Chapter 13
Digging Deeper
Contents:
|THE CASE OF THE DISAPPEARING DIVIDEND TAX | TAX TREATMENT OF CONSTRUCTIVE
DIVIDENDS | STOCK DIVIDENDS—§ 305 | STOCK RIGHTS |
DISPROPORTIONATE REDEMPTIONS AND COMPLETE TERMINATION REDEMPTIONS |
STOCK ATTRIBUTION RULES | LIQUIDATIONS—PARENT-SUBSIDIARY SITUATIONS |
THE CASE OF THE DISAPPEARING DIVIDEND TAX
1. U.S. banks and offshore hedge funds have developed a novel technique for avoiding the tax on
dividends entirely. The strategy involves the use of financial derivatives. A simple version of the
strategy is called a dividend swap. In the swap, a U.S. bank buys a block of stock from an
offshore hedge fund. The bank and the hedge fund also enter into a derivatives contract. The
contract requires the bank to make payments to the hedge fund equal to the total return on the
stock (both increases in fair market value and dividends) for a designated time period. These
payments equal the income and gain the stock would have provided to the hedge fund if it had
continued to own the stock. In exchange for these payments, the hedge fund
agrees to pay the bank an amount based on some benchmark interest rate. The hedge fund also
agrees that it will pay the bank an amount equal to the loss if the fair market value of the stock
declines.
After purchasing the stock from the hedge fund, the bank receives taxable dividend income. For
tax purposes, however, the dividend income is completely offset by the expense of payments
made to the hedge fund under the derivatives contract. In return, the bank receives compensation
from the hedge fund equal to a benchmark interest rate. The overseas hedge fund no longer
receives taxable dividend income, and the swap payments received are not subject to U.S.
taxation. As a result, taxable dividend income is converted to tax-free income.
Some experts estimate that the strategy has allowed hedge funds to avoid paying more than $1
billion a year in taxes on U.S. dividends.
TAX TREATMENT OF CONSTRUCTIVE DIVIDENDS
2. Global Tax Issues—Deemed Dividends from Controlled Foreign Corporations. U.S.
multinational companies often conduct business overseas using foreign subsidiaries. One might
think that these controlled foreign corporations (CFCs) would be ideal for income tax avoidance if
incorporated in a low-tax jurisdiction (a tax haven country). In the absence of any rules to the
contrary, the higher U.S. tax on foreign earnings could be deferred until the earnings are
repatriated to the United States through dividends paid to the U.S. parent.
To prevent this deferral, the tax law compels a U.S. parent corporation to recognize some of the
unrepatriated earnings of a CFC as income. The U.S. parent’s basis in the CFC stock is
increased by the amount of the taxed but unrepatriated earnings. Subsequently, when cash or
property is actually paid to the U.S. parent (i.e., when taxed earnings are repatriated), no income
results. Thus, the CFC rules preclude some deferral but do not lead to double taxation. See
Chapter 16 for more discussion of CFCs.
STOCK DIVIDENDS—§ 305
3. For each of the exceptions listed below, distributions of corporate stock may be taxed as
dividends.
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Distributions payable in either stock or property, at the election of the shareholder.
Distributions of property to some shareholders, with a corresponding increase in the
proportionate interest of other shareholders in either assets or E & P of the distributing
corporation.
Distributions of preferred stock to some common shareholders and of common stock to
other common shareholders.
Distributions of either common or preferred stock to preferred-stock shareholders.
Distributions of convertible preferred stock, unless it can be shown that the distribution
does not result in a disproportionate distribution.
STOCK RIGHTS
4. The rules for determining the taxability of stock rights are identical to those for determining the
taxability of stock dividends. If the rights are taxable, the recipient recognizes gross income to the
extent of the fair market value of the rights. The fair market value then becomes the shareholderdistributee's basis in the rights.1 If the rights are exercised, the holding period for the new stock
begins on the date the rights (whether taxable or nontaxable) are exercised. The basis of the new
stock is the basis of the rights plus the amount of any other consideration given.
If the stock rights are not taxable and the value of the rights is less than 15 percent of the value of
the old stock, the basis of the rights is zero. However, the shareholder may elect to have some of
the basis in the formerly held stock allocated to the rights.2 The election is made by attaching a
statement to the shareholder's return for the year in which the rights are received. 3 If the fair
market value of the rights is 15 percent or more of the value of the old stock and the rights are
exercised or sold, the shareholder must allocate some of the basis in the formerly held stock to
the rights.
Example: A corporation with common stock outstanding declares a nontaxable dividend payable
in rights to subscribe to common stock. Each right entitles the holder to purchase one share of
stock for $90. One right is issued for every two shares of stock owned. Fred owns 400 shares of
stock purchased two years ago for $15,000. At the time of the distribution of the rights, the market
value of the common stock is $100 per share, and the market value of the rights is $8 per right.
Fred receives 200 rights. He exercises 100 rights and sells the remaining 100 rights three months
later for $9 per right.
Fred need not allocate the cost of the original stock to the rights because the value of the rights is
less than 15% of the value of the stock ($1,600/$4,000 = 4%). If Fred does not allocate his
original stock basis to the rights, the tax consequences are as follows.


Basis in the new stock is $9,000 ($90 exercise price  100 shares). The holding period of
the new stock begins on the date the stock was purchased.
Sale of the rights produces long-term capital gain of $900 ($9 sales price  100 rights).
The holding period of the rights starts with the date the original 400 shares of stock were
acquired.
If Fred elects to allocate basis to the rights, the tax consequences are as follows.
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Basis in the stock is $14,423 ($40,000 value of stock/$41,600 value of rights and stock 
$15,000 cost of stock).
Basis in rights is $577 ($1,600 value of rights/$41,600 value of rights and stock  $15,000
cost of stock).
When Fred exercises the rights, his basis in the new stock will be $9,288.50 ($9,000 cost
+ $288.50 basis in 100 rights).
Sale of the rights would produce a long-term capital gain of $611.50 ($900 sales price –
$288.50 basis in the remaining 100 rights).
DISPROPORTIONATE REDEMPTIONS AND COMPLETE TERMINATION REDEMPTIONS
5. Disproportionate Redemptions. A redemption of stock qualifies for sale or exchange
treatment under § 302(b)(2) as a disproportionate redemption if two conditions are met.


After the distribution, the shareholder owns less than 80 percent of the interest owned in
the corporation before the redemption. For example, if a shareholder owns a 60 percent
interest in a corporation that redeems part of the stock, the shareholder’s percentage of
ownership after the redemption must be less than 48 percent (80 percent of 60 percent).
After the distribution, the shareholder owns less than 50 percent of the total combined
voting power of all classes of stock entitled to vote.
In determining a shareholder’s percentage of ownership before and after a redemption, the stock
attribution rules apply.
Example: Bob, Carl, and Dan, unrelated individuals, own 30 shares, 30 shares, and 40 shares,
respectively, in Wren Corporation. Wren has 100 shares of stock outstanding and E & P of
$200,000. The corporation redeems 20 shares of Dan’s stock for $30,000. Dan paid $200 a share
for the stock two years ago. Dan’s ownership in Wren before and after the redemption is as
follows.
Dan's
Ownership
Total Shares Ownership Percentages
Before redemption
After redemption
100
40
40% (40/100)
80
20
25% (20/80)*
80% of Original
Ownership
32% (80%  40%)
*The denominator of the fraction is reduced after the redemption (from 100 to 80).
Dan’s 25% ownership after the redemption meets both tests of § 302(b)(2). It is less than 80% of
his original ownership and less than 50% of the total voting power. The distribution qualifies as a
stock redemption that receives sale or exchange treatment. Therefore, Dan has a long-term
capital gain of $26,000 [$30,000 - $4,000 (20 shares  $200)].
Assume instead that Carl and Dan are father and son. The redemption described previously
would not qualify for sale or exchange treatment because of the effect of the stock attribution
rules. Dan is deemed to own Carl’s stock before and after the redemption. Dan’s ownership in
Wren before and after the redemption is as follows.
Dan's
Dan's Direct and
80% of
Total
Direct
Carl’s
Indirect
Ownership
Original
Shares Ownership Ownership
Ownership
Percentages Ownership
Before
redemption
100
40
30
70
70% (70/100)
After
redemption
80
20
30
50
62.5%
(50/80)
56%
(80%/70%)
Dan's direct and indirect ownership of 62.5% fails to meet either of the tests of § 302(b)(2). After
the redemption, Dan owns more than 80% of his original ownership and more than 50% of the
voting stock. Thus, the redemption does not qualify for sale or exchange treatment and results in
a dividend distribution of $30,000 to Dan.
Complete Termination Redemptions. If a shareholder terminates his or her entire stock
ownership in a corporation through a stock redemption, the redemption qualifies for sale or
exchange treatment. The attribution rules generally apply in determining whether the
shareholder's stock ownership has been terminated. However, the family attribution rules do not
apply to a complete termination redemption if both of the following conditions are met.
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The former shareholder does not hold or acquire any economic interest, other than that
of a creditor, in the corporation after the redemption (including an interest as an officer, a
director, or an employee) for at least 10 years.
The former shareholder files an agreement to notify the IRS of any prohibited interest
within the 10-year post-redemption period and to retain all necessary records pertaining
to the redemption during this time period.
A shareholder can reacquire an interest in the corporation by bequest or inheritance, but in no
other manner. The required agreement should be in the form of a separate statement signed by
the shareholder and attached to the return for the year in which the redemption occurs. The
agreement should state that the shareholder agrees to notify the IRS within 30 days of
reacquiring a prohibited interest in the corporation within the 10-year period following the
redemption.4
Example: Kevin owns 50% of the stock in Green Corporation, while the remaining interest in
Green is held as follows: 40% by Wilma (Kevin's wife) and 10% by Carmen (a key employee).
Green redeems all of Kevin's stock for its fair market value. As a result, Wilma and Carmen are
the only remaining shareholders, now owning 80% and 20%, respectively. If the two requirements
for the family attribution waiver are met, the transaction qualifies as a complete termination
redemption and results in sale or exchange treatment. If the waiver requirements are not
satisfied, Kevin is deemed to own Wilma's (his wife's) stock, and the entire distribution is taxed as
a dividend (assuming adequate E & P).
If Kevin qualifies for the family attribution waiver for the redemption, he treats the transaction as a
sale or exchange. However, if he purchases Carmen's stock seven years after the redemption, he
has acquired a prohibited interest, and the redemption is reclassified as a dividend. Kevin must
notify the IRS and will owe additional taxes due to this revised treatment.
Summary of the Qualifying Stock Redemption Rules
Type of Redemption
Not essentially equivalent to a
dividend [§ 302(b)(1)]
Requirements to Qualify
Meaningful reduction in shareholder’s voting interest.
Reduction in shareholder’s right to share in earnings or
in assets upon liquidation also considered.
Stock attribution rules apply.
Substantially disproportionate
[§ 302(b)(2)]
Shareholder’s interest in the corporation, after the
redemption, must be less than 80% of interest before the
redemption and less than 50% of total combined voting
power of all classes of stock entitled to vote.
Stock attribution rules apply.
Complete termination [§ 302(b)(3)]
Entire stock ownership terminated.
In general, stock attribution rules apply. However, family
attribution rules may be waived. Former shareholder
must have no interest, other than as a creditor, in the
corporation for at least 10 years and must file an
agreement to notify IRS of any prohibited interest
acquired during 10-year period. Shareholder must retain
all necessary records during 10-year period.
Partial liquidation [§ 302(b)(4)]
Not essentially equivalent to a dividend.
Genuine contraction of corporation’s business.
Termination of an active business.
 Corporation has two or more qualified trades or
businesses.
 Corporation terminates one qualified trade or
business while continuing another.
 Contracted business was not acquired in a taxable
transaction within five years.
Distribution may be in form of cash or property.
Redemption may be pro rata.
Stock attribution rules do not apply.
Redemption to pay death taxes
[§ 303]
Value of stock of one corporation in gross estate exceeds
35% of value of adjusted gross estate.
Stock of two or more corporations treated as stock of a
single corporation in applying the 35% test if decedent
held a 20% or more interest in the stock of each of the
corporations.
Redemption limited to sum of death taxes and funeral and
administration expenses.
Generally tax-free because tax basis of stock is FMV on
date of decedent’s death and value is unchanged at
redemption.
Stock attribution rules do not apply.
STOCK ATTRIBUTION RULES
6. A stock redemption that qualifies for sale or exchange treatment generally must result in a
substantial reduction in a shareholder’s ownership in the corporation. If this does not occur,
proceeds received for a redemption of the shareholder’s stock are taxed as ordinary dividend
income. In determining whether a shareholder’s interest has substantially decreased, the stock
owned by certain related parties is attributed to the shareholder whose stock is redeemed. 5
Thus, the stock attribution rules must be considered along with the stock redemption provisions.
Under these rules, related parties include the following family members: spouses, children,
grandchildren, and parents. Attribution also takes place from and to partnerships, estates, trusts,
and corporations (50 percent or more ownership required in the case of corporations). The exhibit
below summarizes the stock attribution rules.
Deemed or Constructive Ownership
Family
Partnership
An individual is deemed to own the stock owned by his or
her spouse, children, grandchildren, and parents (not
siblings or grandparents).
A partner is deemed to own the stock owned by a
partnership to the extent of the partner's proportionate
share in the partnership.
Stock owned by a partner is deemed to be owned in full by
a partnership.
Estate or
trust
A beneficiary or an heir is deemed to own the stock owned
by an estate or a trust to the extent of the beneficiary's or
heir's proportionate interest in the estate or trust.
Stock owned by a beneficiary or an heir is deemed to be
owned in full by an estate or a trust.
Corporation
Stock owned by a corporation is deemed to be owned
proportionately by any shareholder owning 50% or more of
the corporation's stock.
All stock owned by a shareholder who owns 50% or more
of a corporation is deemed to be owned by the corporation.
Example: Larry owns 30% of the stock in Blue Corporation, the other 70% being held by his
children. For purposes of the stock attribution rules, Larry is treated as owning 100% of the Blue
stock. He owns 30% directly and, because of the family attribution rules, 70% indirectly.
Example: Chris owns 50% of the stock in Gray Corporation. The other 50% is owned by a
partnership in which Chris has a 20% interest. Chris is deemed to own 60% of Gray: 50% directly
and, because of the partnership interest, 10% indirectly.
LIQUIDATIONS—PARENT–SUBSIDIARY SITUATIONS
7. Section 332, an exception to the general rule of § 331, provides that a parent corporation does
not recognize gain or loss on a liquidation of a subsidiary. In addition, the subsidiary corporation
recognizes neither gain nor loss on distributions of property to its parent.6
The requirements for applying § 332 are as follows.
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The parent must own at least 80 percent of the voting stock of the subsidiary and at least
80 percent of the value of the subsidiary’s stock.
The subsidiary must distribute all of its property in complete cancellation of all of its stock
within the taxable year or within three years from the close of the tax year in which the
first distribution occurred.
The subsidiary must be solvent.7
If these requirements are met, nonrecognition of gains and losses becomes mandatory. However,
if the subsidiary is insolvent, the parent corporation will have an ordinary loss deduction.
Basis of Property Received by the Parent Corporation. Property received in the complete
liquidation of a subsidiary has the same basis it had in the hands of the subsidiary.8 This
carryover basis in the assets may differ significantly from the parent’s basis in the stock of the
subsidiary. Because the liquidation is a nontaxable exchange, the parent’s gain or loss on the
difference in basis is not recognized. Further, the parent’s basis in the stock of the subsidiary
disappears.
Example: Lark Corporation has a basis of $200,000 in the stock of Heron Corporation, a
subsidiary in which it owns 85% of all classes of stock. Lark purchased the Heron stock 10 years
ago. In the current year, Lark liquidates Heron Corporation and acquires assets that are worth
$800,000 and have a tax basis to Heron of $500,000. Lark Corporation takes a basis of $500,000
in the assets, with a potential gain upon their sale of $300,000. Lark’s $200,000 basis in Heron’s
stock disappears.
Example: Indigo Corporation has a basis of $600,000 in the stock of Kackie Corporation, a
wholly owned subsidiary acquired 10 years ago. It liquidates Kackie Corporation and receives
assets that are worth $400,000 and have a tax basis to Kackie of $300,000. Indigo Corporation
takes a basis of $300,000 in the assets it acquires from Kackie. If Indigo sells the assets, it has a
gain of $100,000 even though its basis in the Kackie stock was $600,000. Indigo’s loss on its
stock investment in Kackie will never be recognized.
In addition to the parent corporation taking the subsidiary’s basis in its assets, the parent’s
holding period for the assets includes that of the subsidiary. Further, the parent acquires other tax
attributes of the subsidiary, including the subsidiary’s net operating loss carryover, business credit
carryover, capital loss carryover, and E & P.
Summary of Liquidation Rules
Effect on the Shareholder
Basis of Property Received
Effect on the Corporation
§ 331—The general rule
provides for gain or loss
treatment on the difference
between the FMV of property
received and the basis of the
stock in the corporation. Gain
allocable to installment notes
received can be deferred to
point of collection.
§ 334(a)—Basis of assets
received by the shareholder
will be the FMV on the date of
distribution (except for
installment obligations on
which gain is deferred to the
point of collection).
§ 336—Gain or loss is
recognized for distributions in
kind and for sales by the
liquidating corporation.
Losses are not recognized for
distributions to related parties
if the distribution is not pro
rata or if disqualified property
is distributed. Losses may be
disallowed on sales and
distributions of built-in loss
property even if made to
unrelated parties.
§ 332—In liquidation of a
subsidiary, no gain or loss is
recognized to the parent.
Subsidiary must distribute all
of its property within the
taxable year or within three
years from the close of the
taxable year in which the first
distribution occurs. Minority
shareholders taxed under
general rule of § 331.
§ 334(b)(1)—Property has the
same basis as it had in the
hands of the subsidiary.
Parent’s basis in the stock
disappears. Carryover rules of
§ 381 apply. Minority
shareholders get FMV basis
under § 334(a).
§ 337—No gain or loss is
recognized to the subsidiary
on distributions to the parent.
Gain (but not loss) is
recognized on distributions to
minority shareholders.
Notes:
1
Reg. § 1.305-1(b).
2
§ 307(b)(1).
3
Reg. § 1.307-2.
4
Reg. § 1.302-4(a)(1).
5
§ 318.
6
§ 337(a).
7
§ 332(b) and Reg. §§ 1.332-2(a) and (b).
8
§ 334(b)(1) and Reg. § 1.334-1(b). But see § 334(b)(1)(B) (exception for property acquired in
some liquidations of foreign subsidiaries).
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