Mastering Corporate Tax

Reginald MombrunNORTH CAROLINA CENTRAL UNIVERSITY SCHOOL OF LAW

Gail Levin RichmondNOVA SOUTHEASTERN UNIVERSITY LAW CENTER

Felicia BranchNORTH CAROLINA CENTRAL UNIVERSITY SCHOOL OF LAW

CAROLINA ACADEMIC PRESS

Durham, North Carolina

Contents

List of Figures xxv

Table of Cases xxvii

Table of Revenue Rulings xxix

Table of Revenue Procedures xxxi

Series Editor's Foreword xxxiii

Preface xxxv

Acknowledgments xxxvii

Part One: Introduction

Chapter 1 • Sources of Tax Law 3Roadmap 3A. Introduction 3B. Legislative Sources 3

1. Internal Revenue Code 3a. Overview 3b. Structure 4c. Dates 4

2. Legislative History 43. Treaties 5

C. Administrative Sources 51. Treasury Regulations 5

a. Overview 5b. Numbering System 6c. Preambles 6

2. IRS Documents 7a. Letter Rulings and Revenue Rulings 7b. Other IRS Documents 7

CONTENTS

D. Judicial Sources ' 8E. Examples of Sources of Law 8Checkpoints 9

Chapter 2 • Corporate Tax Policy and Doctrines 11Roadmap 11A. Policy 11B. Doctrines 12

1. Substance over Form 122. Business Purpose 123. Step Transaction 134. Economic Substance/Sham Transaction 13

Checkpoints 14

Chapter 3 • An Overview of C Corporation Taxation 15Roadmap 15A. Forms of Doing Business 15

1. Characteristics of a Business Entity 152. Determining Which Tax Regime Applies 16

a. Incorporated Entities 16b. Unincorporated Entities: Check-the-Box Regulations 16

3. Who Is Taxed on an Entity's Income? 17B. Avoiding Double Tax on Corporate Earnings 18C. Subchapter C and Corporate Taxation 18D. Taxation of Corporation's Operations: Overview 19E. Gross Income 20

1. General Rule 202. Contributions to Capital 20

F. Deductions 21• 1. Deductions Available to Individuals and Corporations 222. Deductions Available Only to Individuals 223. Deductions Available Only to Corporations 23

a. Organizational Expenditures 23b. Dividends Received and Premium on Repurchasing Debt 25

4. Nondeductible Items 25a. In General 25b. Limitations Applied to Corporations 26c. Sales Between Related Parties 26

G. Accounting Methods 271. In General ' 272. Related Taxpayers 27

CONTENTS

3. At-Risk and Passive Activity Limitations 28H. Taxable Year 29I. Capital Gains and Losses 30

1. Tax Rate Applied to Net Capital Gains 302. Limitations on Deducting Net Capital Losses 303. Sales Between Related Parties 314. Other Capital Gain and Loss Limitations 32

J. Corporate Tax Rates 32K. Credits 33L. Other Corporate Taxes 33

1. Alternative Minimum Tax 342. Accumulated Earnings and Personal Holding Company Taxes 34

a. Accumulated Earnings Tax • 35b. Personal Holding Company Tax 36

Checkpoints 38

Part Two: Formation of C Corporations

Chapter 4 • Incorporation of a Business—Section 351 41Roadmap 41A. Introduction 41

1. Benefits of Corporate Form of Doing Business 412. Policy Reasons for Nonrecognition and Importance

of Section 351 42B. The General Rule of Section 351 43C. The Meaning of Property 44D. What Constitutes a Transfer? 45E. To Whom Must the Property Be Transferred? 46F. Receipt of Stock 47G. Transferor(s) Must Have Control of Corporation 49

1. Description of Control 492. Transferor(s) Must Have Control Immediately after the Transfer 503. A Brief Discussion of the Step Transaction Doctrine 504. Nonsimultaneous Transfers 51

H. Tax Consequences to Transferor(s) 511. General Rule 512. Tax Planning Opportunity? 533. Assumption of Liabilities 53

a. General Rule 53b. Exceptions to the General Rule 54

CONTENTS

4. Basis Consequences5. Allocating Basis to Stock Received6. Assumption of Liabilities7. Holding Period

I. Tax Consequences to Transferee Corporation1. No Gain or Loss2. Basis of Property

a. General Ruleb. Loss Limitation under Section 362(e)

3. Holding Period of Property ReceivedJ. Transfers to an Investment CompanyK. Overlap with Other Code SectionsL. Miscellaneous Procedural MattersCheckpoints

Chapter 5 • Corporation's Capital StructureRoadmapA. Types of CapitalB. Nontax Characteristics of Debt and Equity: An Overview

1. Debt2. Equity

C. Tax Characteristics of Debt and Equity1. Debt

a. Corporate Debtorb. Creditor

2. Equitya. Corporate Issuerb. Shareholder

D. Hybrid InstrumentsE. Section 385

1. Factors2. Classification by the Issuer

Checkpoints

Part Three: Corporate Distributions

Chapter 6 • Dividend DistributionsRoadmapA. Distributions Covered by Section 301

1. Distributions of Property

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CONTENTS

2. To a Shareholder 783. With Respect to the Shareholder's Stock 78

B. Amount Distributed 79C. Dividend 80D. Corporation's Tax Consequences 80

1. Taxable Amount 802. Effect on E&P 81

E. Shareholder's Tax Consequences 821. Income Tax 82

a. Gross Income 82b. Dividends Received Deduction 83c. Tax Rate 84

2. Basis and Holding Period of Property Received 843. Basis of Shareholder's Stock 84

F. Nontaxable Distributions of Stock or Rights 851. Exclusion from Shareholder's Gross Income 852. Basis and Holding Period of Stock and Stock Rights 86

a. General Rule 86b. Rights to Acquire Stock 86

3. Effect on Issuing Corporation 88G. Taxable Distributions of Stock or Rights 88

1. Distributions Covered by Section 305 (b) 88a. Distributions in Lieu of Money 88b. Disproportionate Distributions 88c. Distributions of Common and Preferred Stock 90d. Distributions on Preferred Stock 91e. Distributions of Convertible Preferred Stock 91f. Transactions Treated as Distributions 92

2. Tax Consequences of Taxable Stock Distributions 93H. E&P 93

1. Items Affecting E&P 93a. Accounting Methods and Timing 94b. Income 95c. Deductions 95

2. Current and Accumulated E&P 953. Allocating E&P to Distributions 96

a. Current E&P 96b. Accumulated E&P 97

Checkpoints 100

CONTENTS

Chapter 7 • Redemption Distributions 103Roadmap 103A. Overview 104B. Constructive Ownership 104

1. Family Attribution 105a. Multiple Attributions 106b. Family Hostility 107

2. Attribution from an Entity 107a. Entities 107b. Multiple Attributions 109

3. Attribution to an Entity 109a. Entities 109b. Multiple Attributions 110

4. Option Attribution 110C. Section 302 Redemptions 110

1. Substantially Disproportionate Redemption 111a. Ownership Percentage after the Redemption 111b. Reduction in Voting Stock Percentage 112c. Reduction in Common Stock Percentage 112d. Multiple Redemptions 113e. Effect of Constructive Ownership 113

2. Complete Termination of the Shareholder's Interest 114a. Constructive Ownership 114b. Waiving Family Attribution by Family Members 115c. Waiving Family Attribution by Entities 116

3. Partial Liquidation , 117a. Qualifying Shareholders 117b. Qualifying Redemptions 118c. Pro Rata Redemptions 119

4. Redemption That Is Not Essentially Equivalent to a Dividend 1205. Redemption That Qualifies under More Than One Provision 121

D. Section 303 Redemptions 1211. Limitation on Qualifying Amount 1222. Requirements to Qualify 122

a. Inclusion in Gross Estate 122b. Required Stock Value 123c. Required Burden on Shareholder's Interest in Estate 124d. Time Periods for Redemption 124

E. Section 304 Redemptions 124

CONTENTS

1. Related Corporations 125a. Brother-Sister Corporations 125b. Parent-Subsidiary Corporations 126

2. Reconstructing a Section 304 Transaction 126a. Testing for Qualification as a Redemption 126b. Consequences of Failure to Qualify as a Redemption 128

3. Interplay of Sections 304 and 351 128F. Section 306 Dispositions 129

1. Definition of Section 306 Stock 130a. Stock That Is Section 306 Stock 130b. Stock That Is Not Section 306 Stock 130

2. Dispositions of Section 306 Stock 131a. General Rules 131b. Exceptions 132

G. Tax Consequences of Redemption: Corporation 1321. Taxable Income 1322. E&P 133

a. Redemption Treated as a Dividend 133b. Redemption Treated as an Exchange 133c. Certain Dispositions of Section 306 Stock 134

3. Basis of Stock Acquired in a Section 304 Transaction 134H. Tax Consequences of Redemption: Shareholder 135

1. Redemption Treated as a Distribution 135a. Taxable Income 135b. Basis and Holding Period of Property Received 135c. Basis of Stock Retained 135

2. Redemption Treated as an Exchange 136a. Taxable Income 136b. Basis and Holding Period 136

3. Section 304 Redemptions 136I. Transfers of Control 137

1. Marital Dissolution 137a. Background 137b. Treasury Regulations 138

2. Other Transfers of Control 139Checkpoints 139

CONTENTS

Part Four: Tax-Free Restructurings (Reorganizations)

Chapter 8 • Acquisitive Reorganizations 143Roadmap 143A. Introduction 143B. Transactions That Qualify as Reorganizations 144C. General Reorganization Requirements 144

1. Business Purpose 1452. Continuity of Interest 1453. Continuity of Business Enterprise 1464. Step Transaction Doctrine 147

D. Technical Requirements of the A Reorganization 1481. Introduction 1482. The Disregarded Entity Merger 151

a. In General 151b. Liabilities of Disregarded Entities 152

3. The Triangular A Reorganizations 153a. The Forward Triangular Merger 153b. The Reverse Triangular Merger 154

4. Review of the A Reorganization 154E. Technical Requirements of the B Reorganization 155

1. Introduction 1552. Creeping B Reorganizations 1553. Boot Concerns 1564. Review of the B Reorganization 157

F. Technical Requirements of me C Reorganization 1571. Introduction 1572. The Solely for Voting Stock Requirement 1583. The Liquidation Requirement 1594. The Substantially All Requirement 1595. Creeping C Reorganizations 1606. Final Concerns 1617. Review of the C Reorganization 161

G. Technical Requirements of the Acquisitive D Reorganization 1621. Introduction 1622. Transfer of Assets 1633. The Control Requirement 1634. The Distribution Requirement 1645. Review of the Acquisitive D Reorganization 164

H. The G Reorganization 164

CONTENTS

I. Asset Drop-Downs Following an Acquisitive Reorganization 165J. Push-Ups of Assets 166K. Reorganizations Involving Investment Companies 166L. Exchange and Receipt of Net Value 167M. Tax Consequences to Shareholders 168

1. In General 1682. Party to a Reorganization 1683. Gain or Loss to Acquiring Shareholders 1694. Gain or Loss to Target Shareholders 1695. Nonqualified Preferred Stock 1706. Transactions Involving Railroads 1707. Warrants 1718. Treatment of Boot 1719. Basis Consequences to Target Shareholders 172

a. In General 172b. Basis in Triangular Reorganizations 173

10. Assumption of Liabilities 17411. Holding Period of Acquiring Stock in the Hands

of Target Shareholders 174N. Tax Consequences to the Acquiring Corporation 175

1. Introduction 1752. Gain or Loss to the Acquiring Corporation 1753. Basis Consequences to the Acquiring Corporation 1754. Holding Period 1765. Carryover of Tax Attributes , 176

O. Tax Consequences to the Target Corporation 1761. Gain or Loss ' 1762. Basis and Holding Period of Property Received 177

Checkpoints 177

Chapter 9 • Nonacquisitive, Nondivisive Reorganizations(Recapitalizations, F Reorganizations) 179

Roadmap 179A. Introduction 179B. What Is a Recapitalization? 180C. Boot Recognition and Loss Limitation 181D. COI and COBE in Recapitalizations 182E. Technical Requirements of the F Reorganization 183

1. Introduction 1832. Change of Tax Status 184

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3. Identification of Shareholders 1844. Advantages of the F Reorganization 184

F. Tax Consequences of Qualifying as an E or F Reorganization 1851. Shareholders Recognize No Gain or Loss 1852. Basis of Stock or Securities Received in an E or F

Reorganization 1863. Holding Period 187

Checkpoints 187

Chapter 10 • Divisive Reorganizations — Section 355 189Roadmap 189A. Introduction 189

1. Overview 1892. Types of Section 355 Transactions 190

B. Basic Requirements 1901. Distribution of Stock or Securities 1922. Distribution of Stock of Controlled Corporation 193

a. In General 193b. Control Immediately Before the Distribution 194c. Impact of Warrants and Options 195

3. The Anti-Device Requirement 195a. Device Factors 195b. Nondevice Factors 198c. Transactions Not Ordinarily Considered Devices 199

4. The Active Trade or Business Requirement 200a. In General 200b. Definition of Trade or Business 200c. What Constitutes "Active"? 200d. Ownership of Real Property 202e. Activities of Independent Contractors 202f. Employees of Related Entities 202g. Active Trade or Business in a Partnership 203h. Attribution of Active Trade or Business from a Corporation 203i. The Five-Year Requirement 204j . Expansion of a Business 205

5. The Continuity of Interest Requirement 2056. The Business. Purpose Requirement 206

a. Criteria for Business Purpose 206b. Deciphering the Business Purpose 207

C. Certain Transactions That Will Not Qualify under Section 355 208

CONTENTS xvii

1. In General 2082. Section 355(d) — In General 2103. Section 355(e) 2134. Section 355(f) 2155. Section 355(g) 215

D. Tax Consequences to Distributing Corporation 2161. Gain or Loss 2162. Liabilities Transfer—General Rule 216

a. Avoidance of Federal Income Tax 216b. Liabilities in Excess of Basis 217

3. Gain or Loss in D/3 5 5 Transactions 217E. Tax Consequences to Shareholders 218

1. Gain or Loss 218a. Section 355(a) 218b. Receipt of Securities 220c. Receipt of Property Attributable to Accrued Interest 220d. Characterization of Boot Received 220

2. Basis of Stock or Securities 221a. Basis of Stock 221b. Basis of Securities and Other Boot Received 222

3. Holding Period 222F. Distributing Corporation's Tax Attributes 222G. Tax Consequences to Controlled Corporation 223

1. In General 2232. Recognition of Gain or Loss , 2233. Basis of Controlled Corporation's Assets 2234. Transfer of Tax Attributes 223

H. Tax Consequences of Taxable Spin-off 2241. Recognition of Gain or Loss 2242. Basis of Stock 2243. Transfer of Tax Attributes 225

I. Conclusion 225Checkpoints 227

Chapter 11 • Termination of the Corporation (Corporate Liquidation) 229Roadmap . 229A. Introduction 229B. Liquidations of Corporations Other Than Subsidiaries 230

1. Liquidating Corporation's Tax Consequences 230a. Gain or Loss on Distribution 230

CONTENTS

b. Liabilities 230c. Loss Limitations 231d. E&P Account 234

2. Recipient Shareholder's Tax Consequences 234a. Gains and Losses 234b. Basis for Property Received 234c. Holding Period for Property Received 234

C. Liquidations of Corporate Subsidiaries 2351. Introduction 235

a. Control Requirement 235b. Timing 236c. Plan of Liquidation 237

2. Liquidating Corporation's Tax Consequences 237a. General Rule 237b. Distributions to Minority Shareholders 237c. E&P Account and Other Tax Attributes 238

3. Corporate Parent's Tax Consequences 238a. Gains and Losses 238b. Basis for Property Received 239c. Holding Period for Property Received 240d. E&P and Other Attributes 240

Checkpoints 241

Chapter 12 • Carryover of Tax Attributes 243Roadmap , 243A. Introduction 243B. Section 381 ' 244

1. Scope of the Section 2442. Acquisitions Covered 2443. Acquiring Corporation 2454. Attributes 245

C. Section 381(b) Operating Rules 2461. End of Taxable Year 2462. Date of Distribution or Transfer 2463. NOL and Capital Loss Carryovers 247

D. Tax Attributes Governed by Section 381 2471. Overview - 2472. NOL Carryovers 2483. Capital Loss Carryovers 2484. E&P Carryovers 249

CONTENTS xix

5. Accounting Methods 249E. Section 382 249

1. Comparison to Section 381 2492. Section 382 Loss Limitation 2503. Section 382 Definitions 250

a. Loss Corporation 250b. Ownership Change 250

4. Operation of Section 382 2525. Changes Made by the American Recovery and

Reinvestment Act of 2009 252F. Section 383 253G. Section 384 253Checkpoints . 254

Part Five: Taxable Acquisitions

Chapter 13 • Certain Taxable Transactions 257Roadmap 257A. Introduction 257

1. Significance of Section 338 2572. Origins of Section 338 258

B. Section 338 Terminology 260C. Qualifying for Section 338 260

1. In General 2602. Making the Section 338(g) Election 261

D. Effect of Section 338 Election 261E. Target Corporation's Tax Consequences 262

1. Gain or Loss on Deemed Sale 262a. 100 Percent of Target's Stock Acquired 262b. Less Than 100 Percent of Target's Stock Acquired 263

2. Basis for Assets Deemed Purchased 264a. Basis Attributable to Stock 264b. Election for Nonrecently Purchased Stock 265c. RedeterminationofADSPandAGUP 265

3. Allocation Rules 2654. Holding Period • 266

E Asset and Stock Consistency Rules 266G. Section 338(h)(10) Election 267

1. In General 2672. Step Transaction Issues 268

CONTENTS

H. Section 1060 2681. Introduction 2682. Applicable Asset Acquisition 2683. Asset Allocation Rules 269

Checkpoints 270

Part Six: Corporations That Share the Same Owners

Chapter 14 • Controlled Corporations and Affiliated Corporations 273Roadmap 273A. Introduction 273B. Controlled Corporations 273

1. In General 2742. Parent-Subsidiary Controlled Group 2743. Brother-Sister Controlled Group 2744. Combined Group 2765. Insurance Group 276

C. Restrictions Applied to a Controlled Group 277D. Affiliated Groups 278

1. In General 2782. Definition of Affiliated Group 2783. The 80 Percent Test 2784. Reconsolidation Following Disaffiliation 2795. Definition of Stock 280

a. Statutory Definition 280b. Regulations 280c. Good Faith Affiliation and Disaffiliation 281

6. Ineligible Corporations 282a. General Rule 282b. Exceptions 282

Checkpoints 284

Chapter 15 • Consolidated Returns 285Roadmap 285A. Introduction 285B. Consolidated Return Issues 286

1. In General 2862. Deciding to File Consolidated Returns 286

C. Consent to File Consolidated Returns 287D. Difficulty in Deconsolidating 287

CONTENTS

E. Group Remaining in ExistenceF. Computation of Income and Liability for TaxG. Intercompany Transaction Rules

1. In General2. What Is an Intercompany Transaction?3. Matching and Acceleration Rules

H. The Basis Investment Adjustment Rules1. Introduction2. Adjustments to Basis

I. Loss Disallowance RegulationsCheckpoints

Part Seven: S Corporations

Chapter 16 • Taxation of S Corporations and Their ShareholdersRoadmapA. IntroductionB. Eligibility Requirements

1. Domestic Corporation2. Ineligible Corporation

a. Insurance Companiesb. Financial Institutionsc. DISCsd. Corporations with Possession Tax Credite. Taxable Mortgage Pools

3. Permissible Types of Shareholdersa. Individualsb. Estatesc. Trustsd. Other Eligible Organizations

4. Limit on Number of Shareholders5. One Class of Stock Requirement

a. Buy-Sell and Redemption Agreementsb. Varying Interestsc. Restricted Stock

6. Corporate SubsidiariesC. The S ElectionD. Corporate Effect of S Election

1. Introduction2. Computation of Corporation's Taxable Income

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xxii CONTENTS

3. Built-in Gain Tax 3084. Tax on Passive Investment Income 309

a. Accumulated Earnings and Profits 309b. Gross Receipts Test 309c. Computation of Tax 309d. Coordination with Section 1374 310

E. Shareholder Effect of S Election 3111. Introduction 3112. Pass-Through Items 311

a. Separately Stated Items 311b. Nonseparately Stated Items 314

3. Allocation of Income and Loss 314a. General Rule 314b. Election to Close the Books 314

F. Limits on Losses • 315G. Basis in Stock and Debt 315

1. Initial Stock and Debt Basis 3152. Adjustments to Debt Basis Outside of Subchapter S 315

a. Guarantee of Corporate Debt 315b. Payments on a Guarantee 316

3. Increases to Basis of Stock in S Corporation 3164. Decreases to Basis of Stock in S Corporation 3165. Decreases to Basis of S Corporation Debt 3176. Increases to Basis of S Corporation Debt 318

a. General Rule , 318b. Multiple Indebtedness 318c. Effect of Distributions 319

H. Ordering Rules 320I. Distributions 320

1. Accumulated Adjustments Account 3202. Tax Treatment of Distributions to Shareholders 321

a. Distributions with No E&P 321b. Distributions with E&P 322

3. Timing of Distributions 3234. Accelerating Dividends 3235. Noncash Distributions 3246. Post-Termination Distributions 324

J. Termination and Revocation 3251. Introduction 325

CONTENTS xxiii

2. Events Causing Terminationa. Revocationb. Excess Passive Investment Incomec. Ceasing to Be a Small Business Corporation

3. Inadvertent Terminations4. Effect of Termination5. Reelection

K. Miscellaneous ProvisionsCheckpoints

Mastering Corporate Tax Checklist

About the Authors

Index

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