I.

INTRODUCTION
SPECIAL TERMS
1. INCORPORATED BUSINESS - An incorporated business (also called a corporation) is a type of
business that offers many benefits over being a sole proprietor or partnership, including liability
protection and additional tax deductions. Forming a corporation also allows you raise capital through
sale of shares of your company. According to Small Business Computing, there are three common
corporate structure including: S-Corp, C-Corp, LLC.
2. UNINCORPORATED BUSINESS - A commercial enterprise that is owned privately by one or more
people. One disadvantage of owning an unincorporated business is that it results in unlimited liability
for its owners since it has not been formally registered as a corporation.
3. CLASS A SHARES - Class A shares refers to a classification of common stock that is accompanied by
more voting rights than Class B shares, usually given to a company's management team. For example,
one Class A share may be accompanied by five voting rights, while one Class B share may be
accompanied by only one right to vote.
4. CLASS B SHARES Class B shares are a classification of common stock that may be accompanied by
more or fewer voting rights than Class A shares.
5. COMMON STOCK - Common stock is a security that represents ownership in a corporation. Holders
of common stock exercise control by electing a board of directors and voting on corporate policy.
Common stockholders are on the bottom of the priority ladder for ownership structure; in the event of
liquidation, common shareholders have rights to a company's assets only after bondholders, preferred
shareholders and other debtholders are paid in full.
6. CONSTRUCTIVE DIVIDEND - A concept in U.S. taxation in which various distributions to shareholders are
not labeled as dividends but are still considered dividends by the IRS and taxed as such. Constructive dividends
are most commonly found in companies in which the employees are also the shareholders. You can think of a
constructive dividend as an undeclared dividend by the company that involves the use of corporate assets. For
example, in many small companies, employees who are also shareholders may borrow money from the company
to buy personal items. This loan may be classified by the IRS as a constructive dividend and must be reported on
the tax return of the shareholder. In addition, the company would not be able to take a deduction for the
constructive dividend.
7. VOTING COMMON STOCK - Voting shares are shares that give the stockholder the right to vote on
matters of corporate policy making as well as who will compose the members of the board of directors.
8. VOTING TRUST each beneficial owner is treated as a separate shareholder.
9. STRAIGHT DEBT Sec 1361 (c ) (5) means any written unconditional promise to pay on demand or
on a specified date a sum certain in money if (i) the interest rate (and interest payment dates) are not
contingent on profits, the borrowers discretion, or similar factors, (ii) there is no convertibility (directly
or indirectly) into stock, and (iii) the creditor is an individual (other than a nonresident alien), an estate,
a trust described in paragraph (2), or a person which is actively and regularly engaged in the business of
lending money.
JUDICIAL DOCTRINES

1. SHAM TRANSACTION DOCTRINE: If a transaction is a sham it will not be respected for tax
purposes
Sham is best defined as a transaction that never actually occurred, but is represented by the taxpayer to
have transpired with favorable tax consequences
2. ECONOMIC SUBSTANCE DOCTRINE: Claimed tax benefits should be denied if the transactions that
gave rise to them lack economic substance apart from tax considerations even if the purported activity
actually occurred
Broad Test:

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 i. Establish presence of economic substance
ii. Establish presence of business purpose-it must be bona-fide, profit-seeking business-
Narrow Test:
i. Either economic substance or business purpose
3. SUBSTANCE OVER FORM: Form of transaction is frequently determinative of its tax consequences,
however courts have been willing to go beyond the formal papers and evaluate the substance of a
transaction
4. BUSINESS PURPOSE: A transaction motivated by a business purpose is usually compared to one that has
no substance, purpose, or utility apart from tax avoidance
As originally formulated, the doctrine was applied to deny tax-free status to a transaction that would
not have been consummated but for the tax savings that would result if the form were respected
5. STEP TRANSACTION DOCTRINE: Courts combine (or step) formally different transactions to
determine the tax treatment of the single integrated series of events
i. IRS already knows what you owe from information from employers, banks, etc.
6. OUTSTANDING SHARES: Outstanding shares refer to a company's stock currently held by all its
shareholders, including share blocks held by institutional investors and restricted shares owned by the
companys officers and insiders. Outstanding shares are shown on a companys balance sheet under the
heading Capital Stock.

DOUBLE TAX

1. Double taxation occurs because corporations are considered separate legal entities from their shareholders.
As such, corporations pay taxes on their annual earnings, just as individuals do. When corporations pay out
dividends to shareholders, those dividend payments incur income-tax liabilities for the shareholders who
receive them, even though the earnings that provided the cash to pay the dividends were already taxed at the
corporate level.
2. EXAMPLE
Corporation gets $100 of income at 35% tax rate = $65 after tax income
Shareholder gets $65 dividend income at 15% tax rate = $55.25 after tax income
Variables make this more complicated: Non-profits, capital structures, etc.

CORPORATE CLASSIFICATION

1. C CORPORATIONS: Subject to the double tax regime of Subchapter C

2. PARTNERSHIPS: Governed by the single tax pass-through regime of Subchapter K
3. CORPORATIONS V. PARTNERSHIPS
CHECK THE BOX APPROACH:
i. A business entity can elect to be treated as a corporation or a partnership
ii. If incorporated must be treated as a C Corp.
iii. Non-corporate entity (such as LLC) is classified as a partnership, but can elect for corporate
treatment
a. Single member LLCs are treated as sole-proprietorships, unless an election is made
Changing an election will be treated as a contribution of all asses to a new entity and stock liquidation
Publicly traded partnerships are taxed as corporations
4. CORPORATIONS V. TRUSTS
Business trusts are classified as partnerships and taxed under the check-the-box regulations
Personal trusts are taxed under Subchapter J. Income distributed taxed to beneficiary. Income retained
taxed to trust. No double tax.
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S-CORPORATION________________________________________________________________________
1. Hybrid of corporate and partnership concepts.
2. Small business corp 1361 (b)
3. Take the income generated by the company and they generated that income based upon the percentage
of stock SH-s own.
4. Sec. 1361 (b)(1) the term small business corporation means a domestic corporation which is not an
ineligible corporation(b)(2) and which does not
a. (A) have more than 100 shareholders. For purpose of this limit a husband and wife, all the
members of the family (and their estates) are treated as one shareholder regardless of their form
of ownership. IRC 1361(c )(1)( A) (ii) and . IRC 1361(c )(1)( B) (i). However, if stock is jointly
owned (e.g tenants in common or join tenants) by other than husband and wife, each joint owner
is considered a separate shareholder. A corp still may not make an S corp if any of its corp are C
corp, partnerships, ineligible trusts, or nonresident alien. Husband and wife = one shareholder. 6
generation counts as one
b. (B) have as a shareholder a person (other than an estate, a trust described in subsection (c)(2), or
an organization described in subsection (c)(6)) who is not an individual. In other words, only
shareholders who are individuals, estates, and certain type of trust and tax-exempt organizations
can create an S corp. Partnership, C corp, nonresident alien and certain types of type of Trusts
cannot be in S Corp. However, S Corp CAN invest in those types of entities. Trusts that are
permissible shareholders page 675:
i. Voting trust IRC 1361 ( c) (2) (A) (iv), (B) (iv) vote together
ii. Grantor trust IRC 1361 ( c) (2) (A) (i) retain so much control, so grantor is taxxable
iii. Former grantor trust that continue as testamentary trusts, but only for the 2year period
following the grantors death IRC 1361 ( c) (2) (A) (ii)
iv. Testamentary trusts that receive S ciro stock under the term of a will, but again only for
the 2year period after the date of transfer of the stock to the trust. IRC 1361 ( c) (2) (A)
(iii)
v. Qualified subchapter S trusts (QSSTs) defined generally as trusts all of the income of
which is actually distributed or must be distributed currently to one individual who is a
US citizen or resident 1361 (d)
vi. Electing small business trust (ESBTs), a statutory creation that potentially expands the
usefulness of S corp in estate planning for a family business. IRC 1361 ( e) (1) (A) (i)
c. (C) have a nonresident alien as a shareholder, and
d. (D) have more than 1 class of stock. If you have a cmmon stock and any stock with any
preference (economic, liquidation, etc) you have preferred stock and its not allowed if there is
common and preferred stock. An S corp generally is treated as having one class of stock if all of
its outstanding shares confer identical rights to distributors and liquidation proceeds.
Significantly, differences in voting rights among classes of common stock are disregarded,
permitting S corp to issue both voting and nonvoting common stock. I can have voting and non
voting stock. Safe harbor provisions from reclassification Sec 1361 (c )(5) under which straight
debt is not treated as a disqualifying second class of stock. Other Safe harbor from
reclassification are provided for short-term unwritten advances to the corp that do not exceed
10,000 and obligations held proportionately among the shareholders. Obligations that qualify as
straight debt are not classified as a second class of stock even if they would be considered equity
under general tax principles and they generally are treated as debt for other purposes of the Code.
(IRC 1361 (c )(5) (A), Reg. 1.1361-1(l)(5)(iv).
Also see Reg. 1.1361-1(l)(2)(v).

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5. Eligible Corps no banks or insurance companies, affiliated group member only if Qualified
Subchapter S Subsidiary 100% owned by S corp and election to disregard QSSS as tax entity.
6. If there is no corporate expectation of advantageous RE scheme, then may elect to incorporate as S corp.
Avoids tax liability on corporate earnings, but earnings must be reported. Shareholders are then taxed
on their pro rata share of the corporate earnings no matter the incomes disposition (distributed to
shareholders or not). The income is allocated. Income is treated as an ordinary income (39,6 %
maximum tax rate)
7. The character of the moneys reported (loss, gain, deduction, credit) is retained in
the taxpayers hands (shareholders)
8. Losses shareholders cannot deduct losses in C corp because corporation is separate entity, but S corps
materialize losses as personal losses against unrelated income. 172. Loss "pass-thru" limited to stock
basis + debt basis 1366(d)(1). Less generous than partnership loss allowances, though.
9. Partner basis in their partnership basis are increased by their share of partnership liabilities $752(a),
while debts incurred by an S corp to outsiders have no effect on the basis of the corps shareholders in
their stock.
10. Special allocations bars allocations because of only one class of stock. 1361(a).
11. Owner-firm transactions still controlled by C rules, while partnerships arent. 1371(a)
12. Loss "pass-thru" limited to stock basis + debt basis (1366(d))
a. Debt basis = shareholders who are creditors to that company
b. You can't take losses beyond this basis - they carry over to the future if at a later time the
corporation earns money and the shareholder gets a basis
c. You can't take losses if you don't have basis
d. This can create problems if the corporation borrows money from third party:
13. Corporate debt to third parties does not create usable basis for shareholder ( even if shareholders
guarantee it!)
a. Harris (page 679) and many other cases
b. Losses that represent the corporation burning through the bank loan won't pass through to
shareholder.
c. So, you might not want to put the owners in an s-corp if they are going to be guaranteeing a loan.

14. Instead - have the shareholders borrow the money and then lend it to the s-corp.
15. Under 1366 - income and losses "pass thru" - shareholders must put their pro-rata share of everything
that happens in the corporation. It must be on their tax return regardless of a distribution or not.
a. The character (ordinary v capital) is determined at corporate level (1366(b)) and then retains
that character when it passes through
b. Any elections are made at a corporate level (e.g. 1033) - this is 1366(c)
i. Shareholders are stuck with it

16. When income passes through to the shareholder, their basis on their stock goes up (1367) - same
thing with a deduction (basis in stock would come down). For every pass through action there is a
basis reaction
17. If it was never a C corporation, distributions are treated as return of stock basis, and then capital gain if
it exceeds the basis in the stock ( 1368(b))
18. 1371(c) - s-corporations do not generate E&P while they are S-corps
19. Example:
Three shareholders of S corp. S corp earns 15k profit
This 15k profit passes through to shareholder
- each shareholder pays taxes on 5k of income
Now, their basis in their stock goes up by 5k.
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 Then, if each shareholder takes 5k out as a distribution, this will be tax free for them
Then, their basis in their stock goes down by 5k.
Conduit tax regime ensures that you pay a rate that is proportionate to your overall income, unlike the
note above showing the frustration of vertical equity.
20. Why C Corp better than S corp: fringe benefits to C corp employees, no K1 form and
If I am C corp and lets say I decide to leave 50K in business, I can pay only 15% on tax. There are 2
recent developments. 1st one is rate structure if I am a big hitter ( ) today my personal
rate is 45%. The maximum corporate tax is 34%, If I am trying to grow my business and I am S corp, the
most I can reinvest to grow that business is 55 cents in the dollar (because of 45% tax rate). If I am a C
corp, I can reinvest 66 cents (on corporate level because of 34%). It is a huge difference. And I know
that for every dollar I can invest in my business I can borrow $2. But here is the 2nd one, this happened at
the end of 2015. If I form a C Corp and I have assets of less than $50 million and the investor put their
money into this C Corp and lives it there for 5 years when they sell out they pay 0 taxes. (1202 twist??)

Straight Debt Huge Safe Harbor This Debt will not destroy the S election it wont treated as second
class of stock that could kill the S election
1361(c)(5) Unconditional promise to pay on demand or at specified time.
Interest rate and payments not contingent on profits or discretion.
No convertibility
Creditor actively and regularly engaged in lending money or is individual, estate or trust that
would be eligible S corp shareholder.
Note: If safe harbor met, excess interest may still not be treated as interest for tax purposes.

ELECTION OF S CORPORATION STATUS page 681

RECOGNITION OF THE CORPORATE ENTITY

1. COMMISSIONER V. BOLLINGER (SCOTUS 1988) Pg. 34

Corporation owned legal title as an agent of the shareholder, shareholder conducted all business and
claimed income/expenses on his return. IRS wants the corporation taxed on the income and then the
shareholder taxed on the distribution.
ISSUE: Whether a corporation is an agent of the shareholders or a separate entity
HOLDING: The corporation is an agent of the shareholders when ownership is concerned and should
therefore not be taxed on the income generated by the property
Amounts are treated as income when received in cash (or cash equivalent)
Deductible when paid

II. FORMATION OF A CORPORATION

SECTION 1371 (Subchapter S)_____________________________________
Except as otherwise provided in this title (title S), and except to the extent inconsistent with this
subchapter, subchapter C shall apply to an S corporation and its shareholders.
So, every time you have a tax issue that applies to S Corp you must ask yourself did I deal with this
specific S corp provisions or did they deal with C Corp and that governs this matter. Example Section
351- does that regime applies to both corp or to just C Corp. And it will only apply to C Corp if S Corp
status deals specifically with it. And in more regimes they dont. For example tax consequences of
forming corporation. And because non of that is in Subchapter S, so this regime, we calls 351 regime
applies to both S and C Corp.
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SECTION 351

1. 351. TRANSFER TO CORPORATION CONTROLLED BY TRANSFEROR: No gain or loss shall be

recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in
such corporation and immediately after the exchange such person or persons are in control of the
corporation
REQUIREMENTS RULE 1 -apply to shareholder
Transfers of property no services
Solely for stock
Control immediately after exchange. (Sec 368 (c ) Two 80% requirements 80% of all voting
stock and 80% of total shares of each other class of stock. If there are 2 SH A and B and A
already owns 80%, but then B came and said that he also wants to qualify under 351, we need
to return A in the game and A need to put a not insignificant amount (> 10% of A stock.) in
the transaction of B in order for B to qualify. So A has 50 K (50 shares??) A has to put 5 K of
additional property if A does that in Bs transaction then As ALL previous stock counts even
if A puts only 10% in next transaction. Problem 66.
There can be a control group so long as all members are viewed as an integrated plan of incorporation
Dont missed it up: If I buy stock for cash I cannot trigger a taxable event for myself, buying stock for
cash is not a taxable event.
If I issue stock for services under any condition I got a taxable event, Ive got ordinary income
RULE 2 Boot-apply to shareholder if you exchange of the property and has something else, you
exchange it for some extra, then shareholder recognizes gain on the property transferred to corporation
equal to the lesser of. It could be nonqualified preferred stock (Sec 351(g):
i. 1. The built-in gain on the property transferred the excess of FMV over basis
ii. 2. The FMV of boot received by the shareholder.
Example: If 80k cash boot, Jim recognizes gain equal to boot 80k. If 120k boot paid by XYZ Inc
in addition to stock, Jim would recognize gain equal to 100k excess of 200k FMV over 100k
basis.
If you have boot and more than 1 property transferred you have to separate this properties and
allocate this boot based on the FMV of the each property. So, if I have inventory worth 20K, land
10K and 15 K of boot, then we allocate 66, 6% (20K of 30K) to inventory = 66,6% out of 15K
=10K to inventory. And 33,3% of 15K to land.
RULE 3-apply to a shareholder If 351 DOES NOT apply, my basis in my stock is FMV. If 351
applies to an exchange of property for stock in a corporation, the basis of the stock (SEC 358)received
by the shareholder equals:
1. The basis of the property transferred to the corporation in the hands of the shareholder, plus
2. Any gain recognized by shareholder ala the 351(b) rule, less
3. The FMV of any boot received.
Basis of property transferred 100K (ex. AB Equipment) 100K (ex. AB Equipment)
PLUS +
Gain (NOT BOOT) recognized 80 k 100K
by SH at the 351 (b) rule (even
though we have gain of 100K
(FMV-AB), but our boot is only
80K, so gain will be 80K)
LESS -

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 The FMV of any boot received 80 k 120K
(BOOT)
EQUAL
the basis of the stock received 100K 80K
by the shareholder
DO NOT FORGET FIRST TO FIND THE LESSER OF AMOUNT OF BOOT AS IN
RULE 2, OR EXAMPLE BELOW.

If SH transferring more than 1 property:

Property 1 AB $15K
Property 2 AB $8K
Total value of AB $23 K
Property 1 FMV $10K
Property 2 FMV $10K
Total FMV of both property $20K
AB < FMV NO

AB >FMV Yes
If SH agreed on basis reduction then company take the AB of property and SH has 3 K (AB-
FMV) of loss and 3 K basis reduction, all allocated to built-in loss parcel reducing basis from
15K to 12 K (15K 3K (23 K 20K). As option, C could elect to take 3k basis reduction, so its
basis will be 20K instead of 23 K.

May net built-in gains with built-in losses in applying basis adjustment of 362(e)(2)(A). Thus
only 3k basis reduction, all allocated to built-in loss parcel, reducing its basis to 12k. As option,
C could elect to take 3k basis reduction.

Result: If XYZ Inc issues 100 share of its stock and 80k cash, Jim recognizes gain equal to boot
80k, and Jims basis in stock is equal to 100k (basis in equipment), plus 80k gain less 80k boot =
100k. If 120k boot was paid by XYZ Inc in addition to stock, Jim would recognize gain equal to
100k. Basis in stock would equal 100k plus 100k gain less 120k boot = 80k basis.
RULE 4: SHAREHOLDERS TACKING RULE If I have a qualified 351 transactions and I am
transferring in property that to me a capital asset or 1231 asset, the holding period of the property
transferred by the shareholder is tacked on to the holding period of the stock. No Inventories or
accounts receivables. This means that if I held my equipment for 3 years and I transfer it under 351 and
it qualifies, I received stock that have 3 years and I still can have long-term capital gain. The period
tacked. Also taking: note, equipment. Cash -holding period starts in exchange. If land has FMV of 10K
and equipment has 20K then total is 30K. land 1/3 tacked, equipment 2/3 not tacked.
RULE 5: RULES THAT APPLY TO A CORPORATION
Rule 1: 1032 rule: Corporation never recognizes no gain or loss on receipt of money or property in
exchange for its own stock

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 a. Result: XYZ Inc issues 100 share of its stock and 80k (BOOT) cash to its sole shareholder Jim for
equipment worth 200k that has a basis of 100k. XYZ Inc recognizes no gain or loss.
RULE 6: Rule 2: CORPORATION BASIS. A corporations basis in property acquired in
exchange for its stock in a transaction that qualifies under 351 equals the shareholders basis in the
property basis plus any gain recognized by the shareholder. But if net built-in loss (AB>FMV),
basis of the company limited to FMV of property (so in the answer put FMV absent the agreement
for the company and AB for SH) unless the shareholder agrees to reduce stock basis of
shareholder to FMV so that company will take a higher basis(FMV), then the company can take a
normal basis (AB) rule. Result: XYZ Inc issues 100 share of its stock and 80k cash to Jim, Jim
recognizes gain equal to boot 80k. XYZ Inc.s basis in equipment is equal to 100k (Jims basis in
equipment), plus 80k gain recognized by Jim = 180K.. The company would rather take the smallest
amount and the reason for that is that they dont want each parties to take the highest basis. For
example SH take AB, which is > FMV, and the corp take AB and they both have losses.
Shareholder can capitalize loss in order to avoid double taxation.
Basis of property received 100K (ex. AB Equipment) 100K (ex. AB Equipment)
(Shareholder basis)
PLUS +
Gain (NOT BOOT) recognized 80 k 100K
by SH at the 351 (b) rule (even
though we have gain of 100K
(FMV-AB), but our boot is only
80K, so gain will be 80K)
EQUAL
Corporations basis in the 180K 200K
property acquired

RULE 7: Rule 3: CORPORATE TACKING RULE. If 351 applies to an exchange of property

for stock in a corporation, the holding period of the property transferred by the shareholder is
tacked on in determining the holding period of the property in the hand of the corporation. Result:
Jims holding period of equipment is tacked on in determining XYZ Inc.s holding period of
equipment. This is mean nothing because C-corporations have NO capital gain rates (no
preferential rates, only ordinary). But in S Corp it would matter, because of pass through.
RULE 8: SEC 357 (a) and 358 (d) Assumed liability rule. Scenario: a company instead of boot out
assumes the liability of shareholder (when a shareholder doesnt contribute cash for example, but debt, so
debts are being assumed and paid by the company). The company assumes that the shareholder transfer
assets in.

We want to know what is the impact when a shareholder contributes property, but the company as part of
that transfer assumes the liability that shareholder would otherwise have to pay.
General Rule: If corporation assumes liability of shareholder in 351 exchange:
1. Assumption not considered boot for gain or loss purposes. 357(a).
2. But it is considered boot for purposes of calculating shareholders basis. Assumption does
reduce shareholder stock basis by debt amount. 358(d).
So if I transfer in and the company assumes 40K of my debts, that 40 K is not considered boot for
gain and loss purposes, but in calculating my basis and my stock I must reduce my basis
Exception: (whether or not this debt is treaded as boot for income purposes, but it is always treated as
boot for basis purposes. Debt treated as boot for gain (income) purposes if:

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 a. 1. Tax avoidance purpose or no bona fide business purposes. Burden on taxpayer to prove by clear
preponderance of evidence. If I am transferring business purpose debt that has nothing to do with
the business that would -tip all of the debt that I transfer and make it all taxable income.
b. 2. The total Debt that it assumed by company exceeds MY basis of all property transferred to corp
then excess treated as taxable boot.-INCOME. So, if I am transferring property with a basis of
100 k and FMV of 500K, but it is encumbered by 200 K of debt. I would have to recognize as
boot income the excess of the debt over my basis= 100k. And for each shareholder it is a
shareholder to shareholder determination, based upon all of the assets contributed y that SH.-r
When a SH transfer a debt that exceeds its AB, the SH smth want to do basis stuffy: they want to add
other assets into the mix that will increase their basis, so they dont need to recognize any income. See
Perrachi Case below.
How to figure gain from liabilities if more than 1 property transferred.
Property 1 (inventory) AB 20K 20K 100K
Property 2 (land) subject to 20K 5K
a recourse loan (non
recourse under
professor)30K AB
Total AB 40K 25K
Property 1 (inventory) FMV 10K 10K 400K
Property 2 (land) FMV 40K 40K
Total FMV 50K 50K
Recourse loan 30K 30K 90K
Loan > AB for gain N Yes in 5K. What is the
purposes character of the gain? IRC said
O you allocate this gain
recognized between assets
transferred based upon the
FMV of the asset. So, if I have
inventory worth 20K, land
10K and 15 K of gain, then we
allocate 66, 6% (20K of 30K)
to inventory = 66,6% out of
15K =10K to inventory. And
33,3% of 15K to land. Better
approach per some
commentators and courts is to
allocate based on appreciation
since inventory has no
appreciation, all 5k would be
allocated to land.
So that gain that is allocated to
inventory is ordinary gain and
gain that is allocated to land is
capital

SHs basis
SHs basis in stock 40K 25K 100K
transferred

REDUCED
by the amount of money 30 K 30K 90
(liabilities) (DEBT>AB))
received AND any BOOT
received
INCRESED
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 by the amount of gain 0 5 10 (boot or gain)
recognized on the
liabilities and GAIN equal
to the lesser of. It could
be nonqualified preferred
stock (Sec 351(g):
1. The built-in gain on the
property transferred the
excess of FMV over basis
2. The FMV of boot
received by the
shareholder
EQUAL 10K 0 MUST ALWAYS BE 20
ZERO!!!!! When you
have a situation where
the DEBT> SH basis
in the assets being
transferred.

Companys basis
AB of property received 25
PLUS
Gain recognized by SH 5
Total 30

Companys taxable income include

Accounts receivable not collected by the SH

SHs taxable income include

Dividend

BIG RULE 8 ISSUE: HOW DO WE DETERMINE IF THE LIABILITY THAT IS BEIGN ASSUMED IS
A REAL LIABILITY FOR SEC 357 PURPOSES:
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 Future deductibles: Transferred liability not counted under 357 if it payment would create tax
deduction for corporation. 357 (c) (3) Example: Cash basis APs. Example: When I have a liability
(smbd sends me a bill), there is a couple of different ways I can treat it. If I am an accrual basis, the
minute I get that bill(), I would claim a tax deduction even though I wouldnt pay. So if I had
claimed a tax deduction for that bill and then the company assumes that bill and pays it, that is a true
liability. I have already reflected that bill in my accounting. Therefore when the company assumes it,
they let off the hook ( ). Let suppose I have a bill for my rent and I am a
cash basis taxpayer and I have not yet reflected it as a deductible item in my accounting records. All I
have is the bill. I havent taken any deductions and then I incorporate and the company assumes that bill.
That would not be considered a debt for 357 purposes, because I never reflected in in my tax records.
That was simply when the company pays the liability, the company gets the deduction. If I am a cash
basis taxpayer, many of the liabilities that the company assume may not be considered liabilities for sec
357 purposes, because I didnt reflect them in my accounting.
Future Capital Costs: Transferred liability not counted if payment by corp treated as capital
expenditure. Rev. Rule 95-74 (Environmental expenditures).
Recourse liabilities: Per 357(d), deemed assumed if, based on facts and circumstances, corp has agreed
to, and is expected to satisfy debt, even if shareholder remains liable. So, recourse liabilities it is a debt
that I am responsible for, a credit line for a bankrupthy. I run a business, I have 2 million dollar of credit
line in bank, I am personally liable to that debt, it is a business debt but I am personally liable for this
debt. When I transfer that debt to the corporation the bank isnt let me off the hook. It means the bank
has recourse against that person personally. If that debt transfer for 357 purposes if I am the main liable.
The answer is yes. If the deal between me and my company is that the company is going to pay the
debt, that is a deal I have with my company, the company assuming a debt under 351 transaction, the
deal is that the company is going to pay the debt, then it will be considered a transferred debt event
though I remained personally liable (357 issue). If by chance in my deal with me and my company I am
continuing in paying that debt, the company never assumed it, I do not have 357 issue.
Nonrecourse debts: Deemed assumed if asset subject to debt transferred. If other non-transferred
assets subject to debt, then assumed amount reduced by lesser of the FMV of other assets or portion of
debt agreed to be satisfied out of other assets. Very rare issue. This is very the bank said we will loan
you this money and we are going to look only on certain assets, we are going to look at your accounts
receivable, inventory, we are not going to look at anything else. You are not personally liable. If things
go bad we will collect your accounts receivable, your inventory,etc but we can not come after your
personally. If I transfer those assets that secure a debt, we understand under nonrecourse debt you have
asset secured the debt. There is no bank or plan that will make your nonrecourse loan without non
securing your assets. But if the assets that secure the loan are transferred into the company, than the
liability will be transferred with it.
Conclusion: Every time we see the debt ask yourself if this debt is a debt for chapter 357 purposes. It it
is cash basis taxpayer and this debt wasnt reflected then no. For planning purposes you want to
identify the liability. Ask yourself it they are true 357 liabilities and if they are, then ask yourself do I
have the issue when the liability access the basis. Then ask yourself do I have any situations where any
part of this liabilities could be deemed as personally liability, if they are they kil everything and
everything is getting taxable.
If the diminution of basis through 357 (a) would result in a negative basis, then the transferor is required
to recognize that negative amount as a gain at the time of transfer. 357(c).

2. CONTROL IMMEDIATELY AFTER EXCHANGE

CONTROL: Defined as 80% of all voting classes and 80% of all classes of stock. 368(c).
The requisite control must be obtained by transferor(s) of property in an integrated plan

11
 If more than one non-voting class is issued, IRS requires 80% of each class. Rev. Rul. 59-259
Cannot dispose of the shares pursuant to a binding pre-arranged plan, but a voluntary disposition is
OK
INTERMOUNTAIN LUMBER CO. v. COMMISSIONER (TC 1976) Pg. 62
Taxpayer actually wanted a higher basis because the depreciation will be more. In this case DOES
NOT want 351 treatment.
HOLDING: The control requirement of 351 is not satisfied where, pursuant to a binding
agreement entered into by the transferor (prior to the 351 exchange), the transferor agrees to lose
control of the corporation by a taxable sale of all or part of that stock to a third party (after the
exchange). Therefore it was a sale and taxpayer gets a stepped up basis (higher depreciation
deduction)
a. Although Shook had title to the shares for a little bit, he never actually had control and all was
part of one big transaction
REVENUE RULING 2003-51 (2003) Pg. 66
A 351 exchange of property that is followed by a nontaxable disposition of the stock received
may meet the control requirement, even if the stock received by shareholder transferor is
immediately transferred in nontaxable transaction) pursuant to a prearranged plan
Ruling concludes that, based on the facts presented, the results of 351 treatment could have been
obtained if some of the steps were reversed
a. This made 351 treatment OK

3. TRANSFERS OF PROPERTY AND SERVICES

PROPERTY: Construed broadly to include cash, capital assets, inventory, accounts receivable,
patents.
SERVICES: Are NOT property. 351(d)(1); 1.351-1(a)(1)(i)
If services and property, then all stock received is treated as for property 1.351-1(a)(1)(ii)
If a shareholder transfers property and services then the 351 transaction is valid, however
shareholder will treat services as ordinary income. 1.351-1(a)(2) Ex. 3
MIXED BAG: If both property and services are exchanged for stock, the stock will not be treated as
having been issued for property if the primary purpose of the transfer is to qualify the exchange of the
other property transfers for Nonrecognition and if the stock issued to the nominal transferor is de
minimus in comparison to the value of stock already owned or to be received for services by the
transferor
Transaction fails if the value of the property transferred is de minimus relative to the stock received
for services (FMV of property < 10% of stock received for services). If of the stock you get
10% is paid by property, you become a property transferor and all your stock counts
including your service stock
What impact if compensation related shares subject to forfeiture if Manager leaves within 5 years?
Per Section 83, Manager not recognize until restriction lapse, but then recognize full FMV as
ordinary income. If it is said this stock is vested over 10 years, then every year I have 10% of
income. 83(b) election allows recognition now, against risk of forfeiture and potential of more
favorable capital gain treatment on growth. The stock(property) for services manager get is
compensation for services in the FMV of that property and stock is property.SO if manager received
130K of stock, the manager has stock certificate and 130 K of income.

TAX TREATMENT PURSUANT TO A 351 EXCHANGE

1. TREATMENT OF A TRANSFEROR SHAREHOLDER (SH)

12
 NO RECOGNITION: SH does not recognize if the requirements are met under 351
EXCHANGED BASIS IN STOCK: The basis of the stock received in a 351 exchange shall be the
same as the basis of the property transferred by the SH to the corporation (exchanged basis). 358(a)
(1).
i. i.e. NEW BASIS = Old Basis
ii. UNLESS there is boot (see below)
HOLDING PERIOD: Where a transferor receives property with an exchanged basis such as stock in a 351
exchange, the holding period of that property is determined by including the period during which he held the
transferred property if the transferred property is a capital asset or a 1231 asset - Tacking of holding
periods (Section 1231 property includes buildings, machinery, land, timber and other natural resources,
unharvested crops, cattle, livestock and leaseholds that are at least a year old, but does not include poultry,
trademarks, or inventory);
- if it is not, the transferors holding period begins on the date of the exchange;
TREATMENT OF BOOT: Gain (but not loss) realized is recognized to the extent of boot. 351(b).
NO Loss Recognition always look if b-in loss 1st!
i. Gain will be recognized, but not in the excess of:
a. The amount of money received, PLUS
b. The FMV of such other property received
ii. 358(a)(2): Boot gets FMV basis:
BASIS in BOOT = its FMV
NEW BASIS if (+BOOT) = Exchanged Basis of Pr FMV of Any Other Pr/Cash
Received(Boot) + Gain Recognized (by SH on boot)
If Boot + 2 kinds of stock allocate in proportion to FMV of each stock.
1) Look on how much gain realized and how much loss
2) Any boot?
3) Allocate boot to each prop transferred based on FMV, and use only gain property, disregard loss P.
4) What is Gain recognized? The lesser of BOOT or Built-in gain
5) Aggregate basis in his stock formula above
6) Allocate basis to each kind of stock: FMV of ST1: ST2
If installment
1) first to nonrecognition property
2) Any remaining basis allocation to the boot to limit gain realized amount

2. TREATMENT OF TRANSFEREE CORPORATION

NO RECOGNITION: Corporation does not recognize gain or loss when it issues stock in exchange
for property
BASIS - The corporation takes a transferred basis in any property received under 351 (as it was in
the hands of transferor) PLUS the amount of gain recognized to the transferor (boot)(therefore,
takes the contributing SHs basis or transferred basis)
i. The latter adjustment will only occur when realized gain is recognized (i.e. when boot is included)
ii. Rationale: Unlike the result of a 351 transaction with 358 (SH basis rules) where the SH might
contribute appreciated/depreciated assets, the corp. has not disposed of appreciated/depreciated
assets, thus the exchanged basis required to defer that gain is not necessary in 362
iii. Holding Period tacks on
NET BUILT-IN LOSS If property with a net built in loss is transferred to a corporation in a 351
exchange or as a contribution of capital, then the corporations adjusted basis in such property is
limited to the FMV of the property immediately after such transfer
i. NBL: When the aggregate adjusted basis of the property exceeds the FMV

13
 TREATMENT OF BUILT-IN LOSSES

i. If property with net built in loss is transferred to a corp. in a 351, or a contribution to capital, the
transferee-corporations aggregate adjusted basis of such property is limited to (shall not exceed)
the FMV of the transferred property immediately after the transfer
ii. Therefore, only one level of loss is preserved
a. Corporation receives the built in loss property at its FMV
b. SH holds the exchanged stock with a lower Adjusted Basis than FMV so it will preserve loss
REVENUE RULING 68-55 (1968) Pg. 73
i. To determine the gain recognized when multiple and different properties have been
transferred under a 351 exchange, each asset transferred needs to be considered to have been
separately exchanged.
ii. Cannot total the bases of the various assets transferred
a. Would not be able to tell the type of gain (long vs. short term or ordinary)
iii. FMV of each category of consideration received must be separately allocated to the transferred
assets in proportion to the relative FMV of the transferred assets
iv. Then need to determine the type of gain realized
v. Allocation of boot among transferred assets (if transferor exchanges several assets)
vi. The boot is allocated by percentage of total FMV to EACH asset and is recognized if the asset has a
net gain p.73 see slides
ASSE
TOTAL ASSET I ASSET II
T III
FMV of Asset Transferred $110x $22x $33x $55x
% of Total FMV 20% 30% 50%
FMV of Y Stock Received in Exchange $100x $20x $30x $50x
CASH received in exchange 10x 2x 3x 5x
Amount Realized $110x $22x $33x $55x
14
 Adjusted Basis 40x 20x 25x
GAIN/LOSS REALIZED ($18x) $13x $30x
*Under 351(b)(2) the loss of 18x realized on the exchange of Asset I is NOT recognized. 13x will be recognized
as short-term capital gain in the amount of 3x, the amount of cash received (351(b)(1)). 30x will be recognized
as ordinary income in the amount of 5x, the amount of cash received (351(b)(1) and 1245(b)(3))

ASSUMPTION OF LIABILITIES

1. 357(a) CORPORATION: Assumption of liability by a transferee corporation in a 351 exchange will

1)neither constitute boot(rec.) 2) nor prevent the exchange from qualifying as a 351 exchange
But reduces basis: reduce basis on the Assump of Liability
2. 358(d) SHAREHOLDER: SH-transferor decreases the basis to preserve the gain
SHs basis in stock received in a 351 transfer is an exchanged basis from the property contributed,
reduced by the amount of money (liabilities) received and increased by the amount of gain recognized
Here, SH reduces their basis in the stock received in the exchange by treating the relieved liabilities as
money received by the transferor for purposes of determining the SHs basis
i. NOTE: Deferral; immediately, the relieved liability is not viewed as boot as to trigger recognition,
but adjusting the basis ensures that the gain will be recognized upon disposition

3. EXCEPTIONS TO 357(a)
TAX AVOIDANCE Assumption of liability is treated as boot IF the taxpayers principal purpose in
transferring the liability was the avoidance of federal income taxes or was not a bona fide business
purpose
i. Factors:
a. What the liability was initially used for mortgage is business, personal vacation is not a business
purpose
b. Obvious tax avoidance purpose retaining ownership while limiting tax
ii. NOTE: Entire assumption of liability is treated as boot, whereas in 357 only the excess over basis is
considered boot
a. If both 357(b) and (c) apply, the harsher (b) treatment prevails
EXCESS LIABILITIES If the sum of the liabilities assumed by the corporation exceeds the aggregate
adjusted bases of the properties transferred by a particular transferor, the excess is considered gain
from the sale or exchange of property
i. Otherwise there would be a negative basis the Code hates negative basis
ii. Therefore, any time liabilities are in excess of basis, the excess will be recognized as gain and the
basis will be zero
EXCEPTION to 357(c)
i. No gain recognized IF the obligation WOULD HAVE given rise to a deduction if paid by the SH
(negative basis not created)
a. Ex: SH transfers Accounts Payable, Interest expense on a home mortgage
b. In response to cash basis taxpayers who have not yet deducted AP nor recognized AR (nor
deducted them) and therefore the accounts payable can exceed the basis in assets exchanged
ii. Exception 357(c)(3)(B): The giving rise to a deduction exemption does not apply to liabilities
that result in the creation of, or an increase in, the basis of any property

4. PERACCHI v. COMMISSIONER (9th Cir. 1998) Pg. 84:

15
 RULE: 357(c) gain can be avoided if basis of property contributed under a 351 transfer is
increased with a promissory note from the transferor-shareholder, and where the note is an
enforceable obligation. (personal promises are not enforceable obligations)
Peracchi contributed real estate encumbered by liabilities in excess of his basis in the property and to
avoid 357(c), contributed his own unsecured personal promissory notes to the corp. (claiming the notes
had a basis of the face value)
HOLDING: Basis of a note contributed by a taxpayer to his wholly-owned corp. was equal to its face
amount (rather than zero) because 357(c) treatment could have been avoided through transactions that
were economically equivalent to the contribution of a promissory note (ie. Borrowing from a bank)
i. IRS argued that note was a sham obligation because taxpayer controlled the corporation and could
prevent the corporation from ever enforcing the note
ii. BUT, court said that in bankruptcy, taxpayer would have obligation to pay, so it was genuine debt

IMPERFECT 351 TRANSACTIONS

1. INCORPORATION OF AN ONGOING BUSINESS

ASSIGNMENT OF INCOME DOCTRINE: The person producing the income is taxed on it (i.e.
transferor/shareholder). That is, income tax consequences cannot be assigned/shifted from one person
to another
A/R TRANSFERRED TO A CORPORATION MAY QUALIFY AS A 351 EXCHANGE
i. HEMPT BROS. v. US (3rd Cir. 1974) Pg. 99
a. Conflict between 351 and assignment of income doctrine
b. TPs partnership transferred stuff, including AR, to a newly formed corporation.
i. TP did not want 351 treatment because wanted cost basis in A/R so that there would be no
income when A/R was collected; IRS wanted 0 basis
ii. P.G. Lake corporation assigned oil payment right to president of corp in consideration for
his cancellation of a loan. Not treated as property; no capital gains treatment, just ordinary
income.
c. HOLDING: The court held that A/R CAN be transferred as property and the taxes will be
charged to the corporation (new owner) 351 is in place not to burden the new shareholders
with taxes and the SH received valid consideration (stock) for SHs giving up claim to A/R
(income)
d. A/R is simply income that has not been paid-earned. This meets the definition of property for 351
purposes
e. Legal Fees ARE NOT property (Gregory v. Helvering)
ii. TAX AVOIDANCE: Where there is a tax avoidance purpose, assignment of income doctrine still
applies
TRANSFER OF POTENTIAL/CONTINGENT LIABILITIES WILL NOT TRIGGER 357(c)
GAIN RECOGNITION FOR EXCESS LIABILITIES OVER BASIS
i. REVENUE RULING 95-74 (1995) Pg. 103
a. HOLDING:
i. Just knowing the environmental liabilities were on the horizon did not make them
liabilities
ii. Such liabilities should not be considered in determining whether liabilities exceed basis
(357(c)) and such contingent liabilities should not reduce the SHs basis under 358(d)
iii. Such liabilities assumed by the corporation are deductible as business expenses under 162

2. CONTRIBUTIONS TO CAPITAL: Shareholder transfers property and does not receive stock
consideration = no gain or loss recognized to SH
16
 Shareholder can increase the basis in his stock by the cash or adjusted basis of contributed property.
1.118-1.
Transferee corporation does not include capital contribution in income. 118(a).

3. CONTINGENT LIABILITY TAX SHELTERS

BLACK & DECKER v. US (2004)
i. B&D contributed $561M in cash, and $560M in contingent liabilities in a 351 with subsidiary.
B&D therefore valued the stock at $1M and because of 357(c)(3), held the stock with a basis of
$561M (not reduced because the liabilities would result in a deduction). B&D sold the stock,
and claimed $560M in losses to offset gains
a. Here, the healthcare liabilities would have been deductible by the transferor, so transferor will not
reduce basis (under 358(d)(1)) in the stock received by the amount of liabilities assumed
b. OVERRULED BY 358(h)
358(h): Now blocks the B&D type tax shelter by indicating that Adjusted Basis (including liabilities
assumed by shareholder) (1M) cannot be higher than FMV of property (encumbered by liabilities)
(560)
i. Mandates a reduction in the transferors stock basis by the amount of the liability, but not below
FMV
ii. Therefore, B&Ds basis in the stock would have been $1M and no loss would have been recognized
iii. Exception 358(h)(2): TP can still transfer contingent liabilities without being required to reduce the
stock basis under 358(d)(1) as long as they simultaneously transfer the underlying assets giving rise
to the liability

4. ORGANIZATIONAL AND START-UP EXPENSES:

When you for a company there are about 4 different ways, well just lets take legal fees if you help smbd form
a corp, raise money from investors, transferring assets, borrow money, youve got to take your bill and you are
going to break your bill down into pieces, because there is different tax treatment based upon what you did with
your legal services. Any expenses related to transferring an asset to your business (you got piece of equipment
or real estate appraise) has to be added to the basis of the asset and depreciated as a part of it. Sometimes I
provide legal services related to the secure of the loan, bank debt, whatever, when I do that my legal services
had to be added to and treated as the cost of the loan and have the life of the loan. Sometimes I rendered legal
fees that are considered organizational expenses (248 and Reg. 1.248-1(b)- my work in preparing bylaws,
minutes of incorporation, etc and the way is get to play see below (5000 de minimis.)
Corporation can elect to currently deduct up to $5K of organizational expenditure (the $5K reduced by any
amount over $50K). 248(a)(1).
Amount that is not deductible shall be allowed as a deduction ratably over the 180-month period
beginning with the month in which the corporation begins business
And finally the book of the legal fees typically incurred in many businesses are incurred in connection with
raising capital going out and helping the client raise money from investors -and all legal fees contributed to
that you get virtually no tax benefits anyway, the get added to no asset, you cannot treat them as organizational
expenses or deduct them they just evaporate for tax purposes. But for book purposes, typically you get those
legal expenses and the company books them as a capital cost on the balance sheet of the company just assure
they paid them. But for tax purposes they are nothing.
So we have 4 variables: was it an asset related item, organization related item, true organizational expenses or
was it a capital raising issue?
Organizational Expenditures means any expenditure which
i. Is incident to the creation of the corporation
ii. Is chargeable to capital account; and

17
 iii. Is of a character which, if expended incident to the creation of a corporation having a limited life,
would be amortizable over such life

III. CORPORATE CAPITAL STRUCTURE

OVERVIEW
To understand this the best way is to look on a balance shit. On a balance sheet we have assets (on the left side)
and liabilities(right side).
Assets can come from three places:
1. Borrow money - debt
2. Contributions from the owners -asset
3. Earn money and keep it in the company (retained earnings)
Here we want to focus on how a shareholders can contribute funds to their company:
SH can buy common stock (a common denominator stock in every corporation, it is the bottom line
stock, foundational stock of every corp) -351.
You can also have preferred stock ( that has economic preference attached to it)
o It may be a dividend the stock will get dividends before the common stock
o Liquidation right -we liquidate the company, this stock is going to be paid back at certain amount
before common stock get anything.
o call obligation which means that the company can call the preferred stock at any time, pay off
and get rid of it.
You cannot have any preferred stock in an S Corp, but only in a C Corp
o You can have a shareholder debt shareholders loan money to theirs own company. Advantage: - when
the company is becoming very profitable, the company can pay back this loan tax free to the SH. The
company cannot when they get very profitable pay back common stock tax free. If the company has
earning and it pays it it is dividend. So, the scheme is shareholder loan money and the company
assumes that it will pay this money back to the SH. It is tax free and the company has deduction on
interest. If shareholder just invest money and the company pay earning to him it is taxable event and
the company has no deduction.
The reason why debt is good is because it creates a greater yield for a shareholder.
But any earnings on equity and capital that are distributed would be taxed as dividends.
The government wins when there are more:
o Dividends
o Capital gains
o Payroll taxes.

1. CORPORATIONS CAN BE CAPITLIZED WITH DEBT OR EQUITY

Investors who purchase stock = Equity Holders (subordinate, junior)
Lenders = Debt Holders (preferred, senior)

2. DEBT
Can come from two sources: - bank (outsider) and SH (insider)
Interest income taxed at ordinary rates
Cyclical businesses may have trouble paying interest regularly
Payment of debt is return of capital for the lender
Any gain is capital gain for debt
3. Debt-Equity Factors SEC 385

18
 1. Documentation: Debt Has to be documented as a true debt. That has to be default remedy, an interest rate,
payments must be made. Unconditional promise to pay; specified term; interest rate; default remedies. Termship
never exceed 10 years. How to show that we can pay then we must have projection. You have to demonstrate that if
you operate business like that you will be able to repay the debt. How to demonstrate? -projection
2. Debt/Equity Ratio: Cant have excess of debt/equity ratio. Inside and Outside debt. Book value v. Market
Value. If ratio over 5-to-1 based on total debt and book value, must be able to show consistent profitability and cash
flow will support debt. A debt was excessive if the instruments terms and conditions, viewed in combination with the
corporations financial structure, would not have been satisfactory to a bank or other financial institutions making
ordinary commercial loans. It was not excessive, however, if the outside (all the money the company borrows
including bank) debt/equity ratio did not exceed 10 to 1 and the inside (shareholders: the amount of debt they have
compare to the amount of equity) debt/equity ratio did not exceed 3 to 1 (Prop. Reg. 1.385-6(g)(3).So, if they put
500K of real equity in the company, they can loan the company 1.5 Thus, even proportionate straight debt issued for
cash would not be reclassified if it fell within this safe harbor from excessive debt and bore a reasonable (within
specified ranges) interest rate. It is better to look at cash, basis ration, not FMV. But 385 Regs. Did provide that if a
shareholder who owns more than 25% of the stock (A owns more) makes a non-pro rata loan (what we have here) and
a debt/equity rates exceeds 10:1 (as oppose to 3:1) (based on cost) then we can be in a trouble.
3. Proportionality: Same ratio as stock ownership. (each 20% of debt and each 20% of stock-percentage, not sum).
If all other factors are strong, then proportionality wont kill you. But if some factors are weak factors it will kill you.
4. Subordination: Subordination occurs when I loan my company a lot of money, but the bank comes or some major
vendor and says hey, you guys have money you owe yourself, we dont like that because that makes you a creditor,
but we are a real creditor. We want to subordinate your debt to our position. So if the company goes bad you are not
staying in a line with us a creditor, we get paid before you get paid. We called that subordinating the debt to the debt
of others. But it could hurts you because it looks like everything is an equity, not debt. So in this deal you dont want a
voluntary subordination 9(like we understand thatshareholder debt and we agreed to subordinate this debt to our
creditor position to the bank). If bank forced you to do it-then okay, it wont kill you.
Inside debt inferior to outside debt. You cannot have volunteer subordination. If bank forced you -then okay, it wont
kill you.
5. Convertibility debt convertible to stock. You cannot use any convertible debt. You cant convert issued to SH
debt and say, by the way guys in the future you can convert this debt to equity. If you put any conversion feature in
that debt, they would be classify as equity. So, there is no capacity to use the convertible debt. But for a venture fund
and some private equity funds, convertible debt could be a good idea. Why? If the company is a home run, goes
public, they want to convert common stock and goes upside and if the company goes bas they want to be first in line
on that downside. They dont care about taxes. This is not an issue for ventures.
BUT You cant convert deb, otherwise they will reclassify your debt.
No hope. Too long; The maximum amount to loan should be 10 years
interest will be payable only out of the net profits of the business- You cant have anything that is payable
only out of the net profits -that is equity.
If personally guarantee the loan does that make shareholders debt for purposes of 3:1 debt equity?? it
depends see problems

So, how to deal with the vagueness:

Given vagueness, how to advise:
1. Carefully draft to avoid any hybrid stock attributes. -which means no conversion features at all!!
2. Market interest rate, term, maturity and payment terms.
3. Avoid proportionality and subordination, if possible (often not).
4. Manifest intent to repay (terms, remedies, maybe even security).
5. If possible, keep total debt/equity ration under 10:1 and inside
under 3:1 (the 385 Reg safe harbors).
6. Make sure payments are made.
We dont care about it in S Corp because of the allocation of the income, pay taxes whether or not the
cash is distributed. Debt in S Corp does not accomplish the whole purpose of the debt is to take profits
in a C Corp and transfer them tax free to the SH -that is the benefit.
19
 Balance Sheet
Assets Cost FMV
Cash 80K from Aristocrate +40K 1920K
cash from
Chef+1800Loan=1920K
Building 20K 80K
Goodwill 0 40K
Total 1940K 2040K
Liabilities
Bank Loan 900K 900K
Shareholder Loan 900K 900K
Total 1800K 1800K
Equity (Total Asset-Total 140K 240K
Liabilities)
Total Liab. & Equity 1940K 2040K

DEBT TO EQUITY RACIO

Outside debt Shareholder Debt
Loan (for outside total, for 1800K 900K
inside only SH)
Equity (in FMV table) 240 K 240K
RATIO 7.5:1 3.75:1
Loan (for outside total, for 1800K 900K
inside only SH)
Equity (in AB table) Better to 140 K 140K
look at AB
RATIO 12.9:1 6.4:1

What if company put money into a corporation and the investment going bad? We dont care what happens on
the corporate level, the corporate level then have a big loss. What we care about is if I put money in, how are
my losses treated if I loose my investment?
LTCL means I have deductions and I offset net LTCG, then net SHTG, then 3000 of ordinary income
STCL - It offsets net STCG, then net LTCG, then 3000 of ordinary income.
It may also be treated as a business bad debt Sec 166(d). -ordinary loss dollar a dollar against any
income I have
Non-business bad debt treated like STCLoss
1244 ordinary loss see problem 149 for this example: 200k common stock. Security Sec 165 (g),
unless Sec 1244 applies. Sec 1244 applies only: if all SH-s contribute less than $1M (Sec 1244(c)(3) and
my maximum benefit is 50k (100K if married).
. (1)GENERAL RULE
If any security which is a capital asset becomes worthless during the taxable year, the loss resulting therefrom
shall, for purposes of this subtitle, be treated as a loss from the sale or exchange, on the last day of the taxable
year, of a capital asset.
(2)SECURITY DEFINEDFor purposes of this subsection, the term security means
(A)
20
a share of stock in a corporation;
(B)
a right to subscribe for, or to receive, a share of stock in a corporation; or
(C)
a bond, debenture, note, or certificate, or other evidence of indebtedness, issued by a corporation or by a
government or political subdivision thereof, with interest coupons or in registered form.

3. EQUITY
Qualified dividends taxed at capital gains rates
Entire amount of dividends taxable, no basis recovery
Controlling shareholder can determine timing of income

4. EFFECT ON CORPORATION
Tax bias of debt over equity
Interest on debt is deductible by corporation (no double tax). 163(a).
Dividends are paid out of post-tax income
i. Thus, corporation is taxed THEN shareholder is taxed upon receipt of dividend

DEBT V. EQUITY

1. DISTINGUISHING FACTORS BETWEEN DEBT AND EQUITY

FORM: Whether there is a written unconditional promise to pay on demand or on a specified date a
sum certain in money in return for an adequate consideration in money or moneys worth and to pay a
fixed rate of interest
i. If it sounds like this, then it is likely debt
a. Exorbitant Interest: payments by corp. indicates that corp. is returning Earnings and Profits =
equity (Indmar)
b. Inadequate/Low Interest: By corp. indicates that 3rd party would not make a similar loan = capital
contribution (Fin Hay)
c. Fixed Interest Rate: Payments made on time. Also, interest rate was fixed and was not exorbitant,
which indicates that the corporate profits were not being disguised as debt
d. No mention of interest = very rarely debt
e. Needs a reasonably close fixed maturity date, rather than a demand/long-term maturity
ii. More likely to be treated as equity:
a. If obligation has a long term
i. Because more akin to no right to repayment, like equity investment
ii. Equity investor is like a co-venture who shares in upside and downside
b. Lenders have fixed payments in a fixed period of time
i. More can go wrong in long-term than in short-term
INTENT OF THE PARTIES
i. Intent of the parties to create a debtor-creditor relationship
ii. Measure intent by objective criteria such as lenders reasonable expectation of repayment,
evaluated in light of the financial condition of the company and corporations ability to pay
principal and interest
PROPORTIONALITY to SHARE

21
 i. Debt held in the same proportion as stock might be an indication that debt is equity based on
rationale that the creditors would have no economic incentive to act like creditors by setting or
enforcing terms of the liabilities
DEBT/EQUITY RATIO (OR THIN CAPITALIZATION)
i. Thinly capitalized when: a corporation issues excessive liabilities relative to capital contributions
that it has received (therefore MUCH MORE RISKY)
ii. If thinly capitalized, substantial risk that what purports to be debt will be reclassified as equity on
the theory that no rational creditor would lend money to a corporation with such nominal equity
a. SH is relying on profitability rather than the underlying assets to assure payment
SUBORDINATION
i. Subordination of shareholder debt to claims of general creditors may be sign that shareholders debt
is equity
CONVERTIBILITY INTO STOCK
ALSO CONSIDER:
i. Contingency of Payment
ii. Participate in profits
iii. Voting/Rights of Control
iv. Acquiring Essential Assets

2. INDMAR v. COMMISSIONER (6th Cir. 2006) Pg. 124

Court looked at the Roth Steel Factors to decide debt v. equity
ROTH STEEL FACTORS:
i. Names given to the instruments: absence instruments of debt means it was a capital contribution
ii. Fixed maturity date and schedule of payments:
iii. Fixed interest rate and interest payments: Payments made on time, rate not exorbitant
iv. Source of repayments: SH testimony indicates that he expected the repayments to come from
company profits. E&P indicates equity.
v. Adequacy or inadequacy of capitalization
vi. Creditor and stockholder overlap
vii.The security, if any, for the advances
viii. Ability to obtain financing from outside lenders
ix. Subordination to outside creditors
x. Used to acquire capital assets?
xi. Sinking fund to provide repayments
Tax court believed that the source of repayments came form the profits of the company, which would
make the repayments equity because it is based on the performance of the company
i. Circuit court viewed the reliance on profits as an obvious part of investing into a small company in
that a more profitable company will be better able to pay its debts

HYBRID INSTRUMENTS

1. INCENTIVES TO CREATE HYBRIDS

Corporate interest deductions on certain hybrid instruments
Advantages when debt instruments for tax is treated as equity or part equity for financial accounting,
rating agency, or regulatory purposes

22
2. SECTION 385: Authorizes the Treasury to promulgate such regulations as may be necessary or
appropriate to determine for all tax purposes whether an interest in a corporation is to be treated as stock or
debt
Requires the regulations to set forth factors to be taken into account in determining whether a
debtor=creditor relationship exists and specifies the following factors which may (but need not) be
included in the regulations:
i. Form
ii. Subordination
iii. Debt-Equity ratio
iv. Convertibility into stock
v. Proportionality
BIFURCATION: 385 allows for bifurcating hybrid securities into party debt and party equity rather
than pocking one camp or the other in the case of complex hybrid securities

CHARACTER OF GAIN OR LOSS ON CORPORATE INVESTMENT

1. SALE OF DEBT OR EQUITY: Investments are taxed at capital gain or loss rates

2. GAIN ON SALE OF QUALIFIED SMALL BUSINESS STOCK: Non-corporate original issue SH can
exclude from Gross Income 50% of gain (up to $10M per qualifying corp.) from a sale or exchange of
Qualified Small Business Stock held for more than 5 years. 1202(a)(1).
Corp. issuer must have aggregate gross assets of $50M or less and be active business. 1202(c).
However, (the other 50%) the long term capital 1202 gain is taxed at a minimum of 28%. 1(h)(4).

3. DEBTS NOT EVIDENCED BY SECURITY: For non-corporate lenders business bad debts held for more
than 1 year are ordinary losses. 166(d). Less than a year are sale/exchange of capital asset
To be treated as business bad debt, the debt has to be n proximate relation to the TPs trade or business.
The proper measure of proximity is dominant motivation U.S. v. Greene
Non-business bad debts are artificially treated as short-term capital losses. 166(d).

4. EVIDENCED WORTHLESS SECURITIES: S corp. members, partners, and sole proprietors can deduct
losses from business operations as they are incurred if they materially participate in the activity. 165; 469
(passive participation)
Security: stock, or debt notes/certificates/bonds with coupons (or in registered form. 165(g).

5. SECTION 1244 STOCK: An individual shareholder may treat loss from sale/exchange of worthless small
business corporate stock (C/S or P/S) as an ordinary loss. 1244(a) (ordinary loss limited to $50K)
Small Business Corporation: If aggregate amount capital contributions do not exceed $1M. 1244(c).
But stock issued for services does not qualify for ordinary. 1.1244(c)(-1(d).

6. RECAP
GAIN PROVISIONS
i. Gains from the sale or exchange of stock or debt is treated as capital gains
ii. Qualified Small Business Stock (1202): Individual SHs are entitled to exclude 50% of any gain
from a sale or exchange of such stock held for more than 5 years
LOSS PROVISIONS/WORTHLESSNESS
i. Losses by SH or creditors are generally deductible (key is whether ordinary or capital losses)
a. Losses from Worthless Securities (Equity) = CAPITAL LOSS
23
 i. NOTE: Unregistered = not eligible for worthless security treatment, which is good because
it is then an ordinary loss
b.Worthlessness of Debt = BAD DEBT, therefore
i. Non-business Bade Debt = CAPITAL LOSS (166(d))
ii. Business Bad Debt = ORDINARY LOSS
c. 1244 Small Business Losses = ORDINARY LOSS

C-CORP LINGO

1. Dividend Corp distributes cash or property to shareholders as a result of operations not part of
redemption (buying back) of stock or liquidation. We simply operating, earning money and we distribute it to
the shareholders. Distribution is with respect to stock and qualifies as dividend under: Sec 316.+ 301, 311,
312
2. Return of Capital - Corp distributes cash or property with respect to its stock which is NOT 316 dividend,
nor part of redemption or liquidation. I am giving them back the capital of the company. Generally it is tax free
but is very difficult to get there. But sometimes corporation returns capital to the corporation but it is very rare.
3. Stock dividend Corp distributes its own stock or debt obligation to its shareholders as a result of
operations not associated with a redemption or liquidation. Sec 305and to a lessor extend section 306. This is
were I go to the SH and I say-SH we want to pay you a dividend but we dont have any cash or property to pay
you so what we are going to do is we are going to give you more stock in the company. The stock is your
dividend. IT IS NOT TAXABLE
4. Redemption Corp distributes money or property to shareholder to purchase (or redeem) stock owned by
the shareholder. When the company is buying back its stock. Sec 302, 303 and 304,306 along with 311 and 312.
If you are a SH on practice there are only two ways to sell your stock one is to sell it to other SH( cross
purchase) and the other is to sell it to your company
5. Liquidation Corp distributes money or property to shareholder as part of plan to liquidate or partially
liquidate the business of the corporation. It is not about bankruptcy. But is also about when a company sell his
stock for another company for a bunch of money. Sec 371, 372 or 377 depending on how the company is forms
and who owns the stock

IV. NON-LIQUIDATING DISTRIBUTIONS

DIVIDENDS
A corp may distribute in many forms: it may distribute its
own stock
debt obligations
redeem (repurchase) stock from its shareholders by distributing cash and property
distribute its net assets in liquidation of the entire business.
This section is about non-liquidating (operating) distribution of cash or property -dividends.

1. OVERVIEW
Non-liquidating distributions of property that are dividends by corporation with respect to its stock
MUST be included in SH gross income. 301(c).
Corporate shareholders (A corporate shareholder (non human) is the term used to describe a business
entity that owns shares in another limited company ) will prefer dividends because of the 243
dividend received deduction

24
 i. If corps. Had to pay tax on dividends and then paid dividends to shareholders, then would result in
triple taxation
Not every cash distribution to SHs is a dividend, could be a return of capital

DIVIDEND DEFINED
Distribution is treated as dividend if:
1.Out of earnings and profits accumulated since 2/28/1913
2. Out of its earnings and profits for the current year, determined at end of year and without regard to E & P
amount at time of distribution. So are looking at the last day of the year and calculate what was the
companys E&P (earns and profits) AT THE LAST DAY OF THE YEAR -CURRENT E&P.
For every company you have TWO E&P:
- Accumulated E&P earnings and profits the company accumulated right up to the start of the year
- Current E&P.
E&P is just that. It is what a company have earned. Any distributions out of it TAXED as a DIVIDEND.
E&P (312) is a concept that exclusively relates to C Corp. It doesnt relates to S Corp.
Priority rules:
- Every distribution deemed made from E & P to the extent thereof. Corp cant designate otherwise.
If I pay out of E&P and it is DIVIDEND. Do not have a power to choose.
- Distributions deemed made from the most RECENT E & P. Not the accumulated E&P
DIVIDEND - 316(a): A dividend in any distribution of property made by a corporation to its SHs
out of accumulated OR current Earnings and Profits
i. DISTRIBUTION PROCESS BE C CORPORATION ( 316 and 301)
(1) Look first to current Earnings and Profits determined as of the close of the taxable year in
which the distribution was made
(2) Look to accumulated Earnings and Profits only if distribution exceeds current E&P
(3) Anything exceeding E&P will be viewed as a return of capital and reduce basis
(4) Any excess of that will be recognized as gain (type depends on situation)
DISTRIBUTION OF PROPERTY - 301:
TRIOPLE TAX PRIORITY:
Distribution Amount: Amount of money plus fair market value of property distributed.
STEPS
While distributing dividend ASK YOURSELF:
Q1 - So, if I distributed smth to a SH what is a value? It is an amount of cash? And if I
distribute an equipment it is a FMV of the equipment. Amount of distribution 301 and 301
(d)
Q2- Next question TO WHAT EXTEND I HAVE A TAXABLE DIVIDEND?

Triple Priority: Distribution with respect to stock:

Priority One: If dividend under 316, included in gross income. If the dividend is made with
respect to stock to the extend I have E&P it is taxed under Sec 61 as Gross Income. It may be
subject to preferential tax rates from 15% to 23,8% depending on how much GI you have (look
at your notes first 2 lectures). CORPORATION RECIEVES NOT DEDUCTIONS FOR THE
PAYMENT OF DIVIDENDS.
Priority Two: What if I run out of E&P so it is NOT a dividend. And the SH is being
distributed more money then it is a RETURN OF CAPITAL and it is recovered tax free to
the shareholder up to their basis in the stock. So, applied to reduce adjusted basis of stock.
Tax free return of capital. Example: I have a 100 k in my stock and they distribute to me more
money then we have E&P it is a tax free return of capital that reduce by AB but not below
zero.
25
 Priority Three: If they still distribute to me more money, money that are greater than my AB
in the stock, so the excess excess treated as gain from the sale or exchange of property -excess
is treated that if I sold my stock. Long-term capital gain if I held the stock for more than a year
and short-term capital gain if less then a year.
When there are insufficient current earnings and profits available to cover all cash distributions made during
the year, E&P must be allocated to the distributions in order to determine dividend status under the following
rules:
1. First current E&P determined as of the end of the year are prorated among the distributions by using the
following formula:
Current E&P allocated to distribution = Amount of distribution*(total current E&P/total distributions).
2. Next, accumulate earnings and profits are allocated chronologically to distributions (i.e on a first-come,
first-served basis)
3. If the corp has a current loss but has accumulated E&P from prior years, it will be necessary to
determine the amount of accumulated earnings and profits available on the date of distribution. Unless
the loss can be earmarked to a particular period, the current deficit is prorated to the date of the
distribution.

a. A distribution of property is a dividend to the extent that it is made from current or accumulated
E&P (included in Gross Income)
b. If the distributions exceed the E&P, then the amount of distribution is applied against the
shareholder basis
c. If there is an excess over the SHs basis, the amount is treated as gain from the sale or exchange of
property
Question on exam : You really dont know whether distributions is made during he year and you will not know
how it is going to be taxed at the end of the year because you dont know how the current year is going to look
like. Well I didnt calculate the dividend at the end of the year. YOU CANNOT CALCULATE THE
DIVIDEND AT THE END OF THE YEAR,YOU DONT KNOW EHN THE DISTRIBUTION S MADE
DURING THE YEAR_WHAT IT IS. You have to wait till YA. Sh-I dont know whetehr it is taxable or not
because I dont know if I earn money on this issue. Which means that a big portion of the distribution could be
just return of a capital Listen lecture18/10/16 40 minutes
I cant determine may dividend distribution until the end of the year!!!! exam

DETERMINING E&P
Concept: The true economic growth and improvement of the corporation. No precise definition. It is not the
same as taxable income.
Calculation: Start with taxable income, then:
Add Increase for other economic gains (that are not recognized as taxable income): Tax exempt interest,
life insurance proceeds, tax refunds, etc. (but not nonrecognition gains under 1033, 351, etc.). SO.
Certain items excluded from taxable income must be added back.- Tax-free income
Increase for deductions that have no economic effect: Dividends received deduction, excess
depreciation excess percentage depletion, etc. - Certain items deductible from taxable income must be
added back.
Decrease for economic losses not reflected in taxable income: federal taxes, losses between related
parties, excess T & E expenses -267(a), etc.) Certain nondeductible items must be subtracted.
Nondeductible current expenses (162, bribes, lobbying expenses, fines, etc.)WHERE TO PUT?
Timing differences: Depreciation, 453 installment sales; FIFO inventory, etc
So a company could have positive as well as negative E&P, which in the last case means that the company
cannot pay dividends.
Earnings and Profits (E&P): Assets liabilities SH capital contributions = RE
26
 Technical definition in 312.
ii. Start with corporate TI [corps ordinary method of accounting; tax law realization and recognition laws
govern] iii. Adjustments for:
- Tax-free income
- Nondeductible current expenses (162, bribes, lobbying expenses, fines, etc.) and losses (related party losses
267(a), etc.)
- Timing adjustments
Depreciation ACRS (312(k)(3))
Installment sales (312(n)(5); 453)

1. . SH basis in his stock $10K $10K

2. Current E&P $5K 10K
3. Accumulated E&P 1/1 0
4. E&P deficit for entire 0
taxable year () Prorate to
date of distribution (1/2 of
..)
5. E&P deficit for the prior year 0 $15K
6. EP available (2+3) 5K 10K
7. Distribution7\1 17500 10K
8. E&P reduction taxable To zero (17500 of To zero. 10 K is a taxable
dividend distribution minus E&P dividend even though we has
available 5K). 5K is a taxable a huge E&P deficit.
dividend
9. Accumulated E&P balance
10. Distribution left 12500K (17500 -5K) zero
11. SH basis in his stock To zero (10K 12500K)
reduction tax free
12. Distribution left 2500
13. Gain 2500 May be LTCG

DISTRIBUTION PROCESS BE S CORPORATION ( 1368)

The income of an S corp get allocated to the SH according of how much stock do they own. It could be only
common stock (voting or nonvoting). When it is pass through it increases their basis in the stock and if losses is
pass through it decreases its basis in the stock. In C Corp the basis of your stock is the amount you paid for your
stock or 358S Corp -basis is changing all the time
In S Corp there are 2 situation that you have:
- When you always was a S Corp OR
- You elect to be an S Corp. You used to be a C Corp and at the time of changing status you have /have no
accumulated E&P in S Corp -clean S Corp. -rule can be easier

If No C corp E&P

27
 First Any distribution out of S corp is tax free to extent of shareholders basis in stock. Remember you
basis is being adjusted and it is calculated at the end of the year. If the DISTRIBUTIONS EXCEEDS the basis
of the stock, the excess is treated as long term or short term CG from the sale or exchange of the asset. Even
though you havent sold your stock. And the main question is WHAT IS THE BASIS in S corp stock??? At that
you are going to determine at the end of the year. Reduce basis per 1367.-?????
Second - Excess treated as gain from the sale of stock.
More complicated is when I used to be a C corp and while a C Corp I accumulated E&P that I never paid out. I
left it in the company, I reinvest them. And then I converted to S status .
So, if I have those E&P from C Corp in S sutis the government wants to tax me as dividend income under 301-
read his section when those E&P are paid out. So, there are four test
First - Tax free reduction of basis to extent of AAA (accumulated adjustment account- any money that I
earned and was passed through to me as S Corp earnings while I was S Corp is added to AAA) Example we
start S Corp in 2015 and we starts to earn money. Any money in my AAA which already been pass through and
taxed to me as an S corp I can distributed to me tax free. So, S corp, 2015, company earn 200K and I have a
stock, 100,000 i.e is allocated to me, that drives up my basis, the company can pay me 100K tax free and it will
drive down my basis. But I have enough in my AAA to cover.
Second - Taxable dividend to extent of accumulated E &P. If I ever distributed money greater than AAA by
the S corp, tax . it will not affect my basis, because it is not a distribution against my basis. But if I got an
E&P any distributions in excess of the AAA will be taxed to me as dividend income under 301.Because it is all
stuff from my prior C Corp existence.
At some time I will have distributed all the E&P. One this E&P is gone I am going to the first transh scheme(see
above- If No C corp E&P)
Third - Tax free reduction in basis to extent of remaining basis in stock.
Fourth Excess treated as gain from the sale of stock.
DO WE HAVE AAA IF NO E&P????
NOTE: Any distributions that made out of AAA or any distributions that is made with respect to my stock will
reduce the SHs basis in the stock. Any distributions that is made out of E&P WILL NOT AFFECT MY
BASIS

So you have to worry about three things:

- What is my AAA
- What is my E&P
- What is the SHs basis in the stock.

Section 311 (S and C corp)

Applies when a company distributed property other than cash to its SH in any form (redemption, liquidation,
whatever). When the property is distributed it could be either built in gain or buit in loss property. That is
measured by the FMV as compared to the basis the corps basis in the property.
REMEMBER: SH is always taxed on the FMV of the property.
BUILT-IN GAIN
So if a C(and S below) corp distributed a property FMV of which > AB, the corp has a gain that it must
recognize on a distribution.
In a C Corp world it would drives up the E&P of the Corp.
In an S Corp world that would drive up the AAA account
1. If the company distributed to SH property that is appreciated in value, where the FMV > companys basis
that is taxable income to a S Corp, which is pass through to SH and which increases their basis. So if I am an S
Corp and I distribute to the SH an equipment FMV 5 K and AB 2K, S Corp recognize gain of 2 K. Which in
turn results to 2K being allocated to a SH, which in turns turns up their basis up to 2K. FMV is measure of
distribution to shareholder apply normal distribution rules at shareholder level.
28
 2. If the S Corp distribute the property where AB>FMV. That is built in loss asset no loss is recognized. If it
gain recognize, so it is taxable income under 311. Shareholders basis in property is FMV.
3. S corp has gain equal to excess of FMV over basis, which is passed through to shareholders. 311(b) via
1371(a).
4. No loss recognized if FMV less than basis at corporate level. 311(a) via 1371(a).
BUILT-IN LOSS
When we distributed property AB>FMV the loss does NOT get recognized.
The company gets to reduce its E&P by the basis of the property.
CONSTRUCTIVE DIVIDEND SCENARIO
1. Excessive compensation to shareholder-employees
2. Corporation payment of personal shareholder expenses
3. Equity disguised as debt the interest deduction and return of capital issue
4. Excessive shareholder rental
5. Phony family employment
6. Personal use of corporate assets
7. Bargain sales or rentals of corporate property
8. Brother Sister Corp 482 Trap

2. 301 DISTRIBUTIONS OF PROPERTY

301(a): Except as otherwise provided in this chapter, a distribution of property (as defined in 371(a))
made by a corp. to a shareholder with respect to its stock shall be treated in the manner provided in
subsection (c)
301(c): In the case of a distribution to which subsection (a) applies:
i. (1) AMOUNT CONSTITUTING DIVIDEND: That portion of the distribution which is a dividends
(as defined in 316) shall be included in gross income
ii. (2) AMOUNT APPLIED AGAINST BASIS: That portion of the distribution which is not a
dividend shall be applied against and reduce the adjusted basis of stock
iii. (3) AMOUNT IN EXCESS OF BASIS
a. (A) IN GENERAL: Except as provided in subparagraph (B), that portion of the distribution which
is not a dividend to the extent that it exceeds the adjusted basis of the stock, shall be treated as
gain from the sale or exchange of property
b.(B) DISTRIBUTIONS OUT OF INCREASE IN VALUE ACCRUED BEFORE MARCH 1, 1913:
That portion of the distribution which is not a dividend to the extent that it exceeds the adjusted
basis of the stock and to the extent that it is out of increase in value accrued before March 1, 1913,
shall be exempt from tax

3. CORPORATE SHAREHOLDERS: Corporate shareholders (when C Corp owns stock n another C Corp,
we are not talking about S Corp because a Corporation cannot own stock in S Corp) are allowed a
deduction in the amount of 70% of dividends received (effectively paying a 10.5% tax [35%*30%]). 243.
So, a Corp can deduct from 70 to 100% of dividend depending on how much stock is owned. If there is less
than 80% stock owned the dividend deduction is 70%. If the company owns 80% of the stock then -80%
deduction, if more than 90% - then 100%.
The deduction goes up to 80% if corporate SH owns 20% or more (by vote or value) of the distributing
corporation. 243(c).
AND up to 100% if the 2 corporations are part of the same affiliated group. 243. Situation where
taxpayer includes an amount as income, but in a later year finds out that income was not his

29
4. NONCORPORATE SHAREHOLDERS: Most dividends received by a noncorporate SH are taxed at a
preferential long-term capital gains rates Sec 1(h)(11)

243 DEDUCTION PROTECTORS:

1. 246 Stock not held long enough the company would not get that dividend paid deduction if it did not
owned the stock long enough.
2. 249A - Debt financed stock ownership. If I am buying the stock with money that I have borrowed, I am
not get the deduction to the extent of the borrowed money
3. 1059 - Extraordinary dividends 2 yr rule and consolidated return rule we have a company that pays
out extraudinary large dividends and we are going to give you the deduction, but we are requiring the reduction
in the basis of the stock
4. The Waterman Bootstrap Acquisition

DISTRIBUTIONS OF CASH

1. INCLUDED IN SHAREHOLDERS GROSS INCOME: The amount of distribution of cash is taxable as

a dividend to the extent of corporations current or accumulated E&P. 301(c)(1); 316(a).
Amount distributed in excess of available E&P is first applied to reduce SHs basis in stock. 301(c)
(2).
i. Then to the extent they exceed SH basis it becomes gain from sale of stock. 301(c)(3).
2. Distributions that are not dividends are 1st treated as a recovery of the SHs basis in his stock, and any
excess over basis is treated as gain from the sale or exchange of the stock

3. MULTIPLE DISTRIBUTIONS

REVENUE RULING 74-164 (1974) Pg. 159

SITUATION 1
i. AEP $40K; 6 month operating loss $50K; Current EP $5K; $15K distribution
ii. ANSWER: All $15,000 is taxable as dividend. First, there is $5000 E&P for year and that is taxed.
Next, you take from the $40,000 accumulated E&P (take the remaining $10,000) and that is also
taxed

4.
SITUATION 2
i. AEP DEFICIT $60K; Net profits (6 month) = 75K CEP $5K; $15K distribution
ii. ANSWER: $5000 is taxed as dividend. $10,000 which Is not dividend will be applied against and
reduce the taxpayers basis of the stock in the hands of a SH and to the extend that it exceeds the
AB of the stock was gain from the sale and exchange of the property.

30
 SITUATION 3
i. AEP $40K; CEP DEFICIT $5K (for the entire 1971 year); $15K distribution
ii. ANSWER: Entire $15,000 is dividend. Prorate E&P deficit to date of distribution ($2500). There is
an accumulated E&P of $40,000 so $2500 is subtracted from that ($37,500). There is still enough
leftover to take the $15,000 distribution from so it is all a dividend
Applying this situation the distribution paid by X Corp on July 1, 1971 in each situation was a dividend
within a meaning of sec 316 of the code to the extend indicated as follows:
Accumulated E&P 1/1 40 K less
E&P deficit for entire taxable year (5,000) Prorate 2500
to date of distribution (1/2 of 5,000)
EP available 37,500
Distribution7\1 (15,000) 15,000 taxable as dividend
E&P deficit from 7/1-12/31 2,500
Accumulated E&P balance 12/31 20000
There is still enough leftover to take the $15,000 distribution from so it is all a dividend
SITUATION 4
i. AEP $40K; CEP DEFICIT $55K (1971 taxable year); $15K distribution
ii. ANSWER: $12,500 is taxable as dividend and remainder of $2500 is taken from shareholders
bases. $55,000 deficit is prorated to the date of distribution (50% or $27,500). Subtract the $27,500
from $40,000 ($12,500)
Accumulated E&P 1/1 40 K less
E&P deficit for entire taxable year (5,000) Prorate 27,500
to date of distribution (1/2 of 55,000)
EP available 12,500
Distribution7\1 (15,000) 12,500 taxable as dividend
E&P deficit from 7/1-12/31 27,500
Accumulated E&P balance 12/31 27,500
NOTE: Situation 3 and 4 of Rev. Rul 74-164 do NOT consider the possibility of earmarking the entire 1971
deficit (i.e 5,000 in Sit 3 and 55,000 in Sit 4)to the first half of the year. Under the Reg. 54_____PAGE 165
IF THOSE DIFICITS WERE sustained in the 1st half of the year, the full deficit (not just ) would reduce
the accumulated E&P available to characterize the July 1 distribution as a dividend. This would not affect
the result in Sit 3, but would change Sit 4, where there would be no dividend.
Note: In testing for dividend status, look at the earnings and profits at the close of the
taxable year in which the distribution was made. Any dividend out of current earnings
and profits is taxable, regardless of historical deficits.

31
 WHICH PROPOSED REG??? -55
If TP is financially troubled and cannot repay the debt, the lender may discharge for amount borrower
can pay
If the interest rate on the debt is lower than the current market interest rate, the lender may make
money by letting the borrower pay back less than the full amount owed, then re-lending the money at a
higher interest rate

DISTRIBUTIONS OF PROPERTY

1. CONSEQUENCES TO DISTRIBUTING CORPORATION

Corporations can distribute property as a dividend. 301.
311(a): a corporation does not recognize gain or loss on the distribution of its stock or property

32
 GENERAL UTILITIES DOCTRINE (REPEALED): Non-liquidating distribution of appreciated
property by a corporation to its shareholders does not result in the recognition of gain to the
corporation (replaced by 311(b))
311(b) DISTRIBUTION OF APPRECIATED PROPERTY (CURRENT LAW): If a corporation
distributed appreciated property to shareholder, then the corporation recognizes gain as if the
corporation sold the property for FMV. Gain for a Corp = FMV AB
i. Liability: If encumbered by a liability, the FMV (8K) is treated as not less than the liability
(10K). 311(b)(2)FMV -3000, Liability 4000, so 4000???
ii. No Loss Recognized: Recognition of loss on depreciated property is denied by 311(a)
iii. Adjustment to E&P: E&P is adjusted upwards by gain recognized and downwards at FMV of the
distributed property, having the effect of sale and distribution of proceeds. 312(b).
a. Effect on E&P: 312(a)(b) distributions of appreciated property will first increase E&P by the
amount of gain, and then the FMV of the property will subsequently reduce E&P
i. So, if no accumulated or current E&P, a distribution of appreciated property will result in
the creation and depletion of E&P, and therefore part of the distribution will be viewed as a
dividend
NOTE: the general gain recognition rule does not apply to distributions by a corp of its own debt
obligations. At the SH level both the amount of the distribution and the distributee SHs basis are equal to
the FMV of the obligations. The distributing corporations E&P are reduced by the principal amount of the
obligation, or in the case of an obligation having original issue discount, but its issue price.

2. CONSEQUENCES TO SHAREHOLDERS
AMOUNT OF DISTRIBUTION = FMV of the Property Any Liabilities Assumed. 301(b)
TAX: Amount of Distribution is taxed to the extent of E&P under 301(c)
SH BASIS: In the distributed property is FMV of property at the date of distribution. 301(d).
TP inherits a building worth $262,042.50 (and subject to a $262,042.50 non-recourse mortgage). She
takes depreciation deductions of $25,500. Sells property for $2500 and the buyers takes the building
subject to the mortgage

CONSTRUCTIVE DISTRIBUTIONS

1. OVERVIEW
Compensation and other business expenses are deductible by the corporation, but not dividends
Employment tax, corporations tax rate, and whether SH will qualify for 15% dividend rate may affect
decision whether to characterize as dividend or compensation
Closely Held C-Corporations may distribute earnings in a form thats deductible at the corporate
level to avoid double taxation, but the IRS and courts may re-label the distributions a constructive
dividend
i. CHCs try to avoid the double tax by paying owner/employees inflated salaries or rents for use of
SH property instead of declaring a dividend
RULE: If sale/exchange by corporation of property for less than FMV: Amount of Distribution =
Actual FMV Cost. 1.301-1(j).
i. The amount of distribution is taxed under 301

2. NICHOLLS v. COMMISSIONER (TC 1971) Pg. 169

RULE: Expenses made primarily for the personal benefit of SHs constitute a constructive dividend

33
 Use of a yacht purchased by a closely held corporation was taxable to its SH as a constructive dividend
where the SH made the decision to purchase the yacht, and where the yacht was used primarily by the
SH/employee/ son of the TP rather than for business purposes. Business purposes -25%, personal
75%
i. TP had voting control of the corporation and used that control to provide an economic benefit to his
son
Amount of Dividend was the FMV of a rental rather than its acquisition price because the corporation
still owned the yacht
i. Easily ascertainable number
ii. NOTE: Important that corporation owned and that in a bankruptcy proceeding creditors would seize
it
Holding: The owner (father) gained personal benefit and therefore received a constructive dividend from his
own use and the use of the craft by his sons equaling 75% of the above rental value of that amount he has
voluntarily recognize income to the extent of $1144, 72. Full rental value of the boat 4,000

ANTI-AVOIDANCE LIMITATIONS ON THE DIVIDENDS RECEIVED DEDUCTION

34
1. DIVIDEND RECEIVED DEDUCTION: Rationale is to avoid a triple taxation. Corporate SHs are
allowed a deduction in the amount of 70% of dividends received (effectively paying a 10.5% tax
[35%*30%]). 243. The deduction goes up to 80% if corporate SH owns 20% or more (by vote or value) of
the distributing corporation. 243(c).
243(a)(1): generally a corporation can deduct 70% of dividends received
243(a)(2): Corporations receiving dividends from a corporation in an affiliated group may deduct
100% of the dividends (qualifying dividends)
i. 1504(a) receiving corporation needs to own at least 80% of total voting power and 80% of
total value of distributing corporations stock to be an affiliated group
80% deduction for corporations receiving dividends from a 20% owned corporation
i. 243(c)(2) 20% owned corporation means any corporation if 20% or more of the stock of such
corporation (by vote and value) is owned by the taxpayer-corporation

2. SECTION 246 LIMITATIONS

RATIONALE: Because at a maximum, 30% of dividends received by corporate SHs will be taxed this
leads to techniques to take advantage of the lower effective rate on dividends received by corporate
SHs, so certain limitations have been created t halt this
TAX EXEMPT CORPORATIONS: 246(a) denies the Dividends Received Deduction in the case of
distributions from tax-exempt corporations
i. Logical because DRD is to avoid triple taxation, tax exempt removes a level of tax
SPECIAL HOLDING PERIOD REQUIREMENT - 246(c)
i. A corporation is not entitled to the DRD unless it is willing to hold the stock and incur a genuine
market risk for the requisite period of time (45 days during the 91 day period beginning on the
date which is 45 days before the stock goes ex-dividend)
a. Ex-Dividend: the first date which a buyer of stock to which a dividend has been declared is not
entitled to receive the dividend
i. Required because corporations would purchase stock in anticipation of a dividend, claim
the DRD so the income is taxed preferably, and then because E&P is being reduced, the
stock price will drop and they can claim a loss deduction against income

3. EXTRAORDINARY DIVIDENDS: BASIS REDUCTION

1059: TO deter arbitrage schemes to reduce capital gain tax at the detriment of a smaller increase in
dividend tax, a corporation receiving an extraordinary dividend must reduce its basis in the underlying
stock by the amount of the nontaxed (i.e. deductible) portion of the dividend IF the corporation has not
yet held the stock for more than 2 years before the dividend announcement date

35
EXTRAORDINARY DIVIDEND: Defined in terms of the size of the dividend in relation to the SHs adjusted
basis in the underlying stock
i. If it exceeds 5% of the SHs adjusted basis in preferred stock and 10% of the adjusted basis in
other stock
ii. Aggregation: All dividends received by a SH on certain shares which have ex-dividend dates
within the same 85-day period are treated as one dividend
iii. Alternate Test: If the stock has greatly appreciated, the corporate shareholder can elect to use the
FMV of the stock instead of basis for the above percentages. 1059(c).
2 SPECIAL SITUATIONS WHERE A DIVIDEND IS EXTRAORDINARY
i. 1059(c)(1): A property (301) distribution shall be extraordinary, irrespective of SHs holding period
or size of distribution if it is a distribution in redemption of stock which is (1) part of a liquidation
of the redeeming corporation, or (2) is non-pro rate as to all SHs
ii. 2 others:
a. Certain distributions between an affiliated group of corporations that qualify for the 100% DRD
are NOT treated as extraordinary
b.Special relief provided for qualified preferred dividends:
i. If the dividends received by the shareholder during the period it owned the stock dos NOT
exceed an annualized rate of 15% or lower of: a) the SHs AB OR b) the liquidation
preference of the stock, and the stock is held by a SH for over 5 years.
1059(c) )(3)(A) In addition all dividends received with respect to a share of stock which have ex-
dividend dates during the same period of 365 consecutive days are treated as extraordinary if the
aggregate of such dividends exceeds 20% of the basis in such stock
If the nontaxed portion exceeds the SHs AB in the stock, any excess is treated as gain from the sale
and exchange or property in the taxable year in which the extraordinary dividend is received.
2. DEBT-FINANCED PORTFOLIO STOCK -246A
Certain SH also exploited the dividends received deduction by borrowing funds to acquire dividend paying
stock. Section 246A precludes this strategy by reducing companys dividends received deduction to the
extend the dividend are attributable to debt-financed portfolio stock. A similar policy is reflected in Sec
246(a)(2) which denies deduction for interest incurred to purchase or carry tax-exempt municipal bonds.
Thus, if the portfolio stock is entirely debt financed, Sec 246A denies any dividends received deduction. If
it is debt-financed in some lesser %, then that same % of the dividend received deduction is denied. In all
events the reduction in the dividend received deduction may not exceed the amount of any interest
deduction allocable to the dividend (I.e borrowed funds directly attributable to the stock)

Example: Leverage Corp acquire stock for 10K: 6 K cash 4K borrowed money from X Corp
Dividend 10% of 10 K = 1K

36
The stock is debt-financed to the extent of 4K (40%)- the average portfolio indebtedness as defined in Sec 246A(a). Under the
formula in Sec 246A(a) Leverage subtracts 40% from 100% and then multiplies the result (60%) by the usual 70% dividends received
deduction percentage to reach 42%. The lower figure is substituting the 70% in determining Leverage Sec 243
deduction. Thus, L may deduct only 42% instead of 70%

SEC 301 (e)

Relates to adjustments (see explanation in the code)

Example: Assume P corp owns 100% of the stock of X Corp, Ps basis in such stock is $200, all file separate tax
return X has no current E&P. X sells an asset for 1k INSTALLMENT NOTE REALIZING 800K gain (AR
1000 AB 200). Finally, assume that X borrows 500 secured by the installment note and distribute 500 to P.
Thus P would include 500 in income but would likely qualify for a 100 % dividend received deduction. If P
later sold its X stock for 200In the absence of E&P, 200 of the distribution of X will be a return capital under
Sec 301(2) and 300 will be taxed as gain from the sale and exchange of its X stock under Sec. 301 (c ) (3). Ps
basis of the stock will reduce to zero and it will recognize 200 gain later on the sale of the stock.

USE OF DIVIDENDS IN BOOTSTRAP SALES

1. BOOTSTRAP SALE- Bootstrap sale is a tax-saving device whereby the seller in effect converts ordinary income
from his business into capital gain from the sale of corporate stock. It is a sale or exchange so as to require the shifting
of some business risks.
Target makes a distribution to parent-Sell Corp.
Target stock moves to Buy Corp.
Buy Corp. would pay less to Sell Corp. because Target is worth less having made the distribution
Sell Corp. pays less tax because of DRD and less tax on gain/distribution

2. NON-BOOTSTRAP SALE
Target stock going directly to Buy Corp.
Sell Corp. would be fully taxed on gain
i. Recognized capital gain on the sale of Target stock
Buy Corp. gets additional basis in Target shares but no immediate tax benefit from sale treatment

3. TSN LIQUIDATING v. US (5th Cir. 1980) Pg. 181

RULE: Assets distributed to a corporation by its subsidiary immediately prior to the sale by such
corporation of all the capital stock of the subsidiary should be treated as a dividend if the assets
are retained by the selling corporation and are not considered part of the sale
i. Assets removed in contemplation of sale when retained in good faith by the seller are dividends
the seller merely retained what he didnt want to sell
Facts: TSN, the selling corp, arranged for an in-kind distribution from its target-subsidiary of 1.8M of
assets immediately prior to selling the sub stock to the purchasing corp for $800k. The purchaser then
contributed capital to the target sub to reinfuse the value of the assets distributed to TSN.
i. Government wanted the dividend to be included as part of the purchase price
ii. Taxpayer wanted the distribution to be a dividend, satisfying the DRD
iii. Waterman Precedent: Waterman involved a similar transaction, but was a sham because the
dividend was matched to the amount of gain that would have otherwise been realized on the sale of
the stock in the sub, and therefore the motive was solely stock avoidance.
37
 Court held that transaction was done in good faith and was not tax avoidance
ANALYSIS: To be considered a dividend: seller must retain the distribution in good faith. If the
distributions are subsequently transferred from the seller to the buyer it will be considered part of the
purchase price and not a dividend
i. Substance over form argument
APPLICATION: TSN distributed assets that were not wanted by the purchaser and were subsequently
held by the parent. The fact that the dividend had incidental tax benefits to the TP does not require the
disallowance of a dividend.
Nonrecognition of gain or loss realized on the exchange or trade of business or investment property
for like-kind property that will also be used in the taxpayers trade or business or held for investment

V. REDEMPTIONS AND PARTIAL LIQUIDATIONS

INTRODUCTION

1. REDEMPTION: Non-liquidating distribution where the corporation distributes cash or other property in
return for its own stock

2. COMPLETE TERMINATION OF INTEREST PROVISION: treats these redemptions as sales

Individual shareholders will prefer sale/exchange treatment because:
i. It allows a basis offset that is unavailable in 301 distributions (assuming there is enough E&P that
the distribution is viewed as a dividend and not a tax free return of capital)
ii. If the stock has lost value, the taxpayer can recognize loss upon redemption
iii. Stock is generally a capital asset, and therefore will get favorable capital gains treatment
Corporate shareholders may prefer dividend treatment to take advantage of 243
3. C-CORP REDEMPTION
Redemption: C corp buys stock from shareholder.
Big Question: Is transaction treated as exchange or as a dividend governed by Section 301 rule?
If exchange
- Shareholder has no gain to extent of stock basis.
- Excess subject to capital gain treatment.
If dividend under 301
- All ordinary dividend income to extent of E&P; then basis recovery; then sale treatment.
- Note: with dividend rate now equal to capital gain rate, only substantive difference is priority on
recovery of basis vis--vis E&P.
4. Four Options Under 302(b)
(b)(1) - Not essentially equivalent to a dividend
(b)(2) - Substantially disproportionate
(b)(3) - Complete termination of shareholders interest
(b)(4) - Partial liquidation
TAX CONSEQUENCES TO DISTRIBUTRING CORPORATION: Sec 311
The distributing corp recognized gain on the distribution of appreciated property, but it may not recognize loss
on a distribution of property that has declined in value/
Example:

38
A -SH owns two block of X Corp share. X has no E&P and redeems all As block 2 shares for $300 in a
redemption treated as a Sec 301 distribution
BLOCK 1 BLOCK 2 X corp
# of Shares 50 # of Shares 50 E&P 0

basis 100 basis $200

Per share $2 Per share $4

Redemption. Since X has no E&P, the $300 distribution is first treated as a pro rata REDUCTION IN THE
BASIS OF ALL aS SHARES IN THE REDEEMED CLASS.
DISTRIBUTIO $150 distribution $150
N
basis 100-150=50. So, 0 basis 200-150=50
gain 50 gain 0
Total shares left 50 the prop. Reg $1.302-5(a)(1) treat the remaining
shares as proportionately representing both block 1
and 2. Thus 25 of the remaining shares have a zero
basis (block 1)
Unrecovered $50
basis
Block 1 shares 25 Block 2 25
shares
Block 1 basis zero Block 2 50
basis

39
SECTION 302

1. General Rule: If a corporation redeems its stock (within the meaning of section 317(b)), and if paragraph
(1), (2), (3), (4), or (5) of subsection (b) applies, such redemption shall be treated as a distribution in part or
full payment in exchange for the stock.
2. REDEMPTION WILL BE TREATED AS AN EXCHANGE IF EITHER:
The redemption is not equivalent to a dividend
The distribution is substantially disproportionate with respect to the shareholder
The redemption is in complete liquidation of all the stock of the corporation owned by the shareholder,
OR
Redemption from non-corporate shareholders in partial liquidation

CONSTRUCTIVE OWNERSHIP OF STOCK

1. 302(c): Except as provided in paragraph (2) of this subsection, section 318(a) shall apply in determining
the ownership of stock for purposes of this section
318(a) treats a taxpayer as owning stock that is actually owned by various related parties

2. 318(a) CATEGORIES
3. Family Attribution - Parents, spouse, children, grandchildren. No sibling, in-law or grandparent attribution.
4. Entity from attribution - Proportional attribution to owner or beneficiary for stock owned by partnership,
estate or trust. Corporate proportionate attribution (based on FMV of stock) to shareholder who owns,
directly or via attribution, 50% or more of stock value.
5. Entity to attribution - Stock owned by partners or beneficiaries attributed to partnership, estate or trust.
Attribution to corp only for stock held by 50% or more shareholder.
6. Option attribution - All stock subject to option deemed owned by the holder of option.
7. Chain attribution generally Ok (child to parent to corp), but no double family attribution (child to parent
to grandparent).

FAMILY ATTRIBUTION
ENTITY TO BENEFICIARY ATTRIBUTION
BENFICIARY TO ENTITY ATTRIBUTION
OPTION ATTRIBUTION
BURNET v. LOGAN (1931) pg. 24

8. FAMILY ATTRIBUTION
If spouse, child, parent, or grandparent own it
Sibling and in-laws are NOT family for this purpose

9. ENTITY TO BENEFICIARY ATTRIBUTION

Attribution from partnerships, estates, trusts, and corporations
Stock owned by or for a partnership or estate is considered as owned by the partners or beneficiaries in
proportion to their beneficial interests

10. BENEFICIARY TO ENTITY ATTRIBUTION

40
 Attribution to partnerships, estates, trusts, and corporations
Stock owned by partners or beneficiaries of an estate is considered as owned by the partnership or
estate.
a3C: If 50% or more stock in a corporation is owned directly or indirectly, by or for any person, such
corporation shall be considered as owning the stock owned, directly or indirectly, by or for such person

11. OPTION ATTRIBUTION If any person has an option to acquire stock, such stock shall be considered
owned by such person. For purposes of this paragraph, an option to acquire such an option, and each one of
a series of such option, shall be considered as an option to acquire such stock

12. 303(c)(a) EXCEPTIONS: 318 attribution will not apply IF

Immediately after the distribution, the distributee has no interest in the corporation other than as a
creditor AND
The distributee does not acquire any such interest within 10 years from the date of distribution, AND
The distributee files an agreement to notify the Secretary of any acquisition described in clause (2)
Requires tax avoidance purpose, and if found, then - says 302(c)(2(A) will not apply if any person
owns (at the time of distribution) stock, the ownership of which is attributable to the distributee under
318(a), and such person acquired any stock in the corporation, directly or indirectly, from the
distributee within the 10-year period ending on the date of distribution, unless such stock so acquired
from the distributee is redeemed in the same transaction. (See Rev.Rul 77-293)

302(b)(2) Substantially Disproportionate (exchange if requirements are met)

Three mechanical requirements:
1. After redemption, shareholder owns less than 50% of total combined voting power.
2. After redemption, percent of voting stock less than 80% of percentage of voting before redemption.
Voting shares after redemption/total voting shares outstanding after redemption < 0.80 *voting shares owned
before redemption / total voting shares outstanding before redemption.

3. After redemption, percent of all common (voting and non-voting) less than 80% of
percentage before redemption. Go to step 3 only if you have non voting common stock
Note:

- Full attribution rules apply.

- Multiple transactions part of common plan are aggregated. Rev. Rule 85-14.
The Service also has ruled that a redemption of voting preferred stock from a SH owning no
common stock (either directly or by way of attribution) may qualify under Sec 302 (b)(2) even though
the SH cannot satisfy the 80% test relating to common stock.
EXAMPLE: Corporation M has outstanding 400 shares of common stock of which A, B, C and D each own 100 shares or
25 percent. No stock is considered constructively owned by A, B, C or D under section 318. Corporation M redeems
55 shares from A, 25 shares from B, and 20 shares from C. For the redemption to be disproportionate as to any
shareholder, such shareholder must own after the redemptions less than 20 percent (80 percent of 25 percent) of the 300
(because D is not involved??) 1shares of stock then outstanding. After the redemptions, A owns 45 shares (15 percent), B
owns 75 shares (25 percent), and C owns 80 shares (26 2/3percent). The distribution is disproportionate only with respect
to A.

41
 A B C D
total 100 100 100 100
REDEEMED 55 25 20
left 45 75 80 100
% 15% (45 of 300) 25% 26 2/3%
disproportionate YES NO NO

302(b)(3) Complete Termination

42
 Requirement: Shareholder is finished takes a permanent hike. Only remaining interest can be
creditor nothing else.
The Big Break: No family attribution. Makes it possible to transition corp stock to next
generation.
Special rules:
- 10 year forward rule: Selling shareholder not acquire any stock for 10 years, except by
bequest or inheritance.
- 10 year back rule: Last 10 years, selling shareholder acquired stock from 318 relative or 318
relative acquired stock from selling shareholder. Not apply if tax avoidance not principal purpose

SECTION 303 listen 3-7 minutes of class 10/26 about Imagine the situation when dad own 60-70% of the
company and he dies, so it is always usually impossible to redeem all of the dads stock so they are not going to
get under b3, when you get into this situation when a major owner dies and the company cannot redeem its
stock, and you cannot qualify under b2 or b3, that is why we have Sec 303 and you badly can get money out of
the company to pay death taxes

REDEMPTIONS TESTED AT THE SHAREHOLDER LEVEL

1. SUBSTANTIALLY DISPROPORTIONATE TEST For Exchange treatment, taxpayer must satisfy ALL 3
requisites post-redemption:
Shareholder must own (actually/constructively) LESS THAN 50% of all voting stock.
i. SHs voting stock / All voting stock must be less than 50%
Shareholder must own LESS THAN 80% of the voting stock owned PRIOR to redemption.
i. (SH Voting Shares owned after redemption / Total Voting Shares Outstanding) MUST BE LESS
THAN:
ii. (.8) (Voting Shares Owned Before Redemption / Total Voting Shares Outstanding Before
Redemption)
Voting shares after redemption/total voting shares outstanding after redemption < 0.80 *voting shares owned before
redemption / total voting shares outstanding before redemption.

Shareholder must own LESS THAN 80% of the COMMON STOCK (voting or non-voting)
owned PRIOR to redemption.
i. Shareholders Common Stock amount after redemption must be LESS than (.8) x (Shareholders
Common Stock amount Before Redemption)
ii. If more than 1 class of C/S the test is applied to FMV. 302(b)(2)(C).
Attribution Rules of 318 apply to all of these
REVENUE RULING 85-14 91985) Pg. 202
i. STEP TRANSACTION DOCTRINE: When there are a series of redemptions, the substantially
disproportionate qualifications should be measured after the last redemption
ii. RULE: 302(b)(2) [substantially disproportionate distribution] measurements should be done
after a series of redemptions, rather than after independent redemptions. Any redemption
that is part of a series of redemptions that, taken together, result in a distribution that is not
substantially disproportionate will not get exchange treatment under 302(b). 302(b)(2)(D)
iii. A, B, C, and D held Xs sole class of stock. X had a repurchase agreement with all shareholders
except A. B informed A of Bs intention to resign. A then caused X to redeem some of As stock,
causing A to temporarily lose control. After B resigned and redeemed his shares, A regained
control.
iv. Independently, As transaction would qualify as a substantially disproportionate redemption

43
 v. BUT, considered with Bs redemption, As redemption is not substantially disproportionate
a. No clear time limits between redemptions. Facts and circumstances approach.
vi. Does NOT matter that A and B did not have a plan to arrange redemptions
a. Redemptions causally related because A saw an opportunity to get a favorable exchange treatment
for redemption
vii.302(b) is very mathematical. Dont want to make it easy to dress distribution as a sale. Also gives
taxpayers certainty so that they can plan accordingly.

2. COMPLETE TERMINATION OF A SHAREHOLDERS INTEREST

If ALL of the SHs stock is redeemed, he qualifies for Exchange Treatment (not dividend). 302(b)(3).
WAIVER OF FAMILY ATTRIBUTION: Permits a SH to achieve a complete termination under
302(b)(3) even though (some_ remaining shares are held by close relatives. 302(c)(2). IF:
i. (A) (i) Immediately after the distribution the distributee had no interest (not as an officer/BOD) in
the corporation, other than that of a creditor. (ii) 10 year Look Forward Rule: The distributee does
not acquire such interest within 10 years. (iii) The distributee alerts the IRS if such interest is
acquired
ii. 10 Year Look Back Rule: (B) Family attribution rules may not be waived if during preceding 10
years (i) the redeemed shareholder acquired any of the redeemed stock from a 318 relative, or (ii)
any such relative acquired stock from the redeemed shareholder. BUT, this does not apply if the
acquisition did not have the avoidance of taxes as one of its principal purposes
LYNCH v. COMMISSIONER (9th Cir. 1986) Pg. 206
i. RULE: Independent contractor status/interest post-redemption will not satisfy the 302(c)(2)
constructive waiver requirement and therefore cannot get sale/exchange treatment via 302(b)
(3)
ii. TP and his wife resign as officers and directors and get all their shares redeemed (in exchange for
$17,900 in property and a $771,920 promissory note). Son pledges his 50 shares as guarantee for
the note any default would give TP the right to vote or sell the 50 shares. TP also entered into a
consulting agreement with a salary.
iii. TP who had all his shares redeemed by corporation failed to obtain 302(a) exchange treatment
where subsequent to the redemption he continued to serve the company as an independent
contractor who received a monthly salary. A TP who provides post-redemption services, either as an
employee or an independent contractor, holds a prohibited interest in the Corp because he is not a
creditor.
a. So, TP who wants capital gains treatment upon redemption of all shares must sever all non-
creditor interest in corporation
b. Under the regulations TPs creditors must not be contingent ( )
on earnings of the corporation
REVENUE RULING 59-119 (1959) Pg. 213
i. HOLDING: An agreement between the redeeming shareholder and the remaining shareholders of a
corp., under which a nominee is appointed to serve on the board of directors of the corp. violates
the condition prescribed in section 302(c)(2)(A)(i) of the Code (had no interest NO, he has)
a. However, if representative just attends meetings to ensure the board complies with agreement and
is NOT a director or employee, then this will not adversely affect 302(c)(2)
ii. TPs lawyer served on the board after TPs shares were redeemed by the corporation and where
corporation agreed to pay installments for redemption.
REVENUE RULING 77-293 (1977) Pg. 215
i. HOLDING: Gift of stock to a 318(a) family member within 10 year period ending on the date of
distribution will not violate 302(c)(2) [Determining termination of interest], where tax avoidance
was not a principal purpose of the disposition.
44
 ii. As part of As plan to retire from the business and to give ownership of the business to B (As son),
A gave 60 shares of X stock to B as a gift, and not as consideration for past, present, or future
services. X redeemed the remaining 60 shares of stock owned by A in exchange for property.
iii. Redemption was 302(b0(3) termination of interest even though father gifted stock to son shortly
before redeeming the rest of his shares
iv. NO TAX AVOIDANCE SCHEME
WAIVER OF ATTRIBUTION BY ENTITIES: A trust can waive attribution of Cs shares as long as
the beneficiary joins the waiver and neither the trust nor beneficiary hold an interest in the corporation
directly for 10 years. 302(c)(2)(C).
i. Ex: X Corp. redeems 10 shares of stock held by Trust; C is a beneficiary (son); trust continues to
hold shares for the beneficiary for investment

3. REDEMPTIONS NOT ESSENTIALLY EQUIVALENT TO A DIVIDEND - 302(b)(1)

US v. DAVIS (SCOTUS 1970) Pg. 223 -read before the exam

What did you get from this case? What did you looked for to say I dont qualify under b 2, I dont
qualify under b 3,but I may have an argument that this transaction may qualify under b 1. We are
looking for HAS there been a practical shift in a voting capacity (control) of a shareholder? Does the
shareholder has the Shs capacity to vote in the company been changed? Enough to be a good
argument. If our voting control has reduced meaningfully we may qualify under b1 and you apply
full attribution under b3
i. HOLDING: 318(a) family attribution rules apply in a 302(b)(1) redemption. Need a meaningful
change in ownership.
a. The Court also held that, in order to qualify for 302(b)(1), redemption must result in a meaningful
reduction of the SHs proportionate interest in the corporation.
ii. A closely help corp, owned by TP, wife and children. TP contributed capital for nonvoting
preferred, and the corp would pay him back by redeeming the shares. Basis in the shares were equal
to the cash, so little gain from the redemption. But redemption did not satisfy 302(b), so could not
get sale treatment. Nor could show a meaningful reduction because through attribution, owned
100% before and after.
iii. No 302(b)(1) redemption treatment where TP made additional contribution to corporation for
preferred shares, purpose was to qualify corporation for a loan and where corporation redeemed the
preferred shares
a. TP considered to own shares of his wife and children plus his own
iv. TP argues he only needed to prove a legitimate business motivation for the redemption (besides tax
avoidance)
v. But just having a business purpose does not mean attribution does not apply
a. Court wants to make sure SH is actually giving something up and that ownership stake is actually
changing
b. Here TP owns 100% of shares (actually or constructively) before and after the redemption

45
REDEMPTIONS TESTED AT THE CORPORATE LEVEL: PARTIAL LIQUIDATIONS
302(b)(4) Partial Liquidation Exception looks at corporate level, not SH level
Do not confuse it to Sec. 355. Sec 355 is very powerful! 302 (b)(4) very weak.
If you qualify under b4 and you are individual, you are NOT a corporation, you CAN qualify for an
exchange treatment. B4 would NOT provide ANY relief to a corporate SH.
B 4 is different from B1, b2 and b3 in one SIGNIFICANT respect it does NOT look at the change to
the SH, whose stock has been redeemed, it looks at the change at a CORPORATE LEVEL, what we called a
partial liquidation. Part of the company has been liquidating and if that happens, even if you flunk () b1,
b2, b3 and the partial liquidation is distributed pro rata to the SH, so you have NO change in VOTING power,
you would qualify under b4.
So, what is a partial liquidation? it is essentially an item that at the CORPORATE level is not
equivalent to a dividend. Has a distribution plan and is carried out within a TAXABLE year.
In order to get there are two safe harbors:
1st applies in selected cases but it is very narrow is that a company carry two or more businesses
ACTIVE T/B, cant be an investment, and the company decides to shut down and distributes one of the
businesses to a SH. If the company really does that and it is an active T/B and carry this business for 5 YRS and
you give it to the SH they can get exchange treatment on that. No in transferring that business to the SH you
not only have an exchange tax to the SH, but you also have a company to distribute assets that my appreciate
which my trigger for 311. And after the distribution the company must still be in T/B/ So, essentially youve got
to have 2 or businesses operating for 5 years -that is the only way you can qualify for exchange treatment under
safe harbor.
2nd provision (non safe harbor)) is that there is some kind of catastrophe, or fire, or flood -smth bad
happens that wipes out the major portion of the business, generally considered to be about 20% of the assets, or
the facilities or the revenues of the company. And the company chooses NOT to reinvest the insurance proceeds,
but distribute it to the SH, that would be viewed as a partial liquidation.
302 b (4) Applies:
- Only to noncorporate shareholders, S Corp do not qualify.
- Even thought distribution pro rata and otherwise flunks (b)(1) (b)(3).
- Based on impact at corporate level not shareholder level.
- Stock held by partnership, estate or trust deemed help proportional by partners and beneficiaries.
Requirements: 302(e)
- Not essentially equivalent to dividend (determined at corporate level)
- Distribution pursuant to a plan
- Distribution occurs in taxable year plan adopted or following year.

Partial Liquidation Not Essentially Equivalent to Dividend

Safe Harbor:
- Distribution attributable to ceasing () to conduct qualified trade or business operated
for 5 years and not acquired during 5 yr period in transaction that recognized gain or loss.
- After distribution, corp still involved in active conduct of qualified trade or business.
Non- Safe Harbor Scenarios
- Tough must show serious contraction of business.
- Example: Fire destruction; corporate cutback and all insurance proceeds distributed.
- Bona fide business reason unrelated to desire to bail out liquid assets
- No hope if plan is to bail out accumulated investment assets
46
 (f) Securities portfolio distributed pro rata in redemption. No hope. IT IS NOT AN ACTIVE BUSINESS.
Not partial liquidation or corporate contraction. 301 dividend to all shareholders. No b1, b2, b3 or b4. But you have 311
in play (It is always in play)
(g) A sells stock in B Corp and distributes proceeds pro rata. No. I am NOT liquidated and distributed a
business, I am selling it off. Sub corp stock cant qualify as partial liquidation per Rev. Rule 79-184. Hence, 301
dividend to all shareholders. No, if I liquidate B Corp, which I can do and then distriuted the assets I WOULD qualify
under b4.

REDEMPTION IMPACT ON CORPORATION

When we get redemption under b1,b2,b3,b4 or that does not qualify, the question is what is the impact at the
corporate level?
If I have a redemption what happens at the corporate level? Starting point
Does the corporation have gain or loss on the assets it distributes?
o If it distributes cash the answer is clear no.
o If it distributes an asset other than cash we go back to 311, where the rule Is if it distributes the
appreciated asset the corporation have gain in the amount of appreciation, if it distributes a loss
asset the corp has no gain/loss. The basis and the measure of distributes asset to the SH is
ALWAYS FMV., whether it is a dividend or redemption.
The other impact we have to worry about is E&P. Well that does differ on whether or not the transaction
is treated as an exchange or dividend
o . If it is a dividend -we now the treatment the FMV of the asset reduces E&P. If it is a built-in
gain E&P goes up, we distribute the asset E&P goes down by the FMV of the asset. If it is cash
we just reduce E&P by the FMV of the asset.
o If it is an exchange we got another limitation in Sec 312(n)(7). It says if there is an exchange
the company is redeeming 25% of its stock and that qualifies for the exchange treatment under
any of bs provisions, the companys E&P can NEVER go down by more than PRO RATA share
of the stock been redeemed. It is the amount paid out but no more than the amount of pro rata
share. So, if I am redeeming 25% of the stock of the company and my E&P is 100K, the most
E&P can go down is 25K. If the amount distributed is more than that, it may be, but never more
than the pro rata share. IF MORE THEN ONE SHAREHOLDER: LOOK at percent of
redeeming form 1 shareholder as opposed to the total percentage of shares (ex. If company has 3
shareholder, it redeems ALL the stock of B who owns 15% of the companys shares, companys
E&P reduces only by 15%) So there is an E&P limitation when the redemption qualifies for an
exchange treatment. IF WE HAVE THHE REMAINING $ ___ of the distribution (excess) it is
charged to conmpanys capital account and after the distribution Company has 75K of
accumulated E&P
The last one- remember stock acquisition expenses (appraisal fees, brokerage commission) anything, do not for
any deduction at all under 162, even legal fees. You dont get to amortize, deduct them, nothing. They produce
no tax benefits at all. They just go if they connected with redemption.
Three issues:
- Gain or loss to corp on distribution of property other than cash. 311 governs the same as it does for
non-liquidating distributions. Gain is always recognized by corporation, but losses not recognized.
- E&P impact. E&P reduced by amount of distribution, but per 312(n)(7) reduction can not exceed
ratable share of E&P attributable to redeemed stock. So if 1/3 stock redeemed, E&P before redemption can not
be reduced more than 1/3.

47
 - Stock acquisition expenses paid by corp (brokerage commissions, legal fees, etc) are not deductible
per Section 162(k). They are treated as non-amortizable capital expenditures. Amounts paid that have
no nexus () to redemption (employment agreement amount) are deductible and loan costs and fees
involved in redemption may be amortized over term of loan.

1. 302(b)(4) REDEMPTION FROM NON-CORPORATE SHAREHOLDERS IN PARTIAL

LIQUIDATION: Exchange treatment for redemption of stock held by non-corporate shareholders if the
distribution qualifies as a partial liquidation

2. PARTIAL LIQUIDATION DEFINED - 302(e)(1): A distribution is a partial liquidation IF:

It is pursuant to a plan
Occurs within the taxable year in which the plan is adopted or the succeeding taxable year
It is not essentially equivalent to a dividend

3. NOT ESSENTIALLY EQUIVALENT TO A DIVIDEND DEFINED - 302(e)(2)

Distribution attributable to the distributing corporations ceasing to conduct or consist of the assets of a
qualified trade or business, AND
Immediately after the distribution, the distributing corporation is actively engaged in the conduct of a
qualified trade or business
Corporate Contraction Doctrine: One floor of factory burns down and insurance proceeds are
distributed pro-rate to shareholders; or there is a voluntary bona fide contraction of corporate business
(alternative to qualified business and trade)

4. QUALIFIED TRADE OR BUSINESS - 302(e)(3)

Trade or business must have been actively conducted throughout the 5-year period ending on the date
of distribution, AND
i. Designed to prevent accumulation of earnings in the form of investment assets, followed by bailout
distributions disguised as contractions
a. Buying and selling investments with no material change to operation of business
Must not have been acquired by the distributing corporation in a taxable transaction during that period

5. REVENUE RULING 79-184 (1979) Pg. 238

HOLDING: Distribution of proceeds from the sale of a subsidiarys stock, as opposed to the
subsidiarys assets, will not qualify as a partial liquidation under 302(e)
Distribution of proceeds from the sale of all the stock of a wholly owned subsidiary did not qualify as a
distribution in partial liquidation under 302(e)
Distinction between corporation having two businesses held directly by a parent and a business held by
a subsidiary
302 SAFE HARBOR: If start with a subsidiary and then liquidate the subsidiary and have 2
businesses and then sell one business, court respects structure if transactions are part of a plan
i. Statute satisfied because acquired the business in a transaction where no gain or loss was
recognized
ii. Plus business cannot have been acquired in a 5-year period
When corporation owns the business, the corporate attributes carry over to the parent so that when you
liquidate the corporate attributes travel up to the parent
i. Reason liquidation followed by sale works and simple sale of subsidiary does not

48
6. CORPORATE CONTRACTION DOCTRINE: Distribution qualifies as a corporate contraction if the
distribution results in a 20% or greater reduction in gross revenue, net FMV of assets, and employees
Can qualify as a partial liquidation redemption

CONSEQUENCES TO DISTRIBUTING CORPORATION

1. DISTRIBUTIONS OF APPRECIATED PROPERTY IN REDEMPTION

SECTION 311
i. (a) No gain or loss recognized on distributions
ii. (b): If FMV exceeds basis (gain) then have to recognize

2. EFFECT ON E&P - 312(a)(/(b)

IF A 301 DISTIRBUTION: E&P are decreased by:
i. (1) amount of cash
ii. (2) the principal amount of any obligations, and
iii. (3) the greater of the Adjusted Basis or FMV of the property distributed
a. Increased by amount of Gain (on distribution of appreciated property)
b. Decreased by amount of taxes paid on that gain
IN REDEMPTION OR PARTIAL LIQUIDATION: E&P is reduced by ratable share of the
corporations E&P attributable to redeemed stock. 312(n)(7).
i. (Redeemed Shares / Outstanding Shares) x (Accumulated E&P) = E&P Reduction
a. Rest is applied to corporate capital account
3. Example: X Corp 1000 shares of common stock outstanding. A and B each acquire 500 of these shares at
issuance at a price of $20 per share. Assume further that X is a profitable business that holds 100,000 of net
assets consisting of 50K cash and 50K of appreciated real property and X has a 50K of accumulated E&P. If
X distributed 50K cash to A in redemption of As 500 share, Sec 312 (n)(7) reduces Xs E&P by 25K the
ratable share of Xs 50K E&P attributable to As 50% stock interest that was redeemed. The remaining 25K
of the distribution is charged to Xs capital account and, after the redemption, X has 25K of the remaining
accumulated E&P.

49
4. STOCK REACQUISTION EXPENSES
SECTION 162(k): A corporation cannot deduct (or capitalize/amortize) any expenses in purchasing its
own stock/redemption circumstances, EXCEPT: interest and indebtedness expenses.

TAX CONSEQUENCES RECAP

50
1. SHAREHOLDER
If you satisfy one of 302(b) requirements = Sale or Exchange
i. Basis = FMV because you will pay tax
If you do NOT satisfy 302(b), then it is taxed like property distribution under 301

2. CORPORATION
The distribution of cash or property to a shareholder in a redemption is a distribution with respect to
stock for purposes of 311, therefore same treatment as non-liquidating distribution rules
i. 311(a) no recognition; gain or loss on distribution of property/cash in respect to its stock will not be
recognized
ii. 311(b): Distributions of appreciated property WILL be recognized to the extent of gain
iii. Losses from the distribution of depreciated property will Not be recognized

3. EARNINGS AND PROFITS

312(n)(7): Limits the E&P reduction to an amount not in excess of the ratable share of E&P
attributable to the stock so redeemed.
i. REMEMBER: On distribution of appreciated property that are viewed as a sale/exchange (not to
dividends), E&P is increased by the gain and subsequently decreased by the FMV of the
distribution (limited by 312(n)(7) ratable attribution to SH)

REDEMPTION PLANNING TECHNIQUES

Zens case basically said this: if you have two or more transactions, one a redemption, one a gift, one smth else
and they are linked together, in fact they are planned together, then in applying the test under b1, b2, or b3 you
have to lump together these transactions. And what you need to know is what interest the person, whose stock
redeemed owned before the transaction and what interest do they have after all the transactions. And what Zens
really do was created planning opportunity, kind of three concepts that makes it easier to QUALIFY.
Example 1: a SH sells some stock and then the corp redeems the balance of its shares. I am going to get rid out
of all my stock. I have a guy who says Ill buy a half of your stock and the company says well redeem the
other half. Now if I sell my stock to a third party, even another SH there is no redemption issue, 301, 302 does
not even come into play. 302 comes into a play only if a sell stock and to the extend I sell stock to my company.
If I sell stock to a third party I always get exchange treatment, even if I sell a stock to a SH, that Is an
advantage of cross-purchase arrangement, you dont have to worry about 302, it is an exchange treatment under
302(b)(3). The question is can I sell some to a third party and SELL some to a company and get a complete
termination under b 3, or b2 or b1? The answer is YES, as long as both transactions are linked and they are
made roughly at the same time.
Example 2. Now suppose on the other hand the corp sells some new stock to a new SH. The new SH came and
the company said well sell you some new stock and will redeem some stock from the existent SH and will
sell it to you. So instead of one SH selling to another, the company said we will issue you stock J, and well
redeem your stock K. Will I get a substantially disproportionate treatment under 302 (b)(2)? the answer is
YES. But probably you wouldnt get under b 3 until they buy all your stock
Example 3. Existing shareholder sell some shares to new shareholder or gifts it to him, like a family
member. And then the company redeemed the balance from the existing SH. That would qualify for an
exchange treatment Percentages before and after both transactions control whether (b)(2) substantially
disproportionate tests met. Rev. Rule 75-447
ZENS BOOTSTRAP ACQUISITION:
Three scenarios all part of common plan:
Scenario 1: Shareholder sells some stock and then has corporation redeem balance of shares. Qualifies
under 302(b)(3) even though corporate E & P distributed to help facilitate acquisition. Zenz case/
51
 Scenario 2: Corporation sells new shares to new shareholder and then redeem shares from existing
shareholder. Percentages before and after both transactions control whether (b)(2) substantially
disproportionate tests met.
Scenario 3: Existing shareholder sell some shares to new shareholder and then have corporation redeem
shares from existing shareholder. Percentages before and after both transactions control whether (b)(2)
substantially disproportionate tests met. Rev. Rule 75-447

CORPORATE BUY-SELL AGREEMENT

Most important document in many privately-owned businesses
Determines value and exit opportunities for shareholders
Contain buy-out triggers: death, disability, bankruptcy, expulsion, etc.
Many tax issues, including estate tax valuation.
Often rely on (b)(3) exception for family businesses
Constructive dividend trap
- Co-shareholders become obligated under agreement to buy out a departing shareholder. Cross-
purchase structure.
- Corporation then discharges obligation of co-shareholders by redeeming stock.
- Result is constructive dividend to co-sharholders.
- Often screwed-up through bad life insurance structuring

BOOTSTRAP ACQUISITIONS: This matters for corporate shareholder who wants dividend treatment
CLASSIC BOOTSTRAP: Buyer purchases all or part of the stock of the target corporation
ZENZ v. QUINLIVAN: The sole shareholder of a corporation sold part of her stock for cash. 3 weeks
later the corp. redeemed her remaining stock. IRS argues that if corp. redeemed stock first this would
be a dividend [because 302(b) tests would not be met by SH]
i. HOLDING: Sale of some stock to 3rd party by SH, followed by redemption (corp. purchases SHs
shares back) will get exchange treatment, since SH always intended to dispose of his entire interest
REVENUE RULING 75-447 (1975) Pg. 249: Zenz applies to substantially disproportionate
redemptions as well
i. HOLDING: Sequence in which the redemption couple with a sale or issuance occurs is irrelevant
to treatment of the distribution as an exchange [i.e. satisfying 302(b)] as long as both transactions
are pursuant to a plan
ii. Situation 1: Corp. X had 100 shares of voting common outstanding. A and B each owned 50
shares. To bring C in with an equal stock interest and pursuant to a plan, X issued 25 new shares of
voting common to C and redeemed 25 shares fro each of A and B.
iii. Situation 2: Corp. X had 100 shares of voting common. A and B each owned 50. To bring C in
equally and pursuant to a plan, A and B each sold 15 shares of voting common to C at FMV and X
redeemed 5 shares from both A and B
iv. In situation 1 where the redemption is accompanied by an issuance of stock and Situation 2 which
is a sale of stock and both steps are clearly part of an integrated plan to reduce a SHs interest,
effect will be given only to the overall result for purposes of 302(b)(2) and the sequence will be
disregarded
a. Here both situations satisfy the requirements of 302(b)(2)(C) because the interest was reduced
from 50% to 33%. Therefore, the amounts distributed are distributions in full payment in exchange
for the stock redeemed pursuant to 302(a)

2. CONSTRUCTIVE DIVIDEND ISSUES

52
 REVENUE RULING 69-608 (1969) Pg. 254
i. HOLDING: When a continuing shareholder has a primary and unconditional obligation to
purchase the shares of another shareholder, corporations redemption of such stock for the
continuing shareholder is treated as a constructive dividend to the continuing shareholder.
(Constructive Div taxable under 301)
ii. Concern is that a SH is going to use a corp. that it controls and disguise a dividend as a sale
iii. LOOK FOR UNCONDITIONAL OBLIGATION!
iv. Situation 1: A and B enter agreement that provides in the event B leaves, A will buy his stock. A
causes X to assume the contract and redeem Bs stock. A had a primary and unconditional
obligation to purchase the shares from B at the time the contract was assigned to X.
Therefore, redemption of Bs stock results in constructive dividend to A.
v. Situation 2: (essentially the same as above) A and B contract that after one of their deaths the other
will purchase the decedents stock of X from his estate. Following the death of B, A caused X to
assume the contract and redeem the stock from Bs estate. This would result in a constructive
dividend to A, because after the death of B, A had a primary and unconditional obligation to
perform the contract.
vi. Situation 4: Contract where if B wanted to sell his stock, A would purchase the stock or cause the
stock to be purchased. B could choose to sell his stock to any person other than A. A caused corp
to redeem all of Bs stock. No constructive distribution to A because A did not have an
unconditional obligation to purchase the stock at the time of redemption.
a. Not unconditional because B was free to sell to others
vii.Situation 5: Secondary Purchaser - Agreement existed that X would redeem either A or Bs shares
upon death, in the event that X does not redeem, A or B would, respectively. B dies, and X redeems
all the shares. A was secondarily liable, and X was primarily liable, so A has not received a
constructive distribution when X redeemed the stock.
viii. Situation 6: Assignment dictated in K - A agreed to purchase Bs stock, but contract provided
that A could assign the contract to a corp. A organized a corp. and caused it to purchase Bs stock.
No primary and unconditional obligation because contract could be assigned.
ix. Situation 7: cancellation of an existing contract which would obligate A to purchase and replaced
by a contract that X would redeem does not create a constructive distribution to A
3. Final Regs Under 1041 MARITAL Dissolution

53
Case: Arnes U.S
The Court change Sec 1041 which basically say this if you have a marriage dissolution, redemption,
where corp has to buy the ones party stock in order to settle the divorce. In that situation, the general rule is
that the party whose stock is being bought will have to suffer 302 treatment, which means that they are
going to report a capital gain, unless under the decree of other spouse, whose stock is not bought has a
primarily and unconditional obligations to buy THAT stock of the other spouse and is having the
corporation discharge that obligations. If I have an obligation to buy my wifes stock, but I loop that
obligation and said the company will redeem that stock, than that tax redemption will be taxed to me as a
dividend, because the company is discharging my legal obligations. Same thing if I have a buy-sell
agreement: if I am an obligated to buy your stock and I ask the corporation to buy your stock, I would be
deemed to have constructive dividend. So, actually it means somebody is going to pay for stock and to pay
the dividend.
However the spouse on divorce degree can change the impact if they want, the government doesnt
care who will pay the tax. The government just said -that is a general rule under 1041, but if you guys
want to change the rule we dont care as long as somebody of you have paid the taxes.
LISTEN 74 min.

Issue: If redemption part of divorce, what is relationship of 1041 (no gain or loss on divorce property division) and
302 redemption provisions? PAGE 262
Reg. 1.1041-2(c)
If redemption for benefit of non-transferring spouse under primary and unconditional to pay obligation standard,
then p 269 4th paragrapgh):

- No gain or loss to transferring spouse (Ms. Those who surrender her stock to a corporation) per 1041.
- Constructive dividend to non-transferring spouse (those who receive stock)(tax consequences determined under 302
whether or not the constructive distribution is dividend depends on whether the Corp has E&P and whether any of
the tests for exchange treatment in Sec 302 are met).

54
 If primary and unconditional standard not met for constructive dividend, then 1041 not apply and transferring spouse
must recognize gain or loss (Sec 302 treatment). Parties may elect opposite rule to one that would otherwise apply if
they both agree.
Bottom line: No opportunity to whipsaw and both avoid tax.

4. CHARITABLE CONTRIBUTION AND REDEMPTION

GROVE v. COMMISSIONER (2nd Cir. 1973) Pg. 266: Grove made a charitable donation (FMV of
stock deduction) of stock to a school. The agreement allowed the school to sell stock to corp. (corp.
redeems stock), but restricted the school in its use of the cash allowing it to transfer only to Groves
financial advisor for investment. Grove maintained a life interest in the donation (investment income),
with the remainder (appreciation) going to the school
i. HOLDING: Redemption, by a corporation, of shares gifted to a charity by a TP will not result in a
dividend to the TP, where there is no evidence of an implicit agreement obligating redemption.
ii. A gift of common shares in TPs corp. to a charity while retaining a life interest in the gifted stock
and subsequent election of redemption of the shares (elected by the charity under the right of first
refusal agreement) did not result in a dividend to the donor
iii. REV. RUL. 78-98: The IRS now only asserts dividend treatment for the donor if the donee is
legally bound or can be compelled by the corp. to surrender the shares for redemption
a. Here the charity could have held the shares forever, against the wishes of the corp.
iv. Had there been an agreement that the charity had to redeem the shares, then the transaction would
be viewed as a redemption of shares followed by a gift the result then would be the redemption of
Groves (donor of gift) would be taxable as a dividend, and then a gift of the post-tax proceeds.
TRY TO UNDERSTAND THE LAST SENTENCE. WHO would pay tax, what amount

REEMPTIONS THROUGH RELATED CORPORATIONS

55
56
SECTION 304:

In slides above the common owner of A and B. And C cell stock of B to A in return for PROPERTY. So, a
redemption is tested by changing the ownership in B. So we first are testing whether this transaction will qualify
for 302 exchange treatment or not, and to do that we are looking at change in the ownership at B corp (whose
stock is being transferred / transferor) And we are looking what percentage this guys owned before the transfer
and what did they own after the transfer. And then you apply b1, b2 and b3 standards. But if you flunk at 302
so we are going to treat your distribution as 301 dividend. Then we are going ot treat this money coming out of
A corp not out of B Corp as a dividend. First coming up of the E&P of A corp and if it does not have enough
money so out of B Corp.
We are going to PRETENT in this transaction that the common owners contributed the B Corp stock in return
for A Corp stock in a 351 transaction and then we are going to PRETEND that the A Corp immediately bought
back stock that they/it issued on its own stock in the 351 transaction
Why are they doing that? What happening here is shares of B corp are being transferred to shares of A corp and
you have to determine what As basis is going to be in the shares that is transferred.
However, in applying Sec 318, corporate 50% is reduced to 5%.
Moreover no boot rule under Sec 351, if boot, then everything is treated as a dividend.

For purposes of section 302 and 303, IF:

One or more persons are in control of each of two corporations, AND
In return for property, one of the corporations acquires stock in the other corporation from the person
so in control,

57
 THEN, such property shall be treated as a distribution in redemption of stock of the corporation
acquiring such stock, To the extent that such distribution is treated as a distribution where 301 applies,
the transferor and the acquiring corp ( ). shall be treated in the same manner
as if the transferor had transferred the stock so acquired to the acquiring corp. in exchange for stock of
the acquiring corp. in a 351 transaction, and then the acquiring corp. had redeemed the stock it was
treated as issuing in such transaction
i. CONTROL - 304(c)(1): the ownership of stock possessing at least 50% of the total combined
voting power of all classes of stock entitled to vote OR at least 50% of the total value of shares of
all classes of stock and 318 attribution clearly applies
THEN, apply 302 treatment:
i. IF satisfy 302(b), then entitled to sale/exchange treatment. If the distribution is treated as an
exchange under Sec 302 (a), Y is treated as purchasing the stock of X (transferor corp)
ii. IF FAILS 302(b), then apply 301, but statute requires that the stock transferred be treated as a 351
transaction (where transferring SH receives acquirer stock) and immediately after the acquiring
corp. redeems the shares it was treated as issuing. And the redemption is tested with reference to the
SHs ownership of stock in the issuing (not acquiring) corp. If treated as 301, then SH made a 351
contribution to the acquiring corp., increasing SHs basis in the SHs acquirer shares. And then the
acquiring Y corp is treated as having redeemed from SH the Y stock that is hypothetically issued in
the Sec 351 exchange. If the distribution is treated as an exchange under Sec 302 (a), Y is treated as
purchasing the stock of X (transferor corp)
iii. Acquiring corp. will take SHs basis in the shares

2. BROTHER-SISTER ACQUISTIONS
Section 304(a)(1) applies when one or more SHs who are in control of each of 2 corps., A and B, sells
stock of corp. A (issuing) to Corp. B (acquiring) for cash/property
DIVIDEND EQUIVALENCE: The dividend equivalence under 302(b) is tested by TPs ownership in
issuing Corp. A BEFORE and AFTER the transaction. 304(c)(1).
DIVIDEND SOURCE: Is first determined to extent of E&P of acquiring corp. B and then to the
extent of E&P of the issuing corp. A. 304(b)(2)

3. PARENT-SUBSIDIARY ACQUISITIONS: The above principles apply to a controlled (50%) subsidiary

(acquiring corp.) that acquires stock of its parent (issuing corp.) from a SH of the parent and
subsidiary/acquiring returns property to SH. 304(a)(2).
If the constructive redemption is treated as an exchange, the selling SH-s recognize gain or loss under
normal tax principles.
If the transaction is both brother-sister and perent-subsiduary, the parent-subsidiary rules take precedence.

58
4. COLLATERAL TAX CONSEQUENCES
DIVIDEND TAX TREATMENT: In a 304(a)(1) brother-sister acquisition where the amount paid is
treated as a 301 dividend distribution (because SHs ownership in issuing corp. does not meet any
302(b) tests:
i. SHAREHOLDER: The SH is treated as if he transferred the stock of issuing Corp. A to the
acquiring Corp. B in exchange for Corp. B/acquiring stock in a (deemed) 351 transaction. Then, as
if the acquiring Corp. B redeemed the stock it issued
a. Income: the dividend to extent of E&P is included in SHs Gross Income. 304(a)(1); 1.304-2(c)
Ex. 1.
b. SHs Basis: In the B/acquiring stock in a (deemed) 351 transaction is EQUAL TO SHs basis in
A/issuing stock that SH actually transferred t B. SO SHs existing basis in B increases by that
amount. 304(a)(1); 1.304-1(c) Ex. 1.
i. However, SHs basis in B stock will be decreased on the deemed redemption of B stock if
there is not enough E&P in acquiring & issuing corps. 301(c)(2) 304(b)(2).
ii. B/ACQUIRING: Takes a transferred basis from SH in A/issuing stock under 362
a. E&P: Of B/acquiring reduced first, and then A/issuing E&P (then apply 301 rules). 302(b)(2).
EXCHANGE TREATMENT: In a 304(a)(1) brother-sister acquisition, where the amount paid is
treated as a 302 sale/exchange (because SHs ownership in issuing corp. meets one of the 302(b)
tests:
i. SHAREHOLDERS: the SHs basis in B acquiring corp. remains the same. 304(a)(1)(B); 1.304-
2(c) Ex. 3.
a. GAIN: SH will recognize gain of: AR SHs AB (in A/issuing stock transferred). Id.
ii. B/ACQUIRING: Will be treated as acquiring A Corp. issuing stock by purchase and thus takes a
cost basis (SHs basis in A stock + SHs amount recognized) in A stock under 1012; 1.304-2(c).
Ex. 3.

59
 a. Acquiring Corps E&P: Is reduced by an amount not in excess of the ratable share of E&P
attributable to the stock so redeemed. 312(n)(7). The more difficult question is which corps
E&P. One defensing answer is that the required reduction should be made first to the acquiring
corp E&P and if necessary then to the issuing corp.
i. Ex: If corp. redeems a 10% of a SHs shares the E&P are reduced by 10%

NIEDERMEYER v. COMMISSIONER (TC 1974) Pg. 279

i. HOLDING: Sale of shares by controlling SH to a corporation which is controlled by the
controlling SHs family members (within 318 attribution rules) will be treated as a redemption by
the acquiring corp. (and tax treatment is governed by 302)
ii. Niedermeyer transferred shares of AT&T, which he held a majority of, to Lents which was owned
by his brother. Therefore the transfer of stock from one corporation controlled by the transferor to
another corporation controlled by him (here due to family attribution) will be treated as a dividend.

60
 a. This has no basis offset, nor capital gains treatment
b. TPs bad blood argument was not valid
c. No 302(b)(3) treatment for the redemption because TP held preferred shares immediately after
iii. The Court denies waiver of family attribution rules under 302(b)(3) because SHs still owned over
a hundred Preferred shares and thereby did not completely terminate their interest in the Corp and
did not have any evidence of plan to completely terminate.
iv. If applying 302(b) to such a redemption, measure TPs interest in the issuing corp. (not the
acquiring corp.)
a. Controlling SH is treated as constructively owning a percentage of the acquiring corp.s shares in
the issuing corp. in proportion with the SHs ownership of the acquiring corp.
v. NOTE: Did not file the required paperwork for 302(b)(3) termination of SH interest
The redemption under 302 (b)(3) if making in several steps must occur as part of a plan which is firm
and fixed and in which the steps are clearly integrated Otis P Leleux

REDEMPTIONS TO PAY DEATH TAXES

SECTION 303 listen 3-7 minutes of class 10/26 about Imagine the situation when dad own 60-70% of the
company and he dies, so it is always usually impossible to redeem all of the dads stock so they are not going to
get under b3, when you get into this situation when a major owner dies and the company cannot redeem its
stock, and you cannot qualify under b2 or b3, that is why we have Sec 303 and you badly can get money out of
the company to pay death taxes
So, I can sell stock back to the company, enough stock to cover my expenses and treated as exchange under
303. Timing within 90 days after tax court determination or tax assesment
1. SECTION 303-EXCHANGE: Makes it possible to avoid dividend treatment and achieve full recovery of
basis on a redemption even if the transaction does not come within one of the 302(b) tests
If several detailed requirements are met, distributions in redemption are treated as a sale/exchange
rather than a dividend up to the sum of federal and state death taxes and allowable funeral and
administrative expenses
This Section becomes crucial on the death of the second spouse, on the death of the first spouse who
will get the marital deductions, you dont have to worry about that. But on the death of the second
spouse you want to qualify and what it means you have to regular the estate to make certain than when
that death occurred you are above the 35%.
Which means the FMV of the stock that the person owns in that company > 35% of the persons
gross estate (all the property taxed in the estate) LESS their deductions for deaths, expenses and
losses.
There are two benefits to hiding this 35%:
One is Sec 303 benefit which allows you to pull money out
If you exceed that amount (that 35%) you are allowed to pay estate tax burden over 14 year period under
6166
Now if you have multiple companies for purposes of 35% test you can aggregate any companys in which
you own over 20%, you can bring them together and says together these companys own more that 35% of
my gross estate I get estate treatment. And in calculating whether you own more than 20% of more in
value of each such corporations total outstanding stock I can include my spouses shares, but you may not
include your spouse in calculating toward 35%

b)(2)RELATIONSHIP OF STOCK TO DECEDENTS ESTATE

(A)In generalSubsection (a) shall apply to a distribution by a corporation only if the value (for Federal estate tax
purposes) of all of the stock of such corporation which is included in determining the value of the decedents gross estate
exceeds 35 percent of the excess of
(i)
the value of the gross estate of such decedent, over
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(ii)
the sum of the amounts allowable as a deduction under section 2053 or 2054.(FUNERAL, ADMINISTRATIVE
EXPENSES)
A special rule permits the stock of two or more corporations to be aggregated for purposes of this 35% test if
20% or more in value of each such corporations total outstanding stock is included in the gross estate. For
purposes of 20% requirements, stock held by the decedents surviving spouse as community property, or held
with the decedent prior to death in joint tenancy, tenancy-by-the-entirety, or tenancy-in-common, is treated as if
it were included in determining the value of the decedents gross estate.
Gross estate 7,000K
LESS
Allowable deductions 300K
Total 6700
35% of total 2345
FMV of X stock < 35% YES. 600 FMV
FMV of X stock < 35% YES 1.2 M
20% rule of Y company
FMV out of total FMV 1.2 mill out of 4,8 mill = 25%
Satisfied? Yes
20% rule of X company
FMV out of total FMV 600k FMV X Corp stock (total o/s FMV 4.2
mill) = 14%
Wife attribution Wife 600K. Together 1.2 out of 4.2 = 28%
Satisfied? YES
FMV of X stock >35% NO600M + 1.2 M = 1.8 M

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 VI. STOCK DIVIDENDS AND SECTION 306 STOCK
OVERVIEW

1. STOCK DIVIDEND: A distribution of stock or rights to acquire stock by a corporation to some or all of its
shareholders
Similar to a stock split: Difference is that a stock dividend requires the corporation to transfer an
appropriate amount from retained earnings to paid-in capital
Dividend need not be of the same class

2. PURPOSES
Stock dividends can provide shareholders with some tangible evidence of their interest in corporate
earnings
Closely Held Corporations: Stock dividends may be a vehicle to transfer control

3. EISNER v. MACOMBER: Proportionate distributions of stock dividends are not taxable because same
ownership interest as before stock dividend
Stock dividends can change proportionate interests so there are exceptions to this rule and recognition
may be required

STOCK DIVIDENDS UNDER SECTION

305 is designed to deal with stock dividends.

So what is stock dividend? it is when you have a company issues more of its own shares to a SH as a
dividend. Example: you have 10 SH, they each owned 10,000shares and the company says we are going to give
all of you each an additional 1,000 shares (10%), we are not going to give you any cash/property, just more
peaces of shares, but my percentage in the company doesnt change. So, the general rule is that stock dividend
is NOT taxable because you give nothing except a piece of paper. That is a general rule of 305.
General Rule: Not taxable under 305(a).
HOWEVER THERE ARE 5Exceptions under 305(b) Taxable as 301 dividends. If you do smth stated
below you MAY have as what is called a taxable stock dividend on the FMV of those, which means ex 10% of
my investment is now turned on into taxable dividend. There is nothing more stupid you can do to create
taxable stock dividend
1. Shareholder can take stock or property. If you get any SH the right to take any kind of property in
lieu of the stock then ALL of the SH are taxed on the stock dividend they receive. Doesnt make ANY
difference whether they exercise the right or NO. Then everybody has a taxable dividend
2. Some shareholders get property and proportional interests of others in assets and E & P is increased.
Assume some SHs get some item of property or cash and the proportioned interest in the assets or the E&P of
other SHs increased you got a taxable stock dividend. So, if you play like this class of SH receive stock
dividend and this class of SH property- this is not an option everybody is treaded as receiving taxable stock
dividend.

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 3. Some shareholders get common stock as a dividend and others get preferred stock as a dividend, any kind of
preferred stock, everything that everybody gets is taxable. Everybodys dividend is taxable! On the one hand if
a corp has two classes of common stock, one paying regular cash dividend and the other paying corresponding
stock divided (whether common or preferred), the stock dividend are to be taxable. On the other hand, if a corp
has a single class of common stock and a class of preferred stock that pays cash dividends and is not
convertible, and it distributes a pro rata common stock dividend with respect to its common stock, the stock
distribution is not taxable because the distribution doesnt have the result of increasing the proportionate interest
of any SH. : If common stock SHs get a pro rata common stock dividend and preferred SHs (nonconvertible)
receive cash dividends = Stock dividends NOT included in SH gross income because distributions do not
increase proportionate interest of any SH

4. Distribution on preferred stock (other than to maintain conversion equality). Any distribution on
preferred stock is taxable. The only exception would be if I done some major merger and smth with
conversion in a common. If a distribution has thee result of the receipt of preferred stock by some common SH
and the receipt of common stock by other common shs, all of these shs are taxable (sec 301) on the receipt of
the stock. The second provision - the distribution of stock with respect to preferred stock are taxable
5. Distributions of convertible preferred, unless can prove no change in proportional interests in assets
or E & P. Issue convertible preferred stock means I go to my SH and says guys I am going to pay you stock
dividend preferred stock, I am going give you all preferred stock, but then I says -by the way guys, this is
convertible into common. So, convertible preferred stock is going to be taxable unless I can prove that the
conversion issue is so crappy, that nobody will convert it is the next 20 years
Periodic Redemption Plans Under 305(c): may trigger constructive taxable stock dividend.
REMEMBER: If you have a company that has periodic redemption series Sec 305 (c)will kick in, anyone will
sooner or latter will have a taxable stock dividend when they interest will be increasing, even if you do not issue
somebody a stock dividend. Fortunately, they limited it to serial redemption program, so do not extend it to every situation
where there is a redemption and the corresponding increase. HOWEVER, that does not apply to PUBLIC COMPNANIES
here, they are doing it all the time. So, never apply a serial redemption program in a closely held corporation

So, what is the safe issue I can do to avoid this tracks?

I can issue common on common stock dividend on pro rata. I can issue non convertible preferred to common
shareholders only, everything pro rata, no cash options.
Eisner and Macomber, 252 US 189 (1920( I a stock dividend is taxable if it increases any shs proportionate
interest in the Corp 305 b

And then there is a distribution on 305(c) - REMIND

So!!
Nonconvertible preferred on two common stock, pro rata -ok
Nonconvertible preferred subordinated okay. Nonconvertible preferred not subordinated could be
taxable dividend because preferred stock could cause cash distribution problem 308 (d)

1. GENERAL RULE - 305(a): Except as otherwise provided in this section, gross income does not include
the amount of any distributions of the stock of a corporation made by such corporation to its shareholders
with respect to its stock

2. EXCEPTIONS - 305(b): The following distributions will be treated under 301:

DISTRIBUTIONS IN LIEU OF MONEY - 305(b)(1): If the distribution is, at the election of the
SH, payable in either stock OR property
64
 i. Therefore, there is a possibility that there is a change in the relationship among SHs and SH to
corporation
ii. This applies to all taxpayers when ANYONE has an option to choose cash instead of stock, even if
the specific taxpayer did not have the option
DISPROPORTIONATE DISTRIBUTIONS - 305(b)(2): The distribution has the result of the
receipt of property by some SHs and an increase in the proportionate interests of other SHs in the
assets or E&P of the corporation
i. Could be a series of transactions
ii. Put together with 305(c)
iii. Ex: If common stock SHs get a pro rata common stock dividend and preferred SHs
(nonconvertible) receive cash dividends = Stock dividends NOT included in SH gross income
because distributions do not increase proportionate interest of any SH
DISTRIBUTIONS OF COMMON AND PREFERRED STOCK - 305(b)3): The distribution has
the result of the receipt of preferred stock by some SHs and common stock by others
i. Preferred has capped upside and could sell preferred for cash which would be the same as the
receipt of a cash dividend
ii. Different rights between common and preferred, i.e. upon liquidation
iii. ALL SHs are taxed under 301
DISTRIBUTIONS ON PREFERRED STOCK - 305(b)(4): The distribution is with respect to
preferred stock giving preferred SHs common stock changes the mix of interests; increasing SHs
stake in the corporation. Preferred on preferred okay????
DISTRIBUTIONS OF CONVERTIBLE PREFERRED STOCK - 305(b)(5): Stock is taxable
under 301 unless it is established that either everybody or nobody will convert
i. Can change the proportionate interest in the company; similar to distributions of common and
preferred
ii. Covers everyone if one SH has the right to it, not just those who exercise or have the option to

3. TREATED AS DISTRIBUTIONS - 305(c)

NOTE: This will occur if redemption plan is implemented where one type of stock is redeemed and
the other is not. Therefore the non-redeemed shareholders will increase their interest and must
recognize gain
RATIONALE: Because certain transactions may have the effect of a stock dividend even though no
shares are distributed, Congress treats certain transactions as distributions of stock under 305 and
therefore taxable under 301 if it satisfied any of the 5 categories in 305(b).
TEST
i. First, determine whether the transaction is a distribution transaction that increases proportionate
interest of some SHs
ii. Second, whether it would satisfy any of the categories under 305(b) exceptions
a. Then taxed as dividend under 301
b. If does not, t means proportionate and therefor no recognition under 305
5 CATEGORIES DEEMED TRANSACTIONS UNDER 305(c) FORTUNATE LIMITED TO A
CERIAL REDEMTION PROGRAM, they did not extend it to every situation where there is a
redemption and a corresponding increase in the proportion of other shareholders
i. A change in the conversion ratio
ii. A change in the redemption price
iii. A difference between redemption price and issue price
iv. A redemption treated as a distribution to which 301 applies, or
v. Any transaction (including a recapitalization) having a similar effect on the interest of any SH

65
4. TAX TREATMENT OF 305 STOCK DISTRIBUTION
SHAREHOLDERS
i. Gain or Loss:
a. 305(a): Gain or loss on stock dividends are not taxable (generally only pro-rata)
b. 305(b): lists 5 exceptions, which if satisfied, trigger 301 tax treatment; dividend up to E&P, basis,
gain treatment (generally NON pro-rata distributions)
ii. Basis: If 305(a) Nonrecognition Shareholder must allocate the basis in the stock held prior to the
distribution between the old and new stock in proportion to the relative FMV of each on the date of
distribution. 307(a).
iii. Sec 311 (a)(1) - the distributing corp recognize no gain or loss under Sec 311(a)(1) and it may
reduce its E&P by the FMV of the distributing stock
iv. Holding Period:
a. 307 permits tacking the period SH held the underlying shares to the new shares
i. Important because stock is typically a capital asset, so either LTCG or STCG

CORPORATION
i. 305(a): Pro rata distributions have little to no tax consequences to a corp.
a. E&P 312(d): There will be no E&P reduction if the distribution was non-taxable to the SHs by
reason of 305(a)
ii. 305(b): Under 311(a) corporations do not recognize gain or loss on distributions of its stock
a. E&P: reduce E&P by the FMV of the taxable portion of the stock distribution

5. REVENUE RULING 78-60 (1978) Pg. 299

ISSUE: What are disproportionate distributions under 305(b)(2)?
Z Corp. had 6000 shares outstanding owned by 24 related SHs. Z instituted a plane whereby it will
redeem 40 shares in total annually, and if only 1 SH participates he can have 40 redeemed from him
LAW: A redemption treated as a 301 distribution by SH will be deemed by IRS as a distribution to
which 305(b)(2) applies if the proportionate interest of any SH in the E&P increases. 1.305-7(a).
i. 318(a) family attribution rules are not applicable to 305 under 305
HOLDING: The SHs who did not participate in the redemptions and experienced an increase of
interest in E&P are deemed to have received disproportionate stock distributions to which sections
305(b)(2) and 301 apply
i. The ruling considers the fact that it was not an isolated redemption, but part of an annual plan

SECTION 306 STOCK

66
 Look at the illustration above. Suppose I am a common stock owner in the company and the company
decides to distribute to me a nonconvertible preferred stock dividend under 305, which is tax free because it was
distributed to all of us pro rata. Now I have two classes of stock. I have common and preferred stock. Before
that distribution all I had was common stock. So, now we have to determine what is the basis of the SHs
preferred stock. Lets assume that his basis in the common stock is 1 mil dollars. So, under Sec 307 we have to
allocate his basis. So, SH has to take hos 1mil basis in common and he has to allocate his basis between
common and preferred stock. And we do that based upon a FMV of those stocks at the time he issued the tax
free preferred stock dividend. So lets assume the FMV of preferred stock is 500K and the FMV of the common
AFTER this is done is a 1,5mil. Well, than well allocate 25%??(see calculations in problem table to this class
306 stock or below in th table) to the preferred (250K) and 75%?? to the common or 750K. So he still has 1mil
in basis but we split this basis between the two securities that he has. And he collects 250K basis of preferred
stock tax free. So after that, he wait for year or two and he sells his preferred stock to third party for cash. So
this is 306 stock and it can only be preferred stock, I cant have 306 common stock. So what are the
consequences of this possessive 306 taint? Now, first lets define the transactions that creates this 306 tiant:
1.Non-common stock received by shareholder and not included in gross income by reason of section
305(a) tax free stock dividend.
2. Non-common stock (Preferred) received in tax free corporate division or tax free reorganization,
acquisition.
3. Stock that has basis determined by reference to 306 stock. Carryover taint. So if I have 306 taint
preferred and I EXCHANGE it in transaction of other preferred, that other preferred because I exchange
it will have the same basis. If I give the stock to one of my kids and the basis carry over, the taint is
carry over.

67
 4. VERY IMPORTANT, BUT A LOT OF PEOPLE MISSES IT. Stock acquired (PREFEERED STOCK)
in 351 exchange, in a situation where if that stock has been money, it would have been taxed as cash
under Sec 304, than that stock is 306 stock.where any money that would have been received would have
been taxed as dividend under 304 (related corp redemption). Remember it when you sell stock of one
company you control to other company you control and remember 304 incorporate by reference 302,
301 and 351. Now we have 306 incorporating by reference 304. But this is a situation: I control two
companies (corp A and B). He sells stock of corp B and in return he gets stock of copr A (lets say he
gets common and preferred). Now this is a straight 351 transaction- I transferred property for stock, this
doesnt look like 304 transaction, because there is no money coming out, there is no property, remember
304 only applies when I transfer stock of a company I control and I receive property or stock of
acquiring company, but here I receive stock. So, on its face it is Sec 351, but this is what Sec 306 says
this preferred stock that I took in 351 transaction which is tax free should be considered 306 preferred
taint, IF and ONLY IF, had I taken cash out of this transaction, if that cash would be tax as Sec301
dividend, then this cash that I take would be taint as Sec. 306 preferred. If the cash I took out would not
have been taxed as 301 dividend under Sec 304, the preferred I took would not be Sec 306 taint
preferred. Then you go to 304 rules that measure the change of transferred corporation and you examine
whether or not you fall under 302 b.
5. Big Out: No 306 taint beyond limits of E&P at the time of distribution.
Now lets look at the consequences if I had 306 taint preferred.
306 Impact
Non-Redemption Sale of 306 Stock:
If sell the stock to a third party the money I get on the sale is taxed to me as ORDINARY INCOME
equal to my share on the companys E&P at the time I got the preferred stock. So we go back and look, when I
got that preferred stock, what was my ratable share in the companys E of the companys E&P, how much of the
companys E&P did I owned. If I owned 20% that is my ratable share. To the extend of that ratable share when I
sell my preferred stock that is my ordinary income. It is NOT a dividend because money are not going from the
company and it is not a sale, I dont get to recover my basis. Every dollar I get on it disposition- we call
ordinary income. It does not reduce the companys E&P because the company is not paid out. It is just an
ordinary income. Any excess to me realized over my share of E&P at the time of distribution, not sale, I can
recover my basis and the excess of it is capital gain. If I do not recover my basis it all taxed to me as a dividend,
I take my basis on the preferred that I now sold and I reallocated it back to the common based on the FMV of
that shares at the time of the sale. This ordinary income is TAXED AT CAPITAL GAIN RATES
- Ordinary income for amount realized up to ratable share of E&P at time of distribution of preferred.
Look back to E&P.
- Excess amount realized applied against basis, then gain. No loss allowed.
- If no amount to apply against basis, reallocate basis to common.
- Not treated as dividend, just tax on sale thus no 243 deduction or E&P reduction.
- If no E&P at the time of distribution no ordinary income
Redemption of 306 Stock by Corp:
So, if have 306 preferred stock and sell it back to the company, we dont look at 302, we dont look at
anything, and if company have enough E&P it is also taxed to you as a dividend. And you just got your basis at
preferred stock and allocate it back to the company.
- Ordinary income for amount realized up to E&P at time of redemption.
- Treated as 301 dividend for all purposes E&P reduction and 243 deduction.
- Any lost basis reallocated back to common.
So THREE ANALYSIS:
Do I have 306 taint preferred?

68
 If so do I have a transaction that could trigger 306 taint preferred either I am selling it to a third party or
company redeems it.
Whether or not I qualify for an exceptions that will remove those consequences? See exceptions below.
Five-306 Exceptions (306 consequences will disappear)
1. If I Sale my preferred is to non-318 party and terminates my entire interest in corporation, tested
against full 318 attribution.
2. Redemption that qualifies under 302(b)(3) (complete termination) or 302(b)(4) (partial
liquidation for non-corporate shareholder). So if I am disposing of a preferred in a scenario when I am also
disposing of mu common and the common disposition fits under b (3) then you can remove the taint on the
preferred. I can only waive family attribution, no entity to or entity from attribution.
3. Complete liquidation.
4. Transaction where no gain or loss recognized on sale of 306 stock. That would be a tax free
reorganization. Somebodys coming in the emerging of the company and they will said we will issue you our
shares of stock in return of your shares.
5. Can prove distribution and sale not have tax avoidance as primary purpose. Best where related
common redemption qualify for exchange treatment. One of the way is what if I am selling enough common
stock, I am not disposing all of that, I cant get under 302 b3, but can get under b1 or b2 to no related party, if I
can prove that I am selling enough common to qualify under b2 or b1 and I am selling a bunch of preferred, can
I avoid the consequences of 306 stocK? SO there is a split of thoughts on it. One says yes. The other said -wait a
minute if I they wanted to include 302 b 2 they would put it in #2 exception. Drakes thought If I can show
that I send a substantial block of common and a relatively insignificant 306 preferred I may get ths argument
under 5th exception.

J V
Basis before 2k 2k
After 3k 3K
Preferred stock worth 1K 1k
Basis allocated (common) 2K 2K
Percentage of basis 75% of 2K (3000after 75% of 2K (3000after
allocation basis/ 3K +1K preferred)= basis/ 3K +1K preferred)=
1.5K to common 1.5K to common
0.5 to preferred 0.5 to preferred
Basis new - ?? 3.5 common 3.5 common
0.5 preferred? 0.5 preferred?
A corp gain or loss - no
A corp E&P impact - no

69
THE PREFERRED STOCK BAILOUT: Corporation distributes preferred stock. Shareholder sells preferred
stock to INVESTOR. Corporation then redeems preferred stock from accommodator. Shareholder has cash and
shareholders have the same ownership in corporation as before
306 seeks to preclude this type of transaction
Preferred stock is used because it can be sold without diminishing SHs control or right to growth
profits
Given that capital gains rates equal dividend rates, noncorporate SHs only benefit from basis recovery
Chamberlin v. Commissioner: led to 306 essentially SH received preferred shares, which were then
sold to an insurance company for cash. Shares had a redemption clause that guaranteed the insurance
company that they would be redeemed in 7 years. In substance the transaction was a cash dividend to
SHs, who now were able to get basis recovery because sale treatment, not dividend

2. THE OPERATION OF SECTION 306: Section 306 stock is preferred stock distributed to SH
SECTION 306 DEFINED - 306(c)(1): For purposes of this subchapter, the term section 306 stock
means stock which meets the requirements below:
i. DISTRIBUTED TO SELLER 306(c)(1)(A): Stock distributed to a SH as a tax-free stock
dividend under 305(a), other than common on common (Preferred)
a. Common Stock: In this setting defined as any stock that, if sold, will reduce the SHs equity
position in the company. If the stock has a limited access to dividends or assets on liquidation,
then it is no common for 306 purposes
b. Exception where no E&P: 306 does not include stock which would have been treated as a
dividend (no E&P) at time of distribution if cash was distributed in lieu of stock. 306(c)(2).
ii. ADDITIONAL WAYS TO SATISFY 306 - 306(c)(1)(B): Any stock other than common stock
received tax free in a reorganization, but only to the extent that either the effect of the transaction
was substantially the same as the receipt of stock dividend (think 305(b) categories), or the stock
was received in exchange for 306 stock
iii. STOCK WITH A SUBSTANTIATED BASIS - 306(c)(1)(C)(2): Certain stock, the basis of
which is determined by reference to the basis of Section 306 stock. That is, where the transferee
takes a transferred basis from transferor
a. Ex: 306 stock received as gift under 1015 (which received transferred basis) or stock received
in exchange for 306 stock in a tax-free 351 transaction
iv. STOCK, OTHER THAN COMMON ACQUIRED IN A 351 TRANSACTION - 306(c)(3):
This prevents a corporation with E&P from creating a new corporation via 351 and conducting the
preferred share bailout. 304 applies to look to corporations E&P to see whether the receipt of cash
would have been a dividend. This is because new corp. will not have any E&P.
v. 306(c)(1)(C)(2) NOT 306 STOCK IF NO E&P BECAUSE THERFORE NO DIVIDEND
TREATMENT: any stock not part of the distribution of which would have been a dividend at the
time of the distribution if money had been distributed in lieu of stock.
a. I.e. If there was not enough E&P such that a cash distribution would have been a dividend
i. No E&P = no dividend = no bailout concern

3. DISPOSITION OF SECTION 306 STOCK

Tax consequences vary on whether stock was SOLD or REDEEMED
IF SOLD: Amount Realized is treated as dividend income to the extent of the stocks ratable share
of the amount that would have ben a dividend, if the corporation has distributed cash in an amount
equal to the FMV of the 306 stock at the time of the distribution. 306(a)(1).
i. The balance of amount realized is treated as reduction of basis and any excess (negative basis) is
treated as capital gain on sale. 306(a)(1)(B).
70
 ii. If SHs adjusted basis exceeds the amount realized, no loss is recognized
iii. The excess basis must be allocated back to the stock from which 306 stock was distributed
IF REDEEMED: 301 applies. 306(a)(2).
i. Little weird because in the 301 analysis you are looking at the E&P at the year of disposition as
opposed to the year when the 306 stock was acquired
ii. Corporate SH is still entitled to 234 dividend rate deduction so Corporate SHs dont mind having
306 stock because if redeemed, to the extent of E&P, they dont recognize gain (but still can be
minimized by 1059 extraordinary dividend limitation)

4. DISPOSITIONS EXEMPT FROM SECTION 306

306(a) does not apply to non-redemption disposition if the SH completely terminates interest in the
corp. (31 attributions applicable) or if the result qualifies for 302(b)(3) or (4)
LIQUIDATONS - 306(b)(2): If the 306 stock is redeemed in a distribution in complete liquidation
WHERE GAIN OR LOSS IS NOT RECOGNIZED - 306(b)(3): To the extent that any provision
results in gain or loss to the SH not being recognized on the disposition of the 306 stock
TRANSACTIONS NOT IN AVOIDANCE306(b)(4): When transaction does not have an avoidance
of tax as one of their principal purposes:
i. Fireoved v. US: Fireoved received a preferred dividend on his common stock during a merger to
equate his stock holding with his contribution to the new corp. When the preferred was redeemed
by corp., the TP claimed capital gain and IRS claimed dividend treatment
ii. 306(b)(4)(A): Applies to entire transaction (distribution and disposition/redemption)
a. TP says that issuing 306 preferred stock was for business purpose only so that a partnership could
join, and the TPs contribution would be in proportion to the partnership
b. HOLDING: One of TPs principal purposes (along with his business purpose) could have bee tax
avoidance and TP has not shown enough purpose otherwise
NB In S Corp dont worry about 3056, because S Corp doesnt have preferred stock and also dont worry about
304

VII. COMPLETE LIQUIDATIONS

71
No matter how you shut down the company you have two taxes.
Today we have 331 and 336 which says that if I am liquidating a company via scheme 1, I take the FMV of all
the assets, including the goodwill of the company, the difference between FMV and the basis of the assets is
taxed to the corporation and the difference between FMV of the asset coming to the SH and their basis in the
stock is taxed to a SH. They get two taxes under 331 and 336.
If I do transaction under second scheme if corp sells it to the third party it pays it taxes it gets its cash or
whatever and distributes it to the SH and SH pays also taxes on it.
The only thing that mitigates is when we had in first scheme is that if we have SH, bought their stock after
September 2010, company has assets less than 15 million and SH held his stock for more than 5 years, then you
can avoid the SH level taxes. Same thing with 2nd scheme. Sec 1202.
So no matter how we liquidate the company, we have two taxes on shareholder and corporate level. And the
reason we have those is because of the section we have.
First we have Sec 331- which says a complete liquidation of a corporation treated as a sale or
exchange, GAIN OR LOSS WILL BE RECOGNISE, equal to the difference between the cash and the
FMV the shareholder gets AND the FMV of the shareholder stock. AS if they went down and sold their
stock. And remember when you gets the asset it is not just about the asset that is on the balance sheet,
but it includes goodwill and going concern that usually is the biggest asset. You may have the company
whose balance sheet is $5 M but the company worth $35M and the goodwill is not on the balance sheet.
The Question is: WHEN DOES THE LIQUIDATION BEGAN? because the minute the liquidation began
every dollar going out of the company is deemed to be an exchange for stock. You forget about 301, you
forget dividend none of that applies. SO, the minute the LIQUIDATION START every dollar that is
distributes if distributed AGAINST the BASIS of the STOCK, and is triggering capital gain, you are not
forward about dividend.
HOW TO VALUE THEMSELVES:

72
We need to assess the earning of the business and the earnings of the business is called EBITDA (Earnings
before interest, taxes, depreciation and amortization). Lets say EBITDA - $3M, the operated bottom line of the
company - $2M and thats on the sale of $35M. So when you are looking at the EBITDA the question is what
would somebody pay for it?? Lets suppose somebody says that in order to buy the company he wants a 20%
yield on his money. That means that he is going to buy the company at the price that when he pay this price
based on the EBITDA he will earn 20% on his money. SO, we take $3M divided into 20% , which means that
somebody will pay $15M on the company based upon the earnings.
Question 2 WHAT WOULD DETERMINE THAT YOU ARE ON LIQUIDATION MODE? THE
BOARD of directors adopts the plan of liquidation and from now every distribution we
make to our shareholders is on liquidation. SH gets the complete capital gain treatment
and the recovery of basis. The second deal yo need to deal with is when you go to the
liquidation mode, the SH does not know of how much they are going to get in the end. If
it is impossible to determine giving the nature of the business and the way it is going to
be liquidated, you can use what we call the pen transaction. Where basically the
Shareholder gets to recover their basis first -first they recover their basis everything that
is left over their basis is treated as capital gain
Question 3 WHAT IF THE COMPANY SELLS assets for a PROMISORY NOTE and distribute
these notes to a SH, can the SH receive that note and report their gain and report their
gin on the installment basis as that note paid of by the third-party buyers. If the
company adopts the plan of liquidation, sells assets and receive the notes within 12
month of adopting the plan of liquidation, the SH has benefit of receiving, reporting that
note on the installment basis, they have to recognize gain on it but they can do it over a
period of time.
With 331 comes 336 and 336 talks about the impact on the company. The starting
point is to understand that when the company distributes its asset in a liquidation
that looks like when company transfer business to the SH -336 the company must
book gain or loss on every asset. SO, you always have to book gain on the asset
including the goodwill. You ALWAYS have to book the gain, but you MAY or MAY NOT
deduct the LOSSES. Student always miss this -> there is a practical relationship
between 331 at the SH level and 336 at the corporate level. Because if the
corporation distributes a bunch of assets and triggers a taxable gain and has to
pay taxes, the taxes it has to pay is the LIABILITY OF THE COMPANY. So, if the
company distributes $25M of assets to the SH-s, but the company has $8 M TAX
BILL, that $8 M is subtracted from the amount the SH will get. So, whenever we
have a liquidation, we FIRST calculate tax impact on the CORPORATE LEVEL, then
you assess the impact on the SHAREHOLDER LEVEL.
You may or may not get the loss deduction. Generally speaking, Sec 267 (no loss on sale
to a related person). Sec 267 itself does not apply to a complete liquidation. If it did
any loss the company recognize on the liquidation will be denied. In the Sec 336 we
got two provisions that limit deductions on losses, if these doesnt apply the
company gets the deduction on loss on the asset that has a basis greater than the FMV:

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1. : No loss at all on distribution to related party (Sec 267) in complete liquidation if:
- Distribution not pro rata which means I am giving some loss asset to the big SH and non loss asset
to another SH. But if I distributed everything pro rata every SH gets their peace of EACH asset. SO, I own
60% I got 60% of the inventory, 60% of goodwill, 60% of cash -that is okay. But the minute I am doing it
not pro rata loss deduction is denied If you distribute the loss asset to a small guy that is okay, but not to
a big guy.., or
- Distributed loss property acquired by corp in 351 transaction or as contribution to capital within 5
yrs of distribution (Disqualified Property). If in the last 5 years property was acquired in Sec 351
transaction and you try to distribute a loss asset to a big guy you are not going to get a loss. If you
distribute the loss asset to a small guy that is okay, but not to a big guy. Sec 336 (d)(1)
REMEMBER: This Built in Loss measured at the time of distribution.
PLUS Any distribution within 2 years of the 351 is deemed to be bad purpose unless you can prove
otherwise. That only applies to the Built-in loss that existed at the time it went in to the company, doesnt
apply to loss at the time of the distribution. So if you have $100 loss when you put that in and NOW it is
$400 it IS ONLY ABOUT THAT $100M loss. This 336 (d)(2) avoidance exception has been around forever.
In a pre-dates Sec 362 (e) that says if you contribute built in loss asset in a 351 transaction and it is coming
from a single SH on the net loss of that SH then you have to adjust basis either the company basis has to
be reduced or the SHs basis to the extend somebody took a basis under Sec 362 (e) this section would not
apply.

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OVERVIEW

1. Liquidation status exists when the corporation is no longer a going concern and is winding up its business.
Legal dissolution under State law is not required; the entity may retain a nominal amount of assets to pay
remaining debt or to preserve a legal existence
2. COMPLETE LIQUIDATIONS: Defined to include a series of distributions occurring over a period of
time if they are all pursuant to a plan of complete liquidation (creeping complete liquidations). 346(a).

COMPLETE LIQUIDATIONS UNDER SECTION 331

Complete liquidation: Shareholder Impact

General Rule: Per 331, complete liquidation treated as sale or exchange of stock, producing capital gain
or loss equal to difference between cash and FMV of property received and shareholders basis in stock.
Section 301 not apply.
Timing Issues:
- When did liquidation began and dividends (non-liquidating) distributions end. Fact question. Look
to corporate resolutions and adoption of plan.
- 453 installment sales treatment applies when liquidating distributions over time. Open transaction
treatment very risky; appears trumped by 453.
- 453 installment treatment permitted even as to installment obligations acquired by non-public corp in
asset sell-off and distributed to shareholders. To qualify under 453, corp sale that created obligation must be
within 12 month period after liquidation plan adopted and liquidation must be completed within same period.
Inventory and dealer property qualify allowed only if part of bulk sale of assets.

Complete Liquidation Consequences to Corporation

General Rule: Per 336, Corp recognizes gain or loss on property distributed or sold as part of complete
liquidation. 267 related-party loss limitations not apply in complete liquidation.
(d)(1) Related Party Exception: No loss at all on distribution to related party (per 267) in complete
liquidation if:
- Distribution not pro rata, or
- Distributed property acquired by corp in 351 transaction or as contribution to capital within 5 yrs of
distribution (Disqualified Property). X was not required to reduce its basis under Sec 362(e). Still 300k
gain on Gainacre. 60% portion to Lossacre loss (240k of FMV) not allowed per 336(d) because go to Big GUY
and disqualified property because acquired within 5 yrs in 351 transaction. Property is distributed to a
related person. Loss on portion to F (160k) allowed. I and F still take basis equal to FMV . Same result if
Lossacre has 1 mill FMV and 800k basis on contribution to capital (gain). For 336(d)(1) purposes, built-in
gain or loss not applicable. AT THE CORPORATE LEVEL, not on the SH level. The shareholder books
gain or loss always

(d)(2) Tax Avoidance Exception: No built-in loss (loss at time of acquisition) allowed if property
acquired in 351 transaction or contribution to capital and principal purpose was to recognize loss on liquidation.
If acquired within 2 yrs of plan of liquidation, bad purpose a done deal unless there is clear and substantial
relationship
between property and conduct of business and solid explanation. If outside 2yr window, probably safe
except in most rare cases.
e Gainacre and cash to I; Lossacre to F; Lossacre have no relationship to X business and acquired by 351
transfer from I and F 18 months prior to plan of liquidation when FMV 700k and basis 800k. 336(b)(1)
disallowance not apply because F not 267 related party. But 336(b)(2) anti-stuffing rule might apply
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 because 351 transaction within 2 yrs of plan. If 362(e)(2) basis adjustment made at contribution, no
need for 336(b)(2) anti-stuffing loss never realized. If no 336(e)(2) adjustment, then 100k pre-
contribution loss disallowed per 336(b)(2), but 300k post-contribution loss allowed. No hope of
rebutting 2 yr taint presumption because asset not related to X business.

1. SECTION 331: GAIN OR LOSS TO SHAREHOLDERS IN COMPLETE LIQUIDATIONS

DISTRIBUTIONS IN COMPLETE LIQUIDATION TREATED AS EXCHANGES - 331(a):
Amounts received by a SH in a distribution n complete liquidation of a corporation shall be treated as
in full payment in exchange for the stock
i. Therefore, compute gain as you would from any other sale or exchange (i.e. Amount Realized =
FMV + Cash; and subtract Basis, and stock therefore most likely capital gains)
NONAPPLICATION OF 301 - 331(b): Section 301 shall not apply to any distribution of property
(except for 316(b)(2)(B)) in complete liquidation
i. Designed to reduce the tax burden on low income workers. Perhaps the most significant credit
premised on ability to pay. If the credit amount exceeds the TPs tax liability, the excess amount
is refundable. The 32 credit equals the credit percentage of an eligible TPs earned income up to
the earned income amount. This is phased out as income rises, but the phase out leads to slightly
irregular hills and valleys.
SH BASIS: provides that SH basis in property distributed is FMV of property. 334(a).
i. If the property received is encumbered by a liability: Amount Realized = FMV Liabilities
Assumed
In the case of creeping liquidations, the SHs can defer recognition of gain until the amount received
exceeds basis. However, the obligations must been acquired by the corp in respect of the sale or
exchange of property during the 12-month period beginning on the date a plan of complete liquidation
is adopted and the liquidation must be completed within that 12-month period
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 Permits basis recovery (because exchange rather than dividend treatment)
Permits recognition of loss (unlike 311 operating distributions which do not)
Taxed at corporate level as well
i. Corporate level gain recognized as though the corporation sold assets
Complete liquidations are not tax-free as a matter of policy because not stimulating economic growth
when you liquidate a corporation so Congress does not encourage liquidations by making them tax free
Not treated as a 301 distribution of property dividend because SH would not be able to apply amounts
distributed on liquidation tot heir basis

Arrowsmith v. Commissioner

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 The case involves taxpayers who liquidated a corporation in 1937. The taxpayers (properly) reported the
income from the liquidation as long-term capital gains, thus obtaining a preferential tax rate. Subsequent
to the liquidation in 1944, the taxpayers were required to pay a judgment arising from the affairs of the
liquidated corporation. The taxpayers classified this payment as an ordinary business loss, which would
allow them to take a greater deduction for the loss than would be permitted for a capital loss
The "Arrowsmith Doctrine" is a principle of United States Federal Income tax law that holds that
financial restorations associated with prior income items take the same tax "flavor" as the prior income
items.
The Commissioner of Internal Revenue characterized the payment of the judgment as part of the original
liquidation transaction, and therefore the loss was a capital loss and not an ordinary business loss. The
Tax Court disagreed with the Commissioner and found it to be an ordinary business loss. The Second
Circuit Court of Appeals reversed the Tax Court and held it to be a capital loss. The U.S. Supreme Court
agreed with the Second Circuit and held that it was a capital loss, since they were paid because of
liability imposed on the taxpayers as transferees of liquidation distribution assets

2. CONSEQUENCES TO THE LIQUIDATING CORPORATION - 336

GENERAL RULE - 336(a): Except as otherwise provided in this section or 337, gain or loss shall be
recognized to the liquidating corporation on the distribution of property in complete liquidation as if
such property were sold to the distributee at its FMV
TREATMENT OF LIABILITIES - 336(b): If any property distributed in the liquidation is subject
to a liability or the SH assumes a liability of the liquidating corporation in connection with the
distribution, for purposes of subsection (a) and 337, the FMV of such property shall be treated as not
less than the amount of such liability (even if the liability exceeds FMV)
LIMITATIONS ON RECOGNITION OF LOSS - 336(d)
i. Related Persons 336(d)(1): No loss recognized in certain distributions to related persons
(remember the problem might say unrelated, but look to 267(b) for related 50% SH, family,
same control group, etc.
a. 336(d)(1)(A): No loss recognized to a liquidating corporation on the distribution of any property
to related persons (within the meaning of 267) IF:
i. such distribution is not pro rata, or
ii. such property is disqualified property
Disqualified Property = Property acquired from a 351 transaction within the prior 5 years
or contributed to capital in the last 5 years
ii. Losses with Tax Avoidance Purpose 336(d)(2): Limits the corporations deductible loss by
requiring the corp. to reduce its basis (not below zero) in the built-in loss property by the amount of
built in loss (AB over FMV)
a. Rule automatically triggered when property contributed within 2 years before liquidation
b. Loss accrued after property is acquired is still deductible
c. This limitation applies when the distributing corporation acquired property in a 351 transaction
or as a contribution to capital as part of a plan the principal purpose of which was to recognize loss
by the corp. in a liquidation
d. 336(d)(1) (related distribution) which disallows entire loss (harsher) supersedes 336(d)(2) when
both apply
3. WHAT is PRO RATA
4.
5.
6.

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What is 'Pro-Rata'

Pro rata is the term used to describe a proportionate allocation. It is a method of assigning an amount to a fraction
according to its share of the whole. While a pro rata calculation can be used to determine the appropriate portions of any
given whole, it is most commonly used in business finance.

BREAKING DOWN 'Pro-Rata'

Some of the most common uses for pro rata calculations are to determine dividend payments due to shareholders, to
determine the amount of premium due for an insurance policy that only covered a partial term, or to allocate the
appropriate portion of an annual interest rate to a shorter time frame.

Dividends

When a company pays dividends to its shareholders, each investor is paid according to his holding. If a company has 100
shares outstanding, for example, and issues a dividend of $2 per share, the total amount of dividends paid will be $200.
No matter how many shareholders there are, the total dividend payments cannot exceed this limit. In this case, $200 is the
whole, and the pro rata calculation must be used to determine the appropriate portion of that whole due to
each shareholder.

Assume there are only four shareholders holding 50, 25, 15 and 10 shares. The amount due to each shareholder is his pro
rata share. This is calculated by simply dividing the ownership of each person by the total number of shares and then
multiplying the resulting fraction by the total amount of the dividend payment.

The majority shareholder's portion, therefore, is 50/100 x $200, or $100. This makes sense because he owns half the
shares and receives half the total dividends. The remaining shareholders get $50, $30 and $20 respectively.

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7. COMMISSIONER v. COURT HOLDING CO. (SCOTUS 1945) Pg. 324b: Corp made a deal to sell its
property (apt building) to unrelated purchaser. At last minute the plan was abandoned because of tax costs.
Instead corp made a liquidating dividend of property (not taxed to corp under general utilities-before
311(b)) and then sale by SHs to purchaser
HOLDING: Where a corporation negotiates the sale of property prior to a complete liquidation, the
subsequent sale of such property by the SHs who received the property in complete liquidation will
not prevent the corporation from being taxed on the sale. (important: General Utilities still around
during case)
Corp. taxed for gain on the sale of property where the corp. was completely liquidated and SHs
themselves sold the property
Taxed at the SH level NOW with the new structure and FMV basis in the distributed dividend upon
liquidation

8. US v. CUMBERLAND PUBLIC SERVICE CO. (SCOTUS 1950) Pg. 326: Same as above, but the deal
was never done through the corp.
HOLDING: Where the SHs rather than the corp. negotiated a sale of corporate assets, no gain is
recognized by the corp. on liquidating distributions of such assets to SH (focus on timing of deal, as in,
in Court Holding, there was a deal, and then a subsequent deal to decide to liquidate, in Cumberland,
there was proposals but not set deal, and the initial deal was to liquidate and there was no other deal.)
Nonrecognition of liquidating distributions to SH where buyer wanted t purchase assets and not stock
of the corp. and where buyer agreed to purchase the assets from the SHs
i. Buyer made deal with SH, rather than with corp.
SO because the SHs/Purchasers negotiated, Corp. recognizes no gain on the liquidating distribution of
assets -CHECK
9. Subsequent response: 1986 appeal of the General Utilities doctrine and gain recognition is required at the
corporate level for all asset sales, including after the liquidation plan adoption. Code 336.
10. Limitations on Corporate Loss Recognition
p.331 Loss can be recognized (sometimes). 336(a).
Cf., 311 no loss can be recognized when a corporation distribution is not in liquidation.
Certain losses are allowed even though the 267 loss limitation may apply to transfers of loss
property between related persons.
Double loss may be permitted (corporation and shareholder levels) after a 351 dropdown of loss
property. But, note: 362(e)(2).
Related Persons:
1) If the distribution is not prorata. 336(d)(1)(A)(i).
2) Where the property is acquired by the corporation within five years of distribution. An anti-stuffing rule.
336(d)(A) (ii).
All shareholders:
336(d)(2) losses with a tax avoidance motive. Then only those losses accruing after contribution of loss
property to the corporation are allowed to corp. on distribution.

LIQUIDATIONS OF A SUBSIDIARY
Generally we have two liquidation provisions:
331 and 336 -straight S Corp, C Corp liquidation

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 332 and 337 liqudation of a subsidiary - a situation when we have an 80 or more % SH (another C
Corporation-Parent) and the other SH who owns less than 80% and we liquidate the Subsidiary. So the
relationship between Parent and Subsidiary are governed by Sec 332 and 337 it is not elective, but
mandatory. The relationship between a minority SH and a Subsidiary is governed by Sec 331 and 336.
What happens when we liquidate a company under 332 and 337 subsidiary?
o Parent has no gain or loss. The Parent corp takes Subsidiarys basis on the asset, plus inherits
E&P in percentage of parent Corp percent of ownership and any other tax attributes. So any E&P
of Subsidiary becomes part of parent E&P. If it is a loss it reduces it, if it is positive E&P it
increases it.
o Subsidiary no gain is recognize by Subsidiary. It even OVERRIIDES 1245.(depreciation
recapture)
o Minority Sh no relief for them. Has to play under 331 and 336. Which means that any assets
that is distributed to them will creates a corporate tax and a SHs tax. No loss recognition to X on
332 liquidation per 336(d)(3).
o Loss assets Sometimes Parent loans money to their Subsidiary and the Subsidiary says -you
know instead of distributing loss asset down, lets distribute a loss asset to pay down the loss and
book the loss as a loss. You cant do this that is between related party and 267 applies here. I
CANNOT TAKE THE LOSS FOR THE DISTRIBUTION MADE TO A PARENT. Plus under
Sec 337 b(2)(A) there is no 337 relief is tax exempt organization owns any stock.
To get there you must have adopted a plan of liquidation, which means a Board of director of the company
(PARENT) decides to liquidate the Subsidiary. The Subsidiarys Board must adopt the plan of liquidation.
1. Parent -80% of total of Sub voting stock owned by corporate parent from adoption of plan until
liquidation. AND 80% of total value of Sub stock owned by corporate parent from adoption of plan until
liquidation
However, sometimes to get the benefit of 332 and 337 you have to have the PARENT CORP to buy some stock
if parent doesnt own 80% of stock.
Plan liquidation must be completed of no more then WITHIN 3 YEARS.
Impacts of qualifying as 332 subsidiary liquidation: - NOT ELECTIVE PROVISION. If you qualify
you are there
- No gain or loss recognized by parent corp per 332.
- Parent corp takes transferred basis in Subs assets per 334(b)(1).
- Parent corp inherits Subs E&P and other tax attributes (pro rata) per 381(a)(1).
- No gain or loss to Sub corp per 337, which overrides 1245, to extent distributions to 80-percent
distributee.
- No relief to minority shareholders: liquidation gain recognized and basis FMV.
- Loss assets to satisfy Parent corp debt not trigger loss per 337(b)(1).
- No 337 relief if tax exempt owns stock. 337(b)(2).

Qualification under 332

Requirements:
2. Plan of complete liquidation adopted.
3. 80% of total of Sub voting stock owned by corporate parent from adoption of plan until liquidation.
4. 80% of total value of Sub stock owned by corporate parent from adoption of plan until liquidation.
5. Timing either:
- One-shot liquidation within one taxable year.
- Plan provides competed within 3 years after year of first distribution.

The Corp in which the parent holds 80%interest is commonly referred to as subsiduary
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1. SECTION 332: No gain or loss shall be recognized on the receipt by a corporation of property distributed
in complete liquidation of another corporation

2. CONSEQUENCES TO THE SHAREHOLDERS (PARENT CORPORATIONS)

332 provides that parent corporation/SH recognizes no gain/loss on the receipt of property in
complete liquidation of an 80% (or more) subsidiary) if certain conditions are met.
REQUIREMENTS: To qualify, the subsidiary must distribute property to parent in complete
cancellation or redemption of its stock pursuant to a plan of liquidation that meets Control and Timing:
i. Control: The parent must own at least 80% of the total voting power and value of the subsidiary
from the date of adoption of the plan of complete liquidation an at all times thereafter until the
parent receives the final distribution
a. To accomplish this, the sub sometimes redeems the minority stock or the parent buys up that stock.
Some corps. Wish to violate this on purpose in order to recognize loss.
ii. Timing: One-shot liquidations qualify if all of the assets are distributed within one taxable year.
a. Otherwise the plan must provide that all assets will be transferred within 3 years after the close of
the taxable year in which the first distribution is made.
CORPORATION/SHAREHOLDER BASIS AND ATTRIBUTES: Corporation/SH takes a
transferred basis in the distributed property. 334(b)(1).
i. Corp./SH inherits the subsidiarys E&P and other tax attributes. 381(a).
MINORITY SHAREHOLDERS: Recognize gain/loss and the liquidating corp. is taxed on the share
distributed to the minority. 334(b).

3. GEORGE L. RIGGS v. COMMISSIONER (TC 1975) Pg. 338

HOLDING: Where a parent owns 80% of the voting stock and total value of the stock at the time the
formal plan of liquidation was adopted, the 332 ownership requirements are satisfied.
332 ownership requirements are satisfied where parent increased its ownership from 72% to 95%
through a repurchase and where formal SH approval of plan of complete liquidation was obtained
subsequent to the repurchase
i. SH agreed to sale of substantially all assets and directors approved complete liquidation plan prior
to the repurchase
The date of adoption of the plan of complete liquidation is when the resolution to liquidate is
actually adopted by the SH, not a proceedings date when BOD decides on a plan to redeem minority
SHs.
Mere general intention to liquidate is NOT the adoption of a liquidation plan
i. SH approval was formal adoption
Dont have to own 80% when preparations COMMENCE for liquidation

VII. TAXABLE CORPORATE ACQUISITIONS

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.
* In Acquisitions the first issue is PRICE
* Answer the fundamental question is the buyer going to sell STOCK or ASSET (going concern and goodwill
of the company)?
* What Liabilities is the seller of the business are these people are going to carry over after this deal is done?
- If the BUYER buy the ASSET (WHICH THE BUYER PREFER MORE THEN STOCK) (goodwill and all the
asset of the business) of the company and pay for e.g $ 30M Buyer take step up in basis, which mean that he
pay $30 M for the asset and has to assign it to the asset. Under Sec 1060 we have the priority system. See
below. For ex. First assign to Priority 1- cash, then to Priority2, 3, 4, 5, 6 and then 7, However, whent buyer
takes asset we have two takes one on corporate level and one on SHs level
If the BUYER pay $30 M for the STOCK, the buyer has NO Basis step up. ZERO. All the Buyer has is just $30
M basis in the stock he just bought, no asset. The old company remains and continues, we just change the
Shareholders. If buyer buy the stock, then we have only one level tax (capital gain on corporate level, that is
why the seller want to sell stock)

TAXABLE ACQUISIOTIN the Buyer comes in and decides that they going to BUY this company, we
are going to use cash or notes, but usually if it is taxable acquisition there are some notes involved.
Listen 11:30
ASSET SALE IMPACT
* Two taxes in a C Corp (corporate and shareholder level)
* Buyer get basis Step-up (For example, an investor purchasing shares at $2 and leaving them to an heir when
the shares are $15 means the shares receive a step-up in basis, making the cost basis for the shares the current
market price of $15. Any capital gains tax paid in the future will be based on the $15 cost basis, not on the
original purchase price of $2)
* Buyer can amortize goodwill and going concern over 15 years.
*Price allocation to asset 197 and 1060
*Pass-thru installment sales to SH not Corp

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 STOCK SALE IMPACT
*SH level tax
*Buyer take the new basis of the stock, but there is NO basis step-up see consequences below and in my
notes

338 election
Buyer and the seller usually for non tax reasons decide that the Buyer is going to buy the Sellers stock. 338 allows the
buyer to buy the STOCK, yet treat the transaction as an ASSET deal and get the basis Step-UP.
338 say this: the Buyer can buy the stock of old SH-s, old SH can take the money, pay the capital gain and right out the
sunset. But now they can qualify for new 1202 and can pay no taxes, they get the money from the buyer and get no tax
liability from the stock sale. IF the Buyer ELECT 338, he gets step up in basis, but then the OLD COMPANY MUST
recognize gain in the amount FMV (including goodwill) offset their basis in the asset RIGHT NOW.

Scenarios where 338 could make sense:

*old company has a huge NOL and want to offset it right now
* old company pay a lot of taxes in a foreign jurisdiction that has a low tax rates, so we can book the income of the old
company, pay a low tax on the gain recognize and then amortize this income over 15 years (SO GOOD FOR
INTERNATIONAL TRANSACTION)
*338 (h)(10) election when you essentially is selling the stock of a wholly owned subsidiary, however, it is treated as if,S
corp (parent (Seller) instead of sell stock of T corp (subsidiary) elect 338h)(10) and treat is as if you sold TS assets. One
level of tax

SEC 336 (e) if you have a subsidiary and want to sell its stock, you can treat it as an asset deal. The Buyer gets the basis
Step-up, the Seller (parent) reports no gain or loss, the company that been sold reports gain on the basis of the assets?????

How to structure acquision:

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A is the sole SH of Target Corp T and has a 200K basis in her T stock. Ts only asset is a parcel of
undeveloped land (Gainacre) with a FMV of 400K and a zero AB. Purchaser, Inc (P) wishes to acquire the
land for 400K cash. Consider 3 simple methods of structuring the acquisition:
1) Liquidation of T Followed by Sh Sale of Assets. T distributes Gainacre to A in complete liquidation
and then A sells Gainacre to P for 400K
2) Sale of T assets Followed by liquidation/ T sells Gainacre to P for 400K and then liquidates,
distributing the after tax proceeds of sale to A
3) Sale of T Stock. A sells her T stock to P for 400K and P either keeps T alive as a whole owned
subsidiary or causes T to liquidate and distribute Gainacre to P

Purchase Price Allocations 197, 1060

197 Anti Soft Dollar Rule: All intangible assets amortized over 15 years information bases,
customer lists, patient files, know-how, licenses, franchises, trade names, goodwill, going-concern value,
covenants not to compete.
1060 Priority Asset Allocation Rules:
Priority One: Cash or cash equivalents.
Priority Two: Highly-liquid securities, foreign currencies and CDs.
Priority Three: ARs, mortgages, credit card receivables.
Priority Four: Inventory and dealer property
Priority Five: Other tangible assets (equipment, real estate, etc.)
Priority Six: Intangibles except goodwill and going concern value.
Priority Seven: Goodwill and going concern value.
Note: Parties can agree on values per agreement, but not change priorities.

STOCK ACQUISITIONS

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1. In a stock acquisition P buys T stock from Ts shareholders. The shareholders recognize gain/loss on the sale
(Amount Realized Adjusted Basis) under 61(a)(3) and 1001; and P takes the cost basis in T stock under
1012.

2. KIMBELL v. COMMISSIONER (TC 1950) Pg. 358

TPs mill burns down (which had AB of $20K) and gets insurance proceeds of $120K. Buys Whaley,
Inc. stock from $120K insurance proceeds and $90K of own cash. TP liquidates Whaley 3 days after
acquiring it and uses the mill. TPs intent was always to get the asset (mill)
ISSUE: What is the TPs basis in the asset (for depreciation purposes)?
i. TP argues for 2 transactions, government argues it was 1
HOLDING: Courts have recognize that where the essential nature of a transaction is the acquisition of
property, it will be viewed as a whole, and closely related steps will not be separated either at the
insistence of the TP or the taxing authority
i. Petitioners basis in these assets, both depreciable and non-depreciable, is, therefore its cost, or
$110,721.71 ($18,921.90, the basis of petitioners assets destroyed by fire PLUS $91,799.84, the
amount expended over the insurance proceeds).
Court sides with the commissioner and looks at TPs intent; Court uses the step transaction doctrine to
indicate that this was one transaction to acquire/buy the asset = cost basis
i. Basis (110K) = (20K) Basis of Destroyed Asset + (90K) Insurance Proceeds

3. SECTION 338: Seeks to equate a purchase of corporation stock to a purchase of the corporations assets
. Concept: Buyer of 80% of more of stock of target corporation over 12 month period can elect to treat
as asset purchase. Basis step-up, all new corp attributes, and now corporate level tax.
Killer: Demise of general utility doctrine gutted any value of 338 election in most cases. Why take tax
hit now to get future benefit of basis step-up?
Two Survivors: 338 still works where:
- Corp has big NOL can than shelter corporate level tax triggered on deemed asset sale.
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 - Stock of sub is sold and gain on sub stock is more than gain on sub assets. Then, 338(h)(10)
election, coupled with 332 and 337, may produce win-win step-up with lower tax to parent corp.
Bottom Line: Demise of General Utilities triggers double tax on nearly all asset sales and stock sales
with 338 election. Hence, structure of choice now in most cases is straight stock sale with no 338 election.

GOALS: In general, the goals are to:

i. Ensure that the target and its shareholders bear the same tax burden on a sale of the targets stock
that they would have incurred on a sale of its assets followed by a complete liquidation;
ii. Provide the buyer with a cost basis in the assets of the target; AND
iii. Terminate the tax attributes of the target and start fresh, without regard to whether or not the target
is actually liquidated
ADSP AND AGUB
i. Aggregate Deemed Sales Price (ADSP): Used to estimate the sale price in the hypothetical 338
sale. 1.338(4)(a).
a. ADSP = Grossed Up Amount Realized on Sale + Liabilities of Old T
i. Grossed up AR on sale if less than 100% bought =
(AR / % of T Stock Value Attributable to Sale) Cost of Sale by T SHs. 1.338(4)(c).
ii. Adjusted Gross-Up Basis (AGUB): Used to calculate the new basis in T assets. 1.338(4)(d).
a. AGUB = Ps Grossed Up Basis in T Stock + Liabilities of New T. 1.338(5)(b)(1).
iii. AGUB is allocated in a similar fashion as under 1060

SALES OF S CORPORATION STOCK

- Generally all capital gain.

- No requirement, as in partnerships, to treat part of gain as ordinary based on nature of assets in
S Corporation.
- Still have capital gains look through on 28% collectibles.
- Buyers stock basis determined by cost.
- If Buyer is C corporation, S election terminates with sale. If no 338 election, only corporation
continues as C corp with old basis in assets and all built-in gain potential.

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 IX. ACQUISITIVE REORGANIZATIONS
TYPE A: STATUTORY MERGERS AND CONSOLIDATIONS

1. SEC 355 allows a corporation to make a tax-free distribution to its shareholders of stock and securities in
one or more controlled subsidiary.
The three type of corporate div isions are commonly known as
spin-offs- , - A spinoff is the creation of an independent company through the sale or distribution
of new shares of an existing business or division of a parent company. If the distributing corporations AB in
the stock of the controlled corporation is less than its FMV, no corporate level gain is recognized on the
distribution. Sec 311 is not applicable here,
split-offs - A split-off is a means of reorganizing an existing corporate structure in
which the stock of a business division, subsidiary or newly affiliated company is transferred to the
stockholders of the parent company in exchange for stock in the latter. Split-offs often occur when
the parent company wishes to draw a greater distinction between itself and the split-off business.
If the distributing corporations AB in the stock of the controlled corporation is less than its FMV, no
corporate level gain is recognized on the distribution. Sec 311 is not applicable here,

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 split -ups - A split-up is a corporate action in which a single company splits into two or
more separately run companies. If the distributing corporations AB in the stock of the controlled
corporation is less than its FMV, no corporate level gain is recognized on the distribution. Sec 311 is not
applicable here. Gain is recognized, however, in the rear case where appreciated boot is distributed in a Sec
355 transaction that is part of a reorganization. Gain must be recognized on a distribution of appreciated
property other than qualified property i.e other than stock or securities in the controlled corporation. Thus,
no gain will be recognized on a distribution of stock or securities of the controlled corporation even if the
receipient shareholder is taxd, but gain is recognized on a distribution of any other appreciated boot.
See my notes for more info.
FOR 355 to apply for:
Four Critical Tests:
- Business Purpose -For example: a) management is fighting, but you have to prove the
problem is legate; b) risk management:
- Trade or Business -both the distributing company and the control corporation must be engage
in an ACTIVE T/B that has a 5 year history. If one company was in business of selling cars for 5 years
and after distribution both companies are selling a car you are okay (case law). I can have functional,
geographic and vertical divisions, but I must say that after the division both companies are involved in
an active T/B and old company was there for at least 5 years before divorce. Both distributing and
controlled corps must be engaged in active trade or business after distribution that has a 5 year history.
Passive business activity wont work. Corp itself must perform active and substantial management and
operational functions. Vertical division of single integrated business permitted. Functional division is
permitted if active, even though all income from related source. Geographical divisions not controlling.
Regs. follow Lockwood case. Active business may not have been acquired within 5 yr period prior to
redemption in transaction where gain or loss recognized. Real estate no hope unless provide
substantial services. Control (80% voting and 80% all classes) of corp conducting business not acquired
by corporate distributee or distributing corp with 5 yr period in which gain or loss recognized. The
distributing corporation must distribute all the stock or securities of the controlled corporation that the
distributing corporation holds or an amount of stock sufficient to constitute control under the meaning of
Section 368(c).
- No Device- the stronger is the business purpose the easier is to satisfy the device
requirements
Safe zones (presumed innocent): PAGE 517 other book. Public companies are safe. But for
privately own companies it is valuable. LISTEN 65 minutes
- No E&P in distributing corp and controlled corp. If company has no E&P It couldnt pay
taxable dividend.
- Absent 355, distribution would qualify to cover death taxes and expenses per 303.
- Absent 355, distribution would qualify as exchange under 302(b).
2. Device Factors Pro rata distribution to shareholders; subsequent sale off of the distributing
stock stock of either corp; nature of assets in controlled corp (cash and investment assets).
3. Non-Device Factors - Strength of business purpose; publicly traded or widely held stock;
availability of 243 dividends deduction available to corporate distributee shareholders of distributing
corp.
https://www.irs.gov/irb/2016-31_IRB/ar11.html

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 - Continuity of Interests LISTEN 60 minutes After distribution, at least 50% of both
distributing and controlled corps must be owned by historic shareholders of distributing corp. If new
company is owned by new shareholders and the old company is owned by historic shareholders, I failed.
How long they should be there to be historic shareholders? The technically correct answer is 2 years. If I
have owned stock for two years I am considering the old SH for purposes of 355 sec. But there is the
other trick id I own my stock for 2 years, but less than 5 years I am considering the old SH, but since I
owe stock for less than 5 years, when the spin up occurs, we are going to allow the tax free treatment on
SH level, but we are not going to allow it on corporate level, Sec 311 will kick in. So, really you have 5
year for shareholders. Sec 355 (d).
Heavily overlaps Device requirement.
Historic shareholder is anyone who acquires distributing corp stock before plan to distribute. Some
claim includes any person who bought stock at least two years before distribution.
Post-Distribution activity (sell off of distributed stock) relevant and may kill if part of the overall
plan.

IMPACT IF 355 APPLIES TO DIVISIONS

Formation of Corp as preparatory step:
- Valid Type D Reorg.
- No gain or loss to parent corp per 361(a).
- Basis in stock received is basis of assets transferred. 358(a).
- Tack holding period to stock received. 1223(2).
- E&P of parent corp allocated to Sub based on relative FMV of assets.
Shareholder impact:
- No boot: No gain or loss on receipt of stock. Allocate stock in parent corp to stock of both parent
and sub based on relative FMV. Tacking of holding period.
- Boot: If received in spin-off, dividend per 301 to extent of distributing corp E&P. Beyond that
return of capital.
If received in redemption, then gain recognized to extent of boot. Test for ordinary gain with 302(b)
before and after standards, assuming no stock of distributing corp with surrendered for stock, but only for the
boot. If flunk 302(b) tests, then boot all ordinary income to extent of gain. - Boot basis is FMV and new holding
period.
Aggregate stock basis is old basis in stock of distributing stock, plus gain recognized, less boot received.
358. Then allocate basis among old stock and new stock.

Tax impact to DISTRIBUTING CORPORATION IF 355 applies

General Rule: No gain or loss to distributing corp (corporation that acquires stock from other
corporation(controlled) on distribution of controlled corp stock or securities. 361(c) and 355(c). If other
appreciated boot also distributed, must recognize gain on it.
Exception 1: Stock of controlled corp acquired by distributing corp within five yrs of distribution
considered boot. Must recognize gain on it. 355(c)(2)(A)
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 Exception 2: If after distribution 50% or more of interest in either distributing or controlled corp owned
by persons who acquired by purchase within 5 year period, then stock distributed is disqualified stock in
disqualifying distribution per 355(d). Distributing corp must recognize gain. Distributee shareholder
not impacted. Purchase exists if no carry-over basis.
Exception 3: Gain recognized as if taxable sale if pursuant to plan 50% or more of stock of distributing or
controlled corp acquired by non-historic shareholders within 4 yr period starting 2 yrs before distribution.
355(e). Anti-Morris trust provision to prevent tax-free dumping of unwanted assets in connection with tax-free
reorgs.

2. TYPE A REORGANIZATIONS - 368(A)(1)(A): A statutory merger or consolidation under State law.

Unless a transaction fits within one of the seven categories listed in paragraph (A) through (G) it simply is
not a corporate reorganization.
MERGER: Under a typical merger, Ts assets and liabilities are transferred to the Acquiring corp.
and the Target dissolves by operation of law.
i. Ts shareholders receive consideration specified in a formal agreement (cash, stock/debt of
acquiring corp.)
CONSOLIDATION: Involves transfer of assets and liabilities of two corporations to a newly created
entity, followed by dissolution of the transferring corps.; shareholders of transferors become
shareholders of the new entity

3. TYPE A REQUIREMENTS
(1) ACQUISITIVE TRANSACTION: To qualify as a Type A reorganization, a merger must be an
acquisitive rather than a divisive transaction
i. Acquisitive: The result of the transaction must be that one corporation acquires the assets of another
(target) corporation by operation of law AND the target must cease to exist
ii. Divisive: One in which a corporations assets are divided among two or more corporations
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 (2) CONTINUITY OF PROPRIETARY INTEREST: Courts are looking to see if Target
shareholders will also become Purchasers shareholders
(3) CONTINUITY OF BUSINESS ENTERPRISE

4. CONTINUITY OF PROPRIETARY INTEREST: QUANTITY AND QUALITY

RULE: The amount of interest retained by Target shareholders in new corporation should be AT
LEAST 38%-50%. 1.368-1(e); Southwest
i. FORMULA: Amount retained = FMV of Target SHs Stock in New Corp. / Total Consideration
Paid by Purchaser
ii. Any Class of Stock: Provides the requisite continuity. Rev. Rul. 66-224.
iii. Boot: Other consideration, such as cash, notes, assumption of liabilities fail to meet the test and are
treated as boot so they must recognize gain. Rev. Rul. 66-224.
iv. Valuation/Measuring Date: The P shares are valued on the day immediately preceding the day on
which the contract became binding. 1.368-1(e)(2).
a. Thus, the fall of P shares, post contract date is irrelevant
NONQUALIFIED PREFERRED STOCK: Defined in 351(g) is also treated as boot because it
feels like secured debt. 356.
i. It is a stock that the P corporation or a related entity has to redeem
DROP DOWN: After the merge P could do a drop down transfer to a subsidiary as long as it retains
80% control under 368(c). 1.368-2(f).
SOUTHWEST NATURAL GAS CO. v. COMMISSIONER (5th Cir. 1951) Pg. 399
i. Merger of Peoples Gas into Southwest. Southwest paid cash, bonds, and stock
ii. TP says that a state law merger occurred and it did
iii. HOLDING: The 1% consideration to the shareholders representing a continuing interest in the
resulting enterprise was not a sufficient continuity of interest to justify reorganization treatment
iv. 16.4 percent of the common stock referred to was represented by 111,850 shares having a market
value of $5592.50, or five cents per share, and represented the continuing proprietary interest of the
participating shareholders in the enterprise, this was less than 1% of the consideration paid by
the acquirer
REVENUE RULING 66-224 (1966) Pg. 401
i. HOLDING: As long as some historic shareholders retain a 40% continuity interest the COI
requirement is met. Not all former Target shareholders have to remain shareholders for the
continuity of interest to be met, some can cash out.
ii. X merged under state law into Y Corp. Shareholders A & B received cash for their respective 25%
interests. Shareholders C & D received stock for their respective 25% interest
iii. COI was satisfied (50% still continued)
a. Alternative option would have been to pay ALL SHs half cash and half stock. Same result.

5. CONTINUITY BY HISTORIC TARGET SHAREHOLDERS

J.E. SEAGRAM CORP. v. COMMISSIONER (TC 1995) Pg. 404
i. Competing tender offers for Conoco between Seagram and DuPont. Neither gets 50%. DuPont
acquires remaining Conoco shares for DuPont stock (including the Seagram shares purchased
previously for cash). Seagram claims a loss but IRS is successful in asserting this was a
reorganization (i.e. continuity of interest did exist).
ii. Basically the merged corp. is composed of 54% DuPont shares and 46% Cash
iii. Continuity by historic T shareholders: Prior law required the court to look at all pre-tender offer
(historic) SHs and if more than 80% of historic SHs sell for cash then no continuity of interest

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 iv. HOLDING: The Court here is not looking to the original Conoco SHs, but to ALL of the SHs at
the end of the plan (when DuPont did acquire 54% of Conoco for its D stock), 32% of which came
from Seagram SH of Target Conoco
a. Too difficult to find historic SHs of public companies

6. POST-ACQUISITION CONTINUITY: Relates to the amount of time that the Target shareholders must
hold their stock in the acquiring corporation
The IRS does not take into consideration subsequent dispositions of stock by ex-Target SHs even if the
dispositions were pursuant to a pre-existing binding contract. 1.368-1(c)(1)(i).
CANNOT SELL TO P OR PS AFFILIATES: If the ex-Target SHs sell their P stock to P or Ps
affiliates, the continuity requirement will NOT be satisfied. 1.368-1(e)(1)(i).
i. Unless it is an open-market repurchase plan (open to all SHs) by P
REVENUE RULING 99-58 (1999) Pg. 410
i. T merges into P (public corp.). T SHs receive 50% new issued stock of P and 50% cash
ii. Later P opens a program to purchase P shares in the open market. Former T SHs and other SHs of P
are welcome to sell their shares. (Basically, this potentially lowers former T SHs ownership below
50%)
iii. Ps intention to repurchase was announced prior to the T merger, but the repurchase program was
not a matter negotiated with T or the T SHs.
iv. HOLDING: Under the facts set forth above, COI is satisfied. There was not an understanding
between the T SHs and P that the T SHs ownership of the P shares would be transitory. Further,
because of the mechanics of an open-market repurchase, the repurchase program does not favor
participation by the former T shareholders.

7. CONTINUITY OF BUSINESS ENTERPRISE

RULE: Continuity of Business Enterprise Doctrine does not require a continuity of the same business,
only that a business is continued. Requires P to either continue Ts historic business OR to use a
significant portion of Ts historic business assets in a business. 1.368-1(d)(1).
BENTSEN v. PHINNEY (1961) Pg. 411: Rio Development merges along with 2 other land
development companies into a new life insurance company. The life insurance company disposes of
the historic business assets and reinvest the proceeds into a life insurance business. Shareholders
received 50% stock in insurance company and 50% cash. Type of business carried on by the survivor
entity was the insurance business (Acquirer).
i. HOLDING: COBE satisfied. Under the Continuity of Business Enterprise Doctrine all that is
required is that there must be continuity of a business activity, such activity need NOT be similar
in kind/identity to Ts former business
REVENUE RULING 81-25 (1981) Pg. 414
i. HOLDING: Acquirer Corp. does not need to continue its own business or assets to fulfill COBE
doctrine
a. ONLY T has to meet the doctrine
ii. Continuity was satisfied where a Transferee corp.:
a. Sold its assets (for sale proceeds) and discontinued its operations,
b. Then acquired the assets of another T corp. in exchange for its voting stock,
c. And used the sales proceeds to expand the business formerly conducted by the acquired corp.

TYPE B: ACQUISITIONS OF STOCK SOLELY FOR VOTING STOCK

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1. TYPE B REORGANIZATION - 368(a)(1)(B): The acquisition by one corporation, in exchange solely
for all or a part of its voting stock (or in exchange solely for all or part of the voting stock of a corporation
which is in control of the acquiring corporation), of stock of another corporation if, immediately after the
acquisition, the acquiring corporation has control of such other corporation (whether or not such acquiring
corporation had control immediately before the acquisition)
Ps acquisition of T stock solely in exchange for P voting stock (or the voting stock of Ps parent)
provided that P emerges with control of T.
REQUIREMENTS:
i. Solely for P Voting Stock
ii. Control of T by P

2. CONTROL: Defined to mean 80% of total combined voting power and 80% of total number of shares
of Ts nonvoting stock. 1.368(1)(f)(2)(i).
When the smoke clears, T remains a controlled subsidiary of P

3. SOLELY FOR P VOTING STOCK: P voting stock is the only permissible consideration in a Type B.
P VOTING STOCK: Has to include an unconditional right to vote on regular corporate decisoons.
1.301-3(a).
i. Class of stock is immaterial as long as it has voting rights
ii. If non-qualfied preferred with coting rights (which gives P or its related party right to redeem ex-T
SHs defined in 351(g)) is transferred, it will qualify as a Type B, however the SHs receiving such
stock will be taxed. 356(e).
iii. The use of an insignificant amount of non-voting stock, debt, or cash will disqualify the B-
reorganization
a. There can be no boot in a B. Chapman v. Commissioner.
EXCEPTIONS
i. SOME CASH ALLOWED: IRS allows an acquiring corporation to issue cash in lieu of fractional
amount of shares. Mills.
ii. EXPENSES: Acquiring corporation is allowed to pay for T Corps expenses relating to the
reorganization (legal, registration, accounting, administrative fees
a. However, payment of these fees for Ts shareholders is forbidden boot. Rev. Rul. 73-54.

4. BUYING OUT DISSENTING SHAREHOLDERS

P/Acquirer cannot buy Target dissenter shareholders shares for cash because that would violate the
solely for voting stock requirement.
However, the IRS allows for Target to redeem the dissenting shares (who want cash, which doesnt
meet Type B) prior to a valid Type B, provided that the cash does not come from P/Acquirer and
continuity of interest test is still met. Rev. Rul. 55-440.

5. DROP DOWN: A B reorganization is NOT disqualified if P transfers all or part of T stock to Ps controlled
subsidiary. 368(a)(2)(C).

6. CREEPING ACQUISITIONS: IRS allows for creeping B reorganization, however all prior acquisitions
must be solely for voting stock (no boot of any kind) or the boot must be old and cold. P corp. must
emerge with 80% control under 368(c).
Old and Cold: Regulations assume that transactions within a 12-month period are related, but NOT if
they are separated by very long intervals (e.g., 16 years). 1.368-2(c).
i. 12 months definitely not enough; 16 years definitely enough; 5 years is probably enough

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7. CONTINGENT CONSIDERATION: The acquiring corp. may issue a specified amount of stock and
securities and agree to issue additional shares under specified contingencies
WILL NOT DISQULAIFY TYPE B IF:
i. ONLY stock is issued (pursuant to contingency),
ii. Within 5 years after the Type B,
iii. For a valid business reason, AND
iv. At least 50% must be issued in initial distribution

TYPE C: ACQUISITIONS OF ASSETS FOR VOTING STOCK

1. TYPE C REORGANIZATION - 368(a)(1)(C): The acquisition by one corporation, in exchange solely

for all or part of its voting stock (or in exchange for all or a part of the voting stock of a corporation which
is in control of the acquiring corporation), of substantially all of the properties of another corporation, but
in determining whether the exchange is solely for stock the assumption by the acquiring corporation of a
liability of the other shall be disregarded.
Acquisition by P of substantially all assets of T in exchange solely for P voting stock
Unlike B because this is Assets for Stock (not Stock for Stock)
VOTING STOCK: Means the same as it does in Type B
DROP DOWNS: are allowed. 368(a)(2)(C).

2. SOLELY FOR STOCK: Solely is NOT the same as in Type B. 2 IMPORTANT EXCEPTIONS:
1. Liability Assumption (or taking encumbered property) by P is NOT disqualifying boot. 368(a)(1)
(C).
i. So, P can assume any amount of liabilities (if it pays no other boot) without failing solely
requirement)
2. Boot Relaxation Rule: Permits the Acquiring corp. to use up to 20% boot. 368(a)(2)(B).
i. However, for this purpose, if P transfers boot AND assumes liabilities, then assumption of
liabilities is considered cash. 368(a)(2)(B). (example on pg. 420)

3. SUBSTANTIALLY ALL ASSETS/PROPERTIES OF T: Could be met by fulfilling one of the following:

1. QUANTITATIVE TESTS: 90% of FMV of net assets and 70% of FMV of gross assets
i. Payments to dissenting SHs before reorganization will be considered assets held by T prior to
reorganization
2. QUALITATIVE TEST: Transfer of all operating assets (even when falling outside of the 90/70
test) meets the substantially all requirement. Rev. Rul. 57-518.
HISTORIC ASSETS: Requirement can also be met when T sells 50% of its historic assets to
unrelated parties for cash. Then T transfers all of its assets, including the cash to A
i. Main factor is that the transaction is not divisive, because the cash proceeds from the asset sale
were not retained by the target or its shareholders

4. LIQUIDATION REQUIREMENT: T has to liquidate and distribute the received securities to its SHs to
receive C Reorganization treatment. 368(a)(2)(G).

5. CREEPING ACQUISITIONS: Allowed in C Reorganizations. 1.368-2(d)(4)(i).

BOOT: Money or other boot distributed to (1) T SHs (other than P, who becomes a SH); to Ts
creditors; and (2) liabilities of T assumed by P (3) and any money/boot P gives to T or T SHs for stock;
i. May not exceed 20% of the value (FMV assets liabilities) of all of Ts properties. 1.368-2(d)(4)
(i).
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 ii. But, any such boot received from P that is old and cold is NOT boot and does NOT count
towards the 20%

6. REVENUE RULING 67-274 (1967) Pg. 422

Y acquired all of the outstanding stock of X from the X SHs in exchange solely for voting stock of Y.
Thereafter X was completely liquidated as part of the same plan and all of its assets were transferred to
Y which assumed all of the liabilities of X. Y continued to conduct the business previously conducted
by X. The former shareholders of X continued to hold 16% of the FMV of all the outstanding stock of
Y.
ISSUE: Whether the transaction qualifies as a B or C reorganization.
HOLDING: IRS decides that the steps (used step transaction doctrine) were all part of the same plan
and the steps may not be considered independently. Therefore, this is a C reorganization.
i. The substance of the transaction is an acquisition of assets

TRIANGULAR REORGANIZATIONS

1. OVERVIEW
The three basic types of reorganizations offer limited flexibility if the acquiring corporation desires to
operate the target as a wholly owned subsidiary
Acquirer may want to keep all the advantages of a C reorganization, but also get a clean ownership,
that is the T SHs hold shares in the P (the holding company) rather than in the Sub (which is the
operating company) and thus do not have a say in new Sub
ISSUES WITH OTHER FORMS
i. P responsible for T hidden liabilities
ii. T SHs do not accept Ps shares
iii. T SH appraisal rights
iv. Also, in B Type, P may want to sue non-voting shares
DROP DOWN: P can drop the stock/assets acquired in A/B/C into a subsidiary. 368(a)(2)(C).
i. Still does not solve hidden liability problem or SH approval
TRIANGULAR B AND C REORGANIZATIONS: Parentheticals in 368(a)(1)(B)/(C) allow for
triangular mergers
i. Triangular: Subsidiary is created with P stock. P stock is later used to acquire T stock (B) or assets
(C)

2. FORWARD TRIANGULAR MERGERS - 368(a)(2)(D): [Target disappears; Subsidiary survives.]

Benefit is that it gives a free pass on remote continuity, since P will not own T directly, but own it through
the S acquirer, thus P is never exposed to Ts liabilities
FORM: S acquires T in a statutory merger, using P stock as consideration. PROVIDED THAT:
i. S acquires substantially all (as defined in C 90% gross or 70% net) of Ts properties
ii. No stock of S is used in the transaction, AND
iii. The transaction would have qualified under Type A if T merged directly into P. 368(a)(2)(D).
a. Basically, just need to pass the COI Doctrine
BOOT: As a result of the continuity of interest, T SHs must receive at least 50% (could be as low as
38%) of P stock (voting or nonvoting), thus up to 50% (maybe 62%) could be Boot
i. Any T SH who receives boot must recognize; others (who get solely stock) do not recognize

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3. REVERSE TRIANGULAR MERGERS - 368(a)(2)(E): [Target survives, Subsidiary disappears.] P does
not want to dissolve T because of state law rights and certain agreements it has. P cant use a Type B
because of solely for stock requirement. P creates S with P voting stock, then S has statutory merger (Type
A) with T under an agreement that provides T SHs will receive P stock in return.
FORM: P creates S, contributing P voting stock. S merges into T under an agreement providing T SHs
will receive P stock (and maybe other stuff) in exchange for their T stock
i. Can also use an existing subsidiary
REQUIREMENTS:
i. 1. Otherwise qualifies as a Type A merger, AND
a. This requires that the transaction must pass the COI doctrine
ii. 2. Surviving corp. (T) has to have substantially all assets of BOTH corps. (T) and (S); AND
a. Substantially all assets as defined in Type C (90% gross/70% net)
iii. 3. Former T SHs have to exchange T stock constituting control (80%) for P voting stock
a. Control is the same as in Type B; 80% of voting and number of shares
BOOT: Only 80% of the T stock must be acquired for P voting stock so the rest up to 20% could be
boot or not acquired if acquiring corp. is willing to deal with minority SHs

X. CORPORATE DIVISIONS
OVERVIEW

1. TYPES OF CORPORATE DIVISIONS

Reorganization a transfer by a corporation of all or part of its assets to another corporation if immediately
after transfer the transferor or its stockholders or both are in control of the corporation to which the assets
are transferred.
SPIN-OFF (EXISTING SUBSIDIARY): Old corporation creates a new corporation and transfers a
part of its business into that entity, distributing the stock of new corporation pro-rata to its shareholders
i. Ex: Chicken ranch and winery business split, Poultry, Inc. formed and chicken ranch assets
transferred to it. Stock is distributed pro rata to SHs
ii. Corp. distributes shares of subsidiary as dividends
iii. When the dust settles, the same SHs own stock in the separate corps., but the proportion of
ownership is equal
iv. Not taxable, IF it were, 311(b) and 301(a) would apply
SPLIT-OFF (EXISTING SUBSIDIARY): Old corporation creates a new corporation and transfers
part of its business into that entity, distributing the stock of the new corporation to some of its
shareholders in complete redemption of their old corporation stock.
i. Ex: Poultry, Inc. formed, but instead of pro rata distribution, only certain shareholders exchange
their old stock for new.
ii. Used if different groups of SHs want to part ways, still 2 separate corporations
iii. A split-off resembles a redemption because the SHs have surrendered stock
SPLIT-UP: Old corporation terminates its corporate existence and divides up into 2 new corporations,
distributing the stock to its shareholders in exchange for all of the old corporate stock (could be pro-
rata or not [i.e., severing the relationships with some SHs])
i. Ex: Corp. forms Vineyard, Inc. and Poultry, Inc. because of a state regulation. Winery assets to V
and ranch assets to P. Assets distributed to SHs.
a. Resembles a complete liquidation because corp. has distributed all of its assets and dissolved

2. NON-TAX MOTIVES FOR CORPORATE DIVISIONS

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 DEVOTION TO SINGLE LINE OF BUSINESS: Want to separate the companies so each can
devote their attention to a single line of business
i. Can have pure play on a particular industry
ii. More narrowly focused company may have greater success
INCREASE MARKET RECOGNITION: Increase recognition of the value of a particular business
i. Executives believe that stock market analysts fail to appreciate the collective value of a corps
business
ACQUIRERS NEED TO PAY DOWN DEBT: Need to pay debt incurred in making an acquisition
by selling off some of the targets businesses or by shedding businesses that depress its value

3. GREGORY v. HELVERING (SCOTUS 1935) Pg. 459: Mrs. Gregory owns UM. UM owns appreciated
MS stock. Mrs. Gregory wants the stock, but does not want to be taxed. UM forms Averill by contributing
MS stocks to Averill. Averill is liquidated and distributes all its assets, namely the MS shares to Gregory.
IRS said that Gregory was liable for a tax as though UM had paid her a dividend consisting of the
amount realized from the sale of the MS shares
HOLDING: Taxpayer followed the law, but the court finds that in substance this was a dividend and
there was no business purpose, therefore, there will be gain on corporate level and as dividend at
SH level. Gregory v. Helvering, 293 U.S. 465 (1935), was a landmark decision by the United States Supreme
Court concerned with U.S. income tax law. The case is cited as part of the basis for two legal doctrines:
the business purpose doctrine and the doctrine of substance over form. The business purpose doctrine is
essentially that where a transaction has no substantial business purpose other than the avoidance or reduction of
Federal tax, the tax law will not regard the transaction. The doctrine of substance over formis essentially that,
for Federal tax purposes, a taxpayer is bound by the economic substance of a transaction where the economic
substance varies from its legal form.
i. A transfer means one that is made in pursuance of a plan of reorganization of corporate business;
and NOT transfer of assets by one corporation to another in pursuance of a plan having no relation
to the business of either, as plainly is the case here

4. SECTION 355: Provides tax-free status to corporate divisions with legitimate business purpose. Allows a
corporation to make a tax-free distribution to its shareholders of stock and securities in one or more
controlled subsidiaries. If a set of statutory and judicial requirements are met, neither the distributing
corporation nor its shareholders recognize gain or loss on the distribution. Must meet:
CONTROL: The distributing corporation or D must distribute to its shareholders (with respect to their
stock) or to security holders (in exchange for securities) the stock or securities of a corporation that D
controls immediately before the distribution (the control corporation or C) Defined in 368(c), which
requires ownership of 80% of the total combined voting power and 80% of the total number of shares
of all the other classes of stock, including non-voting preferred stock, immediately before the
distribution
DISTRIBUTON OF ALL STOCK OR SECURITIES: Must distribute all the stock or securities of
the controlled corporation that the distributing corporation holds or an amount of stock sufficient to
constitute control under the meaning of 368(c)
ACTIVE TRADE OR BUSINESS REQUIREMENT: According to 355(a)(1)(c), both the
distributing corp. and the controlled corp. MUST be engaged immediately after the distribution in
an actively conducted trade or business which has been conducted throughout the 5-year period
ending on the date of the distribution.
i. That business must also NOT have been acquired within the 5-year pre-distribution period in a
taxable transaction. Lockwood v. Commissioner.
NOT A DEVICE: The division must not be used principally as a device for the distribution of the
E&P of either distributor or controlled.
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 i. The mere fact that stock or securities of either corp. are sold after the distribution is NOT to be
considered as evidence of a device unless the sales were pursuant to a pre-arranged plan
BUSINESS PURPOSE AND CONTINUITY OF INTEREST: Non-recognition is available only if
the distribution is carried out for an independent corporate business purpose and the SHs prior to the
division maintain adequate continuity of interest in distributor and controlled, and the COI of
business enterprise is maintained after the distribution
BOOT: Stock rights or warrants, FMV of Controlled debt securities over amount of Distributor
securities surrendered is boot. 355(a)(3)(A). In addition, any stock of controlled corporation acquired
in a taxable transaction within the 5 years preceding the distribution which will come to know as hot
stock constitutes boot.

ACTIVE TRADE OR BUSINESS REQUIREMENT

1. A 355 non-taxable division must meet requirements (a) or (b), AND (c) AND (d):
(a) POST-DIVISION ACTIVE TB REQUIREMENT: After the division, the Distributing and
Controlled corps are engaged in an active conduct of trade or business. 355(b)(1)(A).
(b) PRE-DIVISION: Immediately before distribution C corp. owned ONLY stock or securities in C
Corp. 355(b)(1)(B).
i. This allowed newly created controlled corps to meet the active TB requirement
(c) 5 YEAR PRIOR DIVISION ACTIVE TB REQUIREMENT: D and C corps must have ben
engaged for 5-year period before the date of distribution in the same active trade or business as they
are continuing. 355(b)(2)(B).
i. However, Lockwood and Rev. Rul. 2000-38 and regulations indicate that C corp. can tack on the
period of Ds business operations IF Ds business is similar enough (active TB met even where
location/branch that is divided into a corp. that did not have a 5 year history on its own)
ii. Horizontal/Functional Divisions: Splitting off R&D from manufacturing is OK. 1.355-3(c).
iii. Vertical Divisions Examples in Regulations: Downtown department store D Corp. constructs a
new department store in the suburbs and in 3 years incorporates the new department store. OR if D
Corp. operated in several states and opened a store in a new state. Both OK. 1.355-3(c).
(d) TAXABLE ACQUISITION EXCEPTION: The active TB must not have been acquired in a
taxable transaction within a 5-year pre-distribution period. 355(b)(2)(C).
i. Taxable means the seller of the TV recognized gain/loss (and D takes cost basis)
ii. Active TB also not met if D corp. acquired 80% control (as in 368(c); 80% voting and number of
all shares) of TB in 5-year period prior to distribution in a taxable transaction. 355(b)(2)(D).
Treas. Reg 1.355-3(b)(3)(ii) - In particular, if a corporation engaged in the active conduct of one trade or
business during that five-year period purchased, created, or otherwise acquired another trade or business in the
same line of business, then the acquisition of that other business is ordinarily treated as an expansion of the
original business, all of which is treated as having been actively conducted during that five-year period, unless
that purchase, creation, or other acquisition effects a change of such a character as to constitute the acquisition
of a new or different business.

2. AFFILIATED CORPORATIONS: As defined under 1504(a) (80% or more of voting AND value) are
treated as one corporation for the purposes of the above tests. 355(b)(3).
Thus, a D or C will be treated as meeting the active business requirement IF any lower-tier affiliate in
its group is so engaged [it is possible to meet control under 368(c) but not 1504(a)]

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3. 5S ESATE v. COMMISSIONER (8th Cir. 1965) Pg. 465: Lockwood (D corp.) in Nebraska was
conducting manufacturing/selling potato machinery since 1946. In 1956 a branch in Maine was incorporated
to be the Controlled corp., to continue business activities in Maine. However, Maine control corp. only
started its business in 1953.
ISSUE: Whether the spin-off of part of the business conducted by Lockwood through the organization
of a new corp., Maine, was tax-free to the recipients of the stock of Maine
i. IRS argues that this does not meet the 5 year test
HOLDING: Qualifies under 355 because they carried on an active trade or business in the 5 years
previous to the distribution, although in different locations
COURTS TEST: Whether the D Corp., for 5 years prior to the distribution, had been actively
conducting the type of business now performed by the Controlled corp., without reference to the
geographic area
i. Court is concerned with OVERALL prior activity of Lockwood
ii. Here, Lockwood D Corp. was engaged in a business for 5 years in Nebraska; and Controlled corp.
(Maine) continued to conduct the same type of business
iii. Even though the Maine location has not actively conducted its business for 5 years, Lockwood has
conducted such a business in other geographic locations

4. REVENUE RULING 2003-38 (2003) Pg. 471: D has a retail shoe store business. In Year 8, D creates an
Internet web site and begins selling shoes at retail on the web site. In Year 10 (after 2 years), D transfers all
of the web sites assets and liabilities to corporation C, a newly formed, wholly owned subsidiary of D, and
distributes the stock of C pro rata to Ds shareholders
ISSUE: Whether the creation by a corp. engaged in the retail shoe store business of the Internet web
site on which the corp. will sell shoes at retail constitutes an expansion of the corporations business
rather than the acquisition of a new or different business under 1.355-3(b)(3)(ii)
HOLDING: The creation by D of the website does not constitute the acquisition of a new or different
business
i. 5 year requirement is satisfied because this was a permissible expansion
ii. Changes to the business during the 5 year period will be disregarded, provided that the changes
are not of such a character as to constitute the acquisition of a new or different business.
iii. C corp. conducted a very similar activity to D corp.; it used a lot of Ds know how and goodwill
(websites name same as the store)

5. REVENUE RULING 2007-42 (2007) Pg. 473

ISSUE: Under the facts, is a corporation (D) that owns a membership interest in a LLC classified as a
partnership for Federal income tax purposes engaged in the active conduct of a trade or business for
purposes of 355(b) of the Internal Revenue Code?
HOLDING: If D owns a significant interest (33% is enough) in an LLC, the D corp. is considered to
conduct the active TB of the LLC (if the LLC meets the active TB requirement itself).

JUDICIAL AND STATUTORY LIMITATIONS

1. BUSINESS PURPOSE: Must be a real and substantial non-Federal tax purpose germane to the
business of the distributing corporation. 1.355-2(b).
THIS HAS INCLUDED: Compliance with antitrust and other regulations; resolution of SH disputes;
to permit SHs to pursue separate businesses; increase in aggregate trading stock price; fit and focus
BAD FAMILY BLOOD: Separating a family farm business into 2 corporations, each owned by one
sibling (who disagreed with each other) has business purpose. Rev. Rul. 2003-52.

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 REDUCTION OF STATE TAXES: Reduction of state and local taxed can be a corporate business
purpose, UNLESS the reduction of Federal tax outweighs the local. Rev. Rul. 76-186.
BUSINESS PURPOSE DOES NOT EXIST if the same objective could be made through a non-
taxable transaction that does not require distribution of stock (e.g. drop down into a new subsidiary)
LATER SUCCESS OF MEETING THE STATED PURPOSE IS IRRELEVANT

2. CONTINUITY OF INTEREST: Shareholders who historically owned an interest in the enterprise prior to
a corporate division must emerge to won, in aggregate, an amount of stock that satisfies the continuity
of interest in each of the modified corporate forms post-division. 1.355-2(c)(1).
50% is enough for COI
HISTORIC SHAREHOLDERS: SH acquiring stock prior to the time that the distributing corp.
decided to engage in a division OR if acquisition of stock by SH was more than 32 years prior to
distribution
POST-DISTRIBUTION: SHs of the D Corp. must also maintain COI after the distribution, however
an unanticipated sale should not be a problem

3. THE DEVICE LIMITATION: A corporate division may not be used principally as a device for the
distribution of the Earnings and Profits. 355(a)(1)(B).
TRANSACTIONS ORDINARILY NOT A DEVICE:
i. The distributing and controlled corps do not have accumulated or current E&P as of the date of
distribution (taking into account that the distribution may create E&P)
ii. The distribution would otherwise qualify as a redemption to pay death taxes under 303
iii. The distribution would otherwise qualify, with respect to each distributee SH, as an exchange
redemption under 302(a)
Page 494

DISQUALIFIED INVESTMENT CORPORATIONS

i. 355(g) seeks to prevent the following transaction: I Corp owns an appreciated 30% interest in D
corp and wishes to get tax-free cash. D transfers a small five year TB along with cash to a new C
corp, in exchange for C stock. D then redeems Is D stock by distributing Ds C stock to I in
exchange for I interest in D. I then liquidates C and attempts to treat the transaction as tax-free
under 332.

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 ii. However, a distribution does not qualify as tax-free if immediately after the transaction (1) either
the D or C corp. is a disqualified investment corporation, and (2) any person holds 50% or more
interest (voting and value) in any disqualified investment corp. that the person did not hold
immediately before the transaction. 355(g)(2)(A).
a. Disqualified Investment Corporation: Is one if the FMV of its investment assets is 2/3 or more
of the FMV of ALL of its assets. 355(g)(2)(A).
i. The 2/3 hard standard presents a planning opportunity for split-offs that have less than 2/3
of tainted investment assets

TAX TREATMENT OF PARTIES TO A CORPORATE DIVISION

1. DIVISION PRECEDED BY FORMATION OF A NEW CORPORATION

If one or more corporations are formed as a preparatory step to a qualifying corporate division, the
formation of a new subsidiary is a D reorganization. 368(a)(1)(D).
Tax Consequences to D and C corps:
i. Corp P: (or D/Distributing company) doesnt recognize gain/loss on transfer of assets. 361(a).
a. Basis: Corp. P/D takes an exchanged basis in the new S stock it receives. 358.
b. Tacked holding period under 1223(1)
ii. Corp. S: (or C/Controlled) does not recognize gain/loss on issuance of stock. 1032(a).
a. Basis: Take transferred basis in assets. 362(b).
b. Tacked holding period under 1223(2)

2. CONSEQUENCES TO SHAREHOLDERS AND SECURITY HOLDERS

RECOGNITION: Shareholders do not recognize gain/loss. 355(a)(1).
BASIS: The shareholders aggregate basis is allocated between the distributing and controlled
corporations in proportion to their relative FMV. 358(b)/(c).
i. Tacked holding period under 1223(2)
TREATMENT OF BOOT:
i. Boot: Includes cash, property (other than stock/securities of C), D securities with excess principal,
and hot stock. 356. And stock of the controlled corp. is acquired within 5 years of distribution.
355(a)(3).
ii. Spin-Off: The boot is treated as a distribution under 301 (dividend to the extent of distributing
corps E&P and the balance is a return of capital). 356(b).
iii. Split-Off and Split-Up: SH recognizes any realized gain to the extent of boot received. 356(a)
(1).
a. Basis: covered by 358 (New Basis = Exchanged Basis + Gain Cash FMV of Boot)
i. Is allocated among the 2 resulting corps. In proportion to the FMV. 358(b)(2).
b. Gain: characterized same as under acquisitive reorganizations; if the exchange has the effect of
the distribution of a dividend; that is, the gain recognized is treated as a dividend to the extent of
SHs ratable share of accumulated E&P of the D corp.. 356(a)(2).
REVENUE RULING 93-62 (1993) Pg. 500

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 i. ISSUE: Whether gain recognized on the receipt of cash in an exchange of stock that otherwise
qualifies under section 355 of the IRC is treated as a dividend distribution under section 356(a)(2)
ii. HOLDING: In an exchange of stock that otherwise qualifies under 355 of the Code, whether the
payment of boot is treated as a dividend distribution under 356(a)(2) is determined prior to the
exchange. This determination is made by treating the recipient shareholder as if the shareholder had
retained the distributing corporation stock actually exchanged for controlled corporation stock and
received the boot in exchange for distributing corporation stock equal in value to the boot
iii. 302 is applied BEFORE the exchange
iv. Recipient SH is treated as if the SH had retained the D stock (actually exchanged for C stock) and
received the boot in exchange for D stock equal to FMV of boot
v. Under the facts presented here before the exchange, A owned 400 of 1000 shares, or 40% of the
outstanding Distributing stock. If A has surrendered only the 200 shares for which A received boot,
A would still hold 200 of 800 shares or 25% of the Distributing stock outstanding after the
exchange. This 25% stock interest would represent 62,5% of As pre-exchange stock interest in
Distributing. (my assumption, if 25% of 1000 = 250. So, 250 is 62,5% of 400 (pre-exchange stock
interest in Distributing.) Therefore, the deemed redemption would be treated as an exchange
because it qualifies as substantially disproportionate under Sec 302(b)(2) of the Code.

3. CONSEQUENCES TO THE DISTRIBUTING AND CONTROLLED CORPORATIONS

If a Sec 355 distribution is part of a reorganization plan i.e. where the distributing corporation first
transfers property to the controlled corporation no gain or loss is recognized if the property is contributed
solely in exchange for stock or securities of the controlled corporation.
IF DIVISION IS PRECEDED BY A D-REORGANIZATION - 361(c):
i. No Gain or Loss is recognized if the property is contributed solely for stock/securities of the C
corp.
ii. D corp. may recognize gain if the property transferred has liabilities assume greater than the
aggregate adjusted basis of the property transferred; OR if boot is otherwise received and not
distributed to SHs or creditors as part of the reorganization plan. 361(b).
iii. Distributing corp. does not recognize gain on distribution of qualified property (stock/debt of
controlled corp.). 361(c).
IF DIVISION IS NOT PRECEDED BY D-REORGANIZATION - 355(c):
i. No gain or loss is recognized in a 355 transaction
ii. 355(c) does NOT apply if D makes a distribution of disqualified property (any distribution of
stock/securities of a controlled C sub if immediately after the distribution, any person holds a 50%
interest that consist of disqualified stock) page 511

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 iii. Must recognize gain on appreciated boot property
SEC 355(d) creates a five-year statutory predestribution continuity of interest test. If violated, the test
required the distributing corporation to recognize gain on the distributing of stock or securities of a
subsidiary to a person who ends up with 50% or more of the stock of the subsidiary. Some typical
examples of the application of Sec 355(d) are illustrated by the following excerpt from the legislation
history:

DISPOSITIONS OF UNWANTED ASSETS IN CONJUNCTION WITH TAX-FREE

REORGANIZATIONS

1. COMMISSIONER v. MORRIS TRUST (1966)

Sub is spun-off and Parent is then acquired in a Type A reorganization
The Court allowed tax-free treatment (D-reorganization followed by 355 division and an A-
reorganization)
Issue of COI
Court allowed the transaction

2. SECTION 355(e)
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 Limits Morris Trust
Shareholders of the spun-off corporation must own more than 50% of the acquirer for the
transaction to qualify for tax-free
Leaves open the possibility of tax-free treatment if the transactions are not planned

XI. NONACQUISITIVE, NONDIVISIVE REORGANIZATIONS

TYPE E: RECAPITALIZATIONS

1. IN GENERAL: Recapitalization is a re-shuffling of a capital structure within the framework of an existing

corporation. Done as a condition for borrowing or to improve debt/equity ratio.
REVENE RULING 82-34:
i. The consideration of whether a transaction involved an otherwise taxable transfer of stock or assets
of one corporation to another corporation is not present in recapitalization because a recapitalization
involves only a single corporation
ii. Since 1 Same Corporation: Continuity of SH interest and Continuity of Business Enterprise are
not a requirement for a recapitalization to qualify as a reorganization under section 368(a)(1)(E).
CORPORATE BUSINESS PURPOSE IS NECESSARY: SH business purpose is acceptable
(substitutable for corporate business purpose) in closely held corporations as they are closely
intertwined
TYPES OF RECAPITALIZATIONS
i. Bonds Exchanged for Stock
ii. Bonds Exchanged for Bonds
iii. Stock Exchanged for Stock
iv. Stock Exchanged for Bonds

2. BONDS EXCHANGED FOR STOCK: If a corporation discharges outstanding bonds by issuing

preferred or common stock to the bondholders, the transaction qualifies a an E-Reorganization. 1.368-
2(e)(1).
BONDHOLDER SIDE: The bondholders do not recognize gain/loss under 354.
i. If stock received is attributable to the bonds accrued and untaxed interest, it is ordinary income.
354(a)(2)(B).
SHAREHOLDER BASIS: Basis of stock received will be determined under 358. The holding
period is tacked on under 1223(1).
i. When principal is in excess of old securities and accrued interest
a. 356 boot treatment
CORPORATION SIDE: Corporation does not recognize gain on issuance of stock. 1032
i. However, a debtor corporation is treated as satisfying bond with FMV of stock. 108(c)(8).
ii. It has to pay tax on COD (amount of bonds > FMV stock) unless it is insolvent/bankrupt (make
corresponding reduction in tax attributes under 108(a)(1)(B)

3. BONDS EXCHANGED FOR BONDS

The bondholder does not recognize gain/loss unless the bonds received are attributable to accrued
and untaxed interest (ordinary income). 354(a)(2)(B).
i. OR the principal amount of bonds received exceeds the principal amount of bonds surrendered
(356(a)/(d) boot treatment short/long term capital gain). 354(a)(2)(B).
Same other tax consequences as above.
On the corporate side the primary concern will be the discharge of indebtedness rules in 108
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4. STOCK EXCHANGED FOR STOCK
SHAREHOLDER SIDE: Preferred for common and common for preferred qualify for E-
Reorganization. 1.368-2(e)(2)-4
i. Common for common, preferred for preferred qualify for Nonrecognition under 1036
ii. Recognize Gain: to the extent of the boot received in the exchange. 354/356.
iii. Character of Gain: Is exchange of stock, unless transaction has effect of distribution of
dividend. 356(a).
iv. Basis: Basis in stock received determined under 358. Tacked holding period under 1223(1).
305/306 MIGHT APPLY: If certain conditions are met:
i. 305: Recapitalization will be a distribution if it increases a SHs interest in assets or E&P; or
where there are preferred dividend arrearages and the preferred SH increase his proportionate
interest in the transaction
ii. 306: If 306(c) applies, then the stock is treated as distribution of a dividends (ordinary rates)
a. If it is not common stock; no gain recognized under 354/356
b. And there is a plan for reorganization which has the effect substantially the same as stock dividend
i. If cash received instead of extra stock would be dividend, then it is 306 stock. 356(a)(2).
REVENUE RULING 84-114 (1984) Pg. 521: Corp. X has 420 voting common shareholders. SH A
has 120 shares and in an integrated transaction exchanges 15 voting common shares for cash and 15
for non-voting preferred (no conversion and pay substantially less dividends and liquidation rights than
30 voting common shares) Transaction qualifies as an E recapitalization.
i. ISSUE: When nonvoting preferred stock and cash are received in an integrated transaction by a SH
in exchange for voting common stock in a recapitalization described in 368(a)(1)(E) of the
Internal Revenue Code, does the receipt of the cash have the effect of the distribution of a dividend
within the meaning of 356(a)(2)
ii. Under 302 a redemption is an exchange if it is not essentially equivalent to a dividend
iii. There must be a meaningful reduction in a SHs proportionate interest to meet 302. Davis
(factors are SHs right to vote and exercise control to participate in E&P, and liquidate)
iv. HOLDING: The receipt of cash was not essentially equivalent to a dividend because there was
a meaningful reduction of SHs proportionate interest under 302
a. SH can no longer act in concert with one other SH in order to have majority control

5. STOCK EXCHANGED FOR BONDS

BAZLEY v. COMMISSIONER (SCOTUS 1947) Pg. 524
i. Corp. exchanges 1 common stock (60 par; 800 total shares) for 5 common stock (100 par) plus
bonds and debentures (400k and callable at any time. Corp. has ample E&P. Pro-rate distribution.
ii. Tax court found no legitimate business purpose and not a reorganization
a. Distribution of debentures was just a disguised dividend
iii. HOLDING: This is a taxable distribution because the callable bonds are essentially cash and
because in substance this was a taxable distribution of accumulated E&P. Not an E-reorganization
a. A reorganization which is merely a vehicle, however elaborate or elegant, for conveying
earnings from accumulations to the stockholders is not a reorganization under 368
STOCK FOR STOCK + BONDS: Exchange that is not pro-rate may still qualify as an E-
reorganization
a. SHs Gain: Is a dividends to the extent of the FMV of the binds received and the corporations
E&P. 356(a)(/(d)
i. The receipt of bonds may simply be treated as a 301 distribution. 1.301-1(1).

TYPE D: NONDIVISIVE TYPE D REORGANIZATIONS

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1. SECTION 368(a)(1)(D): Reorganization means a transfer by a corp. of all or part of its assets to another
corp. if immediately after the transfer the transferor, or one or more of its SHs (including SHs who were
SHs immediately before the transfer), or any combination thereof, is in control of the corp. to which the
assets are transferred; but only if, in pursuance of the plan, stock or securities of the corp. to which the
assets are transferred are distributed in a transaction which qualifies under section 354, 355, or 356

2. NONDIVISIVE: In divisive Type Ds, the assets are split. In nondivisive Type Ds substantially all assets
are transferred under 354(b)(1)
If a corp. is formed by transferor (of assets) as a preparation step to qualify as a corporate division, and
the transferor corp. controls (50% voting or value) the new subsidiary, the formation of a new
subsidiary is a D-reorganization under 368(a)(1)(D)
i. Transferor corp. must transfer substantially all of its assets to the controlled new subsidiary corp.
354(b).

3. SMOTHER v. UNITED STATES (5th Cir. 1981 Pg. 530

Dispute arises from the dissolution of one of the Smothers wholly owned business corporations. TPs
contend that the assets distributed to them by that corp. should be taxed at the capital gain rate
applicable to the liquidating corps. The IRS counters by characterizing the dissolution as part of a
reorganization, thereby rendering the TPs receipt of the distributed assets taxable at ordinary income
rates
SH liquidated IUS and sold all of its assets to TIL at FMV and claimed long-term capital gains
treatment
i. IUS sold assets worth 15% of its value to TIL. Stipulated that these assets were not necessary to
carry out trade or business
ii. IUS distributed the rest to SHs. IUS had sufficient E&P so ordinary rates would apply to
distribution. 301.
ISSUE: Whether the 15% of assets sold by IUS to TIL constitute substantially all assets
i. TP argues NO and requirements are NOT met
HOLDING: Substantially all assets should be interpreted as assets that are necessary to operate the
corps trade or business
i. This was in economic reality a reorganization with the substantially all exception and should be
recognized as a dividend
ii. Because IUS most important (necessary to operate) assets of reputation, sales staff, and managerial
services were transferred to TIL
iii. Also, the same enterprise was conducted by the same people

TYPE F: MERE CHANGE IN IDENTITY, FORM, OR PLACE OF ORGANIZATION

1. TYPE F: NY corporation merges into a Delaware corporation with the same shareholders to take advantage
of Delaware corporate law
Generally, present law requires a transferor corporations taxable year to be closed on the date of a
reorganization transfer and precludes a post-reorganization loss from being carried back to a taxable
year of the transferor
A transaction does not qualify as an F-reorg. unless there is no change in existing SHs or in the assets
of the corp. If dissenters owning less than 1% of the outstanding shares of the corp. fail to participate
in the transaction, it will not fail as an F-reorg. Rev. Rul. 96-29.

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 F-reorg. is treated as if there had been non change in the corp. and as if the reorganized corp. is the
same entity as the corp. that was in existence prior to the reorganization. Rev. Rul. 96-29.

2. REVENUE RULING 96-29 (1996) Pg. 543: F reorganization is different/better than a reorganization
because a step transaction is allowed in an F reorganization
Whether transactions below qualify as reorganizations under 368(a)(1)(F)
Situation 1: Corp. has 40% non-voting preferred SHs. Corp. makes a public offering (required under
state law) and creates and merges into a new corp. in a different state. New corp. then sold additional
shares and redeemed all non-voting preferred SHs
Situation 2: Corp. W holds subsidiary Y. Corp. W decides to acquire Z corp. and merge it into Y in
state M. Z SHs receive shares of Y corp.. Then W merges into N in state M and W SHs trade their
shares for same N shares.
ISSUE: Whether F-reorganization is disregarded when it is part of a plan that includes two
transactions/reorganizations
HOLDING: The change in form/identity/place of reorganization can be a step in an overall plan for
reorganization including another 368(a)(1) transaction
i. Ex: If C-reorg. and F-reorg. are undertaken under the same plan, the F-reorg. is not disregarded

XII. AFFILIATED CORPORATIONS

The Code treats related corporation for many purposes as a single economic unit. Thus is about taxation of
affiliated corporation (Affiliated companies are, in general, companies that are less than 50% owned by a parent
company; the parents are minority shareholders. More loosely, the term "affiliated companies" is sometimes
used to refer to companies that are related to each other in some way. For example, Bank of America has
numerous affiliated companies, including Banc of America, US Trust, Landsafe, Balboa and Merrill Lynch)
SEC 1561 -the basic purpose of Sec 1561 is to prevent business owners from obtaining multiple tax benefits by
subdividing their business among multiple corporations.
Sec 1561 targets three specific benefits:
1) the progressive tax rate structure provided by Sec 11(b)
2) the accumulated earnings credit provided by Sec 535
3) the $40K exemption amount used by corporations in calculating their alternative minimum taxable
income
EXAMPLE of the abuse that Sec 1561 is designed to prevent.

110
111
 Section 1561 prevents this result by providing that the benefit received by certain related groups or
corporation CANNOT exceed the benefit that the group would receive if it were a single corporation.
Accumulated earnings credit must be divided equally among the groups members unless the members
formally agree to a different allocation
Thus, if parts and services do not enter into a formal allocation plan, the amounts of income in each taxable
income bracket in Sec 11 (b) will be divided equally between them (to the extend each corporation has
taxable income), resulting in the same aggregating tax liability that they would have if they were a single
corporation

Sec 1561 applies only to the component member of a controlled group of corporations: - defined Sec 1563
(b) and controlled group is defined in Sec 1563(a)
Sec 1563 generally defines three principal types of controlled groups of corporations:
A parent-subsidiary controlled group
A brother-sister controlled group
A combined group
For more explanation see p 601 or my notes

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CONSOLIDATED RETURNS
Purposes why IRS decides to treat some closely held corporations as a single corporation (controlled group):
That means you have only one Sec 11(b) rate structure.
It will take only one 250K accumulated earnings credit
40 K Alternative minimum tax exemption amount

SECTION 531 Accumulated Earning Tax

Imposed upon closely held corporations (C Corp)
So if a C Corp unreasonably accumulate its earnings, that is generates earnings INSIDE the company and it
does NOT pay earnings OUT, then we are going to impose an additional PENALTY TAX on the company =
20% for not paying out dividends. That taxes accumulates every year (20% of that year income in addition to
regular tax). However, you get the rights as a company to accumulate 250k free bite (150k for professional
service organizations) with no questions ask. Any amount accumulated BEYOND 250K will be subject to
penalty tax UNLESS you can establish that you:
have a REASONABLE business need for retaining that money. In the MINUTES you can establish
reasonable business needs.
You pay reasonable dividends. It doesnt mean that you have to pay all the money, but to show that
every year we think about how much to pay and pay them dividends.
you want to be standard and deciding on why we are keeping the money. This why we think we need to
keep the money has to be specific, definite, and feasible within reasonable time.
Two Issues:
- Accumulate for reasonable needs of the business (The Ball Game)
- No tax avoidance purpose (Near Impossible Useless for planning)
2. As to reasonable needs:
- 250k free bite (150k for professional service organizations)
- Standard is specific, definite, and feasible within reasonable time.
- Start with asset side of balance sheet are there unnecessary assets?
- Directors resolutions should spell out needs.
3. Hot issues (good reason to accumulate) :
- Future anticipated needs
- New and expansion opportunities
- Working capital comfort zones
- Redemptions
- IP development
- Competition pressures

541 Personal Holding Company Status - 20% penalty tax

Implied on C Corp that holds primarily investment assets (stock, bonds, rental property). So you simply has
investment assets in that company and those assets paw up inside the C Corp and waiting for some SH to die
and the basis step up and then we liquidates the company. So the government cant get two taxes.
So the personal holding company (PHC) company (C Corp..) meets two Objective Tests:
- Ownership: 50% stock owned by five or fewer individuals. Attribution per 544 proportional for
corps, partnerships, estates and trusts and complete as to family (siblings, spouse, ancestors, descendants).
- Income: 60% of AOGI (adjusted gross ordinary income) is PHC income(interest, dividends,
royalties..).

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 2. AOGI (the Denominator) Gross income less capital and 1231 gains and adjustments for rents and oil,
gas and mineral royalties (only excess over depreciation, depletion, taxes, interest, rent).
3. PHC Income (the Numerator) Standard portfolio income (less capital and 1231 gains), specific talents
(movie star, athletic., and rents and royalties (subject to active exceptions and limitations).
4. Rental income: Active rental. If you have 60% of the income of the entity (AOGI) coming from those
sources your are PHC. Not PLC income if equal 50% or more of AOGI and non-rental PHC income
(net of dividends paid) is less than 10% of gross income.
If you become a PHC there are 2 solutions:
Pay out this PHC oncome as dividend

1. GENERALLY
SECTION 1501: allows affiliate group(defined in Sec 1504) of corporations to file consolidated tax
returns
PROS
i. Offset Parent income with Subsidiary loss
ii. Exclusion of distributions
CONS
i. Permanent election
ii. Extra/complex compliance

2. ELIGIBILITY - 1504(a):
AFFILIATED GROUP: One or more chains of includable corporations connected through stock
ownership to a common parent that is an includible corporation IF:
i. Common parent directly owns at least 80% of the total voting power AND the total value of stock
of at least one of the other includible corporations, AND
ii. Stock possessing at least 80% of the total voting power and total value of the stock of each
includible corporation (other than the common parent) is owned directly by one or more of the
other includible corporations.
Includable Corporation: Does NOT include S-corporations and foreign entities (and 6 others).
1504(b).
Cease to be Includable: If a corp. ceases to be a member, then cannot file as a member for 5 years
i. Subject to waiver under Re. Proc. 2006-1 CB 959
Sec 1504(a)(4) in determining whether an affiliated group of corporations exists this section provides
that nonvoting, nonconvertible stock which is limited and preferred as to dividend and has redemption
and liquidation rights which do not exceed the stocks price, except for a reasonable premium is
disregarded. This provision generally is favorable to taxpayers in that permits a corporation to raise
capital by issuing stock described in Sec 1504(a)(4) without making the corporation ineligible to join in
the filing of a consolidated return. Page 611
Even if two or more corporations constitute an affiliated group, the corporations must file separate
returns unless they affirmatively elect to exercise their privilege of filing a consolidated return. P 612

3. COMPUTATION OF TAXABLE INCOME

FIRST STEP in determining a groups consolidated taxable income is to determine the separate
taxable income (or loss) of each member. 1.1502-11(a)(1).
i. Make adjustments for intercompany transfers (e.g. sales/rent of prop., services, loans/licensing).
List of the most significant are on p 613 last paragraph. Plus see Treas. Reg. 1.1502-12(a), -12(b)
through (r)

114
 a. Matching Rule: Seller (related) corporation recognizes gain only when Buyer corp. resells to an
unrelated buyer and has a corresponding item. 1.1502-13(c)(2)(i).
b. Acceleration Rule: Sellers recognition is accelerated where it is not possible to apply the
matching rule (E.g. Parent sells Buyer (who is yet to resell the land). 1.1502-13(d).
ii. After several adjustments, the separate taxable incomes of the members are combined
Next step, the items of income and deduction that must be determined on a consolidated basis are
calculated in accordance with the regulations and then added to or subtracted from the combined
separate taxable incomes.
The resulting amount is the groups consolidated taxable income, which is subject to tax at the rates
specified in Sec 11. Subject to certain restrictions, the consolidated group is allowed credits against this
tax (and the other federal taxes to which it is subject), including the general business and foreign
credits. Treas. Reg. 1.1502-2, -3, -4
COMPUTATION OF SEPARATE TAXABLE INCOME p 614
INTERCOMPANY TRANSACTION is a transaction between corporations that are members of
the same consolidated group immediately after the transaction. 1.1502-13(b)(1). See example of the
intercompany transaction in my notes or below

The regulations governing intercompany transactions contain rules below that generally attempt to
approximate the results of a transaction between divisions of a single corporation. Terminology:
S selling member in a translation
B buying member
Ss items of income, gain, deduction or loss from an intercompany transaction are referred to as its
intercompany items
Bs tax items corresponding items
A recomputed corresponding item is the corresponding item that B would take into account if S and
B were divisions in a single corporation and the intercompany transaction were between those
divisions.

115
a. Matching Rule: Seller (related) corporation recognizes gain only when Buyer corp. resells to an
unrelated buyer and has a corresponding item. 1.1502-13(c)(2)(i).
b. Acceleration Rule: Sellers recognition is accelerated where it is not possible to apply the
matching rule (E.g. Parent sells Buyer (who is yet to resell the land). 1.1502-13(d).

116
INTERCOMPANY DISTRIBUTION: Cash distribution by subsidiary to a parent to which 301
applies. 1.1502-13(f).
ii. Intercompany distributions are excluded from GI, to the extent that reduces its basis in subsidiary
(negative adjustment) under 1.1502-32, 1.1502-13(f), but P will recognize upon sale of S
a. Excess loss account: Negative basis allowed. 1.1502-32. page 617 last paragraph
iii. Distribution of Appreciated Property: Gain/loss recognized under matching rule. 1.1502-13(f).
a. However, if instead of re-selling Parent distributes property to SH and thereby does not recognize
gain/loss = S loss (on initial distribution) is disallowed and never recognized. 1.1502-13(c).

117
 CONSOLIDATED ITEMS certain items of income and deductions are taken into account on the
consolidated basis and not allowed on separate basis p 618 1.1502-21, -22 ,-23.-24, -26
ALLOCATION OF TAX LIABILITY: For the purpose of determining each members E&P (which
is reduced by tax liability), 1552 provides 3 methods of allocation:
i. Method 1 Ratio: Each members liability to sum of individual members liabilities; individual
liabilities adjusted based upon above
BASIS: Ps stock basis increased by Ss taxable and tax exempt income and decreased by Ss taxable
loss, any noncapital, nondeductible expenses of S, and Ss distributions. 1.1502-32(b)(2).

METHOD 2
118
METHOD 3

119
STOCK BASIS ADJUSTMENTS - p 620

ACCUMULATED EARNINGS TAX

Code: Sec 531, 532
The accumulated earnings tax is a penalty imposed on a corporation formed or available of for the purpose of avoiding
the income tax with respect to its shareholders*** by permitting earnings and profits to accumulate instead of being
divided or distributed. He tax is levied at 20 percent on a C corporations accumulated taxable income, which is
generally defined as taxable income with certain adjustments (e.g. subtracting taxes and dividends paid and adding back
the dividends received deduction) to reflect the true dividend paying capacity of the corporation. (Sec 531, 535)
Sec 532 (b) exception from the tax
Two statutory presumptions assist in determining the presence of a tax avoidance purpose:
The fact that corporate earnings and profits are permitted to accumulate beyond the reasonable needs of the
business is determinative of a tax avoidance purpose unless the corporation proves the contrary by a
preponderance of the evidence
The corporation is a mere holding or investment company
Treas, Reg. 1.533-1(a)(2) - Evidence of purpose to avoid income tax. The existence or nonexistence of the purpose to
avoid income tax with respect to shareholders may be indicated by circumstances other than the conditions specified in
section 533. Whether or not such purpose was present depends upon the particular circumstances of each case. All
circumstances which might be construed as evidence of the purpose to avoid income tax with respect to shareholders
cannot be outlined, but among other things, the following will be considered:
Dealings between the corporation and its shareholders, such as withdrawals by the shareholders as personal loans
or the expenditure of funds by the corporation for the personal benefit of the shareholders,
(ii) The investment by the corporation of undistributed earnings in assets having no reasonable connection with
the business of the corporation (see 1.537-3), and
(iii) The extent to which the corporation has distributed its earnings and profits.
These factors are not conclusive, but the presence of shareholder loans, unrelated corporate investments and poor
dividend history tend to poison the atmosphere on the question of the proscribed tax avoidance purpose.
Donruss case critical inquiry is the reasonableness of the accumulation

Myrons Enterprises v US
Taxpayer: argue on appeal that they are entitled to a full refund
because all of the retained earnings in the years in question were required to meet the reasonable needs of their
business, and
(ii) because they proved by the preponderance of the evidence that they were not availed of to avoid taxes,
despite the contrary finding by the district court.
The Government argues, in response, that taxpayers were not even entitled to a partial refund--that the Commissioner's
initial determination of the reasonable needs of the business was correct and that taxpayers failed to prove lack of tax-
avoidance motivation.2
We conclude that the taxpayers are entitled to the full refund they seek. Therefore, we reverse and remand for such
necessary proceedings as are consistent with this opinion.
Section 537 of the Internal Revenue Code provides that the reasonable needs of a business, for purposes of determining
whether there has been an excess accumulation of earnings, include "the reasonably anticipated needs of the business."
Treas.REg. Sec. 1.537-1(b)(1) provides that to justify an accumulation of earnings on grounds of reasonably anticipated
business needs, a corporation must have "specific, definite, and feasible plans for the use of such accumulation" and must
not postpone execution of the plan "indefinitely."
26 CFR 1.537-2 - Grounds for accumulation of earnings and profits.
(b) Reasonable accumulation of earnings and profits. Although the following grounds are not exclusive, one or more of
such grounds, if supported by sufficient facts, may indicate that the earnings and profits of a corporation are being
accumulated for the reasonable needs of the business provided the general requirements under 1.537-1 and 1.537-3 are
satisfied:
o To provide for bona fide expansion of business or replacement of plant;
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 o (2) To acquire a business enterprise through purchasing stock or assets;
o (3) To provide for the retirement of bona fide indebtedness created in connection with the trade or
business, such as the establishment of a sinking fund for the purpose of retiring bonds issued by the
corporation in accordance with contract obligations incurred on issue;
o (4) To provide necessary working capital for the business, such as, for the procurement of inventories;
o (5) To provide for investments or loans to suppliers or customers if necessary in order to maintain the
business of the corporation; or
o (6) To provide for the payment of reasonably anticipated product liability losses, as defined in section
172(j), 1.172-13(b)(1), and 1.537-1(f).
(c) Unreasonable accumulations of earnings and profits. Although the following purposes are not exclusive,
accumulations of earnings and profits to meet any one of such objectives may indicate that the earnings and profits of a
corporation are being accumulated beyond the reasonable needs of the business:
o Loans to shareholders, or the expenditure of funds of the corporation for the personal benefit of the
shareholders;
o (2) Loans having no reasonable relation to the conduct of the business made to relatives or friends of
shareholders, or to other persons;
o (3) Loans to another corporation, the business of which is not that of the taxpayer corporation, if the
capital stock of such other corporation is owned, directly or indirectly, by the shareholder or shareholders
of the taxpayer corporation and such shareholder or shareholders are in control of both corporations;
o (4) Investments in properties, or securities which are unrelated to the activities of the business of the
taxpayer corporation; or
o (5) Retention of earnings and profits to provide against unrealistic hazards.
Anticipated needs. Section 537 defines the reasonable needs of the business as including the reasonably anticipated
needs. To justify an accumulation as being for a reasonably anticipated needs, a corp must have a business need for the
accumulation and must have plans for the use of the funds which are specific, definitive and feasible

CALCULATION of ACCUMULATED TAXABLE INCOME:

The base for the accumulated earnings tax (AET) is accumulated taxable income, which Sec 535(a) defines as taxable
income of the corporation, adjusted under Sec 535 (b), less the sum of the dividends paid deduction and the accumulated
earnings credit

121
122
 INCOME TEST
Code 542(a)(1), 543
Sec 542(a)(1) - the term personal holding company means any corporation (other than a corporation described in
subsection (c)) if (1) at least 60 percent of its adjusted ordinary gross income (AOGI) (as defined in section 543(b)
(2)) for the taxable year is personal holding company income (Sec 543) page 658

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 TAXATION OF PERSONAL HOLDING COMPANIES
Code 541, 545, page 663
Personal holding companies are subject to a tax of 20 percent of their undistributed personal holding company income
(UPHCI) (Sec 541). The key to understand PHC tax is the concept of UPHCI, The definition of UPHCI bears no
relationship to the definition of PHC income. As defined in Sec 545(a), UPHCI is essentially the corporations after tax
profit less a dividends paid deductions

CARRYOVERS OF CORPORATE TAX ATTIBUTES

SECTION 381 CARRYOVER RULES

1. SECTION 381: provides that in a tax-free liquidation of a subsidiary or reorganization (other than a B/E-
reorg.) the acquiring corporation shall succeed to 26 specified tax attributes of Target (including E&P,
NOLs, accounting and depreciation methods, capital loss, investment credit, and charitable contributions).
381(c)(1)-(26)
381(c)(2) restricts E&P deficit inherited from Loss Corp. from being applied against E&P of the
Profit Corp. that existed prior to the acquisition
i. Loss Corps deficit can only be used to offset post-acquisition accumulated E&P
381(b)(3) prevents Loss Corp. from carrying back any NOLs incurred post-acquisition to offset pre-
acquisition income of Profit Corp. (this is in case Loss Corp. acquires Profit Corp. in an A/C reorg.)
BERCY INDUSTRIES, INC. v. COMMISSIONER: Old Bercy was a profitable corp. and was merged
into an empty subsidiary of Beverly Manor, and renamed New Bercy. In its first year, New Bercy had a
loss and wanted to carry it back to Old Bercys previous years. IRS disallowed.
i. 381(b)(3) doesnt allow for this, but the Court looks at congressional record and states that this
was not meant to be covered by this section

SECTION 382 - LIMITATIONS ON NET OPERATING LOSS CARRY-FORWARDS

1. SECTION 382: Prevents Profit Corp. from shopping around for Loss Corps with NOLs (when Loss
business is not sufficiently continued by Profit/Acquirer Corp.). Limits the use of Loss Corps NOL carry-
forwards in a post-change year when ownership (of Loss Corp.) requirements is met:
One or more shareholders that own 5% (Loss Corp.) has more than a 50% shift (increase/decrease) in
his ownership of stock during a testing period of 3 years or less. 382(g)(1)/(i)(1).
i. 5% SH could be a SH before or after the change in ownership. 382(g)(2).
ii. Shifts: Purchases, 351 exchanges, redemptions, stock issuances, or recapitalizations. 1.382-2T(e)
(1).
iii. All SHs who own less than 5% are treated as a single 5% SH. 382(g)(4)(A).
iv. BUT, Loss Cop. SHs with less than 5% are treated as separate SHs from the Profit Corp. SHs with
less than 5%. (that way public loss corps mergers dont escape 382). 382(g)(4)(B)(i).

2. LOSS CORPORATION: The ownership of the surviving corporation is compared to the pre-
reorganization (Type A/C) ownership of Loss Corp. 382(k).
Ownership change occurs unless at least 50% of post-reorganization stock continues to be owned by
pre-reorganization SHs

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3. LIMITATIONS: Once triggered, 382 limits the use by the new loss corp. of any NOLs of an old loss
corp. for any post-change year. The taxable income of the new loss corp. that may be offset by pre-
acquisition NOLs is limited to the value of the old corp. stock multiplied by the long-term tax exempt
rate.

4. ATTRIBUTION RULES: An individual and family members (spouse, grandchildren and parents) are
treated as 1 SH (but only if they or their grandparents/parents already own shares in loss Corp. Garber.)
318(a)(1) & 382(l)(3)(A).

5. GARBER INUSTRIES v. COMMISSIONER (TC 2005) Pg. 563

ISSUE: Whether stock sale between siblings that increased one siblings percentage ownership of
petitioner by more than 50% resulted in an ownership change under 382 triggering limitations
HOLDING: Family aggregation rule of 382(1)(3)(A)(i) applies solely from the perspective of
individuals who are SHs (as determined under the attribution rules of 382(l)(3)(A) of the Loss
Corp.) THUS,
i. An individual SHs family consists of solely his spouse, grandchildren, children, and parents for
these purposes, and sibling SHs ARE NOT aggregated if none of their grand parents or parents is a
SH of Loss Corp.

RESULTS OF AN OWNERSHIP CHANGE

1. GENERALLY: If 382 is triggered by an ownership change not all NOLs are disallowed, instead (to limit
Profits ability to use Loss NOLs without continuing it) 2 limitations apply:
CONTINUITY OF BUSINESS ENTERPRISE LIMIT
382 LIMITATION

2. CONTINUITY OF BUSINESS ENTERPRISE LIMIT: If Loss Corp. business is NOT continued for at
least 2years after change in ownership, all of NOL is disallowed:
Continuation of Business: Of historic business or significant old assets are used in operation

3. 382 LIMITATION: If Loss Corp. business is continued, the NOL is allowable in any post-change year
only to the extent of: value of the old corporation multiplied by the Long-Term Tax Exempt Rate
Profit/Loss corp. is entitled to take an amount of NOLs attributable to Loss assets
LONG-TERM TAX EXEMPT RATE: Estimates the income generated by the old loss corp. assets
i. It is needed since it is impossible to estimate income attributable to old corp. assets
EXAMPLE: Old Corp. Asset Value of $200K; 800K in NOLs; LT tax exempt rate is 6%
i. $200K x 6% = $12K allowed NOL per year
CARRY-FORWARD OF UNUSED: If new Loss corp. income is $4K, it will carryover $8K to next
years and have an allowed NOL of $20K next year
MID-YEAR: Pro-rate the limitation by portion of year (e.g. 1/3 x $12K)
ANTI-STUFFING RULE: SHs of Loss Corp. cannot inflate the value of Loss Corp. (Which would
increase the NOL under 382 limitations) by contributing cash/property within 2 years before
ownership change
i. Such stuffing is disregarded for purposes of 382 limitation. 382(l)(1).
BUILT-IN LOSSES: Assets that have built-in losses are subjected to 382 limitations. 382(h)(1)(B).
i. De Minimis: Loss is zero if it does not exceed the lessor of (1) 15 % of FMV of assets, or (2)
$10M. 382(h)(3)(B)(i).

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CONVERSION FROM S CORP TO C CORP:

If I have been as an S corp for a period of time and I have generated a positive AAA account (that is money that
I can distribute to myself tax free) so the key here is Sec 1371.
Per 1371(e)(1) distributions of former S corp during post-termination transition period (1 yr after last
S day) may be treated as basis recovery from accum. Adj. account. So, here 5k to each can be basis
recovery (because that each share of 10k accum. Adjust. Account from prior year) and 2k dividend.
So, when the client wants to convert from S corp to C corp you have to tell your client you have one year
to take your money out tax free equal to the AAA earnings that already been pass through and taxed.
Now suppose the company doesnt have cash to be pay out the AAA, and those AAA earning were
accumulated to purpose here. How can we take advantage of one freebe year? You bay out the money, you
write a check, you distribute this money out of AAA account. It comes tax free to a SH. Sh turns around and
loan a company money which is now a C Corp and then when a company has money, it can pays the money
tax free.
If you dont make that distribution of AAA earnings they are gone, waste.
- Per 1371(e)(2), may elect to treat all as dividend. C corp E&P 11k (6k prior and 5k current), do dividend
5.5k to each if election made. Extra 1.5k treated as return of capital.
What might you want to do that? -maybe I have some losses and I cant use such losses util I have a
dividend.

S Corp The Big Tax

If I am a successful C or S Corp I never want to change to partnership tax status, because I will trigger
the tax as if I liquidate the company under 331 or 336.
However, you can change status from S Corp to C Corp, however if you have untaxed accumulated
earnings in S Corp, this money that been pass through, been taxed you, you paid the taxes but this
money was not distributed to you, you sit with positive AAA -YOU HAVE 1 YEAR TO GET THAT
MONEY TAX FREE.
If you are going from C Corp to S Corp there are four traps, but before this be sure you can elect S
status:
o You got to have S Corp eligible (no partnership, corporate shareholder and some trust, etc..)
o Have only one class of stock
o No more than 100 SH-s
So, four traps:
Accumulated E&P carry over with me to S Corp and then establish AAA
Life of inventory trap. When value inventory consider the last that we bought, the first that we sold
(LIFO method inventory). If you use LIFO and the minute you convert from S to C Corp, take this LIFO
inventory savings account and recognize it as income over 4 year period. I cannot continue the LIFO
game in a S Corp status and I cannot continue the past, I need to recapture the past savings over 4 year
period
Sec 1374 -tax the S CORP pays
Sec 1375 -tax the S CORP pays

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 S Corp The Big Tax
26 U.S. Code 1374 - Tax imposed on certain built-in gains when you convert from C Corp to S Corp
every asset you have at that conversion, will now have three items you have to track

Item The basis of this asset FMV at conversion to S The value realized on
sale/disposition of the
asset. LESS THAN 5
YEAR AFTER I
CONVERT I SEL THE
ASSET
Equipment 1M 1,5 M (built in gain) 2.5 M
Goodwill zero 3M 7M
If I were straight S Corp from day one I would recognize the gain (AB day one (1M) and Sale value (2.5M), a
1,5 M gain will be pass through and be taxed to the SH. Goodwill gain 7.
But if I was C corp and then elects to be S Corp, in addition to that gain recognize, they want me to recognize
a second tax equal the difference between basis and the build in gain value.
So, if I sold the goodwill, there will be a 7 M gain recognize and that 7M will be distributed and flow through
to the SH, IN ADDTITION the COMPANY, not SH, will recognize 3M gain that it must pay tax at the
highest marginal tax rate -35%. The only relief is that the amount of tax the company actually pays, the SH
get the deduction for it. So, if you have tax equal 35% of 3M =1050. SH can deduct this 1050 from 7M and
pay tax on the rest.

Huge exception to no entity tax rule

Applies only when C corp has converted to S corp
Purpose is to limit ability to convert and then sell and strip income with no double tax hit
BIG stands for Built-in-Gain
May also have built-in loss
Major factor in converting from C to S corp.
Although BIG tax can be rough, nothing compared to going from C Corp to partnership or LLC

S BIG TAX HOW IT WORKS

Determine built-in gain or loss at time of conversion for all assets. This is gap between FMV and basis.
Requires appraisals.
If asset sold during 5 years after conversion (recognition period), any gain or loss recognized up to
Built-in amount taxed at corporate level.
Tax rate is highest corporate rate 35%.
Income still taxed at shareholder level, but BIG tax treated as loss. 1366(f)(2)
BIG income may not exceed corp income for year if taxed as C corp. Carry forward any excess.
BIG income from any sale may not exceed total BIG income at conversion less BIG income previously
recognized.
Carry-over BIG income potential in non-recognition transactions (i.e. 1031, 1034), tax-free corporate
reorgs.
Installment sales during 5 year period that defers income beyond ten year window doesnt help.
Recognition period extended.

127
26 U.S. Code 1375 - Tax imposed when passive investment income of corporation having accumulated
earnings and profits exceeds 25 percent of gross receipts
Is when we have an S Corp and it used to be C corp and the accumulated E&P has generates, and an S
Corp has set up so that it generated portfolio income (Royalties, Dividends, Interest, Annuities,
passive rental income) years and passive S receipts exceed 25% of gross income, then the amount of that
excess is taxed at the highest corporate rate 35% to the entity and the ENTITY has to pay tax. So, I
take my total gross income, and if my portfolio income is 40%, the portion over 25% is taxed, so you
calculate the tax at 35% rate and the entity itself must pay tax. Furthermore, if that last for more than 3
years you lose you S selection. Once the E&P disappears you lose those risk.
Passive Income S Not Like the Other Passive
Royalties
Dividends
Interest
Annuities
Note: Looks more like portfolio income. But for 1375 purposes, called passive income.
DO NOT CONFUSE WITH 469 PASSIVE INCOME.

PASSIVE INCOME S PENALTIES

Penalty One: S Corp has accumulated earnings and profits for three years and passive S receipts more than
25% total receipts.
S election terminated. 1362(d)(3)
Penalty Two: S Corp has accumulated earnings and profits and passive S receipts more than 25% total receipts.
Entity level tax equal to 35% of excess net passive income. How to calculate:
- First, net passive income is passive income less passive expenses.
- Second, ratio with numerator equal passive income over 25% of gross receipts and denominator equal
to total passive income.
- Third, multiple net passive income by ratio to arrive at excess passive income.
- Limit excess passive income cant exceed corps taxable income

C- CORPORATION TABLE

Items C Corp C-Corp Shareholders Shareholders Excluded

Includible Deductible Includible deductible

LOSS NO
GAIN

CREDIT
DIVIDEND NO YES. Tax at NO NO
preferential tax

128
 rates 15-23.8%.
Sec 1(h)

S- CORPORATION TABLE

Items S Corp S-Corp Shareholders Shareholders Excluded

Includible Deductible Includible deductible

LOSS NO NO YES.
Cannot exceed
shareholders
basis in stock and
debt 1366(D)
GAIN NO NO
DEDUCTION NO NO Cannot exceed
shareholders
basis in stock and
debt???????
CREDIT NO NO
DIVIDEND sec YES?? NO
243
That portion of YES
the distribution
which is not a
dividend tit h
extent that it
exceeds the AB
of stock and to
the extent that it
is out of
increase in value
accrued before
March 1, 1913
Sec 301 (c) (3)
(B)
Organizational YES YES and
exenpenses Sec amortized
248

GAIN LOSS

129
 That portion of the distribution which is not a
dividend tit h extent that it exceeds the AB of the
stock -gain from the sale and exchange of property
301(c )
So if a C(and S) corp distributed a property FMV of When we distributed property AB>FMV the loss
which > AB, the corp has a gain that it must does NOT get recognized. (311)
recognize on a distribution. (311)

Item AB FMV
351 exchange for SH and Corp Yes. Of the property exchanged,
unless AB>FMV , then we have
built in loss
351 AB>FMV Yes.
Corp FMV or the propery.
PROPERTY distributed to the SH Yes.
by a Corp REMEMBER: SH is always taxed
on the FMV of the property.

Selling the property Yes.

C has 15k current E&P, distributes to
Z land FMV 20k, basis 30k.
- S Corp has 10k loss (30k-20k),
but cant recognize per 311(a)
- Z has 20k dividend (FMV) :
Plenty of accumulated E&P
- Z basis in land 20k (FMV).
- C Corp accumulated E&P to
next year is 10k (25k + 15k current,
less 30k basis in land (AB)).
Note: If sold and then distributed
cash, C Corp recognizes 10k loss. Z
still has 20k dividend. C Corps E&P
carryover still 10k (40k less 10k loss,
less 20k distribution (FMV)). Only
difference is 10k recognized loss
Sold for 20 K (FMV)

130