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CHAPTER 19

CORPORATIONS: DISTRIBUTIONS NOT INCOMPLETE LIQUIDATION

LECTURE NOTES

CORPORATE DISTRIBUTIONSOVERVIEW

1. Distributions by a corporation to its shareholders are presumed to be dividends unless theparties can prove otherwise. Section 316 makes such distributions dividend income to theshareholder to the extent of E & of the distributin! corporation "accumulated since1#13$ or to the extent of E & for the current year.

%. Distributions not taxed as dividends "because of insufficient E & $ are nontaxable to theextent of the shareholders stock basis and will reduce that basis accordin!ly. 'ny excessof the distribution over the shareholders basis usually is a capital !ain.

EARNINGS AND PROFITS (E & P) 31

3. E & ( thou!h similar in concept to )retained earnin!s(* is computed differently. +etainedearnin!s computation is based on financial accountin! rules while E & is determinedusin! tax law. ' few of the differences are as follows.

a. ,apitali-ation of stock dividends does not decrease E & they decrease retainedearnin!s.

b. E & is reduced only by strai!ht/line depreciation unless the corporation uses adepreciation method such as )units of production* or )machine hours.*

c. E & may be affected by !ains and losses from property transactions only to theextent they are reco!ni-ed for tax purposes "e.!.( like/kind exchan!es are notreco!ni-ed for taxable income determination or for E & purposes$.

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0. E & is the factor that fixes the upper limit on the amount of dividend income a share/holder must reco!ni-e. t represents the corporations economic ability to pay a dividendwithout impairin! its capital.

C$%/2,$* $5 E & P

2. 'dditions to taxable income. o compute E & ( taxable income is increased for all tax/exempt income items such as municipal bond interest( excluded life insurance proceeds "inexcess of cash surrender value$( dividends not taxed due to the dividends receiveddeduction( and 4ederal income tax refunds for taxes paid in prior years. axable income isalso increased by the domestic production activity deduction "D'D$. hese deduc/tionsare essentially partial income exclusions.

6. Subtractions from taxable income. axable income is then decreased by nondeductibleexpenses and losses to determine E & . hese nondeductible expenses include relatedparty losses( excess capital losses( 4ederal income taxes paid( fines and penalties( expenses

incurred to produce tax/exempt income( and key employee life insurance premiums "inexcess of increases in cash surrender value$.

5. imin! adustments. Some E & adustments shift a transactions impact from the year itis included in taxable income to the year it has an economic effect on a corporation.Excess capital losses( excess charitable contributions( and 789 carryovers all are this typeof adustment.

:. 'ccountin! method adustments. hese adustments relate to differences in accountin!methods re;uired for E & and taxable income. ncluded in this !roup are adustmentsre;uired for depreciation( < 15# expense( installment sales( 948 recapture( intan!ible

drillin! costs( minin! exploration and development costs( amorti-ation of circulationexpenditures( trademarks( or!ani-ational expenditures( and accountin! for constructioncontracts.

#. 'lternative depreciation system "'DS$ must be used for computin! E & . his systemuses strai!ht/line depreciation over a recovery period e;ual to the 'sset Depreciation+an!e "'D+$ midpoint life. herefore( if accelerated depreciation is used to computetaxable income( an adustment to E & must be made.

a. 7o additional first year depreciation is allowed for E & purposes.

b. 'D+ midpoint lives for most assets are set out in +ev. roc. :5/26( 1#:5/% ,.=.650. he recovery period is 2 years for automobiles and li!ht/duty trucks and 0>years for real property. 'ssets with no class life have 1% year recovery period.

c. ?hen the asset is later sold( the increase or decrease to E & is computed byusin! the adusted basis of the asset for E & purposes. Example 5 in the textdemonstrates this concept.

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d. Section 15# expenses must be deducted over five years. hus( in the year < 15# iselected( :>@ is added back to taxable income to arrive at E & . n each of thefollowin! four years( %>@ of the < 15# expense is subtracted from taxable incometo determine E & .

S/%%2'8 $5 E & P A7/+%*+1>. ,oncept Summary 1#/1 lists the adustments that are made to a corporations taxable

income in arrivin! at E & . Some of the more common adustments are as follows.

a. E & is increased by the amount of any deferred !ain in the year in which acorporation sells property on the installment basis. his is accomplished bytreatin! all principal payments as havin! been received in the year of sale forpurposes of computin! E & .

b. ntan!ible drillin! costs allowable as a deduction under < %63"c$ and mineralexploration and development costs allowable as a deduction under months in the case of intan!ible drillin! costs and 1%> months for mineexploration and development costs$. 'ny unamorti-ed balance is written off whenthe well becomes dry or the mineral property is abandoned.

c. 'mounts amorti-ed under

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C/''* -'+/+ A/%/.27 E & P

11. 'ccumulated E & is the total of all previous years current E & "since 4ebruary %:(1#13$ as computed on the first day of each year( reduced by any distributions made fromE & .

1%. t is important to distin!uish between current and accumulated E & because they areallocated to distributions differently.

A..$2,*; E & P $ D,+',4/,$*+

13. ?hen current and accumulated E & are positive( corporate distributions are first madefrom current and then from accumulated. ?hen distributions exceed current E & ( theallocations of current and accumulated are as follows.

a. ,urrent E & is allocated to distributions on a pro rata basis to eachdistribution "proportionately throu!hout the year$.

b. 'ccumulated E & is allocated to distributions in chronolo!ical order durin! theyear( startin! with the first distribution.

c. ,oncept Summary 1#/% lists the steps in allocatin! E & to distributions.

10. 'llocations when either current or accumulated E & has a deficit.

a. f a deficit exists in accumulated and a positive balance exists in current(the two accounts are not netted. nstead( distributions are taxed as dividends tothe extent of the positive balance in current E & .

b. f a deficit exists in current and a positive balance exists in accumulated(the two accounts are netted as of the date of the distribution. he distribution istreated as a dividend to the extent of a positive net balance. Deficit in current E & is allocated ratably throu!hout the year( unless the parties can show otherwise.

12. f current E & is unknown at the end of the shareholders tax year "e.!.( when thecorporation uses a fiscal year and the shareholder uses a calendar year$( current E & isassumed sufficient to cover all distributions made durin! the year to the shareholder. fcurrent E & is determined to be insufficient to cover distributions after the end of thecorporations year( then the shareholder may file an amended return to claim a refund fortaxes paid.

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a. ndividuals in the 1>@ or 12@ tax rate brackets are subect to a 2@ taxrate on ;ualified dividends paid between %>>3 and %>>5 and a >@ tax rate between%>>: and %>1>.

b. he special tax rates on ;ualified dividends also apply under the alternativeminimum tax.

%>. o ;ualify for the special 2@ or 12@ tax rates( dividends must meet three re;uirements.

a. he dividend must be paid by a ;ualifyin! corporation. ualifyin! corporationsinclude domestic corporations( forei!n corporations whose stock is traded on .S.markets( and corporations located in a country that "1$ has a comprehensiveincome tax treaty with the .S.( "%$ has an information/sharin! a!reement with the.S.( and "3$ is approved by the reasury.

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b. Dividends paid to shareholders who hold both lon! and short positions in the samestock do not ;ualify.

c. he stock must be held for more than 6> days durin! the 1%1/day period be!innin!6> days before the ex/dividend date.

%1. Dividends taxed at 2@ or 12@ rates are not treated as investment income for purposes ofthe investment interest expense limitation. axpayers can( however( elect to treatdividends as investment income. f they do( the dividends will be taxed as ordinary income.

PROPERT DIVIDENDS

%%. 'mount distributed as dividends in the form of property rather than cash are measured bythe fair market value of the property on the date of distribution. his amount is reduced byany liabilities associated with the property that are assumed by the shareholder.

%3. Shareholder&s basis in the distributed property is fair market value on the distribution date.

%0. nder < 311"b$( !ain but not loss is reco!ni-ed to a corporation that distributes propertyas a dividend.

a. Distribution of appreciated property is treated as if the property were sold to theshareholder at its fair market value.

b. 4urther( if the property distributed is subect to a liability( or if the shareholderassumes a liability that exceeds the basis of the distributed property( the fair marketvalue of the property shall not be less than the amount of the liability.

%2. Distributin! corporations E & is reduced by the amount of money distributed or by the

!reater of the fair market value or the adusted basis of the property distributed less theamount of any liability on the property.

a. Distributions cannot !enerate or add to a deficit in E & .

b. 8nly corporate losses !enerate or add to a deficit in E & .

%6. Distributin! corporations E & increases by !ain reco!ni-ed on the appreciated propertydistributed. his !ain flows throu!h the tax return.

CONSTRUCTIVE DIVIDENDS

%5. ,onstructive dividends usually arise in the context of a closely/held corporation. heyneed not be formally declared or issued pro rata.

%:. Examples of constructive dividends areB

a. ersonal use by a shareholder of corporate/owned property "e.!.( company/ownedautomobiles( airplanes( yachts( huntin! lod!es$. he measure of the dividendusually is the fair rental value of the property for the period of its personal use.

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b. ' bar!ain sale of corporate property to the shareholders. he measure of thedividend is the difference between the amount paid for the property and its 4FG.

c. he bar!ain rental of corporate property to its shareholders. he measure of thedividend is the amount of the propertys fair rental value that exceeds the rentactually paid.

d. ayments for the benefit of shareholders

"1$ Satisfaction by the corporation of a shareholders personal obli!ation to athird party.

"%$ 4or!iveness of a shareholder debt to the corporation.

"3$ Excessive rentals paid by a corporation for the use of shareholder property.

e. ,ompensation to shareholderHemployee that is unreasonable.

"1$ here are numerous factors that are considered in determinin! whethercompensation is reasonable. See pa!e 1#/15 in text for a list.

"%$ +easonable investor test is relatively new development in reasonablecompensation.

ADDITIONAL LECTURE RESOURCE

,ourt cases concernin! reasonable compensation in closely held corporations have receivedinconsistent treatment. ?hen decidin! these cases( the courts rely on two different types of tests.he 13 4ederal circuits differ in the use of these tests based in part on earlier precedent in theirrespective urisdictions.

M/.,. F2$' A'$2. he first type of test uses multiple factors to assess thereasonableness of compensation( such as the companys financial condition( its dividend history(and the si-e and complexity of its business. he approach also compares compensation tosimilarly situated employees of comparable companies and considers the employees contributionto corporate profits and the relationship between compensation and level of stock holdin!s. histype of analysis ori!inated in the 6th ,ircuit IMayson Manufacturing Co. v. Comm.,0#/% S,

J#065( 3: '4+ 1>%:( 15: 4.%d 112 ",'/6( 1#0#$K and is followed in the 1>th ,ircuit IEberlsClaim Service v. Comm.( :5 '4+%d %>>1/%>52( %0# 4.3d ##0 ",'/1>( %>>1$K.

I*7*7* I*-+$' A'$2. o examine the reasonableness of compensation to theshareholder/employee( other courts are be!innin! to use a new approach( involvin! a hypotheticalindependent investor. he ;uestion asked by the ud!e is )how much would an independentinvestor be willin! to pay the employee( !iven the profits that are !eneratedL* he 5th ,ircuit,ourt is the principal advocate for this standard. 8ther courts "includin! the %nd( 6th( and #th,ircuit ,ourts$ have started to use a hybrid approach( considerin! both the multiple factors

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su!!ested inMayson Manufacturingand the new independent investor test. n many of the casesadoptin! either a hybrid approach or the independent investor test( opinions have often beencritical of the ax ,ourts use of the multiple factor approach. ' brief summary of a few of thesecases follow.

Alpha Medical, Inc. v. Comm.,##/1 S, J2>(061( :3 '4+%d ##/6#5( 15% 4.3d #0%",'/6( 1###$. ?illiam +o!ers( a pharmacist with a history of successful business venturesin the health care industry( started a medical consultin! corporation with a M1(>>>contribution to capital. 'fter 0 years of success "lar!ely attributable to the pharmacistsefforts$( the corporation had taxable income of almost M5(>>>(>>>. he corporation paid+o!ers M0.0 million as compensation. Durin! audit( the +S determined that M0 million ofthe compensation paid was unreasonable. he ax ,ourt split the difference between the+S and taxpayer( findin! M%.3 million of +o!ers pay to be reasonable. 8n appeal(however( the Sixth ,ourt of 'ppeals ruled that all M0.0 million of the compensation paidto +o!ers was reasonable. n its decision( the ,ourt of 'ppeals said that( )in li!ht of+o!ers record of accomplishment( risks he assumed( and ama-in! !rowth( reasonableshareholders would have !ladly a!reed to +o!ers level of compen/sation.*

Leonard ipeline Contractors v. Comm.( #:/1 S, J2>(326( :1 '4+%d #:/63#( 10%

4.3d 1133 ",'/#( 1##:$. n its decision( the 7inth ,ourt of 'ppeals ud!e critici-ed theax ,ourts failure to explain how it arrived at its reasonable compensation fi!ure "abouthalfway between amounts ar!ued by the +S and the taxpayer$. he appellate court notedthat the ax ,ourt simply enumerated the factors to be considered when determinin!reasonableness of compensation and then leapt to an intermediate fi!ure between the +Sand taxpayer.

E!acto Spring Corp. v. Comm., :0 '4+%d ##/6#55( 1#6 4.3d :%% ",'/5( 1###$.

n this decision( the 5th ,ircuit ,ourt was sharply critical of the ax ,ourts use of the

multiple factor approach in !eneral( sayin! that it led to )arbitrary results. he courtsu!!ested that the sole use of the independent investor approach is )simpler and morepurposive than the multiple factor approach.* nder the test( the court ar!ued( the hi!herthe rate of return that an employee can !enerate throu!h their own efforts( the hi!her thecompensation they should be able to command.

Menard, Inc., :: ,F %%#( .,. Femo. %>>0/%>5. Fenard( nc. is a

home improvement store that is closely held( with most of the stock owned by the ,E8(Fr. Fenard. n 1##:( Fr. Fenard received a M6%(0>> salary( M3 million in compensationfrom a profit sharin! plan( and approximately M15 million as a bonus "set at 2@ of netincome before taxes$. he corporation earned a hi!her return on investment than similar

businesses in the industry. n its decision( the ax ,ourt a!reed with the taxpayer that theindependent investor test was satisfied. Cowever( the court held that satisfaction of thistest merely creates a rebuttable presumption that compensation is reasonable. he courtrelied on a statement in +e!. < 1.16%/5"b$"3$B )t is( in !eneral( ust to assume thatreasonable and true compensation is only such amount as would ordinarily be paid for likeservices by like enterprises under like circumstances.* Since ,E8s of publicly tradedcompanies in the same line of business were paid considerably less for their services thanFr. Fenard( the court found that only M5 million of his salary was reasonable.

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f. 'dvances by a corporation to a shareholder that are not bona fide loans.

!. mputed interest element on interest/free "or below/market$ loans by a corporation

to a shareholder.

"1$ Shareholder is deemed to make an interest payment to the corporation tothe extent of the for!one interest.

"%$ ,orporation is then deemed to make a dividend distribution to the share/holder for the same amount.

"3$ 'lthou!h the shareholder may be permitted to deduct the deemed interestpayment( the corporation has interest income.

"0$ 7o correspondin! corporate interest deduction is allowed because imputedinterest element is a constructive dividend.

h. nterest and principal payments made by a corporation where debt owed to itsshareholders is reclassified as e;uity "i.e.( the corporation is thinly capitali-ed$.

i. See the ,lass Exercise on ,onstructive Dividends appearin! at the end ofthe 9ecture 7otes for this chapter. his material can be distributed to the !roup asa take/home or classroom proect. Solutions to the Exercise are also included.

S$> D,-,7*7+ 2*7 S$> R,;+

%#. Stock dividends are not taxable if they are pro rata distributions of stock( or stock ri!hts(on common stock.

3>. Garious disproportionate distributions are taxable under < 3>2.

a. he followin! are 2 situations where stock dividends are taxable under < 3>2.

"1$ f one shareholder can elect payment either in cash or in stock( all stockdividends are taxable.

"%$ Disproportionate distributions of stock dividends are taxable.

"3$ ,ommon stock distributions to some common shareholders and preferredstock to other common shareholders cause stock dividends to be taxable. 'stock dividend of convertible preferred on common is taxable if it isreasonable to expect that some shareholders will convert their preferredshares to common shares and that others will keep their preferred shares.

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"0$ Distributions on preferred stock are taxable "except for chan!es in theconversion ratio of convertible preferred made to account for a stockdividend or stock split$.

"2$ ,onvertible preferred stock distributions that result in disproportionatedistributions are taxable.

b. Section 3>2"c$ provides that transactions increasin! the proportionate interest of ashareholder are taxable even if they are not actually stock dividends.


he followin! examples illustrate the applicability of < 3>2B

' corporation has a dividend reinvestment plan that allows shareholders to choose either a

stock dividend or a cash dividend. he stock dividend is of !reater fair market value than

the cash dividend. n addition( for those electin! to take the stock dividend and therebyreinvest in the corporation( an optional plan to purchase additional common stock of thecompany at a price e;ual to #2@ of the fair market value of the stock is available. hosechoosin! the stock dividend would have a taxable dividend under < 3>2 to the extent ofthe fair market value of the stock received initially. n addition( for shareholders electin!the optional plan( income will be reco!ni-ed to the extent that the fair market value of thestock purchased at the 2@ discount exceeds the purchase price of the stock. +ev. +ul.5:/352( 1#5:/% ,.=. 13>

' corporation has an annual redemption plan whereby shareholders can redeem 1@ of

their stock annually. ?hile those who tender their stock for redemption have dividend

income under < 3>1 "because the provisions of < 3>% are not met$( those who do nottender their stock also have dividend income under < 3>2 because their proportionateshare of E & and assets of the corporation increases. ?hile a distribution of propertyincident to an isolated redemption does not cause < 3>2"b$"%$ to apply "even thou!h theredemption is treated as a < 3>1 distribution$( an on!oin! plan of annual stockredemptions is subect to < 3>2"b$"%$. +ev. +ul. 5:/6>( 1#5:/1 ,.=. :1

' distribution to common shareholders of preferred stock which is immediately

redeemable is taxable as offerin! a choice of stock or cash under < 3>2"b$"1$. +ev. +ul.51#/%2:( 1#51#/% ,.=. #2

' corporation has two classes of common( ' and =. t makes a distribution of class 'common stock to the holders of class ' common stock( and a distribution of newly issuedpreferred stock to the holders of class = common stock. he +e!ulations I+e!. < 1.3>1#/0"b$K hold that both distributions are taxable.

' corporation( havin! one class of common stock( distributes to its common shareholders

a new issue of convertible preferred havin! a six/month conversion period and aconversion price near the market value of the common stock. he +e!ulations provide

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that because early conversion by common shareholders is probable "with the result thatsome common shareholders will hold common stock while others will hold preferred$( thedistribution of preferred is taxed under < 3>2"b$"3$. +e!. < 1.3>1#/0"b$

' payment of interest to a holder of a convertible debenture will cause the distribution of a

stock dividend to the common shareholders to be taxed under < 3>2"b$"%$. he holders ofthe convertible debentures are deemed to be shareholders thus( some shareholders havereceived cash. +e!. < 1.3>1#/3"b$"3$

31. f stock dividends are not taxable( there is no reduction in E & . f they are taxable( thedistribution is treated as any other property dividend.

3%. f the stock dividend is not taxable( < 3>5 applies and a basis allocation is necessary. f thestock dividend is taxable( the basis of the stock received is its fair market value.

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OVERVIEW

33. ,orporate nonli;uidatin! distributions to shareholders are typically treated as dividendincome. Cowever( distributions that ;ualify as stock redemptions are treated the same as asale of stock by the shareholders to a third party. hus( capital !ain treatment normallyresults.

a. ualifyin! stock redemptions provide !reater tax benefits to noncorporate share/holders than non;ualifed redemptions.

"1$ Since ;ualifyin! stock redemptions are treated as sales or exchan!es( theshareholders can offset their amount reali-ed by the basis of the stockredeemed. 'ny !ain remainin! is treated as a capital !ain and taxed at theapplicable capital !ain rates "lon!/term rates are 2@ or 12@$.

"%$ f the distributions do not ;ualify as stock redemptions( they are treated asdividend income and taxed at dividend rates "assumin! ade;uate E & $.

"3$ =y increasin! the amount of capital !ains for the year( redemptions mayincrease the utili-ation of capital losses from other sources. Distributionstreated as dividends cannot provide this same benefit.

b. ,orporate shareholders prefer non;ualified stock redemption "i.e.( dividend$treatment.

"1$ ?ith dividend treatment( corporate shareholders receive the benefits of thedividends received deduction. hus( most of the non;ualified stockredemption income is not taxable.

"%$ ualified stock redemptions produce capital !ains that are fully taxable atthe corporations hi!hest mar!inal rate.


' !ood example of a redemption transaction structured to fail the ;ualifyin! stock

redemption provisions in order to obtain the dividends received deduction is Duont,orporations redemption of stock held by Sea!ram ,orporation. "See( 9ee '. Sheppard(),an Sea!ram =ail 8ut of Duont without ,apital Nain axL* "a! #otes "oday( #2 7

52/0( 'pril 1:( 1##2$. n +ev. +ul. 55/%%6( 1#55/% ,.=. #>( redemption of stock is followedby sale of remainin! stock held by corporate shareholder. he two transactions are part ofinte!rated plan resultin! in complete termination redemption thus the dividends receiveddeduction on redemption transaction disallowed.

Section 1>2#"a$ tempers the advanta!es of these redemption transactions by re;uirin! the

corporate shareholder to reduce its stock basis by the amount of the dividends receiveddeduction( and to reco!ni-e !ain for any excess over the basis.

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30. ,orporations !enerally reco!ni-e both !ains and losses on li;uidatin! distributions thus(preservin! the double taxation inherent in operatin! a business as a , corporation. Somemaor exceptions apply( however.

a. 'ntistuffin! rules limit loss reco!nition with respect to certain distributions "andsales$ pursuant to li;uidation.

b. Subsidiary corporations do not reco!ni-e !ainsHlosses on li;uidatin! distributionsto its parent corporation and it is also !enerally tax/free to the parent.

32. Shareholders of a li;uidatin! corporation receive sale or exchan!e treatment thus( thedifference between the fair market value of all properties received and the stock basis is acapital !ain "or loss$.

STOC REDEMPTIONSSALE OR ECHANGE TREATMENT

36. Stock redemptions ;ualifyin! under < 3>%"b$ or < 3>3 receive sale or exchan!e treatment.o be ;ualified( the distribution must meet one of the followin! re;uirements.

a. 7ot essentially e;uivalent to a dividend under < 3>%"b$"1$.

b. Substantially disproportionate in terms of shareholder effect under < 3>%"b$"%$.

c. ,omplete termination of a shareholders interest under < 3>%"b$"3$.

d. +edemption of noncorporate shareholder in partial li;uidation of the corporation

under < 3>%"b$"0$.

e. +edemption to pay decedent shareholders death taxes and the estates adminis/tration expenses under < 3>3.

35. 'mount of the shareholders !ainHloss is measured by the difference between the amountreceived and the shareholders adusted basis in the stock redeemed.

3:. Shareholders basis in property received in the redemption is its fair market value.

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S$> A',4/,$* R/.+

3#. Nenerally( < 31: constructive ownership rules apply in determinin! whether a distributionis a ;ualifyin! stock redemption.a. ndividuals are treated as ownin! stock owned by their spouses( parents( children( and

!randchildren.

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Example. Oeith owns 6> shares of stock in urple ,orporation. he remainin! 0>shares are owned by the followin! relatives of OeithB Oeiths wife "2$ Oeiths son"%$ Oeiths dau!hter "3$ Oeiths father "1>$ Oeiths brother "6$ and Oeiths aunt"10$. Oeith is deemed to own a total of :> shares in urple. 8nly the stock of hisbrother and his aunt are not attributed to him.

b. Stock owned( directly or indirectly( by a partnership is considered to be ownedproportionately by the partners. Cowever( stock owned by a partner is treated asowned in full by the partnership.

Example. 9ori has a %>@ interest in a partnership which owns 3> shares in ?hite,orporation. 9ori is deemed to own 6 "%>@ of 3>$ shares in ?hite. Cowever( if9ori owned 3> shares in ?hite "rather than the partnership$( the partnership wouldbe deemed to own all of 9oris 3> shares.

c. Stock owned( directly or indirectly( by an estate or trust is considered to be ownedproportionately by the beneficiaries but stock owned by or for a beneficiary is

treated as owned in full by the estate or trust.

Example. 'rnold has a 1>@ beneficiary interest in a trust. he trust owns 2>shares in Nreen ,orporation. 'rnold is considered as ownin! 2 "1>@ of 2>$ ofthese shares. Cowever( if 'rnold owned the 2> shares "rather than the trust$( thetrust would be deemed to own all of 'rnolds 2> shares.

d. Stock owned by a corporation is considered to be owned proportionately by anyshareholder ownin! 2>@ or more of the corporations stock. Cowever( stockowned by a shareholder who owns 2>@ or more of a corporation is considered tobe owned in full by the corporation.

Example. 7ancy owns 6>@ of Nray ,orporation. Nray owns %> shares of =lue,orporation( and 7ancy owns 2> shares of =lue. 7ancy is deemed to own 6%shares in =lue( her own 2> shares plus 6>@ of Nrays %> shares( or 1% moreshares. Nray( on the other hand( is deemed to own 5> shares of =lue( its %> sharesand 7ancys 2> shares.

e. Exhibit 1#/1 in the text summari-es the stock attribution rules.

0>. he stock attribution rules do not apply in certain cases.

a. 4amily attribution rules can be waived in a complete termination redemption.

b. 'll attribution rules are i!nored for partial li;uidations and in redemptions to paydeath taxes.


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,ourts have addressed the issue of whether family discord should affect the application of < 31:.n &obin 'aft "rust( 61 .,. 3#: "1#53$( the ax ,ourt refused to accept a )family fi!ht*exception to the attribution rules. Cowever( the 4irst ,ircuit ,ourt of 'ppeals reversed I52/1S, J#0>#( 32 '4+%d 52/52>( 21> 4.%d 03 ",'/1( 1#52$K and the ax ,ourt ruled that theexistence of family discord could ne!ate the presumption that related taxpayers would exertcontinuin! control over a corporation after their stock is redeemed. n +ev. +ul. :>/%6( 1#:>/1,.=. 66( the +S announced it would not follow the 4irst ,ircuits decision in &obin 'aft "rustbecause( accordin! to the +S( the )family hostility* exception is inconsistent with the le!islativehistory behind the redemption provisions. n Met(ger "rust v. Comm., :%/% S, J#51:( 21'4+%d :3/356( 6#3 4.%d 02# ",'/2( 1#:%$( the 4ifth ,ircuit ,ourt of 'ppeals a!reed with the+S and ruled that there is no family hostility exception to the attribution rules.

N$ E++*,2..8 E6/,-2.* R7%,$*+

01. ' stock redemption under < 3>%"b$"1$ must not be essentially e;uivalent to a dividend.he Supreme ,ourt in %.S. v. )avisestablished the followin! rules as to < 3>%"b$"1$.

a. t is immaterial that the redemption has a business purpose and is not part of a taxavoidance scheme to bail out dividends at favorable tax rates.

b. he redemption must result in a )meanin!ful reduction* of the shareholdersinterest( with a reduction in votin! control bein! the most important factor.

c. ,onstructive ownership rules of < 31:"a$ apply in fi!urin! meanin!ful reductions.


he meanin!ful reduction test is based upon the facts and circumstances of each case I+e!.< 1.3>%/%"b$K. ' redemption of stock from a shareholder havin! a de minimisstock interest bothbefore and after the transaction should ;ualify as a not essentially e;uivalent redemption "+ev.+ul. 51#/3:2( 1#51#/% ,.=. #%$. Cowever( a de minimisshareholder will not ;ualify for < 3>%"b$"1$ treatment if the redemption is pro rata with respect to all shareholders "+ev. +ul. :1/%:#(1#:1/% ,. =. :%$.

' < 3>%"b$"%$ disproportionate redemption re;uires shareholders to own( directly and indirectly(less than 2>@ of the corporations votin! stock after the redemption. ' redemption can ;ualify asa not essentially e;uivalent redemption even thou!h the shareholder owns 2>@ "or possibly more$

of the stock after the transaction. ' reduction in shareholder interest from 25@ to 2>@ was heldto be a not essentially e;uivalent redemption when a sin!le unrelated shareholder owned theremainin! 2>@ interest "+ev. +ul. 52/2>%( 1#52/% ,.=. 111$.

?hen a shareholders interest after a redemption is more than 2>@( the meanin!ful reduction testwill not be satisfied in the +Ss opinion "See( +ev. +ul. 5:/0>1( 1#5:/% ,.=. 1%5( interestreduced from #>@ to 6>@ and +ev. +ul. 55/%1:( 1#55/1 ,.=. :1( interest reduced from 6>@ to22@ did not ;ualify$. Cowever( one court found a reduction in shareholder interest from :2@ to

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61.5@ did satisfy the meanin!ful reduction test when applicable state law re;uired a two/thirdsvote for amendin! articles of incorporation( for mer!er and ac;uisition( and for li;uidationI*right v. %.S.( 53/% S, J#2:3( 3% '4+%d 20#>( 0:% 4.%d 6>> ",'/:( 1#53$K.

0%. +edemption of preferred stock( that is not < 3>6 stock( may ;ualify as a not essentiallye;uivalent redemption.

03. 4or non;ualifyin! stock redemptions( the basis of the stock redeemed attaches to the basisof the shareholders remainin! stock.

a. f the taxpayer owns no stock directly after the transaction( the basis of the stockredeemed attaches to the basis of the stock that was attributed to such taxpayer."See Example 33 in the text.$ here is no !uidance provided for basis allocationwhen the stock of more than one related shareholder is attributed to the taxpayer.

b. he +S has a!!ressively attacked tax shelter transactions that utili-e non;ualified

stock redemptions to shift stock basis to other shareholders. "See the AdditionalLecture &esourcebelow.$


+S 'ttacks =asis/Shiftin! ax Shelters. ?hen a stock redemption does not ;ualify for sale orexchan!e treatment( the basis in the stock redeemed attaches to the shareholders remainin!shares or to stoc+ the shareholder o$ns constructively. ,lever planners have created a tax shelterutili-in! the shift in basis from one shareholder to another shareholder. he shelter works asfollows. ' .S. taxpayer and a forei!n corporation indifferent to .S. tax "e.!.( a ,ayman sland

corporation$ each ac;uire a small number of shares in a forei!n bank. he .S. taxpayer alsopurchases from the forei!n corporation an option to ac;uire at least 2> percent of the forei!ncorporations stock. he forei!n bank then redeems the stock owned by the forei!n corporation.nder the attribution rules( the .S. taxpayer is related to the forei!n corporation by reason of thestock option thus( the redemption results in dividend income to the forei!n corporation "whichpays no .S. tax$. he forei!n corporations basis in the redeemed shares shifts to the shares ofthe .S. taxpayer and those shares are then sold for a loss that is used to offset !ains from otherinvestments.

he +S has announced "7otice %>>1/02( %>>1/% ,.=. 1%#$ that it will disallow the basis shift inthese tax shelter cases and that it will assess penalties on participants and promoters of the tax

shelter. he +S has achieved some success in this area. "See )Austice 'nnounces M026 FillionSettlement with OFN(* "a! #otes "oday( %>>2 7 165/12( 'u!ust %#( %>>2$. hese basisshiftin! transactions are )listed transactions* for purposes of 11( +e;uirin! Disclosure byaxpayers( and 6111 +e;uirin! ax Shelter +e!istration "7otice %>>0/65( %>>0/01 .+.=. 1$.

he +S recently withdrew rop. +e!. < 1.3>%/2 which would have re;uired a dramaticallydifferent treatment for the basis of stock redeemed in a non;ualifyin! stock redemption "see'nnouncement %>>1#/3>( %>>1#/1# .+.=. :5# and the "a! in the #e$son pa!e 1#/5 in the

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text$. nder the proposed re!ulation( shareholders would have reco!ni-ed losses e;ual to theamount of the stock basis redeemed in a non;ualified redemption( and such loss would bedeductible upon the happenin! of some future event "e.!.( shareholders reco!ni-in! !ain on asubse;uent disposition of the corporations stock$. he +S will continue to seek alternatives tothe current rule that allows the shiftin! of stock basis from one taxpayer to another taxpayer.

D,+'$$',$*2 R7%,$*+

00. nder < 3>%"b$"%$ stock redemptions must be substantially disproportionate. o be sub/stantially disproportionate( the followin! stock ownership re;uirements must be met.

a. Shareholder must own( after the distribution( less than :>@ of the total interestowned in the corporation before the distribution( and

b. Shareholder must own( after the distribution( less than 2>@ of the total combinedvotin! power of all classes of stock entitled to vote.

c. n determinin! stock ownership before and after a redemption( the constructiveownership rules of < 31: apply.

d. 4or an example of a disproportionate redemption usin! a bootstrap transaction( see+ev. +ul. 52/005( 1#52/% ,.=. 113 "stock issuance to new shareholder followedby redemption of shares by the two ori!inal shareholders two transactions part ofinte!rated plan resultin! in disproportionate redemption$.


Gotin! stock re;uirement. ' disproportionate redemption only applies to a redemption of votin!stock or to a redemption of both votin! stock and other stock "+e!. < 1.3>%/3$. ' redemption ofonly votin! preferred stock can ;ualify as a disproportionate redemption if the taxpayer owns"directly or indirectly$ no common stock "+ev. +ul. :1/01( 1#:1/1 ,.=. 1%1$. +edemption ofonly nonvotin! stock of one taxpayer can ;ualify as a disproportionate redemption if combinedwith the simultaneous redemption of votin! stock of a related taxpayer. See( +ev. +ul. 55/%35(1#55/% ,.=. ::( where a redemption of nonvotin! preferred stock of father ownin! no commonstock directly combined with redemption of votin! common stock of son is disproportionateredemption for both taxpayers.

Series/of/redemptions rule. Section 3>%"b$"%$"D$ provides that a redemption will not ;ualify asdisproportionate if it is made pursuant to a plan the purpose or effect of which is a series ofredemptions that result in the a!!re!ate in a distribution which does not satisfy the :>@ and 2>@tests "see +e!. < 1.3>%/3"b$( for an example$. he determination of whether a plan exists is basedon all the facts and circumstances. "+e!. < 1.3>%/3$ 'lthou!h there is scant udicial !uidance inthe area( it appears that the series/of/redemptions rule will only apply when stock is redeemedfrom a shareholder who has knowled!e of an impendin! redemption of another shareholdersstock ISee( +ev. +ul. :2/10( 1#:2/1 ,.=. #3 "rule applied even thou!h no a!reement existed

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between the two shareholders re!ardin! their redemptions$ 9tr. +ul. :316>1# "rule does notapply to coincidental redemptions of two shareholders within close proximity of each other$ and9tr. +ul. %>>001>>5 "rule does not apply to redemptions pursuant to corporations articles ofincorporation and with no redeemin! shareholder possessin! knowled!e of any other impendin!redemption$K. he series/of/redemptions rule does not apply to a redemption merely because afuture redemption could be affected under a buy/sell a!reement existin! between the corporationand another shareholder. See lacier State Electric Supply Co.( :> .,. 1>05 "1#:3$( where ana!reement re;uirin! the redemption of another shareholders stock upon death was not sufficientfor the rule to apply. he series/of/redemptions rule has been applied to two redemptions thatwere 12 months apart "9tr. +ul. :135>%3$.

ETHICAL CONSIDERATIONS

,onvertible referred StockP,onversion or +edemption "pa!e 1#/%6$. Fembers of a board ofdirectors serve in a fiduciary capacity on behalf of corporate shareholders. hey are subect to!ood faith and fair dealin! standards with respect to the investors in the corporations convertiblepreferred stock. Niven the recently developed invention( a conversion of the preferred stock tocommon stock appears to be more favorable for the preferred shareholders than havin! theirshares redeemed. ' premium call price is typical of most callable preferred stock( and thepresence of a premium on this preferred stock likely does not relieve the board of their fiduciaryduties. he preferred shareholders should be informed of the new invention before anyredemption transaction transpires. n addition( even thou!h the stock of the corporation is notsellin! publicly( the corporation may be subect to the anti/fraud provisions of the Securities 'ctsfor a small offerin! to members of the public. 7onetheless( the board of directors does not appearto have acted in an ethical manner.

C$%. T'%,*2,$* R7%,$*+

02. Section 3>%"b$"3$ provides that a redemption will ;ualify for sale or exchan!e treatment ifa shareholders interest is completely terminated. n satisfyin! the re;uirement( theconstructive ownership rules of < 31: !enerally apply. Cowever( < 3>%"c$"%$"'$ providesthat the family attribution rules do not apply if all of the followin! re;uirements are met.

a. 4ormer shareholder may not retain any interest in the corporation "includin! aninterest as a director( officer( or employee$ for at least 1> years. =ein! a creditor is

not considered an interest for this purpose. 'lso stock ac;uired by be;uest orinheritance is not prohibited.

b. 4ormer shareholders file an a!reement to notify the +S if a prohibited interest isac;uired within the 1>/year post redemption period.

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Section 3>%"c$"%$"=$ provides that < 31:"a$"1$ family attribution rules are not be waived "despitethe fact that re;uirements set out in item 13. above are met$ if either of the followin! apply.

'ny part of the redeemed stock was ac;uired( directly or indirectly( within the previous 1>

years by the distributee from a related person or

'ny related person owns stock at the time of the distribution and ac;uired the stock(

directly or indirectly( from the distributee within the previous 1> years( unless the stock soac;uired is also redeemed in the same transaction.

Cowever( a family attribution waiver is available if the stock transfer in the previous 1>

years did not have as one of its principal purposes the avoidance of 4ederal income taxes.

Example. aul owns 1>>@ of the stock in eal ,orporation( which has E & of M%>>(>>>. aultransfers 0>@ of the stock to his son Seth. eal redeems all of Seths stock 13 months later forM1>>(>>>. he redemption does not ;ualify as a complete termination of Seths stock because thefamily attribution rules apply. f the transfer of stock to Seth did not have as one of its principalpurposes the avoidance of 4ederal income taxes( the family attribution waiver could apply( andthe result would be a complete termination redemption.Example. Susan owns 1>>@ of laid ,orporations stock. laid has E & of M3>>(>>>. Susantransfers 32@ of the stock to her dau!hter Oatrina. laid redeems all of Susans stock 12 monthslater for M12>(>>>. he redemption does not ;ualify under as a complete termination of Susansstock because the family attribution rules apply. f the transfer of stock to Oatrina did not have asone of its principal purposes 4ederal income tax avoidance( the family attribution waiver could

apply( and the result would be a complete termination redemption.

R7%,$*+ $ P28 D2 T2@+

06. nder < 3>3( a decedent shareholders estate receives sale or exchan!e treatment for aredemption when the stock represents a substantial amount of the !ross estate.

a. o the extent a redemption ;ualifies under < 3>3( the ;ualifyin! stock redemptionrules of < 3>%"b$ and the stock attribution rules of 318 need not be considered.

b. Section 3>3 applies when a distribution is made with respect to the redemption ofstock of a sin!le corporation( the value of such stock bein! included in the !rossestate of the decedent and in excess of 32@ of the value of the adusted !rossestate of the decedent.

c. n determinin! the 32@ adusted !ross estate re;uirement( stock of two or morecorporations is treated as the stock of a sin!le corporation if %>@ or more in valueof the outstandin! stock of each corporation is included in the decedents !rossestate.

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d. Section 3>3 applies only to the extent of the sum of the death taxes imposed byreason of the decedents death plus the amount of funeral and administrationexpenses allowable as deductions to the estate.

"1$ f the redemption exceeds the amount allowed "i.e.( total of death taxes andfuneral and administration expenses$( the < 3>3 amount is still allowed.8nly the excess runs the risk of dividend treatment. Section 3>% may applywith respect to this excess( but the attribution rules "e.!.( attribution from abeneficiary to an estate$ may preclude a ;ualifyin! stock redemption.

"%$ ?aivin! family attribution rules for estates under < 3>%"c$"%$ may assist insatisfyin! the complete termination redemption re;uirements.

e. Due to the )stepped/up* basis the stock receives under < 1>10( a redemption topay death taxes !enerally results in little or no !ain "or loss$.

EFFECT ON THE CORPORATION REDEEMING ITS STOC

R$;*,,$* $5 G2,* $' L$++

05. nder < 311"b$( a distributin! corporation reco!ni-e !ain "but not loss$ when distributin!property other than cash to redeem its stock. 'n exception !ain reco!nition re;uirementapplies to re!ulated investment companies that are distributin! appreciated property "e.!.(appreciated portfolio securities$ to shareholders who demand redemption of their stockI< :2%"b$"6$K. See 9tr. +ul. %>>2>#>13 for application of this exception.

E55 $* E2'*,*;+ 2*7 P'$5,+

0:. nder < 31%"n$"5$( E & is reduced in a ;ualifyin! stock redemption by an amount not inexcess of the ratable share of the E & attributable to the stock redeemed.

R7%,$* E@*7,/'+

0#. Section 16%"k$"1$ disallows a deduction for expenditures incurred in connection with astock redemption.

ETHICAL CONSIDERATIONS

layin! Names with the Statute of 9imitations "pa!e 1#/3>$. Steve is courtin! disaster he cantavoid the !ain tri!!ered by the basis reduction in %>>>. 'n obscure set of ,ode provisions">> and assess a!ainst Steve the tax he would have paid had he properlyreported the dividend income.

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8n the other hand( if Steve stays with the basis reduction he ori!inally made( he has not taken aninconsistent position. herefore(

ch19 notes

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