Corporate Tax Outline

Class 1

ADL Chapter 1: The Corporate Double Tax

1.1 Introduction and History

We have a corporate income tax continuously since 1909, longer than we have had a personal income tax

16th Amendment, passed in 1913, secured the constitutional foundation of the corporate income tax, whether
characterized as an income or excise tax

The Internal Revenue Code is organized thus: subtitles are divided into chapters which are divided into
subchapters which are divided into parts which are divided into sections which are divided into subsections

Most rules of corporate taxation are found in Subchapter C; the basic premise is that a corporation should be a
taxpayer distinct from its shareholder; from this premise flows the basic central feature of corporate taxation –
double taxation of corporate profits

General Utilities doctrine  when a corporation distributed appreciated property to shareholders, the Court
concluded that no gain or loss was recognized at the corporate level; The General Utilities doctrine and
congressional attempts to circumscribe its potential for abuse influenced the development of subchapter C

The General Utilities doctrine was substantially repealed by the Tax Reform Act of 1986

Historically, distributed corporate profits were treated as ordinary income to shareholders, while gain from the sale
of corporate stock has always been treated as capital gain; since 2003, “qualified” dividends paid to individuals have
been taxed at long-term capital gains rates (see §1(h)(11))

Corporations determine their gross income like other taxpayers (§61), may deduct their ordinary and necessary
business expenses (§162), may deduct interest (§163), and may deduct losses (§165) just like individual taxpayers.

ADL Ch 3 The Corporation as a Taxable Entity

ADL 3.01 Corporate Tax Rates and Bases

For corporations with taxable incomes of $100,000 or less:

 15% tax rate up on income up to $50,000

 25% tax rate on income between $50,000 and $75,000
 34% tax rate on income in excess of $75,000

Taxable income in excess of $10M is taxed at 35%

For corporations with taxable income in excess of $18,333,333, all income is taxed at 35%; the graduation is
eliminated in a convoluted manner through two surtaxes

1. An additional 5% tax is imposed on corporate taxable income in excess of $100,000, with a maximum
additional tax of $11,750 (income from $100,000 to $335,000 is taxed at 39%)
2. A surtax phases out the 34% bracket for corporate taxpayers with taxable income exceeding $15M
(corporate taxpayers with incomes between $15M and $18,333,333 face a marginal tax rate of 38%)
“Qualified” personal service corporation  no benefits of gradation; pay taxes at a flat 35% (§11(b))

A corporation is a qualified personal service corporation if it meets a function test and an ownership test

 Function test: substantially all of the activities of the corporation must involve the performance of services
in the fields of health, law, engineering, architecture, accounting, actuarial science, performance arts, or
consulting
 Ownership test: substantially all of the stock (by value) of the corporation must be held directly or
indirectly by employees performing those services, retired employees who performed those services in the
past, by their estates, or by persons who hold stock in the corporation by reason of death of such an
employee or retired employee within the past two years

Benefit of qualified personal service corporation  can use cash basis accounting

The graduated income tax rate structure may lure a high income individual to use the corporate form to shelter
income form the top individual rates (for individuals, the top tax rate applicable to most long-term capital gains and
qualified dividends is 20%, while the top tax rate for ordinary income is 39.6%)

For corporations, capital gains, whether long-term or short-term, are taxed at the same rate as ordinary income

Capital losses of corporations are also treated differently than those of individual taxpayers; a corporation can
deduct capital losses only to the extent of capital gains (other taxpayers can use capital losses to offset up to $3,000
of ordinary income)

Corporations can only carry back losses for three years or carry forward for five years (unlike individuals, who can
carry back or forward indefinitely)

Note that qualified dividend income is still ordinary income, not long-term capital gain, and therefore generally
cannot be offset by capital loss

unlike an individual, a corporation has no AGI from which deductions are taken to determine taxable income; a
corporation computes its taxable income by subtracting all deductions directly from gross income

Corporations (unlike individuals) have no standard deduction, personal exemption deduction, or personal deductions

§162 does allow corporations to deduct expenses incurred for the production of income even if the income is not
derived from a trade or business

§170(b)(2) allows corporations to deduct charitable contributions, but only up to 10% of taxable income

Corporate tax credits offset tax liability dollar for dollar:

 §27 and §901 – foreign tax credits (most significant for corporations)
 §41 – research and development
 §51 – targeted job expenditures
 §§46-48 – rehabilitation and energy expenditures

Corporate alternative minimum tax (§55(a))  taxpayer pays the excess, if any, of its minimum tax liability over its
regular tax liability; in effect, the taxpayer’s total federal income tax liability equals the greater of its regular tax
liability or its minimum tax liability
The corporate minimum tax equals 20% of a corporation’s alternative minimum taxable income (AMTI) less an
exemption amount. (§55(b)(1)(B) and (d)(2)); the exemption amount equals $40,000, reduced, but not below zero,
by ¼ of the corporation’s AMTI above $150,000 (§55(d)(3)); thus, the exemption amount is zero for a corporation
with an AMTI equal to at least $310,000

AMTI is defined as regular taxable income increased or decreased by specific tax preferences and other adjustments.
§55. Many of the adjustments modify the timing of corporate deductions rather than their amount. §§56-58.

e.g. under §168 the cost of depreciable real estate used in a trade or business is recovered ratably over 27.5 years; for
the AMTI the period is lengthened to 40 years; thus, for a piece of real estate costing $275,000, the regular cost
recovery is $10,000 per year ($275,000/27.5) while the annual AMTI deduction is $6,875 per year ($275,000/40);
so, for the first 27.5 years taxable income is increased by $3,125 ($10,000 - $6,875) in calculating AMTI, but in
years 27.5 through 40 taxable income is decreased by $6,875 in calculating AMTI (note that although such a
downward adjustment to AMTI is permitted – see §56(a) – it may produce no tax benefit to the corporation because
the corporation’s effective tax liability is the greater of the regular tax or the AMT)

Alternative minimum tax credit  a credit against the taxpayer’s regular tax liability (§53)

A corporation with earnings in excess of AMTI must include a portion of such excess in AMTI. §56(g)

Corporate AMTI includes ¾ of a corporation’s “adjusted current earnings” over AMTI (determined without the
addition discussed directly above).

Adjusted current earnings consist of AMTI minus the alternative net operating loss deduction and less adjustments
intended to better reflect the economic picture of the corporation

AMTI is computed using an “alternative” net operating loss because “regular” net operating loss may reflect the tax
preferences that the AMT is trying to address. §56(a)(4).

Alternative net operating loss is determined by adding to taxable income any tax preferences or adjustments. §56(d)
(2).

The alternative net operating loss deduction cannot exceed 90% of AMTI. §56(d)(1)(A)(i)(II).

Ex. AMTI = $10M; alternative net operating loss = $11M; the alternative net operating loss reduces AMTI to $1M,
giving rise to $200,000 of AMT liability; the taxpayer may then carry forward $2M of net operating loss

Payroll Taxes; IRC §1411 – Excerpt from JCX-18-10

B. Unearned Income Medicare Contribution (new §1411 of the Code)

Social security benefits and certain Medicare benefits are financed primarily by payroll taxes on covered wages.
FICA imposes tax on employers based on the amount of wages paid to an employee during the year. The tax
imposed is composed of two parts:
(1) OASDI tax equal to 6.2% of covered wages up to the taxable wage base ($106,800 in 2010); and
(2) Medicare hospital insurance (“HI”) tax amount equal to 1.45% of covered wages.
In addition to the tax on employers, each employee is subject to FICA taxes equal to the amount of tax
imposed on the employer. The employee level tax generally must be withheld and remitted to the Federal
government by the employer.

As a parallel to FICA taxes, SECA imposes taxes on the net income from self-employment of self-employed
individuals. The rate of the OASDI portion of SECA taxes is equal to the combined employee and employer OASDI
FICA tax rates and applies to self-employment income up to the FICA taxable wage base. Similarly, the rate of the
HI portion is the same as the combined employer and employee HI rates and there is no cap on the amount of self-
employment income to which the rate applies.

(For purposes of computing net earnings from self-employment, taxpayers are permitted a deduction equal to the
product of the taxpayer’s earnings (determined without regard to this deduction) and 7.65% of net earnings. This
deduction reflects the fact that the FICA rates apply to an employee’s wages, which do not include FICA taxes paid
by the employer, whereas the self-employed individual’s net earnings are economically equivalent to an employee’s
wages plus the employer share of FICA taxes.)

In the case of an individual, estate, or trust an unearned income Medicare contribution tax is imposed.

In the case of an individual, the tax is the 3.8% of the lesser of net investment income or the excess of modified
AGI over the threshold amount.

The threshold amount is $250,000 in the case of a joint return or surviving spouse, $125,000 in the case of a married
individual filing a separate return, and $200,000 in any other case.

Modified AGI is AGI increased by the amount excluded from income as foreign earned income under §911(a)(1)
(net of the deductions and exclusions disallowed with respect to the foreign earned income).

In the case of an estate or trust, the tax is 3.8% of the lesser of undistributed net investment income or the excess of
AGI (as defined in §67(e)) over the dollar amount at which the highest income tax bracket applicable to an estate or
trust begins.

The tax does not apply to a non-resident alien or to a trust all the unexpired interests in which are devoted to
charitable purposes. The tax also does not apply to a trust that is exempt from tax under §501 or a charitable
remainder trust exempt from tax under §664.

The tax is subject to the individual estimated tax provisions. The tax is not deductible in computing any tax imposed
by subtitle A of the Internal Revenue Code (relating to income taxes).

Net investment income  is investment income reduced by the deductions properly allocable to such income.

Investment income is the sum of

(i) gross income from interest, dividends, annuities, royalties, and rents (other than income derived
from any trade or business to which the tax does not apply),
(ii) other gross income derived from any business to which the tax applies, and
(iii) net gain (to the extent taken into account in computing taxable income) attributable to the
disposition of property, other than property held in a trade or business to which the tax does not
apply.

Gross income does not include items, such as interest on tax-exempt bonds, veterans’ benefits, and excluded gain
from the sale of a principal residence, which are excluded from gross income under the income tax.

In the case of a trade or business, the tax applies if the trade or business is a passive activity with respect to the
taxpayer or the trade or business consists of trading financial instruments or commodities (as defined in §475(e)(2)).
The tax does not apply to other trades or businesses conducted by a sole proprietor, partnership, or S corporation.

In the case of the disposition of a partnership interest or stock in an S corporation, gain or loss is taken into account
only to the extent gain or loss would be taken into account by the partner or shareholder if the entity had sold all its
properties for fair market value immediately before the disposition. Thus, only net gain or loss attributable to
property held by the entity which is not property attributable to an active trade or business is taken into account.
(For this purpose, a business of trading financial instruments or commodities is not treated as an active trade or
business.)
Income, gain, or loss on working capital is not treated as derived from a trade or business. Investment income does
not include distributions from a qualified retirement plan or amounts subject to SECA tax.

ADL 3.02 Associations Taxable as Corporations (Check the Box)

Both the regular corporate tax of §11 and the AMT of §55 are imposed on “corporations.” Under §7701(a)(3), the
term “corporations” includes “associations, joint-stock companies, and insurance companies” but not “partnerships.”

“Check the box” regulations allows taxpayers to choose to how their unincorporated business organizations
will be taxed (as corporations or as partnerships)

Under Reg. §301.7701-2(b)(1-8), a variety of business organizations are denied elective classification and must
be taxed as corporations; all other entities are classified as “eligible” entities and can elect to be taxed as
either corporations or partnerships.

If an eligible entity has a single owner and does not elect to be taxed as a corporation, the entity is disregarded for
federal income tax purposes.

An eligible entity may change its election at any time, but once a change is made a subsequent change may not be
made again for 60 months

Some foreign entities are not eligible entities

Hybrid entity  a business form which can be treated as a corporation for foreign purposes and a pass-through
entity for U.S. tax purposes

Reverse hybrid entity  a business form which can be treated as a pass-through entity for foreign purposes and a
corporation for U.S. tax purposes

In §7704, Congress provided that certain publicly traded partnerships will be taxed as corporations; for this purpose,
a “publicly traded partnership” is one whose partnership interests are (1) traded on an established security market or
(2) are readily traded on a secondary market

However, if the income of a partnership consists of 90% or more of investment income as defined in §7704(d), the
partnership will avoid the clutches of §7704(a)

ADL 3.03 Ignoring the Corporation: Dummy Corporations (Respecting the Corporate Form)

Under certain circumstances, taxpayers will use the corporate form but try to avoid the corporate income tax by
ignoring their own incorporation

Tactic 1: taxpayers ask the courts to pierce the corporate veil and attribute the corporation’s income to its
shareholders, arguing that the corporation should not be respected for tax purposes (this tactic rarely succeeds)

Moline Properties, 319 U.S. 436 (1943): the Court held that a corporation engaging in any business activity
will be treated as a taxpayer distinct from its shareholders  taxpayers have to live with both the advantages
and disadvantages of choosing to incorporate (note that the Commissioner is more likely to successfully make
the substance over form challenge when attempting to pierce the corporate veil)

Tactic 2: taxpayers argue that their corporations are dummies not properly taxable on income nominally received
(the corporation is merely acting as an agent, so some other taxpayer should be taxed)

National Carbide Corp. v. C.I.R., 336 U.S. 422 (1949): the Court held that under some circumstances a corporation
could be the true, nontaxable agent for its shareholders.

The Six National Carbide Factors (for when a corporation should be treated as such an agent):
 1. Whether the corporation operates in the name and for the account of the principal,
2. Whether the corporation binds the principal by its actions,
3. Whether the corporation transmits money received to the principal,
4. Whether receipt of income is attributable to the services of employees of the principal and to assets
belonging to the principal, 
5. If the corporation is a true agent, its relations with its principal must not be dependent upon the fact that it
is owned by the principal, if such is the case, and
6. Its business purpose must be the carrying on of the normal duties of an agent

C.I.R. v. Bollinger, 485 U.S. 340 (1988): individuals formed a corporation to hold title to land on which the
individuals constructed apartment complexes; the corporation was formed to obtain financing, which otherwise
would not have been available to the individuals due to anti-usury laws which applied to individual but not corporate
borrowers; Bollinger agreed to assume full liability for the debt and agreed to hold the corporation harmless for any
liability it might sustain as his agent; Bollinger reported income and losses on his individual tax return; the
Commissioner argued that the income and losses should be reported by the corporation under Moline and that the
National Carbide exception did not apply because the corporation’s actions were wholly dependent on its being
controlled by the taxpayers, its shareholders

The Court sided with Bollinger and held that the fifth National Carbide factor serves only as a generalized statement
of the concern that the separate-entities doctrine of Moline not be subverted (the relationship between the
shareholders and the corporation does not need to reflect an arm’s length transaction between principal and agent)

Bollinger rule: an agency relationship is established if a writing memorializes the principal-agency relationship, the
corporation indeed functions as an agent, and the corporation is held out as an agent and not the principal in all third
party dealings

Higgins v. Smith, 308 U.S. 473 (1940): it is impermissible to set up a wholly owned corporation simply for the
purpose of realizing tax benefits through buying and selling securities between the owner and the corporation
(applying Gregory v. Helvering, which held that transactions which do not vary control or change the flow of
economic benefits are to be dismissed from consideration)

ADL Chapter 2: Forming a Corporation

ADL 2.01 Introduction

If a taxpayer exchanges property for other property, he must generally recognize any realized gain or loss on the
exchange. §1001(c). However, Congressional policy is that taxing an exchange event is inappropriate where a
taxpayer maintains a sufficient continuity of investment after an exchange (e.g. §1031).

The essence of §351 and related provisions is to ascertain whether a transferor has a continuing relationship with the
property transferred to a corporation sufficient to justify the non-recognition treatment or whether the transferor has
severed the relationship with the transferred property, justifying recognition.

2.02 An Overview of §351

§ 351. Transfer to corporation controlled by transferor.

(a)  General rule. No gain or loss shall be recognized if property is transferred to a corporation by one or more
persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons
are in control (as defined in §368(c)) of the corporation.
(b)  Receipt of property. If subsection (a) would apply to an exchange but for the fact that there is received, in
addition to the stock permitted to be received under subsection (a), other property or money, then--
(1)  gain (if any) to such recipient shall be recognized, but not in excess of--
(A)  the amount of money received, plus
(B)  the fair market value of such other property received; and
(2)  no loss to such recipient shall be recognized.
(c)  Special rules where distribution to shareholders.
(1)  In general. In determining control for purposes of this section, the fact that any corporate transferor
distributes part or all of the stock in the corporation which it receives in the exchange to its shareholders shall
not be taken into account.
(d)  Services, certain indebtedness, and accrued interest not treated as property. For purposes of this section, stock
issued for--
(1)  services,
(2)  indebtedness of the transferee corporation which is not evidenced by a security, or
(3)  interest on indebtedness of the transferee corporation which accrued on or after the beginning of the
transferor's holding period for the debt, shall not be considered as issued in return for property.
(e)  Exceptions. This section shall not apply to--
(1)  Transfer of property to an investment company.
(2)  Title 11 or similar case. A transfer of property of a debtor pursuant to a plan while the debtor is under the
jurisdiction of a court in a title 11 or similar case (within the meaning of §368(a)(3)(A)), to the extent that the
stock received in the exchange is used to satisfy the indebtedness of such debtor.
(f)  Treatment of controlled corporation. If--
(1)  property is transferred to a corporation (hereinafter in this subsection referred to as the "controlled
corporation") in an exchange with respect to which gain or loss is not recognized (in whole or in part) to the
transferor under this section, and
(2)  such exchange is not in pursuance of a plan of reorganization,
§311 shall apply to any transfer in such exchange by the controlled corporation in the same manner as if such
transfer were a distribution to which subpart A of part I [26 USCS §§ 301 et seq.] applies.
(g)  Nonqualified preferred stock not treated as stock.
(1)  In general. In the case of a person who transfers property to a corporation and receives nonqualified
preferred stock--
(A)  subsection (a) shall not apply to such transferor, and
(B)  if (and only if) the transferor receives stock other than nonqualified preferred stock--
(i)  subsection (b) shall apply to such transferor; and
(ii)  such nonqualified preferred stock shall be treated as other property for purposes of applying
subsection (b).
(2)  Nonqualified preferred stock. For purposes of paragraph (1)--
(A)  In general. The term "nonqualified preferred stock" means preferred stock if--
(i)  the holder of such stock has the right to require the issuer or a related person to redeem or
purchase the stock,
(ii)  the issuer or a related person is required to redeem or purchase such stock,
(iii)  the issuer or a related person has the right to redeem or purchase the stock and, as of the issue
date, it is more likely than not that such right will be exercised, or
(iv)  the dividend rate on such stock varies in whole or in part (directly or indirectly) with
reference to interest rates, commodity prices, or other similar indices.
(B)  Limitations. Clauses (i), (ii), and (iii) of subparagraph (A) shall apply only if the right or obligation
referred to therein may be exercised within the 20-year period beginning on the issue date of such stock
and such right or obligation is not subject to a contingency which, as of the issue date, makes remote the
likelihood of the redemption or purchase.
(C)  Exceptions for certain rights or obligations.
(i)  In general. A right or obligation shall not be treated as described in clause (i), (ii), or (iii) of
subparagraph (A) if--
(I)  it may be exercised only upon the death, disability, or mental incompetency of the
holder, or
(II)  in the case of a right or obligation to redeem or purchase stock transferred in connection
with the performance of services for the issuer or a related person (and which represents
reasonable compensation), it may be exercised only upon the holder's separation from
service from the issuer or a related person.
(ii)  Exception. Clause (i)(I) shall not apply if the stock relinquished in the exchange, or the stock
acquired in the exchange is in--
(I)  a corporation if any class of stock in such corporation or a related party is readily
tradable on an established securities market or otherwise, or
 (II)  any other corporation if such exchange is part of a transaction or series of transactions
in which such corporation is to become a corporation described in subclause (I).
(3)  Definitions. For purposes of this subsection--
(A)  Preferred stock. The term "preferred stock" means stock which is limited and preferred as to
dividends and does not participate in corporate growth to any significant extent. Stock shall not be
treated as participating in corporate growth to any significant extent unless there is a real and meaningful
likelihood of the shareholder actually participating in the earnings and growth of the corporation. If there
is not a real and meaningful likelihood that dividends beyond any limitation or preference will actually
be paid, the possibility of such payments will be disregarded in determining whether stock is limited and
preferred as to dividends.
(B)  Related person. A person shall be treated as related to another person if they bear a relationship to
such other person described in §267(b) or §707(b).
(h)  Cross references.
(1)  For special rule where another party to the exchange assumes a liability, see §357.
(2)  For the basis of stock or property received in an exchange to which this section applies, see §§358 and
362.
(3)  For special rule in the case of an exchange described in this section but which results in a gift, see §2501
and following.
(4)  For special rule in the case of an exchange described in this section but which has the effect of the
payment of compensation by the corporation or by a transferor, see §61(a)(1).
(5)  For coordination of this section with §304, see §304(b)(3).

ADL 2.02(a) Qualification

§351 applies only if transferor of property:

1. Transfers property to a corporation;
2. Receives stock in exchange; and
3. Along with other transferors, if any, controls the corporation immediately after the exchange

§351 can apply both to the formation of a new corporation and to a transfer to an existing corporation (called a mid-
stream transfer).

§351 applies if there is a transfer or property; it does not apply if there is a provision of services (if a person provides
services to a corporation in exchange for the corporation’s stock, that person has compensation income)

§351 applies only if the transferor receives stock in the transferee corporation (not any other corporation)

§351 applies only if the transferor receives stock in the transferee corporation (not the corporation’s debt)

§351 applies only if the transferor(s) maintain(s) control of the corporation immediately after the exchange: control
is defined as:
1. Owning at least 80% of the total combined voting power of all classes of the corporation’s voting stock;
and
2. Owning at least 80% of the total number of each class of the corporation’s non-voting stock (see §368(c)).

Note that it may not be clear when various property transfers should be considered together as part of the same
“transaction.”

Note that diversification of business assets achieved through §351 is permissible (e.g. a dozen different businessman
pool their businesses together and form a new corporation); however, “swap funds” may not take advantage of §351
(see §351(e)(1)).

ADL 2.02(b) Tax Consequences

If §351 applies to a person’s transfer of property to a corporation, the person may recognize gain but not loss.
§351(a),(b). The extent to which the transferor recognizes gain is determined by §§351 and 357. The transferor’s
basis in the stock and other property received from the corporation is determined under §358.

The transferee corporation recognized no gain or loss when it acquires property for its stock. §1032. The
transferee corporation determines its basis in the property received under §362. With adjustments, the
transferee corporation carries over the transferor’s basis, although usually basis cannot exceed the property’s
value. §362(e). The transferee corporation “tacks” the holding period of property received from transferor.
§1232(2).

Ex. B owns building with $70,000 FV and $25,000 AB; C owns real estate with $30,000 FV and $50,000 AB.
Together they form X Corp and enter into a property-for-stock exchange. §351 applies. Neither B nor C recognize
gain or loss. B takes a $25,000 basis in $70,000 worth of X Corp’s stock. C takes a $50,000 basis in $30,000 worth
of X Corp’s stock. However long B and C held their property is then “tacked” onto their shares of X Corp. X Corp
recognizes no gain or loss. X Corp takes a $25,000 basis in the building contributed by B but only takes a $30,000
basis in the real estate contributed by C, b/c basis is crammed down for built-in loss in a §351 transaction. X Corp
“tacks” on the holding period of B for the building and C for the real estate.

Note that the §351 transfer duplicates B’s built in gain (if B sells shares, he recognized a $45,000 gain; also, if X
Corp. sells building, X Corp. recognizes a $45,000 gain); in other words, the same gain may be taxed twice. In
sharp contrast, §358 and §362 do not duplicate built in loss. Consider C’s transfer. If C and X Corp do not make a
§362(e)(2)(C) election, C takes a $50,000 basis in the stock while X Corp only takes a $30,000 basis in the real
estate. If they do make the §362(e)(2)(C) election, C takes a $30,000 basis in the stock while X Corp takes a
$50,000 basis in the real estate. If both were to immediately sell, one would recognize a $20,000 loss while the
other would recognize neither gain nor loss.

§ 358. Basis to distributees.
(a)  General rule. In the case of an exchange to which §§351, 354, 355, 356, or 361 applies--
(1)  Non-recognition property. The basis of the property permitted to be received under such section without
the recognition of gain or loss shall be the same as that of the property exchanged--
(A)  decreased by--
(i)  the fair market value of any other property (except money) received by the taxpayer,
(ii)  the amount of any money received by the taxpayer, and
(iii)  the amount of loss to the taxpayer which was recognized on such exchange, and
(B)  increased by--
(i)  the amount which was treated as a dividend, and
(ii)  the amount of gain to the taxpayer which was recognized on such exchange (not including any
portion of such gain which was treated as a dividend).
(2)  Other property. The basis of any other property (except money) received by the taxpayer shall be its fair
market value.
(b)  Allocation of basis.
(1)  In general. Under regulations prescribed by the Secretary, the basis determined under subsection (a)(1)
shall be allocated among the properties permitted to be received without the recognition of gain or loss.
(d)  Assumption of liability.
(1)  In general. Where, as part of the consideration to the taxpayer, another party to the exchange assumed a
liability of the taxpayer, such assumption shall, for purposes of this section, be treated as money received by
the taxpayer on the exchange.
(2)  Exception. Paragraph (1) shall not apply to the amount of any liability excluded under §357(c)(3).
(e)  Exception. This section shall not apply to property acquired by a corporation by the exchange of its stock or
securities (or the stock or securities of a corporation which is in control of the acquiring corporation) as
consideration in whole or in part for the transfer of the property to it.
(f)  Definition of non-recognition property in case of §361 exchange. For purposes of this section, the property
permitted to be received under §361 without the recognition of gain or loss shall be treated as consisting only of
stock or securities in another corporation a party to the reorganization.
(h)  Special rules for assumption of liabilities to which subsection (d) does not apply.
 (1)  In general. If, after application of the other provisions of this section to an exchange or series of
exchanges, the basis of property to which subsection (a)(1) applies exceeds the FMV of such property, then
such basis shall be reduced (but not below such FMV) by the amount (determined as of the date of the
exchange) of any liability--
(A)  which is assumed by another person as part of the exchange, and
(B)  with respect to which subsection (d)(1) does not apply to the assumption.
(2)  Exceptions. Except as provided by the Secretary, paragraph (1) shall not apply to any liability if-
(A)  the trade or business with which the liability is associated is transferred to the person assuming the
liability as part of the exchange, or
(B)  substantially all of the assets with which the liability is associated are transferred to the person
assuming the liability as part of the exchange.
(3)  Liability. For purposes of this subsection, the term "liability" shall include any fixed or contingent
obligation to make payment, without regard to whether the obligation is otherwise taken into account for
purposes of this title.

§ 362. Basis to corporations.
(a)  Property acquired by issuance of stock or as paid-in surplus. If property was acquired by a corporation--
(1)  in connection with a transaction to which §351 (relating to transfer of property to corporation controlled
by transferor) applies, or
(2)  as paid-in surplus or as a contribution to capital,
then the basis shall be the same as it would be in the hands of the transferor, increased in the amount of gain
recognized to the transferor on such transfer.
(b)  Transfers to corporations. If property was acquired by a corporation in connection with a reorganization to
which this part (§351) applies, then the basis shall be the same as it would be in the hands of the transferor,
increased in the amount of gain recognized to the transferor on such transfer. This subsection shall not apply if the
property acquired consists of stock or securities in a corporation a party to the reorganization, unless acquired by the
exchange of stock or securities of the transferee (or of a corporation which is in control of the transferee) as the
consideration in whole or in part for the transfer.
(c)  Special rule for certain contributions to capital.
(1)  Property other than money. Notwithstanding subsection (a)(2), if property other than money--
(A)  is acquired by a corporation as a contribution to capital, and
(B)  is not contributed by a shareholder as such, then the basis of such property shall be zero.
(2)  Money. Notwithstanding subsection (a)(2), if money--
(A)  is received by a corporation as a contribution to capital, and
(B)  is not contributed by a shareholder as such, then the basis of any property acquired with such money
during the 12-month period beginning on the day the contribution is received shall be reduced by the
amount of such contribution. The excess (if any) of the amount of such contribution over the amount of
the reduction under the preceding sentence shall be applied to the reduction (as of the last day of the
period specified in the preceding sentence) of the basis of any other property held by the taxpayer. The
particular properties to which the reductions required by this paragraph shall be allocated shall be
determined under regulations prescribed by the Secretary.
(d)  Limitation on basis increase attributable to assumption of liability.
(1)  In general. In no event shall the basis of any property be increased under subsection (a) or (b) above the
FMV of such property (determined without regard to section 7701(g) by reason of any gain recognized to the
transferor as a result of the assumption of a liability.
(2)  Treatment of gain not subject to tax. Except as provided in regulations, if--
(A)  gain is recognized to the transferor as a result of an assumption of a nonrecourse liability by a
transferee which is also secured by assets not transferred to such transferee; and
(B)  no person is subject to tax under this title on such gain, then, for purposes of determining basis
under subsections (a) and (b), the amount of gain recognized by the transferor as a result of the
assumption of the liability shall be determined as if the liability assumed by the transferee equaled such
transferee's ratable portion of such liability determined on the basis of the relative FMV (determined
without regard to section 7701(g) of all of the assets subject to such liability.
(e)  Limitations on built-in losses.
(2)  Limitation on transfer of built-in losses in §351 transactions.
 (A)  In general. If--
(i)  property is transferred by a transferor in any transaction which is described in subsection (a)
and which is not described in paragraph (1) of this subsection, and
(ii)  the transferee's aggregate adjusted bases of such property so transferred would (but for this
paragraph) exceed the FMV of such property immediately after such transaction, then,
notwithstanding subsection (a), the transferee's aggregate adjusted bases of the property so
transferred shall not exceed the FMV of such property immediately after such transaction.
(B)  Allocation of basis reduction. The aggregate reduction in basis by reason of subparagraph (A) shall
be allocated among the property so transferred in proportion to their respective built-in losses
immediately before the transaction.
(C)  Election to apply limitation to transferor's stock basis.
(i)  In general. If the transferor and transferee of a transaction described in subparagraph (A) both
elect the application of this subparagraph--
(I)  subparagraph (A) shall not apply, and
(II)  the transferor's basis in the stock received for property to which subparagraph (A) does
not apply by reason of the election shall not exceed its FMV immediately after the transfer.
(ii)  Election. Any election under clause (i) shall be made at such time and in such form and
manner as the Secretary may prescribe, and, once made, shall be irrevocable.

ADL 2.03 Qualification

Three major requirements of §351

 A person must transfer property to a corporation

 The transferor must receive the corporation’s stock in exchange
 The transferor, together with other transferring property in the same transaction, must control the
corporation immediately after the exchange

2.03(a) Property Requirement

Two types of disputes as to what is property:

 A taxpayer may create an asset through her own effort and the Service may asset that the taxpayer created
the asset on behalf of the corporation and therefore provided services to the corporation
 Taxpayer may transfer less than all of the taxpayer’s interest in an asset to the corporation and the Service
may argue that the taxpayer has not transferred “property” in an exchange to which §351 applies

Money qualifies as property for the purposes of §351 (Rev. Rul. 69-357)

To the extent that a person provides services for stock, §351 does not apply

Hempt Bros  Accounts receivable do constitute property for the purposes of §351

Hempt Bros, Inc. v. U.S., 490 F.2d 1172 (3d Cir. 1974)

Facts: Hembt Bros operated a cash-basis partnership. They then formed a corporation and transferred to it the
partnership’s assets in exchange for the corporation’s stock. Among the assets transferred to the corporation was
A/R of $662,824.40 and inventory of $351,266.05. The corporation continued to manage its books in a cash-basis
accounting method. Accordingly, the corporation did not take uncollected receivables into income and did not use
inventories in the calculation of its taxable income. As the corporation collected the A/R, it took the monies into
account in calculating taxable income (over the years 1958-1960). In 1964, the C.I.R. told the corporation to switch
to accrual accounting. The C.I.R. then had the corporation adjust its books accordingly. For the fiscal year 1958,
the C.I.R. determined that the beginning inventory transferred to the corporation should be valued at $0 and the
ending inventory at $258,201.35 (resulting in an increase in taxable income of $258,201.35).
Hempt Bros. tried to argue that A/R was not property so that §351 would not apply to their change of business form;
if this was the case, gains and losses would have been recognized at the time of the transfer. The Hempt Bros.
attempted this strategy because the statute of limitations had passed, and if the partnership had been found to have
taxable gains, the brothers themselves would not have been liable.

The Hempt Bros. also tried to argue it was unfair to them to penalize them for being forced to change their
accounting method because §481 allows for a taxpayer to make adjustments to previous years in such a
circumstance. The court says that §481 does not apply here because the taxpayer is not the same (went from a
partnership to a corporation). The court basically just says tough luck.

Issue: We are called upon to decide the proper treatment of A/R and of inventory transferred from a cash basis
partnership to a corporation organized to continue the business under §351(a).

Law:  Unless there is some special reason intrinsic to §351 the general word "property" has a broad reach in tax
law. For §351, in particular, courts have advocated a generous definition of "property."

Analysis: There is a compelling reason to construe 'property' to include A/R: a new corporation needs working
capital, and accounts receivable can be an important source of liquidity.

Assignment of income doctrine: where the right to receive income is transferred to another person in a transaction
not giving rise to tax at the time of transfer, the transferor is taxed on the income when it is collected by the
transferee

Law: to determine which of the conflicting laws (§351 or the assignment of income doctrine) will control, undertake
a case-by-case determination; no bright line rule as to which will trump the other

Analysis: §351 trumps the assignment of income doctrine in this case; the court makes this determination by
looking at congressional intent in enacting §351, which was to facilitate the incorporation of ongoing businesses and
to eliminate any technical constructions which are economically unsound (“Here we are influenced by the fact that
the subject of the assignment was A/R for partnership's goods and services sold in the regular course of business,
that the change of business form from partnership to corporation had a basic business purpose and was not designed
for the purpose of deliberate tax avoidance, and by the conviction that the totality of circumstances here presented fit
the mold of the Congressional intent to give non-recognition to a transfer of a total business from a non-corporate to
a corporate form.”)

Tax benefit rule: If a taxpayer makes an expenditure or suffers a loss for which it takes a deduction giving rise to a
reduction in its income tax and later recovers the funds or property that it has spent or lost, it must take the amount
recovered as income

Law: the mere fact that an asset has thus been transferred under §351 from a partnership to a corporation does not in
itself alter the tax basis

Analysis: In the case before us, whatever may have been the actual value of the inventory at the time of the transfer,
the basis of the property exchanged remained the same as it appeared in the partnership's books -- zero. §358(a)(1).
As to the distributees, the basis of the stock permitted to be received under §351(a)(1) shall be the same as that of
the property exchanged -- zero. 

Holding: Accounts receivable, for the purpose of §351, constitutes property.

James v. C.I.R.  contract promising to perform services was not property for the purposes of §351

James v. C.I.R., 53 T.C. 63 (1969)

Facts: Mr. and Mrs. Talbot entered into an agreement with Mr. James for the promotion and construction of a rental
apartment project. The agreement provided that on completion of the project the parties would form a corporation to
take title to the project. The transaction was to be structured as a §351 exchange. The Talbots contributed land to
the corporation. Mr. James agreed to promote the project and be responsible for the planning, architectural work,
construction, landscaping, legal fees, and loan processing of the entire project.

James and Talbot argued that the commitments to finance and insure the rental apartment project were property that
James contributed to the corporation in exchange for his shares.

Issue: Whether Mr. James received his Chicora stock in exchange for the transfer of property or as compensation for
services.

Law: For purposes of §351, not every right is to be treated as property. The second sentence of §351 indicates that,
whatever may be considered as property for purposes of local law, the performance of services, or the agreement to
perform services, is not to be treated as a transfer of property for purposes of §351. 

Analysis: Throughout all of his activities, it was contemplated that a corporation would be created and that the
commitment would run to the corporation. Mr. James never undertook to acquire anything for himself; everything
done by him was done on behalf of the contemplated corporation. He never acquired ownership of any of the
commitments to finance or insure the apartment project; he never held property in his own right that he could
transfer to the corporation.

Holding: Mr. James did not transfer any property; he merely performed services for Chicora Corp.

A person’s rights in patents, patent applications, trademarks, trade names, and goodwill constitute property under
§351. Less certain is the status of “know how.”

Note that in the case of certain intangibles, the “transfer” requirement can pose a problem. The Service has taken
the position that in order to qualify under §351, the transfer must amount to a sale or exchange within the meaning
of §1222. However, in E.I. Dupont v. U.S., 471 F.2d 1211 (Ct. Cl. 1973), the court held that the sale or exchange
requirement of §1222 is not embodied in §351. Accordingly, a nonexclusive, royalty-free license exchanged for
stock was a “transfer” within the meaning of §351 because the license was irrevocable and perpetual.

2.03(b) “Stock” Requirement

For §351 to apply to a person’s transfer of property to a corporation, the person must receive the corporation’s stock,
in whole or in part, in exchange.

The term “stock” includes common stock or preferred stock, whether voting or non-voting, but excludes stock
rights, options, warrants, or other rights to purchase stock at a fixed price. Courts have been more lenient towards
contingent stock than stock rights.

“Meaningless gesture” doctrine  stock is deemed issued if, with or without the issuance, the rights of the
corporation’s shareholders would be the same (in such a situation, §351 could apply to a person’s transfer
even if that person actually receives no stock in exchange)

Peracchi v. C.I.R., 143 F.3d 487 (9th Cir. 1998)

Facts: The taxpayer, Donald Peracchi, needed to contribute additional capital to his closely-held corporation (NAC)
to comply with Nevada's minimum premium-to-asset ratio for insurance companies. Peracchi contributed two
parcels of real estate. The parcels were encumbered with liabilities which together exceeded Peracchi's total basis in
the properties by more than half a million dollars. As we discuss in detail below, under §357(c), contributing
property with liabilities in excess of basis can trigger immediate recognition of gain in the amount of the excess. In
an effort to avoid this, Peracchi also executed a promissory note, promising to pay NAC $1,060,000 over a term of
ten years at 11% interest. 

Issue: What is the basis of the note Peracchi contributed to NAC - $1,060,000 or $0? If it is $1,060,000, Peracchi
pays no immediate tax on the half a million dollars by which the debts on the land he contributed exceed his basis in
the land. If it is $0, Peracchi must recognize an immediate gain on the half million.

Law: Economic exposure of the shareholder is the ultimate measuring rod of a shareholder’s investment.

Principle: If the debt has real economic effect, it shouldn’t matter how the shareholder structures the transaction.

Analysis: The key to solving this puzzle, then, is to ask whether bankruptcy is significant enough a contingency to
confer substantial economic effect on this transaction.  If the risk of bankruptcy is important enough to be
recognized, Peracchi should get basis in the note: He will have increased his exposure to the risks of the business -
and thus his economic investment in NAC - by $ 1,060,000. If bankruptcy is so remote that there is no realistic
possibility it will ever occur, we can ignore the potential economic effect of the note as speculative and treat it as
merely an unenforceable promise to contribute capital in the future. When the question is posed this way, the
answer is clear. Peracchi's obligation on the note was not conditioned on NAC's remaining solvent. It represents a
new and substantial increase in Peracchi's investment in the corporation

Holding: The basis of the note = the note’s face value ($1,060,000). Peracchi recognizes no immediate gain. (The
holding does not extend to the partnership or S Corp; the holding is limited to cases in which the note is in fact
worth approximately its face value (meaning little to no credit risk); the holding is limited to cases in which the note
is contributed to an operating business which is subject to a non-trivial risk of bankruptcy or receivership)

Dissent: The basis of the note should be $0; Peracchi has conjured up basis out of thin air.

If a taxpayer transfers property to a corporation in a transaction otherwise satisfying §351 but the property is
encumbered by a liability equal to or in excess of the value of the contributed property, the transaction may not
qualify as a §351 exchange, because the corporation is receiving a net liability. [contrast with Peracchi]

ADL 2.04 Tax Consequences – Shareholders

a. Recognized Gain or Loss

§351 – if it applies to a person’s exchange, the person recognizes either no loss (if there is a realized loss) or a
gain equal to the lesser of gain realized or the FMV of any boot received in the exchange

The gain’s character is determined by the nature of the property transferred (not received)

If taxpayer transferred property used in a trade or business (e.g. machinery) to the corporation, the recognized gain
would be §1231 gain (i.e. capital gain), except to the extent recaptured as ordinary income under §1245. Note that if
a transferor does not recognize a gain on a §351 transaction, no gain is recaptured under §1245 or §1250.

e.g. Taxpayer transfers §1231 property in exchange for cash and stock

 If there is a realized gain, recognize income to the lesser of the realized gain or FMV of boot
 If there is a realized loss, no loss is recognized, and the cash received is treated as return of investment

“Nonqualified” preferred stock is treated as boot for gain/ loss purposes but is treated as stock for purposes of the
control test. §351(g).
“Nonqualified” preferred stock has the following characteristics:

 Must be preferred as to dividends

 Must be limited as to dividends
 cannot participate in corporate growth to any meaningful extent
 cannot be convertible into common stock
 must have either
o a dividend rate tied to interest rates, commodity prices, etc. or
o one of the following three redemption features (but only if they may be exercised within 20 years
of issuance):
 shareholder may require the corporation to redeem the stock;
 the corporation must redeem the stock; or
 the corporation may redeem the stock and the redemption is (as of the issue date) more
likely than not to occur

If a transferor exchanges property for a combination of corporate stock and corporate debt in a §351 exchange, the
debt instruments will be treated as boot. However, see §453.

§453  the transferor may be able to report the gain on the debt instruments under the installment method (but can
elect out of installment reporting); but gain from inventory exchanged for corporate debt must be recognized
immediately

Ex. Suppose T transfers an assets with AB = $10,000 and FMV = $40,000 to X Corp in a §351 exchange for X Corp
stock = $20,000 and X Corp debt = $20,000. Assume §453 applies. T’s $10,000 basis is allocate entirely to the X
Corp stock, so T’s basis in X Corp debt = $0. When X Corp satisfies the debt instrument, T will recognize a
$20,000 gain, reduced by any gain previously recaptured as depreciation recapture) and the character of the $20,000
gain will be determined by looking to the character of the asset transferred in the §351 exchange. (Note that if any
of the asset transferred is subject to depreciation recapture, T must recognize any depreciation recapture as ordinary
income in the year of the §351 exchange, even though no cash is received at that time.)

b. Assumption of Liabilities

(i) In General

“gain first” rule – recognize gain up to boot

“basis first” rule – basis is recovered before gain is recognized

See §357 (put in notes)

§357(a) - under the general rule, if the transferee corporation assumes a liability in a §351 exchange, the assumption
is not treated as the payment of boot.

§357(c)(1) – provides that a transferor generally recognizes gain to the extent that the liabilities which the transferee
corporation assumes exceed the aggregated adjusted basis of all property transferred by the transferor [basis first
rule]

Ex. Suppose T transfers an assets with AB = $40,000 and FMV = $50,000 to X Corp in a §351 exchange for X Corp
stock = $40,000 and assumption of T’s debt = $10,000. T recognizes no gain or loss under §351 and §357. The
liability is not treated as boot for purposes of §351. See §357(a). Further, because the amount of the liability
transferred ($10,000) does not exceed T’s basis in the transferred property ($40,000), T recognizes no gain under
§357(c)(1). Note, however, T’s basis in the X Corp stock will be reduced by $10,000 to account for the liability. [If,
on the other hand T’s basis in the transferred property had only been $6,000, T would have recognized a $4,000 gain
under §357(c)(1).]

§357(b) – transferor treats the assumption of all liabilities by the transferee corporation as the payment of boot for
purposes of §351 if the transferor’s principal purpose with respect to the assumption of any transferor liability was
to avoid federal income tax on the exchange or was not a bona fide business purpose [addresses situations when
§357(c)(1) seems too generous to taxpayer]

§357(c)(3) – provides that a liability is disregarded in §357(c)(1) if it would have given rise to a deduction if paid by
the transferor
Rev. Rul. 95-74 – expanded §357(c)(3) liabilities to include ones that would have created or increased basis if paid
by the transferor [these two rules address situations when §357(c)(1) seems too harsh on the taxpayer]

Ex. Suppose T transfers property with $0 basis to X Corp in a §351 exchange and X Corp transfers to T stock worth
$35,000 and assumes T’s $5,000 account payable, a liability that T could have deducted if he had paid it; because
the $5,000 liability is described in §357(c)(3), it is disregarded in applying §357(c)(1) as well as in applying §351.
The result is that T is treated as having received solely $35,000 worth of X Corp stock in the exchange and
recognizes none of his $40,000 realized gain.

Note that the “wash” treatment of §357(c)(3) may deny the transferor the benefit of enjoying capital gain (taxed at a
preferential rate) and an ordinary deduction that offsets income taxed at a higher rate [see last paragraph in ADL p.
43 for example]

Rev. Rul 80-198  when X Corp pays T’s creditor after it assumes T’s liability in a §351 exchange, X Corp can get
a deduction

(ii) Avoiding Gain under §357(c)(1)

Ex. Suppose T transfers assets with AB = $40,000 and FMV = $100,000 to X Corp for X stock worth $45,000 and X
Corp’s assumption of $55,000 of T’s liabilities.
 If the liabilities are not described in §357(b) or §357(c)(3), then under §357(c)(1) T recognizes $15,000
gain (assumption of liabilities of $55,000 – AB of $40,000).
 If the liabilities are described in §357(b), T would recognize a gain of $55,000 under §351(b) (the smaller
of T’s $60,000 realized gain and the $55,000 of liabilities assumed by X, treated as boot received)
 If the liabilities are described in §357(c)(3), T would recognize no gain, because the liabilities would not be
treated as boot for purposes of §351(b) and would be disregarded for purposes of §357(c)(1)

In the example above, T could avoid the recognition of gain by:

1. T could have X Corp assume only $40,000 of his liabilities; or
2. T could contribute an additional $15,000 of cash or property to X Corp
3. T could contribute to X Corp a written promise to pay X Corp $15,000 (but only if the rationale of
Peracchi is applied and the basis of the note is taken to equal the note’s face value; the IRS continues to
argue that the basis of such a note is zero; if the basis of the note is zero, gain will still be recognized)

(iii) Assuming a Liability

§357(d)(1)(A) - §357 applies even when the transferor remains personally liable on the liabilities assumed by the
transferee-corporation

§357(d)(1)(B) – even a “nonrecourse” liability can be assumed for the purposes of §357; however, if the
nonrecourse liability that encumbers transferred property also encumbers other property and it is expected that the
transferor rather than the transferee will satisfy part or all of the liability, the amount of the non-recourse liability
“assumed” for purposes of §357 cannot exceed the FMV of the property transferred
However, if it is expected that the transferor ultimately will satisfy the liability, the liability is not considered to be
“assumed” for the purposes of §357(c)

(iv) A Curious Case of Double Counting

Ex. Suppose that B owns Blackacre with AB and FMV = $1,000 and wants to buy Whiteacre for $1,000, funded
entirely by seller financing; suppose B offers both Blackacre and Whiteacre as security for the seller’s loan (e.g. pay
nothing down but sign a nonrecourse note for $1,000 secured by both properties);
 now suppose B contributes both properties to newly formed X Corp in exchange for stock (a §351
exchange); B recognizes no gain or loss and takes a $1,000 basis in the stock received;
 instead, what if B contributes each property separately to two different newly formed corporations; B
arguably takes a $0 basis in each corporation’s stock  B can avoid this “double counting” of the liability
by having one corporation agree to satisfy the debt (so long as it is expected that the corporation is expected
to satisfy the debt). See §357(d)(2)(A).

c. Basis and Holding Period

§358(a)(1) and §358(d)  preserves the transferor’s basis; basis of the stock of the transferee corporation received
by transferor generally equals:
a. Aggregate basis of the transferor’s property surrendered in the exchange; plus
b. The transferor’s gain (if any) recognized under §351(b) and §357(c)(1) as part of the exchange; minus
c. The value of any boot received by the transferor in the exchange; minus
d. The amount of the transferor’s liabilities (other than §357(c)(3) liabilities) assumed by the transferee
corporation in the exchange

§358(a)(2) – a transferor takes a basis in any boot received equal to its FMV

§1223(1) – a person’s holding period of property received in a §351 exchange tacks (i.e. includes the holding period
for property surrendered in the exchange) if
a. The person takes an exchanged basis in the property received (i.e. basis in that property is determined by
looking to the basis of the property surrendered); and
b. The property surrendered was a capital asset or a §1231 asset
§7704(a)(44) defines “exchanged basis property”

Holding period may matter for determining if a capital gain or loss is short-term or long-term

Because a transferor cannot tack the holding period of an ordinary income asset surrendered in the exchange,
§1223(1) prevents the transferor from quickly converting ordinary income to LT capital gains via a §351 exchange

If the transferor receives boot in addition to qualified stock, transferor recognizes his realized gain up to the value of
boot received and the value of the boot and gain are taken into account in determining transferor’s basis in the stock

Ex. Assume T transfers property with $21,000 basis to X Corp in exchange for $24,000 of stock and $6,000 in cash.
T recognizes $6,000 in gain (from the boot) and stock basis is $21,000 (the stock basis preserves his realized but not
recognized gain of $3,000); the basis of the boot received in this case would be $6,000 just because it is cash and
cash’s basis always equals face value, but, generally, basis in boot received = FMV in such a situation

Ex. Assume T transfers property with $21,000 basis to X Corp in exchange for $24,000 of stock and $6,000 in debt;
further assume T takes his gain into account under the installment method; T’s basis in the stock = $21,000 ($21,000
AB of property transferred plus $6,000 gain to be recognized minus $6,000 FMV of boot received); The debt
received takes a basis of $0 to preserve the entirety of the $9,000 gain

Ex. Suppose instead that T receives $18,000 stock and $12,000 debt in the exchange (so that boot received >
realized gain); T takes a $12,000 basis in the boot and an $18,000 basis in the stock ($21,000 AB of property
transferred plus $9,000 recognized gain minus $12,000 value of boot received); if the installment method applies,
the stock basis would still be $18,000 and the debt basis would be $3,000 to preserve the $9,000 gain realized

Ex. Suppose instead that T transfers property with $21,000 AB in exchange for $24,000 of stock and the assumption
of $6,000 of liabilities:
 if the liability is described in §357(b), the result is the same as if T had received boot, so T recognizes a
$6,000 gain and takes a $21,000 AB in the stock
 if the liability is described in §357(c)(3), the liability assumed is not treated as boot for purposes of §351(b)
and is disregarded in applying §357(c)(1) and §358; the result is the same as if T had received no boot, so T
recognizes no gain and takes a $21,000 basis in the stock
 if the liability is described in neither §357(b) nor §357(c)(3), the liability will not be taken into account for
purposes of §351(b) but will be taken into account for purposes of §357(c)(1) and §358; because the
liability does not exceed T’s basis in the transferred property, T recognizes no gain under §357(c)(1); his
basis in the stock is $15,000 ($21,000 AB of property transferred minus $6,000 liability assumed); because
the stock is worth $24,000, T’s $9,000 gain is preserved

Regs. §1.358-2(b)(2) – if transferor receives multiple classes of stock of transferee corp, transferor would allocate
his aggregate basis for that stock among the classes in proportion to their relative FMVs

If the property transferor transfers to transferee corporation was a capital or §1231 asset in his hands, he tacks the
holding period of that property on to the holding period for the stock received; otherwise his holding period for the
stock begins on the date of the exchange

d. Multiple Asset Transfers

If a person transfers multiple assets to a corporation in a §351 exchange, an allocable portion of each asset is deemed
transferred for each share of qualified stock received in the exchange, with the allocation made in proportion to the
FMV of the transferred assets

Ex. Suppose T transfers Asset 1 with a $1,000 basis and FMV of $1,000 and Asset 2 with a $200 basis and FMV of
$1,000 to X Corp in exchange for 100 shares of common stock and 100 shares of preferred stock. The shares would
have an aggregate basis of $600 ($1,000($1000/$2000) + $200($1000/$2000)) and each share has an aggregate basis
of $6 ($600/100).

A share may have a split holding period (and split basis) to reflect assets transferred

Ex. Suppose T transfers Asset 1 with a $1,000 basis and FMV of $1,000 and Asset 2 with a $200 basis and FMV of
$1,000 to X Corp in exchange for 100 shares of common stock and 100 shares of preferred stock. Assume Asset 1
was a capital asset held for more than one year while Asset 2 was inventory. Under §1223(a) T can tack his holding
period for Asset 1 but not for Asset 2. Therefore, while each share has an aggregate basis of $6, an undivided half-
interest in each share has a basis of $5 and a holding period of more than one year and an undivided half-interest in
each share has a basis of $1 and a holding period that begins on the date of the exchange. As a result, sale of the
share can result in both ST and LT capital gain.

If a person transfers multiple assets and receives boot in a §351 exchange, the person determines realized and
recognized gain separately for each transferred asset; the total consideration and boot received is allocated among
the transferred assets in proportion to their FMVs.

Ex. Suppose that is a §351 exchange T transfers Assets 1,2,and 3 to X Corp in exchange for stock worth $100,000
and $40,000 in cash; Asset 1 has AB = $20,000 and FMV = $35,000; Asset 2 has AB = $10,000 and FMV =
$35,000; Asset 3 has AB = $80,000 and FMV = $70,000. T is treated as receiving ¼ of each amount for Asset 1
($35,000/$140,000); ¼ for Asset 2 ($35,000/$140,000); ½ for Asset 3 ($70,000/$140,000). T realized $15,000 gain
on Asset 1; $25,000 gain on Asset 2; $10,000 loss on Asset 3; boot is allocated $10,000 to Asset 1 (1/4 of $40,000
cash); $10,000 to Asset 2 (1/4 of $40,000 cash); $20,000 to Asset 3 (1/2 of $40,000 cash).
Recall that under §351(b)(1), transferor recognizes realized gain up to value of boot received while under §351(b)(2)
he recognizes no loss
 Asset 1: boot = $10,000; realized gain = $15,000; recognized gain = $10,000
 Asset 2: boot = $10,000; realized gain = $25,000; recognized gain = $10,000
 Asset 3: boot = $20,000; realized loss = $10,000; recognized gain/ loss = $0
In total, T recognizes $20,000 in gain and aggregate basis = $90,000 ($110,000 aggregate AB plus $20,000
recognized gain minus $40,000 boot received)

e. §358(h) – an anti-abuse rule

Ex. Suppose T transfers property with AB and FMV = $20,000 in exchange for $1,000 of X Corp’s stock and X
Corp’s assumption of $19,000 of T’s deductible expense; T realizes no gain so he recognizes no gain; at first glance
it appears that T has acquired stock with a $20,000 basis and $1,000 FMV. See §358(d)(2).

§358(h)  requires transferor to reduce his basis in transferee Corp stock received by the amount of any liability
that does not reduce basis under §358(d)(1), such as a §357(c)(3) liability

Ex. continuing the example above, applying §358(h) would lead to T holding X Corp stock with a basis of $1,000
($20,000 - $19,000)

§358(h)(2)(A) - §358(h) treatment does not apply if the trade or business with which the liability is associated is
transferred to X Corp

§358(h) may also apply to the assumption of contingent liabilities

Ex. X Corp forms SubCo; X Corp transfer to SubCo real estate with AB and FMV = $100M but subject to
environmental cleanup obligations of the same amount; thus, the stock of SubCo received by X Corp has basically
zero value; however, if the environmental cleanup costs are too contingent to take into account or would be
deductible by X Corp when paid, X Corp. will take a basis in the SubCo stock of $100M (unreduced by the
environmental cleanup liability); If Subco stock is then sold by X Corp, X Corp will be able to claim a capital loss of
the $100M (minus whatever amount it gets for the SubCo shares)  §358(h) bars this result

ADL 2.05 Tax Consequences – The Corporate Transferee

a. In General

§1032 – a corporation recognizes no gain or loss on the receipt of property (including cash) for its stock or stock
rights (corporation also recognizes no gain or loss when it acquires property for cash, its debt, or the assumption of
transferor’s liabilities)

§351(f) – if transferee corporation transfers boot in a §351 exchange, it may not recognize loss, but it may recognize
gain equal to the property’s FMV minus its AB

While §358 gives the transferor an exchanged basis in the qualified stock received, preserving any unrecognized
gain, §362(a) preserves that same gain in the basis that the transferee corporation takes in the transferred property
(the transferor’s basis for the transferred property “carries over” to the corporation)

§362(a) – more precisely, transferee corporation generally takes a basis in the property transferred equal to the
transferor’s basis plus any gain recognized by the transferor under §351(b) and §357(c)(1)

If more than one asset it transferred, gain recognized by the transferor on an asset should be allocated to that asset
under §362 by the corporation

§1223(2) – the transferee corporation tacks the transferor’s holding period for the property
Ex. Suppose that in a §351 exchange T transfers Assets 1,2,and 3 to X Corp in exchange for stock worth $100,000
and $40,000 in cash; Asset 1 has AB = $20,000 and FMV = $35,000; Asset 2 has AB = $10,000 and FMV =
$35,000; Asset 3 has AB = $80,000 and FMV = $70,000. T recognizes $10,000 gain on Assets 1 and 2. Under
§1032 X Corp. recognizes no gain or loss. Under §362(a) X Corp takes a basis in each transferred asset equal to T’s
basis plus T’s gain recognized on the asset
 Asset 1 basis = $30,000 ($20,000 AB plus $10,000 gain recognized)
 Asset 2 basis = $20,000 ($10,000 AB plus $10,000 gain recognized)
 Asset 3 basis = $80,000 ($80,000 AB plus no loss recognized)
Under §1223(2), X Corp tacks T’s holding period for each asset

If X Corp transferred non-cash property to T instead of cash, the results are generally the same except that X Corp
could recognize gain. See §351(f)

Ex. If X Corp transferred an asset with AB = $15,000 and FMV = $40,000 to T (and no other non-recognition rule
applies), X Corp would recognize gain of $25,000; note that the gain recognized by X Corp. does not affect X
Corp.’s basis in the assets received in the exchange. [if there would have been a realized loss instead of a gain, the
loss would simply disappear]

b. §362(e) – Limiting Duplicate Loss

§362(e)(2) – a corporation cannot take an aggregate basis in property contributed by a transferor in excess of the
property’s aggregate FMV

§362(e)(2)(A) - §362(e)(2) applies if the transferee’s aggregate basis in the applicable property received from a
transferor would exceed (under §362(a)) the property’s aggregate value

§362(e)(2)(B) – under §362(e)(2) the aggregate basis is reduced to the property’s aggregate value, and the basis
reduction is allocated among the transferred built-in property in proportion to their built-in losses. (for this purpose,
property has a built-in loss to the extent its AB exceeds its FMV immediately before the transfer)

§362(e)(2)(C)(i) Election – if both the transferor and the transferee corporation agree, the transferor (instead of the
transferee corporation) can apply the basis reduction to decrease his basis in the corporation’s stock received in the
exchange

Note that §362(e)(2) may apply to a transfer of assets even if the transferor’s aggregate basis in the assets does not
exceed their aggregate value but the transferor recognizes gain in the §351 exchange (for example, due to boot),
because this could give rise to a situation where aggregate basis exceeds aggregate value of the transferred assets

c. §362(d) – Limiting “Free” Loss Creation

Ex. Suppose T transfers property with AB = $7,000 and FMV = $30,000 to X Corp in a §351 exchange and the
property is subject to a $60,000 nonrecourse liability secured by the property. If the liability is not described in
§357(b) or §357(c)(3), T recognizes a gain under §357(c)(1) of $53,000 ($60,000 boot due to liability transfer minus
$7,000 basis); without any other provision, X Corp would take a $60,000 basis in the transferred property (T’s
$7,000 basis plus T’s $53,000 recognized gain); §362(d) addresses the problem that would arise from this situation
should X Corp not be taxable on the transfer for whatever reason

§362(d)(1) – the transferee corporation cannot increase its basis in a transferred asset above its FMV because of a
gain like that in the example above
§362(d)(2) – the transferee corporation’s basis increase may be limited if
 A transferor recognizes gain on the assumption of a nonrecourse liability that is secured by assets not
transferred to the transferee; and
 No person is subject to tax on the gain
If §362(d)(2) is triggered, the transferee corporation determines its basis in the transferred property by calculating
the transferor’s gain as if the transferee assumed only a ratable portion of the liability (where the portion is based on
the relative fair market values of all assets subject to the liability)

Ex. continuing the example above, suppose T was not subject to a tax on any gain recognized under §357(c)(1) and
that the assumed liability was secured by property with FMV = $120,000, only $30,000 of which was transferred in
the §351 exchange; to calculate X Corp’s basis increase, X Corp would be deemed to assume ¼ ($30,000/$120,000)
of the liability, or $15,000 (1/4*$60,000) and T would be deemed to recognize only an $8,000 gain ($15,000
liability assumed minus $7,000 basis in the transferred asset); as a result, X Corp would take a $15,000 basis in the
transferred asset (T’s $7,000 basis plus the $8,000 gain deemed recognized)

d. Parent Stock Paid to a Subsidiary Employee

Suppose X Corp owns SubCo and E, an employee of SubCo, is to get X Corp stock.

Regs. §1.83-6(d) – this transaction is tax-free to both corporations; SubCo would take a transferred basis in X Corp
stock, and that basis = FMV, so SubCo recognizes no gain or loss on the transaction

e. A Note on Installment Sales

If a transferor receives transferee debt instruments in a §351 exchange and the installment method under §453
applies, transferor defers gain until the debt instruments are satisfied; the transferee corporation correspondingly
defers its increase in basis to account for that gain (as the transferor recognizes gain under the installment method,
the transferee increases its basis in the transferred assets)

ADL 2.03 Qualification

c. Transferor Group and Control

i. Control

Rev. Rul. 59-259 clarifies §358 by stating that the “at least 80% of the total number of shares of all other classes of
stock of the corporation” applies separately to each class of nonvoting stock

Note that because the Rev. Rul. 59-259 test may apply to a group of transferors, it does not necessarily assure a
significant continuity for any one transfer

Ex. suppose 1,000 transferors form a corporation and each receives the same amount of stock for the same amount
of property transferred; §351 is available even though each shareholder only holds a 0.1% interest in the corporation

Note that a person need not acquire “stock that constitutes control” for §351 to apply

Ex. Suppose years ago X Corp was formed with A controlling 60% and B controlling 40%; if A contributes
additional property to get him an incremental 20%, he now controls 80% of X Corp and satisfies §368(c)

§351(g)(2) taxes certain “disqualified” preferred stock as other property rather than as stock; however, despite that
special treatment, “disqualified” preferred stock is treated as stock in applying the control test (disqualified preferred
stock is treated as stock for purposes of control but as boot for purposes of recognizing gain or loss)

ii. The “Transferor” Group

§351 may apply if a person or persons transfer property to a corporation even if those persons do not make
simultaneous exchanges
Regs. §1.351-1(a)(1) – persons are considered “together” in applying §351 if their rights “have been previously
defined and the execution of the agreement proceeds with an expedition consistent with orderly procedure”

Regs. §1.351-1(a)(1)(ii) – an “accommodation transferor” is a person who:

 In form transfers property and receives stock “which is of relatively small value” compared with stock
already owned (or to be received for services); and
 Whose primary purpose for the transfer is to qualify others under §351
Test (see Rev. Pro. 77-37): the dividing line for “relatively small value” is 10%, where the numerator is dollar
value for property contributed and denominator is dollar value to be received for services or stock already owned
(above 10% and the transaction is not one of “relatively small value”)

Note that if a transferor of services and property counts as a transferor of property, all of that transferor’s stock can
be counted for purposes of the 80% tests – not just the stock received for property transferred

Kamborian  upheld Regs. §1.351-1(a)(1)(ii) and concluded that stock received that was worth about 0.84% of the
stock already owned by the transferor had a relatively small value

iii. “Immediately After the Exchange”

“Control” is determined by comparing the stock owned by the transferor group with all outstanding stock, both
measured “immediately after the exchange”

In deciding whether to combine multiple transactions, courts have articulated a variety of tests

“Mutual interdependence” test (set out in American Bantam Car v. C.I.R.)  were the steps so interdependent
that the legal relations created by one transaction would have been fruitless without a completion of the series?

If there is a binding agreement, transactions will be stepped together; if there is not a binding agreement,
transactions may be stepped together

Aside from the presence or absence of a binding agreement, the amount of time between the transactions is probably
the most important aspect (the closer the transactions are in time, the more likely they will be combined)

Intermountain  held that a subsequent stock sale was stepped with a property transfer, because the transferor had
relinquished his legal right to retain shares sold

Intermountain Lumber Co. v. C.I.R., 65 T.C. 1025 (1976)

Facts: Shook executed a bill of sale for his sawmill equipment and deeded his sawmill site to S & W on July 15 and
16, 1964, respectively. In exchange, Shook received 364 S & W shares on July 15, 1964. Shook and Wilson also
received 1 share each as incorporators. The 364 shares and the 4 incorporation shares constituted all outstanding
capital stock of S & W on July 15, 1964. Also on that date, minutes of a special meeting stated in part that "The
President, Dee Shook, announced that he and Milo E. Wilson had entered into an agreement whereby Mr. Wilson
was to purchase 182 shares of Mr. Shook's stock.

Issue: Did the incorporator (Shook) control the requisite percentage of stock immediately after the exchange within
the meaning of §368(c)?

Law: "Control" is defined for this purpose in §368(c) as ownership of stock possessing at least 80% of the total
combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all
other classes of stock of the corporation.

Test: A determination of "ownership," as that term is used in §368(c) and for purposes of control under §351,
depends upon the obligations and freedom of action of the transferee with respect to the stock when he acquired it
from the corporation. Such traditional ownership attributes as legal title, voting rights, and possession of stock
certificates are not conclusive. If the transferee, as part of the transaction by which the shares were acquired, has
irrevocably foregone or relinquished at that time the legal right to determine whether to keep the shares, ownership
in such shares is lacking for purposes of §351. By contrast, if there are no restrictions upon freedom of action at the
time he acquired the shares, it is immaterial how soon thereafter the transferee elects to dispose of his stock or
whether such disposition is in accord with a preconceived plan not amounting to a binding obligation 

Analysis: Shook, as part of the same transaction in which the shares were acquired, had relinquished the legal right
to determine whether to keep the shares. In effect, Shook had sold the shares to Wilson. The exchange and the
subsequent sale are stepped together to form one transaction; the exchange does not qualify for §351 treatment.

Holding: Shook did not own, under §368(c), the requisite percentage of stock immediately after the exchange to
control the corporation as required for nontaxable treatment under §351.

Takeaway: If the transferor sells his shares as part of the same transaction in which he hopes to qualify for §351
treatment, the transaction fails §351 and is taxable because there has been more than a mere change in form.

Rev. Rul. 2003-51: a pre-arranged transfer of stock in a second §351 transaction will not preclude satisfaction of the
control requirement of a prior §351transaction because the tax-free transfer of stock, being a mere change in form of
ownership, is not necessarily inconsistent with the purposes of §351

Rev. Rul. 84-111: §351 qualification was granted to a partnership converted to corporate form by transferring its
assets to a corporation and then distributing the stock received in complete liquidation of the partnership

In non-commercial settings, it is also less likely that a purported §351 exchange followed by a transferor’s gift will
be stepped together to deny §351 treatment to the transferor

Ex. If B and C form X Corp in exchange for X stock, and B makes a gift of her shares to her daughter shortly after
the exchange, §351 treatment will probably be available

ADL 2.6 The Relationship of §351 to Other Provisions and Legal Doctrines

While §351 is not an elective provision, its requirements offer taxpayers the flexibility to avoid non-recognition
treatment (to “bust” the §351 transaction) when desirable, such as to recognize a loss or to recognize a gain that can
be used to offset an expiring NOL

The ability to sell one’s property to oneself or to a related party is circumscribed by §267; an individual is
considered related to a corporation only if the individual owns more than 50% in value of the corporation, actually
and constructively

a. §351 vs. Sale

Often the owner of appreciated real estate property slated for development would prefer to recognize the gain while
the property is investment property rather than waiting until is converted to property held for sale to customers (by
doing so, the owner may be able to recognize gain at capital gains rate instead of ordinary income rate, or due to
§1211 to allow some capital losses to be deducted against capital gains)

§ 1211. Limitation on capital losses.

(a)  Corporations. In the case of a corporation, losses from sales or exchanges of capital assets shall be allowed only
to the extent of gains from such sales or exchanges.
(b)  Other taxpayers. In the case of a taxpayer other than a corporation, losses from sales or exchanges of capital
assets shall be allowed only to the extent of the gains from such sales or exchanges, plus (if such losses exceed such
gains) the lower of--
(1)  $ 3,000 ($ 1,500 in the case of a married individual filing a separate return), or
 (2)  the excess of such losses over such gains

Ex. Suppose B owns investment real estate with AB = $100K and FMV = $300K; when the land is developed it will
have an FMV = $600K; Suppose that B transfers the undeveloped real estate to X Corp, a previously formed
corporation wholly owned by B, in exchange for 5-year notes with FMV = $300K

B would like to treat the transaction as a sale, reporting $200K of capital gain on the installment method as the notes
are paid off; X Corp would take a $300K cost basis under §1012 and following development and sale of the land
recognize $300K of ordinary income

In some circumstances, §1239 re-characterizes what would otherwise be capital gain as ordinary income on a sale
between related parties; however, the application of §1239 is restricted to property that would be subject to
depreciation in the hands of the purchaser (here, since the transferee-corporation would hold the purchased property
in inventory, §1239 would not apply)

However, the IRS has several ways it could re-characterize the transaction:
 Argue that the notes received constitute stock in the corporation (triggering §351)
 Argue that the transferor’s likelihood of payment is inextricably tied to the performance of the transferee
and therefore there is sufficient continuity to bring the transaction within §351
 Argue that the payment received by the transferor should be ignored because it is so speculative; the
transfer of property would then be treated as a non-taxable contribution to capital and transferee would take
the transferor’s basis under §362(a)

Regs. §1.118-1  when a shareholder makes a contribution to capital, the shareholder recognizes no gain or loss
and must increase his stock basis by the basis of the property contributed

§118  when a shareholder makes a contribution to capital, the corporation recognizes no gain or loss and generally
receives a carryover basis in the property

§301 in such a case, when the corporation makes payments on the notes, the interest may be treated as a dividend
that is ordinary income to the shareholder; retiring the debt may create ordinary income due to redemption

b. Assignment of Income

 Lucas v Earl  the assignment of future income does not shift the future income to assignee for federal tax
purposes
 Helvering v. Eubank  extended the rationale of Lucas to previously earned income
 P.G. Lake  taxpayer assigned an oil payment right to a creditor to discharge a debt; the consideration
received by the taxpayer was taxable as ordinary income rather than capital gain since it was a substitute
for future ordinary income
 Hempt Bros  assignment of income principles do not apply to §351 exchanges

Note that favoring §351 over the assignment of income doctrine does not necessarily shift income
 A/R  transferor and transferee both take the basis that the transferor has, preserving the possibility of a
double-tax – a tax on the transferee corporation when the receivables are paid off and a tax on the
transferor if and when her stock is sold or upon distribution of the receivables’ proceeds
 A/P  transferee-corporation may deduct the payables even though the effect of §357(c)(3) and §358(d)(2)
is to give the transferor an equivalent deduction (converse of A/R treatment)

c. Business Purpose

When §351 is employed for a non-business purpose, the non-recognition principle will often be ignored or give way
to other principles
E.g. a transferor who forms a corporation under §351 solely for the purpose of collecting the transferor’s A/R will be
taxed when the transferee-corporation collects the payment

d. Tax Benefit Rule

Tax benefit rule  a taxpayer who derives a tax benefit (e.g. a deduction) in one year must recover that deduction in
income in a subsequent year if some event inconsistent with the earlier deduction (e.g. a recovery of a deducted
item) occurs

Nash v. U.S.  the Court held that §351 was not inconsistent with the tax benefit rule

Debt vs. Equity

ADL 3.06 A Corporation’s Capital Structure

The tax code treats debt and equity very differently

Interest payments made by the corporation can be deducted by the corporation, while dividend payments made by
the corporation cannot be deducted

For the investor, retirement of corporate debt qualifies for exchange treatment. See §1271(a)(1). The retirement of
stock may qualify for exchange treatment or result in ordinary dividend income. See §301(c)(1),(2),(3).

§ 1271. Treatment of amounts received on retirement or sale or exchange of debt instruments.

(a)  General rule. For purposes of this title--
(1)  Retirement. Amounts received by the holder on retirement of any debt instrument shall be considered as
amounts received in exchange therefor

For corporate taxpayers, all or some dividends received (such as, for example, those from a wholly owned
subsidiary) are deductible. See §243. Interest payments received by a corporation, however, are not deductible.

When shareholders agree to invest additional funds in their corporation in proportion to their current ownership
interests (so that relative ownership does not change, regardless if they invest in debt or equity), both the corporation
and the shareholders benefit more from receiving debt than receiving equity. (Investment as equity subjects the
profits to full taxation at the corporate level and at least some taxation at the shareholder level, while investment as
debt avoids all corporate-level tax)

The issue of whether an investment should be treated as equity or debt arises due to their different tax treatment.

There is no bright-line rule to determine whether an investment will be considered debt or equity for tax purposes.

Factors to consider (See §385, below):

 Debt to equity ratio (the higher the ratio, the more likely the investment will be characterized as equity)
 The proportion in which the nominal debt is held by shareholders (if the shareholder owns the corporation’s
debt in the same proportion in which he owns the stock, the debt gives the shareholder all the benefits
associated with debt without the loss of residual interest)
 Were interest obligations met by the corporation? (if not, the investment is more likely to be characterized
as equity)
 Were the purported “loans” made during the corporation’s formative stage and used to acquire “essential”
corporate assets (it’s hard to understand the rationale for this one)

Fin Hay Realty Co. v. U.S., 398 F.2d 694 (3d Cir. 1968)
Issue: Were funds paid to a close corporation by its shareholders additional contributions to capital or loans on
which the corporation's payment of interest was deductible?

Facts: Finlaw and Hay were equal shareholders in Fin Hay Realty Co. They made subsequent capital infusions
after their initial capital contribution, and they characterized these subsequent capital infusions as debt. After many
years, Finlaw’s daughters inherited the entire corporation. The IRS challenged the prior capital infusions as being
equity rather than debt.

Law: No bright-line test for determining debt vs. equity. The ultimate question is whether the investment, analyzed
in terms of its economic reality, constitutes risk capital entirely subject to the fortunes of the corporate venture or
represents a strict debtor-creditor relationship. The court may look beyond form to evaluate the substance of the
relationship.

Test: Under an objective test of economic reality it is useful to compare the form which a similar transaction would
have taken had it been between the corporation and an outside lender, and if the shareholder's advance is far more
speculative than what an outsider would make, it is obviously a loan in name only.

Analysis: The shareholders had complete control over the loans. The shareholders held notes that could not repaid
for years; investors in an arms length transaction would not have allowed the debt to go unpaid for so many years;
the interest rate on the loans was lower than that which their risk would have otherwise justified. “The form which
the parties gave to their transaction did not match its economic reality.”

Holding (Freedman): The funds contributed were equity, not debt.

Dissent (Van Dusen): The funds contributed were debt. “these loans were bona fide loans, "at risk" in this
enterprise in no different way than any debt investment is "at risk" for general creditor of a real estate holding and
operating corporation.”

Delta Plastics v. C.I.R., T.C. Memo 2003-54

Issue: Should certain payments petitioner made to its shareholders in 1996 be treated as deductible interest on
shareholder loans or as nondeductible dividends on shareholder equity?

Facts: From 1981 to 1987, Schweigert, petitioner's principal shareholder, owned a controlling interest in and was an
officer and employee of Santa Fe Plastics, a successful company that manufactured and sold plastic products similar
to those manufactured and sold by petitioner. From 1981 to 1987, other of petitioner's shareholders, officers, and
directors also were employed in various capacities at Santa Fe.

In October of 1987, Schweigert and TeSelle (Santa Fe’s CFO) sold their respective stock interests in Santa Fe to
Kerr Glass Mfg Corp. In connection with the stock sale, both Schweigert and TeSelle entered into covenants not to
compete with Santa Fe. The covenants not to compete had a duration of 5 years.

During 1991 and 1992, Maffit (Santa Fe’s production manager) and Strand (Santa Fe’s head of marketing) used
their understanding and knowledge of the plastics manufacturing business to put together a business plan that
purported to improve upon the model used to start and develop Santa Fe. Prior to the startup of petitioner's
operations, TeSelle, Maffit, and Strand contacted and received commitments from former customers of Santa Fe,
signed contracts with suppliers and equipment manufacturers, and otherwise prepared for petitioner to begin
operations. The record is unclear as to Schweigert's participation in planning for the startup of petitioner.

Prior to August of 1993, petitioner received as initial capital a total of $183,500 in equity contributions from its 7
original shareholders. Also, petitioner received a total of $2,322,838 in the form of secured startup loans --
$2,169,013 from three unrelated creditors and $153,825 from Schweigert. Each secured loan was evidenced by a
promissory note executed on behalf of petitioner. In addition, petitioner received from a group of individuals
consisting of six of petitioner's shareholders and one other individual ("debenture holders") funds totaling
$1,337,500 (“debenture funds”). Documents entitled debenture notes, executed on behalf of petitioner in favor of the
debenture holders, reflected the debenture funds.

The written debenture notes, provided a 10-year schedule over which petitioner was to repay the debenture holders.
For the first 5 years of the debenture notes, designated interest only was due and payable at the end of the
second, third, fourth, and fifth years at a stated interest rate of 6% per year. For the second 5 years of the
debenture notes, principal and designated interest payments were due and payable in equal monthly installments
with a stated interest rate of 1% above the prime rate of interest. Payments due on the debenture notes were not
dependent upon the profits or losses of petitioner. Priority of payment on the debenture notes was equal
among the debenture holders, and none of the debenture holders received a management position or an
increase in management responsibilities with petitioner as a result of the debenture funds petitioner received.

The debenture notes were unsecured and subordinated to claims of petitioner's secured creditors, and, if not
paid, the debenture holders could enforce payment on the debenture notes only if the holders of more than
50% of the value of all the outstanding debenture notes joined in a proceeding against petitioner to enforce
payment. Petitioner made all scheduled payments of principal and designated interest due on the debenture notes.

When petitioner began operations, the above initial sources of funding (treating the debenture funds as debt of
petitioner and not as equity) resulted in a debt-to-equity ratio for petitioner of approximately 26:1. In just over 3
years, petitioner's D/E ratio (treating the debenture funds as debt of petitioner and not as equity) was reduced to
approximately 4:1. The rapid decrease in petitioner's debt-to-equity ratio from 1993 to 1996 reflected petitioner's
success in generating operating revenue.

As of the time of trial in 2002, petitioner had yet to declare or pay a cash dividend. At the end of 1993, petitioner's
basis in its capital assets including land, buildings, equipment, vehicles, tooling and equipment was $3,598,463. For
1993-1996 and for Federal income tax purposes, petitioner was a cash basis taxpayer. On petitioner's timely filed
1996 corporate Federal income tax return, an interest deduction of $93,746 was reflected for the payments
designated as interest that petitioner made in 1996 on the debenture notes. On audit, respondent determined
that for Federal income tax purposes the total debenture funds of $1,337,500 represented equity to petitioner
rather than debt, and respondent denied petitioner's claimed $93,746 interest deduction.

Law: The overall analysis of the Court seeks to determine whether there was an intent to create a debt with a
reasonable expectation of repayment and, if so, whether that intent comports with the economic reality of
creating a debtor-creditor relationship. The Court can look to several factors; none is determinative on its own.

Factors the court considers in this case:

 Thin or Adequate Capitalization – No specific ratio of debt to equity is determinative as to whether a

corporation is adequately capitalized;
 Extent to Which Funds Were Used To Acquire Capital Assets – N/A
 Proportionality of Interest - Funds received from shareholders in proportion to their respective stock
ownership interests may indicate equity investments;
 Risk – The more risk, the more likely the funds will be construed as equity;
 Third-Party Loans - Funds are more likely to be treated as debt if at the time the funds were received the
corporation had credit available from outside sources;
  Management Participation - Funds received by a corporation will be more likely treated as equity if, as a
result of such receipt, the person transferring the funds had a right to participate in the management of the
corporation;
 Payments - A significant debt-equity factor is whether a corporation repays its obligations on time;
 Intent of the Parties - both objective and subjective evidence of a taxpayer's intent are considered and given
weight in light of the particular circumstances of a case.

Analysis:

 Thin or Adequate Capitalization – Rapid D/E ratio reduction indicates to us, in this case, that despite the
elevated initial D/E ratio, petitioner was adequately capitalized from its inception (contrast with Plantation
Patterns);
 Extent to Which Funds Were Used To Acquire Capital Assets - A substantial portion of the debenture
funds appears to have been used to acquire capital assets;
 Proportionality of Interest - The debenture funds were transferred to petitioner by the debenture holders,
not in exact proportion, but in comparable proportion to the respective stock interests of the debenture
holders;
 Risk - Petitioner's obligation to repay the debenture funds was unconditional. Payments of principal and
designated interest on the debenture notes were not dependent upon profits of petitioner, nor were
payments excused or forgiven in the event petitioner sustained losses. Respondent argues that because the
debenture notes were unsecured and subordinated to the secured debts of petitioner, payments on the
debenture notes depended solely on future earnings of petitioner which put the debenture funds at an equal
amount of risk as petitioner's equity.  Reliance, however, upon future earnings for payment of a purported
debt generally does not cause the funds received by a corporation to be treated as equity;
 Third-Party Loans - petitioner was successful in obtaining secured loans from outside creditors, and at no
time was petitioner refused a loan from a third party;
 Management Participation - none of the debenture holders was granted a management position or an
increase in voting rights as a result of the receipt of the debenture funds by petitioner;
 Payments - Petitioner has timely made all scheduled payments of principal and designated interest due on
the debenture notes;
 Intent of the Parties - credible trial testimony was offered that a debtor-creditor relationship was intended
between petitioner and the debenture holders with regard to the debenture funds

Holding: Petitioner properly treated the $1,337,500 in debenture funds as debt. Petitioner is entitled to an interest
deduction for the $93,746 it paid as interest on the debenture notes.

A particular area of difficulty in the debt vs. equity determination is the treatment of a guarantee. If the shareholder/
guarantor is treated for tax purposes as the true borrower under a third-party loan to a controlled corporation, the
following is generally the result:

1. The guarantor is deemed to have received the funds directly under a loan from the lender
2. The guarantor is treated as having contributed the funds to the underlying corporation as a capital
contribution
3. Any “interest” or “principal” payments made by the controlled corporation to the third-party lender are
treated as dividend distributions to the guarantor (subject to the existence of earnings and profits)
4. The guarantor is treated as having made potentially deductible interest payments to the lender

Plantation Patterns, Inc. v. C.I.R. (5th Cir.)  held for the result described directly above, on the grounds that the
corporation was “thinly capitalized” and the guarantees were the “real undergirding” for the loan
§385(c)(1)  the issuer’s characterization as debt or equity is binding on the issuer (can still be challenged by the
IRS)

§385 allows the IRS to bifurcate the treatment of hybrid securities so that part of the return on the instrument is
treated as interest and part is treated as a nondeductible equity distribution

Hybrid securities often have the following characteristics:

 Ownership solely by shareholders and in the proportion to the stock held

 Transferability permitted only if accompanied by stock transfer
 Lengthy or no fixed maturity dates
 Interest payments that are discretionary or linked to corporate income
 Payment of interest and/or principal subordinate to general creditor claims
 Issuance to a current shareholder for no new consideration

§ 385. Treatment of certain interests in corporations as stock or indebtedness.

(a)  Authority to prescribe regulations. The Secretary is authorized to prescribe such regulations as may be necessary
or appropriate to determine whether an interest in a corporation is to be treated for purposes of this title as stock or
indebtedness (or as in part stock and in part indebtedness).
(b)  Factors. The regulations prescribed under this section shall set forth factors which are to be taken into account in
determining with respect to a particular factual situation whether a debtor-creditor relationship exists or a
corporation-shareholder relationship exists. The factors so set forth in the regulations may include among other
factors:
(1)  whether there is a written unconditional promise to pay on demand or on a specified date a sum certain in
money in return for an adequate consideration in money or money's worth, and to pay a fixed rate of interest,
(2)  whether there is subordination to or preference over any indebtedness of the corporation,
(3)  the ratio of debt to equity of the corporation,
(4)  whether there is convertibility into the stock of the corporation, and
(5)  the relationship between holdings of stock in the corporation and holdings of the interest in question.
(c)  Effect of classification by issuer.
(1)  In general. The characterization (as of the time of issuance) by the issuer as to whether an interest in a
corporation is stock or indebtedness shall be binding on such issuer and on all holders of such interest (but
shall not be binding on the Secretary).
(2)  Notification of inconsistent treatment. Except as provided in regulations, paragraph (1) shall not apply to
any holder of an interest if such holder on his return discloses that he is treating such interest in a manner
inconsistent with the characterization referred to in paragraph (1).
(3)  Regulations. The Secretary is authorized to require such information as the Secretary determines to be
necessary to carry out the provisions of this subsection.

§163(i)  certain high yield discount obligations issued by corporations are also subject to the bifurcation treatment

Under §163(i), the “disallowed amount” of interest payments (meaning the amount that is not deductible) equals:

1. The original issue discount (the dollar amount), multiplied by

2. The “disqualified yield” [which is equal to YTM – (applicable federal rate + 600 bps)], divided by
3. The YTM

“Earnings stripping” problem: when two levels of taxation (both at the investor and corporate level) are avoided by
characterizing certain payments as interest rather than equity distributions; this happens, for example, when the
recipient of the purported interest payment is a tax-exempt entity
§163(j)  deals with an “earnings stripping” problem by denying a deduction for disqualified interest paid to or
guaranteed by a related party exempt from U.S. tax on such interest payments. Additional requirements to be met
before an interest deduction will be disallowed:

 The deductibility of interest paid to tax-exempt, related parties will only be disallowed if the D/E ratio
exceeds 1.5 (as measured on certain days of the year); and
 Interest deductions will be disallowed only if the interest is deemed to be excessive (determined by a
formula)

ADL Ch. 4 Cash and Property Distributions

ADL 4.1 Introduction

§301(a) applies only when a corporate distributes property with respect to its stock; that is, distributions to
shareholders in their capacity as shareholders

§301(b)  if a corporation makes a distribution with respect to its stock, the amount of the distribution equals
[(cash + FMV of other property distributed) – min($0, corporate liabilities assumed by the shareholder in
connection with the distribution)]

§301(d)  Shareholder takes a basis in any distributed property equal to FMV.

Ex. If X Corp distributes its land with FV = $100 to B and B assumes a $40 liability in connection with the
distribution, B will take a basis of $100 even though the amount of the distribution is $60.

§301(c)  determines how to treat the amount of the distribution received

1. Dividend (included in gross income)
2. Recovery of basis (not included in gross income; reduces shareholder’s basis in stock)
3. Gain from the sale or exchange or stock (included in gross income; generally produces capital gain)

§301. Distributions of property.
(a)  In general. Except as otherwise provided in this chapter, a distribution of property (as defined in §317(a)) made
by a corporation to a shareholder with respect to its stock shall be treated in the manner provided in subsection (c).
(b)  Amount distributed.
(1)  General rule. For purposes of this section, the amount of any distribution shall be the amount of money
received, plus the fair market value of the other property received.
(2)  Reduction for liabilities. The amount of any distribution determined under paragraph (1) shall be reduced
(but not below zero) by--
(A)  the amount of any liability of the corporation assumed by the shareholder in connection with the
distribution, and
(B)  the amount of any liability to which the property received by the shareholder is subject immediately
before, and immediately after, the distribution.
(3)  Determination of fair market value. For purposes of this section, fair market value shall be determined as
of the date of the distribution.
(c)  Amount taxable. In the case of a distribution to which subsection (a) applies--
(1)  Amount constituting dividend. That portion of the distribution which is a dividend (as defined in §316)
shall be included in gross income.
(2)  Amount applied against basis. That portion of the distribution which is not a dividend shall be applied
against and reduce the adjusted basis of the stock.
(3)  Amount in excess of basis.
(A)  In general. Except as provided in subparagraph (B), that portion of the distribution which is not a
dividend, to the extent that it exceeds the adjusted basis of the stock, shall be treated as gain from the
sale or exchange of property.
 (B)  Distributions out of increase in value accrued before March 1, 1913. That portion of the distribution
which is not a dividend, to the extent that it exceeds the adjusted basis of the stock and to the extent that
it is out of increase in value accrued before March 1, 1913, shall be exempt from tax.
(d)  Basis. The basis of property received in a distribution to which subsection (a) applies shall be the FMV of such
property.
(e)  Special rule for certain distributions received by 20% corporate shareholder.
(1)  In general. Except to the extent otherwise provided in regulations, solely for purposes of determining the
taxable income of any 20% corporate shareholder (and its adjusted basis in the stock of the distributing
corporation), §312 shall be applied with respect to the distributing corporation as if it did not contain
subsections (k) and (n) thereof.
(2)  20% corporate shareholder. For purposes of this subsection, the term "20% corporate shareholder" means,
with respect to any distribution, any corporation which owns (directly or through the application of §318) --
(A)  stock in the corporation making the distribution possessing at least 20% of the total combined
voting power of all classes of stock entitled to vote, or
(B)  at least 20% of the total value of all stock of the distributing corporation (except nonvoting stock
which is limited and preferred as to dividends),but only if, but for this subsection, the distributee
corporation would be entitled to a deduction under §§ 243, 244, or 245 with respect to such distribution.
(3)  Application of §312(n)(7) not affected. The reference in paragraph (1) to subsection (n) of §312 shall be
treated as not including a reference to paragraph (7) of such subsection.
(4)  Regulations. The Secretary shall prescribe such regulations as may be necessary or appropriate to carry
out the purposes of this subsection.
(f)  Special rules.
(1)  For distributions in redemption of stock, see §302
(2)  For distributions in complete liquidation, see part II (§331 and following).
(3)  For distributions in corporate organizations and reorganizations, see part III (§351 et al)
(4)  For taxation of dividends received by individuals at capital gain rates, see §1(h)(11)

§316  defines “dividends” and provides that distributions out of specified “earnings and profits” are treated as
dividends (but what are “earnings and profits”?)

Even though dividends and capital gains may be taxed at the same rate, they are not the same things (e.g. can’t use
capital loss to offset dividend income, but can use capital loss to offset capital gain)

Corporate shareholders cannot take advantage of preferential dividend tax rates

§316. Dividend defined.
(a)  General rule. For purposes of this subtitle, the term "dividend" means any distribution of property made by a
corporation to its shareholders--
(1)  out of its earnings and profits accumulated after February 28, 1913, or
(2)  out of its earnings and profits of the taxable year (computed as of the close of the taxable year without
diminution by reason of any distributions made during the taxable year), without regard to the amount of the
earnings and profits at the time the distribution was made.
Except as otherwise provided in this subtitle, every distribution is made out of earnings and profits to the
extent thereof, and from the most recently accumulated earnings and profits. To the extent that any distribution
is, under any provision of this subchapter, treated as a distribution of property to which §301 applies, such
distribution shall be treated as a distribution of property for purposes of this subsection.
(b)  Special rules.
(1)  Certain insurance company dividends. The definition in subsection (a) shall not apply to the term
"dividend" as used in subchapter L [§§ 801 et seq.] in any case where the reference is to dividends of
insurance companies paid to policyholders as such.
(2)  Distributions by personal holding companies.
(A)  In the case of a corporation which--
(i)  under the law applicable to the taxable year in which the distribution is made, is a personal
holding company (as defined in §542), or
 (ii)  for the taxable year in respect of which the distribution is made under §563(b) (relating to
dividends paid after the close of the taxable year), or §547 (relating to deficiency dividends), or
the corresponding provisions of prior law, is a personal holding company under the law applicable
to such taxable year, the term "dividend" also means any distribution of property (whether or not a
dividend as defined in subsection (a) made by the corporation to its shareholders, to the extent of
its undistributed personal holding company income (determined under §545) without regard to
distributions under this paragraph) for such year.
(B)  For purposes of subparagraph (A), the term "distribution of property" includes a distribution in
complete liquidation occurring within 24 months after the adoption of a plan of liquidation, but--
(i)  only to the extent of the amounts distributed to distributees other than corporate shareholders,
and
(ii)  only to the extent that the corporation designates such amounts as a dividend distribution and
duly notifies such distributees of such designation, under regulations prescribed by the Secretary,
but
(iii)  not in excess of the sum of such distributees' allocable share of the undistributed personal
holding company income for such year, computed without regard to this subparagraph or §562(b)

§1(h)(11)(iii) and §246(c)  To be a “qualified” dividend (and receive preferential tax treatment), the following
requirement must be met: Shareholder must hold the stock for at least 61 days during the 121-day period that begins
60 days before the ex-dividend date (for common stock); or for at least 91 days during the 181 period that begins 90
days before the ex-dividend date (for preferred stock)

Ex-dividend date is the first day the stock trades without the dividend.

§1(h)(11(D)(i)  Note that qualified dividend income does not include any amount that the shareholder takes into
account as “investment income” for purposes of the investment interest limitation of §163

§311(b)  When a corporation distributes property, it does not recognize loss if a loss is realized, but it does
recognize gain when it distributes appreciated property, computing the gain as if it sold the property to the recipient
for FMV. (when the shareholder receives property with a built-in loss, that built-in loss simply disappears)

§305  distributions of stock

§302  redemptions (distributions in exchange for a shareholder’s stock)
§331-§338  liquidating distributions
§368  distributions in connection with a reorganization

§311. Taxability of corporation on distribution.

(a)  General rule. Except as provided in subsection (b), no gain or loss shall be recognized to a corporation on the
distribution (not in complete liquidation) with respect to its stock, of--
(1)  its stock (or rights to acquire its stock), or
(2)  property.
(b)  Distributions of appreciated property.
(1)  In general. If--
(A)  a corporation distributes property (other than an obligation of such corporation) to a shareholder in
a distribution to which subpart A [26 USCS §§ 301 et seq.] applies, and
(B)  the FMV of such property exceeds its adjusted basis (in the hands of the distributing
corporation),then gain shall be recognized to the distributing corporation as if such property were sold to
the distributee at its FMV.
(2)  Treatment of liabilities. Rules similar to the rules of §336(b) shall apply for purposes of this subsection.

ADL 4.2 Earnings and Profit

The “earnings and profits” concept for tax purposes is not the same as any financial or accounting profit concept; the
term “dividend” may not mean the same thing for tax purposes as for state law purposes
See Rev. Rul. 74-164 for treatment of distributions flow through the “earnings and profit” account and are
thus treated as dividends, basis adjustments, or capital gains.

Ex. Suppose X Corp has $20,000 profit in year one and distributes $20,000 to shareholders  entire $20,000 is
dividend

Ex. Suppose X Corp loses $20,000 in year one and then has $20,000 in profits in year two and after year two
distributed $20,000 to shareholders  entire $20,000 is dividend (even though X Corp has no net accumulated
earnings and profit)

Regs. §1.316-2(b)  If there is more than one distribution, the current earnings and profits are prorated among the
distributions for the purpose of determining if a distribution is a dividend; if total distributions exceed current
earnings and profits, each distribution shares in current earnings and profits in the proportion that the distribution
bears to the total distributions for the year; accumulated earnings and profits are allocated to distributions on a first-
come, first-serve basis

E&P cannot be decreased below zero by a distribution

Ex. Suppose X Corp has $20,000 in earnings and profits in year one, and on the last day of year one, B sells his
stock to C. C then receives a $20,000 distribution from X Corp after the purchase of the stock from B and before X
Corp has any additional earnings. C has dividend income on the distribution even though X Corp earned that
income while B was a shareholder and C wasn’t.

U.S. v. Phellis, 257 U.S. 156 (1921)  explained why the apparent unfairness of the “miracle of income without
gain” is not as troubling as it may seem (see example above); when “Powder” reincorporated into DuPont and
distributed stock to its shareholders, the distribution represented a dividend (i.e. income) to the shareholders

Ex. Suppose B owns 1 share of X Corp with AB = $60 and FMV = $100 and in one month X Corp will distribute
$10 per share (reducing each share’s value to $90). If we assume income is taxed at 30%, a prospective purchaser
will know the share comes packaged with a tax liability of $3 tied to the impending dividend  accordingly, a
prospective purchaser will pay less; B bears the burden not by actually paying the tax but by receiving a reduced
sales price, while the purchaser will actually pay the tax but not actually bear the burden

To get from taxable income to “earnings and profits,” you must make some adjustments:

 Add back some items that are excluded from taxable income but that represent an accretion to the
corporation that can be distributed without impairing the corporation’s original capital; e.g. add back
excluded interest earned on debt-holdings; include gain that might not yet be recognized in taxable income
due to installment method
 Add back some items that are deductible in computing taxable income but require no outlay and therefore
do not deplete what is available for distribution; e.g. add back a dividend-received deduction; net operating
losses; capital loss carrybacks; accelerated depreciation deductions
 Subtract items that reduce what is available for distribution but for which there is no deduction when
computing taxable income; e.g. fines and kickbacks; unreasonable compensation; interest incurred to
produce tax-exempt income

Review example on p. 105 of ADL

ADL 4.3 Relief From Dividends

§243  provides for a deduction equal to a specified percentage of dividends received by a corporation from a
domestic corporation (the percentage depends primarily on the degree of ownership)
 Broadly speaking, if the corporate shareholder is affiliated with the distributing corporation, it is entitled to
a 100% dividends received deduction;
 80% dividends received deduction if corporation owns at least 20% (by vote and value) of the distributing
corporation’s stock
 70% dividend received deduction for all other corporation to corporation dividend transactions

§245  applies §243 treatment if a foreign corporation is subject to U.S. taxation

Certain code sections prevent taxpayers from taxing advantage of the arbitrage opportunities that would otherwise
arise due to the dividends received deduction

§246A (only applies to “portfolio stock” in which the corporation receiving the dividend owns less than 50% of the
distributing corporation)  limits the de facto tax exemption (the dividends received deduction); if a corporation
funds its purchase of another corporation’s stock with a combination of cash and debt, the §243 deduction will be
cut by the “average indebtedness percentage”

Rev. Rul. 88-66  §246A was enacted to reduce the dividends received deduction where indebtedness is directly
attributable to investment in portfolio stock
 Where indebtedness is clearly incurred for the purpose of acquiring portfolio stock or otherwise is directly
traceable to the acquisition, the indebtedness constitutes portfolio indebtedness (e.g. any non-recourse loan
secured in whole or in part with portfolio stock is portfolio indebtedness)
 Where indebtedness is directly attributable to the carrying of portfolio stock, the indebtedness constitutes
portfolio indebtedness (e.g. there is portfolio indebtedness where portfolio stock is acquired by a
corporation using its equity and then later the corporation borrows money using the portfolio stock as
security if the purchaser could reasonably have been expected to sell the portfolio stock rather than incur
the indebtedness)
 Portfolio indebtedness is not required be that of the holder of the dividend paying stock and may exist in
the controlled group situation (e.g. §246A can apply where one member of an affiliated group incurs the
portfolio indebtedness and another member of the group acquires the stock)

Test: is the indebtedness directly attributable to investment in portfolio stock? (is there a direct relationship
between the debt and the carrying of the portfolio stock?)

Note that §246A looks to whether the loan proceeds are actually used to buy portfolio stock (it is an effects test); the
ultimate purpose for the indebtedness is not dispositive (it is not a purpose test)

Progressive Corp. v. U.S., 970 F.2d 188 (6th Cir. 1992)  If a corporation completely hedges its exposure while
owning stock by being long a put and/or short a call, the corporation is not able to take advantage of the dividends
received deduction (because it has a holding period of zero)

§1059  mandates a reduction of basis for corporate shareholders on the receipt of “extraordinary” dividends if the
stock on which the dividends are paid has not been held for more than two years before the dividend announcement
date (for common stock, dividends during any 85-day period that equal or exceed 10% of a taxpayer’s stock basis
generally are considered extraordinary dividends)

§1059 can apply to any transaction taxed as a dividend (including distributions in redemption of stock and
redemptions through related corporations); see §302(d) and §304(a)

§1059 does not generally apply to a 100% DRD transaction

Ex. Assume Parent Corp owns all the outstanding stock of Brother Corp with AB = $5,000 and FMV = $50,000 and
Parent Corp owns all the outstanding stock of Sister Corp with AB = $50,000 and FMV = $50,000. If Parent Corp
sells that stock of Brother Corp to Sister Corp for $50,000 in cash, this transaction is a redemption by related
corporations as described in §304(a) and because Parent Corp retains control of Brother Corp after the transaction, it
is taxable as a distribution pursuant to §304(a). If the combined earnings and profits of Brother and Sister exceed
$50,000, the entire distribution is taxed as a dividend. If the distribution is treated as an extraordinary distribution,
Parent Corp is deemed to contribute its stock of Brother Corp to Sister Corp for Sister Corp stock which is then
redeemed and taxed as a dividend. Thus, Parent Corp would have a $45,000 taxable gain under §1059(a)(2). Parent
Corp would be unable to offset that gain with its pre-existing basis in the stock of Sister Corp that it actually owns.

ADL 4.4 Treatment of the Distributing Corporation

General Utilities doctrine (essentially no longer good law)  a distributing corporation recognized no gain or loss
on a distribution of property with respect to a shareholder’s stock

§311(a) still provides for non-recognition of gain or loss on a distribution with respect to stock; however, §311(b)
provides a substantial exception

§311(b)  a distributing corporation must recognize a gain on a distribution of property (other than the distributing
corporation’s own obligation) where the property’s FMV > AB; the gain is recognized as if the property had been
sold to the shareholders at FMV

The reach of §311(b) is quite broad; a distributing corporation must recognize not only post-incorporation
appreciation but pre-incorporation appreciation, as well.

Note that the §311(b) rule does not apply to a corporation distributing property where FMV < AB (i.e. property with
a built-in loss); the corporation recognizes no loss, and the built-in loss is not preserved for shareholders (it
simply disappears)

§311. Taxability of corporation on distribution.

(a)  General rule. Except as provided in subsection (b), no gain or loss shall be recognized to a corporation on the
distribution (not in complete liquidation) with respect to its stock, of--
(1)  its stock (or rights to acquire its stock), or
(2)  property.
(b)  Distributions of appreciated property.
(1)  In general. If--
(A)  a corporation distributes property (other than an obligation of such corporation) to a shareholder in
a distribution to which subpart A applies, and
(B)  FMV of such property > AB (in the hands of the distributing corporation), then gain shall be
recognized to the distributing corporation as if such property were sold to the distributee at its FMV.
(2)  Treatment of liabilities. Rules similar to the rules of §336(b) shall apply for purposes of this subsection.

§267  prohibits the deduction of losses resulting from the sale or exchange between related parties; a loss is
disallowed when the transferor and the transferee are related and the transferor may be deemed to retain
control of the asset

For purposes of §267, a corporation and a more than 50% (by value) shareholder through either direct or indirect
stock ownership are considered related

There are some peculiar side effects that arise because §267 applies to actual sales but not to deemed sales (i.e.
distributions that are “deemed” sales under §311(b))
§267. Losses, expenses, and interest with respect to transactions between related taxpayers.
(a)  In general.
(1)  Deduction for losses disallowed. No deduction shall be allowed in respect of any loss from the sale or
exchange of property, directly or indirectly, between persons specified in any of the paragraphs of subsection
(b). The preceding sentence shall not apply to any loss of the distributing corporation (or the distributee) in the
case of a distribution in complete liquidation.
(2)  Matching of deduction and payee income item in the case of expenses and interest. If--
(A)  by reason of the method of accounting of the person to whom the payment is to be made, the
amount thereof is not (unless paid) includible in the gross income of such person, and
(B)  at the close of the taxable year of the taxpayer for which (but for this paragraph) the amount would
be deductible under this chapter, both the taxpayer and the person to whom the payment is to be made
are persons specified in any of the paragraphs of subsection (b),then any deduction allowable under this
chapter in respect of such amount shall be allowable as of the day as of which such amount is includible
in the gross income of the person to whom the payment is made (or, if later, as of the day on which it
would be so allowable but for this paragraph).
(b)  Relationships. The persons referred to in subsection (a) are:
(1)  Members of a family, as defined in subsection (c)(4);
(2)  An individual and a corporation more than 50% in value of the outstanding stock of which is owned,
directly or indirectly, by or for such individual;
(3)  Two corporations which are members of the same controlled group (as defined in subsection (f));
(10)  A corporation and a partnership if the same persons own--
(A)  more than 50% in value of the outstanding stock of the corporation, and
(B)  more than 50% of the capital interest, or the profits interest, in the partnership;
(12)  An S corporation and a C corporation, if the same persons own more than 50% in value of the
outstanding stock of each corporation
(c)  Constructive ownership of stock. For purposes of determining, in applying subsection (b), the ownership of
stock--
(1)  Stock owned, directly or indirectly, by or for a corporation, partnership, estate, or trust shall be considered
as being owned proportionately by or for its shareholders, partners, or beneficiaries;
(2)  An individual shall be considered as owning the stock owned, directly or indirectly, by or for his family;
(3)  An individual owning (otherwise than by the application of paragraph (2)) any stock in a corporation shall
be considered as owning the stock owned, directly or indirectly, by or for his partner;
(4)  The family of an individual shall include only his brothers and sisters (whether by the whole or half
blood), spouse, ancestors, and lineal descendants; and
(5)  Stock constructively owned by a person by reason of the application of paragraph (1) shall, for the
purpose of applying paragraph (1), (2), or (3), be treated as actually owned by such person, but stock
constructively owned by an individual by reason of the application of paragraph (2) or (3) shall not be treated
as owned by him for the purpose of again applying either of such paragraphs in order to make another the
constructive owner of such stock.
(d)  Amount of gain where loss previously disallowed. If--
(1)  in the case of a sale or exchange of property to the taxpayer a loss sustained by the transferor is not
allowable to the transferor as a deduction by reason of subsection (a)(1) (or by reason of §24(b) of the Internal
Revenue Code of 1939); and
(2)  the taxpayer sells or otherwise disposes of such property (or of other property the basis of which in his
hands is determined directly or indirectly by reference to such property) at a gain,
then such gain shall be recognized only to the extent that it exceeds so much of such loss as is properly
allocable to the property sold or otherwise disposed of by the taxpayer. This subsection shall not apply if the
loss sustained by the transferor is not allowable to the transferor as a deduction by reason of §1091 (relating to
wash sales) or by reason of §118 of the Internal Revenue Code of 1939.
(f)  Controlled group defined; special rules applicable to controlled groups.
(1)  Controlled group defined. For purposes of this section, the term "controlled group" has the meaning given
to such term by §1563(a), except that--
(A)  "more than 50%" shall be substituted for "at least 80%" each place it appears in §1563(a), and
(B)  the determination shall be made without regard to subsections (a)(4) and (e)(3)(C) of §1563.
 (2)  Deferral (rather than denial) of loss from sale or exchange between members. In the case of any loss from
the sale or exchange of property which is between members of the same controlled group and to which
subsection (a)(1) applies (determined without regard to this paragraph but with regard to paragraph (3))--
(A)  subsections (a)(1) and (d) shall not apply to such loss, but
(B)  such loss shall be deferred until the property is transferred outside such controlled group and there
would be recognition of loss under consolidated return principles or until such other time as may be
prescribed in regulations.

Because §311(b) disallows losses and the built-in loss “disappears” corporations may try to sidestep the
application of §311(b) by, for example, triggering §267 (because at least then the built-in loss is kept); note that
attempts to circumvent the reach of §311(b) will be closely scrutinized; the Service will press to re-characterize such
transactions as distributions falling within the confines of §311(b)

What happens when there are liabilities associated with the distribution?

§311(b)(2)  if the amount of the liability > FMV of the property, the amount realized is stepped up to the amount
of the liability; if the FMV of the property > amount of the liability, the amount realized is simply the FMV of the
property

Note that it is not clear how the regulations or the courts will deal with the distribution of deductible liabilities

ADL 4.5 Effect of Property Distributions on Earnings and Profit

A corporation’s E&P are increased for its income items and reduced for its losses, deductions, and distributions.
Thus, a distribution may affect the amount of E&P available for subsequent distributions

§312(a)  E&P are decreased by the amount of money distributed

What happens to E&P if a corporation distributes property whose basis differs from its FMV?

A corporation increases its E&P by any gain recognized on an asset’s distribution; a corporation decreases its E&P
(after the shareholders account for the distribution) by the greater of the distributed property’s AB or FMV
immediately before the distribution (these determinations are made on an asset-by-asset basis)

e.g. Suppose X Corp. has $0 E&P and distributed property with $0 basis and FMV = $2,000 to shareholders; on the
distribution X Corp. recognizes $2,000 gain under §311(b); the gain increases X Corp.’s E&P to $2,000; under
§301(c)(1) the shareholders will treat the entire distribution as a dividend; therefore, due to §312(a)(3) and (b)(2), X
Corp.’s E&P account will be reduced to $0 because X Corp.’s earnings were fully distributed (note that the
reduction for a distribution occurs only after determining the tax treatment of the shareholders)

What if the corporation distributes its own debt obligation to shareholders?

e.g. X Corp. distributes its own debt obligation with face value of $50,000 (no interest, matures in 20 years, and
interest rate is 10%); obligation has a PV = $7,432; shareholders will only be taxed on the PV, not the face value
(shareholders include the PV as a dividend, at least to the extent of X Corp.’s E&P)

§312(a)(2)  corporation’s E&P account is decreased by the PV of the debt obligation, not its face amount

e.g. X Corp. would decrease its E&P account by $7,432 on issuance (not by $50,000); each subsequent year X Corp.
can reduce its taxable income, and accordingly its E&P, by the portion of the original issue discount that the
shareholders must report as income (See §163(e).)

§312. Effect on earnings and profits.

(a)  General rule. Except as otherwise provided in this section, on the distribution of property by a corporation with
respect to its stock, the E&P of the corporation (to the extent thereof) shall be decreased by the sum of--
(1)  the amount of money,
(2)  the principal amount of the obligations of such corporation (or, in the case of obligations having original
issue discount, the aggregate issue price of such obligations), and
(3)  the adjusted basis of the other property, so distributed.
(b)  Distributions of appreciated property. On the distribution by a corporation, with respect to its stock, of any
property (other than an obligation of such corporation) the fair market value of which exceeds the adjusted basis
thereof--
(1)  the E&P of the corporation shall be increased by the amount of such excess, and
(2)  subsection (a)(3) shall be applied by substituting "fair market value" for "adjusted basis".
For purposes of this subsection and subsection (a), the AB of any property is its AB as determined for
purposes of computing E&P.
(c)  Adjustments for liabilities. In making the adjustments to the E&P of a corporation under subsection (a) or (b),
proper adjustment shall be made for--
(1)  the amount of any liability to which the property distributed is subject, and
(2)  the amount of any liability of the corporation assumed by a shareholder in connection with the
distribution.
(d)  Certain distributions of stock and securities.
(1)  In general. The distribution to a distributee by or on behalf of a corporation of its stock or securities, of
stock or securities in another corporation, or of property, in a distribution to which this title applies, shall not
be considered a distribution of the earnings and profits of any corporation--
(A)  if no gain to such distributee from the receipt of such stock or securities, or property, was
recognized under this title, or
(B)  if the distribution was not subject to tax in the hands of such distributee by reason of §305(a).
(3)  Stock or securities. For purposes of this subsection, the term "stock or securities" includes rights to
acquire stock or securities.

ADL 4.6 Treatment of Shareholders – Property Distributions

§301(b)(2)  if a corporation distributes non-cash property or the shareholder assumes a liability in connection with
the distribution, the amount distributed is reduced (but not below $0) by the liability assumed (or taken subject to)

§301. Distributions of property.
(b)  Amount distributed.
(1)  General rule. For purposes of this section, the amount of any distribution shall be the amount of money
received, plus the FMV of the other property received.
(2)  Reduction for liabilities. The amount of any distribution determined under paragraph (1) shall be reduced
(but not below zero) by--
(A)  the amount of any liability of the corporation assumed by the shareholder in connection with the
distribution, and
(B)  the amount of any liability to which the property received by the shareholder is subject immediately
before, and immediately after, the distribution.
(3)  Determination of FMV. For purposes of this section, FMV shall be determined as of the date of the
distribution.

§301(d)  shareholders take a basis equal to FMV in the property (neither assuming a liability nor taking property
subject to a liability has any effect on the basis of the distributed property)

ADL 4.7: Constructive Dividends

Ways dividends may be disguised:

 Distribution may be disguised as a deductible expense even though the receipt by the shareholder would be
taxable (e.g. compensation)
  Distribution may be disguised as being excludable from income by shareholders while the distributing
corporation receives no deduction (e.g. corporate loans)
 Distribution may be disguised as generating a deduction for the corporation yet is excluded from the
shareholder’s income (e.g. corporation makes a payment on behalf of the shareholder, claiming it to be for
the benefit of the corporation)

Compensation vs. Dividend:

To determine whether the shareholder-employee has performed services commensurate with the payment, the
Service will look to the following:
 Payments to other employees
 Payments to similarly situated employees in comparable companies
 What services the employee actually performed for the corporation
 How those services affected the corporation’s performance
 The corporation’s history (or lack thereof) of paying dividends

Reasons the market may fail to police reasonable compensation:

 High transaction costs (e.g. cost of bringing a lawsuit against the corporation may be very high)
 Market is indifferent about how the corporation’s return is allocated

It is in closely held corporations where most or all of the shareholders are employees where purported compensation
is most likely to be susceptible to being re-characterized as a dividend distribution

If the corporation has never paid dividends, the level of compensation is more likely to be scrutinized

Rev. Rul. 79-8  holds that while the absence of dividends may indicate the presence of disguised dividends, it
does not convert compensation determined to be reasonable into dividends

Note that if a controlling shareholder causes a corporation to pay excessive compensation to a relative (e.g.
shareholder’s child) who may do some work for the corporation, the excessive compensation will be treated as a
distribution to the shareholder, who will then be deemed to make a gift to the relative (so there will be no deduction
for the corporation for the excessive compensation and – assuming sufficient E&P – the shareholder will have
dividend income)

Loan vs. Dividend

The loan vs. dividend question raises two questions:

1. First, the Service must determine if the transfer of funds is in fact a loan
2. Second, if the transfer is a loan, the Service must determine if the loan bears an appropriate interest rate

To determine if the transfer is a loan, the Service will look to the following:
 Does the transaction on its face seem to be a loan?
 Is there a written loan agreement?
 Is an adequate interest rate provided?
 Is the note secured?
 Is there a repayment schedule?
 Have any repayments been made?
 Have any previous loans (if any exist) between the corporation and shareholder been repaid?
 What is the corporation’s dividend history?
 If the corporation has been successful but has made few or no distributions to shareholders, it is more likely
that a purported loan will be closely scrutinized
 Proportionality  If the corporation loans funds in proportion to shareholders’ equity interests, the transfer
is more likely to be closely scrutinized and deemed to be a dividend
Note that a corporate loan to a shareholder may be respected for federal income tax purposes but still result in a
distribution to the shareholder (e.g. suppose X Corp makes a loan to shareholder B that is respected for federal
income tax purposes but the loan makes no provision for interest; the “interest benefit” may be re-characterized as a
distribution to the shareholder)

The personal but below-market use of corporate property (e.g. use of the corporate hunting lodge) by a shareholder
will often give rise to a “constructive” distribution to the shareholder

§7872  constructive distributions are mandated when a corporation makes a below-market interest loan to a
shareholder

 If the loan is payable on demand, the transaction is re-characterized as though the shareholder pays the
market rate of interest (See §7872(f)(2) for definition of market rate of interest); the shareholder is treated
as if he pays a market of rate of interest on the loan to the corporation; corporation is treated as if it makes a
distribution to shareholder in that same amount
Note that for a demand loan, the deemed distribution is matched by a deemed interest payment; historically,
taxpayers offset the income from the distribution with the interest deduction; however, under §7872 the offsetting
deduction is not automatic (e.g. not allowed if the taxpayer uses the borrowed proceeds to purchase tax-exempt
securities or uses the borrowed funds for personal purposes); if a deduction is not allowed, the shareholder who
receives a below-market-interest-rate loan may have dividend income without an offset (assuming the corporation
has adequate E&P)
 If the loan is a term loan, the timing of the deemed distributions and deemed interest repayment differs (see
ADL p. 127 for more)

A loan, lease, or bargain-sale transaction between related corporations may be re-characterized if the Service cannot
find a business reason for the loan and if the loan formalities are not observed

Rev. Rul. 69-630  if the transaction between related corporations X and Y is not respected, the transaction will be
re-characterized as X Corp making a distribution to shareholder B and, in turn, shareholder B making a capital
contribution to Y Corp (for a bargain-sale, X will have income in the amount of the difference between the purchase
price and the property’s FMV, Y’s basis will be stepped up to the property’s FMV, and the amount of the
distribution and capital contribution will both equal the difference between the purchase price and the property’s
FMV)

Rapid Electric Co. v. C.I.R., 61 T.C. 232 (1973)  if the corporation has a valid business purpose for a loan to a
related corporation, then treatment as a constructive dividend is not appropriate

Corporate Deduction with no Shareholder Inclusion:

e.g. Suppose X Corp pays for a “business” trip for controlling shareholder B. X Corp might seek to deduct the
expense; B might argue that the benefit to the corporation exceeds any incidental personal benefit, justifying
exclusion from income

If the transaction is re-characterized, not only will the shareholder have includable income (at least to the extent the
distribution is made out of the corporation’s E&P), but the corporation will lose its deduction

Boulware v. U.S., 128 S.Ct. 1168 (2008)  there is no requirement that a corporation or shareholder “intend” for a
capital return when a distribution is made for the transaction to be considered a distribution (a controlling
shareholder directed funds from his corporation to himself; the distribution from the corporation was not a dividend
because the corporation had no earnings and profits; therefore, the defendant did not have a deficiency on his federal
income tax statement when he failed to report as income the funds received from the corporation; he had no income
because the distribution was not a dividend)

ADL 4.8: Dividends and Corporate Shareholders

While a corporation has incentive to try to disguise dividends as loans, compensation, or other deductible expenses,
a corporation also has incentive to try to disguise sales as dividends

Whether a corporation will succeed in converting sales proceeds into dividends may depend on events surrounding
the distribution; one factor is timing of the dividend declaration:
 Waterman Steamship Corp. v. C.I.R., 430 F.2d 1185 (5th Cir. 1970)  distribution of a note not treated as
dividend when the dividend was declared after the negotiations began
 Litton Industries, Inc. v. C.I.R., 89 T.C. 1086 (1987)  Service respected the dividend distribution, in part
because it was declared before negotiations for a prospective sale began

Litton Industries  provides a blueprint for using a dividend to reduce overall gain on a sale by a parent
corporation of the stock of its subsidiary (declare dividend before announcing sale)

Because a distribution cannot be a dividend without sufficient E&P, the parent may try to increase the subsidiary’s
E&P before the distribution is made; one technique that may be employed is an installment sale (E&P will be
recognized immediately by the full installment gain but its gain recognition may be deferred under the installment
method); however, see §301(e)

§312(n)  certain items deferred from currently taxable income are included for purposes of computing E&P
(installment sale gains are one such item)

§301(e)  adjustments to E&P otherwise mandated by §312(k) (dealing with depreciation) and §312(n) are
generally disregarded in determining the taxable income (and adjusted basis) of any “20% corporate shareholder”
(i.e. where the shareholder owns, directly or indirectly, 20% of the total voting power or value – where value
excludes nonvoting preferred stock – of the distributing corporation)

ADL Ch. 5 Redemptions

ADL 5.01: Introduction

§317(b)  a distribution in redemption of stock is the purchase by a corporation of some of its own stock

§317(b) Redemption of stock. For purposes of this part, stock shall be treated as redeemed by a corporation if the
corporation acquires its stock from a shareholder in exchange for property, whether or not the stock so acquired is
cancelled, retired, or held as treasury stock.

§302  redemptions resembling a sale of stock to a third party qualify for exchange treatment, while redemptions
more closely resembling dividend distributions follow the general distribution rules of §301

The rules of §302 distinguish among types of redemptions by generally considering the effect of the redemption on
the shareholder’s interest in the corporation

Exchange treatment offers to the shareholder whose stock is redeemed the recovery of basis implicit in the definition
of gain (only the excess amount realized over the shareholder’s basis is taxable to the shareholder)

e.g. Suppose that individual B owns 100 shares of X Corp with AB = $70/share and FMV = $100/share; X Corp
redeems 10 shares for $1,000
 Under §301 treatment  B has dividend income of $1,000 (assuming the corporation has sufficient E&P)
  Under exchange treatment  B has capital gain of $300 ($30 built-in gain/share*10 shares)

Note that with a high basis, a shareholder will prefer exchange treatment (if the basis is high enough, the exchange
treatment can even generate a capital loss)

§114  for inherited stock, basis will equal FMV at death (i.e. basis may be “stepped up”)

Due to §114 and §302, the treatment of the redemption can mean that for the devisee either the entire amount could
be taxed (under §301 treatment) or none of it could be taxed (under exchange treatment)

§302 is structured as follows: Exchange treatment is given to the recipient shareholder under §302(a) if and
only if the redemption qualifies under one of the provisions of §302(b). Thus, one obtains the benefit of
§302(a) by qualifying under §302(b). A redemption that fails to qualify under §302(b) is subjected to §301
treatment per §302(d).

§302(b)(2),(3),(4) grant exchange treatment to redemptions based upon objective criteria; §302(b)(1) grants
exchange treatment to shareholders for redemptions “not essentially equivalent to a dividend” (a “last resort”
attempt for shareholders who do not qualify for exchange treatment under §302(b)(2-4))

§302(c)  attribution rules applied to determine qualification under §302(b); these complex rules impute
stock ownership from (and to) entities to (and from) their equitable owners

e.g. if B and C are equal co-owners of X Corp., the redemption by X Corp of all of B’s stock has a substantial effect
on B’s control of X Corp if B and C are strangers but perhaps only a nominal effect if B and C are related (for
example, if B and C are husband and wife)  see §302(c) for redemption treatment

U.S. v. Davis, 397 U.S. 301 (1970)  when a sole shareholder causes part of his shares to be redeemed by the
corporation, such a redemption is always “essentially equivalent to a dividend” under §302(b)(1) so it does not
qualify for exchange treatment

Davis  The redemption of stock from a sole shareholder is taxed like a current distribution rather than as
an exchange (except for partial liquidations under §302(b)(4) and redemption to pay death taxes under §303)

On the other hand, the redemption of all the stock held by one taxpayer will generally qualify for exchange
treatment (see §302(b)(3))

e.g. Suppose X Corp has two shareholders, individual B and Y Corp. If B has no relationship to Y, then the
redemption of all of B’s X stock by X will qualify as an exchange; however, if B owns all of Y, then the redemption
of B’s X stock by X will be treated as a distribution (Y’s ownership of X stock will be imputed to B and B will
therefore be deemed to be the sole shareholder of X both before and after the distribution) See §318(a)(2)(C)

§304  treats the purchase of one corporation’s stock by another corporation as a redemption if the two
corporations have sufficient commonality of ownership

ADL 5.02: Redemptions Taxed as Exchanges

If a redemption is taxed as an exchange, the redeemed shareholder is treated as selling or exchanging his stock for
the redemption proceeds. See §302(a). Thus, under §1001, the shareholder recognizes gain or loss equal to the
redemption proceeds (amount realized) and his basis in the redeemed stock. A redemption is taxed as an exchange
if it is described in §302(b) or §303.

a. Complete Terminations
Under §302(b)(3), a redemption is treated as an exchange if the redemption “is in complete redemption of all the
stock of the corporation owned by the shareholder”

Note that the attribution rules of §318 apply to the determination if a shareholder has sold all the stock of the
corporation owned by the corporation.

In the case of closely held corporations, the burden of divesting all ownership of stock may be difficult to meet
because, under §318(a)(1), any stock owned by the shareholder’s spouse, children, grandchildren, and parents will
be imputed to the shareholder. In particular this renders §302(b)(3) essentially unavailable for parents wishing to
pass control of the family corporation to the younger generation by means of a redemption.

§302(c)(2)  the waiver attribution rule, under which a shareholder seeking to qualify under §302(b)(3) may
elect to waive the family attribution rules in limited circumstances. (note that the waiver attribution rule applies
only to the family attribution rules of §318(a)(1); the entity and stock option attribution rules of §318(a)(2-4)
still apply; also, the waiver attribution rule only applies to §302(b)(3); it does not apply to §302(b)(2) or (4))

Limitations of the waiver attribution rule:

 The rule generally does not apply if the shareholder acquired any of his shares within 10 years of the
redemption from a family member or transferred any of his stock to a family member within the same
period
 Immediately after the redemption, the redeemed shareholder cannot have an interest in the corporation
other than as a creditor. See §302(c)(2)(A)(i). (thus, among other things, the redeemed shareholders cannot
be an officer, director, or employee of the corporation)
 The redeemed shareholder cannot acquire such an interest in the redeeming corporation (other than by
bequest or inheritance) within 10 years after the redemption. See §302(c)(2)(A)(ii).
 A shareholder must file a statement with his return for the redemption year representing that he has not
acquired such an interest in the corporation (other than by bequest or inheritance) since the distribution and
that if he does acquire such an interest within 10 years after the distribution he will notify the Service
within 30 days of the acquisition. See Regs. §1.302-4(a).

All of the problems plaguing the debt/equity issues in other contexts can reappear in the context of trying to
determine if the redeeming shareholder has an interest in the corporation other than as a creditor.

Lynch II rule: a taxpayer who provides post-redemption services, either as an employee or an independent
contractor, holds a prohibited interest in the corporation because he is not a creditor, so the family
attribution rules cannot be waived

Rev. Rul. 77-467: taxpayer can obtain benefit of waiver attribution rule despite being a lessor of the corporation’s
office building

Rev. Rul. 59-119, 1959-1 C.B. 68  for the purposes of §302(c)(2), it is immaterial whether an interest in a
corporation is asserted directly or through an agent; shareholder who was to have all of his shares redeemed
accepted payment in notes; shareholder wanted to appoint a nominee of his law firm to a seat on the board of
directors to protect his interests “as a creditor.” This would violate the no-interest-but-a-creditor rule of §302(c)(2)
(A)(i) and would cause the redemption to be taxed to shareholder as a distribution to which §301 applies. However,
if shareholder designates a representative of his law firm to attend the board meetings solely for the purpose of
determining whether his interests as a creditor were being protected, the redemption could be taxed to shareholder as
an exchange.

While the §302(c) waiver limits application only of the family portion of attribution rules, the waiver itself can be
made by entities as well as individuals. This is important to entities because, under §318(a)(5), the attribution rules
can be used to form chains of attribution between individuals and entities.
e.g. Suppose Father’s estate owns shares in X Corp. and the only beneficiary of Father’s estate is Mother. If X Corp
redeems all of the estate’s shares, the estate will fail to qualify for exchange treatment under §302(b)(3) if Mother
owns any shares of X Corp. The estate can file for a waiver of the family attribution rules, but because Mother’s
stock is imputed to the estate under one of the equity attribution rules, the waiver will not prevent attribution from
Mother to the estate; thus, the redemption will not work a complete termination of the estate’s interest in the
corporation, so §302(b)(3) will not apply.

Suppose, however, that Mother owns no shares of X Corp but Son does. If the estate can file a §302(c) waiver, the
chain of attribution will be broken at the link from Son to Mother, so that the estate will have no actual or
constructive ownership of X Corp after the redemption and §302(b)(3) will apply.

While individual shareholders ordinarily prefer redemptions to qualify for exchange treatment, corporate
shareholders often prefer distribution treatment because of the dividends received deduction of §243. The
safe harbor provisions of §302(b) are not elective, which encourages corporate shareholders to structure redemptions
to fall outside the terms of §302(b).

Bleily & Collishaw v. C.I.R., 647 F.2d 169 (9th Cir. 1981)  a series of redemptions designed to avoid exchange
treatment was re-characterized as a single redemption taxable as an exchange under §302(b)(3).

Ordinarily, §301 (general distribution rules) can be applied to failed redemptions without much difficulty: the basis
of the shares redeemed flows into the shareholder’s remaining stock and the amount distributed is taxed as a
dividend (to the extent of the corporation’s earnings and profits).

However, consider the case of a shareholder whose stock is completely redeemed but whose constructive ownership
does not decrease to zero  Regs. §1.302-2(c)  the shareholder’s basis is transferred to the shares held by
the related shareholder whose stock was imputed to the distributee-shareholder.

e.g. Suppose that individual B and corporation C each owns 50 shares of X Corp. Both have AB = $10/ share and
FMV = $100/share. Suppose further that B is the sole shareholder of C. If X redeems all of the stock owned by B
for $5,000 ($100*50 shares), that amount will be taxed as a distribution, not as an exchange, because C’s shares will
be attributed to B. The basis of B’s shares will be transferred to C’s shares.

Notice 2001-45, 2001-2 C.B. 129  The Service will look through a transaction in which stock of a person (other
than Taxpayer), who is not subject to U.S. tax or is otherwise indifferent to the Federal Income Tax consequences of
redemption, is redeemed; the redemption of stock is claimed to be a dividend under §301 rather than a payment in
exchange for stock under §302(a); and the Taxpayer then takes the position that under §1.302-2(c) all or a portion of
the basis of the redeemed stock is added to the basis of stock in the redeeming corporation that Taxpayer owns, and
then Taxpayer sells the stock and claims a loss or a reduced gain.

Reasons for disallowing a loss or increasing taxable income or gains under Notice 2001-45 include:
 The redemption does not result in a dividend because, viewing the transaction as a whole, the redemption
results in a reduction of interest in the redeeming corporation to which §302(b) applies
 The basis shift is not a “proper adjustment” as contemplated by §1.302-2(c)
 There is no attribution of stock ownership or basis shift because the steps taken to achieve those results are
transitory and serve no purpose other than tax avoidance

b. Substantially Disproportionate Redemptions

If a redemption reduces a shareholder’s interest significantly but not completely, exchange treatment may be
obtained if the following three part test is satisfied (see §302(b)(2)):
 1. The redeemed shareholder must own less than 50% of the voting power of the corporation immediately
after the redemption;
2. The shareholder’s voting power after the redemption must be less than 80% of his pre-redemption voting
power (see Rev. Rul. 81-41); and
3. The shareholder’s percentage ownership of common stock of the corporation after the redemption must be
less than 80% of his pre-redemption ownership (see Rev. Rul. 87-88)

e.g. Suppose individual A owns 90 of 300 outstanding shares of X Corp. X Corp. has only one class of shares
outstanding. X redeems 20 of A’s shares. Does A qualify for exchange treatment under §302(b)(2)?

Before the redemption A owned 90/300 or 30% of X’s shares. After the redemption owns 70/280 or 25% of X’s
shares. Prong 1 is passed because A owns less than 50% of the voting power of X Corp. To see if Prongs 2 and 3
are passed, we must compare 25% to 80% of 30%, which is 24%. Because 25% is greater than 24%, A does not
pass prongs 2 and 3. Therefore, the redemption does not qualify for exchange treatment.

Note that §302(b)(2) computations must take into account the attribution rules of §18, and there is no waiver
available under §302(b) corresponding to that available under §302(b)(3). Accordingly, a shareholder’s actual and
constructive ownership must always be considered under §302(b)(3).

c. The Attribution Rules

§318(a)(1)  family attribution rules

§318(a)(2)  attribution-from-entity rules
§318(a)(3)  attribution-to-entity rules
§318(a)(4)  stock option rule
§318(a)(5)  operating rules (which permit the other attribution rules to be chained together)

§318(a)(1): there is attribution from grandchild to grandparent, but not from grandparent to grandchild; there is no
attribution between siblings; §318(a)(5)(B) provides that stock imputed to a taxpayer under the family attribution
rules may not then be re-attributed under the family attribution rules

§318(a)(2): attribution from trusts, estates, partnerships, and corporations to the beneficial owners of such entities is
pro-rata according to percentage ownership in the entity (note this may be very hard if not impossible to do in
complex partnerships); attribution from corporations to their shareholders is based on the FMV of each
shareholder’s stock interest as compared with the total value of all classes of the corporation’s outstanding shares
and there is no attribution from a corporation to any shareholder owning (actually and constructively) less than 50%
(by value) of the corporation’s outstanding stock (attribution from corporations to their shareholders is limited
to closely held corporations and their majority shareholders)

§318(a)(3): all stock owned by partners, trusts, and estate beneficiaries is attributed to their entities without regard to
percentage ownership (again, attribution from shareholders to corporations is limited to closely held corporations
and their majority shareholders); §318(a)(5)(C) provides that stock ownership imputed to an entity from a beneficial
owner may not then be attributed out of the entity to another beneficial owner

§318(a)(4): any person having an option to acquire stock of a corporation is to be treated as owning the underlying
stock (note that this rule can be used to make it easier for a second shareholder to qualify under the disproportionate
redemption rule of §312(b)(2) by granting an option to the first shareholder while redeeming some of the shares of
the second)

§318(a)(5) example: Suppose X Corp is owned by the ABC partnership. That ownership will be imputed to partner
A. That constructive ownership can in turn be imputed to W, A’s wife. If W is a beneficiary of the T Trust, that
constructive ownership will in turn be attributed to T.
 d. Redemptions Not Essentially Equivalent to a Dividend

§302(b)(1)  a redemption can still qualify for exchange treatment even if it fails the other §302(b) qualification
rules if it is “not essentially equivalent to a dividend”

Davis (1970)  the Supreme Court construed §302(b)(1) narrowly, concluding that a redemption qualified as “not
essentially equivalent to a dividend” only if the redemption resulted in a “meaningful reduction” in the
shareholder’s stock ownership of the distributing corporation

Since Davis, §302(b)(1) has played a decidedly modest role (any time that a redemption works a reduction in a
shareholder percentage in the corporation, the claim can be raised that the reduction was meaningful)

 Henry T. Patterson v. U.S., 729 F.2d 1089 (6th Cir. 1984)  a reduction from 80% to 60% was held to be
“meaningful”
 Rev. Rul. 75-569  a reduction from 90% to 85% was “not meaningful”

Courts and the Service have looked to other factors besides change in percentage ownership, such as the extent of
voting control, to determine if a reduction is “meaningful”

 Wright v. U.S., 482 F.2d 600 (8th Cir. 1973)  a reduction from 85% to 61.7% was “meaningful” because
state law imposed a 2/3 voting requirement on certain corporate actions
 Rev. Rul. 78-401  a reduction from 90% to 60% was “not meaningful” because no corporate action
requiring a 2/3 vote was anticipated

Takeaway  there is no clear line between what counts as “meaningful” and “not meaningful”

Should “family hostilities” be relevant to the application of §302(b)(1) when determining if a reduction is
meaningful? (i.e. should constructive ownership be waived if there is family hostility between family members?)
 David Metzger Trust v. C.I.R., 693 F.2d 459 (5th Cir. 1982)  family hostility should be irrelevant
 Haft Trust v. C.I.R., 510 F.2d 43 (1st Cir. 1975)  family hostility may be relevant

e. Partial Liquidations

A redemption qualifying as a “partial liquidation” within the meaning of §302(b)(4) is taxed to the distributee, non-
corporate shareholder as an exchange under §302(a).

§302(e)(1)(A)  look to a redemption’s corporate-level effects to determine whether it is a partial liquidation

§302(e)(1)(B)  to qualify as a partial liquidation, the distribution must occur no later than the year following the
year in which the plan of partial liquidation was adopted

§302(b)(4)  a partial liquidation is a corporate contraction in which a distinct part of the corporation’s business is
discontinued and the assets (or proceeds from the sale of those assets) are distributed to the corporation’s
shareholders; shareholder aspects of the distribution are irrelevant

Any distribution “not essentially equivalent to a dividend” (determined at the corporate level) will meet the
statutory definition of a partial liquidation in §302(e)(1)(A).

Imler v. C.I.R., 11 T.C. 836 (1948)  after a fire, a corporation decided to exit a business, and it distributed the
insurance proceeds to shareholders; the distribution was held to be a partial liquidation

§302(e)(2)  any redemption meeting the cessation of business test of §302(e)(2)(A) and the continuing
business test of §302(e)(2)(B) automatically will be treated as a partial liquidation
§302(e)(2)(A)  requires only that the redemption be attributable to distributing corporation ceasing to conduct a
“qualified” trade or business

§302(e)(2)(B)  requires that the distributing corporation engages in a “qualified” trade or business immediately
after the redemption

“Qualified” trade or business  one that has been actively conducted (by the distributing corporation or
otherwise) for at least five years and, if the distributing corporation acquired the business during the five-year
period, the acquisition must have been entirely tax-free

Gordon v. C.I.R., 424 F.2d 378 (2d Cir. 1970)  A distribution of less than the entire proceeds from the sale of an
active trade business cannot qualify as a partial liquidation

Rev. Rul. 67-299  a transaction will fail to qualify as a partial liquidation if the proceeds from the sale of
one active business are even temporarily invested in a second trade or business prior to distribution

Note that if the accumulated earnings from an active trade or business are distributed along with the proceeds from
the sale of the assets of that trade or business, the transaction should qualify as a partial liquidation

A redemption of a corporate shareholder cannot qualify under §302(b)(4). However, because of §1059(e), the
corporate shareholder takes into account the non-taxed portion of any dividend received first by reducing its basis in
the stock of the redeeming corporation and then, to the extent that non-taxed portion exceeds basis, recognizes gain
from the sale or exchange of stock.

Note that a partial liquidation can occur without the tendering of any shares by the shareholder (b/c a pro-rata stock
exchange would be a meaningless gesture in a partial liquidation). The shareholder simply computes gain or loss as
if he exchanged stock with a value equal to the redemption proceeds.

f. Redemptions to Pay Death Taxes

§303  exchange treatment is given to redemptions from estates in which more than 35% of the estate’s new value
consists of the stock of a single corporation; in addition, stock of two or more corporations can be combined if the
value of the stock of each corporation is at least 20% of the value of the corporation. When §303 applies, its
benefits are limited in amount to the taxes and expenses incurred by the estate.

Note that the attribution rules of §318 cannot be used to satisfy the 35% test of §303.

When combined with §1014, exchange treatment under §303 means that an estate will pay no taxes on the
redemption of its stock

ADL 5.03: Redemptions Taxed as Distributions

If a redemption fails to qualify for exchange treatment under §302(a) or §303, the amount distributed is
subject to the distribution rules of §301.

If the entire amount distributed in redemption is taxed as a dividend, the shareholder will enjoy no recovery
of basis on the redemption. His basis in the shares redeemed flows into his remaining shares of the
corporation, and it will be recovered when those shares are sold or exchanged.

e.g. Suppose that Father and Daughter each owns 40 of the 100 outstanding shares of X Corp. AB = $10/share and
FMV = $100/ share. If X redeems 20 of Father’s shares for $2,000, Father’s actual plus constructive interest drops
from 80% (40/100 plus 40/100) to 75% (20/80 plus 40/80). Assuming that this reduction is “not meaningful” Father
will be taxed on the distribution of $2,000 under §301. If X Corp has sufficient earnings and profits, Father will
recognize the full amount as dividend income. Father’s basis in the shares redeemed will flow into his remaining
shares, leaving Father will 20 shares with an adjusted basis of $20/share ($400/ 20 shares).

What if the shareholder has no more shares of the corporation?

e.g. Same example as above, but let’s assume that all 40 of Father’s shares are redeemed in the transaction. Father’s
actual plus constructive ownership will fall from 80% to 67% (40/60 shares). Assuming that the reduction in
Father’s interest in X Corp is “not meaningful” and Father fails to file a §302(c)(2) waiver, the redemption will be
taxed under the distribution rules of §301. Under current regulations, Father’s $400 basis will be transferred to
Daughter’s shares. See Regs. §1.302-2(c) Ex. 2.

What if not all of the distribution will be a dividend?

e.g. Same example as directly above, but let’s assume that X Corp only has $3,000 in earnings and profits. Father
will have dividend income of $3,000; of the remaining $1,000, $400 can be used to recover basis, and $600 is left
over. Under current rules, the $600 is taxable as capital gain (i.e. none of the $600 can be used to offset Daughter’s
basis).

ADL 5.04: Corporate-Level Taxation of Redemptions

A distribution in redemption of stock can have two distinct sets of tax consequences for the distributing corporation.

1. If the distributing corporation uses appreciated property in a redemption, it will recognize gain as if it sold
the appreciated property for its FMV. See §311(b). On the other hand, if a corporation distributes built-in-
loss property, it will not recognize loss. See §311(a). If the corporation recognizes gain on the distribution,
it increases its E&P account.
2. Because of the distribution, the corporation reduces its E&P account (if any). For a redemption treated as a
current distribution, the corporation reduces its E&P account by the FMV of the property distributed. In
contrast, if a redemption is treated as an exchange, some part of the amount distributed may be
treated as a return of capital and will not reduce the corporation’s E&P account.

§317(n)(7)  if the distribution in redemption of stock is taxed to the distributee as an exchange, then the
distributing corporation limits its reduction in E&P to “an amount which is not in excess of the ratable share of the
E&P of the corporation attributable to the stock so redeemed” (the rule ensures that a distribution in redemption
of stock will not reduce the E&P account for gain not yet in the E&P account; it is not wise to distribute
appreciated property if the property will be taxed to the distributee as an exchange)

e.g. Suppose X Corp. has $1M in cash and 1,000 shares of stock worth $1,000. If X Corp redeems 100 shares in a
transaction taxed as an exchange under §302(a), the distributee should receive 10% of the corporation, or $100,000.
If X Corp’s E&P account is $400,000, then E&P should be reduced by 10%, or $40,000, to $360,000. Of the
$100,000 distributed, $40,000 would be treated as a distribution of E&P and $60,000 would be treated as a return of
paid-in capital. X Corp’s paid-in capital account would be reduced from $600,000 to $540,000.

e.g. Suppose X Corp. is worth $1M but has cash = $200,000 and Blackacre with FMV = $800,000 and AB =
$450,000. There is a built-in-gain in Blackacre of $350,000. Because the gain is not yet realized, X Corp should
have a total of $650,000 in its E&P plus paid-in capital accounts. Assume E&P = $400,000 and paid-in capital =
$250,000. What happens if 100 shares are redeemed for $100,000, assuming the redemption is taxed to the
shareholder as an exchange? 10% of the $400,000, or $40,000, is allocable to the E&P account. 10% of the
$250,000, or $25,000, is allocable to the paid-in capital account. There is $35,000 remaining. Applying §317(n)(7),
the maximum amount by which E&P may be reduced due to the redemption is 10% of $400,000, or $40,000, so the
$35,000 cannot be used to reduce E&P. State law prohibits the reduction of paid-in capital in this manner.
Therefore, the $35,000, which conceptually should remain available to reduce the E&P account when Blackacre is
eventually sold or exchanged, simply disappears; §317(n)(7) eliminates rather than delays the proper E&P
reduction in Blackacre.

After Blackacre is sold by X Corp for $800,000, X Corp’s E&P account will increase to $710,000 (started at
$400,000 but reduced by $40,000 due to the redemption then increased by the realized gain of $350,000 upon the
sale). The paid-in capital account will equal $225,000 ($250,000 reduced by $25,000 due to the redemption). Note
that the sum of the E&P and paid-in capital accounts is $935,000 even though the company is worth only $900,000
($800,000 from sale of Blackacre plus $100,000 in cash left after the redemption). The extra $35,000 is the $35,000
that “disappeared” during the redemption.

Note that if preferred stock is redeemed, there should theoretically not be any reduction in E&P, unless dividends in
arrears (if any) are distributed as well.

§162(k)  denies a deduction for all expenses incurred in connection with the redemption of stock (including legal
and accounting fees); however, interest expense incurred on funds used by a corporation to repurchase its own stock
is deductible

What if a corporation pays an investment banker a sum of money to guarantee that a loan will be available to redeem
shares of the corporation’s stock if needed? The fee will be deductible under §162(k)(2)(A)(ii).

Can legal and accounting costs connected with a redemption be capitalized? What about the premium (if any) paid?

ADL 5.05 Redemption Related to Other Transactions (Bootstrap sales and Buy-sell agreements)

“Bootstrap” acquisition  part of the consideration used to acquire the target corporation consists of the assets of
the target corporation.

e.g. T Corp owns assets of an active trade or business worth $600,000 and cash of $400,000. Individual B owns all
of T Corp’s stock. B has a basis of $700,000. X Corp would like to acquire the active trade of business of T. X
Corp is willing to pay $600,000 for the active trade or business of T Corp. To ensure that no corporate tax is
incurred on the transaction, X Corp insists on buying T Corp’s shares rather than directly purchasing T Corp’s active
business assets.

B could get exchange treatment by selling all of the T Corp stock to X Corp for $1M, but that would require X Corp
to raise $400,000 more than the value of the assets (and possibly more than X Corp can obtain). To satisfy X Corp
without compromising B’s tax result, the acquisition could be structured as a part sale/ part redemption, with B
selling 60% of his stock in T Corp. to X Corp. and simultaneously causing T Corp to redeem the remaining 40% of
its shares with its liquid assets. X Corp would end up owning all outstanding T Corp stock with a $600,000 basis, T
would retain only its active trade or business, and B would qualify for exchange treatment on the full $1M received,
recognizing an overall gain of $300,000.

Zenz v. Quinlivan, 213 F.2d 914 (6th Cir. 1954)

Issue: Is a distribution of substantially all of the accumulated earnings and surplus of a corporation, which are not
necessary to the conduct of the business of the corporation, in redemption of all outstanding shares of stock of said
corporation owned by one person essentially equivalent to the distribution of a taxable dividend? No.

Facts: Prospective buyer did not want to assume the tax liabilities which it was believed were inherent in the
accumulated earnings and profits of the corporation. To avoid said profits and earnings as a source of future taxable
dividends, buyer purchased part of taxpayer's stock for cash. Three weeks later, after corporate reorganization and
corporate action, the corporation redeemed the balance of taxpayer's stock, purchasing the same as treasury stock
which absorbed substantially all of the accumulated earnings and surplus of the corporation.

Law: Where the taxpayer effects a redemption which completely extinguishes the taxpayer's interest in the
corporation, and does not retain any beneficial interest whatever, that such transaction is not the equivalent of the
distribution of a taxable dividend as to him.

Analysis: Since the intent of the taxpayer was to bring about a complete liquidation of her holdings and to become
separated from all interest in the corporation, the conclusion is inevitable that the distribution of the earnings and
profits by the corporation in payment for said stock was not made at such time and in such manner as to make the
distribution and cancellation or redemption thereof essentially equivalent to the distribution of a taxable dividend.

Holding: The redemption should be treated as an exchange, not a distribution (taxpayer is not liable as a distributee
of a taxable dividend).

Of course, B will only obtain exchange treatment on the sale if he falls within a §302(b) qualification (most likely
§302(b)(3), complete termination of interest). Note that the Service has ruled that the sale and redemption can be
linked so as to satisfy the requirements of §302(b)(2), the substantially disproportionate redemption safe harbor. See
Rev. Rul. 75-447.

Rev. Rul. 75-447:

 The sequence of events will be disregarded and effect will be given only to the overall result in determining
whether a distribution is "substantially disproportionate" in plans calling for a stock redemption
accompanied either by an issuance of new stock or by a shareholder's sale of stock if the events are clearly
part of an overall integrated plan to reduce a shareholder's interest.
 In determining whether the "substantially disproportionate" provisions of §302(b)(2) have been satisfied, it
is proper to rely upon the holding in Zenz that the sequence in which the events (that is, the redemption and
sale) occur is irrelevant as long as both events are clearly part of an overall plan. Therefore, in situations
where the redemption is accompanied by an issuance of new stock or a sale of stock, and both steps (the
sale, or issuance, of stock, as the case may be, and the redemption) are clearly part of an integrated plan
to reduce a shareholder's interest, effect will be given only to the overall result for purposes of §302(b)
(2) and the sequence in which the events occur will be disregarded.
 The computation of the voting stock of the corporation owned by the shareholder immediately before the
redemption for purposes of §302(b)(2)(C)(ii) should be made before any part of the transaction occurs.
Likewise, the computation of the voting stock of the corporation owned by the shareholder immediately
after the redemption for purposes of §302(b)(2)(C)(i) should be made after the whole transaction is
consummated. 

If T Corp is owned by a corporation rather than an individual, the analysis is different. Because of the dividend
received deduction, the seller will likely seek to qualify for distribution (not exchange) treatment. Note that the
Service may argue that the dividend should be taxed as if made to the buyer, who then uses it as part of the
consideration for the transaction.

Waterman Steamship Corp. v. C.I.R., 430 F.2d 1185 (5th Cir. 1970)

Issue: The issue for decision is whether the declaration and payment, in the form of a promissory note, of
$2,799,820 by Pan-Atlantic Steamship Corporation to its parent, Waterman Steamship Corporation, was a tax free,
intercompany dividend, as the Tax Court concluded?  Or was it part of the purchase price paid to Waterman in a sale
by Waterman of the stock of Pan-Atlantic and Gulf Florida Terminal Company to McLean Securities Company, as
the Commissioner contends? 
Facts: Waterman Steamship owned Pan-Atlantic and Gulf Florida. Waterman Steamship’s basis was $0.7M and
the FMV of the two corporations was $3.5M, so there was a built-in gain of $2.8M. McLean was President and
majority shareholder in Trucking. McLean wanted to buy Pan-Atlantic and Gulf Florida to obtain their Interstate
Commerce Commission licenses and be able to run an integrated land and sea transportation operation. “McLean's
attorneys advised him that ICC approval would not be necessary if he divested himself of control in Trucking (by a
management trust) and acquired the stock instead of the assets of Pan-Atlantic and Gulf Florida.”

Since Waterman's tax basis for the stock of these two subsidiaries totaled $700,180 ($576,180 allocated to Pan-
Atlantic and $124,000 to Gulf Florida), a sale of these stocks for $3,500,000 would have produced a taxable gain of
approximately $2,800,000. On the other hand, since the Treasury Regulations on consolidated returns provide that
dividends received from affiliated corporations are exempt from tax (Sec. 1.1502-31A(b)(1)(i) and Sec. 1.1502-
31A(b)(2)(ii)), a sale of stock in these subsidiary corporations for $700,000, after a dividend payment to Waterman
of $2,800,000 would purportedly have produced no taxable gain.

McLean formed Securities to purchase the stock of Pan-Atlantic and Gulf Florida. In quick succession, Pan-Atlantic
paid a $2.8M dividend to Waterman Steamship in the form of a promissory note (because it did not have $2.8M cash
on hand). Waterman’s board sold Pan-Atlantic and Gulf Florida to Securities for $0.7M. After the sale, McLean
and Securities then lent $2.8M to Pan-Atlantic and then Pan-Atlantic redeemed the $2.8M note it had issued to
Waterman Steamship for the dividend.

Law: Tax consequences must turn upon the economic substance of a transaction and not upon the timing sequences
or form of the transaction. Gregory v. Helvering

If, however, the taxpayer enters into a transaction that does not appreciably affect his beneficial interest except to
reduce his tax, the law will disregard it; for we cannot suppose that it was part of the purpose of the act to provide
an escape from the liabilities that it sought to impose. Gilbert v. C.I.R.

Analysis: The plain unadulterated fact is that no dividend was declared or paid by Pan-Atlantic to Waterman or
anyone else. The note issued by Pan-Atlantic was merely a piece of paper, which served only a temporary purpose
and disappeared.

The amount of the dividend is not a true distribution of corporate profits. Here the distribution of funds was supplied
by the buyer of the stock, with the corporation acting as a mere conduit for passing the payment through to the
seller.

Rule: An integrated transaction cannot be separated into its components for the purpose of avoiding taxation.
The test of whether events should be viewed separately or together as part of a single plan is not temporal but
is functional. A pre-sale extraction however, conflicts with the concept of a dividend as a distribution of
earnings and profits made in the context of an ongoing corporation-shareholder relationship.

Holding (Wisdom): The distribution is part of the purchase price, not a dividend.

TSN Liquidating Corp. v. U.S., 624 F.2d 1328 (5th Cir. 1980)

Issue: This case presents the question whether assets distributed to a corporation by its subsidiary, immediately prior
to the sale by such corporation of all the capital stock of such subsidiary, should be treated, for federal income tax
purposes, as a dividend or, as the district court held, as part of the consideration received from the sale of such
capital stock.

Facts: TSN owned over 90% of the stock of CLIC. Union Mutual wanted to buy CLIC. Union Mutual agreed to
buy all of CLIC except for certain assets. CLIC distributed $1.7M in assets to its shareholders as a “dividend.”
Union Mutual then purchased substantially all of the shares of CLIC for $823,822 (of which $747,436 went to
TSN). Union Mutual then contributed to the capital of CLIC $1.12M in muni bonds and purchased from CLIC
additional capital stock of CLIC for $824,598.

TSN reported the distribution from CLIC of $1.7M as a dividend and claimed a dividends received deduction per
§243. The IRS challenged and treated the distribution as having been part of the purchase price of CLIC by Union
Mutual.

Law: Assets removed from a corporation by a dividend made in contemplation of a sale of the stock of that
corporation, when those assets are in good faith to be retained by the selling stockholders and not thereafter
transferred to the buyer, are taxable as a dividend and not as a part of the price paid for the stock for the reason that,
in economic reality and in substance, the selling stockholders did not sell and the buyer did not purchase or pay for
the excluded assets

Test: The controlling distinction is whether the buyer negotiated to acquire and pay for the stock, exclusive of the
assets distributed out as a dividend, or whether the buyer negotiated to acquire and pay for the stock, including the
assets which were then the subject of a sham distribution designed to evade taxes. In the former case there is a
taxable dividend; in the latter case there is not.

Rule: Waterman only applies to cases in which there is a sham and/or tax-motivated transaction.

Analysis:

Who ends up with the assets is important  The distributed assets were retained by the stockholders to whom
they were distributed, rather than being immediately transferred to the purchaser

View motivation of transaction as a whole  We decline to focus on the business purpose of one participant in
the transaction a corporation controlled by the taxpayer and instead find that the business purpose for the transaction
as a whole, viewed from the standpoint of the taxpayer, controls. The facts found by the district court clearly
demonstrate a business purpose for the presale dividend of the unwanted assets which fully explains that dividend.

Is there a tax avoidance motive? There is no suggestion in the district court’s opinion of any tax avoidance
motivation on the part of the taxpayer TSN.

Holding (Randall): We hold that on the facts of this case, the assets so distributed constituted a dividend and we
reverse the judgment of the district court.

While intercorporate dividends effectively are excluded from the tax base of the recipient corporation, the same is
not true for gain from the sale of corporate shares by a corporate shareholder.

Subchapter C may result not only in a potential triple tax of corporate profits (i.e. corporate profit tax, gain on sale to
other corporation, gain on sale of shares) but also possible phantom loss.

e.g. Suppose P Corp. purchases all the stock of Sub Corp. for $1M. The assets of Sub consist entirely of cash. Sub,
when purchased, has E&P of $1M. If P causes Sub to distribute $900,000 in cash, P will receive $900,000 in cash
but pay tax on only $180,000 of that amount because of the 80% DRD (note that the 100% DRD would not apply in
this case because Sub’s E&P arose before P acquired Sub). P can then sell the stock of Sub for its FMV of $100,000
and realize a taxable loss of $900,000. No economic loss has been sustained by P or Sub, but if P is allowed and
utilizes its loss deduction on the sale, it enjoys a net tax loss of $720,000 (equal to the DRD). But see §246A and
§1059.
Takeaway  corporate shareholders should eschew recognizing gain on the disposition of stock in favor of receipt
of intercorporate distributions

Redemptions can play a substantial role not only in the sale of a corporation but also in the retention of corporate
control.

e.g. Suppose that X Corp is owned equally by two unrelated individuals, A and B. If A and B come to a parting of
the ways, one can buy the stock of the other. Alternatively, they can have the corporation redeem the shares of one
of them, which accomplishes their goal while removing substantial assets from the corporation without triggering
the recognition of ordinary income (i.e. dividend income) at the shareholder level.

However, case law has developed a trap for the unwary if a redemption is used when a shareholder has the primary
and unconditional obligation to buy the redeemed stock

e.g. Suppose X Corp is owned 95% by Owner and 5% by Employee. They have agreed that Employee must sell his
stock back to Owner if Employee ever terminates his employment with X Corp. One day Employee quits, tendering
his shares to Owner at FMV. What if Owner decides to structure the transaction as a redemption of Employee’s
shares by X Corp., hoping to use X Corp’s funds to purchase Employee’s shares while avoiding dividend income to
himself?

Rev. Rul. 69-608  concluded that one shareholder received a constructive distribution when a corporation
redeemed a second shareholder’s stock and the first shareholder had a primary and unconditional obligation to
purchase the redeemed stock when the redemption occurred

What should Owner have done: Owner should not assume a primary and unconditional obligation to redeem the
stock; Owner should have provided initially that when Employee terminated his employment with X Corp, Owner
would purchase Employee’s stock or would have the shares acquired by some other person or entity.

Note that this is form over substance, but it works.

Holsey v. C.I.R., 258 F.2d 865 (3d Cir. 1958)

Issue: Did the Tax Court err in holding that the payment by the Holsey Company of $80,000 to the Greenville
Company for the purchase from that company of its stock in the Holsey Company was essentially equivalent to the
distribution of a taxable dividend to the taxpayer, the remaining stockholder of the Holsey Company?

Facts: Greenville Corp. owned 20 shares of Holsey Corp. (which was all of the outstanding shares of Holsey
Corp.). Holsey Sr. was controlling shareholder of Greenville Corp. Holsey Jr. (Taxpayer) acquired an option to
acquire 50% of Holsey Corp. for $11,000 plus another option to acquire 50% of Holsey Corp. within 10 years.
Taxpayer exercised the first option and became owner of 50% of Holsey Corp. The second option was revised.

Under the terms of the revised option, taxpayer was granted the right to purchase the remaining outstanding shares
of the Holsey Company at any time up to and including June 28, 1951, for $80,000. The revised option was in favor
of taxpayer individually and was not assignable by him to anyone other than a corporation in which he owned not
less than 50% of the voting stock. 

Holsey owned 50% of Holsey Corp. and assigned the option to Holsey Corp. On the same date, Holsey Corp.
exercised the option and paid the Greenville Corp. $80,000 for 50% of Holsey Corp’s shares. This transaction
resulted in taxpayer becoming the owner of 100% of the outstanding stock of the Holsey Company (because he
already owned the other half outright). In his income tax return for the year 1951, taxpayer gave no effect to this
transaction. When the second option was exercised, the earned surplus of Holsey Corp. was over $300,000.
Law: Unless a distribution which is sought to be taxed to a stockholder as a dividend is made to him or for his
benefit it may not be regarded as either a dividend or the legal equivalent of a dividend.

Analysis: Where, as here, the taxpayer was never under any legal obligation to purchase the stock held by the other
stockholder, the Greenville Company, having merely an option to purchase which he did not exercise but instead
assigned to the Holsey Company, the distribution did not discharge any obligation of his and did not benefit him in
any direct sense.

Holding (Maris): The Tax Court erred in calling the exercise of the option a dividend

Dissent (McLaughlin): The exercise of the option was for the taxpayer’s personal benefit; it should be taxed as a
dividend to the taxpayer.

If Owner has a primary and unconditional obligation to purchase the shares owned by Employee, and if those shares
are instead by X Corp, the transaction will be taxed as if the redemption proceeds were distributed by X Corp to
Owner who then purchases Employee’s shares. Since those shares actually end up in the corporate treasury, we
must then treat Owner as if he contributed the shares to X Corp.

Note that this characterization (Owner purchases shares from Employee and then X Corp redeems those shares) may
offer Owner the opportunity to argue for exchange treatment under §302(b)(4) if the transaction includes a corporate
contraction. This argument is more likely to succeed if Owner is not the sole remaining shareholder. See Davis.

How should we treat a situation in which husband and wife each own stock in X Corp but then get divorced if
incident to divorce and pursuant to the decree husband is obligated to purchase any stock of X Corp owned by wife?
If instead X Corp redeems wife’s stock, should the transaction be treated as a dividend to husband?

Regs. §1.1041-2  the transaction should be treated as a stock transfer from wife to husband only if husband had an
unconditional obligation to acquire the stock directly. However, such an unconditional obligation will be ignored if
so provided in a divorce decree, separation instrument, or written agreement between the (ex)-spouses. Similarly, a
redemption of stock held by one (ex)-spouse will be imputed to the other (ex)-spouse if such a decree, instrument, or
written agreement so provides. (Thus, the parties largely can control whether the form of the transaction will be
respected or ignored, but in all events the parties must treat the transaction consistently.)

ADL 5.06 Redemptions for More or Less than Fair Market Value

a. Redemption Premiums

§162(k)  in measuring a corporation’s P&L, amounts paid in redemption of stock should be irrelevant

What if a corporation pays a premium when redeeming its stock? Should this amount be treated as a dividend?

Corporations are not allowed to deduct the redemption premium paid to shareholders. However, can they capitalize
the cost?

Under §162(k), payments otherwise deductible will not be rendered nondeductible merely because they are paid
simultaneously with a redemption.

No deduction for premiums paid for greenmail or for fees associated with redemptions (such as fees paid to
accountants, lawyers, etc.)

b. Stock Surrenders
What if a shareholder accepts less than FMV in exchange for redeemed his stock?

Note that in a stock surrender, if not all shareholders surrender their shares, there is an increase in the ownership of
the corporation for the non-surrendering shareholders relative to the surrendering ones; the same effect could be had
by simply paying stock dividends to the non-surrendering shareholders. There is no loss claimable by shareholders
in such a transaction.

Schleppy v. C.I.R., 601 F.2d 196 (5th Cir. 1979)  no deduction for shareholders who surrender stock (at least until
the non-surrendering shareholders sell or exchange their stock)

C.I.R. v. Fink, 483 U.S. 89 (1987)

Issue: May a dominant shareholder who voluntarily surrenders a portion of his shares to the corporation, but retains
control, immediately deduct from taxable income his basis in the surrendered shares?

Facts: Mr. and Mrs. Fink owned a combined 72.5% of Travco Corp. The company was in dire financial condition.
It needed new capital. The Finks voluntarily surrendered some of their shares in Travco in an effort to “increase the
attractiveness of the corporation to outside investors.” The Finks’ combined ownership percentage decreased
slightly to 68.5%. The Finks claimed as a loss their adjusted basis in the surrendered shares. The Commissioner
challenged the deduction, calling the stock surrender a capital contribution with no tax effects.

Rule: A dominant shareholder who voluntarily surrenders a portion of his shares to the corporation, but
retains control, does not sustain an immediate loss deductible from taxable income. Rather, the surrendering
shareholder must reallocate his basis in the surrendered shares to the shares he retains.  The shareholder's
loss, if any, will be recognized when he disposes of his remaining shares.

Analysis: The share surrender is similar to a forgiveness of debt owed by a corporation; such forgiveness of debt is
treated as a contribution to capital rather than a current deduction.

The change is ownership percentage resulting from the stock surrender does not necessarily mean that there has been
a taxable event.

Although the Finks did give up an immediate ownership interest, with its attendant entitlement to future dividends,
appreciation of shares, and claim on assets in bankruptcy, as a practical matter the Finks did not give up very much.
Their reduction in voting power was inconsequential and Travco was not paying dividends because it was in
financial difficulty.

Even though typical contributions to capital have no effect on the contributing shareholder’s proportionate interest in
the corporation and a stock surrender does, plus a typical contribution to capital increases the new worth of the
corporation, while a stock surrender does not change the corporation’s net worth, these facts are not decisive.

Finally, treating stock surrenders as ordinary income might encourage shareholders in failing corporations to convert
potential capital losses to ordinary losses by voluntarily surrendering their shares before the corporation fails.

Holding (Powell): The Finks’ share surrender was a capital contribution with no tax effects, not a deductible loss.

Concurrence (White): The Court’s rationale would also apply to a stock surrender that results in loss of control of
the corporation

Concurrence (Scalia): This is not a capital contribution, but it still isn’t deductible because it’s made to increase the
value of property
Dissent (Stevens): Neither the Court nor the Tax Court should reverse long-standing doctrine; such a decision
should be made via Congress amending the tax code.

Note: The Court seems to accept the argument that the taxpayers surrendered their stock to increase the net value of
the corporation. However, a stock surrender should have no appreciable effect on the value of the corporation; it
merely rearranges the relative interests of the existing shareholders.

The Court also believes that the stock surrender should be treated as a capital contribution to the corporation. The
Court analogizes the surrender of stock to a forgiveness of debt, but the flaw in this analysis is that a surrender of
stock adds nothing to the capital of the corporation while a debt forgiveness does.

Takeaway  Now that the Court has held that surrendering shareholders will not recognize a loss on the
transaction, shareholders should not surrender shares non-pro-rata unless they are compensated

What if a sole shareholder transfers stock or his corporation to a corporate employee as an inducement for the
employee to remain with the corporation? Should the transferor be entitled to a deduction?

e.g. Assume that Owner owns all 100 outstanding shares of X Corp. AB and FMV = $9.50/share. Employee agrees
to perform $50 worth of services for the corporation in exchange for some of Owner’s shares. Before the services,
X Corp is worth $950. After the service, X Corp is worth $1,000. Thus, Owner should transfer to Employee 5
shares of X Corp. Should Owner be allowed to deduct his basis in the 5 shares transferred to Employee?

Regs. §1.83-6(d)  Owner cannot deduct his basis in the 5 shares transferred to Employee for Employee’s services
to X Corp; the transaction is treated as if Owner contributed the five shares as capital to the corporation and then the
corporation distributed the shares to Employee. Owner adds his basis in those five shares to his basis in his
remaining 95 shares.

Note that alternatively, X Corp could just issue 5.263 shares to Employee and the same result would be obtained.

ADL 5.07 Redemptions Through Related Corporations

The rules of §302 ensure that a redemption will not produce exchange treatment to the shareholder unless the
transaction produce a meaningful reduction in the shareholder’s interest in the corporation.

Similar rules do not, in general, apply to a sale of shares to another shareholder, even though the sale may have an
insignificant effect on the selling shareholder’s relation to the corporation. Indeed, if the purchaser is related to the
selling shareholder, application of the attribution rules may suggest that the sale has no effect at all. Nonetheless,
the selling shareholder will generally be entitled to exchange treatment on the disposition, limited only if the sale
produces a loss. See §267.

For the most part, exchange treatment on a sale of shares presents no abuse because the transaction removes no
funds from the corporate solution. However, if the purchaser is itself a corporation, the sale does result in a
corporate distribution (by the purchaser) and the potential for a bailout occurs (a “bailout” refers to a transaction in
which earnings are removed from the corporation solution as capital gain rather than as dividend income under
circumstances in which exchange treatment is inappropriate).

e.g. Suppose individual T owns all the stock of X Corp and all the stock of Y Corp. A redemption by X or Y of any
stock will produce distribution treatment to T under the Davis rule (absent a partial liquidation or qualification under
§303). However, if T simply sells some of his X stock to Y, T seemingly can avoid §302 without relinquishing any
effective control of X. Indeed, if after the purchase a dividend is paid to Y on its X shares, T will have obtained
exchange treatment without regard to §302 even though the purchase price ultimately will have been paid by X Corp
itself. (note that §243 will allow Y to deduct most or all of the distribution from income)  §304 re-characterizes
such transactions as redemptions to which §302 rules apply.

A sale covered by §304 will not necessarily produce distribution treatment to the taxpayer. Rather, distribution or
exchange treatment will turn on the effect (if any) of the transaction on the taxpayer’s relationship with the
corporation whose stock is nominally being sold.
 If the transaction is taxed as a distribution, the transferor is treated as receiving stock from the acquiring
corporation, which is then immediately redeemed, and this redemption is then taxed under §301. This
peculiar hypothetical redemption is important if the transferor is itself a corporation, because in such a
circumstance the transaction will be taxed as an extraordinary dividend under §1059 and affect the
transferor’s tax treatment.

§304 applies in both the brother/sister and parent/sub contexts.

e.g. If taxpayer controls Parent Corp, which in turn controls Sub Corp., a sale of Parent stock by taxpayer to Sub
Corp will be captured by §304 and subjected to the redemption rules of §302.

The touchstone of a §304 transaction is the sale of stock of one corporation to another, where the seller
controls both corporations.

§304(c)  “control” means ownership of 50% of the total voting power or 50% of the total value of all stock

In computing control under §304(c), the attribution rules of §318 are used, and the entity rules of §318(a)(2),(3) are
expanded, applying to 5% or greater shareholders, rather than 50% or greater shareholders; note that stock acquired
in the transaction is counted in determining whether the shareholder is in control of the transferee (i.e. acquiring)
corporation.

“Acquiring” corporation  the corporation purchasing the stock in a §304 transaction

“Issuing” corporation  the corporation whose stock is being sold in a §304 transaction

§304(a)  the rules of §302(b) are applied to the taxpayer’s ownership interest in the issuing corporation

Note that because of the attribution rules, some or all of the taxpayer’s stock sold to the acquiring corporation will
be attributed back to the taxpayer. See §318(a)(2)(C).

e.g. Taxpayer (individual) owns 50 of 100 shares of X Corp and 100 of 100 shares of Y Corp. If taxpayer sells 10
shares of X to Y, B constructively plus actually owns 50 shares of X both before and after the sale.

Rule: If the taxpayer owns 100% of stock of the acquiring corporation, the §304 sale will work no change in
the taxpayer’s constructive ownership of the issuing corporation.

To determine whether the §304 sale qualifies for exchange treatment, compare the taxpayer’s pre-sale ownership of
the issuing corporation to the taxpayer’s after-sale ownership interest in the issuing corporation. In making this
comparison, the rules of §302(b)(2) apply.

e.g. Taxpayer (individual) owns 50 of 100 shares of X Corp and 100 of 100 shares of Y Corp. If taxpayer sells 10
shares of X to Y, B constructively plus actually owns 50 shares of X both before and after the sale. Because the sale
has no effect on taxpayer’s constructive ownership of X Corp, taxpayer cannot qualify for exchange treatment unless
the transaction qualifies as a partial liquidation. See Davis.

e.g. Taxpayer (individual) owns 50 of 100 shares of X Corp and 100 of 100 shares of Y Corp. Suppose taxpayer
sells 10 shares of Y to X. Before the sale, taxpayer actually owns 100% of Y Corp. After the sale, taxpayer actually
owns 90% of Y Corp. Because taxpayer is a 50% owner of X Corp, half of X Corp’s holdings of Y Corp stock must
be attributed to taxpayer. Therefore, taxpayer’s actual plus constructive ownership in Y Corp drops from 100%
before the sale to 95% after the sale. Such a reduction is unlikely to qualify as “meaningful” under §302(b)(1), so
taxpayer is unlikely to be given exchange treatment on the transaction.

e.g. Taxpayer (individual) owns 50 of 100 shares of X Corp and 100 of 100 shares of Y Corp. Suppose taxpayer
sells 100 shares of Y to X. Before the sale, taxpayer actually owns 100% of Y Corp. After the sale, taxpayer
actually owns 0% of Y Corp. Because taxpayer is a 50% owner of X Corp, half of X Corp’s holdings of Y Corp
stock must be attributed to taxpayer. Therefore, taxpayer’s actual plus constructive ownership in Y Corp drops from
100% before the sale to 50% after the sale. Such a reduction is likely to qualify as “meaningful” under §302(b)(1),
so taxpayer is likely to be given exchange treatment on the transaction.

One question that often arises is whether the “complete termination” provision of §302(b)(3) can be useful in a §304
transaction. Can the taxpayer file a §302(c)(2) waiver and thereby avoid application of the family attribution rules
in a §304 transaction involving “family” members? It is not clear.

If a taxpayer qualifies for exchange treatment on the §304 sale, gain or loss will be recognized under §1001 subject
to the loss limitation of §267.

§304(b)(2)  If the taxpayer does not qualify for exchange treatment on the §304 sale, distribution treatment is
mandated and dividend treatment will be accorded up to the E&P of both corporations.

e.g. Assume taxpayer is the sole owner of both X Corp and Y Corp. If taxpayer sells X Corp stock to Y Corp, §304
applies. Because of the attribution rules, the sale will work no change in the taxpayer’s actual plus constructive
ownership of X Corp. Accordingly, taxpayer will be taxed on the amount received from Y Corp under the
distribution rules of §301 (assuming that §302(b)(4) does not apply). Under §304(a)(1), the transaction is treated as
if taxpayer transferred the X Corp stock to Y Corp in a §351(a) transfer. Thus, subject to §362(e), taxpayer’s basis
in the X Corp shares sold will flow into his Y Corp shares and Y Corp will succeed to taxpayer’s basis in the X Corp
shares sold. See §358(a); §362(a).

Note that in the parent/subsidiary context, the basis consequences of the transaction described directly above are less
clear. Presumably, the basis will flow into the taxpayer’s remaining shares of the parent corporation (the issuing
corporation).

§304 applies only to sales of stock to related corporations where “sale” means the exchange of stock for “property”
as defined in §317(a)

§317(a)  the definition of property

Under §304, “property” does not include stock of the acquiring corporation. This means that the transfer of
“Brother” Corp to “Sister” Corp will not fall within §304 if all that is received in exchange is stock of Sister
Corp. Also, a “boot-less” incorporation under §351 cannot fall within §304.

What if there is a §351 incorporation in which boot is received by the transferor/ taxpayer?

e.g. Suppose stock of Brother Corp. is transferred to Sister Corp. in exchange for stock of Sister Corp. and $10,000
in cash. If the transferor meets the 80% control tests of §368(c) with respect to Sister Corp, this transaction meets
the test of an incorporation taxable under §351(b). Therefore, the gain (up to the amount of boot, or $10,000) on the
exchange would be taxable, possibly as capital gain. However, if the transferor also meets the 50% control test of
§304(c) with respect to Brother Corp., §304(a)(1) also seems to apply.
§304(b)(3)  if both §351 and §304 are called into play (as in the example directly above), the rules of §351 must
give way to those of §304. Thus, taxable of the boot will turn on the application of §304 and §302(b). As to the
Sister Corp., however, §351 would apply, because §304 can only apply to “property”

e.g. Taxpayer owns all 100 shares of X Corp. with an AB = $10/share and FMV = $30/share. Taxpayer also owns
50 of the 70 outstanding shares of Y Corp (AB = $1/share). The other 20 shares of Y Corp are owned by an
unrelated party. Taxpayer transfers all his shares of X Corp to Y Corp in exchange for 30 treasury shares of Y Corp.
plus $1,200 in cash. Assume the treasury shares are worth a total of $1,800.

In effect, Taxpayer has received Y Corp stock for 60% of his X Corp shares and cash for 40%. As to the 60%, the
transaction is described in §351 because Taxpayer is in “control” of Y Corp immediately after the transaction
(Taxpayer owns 50 shares from before and 30 treasury for a total of 80 shares out of a total of 70 shares outstanding
plus 30 from treasury equals 100  80 shares out of 100 is 80% ownership  control). Remember that §304
cannot apply to this part of the exchange because Taxpayer receives only stock, which is not “property” under §304.
Therefore, no gain or loss is recognized and Taxpayer’s basis in the shares received is $600 (60% of X Corp shares
is 60 shares; AB = $10/share; $600 basis is carried over to the Y Corp stock received per §358(a)).

As to the other 40% of the transaction, Taxpayer has exchanged X Corp stock for property (i.e. cash). This
transaction meets all the tests of §304, so Taxpayer will be taxed on the $1,200 received as dividend income unless
§302, applied to Taxpayer’s interest in X Corp, gives exchange treatment. Taxpayer’s interest in X Corp drops from
100% (all actual) to 80% (all constructive). Unless this reduction is “meaningful” enough to qualify under §302(b)
(1), the $1,200 will be taxed under the distribution rules of §301.

What about the parent/ subsidiary context (rather than the Brother/ Sister context)?

Qualifying for §304(a) is easier  §304(a)(2) requires only that the parent corporation control the subsidiary, where
control continues to mean direct or indirect ownership of 50% or more (by vote or value) of the stock of the
controlled corporation. Accordingly, §304(a)(2) can apply even if the taxpayer’s ownership interest in the parent
corporation is small

However, the tax situation becomes much more complex in a parent/sub context vs. a brother/ sister context.

e.g. Assume Taxpayer owns all 100 shares outstanding of Parent Corp. and Parent owns all 100 shares outstanding
of Sub Corp. Assume Taxpayer sells 60 of his Parent shares to Sub in exchange for property. Should this
transaction be taxed as a distribution or exchange to Taxpayer? Under §304(a)(2), this question will turn on the
application of the redemption rules of §302 to the transaction. From §304(b)(1), we know that it is Taxpayer’s
change in ownership interest of the issuing corporation (i.e. Parent) that must be examined. “Before” ownership =
100%. What about “after”? Taxpayer actually owns 40%. Can the remaining shares be attributed to Taxpayer via
Sub under §318(a)? We have a circular reasoning problem  we could impute ownership from Sub to Parent
under §318(a)(2)(C) and then apply §318(a)(2)(C) again to impute ownership from Parent from Taxpayer.
However, the attribution of ownership from Parent to Taxpayer will impute to Taxpayer only a proportion of the 60
shares depending on Taxpayer’s percentage ownership of Parent, but what is that percentage? It’s the exact question
we’re trying to answer.

In addition, the attribution of shares owned by Sub to Taxpayer via Parent requires the attribution from Parent Corp
of its own stock. We do not attribute Parent stock actually owned by Parent (i.e. treasury shares) to its shareholder.
Is it appropriate to attribute Parent stock owned only constructively by Parent to its shareholders?

One approach is to treat the Parent Corp shares acquired by Sub on the transaction as no longer outstanding. Indeed,
state law would presumably prohibit Sub from voting the shares. Should we then treat Taxpayer as having 100%
actual ownership of Parent because his 40 shares are the only Parent shares property considered “outstanding”?
Who knows?

Note that if Taxpayer is deemed to own 100% of Parent after the transaction, the proceeds of the sale received from
Sub will be taxed as a distribution.

ADL Ch. 6 Stock Dividends

ADL 6.01 Overview and History

Cash dividends are not exactly income in the sense that they are “undeniable accessions to wealth, clearly realized
over which the taxpayers have complete dominion” in that they reduce pro tanto the value of the corporate stock
held by the shareholders, but they are still taxed.

Congress does not now seek to tax common on common stock dividends (a stock distribution does not remove any
“actual” assets from the corporation).

ADL 6.02 The General Rule of §305(a)

§ 305. Distributions of stock and stock rights.

(a)  General rule. Except as otherwise provided in this section, gross income does not include the amount of any
distribution of the stock of a corporation made by such corporation to its shareholders with respect to its stock.

The general rule on nontaxability under §305(a) only applies to distributions made with respect to a shareholder’s
stock. It does not apply, for example, to a distribution of stock to employee as compensation or to a lender in
discharge of debt. It does not apply to the distribution by one corporation of stock in a second corporation.

Stock received tax-free under §305(a) is treated as a continuation of the recipient’s old stock. Accordingly, the
recipient’s old basis in the old shares divided among the old and new shares in proportion to relative FMV. Also,
the taxpayer’s holding period in the old shares is tacked onto the new shares. §1223(4).

Stock distributions under §305(a) do not reduce the E&P of the distributing corporation. §312(d)(1)(B).

e.g. Suppose that individual B owns all 100 outstanding shares of X Corp. AB = $20/share. Assume X Corp pays a
1 for 1 stock dividend. B will own 200 shares of X Corp. The event is tax-free to B. B will own 200 shares with
AB = $10/share. (the basis of $2,000 is simply divided among 200 shares instead of 100 shares)

ADL 6.03 Exceptions to the General Rule under §305(b)

§305(b)  Exceptions. Subsection (a) shall not apply to a distribution by a corporation of its stock, and the
distribution shall be treated as a distribution of property to which §301 applies--

(1)  Distributions in lieu of money. If the distribution is, at the election of any of the shareholders (whether
exercised before or after the declaration thereof), payable either--
(A)  in its stock, or
(B)  in property.
(2)  Disproportionate distributions. If the distribution (or a series of distributions of which such distribution is
one) has the result of--
(A)  the receipt of property by some shareholders, and
(B)  an increase in the proportionate interests of other shareholders in the assets or earnings and profits
of the corporation.
 (3)  Distributions of common and preferred stock. If the distribution (or a series of distributions of which such
distribution is one) has the result of--
(A)  the receipt of preferred stock by some common shareholders, and
(B)  the receipt of common stock by other common shareholders.
(4)  Distributions on preferred stock. If the distribution is with respect to preferred stock, other than an
increase in the conversion ratio of convertible preferred stock made solely to take account of a stock dividend
or stock split with respect to the stock into which such convertible stock is convertible.
(5)  Distributions of convertible preferred stock. If the distribution is of convertible preferred stock, unless it is
established to the satisfaction of the Secretary that such distribution will not have the result described in
paragraph (2).

Because non-recognition under §305(a) is appropriate only when the stock distribution does not substantially alter
the form of the recipient’s investment in the distributing corporation, the rules in §305(b) tax most stock
distributions that rearrange the relative interests of the shareholders in the distributing corporation.

Additionally, stock distributions appropriately considered to be property distributions followed by a reinvestment of

the distributed property also are removed from the protection of §305(a) by §305(b).

In the case of a stock dividend taxable under §305(b) and §301, §301 rules will apply: the corporation does not
recognize income on the distribution and E&P is reduced per the rules of §312.

§305(b)(1)  covers stock distributions in which any shareholder could have elected to receive money or other
property in lieu of stock. Because shareholders who elect to receive cash or other property would be covered by
§301 anyways, the reach of §305(b)(1) is limited to shareholders electing to receive shares and to shareholders
having no choice but forced to receive stock if any other shareholder had the opportunity to receive cash or other
property. As to each group, the distribution will be taxed as if the distribution had been in cash, followed by a
purchase of additional stock with the cash received.

e.g. Suppose that X Corp. declares a dividend payable in $10 cash or one share of preferred stock with a par value of
$10. Shareholders who elect to receive cash will be taxed directly under §301. Shareholders who elect to receive
stock will also be taxed under §301 because of the application of §305(b)(1). (think of the constructive receipt
doctrine) Even if the choice to receive cash was only available to, say, shareholders holding 4 or more shares, those
shareholders not having any choice as to the form of the dividend would still be taxed under §301 via §305(b)(1).
See Regs. §305-2(a)(5).

An election (whether direct or indirect) to receive stock in lieu of cash or other property will trigger application of
§305(b)(1) whether made before or after the stock distribution.

e.g. Suppose X Corp. has two classes of stock outstanding, identical except that for one class dividends must be paid
in cash and in the other class dividends must be paid in shares. A taxpayer who purchases shares receiving stock
dividends rather than cash dividends has elected to receive stock distributions in lieu of cash within the meaning of
§305(b)(1) so subsequent distributions will be taxed under the rules of §301. See Regs. §305-2(a)(4).

Rev. Rul. 78-375  Corporations sometimes offer dividend reinvestment plans to their shareholders. Such a plan
might provide that shareholders can elect to receive 105% of the value of the declared cash dividend in the form of
additional stock. Shareholders electing to participate in such a plan will be taxed on the FMV of the stock received
due to §305(b)(1).

Frontier Savings Ass’n v. C.I.R., 854 F.2d 1001 (7th Cir. 1988)  a corporation declaring a stock dividend and then
offering to redeem the shares of any shareholder wishing to tender them will not be taxed under §305(b)(1) (but the
tendering shareholders would be taxed under some other theory).
§305(b)(2)  captures stock distributions increasing the recipient’s interest in the distributing corporation, but only
if some other shareholder receives a distribution of cash or some other property

§305(b)(2) tests:

1. Increased interest test  will be satisfied by an increased claim to the assets or earnings and profits of the
distributing corporation
2. Companion distribution test  will usually be met for any stock distribution satisfying the increased
interest test because those shareholders not receiving stock of the corporation ought to receive something
else of value in exchange for a reduction in their ownership of the corporation

e.g. Suppose X Corp has two classes of shares outstanding: A shares are common and B shares are 10% cumulative
preferred. The distribution of B shares to holders of either class of shares will satisfy the increased interest test. On
the other hand, the distribution of A shares will not necessarily satisfy the increased interest test. If the distribution
of A shares is made only to holders of A shares, the increased interest test will not be met; however, if the
distribution of A shares is made only to holders of B shares the increased interest test will be met.

A dividend of cash or property will satisfy the companion distribution test, but so will excess salary payments
constituting disguised dividends. Furthermore, any payment to a shareholder not participating in the stock
distribution will qualify as a companion distribution so long as the payment is made to the shareholder in his
capacity as a shareholder. See Regs. §1.305-3(b)(3). Even a distribution of cash or property not made pursuant to a
plan to give some shareholders an increased interest in the corporation will qualify as a companion distribution if
made within 36 months of the stock distribution. See Regs. §1.305-3(b)(4).

Rev. Rul. 78-60  What if a distribution of stock satisfying the increased interest test is closely followed by or
preceded by a corporate distribution in redemption of some of the corporation’s shares held by taxpayers not
receiving any of the dividend stock? Such other distribution will not satisfy the companion distribution test unless
the redemption is part of a periodic plan to increase the proportionate interests of some of the shareholders. Also see
Regs. §1.305-3(b)(3).

A stock dividend will not be covered by §305(b)(2) simply because cash in lieu of fractional shares is distributed by
the corporation, provided the purpose of the distribution of cash is to save the corporation the trouble, expense, and
inconvenience of issuing and transferring fractional shares. See Regs. §1.305-3(c)(1).

§305(b)(3)  extends the disproportionate distribution rule of §305(b)(2) to include distributions of common stock
to some shareholders and preferred stock to other shareholders. Such stock distributions satisfy the increased
interest test as to both the common and preferred shareholders, but (absent §305(b)(3)) they would fail the
companion distribution test because the definition of “property” applicable to §305 excludes stock of the distributing
corporation per §317(a). The rule of §305(b)(3) overcomes this application of the definition of property, at least in
the specific context of disproportionate distributions of stock to common stockholders.

§305(b)(4) makes taxable any stock distribution made on preferred stock because any stock distribution on
preferred stock will alter the preferred shareholder’s preferred claim to earnings and profits as well as liquidation
proceeds (if preferred stock is distributed) or by adding residual rights to the shareholder’s preferred claims (if
common stock is distributed)

§305(b)(5)  provides that distributions of convertible preferred stock are taxable unless the distribution does not
have the result described in §305(b)(2), the disproportionate provision. The situations intended to be covered by
§305(b)(5) involve the distribution of convertible preferred stock in which the right to convert is limited to a short
time and the price of the common stock into which the preferred is convertible is greater than that of preferred stock
lacking convertibility. See Regs. §1.305-6(b) (example 2). Because the convertibility premium must be exploited
quickly (if at all), those shareholders wishing to hold additional convertible stock will exercise their conversion
rights and those not wishing to convert will sell their preferred shares. In effect, some shareholders will end up with
additional common stock and others with cash, the situation covered by §305(b)(2).

§305(b)(5) does not cover all distributions of convertible preferred stock. It only covers those having a
disproportionate effect on the recipient’s interests in corporate earnings and profits or assets. Such an effect will
only obtain if some but not all of the distributed stock is converted. §305(b)(5) will not cover distributions of
convertible preferred stock if the conversion right can be exercised over many years and the dividend rate is
consistent with market factors. See Regs. §1.305-6(a)(2).

Strangely, §305(b)(5) does not cover situations having the effect described in §305(b)(3), namely when some
shareholders exercise their conversion rights and others decline to exercise their conversion rights.

ADL 6.04 Deemed Distributions under §305(c)

§305(c) Certain transactions treated as distributions. For purposes of this section and §301, the Secretary shall
prescribe regulations under which [a change in conversion ratio, a change in redemption price, a difference between
redemption price and issue price, a redemption which is treated as a distribution to which §301 applies, or any
transaction (including a recapitalization) having a similar effect on the interest of any shareholder] shall be treated as
a distribution with respect to any shareholder whose proportionate interest in the earnings and profits or assets of the
corporation is increased by such change, difference, redemption, or similar transaction. Regulations prescribed under
the preceding sentence shall provide that--
(1)  where the issuer of stock is required to redeem the stock at a specified time or the holder of stock has the
option to require the issuer to redeem the stock, a redemption premium resulting from such requirement or
option shall be treated as reasonable only if the amount of such premium does not exceed the amount
determined under the principles of §1273(a)(3),
(2)  a redemption premium shall not fail to be treated as a distribution (or series of distributions) merely
because the stock is callable, and
(3)  in any case in which a redemption premium is treated as a distribution (or series of distributions), such
premium shall be taken into account under principles similar to the principles of §1272(a).

Many transactions not involving an actual distribution of stock nevertheless can have the effect of a stock dividend.

e.g. Consider X Corp. having 300 outstanding shares. B owns 150 and C owns 150. Assume that X Corp has assets
worth $30,000, so each share is worth $100. If X Corp. distributes $5,000 cash to B and 75 shares to C, the
distribution will be taxable to both shareholders (B will be taxed directly under §301 and C will be taxed under §301
via §305(b)(2)). After the transaction, X Corp will have assets worth $25,000, B will have 150 shares, and C will
have 225 shares. B’s ownership is 150/375 = 40% = $10,000, so each share will be worth $66.67 ($10,000/ 150).
C’s ownership is 225/375 = 60% = $15,000, and, likewise, each share will be worth $66.67 ($15,000/ 225).

The value of the distributed shares is 75*$66.67 = $5,000, and C will be taxed on that amount (the FMV) under the
rules of §301. Note that the decrease in the value of C’s original 150 shares remains unrealized under §305 until C
disposes of those shares.

The same effect could have been obtained by replacing the distributions with a single redemption by X Corp of 50
of B’s shares. B would receive the same $5,000 (50 shares at $100/share) and B’s ownership would drop from 50%
to 40% (150/300 shares to 100/250 shares) while C’s ownership would increase from 50% to 60% (150/300 shares
to 150/250 shares). Each share will continue to be worth $100, so B will have an aggregate value of $10,000 in
shares and C will have an aggregate value of $15,000 in shares.

Because the two transactions described above have the same effect, the second transaction would be subjected to the
rules of §301 via §305(c).

While the thrust of §305(c), that transactions having the effect of a stock dividend should be taxed like a stock
dividend, makes sense, its arbitrary lines and mechanical application undercut its coherence.
For example, the statute re-characterizes as stock distributions only those redemptions failing to qualify for
exchange treatment under §302(a), yet it is precisely those redemptions qualifying for exchange treatment that work
the greatest rearrangement of shareholder interests.

There seems to be no persuasive rationale why highly disproportionate stock distributions should trigger §305 and
result in ordinary dividend income (if corporate E&P is sufficient) while redemptions having the same effect do not
(and typically result in capital gain or loss).

A change in conversion ratio can also trigger application of §305(c), but not all changes in the conversion ratio of
preferred stock are proper candidates for §305(c).

e.g. Suppose X Corp has 100 shares of common stock and 100 shares of convertible preferred stock outstanding.
The preferred shares are convertible one for one into common shares. If the common stock splits (or if a stock
dividend payable in common shares is declared for the common shares), then the conversion rights of the
convertible preferred shares must be adjusted to prevent dilution. The conversion ratio of the convertible preferred
shares being increased (from one to one to two to one) to prevent dilution is explicitly permitted by statute without
taxation. See Regs. §1.302-7(b)(1).

What if the convertible preferred shareholders do not benefit from an anti-dilution provision? Suppose that to
prevent dilution when there is a common for common distribution, the convertible preferred shares also receive a
common share. In this case, the distribution is taxable under §305(b)(4), even though it has the exact same effect as
the transaction directly above.

ADL 6.05 Poison Pills

“Poison pill”  anti-takeover provision in which corporations ensure that takeovers will be too expensive to
consummate

e.g. the corporation might provide that each shareholder can purchase additional shares of the corporation at a 50%
discount if an outsider acquires 20% or more of the company’s stock or announces its intention to make a tender
offer

Rev. Rul. 90-11  the Service ruled that the adoption of a poison pill is not subject to taxation under §305

ADL Ch. 8 Liquidations

ADL 8.01 Introduction

When a corporation is formed, a shareholder typically recognizes no gain or loss (assuming the absence of boot).
See §351. If the shareholder has realized but not recognized gain, the corporation preserves the gain by taking a
transferred basis in the transferred asset and the shareholder preserves the gain by taking an exchanged basis in the
corporation’s stock. §362(a) and §358(a).

However, non-recognition is typically not the treatment if a corporation is liquidated. Instead, a liquidation event is
usually a taxable event to both the liquidating corporation and the shareholders. A liquidation is treated as if the
shareholders had sold their stock in the corporation in exchange for the corporation’s assets.

§336  The liquidating corporation recognizes gain or loss as if the distributed property were sold to the
shareholder at FMV.

§331  The shareholder who receives a liquidating corporation’s assets must recognize gain or loss as the
difference between his basis in the shares and the FMV of the property received.

§334(a)  The shareholder takes an FMV basis in the assets received on liquidation.
e.g. If X Corp has assets with FMV = $15,000, X Corp’s basis in those assets is $5,000, and shareholder’s basis in X
Corp’s stock is $8,000 and X Corp liquidates, then X Corp would recognize a $10,000 gain and shareholder would
recognize a $7,000 gain. Shareholder’s basis in the liquidated assets is $15,000.

However, there is an alternative tax treatment that applies when a subsidiary is liquidated into its parent corporation.
This alternative treatment occurs if there is a “complete liquidation.”

§346(a)  a corporation completely liquidates if it makes a series of distributions in redemption of all of its stock
pursuant to plan

There is no requirement under the definition of a complete liquidation that the corporation dissolve under state law
or adopt a formal plan of liquidation. Nor is there a requirement that assets be converted into cash (an in-kind
distribution will qualify). Furthermore, there is no specific time frame during which a liquidation must be
completed; a corporation might distribute its assets over a period of time while continuing some corporate activities
and still qualify. A general guideline, though, is that anything longer than three years will be given §301 treatment
rather than liquidation treatment. See §332.

§332  postpones the parent corporation’s recognition, requiring the parent to step into the liquidating subsidiary’s
tax shoes; the parent receives the liquidated subsidiary’s assets and takes the subsidiary’s basis.

§337  The liquidating subsidiary generally subsidiary generally recognizes no gain or loss

e.g. Suppose Sub Corp has assets with FMV = $15,000 and AB =$5,000. If Sub Corp liquidates, then Parent Corp
would recognize no gain and would take a $5,000 basis in the assets received from Sub Corp. Parent’s basis in the
Sub’s stock is immaterial and is ignored.

“Hybrid” entity  an entity that is treated one way in a foreign jurisdiction (e.g. as a corporation) and a different
way for U.S. tax purposes (e.g. a disregarded entity); with a hybrid entity, it is possible, for U.S. tax purposes, for a
liquidation to occur even though no assets are transferred.

ADL 8.02 §331 Liquidations

§331. Gain or loss to shareholders in corporate liquidations.

(a)  Distributions in complete liquidation treated as exchanges. Amounts received by a shareholder in a distribution
in complete liquidation of a corporation shall be treated as in full payment in exchange for the stock.
(b)  Non-application of §301. §301 shall not apply to any distribution of property (other than a distribution referred
to in paragraph (2)(B) of §316(b) in complete liquidation.

a. Treatment of the Shareholders

If the shareholder held the exchanged stock as a capital asset, gain or loss is simply the amount received – FMV. If
a shareholder acquired the stock on different dates or at different prices, simply measure gain or loss separately for
each block.

The liquidating corporation’s E&P generally doesn’t affect the shareholders’ taxation in a liquidating distribution.
The exception is for a special election for a liquidating personal holding company. See §316(b)(2).

e.g. Assume X Corp has E&P of $6,000, cash of $5,000, and an asset with AB = $3,000 and FMV = $8,000.
Individual B owns all of X Corp’s shares with AB = $2,000 and FMV = $13,000. If X Corp liquidates, B will
recognize a gain of $13,000 amount realized minus $2,000 basis, or $11,000. Assuming B is not a stock dealer, the
gain will be a capital gain (despite the E&P account of only $6,000). Because B is treated as if he exchanged X
Corp’s stock for X Corp’s assets, B will take an FMV basis in the assets received, or $8,000. See §334(a).
What if there is a liability attached to X Corp’s assets?

e.g. Assume X Corp has E&P of $6,000, cash of $5,000, and an asset with AB = $3,000 and FMV = $8,000 but an
attached liability of $4,000. Individual B owns all of X Corp’s shares with AB = $2,000 and FMV = $13,000. If X
Corp liquidates, B will recognize a gain to the extent of amount realized (which is now $13,000 minus the $4,000
liability, or $9,000) minus basis ($2,000), or $7,000. B’s basis in the asset is still the FMV of $8,000.

Note that if the liability the shareholder inherits is disputed, it will not be taken into account in reducing the amount
realized. If the claim cannot be valued upon liquidation, the shareholder’s gain will remain open until valuation is
possible; however, the Service requires valuation except in rare and extraordinary circumstances. See Burnet v.
Logan, 283 U.S. 404 (1931).

What if a corporation sells it assets on the installment method prior to making a liquidating distribution of the
installment notes?

Although the corporation must recognize FMV – AB on the installment notes, if §453(h) applies the shareholder
receiving installment notes in a §331 liquidation may not have to treat the notes as part of the amount received on
the liquidation. Instead, the shareholders can treat payments on the notes as payments for the corporate stock,
usually resulting in capital gain or loss treatment. If §453(h) does not apply, then the shareholder must include the
FMV of the notes in the amount realized on the exchange of stock in the liquidating corporation.

§453(h)  applies when the sale resulting in the installment notes occurs within 12 months of the adoption of the
plan to liquidate and the liquidation takes place within the same 12 month period; installment reporting is available
to a shareholder on the receipt of the notes from the sale of inventory only if the inventory is sold in a bulk sale to
one purchaser in one transaction

Rev. Rul. 68-348  where liquidating distributions take place over more than one year, shareholders recover basis
before reporting gain

e.g. Assume X Corp has E&P of $6,000, cash of $5,000, and an asset with AB = $3,000 and FMV = $8,000.
Individual B owns all of X Corp’s shares with AB = $2,000 and FMV = $13,000. If X Corp distributed $2,000
worth of assets in year 1 and the remaining $11,000 in year 2, B recognizes no gain in year 1 and $11,000 of gain in
year two (AB = $0 because $2,000 of basis was recovered in year 1).

Compare the treatment above to installment reporting under §453, which, if applicable, would have required B to
prorate the $2,000 basis between years 1 and 2. Note that if B’s AB was, for example, $22,000, B could not report
the $9,000 loss until year 2.

While §267(a)(1) usually disallows recognition of losses on the exchange of property between a shareholder and a
corporation in which the shareholder owns > 50%, losses incurred by shareholders in a complete liquidation are
exempted.

b. Treatment of the Liquidating Corporation

§336. Gain or loss recognized on property distributed in complete liquidation.

(a)  General rule. Except as otherwise provided in this section or §337, gain or loss shall be recognized to a
liquidating corporation on the distribution of property in complete liquidation as if such property were sold to the
distributee at its fair market value.
(b)  Treatment of liabilities. If any property distributed in the liquidation is subject to a liability or the shareholder
assumes a liability of the liquidating corporation in connection with the distribution, for purposes of subsection (a)
and §337, the fair market value of such property shall be treated as not less than the amount of such liability.
(c)  Exception for liquidations which are part of a reorganization. For provision providing that this subpart does not
apply to distributions in pursuance of a plan of reorganization, see §361(c)(4).
(d)  Limitations on recognition of loss.
(1)  No loss recognized in certain distributions to related persons.
(A)  In general. No loss shall be recognized to a liquidating corporation on the distribution of any
property to a related person (within the meaning of §267) if--
(i)  such distribution is not pro rata, or
(ii)  such property is disqualified property.
(B)  Disqualified property. For purposes of subparagraph (A), the term "disqualified property" means
any property which is acquired by the liquidating corporation in a transaction to which §351 applied, or
as a contribution to capital, during the 5-year period ending on the date of the distribution. Such term
includes any property if the adjusted basis of such property is determined (in whole or in part) by
reference to the adjusted basis of property described in the preceding sentence.
(2)  Special rule for certain property acquired in certain carryover basis transactions.
(A)  In general. For purposes of determining the amount of loss recognized by any liquidating
corporation on any sale, exchange, or distribution of property described in subparagraph (B), the
adjusted basis of such property shall be reduced (but not below $0) by the excess (if any) of--
(i)  the adjusted basis of such property immediately after its acquisition by such corporation, over
(ii)  the fair market value of such property as of such time.
(B)  Description of property.
(i)  In general. For purposes of subparagraph (A), property is described in this subparagraph if--
(I)  such property is acquired by the liquidating corporation in a transaction to which §351
applied or as a contribution to capital, and
(II)  the acquisition of such property by the liquidating corporation was part of a plan a
principal purpose of which was to recognize loss by the liquidating corporation with respect
to such property in connection with the liquidation. Other property shall be treated as so
described if the adjusted basis of such other property is determined (in whole or in part) by
reference to the adjusted basis of property described in the preceding sentence.
(ii)  Certain acquisitions treated as part of plan. For purposes of clause (i), any property described
in clause (i)(I) acquired by the liquidated corporation after the date 2 years before the date of the
adoption of the plan of complete liquidation shall, except as provided in regulations, be treated
as acquired as part of a plan described in clause (i)(II).
(C)  Recapture in lieu of disallowance. The Secretary may prescribe regulations under which, in lieu of
disallowing a loss under subparagraph (A) for a prior taxable year, the gross income of the liquidating
corporation for the taxable year in which the plan of complete liquidation is adopted shall be increased
by the amount of the disallowed loss.
(3)  Special rule in case of liquidation to which §332 applies. In the case of any liquidation to which §332
applies, no loss shall be recognized to the liquidating corporation on any distribution in such liquidation. The
preceding sentence shall apply to any distribution to the 80% distributee only if subsection (a) or (b)(1) of
§337 applies to such distribution.
(e)  Certain stock sales and distributions may be treated as asset transfers. Under regulations prescribed by the
Secretary, if--
(1)  a corporation owns stock in another corporation meeting the requirements of §1504(a)(2), and
(2)  such corporation sells, exchanges, or distributes all of such stock,
an election may be made to treat such sale, exchange, or distribution as a disposition of all of the assets of such other
corporation, and no gain or loss shall be recognized on the sale, exchange, or distribution of such stock.

§336(a)  a liquidating corporation generally will be taxed on a distribution of property as if the property had been
sold to shareholders at FMV. (Note that if the shareholder and the corporation are “related” within the meaning of
§1239(b), the corporation must treat the gain on distribution of any depreciable property as ordinary income.)

§336(b)  If property distributed in a liquidation is encumbered by a liability, the amount realized cannot be less
than the amount of the liability
A liquidating corporation must recognize not only the post-incorporation appreciation but the pre-incorporation
appreciation, too.

e.g. Suppose B forms X Corp by exchanging property with $5,000 basis and $20,000 FMV for all of X Corp’s stock.
On the exchange, X Corp carries over B’s $5,000 basis under §362(a). B takes a $5,000 basis in X Corp stock under
§358. Suppose X Corp liquidates some time later and the value of its assets is unchanged. X Corp will realize a
$15,000 gain under §336(a) while B will also recognize a $15,000 gain under §331. B will take a $20,000 basis (the
asset’s FMV) under §334(a).

Note this is not tax-efficient to the shareholder.

Also note that, while a corporation can likewise often recognize losses upon liquidation, some pre-incorporation
losses are not recognized upon liquidation.

§336(d)(1),(2)  address the concern that taxpayers could take advantage of the ability to recognize loss upon
liquidation by artificially creating corporate-level losses

§362(e)(2)  may make the limits imposed by §336(d)(1),(2) too broad

e.g. Suppose that B owns all the stock of X Corp. X Corp has assets with $90,000 AB and $120,000 FMV. B’s X
Corp stock basis is $90,000. B also holds a piece of property with $130,000 AB and $80,000 FMV. If X Corp
liquidates, both X Corp and B will recognize a $30,000 gain. See §336(a) and §331. However, suppose instead that
B exchanges the loss property for additional X Corp stock in a §351 exchange. If §362(e)(2) does not apply, X
Corp’s basis in all of its assets is increased to $220,000 under §362 and B’s basis in all of its X Corp stock is
increased to $220,000 under §358. The total FMV of X Corp’s assets is $200,000. If §336(d)(1),(2) do not apply,
upon liquidation X Corp would recognize a $20,000 loss under §336 and B would also recognize a $20,000 loss
under §331. After the exchange, B’s basis in the loss-property is only $80,000 (FMV) under §334(a).

Both §336(d)(1),(2) and §362(e)(2) target the double-loss treatment described above.

e.g. continued: §362(e)(2)  if it applies to the §351 transaction, X Corp takes an $80,000 basis in the contributed
property (rather than a $130,000 basis) because §362(e)(2) limits the corporate transferee’s basis in property
contributed in a §351 exchange to the property’s FMV. [Note that alternatively the shareholder can take the basis
cram-down under a §362(e)(2)(C) election] B would then take a $220,000 basis in his total X stock holdings while
X Corp’s basis in its total assets would be $170,000. Upon liquidation, assuming §336(d)(1),(2) do not apply, X
Corp recognizes a $30,000 gain and B recognizes a $20,000 loss, thereby eliminated the double-loss. [If the
§362(e)(2)(C) election is made, the party’s recognizing gain and loss simply switch.]

§362(d)(1)  applies if:

1. Liquidating corporation and shareholder are related persons under §267;
2. Liquidating corporation distributed property with a built-in loss to the shareholder; and
3. the loss property is disqualified property or is not distributed pro rata among the shareholders
“Disqualified” property  property acquired by the liquidating corporation in a transaction to which §351 applied
(or as a capital contribution) within five years of the distribution date

If §362(d)(1) applies, the liquidating corporation does not recognize loss on its distribution of built-in loss property
to the related person. However, the shareholder should still be entitled to recognize loss on liquidation under §331.

e.g. continued: Now assume that B and X Corp are related , they make the §362(e)(2)(C) election, and the
contributed built-in loss property is disqualified property. Because of the §362(e)(2)(C) election, upon liquidation,
X Corp would recognize a $20,000 loss and B would recognize a $30,000 gain. §362(d)(1)  if it applies, X Corp
cannot recognize the loss on the built-in loss asset, so now X Corp recognizes a $30,000 gain (due solely from its
original assets with AB = $90,000 and FMV = $120,000). In this case, working in tandem, §362(e)(2) and §362(d)
(1) serve not only to eliminate the double-loss but to eliminate any loss altogether.

Question: couldn’t you get around this problem simply by not making the §362(e)(2)(C) election? Yes.

Note that §362(e)(2) and §362(d)(1) working in tandem would also preclude any loss recognition even if the
property declines in value while held by the liquidating corporation.

§336(d)(1)(B) also applies if the basis of property is determined by reference to the basis of property acquired in the
described transactions (for example, in a §1031 like-kind exchange).

Can §336(d)(1) be avoided through proper planning?

e.g. Suppose that X Corp has two shareholders. B owns 75% (so is a “related” shareholder) and C owns 25%. X
Corp has $4,000 in cash and an asset with AB = $40,000 and FMV = $12,000 (so built-in loss is $28,000). If X
Corp liquidates and distributes the built-in loss asset to B and the cash to C, it cannot recognize the loss because it
makes a non-pro-rata distribution of the asset to a related person, triggering application of §336(d)(1). Suppose
instead that X Corp makes a pro-rata distribution; $3,000 cash and ¾ interest in the built-in loss asset to B and
$1,000 cash and ¼ interest in the built-in loss asset to C. As long as the built-in loss asset is not disqualified
property, now X Corp would be able to deduct the $28,000 loss on the liquidation. (Note that the tax effects on the
shareholders don’t change; either way, B will have an amount realized of $12,000 and C will have an amount
realized of $4,000.)

What if following the pro-rata distribution described above, B agrees to purchase C’s interest in the built-in loss
asset for $3,000?

C would recognize no gain or loss because C is selling for $3,000 and took a $3,000 basis (the asset’s FMV) in the
distribution under §334(a). B could use the $3,000 cash received from the liquidation to fund the purchase. After
the liquidation, the shareholders are in the exact same position as they would be in the non-pro-rata distribution
described above. However, in the non-pro-rata distribution X Corp is not allowed a $28,000 loss, while the pro-rata
distribution followed by sale between shareholders route results in X being allowed to take the $28,000 loss.

Will the transaction above be respected for tax purposes?

American Bantam Car Co. v. C.I.R., 177 F.2d 513 (3d Cir. 1949)  if there was a preconceived and binding plan
for the shareholders to transact after the pro-rata distribution, the liquidation will probably be re-characterized as a
non-pro-rata distribution; on the other hand, if there was no obligation on the selling shareholder to sell the built-in
loss asset to the purchasing shareholder, the transactions will probably stand for tax purposes

Can a liquidating corporation avoid §336(d)(1) by selling its loss property before the liquidation and thereby
ensuring recognition of the loss?

Court Holding doctrine  This doctrine is similar to the step transaction doctrine in that it operates to determine
the tax consequences of a series of transactions by viewing those transactions as a whole. But its effect is often to
alter for analytic purposes the order of the steps.

Note that Court Holding and Cumberland Public Service do not seem reconcilable in principle.

Court Holding Co., 324 U.S. 331 (1945)

Issue: The question is whether the Circuit Court of Appeals properly reversed the Tax Court's conclusion that the
corporation was taxable for the gain which accrued from the sale. No, the Tax Court was correct.
Facts: The respondent corporation was organized in 1934 solely to buy and hold the apartment building which was
the only property ever owned by it. All of its outstanding stock was owned by Minnie Miller and her husband.  
Between October 1, 1939 and February, 1940, while the corporation still had legal title to the property, negotiations
for its sale took place. These negotiations were between the corporation and the lessees of the property, together
with a sister and brother-in-law. An oral agreement was reached as to the terms and conditions of sale, and on
February 22, 1940, the parties met to reduce the agreement to writing. The purchaser was then advised by the
corporation's attorney that the sale could not be consummated because it would result in the imposition of a large
income tax on the corporation. The next day, the corporation declared a "liquidating dividend," which involved
complete liquidation of its assets, and surrender of all outstanding stock. Mrs. Miller and her husband surrendered
their stock, and the building was deeded to them. A sale contract was then drawn, naming the Millers individually as
vendors, and the lessees' sister as vendee, which embodied substantially the same terms and conditions
previously agreed upon. $1,000, which a month and a half earlier had been paid to the corporation by the lessees,
was applied in part payment of the purchase price. Three days later, the property was conveyed to the lessees' sister.

Law: The tax consequences which arise from gains from a sale of property are not finally to be determined
solely by the means employed to transfer legal title. Rather, the transaction must be viewed as a whole, and
each step, from the commencement of negotiations to the consummation of the sale, is relevant. A sale by one
person cannot be transformed for tax purposes into a sale by another by using the latter as a conduit through
which to pass title.

Analysis: Step transaction doctrine rationale.

Holding (Black): The Tax Court was justified in attributing the gain from the sale to the corporation. 

U.S. v. Cumberland Public Service, 338 U.S. 451 (1950)

Issue: The question is whether, despite contrary findings by the Court of Claims, this record requires a holding that
the transaction was in fact a sale by the corporation subjecting the corporation to a capital gains tax. No, it doesn’t.

Facts:  Respondent, a closely held corporation, was long engaged in the business of generating and distributing
electric power in three Kentucky counties. In 1936 a local cooperative began to distribute Tennessee Valley
Authority power in the area served by respondent. It soon became obvious that respondent's Diesel-generated power
could not compete with TVA power, which respondent had been unable to obtain. Respondent's shareholders,
realizing that the corporation must get out of the power business unless it obtained TVA power, accordingly offered
to sell all the corporate stock to the cooperative, which was receiving such power. The cooperative refused to buy
the stock, but countered with an offer to buy from the corporation its transmission and distribution equipment. The
corporation rejected the offer because it would have been compelled to pay a heavy capital gains tax. At the same
time the shareholders, desiring to save payment of the corporate capital gains tax, offered to acquire the transmission
and distribution equipment and then sell to the cooperative. The cooperative accepted. The corporation transferred
the transmission and distribution systems to its shareholders in partial liquidation. The remaining assets were sold
and the corporation dissolved. The shareholders then executed the previously contemplated sale to the cooperative.

Law: Congress has imposed no tax on liquidating distributions in kind or on dissolution, whatever may be the
motive for such liquidation. Consequently, a corporation may liquidate or dissolve without subjecting itself to the
corporate gains tax, even though a primary motive is to avoid the burden of corporate taxation.

Analysis: Court Holding was an approval of the action of the Tax Court in looking beyond the papers executed by
the corporation and shareholders in order to determine whether the sale there had actually been made by the
corporation. We were but emphasizing the established principle that in resolving such questions as who made a sale,
fact-finding tribunals in tax cases can consider motives, intent, and conduct in addition to what appears in written
instruments used by parties to control rights as among themselves

Holding (Black): No, the Court will defer to the finder of fact in characterizing the transaction.

Why Court Holding matters today  if a liquidating corporation distributes built-in loss property described
in §336(d)(1), the loss in gone forever. However, if that same corporation sells the property before the
liquidation, the loss will be recognized (unless some other disallowance rule applies). How far along can a
liquidation be before it is too late to negotiate a sale of the corporation’s assets? There is no clear answer, but
the earlier the better.

§336(d)(2)  restricts a liquidating corporation’s loss recognition and is triggered by a distribution, sale, or
exchange of property that had been acquired in a §351 transaction or as a contribution to capital if the property’s
acquisition was “part of a plan a principal purpose of which was to recognize loss by the liquidating corporation
with respect to such property in connection with the liquidation”

Property acquired by the liquidating corporation after the date two years before the date the corporation adopts a
plan of liquidation is presumed to have been acquired with that principal purpose. Note that the presumption apples
to the date of adoption of the plan, not the date of the liquidation, so §336(d)(2) may apply even if more than two
years elapse between the acquisition of the property and the actual distribution of the property via a liquidation.

It seems like due to legislative history, non-abusive transfers occurring within the two-year period should not fall
within §336(d)(2), but we are not certain about this. Likewise, it would seem that an abusive transfer occurring
outside the two-year period not fall within §336(d)(2), but we are not sure about this, either.

If §336(d)(2) applies, the liquidating corporation is not automatically denied the entire loss deduction. Instead, for
purposes of determining loss, the basis of the property is decreased by the excess of the asset’s basis on the date of
contribution over its FMV at that time.

e.g. Suppose that one year prior to adoption of a plan of liquidation, X Corp acquires, in a §351 transaction, property
that has a $40,000 basis and a $25,000 FMV. The property continues to decline in value. On the date of the
liquidating distribution the property has an FMV of $18,000. Under §336(d)(2), X Corp may recognize the $7,000
that occurred during the time X Corp held the property. [Note that many times §362(e)(2) would prevent this
situation from occurring in the first place by precluding a corporation from using a §351 transaction to create a
corporate built-in loss, but there are circumstances where §336(d)(2) would still apply, such as when a §362(e)(2)
(C) election is made.]

c. The Corporate Triple-tax

The repeal of the General Utilities doctrine increased the potential for a corporate triple-tax in the context of a
liquidation.

e.g. Suppose B owns all of the stock of X Corp, a holding company whose only asset is all of the stock of Y Corp.
All of the stock and assets have appreciated in value (i.e. have built-in gains). C wants to acquire all of Y Corp’s
assets. C buys the Y Corp stock from X Corp and then both B and C liquidate X Corp and Y Corp. C will
recognize no gain or loss on the liquidation of Y Corp because it took a cost basis in the Y Corp stock when it
purchased it (so basis = FMV), but Y Corp will recognize gain under §336. X Corp already recognized gain on the
sale of Y Corp stock to C. B will recognize gain when it liquidates X Corp under §331. The result is that the built-
in gain inherent in Y Corp’s assets is thus realized three times.
Instead, Y Corp could sell its assets directly to C and then Y Corp and X Corp could liquidate. Y Corp would
recognize gain on the asset sale. When Y Corp liquidates into its parent X Corp, X Corp would not recognize gain
under §332. On the liquidation of X Corp, B would recognize gain under §331. Now the built-in gain inherent in Y
Corp’s assets is only taxed twice.

§336(e)  may work to the taxpayers’ advantage by treating the first transaction described above (triple-tax) as if
the parties executed the second (double-tax) by treating the sale of stock of Y Corp as if Y Corp’s assets were sold

§336(e) applies only if a corporation meets the 80-80 ownership tests (i.e. voting and total value of all stock
outstanding) of §1504(a)(2); if §336(e) does not apply, the triple-tax problem endures. Note that the Court Holding
doctrine may play a role in determining who sold what to whom and when.

e.g. if §336(e) applies, X Corp’s gain on the sale of Y Corp’s stock would be the amount realized for Y Corp stock
minus the basis of Y Corp’s assets. No other gain or loss would be recognized on the sale of the Y Corp stock by X
Corp. The basis of Y Corp’s assets would be stepped up to FMV. .

ADL 8.03 Subsidiary Liquidations

§332. Complete liquidations of subsidiaries.

(a)  General rule. No gain or loss shall be recognized on the receipt by a corporation of property distributed in
complete liquidation of another corporation.
(b)  Liquidations to which section applies. For purposes of this section, a distribution shall be considered to be in
complete liquidation only if--
(1)  the corporation receiving such property was, on the date of the adoption of the plan of liquidation, and has
continued to be at all times until the receipt of the property, the owner of stock (in such other corporation)
meeting the requirements of §1504(a)(2); and either
(2)  the distribution is by such other corporation in complete cancellation or redemption of all its stock, and
the transfer of all the property occurs within the taxable year; in such case the adoption by the shareholders of
the resolution under which is authorized the distribution of all the assets of such corporation in complete
cancellation or redemption of all its stock shall be considered an adoption of a plan of liquidation, even though
no time for the completion of the transfer of the property is specified in such resolution; or
(3)  such distribution is one of a series of distributions by such other corporation in complete cancellation or
redemption of all its stock in accordance with a plan of liquidation under which the transfer of all the property
under the liquidation is to be completed within 3 years from the close of the taxable year during which is made
the first of the series of distributions under the plan, except that if such transfer is not completed within such
period, or if the taxpayer does not continue qualified under paragraph (1) until the completion of such transfer,
no distribution under the plan shall be considered a distribution in complete liquidation.
If such transfer of all the property does not occur within the taxable year, the Secretary may require of the taxpayer
such bond, or waiver of the statute of limitations on assessment and collection, or both, as he may deem necessary to
insure, if the transfer of the property is not completed within such 3-year period, or if the taxpayer does not continue
qualified under paragraph (1) until the completion of such transfer, the assessment and collection of all income taxes
then imposed by law for such taxable year or subsequent taxable years, to the extent attributable to property so
received. A distribution otherwise constituting a distribution in complete liquidation within the meaning of this
subsection shall not be considered as not constituting such a distribution merely because it does not constitute a
distribution or liquidation within the meaning of the corporate law under which the distribution is made; and for
purposes of this subsection a transfer of property of such other corporation to the taxpayer shall not be considered as
not constituting a distribution (or one of a series of distributions) in complete cancellation or redemption of all the
stock of such other corporation, merely because the carrying out of the plan involves (A) the transfer under the plan
to the taxpayer by such other corporation of property, not attributable to shares owned by the taxpayer, on an
exchange described in §361, and (B) the complete cancellation or redemption under the plan, as a result of
exchanges described in §354, of the shares not owned by the taxpayer.

§334. Basis of property received in liquidations.

(a)  General rule. If property is received in a distribution in complete liquidation, and if gain or loss is recognized on
receipt of such property, then the basis of the property in the hands of the distributee shall be the fair market value of
such property at the time of the distribution.
(b)  Liquidation of subsidiary.
(1)  In general. If property is received by a corporate distributee in a distribution in a complete liquidation to
which §332 applies (or in a transfer described in §337(b)(1)), the basis of such property in the hands of such
distributee shall be the same as it would be in the hands of the transferor; except that, in the hands of such
distributee--
(A)  the basis of such property shall be the FMV of the property at the time of the distribution in any
case in which gain or loss is recognized by the liquidating corporation with respect to such property
(2)  Corporate distributee. For purposes of this subsection, the term "corporate distributee" means only the
corporation which meets the stock ownership requirements specified in §332(b).

a. Shareholder Treatment

§332  provides that a parent corporation recognizes no gain or loss when it liquidates a subsidiary.

§334(b)(1)  in a parent-sub liquidation, the parent succeeds to the subsidiary’s asset bases and the assets’ holding
periods (see §1223(2))

In effect, for tax purposes, in a parent-sub liquidation, the parent steps into the shoes of the subsidiary.

Regs. §1.332-7  if, as part of the liquidation, the parent corporation receives property in satisfaction of a debt
owed by the subsidiary to the parent, the parent will recognize gain or loss, measured by the difference between its
amount realized for the debt and its basis in the debt

Viewed together, §332 and §334(b)(1) remove any unrealized gain or loss the parent holds in the subsidiary
corporation’s shares.

e.g. Assume Parent owns all of Sub’s outstanding stock with AB = $15,000. Subsidiary’s assets have FMV =
$9,000 with AB = $7,000. Parent has built-in loss of $6,000 in Sub’s stock. In a parent-sub liquidation, the $6,000
built-in loss will not be recognized and it will disappear. The parent will take a $7,000 basis in Sub’s assets. If it
sells those assets for $9,000 (the FMV), Parent will recognize a $2,000 gain.

e.g. Assume Parent owns all of Sub’s outstanding stock with AB = $15,000. Subsidiary’s assets have FMV =
$18,000 and AB = $24,000. Parent has a built-in gain of $9,000 in Sub’s stock. In a parent-sub liquidation, the
$9,000 built-in gain will not be recognized and it will disappear. The parent will take a $24,000 basis in Sub’s
assets. If it sells that assets for $18,000 (the FMV), Parent will recognize a $6,000 loss.

If §332 applies to a liquidation, the non-recognition offered does not apply to every shareholder. It applies only to
those who meet the ownership requirements of §332(b). If those ownership requirements are not met, the tax
consequences for the shareholder are governed by §331 and §334(a).

e.g. Suppose that X Corp has assets with $100,000 FMV and $60,000 AB. X Corp has only one class of stock. B,
an individual, owns X Corp stock with a $20,000 FMV and $6,000 AB. C Corp owns X Corp stock with $80,000
FMV and $30,000 AB.

If X Corp liquidates and makes a pro rata distribution, B recognizes a $14,000 gain on his X Corp stock under §331
and takes a $20,000 basis in the assets received under §334(a). If §332 applies to C Corp, C Corp recognizes no
gain on the distribution and takes a $48,000 (80%*$60,000) carryover basis in the distributed assets under §334(b)
(1).

For §332 to apply, ownership, distribution, and timing requirements must be met:
  parent must satisfy the 80-80 test (voting power and total value) at all times from the adoption of the plan
of liquidation until receipt of the final liquidating distribution;
 the liquidating distributions must be in complete cancellation or redemption of all subsidiary stock; and
 the liquidating distributions must occur within one taxable year or by the end of the third taxable year that
follows the taxable year in which the first liquidating distribution occurs

Note that the 80-80 test offers a relatively easy way for a corporation to purposefully fail the requirements of §332 if
desired. This might be the case if the corporate parent’s stock basis in a subsidiary exceeds the stock’s FMV and the
parent would prefer to recognize the loss under §331 rather than have non-recognition and disappearance under
§332. Note that the attribution rules do not apply to §332, so the parent could even sell the shares to a related party.
Conversely, a parent that wants to trigger §332 can qualify by purchasing sufficient shares in the sub before the plan
of liquidation is adopted. See Rev. Rul. 75-521.

Suppose that a corporation owns somewhat less than 80% of another corporation and wants to qualify under §332:

Rev. Rul. 75-521  transaction qualifies for §332 treatment if the parent owning somewhat less than 80% of the
sub purchases stock in the sub from other shareholders of the sub to increase its ownership above 80%; a mere sale
of stock between shareholders does not constitute an adoption of a plan of liquidation

Rev. Rul. 70-106  transaction does not qualify for §332 treatment if the parent owning somewhat less than 80%
of the sub causes the sub to redeem the minority shareholders’ interest before “adopting a liquidation plan”; the
liquidation fails to meet the 80% ownership requirement because the plan of liquidation is adopted at the time the
parent (owning somewhat less than 80% of the sub) causes the sub to redeem the sub’s shares held by minority
shareholders

George L. Riggs, Inc. v. C.I.R., 64 T.C. 474 (1975)  parent can argue that where redemption of minority
shareholders occurs before a “formal” plan of liquidation is adopted the redemption is not part of the liquidation
(contrast with Rev. Rul. 70-106)

b. Treatment of the Subsidiary

§337. Nonrecognition for property distributed to parent in complete liquidation of subsidiary.

(a)  In general. No gain or loss shall be recognized to the liquidating corporation on the distribution to the 80%
distributee of any property in a complete liquidation to which §332 applies.
(b)  Treatment of indebtedness of subsidiary, etc.
(1)  Indebtedness of subsidiary to parent. If--
(A)  a corporation is liquidated in a liquidation to which §332 applies, and
(B)  on the date of the adoption of the plan of liquidation, such corporation was indebted to the 80%
distributee, for purposes of this section and §336, any transfer of property to the 80% distributee in
satisfaction of such indebtedness shall be treated as a distribution to such distributee in such liquidation.
(c)  80% Distributee. For purposes of this section, the term "80% distributee" means only the corporation which
meets the 80% stock ownership requirements specified in §332(b). For purposes of this section, the determination
of whether any corporation is an 80% distributee shall be made without regard to any consolidated return regulation.

§337  generally provides that the subsidiary recognizes no gain or loss on a distribution to the parent (i.e. the
corporate shareholder meeting the ownership test of §332(b)(1)).

The combination of §337, §332, and §334(b)(1) means that the unrealized gain or loss in the subsidiary assets will
be preserved when the assets are received by the parent.

e.g. Suppose Y Corp is wholly owned by X Corp. Y Corp’s basis in X Corp stock is $7,000. Y Corp owns assets
with AB = $10,000 and FMV = $16,000. If Y Corp is liquidated, neither Y Corp nor X Corp recognize gain, and X
Corp accedes to the Y Corp assets and takes AB = $10,000.
Note that if the parent is tax-exempt, non-recognition under §337 could be the equivalent of a permanent exclusion
from taxation. §337(b)(2)(A) thus provides an exception to the general rule of non-recognition for the subsidiary
upon liquidation to the parent when the parent is tax-exempt. However, non-recognition will still apply to the
subsidiary upon liquidation to the tax-exempt parent if the property distributed by the subsidiary will be used by the
parent in an unrelated trade or business.

If the parent is a foreign corporation beyond the reach of the U.S. tax system, non-recognition upon liquidation of
the subsidiary does not apply. If the parent is a U.S. corporation and the subsidiary is foreign, the U.S. parent is
subject to tax on the foreign subsidiary’s earnings and profits. [Note that the liquidation of a foreign subsidiary by a
U.S. parent cannot be used to import the aggregate built-in losses (if any) on a foreign subsidiary’s assets because
the U.S. parent would take an FMV value as the basis in such built-in loss property under §334(b)(1)(B).]

If a liquidating subsidiary is owned by both a parent and minority shareholders, the tax consequences will be
determined under both §337 and §336.

e.g. Suppose Y Corp’s sole class of stock is 80% owned by X Corp and 20% owned by individual B. Y Corp owns
some assets with built-in gains and some assets with built-in losses. If Y Corp liquidates, it will not recognize gain
or loss on the distribution to X Corp under §337. §336 will govern the portion of the liquidating distribution made
to B. Y Corp will recognize gain on the built-in gain property distributed to B under §336, but Y Corp will not
recognize loss on the built-in loss property distributed to B due to §336(d)(3).

Normally when a taxpayer transfers appreciated property in satisfaction of a debt, gain or loss is recognized.
However, where the transfer occurs in connection with a subsidiary liquidation and the parent is the creditor, it is
difficult to tell if the appreciated property is transferred to extinguish the debt or pursuant to the liquidation.

§337(b)(1)  provides for the subsidiary’s non-recognition of gain or loss on its transfer of property to extinguish a
debt in connection with the liquidation (i.e. treated as if the property transfer is pursuant to the liquidation). The
parent takes the subsidiary’s basis in the transferred asset under §337(b)(2).

What if the subsidiary is insolvent at the time of liquidation (i.e. liabilities of subsidiary exceed subsidiary’s assets)?

Regs. §1.332-2(b)  if the subsidiary is insolvent at the time of liquidation, §332 and §337 do not apply.
Therefore, the transaction is fully taxable to both parent and subsidiary, but the parent is generally entitled to a
“worthless security” deduction. See Rev. Rul. 2003-125

Rev. Rul. 2003-125 When an election is made to change the classification of an entity from a corporation to a
disregarded entity, the shareholder of such entity is allowed a worthless security deduction under §165(g)(3) if the
FMV of the assets of the entity, including intangible assets such as goodwill and going concern value, does not
exceed the entity's liabilities such that on the deemed liquidation of the entity the shareholder receives no payment
on its stock.

Can the parent contribute assets immediately prior to the liquidation of the subsidiary so that the subsidiary is no
longer insolvent and the transaction is then tax-free?

The step-transaction doctrine will look through the infusion of assets and the subsidiary will still be treated as
insolvent. See Rev. Rul. 68-602.

c. Carryover of Tax Attributes

§381  In a parent-sub liquidation, the parent takes, in addition to the subsidiary’s basis in the subsidiary’s assets,
the subsidiary’s tax-attributes (e.g. NOLs, the E&P account, etc.). §269 and §382 are designed to make sure §381
transactions have legitimate, non-tax reasons.

ADL Ch. 9 Taxable Acquisitions

p. 227-229 has a great overview of the different ways a purchaser can acquire a subsidiary’s stock or assets and the
tax treatments of each

§1060  governs acquirer’s basis in (subsidiary) corporation’s assets if acquirer simply purchases the assets directly
from the (subsidiary) corporation

§338 election  may be made if acquirer is a corporation and acquires stock via a “qualified stock purchase”

Tax costs may be deferred in their entirety if the transaction is structured as a nontaxable reorganization

Why an acquisition may not be structured as a nontaxable reorganization:

 The stringent requirements to make the transaction nontaxable may not be able to be met
 Taxable transaction may be cheaper than a nontaxable one (e.g. if able to recognize losses)

ADL 9.01 Asset Purchases

e.g. Suppose S wholly owns X Corp. S has AB in X Corp stock of $200,000. X has $105,000 in cash and an asset
with AB = $150,000 and FMV = $450,000 (built-in gain = $300,000). Assume X Corp is at 35% tax bracket and S
is at 20% tax bracket. B wants X Corp’s stock or assets.

Suppose B buys X Corp’s non-cash assets. X Corp recognized a $300,000 gain and tax a $105,000 tax liability. X
Corp can pay this with its available cash. When X Corp liquidates, S is taxed on a $250,000 gain ($450,000 amount
realized - $200,000 AB) under §331 and §1001. S has a $50,000 tax liability and nets $400,00. Under §1012, B
takes a cost basis of $450,000 in the assets purchased from X Corp (the same result would occur if X Corp was to
merge into B Corp with B Corp receiving cash). The same results obtain if X Corp liquidates and then sells (instead
of selling then liquidating).

§1060  requires a specific method of allocation of purchase price to specific assets (to be followed by both the
seller and buyer) for any “applicable asset acquisition”

“Applicable asset acquisition”  any transfer (direct or indirect) of assets that constitute a trade or business and
with respect to which the transferee’s basis in the purchased assets is determined wholly by the consideration paid
for the assets (i.e. cost basis)

Regs. §1.1060-1(b)(2)(i)(B)  assets constitute a trade or business if, among other things, goodwill or going
concern value could attach to the assets under any circumstances

Under §1060, the purchase price is allocated among the transferred assets using a residual, sever-tiered allocation
method (See Regs. §1.338-6 by way of Regs. §1.1060-1)

 For the first six classes, consideration is reduced by the value of assets in each class; if there is any residual
after the first six classes, that amount is allocated to the seventh class

Some of the allocation disputes under §1090 may be lessened by the enactment of §197

§197  generally requires 15 year, straight-line amortization for all purchased intangibles

ADL 9.02 Stock Purchases

Stock purchase vs. Asset purchase 

 Advantage: may avoid corporate level tax

  Disadvantage: selling corporation retains its historic asset bases

e.g. Suppose S wholly owns X Corp. S has AB in X Corp stock of $200,000. X has $105,000 in cash and an asset
with AB = $150,000 and FMV = $450,000 (built-in gain = $300,000). Assume X Corp is at 35% tax bracket and S
is at 20% tax bracket. B wants X Corp’s stock or assets.

Suppose B buys X Corp stock from S for $450,000 [B would only pay $450,000 rather than $555,000 if B
anticipates that X Corp will either sell its assets or liquidate]. On the sale, S recognizes a $250,000 gain ($450,000
amount realized – $200,000 AB) and pays $50,000 in tax, netting $400,000 in cash. Note that B has acquired X
Corp’s stock without having to pay tax, but also notice that that B has acquired (indirectly through X Corp) assets
(other than the cash) with a basis of $150,000 and a $300,000 built-in gain.

Rev. Rul 90-95  if a purchaser forms a corporation to merge into the corporation whose shares he is interested in
acquiring, for tax purposes the transaction is treated the same as if the purchaser directly purchased the corporation’s
shares.

Note that B may take steps to step up the basis of X Corp’s assets (to $450,000 or FMV) after the transaction. (e.g.
if B is an individual, B can liquidate X Corp, upon where X Corp will recognize a gain of $300,000 and have a
$105,000 tax liability, which it can pay with the $105,000 in cash it has; B will recognize no gain on the transaction
due to §331 and §1001 because B’s basis in the X Corp stock is $450,000, equal to the FMV of the distributed assets
under §334.)

Obtaining a higher basis may benefit B because then he can take larger depreciation deductions going forward or
have a smaller gain or larger loss if the assets are later sold. However, B must have X Corp realize gain or loss to
step up the asset basis. If X Corp has NOLs or built-in losses, B may want to pursue this course of action.

Rev. Rul. 73-427  the transitory existence of a new subsidiary corporation, and the transfer to it of parent stock,
will be disregarded where such subsidiary is organized by the parent corporation to participate in a statutory
merger merely as a conduit to enable parent to acquire stock of another corporation (target). Apply the step
transaction doctrine  the entire transaction is treated as a direct acquisition by the parent of target corporation’s
stock from the target shareholders in exchange for stock of the parent (no gain or loss is recognized to the parent;
gain or loss is recognized to the target corporation’s shareholders)

Rev. Rul. 67-448  a transaction which is stepped together (like that described in Rev. Rul. 73-427) is treated as
direct acquisition by the parent of the target corporation’s stock in exchange for stock of the parent but also
qualifies for §368 reorganization treatment if the continuity-of-interest test of §368(a) is met. See Regs. §1.368-
1(b).

Rev. Rul. 79-273  A statutory merger in which shareholders of a parent corporation receive cash from an
acquiring corporation and also receive stock in a subsidiary corporation of parent corporation represents a sale by
the shareholders of part of their parent corporation stock to the acquiring corporation and a redemption of the
remainder of the parent corporation stock (under §302(b)(3)). Gain or loss is recognized to the parent
corporation’s shareholders on the sale and redemption. The parent corporation does not recognize gain
under §311(d)(1) due to the application of §311(d)(2)(B).

What distinguishes Rev. Rul. 73-427 from Rev. Rul. 67-448?

ADL 9.03 §338 Elections

§338. Certain stock purchases treated as asset acquisitions.

(a)  General rule. For purposes of this subtitle, if a purchasing corporation makes an election under this section (or is
treated under subsection (e) as having made such an election), then, in the case of any qualified stock purchase, the
target corporation--
(1)  shall be treated as having sold all of its assets at the close of the acquisition date at fair market value in a
single transaction, and
(2)  shall be treated as a new corporation which purchased all of the assets referred to in paragraph (1) as of
the beginning of the day after the acquisition date.
(b)  Basis of assets after deemed purchase.
(1)  In general. For purposes of subsection (a), the assets of the target corporation shall be treated as purchased
for an amount equal to the sum of --
(A)  the grossed-up basis of the purchasing corporation's recently purchased stock, and
(B)  the basis of the purchasing corporation's nonrecently purchased stock.
(2)  Adjustment for liabilities and other relevant items. The amount described in paragraph (1) shall be
adjusted under regulations prescribed by the Secretary for liabilities of the target corporation and other
relevant items.
(3)  Election to step-up the basis of certain target stock.
(A)  In general. Under regulations prescribed by the Secretary, the basis of the purchasing corporation's
nonrecently purchased stock shall be the basis amount determined under subparagraph (B) of this
paragraph if the purchasing corporation makes an election to recognize gain as if such stock were sold
on the acquisition date for an amount equal to the basis amount determined under subparagraph (B).
(B)  Determination of basis amount. For purposes of subparagraph (A), the basis amount determined
under this subparagraph shall be an amount equal to the grossed-up basis determined under
subparagraph (A) of paragraph (1) multiplied by a fraction--
(i)  the numerator of which is the percentage of stock (by value) in the target corporation
attributable to the purchasing corporation's nonrecently purchased stock, and
(ii)  the denominator of which is 100% minus the percentage referred to in clause (i).
(4)  Grossed-up basis. For purposes of paragraph (1), the grossed-up basis shall be an amount equal to the
basis of the corporation's recently purchased stock, multiplied by a fraction--
(A)  the numerator of which is 100%, minus the percentage of stock (by value) in the target corporation
attributable to the purchasing corporation's nonrecently purchased stock, and
(B)  the denominator of which is the percentage of stock (by value) in the target corporation attributable
to the purchasing corporation's recently purchased stock.
(5)  Allocation among assets. The amount determined under paragraphs (1) and (2) shall be allocated among
the assets of the target corporation under regulations prescribed by the Secretary.
(6)  Definitions of recently purchased stock and nonrecently purchased stock. For purposes of this subsection--
(A)  Recently purchased stock. The term "recently purchased stock" means any stock in the target
corporation which is held by the purchasing corporation on the acquisition date and which was
purchased by such corporation during the 12-month acquisition period.
(B)  Nonrecently purchased stock. The term "nonrecently purchased stock" means any stock in the target
corporation which is held by the purchasing corporation on the acquisition date and which is not recently
purchased stock.
(d)  Purchasing corporation; target corporation; qualified stock purchase. For purposes of this section--
(1)  Purchasing corporation. The term "purchasing corporation" means any corporation which makes a
qualified stock purchase of stock of another corporation.
(2)  Target corporation. The term "target corporation" means any corporation the stock of which is acquired by
another corporation in a qualified stock purchase.
(3)  Qualified stock purchase. The term "qualified stock purchase" means any transaction or series of
transactions in which stock (meeting the requirements of §1504(a)(2)) of 1 corporation is acquired by another
corporation by purchase during the 12-month acquisition period.
(e)  Deemed election where purchasing corporation acquires asset of target corporation.
(1)  In general. A purchasing corporation shall be treated as having made an election under this section with
respect to any target corporation if, at any time during the consistency period, it acquires any asset of the
target corporation (or a target affiliate).
(2)  Exceptions. Paragraph (1) shall not apply with respect to any acquisition by the purchasing corporation
if--
 (A)  such acquisition is pursuant to a sale by the target corporation (or the target affiliate) in the ordinary
course of its trade or business,
(B)  the basis of the property acquired is determined wholly by reference to the adjusted basis of such
property in the hands of the person from whom acquired,
(C)  such acquisition was before September 1, 1982, or
(D)  such acquisition is described in regulations prescribed by the Secretary and meets such conditions
as such regulations may provide.
(3)  Anti-avoidance rule. Whenever necessary to carry out the purpose of this subsection and subsection (f),
the Secretary may treat stock acquisitions which are pursuant to a plan and which meet the requirements of
§1504(a)(2) as qualified stock purchases.
(f)  Consistency required for all stock acquisitions from same affiliated group. If a purchasing corporation makes
qualified stock purchases with respect to the target corporation and 1 or more target affiliates during any consistency
period, then (except as otherwise provided in subsection (e))--
(1)  any election under this section with respect to the first such purchase shall apply to each other such
purchase, and
(2)  no election may be made under this section with respect to the second or subsequent such purchase if such
an election was not made with respect to the first such purchase.
(g)  Election.
(1)  When made. Except as otherwise provided in regulations, an election under this section shall be made not
later than the 15th day of the 9th month beginning after the month in which the acquisition date occurs.
(2)  Manner. An election by the purchasing corporation under this section shall be made in such manner as the
Secretary shall by regulations prescribe.
(3)  Election irrevocable. An election by a purchasing corporation under this section, once made, shall be
irrevocable.
(h)  Definitions and special rules. For purposes of this section
(1)  12-month acquisition period. The term "12-month acquisition period" means the 12-month period
beginning with the date of the first acquisition by purchase of stock included in a qualified stock purchase (or,
if any of such stock was acquired in an acquisition which is a purchase by reason of subparagraph (C) of
paragraph (3), the date on which the acquiring corporation is first considered under §318(a) (other than
paragraph (4) thereof) as owning stock owned by the corporation from which such acquisition was made).
(2)  Acquisition date. The term "acquisition date" means, with respect to any corporation, the first day on
which there is a qualified stock purchase with respect to the stock of such corporation.
(3)  Purchase.
(A)  In general. The term "purchase" means any acquisition of stock, but only if--
(i)  the basis of the stock in the hands of the purchasing corporation is not determined (I) in whole
or in part by reference to the adjusted basis of such stock in the hands of the person from whom
acquired, or (II) under §1014(a) (relating to property acquired from a decedent),
(ii)  the stock is not acquired in an exchange to which §§351, 354, 355, or 356 applies and is not
acquired in any other transaction described in regulations in which the transferor does not
recognize the entire amount of the gain or loss realized on the transaction, and
(iii)  the stock is not acquired from a person the ownership of whose stock would, under §318(a)
(other than paragraph (4) thereof), be attributed to the person acquiring such stock.
(B)  Deemed purchase under subsection (a). The term "purchase" includes any deemed purchase under
subsection (a)(2). The acquisition date for a corporation which is deemed purchased under subsection (a)
(2) shall be determined under regulations prescribed by the Secretary.
(C)  Certain stock acquisitions from related corporations.
(i)  In general. Clause (iii) of subparagraph (A) shall not apply to an acquisition of stock from a
related corporation if at least 50% in value of the stock of such related corporation was acquired
by purchase (within the meaning of subparagraphs (A) and (B)).
(ii)  Certain distributions. Clause (i) of subparagraph (A) shall not apply to an acquisition of stock
described in clause (i) of this subparagraph if the corporation acquiring such stock--
(I)  made a qualified stock purchase of stock of the related corporation, and
(II)  made an election under this section (or is treated under subsection (e) as having made
such an election) with respect to such qualified stock purchase.
 (iii)  Related corporation defined. For purposes of this subparagraph, a corporation is a related
corporation if stock owned by such corporation is treated (under §318(a) other than paragraph (4)
thereof) as owned by the corporation acquiring the stock.
(4)  Consistency period.
(A)  In general. Except as provided in subparagraph (B), the term "consistency period" means the period
consisting of--
(i)  the 1-year period before the beginning of the 12-month acquisition period for the target
corporation,
(ii)  such acquisition period (up to and including the acquisition date), and
(iii)  the 1-year period beginning on the day after the acquisition date.
(B)  Extension where there is plan. The period referred to in subparagraph (A) shall also include any
period during which the Secretary determines that there was in effect a plan to make a qualified stock
purchase plus 1 or more other qualified stock purchases (or asset acquisitions described in subsection
(e)) with respect to the target corporation or any target affiliate.
(5)  Affiliated group. The term "affiliated group" has the meaning given to such term by §1504(a) (determined
without regard to the exceptions contained in §1504(b)).
(6)  Target affiliate.
(A)  In general. A corporation shall be treated as a target affiliate of the target corporation if each of
such corporations was, at any time during so much of the consistency period as ends on the acquisition
date of the target corporation, a member of an affiliated group which had the same common parent.
(8)  Acquisitions by affiliated group treated as made by 1 corporation. Except as provided in regulations
prescribed by the Secretary, stock and asset acquisitions made by members of the same affiliated group shall
be treated as made by 1 corporation.
(9)  Target not treated as member of affiliated group. Except as otherwise provided in paragraph (10) or in
regulations prescribed under this paragraph, the target corporation shall not be treated as a member of an
affiliated group with respect to the sale described in subsection (a)(1).
(10)  Elective recognition of gain or loss by target corporation, together with non-recognition of gain or
loss on stock sold by selling consolidated group.
(A)  In general. Under regulations prescribed by the Secretary, an election may be made under which if--
(i)  the target corporation was, before the transaction, a member of the selling consolidated group,
and
(ii)  the target corporation recognizes gain or loss with respect to the transaction as if it sold all of
its assets in a single transaction, then the target corporation shall be treated as a member of the
selling consolidated group with respect to such sale, and (to the extent provided in regulations) no
gain or loss will be recognized on stock sold or exchanged in the transaction by members of
the selling consolidated group.
(B)  Selling consolidated group. For purposes of subparagraph (A), the term "selling consolidated
group" means any group of corporations which (for the taxable period which includes the transaction)--
(i)  includes the target corporation, and
(ii)  files a consolidated return. To the extent provided in regulations, such term also includes any
affiliated group of corporations which includes the target corporation (whether or not such group
files a consolidated return).
(C)  Information required to be furnished to the Secretary. Under regulations, where an election is made
under subparagraph (A), the purchasing corporation and the common parent of the selling consolidated
group shall, at such times and in such manner as may be provided in regulations, furnish to the Secretary
the following information:
(i)  The amount allocated under subsection (b)(5) to goodwill or going concern value.
(ii)  Any modification of the amount described in clause (i).
(iii)  Any other information as the Secretary deems necessary to carry out the provisions of this
paragraph.
(11)  Elective formula for determining fair market value. For purposes of subsection (a)(1), fair market value
may be determined on the basis of a formula provided in regulations prescribed by the Secretary which takes
into account liabilities and other relevant items.
(13)  Tax on deemed sale not taken into account for estimated tax purposes. For purposes of §6655, tax
attributable to the sale described in subsection (a)(1) shall not be taken into account. The preceding sentence
shall not apply with respect to a qualified stock purchase for which an election is made under paragraph (10).
 (15)  Combined deemed sale return. Under regulations prescribed by the Secretary, a combined deemed sale
return may be filed by all target corporations acquired by a purchasing corporation on the same acquisition
date if such target corporations were members of the same selling consolidated group (as defined in
subparagraph (B) of paragraph (10)).

a. Overview

If B purchases X Corp stock from S and retains the stock, the tax consequences are the same whether B is an
individual or a corporation (X Corp recognizes no gain; B takes cost basis in X Corp stock).

However, if B then liquidates X Corp, treatment is different depending on if B is an individual or corporation.

 If B is an individual  X Corp recognizes gain and B takes stepped-up bases in X Corp’s assets (see §331,
§336)
 If B is a corporation  X Corp recognizes no gain and B inherits X Corp’s historic bases in its assets rather
than stepping them up (See §337, §332, §334(b)).

§338  provides a way for B Corp to obtain stepped-up bases in X Corp’s assets by purchasing S’s X Corp. stock

§338  allows B Corp to make an election that allows X Corp to take stepped-up bases in its assets, but at the cost
of X Corp recognizing gain inherent in its assets and incurring a tax on the gain. (Thus, from tax standpoint, B Corp
is likely indifferent whether it purchases X Corp’s stock or X Corp’s assets.)

A corporation may make a §338 election for its acquisition of target corporation stock if, within a 12-month period,
it purchases an affiliate interest in that stock (meaning it satisfies the 80-80 test; see §1504(a)(2)).

“Regular” §338 election  affects the target corporation but not the target corporation’s shareholders (target
shareholders simply recognize gain or loss on their stock sale under §1001, just as if no election was made)

§338(h)(10) election  in limited circumstances, §338(h)(10) applies; treats selling target corporation shareholders
as receiving their consideration in liquidation of the target corporation (thus, if the purchasing corporation acquires
the target stock from one corporate shareholder, with a §338(h)(10) election, the shareholder recognizes no gain or
loss on its receipt of the sales proceeds per §332).

Treatment of the target corporation under either §338 or §338(h)(10):

1. Target corporation is deemed to make a taxable sale of its assets

2. Target, treated as a newly formed subsidiary of the purchasing corporation, is deemed to purchase
those assets

In other words, the target corporation is deemed to sell the assets to itself, thereby triggering gain or loss

Under §338, a purchasing corporation secures a cost basis in the target corporation’s assets without having to
liquidate the target; if the purchaser then liquidates the target, §337, §332, and §334 apply to the liquidation, and the
purchaser inherits the target corporation’s asset bases (which were stepped up due to the deemed sale)

Note that §338 cannot apply if an individual purchases the target stock

It often makes sense to make a §338(h)(10) election [the regular §338 election has lost some of its importance since
the repeal of the General Utilities doctrine]. Typically, however, if a §338(h)(10) election cannot be made, it is
better to forego a regular §338 election.
e.g. Suppose S Corp owns all of X Corp stock and has a $150,000 basis in the X Corp stock; X Corp has a $150,000
basis in its assets

 No §338 election  if B Corp buys the X Corp stock from S Corp for $450,000, S Corp recognizes a
$300,000 gain and X Corp recognizes no gain or loss and retains its $150,000 asset basis
 §338(h)(10) election  S Corp recognizes none of its realized gain, X Corp recognizes $300,000 gain and
takes a $450,000 asset basis
 Regular §338 election  X Corp gets a stepped up basis in its assets only if it recognizes its $300,000 gain
and S Corp also recognizes a $300,000 gain on B’s sale of X Corp stock.

Note that in the example above, the corporate level gain recognized is the same ($300,000) but the §338(h)(10)
election allows for the benefit of a step up in basis. Generally, the regular §338 election is not worth it even though
it results in a stepped up basis because it requires recognizing an additional level of taxation.

In some circumstances, though, the regular §338 election may still make sense (e.g. when X Corp has an NOL,
when X Corp has an aggregate built-in loss in its assets, or when B Corp purchases a foreign corporation with
appreciated assets)

b. Qualified Stock Purchases

§338(d)(3)  To make a §338 election, the purchasing corporation must acquire an affiliated interest in the target
corporation by purchase over a 12-month period (this purchase is called a qualified stock purchase or QSP)

§338(h)(3)  “purchase” generally includes all acquisitions except those in which the purchasing corporation
carries over the transferor’s basis or acquires the target stock in an reorganization or makes an acquisition from a
related party

e.g. acquisitions by gift or in a §351 transaction do not qualify

c. Election

§338(g)(1)  either the regular §338 election or the §338(h)(10) may be made any time before the 15th day of the 9th
month following the month that includes the acquisition date (the first date on which the affiliated interest is first
acquired)

§338(g)(3)  both the regular §338 election or the §338(h)(10) election, once made, is irrevocable

Regular §338 election  made exclusively by the purchasing corporation

§338(h)(10) election  must be made jointly by the purchasing corporation and the target’s shareholders

§338(h)(10) election can only be made if the purchasing corporation acquires stock from:

 a consolidated group that includes the target corporation on the acquisition date as a subsidiary
 a domestic corporation that owns an affiliated interest in the target corporation on the acquisition date; or
 S Corp shareholders (but the target corporation must have been an S Corp immediately before the
acquisition date)

d. Consequences to the Target

i. In General
Regular §338 election  any gain or loss recognized by the target corporation on its deemed asset sale cannot be
offset by losses or gains of affiliates in either the selling or purchasing groups

§338(h)(10) election  if the election is made for a target that was a subsidiary of a selling consolidated group, the
target’s gain or loss from the deemed sale can be offset by (or offset) other group members’ losses or gains

ii. Computing the Target’s Aggregate Gain or Loss on its Deemed Asset Sale

In either kind of election  the target corporation is deemed to sell its assets at the close of the acquisition date,
recognizing gain or loss; a new subsidiary of the purchasing corporation is deemed to purchase those assets at the
beginning of the next day

Aggregate Deemed Sales Price (ADSP)  what the target’s assets are deemed sold for in the aggregate:

 Amount paid by the purchasing corporation for the target’s stock in the QSP, plus
 Amount of target’s liabilities

Gross-up  If the purchasing corporation purchases less than 100% of the target stock (but still the required
affiliated interest), the amount paid for the stock is proportionately increased to reflect what the payment would have
been if all of the target stock had been purchased; this grossed-up ADSP is what is used to determine gain or loss
(not the actual price paid for the less than 100% stake in the target)

e.g. if only 80% of the stock is purchased, divide the purchase price plus amount of target liabilities by 80% to
obtain the ADSP

iii. Computing the Target’s Aggregate Asset Basis after the Deemed Asset Sale

§338(a)(2) and §338(b) deal with situations in which the purchasing corporation may not purchase all of the target’s
stock (but will still be deemed to have purchased all of target’s assets) and when the purchasing corporation holds
“non-recently purchased stock” (i.e. all of the target’s stock held by the purchaser on the acquisition date that was
not acquired in the QSP)

Adjusted Grossed-up Basis (AGUB)  equals the aggregate basis of the target’s assets immediately following the
deemed purchase:

 Purchasing corporation’s basis in recently purchased stock of the target, plus

 Purchasing corporation’s basis in non-recently purchased stock of the target, plus
 Target corporation’s liabilities

Just like with ADSP, AGUP is “grossed up” if the purchaser does not acquire 100% of the target’s stock

If there is non-recently purchased stock, it must be excluded from the gross-up calculation.

If there is a built-in gain in the non-recently purchased stock, the AGUB of the recently purchased stock will be
lower by that amount; however, the purchaser can elect to step the basis of the AGUB by recognizing the built-in
gain on the non-recently purchased stock.

Note that losses are not recognized if a gain recognition election is made for non-recently purchased stock

Note that if a §338(h)(10) election is made, a gain recognition election is deemed made for any non-recently
purchased stock
e.g. Suppose that B Corp acquires 80% of X Corp stock for $360,000 during the acquisition period and that B Corp
held an additional 8% of the X Corp stock (acquired before the acquisition period began) with a $20,000 basis and a
$36,000 FMV on the acquisition date (for a built-in gain of $16,000); the remaining 12% of X Corp is held by
unrelated parties; if B Corp makes a regular §338 election, X Corp’s basis in its assets will be $450,000 - $16,000
built-in gain of non-recently purchased stock = $434,000

B Corp’s grossed-up basis = $360,000 (the basis in the recently purchased X Corp stock) * 92% (all X Corp stock –
non-recently acquired X Corp stock) / 80% (the percentage of X Corp stock that is recently purchased stock) =
$414,000

B Corp’s AGUB = $414,000 (B Corp’s grossed-up basis) + $20,000 (B Corp’s basis in its non-recently acquired X
Corp stock) + $105,000 (X Corp’s liabilities) = $539,000  of this amount, reduce by the amount of liabilities,
leaving $434,000 to be allocated to X Corp’s non-cash assets (which B now owns)

iv. Adjustments for Liabilities

Both ADSP and AGUB take into account both stated and unstated liabilities, including the tax on the deemed sale if
borne by the target; a buyer should take into account this tax liability that will arise on the deemed asset sale when
pricing the target stock, treating it like any other liability

e.g. suppose X Corp has assets with $450,000 FMV but the assets are subject to a $100,000 liability; B Corp
purchases all of X Corp’s stock for $350,000; if B Corp makes a regular §338 election, X Corp still recognizes a
$300,000 gain and takes a $450,000 basis in the non-cash assets

If we assume that X Corp pays tax at a 35% rate and will bear tax liability on the sale, ADSP will be $555,000,
which is the amount realized ($350,000) plus the liability of $100,000 plus the tax liability of $105,000 (35% of
$300,000 gain); the ADSP is first allocated to X Corp’s cash of $105,000, leaving $450,000 to be allocated to X
Corp’s non-cash asset (so those assets are deemed sold for $450,000, producing a $300,000 gain if the AB =
$150,000 and a $105,000 tax liability

The AGUB will also $555,000, because it is found by adding $350,000 (B Corp’s basis in the X Corp stock) plus
liabilities of $100,000 plus tax liability on the deemed sale of $105,000; that amount is first allocated to X Corp’s
cash of $105,000 which leaves $450,000 to be allocated to X Corp’s non-cash asset

v. Contingent Liabilities

The ADSP may not equal the AGUB if there are contingent liabilities that are taken into account in determining gain
but cannot be immediately reflected in the purchaser’s basis

vi. Allocating of the ADSP and AGUB among Target Assets

If X Corp holds more than one non-cash asset (including intangible assets), the allocation of amount realized and
basis on a §338 sale are allocated according the seven-tier method used in §1060 asset sales

Note that there are special rules to allocate the AGUB if the purchasing corporation holds appreciated non-recently
purchased target stock but does not make a gain recognition election

e. Consequences to the Purchasing Corporation and Target Shareholders

For a regular §338 election, a purchasing corporation generally determines its tax consequences and its basis in the
target stock in the same way as if a §338 has not been made (e.g. See §1012, §358)
However, if a gain recognition is made (or deemed made), the purchasing corporation recognizes gain but not loss
on its non-recently purchased target stock and takes a basis in that stock tied to the average cost of its recently
purchased stock

For a regular §338 election, generally the target shareholder’s tax consequences are simply to recognize gain or loss
on the target stock sold or exchanged in the QSP; further, to the extent that a target shareholder retains his stock,
nothing happens

However, if a §338(h)(10) election is made, special rules apply to target shareholders other than minority
shareholders, where minority shareholders are target shareholders other than members of the selling consolidated
group, the selling affiliate, or S Corp shareholders (for minority shareholders, treatment is the same as under a
regular §338 election)

Under §338(h)(10) elections, non-minority shareholders are not treated as if they sold target stock; instead, they are
treated as if they received proceeds of a deemed asset sale in complete liquidation of the target

 For a member of the selling consolidated group or the selling affiliate, §332 typically applies (so the
shareholder recognizes no gain or loss)
 For an S Corp shareholder, §331 typically applies (so the shareholder recognizes gain or loss, including on
target stock actually retained by the shareholder); note that the shareholder computes that gain or loss after
adjusting his stock basis to account for the target’s gain or loss recognized in its deemed asset sale under
§338

If a non-minority shareholder retains target stock, the shareholder is treated as acquiring that stock for its FMV on
the day after the acquisition date

The tax consequences of a §338(h)(10) election are in relevant respects identical to the direct asset purchase and
liquidation, while the regular §338 election alternative is less favorable

e.g. suppose that Target Corp holds assets with an aggregate AB = $400,000 and FMV = $1.5M. Target Corp is
owned by Parent Corp. Parent Corp has an AB = $200,000 in Target Corp’s shares. Buyer Corp wants to acquire
Target stock or assets but step up the basis of Target Corp’s assets

 No election  Suppose Buyer Corp bought the Target Corp assets from Target Corp for $1.5M. Target
Corp would recognize a $1.1M gain. Buyer Corp would take a cost basis in the acquired assets of $1.5M.
When Target Corp liquidates, neither Target Corp nor Parent Corp would recognize gain or loss, because
Parent Corp owned all of Target Corp’s shares. See §332, §337. Note that there is only one level of tax.
 §338(h)(10) election  Suppose that Parent Corp sells the stock of Target Corp to Buyer Corp for $1.5M.
Target Corp would be deemed to sell its assets for $1.5M, recognizing a $1.1M gain. Target Corp would
take a stepped up basis of $1.5M in its assets. Target Corp would be deemed to liquidate, and on the
deemed liquidation, Parent Corp would recognize no gain or loss. See §332. Note that there is only one
level of tax.
 Regular §338 election  Suppose that Parent Corp sells the stock of Target Corp to Buyer Corp for $1.5M.
Target Corp would be deemed to sell its assets for $1.5M, recognizing a $1.1M gain. Target Corp would
take a stepped up basis of $1.5M in its assets. However, Parent Corp would be treated as selling its stock
(rather than receiving a liquidating distribution from Target Corp) and on that sale Parent Corp would
recognize gain of $1.3 minus whatever tax liability that it assumed arising from Target Corp’s deemed asset
sale. Note that there are two levels of tax.

f. Consistency Requirements and Deemed Elections

§338(e), (f)  if a §338 election is made, it applies not only to the target corporation but also to any “target
affiliates” whose stock is purchased during the “consistency period”

Consistency period  the period that spans one year before the acquisition period begins, the one year acquisition
period (up to the acquisition date), and the one year period after the acquisition date

If a purchasing corporation makes a §338 election with respect to a QSP of a target corporation, §338(f) deems a
§338 election to be made for any QSP of a target affiliate within the consistency period, but the regulations
interpreting this statute all but eliminate this deemed election.

If a purchasing corporation does not make a §338 election, §338(e) deems one to have been made if during the
consistency period it acquires any assets of the target or a target affiliate, but the regulations interpreting this statute
again take a different approach. The regulations no longer permit the Service to impose a deemed §338
election. However, the regulations sometimes require the purchasing corporation or its affiliate to take a carryover
basis in assets acquired from that target or the target’s affiliate. The rule adopted by the regulations is favorable to
the purchasing corporation in that it is not forced to make an unwanted §338 election.

e.g. Suppose that Target Corp holds two assets: asset 1 has AB = $50,000 and FMV = $200,000; asset 2 has AB =
$150,000 and FMV = $400,000. Target Corp is owned by Shareholder Corp, which has AB = $350,000 in Target
Corp’s stock. Buyer Corp wants to acquire the Target Corp stock and to step up the basis of asset 2 but not asset 1.

Suppose that Buyer Corp purchases asset 2 directly from Target Corp, which reinvests the sales proceeds.
Sometime later, during the consistency period, Buyer Corp buys the Target Corp stock from Shareholder Corp for
$600,000. Under Regs. §1.338-8(d), if Shareholder Corp and Target had filed joint consolidated returns, Buyer
Corp takes a $150,000 carryover basis in asset 2.

On the asset 2 sale, Target Corp recognizes a gain of $250,000. Because Target Corp and Shareholder Corp filed a
joint consolidated return, Shareholder Corp increases its basis in Target Corp stock by $250,000 to $600,000. Thus,
on the sale of the Target Corp stock to Buyer Corp, Shareholder Corp realizes no gain or loss.

If the consistency rules did not apply to Buyer Corp’s purchase of asset 2, Buyer Corp could then take a stepped-up
basis in asset 2 at no real tax cost to the consolidated group of Target Corp and Shareholder Corp. The consistency
rules prevent such a result by requiring Buyer Corp to take a carryover basis in the purchased asset (asset 2).

g. Qualified Stock Purchases and the Step-Transaction Doctrine

§338 repealed the Kimbell-Diamond doctrine.

§338  If a purchasing corporation makes a QSP of a target corporation and liquidate the target as part of the same
plan, the target is only treated as selling its assets if it makes the §338 election. If the §338 election is not made, the
target is not treated as selling its assets and the purchasing corporation takes a carryover basis in the target assets.
See §334(b).

However, the step-transaction doctrine continues to apply to determine whether the purchasing corporation has made
a QSP.

e.g. Suppose that X Corp has one class of stock outstanding and that B Corp acquires the X Corp stock in exchange
for consideration consisting of 30% cash and 70% B Corp stock. As part of the same plan, B Corp then liquidates X
Corp.
Standing alone, the stock acquisition would be a QSP. However, if the step-transaction doctrine applied, we could
assume that the stock acquisition and liquidation would be characterized as a §368 reorganization, in which case the
stock acquisition would not be a QSP (so §338 election could not be made).

Rev. Rul. 2001-46  the step-transaction doctrine should apply to the case described above to determine whether
the stock acquisition was not a QSP

e.g. Suppose that X Corp has one class of stock outstanding and that B Corp acquires the X Corp stock in exchange
for consideration consisting of 10% cash and 90% B Corp stock. As part of the same plan, B Corp liquidates X
Corp. Assume that, standing alone, the stock acquisition would not be a QSP.

Rev. Rul. 2008-25  the step-transaction should apply to the case described above to determine whether the stock
acquisition was a QSP (however, the step-transaction doctrine was not applied more broadly, so that it was not used
to treat the stock acquisition and liquidation together like an asset purchase; instead, they were treated as separate
steps, with the stock acquisition being taxable and the liquidation being tax-free under §332 and §337).