McMahon Corporate Tax I Fall 2010

Downloaded From OutlineDepot.
com
Corporate Taxation I Prof. McMahon CHAPTER 2 Section 1. What Is A Corporation Under The Income Tax? 1. Anne and Bill plan to form a limited liability company to engage in the business of developing and marketing computer software. They have identified between 35 and 50 potential investors who will contribute varying amounts of cash for membership interests totaling approximately 75% - 85% of profits and losses (after Anne and Bill receive handsome salaries). Under the governing state law, the LLC may be member-managed or manager-managed, membership interests may be freely transferable or nontransferable, and the LLC may or may not be dissolved by the death, bankruptcy, retirement, or expulsion of a member, all as provided in the LLC agreement. Anne and Bill want the LLC to be managed by themselves, with the investors having only the minimal rights of members required by state law. Only Anne and Bill will have authority to act on behalf of the LLC. Because of the limited powers that the investor-members will be granted, Anne and Bill think it best that the investors be permitted to sell or assign their membership interests if they so desire, although Anne and Bill think that the actual opportunities for resale will be limited by market forces. Of course, Anne and Bill want the business of the LLC to be uninterrupted by the death, bankruptcy, etc. of an investor-member. Will the LLC be taxed as a corporation if organized in the manner contemplated by Anne and Bill? What is an LLC for federal tax purposes? 7701(a)(3) The term corporation includes associations, joint-stock companies, and insurance companies. 7701(a)(2) The term partnership includes a syndicate, group pool, joint venture, or other unincorporated organization, through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of this title, a trust or estate or a corporation; and the term partner includes a member in such a syndicate, group, pool, joint venture, or organization.
Since an LLC is not defined in the Code, we must turn to the Regulations to determine whether it is a separate entity, and if so, whether it is a business entity classified as a corporation or partnership. The first step under the entity classification regulations is to determine whether a separate entity has actually been created for federal tax purposes. Whether an entity is recognized under local law as a separate entity for federal tax purposes is a question of federal tax law. Reg. 301.7701-1(a)(1) Whether an organization is an entity separate from its owners for federal tax purposes is a matter of federal tax law and does not depend on whether the organization is recognized as an entity under local law.
Downloaded From OutlineDepot.com
Reg. 301.7701-1(a)(2) A joint venture or other contractual arrangement may create a separate entity for federal tax purposes if the participants carry on a trade, business, financial operation, or venture and divide the profits therefrom. . . . Nevertheless, a joint undertaking merely to share expenses does not create a separate entity for federal tax purposes. . . . Reg. 301.7701-1(a)(3) An entity formed under local law is not always recognized as a separate entity for federal tax purposes.
Once it is established that the organization is a separate entity for tax purposes, the entity must further be classified as a corporation, partnership, or trust the entities recognized as separate entities for federal tax purposes. Reg. 301.7701-1(b) Classification of organizations The classification of organizations that are recognized as separate entities is determined under 301.7701-2, 301.7701-3, and 301.7701-4 unless a provision of the Internal Revenue Code . . . provides for special treatment of that organization. Reg. 301.7701-2(a) Business entities For purposes of this section and 301.7701-3, a business entity is any entity recognized for federal tax purposes . . . that is not properly classified as a trust under 301.7701-4 or otherwise subject to special treatment under the Internal Revenue Code. A business entity with two or more members is classified for federal tax purposes as either a corporation or a partnership. . . .
Because a separate entity is a business entity only if it is not properly classified as a trust or otherwise subject to special treatment, it is necessary to establish that the organization is not properly classified as a trust under 301.7701-4. Reg. 301.7701-4(a) Ordinary Trusts " . . . Generally speaking, an arrangement will be treated as a trust under the Internal Revenue Code if it can be shown that the purpose of the arrangement is to vest in trustees responsibility for the protection and conservation of property for beneficiaries who cannot share in the discharge of this responsibility and, therefore, are not associates in a joint enterprise for the conduct of business for profit." Reg. 301.7701-4(b) Business trusts "There are other arrangements which are known as trusts because the legal title to property is conveyed to trustees for the benefit of beneficiaries, but which are not classified as trusts for purposes of the Internal Revenue Code because they are not simply arrangement to protect or conserve the property for the beneficiaries . . . The fact that any organization is technically cast in the trust form, by conveying title to property to trustees for the benefit of person designated as beneficiaries, will not change the real character of the organization if the organization is more properly classified as a business entity under 301.7701-2"
Having determined that a separate entity is a business entity because it is not properly classified as a trust or otherwise subject to special treatment, it is necessary to determine whether the entity is either a corporation or a partnership. 2
Reg. 301.7701-2(b) Corporations For federal tax purposes, the term corporation means (1) A business entity organized under a Federal or State statute, or under a statute of a federally recognized Indian tribe, if the statute describes or refers to the entity as incorporated or as a corporation, body corporate, or body politic; (2) An association (as determined under 301.7701-3); (3) A business entity organized under a State statute, if the statute describes or refers to the entity as a joint-stock company or joint-stock association; (4) An insurance company (5) A State-chartered business entity conducting banking activities, if any of its deposits are insured under the Federal Deposit Insurance Act, as amended, 12 U.S.C. 1811 et seq., or a similar federal statute; (6) A business entity wholly owned by a State or any political subdivision thereof, or a business entity wholly owned by a foreign government or any other entity described in 1.892-2T; (7) A business entity that is taxable as a corporation under a provision of the Internal Revenue Code other than section 7701(a)(3); and (8) Certain foreign entities. (i) In general Except as provided in paragraphs (b)(8)(ii) and (d) of this section, the following business entities formed in the following jurisdictions: [See Reg.] Reg. 301.7701-2(c) Other business entities For federal tax purposes (1) The term partnership means a business entity that is not a corporation under paragraph (b) of this section and that has at least two members.
Since an LLC is not classified as a corporation under 301.7701-2(b)(1), (2), (3), (4), (5), (6), (7), or (8), it will be classified as a partnership if there are at least two members. However, the next issue is whether the LLC is an "eligible entity" that may elect to be classified as a corporation. Reg. 301.7701-3(a) "A business entity that is not classified as a corporation under 301.7701-2(b)(1), (2), (3), (4), (5), (6), (7), or (8) (an eligible entity) can elect its classification for federal tax purposes as provided in this section. An eligible entity with at least two members can elect to be classified as either an association (and thus a corporation under 301.7701-2(b)(2)) or a partnership, and an eligible entity with a single owner can elect to be classified as an association or to be disregarded as an entity separate from its owner. Paragraph (b) of this section provides a default classification for an eligible entity that does not make an election. Thus, elections are necessary only when an eligible entity chooses to be classified initially as other than the default classification or when an eligible entity chooses to change its classification. . . ." Reg. 301.7701-3(b) Classification of eligible entities that do not file an election (1) Domestic eligible entities Except as provided in paragraph (b)(3) of this section, unless the entity elects otherwise, a domestic eligible entity is 3
(i) A partnership if it has two or more members; or (ii) Disregarded as an entity separate from its owner if it has a single owner. Thus, an with two or more members is classified as a partnership unless it elects to be classified as an association (and thus a corporation), in which case it must make an election to do so. 7704 2(a) FMV = > $400 $100 $100 $100 $100
"For federal income tax purposes, gain or loss from the sale or use of property is attributable to the owner of the property." Commn'r. v. Bollinger, 485 U.S. 340 (1988). Thus, "income from real estate held in the name of a nominee will be taxed to the beneficial owner, not to the nominee." Commn'r. v. State-Adams Corp., 283 F.2d 395, 398 (2d Cir. 1960). Do we have any basis for arguing that the corporations should be disregarded for federal tax purposes? Strong v. Commissioner (p. 49) Strong/Moline Properties Test Recognize Don't Recognize Is there a business activity? Yes buying Is it a "passive dummy"? Does it do and selling real estate. anything more than just take and hold title Is there a business purpose? Yes to buy to the land? If so, the corporate form will and sell real estate, and to avoid paying a be respected. premium (which could only be done by using a corporation). Does the corporation have a bank account? Yes. Has the corporation borrowed money? Under Strong/Moline Properties, the corporation will be ignored for federal tax purposes only if it is a "purely passive dummy or is used for tax-avoidance purposes." The rationale is to prevent evasion or abuse of the two-tiered tax structure. Shareholder intent is irrelevant - even if the owners expressly intend the corporation to be a completely passive dummy, the corporation will be recognized for federal tax purposes "so long as [its] purpose is the equivalent of business activity or is followed by the carrying on of business by the corporation."
The degree of corporate purpose and activity requiring recognition of the corporation as a separate entity is extremely low. Borrowing money is a way to have the corporation respected. Note that in Strong and Moline Properties the taxpayers were arguing that the corporation should be completely ignored for federal tax purposes.
"[I]f a corporation holds title to property as agent for a partnership, then for tax purposes the partnership and not the corporation is the true owner." Bollinger, 485 U.S. 340. Do we have any basis for arguing that the corporation was acting as a mere agent of the partnership? Commissioner v. Bollinger (p. 54) National Carbide Factors Operates in the name of the principal Binds the principal Transfers funds received to the principal Income is attributable to the services of employees of the principal and assets belonging to the principal 5. Relationship with principal must not be dependent on the fact that it is owned by the principal 6. Its business purpose must be the carrying on of the normal duties of an agent. 1. 2. 3. 4. "The meaning of National Carbide's fifth factor is, at the risk of understatement, not entirely clear. Ultimately, the relations between a corporate agent and its ownerprincipal are always dependent upon the fact of ownership, in that the owner can cause the relations to be altered or terminated at any time. Plainly that is not what was meant, since on that interpretation all subsidiary-parent agencies would be invalid for tax purposes, a position which the National Carbide opinion specifically disavowed. We think the fifth National Carbide factor so much more abstract than the others was no more and no less than a generalized statement of the concern, expressed earlier in our discussion, that the separate-entity doctrine of Moline not be subverted. "As noted earlier, it is uncontested that the law attributes tax consequences of property held by a genuine agent to the principal; and we agree that it is reasonable for the Commissioner to demand unequivocal evidence of genuineness in the corporation shareholder context, in order to prevent evasion of Moline. We see no basis, however, for holding that the unequivocal evidence can only consisted of the rigid requirements (arm's-length dealing plus agency fee) that the Commissioner suggests. "
It seems to us that the genuineness of the agency relationship is adequately assured, and tax avoiding manipulation adequately avoided when, the fact that the corporation is acting as agent for its shareholders with respect to a particular asset is set forth in a written agreement at the time the asset is acquired, the corporation functions as agent and not principal with respect to the asset for all purposes, and the corporation is held out as the agent and not principal in all dealings with third parties relating to the asset." Bollinger Test
1. Written agreement 2. Acts as agent 3. Held out as agent and not principal in dealings with third parties In contrast to Strong, where the taxpayer was arguing that the corporation should be completely ignored for federal tax purposes, the taxpayers in Bollinger were not arguing that the corporation should be disregarded because it was a "purely passive dummy," but only that the corporation should be treated as their agent. Recognition of the corporate entity because the corporation conducts sufficient business activity does not preclude a Bollinger type argument that the corporation nevertheless was acting merely as the agent of its shareholders. Subsequent decisions have established that no written agreement is fatal to arguing that a corporation was acting only as an agent, but it is not necessarily fatal if the corporation does not hold itself out as agent in dealings with third parties because the corporation may be held liable vis--vis third parties under general principals of agency law. The continued validity and applicability of National Carbide is not clear. After Bollinger, some courts treated it as the exclusive test for determining whether a corporation was acting as a true agent. However, it appears that more courts have adopted the view that Bollinger established a safe-harbor, and that in the absence of compliance with its three requirements, National Carbide still applies to the question whether a true agency relationship exists.
482
CHAPTER 3 Section 1 A. Basic Principles 1. Amy and Ben plan to organize X Corporation to engage in the construction business. Amy will contribute a truck with a basis of $50,000 and a fair market value of $150,000 and a power shovel with a basis of $125,000 and a fair market value of $100,000 in exchange for 20 shares of voting common stock. Ben will contribute $100,000 in cash and undeveloped land, previously held as an investment, having a basis of $20,000 and a fair market value of $150,000, in exchange for 100 shares of $1,000 par value nonvoting preferred stock with an 8% dividend preference and 12 shares of voting common stock. The fair market value of the preferred stock is $100,000. What are the tax consequences to Amy, Ben and X Corporation as a result of formation of the corporation? Specifically, how much, if any, gain must each recognize; what is the basis to each shareholder in the stock received; and what is the corporation's basis in the assets received by it? Amy 20 shares of voting common stock Property Contributed Truck Power Shovel Aggregate AB/FMV AB $50,000 $125,000 $175,000 FMV $150,000 $100,000 $250,000
Ben 100 shares of $1,000 par value nonvoting preferred stock with 8% dividend preference. 12 shares of voting common stock Property Contributed Cash Undeveloped land Aggregate AB/FMV AB $100,000 $20,000 $120,000 FMV $100,000 $150,000 $250,000
Before determining the tax consequences to the shareholders and the corporation, we must first determine whether 351(a) applies. If 351(a) applies, no gain or loss is recognized by a taxpayer who transfers property to a corporation in exchange for stock of that corporation; however, if the requirements of 351(a) are not met (or avoided), incorporation will constitute a taxable exchange under 1001(a), (c), since the transferor's change of status from the owner of an asset to the owner of share of a corporation that owns the asset is a realization event. Burnet v. Commonwealth Improvement Co., 287 U.S. 415 (1932).
Tax consequences to Amy Tax Consequences to Amy Truck Shovel Yes Yes $150,000 $100,000 FMV of Stock Received 7
Property Transferred Realization Event ( 1001) Amount Realized ( 1001(b))
Adjusted Basis Realized Gain/Loss ( 1001(a)) Recognized? Amy's Basis in Stock Corp.'s Basis in SWT Y Corp.'s Basis in LWT
$ 50,000 $125,000 $ 50,000 ($ 25,000) $0 $0 $175,000 $50,000 $125,000
351(a) 358; Treas. Reg. 1.358-1(a) 362(a)(1) 362(a)(1)
Note, there is no 362(e)(2) issue here, because immediately after the transaction the corporation's aggregate adjusted basis in the assets transferred ($175,000) would not exceed the aggregate fair market value of those assets ($250,000). Under 358(a)(1), "[t]he 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." o "The basis of property permitted to be received . . . without recognition of gain or loss," is stock. See 351(a) ("solely in exchange for stock"). The fair market value of each share of common stock is $12,500 ($250,000/20). Since Amy exchanged two properties the truck and the shovel and since 358(a)(1) says "[t]he basis of the property permitted to be received . . . shall be the same as that of the property exchanged," could we not say that Amy exchanged the truck with a fair market value of $150,000 and basis of $50,000 for 12 shares of common stock with an aggregate basis of $50,0001 and exchanged the shovel with a fair market value of $100,000 basis of $125,000 for 8 shares of common stock with an aggregate basis of $125,000? No. Why? Treas. Reg. 1.358-1(a). o Treas. Reg. 1.358-1(a) "In the case of an exchange to which section 351 . . . applies in which . . . only nonrecognition property is received, the basis of all the stock . . . received in the exchange shall be the same as the basis of all property exchanged therefore." (emphasis added). Thus, 358(a)(1) read in conjunction with Treas. Reg. 1.358-1(a) says that Amy exchanged the truck and the power shovel with an aggregate basis of $175,000 for 20 shares of common stock with an aggregate basis of $175,000 ($8750 per share). Under 1223(1), Amy should take a tacked holding period in the stock, and on a sale the stock should be treated as held for the period of the transferred property only if the truck and the power shovel were either capital assets (which they are not) or 1231 gain property.
Tax consequences to Ben 351(a) applies because the preferred stock is not "nonqualified preferred stock" within the meaning of 351(g)(2). For purposes of 351, "property" includes cash. Rev. Rul. 69-357, 1969-1 C.B. 101.
Technically, each share of stock received in the exchange has its own individual basis; however, Treas. Reg. 1.1012-1(c) allows us to lump the basis of shares acquired on the same date and for the same price together.
Treas. Reg. 1.358-2(b)(2) "If in an exchange to which 351 . . . applies property is transferred to a corporation and the transferor receives stock . . . of more than one class . . . , then the basis of the property transferred (as adjusted under 1.358-1) shall be allocated among all of the stock . . . received in proportion to the fair market values of the stock of each class. . . . " Ben takes an "exchanged basis" in the stock received. 358(a), 7701(a)(44). Pursuant to 358(b)(1) and Treas. Reg. 1.358-2(b)(2), Bens basis in the property transferred, i.e., the cash and land, must be allocated among all of the stock received in proportion to the fair market values of the common and preferred stock. Thus, Bens basis in the common stock is $72,000 ($120,000 x ($150,000/$250,000)), and his basis in the preferred stock is $48,000($120,000 x ($100,000/$250,000)). Under 1223(1), Ben should take a tacked holding period in both the common and preferred stock.
Tax consequences to the corporation 1032 provides nonrecognition treatment to a corporation when it issues its stock in exchange for property or services and regardless of whether the person to whom the stock is issued is accorded nonrecognition under 351. Under 362(a)(1), 7701(a)(43), the corporation takes a "transferred basis" in the property When a shareholder exchanges more than one item of property solely for stock in a 351 transfer, the corporation's basis in each item of property is the same as it was in the hands of the shareholder. See P.A. Birren & Son v. Commissioner, 116 F.2d 718 (7th Cir. 1940); Gunn v. Commissioner, 25 T.C. 424, 438 (1955), aff'd per curium, 244 F.2d 408 (10th Cir. 1957). Thus, the aggregate basis is not reallocated among the properties.
2(a) Claire and Don formed Y Corporation to engage in the was hauling and landfill business. Claire contributed a solid waste truck with a basis of $150,000 and a fair market value of $100,000 in exchange for 10 shares of voting common stock. Don contributed land with a basis of $30,000 and a fair market value of $100,000 in exchange for 10 shares of voting common stock. What are the tax consequences to Claire, Don and Y Corporation as a result of the formation of the corporation? 362(e)(2) Transferor Claire Don Property Solid Waste Truck Land Adjusted Basis $150,000 $30,000 Fair Market Value $100,000 $100,000
Claire 10 shares of voting common stock Don 10 shares of voting common stock Tax Consequences to Claire Realization Event ( 1001) Adjusted Basis ( 1011) Less: Amount Realized ( 1001(b)) $150,000 $100,000 9 Basis in solid waste truck Value of stock received
Realized Loss ( 1001(a)) Recognized?
$ 50,000 No 351(a) 362(e)(2)(A) Claire's Basis in Stock $150,000 358(a)(1) Y Corp.'s Basis in Solid Waste Truck $100,000 362(e)(2)(A) OR 362(e)(2)(C) - Election Claire's Basis in Stock $100,000 362(e)(2)(C)(i)(II) Y Corp.'s Basis in Solid Waste Truck $150,000 362(a)(1) Tax Consequences to Don Realization Event ( 1001) Amount Realized ( 1001(b)) Less: Adjusted Basis ( 1011) Realized Gain ( 1001(c)) Recognized? Don's Basis in Stock Y Corp.'s Basis in Land $100,000 $ 30,000 $ 70,000 No $ 30,000 $ 30,000 Value of stock received Basis in land 351(a) 358(a)(1) 362(a)(1)
362(e)(2) is applied on a transferor by transferor basis, not on the aggregate of all the transferors. The reason is the language in 362(e)(2)(A), which says "[i]f property is transferred by a transferor in any transaction . . . and the transferee's adjusted bases of such property. . . ." The question here is what is the antecedent of "such property"? Any time you see "such" before something, you look back and find the earlier description. In this case, the antecedent of "such property" is "property [ ] transferred by a transferor," and that is what tells us that 362(e)(2) is applied on a transferor-by-transferor basis. So the corporation's basis in the truck is $100,000. See 362(e)(2)(A) (flush language) ("[T]he transferee's aggregate adjusted bases of the property so transferred shall not exceed the fair market value of such property immediately after such transaction."). Why is it that double gain is permitted, but double loss is not? This is a new statute that was only enacted in 2005. What would a smart tax lawyer, particularly on behalf of financial services clients do if 362(e)(2) were not there to stop him? o X Financial Instruments Corp. FMV = 100 AB = 500 Loss = (400) Repeat 14 times The result is that you could take a four hundred dollar loss and turn it into a $14,000 loss if you sell the corporations off in the right order. The issue is where does it stop. 362(e)(2) creates a trap.
10
Why does this fact pattern indicate that you have a conflict of interest in representing Claire and Don as well as the Corporation? The potential election under 362(e)(2)(C). A 362(e)(2)(C) election requires the consent of both the transferor and the transferee. If the election is made, the corporation gets a $150,000 basis and Claire only takes a $100,000 basis in the stock. Should the election be made? This is likely a 1231 asset, so we are talking about depreciation deductions immediately. The corporation will get greater depreciation deductions against a corporate tax rate that hits 35% faster than the individual rate, but, at the individual level, making the election converts what would otherwise be a $50,000 capital loss subject to the limitations of 1221(b) into a capital gain taxed at 15%. Thus, if the election is made, Claire is betting on when she will sell the stock. The rub is that Don gets half the benefit of the bump in basis to the corporation, while Claire takes the entire hit on the stock basis. Notice that if Claire is only a 20% shareholder, she takes 100% of the hit on the stock's basis but only gets the economic benefit of 20% of the increased depreciation deductions to the corporation. If you were representing Claire, you should advisor her to make the election only if the corporation is willing to make payments. There are times when you negotiate for tax benefits and there are times when you keep quiet for the sake of putting the deal together. But you have to balance putting the deal together against the friction any negotiations might create between the parties and your obligation to protect your client's interest.
2(b) Suppose alternatively that Claire contributed a solid waste truck with a basis of $150,000 and a fair market value of $100,000 and a liquid waste truck with a basis of $60,000 and a fair market value of $100,000 in exchange for 20 shares of voting common stock. Don contributed land with a basis of $30,000 and a fair market value of $200,000 in exchange for 20 shares of voting common stock. What are the tax consequences to Claire, Don and Y Corporation as a result of the formation of the corporation? 362(e)(2) allocating basis adjustment where there is one appreciated asset and one depreciated asset Transferor Claire Don Property Solid Waste Truck Liquid Waste Truck Land Adjusted Basis $150,000 $ 60,000 $30,000 Fair Market Value $100,000 $100,000 $200,000
Property Transferred Realization Event ( 1001) Amount Realized ( 1001(b)) Adjusted Basis Realized Gain/Loss ( 1001(a)) Recognized? Y Corp.'s Basis in SWT Y Corp.'s Basis in LWT Claire's Basis in Stock
Tax Consequences to Claire SWT LTW $100,000 $150,000 ($ 50,000) No $140,000 $100,000 $ 60,000 $ 40,000 No FMV of Stock Received
$ 60,000 $210,000
351(a) 362(e)(2)(A), (B) 362(a)(1) 358(a)(1)
11
Now we are looking at the effect on basis when Claire contributes two assets, one of which, the solid waste truck, has depreciated in value and the other of which, the liquid waste truck, has appreciated in value. Don's tax consequences are the same, so he is irrelevant to this part of the problem. 362(e)(2)(A) "If (i) property is transferred by a transferor in any transaction . . . , and (ii) the transferee's aggregate adjusted bases of such property would (but for this paragraph) exceed the fair market value of such property immediately after such transaction, then notwithstanding subsection (a), the transferee's aggregate adjusted bases of the property so transferred shall not exceed the fair market value of such property immediately after such transaction." o "If (i) property is transferred by a transferor in any transaction . . . , and (ii) the transferee's aggregate adjusted bases of such property would (but for this paragraph) exceed the fair market value of such property immediately after such transaction . . . " Who is the transferee? The corporation The "if clause" of 362(e)(2)(A) tells us that we are ignoring 362(e)(2), so we first compute the transferee's aggregate basis i.e., the corporation's basis as if 362(e)(2) were never enacted. The question is does the transferee's aggregate basis for the two trucks (but for 362(e)(2)) exceed the fair market value? Yes. But for this section, the aggregate basis would be $210,000 and the aggregate fair market value would be $200,000. Thus, there would be a built-in loss of $10,000. o ". . . then notwithstanding subsection (a) . . ." The "then clause" says "notwithstanding," so this means that we are going to change the result we just reached. o ". . . the transferee's aggregate adjusted bases of the property so transferred shall not exceed the fair market value of such property immediately after such transaction." This tells us that we have to reduce the basis of something by $10,000, so that aggregate basis equals aggregate fair market value. Now the question is how do we reduce the basis? Usually, there are four choices you are facing whenever you have to reduce the basis of something: (1) reduce one before the other, (2) divide the adjustment relative to the fair market value of the properties, (3) divide the adjustment relative to the basis of the properties, or (4) divide the adjustment relative to appreciation or depreciation. These are the basic formats you find whenever you are doing adjustments, like this, where you have too much basis or too little basis. Here, you apportion the aggregate basis reduction of $10,000 among the assets with a basis that exceeds fair market value relative to the depreciation in value built into those assets. Since the solid waste truck is down $50,000 and the liquid waste truck is up $40,000, the basis of the solid waste is reduced from $150,000 to $140,000.
12
Effect of Basis Adjustment: Notice that this adjustment does not completely eliminate the double loss; what it does do is eliminate any built-in loss in the corporation itself. The result is that the aggregate fair market value of the assets is $200,000 and the corporation's aggregate basis in the assets is also $200,000. The fair market value of the solid waste truck is still $100,000, and we reduced the corporation's basis in the solid waste truck from $150,000 to $140,000. Now, if the corporation sold both trucks, it would realize and recognize a $40,000 loss on the sale of the solid waste truck, but that loss would be completely off-set by the $40,000 gain recognized on the sale of the liquid waste truck. Planning Technique: This leaves open the ability to transfer to the corporation an appreciated asset that the corporation is going to hold for a long time and a depreciated asset that the corporation is going to dispose of in the not too distant future. In such case, the corporation could get a loss on the sale of the depreciated asset and the shareholder could take a loss on the sale of the stock.
(c) Suppose alternatively that Claire contributed a solid waste truck with a basis of $150,000 and a fair market value of $100,000, a liquid waste truck with a basis of $40,000 and a fair market value of $100,000, and a bulldozer with a basis of $75,000 and a fair market value of $50,000, in exchange for 25 shares of voting common stock. Don contributed land with a basis of $30,000 and a fair market value of $250,000 in exchange for 25 shares of voting common stock. What are the tax consequences to Claire, Don and Y Corporation as a result of the formation of the corporation? 362 - allocating basis adjustment where there are two depreciated assets and one appreciated asset. Transferor Claire Property Solid Waste Truck Liquid Waste Truck Bulldozer Land Adjusted Basis $150,000 $ 40,000 $ 75,000 $30,000 Fair Market Value $100,000 $100,000 $ 50,000 $250,000
Don
Property Transferred Realization Event ( 1001) Amount Realized ( 1001(b)) Adjusted Basis Realized Gain/Loss ( 1001(a)) Recognized? Y Corp.'s Basis in SWT Y Corp.'s Basis in LWT Y Corp.'s Basis in Bulldozer Claire's Basis in Stock
Tax Consequences to Claire SWT LTW Bulldozer $100,000 $150,000 ($50,000) No $140,000 $100,000 $ 40,000 $ 60,000 No $ 40,000 $70,000 $210,000 $50,000 $75,000 ($25,000) No FMV of Stock
351(a) 362(e)(2)(A), (B) 362(a)(1) 362(e)(2)(A), (B) 358(a)(1)
13
Where multiple assets are involved, 362(e)(2)(A) requires that the aggregate basis of the transferred property be reduced by the excess of the aggregate basis over the aggregate fair market value, and 362(e)(2)(B) requires that the aggregate basis reduction be allocated among the transferred properties in proportion to the built-in losses in the properties before taking into account 362(e)(2). Here, the aggregate fair market value of the three properties that Claire transferred is $250,000 and their aggregate basis is $265,000, thus requiring a basis reduction of $15,000 ($265,000 - $250,000) with respect to the solid waste truck and the bulldozer, the two properties with a basis that exceeds fair market value. The solid waste truck has a built-in loss of $50,000 and the bulldozer has a built-in loss of $25,000. The $15,000 basis reduction is allocated 2/3 to the solid waste truck ($50,000/($50,000 + $25,000)), and 1/3 to the bulldozer ($25,000/($50,000 + $25,000)). Thus, the basis of the solid waste truck is reduced by $10,000 (2/3 or .67 x $15,000) from $150,000 to $140,000, leaving an unrealized loss of $40,000 ($140,000 basis - $100,000 fair market value) inherent in the solid waste truck, and the basis of the bulldozer is reduced by $5,000 (1/3 or .33 x $15,000), from $75,000 to $70,000, leaving an unrealized loss of $20,000 ($70,000 basis - $50,000 fair market value) inherent in the solid waste truck. The proportion calculation that we use is the same proportion calculation that we use to allocate the exchanged basis of stock between common and preferred stock.
B. "Property" And Midstream Transfers of Income 1. Alicia and Bart are the sole shareholders of X Corporation, which is engaged in a financial services business. Alicia and Bart each own 50 shares of common stock. Alicia contributed a 453 installment note with a basis of $20,000 and a fair market value of $100,000 to X Corporation in exchange for 10 shares of stock worth $100,000. Alicia received the note earlier this year for land that she had held for investment for many years. Bart, who has a real estate license but does not actively conduct any real estate brokerage business contributed a cash method account receivable in the amount of $15,000, which arose from brokering a commercial lease on behalf of a friend who owned an office building. Bart also contributed a parcel of land held for sale to customers in the ordinary course of his unincorporated real estate development business, which had a basis of $20,000 and a fair market value of $85,000, and which was subject to a binding executory purchase and sale contract. In exchange, Bart received in exchange 10 shares of stock worth $100,000. What are the tax consequences to Alicia, Bart and X Corporation as a result of the formation of the corporation? Transferor Alicia Bart Property 453 Installment Note Cash Method Receivable Land held as inventory Adjusted Basis $20,000 $0 $20,000 Fair Market Value $100,000 $15,000 $85,000
Class Notes
14
Alicia and Bart have a going corporation that is already in existence. They are 50/50 shareholders. Alicia is going to contribute a 453 installment note with a FMV of $100 and a basis of $20. Bart is going to contribute some cash method accounts receivable with an FMV of $15,000 and a basis of $0, plus land with a FMV of $85,000 and a basis of $20,000.
What is the problem with Alicia? 435B(a) "If an installment obligation is satisfied at other than its face value or distributed, transmitted, sold, or otherwise disposed of, gain or loss shall result . . . " Transferring the note to the corporation satisfies the "if" condition, so gain should result. 453B(d) provides an exception to 453B(a) in the case of a distribution to which 337(a) applies, so Congress has shown us that knows how to make an exception for corporate transactions. There is another exception in 453B(g) for transfers incident to divorce. Another in 453B(h) for certain liquidating distribution by S-corporations. Then we come to the end of the section. This presents a problem because we have 351 that says there is nonrecognition on the transfer of property for stock if the conditions of that section are met. And we have 453B triggering recognition of gain. When we look at 351(a) there is no language that says "notwithstanding any other provisions in this subtitle to the contrary," in 453B we don't find anything that says "except as otherwise provided in this subtitle," and, indeed, we find a list of three exceptions, none of which we meet. Nevertheless, we are saved by the regulations. Treas. Reg. 1.453-9(c)(2) provides that "[w]here the Code provides for exceptions to the recognition of gain or loss in the case of certain dispositions, no gain or loss shall result under section [453B] in the case of a disposition of an installment obligation. Such exceptions include: Certain transfers to corporations under sections 351 and 361. . . ." There are two lessons here: First, very often you'll find two provisions of the IRC that on there face are unrelated, you have a fact pattern where they converge, and they produce different results. o Ex: 1001 and 351 overlap. Where they do, 1001 defers to 351 by virtue of the language in 1001(c). When one defers and says "except as otherwise provided . . . ," you know that that one is trumped by other exceptions (so go look for the exceptions!). When one says "notwithstanding any other provisions in this subtitle to the contrary . . . ," you know that that one trumps. Either of those two clauses will help you out. If neither of them have that you have a problem. But don't give up. Go to the regulations. Treas. Reg. 1.453-9(c)(2) is a long standing regulation. It is so long-standing that it even has some inaccurate language in it. Bart Accounts Recievable/Assignment of Income Doctrine
15
o The term "property" also includes accounts receivable, regardless of whether the transferor used the cash or accrual method of accounting. Rev. Rul. 80-198, 1980-2 C.B. 113. In Hempt Bros., Inc. v. United States, 490 F.2d 1172 (3d Cir. 1974), the court held that application of the assignment of income doctrine to tax the transfer of receivables by a cash method taxpayer would frustrate the policy of 351, which is to facilitate incorporation of a going business. Rev. Rul. 80-198, 1980-2 C.B. 113, adopts the holding of Hempt Brothers, but adds that assignment of income principles will apply to tax the transfer of receivable if that is the only asset transferred to the corporation. o Assignment of income doctrine = true earner of the income is tax, even if the income is assigned to another. o How is Barts case different than the Hempt brothers? The two activities/assets contributed dont seem to be related in this question. Remember, a Rev.Ruling is only authority if the facts are substantially similar. If you think you can convince the IRS that RevRuling 80-198 applies... are there any other tools the IRS can use? Look below at 482! o Notice that the Revenue Service in Hempt Brothers never argued that the accounts receivable were not property. Instead, it argued that assignment of income principles trumped 351 to tax the income to the shareholder instead of the corporation. Land 482 o The issue is whether 482 should apply to reallocate the gain from the impending sale of the land to Bart. o Are the requirements of 482 met? ". . . two or more organizations, trades or businesses . . . "? Yes, Bart's unincorporated real estate business and Corporation X, which is in the financial services business. ". . . owned or controlled directly or indirectly by the same interests . . . "? Bart owns all of the real estate business, but own only half of Corporation X. We arent certain if 50% control is enough here (look at caselaw). o In a case in which two unrelated taxpayers each owned 50% of the stock in a subsidiary corporation, the Tax Court originally held that the predecessor to 482 was not applicable since the subsidiary was not "controlled" by the same interests despite the fact that the taxpayers were acting in furtherance of their common purposes. Lake Erie & Pittsburg Railway Co. v. Commissioner, 5 T.C. 558 (1945). The service initially acquiesced in this decision (1945 C.B. 5), but in 1965 reexamined its position and indicated that it would no longer follow the Lake Erie holding. Rev. Rul. 65-142, 1965-1 C.B. 223. Lake Erie was likewise rejected by B. Forman Co. v. Commissioner, 453 F.2d 1144 (2d Cir. 1972). o We don't need to give a definitive answer. We just need to be able to assess the risk. o " . . . in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades or businesses. . . . " What is the business purpose to contribute these before collection, other than a tax avoidance purpose? Who really earned the gain from that appreciation in the land? Bart.
16
o What if Bart did not already have a contract? Do we still have a 482 problem without a signed contract? Yes. Foster v. Commissioner (9th Circuit) tells us that the transfer of highly appreciated property, "pregnant with income," where the transferor expects to realize the gain soon, and where there is no readily apparent business purpose raises the risk of 482. o 351 requires a business purpose! o Foster held that 482 trumps 351, and Treas. Reg. 1.482-1(f)(1)(iii) now expressly states that 482 trumps 351. o So, 482 overlaps with the Assignment of Income Doctrine. (Check for both! This question is an example of where they overlap.) Thursday, September 2, 2010 C. "SOLELY FOR STOCK" THE RECEIPT OF OTHER PROPERTY 1. Claire, Don, and Erin plan to organize a corporation to engage in the construction business. They will each make the following contributions in exchange for the specified interest in the corporation. What are the tax consequences to each of the investors and to the corporation as a result of the formation of the corporation? Specifically, how much, if any, gain must each recognize; what is the character of the gain; what is the basis to shareholder in the stock or promissory note received; and what is the corporation's basis in the assets received by it? (a) Claire will contribute construction supplies previously held for sale to customers in the ordinary course of business, with a basis of $300,000 and a fair market value of $450,000, in exchange for 20 shares of common stock and a promissory note for $200,000 due in 10 years, with interest at the prime rate payable semi-annually.
Contributor Contribution Claire Construction supplies Don Bulldozer Cement mixer truck Erin Land Building
Character Inventory 1221(a)(1) Equipment 1231 Equipment 1231/gain subject to 1245 recapture Capital asset 1221 Building 1231/not subject to 1245 or 1250 recapture
FMV AB $450 $300 $180 $270 $90 $360 $300 $150 $60 $210
All three exchanged their respective assets for 20 shares of common stock and note for $200,000 due in 10 years w/ adequate interest.
Class Notes
17
It is often important in forming a corporation, for both business and tax reasons, that the corporation issue not just stocks, but also promissory notes. There is often a business reason for issuing notes to some, but not all, of the contributors, and there are tax reasons for issuing notes to all of the transferors, i.e., the interest on the note is deductible, whereas dividends are not, so the corporation can minimize its taxes by paying interest on debt rather than dividends on stock. A non-tax planning reason would be to equalize ownership in the corporation where the promoters make unequal contributions. Thus, the corporation would issue an equal amount of common stock to the contributors and equalize the contributions by issuing notes or preferred stock. Our starting point is 351(b). We have met all of the conditions of 351(a) except "solely for stock." 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 subsection (a), other property or money then (1) gain (if any) to such recipient shall be recognized, but not in excess of (A) the amount of money received, plus (B) the fair market value of such other property received; and (2) no loss to such recipient shall be recognized. Here, Claire is exchanging a single piece of property, for stock and boot. The question is how do we go about applying 351(b) to figure out how much gain Claire must recognize? 351(b)(1) says "gain . . . shall be recognized . . . " You can only recognize realized gain. Unless you first realize gain, it is impossible to recognize gain, so the first step in apply 351(b) is to determine the amount of gain realized under 1001(a).
What is Claire's amount realized? The fair market value of the stock and note received in the exchange. 1001(b). Here, we treat all the supplies as a single fungible asset. Amt Realized = Amt of cash + FMV of property received in the exchange (Stock of 250 +Note of 200 = 450). Basis of Inventory = 300. Gain realized = 450 300 = 150. What is the amount realized attributable to the note? Treas. Reg. 1.1001-1(g)(1) If a debt instrument is issued in exchange for property, the amount realized attributable to the debt instrument is the issue price of the debt instrument as determined under 1.273-2 or 1.274-2; whichever is applicable. If, however, the issue price of the debt instrument is determined under section 1273(b)(4), the amount realized attributable to the debt instrument is its state principal amount reduced by any unstated interest (as determined under section 483).
18
o Under Reg. 1.1001-1(g), the amount realized is the issue price, as long as the promissory note bears adequate interest under the OID rules. The face amount of the note is the issue price. The point of Reg. 1.1001-1(g) is to prevent taxpayers from saying this is a closely held corporation that owes me $200,000; it's a high risk instrument; so, it's really only worth $130,000 if I took it to the bank to resell it. Instead, Reg. 1.1001-(g) says the note is worth $200,000 since it bears adequate interest, and therefore the amount realized attributable to the note is $200,000. Adequate interest is whatever interest the United States government is paying.
How much gain is recognized? 351(b) recognized gain of 150. What is the amount realized attributable to the stock? The aggregate fair market value of the corporation's assets (i.e., everything that was contributed to the corporation), minus the aggregate amount of the corporation's debts equals equity. Equity divided by the total number of shares issued and outstanding equals the fair market value of one share. The fair market value of one shares multiplied by the number of shares that the particular shareholder in question owns equals the fair market value of the stock received. In other words, Assets Liabilities = Equity. Aggregate FMV of corp.'s assets Minus: Aggregate FMV of corp.'s liabilities Equals: Equity Number of shares issued and outstanding FMV of one share FMV of Claire's stock $1,350,000 ($ 600,000) $ 750,000 60 $12,500 $250,000
$750,000/60 $12,500 x 12
Thus, Claire's amount realized attributable to the stock is $250 (($750 FMV of all of the shares issued and outstanding 60, i.e., the total number of shares issued and outstanding) x 20 the number of shares that Claire owns). Aside: A owns all 80 shares of X corporation. X corporation has a piece of land with a FMV of $100. X Corporation transfers 20 new shares to B in exchange for services, so that B only owns 20% of the corporation's shares immediately after the exchange and is not in "control" of the corporation. Without a doubt, B has compensation income. There is no argument that 351 applies. McMahon would give B a more likely than not opinion that B's income is less than $20. Why? Minority discount. In order to make the calculations easy, we are going to assume that the value of stock received equals the proportionate value of the corporation's underlying assets. It ain't true, but we are going to treat it as true.
Claire's gain: Amount realized ( 1001(b)): Stock $450,000 $250,000 19
FMV of 20 shares of stock received
Boot Less: Adjusted Basis ( 1011): Gain Realized ( 1001(a)): Gain Recognized Character
$200,000 $300,000 $150,000 $150,000 OI
FMV of note received AB of construction supplies exchanged 351(b)(1)(B) 1221(a)(1)
The gain realized is the ceiling on the amount of gain that can be recognized. You can never recognize more gain than you realize. Under 351(b), gain is recognized, but not in excess of the boot (i.e., the amount of money plus fair market value of the other property received). Since you cannot recognize gain in an amount that exceeds your realized gain, the amount of gain recognized under 351(b) is the lesser of (i) the boot, or (ii) the realized gain. So, here Claire's realized gain ($150,000) is less than the value of the boot received ($200,000), Claire will recognize her realized gain. 453(b)(2) says that you cannot use the installment method for "dealer dispositions" or dispositions of inventory. So, Claire must recognize immediately the full 150 and cannot use the installment method.
What is the effect on Claire's basis in the stock as a result of the gain recognized? 358(a) In the case of an exchange to which section 351 . . . applies (1) Nonrecognition Property 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 (A) decreased by (i) the fair market value of any other property (except money) received by the taxpayer, (ii) the amount of any money received by the taxpayer, and (iii) the amount of loss to the taxpayer which was recognized on such exchange, and (B) increased by (i) the amount which was treated as a dividend, and (ii) the amount of gain to the taxpayer which was recognized on such exchange (not including any portion of such gain which was treated as a dividend). 358(a) says "[t]he basis of property permitted to be received . . . shall be the same as that of the property exchanged . . . ," so we start with the basis of the property exchanged. Here, Claire's basis in the construction supplies was $300,000. Next, 358(a)(1)(A)(i) tells us to decrease the basis by "the fair market value of any other property (except money) received by the taxpayer." "[O]ther property" means property other than the stock (BOOT). Here, Claire received "other property" in the form of a note with a fair market value of $200,000. Thus, we decrease her exchanged basis of $300,000 by $200,000 to $100,000.
20
Then, 358(a)(1)(B)(ii) tells us to increase the basis by "the amount of gain to the taxpayer which was recognized . . ." Here, Claire recognized gain in the amount of $150,000. Thus, we increase her basis from $100,000 by $150,000 to $250,000. Accordingly, Claire's basis in the stock is $250,000. 358(a) Claire's Basis in the Stock 358(a)(1) basis in property exchanged 358(a)(1)(A)(i) FMV of note received 358(a)(1)(B)(ii) the amount of gain which was recognized 358(a)(1)
decreased by increased by Basis =
$300,000 $200,000 $150,000 $250,000
Whenever the boot exceeds the recognized gain, the basis of the stock equals the fair market value of the stock. To better understand these adjustments, think of basis as a running account of the taxpayer's investment.
What is the basis of the promissory note? 358(a)(2) Other Property The basis of any other property (except money) received by the taxpayer shall be its fair market value. Thus, the basis of the promissory note is $200,000. o Why? The combo of 351 and 358 to preserve in the property received the amount of realized gain that was not recognized. If any of the realized gain is recognized there must be a basis step-up. The boot takes the FMV basis and whatever is left over goes to the stock. We move basis to the boot. So, the 200 subtraction in 358(a)(1) is what matches the 200 basis in the boot. Therefore, Claire's aggregate basis in the stock and the promissory note is $450,000. The statutory rules here work as an application of the real principle of Philadelphia Park Amusement, which is that basis of the property given up, plus gain (minus loss) recognized, yields the basis of the property received. (E = Mc2). Basis transmutes into loss, and gain transmutes into basis. This principle is illustrated as follows: $300,000 Basis of the property given up +$150,000 Gain recognized $450,000 Aggregate basis of the property received Summary of Application of 351(b) and 358(a)(1) Authority for Step Determine gain realized 351(b)(1) Determine amount realized: 1001(a), (b) AR attributable to stock FMV of stock recieved Plus: AR attributable to boot FMV of boot recieved Less: Adjusted Basis 1001(a), 1011 Realized Gain 1001(a) Determine amount of gain recognized 351(b)(1) 21
STEP 1 (a) (i) (ii) (b) (c) STEP 2
STEP 3 (a) (b) (c) STEP 4
Determine shareholder's basis in stock received Start with basis of property exchanged Decrease basis by amounts specified in 358(a)(1)(A) Increase basis by amounts specified in 358(a)(1)(B) Shareholder's basis in other property = FMV
358 358(a)(1) 358(a)(1)(A) 358(a)(1)(B) 358(a)(2)
What are the tax consequences to the corporation? 362(a) for the corporation the Basis = original basis in Claires hands (300) + gain recognized (150) = 450. NB: this only equals the FMV of the property only b/c 100% of the gain that was realized by Claire was recognized. This doesnt always happen! 1032 provided nonrecognition to the corporation when it issued $250,000 worth of stock in exchange for the property. But the corporation also issued a $200,000 note for the property. Does the corporation have to recognized $200,000 worth of gain for issuing that note? The corporation's basis in a promissory note that it issues is $0, so should it recognize gain? If X corp. issues a $200,000 note for property with a fair market value of $200,000. X corp. does not recognized gain by paying for property with a promissory note. The transaction is nothing more than a purchase and sale and the promissory note is just deferred cash. (NB: if the ONLY thing that is transferred from the corporation is a promissory, the transfer would be a sale transaction.) o Has th o e corporation gotten a free step-up in basis b/c the basis is 450? And it only paid out the stock? No... b/c the corporation has to pay the promissory note in the future! Believe it or not, Reg. 1.61-12 is the proper citation for the proposition that a corporation does not recognize gain when it issues its own promissory note in exchange for property. This makes sense because, if you think about it, the corporation did not exchange any property. Until the corporation issues the promissory note it is not in existence, so there was no exchange by the corporation; it was a purchase.
(b) Don will contribute a bulldozer with an adjusted basis of $300,000 and a fair market value of $180,000 and a cement mixer truck with an adjusted basis of $150,000 and a fair market value of $270,000 in exchange for 20 shares of common stock and a promissory note for $200,000 due in 10 years, with interest at the prime rate payable semi-annually. All of the gain inherent in the cement mixer is subject to 1245 recapture. Contributor Contribution Claire Construction supplies Don Bulldozer Cement mixer truck Erin Land Building Character Inventory 1221(a)(1) Equipment 1231 Equipment 1231/gain subject to 1245 recapture Capital asset 1221 Building 1231/not subject to 1245 or 1250 recapture 22 FMV AB $450 $300 $180 $270 $90 $360 $300 $150 $60 $210
The main point of this problem is don't transfer loss property, particularly when you are also transferring gain property because the loss will not be allowed to offset the gain. Rev. Rul. 68-55 (*know this by name!) Don exchanged property with an aggregate basis of $450 for $250 worth of stock and a $200 note, but we cannot say that Don's amount realized is $450 and his basis is $450 and, therefore, he does not realize gain. This is because Rev. Rul. 68-55 requires use to use the asset-by-asset approach for determining gain under 351(b) where multiple assets are transferred in exchange for stock and boot. It requires this methodology because if the aggregate value of the property received was compared to Don's aggregate basis in the property, the effect would be to allow the loss, which 351(b)(2) specifically states shall not be recognized. Really, this is a policy reason. More broadly, everywhere in the income tax when somebody transfers more than one property at one time, you separate it and calculate the gain and loss on each piece of property separately. Rev. Rul. 68-55 address the method for determining the amount and character of gain to be recognized under 351(b) when multiple properties are exchanged for both stock and boot. The first question presented is how to determine the amount of gain to be recognized under section 351(b) of the Code. The general rule is that each asset transferred must be considered to have been separately exchanged. See the authorities cited in Rev. Rul. 67192, C.B. 1967-2, 140, and in Rev. Rul. 68-23, [1968-1 C.B. 144]. Thus, for purposes of making computations under section 351(b) of the Code, it is not proper to total the bases of the various assets transferred and to subtract this total from the fair market value of the total consideration received in the exchange. The second question is how, for purposes of making computations under section 351(b) of the Code, to allocate the cash and stock received to the amount realized as to each asset transferred in the exchange. The asset-by-asset approach for computing the amount of gain realized in the exchange requires that for this purpose the fair market value of each category of consideration received must be separately allocated to the transferred assets in proportion to the relative fair market values of the transferred assets. See section 1.1245-(c)(1). Note: The method for determining gain here is the same method used throughout the Code when multiple assets are transferred. Total $450 $250 $200 Dozer $180 40% $100 $ 80 $180 $300 ($120) No Mixer 270 60% $150 $120 $270 $150 $120 Yes $120 OI
FMV of asset transferred % of total FMV FMV of Stock received FMV of boot received Amount Realized Adjusted basis Gain (loss) realized Is Gain (loss) recognized? If so, how much Character of Gain
FMV of asset/FMV of total assets % of total FMV x FMV of stock % of total FMV x FMV of boot FMV of Stock + FMV of boot
351(b)(2) 351(b) 1245
23
Under 351(b)(2) of the Code, the loss of $120 realized on the exchange of the bulldozer is not recognized. Such loss may not be used to offset the gain realized on the exchange of the cement mixer. Under 351(b)(1) of the Code, gain shall be recognized but not in excess of value of boot received. Here, the value of the boot received equals the amount of gain realized. Thus, Don will recognize all $120 of the gain realized on exchange of the cement mixer. Because the cement mixer is " 1245 property" within the meaning of 1245(a)(3), any gain recognized on the exchange is subject to recapture as ordinary income to the extent the lower of "recomputed basis" or the fair market value of the property exceeds the adjusted basis of the property. However, 1245(b)(3) provides when 351 applies, "then the amount of gain taken into account by the transferor under subsection (a)(1) shall not exceed the amount of gain recognized to the transferor on the transfer of such property (determined without regard to this section)." According, the $120 gain realized and recognized on the exchange of the cement mixer will be characterized as ordinary income. Because it is recapture ordinary gain, it must be reported this year. 453 does not apply. 453(i) says you cannot use 453 for 1245 recapture. The point of this problem is don't transfer loss property, particularly when you are also transferring gain property because you will not be able to offset the gain with the loss. Second, watch out for 1245. Here, there is no loss recognition, no deferral, and ordinary income. Could we not structure the transaction so as to say that Don exchanged the mixer for stock and a $120,000 promissory note and that he exchange the bulldozer for a $180,000 promissory note, so that we have 351 transaction with respect to the mixer and a sale with respect to the bulldozer? Probably not. When 351 applies the taxpayer cannot alter the tax consequences by attempting to denominate part of the transaction as a "sale" of some assets and the balance as a transfer under 351. See Nye v. Commissioner, 50 T.C. 203 (1968). If the asset sold is not a vital asset and there is a sufficient time-lag between the 351 transaction and the "sale," you might be able to bifurcate the transactions. However, if the asset is a vital asset, courts will collapse the "sale" into the 351 transaction. The next issue is what is Don's basis in the stock and note? Don's Basis in the Stock 358(a)(1) basis in property exchanged 358(a)(1)(A)(i) FMV of note received 358(a)(1)(B)(ii) the amount of gain which was recognized 358(a)(1)
$450,000 $200,000 $120,000 $370,000
How do we determine the stock basis when there are multiple assets transferred? Reg. 1.358-1(a) tells us that Don takes an aggregate basis in the stock.
24
Note, 358(a)(1)(A)(iii) does not apply because the loss realized on the exchange of the bulldozer was not recognized. Theoretically, this is correct because if Don sold the stock today, he would recognize a $120,000 loss. Notice, if Don had sold the bulldozer, he would have recognized a $120,000 1231 loss, deductible against ordinary income. By transferring 1231 property that has fallen in value in exchange for stock, not only did we have nonrecognition currently, but we transmuted a potential ordinary loss into something that is for certain only going to be a capital loss. This is like converting platinum into lead. Don's basis in the note is $200,000. 358(a)(2); Treas. Reg. 1.1001-1(g)(1).
The third issue is what is the Corporation's basis in the assets? This problem shows the importance of knowing to proper sequence to apply Code sections. o The first thing we do is calculate the shareholder's gain under 351(b). o The second thing we do is calculate the shareholder's basis under 358. Notice that the calculation of the shareholder's basis under 358, while it might happen to use some of the same numbers as the calculation of the corporation's basis under 362(a), the corporation's basis under 362(a) has nothing to do with the calculation of the shareholder's basis under 358. o Third, we calculate the corporation's basis under 362(a). It says: 362(a) If property was acquired . . . by a corporation (1) in connection with a transaction to which section 351 (relating to transfer of property to corporation controlled by transferor) 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. We find the asset by asset approach in the Beyron (sp?) case and the Dunn case. There is no case or ruling that shows where to allocate, but look at it like the stepup in basis on the mixer was purchased by the gain recognized by Don. Now we have to decide whether we compute the corporation's basis in the dozer or the mixer first. So, we have to decide whether one is a function of the other or not. 362(a) is the basic rule, so we do it first. Here, the basic calculation would be that the dozer takes $300 and the mixer is $150 plus the $120 gain to get to $270. o Fourth, we turn to 362(e): 362(e)(2)(A) "If property is transferred by a transferor in any transaction . . . and the transferee's aggregate adjusted bases of such property would (but for this paragraph) exceed the fair market value of such property immediately after such transaction, then notwithstanding subsection (a), the transferee's aggregate adjusted bases of the property so transferred shall not exceed the fair market value of such property immediately after such transaction." 25
"but for this paragraph" refers to 362(e)(2) "If property is transferred by a transferor in any transaction . . . and the transferee's aggregate adjusted bases of such property would (but for this paragraph) exceed the fair market value of such property immediately after such transaction . . . " This language tells us that we have to do the 362(a) calculation first with respect to gains (because under 362(a)(1) the corporation's basis is the transferor's transferred basis increased by the amount of gain recognized by the transferor on the transaction), then we apply 362(e) for basis reduction. Under 362(a)(1), the corporation's basis in the bulldozer is $300 its basis in the hands of the transferor, and the corporation's basis in the cement mixer is $270 - its basis in the hands of the transferor, $150, increased by the amount of gain recognized by Don, $120. Without regard to 362(e)(2), the aggregate adjusted bases of the property transferred is $570 and the aggregate fair market value of the property is $450. Thus, there is a built-in loss of $120, which is allocated in full to reduce the corporation's adjusted basis in the bulldozer from $300 to $180 i.e., fair market value. 362(e)(2)(A)(flush language) and (B). Be careful! If you paraphrase 362(e), you may forget that it applies here. First you must do the 362(a) basis adjustments and then see if 362(e) applies! What is the effect of 358 w/ respect to the stock? It preserves in the stock any realized but unrecognized gain or loss (a two way swinging door). What does 362 do? It ensures that the corporation doesnt recognize the same loss as the SH, but it can recognize the same gain (gain is preserved, but loss is reduceda one way swinging door!). Class notes on 362(e): If you could transfer property w/ built in losses to a corporation and preserve the loss, then you could keep moving the loss downmultiplying it on the way. That is what 362(e) stops. If the corporation turns around and sells the cement mixer for $300,000 it has a gain of $30,000. Why might this be 1245 recapture income to the corporation and not a 1231 gain? Recomputed basis in 1245(b) includes all depreciation deductions claimed by the taxpayer selling the property or any other person that are reflected in the basis of the property. So, if Don had purchased the cement mixer for $350,000 and had depreciated it down to $120,000 he would have taken $170,000 worth of depreciation deductions. The cement mixer's basis is increased from $150,000 to $270,000 as a result of Don's gain, but Don's $170 worth of depreciation deductions that Don claimed before he contributed it are reflect in the basis of the bulldozer in the hands of the corporation. Therefore, the corporation can have 1245 recapture too. This is not nearly as important as the fact that the corporation under 168(i)(7) steps into Don's shoes for the cost recovery period; it doesn't start over again.
26
(c) Erin will contribute land and a building previously held out for rental. The land has a basis of $60,000 and the building an adjusted basis of $210,000. Their combined fair market value is $450,000. The building is not subject to either 1245 or 1250 recapture. Erin will receive 20 shares of common stock and a promissory note for $200,000 due in ten years, with interest at the prime rate payable semi-annually. (1) Assume that the land has a fair market value of $90,000 and the building a fair market value of $360,000. This problem is meant to show that the land and building are separate and distinct assets. It also illustrates the effect of installment reporting on a 351(b) transaction, namely gain is recognized under 351(b) but it is deferred under 453, so the deferral is the near equivalent of nonrecognition. There is one legal instrument used to convey the land and the building the deed. Do we have to apply Rev. Rul. 68-55? (allocate FMV of that received to that given up)? Yes, because Erin is exchanging two separate properties - land and a building for stock and boot. Regardless of the seller's treatment, on the buyer's side, the building is depreciable and the land is not, so they are clearly separate and distinct assets. If you have an individual seller, the land is pure 1231 or capital 15% rate and the building is subject to the 25% tax rate to the extent the gain is attributable to prior depreciation i.e., unrecaptured 1250 gain. Total $450 $250 $200 Land $90 20% $50 $40 $90 $60 $30 Yes $30 15% Building $360 80% $200 $160 $360 $210 $150 Yes $150 1250
351(b) 351(b)
In each case the gain is recognized because the amount of the boot exceeds the gain that was realized on each piece of property. Total gain realized & recognized of $180.
When is gain recognized? Prop. Reg. 1.453-1(f)(1) and Prop. Reg. 1.453-1(f)(3) allow us to apply installment reporting in this instance.
27
Under Prop. Reg. 1.453-1(f)(1)(ii), the receipt of stock is not considered a "payment" for purposes of apply the installment method. Thus, gain is not recognized until 10 years from now because it is an installment note that may be reported on the installment method. Even though it only calls for one payment 10 years from now, it is an installment note, and it may be reported under the installment method because it was not acquired in exchange for inventory, or personal property subject to depreciation recapture under 1245. Again, here, we have to focus on applying the statutory provisions in the proper sequence. You must cite both: b/c the method is in Prop. Reg. 1.453-1(f)(1)(ii) but the permission to use it is in Prop. Reg. 1.453-1(f)(3)(ii) In 453(f)(6)(C): payment doesnt include prop to be received w/out recognition of gain. Applies to all 453so, the not received can be an installment note!
Start with the stock basis. 358 Erin's Basis in the Stock 358(a)(1) aggregate basis of property exchanged 358(a)(1)(A)(i) FMV of note received 358(a)(1)(B)(ii) the amount of gain which was recognized 358(a)(1)
$270,000 $200,000 $180,000 $250,000
358(a)(1)(B)(ii) says to increase the stock basis by "the amount of the gain which was recognized." (Emphasis added). Notice, the tense of the verb "was" is the past tense. Here, the gain is going to be recognized in 10 years, so does this mean there is no basis increase for the $180 of gain recognized? Prop. Reg. 1.453-1(f)(3)(ii) (sixth sentence) says "[s]olely for the purpose of applying section 358(a)(1), the taxpayer shall be treated as if the taxpayer elected not to report receipt of the installment obligation on the installment method." So, if the installment method did not apply, the $180 of gain goes into the 358 calculation and the stock has a basis of $250
What about the basis of the promissory note? 358(a)(2) says the basis of other property is the fair market value. Why is the basis of the promissory note not $200,000? Erin has not recognized the $200,000 gain yet. Basis is created by either paying cash in after-tax dollars or by recognizing gain. If you have not recognized gain, you cannot create basis without paying cash (or giving a promissory note). Since the gain has been deferred under 453 the promissory note cannot take a fair market value basis. Think about Philadelphia Park. Why is the basis of property received in a taxable exchange fair market value? Because the fair market value of the property received in a taxable transaction is the sum of the basis of the property given up plus the gain recognized on the exchange. So the result here is that the promissory note cannot take a fair market value basis.
28
Prop. Reg. 1.453-1(f)(3)(iii) solves this problem. Under that regulation we take the aggregate basis of the property transferred, $270,000, subtract the basis of the stock (it is allocated firs to the stock), $250,000, that leaves $20,000 which is termed "excess basis" and that becomes the basis of the promissory note (the boot). When a promissory note with a face value of $200,000 is collected in 10 years there is $200,000 received against a basis recovery of $20,000 and, therefore, the gain recognized is $180,000. o Theoretically, with an installment note the stock absorbs basis first up to its FMV and what is left goes to the installment note (as long as youve elected installment method under 453). Why is the note preferable? The corporation can deduct the interest payments, but not dividends (as it would have had it funneled money out through the stock). Notice, if 10 years from now the corporation is insolvent, there is a bad debt deduction of $20,000. If the corporation is insolvent and only pays off $150,000 on the note, there is a $150,000 amount realized on the note minus $20,000 of basis, which equals $130,000 of gain at that time. What we find is that the full $180,000 was recognized, but it was deferred under 453. Keep in mind, the deferral under 453, if it is long enough, is very similar to nonrecognition. The major difference is that nonrecognition can become exemption through 1014, whereas with deferral under 453, the gain has to be reported as income in respect of decedent because there is no step-up in basis for an installment obligation.
What are the tax consequences to the corporation? Prop. Reg. 1.453-1(f)(3)(iii) says that when you apply the installment method to the boot in a 351 transaction, then, unlike in a purchase from an unrelated party, where 453 applies to the seller, the corporation does not get the basis step-up until the note is paid. What happens is that the corporation steps into Erin's shoes for depreciating $210,000 of basis in the building wherever it is in its 39 year useful life. It then starts depreciating a new 39 year useful life on the $180,000 step-up in basis 10 years from now, when Erin includes the amount in income. How can the corporation get an immediate step-up in basis? Elect not to report the gain recognized from the note on the installment method, which the corporation will prefer. 453(d) allows the transferor to elect out of the installment sale treatment in which case the full fair market value of the note is recognized as gain in the year of the exchange. This election would permit the corporation immediately to step-up its basis in the transferred property under 362(a). The election is made by the transferor. Note that the election raises a tax conflict between Erin, on the one hand, and Don, Claire, and the corporation on the other. It is in Don and Claire's interest, in reducing the corporation's taxes, for Erin to elect out of the installment method of reporting. It might or might not be in Erin's best interest. You have a tax conflict in your advice to them. Keep in mind that, technically, we have to bifurcate the promissory note into a promissory note for the land and a promissory note for the building because it is one promissory note that represents the purchase price for two separate and distinct assets.
29
(2) Assume alternatively that the land has a fair market value of $180,000 and the building a fair market value of $270,000. This problem illustrates the importance of appraisals in determining the FMV of land and a building. It also show there is potential tax conflicts with respect to how the FMV is allocated between the land and building. Total $450 $250 $200 Land $180 40% $100 $ 80 $180 $ 60 $120 Yes $ 80 15% Building $270 60% $150 $120 $270 $210 $ 60 Yes $ 60 1250
351(b) 351(b) gain to extent of boot
If the land is worth $180,000 instead of $90,000 and the building is worth $270,000 instead of $60,000, the amount of the gain that Erin recognizes drops from $180,000 to $140,000. And that ripples through the rest of the calculations. Erin's Basis in the Stock (under this variation) $270,000 358(a)(1); Reg. 1.358-1(a) aggregate basis of property exchanged $200,000 358(a)(1)(A)(i) FMV of note received $140,000 358(a)(1)(B)(ii) the amount of gain which was recognized $210,000 358(a)(1)
Now we see that there is gain built-into the stock. There is $40,000 built-in gain in the stock that did not exist before. By readjusting the relative values of the land and building, we reduced the current gain from $180,000 to $140,000. The "price" was losing $40,000 of basis in the stock. That's a good deal because Erin can get it back by dying. The point of this question is to illustrate the importance of the relative fair market values of the building and the land. This shows how critical appraisals can be to tax consequences. Notice, the aggregate fair market value of the property did not change and the basis of the property did not (nor could not) change. Different appraisers will put different values on the land and building. This also shows that there is a conflict created by the different appraisals. Erin likes the appraisal that knocks her gain down to $140,000, whereas Don and Claire like the appraisal that tags Erin with $180,000 of gain because that means more basis increase for the corporation later on. The basis of the buildingin is that the basis of the building decreases to 270 (from 360 in the first option)! That means smaller depreciation deductions for the corporation. 30
Learn to think about how to even the dealhow to please everyone? How the taxes shake out matters to people. You may need to give other benefits to someone who is getting the short end of the tax stick. Also, another moral here is to be careful what appraisal you use!
Tuesday, September 7, 2010 2. Fran, Glenn, and Helen formed Y Corporation by making the following transfers. Fran and Glenn each transferred $100,000 of cash and received 50 shares each of common stock. Helen transferred unimproved real estate with a basis of $25,000 and received 10 shares of common stock, worth $20,000, and X Corporation's note for $80,000 payable in 21 years, with 6% (which you should assume is adequate stated interest). Contributor Fran Glenn Helen Contribution Cash Cash Unimproved estate Character AB $100,000 $100,000 $25,000 FMV $100,000 $100,000 $100,000
real Capital Asset
Fran and Glenn each received 50 shares of common stock
(a) What are the tax consequences to Helen? What is Helen's basis in the Y Corporation stock? What is Y Corporation's basis in the land? Helen: Amount Realized (100) Basis in the Land (25) = Gain (75). This gain can be reported on the installment method; the interest will be income over that time period. Helen received 10 shares of common stock worth $20,000, and Corporation X's note for $80,000 payable in 21 years, with interest payable annually at 6% (adequate interest). Why is the FMV of Helen's stock $20,000? $300,000 - Assets - $ 80,000 Liabilities (i.e., the value of the preferred stock) $220,000 Equity $220,000 /110 (number of shares of common stock issued and outstanding) = $2,000 $2,000 (value of 1 share of common stock) x 10 (number of shares Helen owns) = $20,000 Tax Consequences to Helen $20,000 $80,000 $100,000 $25,000 $75,000 $75,000 351(b) 31
Stock X Corporation's Note Amount Realized ( 1001(b)) Less: Adjusted Basis Realized Gain ( 1001(a)) Recognized?
Helen's Basis in the Stock $25,000 358(a)(1); Reg. 1.358-1(a) aggregate basis of property exchanged $80,000 358(a)(1)(A)(i) FMV of note received $75,000 358(a)(1)(B)(ii); Prop. Reg. 1.453-1(f)(3)(ii) gain which was recognized $20,000 358(a)(1) $5,000 Prop. Reg. 1.453-1(f)(3)(ii)
Helen's basis in the note Corp.'s basis in land Helen's basis in the note:
$25,000 362(a); Prop. Reg. 1.453-1(f)(3)(ii)
There will be 453 installment reporting here because this is land and she is not a dealer in real estate. "Excess basis" is the amount by which the taxpayer's basis in the property transferred exceeds the fair market value of "permitted property" received by the taxpayer. Prop. Reg. 1.453-1(f)(3)(ii). "Excess basis" = Helen 's basis in the note. $25,000 Helen's basis in the property transferred - $20,000 FMV of "permitted property," i.e. stock, received by Helen (allocated to $ 5,000 "Excess basis"
stock)
"Selling price" is the face value of the installment obligation. Prop. Reg. 1.4531(f)(1)(iii) $80,000 "selling price"
"Total contract price" is the "selling price" less liabilities which are not treated as money received under 357. Prop. Reg. 1.453-1(f)(1)(iii) $80,000 "selling price" -$0 liabilities $80,000 "Total contract price"
"Gross profit" is "selling price" less "excess basis" allocated to the installment obligation. Prop. Reg. 1.453-1(f)(1)(iv) Ex. 1. $80,000 Helen's basis in the property transferred - $ 5,000 FMV of "permitted property," i.e. stock, received by Helen $75,000 "Gross profit" 32
"Gross profit ratio" = "Gross Profit"/"Total Contract Price" $75,000/$80,000 = 93.75%
When Helen receives payment of the installment obligation in 21 years, 93.75% of the payment (exclusive of interest) will be gain attributable to the exchange. $80,000 x 93.75% = $75,000
Notice that before you can determine the basis of the promissory note under Prop. Reg. 1.453-1(f)(3)(ii), you have to determine the basis of the stock. Notice that while 351(b) provides that gain shall be recognized to the extent of the boot received, 453(f)(3) provides that " 'payment' does not include the receipt of evidences of indebtedness of the person acquiring the property," and Prop. Reg. 1.453-1(f)(1)(ii) provides that "[r]eceipt of permitted property will not be considered payment." So although Helen recognized $75,000 of gain under 351(b), recognition is deferred under 453 until the note is paid 21 years from now. Accordingly, there is no change in basis. Basis going in, $25,000 (Helen's basis in the land transferred to the corporation) plus gain recognized this year, $0 (see 453), equals the aggregate basis of the property received, $25,000 ($20,000 basis in the stock plus $5,000 basis in the 453 installment note).
Corporation's basis in the property transferred: The corporation's basis in the property transferred is $25,000 (Helens Basis). 362(a); Prop. Reg. 1.453-1(f)(3)(ii). But keep in mind that as Helen recognizes gain on the installment method, the corporation will increase its basis in the property by an amount equal to the amount of gain recognized by Helen. So, in 21 years, the corporations basis in the land jumps to 100 (b/c the 75 is added). Class Notes: What if Helen received pref common stock, as in (b)? o In (a) the stock has a built in gain of 0. The note has a built in gain of 75. o In (b) the stock has a built in gain of 15. The pref stock has a built in gain of 60. o The corporation likes the note better, b/c it gets a stepped up basis eventually & can deduct interest paid on the note. But, from the SH side, under the current tax rate, the dividends are taxed at a lower rate than the interest payments. Remember: the note is most likely to be realized by collecting from the corporation, not by selling the note! If the corp repurchases the pref stock, then we must ask is that really a stock repurchase or a dividend payment to a SH (b/c Helen still has common stock) o When you combine 351 and 358, they are a deferral method! 453 is a deferral method as well! So, move to the other questions! Where is the basis going? What happens if the stock is sold in (a)? Versus what happens if the preferred stock is sold in (b)? o Must be concerned about the preferred stock becoming nonqualified preferred stock under 351(g) (look at (c) below).
33
(b) How would your answer change if Helen received 10 shares of common stock, having an aggregate fair market value of $20,000, and 80 shares of $1000 par preferred stock, which paid a dividend of 6% annually and is redeemable in 21 years at the option of either X Corporation or Helen? The preferred stock had an aggregate fair market value of $80,000. Helen received 10 shares of common stock, having an aggregate fair market value of $20,000, and 80 shares of $1,000 par preferred stock, which paid a dividend of 6% annually and is redeemable in 21 years at the option of either X Corporation or Helen. If it is nonqual preferred stock, it is treated as boot and it is treated like a promissory note. If only nonqual pref stock is received, then it is a basic sale under 1001 (the baseline rule). What if Fran & Glen contributed appreciated property, so it is key to fall under 351... Nonqual pref stock is not treated as stock in 351(a) and (b) (according to 351(g)). It is not not considered stock for purposes of 362. Look at the committee reports w/ 351(g), which says it will be treated as stock for the control question. (see p.133, last paragraph) 351(g) Nonqualified Preferred Stock Not Treated as Stock (1) In General In the case of a person who transfers property to a corporation and receives non qualified preferred stock (a) subsection (a) shall not apply to such transferor, and (b) if (and only if) the transferor receives stock other than nonqualified preferred stock (i) subsection (b) shall apply to such transferor, and (ii) such nonqualified preferred stock shall be treated as other property for purposes of applying subsection (b). The term "preferred stock" is defined in 351(g)(3)(A) as "stock which is limited and preferred as to dividends and does not participate in corporate growth to any significant extent. Stock shall not be treated as participating in corporate growth to any significant extent unless there is a real and meaningful likelihood of the shareholder actually participating in the earnings and growth of the corporation. If there is not a real and meaningful likelihood that dividends beyond any limitation or preference will actually be paid, the possibility of such payments will be disregarded in determining whether stock is limited and preferred as to dividends." o Most of the time when the IRC has a special definition for preferred stock, the IRC focuses on the limitations of the stock (preferred stock = preferred & limited) Under 351(g)(2)(A) preferred stock is "nonqualified preferred stock" if: "(i) the holder of such stock has the right to require the issuer or a related person to redeem or purchase the stock (put option), (ii) the issuer or a related person is required to redeem or purchase such stock, (iii) the issuers or a related person has 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 (call option), or (iv) the dividend rate on such stock varies in whole or in part (directly or indirectly) with reference to interest rates, commodity prices, or other similar indicies (Notice: no time limitation). 34
o So, if put, call, or variable interest rate there is no way to get it in under 351(g)! However, 351(g)(2)(B) limits the definition of "nonqualified preferred stock." It says: "Clauses (i), (ii), and (iii) of subparagraph (A) shall apply only if the right or obligation referred to therein may be exercised within the 20-year period beginning on the issue date of such stock and such right or obligation is not such subject to a contingency which, as of the issue date, makes remote the likelihood of the redemption or purchase." o If the time span is after 20 years, then it is called a springing put option
Here, Helen's preferred stock is "preferred stock" within the meaning of 351(g)(3) because dividends are limited to 6% per year; the dividends are payable annually, so there is a preference; and the facts do not indicate that the stock is convertible into common stock or that it gives Helen rights to dividends declared on the common stock. Although the "preferred stock" is redeemable at the option of either Helen or the Corporation, the stock is not "nonqualified preferred stock" within the meaning of 351(g)(2) because that right may only be excised by either party after 21 years from the issue date. 351(g)(2)(B). Thus, 351(a) applies, and the tax consequences to Helen are as follows:
Tax Consequences to Helen 10 shares of common stock $20,000 80 shares of $1000 par preferred stock $80,000 Amount Realized ( 1001(b)) $100,000 Less: Adjusted Basis $25,000 Realized Gain ( 1001(a)) $75,000 Recognized? $0 351(a) Helen's basis in the stock: 358(b)(1) "Under regulations prescribed by the Secretary, the basis determined under subsection (a)(1) shall be allocated among the properties permitted to be received without recognition of gain or loss." Reg. 1.358-2(b)(2) "If in an exchange to which section 351 applies . . . property is transferred to a corporation the transferor receives in stock . . . of more than one class . . . , then the basis of the property transferred (as adjusted under 1.358-1) shall be allocated among all of the stock . . . received in proportion to the fair market values of the stock of each class. . . . " Reg. 1.358-2(b)(1) defines "stock" for purposes of applying Reg. 1.358-2(b)(2) as "stock which is not "other property" under section 351."
Basis allocation under Treas. Reg. 1.358-2(b) Total Common Preferred Basis of property transferred $25,000 Reg. 1.358-1(a) FMV of stock received $100,000 $20,000 $80,000 % of total FMV 20% 80% Basis $5,000 $20,000 358(a), (b)(1) 35
Corporation's basis in land Class Notes
$25,0000
362(a)(1)
This is nothing but a 351(a) transaction. Compare (a) and (b): On the one hand, Helen has a promissory note, payable in 21 years for $80,000. On the other hand, Helen has preferred stock, redeemable in 21 years for $80,000. Helen has a basis of $20,000 in the preferred stock, so when it is redeemed she'll collect $80,000, and have a gain of $60,000 (if she can get sale or exchange treatment on the redemption and that is a big "if"). But if it is the note, Helen will have a gain of $75,000. Mechanically, the difference between the amount of gain that she would recognize if the corporation issues its promissory note rather than preferred stock is due to the difference between the basis allocation rules. When there is a promissory note (or other boot) the basis allocation rule is a stacking rule. When there is boot and 453 reporting, the stock absorbs all of the basis in the property transferred (up to the value of the stock) and it is only the "excess basis" that is allocated to the promissory note. When there is common stock and preferred stock the basis of the property contributed is pro rated between the common and preferred stock. It is the difference between a stacking rule, where all of the basis goes to one thing before any of it goes to the other, and a pro ration rule, where the basis of the property transferred is divided up. Notice, here we have two instruments that can be very similar, but invoke two very different basis allocation rules. You can write an investment contract, and depending on whether you put the words "Senior Preferred Stock" or "Junior Subordinated Debt" at the top of the instrument, the instrument will be treated as equity or debt. Although the substantive rights of those two instruments do not materially differ, sometimes the label attached to them matters, and as a result you can get a different basis allocation rule. The point is, you can sometimes chose which basis rule you want by tinkering with the bundle of rights just a little bit.
What happens if I make this stock redeemable in 20 years? If the stock is redeemable in 20 years, it may run afoul of 351(g) if: "the holder of the stock has the right to require the issuer or a related person to redeem or purchase the stock." 351(g)(2)(A)(i). Notice the holder of debt wants the ability to either demand payment or have it due on a day certain. So, (2)(A)(i) is the equivalent of a demand promissory note if you have the right to put it. This is like a "put option." "the issuer or a related person is required to redeem or purchase such stock" 351(g)(2)(A)(ii). This is like the requirement to repay a debt, so if it is automatically redeemed 20 years out, (2)(A)(ii) applies. 36
"the issuer or a related person has the right to redeem or purchase the stock and, as of the issue date, it is more likely than not such right will be exercised" 351(g)(2)(A)(iii). This is like a call option (but only if it's expected to be called within 20 years). "the dividend rate on such stock varies in whole or in part (directly or indirectly) with reference to interest rates, commodity prices, or other similar indicies" 351(g)(2)(A)(iv). This applies if you link the interest rate to the LIBOR or other indicies. (c) Would your answer change if the 80 shares of $1,000 par preferred stock Helen received was sinking fund preferred stock redeemable in 21 years at the option of either X Corporation or Helen? What happens if it is "nonqualified preferred stock"? Tax Consequences to Helen Common Stock $20,000 "Nonqualified Preferred Stock" (boot) $80,000 See 351(g)(1)(B)(ii) Amount Realized ( 1001(b)) $100,000 Less: Adjusted Basis $25,000 Realized Gain ( 1001(a)) $75,000 Recognized? 351(b); 351(g)(1)(B) $75,000 Helen's Basis in the Stock $25,000 358(a)(1); Reg. 1.358-1(a) aggregate basis of property exchanged $80,000 358(a)(1)(A)(i) FMV of "nonqualified preferred stock" received $75,000 358(a)(1)(B)(ii) amount of gain which was recognized $20,000 358(a)(1)
Helen's basis in the "nonqualified preferred stock" $80,000 358(a)(2) Helen's basis in land Increased by: Basis $25,000 $75,000 $100,00
362(a)(1)("gain recognized to transferor") 362(a)(1)
"Nonqualified preferred stock" is not an obligation, like a promissory note, so it does not qualify for installment reporting. It's still stock, but it's treated as boot, and thus there is immediate recognition. 351(g)(1)(B). The point is be careful when using preferred stock! If the preferred stock crosses the line and becomes "nonqualified preferred stock," you leap back, not to installment reporting of boot, but to treating it as cash and there is immediate recognition of gain. Sometimes there is harm in trying! Don't get too cute.
Section 2. "Solely" for Stock: Assumption of Liabilities 37
A. Basic Principles General Observations The problems in this section examine what happens when the shareholder transfers property to the corporation and in connection with the transfer the shareholder takes on debt. One of the things that is important when dealing with debts, not just of a corporation, is to keep in mind who owed what to whom at the beginning and who owed what to whom at the end of the transaction and what is the change in the relationship. The treatment of a debtor is different than the treatment of a creditor. Whenever there is a debt involved you have to be very careful to distinguish your analysis of the creditor's side of the transaction from the debtor's side of the transaction. The transfer of property with debts involved is critical in many instances. First, very few people buy land, or any business assets, completely with their own money. The American way is to borrow. It is always going to happen when there is an incorporation of an on-going business. Section 2. Solely for Stock: Assumption of Liabilities General Notes: Whenever there is an ongoing business, there will be debts. 1. Frank, and Jessie plan to organize a corporation to operate a college textbook store, which will be named Fleecem Folio's, Ltd. They will each engage in the exchanges described below. What are the tax consequences to Frank, Jessie, and Fleecem Folios that result from the formation of the corporation? Specifically, how much, if any, gain must each recognize; what is the basis to each shareholder in the stock received; and what is the corporation's basis in the assets received by it? (a) Frank will contribute 10,000 law school text books, previously held for sale to customers in the ordinary course of business, with a basis of $300,000 and a fair market value of $450,000, in exchange for 10 shares of common stock, worth $250,000. In addition, the corporation will assume $200,000 of Frank's debts that are secured by a perfected purchase money security interest in the books. Frank 10 shares common stock w/ FMV of $250 Corporation assumes $200 debt secured by a PMSI Jessie 10 shares common stock w/ FMV of $250 Corporation assumes $100 debt owed to First National Bank NB: when you draw this picture, draw the assumption of debt as something (a promise to pay the debt) the Corporation is giving TO Frank & Jessie. There is no such thing as the contribution of the contributors indebtedness to a third party. Contributor Contribution Character AB FMV Debt Frank 10,000 text books Inventory 1221(a)(1) $300,000 $450,000 $200,000 Jessie Land Capital asset $260,000 $350,000 $0 Tax Consequences to Frank 10,000 Books $250,000 38
Property Transferred Stock
Debt Assumed Amount Realized ( 1001(b)) Adjusted Basis Realized Gain/Loss ( 1001(a)) Recognized?
$200,000 $450,000 $300,000 $150,000 $0
Sum: FMV of stock + Debt Assum.
351(a) and 357(a)
Basis of property exchanged decreased by increased by Basis =
Frank's Basis in the Stock $300,000 358(a)(1) $200,000 358(a)(1)(A)(ii), (d) $0 $100,000 358(a)(1)
Corporation's Basis in the Text Books Frank's basis in text books $300,000 Increased by: Gain recognized to transferor $0 Basis $300,000 362(a)(1) Class Notes As a matter of debtor creditor law and contract law, when Frank transfers the property and the corporation "assumed the debt." The common legal meaning of "assumption of a debt" is that the party who assumes the debt has entered into a contract with the original debtor, where the party assuming the debt promises the original debtor that the party assuming the debt will pay the debt as it falls due. This promise is a valuable contract right. In exchange for that promise, the party assuming the debt receives valuable consideration, which in this case is property (i.e., text books) with a fair market value of $450,000. That's why, in an ordinary sale transaction, if Frank sold books to X and X paid Frank $250,000 worth of gem stones and X promised to pay Frank's $200,000 purchase money debt, Frank's amount realized is equal to $450,000. From that, you subtract Frank's adjusted basis, $300,000, and you get a gain realized of $150,000 and since it is a sale transaction that gain would be recognized. It is important to recognize that the assumption of a debt is fundamentally the receipt of a valuable contract right by the transferor of property whose debt is assumed. NEVER EVER call "debt relief" or "a valuable contract" discharge of indebtedness income. In the problem, Frank has a realized gain of $150,000 because Frank has stock of $250,000 and debt relief (or a valuable contract right) in the amount of $200,000. Thus, his amount realized is $450,000. After comparing his amount realized to his adjusted basis, $300,000, Frank has a realized gain in the amount of $150,000. The legal question is what the amount of Frank's boot, so that we can determine the amount of gain recognized? What is the amount of the boot received by Frank that he must recognize in this situation? Section 357(a) is the starting point of our analysis. If 357(a) applies, the assumption of debt is not treated as the receipt of money or other property by Frank. Section 357(a) says: Except as provided in subsection (b) and (c), if 39
(1) the taxpayer receives property which would be permitted to be received under section 351 . . . without the recognition of gain if it were the sole consideration, and (2) as part of the consideration, another party to the exchange assumes a liability of the taxpayer, then such assumption shall not be treated as money or other property, and shall not prevent the exchange from being within the provisions of section 351. . . . For 357(a) to apply, the taxpayer must receive stock (other than nonqualified preferred stock) and another party must assume a liability of the taxpayer. In addition, we must determine that 357(b) and (c) do not apply. Section 357(c)(1) says "if the sum of the amount of liabilities assumed exceeds the total of the adjusted basis of the property transferred . . ." Here, the if clause is not met, so 357(c)(1) does not apply. o In order to say that 357(b) does not apply, we have to prove that the purpose with respect to the assumption of debt was not a purpose to avoid the Federal income tax and was a bona fide business purpose. So we have to (A) negate a tax avoidance purpose and (B) establish a business purpose for the debt assumption. 357 applies if EITHER, the Principal Purpose: (1) was a purpose to avoid federal income tax OR (2) was not a bona fide business purpose What is the burden of this? 357(b) TP must prove by a clear preponderance of the evidence. Look at 1.357-1(c): such a clear preponderance of the evidence that he absence of the purpose to avoid fed income tax and the presence of the business purpose is unmistakable! If the principal purpose was to avoid federal income tax, it does not matter whether there is also a bona fide business purpose. If the principal purpose was not to avoid federal income tax, we must still establish that there was a bona fide business purposes. If we prove that the principal purpose was not to avoid federal income tax, but fail to establish a bona fide business purpose, 357(b) still applies. o Security helps establish a business purpose, but the fact that the debt is a purchase money secured debt negates any tax avoidance purpose and bolsters the business purpose. See Jewell v. United States, 330 F.2d 761 (9th Cir. 1964) (not applying the predecessor of 357(b) to the transfer of assets to a corporation that assumed transferor's purchase money indebtedness incurred to acquire the assets). o The Jewell case is important authority for the proposition that if the debt assumed is purchase money debt that is secured by a lien on the property there is a bona fide business purpose and not a tax avoidance purpose for the assumption of the debt. o This is so, because there is no cashing out in a tax sense. There is no cashing out, so to speak, because the debt created the books, and more importantly the debt created the basis in the books. The basis in the books is going to the corporation and the books are going to the corporation.
40
Frank either bought the books on credit from the seller, in which case the seller has an account receivable from Frank secured by a security interest in the books, or he borrowed the money from a third party, probably a bank, for the purpose of purchasing the books, in which case Frank signed a note and security agreement under which the seller retained a security interest in the books. In either case, the creditor, i.e., the seller or the third party lender, has a PMSI because credit was extended to purchase a particular asset and was actually used to purchase that asset. Thus, the books were not merely security for a loan that was used for purposes totally unrelated to the books. In general, a taxpayer's cost basis under 1012 includes borrowed funds used to acquire the property. Crane v. Commissioner. However, if borrowed funds secured by property are not actually invested in the property, the basis of the property does not include the debt secured by the property. Cf. Woodsam Associates, Inc. v. Comm'r., 198 F.2d 357 (2d Cir. 1952) (holding that the encumbrance of property after its acquisition, even though the mortgagor is free from any personal obligation to repay and even though the mortgage proceeds exceed the mortgagor's basis in the property, does not constitute a disposition of the property and is not a taxable event). If a taxpayer could obtain the cash proceeds of a loan by pledging property, transfer the property to a corporation, have the corporation assume the debt, and make payments without recognizing any gain on the transaction, the taxpayer would get the benefit of the loan without the burden of the liability. The effect of the transaction would be the same as if a transferor were allowed to receive cash boot without having to recognize gain under 351(b). In contrast, if the proceeds of a loan are used to acquire property, so that the proceeds of the loan are properly includible in the basis of the property, 357(a), in conjunction with 351(a), causes the tax consequences of the transaction to match the economics of the transaction. In such case, nonrecognition is proper because the benefit and burned of the loan run together: The transferor is relieved of his obligation to pay, but in consideration of that promise the corporation gets the benefit of the property in which the loan proceeds were invested and nothing has been retained. o Note on Purchase Money Security Interests: A purchase money security interest ("PMSI") is a special type of security interest in goods that has priority over all other security interests in the same goods if certain requirements are met. A PMSI arises when: (i) a creditor sells the goods to the debtor on credit, retaining a security interest in the goods for all or part of the purchase price (creditor and seller are the same person); or (ii) A creditor advances funds that are used by the debtor to purchase the goods (creditor and seller are different persons). Tax avoidance is not a business purpose. The debt is old and cold. Here, the fact that the debt was a PMSI is important because it shows that there is no tax avoidance purpose and it demonstrates a business purpose. Frank is giving up the thing that was purchased w/ the debt (the books). Frank got the books & basis in the books for the tax free debt. That debt of 200 is reflected in the basis. Franks basis in the stock will be w/ respect to that & adjusted. With a purchase money debt, the debt creates basis. See Jewel v. United States.
What is Frank's basis in the stock?
41
358(d)(1) "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." o Notice that 358(d)(1) says "for purposes of this section" the assumption of debt is treated as money or other property, while, at the same time, 357(a)(1) says, in effect, that for purposes of 351 the assumption of debt is not treated as money or other property. Read together, these provisions appear to provide inconsistent treatment to the assumption of debt; however, this is necessary to preserve the gain that was realized but went unrecognized in the 351 transaction. o The $200,000 of debt relief, by virtue of 357(a), is not treated as boot for purposes of 351(b), so, therefore, there is $150,000 of gain that was realized but went unrecognized as a result of 351(a). o 351 is not supposed to destroy realized gain, it's simply supposed to defer it. Therefore, that $150,000 of gain should be lurking in the stock. The fair market value of the stock is $250,000. Therefore, in order to have $150,000 of gain lurking in the stock, the stock must be assigned a basis of $100,000. The way to do that is to take the basis of the property that was transferred and subtract from that the amount of debt relief that was not taken into account. That will invariably preserve that realized but unrecognized gain in the stock. So, that is the purpose of 385(d). o Frank's basis in the books, $300,000, consisted of $200,000 of debt financed basis and $100,000 of equity the money that Frank actually paid invested. It might have been fully debt financed at one time and the debt has been paid down from $300,000 to $200,000, creating $100,000 of equity. One thing to do whenever you are looking at difficult problems is to remember that the total basis, whenever you are looking at a purchase money debt, consists of two components (1) the equity investment and (2) the amount of the debt that was included in basis for which the taxpayer got advanced credit. Section 358's mechanics, by treating the debt assumed as cash and reducing the basis of the stock from $300,000 to $100,000 leaves just the equity investment as the basis in the stock. 358(d) strips the debt financed portion of the taxpayer's basis in the assets from the taxpayer's basis in the stock and leaves the taxpayer with a basis in the stock equal to the taxpayer's equity investment in those debt financed assets.
What are the tax consequences to the Corporation? Under 362(a)(1), the corporation's basis in the books is Frank's transferred basis in the books, $300,000, increased by the amount of gain recognized to the transferor on the exchange, which here is $0. In a sale transaction, debt assumed by the purchaser is included in the 1012 cost basis of the property purchased. Crane v. Comm'r. So, if the Frank exchanged $450,000 worth of books for gem stones with a FMV of $250,000 and a basis of $10,000 and the Corporation's promise to assume his $200,000 purchase money debt: o FMV of Property received (books) $450,000 o Minus: Debt Assumed $200,000 o Amount Realized $250,000 42
o Adjusted Basis $ 10,000 o Gain Realized $240,000 o The Corporation's basis in the books would be its 1012 cost basis, $450,000. This is because, under Philadelphia Park, the basis of the property received is equal to the basis of the property exchanged, plus gain recognized on the exchange, plus any debt assumed. However, under 362(a)(1) the corporation does not get a $200,000 bump in basis. Why? Conceptually, the corporation's basis in the book under 362(a) is identical to Frank's basis in the books. The corporation's basis in the books consists of the $100,000 equity basis that Frank transferred plus the $200,000 of debt assumed. So, Frank is able to transfer his equity basis and the corporation automatically gets credit for assuming the debt because 362(a)(1) allows the corporation to take as a transferred basis in the property Frank's full basis in the property, not merely his equity basis.
(b) Jessie will contribute land previously held as an investment on which the new corporation will build a store. The land has a basis of $260,000 and a fair market value of $350,000. Jessie will receive 10 shares of common stock and the corporation will assume a $100,000 debt Jessie owed to the First National Bank of Northfield. Tax Consequences to Jessie Land $250,000 $100,000 $350,000 $260,000 $ 90,000 Issue
Property Transferred Stock Debt Assumed Amount Realized ( 1001(b)) Adjusted Basis Realized Gain ( 1001(a)) Recognized?
Jessie will receive 10 shares of common stock and the corporation will assume a $100,000 debt Jessie owed to First National Bank of Northfield. (1)(i) Assume that Jessie's debt was incurred four years ago to pay gambling debts incurred in Atlantic City and is unsecured. Tax Consequences to Jessie Land $250,000 357(b) $100,000 $350,000 $260,000 $ 90,000 351(b) $ 90,000 Jessie's Basis in the Stock 358(a)(1) basis of property exchanged 358(a)(1)(A)(ii) 43
decreased by
$260,000 $100,000
increased by Basis =
$ 90,000 $250,000
358(a)(1)(B)(ii) 358(a)(1) Note: no BIG in the stock
Corporation's Basis in the Land Jessie's basis in Land $260,000 Increased by: "Gain recognized to transferor" $ 90,000 Basis $350,000 362(a) Class Notes 357(b) Tax Avoidance Purpose (1) In General - If, taking into consideration the nature of the liability and the circumstances in the light of which the arrangement for the assumption was made, it appears that the principal purpose of the taxpayer with respect to the assumption described in (a) (A) was a purpose to avoid Federal income tax on the exchange, or (B) if not such purpose, was not a bona fide business purpose, then such assumption (in the total amount of the liability assumed pursuant to such exchange) shall, for purposes of 351 . . . , be considered as money received by the taxpayer on the exchange. (2) Burden of Proof In any suit or proceeding where the burden is on the taxpayer to prove such assumption is not to be treated as money received by the taxpayer, such burden shall not be considered as sustained unless the taxpayer sustains such burden by the clear preponderance of the evidence. Here we have a serious problem with 357(b). "If, taking into consideration the nature of the liability . . . " For instance, unsecured debts, or a debt that was not a purchase money debt. ". . . it appears that the principal purpose of the taxpayer with respect to the assumption . . . was a purpose to avoid Federal income tax on the exchange. . . " Notice, it says "the principal purpose." If it says "a principal purpose" it might be 1 or 3, but since it says "the principal purpose" it must be the dominant purpose. ". . . or (B) if not such purpose, was not a bona fide business purpose, . . . " If it wasn't a purpose to avoid federal income tax, there wasn't a bona fide business purpose. What we have to do is look at the facts. Here, the debt is unsecured and it is unrelated to the asset. The debt is personal. There is no business connection to the asset. The only good fact, here, is that the debt is "old and cold." The authority here is Estate of Stoll v. Commissioner. (p.94) $600k loan taken out to buy life insurance was assumed by the newspaper, for whom the TP worked. A tax avoidance purpose was found. If 357(b) applies, the debt assumed is treated as boot under 351(b) applies. Thus, Jessie will recognize $90,000, the lesser of the debt assumed, $100,000, or the gain realized. 358(d) would not apply. 44
Note, 358(d) does not apply because the debt assumed is treated as boot under 351(b). So we have to compare the boot recd and the gain realized... so there is 90 recognized. The corporation will get a basis step-up under 362(a) subject to the application of 362(b).
(1)(ii) Assume alternatively that Jessie's debt to the First National Bank of Northfield was secured by a mortgage on the land. Tax Consequences to Jessie Land $250,000 $100,000 $350,000 $260,000 $ 90,000 351(a) and 357(a) $0 Jessie's Basis in the Stock 358(a)(1) basis of property exchanged 358(a)(1)(A)(ii), (d) 358(a)(1)(B)(ii) 358(a)(1)
$260,000 $200,000 $0 $ 60,000
Corporation's Basis in the Land Jessie's basis in Land $260,000 Increased by: "Gain recognized to transferor" $0 Basis $260,000 362(a) Class Notes The teaching of the Drybough and Simpson cases (p.95) is that when a liability secured by the transferred property predates the inception of the plan to incorporate, the assumption by the corporation of the liability in connection with the transfer of assets generally has been found not to run afoul of 357(b), regardless of the application of the loan proceeds, because there is a business purpose for the debt assumption, i.e. the debts follow the encumbered asset, and no tax avoidance plan. If the debt secured by the property transferred is old and cold a business purpose exists because the only way to get the property is to assume the debt, and it is very difficult to a business purpose and to also find that the principal purpose was tax avoidance. It is like saying the sun is rising and setting.
45
What if the debt was unsecured and the mortgage was put on the property a month ago? If a liability, such as a bank loan, is incurred just before a transfer of property to a controlled corporation so that the stockholder obtains the cash loan proceeds, the corporation assumes the debt, and subsequently pays the bank, the transaction viewed as a whole is the equivalent of a payment of cash by the corporation to the stockholder in exchange for the property. The assumption of the liability in such cases is found to fall under 357(b), because of the presence of a tax avoidance purpose, whether or not the liability is secured by the transferred property. See Campbell v. Wheeler, 342 F.2d 837 (5th Cir. 1965). The Wheeler case teaches us that if you want to fall within Drybough and Simpson, don't put a mortgage on an asset unrelated to the debt at the last minute before transferring it to the corporation and having the corporation assume the debt. So, although there is still a business purpose for the corporation to assume the debt it is a lien on the property, so assuming the debt is the only way to get it there is also a tax avoidance purpose. So, in fact, we find that under certain fact patterns it is possible to find a business purpose but also find a tax avoidance purpose.
(2) Assume alternatively that the land was used as a parking lot and Jessie's debt was unsecured but was incurred last year to fund deductible operating expenses of the now failed sole proprietorship parking lot business in connection with which Jessie previously used the land. Here, a cash method taxpayer borrowed money, did not include anything in income, used the borrowed money to pay his expenses, and got the deduction on his tax return. This raises the issue of whether there is a tax avoidance purpose? You need a business purpose for the business assuming the debt! (Not a business purpose for the person getting the assumption) A positive fact for the taxpayer is that the debt is at least associated with the land. Is the land going to be used for a parking lot? If it is, it may be ok, but if the land is going to be used for a condo development that will become defunct quickly, then maybe you don't have a business purpose? There is no answer to this problem. It is designed to show the factual inquiry involved in determining if 357(b) applies. Is the lack of a business purpose, then the TP will have a hard time proving that there was no purpose to avoid Federal income tax (a vicious circle)
Thursday, September 9, 2010 2. Al, Bev, and Carl each owned 1/3 of the outstanding stock of X Corporation. Al, Bev, and Carl owned Blackacre as equal tenants in common. Blackacre had a fair market value of $450,000 and was subject to a nonrecourse purchase money mortgage of $450,000. Each of Al, Bev, and Carl had a basis in their respective undivided 1/3 interests of $170,000. Al, Bev, and Carl contributed Blackacre to X Corporation. What are the tax consequences? No-net-value assets What is odd about this question? It doesnt say they received stock in return. However, if you contribute capital (cash/property) there is a deemed exchange under 351 (a constructive issuance of stock). 46
Contributor Al Bev Carl Class Notes:
Contribution 1/3 interest in Blackacre 1/3 interest in Blackacre 1/3 interest in Blackacre
Character
AB $170,000 $170,000 $170,000
FMV $150,000 $150,000 $150,000
Debt $150,000 $150,000 $150,000
Notice, the corporation assume a nonrecourse purchase money mortgage, so there is no 357(b) issue. 357(b)(2) doesnt apply b/c none of them own more than 50% interest. Here the transferors made a contribution to capital, so 351 applies. Prop. Reg 1.351-1(a)(1)(iii) Stock will not be treated as issued for property if either (A) The fair market value of the transferred property does not exceed the sum of the amount of liabilities of the transferor that are assumed by the transferee in connection with the transfer and the amount of any money and the fair market value of any property (other than stock permitted to be received under section 351(a) without the recognition of gain) received by the transferor in connection with the transfer. For this purpose, any obligation of the transferor for which the transferee is the oblige that is extinguished for federal income tax purposes in connection with the transfer is treated as a liability assumed by the transferee; or (B) The fair market value of the assets of the transferee does not exceed the amount of its liabilities immediately after the transfer.
Here, the fair market value of the property does not exceed the amount of the liabilities assumed by the transferee, so under Prop. Reg. 1.351-1(a)(1)(iii), the stock is not considered as issued for property. If the stock is not considered as issued for property, what is the transaction? If it is a sale, they get to recognize their losses, which is exactly opposite to what 351 was intended to do. Here, you have three people who got together, transferred property to a controlled corporation, and now they are trying to claim a loss. If they actually did sell the property to the corporation, they might be able to claim a loss, but that is not what they did. What is interesting is that the proposed regulations don't say what the transaction is. They just say the "stock will not be treated as issued for property." At the time the regulation was drafted, the IRS had not made up its mind as to how to characterize the transaction. That is why it just says "stock will not be treated as issued for property." o b/c of 1001 principals, each one has an amount realized of 150 b/c of getting rid of the debt. So each would have a loss of 20 (b/c A/B=70) It does tell you this: If A and B form a corporation and A contributes a high value, low basis asset for 70 shares of stock and B contributes a no-net-value asset for 30 shares of stock, the control requirement does not exist because B's 30 share are treated as not issued for property. Only 70 out of 100 shares were issued for property; the transferors of property do not control the corporation afterwards; and 351 transaction is busted.
47
267(a)(1) disallows losses on transactions btwn related parties. So, you have to look in 267(b)(1) for the definition of related properties. We can refer to A, B & C as partners (not just co-tenants). If they are partners, then 267(b)(10) says that a corp & a pship if the same persons own more than 50% of the pship and the corp they are related parties.
B. Liabilities in Excess of Basis 1(a) Bonnie and Clyde formed FastGetaway Corporation to engage in a limousine charter service business. Bonnie contributed $50,000 in cash. Clyde contributed a Mercedes-Benz limousine with a basis of $10,000 and a fair market value of $80,000, subject to a purchase money lien indebtedness of $30,000, which was assumed by the corporation. What are the tax consequences to Clyde and the corporation? Contributor Contribution Bonnie Cash Clyde Mercedes-Benz Character ??? AB $50,000 $10,000 FMV $50,000 $80,000 Debt $30,000
Tax Consequences to Clyde Mercedes $50,000 $30,000 $80,000 $10,000 $70,000 $20,000 357(c)(1) Clyde's Basis in the Stock 358(a)(1); Reg. 1.358-1(a) aggregate basis of property exchanged 358(a)(1)(A)(ii), (d)(1) 358(a)(1)(B)(ii) 358(a)(1)
$10,000 decreased by increased by Basis = $30,000 $20,000 $0
Corporation's Basis in the Mercedes Clyde's basis in the Mercedes $10,000 Increased by: "Gain recognized to transferor" $20,000 Basis $30,000 362(a)(1) Class Notes: Ask: What are the liabilities? What is the basis? What is the gain recognized under 357(c)(1) if liabilities exceed basis? Business purpose for debt assumption under 357(b); thus, 357(a) applies and debt assumption is NOT boot
48
o If 357(b) had applied. Then Amt Realized stock (50) + debt (30)= 80. Basis of Mercedes=10. Gain realized=70. Gain recognized=30 (recognized to extent of liabilities). The construct of 357(c) gain is unrelated to gain realized under 1001. 357(c) is an operative rule in and of itself. If the if of 357(c) is met then you go straight to the calculation, where liabilities in excess of basis are recognized. Thus, 357(c) says go directly to gain, do not stop at 1001 (they operate independently). The next thing we do is go to 358; calculate Clydes basis in the stock (above). The 357(c) calculation uses up all the basis, so you will always have a $0 basis in the stock. o Notice: in this narrow example, the basis will always be zero. If, however, there is boot received or multiple assets transferred, that will not be the case. The built-in gain equals $50,000. The gain realized under 1001(a) will always be reflected as the sum of the gain recognized under 357(c) plus the built-in gain in the stock immediately after you calculate its basis under 358(a). So, if there is $70,000 of gain realized and $20,000 is recognized, there must be $50,000 of built-in gain in the stock. If you are doing both a 357(c) calculation 358 calculation and you want see if you got it right, do a 1001 calculation and as long as your gain recognized under 357(c)(1) plus the built-in gain in the stock equals the 1001(a) gain realized, the calculation is right.
Tax consequences to the corporation Why should the corporation get basis for that debt? The corporation assumed more debt than the transferor's equity in the property. That $10,000 of basis that Clyde had represented $10,000 of that debt. The corporation is picking up the entire $30,000 of debt, so the corporation gets the extra basis. That is the conceptual reason.
(b) Assume alternatively that Bonnie contributed $100,000 in cash. Clyde contributed a Mercedes-Benz limousine with a basis of $12,000 and a fair market value of $80,000, subject to a purchase money lien indebtedness of $25,000, which was assumed by the corporation, and a Lincoln limousine with a basis of $48,000 and a fair market value of $60,000, subject to a purchase money lien indebtedness of $15,000, which was assumed by the corporation. What are the tax consequences to Clyde and the corporation? Contributor Contribution Bonnie Cash Character AB $100,000 FMV $100,000 Debt
Contributor Contribution Clyde Mercedes-Benz Lincoln Total
Character ???
AB $12,000 $48,000 $60,000
FMV $80,000 $60,000
Debt $25,000 $15,000 $40,000
49
If we did a Rev Rul 68-55 analysis (asset by asset), then w/ the Mercedes the liability would exceed the basistriggering gain... but.... 357(c)(1) does not apply because the aggregate debt does not exceed the aggregate basis. Total adjusted basis of the property transferredtells you to aggregate. See Reg. 1.357-2(b) Ex. 2. (a) gives a numerical example where multiple properties are aggregated. 357(c) operates w/ the sum of the liabilities & the sum of the adjusted basis. Cs 358 stock basis: computation Basis of cars (60)Debt (40)= Basis 20 How would you make the gain under 357(c) go away? Have the person contribute cash to make liabilities not exceed basis. However, then they will ave to come up w/ the cash! And, any other parties contributing at the same time will also have to come up w/ the cash. Moral to the story: never try to save a dollar of taxes by spending a dollar of cash. It wont work (and if it does it is called a tax shelter.
2. Oscar and Patty formed NHC Corporation. Oscar contributed $250,000 in cash in exchange for 10 shares of common stock. Patty contributed land and a warehouse building. The land has a basis of $10,000 and the building has an adjusted basis of $30,000. The fair market value of the land is $87,500. The fair market value of the building is $262,500. Patty received 10 shares of common stock and the corporation assumed a $100,000 purchase money mortgage secured by the land and building. What are the tax consequences to Patty and the corporation? Contributor Contribution Oscar Cash 10 shares of common stock. Contributor Contribution Patty Land Building Total Character ??? AB $10,000 $30,000 $40,000 FMV $87,500 $262,500 $350,000 Debt Character AB $250,000 FMV $250,000 Debt
$100,000
10 shares of common stock and the corporation assumed $100,000 PMM secured by land and building. Patty recognizes gain in the amount of $60,000. 357(c)(1). Character of Gain Reg. 1.357-2(b) Total Land Building $350,000 $87,500 $262,500 25% 75% FMV of asset/FMV of total assets $60,000 $15,000 $45,000
FMV of asset transferred % of total FMV Gain recognized
What about the character of that $60,000 gain? Reg. 1.357-2(a) (and 1.357-2(b)(ex.2) says that you allocate 357(c)(1) gain for purposes of determining the character of the gain relative to the fair market value of the two assets. So, the land will have tax of 15% rate on 15,000. The building will have a 25% rate on the 45,000. This is important to recognize for planning purposes. 50
Patty's Basis in the Stock 358(a)(1); Reg. 1.358-1(a) aggregate basis of property exchanged decreased by 358(a)(1)(A)(ii), (d)(1) (debt/boot) $100,000 increased by 358(a)(1)(B)(ii) (gain) $60,000 Basis = $0 358(a)(1) See 1.357-2(b)(ex.2). Does the rule in 1.357-2 for interpreting 357(c) control for 362? It doesnt really matter in this question b/c it comes out the same way w/ allocation in proportion to FMV or appreciation, or to original basis. Notice the potential conflict of interest here btwn the SH and the corporation (as far as where they want the basis to go / what type of gain they would rather recognize) $40,000 Corporation's Basis in the Land Patty's basis in the Land $10,000 Increased by: "Gain recognized to transferor" $15,000 Basis $25,000 362(a) Corporation's Basis in the Building Patty's basis in the Building $30,000 Increased by: "Gain recognized to transferor" $45,000 Basis $75,000 362(a) 3(a) Evan and William formed Barleycom Corporation to engage in the distilling business. Evan contributed $250,000 in cash and William contributed land and a warehouse building previously held out for rental. The land had a basis of $10,000 and the building had an adjusted basis of $30,000. The fair market value of land is $87,500 and the fair market value of the building is $262,500. Clyde will receive 10 shares of common stock and the corporation will take the property subject to $100,000 nonrecourse purchase money mortgage lien, but it will not expressly assume the mortgage indebtedness. What are the tax consequences to William and the corporation? Contributor Contribution Evan Cash Contributor Contribution William Land Building Total Character AB $250,000 Character AB $10,000 $30,000 $40,000 FMV $250,000 FMV $87,500 $262,500 $350,000 Liabilities $0 Liabilities $100,000 $100,000
William gets 10 shares of common stock with a FMV of $250,000. Character of Gain Reg. 1.357-2(b) Total Land Building $350,000 $87,500 $262,500 51
FMV of asset transferred
% of total FMV Gain recognized
$60,000
25% 75% $15,000 $45,000
FMV of asset/FMV of total assets
William's Basis in the Stock 358(a)(1); Reg. 1.358-1(a) aggregate basis of property exchanged 358(a)(1)(A)(ii), (d)(1) 358(a)(1)(B)(ii) 358(a)(1)
Corporation's Basis in the Land William's basis in the Land $10,000 Increased by: "Gain recognized to transferor" $15,000 Basis $25,000 362(a) Corporation's Basis in the Building William's basis in the Building $30,000 Increased by: "Gain recognized to transferor" $45,000 Basis $75,000 362(a) The difference between this problem and problem number 2 is that this problem involves a nonrecourse debt. In Patty's situation, Patty was personally liable for the debt, so the bank could have sued her if she didn't pay it and there was a deficiency on the mortgage. Here, the debt is nonrecourse. If William doesn't pay back the loan, the only thing the bank can do is foreclose the mortgage; it cannot recover a deficiency judgment against William. Thus, the Bank bears the risk of loss. Since William does not have to pay back the deficiency if the debt is not paid, the corporation will not promise William that it will service the debt as it falls due. The corporation will only service the debt if it suits its business economically, meaning as long as the property is more valuable than the debt or as long as the corporation believes the property will bounce back and be more valuable than the debt. So, the corporation has no reason to promise William that it will service the debt as it falls due, and William has no reason to demand that. 357(d)(1)(A) and (B) draw a distinction between recourse and nonrecourse debt. And 357(d)(1)(B), subject to the exceptions in 357(d)(2), says that the transfer of property subject to a nonrecourse debt is treated as an assumption for purposes of 357(c)(1). Notice, 357(c)(1) says "if the sum of the liabilities assumed." It does not say "the sum of the amount of liabilities assumed and subject to which the property is taken." So, you find that "and subject to which the property is taken" as being the equivalent of "assumed" in 357(d)(1)(B). Then you have to check the exceptions in 357(d)(2), which reduces the amount of nonrecourse liability treated as "assumed" for purposes of 357(c)(1) by the lesser of: (A) the amount of such liability an owner of other assets not transferred to the transferee and also subject to such liability has agreed with the transferee to, and is reasonably expected to, satisfy, or 52
(B) the fair market value of such other assets (determined without regard to section 7701(g)). Notice, 357(d)(2)(A) says ". . . an owner . . ." It doesn't even have to be another shareholder. So, 357(d)(2)(A) would apply if Q owns Whiteacre and the mortgage encumbers both Blackacre (the land William contributes) and Whiteacre and the bank can foreclose on either of them. This is called cross collateralization and it very frequently used. Usually, the owners of the properties are related in some way, either as family members, partners, etc. If Q agrees that Q will service the debt, Q's promise exonerates Blackacre from the mortgage after all the contractual rights are met and, therefore, that mortgage is ignored in our calculations. 357(d)(2)(B) only applies if 357(d)(2)(A) applies. So, what we find is that the transfer of property subject to a nonrecourse mortgage without an express assumption is treated the same way as a mortgage that is expressly assumed for purposes of applying 357(c)(1). Once it is established that the corporation is treated as having assumed the liability, the arithmetic is the same.
(b) Would your answer differ if the mortgage was a recourse mortgage and the corporation did not expressly assume the mortgage? 357(d)(1)(A) says that "a recourse liability . . . shall be treated as having been assumed if, as determined on the basis of all facts and circumstances, the transferee has agreed to, and is expected to, satisfy such liability . . . , whether or not the transferor has been relieved of such liability." o whether or not...such liabilityspecifies that the corporation doesnt have to make a novation w/ the creditor. This is a two part test: First, it's treated as assumed if based on all the facts and circumstances the transferee has (1) agreed to assume the liability and (2) can be expected to pay. This means if there is a paper promise, it has to be a real promise. Just having a piece of paper that says the corporation assumes the debt is not sufficient. There has to be a reason to expect that the corporation actually will pay the debt when it falls due in the ordinary course of business rather than the shareholder or someone else paying. The problem here is that there is not even a piece of paper that says the corporation expressly assumes the debt. all facts and circumstances modifies both 2 parts of the test and explains that you cant escape 357 by avoiding paper! So, what happens?
53
If the debt is not assumed, there is zero debt assumed and, therefore, 357(c)(1) does not apply because the debts assumed do not exceed basis. Thus, there is no gain recognized. However, in this case, we know that the corporation will assume the debt. If you add up the value of the land and the building, the sum is $350,000. Evan only contributed $250,000. So, to make them equal owners, the corporation has to assume the mortgage. It is very important to distinguish between gross value and net value. The gross value that William put into the deal was $350,000. The net value that William put into the deal was $250,000. Evan also put in $250,000. They got equal amounts of stock. If William, rather than the corporation, pays the mortgage, William will wind up paying $350,000 for the same amount of stock that Evan only paid $250,000 for. This is what tax lawyers call "getting screwed." Alternatively, this could mean there was a deliberate wealth transfer, which would occur if William was Evan's parent. So, what we have, here, is a situation in which everyone knows that the Corporation is going to pay the debt. Thus, the fact that there is no piece of paper that says the corporation expressly assumes the debt is irrelevant. The point, here, is that sometimes we have planning opportunities. However, sometimes tax planning is restrained by nontax rights and liabilities and people do not want to assume excessive liabilities for what turns out to be only a temporary tax advantage. Keep in mind, if this debt is not treated as assumed, there is no gain immediately recognized, but payment on the debt by the corporation is treated as a dividend to William.
(c) How would your answer in part (a) differ if the fair market value of land was $165,000, and the fair market value of the building was $185,000? Contributor Contribution Evan Cash Contributor Contribution William Land Building Total Character AB $250,000 Character AB $10,000 $30,000 $40,000 FMV $250,000 FMV $165,000 $185,000 $350,000 Liabilities $0 Liabilities $100,000 $100,000
FMV of asset transferred % of total FMV Gain recognized
Character of Gain Reg. 1.357-2(b) Total Land Building $350,000 $165,00 $185,000 47.14% 52.86% FMV of asset/FMV of total assets $60,000 $28,284 $31,716 357(c)(1) William's Basis in the Stock 358(a)(1); Reg. 1.358-1(a) aggregate basis of property exchanged 358(a)(1)(A)(ii), (d)(1) 358(a)(1)(B)(ii) 358(a)(1) 54
Tax consequences to the corporation We know that William has $60,000 of 357(c)(1) gain. If we go to Reg. 1.357-2(b) we're told that we allocate that gain between the land and the building relative to the fair market value of the assets. The result we get is that $28,284 ($60,000 x 47.14%) is the gain on the land and $31,716 ($60,000 x 52.86%) is the gain on the building. How do we allocate the gain for purposes of determining the corporation's basis increase under 362(a)(1)? There is no authority on this issue. If the gain is allocated relative to the fair market value of the assets transferred the results are as follows:
Corporation's Basis in the Land William's basis in the Land $10,000 Increased by: "Gain recognized to transferor" $28,284 Basis $38,284 362(a)(1) Corporation's Basis in the Building William's basis in the Building $30,000 Increased by: "Gain recognized to transferor" $31,716 Basis $61,716 362(a)(1) Conceptually, the gain should be allocated relative to appreciation. If we allocate relative to appreciation, the results are as follows:
Gain Allocated Relative to Appreciation Total Land Building FMV of asset transferred $165,000 $185,000 William's basis in asset transferred $10,000 $30,000 Appreciation $310,000 $155,000 $155,000 % of total Appreciation 50% 50% 357(c)(1) gain recognized by William $60,000 Basis increase allocated to each asset $30,000 $30,000 Corporation's Basis in the assets $40,000 $60,000
362(a)(1)
On these numbers, the corporation is better off if it allocates the gain relative to the fair market value of the assets (higher basis = higher depreciation deductions). But on different numbers it will turn out that it is advantageous to allocate the basis increase relative to appreciation. If allocated relative to the BIG (appreciation), the basis increase is allocated by taking into account both the FMV and bases of properties. Depending on the BIG in each property (capital gain property v. non-capital gain), a TP could manipulate his transfers if the gain from 357(c) is allocated to the corporations basis relative to the FMV of the two properties. Allocating the gain with respect to the BIG (appreciation) is the fair way to do it but it is not the way the Regs tell us how to do it.
55
Deuling analogies: how we allocate gain under 1.357-2(b) or how we allocate boot under 351 and Rev Rul 68-55. o Ex: 2 assets: 1. Basis=20; FMV=10. 2. Basis=10; FMV=30. Total basis=30 minus Debt=38. So, 357(c) gain of 8 to be allocated. If we were to allocate according to 1.357-2(b), then we would have to recognize 2 of gain on asset #1, which is a loss asset! That doesnt make sense. So, 1.357-2 is theoretically flawed. Is there a reasonable basis for giving an opinion letter that the correct method for allocating the gain for purposes of determining the basis increase under 362(a)(1) is to allocate the gain relative to the appreciation of the two assets rather than allocating the gain relative to the fair market value of the assets? Yes, you would have a reasonable basis. But dont simultaneously argue two cases w/ opposite positions in the Tax Court. In this case, allocating relative to the appreciation would not be in the best interest of the shareholders. If there was a cash boot situation, the gain would be allocated asset by asset. The whole point of Rev. Rul 68-55 is that when you have multiple assets and boot, you allocate the stock and the boot for purposes of determining the gain under 351(b) relative to the fair market value of each asset transferred. You then recognize gain realized, but not in excess of the boot.
4. Edmund and Tenzig formed Sasquatch Corporation. Tenzig contributed $3,000,000 of cash in exchange for 75 shares of common stock. Edmund contributed land with a basis of $800,000 and a fair market value of $2,000,000, subject to a $1,500,000 nonrecourse mortgage debt, and Edmund's negotiable promissory note payable to the order of Sasquatch Corporation, in the amount of $500,000, in exchange for 25 shares of common stock. Edmund's note bore interest at the prime rate plus 2 percent, payable annually, with $100,000 of principal due on each of the first five anniversaries of the date of the note. What are the tax consequences to Edmund and to Sasquatch Corporation? Contributor Contribution Tenzig Cash Tenzig gets 75 shares. Contributor Contribution Edmund Land Note Character AB $800,000 $0 $800,000 FMV $2,000,000 $500,000 Mortgage $1,500,000 $1,500,000 Character AB FMV $3,000,000 Mortgage
Edmund gets 25 shares. Edmund's gross contribution is $2,000,000 and his contribution net of the mortgage is $1,000,000. What is the basis in the note? 56
IRS will argue Rev Rul & Alderman. Absent other authority, you must flag that you arent following the revenue ruling. If you flag it and claim to follow Perrachi, then if you lose you wont have to pay the 20% penalty. If this case gets litigated in a different circuit... what is the answer most likely to be? A taxpayer has basis in a particular piece of property. What piece of property did Perrachi own? Nothing. As long as Perrachi's hand was on that promissory note, it was not property, so he could not have a basis. The problem is that the property was created in the transaction; property was not transferred. The code & regs dont deal with this. We have no theoretical reason to say the note as a basis of face. We need a code section. But, a promissory note is future cash. If Edmund paid cash, he would get basis for that cash, so why should it not be any different when he gives the corporation a note and says I'll pay you later. There is a problem in the statute. The statute contemplates property that is transferred to the corporation. The statute never contemplated property being created as a result of the transaction. The problem is that when the statute was drafted in 1964 the corporation acts in most states did not allow someone to transfer a note in exchange for stock in the corporation. What indicates that the note in this problem was not a sham? The economics of the situation required it because there was a third party involved. Also, the other shareholder has the majority interest. In Perrachi, there was a question as to whether/not the note was a sham.
Tax Consequences to Edmund: Amount realized = $2.5M ($1.5M mortgage debt assumed + $1M FMV stock) A/B = $1.3M (800k land + 500k note under Peracchi principles in 9th Circuit) Gain realized = $1.2M (not recognized under 351, 357(c)) Gain recognized = $200k (357(c)(1)) liabilities ($1.5M) in excess of basis ($1.3M) Note: 2 issues decided in Peracchi 1. Whether note has a basis or not 2. Whether the note was bona fide Basis in stock under 358(d): Property transferred (358(a): $1.3M (800k + 500k) Less 1.5M debt (358(d)) Plus 200k (recognized gain under 357(c)(1)) BASIS = 0k If Peracchi is not followed AR 2.5M A/B 800k Gain realized = 1.7k gain Gain recognized = 700k under 357(c)(1) Tax Consequences to Corporation Basis in property received: $1.3M (800k land + 500k note) Plus gain recognized: 200k 57
Reg. 1.357-2(b) suggests that the basis increase be allocated in proportion to the FMV of the assets) FMV land = $2M = 80% FMV note = 500k = 20% Thus, 80% of the 200k (160k) should be allocated to the basis in the land and the remaining 20% (40k) should be allocated to the basis in the note) Lands basis = 1.5M Notes basis = 540k McMahon Peracchi is wrong! Not in the result, but in the reasoning. The maker, here Edmund, does not own the note. Thus, there is no property transferred when Edmund gives the note to the corp. It becomes a promissory note only when delivered it was not property before that time. Peracchi Recap: What is the basis of the promissory note? The promissory note is a representation of after-tax cash payment (the person will have to pay on the note w/ after tax dollars). The relevant basis is the basis of property to the SH. Other logical problems w/ Peracchi: p.104 fn.16says the holding doesnt apply to partnership or S Corps... this doesnt make sense! If you want to give Edmund a favorable opinion you can rely on Peracchi & Alderman as subst authority so that you can avoid penalties. You can also make other logic-based arguments (even if they dont jive w/ Peracchi & Alderman). There hasnt been a case on this issue than Peracchi (decided in 1998)... but there is a Rev Ruling (as well as Alderman) on this topic that conflicts w/ Peracchi! If you rely on Peracchi & dont flag that your position conflicts w/ the Rev Ruling and there is an audit client will be subject to automatic 20% penalty. If you flag it will your chance of audit go up? What if you do? We dont know the answer to that question. Tuesday, September 14, 2010 (2) Assumption of Debts That Would Be Deductible When Paid: 357(c)(3). 1. Jack and Abe, who have been conducting separate lobbying businesses in Washington, D.C. as sole proprietors for several years and have joined together to incorporate their businesses as Payoff Peddlers Corp. Each of them received 10 shares of common stock. Jack, who has operated his business on the cash method, contributed the following assets: Contributor Contribution Jack Account Receivable Office Equipment Account Payable PMSI Total AB $0 $28,000 FMV $60,000 $40,000 Debt
$28,000
$100,000
$55,000 $25,000 $80,000 $25,000
58
In addition, Payoff Peddlers assumed $55,000 of accounts payable ( 162 expenses) of Jack's sole proprietorship and a $25,000 purchase money loan on the office equipment. Abe, who has operated his business on the accrual method, contributed the following assets: Contributor Contribution Abe Account Receivable Office Equipment Account Payable PMSI Total AB $60,000 $28,000 FMV $60,000 $40,000 Debt
$88,000
$100,000
$55,000 $25,000 $80,000
In addition, Payoff Peddlers assumed $55,000 of accounts payable ( 162 expenses) of Abe's sole proprietorship and a $25,000 purchase money loan on the office equipment. As permitted by 448(b)(2), Payoff Peddlers elected to use the cash method. Following incorporation, it collected all of the accounts receivable and paid all of the accounts payable. (a) What are the tax consequences to Jack, Abe, and Payoff Peddlers upon incorporation? Illustrating 357(c)(3) general rule Jack is a cash method taxpayer and Abe is an accrual method taxpayer. Abe's accounts receivable have a basis because those accounts were already included in income on Abe's tax return. Likewise, Abe's accounts payable were already deducted on his tax return. Jack is a cash method tax method taxpayer, so he has not yet included those accounts receivable in income on his tax return (because he has yet to actually or constructively receive payment), so basis is zero. Likewise, Jack's accounts payable have yet to be deducted because he has not paid them. 357(c)(3)(A)(i) says, "If a taxpayer transfers, in an exchange to which section 351 applies, a liability the payment of which . . . would give rise to a deduction . . . then, for purposes of paragraph (1), the amount of such liability shall be excluded in determining the amount of liabilities assumed." Notice, 357(c)(3)(A)(i) says ". . . would give rise to a deduction when paid . . . " Abe would not get a deduction when paid because he already got a deduction when the accounts payable accrued. "[W]ould give rise to a deduction when paid" draws a line between those expenditures that are deductible only upon payment and those liabilities that are deductible upon accrual. If a liability is deductible upon accrual, then the liability is not a 357(c)(3) liability. If a liability is deductible only upon payment, then it is a 357(c)(3) liability. For a cash method taxpayer an account payable is deductible only upon payment, therefore Jack's account payable is excluded.
59
Both Jack and Abe are in the same position under debtor creditor law, so why did Congress enact 357(c)(3)? One situation is that you got depreciation deductions using the banks money and not including the borrowed money in income. Another way is to borrow money secured by property and use the money for a purpose unrelated to the property so that debt is not included in basis. 357(c)(3) we do not take into account debt that would give rise to the payment of a deduction. So, the key becomes knowing when an item will be deductible when paid (the cash payment gives rise to the deduction). Jacks Tax Consequences Gain: No gain under 357(c)(1) because 357(c)(3) excludes the accounts payable liability from the determination of the total amount of liabilities assumed (payment would give rise to a deduction). As such, only the $25k PMSI liability is included and it does not exceed the aggregate bases of the property transferred ($28k) Basis: Account payable liabilities ($55k) not taken into account under 358(d) (see Rev Rul 95-74 and 358(d)(2)) Thus, basis = basis of property transferred under 358(a) = $28k less PMSI liability under 358(d) = 25k A/B = 3k Abes Tax Consequences 357(c)(3) does not apply to Abes accounts payable because the payment of the liabilities would not give rise to a deduction. 357(c)(3)(B) provides that liabilities will not be excluded to the extent that the incurrence of the liability resulted in the creation of, or an increase in, the basis of any property. Abe received basis in the accounts payable thus 357(c)(3)(A) does not apply to them and they are included in 357(c) determination. Note, however, that Abe will still not recognize gain under 357(c)(3) because the amount of liabilities assumed under 357(c)(1) (80k) do not exceed the aggregate bases of the property transferred (88k). Thus, no gain would be recognized under 357(c)(1). Abes basis in stock (358(a)) = 88k 80k debt assumption + 0k gain = 8k Corporations Tax Consequences: Accounts payable Only Jacks may be deducted b/c he is a cash method TP and has not received the deduction yet. Abe already received a deduction as an accrual method taxpayer. Rev Rul 80-198 & Hempt brothers tell us that the assignment of income doctrine transferred by Jack would be taxed to the corp, not Jack. Rev Rul 95-74 says that where deductible liabilities are assumed by a corp in connection w/ assets of the going business, the corp will be allowed a deduction.
60
Accounts receivable Collection of Jacks, a cash method TP, are includible upon receipt by the corporation because Jack had not included the income on his return (because he had not received the income). Abe already included his in his basis, which was transferred to the corporation. Therefore, Abes are NOT includible by the corporation. 362: Corp succeeds the SH basis in the asset. So, when the corp collects Jacks account receivable w/ a zero basis, it will have 60 of gain. When it collects Abes account receivable w/ a 60 basis, it will have zero gain. If it collects less than 60, then it will have a loss. Who really contributed what? Did they contribute the same amount? No. Abe has contributed more value than Jack.
2. Jeff and Louis started Border-on-the-Nile.com, Inc. to market and sell books over the internet. Each received 10 shares of common stock. Jeff contributed $200,000 in cash. Louis contributed an inventory of books worth $250,000, with a basis of $40,000. In addition, the corporation agreed to pay a $50,000 prize to whoever holds the winning lottery ticket from a contest run by Louis in his former bricks-and-mortar-based bookstore business. All of the tickets have been distributed, but the winner has not yet been drawn. What are the tax consequences to Louis and Boarder-on-the-Nile.com? Jeff 200 cash Louis Books w/ FMV 250; basis 40 and Debt 50 Although there are certain exceptions, a merchant or a manufacturer is considered to be an accrual method taxpayer for our purposes. Most corporations must be on the accrual method (certain personal service corps may be on the cash method). If there is not 357(c)(3) (debts assumed = 50; basis = 40... gain of 10). Under 358, Book basis 40 + gain 10 Boot 50 = zero basis in stock. Corp would have basis of 50. If it is 357(c)(3) then we have debts of 0 and basis of 40 and no gain. Under 358(d)(2), Book basis 40 + gain 0 liability 0 = 40. Corp would have basis of 40 in books. We have an intersection of 357(c)(3) and 461(h). 461(h) carves out certain kinds of liabilities that an accrual method taxpayer may not deduct under the accrual method. - Have all of the events occurred that fix the fact of liability? Yes. - He has to go through with the drawing under state law. - Is the amount of liability fix with a reasonable certainty? Yes. - Prizes & awards; damages in lawsuit; workers comp = not deductible until paid - Economic performance is required for something like environmental remediation, as in Rev. Rul. 95-74. In Rev. Rul. 95-74, the liability was not a liability that was deductible until paid. Under 461(h), there are certain kinds of liability that are not deductible until paid, such as workers' comp. claims, a structured tort settlement, and lottery and prizes. 61
The real purpose of this particular problem is to show that 357(c)(3) goes way beyond cash method accounts payable and you have to do a lot of work with accrual method accounting to understand whether a liability is not deductible until a particular year in the future. In Rev Rul 95-74 the IRS says the purpose of 357(c)(3) dont take into account any liability if the transferor has not yet received a tax benefit (if the benefit is a deduction in the future or springing basis). 3. Toxic Chemical Corp. formed a new wholly owned subsidiary, Chimera, Inc. by transferring Brownacre, land that is the site of an arsenic mine formerly operated by Toxic, with a gross fair market value of $500,000 and with a basis of $300,000 in exchange for common stock. Chimera agreed to be responsible for any and all future environmental remediation expenses with respect to the property that might be required by the Federal EPA or state Department of Environmental Protection. Toxic estimated that the future environmental remediation expenses would be approximately $400,000. Shortly thereafter, Toxic sold the Chimera stock for $100,000. What are the tax consequences to Toxic? FMV= $500k A/B = $300k Future environmental remediation = approx. $400k If we sold the mine, there would have been a $200,000 gain. The purpose of this transaction was to convert what would be a $200,000 gain into a $200,000 loss. (Toxic would have A/B = 300k minus $100k sale = $200 Loss) Under Rev Rul 95-74 we want to claim the 400k was a liability under 357(c)(3). So that we would recognize a loss of 200 on the stock. If it doesnt fall under 357(c)(3), then there is a gain of 100 on the stock. Under 358(h), we have to reduce the basis of the stock but not below the FMV. "If, after application of the other provisions of this section . . ." This means we have to apply 358(a)-(g) first. " . . . the basis of property to which subsection (b)(1) applies . . . " Meaning the stock. The word property when it stands alone almost always has an antecedent that tells you which property it is talking about. " . . . exceeds the fair market value of such property . . . " Meaning the basis of the stock exceeds the fair market value of the stock. If stock basis is more than FMV The word "property" every place it appears in 358(h) refers to the stock.
62
" . . . then, such basis shall be reduced but not below the FMV. . . " by 357(c)(3) liability OR basis fmv Meaning the basis of the stock. A reduction by the lesser of the 357(c)(3) liability or the (basis fmv) We triggered 358(h) because the basis exceeds the fair market value. (Basis=300. FMV=100) There are actually two different calculations: (1) the trigger calculation, and (2) the reduction calculation. 358(h) Trigger Calculation Basis FMV Excess 358(h) Reduction Calculation Basis (basis fmv)
$300,000 $100,000 $200,000
$300,000 Less $200,000 = $100,000
We know that the buyer would pay less than $100,000 for the stock because the only reason the buyer is buying the stock is to help the buyer convert the gain into a loss. Thus, the buyer would want a commission for its help. Does 358(h)(2)(A) apply? If this was going business 358(h)(2)(A) says that 358(h) does not apply, which means we need to ask whether there are any other assets in Toxic Chemical corporation other than the mine. We need to ask whether there are any other assets transferred to Chimera, Inc. other than the mine. Because the facts indicate that Toxic formerly operated the mine, we can conclude that there was not an on-going business. 358(h)(2)(B) is no longer relevant. Treas. Reg. 1.358-5 says that 358(h)(2)(B) doesn't apply. In essence, the Treasury just erased the statutory rule. 358(h) confines Rev Rul 95-74 to its facts & sends the analysis back to the Rev Rul 75-54 (transfer of assets of an ongoing trade/business) Section 3. The Control Requirement 351(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 . . . of the corporation."
63
The terms "by one or more persons" and "such person or persons" indicates that for purposes of testing control under 368(c) the transferors of property collectively, or as a group, must own at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of each class of stock. 83 and 61(a)(1): any time a person receives property in exchange for services, the person recognizes gain equal to the FMV of the property (b/c remember. Services are not property for purposes of 351see 351(d))
1. Bill owned a copyright on a computer software program, with a fair market value of $10,000,000 and a basis of $1,000. Bill transferred the copyright on the program to newly formed Doors Corporation in exchange for all 30,000 shares of voting common stock. Doors was unable to further develop and market the software without the investment of significant additional capital. To this end, pursuant to a prearranged plan, three months later Merril-Goldman, an investment-banking house, sold $40,000,000 par value nonvoting preferred stock of Doors Corporation to public investors on behalf of Doors. As agreed upon in the contract between Doors and Merrill-Goldman, upon completion of the public offering, Doors issued 10,000 shares of common stock to Merrill-Goldman. What are the tax consequences to Bill and to Doors? Step 1: Bill creates Doors Corporation and contributes a copyright with a basis of $1,000 and a fair market value of $10,000,000 in exchange for 30,000 of voting common stock. Step 2: Pursuant to a prearranged plan Merrill-Goldman sold $40,000,000 par value nonvoting preferred stock of Doors Corporation to public investors on behalf of Doors. Step 3: As agreed upon in the contract between Door and Merrill-Goldman, upon completion of the public offering, Doors issued 10,000 shares of common stock to Merrill-Goldman. Does Bill meet the conditions of 351(a) to get nonrecognition? - notice this problem can arise in a controversy situation if Bill doesnt report any gain saying 351 applies. And the IRS audits Bill & claims gain. Or, if the corp claims a $10mil cost basis and then claims deductions - this situation may also arise in a planning situation - The ultimate question is Bills gain or Corporations amortization. The second question is a good 351/362 corp basis or not a good 351/1012 corp basis. The third question is who are the transferors and when is immediately after. Fourth, what is the scope of the transaction (do we lump Bills and Doors or do we group all togetherBill, Doors, M-G, and Public). Rev Rul 79-70, Intermountain, M? case: stand for proposition of broken control? Check in book... Representing Bill, arguing for 351 transaction as an advocate in adversary position. After considering whether the transactions will be lumped under the binding transaction, we consider if there is another way that the two transactions may be grouped. So, we need to look at intent/end result test and mutual intent test (the three test options are independent)we must argue that the binding commitment test is the only one that should be applied. However, under American Bantam that is not likely to succeed (all three tests were discussed & there was no binding commitment). (Go down to chart where all three are analyzed below) 64
Intermountain Lumber stands for the proposition that if the step-transaction doctrine does not apply, momentary control is sufficient. Reg. 1.351-1(a) says that "the phrase "immediately after the exchange" does not necessarily require a simultaneous exchanges by two or more persons, but comprehends a situation where the rights of the parties have been previously defined and the execution of the agreement proceeds with an expedition consistent with orderly procedure." Before, we said Reg. 1.351-1(a) helps us because we could write a contract that brings in multiple people, even though some of them transfer their property weeks or months later than others. Reg. 1.351-1(a)(3) tells us that we ignore Merrill-Goldman because it is just a conduit (underwriter) for the transaction where Doors is issuing stock to the public for cash. Reg. 1.351-1(a)(3) (last sentence) applies to a firm commitment underwriting, in which the underwriter picks up the unsold stock. Although there aren't going to be very many firm commitment underwriting these days, if there was how do we apply 351(a) and Reg. 1.3511(a)(3) if Merrill-Goldman sells $35,000,000 of stock to the general public, keeps $5,000,000 of stock, and transfers $5,000,000 to Doors out of its own account? In such case, Bill, MerrillGoldman, and the public are all transferors of property for purposes of determining control under 351(a): Bill has transferred the copyright, Merrill-Goldman has transferred $5,000,000 in cash, and the Public has transferred $35,000,000 in cash. Remember, cash is "property" for purposes of 351(a). Thus, if we link Step 1 and Step 2 together, it does not destroy the 351(a) transaction because both Bill and the Public are transferors of property. And, if we look at the first two transactions separately, Bill has a good 351, and if Bill's transaction is the only transaction tested under 351(a), the transaction where the Public acquires its $40,000,000 shares is just a purchase transaction, i.e., cash for stock, so 351 is irrelevant. The problem, here, is that the underwriters are receiving stock in exchange for services. Does it matter whether the stock is voting common or nonvoting common? If the underwriters get voting common, the control test is not met because the transferors of property need 80% of the voting power. So, if the underwriters get voting common, 351 is busted. What if the underwriters get nonvoting common, so that Bill has 100% of the voting common stock, the underwriters have 100% of nonvoting common stock, and the public has 100% of the preferred stock? 368(c) says "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."
65
Does "all other classes of stock" mean ownership of 80% of "all other classes of stock" in the aggregate or 80% of ownership of "[each] other class[ ] of stock"? In Rev. Rul. 59-259 the Revenue Services ruled that "all other classes of stock" means each class of nonvoting stock. The rationale is that you are comparing apples and oranges when you are comparing nonvoting common stock and preferred stock because we could have 80% or not have 80% just by changing the number of shares of preferred or nonvoting common, even though doing so would not change the value of the preferred or nonvoting common. The number of shares in the other classes as a whole is arbitrary. So why not say 80% of value? Because the statute says "80 percent of the total number of shares." So it does not matter if the corporation issues the underwriters voting common or nonvoting common because the control test is failed in either case. If the underwriters are issued voting common, Bill winds up with 75% of the voting power and if the underwriters are issued nonvoting common, Bill fails the control test because the transferors of property, i.e., Bill and the public, do not own any of the nonvoting common. The next question is do we integrate the last step under the step transaction doctrine? We know from American Bantam that the step-transaction doctrine, which is alluded to in the last sentence of Treas. Reg. 1.351-1(a), has to be considered all the time. We know that if we apply the step-transaction doctrine and include all the stock we have a problem. Here, we have 3 separate transactions that have to be tested under the rules of 351(a). Whether or not the step transaction doctrine applies and which steps it applies to integrate critical to many transactions. NB: for step transaction doctrine, you must run all three tests! They are not one large test... any one may act to group transactions. Be careful not to overlap tests... even though in reality intent and mutual interdependence often have a significant overlap. Step Transaction Doctrine (1) Intent of the parties/End result test (intended end result) Under the intent variation of the step-transaction doctrine, the question is what did the parties intend to happen (what the intended deal was)? If the intent variation of the step transaction doctrine were applied here, Bill probably would not have a good 351 transaction. This is because there was a prearranged plan to do this. The intent was that the underwriters would end up with 10,000 shares of common stock. The primary evidence of intent is what actually happened; emails, notes, letters, phone logs, etc., are only secondary evidence of intent. This is why "intent of the parties" is often referred to as the "end result test." Whose intent matters? Is it only Bills intent? Or Doors as well? Unified intent of all the deal-doers? What if there is no mutuality of intent (secret intent)? We will spend all year answering this question... (2) Mutual interdependence Under the mutual interdependence test, the question is whether taking the first step is dependent on going forward and taking the second step. In other words, would there have been no business reason whatsoever for taking the first step unless the second step was taken as well. But note, the mutual interdependence test does not mean that you could not have taken the second step unless you did the first. Rather, it means there would have been no point in taking the first step unless you also took the second step. Thus, if taking the first step 66
without doing anything more would make perfectly good business-sense, the step-transaction doctrine will not apply under this variation. Note that the mutual interdependence test is an inherently factual question, so it could never be decided on summary judgment. This is an objective testwould a business do this? (3) Binding Commitment A taxpayer can use binding commitment as a sword if it wants the transaction stepped together to get a valid 351 transaction. This is because if there are multiple people contributing property to a corporation over a period of time and there is a contract (i.e., a stock subscription agreement) that they have all signed promising that they will transfer property in exchange for stock, there is a binding commitment and the fact that one transfer happens three months after the first is irrelevant because the transfers will be stepped together. If going straight from A to B is a recognition event, but going from A to C is nonrecog and C to B is nonrecog. Then you should be taxed as if you go straight from A to B, unless the step transaction doesnt apply. In this question, it doesnt look like there is tax planning. The step transaction doctrine in this question is an interpretive tool to understand what facts we must take into account in determining if the if portion of the statute is met. In American Bantam, the Court found that there was no binding commitment. Notice that if the Court had decided that the binding commitment test was the only relevant test and there was a binding commitment, the transactions would have been stepped together. If the court had decided that the relevant test was intent, then there is a high probability that the court would have stepped the transactions together, and 351 would not have been met. Instead, the court applied the mutual interdependence variation of the step-transaction doctrine. In American Bantam, the court applied the mutual interdependence test and concluded that there would have been valid business reasons for taking the first step and not taking the second step. Here, if the step transaction doctrine applied, it would apply to integrate steps 2 and 3 because the contract between Doors and Merrill-Goldman says if Merrill-Goldman sells the preferred stock, it gets the common stock. Was there an intent that the common stock be issued if the preferred stock is sold? Yes. Was there a binding commitment obligating Doors to issue common stock to Merrill if the preferred stock was sold? Yes. Would Merrill-Goldman have sold the preferred stock if there was any chance it would not have gotten the common stock? No. Merrill-Goldman would not have undertaken the underwriting if there was no chance that it was not going to get the common stock. So, it really does not matter which variation of the step transaction doctrine you apply here. What kills the deal here is the fact that Doors issued the common stock to Merrill in compensation for its services in marketing the preferred stock to the public. Stepping the second and third transaction together does not necessarily mean that the resulting integrated transaction will also be stepped together with the original step 1, so that Bill's 351 is busted. If the Merrill-Goldman transaction is not stepped together with Bill's original contribution, the result is that Bill still gets nonrecognition under 351, and Merrill-Goldman will be treated as having received the common stock in compensation for its services in a separate, subsequent transaction. 67
On the other hand, if the Merrill-Goldman transaction is stepped together with Bill's transaction so that the whole thing is considered to be one transaction, neither Bill nor Merrill nor the Public will get nonrecognition because Merrill-Goldman will be consider in testing whether the transferors of property controlled the corporation immediately after the exchange. And since the transferors, i.e., Bill and the Public, will fail the control test if either voting or nonvoting common stock is issued, the 351 is busted. Thus, while the Public will not be effected, Bill will recognize gain and Merrill-Goldman will recognize ordinary income under 83(a). So the question we're down to is whether we can say the whole thing is one big transaction? - If we apply the intent/end result test would we combine the transactions together into one big transaction? Yes. - If we apply binding commitment, the question is whether there was a binding commitment on the day that Bill transferred the copyright to the corporation in exchange for stock that provided the subsequent transaction with Merrill-Goldman and the Public would occur? Here, the facts do not indicate that there was a binding commitment (enforceable contract) to issue common stock to Merrill-Goldman in compensation for its services for marketing the preferred stock to the public on the day that Bill transferred the copyright to the corporation. This is because the facts state that Merrill-Goldman only entered the picture 3 months after incorporation, when Doors determined that it was unable to further develop the software without additional capital. However, if there was a contract, and the binding commitment test applies, there is not a good 351. If the mutual interdependence test applies, the question is would incorporating Doors make absolutely no business sense without the Merrill-Goldman transaction. Here, there is an argument that it would because the facts indicate the Doors was unable to further develop the software without additional capital. Mutual interdependence is inherently a factual question, so it could never be decided on summary judgment. If forming doors would be absolutely fruitless, there is a good possibility that the transaction would be stepped together. "Prearranged" is language used in revenue rulings and cases to tell you that this transaction was all hatched in advanced.
68
2(a). Donald Thump owned a hotel property consisting of land and a building. The fair market value of the land was $1,000,000 and the basis of the land was $100,000; the fair market value of the building was $19,000,000, its adjusted basis was $8,000,000 and its original cost (unadjusted basis before depreciation) was $22,000,000. In January, the Tripletree Hotel Corporation, offered to purchase Donald's hotel for $20,000,000. The offer was open until April 15. On February 15th, pursuant to advice from his C.P.A., Ernie Whinney, Donald transferred the land and building to newly formed Apprentice Corp. in exchange for all 100 shares of its stock. On March 1st, Donald counter-offered to Tripletree's offer, stating that he would accept $19,000,000 in exchange for all of the stock of Apprentice Corp. This offer was accepted by Tripletree and the deal was closed on April 1st. Ernie Whinney has advised Donald that the incorporation of Trippletree was tax-free under 351. Is he correct? Land: FMV = 1 million. Basis = 100k. Building: FMV = 19 million. A/B = 8 million. Original cost (unadjusted basis) = 22 million. What is the shooting match about here? If Donald sold the land and the building, he would recognize $900,000 of 1231 gain with respect to the building and $11,000,000 of "unrecaptured 1250 gain" with respect to the building. See 1(h)(6). If he sells stock for cash, it is a recognition event and Donald has a gain of $10,900,000. By selling the stock, he has converted the "unrecaptured 1250 gain" into long-term capital gain. Although he reduces his gain by $1,000,000, he reduces his cash by $1,000,000 (reducing taxes on 1 million gain from 25% to 15%). Nevertheless, in the end, Donald will increase his after tax gain by $250,000 by selling the stock rather than the land and the building. Similar to Rev Rul 70-140 discussed in Rev Rul 2003-51. In this question there are two steps; you cant redraw it to make it only one step. If the IRS cites Rev Rul 70-140 when there are two steps it is trying to recast the transaction (in the initial step transaction case, there was one step made into two from A to somewhere in between to B). So, there is no way to make this one step... so it doesnt seem like the step transaction should really be applied at all. Rev Rul 2003-51 describes Rev Rul 70-140 as a re-cast not a step transaction. If the step transaction doctrine applies, what event was the recognition event? The contribution to the corporation was the recognition event, because control was broken by the subsequent transfer. If the contribution to the corporation is the recognition event, Donald takes a fair market value basis in the stock of the corporation and has little or no gain on the sale of the stock to Tripletree. Binding commitment test: In Intermountain Lumber, there was a binding contract. We don't have a binding contract here, so if the binding commitment test is the test that the court applies, the step transaction doctrine will not apply, and Donald wins. Intent/End result test: On the day Donald formed Apprentice, Tripletree was not involved. As far as Tripletree is concerned, it is contemplating buying land and a building, not stock. It is difficult to apply the intent test when you have unrelated parties in a bi-lateral contract where one of the parties has an undisclosed intent not known to the other. 69
Mutual interdependence test: Under the mutual interdependence test, the question is whether the first transaction makes sense without going forward with the second transaction. What is the purpose for putting that land into the corporation without trying to sell the stock? Why did it made sense to put it in the corporation? Liability is not a reason because you could create a liability shield by dropping the land and building into a single member LLC. The argument might be that it will be easier to dispose of the property later on. However, selling 100% of the stock of a corporation is just as easy as selling all of the membership units of an LLC. Ultimately, whether there is a valid business purpose for incorporating is a factual issue. There are all sorts of business reasons to incorporate a going business.
2(b) Suppose alternatively, that after transferring the hotel to Apprentice Corp. in exchange for all of its stock, pursuant to a pre-arranged plan, Donald transferred all of the stock of Apprentice to Las Margaritas, Inc., in exchange for 100 shares of stock. Simultaneously, Jose Cuervo, who theretofore had owned all 200 shares of the stock of Las margaritas, transferred to Las margaritas a restaurant building with a fair market value of $4,000,000 and a basis of $500,000, in exchange for 20 additional shares of stock. What are the tax consequences to Donald? There is no binding commitment or mutual interdependence. If the intent test applies, clearly this is the intended result. Note: this is very similar to RR 70-140. How do we distinguish these facts from that Ruling? The one big twist here (and in 2003-51) is that there is no subsequent transfer from Las Margaritas into another corporation as was the case in 2003-51 where corp. Y dropped its assets and business into corp. Z. Rev. Rul. 2003-51 is the "no harm, no foul" rule. The issue though is that the logic applied in 2003-51 shouldnt make a difference here and in facts similar to 70-140 because the parties could have gotten to the same place in a different series of transactions. Jose Cuervo's old and cold shares count in determining whether the control test is met. Under Rev. Rul. 2003-51, the issue is whether we could get to the same result tax-free. In our question, we need to decide if there was another way to get the deal done btwn Donald & Jose where we would never question if it was a 351 transaction. D could have transferred the restaurant into Las Margaritas for 100 shares stock and Jose could transfer castthey both get stock back; then Las Margaritas could drop the restaurant down into a newly formed subsidiary. This has the same number of steps, but it is tax-free and no one would question it! So, the IRS will say that they are going to allow the transaction in our problem, b/c there is a way to recast it where it would be tax-free. Remember: you may rely on a Rev Rul if the facts are subst similar, but once you have a differing fact then you must decide if the factual difference effects the analysis in the rev rul. 70
This question shows us that you can acquire a business through a 351 transaction. Is it a significant factual difference that in Rev. Rul. 2003-51 business A got dropped into the subsidiary, but in our problem, the business stays in Las Margaritas. McMahon does not think this is a significant fact. See 1.351-1(a)(1)(ii): if there are 2 or more transferors; B owns 100 of 100 of shares; A puts in assets and gets 50 shares... A doesnt have a 351 transaction. A may ask B to also take 5 shares so they are w/in 351... however b/c of this code section, if the 5 shares are of relatively small value compared to the 100 sharesthen they are not considered to be transferred for property & A still wont have a 351 transaction, but only if the primary purpose was to put A into a 351 transaction. Rev Rul (?)safe harbor for what is not relatively small value. Tuesday, September 21, 2010 Recap from last Thursday: Underwriters are agents of the corporation (so they arent considered in the control group). For step transaction doctrine always look for code sections, rev rulings & regs that call of the step transaction doctrine. p.130-131 of text: Reverse step transaction. Rev Rul 83-34back to back good 351 trans even if it is completely pre-arranged (when T transfers assets to Y who transfers to X and X transfers X more than 80% stock to T) However, Rev Rul 84-44 says this (following) is not a good 351 transactionT transfers assets to X who transfers Ts assets to Y and X transfers more than 80% X stock to T. Why? b/c T didnt receive assets of the Y corporation. So, when do we follow form or when do we follow substance? 3. Paducah Oil Company has recently acquired a chain of gas stations previously operated by Leviathan Oil Corp. in Kentucky, following Leviathan's decision to cease its marketing operations there. In addition to the seventy-five company-owned gas stations acquired from Leviathan by Paducah, leviathan had an additional one hundred or so independent retailers that owned their own gas stations and purchased gasoline from Leviathan Oil. Paducah plans to convert all of the seventy-five gas stations that it acquired from Leviathan to convenience grocery store-gas stations that it will operate under the trade name BlueCat, but which will sell gasoline refined by Paducah. The management of Paducah believes that the outlet name recognition would be enhanced, and hence average profits per store would be enhanced, if substantially more than seventy-five BlueCat stores were operated in Kentucky. Additionally, it is looking for additional outlets for its refined products.
71
To accomplish these goals the management (transaction 1) of Paducah plans to form a subsidiary, BlueCat Stores, Inc., to which it will contribute all of the seventy five gas stations that it purchased from Leviathan, some cash, and a quantity of refined petroleum products. In exchange, Paducah will receive one hundred percent of the voting common stock of BlueCat. Immediately thereafter, (transaction 2) Paducah will offer to exchange with the one hundred independent dealers previously selling Leviathan gasoline in Kentucky a number of its shares of BlueCat equal to the fair market value of each of their respective businesses, in consideration of the transfer directly to BlueCat of all of their business assets, including their gasoline stations, inventory, customer accounts, etc. It is anticipated that if all of the independent owners accepted the offer, in the aggregate the previously independent owners will hold a fifty percent interest in BlueCat. No individual owner, however, will hold more than two or three percent of the BlueCat stock. The owners will continue to operate their stations as managers of the convenience stores and will receive salaries, bonuses and fringe benefits from BlueCat. The management of Paducah is concerned whether this transaction will be a tax-free incorporation. Although Paducah's cost basis for the seventy-five gas stations is not substantially less than fair market value, BlueCat will be a going concern and its stock, therefore, may have a value in excess of the fair market value of the underlying assets. Additionally, the refined gasoline to be contributed has a value substantially in excess of its basis. More importantly, however, Paducah wants to be able to assure the independent retailers that they will not owe any income taxes as a result of the exchange of their business assets for BlueCat stock. If the exchanges are taxable, Paducah is concerned that the station owners may prefer to sell for cash or debt instruments and the Paducah management would prefer not to use a cash or debt acquisition route. Will 351 apply to the incorporation of BlueCat Stores, Inc.? Viewed separately, the first transaction Paducah's contribution to Blue Cat, Inc. in exchange for all of its common stock would satisfy the requirements of 351 because Paducah contributes property to Blue Cat in exchange for 100% of the corporation's stock. The first issue is whether the second transaction the Independent's contribution to Blue Cat, Inc. in exchange for Blue Cat stock from Paducah would satisfy the requirements of 351. Rev. Rul. 79-70, 1979-1 C.B. 144 held that the requirements of 351 had not been met where the prearranged sale of stock was to a creditor of the corporation. In Rev. Rul. 79-70, X Corporation transferred property to newly organized Y corporation and, pursuant to a prearranged binding contract, sold 40% of the Y stock to Z Corporation. Simultaneously, Z purchased securities for cash from Y. The Ruling held that Z Corporation was not a transferor of property because it received only securities from Y. Z's ownership of the Y stock acquired by purchase from X Corporation could not be counted in determining whether the control requirement of 351 was satisfied. Since Z therefore received only securities for cash and was not a stockholder prior to the exchange it was not a member of the control group for 351 purposes. X was the only transferor of property, it received only 60% of the stock, and the transaction therefore did not qualify under 351.
72
Rev. Rul. 84-44, 1984-1 C.B. 105, held that 351 is not applicable to the transferor of property to a corporate subsidiary in exchange for stock of the transferee subsidiary's parent corporation, which is in turn controlled by the transferor. Thus, view separately, the second transaction would not qualify for nonrecognition under 351 because the Independent's did not contribute property in exchange However, the same result can be accomplished by restructuring the transaction as a transfer to the controlled parent corporation first, followed by a transfer by the parent corporation in exchange for stock of its controlled subsidiary. Rev. Rul. 83-34, 1983-1 C.B. 79, holds that although these transfers may be undertaken pursuant to an integrated plan, each transfer is treated as a separate transaction that satisfies 351. Section 4. Receipt of Stock for Services 1(a) Alberto, Beryl, and Chris have been operating a fashion design business (as a partnership) under the name Ritzy Rags for the past several years. Because they are planning to expand to manufacturing, Alberto, Beryl, and Chris are planning to incorporate the business. Debby, an employee who is one of the nation's hottest fashion designers, has been a very important factor in the success of the business. Recently Debby received an offer from another apparel company that included stock and stock options in the compensation package. To induce Debby to remain with Ritzy Rages, Alberto, Beryl, and Chris have offered her twenty-five percent of the common stock of the new Ritzy Rages Corporation, to which the business will be transferred. Advise the parties regarding the tax consequences of the incorporation transaction. Class Notes: A, B, C each transfer property & receive 25 shares each. D receives 25 shares but hasnt contributed property (she is getting it for consideration for past services). At this point, D hasnt provided services for the corporation; she provided services for the partnership! At some point between the partnership and the incorporation, D gave a promise of future services to the pship and gets back a promise of stock in the future corporation. DAngelo (p.129) casethe fact that people that transfer property to a corp only get 50% of stock doesnt necessarily mean it isnt 351. This was a deliberate attempt to break 351. The ct found that the two parents really gave a gift to their children of 50% of the stock, so the parents are treated as receiving the stockso they have 100/100 shares and then send 25 to each child. So, the kids have no income. For tax analytical purposes, even though the parents never had legal title, they are treated as having received the stock. If we apply DAngelo to this question, we can look at the stock given to D as an after the fact bonus. In order to know if it really is a payment for future services we would need to know more facts, ie, info about a contract, what happens if the EE doesnt perform the services! Intermountainthere was a cashing out concept. Is it fair to say that A,B,C have cashed out since all of the pship went into Ritzy Rags?
73
Look at Mojonnier & Sons casethe corporation is arguing that 351 doesnt apply (b/c wants a higher depreciation deduction). The TC said that it was a commitment to give the EE (a son of Mojonnier) portion of company for services rendered to the pship. So, in that intense, it appears that it doesnt matter who gets the stock as long as there is a binding commitment. The IRS issued a nonacquiesence for this case. In most states a K to transfer stock from the corporation is under the SOF (so must be in writing to be enforceable). How do we deal with this? We could make the transfer of stock to D contingent & in portions (not all at once). Stock options/stock warrants are not stock under Reg. 1.351-1(a). If D has a stock option then she will have to buy the stock to exercise the option. So, the reason we say that stock options are not stock is the fear that the stock options will be classified as a separate class of stock (however, see 382 where options are considered or not considered a class of stock). In American Bantam the transfer was contingent upon successful underwriting, so we could argue Am bantam to support the argument that if we make it contingent then it wouldnt break the 351 transaction. Use 83! Issue the stock now but make keeping it contingent on the performance of future services. (b) What if Debby's stock must be sold back to Ritzy Rags for $10 per share if her employment terminates any time in the next four years. The first fact we need to know is the fair market value of the stock because D will recognize compensation income equal to the fair market value of the stock under 83(a). Even if there is no buy back provision, the fair market value of the stock will not equal the fair market value of the underlying assets because the stock will be discounted for a lack of marketability. If D's receipt of stock for services prevents A, B, and C from getting nonrecognition under 351, they are also going to be arguing that the fair market value of the property received was less than the fair market value of the underlying assets of the corporation for the same reason. 83 tells us that as long as it is subject to a subst risk of forfeiture it isnt included in Ds income. When that subst risk lapses, it will be included in Ds income. The value of the stock is a question of fact. Technically, anytime your right to keep the stock is contingent on continued employment the stock is forfeitable unless the corporation has to buy it back at fair market value. What is the impact of making D's stock forfeitable? She doesn't have to recognize income immediately, but she will recognize income when the risk of forfeiture lapses in 4 years. 83(b) election to include the stock at today's fair market value. With this election your betting the stock is going to go up and that it is not going to go down. 83(b) election have to be made within 30 days of the receipt of stock. 74
In many instances, the corporation will condition the issuance of stock for service on the employee making a 83(b) election so it can get a deduction under 83(h) and Treas. Reg. 1.83-6 now. Reg. 1.83-1(a)(1) says that if the stock is forfeitable and D collects dividends the dividends are ordinary compensation to Debbie and the payments are deductible to the corporation. Furthermore, Reg. 1.83-1(a)(i) says the corporation is considered to be the owner of the stock, so can we use that language to save the 351. Or would the step transaction doctrine apply? Here, there is an intent that D gets the stock if she does something, and there is a binding commitment that Debbie gets the stock if she does something. Thus, if you are applying the intent form of the step transaction doctrine or the binding commitment test, the step transaction doctrine would seem to apply. However, one of the things that the court focused on in American Bantam was the contingent nature of the agreement. What we want to do is take that contingency and bring it into the binding commitment test. Federal Grain Corporation control relates to beneficial ownership of stock not the exercise of voting rights. Moral of the story, if you are actually issuing the stock then stop at 20%. If you want to issue more use stock options. (c) What if Debby doesn't receive any stock in Ritzy Rages immediately upon its incorporation, but receives an option to purchase from the corporation at any time in the next five year an amount of stock equal to the number of shares originally received by each of Alberto, Beryl, and Chris (i.e., if Alberto, Beryl, and Chris each received 100 shares, Debby would have an option for 100 shares)? Does it matter whether the option is at the fair market value of the shares on the date the option is granted, or may the option price be at a deep discount without impairing the tax-free status of the incorporation? (disregard last sentence; changed by code) Another way to structure this agreement is to give Debbie an option. "In the money" means the price you pay for the option less than the value of the stock on the day that the option was granted. If the option was "in the money" you create a huge mess with respect to deferred compensation. By giving D forefeitable stock, she is getting a very different deal than options. 1.351-1(a) Options or warrants is not stock. Are options or warrants "other class of stock"?
75
2(a). Fran, Les, Pat, and Sean plan to organize a corporation to engage in the construction business. Fran will contribute $400,000 in cash for 40 shares of common stock. Less will contribute equipment with a basis of $90,000 and a fair market value of the $200,000 for 20 shares of common stock. Pat will contribute building materials with a basis of $210,000 and a fair market value of $200,000 for 20 shares of common stock. Sean will contribute a contract with Falls City University for the construction by Sean or Sean's assignee of a new Dental School building, a letter of intent from the University of the Bluegrass to enter into a contract with Sean or Sean's assignee for construction of a new Engineering School buildings, and Sean's services in organizing the corporation and supervising the construction of the two buildings. Sean will receive 20 shares of common stock. F, L, P get 351 treatment. What is Ss treatment? What are the tax consequences to each of the shareholders and to the corporation of the formation of the corporation? S has 61(a)(1) / 83(a) compensation for services. What is Ss basis in the 20 shares of stock? We have to bifurcate.... If a single transferor transfers both property and services for stock, the transaction must be bifurcated and treated as the receipt of stock for property of equivalent value and the receipt of stock for services. The value of the stock received for services is ordinary income in the year of receipt. However, a transferor who receives stock for services and who also transfers some property to the corporation for stock will qualify as a "transferor of property," so that both the stock received for services and the stock received for property may be counted in determining whether the control test is met. Reg. 1.351-1(a)(2), Ex. 3. - So, w/ the taxable transaction under 1012 basis. For the tax free transaction he will have a 358 basis. We need more information... - The corporation will be able to, under 83(h) and 1.83-6(a)(4), either capitalize or deduct (depending on the nature of the services) as though it had paid the entire amount in tax. - Notice, as we increase the value attributed to the K, Ss position gets better (less income), but the corporation is worse off b/c of smaller deduction. How do we convince the revenue service that the contract is property? In U.S. v. Stafford, the critical fact was that the transferor was not acting as an agent for the corporation. Stafford says that a LOI can be property (often LOI specify that they are not binding contracts). If a LOI is conceptually property, then a contract should also be considered property. US v. FrazellFrazell had geological data that was found to be property (a sort of intellectual property). Frazell & Stafford support that intangible property is considered property for 351. So, we need to value the stock (the FMV) and then allocate the FMV to the contract & LOI. The contract is valued at the net present value of the expected future profitsthose future profits will only be taxed went are received.
76
Remember, business goodwill can be property! What is goodwill? The reputation ability to earn more moneywhat is a contract? the right to earn future money.
(b) How might your answer to (a) differ if Fran were to receive participating preferred stock instead of common stock? Does it matter wither the participating preferred stock has voting rights to elect directors? Fran is putting up cash (he is the venture capitalist). The issue is if the participating preferred is voting or nonvoting. For 368(c) controlif it has voting then they have 80% voting; if it is nonvoting, then As long as we can treat S as a transferor of property (Rev Proc 77-37: property is worth at least 10% of the value of the services.), then every share S gets will be counted. Safe harvbor in Rev Proc 77-37, speaks to the comparison the value of the stock red for property for the value of the stock recd for services. However, that comparison alone is not enough to kick him out of the 351 transaction. Why was the contract contributed? It is the whole reason for getting the corporation going! Participating preferred stock means the preferred stock still has a preference, but the stock also participates in dividends and liquidations determined by a ratio set in the contract. If the stock is voting preferred stock, nothing will change because the test is whether the transferors of property own "at least 80% of the total combined voting power of all classes of stock entitled to a vote." If the preferred stock is nonvoting preferred, then whether the control requirement is met depends on whether Sean is a transferor of property. If Sean is a transferor of property, then the control requirement will be satisfied, because between Fran, Les, Pat, and Sean the transferors of property will own 100% "of the total combined voting power of all classes of stock entitled to a vote and at least 80 percent of the total number of shares of all other classes of stock of the corporation." However, if Sean is not a transferor of property, then the control requirement is not satisfied because the transferors of property will only own 67% "of the total combined voting power of all classes of stock entitled to a vote." The test is that transferors of property have to have 80% of the stock when the smoke clears. 1.351-1(a)(1)(ii). Rev. Proc. 77-37 Safe harbor If the property has a value that is equal to 10% of the value of stock issued for services. The value of the property has to equal 9.09% A revenue procedure tells you what the IRS wants for an advanced ruling.
77
This problem was used to show differences btwn how you look at thing sfrom a aplanning or a controversy perspective; the significance of valuations & how valuations can determine which rule of law applies; how the intent test (subjective intent) combines with the safe harbor (objective test)it is easy from a planning perspective it is easy to deal w/ the objective, but not the subjectiveon a planning level, always try to get yourself out of subjective test if you can. 3. Ellen, Fred, Ginny, and Hank plan to form X Corporation. Ellen, Fred, and Ginny are contributing appreciated property. Hank is contributing only services. Under which of the following, alternative capital structures will the incorporation qualify under 351. (NB: this could also be doen in the context that E,F,G had all the stock and were going to transfer it to H through a contract or through a sale) (a)(1) Ellen, Fred, and Ginny collectively received 80 shares of Class A $1,000 par value, 7%, voting participating preferred stock and Hank receives 20 shares of Class B voting common stock. The Class A participating preferred stock is entitled to a cumulative 7% preferred dividend and a $1,000 per share liquidation preference. After the Class A preference has been satisfied, both Class A and Class B stock share equally, share-byshare, in all current and liquidating distributions. Whether the control test is satisfied depends on the relative voting power of each class. Good 351 here assuming each class of stock has same voting power (1 vote each). (2) What if Hank's Class B common stock was nonvoting? The control test is not satisfied because the transferors of property do not own "at least 80 percent of the total number of shares of all other classes of stock of the corporation." (b/c there is now nonvoting common stock) this is a planning opportunity! If E,F,G are contributing appreciated property, they could issue nonvoting and then break control so 351 wont apply. (3) Ellen, Fred, and Ginny's Class A stock was voting common stock and Hank's 20 shares of Class B stock was $1,000 par value, 7%, nonvoting limited and preferred stock. The control test is not satisfied because the transferors of property do not own "at least 80 percent of the total number of shares of all other classes of stock of the corporation." The control test is not intuitive. One would think that taking voting rights away from the one who is issued stock for services would increase control, but that is not the case under 368(c). If we give Hank nonvoting limited preferred stock, Hank starts to look like a bondholder; however, Hank is in a worse position than a bondholder because he has no preference. (4) Ellen, Fred, and Ginny collectively received 80 shares of voting common stock and Hank received a $20,000 bond (promissory note), convertible at any time in the next four years into 40 shares of voting common stock. A convertible bond is not stock under Reg. 1.351-1(a)(1)(ii) (last sentence). The convertible feature is, in essence, an option! So control is not broken!
78
(b) Ellen, Fred, and Ginny collectively received 80 shares of Class A voting common stock and 80 shares of Class B nonvoting, common stock. Hank receives 20 shares of Class A voting common stock and 20 shares of Class C nonvoting preferred stock. The control test is not satisfied because the transferors of property do not own "at least 80 percent of the total number of shares of all other classes of stock of the corporation." (c) Ellen, Fred, and Ginny collectively receive 75 shares of Class A voting common stock and Hand received a $20,000 bond (promissory note), convertible at any time in the next four years into 40 shares of voting common stock. A convertible bond is not stock under Reg. 1.351-1(a)(1)(ii) (last sentence). Until the 1989 Omnibus Budget Reconciliation Act, 351(a) applied to stock and securities, so most debt was securities. Thursday, September 23, 2010 (missed class) CHAPTER 4: THE CAPITAL STRUCTURE OF THE CORPORATION There are significant tax difference between using debt and equity. Debt Equity Interest is deductible Dividends are not deductible Single tax @ 35% Double tax @ 15% (if held by individual) If debt is a "security," loss is capital loss On worthlessness loss is capital loss, unless A demand note is not a security 1244 applies (Individuals) Nonbusiness bad debt = STCL Debt held by a corporation = ordinary loss Notes: If given the choice, an unrelated investor would prefer a share of preferred stock over a debt instrument as long as the dividend stream is reasonably certain with the preferred stock. The reason why is because the dividends are taxed at 15% while the interest, though taxed only once and deductible by the corporation, the 15% rate is still less than the 35% rate on which the interest is taxed.
Application The first time these issues will arise is when the IRS disallows a deduction for interest on grounds that the interest payments are in fact dividends and thus nondeductible. It may also show up when the investor claims a loss. The holder may claim an ordinary business bad debt. The IRS will say that the loss is a capital loss on stock. In the cases, you have to pay attention to who the petitioner was. If it was the corporation, the issue was usually whether the payment was an interest payment (deductible) or a dividend (nondeductible). In cases where the investor was the petitioner, the issue was whether the loss was capital or ordinary. 79
The case law developed mostly in the context of undercapitalized closely held corporations, where the incorporators has taken back large amounts of debt. Section 1. Debt versus Equity 1 Ultimate Question: (a). How do we go about deciding whether an obligation is debt or equity? First step: What was the intent of the parties? Did they intend repayment at a time reasonably certain with a determinable interest rate, regardless of the success or lack of success of the business? (1) the names given to the certificates evidencing the indebtedness; (2) the presence or absence of a fixed maturity date; (3) the source of payments; (4) the right to enforce payment of principal and interest; (5) participation in management flowing as a result; (6) the status of the contribution in relation to regular corporate creditors; (7) the intent of the parties; (8) "thin" or adequate capitalization; (9) identity of interest between creditor and stockholder; (10) source of interest payments; (11) the ability of the corporation to obtain loans from outside lending institutions; (12) the extend to which the advance was used to acquire capital assets; and (13) the failure of the debtor to repay on the due date or to seek a postponement. Factors = Evidence of intent. Debt to equity ratio If the ratio of debt to equity is high, it makes the shareholder debt look like equity. Low debt to equity ratio makes the shareholder debt look like debt. Proportionality If the debt held by shareholders are proportional, the shareholder/creditor is ambivalent about whether the debt is actually paid or not. If the debt is held disproportionately, there is a greater chance that the debt will actually get paid back. A disproportionately held debt, however, may still be reclassified as equity. Debt Low debt-to-equity-ratio Disproportionately held debt Written Promissory Note w/ due date, interest Can get 3rd party debt Debt is actually paid Equity High debt-debt-to-equity ratio Proportionately held debt Subordination of Corp.'s debt to SH Can't get 3rd party debt Failure to pay interest when due, default not cured.
80
CHAPTER 5 DIVIDEND DISTRIBUTIONS, Tuesday, October 5, 2010 Section 2: Dividend Distributions In General 301(a) (except as otherwise provided in this section) says that 301(c) is the default rule for a distribution of property. 301(c)(1), which is the beginning of the default rule, says the portion of the distribution which is a dividend (as defined in 316) is included in gross income. The rest of 301(c) goes on to tell us what you do with a distribution that is subject to 301(c) that does not fall within the definition of a dividend, as defined in 316. 316 defines dividend, generally, as a distribution out of "earnings and profits." o 1(h)(11) taxes dividends at a special rate (15%) o We need to know what earnings and profits are. 312 does not define "earnings and profits," rather it gives us a long list of some, but not all, of the rules for determining earnings and profits. 317 defines "property" as "money, securities, or any other property; except that such term does not include stock in the corporation making the distribution. (or rights to acquire such stock). Notice that the definition of "property" in 317 includes the common legal meaning of the word property. 317 only applies to part I of subchapter C, which is distributions by corporations. Technically speaking, that definition does not apply anywhere else in subchapter C. 302 overrides 301: 302 provides rules to decide whether or not a distribution is in the form of a corporation repurchasing its own stock should be taxed to the shareholder as a sale of stock to a third party or should be considered under 301 and taxed as a dividend. Thus, the issue is sale or exchange treatment versus dividend treatment. 302 gives a series of tests to determine this. o Under 304 if a related corp buys the stock 305 deals w/ the distribution of the corps own stock to its SH to increase number of shares outstanding. 305 may provide nonrecognition (317)in which case 306 provides an ordinary income taint to the sale/redemption of preferred stock o 305 plays a role because of the definition in 317 of property, which excludes from the term property stock of the corporation making the distribution, i.e., a stock dividend. 305 sorts out those distributions of the stock of the distributing corporation that are tax free and those that will be sent to and dealt with under 301. 306 is an anti-abuse rule for certain transactions involving preferred stock, in which 306 trumps 302. 332 and 337 apply special rules when a parent causes a subsidiary to liquidate.
Two other provision we have to consider in connection with dividend distributions are 1(h)(11) and 243 (intercorporate dividend received deduction). On the corporation's side, if the distribution is a distribution of property other than cash 311 comes into play. Also, 312 applies to the corporation as a result of a distribution.
81
331 and 336 apply to liquidation a festival of taxation. A dividend produces ordinary income vs. A sale/exchange of stock produces capital gain or loss (& how much basis do we use to offset gain or generate loss). Under current law, an individual 1(h)(11) sets a max rate of 15% and a max cap of tax on capital gain is 15%. The difference is TF not the tax rate! It is how much basis the TP will recover. The current laws end 12/31/2010 when dividends will be taxed at max 39.6% and capital gains will be taxed at 20% (200k individuals and 400k joint; approx 2% of US). Operative provision is 301(c)(c)(1) says dividend as defined in 316 will be gross income. 316(a): dividend includes any distribution of money or property out of accumulated or current E&P. Earnings and Profits are explained in 312... we start w/ taxable income (312(n) makes this clear b/c it contains a list of special rules where accounting methods used in calculating income must be changed in calculating E&P... so 312(n) wouldnt make any sense if we didnt start w/ taxable income). However, 312 does have language that is contradictory to this conceptsee 312(f)be careful not to be overly literalistic about 312(f); it is a series of rules to address particular problems w/ earnings and profits. 1. Bugs-R-Us Corporation is an accrual method taxpayer engaged in a local pest control business. Last year it had the following receipts and expenses. Assume that the corporation tax rate is a flat rate of 20% Receipts Amount Received $38,000 $10,000 $5000 $4000 $2000 $119,000
Gross Income from Sales Dividend Income Interest on Municipal Bonds Capital Gain Addl capital contrib. by SH Gross Income/taxable income
Inclusion in Taxable Income $38,000 $10,000 $0 (103) $4000 $0 (1032) $112,000
Expenses/Deductions Amount Spent Wages, Rents, Supplies $33,000 Fines $4000 Depreciation (only $3000 under 168(g)) $8000 Interest on Loan to buy Bonds $3000 Capital Losses $5000 243 Deduction Total Deductions
Amount Deducted $33,000 0 (162(f)) $8000 $0 (162) $4000 (limited by 1211) $7000 $52,000
What are Bug-R-Us Corporation's earnings and profits for the taxable year?
82
Taxable income can be far less than financial income. We don't use financial accounting because it is too subject to manipulation. Nevertheless the concept of earned surplus is to reflect the corporation's dividend paying capacity. The theory is the economic income of the corporation (not cash!) The starting point in calculating E&P is taxable income: Gross income (receipts): Receipts from exterminating services $98,000 Dividend income $10,000 Capital Gain $4,000 $112,000 Deductions Wages, rent, & supplies 168 Depreciation on equipment 243 Div. recd Deduction (70% x 10k) Capital loss (limited to capital gains)
$33,000 $8,000 $7,000 $4,000 (limited by 1211) $52,000 $60,000 x 20% $12,000
Taxable Income Tax rate Taxes paid
The fines not deductible under 162; interest on loan to buy municipal bonds disallowed under 265. Now the question is how do we adjust that taxable income under the rules for earnings and profits? Is there anything that should be added in to our $60k of taxable income? 103 municipal bond interest (not income) 243 dividend recd deduction Excess depreciation $5,000 $7,000 $5,000 $77,000
The 103 municipal bond interest because it is real cash. What this does is undo the exemption of 103. Although the corporation is not taxed on the interest receives, the taxpayers will be taxed on the dividends received which comprise the interest from those bonds. See Reg. 1.312 The excess depreciation. Instead of using the depreciation that is on the tax return, you have to use the alternative depreciation system under 168(g). So, we have to add back the difference between the accelerated depreciation and the alternative depreciation, which equals $5,000. o 312(k)(3)(A) explains that depreciation deductions for computing income is different than the deductions used for determing E&P. We must use 168(g) (an accelerated depreciation deduction) for the regular calculations... so that amount must be added back into E&P. 83
o Why do we do this? b/c the depreciation of the item was not as fast as the accelerated depreciation (to encourage growth, etc)... so we need to add back the amount of excess depreciation to show that the propepty really hasnt depreciated as much as the tax return shows. What we see is that all the incentive rules for computing taxable income are disappearing in computing earnings and profits. The dividends recd deduction must be moved back in b/c the cash is still there (there was actually no outflow... it was all legal fiction) 1032 codified a line of cases that held that a corporation does not realize income on the issuance of its stock.
What about reductions to E&P that should be made? Nondeductible (disallowed) capital loss ($1,000) Fines payable for violation of state law ($4,000) Interest paid to buy bonds ($3,000) Taxes ($12,000) $57,000 Under 265 the interest paid to acquire tax exempt bonds is not deductible. 1.312-7(b)(1) explains why we should remove the disallowed capital loss. Taxes paid: Mazzocchi Bus Co., Inc., (where the TP was a cash method TP) holds that a corporation must use the same accounting method for calculating its earnings and profits as it uses in calculating its income taxes. So, the taxes should be removed in the current year b/c they were included in the accounting method in the current year. o b/c of the deduction for federal taxes, the E&P will often be less than taxable income. Fines: see Rev Rul discussing bribes/fines to foreign entities (find number) $57,000
E&P =
There is a huge amount of grey in the area of earnings and profits. All corps must pay estimated taxes quarterly in advance... if the corp is a cash method TP & we take the Mazzocchi Bus & IRS position we wouldnt include taxes paid (even though it was already required to send in paymentshowever, they could get this back if they go downhill in the last quarter!) Do we treat the advance payments as deposits or as paid items? This looks like a problem, but it really isnt that important b/c E&P seldom comes in to play on a nickel and dime level. 2. Determine the amount of the dividend received by the shareholders of Benny's Bait Shop & Sushi Bar, Inc. and the consequences of any distributions that are not dividends in each of the following situations: (a) Ben owns all the stock of Benny's Bait Shop & Sushi Bar, Inc. His basis in the stock is $24,000. In the first year of existence, Benny's Bait Shop & Sushi Bar, Inc. earned $30,000 of earnings and profits. One half of this sum was earned in the period January to June; the other half was earned in July through December. On July 1, Benny's Bait Shop & Sushi Bar borrowed $50,000 from the Usury National Bank and distributed $40,000 to Ben. 84
Technically, the first question you have to ask is whether the $50,000 borrowing is added to earnings and profits. Obviously not because it is not gross income/economic income (even though it is cash). But notice, you get the same situation if a business accepts refundable deposits that are treated as advanced payments under its accounting method. In that situation, the business has this huge cash hoard, but because of its obligation to refund the deposits at the depositor's requests, the deposits are not included in E&P. On the other hand, if those deposits, because of the deal and tax accounting rules, have to be taken into income as advanced payments, because they are nonrefundable deposits, for example, they do augment E&P. Since it was the source, does that mean that the distribution cannot out of E&P? 316 (a) General rule - For purposes of this subtitle, the term "dividend" means any distribution of property made by a corporation to its shareholders-(1) out of its earnings and profits accumulated after February 28, 1913, or (2) out of its earnings and profits of the taxable year (computed as of the close of the taxable year without diminution by reason of any distributions made during the taxable year), without regard to the amount of the earnings and profits at the time the distribution was made. Except as otherwise provided in this subtitle, every distribution is made out of earnings and profits to the extent thereof, and from the most recently accumulated earnings and profits. To the extent that any distribution is, under any provision of this subchapter, treated as a distribution of property to which section 301 applies, such distribution shall be treated as a distribution of property for purposes of this subsection. Questions we must address: We know that the distribution was actually funded by the bank, so can we argue that there was no distribution out of E&P? No. 316 says "every distribution is made out of earnings and profits to the extent thereof," so since we have E&P, we cannot argue that the distribution was made out of the loan proceeds and not E&P. o The language "every distribution is made out of earnings and profits to the extent thereof" is not designed to prevent us from tracing on the bank loan. Instead, it is designed to prevent us from writing down paid-in surplus and claiming the distribution was not a distribution out of E&P, but was a return of some the capital that was paid into the corporation. It tells us that we cannot use financial accounting to say that the distribution was not a distribution out of E&P, but a rebate of capital paid for the stock. o This language also tells us that it is irrelevant whether there is any documentation apart from check declaring a distribution. The question whether there is a dividend for state law purposes is separate and distinct from the question whether there is a dividend for federal tax purposes. Now we have to decide whether the dividend was only $15,000 because that was the amount of E&P on the date of distribution. NO! 85
o 316(a)(2) says "dividend" means "any distribution of property made by a corporation to its shareholders . . . out of its earnings and profits of the taxable year (computed as of the close of the taxable year without diminution by reason of any distributions made during the taxable year), without regard to the amount of the earnings and profits at the time the distribution was made." This tells us that at the time the distribution is made, we have no idea how much is going to be made out of E&P because we have to wait until the close of the taxable year. If there is $30,000 of E&P at the close of the taxable year, then 301(c)(1) says $30,000 is a dividend. Under 61 this amt., 30k, is included in GI Next, there is still $10,000 to account for. How do we treat that? o 301(c)(2) says the $10,000 is a return of capital, which reduces the basis of the stock. So, the closing stock basis is now $14,000. $10,000 of basis moved from the stock to the cash in order to prevent the cash being taxable income. Notice that for tax purposes we have a return of capital, even though for financial accounting purposes, we may not necessarily have a return of capital. This problem shows that if you make a distribution during the year against what might happen in the future, you don't know how much is going to be a dividend and how much is going to be a return of capital. The closer to the end of the year, the more likely you are to know how much will be characterized as a dividend and how much is a return of capital (The answer is only as good as the projections! Make sure you get the projections & the answer in writing!). On 1/1 of the next year, the corporations E&P is? 312(a)(1) says to decrease the E&P to the extent thereof by the amount of money distributed. So the current E&P of 30 is decreased by 40 (but not to a negative number)... so for the next year the accumulated E&P is zero. NB: always remember that 312(a) deductions are the LAST STEP of an answer!
(b) Assume that in its first year of business Benny's Bait Shop & Sushi Bar lost $20,000, measured by earnings and profits. In its second year of existence, Benny's Bait Shop & Sushi Bar earned $24,000 of earnings and profits and distributed $15,000 to Ben. In year 1, there was a $20,000 loss. In year 2, we earned $24,000 of E&P and distributed $15,000. Over its lifetime, Benny's has only made $4,000; however, the Code tells us that the amount of the dividend is $15,000 under 316(a)(2) and Reg. 1.316-1(a)(1)(ii) (see below)as long as the current E&P are at least equal to the distribution we dont care what the accumulated E&P is. It takes two steps to reach this conclusion under 316(a). In a sense, the question becomes, is Year 2 accumulated or is Year 2 current.
86
o If the current year is negative, conceptually it makes more sense to view Year 2 as connected to Year 1. o If the current year is positive, then conceptually it makes more sense to view them as separate. Notice the construct of 316(a)(1) before the flush language: 316 (a) General rule - For purposes of this subtitle, the term "dividend" means any distribution of property made by a corporation to its shareholders-(1) out of its earnings and profits accumulated after February 28, 1913, or (2) out of its earnings and profits of the taxable year (computed as of the close of the taxable year without diminution by reason of any distributions made during the taxable year), without regard to the amount of the earnings and profits at the time the distribution was made.
The "or" construction, coupled with the flush language in 316(a) that says "every distribution is made out of earnings and profits to the extent thereof, and from the most recently accumulated earnings and profits," tells us that we look to the most recent E&P first, and that the $24,000 of current E&P supports dividend treatment of the full $15,000 so that we cannot net, even if the distribution is on December 31. To get around this, you might just advise the client to wait and cut the check on January 2 of Year 3. Therefore, there is only $4,000 of E&P. Except, the check was paid in Year 3 and you won't know whether or not the distribution was out of Year 3's E&P until the close of Year 3. Reg. 1.316-1(a)(1)(ii) (flush language) (last sentence) says "For purposes of determining whether a distribution constitutes a dividend, it is unnecessary to ascertain the amount of earnings and profits accumulated since February 28, 1913 if earnings and profits of the taxable year are equal to or in excess of the total amount of the distributions made during the taxable year. o This language in the regulations confirms the answer. Notice, however, that the authority for putting that language in the regulations is the statutory analysis above. In summary: look first to current E&P (even if considered w/ accumulated the E&P is negative). (c) Assume that after several years of operation Benny's Bait Shop & Sushi Bar had $36,000 of accumulated earnings and profits. During the current year, Benny's Bait Shop & Sushi Bar earned an additional $24,000 of earnings and profits. On April 1, Benny's Bait Shop & Sushi Bar distributed $40,000 to Ben. On July 1, Ben sold half of his Benny's Bait Shop & Sushi Bar stock to Molly for $50,000. On December 31, Benny's Bait Shop & Sushi Bar distributed $20,000 to each of Ben and Molly. Date 4/1 7/1 Distribution $40 to Benny Ben sells his stock to Molly Current E&P $24,000 $12,000 Accumulated E&P $36,000 $28,000 Dividend $40,000
87
12/31 $20 to Benny $20 to Molly Total Dist=80k
$6,000 $6,000
$4,000 $4,000 Total E&P of 60k
$10,000 $10,000
How do we figure out how much dividend each of them have because we have $80,000 of distributions and $60,000 of E&P. We know that, in total, only 3/4ths of the distribution will be a dividend - $60,000 will be a dividend and $20,000 will be something else. What we have to decide is how to determine who has dividend income, and how much, and who has something else. The first thing we do is allocate current E&P. o We allocated current E&P in proportion to the distributions. Reg. 1.316-1(a) says do current E&P first. Reg. 1.316-2(b) says allocated the current E&P proportionally among those distributions. SH distribution x (Current E&P / Total distributions) Reg. 1.316-2(c) Ex. has a chart similar to the one above. We allocate proportionally b/c the current E&P is calculated at the end of the year w/out any diminutions for distributions made during the year. So, you cant assign current E&P by time (no stacking rule here!). o So, of the current E&P, Ben gets 12k as a dividend for the 4/1 distribution. For the 12/31 distributions, Ben and Molly each have 6k of dividend. Next, we allocate accumulated E&P. o In contrast to the allocation rule used to allocate current E&P, accumulated E&P are essentially allocated according to the FIFO (first in first out; a stacking rule) method. We apply the accumulated E&P to the distributions in order. o $28,000 is going to be allocated to the 4/1 distribution and the remaining $8,000 is allocated to both Benny and Molly for the 12/31 distribution because it was a simultaneous distribution. We know that Benny or Molly received their check first, but despite the rule, which allocates accumulated E&P in on a FIFO method, the remaining $8,000 is allocated to each. Why? b/c it is one distribution to SH! Under corporate law we can distribute to one SH and not another... o Although there is no clear statutory or regulatory provision expressing this rule, this is the interpretation adopted by the Example in Reg. 1.316-2(c). Where else do we get this concept? In 316(a)(2) congress told us to look at the year end current E&P and spread it among the entire year, however in 316(a)(1) doesnt say that! B/c of the lack of direction for proration in (a)(1) (when compared to (a)(2)) we should use a stacking rule in (a)(1). This problem was designed to show you how to read the statute for the proration rule and how if two closely related subsections dealing w/ the same or overlapping things have different verbiage then there is probably a different rule and once you understand theory behind the mechanical rule how to apply the mechanical rule to a question w/out direct guidance. 88
Summary of Ch.5 Sec.2 up to this point: We examined the methodology that we use to allocate current and accumulated earnings and profits among the various distributions of a year, where the distributions exceed current earnings and profits. If the current earnings and profits are more than all of the distributions of the year, all of the distributions for the year will be treated as a dividend and the accumulated earnings and profits starting the next year will be increased only by the net increase when you subtract the dividend from the current earnings and profits. If the distributions for the year exceed the current earnings and profits, we allocate the current earnings and profits among the various distributions proportionately. Having done that, in order to determine the portion of each distribution that is a dividend, we allocate the accumulated earnings and profits among the various distributions in the order in which they occur. And if the distributions are simultaneous, and for tax purposes that would mean related under the step transaction doctrine, then accumulated earnings and profits are pro rated among the distributions. (d)(1) Assume (as in problem (c)) that after several years of operation Benny's Bait Shop & Sushi Bar had $36,000 of accumulated earnings and profits. During the current year Benny's Bait Shop & Sushi Bar has a $32,000 loss (as measured by current earnings and profits) from ordinary business operations. On April 1, Benny's Bait Shop & Sushi Bar distributed $40,000 to Ben. On July 1, Ben sold half of his Benny's Bait Shop & Sushi Bar stock to Molly for $50,000. On December 31, Benny's Bait Shop & Sushi Bar distributed $20,000 to each of Ben and Molly. What are the consequences to Ben and Molly? What are the corporation's accumulated earnings and profits at the beginning of the next year? Date 4/1 7/1 Distribution $40 to Benny Current E&P ($32,000) ($8k) allocated to 1st quarter of year. Accumulated E&P Dividend $36,000 $28,000 (b/c the 8k was 12k return of capital removed from acc E&P) 28k dividend
Ben sells his stock to Molly 12/31 $20 to Benny $20 to Molly
20k under 301(c)(20(3) 20k under 301(c)(20(3)
Total Dist=80k Total E&P of 4k (The corps accumulated E&P as of 1/1 of the next year is a deficit of $24k. B/c they lost money later in the year after a distribution early in the year! The distribution contributes to the reduction of E&P, but it doesnt make the E&P negative... the loss does. So, you want to be able to prove when the loss happened!) What happens when we have distributions in a year in which there are no current earnings and profits and the corporation is losing money?
89
The first analytical question we have to ask when we have a distribution in a year where we start out with accumulated earnings and profits but you lose money during the year, is when do we net the loss of the current year with the accumulated earnings and profits of prior years? If there were no current distributions this year, this year's deficit would reduce the prior year's accumulation. In this problem, the question is whether any portion of this year's loss be attributable to the distribution made on 4/1, and if so, how much? The statute does not say what to do in this case. Reg. 1.316-2(b) (last sentence) says, "In any case in which it is necessary to determine the amount of earnings and profits accumulated since February 28, 1913, and the actual earnings and profits to the date of a distribution within any taxable year (whether beginning before January 1, 1936, or, in the case of an operating deficit, on or after that date) cannot be shown, the earnings and profits for the year (or accounting period, if less than a year) in which the distribution was made shall be prorated to the date of the distribution not counting the date on which the distribution was made." RR 74-174 provides some guidance as described in book tells us to try to figure out what the accumulated E&P was as of 4/1 (the date of the distribution). There are two ways to look at this: One way to look at is to say, there is $36,000 of accumulated earnings and profits. We have no idea as of 4/1 whether or not we will have any current earnings and profits. So, if it turns out that we have no positive current earnings and profits, there was $36,000 available on this date to be a dividend. Thus, one theoretical construct is that the current year's loss does not off-set any of the accumulated earnings and profits until you have ascertained the current year's loss. The other alternative is to allocate a portion of the current loss to the date of the distribution, in which case the portion so allocated would off-set accumulated earnings and profits as of the beginning of the year. We use the allocation over the entire year. One quarter of the year occurred before the distribution so $8k of the loss occurred before the distribution. If the operating result for the current year is a loss, so no current earnings and profits exist, then a distribution during the year will be charged against accumulated earnings and profits computed to the date of the distribution. If the actual current earnings and profits or loss to the date of the distribution cannot be ascertained, then the current loss of the year is prorated and applied to the accumulated earnings and profits as of the beginning of the year. See Rev. Rul. 74-164, 1974-1 C.B. 74. Thursday, October 7, 2010
90
In applying Rev. Rul. 74-164, we would say we have $32,000 of loss and this distribution occurred of the way during the year. Prorating the corporation's $32,000 loss for the year (using a 30-day month convention for simplicity) results in treating $8,000 of the loss ($32,000 x 3/12) as occurring from January 1 through March 31. That leaves the corporation with only $28,000 of accumulated earnings and profits on April 1 ($36,000 $8,000). Thus, only $28,000 of the $40,000 distribution on April 1 constituted a dividend. Pursuant to 312(a), the dividend distribution reduced the corporation's earnings and profits to $0 as of 4/1. 4/1 distribution of $40,000 to Benny $28,000 316 $12,000 return of capital $12,000 ($24,000 - $12,000)
301(c)(1) 302(c)(2) New basis
At the beginning of the year, Benny's basis in the stock was $24,000. To the extent the distribution exceeded earnings and profits, it reduced Benny's basis in the stock of the corporation. 302(c)(2). So, on July 1 when Benny sold half of his shares to Molly, his basis in half of his shares was $6,000. Upon selling half of his shares to Molly, Benny realized and recognized $44,000 of gain. Thus, after July 1, Benny's basis in the remaining shares is $6,000 Benny $20,000 ------------------------------------$6,000 return of capital $14,000 gain Molly $20,000 ------------------------------------$20,000 return of capital $0
12/31 Distribution 301(c)(1) 301(c)(2) 301(c)(3)
Since this is a loss year, there are no current earnings and profits to distribute as of 12/31. And as a result of the 4/1 distribution, there are no earnings and profits available for distribution on 12/31. This is because, after reducing the $36,000 of accumulated earnings and profits by $8,000 of the current year's loss, applying the remaining $28,000 of accumulated earnings and profits to the 4/1 distribution reduced accumulated earnings and profits to zero. At the end of the year, the $24,000 of the corporation's $32,000 loss for the year that was prorated to the period April 1 to December 31 creates a $24,000 deficit in accumulated earnings and profits. Benny's basis going forward is $0. Molly's basis in the shares purchased from Benny on July 1 was $50,000. Since there were no current or accumulated earnings and profits available for distribution on 12/31, none of the distribution is a dividend. 316 and 301(c)(1). Thus, under 301(c)(2) the entire distribution is treated as a tax-free return of capital, which reduces Molly's basis going forward to $30,000 (2) Assume alternatively that Benny's Bait Shop & Sushi Bar's $32,000 loss this year was entirely attributable to the sale of a single 1231 asset on February 1 and that ordinary business operations for the year were exactly break-even. Does your answer change?
91
Reg. 1.316-2(b) (last sentence) says, "In any case in which it is necessary to determine the amount of earnings and profits accumulated since February 28, 1913, and the actual earnings and profits to the date of a distribution within any taxable year (whether beginning before January 1, 1936, or, in the case of an operating deficit, on or after that date) cannot be shown, the earnings and profits for the year (or accounting period, if less than a year) in which the distribution was made shall be prorated to the date of the distribution not counting the date on which the distribution was made." Reg. 1.316-2(b) (last sentence) says you can use the proration if you cannot determine the actual earnings and profits as of the date of distribution, so the negative inference from this sentence is that you can apply the actual current loss as of the date of the distribution to reduce the accumulated earnings and profits as of the beginning of the year if the actual current earnings and profits can be ascertained. In this fact pattern, we started the year with $36,000 of accumulated earnings and profits, and the $32,000 loss is solely attributable to the sale of a single 1231 asset, which occurred on February 1 of the current year. Since we can identify the loss, we can reduce accumulated earnings and profits by that $32,000 as of 4/1, reducing the dividend on the distribution as of 4/1 from $28,000 to $4,000. Notice, that what happens is that all we have done is reduce dividend and increase capital gain. This is a good thing even when tax rates on dividends don't differ because dividends cannot be off-set by capital loss, whereas capital gain can be off-set by capital loss. Another way a corporation could know for sure the amount of a loss for a certain period would be to use quarterly financial statements. However, using quarterly financial statements just pushes the question forward. For instance, if the corporation uses quarterly financial statements and the distribution occurs on May 1, do we use the actual 1st quarter's loss and then pro rate the second quarter's loss? McMahon doesn't know what the answer to this question would be. Why does this netting effect not happen when accumulated earnings and profits are negative and current earnings and profits are positive (as in (b)(1) above)?
92
316(a)(2) says first look at current earnings and profits in isolation, and Reg. 1.316-1(a) makes clear that if the distributions for the year do not exceed current earnings and profits, there is no need to ascertain the amount of accumulated earnings and profits, but if the distributions for the year do exceed current earnings and profits, the accumulated earnings and profits are allocated pro rata among the distributions for the year. Thus, there is no way under the statutory language and the regulations, as they interpret the statutory language, to off-set negative accumulated earnings and profits against positive current earnings and profits. In contrast, where the source of the distribution is accumulated earnings and profits, the only question that 316(a)(1) and Reg. 1.316-2(b) ask is what is the amount of accumulated earnings and profits as of the date of the distribution. Thus, if there are negative current earnings and profits Reg. 1.316-2(b) (last sentence) along with Rev. Rul. 74-164 allow you to offset accumulated earnings and profits as of the date of the distribution by an amount of the loss. If the actual current earnings and profits or loss to the date of the distribution cannot be ascertained, then the current loss of the year is prorated and applied to the accumulated earnings and profits as of the beginning of the year. See Rev. Rul. 74-164, 1974-1 C.B. 74. What you learn here is that you can get different results depending on whether the corporation has quarterly, or sometimes semi-annual, financial statements, so that you might be able to identify a loss that reduces accumulated earnings and profits and, consequently, the amount of the distribution that constitutes a dividend. Thursday, October 7, 2010 (Missed Class 2) 3. Glowing Waters Nuclear Electric Power Corp., has 100,000 shares of $1,000 par value, 7% dividend, preferred stock and 100,000 shares of common stock outstanding. Glowing Waters has no accumulated earnings and profits and this year had current earnings and profits of $850,000. It distributed $700,000 on the preferred stock and $250,000 on the common stock. How much of each distribution should be treated as a dividend? Here, we have a distribution on both preferred and common stock. There are 100,000 shares of preferred stock, which received distributions of $700,000, and 100,000 shares of common stock, which received $250,000. Current earnings and profits = $850,000. Accumulated earnings and profits = $0. The question is how do we allocate the $850,000 of current earnings and profits between the distributions on the preferred and common preferred stock, totaling $950,000. Rev. Rul. 69-440, 1969-2 C.B. 46, involved a corporation that had three classes of stock, the first two of which had priority with respect to dividend payments. The corporation distributed amounts to the first two classes of stock in excess of earnings and profits. The ruling held that if the preferred stock, the first priority stock, had dividend priority under the corporation's charter, then earnings and profits were first to be allocated to all of the dividends paid on the preferred stock. If this treatment exhausted earnings and profits and distributions were made with respect to other classes of stock, then those distributions simply reduced the basis of that stock.
93
Notice that where we have a distribution to a single class of stock that exceeds current earnings and profits, we allocate through a proration rule. But where we have distributions to two different classes of stock with different priorities (and that's the key), then we shift to a stacking rule, under which the stock that has the state law priorities with respect to distributions absorbs current earnings and profits dollar for dollar and only what is left-over afterwards gets allocated to the common stock. This is to the disadvantage of the preferred shareholders and to the advantage of the common shareholders. The rational for shifting from a proration rule to a stacking rule in this situation is that as long as the corporation has assets the preferred shareholders will get what they are entitled to and the common stock gets eroded first. Also, notice that it is the corporation that is going to make the determination of how to allocate earnings and profits between the preferred and common stock. Stacking rule for distributions involving stock with different preferences. Mollys class notes: - The corporations lawyers/acct decide how to allocate e/p among the preferred/common s/h - Rev Rul 69-440: look at the substantive rights of the classes of shares as determined under state law and the corporate charter and bylaws. o Fed tax law tells us to allocate current e/p pro rata across class of stock and allocate accum e/p w/in class of stock, first come first serve, w/in a distribution, and to allocate e/p among classes of stock but the facts to which the rule applies are facts that are determined under state law o State law can turn into a fact for applying federal law o Preferred stock absorbs 700k and common stock has only 150k; remaining 100k is 301(c)(2) and 301(c)(3) 4. Alice owns 900 shares of common stock of E-Machines Computer Corp. She purchased 300 shares six years ago for $9,000 and the other 600 shares fifteen years ago for $2,000. The corporation, which is publicly traded, made a distribution, which was a dividend under state law, of $11 on each share. Alice received $9,900. Because E-Machines Computer Corp. made aggregate distributions to its shareholders in excess of its combined current and accumulated earnings and profits, it properly sent Alice a Form 1099 stating that the amount of the dividends received was only $3,300. How should Alice treat the other $6,600 that she received? Alice receives distributions on two different blocks of stock that she acquired at different times 300 shares $9,000 $3,300 $1,100 $2,200 $6,800 600 shares $2,000 $6,600 $2,200 $4,400 $2,000 301(c)(2) $2,400 Gain 301(c)(3) 94
Basis $11,000 Distribution $9,900 Dividend $3,300 301(c)(2)/(c)(3) $6600 Remaining basis
She did not really get $9,900 on 900 shares of stock. Really, she got a dividend on each and every separate share of stock, but we can bundle the individual shares into a block of 300 shares and a block of 600 shares. See Reg. 1.1012-2(c). Johnson v. United States, 453 F.2d 1257 (4th Cir. 1971), see also prop reg added by sypplement, held that a taxpayer who had several blocks of stock with different bases was required to treat a distribution on the stock not out of earnings and profits as made pro rata among the blocks of stock in order to determine the gain realized by the taxpayer on the distribution; the taxpayer was not allowed to aggregate the total basis in the stock and offset that total against the amount of the distribution. Two thirds of the distribution is attributable to the block of 600 shares purchased 15 years ago for $2,000, and one third of the distribution is attributable to the block of 300 shares purchased 2 years ago for $9000. Accordingly, 2/3 of $9,900 distribution, or $6,600, must be allocated to the block of 600 shares of stock, and 1/3 of $9,900 distribution, or $3,300 must be allocated to the block of 300 shares of stock. Mollys Class notes: - Case law says that when you have different blocks of stock w/ diff bases, a distribution on the stock not out of e/p is made as por rata amont the blocks of stock in order to determine gain realized by the TP; cant aggregate the total basis in tock and offset the total against the amount of the distribution (Johnson v. US) - Alices distribution is 3300 on 300 shares and 6600 on 600 shares - There is a dividend of 1,100 on 300 shares; 2,200 on 600 shares - Basis Recovery: 6600 o Block 1 (300 shares): 2,200 (less than 9k basis) new basis is 6800k o Block 2 (600 shares); 2000 (uses all of basis) new basis is 0 - Cap gain o Block 1: 0 o Block 2: 2400 5. Standard Oil of Alaska, Inc. has a wholly owned subsidiary, Fish Oil Corp. During the current year Standard Oil had accumulated and current earnings and profits totaling $100,000 and Fish Oil had accumulated and current earnings and profits totaling $300,000. Standard Oil distributed $250,000 to its shareholders this year. What portion of the $250,000 distribution constitutes a dividend? The earnings and profits of parent and subsidiary corporations that do not file consolidated returns are generally not consolidated for purposes of determining whether distributions by the parent corporation to its shareholders are out of earnings and profits and hence taxable as dividends. However, members of an affiliated group of corporations filing consolidated returns do combine the earnings and profits of the group. This goes all the way back to the Molline Properties doctrine. Section 3. Distributions of A Dividend In Kind 95
317(a) defines "property. 301 applies to distributions of property 301(b) specifically addresses the amount of distribution when the distribution is in the form of property other than cash; the amount of the distribution is the fair market value of the property received. 301(d) specifically addresses the basis of the property received in a 301 distribution, which is the fair market value of the property. General Utilities came to stand for the proposition that a corporation did not recognize any gain or loss when it distributed appreciated property to its shareholders. In actuality, the Court simply affirmed the lower court's holding that the distribution was a distribution in-kind of the stock of Island Edison and was not a cash distribution that was paid off by the transfer of appreciated property. The lower c ourt had held, and the government had argued, that the dividend was declared in cash and then the obligation to pay off the cash dividend was satisfied by the transfer of appreciated property, which is clearly a gain recognition event. The government argued for the first time in the Supreme Court that, even if the dividend was not a dividend in cash that was paid off by the transfer of appreciated property, the distribution of appreciated property in and of itself is inherently a realization and recognition event. The Supreme Court's response was to say, that is interesting but you did not argue that below, so we'll not consider it here. Thus, the case came to stand for the proposition that no gain or loss is realized or recognized when the corporation distributes appreciated or depreciated property. Congress codified the holding of General Utilities in 311 in 1954. Over the years, however, Congress enacted so many exceptions that the exceptions swallowed the general rule. In the Bush case, the Bush bean company declared a dividend in-kind in Bush baked beans. Since the Bush brothers did not have a place to keep the beans the corporation stored them for the brothers. And since the Bush brothers did not have a distribution network to sell the beans, the corporation distributed the beans for the Bush brothers. In effect, the Bush brothers were able to cut out one level of tax because they took a fair market value basis in the beans under 301(d). Although the revenue service lost the case, Congress closed the loop hole. 311(b) repeals the General Utilities rule. What are the tax consequences to each of the distributing corporation and its shareholders in each of the following situations? Assume that all individual taxpayers report on the cash method. 1(a) Mudville Corp. has $25,000 of accumulated earnings and profits, but no current earnings and profits through December 31st of the current year. On December 31st Mudville Corp. distributes to Casey its sole shareholder, a parcel of land with a basis of $60,000, which the corporate minutes state was distributed with the intention of distributing property worth $60,000.
96
FMV of land Adjusted Basis Gain/loss realized
$60,000 $60,000 $0
311(b) applies, but no gain is realized or recognized because the fair market value of the land does not exceed the corporation's basis. Under 312(f)(1)(B) or (b)(1), but not both, the corporation increases it current earnings and profits by the amount of gain realized and recognized, which is $0 Under 301(b), the amount of the distribution is $60,000. Under 301(c)(1), $25,000 of the distribution constitutes a dividend because the corporation had $25,000 of accumulated earnings and profits. Under 301(c)(2), $35,000 is treated as a return of capital, which reduces Casey's basis in the land from $60,000 to $25,000. Under 312(a)(3) and (b)(2), the corporation reduces its earnings and profits, but not below zero, by the fair market value of the property distributed. See 312(a) ("the earnings and profits of the corporation (to the extent thereof) shall be decreased. . . . "). Since the amount of the distribution exceeds Mudville Corp.'s accumulated earnings and profits, Mudville Corp. decreases its accumulated earnings and profits to zero. (b) The IRS has audited Mudville Corp.'s income tax return for the year. The only item that the IRS proposes to change is to treat the value of the land as $150,000 instead of $60,000. How will Mudville Corp. and Casey be affected if the IRS prevails on this change? Summary of analysis: 311(a), (b) 312(f)(1)(B) or (b)(1), but not both 301(b) 301(c)/ 316 301(d) 312(a), (b), (c). Applying the Code and Regulations in the correct order is critical. Whenever you are dealing with a distribution of property, the first thing you look at is 311. If the FMV of the land is $150,000 and the basis of the land is $60,000, the gain realized is $90,000, and that gain is recognized under 311(b).
97
Next, increase current earnings and profits under either 312(f)(1)(B) or (b)(1), but not both, by the amount of gain recognized by the corporation. Here, we increase current earnings and profits from $0 to $90,000. Thus, the consequence of the revaluation is to create $90,000 of current earnings and profits in the year the gain is recognized.
Third, determine the amount of the distribution under 301(b). Here, the amount of the distribution is $150,000 because that is the fair market value of the property received. 301(b)(1).
Fourth, determine the portion that is a dividend under 301(c). As a result of the distribution, the corporation now has $90,000 of current earnings and profits and $25,000 of accumulated earnings and profits, for a total of $115,000 of current and accumulated earnings and profits. Accordingly, $115,000 of the distribution is a dividend. 301(c)(1). The remaining $35,000 is a return of capital, which reduces Casey's basis in his Mudville Corp. stock from $60,000 to $25,000. 301(c)(2).
Fifth, determine the shareholder's basis in the property received in the distribution under 301(d). Here, the fair market value of the property received is $150,000, so Casey's basis in the property is $150,000.
Finally, we determine the effect on E&P after the distribution occurs. Under 312(a)(3), in conjunction with (b)(2), we decrease E&P by the fair market value of the property distributed. Notice that we turn to 312 twice. The first time we look at 312 is for the purposes of determining increases to earnings and profits. The second time we look at 312 is for the purpose of determining decreases to earnings and profits. If the SOL on Casey's return is closed, it affects our strategy. Likewise, if the SOL is open, it affects our strategy. This raises a tax conflict between Casey and the Corporation. The basis of the property distributed reflects the amount of the dividend plus the basis that migrated from stock to the property distributed. 301(d). FMV may be different for purposes of 311(a), (b) than for purposes of 301(b) and (d). This is due to discounts for lack of marketability as the result of owning a minority interest.
Step 1: 311(b) M Corp. recognizes $90,000 gain. If the corporation distributes depreciable property to its sole shareholder, the gain will be characterized as ordinary pursuant to 1239. Step 2: Under 312(f) or 312(b)(1), but not under both, we increase current E&P by $90,000 98
Step 3: Determine the amount of the distribution. Under 301(b) the amount of the distribution equals the fair market value of the property, which equals $150,000 Step 4: 301(c)/316 Step 4A: $115 E&P ($90,000 of current E&P, and $25,000 of accumulated E&P = 301(c)(1) dividend in the amount of $115. Step 4B: Apply 301(c)(2)/(c)(3) to the remaining $35,000. Step 5: Apply 301(d) to determine Casey's basis in the land, which is the fair market value of the property received in the distribution. Step 6: Apply 312(a)(3) and (b)(2) to reduce E&P, but not below zero. As a result of the distribution, we increased E&P under 312(b)(1) or (f) by the amount of gain recognized to the corporation under 311(b) from $25,000 to $115,000. If we decreased E&P by the fair market value of the property distributed, we would have $35,000 accumulated E&P as of the beginning of Year 2; however, 312(a) says "the earnings and profits of the corporation (to the extent thereof) shall be decreased . . . " so we cannot reduce E&P below zero. Thus, accumulated E&P as of the beginning of Year 2 = $0 What if there were $250,000 of accumulated E&P at the time of the distribution? Step 1: 311(b) M Corp. recognizes $90,000 gain. If the corporation distributes depreciable property to its sole shareholder, the gain will be characterized as ordinary pursuant to 1239. Step 2: Under 312(f) or 312(b)(1), but not under both, we increase current E&P by $90,000 from $0 to $90. Step 3: Determine the amount of the distribution. Under 301(b) the amount of the distribution equals the fair market value of the property, which equals $150,000 Step 4: 301(c)/316 Step 4A: $340 E&P = 301(c)(1) dividend in the amount of $150,000. Step 4B: This step does not apply. Step 5: Apply 301(d) to determine Casey's basis in the land, which is the fair market value of the property received in the distribution. Step 6: Apply 312(a)(3) and (b)(2) to reduce E&P, but not below zero. $340 - $150 = $190. Tuesday, October 12, 2010 Distributions Of Encumbered Property: 2(a) Grand Teton Real Estate Development Corp. has no accumulated or current earnings and profits through December 31st of the current year. On December 31st Grand Teton distributes to Ricardo, its sole shareholder a parcel of land with a basis of $90,000 and a fair market value of $190,000, subject to a mortgage of $140,000, which Ricardo assumed. Step 1: Apply 311(b). Tax consequences to the corporation$100k gain. FMV $190,000 - AB $ 90,000 Gain $100,000
99
The mortgage is reflected in the amount realized. If the corporation had sold the property in an arms length transaction to Ricardo pursuant to a contract under which Ricardo assumed the mortgage, how much cash would Ricardo pay? $50,000. In a sale transaction, the amount realized is the sum of the amount of cash paid plus the amount of the debt assumed. 311(b), which says "gain shall be recognized to the distributing corporation as if such property were sold to the distributee at its fair market value," accounts for the mortgage. So all $100k gain is realized & recognized. Summary of steps 3 through ..Under 301(b) the distribution amount is equal to the FMV of 190 minus the mortgage assumed of 140... = 50k. So, under 316 and 301(c)(1) the dividend is equal to 50; pursuant to 312(a) and (b) we reduce the E&P by 50 (the amount of the distribution); but we actually get to that number by going through 311(a), (b) & (c) say we reduce E&P by the FMV of the property (190) minus the mortgage assumed (140) = reduction to E&P is 50. Reg. 1.301-1(b) tells us to go to read 357(d)mortgage is treated as assumed by transferee only if these conditions are met (requiring that the transfree on basis of facts/circumstances has agreed to pay the debt and is expected to satisfy the liability; special rule for nonrecourse debt in 357(d)(2).
Step 2: Under 312(f)(1)(B) or (b)(1), but not both, adjust current E&P upward to reflect the gain recognized by the corporation on the distribution. Here, the corporation recognized $100,000 of gain, so current E&P is increased by $100,000. Step 3: Determine the amount of the distribution under 301(b). Under 301(b)(2), the amount of the distribution is $50,000, the fair market value of the distribution ($190,000) reduced by the amount of the liability ($140,000) assumed or to which the property was subject immediately before and immediately after the distribution. The economic benefit conferred on the shareholder is the measure of distribution. Step 4: Turn to 301(c) to determine the amount of the distribution that constitutes a dividend, return of capital, and/or gain. Here, the amount of the distribution is $50,000, and the corporation has at least $100,000 of current earnings and profits, so all $50,000 of the distribution constitutes a dividend under 301(c)(1). Step 5: Determine the basis of the property received in the distribution under 301(d). Here, the fair market value of the property received is $190,000, so the basis of the property received is $190,000. Conceptually, this is the correct result because under Philadelphia Park the basis of property received in a taxable exchange is the basis of the property given up ($0), plus the gain recognized ($50,000), plus the amount of any liabilities assumed ($140,000). This is the correct theoretical result because it treats a shareholder who receives a distribution of encumbered property in the same manner as a taxpayer who receives encumbered property in a fully taxable exchange of property, e.g., the receipt of land in exchange for publicly traded stock. 100
Step 6: Reduce earnings and profits under 312(a)(3), (b)(2), and (c). The first place we look is 312(a)(3) and (b)(2), which tells us to reduce E&P by FMV of the property distributed. 312(c) says that a "proper adjustment" shall be made. Treas. Reg. 1.316-2 interprets "proper adjustment" to mean that the reduction to earnings and profits under 312(a) or (b) to reflect the distribution should be reduced by the amount of the liability. Thus, you reduce the reduction that would otherwise be made under 312(a)(3) and (b)(2) (i.e., the fair market value of the property distributed) by the amount of the liability. Thus, the corporation would reduce its earnings and profits by $50,000, the $190,000 fair market value of the property minus the $140,000 mortgage. As a result, the corporation commences the next year with $50,000 of accumulated earnings and profits ($100,000 current earnings and profits - $50,000 distribution).
Step 7: What is Ricardos basis in the property? Ricardos basis in the land is FMV of 190k. If Ricardo has dividend of 50k, how does he get 190k basis? Its b/c he has to pay the debt of 140k. Conceptually 301(d) basis of FMV of property equals the amt taken into account in 301c (dividend income, plus any debts assumed) (b)(1) What if the mortgage was a nonrecourse mortgage and Ricardo took the property subject to the mortgage but did not expressly assume the mortgage? Reg. 1.301-1(g) provides that the amount of indebtedness encumbering distributed property will reduce the amount of the distribution under 301(b) only to the extent that the shareholder assumes the debt within the meaning of 357(d). So, if the debt hasnt been assumed; the amount of the distribution remains to be $190 (notice the risk to the SH if the corp fails to pay on the mortgage; this is assumed not to happen b/c will only really happen when the SH has control of the corp). So, only gain of 100 for the corp. The amount of the mortgage has no effect on the amount realized by the corporation. If the property is transferred subject to a debt that is recourse as to the corporation and the shareholder does not assume the mortgage, the amount of the distribution is the FMV of the property. Same answer as before. Notice, if the SH doesnt assume the debt the E&P reduction is the full 190 b/c there is no adjustment under 312(c) appropriate. (b)(2) What if the non recourse mortgage was $200,000? 311(b)(2) says rules of 336 shall apply that the fair market value of the property for purposes of determining the amount of gain recognized by the corporation cannot be less than the amount of the liability. So, the FMV has to be treated as the full $200k.
101
FMV Mtg. AR Basis Gain
$190,000 $200,000 $200,000 $ 90,000 $110,000
What is the reason for this rule? This is a Tufts & 7701(g) taxable transaction. If we use the assumption that the debt of 200 was the original purchase price & nothing has been paid on that; to get down to 190 wed have to assume that there was 10k of debt relief . another perspective, that the prop was purchased for 90; the corp borred 200 on the property. The property has now fallen in value... the 200k has been tax free so far, but now that the expectation of paying back has been removed b/c of the debt relief we have to account for the 110k. (check this logic)? Whenever property subject to a nonrecourse mortgage is transferred, the amount realized includes the amount of the liability to which the property is transferred subject. What is the amount of the distribution? $0 [FMV of property received (190) debt assumed (200) = amount of distribution (not below zero)] What is the basis of the property? If the amount of the distribution is $0, there is no distribution, so 301(d) does not apply. This is a purchase/sale transaction, so Ricardo's basis is determined under 1012. Why is this a sale? When we are trying to determine what is a dividend under 3011.301-1(c) explains that whatever is transferred to the SH msut be transferred by reason of the person being a SH in the corporation (ie, not by reason of being an EE or a lender or a purchaser). Here, there is no downside to this transactionb/c the mortgage is nonrecourse, he can just walk away. We need to figure out what makes this transaction not a transaction that only could occur btwn the corp and the SH?!?! Could the officers of the corp, w/out consent of the SH & w/out consent of BOD, deed a piece of real estate w/ FMV 190 subject to mortgage of 200 to an individual? Yes! That is smart! Such an action is really only a sale/purchase transaction. What is the dollar amount of the SHs basis if it were a distribution? $190 (b/c 301(b) controls basis). Why does 336(b) not make the FMV of property 200 for purposes of 301(b)? 311(b)(2) invokes 336(b) for purposes of 311(b)(1)... but 336(b) limits its application to 336(a) and 337. If it is a purchase/sale situation then we get the basis from 1012. (didnt cover in class) 2(c) What if the $190,000 mortgage was a recourse mortgage and Ricardo took the property subject t othe mortgage bud did not expressly assume the mortgage? Since the s/h didnt assume the debt, we dont have to reduce, and the amt of distribution is 150k.
102
To determine assumtion 301.1-(g) directs us to 357(d), which tells us that recourse liab is treated as assumed if s/h agreed to and is expected to assume the responsibility of paying the mortgage 3(a) At a time when Bassamatic Corp. had accumulated earnings and profits of $140,000 and during a year in which it had no current earnings and profits from operations, Bassamatic Corp. distributed to Yuan, its sole shareholder, land having a basis of $130,000 and a fair market value of $100,000. (1) How much loss may Bassamatic Corp. recognize? Basis $130,000 FMV $100,000 Loss $ 30,000 Accumulated E&P = $140,000 Step 1: Under 311(a)(2), the amount of the loss is not allowed. This is an asymmetrical rule only gain is recognized to the corporation NOT the loss. Step 2: Apply 301(b) to determine the amount of the distribution (the FMV). The amount of the distribution equals $100,000. Step 3: Increase E&P by $0 (no gain, so no increase in E&P) Step 4: 301/ 316 the amount of the distribution that constitutes a dividend = $100,000 (b/c the amount of E&P is 140k) Step 5: 301(d) Yuans basis = $100,000 Step 6: Reduce E&P under 312 by $130k distribution to $10,000. ($140,000 - $130,000 (as provided in 312(a)(3) and 312(b)) = $10,000). If the accumulated E&P was only 100 then reducing E&P by the FMV would be a better answer than the basis. B/c if the corp sold the piece of property then it would realize & recognize the loss of 30k and then distribute the 100k to the SHif we could identify the date of the loss then we could reduce the E&P by 30 before determining the amount of the distribution. If you look at 312-7(b)(1) it tells us to reduce E&P by recognized losses that are disallowed (ex: loss that is realized & recognized but disallowed by 267 results in a reduction to E&P). So, if the propety had been sold to a related property and the loss (realized & recog) was disallowed, then wed reduce E&P by 30; leaving only 70 E&P... so only 70 of the 100 would be a dividend. Lesson: not always easy to read these all together. It only really matters if the E&P is really low. Generally it wont matter if you reduce E&P and then determine the dividend or if you reverse them.
103
The combination of 311(a) disallowing the loss and 301(d) giving the shareholder a fair market value basis vaporizes basis. Usually, basis is not vaporized without allowing a loss deduction. Note: Reg. 312-7(b)(1) would give you a double deduction against earnings and profits if read literally. But this produces a nonsensical result and nobody really argues this.
(not covered in class) 3(a)(2) What is the amount of the dividend to Yuan? What is Yuan's basis in the land? How much gain must Yuan recognize if Yuan later sells the land for $180,000? Basis $130,000 - AR $100,000 Loss $ 30,000 Yuan later sells for $180,000: AR - AB Gain realized Gain recognized $180,000 $100,000 $ 80,000 $ 80,000
Why does 311(a) disallow the loss? Here, there is a $30k loss that is vaporized. If it is a sale/exchange under 267, the gain recognized by Yuan would be offset by the disallowed loss to the corporation. Why the different result if the property is sold v. distributed? The large part of the reason is that in a sale, the SH has to actually lay down some cash in return for the property as opposed to the distribution situation where the SH receives property for nothing. Also, corporations could distribute loss property (when it suddenly falls in value) and then the loss could be shifted to the SH if 311(a) did not disallow the loss. In the case of a distribution of depreciated property, any loss realized by the corporation is disallowed by 311(a). Additionally, 267(d) does not apply, because a distribution of property is not a "sale or exchange" of property, as required by 267(d)(1). (not covered in class) (b) What would be the consequences if in (a) Bassamatic sold the land to Yuan for $100,000 and Yuan later sold the land for $180,000? See 267. What policy reason might there be for the answer being different than in (a)? If a sale is to a more than 50% shareholder, 267(a)(1) disallows any loss at the corporate level. But if the shareholder later sells the property at a gain, pursuant to 267(d) the gain will not be recognized to the extent of the previously disallowed loss. AR $180,000 - AB $100,000 Gain realized $ 80,000 104
Less Gain recognized
$ 30,000 267(d) $ 50,000
4(a) Omaha Wizard Corp. distributed to Warren, its sole shareholder, 200 shares of stock of Exxon-Mobil Corp., which it purchased on the New York Stock Exchange to hold as an investment. The fair market value of the stock was $100 per share. One hundred of the shares were purchased at $75 per share; the other 100 shares were purchased at $125 per share. Assume that Omaha Wizard Corp.'s accumulated earnings and profits exceed $1,000,000. What are the tax results to Omaha Wizard Corp. and to Warren? 200 shares total Basis ($20,000) FMV ($20,000) Gain/Loss 100 shares $7500 $10,000 $2,500 - 311(b) 100 shares $12,500 $10,000 ($2,500) 311(a)
Here there are two blocks of stock consisting of 100 shares each, acquired on different dates and for different prices. Accordingly, the amount of the distribution is apportioned to each block. This is simply an application of Treas. Reg. 1.1012-1(c). 311(a) applies to one block and 311(b) applies to another block. Reg. 1.1012-1(c) requires that you treat these block by block. Thus, there is gain recognition of $2.5k and a disallowed loss of $2.5k. So, the lesson here is that you cannot wipe out 311(b) gain by distributing loss property. Ws basis in the 200 shares is one 20k lump. What happens if the corporation distributes land with an A/B of $400k and a FMV of $2m and a building with an A/B of $3m and a FMV of $1.4m? The building is depreciable and the land is not. The gain on the land is recognized and the loss on the building is NOT recognized. The planning lesson here is that you must get a separate appraisals for the land and the building separately. Warren wants the value of the building to be high and the land to be low... the corporation wants the building to be low and the land to be high. Even if there is a valid business reason for wanting to dump the parcel/building is that if the corporation sells it to a stranger, the gain and loss will net out. But 267 will disallow this loss if sold to a shareholder. This will come up in redemption distributions. Warren takes a basis in the land of 2M and in the building of 1.4M. Remember: land & building are separate assets2 appraisals are necessary.
5. Ophelia owns 25 shares and Hamlet owns 50 shares of common stock in Elsinore Corp which has 75 shares outstanding and $45,000 of accumulated E/P. On 4/15, Elsinore distributes $70k cash to O and on 9/15, distributed land to Hamlet with an A/B of $50k and a FMV of $140k. What is the amount of the dividend received by each?
105
Timeline: 4/15$70 cash distributed to O. 9/15Property (FMV=140; basis=50) distributed to H. Accumulated E&P = 45. Step 1 apply 311(b) that results in $90k of taxable gain; becomes E&P as taxable income, and increases the Current E/P to $90k. Step 2 prorate the current E/P under Reg. 1.316-2(b) (second sentence if condition is not met in order to get to the then which specifies proration. General counsel memorandum applies proration by analogy to this situation where there is a property distribution w/out regard to the limitation that the distribution is only money.) So, 1/3 of the current E/P is allocated to Ophelia (30k) and 2/3 (60k) to Hamlet. Step 3 allocate the accumulated E/P on a FIFO method Thus, 40k allocated to Ophelia and the remaining 5k allocated to Hamlet. Thus, all of Ophelias $70k distribution is a dividend and Hamlets distribution will be divided into a $65k dividend and a $75k return of capital reducing the basis in his stock by the same amount. One might argue that the total $45k of accumulated E/P should be allocated proportionately according to their interests as shareholders just as the current E/P are allocated. But that is not what the Regulations provide and you would have to argue that the step transaction doctrine applies (b/c the two SH have maintained the same ownership in the corporation) in order to have it allocated that way. The question is what is the date of the distribution & what is the distribution! How can the corp make a distribution only to one SH in April and not the other? There must be an agreement btwn the two of them that they take out at different times... do we collapse them together? b/c we have no doubt that if they happened pursuant to the same directors resolution or on the same day, we would have allocated the accumulated E&P proportionately. This could be a problem if the two SH are in different tax brackets or one is foreign & the other domestic. The theme for Section 3 problems: things arent always what they seem... there may be another way to look at the problem. 6. if the corp distributes a promissory note w/ adequate interest (the applicable federal rate on a similar obligation) the dist will be the face amount of the note 1001-1(g). if there isnt adequate interest then we have to apply the original issue discount rules & discount the note backward at the applicable federal rate to determine how much money would have to be put in today in order to get 50k at the end of 20 years... The current dividend is only 20k, but every year that the bond grows in value there is another dividend although there is no cash.
Section 4. Disguised Dividends October 12, 2010 (Only problems #2 and #4)
106
Reg. 1.301-1(c) provides that any distribution to a shareholder in the capacity of a shareholder that is not excluded from dividend treatment under 301(f) will be taxed as a dividend. However, if the payment is made to a person in his or her capacity as an employee, for instance, is deductible as reasonable compensation under 162. What's at stake Distribution/Dividend
Corporation Individual
Payment to employee who is shareholder Deduction for corp. No Deduction to corporation Deduct as fringe benefit No consequences Includible in income by $10,000 compensation for individual individual shareholder, income taxable at 35% shareholder. taxable at 15% under 1(h)
Business Expense
Nothing in the IRC limits the preferential rate for dividends to formally declared dividends. (not covered in class) 1(a) Wolf and Stein are the shareholder of Mortal Doom Video Games Corp. Wolf owns 60% of the stock and Stein owns 40% of the stock. Mortal Doom is engaged in the design, manufacture, and sale of computer video game software. The corporation has over $20,000,000 of net assets and has 30 employees in addition to Wolf and Stein. Wolf is the vice-president and his salary is $1,200,000 per year. Stein is the president and his salary is $800,000 per year. The corporation had $3,000,000 of earnings and profits after payment of Wolf's and Stein's salaries. This problem raises the issue of whether we have a payment or a distribution to a shareholder. The compensation seems to match the stock ownership rather than the management responsibilities. This case would come to us in the form of a tax controversy, resulting from the IRS asserting that the salary of either or both is unreasonable compensation. How do we determine whether this was for compensation for services rendered or a distribution with respect to the stock? We need to ask questions. Recharacterization of purported compensation as dividends of necessity turn on the particular facts of each case. Although there are many formulations of the relevant factors, the following are among the most frequently enumerated: (1) the extent and importance of the shareholderemployee's role in corporate management; (2) the comparability of the purported compensation with that paid to employees performing similar services for other employers; (3) the size, complexity, and economic condition (profitability) of the corporate business; (4) the relationship of the purported compensation to shareholdings (e.g. proportionality); and (5) the corporation's dividend policy. See Elliotts, Inc. v. Comm'r., 716 F.2d 1241 (9th Cir. 1983), in which the court also considered whether the corporate profits remaining after paying the purported compensation would provide an acceptable rate of return to a hypothetical investment in the corporation's stock by an outside investor. 107
One of the first questions we need to ask before we can evaluate whether the salaries were out of line is what do they do for the company? For instance, is Stein the president of 2 companies? Reg. 1.162-3 make clear that you can have contingent compensation contracts that turn out to pay more than expected, but the formula used under the contracts must be reasonable itself. Note also in 1.162-7 dealing with bonus packages that bonus package contracts should be written in advance. What are people with the same education, skill, and experience getting paid by others in the market? There are $3,000,000 of profits. Wolf and Stein got paid $2,000,000 together. That means there was $5,000,000 before salaries. The question is would an independent investor be willing to accept the return on investment? The return on capital is 15% if you treat the capital as the $20,000,000 in net assets. On the other hand, if Wolf and Stein had taken out $5,000,000 in salary and bonuses, then that would look quite suspicious because an independent investor would not be willing to accept a zero return on its investment. There is another reason that we know the corporation has to have some profits. This is a manufacturing company, so there is a lot of income attributable to invested capital. Thus, unlike lawyers, doctors, or accountants, whose incomes are attributable to their personal services, most of this corporation's income is attributable to yield from capital. What if six doctors incorporate their practice and hire ten nonshareholder physicians, ten nurses, and two physicians assistants, are they in a position to zero out their corporate earnings? If the corporation has employees, some of the profit is attributable to their efforts, so if the corporation zeros out the corporate earnings, or are they in a position where if they zero out the corporate earnings, then a portion of that will be recharacterized as constructive dividend. The problem is that a portion of the corporate earnings is attributable to the billings of the time of the nonshareholder physicians and nonshareholer physician assistants. Therefore, since those people are employees of the corporation, there ought to be a corporate profit realized from the employment of those people for whose time the corporation can bill. This is different from pure support staff, whose costs are incorporated into the billing rates of the professionals. Is it impossible to have a constructive dividend if the company is publicly traded? No. See Ireland v. U.S., 621 F.2d 731 (5th Cir. 1980). Ireland is a good example of payments that are deductible by the corporation and confer a benefit on the shareholder.
108
2. Ponzi & Company, Inc., an investment banking firm in New York owns a working horse farm in Lexington, Kentucky. Carla Ponzi, who owns 80% of the stock, and her family have the exclusive use of a mansion located on the horse farm when they visit Lexington during racing season, which is all of April and October. Last year the corporation deducted $48,000 depreciation on the mansion, paid real estate taxes of $12,000 (attributable to the mansion apart from the working farm), and paid utilities and repair bills for the mansion of $24,000. Carla works full-time in the corporation's investment banking business, but performs no services with respect to the horse farm business of the corporation, which is left entirely to a professional manager. Constructive dividend: any expenditure by the corp that gives an economic benefit to the SH unless the expenditure has primary (not merely incidental) benefit to the corp. NB: you must have E&P to have a constructive dividend. Benefits conferred on a SH dont have to be received in proportion to shares in order to be a disguised dividend. If they are in proportion to shareholding it still may be treated as disguised dividendsmost common here is excessive compensation (a temptation under 162(a)(2) deduction for reasonable compensation). Many expenditures will not be cash but will still be constructive dividendsex: Ireland case. Often you have to cave on certain issues. Note that dividends can be received in the form of mere use of property not the title to the property itself. The bad fact here is that Carla does not have anything to do with the horse business that means she is there for personal reasons nonrelated to the corporations business at all. If she is there for the primary benefit of the corporation with only incidental personal benefit, then it will not be a constructive dividend. She wasnt performing services while she was living in the house so it wont be considered lodging for the convienance of the ER (section 119). The crucial question in the event of a constructive dividend would be the amount of the distribution and whether the fair market value approach (the fair rental value) or the total cost approach (the amount of the actual expenditures) should be used in valuing the dividend. Here, the total cost is $84,000 which amounts to a $7k/mo. cost. If we conclude that she must include $14k in income, the corporation loses the same amount in deductions. Ireland: if the rental value is more than the allocable expenditures it will assert the rental value at the SH level while disallowing the expenditures at the corporate level. If Carla can prove that the rental value is lower than the valued amount then the amount of the dividend will be the rental value. Cerelli case: standard used is corporate expenses are a proxy if no one can determine the valuation. Remember: the TP has the burden of proof on valuation. Under 7491 the TP can only shift the burden of proof w/ adequate records... keep adequate records. 109
This raises the question of whether and how much of the costs should be apportioned to her. To determine whether the costs need to be prorated we need to know whether she was the only one who used it. Here, we need more facts, such as how the mansion was used when it was not being used by Carla, and any comparables available for purposes of determining the fair rental value of the mansion. On other facts, you would also want to consider the argument that the primary beneficiary was the corporation. Here, we know that Carla did not participate in the horse business, so we could not argue that her use of the mansion was for the benefit of the corporation's horse business. When it gets egregious, deducting expenses at the corporate level and not including them in income at the shareholder level will result in free room and board courtesy of the U.S. government. The other situation is where there is a diversion of corporate profits. (briefly discussed in class) 3. Augie owned 100% of the stock of Dog's Breath Saloon & Brew Pub Corp., which has more than $200,000 in earnings and profits. Dog's Breath made a $100,000 interest-free loan to Augie on July 1, 2006. The loan was represented by a promissory note and was for a 10 year term, but was unsecured. The applicable Federal rate on July 1, 2006 was 5%. Assume that the net present value of the $100,000 obligation, discounted at the AFR was $61,000. Loans raise significant issues. Was there a real expectation of repayment? If no, then there may be a dividend. Below market rate loans are a problem. Also consider bargain transactions (any time the corp overpays, services /sales of goods / rentals, a SH relative to what the SH transferred to the corp there is a constructive dividend). The first question is whether there was a reasonable expectation of repayment and an intent to enforce? If the purported loan is not a true loan, the dividend would be all the cash received. In deciding whether the loan was a true loan, the test is the same as the test for debt v. equity. Assuming the loan is a true loan, the second question is whether the loan bore adequate interest, as compared to the interest paid on treasury obligations for a similar term. 7872 tells us that where there is a below market loan, you have to discount the prinicipal amount to net present value using the applicable federal rate.
110
Here, the net present value of $100,000 payable in 10 years, discounted 5% is approximately $61,000. Therefore, Augie has a $39,000 dividend distribution; that was the value of the benefit conferred on him at the present time. The loan is treated as an OID obligation. Thus, Dog's Breath would have interest income each year from Augie, and Augie is treated as paying interest each year to the corporation at 5%. Augie might or might not get a deduction. We need to know what Augie did with the $100,000. If Augie took the money and bought a car, the interest payment would be treated as nondeductible personal interest payment. If Augie bought an interest in a real estate LP, the deduction is limited by the passive activity loss rules of 469. And if Augie invested it in the stock market, then the deduction is limited by 163(d). What this does is prevent the corporation from getting around the double tax by making an interest free loan to the shareholders. (not discussed in class) 4. Kenny owns 100% of the stock of Outron Energy Corporation. Outron has millions of dollars of earnings and profits. Last year Outron sold Kenny and oil well for $1,000,000. Within days Kenny sold the oil well to a major oil company for $3,000,000. Has Outron made a dividend distribution to Kenny? What is the amount, if any, of the dividend? This is a disguised distribution of appreciated property and thus constitutes a constructive dividend to Kenny. Here, you have $2,000,000 of 311(b) gain to the corporation, and Kenny has a $3,000,000 dividend distribution ( 301(b)(1)), not a purchase. Under current law, dividend treatment may be good for Kenny because, even though the amount of the distribution is $3,000,000 pursuant to 301(b)(1), that $3,000,000 will be taxed at the preferential rate of 15 under 1(h), and under 301(d) Kenny will get a stepped-up basis equal to fair market value, or $3,000,000. In contrast, if the transaction is taxed as a sale by the corporation of the oil well to Kenny for $1,000,000, followed by a subsequent sale by Kenny for $3,000,000, Kenny will realize and recognize $2,000,000 of short-term capital gain. In controversy work, one of the questions you have to ask is whether the statute of limitations has run on either the shareholder or the corporation. When the IRS comes and hits the corporation for 311(b) gain, if you don't advise Kenny to file a refund request, and the SOL has expired on filing a refund request, call your malpractice carrier. On the other hand, you have to recognize that there is a conflict of interest in advising Kenny to file a refund request because that will put you in the position of either having to advise the corporation to pay the deficiency or assert that there was a good sale and that there was not a distribution.
111
(not discussed in class) 5(a) George owns 60% of the stock of the Lone Star Pharmaceutical & Brewing Corp; the other 40% is owned by Dick, who is unrelated. In 2006, when it had accumulated earnings and profits of $1,000,000, Lone Star granted to George's daughter, Jenna, who owned no stock, an option to purchase one of its breweries for $750,000. Jenna paid $10 for the option. At that time the fair market value of the brewery was $750,000. The option was exercisable any time during the next three years. In 2008, Jenna exercised the option at a time when the value of the brewery was $1,300,000. At that time the corporation had $500,000 of earnings and profits. At the time when the option was granted, the strike price was equivalent to the fair market value of the brewery, but in 2008 the option price is below fair market value. It's pretty clear that if the brewery was worth $1,300,000 and George caused the corporation to sell the brewery to Jenna for $750,000, there is a dividend in the amount of $550,000 by virtue of the bargain purchase to George, followed by a gift to Jenna. Nothing changes here. Rather it is a bargain sale of the option. The dividend is the fair market value of the option, less $10. If we represent George we want to find comparables that say the option should have been $50,000 or $60,000. If we cannot find comparables, then the government trots out Baumer and argues the open transaction doctrine applies, in which case the amount of the dividend would be the fair market value of the property at the time the option was exercised, minus the sum of the amount paid to acquire the option plus the amount paid to purchase the property upon exercise of the option. $1,300,000 - 750,010 $ 549,990 (not discussed in class) (b) What if the corporation had only $200,000 of total earnings and profits in 2006? (not discussed in class) 6. Jeff owns 100% of the stock of Jeff's Reliable Used Car Corp. and Jeff's Friendly Finance, Inc. Jeff's Reliable Used Car Corp. was caught rolling back odometers and was fined $10,000 as a result of prosecution by the State. Because Jeff's Reliable Used Car Corp. was short of cash, the fine was paid with a check drawn on Friendly Finance, Inc. Might there be a constructive dividend to Jeff? What additional evidence must be developed in order to be certain? The law treats the payment from finance is a dividend to Jeff and a contribution to the capital of used cars. If used cars goes under, then finance goes under, so it is in finance's interest to keep used cars afloat and that Jeff's benefit was merely incidental. The purpose of the dividend received deduction under 243 is to avoid cascading double taxation. 112
When a corporation owns 80% of the voting power and 80% of the value of another corporation, the tax law tries to minimize the tax consequences of transaction between them. 243(c) says that in the case of a "20 percent owned" corporation Under 243(c)(2), "20 percent owned" means 20% or more. Whenever you see "20 percent owned" check to see if that means 20% or more or at least 20%. Until 1987, there were only two dividend received deductions: the 80% received deduction if X owned less than 70%, and 100% deduction if the corporation owned 80% of the voting stock and 80% of the value of the subsidiary. 246(c) The declaration date is the date on which the BOD declares the dividend. Record date is the date on which the corporation looks to its records to determine the shareholders entitled to the dividend. Ex-dividend date - 3 days before the record date is the date on which the stock trades exdividend. 1059 A dividend is extraordinary in amount if it is more than 10% of the basis in the stock in any 85 day period. Public corporation's pay dividend's quarterly, so you are aggregating basis just short of quarterly. 1059 kicks in only if the stock was not owned 2 years before the "announcement date." Any dividend that is a dividend by virtue of a stock repurchase or a redemption that flunks 302, is automatically an extraordinary dividend.
Stock REDEMPTIONS Thursday, October 14, 2010 317(b) defines "redeem." Notice 317(b) says "for purposes of this part." This part means 301-318. Repurchased means the stock remains issued but not outstanding. After the stock is redeemed, we dont care what the corp does with the stock (it may be cancelled). 302(a) 302(a) is the primary operative rule of 302. o 302(a) says that a redemption shall be treated as" a distribution shall be treated as in part of full payment in exchange of the stock." (treated as a sale/exchange 1001) 302(a) does not unambiguously state that it is dealing with the shareholder's side, but 302 is in sub-part I, which deals with the affects on recipients. o 302(a) says if you past the test in 302(b), go to 1001, but if you flunk any of the tests in 302(b), go to 301. 113
o 302(d) says that if 302(a) doesnt control the redemption, go to 301. o Why would the SH rather have 302 instead of 301? b/c under 302(a) SH gets capital gain or loss (unless the stock is held by a dealer in stock) after recovery of basis (which is tax free). Under 301 assuming there is E&P SH gets dividend treatment (ordinary income). NB: if the tax rate is the same on the ordinary income and the capital gain, the difference is the recovery of basis or the recognition of a loss. If the SH is a corporation, the same differences apply as above... but also corp SH gets a 243 dividends received deduction. So for the corp SH dividend treatment may be preferable. Also think about 301 and 316 in connection with 243 (taxes deferred long enough are taxes forgiven)...?? 302(b) 302(b) provides 4 tests: if any one of these tests is met then go to 302(a). 302(b)(1) 302(a) applies if the distribution is "not essentially equivalent to a dividend" 302(b)(2) if the redemption is "substantially disproportionate" o Essentially a two part test: Less than 50% of the voting power, 302(b)(2)(B) and , Less than 80% of pre-redemption voting power. 302(b)(2)(C). Always make sure your calculator is set to at least two decimal points because if the calculator rounds the numbers, you can easily blow the test. Remember to subtract the number of shares redeemed from the total number of shares outstanding (the denominator) as well as from the number of shares owned (the numerator). o This is a mechanical test; it is easy b/c you can confirm it arithmetically o NB: attribution rules of 318 apply here 302(b)(3) "complete termination" of the SHs interest o 302(c)(1) invokes the attribution rules of 318 for 302 o 302(c)(2) says that "family attribution rules" may be waived if certain conditions are met. A complete termination where there is no attribution issue always meets 302(b)(2), unless the stock was nonvoting stock. Thus, the juice in a complete termination lies in the waiver of family attribution under 302(c)(2). 302(b)(4) "partial liquidation" (not discussed in this context) o This test is analyzed from the corporation's side of the transaction. Corporation: 311(b) is triggered not only by distributions of appreciated property but also redemptions of appreciated corporate property.
114
1(a)(1) As of January 1, 2006, Julia, Charlene, Mary Jo, and Suzanne each owned 25 of the 100 outstanding shares of voting common stock of Sugerbaker's Design Corp. Suzanne's basis for her 25 shares, which she had acquired directly from the corporation for cash over ten years ago, was $80,000. Sugerbaker's had $120,000 of accumulated earnings and profits as of January 1, 2006. During 2006, Sugerbaker's had no current earnings and profits from operations. On July 1, 2006, Sugerbaker's distributed a parcel of land to Suzanne in consideration of Suzanne surrendering her 25 shares of common stock. The land had an adjusted basis to the corporation of $90,000, and a fair market value of $150,000. What are the tax consequences to Suzanne and Sugerbaker's? What are Sugerbaker's accumulated earnings and profits as of January 1, 2007? Julia 25 voting common Charlene 25 voting common Mary Jo 25 voting common Suzane 25 voting common, basis = $80,000 $120,000 accumulated E&P as of Jan 1. $0 E& P from operations July 1 distributes land with a basis of $90,000 and an FMV of $150,000 in exchange for Suzannes 25 shares of stock. First determine the consequences to the corporation under 311(b). o We start at the corporate level because we know that 311(b) applies, so we can determine the effect on E&P even if the distribution flunks 302(b). There is a $60,000 gain under 311(b)(1) (FMV of land = 150 less A/B = 90) b/c there is a distribution of appreciated property. Next, increase E&P under 312(f) or (b)(1) to $60,000. (this E&P can support dividends distributed to the other SH! So when you have a distribution of appreciated property to one SH remember that that E&P may support dividends to the other SH). Go to 302(b)(3) which sends you to 1001 Amount Realized $150,000 Less: Basis in Stock $ 80,000 $ 70,000 LTCG o When property is received in a distribution that passes 302(b), the distributee takes a cost basis in the land. So, under 1012 Ss basis in the land is $150,000. Finally, decrease E&P. o (Old rule) Rev. Rul. 70-531: First, the distribution is treated as a return of paid-in capital attributable to the redeemed stock on the corporation's books. If the amount of the redemption distribution exceeds the corporation's paid in capital with respect to the redeemed stock, earnings and profits are then reduced. o However, 312(n)(7) provides that the portion of the distribution chargeable to earnings and profits cannot exceed the ratable share of the earnings and profits attributable to the redeemed stock. The RR 70-531 above is based on 312(e) which is now repealed. So, the above RR 70-531 is not what controls - 312(n)(7) controls. 312(n)(7) sets a ceiling on the amount charged to earnings and profits.
115
Acc E&P of 120. Current E&P of 60. The maximum amount of the reduction in E&P is going to be 45 (1/4 x 180). The question here is what does accumulated mean? Does it mean up to the end of the year or what has been identifiably earned up to the date of distribution? So, how do we deal w/ the 60 E&P created by the distribution of the property? It is all a question of timing... Of the $150,000 distribution: $80,000 is charged to capital. $45,000 is charged to earnings and profits (total E&P reduced by % of stock redeemed here 25% x $180k = $45k). $25,000 is unaccounted for tax purposes. o The $25,000 is not charged to anything because it represents $25,000 of unrealized appreciation. This problem requires a redemption followed by distributions in excess of the minimum conceivable amount of E&P. (very specific & unusual) For these questions: learn to think backwards. If told what the client wants, how would you plan the redemption/distribution/dividend? 1. Champion Breakfast Drink Corp. has 100 shares of common stock and 200 shares of nonvoting preferred stock outstanding. Dwayne owns 70 shares of common stock and Kilgore owns 30 shares of common stock. Kilgore also owns 100 shares of nonvoting preferred stock. Which, if any, of the following alternative redemption transactions qualify under 302(b)(2), and what are the tax consequences of each transaction? Kilgore: 30 common stock/100 common stock 100 nonvoting preferred stock/200 nonvoting preferred stock 70 common/100 common 0 preferred / 200 preferred
Dwayne:
(a) Champion Breakfast Drink Corp. redeems 5 shares of common stock from Kilgore for $5,000. Kilgore's basis in his 30 shares was $900 per share ($27,000 total). 302(b)(2)(B)Immediately after the redemption, Kilgore owns 25 shares of 95 shares common stock issued and outstanding. Therefore, immediately after the redemption Kilgore owns less than 50% (which is 47.5 shares) of the total combined voting power of all classes entitled to vote. Thus, the limitation of 302(b)(2)(B) does not apply so move on to (C). 302(b)(2)(C) For purposes of this paragraph, the distribution is substantially disproportionate if (i) voting stock of the corp. owned by the SH immediately after redemption all voting stock of the corporation immediately after redemption is less than 80 % of (ii) voting stock of the corp. owned by the SH immediately before redemption all voting stock of the corporation immediately before redemption 116
Shareholder Kilgore
After Redemption 25 95 26%
Test Percentage 80% x 30% = 24% > 80% x
Before Redemption 30 100 30%
Is the percentage of stock owned afterwards less than 80% of the percentage of stock owned before? No. (In the real world you would go to 302(b)(1) next.) So, 302(a) does not apply and 301 does apply. Under 302(d), the transaction is treated as a 301 distribution, i.e., a $5,000 dividend assuming sufficient E&P. What happens to the adjusted basis of the stock redeemed since no recovery? If a redemption fails to qualify for exchange treatment under 302(a) and the distribution is a dividend, the basis of the redeemed stock is not relevant in computing the shareholder's income. Under Reg. 1.302-2(c), the basis of the redeemed stock gets added to the basis of the other stock held by the taxpayer. If the taxpayer does not actually own any other stock after the transaction, but is attributed stock in the corporation by, for example, family attribution rules under 318, then Treas. Reg. 1.302-2(c) Ex. 2 suggests that the taxpayer's unrecovered basis in the stock shifts to the family member who actually owns the stock. (b)(1) CBDC redeems 10 shares of common stock from Kilgore for $10,000. Kilgore's basis in his 30 shares of common stock was $900 per share ($27,000 total). 302(b)(2)(B) o Kilgore passes 302(b)(2)(B) because he did not have more than 50% before or after the transaction. 302(b)(2)(C) After Redemption 20 90 22.22% Before Redemption 30 100 30%
Shareholder Kilgore
80% x 30% = 24% < 80% x
We don't have to test Kilgore's ownership of the preferred stock because the flush language of 302(b)(2)(C) only applies if there are multiple classes of "common stock." This is now treated as an exchange under 302(a) and is treated as an exchange under 1001. AR = 10k; A/B = 9k (900 x 10). 10k 9k = Gain of 1k LTCG
(2) What if Kilgore's basis in his 30 shares of common stock was $1,200 per share ($36,000 total)? Now you have a $2k long term capital loss.
117
267(b)(2) has a 50% value test to determine control, if 50% owned then loss is disallowed. So, 267 might deny that loss because even though Kilgore is not related to this corporation which requires more than 50% of vote. Here, Kilgore owned not only the 30 shares of common stock but also 100 shares of nonvoting preferred stock which may push him over the 50% value limit and into the 267 disallowance rule. We need more facts. If he wants to make sure to have the loss think about redeeming preferred stock with the common stock (redeeming preferred wont remove his upside potential). (c) CBDC redeems 35 shares of common stock from Dwayne. Although Dwayne would pass the 80% test under 302(b)(2)(C), Dwayne fails 302(b)(2)(B) because immediately after the redemption he still owns more than 50% of the total combined voting power of all classes of shares entitled to vote. Dwayne still owns 35/60 shares entitled to vote which is greater than the 50% threshold of 302(b)(2)(B). You can have a much more dramatic drop in ownership by a majority shareholder that does not qualify as a redemption than is required by a minority shareholder b/c of the 50% total combined voting test. Dwayne has given up a meaningful share of growth, but he has not given up a meaningful share of control. In 302(b)(2)(B), Congress has decided that, not only must a shareholder give up a meaningful share of the growth, but also that a shareholder must give up a meaningful share of control. It's a policy decision that control is in and of itself something that is valuable. (d) CBDC redeems 40 shares of common stock from Dwayne. Dwayne still fails 302(b)(2)(B) because immediately after the redemption he does not own "less than 50 percent of the total combined voting power of all classes of shares entitled to vote." He also fails 302(b)(2)(C) Shareholder Dwayne After Redemption 30 60 50% Before Redemption 40 100 40%
80% x 40% = 32% > 80% x
Here, Dwayne went from having sole control of the corporation to a deadlock position. So, this may be significant when testing the distribution under 302(b)(1) because that is a fact and circumstances test. The change in ownership is dramaticargue under 302(b)(1). Rev Rul 77502 deals with this fact pattern. (e) CBDC redeems 50 shares of preferred stock from Kilgore. Treas. Reg. 1.302-3(a) states that "Section 302(b)(2) only applies to a redemption of voting stock or to a redemption of both voting stock and other stock. Section 302(b)(2) does not apply to the redemption solely of nonvoting stock (common or preferred)." 118
o Under Treas. Reg. 1.302-3(a), a redemption of either common or preferred nonvoting stock may qualify under 302(b)(2) only if there is a simultaneous redemption of voting stock. A redemption of non-voting stock (preferred or common) alone may not qualify under 302(b)(2); such a transaction is governed by 302(b)(1) and 302(b)(3). Redemptions of nonvoting stock are not within 302(b)(2) because the shareholder does not reduce voting power.
302(b)(2) requires a redemption of voting stock. Notice also that 302(b)(3) would not apply because it requires a complete redemption of all classes of stock, not just one class. The redemption of nonvoting preferred stock, standing by itself, is relegated to 301 distribution rules. (f) CBDC redeems 15 shares of common stock and 50 shares of preferred stock from Kilgore. If a corporation redeems sufficient voting stock from a shareholder to meet 302(b)(2), a redemption of nonvoting preferred stock which is not 306 stock in the same transaction also qualifies as an exchange. Reg. 1.302-3(a). See Treas. Reg. 1.302-3(a) ("However, if a redemption is treated as an exchange to a particular shareholder under the terms of section 302(b)(2), such section will apply to the simultaneous redemption of nonvoting preferred stock which is not section 306 stock) owned by such shareholder and such redemption will also be treated as an exchange.").
(g) CBDC redeems 15 shares of common stock and 90 shares of preferred stock from Kilgore. We can piggyback the redemption of nonvoting preferred stock on common stock redemption. Does the percentage of the common stock redeemed determine the percentage of nonvoting preferred stock that can be piggybacked? Notice the regulation only talks about "nonvoting preferred stock." And it is silent as to how much may be piggybackedthere is no guidance about percentages. No matter how many shares of nonvoting preferred stock have been redeemed, the shareholder's ownership of the corporation has changed so much (because of the redemption of voting stock) that the number of nonvoting preferred shares that are redeemed does not matter. Any amount of nonvoting preferred stock can be piggybacked. Following questions: specific issues with 302(b)....
119
2. Titan Siren Corp. has 100 shares of voting common stock outstanding. Malachi owns 60 shares and Winston owns 40 shares. They have both worked full time for the corporation. On February 1, Malachi went into semi-retirement, leaving most management to Winston, and Titan Siren Corp. redeemed 30 of Malachi's shares. On August 1st, Winston died and Malachi went back to work; in December, the corporation redeemed all of Winston's shares from his estate. Does Malachi's redemption qualify under 302(b)(2)? M: 60 of 100. W: 40 of 100. Redeem 30 of Ms shares on Feb. 1. Redeem all of Ws shares on Aug. 1. Shareholder Malachi After Redemption 30 70 42.8% Before Redemption 60 100 60%
80% x 60% = 48% < 80% x
Malachis redemption, standing alone on February 1, meets 302(b)(2). But then in August, Ms ownership goes to 100%. Generally we only determine immediately after the redemption (language in 302(b)(2)(B) and (C)). But, we must consider whether these redemptions are a Series of Redemptions under 302(b)(2)(D) (a codification of the step transaction doctrine) making the redemption a distribution of a dividend rather than treated as a sale/exchange under 302(a). 302(b)(2)(D) requires the series of redemptions be made pursuant to a plan in purpose or effect. Glacier State Electric provides that redemptions at the death of a SH is not one made pursuant to a plan. If there is a binding buy/sell agreement upon the death of a SH, then you might want to know if Malachis redemption was made when Winston was in bad health to see if a plan existed. 3. Four years ago, Hoover's Pontiac Dealer, Inc. owned 40 shares of voting common stock of Pilgrim Slaughterhouse Corp., which had 100 shares of voting common stock outstanding. Hoover's basis for the Pilgrim Slaughterhouse stock was $600 per share. Billy Pilgrim owned the other 60 shares of voting common stock. Three years ago, Pilgrim Slaughterhouse redeemed 10 shares of stock from Hoover's for $1,000 per share; two years ago Pilgrim Slaughterhouse redeemed 8 shares of stock from Hoover's for $1,000 per share; last year Pilgrim Slaughterhouse redeemed 5 shares of stock from Hoover's for $1,000 per share; this year Pilgrim Slaughterhouse redeemed 3 shares of stock from Hoover's for $1,000 per share. What are the tax consequences to Hoover's Pontiac Dealer, Inc.? Hoover starts with 40 of 100 shares. Shareholder After Redemption Before Redemption Hoover 30 90 80% x 40% = 32% 40 100 33.33% > 80% x 40% 22 82 80% x 33.33% = 26.67% 30 90 26.83% > 80% x 33.33% 17 77 80% x 26.83% = 21.46% 22 82 22.07% > 80% x 26.83% 14 74 80% x 22.07% = 17.66% 17 77 120
18.92%
> 80% x
22.07%
Individually, each of these fail the 302(b) 80% test. This looks like good math for the SH who is a corporation (owning more than 20%). So Hoover gets dividends recd deductions. The issue is whether all of the individual transactions in a series of redemptions should be viewed together (302(b)(2)(D)) as a complete termination for purposes of 302(b)(3) or whether the preliminary transactions must be tested only under other subsections for qualification under 302. Bleily & Collishaw, Inc. v. Comm'r., 72 T.C. 751 (1979), aff'd by order, 647 F.2d 169 (9th Cir. 1981) holds that the intent based variation of the step transaction doctrine may be applied to treat a series of redemptions as a complete termination of a shareholder's interest under 302(b)(3). o If there is a "firm and fixed plan" to eliminate the shareholder from the corporation, the component redemptions will be treated as a single redemption of the shareholder's entire interest. The plan does not need to be enforceable or in writing, but it must be more than a handshake. Bleily & Collishaw, Inc. v. Comm'r., 72 T.C. 751 (1979). See Merrill Lynch & Co., Inc. v. Comm'r., 386 F.3d 464 (2d Cir. 2003) (rejecting taxpayer's argument that a "firm and fixed plan" could be found to exist only when it was "absolutely binding" on the taxpayer, concluding that a plan did not have to be in writing, absolutely binding, and communicated to others in order to be firm and fixed.). o If the time frame for the redemption is vague and the redeemed shareholder retains control over corporate affairs in the interim, however, the individual transactions will not be aggregated; the preliminary redemptions will be treated as 301 distributions. Benjamin v. Comm'r., 592 F.2d 1259 (5th Cir. 1979); Johnston v. Comm'r., 77 T.C. 679 (1981) (individual redemptions were essentially equivalent to dividends if redemption plan not consistently followed). This becomes a factual inquiry. o Viewed all together: H has 40 of 100 shares (40%) and then reduces to 14 of 74 (18.27%). 80% of 40% is 32%... 18.27% is less than 32%, so Hoover falls under 302(b). If the taxpayer-shareholder is a corporation, it is to the taxpayer's advantage to classify the transactions as dividends rather than as redemptions. This is because dividend characterization qualifies the distribution for the intercorporate dividends received deduction under 243, but the gain on a redemption (which is the distribution reduced by the basis of the redeemed stock) is taxed in full. Thus, if the redeemed corporate shareholder's basis for the redeemed stock is less than the dividend received deduction, dividend received deduction, dividend characterization results in less current tax liability than 302 redemption characterization. Any redemption, as defined in 317, that is disproportionate but is a dividend because it flunks 302(b)(2) is an extraordinary dividend under 1059. Therefore, the basis of any remaining stock is reduced under 1059 in an amount equal to the amount of the dividend that was excluded under 243. o There is no ability to transfer basis to other stock. 121
o 1059 was enacted after Bleily & Collishaw. o 1059 partially remedies the abuse in this plan. Thus, the argument would be that Congress has said, through 1059, that what should happen in this situation is a basis reduction, and that the step-transaction doctrine should not apply. 4. Micando Corp. has 100 shares of voting common stock and 400 shares of nonvoting common stock outstanding. Each share of Micando Corp. voting common stock has a fair market value of $100. Each share of nonvoting stock has a fair market value of $50. Jose owns 60 shares of Micando Corp. voting common stock and 200 shares of Micando Corp. nonvoting common stock. The remaining shares are owned by a number of unrelated individuals. (a) If Micando Corp. redeems 30 of Jose's voting common shares, will the redemption qualify for exchange treatment under 302(b)(2)? Jose Voting common 60 Nonvoting common 200 Voting common Shareholder Jose After Redemption 30 70 42.8% Before Redemption 60 100 60% Total 100 $10,000 400 $20,000 $30,000
$6000 $10,000 $16,000
80% x 60% = 48% < 80% x
Rev. Rul. 87-88 Shareholder Jose After Redemption $13,000 $27,000 48.15% Before Redemption $16,000 $30,000 53.33%
80% x % = 42.66% > 80% x
First, we isolate the common stock and apply the 50% test and 80% test to only the voting common stock. Second, we apply the 80% test to the aggregate FMV of the voting and nonvoting common stock as required by the flush language of 302(b)(2). This reflects Congress' decision that there must be a meaningful reduction in a shareholder's share of the profit after the redemption. We flunk this value test mandated by the flush language of 302(b). Go to 302(b)(1) and argue that it is not subst. same as a distribution. If you fail under 302(b)(1) then it will be treated as a dividend under 301 not a sale/exchange under 302(a). Tuesday, October 19, 2010 (missed class). (b) If Micando Corp. redeems 30 of Jose's voting common shares, how many of Jose's nonvoting common shares must be redeemed to qualify the transaction under 302(b)(2)? 122
Answer 6 shares. These shares have a total value of $3,000. This drops the total value owned to $10,000. This will bring the total value percentage owned after redemption to 41.66% ($10,000/$24,000). This is less than 80% of the original ratio (42.66%) and therefore meets the test required by the flush language of 302(b)(2).
5. Rosewater Corporation has 100 shares of voting common stock and 300 shares of voting preferred stock outstanding. Elliot owns 40 shares of voting common stock and 100 shares of voting preferred stock. (a) If Rosewater Corporation redeems all 40 of Elliot's shares of common stock, will the redemption transaction qualify under 302(b)(2)? Original % owned = 140/400 or 35% After redemption = 100/360 or 27.77% Original x 80% = 28% Therefore, the % owned after redemption is less than 80% of that owned originally and 302(b)(2) will apply and the redemption will be treated as an exchange under 302(a). The preferred stock does not have a claim to growth beyond the dividend stated in the contract creating it. (b) If Rosewater Corporation redeems all 100 shares of Elliot's shares of preferred stock, will the redemption transaction qualify under 302(b)(2)? RR 81-41 will apply. This ruling held that 302(b)(2) could apply to a redemption of solely voting preferred stock if the SH did not own any common stock before or after the redemption. If the SH owns common stock, even if nonvoting, sufficient common stock to meet the 80% test must be redeemed along with sufficient voting stock, whether common or preferred, to meet the 50% test. Here, the redemption would pass the first test the 50% test. However, with this redemption, no common stock is redeemed at all and thus the redemption will fail the requirement under RR 8141 that the redemption pass the 80% test required under the flush language of 302(b)(2). 10/21/08 The opening phrase of 318 means that 318 only applies if invoked by another section of the Code. 318(a)(1) deals with family attribution 318(a)(2) deals with attribution from estates, trust, partnerships, and corporations 318(a)(3) deals with attribution to estates, trusts, partnerships, and corporations 318(a)(4) deals with attribution of options 123
318(a)(5) deals with reattribution 6. X Corporation has 100 shares of stock outstanding, all of which are owned by six related individuals as follows: Shareholder Amy Ben Cindy David Evan Fran Relationship Amy's son Ben's wife Ben & Cindy's son Amy's son Evan's daughter Number of Shares 25 15 15 15 15 15
(a) Determine how much stock is owned by each shareholder after taking into account the 318 attribution rules. Amy 25 25 Ben 15 15 15 15 Cindy 15 15 15 David 15 15 15 15 Evan 15 Fran 15 Total 85 70 45 45 55 30
Amy Ben Cindy David Evan Fran
25
15 15
15 15
The term "by or for" encompasses stock owned for a minor child as a custodian under the Uniform Gift to Minors Act. Under 318(a)(5)(A), the general rule is that stock that is constructively owned is reattributed. However, 318(a)(5)(B) prevents reattribution of stock that is treated as constructively owned under (a)(1). Under 318(a)(1)(A)(ii), a grandparent is treated as owning the stock owned by a grandchild, but a grandchild is not treated as owning stock actually owned by his or her grandparent. Everybody who has stock attributed from someone else is someone who could be expected to influence the other. (b) Would a redemption of 14 shares from Ben qualify under 302(b)(2)? Ben actually owns 15 shares and constructively owns 55 shares. Thus, Ben owns 70 out of 100 before the redemption. After the redemption, Ben owns 56/86. This does not pass the first 50% test and is a 301 distribution. (c) Would a redemption of 14 shares from Cindy qualify under 302(b)(2)? Cindy actually owns 15 shares and constructively owns 30 shares for a total of 45 out of 100 before the redemption. 124
After the redemption, she owns 31/86 or 36.04%. This passes the 50% test. However, the percentage she owns after redemption (36.04%) is slightly higher than 80% of the percentage she owned before the redemption (36%). Thus, 301 applies. (d) Would a redemption of 10 shares from Fran qualify under 302(b)(2)? Fran owns 30 out of 100 20/90 Good 302(b)(2). 7. Y Corp. has 100 shares of common stock outstanding. 15 shares are owned by A. 40 shares are owned by Z Corp., and A owns 60 of the 100 outstanding shares of stock of Z Corp. The remaining 45 shares of stock of Y Corp. are owned by the ABC Partnership which A is a one-third partner. Would a redemption of 10 of A's Y Corp. shares qualify under 302(b)(2)? Entity Attribution Before redemption A directly owned 15 shares Under 318(a)(2)(C), 24 of the 40 shares owned by Z Corporation are attributed to A. 60% (the percentage of shares of Z's stock owned by A) x 40 (number of shares of Y stock owned by Z) 24 Under 318(a)(2)(A), 15 of the 45 shares owned by ABC partnership are attributed to A because A is a 1/3 partner in ABC partnership. Thus, before the redemption, A owns directly or indirectly 54 out of 100 shares, or 54%, of Y Corp.'s common stock. After the redemption, A owns 44 out of 90 shares, or 48.88%, of Y Corp.'s common stock. Although A reduced his ownership to less than 50% of the total combined voting power of all classes of stock entitled to vote, as required by 302(b)(2)(B), A owns 48.88% of the Z Corporation voting stock, which is greater than 43.20% (80% of voting stock owned by A immediately prior to the redemption). Under 301(c)(1), the distribution is a dividend to the extent of earnings and profits.
125
8. D owns 50 percent of the stock of each of V Corporation and W Corporation. The other 50 percent of the stock of each corporation is owned by various unrelated persons. V Corporation and W Corporation each own 40 shares of common stock of Q Corporation, which has 100 shares outstanding. The other 20 shares of the stock of Q Corporation are owned by various unrelated persons. Q Corporation redeemed 21 shares of its stock (with a basis of $40,000 318(a)(2)(C) From Corporations If 50 percent or more in value of the stock in a corporation is owned, directly or indirectly, by or for any person, such person shall be considered as owning the stock owned, directly or indirectly, by or for such corporation, in that proportion which the value of the stock which such person so owns bears to the value of all the stock in such corporation. 318(a)(3)(C) To Corporations If 50 percent or more in value of the stock in a corporation is owned, directly or indirectly, by or for any person, such corporation shall be considered as owning the stock owned, directly or indirectly, by or for such person. 318(a)(5)(C) Partnerships, Estates, Trusts, And Corporations Stock constructively owned by a partnership, estate, trust or corporation by reason of the application of paragraph (3) shall not be considered as owned by it for purposes of applying paragraph (2) in order to make another the constructive owner of such stock. o This means that attribution to a corporation from a shareholder will not be attributed out again. This means you cannot go 318(a)(3) then 318(a)(2). However, In this problem we did 318(a)(2) first then 318(a)(3). You have to pay attention to the language and the exact sequence in which the attribution occurs. When you have reattribution under 318(a)(5)(A) you have to pay attention to the sequence of the attribution rules. W is the shareholder being redeemed, so the question is how many shares does W own for purposes testing the redemption. D owns 50% of the stock of V Corp., and V Corp. owns 40 shares of Q Corp. Thus, under 318(a)(2)(C) 20 shares of Q Corp. stock actually owned by V Corp. are attribute to D. Since D owns 50% of the stock of W Corp., under 318(a)(3)(C), W Corp. is "considered as owning the stock owned, directly or indirectly, by" D. Thus, W Corp. is considered as owning the 20 shares of Q Corp. stock actually owned by V Corp and constructively owned by D as a result of attribution under 318(a)(2)(C). Therefore, for purposes of testing the redemption, W Corp. is treated as owning 60 shares of Q Corp. stock (40 shares actually owned by it and 20 shares constructively owned by it as a result of attribution under 318(a)(3)(C)).
126
Although D also owns 50% of the stock of W Corp, and thus D would be treated as owning 20 of the Q Corp. shares actually owned by W Corp. under 318(a)(2)(C), W Corp. is the shareholder being redeemed. Since the question, here, is how many shares is W Corp. treated as owning for purposes of testing the redemption, none of the shares actually owned by W Corp. are not attributed to D under 318(a)(2)(C) and reattributed to W Corp. under 318(a)(3)(C) because that would result in double inclusion. On the other hand, the 20 shares of Q Corp. stock would be attributed to D if we were trying to figure out how much stock D owns to test against D. Thus, while D is treated as constructively owning 20 shares of Q Corp. stock actually owned by W Corp., in this instance we not going to attribute that stock back to W Corp. under 318(a)(3)(C).
W owns: Actual 318(a)(2)(C) 318(a)(3)(C)
40 20 shares of stock actually owned by V corp./const. owned by D 60/100 (48%) -21 39/79 (49.37%)
Thus, the % owned after redemption (49.37%) is greater than 80% of the % owned before (.48 x .8 = 38.4%). As such, 301 applies and to the extent the distribution is out of earnings and profits, it is a dividend. The $40k basis is shifted to the remaining 19 shares owned by W and is irrelevant in computing Ws income. Section 3. Termination of a Shareholder's Interest 1.Tony and Corrado each owned 50 shares of stock in Bada Bing Corporation. Bada Bing redeemed all 50 shares of Corrado's stock for $1,000,000 in cash. Corrado continued to work full-time for Bada Bing as public relations manager. Tony is Corrado's nephew. Does the redemption qualify under 302(b)(3)? If 318 does not apply, you don't have to read anything in 302(c)(2). Here, 318 does not apply because there is no family attribution between uncles and nephews. 2. Paradise Scenic Railway Corp. has 100 shares of voting common stock outstanding. Seventy shares are owned by Henry, and thirty shares are owned by his granddaughter, Jean. Which, if any, of the following redemption transaction qualify under 302(b)(3)? (a) Paradise redeems all of Henry's shares for a lump sum cash payment. The purpose of the agreement is to extend the SOL. The SOL expires 1 year after the notice is filed. Don't send in the notice, there's no SOL. Filing the notification is quite critical. Treas. Reg. 1.302-4(a)(1) provides that the agreement required by 302(c)(2) must be filed with the tax return reporting the redemption distribution, but the courts have been much more lenient in their interpretation of the requirement.
127
(b)(1) Paradise redeems all of Henry's shares for a promissory note, payable in ten equal annual installments (including interest at the prime rate plus 3%), and the note is secured by a mortgage lien on all of the corporation's assets. Creditor does not have any control nor any upside growth potential. Treas. Reg. 1.302-4(e) provides that the acquisition of the corporation's assets to enforce the redeemed shareholder's rights as a creditor is not prohibited interest; but reacquisition of stock in enforcing the shareholder's creditor's rights is a prohibited interest. Even though the reacquisition of the corporation's stock pursuant to a security agreement is the reacquisition of a prohibited interest, in Lynch v. Comm'r., 83 T.C. 597 (1984), revd. On other grounds 801 F.2d 1176 (9th Cir. 1986), the Tax Court held that a security interest in stock of the corporation, standing alone, does not constitute a prohibited interest. See also Hurst v. Comm'r., 124 T.C. 16 (2005).
(2) Same as in (b)(1), but Paradise agrees that during the term of the note it will not pay any dividends, incur any indebtedness outside the ordinary course of business, or acquire any new business, be acquired, or liquidate, without Henry's consent. Treas. Reg. 1.302-4(d) o This is a factual conclusion. Hurst says the test is what is commercially reasonable. Document normal bank lending practices for similar sized businesses of a similar type.
(3) Same as in (b)(1) but Henry agrees to subordinate his note to any third party lender to the corporation upon request. A bank extending a line of credit is most likely to request a subordination agreement. (4) Skip 3. Bassbuster Boat Corp. has 100 shares of common stock outstanding. Roland owns 60 shares and his son Orlando owns 40 shares. Roland plans to retire this year and turn complete management of the company over to Orlando. Because the corporation has inadequate retained earnings to redeem all of Roland's stock at one time and cannot borrow sufficient money to do so without incurring unreasonable business risks, the corporation will redeem 15 of Roland's shares this year and 15 shares in each of the next three years. Assuming that Roland files the 302(c)(2) agreement, can the redemptions this year and in each of the next two years, as well as the final redemption, all qualify under 302(b)(3)? "Firm and fixed plan" o The Revenue Service won both Bleily & Collishaw and Merrill Lynch, the Revenue Service successfully asserted the application of the intent based step transaction doctrine. o In Benjamin and Johnston, the taxpayer were arguing that there was a firm and fixed plan, but the court basically said show it to us. 128
Tuesday, October 26, 2010 3. (McMahon can't count). Advanced Motor Car Concepts, Inc. has two shareholders, Tucker, who owns 60 shares, and his son, Edsel, who owns 40 shares. If the corporation redeems all of Tucker's shares and Tucker files the 302(c)(2) agreement, will the redemption qualify under 302(b)(3) in the following alternative circumstances? Recap after all sub-problems have been discussed: T has a basis of 600k in the stock (fact added)... what happens to that basis if there is a retained prohibited interest? The money that T gets from AMC is a distribution under 301 and may be a dividend under 316. Depending on E&P, the distribution will reduce Ts basis. Under Reg. 1.302-1(c)(2) the remaining basis goes to the related persons basis (Es). Look at Prop Reg 1.302-5: put the basis in an expense account where it is a loss waiting to happen... the loss is allowed at an inclusion date. There are examples of when the loss will be allowedthe best example here would be that the loss is allowed when the employment ends/resigns from the board; or when the related person (E) sells the stock to an unrelated person. McMahon thinks this Prop Reg will be finalized. (a) Tucker remains as an unpaid director of the corporation. In Rev. Rul. 56-556, 1956-2 C.B. 177 the Revenue Service took the position that compensation is irrelevant. So, he cant take this position b/c he will still have control. Rev Rul 59-119: impermissible retained interest if that SH has his representative on the board of directors. (b) The corporation promises to pay Tucker a "pension" of $20,000 for each of the next ten years. Tucker agrees not to establish any competing business and to render such consulting services as the corporation may from time to time request. Rev. Rul. 84-135, 1984-2 C.B. 80, held that the right to receive a lifetime pension under a pre-existing unfunded nonqualified pension plan was not a prohibited interest. Here, the pension was not pre-existing. The Revenue Service could conclude that this pension is a prohibited interest if the payments resemble a continued financial interest in the corporation. The consulting: Rev Rul 71-104 (p.259): says that consulting is a problem; may retain an interest even as an independent contractor Saron case p.259 (discussed in family hostility section) What fact would we need to remove the control aspect? The fact that hes not competing makes the 20k look like a payment for thatwe could separate the amt for the payment not to compete and the non-compete. We should look at whether the consulting services are extensive enough and of the nature to provide controlassuming that they are of the nature, wed want to look at if the consulting was extensive. Rendering consulting services would create a conflict of interest if the non-compete was violated (enhances the enforceability under state law)so look at the sate law to see if that is why it was include. Also look at if the pension is a flat sum or if it is contingent on the corps business; also look at when the pension was entered into. (c) Tucker is a lawyer and four years later Tucker represented the corporation in a product liability litigation matter for a contingent fee. (discussed w/ (d) below)
129
(d) Tucker is an engineer and five years later Tucker is hired as a consultant to help eliminate problems with the design of the company's vehicles revolutionary new engine that runs on poultry waste. Tucker's compensation was a fixed fee plus a percentage of gross sales from the first five years of sales of vehicles using the new engine. The Revenue Service takes the strict position that a "consulting contract" is a prohibited interest. o Rev. Rul. 70-104, 1970-1 C.B. 66, held that a five-year "consulting contract" was a prohibited interest without examining the particular services to be provided and the terms of compensation. The Tax Court, however, applies a facts and circumstances test based on "whether the former stockholder has either retained a financial stake in the corporation or continued to control the corporation and benefit by its operations. Lynch v. Comm'r., 83 T.C. 597, 605 (1984), rev'd, 801 F.2d 1176 (9th Cir. 1986). o The tax court does not like to see management participation. Compare Chertkof v. Comm'r., 72 T.C. 1113 (1979), aff'd, 649 F.2d 264 (4th Cir. 1981), in which the Tax Court found a prohibited interest because the former shareholder had provided management services as an independent contract, with Estate of Lennard v. Comm'r., 61 T.C. 554 (1974) (Nonacq.), in which the court held that rendering accounting services as an independent contractor was not a prohibited interest. If the services are services provided by someone outside the corporation that the corporation would regularly hire to perform the service, the consulting agreement will probably pass muster. However, if the services are more similar to those regularly performed in-house, consulting agreement will constitute a continuing interest. What if Tucker moves to Oregon to ski and drink beer? If he is in the 9th circuit it would be per se prohibited. o The Ninth circuit reject the Tax Court's facts and circumstances test in favor of a per se prohibition on post redemption provision of services to the corporation. Lynch v. Comm'r., 801 F.2d 1176 (9th Cir. 1986). This per se rule was then applied to deny waiver of family attribution. The Ninth Circuit expressly rejected the Tax Court's Estate of Lennard decision, and held that no qualitative judgments regarding the value of the retained interest are permissible. Royalty: looks like a financial state b/c it depends on how the corp does. The lawyer for the contingent fee: depends on how the case turns out, but the amt earned as a lawyer doesnt vary with the financial success of the corporation. So his fee doesnt give him a financial stake. How do we marshal evidence to get us under a certain rule? That is the important question... Management or contingent on success of corporation = bad. Fixed fee or one time deal = good. The IRS stands against this 100%; the TC applies facts & circumstances test... it is your job to determine what should be done and for the client to decide. What if the person was maintained as a recipient of income from a lease? Overall, that isnt a problem...but if the lease is a gross receipts lease (tied to the receipts of the store) that may begin to look like it is tied to the financial success of the corporation (assuming the corp is the one that is leasing the property) 130
4(a) John owned 70 out of 100 shares of the common stock of Walton's Lumber Mill Corp. John's son John-Boy owned the other 30 shares. John gave 20 shares to his grandson JimBob and four months later Walton's Lumber Mill redeemed John's remaining 50 shares. Does the redemption transaction qualify under 302(b)(3)? If you satisfy the "if condition" (under (i) or (ii)) of 302(c)(2)(B), you lose the ability to waive family attribution even though there was no prohibited interest retained, and therefore attribution rules apply and there is not a complete termination, and thus you would have to resort 302(b)(1). o 318(a)(1) attributes Jim Bob's stock to John because the stock of a grandchild is attributed to a grandparent. o Here, the "if condition" of 302(c)(2)(B)(ii) is met because Jim Bob owns 20 shares of stock which is attributable under 318(a)(1) to his grandfather, John, and Jim Bob acquired the stock directly from the distributee (John) four months prior to the date of the distribution. However, The flush language of 302(c)(2)(B) is our out here. It says, "The preceding sentence shall not apply if the acquisition (or in the case of clause (ii), the disposition) by the distribute did not have as one of its principal purposes the avoidance of Federal income tax." o Notice the flush language says 302(c)(2)(B) does not apply if the disposition "did not have as one of its principal purposes the avoidance of Federal income tax." It does not say "the principal purpose," it says "one of its principal purposes." When it says "the principal purpose," that means more than 50%. But when it says "one of the principal purposes," 25% might satisfy the test. Here, the argument that tax avoidance was not one of the principal purposes of the distribution is that we are trying to pass down the family business. In Rev. Rul. 77-293, 1977-2 C.B. 94, a minority shareholder first sold to his father, the controlling shareholder, a number of shares received from the father by gift two years earlier, and the corporation then immediately redeemed the son's remaining shares, which he had acquired by bequest. The ruling held that there was no tax avoidance motive present and suggests that tax avoidance exists only if the transferor seeks to retain indirect control, such as by transferring stock to a spouse prior to a redemption of all of the shares actually owned, or if the transfer is in contemplation of a redemption of the shares from the transferee. Suggests that estate planning to turn the corp over to younger generations then that fact may trump the one of its main purposes language to avoid federal income tax. (b) John gave 40 shares to his wife, Olivia, and three months latter Walton's Lumber Mill redeemed John's remaining 30 shares. This leaves John with zero shares & files to waive family attribution (with it he owns the 40 shares owned by his wife and 30 shares owned by John-Boy). 131
Progression of the statute: o 302(c)(1): Family attribution applies (general rule). o 302(c)(2)(A): turns off 302(c)(1) (exception to general rule). o 302(c)(2)(B): turns off 302(c)(2)(A), thus back to 302(c)(1) (exception to exception puts us back into the general rule). (B)(i): If any portion of stock redeemed was acquired w/in 10 year period... (doesnt apply here). (B)(ii): acquired w/in 10 year period creates a problem! In order to get out of this that stock must also be redeemed. Flush language is the condition to 302(c)(2)(B) turning off 302(c)(2)(A). this will apply unless there is a tainted transactionhere it is the fact that J transferred to O (his wife) in order (primary purpose) to avoid federal income tax. So, the transaction falls back to 302(c)(1). Rev Rul 85-19: deals w/ language in 302(c)(2)(B); this explains that b/c indirect control is maintained the purpose was to avoid federal income tax.
(c) John gave 20 shares to his grandson Jim-Bob and six months later Walton's Lumber Mill redeemed Jim-Bob's 20 shares. Here, the "if condition" of 302(c)(2)(B)(i) would not be met is met because, even though the 20 shares of stock that are being redeemed were acquired 6 months prior to the distribution by the distributee, Jim Bob, those shares were not acquired "from a person the ownership of whose stock would (at the time of distribution) be attributable to the distributee under section 318(a)." This is because 318(a)(1) does not attribute stock owned by a grandparent to a grandchild (it only attributes from grandchild to grandparent). 302(c)(2)(B)(i) says that the redemption from the donee does not qualify for beneficial treatment from someone whose stock would be attributed to the donee. o A grandparent's stock is not attributed to a grandchild, but a grandchild's stock is attributed to a grandparent. It is a one way arrow. o Notice, however, that between husband and wife, or parent and child attribution goes back and forth. Thus, 302(c)(2)(B)(i) would apply if John gives the stock to John Boy (his son) and John Boy's stock is redeemed, or if John gives it to Olivia (John's wife) and her stock is redeemed. (assuming the transfer was w/in the 10 year period) 5. (skipped) This problem only shows: Reacquisition w/in 10 years by inheritance is not a prohibited reacquisition. Reacquisition by gift is prohibited. Why? Both gifts and inheritances can be disclaimed. If one is anothers only living heir in intestacy, if that person disclaims it will escheat... that is problematic. 6. E-Z Rider Motorcycle Manufacturing Corp. has 100 shares of common stock outstanding. Peter owns 25 shares and Jane, Peter's sister, owns 25 shares. The other 50 shares are owned by the estate of Henry. Henry was the father of Peter and Jane. Can a redemption of the 50 shares owned by Henry's estate qualify under 302(b)(3) by virtue of the waiver of attribution rules under the following alternative circumstances?
132
(a) Frances, who is Peter's and Jane's mother, is the sole beneficiary of the estate. 318(a)(1) attributes the stock owned by Peter and Jane to Frances (so F owns 50). 318(a)(3) attributes the stock owned by the estate to Francis. 318(a)(3)(A) stock owned by Francis (both actually and constructively) is attributed to the Henrys estate (so the estate now owns 100 of 100; then 50 are redeemed, so it owns 50 of 50). 318(a)(5)(A) applies to attribute the stock constructively owned. 302(c)(2)(C): F waives attribution from P & J. So, Hs estate only has shares actually owned y F attributed to it. F & Hs estate have to meet all the requirements to get this benefit. Both must file agreement w/ govt (C)(i)(II): each related person agrees to be jointly & severally liable for any deficiency created by reacquisition. Hs estate may also be a corporation that F owned all the stock in. (b) Frances is the residuary beneficiary of the estate, Peter and Jane each received specific cash bequests. Treas Regs say that the recipient of a cash bequest is a beneficiary of the estate. So, P & J are beneficiaries... they would have to meet all the requirements of 302(c)(2)(A)(i). Just pay the specific bequest and then they are no longer beneficiaries! They are entitled to the specific bequest before the remainder anyway; then redeem the stock. (c) Peter and Jane are the residuary beneficiaries of the estate. (skipped) Section 4. Distributions Not "Essentially Equivalent to a Dividend 302(b)(1) p.266 Before Davis: o Before the 1954 Code was enacted, business purpose mattered. Davis held that the enactment of the 1954 Code changed the rules and business purpose is no longer relevant. o Notice how the Court went about reaching its conclusion that business is no longer relevant it looked to the legislative history in two ways. First, it looked at how the provision progressed through the House and the Senate. Second, it looked to the Committee reports. 302(b)(1): applies if NOT essentially equivalent to a dividend.... so how do you know? Essentially Equivalent: o After Davis, a distribution to a sole shareholder is always essentially equivalent to a dividend. Also, a pro-rata distribution in a multiple shareholder corporation is always essentially equivalent to a dividend. o Proportional distributions Except where you have a sole SH if you have multiple classes of stock this will be a difficult question. Not Essentially Equivalent: o After Davis, "a redemption must result in a meaningful reduction of the shareholder's proportionate interest in the corporation." Davis held that attribution rules apply to 302(b)(1) distributions.
133
1. Blueberry E-Mail Systems, Inc. has 100 shares of common stock outstanding, which are owned as follows: Amanda Bill Clarissa Derek 28 25 24 23 In each of the following alternative situations, determine whether the redemption qualifies as not essentially equivalent to a dividend under 302(b)(1). (a)(1) Blueberry redeems 5 shares from Bill, who is Amanda's son. (318 attribution) The shareholders are otherwise unrelated. Before, they had 53 out of 100. After they had 48 out of 95. They went from 53% of the voting power to 50.5%. This is not a "meaningful reduction" in voting power because the redemption did not change the shareholder's voting control over the corporation. Rev. Rul. 77-218, 1977-1 C.B. 81 (8 percent reduction in actual and constructive ownership that left the shareholder with more than 50 percent of the voting stock because of the attribution rules was not a meaningful reduction even though all of the shares actually owned by the taxpayer were redeemed). (2) Blueberry redeems 5 shares from Amanda, who is Bill's mother. Amanda, who is a graduate of Enormous State University, and Bill have not been on speaking terms since Bill refused to attend ESU and instead enrolled at Athletic State A&M University, ESU's biggest sports rival. Family hostility, see p. 274. IRS says that this doesnt matter. Rev Rul 80-26. Caselaw: Robin Haft Trust v. Commr (1st Circuit) says that it may be relevant. 5th Circuit says it isnt relevant. Tax court has come on both sides... seems to think it may be relevant, but only if an unrelated SH increases interest. The Cerone cite (p.274, TC) may be dismissed as dicta. Overall, not a good tax planning move. (b) Blueberry redeems 5 shares from Clarissa, who is Amanda's daughter. The shareholders are otherwise unrelated. 318(a)(1) attributes the 28 shares owned by Amanda to Clarissa, so before the redemption she owned 52 out of 100 shares, or 52% of the common stock. As a result of the redemption, Clarissa owned directly and indirectly 47 out of 95 shares, or 49.47%. Although she reduced her ownership below 50% and, therefore, would satisfy the requirement of 302(b)(2)(B), the redemption is not substantially disproportionate because she did not reduce her ownership by at least 80% (i.e., 42%). Rev. Rul. 75-502, 1975-2 C.B. 111 held that a redemption that reduced the shareholder's voting stock interest in the corporation from 57% to 50%, with the other 50% being held by a single unrelated shareholder, qualified as a meaningful reduction. The revenue ruling indicated that if the redemption had not reduced the shareholder's interest in the voting stock to 50% or less, then 302(b)(1) would not have been applicable. o This Rev. Rul. only involves 2 shareholders! We have 3 SH involved after the redemption. 134
o It takes both B and D voting against A/C in order to beat them. This wasnt really changed after the redemption. B and D must both vote against C in order to outweigh her vote. Substantially similar is what is necessary to apply the Rev. Rul. by analogy. Start w/ the Rev. Rulings then go to TC cases. Speak to your audience! The TC will care more about cases; the IRS will care more about Rev. Rulings. When you are planning consider both. Roebling v. Commr p.272: loss of voting control is important; this would be a good case to cite b/c there are multiple SH involved in that case.
(c) Blueberry redeems 4 shares from Clarissa, who is Amanda's daughter. The shareholders are otherwise unrelated. After the redemption Clarissa still owns either directly or indirectly 50% of the corporation's common stock. Although Rev. Rul. 75-502 held that a reduction from 57% to 50% was a meaningful reduction, the facts of that revenue ruling involved only two shareholders. In that case, a reduction in ownership to 50% left the shareholders in a deadlock position, with neither being able to assert effective control over the corporation. Here, in contrast, there are a total of 4 shareholders, so Clarrisa and Amanda still have effective control over the corporation. (d) Blueberry redeems 7 shares from Amanda. The shareholders are unrelated. Before A had 28/100 shares. After A has 21/93. Before she could control the vote by getting B, C, or D to vote with her, but after the phone does not ring b/c no one wants to get A... B is now in the drivers seat w/ the most shares. In Rev. Rul. 76-364, 1976-2 C.B. 91, the shareholder held 27 percent of the voting stock of the corporation and three other unrelated shareholders each had a 24.3 percent interest. A redemption that reduced the shareholder's 27 percent interest to 22.27 percent was held to be a meaningful reduction since through the redemption the shareholder lost the ability to control the corporation by acting in conjunction with only one of the other shareholders. (e) Blueberry redeems 5 shares from Derek, who is Clarissa's brother. The shareholders are otherwise unrelated. Although there is attribution between siblings under 267, there is no attribution between siblings under 318(a)(1). Before D has 23/100. After D has 18/95. Does Rev Rul 76-364 apply? Not really... after the redemption neither B or C can ally with D in order to get a majority. A small reduction in the interest of a minority shareholder who retains a large interest does not qualify. Rogers P. Johnson Trust v. Comm'r., 71 T.C. 941 (1979) (Acq.), held that a reduction from 43.6% to 40.8% of the voting stock of the corporation was not meaningful (p.273).
135
Thursday, October 28, 2010 Redemptions of nonvoting stock: How do we apply 302(b)(1) when we have nonvoting preferred stock? Missing problem: Voting Common Nonvoting Preferred A 60 10 B 25 55 C 15 15 D 0 20 302(b)(3) Complete termination Rev Rul 77- : if person has only nonvoting stock, any redemption from that person is meaningful. If the corp redeems the entire class of nonvoting preferred? There used to be a Rev Rul 55-540; the IRS obsoleted this Rev Rul, which means that it is no longer relevant. That Rev Rul said that if an entire class of stock is redeemed tat would be a 302(a) redemption w/out explaining why. Davis overcomes this Rev Rulwith its meaningful reduction requirement. D is easy. She has a complete termination under 302(b)(3). What about C, B or A? Rev Rul 85-106: three factors to consider: o Right to vote o Right to participate in E&P o Rights in liquidation In this case, the right to vote stays the same b/c only nonvoting preferred is redeemed. The right to E&P... As right to E&P went upwhen he started he had 10 of 100 shares; after the redemption he had 10 of 80. Bs claim went downwhile the preferred stock is there B gets 55% of the first money out of the corp at liquidation/dividend, but once it is redeemed hell get only 25% on a dividend on the common stock. Cs stays the same. This is called comparative dividend analysiscompare dollars received in redemption to the dollars received if the corp had paid a dividend on the common stock. Ex: If A had a dividend on the preferred, hed get 10k of 1M dividend... if the preferred was redeemed hed get 60k of the 1M. For publicly held corporations: if the publicly held corp wants its stock back it will buy it on the open market. How do you apply this analysis to those corps? B/c you dont know who is buying the stock when you sell it. Rev Rul says that if a SH of a publicly held company sells a percentage of their stock identical to the amt the corp redeems it is a 301 distributionthis is completely unenforceable b/c you dont know if the stock was sold back to the corp or not! If the corp buys back stock on the stock exchange, then it can redeem and get the stock back and the SH gets capital gains treatment (everyone wins).
136
Section 5. Partial Liquidations 302(b)(4); defined in 302(e) 1. Griswold Corporation has one class of common stock outstanding, which is owned equally by Clark and Eddie. Each shareholder owns 1000 shares. Clark's basis is $900,000, Eddie's basis is $12,000,000. The fair market value of each share of Griswold is $10,000. The aggregate value of the shares is $20,000,000. Griswold directly operates two distinct businesses, "Wings," an air charter business with three airplanes, and "Wally World," an amusement park. Griswold also owns all of the stock of Caddy Shack Golf Club Manufacturing, Inc., which it has held for seven years. C: owns 1000 of 2000. Basis 900k. D: owns 1000 of 2000. Basis 12M. Griswold: FMV is 20M. Has 2 Divisions: Wings and Wally World. Wally World worth 4M. Also owns all the stock of Caddy Shack w/ FMV 2M. What are the tax consequences of the following alternative transactions? (a)(1) Griswold sells Wally World for $4,000,000 and distributes the cash proceeds pro rata to its shareholders. Each shareholder receives $2,000,000 and surrenders 200 shares of stock. Griswold has operated Wings and Wally World for more than five years. Is this going to be a partial liquidation? 302(e)(1) "not essentially equivalent to a dividend" then it is treated as a partial liquidation; determined at the corporate level (302(e)(1)(A)) o NB: in 302(b)(1) the determination is made by looking at the effect on the SH. In 302(b)(4) the determination is made at the corporate level. o 302(e)(1)(B): requires the distribution is pursuant to a plan and is completed w/in the taxable year or in the next taxable year. Formal plan (board of directors resolution). Informal plan (a plan that can be proved through other evidence, ex: email; look at timingif close together then may fall into a plan, if far apart less likely to be a plan; if you have an informal plan then you will have difficulty if it falls into one of the years required by (e)(1)(B)) 302(e)(2) safe harbor with 2 requirements. o If you fall within the safe harbor, you are deemed to have met the "not essentially equivalent to a dividend" requirement of 302(e)(1)(A). 2 Requirements: 302(e)(2)(A): attributable to (explains why the sale of assets and then distribution of cash is okay) 302(e)(2)(B): We fall within the safe harbor because we sold and distributed the assets of Wally World, as required by 302(e)(2)(A), and retained the assets of Wings, as required by 302(e)(2)(B). 302(e)(3) defines "qualified trade or business" o Actively conducted for 5 year period o Not acquired within the past 5 years in a taxable transaction. Davis says that in order to have a redemption that is not essentially equivalent to a dividend under 302(b)(1) the distribution cannot be pro rata; however, 302(b)(4) specifically states that whether or not the distribution is pro rata is irrelevant.
137
o This tells us that 302(b)(4) looks to the effect of the distribution on the corporation, whereas 302(b)(1), (2), and (3) look at the effect on the shareholder. o We are looking at the impact on the size and operations of the corporation. 302(e)(1)(B) limits partial liquidation treatment to redemption distributions that (1) are "pursuant to a plan," and (2) occur within the taxable year in which the plan is adopted or in the succeeding taxable year. o The best day to sale the assets is Jan 2 because you have to make the distribution by the close of the taxable year following the year in which the sale occurs. Thus, if you are concerned about your ability to get everything done in time, the best thing to do is start as early in the year as possible. It is not from the date of the sale that you have to make the distribution, it is from the date of adoption of the plan. You should find a buyer before formally adopting a plan. The result is that we get capital gain treatment and we turn in 200 shares. o Clark AR $2,000,000 AB (200 shares) $ 180,000 Gain $1,820,000 o Eddie AR $2,000,000 AB $2,400,000 Loss ($ 400,000) Rev Rul 56-515: says the loss is allowed Eddie escapes 267 because that section says "more than 50%." However, a partial liquidation from a majority shareholder that results in a loss is disallowed by 267. o 267 has a specific exception for complete liquidations. If there is an exception for complete liquidations, does that imply there is no exception for partial liquidations? We dont really know... In Frink, the issue was whether a majority shareholder who surrendered shares back to a corporation for nothing could claim a loss. The Supreme Court said no because the shareholder had not closed out his investment.
(2) What if each shareholder surrenders 400 shares of stock? If each sells 400 shares back, can Clark increase the amount of basis used by $180,000, thereby reducing the amount of gain down to $1,640,000 and, assuming that Eddie can claim his loss, that Eddie can claim a $2.8 million loss. There is no doubt that if Clark sold 400 shares to a complete stranger that Clark's gain would be $1,640,000 and that Eddie would have a $2.8 million loss, so can we deal with the basis issue that way?
138
Rev. Rul. 56-513 holds that if the corporation is not publicly traded, the number of shares deemed surrendered is considered to be the same ratio of total shares as the amount of the distribution bears to the value of all the corporate assets prior to the distribution regardless of actual shares surrendered. Look at the distribution: determine what percentage of the corps assets was the distribution? Then you can only use that percent of basis. Rev. Rul. 77-245 holds that if the corporation is publicly traded, the number of shares deemed surrendered is considered to be the same ratio of total shares as the amount of the distribution bears to the fair market value of all of the outstanding stock immediately before the distribution. (market capitalization)
(3) What if neither shareholder surrenders any stock? An actual surrender of the shares is not required in the case of a pro rata distribution. Rev. Rul. 90-13, 1990-1 C.B. 65; Fowler Hosiery Co. (b) Would your answer to the question in part (a)(1) differ if Griswold distributed only $3,000,000 to its shareholders and used the other $1,000,000 to expand the Wings business? Kenton Meadows, Inc. v. Comm'r., 766 F.2d 142 (4th Cir. 1985); Rev. Rul. 79-275 (distribution of unrelated assets rather than promissory notes received on sale of terminated business did not qualify). These require that all of the assets are distributed, even though the statute alone doesnt say that all the assets must be distributed for the safe harbor. 302(e)(2)(A) says "The distribution is attributable to the distributing corporation's ceasing to conduct, or consists of the assets of, a qualified trade or business." The IRS's position is that " . . . consists of the assets of, a qualified trade or business" means all of the assets of the trade or business, and since all of the assets of the trade or business must be distributed, if you distribute the proceeds of the sale, all of the proceeds must be distributed. Although we could not meet the safe harbor by distributing only $3,000,000 of the proceeds to the shareholders, this does not mean that the distribution does not qualify as a partial liquidation. If you flunk the safe harbor, you can rely on the corporate contraction doctrine to argue that the distribution is "not essentially equivalent to a dividend" within the meaning of 302(e)(1)(A). So, if you fail the safe habor use the corporate transaction test. However, it is unlikely that this distribution would constitute a sufficient corporate contraction. In order to obtain an advanced ruling that a redemption is a partial liquidation the corporation must reduce the net fair market value of its assets, gross revenues, and number of employees by 20 percent. Rev. Proc. 2005-3, 4.01(22), 20051 C.B. 118. (c)(1) What would be the result in (a)(1) if Griswold had started the Wings business three years ago out of retained earnings? Not a qualified trade or business. Under 302(e)(3) both trade/business have to be conducting business for the five years before the date of redemption.
139
The purpose of the 5 year aging rule is to prevent corporations from simply parking cash that would otherwise be available for distribution and then terminating the newly acquired business. We've had Caddyshack for at least 5 years, so can we count Caddyshack as a business? No. o A subsidiary is not treated as a wholly owned business. Rev. Rul. 79-184. However, if Caddyshack was a single member LLC, and therefore disregarded as an entity separate from its owners for federal income tax purposes, it would qualify as a business. If Wings and Wallyworld were dropped into single member LLC's Griswold could offset the profits from one of the businesses against the losses from the other. The form of organization here is critical.
(2) Would the answer differ if Griswold also owned 5,500 acres of undeveloped land that it purchased nine years ago as an investment, but grazing rights on the undeveloped land have been leased to a rancher for more than five years? The question is if this is an active trade/business. This is not an active enough trade or business. Passive leasing activities are not an "actively" conducted trade or business (unless you are renting short term and must provide a lot of services, ex: rental cars). See Rev. Rul. 56512, 1956-2 C.B. 173 (distribution by corporation engaged in paper business of mineral land leased for royalties did not qualify because the corporation was not engaged in a trade or business with respect to the distributed property); Rev. Rul. 76-526, 1976-2 C.B. 101 (same as to distribution of parcel of land subject to a net lease). (3) Would the result in (a)(1) differ if Wings had been established six years ago by Joe Hacket and was purchased for cash by Griswold three years ago. Two part test: business must have a 5 year history ((e)(3)(A)) and the particular business cant have been acquired w/in 5 years in a transaction in which gain/loss was recognized in whole or in part ((e)(3)(B)). o In whole or in part: an acquisition that has a lot of stock but a little cash would fall under the in part (even though it may still qualify as a tax free acquisition); a euphemism for taxable transaction So a tax-free merger would be okay. If gain/loss was recognized then the corporation used some cash! So there is still a cash parking problem. If the corp wants to it can acquire a business in a tax free merger w/out giving any cash (by using only stock) (4) Would the result in (1)(a) differ if Wings had been established six years ago by Joe Hacket and was acquired in a tax free merger of Wings into Griswold three years ago? Since tax free reorganizations entail acquisitions in exchange for stock of the acquiring corporation rather than cash, the same considerations do not apply. The liquidation of a sub into its parent is a completely tax-free transaction, so if Caddyshack has a 5 year operating history and we merge Caddyshack into Griswold, we now have two qualified businesses within the meaning of 302(e)(3) and the existence of Wing's tainted business will not ruin the 302(b)(4). 140
(d)(1) All of Griswold's businesses have been owned and operated for more than five years. The largest of Wing's several airplanes was destroyed in a hurricane and Griswold received $5,500,000 of insurance proceeds. Griswold used $2,000,000 of the insurance to buy a replacement airplane that was much smaller and carried many fewer passengers, and distributed the remaining $3,000,000 equally among its shareholders in redemption of 150 shares of stock (worth $1,500,000) from each. 302(e)(2) does not apply because we've never ceased to conduct a business, and we never distributed all the assets of the business or the proceeds therefrom. The issue is whether the corporate contraction doctrine would apply. The language in 302(e)(1)(A) which says "the distribution is not essentially equivalent to a dividend (determined at the corporate level rather than at the shareholder level)," is interpreted to require a significant contraction of the corporate business. Thus, that language is the basis for the corporate contraction doctrine. The leading case finding sufficient corporate contraction to constitute a partial liquidation is Imler v. Comm'r., 11 T.C. 836 (1948) (Acq.). In that case, a corporation, whose stock was held by three stockholders, owned a seven story building and several smaller buildings and was engaged in retinning and soldering metals. It also rented its excess space. A fire destroyed the upper two floors of the seven story building in 1941. Because of the shortage of building materials, the corporation did not rebuild the two floors but reduced the building to a five-story building. Finding its facilities inadequate to store materials for the retinning and soldering activities and also that a scarcity of materials made those operations unprofitable, it discontinued those operations. The corporation distributed $15,000 pro rata in redemption of part of its stock, the cash in part representing the excess of the insurance proceeds over the repair costs. The redemption was held not to be a dividend, the court stressing the bona fide contraction of business operations, the consequent reduction in capital needed, and the fact that except for the fire no distribution would have been made. o The corporate contraction doctrine is memorialized in Treas. Reg. 1.346-1. (partial liquidations used to be in section 346) Here, the question is how much do we have to contract? Rev. Proc. 2005-3, 4.01(22), 2005-1 C.B. 118 (Internal Revenue Service will not issue ruling that redemption is a partial liquidation unless corporation reduces net fair market value of assets, gross revenues/receipts, and number of employees by 20 percent). o Key=contract the entire corporation. o Basically, under Rev. Proc. 2005-3 you have to start pink slipping people. By distributing only $3,000,000 of the $5,500,000 Griswold has only contracted its assets by 15% ($3,000,000 20,000,000). That's not good enough to get an advance ruling under Rev. Proc. 2005-3. On the other hand, because it is just a revenue procedure for advanced ruling, if the client comes into the office and says we distributed 15% of the assets, fired 19% of the employees and capacity has been cut back significantly, there is a substantial authority (which can be a reasoned interpretation of the statute) for the position that such a reduction qualifies as a sufficient corporate contraction. o The rule requiring the distribution of all the assets or proceeds from the sale of the assets of a qualified trade or business only applies to the safe harbor. 141
(2) Would the answer differ if Griswold distributed $4,000,000 of insurance proceeds and used the other $1,000,000 to expand the Wally World business? In this variation, we have a 20% contraction. (3) Would the answer in part (c)(2), above, differ if Griswold also owned 5,000 acres of undeveloped land that it purchased nine years ago as an investment. An investment is not a trade or business. The question is what is wrong with having an investment if we want to qualify for the contraction test? o An investment represents an asset that you can distribute to the shareholders without contracting its business. A corporation with investment assets has the wear-with-all to make a distribution without contracting its business. Even thought the land is an illiquid asset, it is still a cash asset. The distribution has to be attributable to the contraction... if there are cash assets sitting there the IRS will think that the corp was just getting rid of the investments not actually contracting. In Estate of Chandler v. Comm'r., 22 T.C. 1158 (1954), the taxpayer lost because the distribution was attributable to the earned surplus the corporation had accumulated before the department store was sold, not the proceeds from the sale of the department store. We know this because the corporation had a cash hoard, and that cash hoard was large enough to approximate the amount of cash that was distributed after the sale of the department store, even though the amount of capital invested in the much smaller ladies-ready-to wear store was approximately equal to the amount of the capital invested in the department store. A cash hoard easily translates into marketable securities, so the question becomes what about when we move to something as illliquid as 5,000 acres of land. In that case the corporation could still have distributed value equal to $5,000 without having to sale the land by simply distributing the land in-kind to the shareholders. It is there to distribute and its distribution would not affect the corporation's business activities. Every real estate investment that is 100% equity financed produces negative cash flow because of real estate taxes due on the land each year, so the only reason this land is leased for grazing rights is to produce income to pay the real estate taxes. The point of the is problem is to show how fact specific the inquiry is when you are trying to argue for a partial liquidation under the corporate contraction doctrine. (e) Griswold distributed pro rata 5,000 acres of undeveloped land that it purchased nine years ago as an investment, but grazing rights on the undeveloped land have been leased to a rancher for more than five years. This is not really an active trade or business, so simply distributing undeveloped land would result in flunking both 302(e)(2) and the corporate contraction test, which requires you contract the actual business not just the size of the corporation. Also, distributing the land would result in corporate level gain under 311(b). 142
(f)(1) Griswold sells all of its Caddy Shack stock for $2,000,000 and distributes $1,000,000 to each shareholder in redemption of 10 shares from each. If a parent corporation operating a business also owns the stock of a subsidiary operating a five-year active business, a sale of the stock and distribution of the proceeds does not satisfy 302(e). Rev. Rul. 79-184, 1979-1 C.B. 143 (holding stock is not an active trade or business). (2) Griswold liquidates Caddy Shack, acquiring all of its assets as the sole shareholder, sells the assets for $2,000,000, and distributes $1,000,000 to each shareholder in redemption of 20 shares from each. Rev. Rul. 79-184, 1979-1 C.B. 143 hold that the sale of stock of a subsidiary and distribution of the proceeds to the shareholders of the parent corporation does not satisfy 302(e). On the other hand, the parent could liquidate the subsidiary, sell its assets, and then make a qualifying distribution of the proceeds under 302(e). Alternatively, the subsidiary could sell the assets prior to its liquidation with the parent in turn distributing the proceeds under 302(e). Rev. Rul. 75-223, 1975-1 C.B. 109; Rev. Rul. 77-376, 1977-2 C.B. 107. What we would do is establish Caddy Shack, LLC, which was wholly owned by Griswold. We would do this under the law of a state that would allow us to merge Caddy Shack, Inc. into Caddy Shack, LLC. Caddy Shack corporation would disappear and now Griswold would own Caddy Shack LLC. For federal tax purposes, this is a liquidation of Caddy Shack corporation into Griswold because Caddy Shack LLC does not exist it's a single member LLC, so it is disregarded for federal tax purposes. That is a tax-free liquidation of Caddy Shack. Griswold then sells the 1 and only membership unit of Caddy Shack LLC for $2,000,000 cash and distributes $1,000,000 to each of Clark and Eddie. This transaction qualifies a partial liquidation under Rev. Rul. 75-223, 1975-1 C.B. 109; Rev. Rul. 77-376, 1977-2 C.B. 107, as long as all the other requirements are met. Form is entirely controlling here (not substance!). The one little difference is that when Griswold sells Caddy Shack corporation its gain or loss is computed with reference to its basis in Caddy Shack's stock, but if Griswold sells the assets of Caddy Shack its gain or loss is computed with reference to its basis in Caddy Shack's assets. It is hard to fathom why that should effect the treatment of Clark and Eddie at the shareholder level; nevertheless, it does. Although selling the stock and selling the assets are fundamentally the same transaction, they produce dramatically different tax consequences. However, this is a good thing for a tax lawyer because it allows you to qualify a transaction or not qualify a transaction as you chose.
143
2. Ward owned 30 shares of Cleaver Cutlery Manufacturing Corporation, Ward's wife June owned 30 shares, and their son. Theodore owned the other 40 shares. Cleaver Cutlery Manufacturing Corporation had two divisions, the kitchen cutlery division and the tableware division. Cleaver Cutlery Manufacturing Corporation sold its tableware division, and distributed the proceeds to Ward in redemption of all of his stock. June continued to hold her stock in Cleaver Cutlery Manufacturing Corporation, and Ward and June continued to serve on the board of directors. What are the tax consequences of the redemption of Ward's stock? Does W get capital gains treatment? All his stock was redeemed, but he still continues to be on the BOD... so he cant waive family attribution. Even though 318 is invoked in 302(c)(1), 318 is not relevant to 302(b)(4) because we are looking at the distribution at the corporate level and not the shareholder level. If you meet the requirements of 302(b)(4) you don't have to worry about the family attribution rules, waiver of family attribution, and prohibited interest. See 302(b)(5). Treas Reg 1.346-2: even though this is pro rata (flunks 302(b)(2)), as long as it is measured at the corporate level under 302(b)(4) and 302(e) as a partial liquidation. 3. Ahab Corporation has 200 shares of common stock outstanding, which are owned equally by Jonah and Leviathan Corporation. Jonah's basis for his stock is $2,000,000; Leviathan's basis for its stock is $4,000,000. Ahab has operated two distinct businesses, a wholesale fish bait business and chain of fast-food sushi bars, for over ten years. The sushi bar business is worth $6,000,000; the wholesale fish bait business is worth $14,000,000. What are the tax consequences of the following alternative transactions? (a) Pursuant to a plan of partial liquidation, Ahab distributes the assets of the sushi bar business to its shareholders pro rata in redemption of 30 shares from each of them. For noncorporate SH, this falls under the safe harbor & is partial liquidation under 302(b)(4). Jonah: AR= 3M. Basis = 300k. Gain = 2.7M A distribution described in 302(e) does not qualify as a partial liquidation under 302(b)(4) if received by a corporate shareholder. The result is that the distribution to Leviathan is treated as a 301 distribution. $3,000,000 dividend -$2,400,000 243(c) dividend received deduction (80% for more than 20% SH) $ 600,000 Net Taxable 1059: applies to corporate SH, requires a reduction in basis for extraordinary dividends (which includes any distribution in partial liquidation). Original Basis $4,000,000 - 1059/243 $2,400,000 New basis $1,600,000 So, when it sells the shares or Ahab liquidates it has an additional 2.4M of gain b/c of the basis reduction. Corporation recognizes gain under 311(b). (b) Pursuant to a plan of partial liquidation, Ahab distributes the assets of the sushi bar business to Leviathan Corporation in redemption of 60 of its shares.
144
This falls under (b)(2). Starts at 100/200. Goes down to 40/160. Must get below 40% to qualify under (b)(2), and this is only 28.57%. No DRD. Goes through 1001; loses 60% of basis; takes a 1012 cost basis in the assets it acquired (FMV of the stock). Tuesday, November 2, 2010 Section 6. Redemptions Through the Use of Related Corporations 304 Overview: Ex: A owns all the shares of X and Y Corp. A sells 60 shares of X to Y (reduces the X shares to 40). No change of ownership b/c of attribution rules. 304 designed to deal w/ this problem. Another example is B owns 80 of 100 stock of Z Corp., who owns all stock of S Corp. B sells 40 shares of Z to S Corp... to what extent has B actually reduced his interest? 2 Important Aspects of 304: Rules: o 304 is full of rules the modify rules weve already seen: ex: 318 attribution rules are modified; o Control: for purposes of 304: Bro-Sis: one or more persons is in control of 2 corps. What does control mean? Need for backstopping rule (designed to prevent turning dividends into capital gains by selling stock to related corp instead of just issuing a dividend); 304 is also an anti-abuse rule (1) Are 1 or more persons in control of each of 2 corps or does one corp control another? 304(c)(1) defines "control" as 50% or more of the stock entitled to vote OR the value of all classes of stock. 318 attribution rules apply in determining control, and corp attribution rules modified by substituting the 5% thresholds for the 50% thresholds (attribution from SH to corp is made proportionate btwn 5 and 50% ( 304(c)(3)). (2) If yes, did the controlling person/group sell stock from one controlled corp to another ((a)(1)), or did a SH of the controlling corp sell stock of that corp to its controlled sub ((a)(2))? (3) 304(b)(1) modifies 302(b). 302 applies to test whether the corp whose stock was sold qualifies as an exchange. Same # of shares remain outstanding 318 attribution rules apply as they always do under 302, except that the corp attribution rules are modified by removing the 50% thresholds (purpose: deal w/ people spreading out ownership to avoid 304 & the attribution of ownership under it) (4) if the transaction fails to qualify as an exchange, it is a 301 distribution & the dividend amt will be determined under that section E&P of both corps will be used to determine the dividend amt (302(b)(2) (you have a bigger dividend under 304 than you could have if you had a corp whose stock was to be sold would redeem the stock) b/c of deemed 351 contribution, corp takes a 362 basis (5) if the answer to (1) and/or (2) is no, then the trans is a sale, taxable under 1001 (takes basis under 1012) See p. 52 of CorpTax.doc in Other
145
1. Alicia owned all 100 outstanding shares of X Corp., with a basis of $60 per share. Alicia sells 60 shares of X Corp. stock to Y Corp. for $18,000 ($300 per share). Prior to the sale, X Corp. had accumulated earnings and profits of $8,000. Y Corp. had accumulated earnings and profits of $2,000 and current earnings and profits of $1,000. What re the tax consequences of the sale in the following alternative situations? (a) Alicia is the sole shareholder of Y Corp. Alicia's basis in the Y Corp. stock is $2,000. Described in 304(a)(1) (b/c A is in control of X and Y). So next, test the ownership change... the owership change is zero (b/c of the 318 attribution). What happens nexthow is the 18k that A received treated? If you flunk 302(d) then you have to go to 301 (to determine what he dividend will be). $11k will be a dividend (use both corps E&Pfirst look at the E&P of the acquirer and use it all, then look at the other corps E&P) 302(c)(2) Recovery of basis. o If a SH already owns a corp and contributes property tot hat corp, they get exchanged basis in the property they transferred to the corp. o 304(a)(1): 5,600 recovery of basis (that accounts for 16,600 of the total distribution) o $1,400 capital gain under 301(c)(3) What is Y Corps basis in the X stock? 362 transferred basis of What is the policy question that we have to address here? Whether there has been any economic change for the shareholder. The transaction is either going to be characterized as a 301 distribution, on the one hand, or a redemption on the other. Thus, the issue is whether there is going to be a distribution resulting in a dividend, taxed at 35% (potentially), or is the transactions going to be characterized as a redemption. Normally, a 301 distribution reduces the net worth of the company making the distribution. However, with this transaction, Y gets something of value. If you relax the Molline Properties doctrine and either X or Y makes a distribution to A, then the net worth of the shareholder has not changed; it's just been shifted. We are trying to determine whether A's ownership interest has changed sufficiently so that the transaction should be treated as a sale or exchange. The purpose of 304 is to sort out the transactions in which a common shareholder causes the sale of stock from one corporation to another. We look at the effect on the sale on the shareholder's ownership of the corporation that was sold. We decide whether the hypo redemption of Y stock gets sale or exchange treatment by looking to see whether there is a sufficient change in ownership of X corporation. If you make a dist from a corp and you Tax consequences: First, look to the flush language of 304(a). A takes an exchanged basis in this hypothetical Y stock. A has a basis in Y of the $2000, originally, plus a $3,600 basis in the hypothetical Y stock. Then stock is treated as having been redeemed. 146
304(b)(2) 304(b)(1) says to apply 302(b) w/ respect to the stock that was sold. First we use Y's earnings and profits, then we look to X's earnings and profits. First you look to the acquirer's earnings and profits, then you look to the issuer's earnings and profits. $18,000 distribution - $11,000 301(c)(1)/ 316 $ 5,600 301(c)(2) $ 1,400 301(c)(3) gain Since this is a distribution by Y with respect to Y stock, even though for 301(c)(1) we are using the E&P of both corporation's, first Y and then X, we are using the basis of the Y stock. Here, there is harm in trying to avoid the anti-abuse rule! What is Y corporation's basis in the 60 shares of X corporation stock? Since Y corporation is considered to have acquired that stock in a 351 transaction, Y takes a transferred basis plus the gain recognized by the transferor. 362(a). However, notice that the gain is not triggered by the transfer of the stock to Y corporation, but the redemption by Y stock of the hypothetical stock issued. Thus, technically, Y corporation's transferred basis should not be in X stock should not be increased under 362(a). Look at Freirs Finance casesays language of 362(a) provides for an increase in basis for gain recognized by the SH (so the basis should be increased from 3,500 to 5k). o Why is this wrong? The gain was recognized on the hypothetical redemption of Ys stock! Not on the transfer of stock. With Fiers as the only case on the book, you have substantial authority (or even more likely than not authority)... but the question is if you get to the level of should (as in, this is the decision the court is likely to reach). (b) Alicia is the sole SH of Y Corp. Alicias basis in the Y Corp. stock is $2,000. (Skipped) (c) Alicia is the sole SH of Y Corp. but Y Corp. has no current E&P and a $9,000 deficit in accumulated E&P. Under 304(b)(2), look to acquiring corp first (where there is nothing), then look at transferring corp (where there is 18,000 E&P). You dont get to net the E&P! You must go in order. What would the dividend had been if Y Corp had distributed 8k in cash to A and in an unrelated transaction, A had contributed 60 shares of X Corp to Y Corp? There would have been no dividend (b/c no E&P). What if A owns only 40% of Y Corp? You dont even get to 304 b/c control requires 50% or more ownership of voting control or value. Here A is not in control. You dont worry about the modification of 310 attribution rules until you get into 304(a).... which you dont get into b/c A doesnt meet the 304(c) control test. (d) Alicia owns no stock of Y Corp., but her daughter is the sole SH of Y Corp. 147
The issue is whether 318 attribution applies in determining whether the control test is met. Remember, 318 only applies if it is invoked by the statutory provisions. 304(c)(3)(A) invokes 318 family attribution attribution for purposes of determining control. So, A is treated as owning 100% of Y (40 she owns actually and 60 through attribution under 318(a)(1)). So, assuming there is enough E&P there will be an $18,000 dividend (this is the Feirs Finance case where the children owned all the stock of the corp. Remember: you can use 302(c) waiver of attribution! In the tax court case of Feirs Finance, the parents won b/c they filed a waiver of attribution even though they filed it latethe ct said substantial compliance). 2. Becky owns 60 of 100 outstanding common shares of W Corp and 50 out of 100 common shares of Z Corp. Becky sells 30 shares of W Corp, having a basis of $10,000, to Z Corp for $50,000. W Corp and Z Corp each have accumulated E&P of more than $50,000. What are the tax consequences to Becky? This is 304(a)(1)B controls Z; Z controls W. Before B had 60%. After, B owns 30/100 directly. Because we are in section 304, 304(b)(1) tells us that we apply the attribution rules without regard to the 50% limitation. Therefore, Becky owns half of what Z ownsso she has 15/100 shares of W Corp stock through Z corp. She now has 45%. The 302(b)(2) less than 80% of what she had before, she needs to decrease below 60% x 80% = below 48%. So, B meets the test in 302(b)(2). The redemption is hypothetical! The denominator never changes in a 304 transaction. What is Z Corps basis in the stock? $50,000 the cost basis under 1012. But, Reg. 1.3042(c)(Ex.3) where there is a similar fact patternthe ex says the acquiring corps basis in the stock is calculated as the basis of the transferor increased by amt of gain recognized to the transferor. Why do we care? 1012 cost basis is not the same as the sellers basis + gain. Why? b/c of transaction costs! The transaction cost of an atty will decrease the sellers gain but for the corp the transaction cost of an atty will be added to the corps cost basis. 3. Carmela owns 80 shares of common stock of X Corp, which has 100 shares of common stock outstanding. X Corp owns 65 shares of common stock of Y Corp, which has 100 shares outstanding. Carmela sells 35 shares of X Corp stock to Y Corp for $100 per share. Assume that Carmela has a basis of $25 per share in the X Corp stock, and that X Corp has $4,000 and Y Corp has $6,000 of accumulated E&P. What are the tax consequences to Carmela? The fact that C owns X corp is neither here nor there Before, C owns 80. After, C directly owns 45; indirectly look at 318 attribution (there is no 50% threshold!) o 35 shares of X (attributed back to X) x 65% (Xs Y stock) x 45% (deemed owned by C by reason of 318) = 55.23% owned by C. Sorry, she doesnt qualify under 301(b)(2) (reduction from 80% to 55% is not good enough). o There is an argument for (b)(1) b/c of 20 shares of X Corp are owned by D (another random SH), but thats the largest second holder then the 45% turns out to be a rather large super majority. o Corporations A/B in Y Stock362(a) b/c of deemed351 transaction 148
4. Gabrielle owned 70 out of 100 shares of common stock of Q Corp and 30 out of 80 shares of Q Corp stock, with a basis of $40,000, to V Corp in exchange for 20 shares of V Corp stock worth $50,000 and $50,000 cash. V Corp had over $100,000 of E&P. What are the tax consequences to Gabrielle? Before, G owns 70/100 of Q Corp and 30/80 of V Corp. Then she transfers 30 shares of Q Corp to V Corp; shares have basis of 40k for 20 shares V w/ FMV of 50k and 50k cash. After, G owns 40/100 of Q and 50/100 of V Corp. Why does 304 even apply? The mystery is why the language in Reg. 1.304-2(a). Look at control of the issuer before the transaction (even if it no longer controlled afterward); look at control of the acquirer after the transaction (to take into account a situation like this one where addl stock is issued and take into account a simultaneous owner of two corps). After: Direct owns 40/100 plus 15/100 through V Corp and (30 x ) = 55 of 100. Remember the Rev Rul holding if there are exactly two SH and there is a redemption of one that reduces that maj SH to 50% exactly, then that counts under 302(b)(1) b/c of the deadlock that is created. The 30 shares of Q that are now owned by V Corp are voted according to Vs BOD (and G only has 50% authority to choose the BOD of V Corp) so there has acatully been some loss of control. What is the amount of the dividend? The cash (property) is a dividend b/c 304(a)(1) applies to it. What about the 20 Shares of V stock worth $20,000? 304(a)(1) only applies to property. The stock of V corporation (the corporation making the distribution) is not property because of 317(b). o 15 shares of Q w/ basis 20k put in. Gets back 20 shares V stock. 304(c)(1) control applies... but does 364(c) control (which governs 351 transactions) apply? The last sentence of 304(a)(1) that deems a 351 transaction doesnt apply (b/c we didnt meet the if clause). So, do we have an actual 351 transaction. No, b/c there is not 80% control of vote and value. o So, it appears that this would be a sale transaction... o 304(b)(3) has an extensive coordination rule w/ 301. That is intended to deal w/ the argument that would otherwise exist that if in this fact patter G got cash but also enough V stock to reach 80% ownership in vote & value (as defined in 368(c)). (This was put in b/c TP were arguing that the cash was boot in a 351 transaction.) If enough stock was transferred to meet the 368(c) reqs then the cash will be run through 304 while the stock recd would be 351 stock. 5. Felicity owned all of the stock in Transamerica, Inc. and Desperate Soap Corp. Felicitys basis in the Transamerica stock was $999,999. For many years, Despearte Soap had operated separately an advertising business and a chain of daycare centers. This year, Desperate Soap sold the day care center business for $1M and used the proceeds to purchase all of Felicitys Transamerica stock. Desperate Soap had over $1M of E&P. What are the tax consequences to Felicity? 149
o Looks like a straightforward 304(a)(1) resulting in a dividend (instead of $1 capital gain). This could be seen as a partial liquidation under 302(b)(4). The $1M is attributable to the cessation of the daycare business. We measure the contraction o Blotchka case (??) addressed this issuethe ct concluded that the partial liquidation test would be applied at the purchaser corporations level. o Avoid dividend treatment here by treating it as a partial liqudation under 302(b)(4) of Desperate Soap. If so, the basis equals the percentage of Fs DS basis equal to the percentage of DS assets distributed. So, of Fs basis will be used. Do we add the FMV of Ts assets to the % of DSs assets to determine the percentage of assets distributed? And, if we do, do we add Fs basis in Transamerica to Fs basis in DS in determining what is of her basis. There hasnt been a case or a Rev Rul on this issue.
Thursday, November 4, 2010 (Missed class see notes in file) Chapter 7 Stock Dividends Section 1. Taxable versus Nontaxable Stock Dividend Many stock dividends will effect a restructuring of the capital of the corporation. Economically, a stock dividend does not result in income because there is no incremental change in value of the shares owned by each shareholder or of control of the corporation. Essentially, the only thing a stock dividend does is divide the pie into bigger pieces. 305 The promise land is 305(a). 317 provides that a distribution of the stock of the distributing corporation is not a distribution of other property; however, 305(b) says that, notwithstanding 317, the distribution of stock of the distributing corporation is taxable if the conditions of 305(b)(1), (2), (3), (4), or (5) are met. 305(c) codifies the substance over form doctrine. 1(a) X Corp has single class of voting common stock with 10,000 shares outstanding. The FMV of each share is $300. If the corporation declares a dividend of one share of nonconvertible $200 par value preferred stock on each share of common stock, will the stock dividend be taxable or tax-free under 305? Is this a taxable stock dividend of a tax-free stock dividend? Does it fall within any of the exceptions in 305(b)? No. Therefore, it is taxfree under 305(a). What is important to understand is how mechanical 305 is. The question we are asking is not, universally, did the shareholder get something that they did not have before. Here, none of the rights that the shareholder had before changed. There is also potential for abuse. For example, you find a friendly investment banker to buy all of the preferred stock for cash, and several years latter you redeem the investment banker for cash. That is why 306 provides that the preferred stock is forever thereafter tainted with ordinary income.
150
(b) Arnie, one of the s/h of X corp, owns 200 shares of common stock (purchased in a single block with a basis of $6,000. Assuming that the FMV of the preferred stock after issuance is $100, what are the bases of Arnies 200 shares of common and 200 shares of preferred respectively? The par value of preferred stock is the amount entitled to which the shareholder is entitled to on liquidation or the base for determing the amount of dividends. We have to determine Arnie's basis in the preferred and common stock after the distribution. If the stock distribution is not taxable by virtue of 305(a), then the basis of the stock with respect to which the stock distribution is issued is allocated between the old stock and the new stock in proportion to the fair market value of each on the date of the distribution. Treas. Reg. 1.307-1(a). The basis apportionment rules are almost always a pro ration rule or stacking rule. Common: $6,000 x ($40,000/$60,000) = $4,000 = $20/per share Preferred: $6,000 x ($20,000/$60,000) = $2,000 Stock dividends change the value of the stock on which the dividend was declared. Our methodology was to take the value of the common stock before the dividend and subtract the value of the preferred stock after. The value of preferred stock is simply the net present value of the cash flow. The common stock is much more difficult to value. The point is that you have to get the valuation's after. It is entirely possible that the value of the two classes combined after the stock dividend. 2(a) Y Corp has a single class of voting common stock outstanding. Y Corp maintains a dividend reinvestment program by which any s/h may elect to receive additional shares of common stock in lieu of cash dividends. If a s/h elects to receive stock instead of cash, the stock dividend will consist of a number of whole or fractional shares having a FMV equal to 110% of the dollar value of the declared cash dividend. Thus, for example, if the declared cash dividend is $1 per share at a time when shares are trading at $10 per share, a holder of 500 shares who elected to receive stock would receive 55 shares instead of a cash dividend of $500. Are the stock dividends taxable? If so, what is the amount of the distribution? This is a taxable distribution under 301 because 305(b)(1) applies. See Rev. Rul. 78-375. When a stock distribution is taxable under 305(b), it is treated as a distribution of property to which 301 applies, and a dividend results under 301(c)(1) in the amount of the fair market value of the stock dividend (either actual or constructive) if the distributing corporation has sufficient earnings and profits. Treas. Reg. 1.305-2(b), Ex. (1). In situations to which 305(b)(1) applies, the amount that is taxable is the fair market value of the stock dividend itself and not the cash dividend that was foregone in lieu of the stock dividend should these two amounts for any reason not be equivalent. See Treas. Reg. 1.301-1(d)(1)(ii); see also Rev. Rul. 76-53, 1976-1 C.B. 87 (holding that the amount taxable under 305(b)(1) was the full fair market value of the stock received and not the cash dividend). 307 does not apply because that section only applies if 305(a) applies. (b) Would the stock dividends be taxable if every s/h elected to receive additional stock and none recd cash?
151
Section 305(b)(1) applies if the effect of an election is achieved by issuing E, F, G, and H are stuck with a taxable stock dividend even though it was only A, B, C, and D that had the option. Treas. Reg. 1.305-2(a)(5). See Rev. Rul. 83-68, 1983-1 C.B. 75. 4. (a)(1) Immediately before the stock distribution if the corporation had only $350,000 on liquidation the Class B preferred shareholders with $200,000 worth of Class B shares would get their $200,000 liquidation preference and the remainder would go to the shareholders of Class A common shares. However, if the corporation distributes $200,000 worth of Class B preferred to Class A common shareholder's and the value of the corporation's assets on liquidation were only $350,000, then the Class A shareholder's would increase their preference on liquidation. Treas. Reg. 1.305-3(e) Ex. 3 (a)(2) Reg. 1.305-3(b)(6) C 10 10 10 P 0 10 20 New Preferred 10 10 10
A B C
The regulation is not consistent with this fact pattern when you have only a single shareholder. The Code seems to contemplate that there has to be at least 2 shareholders to trigger 305(b)(2). (b) X Corp distributes a stock dividend of newly issued Class C preferred to the Class A s/h. The Class C preferred is junior to the Class B preferred. Is the distribution taxable? See end of answer to (4)(a) (in missed class notes) No, because the liquidation rights on the Class C junior preferred is subordinate and, therefore, does not increase the shareholder's proportionate interest in the corporation. 5. Y has only a single class of voting common stock outstanding. Y Corp also has issued a series of $1,000, 6% debt instruments convertible into common stock at the rate of ten shares of common stock for each $1,000 debt instrument. Y corp declared a two-for-one stock split, distributing to each s/h newly issued shares equal in number to the shares previously held. Must the conversion ratio on the debt instruments be increased to avoid a taxable stock dividend? Under corporation law, if there is a stock dividend, the corporation transfers an appropriate amount from earned surplus to paid-in capital. But with a stock split, you simply adjust the amount of paid-in capital per share. 305(b)(2). If we pay interest on the bonds and do not increase the conversion ratio, results in increasing the interest of the original common shareholders of the corporation. 1.305-3(e), Ex. 4
152
Tuesday, November 9, 2010 6. Z Corp has outstanding Class A voting common stock and Class B participating preferred stock. Class B is entitled to a noncumulative preferred dividend of $1 per share if cash dividends are declared, and a liquidation preference of $100 per share. After the preference is satisfied, Class A and Class B share dividends and liquidation proceeds in a 60% to 40% ratio. Z Corp declared a stock dividend of one share of Class A stock on each share of Class A stock and one share of Class B stock on each share of Class B stock. Is the distribution taxable? What we are trying to do is replicate a stock split (recall, if you double the number of shares outstanding under a stock split or a stock dividend). Here we increase Class A common (60% growth) and Class B Participating $100 preferred (40% growth). Is there a distribution on preferred stock in this question? Class B is labeled preferred stockbut what is preferred stock for purposes of 305(b)(4) or (b)(3)? If some SH receive common and some receive preferred or if there is a distribution on preferred stock there is a taxable stock dividend. o Preferred stock is defined in? 305(d) where there are defn it isnt there! Go to Reg 1.305-5(a) that says term preferred stock enjoys limited rights & privileges...but doesnt participate in corp growth to any significant extent. o If the Class B stock is "preferred stock" within the meaning of Reg. 1.305-5(a), 305(b)(4) would apply because it would be a dividend on preferred stock. However, this is not preferred stock because it shares in growth of equity (it is participating). Not 305(b)(1) not (b)(3) not (b)(4) or (b)(5)... What about 305(b)(2)? Lets assume that ordinary dividends have been paid all along? Has one of the classes of stock increased its claim on corp assets relative to the other classes of stock? Yes! The class B shares have $100 preference. Before the distribution the first 100k went to the class B stock and then 60% of whats left went to class A and 40% went to class B. After, the first $200k goes to Class B then 60% of whats left goes to class A and 40% goes to class B. o Class B stock on liquidation, if things go really bad, goes up by $60k. (b/c of the addl 100k they would have gotten only 40k and they now get 60k) o If we go 6 years w/out paying dividends on the common stock then we may be able to effectuate a stock split (If you freeze the dividends on Class A stock for 3 years before and for 3 years after, this would not be a taxable dividend. However, this would probably result in a suit by class a shareholders against the BOD for breach of fiduciary duties.) If you issue common on common and pref you increase the upside claim then you still increase the preferred upside. Can you create a new class of stock? Just something to think about... If we want to double the number of shares outstanding and not have a taxable stock dividend, we have to reduced the liquidation and dividend preference. From a corporate law perspective, we would probably have to have a recapitalization. In order to trigger 305(b)(2) Class A would have to receive dividends. See Reg. 1.305-3(b)(4) (stating that if the stock distribution and the property distribution are more than 36 months apart, they will be presumed not to have the proscribed statutory result unless made pursuant to a "plan"). The distribution to Class B was the distribution that resulted in receiving an increased interest. 153
If the Class A common stock were to have a taxable stock dividend, what should be it's value? For Class B it is $100 per share. If you have a taxable stock dividend, the amount that's taxed is the FMV of the increased interest in the corporation. Here, Class A interest in the corporation actually decreased, so the FMV would be negative. When you have multiple classes of stock and each class receives a stock dividend you have to carefully analyze what was the claim of each class before the stock dividend and what was the claim of each class after the stock dividend. Here, the only difference was that Class be doubled its liquidating and dividend preference. 7. (see missed class notes in file) X Corp has outstanding Class A voting common stock and Class B nonvoting convertible preferred stock. The Class B stock is convertible into Class A at the ratio of ten shares of Class A for each share of Class B. X Corp pays regular dividends on the Class B preferred stock. Two classes of stock, Class A and Class B. Before the distribution the Class B was convertible into 10 shares of Class A common for each Class B share. The 1 for 1 stock dividend on the Class A common doubled the number of Class A common shares, so doubling the conversion ratio on the Class B common is necessary to maintain the proportionate interests of the Class B shareholders. 305(b)(4) specifically allows us to adjust the conversion ratio. (a) X Corp declares a one-for-one stock dividend on the Class A common stock and the conversion ratio for the Class B stock is increased to 20 to 1. Is there a taxable dividend? Rev. Rul. 83-42 305(b)(4) says "if the distribution is with respect to preferred stock, other than an increase . . . " Here, the if clause is satisfied: There was a distribution on preferred stock. (b) Would there be a taxable stock dividend if the ratio at which Class B was convertible into Class A stock were adjusted 21 to 1 When you have a rule that says if you cross a line that says you move from nontaxable to taxable, the question is whether all of it is taxable or whether only the excess is taxable. Reg. 1.305-3(e) Ex. 6 says only the overage is taxable. (c) Would there be a taxable stock dividend if the ratio at which Class B was convertible into Class A stock were adjusted 19 to 1 Class A would have a taxable stock dividend because we have diluted the conversion ratio. The point of this problem is that you have to hit the conversion ratio perfectly in order to prevent having a taxable stock dividend to somebody. 8. Y corp has outstanding a single class of voting common stock. The corp declared a dividend on the common of newly issued convertible pref stock. The pref stock is convertible into common stock at any itme in the next 20 years at a price equal to 110% of the common stocks market price on the date of the distribution of the convertible pref stock. Is the stock dividend taxable? 154
305(b)(5) says taxable unless not leading to a result described in paragraph 2 (disproportionate distribution). Reg. 1.305-6(a)(2): likely to have the proscribed effect if the rights have to be exercised in a relatively short period of time AND taking into account factors (see code) some will exercise and some will not. A long time dividend rate is appropriate, then there is no basis for predicting. If there is no basis for predicting, then the govt wins (b/c the TP must establish that either all will convert or none will convert) If it isnt publicly traded (and it is illiquid) a risk adverse SH will sit on the pref. and a risktaker will elect and change into common. McMahon thinks that this code section was enacted and congress didnt think any TP could carry the burden of proof (b/c the TP would have to have a crystal ball). Short time to convert = likely (probably will have a taxable stock dividend) (see example at (b)(2)) Long time to convert = cannot predict. See example at (b)(1): this problem is taken from this example. What triggers 305(b)(5) is that some SH will convert and some wont convert. 9. W Corp, the common stock of which is publicly traded, proposes to distribute as a pro rata stock dividend on its common stock newly issued $100 par value, 10% Class B nonvoting convertible pref stock. The pref stock will be callable by W Corp after 10 years at $120, and, if it is not called, it becomes convertible into W Corp common stock at a rice equal to 50% of the then current trading price of the common stock. How ill the pref stock be treated if it is issued? Is this 305(b)(5)? 10 years is a reasonably long period of time; either everyone will exercise b/c of the bargain or all the stock will be called (so it is likely that all will exercise or not). So, 305(b)(5) wont catch this. Is it likely that it is going to be called? Are the directors going to allow the conversion to happen? No, they will call the stock. Now we have callable pref stockdoes that present a problem? 305(c)there has, in essence, been a distribution here of more preferred stock. For every share of pref stock (worth $100 originally) now there is a value of $120so each one share is now worth 1.2 shares. This is why 305(c) existsif you take a back door to get the effect of a transaction in (b)(1) through (b)(5) then (c) will catch you! Treas. Reg. 1.305-3(b) states that redemption transactions will not generate a taxable deemed distribution to the remaining shareholders under 305 if the redemption itself is entitled to capital gains treatment by the redeemed shareholders. However, if the redemption distribution is treated as a dividend under 302(d) and 301, the increase in proportionate interest on the part of the other shareholders can be taxable under 305(b)(2) and 305(c). See Treas. Reg. 1.305-7. If the stock is callable... 1.305-5(b): if there is a right to call but not mandatory there is a constructive 305(b)(4) if it is more likely than not that the stock will be called (that is the case here!).
155
o So there is a constructive dividend of pref stock on pref stock. So the $20 is ordinary income; we must apply the original issue discount rulesso over 10 years there is a dividend of 1.83% (b/c increase of $20 over ten years; each year the dividend increases b/c it is on a percent of the value of the shares) o If the premium is a reasonable call premium then you dont have to apply these rules. o We need to know the starting amount the ending amount and how long the period is in between to apply these rules. 10. Z corps stock is publicly traded. If Z corp purchases ten percent of its outstanding common stock on the open market, for the purpose of enhancing the value of the shares remaining outstanding, have the holders of the remaining stock recd a taxable stock dividend? What happens when we distribute cash and redeem shares of group A; the group B will see their percentage of shares go up. Reg. 1.305-3(e), Ex. 13, exempts such transactions from the application of 305(b)(2) if the shares are purchased for use in connection with employee stock investment plans, for future acquisitions, etc., and there is no plan to increase the proportionate interests of some shareholders and distribute property to other shareholders. You cannot have a constructive 305(b)(2) via (b)(3) if the redemption qualifies for capital gins treatment. In effect, there are different rules that apply to the closely held corporations than to the publicly held corporations (who will never fall under (b)(2) tests, so they automatically pass under (b)(1)). 11. X Corp has one class of outstanding common stock, which is held by unrelated individuals D (500 shares), E (300 shares) and F (200 shares). Will 305(c) create a constructive stock dividend if X corp agrees to redeem annually 50 shares of stock at the election of each SH, and D makes such election for 2 constructive years? This is a closely held corp situation. D is getting cash (and his ownership goes down from 50% to 47.37 to 44.44%) and E and Fs percent ownership are going up (to 55.56%). Does 305(b)(2) apply to catch E & F and trigger a constructive stock dividend via 305(c)? 1.305-3(b)(2): mere effect is sufficient. Here, there is the effect of a recept of cash by some and an increase in interest by other. 305-3(b)(3) says it has to be a 301 distributionis it a 301 distribution for D? It isnt 302(b)(2). The first reduction is arguably 302(b)(1). An isolated redemption that doesnt pass 302(b)(2) and TF the redeemed SH is taxed under 301, doesnt trigger a constructive dividend to the other SH. This isnt isolated! b/c there are two redemptions! One of the two redemptions by itself looks like a 302(b)(1) the other falls under 301. We dont know what the answer is... if there is another redemption next year and D gets 301 treatment again, then it will begin to look like E & F have a taxable stock dividend.
Section 2. The Preferred Stock Bailout p.330 Chamberlain case: only common outstanding, distributed preferred pro rata to all SH, qualifies as stock dividend. The money really came from X corp. Chamberlain managed to convert ordinary income into capital gains. And won, no step transaction applied. 156
306 The first question is why not just make the distribution taxable instead of providing that 306 stock has an ordinary taint? When family businesses were organized as C Corporations, which was true when 305 and 306 were enacted, there were legitimate reasons for making a dividend of preferred stock on common stock. For instance, if A has two children B, who works in the business, and C, who does not, then giving C preferred allows A to give C his inheritance but B will still have all the upside. 1. First we have to determine the new basis of the common stock and the basis of the preferred stock. Basis in the common stock - $15,000 Basis in the common stock - $30,000 (a)(1) First thing to do is check to see if it is 306 stock. What is 306 stock? It is stock other than common stock (usually preferred but doesnt have to be) (306(c)(1)(A)). The rev rulings tell us what this meanssee p. 338-39 (76-3987)as long as the stocks rights are limited it is other than common stock (ex: participating preferred stock isnt going to be 306 stock. 306 stock is limited. Callable preferred is still limited b/c it has a dollar cap. If a stock is only entitled to a horizontal slice of money then it is limited & is 306 stock). It doesnt matter if the stock is voting. 306(a)(1): says if it is 306 stock then the amount realized is treated as ordinary income. the starting point is the amt realized is ordinary income; the ceiling on the amt that is ordinary is the amt that would have been a dividend if the corp had distributed stock (check code). Ordinary income & dividend possibility looming. o 50/150 x 45 = 15 o 100/150 x 45 = 30 o the other 40k o Prefd on common pro rata is tax free on 305(a). Anything other than a common on common has the potential to be 306 stock. Rev. Rul. 82-91 tells us that voting stock can be "other than common stock." We look back to what would have been a dividend if $100,000 had been distributed to each shareholder on the date of the distribution. In 2003 the E&P were $295,000, so each shareholder's pro rata share of the E&P for that year was $59,000. $100,000 -$59,000 Taxed as ordinary income $40,000 $11,000 capital gain
157
(a)(3): lots of E&P in year of distribution... there is 100k amt realized; that is ordinary income but not in excess of a ratable share of E&P (amt that would have been a dividend if cash was distributed). Full 100k amt realized is ordinary income. what happens to the 30k basis? (in the first example we used it as a tax free return of capital) the regs in 306-1(b)(2)(Ex 2) send the basis back to the prefd stock. (a)(4): do we still have ordinary income treatment in this question? Look at exceptions in 306(b). This question would qualify if he sold all common and all pref to one person under (b)(1)(A). Look at (b)(4): requires (A) that distribution and disposition or (B) simultaneous disposition of common and prefd THAT was not in avoidance of federal income tax. You must fit into either (A) or (B) and not be in avoidance of federal income tax. Pescasolito (sp?) goes for (A) (shows that the exceptions must be read narrowly. We are shooting for (B). Burke moves from 1/5 to 1/10 of the voting power. Is that a meaningful change? We dont know! Wed only know if we got a ruling from the IRS. (a)(6) : if you look at defn of 306 stocksee 306(c)(1)defined w/ ref to the personal identity of the SH who got the stock in the distribution. If it was 306 stock to a transferor and the tranferee gets a transferred basisthen the stock is 306 in the hands of the transferor. If the stock is redeemed by the corporation just go straight to section 301 (dont worry about 302). You can have prefd stock that isnt 306 stockin order to be 306 it must have been distributed tax free under 305 (so if prefd stock was purchased then it isnt 306 stock or if it was issued upon initial incorporationb/c there was no E&P) Tuesday, November 16, 2010 CHAPTER 8 CORPORATE LIQUIDATIONS Section 2. Treatment of the Corporations Section 3. Treatment of Shareholders What is a corporate liquidation? 336 overrides 311 (which would apply if we werent in a liquidation situation. o 336 allows both gains & losses 336(a) PlanSeries of distributions allowed: how do we know when the distributions end and the (plan should be in resolution of BOD & SH approval) 332: liquidations of a subsidiary that is a member of Parents affiliated group; difference btwn dividend distribution & liquidation distribution moves from gross income to 332: defn of liquidation ceases to be a going concern; activities for winding up affairs, paying debts o 311 controls at SH level providing sale/exchange treatment (displacing 301 and 302 that would apply at the SH level if there was not a liquidation) o 346(a): redemption entails all of the stock (no SH left); all of the corps property distributed. Context of Liquidation: o most common, sale of all assets for cash or promissory notes & distribution of cash/prom notes to SH. 158
o Second most common, is the conversion of the corp into a pship (w/ multiple SH) or a sole proprietorship (if only 1 SH) to get out of the double tax system (this is very easy to accomplish in the check the box system). Ex: A & B have a corporation (X) then X is converted into a LLC (under & allowed by state law) o Dispursal sale: leads to a series of distributions Not all dissolutions are liquidations. In order for the liquidation rules to apply the SH has to get something (an insolvent corporation cant liquidate for tax purposes; under state law the creditors get first payment, so if there isnt enough to pay debts then the SH wont get anything. w/ a transfer to a creditor 1001 applies b/c paying a debt; to the creditor it can be 1001 but also 165 loss and under certain circum 166 bad debt)
For assignment 19, read p. 363 and 364; and illustrative material number 6 Note there are exceptions to 331, dealing with the treatment of shareholders, if the corporation is liquidate part and parcel as part of a tax-free reorganization. It is possible that a corporation can dissolve, but not liquidate for tax purposes There are a number of code sections that have to come together (and be applied in the proper order) when analyzing a corporate liquidation. First, you have to apply 336, which says that the corporation recognizes gain and loss upon the distribution of assets in-kind. o If the corporation sells all of its assets to another corporation for cash, the gain is recognized under 1001, so 336 does not apply because the corporation is not distributing property. o Likewise, if the corporation has a disbursal sale of its assets, where assets are sold to various purchasers rather than being sold as a going business, the gain is recognized under 1001. It is possible in a disbursal sale that not all of the assets will be sold, so 336 will be relevant if any assets are distributed to the shareholders. The shareholder's tax consequences are determined under 331, with a little bit of concern with 1244 with respect to the character of the gain. 334(a) governs the shareholder's basis in any assets the shareholder receives if the shareholder receives property in-king. 1239 applies to determine the character at the corporate level if it distributes assets inkind. If the shareholder is a corporation that owns both 80% of the vote and 80% of the value of the liquidating corporation, then 336 and 331 are displaced and 332 applies to the shareholder corporation and 337 applies to the liquidating corporation. Both 332 and 337 provide for nonrecognition. The shareholder corporation's basis in the assets received is determined under 334(b). In addition, 381 provides that the parent corporation succeeds to all of the subsidiaries tax attributes, such as earnings and profits, net operating loss carryovers and the like. Liquidations are a festival of taxation: the liquidating corporation recognizes gain or loss on all of its assets, as do the shareholders. After that everything else becomes transactional details. The problems are meant to raise the most common types of transactional details. 159
1. Wilbur owns 600 of 1000 outstanding shares of Dayton Airplane and Bicycle Corporation. Wilbur acquired 400 shares for $50,000 approximately 20 years ago and 200 shares late last year for $1,900,000. What are the tax consequences to Wilbur on the liquidation of Dayton Corporation in the following alternative situations? This is a cash distribution. With a cash distribution, we don't have much to worry about with the liquidating corporation. Subchapter C issues only arise when the liquidating corporation distributes assets in-kind.
(a) Dayton sells its assets for cash, after which it has aggregate current and accumulated earnings and profits of $7,400,000. After paying all its debts, Dayton distributes $6,000,000 to Wilbur in complete liquidation. Where a series of liquidating distributions are received or where the shareholder owns different blocks of stock acquired at different times and at different costs, each distribution must be allocated to each block of stock and gain or loss is computed separately for each block of stock. Treas. Reg. 1.331-1(e). Total basis = 1,900,000M Wilbur gets 6,000,000M in liquidation Wilburs gain seems to be 4,050,000... but we cant calculate it this way! We have to calculate block by block. Computation of gain and loss on a block-by-block basis when the shareholder receives a single liquidating distribution generally is relevant either if long-term capital gains are taxed differently than short-term capital gains or if liquidating distributions are made over the course of two years or more. (400/600) x $6,000,000 = $4,000,000 (200/600) x $6,000,000 = $2,000,000 400 $4,000,000 $50,000 $3,950,000 200 $2,000,000 $1,900,000 $100,000
600 shares AR Basis Gain/Loss
Why do we care that the gain is calculated by block? o If Wilbur's 200 shares acquired late last year were not held for more than one year, then the distribution with respect to those shares will be short term capital gain. The distribution with respect to the 400 shares acquired 20 years ago will be long-term capital gain. o So, some gains may be long term others short term. Also possible that one block produces LTCT and STCL These gains and losses are not directly netted, but are taken into account separately in calculating Wilbur's net long-term capital gain and net short-term capital loss for the year pursuant to 1222.
160
(b) Dayton sells its assets for cash, after which it has a deficit in earnings and profits. Dayton distributes $300,000 to Wilbur in complete liquidation. 600 shares 400 200 AR $200,000 $100,000 Basis $50,000 $1,900,000 Gain/Loss $150,000 ($1,800,000) Character LTCG STCL W owns 600 of 1000 shares. Can W recognize the short term capital loss? What about 267(a) that disallows losses on sales/exchanges btwn related SH. A related SH is more than 50% owner of a corp by vote or value. 331: treated as full payment/exchange for the stockgo to 1001. When we go to 267(a), the second sentence calls off 267 in a complete liquidation situation. Why? 267 is to stop people from choosing losses (cherry picking) w/out really any change in the ownership of the corporation. With a complete liquidation, there is no cherry picking going on... everything is on its way out. (c) Dayton was unable to find a single purchaser for all of its assets. It sold some of its assets last year and distributed $3,000,000 to Wilbur last year. This year, after selling its remaining assets and paying its debts, it distributes $1,500,000 to Wilbur. Is the date of adoption of a formal plan of liquidation crucial? Does the nature of the assets sold last year have any bearing on whether the adoption of a formal plan of liquidation is important. 400 Shares, Basis 50k Last year $3M This Year $15M Where a liquidation is accomplished through a series of distributions, 346(a) provides that all distribution in the series pursuant to a plan to liquidate the corporation will be treated as liquidating distributions. The first question is whether there was a plan to liquidate? o If it isnt a plan of liquidation, then the dividend rules apply o We need to establish that a state of liquidation existed last year before the $3M... by looking at Maguire and Olmstead In Estate of Maguire v. Comm'r., 50 T.C. 130 (1968), the court formulated the test for determining whether a liquidation has in fact occurred as follows: "There are three basic tests: (1) There must be a manifest intention to liquidate; (2) there must be a continuing purpose to terminate corporate affairs; and (3) the corporation's activities must be directed to such termination." o If we are doing this in advance we want the plan that is referred to in 346(a) in a director's resolution to satisfy the intent element of Maguire. o Best option, show that the $3M came from selling operating assets. Worst option, $3M from sale of investment assets or inventory. 200 Shares, 1.8M basis
161
Neither the Code nor the regulations under 331 define a "liquidation." However, Treas. Reg. 1.332-2(c), which defines the term "liquidation" in the context of a corporate subsidiary, provides some guidance: "A status of liquidation exists 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." o What other inquiries do should we make, even though we have a director's resolution, before we can confidently say that that $3,000,000 is treated as a liquidating distribution rather as a dividend (because we have E&P). We want to look at the nature of the assets sold. What if some of the operating assets were sold & some of the inventory was sold for the last year distribution? This may make us fall out of liquidation status... if the first distribution falls outside of liquidation, it may be a contraction / partial liquidation under 302(b)(4) Here, the name of the company is "Dayton Airplane and Bicycle Corporation," so if the name of the company is indicative of its businesses, then that means that they have two different businesses. So we would want to know what assets were sold last year. What if the assets sold last year were all of the assets of the airplane business, but we still have the bicycle business, as opposed to selling off both factories? If it is the bicycle business that is sold in the second year the facts that would establish that the first distribution was pursuant to a plan of distribution would be that we ceased operating the bicycle business. However, you are not going cease operating because if you want to get maximum value you would sell the business as a going concern. Even though you are keeping the bicycle business operating, you want to demonstrate that you are making an effort to sell by contacting potential buyers, going to an investment banker, hiring a consultant, getting valuations, etc. Evidence that tends to show that the business is not in a status of liquidation would be an expansion of the business (i.e. purchasing new equipment). McGuire and Olmstead illustrate the factors to consider. 400 $2,000,000 $50,000 $1,950,000 LTCG 400 $1,000,000 $0 $1,000,000 LTCG 200 $1,000,000 $1,900,000 None, new basis is $900k
Last year: $3,000,000 AR Basis Gain/Loss Character This year: $1,500,000 AR Basis Gain/Loss Character
200 $500,000 $0 $500,000 STCG
162
The next question is when do we recognize the gain or loss and the method we use to determine how much gain is recognized in year 1 and 2? Basis used after in liquidation status: After each distribution has been allocated among the blocks of stock, gain is recognized with respect to a block of stock after its basis has been recovered. This treatment, ratified by Rev. Rul. 85-48, reflects the "open transaction doctrine" (use all basis dollar for dollar until you run out of basis) of Burnet v. Logan, 283 U.S. 404 (1931), even though such treatment generally is not available for installment sales. See Treas. Reg. 15A.453-1(c). However, no loss is recognized in a 331 liquidation until after the corporation has made its final distribution. Rev. Rul. 68348, 1968-2 C.B. 141; Schmidt v. Comm'r., 55 T.C. 335 (1970). Thus, gain may be recognized on a particular block before basis has been completely recovered on another block. Furthermore, where the series of distributions spans two or more years, it is possible for a shareholder with no overall gain to realize capital gain in one year and a capital loss in a subsequent year, without being able to offset the two. o The rationale for allowing use of the open transaction doctrine is that we won't know whether there will be a gain or loss overall until after the last distribution. We dont know how many distributions there will be! So we cant apportion btwn the distributions. Even if the distribution in year 1 is not a liquidating distribution, it is entirely possible that the sale of the airplane business and the distribution of the proceeds of sale of the airplane business would be a partial liquidation entitling the shareholder to capital gains treatment, albeit using only part of the basis, so if we go back to where basis was at $50,000, we would have to say that since we distributed 2/3rd's of the corporation's assets, 2/3rd's of the basis would have to be used. Thus, one consequence of characterizing this as a partial liquidation is that you get a different basis number. Distributions that are one of a series leading to complete liquidations are treated as distributions in complete liquidation under 331, rather than as distributions in partial liquidation. Characterization of a distribution in this regard mad be important as reqpects the shareholder for two reasons. First, a loss may be realized and recognized on a distribution in partial liquidation. See Rev. Rul. 56-513, 1956-2 C.B. 191. But in a complete liquidation, no loss may be claimed until the series of distributions is completed. Second, corporate distributes never qualify for exchange treatment under 302(b)(4), but always will be accorded exchange treatment if the distribution is pursuant to a plan of complete liquidation. From the perspective of the distributing corporation, the difference is significant because the corporation under 311 recognizes only gains (with realized losses being disallowed) on the distribution of property in a partial liquidation, but recognizes both gains and losses on the distribution of property in complete liquidation under 336. Consider tax planning: If you have a distribution that will cause a loss, should that distribution have been lumped into a year with a gain so that they can offset each other? Would there be any reason to delay a distribution?
163
(d) Assume that Wilbur acquired all 600 shares at the same time for $2,000,000. Dayton sells its assets and distributes to Wilbur in complete liquidation $4,500,000 of cash and a promissory note from Armstrong Corp., which purchased some of the Dayton assets, with a principal amount of $1,500,000, due in five years, with interest payable semiannually at the prime rate plus 3%. (1) What if the promissory note was received by Dayton two years ago in exchange for a bicycle factory building, which had an adjusted basis of $300,000? Gross profit = selling price AB o $1,500,000 - $300,000 = Total contract price is the selling price reduced by that portion of any qualifying indebtedness assumed or taken subject to by the buyer, which does not exceed the seller's adjusted basis in the property. o Here, the total contract price is $1,500,000 because there is no qualified indebtedness. Gross profit ratio = gross profit/total contract price o $1,200,000/$1,500,000 = 80% What is the first tax consequence that must be determined? What the corps tax consequences areb/c that affects the amt of cash that it has to distribute to a SH. Whenever you have something other than cash within the corp to deal with this must be the first question. o 336(a) provides that on a distribution in complete liquidation the corporation must recognize gain as if the property were sold to a third party at its FMV. o OR 453B provides that when a promissory note is distributed gain is recognized immediately on the difference between the amount realized on the distribution and the adjusted basis of the note ($300,000) 453B(b) provides that the basis of an installment note is "the excess of the face value of the obligation over an amount equal to the income which would have been returnable were the obligation satisfied in full." $1,500,000 -1,200,000 $ 300,000 453B(b) (basis of installment note) o Thus, under 336(a)/453B the corporation has gain of $1,200,000 (on which it pays taxes at the appropriate rate) As to the shareholder (W), the entire amount is amount realized because 453(h) does not apply because the plan of liquidation was not completed within 12 months after it was adopted. Under 331, the amt realized is the cash (4.5M), the FMV of the note (1.5M, see Reg. 1.1001-1(g) in a taxable transaction the FMV of a promissory note that bears adequate interest for the term of the note is its principal amountno inquiry in the creditworthiness of the maker of the note) total is 6M. o Amount realized: $4,500,000 +1,500,000 $6,000,000 Adjusted basis $2,000,000 Gain Realized $4,000,000 164
(2) What if the promissory note was received by Dayton eleven months ago, after Dayton had adopted a resolution to liquidate, in exchange for a bicycle factory, which had an adjusted basis of $300,000? 453(h) would apply, so we treat the shareholder as disposing of his stock in an installment sale transaction. SH allowed to use the installment method o Because 453(h) applies we apply the whole liquidating distribution is treated as an installment sale. Thus, the $4,500,000 received year would be treated as a "payment" to which Wilbur would apply his gross profit ratio in order to determine the amount of gain to be recognized this year. Installment = Payment x (Profit / Contract Price) Gross profit ratio = $4,500,000/$6,000,000 = 75% of each payment will be gain 75% x $4,500,000 (payment received this year) = $3,375,000 (gain recognized this year). 75% x $1,500,000 (payment received in year 5) = $1,125,000 (gain recognized in year 5). The corporation's taxation does not change at all. 453(h) applies to only to give the shareholder installment sale treatment. What are the conditions on 453(h)? o Need a liquidation to which 331 applies (not a partial liquidation). o Note must be recd after the plan has been adopted. Installment notes that preexisted the plan of liquidation do not get this treatment o The liquidation process (the note all everything else distributed) has to be complete within 12 from adoption of the plan of liquidation. (This teaches us that: it is very important to identify the date the plan was adopted, so its best to go through the formalities of adopting a plan; before you adopt the plan, you had better find a buyer b/c you only have 12 months)
(3) What if the promissory note was received by Dayton eleven months ago, after Dayton had adopted a resolution to liquidate, in exchange for all its inventory which had an adjusted basis of $300,000? 453(h)(1)(B): 1 sale to 1 person of subst all inventory of trade/business
(4) What if the promissory note was received by Dayton eleven months ago, after Dayton had adopted a resolution to liquidate, in exchange for all its inventory, which had an adjusted basis of $300,000? all the inventory of a trade/business has to be soldso if the corp has multiple trade/businesses it can have multiple bulk sales of inventory What if what they sold was the actual bicycles to one person and the ancillary inventory (such as helmets) to another person? Then, you might have a fragmentation problem.
165
2. Steve owned 500 shares of stock of Florida Gator Farms, Inc. His basis for the stock was $1,000,000. Florida Gator Farms, Inc. liquidated, and in the process, after the corporation paid all of its debts (other than mortgages encumbering distributed real estate), it distributed to Steve Swampacre, a parcel of real estate previously used in its trade or business. Florida Gator's adjusted basis for Swampacre was $3,000,000. Its fair market value was $10,000,000. Distribution of Property in Kind problem (a) How much gain or loss must be recognized by Florida Gator Farms and by Steve? Start w/ the Corporation: Under 336(a), the corporation has a gain (as if such property were sold to the distributee at its FMV) of $7,000,000 (NB: no exceptions for gain recognition in 336; 337 doesnt apply b/c it requires a parent & sub who are affiliated) Next, consider the SH: Under 331(a), Steve has a capital gain of $9,000,000 (sale/exchange of stock; amt realized = FMV of item received). 334(a) gives Steve a basis of $10M in Swampacre $16,000,000 of taxable income was created by the transfer of $10,000,000 of property. Steve gets a basis in the property equal to $10,000,000. 334(a). There was a step up in basis from $3M to $10M. The problem could get more complicated if the corporation had not paid its debts, including tax liability. If the corporation distributes all of its assets to its sole shareholder and doesn't pay its taxes, the government will go after Steve. The government has a number of ways to go after Steve. You have to remember that when you are liquidating in-kind, you better figure out how to get the taxes paid. If the property is depreciable in Steve's hands and Steve is related to the corporation, 1239 applies and the gain is ordinary income that cannot be offset with capital loss carryovers. o If Steve is a majority SH, 1239 provides that if the property is depreciable in the hands of the transferee (the majority SH) then the gain is ordinary income. if the corp is a C corp, it probably doesnt matter unless the corp has capital losses. If it is an S corp, gain passed through to the SH so, the capital status would make a difference to the SH (for the tax rate)
(b) How much gain or loss must be recognized by Florida Gator Farms and by Steve if Swampacre is subject to a mortgage of $4,000,000 that Steve assumes? The corporation does not take the mortgage into account in calculating its gain under 336(b). (taxed as if the property had been sold at FMV;) o Statutorily, this result flows from the negative pregnant of 336(b). o Theoretically, this is property because if the property were sold for its fair market value the transaction consists of $6,000,000 in cash and $4,000,000 of debt relief. (If he was a 3rd party, Steve would have given the corp $6M for the property if there was the $4M mortgage on it that he had to assume.) Thus, the total amount realized would be $10,000,000 Corporation's Gain: Amount Realized $10,000,000 Minus: AB -$3,000,000 166
Gain Realized $7,000,000 Where property is distributed in liquidation and the shareholder assumes liabilities of the corporation in connection therewith, the shareholder's gain is computed by subtracting the basis of his stock from the fair market value of the property received less any liabilities assumed. Rev. Rul. 59-228, 1959-2 C.B. 59. o Steve's Gain: Property $10,000,000 - Debt Assumed $4,000,000 AR $6,000,000 AB of stock $1,000,000 $5,000,000 This is the exact same computation that we use under 301, but whereas 301(b)(1) and (2) spell out how to calculate gain, 331 does not. Rather, it just says go to 1001. If in a 1001 transaction somebody trades a guitar that was played by Elvis with a basis of $1,000,000 for a piece of land with a FMV of $10,000,000 but subject to a $4,000,000 mortgage, the amount realized would be $6,000,000 and, therefore, the person's gain would be $5,000,000. That is why it is proper to reduce the amount realized when a shareholder assumes a liability in connection with a liquidation. For purposes of computing gain on subsequent sale, the shareholder's basis for the property under 334(a) is the fair market value of the property at the time of the distribution without any adjustment to reflect the assumed liabilities. Ford v. U.S., 311 F.2d 951 (Ct. Cl. 1963). o Here, Steve's basis is $10,000,000. (334 says basis is the FMV of the property) o Theoretically, this is the correct result because basis of the property received in a taxable exchange equals the basis of the property given up, plus any gain recognized (or that should have been recognized on the exchange), or minus any loss recognized (or that should have been recognized on the exchange), plus any debt assumed. Basis of stock $1,000,000 + Gain $5,000,000 + Debt assumed $4,000,000 $10,000,000 Section 331 does not have the rules for calculating gain, it just says go to 1001. Under 1239, the character of the gain will be ordinary to the extent the property is depreciable in Steve's hands.
(c) Would your answer differ if the mortgage was a nonrecourse mortgage and Steve merely took the property subject to the mortgage rather than assuming the mortgage? Unlike 301 distributions and 351 transactions, there is no statutory or regulatory rule defining what is an assumption of a mortgage in a complete liquidation. The reason is the expectation of what is going to happen. From a corporate law perspective, the first thing it has to do when it dissolves is either pay its debts or arrange to have its debts paid.
167
(d) How would your answers in parts (a) and (b) differ if the amount of the mortgage were $11,000,000? 336(b) tells us that the corporation recognizes a gain of $8,000,000 because the fair market value cannot be any less than the amount of the mortgage. 336(b) is a really a codification of Tufts. What is Steves basis? 334 says FMV is the basis. If it is a 10M basis, how does he avoid having 1M gain if he quitclaims the deed to the lender the next day? We dont know! Assume that Steve also got $1,000,000 of cash in the transaction. Steve got a liquidating distribution, so 334 would seem to control the basis of Swampacre and make it 10M... but we dont really know! Logic/theory say that Steve shouldnt have any gain if he walks away from the property Thursday, November 18, 2010 3. Joe is the sole shareholder of Milargo Bean Corporation. His basis for the stock is $200,000. The sole asset of Milargo Bean Corporation is a parcel of farm land. This is a variation on problem 2. (a) The corporation's adjusted basis for the land is $300,000. The fair market value of the land is $300,000. How much gain or loss must be recognized by Milargo Bean Corporation and Joe if the corporation distributes the property to Joe subject to a mortgage of $300,000? What is Joe's basis in the property after it is distributed? Facts: J owns Milargo. Has basis in stock of 200k. J receives land from Milargo land w/ FMV of 300k and Mortgage of 300k and basis of 300k. Start w/ Corporation: What is this transaction? We need to know what the transaction is to know what code sections apply! Sometimes we need to look at the SH to determine the type of transaction. This is a 1001 transaction b/c it is a sale & exchange. It isnt a liquidation b/c When a corporation has zero net worth. It can dissolve for state law purposes, but it cannot liquidated for tax purposes. See Aldrich. Joe has received nothing, so there has been no liquidating distribution and no liquidation. TF, Joe has a $200,000 loss on his stock. So, 331 doesnt apply to Joe b/c he didnt receive anything. o One minute before this transaction, Joe could not have sold his stock for anything (b/c the corp has net value of zero). Joe has worthless stock, and a loss of 200k for worthless stock is recognized under 165(g) in the year the stock becomes worthless. Under 1244 up to 150k of that 200k may be an ordinary loss. o So, Joe takes 1012 cost basis of 300k in the property. So, 336 doesnt apply to Milargo. (Milargro Bean has no gain realized under 336.) Milargo has a sale/exchange transaction under 1001 (b/c Joe took on the mortgage). o So, 1001: Amount realized of 300K minus basis of 300k = 0 gain. (b) How would your answer differ if the corporation's adjusted basis for the land was $320,000 and the amount of the mortgage was $315,000?
168
The corporation is treated as if it sold the property to the shareholder. The amount realized is $315,000; its basis is $320,000 and it has a loss of $5000. 267(a)(1) says on sale/exchange btwn corp and more than 50% SH the loss is disallowed, but this doesnt apply in a liquidation. Joe still has a worthless stock deduction under 165(g). This is important because if this falls out of the definition of liquidating distribution, does that mean that the second sentence of 267(a) does not apply and, therefore, Milagro Bean does not get to claim its loss because it has sale or exchange treatment under 1001, not under 336? If, in addition to the land, the corp distributed $1 cash, then it is a liquidation! B/c Joe received something (the $1). So, then the loss would be allowed under 267(a). You would argue this and ask why the $1 should really make any difference. (c) How would your answer differ if the corporation's adjusted basis for the land was $200,000 and the amount of the mortgage was $300,000. Under 11 the tax is 22,250, but the corporation has no cash! Remember, we gave Joe a 200k worthless stock deduction. Is Joe personally liable for this tax? He may be b/c it looks like a fraudulent transfer. There is no doubt that Milagro Bean has to recognize a $100,000 gain under either 1001 or 336. There are two debts here, one to the corporation for the mortgage and another for the amount of taxes. 4. The outstanding stock of the Bassamatic Corporation is owned by Julia, who owns 60 shares, and Mario, who owns 40 shares. Bassamatic's assets are as follows: Asset Factory Equipment Inventory Cash Adjusted Basis $100,000 $300,000 $100,000 $300,000 FMV $300,000 $200,000 $200,000 $300,000
+ $200 gain - $100 loss + $100 gain
On January 1 of the current year, Bassamatic adopted a plan of complete liquidation. What are the tax consequences to Bassamatic of each of the following alternative distributions? Assume that Bassamatic had a second line of business and this was a partial liquidation. In that case, 311(b) disallows losses to the corporation. (a)(1) Bassamatic distributes its assets pro rata to Julia and Mario, who will thereafter operate the business as 60/40 partners. In the real world Bass deeds the factory to J and M as tenants in common w/ a 6/10 interest to Julia and a 4/10 interest to Mario. Start at the corporate level: under 336(a) there is a gain of 200 on the factory; 100 gain on inventory; 100 loss on the equiptment. Will that realized loss of 100 be recognized? 169
336(a) has rules for recognizing gain/loss 336(d) has rules for not recognizing gain/loss o if there is a distribution to a related person and such distribution is not pro rata or such distribution is disqualified property then (d)(1) applies then no loss recognized. The property is not disqualified as long as it was not purchased by the corp w/in 5 years or contributed...... etc... (check code). This is a pro rata distribution. So, the loss is recognized Loss is recognized unless: o (d)(1)(A)(i): non pro rata dist of a loss asset to a 50% or more SH (using stock attribution rules in 267) o (d)(1)(A)(ii): NB: w/in 5 years of the date of the distribution (not when the plan was adopted) o 336(a)(2) eliminates built in loss (discussed later) Character: o Gain on inventory is ordinary income o Factory gain of $200 is 1231 gain; may be unrecaptured 1250 gain (b/c of prior depreciation on the building, taxed at 25%) o The $100k loss is 1231 loss
(a)(2) Bassamatic transfers all of the assets to the newly formed Pasta Magic LLC in exchange for all 10 membership units of the LLC, immediately after which Bassamatic liquidates by distributing 6 Pasta Magic LLC units to Julia and 4 Pasta Magic LLC units to Mario. Giving J a 60% ownership in LLC and M a 40% interest in LLC. The answer doesnt change here. The LLC is a disregarded entity at the time it is formed and it becomes a partnership in the hands of Julia and Mario. Converting the business from the corporate form to a partnership or disregarded entity is known as "disincorporation." (b) Bassamatic distributes the Factory, Inventory, and $100,000 of cash to Julia and the Equipment and $200,000 of Cash to Mario. Julia Factory Inventory Cash Mario Equipment Cash Adjusted Basis $100,000 $100,000 $100,000 Adjusted Basis $300,000 $200,000 FMV $300,000 $200,000 $100,000 FMV $200,000 $200,000
+ $200 + $200
- $100
170
In 336, a non pro rata distribution must be asset by assetnot in the aggregate. The distribution to M is not pro rata, but he isnt a related party! (b/c he doesnt own at least 50% of the stock of the corp; unless M is related to J.. if M is related to J then is it still non pro rata? We dont know...) So there is the same result as before. (c) Bassamatic distributes the Factory, Equipment, and $100,000 of cash to Julia, and the Inventory and $200,000 of cash to Mario. 336(d)(1)(A)(i) disallows a loss deduction to the corporation on a non pro rata distribution of property to a shareholder. Non pro rata is measured asset by asset. What is Ms basis in the equipment? Under 334, the basis is FMV of 200k. Js basis in the inventory is 200k. If J and M exchange the inventory and the equipment... This is a step transaction doctrine problem! Asset by asset approach also applies to loss assetseven though this isnt specifically stated... see 336(d)(1)(A). **KEY: asset by asset. Look for on final exam. 5. Shrub Game Farm and Real Estate Development Corp. has 100 shares of common stock outstanding. George owns 80 shares and Dick owns 20 shares. Shrub owns two parcels of land, Carlsbad and Teton, and has $200,000 in cash. Both properties have been operated as game farm hunting reserves, where well-healed lawyers and lobbyists could entertain politicians (for a price, of course). The basis and fair market values of the properties are as follows: Asset Carlsbad Teton Adjusted Basis $400,000 $500,000 FMV $600,000 $200,000
+200 gain -300 loss
What are the tax consequences to the corporation of the following alternative liquidating distributions? (a) Shrub distributes its assets to George and Dick as tenants in common, George taking an undivided 4/5ths in each parcel of real estate (and $160,000 in cash) and Dick taking an undivided 1/5th in each parcel of land (and $40,000 in cash). Teton was acquired four years ago, when its fair market value and basis were both $500,000, as a contribution by George in a 351 transaction in exchange for enough stock to increase his ownership from 40 percent to 80 percent. This distribution is pro rata, so 336(d)(1)(A)(i) doesnt apply. Can (d)(1)(A)(ii) apply? There was no evil intent here. The purpose of this rule is to prevent double counting of losses. When contributed, G got 500k of basis in stock under 358. When Teton comes back to him at FMV of 200k. Under 331, G has a loss of 300k. As a result of the contribution (compared to what would have happened had he not contributed), G has a 300k loss. The purpose of (d)(1)(A)(ii) is to prevent the double loss. Only 4/5 of the loss is disallowed. SO, disallow 240 and 60 of the loss is allowed.
171
How do you avoid the loss disallowance? We can wait so that we arent w/in 5 years of the date of the distribution. Give Teton to Dick and give Carlsbad to George and tinker with the cash to make everything even so then the distribution is not pro rata. 336(d)(1) doesnt apply b/c D and G arent related. (d)(2) doesnt apply b/c there wast a built in loss at the time of distribution.
(b)(1) Shrub sells Carlsbad for $600,000 and Teton for $200,000 and distributes $800,000 in cash to George and $200,000 in cash to Dick. Carlsbad had been held for six years, but Teton, and another property, Old Faithful (which was sold last year), were contributed by George eighteen months ago in exchange for stock in 351 transaction. Teton's fair market value at that time was $380,000 and its adjusted basis was $500,000. Old Faithful's fair market value at that time was $200,000 and its adjusted basis was $80,000. Both Carlsbad and Teton were operated as hunting reserves and the primary customers were well-healed lawyers and lobbyists who paid the corporation to use the facilities to entertain politicians. Basis 500 80 FMV 380 200
Teton Old Faithful
-120 depreciated +120 appreciated
Here, the property was depreciated when contributed. Remember, 362(e)(2). 336(d)(2): applies to distribution to 50% more and minority SH and a sale by the liquidating distribution. How do we know if a sale is by a liquidating corp or a nonliquidating corp? If the sale occurs after the plan of liquidation has been adopted, then sale by liquidating corp. So, here we have a sale by liquidating corp. Go to subparagraph (b) we have to have evil intent! There was an appreciated asset and a depreciated asset! If only Teton had been contributed, the corps basis in Teton would have be $380k under 362(e)(2). ..... It looks like we have a problem w/ 336(d)(2)(A), but we have no evil intent. (d)(2)(ii) after the date 2 years before the adoption of the planso this property is tainted forever if acquired w/in 2 years of adoption of the plan. There are no regulations to help us determine whether well be blamed w/ evil intentwhy? b/c there is basically a presumption here that there is evil intent if there is this timing. On the sale, we knock the basis of Teton down to 380; there is only a 180 loss allowed on the sale of the property. NB: just b/c the presumption doesnt apply doesnt mean the IRS cant come in and say that you had evil intent, although this is much more difficult for the IRS. 336(d)(1)(B) has a five year rulepreventing the double loss. 336(d)(2) is also designed to prevent double losses and only has a 2 year rule... what where they thinking? We dont know... (rest of problem 3 skipped)
172
6. Jordan and Garret each own 50 shares of stock of Cavanaugh & Macy, PSC, which operates a pathology lab. Each of them has a basis of 20,000 in their stock. The corporation has over 20 EEs. The corps tangible assets consist of equipment w/ a FMV of 50,000 and a basis of 15,000. ... continued... Under 336(a), the corporation would have to recognize gain as if it sold the equipment. So, the corporation will have $35,000 of gain. It appears that this corporation has both goodwill and going concern value. This goodwill & going concern is also being distributed. For most tax purposes, we do not distinguish between goodwill and going concern value because they are both class VII assets from the buyer and seller's side and they are amortizable 197 intangibles to the buyer. o The offer is evidence that the value of the goodwill and going concern value is $950,000. Furthermore, since the goodwill and going concern value is not on the corporation's balance sheet, the basis of the goodwill and going concern value is zero. Goodwill and going concern value is not on the corporation's balance sheet because it was self-created. o SH receive goodwill & going concern value b/c all the EEs come to work; all customers still coming; so nothing has changed... or has it? Check out the caselaw... o The 20 employees in place goes toward going concern value because it is a separate and distinct work force in place. Here, there is a factual question as to whether or not this goodwill is goodwill that belongs to the corporation or to the shareholders individually. o Favorable to the SH (it is the SH goodwill): In Norwalk v. Commissioner, T.C. Memo 1998-279, an accounting services professional corporation dissolved and distributed its assets to its two CPA shareholders, who in turn contributed the assets to a partnership that they joined the same year. The IRS asserted that in addition to its tangible assets, the corporation distributed to its shareholder customer based intangible assets, including the corporation's client base, client records, and going concern value, which resulted in an additional gain to the corporation under 336 and also increased the amount realized and thus the capital gain recognized by the shareholders on the liquidation. In Norwalk, the only EEs were the SH; there was a finding of fact that the clients of the firm werent coming to the firm but they were coming to the individual CPAs w/in the firm. SO, the firm itself didnt have any goodwill. In this question we have 20 other EEs. o Favorable to the SH: In Martin Ice Cream, the shareholder never assigned the distribution agreement to the corporation. Only the shareholder had the relationship with the corporation. The shareholder distributed Hagen Das through Martin Ice Cream. If the offer was that the shareholder's had to continue on as employees, the offer would be evidence that there was personal goodwill involved. If the factual conclusion is that the goodwill and going concerned value belonged to the corporation, there is $985,000 gain recognized at the corporate level under 336(a), and each of the shareholders will recognize $480,000 of capital gain under 331(a).
173
7. Dill is the sole SH of Pastel Pill Corp. Pastel Pills sole asseet is a patent ona parm product that has been licensed to Miracle Drugs, ..... If you are treating this an open transaction, the Dill might get capital gain treatment rather than ordinary income treatment. We have distributed intellectual property (patent & licensing rights); that is double taxed b/c it was put into a corp. 336 applies; SH got property under 331. The issue is what is the value? This is a fact question... $5M times ten years50M... about $26 discounted. It will be very expensive to disincorporate! This is a problem that arise when you lock intellectual property into a corporation (S corps can have problems with this too). After the transaction the stock in Purple Pill is vaporized, so arguably it is not a sale within the meaning of 453, even though it is arguably a sale within the meaning of 331. So, the most likely conclusion is that 453 does not apply and that the transaction will be treated as either an open transaction or a closed transaction. The problem with open transaction treatment is that Purple Pill will disappear after the liquidation. So we are left with closed transaction treatment. The problem with closed transaction treatment is that now you have to put a value on the patent. It is possible that the Corporation and Dill could take inconsistent position as to the value of the patent. Section 4. semester) 1. Liquidation of Subsidiary Corporations Section 332 (Not covered this
For Global, 332 and 334(b) apply. For Specific, 337 and 336(d)(3) apply For Tucker, 331 applies Why is it that 332 applies to Global and 331 applies to Tucker? 332(a) says no gain or loss recognized by Global or Tucker 332(b)(1) control requirement. Global meets the condition of 332(b)(1), but Tucker does not. There are other conditions to be met, in terms of timing and adoption of the plan in 332(b)(2) and (3). If these conditions are met, there is no gain recognized. The price of nonrecognition is that Global's basis is not determined under 334(a), but 334(b), which tells us that Global takes a transferred basis. In addition, 381 says that Global steps into Specific's shoes with respect to Specific's tax attributes. So, if this building was in the 15th year of depreciation, you don't start all over again. With respect to Specific, 337(a) trumps 336. However, 337(a) only applies to the distribution by Specific to Global. 337(a) does not apply to the distribution to Tucker. Specific recognizes gain under 336 on the distribution to Tucker. (b) No loss is recognized under 332(a).
174
(c) Specific has a $10,000,000 loss realized on the factory, but 337 compels nonrecognition. 336(d)(3) prevents cherrypicking. Since Tucker is not an 80% shareholder, 336 is what compels recognition of gain on distribution of Adobe if Adobe was appreciated. The distribution of an asset to a minority shareholder results in gain recognition to the subsidiary, but loss recognition is denied. 336(d)(3). Tuesday, November 23, 2010 PART II ELECTIVE PASSTHROU TAX TREATMENT Chapter 9 S Corporations Section 2. Eligibility, Election And Termination S Election: displace application of 11 tax; application of 301(c) (301(a), (b), and (d) still apply); and application of Earnings & Profits concept If this corporation, makes the S election, and the corporation earns $100 of ordinary income and capital gains, the corporation owes no taxes. 11 does not apply. Instead, A pays taxes on $60 of ordinary income and $24 of capital gain and B pays taxes on $40 of ordinary income and $16 of capital gain, whether there is a distribution or not. As a result of paying taxes, A gets a basis increase to $84 and B gets a basis increase to $56. Next year, if the corporation makes a distribution, the shareholders will reduce their basis as a result of the distribution 1361: definition of S corp 1362: Election & Termination 1363 says that 11 does not apply and the corporation is not taxed 1366 says that income passes through to the shareholders, and 1377 says that that happens day by day. 1367 provides for basis adjustments up or down for S corp stock 1368 distributions from S corp reduce basis & when distribution exceed basis gain is recognized; says 301(c) does not apply 1371 says all other subchapter C sections apply to S corps This means 311 applies if a corporation distributes appreciated property; that 302 applies if the corporation redeems the stock. 1372 provides that a more than 2 % S Corporation shareholder will be treated in the same way as a partner in a partnership is treated for fringe benefits, meaning they are not available to such shareholders. 1378 says that S Corporation's must use a calendar year, unless there is a natural business purpose (if 25% or more of income is earned in two month period, then year can end at the end of that period) 1374
175
Eligibility reqs: S corp election available for only small business corp which is defined in 1361(b). Only individuals, certain trusts and charitable orgs & ER pension plans may own the stock of a corp if the corp wants to make an S election. If an IRA, corporation owns stockmay not make an S election. 1. Would X Corp., a domestic corporation, qualify to make a valid Subchapter S election under the following alternative situations? (a) X Corp. has 101 individual shareholders all of whom are unrelated except that two of them are husband and wife. 1361(b)(1)(A): S corp may not have more than 100 SH. So, if there are 101 completely unrelated individuals, that corp cant make an S election. If they are married, then 1361(c)(1) husband & wife counted them as only 1 SH for purposes of counting the SH. Community property states: Cant have nonresident alien SH; can have a resident alien SH o If one person has a resident alien spouse in a community property then youd need to put a call or buy/sell agreement on the stock so that the corp could get the stock back if the US spouse died o Notice if a US person is married to a NRA in a country like Canada (noncommunity property) then not a problem, b/c the stock is only owned by the US person (b) X Corp. has 101 individual shareholders, all of whom are unrelated, except for Al and Beryl, who are parent and child. What if they are parent & child? See 1361(c)(1)(B), all members of a family are treated as single SH; (c)(1)(B) family defined as six generations back (group of 100 may be extremely large b/c of this; realistically they should repeal the limit) (c)(1) X Corp. has 101 unrelated individual shareholders except that two of whom are remote cousins whose grandmothers were sisters. (2) X Corp. has 150,000 shareholders, each of which belongs to one of 99 different families, within which each family member/shareholder can trace ancestry to a single great-greatgreat-great grandparent. (3) X Corp. has 1,500 shareholders, each one of which belongs to one of 101 different families, within which each family member/shareholder can trance ancestry to a single great-great-great-great grandparent. (d) Skip (e) X Corp. has 10 equal shareholders. Nine of the shareholders are individual U.S. citizens. The tenth is a general partnership, the partners of which are two individual U.S. citizens.
176
Partners are 2 US citizens. Only 11 beneficial owners. If the 2 US citizen partners then X would be eligible to make an S election. Can a pship be a SH in an S Corp? No! A Pship cannot be a SH in order to make an S election. NB: this also catches LLCs unless it is a disregarded entity (making the member of the LLC the owner of the stock) 2 S corps may be partners in a pship (allowing the two S corps to have 100 SH each) and may still run one business. 2. SH Eligibility: 1361(c)(2) permits a variety of trusts to be SH in S corp. Revocable trust: not a separate taxable entity; described in (c)(2)(A)(i)any trust all of the income of which is taxed to the grantor will be an eligible SH (c)(2)(A)(ii)allows grantor trust to be an eligible SH for 2 years after death (c)(2)(B) ESBIT (?) election (c)(2)(A)(iv) voting trusts are not eligible 1361(b)(1)(B) permits an estate to be an eligible SH 1361(d): qualified subchapter S trust is (only 1 lifetime beneficiary; see other limits) eligible SH Corporate Structure: Common stock only (no preferred). Nonvoting common stock is allowed (1361(c)(4) permits differences in voting rights).
B. Corporate Eligibility 1. A, B, and C, all of whom are resident individuals, are planning to form Z Corp. Assuming that Z Corp. otherwise will qualify to make an S election, will the following alternative capital structures affect the Z Corp.'s eligibility? 1361(b)(1)(D) (a) A and B each will receive 100 shares of voting common stock. C will receive 100 shares of nonvoting preferred stock.
(b) A and B each will receive 100 shares of voting common stock. C will receive 100 shares of nonvoting common stock. IRC 1361(c)(4) and Treas. Reg. 1.1361-1(l)(1) say we can have different voting rights. This is ok. (c) A and B each will receive 1000 shares of voting common stock. C will receive 1000 shares of voting preferred stock. (d) A, B, and C will receive 100 shares of voting common stock. C, who will receive the stock for services (unlike A and B, who are contributing cash), has signed a shareholder's agreement providing that she may not transfer her shares without the consent of A and B, but if they do not consent they must purchase C's shares at book value. A and B are not subject to any restrictions on transfer.
177
When stock is issued for services we like to keep a lot of strings on it. Here, C, who was issued stock for services, is allowed to keep that stock only as long as C keeps providing services. Treas. Reg. 1.1361-1(l)(2)(iii): restriction on transfer generally dont create a second class of stock It is difficult to create a second class of stock w/ normal buy/sell agreements. Option at deep discount may create a second class of stock (b/c they are getting a better yield on investments than the other SH do). 409A 1361(c)(5): straight debt not treated as a second class of stock. Subordinating a prom note to other creditors doesnt make it not straight debt but making it convertible debt may take it out of the straight debt category. (e) A, B, and C each will receive 100 shares of voting common stock. To attract D, who will be a key employee, Z Corp. will issue to D an option to acquire 100 shares at 80% of the then current fair market value. Dumb idea! 2. E, F, and G, all of whom are resident individuals, are planning to form Q Corp. E, F, and G each will receive 100 shares of voting common stock. Assuming that Q Corp. otherwise will qualify to make an S election, will the following alternative capital structures affect Q Corp.'s eligibility? (a)(1) E will lend Q Corp. $600,000 and receive a promissory note due in 30 years, with interest payable annually at the prime rate plus 4%. 1361(c)(5) authorizes "straight-debt" safe harbor in the regulations. See Treas. Reg. 1.13611(l)(5). If it is linked to the profits, it would start to look like equity. The probhition on conversion prevents any growth. The statute also requires a written unconditional promise to pay on demand or a specified date a sum certain. (2) What if E's not is subordinated to all third party creditors, including trade creditors? Subordination agreement is ok. (3) What if the promissory note E receives is convertible into Q Corp. common stock based on a price estimate to be 110 percent of the fair market value of the Q Corp. common stock on the date the note was issued? Treas. Reg. 1.1361-1(l)(4)(iv). When you fall out of the safe harbor it does not mean that you have two classes of stock. Then you go to Treas. Reg. 1.1361-1(l)(4)(ii), look at the promissory note and determine whether it is debt under the general debt/equity principles. If it is debt, it will not be treated as a second class of stock even though it is convertible. However, if it is not debt under the debt/equity rules and . . . , then it will be reclassified as a second class of stock. (b) E, F, and G each will lend Q Corp. $200,000 and receive a convertible promissory not due in 30 years, with interest payable annually at the prime rate plus 3%. The notes are convertible into Q Corp. common stock based on a price estimate to be 90 percent of the fair market value of the Q Corp. common stock on the date the note was issued. This is not straight debt because of the conversion feature. Further, it's highly risky under the general debt/equity principals because of this conversion feature. Is there any other rule that we can rely on as a safe harbor? 178
Reg. 1.1361-1(l)(4)(ii)(B)(2) Proportionately-held obligations. D. 1. Z Corp. has had a valid S election in effect for several years. G owns 40% of the stock; each of H, I, J, and K own 15%. (a) How can Z Corp. revoke its S election for the current year? (b) How can Z Corp. revoke its S election for the subsequent year? (c) If Z Corp. revokes its election for the current year, when can Z Corp. make a new effective subchapter S election? (d) Suppose that in (b), the revocation was filed on July, 1, 2006, to be effective as of January, 1, 2007, but that on September 3, 2006, G, H, I, and J decide they want to revoke the termination election. K does not want to revoke the termination election. Can the termination election be revoked? SECTION 3. EFFECT OF THE SUBCHAPTER S ELECTION BY CORPORATION WITH NO C CORPORATION HISTORY 1. Cyclone Video Corp. elected S corporation status for its first year of operation. Cyclone Video Corp.'s common stock is owned by Andrea (100 shares with a $20,000 basis) and Barry (50 shares with a $22,000 basis). Cyclone Video Corp.'s operating income is derived primarily from movie and video game DVD rentals. During the current year, Cyclone Video Corp. had the following income and expense items: Income DVD rental receipts Tax-exempt interest Gain from the sale of a building ( 1231 gain) STCG from the sale of publicly traded stock Expenditures and Losses Salaries Equipment expenses deducted under 179 Depreciation Rent Interest expense (on loan to purchase DVD's) LTCL from the slae of investment real estate Lobbying expenses re: anti-pornography legislation
$198,000 $ 6,000 $ 36,000 $ 30,000
$62,000 $15,000 $ 9,000 $40,000 $12,000 $18,000 $12,000
(a) How should Cyclone Video Corp., Andrea, and Barry report these items? A 100 shares $20,000 179 B 100 Shares $22,000
Starting Basis
Separately Stated Income Tax exempt $6000 1231 Gain $36,000 STCG $30,000 Separately stated expenditures & losses 179 ($15,000) LTCL ($18,000) Lobbying ($12,000) Nonseparately State Items Ending Basis
$4000 $24,000 $20,000 ($10,000) ($12,000) ($8,000) $50,000 $88,000
$2000 $12,000 $10,000 ($5,000) ($6,000) ($4,000) $25,000 $56,000
Rental Salary Depreciation Rent Interest Total
Nonseparately Stated Items $198,000 ($62,000) ($9,000) ($40,000) ($12,000) $75,000
1366(b) tells us that we determine character at the corporate level. 1366 gives us the pass-through rule. 1366(a) tells us that we have to segregate "items of income (including tax-exempt income), loss, deduction, or credit the separate treatment of which could affect the liability for tax of any shareholder" from "nonseparately computed income or loss." Treas. Reg. 1.1366-1(a)(2) lists some of the items that must be separately stated, including capital gains and losses and 1231 gains and losses. o We don't net the STCG with the LTCL because they go into different places in the netting mechanism under 1222. o We have to separately state 179 deductions because there are limitations on the dollar amount of the deduction at the shareholder level. For instance, it could be that the shareholder has other 179 deductions from other S corporations or a partnership that already exceed the limitation on deductibility under 179(b). Note that 179(d)(8) applies the dollar limitation to both the S Corporation and the individual shareholders. o We have to separate state 1231 gain because we don't know whether or not this 1231 gain is going to be ordinary or capital on the individual shareholder tax returns because we don't know whether the shareholder has any other 1231 gains or losses that could affect the character of this 1231 gain. o Tax-exempt income and nondeductible, noncapital lobbying expenses are passedthrough to the shareholder's for basis adjustment purposes. Next, we net the nonseparately stated items. With nonseparately stated items, it is just the bottom line that is passed-through to the shareholders. Third, we determine the impact on basis. 180
o Starting basis was $20,000 for A and $22,000 for B. o 1367(a)(1) says that we increase basis by the sum of the income described in 1366(a)(1)(A), which is the separately stated items, and 1366(a)(1)(B), which is the nonseparately stated items. o 1368 says we can take the profits out of the corporation tax-free, but items, such as the nondeductible, noncapital lobbying expense affect the amount that you can take out tax-free because there was a basis reduction by that amount. On the other hand, this also means we can take the tax-exempt income out tax free because there is an upward . o If you didn't increase the basis to account for the tax exempt income, you would be taxed on a distribution of the cash at a later date. In effect, not increasing basis to account for the tax exempt would only result in deferral. Thus, the shareholder would not the benefit of the exclusion afforded by 103. o Likewise, not adjusting basis downward to reflect the nondeductible, noncapital expense would allow the shareholder to recognize a loss at a later date for a loss that is otherwise disallowed. 2. The stock of Hurricane Hardware & Lumber Co., Inc., which has had a valid S election in effect at all times, is owned equally by Chantal and Dean, each of whom had a $6,000 basis in the stock as of January 1, 2006. On July 1, Chantal lent $7,000 to Hurricane Hardware & Lumber Co. and received a 6% demand note from the corporation. (a)(1) What are the consequences to Chantal and Dean if Hurricane Hardware & Lumber Co. has a $20,000 loss from business operations in 2006? Chantal Dean 1366(a) Loss ($20,000) $10,000 $10,000 Stock basis $6,000 $6,000 Loss allowed 1366(d)(1)(A) $6,000 $6,000 1367 new stock basis $0 $0 Corporate debt basis $7,000 $0 Loss allowed 1366(d)(1)(B) $4,000 $0 1367 new debt basis $3,000 $0 Disallowed Loss $0 $4,000 First, we apply 1366 to determine the amount of loss that is allowed this year, then apply 1367 to determine the impact on the basis of the stock. 1367 addresses basis adjustments. Basis adjustments happen after we determine the income tax consequences gain and loss. Before you can ever determine changes in basis, you have to determine the gain or loss recognized on the transaction. So, we need to see whether the existence of that $7,000 debt has an impact under 1366 on the amount of the $10,000 loss that can be claimed. 1366(d)(1)(A) limited loss to the extent of the shareholder's basis in the stock of the corporation; however, 1366(d)(1)(B) limits the shareholder's basis in indebtedness of the corporation. The $4,000 of loss is not really disallowed, because 1366(d)(2) says that Dean is allowed to carry forward that loss indefinitely.
181
The lesson to be learned here is that with an S corporation, if one shareholder makes cash advances that support the pass-thru of losses and the others don't, even if there is a 50% pass-thru of losses, if they have run out of stock basis one of them is not getting the benefit of the deductions. Economically, however, this makes sense. What 1366(d)(1)(B) is doing is giving the shareholder an advanced deduction for a potentially bad debt. Once you recognize that in many instances the loans will be pro rata, the debt starts to look like equity. But if an S Corporation has pro rata debt we don't worry about it being a second class of stock, even though it is in effect functioning as a second class of stock. Thus, if effect 1366(d)(1)(B) is saying that that pro rata debt is as good as equity.
(2) Would your answer differ if on December 30, 2006, Hurricane Hardware & Lumber Co. repaid Chantal the $7,000 owed on the promissory note. This is bad tax planning. The regulations say that the determination of basis is made at the end of the year. If the debt were repaid before the end of the year, then Chantal would not have a debt at the end of the year. Thus, Chantal would be in the same position as Dean, above, if the debt gets repaid before the end of the year. With that said, however, there are special rules for open account indebtedness. Also, you can always make a new loan before the end of the year in anticipation of losses.
(b)(1) If after losing $10,000 in 2006, Hurricane Hardware & Lumber Co. realizes $12,000 of net income from business operations in 2007, what are the consequences to Chantal and Dean? Assume that the $7,000 debt from the corporation to Chantal remains outstanding. Chantal $6,000 ( 1366(a)(1)) Dean $6,000 ( 1366(a)(1)(B)) (4,000) ( 1366(d)(2)) $2000 (maybe) $0 $6,000 ( 1367(a)(1)(B)) (4,000) ( 1367(a)(2)(B)) $2,000 ( 1367(a)(1)) N/A
Income $12,000
Old stock basis New stock basis
$0 $2,000
Old debt basis New debt basis
$3,000 $7,000
182
One of the questions from the statute is the order in which you do things. 1366(d)(2) says that the loss is treated as being incurred by the corporation in the succeeding taxable year with respect to that shareholder. Does this mean that 1366(d)(2) cycles that $4000 loss back into 1366(a) as an item that comes out of the corporation. It might be that the proper answer is to say that, while Chantal has $6,000 of income from the corporation, Dean has $6,000 of income and a $4,000, or $2,000 of net income. Then under 1367, we have a new stock basis of $2,000, regardless of whether or not it was proper to net the income and loss, or whether the income is a nonseparately stated item and the loss is a separately stated item. We know that the $6,000 is a nonseparately stated item. If the $4,000 is also a nonseparately stated item, the proper answer is to net them to $2,000 and have a $2,000 basis increase from $0 to $2,000. On the other hand, if the $4,000 is a separately stated item, the proper result is to add $6,000 to the basis of the stock under 1367(a)(1)(B) and then subtract $4,000 from the basis under 1367(a)(2)(B), for a net increase in basis from $0 to $2,000. In any event, there Dean has $2,000 of basis at the end of the year. With respect to distributions, the last sentence of 1368(d) tells us that "the adjusted basis of stock shall be determined with regard to the adjustments provided in paragraph (1) of 1367(a) for the taxable year," and 1367(a)(1) is increases in basis. Thus, one way to look at it is to say, that this $6,000 triggers the basis increase, then you are allowed the $4,000 (if you don't net the $6,000 and the $4,000 to $2,000). 32:44 Even after you get through the S-corporation filters, you have to pass the passive activity rules of 469. (2) C $0 $3,000 $6,000 $6,000 $0 $3,000 D $0 $4,000 $6,000 (4,000) = $2,000 $6,000
Stock basis Debt basis Carryover Income Distribution New stock basis New debt basis
It is only the net increase that is going to be allocated to the debt and Reg. 1.1376-2(c) tells us . .. With Chantal, the issue is what is the ordering rules for basis adjustments? See 1367(b)(2)(B): 1. Stock = distributions 2. Debt 3. Stock With Dean, the issue is what is the ordering rules for purposes of distributions? 1368(d) provides that the ordering rule is as follows 1. 1367 increases 2. distributions 183
3. 1367 decreases. 12/04/08 Hint on exam: Nothing really helpful. Don't abbreviate. For example, you cannot use AB, you must say "adjusted basis." However, IRC, Treas. Reg., Rev. Rul., and (in the middle of a sentence)" are accepted abbreviations. On average, you have only 4 double spaced pages to answer each questions. The first sentence needs to say: "The point of this question is whether this transaction qualifies under 351." The next sentence should say: "Section 351 applies because A transferred property to the corporation in exchange for 100% of the coporation's stock and, immediately thereafter, was in control of the corporation." Just apply the rules to the facts, don't explain why the rules apply. Under 362, the corporation takes a transferred basis of $10,000. B. Distributions 1. This is really a review question. Under 1368(d) take into account upward basis adj for the year before taking into account downward basis adj for distributions for the year. The date of the distributions doesnt matterall of the distributions are collapsed to the end of the year (even if the distribution was on Jan. 2 and the income was all b/c of sale of single asset on Dec. 31). S corp SH may w/draw money periodically throughout the year w/out having adverse tax consequences before the end of the year. If there is a change in stock ownership during the year, you have to take that into account by changing the basisthis may make it harder to pull money out b/c basis has to be calculated. (a) Arthur 1/3 Bertha 2/3 Stock basis $6,000 $2000 Income $36,000 $12,000 $24,000 Basis $18,000 $26,000 Distribution ( 301(b)) $16,000 $32,000 Remaining basis $2,000 $0; Gain of 6,000
(b) What is the first tax consequence for S corp when it distributes the property. 311 still appliesso there is a gain of 4 and a gain of 2 under 311(b) w/ respect to dist of property. So, that gives separate income of six. The amt of income recog to the corp doesnt directly relate to the amt of gain recog by the SH. Take the income from both properties and allocate to both SH according to the profit share ratio. The 6k is allocated according to share of the profit. 301(b) tells the amt of a dist by a corp to a SH the FMV of the property. Arthur 1/3 Bertha 2/3 Stock basis $6,000 $2000 Income $36,000 $12,000 $24,000 Separately stated $6,000 $2,000 $4,000 Interim Basis $20,000 $30,000 184
Distribution ( 301(b)) $12,000 Remaining basis $8000 Basis in property recd in 301 dist is FMV under 301(d) 12,000
$24,000 $6000 24,000
Nonseparately stated item of income 1368 replaces 301(c) and 1367(c)(1) tells us that an S-corporation does not generate earnings and profits. The amount of the distribution is determined under (c) distribution of loss property. How do we take the loss into account? Losses are taken into account after distributions. There is a loss on the property of $6,000 (b/c FMV is 36k and basis is 42k). The loss is disallowed to the corp under 311(a). 1367(a)(2)(D) requires basis adjustment for losses described in 1366(a)(1) (? Check cites?) Arthur 1/3 $6,000 $12,000 $18,000 $18,000 $0 Bertha 2/3 $2000 $24,000 $26,000 $36,000 $0 $10,000
Stock basis Income $36,000 Basis before Distribution Distribution ( 301(b)) Remaining basis Gain ( 1368(b)) 2. T 60 \ [TB] 336 Black Acre FMV $1,200 Basis $ 200 Gain $1,000 (b/c 336) L / 40
White Acre FMV $1,100 Mortgage $ 300 Basis $1,400 Loss $ 300 (not caught by 336(d) b/c L is a minority SH; no stuffing going on)
Net gain of $700. 336 triggers gain on the corporate level. 1366 triggers gain passed through to the SH. So, T recognizes 420 of gain (as 60% SH); L recognizes 280 gain (b/c 40% SH). B/c 1367 basis adjustmentsT has 700 basis and L has 500 basis. 331 applies to the distribution nextthe amount realized under 331 for T is 1200; for L the amt realized is 800. So, T has gain of 500; L has gain of 300. Where we have both positive income under 1366(a)(1) and (2), and we have distributions during the year, and we have losses, 1368(a)/ 1367 . . . There is a $3,000 loss but the loss is disallowed by 311(b). 185
Even if the loss was recognized, the Positive basis adjustments first for income and gain, then distribution, then after distributions take into account negative basis adjustements. Bertha's $10,000 is recognized under 1368(b). When you find gain under 1368(b) (or even under 301(c)) the character is determined by reference to the stock. Thus, gain is capital. 336(d) does not disallow the loss because it is not "disqualified property." If loss property was distributed to Thelma, 336(d)(1) would disallow the loss, but since the property is distributed non pro rata, the loss is allowed. When you are in a C-corporation if the distribution flunks 302 you get to use all of the basis, but when you are in an S-corporation if you funk 302 you can only use a pro rata share of the basis. In a C-corporation, your goal is to get the distribution under 302, but with an S-Corporation you whole goal is to flunk 302. QSUB An S corporation is now permitted to won the stock of a C corporation. If the S corporation makes an election, the QSUB is disregareded. QSUB must be wholly owned. 99 out of 100 shares will not suffice.
186

McMahon Corporate Tax I Fall 2010

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

McMahon Corporate Tax I Fall 2010

Uploaded by

Copyright:

Available Formats

Downloaded From OutlineDepot.

Downloaded From OutlineDepot.com

Downloaded From OutlineDepot.com

Downloaded From OutlineDepot.com

Downloaded From OutlineDepot.com

Downloaded From OutlineDepot.com

Downloaded From OutlineDepot.com

Property Transferred Realization Event ( 1001) Amount Realized ( 1001(b))

Downloaded From OutlineDepot.com

$ 50,000 $125,000 $ 50,000 ($ 25,000) $0 $0 $175,000 $50,000 $125,000

351(a) 358; Treas. Reg. 1.358-1(a) 362(a)(1) 362(a)(1)

Downloaded From OutlineDepot.com

Downloaded From OutlineDepot.com

Realized Loss ( 1001(a)) Recognized?

Downloaded From OutlineDepot.com

351(a) 362(e)(2)(A), (B) 362(a)(1) 358(a)(1)

Downloaded From OutlineDepot.com

Downloaded From OutlineDepot.com

351(a) 362(e)(2)(A), (B) 362(a)(1) 362(e)(2)(A), (B) 358(a)(1)

Downloaded From OutlineDepot.com

Downloaded From OutlineDepot.com

Downloaded From OutlineDepot.com

Downloaded From OutlineDepot.com

Downloaded From OutlineDepot.com

Downloaded From OutlineDepot.com

Claire's gain: Amount realized ( 1001(b)): Stock $450,000 $250,000 19

FMV of 20 shares of stock received

Downloaded From OutlineDepot.com

$200,000 $300,000 $150,000 $150,000 OI

FMV of note received AB of construction supplies exchanged 351(b)(1)(B) 1221(a)(1)

Downloaded From OutlineDepot.com

decreased by increased by Basis =

$300,000 $200,000 $150,000 $250,000

STEP 1 (a) (i) (ii) (b) (c) STEP 2

Downloaded From OutlineDepot.com

STEP 3 (a) (b) (c) STEP 4

358 358(a)(1) 358(a)(1)(A) 358(a)(1)(B) 358(a)(2)

Downloaded From OutlineDepot.com

351(b)(2) 351(b) 1245

Downloaded From OutlineDepot.com

decreased by increased by Basis =

$450,000 $200,000 $120,000 $370,000

Downloaded From OutlineDepot.com

Downloaded From OutlineDepot.com

Downloaded From OutlineDepot.com

Downloaded From OutlineDepot.com

decreased by increased by Basis =

$270,000 $200,000 $180,000 $250,000

Downloaded From OutlineDepot.com

Downloaded From OutlineDepot.com

351(b) 351(b) gain to extent of boot

decreased by increased by Basis =

Downloaded From OutlineDepot.com

real Capital Asset

Fran and Glenn each received 50 shares of common stock

Downloaded From OutlineDepot.com

decreased by increased by Basis =

$25,000 362(a); Prop. Reg. 1.453-1(f)(3)(ii)

Downloaded From OutlineDepot.com

"Gross profit ratio" = "Gross Profit"/"Total Contract Price" $75,000/$80,000 = 93.75%

Downloaded From OutlineDepot.com

Downloaded From OutlineDepot.com

Downloaded From OutlineDepot.com