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Corporate Tax Outline

Spring 2010

An overview of the Taxation of Corporations and Shareholders:

Forms of Business Organization

(1) Sole Proprietorships- Businesses operated and owned by a single individual

(2) Corporations- fictitious legal entities that offer limited liability to their owners.
(3) Partnerships
limited partnerships,
Joint ventures
(4) LLC- provides limited liability for all its members

Conceptual Taxation Models

(1) Aggregate Concept

A business organization is viewed as an aggregation of its owners, each of whom holds a
direct undivided interest in the assets and operations of the enterprise
Each of the owners takes into his account his or her respective share of income and
expenses for tax purposes

(2) Entity Concept

Corporation is separate and distinct from its owners.
Entity is taxed on its taxable income and transactions between owners and entity are
taxable events
“Double Tax”

(3) Hybrid Concept

Occurs with S corps and Partnerships
Organization is separate entity for things such as filing of tax returns
Aggregate  passing through of income, and expenses to the owners, etc

Influential Policies

Double Tax
Rule: Corporation is taxed on its earnings and Shareholders are taxed when they receive
Prior Rule: General Utilities Doctrine Distributions were non-taxable events.
DT of C increases the cost of operating a business as a C Corp and often provides TP’s an
incentive to choose a partnership or S corp. for business and investment activities
Rate Structure:
In Past, Usually, min. individual tax rate has exceeded the corp. tax rate and gave
incentive to operate as a C corp.
Ex: 1980 and 1987 in class we saw that there was a big difference
Current Day: Not as clear because indiv. And corp. rates are approx. 35% and thus it is a
fact and circumstance test.

Preferential Capital Gains Rates:

TP are motivate to devise strategies to convert ord. income into capital gains, such as
“bailing out” C corp. profits at capital gain rates

Non Recognition
Corp. and partnership transactions qualify for no recognition treatment b/c they are mere
changes in form which result in continuity of investment.

Classification of Business Entities

Corporation Defined
Defined under §7701(a)(3)
Associations, joint stock companies, and insurance companies
Certain unincorporated entities “associations” are treated as corporations for federal tax

Pre-1997 Regulations
Six Characteristics of a “pure corporation”
An objective to carry on a business and divide the profits
Continuity of Life
SH goes bankrupt or dies, no affect on corporation
Centralization of Management
BOD has power and responsibility of operating the business.
Liability for debts limited to Corporate Property
SH not personally liable
Free Transferability of interest
SH can dispose of shares at anytime
Ex: You own GM, and you can transfer your interest to someone else and that transferee
will step into your shoes.
So if there was an unincorporated entity, and it characteristics EXCEEDED any non
corporate characteristic, it was a corporation for tax purposes
State laws created LLC and now there was a blur b/t a corp. and unincorporated entity
New Regulations were proposed and “check the box” regulations were finalized in 1997.

Check The Box Regulations:

Began in 1997
Reg §301.7701-2(b)(1)
Corporation means a business entity organized under a federal or state statute or under a
statute of federally recognized Indian Tribe, if the statute describes or refers to the entity
as incorporated or as a corporation, body corporate or body politic
Reg §301.7001-3(a)
A business entity that is not classified as a corporation can elect its classification for
federal tax purposes.
Does not apply to publicly traded entities
Publicly traded partnerships will be taxed as a corp.
§7704(b) Partnership whose interests are traded on an established securities market or
are readily tradable on a secondary market.

No matter what, once you are publicly traded you are a corporation for tax purposes.
Existing Entities:
An entity in existence before 1997, generally retains the same classification that it had
under the prior association regulations
Exception- Single owner entity that claims to be a partnership
Election under REG§301.7701-3(c)
An entity wishes to change its classification must file an election, which is effective up to
75 days before or 12 months after it file
Must be:
(1) Signed by each member of the entity, including prior members affected by
retroactive elections OR
(2) AN officer, manager or member authorized to make the election.
Can not change for 60 months, unless Service p[permits the change and 50% of
ownership interests are owned by persons who did not own any interests when the
election was first made

Check the Box Hypos:

See attached

§351(a), (c), (d)(1), (d)(2)


A. Introduction:
a TP who transfers property to a newly formed corp., in exchange for stock would
recognize a gain or loss measured by the difference b/t FMV and AB.
AR – AB = Gain (loss)
Also, Corp may realize on issuance of stock for property.
Allows no G or L to newly formed S or C Corps.
§1032(a) provides that a
corp., does not recognize a gain or loss when it receives money or property in exchange
for stock.
Rationale these transactions are mere changes in form of SH investments and thus non-
taxable events.
§351 preserves unrecognized gain or loss in the SH stock’s basis under §358 and in
corp.’s basis in the transferred property under §362.
Recognition of Gain or Loss (Transferor)
§351 states:
Certain transfer of property to a newly formed or preexisting controlled (80% owned)
corporation are not taxable events.
Unrecognized gain or loss is preserved through transferred and exchanged basis rules
Basically no gain or loss will be recognized if property is transferred and all elements
are met.
Normal §1001(a) Rule does not apply.
Rationale Congress felt that a gain or loss should not be recognized because the
transferor still has a financial interest in the property and still has control.
There is a continuity of proprietary interest. (continuing investment)
Remember the gain is not forgiven, rather it is deferred until Transferor sells corp.’s

B. Elements for Non-recognition under §351

(1) One or more persons (including individuals, corporations, partnerships, or other

entities) must transfer property to a corporation

(a) Property
Cash, inventory, accounts receivable, patents and other intangibles such as goodwill and
industrial know-how
Property does not include:
Past, present or future services

(b) Transfer
All substantial rights in the property must be transferred
So if you transfer a limited license element has not been met.

(2) The Property must be transferred solely in exchange for stock of the transferee

(a) Solely in Exchange for Stock

Must be for stock, but does not include:
Stock rights, warrants, or convertible debt securities”boot” (see below) Reg 1.351-1(a)
Exception: Nonqualified preferred stock
Treated as other propertyboot rather than stock under §351(g)(1)
§351(g) defines nonqualified preferred.
Preferred stock (does not participate in corp., growth and limited to dividends) with any
of the following debt-like characteristics
(1) SH has the right to require the issuing corp., or related person (ex, families, etc) to
redeem or purchase stock
(2) Corp. issuer (or a related affiliate) is required to redeem or purchase stock
(3) Issuer 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 exercise or
(4) Stock’s dividend rate is variable- set by reference to mkt. interest reates, commodity
prices or similar indicies
Even though boot for gain purposes, Under §351(g)- still stock for control test purposes.

(3) The transferors, as a group must be in control under §368(c)of the corp., immediately
after the exchange.
(a) Control
§368(c) defines control as:
People transferring property 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 nonvoting stock.
Simultaneous exchanges:
Reg §1.351-1(a)(1) Simultaneous exchanges are not required where the rights of the
parties have been “previously defined” and the agreement proceeds with an “expedition
consistent with orderly procedure”
Example 1:
A receives 50 shares of voting stock, B receives 50 share of nonvoting common stock,
and C receives 50 shares of nonvoting preferred stock that is not nonqualified preferred
Control test is satisfied because the property transfers, as a group own at least 80% of
class of stock
Example 2:
Now C, gets stock for services, so 100/150 is transferred and this is only 67% and thus
not 80% and control has not been met. A and B must recognize gain and loss on their

Basis and Holding Period:

Shareholder’s Basis
§351 Transferor’s basis in the stock received will equal his basis in the transferred
property immediately prior to the exchange §358(a)(1).
For more than 1 class of Stock aggregate basis is determined under §358(a)(1) as
allocated among all classes of stock received in proportion to the FMV of each class
§358(b), Reg §1.358-2(a)(2)
§358 (FILL IN) used for determining adjusted Basis in Stock and Boot Received

2. Shareholder’s Holding Period

§1223(1) Tacking
A transferor’s holding period for stock received in a §351 transaction in exchange for a
capital or §1231 asset includes the holding period of transferred property.--> Tacking!
Rule 2: Holding period of stock received in exchange for an ordinary income asset
(inventory or services) begins on the date of exchange.
No tacking for
Accounts Receivable for sale of inventory or the providing of services is excluded
Real property that is used in TP’s Trade of business or depreciable property held for 1
year or less
Rationale If there was tack on for this type of property, a TP can always transfer stock
for a preferential capital gain treatment (since stock is always a capital asset)…so it
makes sense that there is no tack on.
Combination If stock is received in combination of capital asset and ordinary income
assets, each share of stock takes a split holding period allocated in proportion to the FMV
of the transferred asset. Rev Rul 85-164
This says that when you have land and inventory (or another non tack on) you proportion
the amount based on the FMV
Once you do the FMV by percentage, you take that percentage to get what will be capital
gain and what would be ordinary income.

3. Corporations Basis and Holding Period in Transferred Assets

Corp’s basis is the same as the transferor’s basis. §362(a)
§362(a) states that :
If property was acquired on or after 6/22/1954, by a corp., in connection w/ a transaction
to which §351 applies, then basis shall be the same it would be in the hands of the
transferor increased in the amount of the gain recognized to the transferor (boot)
Exception on 362(e)(2)
If transferee’s aggregate Adjusted Basis of such property so transferred would exceed the
FMV of such property immediately after such transaction then, notwithstanding (a) the
transferee’s aggregate AB of the property so transferred shall note exceed the FMV of
such property immediately after the transaction.
Aggregate AB must exceed FMV of transferred property
Allocation §362(e)(2)(b)
Allocated amongst the property in proportion to its built in losses.
Ex: 23AB and 20 FMV..so 3k difference reduce the basis by 3k in the property
Now, since corp. has reduce the basis from 140k to 100, corporation and A can agree to
elect A have the basis in stock be lower.
Only one party can take the loss, not both. So can elect if Corp or SH should take the loss
and if you pick SH, then SH doesn’t take the basis of the stock.
Holding Period includes the transferor’s holding period, without regard to whether the
property was a capital or §1231 asset in the transferor’s hands §1223(2)
See parcel table below.

Hypo 1:
A transfer land (§1231 asset) held long term with a basis of 10k and FMV of 60k, and
inventory with a basis of 30k and a value of 40k, in exchange for 100 shares of Newco
common stock with a FMV of 100k.
Issue 1: Is this a §351 transaction?- Yes, on exam analyze all the properties and say
that it is
Issue 2: What is transferor’s basis in the stock?
A’s basis is 40,000 because the rule under §358(a)(1) is the transferor’s basis in the stock
received will equal his basis in the property immediately prior to the exchange.
Here, transferor’s basis in the land is 10k, and in the inventory is 30k, so the total basis is
Issue 3: What is A’s Holding Period?
A’s Holding period depends on whether it is a capital, 1231 asset or ordinary income.
Here, the land is a 1231 asset and the inventory is ordinary income.
Under Rev. Rul 85-164, there is a split holding period allocated in proportion to the FMV
of the transferred asset.
Total FMV of property is 60k land and 40k inventory so 100k, 60% is land and 40% is
So for holding period, 60% of the time is of the land, and 40% of the stock is from the
day of the exchange.
Issue 4: Say that A sells stock the next day, what is his gain or loss on the stock?
Gain AR- AB 100k- 40k= 60k
60k*60%=36k (Land tack on so LTCG)
60k*40%=24k(Ordinary Income so ST capital gain)
Issue 5: Newco’s Basis and Holding Period
Newco’s basis in land is 10k and 30k in the inventory under §362(a)
Holding PeriodTacked under §1223(a)(2)

Hypo 2:
Same facts as above, except now A receives 80 shares of Newco Common stock and 20
shares of Newco preferred stock. Remember combined basis in both was 40k so:
As basis in both classes of stock is 40k and 80% is common, so 32k and 20% is preferred,
so 8k.
Holding Period
Split Holding Period for each share of common and preferred stock
60% tacked from land and 40% commencing on date of exchange.
Page 64 Problem:
A, B, C, D, E form X Corporation to engage in a manufacturing business.
X issues 100 shares of common stock.
A transfers 25k for 25 shares
B transfers inventory with a value of 10k and a basis of 5k for 10 shares
C transfers unimproved land with a value of 20k and a basis of 25k for 20 shares
D transfers equipment with a basis of 5k and a value of 25k (prior depreciation was 20k)
for 25 shares
E transfers 20k note for 20 shares. E received the note in exchange for land with a 2k
basis he sold last year. The note is payable over a 5 year period beg. In two years at 4k
per year plus market rate interest
What are the tax consequences (G or L recognized)
Does 351 apply?
1. Yes
2. Yes
3. In control yes

Effect on Transferor:
ABFMVAmount of sharesGain realizedGain RecognizedBasisHolding PeriodA-Cash---
25k250025kNo Tack on- New Holding PeriodB-Inventory5k10k205k05kNo Tack on
because does not fit categoriesC-Land25k20k20(5k)025kTack On! Capital assetD-
Equipment5k25k25 shares20k05kTack onE- Note2k(amount paid)20k2018k02kOnly
tack on if land is a capital improvement land.
Key Things to rememember:
Transferor takes basis. (find out rule if AB>FMV)
For the equipment, the depreciation is normally a gain under §1245, but under §351 it
will not be an actual realized gain!

(b)Effect on Corporation for shares

ABFMVAmount of sharesGain realizedGain RecognizedBasisHolding PeriodA-Cash---
25k2525k0N/ANo Tack on- New Holding PeriodB-Inventory5k10k2010k05kTack on!
C-Land25k20k20(20k)020kTack On! Capital asset

(c)- Parcels

ABFMVBuilt in G/LAdjustmentRevised ABParcel 115k10k(5k)(3k)12kParcel

28k10k2k-8k23k20k(3k)What if there were two parcels with loss. must allocate loss
based proportionally
Corporation will take the adjusted basis unless they make an election that SH is taking
the adjusted basis.

(d) If there is an inherent gain and also a gain to the SH, both will be taxed. Double tax
Rationale- else everyone would try to make it a capital gain and always escape ordinary
CONTROL Immediately after the exchange
Transferor’s of property must have control of “NEWCO” immediately after the
Issue when a transferor disposes of stock shortly after an incorporation exchange,
§1.351-1(a)(1)page 1146 of code - immediately after exchange does not require
simultaeneus transfer. Can be at different time and considered the same transaction - -
does include time where rights of parties were previously defined and completed in a
reasonable time frame.
Case Law about two transfers that are interdependent
Binding Agreements to Dispose of Stock
If a SH disposes of stock received in exchange for property pursuant to a prearranged
binding agreement entered into prior to an incorporation exchange, the control test is
applied after the stock disposition
So look at situation immediately after the transfer!
A disposition of more than 20% of voting power or more than 20% of any class of
nonvoting stock will cause a loss of control because the person ultimately acquiring the
stock was not a transferor of property to NEWCO.
A transfers land with a basis of 10k and value of 60k in exchange for 60 shares of Newco
(60%) and B transfers equipment with Basis and FMV of 40 for 40 shares (40%)
Two months later, pursuant to a prearranged binding agreement B transfers all her Newco
stock to C for 40k cash.
Control test is applied after the transfer to C, since C was not a transfer or property to
Newco, her ownership cannot be counted in testing for control, and A only owns 60% of
NEWCO immediately after exchange and thus 80% is not satisfied.
A must recognize a 50k gain on the transfer of land because this is not a §351 transaction
Intermountain Lumber
Argued that trans was not a good 351 (bc it wanted higher basis to depreciate).
IRS argued it was a good 351 trans. Bc lower depreciation deduction (taking shooks
Rule §351 – no gain or loss recognized if prop is transferred for stock IMMEDIATELY
AFTER the exchange.
Technically this happened but there was an agreement for Shook to sell 50% of stock
(over time) to Wilson.
Ct says control must include freedom of action – was contracted to sell 50% of stock.
Only applies if there is a binding obligation.
Court justifies this holding by – saying that 351 affects non-recognition of gain or loss
that is only a change of form --- here there is more than a mere change of form.
Prof says this is a bad decision -
If prior to time you make transfer to a corporation, there is a pre-existing binding
agreement where transferor will see so he loses control, not a good 351 transaction
RJ This case does not further §351 policy for formation of corporation, rather it
imposes an obligation.
Hypo: A owns property with a FMV of 100 and Basis of 10k and sells B an interest of
30%, so now A only has 70%, so B has a gain of 3k, and now B says A you get 100%, A
has to recognize the 27k (30k - .3 * 10) = 27k
A does not want this so
A transfer biz to new corp called X. pursuant to agreement A agrees to transfer 30% of
stock to B - thus this is not a good 351 (intermountain says this is not 351 but 1001)
A would recognize a gain of 90K
Heta go see RJ

Voluntary Donatives Dispositions of Stock

A voluntary disposition of stock (ex: gift) after an otherwise qualified §351, transfer will
not cause the transaction to fail the control requirement.
Result is same, if Newco issues the stock DIRECTLY to the transferee’s donee.
Corporate Transferors
The fact that a corporate transferor distpurtues part or all of the Nexco stock that it
receives to its SH is not taken into account under 351(c)

Special Problems:
Stock for Services
§351(d)(1) stock issued for services is not considered as issued in return for property,
and thus this is a taxable event! §351(d)(1) and Reg §1.351-1(a)(1)(i)
Tax consequences of this transaction is determined under §61 and §83
Problem: A person who receives stock solely in exchange for services may cause the
other parties to the incorporation to recognize gain or loss.
TransferorTransferred AssetAdjusted BasisFMVStock
Here, this works as a good §351 transaction under §351(a) Because both C and S make
up 100%, thus all stock received can be counted for purposes of 80% control
Exception: Reg §1.351-1(a)(1)(ii)
If the value of the property transferred is of relatively small value relative to the stock
received for services and the primary purpose of the property transfer is to qualify the
exchanges of other transferor for non-recognition, then CANNOT use for 80%
RELATIVELY SMALL VALUE under Rev Proc. 77-37
Property is not relatively small if it equals to or in excess of 10% of the FMV of stock
already owned by the transferor.
So Compare the other property to the services, and if the property is relatively small,
probably won’t be §351 transaction

A receives 70 Shares of CS (70k) in exchange for land (FMV-70k and basis-20k) and B
receives 30 shares (FMV-30k) in exchange for 1k cash and services.
A70% (property)
B 30%,
B receives 1k cash, and 29k services, so the cash is of a relatively small in comparison to
the services, (less than 10%) so not a §351 transaction, and both A and B recognize gain
and loss, because A does not have more than 70%
Hypo 2:
Now, B receives 5 shares (5k) for 5k cash and 25 shares for 25k services.
Here, cash is for 5k and it is 10% of 25k which is 2,500, so will be a 351 transaction, but
B STILL RECOGNIZES a gain on the stock received for services So there is a gain of
the 25k as ordinary income.

Page 73 Problem 1: CONTROL issue

Does the following qualify under §351?
(a) A and B are unrelated individuals. A forms Newco, Inc. on Jan 2 of the current year
by transferring property with a basis of 10k and value of 50k for all shares of Newco CS.
On March 2, in an unrelated transactions, B transfers property with a basis of 1k and
value of 10k for 10 shares Newco nonvoting preferred stock (this is not nonqualified
preferred stock)
A’s transaction qualifies as a §351 transaction. A is control of more than 80% and thus
he qualifies under §351
He will not recognize a gain or loss and will be able to tack on.
B’s transaction is not a §351 transacton because he only has 10 shares of nonvoting
preferred stock which is not 80%.
No tack on and qualifies under §1032 so basis in property is FMV

(b) Same as (a) above, except the transfers by A and B were part of a single integrated
§368(c)- look at A and B collectively, and now they own 100% of voting and nonvoting
so they both qualify under 351 this transaction
A has same consequences as above
B- B’s basis is 1k and corp takes basis of 1k.
§1231- real estate with trade or business, so B can tack on if property is either a capital
asset or 1231 property and the corp., can take the same basis

(c) Same as (b) above, except A transferred 25 of her 50 shares to her daughter as a gift
on 3/5 (3 days after B’s transfer). What if A’s gift was on 1/5?
A get shares on 1/5 and then transfers to daughter
Here, there is no change and A still has control – because intermountain says that there
need be only a freedom of action with regard to the stock after completion of the initial
Hypo- Say A received it as a binding contractual relaton
No §351- b/c under binding agreement there is no control
Here he was OBLIGATED to sell, 50% so not 80% and thus no control

(d) Same as (b) above, except that two months after B’s transfer, A sold 15 shares to E
pursuant to a preexisting oral understanding w/o which Newco would not have been
Interdependent Test
If two transfers are interdependent they will be treated as part of the same transaction
Here, 15 shares were sold, so now only 70% and requirement has not been made, so not a
§351 transactions.
What if A transfers services for stock (20%)
A pays taxes as ordinary income
B transfers property and retains 80% thus meets 351 test
What if A transfers services for 30% stock
A still pays ordinary income tax
B does not retain 80% - 351 does not apply and must pay tax on the gains.
What if C transfers ppty for 50% and S transfers ppty 10% and services 40%. (thus 60%
of stock transferred for
Does this qualify for 351 treatment?
Yes both C and S both transfer property and retain 100% of stock ownership. (does not
matter that services were used to transfer also.)
However, Reg 1.351-1(a)(1)(ii) if property transferred for the stock is so small compared
to stock transfer for the property and purpose is to create a 351 situation for another
person.. then that person does not qualify as transferring property for the transaction.
Rev proc 77-37 ( FMV of stock received >= 10 % FMV of stock received for services.
Here S would be counted as a property transferor.
10% of 40% is 4 and 10 > than 4 thus transferred property. (this is a deminimus rule)
Problem 2:
Java has operated a chain of coffee houses as a sole proprietorship over the past three
years and is now interested in expanding his horizons and limiting his liability.
To do so, he wishes to incorporate, raise 150k of addl’t capital and hire, an experienced
person to manage the business. He has located Venturer, who is willing to invest 150k
cash and Manager, who has agreed to serve as chief operating officer if the terms are
The parties have decided to join forces and form Java Jyve, inc
Java will transfer assets with an AB of 50k and FMV of 200k
Venturer will give 150k Cash, and M will enter into 5 year employment agreement
Java wants control, V wants a guaranteed investment but wants to share in growth of
business, mgr., wants to be fairly compensated (believes her services are worth 80k/year)

(a) J will get 200 shares and V will get 150 shares. M will get a salary of 40k/year and
receive 150 shares. FMV of stock is 1k/share.
Java wants >50% of stock, here he only gets 40% so it doesn’t satisfy Java’s goals
J and V have 70% and not 80% so this is not a §351 transaction and will be taxed on
Managers share do not count because she gets services instead.
So here J’s AB is 50 and FMV is 200, so he has a gain of 150, and Basis of 200k
VBasis of 150k
Manager ordinary income of 40k, and 150k of Shares

(b) same as (a), but M gets compensation of 80/year and will pay 150k for her stock.
Qualifies as a §351, when she pays, because now it is cash and not services.
Where as, V still does not own or have control
Now mgr. gives a note this is still property (unlike services) but manager has to pay the
note eventually and pay service

(c) same as(a) except M will pay 1k for her 150 shares and the incrop., documents specify
she is getting shares in exchange for her cash contribution rather than for future service
Stock is worth 150k and so here FMV of stock is 1k and services is 149k, so here 1k is
relatively small and under regulation not a §351 transaction.
Here J and V, will not have 80% because cannot use it for these purposes.

(d) Same as (c) except M will pay 20k rather than 1k

Now she pays 20k and 130k in services, so nowstock for property is are more than 10%
of amount of services and this will be a §351 transaction.
10% of 130k = 13k 20k>13k
manager pays ord income on 130k but Java is off the hook for the transaction.
Treatment of Boot

In General
If a transferor receives property other than stock, e.g. cash, corporate debt, securities,
nonqualified preferred stock or other property, boot, in a §351 transaction,
§351(b) provides that the transferor’s realized gain is recognized to the extent of the cash
and FMV of any other boot received
No Loss Rule Even if boot is received by transferor, no loss is recognized. §351(b)(2).
Character of Gain
Determined by reference to the character of the transferred asset to which the gain is
attributable taking into account the depreciation recapture provision under §1245 and
other applicable characterization rules under §1239
Gain is triggered by the receipt of boot results in increases to the SH basis in the stock
received and the Corp’s basis in the transferred property.
Gain Rule Gain recognized on boot is limited to the gain realized (so it is the lesser of
the boot received or the gain realized)
If property transferred is capital then the recognized gain is capital.
If part capital part ordinary – then you bifurcate the transaction by capital and ord
Step One:
Determine the realized gain on the exchange
Example: A gives property with an AB of 70 and receives 80k stock and 20k cash.
AR-AB 100k-70k30k Realized Gain, RECOGNIZE 20k
Recognized Gain EXTENT OF CASH!!!!!!!!!!!!!!!!!!!!!!!!!!!
§351(b) says gain recognized is to extent of cash AND FMV of boot, so here, the extent
of it is 20k
lesser of boot received or realized gain of pproperty transferred.
Example 2:
A gets 60k cash and 40k stock and gives corp. land with FMV is 100k and 70k is AB.
AR-AB 100k-70k30k, but here cash is 60k, but YOU CAN ONLY RECOGNIZE
30k, so here,
Rule Recognize the lesser of the boot or realized gain

Transferor’s Basis in Stock

Formula under §358(a)(1)
Transferor’s Adj Basis in property Transferred
(-) Amount of Cash and FMV of Boot (Debt and other non-stock property)
(+) Gain Recognized by transferor
= transferors AB in stock received
More than one class of Newco Stock
Aggregate basis determined above is allocated among the various classes in proportion to
fmv of each class§358(b), §1.358-2(a)(2)
So In example 1 basis is70k – 20k +20k70 K basis
§358(a)(2) Boots basis is FMV
Corporation’s Basis
If the transferor recognizes gain b/c of the receipt of boot
The corp.’s basis in the property received is TRANSFEROR’s BASIS + ANY GAIN
Allocation of Boot
Rule- When several assets are transferred in exchange for a combination of stock and
boot, Boot is allocated among the transferred assets in proportion to their relative FMV
Realized gain on transferred asset is recognized to the extent of the boot allocable to that
asset, but no realized loss may be recognized under §351(b) Rev Rule 68-55
Boot allocated to a loss asset will not cause gain or loss recognition.

Hypo 1:
A transfers 50k cash in exchange for 50k stock
B transfers a capital assets with Basis of 5k and a value of 30k and equipment with a
basis of 5k and a value of 20k (10k is recapture under §1245) in exchange for 40k stock
and 10k cash
Issue 1: Where is the boot allocated for B?
B has boot of 10k and it is allocated b/t capital asset and equipment in proportion to the
Here, 30k is land and 20k is equipment, so 60% goes to land and 40% goes to equipment
So 6k of Capital Gain on capital asset and 4k on ordinary income.
Hypo 2:
Same as Hypo 1, except that B’s basis in 30k capital asset is 40k rather than 5k.
The 10k cash boot is still allocated 6k and 4k to the equipment.
B recognizes 4k of ord. income on the equipment but may not recognize any loss, on the
capital asset.

Installment Boot
§453 A transferor who receives boot in the form of a newco debt instrument may be
allowed to defer recognition of any §351 gain.
Two Parts:
(1) A §351(a) recognition exchange to the extent of the stock (“permitted property)
received by the transferor and (2) a taxable installment sale to the extent of the boot
Basis of the transferred property is first allocated to the nonrecognition exchange and any
remaining basis (“Excess basis”) is allocated to the installment sale.
Installment Method
If transferor defers any gain recognized under the §453 installment method, corp. may
increase its basis under §362(a) only when that gain is recognized§1.453-1(f)(3)(ii)
Handout Example:
A transfers property (AB- 20k and FMV-60k) to X in a transaction under §351 and
receives an exchange stock (FMV-10k), cash of 5k and a note of 45k
Step 1: AB of transferred property to the stock up to the amount of the stock FMV
Here, the AB is 20k, and the FMV is 10k, so AB is 10k
Step 2: Remaining amount. Is then allocated to the installment sales portion
Here, it is 10k, so you end up applying the installment sales method:
AR which si 5k cash and 45k note50k
Subtraict AB allocated-10k
Now there is a gain for 40k
Step 3: Gross Profit %-->
Gross Profit (Gain) / Total Sales Price 40k/50k 80%
Gain on cash received is 4k (80% of 5k) and Gain on recognized payments of not is 36k
Step 4: SH AB in stock:
Elect as though there was no installment method and compute under §351
AB of Transferred Property- FMV of Boot + gain Recognized
So here 20k-50k (note+cash)+40k10k gain
Step 5: Corp’s AB in property received:
AB in the property is equal to the transferor’s AB, which is 20k, and increases AB when
S recognizes gain.
Page 83 problem

A, B, and C form X corp., by transferring the following Assets, each of which has been
held long-term

TransferorAssetABFMVAEquipment §1245
In exchange,
A receives 15 shares of X common stock (value-15k) 2k cash and 100 shares of preferred
stock with value of 5k)
B receives 15 shares of X Common stock (15k) and 15k cash
C receives 10 shares of X C.S (10k) 5k cash and X’s note for 35k payable in two years.
A- not qualified preferred stock

(a) What are the tax consequences of the transfers to each SH and to X corp?
Step 1 Is this a §351 Transaction
Yes, 100% and control, exchange property, just be aware of services and that they don’t

Step 2 A
A is getting boot in this transaction. So here need to do formula:
Gain Realized is AR- Ab, so here, 17k (15+2) – 15k2k
Here 2k is recognized! - of ordinary income (due to recapture of depreciation)
AB of property given is 15k less 2k(amount of cash) + 2k So here the AB is 15k.
But you need to proportionate by the type of stock, because we have common and
15k/20k is common and 5k/20k is preferred, so you have 75% of common 25% of
preferred or 1$ 1,250 basis in common stock and $ 3,750 AB in preferred stock.
Holding period = if held for more than one year its 1231 and tack on permitted. Holding
period is based on the proportion received. Here 2/3 gets a new holding period 1/3 gets a
tack on period. (p. 80)

Corp AB + Gain Recognized, so here it is 15k +2k, or 17k.

Gain Realized 20k(k) Amount of stock given b/c it is the FMV of the stock- AB
(which is 0 to corporation
§1032, no G/L recognized
Boot Formula is AB + gain recognized. So 15+2 which is 17k.

Step 3 B has two properties, Land and Inventory.

Note- When you have two properties, need to spit up by FMV, so in this case 2/3 goes to
inventory and 1/3 goes to land
Boot 15k
2/3 Inventory10k
1/3 Land 5k
(1)Gain or Loss Realized on Boot (Inventory)
AR(20k)- AB(7k)13k
Boot10k, so recognize ord. income on 10k. (gain is ordinary)
(2) Gain or Loss Recognized on Boot (Land)
AR (10k)- AB(25k) (15k) Loss
No loss is recognized on boot!
(2)- To get value of stock must do Aggregate Basis:
AB in property 20k
(-)FMV of boot (15k)
(+) Gain recognized 10k
Basis in stock is 15k
(3) Effect on Corporation:
(1) Realized Gain- 15k (fmv of stock)
(2) Recog- 0
(3) Basis in Assets
Inventory: Basis + Recognized gain
7k+10k- 17k
Land: basis + Recognized gain on boot
Here you have to do §362(e) adjustment
Land and Inventory have an AB of 20k and FMV of 30k, so need to adjust the AB of
land by 10k so 25k-10k is 15.
There was no recognized boot here.

C- Land of 20k AB with FMV of 50k

C gets 10 shares with 10k FMV and 5k cash and 35k Note
Step 1 with Installment Method:
Allocate basis in stock up to FMV = 10k to the 20k AB in land
So here AB of the stock is 10k
Step 2: Remaining amount
Allocate to installment sales portion
AR40k (Note and FMV of boot received ( here, cash))
AB allocated-10k
Gain is 30k
GP% is 30/40 or 75%
Gain Recognized in year 1:
75% of cash received, or 5k is 3,750
75% of note is 26,250
Step 3: Tax payer Basis in stock received is:
AB in property( 20k
(-) Boot----- 40k (Note +Cash)
(+) Gain recog 30k
Basis- 10k.
AB of 20k+ 3,750 cash. 23,750 and then increases AB when gain is recognized.
26250 + 23750 = 50k
Effect on TransferorsEffect on Transferee-Corp. G/LBasisHolding PeriodG/LBasis in
AssetsHolding PeriodRealizedRecognizedReal.RecognizedA7k2k of Ordinary Income
from BootCS- 11,250
PS-3750Tack on b/c §123120k017kTack onB(2k)10k ord. income on inventory boot.
27kTack on
1/3 for land (fmv)
New 2/315k0Inv-17
Land-13kTack onC30k3,750 and 26,25010kTack on10k023,750Tack on
§357(d) Skim


In General:
§357 (a) Rule: If under §351 exchange, a company assumes a liability of the transferor
SH, the assumption is not boot received by the transferor. Unless the assumption was for
the purpose of avoiding gain – then total amount of liabilities is treated as boot
(recognized gain).

§358(d) Transferor’s basis: Liability is treated as boot for purposes of determining

transferor’s basis in the Newco stock
So only use liability in boot equation

A transfers land with a basis of 30k and a FMV of 100k and subject to a 10k liability in
exchange for Newco common stock worth 90k (mtg of 10).
(1) What is A’s gain?
0- because the transfer of liability under §357(a), is not boot received and no gain or loss
is recognized.
(2) what is A’s Basis in Newco Stock?
Formula under §358(a)(1)
Transferor’s Basis in property Transferred
(-) Amount of Cash and FMV of Boot (Debt and other non-stock property)
(+) Gain Recognized by transferor
Applied to this formula:
Basis20k -10k – 010k basis
10k basis, preserves 40k in land (60-20=40)

Determination of Amounts of Liabilities assumed:

§357(d)(1)(A) A recourse liability is treated as having been assumed to the extent that,
based on all the facts and circumstances, the transferee has agree and is expected to
satisfy the liability , whether or not the transferor-SH has been relieve d of it.
§357(d)(1)(B) A nonrecourse liability is treated as having been assumed when an asset is
transferred to Newco subject to the liability
S357(d)(2) But when more than one asset secures a nonrecourse liability, the amount
of the liability treated as assumed must be reduced by the lesser or:
(1) The amount of that portion of the liability which an owner of other assets not
transferred to Newco and also subject to the liability has agreed to and is expected to
satisfy; or
(2) the FMV of the other assets to which the liability is subject
Purpose: Foreclose abusive result by preventing the liability from being counted more
than once to make an upward adjustment under §362.

Exception 1Tax Avoidance Transactions

§357(b) Assumption of liability is treated as boot if the TP’s principal purpose
transferring the liability was the avoidance of federal income taxes or not a bona fide
corporate business purposes.
Reg §1.357-1(c) all the relieved liabilities, not just the abusive debts are treated as
TP has burden of proving the absence of an improper purposes by the clear
preponderance of evidence§357(b)(2)
Improper Tax Avoidance Ex: (1) company assumes personal debts, or (2) Encumbering
personal property for personal Reasons
A transfers land with a basis of 20k, FMV of 60k and subject to a 10k liability in
exchange for 50k stock
A encumbered the land shortly before the transfer in order to raise funds to pay personal
expenses here this is tax avoidance, and 10k boot under §351(b)
As basis in stock is 20k-10k +10k20k

Exception 2Liabilities in Excess of Basis

§357(c)(1)Sum of liabilities assumed in §351 transaction exceed the aggregate AB of
the properties transferred by a particular transferor, the excess is treated as a gain from
the sale or exchange of property. Applied sep. to each transfer or property
Purpose: prevent a negative basis to stock
Rule: §357(c)(2)(A) if §357(b) and §357(c) both apply, then, §357(b) (tax avoidance)
takes preference
A transfers land with Basis of 30k, a FMV of 100k and subject to a 55k liability in
exchange for stock worth 45k
§357(a) A would have no gain, but basis in stock would be 30-55 and thus negative so
A must recognize 25k gain (excess of liabilities over debt)
A’s basis in the Newco stock is 30k (basis of land) - 55k (Debt relief) + 25k (gain
recognized)- 0
So if §357(c) applies, basis in stock will ALWAYS BE 0!

(cash basis based v. accruel based)

cash- reports income when receives it and takes deduction when pays the expense.
A/R are greatest asset. And basis is zero.
If created corp would assume trade payables say 300 – thus would recognize a gain of
300 amount of boot including assumption of liability. This is not fair.
If given cash instead ot assuming liability taxed on the lesser of fmv or the
amount of boot. Ie 300 gain. Would get offsetting deduction to when paid the trade
payables and recognize no gain.
However bc of 357c assumed liability here is not treated as boot.
Accruel -

Transferor Remains Liable to Creditor

Case: Owen v. Commissioner:
A transferor does not avoid §357(c) gain by remaining personally liable for debts
encurmbering property transferred to Newco in a §351 transaction

Avoiding §357(c) by Transfer of Note

Facts- P’s liabilities would have exceed basis, and he would have ord. income, so he
decides to gives his note of 1.060m and now liabilities doe not exceed basis
Liabilities of 1.550
(-)AB .980
= .570
IRS says No you can’t do this b/c it is just a note and an IOU. – note has a basis of
TP had a basis equal to face value in his own note transferred to a wholly owned
corporation b/c the note was a corporate asset subject to the claims of creditors in the
event of a bankruptcy.
Thus real and substantial increase in TP’s corporate investment.
LIMITED to notes that have economic substance and have a FMV roughly equal to
face value in his own note transferred to a wholly owned corporation b/c the note was a
corporate asset subject to the claims of creditors in the event of a bankruptcy.
RJ’s issue with case what is a “bona fide debt”
It was a legitimate 351 transaction – he was a 100% owner of stock after the trans.

Rule: A TP who transfers his own enforceable note to a controlled corp. in a §351
transaction may avoid recognizing gain under §357(c)
Sine the corporation took the note with a basis equal to its face value; the TP should not
be required to recognize any gain.
Statute does not support this rationale.

Here IRS says that TP has 0 basis but this is an unsettled part of the law!

Character of §357(c) Gain

The character of gain is determined by allocating the gain among the transferred assets in
proportion to their respective FMV
§357(c) may be characterized by reference to an asset who has no built in gain
A transfers inventory with a basis and FMV of 10k and a capital asset with a 25k liability
with a basis of 5k and a FMV of 30k.
Gain Recognized Basis of Assets 15k-25k (Liability)10k
Gross asset value is 40k10/40 (25%) is inventory, and 75% is capital asset.
So 25% is ordinary income (inventory) and 75% is capital gain even though A had no
built in gain realized on inventory.

Excluded Liabilities:
Liabilities assumed by Newco that have not yet bee taken into account by the transferor
for tax purposes (either §162 or increasing the basis for property) are not treated as
“liabilities” for purposes of determining gain recognized under §357(c)(1) or basis under
§358. §357(c)(3) and §358 (d)(2)
Example 1:
A, a cash method TP, transfers 50k cash and 200k AR (0 basis) in exchange for 150k and
Newco’s assumption of 100k of A’s AP which would have been deductible under
§162(a) if paid by A
§357(c)(1) A would recognize 50k gain (excess of 100k AP over 50k cash)
§357(c)(3) AP are not treated as liabilities, A thus recognizes no gain.
A’s basis in stock is 50k and it is not reduced by AP assumed by newco.
Example 2:
Newco is formed, B, an accrual basis TP, transfers contaminated land w/ associated
contingent env. Liabilities in exchange for all of Newco’s stock.
B neither deducted nor capitalized any amount with respect to liabilities
The liabilities assumed by Newco in the exchange are not liabilities under §357(c)(1) and
§358(d) because NEVER DEDCUTED by B and they did not create or increase the basis
of property prior to transfer

Limit on Basis Increase Attributable to Liability assumption

Page 102

A organized X corp by transferring the folliwng:

Inventory AB- 20k and FMV-10k
Unimproved Land- AB-20k and FMV-40k with a recourse debt of 30k
X took land subject to liability and gave 20k of stock to A

(a) Assuming that §357(b), is not applicable how much gain does A recognize and what
is A’s basis and holding period of the stock?
AB is 40k (aggregate 20k + 20k) and Debt assumed is 30k. So here there is no excess
No gain or loss is recognized when debt is assumed; it reduces the basis in stock received
AB in stock received is:
AB – 40k
(-) FMV of boot- Debt- 30k
(+)gain recognized = here none
So total is 10k basis.
Inventory No tack on and it is 50/50 split.
You get a tack on where a capital asset or 1231 asset. Inventory not included.
So each share you get back there is a split holding period.
Ie inventory – each share is 10k = so ten shares for inventory
Land – each share is 10k = so ten shares for land
Corp takes - basis of property transferred. Ie 20k and 20k

(b) and (C) Now basis in land is only 5k

Now the problem is that Debt exceeds the AB of the stock, so you need to recognize a
Liability assumed is 30k and total AB of transfer is 25k, so gain recognized is 5k
Whenever this happens basis is always 0, but do the math and:
Character of the 5k gain
(4/5) 80% is capital gain and (1/5) 20% is ordinary gain
§1.357-2(b). Allocate the §357(c) gain between the transferred assets based on the
relative fair market property values (without consideration of the debt).

(d) What is Corps’s Basis in the properties Received in (b)

corp takes transferred basis plus any unrecognized gain.
5k(20% to inventory and 80% to land) so here 1k and 4k are added to the basis
reg says - 21k (20k +1) for inventory, and 9k (5k + 4k) for land
tax ct says 20k and 10k

(e) A could have avoided by:

Giving cash of 5k to Corp
Paying off some of the debt
Giving another asset that would increase basis.
Perachi case – can transferor provide a note of the amount (see perachi above)

Problem 2:
B organized Y corp. and x-ferred bldg. with AB of 100k and FMV of 400k. Bldg. is
subject to mtg. of 80k which was incurred two years ago for valid business reasons.
B borrowed 10k for personal purposes with a secured loan on mortgage (this debt is
Y corp will issue 310k of common stock to B and will take bldg. subject to mortgages.
(a) What are the tax consequences to B on x-fer of bldg to Y corp.
Step 1: Liability is 90k which is less than AB
(2) Is there a tax avoidance purpose so here yes the 10k, under regall liabilities will
be treated as boot!
AR here is 400k and AB is 100k  so the lesser of 300k gain and boot is 90, so
recognize gain of 90k
Basis in stock is: 100k -90+90 100k Basis
(b) What if B did not borrow 10k and instead Y borrowed 10k from a bank and gave B
310k of Y c.s., 10k cash and will take the bldg. subject to the 80k mortgage
Now the 80k is not boot, but there is boot of 10k
10k boot is recognized gain
Basis- 100k -90+10 20k basis in stock
(c) Is the difference justified
In A, it was tax avoidance so that is why it was treated as boot.
(d) When might there be a leg. reason for corp to assume a property’s debt?
Bona fide business purposes.


Incorporation of a Going Business

(1) Assignment of Income Doctrine

Assignment of Income doctrine does not apply to a transfer to Newco of AR by a cash
basis TP unless TP has a tax avoidance purposeHempt Bros
Ex A transfers the assets of her cash method sole proprietorship, including 0 basis AR,
in exchange for Newco stock
Here although A earned income, she is not taxed, Co., will have a 0 basis and get taxed
when they get the income
Accrual Basis Basis is equal to amount already included in income, and newco takes
that same basis and recognizes no add’l income when it collects the receivables.
Corp takes basis

(2) AP and Contingent Liabilities

AP transferred to Newco by a cash basis TP or contingent liabilities for which the
transferor has not received any tax benefit are not liabilities for §357(c)(1) Purposes
IRS permits Newco to deduct the payable when they are paid I they would have been
currently deductible by the transferor or to treat them as cap-ex as appropriate under
Newco’s method of accounting.
Accrual- take this into account when calculating §357 boot and AB of transferor.

(3) Tax Benefit Rule

TB rule requires a TP who derives a tax benefit, such as a deduction, in one year to
recognize income in a sub year on the occurrence of an event, such as a recovery of the
amount deducted, that is inconsistent with the earlier deduction
Nash SC held that the tax benefit rule did not require an accrual basis TP to recognize
income on the transfer of AR in a §351 transaction when the TP had previously deducted
some of the AR as uncollectible by creating a bad debt reserve
No recovery because the TP received NEWCO stock equal to the value of the AR less
previously deducted debt reserve
No longer important because- TP generally may not deduct bad debt reserves
§351- override TB rule in situation where the TB can be preserved and later “recaptured”
through a transferred basis.

Rev Rul-95-74

Page 112 Problem

Key Notes:
General Rule of 357(c) Liabilities assumed (100k) – AB (60k) = 40k. However, AP is
not a liability whose payment by transferor would have given rise to a deduction/is not a
liability for §357(c) purposes (if architect paid them they would be deductible as a
business expense). So never use AP to increase the basis. Thus liabilities assumed is 30k
not 100k and thus basis is not > than liabilities assumed.
AB = AB=(60) – liabilities (30K) – gain (0) = 30k
What about the toxic liabilities.
Rev Rule 95-74- Contingent liabilities whose payment have been deduct do not increase
basis and not under §357(c)
So: do not use AP or contingent liability to calculate boot and AB of Transferor.

(b) Tax of AR that hasn’t been paid yet and is transferred is tax to the receiving
(c) For contingent liabilities the rule is:
Deductible by the corp., as a business expense under §162 or are capital expense under
§263 as appropriate under S’s method of accounting determined as if S has owned the
land for the period and in the same manner as it was owned by the P.
Reasoning for 357 © TP would get an offsetting deduction from the AR and AP but this
would not happen.

TP would not recognize gain for AP but

Adj basis in stock transferred to TP

AB in Transferred Prop = 60
(-) FMV of boot = (30)
(+) any gain recog= 0
total = 30

Holding period = nature of assets being transferred

AR are not cap or 1231
Supplies are not cap asset or 1231
Thus there is a split holding period in each share of stock 120/200 = 60 % tack on
80/200 = 40% new period.

Basis for corp = no gain recognized so will take basis that TP transferred.

Peculiarities found in the problem - environmental contingent liabilities – in problem

corp assumed those.
To the extent those would be deductible (paid by the transferor) they would not be
attributed to basis in 357(c).

the liabilities may be capitalized – part of the cost of the underlying capital asset (the land
that is polutted)
95-74 Rev. Rul = see above
Should tax benefit rule (recovery of money from previous deduction (ie supplies) from
sale be applied to a 351 - NO

(b) Who pays the Receivables – from hempt bros case. See above.
(c) Can AP once paid by Design be deducted as an expense – YES design can.
(d) TP is trying to mismatch revenue and expense. – TP wants to deduct the expenses to
reduce his tax And allocate all the income to the Corp. TP would have to incur the

What if TP was accruel

Assets = what would his basis in the assets be different.

Here Liab asummed 70 (not 30: 357c exclusiont not applicapble here)
AB of transferred prop 120

AB of transferred Prop 120

(-) FMB of Boot 100 (70 + 30)
(+ gain 0
= 20k
CH 3 Capital Structure of a CORP.

(1) Sources of Corporate Capital

Debt and Equity create Capital Structure
(A) Equity:
Equity is contributed to a corp., in exchange for an ownership interest evidenced by
shares of stock
Types Preferred, Common and Convertible
(B) Debt:
Evidence by a written unconditional obligation of the corp., to pay a specified amount on
demand or on a certain date.

(2) Tax Advantages

(A) Debt
Interest Deduction
Principal tax advantage of debt is avoidance of the “double tax” on corporate profits
A corporation can deduct interest paid on its debt under §163, but not dividends –
mitigated by consequences to lender.
Repayment of Principal
A tax free return of capital to the lender
§1271 if amount repaid exceeds lender’s basis, excess is generally treated as a capital
Defense against Accumulated Earnings Tax
(B) Equity
§351 Non-recognition
Character of Loss on Worthlessness
Corporate SH
Qualified Business stock

What happens when a shareholder loans to the company. Is repayment of the loan a
dividend payment or loan repayment.?
1. Debt equity test – compare the debt of sh with SH equity 1:1. Or 9:1 lenders
prefer to lend to the former. Because it signifies how much a biz can lose but pay its
debts. The second number in the ratio is called the equity cushion. Amount that can be
lost and pay the outstanding debt.

(3) Deciding Equity or Debt

Note Courts use factors, but ultimate question is it ”risk capital” or strict debtor
creditor relationship viewing the transaction as if it were w/ an o/s lender.
(1) Form of the Obligation
An unconditional promise to pay
A specific Term
A stated rate of interest payable in all events
Hybrid Instruments that have voting rights or make interest payments CONTINGENT on
earning are likely to be treated as equity
(2) Proportionality
Debt held by SH in the same proportion as their stock is subject to special scrutiny
Rationale SH have no economic incentive to act like creditors by setting or enforcing
the terms of the purported debt. If co. fails would lose same amount as if it were a
creditor or SHer. Only difference was a tax difference.

Ex. 3 SH abc raises suspicion

Stock Debt
A 300k 300k
B 500k 500k
C 200k 200k

As opposed to
Stock Debt
A 300 1000
B 500 0
C 200 0

Here the presumption that the debt of 1000 is valid.

(3) Debt/Equity Ratio

This is the ration between corp.’s debt and equity
High D/E is “thinly capitalized” and service will make debt equity on theory that
purported debt is really at risk in the venture b/c no rational creditor would loan money to
a thinly capitalized corp.,
Debt Calculation
Debt includes loans from SH.
The ratio of SH debt to SH equity is sometimes called the “inside debt/equity”
All long-term Liabilities is “o/s debt equity” including inside and outside creditors.
Equity Calculation
SH ownership interest in the corp.
For exam, calculate based on AB and FMV
§385 used AB, but current value is more accurate
Excessive when:
Inside 3:1 or lower is normally not excessive
Outside Debt equity ratio did not exceed 10:1 (proposed §385)

Problem: see shareholder debt problem sheet.

P. 1554-157 1244 stock for small corps - if sell stock at a profit get cap gain if lose
money can treat loss as ord deduction but limited to 50k (100k per married couple) per
Character of Loss on Corporate Investment:

Stock and debt instruments are capital assets, any loss on their sale or exchange is a
capital loss

Special Issues of Capital loss

(1) Loss on Worthlessness of debt

See if instrument is a security as defined under §165(g)(2) and if not, whether the debt is
a business or non-business bad debt
Debt Evidenced by Security:
Bonds, debentures, notes or other corporate debt instruments w/ interest coupons or in
registered form
A loss by a corporation of securities for an “affiliated corp.” is an ordinary loss!
Affiliated Corp
Corp holder owns at least 80% of its voting power and value and more than 90% of its
gross receipts are from sources other than passive investment income. §165(g)(3).
Debt not Evidenced by Security:
Losses on corp. debts not evidenced by a security are characterized by bad debt
provisions in §166
§166(a) losses from wholly or partially worthless business bad debts are ordinary.
§166(d) Losses of non-corporate lenders from a wholly worthless non-business bad
debt are treated as STCL.
Losses from partially worthless non-business bad debts, are not deductible!!
Business vs. Non-Business Bad Debts
A non-business bad debt is a debt other than:
(1) a debt created or acquired in connection w/ the Tp’s trade or business, or
(2) a debt or loss from the worthlessness of which is incurred in TP’s Trade or business.
If a SH is an employee and loans money to a closely held corp., any resulting loss is
treated as a non-business bad debt on the theory that the loan was made in TP’s capacity
as an investor
For business bad debt deduction- TP must show that his dominate motivation or making
the loan was related to his trade or businessUS v. Generes

(2) Loss on Worthlessness of Equity

A loss incurred by a non-corporate SH on the sale of stock is treated as a capital loss, if
the stock is a capital asset
§165(g)(1) “If stock is security under §165(g)(2)”, a loss on the worthlessness of stock
held as a capital asset is treated as a capital loss on the last day of the taxable year in
which the loss is incurred.
§1244 Stock
§1244 stock is deductible as an ordinary loss
Qualifying SH
§1244(a)- individual TP and partnerships who were original issues of §1244 are stock are
Does not include trusts, estates and corporate SH.
§1.1244(a)-1(b)(2) Partners qualify only if they were partners when the partnership
acquired the stock!
Qualifying stock
CS or PS that has been issued by a domestic corp. for money or property §1244(c)(1)
§1.1244(c)-1(d)- Stock issued for services does not qualify
Small Business Corp Status
Must be a small corp.

Gross Receipts Test when Loss Sustained

Limit on Amount of Ordinary Loss
Reduction of Ordinary Loss
Chapter Four- Non-liquidating Distributions

(1) Distribution vs. Dividend

Distribution is any kind of payment by a corp. to its SH w/ respect to their stock
Dividend is a distribution out of current or accumulated Earnings &Profits of a corp.
(what if it exceeds E and P – applied to the adjusted basis of the stock of the taxpayer)
(what if it exceeds the AB of taxpayers stock – treated as capital gain from sale of the
Non-Liquidating ongoing corp.!

(2) Distributions under IRC

(a) Analysis:
(1) Determine the amount of the distribution under §301(b)
(2) How much of that is a dividend under §316
(3) Specific tax treatment of those amounts provided in §301(c)

(b) Amount of Distributions

Cannot be stock of the issuing corp!
Cash received by SH + FMV (determined on date of distribution) of any other prop.,
received reduced by any liabilities assumed by the SH in connection w/ the distribution or
liabilities to which the property is subject before and after the distribution§301(b)
(1) Amount of Money received + FMV of other property
(2) Reduction of Liabilities

(c)Amount of the Dividend

§316(a)Distribution is a dividend to extent it is made out of E&P for taxable year in
which the distribution is made or (2) E&P accumulated by corp. since 2/28/1913
computed at the close of the year
there is no reduction for distribution during the year.

The two basket approach

1. Current E P Basket 2 Acumulate E & P basket

Computed at close of Yr (accumulated basket can

No reduction for distributions during the year negative but earnings during
the year are can be distributed despite being negative) if there is no E and P it is a
reduction in the basis of the stock if that is exhausted then it is deemed a gain.
(d) Tax Treatment of Distributions
§61(a)(7) and §301(c)- Dividend is OI for SH
(1) First include distribution in GI
(2) Reduce basis- §301(c)(2)
(3) Excess is capital gain- §301(c)(3)
E has 5k of E&P and no accumulated E&P
X gives 12k cash to A who has an 8k of basis
(1) 5k is income (still have 7k left)
(2) 7k reduce basis, so now basis is 1

Earnings and Profits

Not defined by statute - formed by case law.

Determining E&P
§312- effect of various transactions on E&P
E&P are determined by starting with TI and making Adjustments

E&P Formula:
Taxable Income Starting Point
(+) Items Excluded from taxable Income must be added back
Such as municipal bond interest, life insurance proceeds and fed tax refunds §1.312-6(b)
(+) Add Back Certain Tax-Deductible Items
§243 dividend received deduction
Remember 70% and 80% deduction, gets added back in (happens because of
subsidiary/parent relationship)
§243 dividends rec’d deduction – a deduction where a company that pays dividend to
another corp that ends up paying divident to ultimate shareholder. (the second co gets the
(-) Subtract Non-Deductible Items
Fed tax paid
Capital Loss Carryovers you can only deduct to extent of capital gain for tax purpose,
so anything in excess should be used to reduce for E&P
Remember Carryovers from prior years cannot be subtracted b/c you took it once in the
prior year.
(+/-) Timing Adjustments (such as depreciation)
RJ said he probably won’t test on this.

Page 169 Problem see sheet.

Cash Distributions

Cash Distributions are dividends to the extent they are made out of current or
accumulated E&P  §316(a) and §1.316-2(a)

Current E&P Exceeds Distributions

Current E&P > Cash distributions, then distribution is a taxable dividend
Remaining Current E&P is added to the accumulated E&P account§1.316-2(b)

Distributions Exceed Current E&P

Cash Distributions exceed current E&P, portion of each distribution that is treated as
coming from current E&P is determined by a formula (§1.316-2(b))
Amount of Each Distribution x (Current E&P/Total Current Distributions)
Remainder of each distribution is a dividend to the extent of the accumu. E&P available
on the date of the distribution.
If there is no Accuum. E&P. then it is a capital gain.
At beg of year, has Current E&P- 12k, Accum E&P-5k
Distributes 10k on 4/1 and 10k on 10/2
Formula Amount of Each Dis x Current E&P/Total Current Distribution
10k x 12k/20k 6k is Amount of distribution that is dividend for each payment
April 1 Payment:
6k is dividend using formula, so you have 4k left
At 4/1, you had 5k of accum. E&P, so here, all 4k is a dividend!
Remember only 1k left of Accum. E&P
October 1:
10k Dividend, 6k is Dividend based on Form.
4k left, out of 4k, 1k can be used from Accum (see above)
3k left, so 3k reduces SH basis in stock.

Accumulated E&P but Current Deficit

Beg of Year, has :
12k- Accum E&P
(10)k- Deficit for Current E&P
20k- Cash Distributions (10k April 1, and 10k October 1)
A’s Basis in stock is 40k
Issue 1- A cannot show when deficit was incurred
Pro-rate deficit over the year, which is 10k/4, or 2.5 per Q in deterring the Accumulated
E&P at date of distribution
4/1 Accum., E&P is 12k-2.5k9.5k
So here, 9.5k is dividend and the 500 reduces basis
October There is no accumulated E&P, so the entire amount is a reduction to basis.
Year 2 Accumulated Earnings Deficit is-
Issue 2: A can show when deficit occurred:
10k deficit in 1Q o the year and broke even for 9 months, the deficit would eliminate 10k
of the Accum E&P and only 2k would be a dividend
PROBLEM p. 173

Ann owns 100% of Pelican co. Adj basis is 10k.

A) Pelicans current E &P is 5k. Accumulated = 0 and distribution is 17,500.
Answer. Look to current E & P = 5k is a dividend. Then to Accumulated = 0
thus 12,500 reduces her basis – (10k). so there is 0 basis. And 2,500 left. This 2500 is
capital gain.
B) 15k Accumulated deficit. 10k of current EP and distributes 10k.
Answer. Look to current EP = 10k and thus there is a 10k dividend.

C) 10k accumulated EP. 4k current EP on July 1 sells ½ her stock to baker for 15k on
April 1 distributes 10k and then on Oct 1 distributes 5k to ann and 5k to baker.
Total distributions for the year = 20k
Answer: allocate the 4k among the distributions.

Amount of distribution X total current EP / Total distributions

10k X 4k/20k = 2k
5k X 4/20 =1k
5K X 4/20 =1K

NOW accumulated distributions = allocate in chronological order.

10k of accumulated e and p
thus 8k allocated to the first distribution
remaining 2k allocated to the second distrubitions

10k of first distribution is dividend

2k of second distribution to ann is dividend rest is cap gain (3k)
2k of distribution to baker is dividend rest is cap gain (3k)

D) Rule 3 page 170 10k defict in E& P

Find amount of accumulated earnings on date of distribution
4/1 10k - (prorated loss = 2.5k) = 7.5k is dividend 2.k is return of capital.
10/1 5k – (prorated loss = 5k) = 5k and 5k is return of capital.

Property Distributions
Consequences to the Corp:
(a) Background:
General Utilities
SC held that a corp. did not recognize a gain on a distribution of appreciated property to a
SH even though the SH took a FMV basis in the distributed asset.
§311(a) only applies to nonliquidating distribution of loss property
§311(b) Applies to appreciated property

(b) Appreciated Property

A corp. recognizes a gain on a nonliquidating distribution of appreciated property in an
amount equal to the difference b/t the FMV of the property and its AB. §311(b)(1)
Ex: X distributes Gain acre (FMV-30k and AB-10k) to its SH. (FMV –AB)
A recognizes 20k on the distribution, and increases X’s current E&P
Treatment of Liabilities:
If distributed property is subject to a liability or if a SH assumes a liability of the
distributing corp., in connection w/ the distribution, the FMV of the distributed property
is treated as not less than the amount of liability. §311(b)(2) and §336(b)
(c) Loss Property
§311(a)- Cannot recognize loss when AB >FMV
X distributes Lossacre (10k FMV, 30kAB) to its sole SH.
X may not recognize its 20k loss.
X should have sold Lossacre, recognized that 20k Loss (which would have reduced
current E&P by 20k) and distributed the 10k cash proceeds to A

(d) Effect of Distributions on E&P§312(a)

(1) Generally under §312(a)

Current E&P are determined as of the end of the taxable year w/o regard to distributions
made during the year
Although a distribution may be a dividend “out of” current E&P, it does not reduce
current E&P.
To determine accumulated E&P at the beg. Of the follow year, accumulated E&P as of
the beg of the year are increased by current E&P of the prior year, and then reduced by
the amount of the distribution
A distribution may not, create, a deficit in accumulated E&P

(2) Appreciated Property

When corp distributes appreciated property:
§312(b)(1)- (1) Increase current E&P by the gain recognized under §311(b)
Accumulated E&P are reduced by the FMV of the distributed property §312(a)(3)(b)
If SH assumes liabilities encumbering the distributed property or takes the property
subject to liabilities, decrease in E&P resulting from the distribution is reduced by the
amount of the liabilities. §312(c), Reg 1.312-3
Liability relief increases E&P
“The amount of any reductions in earnings and profits described in section 312 (a) or (b)
shall be (a) reduced by the amount of any liability to which the property distributed was
subject and by the amount of any other liability of the corporation assumed by the
shareholder in connection with such distribution, and (b) increased by the amount of gain
recognized to the corporation under section 311 (b), (c), or (d), or under section 341(f),
617(d), 1245(a), 1250(a), 1251(c), 1252(a), or 1254(a).”
X Corp., has 35k of accumulated E&P and 0 current E&P.
X distributes Gainacre (FMV-50k, and AB-30k) to SH A who takes the property subject
to a 10k mortgage
X recognizes gain of 20k under §311(b) and increases CURRENt E&P.
Distribution to SH is 40k (50k-10k)
First take, 20k from Current and then 20k from Accumulated.
Accumulated E&P at 1/1 is:
Accumulated – 35k
Plus Current E&P- 20k
Minus FMV of distribution- 50k
Plus Mortgage Relief- 10k
(3)Loss Property
§312(a)(e)- Current E&P are not affected by a distribution of a loss property and the
corp., reduces accumulated E&P by the AB of the distributed property.

(4) Corp’s Own Obligations

General gain recognized in §311(b) does not apply to distributions of a corp’s own debt
§311(a) applies, and no G/L is recognized by the distributing corp
Effects on E&P§312(a)(20
A corp that distributes its own debt obligation reduces accumulated E&P by the principal
amount of these obligations.
A corp., distributes a debt obligation with a FMV that is less than its face amount, (b/c for
example, the obligations have a stated interest rate that is below prevailing market rates),
it reduces the Accumulated E&P by the “issue price” of the debt at the time of the
So, if Corp gives principal note of 100k with FMV of 5k, reduce Accumulated E&P by

Consequences to SH – same as a cash distribution except for 301(d)

Amount of property distribution is the FMV of the distributed property on the date of the
distribution reduced by any liabilities to which the property is subject.
Portion that is dividend is determined under the same rules applicable to cash
P177 Problem

Constructive Dividends
Transaction may not be labled as a dividend, but may be treated as constructive dividends
if there is an economic benefit to the SH.
Unreasonable comp
Low-interest loans
Bargain sale or bargain leases
Payment of SH personal expenses
Excessive payment to SH for purchase of corp. property
Transfers b/t commonly controlled corp.
Case: D’Agostino  No E&P and thus no dividend
Appellants, who were owners of two corporations, were convicted of conspiracy to
defraud the United States and tax evasion under HYPERLINK
zSkAW&_md5=34e0497aba54e4f176689643104dd752" µ18 U.S.C.S. �� 371§,
HYPERLINK "https://www.lexis.com/research/buttonTFLink?
zSkAW&_md5=1efcbb4319c4d9579dec04aefe1a1724" µ3551§ as well as four counts of
attempted tax evasion in violation of HYPERLINK
zSkAW&_md5=d4d49062206bae352f0b268b1fc46208" µ26 U.S.C.S. � 7201§ and
HYPERLINK "https://www.lexis.com/research/buttonTFLink?
zSkAW&_md5=bcfb998700538ee7faaae76f70e9966d" µ18 U.S.C.S. �� 2§,
HYPERLINK "https://www.lexis.com/research/buttonTFLink?
zSkAW&_md5=63a5c05b8f15fde8f70fdb1353aa0787" µ3551§.
However, on appeal, the court reversed and remanded the convictions holding that the
corporate funds, which appellants had diverted, were not taxable.
The court further held that under the no earnings and profits, no income rule, because
appellants’ corporation had not realized profits during the applicable tax years, the
diverted funds were received as the repayment of a loan from appellants to the
Case- Boulware: “intent of parties”
The question was whether a 41istribute accused of criminal tax evasion could claim
return-of-capital treatment without producing evidence that either he or the corporation
intended a capital return when the distribution occurred.
Language of HYPERLINK "https://www.lexis.com/research/buttonTFLink?
zSkAW&_md5=66589bc7a92ea822941ece7d7ed670b2" µ26 U.S.C.S. �� 301§ and
HYPERLINK "https://www.lexis.com/research/buttonTFLink?
zSkAW&_md5=7b8f9f1fcfcf7d4fc63d50e7fe7754ab" µ316(a)§, which stated that the tax
consequences of a distribution by a corporation with respect to stock depended on
whether the corporation had earnings and profits and the amount of the taxpayer’s basis
for his stock. The lower court’s view also created a tax limbo or forced resort to an
atextual stopgap as the interpretation created a disconnect between civil and criminal
In sum, HYPERLINK "https://www.lexis.com/research/buttonTFLink?
zSkAW&_md5=ef5d28af0c16eb3475cdd239ef99f3ef" µ�� 301§ and HYPERLINK
zSkAW&_md5=eca9b3277b2a9d6ac135a4e6bcf126ef" µ316(a)§ governed the tax
consequences of constructive distributions made by a corporation to a shareholder with
respect to its stock.
A defendant in a criminal tax case did not need to show a contemporaneous intent to
treat diversions as returns of capital before relying on those sections to demonstrate no
taxes were owed.

Case – Nicholls, Northy, Buse Co.

Smaill family co. purchased a yacht for the child non voting shareholder to use. The
IRS tried to tax the father voting sh (a constructive dividend). Ct said – bc father was able
to confer benefit to son thus he controlled the direction of the funds and thus should be
taxed on the dividend. The amount of the dividend was the cost of the yacht. The corp
held the title of the boat. Herbert was taxed on 75% of the daily rental rate.

Personal Benefit to SH
Corporate payments of expenses (meals, travel, entertainment) that provide only an
incidental benefit to the business and are primarily for the personal benefit of the SH or
his family may be classified as constructive dividends.
Ex: Nichols 75% personal use of corp., yacht was constructive dividend, to extent of
75% of yacht Fiar rental value
Rev Ruling 69-630
§482- authority to distribute, apportion, or allocate GI, deductions and credits among
related org., trades or bus., if it is necessary in order to clearly reflect the income of such
entites or to prevent the evasion of taxes
§482- bargain sail transaction b/t bro-sis corp that result in shifting of income
Amount of allocation will be treated as a distribution of the controlling SH, with respect
to the stock of the entity whose income is increased and as a capital contribution by the
controlling SH, to the other entity involved gives rise to §482
Issue- A owns 100% X and 100% Y. A caused X to sell its property to Y for less than
arm’s length FMV price. Assume FMV for 100 sold for 80.
X’s income was understated b/c avoidance of income.
X will increase income to reflect arm’s length price of the property sold to Y
Basis of Y will reflect arm’s lentgth price.
Amount of such increase will be treated as a distribution ot A< with respect to his stock
of X and capital contribution by A to Y
Thus X income increases by 20 (as though sold for FMV) and thus Y basis increase by 20
(paid FMV)
To bring this inline with economic reality - the $20 is treated as distributed as Corp dist.
(301 could be ) to A. and then A made a capital contribution of 20 to Y corp. increasing
A’s basis in the Y corp
Using of Dividends in Bootstrap Sales see TSN Liquidating case.
A parent corp., that is about to sell stock of a sub in a taxable transaction may attempt to
convert capital gain on the sale to dividend income by causing the sub to make a large
distribution shortly prior to the acquisition
Success depends on time of the distribution and source of the distributed money
X owns all the stock of T which has a value of 1m
X’s basis in the stock is 200k
T has ample E&P
P wishes to purchase the Stock
If X sells its T stock to P for 1m cash, X realizes 800k of gain taxable at 35k
If X causes T to distribute 800 to X and the entire amount is a dividend, X may deduct
100% under §243(a) and realizes no gain on the sale of the stock for 200k
If, after neg. began for the sale of T, the distribution were paid in the form of a T
promissory note that was later paid off with funds supplied by P, it likely will be
reclassified as a payment of the purchase price.
If T distributed its own excess liqudi assets, dividend will likely not be reclassified even
if the buyer infuses T with liquid assets shortly after the purchase.
Caveat- Strategy may not be viable if X and T file a consolidated return of if distribution
to X is extraordinary dividend under 1059.

TSN Liquidating See chart.

TSN wanted to sell a sub CLIC to UNION MUTUAL
UM did not want some small cap stock owned by CLIC – so prior to sale CLIC
dividended out stock to TSN sold CLIC to UM and UM invested Bonds into CLIC
TSN claimed it was a dividend and claimed dividends received deduction of 85% - 1.
IRS argued that it was part of the sales price.

Waterman Case disposition was a dividend- IRS said waterman was different from here,
bc UM reinfused the CLIC with assets same as a beginning. Ct disagreed.
Facts of waterman –
Waterman owned PA with a FMV of 3.5
Securities wanted to buy

Waterman wanted a 2.8 dividend ( a promissory note) Securities paid waterman

700k ( the AB in the stock owned by waterman) so there was not gain from the

Securities lent PA 2.8 million dollars and satisfied the note to waterman.

Ct said it was part of the purchase price. Securities was using Pan atlantic as a conduit to
transfer cash to Waterman.
It differs from TSN bc in TSM the targets assets changed substantially.
PA did not
Chapter 5- Redemptions and Partial Liquidations:

§302: Distribution in Redemption of Stock


A. Introduction

(1) Redemption Defined

Redemption is a repurchase of a corporate security by its issuer.
A redemption is defined as an acquisition by a corporation of its stock from a SH in
exchange for cash, debt securities or other property, whether or not the acquired stock is
cancelled , retired or held as a treasury stock.

(2) Overview of Tax Consequences

Consequences to Distrubutee SH
Need to see if distribution is more like a (1) dividend or (2) Sale
(1) Dividend if:
Corp distributes money or property in exchange for its own stock and the distributee SH
equity in the in the corp., is essentially unchanged.
(2) Sale or exchange of stock if:
Significantly, reduces SH equity interest
Consequences to Distribution Corporation

(3) Tax Stakes To Shareholders

Noncorporate SH prefer exchange
Corporate SH prefer dividend treatment if 243 dividend deduction or consolidated return.

B. Constructive Ownership of Stock

§1.318-1(a), (b)
§1.318-3(a), (b)

(1) Generally:
An individual or entity is treated as owning stock owned by certain related family
members, corporations, partnerships, estates and trusts under the attribution rules in §318.
(for §302 purposes) §302(e)(1)
Rationale- related individuals and entities have a unity of economic interest.

(2) Family Attribution:

An individual is treated as owning stock owned by her spouse, children (legally adopted),
grandchildren and her parents, but not, siblings or in-laws.
Grandchildren are not considered to own stock owned by their grandparents
§318(a)(5)(B)- Stock constructively owned by one family member may not be
reattributed to another family member. So can’t attribute from parent to child and then to
child’s spouse.
X Corp’s 100 o/s shares are owned by H (10), his wife (20), their child (20), Wife’s
Father(30) and Wife’s sister(20)
SHActualConstructiveH- 1010%40% (W +C)W-2020%60% (H+C+WF_C-2020%30%
(H+W)WF-3030%60% (C+WS+W)WS-2020%30% (WF only!)Total- 100100%

(3) Entity to Beneficiary Attribution

(a) From Partnership or Estates

Stock owned by or for a partnership or estate is considered as owned by the partners or
beneficiaries with present interests  ex. Life estate in proportion to their beneficial
interest. §318(a)(2)(A)
Reg 1.318-3(a)- A person ceases to be a beneficiary of an estate when he receives all
property to which he is entitled (ex. A specific bequest) and the possibility that the person
must return the property to satisfy a claim is remote§1.318-3(a)

Ex 1- A, B and C are equal partners in ABC Partnership. The partnership owns 120
shares of X corp. stock. A,B, and C each are considered to own 40 shares of X.

Ex 2- D dies leaving a 50 k specific bequest to E, and his residuary estate to F. E is no

longer a beneficiary for attribution purposes after she receives her bequest, but F remains
a beneficiary until the estate is closed.

(b) Trusts
Stock owned by a trust (not qualified employee retirement plan) is considered owned by
its beneficiaries in proportion to their ACTUARIAL interests in the trust, however small
or remote.
Stock owned by a grantor trust is considered as owned by the person who is taxable on
the income of the trust
Trust owns 100 shares of X corp. A is the income beneficiary of the trust and B is the
remainder person. A and B’s actuarial interests are 60% and 40% collectively. So A owns
60 shares and B owns 40 shares of X corp.

(c) From Corporations

Stock owned by a corporation is considered as owned proportionately, (by reference to
value) by the SH who owns, actually or constructively, 50% or more in value of the
corporation’s stock.
A owns 60% (by value) of the stock of X corp. X corp., owns 100 shares of Y corp. So, A
is considered to own 60% or 60 shares of Y corp.
Now say, A owned only 40%, A would not be considered, owning any shares of Y
through X.
If A owned 40% of X corp., actually and another 20% constructively (ex- through family
member), A would be a 50% or more SH and thus would constructively own 60 shares of
Y through X.

(4) Beneficiary (or Owner) to Entity Attribution

(a) To Partnerships or Estates

All stock owned actually or constructively by partners or beneficiary of an estate is
considered as owned by the partnership or estate §318(a)(3).
A,B, and C are equal partners of the ABC general partnership. A owns 60 shares of X
corp., actually and is considered owning 40 shares from his wife, W. So ABC is
considered to own 100 shares of X corp., form A as well as any shares owned actually
and constructively by B and C.

(b) To Trusts
All stock owned by a trust beneficiary is attributed to the trust unless the beneficiary’s
interest is both remote and contingent.
Remote 5% or less of the value of the trust property, assuming the trustee will exercise
minimum discretion in favor of the beneficiary. §318(a)(3)(B)(i).
§318(a)(3)(B)(i)- Grantor trusts are considered as owing stock owned by the grantor or
other person taxable on the trusts income.
A is the income beneficiary of Trust. A owns 100 shares of X corp., all of which is
considered owned by the trust. If A had only a contingent remainder which was 5% or
less of trust property, none of A’s shares would be attributed to the trust

(c)To Corporations
All stock owned by a SH who actually and constructively owns 50% or more of a corp.’s
stock is attributed to the corporation§318(a)(3)(C)
Ex: A owns 60% (by value) of X corp. stock. A owns 100 shares of Y corp. X corp., is
considered to own 100 shares of Y corp. from A.
If A owned less than 50% of X, however, none of A’s shares in Y would be attributed to

(5) Option Attribution

§318(a)(4) A person holding an option to acquire stock is considered as owning the
§318(a)(5)(E) If stock may be considered as owned by an individual under either
family attribution or option attribution, Option attribution takes precedence.
Permits reattribution of the optioned stock to another family member despite the no
double family attribution rule.
H has an option to acquire 100 shares of X corp., stock owned by Child.
H is considered to own Child’s 100 shares under the stock option attribution rules.
H can reattribute these to other family member, but if he did not hold the option, he
would still be considered as owning family attribution shares, but can not reattribute to
other members.

(6)Other Operating Rules

(a) Reattribution
Stock constructively owned by a person under §318 is considered as actually owned for
purposes of reattribution that stock to another person.
A and B (unrelated) each own 50 of the 100 o/s shares of X.
X owns 100 shares of Y corp.
A is 50% partner in the AC partnership
B is the sole beneficiary of Trust
A and B each is considered as owning 50 shares of Y through .
A’s shares of Y are reattributed to AC partnership and B’s shares are reattributed to the
Partnership and Trust each is deemed to own 50 shares of X directly from A and B

(b) No Double Family Attribution

Stock constructively owned under family attribution rules of §318(a)(1) may not be
reattributed to another family member under §318(a)(5)(B).
Ex. Parent son and daughter
Son owns 100 shares.
Daughter does not constructively own
Father does.
But daughter does not constructively own the fathers constructive share.
(c) Anti Sidewise Attribution
Stock owned by a beneficiary partner, or SH, that is attributed to an entity may not be
rattributed from the entity to another beneficiary, partner or SH. §318(a)(5)(C)
A and B, unrelated, are equal partners in the AB general Partnership
A owns 100 shares of X corp stock
Partnership is considered to won A’s 100 share of X corp under §318(a)(3)(A), but those
shares may not be reattributed to B from the partnership under §318(a)(2)(A)

Problem page 213

Wham Corp has 100 shares of CS Outstanding. 25 are owned by G, 20 are owned by
GF’s Daughter (Mother), 15 shares are owned by Mother’s Daughter, 10 Shares are
owned by Mother’s adopted Son, and remaining 30 shares are owned by Gma’s estate of
which mother is 50% beneficiary. Mother also has the option to purchase 5 of son’s
I: How much Wham stock to Grandfather, Mother’s daughter, and Grandma estate own
after application of S318
Owns own shares 25
Mothers 20
Grand daughter 15
Grand son 10
Mothers beneficiary shares – (owns 50%) thus 15
Total 85 shares

Mothers daughter
Own share 15
Mother 20
Mothers share of gm estate 15
Mothers option to purchase son shares 5
Total = 55

GM estate
Own share 30
Attribution from mother (bc beneficiary) 20 + GF (25) + 15 + 10 =
Total 100 = all the shares.

All of the 100 Shares of X corp. are owned by a partnership, in which A,B,C,D are equal
partners . W, A’s wife, owns all of the 100 shares of Y corp.
(a) How many share, of X corp. are owned by A, W and M (W’s Mom)
A owns
Own shares 25 (100 shares * .25)
W owns
Her husbands shares 25 shares
M owns

(b) How many shares if any of X are owned by Y? Would Y constructively own any
shares of X if W owned only 10% of Y
Y owns
Flow from A to wife to Y. = 25 shares.
If W owned 10%
Flows from A to wife. But bc not 50% or more there is no flow to Y. = 0
(c) How many shares, if any, of Y are owned by B,C,D, and X?
Partnership =
Wife owns 100 shares
A constructively owns 100 through family.
All of those are attributed to Partnership
Wife owns 100
A constructively owns 100
Then go to Partnership
But bc of anti sidewise – those don’t get attributed to BCD
Wife owns 100
A owns 100 constructively
P owns bc a partner
Then it is attributed to X bc P is a beneficial owner of X. = 100.

C. Redemptions Tested at the SH level

Redemption in §302(b)(1)-(4) is treated as an exchange §302(a).
Otherwise §301 applies (§302(d)) and it is a distribution - follows dividend rules
(1) Substantially Disproportionate Redemptions

(1) Substantially Disproportionate Redemptions

A redemption that is described in §302(b)(1)-(4) is treated as an exchange. §302(a).
Otherwise §301 applies and it is a distribution §302(d)

(a) Requirements for Exchange treatment

§302(b)(2)- A distribution in redemption is treated as an exchange if it is “substantially
disproportionate” with respect to the SH.
There are Three requirements for substantially disproportionate:
(1) Immediately after the redemption, SH must own less than 50% of the total combined
voting power of all classes of stock entitled to vote
(2) Percentage of Voting Stock owned by the SH immediately after the redemption must
be less than 80% of percentage of voting stock owned by that SH immediately before the
Need to do 80% of voting percentage before Ex: 60% x 80%
(3) Percentage of C.S. owned by the SH immediate after the redemption must be less than
80% of the percentage of C.S owned immediately before the redemption. F there is more
than one class of C.S. O/S, this test is applied in the aggregate by reference to FMV. Rev
Rule 87-88.
A owns 60 out of the 100 shares of X Corp. (60%)
X redeems 20 of A’s shares so that after redemption A owns 40 out of 80 shares still o/s
Redemption is not substantially disproportionate b.c:
A does not owe less than 50% of X’s voting power
This focuses on a significant reduction of voting power. So if no voting shares are NOT
redeemed , the redemption cannot qualify as a substantially disproportionate redemption

(b) Series of Redemptions:

A redemption is not substantially disproportionate if it is made pursuant to a plan which
has the purpose or effect of a series of redemption, that taken together, result in
distributions that are not substantially disproportionate.
A plan exists if a series of redemptions are “casually related” even if they are not part of a
joint plan or arrangements. RevRuling 85-14 – does not have to have an explicit

Problem page 217

Y corp. has 100 shares of CS and 200 shares of nonvoting preferred stock o/s.
A owns 80 shares of Y CS and 100 shares of PS.
Cathy owns remaining 20 shares of Y CS and 100 shares of Y PS.
A and C are not related.
Does redemption satisfy the §302(b)(2) requirements?
(a) 1/15, Y corp., redeems 75 of A’s PS
This does not qualify b/c it is not voting power. So dividend treatment under 301 would
(b) Y also redeems 60 shares of A’ CS
Alice owns 80 shares so her percentage is 80%.
Her new percentage is 20 shares are remaining so this is 20/40. So here this is 50%
SO remember, you need to subtract from the total shares.
So now the first step doesn’t work because it is NOT less than 50%.
(c) Y also redeems 70 shares of A’ CS
Y now has 10/30, or 33 1/3%
First step is made because <50%
(3) Now she owes 33 1/3 %, and this is exchange treatment.
(d) What difference would it make in (c) above if on 12/1 of the same year, Y redeems
10 shares of C’s CS?
Y redeems 10 shares of C’s CS
A started with 80% voting power. 80/100
A reduced by 70 and C reduced by 10 thus-
20% and now it would be 10/20, so A has 50% voting power.
(1) Need to see if there is a plan if we take into consideration Kathy’s redemption, this
would not apply under the first prong! Alice would not reduce less than 50%
(2) Was there a plan to defeat the requirements of §302(b)(2)
What if Alice knew that Kathy would have 10 shares redeemed, and in anticipation she
would be related b/c if one SH schedules a redemption to temporarily satisfy 302(b)(2)
but with knowledge that voting interest would increase, that is a plan and thus,
redemption would not satisfy 302(b)(2)(d).
If she knew it would be temporary, this is a plan and thus this would be a dividend. Alice
has <50% and it wouldn’t qualify.

(2) Z Corp has 100 shares of voting CS and 200 shares of nonvoting CS. Every share of
ZCS has a FMV of 100. D owns 60 shares of Z voting CS, and 100 of Nonvoting CS..
J owns all the remaining stock of Z40 Voting, and 100 Non voting. D and J are not
related. If Z redeems 30 of Don’s voting CS (now Don will have 30)¸will redemption
qualify under §302(b)(2) for exchange treatment?
D- 60 Voting and 100 Nonvoting (60%)
J- 40 Voting and 100 Non Voting
Common Stock- 100 and 200 Non Voting
D- Before 60% or 48% or less or step (2)
D- After 30/7042.9%
Step 1 <50%
Step 2 <48%
Step 3 Common Stock FMV is 100 per share
CS Before 300 x 10030k
Don owned 160 x10016k which is 16/3053.3 * .842 2/3 %
Don After 130x10013k and CS after is 270 x 100k27k which is 48.1%
This is not less than 42.3% so this step fails to qualify.

(2) Complete Termination of SH interest

In General
A redemption that completely terminates a SH actual and constructive interest in the
corporation will be treated as an exchange under §302(b)(3).
If a corp. distributes its debt obligations in exchange for the redeemed stock the SH may
recover the stock if Corp defaults, and IRS may contend that SH has not terminated their
equity interest.
(a) Waiver of Family Attribution
§302(c)(2) A redemption that completely terminates a SH actual interest in a
corporation will be treated as an exchange even if the SH (called the distributee in
§302(c) constructively owns stock of a family member under §318(a)(1) provided
following requirements for waiver of family attribution in §302(c)(2) are met
(1) All Interests are Terminated
Distributee may have no interest in the corporation as a SH, officer, director or employee,
immediately after the distribution.
Case: Lynch v. Commissioner:
Parents wanted to turn co over to son.
Corp sold 50 shares to son (16k was a gift)
Corp redeemed stock in form of prop and a note
Son needed help .. father was kept as a consultant.
9th Circuit Ct held that a TP who performs post-redemption services for the corp. as an
independent contractor retains a prohibited interest.
Father was only engaged for limited purpose and he did not have a financial interest in
the corporation.
Two Prong Analysis by tax court
1. Whether there is a significant financial stake or
2. Did he retain control of the company
Tax court held that F did not have a continuing interest in the corp., and no financial
stake (500/month fee) thus waiver was satisfied.
9th circuit/holdingCongress wanted to establish a bright line test. - see above.
Hypo: What if you perform tax services, does this have an interest (under Lynch yes)
Hypo: Father owns a filling station and trucks stop and get their tanks filled. Is this a
continuing interest in the corporation so that it disqualifies a waiver of family attribution
rules. Jensen says no, he thinks 9th circuit approach is not good.
Employee vs. Independent K Employer has right to determine rights of employee and
not the independent K. Independent K performs limited functions for the partnership.
§1.302-4(d) the retention or acquisition of an interest as a creditor is permitted. A
person is considered to be a creditor only if her rights are not greater or broader in scope
than necessary for enforcement of the claim.
(2) Ten-Year-Look Forward Rule
The distributee may not acquire any of the forbidden interests (other than stock acquired
by bequest or inheritance) during the 10 year period beg. The date of the distribution in
redemption. §302(c)(2)(A)(ii).
§.1302-4(e) Distributee who remains a creditor of the corporation after a redemption is
not considered as acquiring a prohibited interest by acquiring corporate assets to enforce
her rights as a creditor, but an acquisition of stock is prohibited.
(3),Procedural Requirement
§302(c)(2)(A)(iii)- Distrubutee must attach a statement to her income tax return for the
year of the redemption reciting that she has not acquired any prohibited interest since the
distribution and agreeing to notify the service of any such acquisition w/in 30 days after it
occurs during the 10 year-look forward period and to extend the SOL for assessing and
collecting a tax with respect to the distribution on year after the notice
§1.302-4(a)(2)- IRS may grant extensions for filing the agreement if TP shows
“reasonable cause” for a late filing.
(4) Ten Year Look Back RuleEXCEPTION
(1) Distributee must not have acquired any portion of the redeemed stock w/in the 10
year period preceding the distribution from a person who stock is attributable to the
distrbutee under the family attribution rule in §318(a)(1)
(2) At time of distribution, no person may own stock which is attributable to the
distrbutee under the family attribution rules if that related family member acquired any
stock in the corporation from the distribute within the 10-year-look-back period.
§302(c)(2)(B)- Acquisition or disposition by the distribute during the 10 year look back
period was not principally motivated by a tax avoidance purpose.
§1.302-4(g)- A gift of stock is not principally motivated by tax avoidance merely because
the donees is in a lower income tax bracket.
Parent and child own 50 of the 100 o/s shares of X Corp.
Parent, who wishes to retire and shift control of X to child, makes a gift of 20 shares to
child and X corp. redeems parent’s other 30 shares, leaving child as the sole SH.
Parent retains no other interest in X Corp.
Here: Tax avoidance was not one of the principal purposes of the transfer to child, and
the 10 year look back rule will not prevent the redemption form qualifying for waiver of
family attribution under §302(c)Rev Rule 77-293.
Page 235
Corp owned by J, daughter, and son. John owns 100, daughter 50 son 25
A) before owns 100% after owns 100% redeems 50 shares. Would qualify as an
exchange if waived the family attribution rules.
B) if didn’t file agreement not to notify IRS – then not eligble for exchange treatment
C) what if shares contignent on R’s future profits ? this is some financial interest – regs
say specifically that this is a prohibited interest (§1.302-4(d))
D) R redeems 20 of alisons shares in year one; and remaining 30 shares on year two.
Here could argue that this was part of a single transaction. – substance over form.
Test - yr 2 redemption would have to be fixed and determined at the time of the
initial transaction.
E) randall remains a director – this is a prohibited interest
F) R forms a subsidiary and Alison becomes an employee of the sub. – this is a
prohibited interest (§1.302-4(c))
G) son dies and leaves Alison shares. – here she regains interest within 10 years – this is
allowed. (gain by bequest or inheritence)

B&B . created by betty and billy.

Still own 120 shares

A) is it an exchange?
Son received interest prior to redemption this would not qualify. But this is as valid
business purpose. See 77-293
The note paid to parents for redemption lasts 20 year period. - a long term note – is
more like equity – is more risky. However, Cts have allowed debt instruments to qualify.
Agreement to restrict dividends and such other – Code says – can continue as a creditor
– is it unusual to put a restriction No creditors often do this.
The lease? Redeemed SH can enter into an arms length lease with co.

B) B creates a consulting firm. And wants to consult for B&B – lynch says no. there is no
Ind Contracter relationship permitted.
Tax ct; would use test;
1. Whether there is a significant financial stake or
2. Did he retain control of the company

3. Cinelab 100 shares outstanding. J owns 50 sister owns 30 estate of father owns 20.
Sams widow is beneificiary
(a) cinelab redeems estates 20 shares . – bella owns J and M shares and estate owns all
Before = actually own 20% const 80%
After = actual non- const 100% - so there is a problem – a complete redemption
can be waived where family attribution rule applied. See waiver by entity below.
Estate must agree to have no interest in co. bc of 302©2© bella must also agree to all 3
(b) J and M have specific legatees and B has residuary Here bc J and M have attribution
through beneficial ownership. The estate can only waive family attribution and not
beneficial owner
© J and M are residuary beneficiaries – here to solve the problem would typically pay J
and M their interest but.. they are residuary benes and thus cant pay off.
(d)20 shares owned by a trust providing income to bella and remainder to nancy. The
trust can waive the attribution through family attribution.
Nancy is a sibling and there is no family attribution concerns between siblings.

(b) Waiver of Family Attribution by Entities

§302(c)(2)(C)- permits an entity to waive the family attribution rules.
A waiver may be useful when a redemption terminates and entity’s actual ownership but
the entity still owns stock that is attributed from one family member to another “related
person” and is then reattributed to the entity.
Only applies to waive family attribution under §318(a)(1)
DOES NOT WAIVE direct beneficiary or owner under §318(a)(3)

(1) Entity defined

§302(c)(2)(C)(ii)(I) partnership, estate, trust or corporation.

(2) Related Person Defined

A related person is any person to who ownership of stock in the corporation is (at the
time of the distribution) attributable under the family attribution rules if the stock is
further attributable to the entity. §302(c)(2)(C)(ii)(II)
Ex 1: A and Estate each own 50 of the 100 outstanding shares of X corp. The sole
beneficiary of Estate is A’s son, S. A’s shares are attributed to S under §318(a)(1) and are
further attributable from S to Estate under §318(a)(3)
S is a related person. If S actually owned 50 shares, he would not be a related person.

(3) Conditions for Entity Waiver

An entity may waive family attribution if (1) entity and each related person meet the
usual requirement for waiver under §302(c) and (2) each related person agrees to be
jointly and severally liable for any tax deficiency that may result if an interest is acquired
in the 10 year look forward period. §302(c)(2)(C)(i).
Example 2:
Assume in Ex above that X corp., redeems Estate’s 50 shares.
Estate has terminated its actual ownership in X but continues to own 50 shares from A
through beneficiary S.
Assuming no 10 year look back rule problems, Estate can waive family attribution and
break the chain from A to S if Estate and S jointly agree not to acquire a prohibited
interest for 10 ear and agree to notify IRS if an interest is so acquired
S also must agree to be jointly and severally liable for any tax deficiency
If S actually owned 50 shares of X, S’s shares would be directly attributed to the Estate,
and entity waiver rules would not allow Estate to terminate its interest under §302(b)(3).

(3) Redemption NOT essentially Equivalent to A dividend

(a) The meaningful Reduction Standard
If a redemption does not satisfy one of the specific §302 safe harbors, it still is treated as
an exchange under §302(b)(1) if it is not “essentially equivalent to a dividend”
US v. Davis:
Redemption is not essentially equivalent to a dividend if it results in a “meaningful”
reduction of the SH proportionate interest in the corporation.
§1.302-2(b)- Dividend equivalence “depends upon the facts and circumstances of each
§318 attribution rules fully apply, and a business purpose or lack of tax avoidance motive
is irrelevant.
See Role of § 302 (b) (1) After Davis
On the formation in Y1, X corp. issues 25 shares of common stock each to Father,
Mother and their two children.
In Year 3, for a valid business purposes, Father contributes 25k to X corp. in exchange
for 100 shares of nonvoting preferred stock.
In Year 5, X distributes 25k to Father in redemption of all his preferred stock.
Under the attribution rules, Father is considered to be a 100% SH before and after the
The redemption of the P.S. is essentially equivalent to a dividend.

(b) Meaningful Reductions- Ex:

IRS considers the three most significant SH rights to determine whether a reduction is
meaningful: Rev Rule 81-289
(1) Voting
(2) Participation in current earning and corporate growth
(3) Sharing in net assets on liquidation
Rev. Rule 85-106- If the redeemed SH has a voting interest, a reduction in voting power
is a key factor, together w/ a potential to participate in a control group with other SH.
(1) Partial Redemption of Nonvoting P.S
If a corp. redeems ½ of the nonvoting P.S of a SH who owns no other class of stock, the
distribution ordinarily is not essential equal to a dividend §1.302-2(a)
(2) Significant Loss of Control
Rev Rule 75-502- A reduction of voting rights from 57% to 50% (with corresponding
reductions in rights to earning and net assets on liquidation) has been ruled to be
“meaningful” where the remaining shares are held by one unrelated SH.
(3) Loss of Control in Concert with Others
A reduction of common stock ownership from 27% to 22% is meaningful where the
remaining shares are owned by three unrelated SH b/c the redeemed SH lost the power to
control the corp. in concert with one other SH. Rev Rule 76-364
(4) Reduction of Ownership by Isolated Minority SH
Rev Rule 75-512- A reduction of C.S by a minority shareholder from 30% to 24.3% is
Even a very minimal reduction of a SH interest is meaningful if the SH exercises no
control- ex: minims reduction resulting from a tender offer by a publicly traded corp.
A pro-rata redemption of stock by a public company is not a meaningful reduction even if
the SH has a small minority interest. Rev rule 81-289.

(5) Family Discord

Haft- Evidence of family discord may negate the presumption of the family attribution
rules for purposes of §302(b)(1).
IRS and other courts disagree, but Tax courts says family discord may be a relevant facts
and circumstance test after family attribution rules have been applied

Problem page 247

(1)Z corp has 100 shares of C/S o/s owned by A (28 shares) B (25 shares), C (23) and
Unless o/w indicated, assume no relation. Determine whether the redemption is not
essentially equivalent to a dividend?
(a) Z redeems 7 shares from A – A yes there is a meaningful control change – before he
could ask only one person to form a majority. Now he has to ask two to form a majority.
Make sure to consider majority by the reduced
(b) X redeem 5 shares from A and A and D are mom and daughter. Before comblinec
control of 52% now 49.47% - this is a meaningful reduction
(c) Z redeems 5 from A and A and B are mom and daughter A and B together still have a
majority and not meaningful
(d)Same as (c) except that A has not spoken to B since B married “o/s faith” . there are
approaches. ... IRS does not care about family disputes. Other cases say.. if there is a
slight reduction in interest then can consider all facts and circumstances.

(2) Y corp. has 100 shares of C/S and 100 shares of nonvoting preferred o/s stock. The
p/s is not convertible into Y C/S and is not §306 stock. The Y common and P/s are owned
by the following unrelated SH
SHCommon SharesPreferred SharesA400B2055C2510D1515E020
a) Y redeems 5 preferred shares from E
this is redemption not equivalent to a dividend – no meaning ful control change
b) Y redeems all of its outstaning preferred stock.
For E its an exchange.
For the other sh’s – if sh can control corp with help of small number of other sh’s then
IRS only focuses on power to control.
Here bcd can control the corp by colluding with a – here it would not qualify as an
(3) Indv. Owns 10 shares of CS with AB of 15k. 5 shares are redeemed in a transaction
that is a dividend. What if 10 are redeemed which is properly classified as a dividend
because §302(c)(2) waiver of family attribution is not available?
A receives a dividend.
Here the basis transferes from the 5 shares redeemed to the 5 shares that remain.
Bc it is a dividend and will be paying tax on it as ordinary income.
What if all ten shares are redeemed (thus no shares left) . it is still taxed as a dividend
bc he was unable to waive the family attribution rules.
The Basis passes to the shares that he is deemed to own by construction.

(4) Partial Liquidations

Occurs when a corp., significantly contracts its business and makes related distribution
(of assets or their sale or insurance proceeds) to its SH in redemption of all or part of their
When distributions in redemption results from such a “corporate contraction” the
transaction is more like a sale than a dividend.
§302(b)(4)- exchange treatment for distributions in redemption of stocked held by
noncorporate SH if the transaction is a “partial liquidation under 302(e) of the
distributing corporation
§302(b)(4) looks on the nature of the assets distributed and the corp’s reason for making
the distribution. (other tests look to the effect of a redemption on the distribute SH)

(a) NONCORPORATE SH’s qualify

§302(b)(4)- only noncorporate SH qualify for partial liquidation treatment.
S Corps are treated as individuals for this purpose and qualify
§302(e)(5)- Stock held by a partnership, estate or trust is treated as if held proportionally
by its partners or beneficiaries.

(b) Partial Liquidation Defined §302(e)(1)

(1) Not essentially equivalent to a dividend ( definition not in the statutes)
Determine at corporate level rather than a SH level
Satisfy the
(a) corporate contraction doctrine – or
(b) “termination of Business Safe Harbor”
(2) distribution is pursuant to a “plan” (a simple corporate resolution wil suffice)
(3) Distribution occurs w/in the taxable year in which the plan is adopted or the
succeeding taxable year

Corporate Contraction Doctrine (amorphous and cannot be relied upon w/ assurance for
A distribution in partial liquidation is not essentially equivalent to a dividend if it result
from a (permenant) contraction of the corporation’s business such as:
(1) Involuntary Events
After a fire damages a manufacturer’s factory, co., distributes the insurance proceeds and
contracts its business operations. Imler v. Comm’r and reg 1.346-1
(2) Change in Nature of Business
A corporation distributes working capital that is no longer needed b/c of a change in the
scale of its operations
(3) reserve for Expansion
A corporation no longer needs funds that had been accumulated for expansion/ Reg

Termination of Business Safe Harbor

(1) Attributable to the termination of a “qualified trade or business” and
(2) Corp continues to be engage in the conduct of another qualified trade or business
(a) Qualified trade or Business§302(e)(3)
Any trade or business conduct t/o the five year period ending on the date of the
distribution and was not acquired (by the distributing corporation) in a taxable transaction
during that five year period. §302(e)(3).
Raw land held for investment or a securities portfolio is not an active trade or business
§1.355-3(b)(2)(iv), which applies to similar active trade or business under 355.
Ex: Corp acquires an active trade or business in a non-taxable acquisition/re-org., and in
this situation so long the business is done by someone for five years, the distribution will

(b) Distribution of Assets or Proceeds of Sale

The terminated business must be operated directly by the distributing corporation
Must be o assets of that business or the proceeds of sale of those assets
Sub stock or proceeds of sale of such stock NOT PARTIAL Rev Rule 79-184
May qualify as a tax-free corporate reorganization under 355
Stock for stock
Also c, d, types
(c) Pro Rata Redemptions
Under business safe harbor, no regard to whether the redemption is pro rata to the SH

(f) No Surrender of Stock Required

Actual surrender of shares is not required if it would be a “meaningless gesture” such as
on a pro rata distribution.
Each SH is deemed to have surrendered shares w/ the value equal to the amount of the
distribution, and an appropriate portion of the SH stock basis is allocated to the shares
deemed surrendered. Rev Rule 90-13
A, B and C each own 100 shares of X Corp., w/ a basis of 15k and a value of 100k. X
corp. distributes 50k pro rata to each SH in transaction that qualifies as a partial
liquidation but SH do not surrender any stock.
Each SH is deemed to have surrendered 50 shares of X stock with a basis of 6k (.40*15)
in exchange for the 40k distribution, so AR is 40 and AB is 6- so gain is 34k LTCG

Problem Page 253

A corp operates a book and cram division. A’s single class of c/s O/S are owned in equal
shares by M, P (M’s wife) and I Corp. Neither M nor P own any stock in Iris. A also
owns all of the stock of Beta Corp, a separately incorp., company which is engaged in the
beta processing business, and it directly owns a diversified portfolio of securities
(a) A has operated B and C for more than five years and it distrubtes the assets of Books
to its 3 equal SH in redemption of 50 shares from each SH. Does result matter if there is
no actual redemption of shares - can qualify or exchange treatment under the safe
harbor provision under e2 a and b met. Does not apply to the corporation bc they cant
qualify for exchange treatment here – here it is a distribution under 301.
(b) A purchased Books three years ago for cash, if so why does that matter? What if A
acquired books 3 years ago in a tax free re-org?
bc it was purchased within 5 year period with cash (someone recognized gain or loss)
if it acquired in a tax free organization – will get exchange treatment under the safe
harbor as long as it operated for 5 years prior.
(c) All assets of books were destroyed by fire and A distributes ½ of the insurance
proceeds equally to its 3 SH in redemption of an appropriate number of shares of stock
and retains the remaining proceeds to carry on its book publishing business on a
somewhat smaller scale
won’t qualify under the safe harbor. (not distributing all the assets i.e. the insurance)
Might qualify under imler if it is a permanent reduction of the business.
(d) Same as (a) except A distributes assets of Books to Michael in redemption of all stock
can qualify as an exchange under the safe harbor.
(e) Same as (a) except A distributes the assets of Books to Iris for all of A’s stocks
does not qualify as a partial liquidation bc it was a corp
may qualify as a complete termination of interest. – and get exchange treatment
(f) A distributes the securities portfolio to its 3 equal SH in redemption of 20 shares from
each SH
(g) A sells all of its Beta stock and distributes the proceed pro rata to SH in redemption of
20 shares from each
not a partial liquidation – selling a subsidiary does not qualify under the safe harbor –
beta is an investment and thus is not a qualified business and not ceasing to conduct a
(h) Same as 9(g), except that A liquidates B and then distributes the assets of B’s
business which has been operated more than 5 years.
Will qualify under the safe harbor
D. Specific Tax Consequences of Redemptions

(1) Consequences to SH

(a) Exchange:
If redemption is treated as an exchange, the distributee SH computes gain or loss as if the
redeemed stock had been sold to an o/s.
In case of losses- §267(a)(1)- disallows a deduction if the redeemed SH owns
(directly/indirectly) more than 50% of the corp. stock.

(b) 301 Distrbution

Dividends to extent of distributing corp’s E&P and reduction of Basis and capital gain to
the extent of the balance of the distbrution

(c) Basis of Distributed Property

§301 FMV on date of distribution. §301(d)
Exchange FMV@

(d) Corp. SH
§243 dividends received deduction

Effect of Redemption on E& P handout-See/attach

(2) Consequences to Distributing Corporation

(a) Recognition of Gain or Loss

§311(a), (b)- Distribution corporation recognizes gain on a distribution of appreciated
property in redemption of stock, but it may not recognize loss on the distribution of
property that has declined in value.
Does not matter if it is exchange or distribution to SH

(b) Effect on E&P

(1) Distribution of Appreciated Property

Distributing corporation increases its current E&P by the gain recognized on distribution
of appreciated property §312(b)
If the basis for property for E&P purposes is different from its basis for taxable income
purposes, the increase is the E&P gain, not the taxable gain.

(2) Reemption Treated as §301 Distrbution

If redemption is treated as §301 distribution, the effect on E&P is the same as any ord.,
§312(a), (b)- Accumulated E&P are reduced by the amount of money, the FMV of any
appreciated property distributed, the E&P AB of any loss property distributed and the
principal amount of debt obligatons.
(3) Redemption Treated as Exchange
E&P are reduced in an amt., that may not exceed the ratable share of accumulate E&P
attributable to the redeemed stock. §312(n)(7) (cant be reduced more than amount in
dollars = percentage of the shares redeemed)
E&P amount cannot exceed the distribution
If Corp has only one class of stock o/s, the E&P attributable to the redeemed stock are
determined by multiplying
Ex: X corp. has 1k shares of C.S. O/S (its only class), owned equally by A and B. X has
160k of accumulated E&P and no current E&P. X gives 100k in redemption of A’s 500
shares. Since the redeemed stock is 50% of the total number of shares (1k), X may reduce
E&P by 80k (160 *.5). reason is the E&P is 160k, if E&P was 240, then can do the entire
amount of the distribution.

Problem page 260

X corp has 200 shares of C.S o/s. A and B each acquired 100 shares of X upon their
issuance at a price of 1k per share, and they each have an AB of 100k in their X stock.
Beg of Year- X has 100k of Accum. E&P abd ut gas 50k of E&P in the current year
I- tax consequences to X of the following alternative redemptions of A’s stock, assuming
in each case that the redemption qualifies for exchange under §302(a)?
(a) In redemption of A’s 100 shares, X distributes land(250k FMV, 200 AB) held as an
(b) Same as (a) above, except X’s AB in the land is 300k
You would need to know the date of redemption. Adj acuum E and P from beging of year
to date of redemption. Pro rate 100k for current year.
Begin with 100k on 1/1
1/1 – 6/30 = 50k
150k *.5 = 75k

(c) Stock Reacquisition Expenses

A corp may not currently deduct any expenses paid in connection w/ the reacquisition
(including redemption) of its own stock ... ie greenmail
They are nondeductible, nonamortizable capital expenditure §162(k)(1)
Disallowance deduction rule does not apply to the allocable costs of borrowing to finance
a stock redemption
Borrowing costs may be amortized over the term of indebtedness §162(k)(2)(ii)
Rationale: borrowing is separate from redemption
Other corporate payments such as payments to employees, etc., done with reacquisition
rule are not subject to disallowance under §162(k).

Redemptions and Related Transactions

(1) Bootstrapping
Zenz v. Quinlivan
If a redemption and sale are part of an integrated transaction to dispose of a SH entire
interest in the corporation, the redemption will qualify as a complete termination under
§302(b)(3) whether it occurs before or after the sale.
SH use this to remove liquid assets from a corp and sell the remaining stock at a reduced
price known as a bootstrap
Rev Rule 75-447
A sale and redemption also may be combined to qualify the redemption as “substantially
disproportionate” under §302(b)(2).
Ex 1:
A owns 100 o/s shares of X. The value of X is 100k including 20k in cash a nd 80k
operating assets
X has 50k of E&_.
B wishes to by X for 80k.
X first distributes 20k to A in redemption of 20 shares. A sells remaining 80 for 80k to B.
If the redemption and sale are part of an integrated plan, A is considered to have
completely terminated interest in X and exchange under §302(b)(3)
Ex 2:
A and B are unrelated and each own 50 of X’s 100 o/s shares
C also unrelated wants to come in business, X issues 25 c/s to C and pursuant to the same
plan redeems 25 shares of its stock from A and B. So now 25 each out of 75 ps/
A and B’s interests are reduced from 50% to 33.5 and thus, this a substantially
disproportionate under §302(b)(2)

(2) Redemptions pursuant to Buy-Sell Agreements

(a) Buy-Sell Agreement

Closely-held corp., use buy-sell stock purchase agreements to provide for a continuity of
business, to satisfy economic and tax goals when a SH dies or retires and to resolve SH
Departing SH or his estate sells the stock to the continuing SH
Entity purchase
Corp., redeems the departing SH stock
Buy/sell can be mandatory or optional
Typically, include other restrictions on the transfer of shares and provisions to determine
the value of any stock purchased pursuant to the agreement.

(b) Constructive-Dividend
Problems arise when a continuing SH is personally and unconditionally obligated to
purchase stock pursuant to a buy/sell agreement and that obligation is assumed by the
corporation. Sullivan
A mere assignment to the corp of an option to purchase stock from another SH is not a
constructive dividend, Holsey.
Ex 1:
A and B, who are unrelated, own all 100 shares of X
A and B agree upon the death of either SH, the survivor will be unconditionally obligated
to purchase decedent’s X stock from his state
B dies, A causes the corp to assume his obligation and redeem the stock from B.
Redemption is a constructive distributon to A Rev Rule 69-608
Ex 2:
Same as (1) but agreement provides that upon the death of either SH, X corp., has an
option to purchase the decedent’s stock.
If X chooses not to exercise the option, Survivng SH is obligated to purchase any
redeemed shares.
If B dies and X redeems all of B’s stock, the redemption is not constructive toA, because
A was not primarily obligated to buy the stock. Rev Rule 69-608
Ex 3:
Now, agreement says either SH has an option to purchase stock of other b/c of certain
events but is free to assign the options ot others.
At B’s retirement, A ssigns his option to X corp., which redeems all of B’s stocks.
Redemption is not constructive to A b/c A had no unconditional obligation to buy the
stock Rev Rule 69-608

Page 283 Problems:

(4) Charitable Contribution Followed by redemption

A SH of a closely held corp., may indirectly w/d earnings but avoide dividend treatement
by contributing stock to charity and causing the corp., to redeem the stock from the
charitable doness.
Rule- A contribution of stock followed by a redemption shall be treated as a dividend to
the donor only if the charitable doness is legally bound or can be compelled by the corp
to surrender the shares for redemption. Rev Rule 78-197.

Redemption Through Related Corporations


§304 prevents a SH from selling stock of one corp to another related corp in order to w/d
(bail out) earnings while treating the transaction as a sale rather than a dividend.
§304 applies when one or more controlling SH sell stock of one corp., to another
controlled corp (“brother-sister acquisition) or when any SH of a parent corp sells stock
of the parent to a sub (parent-sub)
§304 looks for dividend equivalency by applying §302 to determine if SH has sufficiently
reduced his interest in the corp., whose stock has been transferred
A owns all stock of X and Y, each who have a lot of E&P.
If either corp were to redeem shares held by A, distribution would be a dividend.
If A sells or part of her X stock to Y, the effect of the transaction is the same as a
dividend b/c A has w/d funds from Y w/o reducing her 100% control of corp

§304 Definitions:

§304 applies only to acquisitions of stock in return for “property”
“property- money securities, and other property but not stock, in the corporation making
the acquisition.

Acquiring Corporation
Corp that acquires stock form a SH of another related corp., in return for property

Issuing Corporation
Corp whose stock has been transferred.
(1) Ownership of stock possession at least 50% of the total combined voting power of all
classes of stock entitled to vote, or¸ 50% of the total value of shares of all classes of
stock §304(c)(1)
§318 attribution applies. §304(c)(3)

Mode Analysis

(1) Does §304 apply

More than 50% of value

(2) Does the constructive dividend qualify under §302 as a redemption determine if its a
Calculate amount of stock before in corporation
Calculate amount of stock in corp (remember to multiply %)

(3) If does not come under §302, then it is §301,

1. and you need to determine amount and source of dividend by looking at (1)
Acquiring corps E&P, and then (2) Issuing corp.’s E&P §304(b)(2)
2. and Acquring corp will take the transferors AB in the transferred stock
3. transferor increases his AB in the stock of the acquinring corp by his AB in the
transferred stock..

ex. (treated as A transferring the stock to Acquiring co in a 351 trans. Getting stock back.
A’s basis is the same as the basis in transferred asset; corps basis is the b transferred basis
of the stock)

If the constructive redemption is an exchange:

(where the before and after analysis provides or exchange treatment)
then A taxed under 1001 – if a gain its AR – AB = taxable gain = probably capital
gain (or loss) Acquiring corp takes the cost basis in the stock acquired.

(2) Brother-Sister Acquisition

Constructive Redemption
If one or more persons are in “control” of each of 2 corp nad sell stock of 1 corp to the
other corp., in retrun for property, property is treated for purpose of §302 and §303 as a
distributuion in redemption of the stock of the acquiring corp. §304(a)(1)
§304(a)(1)- 2 or more unlreated SH who in the agg. Control each of the 2 corp., sell stock
of one corp., to the other in related transaction even if no SH has control

Tax Consequences:
1) §301 Distribution
If under §301, look at E&P of acquiring corp., then E&P of issuing corp. §304(b)(2)

2) Exchange
SH recognizes a gain or loss measured by the difference b/t the AR and the AB in the
transferred stock
SH basis in the stock remains unchanged and acquiring corp takes a §1012 cost basis in
the issuing corp’s stock §1.304-2(a)
E&P reduction I limited by §312(n)(7) to an amount not in excess of redeemd stock’s
ratable shares of E&P.
Ex 1:
Ex 1:
A&B (unrelated) own 100 of the 200 shares of X corp and Y corp. respectively
X has 70K E&P, and Y has 40k E&P.
A sells 30 shares of X corp with AB of 10k to Y for 100k
Does this qualify under §304:
(1) A owns at least 50% of all classes YES! So §304 applies
(2) Before transfer A’s shares in issuing corp (X)- 50%
(3) After transfer A’s shares in issuing corp (X)- 70+1585/200- 42.5
(4) No change under §302 (need to analyze each, so comes under §301)
(5) §301 dividend treatment, so it will be 10k coming out of Y (Acquiring corp.) E&P.

(4) Relationship of §304 to Other Code Sections

(a) §351
§304(b)(3)(A)- §351 will not apply to any property received in a §304(a) distribution,
except that §304 will not apply to any debt incurred or assumed in connecton with the
acquisition of the transferred stock. §304(b)(3)(B)
Ex (1)
A owns 80/100 o/s shares of X corp. and Y corp
Both have E&)P
The remaining stock is owend by unrelated SH
A sells 20 shares of X (AB-4k, value 15k) to U for 15 shares (15k) and 5k cash
Transfer qualifies under §351 for the stock but §304 applies for the cash
Ex (2):
Same as above, except A transfer 20 shares of X to Y for 15 shares and a liability
incurred by A when he acquired X
A recognizes now gain under §351 and §357, and §304 does not apply to Y’s assumption
of liability.

Problem Page 299

(1) The Niedermeyer case is a good example of tax planning blunder. Illustrates the need
for §304
(a) Why did §304 apply to the sale by the TP of their AT&T common stock to Lents
(b) Given that §304 applied, how do you test the redemption to determine if the TP have
a dividend
(c) Why were the TP unable to waive family attribution and qualify for “sale” treatment
under §302(b)(3) – did not have complete termination of their interest.
(d) How could they have avoided this unfortunate result - if they had donated the
preferred shares before the transaction they could have waived the family attribtion rules
and thus would not have cnstructively owned AT and T

TP argued that it was a dividend not equivalent to - saying there was family animosity
- ct said should never consider family animosity
- txct says that if there is any reduction in ownership then can consider
TP argued that the PS was actually debt – this argument fails

TP can only integrate two tax transactions where there was a fixed and firm intent to
complete the second transaction,

(2) - P. 299
Bail corp. and Out corp each have 100 share of Common stock O/S.
Claude owns 80 share of Bail stock (AB of 40k or 500 per share) nad 60 shares of Out
stock (AB of 9k or 150/share)
Remaining B&O shares are owned by 1 individual who is not related to Claud
Bail hs no current or Accumulated E&P.
Out has no current and 5k of accumulated E&P
(a) Claude sells 20 of his out shares, in which he has 3k AB, to Bail for 4k – 304 governs
because claude owns 50% of the control of each.
- therefore it is a constructive redemption
is it a 301 or is it an exchange
do a before or after analysis
before – 60% before after – Actual 40 + constructive 16% (80% of 20%) = 56% ( does nt
satisfy substantial (not less than 50%) not dividend equal and went from 60% to 56%
thus its not an exchange
4k dividend results = Accumulated E & P is reduced from 5k to 1k Claudes basis is
increased by 3k in bail. And bails basis is 3k in the transferred shares.

(b) C sells all out to B for 12k –

304 applies as above
it’s a constructive redemption – is it exchange treatment
do a before after analysis
Before (A) 60% after (A) )0 and (C) is 48%
Not a substantially disproportionate 80% of 60% = 48% > 46% and thus not
Not a complete termination
Redemption not essentially a dividend – yes – he had control and now it’s a minority.
This it’s a meaningful reduction. – exchange treatment.
Bails basis in 60 shares is 12k. Claudes is taxed under 1001 AR = 12k AB = 9k = gain of
3k =its cap gain and held for longer than one year its cap gain.

(c) Same as (a), except that C receives 3k and 1 share of Bail (FMV of 1k) for his 20 of
out shares
this would qualify under 351 and 304 – in these circumstances 304 governs
transfer of prop in addition of stock
receive in exchange stock
(d) same as (a) except that Clreceives one share and 3k in liability. 304 still governs.
304b3b situation not governed by 304 if liability incurred to acquire the stock. (see
page 291-292)

immediately after must control (ie 80%) - tax consequences - got boot - tax the lesser of
the realized gain (AR 4k – AB 3k = 1k) or the boot ( 3k) thus taxed on 1k its also capital
However – t304 says the boot requires treatment as dividend.
(2) §304 still necessary

Chapter 6: Stock Dividends and §306 Stock

(a) Types of Stock Distributions:
Corp makes a stock distribution when it distributes its own stock to some or all of its SH
Stock distributions include:
Stock dividends and Stock splits
Stock dividend may differ from a stock split
Stock Split- increasing number of o/s shares of the same class
Stock Dividend- smaller and may be of another class of stock (ex- preferred)

(b)History of Taxation of Stock Distributions

Eisner v. Macomber;
Common on common stk dividend was not taxable b/c not gross income under 16th
Common on preferred stock dividend was taxable b/c the SH received an interest
different from her former stock holdings. Koshland v. Hlevering
Test Stock dividend is only table only if it increased a SH proportionate interest in the
Strossberger v. commissioner – dividend of PS does not create ataxable event – see 305
§305 is new rule
Policy of §305
Stock dividend is not taxable if it does not increase a SH proportionate ownership interest
in the corporation.
If it does increase the interest or SH gets cash or property and other increase their
proportionate interest, then taxable

(2) Nontaxable Stock Distributions

(a) General Rule
§305- stock distributions are not includible in GI unless an exception in §305(b) applies
Ex of non-taxable dividends are “common on common and preferred on common” where
no other classes of stock are o/s

(b) Allocation of Basis

“new stock” is not taxable, the SH basis in the stock held prior to the distribution “old
stock” is allocated b/t the old and new in proportion to the relative FMV of each on the
date of the distribution. §307(a)
Ex 1
A owns 100 of X c/s worth 12k or 120/share
2 for 1 split gets another 100 CS shares
Not taxable, and A allocates his 12k basis b/t old and new shares, 12k/200 so $60/share
Ex 2
A owns 100 shares of X, with basis of 12k (120/share)
2 for 1 split A gets 25 shares with 25k (100/share)
Value of A’s common stock after distribution is 75k
A allocated 12k basis in the common b’/t common and preferred based on FMV. (75%
common and 25% preferred)

(c) Holding Period of New Stock

Holding period of the old stock. §1223(5) ie you can tack.

(d) Consequences to Distributing Corporation

Distributing corp., recognizes no gain or loss on nontaxable stock distribution (§311(a)
(1)) and may not reduce E&P §312(d)(1)(B) ie no effect on e & p

(3) Taxable Stock Distributions

Stock distributions in §305(b) are treated as distributions to which §301 applies and thus
are dividends to the extent of the distributing corp. available E&P if it exceeds it reduces
the basis of the stock once reduced to zero then it is capital gain
Amount of the distribution is the FMV of the distributed stock. §1.305-1(b)(1)

(a) Election of Stock or Property

§305(b)(1) If distribution , at ANY sh election is payable either in (1) stock of the dis.
Corp, or (2) ccash or other property, the distribution is taxable to all SH regardless of
wehter any SH exercises the election.
SH who participate in stock reinvestment plans by acquiring stock in lieu of cash
dividends are taxable under §305(b)(1) on the FMV of the stock received. Rev Rule 78-
X only has common stock o/s.
X declares a cash dividend of 10/share or SH may elect to receive add’l C.S with a value
of 10/share held
SH who elect to receive stock are treated as a §301 distribution of 10/share, even if all SH
elect stock. Reg 1.305-2(a)
(b) Disproportionate Distributions
If result is that some SH receive cash or other property, while other increase their
proportionate interest in the earnings or assets of the corp., those who increase their
proportionate interest are taxed on the value of the increased interest. §305(b)(2)
Cash and stock distributions can have a disproportionate effect even if they are not
pursuant to a plan and are unrelated.
If separated by more than 36 months, the are presumed to be beyond the reach of §305(b)
(2) unless they are made pursuant to an integrated pan. Reg 1.305-3(b)(2), (4)
X corp has 2 class of CS o/s.
A and B and each class has equal right
X pays a 10/share on A stock dividend and a dividend on class B stock payable in
additional shares of B stock with 10/share
Taxable- B SH increase their proportionate interest in earnings and assets of X while the
Class A SH receive cash. Reg 1.305-3(e)
Ex 2:
X has 2 class of stock o/s- Common and Preferred
X declares dividend on the Common payable in a add. Common stock and pays a cash
dividend on the preferred stock.
Cash dividend taxable, but common on common is not b/c does not increase the
proportionate. Reg. 1.305-3(e)- Ex 2
Ex 3:
Now, C.S dividend is shares of prereed. Now C.S proportionate has increased, dividend is
If it was subordinate to all preferred stock, not taxable b/c no increase in proportionate
interests of the common SH.
Issuance of junior preferred stock does not give the common SH more than they had
before the distribution. §1.305-3(e).

(c) Distributions of Common and Preferred stock

If a distribution has the result of some common SH receiving preferred stock, and other
receiving common stock, all are taxable. §305(b)(3)
X has Class A and Class B CS
X declares a divdened on Class A stock payable in addl’t shares of Class and a dividend
on Class B stock, payable in preferred stock.
Both distributions are taxable. Reg. 1.305-4(b).
(d) Distributions on preferred stock
All distributions on P.S are taxable except for an increase in the conversion ratio of
convertible preferred stock that is made solely to take account of a stock dividend or split.
Reg. 1.305-5(a)- PS is any stock which does not participate in corp., growth to any
significant extent and has limited rights and privileges.
Ex 1:
X has two class of stock o.s. (1) common and non-convertible preferred
X declares a dividend on both common and preferred, in each case payable in additional
shares of the common.
Distribution is taxable to the preferred but not the common.
Ex 2:
X has two class of stock o/s. one common and one preferred
Each share of preferred is convertible into 2 share of common. X pay a dividend of one
share of common stock for each common share held and doubles the conversion ration of
Neither the C.S or doubling of conversion ratio is taxable.
(e) Distributions of Convertible Preferred Stock
A distribution of convertible P.S is taxable unless the P establishes to the satisfaction of
the service that it will not have the result of a disproportionate distribution. §305(b)(5)
Disproportionate right to convert must be exercised w/in a short period and it is likely
that some SH will convert and others will not, taking into account factors such as the
dividend rate and market conditions
If right is exercised over many years, and the extent of conversion cannot be predicted,
the corp., probably can establish that the distribution will not have a disproportionate
effect. Reg 1.305-6(a)(2).
X corp. has only 1 c/s o/s
Declares a dividend payable in the new issue of preferred stock convertible into common
for a period of 20 years.
If corp., can show that it is impossible to predict the extent to which the preferred will be
conveterd, distribution is not taxable.
If however, the prefreed was over a short period of time, and on the facts, it was likely
that some SH would covert while others would sell their stock, the distribution is taxable,
b/c it result in the receipt of case by some SH and an increase in the proportionate
interest of others. Reg. 1.305-6(b). Ex (1), (2).

(g) Basis and Holding Period

Basis to a SH who receives a taxable stk dividend is the FMV of the distributed stock.
Holding period of the stock commences as the date of the distribution.
(h) Consequences to the Distribution Corp.,
Distributing corp., recognizes no gain or loss on a taxable stock distribution/ §311(a)(1)
Corp may reduce its E&P by t he FMV of the distributed stock. Reg 1.312-1(d)

(4) Distributions of Stock Rights

(a) Rights Defined
Rights are options to purchase shares from an issuing corp., at a fixed priced during a
relatively short period of time.
(b) Nontaxable Rights
Taxed if it has one of the effects described in §305(b).


In the case of a redemption – the commissioner has the authority to declare it a
constructive cash dividend. –
Ex. a owns 80 and b owns 20. A gets cash for 10 shares redeemed. B gets increased
percentage of ownership - and thus a disproportionate distrubution –
only under 301 and
occur under a periodic redemption plan.

What if b gets additional shares to compensate – that’s ok

Problem Page 313 – see problems

Hilll is organized into two classes of stock Frank owns 100 shares of Class A and Fay
and Joyce each own 50 shares of class B.

A) Pro rata share of non convertible PS – this is not taxable

B) class b have option to take cash in lieu of distribution. – this is taxable 305b1 – this is
true for those that elect to take cash and those that don’t and applies to all classes of
C) a pro rata distrubition on class a and cash on class b – this is taxable to all due to
D) class b is nonconvertible PS and Hill distributes class b stock to class A - 305b2 this
is taxable
E) same as d above hill distributes a class of PS that is Juniour to Class B
current E and P = 100
dividend ps = 20
CS = 80

non taxable –
f) assume on one class common outstanding. Issue – 10% debentures –convertible into
common stock at 1 Cs:: $1000 debenture.
hill makes annual interest payment and one month later distribute common on common
stock dividend w/o adjusting the conversion ration of the debentures

the treatment of the convertible debenture is considered stock - 305(d)

thus this is a disproportionate distribution under 305b2 bc frank gets a greater interest in
the corp on distrubtion – if the conversion ratio changed to reflect this and keep her %
interest in the biz the same.

g) same as f but the debentures are convertible preferred stock. Corp declares a one for
one split on the CS and the preferred ratio is doubled. –
this is non taxable – it’s a proportionate ratio

h) 305b3 - taxable. Class a get common and class b get preferred.

i) a gets 100 cs and b gets conv preffered over long term. -

if short term – some would convert and some would not convert – causing a
disproportionate dist. – with long term --- there is no disproportionate dist.

a has 500sh
b has 300sh
c has 200sh

z corp has one class of CS – will 305c3 if there is a redemption plan for a shares.

Before is a 50%/30%20%
Yr 1 After its 47.4%/31.6%/21.0%

Is it a redemption – exchange treatment – 302b1 as a redemption not equivalent to the

dividend - he had veto power before now he doesn’t. this is not taxed under 301 and
thus commissioner could not regard this a a constructive dividend.
Yr 2 – 44.4/33.3/22.0

This redemption is no longer meaningful. – and does not satisfy the 8% test. – 301
applies. And could treat it as a constructive stock dividend.

§306 STOCK

(1) Preferred Stock Bailout

(a) Background
Device used by SH before 1954 to w/d corporate earnings at LTCG rates.
Profitable corp., would make a tax-free distribution of preferred stock to its common SH.
SH would then sell preferred stock to an investor, reporting LTCG- corp would then
repurchase the PS from the investor after a number of years.
In computing the gain, a SH basis in the common was allocated to the preferred.
Net effect was that SH received cash w/o reducing their prop., interest in the corp., the
essence of a dividend
Chamberlin v. CommissionerRejected IRS saying this was taxable like a dividend and
held that it was a good transaction.

(b) Overview of §306

§306 stock stock with bailout potentional
SH must recognize ord. income rather than capital gain on sale, redemption or other
disposition of stock.
D/A under §305- SH may not offset her stock basis against the AR on a disposition of
§306 stock.
Exceptions for dispositions, such as complete terminations of a SH interest in the corp.,
that do not have bail out potential.

(2) Definition of §306 Stock

(a) In General
Principal category of §306 stock is: Preferred stock distributed to a SH as a tax-free
dividend under §305(a);
Common stock is not included b/c it participates in corporate growth and thus lacks bail-
out potential. §306(c)(1)(A)
If stock has either a limited right to dividends or limited right to assets upon liquidations,
it is not “common stock” for this purposes. Rev Rule 79-163
Voting C.S that is subject to the issuing corp. right of first refusal at net book value is
“common stock” Rev Rul. 76-386
(b) No E&P
§306 does not include stock distributed by a corp w/ no current or accumulated E& P for
the year of distribution.
Test- whether no part of a tax-free stock distribution would have been a dividend if cash
has been distributed instead of stock. §306(c)(2)
If even a small part of a cash distribution would have been a dividend, then all the stock
is §306 stock.
X. corp, makes a tax-free distribution of preferred stock with a value of 25k to its
common SH.
X has no accumulated E&P
On July 1, X has current E&P of 10k but at end of year, 1k E&P deficit.
Preferred stock is not §306 stock b/c a distribution of cash in lieu of stock would have not
been a dividend.
If X had ended the year w/ S20 current E&P, all preferred stock would be §306 stock.

(c) Stock with Transferred or Substituted Basis

§306 stock includes stock which has a transferred or exchanged basis determined by
reference to the basis of §306 stock. §306(c)(1)(c)
Ex include
Stocks received as a gift
Stock received in exchange for §306 stock in a tax-free §351 transaction
§306 taint is removed for death, b/c §1014, date of death basis
Death FMV so no 306 taint!
Ex 1:
Parent gives 100 shares of X corp to child of §306
Stock remains §306 stock in child’s hand.
If parent were to die and bequeath the stock to child,
It would no longer be §306 stock
Ex 2:
A transfers 100 shares of §306 p.s. to Y in exchange for 100 shares of Y corp. common
stock that is tax-free under §351(a)
X corp., preferred stock (§362(a) basis) and the Y corp. common stock (substituted basis
determined by reference to the Y corp., under §358(a)) are each §306 stock.

(e) Certain Stock Acquired in a §351 Exchange

Preferred stock acquired in a §351 exchange is §306 stock if the receipt of money instead
of the stock would have been treated as a dividend to any extent. §306(c)(3).
A is the sole common SH of X corp., with ample E&P
A transfers her X common stock to a newly formed Y corp., in exchange for Y common
and Preferred stock
Y preferred stock will be §306 stock b/c a transfer of cash to A in lieu of the preferred
stock would have been treated as a dividend under §304(a)(1)

(3) Dispositions of §306 Stock

(a) Redemptions
If §306 stock is redeemed, the AR by the redeemed SH is treated as a distribution of
property as to which §301 applies and this is taxable as a dividend to the extent of the
corp.’s current or accumulated E&P at the time of the redemption. §306(a)(2)
Balance, if any, of the AR is first treated as a reduction of basis and then if necessary as a
capital gain under distribution rules of §301
X makes a tax-free distribution of preferred stock with a value of 20k to its common SH
X has 5k of E&P at time of distribution
A’s allocable basis in the P.S(§306) is 10k
2 years later, X redeems A’s preferred stock for 20k, at a time when X has 30k of E&P
A continues to own 100% of common stock.
Entire 20k AR on the redemption is a dividend.
A’s basis in the preferred stock probably is added back to the basis of A’s common stock.
If X had no E&P at the time of the redemption, entire 20k would be return of capital
under §301©(2)
A probably could reduce his basis in both the preferred and the common stock before
recognizing any gain.

(b) Sales and Other Dispositions

On a sale or other disposition of §306 stock, the AR is first treated as Ordinary income to
the extent of the stock’s ratable share of the amount that would have been a dividend at
the time of the distribution if cash, rather than stock had been distributed.
O.I is not considered a dividend, and thus corporate SH are not allowed a §243 dividends
received deduction, and the corp., may not reduce its E&P. Reg 1.306-1(b)
The balance, if any, of the the amount realized first reduces the basis of the §306 stock,
and any excess is treated as a gain from the sale or excahgne fo the stokc. §306(a)(1)(B).
No loss may be recognized on a disposition of §306 stock, but any unrecovered basis is
allocated back to the stock w/ respect to which the §306 stock was distributed. §306(a)(1)
(C) Reg 1.306-1(b)(2) Ex 2 and 3
Ex 1
X corp., makes a tax-free distribution of prefreed stock with a value of 20k to its sole
common SH A
X has 50k of E&P at the time of the distribution
A’s allocatable basis in the preferred stock (§306) is 2k
Two years later, X has no E&P, A sells the §306 stock for 24k
Of this amount, 20k is treated as ordinary income; this is the amount that would have
been a taxable dividend if cash, rather than stock has been distributed at the time of the
This the amount that would have been taxable if cash rather than stock has been
distributed at time of distribution
2k is a reduction of A’s basis in the P.S and 2k is treated as a gain from sale of stock
Ex 2
Say X’s E&P was 8k, at time of distribution, A’s AR on sale of §306 is ordinary income
the 2k is reduction of basis, and 14k is treated as a gain from sale of the stock.
Ex 3
Same as (1), except A sells the §306 stock for 21k. Of this amount, 20k is treated as
ordinary income, and 1k is a reduction of A’s 2k basis in the preferred stock.
No loss will be allowed.
A may add the remaining 1k basis in the preferred back to his basis in the X common
stock. Reg 1.306-1(b)(2) Example 2.

(c) Exempt Dispositions

Four types of dispositions are exempted from the rule of §306(a) b/c they do not
represent any opportunity for bail out.

(1) Complete Terminations and Partial Liquidations

Disposition of §306 stock in a transaction (other than a redemption) that terminates the
SH entire stock interest in the corp is exempt if the SH does not transfer the stock to a
§318 related person or entity. §306(b)(1)(A)(ii)
§318 attribution rules apply. §306(b)(1)(A)(iii)
Redemption of §306 stock that result in complete termination of the SH interest under
§302(b)(3) or qualify as partial liquidation under §302(b)(4) are also exempt. §306(b)(1)
A owns 500 shares of X corp., common stock and 250 shares of X corp. preferred §306
stock. She owns no X stock constructively.
A sells all of her common and preferred stock to an unrelated person.
A’s sale of the preferred stock is not subject to §306(a) b/c she completely terminates her
interest in the corporation.
(2) Complete Liquidations
§306(a) does not apply to a redemption of §306 stock in a complete liquidations.
(3) Nonrecognition Transactions
Dispositions that qualify for nonrecognition treatment, such as §351 transfers,
contributions to capital and tax-free exchanges of stock under §1036 are exempt. §306(b)
Any stock received in a tax-free exchange, however, becomes §306 stock. §306(c)(1)(C).

4) Transactions Not in Avoidance of Tax

§306(a) does not apply if the TP satisfies the service that either:
(a)distribution and the subsequent disposition or redemption of §306 stock or
(b)in the case of a prior or simultaneous disposition (or redemption) of the underlying
stock with respect to §306 stock was issued, the disposition or redemption of the §306
stock was not made pursuant to a plan having federal tax avoidance as one of its principal
purposes. §306(b)(4)
§306(b)(4) relief is not automatically available, on dispositions of prefreed stock of
wildely held corp.
Case: Fire Oved:
The court in Fireoved held that the prior sale of a portion of the common did not exempt
a corresponding portion of the preferred from § 306(a) treatment b/c the taxpayer had the
same degree of control after the sale of the common stock as he did before.
The court asserted that the evil § 306 was enacted to address was the ability of a
shareholder to realize upon the accumulated E & P of the corporation (through the sale of
preferred stock to a third party) without diminishing his control.
Problem here veto power
See – handout on 306 for step by step

P. 330 – Corp non convert non vote PS worth 1k to J and V each had basis of 2k prior to
dist and avalue of 3k after. Corp. had E and P of 2k and Y3 E and P of 3k

a) in yr 1: distribution of PS is tax free (no gain or loss (305a)) and have to reallocate
basis after distribution from CS to CS and PS
AB of PS= FMV of New / FMV of OLD * old basis
1k/ 3k +1k = ¼ * 2k = 500 basis in pf and 1500 basis in
No tax consequences to arg. – no reduction of e and p
b) V sells PS to Carl for 1k in year 3. There was 2k in E and P thus all 2k would be a
cash dist (dividend). she received 1k. J received the other 1k: AR on sale is Ord Income.
all 1k is taxed as OI – 15% dividend rate.
Problem is she had a basis in the PS of 500; this disappears and flows back into the
common. Thus the CS basis returns to 2000 (from 1500 after reallocation)

c) same as B but V sells to carl for 1750 – the first 1k is treated as OI (as above). the next
500 reduces basis in the PS to zero. The rest (250) is capital gain.

d) same as b but there is no E and P at time of distribution. 306 is designed to prevent a

bailout of E&P if there is no E&P there is no need to apply 306. This is not 306 stock
then normal rules apply. its 1001 AR-AB 1000-500 = cap gain of 500.

e) if J gives to grandson. Generally - GS gets the transferred basis (still 306) sells stock to
unrelated party. 306 does not apply in certain circumstances (see above) grandson does
not have attribution interest—it’s a complete termination of interest. GS sold stock to
unrelated party for 1000. Exceptions: 306b1 termination of sh interest not in redemption.
This is treated as a sale AR –AB = 1000-500 = Cap gain of 500.

306 does not apply in death bequeaths – the stock loses its 306 status. There is a step up
in basis to FMV at the time of death.

f) skip

g) see firoved handout – CS - before and after analysis before 50% after 33 1/3 % - is
this substantially disproportionate. – 1. Must have less than 50% and voting power must
be 80% of what it was before. Both satisfied. Thus is a substantially disproportionate
Redemption of 306 exception (and wont apply) – complete termination of interest or
partial liquidation. Does not occur here. Must argue that qualify under 306b4 see
fireoved. In fireoved – he maintained his same level of control (veto power) here
probably did not retain the same level of control after the redemption. Went from veto to
no veto. – should be able to get exchange treatment.

Chapter 7 Complete Liquidations

(A) Complete Liquidation Defined

Corp distributes all of its assets (or proceeds of their sale) subject to any liabilities, to its
SH in exchange for all their stock
Corp then dissolves under state law.
§1.332-2(c)- Corp. liquidates for tax purposes when it ceases to be a going concern and
its activities are merely for the purpose of winding up its affairs, paying its debts and
distribution any remaining balance to SH
Corp sells to 3rd party assets to pay creditors and give cash to SH and to satisfy claims to
creditors and SH.

(B) Complete Liquidation under §331

(1) Consequences to the SH

Recognition of G/L
§331(a)- Amounts distributed to a SH in a complete liquidation are treated as in a full
payment in exchange for the SH stock.
Capital Gain or Loss AR – AB in stock
AR-amount of money and the FMV of all other property received from the liquidating
corporation – liabilities assumed by the SH or encumbering property.
Remember it triggers 1001 = AR-AB = G/L ( cap gain or loss.

(2) Basis of Distributed Property

§334(a)- SH basis on §331 is FMV of the property on the date of distribution, w/o
reduction for any liabilities to which the property is subject.

(C) Consequences to the Corporation under §336

(1) Recognition of Gain or Loss

Corp., recognizes G or L (different from non liquidation dist) when it distributes
property in a complete liquidation as if it had sold the property to the distrbutee for its
G/L is determined seperatly on each asset.
Exception to Loss Channel stuffing provisions

(2) Limits on Gain or Loss

S336(d) Limits the recognition of loss by distributing corp., in 3 situations
(1) Distributions to Related Persons §336(d)(1)(B)
No loss can be recognized to a §267 related person if the distribution is:
Not pro rata or is
Disqualified property
Related person
§267(b)(2) SH owns directly or indirectly through attribution >50% in value of corp.’s
o/s stock.
Non Pro-rata
§336(d)(1)(A)(i)- not distributed to the SH in the same proportion as their stock
ownership in the corp.
Disqualified Property:
Any property acquired by the liquidating corp. in a §351 transaction or as a contribution
to capital during the 5-year period ending on the date of distribution. §336(d)(1)(B)
(2) Property Acquired for Tax Avoidance Purpose§336(d)(2)
§336(d)(2) 2 years, and only to extent of built in loss. (look at old exam)
If property distributed, sold or exchanged by corp., was acquired in a §351 transaction or
as a contribution to cap as part of plan where principal purpose was to recognize a loss in
connection w/ liquation.
Can only disallow the loss that accrued before the corp., acquired property.
Corp has to reduce its basis for determining the loss by the pre-contribution built in loss
i.e- excess of the AB of the property when it was acquired over the FMV of the property
at that time.
P. 349

a) Corp will recognize a gain of 300k. and a loss of 400k. no disqualified property
distributed pro rata. And no distribution within 2 years ie net loss of 100k

b) this is not a pro rata distribution thus cant recognize the loss of 400k. thus there is a
gain of 300k

c) gainacre gain is 300k loss acre loss of 400k = just net the gain and loss 336d1 and
2 don’t apply 1. Not related 2. After 5 years.

d) not subject to d2. Is it a distribution to related person that is disqualified. – is

disqualified bc it is a contribution to capital within the 5 year property. Isqualifies the
protion of the los distributed to the related person. Thus cant recognize the 240k loss
distributed to ivan

recall - Exception on 362(e)(2)

If transferee’s aggregate Adjusted Basis of such property so transferred would exceed the
FMV of such property immediately after such transaction then, notwithstanding (a) the
transferee’s aggregate AB of the property so transferred shall note exceed the FMV of
such property immediately after the transaction.
Aggregate AB must exceed FMV of transferred property
Allocation §362(e)(2)(b)
Allocated amongst the property in proportion to its built in losses.
Ex: 23AB and 20 FMV..so 3k difference reduce the basis by 3k in the property
E) 362 did not apply - 336d2 applies here bc transfer is within 2 years of liquidation - is
an irrebutable presumption – unless there is a relationship to the business operations.
Bc 336d2 applies - you squeeze out the built in loss of the property- thus you step
down the basis from 800k to fmv at time the asset was transferred to corp. 300k gain of
gain acre and a 300k loss of lossacre

What happens if 362(e) (2) did apply at the time property transferred to the corp. step
it down at the time of the transfer – result is the same.

F) if 362 e2 applied –

Ivan contributed gainacre and 362e2 applied - trying to reduce the aggregate
basis fro 900k aggregate to 800k aggregate. With respect to lossacre you reduce it to
700k reduce the aggregate basis to the aggregate fmv.
property – thus cant recognize loss of DQ prop to related person – only recognize a loss
of 60k by flo.

g) 362e2 applied to ivans contribution to x and 336d2 applied to lossacre bc there

was a plan. - at time of contribution there was a step down from 700k to 400k
then there is a distrubition to I and F – 336d2 applies. corp Cant recognize loss to
distribution to Ivan. As to Flo bc 336d2 applies – corp
At time of transfer
362e2 applies corp would take basis fmv (reduce adj basis of the poperites by 100k to
800k – allocate to the loss property)
properties are disqualified - since we are distributing lossace must eliminate the built in
loss (here 300k) 700k to 400k.

Redo of the last problem

F) now assume that Ivan and Fow own 80/20 of X Ivan contributed Gainacre and
Flo contributed 200k
Lossacre is a 336d1 disqualified property
362e2 applied to ivans contributions to X but 336d2 does not apply to the liquidation
distrbution of lossacre because there ws no plan for X to recognize loss


Subsidiary Liquidation
Viewed as a mere change in form – not a taxation event
80% total value of all stock – and 80% of the total voting power (BOTH)
§332 and §337 generally provide that neither the parent SH nor the liquidating corp
recognize gain or loss on the receipt of property in complete liquidation of an 80% or
more subsidiary.
Parent takes the distributed assets with a transferred basis under 334b1
Holding period also tacks on.
Sub asset bases and other tax attributes transfer to the parent

Consequence to SH basis in Distributed Property

Parent- transferred basis and a tacked holding period in a §332.
treated as a normal liquidation
distributed to Minority SH Basis is FMV
holding period begins on the date of distribution

Effect on Recipient Taxable Income No g/l

Distribution to 80%- 80%
§332 No gain or loss
Distribution to Minority §331
§331 No gain or loss

Effect on Corp’s Taxable Income

If §332 applies, sub recognizes no gain or loss.
Minority§336 included §336(d)(3)
Can recognize Gain but not loss to a minority SH in a §332 Liquidation

a) S recognizes a gain on the distribution if inv. No gain recognized on Land to P

P wont recognize gain – uses a transferred basis. I recognizes a gain in excess of its basis
thus there is a gain of 800. Takes a basis of 1000k. S recognized gainon inventory of 900

b)S gets no loss recognized for distribution of equip to I . no gain or loss recognized
to P
P does not recognize a gain or loss and takes a transferred basis. I takes a basis of 1k in
What could it do – sell the equipment and take the loss – if 336d2 applied however,
reduce the basis of the equipment to 1000. (sold in connection with a liquidation).


Reorg occurs where corp acquires stock of another corp for its own stock


P= Parent/Purchaser

T merges into P
P survives
SH of T receive shares of P this is a tax free reorg 368.

This is tax free to the SH of T (351)

Reason is that they have not cashed out – continued their investment
SH take the same basis in the new shares that they had in the original stock
Holding period tacks on.

If the SH receive anything other than stock – it is deemed as boot.

Basis is the adj basis in the old T stock minus the FMV of the boot + the gain recognized.
The gain recognized – is the lesser of the realized gain or the FMV of the boot

The trick is to determine what a tax free reorganization is


acquisitive reorganizations are set forth in 368a1a,b,c,

(A) a statutory merger or consolidation;
(B) STOCK FOR STOCK EXCHANGE - the acquisition by one corporation, in
exchange solely for all or a part of its voting stock (or in exchange solely for all or a part
of the voting stock of a corporation which is in control of the acquiring corporation), of
stock of another corporation if, immediately after the acquisition, the acquiring
corporation has control of such other corporation (whether or not such acquiring
corporation had control immediately before the acquisition);
(C) STOCK FOR ASSETS - the acquisition by one corporation, in exchange solely for
all or a part of its voting stock (or in exchange solely for all or a part of the voting stock
of a corporation which is in control of the acquiring corporation), of substantially all of
the properties of another corporation, but in determining whether the exchange is solely
for stock the assumption by the acquiring corporation of a liability of the other shall be

Control is defined in 368c - 80% of voting power and 80% of all other stock

CTs have added their own requirements to reorganizations

SC held that a 99cash 1% stock – was not a valid transaction – this was not
intended to be a reorganization – too much like a purchase of assets . – amount of
consideration of stock must be stock
40% stock to boot ratio is ok. So 10% stock is not a reorganization. – not a continuity
of interest.

Does there have to be historic continuity?

No. it doesn’t make a difference if a sufficient number of old sh receive stock.

100% of SH receive stock but pursuant to preexisting agreement that sale of new stock
is this a reorg.

Judicial Requirements for a tax free Reorg

1. continuity of proprietary enterprise

(Boot can be 60%)
2. continuity of business enterprise
IRS used to require that new biz conduct identical business as prior to reorg.
Now that is not the case, just have to use the business assets
3. business purpose.
There must be a purpose.


Must be voting Stock

Corp acquiring must become the controlling sh (80%)
Cant have two transactions that constitute a single transaction – and one
transaction has some boot.


acquiring corp must get substantially all the assets of the target
what is substantially all?
Gross assets – liabilities = net assets
It is substantially all if 70% of gross assets AND 90% of net assets.

You can have some boot in a C reorg – up to 20% can include boots – includes
assumed liabilities)
Target must dissolve.


Can create a drop down subsidiary – if T ( P then P acquires all liablilites

If use a B or C can use parents stock

Forward triangular merger

P drops down S and S acquires T T dissolves.

Reverse triangular merger

P drops down S and T acquires S S dissolves