As will be seen in Chapter 5, where the major deviations between the corporate income tax and the individual
income tax are discussed, the most vexing tax problems in the use of the corporation do not arise in determining its income tax liability. The principal difficulties arise, rather, because (1) distributed corporate income is taxed to the shareholder, while undistributed income is not; (2) an exchange of stock or securities by the investor may or may not be an appropriate occasion for recognizing gain or loss, and a sale may be a dividend in disguise; and (3) transactions between a corporation and its shareholders and affiliates often are not conducted at arm's length. The succeeding chapters of this book address in detail the ramifications of these problems, but a few words of introduction may be in order. But 2003 legislation lowering the top rate on dividends and capital gain to 15 percent effected a profound (albeit temporary) change in the corporate-shareholder relationship which resonates throughout this work. 10.1 A return to higher rates, however, seem increasingly likely.
¶ 1.03 Distributed Corporate Income
Although the accumulated income of C corporations is not subjected to the individual income tax, the other face of this coin is that income distributed as dividends to shareholders of C corporations is taxable to them as ordinary income. This characteristic of the federal tax system²the so-called double taxation of distributed corporate income²must be addressed, since corporations exist to feed their shareholders. It can be illustrated by assuming a single tax rate of 30 percent applicable to both individual and corporate income, applied first at the corporate level to business income of $500,000, and then to the corporation's after-tax income of $350,000 ($500,000 less corporate income tax of $150,000) when distributed in the form of dividends to the shareholder. The result is an after-tax residual of $245,000 ($350,000 less individual tax of $105,000) for the shareholder, as compared with an after-tax amount of $350,000 had the same business been conducted as a proprietorship or partnership. This is not the place for an extended discussion of the equity and economic consequences of imposing independent taxes on the C corporation and its shareholders, but surely the real issue is not whether in legal form there are two separate entities. 22 For many closely held enterprises, which can choose between the C corporation and either the S corporation, the proprietorship, or the partnership as a form for doing business, the Code offers an election; some find it no more, or even less, expensive to follow the double tax route. For those that must use the C corporation for business reasons, the real issue is not the validity of the label ³double taxation´ but whether corporate earnings are overtaxed (or undertaxed) in relation to other types of income and, if they are overtaxed, whether there are compensating tax or other advantages to the C corporation form. These matters are further discussed later in this chapter. 23 Of course, some closely held enterprises avoid double taxation by an election under subchapter S, which subjects the corporation's earnings, whether or not distributed, to taxation only at the shareholder level. 24 Thus, the owners of the enterprise obtain the nontax advantages of operating in corporate form (such as limited liability) without subjecting the business profits to taxation at the corporate level. As noted previously, another common method of mitigating the potential burden of double taxation on distributed corporate income is the payment of salaries to shareholder-employees of C corporations. 25 Since the corporation can deduct these amounts as business expenses under § 162, this portion of the business profits is taxed only at the shareholder-employee level. For many closely held businesses, salaries to shareholderemployees afford a method of withdrawing business profits in large part or even in their entirety, with the result that in these instances the federal income tax liability is about the same as it would be if the enterprise had been conducted as a proprietorship or partnership. Such an arrangement to avoid double taxation of distributed corporate income is feasible, however, only to the extent that the compensation paid to the shareholder-employee can be justified as ³a reasonable allowance«for personal services actually rendered´ so as to be deductible under § 162; if the amount is excessive, it can be disallowed as a corporate deduction pro tanto. 26 Although the possibility of disallowance is always present, especially if earnings fluctuate widely and shareholder salaries are adjusted from year to year to exhaust the earnings, many closely held corporations are able to pay out their entire business earnings, give or take a few dollars, year after year. Other methods by which shareholders may withdraw funds from the corporation in a form that will give rise to a deduction at the corporate level are: 1. Interest on shareholder loans to the corporation;
2. Rent on property leased by the shareholders to the corporation; and 3. Royalties on patents owned by the shareholders and used by the corporation under licenses. As with salaries, however, these payments must be justified as bona fide arrangements rather than as disguised dividends. 27 Entrepreneurs also can avoid a second round of taxation by eschewing distributions of the corporate earnings until the stock can be exchanged for the stock of a publicly held corporation in a tax-free exchange 28 or, as discussed previously, by holding the stock of the original corporation until death, when it passes to the heirs with a new basis equal to the fair market value of the stock at that time. 29 Finally, to the extent that there is a substantial capital gains preference for individuals, as there is now and as there was before enactment of the Tax Reform Act of 1986, the double taxation of corporation income can be greatly curtailed, since the shareholders can convert the corporation's undistributed earnings into cash by selling their stock and reporting the profits as long-term capital gains. For example, if individuals were taxed on ordinary income and long-term capital gains at 30 percent and 10 percent, respectively, and the corporate rate was 30 percent, business profits of $100,000 would result in after-tax income of $70,000 ($100,000 less tax of $30,000) for the corporation; if the shareholders realized this net amount by selling their stock, the tax on their long-term capital gains would be $7,000 (10 percent of $70,000), leaving them with $63,000 ($70,000 less $7,000) net after taxes as compared with $49,000 ($70,000 less $21,000) if the business profits had been paid out as dividends. If the business had operated as a proprietorship or partnership, the individual would have netted $70,000. In practice, of course, such sales are not annual events even in years when a substantial capital gains preference exists. Instead, shareholders often allow the business profits to accumulate for years or even decades so that a sale of stock reflects a long-term accumulation, including the corporation's profits from reinvesting the retained earnings. The regime, under which double taxation was often preferable to a single tax because of the rate differential, ended when the 1986 Act eliminated (temporarily, it turned out) the substantial rate differential between ordinary income and long-term capital gains and imposed a top tax rate higher on corporations than on individuals; but it was partially reinstated when Congress returned to the historic practice of taxing long-term capital gains at a lower rate than ordinary income, and raised the individual income tax rate to a level above the corporate rate. The 1997 tax legislation added an even greater preference for long-term capital gain of individuals (nearly a twenty-point spread); and 1998 legislation reduced the period for long-term treatment from more than eighteen months to more than one year. Finally, 2003 legislation reduced the top rate on capital gain to 15 percent and, even more significantly, extended that treatment to dividends for individuals as well.
¶ 3.01 Introductory
In general, a corporation does not recognize either gain or loss upon issuing its stock. 1 As for a shareholder, absent an element of compensation or some similarly intended taxable benefit, the acquisition of stock for cash even at a bargain price similarly entails no immediate tax consequences: The shareholder has made an investment on which the gain or loss will be reckoned only when he sells or otherwise disposes of the stock or when, to his chagrin, the stock becomes worthless. 2 If, however, the stock purchaser (generally referred to in this chapter as the transferor, in reference to his transfer of cash or other property to the corporation) acquires the stock in exchange for appreciated or depreciated property rather than for money, he may have to recognize gain or loss on the transaction. The transfer is a ³sale or other disposition´ of the property within the meaning of § 1001(a), upon which the transferor realizes gain or loss equal to the difference between the adjusted basis of the property given up and the value of the stock received in exchange, regardless of whether the transferee is an S corporation or a C corporation. By virtue of § 1001(c), the transferor recognizes the entire amount of the realized gain or loss unless the transaction falls within one of the nonrecognition provisions of the Internal Revenue Code. 3 Since corporations frequently issue stock for property other than cash, especially upon organization of a new corporation but also in reorganizations, the following nonrecognition provisions relating to such transactions are of great importance:
1. Section 351(a)²providing that the transferor shall recognize no gain or loss if property is transferred to a corporation solely in exchange for its stock, and if the transferor or transferors control the corporation immediately after the exchange. 4 2. Section 361(a)²providing that a corporation that is a party to a reorganization shall recognize no gain or loss if it transfers property to another corporation that is a party to the reorganization solely for the latter's stock or securities . 5 This chapter deals primarily with transfers under § 351, which need not be solely for stock, as will be discussed further below. 6 This section of the Code is of particular importance when individual proprietorships and partnerships are incorporated. It also embraces the transfer of property to a previously organized corporation by its controlling shareholders. A transfer may qualify under both § 351(a) and § 361(a) (e.g., when a corporation creates a subsidiary by transferring part of its property for all the stock of the subsidiary and then distributes the subsidiary's stock as described in § 368(a)(1)(D)). 7 Whether a transaction qualifies under § 351 is a question that may arise either at the time the transaction occurs or at some later date. When the property-for-stock exchange occurs, the applicability of § 351 is critical because it determines whether the transferor recognizes gain or loss on the transfer. The applicability of § 351, however, may be put in issue later on, when the transferor sells the stock received for the transferred property or when an S corporation shareholder's deduction for passed-through losses is limited by his stock basis, 8 since in both cases, the stock's basis depends on whether the exchange in which it was acquired met the conditions of § 351. If it did, the normal corollary of nonrecognition applies: The basis of the stock is the same as the basis of the property that was given up. 9 If, on the other hand, the exchange was not within § 351 (so that the transferor recognized gain or loss), the basis of the stock is its cost, 10 ordinarily the fair market value of the property given up. 11 The corporation's basis for the acquired property similarly depends, under § 362, on whether the transfer met the requirements of § 351. As a result, controversy over the application of § 351 to a given transaction may arise decades after the transaction occurred, when the stockholder ultimately disposes of the stock or when the transferee corporation disposes of the transferred property. 12 The basic premise of § 351, like that of most other nonrecognition rules in the Code, is that the transaction does not ³close´ the transferor's investment with sufficient economic finality to justify reckoning up the transferor's gain or loss on the transferred property. 13 In Portland Oil Co. v. CIR, for example, the Court of Appeals for the First Circuit said: It is the purpose of [§ 351] to save the taxpayer from an immediate recognition of a gain, or to intermit the claim of a loss, in certain transactions where gain or loss may have accrued in a constitutional sense, but where in a popular and economic sense there has been a mere change in the form of ownership and the taxpayer has not really ³cashed in´ on the theoretical gain, or closed out a losing venture. 14 The premise on which § 351 rests is in general sound, even though for most purposes the controlled corporation is treated as an entity separate from its shareholders. 15 In point of fact, however, the language of § 351 goes beyond its purpose and embraces some transfers that arguably ought to be treated as sales, because the taxpayer seems to have cashed in on the gain, either in whole or in part. 16 Thus, § 351 is not restricted to transfers by a single individual to a one-person corporation; it also embraces transfers by two or more persons to a corporation that those persons control collectively.
If A owns a patent with a cost of $1,000 and a fair market value of $10,000 and B owns land with a cost of $20,000 and a value of $10,000, and if A and B transfer their property to a new corporation in exchange for the stock of the corporation (each taking half), § 351 applies to both transfers. It might be argued that this transfer is not merely a matter of form and that A's and B's economic positions have changed sufficiently so that A's gain ($9,000) and B's loss ($10,000) should be recognized. It has long been established, however, that § 351 embraces transfers of property by two or more persons who were not previously associated on the ground that ³instead of the transaction having the effect of terminating or extinguishing the beneficial interests of the transferors in the transferred property, after the consummation of the transaction the transferors continue to be beneficially interested in the transferred property and have dominion over it by virtue of their control of the new corporate owner of it.´ 17 While in many cases the transferors of property to a controlled corporation ³continue to be beneficially interested in the transferred property,´ sometimes the transferor's interest is so attenuated that economically the transaction can hardly be regarded as a mere change of form. For example, if the owner of a corner grocery store transfers his assets to a newly organized corporation for 0.01 percent of the stock, and a national grocery chain simultaneously transfers assets in exchange for the other 99.99 percent of the
02 Transfer of Property ¶ 3. Moreover. The transferor or group of transferors must be ³in control´ of the corporation immediately after the exchange. the transferor's basis for the stock received is the same as the transferor's basis for the property transferred. The transfer must be solely in exchange for stock in such corporation. If these requirements are met. these are its major requirements: 1. which would have been recognized by the individual.´ This is hardly true. (1) the transferor or transferors recognize neither gain nor loss on the exchange. the individual holds the stock and the corporation holds the property with the same basis that the property formerly had in the hands of the transferor. Except for the three specific exclusions found in § 351(d) (relating to services. the cost of deferral under § 351 is that gain or loss accruing during the individual transferor's ownership is escalated from the one-tier tax treatment of individuals to the twotier corporate regime.g. and costly.02 In General: Cash and the Transferee's Stock
Section 351 provides that no gain or loss shall be recognized if property is exchanged solely for stock of a controlled corporation. complicated.
¶ 3. the nonrecognition rule of § 351 still can apply in part. the national company certainly continues to be ³beneficially interested in the transferred property. as it has successfully done in analogous transactions falling outside the spirit of the law. This is one of the features making life in the subchapter C lobster pot 22 confining. 18 Fortunately for the tax adviser. 2. In short. however. and most transactions seeking to qualify for nonrecognition under § 351 are relatively straightforward. 19 These basic rules create an anomaly in subchapter C's two-tier tax regime. however. If the transaction fails the § 351 requirements only because the transferors receive other consideration (so-called boot) in addition to stock. which is ordinarily taxed only to them. 24 A newly organized corporation almost always needs cash for working capital. 26 The Service has ruled that when § 351 applies to such an exchange. under which corporate income is ordinarily taxed first to the corporation and a second time to the corporation's shareholders when distributed to them²a double tax result that contrasts with the treatment of income realized by individuals. 21 Thus. the Service might seek to tax his gain. each corporation holds the other corporation's stock with a zero basis. (2) under § 362.. 27
. whereas but for the § 351 exchange. and 3. and accrued interest owed by the corporation). Although his part of the transaction fits snugly within the letter of § 351. and (3) under § 358. § 351 alters the treatment of gains and losses on appreciated and depreciated property transferred by individuals to corporations. and for a compelling reason.´ 23 but the absence of a definition ordinarily has not been troublesome. each has a gain (or loss). its own stock seems to constitute property for purposes of § 351. One or more persons must transfer property to a corporation. of the corner grocery store owner. if one of the transferors is a corporation (e. who intends to forget his customer's complaints about his pork chops and plans instead to devote more time to reading the Wall Street Journal. is usually simple and painless. the statute does not define the term ³property. even though entry. where a parent exchanges its newly issued or treasury stock for stock of a controlled subsidiary). certain debt of the corporation. as defined by § 368(c). there would have been only a single gain or loss.corporation's stock. It is clear that ³property´ includes money under § 351. As for the details of § 351. If § 351 did not include the transferors of cash in the control group²the group of transferors who must control the corporation immediately after the exchange 25 ²the section would either lose much of its usefulness or invite evasion in the form of a transfer of cash in an allegedly independent transaction after the other assets had been transferred under § 351. since after a § 351 transfer. marginal cases of this type are relatively rare. the transferee corporation takes over the transferor's basis for the property it receives. thanks to § 351. 20 Cutting across this distinction between corporate and individual income. if the individual sells the stock and the corporation sells the property.
30 The function of this restriction is to require the person providing the services to report currently (in most cases) the value of stock received as compensation for services. their exchange of property for stock qualifies under § 351. The regulations treat such a transaction as if (a) the corporation had issued all the stock to the proprietor in exchange for the assets of the business and (b) the proprietor had then used part of the stock to pay his debts or to make the gift. however. 34 If. the property transferred by the service provider is of nominal value. all of the stock received is counted in determining whether the group of property transferors has control of the corporation.A shareholder's own note to the corporation should be property for purposes of § 351. A and B received 80 percent or more of the stock and C received 20 percent or less. in the same transaction. receives 22 percent of the stock for services rendered to the corporation. 38 although the assignment of income doctrine might apply.´ as defined by § 368(c) for purposes of § 351. Instead. even though the corporation at the same time issues stock for services to one or more other persons. serving merely to camouflage the true nature of the transaction. The disqualification of services for purposes of § 351 probably does not apply to stock issued for property that was. however. the property transfer does not qualify under § 351. 33 Moreover. however. 43 It is possible that such a transaction might be structured (or
. if a person who transfers property in exchange for stock also receives. in which event none of the stock received by C would count toward control and § 351(a) would not apply to A. the property exchanges would qualify. 42 the proprietor will recognize gain or loss on the difference between the amount of the debt and the adjusted basis of the stock. it is likely that the existence of control will be tested by reference to the facts immediately after the stock is issued.02 Services and Assets Created by Services
If A and B transfer property to a newly organized corporation for 78 percent of the corporation's stock. Moreover. with the effect of taxing the assignor. § 351(d)(1) provides that stock issued for services rendered to or for the benefit of the issuing corporation is not considered issued for property. If § 351 applies to the transaction. The stock received by C for services would produce taxable income. such as one of the transferors of property. 36 Disqualification under § 351(d)(1) of stock issued for services assumes that the services were rendered to or for the benefit of the issuing corporation. however. 41 If the proprietor in such a case is regarded as paying his debt to the employee with stock. earned by the transferor by performing services for others. is not automatically cast out of § 351 merely because the corporation also issues stock for services. if the proprietor gets less than 80 percent of the stock. 32 If. additional stock in exchange for services. 31 An exchange of property for stock. 39 In a more common transaction. not even the stock actually received for property will count toward control. B. with a possible exception for services that were merely ancillary to the § 351 property transfer. 35
¶ 3. however. 28 The first of the three § 351(d) exclusions mentioned previously 29 is found in § 351(d)(1). the proprietor's stock basis will be his historic basis in the transferred property. if A and B received 78 percent of the stock for property and C received 22 percent for a combination of services and property. the transfer will not qualify unless it can be established that issuing the rest of the stock to the employee or donee (who transfer no property) is not an integral part of the incorporation event. and he may both recognize gain or loss on the stock transfer and be allowed a deduction for compensation paid. the property transfers would qualify unless C's transfer of property was nominal in amount or was merely a sham designed to support a claim by A and B for nonrecognition of gain or loss. they are in control. If the corporation issues stock simultaneously to the proprietor in exchange for his property and to his employee or donee. in turn. and C. the effect of § 351(d)(1) is that a person receiving stock in exchange for services cannot be counted in determining whether the transferors of property are in control of the transferee corporation immediately after the exchange. taking part of the stock himself and directing that the rest be issued to an employee as compensation for services performed in years past or to a relative as a gift. or C . because the transferors of property (A and B ) have less than 80 percent of the stock and hence do not have ³control. Thus. an individual proprietor may incorporate his business. but the Tax Court has refused to count the shareholder's obligation for basis purposes. 37 The transaction takes on another complexion if the services were performed for someone else. rather than reporting capital gain when and if he or she sells the stock. As interpreted by the regulations. If. as part of the same transaction. 40 The proprietor's transfer qualifies under § 351 if he retains at least 80 percent of the stock ³immediately after´ the exchange.
Frazell is a graphic example of this difficulty.02 Debt of the Corporation
Sometimes the holder of a corporation's debt obligations transfers the obligations to it in exchange for its stock. professional goodwill. and recognition as to interest accrued thereafter. open-account indebtedness).351-1(a)(2). 45 US v. in connection with transfers of know-how. trade secrets.
¶ 3. that the transfer of protectible property interests will qualify unless ³the information transferred has been developed specially for the transferee. Example (3) indicates that that alternative assumed that the stock was issued for services performed for the corporation. however. hence. of course. the debt does not qualify as property by virtue of § 351(d)(2). 52 the transferor must recognize any market discount accrued on the transferred debt. and so forth. and the taxpayer received 13 percent of the corporation's stock free of any contingency. 53 If. or for some combination of these reasons. the Service has been vigilant to guard against potential abuses. whether the transaction is an ³exchange´ within the meaning of § 351. The meaning of the second alternative is ambiguous because the court's citation of Regulations § 1. any interest thereon is denied property status by § 351(d)(3) if it accrued on or after the transferor's holding period for the debt. 46 In that case. broadly to include such commonly encountered intangibles as legally protectible industrial know-how. 48 Since § 351 was intended to permit the tax-free incorporation of going businesses. trade names.02 Accrued Interest
Even if a debt is evidenced by a security and can therefore qualify as property under § 351(d)(2). and that it then distributed stock to the taxpayer as vested taxable compensation. Shortly before this interest was to vest in (and be recognized as compensation by) the taxpayer. The court held that the value of the stock measured the taxable compensation for the taxpayer's prior services to the partnership either (1) because a partnership interest of the same value vested as taxable compensation immediately before the § 351 transfer to the corporation or (2) because the taxpayer received the stock in lieu of the vesting of the partnership interest. 54 This exclusion evidently is intended to permit open-account creditors to claim an immediate bad-debt deduction even though they receive some of the debtor's stock.characterized) as a nontaxable transfer of property by the proprietor in exchange for stock and an assumption of the proprietor's indebtedness to his employee by the corporation. The second alternative might be explained by the view that the taxpayer was not a transferor of anything in the exchange. 49 The Service has stated. the courts generally have interpreted ³property. Thus. however.. the obligations are not evidenced by securities (e. 51 and in appropriate cases the Service could rightly treat an alleged transfer of property as a device. it may be difficult to determine whether a corporation issues stock for services performed in the past for one of the transferors. for services performed on behalf of the corporation incident to the corporation's organization. 55 Conversely. 47 The transfer of assets created by a transferor's personal efforts often involves two related tax issues: (1) whether a transaction should be characterized as a transfer of property owned by the transferor for stock or instead as a payment of stock for services in creating a corporate asset. to compensate the transferor for past services or to convert an analogous income item whose sale would produce ordinary income into a block of stock in order to qualify it as a capital asset upon sale. Since the transferor can recognize either
. the contract was terminated. however. a transfer for stock of debt evidenced by a security debt with accrued interest can result in nonrecognition treatment as to the principal plus the interest that accrued before the transferor acquired the debt. 44 In practice. the partnership's assets were transferred to a newly created corporation.´ as used in § 351. and it seems that the court was motivated by the fact that the vesting (and.
¶ 3. followed by a payment of the debt by the corporation through issuance of the corporation's stock to the creditor. The decision did not press that point. the taxpayer contracted to receive a contingent 13 percent interest in the income from oil properties owned by an oil partnership for performing geological services. as an incentive (or reward) for the future performance of services for the corporation. that the partnership transferred its assets for stock in the § 351 exchange. this provision could cause a transferor that had purchased a nonsecurity debt at a discount to realize and recognize gain on later exchanging it for stock of the debtor corporation with a value exceeding the transferor's adjusted basis for the debt.´ in which case the stock may be treated as received for services.g. 50 In granting rulings. normal recognition) of the compensation occurred simultaneously with the putative § 351 transaction. and (2) if the former characterization is accepted. Although the obligations themselves qualify as property under § 351. in whole or in part. employment contracts.
gain or loss, it would seem that the stock received would be allocated pro rata to the two portions of debt to determine the amount recognized. As discussed later in this chapter, the courts have reached similar results in certain situations involving the midstream transfer of so-called income items in exchange for stock of a controlled corporation.
¶ 3.03 Exchange for Stock: Problems of Classification ¶ 3.03 ³Exchange´ Requirement
By referring to transfers of property in ³exchange´ for stock, § 351 arguably appears to incorporate the similar requirement of § 1222 that property must be transferred in a sale or exchange to qualify for capital gains treatment. 57 Disputes about whether the transfer qualifies as a sale or exchange (or should instead be classified as a ³license´ or other arrangement) have arisen most often in the case of assignments of intangibles (e.g., patents or technical information) to a controlled corporation, where the failure to assign all substantial rights in the property may cause the transaction to be treated as a license rather than an exchange. To avoid this treatment, the transfer must encompass the exclusive rights to the use, exploitation, and disposition of the property within a designated area for the foreseeable economic life of the property. 58 The government's view that the requirements for a § 351 exchange are as stringent in all respects as those for a capital gain, however, has not fared well in the courts. Thus, nonrecognition has sometimes been accorded to a transfer even though the transfer would not have been treated as a sale or exchange for capital gains purposes. 59 Treasury proposes to follow DuPont and allow a transfer of less than all rights to intangibles as a good § 351 transaction, but also would require basis to be allocated between the retained and transferred rights. 60 If the transaction extinguishes the transferor's property rights, it may not constitute a § 351(a) exchange but instead be merely a § 1001(a) disposition, so that gain on the transaction would be taxable currently as ordinary income. The government, however, failed in an attempt to apply this rationale to a stockholdercreditor's collection of a debt by accepting additional stock from the debtor corporation, and has acquiesced in the court's conclusion that the conversion of debt into stock can qualify as an exchange. 61 Although the term ³exchange´ usually implies a voluntary or consensual transaction, the Service has ruled that it embraces the mandatory exchange of stock under the laws of states that require the shareholders of a target corporation to accept an acquiring corporation's stock if enough of them vote in favor of the takeover. 62
¶ 3.03 Stock
Section 351(a) permits the tax-free transfer of property to a controlled corporation only if the transfer is ³solely in exchange for stock in such corporation.´ This requirement is designed to ensure that the transferor will retain a continuing equity interest in the transferee corporation so as to justify nonrecognition of the gain or loss that is realized upon the exchange. In the absence of such a continuing interest, the transaction constitutes a sale, to which § 351 would not apply. 63 The regulations have long stated flatly that stock rights and stock warrants do not qualify as ³stock.´ 64 The inspiration for this statement may be Helvering v. Southwest Consol. Corp., holding that warrants are not ³voting stock´ within the meaning of § 368(a)(1)(B), relating to corporate reorganizations. 65 Perhaps potential equity interests such as stock rights and warrants should not be taken into account in determining under § 351 whether the transferors of property are in control of the corporation immediately after the exchange; 66 but if the transferors do have control, there seems to be no good reason for disqualifying from § 351 a transfer of property in exchange for stock rights or warrants or for treating the rights or warrants as boot. A Tax Court case accepts this view with respect to nontradable contingent rights to receive additional stock. 67 While this position seems equally applicable to rights and warrants, the Service views tradable rights as beyond the pale. 68 The courts have held that a constructive stock issuance occurs for purposes of § 351 when a shareholder who owns all the stock of a corporation makes a contribution to the corporation's capital. This species of constructive ³stock´ is discussed below.
¶ 3.04 ³Stock or Securities´: Prior Law
Before 1989, § 351 allowed persons transferring property to a controlled corporation to receive both stock and ³securities´ 70 tax-free, although the securities were not taken into account in determining whether the transferors had ³control´ of the transferee within the meaning of § 368(c). 71 Congress withdrew this lenient treatment of securities in 1989 because it permitted a transfer of appreciated property to qualify for nonrecognition of gain even though it was tantamount, in whole or in part, to an installment sale (but did not meet the requirements of § 453) 72 and also because it was inconsistent with the rules governing corporate reorganizations and divisions, under which securities can be received tax-free only if the taxpayer surrenders an equal amount of the corporation's securities. 73 As a result of the 1989 disqualification of securities, they now constitute boot when issued in a § 351 exchange. Pre-1989 law is now old, but it is not yet cold: It continues to govern the basis of the stock and securities received by the transferor in pre-1989 transactions, as well as the basis of the property received by the controlled corporation. 74 Moreover, by treating securities received by the transferor as boot in a § 351 exchange, current law on occasion requires purported debt to be analyzed to see if it should be recharacterized as equity, 75 in which event it is tantamount to stock, not boot.
¶ 3.05 ³Solely in Exchange´: The Receipt of ³Boot´ ¶ 3.05 Basic Rule
Section 1001(c) provides that taxpayers must recognize all gain or loss realized on the sale or exchange of property, ³except as otherwise provided.´ Section 351(a) provides that no gain or loss shall be recognized if property is transferred to a controlled corporation ³solely´ in exchange for its stock. If the transferor receives not only stock (nonrecognition property) but also money or other property (³boot´) in the exchange, § 351(b) comes into play and requires that gain (but not loss) must be recognized to the extent of the fair market value of the boot, but not in excess of the amount of the transferor's realized gain under § 1001. 76
If taxpayer A transfers property with an adjusted basis of $10,000 and a fair market value of $50,000 to a controlled corporation in exchange for stock worth $30,000, cash of $10,000, and other property with a fair market value of $10,000, A's ³amount realized´ under § 1001(b) is $50,000 and A's realized gain under § 1001(a) is $40,000, but only $20,000 of the gain is recognized under § 351(b). The computation is as follows: 1. Amount realized under § 1001(b): a. Stock $30,000 b. Cash (boot) 10,000 c. Other property (boot) 10,000 ------d. Total $50,000 2. Less: adjusted basis of property transferred 10,000 3. Gain realized under § 1001(a) $40,000 4. Gain recognized (line 1b plus line 1c, or line 3, whichever is less) $20,000 -------
If the adjusted basis of the property (line 2) were $45,000 instead of $10,000, the gain realized would be only $5,000, and A would recognize this amount under § 351(b). If the adjusted basis of the property were
more than $50,000, there would be a realized loss under § 1001 but by virtue of § 351(b)(2), A could not recognize the loss despite his receipt of boot. 77
¶ 3.05 Boot and Multiple Properties
If the property transferred in the previous example consisted of two assets (land and a building), each having an adjusted basis of $25,000, the building having a fair market value of $5,000 and the land having a fair market value of $45,000, there would be no realized gain if the adjusted bases of the two assets were combined on line 2. While neither the Code nor the regulations prohibit such an aggregation of basis, the Service has ruled that each asset should be considered separately.Proposed regulations issued in January 2009 codify the principles of this ruling. 77.1 Thus, there would be a realized gain of $20,000 on the land and a realized loss of $20,000 on the building. 78 The transferor would not recognize the realized loss by virtue of § 351(b)(2), and the amount of the realized gain to be recognized under § 351(b)(1) would depend on the method used to allocate the stock, cash, and other property received between the land and building. If the consideration received is allocated to the assets in proportion to their relative fair market values (which the Service considers to be the right approach, and now so do proposed regulations). ), 79 the land accounts for nine tenths of the stock, cash, and other property, so that the $20,000 of realized gain on the land is recognized only to the extent of its share of the boot ($18,000), and the transferor receives $2,000 of boot tax-free. If the exchange agreement explicitly adopts its own method of allocating the consideration to be paid for the transferred property (e.g., assigning stock exclusively to the appreciated property and assigning the boot exclusively to assets on which there is no realized gain), is the agreed allocation controlling? In view of the non-arm's-length character of the average § 351 transaction, this does not seem to be a very promising gambit; but if the allocation serves a business purpose and is free of self-dealing because there are several independent transferors, perhaps it will pass muster. 80 Another possibility in this area is a tax-free § 351 exchange of the appreciated property and a separate sale or exchange of the depreciated property for the boot. If prearranged, however, the two transfers may be amalgamated for tax purposes under the step transaction doctrine. 81
¶ 3.05 Timing and Character of Boot Recognition
As noted earlier, the pre-1989 possibility that property transferors could receive the corporation's debt securities in a § 351 exchange for appreciated property and report their gain periodically as the debt was collected without qualifying under the installment-sale rules of § 453 was one of the reasons Congress removed securities from nonrecognition treatment under § 351(a) in 1989. 82 Therefore, it is likely that § 453(f)(6) now requires application of the installment-sale rules to any corporate debt received as boot. 83 When the transferor must recognize gain because it has received boot in a § 351(b) exchange, the character of the asset transferred usually determines (under the asset-by-asset approach discussed above) whether the gain is ordinary income or capital gain and, in the latter case, whether it is long-term or short-term gain. 84 If the property transferred qualified (or, in the hands of the transferee, will qualify) for depreciation, amortization, or certain other accelerated deductions, the capital gain component of the transferor's recognized profit may be converted, in whole or in part, into ordinary income by several recapture and similar remedial provisions. The most important of these provisions are as follows: 1. Section 1239²providing that gain recognized on the transfer of property to a corporation that it can depreciate must be treated as ordinary income if more than 50 percent of the value of the transferee corporation's stock is owned directly, indirectly, or constructively by the transferor (the same control test as for § 267(a)). 85 2. Section 1245²providing for the recapture of the transferor's post-1961 depreciation as ordinary income if the transferor recognizes gain on a § 351 transfer of certain types of property (other than real property). 86 3. Section 1250²providing for the recapture as ordinary income of post-1963 depreciation on similar transfers of real property, but in more limited circumstances.
However. 318. (5) how will it be treated under § 338. § 351(g) has proved to be a minor irritant at most (and a useful planning tool for those who want its provisions to be invoked). the corporation would be able to step
. (6) will it constitute boot for § 368(a) definitional purposes if it votes. 87 Proposed legislation in the Administration's budget bill of 1995 88 classified certain ³debt-like´ preferred stock as ³boot´ for purposes of §§ 351 and 356. under the reorganization provisions..06 History
On the sale or other disposition of property. however. if any. thus resulting in taxable gain but no loss to the recipient of such stock. (4) how will the stock be treated under § 332 and § 337.e. (2) subject to a holder put to the issuer (or to a § 267(b) related affiliate). and ³capped´ on the upside (i. and (7) who on earth ever thought of such a disruptive and unnecessary provision? The provision passed in 1997. the 1997 version states that these regulations will be prospective only. Similarly. Among the many unanswered questions spawned by this unfortunate foray into subchapter C are the following: (1) what impact. the Treasury Department recognized that a host of earlier incorporations and reorganizations that were thought to be tax-free when consummated might.. the transferee's assumption of the transferor's liabilities (or the transferee's taking the property subject to liabilities) ordinarily requires the transferor to treat the amount of the liability as if it were cash received in the amount of the debt when computing gain or loss realized and recognized. in fact. the transferors could step up the basis of the stock or securities received to market value (to reflect the gain that should have been. 92 but in the income tax's early years. Dutch auction preferred). 306. the stock must either be (1) mandatorily redeemable (by the issuer or a related party). it has no significant participation in growth). reported). and we are stuck with it.1 narrowed the definition of ³preferred stock´ in § 351(g)(3)(A) by providing that preferred stock will not be treated as participating in corporate earnings and growth (and thus will be preferred stock) unless there is a real and meaningful likelihood of actually participating in earnings and growth. (2) will this stock count in determining § 368(c) control.The foregoing provisions come into play only if the transferor receives boot for the affected property. however. 93 Immediately after winning this decision. Several exceptions to boot treatment were provided for various recapitalization exchanges. although the Conference Report makes clear that this boot-tainted stock is merely ³equity boot´ for gain recognition purposes under § 351(b).
¶ 3. or general continuity of interest limitations. will such stock have under § 1504(a). since virtually all § 351 and reorganization exchanges of going businesses involve a shifting of responsibility for the enterprise's existing debt. (3) will it qualify for the § 243 dividends-received deduction. (3) subject to a call by the issuer (or a related party) that is more likely than not to be exercised. 91. have been partially taxable because of the assumption of liabilities. it was assumed that such a transaction would not require the transferor to recognize gain under § 351 or the analogous reorganization sections. but it is also possible for various depreciation and business credit capture rules to be triggered by § 351 exchanges that do not include boot. Hendler. 90 and regulation authority was granted to provide for § 453 treatment and for the consequences under other Code sections (e.g. and 368(c)). but was not. US v. Preferred stock subject to boot classification treatment generally must be limited and preferred as to dividends. and (4) one that has a floating dividend rate (e. at least in some circumstances..05 Debt-Like Preferred Stock as Boot
¶ 3.2 On the whole. In an important case involving a reorganization. If correction of pre-Hendler errors was barred by the statute of limitations and if the doctrine of estoppel did not apply. and that its status as ³stock´ continues for all other purposes unless and until prospective regulations under § 351(g)(4) change its status as such. the Supreme Court held that the assumption and payment by a transferee corporation of the transferor's liability constituted boot to the transferor. and thereby reduce their gain (or increase their loss) on a subsequent sale of the stock or securities.g. 91 The American Jobs Creation Act of 2004 (the 2004 Jobs Act) 91. 89 In addition. as explained later in this chapter.06 Assumption of Liabilities ¶ 3. §§ 304.
in the capacity of a surety). if the transferor's liability is not discharged by payment or novation at the time of the exchange. is $10. a later payment of the debt by the transferee ought not to be treated as taxable income to the transferor. 96 Thus. and thereby increase its depreciation deductions or reduce its gain (or increase its loss) on disposing of the property. 101 Otherwise. 102 If. is a reduction of the basis of the stock received by the amount of the debt. recourse debt secured by transferred property if the transferee agrees to pay (whether or not the transferor is released). Moreover. § 357(a) ought to be construed to cover such situations as well as a discharge of the liability that is simultaneous with the exchange. but the courts have been chary about reopening an area that Congress attempted to put to rest. This includes nonrecourse debt secured by transferred property. assuming no changes in value. under current law.000 will be taken into account when he disposes of the stock (with a fair market value of $70. unless the transferor remains liable to pay that debt (as between the transferor and the corporation) and the transferee pays the fair unencumbered market value to the transferor for the property.000 and a gross value of $100. however.000. A's realized gain of $60.000). thus frustrating the purpose that prompted Congress to overrule the Hendler decision by enacting § 357. because the property has a basis in its hands of only $40. since § 357(a) provides that the assumed liability is not boot under § 351(b).
Section 357 covers liabilities that are assumed by the transferee corporation even if the transferor is not thereby discharged. and hence is not boot under § 351(b). under § 358 (property basis of $40. is recognized only if and to the extent that he receives money or other property in exchange for the transferred property. and many incorporation transfers would become partially taxable. 97 Since § 357(a) is concerned primarily with reversing the earlier rule that the discharge of a debt discharged in an exchange is treated as cash received (which Hendler treated as taxable boot). less A's $40.000. taken into account in computing the amount of gain realized. Congress responded with the statutory principles that are now embodied in the general rule of § 357(a) and the exception of § 357(b).000 (the value of the X stock plus assumption of A's debt. even though the corporation assumes or acquires property subject to liabilities. 98 The general rule of § 357(a) also includes recourse debt that the corporation does not formally assume.000. but X's basis for the property will be $40. The transferor's gain. the corporation later pays a debt of a transferor that the corporation did not assume or that was not secured by property transferred to the
.000 less the assumed liability of $30. however.000) to controlled corporation X in exchange for stock worth $70.000 (the net value of the property) and X's assumption of the mortgage. rather than $40.000. The statutory language leaves something to be desired in the way of clarity. 94
¶ 3. The upshot was that in 1939 the Treasury Department urged Congress to enact legislation that would relinquish the victory it had just won in the Hendler case by providing that the transferee corporation's assumption of liability (or its receipt of property subject to a liability) in a § 351 exchange would not constitute boot to the transferor. as explained below. he does not recognize discharge-of-indebtedness income. therefore.000. the utility of § 357 would be undermined.000 under § 362(a)(1). the immediate recognition of gain when liabilities were transferred in otherwise tax-free § 351 and reorganization exchanges would greatly impair the usefulness of these nonrecognition provisions.000 but a basis of only $10. as it would have been without a debt assumption. however. but if he is.
A transfers property with a basis of $40.06 General Rule
The general rule of § 357(a) provides that the transferee corporation's assumption of liability or its acquisition of property subject to a liability is not treated as money or other property. Indeed.000) and the transferee corporation will similarly have a potential gain of $60.000 (but subject to a mortgage of $30. Moreover. the incorporation of encumbered property or of the assets and liabilities of a going business ordinarily qualifies as a tax-free transaction under § 351(a). and unsecured recourse debt that the transferee agrees to pay (whether or not the transferor is released). A realizes gain of $60.up the basis of the property received to reflect the gain that the transferor should have reported.000 basis for the property). A's basis for his stock.) 95 The tradeoff for excluding the liabilities from the amount of boot received.000 despite its gross fair market value of $100. since the Hendler case itself involved a prompt (and no doubt prearranged) payment of the assumed liabilities by the transferee corporation. it is clear that any debt covered by that rule would be covered by § 357(a). but A's recognized gain is zero. $100. and the transferor remains liable (ordinarily. Thus. The operation of § 357(a) required both a liability and an assumption of (or taking subject to) the debt. (The liabilities assumed or to which the property is subject are. 100 even if he is the former debtor.
The legislation finally passed in 1999. 111 Moreover. even borrowing on the eve of a transfer under § 351 is not necessarily fatal. 114
¶ 3. 109 In practice. 112 The Treasury's 1999 revenue-raising proposals would tighten the anti-abuse rule of § 357(b) in two ways: (1) They would delete the requirement that the tax avoidance test applies only to the § 351 exchange transaction and (2) they would change the principal purpose to a principal purpose standard. while the stock basis is decreased by the total amount of the debt under § 358(d). On the other hand.e. ³taking into consideration the nature of the liability and the circumstances in the light of which the arrangement for the assumption or acquisition was made. rather than the exception of § 357(b).´ Section 357(b)(1) goes on to provide that if an improper purpose exists with respect to any liability.. For the transferor. 104 Versions of this legislation passed one house of Congress several times in 1998. 105 But proposed regulations issued in March 2005 105. or (2) the value of the transferee's assets does not exceed the amount of its liabilities immediately after the transaction (i.corporation. trade obligations. the obligations.e.06 Exception for Tax-Avoidance Transactions: § 357(b)
¶ 3. it appears that the principal purpose of the taxpayer«was a purpose to avoid Federal income tax on the exchange.1 provide that stock will not be treated as issued for property under § 351 if either (1) the value of the transferred property does not exceed liabilities assumed in the transaction. 113 As discussed below. was not a bona fide business purpose. the courts examine both the transferor's purpose for incurring the liability (particularly if the debt was incurred shortly before the assumption) and the business justification for the corporation's assumption. the regulations provide that the income tax returns of both the transferor and the corporation for the year of the exchange must state ³the corporate business reason´ for the assumption of any liability (emphasis added). 103 The Treasury's fiscal 1999 budget proposals would ³clarify´ § 357 by eliminating the distinction between ³assumption of´ and taking ³subject to´ liabilities under § 357. § 357(b) carves out an exception to the general rule of § 357(a): The assumption or acquisition is to be treated as money received by the transferor (i. there is not an exchange of net value).06 Exception for Liabilities in Excess of Basis: § 357(c)
. if § 357(b) applies. since the taxpayer may be able to establish valid business reasons for doing so. as boot under § 351(b)) if. 110 The tax-avoidance approach of § 357(b) probably would condemn not only the hypothetical case of a liability created just before the § 351 exchange in order to wring some cash out of the transaction. or take property subject to. the basis of the stock received is increased by the amount of gain recognized under § 358(a)(1)(B)(ii). at the time of the § 351 exchange. and the like arising in the ordinary course of business. alimony. it might tempt the transferor of appreciated property under § 351 to borrow against the property just before the exchange. when the taxpayer has the burden of proof. the general rule of § 357(a).. with the intention of keeping the borrowed funds and causing the corporation either to assume the liability or to take the property subject to the liability. the corporation's assumption of the liability or acquisition of the property subject to the liability would not be treated as boot. but if the general rule of § 357(a) were applicable. or«if not such purpose. customers' deposits.2 Although the principle of § 357(a) makes good sense as a general rule. 106 Moreover. but also the assumption by a transferee corporation of personal obligations (grocery bills. rent. 107 he or she must negate both taints (tax avoidance purpose and a lack of a bona fide business purpose) by ³the clear preponderance of the evidence. but never at the same time. the total amount of all liabilities involved in the exchange is considered money received by the taxpayer. is able to pay such obligations himself but chooses instead to have the transferee corporation assume. To frustrate bailout transactions of this type. 105. the regulations emphasize the point that a single bad apple spoils the entire barrel. unless there was a bona fide business purpose for such unusual action. such payment is likely to be treated as a potentially taxable distribution to the transferorshareholder. bank loans. this chain of events could be the equivalent of receiving cash boot from the corporation in exchange for unencumbered property. and so forth) that are not ordinarily taken over in a § 351 exchange. instead the extent to which a liability would be treated as assumed for § 357 purposes would be a question of fact. ordinarily should be applicable to mortgages. and this should be true even though the transferor.´ 108 Although § 357(b) focuses on the transferor's principal purpose. as in most Tax Court proceedings.
so to speak. but the mandate of § 357(c) is clear. except as this may be reflected indirectly in the value of the stock received). Under § 357(c).e. Congress crafted a more objective measure. to treat the excess debt as income. an exchange can fit within both provisions. 117 It is the Service's last clear chance.000 subject to a mortgage liability of $30. 357(b). exceeds the transferor's aggregate basis for the property transferred. or to which the transferred property is subject. A realizes gain under § 1001(a) of $60. $5. 120 In some circumstances. Section 357(c)(1) requires an accounting when liabilities exceed the basis of the transferred property because the owner has ³cashed out´ his investment pro tanto. 121 Treasury proposed to amend § 357(c) to eliminate the distinction between an ³assumption´ and ³taking subject to´ liabilities (including nonrecourse liabilities)²instead. he is already home free to the extent of the excess. 116 no matter how low the property's value may sink in the future.000 gain on the transaction above even if the value of the transferred property were only $25. while § 357(c) rests on an arithmetical computation (an excess of liabilities over basis). or (2) to tax part of the withdrawal of borrowed cash obtained from loans secured by the assets transferred. income than § 357(c). but because the exchange is a convenient time for a reckoning.000 (i. which must be recognized if the transaction has a tax avoidance element as required by § 357(b). less the property's basis) but does not recognize that gain.000). A must recognize gain in the amount of $20. and (2) § 357(b) applies only if and to the extent that the transferor realized gain.000) if he sells the stock for its market value ($40. This is true because. A will recognize the balance of his realized gain ($40. This is the amount of A's economic gain if the stock received is ignored as merely being the property in a different form. necessarily produces at least as much.000 and the transferee's assumption of the mortgage. 122
¶ 3. § 357(c). when this occurs. the exchange worsens his position by cutting off his opportunity to profit if the property grows in value.000.000 (the value of the stock received plus the liability assumed. which takes precedence by virtue of § 357(c)(2)(A). A is taxed on the excess of liabilities over basis regardless of the amount of gain realized and even if none is realized. § 357(b). Thus. as required for § 357(c) to apply. then the liabilities plus the value of the stock (and of the boot. § 357(b) is unsatisfactory because it does not result in self-assessment but operates only through audit detection of a purpose to avoid tax and assessment of additional taxes. however. at least in the case of nonrecourse debts. since the basis of the stock will have been reduced to zero under § 358(d) to take account of the liability assumed by the corporate transferee. and 357(c) both require the transferor in a § 351 exchange to take liabilities into account in computing gain. and this means that the transferor has realized a gain. 115 This exception to § 357(a)'s immunization of liabilities from the recognition of gain or loss has two principal aims: (1) to recapture the tax benefit that was enjoyed by the transferor through writing off the basis of the property faster than the purchase-money debt that created the initial basis was reduced.
A exchanges property with an adjusted basis of $10. if any) must exceed the basis by an even larger amount. indeed. This gain is recognized by § 357(c) not because the § 351 exchange itself improves the transferor's economic position (the profit has already accrued.000 for stock of a controlled corporation worth $40. The excess amount is treated as recognized gain from the sale or exchange of the property. if the liabilities exceed the transferor's basis for the transferred assets. Recognizing this limitation. which applies by selfassessment (although § 357(b) can trump it) where the aggregate debt assumed. but they are fundamentally different in two respects: (1) § 357(b) requires a judgment about the transferor's motives (with respect to both tax avoidance and business purpose). 118 A might complain about this result if there is a substantial likelihood of default by the corporation. because of § 357(a).000 and a fair market value of $70.000 less than the mortgage) and no stock was received in the transaction. while § 357(c) can apply whether the transferor realizes gain or loss.. A would recognize $20.¶ 3. and usually more. the extent to which liabilities will be treated as assumed for tax purposes would be a question of fact²and Congress finally accepted this proposal in 1999 legislation. Although the example just used to illustrate § 357(c) involves a realized gain to the transferor on the § 351 exchange. 119 As exceptions to §§ 357(a).06[a] In General
From the government's viewpoint.06[b] Reducing Excess of Liabilities Over Basis
not that the owner actually paid any tax on acquiring it. acquires a basis in the transferor's note equal to its face amount. 129 Section 357(c) can be avoided by a transfer of enough cash to eliminate any excess of liabilities over basis. 126 The Service. because the note in fact eliminates the benefit that the transferor gets from transferring property subject to liabilities in excess of basis²the very same protective job assigned to § 357(c). 123 If these tactics are not feasible. however. on the ground that a note has a zero basis in the debtor's hands. if a cash-basis taxpayer purchased small tools on credit and transferred them along with liability for the related account payable under § 351. § 357(c) could be an unexpected pitfall for cash-method taxpayers who transferred zero basis receivables for stock and an assumption of the transferor's accounts payable (such as rent). CIR (1989) that the transferee. to liabilities that resulted in the creation of (or increase in) the basis of any property. the Court of Appeals for the Second Circuit ruled in Lessinger v.´ 128 It remains to be seen whether this construction of § 357(c) will gain acceptance outside the Second Circuit's territory. the note²assuming it's bona fides²has about the same effect as a note given by the transferor to a bank or other third party before the § 351 exchange to raise cash to reduce the liabilities to which the transferred property will be subject. if this analogy is accepted. by subjecting itself to the transferor's liabilities. § 357(c)(1) applies. otherwise the liability would be disregarded under § 357(c)(3) and the transferor's temporary basis in the tools could be used to shelter other liabilities transferred in the § 351 exchange. 132 the assumption of the payables is ignored for purposes of § 357(c). Although the decision obviously puts a strain on the language of § 357(c). thus increasing the transferor's aggregate basis enough to equal the liabilities assumed or to which the property is subject. but this would not compromise its function. the court observed. that the plan does not undermine § 357(c) any more than a tax on the manufacture of assault weapons is undermined when a manufacturer shifts to the production of non-assault weapons. it is not the first time that the meaning of ³basis´ has been stretched in a good cause: we routinely treat cash as having a ³basis´ equal to its face amount. the corporation takes a carryover zero basis in such receivables under § 362(a). In the same vein. 135
. so that the excess of the liabilities over the debtor-transferor's basis for the transferred property is not diminished by his note. and it is also curious that you get a ³cost´ basis if you borrow money from a friend. 134 The § 357(c)(3) exemption is denied. ³cost´ is an odd²but long-sanctioned²phrase when applied to property acquired in a myriad of offbeat ways²including theft²on the theory that its ³cost´ is its ³tax cost. 127 Looking more to the function of § 357(c) than to its language. 133 Therefore. and since a note given by a solvent obligor in purchasing property is routinely treated as the equivalent of cash in determining the basis of the property. For example. has rejected the transferor-note route around § 357(c). and the transferor's stock basis is not increased because of the receivables or decreased under § 358(d)(2) because of the assumption of the payables.Transferors holding property subject to liabilities in excess of basis can avoid recognizing income under § 357(c) by reducing or paying off the excess liabilities before entering into a § 351 exchange. § 357(c) would lose its potency. in short. by contrast. except for a tourist's purchase of local currency in a foreign land. 131 Under current law. however. Otherwise. 124 From a financial point of view. and that this basis serves to eliminate the excess of liabilities over basis that would have existed had the note not been issued by the transferor. produced taxable ordinary income to the extent that the assumed liabilities exceeded the zero basis of the transferred receivables. although the phrase ³the basis of property shall be the cost of such property´ as used by § 1012 is an odd way of describing the acquisition of money. To be sure. 125 It is arguable.´ when the latter phrase merely means that the property is includible in gross income. since § 357(c). it seems reasonable to give it the same treatment in determining the basis of the property transferred in a § 351 exchange.06[c] Deductible Liabilities of Cash Basis Taxpayers
Liabilities of a cash basis transferor that will be deductible when paid are exempted by § 357(c)(3) from the liabilities-in-excess-of-basis principle of § 357(c). or by getting the creditors to agree to look for payment solely to them personally or to property that is not to be transferred. 130 Before the enactment of this exemption in 1978. however. the transferor would be taxed on ³a truly phantom gain. and the net income from the collection of the receivables is shifted to the corporation. a much discussed alternative is a promissory note given by the transferor to the transferee corporation: the hope is that the note will eliminate the excess of liabilities over basis on the theory that it has a basis equal to its face amount. if applied literally. but not if you borrow his car. the transferor's entire potential gain is deferred.
¶ 3. as discussed later in this chapter.
While cash-basis taxpayers are the prime beneficiaries of § 357(c)(3)(A). the excess is ³considered as a gain´ from the sale or exchange of a capital asset or a non-capital asset. the recognized gain should be allocated among the various classes of assets in proportion to their relative fair market values. must be reported as ordinary income. 145 IRS has announced an ambitious regulations project to clarify various issues under §§ 357(d) and 362(d) (and other related provisions as well) which has all the earmarks of a major undertaking. the extent to which a liability would be treated as assumed for tax purposes will be determined under all the facts and circumstances.000. and 368. 137 If more than one type of property is transferred. or (2) are delayed under economic performance occurs under § 461(h). the 1999 amendments to § 357 144 adds §§ 357(d) and 362(d) clarifying the effect of liability assumptions under §§ 357. rather than to aggregate the property transferred by all transferors. it seems appropriate to apply § 357(c) on a person-by-person basis. nonrecourse liabilities are treated as assumed by the transferee of any asset subject thereto. the theory underlying § 357(c)'s use of the total basis of all property transferred in measuring A's gain may be that the properties transferred constitute a single investment of $20. satisfy them (whether or not the transferor is released from liability). 141 Although at first it may seem strange that A can reduce his gain by transferring other property along with the mortgaged property. 146 If the stock has been
¶ 3.000 subject to a mortgage of $30. recourse liabilities would be treated as assumed under § 357 only if the transferee agrees to. or short-term capital gain according to the nature and the holding period of the transferred property. 145. satisfy. 142 Recent legislation eliminates the distinction between an ³assumption´ of liabilities and taking ³subject to´ liabilities under § 357(c). the aggregate amount of the liabilities is compared with the aggregate adjusted basis of the assets transferred.000 from which A 's total return so far amounts to $30.06 Effect of Default by Transferee Corporation
. therefore.06[e] Computation of Amount of § 357(c) Gain
In determining whether § 357(c) is applicable. as the Service has ruled.000 less aggregate basis of $20. as well as the general rule of § 357(a).000).06[d] Character of § 357(c) Gain
When § 357(c)(1) applies to an excess of liabilities over basis. the outlay should either be deducted as a loss from a bad debt (the defaulting transferee's failure to indemnify the transferor) or treated as a contribution to the transferee's capital and added to the transferor's basis for the stock received in the exchange. 358(d). 362.1 The special rules of §§ 357(b) and (c). 139
If. and is expected to. the transferee defaults and the transferor must pay off the liabilities. but § 357(d)(2) reduces such amount by the lesser of liabilities attributable to assets not transferred that are also subject to that liability and which the owner of those assets has agreed with the transferee to. the gain to be reported would be only $10.
¶ 3.´ The term ³considered´ recognizes that the excess is taxable even if the transferor did not realize gain from the exchange in the sense used by § 1001. 136
¶ 3.´ § 357(a)(1) leaves the classification of the ³gain´ to other provisions of the Code.000. and is expected to. 140 A had transferred not only property with a basis of $10. ³as the case may be. instead. it could also cover the liabilities of an accrual-basis taxpayer that (1) are not presently accruable under the all-events test because contingent or contested.000 but also unencumbered property with a basis of $10. 143
¶ 3. long-term capital gain.06[f] New § 357(d)
In addition to abolishing the distinction between assumption of liabilities and taking property subject to liabilities. compute the transferor's gain on a § 351 exchange on the assumption that the liabilities assumed or to which the transferred property is subject will be paid by the transferee in the normal course of events. Under new § 357(d)(1). 138 Gain recognized by virtue of § 357(c). If. however. If there are two or more transferors. and by using the term ³as the case may be. or by the value of those assets (without regard to § 7701(g)).000 (liability of $30. in the previous example.
Although this transfer could be viewed as a brother-sister redemption of the target's stock by the new holding company under § 304 (which in turn would bring § 301 into force and create dividend income to the extent of the target company's earnings and profits). it seems that §§ 357(b) and 357(c) could have a delayed effect when the liability becomes fixed. Likewise. at least from the Service's point of view.3 and has also issued proposed regulations under § 358(h) on June 24. finally passed on December 21. does § 357(b) apply? 3. should be increased in like amount. 147
¶ 3. IRS has announced a major regulation project dealing with liabilities. and (3) the subsidiary stepped into the parent's shoes as to later deductibility or capitalization of the liability when paid or accruable. 149 Similarly. If the assumption of the liabilities was for tax-avoidance purposes. Can the transferee deduct the payment? 153 While there is little in the way of directly applicable law on the subject. or if they are assumed by the transferee. if the transferor subsequently is required to recognize gain. subject to the debt. Is the transferor still protected by § 357(a)? 2. If the transferor belatedly recognizes gain. 156 and the same should be true upon a disposition by the corporation of the property transferred to the corporation. the transferor's stock basis.2 Moreover.06 Overlap Between §§ 351 and 304
In a leveraged buyout or similar acquisition of the stock of a corporation from its shareholders. subject to the possible application of § 357(c)(3). as the case may be. the acquirer often borrows to purchase the stock and then shifts the liability for the debt to another corporation in a § 351 transaction (e.
¶ 3. at least if the sale of stock was treated as a capital gain or loss transaction.07 Control: The 80 Percent Rule
¶ 3. and the transferee's property basis.sold by the transferor before he is called upon to pay the debt. § 358(h). If the liabilities exceed the transferor's basis in the transferred property. by transferring the target company's stock. Is the transferor's basis in the stock received reduced under § 358(d)? 151 5. it seems that § 357(a) should continue to protect the transferor if the actions that created the transferor's legal liability occurred before the § 351 transfer and if the liability was assumed in the § 351 exchange or the property transferred in the exchange was subject to it. the liabilities are actually paid or ripen into fixed obligations at a later date. 157 But a Treasury proposal introduced in February 1999. 2003.1 IRS has proposed guidelines and procedures for settling § 351 contingent liability shelter cases. 148 The exchange does not trigger gain under § 357(b) or (c). his loss on payment probably would be treated as a capital loss. If the transferor recognizes income. under the ³open transaction´ approach.06 Contingent Liabilities
Liabilities assumed can be so contingent and speculative as to be excluded from the cost basis of property acquired. 158. because no gain is realized and the purchase-money debt does not exceed the basis of the stock transferred. any later gains from that event should be characterized as capital gain or ordinary gain. however. can the transferee belatedly increase the basis of property under § 362(a)? 152 6. Some of the questions in this area were answered. the transferor should not be required to take them into account in determining whether gain is realized and recognized under § 357(b) or § 357(c) at the time of the exchange. however. by a 1995 ruling holding that (1) contingent liabilities of an accrual basis parent assumed by its accrual basis subsidiary were covered by the exception in § 357(c)(3)(A). under the Arrowsmith principle. would require stock basis reduction if a deduction generating liability is treated as boot under tightened § 357(b) amendments.g.. to a new holding company). 2008. 158. 158 A modified version of this proposal. 154 In such cases. If. 155 If the shareholder has disposed of his stock before the liability ripens into a taxable event. (2) that no stock basis adjustment was required under § 358(d)(2). 158. it would seem that if property is transferred under § 351 subject to indeterminent liabilities of this type. this calamitous result is prevented by § 304(b)(3)(B). which provides that § 351 controls when it overlaps with § 304. 2000. which were adopted as temporary regulations in May of 2005. 158. does § 357(c) apply? 4.4 and as final regulations on May 8. the following questions arise: 150 1. can he take an offsetting deduction? 7.
. since virtually all states vest the power to vote on such proposals in all classes of stock. the transaction satisfied the control test for purposes of the applicable nonrecognition provision despite the divergence of values between the classes of voting stock.´ The voting to which § 368(c) refers has been held to mean the power to vote for directors. 166
¶ 3. This. either because the corporation issues only one class of stock or because the transferors receive all stock of all classes.. § 351 embraces transfers of property to a corporation already controlled by the transferor.07 Voting Stock and Voting Power
In many cases. 164 but the automatic transfer of definitions from other parts of the Code can be perilous. the Service has ruled that ³80 percent of the total number of shares of all other classes of stock. as defined in § 368(c). ownership must be direct. the transferors must own at least 80 percent of the total number of such shares in order to qualify under § 351. 159 The requisite control need not be acquired through the exchange itself. 162
¶ 3. as well as transfers to newly organized corporations. It is usually assumed that the computation of total combined voting power does not take account of shareholders' voting agreements or similar arrangements even though such arrangements may alter the balance of power. 165
¶ 3. so that ownership of less than 80 percent of the total market value or of the total number of shares may qualify. This is fortunate because there are few guides to the meaning of ³total combined voting power´ or ³stock entitled to vote. Although § 368(c) appears to lump all nonvoting shares together regardless of class or privileges. Once the stock entitled to vote has been identified and segregated. control would require 80 percent of the vote and value (disregarding § 1504(a)(4) preferred stock for this purpose).¶ 3. Such results would no longer be possible if the Treasury's conformity rule is adopted. 161 although a consolidated return group's ownership of the transferee's stock is aggregated. 169 since all voting stock is aggregated and treated as one class of stock for purposes of § 368(c). immediately after the exchange.´ as used in § 368(c). the control requirement of § 368(c) presents no problems of interpretation. at least when the proposed action will affect their interests. §§ 332 and 338). 167 Other sections in subchapter C previously have conformed their control tests to the § 1504(a) standard (e.g. but the question is not foreclosed by case law or rulings. § 368(c) would encompass almost all stock (leaving little if any room for ³other classes´ of stock). and not by attribution. means 80 percent of the total number of shares of each class of stock. 168 This proposal apparently was inspired by several widely publicized transactions using multiple classes of voting stock with disparate values. and (2) the total number of shares of all other classes of stock of the corporation. 160 Section 368(c) defines the term ³control´ to mean the ownership of at least 80 percent of (1) the total combined voting power of all classes of stock entitled to vote. For this purpose. it is necessary to determine whether the transferors of property own 80 percent or more of the total combined voting power. 163 if it were expanded to include stock that can vote on such extraordinary events as charter amendments and sales of assets. such as preferred stock that may vote for directors if dividends are passed for a stated period.07 Other Classes of Stock
If the corporation has nonvoting stock outstanding. As to stock with contingent voting rights.07 In General
Section 351 applies only if the transferor or transferors of property are ³in control´ of the corporation. however. regulations under the stock redemption rules of § 302 state that such stock is generally not voting stock until the specified event occurs. requires a realistic weighting of the stock's right to vote for directors if the shares are not fungible as regards their power to vote.07 Revision of § 368(c) Control Test
The Treasury's 1999 revenue proposals would conform the § 368(c) control test to the ³affiliated group´ definition of § 1504(a)(2)²that is.
08 Disproportionate Exchanges
Section 351 requires the transferors of property to be in control of the corporation ³immediately after the exchange. even if B's exchange is not simultaneous with C's. 178 A realignment of the transaction also may affect the computation of control.´ The regulations say of this requirement: The phrase ³immediately after the exchange´ does not necessarily require simultaneous exchanges by two or more persons. 171 To be included in the group of shareholders whose stock ownership is measured against the 80 percent requirements (the ³control group´). 175 In these ³accommodation transferor´ cases. 173 and own the stock ³immediately after´ the exchange 174 ²all as part of an integrated transaction between the corporation and the other transferors of property. each one ordinarily receives. For example. 176 they may have side effects. the stockholdings of two or more transferors can be aggregated in determining whether the transferors control the corporation immediately after the exchange if their transfers are part of a single transaction. on the strength of their own stock ownership. if they can. more shares than are actually issued to them. the remaining transferors of property must satisfy § 368(c). immediately after the exchange. but comprehends a situation where the rights of the parties have been previously defined and the execution of the agreement proceeds with an expedition consistent with orderly procedure. and if the corporation is to be expanded under an integrated plan by issuing 200 shares to B for property and 200 shares to C for other property. the transferor may have to recognize gain or loss on his constructive disposition of appreciated stock and may be entitled to a business expense deduction under § 162(a). at least if their use of shares to make gifts. Although discrepancies between the two values do not render § 351 inapplicable to the transaction as a whole. there is sometimes more than one transferor of property. since the transferors of property may be treated as constructively owning. and so forth is not an integral step in the entire transaction. or to satisfy obligations of the transferor of any kind.´ Thus. pay compensation. the entire transaction qualifies as tax-free under § 351 if the transferors as a group are in control of the corporation immediately after the exchange. In applying the 80 percent tests. 172 receive only stock in the exchange (or stock plus boot). 180 Under this interpretation.08 Two or More Transferors ¶ 3. Post-exchange transfers of stock can make or break control. the § 351(a) ³exchange. stock previously owned by a member of the control group is added to the stock received by them in exchange for the transferred property.¶ 3. stock and boot with a fair market value equal to the property transferred. each transferor must transfer property. as a result of arm's-length bargaining.09 Control ³Immediately After the Exchange´
. depending on whether they are taken into account under the principles discussed below.08 Control Group
As the language of § 351 explicitly recognizes.
When there are two or more transferors. if A performs services for a newly organized corporation for 25 percent of its stock and transfers 10 percent to B. who transferred property for the
¶ 3. 179
¶ 3. as explained by the regulations: [I]n appropriate cases the transaction may be treated as if the stock«had first been received in proportion [to the value of the property transferred] and then some of such stock had been used to make gifts [subject to gift tax under § 2501]. 177 In addition to these tax consequences. B and C will be in control of the corporation immediately after the exchange (by virtue of owning 400 out of 500 shares. if A owns all 100 shares of the stock of a corporation. In such cases. or 80 percent). to pay compensation [taxable as income under § 61(a)(1)]. unless the stock received by the preexisting shareholder for his currently transferred property is ³of relatively small value in comparison to the value of the stock«already owned«´ and if the primary purpose of the transfer is to enable the remaining transfers to qualify under § 351.
The court held as follows: This depends upon whether the transfer of assets to Auto-Lite in exchange for its stock and bonds and the transfer of stock and bonds to the underwriters were mutually interdependent transactions.´ as that term is used in section 368(c) and for purposes of control under section 351.000 shares to the corporation. it is immaterial how
. as part of the transaction by which the shares were acquired. 187 In reaching this conclusion.. 1922.. which concerned a 1922 transfer of certain assets by one Miniger to Electric Auto-Lite Company in exchange for 250.09 Step Transaction Doctrine
Litigation abounds over the requirement that the transferors control the transferee corporation immediately after the exchange. to children) or because the corporation issues additional shares to employees or other investors. If the transferee. voting rights.«Miniger could not have completed the purchase of the assets without the cash supplied by the underwriters and could not have had the cash except in exchange for the bonds and stock and could not have secured the bonds and stock except for the assets. then the stock ownership of the original shareholders as diminished by the second transfer is the basis for determining whether the group has control. the court cited and distinguished American Bantam Car Co.. but not otherwise. but less than the requisite 80 percent when the plan was fully consummated. who received the other 15 percent for services.000 shares of common stock and $3 million in bonds. and to turn back 49. and possession of stock certificates are not conclusive. At no time did he have the right to hold more. 188 In a later case.000 shares to Auto-Lite as a contribution to capital.000 shares of stock to the lender. but not otherwise.remaining 75 percent. X has control if the X-Y transfer is disregarded.«The 1922 transaction was taxable as the petitioner contends. The principal problem is whether the statute is satisfied if the transferors own 80 percent or more of the stock momentarily. ownership in such shares is lacking for purposes of section 351. and was subject to cancellation at the option of the transferors. The test is. By contrast.
¶ 3. which also involved a loss of control as a result of an underwriting agreement but which was held to qualify for nonrecognition under the predecessor of § 351 because the arrangement with the underwriters for a sale of preferred stock to the public. then the stock ownership of the group members after the second transfer will be the basis for determining whether it has control. to deliver the bonds and 75. 184 Although some early decisions held or suggested that momentary control was sufficient.«In the present case when the transfer of assets to Auto-Lite occurred on July 17. for which they were to be compensated with common stock. Conversely. but then drop below that benchmark because they sell or give away some of their stock (e. If as an integrated part of a § 351 exchange. of the voting stock. depends upon the obligations and freedom of action of the transferee with respect to the stock when he acquired it from the corporation. if X transfers property for 85 percent of the stock. if there are no restrictions upon freedom of action at the time he acquired the shares. Such traditional ownership attributes as legal title. a member of the control group 181 transfers stock received from the corporation in the exchange to another member of the control group.g. were the steps taken so interdependent that the legal relations created by one transaction would have been fruitless without a completion of the series. which is further discussed below. was not an integral part of the original transfer of property (the assets of a manufacturing business) to the corporation in exchange for common stock. 185 the control requirement is not satisfied under current law if the transferors of property agree beforehand to transfer enough of their stock to lose control or if such a transfer is an integral part of the plan of incorporation. 186 Miniger had purchased the assets with borrowed funds under an agreement requiring him to transfer the assets to Auto-Lite in exchange for the stock and bonds. 182 If. 183 In such circumstances. of which he transfers one-half to Y. An illustration of this principle is Manhattan Building Co. After the exchanges Miniger had«less than 80 percent. the second transferee is not a member of the control group because that party made no property transfer for stock. Miniger was under a binding contract to deliver the bonds and 75. the exchange meets the control requirement of § 351 if the A-B transfer is taken into account.09 Retransfers Within the Control Group
¶ 3. the Tax Court summarized this freedom-of-action approach as follows: A determination of ³ownership. however. under which Miniger fleetingly owned 100 percent of the stock. has irrevocably foregone or relinquished at that time the legal right to determine whether to keep the shares. The question before the court was whether the predecessor of § 351 was applicable to this transaction. the key issue is whether the second transfer is part of the § 351 exchange.000 shares of stock to the underwriters and to return 49.
and in practice the courts seem to do so. 197
¶ 3.09 Corporate Transfers of Stock
Section 351(c) provides that if a corporate transferor of property receives stock in a § 351 exchange. however. case. that ³the steps taken [were] so interdependent that the legal relations created by one transaction would have been fruitless without a completion of the series. the fact that it distributes part or all of the stock to its own shareholders is not taken into account. 190 It can then be said. in such a case. not on the narrow ground that the transferor owned the shares of the corporation for an instant but on a broader ground: In the absence of any restriction upon [the transferor's] freedom of action after he acquired the stock. And that is equally true whether the transaction is viewed as a whole or as a series of separate steps. 189 As generalizations go.´ 191 It is important to remember that the step transaction doctrine can be brought into play upon either (1) immediate sales of their stock by members of the control group. which applied if the distribution met the requirements of § 355. which can result in a loss of control (because the buyers transfer nothing to the corporation and are not preexisting shareholders and hence do not become part of the control group). 193
¶ 3. however. shareholders must own more than 50 percent of both the vote and the value of the distributed transferee's stock immediately after the distribution. much can be said for treating these situations differently. Thus. is both part of a preconceived plan and a sine qua non thereof. 195 The same principle has been applied to a case in which the stock was issued directly to the donees on the sensible ground that what matters is ³the power of the transferor [of property] to designate who will receive the stock rather than the precise moment that the power was exercised. 192 or (2) sales of other stock by the corporation itself (since purchasers from the corporation can become part of the control group by virtue of their transfers of cash to the corporation). Rejecting a 1978 ruling. the requirements of the statute are fully satisfied. he had ³immediately after the exchange´ as much control of the [corporation] as if he had not before made up his mind to give away most of his stock and with it consequently his control. since the distribution may be both a taxable event for the distributing corporation by virtue of § 311 and a taxable dividend to the distributee shareholders under § 301. he gave more than 20 percent to members of his family.09 Retransfers of Stock for Personal Reasons
Although the courts have not articulated a distinction between commercial and noncommercial transactions when deciding whether a loss of control after the initial exchange is fatal. 200 But legislation enacted in 1998 201 amended § 351(c)(2) (retroactively) to provide that shareholder dispositions of the distributed stock are disregarded in determining § 351 control with respect to the corporation's property transfer transaction.´ 196 When the property transferor.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. has a long-standing contractual obligation (albeit to a relative) contemplating that he would receive less than 80 percent of the stock. this seems quite satisfactory. the courts usually have found § 351 to apply. with a caveat for situations where the loss of control. on the day the transferor received the stock. One case concerned a transfer of property for all the stock of a newly organized corporation. If the transferors of property receive all the stock of the transferee corporation and then reduce their ownership below the requisite 80 percent by giving some of the stock to their spouses or children. the corporate transferor's fleeting ownership of the shares is counted in determining whether it is in control of the transferee corporation immediately after the property-for-stock exchange. 194 The court held that the transfer of property to the corporation was a tax-free exchange under § 351. his power can be so circumscribed that he never obtains the control required by § 351. may be too costly to exercise. 198 This option to realign ownership of the stock without losing ³control´ for § 351 purposes. regulations promulgated in 1996 accord the same treatment to firm-commitment and best-efforts underwriting agreements. in the words of the Manhattan Building Co. 199 The 1997 tax bill amended § 351(c) by adding new § 351(c)(2). holding that the ultimate purchasers are the transferors in either case. although not pursuant to a binding obligation. 202
.«Where the recipient of the stock on the exchange has not only the legal title to it ³immediately after the exchange´ but also the legal right then to determine whether or not to keep it with the control that flows from such ownership.
the freedom-of-action principle discussed previously would seem to apply so that the control requirement would be satisfied despite the prompt retransfer of part or all of the stock. in exchange for additional S-2 stock. in exchange for additional S-1 stock. In the simplest situation²that is. 206. the Service did not succumb to the temptation to rule that in effect. corporation P transferred property to its wholly owned subsidiary. but if exercise of the option is a foregone conclusion (e. to terminate the transferors' control? In the American Bantam Car Co. S-1 transferred the same property to S-1's wholly owned subsidiary. if only a nominal consideration is payable for valuable stock). but it says nothing about ownership of the transferred property. Under the facts of a 1977 ruling. § 358(b)(1) requires an allocation of the basis of the transferred property among the classes received in the exchange. an exchange under § 351 of property solely for stock²§ 358(a)(1) provides that the basis of the stock received is the same as the basis of the property transferred.
¶ 3.000 and the transferor received in exchange common stock worth $60. the transfer of the stock is not an integral part of the plan.10 In General
A recurring theme of fundamental importance in the income tax is that when gain or loss goes unrecognized at the time of an exchange of property for property. although admittedly parts of a single plan. the Tax Court held that an exchange of property for common stock qualified under § 351's control test even though the transferors would have lost control if the underwriters of an issue of preferred stock sold enough to the public to earn a substantial amount of common stock as compensation for their services²a business bargain that could be viewed as an option. 209 Thus. The Service ruled that the transfers.09 Transferred Property²Multiple Drop-Downs
The control requirement of § 351 looks to the ownership of the transferee corporation's stock immediately after the exchange. There is no counterpart of § 351(c) exonerating such transfers. 205 A 1983 ruling amplified the 1977 ruling to cover a similar plan in which the subsidiary transferred the assets to an affiliated partnership rather than to a second-tier subsidiary. 203 If. so the actual method used did not violate the purposes of § 351. a corporate transferor of property may wish to transfer the stock downstream to a subsidiary.1 to save a multi-step series of transactions that technically resulted in a loss of control but could have easily been done in ³double-drop´ mode. if the basis of the transferred property were $50.g.09 Options
Do the transferors of property have control ³immediately after the exchange´ if another person has an option to acquire enough shares. Immediately thereafter. P transferred the property to S-2 in exchange for S-1 stock and that P was not in control of S-2 immediately after the hypothetical exchange..2
¶ 3. 204
¶ 3. either from the corporation or from the transferors themselves. S-2 . nor is there a statutory sanction for attributing the subsidiary-held stock back to the parent in determining whether the transferors of property (including the parent) own 80 percent of the stock immediately after the exchange. 207 This approach has much to commend it.Instead of distributing the stock received in a § 351 transaction upstream. 206 IRS applied these multiple drop-down rulings expansively (and mercifully) in a 2003 ruling 206.000 and preferred stock worth
. Thus. and the regulations provide for an allocation in proportion to their market values. 208 If the transferor receives several classes of stock. case. S-1.10 Transferor's Basis for Stock ¶ 3. as explicitly permitted by § 351(c). The option can properly be disregarded if there is a genuine possibility that it will not be taken up. Section 358 applies this principle to an exchange under § 351. however. constituted two separate transactions. it may take the transaction outside of § 351 unless the option holder can himself be regarded as a transferor of property to be aggregated with the other transferors in computing control or unless the transfer of property and the option are not integral steps in a single transaction. each of which satisfied the requirements of § 351. the transferor's basis for the property given up is ordinarily preserved and applied to the property received.
reflecting a potential loss of $30.000). T would recognize $4. under § 358(a)(2).000.$40.000) and the value of the stock received in exchange ($100.500. Gain recognized (line 1b plus line 1c. Other property 2.000).500 c. Stock (line 3. which would be recognized under § 351(b) to the extent of the boot.000 received on the exchange. but in unusual circumstances could be applicable to an exchange under § 351.500.000. is equal to the gain that went unrecognized on the exchange itself because of § 351(a)²the difference between the basis of the property transferred ($50.000. is primarily concerned with certain transactions under § 306. if the value of what he received exceeded the adjusted basis of the property he gave up) to the extent of the fair market value of the boot. less the money and the fair market value of the boot received. 210 If the transferred property's basis in the above example had been $150.000 and the basis of the preferred stock would be $60.e. the common stock basis would be $90. Basis of property received: a. but the service has applied § 358(e) when a parent corporation makes a § 351 contribution of its own stock for stock of a subsidiary. Cash 1. providing for a further upward adjustment if any part of the property received on the exchange was treated as a dividend. plus the gain recognized by the transferor on the exchange. 211 In such a case. Section 358(a)(1)(B)(i). and other property of $500.000 × 50.000 $ 6. the stock received on the exchange) is the same as the basis of the property given up. Less: Adjusted basis of transferred property 4. Gain realized 5. The basis of the other property received by T would be.000 of gain on selling the common stock and $20.000 ÷ 100. Section 358 also is applicable if the transferor received boot on the exchange. T realizes gain of $6.. there is uncertainty as to whether the available basis is entirely allocated to the stock or somehow apportioned in
.000).000 × 50. Section 358(a)(2) provides that the boot (except U. which.000 (40.000 on the common stock and $20. The basis of the stock (the nonrecognition property) would be $4.000. would equal T 's full economic gain of $6. the basis of the cash would be $1. added to the $2. or line 4. less cash of $1. Amount realized: a. Other property (fair market value) $ c. currency.000) and the basis of the preferred stock would be $20.000 less adjusted basis of $4. the transferor would realize $30. plus gain recognized of $2.000 (adjusted basis of property given up. Assuming no later fluctuations in value. $4. 212 The computation is as follows: 1. it will be noted.000 on the preferred stock²equal to the $50.000). In addition. The total gain of $50.000 in exchange for stock worth $8.000 500 $ 4.000
If T then sold the stock for its market value ($8.
Assume T transfers property that had an adjusted basis of $4. § 351(b)(1) requires the transferor to recognize his gain on the exchange (if any was realized.000 on the stock ordinarily would qualify as capital gain regardless of the nature of the property transferred to the corporation.e. The gain of $50..000.000).000. Stock b.000 3.000 of gain. i. the basis of the common stock would be $30. Total $10.000 (60. whichever is less) 6. 214 When and if recognized gain reflected in boot can be reported on the installment method.000 of gain on selling the preferred.000 500 4.000).000 $ 2.S. less lines 1b and 1c. § 358(a)(1) provides that the basis of the nonrecognition property (i. concluding that each corporation had a zero basis in the respective stock received. in effect.000. 213 Section 358(e) excludes from the application § 358 the receipt of property by a corporation for its own stock on the theory that in nontaxable exchanges the corporation should obtain its basis from the other party under § 362(a). In effect. always has a basis equal to its face amount) be given a basis equal to that same fair market value.000 loss that was unrecognized because of § 351.000 of gain recognized at the time of the § 351 exchange. cash in the amount of $1.000 (value received of $10. and other property worth $500. plus line 5) $ 8. which. or $2.000 (total value of $10.000 ÷ 100. $500. less adjusted basis of original property of $4. its fair market value.500. Cash NA b.
obviously. 221 At the time of a § 351 exchange.10. If the transferor treats an exchange as nontaxable but later claims a stepped-up basis on the ground that he should have recognized gain²when the § 351 exchange occurred²and if the statute of limitations has run on an assessment of additional tax for that year. it does not require the recognition of gain. the spirit of estoppel is that two wrongs make a right. 220 has the effect of reducing pro tanto the basis that otherwise would be allocated under § 358(a)(1) to the nonrecognition property. Provided the mortgage is discharged by the corporation in due course. The reader will have noted that the basis of the property received on the exchange in the previous example (line 6) reflects. as discussed previously. but according to §§ 1311±1315. 218 but this will ordinarily ³mitigate´ (i. If a borderline liability is sufficiently fixed for § 357(b) or § 357(c) purposes. respectively). also clearly is debt to which the property is subject. is he barred by estoppel principles from using a stepped-up basis because he failed to recognize the gain? 217 There is authority by analogy for allowing the recipient of unreported boot to use a stepped-up stock basis. however.10 Estoppel
¶ 3. 223 Recourse debt to which transferred property is subject. If the transferee corporation fails to pay the debt at maturity and A is called upon to pay it. sort of. 215 For the shareholders of an S corporation. this tax treatment accords with economic reality: A 's net investment was $20. in applying §§ 357(b) and 357(c) (relating to tax avoidance transfers and debt-in-excess of basis.e. because the basis sets a ceiling on the amount of corporate losses that can be passed through to the shareholders under the S corporation regime. and losses that cannot be currently deducted because of the exhaustion of stock basis can be carried forward indefinitely and deducted to the extent of any subsequently created basis. 222 either way. or comes within the general rule of § 357(a).000 (the basis of the transferred property. the price exacted by § 351 for the nonrecognition of gain on the transfer of appreciated property²a low basis for the stock received²is doubly burdensome.
¶ 3. and so reduces basis in the stock pro tanto. 219 In short.000 (the cost of the land less the amount of the mortgage). 225 Even when §§ 357(b) and 357(c) do not apply to such debt. by shareholder loans to the corporation (though that may be throwing good money after bad). under § 358(a)(1)(B)(ii). the transferor may specifically agree to pay as between the two parties. however.. two rights are even better. at least where the failure to recognize gain on the exchange was not fraudulent or otherwise blameworthy. and A ultimately realized $25. If A then sells the stock for $25.000. A presumably would be entitled either to increase the basis of his stock (if he still owns it) by the amount of his outlay or to take a deduction under § 165 or § 166. it is not ordinarily necessary to determine whether a liability that is assumed by the transferee corporation or to which the transferred property is subject is too contingent to be taken into account or is instead fixed so as to qualify for the exemption of § 357(a). The debt must be properly classified. 224 In some cases of such recourse debt. then it would seem that the transferor should be required to reduce (or adjust) his basis in the stock received for the property under § 358(a)(1)(A)(ii).000 mortgage. minus the liability. which is treated as boot for this purpose). A will realize $5. A's basis for the stock will be $20. 216 The ceiling can be increased.000.000 to a corporation for all the corporation's stock plus the assumption of a $30. the ³amount of gain to the taxpayer which was recognized ´ (emphasis added) on the § 351 exchange. but which the corporation does not assume.000 of gain. which is applicable whether the liability gives rise to income at the time of the exchange under § 357(b) or § 357(c). it still is necessary to determine whether such debt results in a decrease in the basis of the stock received under §§ 358(d)(1) and
. however. the Service would prefer front loading the basis into the stock so as to increase the gain to be recognized on the installment method. This requirement. For new proposed regulations providing for a limited basis tracking regime (where no liabilities are allowed).10 Assumption of Liability
Section 358(d) provides that the amount of the liability assumed by a transferee corporation or subject to which it takes the transferred property (other than a liability excluded under § 357(c)(3)) should be treated as money received by the transferor upon the exchange.part to the installment debt so as to reduce the recognized gain.
If A transfers property with a cost basis of $50. reopen) the statute of limitations otherwise applicable to the year of the exchange under §§ 1311±1315. see infra ¶ 3.
´ The stock readily satisfies this requirement if the § 351 exchange is wholly tax-free.
¶ 3.. at the least the transferor should be able to increase the stock basis if and when he pays the debt. the basis of the stock is its fair market value at the time of the exchange and hence is not determined in whole or in part by reference to the basis of the transferred property. and § 1223(1) is no more helpful.1 But if liabilities are assumed. 226 the answer must be yes. ³the same basis in whole or in part«as the property exchanged. provided the transferred property was either a capital asset or a § 1231(b) asset. increased by the amount of gain recognized to the transferor. the transferor determines his holding period under § 1223(1) by including (³tacking´) the period during which he held the property transferred to the corporation. In carrying the transferor's basis for the property over to the transferee corporation. the transferor's gain is fully recognized.
¶ 3. 229
¶ 3. Consistent with the Service's view of the income side of such transactions. and noncapital assets. but only where no liabilities are assumed in the transaction. for determining gain or loss on a sale or exchange. Section 358 and the regulations promulgated thereunder seem to contemplate that the aggregate basis of the property transferred will be assigned to the properties received (and then presumably allocated among the items in proportion to their relative market values). however.11 Transferee Corporation's Basis for Assets ¶ 3.g. 227 This proviso was enacted to prevent the conversion of ordinary income into long-term capital gain by a prompt sale of stock acquired under § 351 in exchange for appreciated inventory. 229.10 Holding Period. because some of the shares are likely to be sold at an early date)? It is doubtful that such an earmarking of the transferred property would succeed if both transfers were interdependent steps in a single transaction. such as the ³lower of cost or value´ rule in the case of personal-use property that is converted to income-producing or business functions. Perhaps. leaving little room for any planning of basis by the foresighted taxpayer. 231
. 230 In keeping with the transferor's nonrecognition of gain in connection with debt assumed under § 357(a). as in the ordinary case of incorporating a going business. with the result that the basis of each share will be divided for holding-period purposes. but even if part of the transferor's gain is recognized because boot is received. only if the property whose holding period is to be determined has. If. Section 1223(1) applies. the transferor can offset that basis reduction with a corresponding increase based on a contribution-to-capital theory with respect to the transferor's debt assumption. since its applicability depends on § 358. however. an assumption of liabilities by the transferee does not enter into the computation of the transferee's basis for the transferred property except to the extent the transferor recognizes gain under § 357(b) or § 357(c). the stock's basis is determined by reference to the basis of the transferred property.358(a)(1)(A)(ii).2 The reason for not applying basis tracing in the liability assumption case is because aggregate basis rules apply for determining § 357(c) gain. special basis adjustments may be required. 228 If the transferred property consists of a mixture of capital assets. 229.10 Proposed Regulations Limited Basis Tracing Rules
Regulations proposed in January 2009 provide for a limited basis tracing rule in the case of § 351 exchanges. however.11 In General
Section 362(a) provides that the basis to the transferee corporation of the property received on the exchange is the transferor's basis for the property. the aggregate basis of the transferred properties (after adjustments for boot and gain recognized) is allocated among all the shares of stock in proportion to the value of each share. § 1231(b) assets. it may be necessary to make an allocation under § 1223(1). Tracing Basis
Upon selling stock received tax-free under § 351(a). Can the transferor deliberately transfer some assets for specified shares or a certain class of stock and others for a different group of shares or another class in order to control the basis or holding period of the stock received (e.
which encompasses the liabilities described by § 357(c)(3).000 and another asset with an adjusted basis of $20.What if the transferor erroneously recognized (or erroneously failed to recognize) gain on the § 351 exchange? Does § 362 mean actual recognition. then it would seem reasonable to apportion any gain attributable thereto according to relative asset appreciation. then the asset-by-asset approach as applied in the case of boot received by the transferor runs into difficulty because § 357(c) is not based on a calculation of aggregate gain realized on the transfer but rather on the amount of debt in excess of basis. 232
¶ 3. or should this language be read as meaning recognizable? The latter construction has won judicial support. If both types of debt are involved. If an assumed debt is not secured by any particular asset. since § 362(a) takes account of only the transferor's basis and the gain recognized by the transferor. the transferee's payments could have been deducted by the transferor had they been made before the § 351 exchange²as in the case of a cash basis transferor's liabilities for rent. while the transferee's basis in the acquired assets is increased under § 362(a) pro tanto as the gain is recognized. however. however. etc.²the Service acknowledges that the transferee is entitled to a deduction. whether the transferor's error was in recognizing or in failing to recognize gain.
¶ 3. 236 This concession. Since the Service believes that for purposes of computing the shareholder's recognized gain. and both must have arisen in the ordinary course of business and must not have been accelerated or prepaid for a tax-avoidance purpose. it would seem reasonable to allocate the gain attributable thereto specifically to that property.000 and a value of $10. § 362(a) provides that the basis to be assigned to the transferred assets is to be increased by the amount of gain recognized. 240
¶ 3. wages. and (2) the liabilities must be transferred together with their related receivables.000 and a value of $50. If an item of transferred property is specifically subject to a debt in excess of the property's basis. if the corporation issues stock in exchange for an asset with an adjusted basis to the transferor of $10. If the § 351 exchange is taxable in part because the transferor received boot.11 Zero Basis Problem
. but neither the Code nor the regulations state how this increase should be allocated among the assets. which usually exists when all the receivables and payables of a going business are transferred. 237 is subject to two broad limitations: (1) There must be a valid business purpose for the transfer of the liabilities. because otherwise a substantial part of the aggregate basis might have to be assigned to goodwill²thereby reducing the amount allocated to inventory (generating a corresponding increase in ordinary income on sale) and to depreciable assets. 239 the transferor's basis for transferee stock evidently can be increased under § 358(a) immediately by the full amount of the gain. or should the transferor's basis for each asset be preserved? Under the statutory predecessor of § 362(a). the Court of Appeals for the Seventh Circuit opted for the latter principle. 233 This rule avoids an appraisal of the assets at the time of the exchange. 235 If. and it ordinarily is helpful to the transferee corporation when a going concern is incorporated. it evidently also believes that the gain thereby recognized on a specific asset should increase the basis of that asset. For example.11 Installment Boot
When a transferor receives boot in the form of transferee debt and reports gain on the installment method under § 453(f)(6). an allocation based on either relative asset basis or relative fair market values may be a fair way to avoid needless complexities (but see discussion of § 362(d) below). the boot must be allocated among the assets on the basis of the assets' relative fair market values.11 Allocation
Neither the Code nor the regulations state how the basis transferred to the corporation is to be allocated by it among the assets received. is the aggregate transferred basis of $30.000 to be divided between the two assets in proportion to their market values. 234 This has the merit of assigning the increase in basis to the assets responsible for it.11 Corporation's Deductions for Payment of Assumed Liabilities
The corporation's payment of assumed liabilities does not increase its basis in the assets acquired.000. If the § 351 exchange is taxable in part because of § 357(c). 238
the ³anti-loss duplication´ provision of § 362(e). the entire amount realized will be gain. in that case. 249.2 adopted an anti-loss duplication rule in § 362(e)(2) where there is an aggregate net built-in loss on the transferred assets. 2006. and the payee recipient must take a cost basis for that stock.e. not all the assets are transferred. because the transferor parent's basis for its own stock is zero and this basis (or lack thereof) carries over to the transferee. based on relative values of the transferred and retained assets. the parent stock must be contributed to the subsidiary in a § 362(a) carryover basis transaction.11 Basis Limitation for Assumed Liabilities: § 362(d)
Recent legislation now limits basis increases for transferred assets that result from assumed liability gains under § 357 to the fair market value of the transferred assets. 249. 246 Under § 1032-3(c). the basis of each loss asset is stepped-down to its share of the asset's proportionate share of the net built-in loss (allocated in proportion to each asset's built-in loss). Proposed Regulations § 1. IRS rulings also protect the subsidiary against the perils of a zero basis if it uses the stock of its parent to compensate employees. But if both the transferor and transferee (irrevocably) elect.6 The regulations clarify that § 362(e)(2) applies separately to each transferor (and also must reflect any basis step-up as a result of recognized gain).Addressing a specialized § 351 situation²a corporation's transfer of its own stock to its subsidiary in exchange for additional stock in the subsidiary²the Service has ruled that the subsidiary's basis for the stock is zero. whether done domestically or cross-border. however. 249 A special rule in § 362(d)(2) deals with a case where nonrecourse liabilities secure multiple assets. 247
¶ 3. did not supply an articulated rationale for their conclusions.4 Thus. and can evidently do so even if they were not capital assets when so held. the subsidiary is a mere ³conduit´). 245 The regulations adopt a cash purchase model here. 249. 248
¶ 3. any basis increase is limited to the transferee's ratable portion of the liability. it is no longer possible to duplicate losses by § 351 drop-downs. the transferee corporation is allowed by § 1223(2) to include the period they were held by the transferor. computed by deducting its cost from the amount realized. 249.
¶ 3. 249.g. 244 These rulings. however. a basis step-down in the transferee's § 358 stock basis can be made in lieu of asset basis reduction. and then sold the stock.11 Basis Limitation Where Transferred Property Has Net Built-In Loss: § 362(e)
. IRS announced a major regulation project to clarify various issues under §§ 357(d) and 362(d) (and other related issues as well). acquire a basis in the hands of their new owners equal to the basis of the target shares surrendered by them.. although if it had sold its own stock to third party investors and used the proceeds to purchase stock of its parent on the market.1032-3. were issued on October 23. The proposals also revise and expand Notice 2005-70 249.3 in such case. which had a zero basis in the hands of the subsidiary. 242 The subsidiary's zero basis dilemma as described above is sidestepped if the § 351 parent-subsidiary exchange is the prelude to the acquisition of a target company.. where the transferor distributes transferee stock under § 351(c) without recognizing gain or loss on the distribution). would further extend § 1032 nonrecognition protection where the subsidiary is essentially a ³conduit´ using parent stock (or options) to acquire cash or property or to pay compensation. the Service treats the subsidiary's use of its parent's stock to acquire the target as a tax-free transaction. treating the subsidiary as if it had purchased parent stock with cash contributed to it for that purpose. In such a triangular corporate reorganization.5 Proposed regulations under § 362(e)(2). and no person is subject to tax on any gain recognized as a result of the liability assumed on the transfer. if there is no loss duplication as a result of the transaction (e. whose shareholders thus wind up with an equity interest in the parent. the stock must be used ³immediately´ by the subsidiary (i.7 to provide more methods and time periods in which to make elections under § 362(e)(2)(C). The regulations will not apply. it would recognize gain or loss. 243 so that the parent's shares.11 Holding Period
In measuring its holding period for assets received in a § 351 exchange.1
The Jobs Act of 2004 249. however. in which the subsidiary exchanges its shares in its parent for the shares of the target. 241 If the subsidiary then disposes of the stock in a taxable transaction.
Section 1032. so has the corporation made a transfer (i. Section 1032(a) applies the same nonrecognition rule to gains and losses realized by a corporation on a lapse or an acquisition of an option to buy or sell its own stock. because such a transaction did not involve ³deal[ing] in its own shares as it might in the shares of another corporation. although enclosed in parentheses. or fair market value) to acquire property. 257 and regulatory authority would be granted to classify such stock as ³non-stock´ (e.e. an exchange of its stock for the property). since otherwise the anomalous pre-1954 distinction between treasury shares and previously unissued shares would be perpetuated in stock-for-services exchanges.g. neither of these proposals has received much. since it was enacted to reject the result reached by some cases under pre-1954 law that required a corporation to recognize gain if the corporation ³deals in its own shares as it might in the shares of another corporation´ 251 ²for example. 259 However. a derivative or as stock of another corporation) and increase basis in the tracked asset. if any. stated.. A similar result was reached with respect to fees paid for membership certificates in a retail ³nonprofit´ organization. including treasury shares. 253 Section 1032.000. for which the corporation had paid $25. or Deduction on Issue or Sale of Its Stock ¶ 3.12 Corporation's Gain. or share in the company's assets upon liquidation until the Class A stock had been paid in full. participate in the profits of the company. 261 The stock was redeemable at par and did not entitle the owner to vote. by using appreciated treasury shares. did not qualify for exemption under § 1032 and thus constituted taxable income to it under § 61.¶ 3. 255 a sensible extension. one case held that amounts received for so-called Class B stock.
¶ 3. actually is the crux of § 1032. 254 Although § 1032 itself refers only to transactions involving the issue of stock for money or other property. it was repudiated by the enactment in 1954 of § 1032. as debt. to pay for property with a fair market value of $100. congressional interest following their submission. 252 By contrast. 256 The Treasury's February 1999 budget plan proposed to carve out two transactions from the nonrecognition protection of § 1032: (1) The issuance of ³tracking stock´ for cash or other property that would be taxable to the extent of any built-in gain (though not loss) attributable to the ³tracked´ asset.. explicitly applies only to a corporation's transfer of its own stock and not to transfers of stock of its parent or subsidiary. Loss.12 Section 1032: The Basic Rule and Its Purpose
Just as the transferor of property to a corporation in exchange for its stock has made a ³disposition´ of property that might result in gain or loss recognition under § 1001. however.´ 250 The reference to treasury stock.000 to repurchase them from a shareholder.´ 260 Thus. because the substance of the transaction was a payment for the privilege of buying goods at a savings rather than an equity investment in the taxpayer. however. which customers had to purchase as a condition to the receipt of television services to be furnished by the issuing corporation. provides an exception to the general recognition rule for a corporation receiving ³money or other property in exchange for [its own] stock (including treasury stock). 258 and (2) issuance of stock in a ³forward sale´ transaction would be subjected to time value of money principles by applying § 483 to the deferred payments. and on several occasions the courts have had to say whether a corporation was entitled to the benefit of § 1032 on receiving payment for rights embodied in a document of ambiguous character by assessing the equity features of the purported ³stock.´ Because this tax distinction did not reflect any business or financial differences between treasury and previously unissued stock. even though the holders were entitled to vote and to share in assets upon liquidation. 262
The term ³stock´ is not defined in § 1032 or elsewhere in the Code. pre-1954 law did not require gain or loss recognition if a corporation used authorized but previously unissued stock (regardless of its par. the regulations apply the same nonrecognition principle to the use of stock to pay for services.
if the corporation takes the buyer's note in payment for stock. 265 Although § 1032 applies whether or not the transferor's exchange is subject to § 351. it does not govern events occurring thereafter. 274
¶ 3. along with its own stock. for example. as compensation for services or as a charitable deduction²if a cash payment would have been deductible. 273 If a payment in cash would not be currently deductible but would give rise to deductible amortization or depreciation. but it does not preclude deductions when stock is issued as coin of the corporate realm²for example. it will be taxed in accordance with its own true character. however. 268 Moreover.Similar questions of taxability arise when corporations receive contributions to capital and in determining whether a payment is received for stock or for some other valuable consideration.´ 277 and to increase basis in the tracked assets by the amount of recognized gain.12 Issue of ³Tracking Stock´²Nonapplication of § 1032
Revenue proposals in the Treasury's fiscal year 2000 budget plan would tax a corporation on its issuance of ³tracking stock´ 276 in an amount equal to the built-in gain (though not loss) inherent in the tracked asset. The regulations limit § 362 to exchanges in which the transferor enjoys the benefit of a nonrecognition rule. the basis of the property to the corporation will be the fair market value of the stock given up. 269 Proposed legislation in Treasury's 1999 budget plan would tax the corporation on a forward sale contract to issue its stock by applying § 483 and time value of money principles to the deferred payments under that contract. Regulatory authority also would be granted to classify such stock as ³nonstock. 271 Thus. and finally was eliminated in 1993. Section 1032(b) refers to § 362 as governing the corporation's basis in ³certain´ exchanges. 272 Section 1032 exempts corporations from recognizing gain (or loss) on the exchange of stock for money or other property. it may realize original issue discount income on the note. 267 If another transaction occurs in tandem with the issuance of stock.12 Transfer of Boot
By virtue of § 351(f). as explained later in this work. does not sanction the recognition of loss on transferring depreciated property as boot.13 In General: Corporate Nonrecognition of Income
.12 Stock Issued for the Corporation's Own Debt
If a debtor corporation issues stock in discharge of its debts. if stock is issued to acquire property from someone other than a controlling shareholder under § 351. 266 § 1032 applies only to the corporations's receipt of consideration in ³exchange´ for the corporation's stock. 263
¶ 3. § 1032²despite its general protective rule² does not shield the corporation from recognizing discharge-of-indebtedness income if the stock is worth less than the face amount of the liabilities thus discharged. § 1032 does not protect a corporation from recognizing gain on a § 351 exchange if it transfers appreciated property to the transferor as boot. the fair market value of the stock should be similarly deductible over time. 270 The regulations clarify a statutory ambiguity in determining the corporation's basis for property acquired in exchange for the corporation's stock. Section 351(f). An historic exception to the recognition of income in this situation 264 was gradually eroded by a series of statutory amendments between 1980 and 1992.
¶ 3. Cost Basis and Deductions
¶ 3. even if § 1032 applies when stock is issued. Tracking stock would be defined as stock whose dividend or liquidation rights are keyed to economic performance of less than all of the issuing corporation's assets. 275
¶ 3.13 Contributions to Capital ¶ 3. and state that the basis of property acquired by the corporation in exchanges that are taxable to the other party will be governed by § 1012 (basis of property is ³cost´).12 Exchanges Outside § 351.
the as-if rule of § 108(e)(6) can generate taxable income for the corporation if the shareholder-creditor's adjusted basis for the debt is less than its amount. 281 Section 118(a) applies to three types of transactions. the Service pledged its continuing allegiance to a Supreme Court listing of the following indicia of a taxexempt nonshareholder contribution. or a transfer to a third party for the benefit of the corporation. 288 The regulations 289 distinguish between (1) contributions ³by a governmental unit or civic group to induce the corporation to locate its business in a particular community or to expand its operating facilities. to which § 118(a) is inapplicable. under which the issue of stock does not produce corporate gain or loss. § 118(a) can apply to exclude from a corporation's income money or other property transferred by a nonshareholder. of which two involve shareholders and one involves nonshareholders. if a shareholder-creditor forgives a corporate debt as a contribution to capital²one of the most common contexts for making a contribution to capital²the transaction is not governed by § 118 (which would exclude the contribution from the corporation's gross income). 292 If the shareholder's adjusted basis for the debt is equal to its face amount (e. that will result in an acceleration of benefits to the transferor. the same approach can be extended to a non±pro rata contribution by a shareholder who is acting voluntarily in his capacity as such. the debtor corporation realizes discharge-of-indebtedness income as though it had satisfied the debt with an amount of money equal to the shareholder's adjusted basis in the debt.13[a] Shareholder Contributions
First.´ § 118(b) states that the term does not include ³any contribution in aid of construction or any other contribution [by a party in its capacity] as a customer or potential customer. 284 Whether a shareholder makes a contribution in his capacity as a shareholder or instead as a creditor. In other circumstances. as discussed in the previous section. however. gross income shall not include any ³contribution to the capital of the taxpayer. 279 A contribution to capital may be in the form of a transfer directly to the corporation. Second. and (5) the contribution must ordinarily be employed to generate additional income. Indeed. if the shareholder lent the face amount in cash to the corporation and has properly accrued all appropriate interest income).
. 283 and the exclusion from gross income can be regarded as a corollary to § 1032.´ The exclusion of contributions to capital from the corporation's gross income is not an unmitigated blessing.g. especially in the case of closely held corporations) normally are contributions to capital.13[b] Nonshareholder Contributions
Third. 287 Evidently..
¶ 3. as explained later in this work. customer. instead. or that otherwise causes a customer to be favored. discussed below. the primary purpose of § 118 was to give a congressional blessing to pre-1954 cases holding that certain contributions by nonshareholders were not taxable as income. Congress intended to exclude from § 118(a) any transfer that is a prerequisite to a direct commercial benefit to the transferor. 285 In a 1993 ruling. (2) the contribution must not be compensation for specific quantifiable services. 280 including a transfer of property by a shareholder to a corporate employee for the corporation's benefit. 282 Such transfers can be regarded as an additional price paid for the stock. 286 Although § 118 does not define the term ³contribution to capital.
¶ 3. since it requires a reduction of basis that in later years will increase the corporation's gain or decrease its deductions for depreciation and losses.Section 118(a) provides that in the case of a corporation. even though the case involved a transaction governed by pre-1954 law: (1) The contribution must become a permanent part of working capital. 291
¶ 3. or person expecting a commercial benefit from the corporation is a question of fact that is analogous to the determination that must be made with respect to nonshareholder transfers. an excessive payment to the corporation for goods or services.13 Debt Forgiveness
Under § 108(e)(6).´ which qualify under § 118(a) 290 and (2) payments for goods or services rendered and subsidies paid to induce the corporation to limit its production. voluntary pro rata transfers to a corporation by its shareholders (by far the most common of the three types. (3) the contribution must be bargained for. because the hypothetical payment by the corporation does not exceed the claim's adjusted basis in the hands of the shareholder. (4) the contribution must forseeably benefit the corporation in an amount commensurate with its value. the corporation realizes no income when the shareholder contributes the claim to the corporation's capital.
the long-standing principle that a shareholder's voluntary contribution of property to a corporation results in an increase in the basis of his shares equal to his adjusted basis in the surrendered property was extended by the Court to a non-pro rata contribution by two dominant shareholders (husband and wife) of some of their shares in a financially distressed corporation. however. That term normally refers to property received by a corporation for the corporation's stock in excess of the stock's par value. then the contributed debt has a zero basis in the shareholder's hands and the corporation realizes debtdischarge income under § 108(e)(6). being a cash-method taxpayer. giving rise to a deduction for the loss. 301 Section 362(c) is evidently inapplicable to property or money received by a corporation as a gift for the benefit of its shareholders. presumably has the same meaning as under § 118. 293 These rules are superseded for insolvent debtors. 297 Since paid-in surplus can arise outside of § 351.13 Corporate Basis and Deductions
Section 362(a)(2) provides that the corporation's basis for property acquired as paid-in surplus or as a contribution to capital is the same as the transferor's basis. for example. the basis of other property held by the corporation must be reduced pro tanto. rather than the taxpayer. if the payment is otherwise deductible. it would not have to recognize any income. it may be that § 362(a)(2) applies even to an exchange that is fully taxable to the shareholder. it ordinarily is the government. ³Contribution to capital.´ for purposes of § 362(a)(2). Fink (1987). did not take the debt into income. as discussed later in this work. 304 In such cases. the corporation may deduct it. 299 Section 362(c)(2) provides that if the contribution consists of money. increased by gain recognized to the transferor on the transaction.
¶ 3.For example. some viewed each shareholder's investment as a series of separate investments in each share. as a civic booster.´ then by definition the transfer is not a payment for goods or services and so must be made. the corporation must reduce the basis of any property acquired within the following twelve-month period with the contributed money. and is discussed later in this work. The meaning of ³paid-in surplus´ is more obscure. 303 Sometimes a contribution to capital is made in the form of a shareholder payment of a corporate expense. 294 The capital contribution concept is often invoked in cases involving alleged purchases of property by a corporation from its shareholders for debt if the arrangement shows an intention to commit the property to the risks of the business or if the corporation is thinly capitalized. the payment is deemed to have been made by the corporation with its own funds. so that the surrendered shares could be treated as worthless.13[a] Contributions by Shareholders
In CIR v. while other courts accepted an ³integrated´ analysis of the investment. 302 A redemption of stock made by a related corporation formerly was treated as a contribution to capital. that if enough property is not so acquired. the corporation was on the cash method and had not yet deducted the compensation. 306 The Circuit Courts of Appeals had split on this issue. 300 If a shareholder makes a transfer that is a contribution to capital but the transfer is not made in the shareholder's capacity ³as such. in order to enhance its appeal to outside investors. In this case. and. if the debt reflects an amount owed to the shareholder for services performed for an accrual method corporation and the shareholder. This is the same result as applied by § 362(a)(1) to property received by the corporation in exchange for stock in a transaction under § 351.13 Treatment of Contributors ¶ 3. 298 Because an outsider's contribution to a corporation's capital increases the corporation's net worth at no tax cost under § 118. 296 which meaning is informed by the reference of § 362(c)(1)(B) to a contribution ³by a shareholder as such´ (emphasis added). in such a case the corporation would carry over the donor's basis under § 1015 as if the donor had given the property to the shareholders and the shareholders had contributed property to the corporation. If. § 362(c)(1) provides that property that is ³not contributed by a shareholder as such´ has a zero basis in the hands of the transferee corporation. leading to the conclusion that the shareholder realizes no gain or loss until the remaining shares (whose basis would be increased by the basis of the surrendered shares) were sold or otherwise
. that seeks to characterize the transaction as a contribution to capital. and. whose debt-discharge income is not currently taxable but is instead applied in reduction of the corporation's tax attributes.
so that (1) the gain would qualify as longterm capital gain (sometimes reported over a period of years under the then lenient installment sale provisions 313 ). 311 Otherwise. Their tax gambit consisted of purported sales of appreciated land to controlled corporations. The Supreme Court accepted the latter theory. but an equal allocation among all retained shares of the same class seems reasonable. the seller-shareholder recognizes gain (or loss.1 The search for technical perfection in the new basis regulations. but. 309. and the property gets a cost basis equal to its fair market value basis in the hands of the corporation. however. 314 Similar tax benefits could be obtained if shareholders sold highly appreciated depreciable business property to their controlled corporations. since they could report their profit as capital gain. and the corporation could depreciate its resulting higher cost basis against its business income.g. and it would also bring §§ 357(b) and 357(c) into force if the contributed property is subject to debt. and longterm capital gains were taxed at much lower rates than ordinary income. as a dissenting judge noted. the value of suitable raw land was on its way to the wild blue yonder. will result in a formidable array of computations for many garden variety corporate transactions without any especially redeeming value to the FISC. even if they were acquired at different times and prices. would report correspondingly less ordinary income from the construction and sale of the houses. rather than a non-taxable exchange under § 351.14 In General
Nothing in § 351 prohibits shareholders from selling property to their controlled corporations for stock (or stock plus debt) on arm's-length terms that would be reached with an unrelated buyer. which sought to undermine their fundamental premise²the claim that the transaction was a bona fide sale of the property to the corporation..13[b] Contributions by Nonshareholders
Nonshareholder contributions to a corporation's capital might be deductible business expenses (e. When a contribution to capital is made by a sole shareholder.disposed of. even if no additional stock is issued. 309 The 2009 proposed regulations noted above applying a share-by-share tracing model (with a deemed stock issue and a deemed recapitalization) seem to add unnecessary complexity to an area not crying out for reform. a shareholder's payment of an assessment is not a voluntary event. gain or loss is probably recognized if the assessment is discharged with appreciated or depreciated property. These results. unless § 267 applies 312 ) under § 1001. the prevailing current view is to treat the transaction like a § 351 exchange.14 Transfer Under § 351 Versus Sale ¶ 3. a result that should be reflected by increasing the basis of the stock giving rise to the assessment.
¶ 3. the contributor is probably entitled to nothing more than the community's gratitude for his civic boosterism. when residential subdivisions were springing up everywhere. In contrast to the treatment of contributions to capital. This makes § 358 applicable in determining the basis of the retained stock. and (2) the corporation. resulting in a carryover of the property's low
. If the sale is not recharacterized as a § 351 exchange. having a higher starting basis for the land. These principles were exploited during the 1970s and early 1980s. while perhaps elegantly logical. But new proposed regulations 308.1 apply a share-by-share basis tracing model to capital contributions (a controversial result). it is difficult to perceive in the Fink opinion ³any principled ground for distinguishing a loss-of-control case from this one.´ 307 The Court observed that it had no occasion for deciding whether a loss would be deductible if the dominant shareholders had contributed enough shares to lose control of the corporation. 310
¶ 3. if the contributor expects to derive business benefits from the relocation of the corporation to his area). ruling that a contribution of stock ³like contributions of other forms of property to the corporation. were not achieved without resistance by the Service. Accordingly. the Court did not address the way in which the adjusted basis of the surrendered shares should be allocated among the retained shares.´ 308 In Fink. is not an appropriate occasion for the recognition of gain or loss.
that a purported § 351 exchange is ³really´ a sale. or that a purported sale is ³really´ a § 351 exchange. In more naive days. moreover. For example. The risk of boot treatment is not so great. but only if the transferor has also received stock). it is difficult to see how the parties can avoid the application of § 351(a).14 Sales That Are Not Integrated
On the other hand. § 351 is inapplicable because it requires that the transferor receive some stock.
. wishing to deduct a loss on depreciated property. if property is transferred to a controlled corporation solely for cash. In recharacterizing borderline transactions of this type as tax-free exchanges. Section 351 is applicable ³if property is transferred to a corporation«solely in exchange for stock. 318 If. however.1241&feature=tcheckpoint&jsp=%2FJSP%2FdocText. however. 322 it would be but a small additional step to convert a nominal sale by a 100 percent shareholder to the shareholder's corporation into a § 351 exchange with boot or a contribution to capital coupled with a distribution.riag. the Service found itself in the unusual posture of attempting to force tax-exempt status on unwilling taxpayers. Protection against § 351
in these circumstances. the transferor's purpose is to give the property a stepped-up basis in the hands of the corporation rather than to enjoy a deductible loss. 316
¶ 3. in contravention of the congressional purpose. Even if the transaction is cast in the form of a ³sale´ of property for stock plus cash or other property. but the quietus was put on such transactions as early as 1932 by disregarding the cash circular transfers. to assume that a transaction falling outside § 351 is necessarily a sale merely because it bears that label. the transferor does not have (alone or with other transferors) the requisite 80 percent control of the transferee corporation immediately after the exchange.
If property is to be transferred to a controlled corporation solely for stock. respectively. Integrated Exchanges
https://checkpoint.124&docTid=T0 BE%3A4056.bc. however. Again. § 351 will apply. a contrary construction would endow the transferor with an option that was not intended by Congress.com.14 Incorporation Coupled With Purported Sale. If. would be indefensible because it would convert § 351 into an optional provision.checkpoint. in other situations the Service and taxpayer resume their more normal roles by arguing.basis.jsp&lastCpReqId=3294672&lkn= docText&searchHandle=ia744cc630000012cc29d6edbb3ee6089 FN%20%3Ca%20name=315">315 and the practice is not likely to be revived.tta. 317 Moreover. if the payment consists of purported corporate debt that is recharacterized as equity. but the taxpayer still may have to establish that the transfer is a sale rather than a contribution of the property to capital coupled with a distribution of the cash.
¶ 3. If the two steps are integral parts of a single transaction (a factual issue). the division will not be respected.´ and the impact of this language can hardly be avoided by affixing the label ³sale´ to the transfer. the transfer falls outside § 351. 319 It would be perilous.lawezproxy. if property is transferred to a controlled corporation solely for cash or property and is not part of a related § 351 exchange.edu/app/servlet/com. however. as the analysis below indicates. so that the transferor will recognize gain (but not loss) to the extent of the boot. there is precedent for treating contributions to capital by 100 percent shareholders as § 351 exchanges. the transfer seemingly cannot qualify under either § 351(a) (which requires receipt of stock) or § 351(b) (which permits the receipt of boot. 320 Moreover. and the transaction will instead be treated as a unitary § 351 exchange with boot. however. could purchase the corporation's stock for cash in a § 351 exchange and then successfully sell the property to the corporation for the cash just paid in.ser vlet. 321 Since such cases have involved payment for the stock in the form of debt assumption by the corporation. and gain or loss may be recognized under § 1001. More commonly. a transfer under § 351 for stock and boot may be a satisfactory alternative to a sale. transferors attempt to alter the tax consequences of a § 351 exchange by dividing it into a sale of some of the property for cash or other property and a transfer of the balance for stock. its tax consequences are governed by §§ 351(a) and 351(b).CPDocTextServlet?usid=134bb4a36cc&DocID=T0BE%3A4056. it was sometimes thought that the organizers of a corporation.
¶ 3. If the parties characterized the transaction as a sale at the outset. Congress. A transferred property to newly organized company X for X's stock. or similar business. Treating the entire receipt as a distribution could be much more damaging to the shareholder. company Y simultaneously transferred its assets to X for X's stock and then liquidated so that Y's shareholders became X 's shareholders. 329 Expanding on these criteria. which makes the nonrecognition principle of § 351 inapplicable to transfers of property ³to an investment company.since the gain (but not loss) recognition and basis consequences should be the same either way. Literally. the transaction may be financially tantamount to a sale.15 Transfers to Investment Companies
As previously noted.´ 328 The regulations add badly needed flesh to this statutory skeleton by providing that the prohibited transfers are those that (1) result. X was a mere continuation of Y. By setting out a short list of companies encompassed by the broad statutory reference to ³investment company. as required by § 351 for a tax-free transfer by A to Y for the latter's stock. is tantamount to a sale. in diversification of the transferors' interests. A. directly or indirectly. 330 Although the impetus for these restrictions on § 351's rule of nonrecognition was the transfer of appreciated securities. hence. and (2) are made to a regulated investment company. insurance. the regulations state that (1) diversification occurs if two or more persons transfer nonidentical assets to the corporation unless these assets are an insignificant portion of the total value of the transferred properties. In one such ruling. if two or more unrelated persons transfer separately owned property to a controlled corporation in exchange for the corporation's stock. so-called swap funds were devised in the early 1960s to permit unrelated investors holding highly appreciated securities to unlock their positions (without being taxed) by exchanging their securities for the shares of a newly organized mutual fund to be managed by the promoter of the plan. a minority stock interest in an acquiring corporation. § 351 applied to the transfers by A and Y. though this is only cold Code comfort for the luckless investors. Since A did not control Y (or its alter ego. 327 and. a real estate investment trust.14 Attempts to Avoid Sale Treatment
Note that the shoe may be on the other foot: The taxpayer may seek to apply § 351 to a transaction (usually a transfer of appreciated property) that. A's transfer was a taxable event. brokerage. § 351 permits the transferors to achieve a degree of diversification without recognizing gain. but the Service ruled that X should be disregarded because X was organized merely for the purpose of enabling A to transfer his property on a tax-free basis. Several IRS rulings indicate that such efforts may in some cases be frustrated with the aid of the step transaction doctrine 325 when an individual. or a corporation more than 80 percent of whose assets (excluding cash and nonconvertible debt securities) are held for investment and consist of readily marketable stock or securities or of interests in regulated investment companies or real estate investment trusts. the courts are not likely to welcome a belated claim by the taxpayer that the transaction was ³really´ a § 351 exchange. (2) securities are held for investment unless they are dealer property or are used in a banking.15 Statutory Exclusions From § 351 ¶ 3. even if the technical elements of estoppel are not present. X ). Exploiting this feature of § 351. 323
¶ 3. if the diversification is sufficiently dramatic. enacted the statutory predecessor of § 351(e)(1). 324 More foresighted taxpayers may attempt to cloak a transaction from its inception in the garb of a § 351 exchange. recognizing that these transactions were more like sales than conventional § 351 transactions. and (3) securities are readily marketable if (but only if) they are part of a class that is traded on a securities exchange or traded or quoted regularly in the over-the-counter market. for practical purposes. in the end. transfers appreciated property for what is initially a large interest in a corporation but that becomes.´ the regulations may tempt owners of appreciated securities to assume that no other transferees
. § 351(e)(1) allows transferors of depreciated securities to recognize their losses.
or any similarly held properties or interests to a corporation in exchange for shares of stock of such corporation when (i) the transfer is the result of solicitation by promoters.
¶ 3. it is equally possible that a distribution of money or other property in similar circumstances would be taxed as a dividend under § 301 rather than as boot under § 351(b). brokers. Congress enacted § 351(e)(2). if and to the extent that the excess is covered by earnings and profits. the corporation is a separate taxable entity under the Internal Revenue Code.15 Transfers by Bankrupt Corporations
When a corporation in bankruptcy plans to transfer its assets to a new corporation and to distribute the stock so obtained to its creditors in discharge of their claims. so that corporate income is taxed to the corporation and dividends paid by the corporation are taxable to the shareholders. widely held oil and gas properties or interests therein. which includes: [w]hether section 351 applies to the transfer of widely held developed or underdeveloped real property or interests therein. 339 Another transaction that can produce dividend income even though it fits within § 351 is the receipt of the transferee corporation's securities. gain). 337 and (2) a receipt of debt securities in the course of an otherwise tax-free recapitalization. money or other property in exchange for stock of an affiliated corporation. rarely. regulates the transaction in greater detail) rather than using a § 351 exchange. with related provisions. but is instead required to reduce specified tax attributes.
¶ 8. 338 Although the regulations speak only of a distribution of stock or securities. 334 The result is similar to an exchange of the bankrupt's assets for its debts and a hypothetical transfer by the creditors of the assets to the resulting new corporation. it usually effects the plan through a Type G reorganization (which. and the bankrupt's transfer of the stock to the creditors in discharge of its debts will produce discharge-of-indebtedness income equal to the difference between the bankrupt's cost basis in the stock and the amount of debt discharged. 331 But expansion of § 351(e)(1) by the 1997 legislation likewise shows that Congress intends to impose an expansive scope on this provision. or investment houses. since such an exchange can also be a redemption subject to § 304. Consequently. the possibilities include (1) the receipt by the transferor of property in a § 351 exchange of transferee corporation stock with a fair market value in excess of the value of the property transferred. which provides that § 351(a) does not apply to the transfer by a debtor in bankruptcy of assets to a corporation to the extent the stock received is used to satisfy the bankrupt's debts. with a basis equal to their current fair market value rather than the bankrupt's possibly higher historical basis. This chapter examines in more detail a subject of wonderful intricacy: the taxation of
. 333 To clarify the consequences of a transaction's failure to qualify as a reorganization.16 Transfer Under § 351 Versus Dividend
The regulations under § 351 suggest the possibility that a distribution by a corporation of its stock or securities ³in connection with an exchange subject to section 351(a)´ may have ³the effect of the distribution of a taxable dividend. the bankrupt's transfer of assets to the corporation will produce recognized loss (or.01 Introductory Dividends & other nonliquidating distributions
As noted in Chapter 1. such as the basis of its assets. but a caveat against pushing the envelope can be found in the Service's list of areas in which rulings will not be issued until unsettled questions are resolved. The bankrupt is not required to recognize this income currently. 332
¶ 3. or (ii) the transferee corporation's stock is issued in a form designed to render it readily tradable.´ 336 Although this part of the regulations does not identify the circumstances under which such a distribution might occur.are tainted. which by virtue of § 304(b)(3) (enacted in 1982) is controlling when it overlaps with § 351.
hence. To the extent that a distribution by a corporation is not out of current or accumulated earnings and profits. and 316 provide a framework for the taxation of such corporate distributions of property. If the distribution exceeds the adjusted basis of the stock. This bonanza can occur if the corporation has neither cumulative post-1913 nor current-year earnings and profits and if (to reverse the discount theory of the Phellis case) the shareholder did not pay a premium upon purchase for the tax advantage lurking in the corporation's deficit. 1913. and so forth) 14 is a dividend (a subset of distributions) that must be included in the shareholder's gross income as ordinary income under §§ 301(c)(1) and 61(a)(7) if. the reason for gearing the taxability of its distributions to its record of earnings and profits is clear enough. a corporate distribution with respect to stock (and not with respect to the shareholder's status as an employee. however. it comes ³out of´ either ³earnings and profits´ (a tax term. however. 13 By virtue of these provisions. or the corporation's earnings and profits of the current taxable year. This ³miracle of income without gain´ 17 was certified long ago by the Supreme Court in US v. and. shower the shareholder with riches on occasion. and that usually are not part of a corporate reorganization or division. of the stockholder whose shares he acquired. and in reduction of. 18 In point of fact. so it may. the surprised new shareholder realizes income upon the distribution. with the exception (of increasing insignificance) for distributions out of an increase in the value of corporate property accrued before March 1.nonliquidating corporate distributions that are not part of a stock redemption that is treated as a sale of the stock. the distribution will be a dividend under § 316 only if it is paid from the corporation's earnings and profits. in this as in other respects. if ever. the purchaser of stock must bid against many other potential buyers who would be affected in varying degrees by the income tax on a dividend. § 301(c)(2) treats that distribution as a return of capital to the shareholder that is to be applied against. The equity of §§ 316 and 301(c) is far less clear in a case in which the stock changes hands after a period of corporate profits and there is a distribution to the new shareholder before additional earnings arise (e. with equal irrationality. even though the distributions reflect earnings by the corporation after the stock is purchased. the adjusted basis of the shareholder's stock. any distribution to its original shareholders is a return of the shareholders' investment and not income. are taxed as ordinary income to the shareholders. seller. 15 Most property distributions of most corporations fall well within this category of taxable dividends and. 1913. ³Property´ refers to all items of economic benefit to shareholders other than the corporation's own stock and stock rights. so the price would rarely. and presumably the prospect of a dividend influenced the price paid. however. and some of whom might be tax-exempt organizations. creditor. [the shareholder] of course acquired as a part of the valuable rights purchased the prospect of a dividend from the accumulations²bought ³dividend on. Just as the use of earnings and profits to taint distributions as dividends may be unfair to a shareholder who buys stock before a corporate distribution. Until the corporation has engaged in profitable operations. 301(c). Moreover. sometimes referred to as E&P) of the corporation accumulated after February 28. Once the corporation has realized profits. if the stock is publicly traded. Phellis: In buying at a price that reflected the accumulated profits. the excess ordinarily is taxed as capital gain. If the corporation into which the purchaser buys has a deficit of earnings and profits. but §§ 301(c) and 316 are inescapable. Another source of complexity in the system of defining ³dividends´ is that it produces different tax results for different types of shareholders. He simply stepped into the shoes. distributions by the corporation may be treated as wholly or partly tax-free returns of capital to the shareholder. be accurately ³discounted by the prospect of an income tax to be paid´ on dividends that may be declared immediately after the stock is purchased. even if the purchaser were so foresighted as to anticipate the problem. 16 Assuming that a corporation is newly organized with cash. the next day). since the calculation of earnings and profits is a complex operation.´ as the phrase goes²and necessarily took subject to the burden of the income tax proper to be assessed against him by reason of the dividend if and when made. to the extent of the shareholder's share of the corporation's earnings and profits passed out in the distribution. 12 Sections 301(a). 19 the purchaser may not know the proper discount to apply (except in the case of stock in traditionally profitable publicly traded companies and possibly in the case of a closely held corporation).g. Individual shareholders generally favor nondividend distributions over dividends because (1) the full amount of a dividend is includible in gross income without offset for stock basis and (2) that amount is taxed as ordinary income (in contrast to any current preference for capital
. its distributions may be fairly regarded as income to the shareholders pro tanto. and was discounted by the prospect of an income tax to be paid thereon. Therefore.. Has there been a return of this shareholder's capital as well? The economist might say that a distribution in these circumstances ought to be regarded as a return of capital. discussed below. and to the extent that.
02 ³Dividend´: A Term of Art ¶ 8. the government tends to be whipsawed by rules designed to enhance earnings and profits if it forgets about the existence of corporate shareholders. Distributions in kind of the corporation's own stock or of rights to purchase its stock. On the other hand. 30 The explanation.´ 31 Conversely. ³[W]hat the distributing corporation may call a dividend.´ as defined for income tax purposes by § 316(a).
¶ 8. 20 Thus. real estate or marketable securities)). Congress has shown no disposition to depart significantly from the present method. is that a realization event has occurred since the shareholder now has converted part of his stock into another form. 21 Despite these shortcomings. The dividend is taxed despite the fact that it does not enlarge the shareholder's net worth but merely transfers part of the value represented by the shareholder's stock out of corporate solution and into his personal possession. nor are earnings and profits represented by a bank account or other specific corporate asset (although. 23 2. 25 4. Distributions in kind generally (i. does not correspond to the term ³dividend´ under state law. 33 but it must be pointed out here that the term is not identical to financial accounting ³earned surplus´ or ³retained earnings´. Distributions of the corporation's own obligations. is not necessarily a µdividend' for federal income tax purposes. or what the state law may call a dividend. and no tracing or earmarking of funds or assets is required. Distributions in redemption of stock. including partial and complete liquidations.02 General Rule
Under § 301(c).gain). 1913. of course. and thereafter taxable gain under § 301(c)(3). Many additional dividend-related issues are raised by distributions in kind. Preferred stock bailouts. Distributions in corporate reorganizations and similar transactions. and these are discussed later in this chapter. if earnings and profits exist. 26 5. 22 Before turning to the details of the general rule under which a distribution by a corporation is a dividend if it comes out of current-year or post-1913 accumulated earnings and profits but is a return of capital to the extent of any excess.. corporate property other than money (e.e. a corporate distribution may be a ³dividend´ under § 316(a) even if it impairs capital or is otherwise unlawful under state law. it should be noted that special rules are provided for certain categories of distributions: 1. A distribution is ³out of´ earnings and profits if the corporation operated profitably so as to generate earnings and profits in the period under consideration. 29 the balance of the distribution. 27 and 6. or (2) earnings and profits of the taxable year. corporate shareholders usually prefer to identify a distribution as a dividend because corporate shareholders enjoy dividends-received deductions. a distribution is includible in a shareholder's gross income under § 61(a)(7) to the extent that it is a ³dividend´ as defined in § 316.g. 24 3. The term ³dividend. While a better response to this need could no doubt be devised. Consequently. it is possible for a distribution to constitute a lawful ³dividend´ under state law without qualifying as a ³dividend´ under § 316(a). is a return of capital under § 301(c)(2). 32 The definition of ³dividend´ in § 316 is two-fold: A property distribution by a corporation to its shareholders is a ³dividend´ if it is made out of (1) earnings and profits accumulated after February 28.. ³Earnings and profits´ is a term of art that will be examined in detail. if any. or even what the recipient thinks of without question as a dividend. the corporation ordinarily will own roughly commensurate unencumbered cash or undepreciated assets). the existing system of relating the tax status of corporate distributions to the corporation's earnings and profits is an important component of the two-tier taxation of corporate income and is responsive to the need for a method of protecting returns of capital from the tax on dividends. 34 One of these issues that is of possible relevance to cash distributions is the determination of the amount of the distribution when the shareholder assumes a corporate liability in connection with the
if the concept of earnings and profits serves any useful purpose. To enable such corporations to obtain a credit for distributions out of current-year earnings. conversely. since it will fall under neither § 316(a)(1) (accumulated earnings and profits) nor § 316(a)(2). the corporation would be unable to avoid the undistributed-profits tax. For cases in which the distributions for the year exceed in amount both the earnings and profits of the current taxable year and the post-1913 accumulated earnings and profits. it is partly undermined by § 316(a)(2). § 316(a)(2) provides that the earnings and profits for the year are to be computed as of the close of the year without diminution by reason of distributions during the year. While this may be convenient. § 316(a)(2) often makes it unnecessary to compute the corporation's post-1913 accumulated earnings and profits. for example. 36 After the corporation's current. Therefore. Congress apparently gave no thought to the effect of the new subsection apart from the undistributed-profits tax. a corporation having current-year earnings and profits. 38 In determining whether a distribution is out of earnings and profits of the current taxable year. it is often unnecessary to compute the latter amount if the distributing corporation is currently profitable.02 From Current Earnings
. Unless a corporation with a deficit in accumulated earnings and profits (including a profitable current year) could treat distributions out of current-year earnings as ³dividends´ for this purpose. and pre-1913 accumulated earnings and profits cannot make a nontaxable distribution from the pre1913 earnings and profits until the current and then the post-1913 accumulated earnings and profits have been exhausted. Because the ordering rule discussed above mandates that dividends come first from current-year earnings and profits. there is no economic difference between a distribution made before the corporation has had any earnings. 35
¶ 8. Section 316(a)(2) has a curious ancestry. the corporation may be able to earmark a distribution so as to qualify the distribution for the exemption conferred by § 301(c)(3)(B) (pre-1913 increase in value) and thus protect its shareholders against a capital gains tax under § 301(c)(3)(A) to the extent the distribution exceeds the dividend portion and the stock basis. the latter distribution is a ³dividend´ under
¶ 8. That tax was imposed on the undistributed part of corporate income. which distribution is not a ³dividend´ under either § 316(a)(1) or § 316(a)(2). the regulations prescribe methods of allocating the two categories among various distributions in order to ascertain the ³dividend´ component of each distribution. Congress enacted § 316(a)(2). although it is unlikely. the amount of the distribution would be reduced by the amount of the liability assumed. 46 Since corporations making distributions generally are currently profitable. This prevents earmarking a distribution to control its tax status. If the corporation has no earnings in that year and still has a deficit in accumulated earnings and profits. as described in an example later in this chapter. Such assumption could possibly occur upon a cash distribution. post-1913 accumulated earnings and profits. no matter how large were its distributions to stockholders. it means that a distribution may be a taxable ³dividend. 40 Distributions on preferred stock absorb available earnings and profits before distributions on common stock.02 Ordering and Tracing Rules
The second sentence of § 316(a) lays down an irrebuttable presumption that every distribution is out of earnings and profits to the extent thereof and that the distribution comes from the most recently accumulated earnings and profits. 37 however. 39 This means that a distribution will be a ³dividend´ if the corporation has earnings and profits at the end of the current taxable year. 42 such reduction is made after the reduction for ordinary distributions from the current-year earnings and profits. and pre-1913 earnings and profits have been exhausted. and only thereafter from accumulated earnings. In any event. 43 Section 316(a)(2) provides that a distribution is a ³dividend´ if it comes from earnings and profits of the corporation's current taxable year.´ even though the corporation has an accumulated earnings and profits deficit. For the original shareholders of a corporation. 41 To the extent stock redemptions that are treated as exchanges reduce earnings and profits. However. and § 316(a)(2) was left intact when Congress repealed that tax in 1939. the distribution will be received tax-free. a distribution that seemed to be a ³dividend´ when made may turn out to be a return of capital because the corporation has no earnings and profits at the end of the year or for prior years. computed by deducting ³dividends´ from total income. 44 The impact of such a ³nimble dividend´ 45 by § 316(a)(2) can sometimes be avoided by postponing the distribution until the next year. It was enacted in 1936 as a relief measure when the undistributedprofits tax was in effect. even though it had none when the distribution occurred. post-1913. and a distribution made after the corporation has suffered a cumulative loss.cash distribution.
thus. if the corporation was incorporated after 1913 and did not succeed to the tax history (through attribute carryovers) of a preexisting. the shareholder may recognize gain on low-basis shares. 47 Since even a corporation that belongs to this select group is likely to keep its distributions to shareholders well within its current or recent earnings and profits. the adjusted basis of the shareholder's stock. It obviously affects only corporations organized on or before February 28. pre-1913 corporation). however. 52 Several aspects of the return-of-capital distribution rules of §§ 301(c)(2) and 301(c)(3) deserve special comment. such gain has been held not to be reportable on the installment method. Since distributions only reduce earnings and profits under § 312(a) ³to the extent thereof. even if those earnings are insufficient to repair the deficit. The first occurs when the corporation has accumulated prior-year earnings. would include the current year. it is not clear whether the shareholder is entitled to recover his aggregate stock basis before reporting any gain. however.´ 60 Proposed Regulations issued in January 2009 adopt this latter approach. which provides that a distribution is a ³dividend´ if it comes from earnings and profits accumulated since February 28. where the accumulated earnings and profits available on the date of the distribution will be relevant. it is subject to §§ 301(c)(2) and 301(c)(3). 48 While the accumulated earnings and profits referred to by § 316(a)(1).§ 316(a)(2) if there are current earnings.1
. at least some distributions will be taxed to the shareholders as ³dividends. in theory. instead. If the corporation has operated profitably in the aggregate since 1913 (or since organization. as capital gain if the stock is a capital asset). the earnings accumulated to the date of the distribution will control. unless it is out of a pre-1913 increase in the value of the corporation's property. 54 In computing gain under §§ 301(c)(2) and 301(c)(3). and the same approach presumably should be applied to the computation of shareholder gain under §§ 301(c)(2) and 301(c)(3). the complicated network of law built on the 1913 benchmark is of interest to very few shareholders. more defensible.02 No Current or Accumulated Earnings: Return-Of-Capital Distributions
If the corporation has neither post-1913 accumulated earnings and profits nor current earnings and profits. 57 the shareholders generally compute gain or loss on a share-by-share basis. 1913. since its impact can be avoided if the distribution can be postponed until a year in which the corporation has no earnings and profits. first-out ordering rule and the alternative route to dividends out of currentyear earnings generally is to confine the term ³accumulated´ to earnings accumulated through the end of the immediately preceding year. 53 Moreover. Under § 301(c)(2). In that situation. 55 When a stock redemption is treated as a sale under § 302(a). 50
¶ 8. a distribution cannot be a ³dividend´. but cannot produce a deficit therein. 1913 (the date of the first federal income tax imposed after the adoption of the Sixteenth Amendment) is a matter of legislative grace rather than constitutional right. and their successors. they reduce earnings and profits first in the order in which they occur. The sale gain created by § 301(c)(3) will be entitled to capital gains treatment only if the stock is a capital asset in the shareholder's hands. looks to the financial success of the corporation over the long haul. distributions can only reduce earnings to zero. 49 Similarly.02 From Accumulated Earnings (Historical Earnings and Profits)
Section 316(a)(1). and reduces. in which event it will enjoy an exemption from tax. of course. 51 If the distribution is greater than the adjusted basis of the stock. even though the basis of the shareholder's high-basis shares has not been fully recovered. For shareholders who acquire their stock after the deficit but before the earnings. If the gain or loss on the distribution must be computed on a share-by-share basis.´ It is notable that the exemption of earnings and profits accumulated on or before February 28.
¶ 8. however. the effect of the last-in. 58 Note that a deficit in accumulated earnings and profits results from an excess of losses over post-1913 earnings. 56 or when corporate assets are distributed in complete liquidation. the distribution is applied against. but incurs a current-year deficit. 1913. 59 such deficit must be restored by undistributed current-year earnings before the corporation can again have accumulated earnings and profits. the excess is treated by § 301(c)(3) as gain from the sale or exchange of property (and. § 316(a)(2) does not go far enough in this case. § 316(a)(2) is. 58. Two situations can arise. when there are two or more distributions in a taxable year.
and each shareholder's gain is computed accordingly.000. the normal top corporate tax rate of 35 percent (2005) is imposed on only 30 percent of the dividends received.000. However. that is. while if the deficit is traceable to post-July 1 events.02 Examples
Current-year earnings.000 during Year 2.000 in its earnings and profits at the beginning of Year 2.000 during Year 2. the accumulated earnings having been exhausted by the April distribution). If company X in Example 1 waits until Year 3 to make the distribution and has no current earnings and profits in that year. accumulated earnings will be reduced by $16. 168 The deductions cause corporate investors to favor holding corporate equity (and sometimes to accept a lower rate of return on relatively secure equity. since X's Year 2 earnings and profits will be absorbed by X's deficit. and the distribution will be a dividend to this extent.000 are prorated between the April and September distributions. § 243(a)(1) is of principal importance. These deductions (complemented by the consolidated return rules) function somewhat imperfectly to tax corporate income only once until it is finally distributed to noncorporate shareholders. the distribution will be treated as a return of capital under §§ 301(c)(2) and 301(c)(3). has earnings and profits of $10.000 (one half of the deficit) to $12. 60. notwithstanding X's deficit.000 in September of Year 2. has earnings and profits of $10. § 244 (at 2005 rates.5 percent the effective maximum tax rate on dividends received by a corporation on portfolio stock. Because the current earnings and profits of $10. or 100 percent of dividends received from a domestic corporation subject to federal income taxes).000 of the September distribution is a dividend ($5. or § 245 (70 percent. and distributes $20. The regulations suggest that the current deficit is prorated throughout the year if it cannot be allocated specifically to a part of the year. 61
Current deficit. The rest is applied against the basis of the stock.5 percent (15 percent of 30 percent of dividends received) to
. and distributes to its shareholders $10.000 on July 1 of Year 2. the effective tax rate on dividends received can range from a low of 4. leaving no accumulated earnings to support dividend treatment in Year 3. Company Z has accumulated earnings of $20.000 in April and $20. accumulated earnings at the date of the distribution will be reduced by $8.
¶ 5.000 to its shareholders on July 1 of Year 2. Company Y has accumulated earnings and profits of $15. 80 percent.05 Dividends-Received Deduction and Related Problems
Dividends received by a corporate taxpayer ordinarily qualify for the dividends-received deduction provided by § 243 (either 70 percent.¶ 8. If the deficit is prorated. if the deficit can be traced and allocated in full to the first half of Year 2.000 on January 1 of Year 2.000 in Year 2. the April distribution is a dividend in its entirety ($5.000 from the prorated current earnings. X has a deficit of $20. § 243 reduces to 10.000. incurs a current operating deficit of $16. Under § 316(a)(2). and they tend to counterbalance the usual preference of corporations for issuing debt when they need to raise capital. while only $5. and the dividend portion of the distribution will be only $4. Of these provisions. By permitting the corporate taxpayer to deduct 70 percent of dividends received from other corporations. the entire distribution would constitute a dividend. the Year 2 distribution is a taxable dividend. calendar-year method of accounting. Assume that company X and its shareholders are on the cash-basis.
No current earnings. and the balance comes out of accumulated earnings).000 is out of the prorated current earnings.000 at the start of Year 2.1
Distributions in excess of current earnings. or 100 percent of a specified portion of dividends received from certain foreign corporations). all subject to the limitations imposed by § 246. This distribution is applied on a share-by-share basis as well as upon each class on which the distribution is made. as compared with debt). and distributes to its shareholders $20. 80 percent. If the corporation's taxable income is below $15 million (the start of the top rate bracket). about 48 percent of dividends received on certain preferred stock of public utilities).
a basis increase similar to those in consolidated returns can be obtained by contributing the deducted dividend back to the paying corporation. At the 35 percent rate (for 2005). the common parent of the group must file an election to which all members consent (a wholly owned subsidiary is deemed to consent). first-out tracking rule for earnings and profits is favorable to the newcomer. it is entitled to an 80 percent deduction. they reflect income that has been subjected to U. 60 percent of its dividends will be eligible in the hands of a recipient corporation for the 70 percent or 80 percent deduction. In harmony with this principle. roughly speaking.05 Dividends From Certain Foreign Corporations ¶ 5. because a foreign corporation cannot be a member of an affiliated group.05[a] Doing Business in the United States
Dividends paid by a 10 percent owned foreign corporation qualify for the dividends-received deduction under § 245 if (1) the paying corporation is not a foreign personal holding company or a passive foreign investment company. the shareholder owns 20 percent of the stock by vote and value (or more). 173 Thus. however. determined by reference to the ratio of the payor's post-1986 undistributed earnings from sources within the United States to its total post-1986 undistributed earnings. 169 The tax benefit of this deduction is of course greater if the dividends qualify for the 80 percent or 100 percent deduction. To counterbalance the utility's right to deduct certain dividends paid by it under § 247. indeed. 1942. in lieu of the normal deduction under § 243.
¶ 5. If the dividends qualify under these tests. the foreign corporation is wholly
. 175 Thus. however. § 247 allows public utility corporations to deduct a portion of dividends paid by them on preferred stock issued before October 1.05 Dividends From Domestic Corporations
Section 243(a)(1) provides generally that 70 percent of the amount received as dividends from a domestic corporation that is subject to federal income taxation may be deducted. with certain minor modifications. 177 (2) it is subject to federal income taxation. taxation. 170 If. complete tax immunity for dividends is ordinarily feasible for an affiliated group. By virtue of these complex limitations. or issued thereafter to refund debt or preferred stock issued before that date. 174 Qualifying dividends must be paid from earnings and profits accumulated during the period of affiliation.S. 176
¶ 5. Thus. To qualify for the 100 percent deduction. if 60 percent of a 20 percent owned foreign corporation's earnings are from business sources within the United States.05 ³Qualifying Dividends´ of Affiliated Groups
Section 243(a)(3) permits a 100 percent deduction for certain intercorporate dividends received from a member of the same ³affiliated group. 171 The requirement that the paying corporation be subject to income taxation reflects the fact that the purpose of the deduction is to mitigate the multiple taxation of corporate earnings.10. § 244 allows the recipient corporation to take only about 48 percent of the dividend into account in computing its dividends-received deduction. Indeed. the deduction embraces dividends paid by a foreign corporation only to the extent that.´ This term has the same meaning as for determining whether corporations can file consolidated returns. 178 If. and certain dividends received from regulated investment companies also receive special treatment. the 70 percent or 80 percent deduction of § 243 is applied to a portion of the dividends. fourteen thirty-fifths (40 percent) of the dividend paid is deductible by the paying corporation. a corporation cannot buy into the deduction. The 100 percent deduction of § 243(a)(3) for qualifying dividends cannot apply. 172
¶ 5. although the regulation's last-in.2 percent (34 percent of 30 percent of dividends received). and (3) at least 10 percent (by voting power and value) of its stock is owned by the recipient corporation. both corporations must have been members of the affiliated group for each day of the year in order for the earnings of the year to count. dividends paid by mutual savings banks and domestic building and loan associations (loosely referred to as interest) and by real estate investment trusts do not qualify for the deduction.05 Dividends on Public Utility Preferred Stock
In increasingly rare instances. whether or not it elects to file a consolidated return.
are allowed to deduct items that are effectively connected with the U. since the corporate investor is receiving interest rather than dividend income. business income. that is. § 316 defines the term ³dividend´ for purposes of the entire income tax subtitle. 190 Corporate shareholders about to sell stock in a controlled corporation often arrange to receive a dividend shortly before the stock sale for the purpose of stripping value out of the stock at a lower overall tax cost (because of the dividends-received deduction) than would be imposed if they sold the stock and were taxed on their capital gain. For this reason. for that matter. 182
¶ 5. any other deductions.05[b] Doing Business Abroad: The Deemed Paid Foreign Tax Credit
While intercorporate dividends between domestic corporations are substantially relieved from double taxation by the deduction mechanism of § 243. Thus. § 301 defines ³amount of the distribution´ to be the fair market value of property or the amount of cash received and requires that the resulting dividend portion of that distribution be included as such in gross income. whether such amounts are treated as dividends or as a return of stock basis. however.S. the dividends qualify for a 100 percent deduction. 181 Foreign corporations with a domestic business situs. but is not allowed the 70 percent or 80 percent dividends-received deduction or. 185 Furthermore. (2) redemption proceeds that are treated as received in a sale or exchange of the stock under § 302(a). the so-called deemed paid foreign tax credit of § 902.05 Deductions by Foreign Corporations
A foreign corporation not engaged in trade or business in the United States is taxed on dividends received from U. 188 and (4) receipts that are not received by a shareholder with respect to his stock but are received in some other capacity. including §§ 243 through 245. and the Service agrees.S. stock dividends that are excluded from gross income under § 305 should not give rise to a dividends-received deduction. 186 Nondividend distributions from a corporation that clearly should not be entitled to the dividends-received deduction include (1) distributions in excess of earnings and profits. as a distribution of property by a corporation to its shareholders from its accumulated or current earnings and profits. the taxable recipient of a dividend is the owner of the stock on the dividend record date.S.S. corporations. business. 189 Reorganization boot dividends. in this situation.´ as opposed to capital gain or some other type of nondividend income and. if it is a dividend. what is its amount.05 Definition and Amount of ³Dividend´
Although §§ 43 through 245 do not say so explicitly. Generally. In so doing. 180
¶ 5. if the distribution is not made with respect to ³stock. 179
¶ 5. if the dividend is actually paid from the controlled corporation's assets rather than from the assets of the acquiring party. dividends should not qualify for the dividendsreceived deduction unless they are includible in the recipient's gross income. have been held by the courts to qualify for the § 243 dividends-received deduction. enterprise.´ no dividends-received deduction is allowed. Thus. allows a domestic parent corporation that owns 10 percent or more of a foreign corporation and receives a dividend therefrom to elect to claim a so-called derivative foreign tax credit for taxes paid by the foreign corporation. including dividends received if they constitute U. One of these provisions. relief from international double taxation is generally accomplished by means of the foreign tax credit rules of §§ 901 through 906. corporations desiring to raise capital from corporate investors often strive to
.S. As discussed later in this book. even though another person owns the stock on the later ex-dividend date. are whether an includible amount qualifies as a ³dividend. however. 192 Of course.´ but is paid instead as a return on a ³debt. business. 184 Section 301 prescribes the treatment of property distributions by corporations to their shareholders. the foreign subsidiary is treated as the economic equivalent of a U. 187 (3) liquidation proceeds.S.owned by U. corporate shareholders and if all of its gross income is effectively connected with a U. this ploy will work if the proper formalities are observed. however. a matter discussed later in this book. the rules of §§ 301 and 316 for determining the amount of the distribution and the dividend component thereof control not only the shareholder's taxable portion of the distribution but also the correlative amount of a corporate shareholder's dividends-received deduction. 183 More difficult issues. 191 Similar threshold distributions made in close proximity to the corporation's liquidation also receive close scrutiny as to their true character: ordinary dividends or liquidating distributions.
the earnings will be taxed for the first time at the corporate level. 196 These corporations are disqualified because their earnings are wholly or partially taxexempt. 200
¶ 5.05[a] Certain Distributing Corporations Excluded
Section 246(a) provides that the dividends-received deductions of §§ 243 through 245 do not apply to dividends paid by corporations that are exempt from tax under § 501 (charitable corporations. 201 A similar manipulative device was the maintenance of both long and short positions in the stock over the dividend payment date in order to deduct the amount of the dividend paid to the lender of the short stock from ordinary income while reporting only 15 percent of the dividend received on the long stock.and post-dividend terms. federal instrumentalities. and this proposal was adopted in the 1997 Tax Act.05[b] Ceiling on Aggregate Deduction
Unless the taxpayer corporation has incurred a net operating loss in the taxable year (computed under the usual rules of § 172. under which interest on debt incurred to finance the investment was fully deductible while the associated dividend
. the holding period being tolled if the taxpayer substantially diminished its risk of loss from holding the stock. the dividends-received deduction held out to the corporate taxpayer the possibility of buying stock just before a dividend became payable and selling it immediately thereafter in order to deduct the loss on the sale (presumably equal to the amount of the dividend. 80 percent of the recomputed taxable income is compared with the normally allowed 80 percent deduction with respect to dividends from 20 percent owned corporations. 198 Second. a limit is applied to the aggregate of its 70 and 80 percent deductions plus most of its other deductions under §§ 244 and 245. 202 To close these loopholes. and the lesser amount is allowed as the actual deduction with respect to those dividends for the year. 80 percent. 195 mutual telephone companies. assuming no interim market fluctuations). 207 Note that this limitation also applies to individuals' reduced rate dividends. § 244.05 Overall Restrictions on Deductions
Although there are technically three separate dividends-received deductions (§ 243. 193
¶ 5. and § 245. for dividends paid by domestic corporations in the amount of 70 percent. with respect to which a 70 percent deduction normally is allowed). portfolio dividends from less than 20 percent owned corporations. 207. and the dividends-received deductions subject to this process. 197 This limitation is computed first by recomputing taxable income without regard to net operating loss carryovers.1
¶ 5. capital loss carrybacks. for certain preferred dividends paid by public utilities. 70 percent of the recomputed taxable income is compared with the normally allowed deduction with respect to all other dividends subject to the rule (principally. or was subject to a similar obligation with respect to the dividend. or 100 percent of the dividend. 204 Section 246(c) denies any deduction under §§ 243 through 245 if the stock is not held for more than forty-five days (ninety days in the case of certain preferred stock). they are aggregated in large part by § 246 for the purpose of imposing the limitations explained in the following text. Congress enacted § 246(c) in 1958 203 and strengthened it in 1984. and so forth) or § 521 (farmers' cooperative associations). 205 The deduction is also denied if the taxpayer maintained a short position in substantially similar or related stock or securities. for dividends paid by certain foreign corporations). without any ceiling on the dividends-received deduction).05[c] Brief Holding Periods
Before 1958. while paying income tax on only 15 percent (under then applicable law) of this amount.
¶ 5. when another corporation receives their earnings in the form of dividends. 194
¶ 5. 199 Third. with certain other adjustments. 206 Proposed legislation in the Clinton 1996 and 1997 budget bills would extend the § 246(c) holding period to include both pre. and the lesser amount is allowed as the actual deduction with respect to those dividends for the year.05[d] Debt-Financed Portfolio Stock Dividends
Section 246A deals with the tax rate arbitrage effects created by the use of leveraged portfolio stock.provide their investors with debt-like paper with a sufficient equity flavor to qualify payments thereon for the dividends-received deduction.
P's basis in the T stock (at least prior to 1984) would be undiminished. but they are too good to be true. which then distributed a dividend equal to or greater than 10 percent of P's basis for its T stock. regardless
. Section 246A reduces the recipient corporation's § 243 deduction to the extent of the debt-financed percentage of the stock. however.
The Treasury has proposed to tighten § 246A by adopting a new and far looser ³linkage´ test: 210 that is. this deferral rule resulted in the creation of a negative basis for the stock. are automatically deemed to be extraordinary: (1) redemptions that either are treated as partial liquidations or that are non±pro rata but nevertheless are treated as dividends. however. and the market value of the T stock should drop by approximately the amount of the dividend. if the taxpayer acquired at least 50 percent of the stock (or owned at least 20 percent. it is important to understand some significant limitations on the application of § 1059. On a later sale or exchange of the stock. There are various mechanisms for dealing with this scenario in the context of affiliated corporations filing consolidated returns. as will be discussed later in this book. If the amount of the dividends-received deduction is not fully absorbed by the stock's basis. however. Obviously.05 Basis Reduction for Extraordinary Dividends: § 1059
If corporation P purchased common stock of target T. 217 Section 1059 does not apply to qualifying dividends that are eligible for the 100 percent dividends-received deduction. 218 It also does not apply to certain preferred stock dividends if the taxpayer holds the stock for more than five years.´ 216 or to stock held during the entire period of the payor's existence. and five or fewer corporate shareholders owned at least 50 percent of the paying corporation). the remainder was (between 1986 and 1997) treated as gain at the time of a later stock sale.. 211 In the unconsolidated context. P's dividend income will be reduced by the 70 percent or 80 percent dividends-received deduction (or possibly even the 100 percent deduction if T becomes part of P's affiliated group and the dividend is paid from earnings for a full year of affiliation). 214 Because its consequences are so significant.g. P would reduce the basis of the T stock (but not below zero) by the amount of its § 243 deduction unless the transaction satisfied one of § 1059's exceptions. however. if half of the stock basis is debt-financed. provided the payor corporation's earnings and profits have not been augmented by earnings and profits of other corporations (e. These results not only appear to be too good to be true. unless the stock was held for more than two years before the ³dividend announcement date´ or satisfies certain other conditions. except to the extent attributable to earnings accumulated prior to the time of affiliation. to claim a capital loss equal to the decline in value when the stock goes ex-dividend. 213
¶ 5. half of the § 243 deduction can be denied. and (until regulations are issued to the contrary) it does not apply to dividends from an affiliated group member with which the recipient files a consolidated return. If T pays a dividend shortly thereafter. the new limitation would be the sum of (1) the percentage of stock directly financed by debt and (2) the percentage indirectly financed by debt determined by using a pro rata allocation concept. which does not reduce the dividends-received deduction itself but instead imposes a special basis reduction rule that requires a corporate shareholder to reduce its basis for stock owned by it to the extent of the nontaxed portion of any ³extraordinary dividend. 219 Certain dividends. but was changed in 1997 to an immediate gain recognition rule. assuming no interim market fluctuations. using a broad definition of ³announcement. 215 It also does not apply to dividends announced more than two years after the stock acquisition.income on the acquired stock was taxed at a low effective rate because of the dividends-received deduction. cannot exceed the amount of deductible interest. nor does it apply if the taxpayer is entitled to the 100 percent dividends-received deduction. P 's gain or loss would be computed by reference to its stock basis as reduced by § 1059. If corporation P buys stock in corporation T. the reduction. permitting P to sell the T stock and.´ The latter is a dividend equaling or exceeding a prescribed ³threshold percentage´ (5 percent for preferred stock and 10 percent for other stock) of the underlying stock basis. the statutory mechanism is § 1059 212 (first enacted in 1984 and later modified in 1986 and 1997). 208 This provision does not apply. § 1059 applies only to corporate shareholders who enjoy a dividendsreceived deduction. through mergers) with which the shareholder did not have the same historic relationship. Thus. the purchase price will presumably reflect the value of any potential dividends inherent in the stock. or to gain on the payor's property that accrued before the payor became a member of the affiliated group.
and reduces the adjusted basis of.20 Introductory Property distributions in kind ¶ 8. has no problem of basis.
¶ 8.´ as defined in § 317(a). stock that has a declining dividend rate or a redemption price less than its issue price or stock that is otherwise structured so as to enable corporate shareholders to reduce tax through a combination of dividends-received deductions and loss on the sale of the stock. The balance. 226 Finally. The shareholder. 309 however. Finally.S. 229 The current 100 percent dividends-received deduction for 80 percent owned corporations would be retained. if any. in calculating the 5 percent or 10 percent thresholds. regulations proposed in 1996 and adopted in 1997 222 provide (prospectively) that § 1059(e)(1) trumps any of the exceptions to § 1059. the shareholder has the option to show the fair market value of its stock in the payor corporation as of the day before the ex-dividend date. Any excess is subject to § 301(c)(3).20 General Issues and Stakes
When a corporation distributes cash to its shareholders. is applied against. rather than its adjusted stock basis. However. while another rule treats as extraordinary all dividends with ex-dividend dates during the same 365 consecutive days if their total exceeds 20 percent of the stock's basis. having received cash. Other issues include: does the distribution of depreciated property produce a corporate loss? How does a distribution of property affect earnings and profits? What is the basis of the distributed property in the hands of the shareholders? There may also be a threshold issue of whether the corporation distributed ³property. since dividends obviously can be segmented. 227
¶ 5. or instead made an anticipatory assignment of income that may be property under state law but that will not shift the taxation of future income away from the corporation to the shareholders transferees. The corporation's earnings and profits are reduced to the same extent that the distribution is a ³dividend´ to the shareholders.20 Pre-1954 Code: Judicial Nonrecognition Regime
.05 Proposed Dividend Exclusion: Effect on § 243 DividendsReceived Deduction
The Treasury's proposed exclusion for dividends paid from previously taxed income 228 would apply to corporate shareholders as well as individuals. In turning from a corporate distribution of cash to a distribution in kind. 223 The Treasury's proposed dividend exclusion 224 would also extend the § 1059 basis reduction rules to tax-exempt dividends and basis step-up allocations to all shareholders. Thus qualified dividends would be exempt at the corporate level as well and would increase its excludable distribution amount (and hence will remain excludable when redistributed by the recipient corporation). the distribution itself is not a taxable event. one rule aggregates all dividends received within an 85-day period. the shareholder's stock under § 301(c)(2). 225 The normal rules for identifying an extraordinary dividend require a comparison of the amount of the dividend with the underlying stock's adjusted basis. The principal issue is whether the mere distribution of appreciated property creates corporate income. The distribution is a ³dividend´ to the extent of the corporation's current and accumulated post-1913 earnings and profits.of the holding period of the stock. 221 Moreover. proposed legislation would expand the per se basis reduction rules of § 1059(e)(1) (once again) to include all dividends not subject to current U. but the 80 and 70 percent deductions would be phased out under a transition rule. including a proportional part of dividends subject to reduced treaty rates. that is. 220 and (2) dividends on so-called self-liquidating preferred stock. problems quickly proliferate. 230 But this proposal failed to pass. and to use that amount. corporate and individual. tax. As to the corporation. the tax consequences to both the recipient and the corporation can be easily determined if the corporation's earnings and profits are known.
first-out property and of other appreciated property if subject to a liability in excess of its basis. v. the issue had arisen before the General Utilities case. while preserving intact the nonrecognition principle for the corporation's losses on depreciated property. moreover. the Treasury. assets generally are permitted to leave corporate solution and to take a stepped-up basis in the hands of the transferee without the imposition of a corporate-level tax. usually with a citation to General Utilities & Operating Co. and other similar amounts). Where the General Utilities rule applies. 311 Actually. 313 Even though the question was not foreclosed by that opinion. as to liquidating distributions. the result was endorsed. and the specialized nonrecognition rule of § 336 for liquidating distributions of appreciated and depreciated property. by the 1954 enactment of the statutory predecessors of § 311(a)(2). a corporation realized taxable income just as if it had sold the property for the property's fair market value or had used the property to satisfy an obligation in that amount. Application of this general rule is relatively easy when the taxpayer receives ascertainable value in an exchange. which effectively repealed both the general nonrecognition rule of § 311(a)(2) for nonliquidating distributions of appreciated property. It had been held that a corporation should not recognize loss upon distributing depreciated property to shareholders because Treasury regulations had long denied loss recognition upon liquidating distributions and ³no difference exists in principle´ between liquidating and nonliquidating distributions in kind. but it appears more difficult when there is no formal exchange present.20 Repeal of General Utilities Doctrine. as far as nonliquidating distributions of appreciated property were concerned. thus assuring that a tax will eventually be collected on the appreciation. Under normally applicable tax principles. that a corporation did not recognize gain or loss on a distribution of appreciated or depreciated property to its shareholders with respect to their stock. Congress created more and more exceptions to the ostensible general rule of nonrecognition. namely. tax benefit. as to nonliquidating distributions.Section 1001(c) (and its predecessor) requires the recognition of gain and loss realized upon the disposition of property. Moreover. For this reason.20 1954 to 1986: Rise and Fall of General Utilities Doctrine
As originally enacted. and § 336. Congress offered this rationale: 321 [T]he General Utilities rule tends to undermine the corporate income tax. Current Law
This legislative trend reached its zenith in the Tax Reform Act of 1986. however. payment of the capital gains tax is deferred because the shareholder's gain is reported under the installment
. Helvering . The courts consistently rejected the Treasury's argument. To the extent that the general recognition rule of § 1001(c) does not apply to corporate distributions in kind. a single shareholder-level capital gains tax (and perhaps recapture. nonrecognition of gain is available only if the transferee takes a carryover basis in the transferred property. in the context of a taxpayer's seeking to recognize a loss. the effect of the rule is to grant a permanent exemption from the corporate income tax. at most. 320 In enacting current § 311(b). * The price of this basis step up is. 312 Although the government had argued for the recognition of taxable income upon a distribution of appreciated property simply because a property disposition had occurred in General Utilities. 314
¶ 8. as tax issues often do. over the course of time. before 1954. which was less a break with tradition than the culmination of a gradual process. 319 subject to an intricate web of transitional exceptions. on a number of occasions.* Thus. the Supreme Court did not find it necessary to pass on this particular ground in denying the assessment against the distributing corporation. 315 The 1954 statutory nonrecognition principle was qualified from the outset by the uncertain judicial practice of imputing some shareholder sales and other dispositions of distributed property to the corporation 316 and by several explicit statutory exceptions in old § 311 317 that required the corporation to recognize gain on certain distributions of appreciated last-in. § 311(a)(2). 318
¶ 8. codified what had come to be called the General Utilities doctrine. the two-tier taxation of corporate income does not result. In some cases. in the absence of statutory rules governing this area. advanced the theory that upon distributing appreciated property to its shareholders. at least for the future.
the Service made this argument in General Utilities. or vendee is a shareholder is incidental to the transaction. The same principle applies if property is transferred to pay a debt owed to a shareholder. which treatment. however. depended on the fact that the quantity of the property was not fixed by the resolution but could vary according to the property's value relative to the debt at the time of distribution. creates a special problem if the underlying obligation was created by a corporate resolution to distribute property as a dividend to the corporation's shareholders.21 Introductory
Section 311(a)(2) states that ³no gain or loss shall be recognized to a corporation on the distribution. the two steps should be respected as such. and a better tax result is obtained by separating the steps (as in the case of loss property). whether the redemption is treated as an exchange or as a § 301 distribution.21 Corporate Gain or Loss on Distributions of Property ¶ 8. usually must be treated as a dividend in part.21 Losses
. 325 Therefore. however. Before examining these rules. where (1) the dividend resolution created an obligation that was treated as the distribution and (2) the transfer of the property to the shareholder was deemed to be a separate event. where the fact that such debtor. enacted in 1954 to codify the General Utilities doctrine. the obligation was merely to distribute a fixed number of shares of stock. creditor. rather. 330 The debt-discharge situation. since the fact that the buyer is a shareholder is incidental to the transaction.¶ 8. employee. in addition to the nonredemption distributions that are the subject of this chapter. For distributions after 1986. or vendee. 324 First. but the Supreme Court rejected it on the ground that the dividend resolution in that case did not create a fixeddollar indebtedness. 326 the same rules basically apply to both types of distributions. only complete liquidations are excluded by § 311(a). valuation. Indeed. since the distribution is not made ³with respect to its stock. employee. The regulations expand on the phrase ³with respect to its stock´ by stating: ³Section 311 does not apply to transactions between a corporation and a shareholder in his capacity as debtor. 332 The continued viability of this approach could be relevant to the recognition of losses (discussed in the next subparagraph) and to the different timing. a successful step transaction attack can be expected. 328 A ³bargain sale´ to a shareholder. 329 The corporation also recognizes gain or loss under the general rules of § 1001 if it uses appreciated or depreciated property to pay compensation to an employee-shareholder.. while the corporate recognition issue will be discussed again in connection with redemptions. The argument was successful. 333
¶ 8. of«property. corporations were held to realize gain or loss on the distribution of appreciated or depreciated property to their shareholders because the resolution authorizing the distribution created an enforceable obligation in a specified dollar amount (i. a preliminary comment on the scope of the term ³with respect to its stock´ may be useful. however. In several pre-1954 cases. 323 § 311(b) requires a corporation to recognize gain on nonliquidating distributions of appreciated property as if the corporation had sold the property for its fair market value except as to distributions in tax-free reorganizations and similar transactions. the term encompasses transfers in redemption of stock. with respect to its stock. so distributions in partial liquidation are covered by its provisions. creditor. thus establishing the value at which the property would be distributed instead of using its actual value at the date of distribution. Where the corporation contemplates satisfaction of the debt in kind from the outset.´ This self-styled general rule. Where the corporation clearly intends the dividend to be paid in the form of a corporate obligation and where satisfaction of the obligation with corporate property clearly is a later separate step (which usually will necessitate the shareholders' agreeing to accept satisfaction in kind). and earnings and profits results that could flow from treating the step of creating an obligation that itself is the distribution transaction as a step that is separate from a later satisfaction of that obligation.´ even though the employee also happens to be a shareholder. if the corporation sells property for cash to one of its shareholders in the ordinary course of business. 322 is general only as to losses on the distribution of depreciated property.e. the corporation recognizes gain or loss in the usual manner. the resolution created a debt. Furthermore. in part.´ 327 Thus. which was the distribution) 331 and because the corporation satisfied this debt by the disposition of property with a fair market value equal to the amount owing but with an adjusted basis to the corporation that was either less than or greater than the property's value.
345 Congress enacted § 311(b)(1). To correct the deficiencies perceived in pre-1986 law. 336 Other than the impact on earnings and profits discussed later.21 Gains
. the legislative reports offer no explanation for perpetuating the 1954 rule for nonliquidating distributions of depreciated property. A surprising ancillary application of § 311(a). even though Congress then repealed the General Utilities nonrecognition doctrine regarding appreciated property and. 343 Such a recharacterization of the transaction would result in nonrecognition of the loss at the corporate level on the theory that. 339 Because stock ownership for this purpose includes stock owned by specified members of the buyer's family. 335 Despite these dramatic changes. In unusual circumstances. in substance. namely. however.´ Corporations wishing to recognize losses and to distribute the value of certain loss property to shareholders should simply sell the property at a loss and distribute the proceeds. the Service might succeed in imputing the sale to the shareholders by analogy to the Court Holding Co. which has been mandated by § 311(a)(2) since 1954. 344 would then realize no loss on their sale to the ultimate purchaser. nonliquidating distributions are more open to manipulation with respect to both timing and bona fides. at the last minute and without any business purpose. 338 Corporations wishing only to transfer depreciated property to their shareholders and to recognize the losses thereon may seek to circumvent § 311(a)(2) by a variety of tactics. This rule. if a distribution-cum-shareholder-sale is planned but called off at the last minute in favor of a sale by the corporation and a distribution by it of the proceeds. no comparable relief is available under § 311(a)(2). an ostensible corporate-level sale to an outsider might be recharacterized as a distribution to the shareholders followed by a sale by the shareholders to the purchaser. a distribution in redemption of stock. however.Section 311(a)(2) supersedes the general recognition rule of § 1001(c) and provides that a corporation cannot recognize the loss it realizes upon distributing depreciated property to its shareholders. even if stock ownership is sufficiently dispersed to avoid application of § 267(a). it was thought that compared to liquidating distributions.
¶ 8. the plan was changed to an ostensible shareholder sale. whose basis for the property would be the property's fair market value when received by them. the corporation did not sell the property but instead distributed the property to its shareholders within the meaning of § 311(a)(2). allowed losses to be recognized when a corporation distributes depreciated property in complete liquidation. since losses disallowed under § 267(a) may be taken into account when the shareholder ultimately disposes of the property. the depreciated property does not end up in the hands of the corporation's shareholders. which involved the converse situation. for the first time. must run the gauntlet of §§ 267(a)(1) and 267(b)(2). The shareholders. 340 Indeed. which generally are within the § 317(a) definition of ³property´) to a shareholder in a distribution to which §§ 301 through 304 apply. has been its use by the Service and some cases to deny not only gain and loss recognition but also any corporate deduction on account of distributions with respect to stock. especially if the two steps are prearranged or occur in such rapid succession that prearrangement can be inferred. Moreover. 346 This includes a distribution not in redemption of stock. closely held corporations will usually find that sales are not a feasible way of avoiding § 311(a)(2). 334 was carried forward in 1986. 337 there is little more to be said about the nonrecognition rule itself. this approach is potentially more damaging to the shareholders than a simple application of § 267(a). which requires that the corporation recognize gain upon distributing property (other than its own obligations. however. case. 342 If. presumably. a purported sale may be brushed aside as a sham or recharacterized as a mere distribution coupled with a functionally unrelated contribution by the shareholders to the corporation's capital of the amounts ostensibly paid by them for the property. a shareholder sale of distributed property that was imputed to the corporation because. For example. 341 An attempt to avoid the application of § 311(a)(2) by the corporation's purported sale of the depreciated property to an outsider may be attacked by the Service as a sham or a step transaction if the property is resold by the ostensible buyer to the shareholders. since that section applies only to a distribution of property ³with respect to [the distributing corporation's] stock. which disallow any deduction for losses on the sale of property by a corporation to a person owning more than 50 percent (by value) of the seller's outstanding stock. however. § 311(a)(2) will not ordinarily pose any threat to the corporation's right to recognize the loss. Sales directly to shareholders. such as declaring a dollar-amount dividend and later satisfying it with a distribution in kind (as discussed in the preceding subparagraph) or selling the property to the shareholders or to third persons who then resell the same property to the shareholders.
jsp&lastCpReqId=3518771&lkn= docText&searchHandle=ia744cc630000012cc343e4c118dac1ba FN%20%3Ca%20name=351">351 but also identifies the vendee. shareholder activities could be characterized as a trade or business if such activities disposed of the property over time.000 minus $90.edu/app/servlet/com.CPDocTextServlet?usid=134bb4a621d&DocID=T0BE%3A4152. trades.checkpoint. Section 311(b)(3) replaces the predecessor rule of § 386(d) and grants regulatory authority to deal with distributions of partnership or trust interests where contributions of built-in-loss property to the partnership or trust have been made for the principal purpose of sheltering potential § 311(b)(1) gain. this provision was successfully invoked by the Service to sidestep the nonrecognition principle of old § 311 in several cases under circumstances that still remain to be clarified.000 ($125. which would permit the gains and losses to be offset against each other resulting in a recognized net gain or loss. Section 311(b) cannot apply to distributions in complete liquidation. the statute not only creates a ³sale. if the sale is effected with the use of corporate facilities or with corporate participation. and. tax-free reorganizations. and hence § 311(b)(2).000. 358 When the distribution involved affiliated corporations.000 and a fair market value of $100. does not distinguish between recourse and nonrecourse liabilities.whether treated as a distribution or as in exchange for the stock. First State Bank of Stratford. and spin-offs.2081&feature=tcheckpoint&jsp=%2FJSP%2FdocText. Unlike an actual sale of a mixed bag of assets. trades. § 482's prerequisite of two or more organizations. however.´ which may enable the disposition to meet the definition of ³capital gain. 352 Thus. Also unclear is whether the Service's authority under § 482 to reallocate income among two or more organizations. despite the fact that § 311(b)(1) says nothing about whether the hypothetical sale generates capital gain or ordinary income. Although § 311(b)(1) does not explicitly supersede it. 357 It is possible that such an imputation may be appropriate in unusual situations. Section 336(b). 347 and a stock purchase by a related corporation that is treated as a distribution under § 304. this issue (including the impact of any applicable recapture rules) is no doubt governed by the same principles that would apply to an actual sale to the distributee. or businesses ³to prevent evasion of taxes or clearly to reflect the income [of the parties]´ has any continuing vitality here following enactment of § 311(b). 349 Section 311(b).208&docTid=T0 BE%3A4152. as in CIR v. when applicable. the distributing corporation's gain is $35. 348 With respect to nonliquidating distributions. § 482 added little if anything to the case law. and so the same result would be reached if the shareholder assumed the $125. because such distributions are excluded from § 311(a) and because § 311(b) does not require gain to be recognized on distributions governed by other provisions of the Code.000 liability rather than took the property subject to it.bc. such as a shareholder's sale of the property for more than the property's fair market value when distributed.000). 354 providing that if a corporation distributes property subject to a liability.´ 351">
https://checkpoint. or if a corporate liability is assumed by a shareholder in connection with the distribution. even in the case of distributions to individual shareholders. there is no exception analogous to § 337 that prevents application of the general recognition requirement to a distribution to a controlling parent corporation. 356
If the corporation distributes property with a basis of $90. whose identity also may have other
significance.riag. however. or business was not likely to be satisfied. although the gain may be deferred if it arises in a consolidated group. as in the General Utilities case. the breadth of § 311(b)(1) renders obsolete the case law under which shareholder gains on the sale of distributed property were sometimes imputed back to the corporation. subject to a liability of $125. § 482's prerequisite of a separate organization.ser vlet. trade. such as the rules governing complete liquidations. 353 Section 311(b)(1) is buttressed by § 311(b)(2). 359 In that situation.
.com. the fair market value of the property shall be treated as not less than the amount of that liability. 350 Thus.000. or businesses was easily satisfied. §§ 311(a) and 311(b)(1) together may produce an unappetizing combination of recognized gains and nonrecognized losses. which incorporates by reference rules similar to those prescribed by § 336(b).tta. if the distribution involved only a single asset with no continuing association among the shareholders. requires the corporation to recognize gain as though the corporation had sold the distributed property ³to the distributee´ at the property's fair market value. Before 1986.lawezproxy. 355 This rule will most likely apply on an asset-by-asset basis.
alter the calculation set out above. The valuation issues here are similar to those that can arise in numerous other places throughout the Code. 364 As discussed below. with earnings and profits of $10. the regulations provide that the distribution is a ³dividend´ only to the extent of the earnings and profits. debt assumed or to which property is subject normally is included in cost basis under § 1012. the distribution is a taxable dividend to A in the amount of $10. 361 the distribution is a taxable ³dividend´ to the extent of the property's fair market value as of the date of distribution 362 under §§ 301(b)(1).000. 373 The distribution amount is net (but not below zero) of any liability assumed by the shareholder in connection with the distribution and liability to which the property is subject ³immediately before.000.22 Amount of Distribution and Basis Effects to Shareholders
The ³amount´ of a distribution in kind is the fair market value of the property. property basis is probably limited to the property's value if that value is less than debt assumed or to which property is subject. to $14.000. The remaining $6. and if the resulting gain is taxed to X under § 311(b)²as will ordinarily be the case 367 ²X's earnings and profits will be increased by the gain recognized and reduced by the resulting corporate tax on that gain. 376 this fair market value basis in effect reflects the shareholder's ³cost´ in the property. 368 This adjustment to the earnings and profits will. and much of the post-1986 Act administrative and legislative activity has focused on attempts to ensure that the corporate-level gain recognition principle is preserved.000. 301(c)(1). the distribution may be held not to constitute a present property interest or may be held to constitute taxable property only if and when the property can be valued. the basis is less than $16. 360 While these developments have done much to preserve the integrity of General Utilities repeal.000 to its sole shareholder. 370 Although valuation affects both the shareholder and the corporation. they also demonstrate that taxpayers and their advisers will continue to press heavily on the statutory structure in a relentless search for weak spots in its defenses.22 Taxability of Distributions to Shareholders ¶ 8. 365 the distribution itself can increase the amount of available earnings and profits as a result of the required gain recognition created by § 311(b). under a ³cost´ analysis. 375 The shareholder takes a fair market value basis in the distributed property. the ³General´ has died hard. the statutory requirement of continuation of the debt arguably excludes a debt to the shareholder that is extinguished (by merger) in the distribution.¶ 8. and 316(a) .000 will be subject to §§ 301(c)(2) and 301(c)(3). and immediately after´ the distribution. and the excess over basis (if any) generates capital gain under § 301(c)(3).000 is applied against the basis of A's stock under § 301(c)(2). 366 If. the value of the distributed property exceeds the corporation's current and post1913 earnings and profits. and the remaining $2. 369 For example.
¶ 8. Nevertheless. distributes property having a fair market value and basis of $16. of course. if X's earnings and profits are increased by $4. and the remaining amount reduces the shareholder's stock basis and any excess value is recognized as gain. or cannot be valued with a reasonable degree of accuracy. however. The major developments along this front are listed in a later section. If this amount is covered by the corporation's current or post-1913 earnings and profits. 371 the corporation's reasonable determination will ordinarily control the issue by virtue of the corporation's duty to report that value to the shareholder and to the Service. 372 If a distribution is valueless. and. the distribution will be a dividend to A in the amount of $14. and this basis is not reduced by debt assumed or to which property is subject. 377
If corporation X. although it would appear that the shareholder ought to get credit for his ³payment´ (by analogy to the bargain purchase dividend rules) to the extent of that canceled debt. however. A. 363 If.000. 374 While a distribution might be linked to a debt cancellation by a third-party creditor.21 Collateral Defenses to General Utilities Repeal
Although the repeal of General Utilities in the 1986 legislation was considered (by some) to have been a stunning coup for the cause of tax reform.
If A assumes (or takes the distributed property subject to) a $20.22 Effect on Distributor's Earnings and Profits
While the effect of a distribution of property on the distributing corporation's earnings and profits was clouded in obscurity for many years.000. has no application to distributions of depreciated property. determined following the distribution for the purpose of determining the extent to which the distribution is a dividend. the distribution is a dividend of only $10. the 1986 revision of § 312(b) adopted in connection with the repeal of the General Utilities doctrine generally clarified and greatly simplified these rules. the amount of the distribution is reduced to zero by § 301(b)(2).000 (rather than $20. the earnings and profits decrease still would be limited to $15.000 and a fair market value of $10. determined under the general holding period rules of § 1222. 380 Section 312(b). is the ability of such a distribution to sweep more earnings and profits out of the corporation than the shareholder has to recognize with respect to his dividend.000. one slight advantage of a distribution of loss property.000. In Example 2 .
If a corporation that already has $15.000. A's basis for the property probably remains at $16.g. 378 earnings and profits are first increased by the amount of the excess and then decreased by the property's fair market value (but not below zero). and thus does not generate a § 312(f)(1) reduction to earnings and profits due to recognized loss.000 liability of the distributing corporation. because of lower § 312(k) depreciation). the same as the amount of the distribution under § 301(b). because a distribution cannot create a deficit of earnings and profits.000 fair market value minus $600 basis).e. which are treated as follows: (1) By virtue of § 311(a)(2). On a distribution of property whose fair market value exceeds its adjusted basis (note that basis for this purpose is the earnings and profits basis of the property). begins with the date of the distribution. Thus. Any corporate tax resulting from the recognized § 311(b) gain presumably would reduce the amount of the interim earnings and profits account.Continuing the previous example. A's basis for the distributed property under § 301(d) likewise is $16. 384
. the corporation does not recognize the loss on a distribution of depreciated property.. Such liabilities cause an upward adjustment to earnings and profits by reducing the reductions to that account. the earnings and profits account is increased by $900 so that the distribution is a ³dividend´ to the extent of this appreciation. but it wipes out the corporation's earnings and profits account.
¶ 8. The distributee's holding period for the property. the distribution does not affect interim earnings and profits).000. 383
If the § 312 bases in Example 1 and Example 2 were $600 and $16. the amount of the dividend in Example 1 would be $400. 379 Any earnings and profits reduction that is unused disappears. and (3) earnings and profits are decreased under § 312(a)(3) (but not below zero) 381 by the adjusted basis of the property.000 figure. which tends to offset the disadvantage of not recognizing the loss. The $100 ³unused´ earnings and profits reduction (attributable to the property's basis) disappears.. Section 312(c) requires further adjustment to the adjustments under § 312(a) for liabilities to which the property is subject or that are assumed by shareholders in connection with the distribution. the former figure must be used for purposes of both §§ 312(a)(3) and 312(b) as well.000. 382 If the basis of the distributed property for earnings and profits purposes differs from regular adjusted basis (e. the amount of earnings generated by the distribution ($1.
If the earnings and profits account is zero at the beginning of the taxable year and the corporation's only transaction is a distribution of property with an adjusted basis of $100 and a fair market value of $1. and the treatment of accrual-method and cash-method corporations in this regard may differ. although authority does exist for claiming the $20.000 of earnings and profits distributes property with an adjusted basis of $15. The $900 interim earnings and profits account is then reduced to zero (distributions do not create a deficit) as of the end of the year to reflect the negative effect of the distribution and to determine ending earnings and profits. respectively.000) under § 301(d). (2) the distribution is a dividend to the extent of the property's fair market value up to the amount of any earnings and profits the corporation may have from other transactions (i. however. while A will not take any amount into income. The $900 may be thought of as an interim earnings and profits account.
§ 311(b)(2) requires the debt to be used as the deemed sales price. or a § 355 division. the transaction arguably will improve X's economic worth by $7. which reduction. however.23 Distributions of Corporation's Own Obligations ¶ 8. When debt on distributed property exceeds the value of the property. 386
X distributes property worth $10. subject to nonrecourse debt of $12. (relating to appreciated property) it should no longer (after 1984 and 1986) have a role to play here because the deemed sale now required by § 311(b) fully reflects the upward adjustment to fair market value also required by § 312(b) and § 312(c). If actual fair market value is used to so limit the increase.000. the net charge to earnings and profits is only $13. Perhaps § 312(c) has a role to play in this case where debt exceeds value by further increasing the interim earnings and profits increase under § 312(b) to the amount of the excess. § 312(b) seems to require an earnings increase with no offsetting earnings decrease on nonrecognition distributions such as a § 332 liquidation.000. 385 Section 312(b)(1). in Example 2 .000 gain under § 311(b)(2) (ignoring taxes on this recognized gain for simplicity).000 (the balance of the debt to be accounted for by § 312(c)). instead of applying § 312(c) only after the distribution to increase final earnings and profits by the amount of the excess debt. rather. This result might be reached by applying § 312(c) to adjust the § 312(b) adjustment so that X 's interim earnings and profits account increases by the full $7. There may be such a role for § 312(c).
¶ 8.23 Identifying the Obligation
. 384.000). Consequently.000.000 debt. X 's earnings and profits would be reduced by the property's full fair market value of $10. it probably should not apply at all to nonrecognition dispositions.000. it should apply only to those distributions that previously enjoyed General Utilities protection but are now subject to deemed-recognition treatment under §§ 311(b) and 336 . 387 While the amount paid by the shareholder would not affect the increase in the corporation's earnings and profits. The approach of § 312(c) should also be applied to the case of a bargain sale of property to a shareholder. To account for the impact of the distribution transaction on final earnings and profits. which is treated as a distribution to the extent the fair market value of the property exceeds the amount paid by the shareholder for the property. limits the increase to the excess of fair market value over basis. however.000 because of the debt relief.000. Since § 312(b) was probably enacted as a ³belt and suspenders´ supplement to § 312(f)(1). meaning that there is no reduction in X's earnings and profits in this transaction. This treatment could cause problems under the alternative minimum tax and consolidated return rules. the property was subject to a $2. leaving the corporation with $100 of earnings and profits (but the shareholder's net dividend is only $800 as well). § 312(b)(1) would appear to increase interim earnings and profits by only $5. That excess probably should be required to be reflected in the interim earnings and profits. Assuming § 312(f)(1) does not apply. is then reduced by $10.000 under § 312(b) (or simply providing for the full increase to reflect the actual gain triggered by § 311(b) here).1 If. the net reduction to earnings and profits would be only $800. it should reduce the decrease in the earnings and profits under § 312(a) in the same manner as would a debt assumption by the shareholder. which improvement should be reflected in the interim earnings and profits account because of the § 311(b) gain recognition computation. while the decrease rule of § 312(a) is limited by § 312(d) so as not to apply to various nonrecognition distributions. One area of unresolved confusion surrounding §§ 312(a) and 312(b) relates to the fact that § 312(b) appears to mandate an earnings increase for any distribution of appreciated property. a Type C reorganization.000. however. and § 312(f)(1) appears to require the gain so recognized to be added to earnings and profits. leaving the corporation with $2.Example 4
If the distributed property in Example 1 was subject to a $200 debt. However. X recognizes a $7. when distributed property has debt in excess of value. Even though § 312(c) refers to adjusting the adjustments in both 312(a) and 312(b). and having a basis of $5.000 of earnings and profits (but the shareholder's net dividend is only $8. and there is no clear indication that fair market value for this purpose is governed by § 311(b)(2). interim earnings and profits will not reflect the amount of the corporation's debt relief in excess of the property value.
405 The final version of the 1997 legislation adopting this proposal clarified its scope
. 390 or whether the corporation has only declared a dividend to be paid in the future.23 Distribution Amount and Shareholder Basis
In these respects. in which case the payment is the distribution and there is no preliminary distribution of a debt obligation. or other securities.
¶ 8. This treatment is consistent with the general principle that the issuance of debt is not a realization event to the debtor. or under the similar § 305(b) rules discussed later in this chapter 404 ).
¶ 8. and so there is no upward adjustment of earnings and profits upon their distribution. The corporation's obligations are excepted from the category of appreciated property in § 312(b). The general rule of § 311(a) applies. however. because accrual-method shareholders have traditionally been placed on the cash method for dividends. ordinarily evidenced by notes. may extend to § 305 as well. bonds. bond premium). as previously discussed. the same amount used in computing the § 301(b) distribution. 392
¶ 8. its status as debt or equity should be determined under the usual rules. 395 Obviously.´ 401 If the obligation is not publicly traded but bears adequate stated interest. Treasury's broad regulatory authority must be affirmatively exercised to extend taxable boot treatment beyond the § 351 and § 356 nonrecognition areas.Although the initially brief description of this provision was menacingly unclear on this point (and numerous others as well).Distributions of ³property´ that are governed by § 301 and are potentially taxable as dividends include distributions of the corporation's own obligations. this amount is not necessarily the face amount of the debt. 393 The amount of the distribution under § 301(b)(1) 394 is the fair market value of the obligation. there is no difference between a distribution of the corporation's own obligations and a distribution of other types of property.23 Effect on Earnings and Profits
¶ 8. as just described. Rather. ³open transaction´ treatment has been applied. if there is a difference because the obligation has original issue discount.. debentures. 389 A preliminary issue is whether the corporation has actually distributed an obligation. in which case the obligation itself is the distributed property.23 No Corporate Gain or Loss
A corporation does not recognize either gain or loss on a distribution of its own obligations. 403 and this proposal. Although the fair market value of the corporation's obligations controls both the amount of the distribution and the basis of the obligations. because its value reflects the interest rate and the creditworthiness of the issuer. and such obligations are specifically excluded from the countervailing recognition rule of § 311(b)(1). § 312(a)(2) provides that the distributing corporation's earnings and profits generally are reduced by the principal amount of the obligations. § 312(a)(2) substitutes the aggregate issue price for the principal amount. 398 However. 400 Under § 301(d). 397 An accrual-method shareholder that does not report a debt on the installment method normally must report the face amount of the debt rather than the debt's value. 399 If the obligation cannot be reasonably valued at the time of its distribution. Collections of the note in excess of its basis are treated as a sale or exchange of the note for capital gains purposes by virtue of § 1271(a)(1). distribution of the recharacterized stock as a purported tax-free ³stock dividend´ instead would become immediately taxable (either in the manner of a debt dividend. In many cases. That issue price is the obligation's fair market value if the obligation is publicly traded and bears ³adequate stated interest. which passed in 1997.g. the basis of the distributed obligation in the hands of the distributee would likewise be its fair market value. these amounts will be identical. but. its issue price is the stated redemption price at maturity.23 Distributions of ³Debt-Like´ Preferred Stock
The Clinton Administration's budget bills proposed to treat certain debt-like preferred stock as boot for purposes of § 351 and § 356. the principal amount is controlling. If so. 396 The shareholder apparently cannot use the installment method in reporting any § 301 gain resulting from the distribution. 391 Corporate debt held by shareholders should not be treated as equity simply because it is distributed to shareholders as a dividend. this rule may not apply to debt dividends. 402 If the difference between face amount and value is attributable to some other feature of the transaction (e.
as explained below. effects a sale to the corporation. When the ³essentially equivalent to the distribution of a taxable dividend´ language first appeared.01 Evolution of Sale Test: Pre-1954
. Later. The sale analogy is appropriate. when the owner of a one-person corporation having only common stock outstanding forgoes dividends for a period of years and then ³sells´ some shares back to the corporation for cash. if necessary. If the redemption was not
¶ 9. the transaction may resemble either an ordinary sale of stock to an outsider in an arm's-length bargain or the receipt by the shareholder of a distribution from the corporation that may be a dividend depending on corporate earnings and profits. by chance. the tax on dividend income would become a dead letter because sale treatment of the redemption allows the redeemed shareholder to include as income only the excess of the amount received in the redemption over the shareholder's basis in the stock redeemed as well as the benefit of any currently available tax preference for capital gains. which happens to be buying up its preferred stock at the time. reporting the difference between the adjusted basis and the sales price as capital gain or loss. while employing tax-free stock dividends. the courts increasingly assumed that any pro rata redemption was equivalent to a taxable dividend. then. the transaction is much more like a dividend (i. to replace redeemed shares and to restore the corporation's stated capital for the benefit of nervous creditors. and the courts over the years²to which there can never be a universally acceptable solution²is the determination of which transfers of stock are to be classified as dividends and which transfers of stock are to be treated as sales. thus. then it must have a twenty-year term and not carry a floating dividend rate. 1 in which event the entire distribution was taxed as a dividend to the extent of current and post-1913 earnings and profits. however. a few words of history are necessary before turning to the statutory language of the 1954 and 1986 Codes.
¶ 9. In order to escape classification as tainted debt-like preferred. that a ³sale´ of stock by a shareholder to his corporation is sometimes taxed as a dividend instead of as a sale. the stock must either participate meaningfully in corporate growth or. Although current law. Moreover. Although the shareholder has surrendered some of his stock. his interest in the corporation's assets and his control of the corporation's fate are undisturbed. It should not be surprising. an extraction of corporate earnings and profits) than a sale. the courts were reluctant to tax redemptions as dividends unless the redeemed shares had been issued as taxfree stock dividends or in anticipation of a later redemption. shareholders could embark upon long-range programs of intermittent redemptions to extract corporate earnings. casting on the taxpayer the burden of establishing that the redemption ought to be treated as a sale instead. and that ³stock´ status will continue for all other purposes unless and until prospective regulations alter that status. if such transactions were not taxed as dividends under these circumstances.01 Introductory
When a shareholder transfers stock to the issuing corporation in exchange for money or other property. On the other hand.. is much more elaborate. it preserves this ancient and troublesome phrase. In effect.01 Sale of Dividend: Background and General Concepts ¶ 9.e. and 355. the general rule was that such transactions were sales unless the transaction was ³essentially equivalent to the distribution of a taxable dividend´ within the meaning of § 115(g) of the 1939 Internal Revenue Code. 354. or unless it has a meaningful upside participation potential). when the owner of preferred stock instructs a broker to sell the stock and the broker. The knotty problem that has faced Congress. If a corporation's shareholders could adopt such a plan of intermittent ³sales´ of stock. adoption of this proposal makes preferred stock dividends a risky business for the distributees (unless the stock is ³plain vanilla´ evergreen preferred with a fixed dividend rate. if not. The preferred shareholder ought to be able to treat the transaction in the same manner as any other sale.as merely creating ³equity boot´ for purposes of gain recognition under §§ 351. for example. the Treasury. For a period of more than thirty years ending in 1954.
since exchange treatment means that the amount includible in income is not necessarily the full amount received but is rather the full amount received less the adjusted basis of the stock. the courts began to transmute this test into a restatement of the ³essentially equivalent´ language of the statute or. however. and 4. 2 and on the theory that a redemption of part of a shareholder's stock could be equally efficacious in changing ³his interest in the corporation in the same way that redemption of all of his stock would do. In its infancy. Even less helpful was the solemn announcement that the true test was whether the net effect of the redemption was the distribution of a dividend. 302(b)(2).
Of the four categories of redemptions that § 302(b) treats as exchanges. A redemption of all the shareholder's stock under § 302(b)(3). the courts did not agree on the meaning of that phrase. 6 The upshot was that in applying § 115(g) of the 1939 Code. a redemption that does not fall within any of these categories is to be treated as a distribution under § 301 (i. A redemption that is not essentially equivalent to a dividend under § 302(b)(1). dividend treatment under § 302(d) may be preferable because the amount received qualifies for the 70 percent. if complied with carefully. 5 Since virtually all pro rata redemptions have the net effect of a dividend. A partial liquidation under § 302(b)(4) (applicable only if the redeemed shareholder is not a corporation). any gain on the redemption is capital gain if the stock is a capital asset in the shareholder's hands (as is usually the case).´ 8 The first of these two categories. Furthermore. for legitimate business purposes. which preserves the corporate contraction doctrine of pre-1954 law (but only for the benefit of noncorporate distributees). into a pseudonym for the business-purpose doctrine that it was created to avoid. the selling shareholder may be entitled to defer his gain under § 453 if the stock redeemed and the debt received are not publicly traded. By virtue of § 302(d).´ 3 As dividend treatment for pro rata redemptions came to be the norm rather than the exception. 80 percent. is embodied in § 302(b)(4). and predictions were hazardous. this test was an attempt to escape an inquiry into the motives and plans of the shareholder and his corporation. 14 The rules of these two sections. Taxpayers who cannot bring transactions within these requirements can try to avail themselves of § 302(b)(1) by establishing that
. 2. it was ordinarily treated as a sale of stock by the shareholder on which the shareholder would realize capital gain or loss. § 302(a) provides that a redemption of stock ³shall be treated as a distribution in part or full payment in exchange for the stock´ if the transaction fits into any one of the following four categories: 9 1.01[a] Introductory
The drafters of the 1954 Code sought to bring order to this messy area by distinguishing between distributions that ³may have capital-gain characteristics because they are not made pro rata among the various shareholders´ and distributions ³characterized by what happens solely at the corporate level by reason of the assets distributed. 3. there was no escape from an inquiry into all the facts and circumstances of each case. and 302(b)(3) of current law under the 1986 Code. however. and any tax preference for capital gain will favor the sale treatment over the distribution treatment (and such a preference has returned in force in 1997). provide safe-conduct passes to the promised land of sale treatment. was ³not taxable as a dividend´. 10 Exchange treatment under § 302(a) is almost always more advantageous to noncorporate shareholders than distribution treatment. sometimes. as a dividend to the extent of current and post-1913 earnings and profits and as a return of capital to the extent of any balance). which carries forward the non±pro rata concept of pre-1954 law. 7
¶ 9.01 Current Law ¶ 9.. is governed by §§ 302(b)(1). was not essentially equivalent to a dividend. however. The second category. A substantially disproportionate redemption under § 302(b)(2). the most important in planning financial transactions are redemptions under § 302(b)(2) (substantially disproportionate redemptions) and § 302(b)(3) (complete termination of shareholder's interest). if the redemption that is treated as a sale is on credit. taxpayers found that the most promising escape was a judicial doctrine that a redemption resulting from a corporate contraction. or 100 percent dividendsreceived deduction of § 243 or is eliminated from income if the two corporations file a consolidated return. More specifically. however.pro rata. 4 The courts also agreed that a redemption.e. which provided for sale treatment if all of a particular shareholder's stock was redeemed. This exemption for disproportionate redemptions was based both on the regulations. 12 For corporate shareholders. 11 Moreover. or a ³legitimate shrinkage´ in the corporation's business activities.
presupposes that the redeemed instrument is properly classified as stock.01[b] Definition of ³Redemption´
Section 317(b) defines ³redemption´ for purposes of § 302 as a corporation's acquisition of its stock from a shareholder in exchange for ³property. In such instance. 16
¶ 9. retired. 25 On the other hand. However. purported stock is sometimes reclassified as debt (in which event. on occasion. then no redemption has occurred and the shareholder probably has merely made a contribution to capital. Redemption for corporate debt with the stock held as security for the debt and with the possibility that the stock may be returned to the seller. 32 2. 15 Section 302(b)(4). in the case of a ³cash-out´ reverse merger where cash paid to the target's shareholders comes from the target. As explained earlier. it may be in the corporation's interest to shift part of the redemption price to a deductible compensatory-type payment. is useful only if the redeeming corporation carries on two or more ³qualified trades or businesses´ (as defined) or is. relating to partial liquidations. with any down payment in the form of cash being treated as boot. as discussed below. 20 If the shareholder receives nothing of value for his stock. § 302 is inapplicable) and vice versa. it is also possible that a later payment of the obligations would be regarded as a redemption.the redemption is not essentially equivalent to a dividend. The regulations under § 311 indicate that a shareholder's exchange of stock for corporate property may not be a redemption at all if the distribution is made in some capacity other than the corporation-stockholder relationship. and any other property but not stock or rights to acquire stock in the distributing corporation. while the shareholder's interest would be the reverse.01[c] No-Ruling Areas
Because each of the exceptions to § 301 distribution treatment depends on some sort of reduction in stock ownership.´ regardless of whether the stock is canceled. it would seem that the normal rules for fixing the date of a § 1001 sale by reference to the change of beneficial ownership should apply here. The transaction might be regarded as a tax-free exchange under § 1036 or § 368(a)(1)(E). such as a severance agreement with departing employees. this. 19 ³Property´ means money. 18 It appears that options to acquire stock generally are not treated as present stock for purposes of § 302. because the transaction fails the definition of ³redemption´ in § 317(b).´ as well as § 302 itself. the Service is sensitive to whether a reduction has in fact occurred. 21 If a corporation redeems its stock by issuing debt that later is reclassified as equity. the Service will still be concerned about the transaction's parameters and whether part of the consideration is paid to the shareholder other than in his capacity as such. 24 for example. able to effect a bona fide ³contraction´ of its business. further. Thus. however. the Service has identified several scenarios in which it will not issue private rulings under § 302(b) 31 (although the courts have ruled in favor of taxpayers in several cases involving these scenarios): 1. securities. 30
¶ 9. to be employed only as a last resort. except where the special rules governing § 301 distributions overrule them. or held as treasury stock. 22 the transaction cannot be governed by § 302. Therefore. is a treacherous route. 17 The definition of ³redemption. by reason of extraneous circumstances. it applies only to noncorporate shareholders. 26 The Internal Revenue Service has. 29 A redemption often occurs in connection with another transaction. a shareholder faced with the bona fide choice of selling his shares to a third person or having them redeemed can normally sell and enjoy exchange treatment even if the buyer subsequently has the stock redeemed. 27 Pinpointing the date of the redemption may be important for the reasons discussed previously in connection with § 301 distributions 28 as well as for the determination of relative stock ownership changes. 33
. which excludes transactions where stock is repurchased in exchange for stock of the same corporation (because § 317(a) denies ³property´ status for that stock). even though a stock redemption transaction has in fact occurred. 23 Transactions that do not initially appear to be in the form of a redemption nevertheless can be recharacterized as such. Redemption for a corporate obligation to pay some amount based on future earnings or a similar contingency. the next step is far from certain. once it is decided that the transaction is not a redemption or that the corporation's obligations are not property. asserted that an apparent redemption actually is a sale of corporate assets. nevertheless. Even if the sale is treated as a distribution.
such as a trust or corporation. B's actual and constructive ownership of 25 percent of the stock does not reduce A's percentage of ownership from 85 percent to 75 percent. however. As will be seen. however. in the area of redemptions and are. Section 318(a) applies to transactions governed by subchapter C (i. no ³common law´ of attribution. no ruling).02 In General
In determining whether a redemption qualifies as an exchange under §§ 302(b)(1) through 302(b)(3). where
. Redemption followed by the corporation's using the shareholder's property and paying therefor an amount based on corporate earnings or subordinate to general creditors. the attribution rules operate to increase.´ therefore.
If A owns 85 percent of a corporation's stock and B. which are concerned with the degree of decrease in the shareholder's voting control of the corporation. the constructive ownership rules of § 318(a) must be taken into account.´ i. A few words on terminology are in order here. 41 Hence. 38 and the regulations extend their coverage to § 302(b)(1) redemptions.
¶ 9. §§ 301 through 385. also referred to as ownership by attribution. 45 In other words.02 Constructive Ownership of Stock: § 318 ¶ 9.. 43 There is. direct and indirect actual stock ownership plus the deemed actual stock ownership under § 318 are combined to determine total stock ownership for purposes of the § 302 rules.e.3. but not all. their divergencies are frequently trivial and almost always inexplicable. which rules differ among themselves in such details as the degree of family relationship warranting the attribution of stock from one person to another and in the way stock owned by a trust is allocated to its beneficiaries. and so attention to the rules of the particular attribution regime at hand is important. a taxpayer is considered to own stock owned by various other persons or entities. Section 318 creates ³constructive´ stock ownership. Intricately devised. 42 Although in theory each set could be crafted to suit the transaction to which it applies. to persons beneficially interested therein. covering most. these constructive ownership rules are expressly made applicable to §§ 302(b)(2) and 302(b)(3) redemptions by § 302(c)(1). The rules apply to any transaction within the ambit of subchapter C to which they are expressly made applicable (but not otherwise) and. ³Indirect ownership. thus. but that stock is not also attributed away from those other persons for purposes of reducing their particular share-ownership interests. stock ownership. 35 This reluctance to rule is a warning that in appropriate cases. 39 Because of the pervasive effect of constructive ownership on the redemption of the stock of family and other closely held corporations. (2) from an entity. discussed at this point. the Service might argue that similar facts justify a finding that a reduction in stock ownership has not occurred either because the shareholder may recover the stock redeemed or because the corporate obligation given in exchange for the stock is tantamount to a continuing equity interest. § 318 is only one of several sets of constructive ownership rules prescribed by the Code. § 318 is examined here in some detail before consideration of the substantive rules of § 302(b). 37 The § 318 attribution rules have taken on special importance. 44 By virtue of § 318(a). Redemption for payments over a period in excess of fifteen years (ordinarily.. of the transactions discussed in this work) but only if expressly made applicable by the relevant statutory provision. 40 ³Actual stock ownership´ is referred to in various provisions of § 318 as stock owned ³directly or indirectly.e. not decrease. stock titled in the name of the owner (direct ownership) or held by an agent (indirect ownership). The types of attribution prescribed by § 318 may be divided into attribution (1) from one member of a family to another (sometimes called collateral attribution ). so that no ³redemption´ (as defined in § 317(b)) has occurred. owns the other 15 percent and has an option to increase his percentage of ownership to 25 percent by acquiring unissued shares. are by no means confined to stock redemptions. therefore. or vice versa (vertical or direct attribution. a person unrelated to A under § 318. and 34 4. These rules attribute stock owned by one person to another on the basis of various relationships. Section 318 generally treats such deemed ownership as if it were ³actual´ stock ownership. does not mean ownership by attribution.
estate. B. 50. and it causes much of the complexity and most of the confusion in applying § 318. 54 moreover. stock owned by partners or beneficiaries of an estate 61 is attributed in full to the partnership or estate. and then down through the family of man to Eustice. nothing has been done to do so. S. ³directly or indirectly. is reattributed to the members of the beneficiary's family (and family stock attributed to a beneficiary is reattributed to the entity). then H. 50 The Joint Committee Tax'n Staff in its April 2001 simplification report urges (as many did who have gone before) that a uniform definition of ³family´ should be adopted. unless the beneficiary has only a ³remote
. attribution or is called reattribution.1 As usual. Thus. stock owned by a beneficiary of a trust (other than a § 401(a) employees' trust) is attributed to the trust. Under § 318(a)(2). 48 A fortiori. trusts. 47 § 318(a)(1) does not attribute stock from one brother or sister to another. G . 55 Stock owned by a trust (other than a § 401(a) trust for employees) is considered to be owned by the beneficiaries and. The following paragraphs describe the constructive ownership rules of § 318 in greater detail. S). and parents. since stock owned by one beneficiary of an entity could be attributed to the entity and thence to another beneficiary. a combination of items (1) and (2) that is sometimes called chain. and so on back to Adam and Eve. 60
¶ 9. and shareholders generally is attributed in full to the partnership.02 Family Attribution
Under § 318(a)(1). This form of reattribution. this limitation ensures that stock owned by Bittker will not be attributed to his parents and then from them to their parents. on the other hand. Note that H and W. and S are each deemed to own 100 shares of X by virtue of § 318(a)(1). a fourth category of attribution was possible. which can also occur via the option rule of § 318(a)(4). constructively own his stock. children. own twenty-five shares of corporation X each. or corporation. only a ³direct present interest´ (not a remainder after a life estate) counts as an estate beneficiary for this purpose. 57 In the case of a so-called grantor trust described in §§ 671 through 679. stock owned by or for a partnership 51 or estate 52 is considered as owned by the partners or estate beneficiaries 53 in proportion to their beneficial interests. family blood affinity is lineal only (two steps down and one step up). thus. as discussed below. and corporations generally is attributed to the beneficial owners only in proportion to their ownership interests. trust. according to the Service and most courts.02 Beneficiary-To-Entity (Inbound) Attribution
Under § 318(a)(3). Thus. and their grandson. This type of reattribution is now prevented by § 318(a)(5)(C).the entity's stock is attributed upstream to its owners or beneficiaries. conversely. estates. G's grandparents. their son. was unaffected by the 1964 change. or double.´ by partnerships. the trust's stock is attributed to them 56 in proportion to their actuarial interest in the trust (regardless of how small. and back attribution. Unlike the proportionality rule in entity-to-beneficiary attribution. Unlike some other attribution rules in the Code. Before 1964. and (3) from an entity to its owners or beneficiaries and from them to members of their family (or. 62 If the entity is a trust. W. The family attribution rules apply without regard to hostility between the family members. however. however. stock owned. 46 Stock owned by the entity and attributed to a beneficiary thereof. ³directly or indirectly. an individual is deemed to own stock owned by his spouse. from family members to beneficiaries and thence up to the entity). 49 but they are subject to an important exception in the case of complete redemptions. even though he does not constructively own theirs. 59 But stock attributed from a beneficiary to an entity cannot be reattributed out from it to another beneficiary.
¶ 9.02 Entity-To-Beneficiary (Outbound) Attribution
¶ 9. stock owned. S . grandchildren. 58 Stock owned by a corporation is attributed pro rata only to those shareholders (if any) who own (actually or by attribution) 50 percent or more by value of the corporation's stock. where the owners' or beneficiaries' stock is attributed downstream to the entity). is deemed to own only fifty shares (twenty-five directly and twenty-five constructively from his father.´ by partners. the person taxable on its income is the constructive owner of the stock.
If H. no stock would be attributed from G to B through their father. or contingent the interest may be). his wife. remote. G. beneficiaries. Stock attributed from family member A to family member B under § 318(a)(1) is not reattributed from family member B to members of B's family. If G had a brother. however. W.
however. only stock actually issued and outstanding is counted. 72 Another issue concerns whether options on unissued stock can be used to increase the total number of shares deemed to be outstanding. Although the attribution rules of § 318 are ordinarily disadvantageous to taxpayers. 71 however. which can affect the determination of the proportionate ownership of the taxpayer whose shares have been redeemed. 80 since § 318 will treat both H and W as owning fifty shares out of 100 before the redemption.
Example 1 58
. or shareholders of the same entity. of the stock. The Service takes the position that the option attribution rules can be applied only to increase the stock ownership of the redeemed shareholders.02 Option Attribution
Under § 318(a)(4). 77 and (2) stock is not counted more than once²for example.
If both the option attribution rules and family attribution rules can apply. rather than only 50 percent. only stock owned by a shareholder owning (actually or by attribution) 50 percent or more of the value of its stock is attributed to the corporation. or shareholder to an entity is not reattributed out to other partners. the beneficiary is charged with all.and contingent interest. they occasionally may be used affirmatively to qualify a particular transaction for favorable treatment.g. beneficiaries. have allowed the ownership fraction's denominator to be increased by stock optioned from the corporation. if a partnership. 70 Contingencies that remove the election from the optionee's unilateral control generally prevent attribution. 78 In determining constructive stock ownership. or corporation has an option on stock owned by a partner. and other noncontingent rights to obtain stock at the holder's election will result in attribution of the optioned shares to the optionee. the option attribution rules take precedence.
¶ 9. trust.02 Other Aspects of § 318
The regulations and a ruling clarify two ambiguities in the language of § 318: (1) a corporation is not deemed to own its own stock by attribution from shareholders or by option. have applied option attribution to unissued stock. estate. W (H's wife) owns ten shares. beneficiary. if a 50 percent trust beneficiary has an option on all the stock of corporation X owned by the trust. 73 Some courts. 79 Thus. 75 A reattribution of the optioned stock to another member of the option holder's family is thus permitted. 67 The regulations state that for purposes of the substantially-disproportionate test. 69 It is clear that warrants. in which it is assumed that the parties are unrelated unless otherwise stated. and A (unrelated) owns fifty shares. the change in W's ownership (from ten shares out of 100 to eight shares out of seventy-five) would not be sufficiently disproportionate for favorable treatment under § 302(b)(2). Similarly. an option exercisable by right only after a lapse of time has been ruled subject to attribution. or shareholder. a person who has an option to acquire stock is deemed to own the optioned stock (but not other stock owned by the optionor). stock owned by a beneficiary of a trust is not attributed to the trust and then reattributed to the beneficiary. since the option rules result in greater constructive ownership. and only twenty-five out of seventyfive thereafter. the stock is to be attributed in such a way as to maximize the taxpayer's ownership.. however. an option exercisable upon a merger or a shareholder's death) and to options on unissued (or treasury) stock is unclear. 63 Stock owned by a person taxable on trust income under §§ 671 through 679 (the ³grantor trust´ rules) is attributed to the trust. The relationship of § 318(a)(4) to contingent options (e. Were it not for § 318. 68 The Service and several courts. however. 66
¶ 9.´ as defined. beneficiary. 65 As noted previously. stock attributed from a partner. that stock can be reattributed out to other beneficiaries of the entity.02 Examples
The provisions of § 318 may be illustrated by the following examples. 76
H owns forty shares of corporation X. convertible debentures. A redemption of twenty-three of H's shares and two of W's shares will qualify both H and W for the favorable treatment accorded by § 302(b)(2) to substantially disproportionate redemptions. 64 If the entity is a corporation. however.
it would not be reattributed from the parents to B. an individual. That is. owns fifty shares (W is the life beneficiary of the property administered by the estate. The partnership is considered as owning 100 percent of X. is deemed to own 70 percent of X. thirty by attribution from W.Partnership-partner attribution. but the trust's stock would be attributed proportionately to C.e. but none of A 's shares that the partnership constructively owns. E owns 100 shares of X. and fifty from E to W to S. who are brothers. and C. B has an option on stock owned by his sister. C's stock would not be attributed to the trust. and 15 percent by attribution from related family member. 82 and twenty from S by family attribution. the stock in the other corporation that is attributed from A to X and Y is not reattributed out to B. X is deemed to own 100 percent of Y. the number owned directly. owns twenty shares. however. are 50 percent. and W would also own only eighty shares as well. If S and W were unrelated.
. B's being subject thereto because B owns 30 percent of X directly and 70 percent by attribution from A. X is considered to own 100 percent of Y. W owns thirty shares. B. and forty shares by a trust. A and B own 50 percent of corporation X and 50 percent of corporation Y each. 50 percent of Y is attributed from A to B under family attribution. S likewise owns 100 shares of X. thirty from W. If A and B are related family members. B . thirty directly. A and B own only 50 percent of X and 50 percent of Y each. and C. A also owns 100 percent of Y (50 percent directly. then 100 percent from A to Y). 35 percent by attribution from X . computed actuarially. B . and E . while A is deemed to own 85 percent of Y. 35 percent of Y is attributed from X to A to B by a combination of corporate and family attribution. Although S's stock is also attributed to S's parents. in addition to the twenty shares each owns directly. Corporation X has 100 shares outstanding. however. on the other hand. B is deemed to own 100 percent of Y (85 percent by attribution from A and 15 percent by virtue of B's 30 percent actual interest in X). an estate.
Option attribution. Y is considered as owning 100 percent of X (30 percent from B to A. S's stock is attributed to B by the option attribution rules and is reattributed to any children of B and to B's wife under the family attribution rules. and C. Y. A owns 70 percent and B owns 30 percent of corporation X's stock. A. fifty directly. since W has the direct present interest in estate assets or income).)
Trust-beneficiary attribution. and 15 percent of Y is attributed from X to B by corporate attribution. or vice versa.. twenty directly. W's son. owns 50 percent of corporation X 's stock. eight.
Reattribution. W also owns 100 shares of X. (A's partners also own their proportionate interests of the partnership's 50 percent direct ownership of X. The other 50 percent is owned by a partnership in which A has a 20 percent interest. and Y is considered to own 100 percent of X. worth 4 percent or less) and contingent. and 30 percent. The trust is considered to own all of the stock in X. and twelve shares by attribution from the trust. B. By virtue of § 318(a)(5)(C). and A is considered as owning 10 percent in addition to the 50 percent A actually owns.
Estate-beneficiary attribution. If C's interest in the trust were both remote (i. fifty from E (W is considered to be the sole beneficiary. the estate would own only eighty shares of X (those owned directly plus those attributed from W. and S is the remainderman). and twenty from S to W (by family attribution) and thence from W to E (by beneficiary-to-estate attribution). Corporation X's 100 shares of stock are owned as follows: twenty shares each by A. 81
Corporation-shareholder attribution. S. S. to whom the 15 percent was attributed from X). in which the interests of A. respectively. respectively own twenty. 20 percent. S would own only twenty shares. since S is not considered a beneficiary). A and X each own one half of corporation Y's stock. whereas A.
In order to qualify as substantially disproportionate. 83 For this reason. the redemption must meet three requirements: 1.g. No stock is considered constructively owned by A . The two 80 percent tests (which coalesce if the corporation has only one class of stock) envision substantial shareholder-level contractions in the redeemed shareholder's equity and voting interest in the corporation. if it is coupled with a redemption of voting stock that would qualify if it stood alone. For example. such shareholder must own after the redemption less than 20 percent (80 percent of 25 percent) of the 300 shares of stock then outstanding. Corporate shareholders. C and D each own 100 shares or 25 percent. the redemption cannot qualify under § 302(b)(2). 84 2. C or D under section 318. however. The constructive ownership rules of § 318 are applicable in determining whether a redemption is substantially disproportionate under § 302(b)(2). Immediately after the redemption. The shareholder's percentage of outstanding common stock (voting or nonvoting) after the redemption must be less than 80 percent of the shareholder's percentage of ownership before the redemption. whereas a non±pro rata redemption frequently does change those relative interests. 88 A redemption of voting preferred stock can qualify even if the shareholder owns no common stock.03 In General
An ordinary dividend typically effects a distribution of money or property to the corporation's shareholders without disturbing the shareholder's relative interests in the assets and earning capacity of the corporation. The distribution is disproportionate only with respect to A. This illustration can be recast in tabular form:
. § 302(b)(2) treats a ³substantially disproportionate´ redemption as a sale of the stock rather than as a § 301 distribution. and C owns 80 shares (26 2/3 percent). Stock with contingent voting rights (e. if a 50-percent shareholder seeks to avoid the first of the above requirements by gifts to children or grandchildren. like rearranging the deck chairs on the Titanic on the evening of April 14. so that multiple redemptions may be substantially disproportionate as to one shareholder but not as to others. and 3. and 20 shares from C. so the gifts are an exercise in futility. on the other hand. the shareholder must own less than 50 percent of the total combined voting power of all classes of outstanding stock entitled to vote. the attribution rules put him back where he started. 1912. These tests are applied on a shareholder-by-shareholder basis. because it will not reduce the shareholder's proportionate ownership of voting stock. B.´ 86 The common-stock-reduction test is measured on an aggregate fair-market-value basis (rather than on a class-by-class basis. 89 The regulations set out the following illustration to explain the application of the two 80 percent tests in § 302(b)(2)(C): 90 Corporation M has outstanding 400 shares of common stock of which A. Corporation M redeems 55 shares from A. have been alert to the planning possibilities offered by § 318 in seeking to avoid application of § 302(a). For the redemption to be disproportionate as to any shareholder. After the redemptions.¶ 9. 85
¶ 9. 25 shares from B.03 The 50 Percent and 80 Percent Tests
The 50 percent restriction in § 302(b)(2)(B) is presumably based on the theory that a reduction in the shareholder's proportionate ownership is not significant if the shareholder continues to own (directly or constructively) stock representing 50 percent or more of the voting power.. The shareholder's percentage of the total outstanding voting stock immediately after the redemption must be less than 80 percent of his percentage of ownership of such stock immediately before the redemption. B. A owns 45 shares (15 percent). B owns 75 shares (25 percent). and these rules materially reduce the feasibility of such redemptions by closely held family corporations. preferred stock with a power to vote only if dividends are passed) is generally excluded from the term ³voting stock. A redemption of nonvoting stock can qualify. 87 If the corporation redeems only nonvoting stock (common or preferred). where there is more than one class of common stock outstanding).03 Substantially Disproportionate Redemptions: § 302(b)(2) ¶ 9.
a redemption of all the stock of either A or B will clearly qualify under § 302(b)(3).03 Disproportionate Redemptions and Corporate Shareholders ¶ 9.03[a] General
In response to the widely publicized Seagram-Dupont transaction. not 18. also. to return to the previously mentioned illustration. After the second step. regulations so provided. so that shares owned by one are attributed to the other²a common phenomenon in the case of closely held corporations²§ 302(b)(2) is difficult to satisfy.04 Introductory
Section 302(b)(3) provides that a redemption must be treated as a sale if it ³is in complete redemption of all the stock of the corporation owned by the shareholder. The redemption of D's shares.
¶ 9. 92 To prevent an obvious abuse of § 302(b)(2).´ 104 If two unrelated persons. own all the stock of a corporation. the statute explicitly provides that it does not apply to any redemption under a plan that contemplates a series of redemptions that. 91
¶ 9. would apparently qualify.
¶ 9. A would own 20 percent of the total outstanding shares (forty-five shares out of 225). or a dividend-equivalent (though not fully pro rata) redemption distribution. the explicit reference in § 302(b)(2)(D) to a ³series of redemptions´ is not the Service's only weapon against attempts to abuse § 302(b)(2). if a redemption viewed in isolation is substantially disproportionate as to a shareholder. 94 As indicated earlier. 96 Under proposed § 302(b)(5). 97 The proposal was not intended to apply in consolidated returns (unless regulations so provided). the principal importance of § 302(b)(3) lies in its waiver. an insufficient reduction in A's percentage.
If A and B are related. In the table above. of the application
. for example. 95 legislation was proposed in May 1995 to repeal the basis reduction rule of § 1059(e)(1) and add a per se sale rule for redeeming corporate shareholders that would have been subject to the former § 1059(e)(1) per se basis reduction rule. For example. A redemption of this type would also qualify under § 302(b)(2) unless only nonvoting stock is redeemed. § 302(a) would apply to a corporate shareholder receiving a partial liquidation-type distribution. however. available in certain limited circumstances under § 302(c). the ³common law´ step transaction doctrine would prevent the redemption from satisfying § 302(b)(2). if the redemption of the stock of A. B owns 25 percent after the redemption (seventy-five shares out of 300 shares). 93 Thus.04 Termination of Shareholder's Entire Interest: § 302(b)(3) ¶ 9. For example. the redemption of A's shares would not meet the test of § 302(b)(2). B. however.03 Step Transaction Aspects
Application of the step transaction doctrine can both cause and prevent the application of § 302(b)(2). in the aggregate. In computing the percentage of stock owned by each shareholder after the redemption. and C was in accordance with a plan by which seventyfive of D's shares would later be redeemed.under § 302(b)(2). Thus. care must be taken to reflect the smaller number of shares outstanding. and to the extent. a gift or sale of stock by the redeemed shareholder or an issuance of shares by the corporation that is an integrated part of the redemption transaction will be counted in determining whether a disproportionate redemption has occurred. will not be substantially disproportionate with respect to the shareholder. no loss would be allowed if.75 percent (seventy-five shares outof400 shares). even though it was the occasion for disallowing the redemption of A's shares. A and B. but the other shareholders have agreed to sell enough stock to him after the redemption to restore the status quo.
except where the debt obligations seem to represent a continued. however. 115 If the seller acquires the forbidden interest.04[a] In General
If all of the stock actually owned by a shareholder is redeemed by the corporation. 111
¶ 9. and the transaction may then be treated as a sale. however. the redeemed shareholder is charged with the stock owned by the remaining shareholders under the attribution rules. because. director. This waiver provides an escape route for closely held corporations that cannot meet the tests for a substantially disproportionate redemption under § 302(b)(2). to forgo for a ten-year period any interest in the corporation (other than an interest retained as a creditor or acquired involuntarily by bequest). other than an interest as a creditor. although disguised. because they impute stock on the
. If constructive ownership under the family attribution rules alone prevents an otherwise clean termination. or § 302(b)(4). however. This waiver is permitted if the shareholder (1) retains no interest in the corporation after the redemption (including any retained proprietary interest as well as an interest as officer. 112 (2) does not acquire any such interest (other than stock acquired by bequest or inheritance) within ten years from the date of the distribution.04 Waiver of Family Attribution ¶ 9. 113 and (3) agrees to notify the Service of the acquisition of any forbidden interest within the ten-year period. not the entity-beneficiary or option attribution rules. This exception does not encompass the entity-beneficiary or option attribution rules. It is sufficiently possible that the seller will thereby continue his interest in the corporation (without interference from the outside that might have resulted from a sale to a third person) so that an attribution of his relative's shares to him is a reasonable rule of thumb. § 302(b)(3) easily applies to treat the transaction as a sale. 118 A look-back rule prescribed by § 302(c)(2)(B) also may bar a waiver if certain changes in stock ownership occurred during the ten-year period preceding the distribution. 119 Note also that the family attribution waiver applies only to § 302(b)(3). in applying that provision. 107 The Service has been reluctant to approve credit redemptions where there is a possibility of recapture of the redeemed stock upon default by the corporation or where the payout term is unreasonably long. If. and not to redemptions seeking protection under § 302(b)(1).of the family attribution rules of § 318. § 302(b)(2). after the redemption. the proprietary interest can be terminated even if the shareholder retains or acquires some other type of interest in the corporation. 110 the Sixth Circuit held that a § 302(b)(3) termination can occur through the combination of redemption by the corporation of part of the stock and sale of the rest to third persons provided that both dispositions are parts of a single transaction. Quinlivan. If the seller is willing. however. In order to qualify for protection under § 302(b)(3). or successor corporation is equally fatal. a redemption must completely terminate the shareholder's proprietary interest in the corporation. The sale analogy is not appropriate. the claim that the shareholder completely terminated his proprietary interest may be open to question. 108 The courts. it is reasonable to waive the family attribution rules and treat the redemption as a sale. the application of those rules can be waived under § 302(c)(2). 114 The regulations provide that acquiring an interest in a parent. members of the ex-shareholder's immediate family own stock. the shareholder takes notes or other credit instruments in exchange for his stock. then the tax due for the year of redemption must be recomputed on the basis of dividend treatment. if. and no stock outstanding thereafter is attributed to the shareholder by § 318. but only in limited circumstances. redemptions effecting a complete termination of the shareholder's interest. equity interest in the corporation. 116 It is important to note that § 302(c)(2) waives only the family attribution rules. Apart from the more stringent requirement of ³interest termination´ in connection with use of the attribution waiver. or employee of the corporation). subsidiary. have been more tolerant. 117 Entities can waive the family attribution rules. however. however. 109 In the widely cited case of Zenz v. 106 A termination of proprietary interest is easy to identify if the shareholder is paid in cash. The theory of the family attribution rules and their waiver may be stated in this fashion: A redemption of all of a shareholder's stock is properly treated as a sale because it terminates the shareholder's interest in the corporation as effectively as a sale to a third person.
127 Although the prohibition of an ³interest as officer. or shareholder owns constructively by attribution from a member of the partner's. 126 unless the fiduciary capacity is testamentary. 131 Since § 302(c)(2) permits the retention or acquisition of an interest as a creditor. 120 partnerships. however. beneficiary. or employee´ might be construed to bar such a relationship only if coupled with a profit-sharing or similar financial ³interest´ in the corporation. beneficiary's. The regulations warn. or shareholder (1) owns directly. 124 ³Interest. some support for viewing independent contractor status as well as other roles that do not actually involve control or compensation as not tainted interests. rather than a family relationship that does not necessarily bespeak an identity of economic interest. in substance.04[b] Waivers by Entities
By virtue of § 302(c)(2)(C). does not completely terminate T's stock interest in X. because A's shares are attributed to B under § 318(a)(1)(A)(ii) and then are reattributed from B to T under § 318(a)(3)(B)(i). on these facts.basis of an economic interest. 121 ³Related person´ is specially defined for these purposes as any person to whom stock is attributable under § 318(a)(1) at the time of the distribution if the stock would be further attributable to the entity under § 318(a)(3). the shareholder will be able to sell his stock to the corporation on credit rather than for cash. estates.e. and to waive the family ownership rules if the ex-shareholder's conduct falls in the latter category. and corporations can waive the family attribution rules as applied to stock that the entity's partner. This special rule applies if two conditions are met: (1) both the entity itself and each related person must satisfy the normal requirements for a waiver (i. trusts. T and B comply with the waiver conditions and execute the notification agreement. T) is not considered as owning A's shares. the redemption qualifies because B (and. is the sole beneficiary. a complete termination vis-à-vis T. Stock acquired by a distributee in a fiduciary capacity is a tainted interest.
¶ 9.. beneficiary. therefore. A redemption of T's shares. 123
¶ 9. or shareholder's family. If. Section 302(c)(2)(C) does not apply to stock that the partner. a trust of which A's daughter. no acquisition of an interest within ten years from the date of the redemption. that an obligation ³in the form of a debt´ may. 122 The waiver would not work if A were not B's parent but rather a corporation in which B was a shareholder or an unrelated person whose shares B held an option to buy. is fatal. the redemption is. If A owned fifty. and filing of the notification agreement) and (2) each related person must agree to be liable along with the entity for any deficiency (including interest and additions to tax) resulting from a tainted acquisition of an interest during the ten-year period. 130 It would be more consonant with the purpose of § 302(c)(2) to distinguish between conduct supporting an inference that the ex-shareholder did not effectively terminate his financial interest in the corporation and conduct that is consistent with such a termination. (2) is considered as owning by attribution from another entity. the redeemed shareholder has no direct or indirect interest in the corporation immediately after the redemption and does not acquire such an interest (other than inherited stock) for ten years thereafter. T owned twenty-five. no postredemption interest in the corporation. going on to provide that (1) the ex-shareholder's rights must not be greater than necessary for the enforcement of his claim. with or without compensation. (2) the debt must not be subordinate to claims of general creditors. director. X redeemed T's and B's shares simultaneously. 125 or employee but excludes an interest as a creditor. 129 There is. a waiver would be fruitless because it could apply only to A's shares. a waiver of the family attribution rules is allowed only if. however. a waiver under § 302(c)(2)(C) would evidently be efficacious for both T and B. however.´ defined by § 302(c)(2)(A)(i) for this purpose. B. but some appellate courts have found this effort too difficult. give the owner a proprietary interest in the corporation. thus. leaving intact the attribution of B's stock to T. among other conditions. have supported this interpretation. and B owned twenty-five shares of stock. the Service has espoused the stricter view that performing services or simply holding a position as officer or director. however. or (3) can acquire under an option to purchase. 128 and some (but not all) courts. If. at least. and (4)
. 132 (3) payments of principal must not be contingent on earnings as respects their amount or certainty. director.
Assume that the stock of corporation X is owned equally by A and by T. This would mean that the redemption of T's own shares would not be ³complete´ within the meaning of § 302(b)(3). includes an interest as officer.04[c] Tainted Postredemption ³Interest´ in Corporation
As stated previously.
in turn. 136 the son can claim the shelter of § 302(b)(3) by filing a waiver of the family attribution rules under § 302(c)(2) (thus avoiding the attribution of his father's stock to him) and complying with the 10-year post-redemption rules. directly or indirectly. are permissible if the rent is neither dependent upon earnings nor subordinated. Before examining these conditions. or (in certain cases) its subsidiary is thus acquired. its parent. use funds that he received as dividends. Finally.enforcement of the ex-shareholder's rights as creditor upon a default by the corporation will not constitute the acquisition of a forbidden interest unless stock of the corporation. 133 Other creditor relationships. 134
¶ 9. it may be useful to give an illustration of their purpose. the redemption will probably be taxed as a dividend. The attribution rules prevent a merely formal termination of the interest of a shareholder who retains an indirect stake in corporate affairs through his family.04[d] Ten-Year Look-Back Rule
The waiver of the family ownership rules granted by § 302(c)(2)(A) is denied in certain circumstances on the basis of events preceding the redemption.´ 142 Because of this provision.05 In General
Section 302(b)(1) provides that a redemption will be treated as a sale of the redeemed stock if it is not ³essentially equivalent to a dividend. however. To frustrate plans of this type.e. from the distributee within the previous ten years. 137 or (2) if any related person owns stock at the time of the distribution and acquired any stock. The waiver. § 302(b)(3) (complete
. but this restriction is mitigated by the waiver of the family attribution rules. If A owns all the stock of a corporation and wishes to give his son a gift of cash. is subject to an exception for an interest acquired by bequest.05 Redemptions Not Essentially Equivalent to Dividends: § 302(b)(1) ¶ 9. which are set out in § 302(c)(2)(B). However. a ruling suggests that acquisitions of stock during the ten-year look-back period are not fatal unless they manifest a tax-avoidance purpose of a limited type (i.´ 138 The regulations state that a transfer ³shall not be deemed´ to have the avoidance of federal income tax as one of its principal purposes merely because the transferee is in a lower income tax bracket than the transferor. 140 Moreover. A can. a redemption that fails to qualify for exchange treatment under § 302(b)(2) (substantially disproportionate redemption). 139 Therefore. a transfer from a retiring parent to a child who will be active in the corporate business generally will pass muster. of course. a series of checks and balances as intricate as a baroque fugue is found.04 Summary and Conclusion
In reviewing the historical progression in the treatment of redemptions terminating the shareholder's entire interest. or the disposition in the case of situation (2) above. This condition. becomes retroactively invalid if an interest is acquired during the ten-year period following the redemption. such as a lessor. If A raises the funds by causing the corporation to redeem part of his stock. an attempt to retain a continuing interest in the corporation despite the redemption). 135 However. 141
¶ 9. but only after the funds have been reported by A as income. did not have ³as one of its principal purposes the avoidance of Federal income tax. leaving the couple with continued stock ownership. what happens if A gives his son some stock in the corporation and then causes this stock to be redeemed? If the transaction is not disregarded as a sham.. The second situation could arise where one spouse gives stock to the other spouse and then the rest of the donor's stock is redeemed. such a preredemption transfer is disregarded if not motivated by tax avoidance. § 302(c)(2)(B) provides that the family attribution rules may not be waived (1) if any part of the redeemed stock was acquired directly or indirectly within the previous ten years by the distributee from a related person. the ten-year good-behavior period is available only to shareholders who have not participated during the preceding ten years in transfers to or from a related person. unless the stock so acquired is redeemed in the same transaction. These limitations on the waiver of the family attribution rules are not applicable if the acquisition in the case of situation (1) above.
§ 302(b)(3). or § 302(b)(4) is not taken into account.´
¶ 9. 147 and the Supreme Court also endorsed this principle in the Davis case. a pro rata redemption generally will be treated as a distribution under § 301. are ³always essentially equivalent to a dividend´ under § 302(b)(1). if the corporation has more than one class outstanding. can no more be reduced to a mathematical formula than can the emotional ingredients of a ³meaningful personal relationship. as will be seen. or § 302(b)(4) (partial liquidation) 143 has a last clear chance²more accurately. although stating that dividend equivalence depends on the ³facts and circumstances of each case. In addition. redemptions. 150 But if Treasury's February 2003 dividend exclusion proposal 150.termination of shareholder's interest). however. (This was the version that ultimately prevailed in the final 2003 tax bill). this complaint has proved to be erroneous.05[a] In General
Davis made clear that when a shareholder gets cash or other property out of a corporation through a redemption without changing his proportionate equity interest in the corporation in any significant way (counting constructive ownership). When some change in proportionate interest results from the redemption.05 Nature and Amount of Meaningful Reduction ¶ 9.
In applying § 302(b)(1). Davis that neither the absence of a tax-avoidance motive nor the presence of a business purpose for the redemption would protect it against dividend treatment. a last cloudy chance²to qualify by meeting the vague standards of § 302(b)(1). The taxpayer's wife and two children owned 25 percent of the common stock each. This standard. As with the other exceptions in § 302(b). redemption of an entire class also generally will fall under § 301 if all classes of stock are held in the same proportion. the regulations state that if the redeeming corporation has only one class of stock outstanding. 148 and Davis likewise endorsed this position. In the Davis case. albeit modest. the distinction between dividend and capital gains treatment would be neutralized as to tax rates.1 had been enacted. Finally. and issuances. it is clear that the relevant ³facts and circumstances´ should include other integrated stock sales.05 Dividend Equivalence: The ³Meaningful Reduction´ Test
¶ 9. while dividend equivalency may well be the taxpreferred result. but retroactive technical connections fixed apparently this problem by raising the test period zone to 121 days). 149 Similarly. the provision has played a real.´ provide that the constructive ownership rules must be considered in making this determination. the cash or property received is equivalent to the distribution of a pro rata dividend without any surrender of stock. it
. including a constructive sole shareholder. But these low rates are slated to expire in 2011 unless Congress acts to extend them (which seems unlikely at this time). 151 (2) redemptions of stock of a sole shareholder.2 But initial holding period problems under § 1(h)(11)(B)(iii) could deny low rate benefits here (since the required 61-day and 120 day period ³straddles´ the redemption date. role by conferring exchange treatment on redemptions that are not ³substantially disproportionate´ within the meaning of § 302(b)(2) but that nevertheless result in a ³meaningful reduction´ in the shareholder's proportionate interest in the corporation. qualification under § 302(a) for sale treatment would become less attractive. 152 (3) a business purpose is irrelevant in determining dividend equivalency under § 302(b)(1). a redemption's failure to satisfy requirements of § 302(b)(2). the majority in Davis held that (1) the constructive ownership rules of § 318 apply to dividend-equivalency determinations under § 302(b)(1). Even under Ways and Means Chair Thomas's alternative proposal to tax dividends of individual shareholders at capital gains rates. the redemption must result in a ³meaningful reduction of the shareholder's proportionate interest in the corporation. 145 The Supreme Court held in US v. The same can be said of pro rata redemptions from all shareholders. 150. however. the only example of a qualified § 302(b)(1) redemption given by the regulations is a redemption of one half of the nonvoting preferred stock of a shareholder who owns no shares of any other class of stock. the Supreme Court was faced with a redemption of preferred stock by a corporation of which the taxpayer directly owned 25 percent of the common stock and all of the preferred stock. In reversing a lower court decision in favor of § 302(b)(1) qualification.´ 154 As a prediction. 146 The regulations. and (4) in order to avoid dividend equivalency.´ 153 A dissenting opinion in Davis asserted that the majority opinion ³effectively cancels § 302(b)(1) from the Code.
¶ 9. the regulations illustrate § 302(b)(1)²as they did before Davis was decided²with an example of a shareholder owning only nonvoting preferred stock that is limited as to dividends and liquidating distributions. but this did not change the voting power that he constructively possessed from members of his family. Davis held that such redemption is a dividend when the shareholder owns 100 percent of the stock outstanding. the court determined that the redemption was not essentially equivalent to a dividend. Furthermore. and Nonvoting Stock Is Redeemed
As already discussed. because the shareholder got twice as much as he would have received (directly or constructively) if the same amount had been paid as a pro rata dividend on common. stating that a redemption of half of the shareholder's stock will ordinarily qualify under § 302(b)(1).05[c] Redeemed Shareholder Owns Both Voting and Nonvoting Stock. the voting interest cannot be used to determine the meaningful reduction in proportionate interest in such cases. however. Much can be said. 165 Where the shareholder's voting power is small. directly or constructively. 163 but judicial consideration of factors other than the power to vote nevertheless has continued. determine the
. which requires a reduction in the shareholder's ownership of voting stock. and the earnings and assets interests accordingly must govern. and hence could be only a lonely voice crying in the wilderness at stockholders' meetings. (2) interests in the earnings of the corporation through dividends.05[b] Redeemed Shareholder Owns Only Nonvoting Stock
The meaningful-reduction principle has been especially important to shareholders owning only nonvoting stock. the regulations state that the redemption of all of one class is a dividend when the shareholders hold all classes in the same proportions. however. at least in the case of closely held corporations. for giving special attention to control. in turn. cannot qualify for the protection accorded to substantially disproportionate redemptions by § 302(b)(2).´ The Second Circuit in Himmel 155 (a pre-Davis opinion) correctly observed that stock represents three potentially relevant interests in a corporation: (1) interests in the control of the corporation through voting. however. with substantial support from the courts. rejects Himmel and takes the position that when the redeemed shareholder has a voting interest (either directly or by attribution). a reduction in voting power is a ³key factor´ (virtually a ³super factor´) in determining the applicability of § 302(b)(1). 160 In addition. 162 Other decisions have not followed the Himmel approach of comparing the amount the redeemed shareholder actually received with the amount the shareholder would have actually or constructively received if a dividend on common stock in the same amount had been paid. is a meaningful reduction under Davis because ³the rights represented by the redeemed shares were yielded to the common shareholders of the corporation and could not be recovered through the taxpayer's continued stock ownership.becomes necessary to identify the relevant shareholder interest(s) and the amount of any change therein that will be ³meaningful. even though it does not qualify under § 302(b)(2). 164 The Service disagreed with the result in Himmel because the shareholder did not lose the potential for joint voting control of the corporation as a result of the redemption.05[d] Voting Stock Is Redeemed
In rejecting the Himmel case. 159 Thus. Even so. the Service did not rule that control is invariably more important than the shareholder's continuing direct or constructive interest in current and liquidating distributions. 156 For a redemption to be not essentially equivalent to a dividend. joint. The corporation in Himmel redeemed some of the taxpayer's nonvoting preferred stock. 157 It may be that the Himmel result would be accepted if the shareholder whose nonvoting stock was redeemed did not belong to a group that actually or constructively owned a controlling interest in the corporation.
¶ 9. whose controlling shareholders can (1) determine business and financial policies that. through a quirk of draftsmanship. and (3) interests in the assets of the corporation upon liquidation. a 1977 ruling holds that the redemption of an even smaller amount of such stock from a shareholder owning no stock of any other class. and other levels of voting control of the corporation will be discussed more fully in the following paragraph.´ 161
¶ 9. The Service. Obviously. the shareholder's proportionate interest in one or more of these three areas must drop to some extent. 166 The significance of sole. which. a redemption of nonvoting preferred has been held to be a sale since Davis.
173 Where there is no possibility of control participation by a minority shareholder. if the redeemed shareholder does not drop below that line. 168 The Service. it could have far-reaching ramifications. or to increase by a minuscule amount. however. The Service has relied on the fact that there was no reduction in the shareholder's ³potential (by attribution from [its sole beneficiary]) for participating in a control group by acting in concert with two other major unrelated shareholders. Whether or not any such ³super-control line´ is relevant. the Service has ruled that such a redemption is a sale. 170 The result might be different if the remaining shares are widely dispersed and 50 percent of the vote amounts to effective control. however. 174 unless the redemption is part of an ongoing plan under which the shareholder can choose whether or not to have a small number of shares redeemed each year.85 percent resulted in dividends where there was no loss of potential conjunctive control of the corporation. even a trivial degree of vote reduction will apparently result in sale treatment. 169 Once a shareholder's vote drops down to 50 percent. 177 This result cannot be disputed²however. if taken into account for tax purposes.6 percent to 40 percent and from 45 percent to 42. his ability to control the corporation certainly can be jeopardized. does not agree to the significance of a super-control line when the redeemed shareholder continues to own more than half of the voting stock. 172 On the other hand. 171 Reductions of the vote from one level below 50 percent to another level are more troublesome. in theory. 167 The Sixth and Eight Circuits have held that crossing such a super-control line distinguishes a sale from a dividend. but. are subject to a rule of reason but that. such as two thirds. A redemption that results in crossing the 50 percentcontrol line is most likely not equivalent to a dividend. those reductions qualify the redemptions as sales. necessary to cause major corporate changes. in practice.57 percent to 23. Some courts have evidenced an interest in state laws that require a high vote. the Service has agreed that voting reductions from 27 percent to 22. however. Courts have held that drops from 43. is ³meaningful reduction´ the proper label when an infinitesimal percentage is nudged infinitesimally closer to zero? If.08 percent resulted in sale treatment when the redeemed shareholders lost conjunctive control of the corporation. 175 Emphasis on the potential for joint control in cooperation with other persons by reason of the way the corporation's voting stock is dispersed is debatable. the Service will treat the redemption as a dividend.corporation's risk-to-return ratio and (2) avail themselves of corporate perquisites that. many redemptions by public companies involve minuscule reductions in the vote of common shareholders. or at least drop down to 50 percent of the vote.
. the shareholder's voting power happens to remain the same.27 percent and from 28.´ 176 Such a continuing capacity for maneuver is undoubtedly important in the real world. since virtually any shareholder²depending on how the other shares are divided²can cast a decisive vote. as a result of the responses of other shareholders to a redemption tender offer. then the redemption most likely will be treated as a dividend. can seldom be restrained by the minority shareholders. No matter how small. Finally. If the only other shareholder is unrelated.