Review Question #1. Husband and Wife decide to form a corporation with their friend, Friend, who they have known for many years. They propose to contribute land, owned by Husband alone, worth $100,000, Wife's services to be rendered to the corporation, and all of the assets of Wife's consulting business (which is currently being operated as a sole proprietorship; such assets consist of equipment worth $3,500 with an adjusted basis to Wife of $2,000 [previous depreciation deductions were taken on the equipment of $2,000], accounts receivable worth $8,000 and accounts payable amounting to $1,500). Friend will contribute land worth $100,000 (with an adjusted basis to Friend of $30,000 and subject to a mortgage of $50,000). Wife estimates that her services are worth $40,000 per year; she expects to work full-time for the new company. All three proposed shareholders come to see you.

The overall answer is that it really does not matter. Whether or not she does this, she will qualify as a "transferor" for §351 purposes, thus qualifying the transfers by Husband and Friend under §351 also. Typically, a transfer of future services to a newly formed corporation in exchange for stock does not qualify under §351, because services are not "property" within the meaning of §351(a), §351(d)(1), Regs. §1.351-1(a)(1)(i). However, when a new shareholder transfers in property and services, her transfer may qualify under §351 if the amount of property transferred in is not "of relatively small value in comparison to the value of" her future services (Regs. 1.351-1(a)(1)(ii)). Revenue Procedure 77-37 interpreted this regulation, however, to provide a safe harbor: a transferor will qualify under §351 and their transfer will qualify under §351 if the value of the stock to be received in exchange for property is at least 10% or more of the value of the stock received for services. See p. 53 of text. There is also probably a business purpose for her transfer in of this property.

Here, the value of Wife's stock to be received for "property" is $10,000, and the value of her stock to be received for services is $40,000. Since $10,000 > 10% of $40,000, this ruling will apply and Wife will qualify as a §351 transferor. Thus, Wife's, Husband's, and Friend's transfers may all qualify as §351 transfers.

However, Wife will recognize $40,000 of ordinary §61 compensation income on the incorporation of Newco, Regs. §1.351-1(a)(2) Ex. (3). (It is unclear whether she will recognize it at the end of the tax year, after she has rendered the services, or upon incorporation, but the timing may not matter, as a practical matter.) It will have the same result as if Wife had bought her stock for $40,000 cash and $10,000 property and been paid a salary of $40,000. Query whether Newco is entitled to a §162 deduction for compensation paid to Wife, upon the incorporation (or perhaps at the end of the tax year, after Wife has rendered her services to Newco).

§351 analysis: Does §351 apply to the transfers by H, W, and F? Yes.

1. property is transferred: All of the items being transferred into Newco are "property" with the exception of Wife's services. However, Wife's services will allow her to be included as a transferor under the safe harbor of Revenue Procedure 77-37 but are still not "property" (see above answer). Accounts receivable are property (see Hempt Bros. case and Rev. Rul. 80-198, p. 88 of text – assignment of income doctrine does not override §351 w.r.t. A/R);

2. to a corporation: Newco is a corporation;

3. by one or more persons: Here, H, W, and F are all in the transferor group, so they qualify as one or more persons (person is defined by §7701(a)(1) as including individuals);

4. solely in exchange for stock in Newco: Here, the transferors are receiving only stock and "boot" under §351(b), which qualifies;

5. and there is control immediately after the exchange: Here, H, W, and F will own 100% of the stock of Newco immediately after the exchange; control is defined in §351(a) by reference to §368(c), which defines it as at least 80% of the voting power of the voting stock and 80% of the total number of shares of all other classes of stock of Newco, so this is met.

So, §351 applies to all three shareholders' transfers to grant them nonrecognition of realized gain or loss.

H transfers in appreciated land in exchange for stock and a note. H has §351(a) nonrecognition of gain or loss on the transfer.

Realized Gain = Amount Realized $100,000 (value of 70 shares of stock = $70,000 plus value of note = $30,000) - H's adjusted basis in land $80,000 = $20,000 gain.

However, the note is "boot," up to its fair market value ("FMV") of $30,000, §351(b), so H will recognize all $20,000 of his gain. Character of gain is probably LTCG (determined by reference to the character of the land in H's hands). Installment sale stuff you could omit: the timing of H's gain, however, is deferred by the installment method, under Prop. Regs. §1.453-1(f)(3)(ii) and -1(f)(1)(iii). [Prop. Regs. §1.453-1(f)(1)(iii) would give H an adjusted basis in his Newco 70 shares equal to the FMV of the stock = $70,000, and allocate the excess basis from the land of $10,000 to the note. Then, the profit ratio for installment method purposes would be:

H's basis in his stock may also be calculated under §358(a)(1) as: his basis in the land of $80,000, plus gain recognized to him on the transfer of $20,000, minus the FMV of boot received of $30,000 = $70,000, under §358(a)(1).

H's holding period for the land tacks to his stock under §1223(1) because the land is a capital or §1231 asset.

Has no gain or loss on the transfer under §1032(a); takes an adjusted basis in the land of $80,000 plus whatever gain H recognizes on the note, over time, as H recognizes it.

(this is the springing or "rollercoaster basis" under Prop. Regs. §1.453-1(f)(3)(ii)). See p. 63 of text and Problem (a) on p. 64.

Newco tacks H's holding period for the land, under §1223(2), regardless of the character of the land.

W transfers in future services, equipment, and accounts receivable, and a debt (accounts payable), in exchange for stock.

W recognizes $40,000 of ordinary, §61 compensation income on the transfer, under Regs. §1.351-1(a)(2) Ex. (3). §351 applies to her transfer, see answer above.

The accounts payable transferred in by W, even though they are a liability, do not create "boot" to her under §357(a), assuming that §357(b) "nasty purpose" does not apply. §357(c) does not apply because liabilities do not exceed basis of assets transferred in by W. Also, accounts payable, because the payment of them would generate a deduction, are not considered to be liabilities for §357(c) purposes, thus under §357(c)(3) are "excluded liabilities", thus §357(c) is again not applicable.

W should be able to transfer in the accounts receivable and the accounts payable without triggering assignment of income or another judicial doctrine overriding the nonrecognition rule of §351, because she has a valid business purpose for transferring them in, see Rev. Rul. 80-198. Also note that the §1245 depreciation recapture provision does not override the nonrecognition principle of §351.

So, W should get full nonrecognition on this transfer (except for the compensation income).

W's adjusted basis in her Newco 50 shares will be a substituted basis equal to her basis in the equipment of $2,000 plus her basis in her services of –0- and the accounts receivable of $ -0-.

It is unclear if she will be allowed to increase her basis in the Newco stock by the $40,000 of compensation income she will be required to recognize on this incorporation. You do not decrease her basis in her stock for the accounts payable (a liability), because they are ignored for basis purposes, under §358(d)(2) and §357(c)(3), as "excluded liabilities."

Her holding period for the stock does tack with respect to the equipment only, under §1223(1). W must have a split holding period for each share, determined on the basis of the FMV of the assets transferred in by W. Presumably, 3,500/50,000 of each share will have a tacked holding period from the equipment; the remainder of each share's holding period will start on the date of incorporation, under Rev. Rul. 85-164 (note that I am netting the accounts payable against the accounts receivable for this FMV calculation for holding period purposes).

Newco: Has §1032(a) nonrecognition; its adjusted basis in the equipment will be a transferred basis from W of $2,000 under §362(a), and W's holding period tacks to Newco with respect to the equipment, under §1223(2). Its adjusted basis in the accounts receivable will be a transferred basis from W of -0- under §362(a) (HP would tack, but it is irrelevant/academic). Newco will be taxed on receipt of the accounts receivable (Hempt Bros. and Rev. Rul. 80-198) and will be entitled to a deduction on the payment of the accounts payable (Rev. Rul. 80-198). Newco may get a §162 deduction of $40,000 for the stock it issued for W's services.

F transfers in appreciated land subject to a mortgage in exchange for stock. Here, the mortgage amount ($50,000) exceeds F's basis in the land ($30,000), so liabilities do exceed basis and §357(c) applies to create "boot." F has §351 nonrecognition, except F must recognize a §357(c) gain of $20,000 ($50,000 liabilities - $30,000 basis) on this transfer.

F's realized gain is:

Amount Realized = $100,000 (FMV of stock recv'd + debt relief)

Adjusted Basis in land = $ 30,000

Realized Gain = $70,000; of this, $20,000 is recognized and $50,000 is not, §357(c).

Character of gain is determined by reference to the character of the land in F's hands, so probably LTCG - flush language of §357(c)(1).

F's adjusted basis in his Newco 50 shares = his adjusted basis in the land of $30,000, plus gain recognized to F on the transfer of 20,000, minus liabilities relieved of, of $50,000 (§§358(d) and (a)(1)(A)(ii)), for a total of: $ -0-.

[NOTE: There is always a zero stock basis when there is a §357(c) gain.]

F's holding period for the land tacks to his Newco stock, under §1223(1).

(Review problems p. 80 of text.)

Newco: Has §1032(a) nonrecognition on the transfer. Takes an adjusted basis in the land equal to F's adjusted basis in it (a transferred basis) of $30,000, under §362(a), increased by gain recognized by F on the transfer of $20,000, for a total of $50,000. Newco's holding period for the land includes F's holding period for the land, under §1223(2).

Review Question #2. What if, in Review Question #1, Newco pays all of the organizational expenses of forming Newco (i.e., legal fees of preparing the corporate organizational documents and the shareholders' buy-sell agreement, legal fees of transferring the land and mortgage to Newco, filing fees, recording fees, printing costs, and accountants' fees)? What are the tax consequences to it of these payments?

Sketchy Answer: Then, if Newco properly elects under §248, it will be able to amortize the expenses over 60 months. Note that the legal fees associated with the organization of Newco are amortizable, under Regs. §1.248-1(b)(2). However, the fees associated with the transfer of the assets to Newco will not be amortizable, under Regs. §1.248-1(b)(3)(ii). Instead, they must be capitalized and added to Newco's basis in the land parcels.

Review Question #3. (a) Suppose you structure Newco in Review Question #1 so that Husband and Wife receive common stock and Friend receives debentures convertible into common stock, on which Newco will pay regular, annual interest, at a market rate. What are the advantages and disadvantages, tax-wise, of this capital structure?

Sketchy Answer: The issue here is whether Friend's debentures will be classified as "debt" or as "equity." Because of the convertible nature of the securities, there is a risk that they will be recharacterized as equity. Note that the withdrawn, never-finalized proposed regulations under §385 would have automatically reclassified this convertible debt as equity. As a result, Newco would lose its interest deduction for any interest payments made to Friend with respect to the debentures and interest payments to Friend would be recharacterized as dividends to Friend.

Sketchy Answer: Section 305 won't apply to the stock dividend to give it tax-free treatment because holders of the convertible debentures (which are securities) are deemed to be "shareholders" under §305(d)(2). Then, the stock dividend to Husband and Wife and the regular payment of annual interest on the debentures, together, create a situation where some shareholders are getting "property" (the interest to Friend) and some shareholders are getting common stock (Husband and Wife), which is one of the exceptions to tax-free §305(a) treatment, under §305(b)(2). So, the stock dividend will be totally taxable as a §301 distribution to H and W, under 305(b)(2), which is characterized as ordinary income to the extent of earnings and profits, under §301(c)(1) … [continue]

Sketchy Answer: This is a §301 distribution-in-kind of $50K each in value to H and W. You would have to go through all of the rules for a regular, §301 dividend, but note that the corporation is distributing a loss asset (not an appreciated asset).

Newco will have no recognized loss under §311(a). Deal with any effects on Newco's e+p (should be none, since no loss or gain is recognized, but e+p is usually reduced by the FMV of the distribution,§ 312(a)(3), but can't be reduced below zero by reason of a distribution, §312(a) flush language, so e+p would remain at zero).

The shareholders will have no §301©(1) ordinary dividend income, since Newco has no current or accumulated e+p, but the distribution will reduce their stock bases by $50K each under §301(c)(2). Wife will have her stock basis reduced to -0- and then have LTCG of either $48,000 or $8,000 under §301(c)(3). H and W would have an adjusted basis in the land of its FMV of $100K under §301(d). This answer needs proper citations to authority, as well.

Review Question #4. A, a trust of which A's daughter is the sole beneficiary, and B, an unrelated third party, own all of the stock of X Corporation, and A and her friend, D, own all of the stock of Y Corporation, as follows:

First, because there are two corporations owned by some of the same shareholders, one should consider whether §304 applies.

1. Is one or more persons in "control" of both X and Y under §304(a)(1)(A)? Yes, A is in "control," as defined in §304(c) as owning at least 50% of the stock of both corporations, of both X and Y, by virtue of the attribution rules. For purposes of §304, the §318 attribution rules apply, §304(c)(3)(A), so that A is deemed to own all of the shares of X corporation owned by the Trust. A's daughter, as sole beneficiary, is deemed to own all of the X stock owned by Trust, under §318(a)(2)(B) (entity attribution), and A is deemed to own all of the X stock constructively owned by her daughter, under §§318(a)(1)(A)(ii) and (a)(5)(A) (family attribution).

Thus, A owns 52% of Y and 55% of X; and

2. In return for "property" (cash is property under §317(a)), Y acquires stock in X from A, thus fulfilling §304(a)(1)(B).

So, §304(a)(1) applies to this transaction. §304(a)(2) does not apply, because brother-sister corporations such as X and Y are not constructively made into parent-subsidiary corporations by application of the attribution rules, under Regs. §1.304-2(c) Ex (1).

§304(a)(1) treats the cash received by A from Y as a distribution in redemption of A's Y stock, but the §302 tests are made with respect to A's stock in X, under §304(b)(1).

1. §302(b)(4) does not apply, no partial liquidation of X.

2. §302(b)(3) does not apply, because A continues to own stock of X directly and indirectly after the sale. No complete termination of A's interest in X. A waiver of family attribution rules would be ineffective here because A continues to own stock in X directly

3. §302(b)(2) does not apply, because A owns more than 50% directly and indirectly of X immediately after the sale, thus failing §302(b)(2)(B) (see also §302(c)(1) and §318).

4. §302(b)(1) is A's only hope: A owns 55% of X before the sale (20% directly and 35% through her daughter, from the Trust (see above analysis of §318); and A owns 52.6% of X after the sale, as follows:

Total = 52.6 shares out of 100 shares of X stock = 52.6%.

Typically, a drop of 55% to 52.6% is not "not essentially equivalent to a dividend" under §302(b)(1) and is not a "meaningful reduction in the shareholder's proportionate interest in the corporation," under the Davis case. See also Rev. Rul. 75-502. You should mention and briefly discuss the three factors of the Davis case: right to vote and exercise control; right to participate in current earnings and accumulated surplus; and right to share in net assets on liquidation.

So, §302 will likely not apply, so under §302(d), §301 will likely apply to this deemed redemption.

a) A is deemed to have made a contribution to the capital of Y of the 5 shares of X stock, with an adjusted basis to A of $5,000 and worth $20,000. Thus, A's basis in her Y stock will be increased by the adjusted basis of the contributed property, which is $5,000, under Regs. §1.118-1 and §1.304-2(c) Ex (1), from $5,200 to $10,200.

b) The $20,000 cash transferred from Y to A is treated as if it had been distributed first by Y and then by X, with respect to their earnings and profits:

Y's e+p = 11,000

X's e+p = -0-

Total = 11,000

So, $11,000 of the $20,000 deemed distribution will be ordinary, dividend income to A, under §301(c)(1).

$9,000 is left, and this $9,000 reduces A's stock basis in her Y stock (Regs. §1.304-2(a)), which is now $10,200, to $1,200, under §301(c)(2). I will accept answers which state that her adjusted basis in her Y stock is $5,200 or $10,200, but the better answer is that it is $10,200 for purposes of this distribution. If you say her AB in her Y stock was $5,200, then her stock basis is reduced to -0- under §301(c)(2) and she has $3,800 of LTCG under §301(c)(3).

c) Y's e+p is then reduced by virtue of this deemed distribution to -0-, by §312(a)(1).

d) Y's adjusted basis in the 5 shares of X stock it receives from A is a transferred basis from A of $5,000, under §362(a)(2) and Regs. §1.304-2(c) Ex. (1).

NOTE: No real tax consequences to X, in this problem (there might've been, if X had had any e+p).

Review Question #5. Oldco is a family-owned business. No one in the family has ever gotten along with Daughter. She is a passive shareholder, is not a director, officer, or employee of Oldco, does not attend any of the shareholders' meetings and does not participate in the management of its business. She is a little irrational, according to the other family members, a great deal of hostility exists between her and the other family members, and she has recently indicated an intent to be disruptive. The other shareholders would like to get her "out" of the company. All of the issued and outstanding stock of Oldco is held as follows:

This is a redemption in kind of one shareholder. First, you must determine whether the redemption qualifies under §302 or, if not, whether it then is treated as a §301 distribution.

§302(c)(1) states that the §318 attribution rules shall apply for purposes of §302. These §318 attribution rules result in Daughter owning 75 shares of Oldco, directly and indirectly, immediately before the redemption and owning 65 shares indirectly after the redemption, as follows:

Before:

35 shares to Daughter from Dad - §318(a)(1)(A)(ii)

25 shares to Daughter from Mom - §318(a)(1)(A)(ii)

10 shares directly

5 shares to Daughter from Trust - §318(a)(2)(B)(i)

Total: 75 (Note: 75/100 = 75%)

After:

35 shares to Daughter from Dad - §318(a)(1)(A)(ii)

25 shares to Daughter from Mom - §318(a)(1)(A)(ii)

5 shares to Daughter from Trust - §318(a)(2)(B)(i)

Total: 65 (Note: 65/90 = 72%)

Now, test redemption under four types of redemptions in §302(b):

1. §302(b)(4) does not apply, because the condo is not a qualified trade or business, so the safe harbor of §302(e)(2) does not apply. The distribution of the condo by Oldco is not a partial liquidation of its business, under §302(e)(1), because it is not "not essentially equivalent to a dividend ... at the corporate level."

2. §302(b)(2) does not apply, because Daughter does not actually and constructively own less than 50% of the stock of Oldco immediately after the redemption, under §302(b)(2)(B).

3. §302(b)(3), a complete termination of the shareholder's interest, might apply if Daughter could waive family attribution under §302(c)(2)(A), assuming that there are no additional facts (not given in the problem) that would cause §302(c)(2)(B) to apply? The problem here with waiving family attribution is that it will not avoid the entity attribution of the shares of stock from the Trust to Daughter. Note that §302(c)(2)(C) allows entities to waive family attribution, but not entity attribution, and Daughter will continue to own 5 shares of Oldco stock after the redemption via entity attribution, not via family attribution. Thus, she cannot meet §302(b)(3) because there is no complete termination of her interest in Oldco, even if she waives family attribution.

4. §302(b)(1) will likely not apply, because her direct and indirect stock ownership goes from 75% to 72%, which drop is probably not enough to meet the requirement of "not essentially equivalent to a dividend" or a "meaningful reduction in the shareholder's proportionate interest in the corporation" under the Davis case. Note that the Davis case indicated that the attribution rules do apply for purposes of §302(b)(1).

However, if Daughter could argue that the family hostility between herself and the other family members effectively cut off the application of the family attribution rules, then her stock ownership would have dropped from 15% (10 directly, 5 from the Trust, 15/100) to 5.6% (5 from the Trust, 5/90) and she might qualify for §302(b)(1). However, the courts and commentators are split on this issue (see text p. 217-19). The Tax Court and the 5th Circuit do not view family discord as nullifying the application of the attribution rules; the 1st Circuit says that family hostility might negate the presumption of the attribution rules. The Tax Court does, however, state that family discord may be relevant to a §302(b)(1) determination after application of the attribution rules. So, there is some room for argument, here.

You may conclude that §302(b)(1) may apply, or that §302 does not apply, so that §302(d) requires the application of §301 to the redemption distribution. Either will be considered to be correct; however, it is more likely that §301 will apply.

If you concluded that §302(b)(1) applies, then:

Daughter has sale or exchange treatment on her stock: - §302(a)

Amount Realized = $25,000 (FMV of condo)

Adjusted Basis in redeemed stock = $10,000

Realized and Recognized Gain = $15,000 - §1001(a); character = probably LTCG

Daughter's AB in the condo is a cost basis of $25,000 under §1012.

Oldco has gain under §311(b):

Amount realized = $25,000 (FMV of condo)

Adjusted Basis in condo = $12,000

Realized and Recognized Gain = $13,000 - §1001(a); character = probably LTCG

Oldco's e+p are increased by this gain under §312(b)(1) and (f)(1) from $30,000 to $43,000;

and decreased as a result of the redemption under §312(n)(7) by the ratable share of e+p attributable to the redeemed stock (capped by the amount of the redemption). Here, the charge to e+p would be 10% (since 10% of the stock was redeemed) of Oldco's e+p of $43,000, which is $4,300;

so Oldco's e+p = 30,000 + 13,000 gain - 4,300 §312(n)(7) charge = = 38,700.

If you concluded that §301 applies, then:

Oldco has gain under §311(b) equal to the difference between the FMV of the condo and the adjusted basis to Oldco of the condo =

$25,000 - $12,000 = $13,000.

Oldco's current e+p is increased by the gain, under §312(b)(1) and (f)(1), of $13,000, for purposes of calculating Daughter's dividend.

Now, switch to Daughter's tax consequences:

Daughter has received a distribution of $25,000 (the FMV of the condo), under §301(b)(1).

Oldco's e+p is $30,000. Assuming that Oldco does not make any other distributions in the year, then its current e+p is increased by its gain on the distribution (under §311(b) and §312(b)(1) and (f)(1)) of $13,000, to equal $43,000. Thus, all $25,000 of her distribution is taxable as dividend, ordinary income to Daughter under §301(c)(1) and §316(a).

Daughter's basis in the condo is its FMV of $25,000, under §301(d).

Now, calculate Oldco's accumulated e+p to be carried over to next year:

This is then $43,000, decreased by the FMV of the property distributed (because the property has appreciated), under §312(b)(2), which is $25,000, for a total of $18,000.

Note: The net result of these rules is the same as if Oldco sold the condo at its FMV and distributed the $25,000 cash to Daughter.

Review Question #6. Marty and Maura own all of the stock of Sullivan Company. Three years ago, when Sullivan Company had $20,000 in earnings and profits, the corporation declared and issued a pro rata stock dividend to Maura and Marty consisting of nonconvertible preferred stock worth $10,000 to each shareholder. At the time, Maura and Marty each had an adjusted basis in his or her stock of $20,000 and each one's stock was worth $40,000. Maura now wishes to sell her preferred stock to Marty, to raise some much-needed cash (she is in a financial bind). Currently, Sullivan Company has no earnings and profits. Marty is willing to give Maura $12,000 in cash for all of her preferred stock. Advise Maura as to the tax consequences of her proposed sale.

This looks like a subsequent sale under §306 of stock received in a §305 tax-free stock distribution:

1. First, determine if §305 applied to the issuance of the nonconvertible preferred stock to Maura:

This stock dividend is a pro rata dividend of nonconvertible preferred stock, which is the classic situation for the application of §305(a). None of the exceptions in §305(b) or (c) appears to apply. The result to Maura and Marty of this stock dividend was that it was nontaxable to them, and their adjusted basis in their common stock was "spread" between their common stock and their new preferred stock, according to relative fair market value, under Regs. §1.307-1(a).

Maura's adjusted basis in the preferred stock thus was:

Her adjusted basis in her common stock $20,000, allocated to her common stock worth $40,000 and her preferred stock worth $10,000, as follows:

C/S 40,000/50,000 x 20,000 = AB of $16,000 - Regs. §1.307-1(a)

P/S 10,000/50,000 x 20,000 = AB of $ 4,000 - "

[The consequences to Sullivan Company of this stock dividend were: no gain or loss on the distribution, under §311(a)(1), and no change to its e+p, under §312(d)(1)(B).]

2. Then, if §305 applied to the earlier stock dividend, §306 will apply to the proposed sale by Maura:

Here, §306 will apply to this proposed sale. The preferred stock qualifies as §306 stock, under §306(c)(1)(A), because Maura received it in a §305(a) nontaxable stock dividend (and, it is not common stock). Also, Maura is selling it - §306(a).

The consequences to Maura will be that part of the amount realized may be taxed as a dividend to her, as if she had received a cash dividend from Sullivan Company at the time of the preferred stock dividend, under §306(a)(1)(A). §306(a)(1) applies to a non-redemption disposition of §306 stock, as follows:

The preferred stock's ratable share of the amount which would have been a dividend at the time of distribution if Sullivan Company had distributed $10,000 in cash (the FMV of the preferred stock she received) to Maura, will be treated as ordinary income by §306(a)(1)(A). If Sullivan had distributed $10,000 to Maura three years ago, when its e+p was $20,000, then all $10,000 would have been ordinary, dividend income to her (her ratable share of the e+p was 50%, as she is a 50% shareholder). §316(a), 301(c)(1).

Her amount realized would be $12,000; $10,000 of this would be ordinary income to Maura on the sale. The excess of $2,000 would be treated as return of her basis in the preferred stock; her basis in the preferred stock is $4,000, so all of the $2,000 would be return of basis under §306(a)(1)(B)(ii), and no gain will be recognized by Maura (§306(a)(1)(B)). She will not be able to recognize a loss for the $2,000 of her stock basis which goes unrecovered - §306(a)(1)(C). Instead, the unrecovered basis of $2,000 should shift back to her common stock, bringing Maura's adjusted basis in her common stock to $16,000 + $2,000 = $18,000, under Regs. §1.306-1(b)(2) Ex. (2).

With respect to Sullivan Company, there is no charge to its e+p as a result of the proposed sale, because there is no actual §301 distribution to Maura on the proposed sale, see Regs. §§1.306-1(b)(1) and 1.312-1(e).

Review Question #7. Do Problem 1(a) on page 341 of the text.

S will liquidate and distribute the inventory to I (gain asset to a minority individual shh) and all of its other assets to P (gain and loss asset to a majority corporate shareholder).

This appears to be a complete liquidation of S. Typically, §331 would apply to complete liquidations of subchapter C corporations such as S; however, because another corporation is a 90% shareholder of the liquidating corporation, a §332 analysis must be made.

§332 analysis: is it a §332/337 liquidation? Yes.

Elements:

1. P was, on the date of the adoption of the plan of liquidation, and at all times until the receipt of S's assets on liquidation, the owner of stock in S meeting the requirements of §1504(a)(2), under §332(b)(1). §1504(a)(2) requires that P own 80% of the total voting power and 80% of the total value of S's stock; here, P owned 90% of both, so §1504(a)(2) is met and §332(b)(1) is therefore met.

2. The distribution by S is in complete cancellation or redemption of all its stock - §332(b)(2); and

3. The transfer of S's assets to its shareholders presumably occurs within one taxable year - §332(b)(2),

so the distribution to P will be considered to be in complete liquidation for purposes of §332(b) and (a).

Result: P has no gain or loss on its receipt of assets from S in this liquidation. §332(a).

P's realized gain is:

Amount Realized = FMV of assets received = $9,000

P's Adjusted Basis in S stock = 3,000

Realized (not Recognized) Gain = $6,000

P will take S's assets (the land and equipment) at a transferred basis under §334(b)(1). Thus, P's basis in the land will be $3,000 and its basis in the equipment will be $2,500. Holding period of S will tack to P for both assets under §1223(2).

P also inherits S's tax attributes, including 90% of S's e+p (because P was a 90% shareholder of S) under §381(a)(1).

S's e+p is $2,000, increased by any gain recognized by S on the liquidation. S will recognize $900 of gain on the distribution of inventory to I, because I is an individual, minority shareholder to which §332 and §337 do not apply, so S's e+p is increased by this $900 to $2,900. 90% of $2K + 900 is $2,610; this is the amount which P adds to its own e+p under §381(a)(1) and Regs. §1.381(c)(2)-1(c)(2).

P's Adjusted Basis in its S stock disappears (text p. 330 n.1).

S will not recognize any gain or loss on assets distributed to P in this liquidation, under §337(a), because §332 applied to P.

Because I is an individual, minority shareholder, §332 does not apply to I and consequently, §337 does not apply to S with respect to assets distributed by S to I. Instead, §331 will apply to I and §336 will apply to S's distributions to I, as follows:

S will recognize gain on its inventory distributed to I, under §336(a), of 900K. It is treated as if it had sold the inventory at its fair market value (FMV of $1,000 - adjusted basis of $100 = $900 gain), see §336(a). The character will probably be ordinary income.

I receives sale or exchange treatment with respect to his S stock on this liquidation, under §331(a). Thus, I has a realized and recognized gain of $800 on his stock on the liquidation (FMV of inventory received = $1,000 - adjusted basis of I in his stock of $200 = $800 gain). The character will probably be LTCG, based on the character of I's S stock in I's hands.

I will have a FMV basis in the inventory received from S, of $1,000, under §334(a).

This problem illustrates the bifurcated nature of liquidations when there is an 80% or more corporate parent and a minority shareholder.

Review Question #8. (All amounts are in thousands.) M is an individual who is a dealer in commercial real estate such as office buildings and hotels. M had an opportunity to buy an old hotel for $650, which needed about $250 in renovations and $100 in new furnishings. M formed a new corporation, Hotel, to buy this hotel, capitalizing it with $150 in his own cash. M found 10 investors to buy stock in Hotel; each paid $15 for 15 shares of H's stock. M owns 150 shares of the 300 issued and outstanding shares of Hotel's stock. Hotel then purchased the old hotel, financing $700 of the cost of the hotel and renovations, etc. with a loan from a bank, and completed the renovations. After two years of operations, Hotel was approached by Hilton Corp., who wished to acquire all of the assets of Hotel for $1,000 or all of its stock for $400. Hotel has a $800 adjusted basis in the hotel and land, with a FMV of $1,000. $200 of depreciation deductions have been taken. Hotel has a $300 net operating loss carryforward. All of the shareholders of Hotel are willing to sell to Hilton. What will the tax consequences to the shareholders, Hotel, and Hilton be if: (1) Hilton buys all the assets of Hotel for $1,000 in cash and Hotel then liquidates, distributing all its assets (cash) to its shareholders; or (2) Hilton buys all the stock of Hotel for $400 in cash? (Ignore any collapsible corporation issues under §341; they are outside the scope of the course.)

Results of the Taxable Transaction:

(1) Hotel sold all its assets at their FMV for $1,000 in cash and is fully taxable on these sales, so it has a $200 capital gain (may be short term?) on the land and building (§1231 gain on the building), except that $200 of previous depreciation deductions were taken, so the entire $200 gain is ordinary income as it is recapture income (§1250). This income will be entirely offset by Hotel’s $300 NOL carryforward, for a net taxable gain/income of –0-.

On the liquidation, Hotel has §336(a) full recognition of gain or loss, but it now has as its assets only $1,000 in cash, so no gain or loss is realized. It pays off its $700 bank loan, pays its taxes (which should be -0- because of the NOL carryforward), and distributes the rest, which should be about $300.

M gets half of this amount, or 150; each of the 10 investors gets 5% of this amount, or 15 each. Each of the shareholders has §331(a) recognized gain or loss on the Hotel stock, as follows:

SHH Amount Realized AB Realized Gain or Loss

M 150 150 -0-

each of 10 investors 15 15 -0-

The character of any realized gains or losses would be long-term capital (ignoring any application of §341). After-tax proceeds to M (assuming a 20% tax on LTCG) will be $150.

Hilton's basis for the Hotel assets would be a FMV, §1012 cost basis of $1,000, which amount would be allocated between the assets (land and building) under the principles of Code §1060. In other words, the allocation of amount realized by Hilton and Hotel in the asset acquisition agreement would control this allocation of basis by Hilton. Hilton will have all of Hotel’s assets inside of it and Hotel’s corporate existence will terminate.

(2) If Hilton buys all the stock of Hotel for $400 in cash, each Hotel shareholder will receive the following:

SHH Amount Realized AB Realized Gain or Loss

M 200 150 50

each of 10 investors 20 15 5

These gains would be fully recognized under §1001, and would most likely be LTCG. [You will not know that Hotel may be a "collapsible corporation" within the meaning of §341, which would change the results here, but this is outside the scope of the course.] After-tax proceeds to M (assuming a 20% tax on LTCG) will be $190. Query whether Hilton should negotiate a lower acquisition price for the stock, or whether the Hotel shareholders should negotiate a higher acquisition price for the assets?

The acquisition will have no effect on Hotel's basis for its assets or its tax attributes such as e+p (in general, no real effect except for limitations on uses of tax attributes such as net operating loss carryforwards). Hilton will now own Hotel as a 100% subsidiary (i.e., Hilton will own 100% of the stock of Hotel); Hotel will still have its assets, at their old, low, historical basis, and liabilities.

Hilton's AB in the stock of Hotel would be a cost basis of $400 under §1012.

You should ask whether there is an error in the calculation of the acquisition price, since the after-tax results are so different. It is more likely that Hilton would want to pay $300 for the Hotel stock. Further, the deal gives the Hotel shareholders no economic gain on their investment. And, acquisition of stock carries disadvantages to Hilton that acquisition of assets does not. Finally, you might consider whether a §338 election is advisable, given Hotel’s NOL carryforward.

Review Question #9. Silver King will acquire Home Shopping Network in the following way: Telecommunications, Inc. (TCI), the nation's largest cable operator corporation, agreed to exchange its stock in Home Shopping Network corporation (HSN), which represented 80% of the voting power of the outstanding stock of HSN, for stock in Silver King (a corporation unrelated to HSN or TCI) (SK). At the same time, Silver King acquired all of the stock of Savoy Pictures Corporation (SP) in exchange for shares of Silver King common stock. Silver King will pay cash to SP and TCI in lieu of fractional shares, if the share exchange ratios do not result in a "whole" number of Silver King stock.

This is a fact pattern taken from a business transaction described in the New York Times on 12/4/95. This problem simply illustrates the way in which "real" transactions are sometimes structured. These will be valid §368(a)(1)(B) reorgs; one is a triangular "B." The advantages are generally that the transactions will be tax-free to all parties involved. Also, the corporate existence of the target corporations is maintained, stock acquisitions are often easier to execute than asset acquisitions (there is no need to transfer each individual asset or try to assign sometimes nonassignable contract rights).

236-6273; email: sdaicoff@law.capital.edu.