CORPORATE TAX OUTLINE

SPRING 2007

Professor D. Brennan

1
Corporate Tax Outline
Spring 2007

1) BACKGROUND
a) Two types of corporate entities
i) C Corp
(1) This is a corporation that is not an S-corp 1361(a)(2)
ii) S corp
(1) Requirements 1361(b)
(a) Does not have more than 100 shareholders
(b) Does not have as a shareholder a person who is not an individual
(c) Does not have a nonresident alien as a shareholder
(d) Does not have more than 1 class of stock.
(2) Election 1362(a)
(a) A small business corp may elect, in accordance with the provisions of this section, to be an S-corp.
b) Important Code Sections
i) 61 Gross Income
(1) Gross income means all income from whatever source derived (see list for examples.
(2) (a)(3) gains derived from dealing in property
(a) Two types of property we deal with
(i) Tangible and intangible
(ii) Tangible consists of real and personal
(b) Gain arises when you get out more money than you put in.
ii) 11 Tax Imposed
(1) A tax is hereby imposed for each taxable year on the taxable income of every corporation
iii) 63 Taxable Income
(1) (a) taxable income means gross income minus the deductions allowed.
(a) Taxable Income = Gross income Chapter 1 deductions.
iv) 162 Deductions
(1) (a) Generally there shall be allowed as a deduction all the ordinary and necessary expenses paid or
incurred during the taxable year in carryong on any trade or business including (see )
v) 165, 262 Losses
(1) You cannot deduct losses on the sale of personal property
vi) 1001 Determination of Amount of And Recognition of Gain or Loss
(1) 1001(a) - Generally
(a) Gain Realized = Amount Realized Adjusted Basis
(b) Loss Realized = Adjusted Basis Amount Realized.
(2) 1001(c) the entire amount of the gain or loss on the sale shall be recognized unless told otherwise.
vii) 1011 Adjusted Basis for Determining Gain or Loss
(1) We know that basis starts with some concept of cost either out of pocket cost or a tax cost (if you have
a capital asset there may be some depreciable tax cost in there so your basis may be less than what paid
out of pocket)
(2) Adjustments to basis the adjusted basis is the initial basis adjusted to reflect increases or decreases in
basis.
(a) Conceptually, we want our basis in property to be as high as possible so that when we sell it we have a
loss or as small a gain as possible.
viii) 1012 Basis of Property: Cost
(1) When we pay for something in cash the basis is the amount we paid for it.
ix) 1014 Basis of Property acquired from a decedent
(1) Generally, fair market value.
x) 1015 Basis of Property Acquired by Gifts and Transfers
(1) Generally, transferred Basis
xi) 1016 Adjustments To Basis
2
 (1) Look to
xii) 1211 Limitations on Capital Losses
(1) In the case of a corporation, losses from sales or exchanges of capital assets shall be allowed only to the
extent of gains from such sales or exchanges.
xiii) 1221 Capital Asset Defined (Characterization of a transaction)
(1) The term capital asset means property held by the taxpayer but does not include what is listed.
(2) In general, the types of property the code tries to capture as ordinary property will it be useful to income
over an extended period.
(a) Conceptually, a capital asset is something that can be useful to a business, like inventory.
(3) Stock in a corporation will generally be considered to be a Capital Asset.
xiv) 1222 Other terms relating to Capital Gains and Losses
(1) (1) Short Term Capital Gain the term means gain from the sale or exchange of a capital asset held for
not more than 1 year, if and to the extent such gain is taken into account in computing gross income.
(2) (2) Short Term Capital Loss loss from the sale or exchange of a capital asset held for not more than 1
year if and to the extent it is taken into account in computing taxable income.
(3) (3) Long Term Capital Gain Gain from the sale or exchange of a capital asset held for more than 1 year,
if and to the extent such gain is taken into account in computing gross income. This is taxed at a
preferential rate under 1(h), no 1(a).
(4) (4) Loss from Long term Capital asset sale.
xv) 1223 Holding Period of Property
(1) This provision tells us how to figure out how long we have held the property under 1222.
(2) Look to the section to see if there is tacking.
xvi) 1031 Exchange of Property held for Productive use or Investment
(1) (a) Nonrecognition of gain or loss from exchanges solely in kind. 1031 is basically a deferral provision.
(a) Generally no gain or loss recognized on the exchange of property held for productive use in a trade
or business or for investment if such property is exchanged solely for property of like kind which is to
be held either for productive use in a trade or business or for investment
(i) DOES NOT APPLY TO STOCKS
(2) (b) Gain from exchanges not solely in kind
(a) This is the BOOT provision it is recognized to the extent of the boot.
(3) (c) Loss from Exchange not solely in kind
(a) No loss from boot.
(4) (d) Basis
(a) The basis is the same as that of the property exchanged, decreased in the amount of any money
received by the taxpayer and increased in the amount of gain or decreased in the amount of loss to the
taxpayer that was recognized on such exchange.
(b) If there are different properties received in exchange, basis is allocated among them (except for cash)
for the purpose of allocation, it shall be allocated equivalent ot its fair market value at the date of
exchange.
(c) Assumption of liability is treated as cash received by the taxpayer on the exchange.
c) To Figure Out Tax Consequences
i) Shareholder
(1) Gain or Loss: 1001(a), 351(a), then 1001(c) to see if the exclusion applies
(2) Basis: 1012/ 1016, 1011(a)/(b), but for corporations look to 358(a)
(3) Holding Period: 1223, was the property capital or a 1231 asset, to the extent it was neither there will be
tacking.
ii) Corporation
(1) Gain or Loss: 1032 no gain or loss for property given for its own stock. Even if 351 does not apply
the corporation still has no gain or loss.
(2) Basis: Cash whatever the amount of the cash is. For other property look to 362 (if property is obtained
in a 351 transaction basis is the same as it was in the hands of the shareholder). If not a 351 txn look to
the rest of 362, and if nothing we are left with the 1012 rule.
(a) Property with a built in loss - 362(e): Basis is the FMV immediately after the transaction.

3
 (i) Under 362(e)(2) the shareholder can elect to keep the loss for himself and not have it go to the
corporation. LOOK IN LEXIS GUIDE
(3) Holding Period: 1223(2): The basis is by reference to the basis in the hands of the transferor, and then
you apply 1223. You have to have a 351 transaction for 1223 to apply. However, holding period doesnt
really matter for corporations because there is no rate preference for corporations.
d) Two Important Concepts: Nonrecognition and Boot
i) Nonrecognition
(1) The biggest timing issues in the federal income tax are those relating to realization and recognition.
(2) Generally, gain or loss from a change in value of an asset held by the taxpayer is not taken into account
under the income tax until a realization occurs
(a) Even then, only in the absence of a nonrecognition statute.
(3) HYPO: A gives a house to B that is worth 150,000 and that had been bought for 100,000. Bs basis is
100,000 under 1015 (transfer basis for gift), and his balance sheet is now worth X + 150,000. He does
NOT have to include the 150,000 in income under 102(a)
ii) Boot
(1) Usually occurs in special cases usually in the nonrecognition transactions. i.e. you receive some property
that qualifies under a nonrecognition provision, but also receive some non qualifying property.
(2) If there is boot thrown into a transfer, which is nonrecognition, then the gain is realized up to the amount of
the boot.
e) Introduction to Corporate Taxation
i) A corporation will be recognized as a separate tax paying entity.
ii) Remember There are two types of Corporations, S and C corps. You have to elect to be an S Corp
(1) 1361 is the provision that defines an S-Corp under federal income tax law.
iii) Differences between S and C corps
(1) Income is taxed to individual shareholders in an S corp. In a C corp income is taxed to the entity. With C-
corps there is a second layer of tax when it comes out as a dividend.
(2) S-corps are a lot like partnerships in that they are treated as a conduit or a pass through entity not a
taxable entity. Income is taxed only at the SH level.
(3) C-Corps are taxed at a rate determined by 11 (individuals are taxed as per 1)
(4) Capital gains are treated differently. At the corporate level there is no difference between personal and
business like we do for individuals.
iv) Corporations utilize dividends. When corporations receive dividends, they can actually deduct them that is
designed to eliminate a triple taxation.
v) Most corporations have to use the accrual method unless they meet one of the requirements in 448.
(1) Accrual-basis accounting records financial events based on events that change your net worth (the amount
owed to you minus the amount you owe others). Standard practice is to record and recognize revenues in
the period in which they incur and to match them with related expenses in a process known as matching or
expense matching. Even though cash is not received or paid in a credit transaction, they are recorded
because they are consequential in the future income and cash flow of the company.
vi) FLOW CHART FOR DETERMINING CORPORATE TAX LIABILIET
(1) First, go to 11 to see that liability is (taxable income)x (tax rate).
(2) Second, to determine taxable income, go to 63 (taxable income = gross income minus deductions)
(3) Third, to find gross income we go to 61 (if you have interest on state and local bonds that is excluded
under 103).
(4) Fourth, go to 162 for deductions (163(m) limits deductions for extraordinary salaries). (If there is
depreciation go to 167 for depreciation). The authority to deduct losses is section 165 and 1211 (1211
tells us we can only deduct losses to the extent of gains from sale).
vii) Strategies to minimize double taxation
(1) Salaries (but see 162m)
(2) Health insurance payout
viii) The Common Law of Corporate Taxation
(1) Generally
(a) Viewed most broadly, the judicial doctrines ask a simple question that is central to almost every
transaction studied: HAVE THE TAXPAYERS ACTUALLY DONE WHAT THEY, AND THEIR
DOCUMENTS, REPRESENT, OR ARE THE ECONOMIC RELITES OF THE TRANSACTION
4
 AND THE ATTENDANT TAX CONSEQUENCES OTHER THAN WHAT THE TAXPAYERS
PURPORT THEM TO BE?
(2) Sham Transaction and Economic Substance Doctrines
(a) Shams will not be respected for tax purposes.
(b) To treat a transaction as a sham, the court must find that the taxpayer was motivated by no business
purpose other than obtaining tax benefits in entering the transaction, and that the transaction has no
economic substance because no reasonable possibility of a profit exists. - 14th Cir.
(3) Substance Over Form
(a) Despite the influence of this doctrine over time, the courts have shown some reluctance to accept
recent attempts by the Service to restructure legitimate transactions to reach a result that will produce
more revenue.
(b) i.e. the tax court is wary of extending the judicial doctrines where Congress has mandated that
particular results shall flow from a given form and the taxpayers have carefully structured an otherwise
legit transaction to comply with the statutory requirements.
(4) Business Purpose
(a) The business purpose 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 its form were respected.
(5) Step Transaction Doctrine
(a) Courts combine formally distinct transactions to determine the tax treatment of the single integrated
series of events.
(b) Standard:
(i) Some courts require a binding legal commitment to complete all the steps from the outset before
combining them
(ii) Others require only a mutual interdependence of steps or a preconceived intent to reach a
particular end results.
f) The Corporation as a Separate Tax Entity
i) Corporate Income Tax
(1) Rates
(a) C corp is a separate taxable entity. See 11 for rates.
(2) Determination of Taxable Income
(a) 63(a) defines taxable income as gross income minus the deductions
(b) Corporations are allowed to deduct dividends to avoid the double tax.
(i) The idea of INTEGRATION is to eliminate or reduce the tax on one of the levels of tax.
(c) Corporations may deduct capital losses only to the extent of capital gains during the taxable year.
(3) Taxable Year and Accounting Method
(a) In general, corporations are required to use the accrual method of accounting.
(4) Check the Box Provision
(a) The service issued some proposed regulations that allowed unincorporated entities to elect if they
wanted to be treated as corporations or partnerships for tax purposes.
(b) As long as you are not a corporation for state law purposes you get to choose how you will be treated
for federal tax purposes.
(c) You only get to choose if you are an unincorporated entity. If you are a corporation you cant choose to
be taxed as a partnership.
ii) The Corporate AMT
(1) AMT is designed to ensure that not taxpayer with substantial economic income can avoid significant tax
liability by using exclusions, deductions, and credits.
(2) The MAT generally can be described as a flat rate tax which is imposed on a broader income base than the
taxable income yardstick used for the regular corporate tax
(3) The MAT generally is 20 percent of the amount by which a corporations alternative minimum taxable
income (see 55(b)(2)) exceeds a 40,000 exemption amount.
iii) Corporate Tax Shelters
(1) Defined (generally)
(a) Realization of tax losses without corresponding economic loss through transactions having
questionable economic substance apart from the desire to reduce US income taxes

5
 (b) Realization of in come by tax-indifferent facilitators such as foreign affiliates, domestic corps with
soon to expire loss carryovers, and tax exempt orgs.
(c) Reliance on the literal language or ambiguities in the IRC to support a result that may be technically
defensibly but is inconsistent with the spirit of the law and well accepted tax principles.
(d) Marketing of transactions under a veil of secrecy by entrepreneurial accounting firms and investment
banks in exchange for enormous fees
(e) Inconsistent treatment for financial account and tax proposes of items resulting from the same
transaction
(f) The willingness of corporate managers and their advisors emboldened by reasoned opinions of tax
counsel and the knowledge that IRS audits have been reduced to play audit roulette by taking
questionable tax return reporting positions with the hope that they will never be scrutinized.
(2) Defined (simply) a deal done by very smart people that absent tax considerations would be very stupid.
(3) UPS v. Commissioner (pg 26)
(a) Facts
(i) The taxpayer was a package shipper. It profited from assuming liability for loss of parcels up to
their declared value for customers who paid an "excess-value charge."
(ii) In 1983 the taxpayer restructured the claims process by
1. (1) forming and capitalizing a foreign subsidiary;
2. (2) purchasing an insurance policy for customers' benefit, where the insurer assumed the risk
of loss;
3. (3) paying premiums in the amount of excess-value charges collected from customers; and
4. (4) the subsidiary's entering into a reinsurance treaty with the insurer, in exchange for
premiums paid to the subsidiary equaling the excess-value payments.
(iii) The court of appeals held that this arrangement created genuine obligations enforceable by an
unrelated party.
(iv) There was a real insurance policy that gave the insurer the right to receive the excess-value
charges.
(v) The insurer assumed liability for shippers' losses (in the taxpayer's stead), again a genuine
obligation.
(vi) The reinsurance treaty did not completely foreclose the risk of loss. The subsidiary was an
independently taxable entity not under the taxpayer's control.
(vii) The taxpayer really did lose the stream of income it had earlier received from excess-value
charges.
(b) The kind of "economic effects" required to entitle a transaction to respect in income taxation includes
the creation of genuine obligations enforceable by an unrelated party.
(c) For purposes of federal income taxation, a "business purpose" does not mean a reason for a transaction
that is free of tax considerations. Rather, a transaction of a going concern has a "business purpose" as
long as it figures in a bona fide, profit-seeking business. This concept of "business purpose" is a
necessary corollary to the venerable axiom that tax-planning is permissible.

2) CHAPTER 2: FORMATION OF A CORPORATION

a) Introduction to 351
i) Relevant
(1) 351(a) General Rule
(a) 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 (see 368 (c)) of the corporation.
(b) The basic premise behind 351 is that you are not losing your property, you are just holding it in a
different form.
(2) 1032(a) Exchange of Stock for Property (Nonrecognition of Gain or Loss)
(a) No gain or loss shall be recognized to a corporation on the receipt of money or other property in
exchange for stock including treasury stock, of such corporation. No gain or loss shall be recognized
by a corporation with respect to any lapse or acquisition of an option or with respect to a securities
futures contract to buy or sell its stock.
(i) REGS: 1.1032(1)(d) tells us that for basis of property, whenever you have a 1031 exchange
with no 351 you go to the regular basis under 1012.
(3) 358 Basis to Distrubtees

6
 (a) (a) the basis of the property permitted to be received under such section without the recognition of gain
or loss shall be the same as that of the property exchanged
(i) Decreased by (1) the FMV of any other property except money received by the taxpayer, (2) the
amount of any money received and (3) the amount of loss ot the taxpayer which was recognized
on such exchange and
(ii) Increased by (1) the amount which was treated as a dividend and (2) the amount of gain to the
taxpayer which was recognized on such exchange.
(4) 362(a) Basis to Corporation (Property acquired by issuance of stock or as paid in surplus)
(a) If property was acquired by a corporation
(i) In connection with a transaction to which section 351 applies then the basis shall be the same as it
would be in the hands of the transferor, increased in the amount of gain recognized to the
transferor on such transfer.
(5) 368(c) Definitions Relating to Corp Reorganizations (Control Defined)
(a) The ownership of stock possessing at least percent of the total combined voting power of all classes of
stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock
of the corporation
ii) Policy of 351
(1) Generally, a corporation obtains its start up assets by issuing stock in exchange for cash or other property or
borrowing
(a) When a corporation raises its equity capital by issuing stock solely for cash the tax consequences are
routine:
(i) The shareholder simply has made a cash purchase and takes a cost basis in the shares acquired.
(b) If the corporation issues stock for property other than cash the exchange would be a taxable event
without a special provision of the code.
(i) SH recognizes gain or loss equal to the difference between the fair market value of the stock
received and the adjusted basis of the property transferred to the corporation.
(ii) The gain to the corporation (theoretically) would be the excess of the FMV of the cash and
property received over the corporations zero basis in the newly issued shares.
(2) The transfer of appreciated or depreciated property to a corporation controlled by the transferor is viewed
as a mere change in the form of a shareholders interest.
iii) Basic Requirements of 351
(1) The three major requirements to qualify for nonrecognition of gain or loss under 351 are:
(a) One or more persons must transfer property to the corp
(b) The transfer must be SOLELY in exchange for stock of the corp
(c) The transferor or transferors as a group must be in control of the corporation immediately after the
exchange.
(i) Control 368(c) The ownership of stock possessing at least percent of the total combined voting
power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of
all other classes of stock of the corporation
iv) Shareholder Basis and Holding Period
(1) BASIS
(a) If 351 applies to a transfer, any gain or loss realized by the shareholder is not currently recognized.
The policy of nonrecognitiopn requires the preservation of these tax attributes top prevent total
forgiveness of the unrecognized gain or forfeiture of any unrecognized loss, a goal achieved by
358(a)
(b) 358(a)(1) Nonrecognition Property The basis of the property permitted to be received under
351 without the recognition of gain or loss shall be the same as that of the property exchanged.
(i) This section provides that the basis of the stock received in a 351 exchange shall be the same as
the basis of the property transferred by the shareholder to the corporation.
(2) HOLDING PERIOD
(a) 1223(1) 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. If it is not,
the transferors holding period begins on the date of the exchange.
v) Tax Consequences to Transferee Corporation

7
 (1) 1032 provides that a corp does not recognize gain or loss when it issues stock in exchange for money or
property
(2) 362 prescribes a transferred basis, i.e. the corporations basis in any property received in a 351 exchange
is the same as the transferors basis, thus preserving the gain or loss inherent in the asset for later
recognition by the corporation.
(3) 1223(2) provides that if property has a transferred (i.e. carryonver) basis to the corporation, the
transferors holding period likewise will carry over.
vi) Limitations on Transfer of Built in Losses
(1) If property with a net built in loss is transferred to a corporation in a 351 transaction or as a contribution to
capital, the transferee corporations aggregate adjusted basis fo such property is limited ot the fair market
value of the transferred property immediately after the transfer.
(a) Transferred property has a net built in loss when the aggregate adjusted basis of the property exceeds
its FMV.
(b) The basis limitation only applies when there is a NET built in loss. If more than one property with a
built in loss is transferred, the aggregate reduction in basis is allocated among the properties proportion
to their respective built in losses immediately before the transaction.
(2) Alternatively, the shareholder and the corp may jointly elect to reduce the shareholders basis in the stock
that it receives to its FMV. If the election is made the assets continue to have a built in loss in the hands of
the transferee corp, but the loss will not be duplicated on the disposition of the shareholders stock.
b) Requirements for Nonrecognition of Gain or Loss Under 351
i) Control Immediately After the Exchange
(1) CONTROL DEFINED
(a) 368(c): Control Defined The term Control means the ownership of stock possessing at least 80
percent of the total combined voting power of all classes of stock entitled to vote and at least 80
percent of the total number of shares of all other classes of stock of the corporation.
(i) Ownership of at least 80 percent of the total combined voting power of all classes of stock entitled
to vote
(ii) At least 80 percent of the total number of shares of all other classes of stock
(b) Requisite control must be obtained by one or more transferors of property who act in concert under a
single integrated plan
(i) For an integrated plan, the transfers need not be simultaneous, it is sufficient if the rights of the
parties are previously defined and the agreement proceeds with an expedition consistent with
orderly procedure.
(ii) What is important is whether the steps are mutually interdependent steps in the formation and
carrying on of the business.
(2) IMMEDIATELY AFTER THE EXCHANGE
(a) Momentary control will not suffice if the holdings of the transferor group fall below the required 80
percent as a result of dispositions of stock in a taxable transaction pursuant to a binding agreement or a
prearranged plan.
(b) HOWEVER, a voluntary disposition of stock, particularly in a donative setting, should not break
control even if the original transferor of property parts with the shares moments after the incorporation.
(c) Reg 1.351-1(a)(1) exchanges dont have to be simultaneous. However, how far you can take this is
a whole different issue.
(3) Intermountain Lumber v. Commissioner (pg 64)
(a) Facts
(i) Prior to issuance of petitioner sawmill's stock, the incorporators agreed that half the shares of the
stock would be owned outright by the transferee incorporator, while the other half were in escrow
subject to transfer upon payment of the purchase price by the transferor incorporator pursuant to a
sale agreement.
(ii) An incorporator irrevocably contracted, as part of the incorporation transaction, to sell to a third
party 50 percent of the stock the incorporator received in exchange for his transfer to the
corporation of all its property.
(b) Held
(i) The court held in favor of petitioners, company, affiliates, and saw mill, because the initial transfer
of stock from petitioner saw mill to the incorporators was not a nontaxable event under the
Internal Revenue Code. The transferee incorporator was not in control of petitioner sawmill after
the transfer.
8
 (ii) the incorporator did not "control," within the meaning of sec. 368(c), I.R.C. 1954, the requisite
percentage of stock immediately after the exchange for the incorporation to be a tax-free exchange
under sec. 351(a)
(c) This case stands for the proposition that under the step transaction doctrine, you look to whether at the
time the initial transaction was entered into there was a binding commitment to undertake the
subsequent steps.
(d) If a third party purchases previously issued stock form a member of the original control group control
may be binding.
(4) American Bantam Car v. Commissioner (pg 63, fn 4)
(a) Facts
(i) The court found that a group had bought the assets of a company subject to liabilities.
(ii) The group then transferred the assets, the liabilities, and some cash to a new corporation in
exchange for a proportionate amount of common stock.
(iii) After the initial exchange, the taxpayer made an agreement with underwriters to transfer common
stock to them in exchange for selling preferred stock.
(iv) The court affirmed the IRS's decision that the exchange was non-taxable and that the taxpayer's
basis in the assets was the same as in the hands of the transferring group.
(v) **Note here the taxpayer wanted to fail 351so they could depreciate more.
(b) Held
(i) 351 had been met and the exchange was tax free.
(c) This case stands for the proposition that momentary control will not suffice if the holdings of the
transferor group fall below the required 80 percent as a result of disposition of stock in a taxable
transaction pursuant to a binding agreement or a prearranged plan.
(i) HOWEVER, a voluntary disposition of stock, particularly in a donative setting, should not break
control even if the original transferor of property parts with the shares moments after
incorporation exchange.
(ii) There is no evidence here that the control group was COMPELLED to transfer their shares after
the exchange.
(d) NUTSHELL: In this case the transferors contributed cash and other property to a new corporation in
exchange for 100 percent of its common stock. Five days later the transferor shareholders entered into
an agreement to transfer a portion of the common stock to underwriters as compensation for their
services if the underwriters succeeded in selling the corporations preferred stock to the public. Upon
successful completion of the public offering approximately 15 months later, more than 20 percent of
the common stock was transferred to the underwriters. The court held that the control requirement of
351(a) was satisfied despite the subsequent transfer, because the 351 exchange and the subsequent
transfer ere not mutually interdependent.
ii) Transfers of Property and Services
(1) What is Property?
(a) It has been broadly construed to include cash, capital assets, inventory, accounts receivable, patents,
and in certain cases other intangibles
(2) 351(d)(1): Services . . . not treated as property Stock issued for services shall not be considered as
issued in return for property.
(a) If stock is compensation for services tax consequences are determined under 61 and 83
(3) The pure service provider is not considered a transferor of property and may not be counted as part of the
control group for purposes of qualifying the exchange under 351. However, if a person receives stock in
exchange for BOTHJ property and services ALL of his stock is counted towards the 80 percent control
requirement. Reg 1.351-1(a)(1)(ii) 1(a)(2), Ex. 3.
(4) However, regulations provide that stock will not be treated as having been issued for property if the
primary purpose of the transfer is to qualify the exchanges of the other property transferors for
nonrecognition and if the stock issued to the nominal transferor is of relatively small value in comparison to
the value of the stock already owned or to be received for services by the transferor.
(a) i.e. if the value of the property transferred is de minimis relative to the stock received for services.
iii) Solely For Stock
(1) Stock generally means an equity investment in the company and in this context the term has presented
relatively few definitional problems

9
 (2) Certain preferred stock with debt like characteristics listed in 351(g)(2) nonqualified preferred stock is
treated like other property. Nonqualified preferred stock is generally defined as preferred stock with any of
the following characteristics
(a) Stockholder ahs the right to require the issuing corp or a related person to redeem or purchase the stock
(b) The issuer or a related person is required to redeem or purchase the stock
(c) The issuer or a related person ahs the right to redeem or purchase the stock and as of the issue date it is
more likely than not that such right will be exercised
(d) Or the dividend rate on such stock varies in whole or in part with reference to interest rates,
commodity prices, or similar indices.
(3) Purpose of 351(g) is to treat debt like preferred stock as boot, resulting in potential recognition of gain to
the recipient under 351(b).
c) Treatment of Boot
i) In General
(1) CODE
(a) 351(b): Receipt of Property if subsection (a) would apply to an exchange but for the fact that
there is received in addition to the stock permitted to be received under (a) other property or money
then
(i) Gain if any, to such recipient shall be recognized, but not in excess of
1. The amount of money received, plus
2. The fair market value of such other property received; and
(ii) No loss to such recipient shall be recognized.
(2) TRANSLATED
(a) Any gain realized by a transferor on an otherwise qualified section 351(a) exchange must be
recognized only to the extent of the boot received.
(i) Gain is characterized by reference to the character of the assets transferred, taking into account the
impact of the recapture of depreciation provisions.
(ii) NO LOSS may be recognized under 351(b).
(3) To avoid potential double taxation, a shareholder may increase his basis increase his basis in the stock,
securities, and other property received by an amount equal to the gain recognized on the transfer.
(a) Therefore, the shareholders combined basis in what he received equals the basis in the property
transferred to the corporation, increased by the gain recognized on the transfer. (see page 74 for
examples)
(4) At the corporate level, 362(a) provides that the corporations basis in the property received on a 351
exchange is the same as the transferors basis, increased by any gain recognized on the exchange (i.e. boot).
(5) Revenue Ruling 68-55
(a) If a transferor transfers several different assets and receives some boot (in addition to stock), it is
necessary to allocate the consideration received separately to each asset for purposes of determining
the amount and character of gain recognized.
(b) It is not proper to total the bases of the various assets transferred and to subtract this total from the
FMV of the total consideration received in exchange. You go with an asset by asset approach.
(6) Revenue Ruling 86-164
(a) Provides for split holding periods where the transferor transferred multiple properties. This ruling
involved a taxpayer who transferred to a newly organized controlled corp machinery with a fair market
value of 10x dollars, real estate (land and building) with a fmv of 30x dollars, and accounts receivable
with a fmv of 60x dollars, The taxpayer had held the real estate and machinery for more than one year
and both were quasi capital assets under 1231 .
ii) Timing of 351(b) Gain
(1) 453 Installment Method directs the seller to construct a fraction by dividing the realized gain by the
total principal payments to be received on the sale. The seller then applies the f raction to each payment
received to determine the gain recognized in the year of sale and as installme nt payments are later made.
(2) A transferor may immediately increase the basis in any nonrecognition property received (i.e. stock) by the
transferors total potential recognized gain, but the corporations corresponding 362(a) basis increase is
delayed until the transferor actually recognizes gain on the installment method.
(a) Example:
(i) A sells his appreciated asset (X) which has an adjusted basis of 10 and a fmv of 100 for 80 cash
and a 20 note with market rate interest and principal payable in equal installments over the next 5

10
 years. As realized gain is 90 dollars (100 10 basis). As total payments will be 100: 80 in the
year of sale and 20 in subsequent years. Under the installment method, 90/100 of each payment
received must be reported as taxable gain.
(b) Now, assume that A transfers X to D-Corp in exchange for 80 shares of D-Corp stock (worth $80) and
a 20 dollar D-Corp 5 year note. A again realized 90 of gain, but recognizes that gain only to the extent
of the 20 boot received. For timing purposes, the regulations divide the exchange into two separate
transactions. a 351(a) nonrecognition exchange to the extent of the stock received by the transferor
and an installment sale to the extent of the boot received. The basis of the transferred property is first
allocated to the nonrecognition transaction. The regs implement this bifurcation approach as follows.
(i) As basis in X (10) is first allocated to the D-Corp stock (nonrecognition property) received in the
exchange in an amount up to the FMC of that property. Therefore the enture 10 of basis is thus
allocated ot the 80 venture stock received.
(ii) If the transferors basis in the transferred property exceeds the FMV of the nonrecognition
property received that excess basis is then allocated ot the installment portion of the transaction.
There is no excess basis to allocate in this example because the X basis does not exceed the value
of the nonrecognition property.
(iii) 453 is then applied to the installment portion of the transaction. Here, the selling price is the sum
of the face value of the installment obligation (20) and the FMV of other boot (none here). Total
contract price here is 20 (because there are no liabilities). The gross profit is the selling price less
any excess basis allocated to the installment obligation (20-0=20). As gross profit ratio is thus
20/20 or 100 percent. To determine his recognized gain, A applies that percentage to any boot
received in the year of sale and to payments as they are received on the installment note. A thus
recognizes no gain in the year of exchange; his entire boot gain is recognized as the note is paid
off over the next 5 years. Note that the gross profit ratio is normally 100 percent if the boot
received is less than the realized gain.
(3) Determining the corporations basis in the transferred property is more complicated (when there is a note)
(a) Basically, as the transferee recognizes gain, the corporations basis in that property increases
correspondingly.
d) Assumption of Liabilities
i) Generally
(1) In most circumstances, a taxpayer who is relieved of a debt in connection with the disposition of property
must include the debt relief in the amount realized even if the debt is non-recourse.
(2) However, if that rule applied to a corporate formation, many incorporations of a going business would
become taxable events to the extent of the liabilities assumed and the policy of section 351 would be
frustrated.
(a) Therefore, Congress enacted 357
ii) 357- Assumption of Liability
(1) 357(a): General Rule Provides that the assumption of a liability by a transferee corporation in a section
351 exchange will neither constitute boot nor prevent the exchange from qualifying under 351.
(a) Rather than treating the debt relief as boot, the Code postpones the recognition of any gain attributable
to the transferred liabilities.
(b) This deferral is accomplished by 358(d) which reduces the basis in the stock received in the exchange
by treating the relieved liabilities as money received by the transferor for purposes of determining the
shareholders basis.
(c) The regs say that when 357 applies to more than one type of property transferred, basis has to be
allocated according to FMV.
(2) 357 is subject to two exceptions. 357(b) abuse and 357(c) negative basis.
(3) 357(b): Tax Avoidance Purpose the assumption of a 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.
(a) This essentially factual determination is made after taking into consideration the nature of the liability
and the circumstances in the light of which the arrangement for the assumption or acquisition was
made.
(b) If an improper purpose exists, all the relieved liabilities, not merely the evil debts, are treated as boot.
(c) This provision was designed to prevent taxpayers from transferring personal obligations to a newly
formed corp or from achieving a bail out without boot by borrowing against property on the eve of
incorporation and then transferring the encumbered assets to the corporation.

11
 (4) 357(c): Liabilities in Excess of basis if the sum of the liabilities assumed by the corporation exceed the
aggregate adjusted bases of the properties transferred by a particular transferor the excess shall be
considered as gain from the sale or exchange of the property.
(a) i.e. A transfers a building with adjusted basis of 30 and FMV of 100 and outstanding mortgage of 55 to
C-Corp for assumption of debt and 45 worth of stock. Technically A has a -25 basis (30 basis of
building 55 assumed liability) but the code abhors negative basis.
(b) 357(c) often causes cash basis taxpayers to recognize more gain by having their obligations assumed
than they would have recognized if they received equivalent cash boot or withheld sufficient assets to
pay the liabilities.
iii) 358(d): Assumption of Liabilities
(1) In General where as part of the consideration to the taxpayer, another party to the exchange assumed a
liability of the taxpayer such assumption shall, for purposes of this section, be treated as money received by
the taxpayer on the exchange.
(2) Exception does not apply to the amount of any liability excluded under 357(c)(3) (negative basis rule)
(a) Basically, the way 358(d) works is that we count the amount of the debt relief as if it were cash
received.
e) Special Problems
i) Incorporation of a Going Business
(1) Hempt Bros. v. U.S. (pg 101)
(a) Facts
(i) A partnership had transferred its assets to a newly organized corporation under 351.
(ii) The assets transferred to the corp included accounts receivable.
(iii) If section 351 applied to accounts receivable to the corporation then, under 362 the corp would
take them at their basis in the hands of the partnership, which was zero because the partnership
used cash method and had not yet taken them into income.
(iv) Therefore upon collection of the receivables the corp would have gross income.
(b) Held
(i) The court held that accounts receivable WERE property (despite Hempts argument
(c) Unless there is some special reason intrinsic to 26 U.S.C.S. 351, the general word "property" has a
broad reach in tax law. For 351, in particular, courts have advocated a generous definition of
"property."
(d) The mere fact that an asset has been transferred under 26 U.S.C.S. 351(a) from a partnership
ownership to a corporate ownership does not in itself alter its tax basis.
(e) Assignment income, which would keep the liability with the taxpayer, to be paid off when the accounts
are paid off was not accepted.
(2) Rev Ruling 95-74
(a) This revenue ruling held that assumed environmental liabilities give rise to deductible or capital
expenditures.
(i) If liabilities have not been taken into account by transferor prior to the transfer, and therefore
neither given rise to deductions nor resulted in the creation of or increase in basis in any property,
they are not liabilities under 357(c)(1)
(b) Including in the 357(c)(1) determination liabilities that have not yet been taken into account by the
transferor results in an overstatement of liabilities of and potential inappropriate gain recognition to the
transferor because the transferor has not received the corresponding deduction or other corresponding
tax benefit.
(3) Receivables and Payables
(a) When there is a valid business purpose for the transfer of receivables and payables on the incorporation
of a going business, the Service will issue a ruling that the transferee corp and not the transferor must
report the receivables in income as they are collected and deduct the payables when they are paid.
(4) Tax Benefit Rule
(a) Under this rule, if an amount has been deducted and a later event occurs that is fundamentally
inconsistent with the premise on which the deduction was initially based ,the earlier deduction must be
effectively cancelled out by the recognition of income equal to the amount previously deducted.
(i) If a taxpayer recovers an amount that was deducted or credited against tax in a previous year, the
recovery must be included in income to the extent that the deduction or credit reduced the tax
liability in the earlier year. If no tax benefit was derived from a prior-year deduction or credit, the
recovery does not have to be included in income.
12
 (ii) If a taxpayer repays an amount that was previously included in taxable income, the repayment can
be deducted in the year in which it is repaid.
(b) Hypo: Taxpayer pays 1000 for minor office supplies to be used in his business would deduct that
amount when paid on the assumption that those supplies soon would be exhausted. If taxpayer later
incorporates before the supplies are used and receives 1000 of stock in exchange, an event has
occurred that is inconsistent with the presumption upon which the earlier deduction was based. But
recognition of 1000 of current income on the transfer of the supplies to a controlled corporation in
exchange ofr its stock is also inconsistent with 351.
(i) The SC has held that the tax benefit rule applies whenever a later unforeseen event is
fundamentally inconsistent with the premise underlying a taxpayers earlier deduction.
ii) Contingent Liability Tax Shelters
(1) Generally
(a) Generally set up to create capital losses to offset capital gains.
(b) Can be set up by forming a new corporation and transferring cash in return for stock and a type of
liability that would not be considered a liability under 357 and 358. The transferor is another
corporation, so the existing corporation contributes cash to a newly formed corp for stock and the stock
has a value less than the amount of cash transferred and the assumption of the contingent liability
which equals the excess of the cash over the newly acquired stock.
(2) Black and Decker v. US (pg 111)
(a) Facts
(i) B and D created BDHMI
(ii) BD transferred approximately 561 million dollars to BDHMI along with 560 million in contingent
employee healthcare claims in exchange for newly issued stock.
(iii) The stock was sold for 1 million.
(iv) Because BD believed it had a 561 million dollars basis in the stock, the value of the property
transferred, they claimed 560 million dollars capital loss on the stock sale.
(b) Issue
(i) Is the basis in the stock 1 million or 561 million. Is the 560 considered cash boot or not?
(ii) If it is boot then the basis is 1 million.
(iii) Stock basis is not reduced for the amount of a liability governed by 357(c)(3).
(c) Analysis
(i) 358(d) Generally, assumption of liability is treated as cash boot, but must look at 357(c).
1. 357(c)(3)(a) provides that if the contingent liabilities transferred would give rise to a
deduction, then the amount of such liabilities shall be excluded in determining the amount of
liabilities assumed. The issue is whether they are in the ordinary course.
2. 357(c)(3)(a) does not explicitly state whether contingent liabilities must be deductible by
the transferor or the transferee in a 351 exchange to fall within this exception
(ii) Held
1. The BDHMI transaction was not a shame because it had very real economic implications for
every beneficiary of BDs employee benefits program as well as f or the parties to the
transaction.
(d) 358(h) a response to this type of transaction
iii) Intentional Avoidance of 351
(1) Generally
(a) A taxpayer may want to fail 351 so that they have a higher basis in contributed assets.
(b) Also, if you are contributing loss property that you want to recognize immediately or he wants to
recognize gain immediately to use losses that he has.
f) Collateral Issues
i) Contributions to Capital
(1) Contributions can be made by shareholders or nonshareohlders
(2) When there is a contribution to capital made you can increase your basis in the stock assuming there is no
new stock issued.
(a) Contributions to capital b shareholders are also excludable from the gross income of the transferee
corporation.
(b) Basis is the same as the transferors.
(3) If you are a nonshareholder, the corporate basis in the property is zero. If money is contributed, the basis in
the property purchased with it is zero.
13
 (4) The court will find a constructive 351 exchange even if no stock is issued if a sole shareholder transfers
property to ca corp or if all shareholders transfer property in the same proportion as their holdings.
(5) Commissioner v. Find (pg 117)
(a) Facts
(i) The principal but not sole shareholder of a financially troubled corporation voluntarily surrendered
shares of stock in the corp in an effort to increase the attractiveness of the corp to outside
investors.
(b) Held
(i) No deductible loss arises when a dominant shareholder surrenders some stock non pro rata but
retains voting control over the corporation after the surrender.
(ii) The SC treated the surrender as a nontaxable contribution to capital even though there was no
increase in the corporations net worth. Therefore, the basis in the shifted stock was just
transferred back to the shareholders remaining stock.
(iii) The surrendered stock was a contribution to capital.
3) CHAPTER 3: THE CAPITAL STRUCTRE OF A CORPORATION
a) Introduction
i) The simplest method of raising capital = issuing stock. Can also raise capital by borrowing. However, there is
a benefit to contributing debt in the code.
ii) Main advantage in issuing debt as opposed to equity is avoidance of the double tax.
(1) Other advantage: (1) repayment of principal on a corporate debt is a tax free return of capital to the lender.
If the amount repaid exceeds the lenders basis in the debt the difference generally is treated as capital
gains.
(a) In contrast, when a corporation redeems stock form a shareholder, a similar transaction, the entire
amount received may be taxed as a dividend if the shareholder or related persons continue to own
stock in the corp.
(b) Other Advantage (2) the issuance of debt at the time of inc also may provide a defense against
subsequent imposition of the accumulated earnings tax. The obligation to pay a debt at maturity may
qualify as a reasonable business need, justifying an accumulation of corporate earnings, while the same
type of accumulation for redemption of stock normally is not regarded as reasonable for purposes of
the accumulated earnings tax.
b) Debt vs. Equity
i) Code
(1) 385: Treatment of Certain Interests in Corporations as Stock or Indebtedness (leg history says
neither factor is determinative, lessening their force)
(a) (b): Factors the regulations prescribed under this section shall set forth factors which are to be
taken into account in determining with respect to a particular factual situation whether a debtor-
creditor relationship exists or a corporation-shareholder relationship exists
(i) 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.
1. should bear the general indicia of debt unconditional promise to pay, specific term,
remedies for default, stted interest that is rZ
2. Avoid equity characteristics, i.e contingent interest on earnings or providing voting rights.
(ii) Whether there is subordination to or preferences over any indebtedness of the corporation
1. common shareholders have a residual interest in the company and that interest basically
means they are last in line to get paid. The fact that something is subordinate looks more like
debt.
(iii) The ration debt to equity of the corp
1. want to make sure assets exceed obligations. If there is a very high debt to equity ratio
rationale lenders wont lend or will demand high interest rates.
(iv) Whether there is convertibility into the stock of the corp and
1. to the extent it is convertible looks more like equity.
(v) The relationship between holdings of stock in the corp and holdings of the interest in question.
1. if you hold stock dont want to force the corp into bankruptcy.
ii) Form of Payment
(1) The service has ruled that an instrument may be classified as debt where a holder has the right to be repaid
in cash or stock
(a) If a holder is required to accept stock it will not qualify as debt.
14
 (b) If a holder has choice between cash or stock but is tructered to ensure selection of stock it will not be a
debt.
iii) Fin Hay Realty v. US (pg 135)
(1) The court found 16 factors to delineate debt from equity, and focused on the intent of the parties.
(2) Facts
(a) The taxpayer was a close corporation formed by two shareholders, who contributed equal amounts and
thereafter advanced funds for which they received promissory notes.
(b) While the formal indicia of loan obligations were present, the corporation was the complete creature of
the shareholders who had the power to create whatever appearance would be of benefit to them,
despite the economic reality of the situation.
(3) Held
(a) the funds paid to the taxpayer by its shareholders, while having the indicia and form of loans, were
actually contributions to capital; thus, deductions for interest on the loans were improper.
(4) There are a number of criteria by which to judge the true nature of an investment in the form of a debt: (1)
parties' intent; (2) identity between creditors and shareholders; (3) extent of the instrument holder's
participation in management; (4) corporation's ability obtain funds from outside sources; (5) capital
structure's "thinness" in relation to debt; (6) risk involved; (7) arrangement's formal indicia; (8) obligees'
relative position as to other creditors regarding payment of interest and principal; (9) instrument holder's
voting power; (10) provision of a fixed rate of interest; (11) contingency on the obligation to repay; (12)
source of interest payments; (13) presence or absence of a fixed maturity date; (14) provision for
redemption by the corporation; (15) provision for redemption at the holder's option; and (16) timing of the
advance with reference to the corporation's organization.
(5) In a corporation which has numerous shareholders with varying interests, the arm's-length relationship
between the corporation and a shareholder who supplies funds to it inevitably results in a transaction whose
form mirrors its substance. Where the corporation is closely held, however, and the same persons occupy
both sides of the bargaining table, form does not necessarily correspond to the intrinsic economic nature of
the transaction, for the parties may mold it at their will with no countervailing pull. This is particularly so
where a shareholder can have the funds he advances to a corporation treated as corporate obligations
instead of contributions to capital without affecting his proportionate equity interest. Labels, which are
perhaps the best expression of the subjective intention of parties to a transaction, thus lose their
meaningfulness. Under an objective test of economic reality it is useful to compare the form which a
similar transaction would have taken had it been between the corporation and an outside lender, and if the
shareholder's advance is far more speculative than what an outsider would make, it is a loan in name only.
c) The Section 385 Saga
i) See Above for the statute.
(1) 385(b) sets forth the factors.
ii) Regulations Stated: A debt is excessive if the instruments term sand conditions, viewed in combination with the
corporations financial structure, would not have been satisfactory to a bank or other financial institution
making ordinary commercial loans.
(1) Inside debt/equity cant exceed 3:1 and Outside debt/equity cant exceed 10:1
(a) Inside: considering only shareholder debt
(b) Outside: takes into account ALL liabilities including those to independent contractors.
(2) Regs were pulled because of lobbyists.
iii) If something is recharacterized it will be done so as a dividend. Shareholders dont care if its interest or a
dividend, but the corp can write off interest payments but not a dividend payment avoid double tax.
d) Character of Gain or Loss on Corporate Investment
i) Generally
(1) Since equity and debt securities held by investors are capital assets, gain or loss on the sale of stock, bonds,
and other debt instruments generally is a capital gain or loss. The Code also includes a few special
characterization rules, some to stimulate investment and others to clarify the tax treatment of transactions
that technically do not constitute a sale or exchange.
ii) Gain on Sale of Qualified Small Business Stock
(1) 1202 permits noncorporate shareholders to exclude from gross income 50 percent of the gain from a sale
or exchange of qualified small business stock held for more than 5 years.
(a) To qualify its stock for this tax benefit, the issuer must be a C-Corp with aggregate gross assets of 50
million or less at the time the stock is issued.

15
 (b) The Bad News: long term capital gain from the sale of qualified small business stock is taxed at a
minimum rate of 28 percent, called 1202 gain.
(i) Therefore, the maximum effective rate on a sale of qualified small business stock after taking into
account the 50 percent exclusion is 14 percent, not much better than the generally applicable 15
percent max rate.
(2) 1045 provides a more meaningful tax benefit, it allows noncorporate shareholders to elect to defer
otherwise taxable gain from a sale of qualified small business stock held for more than 65 months my
rolling over the proceeds into new qualified small business stock within 60 days of sale.
iii) Worthless Securities
(1) GENERALLY
(a) Sole proprietors, partners, and shareholders in an S-Corp usually may deduct the losses from their
business operations as they are incurred if they materially participate in the activity.
(b) But shareholders or creditors in a C-Corp normally must be content to recognize a capital loss at the
time their investment is sold or becomes worthless.
(i) Of a loss results from the worthlessness of stock or debt evidenced by a security which is a capital
asset, the calamity is treated as a hypo sale or exchange on the last day of the taxable year in
which the loss is incurred.
(2) US v. Generes (pg 148)
(a) Purpose
(i) Provides the importance of distinguishing between business and nonbusiness bad debts in a corp
that went under.
(b) Facts
(i) The president of a closely held corporation, which employed the president's son-in-law as
executive vice president, owned 44 percent of the corporation's outstanding stock, for which he
originally invested $ 38,900.
(ii) The corporate president made loans to the corporation, guaranteed loans made to the corporation
by banks, and signed a blanket agreement with the corporation's surety agreeing to indemnify the
surety for any loss it suffered as the corporation's surety.
(iii) The corporation defaulted in its performance of two contracts, the surety made good the
corporation's default, and the corporate president indemnified the surety to the extent of $
162,104.57.
(iv) The corporate president claimed the indemnification loss as a business bad debt on his 1962
federal income tax return. The Internal Revenue Service disallowed the claim and levied
assessments against the corporate president.
(v) The corporate president paid the assessments and filed refund claims in the United States District
Court for the Eastern District of Louisiana.
(vi) At a jury trial, the corporate president testified that although his annual income was $ 40,000, he
signed the indemnity agreement to protect his $ 12,000-per-year job with the corporation, and
never once gave a thought to his investment in the corporation.
(vii) By special interrogatory, the jury was asked to determine whether the president's signing the
indemnity agreement was proximately related to his trade or business of being an employee of the
corporation.
(viii) The trial court charged the jury that significant motivation satisfied the requirement of a
proximate relationship, and refused the government's request for an instruction that dominant
motivation was the applicable standard.
(ix) The jury returned a verdict for the corporate president, on which judgment was entered.
(c) Held
(i) dominant motivation rather than significant motivation is the proper test
(ii) in expressing the views of four members of the court, that a jury could not find that the corporate
president's dominant motivation in entering into the indemnity agreement was protecting his $
12,000 annual salary.
(d) In determining whether a bad debt is a business or a nonbusiness obligation, the United States Treasury
Department Regulations focus on the relation the loss bears to the taxpayer's business. If, at the time of
worthlessness, that relation is a "proximate" one, the debt qualifies as a business bad debt.
(e) In determining whether a bad debt has a "proximate" relation to a taxpayer's trade or business, as the
Regulations specify, and thus qualifies as a business bad debt, the proper measure is that of dominant
motivation, and that only significant motivation is not sufficient.

16
 (f) The dominant-motivation test strengthens and is consistent with the mandate of 262 of the Internal
Revenue Code, 26 U.S.C.S. 262, that no deduction shall be allowed for personal, living, or family
expenses except as otherwise provided. It prevents personal considerations from circumventing this
provision.
(3) FROM LEXIS SUPPLEMENT
(a) Generes provides an example of the importance of the distinction between business bad debts and
nonbusiness bad debts in the context of a corporation that foundered.
(i) Taxpayer was a 44 percent owner and president of KG. Taxpayer occasionally lent the corporation
money from his personal funds, and guaranteed loans made to the corporation by banks. He lent
substantial funds, and when the corp went under he was unable to recover those funds.
(ii) Look to 165(g) for the definition of a worthless security.
(b) Issue: Are these bad debts business bad debts
(i) The primary inquiry is the relation the loss had to the taxpayers business.
(ii) 108 deals with discharge of indebtedness.
(iii) Business bad debts can write off against business income, regular bad debts can only be taken as
capital losses.
1. Under 166(d)(1)(b) nonbusiness bad debts are short term capital losses. Under 1211 can
only deduct up to the extent of capital gains plus up to another 3000. You can carry it back a
little look at 1212 (3 years).
2. Regs: 1.165(b) need a proximate relationship.
(c) Held
(i) The taxpayers dominant motivation is key a significant business motivation is not enough.
Dominant motivation was not business, so not a business bad debt.
4) CHAPTER 4: NONLIQUIDATING DISTRIBUTIONS
a) Introduction
i) Generally
(1) There are three general tax consequences we are concerned with
(a) Taxable amount
(b) Character of the loss (capital or ordinary)
(c) Holding period
(2) 316: Dividend Defined: (a) General Rule dividend means any distribution of property made by a
corporation to its shareholders
(a) out of earnings and profits accumulated
(b) out if its earnings and profits of the taxable year without regard to the amount of and profts at the time
the distribution was made
ii) Dividends in General
(1) 301 governs the amount and classification to corporate and noncorporate shareholders of distributions of
property made by a C corp with respect to its stock
(a) 301(c)(1) - distributions that are dividends within the meaning of 316 must be included in gross
income.
(i) in order to avoid double tax, corporate shareholder may deduct 70 100 percent of the dividends
received.
(ii) Dividends received by non-corporate shareholders are usually taxed at preferential long term
capital gains rates.
(iii) Distributions not dividends are first treated as a recovery of shareholders basis in his stock and any
excess over basis is treated as gain from the sale or exchange of the stock.
(2) 316(a) defines a dividend as any distribution of property made by a corporation to its shareholders out of
(1) E and P accumulated or (2) current E and P.
(a) This provision contains two irrebuttable presumptions: (1) every distribution is deemed to be made out
of E and P to the extent that they exist and (2) is deemed to be made from the most recently
accumulated E and P.
(3) When there is a distribution of property, 301(a) sends us to 301(c)
(a) 301(c)(1) - First, if there is enough E and P the distribution is a dividend
(b) 301(c)(2) Second, we look to a return of capital on the basis.
(c) 301(c)(3) Third, we treat the excess as gain on a normal sale or exchange.
iii) Qualified Dividends
17
 (1) Effective for eligible dividends received from 1/1/03 through 12/31/08 the max rate on qualified dividend
income is reduced to 15 percent for taxpayers whose ordinary income otherwise would be taxed at higher
rates and to 5 percent for lower income taxpayers whose ordinary income would be taxed in the 10 or 15
percent bracket.
iv) Impact of Taxes on Corporate Dividend Policy
(1) The distribution policies of closely held C corps are largely motivated by the goal of getting corp profits to
the shareholders at the lowest tax cost.
b) Earnings and Profits
i) Generally (162, 167 and 168 discuss some general business deductions for tax purposes)
(1) Distributions are dividends only to the extent that they come from the corporations earnings and profits,
but the code does not define them.
(2) 312 describes the effects of certain transactions on E and P and the accompanying regs provide ample
elaboration, but a precise definition of the term is nowhere in the code.
(3) The function of E and P is clear: It is a measuring device used to determine the extent to which a
distribution is made from a corporations economic income as opposed to its taxable income or paid-in
capital.
(4) E and P are not identical to taxable income E and P is designed to measure the economic performance of
the corporation. Taxable income does not provide a true financial picture because that concept is cluttered
with a host of policy incentives and relief provisions that bear little or no relationship to the corporations
capacity to pay dividends.
ii) Calculations: although E and P can be determined by making adjustments to either retained earnings or taxable
income, the traditional approach is to start with a corporations taxable income and to make adjustments that fall
into the four broad categories below.
(1) Certain Items excluded from taxable income must be added back
(a) items that represent TRUE FINANCIAL GAIN but are exempt from tax, such as municipal bond
interest, life insurance proceeds and fed tax refunds and otherwise excludable discharge of
indebtedness income are included in earnings and profits.
(b) Contributions to capital and gains that are realized but not re3congized for tax purposes (i.e. like kind
exchanges, 351 transfers) are not added back in computing E and P.
(2) Certain items deductible in determining taxable income must be added back
(a) Certain deductions and benefits allowed in computing taxable income which do not reflect a real
decrease in corporate wealth are not permitted or are restricted in determining earnings and profits. i.e.
a deductible item that involves NO actual expenditure, such as the dividends received deduction, must
be added back to taxable income in determining E and P.
(3) Certain Nondeductible items must be subtracted
(a) Some items not allowed as deductions in computing taxable income in fact represent actual
expenditures that diminish a corporations capacity to pay dividends. These items reduce E and P. i.e.
federal income taxes paid during the year by a cash method corporations will reduce E and P, as will
losses and expenses disallowed under provisions such as 265, 267 and 274 and charity
contributions in excess of the ten percent corporate limitation.
(b) Additionally, net operating losses and capital losses in excess of capital gains reduce E and P in the
year they are incurred. To avoid double tax benefit they may not be carried back or forward in
determining E and P.
(4) Certain Timing adjustments to be made
(a) A variety of adjustments are required to override timing rules that allow corporations to artificially
defer income or accelerate deductions in computing taxable income.
(i) i.e. may not use accelerated cost recovery system (ACRS). Instead the cost of depreciable
property must be recovered in computing E and P under the straight line method.
(b) Realized gains that are deferred for taxable income purposes under the installment sale method must be
currently included in E and P.
(i) Also, gains on the sale of inventory are reported under FIFO rather than LIFO.
c) Distributions of Cash
i) Generally
(1) The amount of the distribution is simply the amount of money received by the shareholder.
(a) That amount is taxable as a dividend to the extent of the distributions current or accumulated E and P
(301(c)(1)).

18
 (b) Amounts distributed in excess of available earnings and profits are first applied against and reduce the
basis of the shareholders stock (301(c)(2))
(c) And to the extent they exceed basis they are treated as gain from the sale or exchange of the stock
(301(c)(3)).
(2) 312 says that distributing corp can reduce E and P by the amount of money distribted, except that E and P
may be reduced as a whole only to the extent they exist.
(3) When there are insufficient current E and P available to cover all cash distributions (determined at the end
of the year, regardless of when the distribution was) (316, Reg 1.316-2a), E and P must be allocated to the
distributions in order to determine dividend status under the following rules:
(a) First current E and P are prorated among the distributions by using the formula: Current E and P
Allocated To Distribution = Amt of Dist x (Total Current E and P/ Total Distributions).
(b) Next, accumulated E and P are allocated chronologically to distributions on a first come first served
basis Reg 1.316-2c (this happens when there is a shift in ownership during the year).
(c) If the corp has a current loss, but has accumulated E and P from prior years, it is necessary to
determine the amt of accumulated E and P available on the date of distribution.
(4) If distributions are only of money and exceed current E and P, then that portion of each distribution which
the total current E and P bears to the total distribution during the taxable year comes out of current E and P.
(a) That is, current E and P is allocated Pro rata to each of the years distributions (1.316-2(b)).
(b) The easiest way compute this is to allocate E and P proportionally to each of the distributions to that,
for example, if there are three equal distributions, current E and P is allocated one third to each
distribution.
d) Distributions of Property
i) Consequences to the Distributing Corporation
(1) GENERAL UTILITIES DOCTRINE
(a) Background: The General Utilities Doctrine
(i) General Utilities v. Helvering (pg 173)
1. Facts
a. SC first considered the corporate level tax consequences of a nonliquidating distribution
of appreciated property by a corporation to its shareholders.
b. Gen Util distributed property to shareholders with the understanding they would sell it to
the target.
c. The service contended this was a taxable transaction at the corporate level.
2. By the time the controversy reached the Supreme Court, the governments principal argument
was based on the premise that Gen Util had created an indebtedness to its shareholders by
declaring a dividend.
a. it contended that using appreciated property to discharge that indebtedness was a taxable
event.
3. Held
a. the corporation recognized no gain because the distribution was not a sale and the
corporation did not discharge indebtedness with the appreciated assets.
4. It was long assumed that this case stood for the broader proposition that a distributing corp
does not recognize gain or loss when it makes a distribution in kind with respect to its own
stock.
(ii) 311(a)(2) codified Gen Utilities. provides that a corporation generally does not recognize gain
or loss on a nonliquidating distribution of property.
(b) Corporate Gain or Loss
(i) 311: Taxability of Corp on Distributions
1. (a) GENERAL RULE: Except as provided in subsection (b), no gain or loss shall be
recognized to a corporation on the distribution (not in complete liquidation) with respect to its
stock, of
a. Its stock (or rights to acquire stock) or
b. Property.
2. (b) stands the rule in (a) on its head for nonliquidated distribution of appreciated property.
a. If a corporation distributes appreciated property in a nonliquidating distribution, it must
recognize gain in an amount equal to the excess of the fair market value of the property
over its adjusted basis.
b. If it is distributed subject to the liability, the fair market value is no less than the liability.

19
 c. The General Utilities doctrine therefore is no longer applicable to nonliquidating
distributions of appreciated property.
d. Basically, if the corporation is going to distribute property that is appreciated they will
have to recognize gain of FMV-Adj Basis.
i. Conceptually, the c orproation has to recognize gain because if they went out and
sold it to a third person they would have to recognize gain. They are just treating this
property as being sold to the shareholders.
ii. The shareholders basis will the FMV on the date of distribution
(c) Effects on the Distributing Corporations Earnings and Profits.
(i) Generally
1. Gain recognized by the corporation on the distribution naturally increases current E and P
2. After a property distribution, the distributing corporation may reduce accumulated E and P
under 312(a)(3) by the adjusted basis of the distributed property.
3. On a distribution of appreciated property the rule is modified by 312(b)(2) which provides
that the E and P reduction rule in 312(a)(3) is applied by substituting the far market value of
the property for its adjusted basis.
a. This allows a corp distributing appreciated property to make a downward adjustment to
accumulated E and P in an amount equal to the full fair market value of the property.
(d) Consequences to the Shareholders
(i) The rules governing the shareholder level tax consequences of property distributions are
essentially the same as those for cash distributions.
(ii) The amount of the distribution is the farir market value of the distributed property, reduced by any
liabilities assumed by the shareholder or to which the property is subject (312(b)(1), (f)(1)).
(iii) The amount is taxed under 301(c)(1), and the basis in the distributed property is its fmv as of the
date of distribution (301(d)).
e) Constructive Distributions
i) Generally
(1) To avoid the double tax, closely held C corps have attempted to distribute earnings in a form that may be
deductible at the corporate level. i.e.
(a) excessive compensation to shareholders or relatives,
(b) expenses paid for the personal benefit of shareholders,
(c) excessive rent for corporate use of shareholder property
(d) interest on shareholder debt that in substance represents equity.
(2) You want to look to see if there is equivalent value flowing from the shareholder to the corp as from the
corp to the shareholder.
ii) Nicholls v. Commissioner
(1) Facts
(a) The commissioner disallowed depreciation and operating expense deductions for the boat purchased
with corporate funds, and the commissioner also disallowed the taxpayers' related investment credit.
(b) Based on the theory that a constructive dividend was received by the taxpayers to the extent of either
the purchase price of the boat or the value of the use of the boat, the commissioner determined a
deficiency in the taxpayers' federal income tax.
(c) The taxpayers contested the commissioner's determinations.
(d) The court found that the boat was acquired and used for corporate business purposes.
(e) Accordingly, the depreciation and operating expenses were deductible under I.R.C. 167, 162
(1954).
(f) The court determined that the records for the use of the boat failed to meet the substantiation
requirements of 274, failed to meet the ordinary-and-necessary test of 162, and constituted a
constructive dividend to the taxpayers to the extent of their use of the boat.
(g) Because the yacht failed to qualify either in whole or in part as a depreciable asset, it did not meet the
48 definition of property qualified for investment credit, and the credit was disallowed.
(2) Held
(a) The court ruled that the commissioner was correct in the determination that the taxpayers had
deficiencies in their federal income taxes. The court determined that the taxpayers' records were
insufficient to support the deductions and investment credit claimed for the business use of a boat. The
court also found that the taxpayers had a taxable constructive dividend for their personal use of the
boat that was purchased with corporate funds.
20
 (b) Measure of constructive dividend when facility is owned by the corporation is the fair rental value for
the period in question rather than the total cost of acquisition.
(3) The general requirement of both 162 and 167 that expenses and assets be attributable to a trade or
business has led to repeated litigation involving both the nexus between expenditure and enterprise and the
quantum of evidence necessary to substantiate the event and its surrounding circumstances. Section 274
(1962) is applicable for the purpose of limiting substantial abuses in the area of deductions for
entertainment and entertainment facilities.
(4) The requirement of Treas. Reg. 1.274-2(e)(4)(iii) is that on more than 50 percent of the total calendar
days of use of the facility there must have been a qualifying business use.
iii) Rev Ruling 69-630
(1) Facts
(a) A controlled X and Y corp and caused X to sell property to Y for less than an arms length price for tax
avoidance purposes.
(2) Held
(a) Xs income was increased under 482 of the code to reflect the arms length price. Ys basis in the
property was similarly increased and the amount of such increase will be treated as a distribution to A,
the controlling shareholder, with respect to his stock of X and as a capital contribution by A to Y.
iv) Compensation vs. Constructive Dividend
(1) Compensation is also taxable at the highest ordinary income rate and is subject to employment taxes.
However, compensation and the employers a share of the employment taxes is deductible while dividends
are not.
(2) Under old arithmentic with wages and dividends taxes at the same ordinary income rate it almost always
was advantageous to classify distributions to shareholder employees as compensation rather than a
dividend so that the corporation could deduct the payment.
(a) However, under current law, as long as dividends are taxable at only 15 percent, there now are
situations where the aggregate amount of federal taxes is lowed if payments are classified as dividends
rather than compensation.
f) Anti-Avoidance Limitations on the Dividends Received Deduction
i) Generally
(1) Dividends received by corporate shareholders are treated more generously for tax purposes than dividends
received by individuals. 243 generally permits corp shareholders to deduct 7u0 percent of dividends
received from other corporations, increasing incrementally.
ii) Special Holding Period Requirements
(1) 246(c) there is a holding period of more than 45 days in a 91 day period beginning on the date which is 45
days before the stock goes ex dividend.
(2) In the case of certain preferred stock, the required holding period is 90 days during the 181 day period
beginning on the date which is 90 days before the ex dividend date.
(3) This period is tolled whenever the corporate shareholder diminishes its risk of loss with respect to the stock
in any one of several ways.
(4) Net result: a corporation is not entitled to the dividends received deduction unless it is willing to hold the
stock and incur a genuine market risk for the requisite period of time.
(5) 246A this is to prevent the shareholder from getting an interest expense deduction and at the same
getting a dividends received deduction.
(a) If this provision applies you receive the dividends received percentages TO THE EXTENT that it is
debt financed, so if they borrowed half the cost of the stock they receive only half of the dividends
received deduction
iii) Extraordinary Dividends: Basis Reduction
(1) If the dividend to be received is extraordinarily large in relation to the price of the stock, a corporate
shareholder may incur a minimal risk of loss even if it holds the stock for more than 45 days.
(a) While 246 takes away the dividends received deduction, 1059 triggers a basis reduction.
(2) 1059: provides that a corporate shareholder receiving an extraordinary dividend must reduce its basis in
the underlying stock (but not below zero) by the amount of the non-taxed (i.e. deductible) portion of the
dividend if the corp has not held the stock for more than 2 years before the dividend announcement date
i.e. the earliest date when the distributing corp declares, announces, or agrees to the amount or payment of
the dividend.

21
 (a) 1059(c) defines an extraordinary dividend in terms of the size of the dividend in relation to the
shareholders adjusted basis in the underlying stock. A dividend is extraordinary if it exceeds certain
threshold percentages 5% of the shareholders adjusted basis in the case of most preferred stock and
10 percent of the adj basis in the case of any other stock.
(i) (c)(3)(a): to prevent easy avoidance of these percentage tests, all dividends received by a
shareholder with respect to any shares of stock which have ex dividend dates within the same
period of 85 consecutive days are combined and treated as one dividend.
(ii) (c)(4): an alternate test says a taxpayer may elect to determine the status of a dividend as
extraordinary by reference to the fair market value (rather than the adjusted basis) of the stock as
of the day before the ex dividend date.
1. This would be beneficial if there has been a substantial appreciation since shareholder
acquisition.
(3) The basis reduction in 1059 is only for the nontaxed portion of an extraordinary dividend. The nontaxed
portion is the total amount of the dividend reduced by the taxable portion i.e. that which is includable in
gross income after application of dividends received deduction.
(4) If the nontaxed portion of an extraordinary dividend exceeds the shareholders adjusted basis in the stock,
any excess is treated as gain from the sale or exchange of property in the taxable year in which the
extraordinary dividend is received.
(5) 1059(e) broadens the general definition of extraordinary dividend.
(a) (e)(1) provides that any amount treated as a 301 distribution to a corporate shareholder shall be an
extraordinary dividend, irrespective of the shareholders holding period on the stock or the size of the
distribution, if it is a distribution in redemption of stock which is
(i) Part of partial liquidation of the redeeming corp
(ii) Or is non pro rata to all shareholders
iv) Debt-Financed Portfolio Stock
(1) 246A(a) General Rule In the c ase of any dividend on debt financed portfolio stock, there shall e
substituted for the percentage which but for this section would be used in determining the amount of the
deductions a percentage equal to the product of
(a) 70 percent and 100 percent minus the average indebtedness percentage
(2) Thus, if the portfolio stock is entirely debt financed this section denies any dividends received deduction.
(3) To be debt financed portfolio stock must have been purchased with borrowed funds or that the borrowing
must be directly traceable to the acquisition, such as where the stock was pledged as security for a
subsequently incurred debt in a case where the corporation reasonably could have been expected to sell the
stock rather than incur the indebtedness.
v) Section 301(e)
(1) 301(e) provides that the adjustments required by 321(k) and 312(n) shall not be made for purposes of
determining the taxable income of (and the adjusted basis of stock held by) any 20 percent corporate
shareholder.
(a) A 20 percent corporate shareholder is any corporation entitled to a dividends received deduction with
respect to a distribution that owns, directly or through the section 318 attribution rules, either (1) stock
in the distributing corporation possessing at least 20 percent of the total combined voting power, or (2)
at least 20 percent of the total value of all of the distributing corporations stock except nonvoting
preferred stock.
(2) The general effect of 301(e) is to reduce the distributing corporations earnings and profits in determining
the tax consequences of distributions to 20 percent corporate shareholders.
(a) This reduction in turn may cause a distribution to be treated as a return of capital coupled with a
reduction in the basis of the distributing corporations stock
g) Use of Dividends in Bootstrap Sales
i) Generally
(1) This provision applies to transactions designed to obtain the benefit of the DRD incident to a sale of stock
of the corporation paying the dividend.
(2) See Lexis Book pg 110 for example)
ii) Cases
(1) Waterman Steamship WS was the sole ownder of two subs GFT and PAS. There was an offer to buy
the stock of one of the sub, and WS determined if the yaccepted the offer they would reaslize 2.8 million in
capiutal gains. WS offered to sell the stock for their basis amt (700K) after the directors of the subs had

22
 arranged dividends. All of the steps occurred nearly simultaneously so the court restructured the
transaction.
(2) Basic The steps did not happen so closely together so the court allowed it to be dividend and granted a
DRD.
(3) TSN Liquidating Corp v. US (pg 193)
(a) Issue
(i) Whether assets distributed to a corporation (TSN) by its sub (CLIC) immediately prior to the sale
by TSN of all CLOCs stock to a third party (UM) should be treated as a dividend subject to an 85
percent DRD, or should it be treated as consideration received from the sale of stock.
(b) Facts
(i) In 1969 TSN owned 90 percent of CLIC and in the beginning of that year, CLIC began
negotiations for the sale of all its stock to UM.
(ii) On May 5 TSN and other CLIC shareholders entered into a stock purchase agreement with UM.
UM didnt want all of CLICs stock, so that was distributed.
(c) Held
(i) This was a legit transaction UM had a right not to want all of CLICs stock, and the fact that it
was distributed so close did not mean that they should be required to buy that amount of stock.
5) CHAPTER 5: REDEMPTIONS AND PARTIAL LIQUIDATIONS
a) Introduction
i) 302(b): Distributions In Redemption of Stock: Redemptions Treated As Exchanges
(1) 302(a) General Rule If a corporation redeems it stock within the meaning of (b1 b4) such redemption
SHALL be treated as a distribution in part or full payment in exchange for the stock.
(2) Redemptions Not Equivalent to Dividends The general rule that if a corporation redeems its stock such
redemption shall be treated as a distribution in part or full payment in exchange for the stock shall apply if
the redemption is not essentially equivalent to a dividend.
(3) Substantially Disproportionate Redemption of Stock
(a) IN GENERAL: The general rule shall apply if the distribution is substantially disproportionate with
respect to the shareholder.
(b) LIMITATIONS: This paragraph shall not apply unless immediately after the redemption the
shareholder owns less than 50 percent of the total combined voting power of all classes of stock
entitled to vote
(c) DEFINITIONS: See
(d) SERIES OF REDEMPTIONS: This paragraph shall not apply to any redemption made pursuant to a
plan that when viewed in the aggregate is not substantially disproportionate
(4) Termination of Shareholders Interests Subsection (a) general rule shall apply if the redemption is in
complete redemption of all of the stock of the corporation owned by the shareholder.
(5) Redemption From Non-corporate Shareholder in Partial Liquidation (a) shall apply to a distribution if
such distribution is (1) in redemption of stock held by a shareholder who is not a corporation and (3) in
partial liquidation of the distributing corp.
ii) Logic of 302
(1) 302(a) provides that a redemption will be treated as an exchange if it satisfies one of four statutory tests in
302(b)
(a) Exchange status means that the shareholder generally will recognize capital gain or loss to the extent of
the difference between the amount of the distribution and the shareholders basis in the redeemed stock.
(2) A redemption falling outside of 302(b) is treated under 302(d) as a distribution to which 301 applies.
(a) That means that it will be ad ividend to the extent of the corporations current and accumulated E and P,
and then a return of capital to the extent of basis and finally gain from the sale or exchange of the stock
to the extent of any balance.
(3) 302(b) is the nerve center for detemining the shareholder level tax consequences of a redemption and
principal focus of this chapter.
(a) (b)(1) (b)(3) examine whether there has been a sufficient reduction in the shareholders ownership-
interest in the corp to justify treating the redemption as an exchange. (see 318)
(b) (b)(4) shifts the focus to the corporate level and provides exchange treatment for any distribution that
qualifies as a partial liquidation under 302(e) because it involves a genuine contraction of the
distributing corps business.
iii) Basic Consequences
23
 (1) If a redemption is treated as a sale, the basis of the redeemed stock is taken into account in determining the
shareholders gain or loss.
(2) If a redemption is treated as a dividend, the regulations historically have provided that the shareholders
basis in the redeemed stock does not disappear but may be added to the basis of the shareholders retained
stock.
(3) If the shareholder no longer owns any stock after the redemption, the basis of the redeemed stock may be
added to the basis of the stock held by family members or entities whose stock was attributed to the
redeemed shareholder under 318.
iv) Tax Consequences to Distributing Corp
(1) Whether a redemption is treated as an exchange or a section 301 distribution at the shareholder level, the
tax consequences to the distributing corporation of a distribution of property in a redemption are governed
by 311.
(2) The distributing corporation recognizes gain on a distribution of appreciated property, but it may not
recognize loss on a distribution of property that has declined in value.
v) The Nontax Context
(1) Redemptions are used to accomplish a variety of corporate and shareholder planning objectives.
(2) In the case of closely held corps, a redemption may b e the vehicle for a shift of corporate control for a the
buyout of a dissatisfied or decease shareholder.
b) Constructive Ownership of Stock
i) 318 is one of several sets of constructive ownership rules in the IRC and applies only when it is expressly
made applicable by another provision of the code.
ii) Its principal role is in the redemption area, where it treats a taxpayer as owning stock that is actually owner by
various related parties.
iii) The attribution rules fall into the following four categories:
(1) Family Attribution
(a) An individual is considered as owning stock owned by his spouse, children, grandchildren, and
parents.
(b) Siblings and in laws are not part of the family for this purpose, and there is no attribution form a
grandparent to a grandchild.
(2) Entity to Beneficiary Attribution
(a) Stock owned by or for a partnership or estate is considered as owned by the partners or beneficiaries in
proportion to their beneficial interests.
(b) A person ceases to be a beneficiary of an estate for this purpose when she receives all property to
which she is entitled and the possibility thats he must return the property to satisfy claims is remote.
(c) Stock owned by a trust is considered as owned by the beneficiaries in proportion to their actuarial
interests in the trust.
(d) Stock owned by a corp is considered owned proportionally by a shareholder who owns directly
through attribution rules, 50 percent or more in value of that corp.
(3) Beneficiary to Entity Attribution
(a) Stock owned by partners or beneficiaries of an estate is considered as owned by the partnership or
estates.
(b) All stock owned by a trust beneficiary is attributed to the trust except where the beneficiarys interest is
remote and contingent.
(c) All the stock owned by a 50 percent or more shareholder of a corp is attributed to the corp.
(4) Option Attribution
(a) A person holding an option to acquire stock is considered as owning that stock.
iv) These general rules are supplemented by a set of operation rules in 318(b)(5) which generally authorized chain
attribution (i. parent to child to childs trust) except that there can be NO double family attribution (i.e. no
attribution from parent to child to childs spouse) or sidewise attribution (i.e. stock attributed to an entity from a
partner beneficiary or shareholder may not be reattributed from that entity to another partner beneficiary or
shareholder).
(1) Also, option attribution takes precedence over family attribution where both apply
(2) S corp is treated like a partnership and S corp shareholders like partners.
c) Redemptions Tested at the Shareholder Level
i) Substantially Disproportionate Redemptions
24
 (1) If a shareholders reduction in voting stock as a result of a redemption satisfies three mechanical
requirements that redemption will be treated as an exchange. Those requirements are (remember 318
attribution rules apply in measuring stock ownership for these tests):
(a) Immediately after the redemption the shareholder must own (actually and constructively) less than 50
percent of the total combined voting power of all classes of stock entitled to vote.
(b) The percentage of total outstanding voting stock owned by the shareholder immediately after the
redemption must be less than 90 percent of the percentage of total voting stock owned by the
shareholder immediately before the redemption
(i) If the taxpayer whose shares were redeemed holds less than 50 percent of the votes after the
redemption, the next step is to determine the ratio of the percent of votes that shareholder held
before the redemption to the percent of votes he or she held after the redemption. The taxpayer
must have less than80 percent of the votes he or she had before the redemption for it to qualify as
substantially disproportionate.
(c) The shareholders percentage of ownership of common stock (voting or not) after the redemption also
must be less than 90 percent of the percentage of common stock owned before the redemption. If there
is more than one class of common stock the 80 percent test is applied by reference to FMV.
(2) 302(b)(2)(D) notes that the substantially disproportionate redemption safe harbor does not apply to any
redemption made pursuant to a plan which has the purpose or effect of a series of redemptions that, taken
together, result in a distribution that is not substantially disproportionate with respect to the shareholder.
(a) This statutory application of the step transaction doctrine is the subject of the ruling that follows.
(b) Rev Ruling 85-14 (pg 215)
(i) Facts
1. The sole class of stock of corporation X was owned by four shareholders:
a. A with 1466
b. B with 210
c. C with 20
d. D with 155
2. X had a repurchase agreement with every shareholder but A. The agreement provided that if a
shareholder ceased to be actively connected with the business operations of X the shareholder
would promptly tender his X shares to X for an amount equal to the book value of the stock.
3. X would then be required to purchase the shares at book value within six months.
4. B informed A that B would be resigning. Two months later and only one week before the date
of Bs resignation, A caused X to redeem 902 of As shares, leaving A with less than 50 percent
of Xs shares.
5. B subsequently tendered Bs shares to X and A regained majority ownership of X.
(ii) Found
1. the required plan can be the design of a single shareholder to use a series of transactions to
regain majority voting control over a corporation after that control was apparently lost. Thus
although there was no actual agreement between A and B, the transactions of A and B
qualified as a plan
2. when the transactions were aggregated, As redemption was not substantially disproportionate
under 302(b)(2).
ii) Complete Termination of a Shareholders Interest
(1) Waiver of Family Attribution
(a) GENERALLY
(i) The theory of substantially disproportionate safe harbor is that exchange rather than dividend
treatment is appropriate when a distribution in redemption causes a significant reduction in the
shareholder interest in the corporations voting stock. This is even a greater concern when there is
a complete termination of shareholder interest under 302(b)(3)
(ii) To ease the path toward a complete termination 302(c)(2) provides for waiver of family attribution
if certain conditions are met. Note, though, it only applies to family attribution, not entity and
option attribution.
(iii) There must be no interest aside from that of creditor left after the attribution.
1. 302(c)(2)(A) includes a 10 year look forward rule, under which the shareholder may not
retain or acquire any of the forbidden interests in the corporation outside of creditor.
2. 302(c)(2)(B) provides a ten year look back rule under which hthe family attribution rules
may not be waived if during the ten years preceeding the redemption
a. the redeemed shareholders acquired any of the redeemed stock form a 318 relative or
b. any such close relative acquired stock from the redeemed shareholder.
25
 (b) Lynch v. Commissioner (pg 219)
(i) Facts
1. Appellee transferred control of a corporation to his son by selling a small number of shares to
his son and arranging for the corporation to redeem the remaining shares.
2. After the redemption, appellee provided consulting services to the corporation.
3. The tax court held that the redemption was a sale or exchange subject to capital gains
treatment.
(ii) Held
1. The appellate court reversed the tax court, finding the distribution taxable as ordinary income;
petitioner appellee provided post-redemption services and had an interest in the corporation,
which was prohibited because he was not a creditor.
(iii) An individualized determination of whether a taxpayer has retained a financial stake or continued
to control the corporation after the redemption is inconsistent with Congress' desire to bring a
measure of certainty to the tax consequences of a corporate redemption. A taxpayer who provides
post-redemption services, either as an employee or an independent contractor, holds a prohibited
interest in the corporation because he is not a creditor.
(c) Rev Ruling 59-119 (pg 227)
(i) The shareholder kept an attorney on the board of directors to protect his interest. His redemption
was paid out over 8 years, so he wanted the attorney to be there to keep his best interests up front.
(ii) Because the attorney was a part of the board it was held that this taxpayer did not fully divest
himself of power.
1. The attorney could have just showed up to keep an eye on things.
(d) Rev Ruling 77-293
(i) This provides for a testing of a tax avoidance motive in the context of a transfer of shares to a
related person during the ten year look back period.
(ii) Facts
1. taxpayer-father transferred half of his stock in the he familys business to his son, who had
been working with him for some time to learn the skills necessary to run the business.
2. Shortly thereafter the taxpayer resigned and his son became president of the board of directors
of the company.
3. Also, soon after the gift the corporation redeemed the taxpayers remaining shares.
(iii) Because the taxpayer-father constructively owned all of the corporations stock via his son the
redemption would be taxed as a section 301 distribution instead of an exchange if family
attribution rules applied
1. by following the provisions of 302(c)(2)(A), the taxpayer tried to avoid the application of
family attribution
2. However the taxpayer had transferred stock to his son, a related party, within ten years of the
redemption, and the son still owned stock in the corporation at the time of redemption.
3. Therefore, only if the transfer to the son did not have a principal purpose of tax avoidance
would the taxpayer be eligible to elect waiver of the family attribution rules.
(iv) Found
1. the purp-ose of 302(c)(2)(B) is to prevent the bail out of earnings and profits as capital gain
while retaining control or economic interest in the corp via a related person. This is a facts
and circumstances determination.
2. The IRS found that because the transfer was to a knowledgeable party who planned to manage
the corporation, the transfers main purpose was to allow the taxpayer father to retire, not
tax avoidance, although the transfer did reduce his tax liability.
iii) Redemptions Not Essentially Equivalent to a Dividend
(1) 302(b)(1): Distributions in Redemption of Stock: Redemptions not Equivalent to Dividends
General rule shall apply if the redemption is not essentially equivalent to a dividend.
(2) US v. Davis (pg 235)
(a) Facts
(i) Davis and Bradley organized a corporation
(ii) Davis and his wife held 250 shares of common stock and Bradley held 500. In order for the
corporation to be eligible for a loan, Davis purchase 1000 shares of preferred stock at 25 per share
with the understanding that the corporation would redeem the shares after the loan was repaid.
(iii) Before the Loan was repaid, Davis purchase Bradleys 500 shares and gave them to his son and
daughter.
(iv) Once the loan was repaid the corporation redeemed Daviss 1000 shares of preferred stock.

26
 (v) Davis treated the 25K redemption proceeds as a sale of stock with no gain realized.
(vi) The IRS said it was essentially equivalent to a dividend.
(b) Held
(i) To qualify for preferred treatment under 302(b)(1) a redemption must result in a meaningful
reduction of the shareholders proportionate interest in the corporation.
(ii) Applying the attribution rules, Davis owned 100 percent of the stock before and after the
redemptions is there was no reduction of his interest and the transaction was essentially equivalent
to a dividend under 302(b)(1)
(iii) The corporations business purpose was irrelevant.
(iv) EXCHANGE TREATMENT IS ONLY AVAILABLE IF TEHRE IS A MEANINGFUL
REDUCTION OF THE SAHREHOLDERS PROPORTIONATE INTEREST IN THE
CORPORATION!!!!!
(c) Teaches
(i) Where a sole shareholder has part of his per her stock redeemed, that will ALWAYS be taxed a s
301 distribution rather than as an exchange.
(ii) In contrast to Davis, if a shareholder owns only nonvoting preferred stock of a corp and the stock
is not section 305, the redemption of a part of that stock generally will qualify under 302(b)(1)
although it does not otherwise qualify under 302(b) (see Reg 1.302-2(a)).
(3) Rev Ruling 85-106
(a) The service found dividend equivalency even though the redemption concededly resulted in a
reduction in the shareholders economic interest.
d) Consequences To the Distributing Corporation
i) Distributions of Appreciated Property in Redemption
(1) The final demise of General Utilities in the redemption context came with 311
(2) In adopting 311(b), which also applies to nonliquidating distributions, Congress repealed all the remaining
exceptions that had provided for nonrecognition of gain to the distributing corporation.
(a) As a result,, a corporation distributing property in redemption of stock (including a partial liquidation),
always recognizes gain but may not recognize loss.
(3) 311: Taxability of Corporation on Distributions
(a) General Rule: Except as provided n subsection (b), no gain or loss shall be recognized to a
corporation on the distribution (not in complete liquidation) with respect to its stock of
(i) Its stock (or rights to acquire its stock)
(ii) Or property.
(b) Distributions of Appreciated Property
(i) In General: If
1. a corporation distributed property other than obligations to a shareholder in a distribution to
which A applies, and
2. the FMV of such property exceeds its adjusted basis in the hands of the distributing corp
then gain shall be recognized to the distributing corporation as if such property were sold to the
distributee at its FMV.
ii) Effects on E and P
(1) 312(n)(7): Effects on E and P: Redemptions If a corporation distributes amounts in a redemption to
which 302a or 303 applies, the part of such distribution which is properly chargeable to earnings and profits
shall be an amount which is not in excess of the ratable share of the earnings and profits of such
corporation accumulated attributable to the stock redeemed
(2) The effect of a stock redemption on the distributing corporations earning and profits initially depends upon
the tax consequences of the redemption at the shareholder level
(a) If the redemption is treated as a distribution to which 301 applies, the distributing corp adjusts its E
and P in the same manner as on other nonliquidating distributions i.e. E and P are decreased by the
amount of cash and the principally amount of any obligations, and by the greater of the adj basis or the
fmv of any property distributed.
(b) In addition the corp always recognizes gain and correspondingly increases its current E and P on a
distribution of appreciated property and it reduces current E and P by any taxes paid on that gain.
(3) HOWEVER, if a redemption including a partial liquidation, is treated as an exchange to the redeemed
shareholder, the effect on E and P is more complex.

27
 (a) 312(n)(7) provides that the part of the distribution in redemption that is properly chareable to E and P
shall be an amount which does not exceed the ratable share of the corporations accumulated E and P
attributable to the redeemed stock.
e) Redemption Planning Techniques
i) Bootstrap Acquisitions (these are situations where the taxpayers decided to combine a redemption with some
sort of a sale transaction to accomplish a goal (such as transfer of ownership of a corporation with minimal tax
impact)
(1) Rev Ruling 75-447 (pg 258) ??????(CURRENT LAW??????)
(a) This ruling references the Zenz v. Quinlivan case
(i) Facts
1. Mrs. Zenz, the sole shareholder of a corporation, sold some of her stock in the corporation,
and htenn had the corporation redeem the remainder.
2. Under the then current law, the redemption absorbed substantially all of the accumulated E
and P of the corporation. Zenz argued that the redemption was a complete termination of all
of her interest in the corporation and should not be treated as a dividend for tax purposes.
(ii) Found
1. Even though Mrs. Zenz had structured the transaction to limit taxation, the court of Appeals
reversed the DC and found that because the redemption completely extinguished the
taxpayers interest in the corp, it should not be taxed as a dividend.
a. Because the taxpayer became separated from all interest in the corporation, her
redemption was not equivalent to a dividend.
(b) The revenue ruling held that a sale and redemption may be combined in order to qualify the
redemption under the substantially disproportionate test of 302(b)(2)
(i) This means that you can have sale or exchange treatment even if the redemption precedes the sale
of the rest of the taxpayers stock.
(ii) You look at the stock holdings immediately before and immediately after the entire transaction to
make the evaluations.
(2) PROBLEM PG 260???
ii) Buy/ Sell Agreements
(1) REDEMPTIONS INCIDENT TO DIVORCE
(a) Arnes v. US (pg 266)
(i) Facts
1. a husband and wife incorporated a corporation, together owning all of its stock.
2. Later there was a divorce and arranged for the wirfes shares to be bought out.
3. The buy out was done by having the corporation redeem the wifes shares.
(ii) Held
1. Appellee taxpayer's transfer of her share of a jointly owned corporation to the corporation as
part of a divorce property settlement was a transfer on behalf of her former husband, and she
was not liable for capital gains on the transfer.
(iii) The purpose of 26 U.S.C.S. 1041 is to defer the tax consequences of transfers between spouses
or former spouses. Property received in such a transfer is excluded from the recipient's gross
income. The recipient's basis is then equal to the transferor's basis. 26 U.S.C.S. 1041(b)(2).
Later, when the recipient transfers the property to a third party, the gain or loss must be
recognized.
(iv) Where divorcing spouses takes inconsistent positions in separate proceedings the government
faces a potential whipsaw problem
1. i.e. for example in Arnes the wife was not taxed because of 1041 And then, in the sequel,
the tax court held that the husband received no constructive dividend because he lacked a
primary obligation to purchase the redeemed stock.
(v) Notes
1. Tax Consequences to Nontransferor Spouse Where divorcing spouses takes inconsistent
positions in separate proceedings the government faces a potential whipsaw problem
a. i.e. for example in Arnes the wife was not taxed because of 1041 And then, in the
sequel, the tax court held that the husband received no constructive dividend because he
lacked a primary obligation to purchase the redeemed stock.
2. Regs to the Rescue The threshold question posed by the regs is whether a divorce related
redemption results in a constructive distribution to the nontransferor spouse under applicable
tax law.

28
 a. If the redemption does not result in a constructive distribution, eg because it does not
satisfy a primary and unconditional obligation of the nontransferor spouse the regs
respect the form of the transaction
b. That means that the corp is treated as having redeemed the stock directly from the
transferor spouse in a transaction in which the nontransferor spouse is not a party.
Therefore, (1) 1041 does not apply, (2) the transferor spouses tax treatment is
determined under 302 (likely capital gain) and (3) the nontransferor spouse is not taxed.
iii) Charitable Contributions and Redemption
(1) Grove v. Commissioner (pg 274)
(a) Facts
(i) Grove, a successful engineer, began making yearly contributions to his alma mater RPI
(ii) Grove was the majority shareholder in GSWC corp, a closely held corp engaged in civil
engineering projects in US and abroad
(iii) Because these projects were capital intensive, the corp did not pay dividends, but rather reinvested
its earnings.
(iv) Under a plan created by RPI, Grove would donate stock to RPI (subject to a right of first refusal
by the Corp_ on a yearly basis while retaining a life interest in the income from the gift.
(v) RPI would have the corp redeem the shares a year or two later.
(vi) Following each redemption, RPI would invest the cash proceeds in an investment company
suggested by Grove, the income from which would be given to Grove for life under the donation
agreement.
(vii) After Groves life interest terminated the corpus and income from the donation would belong to
RPI.
(b) Held
(i) The court ruled that even though Grove owned a majority of the corp shares and was able to force
redemptions because the corporation was not obligated to redeem RPIs shares, RPI was not
merely a conduit to reduce Groves taxes. Therefore, the transaction was not taxed as a
redemption of Groves shares.
(c) A gift of appreciated property does not result in income to the donor so long as he gives the property
away absolutely and parts with title thereto before the property gives rise to income by way of sale.
(d) One desirable aspect of the transaction in Grove was his ability to retain a life income interest in a
diversified portfolio managed by his personal investment advisor.
(i) This format is no longer available to the philanthropic shareholder unless certain additional
requirements are met.
(ii) In general a donor who wishes to retian a life income interest in contributed property will not
qualify for charitable income and figt tax deductions unless the gfigt is made to a qualified
charitable remainer annuity trut or unitrust or a pooled income fund.
(2) Rev Ruling 78-197 a charitable contribution of stock followed by a redemption would be treated as a
dividend to the donor only if the donee is legally bound or can be compelled by the corporation to surrender
the shares for redemption
(a) Although they may not be legally obligated to do so most charities will be highly motivated to offer the
shares for redemption in order to convert the stock into a more liquid and diversified investment.
f) Redemptions Through Related Corporations
i) Generally
(1) 304 is designed to prevent an end run around 301/ 302.
(2) 304 basic purpose: to prevent controlling shareholders from claiming basis recovery and capital gain
treatment on transactions that result in a bailout of corporate earnings without a significant reduction in
control
ii) Brother/ Sister Acquisitions
(1) 304(a)(1) applies when one or more persons who are in control of each of two corporations transfer
stock of one corp to the other in exchange for cash or other property.
(a) Control for this purpose is defined as at least 50 percent of ownership of either the corp voting power
or of the total value of all classes of stock (304(c)(1))
(2) If 304(a)(1) applies, Congress devised an intricate method to test the sale for dividend equivalence.
(a) We then look to 304(b) which says in (b)(1) that in the case of any acquisition of stock to which (a)
applies, determinations as to whether the acquisition is, by reason of 302(b), to be treated as a
distribution in part or full payment in exchange for the stock shall be made by reference to the stock of

29
 the issuing corp. In applying 318 with respect to 302(b) for the purposes of this paragraph there shall
not be the 50 percent limitation.
iii) Parent/ Subsidiary Relationship
(1) 304(a)(2) applies similar principles when a controlled sub acquires stock of its parent from a shareholder
of the parent in return for property.
(a) This relationship is defined by the same 50 percent control test as above.
(2) The property used to make the acquisition is treated as a distribution in redemption of the parents stock for
purposes of testing dividend equivalency under 302.
(a) If the redemption fails to qualify an exchange and this is treated as a 3401 distribution, the amount and
source of any dividend is first determined by reference to the earnings and profits of the acquiring
(sub) corp and then if necessary by the E and P of the issuing (parent) corp.
(3) Parent/ Sub rules take priority over Brother/ sister rules.
iv) Collateral Tax Consequences
(1) In the basic 304(a)(1) brother/ sister acquisition where the amount paid is treated as a 301 distribution, A is
deemed to have transferred the X stock to Y in exchange for Y stock in a 351 exchange. Y thus takes a
transferred basis from A in the X stock received in the deemed 351 transaction is equal to As basis in the X
s tock that A actually transferred to X.
(a) Under the current regs, As basis in the Y stock is decreased on the subsequent deemed distribution of
Y stock only if part of the distribution is applied against the Y stocks basis under 301(c)(2).
(2) In bro/ sister, where the redemption is treated as an exchange, any reduction of E and P is limited by the
312(n)(7) to an amount not in excess of the redeemed stocks ratable share of E and P.
v) Coordinating with 351
(1) Where there is overlap between 304 and 351, 304 trumps.
(2) Niedermeyer v. Commissioner (pg 288)
(a) Facts
(i) Petitioners, husband and wife, owned 22.58 percent of the common stock of AT&T and 125 shares
of its preferred stock.
(ii) Two of petitioners' sons owned 67.91 percent of the common stock of AT&T.
(iii) Petitioners owned no stock of Lents but three of their other sons owned 67 percent of its common
stock.
(iv) On Sept. 8, 1966, petitioners sold their AT&T common stock to Lents, and on Dec. 28, 1966,
petitioners contributed their AT&T preferred stock to the Niedermeyer Foundation
(b) Held
(i) the sale of the AT&T common stock constituted a redemption through the use of a related
corporation under sec. 304(a)(1)
(ii) such redemption does not qualify for treatment as an exchange under either sec. 302(b)(1) or sec.
302(b)(3), thus the proceeds are to be treated as distributions of property to which sec. 301 applies.
6) CHAPTER 6: STOCK DIVIDENDS AND 306 STOCK
a) Introduction
i) A stock dividend is simply a distribution of stock (or rights to acquire stock) by a corporation to some or all of
its shareholders.
(1) Stock dividends accomplish a variety of business objectives. Some public companies periodically pay
small common on common stock dividends instead of cash ostensibly to provide their shareholders with
some tangible evidence of their interest in corporate earnings while allowing the corporation to retain cash
for use in the business.
ii) 305(a) generally provides that gross income does not include a distribution of stock by a corporation to its
shareholders with respect to its stock.
(1) This rule is subject to exceptions to be explored below.
b) Taxation of Stock Dividends Under 305
i) 305: Distributions of Stock and Stock Rights
(1) (a) General Rule: Except as otherwise provided in this section, gross income does not include the amount
of any distribution of the stock of a corporation made by such corporation to its shareholder with respect to
its stock.
(2) (b) Exceptions: (a) shall not apply to a distribution by a corporation of its stock and the distribution shall
be treated as a distribution of property to which 301 applies if . . .

30
 (a) (1) Distributions in lieu of money: if the distribution is, at the election of the shareholder (whether
exercised before or after the declaration thereof), payable either
(i) In its stock
(ii) Or in property.
(b) (2) Disproportionate Distributions: If the distribution (or a series of distributions of which such
distribution is one) has the result of
(i) The receipt of property by some shareholders AND
(ii) An increase in the proportionate interests of other shareholders in the assets or earning and profits
of the corp.
(c) (3) Distributions of Common and Preferred Stock: if the distribution (or a series) has the result of
(i) The receipt of preferred stock by some common shareholders AND
(ii) The receipt of common stock by other common shareholders.
(d) (4) Distributions on preferred stock: If the distribution is with respect to preferred stock, other than
an increase in the conversion ratio of convertible preferred stock made solely to take account of as tock
dividend or stock split with respect to the stock into which such convertible stock is convertible
(e) (5) Distributions of Convertible Preferred Stock: If the distribution is of convertible preferred
stock, unless it is established to the satisfaction of the secretary that such distribution will not have the
result described in (2)
ii) Understanding 305
(1) 305(b) provides 5 exceptions to the general rule that stock dividends are tax free.
(a) In general, the exceptions focus on stock distributions that cause a change in some shareholders
proportionate interest in the corporation.
(b) The determination of whether a dividend falls within this section is determined without regard to the
presence of E and P.
(c) Then, if any of the 5 exceptions applies, the stock distributions is treated as a 301 distribution in an
amount equal to the fair market value of the distributed stock (1.305-1b)
(d) This distribution is a divide3nd to the extent of distributing corps E and P, and E and P will be reduced
accordingly.
(2) Rev Ruling 78-375 Deals with a standard method of offering a choice of stock or property distribution
as a dividend reinvestment plan.
(a) Facts
(i) Corp X offered a plan that provided, in part, that a shareholder could elect to have all of the cash
dividends otherwise payable to him automatically reinvested in shares of X common stock at a
price equal to 95 percent of the FMV of the stock on the dividend payment date.
(b) The presence of the plan enabled shareholders to opt to receive stock dividends rather than the cash
they would otherwise receive. Therefore, the stock dividends received under the plan fell within
305(b)(1)
(c) The basis of these reinvested shares was equal to the fair market value of C common stock on the date
of distribution, and that a deduction would be allowed for the quarterly service charge.
(d) Therefore, participants in a dividend reinvestment plan are subject to 301 under 305(b)(2)
(3) SEE LEXIS BOOK Pg 166 170 for explanation of (b)(1) (b)(5)
c) 306 Stock
i) The Preferred Stock Bailout
(1) Chamberlin v. Commissioner (pg 309)
(a) This is the leading case for stock bailouts
(b) Facts
(i) C and five other shareholders owned all of the outstanding common stock in Metal from 1940
1946.
(ii) In December 1946, Metal authorized 8020 shares of preferred stock, and then distributed the
preferred stock to C and the other common stock shareholders on a pro rata basis.
(iii) Two days later the shareholders sold approximately half o Metals preferred stock to two insurance
companies pursuant to purchase agreements with specific redemption requirements.
(iv) C and the other shareholders treated the transactions as exchanges with gain taxed at long term
capital gains rate.
(c) Held
(i) The preferred stock dividend should not be taxed as ordinary income

31
 1. a non-taxable stock dividend does not become a taxable cash dividend upon its sale by the
recipient and the legal effect of the dividend with respect to rights in the corporate assets is
determined at the time of its distribution, not by what the stockholders do with it after its
receipt.
(ii) This was a bona fide transaction un substance as well as in form because a large portion of the
preferred stock remained in the hands of the investing public.
(2) 306 was enacted to deal with a preferred stock bailout that enabled shareholders to withdrawn corporate
profits as long term capital gains.
(a) 306 is logically linked to 305 because one way that section 305 stock is created is through the
distribution of a tax free preferred stock dividend.
(3) 306 provides special rules for disposition of section 306 stock that traditionally sought to tax an
appropriate amount of sales proceeds as ordinary income.
ii) The Operation of 306
(1) 306 Stock Defined
(a) The principal category is stock distributed to a shareholder as a tax-free stock dividend under 305(a)
other than common on common stock 306(c): Section 306 Stock Defined
(i) Common stock is excepted because it lacks bailout potential it may not be sold without
diminishing the shareholders control and interest in corporate growth.
1. Rev Ruling 79-386: ways to test if common stock will be treated as preferred
a. Whenever there is a limitation as to the amount you can earn in E and P or assets on
liquidation, it will be treated as preferred.
(ii) If stock has either a limited right to dividends or to assets upon liquidation, it is not common
stock for 306.
(iii) 306 stock does include stock with a transferred or substituted basis (306(c)(1)(C)).
(iv)
(b) The final category of 306 stock was added by Congress to thwart the use of a holding company to bail
out earnings
(i) i.e. S holds only common stock in P. S organizes H, exchanging her P common stock for newly
issued H common and preferred stock in a tax free 351 deal. 306(c)(3) characterizes the
preferred stock of H as 306 stock.
(2) Disposition of 306 Stock
(a) The tax consequences of a disposition of 306 stock vary depending on whether the stock is sold or
redeemed
(i) On a sale amount realized is treated as dividend income to the extent of the stocks ratable
share of the amount that would have been a dividend if the corp had distributed cash in an
amount equal to the FMV of the stock at the time of distribution. 306(a)(1)(A),(D)
1. SH looks back to the time of distribution to determine to what extent a cash distribution
would have emanated from the corps current or accumulated E and P at that time.
2. the balance is realized amount is treated a reduction of basis of the 306 stock, and any excess
is gain from sale or exchange.
3. If SH adjusted basis in the stock exceed the amount realized any un-recovered basis must be
allocated back to the stock with respect to which the 306 was distributed.
4. For the corporation if we have 306(a)(1) treatment, then under 311 there is no gain or loss
under the distribution and under 312 no adjustment to E and P because there is no dividend
treatment.
(b) A shareholder who receives a nontaxable stock dividend of 306 that later is redeemed by the
corporation has used two steps to achieve what could have been accomplished in a single transaction:
withdrawal of cash from the corp.
(i) 306(a)(2) provides that the amt realized on a redemption of 306 is treated as a 301 distribution,
taxable as a dividend to the extended of the current or accumulated E and P in the year of
redemption.
(ii) Balance of the distribution is treated as reduction of basis, and then capital gain under the rules
generally applicable to nonliquidating distributions.
(iii) In a redemption, the corporation can reduce E and P because we are dealing only with the
shareholder and not some hypothetical third party.
(3) Dispositions Exempt for 306
(a) A shareholder who sells her entire interest in a corp is not withdrawing corp earnings while preserving
control. 306(b)(1) provides that 306 doesnt apply to a complete termination of interests.

32
 (b) Fireoved v. US (pg 318)
(i) Facts
1. The court addressed the question of whether a prior sale of a portion of the taxpayers
underlying common stock removed the 306 taint from an equivalent portion of the taxpayers
306 stock, in the context of a redemption.
(ii) Held
1. 306(b)(4) was inapplicable, in part because the taxpayer retained effective control of the
corporation despite the prior sale of common stock.
2. When only a portion of the underlying common stock is sold, and the taxpayer retains
essentially all the control he had previously, it would be unrealistic to conclude that Congress
meant to give that taxpayer the advantage of section 306(b)(4) when he ultimately sells his
306 stock.
(4) 306 statute
(a) 306(a)(1)(A): In a non-redemption of 306 stock the amount realized shall be treated as ordinary
income. That does not apply to the extent that
(i) The amount realized exceeds
(ii) Such stocks ratable share of the amount which would have been a dividend at the time of
distribution if (in lieu of 306 stock) the corporation had distributed money in an amount equal to
the FMV of the stock at the time of distribution.
(b) 306(a)(1)(B): Any excess of the amount realized over the sum of
(i) the amount treated as ordinary income plus
(ii) the adjusted basis of the stock
(iii) shall be treated as gain from the sale of such stock.
(iv) There is no loss if the basis exceeds the FMV (additional basis added back to remaining shares.
(c) 306(b)(1)(A) exceptions; termination of SH interest: Subsection (a) doesnt apply if the
disposition
(i) is not a redemption
(ii) is not directly or indirectly to a person the ownership of whose stock would be attributable to the
shareholder AND
(iii) terminates the entire stock interest of the shareholder in the corporation
(d) 306(b)(1)(B) In Redemption: If the disposition is a redemption and paragraph (3) or (4) of
302(b) applies
(e) 306(b)(4) Transaction Not In Avoidance: If it is established to the satisfaction of the secretary
(i) That the distribution and the disposition or redemption OR
(ii) In the case of a prior or simultaneous disposition or redemption of the stock with respect to which
306 stock was disposed or redeemed was issued, that the disposition of the section 306 stock was
not in pursuance of a plan having as one of its principal purposes the avoidance of Federal Income
Tax.
(f) 306(c): Stock Defined
(i) In General, for purposes of this chapter, 306 stock means stock which
1. Distributed to Seller: stock which was distributed to the SH selling or otherwise disposing
of such stock if by reason of 305(a) any part of such distribution was not includible I the gross
income of the shareholder.
2. Received in a Corporate Reorganization or Separation: stock not common stock
a. Which was received by the shareholder selling or otherwise disposing of such stock in
pursuance of a plan of reorganization AND
b. With respect to the receipt of which gain or loss to the shareholder was to any extent not
recognized by reason of part III, but only to the extent that either the effect of the
transaction was substantially the same as the receipt of a stock dividend, or the stock was
received in exchange for 306 stock. For purposes of this section, a receipt of stock to
which the foregoing provisions of this subparagraph apply shall be treated as a
distribution of stock.
3. Stock having transferred or substituted basis.
(ii) 306(c)(2): Exception where no E and P: 306 stock does not include any stock no 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 the stock.
7) CHAPTER 7: COMPLETE LIQUIDATIONS
a) Introduction

33
 i) A Complete Liquidation exists for tax purposes when the corporation ceases to be a going concern and its
activities are merely for the purpose of winding up its affairs, paying its debts, and distributing any remaining
balance to its shareholders.
(1) Legal dissolution under state law is not required for the liquidation to be complete, and a transaction will be
treated as a liquidation even if the corporation retains a nominal amount of assets to pay any remaining
debts and preserves its legal existence.
ii) Liquidations are often preceded by a sale of substantially all of a corporations assets and a distribution of the
sales proceeds to the shareholders in exchange for their stock.
(1) Alternatively, the buyer of a corporate business may acquire all the stock of the target company and either
keep the old corp alive or cause it to be liquidated.
b) Complete Liquidations under 331
i) STATUTES
(1) 331: Gain or Loss to Shareholders in Corporate Liquidations
(a) (a) Distributions in Complete Liquidation treated as exchanges amounts received by a
shareholder in a distribution in complete liquidation of a corporation shall be treated as in full payment
in exchange for the stock.
(b) (b) Nonapplication of 301 301 (relating to effects on SH of distributions of property) shall not
apply to any distribution of property in complete liquidation.
(c) **Upshot** a shareholder computes realized gain or loss by subtracting basis in the stock from the
amount realized, and reports the difference as capital gain or loss.
(i) Gain or loss is calculated on a per-share basis, so different blocks of stocks bought at different
times are treated differently.
(2) 346(a): Complete Liquidation a distribution is treated as in complete liquidation of a corporation if
the distribution is one of a series of distributions in redemption of all of the stock of the corporation
pursuant to a plan
(a) Shareholders can recover basis first in creeping liquidations, even though this does not square with the
453 rule about ratable basis recovery.
(3) 336(a): Gain or Loss Recognized on Property Distributed in Complete Liquidation General Rule
generally, gain or loss shall be recognized to a liquidating corporation on the distribution of property in
complete liquidation as if such property were sold to the distribute at its fair market value.
(a) **shareholder would therefore get a FMV basis).
ii) CONSEQUENCE TO SHAREHOLDER
(1) 331(a) sets the rule. You can fully recover basis on installment based payouts, even though this seems
inconsistent with 453.
iii) CONSEQUENCE TO CORPORATION
(1) Background
(a) Commissioner v. Court Holding Co. Applied the substance over form doctrine. The corporation
was about to enter into a transaction whereby they sold their only asset, an apartment building to a
third party. However, since the income tax consequences would have been too severe, the corporation
withdrew the offer, liquidated and distributed the apartment building to the shareholders, and the next
day the shareholders sold the building to the third party.
(i) Because of the agreement the court applied substance over form and held the liquidating invalid.
(b) US v. Cumberland Public Service Co. Utility Coop A tried to sell out to Coop B. However, B
only wanted to buy certain assets of the Coop A. Coop A declined because of tax consequences.
Shareholders then took the assets in a liquidation and sold them to Coop B. This was allowed because
there had never been an agreement already in existence that was continued, just in a different form.
(2) Liquidating Distributions and Sales
(a) General Rule of 336(a) requires a liquidating corp to recognize gain or loss on the distribution of
property in complete liquidation as if the property were sold to the distribtuee at its FMV.
(b) If the distributed property is subject to a liability or the distribute shareholder assumes a liability in
connection with the distribution, the FMV of the property is treated as being not less than the amount
of the liability.
(3) Limitations on Recognition of Loss
(a) Generally
(i) 336(a) allows the distributing corporation to recognize loss as well as gain, in contrast to 311

34
 (ii) 267 disallows losses on sales of property by a corporation to a related party (i.e. controlling
shareholder), it does not disallow them on liquidating distributions to related parties.
(b) Distributions to Related Persons
(i) 336(d)(1) partially reinstates the policy of 267 by providing that no loss shall be recognized by
a liquidating corp on the distribution of property to a 267 related party if EITHER
1. the distribution is not pro rata among the shareholders OR
2. the distributed property was acquired by the liquidating corp in a 351 transaction or as a
contribution to capital within the five year period ending on the date of distribution.
(ii) 336(d)(1)(A)(ii) creates a rule that extends 267 to pro rata liquidating distributions of
disqualified property to a related person.
1. Disqualified property is defined as any property acquired by the liquidating corp during the 5
year period preceding the distribution in a 351 transaction as a contribution to capital.
(c) Losses With Tax Avoidance Purposes
(i) 336(d)(2) prevents the duplication of pre-contribution built it losses even on certain distributions
to minority shareholders.
(ii) This limitation applies only if the distributing corporation acquired property in 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 on a liquidating sale, exchange or distribution of property.
(iii) 336(d)(2) limits the corp deductible loss to the amount that accrued after the corp acquired the
property. Pre-contribution losses are disallowed by a basis step down rule which requires the corp
to redeuce its basis in the affected property by the amount of built in loss in the property at the
time it was acquired by the corp.

35