CHAPTER 19 CORPORATIONS: DISTRIBUTIONS NOT IN COMPLETE LIQUIDATION

LECTURE NOTES
CORPORATE DISTRIBUTIONSOVERVIEW 1. Distributions by a corporation to its shareholders are presumed to be dividends unless the parties can prove otherwise. Section 316 makes such distributions dividend income to the shareholder to the extent of E & of the distributin! corporation "accumulated since 1#13$ or to the extent of E & for the current year. Distributions not taxed as dividends "because of insufficient E & $ are nontaxable to the extent of the shareholder&s stock basis and will reduce that basis accordin!ly. 'ny excess of the distribution over the shareholder&s basis usually is a capital !ain.

%.

EARNINGS AND PROFITS (E & P) 31 3. E & ( thou!h similar in concept to )retained earnin!s(* is computed differently. +etained earnin!s computation is based on financial accountin! rules while E & is determined usin! tax law. ' few of the differences are as follows. a. b. c. ,apitali-ation of stock dividends does not decrease E & . they decrease retained earnin!s. E & is reduced only by strai!ht/line depreciation unless the corporation uses a depreciation method such as )units of production* or )machine hours.* E & may be affected by !ains and losses from property transactions only to the extent they are reco!ni-ed for tax purposes "e.!.( like/kind exchan!es are not reco!ni-ed for taxable income determination or for E & purposes$.

19! 0.

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C$%&/121,$* $5 E & P 2. 'dditions to taxable income. 3o compute E & ( taxable income is increased for all tax/ exempt income items such as municipal bond interest( excluded life insurance proceeds "in excess of cash surrender value$( dividends not taxed due to the dividends received deduction( and 4ederal income tax refunds for taxes paid in prior years. 3axable income is also increased by the domestic production activity deduction "D 'D$. 3hese deduc/tions are essentially partial income exclusions. Subtractions from taxable income. 3axable income is then decreased by nondeductible expenses and losses to determine E & . 3hese nondeductible expenses include related party losses( excess capital losses( 4ederal income taxes paid( fines and penalties( expenses incurred to produce tax/exempt income( and key employee life insurance premiums "in excess of increases in cash surrender value$. 3imin! ad6ustments. Some E & ad6ustments shift a transaction&s impact from the year it is included in taxable income to the year it has an economic effect on a corporation. Excess capital losses( excess charitable contributions( and 789 carryovers all are this type of ad6ustment. 'ccountin! method ad6ustments. 3hese ad6ustments relate to differences in accountin! methods re;uired for E & and taxable income. 1ncluded in this !roup are ad6ustments re;uired for depreciation( < 15# expense( installment sales( 9148 recapture( intan!ible drillin! costs( minin! exploration and development costs( amorti-ation of circulation expenditures( trademarks( or!ani-ational expenditures( and accountin! for construction contracts. 'lternative depreciation system "'DS$ must be used for computin! E & . 3his system uses strai!ht/line depreciation over a recovery period e;ual to the 'sset Depreciation +an!e "'D+$ midpoint life. 3herefore( if accelerated depreciation is used to compute taxable income( an ad6ustment to E & must be made. a. b. 7o additional first year depreciation is allowed for E & purposes.

6.

5.

:.

#.

'D+ midpoint lives for most assets are set out in +ev. roc. :5/26( 1#:5/% ,.=. 650. 3he recovery period is 2 years for automobiles and li!ht/duty trucks and 0> years for real property. 'ssets with no class life have 1% year recovery period. ?hen the asset is later sold( the increase or decrease to E & is computed by usin! the ad6usted basis of the asset for E & purposes. Example 5 in the text demonstrates this concept.

c.

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19!3

Section 15# expenses must be deducted over five years. 3hus( in the year < 15# is elected( :>@ is added back to taxable income to arrive at E & . 1n each of the followin! four years( %>@ of the < 15# expense is subtracted from taxable income to determine E & .

S/%%2'8 $5 E & P A79/+1%(*1+ 1>. ,oncept Summary 1#/1 lists the ad6ustments that are made to a corporation&s taxable income in arrivin! at E & . Some of the more common ad6ustments are as follows. a. E & is increased by the amount of any deferred !ain in the year in which a corporation sells property on the installment basis. 3his is accomplished by treatin! all principal payments as havin! been received in the year of sale for purposes of computin! E & . 1ntan!ible drillin! costs allowable as a deduction under < %63"c$ and mineral exploration and development costs allowable as a deduction under << 616"a$ or 615 are re;uired to be capitali-ed for purposes of computin! E & . 8nce capitali-ed( these expenditures are char!ed to E & over a specified period "i.e.( 6> months in the case of intan!ible drillin! costs and 1%> months for mine exploration and development costs$. 'ny unamorti-ed balance is written off when the well becomes dry or the mineral property is abandoned. 'mounts amorti-ed under << 153 "circulation expenditures$( 155 "trademark and trade name expenditures$( and %0: "or!ani-ational expenditures$ are to be capitali-ed for purposes of determinin! E & . 3here is no amorti-ation if the property does not have a reasonably determinable useful life. ,onstruction period interest( taxes( and carryin! char!es are capitali-ed as a part of the asset to which they relate for purposes of computin! E & . 'ny increase in the 9148 recapture amount "excess of 4148 over 9148 inventory value$ durin! the year is added to taxable income to determine current E & . Decreases in the 9148 recapture amount are subtracted from taxable income. roblem 33 in the text is an effective in/class exercise for teams of two or three students to complete after discussin! the rules for computin! E & . ,omplete the problem and then discuss the solution.

b.

c.

d. e.

f.

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C/''(*1 -('+/+ A33/%/.21(7 E & P 11. 'ccumulated E & is the total of all previous years& current E & "since 4ebruary %:( 1#13$ as computed on the first day of each year( reduced by any distributions made from E& . 1t is important to distin!uish between current and accumulated E & allocated to distributions differently. because they are

1%.

A..$321,*; E & P 1$ D,+1',4/1,$*+ 13. ?hen current and accumulated E & are positive( corporate distributions are first made from current and then from accumulated. ?hen distributions exceed current E & ( the allocations of current and accumulated are as follows. a. ,urrent E & is allocated to distributions on a pro rata basis to each distribution "proportionately throu!hout the year$. b. c. 10. 'ccumulated E & is allocated to distributions in chronolo!ical order durin! the year( startin! with the first distribution. ,oncept Summary 1#/% lists the steps in allocatin! E & to distributions.

'llocations when either current or accumulated E &

has a deficit.

a. 1f a deficit exists in accumulated and a positive balance exists in current( the two accounts are not netted. 1nstead( distributions are taxed as dividends to the extent of the positive balance in current E & . b. 1f a deficit exists in current and a positive balance exists in accumulated( the two accounts are netted as of the date of the distribution. 3he distribution is treated as a dividend to the extent of a positive net balance. Deficit in current E & is allocated ratably throu!hout the year( unless the parties can show otherwise. 12. 1f current E & is unknown at the end of the shareholder&s tax year "e.!.( when the corporation uses a fiscal year and the shareholder uses a calendar year$( current E & is assumed sufficient to cover all distributions made durin! the year to the shareholder. 1f current E & is determined to be insufficient to cover distributions after the end of the corporation&s year( then the shareholder may file an amended return to claim a refund for taxes paid.

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ETHICAL CONSIDERATIONS Shiftin! E & "pa!e 1#/1>$. Ethical decisions can sometimes be reached via stakeholder analysis. 1deally( all stakeholders will be better off as a result of the solution. costs and benefits should be fairly distributed. and stakeholders& ri!hts should be preserved. 3o move toward an ethical solution( the instructor should encoura!e a discussion of what each stakeholder stands to !ain or lose as a result of Aoe&s decision. =$(B 'ssumin! his tax rates will not chan!e over the two/year period at issue( it is in Aoe&s self/ interest to defer the income until next year because of the time value of money. Aoe&s benefit from deferral is e;ual to the return he can earn on the tax liability for one year. F'2*>,(B 1f Aoe defers the income until next year( 4rankie&s distribution will be tax free to the extent of his stock basis and taxed as a capital !ain if the distribution exceeds basis. 1f 4rankie&s stock basis is reduced( he will reco!ni-e a lar!er capital !ain on the sale of his stock to ,indy at the be!innin! of next year. 1n contrast( acceleration of the income into this year will tri!!er dividend treatment on the distribution with no basis reduction. 3hus( for 4rankie( the decision trades off dividend income this year with a similarly taxed capital !ain next year. C,*78B 1f Aoe defers the income( the distribution to ,indy next year will be taxed as a dividend and her stock basis will be preserved. 3he present value of savin!s !enerated by preservin! her stock basis will be small relative to the tax cost of the dividend because she will probably hold her stock for several years. 'lternatively( if Aoe accelerates the income into the current year( ,indy&s distribution will be tax/free and reduce the basis in her stock. 3he basis reduction will create !ain potential at some later date( but the present value of the tax cost is probably low( because any stock sale by ,indy is likely to be far into the future. ,indy trades off a tax on dividends next year with a heavily discounted capital !ain tax. ,omparin! the costs and benefits faced by ,indy and 4rankie re;uires some assumption about relative tax rates. 1f we assume that ,indy and 4rankie have similar mar!inal rates( then ,indy stands to !ain more than 4rankie will lose if Aoe accelerates the income into the current year. 3he benefit to ,indy probably also outwei!hs the small deferral benefit accruin! to Aoe. ,onse;uently( to minimi-e the overall tax cost for all parties involved( Aoe&s best decision is to accelerate the income into the current year. 3he proposed solution still falls short of the criteria established for an ethical decision. 1n particular( one mi!ht ;uestion whether the resultin! distribution of costs and benefits is fair and whether stakeholder ri!hts are preserved. =oth Aoe and 4rankie are made worse off by this decision. 3o improve the solution( Aoe should search for a way for both himself and 4rankie to share in ,indy&s benefits. 4rankie mi!ht be able to offset the costs of acceleratin! the income by ne!otiatin! a hi!her stock price with ,indy in return for the income acceleration. Aoe mi!ht participate in the ne!otiations and attempt to capture a portion of the benefits as well "assumin! the monetary benefits he receives outwei!h any !ood feelin!s arisin! from transferrin! some wealth to his sister$.

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G$-('*%(*1 (T)( P/4.,3)B 3he role of the !overnment as a stakeholder should also be addressed. 1f one considers the !overnment&s position to be improved with lar!er amounts of taxes collected( the proposed solution appears to be at lo!!erheads with the !overnment&s interests and the criteria for an ethical solution are not met. Cowever( this view can be called into ;uestion by discussin! the role of !overnment and the role of tax law. 1n particular( the instructor should lead a discussion re!ardin! whether or not the public&s interest is served or harmed by careful tax plannin!. DIVIDENDS 16. 3he tax treatment of dividends is affected in part by whether the shareholder is an individual( a corporation( or another type of taxpayin! entity. a. b. ,orporations receivin! dividends are taxed at ordinary rates on amount remainin! after subtractin! the dividends received deduction. 8ther taxpayers receive a reduced rate of tax on ;ualifyin! dividends( while non/ ;ualifyin! dividends are taxed as ordinary income.

R21,$*2. 5$' R(7/3(7 T2@ R21(+ $* D,-,7(*7+ 15. 1:. +eduction in the tax rate on dividends paid to individuals was made to reduce distortions attributable to the double tax on dividends and to stimulate the economy. +eduction in the double tax should also make the D.S. more competitive in international markets( because most other countries assess only one level of tax on corporate earnin!s.

Q/2.,5,(7 D,-,7(*7+ 1#. 4rom %>>3 to %>1>( ;ualified dividends are sub6ect to a maximum 12@ tax rate for most individual taxpayers. 'fter %>1>( dividends revert to ordinary income treatment. a. 1ndividuals in the 1>@ or 12@ tax rate brackets are sub6ect to a 2@ tax rate on ;ualified dividends paid between %>>3 and %>>5 and a >@ tax rate between %>>: and %>1>. b. 3he special tax rates on ;ualified dividends also apply under the alternative minimum tax. %>. 3o ;ualify for the special 2@ or 12@ tax rates( dividends must meet three re;uirements. a. 3he dividend must be paid by a ;ualifyin! corporation. Eualifyin! corporations include domestic corporations( forei!n corporations whose stock is traded on D.S. markets( and corporations located in a country that "1$ has a comprehensive income tax treaty with the D.S.( "%$ has an information/sharin! a!reement with the D.S.( and "3$ is approved by the 3reasury.

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19!A

Dividends paid to shareholders who hold both lon! and short positions in the same stock do not ;ualify. 3he stock must be held for more than 6> days durin! the 1%1/day period be!innin! 6> days before the ex/dividend date.

Dividends taxed at 2@ or 12@ rates are not treated as investment income for purposes of the investment interest expense limitation. 3axpayers can( however( elect to treat dividends as investment income. 1f they do( the dividends will be taxed as ordinary income.

PROPERTB DIVIDENDS %%. 'mount distributed as dividends in the form of property rather than cash are measured by the fair market value of the property on the date of distribution. 3his amount is reduced by any liabilities associated with the property that are assumed by the shareholder. Shareholder&s basis in the distributed property is fair market value on the distribution date. Dnder < 311"b$( !ain but not loss is reco!ni-ed to a corporation that distributes property as a dividend. a. b. Distribution of appreciated property is treated as if the property were sold to the shareholder at its fair market value. 4urther( if the property distributed is sub6ect to a liability( or if the shareholder assumes a liability that exceeds the basis of the distributed property( the fair market value of the property shall not be less than the amount of the liability.

%3. %0.

%2.

Distributin! corporation&s E & is reduced by the amount of money distributed or by the !reater of the fair market value or the ad6usted basis of the property distributed less the amount of any liability on the property. a. b. Distributions cannot !enerate or add to a deficit in E & . 8nly corporate losses !enerate or add to a deficit in E & .

%6.

Distributin! corporation&s E & increases by !ain reco!ni-ed on the appreciated property distributed. 3his !ain flows throu!h the tax return. CONSTRUCTIVE DIVIDENDS %5. %:. ,onstructive dividends usually arise in the context of a closely/held corporation. 3hey need not be formally declared or issued pro rata. Examples of constructive dividends areB a. ersonal use by a shareholder of corporate/owned property "e.!.( company/owned automobiles( airplanes( yachts( huntin! lod!es$. 3he measure of the dividend usually is the fair rental value of the property for the period of its personal use.

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b. c.

' bar!ain sale of corporate property to the shareholders. 3he measure of the dividend is the difference between the amount paid for the property and its 4FG. 3he bar!ain rental of corporate property to its shareholders. 3he measure of the dividend is the amount of the property&s fair rental value that exceeds the rent actually paid. ayments for the benefit of shareholders "1$ "%$ "3$ Satisfaction by the corporation of a shareholder&s personal obli!ation to a third party. 4or!iveness of a shareholder debt to the corporation. Excessive rentals paid by a corporation for the use of shareholder property.

d.

e.

,ompensation to shareholderHemployee that is unreasonable. "1$ "%$ 3here are numerous factors that are considered in determinin! whether compensation is reasonable. See pa!e 1#/15 in text for a list. +easonable investor test is relatively new development in reasonable compensation. ADDITIONAL LECTURE RESOURCE

,ourt cases concernin! reasonable compensation in closely held corporations have received inconsistent treatment. ?hen decidin! these cases( the courts rely on two different types of tests. 3he 13 4ederal circuits differ in the use of these tests based in part on earlier precedent in their respective 6urisdictions. M/.1,&.( F231$' A&&'$23). 3he first type of test uses multiple factors to assess the reasonableness of compensation( such as the company&s financial condition( its dividend history( and the si-e and complexity of its business. 3he approach also compares compensation to similarly situated employees of comparable companies and considers the employee&s contribution to corporate profits and the relationship between compensation and level of stock holdin!s. 3his type of analysis ori!inated in the 6th ,ircuit I Mayson Manufacturing Co. v. Comm., 0#/% DS3, J#065( 3: '43+ 1>%:( 15: 4.%d 112 ",'/6( 1#0#$K and is followed in the 1>th ,ircuit I Eberls Claim Service v. Comm.( :5 '43+%d %>>1/%>52( %0# 4.3d ##0 ",'/1>( %>>1$K. I*7(&(*7(*1 I*-(+1$' A&&'$23). 3o examine the reasonableness of compensation to the shareholder/employee( other courts are be!innin! to use a new approach( involvin! a hypothetical independent investor. 3he ;uestion asked by the 6ud!e is )how much would an independent investor be willin! to pay the employee( !iven the profits that are !eneratedL* 3he 5th ,ircuit ,ourt is the principal advocate for this standard. 8ther courts "includin! the %nd( 6th( and #th ,ircuit ,ourts$ have started to use a hybrid approach( considerin! both the multiple factors

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su!!ested in Mayson Manufacturing and the new independent investor test. 1n many of the cases adoptin! either a hybrid approach or the independent investor test( opinions have often been critical of the 3ax ,ourt&s use of the multiple factor approach. ' brief summary of a few of these cases follow. Alpha Medical, Inc. v. Comm., ##/1 DS3, J2>(061( :3 '43+%d ##/6#5( 15% 4.3d #0% ",'/6( 1###$. ?illiam +o!ers( a pharmacist with a history of successful business ventures in the health care industry( started a medical consultin! corporation with a M1(>>> contribution to capital. 'fter 0 years of success "lar!ely attributable to the pharmacist&s efforts$( the corporation had taxable income of almost M5(>>>(>>>. 3he corporation paid +o!ers M0.0 million as compensation. Durin! audit( the 1+S determined that M0 million of the compensation paid was unreasonable. 3he 3ax ,ourt split the difference between the 1+S and taxpayer( findin! M%.3 million of +o!ers pay to be reasonable. 8n appeal( however( the Sixth ,ourt of 'ppeals ruled that all M0.0 million of the compensation paid to +o!ers was reasonable. 1n its decision( the ,ourt of 'ppeals said that( )in li!ht of +o!ers& record of accomplishment( risks he assumed( and ama-in! !rowth( reasonable shareholders would have !ladly a!reed to +o!ers& level of compen/sation.* Leonard ipeline Contractors v. Comm.( #:/1 DS3, J2>(326( :1 '43+%d #:/63#( 10% 4.3d 1133 ",'/#( 1##:$. 1n its decision( the 7inth ,ourt of 'ppeals 6ud!e critici-ed the 3ax ,ourt&s failure to explain how it arrived at its reasonable compensation fi!ure "about halfway between amounts ar!ued by the 1+S and the taxpayer$. 3he appellate court noted that the 3ax ,ourt simply enumerated the factors to be considered when determinin! reasonableness of compensation and then leapt to an intermediate fi!ure between the 1+S and taxpayer. E!acto Spring Corp. v. Comm., :0 '43+%d ##/6#55( 1#6 4.3d :%% ",'/5( 1###$. 1n this decision( the 5th ,ircuit ,ourt was sharply critical of the 3ax ,ourt&s use of the multiple factor approach in !eneral( sayin! that it led to )arbitrary results. 3he court su!!ested that the sole use of the independent investor approach is )simpler and more purposive than the multiple factor approach.* Dnder the test( the court ar!ued( the hi!her the rate of return that an employee can !enerate throu!h their own efforts( the hi!her the compensation they should be able to command. Menard, Inc., :: 3,F %%#( 3.,. Femo. %>>0/%>5. Fenard( 1nc. is a home improvement store that is closely held( with most of the stock owned by the ,E8( Fr. Fenard. 1n 1##:( Fr. Fenard received a M6%(0>> salary( M3 million in compensation from a profit sharin! plan( and approximately M15 million as a bonus "set at 2@ of net income before taxes$. 3he corporation earned a hi!her return on investment than similar businesses in the industry. 1n its decision( the 3ax ,ourt a!reed with the taxpayer that the independent investor test was satisfied. Cowever( the court held that satisfaction of this test merely creates a rebuttable presumption that compensation is reasonable. 3he court relied on a statement in +e!. < 1.16%/5"b$"3$B )1t is( in !eneral( 6ust to assume that reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances.* Since ,E8s of publicly traded companies in the same line of business were paid considerably less for their services than Fr. Fenard( the court found that only M5 million of his salary was reasonable.

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f. !.

'dvances by a corporation to a shareholder that are not bona fide loans. 1mputed interest element on interest/free "or below/market$ loans by a corporation to a shareholder. "1$ "%$ "3$ "0$ Shareholder is deemed to make an interest payment to the corporation to the extent of the for!one interest. ,orporation is then deemed to make a dividend distribution to the share/ holder for the same amount. 'lthou!h the shareholder may be permitted to deduct the deemed interest payment( the corporation has interest income. 7o correspondin! corporate interest deduction is allowed because imputed interest element is a constructive dividend.

h.

1nterest and principal payments made by a corporation where debt owed to its shareholders is reclassified as e;uity "i.e.( the corporation is thinly capitali-ed$. i. See the ,lass Exercise on ,onstructive Dividends appearin! at the end of the 9ecture 7otes for this chapter. 3his material can be distributed to the !roup as a take/home or classroom pro6ect. Solutions to the Exercise are also included.

S1$3> D,-,7(*7+ 2*7 S1$3> R,;)1+ %#. 3>. Stock dividends are not taxable if they are pro rata distributions of stock( or stock ri!hts( on common stock. Garious disproportionate distributions are taxable under < 3>2. a. 3he followin! are 2 situations where stock dividends are taxable under < 3>2. "1$ "%$ "3$ 1f one shareholder can elect payment either in cash or in stock( all stock dividends are taxable. Disproportionate distributions of stock dividends are taxable. ,ommon stock distributions to some common shareholders and preferred stock to other common shareholders cause stock dividends to be taxable. ' stock dividend of convertible preferred on common is taxable if it is reasonable to expect that some shareholders will convert their preferred shares to common shares and that others will keep their preferred shares.

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19!11

Distributions on preferred stock are taxable "except for chan!es in the conversion ratio of convertible preferred made to account for a stock dividend or stock split$. ,onvertible preferred stock distributions that result in disproportionate distributions are taxable.

"2$ b.

Section 3>2"c$ provides that transactions increasin! the proportionate interest of a shareholder are taxable even if they are not actually stock dividends. ADDITIONAL LECTURE RESOURCE

3he followin! examples illustrate the applicability of < 3>2B ' corporation has a dividend reinvestment plan that allows shareholders to choose either a stock dividend or a cash dividend. 3he stock dividend is of !reater fair market value than the cash dividend. 1n addition( for those electin! to take the stock dividend and thereby reinvest in the corporation( an optional plan to purchase additional common stock of the company at a price e;ual to #2@ of the fair market value of the stock is available. 3hose choosin! the stock dividend would have a taxable dividend under < 3>2 to the extent of the fair market value of the stock received initially. 1n addition( for shareholders electin! the optional plan( income will be reco!ni-ed to the extent that the fair market value of the stock purchased at the 2@ discount exceeds the purchase price of the stock. +ev. +ul. 5:/352( 1#5:/% ,.=. 13> ' corporation has an annual redemption plan whereby shareholders can redeem 1@ of their stock annually. ?hile those who tender their stock for redemption have dividend income under < 3>1 "because the provisions of < 3>% are not met$( those who do not tender their stock also have dividend income under < 3>2 because their proportionate share of E & and assets of the corporation increases. ?hile a distribution of property incident to an isolated redemption does not cause < 3>2"b$"%$ to apply "even thou!h the redemption is treated as a < 3>1 distribution$( an on!oin! plan of annual stock redemptions is sub6ect to < 3>2"b$"%$. +ev. +ul. 5:/6>( 1#5:/1 ,.=. :1 ' distribution to common shareholders of preferred stock which is immediately redeemable is taxable as offerin! a choice of stock or cash under < 3>2"b$"1$. +ev. +ul. 51#/%2:( 1#51#/% ,.=. #2 ' corporation has two classes of common( ' and =. 1t makes a distribution of class ' common stock to the holders of class ' common stock( and a distribution of newly issued preferred stock to the holders of class = common stock. 3he +e!ulations I+e!. < 1.3>1#/ 0"b$K hold that both distributions are taxable. ' corporation( havin! one class of common stock( distributes to its common shareholders a new issue of convertible preferred havin! a six/month conversion period and a conversion price near the market value of the common stock. 3he +e!ulations provide

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' payment of interest to a holder of a convertible debenture will cause the distribution of a stock dividend to the common shareholders to be taxed under < 3>2"b$"%$. 3he holders of the convertible debentures are deemed to be shareholders. thus( some shareholders have received cash. +e!. < 1.3>1#/3"b$"3$

31. 3%.

1f stock dividends are not taxable( there is no reduction in E & . 1f they are taxable( the distribution is treated as any other property dividend. 1f the stock dividend is not taxable( < 3>5 applies and a basis allocation is necessary. 1f the stock dividend is taxable( the basis of the stock received is its fair market value.

C$'&$'21,$*+: D,+1',4/1,$*+ N$1 ,* C$%&.(1( L,6/,721,$* OVERVIEW 33.

19!13

,orporate nonli;uidatin! distributions to shareholders are typically treated as dividend income. Cowever( distributions that ;ualify as stock redemptions are treated the same as a sale of stock by the shareholders to a third party. 3hus( capital !ain treatment normally results. a. Eualifyin! stock redemptions provide !reater tax benefits to noncorporate share/ holders than non;ualifed redemptions. "1$ Since ;ualifyin! stock redemptions are treated as sales or exchan!es( the shareholders can offset their amount reali-ed by the basis of the stock redeemed. 'ny !ain remainin! is treated as a capital !ain and taxed at the applicable capital !ain rates "lon!/term rates are 2@ or 12@$. 1f the distributions do not ;ualify as stock redemptions( they are treated as dividend income and taxed at dividend rates "assumin! ade;uate E & $. =y increasin! the amount of capital !ains for the year( redemptions may increase the utili-ation of capital losses from other sources. Distributions treated as dividends cannot provide this same benefit.

"%$ "3$

b.

,orporate shareholders prefer non;ualified stock redemption "i.e.( dividend$ treatment. "1$ ?ith dividend treatment( corporate shareholders receive the benefits of the dividends received deduction. 3hus( most of the non;ualified stock redemption income is not taxable. Eualified stock redemptions produce capital !ains that are fully taxable at the corporation&s hi!hest mar!inal rate. ADDITIONAL LECTURE RESOURCE

"%$

' !ood example of a redemption transaction structured to fail the ;ualifyin! stock redemption provisions in order to obtain the dividends received deduction is Du ont ,orporation&s redemption of stock held by Sea!ram ,orporation. "See( 9ee '. Sheppard( ),an Sea!ram =ail 8ut of Du ont without ,apital Nain 3axL* "a! #otes "oday( #2 373 52/0( 'pril 1:( 1##2$. 1n +ev. +ul. 55/%%6( 1#55/% ,.=. #>( redemption of stock is followed by sale of remainin! stock held by corporate shareholder. 3he two transactions are part of inte!rated plan resultin! in complete termination redemption thus the dividends received deduction on redemption transaction disallowed. Section 1>2#"a$ tempers the advanta!es of these redemption transactions by re;uirin! the corporate shareholder to reduce its stock basis by the amount of the dividends received deduction( and to reco!ni-e !ain for any excess over the basis.

19!1:

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30.

,orporations !enerally reco!ni-e both !ains and losses on li;uidatin! distributions thus( preservin! the double taxation inherent in operatin! a business as a , corporation. Some ma6or exceptions apply( however. a. b. 'ntistuffin! rules limit loss reco!nition with respect to certain distributions "and sales$ pursuant to li;uidation. Subsidiary corporations do not reco!ni-e !ainsHlosses on li;uidatin! distributions to its parent corporation and it is also !enerally tax/free to the parent.

32.

Shareholders of a li;uidatin! corporation receive sale or exchan!e treatment. thus( the difference between the fair market value of all properties received and the stock basis is a capital !ain "or loss$.

STOCC REDEMPTIONSSALE OR EDCHANGE TREATMENT 36. Stock redemptions ;ualifyin! under < 3>%"b$ or < 3>3 receive sale or exchan!e treatment. 3o be ;ualified( the distribution must meet one of the followin! re;uirements. a. b. c. d. e. 35. 3:. 7ot essentially e;uivalent to a dividend under < 3>%"b$"1$. Substantially disproportionate in terms of shareholder effect under < 3>%"b$"%$. ,omplete termination of a shareholder&s interest under < 3>%"b$"3$. +edemption of noncorporate shareholder in partial li;uidation of the corporation under < 3>%"b$"0$. +edemption to pay decedent shareholder&s death taxes and the estate&s adminis/ tration expenses under < 3>3.

'mount of the shareholder&s !ainHloss is measured by the difference between the amount received and the shareholder&s ad6usted basis in the stock redeemed. Shareholder&s basis in property received in the redemption is its fair market value.

C$'&$'21,$*+: D,+1',4/1,$*+ N$1 ,* C$%&.(1( L,6/,721,$*

19!1<

ADDITIONAL LECTURE RESOURCE Stock =uybacks Stimulate +edemptions. Stock redemptions often are motivated by corporate reasons. 4or instance( when a corporation considers its stock undervalued( it may repurchase its shares throu!h a )tender offer.* =y reducin! the number of shares outstandin!( the corporation may be able to increase its earnin!s per share and related financial ratios. 'lthou!h the purchase is motivated by corporate reasons( each redeemin! shareholder must consider the ;ualifyin! stock redemption rules to determine whether sale or exchan!e treatment is available. 1n most cases( however( the shareholders redeemin! stock in these buybacks hold small stakes in the corporation and( as such( are not hindered by the ;ualifyin! stock redemption re;uirements. See( +ev. +ul. 51#/3:2( 1#51#/% ,.=. #% "redemption of stock from shareholder with de minimis interest ;ualifies as a not essentially e;uivalent redemption$. Cowever( a de minimis shareholder will not ;ualify for < 3>%"b$"1$ treatment if the redemption is pro rata with respect to all shareholders "+ev. +ul. :1/%:#( 1#:1/% ,.=. :%$. 3he "a! in the #e$s on p. 1#/2 of the text illustrates a problem encountered by nonresident alien shareholders when their stock is redeemed in tender offers "See 9tr. +ul. %>>22%>>5$.

ADDITIONAL LECTURE RESOURCE Stock +edemptions 1ncident to Divorce. roperty transferred pursuant to a divorce under < 1>01 results in no !ain "or loss$ to the transferor ex/spouse and a carryover basis to the recipient ex/ spouse. 3he deferred !ainHloss is typically reco!ni-ed when the recipient disposes of the property in a taxable event. ?hen the property is stock of a closely held corporation "e.!.( wholly owned by one or both spouses$( and the stock is redeemed because of a divorce a!reement( an alternative result can occur. 1n some cases( the redemption transaction will be treated as a distribution to the transferrin! spouse and a subse;uent transfer of the proceeds to the recipient spouse. 3he transferrin! spouse&s remainin! stock ownership in the corporation !enerally precludes ;ualifyin! stock redemption treatment( and the result is a dividend distribution to such spouse ISee( Craven v. %.S.( %>>%/% DS3, J2>(201( :2 '43+%d %>>>/%%%#( %12 4.3d 1%>1 ",'/11( %>>>$. and Carol M. &ead( 110 3.,. 10 "%>>>$K. 3he +e!ulations for < 1>01 permit taxpayers to establish the tax conse;uences associated with the redemption of stock pursuant to a divorce. Dnder +e!. < 1.1>01/%"c$( taxpayers can dictate in the divorce or separation instrument which spouse is be taxed on the stock redemption.

S1$3> A11',4/1,$* R/.(+ 3#. Nenerally( < 31: constructive ownership rules apply in determinin! whether a distribution is a ;ualifyin! stock redemption. a. 1ndividuals are treated as ownin! stock owned by their spouses( parents( children( and !randchildren.

19!1?

""# C$%&'()(*+,-( V$./%(0S$./1,$*+ 1$ R(+(2'3) P'$4.(%+ Example. Oeith owns 6> shares of stock in urple ,orporation. 3he remainin! 0> shares are owned by the followin! relatives of OeithB Oeith&s wife "2$. Oeith&s son "%$. Oeith&s dau!hter "3$. Oeith&s father "1>$. Oeith&s brother "6$. and Oeith&s aunt "10$. Oeith is deemed to own a total of :> shares in urple. 8nly the stock of his brother and his aunt are not attributed to him. b. Stock owned( directly or indirectly( by a partnership is considered to be owned proportionately by the partners. Cowever( stock owned by a partner is treated as owned in full by the partnership. Example. 9ori has a %>@ interest in a partnership which owns 3> shares in ?hite ,orporation. 9ori is deemed to own 6 "%>@ of 3>$ shares in ?hite. Cowever( if 9ori owned 3> shares in ?hite "rather than the partnership$( the partnership would be deemed to own all of 9ori&s 3> shares. c. Stock owned( directly or indirectly( by an estate or trust is considered to be owned proportionately by the beneficiaries. but stock owned by or for a beneficiary is treated as owned in full by the estate or trust. Example. 'rnold has a 1>@ beneficiary interest in a trust. 3he trust owns 2> shares in Nreen ,orporation. 'rnold is considered as ownin! 2 "1>@ of 2>$ of these shares. Cowever( if 'rnold owned the 2> shares "rather than the trust$( the trust would be deemed to own all of 'rnold&s 2> shares. d. Stock owned by a corporation is considered to be owned proportionately by any shareholder ownin! 2>@ or more of the corporation&s stock. Cowever( stock owned by a shareholder who owns 2>@ or more of a corporation is considered to be owned in full by the corporation. Example. 7ancy owns 6>@ of Nray ,orporation. Nray owns %> shares of =lue ,orporation( and 7ancy owns 2> shares of =lue. 7ancy is deemed to own 6% shares in =lue( her own 2> shares plus 6>@ of Nray&s %> shares( or 1% more shares. Nray( on the other hand( is deemed to own 5> shares of =lue( its %> shares and 7ancy&s 2> shares. e. Exhibit 1#/1 in the text summari-es the stock attribution rules.

0>.

3he stock attribution rules do not apply in certain cases. a. b. 4amily attribution rules can be waived in a complete termination redemption. 'll attribution rules are i!nored for partial li;uidations and in redemptions to pay death taxes. ADDITIONAL LECTURE RESOURCE

C$'&$'21,$*+: D,+1',4/1,$*+ N$1 ,* C$%&.(1( L,6/,721,$*

19!1A

,ourts have addressed the issue of whether family discord should affect the application of < 31:. 1n &obin 'aft "rust( 61 3.,. 3#: "1#53$( the 3ax ,ourt refused to accept a )family fi!ht* exception to the attribution rules. Cowever( the 4irst ,ircuit ,ourt of 'ppeals reversed I52/1 DS3, J#0>#( 32 '43+%d 52/52>( 21> 4.%d 03 ",'/1( 1#52$K and the 3ax ,ourt ruled that the existence of family discord could ne!ate the presumption that related taxpayers would exert continuin! control over a corporation after their stock is redeemed. 1n +ev. +ul. :>/%6( 1#:>/1 ,.=. 66( the 1+S announced it would not follow the 4irst ,ircuit&s decision in &obin 'aft "rust because( accordin! to the 1+S( the )family hostility* exception is inconsistent with the le!islative history behind the redemption provisions. 1n Met(ger "rust v. Comm., :%/% DS3, J#51:( 21 '43+%d :3/356( 6#3 4.%d 02# ",'/2( 1#:%$( the 4ifth ,ircuit ,ourt of 'ppeals a!reed with the 1+S and ruled that there is no family hostility exception to the attribution rules. N$1 E++(*1,2..8 E6/,-2.(*1 R(7(%&1,$*+ 01. ' stock redemption under < 3>%"b$"1$ must not be essentially e;uivalent to a dividend. 3he Supreme ,ourt in %.S. v. )avis established the followin! rules as to < 3>%"b$"1$. a. b. c. 1t is immaterial that the redemption has a business purpose and is not part of a tax avoidance scheme to bail out dividends at favorable tax rates. 3he redemption must result in a )meanin!ful reduction* of the shareholder&s interest( with a reduction in votin! control bein! the most important factor. ,onstructive ownership rules of < 31:"a$ apply in fi!urin! meanin!ful reductions. ADDITIONAL LECTURE RESOURCE 3he meanin!ful reduction test is based upon the facts and circumstances of each case I+e!. < 1.3>%/%"b$K. ' redemption of stock from a shareholder havin! a de minimis stock interest both before and after the transaction should ;ualify as a not essentially e;uivalent redemption "+ev. +ul. 51#/3:2( 1#51#/% ,.=. #%$. Cowever( a de minimis shareholder will not ;ualify for < 3>%"b$ "1$ treatment if the redemption is pro rata with respect to all shareholders "+ev. +ul. :1/%:#( 1#:1/% ,. =. :%$. ' < 3>%"b$"%$ disproportionate redemption re;uires shareholders to own( directly and indirectly( less than 2>@ of the corporation&s votin! stock after the redemption. ' redemption can ;ualify as a not essentially e;uivalent redemption even thou!h the shareholder owns 2>@ "or possibly more$ of the stock after the transaction. ' reduction in shareholder interest from 25@ to 2>@ was held to be a not essentially e;uivalent redemption when a sin!le unrelated shareholder owned the remainin! 2>@ interest "+ev. +ul. 52/2>%( 1#52/% ,.=. 111$. ?hen a shareholder&s interest after a redemption is more than 2>@( the meanin!ful reduction test will not be satisfied in the 1+S&s opinion "See( +ev. +ul. 5:/0>1( 1#5:/% ,.=. 1%5( interest reduced from #>@ to 6>@. and +ev. +ul. 55/%1:( 1#55/1 ,.=. :1( interest reduced from 6>@ to 22@ did not ;ualify$. Cowever( one court found a reduction in shareholder interest from :2@ to

19!1#

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61.5@ did satisfy the meanin!ful reduction test when applicable state law re;uired a two/thirds vote for amendin! articles of incorporation( for mer!er and ac;uisition( and for li;uidation I*right v. %.S.( 53/% DS3, J#2:3( 3% '43+%d 20#>( 0:% 4.%d 6>> ",'/:( 1#53$K.

0%. 03.

+edemption of preferred stock( that is not < 3>6 stock( may ;ualify as a not essentially e;uivalent redemption. 4or non;ualifyin! stock redemptions( the basis of the stock redeemed attaches to the basis of the shareholder&s remainin! stock. a. 1f the taxpayer owns no stock directly after the transaction( the basis of the stock redeemed attaches to the basis of the stock that was attributed to such taxpayer. "See Example 33 in the text.$ 3here is no !uidance provided for basis allocation when the stock of more than one related shareholder is attributed to the taxpayer. 3he 1+S has a!!ressively attacked tax shelter transactions that utili-e non;ualified stock redemptions to shift stock basis to other shareholders. "See the Additional Lecture &esource below.$ ADDITIONAL LECTURE RESOURCE

b.

1+S 'ttacks =asis/Shiftin! 3ax Shelters. ?hen a stock redemption does not ;ualify for sale or exchan!e treatment( the basis in the stock redeemed attaches to the shareholder&s remainin! shares or to stoc+ the shareholder o$ns constructively. ,lever planners have created a tax shelter utili-in! the shift in basis from one shareholder to another shareholder. 3he shelter works as follows. ' D.S. taxpayer and a forei!n corporation indifferent to D.S. tax "e.!.( a ,ayman 1sland corporation$ each ac;uire a small number of shares in a forei!n bank. 3he D.S. taxpayer also purchases from the forei!n corporation an option to ac;uire at least 2> percent of the forei!n corporation&s stock. 3he forei!n bank then redeems the stock owned by the forei!n corporation. Dnder the attribution rules( the D.S. taxpayer is related to the forei!n corporation by reason of the stock option. thus( the redemption results in dividend income to the forei!n corporation "which pays no D.S. tax$. 3he forei!n corporation&s basis in the redeemed shares shifts to the shares of the D.S. taxpayer and those shares are then sold for a loss that is used to offset !ains from other investments. 3he 1+S has announced "7otice %>>1/02( %>>1/% ,.=. 1%#$ that it will disallow the basis shift in these tax shelter cases and that it will assess penalties on participants and promoters of the tax shelter. 3he 1+S has achieved some success in this area. "See )Austice 'nnounces M026 Fillion Settlement with O FN(* "a! #otes "oday( %>>2 373 165/12( 'u!ust %#( %>>2$. 3hese basis shiftin! transactions are )listed transactions* for purposes of << 6>11( +e;uirin! Disclosure by 3axpayers( and 6111 +e;uirin! 3ax Shelter +e!istration "7otice %>>0/65( %>>0/01 1.+.=. 1$. 3he 1+S recently withdrew rop. +e!. < 1.3>%/2 which would have re;uired a dramatically different treatment for the basis of stock redeemed in a non;ualifyin! stock redemption "see 'nnouncement %>>1#/3>( %>>1#/1# 1.+.=. :5# and the "a! in the #e$s on pa!e 1#/5 in the

C$'&$'21,$*+: D,+1',4/1,$*+ N$1 ,* C$%&.(1( L,6/,721,$*

19!19

text$. Dnder the proposed re!ulation( shareholders would have reco!ni-ed losses e;ual to the amount of the stock basis redeemed in a non;ualified redemption( and such loss would be deductible upon the happenin! of some future event "e.!.( shareholders reco!ni-in! !ain on a subse;uent disposition of the corporation&s stock$. 3he 1+S will continue to seek alternatives to the current rule that allows the shiftin! of stock basis from one taxpayer to another taxpayer.

D,+&'$&$'1,$*21( R(7(%&1,$*+ 00. Dnder < 3>%"b$"%$ stock redemptions must be substantially disproportionate. 3o be sub/ stantially disproportionate( the followin! stock ownership re;uirements must be met. a. b. c. d. Shareholder must own( after the distribution( less than :>@ of the total interest owned in the corporation before the distribution( and Shareholder must own( after the distribution( less than 2>@ of the total combined votin! power of all classes of stock entitled to vote. 1n determinin! stock ownership before and after a redemption( the constructive ownership rules of < 31: apply. 4or an example of a disproportionate redemption usin! a bootstrap transaction( see +ev. +ul. 52/005( 1#52/% ,.=. 113 "stock issuance to new shareholder followed by redemption of shares by the two ori!inal shareholders. two transactions part of inte!rated plan resultin! in disproportionate redemption$. ADDITIONAL LECTURE RESOURCE Gotin! stock re;uirement. ' disproportionate redemption only applies to a redemption of votin! stock or to a redemption of both votin! stock and other stock "+e!. < 1.3>%/3$. ' redemption of only votin! preferred stock can ;ualify as a disproportionate redemption if the taxpayer owns "directly or indirectly$ no common stock "+ev. +ul. :1/01( 1#:1/1 ,.=. 1%1$. +edemption of only nonvotin! stock of one taxpayer can ;ualify as a disproportionate redemption if combined with the simultaneous redemption of votin! stock of a related taxpayer. See( +ev. +ul. 55/%35( 1#55/% ,.=. ::( where a redemption of nonvotin! preferred stock of father ownin! no common stock directly combined with redemption of votin! common stock of son is disproportionate redemption for both taxpayers. Series/of/redemptions rule. Section 3>%"b$"%$"D$ provides that a redemption will not ;ualify as disproportionate if it is made pursuant to a plan the purpose or effect of which is a series of redemptions that result in the a!!re!ate in a distribution which does not satisfy the :>@ and 2>@ tests "see +e!. < 1.3>%/3"b$( for an example$. 3he determination of whether a plan exists is based on all the facts and circumstances. "+e!. < 1.3>%/3$ 'lthou!h there is scant 6udicial !uidance in the area( it appears that the series/of/redemptions rule will only apply when stock is redeemed from a shareholder who has knowled!e of an impendin! redemption of another shareholder&s stock ISee( +ev. +ul. :2/10( 1#:2/1 ,.=. #3 "rule applied even thou!h no a!reement existed

19! "

""# C$%&'()(*+,-( V$./%(0S$./1,$*+ 1$ R(+(2'3) P'$4.(%+

between the two shareholders re!ardin! their redemptions$. 9tr. +ul. :316>1# "rule does not apply to coincidental redemptions of two shareholders within close proximity of each other$. and 9tr. +ul. %>>001>>5 "rule does not apply to redemptions pursuant to corporation&s articles of incorporation and with no redeemin! shareholder possessin! knowled!e of any other impendin! redemption$K. 3he series/of/redemptions rule does not apply to a redemption merely because a future redemption could be affected under a buy/sell a!reement existin! between the corporation and another shareholder. See ,lacier State Electric Supply Co.( :> 3.,. 1>05 "1#:3$( where an a!reement re;uirin! the redemption of another shareholder&s stock upon death was not sufficient for the rule to apply. 3he series/of/redemptions rule has been applied to two redemptions that were 12 months apart "9tr. +ul. :135>%3$.

ETHICAL CONSIDERATIONS ,onvertible referred StockP,onversion or +edemption "pa!e 1#/%6$. Fembers of a board of directors serve in a fiduciary capacity on behalf of corporate shareholders. 3hey are sub6ect to !ood faith and fair dealin! standards with respect to the investors in the corporation&s convertible preferred stock. Niven the recently developed invention( a conversion of the preferred stock to common stock appears to be more favorable for the preferred shareholders than havin! their shares redeemed. ' premium call price is typical of most callable preferred stock( and the presence of a premium on this preferred stock likely does not relieve the board of their fiduciary duties. 3he preferred shareholders should be informed of the new invention before any redemption transaction transpires. 1n addition( even thou!h the stock of the corporation is not sellin! publicly( the corporation may be sub6ect to the anti/fraud provisions of the Securities 'cts for a small offerin! to members of the public. 7onetheless( the board of directors does not appear to have acted in an ethical manner.

C$%&.(1( T('%,*21,$* R(7(%&1,$*+ 02. Section 3>%"b$"3$ provides that a redemption will ;ualify for sale or exchan!e treatment if a shareholder&s interest is completely terminated. 1n satisfyin! the re;uirement( the constructive ownership rules of < 31: !enerally apply. Cowever( < 3>%"c$"%$"'$ provides that the family attribution rules do not apply if all of the followin! re;uirements are met. a. 4ormer shareholder may not retain any interest in the corporation "includin! an interest as a director( officer( or employee$ for at least 1> years. =ein! a creditor is not considered an interest for this purpose. 'lso stock ac;uired by be;uest or inheritance is not prohibited. 4ormer shareholders file an a!reement to notify the 1+S if a prohibited interest is ac;uired within the 1>/year post redemption period.

b.

C$'&$'21,$*+: D,+1',4/1,$*+ N$1 ,* C$%&.(1( L,6/,721,$*

19! 1

ADDITIONAL LECTURE RESOURCE Section 3>%"c$"%$"=$ provides that < 31:"a$"1$ family attribution rules are not be waived "despite the fact that re;uirements set out in item 13. above are met$ if either of the followin! apply. 'ny part of the redeemed stock was ac;uired( directly or indirectly( within the previous 1> years by the distributee from a related person or 'ny related person owns stock at the time of the distribution and ac;uired the stock( directly or indirectly( from the distributee within the previous 1> years( unless the stock so ac;uired is also redeemed in the same transaction. Cowever( a family attribution waiver is available if the stock transfer in the previous 1> years did not have as one of its principal purposes the avoidance of 4ederal income taxes.

Example. aul owns 1>>@ of the stock in 3eal ,orporation( which has E & of M%>>(>>>. aul transfers 0>@ of the stock to his son Seth. 3eal redeems all of Seth&s stock 13 months later for M1>>(>>>. 3he redemption does not ;ualify as a complete termination of Seth&s stock because the family attribution rules apply. 1f the transfer of stock to Seth did not have as one of its principal purposes the avoidance of 4ederal income taxes( the family attribution waiver could apply( and the result would be a complete termination redemption. Example. Susan owns 1>>@ of laid ,orporation&s stock. laid has E & of M3>>(>>>. Susan transfers 32@ of the stock to her dau!hter Oatrina. laid redeems all of Susan&s stock 12 months later for M12>(>>>. 3he redemption does not ;ualify under as a complete termination of Susan&s stock because the family attribution rules apply. 1f the transfer of stock to Oatrina did not have as one of its principal purposes 4ederal income tax avoidance( the family attribution waiver could apply( and the result would be a complete termination redemption. R(7(%&1,$*+ 1$ P28 D(21) T2@(+ 06. Dnder < 3>3( a decedent shareholder&s estate receives sale or exchan!e treatment for a redemption when the stock represents a substantial amount of the !ross estate. a. b. 3o the extent a redemption ;ualifies under < 3>3( the ;ualifyin! stock redemption rules of < 3>%"b$ and the stock attribution rules of 318 need not be considered. Section 3>3 applies when a distribution is made with respect to the redemption of stock of a sin!le corporation( the value of such stock bein! included in the !ross estate of the decedent and in excess of 32@ of the value of the ad6usted !ross estate of the decedent. 1n determinin! the 32@ ad6usted !ross estate re;uirement( stock of two or more corporations is treated as the stock of a sin!le corporation if %>@ or more in value of the outstandin! stock of each corporation is included in the decedent&s !ross estate.

c.

19!

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d.

Section 3>3 applies only to the extent of the sum of the death taxes imposed by reason of the decedent&s death plus the amount of funeral and administration expenses allowable as deductions to the estate. "1$ 1f the redemption exceeds the amount allowed "i.e.( total of death taxes and funeral and administration expenses$( the < 3>3 amount is still allowed. 8nly the excess runs the risk of dividend treatment. Section 3>% may apply with respect to this excess( but the attribution rules "e.!.( attribution from a beneficiary to an estate$ may preclude a ;ualifyin! stock redemption. ?aivin! family attribution rules for estates under < 3>%"c$"%$ may assist in satisfyin! the complete termination redemption re;uirements.

"%$ e.

Due to the )stepped/up* basis the stock receives under < 1>10( a redemption to pay death taxes !enerally results in little or no !ain "or loss$.

EFFECT ON THE CORPORATION REDEEMING ITS STOCC R(3$;*,1,$* $5 G2,* $' L$++ 05. Dnder < 311"b$( a distributin! corporation reco!ni-e !ain "but not loss$ when distributin! property other than cash to redeem its stock. 'n exception !ain reco!nition re;uirement applies to re!ulated investment companies that are distributin! appreciated property "e.!.( appreciated portfolio securities$ to shareholders who demand redemption of their stock I< :2%"b$"6$K. See 9tr. +ul. %>>2>#>13 for application of this exception.

E55(31 $* E2'*,*;+ 2*7 P'$5,1+ 0:. Dnder < 31%"n$"5$( E & is reduced in a ;ualifyin! stock redemption by an amount not in excess of the ratable share of the E & attributable to the stock redeemed.

R(7(%&1,$* E@&(*7,1/'(+ 0#. Section 16%"k$"1$ disallows a deduction for expenditures incurred in connection with a stock redemption. ETHICAL CONSIDERATIONS layin! Names with the Statute of 9imitations "pa!e 1#/3>$. Steve is courtin! disaster. he can&t avoid the !ain tri!!ered by the basis reduction in %>>>. 'n obscure set of ,ode provisions "<< 1311/1310$ serves to miti!ate the effect of the statute of limitations. =ased on the concept of e;uity( these provisions preclude both the 1+S and taxpayers from takin! current advanta!e of past errors( the correction of which is no lon!er possible. 3hese provisions would permit the 1+S to reopen tax year %>>> and assess a!ainst Steve the tax he would have paid had he properly reported the dividend income.

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19! 3

8n the other hand( if Steve stays with the basis reduction he ori!inally made( he has not taken an inconsistent position. 3herefore( << 1311/1310 cannot be used by the 1+S.