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|Corporate Taxation Winter 2002|
II. Corporate Formation - §351
A. §351 Generally
1. Defers tax on corporate formation and additional capital contributions. No gain or loss on the transaction, but the A/B of the prop. Carries over to the stock.
2. It is based on the notion that the s/h still have an indirect interest in their transferred property through the corp. – continuity of interest.
3. It is a mandatory provision if it applies – is not elective.
4. Sales of assets from s/h to corp. may have to be reclassified as a §351 exchange
B. Requirements for §351 to Apply: (§351(a))
1. Property - One of more persons (including entities) transfer property to the corp.,
a. Property does not include - §351(d)
- A person who contributes services is not considered part of the control group for the 80% test, but if the other people pass, §351 will apply for them, but not for the person contributing services… must recognize G.
(2) Debt not evidenced by a security, and
– A security is long-term debt… short-term debt does not qualify as prop.
(3) Unpaid interest of debt owed by the corp.
b. Prop & Services together: De minimis prop. - If prop. Is relatively small in comparison to the value of the stock already owned by the transferor, the prop. Will not be considered prop. For purposes of §351 (§1.351-1(a)(ii)). The IRS defines “relatively small” as < 10% of the stock or securities already owned by the transferor (Rev. Proc. 77-37)
Ex: A wants to transfer prop. To corp. for 10% of its stock and avoid tax. To meet 80% test, A gets B, a 75% s/h, to contribute $1 to the corp, so that the two contributors now own 80%… doesn’t qualify under this rule.
c. Stock given for prop. and services – recognize G for services, but the stock received for services counts towards 80% control test. (§1.351-1(a)(2)). De minimis prop. Rules apply for this as well. The FMV of the prop. Should be at least 10% of the FMV of the services. (Rev. Proc. 77-37)
d. S/h can contribute shares back to the corp. to increase the % of stock held by other s/h. The contributing s/h can’t take a loss… can only allocate the basis of the contributed shares to his remaining shares. (Fink)
e. A/R is prop. If cash basis s/h contributes A/R to corp. that s/h has not recognized income on yet, the corp. must recognize income when it receives payment for the A/R. (Hempt Bros.).
- If A/P is contributed to corp. by cash basis s/h, the corp. recognizes expense when paid. (Rev. Rul. 80-198)
2. The transfer is solely in exchange for the stock of the corp., and
a. Stock rights and warrants are not stock
3. The transferors are in “control” of the corp. “immediately after the exchange”
a. Control - §368(c) – ownership of stock w/ >= 80% of the total combined voting power of all classes of voting stock and >= 80% of the total number of shares of all other classes of stock
- §318 attribution rules for constructive ownership do not apply for control test (Rev. Rul. 56-613)
b. It doesn’t matter how much stock the transfer group owned before the transfer, only after the exchange.
c. Immediately after the exchange:
(1) All transactions are considered together. If part of the same plan, it qualifies.
(2) If s/h gives away some shares to fall below 80% rule, §351 will still apply and the shares given away will be considered a separate gift transaction.
(3) A prior commitment by a contributor of prop. to sell the corp. stock at the time of the transaction will ruin §351.
- Exception for underwriters, who are treated as agents (§1.351-1(a)(3))
C. Results of §351 Transaction
1. The Corporation
(1) §1032 – A corp. does not recognize G/L on transfer of its own stock (including treasury stock) for prop. Rule applies whether or not §351 applies.
(a) Services are considered prop. for these purposes (Reg. §1.1032-1(a))
(b) §1032 doesn’t apply to a corp. reacquiring its own stock unless it is issuing its own stock in return.
(2) §118 – Contributions of money or prop. to corp. is not income to the corp.
(a) The corp. does not have to issue new stock to existing s/h for this to apply
(i) excludes amounts given as part of the ordinary course of business from customers and amounts used to aid construction.
(ii) does include non-quid pro quo grants of prop. from unrelated parties… e.g., gov’t or civic group grants land to corp. as inducement to relocate – falls under §118.
(c) Exception - §108(e)(6) – if a s/h forgives debt owed to him by the corp., §118 doesn’t apply and the corp. recognizes income equal to the difference between the face value of the debt and the s/h A/B in the debt.
b. Adjusted Basis - §362(a) – A/B of prop to corp. is A/B of transferor + G recognized by transferor
(1) Assumption of liab. doesn’t affect corp’s A/B unless transferor recognizes a G
(2) If multiple assets were transferred and G is only recognized on some of them after the boot is allocated to them, the corp. adjusts the A/B of only the assets that had gain recognized on them by the s/h (Rev. Rul. 68-55)
c. Holding Period - §1223(2) - the holding period of all assets carry over for corp.
2. The transferor
a. Gain/Loss - §351 - no G/L on the transaction w/o boot
If there is Boot
(1) G recognized up the FMV of the prop. – no L recognized (§351(b))
(2) Assumption of liab. is not treated as boot (§357(a)) - exceptions:
(a) Liab. in Excess of Basis EXAM: If aggregate liab. on prop. transferred > aggregate A/B of prop. transferred, the excess liab. is treated as a gain from sale (§357(c))
(i) If liab. would produce a deduction in the hands of the corp., it isn’t a liab. for these purposes (§357(c)(3)). This includes contingent liabilities, such as possible environmental suits (Rev. Rul. 95-74)…. however, payment of mtg. doesn’t produce an expense.
(ii) the s/h may be able to avoid gain for excess liab., by promising to pay the corp., though a bona fide debt instrument, the excess of liab. over the basis of the assets… this will increase his A/B in the prop. transferred by the face value of the debt. (Lessinger)
- However, this rule has only been accepted by the 2nd and 9th Cir. and may not be valid law elsewhere.
(b) If the debt is taken or the assumption is done for a clear tax avoidance reason (no valid business reason), the entire assumption of liab. will be taxed, even if only a portion of the debt was assumed/taken for improper reasons. The burden is on the taxpayer to show business reason. (§357(b))
(3) Installment Sales Accounting (NOT ON EXAM) - §453 - installment method of accounting may apply to defer G when boot prop. (e.g., corp. note) is received
(a) Applies if non-inventory prop is transferred and there is at least one payment to be received after the current taxable year (i.e., through debt instruments) - §453(b)
(b) New amendment to the law in 2000…. Accrual method taxpayers can’t use the installment method (§453)
(c) Installment method:
(i) Allocate the A/B of the prop to the stock up to the FMV of the stock
(ii) If A/B in the prop. exceeds the FMV of the stock, the excess basis is allocated to the note for installment treatment.
(iii) Installment treatment:
(A) First, determine the gross profit on the note = FMV of the note – excess basis
(B) Then, determine the gross profit ratio on the note =gross profit / FMV of the note (or selling price)
(C) Every time a payment of principal is made, the amount of payment is multiplied by the gross profit ratio and that amount is taxable as a G to the s/h.
(D) For each payment that creates a G to the s/h, the corp. must increase it’s A/B in the prop. by the amount of that G.
(4) If multiple assets are transferred in exchange for stock that comes with boot, the boot is allocated to each of the assets based upon FMV and the G on each asset is determined separately. (Rev. Rul. 68-55). EXAM; add up fv of assets transferred this becomes the denominator then put each asset fv over separately to get % then take % X gain on get recognizing gain separately.
(5) The character of the G depends on the type of prop. given up.
(1) If no boot, the A/B of the stock is the same as prop. exchanged (§358)
(2) If boot
(a) A/B of stock =A/B in prop. – FMV of boot + G recognized – L recognized + amount treated as a dividend
(b) A/B of boot is FMV (§358(a)(2))
(c) A/B is allocated among non-recognition prop. (§358(b)(1))
- If the transferor receives non-recognition property of stock and securities or stock of different classes, basis is allocated to each based upon the FMV of each security/stock (§1.358-2(b)).
(d) Assumption of liab. is treated as boot for purposes of A/B. (§358(d)(1))
- If liab. would produce a deduction in the hands of the corp., it is not considered a liab. for these purposes (§357(c)(3)). This includes contingent liabilities, such as possible environmental suits (Rev. Rul. 95-74)…. however, payment of mtg. doesn’t produce an expense.
c. Holding period – holding period carries over to the stock for §1221 capital asset and §1231 business asset property. However, the holding period of assets used in the ordinary course of business do not carry over.
3. Transactions involving §1231 depreciable prop. - §1245 depreciation recapture
a. Any boot recognized as G is automatically considered ordinary income up to the amount of depreciation taken on the prop. (§1245(b)(3))
b. Depreciation recapture that isn’t recognized is transferred to the corp., and the corp. has to recognize the carryover depreciation recapture when it sells the asset.
c. Even if the transferor did not use the asset as a §1231 depreciable asset, if the org. is a related party under §267 rules (see below), any gain on the transfer is ordinary income if the corp. uses the asset as a depreciable asset. (§1239)
D. If §351 Does Not Apply to Transaction
a. G/L - Should not recognize gain on transfer of stock for prop. under §1032 – even services are considered prop. for these purposes. (§1.1032-1(a)). The corp. is allowed an expense deduction for the FMV of the services provided
b. A/B – the corp. will take the prop. at FMV.
2. Contributors (s/h’s)
a. Recognize G as if sale of assets and bought stock with proceeds.
b. May be able to recognize loss, if §267 related party transaction rules do not prevent s/h from doing so.
§267 – no deduction or loss is allowed for transactions between related parties. (1)Related parties includes: (§267(b))
(a) Individual and corp. where individual owns, either directly or indirectly through constructive ownership rules, > 50% of outstanding stock (§267(b)(2))
(b) Two corps which are members of a controlled group
(c) C corp. and p-ship, S corp. and C corp., or two S corps. if same person owns > 50% of the value of the stock/p-ship interest (§267(b)(10)-(12))
(2) Constructive ownership (§267(c))
(a) Stock owned by a corp., p-ship, or trust is owned proportionately by s/h, p-ners, and beneficiaries. (§267(c)(1))
- This is treated as actual ownership, so a second constructive ownership can apply beyond this (§267(c)(5))
(b) Stock owned by family - family is sibling, spouse, lineal ancestors and lineal descendants.
- A second constructive ownership cannot apply beyond this (§267(c)(1) is not treated as constructive ownership for this purpose)
(c) Person owning stock in a corp. owns the stock of his partners in a p-ship.
- A second constructive ownership cannot apply beyond this (§267(c)(1) is not treated as constructive ownership for this purpose).
Ex: 3 members of family each contribute prop. for 25% stock. One of the person’s prop. has a built in loss. They do not qualify for §351 because they fail the 80% test, and because the family member’s stock is attributed to each other, each owns >50% of corp., meaning that losses from transaction between s/h and corp. will be disallowed.
- If loss is disallowed, and s/h later sells his stock for a gain, the amount of gain up to the disallowed loss is not recognized on the sale.
c. A/B in stock – s/h take the stock at the FMV of the net assets (assets-liabilities) that they gave up or the FMV of the services that they provided.
III. Dividends and Corporate Distributions
A. Corporate Distributions in General
1. Tax consequences to s/h
a. Prop. distributed to s/h
(1) 301(a) Are treated as dividends to the extent that the corp. has E&P.
(2) 301(b) When the corp. runs out of E&P, the distributions are treated as returns of capital and reduce the s/h’s A/B in his stock.
(3) 301© Once A/B drops to 0, additional distributions are treated as G from sales of prop. (§301(c))
(a) It is subject to cap G. if prop. is cap. asset in hands of s/h and it is LTCG if the stock was held for > 1yr by the distribution date
(b) However, it is technically not a sale and rules specifically designed for sales do not apply (i.e., installment method for notes received) (Cox)
(1) For dividend purposes, prop. includes money, securities, and other prop., but does not include stock or stock rights of the corp. making the distribution. (§317(a))
(2) If the corp. cancels debt owed by the s/h, it is treated as distribution of prop. (§1.301-1(m))
c. Amount Realized - amount realized by the s/h from the distribution is the FMV of the asset on date of distribution minus liab. assumed. This amount can’t drop below 0, though. (§301(b))
d. A/B - s/h takes the prop. at FMV on date of distribution, but it is not reduced by liab. assumed (§301(d))
e. The holding period of the corp. in the asset doesn’t carry over.
f. Dividends Received Deduction - §243 – see below
2. Tax effect to distributing corp.
a. Corp. must recognize G for appreciated prop. as if it sold the prop, but it can’t recognize a L.(§311(a),(b))
(1) If a liab. > FMV of the prop. is transferred in addition, the FMV of the prop. for the G is the amount of the liab. (§311(b)(2) & 336(b)) The s/h takes the amount of the liab. as his A/B.
(2) Until the 1986 tax act, the rule was that there was no G or L from distribution of prop. (General Utilities). This rule allowed a single layer of tax on asset sales by distributing appreciated prop. and having s/h sell it… resulted in a lot of abuse.
b. A corp. does not recognize G or L when it distributes its own notes to s/h (§311(b)(1)(A))
c. If corp. is distributing an installment note from someone else,
(1) corp. must recognize a G from the diff. Between FMV and A/B. (§453B(a))
(2) A/B is face value minus unrecognized gross margin remaining from original sale.
3. Constructive dividends – includes excessive salary, excessive payment to buy or use prop., corp. payments for s/h benefit, bargain purchase of corp. prop. by s/h, and free use of corp. prop. by s/h
Bargain purchase treated as part sale/part distribution:
a. the price paid is sale, and the FMV above the price paid is distribution.
b. the A/B is allocated for each part based on dollar amount to determine G or L to corp. (loss disallowed for distribution and may be disallowed for sale under §267)
c. s/h takes A/B as FMV of assets.
B. Earnings and Profits – Current and Accumulated
1. E&P provides a measure of the corp’s economic ability to pay dividends to s/h’s.
2. Dividends are distributions made out of either accumulated E&P or current E&P at the end of the year. (§316(a))
a. If curr. E&P for the yr is positive, only look at curr. E&P as of the end of the year, not at the time the dividend is made… if there is E&P during the middle of the yr, but not at the end, the distribution is treated as if made at the end of the yr and is return of cap. (Rev. Rul. 74-164)
b. If curr. E&P for the yr is negative EXAM, the amount of E&P must be pro-rated for the yr at the time the distribution is made to reevaluate accum. E&P, to see if there is sufficient accum. E&P to cover the distribution. (Rev. Rul. 74-164)
c. Dividends come out of curr. E&P first, then accum. E&P (§1.316-2(a)) If curr. E&P is sufficient to cover the distributions, then all is div. even if accum. E&P is at a deficit.
d. Multiple distributions: If multiple distributions total > curr. E&P for yr,
(1) current E&P is allocated to each distribution on a pro-rate basis of distribution amount, regardless of when the payments are actually made (§1.316-2(b)).
ex: distributions in Feb of $15K, Mar of $21K, Nov of §24K, Curr. E&P for yr is $40K… current E&P is §10K for Feb., $14K for Mar., $16K for Nov.
(2) accum. E&P is distributed on a first come first serve basis - §316(a)
3. Timing of Dividend
a. S/h recognize a distribution on the date of receipt of stock (§1.301-1(b)), but the corp. adjusts E&P when the dividend is payable. If payment not received until following yr, the corp. will adjust E&P, but the s/h will not have income for the current yr.
4. Calculating E&P EXAM- §312
a. Adjustments to E&P from distributions – should be net of taxes
(1) Curr. E&P is increased by any G recognized on the distribution
- losses aren’t recognized in these transactions, so losses don’t affect E&P
(2) Accum. E&P is decreased by distributions for the following yr… these do not affect current E&P
(a) at FMV if appreciated prop., otherwise A/B (§312(b))
(b) it is increased by any liab. distributed (§312(c))
(3) If the corp. distributes its own debt instruments to the s/h, E&P is reduced by the principal amount of the note. §(312(a)(2)
b. Distribution of the corp’s stock, securities, or stock rights, or the stock or security of another corp., or any other prop. doesn’t affect E&P if the s/h does not recognize a G from the receipt of the prop./stock. (§312(d))
c. Only gains that are recognized in the current yr are included in E&P, even if they are realized…. deferred gains are not part of E&P (§1.312-7(b) and Bangor)
(1) Tax-exempt transactions where G will never be realized (e.g., interest on tax-exempt bonds) are included in E&P when received.
(2) If the L is recognized, but disallowed for some other reason (e.g., §267), the L is still included in E&P. (§1.312-7(b))
d. E&P is based upon the tax books, not accounting books (§1.312-6(a)). To calc. Curr. E&P:
(1) start w/ corp’s taxable income or NOL for the yr.
(2) subtract amounts that reduce the amount available to pay dividends to s/h: fed income taxes; life insurance premiums where corp. is beneficiary; excess charitable contributions and capital losses that must be carried over; expenses related to tax-exempt income; and amounts that are nondeductible from losses on sales to related parties, penalties and fines, and political contributions.
(3) add amounts that are not contributions to capital but increase the corp’s ability to pay a dividend: tax-exempt income; life insurance proceeds where corp. is beneficiary; fed. tax refunds from prior years; div. rec. deduction; carryovers used in the current yr from NOL’s, charitable contributions, and capital losses;
(4) also need to adjust deprec. – must be on alternative deprec. system for MACRS prop. (§312(k)(3)). Also have to adjust §179 & spread it out over 5 yrs.
(5) deferred amounts from installment sales are added back to current E&P in the year of the sale.
(6) When determining the taxability of a distribution made to a 20% corp. s/h, the distributing corp. doesn’t have to make the depreciation adjustment or adjust for installment sales under §312(n). (§301(e)).
- This only applies in treatment to the 20% corp. s/h. The distributing corp. determines E&P normally, but when distributions are made to the corp. s/h, the corp s/h does not get to use E&P to label distribution as dividends.
C. Dividends Received Deduction (DRD)
1. §243 – A corp. can exclude dividend income received from corps. that it owns
(a) own <20% of stock = 70% DRD
(b) own b/w 20% and 80% of vote and value = 80% DRD (§243(c))
(c) own 80%+ of vote and value = 100% DRD
- ownership is measured on day of distribution
2. Dividends distributed in connection with a sale of a corp. without a valid business reason may be considered part of the sales price. (Waterman Steamship)
a. The corp. saves on taxes by having part of the sale be a div, since it gets the DRD
b. Factors to determine whether div. is part of sale or separate div.
(1) Time lag between div. and sale… the farther the sale is from the div., the more likely it is to be a div. (Litton)
(2) If the div is paid before a buyer is found, it is more likely to be div. (Litton)
(3) Legitimate business reason - buyer doesn’t want assets and won’t pay more for them (TSN Liquidating Co.). This includes cash that buyer isn’t interested in (Litton & Rev. Rul. 77-493)
(4) What kind of prop. is distribution? Better if cash or tangible prop. If a note is distributed, the buyer is still obligated to pay the note, so it is part of the sale (Rev. Rul. 77-493)
c. Best way to avoid this problem is to have sub. distribute div. to parent each yr, and if it needs cash, the parent can make a loan… avoids the issue of whether the distribution is connected with the sale.
3. Limitations on DRD
a. §246(c) – the corp. must hold the stock for > 45 days to qualify for DRD… this prevents corp. from creating a tax arbitrage with its DRD by buying stock, getting the div. and immediately selling for a loss equal to the div…. net tax loss because of DVD, but no economic loss.
- If §246(c) applies, §246A and §1059 are not used.
b. §246A – Debt financed stock
(1) If the stock acquisition was debt financed, the DRD is reduced by the % of the stock cost (A/B) that was debt financed.
(a) Formula: DRD% x (100% - avg. indebtedness %)
(b) Avg. indebtedness % = avg. amount of portfolio debt / avg. A/B of stock
(2) Doesn’t apply to 80% controlled subsidiary – gets full 100% DRD
(3) The stock is not portfolio stock subject to the provision if the s/h owns 50% of vote and value or 20% of vote and value if only < 5 corp. s/h (§246A(c))
(4) The reduction in DRD can’t be > amount of interest deduction allocable to dividend (§246A(e)). When §246A applies, the s/h’s DRD will be the greater of the reduced DRD or the normal DRD less interest expense on the debt.
(5) There must be a direct relationship between the loan and the stock purchase for the loan to be portfolio debt (§246A(d)(3)(A)). Simply having outstanding debt does not cause a problem if the debt was not taken to finance the acquisition of the stock.
(6) §1059 still applies after §246A
c. Extra-ordinary dividends - §1059
(1) If a corp. s/h receives extra-ordinary div. when it has not held the stock for at least 2 yrs, the A/B in the stock is reduced by the amount of the DRD. Once the A/B hits 0, excess amounts are treated as income from sale of the stock in the yr the div. is received.
- It doesn’t matter how long the corp. holds the stock after the div.
(2) “Extra-ordinary div.” – Div is >= 10% of A/B - §1059(c)
(a) FMV can be used instead of A/B if FMV is reasonably attainable on the day of the div. (i.e., public stock) - §1059(c)(4)
(b) A 5% div. threshold is used instead of 10% for preferred stock.
(3) Aggregation of div.
(a) Dividends received in an 85 day period are aggregated for this test
(b) If total dividends within 1 yr period is > 20% of A/B (or FMV if attainable) they are all aggregated for this test.
(4) §1059(e)(2) - §1059 does not apply to div. from a controlled sub, which is measured as 80% of vote and value under §1504(a)(2) through §243(b)
(5) If div. from redemption or reorg. under §356, the 2 yr period is not relevant… any extraordinary div. falls under the rule. (§1059(e)(1))
1. If a repurchase of stock by a corp. qualifies as a redemption that is an exchange under §302(a), it is treated as a sale. If not, it is treated as s/h distribution, subject to §301 dividend rules. (§302(d))
a. A corp. redeems its stock when it acquires the stock for prop., no matter what it does with the stock afterwards (§317(b))
b. The corp. can’t take an expense for reacquiring its own stock (§162(k))
2. Tax Effects from Redemption
a. The A/B of the stock redeemed is allocated to the s/h’s remaining shares, no matter how few are left. (1.302-2(c))
- If the s/h has no more shares, but did not qualify under complete termination rule because of attribution, the A/B is allocated to the person or entity who attributed ownership to him. (1.302-2(c))
b. Accumulated E&P is reduced pro-rata for shares redeemed. (§312(n)(7)). The E&P is reduced by the % of stock outstanding that is eliminated…. e.g., if 30% of total original stock is eliminated, the Accumulated E&P is reduced by 30%. Current E&P is unaffected by this.
(1) This rule doesn’t apply if the redemption is a div. (so §301(e) is not an issue). If it is a div., use normal §301 rules for E&P.
(2) If the price paid by corp. to redeem the stock is less than amount of E&P reduced, the price paid is used. If §312(a) is less, it will be used.
c. If the redemption is treated as a sale, and the s/h suffers a loss on the sale, the loss may be disallowed by §267 if the s/h owns > 50% of the corp. before the sale.
d. If the redemption is treated as a div., it may be subject to §1059 extra-ordinary dividend restrictions if the s/h is a corp. However, under §1059(e), for redemptions under §302 or §304 (affiliated corps), the length of ownership before the redemption doesn’t matter.
3. If there are other transactions connected with the redemption, the final result of all the transactions is what matters (Zenz (final result was complete termination of interest) and Rev. Rul. 75-447 (capital contribution w/ redemption - final result passed (b)(2) test)… the rule is consistent with Waterman Steamship
a. The order of the transactions is irrelevant.
b. Ownership is measured before and after the set of transactions.
4. Redemptions as Constructive Dividends:
a. If the s/h has created an unconditional primary obligation to repurchase other s/h’s stock (i.e., upon death or retirement), he will be considered to have received a constructive dividend if the corp. redeems the other s/h’s stock for him. (Rev. Rul. 69-608 – based on law of Old Colony Trust)
(1) Easy ways to avoid this: (Rev. Rul. 69-608)
(a) promise that the corp. will repurchase the stock,
(b) make it a right of first refusal or option to buy,
(c) make it a secondary obligation… e.g., if the corp. doesn’t pay.
(d) not agree to buy it in your own name… i.e., B or B’s assignee will buy stock.. This isn’t a firm obligation
(2) Tearing up a K with an unconditional primary obligation before it is executory (i.e., person has retired or died) and writing a new one without an unconditional primary obligation is fine. (Rev. Rul. 69-608)
(3) The corp. cannot deduct any expenses that it incurs in repurchasing the stock (e.g., appraisal, legal, or administration fees) - §162(k).
b. Just because the other s/h’s interest increases from a redemption doesn’t mean that he is forced to recognize a constructive div… must get actual monetary benefit (Holsey)
B. Constructive Ownership of Stock under §318
1. Family attribution – attributed stock owned by spouse, children, grandchildren (but not from grandparent to grandchild), and parent. (§318(a)(1))
- The fact that the family doesn’t get along is generally meaningless to combat this (although one ct. held so (Robin Haft Trust), the IRS will not follow it (Rev. Rul. 80-26))
2. Attribution from entities to s/h – attributed proportional to s/h interest (§318(a)(2))
a. P-ship, trust, and estate – stock owned by entity is owned proportionately by partners or beneficiaries.
b. Corp. – if s/h directly or indirectly (do other attributions first) owns >50% of value of stock of the corp., the s/h owns a the stock that the corp. owns in prop. to his interest in the corp.
3. Attribution to entities from s/h – no proportionality – entity owns all of the s/h’s interest (§318(a)(3))
a. P-ship, trust, and estate – stock owned by beneficiary or partner is owned by the entity.
- rule doesn’t apply for trusts is the beneficiary only owns a remote contingent interest worth < 5% of trust prop.
b. Corp. – if s/h directly or indirectly (do other attributions first) owns > 50% of the value of stock of the corp., the corp. owns all of the s/h’s stock.
4. Options/warrants are treated as stock ownership. (§318(a)(4))
a. This attribution takes place only if the s/h has a unilateral right to exercise the options. (Seagram’s)
b. The option rule takes precedence over family attribution rule (§318(a)(5)(D)).
5. MULTIPLE ATTRIBUTIONS: Only 1 attribution is allowed for some. Some ownership is only constructively owned after the attribution.. can’t be attributed a second time: (§318(a)(5)(B)&(C))
b. No sidewise attribution - Stock attributed to an entity from an owner/beneficiary can’t be reattributed to another owner.
- However, stock can be attributed from one entity to owner to then another entity.
C. Qualifying a Redemption (is liquidating) as a Sale: (§302(b))
1. The redemption is not equivalent to a dividend (§302(b)(1))
a. There must be a meaningful reduction of the s/h’s proportionate interest in the corp., directly and by attribution (Davis). SUBJECTIVE TEST!
(1) A legitimate business purpose is irrelevant for these purposes. (Davis)
(2) The constructive ownership rules of §318 apply. (Davis)
(3) It is determined on a s/h by s/h basis (Davis)
(4) It is based upon facts and circumstances. Significant factors that should be compared from before to after the redemption: (Himmel and Rev Rul 81-289)
(a) the right to vote and exercise control – Most Important (Rev. Rul. 85-106),
(b) the right to participate in current and retained earnings,
(c) the right to share in net assets upon liquidation.
(5) What is meaningful?
(a) A reduction to deadlock control (two equal 50% s/h) is meaningful (Rev. Rul. 75-502). It is significant that the other 50% not be widely owned.
(b) A reduction that requires another significant control block to support you is meaningful. (Rev. Rul. 76-364)
ex: 4 s/h, A w/ 27%, rest w/ 24% - A only needs 1 other s/h’s support for control. Change to 22% for A and rest went to 26% - A now needs 2 other s/h support for control.
(c) A reduction below super-voting level (e.g., 66%) isn’t meaningful if the s/h still owns > 50% and there is no showing of an extra-ordinary corp. event requiring super-voting on the horizon. (Rev. Rul. 78-401)
(d) if the redeemed s/h is not in control after the redemption and barely misses mechanical test, it may be meaningful. (Rev. Rul. 76-364)
(e) if a s/h owns a de minimus amount of stock (e.g., < 1% of a public co.), the rule is very liberal… a small reduction in voting interest will qualify. (Rev. Rul. 76-385… only 4%). However, there must be some reduction, not a pro-rata redemption among all s/h (Rev. Rul. 81-289)
b. The fact that it doesn’t meet the other §302(b) tests is irrelevant (§1.302-2)
c. The corp. doesn’t need E&P to qualify for this. (§1.302-2)
2. There is a substantially disproportionate redemption (§302(b)(2))
a. Three part test… all must be met:
(1) s/h must own < 50% of voting total power after redemption, AND
(2) s/h must have less than 80% of the voting stock that he held before the redemption
(a) based on total votes, not shares… interest must be reallocated among remaining shares for test
(b) # of sh that need to be = votes owned x total votes in corp. redeemed to hit 80% rule (5 x total votes) – (4 x votes owned)
(c) doesn’t matter whether the stock is common or preferred as long as it can vote.
(3) s/h must own less than 80% of the FMV of common (voting and non-voting) stock he owned before the redemption.
(a) if one class of common stock, (b) & (c) are the same.
(b) preferred stock doesn’t affect this, only common.
(c) this part of the test doesn’t apply if the s/h doesn’t own any common stock (Rev. Rul. 81-41) – i.e., only owns voting preferred stock.
b. Disproportionate rules are applied separately to each s/h
c. If there are a series of redemptions as part of a plan, the redemptions must be aggregated for the test. (§302(b)(2)(D)). A plan can be just a design by one redeemed s/h to arrange a redemption of another s/h as a sequence of events that would ultimately return control to the first s/h… no need for an agreement among s/h (Rev. Rul. 85-14)
d. Disproportionate redemption test does not apply to a redemption of solely non-voting stock. (§1.302-3)
(1) If both voting and non-voting redeemed, the rule applies. If it passes, the non-voting stock is piggybacked on the voting stock to get sale treatment. (1.302-3(a)). However, §306 preferred stock doesn’t piggyback (see §306 stock)
(2) If it is solely non-voting stock or a de minimus amount of voting stock, may be able to qualify as exchange under b(1) if the non-voting stock redemption is highly material (i.e., > 50% reduction), based on economic consequences. (Rev. Rul. 85-106)
(3) Contingent voting or conversion to voting stock is not voting stock.
3. Complete termination of s/h interest – can’t have any interesst, direct or indirect attribution (§302(b)(3))
a. Waiver of family attribution – only applies to termination of interest: (§302(c)(2))
(1) Requirements: (§302(c)(2)(A))
(a) s/h can’t have direct or non-family indirect interest after distribution other than as a creditor,
(i) To be a creditor, the former s/h’s rights can’t be beyond the scope of what is necessary to enforce his claim (§1.302-4(d))… the interest can’t be too similar to equity:
(i) loan/note is too long-term – 15-20 yrs
(ii) the interest is based upon profits
(iii) the debt does not pay market interest
(iv) subordinated to all other creditors
(v) undercapitalization of corp. (debt to equity ratio of 4:1 is usually OK)
(ii) If the former s/h’s loan is secured by the stock of the corp., it is allowable under the rule. However, if there is a default on the note, the former s/h can’t take back his stock… he must sell it. (§1.302-4(e))
(iii) The s/h can’t have any kind of employment interest either, including working as an independent contractor (Lynch).
- Even if he is uncompensated, the s/h may fail the test if he is active in the business as a director.
(b) s/h can’t reacquire his interest within 10 yrs from date of distribution, and
(c) s/h must file waiver w/ IRS.
(2) If the stock redeemed was acquired: (§302(c)(2)(B))
(a) by the s/h from a §318(a)(1) family member, or
(b) by a family member from the s/h
in the 10 yrs before the redemption, it must be shown that primary purpose of the transaction was not tax avoidance.
Tax avoidance purpose:
(i) A mere gift of stock to a person in a lower tax bracket is not tax avoidance motive (§1.302-4(g)(2))
(ii) If the main purpose was to transfer business control to another family member, then tax avoidance was no the principle purpose in the transaction (Rev. Rul. 77-293)
b. Waiver of family attributions by entities (§302(c)(2)(C))
(1) For attribution from family member to owner/beneficiary to entity, the attribution from the family member to the owner is waived.
- However, if the owner/beneficiary still has his own direct or indirect non-family interest, it is not waived at all
(2) Requirements to qualify for the waiver:
(a) The entity and each related person (i.e., owner/beneficiary) must meet the family waiver provisions under (§302(c)(2)(A)), and
(b) Each related person (i.e., owner/beneficiary) agrees to be jointly and severally liable for any tax deficiency if the entity or any one of the related parties takes an interest in the distributing corp. w/in 10 yrs.
- Related persons – any person to whom ownership of stock in the corp. (at the time of the distribution) is attributable under family attribution of §318(a)(1) if the stock is further attributable to the entity under §318(a)(3). – i.e., owner or beneficiary.
4. Partial liquidation (§302(b)(4)) – a substantial change in the distributing corp.
a. If the co. is engaged in 2 or more qualified trade or businesses (i.e., engaged for 5 yrs itself, not through a sub). If it then liquidates one trade, but continues the other, it will qualify.
b. Corp. s/h can’t take advantage of partial liquidation treatment.
b. The distribution must be pursuant to a plan and occur within the yr the plan is adopted.
5. For the ownership tests, the attribution rules of §318 apply
6. Seagram’s - abuse of the rules – the corp. redeemed most of it’s stock for cash and out of the money options that weren’t worth much so that it could get it’s money out of the corp., but have div. treatment and get DRD. Attribution rules of §318(a) for options meant that it still had the same ownership interest, even though it had little financial interest, so it didn’t pass any of the three redemption as exchange tests. The corp. faced the §1059 excess dividend rule, but §1059 used to only suspend dividends in excess of A/B rather than treat them as a sale… since corp. had relatively low basis, much of the gain on the sale could be suspended for a long time. Congress changed §1059 in response to this action by Seagram’s.
7. Charitable contributions – s/h can avoid cap G on sale and get charitable contribution by donating stock to charity and then having the corp. redeem the stock from the charity. As long as there was no binding agreement upon the charity at the time of the gift that required the redemption to occur, the s/h will get away with it. (Grove and Rev. Rul. 78-197). The taxpayer can’t retain an interest in the stock when transferring it to charity… e.g., keep stock but transfer div… the div. are income to the s/h (Hoarst and Harrison)
D. Redemptions by Affiliated Corps. - §304
1. §304 reclassifies sales between a controlling s/h and an affiliated corp. as redemptions under §302, where §302 would not otherwise be applicable.
2. Brother-Sister relationship (§304(a)(1)):
a. When one or more persons controls 2 corps, and one of the corps. (Y) acquires the stock of the other (X) from the controlling person(s) with some form of prop.
- Property includes money, securities, and other prop. (including notes of the acquiring corp.), but doesn’t include the stock of acquiring corp. – that is a §351 transaction. (§317(a)).
b. The transaction is treated as if the controlling person did a §351 transaction with the acquiring corp (Y) by contributing the other/issuing corp’s (X) stock and then had the acquiring corp. (Y) redeem the stock that it issued.
(1) If the redemption doesn’t pass the §302(b) tests and is treated as a §301 distribution
(a) transfer of stock will be treated as a contribution of cap. to the acquiring corp’s (Y) A/B.
- The acquiring corp’s (Y) A/B in the other corp. (X) stock is A/B in the hands of the controlling transferor + G recognized on the transaction by s/h excluding div (but including cap G amounts in excess of E&P and A/B). (§362(a)(2))
(b) determining if cap gain from distributions in excess of E&P and A/B
(i) It is done solely in reference to the A/B of the acquiring corp (Y) stock
(ii) The transferor’s A/B in the other/issuing corp’s (X) stock that was transferred to the acquiring corp. (Y) is added to his A/B in the acquiring corp. (Y) stock as a §351 capital contribution. (§1.304-2(a))
(iii) Then, the s/h’s A/B in the acquiring corp. (Y) is reduced as required by §301 for insufficient E&P. When the s/h’s acquiring corp. (Y) stock hits 0, he must recognize additional amounts as cap gain.
(c) Calculation of amount of dividend – amount of div. under §301(c) is calculated first to the extent of the acquiring corp’s (Y) E&P and then to the extent of the other corp’s (X) E&P (§304(b)(2))
(2) If the redemption is treated as a sale or exchange under §302(b), acquiring corp. takes FMV/cost basis and transferor recognizes cap. gain.
- The E&P that must be reduced proportionately for the redemption under §312(n)(7) is the issuers (per Kurtz)
c. Because bro-sis relationship can always be converted into par-sub by use of constructive ownership rules (i.e., the corp’s are attributed all of their controlling owner’s shares, so by definition they each own >50% of each other), only actual ownership before the transaction is used to see whether relationship is bro-sis or par-sub.
3. Parent-Subsidiary relationship (§304(a)(2)):
a. When s/h transfers stock of one corp. (X) to the acquiring corp. (Y) in exchange for prop, and the other/parent corp. (X) is in control of the acquiring/sub corp. (Y)
b. The distribution of prop. is treated as a redemption of the parent/issuing/other corp. (X) stock under §302. Mechanically it is as if Y issued dividend to X and X redeemed… however, the dividend to X is not taxed to X.
(1) Sub. will always receive FMV/cost basis in the parent’s stock.
(2) If the transfer doesn’t pass 302(b) and is treated as a §301 distribution,
(a) The transferor’s A/B in the remaining parent (X) stock in increased by the A/B of the of the parent (X) stock sold to the sub (Y). (§1.403-3(a))
(b) If the transferor has no stock remaining in parent, his A/B in the stock sold is transferred to the people or entities whose relationship caused the attribution of ownership…. the acquirer/sub (Y). (§1.302-2(c))
(c) The E&P of both corp’s is used for div., first the acquiring corp (Y), then the issuing corp. (X)
(3) If it is treated as a sale or exchange, the transferor has a cap gain on the sale.
4. Control for purposes of §304(a) (§304(c))
a. Control is owning >= 50% of voting power OR value
b. Control for §304(a) is tested before the transaction takes place
c. If person is in control of a corp. and that corp owns 50% of vote or value in another corp., then the person owns control of the other subsidiary corp. w/o regard to §318(a) attribution rules. The control is considered total control for further attributions in this case. (§304(c)(1))
d. In order to determine control in the two corps, modify §318(a)(2)(C) and (3)(C) to require only 5% control in a corp. for attribution to occur instead of 50%. However, for amounts between 5% and 50%, the ownership attribution is proportional to ownership. (§304(c)(3)(B)(ii)(II)) Amounts above 50% are attributed normally.
e. Control group - If 2 (or more) people control the stock, even if one person receives acquirer (Y) stock instead of prop. for his transfer of the other corp. (X) stock. (i.e., a §351 transaction for him), as long the other person contributed some prop. and both s/h retain or obtain some stock of acquirer (Y), the test for control includes both people - §304(c)(2)(B)
5. Redemption inquiries under §302(b) for §304 redemption (§304(b)(1))
a. The §302(b) redemption inquiry of distribution or sale is made with respect to the stock of the other/issuing corp. (X) only.
b. In order to determine the s/h’s interest for §302(b) tests, §318(a)(2)(C) and (a)(3)(C) for attributions to and from corp. entities is applied without regard for 50% limitation.
c. For a par-sub transaction, the stock sold to the sub. (Y) by the s/h is reattributed through the parent (X) back to the s/h.
6. Overlap of §304 and §351
a. If the other/issuer corp. (X) stock is transferred to the acquiring corp. (Y) in exchange for prop. and stock in the acquiring corp. (Y), the transaction is split up into a §351 transaction for the stock and a §304 transaction for the prop.
- the A/B of each stock owned in the acquiring corp. (Y) afterwards is kept separately… A/B of new stock is solely from §351 separate from other stock subject to §304 part.
b. §304 doesn’t apply for any liability assumed by the acquiring (Y) corp. if the liability was incurred by the transferor to acquire the issuing/other (X) stock (§304(b)(3)(B))
(1) The assumption of liability is considered a sale (since §304 doesn’t apply), separate from the §351 part of the transaction.
(2) If the debt is not incurred to acquire the stock, §304 applies to it.
7. Can have combination of par-sub and bro-sis relationship
Ex 1: X - Y sells S stock to Z
70% 100% - Y controls S directly and controls Z indirectly
Y Z through X.. Under §318, X’s entire ownership of
100% Z is attributed to Y(not a sidewise attribution), so Y
S owns 100% of Z… §304 applies
- It is a §301 distribution since it fails §302(b)
- However, Y’s A/B in S disappears since Y owns no other prop. to attach it to.
Ex 2: A
51% 51% - A transaction between N and Z would be an
N X affiliated corp. transaction subject to §304…
51% Z is attributed to X at 51% and to A at 51%,
Y then from A to N at A’s total ownership %,
51% which is 51%.
V. Stock Dividends
A. Stock Dividends - §305
1. Generally gross income doesn’t include distributions from a corp. of its own stock. (§305(a))(i.e., stock splits).
a. If the distribution of the stock dividend doesn’t change the proportional ownership, then the dividend is not taxed… no real economic effect from div.
b. Stock includes stock and stock rights and warrants. (§305(d)(1))
c. The fact that treasury stock is distributed as opposed to new issues isn’t a problem (§1.305-1(a))
2. Exceptions to rule – Taxable stock dividends: (§305(b))
a. If s/h has the choice to receive stock or cash/property, then the entire distribution is taxable, whichever he receives. (§305(b)(1))
(1) It doesn’t matter if nobody actually takes the cash… choice alone is enough to cause taxable dividend.
(2) If part of the distribution is subject to choice, but another part isn’t, only the part subject to the choice is considered taxable (e.g., each s/h gets 1 sh. and choice of another share or cash… the 1st share isn’t taxable, only the second one subject to choice). (§1.305-2(b)(Ex. 1))
b. #1 If the distribution is disproportionate EXAM– (1) some s/h receive prop. and (2) others increase their proportionate interests in the assets or profits of the corp. (§305(b)(2)) (e.g., cash to preferred s/h and common stock to common s/h)
(1) Both requirements must be met for this to apply.
Ex: p/s is issued to common s/h - it reduces the interests of the old preferred s/h and increases the interests of the common s/h who now have p/s, but without additional prop. being distributed to the preferred s/h (within 3 yrs – see below), the distribution does not qualify as a §301 distribution under this exception, and is not taxed.
- the fact that the same s/h owned equal proportions of each is irrelevant… the test looks at the interests of the classes rather than the individual s/h.
(2) Prop. Requirement:
(a) Series of distributions are aggregated. (§1.305-3(b)(1))
(i) The series do not need to be a part of a plan (§1.305(b)(2))
(ii) If the receipt of cash or prop. doesn’t occur 3 yrs before or after the distribution of the stock, then they are not aggregated and the prop requirement isn’t met. (§1.305-3(b)(4))
(b) Distributions of cash in lieu of fractional shares (§1.305-3(c))
(i) Should be done for administrative purposes, rather than to increase proportional interests.
(ii) If the total cash distributed for this reason is <= 5% of the FMV of the stock distributed, it qualifies for this and is doesn’t fall under §305(b)(2).
(iii) It is treated as a distribution of the fractional shares and then a redemption of them, which would be too small to pass a §302(b) test.
(3) Disproportionate Distributions:
(a) If p/s is issued to common s/h and there are preferred s/h, the common s/h interest is increased in assets and earnings to the detriment of preferred s/h
(b) If the newly issued p/s is subordinate to the old p/s, the distribution is not treated as a §305(b)(2) distribution, because the p/s still has priority interest in the assets of the corp. (§1.305-3(e)(Ex. 3))
(c) If there is more than 1 class of stock outstanding you treat each class separately
(4) Redemptions can also be considered stock distributions to unredeemed s/h under §305(b)(2) disproportionate distributions since stock does not have to actually be issued to be a distribution (i.e., one s/h received prop and the other’s interest increased) (§1.305-3(b)(3) & §305(c)).
(a) If the s/h meets §302(b) test and the redemption is treated as a sale, §305 doesn’t apply (§305(c))
(b) If it is a §301 distribution,
(i) If the redemption is isolated and not part of a periodic redemption plan §305(c) doesn’t apply. (§1.305-3(b)(3))
(ii) §305(c) applies if the redemption isn’t isolated.
The unredeemed s/h is deemed to have received §301 distribution to the extent of their interest in the corp. is increased..
(A) # of shares considered to be distributed to the other s/h:
(old # of s/h + X) / (total old # of shares + X) = # of sh after redemption / total # of shares after redemption
(B) fictional shares are valued at the value of the shares redeemed.
Ex: 2 s/h.. 1 w/ 90 A sh. & other w/ 180 B sh…. 60 B sh redeemed. B still has control, so §301 applies. Looking for tax to A: Number of new sh for A is (90+x)/(270+x)=90/210… X=45 They are valued at the FMV of B shares
(5) Conversion ratios on convertible p/s
(a) If common s/h distributed c/s, the conversion ratio of the p/s should increase accordingly (not a problem under §305(b)(5)). (§1.305-3(d))
- If the ratio doesn’t increase, it causes an increase in the interests of the common s/h… if prop. is distributed to preferred s/h in the 3 yr period before or after, the c/s distributed to common s/h becomes taxable.
(b) If the corp. distributes cash to p/s and lowers their conversion ratio, the common s/h are taxed for their increase in interest under §305(b)(2) and §305(c), the same as a redemption. (Reg. §1.305-3(e)(Ex. 7))
c. #2 Distributions of p/s to common s/h and c/s to other common s/h (§305(b)(3)).
(1) purely c/s to common holders can’t be taxed even if there are other classes of stock unless the other securities have conversion rights that are affected; they are already at the bottom of the pool in terms of interest
(2) if only c/s, p/s issued to them will not cause a problem because everyone still has the same interest.
d. #3 Distributions on p/s. (§305(b)(4)) – any distribution on p/s is taxable.
(1) If preferred s/h get anything in the transaction it is taxable to all.
(2) An increase in conversion ratio of convertible p/s to keep pace w/ a common stock split isn’t a problem.
e. #4 Distributions of convertible p/s, unless IRS is convinced that it will not cause a change in ownership interests (§305(b)(5))
3. Tax effects:
(1) corp. - doesn’t recognize income if the distribution is under §305(a). The distribution of its own stock will not create a recognizable gain to the corp. However, it may recognize G for appreciated prop. if under §305(b). (§311(a))
- §1032 doesn’t apply because there is no transfer of the prop. in exchange. to the corp.
(2) s/h - If the stock dividend is taxable, it is treated as a distribution under §301 and the distribution amount is the FMV of the stock or stock rights on the date of distribution. (§1.305-1(b))
(a) For corp. s/h - different rule for corp. s/h if prop. other than notes of the distributing corp. is distributed… the amount realized in the distribution is the lesser of: (§1.301-1(d))
(1) the FMV of prop distributed or
(2) the A/B of the prop. in the hands of the distributing corp.
(b) The FMV is not adjusted for the fact that the value of the old shares has decreased.
(c) If there is a choice of stock or cash, the stock received is valued at the higher of the FMV of the stock or amount of cash that was offered as the other choice. (1.305-1(b)(2))
(1) If distribution taxed as dividend under §301, the new stock’s A/B is the FMV of the stock. The A/B of the old stock is unaffected.
(2) If it isn’t taxed, the old A/B is allocated among the new shares and stock rights based upon the relative FMV of each at the date of distribution. (§1.307-1)
(a) If stock rights are exercise, the A/B of the stock issued is the A/B of the option + the exercise price.
(b) If §305(a) applies and the FMV of the stock rights distributed are less than 15% of the FMV of the stock at the time of distribution, the A/B for the rights will be 0 unless the s/h elects otherwise (then the allocation based upon FMV will occur) (§307(b))
(c) The holding period of the old stock tacks.
c. E&P – if taxable, the distributing corp. reduces E&P by amount of distribution. If it isn’t taxable, don’t reduce E&P. (§1.312-1(d))
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