Corporate Taxation Outline

Table of Contents

FORMATION OF A CORPORATION 2
INTRODUCTION TO §351 2
CONTROL, PROPERTY AND STOCK 3
TREATMENT OF BOOT 4
ASSUMPTION OF LIABILITIES 6

CAPITAL STRUCTURE 7

NONLIQUIDATING DISTRIBUTIONS 8
DIVIDENDS 8
EARNINGS AND PROFITS 9
DISTRIBUTIONS OF CASH 9
DISTRIBUTIONS OF PROPERTY 10
CONSTRUCTIVE DISTRIBUTIONS 11

REDEMPTIONS 12
CONSTRUCTIVE OWNERSHIP OF STOCK 12
SUBSTANTIALLY DISPROPORTIONATE 13
COMPLETE TERMINATION 13
NOT ESSENTIALLY EQUIVALENT TO A DIVIDEND 14
TAX CONSEQUENCES TO THE CORPORATION 14

LIQUIDATIONS 15
COMPLETE LIQUIDATIONS 15
PARTIAL LIQUIDATIONS 16
LIQUIDATION OF SUBSIDIARY 16

TAXABLE ACQUISITIONS 17

ACQUISITIVE REORGANIZATIONS 19
A REORGANIZATION 19
B REORGANIZATION 20
C REORGANIZATION 20
FORWARD TRIANGULAR MERGER 20
REVERSE TRIANGULAR MERGER 21
TAX CONSEQUENCES 21

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Formation of a Corporation
 Corporate transaction, always analyze
o Tax consequence to SHs, and
o tax consequence to corporate entity
 Basis is a measure of your after-tax investment
 Corporations have $0 basis in their own stocks
o No after-tax investment in stock  basis = $0

SH transfers a car worth $1k with a basis of $200 to the Corp in exchange for 100 shares of stock. What is
SH’s tax consequence and what is corp’s tax consequence?
 Corp: realizes $1k gain, car w/ basis = $1k
o $1k gain = amount realized ($1k) – adjusted basis ($0)
 Corp has no after-tax investment in stocks  stock basis = $0
 SH: realizes $800 gain, stock w/ basis = $1k
o Not arm length’s transaction, cannot assume value received = value give up
o Use book value – SH equity = assets – liabilities
Assets Liabilities
Car - $1k 0
$1k – SH Equity
$1k $1k

Introduction to §351
Analyzing a Nonrecognition Transaction
1. Calculate the realized gain or loss w/o nonrecognition provision apply
2. Determine whether this transaction qualify as §351
3. If not meet §351(a) requirements, does it meet §351(b)
4. If meets §351 requirements, work through the nonrecognition provision
 Presume money’s basis = face value
5. Check
 Is TP in the same position at the end of transaction as he is at the beginning?

Shareholder
Sec. 351 Transfer to corporation controlled by transferor (tax deferral)
a) No gain or loss shall be recognized if property is transferred to a corporation by
 one or more persons
 solely in exchange for stock in such corporation AND
 immediately after the exchange such person(s) are in control of the corporation
o §368(c) “Control” – 80% of voting stock and 80% of each class of non-voting stock

Sec. 358 Shareholder basis

(a)(1) Basis of stock received in a §351 exchange = basis of property transferred by SH to the corporation

Corporation
Sec. 1032 Exchange of stock for property
(a) No gain or loss shall be recognized on the receipt of money or other property in exchange for its stock
(including treasure stock).

Sec. 362 Basis to corporations

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(a) Corporation’s basis in any property received in a §351 exchange is the same as the transferor’s basis
(e)(2) Limitations on built-in losses
A. If property with a net built-in loss is transferred to a corporation, the corporation’s aggregate
adjusted basis of such property is limited to the FMV of the transferred property
 If transferee’s aggregate adjusted basis of assets transferred > aggregate FMV  transferee’s
aggregate adjusted basis = FMV
B. Allocation of basis reduction. The aggregate reduction in basis is allocated among the properties
in proportion to their respective built-in losses immediately before the transaction.
C. SH and the corporation may jointly elect to reduce SH’s basis in the stock. Stock basis reduction =
amount of asset reduction required under §362(e)(2)

E.g. Asset 1: FMV=$5k, basis=$10k; Asset 2: FMV=$15k, basis=$25k.

 Aggregate loss = $35k - $20k =$15k
 Asset 1 = $5k (built-in loss) / $15k =1/3; Asset 2 = $10k / $15k = 2/3
 Total basis reduction = $15k  Asset 1 basis = $5k; Asset 2 = $15k

C transfers 2 parcels of unimproved land (Parcel 1 and Parcel 2), each with a value of $10k. C’s basis in
Parcel 1 is $15k and C’s basis in Parcel 2 is $8k for 20 shares of common stock. What result to C and X
Corporation.
 C’s combined basis = $23k, combined FMV = $20k  §362(e)(2) would limit X Corp’s basis in
the properties to aggregate FMV
 There is only one property with built-in loss  $3k basis reduction is allocated to that property 
Corp’s basis in Parcel 1 = $15k - $3k = $12k; Parcel 2 = $8k
o Corp still has a loss in Parcel 1, but that loss is offset by the inherent gain in Parcel 2
 OR, C and Corp can make an election to reduce C’s stock basis by $3k and give Corp full basis of
$15k in Parcel 1
o Might be useful if Corp were going to immediately sell the property and use the loss to offset
other income

Control, Property and Stock

1. Transfer of “Property”
 Reg. §1.351-1(a)(1)(i) – services are not property
o Pure service provides is not considered a transferor of property
o If transfer both property and services, all that SH’s stock is counted toward the 80% control
requirement
 If property transferred is “relatively small value” in comparison to the stock received for
services, §351 does not apply
 The property transferred must be at least 10% of the value of stock already owned / to be
received for services
 Not meet the 10% requirement, if property transferred is essential to the incorporation of
the business  qualify §351
2. “Solely” for Stock
 Has to be stock
o Ownership interest
 Voting rights
 Right to current earnings (dividends)
 Liquidation value
o Common stock – stock has all of these interests
o Preferred stock – has some preference with regard to economic value

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  Give the owner the first rights to dividends out of corporation
 Get first liquidation value
 NOT corporate bond (debt)
3. Control Immediately After
 “Control” requirement - §368(c)
o 80% of total combined voting power, AND
o 80% of each class non-voting stock
 Immediately after

Intermountain Lumber Co. v. Commissioner

S’s sawmill burns down. S and W agree to rebuild. S transfers property to Corp in exchange for 100% of
stock. S sells 50% of stock to W.
 “Immediately after the exchange” means at the end of business deal
o Test “control” at the last step of business deal
 Really cares about – when does business deal begin? When does business deal end?
 At the end of business deal, W owns 50% stock. Test control here
 Transferor of property is S  not qualify §351
o W did not transfer any property to Corp

Step Transaction Doctrine

 Test transaction after all the steps of the part of business transaction are done
 2 tests determine when does business deal end
o Binding Commitment Test
 The deal is all the party agree to
 Was there an enforceable contract to do step 2 / step 3?
 If yes, business deal ends after step 2 / step 3
o Interdependence Test
 Step 1 makes no economic sense w/o taking step 2 and step 3
 The last step has to occur otherwise the first step would be economic senseless
 In general, gift is considered to be independent transaction
 Double Drop Down
o P Corp transfers assets to S1 in exchange for S1’s stocks. S1 then transfers assets to S2 in
exchange for S2’s stocks.
 IRS Ruling considers this qualify §351

E.g. Manager will pay $20k cash for her 150 shares ($1k/share) and the incorporation document specify
that she is receiving those shares in exchange for her cash contribution rather than for future services.
 Qualify §351
o Manage will receive stock for services worth $130k and stock for property of $20k
o $20k is more than 10% of $130k, transaction qualifies §351

Treatment of Boot
Sec 351(b)
 Any gain realized by a transferor on an otherwise qualified §351(a) exchange must be recognized
only to the extent of the boot received.
o Gain recognized is the LESSER of gain realized or boot received
 SH can never recognize more gain than actually realized  boot does not create gain
 No loss may be recognized under §351(b)

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Rev. Rul. 68-55
 If transfer multiple assets, allocate boot to each asset in proportion to the relative FMV of the
transferred assets. Then recognize gain / loss to each asset

SH’s Basis
 SH’s basis in stock = basis of asset transferred – boot received + gain realized - §358(a)(1)
 Basis of boot property = FMV - §358(a)(2)
 If SH receives more than one class of stock, SH need to allocate his aggregate exchanged basis
among the various classes of stock received in proportion to their relative FMV – Reg. §1.358-
2(b)(2)

Corp’s Basis
 Corporation’s basis in asset = transferor’s basis + gain recognized - §362(a)

E.g. B transfers land and inventory to X Corp and receives 15 shares of X common stock ($15k value)
and $15k cash.
FMV Basis Realized gain / Boot Recognized
loss Received gain
Land 10k 13k (3k) $5k $0
Inventory 20k 7k 13k $10k $10k
Total $30k $20k $10k $10k
 Calculate ordinary tax consequences that would occur if the transaction was taxable
 Does this transaction qualify for §351 treatment? – Yes
 Calculate SH’s gain recognized
o Must allocate boot received between the 2 assets transferred – Rev. Rul. 68-55
 Inventory will get 2/3 of the boot and land will get 1/3
o B will recognize $10k gain on the inventory, but no loss on the land
 Determine SH’s basis in the shares received
o B’s stock basis = $20k - $15k + $10k = $15k
 Check – is this the right answer? Yes
o B starts this process with a $3k built-in loss and a $13k built-in gain
o On the transaction, he recognizes $10k of the built-in gain, but none of the built-in loss
o The $10k built-in gain he recognized in the transaction is in fact his overall gain  B should
have no further tax consequences in the stock received
o B’s stock is worth $15k and its basis is $15k
 Corp
o Never recognize gain or loss on the issuance of stock for property - §1032
o Inventory basis = $17k, land basis = $13k
 Aggregate adjusted basis of assets is $30k, and the aggregate FMV is $30k  §368(e)(2)
not apply
 If Corp sold both assets, it would have a $3k gain on the inventory and a $3k loss on the
land, exactly offsetting.

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Assumption of Liabilities
Sec. 357
(a) Assumption of a liability by a transferee corporation in a §351 exchange will neither constitute
boot nor prevent the exchange from qualifying under §351
Exception
(b) Tax Avoidance
 The assumption of a liability is treated as boot if TP’s “principal purpose” of transferring the
liability was the avoidance of federal income taxes or was not a bona fide business purpose
o If an improper purpose exists, ALL the relieved liabilities are treated as boot
(c) Liabilities in Excess of Basis
 (1) In general. If total liabilities assumed > total adjusted basis of assets transferred, the excess
shall be considered as gain
 (3) Certain liabilities excluded. If a TP transfers, in an exchange to which §351 applies, a
liability the payment of which EITHER would give rise to a deduction, OR would be described
in §736(a), then the amount of such liability shall be excluded in determining the amount of
liabilities assumed.

Sec. 358(d)
 When liability is assumed by a corporation, for purposes of determining the SH’s basis, the
assumption of liability will be treated as money received

 §357(c) and §358(d) provide that deductible obligations are NOT considered “liabilities” for these
limited purposes.
o E.g. accounts payable

Suppose SH borrowed $100k from bank, then transferred his land to the Corp subject to $100k loan
 Under §357(a), no boot, no gain recognized
 How do you know the tax avoidance purpose?
o Timing
 If put debt on property shortly before transferring it to corp.  probably tax avoidance
o What did SH do with the cash
 Spent on personal item as opposed to invest in the business

E.g. A organized X Corp. by transferring inventory and land. In return, A received 20 shares of X stock
(FMV $20k) and X took the land subject to the debt of $30k.
FMV Basis Realized gain /
loss
Inventory 10k 20k (10k)
Land 40k 5k 35k
Total $50k $25k $25k
What is A’s basis and X Corp’s basis?
 A:
o Total debt assumed > total basis of transferred assets,  A must recognize $5k in gain

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 o A’s stock basis = $25k - $30k + $5k = $0
 A started with total built-in gain of $25k. On the transaction, she was forced to recognize
$5k gain under §357(c), leaving $20k of her overall gain deferred.
 A’s stock is worth $20k. Since A has a $0 basis, if she sells it, she will have a gain of $20k.
 X Corp
o A recognized $5k gain overall, but is that gain allocated among the 2 assets?
 Allocate the boot gain in accordance with the relative built-in gains of the assets transferred
o Land was the only asset with a gain  all of the gain should be allocated to the land
 Inventory basis = $20k, land basis = $10k
o Although inventory has a built-in loss, aggregate basis of the assets transferred < aggregate
FMV  no §362(e) issue

Capital Structure
Debt and Equity
 Stock represents equity ownership
o If business is sold / liquidated, after paying debts, SHs are entitled to all residual value of the
business
 Debt: borrowing money and pay it back with interest
o E.g. corporate bond – creditor

Advantage of Issuing Debt

 Avoidance of the “double tax”
o Dividends are taxable to SH and corporation
o Interest paid on debt is taxed to creditor, but deductible by corporation
 Repayment of principal on a debt is a tax-free return of capital to creditor
 Provide a defense against subsequent imposition of the accumulated earnings tax

Debt vs. Equity

 To prevent tax avoidance through the use of excessive debt, IRS may recast a purported debt
obligation as equity
 Factors considered:
o Form of the Obligation
 Debt instrument should bear usual indicia of debt – unconditional promise to pay, specific
term, and reasonable interest rate, payable in all events
 Should avoid equity characteristics
o Debt/Equity Ratio
 High D/E ratio (thin capitalization) creates a risk that debt will be reclassified as equity,
because no rational creditor would lend money to a corporation with such nominal equity
o Intent
 Use objective criteria: lender’s reasonable expectation of repayment, evaluated in light of
the financial condition of the company, and the corporation’s ability to pay principal and
interest
o Proportionality
 Debt held by SHs in the same proportion as their stock holdings may be suspicious
 If debt is held in roughly the same proportion as stock, creditors have no economic
incentive to act like creditors by setting or enforcing the terms
o Subordination

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  Debt subordinate to everyone else’s debt. If it is, it is common stock

Debt Form Risk

Unconditional promise to pay. Real question is would a bank want money?
 Debt – promise to pay. (Balloon would the creditor have loaned money under
payment, scheduled payment, these terms?
etc)
 Equity – no promise to pay. Proportionality. Q. Do the shareholders have the
debt structured so it is in the same proportion as
Sum Certain. (you borrow a set amount) their interest in corporation. (25% stock and 25%
debt). Proportionality is bad.
Fixed interest rate. (including varying
rate based on an external factor/rate. It Subordination. (if subordinate to anyone else 
has nothing to do whether the business is equity). No creditor would agree to
successful) of return subordination at that level.

Reasonable term. (5, 10 years, Debt/equity ratio: How much debt $100k, $10k
Construction loan -5 yrs, mortgage 30 yrs) worth of stock --> 10:1) the higher the first
if the term is 100 years, that is not loan number, the worse it is. There is no defined good
that will be stock.) or bad ratio.

Convertibility. No equity features Hindsight: Did the corporation treat it as debt?

convertibility. Did they skip payments? If regular payment 
seems to be debt. (Professor Colombo thinks the
court should not look at this).

Nonliquidating Distributions
What is distribution?
 Economic transfer from a corporation to a SH because of that person’s status as SH
o Why did this transfer occur?
 Not salary; not payment for services rendered; not interest
 Not all distributions are dividends for federal tax purposes

Dividends
 If have a distribution, go to §301(c) to determine tax treatment

Sec. 301(c)
1) Distributions that are dividends (§316) must be included in gross income
2) Distributions that are not dividends are first treated as a recovery of SH’s basis in his stock
3) Any excess over basis is treated as gain from sale or exchange of the stock

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Sec. 316 Dividend defined
(a) Dividend means any distribution of property made by a corporation to its SHs out of
(1) accumulated earnings and profits, OR
(2) current earnings and profits
Every distribution is deemed to be made out of E&P to the extent they exist and is deemed to be made
from current E&P first.

Earnings and Profits

 How much of the corporation’s wealth, which if give to the SH, would make the SH richer?
 It is all about SH’s economic position
 2 ways to calculate E&P
1. All economic inflows – All economic outflows
2. Start with taxable income, then make certain adjustments
o Add back certain items excluded from taxable income
 Tax-exempt interest
o Add back certain items deductible in determining taxable income
 §243 dividends received deduction
o Subtract certain nondeductible items
 Federal income tax
 Capital loss in excess of capital gain
o Make certain timing adjustments
 Depreciation

Distributions of Cash
 Corporation can reduce its E&P by the amount of money distributed, but only to the extent they
exist
 A deficit in E&P may result from corporate operations / losing money
 A distribution NEVER cause a deficit in E&P

Accum. E&P Current E&P Single Distribution

+ +  If distribution < E&P, all of distribution is dividend
 If distribution > E&P, use current E&P first, then accum. E&P
- - None of the distribution is dividend
Closing E&P = accum. E&P + current E&P
- +  If distribution < current E&P, all of distribution is dividend;
closing E&P = rest current E&P + accum. E&P
 If distribution > current E&P, use current E&P against
distribution; closing E&P = accum. E&P
+ - Temporarily prorate the deficit to the date of distribution, subtract
from accum. E&P  E&P to the date of distribution (use this against
distribution)
Closing E&P = remaining current E&P + leftover E&P (to the date of
distribution)

E.g. Suppose current E&P = ($5k), accumulated E&P = $10k, and distribution of $7k on 7/1/2019
 Temporarily prorate current E&P: ($5k) x ½ = ($2500)
 E&P available 7/1: $10k - $2500 = $7500
 All of distribution is dividend

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  Closing E&P = remaining current E&P + leftover E&P = ($2500) + $500 = ($2000)

Multiple Distribution
Accum. E&P Current E&P Multiple Distribution
+ +  Apportion current E&P to each distribution in accordance with
their relative amounts
 Do not apportion accum. E&P. Apply it on a first come first serve
basis until it is used up
 Closing E&P = remaining accum. E&P
- - None of the distribution is dividend
Closing E&P = accum. E&P + current E&P
- +  Apportion current E&P to each distribution
 Closing E&P = accum. E&P + remaining current E&P
+ -  Temporarily prorate deficit to the 1st distribution. Subtract from
accum. E&P  E&P available at 1st distribution
 Calculate current E&P between 1st and 2nd distribution. Subtract
from remaining accum. E&P  E&P available at 2nd distribution
 Closing E&P = remaining current E&P + remaining accum. E&P

E.g. Suppose current E&P = (10k), accum. E&P $13,500, $5k distribution on 4/1 and $15k distribution on
10/1.
 Temporarily prorate deficit to 1st distribution: ($10k) x ¼ = ($2500)
 E&P available on 4/1: ($2500) + $13500 = $11k
o Entire 1st distribution is dividend
o Use $5k against 1st distribution: $11k - $5k = $6k
 Between 1st and 2nd distribution, Corp has wrapped up ($5k) current E&P
 E&P available on 10/1: ($5k) + $6k = $1k
o $1k of 2nd distribution is dividend
o Apply §301(c) tier rules to the rest
 Closing E&P = ($2500)

E.g. Suppose current E&P = $15k, accum. E&P = $25k, SH’s stock basis = $9k, and distribution of $40k
on 4/1 and $20k on 10/1.
 Apportion current E&P to each distribution.
o 4/1 current E&P = $15k x 2/3 = $10k
 $40k / ($40k + $20k) = 2/3
o 10/1 current E&P = $5k
 Apply accum. E&P in the order the distributions are made
o 4/1: First $10k of distribution is a dividend out of current E&P. Next $25k of distribution is a
dividend out of accum. E&P, which is now exhausted. Remaining $5k is a return of basis. SH’s
stock basis = $4k
o 10/1: $5k of distribution is a dividend out of current E&P. $4k is a return of remaining basis in
the stock and remaining $11k is capital gain.
 Closing E&P = $0

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Distributions of Property
Appreciated Property
 If a corporation distributes an appreciated property, current E&P goes up to the extent of gain
o Can assume that corporation sold the property and distributes cash to SH

Depreciated Property
 Corporation cannot recognize loss, current E&P cannot be adjusted for the loss

Sec. 311 Taxability of Corporation on Distribution

a) No gain or loss shall be recognized to a corporation on the distribution of property
 General Utilities v. Helvering: Distribution property by a corporation is not a taxable event
b) If a corporation distributes appreciated property (FMV > adjusted basis), gain shall be recognized
to the distributing corporation

Sec. 312 Effect on Earnings and Profits

(a)(3) Following a property distribution, the distributing corporation may reduce E&P by the adjusted
basis of the distributed property
 Overrides normal adjustment
(b)(2) Appreciated Property. Distributing corporation may reduce E&P by the FMV of the property
(c) Adjustments for Liabilities. Proper adjustment shall be made for the amount of liability assumed by
SH
 Closing E&P goes down by the NET amount of distribution

Sec. 301
(b) Amount Distributed
(1) Amount of distribution = money + FMV property
(2) Reduction of Liabilities. Amount of distribution shall be reduced by the amount of liability SH
assumed. But not below zero.
(d) Basis of property received in a distribution shall be the FMV of such property.
Suppose Corp. has accum. E&P = $0, current E&P = $40k, and land with $100k basis and $30k FMV.
Corp. distributes land to SH.
 §301(b): distribution = FMV of land = $30k
o Current E&P = $40k
o Entire distribution is dividend
 §312(a): In calculating closing E&P, corp is entitled to reduce E&P by the adjusted basis of
property but not to create a deficit
o Closing E&P = $0
 §301(d): SH’s basis in the land = $30k

Constructive Distributions
 A payment from corporation to SH that is labeled something else other than dividend
o If this is an arm’s length transaction, this would not happen
 2 scenarios
o Overpayment

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  Corporation pays too much for something that it receives from SH
 Excessive compensation to SHs or their relatives
 Excessive rent for corporate use of SH property
o Free / Below market use of corporate property by SH
 Corporation is not getting FMV for something that it is giving to SH
 Use corporate jet to take a vacation in Utah
o The use value of the property is a constructive distribution (what is the rental value?)

E.g. A is sole SH of both X corp. and Y corp. Y pays X $5m for a piece of land that worth $3m.
 $2m constructive distribution from Y to A, followed by a capital contribution from A to X (§351
transaction)
 Why did this happen?
o Because SH said to make this happen
o Excess value is the distribution to SH

Redemptions
 Corporation buys back its own shares from SH(s)
 Need to draw a line between redemption that resemble a sale and redemptions that resemble a
dividend
o Sale - transactions result in a meaningful reduction in the SH’s proportionate interest
o Dividend – transactions that enable SHs to withdraw cash / property while leaving their
proportionate interest intact

Sec. 302 Distributions in Redemption of Stock

(d) If a corporation redeems its stock AND if §302(a) does not apply, such redemption will be treated
as a §301 distribution.
 Default rule: every redemption will be presumed as a §301 distribution
a) If a corporation redeems its stock AND if §302(b) applies, such redemption will be treated as a
§1001 property sale transaction.
b) Redemptions Treated as Exchanges
1) Redemptions not equivalent to dividends
2) Substantially disproportionate redemption of stock
3) Complete termination of ownership
 Whether there has been a sufficient reduction in SH’s ownership interest in the corporation?
c) Must use §318(a) in determining the ownership of stock

Constructive Ownership of Stock

Sec. 318 Constructive Ownership of Stock
1) Family Attribution. An individual is considered as owning stock owned by his spouse, children,
grandchildren and parents.
2) Outbound Attribution. From entity to owner – proportional
 Partnership and Estate. Stock owned by a partnership / estate is considered as owned by the
partners / beneficiaries in proportion to their ownership interests.
 Trust. Stock owned by a trust is considered as owned by the beneficiaries in proportion to their
actuarial interests in the trust.
 Corporation. Stock owned by a corporation is considered owned proportionately by a SH only
if SH owns at least 50% in value of that corporation’s stock.
3) Inbound Attribution. From owner to entity

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  Partnership and Estate. All stock owned by partners / beneficiaries is considered as owned
by the partnership / estate.
 Trust. All stock owned by a trust beneficiary is attributed to the trust.
 Corporation. All stock owned by a SH is attributed to the corporation only if SH owns at least
50% in value of that corporation’s stock.
4) Option Attribution, A person holding an option to acquire stock is considered as owning that
stock.
5) Reattribution Rule. Stock constructively owned by a person by reason of attribution rule shall be
considered as actually owned by such person.
 No double family attribution
 No sidewise attribution – inbound attribution followed by outbound attribution
 Option attribution takes precedence over family attribution where both apply

Substantially Disproportionate
Sec. 302(b)(2)
1) 50% Ownership Test
 Immediately after the redemption, SH must own (actually and constructively) less than 50% of
the total combined voting power
2) I. 80% Test
 % of total voting stock owned by SH after redemption must less than 80% of the % of total
voting stock owned by SH pre-redemption
Voting shares owned after redemption
< 0.8 x
Total outstanding voting shares after redemption
Voting shares owned pre−redemption
Total outstand voting shares pre−redemption
3) II. 80% Test
 SH’s common stock % after redemption must be less than 80% of SH’s common stock % pre-
redemption
 After the redemption, the total number of outstanding shares goes down

Step Transaction Doctrine - Sec. 302(b)(2)(D)

 If two redemptions are part of a plan, then test SH A’s redemption after SH C’s redemption is
done.
o “Plan” does not require any kind of collusion or collective action by SHs
o Steps qualify as a “plan” if SH A does a redemption because A knows that C is going to do a
redemption – A’s redemption is motivated by the knowledge of C’s redemption, there is a
“plan”
 Need to ask what motivated A’s redemption?
o Was it the knowledge that C was doing a redemption? Was it something else (e.g. a need for
cash?)
o What did A know about C’s redemption when she was planning her own redemption, and did
that knowledge motivate her to do her own redemption transaction

Complete Termination
Sec. 302(b)(3)
 If SH completely sever his relationship with the corporation, redemption is treated as a sale

Waiver of Family Attribution

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  Context: Closely held family corporation, SH wants a complete termination but the remaining
shares are held by close relatives.
 Sec. 302(c)(2) – family attribution waiver available if 3 requirements are met:
o No post-redemption interest in the corp (other than as a creditor)
 Literally no connection with the corp
 Cannot be an officer, director, or employee
 Ok to have informal, unpaid advice
o Cannot retain or acquire any interest for 10 years (other than by inheritance)
o File closing agreement with IRS
 §302(c)(2) ONLY applies to family attribution

Not Essentially Equivalent to a Dividend

Davis per se rule
 If taking into account §318 attribution rule and there is no change in a SH’s ownership interest,
redemption does not qualify for sale treatment.

U.S. v. Davis
Davis and his family owns X corp. Davis, wife, and 2 children each owns 250 shares of X corp. In 1945,
Davis transfer $25k to X corp in exchange for 1000 preferred stock. In 1963, X corp has > $25k in E&P
and Davis had X corp redeemed all of his preferred stock.
 §318(a) attribution rules apply to all of §302(b)
 To qualify for preferred treatment under §302(b)(1), a redemption must result in a meaningful
reduction of the SH’s proportionate interest in the corporation.
o Did the redemption change SH’s ownership interest?
 If no change, not meet §302(b)(1) test
o If there is an ownership interest change, how much change?
 Taking into account family attribution, Davis owns 100% before and after redemption  not meet
§302(b)(1) test  redemption treated as dividend

Meaningful Reduction Standard

 Redemption effect on the redeemed SH’s voting power, distribution rights and liquidation rights
o If SH has a voting interest, the key factor is the reduction in the SH’s voting power
 SH’s voting interest went from 57% to 50% and the remaining voting stock owned by an
unrelated SH  meaningful reduction
 If SH went from a position controlling the corp to a position not controlling the corp 
meaningful reduction
o For true minority SH (literally have no way to engage in management decisions), any
redemption reduces ownership interest will meet §302(b)(1) test
 Focus upon the effect of the redemption upon SH’s control of corporate affairs
o A pro rata redemption never changes a SH’s interest in the corp  never meet Davis test
o If SH only owns nonvoting preferred stock, any redemption would meet Davis test
o For publicly-held company, even tiny changes in ownership will meet §302(b)(1) test, because
no single SH can exercise control over corporate affairs

Tax Consequences to the Corporation

Sec. 311(b)
 A corporation distributing property in redemption of stock always recognizes gain but may not
recognized loss.

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 o Any gain recognized on a distribution of appreciated property increase current E&P.

Effect on Earnings and Profits

 If redemption is treated as a distribution, §312(a)(3) and (b)(2) apply
 If redemption is treated as a sale, closing E&P is adjusted down by percentage of outstanding
stock redeemed, not to exceed price paid by corporation

Liquidations
Complete Liquidations
When does a corporation going to liquidation?
 Legal dissolution under state law is not required
 Liquidation – corporation has ceased doing business and is merely in the process of winding up its
affairs
o No time limit on liquidation (can take more than a year)
 Liquidation occurs when board of directors should adopt a liquidation resolution and the
resolution should state that the corporation is going out of business and winding up its affairs
o If no resolution, has to factually establish when the decision was made that the corporation is
going out of business
 Once a corporation is in liquidation, any distribution to SH will be considered as liquidating
distribution
o This is a sales transaction  E&P account is irrelevant

Consequences to SHs
 Sec. 331(a) – SH is treated as sold his stock back to the corporation in exchange for liquidating
distribution
 Sec. 334(a) – SH’s basis in property distributed by a corporation in a complete liquidation shall be
the FMV of the property
 If a liquidation extends beyond a single taxable year, SH is entitled to use his basis first. Once the
basis is exhausted, the remainder becomes gain from sale of stock.

E.g. A owns 100 shares of X Corp which he purchased several years ago for $10k. X has $12k of accum.
E&P. What is tax consequence to A if X distributes $10k in the current year and $10k in year 2 in
exchange for his stock?
 A has $10k basis. The first distribution A would get tax free – return of basis
 A would have a $10k gain from sale of stock in year 2

Consequences to Liquidating Corporation

 Sec. 336(a) - General rule: liquidation treated as a taxable sale of assets by corporation, with
recognition of gain / loss
 Sec. 336(d) Loss Limitation Rules
o Related party rule. No loss shall be recognized by a liquidating corporation on the distribution
of property to a related party if either
 the distribution is not pro rata among the SHs; OR
 Related party – SHs who own directly or through §267 attribution rules more than 50%
in value of the stock of the distributing corporation
 Pro rata distribution – each SH gets their percentage interest in each asset

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 o E.g. Suppose have 2 SHs. SH1 owns 60% and SH2 owns 40% of the corporation. If
Corp distributes land, SH1 has 60% and SH2 has 40% interest in the land.
 the distribution is of disqualified property
 Disqualified property – property acquired in a §351 transaction or as a contribution to
capital within the 5-year period ending on the date of distribution
o Anti-stuffing rule
 Asset was acquired by a corporation in a §351 transaction during a 2-year period prior to
adoption of plan of liquidation  presumption of evil plan (evading taxation) 
corporation is prohibited from recognizing built-in loss
 For purpose of calculating loss on either a sale of the asset to a 3d party OR a
liquidating distribution to any SH, corporation’s basis in the asset is limited to the FMV
at time of distribution  built-in loss is eliminated
 SH can factually establish asset is transferred to the corporation for a legitimate business
purpose (extremely difficult)

Partial Liquidations
Sec. 302(b)(4)
 If a transaction qualifies as a partial liquidation, that transaction will be treated as a sale
transaction
o Partial liquidation – a distribution is pursuant to a plan, occurs within the taxable year in which
the plan is adopted or the succeeding taxable year, and is “not essentially equivalent to a
dividend” (determined at the corporate level)
 Genuine contraction of the corporation’s business – whether corporation has discontinued
and liquidated a line of business
 Corporation operates multiple lines of business and decides to kill one line of the
business
 In a single line of business but contract that business by significant amount

Safe Harbor Test – Sec. 302(e)(2) (do not need to worry about this)
 Treated as partial liquidation if the distribution consists of assets of a qualified trade or business
OR is attributable to the termination of such a trade of business, AND immediately after the
distribution the corporation continues to conduct another qualified trade or business

Earnings and Profits

 A partial liquidation is treated as a redemption transaction which is a sale. In the case of a
redemption treated as a sale, the corporation’s E&P is adjusted downward by the percentage of
stock redeemed (not to exceed the price paid)
o E.g. Assume X corp operates Business A and Business B. Each business is worth $2M. X corp
ends Business B, and either distributes the asset in kind to SHs pro-rata or sells the assets and
distributes the proceeds.
o IRS would treat this as X corp has redeemed half of SHs’ stock in a transaction treated as sale
 X corp would reduce E&P by 50% (or the amount distributed, whichever is less) in
calculating its ending E&P for the year. If the transaction is a distribution of assets in kind, X
corp would have to recognize any gain on the assets under §311, which would in turn cause
E&P account to increase. Closing E&P = augmented E&P reduce by 50%

Liquidation of Subsidiary
Consequences to Parent

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  Sec. 332 - a parent corporation recognizes no gain or loss on the receipt of assets in liquidation if
o Control – Parent must own at least 80% of voting and value of the subsidiary
 From the date of adoption of the plan till the parent receives the distribution
 Sometimes a parent corporation intentionally violates 80% tests to avoid §332 and
recognize a loss
o Subsidiary must adopt of a plan of liquidation
 Corporate resolution is enough
o Timing
 Subsidiary distributes all of its assets within one taxable year of the plan adoption, OR
 If specified in the plan, can take up to 3 taxable years
 Sec. 334(b) – parent takes the distributed assets with a transferred basis
o If parent has basis in the stock, it is irrelevant – P’s stock basis in the subsidiary disappears
 Sec. 381 – P inherits S’s tax history – S’s E&P account, net operating loss

Consequences to Minority SHs

o Complete taxable transaction per §331

Consequences to Subsidiary
 Parent: Sec 337 – Subsidiary does not recognize gain or loss on distributions of property to its
parent in a §332 liquidation
 Minority SHs: Sec 336(d)(3) – No loss shall be recognized to a subsidiary on a distribution of
property to minority SHs in a §332 liquidation
o Minority SH takes the distributed assets with a basis of FMV
o Subsidiary will recognize gain but not loss

Earnings and Profits

 When the subsidiary liquidates, its taxable year ends. At that point, any Sub’s current E&P is
added to its accumulated E&P. The accumulated E&P is then inherited by the parent (added to
parent’s accumulated E&P). This does not affect the parent’s current E&P for its own taxable
year.

E.g. P owns 90% of S’s stock and M owns 10% of S’s stock. P’s basis in S stock is $30k. S has the
following assets:
Asset Adjusted Basis FMV
Land $30k $8k
Equipment $2500 $1k
Inventory $100 $1k
S wishes to liquidate and distribute equipment to M and the other assets to P. How might S improve this
result?
 If P has a $30k basis in stock, a taxable liquidation would permit P to recognize a loss of $21k
($30k basis - $9k value received) on that stock. But in a §332 liquidation, P’s stock basis becomes
irrelevant. While P would inherit the land with a $30k basis, preserving the inherent loss in the
land, P’s loss on its stock is gone.
 To improve the result: S can have P sell 11% of its stock to an outsider prior to liquidation 
violate §332 ownership requirement  taxable liquidation to P and M. Or, P could intentionally
violate the timing rules of §332 (e.g. take more than 3 years to accomplish the liquidation). Then if
loss property is distributed pro-rate, S gets to recognize its loss (neither §336(d)(1) or (d)(2) would
be applicable) and P will get to recognize its loss on S stock.

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Taxable Acquisitions
 Tax values
o Tax system does not take into account the future value / present value of the payment
o A deduction is worth the TP’s tax rate (tax rate x deduction). $1 deduction worth 21 cents to
corp if it has enough income to absorb deduction
 E.g. $100 taxable income  $21 tax. But if the corp also has a $100 deduction, taxable
income goes to zero and wipes out $21 tax bill.
o Deductions and tax payments should also be valued according to time-value principles
 E.g. a $1 deduction this year worth 21 cents. But a $1 deduction 30 years from now worth
only 4 cents.
o If you pay $1 in tax today, you are out $1. But if you can delay your tax payment for 30 years,
$1 is only worth 17 cents.
o Moral: delay paying tax as long as possible. Accelerate deductions to current year if possible.

Assume T (Target) is wholly owned by A, who has 0 stock basis. T has the following assets:
Asset FMV Basis
Land $2M $1M
Equipment $3M $0
Goodwill $1M $0
P offers to buy T’s assets for $6M. Tax consequences: T has $5M gain, pays tax of $1M (20%)
and distributes remaining $5M to A in liquidation, who pays tax of $1M leaving A with $4M in
pocket. Would P pay $6M for T stock? – No
 When P buys assets, it gets a cost basis in the asset, and depending on the assets, gets
valuable tax benefits. For example, P will get $3M basis in the equipment, which under
current law could be deducted in one year. That’s an immediate tax benefit of $600k.
Similarly, P can amortize $1M of basis in goodwill over 15 years; PV of $140k (deduction
of $67k per year, worth 20% per year, discounted to PV over 15 years at 6%). Note that
land will get a basis of $2M, but land is not depreciable, basis would be recovered only on
sale, which may be never. So, assume no tax benefit from basis in land.
 So, on an asset purchase, P’s real cost after taking into account tax benefits is more like
$5,260,000 ($6M purchase price, less $740k of tax benefits). P would not pay more than
$5,260,000 for T stock.
 Note, however, that $5.26M is $260k better for A than an asset sale. A would owe 20%
tax on the extra $260k, but that still leaves A with $208k more in-pocket than asset sale.
 Why did this happen? The $260k represents the tax that T would have to pay on an asset
deal that P cannot immediately recover via deductions / depreciations. T will pay a tax of
$200k on the sale of the land, but P will not get any benefit from the basis increase in the
land. Similarly, T must immediately pay $200k in tax on the $1M gain from the sale of its
goodwill, but P will recover only $140k of that via the amortization deductions over 15
years (present value). So, T pays an extra $260k in tax now, but P does not get any benefit
from the cost basis. By doing a stock deal, T postpones paying that tax. In other words, the
$260k extra comes from not pre-paying taxes to the federal government.
If T has $5M net operating loss (can offset the tax gain), prefer asset deal. Have extra $740k
floating around.

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Acquisitive Reorganizations
 One corporation acquires the assets or stock of another corporation

A Reorganization

 Statutory merger or consolidation

 Accomplished under state law. Parties sign acquisition agreement and file articles of merger,
which specifies effective date. On the effective date, by operation of state law, all of T’s assets and
liabilities are transferred to P, and T as a corporate entity disappears (T’s stock disappears). P pays
T’s SHs for acquisition.
 This is an asset transaction.
 Judicial requirements
o Continuity of proprietary interest
 Rev. Rul. 66-224: 40% of the total consideration (SHs received) has to be stock of P
 Can be any kinds of stock
 This is an aggregate calculation (analyze SHs as a group)
 Step transaction issues
 Do NOT care about historical owners
 T’s SHs immediately selling P stock they get in a merger, even if that sale was
contemplated before completion of the merger – OK
o Exception: if T’s SHs sold their P stock for cash to P or a related party, not part of the
continuity percentage
o Continuity of business
 P must continue the historical business of T, OR use a substantial portion of T’s assets in
P’s business post-acquisition (for some undefining period of time)
o Business purpose
 All of acquisitive reorganizations have a business purpose – to acquire T

Step Transaction Issues

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Assume A sells her T stock to B immediately before the merger. P completes transaction with B. OK? –
Yes
 Do not care who the historical owners are. Only care about whoever owns the stock on the
effective date of the merger, did they get 40% of consideration of P’s stock.

If A receives 100% consideration of P’s stock and A sells 70% P stock she got in merger to B
immediately after. OK? - Yes (even if that sale was contemplated before completion of the merger)
 As long as T’s SHs sale P stock to 3d parties.
 If T’s SHs get money from P as part of an overall plan of acquisition, that is not part of the
continuity percentage.
B Reorganization

 Tax deferred stock acquisition

 Requirements
o Can ONLY using P’s voting stock to pay for T stock
o Control (80%) test immediately after
 80% total voting power and 80% of each other class of stock
 P does not need to acquire 80% of T’s outstanding stock in the reorganization
 Creeping acquisition: OK for P to buy T stock for cash in earlier transactions, as long as such
purchases were not part of an overall plan to gain control of T
o E.g. P goes out and buys 30% T stock on open market for cash. Later, P uses its voting stock to
buy the remaining 70% T stock  qualify as B reorg, as long as the cash transaction is not part
of the acquisition plan

C Reorganization

 Asset acquisition. Structure looks like a merger transaction.

 Requirements
o T transfer “substantially all” of its assets solely in exchange for P’s voting stock
 Substantially all
 90% of FMV of the net assets and 70% of FMV of gross assets
 Solely
 If no boot other than liabilities, assumption of liabilities by P is not treated as
disqualifying boot
 Boot relaxation rule: permits P to use up to 20% boot. But if boot used, transferred
liabilities are considered as boot

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Forward Triangular Merger

 P sets up a separate subsidiary, T merges into S, and P pays for the merger
o Isolate T’s liabilities in a separate subsidiary of P. P never owns T’s assets directly.
 Requirements - §368(a)(2)(D)
o S acquires substantially all of T’s assets
 90% of net assets and 70% of gross assets
o No stock of S is used in the transaction
o The transaction would have qualified as a A Reorg if T had merged directly into P
 Continuity of interest
 40% of consideration has to P stock
 Continuity of business
 Business purpose

Reverse Triangular Merger

 Stock transaction
 P sets up a subsidiary and S merges into T. P pays A for T stock and T becomes a subsidiary of P.
o Why do this transaction?
 T has an asset that is non-transferable under law / licensing agreement  want T to stay
intact
 Requirements - §368(a)(2)(E)
o Post-acquisition, T must hold substantially all the properties of S and T
o SHs of T must exchange 80% control for P voting stock (in a single transaction)
 80% T stock must be acquired for P voting stock  only 20% boot permitted

Tax Consequences
 SHs (A)
o Sec. 354(a) – No gain or loss shall be recognized if SHs exchange T’s stock / securities for P’s
stock or securities
 Securities: corporate bond / long-term debt
 T’s stock for P’s stock OR T’s securities for P’s securities  OK
 If SHs exchange T’s stock and bond for P’s stock and bond  §354(a)(2) limitation
 E.g. SHs have $1M T’s stock and $1M T’s corporate bond in exchange for $800k P’s
stock and $1.2M P’s bond.
 Excess amount P’s bond SHs receive over T’s bond SHs give up is treated as boot.

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 o Sec. 356 – If SHs receive boot (cash / excess bonds), must recognized gain in the lesser amount
of gain realized or boot received.
 Characterization of gain – Clark Analysis
 How much stock of P T’s SHs would have gotten if it has been all stock transaction?
(pretend T’s SHs only receive P’s stock)
 Pretend P redeemed some of that stock in exchange for the actual boot
 Apply §302. If meets one of §302(b) tests, the gain is a capital gain. If not, the gain is a
dividend to the extent of the SH’s ratable share of the E&P of T immediately prior to
the acquisition.
o E.g. T has $50k of E&P. A owned 10% of T. A’s ratable share of E&P is $5k.
o Sec. 358 – Basis in P’s stock = transferred basis – boot received + gain recognized
 Target (T)
o Sec. 361(a) – No gain or loss shall be recognized if T exchanges property solely for P’s stock /
securities
o Sec. 357 – assumption of liabilities of T by P is not considered boot in a reorganization
o Sec. 361(d) – If T receives boot, no gain or loss shall be recognized as long as T distributes the
boot to T SHs as part of the reorganization.
 Acquiring Corporation (P)
o Sec. 1032 – P does not recognize gain or loss on the issuance of its stock / securities for T’s
assets / stock
o Sec. 362(b) – Basis in assets = transferred basis

E.g. Clark Analysis

Assume P has 10 shares of common stock and is worth $10M. P acquires T in an A reorg for $5M: $4M
of newly-issued P stock (4 shares) and $1M in cash.
 Assume SH gets all stock – it would be 5 shares, since each share is worth $1M
 Assume P redeems enough stock to represent the value of the boot – SH got $1M in boot, so P
would have redeemed 1 share
 Apply §302. Before redemption, SH would have owned 5/15 P shares (33.3%). After redemption,
SH owns 4/14 shares (28.6%).
o Not a complete termination
o Not substantially disproportionate. <50% test is met, but 80% is not. 80% of 33.3% is 26.6%
and A’s ownership is more than that.
o Probably meets not essentially equivalent test. A is a minority SH of P, and with 4 shares
probably has not meaningful way to participate in control of P. (We’d probably want to know
more about who owns other shares of P – but say the other 10 shares are owned by a single SH,
B. If the shares were owned equally by 2 SHs, B & C, then there is a possibility A could
participate in a “control group” with either B or C, and thus might not meet the Davis test).
 If P is a publicly-held company with widely dispersed shares, the boot paid to A will nearly
always meet the Davis test, because A will be a true minority SH with no management rights.
Under Davis, any change in such a SH’s stock percentage meets the “not essentially equivalent”
test.

Nonrecognition Analysis (see problem on page 450)

1. Determine regular tax consequences to the parties
2. Determine whether the transaction qualifies for nonrecognition.
3. Determine if there is any boot gain
(a) If there is boot, gain is recognized to the extent of the LESSER of the gain realized or the amount
of the boot

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 (i) Apply Clark analysis – characterize that gain as a dividend or gain from sale of stock
(b) If no boot, no boot gain to consider
4. Determine SH’s basis in the stuff received from P
5. Final check

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