Corporate Tax Notes

The corporate income tax is one of the best examples in American
political history of the law of unintended consequences.
--John Gordon Steele
 

Chapter 1

Introductory

Sec. 11--Establishes that corporations are separate taxpaying entities, sets corporate tax rates, and provides that the maximum tax rate applies to personal service corporation income. Also exempts foreign corporation from regular taxation, but specifies that foreign corporations are taxed under Sec. 882. Sec. 301--Provides that dividends are taxable to shareholders to the extent that they are paid from earnings and profits, and further provides that distributions in excess of earnings and profits constitute a return of capital to the extent of the stock's basis. Secs. 61, 1001, 1011, and 1201--Provide that gains from sales of stock are taxable, that losses are deductible (subject to several limitations), and further provide that the gains and losses are ordinarily capital gains and losses. Sec. 882--Specifies that foreign corporations are taxed on income from a  U. S. trade or business and from income effectively connected to the U. S. trade or business.  Sec. 881--States that foreign corporations are taxed on other U. S. source income at a flat rate of 30%, but provides exceptions. Secs. 1361-1379--Provides that an S corporation is generally exempt from the corporate income tax, and explains that the income passes through to shareholders.

 
 

Constraints on Tax Planning Substance over form The the essential characteristics of a transaction determines how it will be treated not the labels that are placed on the transaction by the parties. For example, an investment in a corporation is treated as a loan or stock depending on the characteristics of the investment and not the labels used. In tax cases the idea is sometimes referred to as the economic substance (or economic reality) of the transaction. For tax issues, often it is the economic impact of a transaction that indicates it substance. Business purpose Spin off of liquid assets into new corporation followed by liquidation taxed as a dividend even though transaction met the requirements of reorganization-liquidation. Supreme Court established business purpose as a requirement for some but not all transactions. Evelyn F. Gregory v Helvering, 14 AFTR 1191, 35-1 USTC  ¶ 9043 (USSC, 1935). Step transaction Combine many steps to determine appropriate treatment of events. Rule from common law. Could be applied to Gregory situation. Clear reflection of income Accounting methods used by taxpayer must clearly reflect income. IRS can accelerate the reporting income or defer deductions or make other changes in order to clearly reflect income. Sec. 446(b). Constructive receipt Taxed on income if it is available to taxpayer even if taxpayer has not yet received it. Reasonable amount Sec. 162 limits the deduction for compensation to a "reasonable amount." This limitation probably can be extended to rent, interest, royalties, etc. In other words, arm's length dealing and fair market value are ways to determine the substance of a transaction. Thus,  excessive "rent" paid to a shareholder  may be reclassified as a nondeductible dividend.  Assignment of income Lucas v. Guy C. Earl, 8 AFTR 10287, 2 USTC  ¶ 496 (USSC, 1930)--husband's income taxed to him in spite of agreement to share income with wife.  Helvering v. Paul R. Horst, 24 AFTR 1058, 40-2 USTC  ¶ 9787 (USSC, 1940)--coupon interest taxed to father who owned bonds rather than son who was given the coupons and cashed them.  George B. Clifford, Jr. v. Helvering, 23 AFTR 1077, 40-1 USTC  ¶ 9265 (USSC, 1940)-- income from a grantor trust is taxed to the grantor.  Reallocation of income Sec. 482 grants the IRS the authority to reallocate income, deductions, gains, losses, and credits among related taxpayers. An extension of assignment of income that is particularly useful relative to families, related corporations, and international operations. Thus, "salary" paid to a child may actually be a dividend to father and a gift to the child. Income of foreign subsidiary  may actually be parent corporation's income.

How many people were taxed, who was taxed, and
what was taxed tell more about a society than anything else.
--Charles Adams, U. S. Ambassador to Great Britain, historian, and writer
 

Chapter 2

Definition of  "Corporation"

Sec. 7701--Although Sec.11 imposes the corporate income tax on "every corporation," it does not define the term corporation. The regulations identify six characteristics that are considered when classifying organizations. These are: (1) association, (2) business purpose, (3) continuity, (4) centralized management, (5) limited liability, and (6) transferability.  Now, however, the IRS allows most entities, other than those specifically identified as corporations under state law, to choose to be treated as partnerships. In general, entities that are not identified as corporation under state may elect to be so treated.

 
 

Personal Service Corporations: Three Definitions

Sec. 448(d)(2)--Perform personal services (health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting) and substantially all stock is owned by employees who perform such services .

May use cash basis (Sec.448(b)(2))

35% tax rate applies to all income (Sec. 11(b)(2))

Sec. 269A(b)(1)-- Personal services are substantially performed by greater than 10% owners:

IRS can make allocations between corporation and owners under Sec.269A

Sec.441(i)(2)--At least 10% of the stock must be held by owner-employees who provide personal services:

Limit on fiscal years (same as shareholder or make required distributions) (Secs. 441(I)(1) and 444(f))

Deductions/income "matched" for corporation and shareholders (Sec. 267)

Subject to passive loss limitation (Secs. 469(j)(2) and 58(a)(3))

 
 

Organization and Similar Costs
Category	Costs Included	Treatment
Investigation and start up costs if actually start business	Investigation costs include market, labor, and transportation studies. Start-up expenses include pre-opening advertising, salary for training, rent, professional fees, and utilities.	May elect to expense first $5,000 of such costs. Amortize over 15 years  next $45,000 of such costs. If costs exceed $50,000, current deduction for first $5,000  reduced by the excess.  May elect to deduct at liquidation. (Sec.195)
Investigation and start up costs if do not actually start business	See above.	No deduction unless are already in business.  If consider expanding existing business, but decided not to can deduct costs.
Organization	Legal fees, accounting fees, state filing fees, costs of organization meeting.	May elect to expense first $5,000 of such costs. Amortize over 15 years  next $45,000 of such costs. If costs exceed $50,000, current deduction for first $5,000  reduced by the excess.  May elect to deduct at liquidation (Sec. 248)
Stock issuance costs	Commissions, professional fees, certificate printing costs, listing on exchange.	Reduces proceeds. No tax benefit ever.
Reorganization	Legal fees, accounting, state filing fees.	Un settled. See below.

 
 

Reorganization/Expansion Costs

Reorganization Sec. 248--Describes treatment of organization costs, but does not mention reorganization costs. Sec. 197(e)(8)--Says that professional fees and other costs incurred in a tax free corporate transaction may not be amortized over 15 years. In INDOPCO, Inc. v. CIR, 69 AFTR2d 92-694, 92-1 USTC  ¶ 50,113 (USSC, 1992) the Supreme Court denied a deduction for advisory fees paid in connection with a friendly take-over. Court concluded that corporation received a future benefit and, as a result, the costs must be capitalized. Deductions have been permitted for court ordered transactions (U.S. v. General Bancshares Corp., 21 AFTR2d 352, 68-1 USTC  ¶ 9664 (8th Cir., 1968)). It is likely that capitalized reorganization costs and unamortized organization are deductible upon the liquidation of a corporation. Similarly, capitalized costs associated with a stock redemption or an earlier partial liquidation are deductible upon complete liquidation. It is not clear what happens to such costs when a corporation terminates, as part of a reorganization. May deduct costs incurred while considering possible reorganization (Wells Fargo & Co. v. CIR, 86 AFTR2d 5815, 2000-2 USTC  ¶ 50,697 (CA-8, 2000)) including cost incurred if  abandon plans (El Paso Co. v. U.S., 51 AFTR2d 83-465, 82-2 USTC ¶ 9711 (CA-FC, 1982)). In at least two cases, individual shareholders have been permitted to deduct the cost of tax advice. (Basil Kaufmann v. U.S., 13 AFTR2d 887, 64-1 USTC  ¶ 9235  (WD Mo., 1963) and Philip Sharples v. U.S., 37 AFTR2d 76-1223, 76-1 USTC  ¶ 9256 (Ct. Cl., 1976). Expansion Although Sec. 195 seems to state that costs associated with the expansion of an existing business are "deductible," there is still the question of whether such costs may have to be capitalized because of FMR Corp. and Subsidiaries, 110 TC 402 (1998). The court held that costs associated with the creation of new mutual funds in the Fidelity family were not currently deductible even though they related to the expansion of FMR's existing business of serving mutual funds. The court concluded that the costs provide significant future benefits. The obvious question is what constitutes a new business versus what constitutes an expansion.

The United states is the only country where it takes more brains
to figure your tax than to earn the money to pay it.
--Edward J. Gurney
 

Chapter 3

Organization of a Corporation: Section 351 and Related Provisions

Sec. 1001--Provides that gain on the sale or other disposition of property is taxable unless a nonrecognition rule applies. Sec. 165--Permits losses. Sec. 1032--Provides that no gain or loss is recognized by a corporation on the receipt of money or other property in exchange for its stock. Applies to options. (note this does not mention other securities, nor does it mention gains on property issued in connection with the redemption of stock, nor does it mention the shareholder, nor does it mention stock of an affiliate). Sec. 351--Provides that no gain or loss is recognized on transfers of property to a controlled corporation if the transfer is solely in exchange for stock of that corporation (only stock mentioned, only if solely, etc.). Recognize gain up to amount of boot received. Sec. 357--Gain must be recognized in cases of debt relief (if debt relief exceeds of basis or tax avoidance motives). Sec. 358--Specifies that basis of stock received equals basis of property transferred to corporation increased by gain recognized and decreased by value of other property received and debt relief.  See Sec. 362 for an alternative. Sec. 362--Corporation's basis for property received is equal to the shareholder's basis increased by gain recognized by the shareholder, but is limited to the fair market value of the transferred property. Any basis reduction as a result of the fair market value limitation is allocated among the transferred properties in proportion to their respective built-in losses. Shareholders may elect to reduce their basis for the company's stock in lieu of reducing the corporation's basis for the assets it receives. Sec. 118--Contributions to capital by both shareholders and others are not taxable. Sec. 362 states that the basis of property contributed  by others is zero.  Sec. 453--Permits use of installment method which may be available to an investor who receives debt rather than stock. Preferable to Sec. 351 in some instances because corporation receives higher basis in assets.  Gain may not have to be recognized until investor receives payment. Sec. 267--Denies deduction of losses on transfers between related person. Applies to corporations and controlling shareholders as well as controlled groups of corporations. Sec.1202--Small Business Stock. Only one-half of gain from Small Business Stock is taxed, but it is taxed at the tax rate associated with collectibles  resulting in an effective tax rate of 14% (0.50 X 28%) except for taxpayers who are in the  10% or 15% tax brackets in which case the effective rate is  5% (0.50 X 10%) or 7.5% (0.50 X 15%). Because the current maximum tax rate for long-term capital gains is 15% the tax rate advantage is small for many taxpayers. However, reinvestment (discussed below) may still be desirable. To receive this favorable treatment, stock must have been issued after August 10, 1993 and held for more than 5 years. The amount of gain that so qualifies is limited to the greater of: $10 million reduced by amounts previously excluded for gains on the company's stock, or the aggregate adjusted basis of stock sold during the year times 10. Must be a C corporation with assets having an adjusted basis of no more than $50 million. At least 80% of the value of its assets must be used in the active conduct of one or more qualified businesses (businesses other than those providing professional services, financial services, hospitality, extraction, and farming). Sec. 1045--Specifies that taxpayers other than corporations may elect to not recognize gain from the sale for Small Business Stock (Sec. 1202 Stock) if they purchase other small business stock within 60 days. The stock that was sold must have been held more than six months.  Under the election, gain is recognized only to the extent the amount realized on the sale exceeds the cost of the newly acquired stock. The basis of the new stock is reduced by the amount of unrecognized gain.

 

Section 351 Examples
Example 1 Property transferred to corporation: Basis FMV	$10,000   50,000
Transferred to shareholder: Stock (FMV)  Cash Other property (FMV and basis)  Total	$30,000  10,000  10,000 $50,000
Shareholder's recognized gain is equal to the lesser of: a. Cash and property received, or b. FMV of stock and property received by shareholder      Less: Basis of property transferred to corporation      Realized gain	$20,000 $50,000 (10,000) $40,000
Corporation's recognized gain Gain,  but not loss, is recognized on property transferred by the corporation to the shareholder.	-0-
Shareholder's basis for stock: Basis of property Plus: Gain recognized Less: Boot Basis of stock	$10,000 20,000 (20,000) $10,000
Corporation's basis for property it receives: Shareholder's basis for property Plus: Gain recognized by shareholder Corporation's basis for property	$10,000   20,000 $30,000

 

Example 2 Same facts except shareholder receives stock worth $30,000 and debt relief of $20,000 (i.e., corporation assumes $20,000 of shareholder debt).
Shareholder's recognized gain is equal to the lesser of: a. Boot and mortgage in excess of basis b. FMV of stock and debt relief received by shareholder     Less: Basis of property transferred to corporation     Realized gain	$10,000 $50,000 (10,000) $40,000
Corporation's recognized gain Gain would, but not loss would be recognized on property transferred by the corporation to the shareholder.	-0-
Shareholder's basis for stock: Basis of property Plus: Gain recognized Less: FMV of property received Less: Debt relief Basis of stock	$10,000   10,000     -0- (20,000)     -0-
Corporation's basis for property it receives: Shareholder's basis for property Plus: Gain recognized by shareholder Corporation's basis for property	$10,000   10,000 $20,000

 

Example 3 Assume the below assets are transferred to a controlled corporation under Sec. 351.   Basis FMV Gain Loss Land $80,000 $60,000   $20,000 Equipment 0 25,000 25,000   Investments 70,000 40,000   30,000 Total $150,000 $125,000   $50,000 Basis of assets is limited to $125,000. Land basis is reduced by $10,000 ($20,000/$50,000 X $25,000) to $70,000. Investments basis is reduced by $15,000 ($30,000/$50,000 X $25,000 to $55,000. Basis of equipment remains zero.

American workers spend more of their day working to pay
taxes than they do to feed, clothe and house their families.
--The Tax Foundation
 

Chapter 4

Corporation's Capital Structure: Debt vs. Equity

Sec. 385--Briefly describes some characteristics which may be used to distinguish debt from stock. Characteristics of debt include maturity date, certain return, lack of vote, participate in neither gains or losses, and a remedy in case of default. Courts also consider whether participants act like lender and borrower. Is interest paid on time? Is debt held in same proportion as stock? Is debt to equity ratio reasonable? Are terms similar to those available from others?

Sec. 1244--May treat loss on small business corporation stock as ordinary if within limits. Available to first holder if an individual or partnership and stock is issued for property other than stock or securities.  Ordinary loss limited to $50,000 per year ($100,000 on joint return). Corporation may issue up to $1,000,000 of Sec. 1244 stock (measured by the adjusted basis of property received reduced by debt payable to non-shareholders). May designate which shares are covered by Sec. 1244 in year pass $1,000,000 threshold. Greater than 50% corporation's receipts must be from an active business in 5years prior to loss. Does not apply to built-in losses, contributed capital, or AAA basis of S corporation (but may be able to avoid by selling corporate assets).

Secs. 1272 and 1273--Original investor must amortize original issue discount if it exceeds 1/4 of 1 percent multiplied times number of years to maturity.

Secs. 1276, 1277, and 1278--Investor need not amortize market discount, but must report it as ordinary income on retirement if it is not amortized.

 
 

Treatment of Gains and Losses
Type of Interest	Individual Investor	Corporate Investor
Stock	Capital gain or loss (exception: Sec. 1244, etc.)	Capital gain or loss (exception: ordinary loss on worthless stock of affiliate (80% or greater))
Security (such as a bond or stock option)	Capital gain or loss (exception: inventory)	Capital gain or loss (exception: ordinary loss on worthless security of affiliate (80% or greater))
Other debt evidenced in writing (such as a note or mortgage)	Nonbusiness bad debt (STCL) unless business related then a business bad debt.	Capital gain or loss (exception: ordinary loss on worthless debt of affiliate (80% or greater))
Receivables	Probably ordinary gain or loss. Could be nonbusiness bad debt.	Probably ordinary gain or loss.
Loan guarantees by investors	Nonbusiness bad debt (STCL) unless business related then a business bad debt.	Nonbusiness bad debt (STCL) unless business related then a business bad debt.
Note: Capital gain or loss treatment may be over-ridden by anyone of several special rules. For example, Sec. 1244 can convert losses to ordinary, or a broker's inventory is treated as an ordinary asset. As corporate capital gains are taxed at the same rate as other income the main advantage to corporation having a capital gain is that it can be offset with by capital losses.

All the Congress, all the accountants and tax lawyers, all the judges,
and a convention of wizards cannot tell for sure what the income tax law says.
--Walter B. Wriston, Former Chairman of Citicorp.
 

Chapter 6

Corporate Elections Under Subchapter S

Sec. 1361--Defines S corporation. Lists eligible shareholders as individuals who are U. S. citizens or residents, estates, organizations exempt under Secs. 401 and 501, other S corporations (but only if 100%) and certain trusts. Eligible trusts include grantor, testamentary (2 year time limit), qualified subchapter S trusts, and small business trusts.

Sec. 1363--Explains effect of election on corporation. Exempt from income tax, but files return reporting special items separately.

Sec. 1362--Explains election, revocation, and termination. All shareholders must elect. Use Form 2553.  Election must be by 15th day of 3rd month.

Sec. 1366--Explains pass throughs of items to shareholders. Income and losses along with special items allocated between shareholders based on number of shares owned.  Per day allocation if stock ownership changes.

Sec. 1367--Explains adjustments to basis of stock. Income increases stock basis while losses reduce basis, but not below zero. Additional losses carried over.

Sec. 1368--Explains distributions. Distributions reduce basis and are generally not taxable.

Sec. 1371--Coordinates S and C corporation rules (E&P survives, carryovers time lapses).

Sec. 1372--Treats S corporation as partnership for purposes fringe benefits.

Sec. 1373--Treats S corporation as having sold foreign assets and must recapture foreign losses when change status (to or from S corporation status).

Sec. 1374--Imposes tax on built-in gains. Applies to gains for 10 years after an S election is made by a C corporation. Applies to LIFO reserve.

Sec. 1375--Imposes passive income tax.

Sec. 1376--Explains impact of partial years (transfer of stock and midyear terminations).

Sec. 1378--Limits available taxable years.

Sec. 1379--Deals with transitions that result from previous tax changes (treatment of previously taxed income).

 
 

Distributions by S Corporations with E & P
Source	Impact on Taxable Income	Impact on Basis	Comments
1. Accumulated Adjustments Account (AAA)	None as income taxed even if not distributed.	Reduces basis (income increases basis).	May elect to skip this step.
2. Previously Taxed Income (PTI)	None as income taxed even if not distributed.	Reduces basis.	AAA for years before 1982. Omit this step in case of noncash distributions.
3.Post-2/28/13 Earnings and Profits (E&P)	Taxable as a dividend.	None.	From C years, and from mergers, etc. with C corporations.
4. Other Adjustments Account (OAA)	Not taxable.	Reduces basis.	If no E&P, OAA is part of AAA.
5. Remaining Stock Basis	Not taxable.	Reduces basis.	Original stock basis exclusive of AAA and OAA.
6. Pre-3/1/13 E & P	Not taxable.	None.
7. Remaining Amounts	Taxable, normally as a capital gain.	None.
Note: If no E&P, distributions reduce basis of stock. Distributions in excess of basis are gains. AAA and OAA are not kept separate.

 
 

S Corporation Distribution Example
Part a  S corporation is owned by Jane. Jane's stock basis at January 1 is $50,000 consisting of AAA $10,000, PTI $5,000, OAA $2,000, and other basis of $33,000.  AE&P is $12,000. During the current year, S corporation earns $5,000 of taxable income and $1,000 of exempt income and distributes $78,000 to Jane. What does Jane report on her personal return this year? What is the basis of her stock at year end?
	Beginning Basis	Income	Basis before Distribution
AAA  PTI  AE&P ($12,000)  OAA  Other basis Total stock basis	$10,000 5,000 2,000 33,000 $50,000	$5,000                        1,000 _____  $6,000	$15,000 5,000 3,000 33,000 $56,000
In summary, the $78,000 distribution results in Jane recovering all $56,000 of stock basis reducing the stock basis to zero, and reporting income of $22,000 income ($12,000 dividend and $10,000 gain). AAA, PTI, AE&P, OAA, and other basis are all reduced to zero. Jane also reports the $5,000 of income that passes through the corporation. Part b Now assume no distribution to Jane. Instead, she sells the stock to Joe for $70,000 at the beginning of the next year. What does Jane report on her return?  This year, Jane report $5,000 of ordinary income and adds $6,000 to her stock basis resulting in a year end basis of $56,000. Next year, she reports a gain on the stock sale of $14,000 ($70,000 selling price - $56,000 stock basis).  What is Joe's basis and of what does it consist?  Joe's basis is $70,000 consisting of AAA $15,000, OAA $3,000, and other $52,000. The corporation retains it AE&P. The basis of the corporation's assets is not adjusted to reflect the gain recognized by Jane.

The first 9 pages of the Internal Revenue Code define income;
the remaining 1,100 pages spin the web of exceptions and preferences.
--Warren G. Magnuson, U.S. Senator
 

Chapter 7

Penalty Taxes on Undistributed Corporate Income

Accumulated earnings tax

Sec. 531--Imposes a tax equal to 35% (temporarily 15%) of "accumulated taxable income."

Sec. 532--Says the tax is imposed on corporations formed or availed of for the purpose of avoiding the income tax on shareholders. Exempts from the tax personal holding companies, foreign personal holding companies, exempt corporations, and passive foreign investment companies. (S corporations are effectively exempt because shareholders are automatically taxed on corporation's income.)

Sec. 533--Exempts income accumulated to meet "reasonable needs of the business", but states that a mere holding or investment company shall be prima facie evidence of the purpose of tax avoidance.

Sec. 534--Imposes burden of proof on corporation unless it provides required written explanations.

Sec. 535--Explains computation of "accumulated taxable income". Exempts capital gains, but otherwise moves toward accounting income. Provides for an exemption of $250,000 ($150,000 for service corporations).

Sec. 537--Defines "reasonable needs of the business" to include reasonably anticipated needs, Sec. 303 redemptions (estate tax), and excess business holdings redemption (private foundations).

Secs. 561 to 565--Explains deductions for dividends paid.

Personal holding company tax

Sec. 541--Imposes a tax equal to 35% (temporarily 15%) of "undistributed personal holding company income."

Sec. 542--Defines "personal holding company" as corporations with at least 60% of adjusted ordinary gross income consisting of personal holding company income and over 50% of stock owned, directly or indirectly, by 5 or fewer individuals or tax exempt organizations. Exempts banks, life insurance companies, lending company, foreign corporations, exempt corporations, etc.

Sec. 543--Defines personal holding company income to include dividends, interest, rents, royalties, and income from personal service contracts. Creates special exceptions for companies engaged in the real estate rental business, oil and gas producers, etc.

Sec. 544--Explains constructive ownership rules used to decide whether control exists.

Sec. 545--Defines "undistributed personal holding company income" as being computed by starting with taxable income and making adjustments for distributions, income taxes, unallowable contributions, dividend received deduction, NOL, etc.

Sec. 547--Permits a deficiency dividend which eliminates the tax if shareholders agree to include in their incomes the corporation's income that would otherwise be subject to the tax.

Secs. 551 to 557--Establishes rules for foreign personal holding company. Basically U.S. shareholders must include the foreign personal holding company's income in their own income.

Secs. 561 to 565--Explains deductions for dividends paid.

Nuclear physics is much easier than tax law.
It's rational and always works the same way.
--Jerold Rochwald
 

Chapter 8

Dividend and Other Nonliquidating Distributions

Sec. 61--States that dividends are taxable.

Sec. 316--Defines dividend as distributions of current or accumulated earnings and profits (but does not define E & P).

Sec.  312--Does not define E & P, but does discuss the impact of distributions, reorganizations, divisions, depreciation, and certain other events on E & P.

Sec. 301--Says distribution of property is taxable if have E & P; that the dividend equals the value of the property reduced by any liability; that the basis of the property is equal to its value; and the basis of stock is reduced if distribution exceeds E & P.

Sec. 311--Says that corporation recognizes gain (but not loss) if it distributes appreciated property in a dividend and in most other transactions.

Sec. 305--Says that stock dividends and distributions of stock rights are not taxable, but creates several exceptions. The exception make stock dividends taxable if  a shareholder has the option to receive cash or other property instead of stock,  if the dividend is disproportionate, if some some shareholders receive common and others receive preferred, if the distribution is on preferred stock,  if the distribution is of convertible preferred stock, or if the transaction changes conversion or redemption rights.

Sec. 307--Says that part of basis of old stock is allocated when receive stock dividend or stock rights, but does not require allocation if stock rights are worth less than 15% of the value of old stock.

Sec. 306--Defines "Sec. 306 stock" to include preferred stock, nonvoting common, options, rights, and convertible stock received as a dividend, gift, in a reorganization or division. The redemption of "Sec. 306 stock" results in dividend income to extent of E&P at time of redemption. Sale results in dividend income to extent of E&P at time of issue. In neither case is E&P reduced by amount of dividend.

Sec. 243--Provides that corporations may claim a dividend received deduction equal to 100% of dividends received from 80% or greater subsidiaries, 80% of dividends received from 20% (but less than 80%) subsidiaries, and 70% of dividends received from other corporations. Does not apply to dividends received from foreign subsidiaries.

Sec. 1059--Requires corporations to reduce the basis of stock held if they receive "extraordinary dividends" within 2 years of acquisition of the stock.  Applies if dividends exceed 10% of basis (5% of basis if preferred stock) paid within an 85 day day period (or 20% of basis paid within a one year period). Basis is reduced by amount of dividend received deduction.

 

Example 1: A corporation distributes land with a basis of $40,000 and a value of $60,000 to its sole shareholder, an individual whose stock basis is $500,000.  Corporation's  current and  accumulated E&P total $200,000. Corporation reports a gain on the land of $20,000.  E & P is increased by $20,000 (assuming E & P basis is the same as income tax basis), reduced by the income tax on the distribution ($7,000 assuming a 35% tax rate), and reduced by the amount of the distribution $60,000.   Shareholder reports $60,000 of dividend income. Stock basis is unchanged. Land basis is $60,000.  Assume same facts, except that current E&P is $20,000 (current E& P is determined at the end of the year and would include the gain on the distribution net of tax) and accumulated E&P is $30,000.  Distribution is assumed to first come from current E&P followed by accumulated E&P. The remaining distribution of $10,000 is a return of  capital reducing the shareholder's basis by $10,000 to $490,000. Land's basis is $60,000.  Assume shareholder is another corporation that purchased stock years ago.  Shareholder reports $60,000 of dividend in the first situation and takes a $60,000 dividend received deduction.  In second situation, shareholder reports a $50,000 dividend, claims a $50,000 dividend received deduction, and reduces stock basis by $10,000. Land's basis is $60,000 in both situations. Assume same facts except the shareholder is a corporation that recently purchased the stock.  In first instance dividend is extraordinary because $60,000 > 10% X $500,000. Dividend received deduction of $60,000 is available. Stock basis is reduced by full amount of dividend received deduction. Possibly the distribution in the second instance (where E & P is only $50,000) basis is reduced by only $10,000 because the dividend is $50,000 and that is not greater than 10% of basis. That, however, is not certain.  Example 2: Preferred Stock Bailout (Sec. 306 stock). Shareholder owns 100 shares of common stock with a total basis of $1,000. Corporation pays to shareholder 10 shares of preferred stock. Value of common after the distribution is $1,500 and value of preferred is $500. Although a dividend on preferred stock is taxable, a dividend of preferred stock is not (unless of course it is paid on preferred stock). Nevertheless, complex rules take away advantages and create recordkeeping challenges.  Basis is allocated between old common and new preferred share using value even is value is less than 15%. Basis of $1,000 allocated between preferred and common. Preferred stock:   $500/$2000 X $1,000 = $250 Common stock:   $1,500/$2,000 X $1,000 = $750 Although basis is allocated to the preferred shares, the transaction is subject to the "preferred stock bailout" rules of Sec. 306. As a result, the sale of the preferred stock is taxable as a dividend assuming the corporation had E & P at time of issue (without any corresponding reduction in E&P). If preferred stock is sold for $400, shareholder reports $400 of dividend income assuming the corporation had at least $400 of E&P at the time of issue. A redemption also is taxable as a dividend, but the E&P is measured at the time of the redemption. The shareholder is permitted to return  the "unrecovered" basis of the preferred stock back to the common stock. If there is no E&P, the shareholder can recover the basis of the preferred stock tax free, and any amount in excess of the basis is a gain.

 
 

Order of distribution by C Corporation:

Rule: Dividends are taxable if paid out of either current or accumulated earnings and profits. Distributions are assumed to occur in the following order:

1. Current earnings and profits (for entire year, if positive).

2. Post 2/28/13 accumulated earnings and profits (if there is a current loss, then AE&P as of date of distribution, if a current profit as of beginning of the current year).

3. Return of capital (figured in aggregate).

4. Pre 3/1/13 accumulated earnings and profits.

5. Gain.

Order of distribution by former S Corporation:

1. Accumulated adjustments (but only during post-termination period which generally is the latest of (a) one year after termination, (b) due date, including extensions, of last S return, (c) 120 days after a determination the S election has terminated (for example, court decision, closing agreement, etc.)), (d) 120 days after a re-determination of the former S corporation's income by the IRS during an audit.

2. Items 1 through 5 for other C Corporations.

Order of distribution by S Corporation:

1. Accumulated adjustments

2. Previously taxed income

3. Post 2/28/13 accumulated earnings and profits

4. Other adjustments

5. Return of capital

6. Pre 3/1/13 accumulated earnings and profits

7. Gain

I owe the government $3,400 in taxes. So I sent them two hammers and a toilet seat.
--Sue Murphy, Comedian
 

Chapter 9

Stock Redemptions

Sec. 302--States that a redemption of stock is treated as a sale of stock permitting taxpayer to recover the basis of the stock and report a capital gain or loss if the redemption is (1) substantially disproportionate, (2) redemption of all of the shareholder's stock, (3) a partial liquidation, or (4) not essentially the equivalent of a dividend.

Sec. 318--Contains constructive ownership rules used in deciding if redemption is substantially disproportionate or if all of the shareholder's stock is redeemed.

Sec. 303--States that certain redemptions of stock from estates to pay death taxes and expenses are treated as a sale of stock.

Sec. 311--States that corporation recognizes gain (but not loss) when it distributes property to shareholder in a redemption.

Sec. 312--Distribution of appreciated property in a stock redemption generates earnings and profits equal to the E & P gain (which is not necessarily by the same amount as is recognized as income) regardless of whether the redemption is treated as a sale or a dividend.  If redemption is treated as a dividend, E&P is reduced by the value of property (or basis if greater). If redemption is treated as a sale, E&P is reduced proportionately (or, if less, by the amount of  the reduction that would be made if the transaction were treated as a dividend).

Sec. 1012--States that basis of property received is equal to its value.

Sec. 304--Extends redemption rules to certain stock purchases by affiliated corporations.

 
 

Constructive Ownership Under Section 318

1. Family  a. Individual is attributed shares held by spouse, children, grandchildren, and parents (note siblings are omitted).  b. One-step family attribution, but entity to beneficiary rules are applied first.  2. Entity to beneficiary  a. Stock held by a partnership, S corporation,  trust, estate is attributed proportionately to its owners.  b. Stock held by a  C corporation is attributed proportionately to greater than 50% shareholders. Corporation to shareholder is multi-step.  3. Beneficiary to entity  a. All stock held by partners, S corporation shareholders, and beneficiaries of estate and trusts is attributed to the entities except stock held by individuals who have a "remote" interest in a trust (generally 5% or less).  b. Stock held a 50% or greater shareholder in a C corporation is attributed to the C corporation (all).  c. One way. That is, not back to other partners, shareholders, etc.  d. Multilevel. That is, may go from second level subsidiary up to parent.  Note: Because of family attribution rules, a corporation may have many "greater than 50% shareholders," but only stock actually owned by such shareholder is attributed.  4. Options  a. Generally person who holds an option is treated as holding the actual stock.  b. Optioned shares can be attributed to other family members.

 
 

Stock Redemption Example
L & L Corp. has two unrelated shareholders, Long and Lopez. L & L Corp. redeems 100 shares of stock from Long for $5,000. L & L's earnings and profits, prior to the redemption, equals $50,000. No other redemptions take place other than those described in each part.
	Long	Lopez	Total
Shares held Total basis Per share basis Share redeemed Amount	300 $12,000 $40 100 $5,000	1,200 $48,000 $40 0 0	1,500 $60,000 $40 100 $5,000
Part a 1. Is the redemption substantially disproportionate? Show computation. (200/1400)/(300/1500) = 14.29%/20% = 71.43%. Yes. 2. Assuming the redemption is treated as a sale, how much gain does Long recognize? $5,000-$4,000 = $1,000 3. Assuming the redemption is treated as a sale, what is Long's basis for her 200 remaining shares? $40/share or $8,000 4. Assuming the redemption is treated as a sale, what is L & L's earnings and profits after the redemption? $50,000 - 100/1,500 X $50,000 = $46,667 Part b For part b, assume that L & L also redeems 400 shares from Lopez for $20,000. 5. Is the redemption substantially disproportionate? (200/1,000)/(300/1,500)= 20%/20% = 100%. No 6. Assuming the redemption is treated as a dividend, how much dividend income does Long recognize? $5,000 7. Assuming the redemption is treated as a dividend, what is Long's basis for her remaining shares? $12,000/200 = $60 8. Assuming the redemption is treated as a dividend, what is L & L's earnings and profits after the redemption of   500 shares. $50,000 - $25,000 = $25,000 Part c For this part assume that L & L redeems 100 shares from Long and 400 shares from Lopez as in part b. Also assume earnings and profits before the redemption is only $2,000.  9. How much dividend income must Long report? $5,000/$25,000 X $2,000 = $400 10. What is the balance in E & P after the redemption of the shares from Long and Lopez? -0- 11. What is the basis of Long's remaining shares? $12,000 - ($5,000 - $400) = $7,400

In a reversal of "No taxation without representation," women
were required to pay federal income tax seven years before they won the right to vote.
--Loch Adamson, Writer
 

Chapter 10

Complete Liquidations and Other Taxable Dispositions

of Corporate Stock and Assets in Bulk

Sec. 331--States that a liquidation of a corporation shall be treated as a sale of the shareholder's stock.

Sec. 1001--Provides that the gain or loss on the sale of stock is equal to the difference between the adjusted basis of the stock and the net distribution. Provides creditors (including parent corporations) recognize gain if amount received exceeds the basis of debt instrument.

Sec. 334--Provides that the basis of property received in a liquidation is equal to its value (assuming gain or loss is recognized).

Sec. 336--Provides that the corporation recognizes both gains and losses on property that it distributes in a complete liquidation. Losses may not be deducted, however, if the property is distributed to a related person (as defined by Sec. 267) on a non pro rata basis, was transferred to the corporation by a related person in a nontaxable transaction within the last five years, or if the property was contributed to the corporation within the last two year for purposes of permitting the corporation to deduct loss.

Sec. 332--Provides that the liquidation of an 80% subsidiary is not taxable to either the parent or the subsidiary and that the basis of assets, earnings and profits, and most other attributes transfer to the surviving parent. Minority shareholders are still covered by Sec. 331. Generally unavailable in the case of the liquidation of an insolvent subsidiary because the parent receives nothing for the stock. Everything goes to creditors. The parent probably can deduct a loss equal to basis of the subsidiary's stock.

Sec. 338--Establishes an exception that allows parent to elect to step up or down the basis of the subsidiary assets if the subsidiary was acquired in a transaction taxable to prior shareholders during the preceding 12 months and the write up or down is reported as taxable income. It is not necessary to liquidate the subsidiary to make this election. Subsidiary's tax attributes disappear. This election is sometimes made by S corporations. The gain recognized on the corporate assets passes through to the S corporations former shareholders increasing their stock basis and reducing the gain on the stock. The result is a higher basis for the assets acquired from the S corporation.

Sec. 341--Repealed. Sec. 1244--Allows eligible shareholders to treat limited amounts of loss on stock as ordinary.  Can apply to liquidation.

 

Summary of Liquidation Provisions
Treatment of shareholders:
Rule	Sec. 331  General	Sec. 332  Liquidate Subsidiary	Sec. 338 Liquidate Subsidiary (optional)	Sec. 1244 Small Business Stock
Applicable to gain or loss	Both	Both	Both	Loss
Applicable to corporate shareholder	Less than 80%	80% or greater	80% or greater	No
Must liquidate for rule to apply	Yes	Yes	No	No
Elective	No	Sometimes may elect Sec.338	Yes	No
Time limit on liquidation	None	3 years	1 year	None
Basis of property	Value	Prior	Formula based on price paid for stock	Value
Treatment of gain or loss	Recognized, Equals value received less basis of stock	Parent recognizes none	Former shareholders probably taxed, parent is not.	Ordinary loss within limits

 
 

	Treatment of corporation:
Rule	Sec. 336--General	Sec. 332--Liquidation of subsidiary
When used	Used unless parent liquidates subsidiary under Sec.332	Applies when parent corporation liquidates a subsidiary unless Sec.338 is elected.
Tax attributes (e.g., NOL, E&P)	Generally disappear	Carryover to parent
Gain or loss recognized on assets	Yes	Gain on assets distributed to minority shareholder.

 
 

Liquidation Example Shareholders of Z corporation vote to liquidate.
Shareholder	Shares owned		Total basis		Per share basis
X	900		$108,000*		$120
Y	100		12,000		$120
Total	1,000		$120,000
*For Sec. 338, we will assume X sells his 900 shares of stock to a corporation for $140 per share or a total $126,000.
In a Sec. 331 liquidation the corporation is taxed. Y receives $14,000. X receives the remaining cash of $6,000 and the land, subject to the mortgage, with a net value of $120,000 for total of $126,000.
		Basis		Adjustment	Adjusted	To Y	To X
Cash  Land (FMV $160,000)  Total		$ 30,000  100,000 $130,000		($10,000) 60,000 $50,000	$  20,000 160,000 $180,000	$ 14,000 ___0__  $14,000	$6,000     160,000  $166,000
Mortgage payable Common stock  Earnings and profits Total		$40,000   70,000   20,000 $130,000		50,000 $50,000	$40,000    70,000  70,000 $180,000		$40,000

 

Comparison of Alternative Rules that Apply to Liquidation
 

Section	Governing provision	Treatment of shareholder X	Treatment of shareholder Y
Sec. 331	Corporation recognizes gain or loss. Attributes terminate.	Gain: Received  $  126,000 Basis            108,000 Gain          $     18,000  Land basis: Value          $160,000	Gain: Received  $14,000 Basis          12,000 Gain            $ 2,000
Sec.  332	Corporation does not recognize gain or loss. Attributes survive.	Gain:                   None Land basis: Cost          $100,000	Gain of $2,000 assuming still received $14,000.
Sec. 338	Corporation recognizes gain or loss. Attributes terminate.	Gain: Received  $126,000  Basis         108,000 Gain            $ 18,000   Land basis: Grossed up stock value*         $140,000 Mortgage       40,000 Total basis  $180,000   To cash        (20,000)   Land basis $160,000	If actually liquidate and Y receives cash same as above. If not, Y keeps stock with a basis of $12,000.
Sec. 1244	Same as Sec. 331.	Same as Sec.  331 since realized a gain.	Same as Sec.  331 since realized a gain.
*Cost of stock to new shareholder is grossed up to the price that would have been paid for all shares:  $126,000 X 100%/90% = $140,000 or $140 X 1,000 = $140,000

Why does a slight tax increase cost you $200
and a substantial tax cut save you 30 cents.
--Peg Bracken, Writer, humorist
 

Chapter 11

Corporate Divisions

General rule: Sec.355--States that shareholders are taxed in a divisive reorganizations only if they receive boot. Defines divisive reorganizations to include spin-offs, split-offs, and split-ups. If a corporation already has a subsidiary, Sec. 355 permits a tax free disposition to shareholders. If the corporation does not have a subsidiary, Sec. 368(a)(1)(D) may be used to create one.  Need a subsidiary: Three provisions together (Secs. 368(a)(1)(D), 356(b), and 357(c)) indicate that in a reorganization, a parent recognizes income upon the creation of a subsidiary only if it receives boot or if debt assumed by the subsidiary exceeds the basis of property transferred to the subsidiary.  Sec. 368(a)(1)(D)--Includes within the definition of a reorganization the formation of a subsidiary as a lead into to a divisive reorganization.  Sec. 356(b)--States that forming a subsidiary is taxable to the parent if the parent receives boot.  Sec. 357(c)--States that forming a subsidiary is taxable to the parent if parent's debt assumed by the subsidiary exceeds the basis of the parent's property transferred to the subsidiary.  Corporation distributing subsidiary's stock: Sec. 355(c)--If the distribution is not part of a reorganization under Sec. 368(a)(1)(D), no gain or loss is recognized on distribution of the subsidiary's stock or securities unless it is a disqualified distribution described in Sec. 355(d).  Sec. 355(d)--Defines a disqualified distribution as a distribution by a parent to a 50% or greater shareholder who has acquired the interest within the last five years.  Sec. 361(c)(1)(D)--Provides for nonrecognition of gain or loss by a corporation distributing a subsidiary's stock or securities in a Sec. 368 reorganization. Distributions of nonqualified property (such as stock warrants and property) are taxable.

 

Division Case

Pace Company has been in the business of manufacturing boats and engines for over 20 years. Lee owns 10% of Pace's stock with a basis of $40,000 and a value today of $125,000. For valid business reasons, a decision has been reached to divide the boat and engine manufacturing businesses into two separate corporate shells. Pace's earnings and profits equals $250,000, and the total basis of its assets is $1,400,000.

1. Can Pace divide under Sec. 355 if there is only one corporate entity at the present time? Yes, assuming conditions are met.  Form subsidiary under Sec. 368(a)(1)(D) in preparation for the division.  2. If Pace divides can it choose a spin-off, a split-off, or a split-up? Yes, but a spin-off is not useful for a dispute.  Would have to form two subsidiaries to split-up business.

For parts 3 through 6, assume a subsidiary called Pace Engines is formed and it receives assets relating to the engine manufacturing operations. Further assume a spin-off follows and that Lee receives 250 shares of stock in the new corporation and that stock is worth $50,000. 3. Does Lee have to report any income from the spin-off? Assuming requirements are met, no. 4. What is the basis of the Lee's Pace Engines shares? (You will have to make an assumption about the value of Pace's stock.) What is their holding period? $50,000/($50,000+$75,000) X$40,000 = $16,000 Tacks. 5. What happens to Pace's earnings and profits? E & P divides perhaps using relative FMV (40% to Pace Engines and 60% to Pace. 6. Is Pace Engines treated as a new company with respect to elections relating to accounting methods and taxable  periods? Yes. 7. Assume that transaction does not meet the requirements of Sec. 355. How much income will Lee have to report? What happens to Pace's earnings and profits? What is the basis of Lee's Pace Company stock and Pace Motors stock? Distribution of stock is a dividend, but is limited to E&P of $250,000. Lee's dividend income is limited to his share of E&P(10% x $250,000) or $25,000. E&P is reduced to zero. The rest of the distribution, $25,000 (value of stock distributed $50,000 - taxable portion of $25,000 )  is a return of capital which reduces the basis of Pace Company stock.  That is, the original  basis of the Pace Company stock ($40,000) is reduced by the return of capital ($25,000) to $15,000  Lee's basis for Pace Motor stock is its value or $50,000 because it is property received as a dividend. The total basis for the two stocks is $65,000 ($15,000 + $50,000).  That is the total of Lee's original basis ($40,000) plus the amount of dividend income recognized ($25,000).

For parts 8 through 10, assume that Pace Engines is formed, but that a split-off takes place. In the split-off Lee receives Pace Engines stock in exchange for Pace stock. 8. Does Lee have to report any income? No if requirements for a split-off are met. 9. What is Lee's basis for the Pace Engine stock? Same as Pace Company stock, $40,000. 10. Assume that the transaction does not meet the requirements of Sec. 355. How much income does Lee report? What is the basis for the Pace Engine stock? Transaction likely would be treated as a sale resulting in a gain of $85,000 ($125,000 - $40,000).  Basis of stock  is $125,000. For the remaining parts assume that Pace Company is split-up. The is done by Pace first forming two subsidiaries, Pace Boats and Pace Motors, then transferring all assets to the subsidiaries. Pace Company distributes the stock in the two subsidiaries to its shareholders and then liquidates. 11. Does Lee's tax situation differ depending on whether he receives stock in only one or both new companies? Only with respect to the basis for the stock. If Lee receives stock in both corporations basis is divided between two stocks using value. 12 Are Pace Boats and Pace Motors treated as new corporations with respect to accounting methods, taxable periods, and earnings and profits? Yes, for methods and periods. No, for E&P. 13. Will Lee be taxed if he receives Pace Boats stock worth $100,000 and Pace Motors securities worth $25,000? Yes, if securities represent debt as there is an increase in principal.  Although securities are covered, increase in principal is not.

My company fills out 39,000 tax forms a year . . .
--Michael Armstrong, CEO AT&T
 

Chapter 12

Corporate Reorganizations

Sec. 368--Describes the different types of reorganizations. To receive favorable tax treatment, transaction must meet the requirements of one of the below listed reorganization types and must satisfy several general requirements such as there being a  plan, and the transaction having business purpose as well as there being continuity of business  and continuity of ownership. The overall nature of the transaction is considered. Thus, the overall  substance and not just the form is considered. Events over time are considered and not just individual steps. Further, the transaction should not be a devise for distributing E & P.

A -- Statutory merger or consolidation (fusion)--Corporations combine under state law. Surviving corporation assumes liabilities. Can be triangular with target corporation merging with subsidiary. If existing corporation survives transaction is a merger.  If new corporation survives transaction is a consolidation. Can buy out some shareholders.

B -- Stock for stock (acquire subsidiary)--At least 80% of target corporation stock is acquired by exchanging acquiring corporation's stock for target's stock. Only acquiring corporation's stock can be used. Acquiring corporation does not assume target's liabilities.

C -- Stock for Property (fusion)--Acquiring corporation receives target's assets in exchange for its own stock.  Target distributes the acquired stock to its shareholders and goes out of existence. Acquiring corporation does not assume target's liabilities. Can be triangular in that targets assets are transferred to acquiring company's subsidiary.

D -- Property for stock (either a combination or a division when used with (Sec.355))--Can be acquisitive or divisive.  In an acquisition, the acquiring corporation transfers substantially all of its assets to target in exchange for at least 50% of target's stock. The acquiring corporation then goes out of existence.  In a division, the dividing company transfers assets to an 80% or greater subsidiary.  The transfer is followed by a Sec. 355 spin-off, split-off, or split-up.

E -- Recapitalization (change a single corporation)--Investors interest in corporation is restructured.

F -- Mere change of name, etc. (change a single corporation)--Corporation changes name, reincorporates, incorporates in new state, changes articles of incorporation or under takes other changes.

G --Reorganization in bankruptcy--Reorganization takes place as part of bankruptcy proceeding. Of involves transfer of ownership to creditors.  Not automatically considered to be a violation of continuity of interest requirement.  Investors may prefer that transaction avoid tax free status in order to permit loss deduction. Nevertheless, continuation of attributes such as an NOL may make transaction desirable.

Sec. 354--Shareholder who exchanges stock or securities in a reorganization recognize no gain or loss if issuing corporation is a party to the reorganization. Exceptions are found in Secs. 356 and 357.

Sec. 361--Corporation recognizes no gain or loss on its property unless it is distributed to someone other than another corporation that is a party to the reorganization.

Sec. 356--Investor who receives "boot" does recognize gain.  Increase in principal amount owed to investor is considered boot. Basis is increased if gain is recognized.

Sec. 357--Corporation and shareholder recognize gain if either transfers property with a mortgage in excess of basis. Basis is increased by gain recognized and reduced by amount of mortgage, even if if gain is not recognized.

Secs. 358 & 362(b)--Provide for substituted  and carryover basis. Basis of assets remains unchanged  unless gain is recognized. Related attributes such as depreciation method are preserved if assets remain in the corporation or are transferred to another corporation that is a party to the reorganization. Shareholder's total stock basis normally remains unchanged.  Basis is allocated using fair market value if shareholder receives stock in more than one corporation or multiple classes of stock in one corporation.  If corporation  exchanges its stock for another corporation's stock (for example, in a B reorganization) the basis is equal to the basis of the transferor.

Secs. 381, 382, and 383--Set out rules relating to survival of tax attributes including NOLs and other carryovers, earning and profits, accounting methods, etc.

Sec. 1032 - Corporation issuing stock recognizes no gain or loss on issuance.

 
 

Reorganization Case
Assume B corporation merges into A corporation. B is owned by three unrelated individuals, X, Y, and Z. X and Y each own 400 shares of B and are to receive 800 shares of A. Z owns 200 shares of B and is to receive $20,000 cash. Each shareholder has a basis of $21 per share. A corporation stock is worth $50 per share. B's balance sheet is as follows:
	Basis	Value
Cash Inventory  Building  Land Goodwill  Total  Mortgage  Common stock  E & P  Total  *Net of $10,000 of accumulated depreciation	$20,000 15,000   40,000* 10,000 _____ $85,000 $35,000  25,000 30,000 $85,000	$20,000 17,000 50,000 20,000 __?__ ?
1. What subjective conditions must be meet for this reorganization to be treated as a tax exempt reorganization? For the remaining questions, assume these conditions are met. Continuity of interest, step transaction, plan, business purpose, continuity of business, etc. 2. What code section covers this transaction? Sec. 368(a)(1)(A). 3. a. What is B company's stock worth? $100 per share or $100,000 total (1,000 X $100).  Z is receiving $100 per share ($20,000 cash / 200 shares). X and Y are each receiving $40,000 (800 share times $50 per share) of A company stock for their 400 shares of B stock which also is $100 per share ($40,000/ 400 shares).     b. How much is B's goodwill worth? Value of corporation is $135,000 (Stock value $100,000 + debt $35,000). Value of listed assets is $107,000. Goodwill is $28,000 ($135,000 - $107,000).      c. Will it be booked for tax purposes? No. 4. Will B report any income from the reorganization? No. 5. Would it make any difference if Z were given the land instead of the cash? Yes, corporation will recognize $10,000 gain. 6. What happens to B's E & P? Transfers to A, but may be adjusted properly. 7. If B had an NOL, what would happen to it? Transfers to A, but use limited. 8. a. What happens to the basis of B's assets? Unchanged.     b. How is depreciation computed on the building after the merger? Continue as before.  9. Does A recognize any gain? No. 10. a. Does Z recognize capital gain, ordinary gain, or dividend income?  Probably capital gain.      b. How much?  $15,800 = $20,000 - $21 X 200       c . Would it make any difference whether A or B's cash is used? No.  11. a. Do X and Y recognize any income? No.        b. What is their basis in the A stock they receive? $10.50 per share or $8,400 for each investor.        c. Would it make any difference if X and Y received preferred stock instead of common? Probably not, but could raise  continuity of interest and preferred stock bailout issues.        d. Would it make any difference if X and Y later sold the stock they received? Yes, may not meet continuity of interest requirements.        e. Would it make any difference if X, Y, or Z were corporations instead of individuals? No.        f. How would X, Y, and Z be taxed if the $20,000 cash were paid out proportionately and each received the balance in the form of A stock. Each would report dividend income (X $8,000, Y $8,000, and Z $4,000). Some might claim transaction produces a capital gain.  12. Record the transfer of B assets to A on A's books. Assume the original transaction is carried out. Inventory        15,000 Building         40,000 Land              10,000         Mortgage            35,000         E&P                  24,000         Common stock      6,000  13. If A wanted to achieve a step up in the basis of B's assets how could they achieve it? There are at least two things they could do differently to accomplish this result. Purchase assets or purchase stock and make Sec. 338 election.

It took an IRS accountant to catch Al Capone.
--IRS recruiting poster
 

Chapter 13

Affiliated Corporations

Sec. 482--Allows the IRS to reallocate income deductions, gains, losses and credits between related persons.

Sec. 1501--Provides that an affiliated group may elect to file consolidated tax returns.

Sec. 1504--Defines an affiliated group to include a parent and 80% controlled subsidiaries (by both vote and value). Excludes exempt, foreign, insurance, possessions, regulated investment companies, real estate investment trusts, and DISCs. (Other provisions exclude foreign sales corporations).

Sec. 1502 Regulations--Separate return limitation year (SRLY) rule prevents the use of an NOL carryover to offset income of other members of a consolidated group if the corporation generating the loss was not a member of the group when the loss occurred. Rule also extends to "built-in deductions" such as "depreciated assets." Rule does not apply to parent’s own losses as long as the parent’s shareholders maintain control (50% or greater).

Regulations also provide that subsidiary's losses that occur during period of consolidation can offset the income of other members of the group, and that the offset is not limited to the parent’s basis in the subsidiary's stock. Losses reduce parent’s basis in the subsidiary's stock. If losses exceed the basis, the excess is accumulated in an "excess loss account" (ELA). Sale of subsidiary stock can result in a gain greater than the sales price of the stock. A liquidation purges the balance without any gain recognition.

Sec. 1561--Establishes a one-group/one allowance barrier that limits tax benefits for members of a controlled group. The rule applies to tax brackets, accumulated earnings credit, AMT exemption, the limit for credits, the Sec. 179 write-off for equipment, and various pension rules.

Sec. 1563--Defines a controlled group to include:  Parent-subsidiary--80% ownership and  Brother-sister--5 or fewer individuals, estates, or trusts own at least 80% of all corporations in group and 50% when considering the smallest interest in any corporation in a group.  Combinations of the above.  Stock held by partnerships, corporations, estates, and trusts are attributed to those who have a 5% or greater interest in proportion to the interest. In general, stock held by an individual's spouse and minor (under age 21) children are attributed to an individual. Stock held by grandchildren and adult children are attributed to an individual who owns more than 50%.  Sec. 269--An acquisition of a 50% interest for tax avoidance reason can result in the disallowance of any deduction, credit or other allowance.

 
 

Affiliated Corporations Case
For years, the Lee family has owned three businesses, X partnership, Y corporation, and Z corporation. X partnership owns several pieces of real estate including properties rented to their other businesses, apartments rented to tenants, and undeveloped real estate held for expansion and appreciation. The partnership assets are valuable. Several of the assets have a value that is significantly higher than their bases either because of appreciation or because of accumulated depreciation.  Y corporation, which made an S election in 1986, provides real estate services including appraisals, surveys, inspections, management, repairs, mortgage banking and other services. Several family members have licenses which enables Y corporation to offer these services. Given the nature of Y, it does not have many assets of any real value other than possibly goodwill. There, of course, are cash basis receivables.  Finally, Z corporation is involved in real estate construction. Z corporation has some equipment and contracts in progress. Each of eight members of the family owns an interest in each business, and the plan is to maintain overlapping ownership.  The percentages of ownership, however, are not identical. The children are in their middle to late twenties while the grandchildren are preschoolers. As more grandchildren are born, they will be given an interest in the family businesses. Current interests are as follows:
	X	Y	Z
Parents: Ed May Children: Jane Tom Bob Ted Grandchildren (Jane's children): Jean Sue	18% 18 16 16 10 10 6 6	18% 18 15 10 17 19 2 1	20% 20 16 16 17 9 1 1
The family is considering the possibility of creating additional corporations in order to protect the family from liability. A law suit resulting from the injury to a employee involved in the construction project was settled for an amount significantly more than available insurance, and caused the family to think what could happen if a similar event occurred in the future. Z corporation now has a large NOL carryover as a result of the accident.  Assume the family is considering the creation of two new C corporations and three new S corporations. Construction projects would be divided between the two new C corporations and the existing Z corporation. The real estate services would be divided up between two of the new S corporations and the existing Y corporation. X partnership assets would be transferred to the third new S corporation.  1. Do you see any current or future problems of incorporating X partnership? Transferring assets to corporation will likely lead to future gain.  Lose advantages of partnerships including special allocations.  Perhaps LLC would be useful. 2. Think for a moment about the possibility for the new corporations being subsidiaries of the existing corporations or being separately owned by the individuals.  a. Can they use Sec. 351 to form the new corporations? Is there a problem that you can see? (Remember there are a lot of assets being moved around and a lot of corporations. What may work for one may not work for another.) Sec. 351 can be used, but subsidiaries will not protect the family as parent's creditors have access to subsidiary stock. Some protections might be available from the subsidiary's creditors. One possible option might be to place each operating business in a separate subsidiary. b. Can they use Secs. 355 and 368 to form the new corporations? Any problems? Yes, assuming the businesses have 5 year histories. No specific problems with the transactions. c. Given this, exactly how do you recommend they form the corporations? Discuss which code sections you will rely on, which corporations will be subsidiaries, and whether the corporations will be subsidiaries. You need not explain who will have an interest in the corporations if they are not subsidiaries. Use Sec. 351 to transfer partnership to the new S corporation and Secs. 355 and 368 to divide existing S corporations if they are "old" enough. If they are not old enough can wait. d. What will happen to the NOL assuming the new C corporations are subsidiaries of the old Z corporation. For example, it stays with Z, it is allocated, or it disappears. Stays with Z if use Sec. 351. e. What will happen to the NOL assuming the new corporations are not subsidiaries of the old Z corporation? Stays with Z. f. If the IRS were to challenge a future use of the NOL, what do you think would be the most likely basis for the challenge given what you are doing now? Could have a change of ownership.  Might be question regarding continuity of business.  Tax avoidance does not seem to be an issue. 3. a. Assume the new C corporations are subsidiaries of the existing Z corporation. Should they file consolidated tax returns? Discuss. Perhaps given the sporadic nature of construction.     b. Are the SRLY rules a problem? Explain. Not if it is the parent's loss.  Reg. Sec. 1.1502-1(f) and 1.1502-21(c). 4. Assume the new C corporations are not subsidiaries of the existing Z corporation.  a. How can they structure the ownership of the C corporations in order to obtain separate allowances (e.g., tax brackets, Sec. 179 write offs, etc.) for each corporation. Give an specific explanation if you think you can do it.Have separate ownership or use nonvoting stock. b. Will the S corporations receive separate allowances from the C corporations? Explain. (Some allowances are irrelevant to S corporations but others are relevant as the items pass through to shareholders.) Subject to same limitations. c. Will each new corporation be able to elect its own accounting methods, tax years, etc. Yes, as a new corporation.  5.a. Is Sec. 269 of concern? Not an acquisition for tax avoidance purposes.     b. What about Sec. 267? Would deny losses from asset transfer and would limit inter-company deductions if there are timing differences.     c. Sec. 482? Could be used to review inter-company prices. 6. Considering the passive loss limitation, what problems or advantages do you see? It is reasonable to assume that some family members may have other investments that produce either passive income or losses. Some S corporation interests are probably passive. 7. Obviously forming all of these corporations creates a lot of problems including additional compliance costs. Is there another way to accomplish the family's objectives? Might separate "risky businesses" in to one corporation, and use insurance generally to procect investments.

The reward of energy, enterprise and thrift--is taxes.
--William Feather, Author and publisher
 
 

Chapter 14

Corporate Tax Attributes: Survival and Transfer

Sec.269--Disallows any deduction, credit or other allowance if acquire stock or property for tax avoidance motive.  Sec.382(c)--Prohibits a carryover from being used to offset income with a loss from a different business (Libson Shops v. Koehler, 51 AFTR 43, 57 USTC  ¶ 9691 (USSC, 1957).  Sec.382(g)--Limits use of NOL if there is a change in ownership (tax exempt rate times value of stock).  Sec.383--Limits foreign tax credit and capital loss.  Sec.384--Limits use of pre-acquisition NOLs and built in losses to offset built-in gains (appreciation and burnt-out tax shelters).  Sec.381--Enumerates 21 tax attributes and states that they are preserved in certain corporate acquisitions (NOL carryback isn't one of the attributes except in an F reorganization. Does not mention tax year, S election

 

Sec. 381 applies to:  Sec.332 liquidation of subsidiary, Sec.368(a)(1)(A) merger or consolidation, Sec.368(a)(1)(C) acquisition of property, Sec.368(a)(1)(D) but only if non divisive, Sec.368(a)(1)(F) mere name change, etc. and Sec.368(a)(1)(G) insolvency reorganization where transferor terminates.

Just because Sec.381 says the attributes ordinarily survives does not mean they are automatically available. Secs. 269, 382(c), etc. may cause the taxpayer to lose the attribute. Further, Sec.382(g) and the SRLY rule can limit the use of an NOL.

Also, the fact that Sec. 381 does not mention the transaction does not necessarily mean that the attributes expire. Or at least so says the committee report, but in Denver & Rio Grande Western Railroad, 38 TC 557 (1962) the court held the opposite. This may not necessarily mean that the court rejected the committee report, but rather the court felt that in the specific situation at hand the attribute should not survive.

Sec.338 liquidation of subsidiary--attributes probably terminate.

Sec.368(a)(1)(E) recapitalization--attributes probably survive.

Sec.368(a)(1)(D) divisive followed by a split off--parent's probably survive.  Sec.368(a)(1)(D) divisive followed by a split up--probably terminate.

Sec.304(b)(2) partial liquidation--probably terminate

Sec.368(a)(1)(G) transferor survives--not clear

Sec.368(a)(1)(B) stock for stock--not clear.

 
 

Corporate Attributes Case
The Hill family has owned Hill Nursery and Hill Landscaping, two C corporations, for years. Mrs. Hill has managed the nursery business while Mr. Hill has been in charge of landscaping. Both Mr. and Mrs. Hill have drawn large salaries and rent from the corporations so that they have paid little corporate income tax. Because of their age, they are looking to the future when they will retire. In fact, Mr. Hill has limited his involvement in the landscaping operations for over two years because of back problems. As they have lived off of the income from the business, they need an alternative source of income for retirement. In fact, the landscaping business has shown losses since Mr. Hill injured his back and the corporation has an NOL carryover as a result. After some review, you have decided that there is support for the salary deduction because Mr. Hill has an employment contract with the corporation that guarantees his salary. Their adult son and daughter do not plan to work in the business as they both have their own careers, but they have both expressed a desire to acquire the corporation's stock so they can receive future dividend income. Obviously, the company would have to begin paying dividends for this to happen.  On the other hand, National Nurseries has expressed an interest in acquiring the nursery operation because of its reputation and location. The land is actually owned by Mr. and Mrs. Hill who rent it to the corporation.  National, however, does not do landscaping. Tom Green, a long time employee of the landscaping operation, has indicated that he is interested in acquiring that business, but he has very limited resources. After some discussion the family is leaning toward selling the land to National for cash. Hill Nursery will merge into National and they will receive National stock in exchange. Finally, they plan to recapitalize the Hill Landscaping by issuing equal amounts of common and preferred stock for their existing common stock. Tom Green will have the option of purchasing the common stock over a six year period. As Green will be running the corporation they plan to increase his salary, and they hope that he will then be able to purchase the common stock using part of his salary. Over time, the Hills plan to give the preferred stock to their children. Mr. and Mrs. Hill will no longer draw their salaries. An preliminary examination suggests the following:
	Basis	Value
Land Nursery stock Landscaping stock	$ 25,000 100,000 20,000	$500,000   500,000   300,000
1. Which of the events described above are currently taxable? Land sale.  Could transfer land to corporation then receive more stock from National.  Also, an installment sale could delay gain recognition. 2. Which of these event will likely produce a future tax? Low basis of National stock suggests a future tax.  Planned sale of Landscaping stock will be taxable.  Gift of preferred stock could produce gift tax. 3. Assume the recapitalization of the landscaping business takes place as planned. Will the tax attributes of the corporation survive? Specifically, does the exchange of common for preferred and common impact the future use of the NOL? Yes. No, but sale could limit use of NOL.  The change of ownership test is based on value, not vote. The question is whether the Hills maintain 50% or greater ownership. 4. a. What impact will the gifting of stock have on tax attributes? Gifts are exempt.     b. Would it make a difference if they were given common instead of preferred stock? Sec. 382 may not apply to preferred stock.      c. Would it make a difference if the children purchased the stock instead of receiving it as a gift? Interfamily transfers are exempt. 5. a. Assume Mr. Green borrows funds from a local bank and purchases all of the common stock in the landscaping corporation after two years. What impact does this have on the Hills? On their children? Taxable transaction.  Limits use of losses if value is greater than 50%.  No impact on children at this time.    b. Assume a small portion of the NOL has been used up. Is the balance still available after the transfer? Depends on value.  If greater than 50% change than limit applies.    c. Assume that Mr. Green decides to discontinue the landscaping business and open a nursery. What implications does this have? Is this a change of business?  If so, lose NOL.

These days it is hard to believe that America was founded to avoid high taxation.
--Unknown