness, options, forward or
future contracts, notional principal contracts, and
derivatives); foreign currency; interests in RICs, REITs,
common trust funds, and publicly-traded partnerships;
instruments convertible into equity interests; interests in
precious metals (unless used by the transferee in the active
conduct of a trade or business); and any other asset
described in Treasury regulations
d.
IRRA 98
(1)
certain preferred stock treated as boot -- the provision
amends section 351(g) to clarify that section 351(b)
(providing that gain but not loss is recognized) applies to a
transferor who transfers property in a section 351 exchange
and receives nonqualified preferred stock, if and only if, the
transferor also receives stock other than nonqualified
preferred stock. Otherwise, the transferor is treated as if
- 34 they had received solely "other property" of any other type
-- the provision applies to transactions after June 8, 1997
e.
C.
The Administration’s Revenue Proposals for Fiscal Year 2001
contain a provision that would clarify the definition of
nonqualified preferred stock to ensure that stock for which there is
not a real and meaningful likelihood of actually participating in the
earnings and growth of the corporation is included in the definition
Related Statutes
If section 351 applies (not elective -- if tests met it applies -- Gus Russell, Inc. v.
Commissioner, 36 T.C. 965 (1961)), the following statutes apply --
D.
E.
1.
Section 351 -- nonrecognition of gain or loss to the transferor
2.
Section 1032 (not section 361) -- nonrecognition of gain or loss to the
transferee corporation
3.
Section 358 -- basis of corporate stock received by the transferor generally
is basis of property transferred (substituted basis)
4.
Section 362 -- basis of property to the corporation generally is basis of
property in the hands of the transferor (carryover basis)
5.
Stock and assets take the same basis (substituted and carryover basis) -causes double tax on sale of stock and assets
Section 351 -- Statutory Requirements
1.
One or more persons
2.
Transfer property to a corporation
3.
Solely in exchange for stock, and
4.
The transferor(s) are in control of the corporation immediately after the
transfer
Administrative Requirement -- Business Purpose
1.
TAM 8045001 -- a valid business purpose is necessary for a transaction to
qualify under section 351; see also Estate of Kluener v. Commissioner,
154 F.3d 630 (6th Cir. 1998) (The sole shareholder of a financially
troubled corporation transferred property to the corporation. The property
was then sold in the corporation’s name. The taxpayer intended the gain
from the sale of the property to be offset by the corporation’s NOLs. The
Court found that the transfer of the property to the corporation prior to its
sale had no business purpose.)
2.
May be used by IRS to attack tax avoidance transactions
- 35 -
F.
G.
3.
No express statutory authority, but one court has inferred a Congressional
intent to require a business purpose for section 351 transactions on the
grounds that section 351 is closely related to section 368, which requires a
valid business purpose for reorganizations -- see Caruth v. United States,
688 F. Supp. 1129 (N.D. Tex. 1987), aff'd, 865 F.2d 644 (5th Cir. 1989).
The Service cited to Caruth approvingly in FSA 200001001 (Jul. 28,
1999)
4.
In the case of partnerships, similar limitations apply to capital
contributions -- the IRS recently finalized regulations that would provide it
with authority to recast transactions structured to avoid tax -- see Treas.
Reg. § 1.701-2
One or More Persons
1.
Section 7701(a)(1) -- "person" is broader than "individual" -- covers
corporations, partnerships, estates, and trusts
2.
Multiple persons may transfer property for stock
3.
Transfers need not be simultaneous -- so long as all are pursuant to a
single plan (with orderly execution) and parties' rights are defined in
advance -- Treas. Reg. § 1.351-1(a)(1)
Transfer of "Property"
1.
2.
Not defined in the statute
a.
section 317 defines property but it applies only to Part I of
Subchapter C (which does not include section 351)
b.
property includes most assets -- it includes money -- Rev. Rul. 69357, 1969-1 C.B. 101
c.
nonexclusive license -- held to be property -- E. I. DuPont De
Nemours & Co. v. United States, 471 F.2d 1211 (Ct. Cl. 1973)
d.
corporate name and goodwill -- held to be property -- Rev. Rul. 79288, 1979-2 C.B. 139
e.
letter of intent relating to the financing of the construction of a
hotel -- held to be property -- United States v. Stafford, 727 F.2d
1043 (11th Cir. 1984)
Services are not property -- section 351(d)(1) -- example -- receive stock
for legal and accounting services
a.
recipients of stock for services recognize income to the extent of
value of stock received -- James v. Commissioner, 53 T.C. 63
(1969); cf. Hospital Corporation of America v. Commissioner, 81
T.C. 520 (1983)
- 36 -
3.
b.
persons who receive stock for services cannot be counted in
determining whether transferors of property are in control -- Treas.
Reg. § 1.351-1(a)(1) -- discussed below
c.
intangible rights created by personal services -- property or
services
(1)
"know-how" including secret processes and formulas can
qualify as property -- G.D. Searle & Co., 88 T.C. 252
(1987) (patents, trademarks, copyrights, technical data,
manufacturing know-how and contract rights constitute
"property"); Rev. Proc. 69-19, 1969-2 C.B. 301, amplified
by Rev. Proc. 74-36, 1974-2 C.B. 491; Rev. Rul. 64-56,
1964-1 C.B. 133
(2)
lease and loan commitments -- services create property
(3)
the Administration’s Revenue Proposals for Fiscal Year
2001 contain a provision that would provide that the
transfer of an interest in intangible property constituting
less than all of the substantial rights of the transferor in the
property would be treated as a transfer of property for
purposes of section 351
(a)
consistent reporting by the transferor and transferee
would be required
(b)
in the case of a transfer of less than all of the
substantial rights, the transferor would have to
allocate the basis of the intangible between the
retained rights and the transferred rights based upon
respective fair market values
(c)
the proposal would be effective for transfers on or
after the date of enactment
Indebtedness of the transferee corporation (not evidenced by a security) is
not property -- section 351(d)(2) and (3)
a.
b.
Bankruptcy Tax Act of 1980 -- amended section 351 to treat the
following as "non-property" -(1)
debts of the transferee corporation not evidenced by a
security
(2)
interest on the transferee's debt accrued during the
transferor's holding period
persons who receive stock in exchange for unsecured debt of the
transferee corporation or accrued but unpaid interest will recognize
- 37 gain or loss on the exchange -- cf. Rev. Rul. 77-81, 1977-1 C.B.
97; PLR 8245010
c.
4.
H.
purpose -- to tax a creditor who receives stock in exchange for debt
unless the exchange qualifies under section 368(a)(1)(G) as a
bankruptcy reorganization
Transfer of property by a debtor corporation in a bankruptcy proceeding -section 351(e)(2) -- Bankruptcy Tax Act made section 351 inapplicable to
a transfer of property by a debtor corporation in a bankruptcy proceeding
where the stock received in the exchange is used to pay debts of the
corporation
Solely
Section 351(b) applies if the transferors receive property other than stock
I.
J.
In Exchange
1.
Transfer entire interest in property or an interest which is continuous,
perpetual and irrevocable -- E. I. DuPont De Nemours & Co., supra, 471
F.2d 1211; Rev. Rul. 71-564, 1971-2 C.B. 179; Rev. Rul. 69-156, 1969-1
C.B. 101; Rev. Rul. 64-56, 1964-1 C.B. 133
2.
Transfer of a limited interest with retained economic ownership may
constitute a license and not an exchange -- see also TAM 9215005
For Stock
1.
"Stock" -- new section 351
a.
no statutory definition
b.
broad interpretation -- need not be voting stock
c.
same meaning as in the reorganization area (sections 354 and 361
et al.)
d.
stock rights and warrants do not qualify
e.
contingent right to acquire additional stock may qualify
f.
wholly owned corporation need not issue new stock when its
owner transfers property to it -- section 351 does not require this
"meaningless gesture" -- Lessinger v. Commissioner, 85 T.C. 824
(1985), rev'd on other grounds, 872 F.2d 519 (2d Cir. 1989); see
also Scallen v. Commissioner, 54 T.C.M. 177 (1987), aff'd, 877
F.2d 1364 (8th Cir. 1989)
g.
section 351(g), added by TRA 97, excludes "nonqualified
preferred stock" from the definition of "stock" for purposes of
section 351 (and sections 354, 355, 356, and 1036)
- 38 (1)
h.
nonqualified preferred stock is defined as preferred stock
that is limited and preferred as to dividends and does not
participate in corporate growth to any significant extent and
for which:
(a)
the holder has the right to require the issuer or a
related person to redeem or purchase the stock;
(b)
the issuer or a related person is required to redeem
or purchase the stock;
(c)
the issuer or a related person has the right to redeem
or purchase the stock and, as or the issue date, it is
more likely than not that such right will be
exercised; or
(d)
the dividend rate for the stock varies in whole or in
part (directly or indirectly) with reference to interest
rates, commodity prices, or other similar indices
(2)
the rules related to redemption or purchase do not apply if
the right or obligation cannot be exercised within 20 years
of the date the right or obligation is issued or if the right or
obligation is subject to a contingency which, as of the issue
date, makes the likelihood of purchase or redemption
remote
(3)
the provision contains additional exceptions to this general
rule
(4)
the provision generally is effective for transfers after June
8, 1997
(5)
the Administration’s Revenue Proposals for Fiscal Year
2001 contain the provision that would clarify the definition
of nonqualified preferred stock to ensure that stock for
which there is not a real and meaningful likelihood of
actually participating in the earnings and growth of the
corporation is included in the definition
IRRA 98 amended section 351(g) to clarify that section 351(b)
(providing that gain but not loss is recognized) applies to a
transferor who transfers property in a section 351 exchange and
receives nonqualified preferred stock, if and only if, the transferor
also receives stock other than nonqualified preferred stock.
Otherwise, the transferor is treated as if they had received solely
"other property" of any other type -- the provision applies to
transactions after June 8, 1997
- 39 -
2.
(1)
Example (1): A transfers appreciated property to
Corporation X in exchange for “nonqualified preferred
stock” within the meaning of section 351(g) --result:
section 351(b) does not apply; A is deemed to have sold the
property in a section 1001 transaction, the gain in the
property is recognized
(2)
Example (2): A transfers loss property to Corporation X in
exchange for “nonqualified preferred stock” within the
meaning of section 351(g) -- result: section 351(b) does not
apply; A is deemed to have sold the property in a section
1001 transaction, A recognizes a loss on the sale of the
property
(3)
Example (3): A transfers loss property to Corporation X in
exchange for one share of common stock and “nonqualified
preferred stock” within the meaning of section 351(g) -result: section 351(b) applies because A receives common
stock as well as nonqualified preferred stock in the transfer
-- such nonqualified preferred stock is “other property” for
purposes of section 351(b) -- therefore, under section
351(b), the loss is not recognized
"Stock or Securities" -- old section 351 -- prior to OBRA 89, a transferor
of property to a controlled corporation could receive securities, as well as
stock, and the securities did not constitute boot
a.
no statutory definition
b.
refers to debt instruments having some degree of permanence, i.e.,
not short-term notes -- cf. Lagerquist v. Commissioner, 53 T.C.M.
530 (1987)
c.
if maturity is more than ten years, the debt probably qualifies -- if
less than five years, it probably does not -- in between lies a
questionable area -- see Bradshaw v. United States, 683 F.2d 365
(Ct. Cl. 1982)
d.
if transfer property solely for securities (and own no stock of the
corporation), then will not qualify under section 351 -- Rev. Rul.
73-472, 1973-2 C.B. 114
e.
but if already own stock of the corporation and transfer property
for securities and stock or solely for securities, will qualify under
section 351 -- Rev. Rul. 73-473, 1973-2 C.B. 115
f.
original issue discount -- transferor must recognize interest income
currently under OID rules (section 1272 et seq.) on debt
instruments received in a section 351 transaction if stated
- 40 redemption price at maturity exceeds the issue price of such
instruments
g.
3.
(1)
stated redemption price at maturity --defined at section
1273(a)(2)
(2)
issue price -- defined at sections 1273(b) and 1274(a)
market discount -- section 1278(a)(2), added by DEFRA 84, would
cause the transferor of property to recognize ordinary income to
the extent that the stated redemption price at maturity of the debt
received exceeds the basis of property transferred
(1)
TRA 86 (technical corrections) provides an exception for
newly issued debt -- section 1278(a)(1)(C)(i)
(2)
exception may not apply if section 351 not met -- see
section 1278(a)(1)(C)(ii)
Classification of instrument as stock or debt
a.
the use of debt offers a number of advantages from a planning
perspective -- interest is deductible and thus the distribution of
income is not subject to two levels of tax -- in the consolidated
group context, income generally is subject to only one level of
corporate tax, however basis received in debt is not subject to
disallowance under Treas. Reg. § 1.1502-20 -- thus, the taxpayer
frequently has an incentive to characterize its interest in a
corporation as debt rather than equity -- see William T. Plumb, Jr.,
The Federal Income Tax Significance of Corporate Debt: A
Critical Analysis and a Proposal, 26 Tax L. Rev. 369 (1970)
b.
factual issue -- IRS and courts refuse to accept the form of the
instrument in determining its character -- Segel v. Commissioner,
89 T.C. 816 (1987); TAM 8735008
c.
section 385 authorizes the IRS to issue regulations to determine
whether an interest in a corporation is to be treated as stock or
indebtedness
(1)
factors to consider:
•
written unconditional promise to pay at demand or
fixed date with fixed rate of interest
•
subordination of debt
•
convertibility of debt
•
debt/equity ratio
- 41 •
d.
e.
f.
proportionate holdings between stock and debt
(2)
although the IRS has issued regulations in this area, the
regulations were withdrawn. Rev. Rul. 83-98, 1983-2 C.B.
40
(3)
the IRS has issued a series of pronouncements indicating
that it will closely scrutinize instruments which are
designed to be treated as debt for federal income tax
purposes but as equity for regulatory, rating agency, or
financial accounting purposes -- Notice 94-47, 1994-1
C.B. 357; see also Notice 94-48, 1994-1 C.B. 357; Rev.
Rul. 94-28, 1994-1 C.B. 86
under section 385(a), IRS is authorized to characterize an interest
in a corporation that has "significant debt and equity
characteristics" as part debt/part equity -(1)
debt instrument that provides for payments that are
dependent to a significant extent on corporate performance,
through equity kickers, contingent interest, etc.
(2)
significant deferral of payment,
(3)
subordination,
(4)
interest rate sufficiently high to suggest a significant risk of
default
sections 163(e)(5) and 163(i) -- "applicable high yield discount
obligations" -- authorize the IRS to treat certain debt as part debt
and part equity
(1)
exception -- C corporations not entitled to deduct
"disqualified portion" of interest payment on certain debt
instruments -- remainder cannot be deducted until paid
(2)
applicable to instruments with -(a)
maturity date more than 5 years from date of issue
(b)
yield to maturity equals or exceeds applicable
federal rate (AFR) plus 5 points
(c)
significant OID -- see sections 163(e)(5)(F) and
163(i)(1)
section 385(c) provides rules that apply if an issuer characterizes
an interest as debt or equity at the time of issuance -(1)
such characterization is binding on the issuer and all
holders of the interest,
- 42 -
g.
4.
K.
(2)
such characterization is not binding on the IRS, and
(3)
a holder who treats such an interest in a manner
inconsistent with the issuer's characterization must make
disclosure to that effect on his return
TRA 97 enacted section 163(l) which denies interest and original
issue discount deductions on corporate instruments that are payable
in stock of the issuer or a related party, including instruments
which are mandatorily (or at the option of the issuer or a related
party) payable or convertible into such stock. Interest and original
issue discount deductions are also denied for instruments the
payments on which are made by reference to the value of stock; or
that are part of an arrangement designed to result in a payment of
the instrument with or by reference to such stock -- generally
effective for instruments issued after June 8, 1997
Disproportionate transfers
a.
stock need not be issued in proportion to FMV of property
transferred -- Treas. Reg. § 1.351-1(b)(1); Weisbart v.
Commissioner, 79 T.C. 521 (1982)
b.
may result in gift or compensation to recipient -- section 351(g)(3)
and (4)
c.
gift tax liability or deduction to payor
Control
1.
Transferor or transferors must be in control of the corporation
2.
Control need not be obtained in this transaction -- can own stock from
previous transactions
3.
Defined in section 368(c): (a) 80% of total combined "voting power" of all
stock "entitled to vote," and (b) 80% of the total number of shares of each
class of nonvoting stock -- Rev. Rul. 59-259, 1959-2 C.B. 115
4.
The Administration’s Revenue Proposals for Fiscal Year 2001 contain a
provision that would change the test for control under section 351. Under
the proposal, control would be defined as the ownership of at least 80% of
the total voting power and at least 80% of the total value of a corporation’s
stock
5.
General rules
a.
outstanding stock not authorized stock or treasury stock
b.
beneficial ownership not mere legal title
- 43 -
6.
c.
constructive ownership provisions do not apply -- see Yamamoto
v. Commissioner, 51 T.C.M. 1560 (1986), aff'd in part and
dismissed in part without published opinion, 891 F.2d 297 (9th Cir.
1989)
d.
convertible stock or debentures and preferred stock having
contingent voting rights -- not voting stock
e.
little guidance in defining "voting power" or "voting stock"
(1)
troublesome if multiple classes of stock with
disproportionate voting and equity rights
(2)
other Code sections -- section 302(b)(2)(B);
section 304(c)(1); section 332(b)(1); section 338(d)(3);
section 368(a)(1)(B) and (C); section 1504(a)(2);
section 1563(a)
Consolidated returns
a.
the aggregate stock ownership rules of Treas. Reg. § 1.1502-34, in
which all stock owned by members of an affiliated group that files
a consolidated return is taken into account, apply for the purpose of
determining whether a member satisfies the 80% rule of section
351(a) -- Rev. Rul. 89-46, 1989-1 C.B. 272
(1)
example
facts -- P has two wholly owned subsidiaries, X and Y, that
are members of an affiliated group that files a consolidated
return -- X transfers property to Y in exchange for stock of
Y
result -- under Treas. Reg. § 1.1502-34, even though X
does not actually own an amount of stock constituting
control of Y, X is considered for purposes of section 351(a)
as in control of Y, by virtue of P's ownership -- therefore, X
satisfies the control requirement of section 351(a)
7.
Multiple transferors
a.
can have more than one transferor and qualify under section 351 -provided transferors as a group have control
(1)
existing shareholders who do not transfer property are not
transferors
(2)
a person who receives stock for services only is not a
transferor
- 44 -
b.
c.
(3)
a person who receives stock for indebtedness of the
transferee corporation (not evidenced by a security) is not a
transferor
(4)
if a person transfers property for stock and also receives
stock for services or indebtedness -- all of his stock is
counted in determining whether transferors have control -Treas. Reg. § 1.351-1(a)(2), ex. 3
(5)
person who transfers stock or property to a subsidiary in
exchange for parent's stock is not counted in determining
whether group of transferors has control of parent -- Rev.
Rul. 84-44, 1984-1 C.B. 105
(6)
factual question whether transferor is part of control group
-- Russell v. Commissioner, 832 F.2d 349 (6th Cir. 1987)
examples
(1)
A owns 100% of the stock of X corporation, B transfers
assets to X for 25% of the X stock -- section 351 does not
apply because B is not in control -- B is taxed
(2)
A, B, and C form X corporation, A and B transfer property
for 78% of the X stock, C performs services for 22% of the
stock -- section 351 does not apply because persons who
transferred property are not in control -- A, B, and C are
taxed
(3)
A and B receive 80% of the X stock for property and C
receives 20% of the stock for services -- section 351 applies
to A and B, but C is still taxed
(4)
A and B receive 78% of the stock for property, C receives
22% of the stock for property and services -- section 351
applies regardless of the amount of property transferred by
C (provided the property transferred by C is not only of
nominal value) and C is taxed to extent he receives stock
for services
(5)
similar rules should apply if the shareholder exchanges
property and transferee corporation indebtedness for stock
accommodation transferor -- transfer of minor amount of property
so that the group of transferors have control -- will not be
recognized
(1)
A owns 100% of X corporation -- B transfers assets to X
for 25% of stock -- section 351 does not apply because B is
not in control
- 45 -
L.
(2)
same facts but A also transfers nominal amount of assets
for one additional share of X stock; technically A and B are
both transferors and they are in control, but A will not be
recognized as a transferor for purposes of section 351 -Kamborian v. Commissioner, 56 T.C. 847 (1971), aff'd,
469 F.2d 219 (1st Cir. 1972)
(3)
Rev. Proc. 77-37, 1977-2 C.B. 568 -- to qualify as a
transferor a shareholder must convey property valued at
10% of stock already owned (for advance ruling)
Immediately After the Exchange
1.
2.
Is there control if the shareholder disposes of part of the stock shortly after
receiving it -- examples:
a.
shareholder receives 100% of the stock and immediately sells 25%
b.
shareholder receives 100% of the stock and gives 25% to his/her
spouse
c.
shareholder receives 100% of the stock and the corporation issues
additional stock reducing the shareholder's interest to 75%
Step transaction doctrine -- momentary control is generally not sufficient
a.
transferor agrees prior to transfer to dispose of sufficient stock to
cause loss of control -- need not be binding commitment
b.
the subsequent transfer is an integral part of the incorporation, i.e.,
first transfer would not have happened without the second
c.
authority
(1)
McDonald's of Zion, Inc. v. Commissioner, 688 F.2d 520
(7th Cir. 1982); Intermountain Lumber Co. v.
Commissioner, 65 T.C. 1025 (1976); American Bantam
Car v. Commissioner, 11 T.C. 397 (1948)
(2)
cf. National Bellas Hess, Inc. v. Commissioner, 20 T.C.
636 (1953) (transferor's control "real and lasting," not
momentary formality, subsequent relinquishment not part
of plan of reorganization or exchange)
(3)
Rev. Rul. 79-70, 1979-1 C.B. 144 -- section 351 not
applicable because of required subsequent transfer
(4)
Rev. Rul. 79-194, 1979-1 C.B. 145 (Situation 1) -transferor sells stock to another transferor -- section 351
applies
- 46 (5)
d.
e.
TAM 8735009 -- section 351 applies to transfers by two
corporations notwithstanding right of one corporation to
purchase stock initially acquired by second corporation
case law distinguishes commercial and non-commercial transfers
(1)
transfer with prearranged sale of 25% of the stock -section 351 does not apply
(2)
same facts but shareholder gives 25% of stock to spouse -section 351 applies (rationale: transferor had power to
retain stock or to give it away) -- D'Angelo Associates, Inc.
v. Commissioner, 70 T.C. 121 (1978)
Treas. Reg. § 1.351-1(a)(3) -- if a person acquires stock of a
corporation from an underwriter in exchange for cash in a qualified
underwriting transaction, the person who acquires stock from the
underwriter is treated as transferring cash directly to the
corporation in exchange for stock of the corporation and the
underwriter is disregarded
(1)
a qualified underwriting transaction is a transaction in
which a corporation issues stock for cash in an
underwriting in which either the underwriter is an agent of
the corporation or the underwriter's ownership of the stock
is transitory
(2)
this regulation supersedes Rev. Rul. 78-294, 1978-2 C.B.
141 -- firm commitment underwriter treated as transferor
despite transitory ownership
f.
section 351(c) -- transferor corporation can distribute stock to its
shareholder without violating control; technical corrections to TRA
97 and IRRA 98 clarify that for certain divisive transactions in
which a corporation contributes assets to a controlled corporation
and then distributes the stock of the controlled corporation in a
transaction that meets the requirements of section 355, two factors
shall not be taken into account: (1) the fact that the shareholders of
the distributing corporation dispose of part or all of the distributed
stock; and (2) the fact that the corporation whose stock was
distributed issues additional stock
g.
Rev. Rul. 84-111, 1984-2 C.B. 88, describes consequences of three
different situations involving transfer of partnership assets and
liabilities to a newly formed corporation (supersedes and revokes
Rev. Rul. 70-239, 1970-1 C.B. 74)
h.
prearranged disposition through a reorganization will destroy
section 351 application
- 47 -
3.
M.
(1)
example: A transfers assets to X corporation for all the X
stock -- Y corporation then acquires the X stock from A for
Y stock (B reorganization) -- section 351 does not apply
(2)
West Coast Marketing Corp. v. Commissioner, 46 T.C. 32
(1966) (incorporation followed by sale of stock treated as a
sale of assets); Rev. Rul. 80-221, 1980-2 C.B. 107; Rev.
Rul. 70-140, 1970-1 C.B. 73
i.
Where there is no prearranged disposition of stock and business
purpose for incorporation exists, subsequent disposition of stock in
a "B" reorganization will not destroy section 351 -- Weickel v.
Commissioner, 51 T.C.M. 432 (1986); Vest v. Commissioner, 57
T.C. 128 (1971)
j.
Option to buy stock of transferee from transferor corporation after
section 351 transaction does not violate control requirement -- PLR
8735009
Successive transfers
a.
A transfers assets to Y corporation in exchange for all the stock of
Y, and Y immediately transfers the assets to Z corporation in
exchange for all the Z stock
b.
does section 351 apply to each exchange -- does A have "control"
c.
Rev. Rul. 77-449, 1977-2 C.B. 110, treats each transfer as a
separate transaction --section 351 applies to each exchange
d.
Rev. Rul. 83-34, 1983-1 C.B. 79, same facts as above except A
holds only 80% of the Y stock and Y holds only 80% of the Z
stock --section 351 applies to each exchange -- see also Rev. Rul.
83-156, 1983-2 C.B. 66
e.
unclear whether result changes if Y receives only 50% of the Z
stock and a third party (which also transfers property to Z) receives
the other 50%
f.
see PLR 9137003 -- successive transfers among related parties are
in the nature of a business adjustment and do not have the effect of
the taxpayer's "cashing in" of a gain
Section 351(b) -- Transfers Not Solely for Stock
1.
Transfer of property in exchange for stock and other consideration -- cash,
securities or other property (i.e., boot) -- "solely" requirement of
section 351(a) is not met
2.
Section 351(b) provides for limited recognition of gain
- 48 -
3.
a.
realized gain (FMV of stock and boot received less basis of
property given up) is recognized to the extent of the value of the
boot received
b.
no loss recognized
Example
A transfers assets:
A receives:
4.
5.
FMV
$50,000
basis $10,000
stock (FMV)
cash
other property (FMV)
total
$30,000
$10,000
$10,000
$50,000
less basis
equals realized gain
$10,000
$40,000
recognized gain (boot)
$20,000
Character of gain (capital gain or ordinary income)
a.
depends on character of property transferred
b.
sections 291, 1239, 1245, 1250 apply if gain is recognized
c.
section 47 -- must retain a "substantial interest" to avoid
investment tax credit recapture -- Treas. Reg. § 1.47-3(f); Rev.
Rul. 83-65, 1983-1 C.B. 10
d.
under section 1239 gain recognized on a sale or exchange of
depreciable property between "related parties" is taxed as ordinary
income -- related party transactions include a sale or exchange
from a parent corporation to its subsidiary or from a corporation to
a commonly controlled partnership
Multiple assets -- amount and character of gain determined on an
individual asset basis -- Rev. Rul. 68-55, 1968-1 C.B. 140
example
A transfers
Asset 1:
Asset 2:
FMV
basis
FMV
basis
$45,000
$25,000
$5,000
$25,000
- 49 A receives
stock:
boot:
FMV
FMV
FMV
$30,000
$20,000
Total
$50,000
(100%)
boot allocated to each asset:
Asset 1
$45,000
(90%)
Asset 2
$5,000
(10%)
$20,000
x 90%
$18,000
$20,000
x 10%
$2,000
stock (FMV)
plus boot (FMV)
equals amount realized
$30,000
$20,000
$50,000
$27,000
$18,000
$45,000
$3,000
$2,000
$5,000
minus basis
equals gain realize
$50,000
-0-
$25,000
$20,000
$25,000
($20,000)
$18,000
-0-
gain recognized
6.
Multiple assets -- allocate aggregate basis of property among stock and
securities received in exchange in proportion to the latter's fair market
value -- taxpayer may not designate specific property to be exchanged for
particular stock or securities -- Rev. Rul. 85-164, 1985-2 C.B. 117
7.
Receipt of installment obligations
a.
Installment note will constitute boot in a section 351 transaction -installment method can apply to defer gain. Prop. Treas. Reg.
§ 1.453-1(f)(3) sets forth rules for the treatment of short term
installment notes as boot
b.
The installment method is not applicable to sales of inventory, or
sales of depreciable property between a shareholder and a related
party -- sections 453(b)(2)(B) and 453(g)
c.
example
B transfers property with a basis of $250,000 and fair market value
of $300,000 to newly formed corporation Y in exchange for all of
the stock of Y (worth $200,000) and a $100,000 installment
obligation (bearing adequate interest) issued by Y. The installment
obligation is payable in full on the second anniversary of the date
of issue. The installment obligation is boot received by B in the
exchange. However, the installment sale rules prevent B from
recognizing gain immediately. Instead, B’s basis is first allocated
to the Y stock (but not in excess of the fair market value of the Y
- 50 stock) and then to the installment obligation. Since the fair market
value of the Y stock is $200,000, B has a $50,000 basis in the
installment obligation. If the $100,000 installment obligation is
paid in full on the second anniversary date, B will recognize gain
of $50,000 at that time ($100,000 received less B’s $50,000 basis
in the installment obligation) and Y at that time will increase the
basis at which it holds the property. See Prop. Treas. Reg. §1.4531(f)(3), ex. 2
d.
N.
O.
P.
Section 453(a)(2, added by the Ticket to Work and Work
Incentives Improvement Act of 1999, provides that the installment
method cannot be used to report income from installment sales if
such income would be reported under an accrual method of
accounting
Section 351(f) -- Exception for Section 311 Transfers
1.
TAMRA 88 added section 351(f), effective for transfers occurring on or
after June 21, 1988
2.
Where a corporation participates in a section 351 transaction which is not
part of a plan of reorganization, the corporation must recognize gain (if
any) on property which is transferred to a shareholder, pursuant to
section 311 (see Part VII, infra)
Section 1032 -- No Gain or Loss Recognized to the Corporation on Receipt of
Property
1.
Corporation recognizes no gain or loss on the receipt of property in
exchange for its stock
2.
Section 1032 applies whether or not section 351 applies -- i.e., even if
section 351 is not applicable the corporation recognizes no gain
Section 358 -- Basis of Stock Received by Transferor-Shareholder
1.
2.
Concepts of basis
a.
cost basis -- what you pay
b.
substituted basis -- the basis of property received takes the basis of
the property given up -- section 7701(a)(44)
c.
carryover (or "transferred") basis -- the basis of the property
received is equal to the basis of the property in the hands of the
transferor -- section 7701(a)(43)
Section 358 -- generally the basis of the stock received by the transferor
equals the basis of the property given up (substituted basis)
a.
reduced by money or other property received (i.e., boot)
- 51 b.
increased by gain recognized
3.
Basis of money is face amount -- basis of other property is FMV
4.
Example 1
A transfers
Asset 1:
A receives
stock:
cash
other property
total FMV received
less basis
equals gain realized
FMV
basis
FMV
(FMV)
(FMV)
gains recognized (section 351(b)):
basis of stock (section 358):
old basis
less boot
plus gain recognized
equals
$20,000
$10,000
-$20,000
+$20,000
$10,000
basis of boot (i.e., its FMV):
5.
$20,000
Example 2
B transfers
assets:
B receives
stock
cash
other property
less basis
equal gain realized
FMV
basis
(FMV)
(FMV)
(FMV)
gain recognized (section 351(b))
basis of stock (section 358):
old basis
less boot
plus gain recognized
equals
basis of boot (i.e., its FMV):
6.
$50,000
$10,000
$30,000
$10,000
$10,000
$50,000
-$10,000
$40,000
$50,000
$40,000
$30,000
$10,000
$10,000
-$40,000
$10,000
$10,000
$40,000
- $20,000
+$10,000
$30,000
$20,000
If the transferor receives several classes of stock, the basis is allocated
among the stock on a FMV basis -- Rev. Rul. 85-164, 1985-2 C.B. 117
- 52 7.
Q.
Section 358 and liabilities -- liabilities assumed by the corporation (for
purposes of determining basis) are treated as money received -- reduce
shareholder's basis in the stock -- section 357 determines whether gain is
recognized on assumption of liabilities
Section 362 -- Basis of Property to the Corporation
1.
Property in hands of the corporation has the same basis as in the hands of
the transferor (carryover basis) -- increased by gain recognized to the
transferor
2.
Prior example:
shareholder basis in property
plus gain recognized
basis to the corporation
$10,000
$20,000
$30,000
3.
It is unclear whether the transferee's payment of an assumed liability
should be capitalized or deducted -- see Holdcroft Transp. Co. v.
Commissioner, 153 F.2d 323 (8th Cir. 1946) (capitalization); cf. Rev. Rul.
80-198, 1980-2 C.B. 113 (deduction); PLR 7830010 (deduction); Rev.
Rul. 95-74, 1995-2 C.B. 36 (1995) (deduction or capitalization as
appropriate under the taxpayer’s method of accounting)
4.
If section 351 does not apply, then the corporation takes a purchase basis - FMV of assets -- section 1012; Treas. Reg. § 1.1032-1(d)
5.
Zero basis problem -- parent corporation (P) transfers its stock to a
subsidiary corporation (S) in exchange for S stock in a section 351
transaction -- basis of P stock and basis of S stock are zero -- Rev. Rul. 74503, 1974-2 C.B. 117
6.
Zero basis relief -- Treas. Reg. § 1.1502-13(f)(6) provides some relief
from the zero basis problem in the consolidated context -- if the
disposition qualifies for relief, the member is treated as having purchased
the parent stock for its fair market value and therefore takes a basis equal
to value -- however, relief is only available if -a.
the member acquires the P stock directly from the common parent
as a contribution to capital
b.
the member transfers the stock immediately to an unrelated
nonmember as part of the plan
c.
no nonmember receives a substituted basis in the stock
d.
the stock is not exchanged for other parent stock
e.
the parent corporation does not become, or ceases to be, the
common parent as part of the disposition or plan
- 53 f.
7.
On May 11, 2000, the Service published final regulations Treas. Reg. §
1.1032-3, T.D. 8883, relating to the treatment of a disposition by a
corporation of the stock of another corporation in a taxable transaction
a.
If the regulations apply, the acquiring corporation does not
recognize gain or loss on the disposition of the issuing
corporation's stock. The transaction is treated as if, immediately
before the acquiring entity disposes of the stock of the issuing
corporation, the acquiring entity purchased the issuing
corporation’s stock from the issuing corporation for fair market
value with cash contributed to the acquiring entity by the issuing
corporation or an intermediate corporation or partnership
b.
The regulations apply to issuing corporation stock options in the
same manner as it applies to issuing corporation stock
c.
The regulations apply only if, pursuant to a plan to acquire money
or other property, see Treas. Reg. 1.1032-3(c):
d.
R.
the member is not a nonmember that becomes a member, or a
member that becomes a nonmember, as part of the disposition or
plan
(1)
The acquiring corporation acquires stock of the issuing
corporation directly or indirectly from the issuing
corporation in a transaction in which, but for this section,
the basis of the stock of the issuing corporation in the hands
of the acquiring corporation would be determined, in whole
or in part, with respect to the issuing corporation's basis in
the issuing corporation's stock under section 362(a) or 723;
(2)
The acquiring corporation immediately transfers the stock
of the issuing corporation to acquire money or other
property;
(3)
No party receiving stock of the issuing corporation from
the acquiring corporation receives a substituted basis in the
stock of the issuing corporation within the meaning of
section 7701(a)(42); and
(4)
The issuing corporation stock is not exchanged for stock of
the issuing corporation
The final regulations apply to transactions occurring on or after
May 11, 2000
Section 1223 -- Holding Period of Stock and Property
1.
Section 1223(1) -- the transferor's holding period of the stock received
includes the holding period of the property exchanged ("tack" holding
- 54 periods) -- provided the property exchanged is a capital asset or a
section 1231 asset -- Rev. Rul. 85-164, 1985-2 C.B. 117 transferor's
holding period of boot received -- does not include the holding period of
the property exchanged -- section 1223(1) by its terms only applies to
property which has the same basis in whole or in part as the property
exchanged and section 358(a)(2) states that the basis of boot to the
transferor is its FMV
2.
S.
Section 1223(2) -- the holding period of the property in the hands of the
corporation includes the transferor's holding period -- whether or not the
property exchanged is a capital asset or a section 1231 asset this rule
applies even if the transferor receives boot -- section 1223(2) requires only
that the transferee's basis in the property be the same in whole or in part as
the transferor's basis and under section 362(b) the basis of the property to
the corporation is the same as it would be in the transferor's hands,
increased by any gain recognized by the transferor on the transfer
Section 357 -- Assumption of Liabilities by the Corporation (or Property
Transferred "subject to" Liability)
1.
Liability assumed or property taken subject to
a.
assumption of liability -- transferee corporation becomes obligated
to pay debt whether or not transferor is relieved of liability
b.
property subject to liability -- no personal liability to transferee
corporation -- liability secured only by asset -- unclear whether
transferor can retain liability and convey property -- see Jackson v.
Commissioner, 708 F.2d 1402 (9th Cir. 1983); Rosen v.
Commissioner, 62 T.C. 11 (1974), aff’d, 515 F.2d 507 (3d Cir.
1975); Parsons v. Commissioner, 31 T.C.M. 290 (1972)
c.
section 357(d), added by the Miscellaneous Trade and Technical
Corrections act of 1999, eliminates the distinction between the
assumption of a liability and the acquisition of an asset subject to a
liability. Section 357(d) generally applies to transfers after
October 18, 1998. Under section 357(d)
(1)
a recourse liability will be treated as assumed to the extent
that, based on all the facts and circumstances, the transferor
has agreed to, and is expected to, satisfy such liability (or
portion thereof), whether or not the transferor has been
relieved of such liability
(2)
where property is transferred subject to a nonrecourse
liability, unless the facts and circumstances indicate
otherwise, the transferee would be treated as assuming a
ratable portion of the liability, based on the relative fair
market values of all assets subject to such liability
- 55 d.
2.
the Administration’s Revenue Proposals for Fiscal Year 2001
contain a provision according to which, if the basis of the stock
received by a transferor as part of a tax-free exchange with a
controlled corporation exceeds the fair market value of the stock,
then the basis of the stock received would be reduced (but not
below the fair market value) by the amount of any liability that (1)
is assumed in exchange for such stock, and (2) did not otherwise
reduce the transferor’s basis of the stock by reason of assumption
Section 357(a) -- general rule
a.
the assumption of a liability of the transferor by the corporation is
not treated as money or other property (i.e., not boot) for purposes
of determining gain (it is treated as money when determining basis
-- section 358)
b.
result -- liability generally does not cause recognition of gain to the
transferor
c.
permits ongoing business to incorporate without fear of tax
d.
immediate payment of liability by the corporation -- no gain
recognized, treated as an assumption and not a distribution of boot
-- see Kniffen v. Commissioner, 39 T.C. 553 (1962); Rev. Rul. 74477, 1974-2 C.B. 116 (payment or assumption of expenses
incurred by the transferor in a section 351 transaction does not
constitute boot)
e.
example
A transfers
assets:
FMV
basis
liabilities assumed
$50,000
$10,000
$5,000
A receives
stock
(FMV)
plus liabilities assumed
equals amount realized
$45,000
$5,000
$50,000
less basis
equals gains realized
$10,000
$40,000
gains recognized
basis of stock (section 358) -old basis
less liability assumed
equals
-0-
$10,000
- $5,000
$5,000
- 56 3.
Section 357(b) -- exception to general rule -- no bona fide business
purpose
a.
if the principal purpose for the assumption of the liability was
(1)
to avoid tax, or
(2)
not a bona fide business purpose
then the entire amount of the liability is considered money,
contrary to the general rule of section 357(a)
b.
gain or loss is thus recognized pursuant to section 351(b)
c.
example
A transfers
assets:
FMV
basis
business liabilities assumed
personal liabilities assumed
$50,000
$10,000
$5,000
$5,000
A receives
stock
(FMV)
plus liabilities assumed
equals amount realized
$40,000
$10,000
$50,000
less basis
gain realized
$10,000
$40,000
section 357(b) gain recognized
4.
$10,000
d.
if section 357(b) applies to one liability it applies to all liabilities
assumed -- Treas. Reg. § 1.357-1(c)
e.
section 357(b)(2) places the burden of proof on the taxpayer
f.
generally applies to liabilities created shortly before incorporation
and to personal liabilities of a shareholder not related to the
business
Section 357(c) -- exception to general rule when liabilities exceed basis of
assets
a.
if the liabilities of the transferor assumed by the corporation
exceed the basis of the assets transferred -- excess of liabilities
over basis is treated as gain from sale of the assets
compare section 357(b) (all liabilities treated as boot -- recognized
only if gain realized) with section 357(c) (excess liabilities treated
as if gain recognized on sale -- whether or not gain realized)
- 57 b.
example
A transfers
assets:
FMV
basis
liabilities assumed
$50,000
$10,000
$30,000
A receives
stock:
$20,000
FMV
liabilities assumed
less basis
equals section 357(c) gain recognized
$30,000
$10,000
$20,000
c.
policy -- section 357(c) is required or gain would never be taxed -alternative is to use negative basis
d.
character of gain -- capital gain or ordinary income depends on
nature of property transferred -- if multiple assets, then allocate
gain among assets on FMV basis (similar to boot provision of
section 351(b))
e.
aggregate basis of all assets transferred compared to total liabilities
-- Treas. Reg. § 1.357-2(a); PLR 8715003
f.
two or more transferors -- section 357(c) applied to each
shareholder separately --Smith v. Commissioner, 84 T.C. 889
(1985); Rev. Rul. 66-142, 1966-2 C.B. 66
g.
section 357(c)(2)
(1)
if both section 357(b) and section 357(c) apply, then
section 357(b) controls
(2)
section 357(c) does not apply to a bankruptcy
reorganization pursuant to section 368(a)(1)(G)
h.
it has been held that a taxpayer does not recognize gain when he
retains genuine personal liability for the excess amount of
liabilities over basis; in effect, the taxpayer's debt is not canceled -Lessinger v. Commissioner, 872 F.2d 519 (2d Cir. 1989), rev'g, 85
T.C. 824 (1985); Jackson v. Commissioner, 708 F.2d 1402 (9th
Cir. 1983); but see Smith v. Commissioner, 84 T.C. 889 (1985),
aff'd without published opinion, 805 F.2d 1073 (D.C. Cir. 1986)
(357(c) gain determined where partnership interest subject to
liability was contributed to corporation notwithstanding that
partner retained personal liability thereon)
i.
in a recent case, the Ninth Circuit concluded that section 357(c)
was not triggered when a taxpayer transfers, in addition to property
- 58 with liabilities in excess of basis, a promissory note in an amount
exceeding the potential section 357(c) gain -- the court held that
the taxpayer had a face value basis in the note, and therefore there
was no section 357(c) gain -- Peracchi v. Commissioner, 98-1 U.S.
Tax Cas. (CCH) ¶50,374, 81 A.F.T.R.2d 1754 (9th Cir. 1998),
rev’g 71 T.C.M. (CCH) 2830 (1996)
j.
incorporating business with deductible liabilities
(1)
Revenue Act of 1978 added section 357(c)(3) to cure
problem created on incorporation of cash basis business
(2)
example -- incorporate professional partnership (doctors,
lawyers, etc.) on cash basis
Assets
cash
$10,000
A/R $100,000
Liabilities
A/P $50,000
equity $60,000
but A/R have no basis -- prior law would require that
shareholders recognize $40,000 of gain
(3)
Numerous cases: Bongiovanni v. Commissioner, T.C.
Memo. 1971-262, rev'd, 470 F.2d 921 (2nd Cir. 1972);
Focht v. Commissioner, 68 T.C. 223 (1977); Thatcher v.
Commissioner, 61 T.C. 28 (1973), rev'd in part and aff'd in
part, 533 F.2d 1114 (9th Cir. 1976)
(4)
section 357(c)(3) (prior to Technical Corrections Act of
1979) –
(a)
if cash basis taxpayer
(b)
exclude from liabilities accounts payable which
would be deductible by transferor
Rev. Rul 80-199, 1980-2 C.B. 122, applies section
357(c)(3) to pre-1978 years
(5)
Section 358(d)(2) -- accounts payable are not treated as a
cash distribution and do not reduce shareholder's basis in
the stock
(6)
Technical Corrections Act of 1979 amended section
357(c)(3) as follows:
(a)
all taxpayers (cash or accrual)
- 59 (b)
T.
exclude all liabilities (not limited to accounts
payable) which would be deductible by the
transferor
(7)
Orr v. Commissioner, 78 T.C. 1059 (1982) -- customer
deposits transferred to a corporation in a section 351
transaction constitute liabilities -- section 357(c)(3) does
not apply because the deposits are not deductible when paid
(8)
Rev. Rul. 95-74, 1995-2 C.B. 36 -- contingent
environmental liabilities are not included in determining
whether liabilities assumed exceed basis if contingent
environmental liabilities had not yet been taken into
account, i.e., have not given rise to capital expenditure or
effected basis -- expands the scope of 357(c)(3) to exclude
not only deductible liabilities, but some capital
expenditures as well
Contributions to Capital
1.
General concept -- transfer of property to a corporation without the receipt
of stock
2.
Section 118 makes contributions to capital nontaxable to the corporation -see PLR 8808004 (amounts received by a corporation for nonvoting stock
are excludable from gross income because of the returnable nature of the
payment whether deemed debt or equity)
3.
Section 362(a)(2) -- corporation's basis in the property is equal to
transferor's basis (carryover)
4.
Contributing shareholder normally increases his stock basis -- he
recognizes no gain since he has not received any additional consideration - see Commissioner v. Fink, 483 U.S. 89 (1987) (shareholder who
voluntarily surrenders portion of shares to the corporation, but who retains
control, does not sustain a deductible loss; shareholder has made
contribution to capital and must reallocate basis in surrendered shares to
shares he retains)
5.
Contribution by person not a shareholder -- basis to corporation governed
by section 362(c)
see Rev. Rul. 93-16, 1993-1 C.B. 26 (federal improvement grants to
corporate owner of public airport constitute a non-shareholder contribution
to capital under section 118); TAM 9238007 (payments by governmental
entity to a corporation to induce it to locate in a certain state constitute a
non-shareholder contribution to capital under section 118)
- 60 -
6.
Debt forgiveness
a.
Gross income includes income from discharge of indebtedness.
Section 61(a)(12). See U.S. v. Kirby Lumber, 284 U.S. 1 (1931)
(gain or saving realized by debtor upon reduction or cancellation of
its outstanding indebtedness for less than the amount due may
constitute "income")
b.
Section 108(a) -- gross income does not include income from
discharge of indebtedness where it occurs in a Title 11 bankruptcy
proceeding, or when, and to the extent, the taxpayer is insolvent
c.
Section 108(b) -- taxpayer must reduce certain tax attributes to
compensate for the elimination of debt cancellation income under
section 108(a). These attributes include: net operating losses,
business credits, capital losses, tax basis in assets, and foreign tax
credit carryovers. Ordering rules are described in section
108(b)(4)
d.
Section 108(e)(6) -- indebtedness contributed to capital
e.
(1)
debtor corporation acquires its own indebtedness from a
shareholder as a contribution to capital
(2)
the corporation is treated as having satisfied the debt with
cash equal to the shareholders adjusted basis in the debt -the corporation will recognize income to the extent of the
difference between the face amount of the obligation and
the shareholder's basis in the debt
(3)
example -- the corporation accrues and deducts salary owed
to an employee; the employee, on the cash basis, does not
include the salary in income and later cancels the debt -the corporation has income -- reverses Putoma Corp. v.
Commissioner, 66 T.C. 652 (1976), aff'd, 601 F.2d 743 (5th
Cir. 1979)
108(e)(4) -- acquisition of debt by related party
(1)
debt acquired by a related party of the debtor corporation is
treated as acquired by the debtor corporation
(2)
if the related party acquires the debt at a discount, the
debtor corporation has income
(3)
example -- parent corporation acquires subsidiary's
outstanding obligation from a third party at a discount -- the
subsidiary has income
- 61 (4)
f.
similarly, if a holder of outstanding indebtedness becomes
related to the debtor, or acquires the indebtedness in
anticipation of becoming related to the debtor, the debtor
has income -- Treas. Reg. § 1.108-2(c)
108(e)(8) -- indebtedness satisfied by corporation’s stock
if a debtor-corporation transfers stock to a creditor in satisfaction
of a debt, the debtor shall be treated as having satisfied the
indebtedness with an amount of money equal to the fair market
value of the stock
7.
8.
Repeal of stock for debt exception
a.
the stock for debt exception -- under prior law, a corporation could
issue stock in exchange for its outstanding indebtedness without
realizing cancellation of indebtedness income
b.
DEFRA 84 codified and restricted the stock for debt exception to
circumstances of bankruptcy or insolvency
c.
OBRA 93 completely repealed the stock for debt exception for
stock transfers occurring after December 31, 1994
(1)
As of January 1, 1995, an exchange of stock for debt will
be treated as if the issuer satisfied its debt with an amount
of money equal to the fair market value of the transferred
stock, whether or not the issuer is insolvent
(2)
A debtor who is insolvent (a prerequisite to qualifying for
the old stock for debt exception) will still be able to
exclude the COD from income under section 108(a). In
effect, therefore, the only result of the repeal of the stock
for debt exception will be to require attribute reduction for
insolvent debtors who satisfy their debt by issuing stock
Debt for debt exchanges
a.
OBRA 90 added current section 108(e)(10) -- if a debtor issues a
debt instrument in satisfaction of indebtedness, the debtor is treated
as having satisfied the indebtedness with an amount of money
equal to the issue price of the debt instrument
b.
thus, a corporation has income to the extent that the issue price of
the debt extinguished exceeds the issue price of the new debt
instrument
c.
the issue price of the debt instrument generally is determined under
sections 1273 and 1274
- 62 -
d.
U.
example
(1)
facts -- a corporation issued for $1,000 a publicly traded
bond that provided for annual coupon payments based on a
market rate of interest -- some time later when the old bond
is worth $600, the corporation exchanges the old bond for a
new bond that has a stated redemption price at maturity of
$750
(2)
result: the new bond will have an issue price of $600 (the
fair market value of the old bond) and deductible OID of
$150 ($750 redemption price at maturity less $600 issue
price) and the corporation will have cancellation of
indebtedness of $400 ($1,000 adjusted issue price of the old
bond less $600 issue price of the new bond)
Special Problems
1.
Corporation is a separate taxpayer -- the tax status of the corporation is
both integrated with and separated from the transferor
a.
b.
integrated aspects:
(1)
carryover basis of assets -- section 362
(2)
tacked holding periods of assets -- section 1223(1) and (2)
(3)
section 351 does not cause depreciation recapture provided
no boot is received -- Treas. Reg. § 1.1245-4(c)
(4)
section 351 does not cause investment tax credit recapture
provided: (1) no boot is received, (2) the transferor retains
a substantial interest in the assets, and (3) substantially all
of the assets of the unincorporated business are transferred
to the corporation -- Treas. Reg. § 1.47-3(f)(1); Rev. Rul.
83-65, 1983-1 C.B. 10; see also Burwell v. Commissioner,
56 T.C.M. 490 (1988); Loewen v. Commissioner, 76 T.C.
90 (1981)
(5)
a transfer of an installment obligation to a corporation is
not a disposition -- but see Rev. Rul. 73-423, 1973-2 C.B.
161 (corporate transferee was obligor on note)
independent aspects -- corporation as separate taxpayer
(1)
elect taxable year -- see new section 444, added by OBRA
87, permitting partnerships, Subchapter S corporations, and
personal service corporations to elect a taxable year other
than the required taxable year
- 63 -
c.
2.
(2)
elect cash or accrual method for reporting income and
deductions, subject to the limitations of section 448
(3)
select inventory method
(4)
bad debt method
(5)
method of depreciation
(6)
elect installment reporting
(7)
elect Subchapter S
(8)
section 1033
(9)
section 381 does not apply -- tax attributes do not carry
over
(10)
pay estimated taxes -- see OBRA 87, sections 10301(a)
(which amends section 6655) (corporation's failure to pay
estimated income tax) and 10301(b) (relieving large
corporations from liability for certain estimated tax
penalties for 1987)
LIFO inventory
(1)
corporation that transfers LIFO inventory to subsidiary in
section 351 exchange must calculate basis of inventory on a
pro rata basis
(2)
newly formed corporation that obtains LIFO inventory in
section 351 exchange shall treat that inventory as its
opening inventory, with the same basis as that of the
transferor, under section 362(a)(1) -- Rev. Rul. 70-564,
1970-2 C.B. 109; see also PLR 9215005 (transaction
determined to be a purchase, not section 351 transaction, so
Rev. Rul. 70-564 does not apply)
(3)
ongoing corporation using LIFO method that receives
LIFO inventory in a section 351 exchange must integrate
the basis of the acquired inventory into its own LIFO layers
-- Rev. Rul. 70-565, 1970-2 C.B. 110
Midstream transfers -- incorporation of an ongoing business
a.
nature of the problem -- income earned but not yet reported;
deduction claimed but valuable asset remains -- must transferor
include income or recapture deduction
(1)
accounts receivable not included in income
(2)
accounts payable incurred but not deducted
- 64 -
b.
c.
(3)
work in process not yet sold
(4)
costs of materials and supplies deducted but not used
(5)
bad debt reserves previously deducted
section 351 may be subordinated to other judicial doctrines or
statutory provisions in order to tax transferor
(1)
assignment of income
(2)
tax benefit rule
(3)
section 446 -- clear reflection of income
(4)
section 482 -- allocate income between related taxpayers
assignment of income
(1)
shareholder transfers claim for personal services or
accounts receivable to the corporation -- the shareholder is
taxed on collection -- see O'Bryan v. Commissioner, 62
T.C.M. 1347 (1991)
(2)
Hempt Bros. Inc. v. United States, 354 F. Supp. 1172, aff'd,
490 F.2d 1172 (3rd Cir. 1974) (accounts receivable of a
partnership are transferred to a corporation; the court held
that the corporation is taxed on collection of the receivable;
assignment of income doctrine serves a limited role in a
section 351 transaction) -- see also al-Hakim v.
Commissioner, 53 T.C.M. 352 (1987)
(3)
Rev. Rul. 80-198, 1980-2 C.B. 113 -- incorporation of
medical practice and shareholder conveys accounts
receivable and accounts payable to the corporation in
exchange for stock -- ruling holds that
(4)
(a)
corporation (not shareholder) is taxed on accounts
receivable when collected
(b)
corporation (not shareholder) deducts accounts
payable when paid
(c)
however, judicial doctrines may override
section 351 if facts reflect tax avoidance purpose or
to clearly reflect income
Rev. Rul. 95-74, 1995-2 C.B. 36 (1995) -- a company
transferred its manufacturing business to a newly formed
corporation in exchange for all of the corporation’s stock
and the corporation’s assumption of the manufacturing
- 65 business’s liabilities (including contingent environmental
liabilities)-- the ruling holds that:
d.
(a)
the liabilities assumed by the newly formed
corporation were not liabilities for purposes of
section 357(c)(1) and 358(d) because the liabilities
had not yet been taken into account by the company
prior to the transfer
(b)
the liabilities assumed by the newly formed
corporation are deductible as business expenses
under section 162 or are capital expenditures under
section 263, as appropriate, under the corporation’s
method of accounting
(5)
PLR 8139073 -- applied the assignment of income doctrine
where the transferor retained a portion of the assets
(6)
Compare PLR 8213051 (transferee corporation permitted to
deduct guaranteed payments (section 736(a)(2) payments)
due retired partners) with David R. Webb Co. v.
Commissioner, 77 T.C. 1134 (1981), aff'd, 708 F.2d 1254
(7th Cir. 1983)
clear reflection of income
Palmer v. Commissioner, 267 F.2d 434 (9th Cir.) cert. denied, 361
U.S. 821 (1959), taxpayer in construction business on completed
contract method incorporates shortly before payment received -court put taxpayer on percentage of completion method
e.
tax benefit rule
(1)
(2)
must accrual basis transferor include bad debt reserve
previously deducted when he incorporates
(a)
United States v. Nash, 398 U.S. 1 (1970), no,
transferor did not recover reserve for bad debts
(b)
Rev. Rul. 78-280, 1978-2 C.B. 139, transferor's
basis for stock equal to net value of receivables (i.e.,
less reserves)
transfer materials and supplies previously deducted and
receive value (i.e., stock) -- unclear whether transferor must
include the value of the stock in income -- see Hillsboro
National Bank v. Commissioner, 460 U.S. 370 (1983) -- in
a section 333 liquidation, the liquidating corporation must
include the value of cattle feed previously deducted -- not
- 66 entirely clear how this decision affects section 351
transactions
f.
3.
allocation of income between related taxpayers -- section 482
(1)
Treas. Reg. § 1.482-1(f)(1)(iii) -- "If necessary to prevent
the avoidance of taxes or to clearly reflect income, the
district director may make an allocation under section 482
with respect to transactions that otherwise qualify for
nonrecognition of gain or loss under applicable provisions
of the Internal Revenue Code (such as section 351) . . . ." -confers broad authority on Commissioner to allocate
income or deductions among commonly controlled entities
where lack of arms-length bargaining leads to a distortion
of income
(2)
Rooney v. United States, 305 F.2d 681 (9th Cir. 1962),
taxpayer incorporated his farming business after deducting
expenses of planting crops but before harvest -- court
allocated all expenses to the corporation -- see also Eli Lilly
& Co. v. Commissioner, 856 F.2d 855 (7th Cir. 1988);
G.D. Searle & Co. v. Commissioner, 88 T.C. 252 (1987)
(3)
section 482 may be applied in the context of professional
corporations to allocate income from the corporation to the
shareholder/employee -- this allocation reduces the income
subject to contribution to the corporation's pension plan -see Foglesong v. Commissioner, 691 F.2d 848 (7th Cir.
1982); Pacella v. Commissioner, 78 T.C. 604 (1982);
Keller v. Commissioner, 77 T.C. 1014 (1981), aff'd, 723
F.2d 58 (10th Cir. 1983)
(4)
Perryman v. Commissioner, 55 T.C.M. 1588 (1988) -taxpayer in section 351 exchange transferred property to
corporation which sold property shortly thereafter -taxpayer held to have used corporation as mere conduit to
reduce his tax liability -- gain attributed to taxpayer under
section 482
(5)
section 269A -- personal service corporations used to avoid
income tax
Abuses of section 351
a.
investment diversification (swap funds)
(1)
transferors attempted to diversify portfolio in a section 351
transfer -- shareholders transfer stock of publicly held
corporations to closely held investment company
- 67 (2)
section 351(e)(1) -- no section 351 treatment on transfer of
property to investment company
(3)
Treas. Reg. § 1.351-1(c) -- section 351 does not apply if --
(4)
(5)
(a)
transfer results in diversification, and
(b)
transferee is an investment company
diversification -- two or more persons transfer nonidentical
assets to a corporation -- Treas. Reg. § 1.351-1(c)(5)
(a)
includes transfers to a pre-existing corporation
unless transferee's assets are identical to the assets
transferred
(b)
does not prevent tax-free combinations of already
diversified portfolios -- transfers of assets will not
be treated as transfers that result in diversification if
each transferor transfers a diversified portfolio of
assets that satisfy section 368(a)(F)(ii), as modified
– see Treas. Reg. § 1.351-1(c)(6); see also PLR
9328035 (Apr. 20, 1993)
Treas. Reg. § 1.351-1(c)(1) -- investment company includes
the following:
(a)
regulated investment company -- section 851
(b)
real estate investment trust -- section 856
(c)
corporation 80% of whose assets are held for
investment and are stock or securities
(6)
Rev. Rul. 88-32, 1988-1 C.B. 113 -- transfer of marketable
stock by several transferors to newly formed corporation,
which pursuant to a pre-existing plan sells the stock and
purchases other stock and securities, did not constitute
transfers to an "investment company" under
section 351(e)(1) -- thus, section 351 applies
(7)
Rev. Rul. 87-9, 1987-1 C.B. 133 -- transfer of marketable
stock by some transferors and cash by others in exchange
for stock of regulated investment company (89% and 11%,
respectively) constituted transfers to investment company -section 351 did not apply -- instead, gain determined under
section 1001
(8)
Treas. Reg. § 1.351-1(c)(1) -- expands definition of
investment company to include a corporation which is an
investment company as defined in section 368(a)(2)(F) if
- 68 one or more of the transferors also is an investment
company -- section 368(a)(2)(F) defines an investment
company as a corporation 50% of whose assets are stock
and securities and 80% of whose assets are held for
investment
b.
(9)
a TRA 97 provision expanded the scope of assets that are
counted toward the 80 percent test to include: stocks and
securities (both readily marketable and not readily
marketable); money; equity interests in corporations
(including evidences of indebtedness, options, forward or
future contracts, notional principal contracts, and
derivatives); foreign currency; interests in RICs, REITs,
common trust funds, and publicly-traded partnerships;
instruments convertible into equity interests; interests in
precious metals (unless used by the transferee in the active
conduct of a trade or business); and any other asset
described in Treasury regulations -- effective for transfers
after June 8, 1997, with an exception for transfers made
pursuant to certain binding contracts in effect on June 8,
1997
(10)
the Administration’s Revenue Proposals for Fiscal Year
2001 include provisions prohibiting tax deferral on
contributions of appreciated property to swap funds. The
proposals would add limited or preferred partnership
interests to the list of assets that are taken into account in
determining whether a corporation (or partnership) is an
investment company; and require recognition on the
transfer of a non-diversified portfolio of marketable
securities to any corporation (or partnership) that is either
(1) registered as an investment company, (2) falls within
the qualified purchasers exception to the registration
requirement, or (3) otherwise is marketed or sold to
investors as providing a means of tax-free diversification
section 351 vs. sale
(1)
shareholder attempts to avoid section 351: appreciated land
is held as a capital asset by a shareholder, who sells the
land to the corporation, takes back notes, and reports
capital gain -- the corporation subdivides and sells the land
as an ordinary income asset and because the corporation's
basis in the land is high, it has little income
(2)
sell depreciable property to the corporation to increase the
corporation's depreciation deductions
- 69 -
4.
(3)
IRS will often challenge and treat as section 351 transfer -see Burr Oaks Corp. v. Commissioner, 365 F.2d 24 (7th
Cir. 1964), cert. denied, 385 U.S. 1007 (1967); TAM
9304002
(4)
Bradshaw v. United States, 683 F.2d 365 (Ct. Cl. 1982)
(transfers of real estate to corporations in exchange for
assumption of debt held to constitute sales and not
section 351 transactions); see also Utley v. Commissioner,
56 T.C.M. 885 (1988)
Section 351 and the reorganization provisions
a.
section 351 transfer may also constitute "B" reorganization -shareholders of X corporation transfer an amount of X stock
sufficient to constitute control to Y corporation in exchange for an
amount of Y stock sufficient to constitute control of Y -- not clear
which provision controls
b.
section 351 transfer may also constitute "C" reorganization
(1)
X corporation transfers all of its assets to Y corporation in
exchange for an amount of Y stock sufficient to constitute
control
(2)
DEFRA 84 requires that X corporation liquidate following
the asset transfer -- section 368(a)(2)(G)
c.
section 351 transfer may also constitute "D" reorganization -- X
corporation transfers certain assets to Y in exchange for an amount
of Y stock sufficient to constitute control, and X distributes the Y
stock to its shareholders in a transaction qualifying under section
355
d.
section 351 can be used to avoid tougher requirements of the
reorganization provisions
(1)
to combat this use, the IRS requires a business purpose for
section 351 transactions -- TAM 8045001
(2)
section 351 may apply to an acquisitive transaction
(commonly referred to as the National Starch/Unilever
transaction -- PLR 7839060) even though the acquisitive
transaction does not qualify as a nontaxable reorganization
-- Rev. Rul. 84-71, 1984-1 C.B. 106 (revoking Rev. Ruls.
80-284, 1980-2 C.B. 117, and 80-285, 1980-2 C.B. 119)
(3)
example
P wishes to acquire Target (T). Most of the T shareholders
- 70 want to sell their stock to P for cash, but, A, who owns 14
percent of T’s stock, insists on a tax-free transaction.
P transfers cash to a newly formed corporation (N) in
exchange for voting common stock of N. A transfers its T
stock to N in exchange for N preferred stock. N forms a
wholly owned subsidiary S, by transferring cash to S in
exchange for all of the S common stock. S is merged into
T. The shareholders of T, other than A, exchange their T
stock for cash. T becomes a wholly owned subsidiary of N.
The IRS ruled that this transaction satisfies the
requirements of section 351 -- Rev. Rul. 84-71, 1984-1
C.B. 106
(4)
5.
V.
Section 351(g), added by TRA 97, treats nonqualified
preferred stock as boot for purposes of section 351.
Therefore, if the preferred stock received by X is
nonqualified preferred stock, X’s exchange of T stock will
be fully taxable
Section 351 and Section 304
a.
section 304 takes precedence over section 351 when both sections,
by their terms, apply -- section 304(b)(3), amended by the Deficit
Reduction Act of 1984, section 712(l)
b.
pre-DEFRA 84 -- see Gunther v. Commissioner, 92 T.C. 39
(1989), aff'd, 909 F.2d 291 (7th Cir. 1990) (section 351 takes
precedence over section 304)
c.
see discussion of section 304 at Part XVII, infra
Disclosure Requirements and Ruling Requests
1.
2.
Disclosure -a.
Treas. Reg. § 1.351-3 sets forth information to be filed with the
IRS and records to be maintained in a section 351 transaction
b.
requirements apply to both transferor and transferee corporation
Ruling requests
a.
Rev. Proc. 2000-1, 2000-1 I.R.B. 4, sets forth procedures for
issuing ruling letters
b.
Rev. Proc. 83-59, 1983-2 C.B. 575, sets forth information to be
included in a section 351 request for rulings
c.
Rev. Proc. 2000-3, 2000-1 I.R.B. 103
- 71 (1)
section 3.01(22) -- IRS will not rule on whether section 351
applies to an exchange of stock for stock in the formation
of a holding company, and whether the taxpayer is subject
to the consequences of qualification under that section that
are adequately addressed by a statute, regulation, decision
of the Supreme Court, tax treaty, IRS ruling or other
authority published in the I.R.B.
(a)
in a change from the previous no-rule position, the
Service will rule on transfers of stock to a
controlled corporation where such transfers are
undertaken prior to the distribution of the stock of
the controlled corporation in a transaction
qualifying under section 355
(b)
in its discretion, the Service will also rule on
significant subissues that must be resolved to
determine whether a transaction that is in the norule area qualified under section 351, provided that
such subissues are, in the view of the Service,
significant and not adequately resolved by any other
authority
(2)
section 4.01(30) -- IRS ordinarily will not rule on the tax
effect of issuing evidences of indebtedness (notes, bonds,
debentures) in a section 351 transaction and on the tax
effect of a transaction where section 351 treatment depends
on debt/equity determination
(3)
section 4.01(31) -- IRS ordinarily will not rule on whether
section 351 applies to a transfer of an interest in real
property by a "cooperative housing corporation" to a
corporation if the transferee engages in commercial activity
with respect to the real property interest transferred
(4)
section 5.16 -- IRS will not rule (until study completed) on
whether section 351 applies to a transfer of widely-held
property (real estate, oil and gas interests) in exchange for
stock if (a) the stock is issued in a form designed to make it
readily tradable or (b) the transfer was initiated by a
promoter, broker, or investment house
d.
Rev. Proc. 77-37, 1977-2 C.B. 568, sets forth rules for issuing
ruling letters when stock issued for property of relatively small
value
e.
Rev. Proc. 85-22, 1985-1 C.B. 550, sets forth guidelines for
contingent stock and escrowed stock rulings
- 72 III.
DISTRIBUTIONS
A.
Preliminary Concepts
1.
Issue -- once corporation has been formed and is operating, how should
transfers ("distributions") of corporate property to shareholders with
respect to their stock be treated for tax purposes
2.
Policy options
a.
corporations and shareholders are separate taxpayers -- cannot use
"flow-through" approach -- compare:
(1)
parent-subsidiary relationship
(2)
section 243 dividends received deduction
(a)
(3)
b.
note: OBRA 87 reduced the dividends received
deduction from 80% to 70% if the corporate
shareholder owns less than 20% of the distributing
corporation's stock (determined by vote and value) - section 243(a) and (c)
consolidated returns
parameters of tax to shareholder
could make all distributions to shareholders ordinary income -rejected because may subject shareholder to tax on a return of
capital
c.
(1)
limit ordinary income treatment to distributions that
represent corporate earnings -- adopted
(2)
limit ordinary income to distributions from earnings earned
while shareholder held stock -- rejected
(a)
shareholder buys stock of ongoing corporation and
purchase price reflects corporate earnings -distribution of preacquisition earnings taxed to
shareholder
(b)
United States v. Phellis, 257 U.S. 156 (1921)
integration proposals modify double tax concept
(1)
flow-thru treatment
(2)
deduction to corporation for dividends paid
(3)
credit to shareholders for corporate tax paid
- 73 -
B.
C.
IV.
Statutory Framework
1.
Section 301 - tax treatment of distributee shareholder
2.
Section 311 - tax treatment of distributing corporation
3.
Section 312 - earnings and profits
4.
Section 316 - definition of dividend
5.
Section 317(a) - definition of property
Types of Distributions
1.
Distribution of money
2.
Distributions of property (other than money)
3.
Distributions of the corporation's own obligations
4.
Distributions of the corporation's own stock
5.
Distributions in redemption of stock
SECTION 301 -- TAX TREATMENT OF DISTRIBUTEE
A.
Section 301(a) -- General Concepts
1.
A "distribution" of "property" made by a corporation to a shareholder
"with respect to its stock" shall be treated in the manner provided in
section 301(c)
2.
"Distribution" -- can be read as "payment"
3.
4.
a.
actual distribution
b.
constructive distribution
"Property" -- defined in section 317(a)
a.
includes money, securities and any other property except stock in
the distributing corporation or rights to acquire such stock -- see
Bhada v. Commissioner, 89 T.C. 959 (1987), aff'd, 892 F.2d 39
(6th Cir. 1989) (defining "property" in section 304 context); PLR
8748049 ("property" includes vouchers to purchase company's
product at discount)
b.
section 305 governs distributions of stock
"With respect to its stock"
a.
Treas. Reg. § 1.301-1(c) -- payment to shareholder in capacity as
shareholder
- 74 b.
B.
does not include
(1)
compensation to shareholder/employee -- see Melvin v.
Commissioner, 88 T.C. 63 (1987), aff'd on other grounds,
894 F.2d 1072 (9th Cir. 1990) (personal use of
corporation's cars was constructive dividend not
compensation)
(2)
payment for property to shareholder/vendor -- see Litton
Industries, Inc. v. Commissioner, 89 T.C. 1086 (1987)
(parent held to receive dividend and not proceeds from sale
of subsidiary where dividend and sale were separate
transactions)
(3)
rental payments to shareholder/lessor
(4)
interest payments to shareholder/creditor
(5)
royalty payments to shareholder/patent holder -- Belknap v.
Commissioner, 57 T.C.M. 301 (1989) (reasonable royalty
payments not recharacterized as dividends)
Section 301(b) -- Amount Distributed
1.
2.
3.
General rule -- section 301(b)(1)
a.
amount of money, plus
b.
fair market value of property received
TAMRA 88 retroactively repealed section 301(b)(1)(B), effective January
1, 1987 -- under old section 301(b)(1)(B), the amount of a distribution for
a corporate distributee was -a.
amount of money, plus
b.
lesser of
(1)
fair market value of property received, or
(2)
basis of property received (in hands of distributing
corporation) plus gain recognized to distributing
corporation
TAMRA 88 also retroactively repealed section 301(b)(1)(C) and (D),
effective January 1, 1987
a.
special rules for distributions from a foreign corporation to
corporate shareholder
b.
special rules for distributions to a foreign corporate shareholder
- 75 -
4.
Reduction for liabilities -- section 301(b)(2)
a.
b.
5.
6.
C.
amount of distribution reduced by
(1)
amount of liability assumed by shareholder, and
(2)
amount of liability to which property is subject
liabilities cannot reduce distribution below zero
Fair market value of property distributed -- section 301(b)(3)
a.
determined as of the date of distribution
b.
whether or not the same date is used to include the distribution in
the shareholder's income -- Treas. Reg. § 1.301-1(b)
Distribution is taxable to shareholder
a.
on receipt, or
b.
when unqualifiedly made subject to his demand
(1)
Treas. Reg. § 1.301-1(b)
(2)
this determination is based on (1) the shareholder's
unrestricted legal right to demand payment at any time,
(2) no agreement involving shareholders to defer payment,
and (3) the ability of the corporation to fulfill the dividend - see Moser v. Commissioner, 56 T.C.M. 1604 (1989);
Bush Bros. & Co. v. Commissioner, 73 T.C. 424 (1979),
aff'd, 668 F.2d 252 (6th Cir. 1982)
(3)
constructive receipt doctrine -- Treas. Reg. § 1.451-1(a)
and -2(a)
Section 301(c) -- Amount Taxable
1.
Dividend -- section 301(c)(1) -- portion of distribution which is a dividend
is included in income -- section 316 defines dividend
2.
Return of capital -- section 301(c)(2) -- portion of distribution which is not
a dividend shall reduce the shareholder's stock basis
3.
Sale or exchange -- section 301(c)(3)(A) -- portion of distribution which is
not a dividend and which exceeds shareholder's stock basis shall be treated
as gain from the sale or exchange of property
a.
note: after TRA 86, corporate capital gain income is taxed at the
same rate as ordinary income
- 76 -
D.
E.
V.
Section 301(d) -- Basis of Property to Distributee
1.
Basis of property to distributee is fair market value of property
2.
TAMRA 88 retroactively repealed section 301(d)(2), which provided that
basis for a corporate distributee was the lesser of
a.
fair market value of property, or
b.
adjusted basis of property (in hands of distributing corporation)
plus gain recognized by distributing corporation
Section 301(e) – Special Earnings and Profits Rules
1.
DEFRA 84, OBRA 87, and TAMRA 88 added special rules to cover
distributions to corporate shareholders
2.
Section 301(e) earnings and profits computed without regard to
section 312(k) (accelerated depreciation) and section 312(n) (economic
gain or loss) for purposes of determining taxable income of corporate
shareholders owning 20% or more of the stock of the distributing
corporation
3.
TAMRA 88 retroactively repealed old section 301(e) which determined
the holding period of property distributed to a corporate shareholder where
section 311(b)(1) applied to the distribution (note that old section 301(e)
erroneously stated section 311(d)) -- legislative history to TAMRA 88
indicates that old section 301(e) was repealed as deadwood, since the
holding period of distributed property begins on the date of distribution
SECTION 316 -- WHAT IS A DIVIDEND
A.
Introduction
1.
Dividend for Federal tax purposes does not necessarily correspond to state
law definition of dividend
2.
A distribution may be taxable as a dividend even though it impairs
corporate capital
3.
A distribution may be a dividend under state law and not a dividend for
Federal tax purposes -- see Rev. Rul. 90-11, 1990-1 C.B. 10 (adoption of a
"poison pill" plan does not constitute a distribution of stock or property by
the corporation to its shareholders, although under state law, adoption of
plan constituted a dividend; purpose of plan was to establish a mechanism
by which corporation could in the future provide shareholders with rights
to purchase stock at substantially less than fair market value in response to
"unsolicited" tender offers)
- 77 4.
B.
TAM 8022010 -- X corporation distributes cash to partnership Z, its sole
shareholder, which then distributes cash to its partners which included X -held: X is not taxed on the portion of its income received through Z
Section 316(a) -- General Rule
1.
2.
A dividend is a distribution of property out of:
a.
earnings and profits accumulated after February 28, 1913 -accumulated earnings and profits
b.
earnings and profits of the taxable year -- current earnings and
profits
Earnings and profits -- section 312
a.
discussed in greater detail below
b.
not the equivalent of earned surplus or retained earnings -accounting concepts
c.
not the equivalent of taxable income
3.
Accumulated earnings and profits reflect the financial success or failure of
the corporation over its history -- if the corporation is profitable the
distribution is taxed as a dividend
4.
Current earnings and profits
5.
a.
determined as of the close of the taxable year
b.
without reduction for distributions made during the year
c.
without regard to earnings and profits at the time of the distribution
(1)
may have earnings and profits at the time of the distribution
and no earnings and profits at the close of the year -- the
distribution is not taxed as a dividend
(2)
may have a deficit at the time of the distribution and
positive earnings and profits at the close of the year -distribution is taxed as a dividend
Operating rules
a.
every distribution is made out of earnings and profits to the extent
available -- cannot earmark
b.
a distribution is deemed to come first from current earnings and
profits and then the most recent accumulated earnings and profits
(reverse chronological order) -- section 316(a); Treas. Reg.
§ 1.316-2(a)
- 78 c.
a distribution covered by current earnings and profits is taxed as a
dividend even if the corporation has an accumulated deficit which
exceeds current earnings and profits --- i.e., do not net current
earnings and profits with accumulated deficit
d.
if cash distributions exceed current earnings and profits then
current earnings and profits are prorated among each distribution -Treas. Reg. § 1.316-2(b)
e.
f.
(1)
excess distributions are taxable as a dividend to extent of
accumulated earnings and profits
(2)
accumulated earnings and profits are not applied pro rata -determine accumulated earnings and profits available at the
date of distribution -- i.e., apply earnings and profits to first
distribution and any excess carries to subsequent
distributions
(3)
current deficit in earnings and profits prorated over year to
determine available accumulated earnings and profits at
date of distribution -- however, if can determine the date
the deficit is incurred, need not prorate current deficit
whether distribution is from current or accumulated earnings and
profits is relevant if
(1)
stock ownership changes during the year
(2)
the distributing corporation and the shareholders are on
different taxable years
if the corporation has no current or accumulated earnings and
profits the distribution cannot be a dividend
(1)
section 301(c)(2) and (3) apply
(2)
first reduce stock basis, to the extent the distribution
exceeds the stock basis, the excess is gain
(3)
(a)
unclear if recover aggregate basis on all shares or if
determine on a share-by-share basis
(b)
if share-by-share basis applied, then non-dividend
distribution can trigger gain in some shares before
all basis recovered -- see Johnson v. United States,
435 F.2d 1257 (4th Cir. 1971); see also Anderson v.
Commissioner, 92 T.C. 138, 145 n.5 (1989)
section 301(c)(3) -- excess over basis is capital gain (if
stock is a capital asset)
- 79 g.
6.
the taxpayer has the burden to establish that a corporate
distribution is a return of capital and that the corporation has no
current or accumulated earnings or profits -- see Estate of Foster v.
Commissioner, 56 T.C.M. 163 (1988); Commissioner v. Delgado,
55 T.C.M. 155 (1988)
Examples
a.
on January 1, 1996, corporation X has accumulated earnings and
profits of $25,000; in 1996 X has $15,000 of current earnings and
profits -- X distributes $10,000 to its shareholders on July 15,
1996 -- the distribution (which is covered by current earnings and
profits) is taxable as a dividend and the accumulated earnings and
profits at the end of 1996 are $30,000
b.
assume the same facts as above, except X distributes $20,000 -- the
distribution is taxable as a dividend -- $15,000 out of current
earnings and profits and $5,000 out of accumulated earnings and
profits -- accumulated earnings and profits at the end of 1996 are
$20,000
c.
on January 1, 1996, corporation Y has an accumulated deficit of
($15,000); in 1996 Y has current earnings and profits of $12,000
and Y distributes $8,000 to its shareholders -- the distribution is
taxable as a dividend despite the accumulated deficit -- Y's
accumulated deficit at the end of 1996 is reduced to ($11,000) -($15,000) plus $4,000 of undistributed current earnings and profits
d.
if Y had waited until 1997 to make the distribution, the distribution
would not have been taxable as a dividend (assuming Y had no
current earnings and profits in 1997)
e.
on January 1, 1996, corporation Z has $25,000 of accumulated
earnings and profits; in 1996 Z has current earnings and profits of
$20,000 -- Z distributes $15,000 in March, June, September, and
December -- current earnings and profits are allocated pro rata and
the balance of the distributions are covered by accumulated
earnings and profits in chronological order as shown -Current Accumulated Total
Date
March
June
September
December
Amount
15,000
15,000
15,000
15,000
E&P
5,000
5,000
5,000
5,000
E&P
10,000
10,000
5,000
---
Dividend
15,000
15,000
10,000
5,000
- 80 f.
7.
Other operating rules
a.
b.
VI.
on January 1, 1996, corporation Z has $20,000 of accumulated
earnings and profits; in 1996 Z has a current deficit of ($16,000) -Z distributes $20,000 on July 1, 1996 -- the deficit is prorated
unless it can be specifically allocated -- thus, as of July 1 available
earnings and profits are $12,000 ($20,000 less 1/2 of $16,000
deficit) and $12,000 of the distribution is taxed as a dividend
current earnings and profits are allocated first to distributions on
"priority" classes of stock -- preferred stock absorbs earnings and
profits before common stock
(1)
Rev. Rul. 69-440, 1969-2 C.B. 46
(2)
unclear if same rule applies for accumulated earnings and
profits or if they are allocated based on date of distribution
distribution and redemptions
(1)
current earnings and profits are allocated first to
distributions then to section 302(a) redemptions -- see
below
(2)
accumulated earnings and profits are allocated to
distributions and redemptions based on time of the
transaction
(3)
see Rev. Rul. 79-376, 1979-2 C.B. 133; Rev. Rul. 74-338,
1974-2 C.B. 101; Rev. Rul. 74-339, 1974-2 C.B. 102
SECTION 312 -- EARNINGS AND PROFITS
A.
Introduction
1.
The term "earnings and profits" is not defined in the Code or regulations
a.
section 312 specifies the effect of distributions on earnings and
profits
b.
section 312 also sets forth certain special earnings and profits rules
2.
Earnings and profits also has no counterpart in corporate law
3.
Rev. Proc. 75-17, 1975-1 C.B. 677, sets forth guidelines for determining
earnings and profits
4.
Effect on earnings and profits is a no ruling area -- Rev. Proc. 2000-3,
section 3.01(21), 2000-1 I.R.B. 103
5.
Statute of limitations is not applicable to earnings and profits -- keep
permanent records
- 81 6.
B.
Generally do not need to know earnings and profits with precision -exceptions: sections 531, 902, 951, 1248
Concept of Earnings and Profits
1.
Measurement of profit in broad economic terms
2.
Stated differently, the corporation's ability to make a distribution
3.
Earnings and profits are not equal to taxable income; also not equal to
surplus -- there is a relationship among all three
schedule M on tax return -- reconcile income and surplus
4.
C.
To determine earnings and profits, start with taxable income and make
adjustments
Calculation of Earnings and Profits -- Taxable Income Subject to Adjustments -Treas. Reg. § 1.312
1.
2.
Additions to taxable income (items excluded from taxable income must be
added back)
a.
tax exempt municipal bond interest -- section 103
b.
life insurance proceeds -- section 101; Rev. Rul. 54-230, 1954-1
C.B. 114
c.
cancellation of indebtedness income excluded under section 108,
to the extent the taxpayer does not reduce basis in property under
section 1017 -- section 312(l)(1)
Deductions from taxable income not deductible for earnings and profits
(deductions which do not represent actual expenses)
a.
excess of percentage depletion over cost depletion
b.
dividends-received deduction -- section 243
c.
net operating loss deductions -- section 172
d.
capital loss carryback and carryover -- section 1212
e.
excess of accelerated depreciation over straight line -section 312(k)(1)
f.
accelerated cost recovery system ("ACRS") -- must use new
section 168(g)(2) alternative depreciation system -section 312(k)(3)
- 82 -
(1)
Property Classification
E&P Period
Personal property with
12 years no class life
nonresidential real property 40 years
residential rental property
40 years
all other property the class life
(2)
3.
4.
section 168(i)(1) -- "class life" means class life under
section 167(m) as of January 1, 1986, as modified by
section 168(g)(3)
Items not deductible from taxable income can be deducted from earnings
and profits (expenses which deplete cash available for distributions)
a.
dividend distributions in prior years -- section 312(a)
b.
federal income taxes
c.
expenses incurred in earning tax exempt interest -- section 265
d.
excess charitable contributions -- section 170(b)(2)
e.
excessive compensation
f.
life insurance premiums -- section 264
g.
excess capital losses
h.
nondeductible losses under section 267
i.
lobbying expenses - section 162(e)
j.
political contributions
k.
unclear whether earnings and profits are reduced for nondeductible
expenses under section 162(c) -- against public policy
l.
section 964(a) -- earnings and profits are not decreased by foreign
kickbacks -- cf. Rev. Rul. 77-442, 1977-2 C.B. 264
DEFRA 84 and TRA 86 added the following rules for computing earnings
and profits to more accurately reflect "economic gains and losses":
a.
increase earnings and profits on a distribution of property to the
extent that the FMV of the property exceeds its adjusted basis -section 312(b)(1) -- see Rev. Rul 87-1, 1987-1 C.B. 132
b.
capitalization of construction period carrying charges -section 312(n)(1)
- 83 -
5.
6.
c.
capitalization and amortization of intangible drilling costs -section 312(n)(2) -- OBRA 89 amended section 312(n)(2)(A)(ii) to
allow deduction ratably over 60 month period beginning with
month "in which amount was paid or incurred" instead of "in
which the production from the well begins"
d.
capitalization of deductions allowed under section 173 and 248 -section 312(n)(3)
e.
increase earnings and profits to reflect changes in the LIFO
recapture amount -- section 312(n)(4) (as redesignated by TRA 86)
f.
current reporting of gain from installment sales -- section 312(n)(5)
(as redesignated by TRA 86)
g.
must report long-term contracts on the percentage completion basis
-- section 312(n)(6) (as redesignated by TRA 86)
h.
in connection with redemptions, reduction of earnings and profits
only to the extent of the redeemed stock's "ratable share" of
earnings and profits -- section 312(n)(7) (as redesignated by TRA
86)
OBRA 87 added the following rules for determining adjustments to basis
of intragroup stock when such stock is disposed of and results in gain or
loss for purposes of section 1503 -a.
earnings and profits shall be determined as if section 312 were
applied for the taxable year and all preceding consolidated years
without regard to section 312(k) and section 312(n) (reverses
Woods Investment Co. v. Commissioner, 85 T.C. 274 (1985))
b.
earnings and profits shall not include any amount excluded from
gross income under section 108 to the extent the amount excluded
was not applied to reduce tax attributes other than basis in property
c.
the adjustments to basis are made solely to determine gain or loss
on disposition of intragroup stock and not to affect the earnings
and profits for any other purpose, such as the character of the
distribution
d.
the changes to section 1503 described in a. through c. supra are
made irrelevant by Treas. Reg. § 1.1502-32 which determines the
basis of intragroup stock by means of a hybrid measure of taxable
income (i.e., basis is no longer measured by reference to earnings
and profits)
As noted above, OBRA 87 amended the present section 301(e) so that
earnings and profits are computed without regard to section 312(k)
(accelerated depreciation) and section 312(n) (economic gain or loss) for
- 84 purposes of determining taxable income of corporate shareholders owning
20% or more of the stock of the distributing corporation
7.
Tax accounting principles and earnings and profits
a.
b.
D.
method of accounting used to determine taxable income is used to
calculate earnings and profits
(1)
cash or accrual
(2)
installment reporting
(3)
inventory method
accounting for dividends -- generally reduce earnings and profits
on date of payment, not date dividend declared -- Rev. Rul. 62131, 1962-2 C.B. 94 -- however, different rules may apply to
consolidated dividends -- see Treas. Reg. § 1.1502 - 32(f)(2)
Effect of Distribution on Earnings and Profits -- Section 312(a) and Treas. Reg.
§ 1.312-1
1.
Distribution of property by corporation with respect to its stock reduces
earnings and profits by
a.
amount of money
b.
principal amount of the debt obligations of the distributing
corporation
(1)
c.
if a corporation distributes its own discount obligation,
earnings and profits are reduced by the issue price of the
obligation
adjusted basis (or fair market value if higher) of other property
2.
Earnings and profits are not reduced below zero by a distribution
(although deficits in earnings and profits may result from operations)
3.
Reduction in earnings and profits is the same whether the recipient
shareholder is an individual or a corporation
4.
Earnings and profits reduction rule applies regardless of how the recipient
shareholder is taxed
5.
Earnings and profits are increased by the excess of fair market value over
the adjusted basis of appreciated property distributed by the corporation
(except for the corporation's obligations)
- 85 -
VII.
DISTRIBUTIONS OF PROPERTY IN KIND -- (EFFECT ON DISTRIBUTING
CORPORATION AND EARNINGS AND PROFITS)
A.
Introduction
1.
2.
B.
The tax consequences of a distribution of cash are easily determined
a.
to the shareholder -- distribution is a dividend to the extent of
earnings and profits and the excess is a return of capital or capital
gain
b.
to the corporation -(1)
the distributing corporation recognizes no gain or loss -section 311(a)
(2)
earnings and profits are reduced to the extent of the cash
Property distributions are more difficult
a.
does a distribution of appreciated property create income or
earnings and profits to the distributing corporation
b.
does a distribution of depreciated property produce a loss
c.
how are earnings and profits affected
Distributing Corporation -- Effect of Distribution of Property -- Old Section 311
1.
2.
Background
a.
Pre-1954 -- Treasury took the position that a corporation
recognized gain on a distribution of appreciated property
b.
General Utilities & Operating Co. v. Helvering, 296 U.S. 200
(1935), is generally held to stand for the proposition that a
distribution of appreciated property does not result in gain (or loss)
to the distributing corporation
c.
old section 311(a) -- codification of General Utilities
d.
TRA 86 repealed the General Utilities doctrine (subject to certain
transitional rules) -- general rule now is that gain (but not loss) is
recognized by the corporation on nonliquidating distributions of
property -- new section 311, added by TRA 86
(1)
old section 311 is covered in Part VII.B.2., infra
(2)
new section 311 is covered in Part VII.C, infra
Old section 311(a) -- a corporation generally did not recognize gain or loss
on a distribution of its stock or property -- exceptions:
- 86 a.
LIFO inventory -- corporation recognizes income equal to the
LIFO reserve -- FIFO value less LIFO value of inventory
distributed (can use inventory method other than FIFO) -section 311(b)
b.
liabilities exceed basis -- corporation recognizes gain equal to the
difference between the liability and the basis of the asset -section 311(c)
c.
(1)
liabilities are allocated on an asset-by-asset basis, not in the
aggregate -- H&M Auto Electric, Inc. v. Commissioner, 92
T.C. 1269, (1989) (bank note secured by property allocated
to the property that secures the note; unsecured liability
allocated among all the properties distributed according to
the relative fair market values of the distributed assets);
Rev. Rul. 80-283, 1980-2 C.B. 108
(2)
liabilities considered include nonrecourse debt -section 7701(g)
(3)
character of gain on the distribution is also determined on
an asset-by-asset basis, by looking at the distributing
corporation -- H&M Auto Electric, supra
distribution of appreciated property -- corporation recognizes gain
upon a nonliquidating distribution of appreciated property -section 311(d)(1)
(1)
example
X corporation distributes property with a FMV of $10,000
and a basis of $5,000 to its sole individual shareholder A -X recognizes $5,000 of gain on the distribution
(2)
exceptions to section 311(d)(1)
(a)
redemption from noncorporate shareholder in
partial liquidation -- section 311(d)(2)(A)(i)
(b)
distribution to noncorporate shareholder of property
used by corporation in active business (which is not
section 1221(1) or (4) property), which is a
dividend -- section 311(d)(2)(A)(ii)
(c)
certain distributions of stock or obligations of
controlled corporations -- section 311(d)(2)(B) and
(e)(2) -- see Esmark, Inc. v. Commissioner, 90 T.C.
171 (1988) aff'd without published opinion, 886
F.2d 1318 (7th Cir. 1989)
- 87 -
d.
(d)
distributions to which section 303(a) apply -section 311(d)(2)(C)
(e)
distributions to a private foundation in redemption
of certain stock -- section 311(d)(2)(D)
(f)
redemption of regulated investment company stock
upon demand of the shareholder -section 311(d)(2)(E)
installment obligations -- section 453B and section 311(a)
(1)
corporation recognizes gain equal to FMV of obligation
less its basis
(2)
Rev. Rul. 74-337, 1974-2 C.B. 94
e.
recapture of depreciation, depletion, and intangible drilling costs -sections 291, 1245, 1250, 1254
f.
investment tax credit recapture -- section 47
g.
other statutory provisions included in Treas. Reg. § 1.311-1(a)
h.
distribution of property for which corporation previously claimed a
deduction -- Commissioner v. First State Bank of Stratford, 168
F.2d 1004 (5th Cir.), cert. denied, 335 U.S. 867 (1948)
i.
corporation negotiates a sale of its property but distributes the
property to its shareholder and the shareholder sells -- sale imputed
to corporation -- Court Holding doctrine -- Treas. Reg. § 1.3111(a)
j.
(1)
Rust Communications Group, Inc. v. United States, (U.S.
Claims Ct. No. 604-87T, May 14, 1990) (summary
judgment denied on company's partial liquidation followed
by shareholders' asset sale because the trial court had to
examine motive, intent and conduct of the corporation to
see if transaction was indeed a genuine shareholder sale)
(2)
see also Hines v. United States, 477 F.2d 1063 (5th Cir.
1973); United States v. Lynch, 192 F.2d 718 (9th Cir.
1951), cert. denied, 343 U.S. 934 (1957); Bush Bros. & Co.
v. Commissioner, 73 T.C. 424 (1979), aff'd, 668 F.2d 252
(6th Cir. 1982); but see Anderson v. Commissioner, 92
T.C. 138 (1989) (sale not imputed to corporation)
assignment of income principles
- 88 -
C.
Distributing Corporation -- Effect of Distribution of Property -- New Section 311
1.
Following TRA 86, general rule is that corporations must recognize gain
(but not loss) on a distribution of property with respect to its stock -- new
section 311(a) and (b)
a.
gain recognized as if corporation sold the property to a buyer at its
FMV -- new section 311(b)(1)
FMV determined as if the corporation had sold the property at the
time of the distribution, not determined by value of the property in
the hands of the shareholder -- Pope & Talbot v. Commissioner,
104 T.C. 574 (1995), aff’d, 83 A.F.T.R.2d ¶ 99-319 (9th Cir. 1999)
cf. Rev. Rul. 87-96, 1987-2 C.B. 209 -- section 311(b) gain from
distribution of appreciated stock of controlled foreign corporation
treated as a sale under section 1248(a) and deferred under
consolidated return regulations
2.
b.
FMV may not be less than any liability assumed by the shareholder
or to which the property is subject -- new section 311(b)(2); cf.
section 7701(g) (for all purposes of the Code, the fair market value
of property subject to nonrecourse debt will be treated as at least
equal to the amount of such debt)
c.
TRA 86 repealed four out of five of the exceptions for
nonrecognition treatment contained in old section 311(d)
(1)
fifth exception -- old section 311(d)(2)(E), dealing with the
redemption of regulated investment company stock upon
demand of the shareholder, was moved to new
section 852(b)
(2)
repeal intended to create parity between liquidating and
nonliquidating distribution, i.e., gain recognition on both
types of distributions
New section 311(b) applies only to "distributions to which Subpart A
applies"
a.
Subpart A includes sections 301-307 (e.g., redemptions and
dividend distributions)
b.
distributions in complete liquidation covered by new sections 336337
c.
section 355 transactions and distributions occurring in
reorganizations generally are not covered
- 89 -
D.
3.
Section 311 applies only if corporation distributes property "with respect
to its stock" -- distributions to shareholders in their capacity as creditor,
employee, etc. are not covered by section 311 -- Former Treas. Reg.
§ 1.311-1(e)(1)
4.
New section 311(b), subject to transitional rules, applies to nonliquidating
distributions made after December 31, 1986
5.
TAMRA 88 provides that section 311 applies to section 351 exchanges
which are not pursuant to a plan of reorganization (see new section 351(f))
(effective on or after June 21, 1988) and to certain section 355 transactions
which are not pursuant to a plan of reorganization (see new
section 355(c)), and that section 311 does not apply to distributions to
shareholders pursuant to a plan of reorganization in accordance with
section 361(c)(1) (see new section 361(c)(4))
6.
TAMRA 88 added new section 311(b)(3), providing that if a partnership
or trust interest is distributed, the IRS may issue regulations preventing
any loss on property that was contributed to the partnership or trust from
reducing the amount of gain recognized on the distribution
7.
TRA 86, as amended by TAMRA 88, provided in section 337(d) that the
IRS could issue regulations to preclude avoidance of the repeal of the
General Utilities doctrine -- pursuant to this authority, the IRS has issued
regulations, Prop. Treas. Reg. § 1.337(d)-3, 57 Fed. Reg. 59,327 (1992),
providing that section 311(b), rather than the general nonrecognition rule
of section 731(a), will be applicable whenever a partner receives a
distribution of its own stock or stock of any member of the affiliated group
of which the partner is a member -- Notice 89-37, 1989-1 C.B. 679,
modified by Notice 93-2, 1993-1 C.B. 292
Earnings and Profits -- Effect of Distribution of Property
1.
Section 312(a) -- general rule is to decrease earnings and profits by the
basis of the property distributed
2.
Section 312(b) -- appreciated property
a.
b.
if the FMV of distributed property exceeds its adjusted basis -earnings and profits are adjusted as follows –
(1)
earnings and profits are increased by excess of FMV over
adjusted basis -- section 312(b)(1)
(2)
earnings and profits are decreased by the FMV of the
property -- section 312(a)(3) and (b)(2)
definition -- adjusted basis is the property's adjusted basis for
earnings and profits purposes
- 90 c.
example:
X corporation has $5,000 of earnings and profits -- X distributes
property with a FMV of $10,000 and a basis of $5,000 to its
individual sole shareholder A
d.
3.
(1)
X recognizes $5,000 of gain on the distribution (new
section 311(b)) which creates an additional $5,000 of
earnings and profits (ignoring tax liability)
(2)
earnings and profits are reduced by $10,000 -- the FMV of
the property (section 312(b))
TAMRA 88 excludes from the meaning of property in
section 312(b) any obligation of the corporation
Section 312(c) -- adjustments for liabilities
a.
reduction in earnings and profits on a distribution is itself reduced
for liabilities assumed by the shareholder -- Treas. Reg. § 1.312-3
b.
example:
corporation X distributes to its sole shareholder, individual A,
property having an FMV of $5,000 and an adjusted basis for
earnings and profits purposes of $3,000 -- A takes the property
subject to a mortgage of $2,000
VIII.
(1)
X increases earnings and profits by $2,000 ($5,000 $3,000)
(2)
X reduces earnings and profits by $3,000 ($5,000 - $2,000)
CONSTRUCTIVE DISTRIBUTIONS
A.
In General
1.
Section 301 applies only if there is a distribution to a shareholder in his
capacity as a shareholder
2.
Section 301 may apply if a shareholder derives an economic benefit from
the corporation even though not formally declared -- constructive
distribution -- see P.R. Farms, Inc. v. Commissioner, 820 F.2d 1084 (9th
Cir. 1987)
a.
Treas. Reg. § 1.301-1(j), (l), and (n)
b.
need not constitute a distribution for state law
c.
can be made to only a few shareholders
d.
applies most often to closely held corporations
- 91 3.
B.
If the corporation has earnings and profits the distribution will be taxed as
a dividend
Examples of Constructive Dividends
1.
2.
Corporate loan to shareholder -- no intent to repay -- Jacques v.
Commissioner, 935 F.2d 104 (6th Cir. 1991) (taxable income and not
loans where sole owner of professional corporation did not intend to repay
cash withdrawals and made only small sporadic repayments); Alterman
Foods, Inc. v. United States, 611 F.2d 866 (Ct. Cl. 1979); Sprague v.
Commissioner, 56 T.C.M. 1511 (1989); Thielking v. Commissioner, 53
T.C.M. 746 (1987); TAM 8749002; cf. McGee v. Commissioner, 62
T.C.M. 1375 (1991) (withdrawals from closely held corporation bona fide
loans, not dividends; loans recorded as such and repaid); In re: Clement
Betpouey III, 82 AFTR2d ¶ 98-5373 (1998) (cash advances to sole
shareholder held to be bona fide loans even though not evidenced by loan
formalities, fact that shareholder was able to repay and made some
attempts to repay were sufficient)
a.
corporation assumes shareholder debt --dividend on payment -Rev. Rul. 77-360, 1977-2 C.B. 86
b.
novation of debt -- dividend at time of transfer (not on payment) -Rev. Rul. 78-422, 1978-2 C.B. 129
c.
corporation assumes corporate shareholder's debt -- dividend on
assumption -- PLR 9133025
Corporate loan to shareholder -- no interest or below market interest -section 7872, added by DEFRA 84
a.
b.
term loans -- taxable dividend to shareholder equal to difference
between the amount loaned and present value of all payments due
under the terms of the loan
(1)
present value determined using applicable federal rate
(AFR) as the discount rate
(2)
difference generates OID -- section 7872(b)(2)
(3)
OID must be taken into income currently by corporation
under OID principles -- section 1272 et seq.
demand loans
(1)
triggers annual dividend to shareholder equal to that year's
"foregone interest"
(2)
"foregone interest" -- difference between amount payable
and amount that would have been payable if AFR had been
charged
- 92 3.
4.
Shareholder loan to corporation -- debt treated as equity
a.
section 385
b.
payment on debt treated as dividend distribution on stock -- See
Ward v. Commissioner, 53 T.C.M. 685 (1987)
c.
foregone interest on demand loan made by sole shareholder to a
corporation is included in the shareholder's gross income as
interest -- McGinnis v. Commissioner, T.C. Memo 1993-45
Corporate payment for shareholder benefit
a.
Old Colony Trust Co. v. Commissioner, 279 U.S. 716 (1929) -employee has income when his legal obligations are paid by
employer -- see also Hagaman v. Commissioner, 54 T.C.M. 992
(1987)
b.
was corporate expenditure incurred principally to benefit business
or shareholder
c.
result -- disallow corporate deduction and treat as dividend to
shareholder
d.
examples:
e.
(1)
corporation owns and cares for boat used by shareholder -Security Associates Ins. Corp. v. Commissioner, 53 T.C.M.
1239 (1987)
(2)
corporation pays personal expenses of shareholder -Bennett v. Commissioner, 53 T.C.M. 403 (1987)
(3)
personal use of cars, planes, etc.-- L&L Marine Service,
Inc. v. Commissioner, 54 T.C.M. 312 (1987)
(4)
corporation assumes shareholder's obligation to purchase
decedent's stock -- Ross v. Commissioner, 58 T.C.M. 1200
(1990); Gerson v. Commissioner, 56 T.C.M. 1202 (1989)
(5)
corporation pays shareholder's personal obligations -Sparks Farm, Inc. v. Commissioner, 56 T.C.M. 464 (1988)
cf. Gulf Oil Corp. v. Commissioner, 914 F.2d 396 (3d Cir. 1990) -payments in form of insurance premiums to captive insurance
company are not constructive dividends
5.
Bargain purchase or bargain use of corporate property
6.
Excessive payment by corporation to shareholder for
a.
purchase of shareholder property
- 93 -
C.
b.
rental of shareholder property
c.
compensation -- Rutter v. Commissioner, 853 F.2d 1267 (5th Cir.
1988)
7.
Advances between related corporations -- constructive dividend to
common shareholder followed by a contribution to capital -- Stinnett's
Pontiac Service, Inc. v. Commissioner, 730 F.2d 634 (11th Cir. 1984),
aff'g, 44 T.C.M. 55 (1982); Morowitz v. United States, 15 Cl. Ct. 62
(1988) (no business purpose for making payments); Scallen v.
Commissioner, 54 T.C.M. 1177 (1987), aff'd, 877 F.2d 1364 (8th Cir.
1989); cf. Schnallinger v. Commissioner, 52 T.C.M. 1311 (1987)
(advances were bona fide loans)
8.
Rev. Proc. 87-22, 1987-1 C.B. 718, provides checklist for request for
ruling under section 1001 so sale of stock by employee-shareholder to
employer's section 401(a) plan not treated as a dividend
9.
Diverted corporate funds constitute constructive dividend to shareholder -Rescigno v. Commissioner, 62 T.C.M. 854 (1991); Delgado v.
Commissioner, 55 T.C.M. 155 (1988); Truesdell v. Commissioner, 89
T.C. 1280 (1987)
Limits on Abuse of Distribution Transactions
1.
2.
Section 246A may limit the dividends-received deduction where a
shareholder invests in dividend-paying stocks with borrowed funds
"directly attributable" to the investment -a.
to combat this perceived abuse the percentage of the otherwise
allowable dividends-received deduction (70% or 80%) is reduced - however, the limitation does not apply to the 100% dividendsreceived deduction
b.
H Enterprises Int'l Inc. v. Commissioner, 105 T.C. No. 6 (1995),
held that section 246A may apply when one member of an
affiliated group is the borrower and another member is the
purchaser of portfolio stock -- whether the investment in portfolio
stock by one member is directly attributable to borrowings by the
other member is a question of fact
Section 1059 provides that if a corporation receives an extraordinary
dividend on stock that it has not held for more than 2 years, its basis in the
stock will be reduced (but not below zero) by the nontaxed portion of the
dividend.
a.
extraordinary dividends are defined as dividends on preferred stock
that exceed 5% of the taxpayer's adjusted basis in the stock with
respect to which the dividend is distributed and dividends on other
stock that exceed 10% of the taxpayer's adjusted basis in the stock
- 94 -
3.
b.
dividends that have ex-dividend dates within an 85-day period are
treated as one dividend
c.
if the aggregate of dividends that have ex-dividend dates within a
365-day period exceed 20% of the taxpayer's adjusted basis in the
stock, then such dividends are treated as extraordinary dividends
Courts will recharacterize a "dividend" paid by a subsidiary to a parent
where it is used to reduce the parent's tax liability
a.
Waterman Steamship Corporation v. Commissioner, 430 F.2d
1185 (5th Cir. 1970) (dividend paid as a note by a subsidiary to its
parent is recharacterized as part of the purchase price of the
subsidiary by outside purchaser)
b.
Basic Incorporated v. United States, 549 F.2d 740 (Ct. Cl. 1977)
(first-tier subsidiary distributes the stock of a second-tier
subsidiary to the parent corporation prior to the sale by the parent
of the stock of both subsidiaries -- the distribution was
disregarded)
c.
but see TSN Liquidating Corporation, Inc. v. United States, 624
F.2d 1328 (5th Cir. 1980) (distribution of unwanted assets by
subsidiary to its parent prior to parent's sale of the subsidiary stock
is treated as a dividend, not as part of the consideration received
from the sale)
d.
Litton Indus., Inc. v. Commissioner, 89 T.C. 1086 (1987) -- a
dividend was paid, in the form of a promissory note, at a time
when a sale of the distributing corporation was contemplated, but
prior to commencing negotiations -- because the dividend was
declared and paid prior to the time the parent corporation was
committed to a sale of the target, the court held that the dividend
had significance independent of the sale and would be respected
e.
it appears that the two factors which are considered in determining
whether a pre-sale dividend will be respected as such are (i) timing
of the dividend vis-a-vis the sale negotiations and (ii) the origin of
the cash used to pay the dividend -- however, the IRS has recently
been reluctant to apply the binding commitment test in determining
whether to integrate transactions -- see Rev. Rul. 96-30, 1996-1
C.B. 36; Treas. Reg. § 1.351-1(c)(3) superseding Rev. Rul. 78-294,
1978-2 C.B. 141
- 95 IX.
DISTRIBUTION OF CORPORATION'S OWN STOCK
A.
B.
In General
1.
Section 317 -- stock of distributing corporation is not property -- see
Bhada v. Commissioner, 89 T.C. 959 (1987), aff'd, 892 F.2d 39 (6th Cir.
1989) (defining "property" in section 304 context)
2.
Section 301 does not apply
3.
Section 311(a) -- no gain or loss to corporation
Section 305
1.
Section 305(a) -- distributions of corporation's stock to its shareholders
("stock dividends") are generally nontaxable to the shareholder -- see
Colonial Savings Ass'n and Subsidiaries v. Commissioner, 854 F.2d 1001
(7th Cir. 1988), cert. denied, 489 U.S. 1090 (1989), acq., 1990-1 C.B. 1;
see also First Federal Savings Bank of Elizabethtown v. United States, 901 U.S.T.C. d 50,218 (D. Ky); Rev. Rul. 87-132, 1987-1 C.B. 82 (issuance
of stock prior to section 303 redemption)
2.
Section 305(b) -- exceptions
a.
where shareholder can elect to receive stock or property -- see First
Federal Savings Bank of Elizabethtown v. United States, supra, (no
election where distributor has discretion over whether to allow
redemption); see also Western Federal Savings & Loan Ass'n v.
Commissioner, 880 F.2d 1005 (8th Cir. 1989); Rev. Rul. 90-98,
1990-2 C.B. 56
b.
shift in proportionate interest -- Hagan v. Commissioner, 57
T.C.M. 1489 (1989), aff'd, rev'd, and rem'd on other issues, 92-1
U.S.T.C. d 50,030 (10th Cir. 1992) (disproportionate distribution
of stock is not includible in income under section 305(b)(2) unless
accompanied by receipt of property by other stockholders)
c.
distribution of common and preferred stock on common stock
d.
distributions on preferred stock and certain convertible preferred
stock
e.
constructive distributions -- see PLR 9835011 (capitalization of a
foreign sub’s undistributed earnings through a cash distribution to
the U.S. shareholder’s temporary foreign bank account, followed
by payment from the account back to the foreign sub, will be a
nontaxable stock distribution. No new subsidiary shares were
created or distributed in the transaction) -- but see Colonial
Savings Ass'n v. Commissioner, supra
- 96 3.
4.
X.
Section 305(c) provides that the Secretary will prescribe regulations to
determine under what circumstances certain transactions (such as a change
in conversion ratio or redemption price or a difference between
redemption price and issue price) that increase a shareholder's
proportionate interest in a corporation shall be considered a taxable
distribution under section 301
a.
OBRA 90 amended section 305(c) to provide that regulations shall
provide that a redemption premium for stock redeemable at the
option of the stockholder shall be reasonable only if the amount of
such premium does not exceed the amount determined under the
OID de minimis rule of section 1273(a)(3)
b.
whenever a redemption premium is treated as a distribution, such
premium will be taken into account under the OID rules of section
1272(a)
c.
regulations implementing revised section 305(c) were finalized at
the end of 1995 -- see TD 8643 (Dec. 20, 1995)
Section 312(d) -- nontaxable stock dividend does not reduce earnings and
profits
REDEMPTIONS
A.
B.
Definition
1.
Section 317(b) -- a corporation's acquisition of its own stock from a
shareholder in exchange for property (except the corporation's own stock)
2.
State (corporate) law is irrelevant
3.
Stock is treated as redeemed whether or not the stock is cancelled, retired,
or held as Treasury stock
Section 302 -- Determines Whether a Redemption is an "Exchange" or a
"Distribution”
1.
Section 302 does not prescribe the tax consequences of a redemption -- it
classifies a redemption as an exchange or distribution -- other Code
sections determine the tax consequences
2.
Individuals prefer exchange -- corporations prefer distribution
3.
Section 302(a)
a.
a redemption is treated as an exchange if it is one of the four types
described in section 302(b)
(1)
section 302(b)(1) -- not essentially equivalent to a dividend
- 97 -
b.
4.
5.
(2)
section 302(b)(2) -- substantially disproportionate
redemption
(3)
section 302(b)(3) -- complete termination of interest
(4)
section 302(b)(4) -- partial liquidation
tax consequences to redeeming shareholder if redemption
constitutes an exchange
(1)
section 1001 -- sale or exchange and gain or loss is
recognized
(2)
sections 1221 and 1223 -- long-term capital gain if capital
asset and stock held more than one year -- for redemptions
between July 29, 1997 and December 31, 1997, holding
period of more than 18 months required to be entitled to
lower long-term capital gain tax rate. Stock redeemed
during this period that was held for more than a year, but
less than 18 months, is entitled to a “mid-term” capital gain
tax rate
(3)
basis -- if shareholder receives property in exchange for
stock -- basis of property equals its tax cost – FMV
Section 302(d)
a.
if the redemption does not fit within the requirements of
section 302(b), it is treated as a distribution -- section 301 controls
b.
tax consequences to shareholder
(1)
distribution is treated as a dividend to extent of earnings
and profits
(2)
distribution in excess of earnings and profits is a return of
capital and capital gain
(3)
basis -- if the shareholder continues to hold stock the basis
of the stock redeemed is added to the basis of stock
retained
(4)
basis -- if the shareholder holds no stock after redemption
(owns stock constructively) basis of stock added to basis of
shares held by related taxpayers -- Treas. Reg. § 1.302-2(c),
ex. 2
Explanation of principle underpinning section 302 -- Clark v.
Commissioner, 828 F.2d 221 (4th Cir. 1987), aff'd, 489 U.S. 726 (1989)
(in section 368 reorganization context, boot distributed in section 356
- 98 exchange treated as hypothetical redemption of acquiring corporation's
stock)
C.
Legislative History
1.
2.
3.
Pre-1954 Law -- Section 115(g)
a.
"essentially equivalent to a dividend" language in Revenue Act of
1921 (section 201(d)) -- after Eisner v. Macomber, 252 U.S. 189
(1920) -- stock dividend taxed if distribution of stock followed by
immediate redemption -- equivalent to a dividend
b.
statute amended to apply to any redemption if equivalent to a
dividend
(1)
facts and circumstances
(2)
pro rata redemption a dividend and non-pro rata redemption
an exchange
(3)
exceptions to pro rata dividend rule -(a)
business purpose
(b)
corporate contraction -- see section 346 prior to
amendment by the Tax Equity and Fiscal
Responsibility Act of 1982 (TEFRA)
1954 Code
a.
section 302 enacted to provide certainty as to taxation of
redemptions and prevent "bail-out" of earnings at capital gain rates
b.
House bill contained only section 302(b)(2) and (3)
c.
Senate bill added section 302(b)(1) -- essentially equivalent to a
dividend -- to broaden statute and cover, for example, redemptions
of nonvoting preferred stock
d.
result -- two safe harbor tests and subjective test of 1939 Code
e.
section 318 -- constructive ownership provisions -- enacted in 1954
Code
TEFRA -a.
added section 302(b)(4) partial liquidation for noncorporate
shareholders
b.
section 302(b)(4) replaces former section 346
- 99 4.
D.
XI.
"Greenmail" -- section 5881, added by OBRA 87 and amended by
TAMRA 88, imposes an excise tax equal to 50% of the gain or other
income of any shareholder who receives greenmail -- see XIX.C.7
Ruling Requests
1.
Rev. Proc. 86-18, 1986-1 C.B. 551 -- sets forth information to be included
in requests for rulings under sections 302 and 311
2.
Rev. Proc. 2000-3, 2000-1 I.R.B. 103, sections 3.01(16)-(20) (areas in
which rulings will not be issued under section 302), sections 4.01(21)-(23)
(areas in which rulings will not ordinarily be issued under section 302),
and section 5.13 (areas of section 302 under study in which rulings will
not be issued until resolved by the IRS)
SECTION 318 -- CONSTRUCTIVE OWNERSHIP OF STOCK
A.
B.
In General
1.
Section 318 applies only where expressly made applicable
2.
Section 318(b)(1) and section 302(c)(1) apply section 318 to redemptions
3.
Terms of section 318 often modified by other statutory provisions -- e.g.,
sections 304(c)(3) and 382(l)(3)(A)
4.
Many other constructive ownership provisions in the Code -sections 267(c), 425(d), 544, 1563(e)
5.
Types of attribution
a.
section 318(a)(1) -- family attribution -- from one family member
to another
b.
section 318(a)(2) -- entity to beneficiary attribution -- from
corporations, partnerships, trusts and estates to shareholders,
partners and beneficiaries
c.
section 318(a)(3) -- beneficiary to entity attribution -- from
shareholders, partners and beneficiaries to corporations,
partnerships, trusts and estates
d.
section 318(a)(4) -- option attribution
Family Attribution -- Section 318(a)(1)
1.
Individual constructively owns any stock owned by:
a.
spouse
b.
children
c.
grandchildren
- 100 d.
parents
2.
No attribution among brothers and sisters
3.
Section 318(a)(5)(B) -- attribution from one member of family to another
is not reattributed to a third member
4.
Example
a.
facts -- X corporation has 100 shares of common stock outstanding
-- husband (H) owns 25 shares, wife (W) owns 25, son (S) owns
25, and grandson (GS) owns 25
b.
result –
H - 100 shares
W - 100 shares
S - 100 shares
GS - 50 shares
C.
Entity to Beneficiary Attribution -- Section 318(a)(2)
1.
2.
Partnership -- stock owned by partnership is constructively owned by its
partners
a.
partners own in proportion to their interest in partnership
b.
it is unclear how provision applies if profits interest and capital
interest in partnership are held in different proportions
c.
example
(1)
facts -- partnership (P) owns 50 shares (50%) of X
corporation stock -- A has a 25% interest in P
(2)
result -- A constructively owns 12.5 shares of X stock (50 x
25%)
Estate -- stock owned by an estate is constructively owned by its
beneficiaries
a.
beneficiaries own in proportion to their interest in the estate
b.
beneficiary -- person entitled to receive property of a decedent by
will or intestacy -- Treas. Reg. § 1.318-3
c.
beneficiary's interest must be a direct and present interest -remainderman not a beneficiary of an estate (compare trust rules)
d.
cease to be a beneficiary when --
- 101 -
e.
(1)
all property to which he is entitled has been distributed, and
(2)
only a remote possibility that estate will retake property to
satisfy claims
example
(1)
facts -- H and W each own 50 shares of X corporation stock
-- H dies and the beneficiaries of his estate are H's brother
(50%) and W (50%)
(2)
result
B -W --
3.
25
75
shares (constructively)
shares (50 shares actually
and 25 shares constructively)
Trust -- stock owned by a trust is constructively owned by its beneficiaries
a.
section 401 employee trust is excluded from constructive
ownership rules
b.
beneficiaries own in proportion to their actuarial interests in the
trust
c.
note -- estate attribution based on proportionate interest -- trust
attribution based on actuarial interest
d.
rule applies regardless of how small or remote interest is
(1)
applies to remainder interest -- compare to estate
(2)
compare attribution from beneficiary to trust -- 5% remote
interest rules
e.
actuarial interest depends in part on age
f.
example
(1)
facts -- trust A owns 100 shares (100%) of X corporation
stock -- W holds a life estate (15% interest); S has a life
estate after W's death (25% interest); GS has remainder
interest (60% interest)
(2)
result -attribution
from trust
W:
S:
GS:
15
25
60
family
attribution
+
+
+
25 + 60
15 + 60
25
=
=
=
100
100
85
- 102 -
4.
Corporation -- stock owned by the corporation is constructively owned by
its shareholders
a.
statute applies only if the shareholder owns 50% or more in value
of the corporation's stock
b.
constructive ownership is based on proportionate value of stock
owned by the shareholder
c.
d.
D.
(1)
number of shares irrelevant
(2)
significant where multiple classes of stock outstanding
example
(1)
facts -- H owns 70% in value of X corporation stock -- X
owns 100% of Y corporation stock
(2)
result -- H constructively owns 70% of Y corporation
example
(1)
facts -- H owns 30% of X corporation
(2)
result -- H constructively owns zero stock of Y corporation
e.
constructive ownership rules apply to determine if the shareholder
owns 50% of the stock
f.
example
(1)
facts -- X corporation owns 80 shares (80%) of Y
corporation -- H owns 40 shares (40%) of X corporation
and W owns 20 shares (20%) of X
(2)
result -- H owns 60 shares (60%) of X (40 actually and 20
constructively from W) -- thus H owns over 50% of X
corporation
H -- 48% of Y corporation (60% of 80%)
W -- 48% of Y corporation
Beneficiary to Entity Attribution -- Section 318(a)(3)
1.
Partner -- stock owned by partner is constructively owned by partnership
a.
all stock owned by partner is deemed owned by partnership -proportionate ownership in partnership is irrelevant
b.
example
(1)
facts -- A owns 50 shares (50%) of X corporation stock -A also is a 25% partner in partnership P
- 103 (2)
2.
Beneficiary -- stock owned by a beneficiary is constructively owned by
the estate
a.
all stock owned by beneficiary is deemed owned by estate -interest in estate is irrelevant
b.
example
c.
3.
(1)
facts -- H owns 100 shares (100%) of X corporation stock - H's brother (B) dies leaving one-half of his property to H - H is thus a beneficiary of B's estate
(2)
result -- B's estate constructively owns 100% of X
avoid attribution -- distribute property to beneficiary so no longer
beneficiary of estate
Beneficiary -- stock owned by a beneficiary is constructively owned by
the trust
a.
all stock owned by beneficiary is deemed owned by trust
b.
exception -- attribution rule does not apply if beneficiary's interest
in trust is "remote and contingent"
c.
4.
result -- P constructively owns 50 shares of X
(1)
contingent -- not vested -- e.g., remainder interest
(2)
remote -- 5% or less in value
example
(1)
facts -- W owns 50 shares (50%) of X corporation stock -W is a life beneficiary of trust A
(2)
result -- trust A constructively owns 50 shares of X
Shareholder -- stock owned by a shareholder is constructively owned by
the corporation
a.
statute applies only if the shareholder owns 50% or more in value
of the corporation's stock
b.
if 50% test met, all stock owned by the shareholder is deemed
owned by the corporation
c.
example
(1)
facts -- H owns 50% of X corporation and 100% of Y
corporation
- 104 (2)
E.
result -- X constructively owns 100% of Y and Y
constructively owns 50% of X
Option Attribution -- Section 318(a)(4)
1.
Person with option to acquire stock is considered to own that stock -- i.e.,
treated as if already exercised option
a.
Rev. Rul. 89-64, 1989-1 C.B. 91 -- option which is exercisable
only after fixed period of time is an option for purposes of section
318(a)(4); Rev. Rul. 68-601, 1968-2 C.B. 124, clarified ("at the
election of the shareholder" distinguishes unilateral right from
bilateral contract)
2.
Option to acquire an option to acquire stock -- treated as owning stock
3.
Contingent options – unclear whether statute applies; compare T.D. 8149,
1987-2 C.B. 85 (the option attribution rule under section 318(a)(4) ignores
any contingency relating to the exercise of the option) with Field Service
Advice 199915007 (December 21, 1998) (contingencies that removed the
election from the optionee’s unilateral control prevented attribution for
section 318(a)(4) purposes)
4.
Options to acquire unissued stock -- law unclear
a.
stock outstanding solely for person holding option
b.
compare Northwestern Steel & Supply Co. v. Commissioner, 60
T.C. 356 (1973) and Rev. Rul. 68-601, 1968-1 C.B. 124 with
Sorem v. Commissioner, 334 F.2d 275 (10th Cir. 1964) and Henry
T. Patterson Trust v. United States, 729 F.2d 1089 (6th Cir. 1984)
5.
If both option and family attribution apply, option attribution controls -section 318(a)(5)(D)
6.
Example
7.
a.
facts -- A and B each own 50% of X corporation -- A has an option
to acquire 25% of B's stock in X
b.
result -- A owns 75% of X (50% actual ownership and 25%
constructive ownership)
Seagram/Dupont transaction
a.
In April 1995, in order for Seagram to raise money to buy MCA,
DuPont repurchased DuPont shares held by Seagram. Seagram
turned back 156 million shares to DuPont in exchange for $8.3
billion in cash and notes and $500 million in warrants to purchase
DuPont shares
- 105 For tax purposes, the repurchase was carefully structured so that it
wouldn't be a redemption under section 302(b), so that Seagram
would not be subject to a tax on capital gain. Instead, the
redemption is treated, under section 302(d), as a distribution to
which section 301 applies. Because Seagram owned at least 20%
of DuPont's outstanding stock, the dividend is eligible for the 80%
dividends received deduction in section 243(c)
The key to dividend rather than exchange treatment is that
Seagram received warrants pertaining to the same number of
shares it surrendered in the redemption. Because Seagram is
treated as owning stock on which it holds an option under section
318(a)(4), Seagram did not experience a reduction in its
proportionate interest in DuPont
b.
A provision in TRA 97 amended section 1059 to prevent
duplication of the Seagram/Dupont transaction
Under the provision, a corporate shareholder recognizes gain
immediately with respect to any redemption treated as a dividend
(in whole or in part) when the nontaxed portion of the dividend
exceeds the basis of the shares surrendered, if the redemption is
treated as a dividend due to options being counted as stock
ownership -- in addition, the provision requires immediate gain
recognition wherever the basis of stock with respect to which any
extraordinary dividend was received is reduced below zero. The
reduction in basis of stock would be treated as occurring at the
beginning of the ex-dividend date of the extraordinary dividend to
which the reduction relates -- the provision is generally effective
for distributions after May 3, 1995
F.
Reattribution -- Constructive Ownership as Actual Ownership -Section 318(a)(5)
1.
Section 318(a)(5)(A)
a.
stock constructively owned by reason of section 318(a)(1), (2), (3)
or (4) is considered actually owned for purposes of reapplying
attribution rules
b.
example
(1)
facts -- X corporation owns 100 shares of Y corporation
and trust A owns 50 shares of X -- W has a 50% interest
(actuarially) in trust A -- S (W's son) owns no stock of X
directly
- 106 (2)
2.
result -- S constructively owns 25 shares of Y corporation
(X owns 100% of Y; T owns 50% of what X owns; W
owns 50% of what T owns; S owns what W owns)
Limitations on reattribution
a.
section 318(a)(5)(B) -- family reattribution
(1)
stock constructively owned by family attribution is not
treated as actually owned to again apply family attribution
(2)
example
(a)
facts -- H owns 50 shares of X corporation -- S
(son) and D (daughter) each own 25 shares of X
(b)
result -H --
100 shares (50 actually; 25 constructively
through S; 25 constructively through D)
S --
75 shares (25 actually; 50 constructively
through H)
D --
75 shares (25 actually; 50 constructively
through H)
Note that H owns what S and D own, but his
constructive ownership is not reattributed to each
child
b.
section 318(a)(5)(C) -- sideways attribution
(1)
stock constructively owned by an entity from its
beneficiary is not considered owned for purposes of
attribution from entity to other beneficiaries
(2)
example
(a)
facts -- A and B each own 50 shares of X
corporation -- A owns 25 shares of Y corporation
(b)
result -- X constructively owns 25 shares of Y held
by A -- B does not constructively own Y stock
constructively held by X
- 107 -
XII.
SECTION 302(b)(2) -- SUBSTANTIALLY DISPROPORTIONATE REDEMPTIONS
A.
B.
In General
1.
A redemption is treated as a sale if the redemption is substantially
disproportionate with respect to the redeeming shareholder
2.
Treated as a sale because shareholder's interest in corporation is
significantly reduced
3.
Safe harbor provision -- mechanical test applied
4.
Commissioner v. Clark, 489 U.S. 726 (1989) -- dividend characterization
was not appropriate for substantial cash payment made in connection with
stock for stock exchange -- apply section 302(b)(2) mechanical test after
the reorganization; see also Rev. Rul. 93-61, 1993-2 C.B. 118; Rev. Rul.
93-62, 1993-2 C.B. 118
Statutory Tests
1.
2.
A redemption is substantially disproportionate if it meets three mechanical
tests
a.
50% test -- immediately after the redemption, shareholder owns
less than 50% of the total combined voting power of all classes of
stock entitled to vote -- section 302(b)(2)(B)
b.
80% voting stock test -- immediately after the redemption
shareholder owns a percentage of voting stock which is less than
80% of his percentage of voting stock immediately before the
redemption -- section 302(b)(2)(C)
c.
80% common stock test -- immediately after the redemption
shareholder owns a percentage of common stock (voting and nonvoting) which is less than 80% of his percentage of common stock
immediately before the redemption -- section 302(b)(2)(C)
Example
a.
facts -- A and B hold 60 shares and 40 shares respectively of X
corporation common stock -- X corporation redeems 20 shares of
its stock held by A
b.
result -- the threshold test is whether after the redemption A owns
less than 50% of the total combined voting power of all classes of
stock entitled to vote
- 108 -
A
before
after
60 = 60%
100
40 = 50%
80
thus, A flunks the 50% test
3.
Example
a.
facts -- same as above, except X redeems 25 shares of stock
b.
result -- this time, A passes the 50% test
A
before
after
60 = 60%
100
35 = 46%
75
in addition, A passes both 80% tests
4.
C.
% of voting stock after redemption
=
% of voting stock before redemption
46% = 77%
60%
% of common stock after redemption =
% of common stock before redemption
46% = 77%
60%
If more than one class of common stock is outstanding, apply
section 302(b)(2)(C) in an aggregate and not a class-by-class manner -Rev. Rul. 87-88, 1987-2 C.B. 81; Rev. Rul. 89-57, 1989-1 C.B. 90
Operating Rules
1.
Section 318--constructive ownership
a.
constructive ownership provisions apply to all three tests
b.
example
facts -- H and W each own 50 shares (50%) of X stock -- X
redeems 25 shares of stock from H
result -- H owns 100% of X stock before and 100% after -- section
302(b)(2) does not apply
- 109 -
2.
Multiple redemptions
a.
statute applied on a shareholder by shareholder basis -- multiple
redemptions look at each shareholder before and after entire
transaction
before redeem
after 80% test
A
100 = 25%
400
55
45 = 15%
300
15 = 60%
25
B
100 = 25%
400
25
75 = 25%
300
25 = 100%
25
C
100 = 25%
400
20
80 = 27%
300
27 = 108%
25
D
100 = 25%
400
0
100 = 33%
300
33 = 132%
25
result -All of the parties pass the 50% test (i.e., none of them owns 50%
or more of the total combined voting power of all classes of stock
entitled to vote)
However, A is the only shareholder that passes the 80% test. After
all of the redemptions, A owns only 60% of the stock that it owned
before the redemptions. Therefore, the shareholders will treat the
redemptions as follows:
A - sale (capital gain)
B - dividend
C - dividend
b.
formal plan for series of redemptions not necessary -- consider two
or more redemptions together if they are causally related -- Rev.
Rul. 85-14, 1985-1 C.B. 93
3.
Redeem only non-voting stock -- section 302(b)(2) does not apply
4.
Redemption of non-voting stock may qualify if also redeem voting stock
and the voting stock redemption satisfies the section 302(b)(2) tests
a.
Treas. Reg. § 1.302-3(a)
b.
Rev. Rul. 77-237, 1977-2 C.B. 88
- 110 c.
5.
Redemption of voting preferred stock can qualify under section 302(b)(2)
-- Rev. Rul. 81-41, 1981-1 C.B. 121
6.
a.
50% test and 80% voting stock test met
b.
shareholder owns no common stock
c.
80% of common stock test not applicable
Formula -- minimum number of shares redeemed to qualify under section
302(b)(2)
a.
b.
X
7.
Rev. Rul. 87-88, 1987-2 C.B. 81 -- section 302(b)(2)(C) applies to
multiple classes of common stock in aggregate, not class-by-class
basis
=
formula
(1)
X = NT
5T-4N
(2)
X -- number of shares to be redeemed
(3)
N -- number of shares shareholder owns before redemption
(4)
T -- number of shares outstanding before the redemption
example
(1)
facts -- X corporation has 100 shares of stock outstanding.
A owns 60 shares
(2)
result --
60*100
(5*100) – (4*60)
=
6000
500-240
=
6000
260
=
23.07
=
24
Redemptions that are designed to return a shareholder’s economic
investment as dividends can be recharacterized as fast-pay arrangements.
On Jan. 7, 2000, the Service issued final regulations relating to financing
arrangements involving fast-pay stock. See T.D. 8853, 2000FED ¶47,015.
Under the regulations, stock is fast-pay stock if it is structured so that
dividends paid by the corporation with respect to its stock are
economically (in whole or in part) a return of the holder’s investment.
The regulations provide that stock is not fast-pay stock solely because a
redemption is treated as dividend by section 302 unless there is a principal
purpose of achieving the same economic and tax effect as a fast-pay
arrangement
- 111 XIII.
SECTION 302(b)(3) -- TERMINATION OF SHAREHOLDER'S INTEREST
A.
Statutory Requirements
1.
A redemption is treated as a sale if it is a redemption of all of the stock
owned by the shareholder
a.
generally effected by a single transfer of shares to the corporation
b.
a series of redemptions may be treated as parts of a single
redemption provided they are executed pursuant to a fixed plan to
terminate the shareholder's interest
Bleily & Collishaw, Inc. v. Commissioner, 72 T.C. 751 (1979),
aff'd without published opinion, 647 F.2d 169 (9th Cir. 1981)
2.
Retention of non-proprietary interest
a.
b.
B.
statute requires that the shareholder terminate his proprietary
(stock) interest -- shareholder may retain nonproprietary interest
(1)
officer, director, employee -- Rev. Rul. 76-524, 1976-2
C.B. 94
(2)
lessor of property (fixed rental payments -- not contingent
on earnings) -- see Rev. Rul. 77-467, 1977-2 C.B. 92 -- see
also Rev. Proc. 2000-3, section 3.01(18), 2000-1 I.R.B. 103
(no ruling if rent is contingent on future earnings or lessor's
claims are subordinate to general creditors)
(3)
creditor -- notes issued in redemption of stock
(a)
notes issued in redemption -- debt or equity -section 385
(b)
reacquire stock on default -- stock held as security - Rev. Proc. 2000-3, section 3.01(16) 2000-1 I.R.B.
103 (nonruling area)
retention of non-proprietary interest is a problem if shareholder
must waive family attribution to achieve exchange treatment
Constructive Ownership Provisions
1.
Constructive ownership provisions apply to determine if all the
shareholder's stock is redeemed -- section 302(c)(1)
example
a.
facts -- H and W each own 50 shares of X stock -- X redeems all of
the stock held by H
- 112 b.
2.
result -- section 302(b)(3) does not apply -- H constructively owns
the stock held by W
Section 302(c)(2)(A) -- waiver of family attribution rules -- the family
attribution rules at section 318(a)(1) do not apply to a termination of
interest (section 302(b)(3) redemption) if three requirements are met
a.
b.
redeeming shareholder retains no interest in the corporation other
than an interest as a creditor
(1)
statute expressly prohibits retention of officer, director or
employee interests -- section 302(c)(2)(A)(i)
(2)
where shareholder retains interest not expressly prohibited,
Tax Court applies a "facts and circumstances" test in
determining if prohibitive interest is retained -- interprets
statute as prohibiting retained financial stake or control -see Estate of Lennard v. Commissioner, 61 T.C. 554
(1974); Chertkof v. Commissioner 72 T.C. 1113 (1979),
aff'd, 649 F.2d 264 (4th Cir. 1981); but see Seda v.
Commissioner, 82 T.C. 484 (1984) (applied facts and
circumstances test even though employee interest retained);
Cerone v. Commissioner, 87 T.C. 1 (1986)
(3)
Seventh Circuit rejected "facts and circumstances" test -Lynch v. Commissioner, 801 F.2d 1176 (1986), rev'g, 83
T.C. 597 (1984) -- all noncreditor interests are prohibited,
including interest as an independent contractor
(4)
retention of pension rights not a prohibited interest -- Rev.
Rul. 84-135, 1984-2 C.B. 80
(5)
cannot acquire interest in a successor corporation -- Treas.
Reg. § 1.302-4(c)
(6)
Treas. Reg. § 1.302-4(d) -- definition of creditor -- no
subordinated interests, no percentage of profits, etc.
redeeming shareholder does not acquire a prohibited interest within
10 years from date of redemption distribution
(1)
cannot acquire stock or any other prohibited interest in
corporation
(2)
acquisition by constructive ownership will violate
requirement -- H waives W's ownership and W later puts
stock in partnership in which H is a partner
(3)
can acquire stock by inheritance
- 113 (4)
c.
3.
under section 302(c)(2)(A), family attribution is waived in
determining whether there is an acquisition of a prohibited
interest -- Rev. Rul. 88-55, 1988-2 C.B. 45; Rev. Rul. 71562, 1971-2 C.B. 173
redeeming shareholder files an agreement pursuant to section
302(c)(2)(A)(iii) to notify the IRS of a prohibited acquisition
within the 10-year period
(1)
the agreement must be filed with the shareholder's return
for the year of the redemption -- Treas. Reg. § 1.3024(a)(1)
(2)
District Director may grant an extension if there was
reasonable cause for failing to file and the extension
requested is filed within reasonable time -- Treas. Reg.
§ 1.302-4(a)(2)
(3)
former shareholder did not violate section 302(c)(2)(A)(iii)
agreement when section 304(a)(1) applied to subsequent
sale of stock in a related corporation -- Rev. Rul. 88-55,
1988-2 C.B. 45
Section 302(c)(2)(B) -- exception to waiver of attribution rules
a.
b.
c.
waiver rules do not apply if within the 10-year period prior to the
redemption the redeeming shareholder either
(1)
acquired stock of the corporation from a related party, or
(2)
transferred stock of the corporation to a related party
examples
(1)
H owns 100 shares of X corporation stock -- H transfers 20
shares to W as a gift and X redeems the stock from W
(2)
H owns 100 shares of X corporation stock -- H transfers 80
shares to W and X redeems 20 shares from H
exception to the exception -- may waive the attribution rules even
if acquire or convey stock within 10 years -- if the transfer was not
done principally to avoid tax
(1)
Rev. Rul. 77-293, 1977-2 C.B. 91 -- gift from father to son
to permit son to take over business; son active in business - not tax avoidance
(2)
Rev. Rul. 85-19, 1985-1 C.B. 94 -- child inherited 80
shares from deceased parent and was given 20 shares from
- 114 parent; parent reacquired the 20 shares just before
redemption of 80 shares -- not tax avoidance
(3)
4.
other rulings -- Rev. Rul. 79-67, 1979-1 C.B. 128; Rev.
Rul. 77-293, 1977-2 C.B. 91; Rev. Rul. 77-455, 1977-2
C.B. 93; Rev. Rul. 57-387, 1957-2 C.B. 225; Rev. Rul. 56584, 1956-2 C.B. 179
Limitation on waiver of attribution rules
a.
section 302(c)(2) provides that section 318(a)(1) will not apply to a
section 302(b)(3) redemption if the requirements are satisfied
b.
section 318(a)(1) applies only to family attribution rules -- entity
attribution and option attribution cannot be waived
c.
(1)
example -- Estate (E) owns 50% of X corporation. W, a
beneficiary of E, also owns 50% of X corporation. Neither
E nor W can waive the attribution rules -- section 318(a)(2)
and (3) apply
(2)
compare Rickey v. United States, 592 F.2d 1251 (5th Cir.
1979) (estate can waive) with David Metzger Trust v.
Commissioner, 76 T.C. 42 (1981), aff'd, 693 F.2d 459 (5th
Cir. 1982), cert. denied, 463 U.S. 1207 (1983) (no waiver
by trust)
unclear who may waive family attribution
(1)
(2)
IRS position (pre-TEFRA) -- only an individual may waive
the attribution provisions -- entities may not
(a)
Rev. Rul. 59-233, 1959-2 C.B. 106; Rev. Rul. 72472, 1972-2 C.B. 202
(b)
example -- Estate (E) owns 50% of X corporation -W is the sole beneficiary of E; W's son S also owns
50% of X -- thus, W owns stock of S by section
318(a)(1) and E owns stock of W by section
318(a)(3) -- IRS position was that E cannot waive
attribution between W and S
court position -- entities may waive the family attribution
provisions
(a)
Crawford v. Commissioner, 59 T.C. 830 (1973),
acq., 1984-2 C.B. 1 -- estate can waive attribution
(b)
Johnson Trust v. Commissioner, 71 T.C. 941
(1979), acq., 1984-2 C.B. 1 -- trust can waive
attribution
- 115 d.
XIV.
section 302(c)(2)(C), added by TEFRA, permits an entity to waive
the family attribution rules if the following requirements are
satisfied
(1)
the redeeming entity and each related person hold no
interest in the corporation; agree not to acquire such
interest for ten years; and file the required waivers
(2)
the redeeming entity and each related person agree to be
jointly and severally liable for tax which results from a
prohibited acquisition
SECTION 302(b)(4) -- PARTIAL LIQUIDATIONS FOR NONCORPORATE
SHAREHOLDERS
A.
Partial Liquidations
1.
Section 302(b)(4) -- operative provision
a.
(1)
the stock redeemed is held by a noncorporate shareholder,
and
(2)
the redemption qualifies as a partial liquidation of the
redeeming corporation
b.
capital gain to redeeming shareholder
c.
the provision is limited to redemptions of stock from noncorporate
shareholders
d.
2.
a redemption of stock will qualify as a sale or exchange if:
(1)
prior law permitted sale or exchange treatment regardless
of the type of shareholder
(2)
reason for the statutory change -- U.S. Steel/Marathon
transaction
Rev. Rul. 90-13, 1990-1 C.B. 65 (pro rata distribution by
corporation to its shareholders (individuals) qualifies as a
distribution in redemption of stock in partial liquidation under
section 302(b)(4) and (e) even though the shareholders did not
surrender any of their shares)
Section 302(e) -- defines partial liquidation
a.
section 302(e)(1) -- the distribution in redemption of stock is:
(i) not essentially equivalent to a dividend (determined at the
corporate level), and (ii) pursuant to a plan which occurs in the
year the plan is adopted or in the next succeeding year
(1)
"not essentially equivalent to a dividend"
- 116 (a)
identical to pre-TEFRA statute; pre-TEFRA law
thus continues to be relevant
(b)
similar to section 302(b)(1) but tested at the
corporate level -- entitled to capital gain even if the
redemption is on a pro rata basis
(c)
"corporate contraction" concept -- adopted in pre1954 case law Imler v. Commissioner, 11 T.C. 836
(1948), acq., 1949-1 C.B. 2
(d)
facts and circumstances test to determine if true
termination or reduction of business -- Mains v.
United States, 508 F.2d 1251 (6th Cir. 1975)
(e)
looks like dividend --
earnings and profits
pro rata
continue business
potential to avoid dividends
-- not often applied
(f)
examples of corporate contraction
(a)
part of business destroyed by fire, insurance
proceeds distributed -- Treas. Reg. § 1.3461(a)(2); Imler v. Commissioner, supra
(b)
sale of part of business -- Rev. Rul. 75-223,
1975-1 C.B. 109; Rev. Rul. 74-296, 1974-1
C.B. 80; Rev. Rul. 71-250, 1971-1 C.B. 112
(g)
no corporate contraction
(a)
distribution of passive real estate -- Rev. Rul.
76-526, 1976-2 C.B. 101
(b)
distribution of cash reserved to replace
equipment -- Rev. Rul. 78-55, 1978-2 C.B. 88
(c)
correct distribution of assets unrelated to
corporate contraction -- Rev. Rul. 79-275, 19792 C.B. 137
(d)
sale of stock of subsidiary -- Rev. Rul. 79-184,
1979-1 C.B. 143
(e)
redemption pursuant to a plan in the year the
plan is adopted or in the next succeeding year
- 117 b.
section 302(e)(2) -- a distribution which terminates one of two or
more businesses engaged in by the corporation (corporate
contraction concept with objective test)
(1)
(2)
(3)
B.
statutory tests
(a)
the corporation sells or distributes the assets of a
"qualified trade or business"
(b)
the corporation continues to carry on a "qualified
trade or business"
qualified trade or business -- a trade or business which was
actively conducted for five years on the date of the
distribution and was not acquired by the corporation within
the five-year period in a taxable transaction
(a)
purpose -- to permit capital gain if business
contracts without requiring a factual inquiry of tax
avoidance potential
(b)
assets of business may be sold and cash distributed
or assets can be distributed in kind
(c)
section 355 definition of business applied -- Treas.
Reg. § 1.355-3
(d)
active business required to prevent avoiding
dividend tax on investment type assets
(e)
five-year requirement to prevent purchase of active
business shortly before redemption of stock
See White's Ferry, Inc. v. Commissioner, 66 T.C.M. 1855
(1993) -- ownership and management of real property
constituted a business activity, albeit a minor one, so
distribution of the property to shareholders in redemption
of stock resulted in a significant contraction in capital and
business activity; therefore, the distribution was a
distribution in partial liquidation under section 302(e)
Ruling Requests
1.
Rev. Proc. 81-42, 1981-2 C.B. 611, sets forth information to be included
in a section 346 request for rulings prior to the enactment of section
302(b)(4)
2.
It appears that this procedure continues to apply to partial liquidations
after TEFRA -- see Rev. Proc. 86-18, section 4.02, 1986-1 C.B. 551
- 118 -
XV.
3.
Rev. Proc. 2000-3, section 4.01(22), 2000-1 I.R.B. 103 -- ordinarily no
ruling on whether distribution is a partial liquidation under section
302(b)(4) unless it results in 20% or more reduction in: (1) gross revenue,
(2) net FMV of assets, and (3) employees
4.
Rev. Proc. 2000-3, section 4.01(23), 2000-1 I.R.B. 103 -- ordinarily no
ruling on the tax effect of the liquidation of a corporation preceded or
followed by the reincorporation of all or part of the business and assets
when more than a nominal amount of the stock (i.e., more than 20% in
value) of both the liquidating corporation and the transferee corporation is
owned by the same shareholders; or when a liquidation is followed by the
sale of the corporate assets by the shareholders to another corporation in
which such shareholders own more than a nominal amount of the stock
(i.e., more than 20% in value)
SECTION 302(b)(1) -- NOT ESSENTIALLY EQUIVALENT TO A DIVIDEND
A.
Statutory Requirement
1.
B.
A redemption is treated as a sale if the redemption is "not essentially
equivalent to a dividend"
a.
facts and circumstances
b.
section 302(b)(5) -- failure of redemption to qualify under section
302(b)(2), (3) or (4) is irrelevant
United States v. Davis, 397 U.S. 301 (1970)
1.
2.
Conclusions of Davis
a.
redemption must result in a "meaningful reduction of shareholder's
proportionate interest in the corporation"
b.
business purpose is irrelevant in applying section 302(b)(1)
c.
redemption from sole shareholder cannot qualify as "not
essentially equivalent to a dividend"
d.
constructive ownership provisions apply to section 302(b)(1)
redemptions
Unanswered questions of Davis
a.
definition of "meaningful reduction"
b.
what stock ownership characteristics are relevant in measuring
interest in corporation
c.
whether tests are different for majority or minority shareholder,
common or preferred shareholder, voting or nonvoting shareholder
- 119 d.
3.
C.
how voting power and economic interest interrelate
Dissent -- Davis writes section 302(b)(1) out of the Code
Meaningful Reduction -- Cases and Rulings After Davis
1.
2.
Stock ownership characteristics used to measure interest in corporation -Himmel v. Commissioner, 338 F.2d 815 (2d Cir. 1964); Rev. Rul. 75-502,
1975-2 C.B. 111
a.
right to vote and thereby exercise control
b.
right to participate in current earnings and accumulated surplus
c.
right to share in net assets on liquidation
Case law has extended Davis well beyond its facts to cover
a.
common stock redemptions
b.
redemptions involving multi-shareholder corporations
c.
non-pro rata redemptions
3.
Post-Davis case law adds little analysis -- quotes Davis and reaches
conclusions
4.
Redemption of voting stock -- majority interest
a.
cases and rulings look exclusively at voting power
b.
majority of cases and rulings have held reductions not to be
meaningful -- dividend
(1)
98.5% to 96.1% -- Jones v. United States, 72-1 U.S.T.C.
9349 (D.N.J.)
(2)
98.2% to 88.6% -- Fehrs Finance Co. v. Commissioner, 58
T.C. 174 (1972), aff'd, 487 F.2d 184 (8th Cir. 1973), cert.
denied, 416 U.S. 938 (1974)
(3)
90% to 83% -- Niedermeyer v. Commissioner, 62 T.C. 280
(1974), aff'd, 535 F.2d 500 (9th Cir. 1974), cert. denied,
429 U.S. 1000 (1976)
(4)
98.50% to 98.05% -- Estate of Schneider v. Commissioner,
88 T.C. 906 (1987), aff'd, 855 F.2d 435 (7th Cir. 1988)
(5)
100% to 81% -- Rev. Rul. 73-2, 1973-1 C.B. 171
(6)
90% to 60% -- Rev. Rul. 78-401, 1978-2 C.B. 127
(7)
60% to 55% -- Rev. Rul. 77-218, 1977-1 C.B. 81
- 120 c.
5.
(1)
85% to 61.7% -- Wright v. United States, 482 F.2d 600 (8th
Cir. 1965)
(2)
80% to 63% -- Henry T. Patterson Trust v. United States,
729 F.2d 1089 (6th Cir. 1984)
(3)
57% to 50% -- Rev. Rul. 75-502, 1975-2 C.B. 111
Redemptions of minority interests
a.
b.
6.
cases and rulings holding reduction meaningful
issues to consider
(1)
whether corporation is closely held or publicly traded
(2)
whether stock redeemed is voting or non-voting, preferred
or common
(3)
how many classes of stock are outstanding and how many
does shareholder hold
(4)
whether minority interest is nominal or large enough to
exercise effective control
very little case law -- recently IRS has been issuing favorable
rulings -- IRS has determined that there has been a meaningful
reduction where ownership was reduced from:
(1)
11% to 9% -- Rev. Rul. 56-183, 1956-1 C.B. 161
(2)
30% to 24.3% -- Rev. Rul. 75-512, 1975-2 C.B. 112
(3)
27% to 22.27% -- Rev. Rul. 76-364, 1976-2 C.B. 91
(4)
de minimis -- Rev. Rul. 76-385, 1976-2 C.B. 92
(5)
.414% to .361% -- meaningful reduction -- TAM 8504009
(6)
vote 1.72% to 1.56%, value 5.91% to 5.10% -- PLR
9829008
Redemptions of preferred stock
a.
characteristics of preferred different from common -- no vote,
limited dividend and liquidation rights, does not participate in
growth
b.
redemption of preferred stock from shareholder holding only
preferred stock always is a meaningful reduction -- Rev. Rul. 77426, 1977-2 C.B. 87
- 121 c.
7.
D.
(1)
example -- A holds 50% of the preferred stock and 100% of
the common stock. Corporation redeems all of A's
preferred stock. Redemption is a dividend -- before
redemption A's interest was 100% less 50% preferred stock
-- after redemption his interest is the same
(2)
redemption of preferred stock from majority shareholder -dividend
(3)
redemption of preferred stock from minority shareholder
who has capacity to act with others as part of a control
group -- dividend -- Rev. Rul. 85-106, 1985-2 C.B. 116
(4)
redemption of preferred stock from minority shareholder -may be sale
(a)
PLR 7735031 ---
11.8% C.S.
100% P.S.
(b)
PLR 7750041 ---
5.86% C.S.
100% P.S.
Redemptions of nonvoting common stock -- treat like preferred stock
Constructive Ownership Rules
1.
2.
XVI.
redemption of preferred stock can be a dividend -- depends on
ownership of other classes of stock
Davis holds section 318 applies to section 302(b)(1)
a.
section 302(c)(1) states that section 318 applies in determining
stock ownership for purposes of section 302
b.
section 302(b)(1) does not refer to stock ownership
Family hostility -- can it make family attribution rules inapplicable
a.
family hostility can overcome attribution rules -- Robin Haft Trust
v. Commissioner, 510 F.2d 43 (1st Cir. 1975)
b.
family hostility does not override attribution rules -- Cerone v.
Commissioner, 87 T.C. 1 (1986); David Metzger Trust v.
Commissioner, 76 T.C. 42 (1981), aff'd, 693 F.2d 459 (1982), cert.
denied, 463 U.S. 1207 (1983); Rev. Rul. 80-26, 1980-1 C.B. 66
REDEMPTIONS AND BOOTSTRAP ACQUISITIONS
A.
In General
1.
Selling shareholder sells a portion of his stock to buyer and causes
corporation to redeem the remainder -- tax consequences
- 122 -
2.
B.
a.
sell all stock to buyer -- section 1001 -- capital gain
b.
redeem all stock -- section 302(b)(3)
Purpose
a.
capital gain to seller
b.
control of corporation to buyer
c.
buyer uses corporate dollars (i.e., no double tax) to pay for stock
Seller Issues
1.
2.
Zenz v. Quinlivan, 213 F.2d 914 (6th Cir. 1954) -- taxpayer sells a portion
of stock and has corporation redeem the remainder
a.
pre-1954 Code case
b.
holds transaction not essentially equivalent to a dividend -redemption which completely terminates interest
IRS has acquiesced in Zenz
a.
Rev. Rul. 55-745, 1955-2 C.B. 223 -- sale and redemption of
shareholder's entire interest
b.
Rev. Rul. 75-447, 1975-2 C.B. 113
c.
d.
(1)
A and B each hold 50 shares of X stock -- X sells 25 shares
to C and simultaneously X redeems 25 shares each from A
and B
(2)
A and B each hold 50 shares of X stock -- A and B each
sell 15 shares to C and simultaneously X redeems 5 shares
from A and B
Rev. Rul. 77-226, 1977-2 C.B. 90
(1)
corporate shareholder buys stock and then has it redeemed
pursuant to same plan -- reports redemption as a dividend
in part to claim a dividends received deduction
(2)
ruling concludes that Zenz controls
see also PLR 9148037
3.
Sale and redemption need not occur simultaneously provided part of the
same plan
4.
Step transaction doctrine may apply in characterizing transaction as
redemption
- 123 -
5.
6.
C.
a.
sale of stock by corporation to employees pursuant to stock bonus
plan utilizing stock of majority shareholder recharacterized as
redemption -- Estate of Schneider, 88 T.C. 906 (1987), aff'd, 855
F.2d 435 (7th Cir. 1988)
b.
TAM 8646002 -- step transaction doctrine not applied; first
transaction is a redemption; second transaction is a "D"
reorganization
c.
Esmark, Inc. v. Commissioner, 90 T.C. 171 (1988), aff'd without
published opinion, 886 F.2d 1318 (7th Cir. 1989) -- tender offer
followed by redemption of stock acquired respected
Boot in section 356 exchange treated as redemption -- Commissioner v.
Clark, 489 U.S. 726 (1989)
a.
taxpayer exchanged his stock in a wholly owned corporation for
less than one percent of the stock of a corporation in which he had
no prior interest and $3.25 million in boot
b.
IRS argued that boot had the effect of a dividend distribution
pursuant to section 356(a)(2) and that boot payment should be
treated as hypothetical cash payment prior to reorganization and
taxed as ordinary income
c.
held: boot payment treated as hypothetical redemption of stock
after the reorganization and taxed as capital gain. Payment was
part of integrated exchange; there would have been no cash
payment absent the exchange
shareholders who purchased property from corporation at bargain and on
same day sold all their stock in corporation to another shareholder could
not recast the transaction as a redemption -- shareholders had constructive
dividend equal to gain on bargain purchase and exchange treatment on
sale of stock -- Durkin v. Commissioner, Dec. 48,644, 99 T.C. 651 (1992)
Continuing Shareholder Issues
1.
Redemption of stock is a dividend to remaining shareholder only if the
corporation pays the primary and unconditional obligation of the
remaining shareholder
a.
Schroeder v. Commissioner, 831 F.2d 856 (9th Cir. 1987)
(shareholder purchases stock with loan and has corporation redeem
portion of purchased stock to pay off loan); Wall v. United States,
164 F.2d 462 (4th Cir. 1947) (remaining shareholder purchases
stock but causes corporation to pay shareholder's note)
- 124 b.
c.
2.
if obligation to pay redeeming shareholder is the corporation's -no dividend -- Holsey v. Commissioner, 258 F.2d 865 (3d Cir.
1958); Edenfield v. Commissioner, 19 T.C. 13 (1952)
(1)
corporate obligation to buy stock
(2)
shareholder guarantees corporate obligations
(3)
shareholder conveys option to buy to corporation
Rev. Rul. 69-608, 1969-2 C.B. 42 -- sets forth seven examples
Section 305(c) -- periodic plan of redemption may result in constructive
dividend to continuing shareholder
XVII. SECTION 304 -- REDEMPTIONS THROUGH RELATED CORPORATIONS
A.
In General
1.
Shareholder sells stock of one corporation to a purchasing corporation
a.
section 302 does not apply
b.
if sale to unrelated purchaser -- capital gain under section 1001
c.
if sale to affiliated corporation, should transaction be treated as a
sale
(1)
A owns stock of X and Y corporation; A sells part of X
stock to Y
(2)
effect of transaction is a dividend
2.
Section 304 treats a sale of stock by a shareholder to a related corporation
as a redemption subject to section 302
3.
Pre-1954 Code dealt only with parent-subsidiary relationships -- section
115(g)(2)
4.
Section 304 enacted in 1954 covers brother-sister and parent-subsidiary
transactions
5.
A TRA 97 provision provides that if a section 304 transaction is treated as
a dividend to which the dividend received deduction applies, the dividend
is treated as an extraordinary dividend in which only the basis of the
transferred shares would be taken into account under section 1059
6.
Treas. Reg. § 1.1502-80(b) provides that section 304 shall not apply to any
acquisition of stock of a corporation in an intercompany transaction or to
any intercompany item from such transaction occurring on or after July
24, 1991
- 125 -
B.
Section 304(a)(1) -- Brother-Sister Acquisitions
1.
One or more persons in control of two corporations
a.
304(c) -- control is 50% of voting power or value
(1)
b.
2.
the value test is applied, not class-by-class, but on the basis
of the aggregate value of all classes of stock -- Rev. Rul.
89-57, 1989-1 C.B. 90
section 318 applies with modifications
(1)
de minimis rule -- constructive ownership is not applied if
shareholder owns less than 5% in value of the corporation's
stock; and
(2)
a proportionate rule -- if shareholder owns less than 50% in
value of corporation's stock, then attribution to the
corporation is limited to the proportion of stock the
shareholder owns. Sections 304(c)(3)(A) and (B)
(a)
see Continental Bankers Life Insurance Company of
the South v. Commissioner, 93 T.C. 52 (1989)
(applying constructive ownership rules of section
318(a) for purposes of control)
(b)
See Rev. Rul. 91-5, 1991-1 C.B. 114
If shareholder sells stock of one corporation to the other, then treated as
follows
a.
redemption of stock of acquiring corporation
b.
section 302 standards applied to stock of issuing corporation -section 304(b)(1)
c.
to the extent that the transaction is taxed as a distribution, section
304(b)(2) characterizes the distribution as follows
(1)
first as a deemed distribution by the acquiring corporation
to the selling shareholder to the extent of the acquiring
corporation's earnings and profits,
(2)
then as a deemed distribution by the issuing corporation to
the selling shareholder to the extent of the issuing
corporation's earnings and profits, and
(3)
acquiring corporation considered to have received the stock
as a contribution to capital
- 126 d.
to the extent that the transaction is treated as an exchange, section
304(a) provides that the acquiring corporation will be treated as
purchasing the stock -- section 338 may apply
3.
OBRA 87 added new section 304(b)(4) to provide that proper adjustments
are to be made to (1) the adjusted basis of any intragroup stock and (2) the
earnings and profits of any member of the affiliated group to the extent
necessary to carry out the purposes of section 304(a) -- however, this
amendment contained no specific rules "to carry out the purposes" of
section 304 -- the IRS response was to issue regulations providing that in
the case of acquisitions of stock within consolidated groups, section 304
would not apply -- see Treas. Reg. § 1.1502-80
4.
Example
a.
facts -- X and Y corporations each have 200 shares of common
stock outstanding; A and B each own 100 shares of X and Y -- A
sells 30 shares of X to Y
b.
result -(1)
determine if redemption is a sale or a section 301
distribution by A's ownership of X before and after
redemption -- prior to transaction, A owned 100 shares of
X; after transaction, A owns 70 shares directly and 15
shares constructively (Y owns 30 shares of X and A owns
50% of Y)
50% test
before
100 = 50%
200
after
85 = 42.5%
200
80% tests
42.5% = 85%
50%
thus, section 302(b)(2) does not apply (A flunks both 80%
tests) and assume for this example that section 302(b)(1)
does not apply
5.
(2)
section 301 distribution to A -- reduce earnings and profits
of Y and to the extent the distribution exceeds Y's earnings
and profits, reduce earnings and profits of X
(3)
basis of stock redeemed is added to A's basis in his Y stock
-- basis of X stock to Y is equal to A's basis in the X stock
Example
a.
facts -- same facts except A sells 50 shares of X stock to Y
- 127 b.
results -- prior to transaction, A owned 100 shares of X; after
transaction, A owns 50 shares directly and 25 shares constructively
(Y owns 50 shares of X and A owns 50% of Y)
(1)
prior to transaction, A owned 100 shares of X; after
transaction, A owns 50 shares directly and 25 shares
constructively (Y owns 50 shares of X and A owns 50% of
Y)
50% test
before
after
80% tests
100 = 50%
200
37.5% = 75%
50%
75 = 37.5%
200
thus, section 302(b)(2) applies
6.
(2)
A recognizes capital gain -- selling price less basis of stock
(3)
Y treated as acquiring X stock by purchase -- basis in X
stock is equal to Y's cost
Example
a.
facts -- P owns all of the stock of X, and X owns all of the stock of
Y and Z -- the group does not file a consolidated return -- X sells
50% of its appreciated Y stock to Z in a section 304 transaction
that is treated as a dividend of the earnings and profits of Z to X
and a contribution of the stock of Y to the capital of Z
b.
results -- prior to transaction, X owned 100% of Y; after the
transaction X owns 50% of Y directly and 50% constructively
(1)
section 302(d) applies and the distribution is subject to
section 301 -- reduce earnings and profits of Z and to the
extent the distribution exceeds Z's earnings and profits,
reduce earnings and profits of Y
(2)
the amount treated as a dividend is effectively not taxed as
a result of the dividends-received deduction
(3)
X's basis in the stock of Y it sold to Z is added to X's basis
in its remaining Y stock -- the additional basis reduces X's
built-in gain in the remaining Y stock -- arguably, however,
adjustments must be made to the stock bases of the
members of the group to preclude the sale of Y stock
without recognition of the built-in appreciation -- see
section 304(b)(4)
- 128 -
C.
Section 304 and Section 351
1.
TEFRA and DEFRA 84 -- amended section 304 to clarify that section 304
takes precedence over section 351
2.
Pre-TEFRA example -- A owns all of the stock of two corporations (X and
Y); A transfers part of the stock of X to Y in exchange for additional Y
stock and either securities or cash, in a transaction which qualifies for
section 351 treatment
3.
If section 351 controlled, the securities are not taxed and the cash is taxed
at capital gain rates; if section 304 controlled, the securities and cash
would constitute a dividend (up to Y's and X's earnings and profits)
4.
Conflict in authority under old law
5.
a.
section 351 controls -- Gunther v. Commissioner, 92 T.C. 39
(1989) (Tannenwald, J.) (separate opinion), aff'd, 909 F.2d 291
(7th Cir. 1990); Haserot v. Commissioner, 46 T.C. 864 (1966),
aff'd, 399 F.2d 828 (6th Cir. 1968);
b.
section 304 controls -- Rose Ann Coates Trust v. Commissioner,
480 F.2d 468 (9th Cir.), cert. denied, 414 U.S. 1045 (1973); Rev.
Rul. 78-422, 1978-2 C.B. 129
TEFRA and DEFRA 84
a.
section 304(b)(3)(A) -- section 304 overrides section 351 with
respect to the receipt of "property" as defined in section 317 (cash,
securities, etc.); section 351 continues to apply to the receipt of
stock -- Bhada v. Commissioner, 89 T.C. 959 (1987), aff'd, 892
F.2d 39 (6th Cir. 1989)
b.
section 304(b)(3)(B) -- exception for acquisition indebtedness,
limited to acquisitions from a person whose stock is not
attributable to the person transferring the stock to the acquiring
corporation
(1)
c.
6.
exception to the exception -- if the related person
terminates his/her interest, does not acquire additional
interest in either the issuing or the acquiring corporation for
10 years, and files an agreement with IRS
section 304(b)(3)(C) -- special rules for formation of bank holding
companies -- assumption of acquisition indebtedness incident to
formation of bank holding company not treated as distribution of
property
newly formed corporations before TEFRA and DEFRA 84 -- A owns all
of the stock of X corporation; A forms new corporation Y and conveys X
- 129 stock to Y in exchange for Y stock and cash (borrowed by Y from bank) -loan is later repaid by Y with dividend from X
7.
D.
a.
IRS initially ruled that section 304 did not apply because A did not
control Y before the exchange -- i.e., section 351 transaction -- see
Treas. Reg. § 1.304-2(a); PLR 8008205; PLR 7947070
b.
IRS subsequently reversed its position and would no longer issue
such rulings -- however, even if section 304 applied, Y had no
earnings and profits (because Y was a newly formed corporation)
and the cash was treated as a return of capital or capital gain
c.
Rev. Rul. 80-239, 1980-2 C.B. 103, holds that neither section 351
nor section 304 applies -- cash distributed to A is a dividend from
X
newly formed corporations after TEFRA and DEFRA 84
a.
section 304(c)(2) -- control determined by including stock received
in the transaction
b.
section 304(b)(2)(A) -- measure dividend to A by reference to
earnings and profits of Y (acquiring corporation), up to the amount
of the distribution; if distribution exceeds Y's earnings and profits,
then combine with earnings and profits of X (issuing corporation)
to measure A's dividend
Section 304(a)(2) -- Parent-Subsidiary Acquisitions
Shareholder sells stock of parent corporation to subsidiary -1.
treated as a redemption of stock by parent -- section 302 applied to stock
of parent
2.
operating rules if transaction taxed as dividend (sections 302(d) and 301) a.
section 304(b)(2) provides that the dividend is first deemed
distributed by the acquiring corporation to the selling shareholder
to the extent of acquiring corporation's earnings and profits; and
then deemed distributed by the issuing corporation to the extent of
the issuing corporation's earnings and profits
b.
earnings and profits of corporation deemed making the distribution
are reduced accordingly -- H.R. Rep. No. 861, 98th Cong., 2d Sess.
1223 (1984) -- see Caamano v. Commissioner, 879 F.2d 156 (5th
Cir. 1989); Bhada v. Commissioner, 89 T.C. 959 (1987), aff'd, 892
F.2d 39 (6th Cir. 1989); GCM 39280 (June 22, 1990) (section
304(a)(2) does not apply where shareholder exchanges stock of
parent corporation for stock of subsidiary; subsidiary's stock is not
property under section 317(a))
- 130 XVIII. SECTION 303 -- REDEMPTIONS TO PAY DEATH TAXES
A.
B.
C.
XIX.
Section 303(a)
1.
Policy -- allows payment of death taxes without forcing liquidation or sale
of business
2.
Redemption of stock is treated as a sale to the extent the distribution does
not exceed
a.
estate, inheritance and transfer taxes, and
b.
funeral and administrative expenses
3.
Statute applies even if the redemption would otherwise be taxed as a
dividend -- e.g., estate owns 100% of stock and redeems 50%
4.
Little or no gain on redemption -- stepped up fair market basis on death
Limitations and Requirements
1.
Stock must be owned by decedent at date of death and includible in estate
-- Rev. Rul. 84-76, 1984-1 C.B. 91
2.
The value of the stock must be more than 35% of the value of the adjusted
gross estate
Rev. Rul. 87-132, 1987-2 C.B. 82 -- section 303(a) applies to distribution of cash
by corporation to an estate in redemption of stock that is newly issued to
corporation's shareholders as part of same transaction; stock issuance nontaxable
under e 305(a)
EFFECT OF REDEMPTION ON THE CORPORATION
A.
Recognition of Gain to the Corporation as a Consequence of a Distribution in
Respect of Its Stock
1.
Section 311(a) generally provides that a corporation recognizes no gain or
loss on the distribution of property with respect to its stock
2.
However, as noted above at Part VII.C., supra, new section 311(b)
provides that a corporation must recognize gain where it distributes
appreciated property in redemption of stock
a.
old section 311 may apply to "qualified corporations" during the
transition period
b.
if old section 311 applies, gain will not be recognized if an old
section 311(d)(2) exception applies (exceptions are noted supra at
Part VII.B.2.c.ii) -- see Esmark, Inc. v. Commissioner, 90 T.C. 171
(1988), aff'd without published opinion, 886 F.2d 1318 (7th Cir.
1989)
- 131 B.
Effect of a Redemption on the Corporation's Earnings and Profits
1.
2.
3.
The adjustment to earnings and profits to reflect a redemption is
determined in part by the characterization of the redemption at the
shareholder level
a.
if the redemption is taxed as a dividend under section 301,
corporate earnings and profits are decreased pursuant to section
312(a) by the sum of the amount of money, the principal amount of
the corporation's own obligations and the adjusted basis (or fair
market value if higher (see below)) of any property distributed
b.
if a redemption qualifies as a sale or exchange under sections
302(a) or 303, then earnings and profits are reduced in proportion
to the stock redeemed -- section 312(n)(7)
(1)
earnings and profits are not allocated to preferred stock
unless the stock is convertible or participating -- a
redemption of preferred stock results in a reduction of the
corporation's capital account only
(2)
priorities are taken into account in determining the amount
of earnings and profits allocable to different classes of
stock
If the corporation distributes appreciated property, additional adjustments
to earnings and profits are required, regardless of the characterization of
the redemption at the shareholder level
a.
earnings and profits are increased by the amount of appreciation -section 312(b)
b.
earnings and profits are reduced by the fair market value of the
distributed property
c.
these rules apparently apply even if an old section 311(d)(2)
exception is available (i.e., no gain recognized)
Withholding Issues
a.
Rev. Rul. 92-85, 1992-2 C.B. 69 -- if (1) a redemption is treated as
a deemed dividend under section 304(a)(1), (2) the dividend is
deemed to be paid in whole or part by a domestic corporation to a
foreign corporation, and (3) the dividend paid by the domestic
corporation is U.S. source income, then the domestic corporation is
subject to the withholding rules of section 1442 -- similarly, a
foreign corporation in the same position is also subject to the
withholding rules unless it can establish that the dividend is foreign
source income -- see also Rev. Rul. 92-86, 1992-2 C.B. 99 (foreign
- 132 tax credit implications if domestic corporation is deemed to receive
a dividend from a foreign corporation under section 304(a)(1))
C.
Deductibility by Corporation of Stock Redemption Expenses
1.
Prior to TRA 86, some corporate taxpayers took the position that expenses
incurred to repurchase stock from corporate raiders ("greenmail
payments") could be deducted
2.
TRA 86 clarifies that no deduction is allowed for amounts paid or incurred
by a corporation in connection with a redemption of its stock -- section
162(k)(1)
a.
amounts included under section 162(k) include amounts paid to
repurchase stock, fees incurred in connection with such repurchase
(i.e., legal, accounting, appraisal, and brokerage fees), and any
other expenditures necessary or incidental to the repurchase. See
H.R. Rep. No. 426, 99th Cong., 1st Sess., at 249; S. Rep. No. 313,
99th Cong., 2d Sess, at 223
b.
payments made under agreements to refrain from purchasing stock
("standstill agreements") also covered, provided there is actual
purchase of all or part of payee's stock -- H.R. Rep. No. 841, 99th
Cong., 2d Sess. II-169 (1986)
c.
does not cover payments in discharge of contractual obligations or
other rights
(1)
(2)
d.
e.
examples:
(a)
payments in litigation settlement
(b)
obligations under employment contracts
IRS will scrutinize payments made in proximity to stock
redemption
Interest payments to shareholder remain deductible -- section
162(k)(2)(A)
(1)
corporation acquires own stock in exchange for debt
instrument
(2)
interest payments are deductible; principal payments are
not
investment banking fees and printing costs incurred in response to
hostile offers are deductible even if merger eventually takes place - such costs seek to preserve the status quo, not to produce future
benefits, and are therefore deductible -- A.E. Staley Mfg. Co. v.
- 133 Commissioner, 97-2 U.S.T.C. (CCH) ¶ 50,521 (1997), rev'g 105
T.C. 166 (1995)
3.
f.
the cost of acquiring property with a useful life substantially
beyond the taxable year is a capital expenditure -- INDOPCO, Inc.
v. Commissioner, 503 U.S. 79 (1992)
g.
section 5881, added by OBRA 87, imposes an excise tax on any
shareholder who receives greenmail equal to 50% of the gain or
other income recognized by such shareholder with respect to the
greenmail
The Small Business Job Protection Act of 1996 made two significant
changes to section 162(k)
a.
b.
Section 162(k) was amended to include not just redemption
expenses, but expenses incurred in any acquisition of previously
outstanding stock of the corporation or any related person
(1)
thus, the section 162(k) rules now apply to transactions
treated as a reorganization, a dividend, a sale of stock, or
any other transaction involving a corporation's acquisition
of its own stock. House Committee Report on the Small
Business Job Protection Act of 1996, at CCH ¶11,055
(2)
the amendment applies to amounts paid or incurred after
September 13, 1995
Section 162(k)(2)(A)(ii) was added, it provides that the
disallowance rules of section 162(k)(1) shall not apply to any
"deduction for amounts which are properly allocable to
indebtedness and amortized over the term of such indebtedness"
(1)
thus, corporations are permitted to amortize costs
attributable to obtaining debt financing for reacquiring its
own (or a related party's) stock, and deduct them over the
term of the loan
(2)
this new exception applies to amounts paid or incurred after
February 28, 1986
(3)
prior to the legislative change to section 162(k) in the Small
Business Job Protection Act of 1996, there were divergent
authorities on the issue of whether or not costs incurred by
a target in obtaining loans to purchase target stock were
amortizable over the term of the loan. These divergent
authorities lead to the enactment of new section
162(k)(2)(A)(ii), and are described below
- 134 -
4.
XX.
Divergent Authorities Prior to Legislative Change
a.
In In re Kroy, 27 F.3d 367 (9th Cir. 1994), the Ninth Circuit held
that loan fees incurred in obtaining a loan for a leveraged buyout
("LBO") could be amortized and deducted over the term of the
loan -- the court reasoned that, although the term "in connection
with the redemption of stock" is critical, the fees were incurred as
compensation for services rendered in a "separate and
independent" borrowing transaction, and not in a redemption
transaction
b.
In Fort Howard Corp. v. Commissioner, 103 T.C. 345 (1994), the
Tax Court disagreed with In re Kroy, and held that costs incurred
in debt financing an LBO (other than interest costs) are
nondeductible under section 162(k) (prior to its change in 1996), as
well as nonamortizable -- the court noted that there would be no
reason to have an interest exception in section 162(k) if financing
costs were not related to redemptions
c.
The amendment to section 162(k) included in the Small Business
Job Protection Act of 1996 effectively overruled Fort Howard. In
fact, the Tax Court has issued a new opinion in Fort Howard,
ruling that the amendment does not preclude the taxpayer in Fort
Howard from deducting and amortizing its financing costs and fees
over the term of the loan. Fort Howard Corp. v. Commissioner,
107 T.C. No. 12 (1996)
LIQUIDATION OF THE CORPORATION
A.
Concepts
1.
2.
3.
Conveyance by the corporation to its shareholders of property in
retirement of stock because of:
a.
cessation of corporate activities (complete liquidation)
b.
distinguish from redemption
(1)
also a transfer in retirement of stock
(2)
does not involve termination of a business
In liquidation, corporate stock is cancelled and shareholders succeed to
ownership of the corporate assets
a.
corporation may sell assets and distribute cash in liquidation
b.
corporation may distribute assets in kind and shareholders may sell
or retain and operate business as sole proprietorship or partnership
Complete liquidation not defined in Code
- 135 a.
Treas. Reg. § 1.332-2(c) -- status of liquidation exists when
corporation ceases to be an ongoing concern and its activities are
merely for winding up affairs and paying debts
b.
Olmsted v. Commissioner, 48 T.C.M. 594 (1984) -- liquidation is a
process, not an event -- test for status of liquidation: (1) a manifest
intent to liquidate, (2) a continuing purpose to achieve liquidation,
and (3) corporate activities oriented toward liquidation
(1)
4.
5.
B.
distribution not in liquidation where intent to liquidate not
shown -- Griffith v. Commissioner, 56 T.C.M. 1263
(1989); Estate of Foster v. Commissioner, 56 T.C.M. 163
(1988); Householder v. Commissioner, 56 T.C.M. 829
(1988)
Distinguish from dissolution
a.
liquidation is a Federal tax term -- relates to movement of assets
out of corporation -- conceptually a distribution
b.
dissolution is a state law term -- relates to end of corporate
existence under state law
c.
a corporation which is completely liquidated may or may not be
dissolved under state law
d.
the retention of a nominal amount of assets for the sole purpose of
preserving the liquidating corporation's name will not prevent the
transaction from qualifying as a complete liquidation. Rev. Rul.
84-2, 1984-1 C.B. 92
Plan of liquidation
a.
informal plan of liquidation may be okay -- i.e., simply distribute
assets
b.
advisable to adopt formal written plan
Liquidation Provisions
TRA 86 substantially revised the liquidation provisions of the Code
1.
Section 331 -- complete liquidation -- taxable to shareholder
2.
Section 332 -- liquidation of a subsidiary -- tax-free to shareholder
3.
Section 336 -- effect of liquidation on liquidating corporation -- taxable
transactions
4.
Section 337 -- distributions to controlling shareholder -- tax-free
5.
Section 338 -- purchase of stock treated as taxable purchase of assets
- 136 XXI.
SECTION 331 -- COMPLETE LIQUIDATION (EFFECT ON SHAREHOLDERS)
A.
B.
C.
In General
1.
Enacted in the Revenue Act of 1924
2.
General liquidation provision
3.
Applies to all classes of shareholders -- individuals, corporations, trusts,
partnerships, estates
4.
Does not apply to distributions to shareholder/ creditor in status as creditor
-- Braddock Land Co. v. Commissioner, 75 T.C. 324 (1980); see also
Stoecklin v. Commissioner, 54 T.C.M. 452 (1987), aff'd, 865 F.2d 1221
(11th Cir. 1989) (distributee held equity interest, not interest as creditor or
employee)
Statute
1.
Section 331(a) -- distribution treated as in full payment in exchange for
stock
2.
Section 331(b) -- section 301 not applicable, i.e., no dividend
consequences attach
Tax Consequences to Shareholder
1.
Shareholder is deemed to have sold his stock to the corporation in
exchange for assets received in the liquidation
2.
The shareholder recognizes gain or loss to the extent of the difference
between the FMV of the assets received and the shareholder's basis in his
stock -- section 1001
a.
gain or loss is usually capital gain or loss (unless sections 341,
1246, 1248, 1291, dealer situations, or Corn Products doctrine
apply) -- section 1221
(1)
Arkansas Best Corp. v. Commissioner, 485 U.S. 212
(1988), significantly narrowed the scope of the Corn
Products doctrine holding that (1) a taxpayer's motivation
in purchasing an asset is irrelevant to the question whether
it is a "capital asset" under section 1221, (2) hedging
transactions in Corn Products fell within the inventory
exception and (3) stock constitutes a capital asset
(2)
see also Circle K Corp. v. U.S., 23 Cl. Ct. 161 (1991)
(source-of-supply stock purchase may qualify as a hedging
transaction if it is an integral part of the company's
inventory-purchase system)
- 137 b.
nature of capital gain or loss will depend on the holding period for
the stock and when the stock is deemed to have been sold
(1)
due to recent changes to the Code, this determination is
more complicated than previously. IRRA 98 reinstated the
long-term capital gain tax rate holding period of more than
one year, the holding period had recently been lengthened
to more than 18 months by TRA 97
(2)
for assets sold after January 1, 1998, or between May 7,
1997, and July 28, 1997:
(3)
(4)
c.
(a)
short-term capital gain tax rates apply if the asset
was held for less than one year (maximum rate of
39.6%)
(b)
long-term capital gain tax rates apply for assets held
more than one year (maximum rate of 20%)
(c)
generally, for assets sold after December 31, 2000,
a lower long-term rate will apply for assets held for
more than 5 years (maximum rate of 18%)
for assets sold after July 29, 1997 and before January 1,
1998:
(a)
short-term capital gain tax rates apply if the asset
was held for less than one year (maximum rate of
39.6%)
(b)
the prior long-term capital gain tax rates (now
called a "mid-term rate") apply for assets held more
than one year, but not more than 18 months
(maximum rate of 28%)
(c)
long-term capital gain tax rates apply for assets held
more than 18 months (maximum rate of 20%)
For assets sold before May 7, 1997:
(a)
short-term capital gain tax rates apply if the asset
was held for less than one year (maximum rate of
39.6%)
(b)
long-term capital gain tax rates apply for assets held
more than one year (maximum rate of 28%)
example -- A owns 10 shares of X corporation stock which he
purchased on January 1, 1985, for $10,000 (1,000 per share) -- on
July 1, 1989, X is liquidated and distributes $30,000 in cash to A
- 138 gain to A:
cash
less basis
LTCG
d.
e.
$30,000
-$10,000
$20,000
amount and character of gain determined on a per share basis
(1)
if acquire stock in one block simply determine gain or loss
for entire block
(2)
if hold several blocks of stock, determine gain or loss for
each block --can have gain on some and loss on others and
because of different holding periods can have short-term
and long-term gains and losses
example
A owns 10 shares of X stock -- 5 shares acquired on January 1,
1995 for 12,000, and 5 additional shares acquired on January 15,
1997 for 17,000 – on January 1, 1998, X is liquidated and A
receives $30,000 for his stock ($3,000 per share)
f.
1995 shares
1997 shares
5 x 3,000 = 15,000
less basis
-12,000
LTCG
3,000
5 x 3,000 = 5,000
less basis -17,000
STCL
(2,000)
section 346(a), added by TEFRA, provides that a distribution shall
be treated as a complete liquidation if the distribution is one of a
series of distributions in redemption of all of the stock of the
corporation
(1)
similar to section 346(a)(1) prior to TEFRA
(2)
recover basis first, then report gain --Rev. Rul. 68-348,
1968-2 C.B. 141
(3)
if the shareholder holds several blocks of stock -- allocate
each distribution to each block of stock and recover basis
first and then gain for each block -- Rev. Rul. 85-48, 19851 C.B. 126
(4)
the Installment Sales Revision Act of 1980 initially created
some doubt regarding the continued availability of cost
recovery reporting under Rev. Rul. 68-348, supra, for serial
liquidating distributions
- 139 (a)
section 453 provides for ratable basis recovery on
installment sales -- an installment sale is now
defined as "any disposition of property where at
least 1 payment is to be received after the close of
the taxable year"
(b)
serial liquidating distribution made over two or
more years would appear to meet this definition and
should constitute an installment sale
(c)
thus, ratable basis recovery under section 453 rather
than cost recovery under Rev. Rul. 68-348, supra,
would appear appropriate
(d)
Section 453(a)(2), added by the Ticket to Work and
Work Incentives Improvement Act of 1999,
generally repeals the use of the installment method
for accrual method taxpayers effective for sales or
other dispositions entered into on or after December
17, 1999
(5)
notwithstanding the Installment Sales Revision Act, Rev.
Rul. 85-48, supra, continues to authorize cost recovery
reporting
(6)
example -A owns 30 shares of X stock -- 10 shares acquired in 1985
for $10,000 and 20 shares acquired in 1989 for $40,000. In
1991, X distributes $45,000 to A as part of a plan of
liquidation. In 1992 X makes a final distribution to A of
$135,000
First Distribution
1985 shares
10/30 x 45,000 =
less basis
LTCG
$15,000
- $10,000
$5,000
- 140 -
1989 shares
20/30 x 45,000 =
less basis
result -- no gain
$30,000
- $40,000
Final Distribution
1985 shares
10/30 x 135,000 =
less basis
LTCG
$45,000
0
$45,000
1989 shares
20/30 x 135,000 =
less basis
LTCG
3.
$90,000
- $10,000
$80,000
Time of the liquidating distribution -- the shareholder is deemed to have
received a distribution on the date it becomes payable, regardless of when
the shareholder turns in the shares for the cash distribution -- Rev. Rul. 80177, 1980-2 C.B. 109
a.
application of constructive receipt doctrine -- Treas. Reg. § 1.4511(a) and -2(a)
b.
compare to old section 337 liquidation -- constructive receipt
doctrine did not apply -- Vern Realty, Inc. v. Commissioner, 58
T.C. 1005 (1972), aff'd, 73-1 U.S.T.C. d 9455 (1st Cir.)
c.
shareholder transfers shares after liquidation process began but
prior to distribution -- who is taxed on distribution -- if liquidation
is a "sure thing" at time of transfer, transferor is taxed -- compare
Jacobs v. United States, 390 F.2d 877 (6th Cir. 1968) and Rushing
v. Commissioner, 52 T.C. 888 (1969), aff'd, 441 F.2d 593 (5th Cir.
1971) with Dayton Hydraulic Co. v. United States, 592 F.2d 937
(6th Cir.), cert. denied, 444 U.S. 831 (1979) and Jones v. United
States, 531 F.2d 1343 (6th Cir. 1976)
4.
Non-pro rata distribution -- treated as a pro rata distribution to each
shareholder followed by a payment from one shareholder to another -Rev. Rul. 79-10, 1979-1 C.B. 140; cf. Rev. Rul. 83-61, 1983-1 C.B. 78
5.
In-kind liquidating distributions
- 141 a.
valuation
the amount realized on an in-kind distribution of assets in
liquidation is the fair market value of the assets on the date of the
distribution
b.
(1)
ordinarily, the valuation of assets distributed in liquidation
is readily accomplished through an appraisal or other
estimate
(2)
valuation problems may be presented by the distribution of
contingent claims, contract rights, goodwill, mineral
interests, and other intangible assets
"open" versus "closed" transaction treatment -- where the value of
some or all of the assets received by the shareholder cannot be
ascertained with reasonable accuracy, shareholders have been
permitted to keep the transaction "open" until collection -- in this
case, recognition of gain is deferred until the cash or the value of
the property received by the shareholder exceeds his basis in his
stock -- the shareholder is permitted to recover his basis
completely before reporting any gain on the liquidation
(1)
as a result, under the open transaction method, a
shareholder could delay reporting gain, while amounts
collected later in excess of basis will be taxed as capital
gain
(2)
in a "closed transaction," by contrast, an asset must be
valued at liquidation and any amount collected
subsequently in excess of the estimated value will receive
ordinary income treatment
(3)
example -- open vs. closed transaction -- A is the sole
shareholder of X corporation and X is liquidated
A's stock basis
$50,000
A receives cash:
equipment (FMV):
$10,000
$30,000
contingent claim:
face amount
FMV
ultimately collected
$50,000
$30,000
$40,000
- 142 -
cash
equipment
claim
less basis
gain
open
transaction
$10,000
$30,000
$40,000 collect
$80,000
closed
transaction
$10,000
$30,000
$30,000 FMV
$70,000
$50,000
$30,000
$50,000
$20,000
-- under the open transaction model, no gain is recognized
until collection -- until then, the amount received is less
than basis
-- under the closed transaction model, there is an immediate
20,000 capital gain upon liquidation -- upon collection, the
remaining 10,000 of gain is picked up as ordinary income
c.
availability of open transaction treatment
(1)
open transaction treatment was approved by the Supreme
Court in Burnet v. Logan, 283 U.S. 404 (1931)
(2)
the IRS vigorously opposes the use of the open transaction
method -- see Rev. Rul. 58-402, 1958-2 C.B. 15, which
states that only on "rare and extraordinary" circumstances
will an asset's value be considered to be unascertainable;
see also Temp. Treas. Reg. § 15 A.453-1(d)(2)(iii); Webbe
v. Commissioner, 54 T.C.M. 281 (1987), aff'd, 90-1
U.S.T.C. d 50,254 (8th Cir.) (method disallowed because
property had a readily ascertainable value and thus
payments were not contingent); cf. Cloward Instrument
Corporation v. Commissioner, 52 T.C.M. 34 (1986), aff'd
without published opinion, 842 F.2d 1294 (9th Cir. 1988)
(distribution of contract rights to future payments not
susceptible of valuation)
(3)
the enactment of the Installment Sales Revision Act of
1980 raises doubts about the survival of the open
transaction method
(a)
the Senate Finance Committee Report states that the
cost recovery method will not be available in the
case of sales for a fixed price -- for contingent
payment sales, the Committee Report adopts the
IRS' view that reporting methods other than the
installment method are available only in the "rare
- 143 and extraordinary" case when the fair market value
of the purchaser's obligation cannot reasonably be
ascertained -- S. Rep. No. 1000, 96th Cong., 2d
Sess. 24 (1980)
(b)
installment reporting is not available in the context
of a liquidation (except as noted in paragraph (c)
below). In light of the legislative history's aversion
to open transaction treatment, and the unavailability
of installment reporting, the shareholder of a
liquidating corporation may be forced to apply the
closed transaction doctrine
(c)
exception -- if in section 331 liquidation
•
shareholder receives installment obligation
•
acquired by corporation from sale or exchange
during 12-month period beginning on date that
the plan of liquidation is adopted
•
and corporation liquidates within 12-month
period
then receipt of payment on obligation is treated
as receipt of payment on stock -- notes acquired
on sale of inventory qualify only if sale is a bulk
sale -- sections 453(h)(1)(A) and (B) -- and sale
is to one person in one transaction (amended by
TAMRA 88)
6.
7.
Corporate liabilities assumed by shareholder
a.
reduce gain recognized by shareholder -- Ford v. United States,
311 F.2d 951 (Ct. Cl. 1963)
b.
unknown, speculative or contingent liabilities -- do not reduce gain
-- later payment by shareholder (as transferee) relates back to gain
-- if capital gain on liquidation, then capital loss on contingent
liability stemming from liquidation -- see Arrowsmith v.
Commissioner, 344 U.S. 6 (1952); Rev. Rul. 78-25, 1978-1 C.B.
270; TAM 8617001
Basis of assets to shareholder
a.
section 334(a) -- basis of property received is its fair market value
at time of the distribution
b.
appreciated inventory
- 144 -
c.
8.
(1)
prior to TRA 86, shareholder received step-up in basis at
capital gain rates
(2)
after TRA 86, shareholder still receives step-up but capital
gains are taxed as ordinary income, subject to section 1(h)
capping the tax on net capital gains at 28% for individuals
character of gain on subsequent sale of assets depends on character
of assets in shareholder's hands
Liquidation/reincorporation
a.
b.
pre-TRA 86 strategies
(1)
shareholder liquidates the corporation, retains the cash and
immediately reincorporates the operating assets under
section 351
(2)
the corporation sells the operating assets to a related
corporation under old section 337, liquidates and distributes
the cash to the shareholder
tax consequences -- if treated as a liquidation
(1)
capital gain to the shareholder
(2)
stepped-up basis for the operating assets
(3)
tax attributes disappear
c.
substance of the transaction -- withdraw cash and leave operating
assets in corporate solution, i.e., a dividend
d.
liquidation envisions termination of the corporation as an operating
entity
e.
IRS will challenge
(1)
in effect simply a dividend -- Treas. Reg. § 1.301-1(l);
Treas. Reg. § 1.331-1(c); Rev. Rul. 61-156, 1961-2 C.B. 62
(2)
section 368(a)(1)(D) reorganization -- Smothers v. United
States, 642 F.2d 894 (5th Cir. 1981); Rose v. United States,
640 F.2d 1030 (9th Cir. 1981); Viereck v. United States,
83-2 U.S.T.C. ¶ 9664 (Cl. Ct.)
(3)
DEFRA 84 amended the control definition for acquisitive
D reorganizations -- Section 368(a)(2)(H) (as redesignated
by TRA 86) adopts the control definition of section 304(c)
which uses a 50% control test and applies the section 318
constructive ownership provisions
- 145 -
9.
(4)
lack of complete liquidation -- Telephone Answering
Service, Co. v. Commissioner, 63 T.C. 423 (1974), aff'd
without published opinion, 546 F.2d 423 (4th Cir. 1976),
cert. denied, 431 U.S. 914 (1977)
(5)
Rev. Proc. 2000-3, section 4.01(23), 2000-1 I.R.B. 103 -IRS will not ordinarily rule on the tax effect of a liquidation
followed by a reincorporation if more than 20% of the
stock of the liquidated corporation and the newly formed
corporation are owned by the same shareholders
f.
TEFRA repealed the partial liquidation provisions of section 346
and substituted new section 346(b) -- this provision grants the IRS
broad authority to prevent taxpayers from accomplishing the
economic equivalent of a partial liquidation and may permit the
IRS to deal more effectively with liquidation/ reincorporation
issues
g.
effect of TRA 86
(1)
imposition of corporate level tax and elimination of capital
gain rates (except for capping of capital gain rate for
individuals at 28%) reduces the advantages of liquidation/
reincorporation scheme
(2)
liquidation or sale to related corporation forces corporation
to pay tax on appreciation in operating assets (35%) and
shareholder must pay tax as well (28%) on subsequent
distribution
(3)
still marginally better than dividend -- corporation still pays
35% tax on earnings, but shareholder must pay 39.6% (not
capital gains rate) on dividend -- however, in the case of a
corporate shareholder which can use the dividends received
deduction, a dividend is superior to a liquidation/
reincorporation
Disclosure requirements
a.
30 days after the plan of liquidation is adopted the corporation
must file Form 966 with the District Director along with the plan
of liquidation -- Treas. Reg. § 1.6043-1
b.
failure to file the form will not invalidate the liquidation -- Rev.
Rul. 65-80, 1965-1 C.B. 154
c.
the corporation files Forms 1096 and 1099L on or before February
28 of year following the year of distribution
d.
shareholders must disclose liquidation on their return
- 146 XXII. SECTION 332 -- COMPLETE LIQUIDATION OF CORPORATE SUBSIDIARY
(EFFECT ON CORPORATE SHAREHOLDER)
A.
B.
Introduction
1.
General rule -- under section 331, a liquidation is treated as a sale or
exchange and gain must be recognized
2.
Section 332(a) exception -- gain (or loss) realized but not recognized by
parent corporation on liquidation of subsidiary
3.
This type of transaction is in the nature of a reorganization -- combining
business operations rather than terminating
4.
History
a.
enacted in Revenue Act of 1935
b.
encourage simplification of corporate structure through tax free
liquidation of subsidiaries
Requirements of Section 332
1.
Section 332(b)(1) -- requires that parent corporation ("P") own on the date
the plan of complete liquidation is adopted, and every day thereafter until
the receipt of the property, stock meeting the requirements of section
1504(a)(2):
a.
80% of the total voting power of subsidiary corporation's stock
("S") and 80% of the total value of stock
b.
general intent is that other parts of section 1504(a) apply including
sections 1504(a)(4) and (5) (other than section 1504(a)(5)(E)) -H.R. Rep. No. 426 99th Cong., 1st Sess. 894 (1986)
c.
thus, in applying 80% vote/80% value test -- nonvoting,
nonparticipating, nonconvertible, limited and preferred stock is
excluded -- section 1504(a)(4)
(1)
d.
see also Treas. Reg. § 1.1504-4 for regulations issued under
section 1504(a)(5)(A) and (B) that treat certain options as
exercised, certain warrants as stock, and certain stock as
not stock -- according to Notice 87-63, 1987-2 C.B. 375,
such regulations will not apply to liquidation plans adopted
under section 332(b)(1) on or before the date the
regulations were published in proposed form (i.e., March 2,
1992) -- applies also to old sections 337 and 338(d)(3))
the aggregate stock ownership rules of Treas. Reg. § 1.1502-34, in
which all stock owned by members of an affiliated group that files
a consolidated return is taken into account, apply for purposes of
- 147 determining whether a member satisfies the 80% test of section
332(b)(1) -- see also Rev. Rul. 89-46, 1989-1 C.B. 272
2.
Section 332(b)(2) -- S, pursuant to a plan of liquidation which does not
specify the time for distribution, must distribute all of its assets in
complete liquidation in one taxable year, or
3.
Section 332(b)(3) -- S, pursuant to a plan of liquidation, must distribute all
of its assets in complete liquidation within three years from the close of
the year the first distribution is made
4.
S need not be formally dissolved pursuant to state law -- Rev. Rul. 84-2,
1984-1 C.B. 92
5.
P need not continue S's business following the liquidation -- Rev. Rul. 70357, 1970-2 C.B. 79; but see Fairfield S.S. Corp. v. Commissioner, 157
F.2d 321 (2d Cir.), cert. denied, 329 U.S. 774 (1946); TAM 8837003
(circumstances evidenced an intent of S corporation to acquire T
corporation's assets by purchasing T's stock to be followed by a liquidation
under section 332; because S's stock ownership of T was transitory and for
the end purpose of acquiring T's assets, T cannot be deemed to be
affiliated with S and parent corporation and may not join in the
consolidated return)
6.
Redemption of all stock required
a.
for section 332 to apply, P must receive a distribution with respect
to "all its stock" -- sections 332(b)(2) and (3) -- if more than one
class of stock held, then distribution must be made as to each class
b.
Spaulding Bakeries, Inc. v. Commissioner, 252 F.2d 693 (2d Cir.
1958), aff'g, 27 T.C. 684 (1957), nonacq. 1957-2 C.B. 8 -liquidation did not meet section 332 requirements where
distribution made only with respect to nonvoting preferred stock
and not common stock
c.
(1)
taxpayer could argue common stock should be ignored
where it has zero equity -- see Helvering v. Alabama
Asphaltic Limestone Co., 315 U.S. 179 (1942)
(2)
alternatively, recapitalization prior to liquidation to convert
into one class of stock -- but see Rev. Rul. 68-602, 1968-2
C.B. 135
Tax Court reaffirmed Spaulding principle -- H.K. Porter Co. v.
Commissioner, 87 T.C. 689 (1986)
(1)
subsidiary did not have sufficient assets to pay liquidation
preference on preferred stock
- 148 (2)
7.
C.
therefore, section 332 did not apply; no distribution in
cancellation of "all its [parent's] stock" -- i.e., the stock the
parent owned in the subsidiary
Tax consequences to S if section 332 not met -- following TRA 86, if the
liquidation does not qualify under section 332, the distributions will be
fully taxable to the liquidating corporation -- new sections 336 and 337
Avoid or Comply with Section 332
1.
2.
Avoid application of section 332
a.
sell sufficient stock to reduce interest below 80% between
adoption of plan and distribution
b.
spread distributions out over more than three years
c.
section 332 does not apply even if sole motive was to avoid the
statute -- Avco Manufacturing Corp. v. Commissioner, 25 T.C. 975
(1956)
d.
effort to avoid application unsuccessful -- Associated Wholesale
Grocers, Inc. v. United States, 720 F. Supp. 887 (D. Kan. 1989),
aff'd, 927 F.2d 1517 (10th Cir. 1991) -- step transaction doctrine
applied; sale of stock not bona fide -- section 332(a) applied to
deny taxpayer capital loss treatment
e.
if section 332 does not apply, subsidiary is taxed under section 336
Comply with section 332 -- acquire stock shortly before the plan is
adopted
a.
Rev. Rul. 75-521, 1975-2 C.B. 120 -- purchase stock from third
party to reach 80% -- section 332 applied because purchase of
shares occurred prior to plan of liquidation
b.
Rev. Rul. 70-106, 1970-1 C.B. 70 -- redemption of minority
shareholder to increase P's interest to 80% -- section 332 does not
apply because redemption was part of the plan of liquidation
(1)
but see Madison Square Garden Corp. v. Commissioner, 58
T.C. 619 (1972), aff'd in part and rev'd in part, 500 F.2d
611 (2d Cir. 1974); George L. Riggs, Inc. v. Commissioner,
64 T.C. 474 (1975)
(2)
a similar issue exists in section 338 -- Temp. Treas. Reg. §
1.338-3T(b)(5) provides that a redemption from an
unrelated person is taken into account for purposes of
determining whether the percentage ownership
requirements of section 338(d)(3) are satisfied
- 149 D.
Effect of Section 332
1.
P recognizes no gain or loss
2.
The basis of the assets in the hands of S carries over to P -- section
334(b)(1) -- see also TAM 9003005 (basis of property not limited to FMV
on date of distribution)
3.
P's basis in S stock disappears
4.
P succeeds to the tax attributes of S -- section 381 (net operating losses,
capital loss carryovers, earnings and profits, etc.) -- note possible
application of section 269(b), enacted in DEFRA 84
5.
a.
but see Russell v. Commissioner, 832 F.2d 349 (6th Cir. 1987),
which held that the parent corporation could not carryback an
NOL of its subsidiary which liquidated pursuant to section 332 and
old section 334(b)(2) because basis stepped up
b.
see also section 384(a)(2), added by OBRA 87, which limits a
corporation that acquires the assets of its subsidiary in a section
332 liquidation from offsetting any built-in gain of the subsidiary
with any preacquisition loss of any other corporation unless at least
50% of the stock (by vote and value) of the subsidiary was held
throughout the 5-year period ending on the acquisition date by the
acquiring corporation or members of its affiliated group
Examples
P's basis in S stock
S's basis in assets
FMV of assets
Ex. 1
FMV of assets
less basis of stock
realized loss
(not recognized)
Ex. 1
100,000
40,000
75,000
75,000
100,000
(25,000)
P takes S's basis in assets = 40,000
if P sells assets, will have 35,000 gain
Ex. 2
FMV of assets
less basis of stock
realized gain
(not recognized)
P takes S's basis in assets = 135,000
125,000
100,000
25,000
Ex. 2
100,000
135,000
125,000
- 150 if P sells assets, will have a (10,000) loss
E.
Method of Effectuating Liquidation Under State Law -- Dissolution v. Merger
1.
Dissolution
a.
may require in-kind distribution of interest in assets to all
shareholders
b.
problems of conveyancing are substantial
c.
2.
F.
G.
(1)
transfer title
(2)
notify creditors
(3)
publish in newspapers
if there are minority shareholders
(1)
issue of division of property
(2)
taxable transaction to minority shareholders
(3)
distributing corporation realizes gain or loss with respect to
property distributed to minority shareholders
Merger (S into P)
a.
no distribution of assets required -- ownership of S assets
automatically vests in P
b.
minority shareholders of S receive stock of P in exchange for
shares of S or, alternatively, they dissent and receive the cash value
of their shares
c.
for tax purposes the transaction qualifies as a liquidation to P under
section 332 even though it is treated as a merger for state law -section 332(b) (last paragraph)
Tax Consequences to Minority (20% or Less) Shareholders
1.
Section 332 only applies to P
2.
Minority shareholders generally fit under section 331 -- recognize gain or
loss
3.
If combination of P and S consummated by merger, minority shareholders
may receive P stock in a tax free transaction
Intercorporate Liabilities
1.
S owes money to P
- 151 -
2.
a.
if S is indebted to P, its assets will be used to pay off debt as well
as cancel stock in liquidation
b.
pre-1954 -- S recognized gain if it used appreciated property to
satisfy liability
c.
new section 337(b)(1) (replacing section 332(c)) -- S recognizes no
gain or loss on payment of P debt in liquidation
d.
new section 337(b)(1) does not protect P -- if P's basis in the debt
is below its face P will recognize gain when paid by S (P buys S
bond from third party at a discount) -- Treas. Reg. § 1.332-7; but
see section 108(e)(4)
e.
section 334(b)(1) -- basis of assets used to satisfy debt carry over
from S to P
P owes money to S
a.
3.
note from P held by S and distributed to P in liquidation -- no
income to P, treated as a distribution of property under section 332
-- Rev. Rul. 74-54, 1974-1 C.B. 76
S is insolvent -- liabilities exceed fair market value of assets
a.
if S is insolvent, section 332 does not apply -- the distribution of its
assets to P is in partial satisfaction of debts and P receives no
distribution on its S stock
(1)
Treas. Reg. § 1.332-2(b) -- section 332 applies only if P
receives at least partial payment for its stock
(2)
see Inductotherm Industries, Inc. v. Commissioner, 48
T.C.M. 167 (1984) (solvent because corporate shareholder
advances held to be equity; section 332 available);
Continental Grain Co. v. Commissioner, 56 T.C.M. 900
(1989) (fact that no debt instruments were drafted or
reflected on books or tax returns did not preclude finding of
subsidiary indebtedness)
b.
since section 332 does not apply, attributes (including NOL) do not
carry over to P
c.
P is entitled to a loss deduction to the extent of its basis in the S
stock
d.
section 165(g) -- worthless security is generally a capital loss
e.
section 165(g)(3) -- P may be entitled to an ordinary loss if
(1)
P owns 80% of the S stock
- 152 (2)
f.
H.
over 90% of S gross receipts is not passive type income
(rents, royalties, dividends, interest, etc.)
Rev. Rul. 68-602, 1968-2 C.B. 135 -- P cannot cancel its debt to S
in order to make S solvent and thereby fit into section 332
Ruling Requests
Rev. Proc. 90-52, 1990-2 C.B. 626 -- sets forth information to be included in a
section 332 request for ruling
XXIII. SECTIONS 336 AND 337 -- DISTRIBUTION IN COMPLETE LIQUIDATION
(EFFECT ON CORPORATION)
A.
Treatment of Liquidating Distributions -- Section 336
1.
2.
General rule
a.
corporation recognizes gain or loss on distribution as if it sold
property at FMV to the distributee shareholder -- section 336(a)
b.
FMV may not be less than amount of liability which shareholder
assumes or to which property is subject -- section 336(b)
(1)
nature of liability as recourse or nonrecourse is apparently
irrelevant
(2)
unclear how unsecured liability will be allocated to
distributed property for purposes of computing gain to
corporation
Limitation on loss recognition -- section 336(d) -- TRA 86 drafters were
concerned that the general loss recognition rule could be abused through
contributions of built-in loss property -- three anti-abuse provisions were
added:
a.
distributions to related persons -- no loss may be recognized on a
distribution to a "related person" unless the distribution is pro rata
and property was not acquired within 5 years as contribution to
capital or in a section 351 transaction
(1)
"related person" -- defined in section 267(b) -- includes
shareholders owning 50% (by value) of corporation's stock
(2)
loss can be disallowed even though there was no "built-in
loss" at time of contribution
(3)
unclear whether recipient shareholder may reduce gain (if
any) on a subsequent disposition to the extent of losses
disallowed on the liquidation -- cf. section 267(d)
- 153 b.
c.
3.
contributions where prohibited purpose exists -- shareholder
contributes built-in loss property to corporation -- a principal
purpose is to recognize loss upon corporate sale or distribution -basis in corporation's hands must be reduced by amount of loss
inherent at time of contribution
(1)
any property acquired within 2 years in a section 351
transaction or as a capital contribution -- presumed to have
been transferred with the forbidden purpose
(2)
period begins 2 years prior to adoption of the plan of
liquidation and continues thereafter -- section
336(d)(2)(B)(ii)
(3)
regulations may provide exceptions where:
•
there is a "clear and substantial" relationship between
the contributed property and the conduct of a
corporation's current or future business
•
loss results from disposition of the assets of the trade or
business (or a line of business) and a "meaningful
relationship" exists between the business and the
corporate form, i.e., the contributed business is not
disposed of immediately after the contribution
•
the corporation acquires assets within its first two years
of existence
loss limitation in section 332 liquidations -- section 336(d)(3) -- no
loss may be recognized by the corporation with respect to any
distribution to minority shareholders in a section 332 liquidation -see section 337
Distributions or sales of subsidiary stock -- special election under section
336(e)
a.
under regulations to be issued, an election may be made to elect to
treat a sale, distribution or exchange of stock in a "controlled
corporation" as a disposition of all of the assets of such controlled
corporation
(1)
corporation is a "controlled corporation" if its parent owns
80% of the voting power and 80% of the value of the stock
in the corporation
(2)
unclear whether some stock may be sold and some
distributed
- 154 (3)
election apparently not available until regulations are
issued
b.
section 336(e) -- no gain or loss on actual stock transfer
c.
section 336(e) applies principles similar to section 338(h)(10)
d.
(1)
section 336(e) election is not tied to section 338 election by
the buyer as is section 338(h)(10)
(2)
section 336(e) election may be made regardless of whether
controlled corporation stock is "purchased" -- cf. section
338(d)(3)
purpose of the election -- to avoid multiple taxation at corporate
level on the same economic gain where appreciated stock is
transferred without commensurate basis step-up in underlying
assets
example:
P owns all of the stock of S. P liquidates and distributes S stock to
A, its sole shareholder. S later is liquidated by A. A triple tax may
be imposed as follows:
e.
(1)
P recognizes gain upon distribution of S stock to A
(2)
A recognizes gain upon disposition of his P stock in
liquidation of P
(3)
S recognizes gain upon its subsequent liquidating
distributions to A
it is unclear how the section 336(e) election will impact minority
shareholders
example:
individual B owns all of the stock of P. P owns 80% of the stock
of S. P and S do not file consolidated returns. The other 20% of S
is owned by individual A. P distributes all of the S stock it owns
(80%) to B and makes a section 336(e) election to treat the
transaction as an asset sale by S
(1)
which entity will recognize the gain on the deemed asset
sale, P or S?
(2)
if the gain is taxed to P, A receives a windfall since he now
owns stock in S which has a stepped up basis in its assets
- 155 (3)
4.
if the gain is taxed to S, A suffers a detriment because the
tax liability imposed upon S will reduce the value of A's
stock in S
Exception to recognition rule
gain or loss under section 336 will not be recognized for distributions
pursuant to a plan of reorganization -- section 336(c) -- see also section
361(c)(4)
B.
Section 337 -- Liquidating Distributions to an 80% Distributee
1.
section 337(a) -- no gain or loss on liquidating distributions to an "80percent distributee"
a.
"80-percent distributee" is "only the corporation which meets the
80-percent stock ownership requirements specified in section
332(b)" -- section 337(c)
b.
section 332(b) contains an 80% vote and value test. See Part
XXII.B.1, supra
c.
OBRA 87 amended section 337 to provide that the determination
whether any corporation is an 80% distributee is made without
regard to any consolidated return regulation
2.
The distributee must meet the 80% ownership test on the date that the plan
is adopted and at all times thereafter until receipt of the property
3.
The controlling corporate shareholder takes a carryover basis in the
distributed property -- section 334(b)(1)
4.
Section 367(e)(2) provides that nonrecognition treatment under section
337 is not available in the case of liquidations of controlled domestic
subsidiaries into foreign parent corporations -- see Notice 87-66, 1987-2
C.B. 376 -- TAMRA 88 clarified that a non-liquidating transfer to a
foreign corporation that would otherwise qualify as a tax-free
reorganization is treated in the same manner -- this rule does not apply if
the domestic transferor corporation is 80% controlled by five or fewer
domestic corporations (counting members of an affiliated group as one
corporation) -- see section 367(a)(5)
5.
Distributions to minority shareholders in complete liquidation taxed
generally as nonliquidating distributions -- gain but not loss is recognized
a.
prevents the liquidating corporation from selectively recognizing
losses by distributing loss property to minority shareholders
b.
rule applies only to extent that property is actually received by
minority shareholders
- 156 6.
Gain or loss is recognized if the 80% distributee is a tax-exempt
organization (other than a section 521 cooperative) unless such
organization uses such property in an unrelated trade or business and the
income is subject to tax under section 511(a) -- section 337(b)(2), as
amended by TAMRA 88
7.
OBRA 87 added section 337(c) to eliminate mirror transactions -- under
this provision, a subsidiary member of a consolidated group will recognize
gain upon its complete liquidation to the extent any of its shareholders
own less than 80% of the liquidating subsidiary stock
8.
Section 337(d) instructs the IRS to issue regulations to assure that the
congressional purpose in repealing the General Utilities doctrine is not
circumvented through the use of any provision of law or regulations or
through the use of a RIC, REIT or tax-exempt entity. The legislative
history also indicates that the IRS is expected to issue regulations
preventing the avoidance of the repeal of General Utilities through
contributions of property with built-in loss to a corporation before it
becomes an S corporation
a.
b.
The IRS has issued regulations under section 337(d) that
implement aspects of the repeal of the General Utilities doctrine by
limiting losses of consolidated groups with respect to the stock of
subsidiaries for certain transitional periods
(1)
Treas. Reg. § 1.337(d)-1 coordinates section 337(d) with
the consolidated return loss deferral rules
(2)
Treas. Reg. § 1.337(d)-2 provides a transitional rule that
allows loss to the extent that the consolidated group
established that the loss is not attributable to the
recognition of built-in gain
(3)
Prop. Treas. Reg. § 1.337(d)-3 provides rules to prevent
taxpayers from using a partnership to avoid section 337(d) - see also Notice 89-37, 1989-1 C.B. 679
(4)
Treas. Reg. § 1.337(d)-4 provides that generally, a
corporation must recognize gain or loss when it transfers all
or substantially all of its assets to a tax-exempt entity or
converts from a taxable corporation to a tax-exempt entity - the regulations are effective as of January 28, 1999. See
T.D. 8802
The IRS has issued temporary regulations under section 337(d) to
prevent the avoidance of corporate level taxation of net built-in
gain of corporate assets through RICs or REITs. See T.D. 8872,
65 F.R. 5775-5777 (Feb. 7, 2000)
- 157 (1)
Temp. Treas. Reg. § 1.337(d)-5T(a)(3) requires a
corporation that transfers its assets to a RIC or REIT in a
carryover basis transaction to recognize gain as if it sold the
assets at their fair market value and immediately liquidated
(2)
Temp. Treas. Reg. § 1.337(d)-5T(b) permits the transferee
RIC or REIT, in lieu of the deemed corporate liquidation,
to be subject to tax under section 1374. Net built-in loss,
however, may not be recognized. Temp. Treas. Reg.
§ 1.337(d)-5T(a)(4)
(3)
the temporary regulations are effective retroactively as of
June 9, 1987