19 CHAPTER CORPORATIONS: DISTRIBUTIONS NOT IN COMPLETE LIQUIDATION
LECTURE NOTES
CORPORATE DISTRIBUTIONSOVERVIEW 1. Distributions by a corporation to its shareholders are presumed to be dividends unless the parties can prove otherwise. Section 316 makes such distributions dividend income to the shareholder to the extent of E & P of the distributing corporation (accumulated since 1913) or to the extent of E & P for the current year. Distributions not taxed as dividends (because of insufficient E & P) are nontaxable to the extent of the shareholders stock basis and will reduce that basis accordingly. Any excess of the distribution over the shareholders basis usually is a capital gain.
2.
EARNINGS AND PROFITS (E & P) 312 3. E & P, though similar in concept to retained earnings, is computed differently. Retained earnings computation is based on financial accounting rules while E & P is determined using tax law. A few of the differences are as follows. a. b. c. Capitalization of stock dividends does not decrease E & P; they decrease retained earnings. E & P is reduced only by straight-line depreciation unless the corporation uses a depreciation method such as units of production or machine hours. E & P may be affected by gains and losses from property transactions only to the extent they are recognized for tax purposes (e.g., like-kind exchanges are not recognized for taxable income determination or for E & P purposes).
4.
E & P is the factor that fixes the upper limit on the amount of dividend income a shareholder must recognize. It represents the corporations economic ability to pay a dividend without impairing its capital.
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Computation of E & P 5. Additions to taxable income. To compute E & P, taxable income is increased for all taxexempt income items such as municipal bond interest, excluded life insurance proceeds (in excess of cash surrender value), dividends not taxed due to the dividends received deduction, and Federal income tax refunds for taxes paid in prior years. Taxable income is also increased by the domestic production activity deduction (DPAD). These deductions are essentially partial income exclusions. Subtractions from taxable income. Taxable income is then decreased by nondeductible expenses and losses to determine E & P. These nondeductible expenses include related party losses, excess capital losses, Federal income taxes paid, fines and penalties, expenses incurred to produce tax-exempt income, and key employee life insurance premiums (in excess of increases in cash surrender value). Timing adjustments. Some E & P adjustments shift a transactions impact from the year it is included in taxable income to the year it has an economic effect on a corporation. Excess capital losses, excess charitable contributions, and NOL carryovers all are this type of adjustment. Accounting method adjustments. These adjustments relate to differences in accounting methods required for E & P and taxable income. Included in this group are adjustments required for depreciation, 179 expense, installment sales, LIFO recapture, intangible drilling costs, mining exploration and development costs, amortization of circulation expenditures, trademarks, organizational expenditures, and accounting for construction contracts. Alternative depreciation system (ADS) must be used for computing E & P. This system uses straight-line depreciation over a recovery period equal to the Asset Depreciation Range (ADR) midpoint life. Therefore, if accelerated depreciation is used to compute taxable income, an adjustment to E & P must be made. a. b. No additional first year depreciation is allowed for E & P purposes. ADR midpoint lives for most assets are set out in Rev. Proc. 87-56, 1987-2 C.B. 674. The recovery period is 5 years for automobiles and light-duty trucks and 40 years for real property. Assets with no class life have 12 year recovery period. When the asset is later sold, the increase or decrease to E & P is computed by using the adjusted basis of the asset for E & P purposes. Example 7 in the text demonstrates this concept. Section 179 expenses must be deducted over five years. Thus, in the year 179 is elected, 80% is added back to taxable income to arrive at E & P. In each of the following four years, 20% of the 179 expense is subtracted from taxable income to determine E & P.
6.
7.
8.
9.
c.
d.
Corporations: Distributions Not in Complete Liquidation Summary of E & P Adjustments 10.
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Concept Summary 19-1 lists the adjustments that are made to a corporations taxable income in arriving at E & P. Some of the more common adjustments are as follows. a. E & P is increased by the amount of any deferred gain in the year in which a corporation sells property on the installment basis. This is accomplished by treating all principal payments as having been received in the year of sale for purposes of computing E & P. Intangible drilling costs allowable as a deduction under 263(c) and mineral exploration and development costs allowable as a deduction under 616(a) or 617 are required to be capitalized for purposes of computing E & P. Once capitalized, these expenditures are charged to E & P over a specified period (i.e., 60 months in the case of intangible drilling costs and 120 months for mine exploration and development costs). Any unamortized balance is written off when the well becomes dry or the mineral property is abandoned. Amounts amortized under 173 (circulation expenditures), 177 (trademark and trade name expenditures), and 248 (organizational expenditures) are to be capitalized for purposes of determining E & P. There is no amortization if the property does not have a reasonably determinable useful life. Construction period interest, taxes, and carrying charges are capitalized as a part of the asset to which they relate for purposes of computing E & P. Any increase in the LIFO recapture amount (excess of FIFO over LIFO inventory value) during the year is added to taxable income to determine current E & P. Decreases in the LIFO recapture amount are subtracted from taxable income. Problem 33 in the text is an effective in-class exercise for teams of two or three students to complete after discussing the rules for computing E & P. Complete the problem and then discuss the solution.
b.
c.
d. e.
f.
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Current versus Accumulated E & P 11. Accumulated E & P is the total of all previous years current E & P (since February 28, 1913) as computed on the first day of each year, reduced by any distributions made from E & P. It is important to distinguish between current and accumulated E & P because they are allocated to distributions differently.
12.
Allocating E & P to Distributions 13. When current and accumulated E & P are positive, corporate distributions are first made from current and then from accumulated. When distributions exceed current E & P, the allocations of current and accumulated are as follows. a. b. c. 14. Current E & P is allocated to distributions on a pro rata basis to each distribution (proportionately throughout the year). Accumulated E & P is allocated to distributions in chronological order during the year, starting with the first distribution. Concept Summary 19-2 lists the steps in allocating E & P to distributions.
Allocations when either current or accumulated E & P has a deficit. a. If a deficit exists in accumulated and a positive balance exists in current, the two accounts are not netted. Instead, distributions are taxed as dividends to the extent of the positive balance in current E & P. If a deficit exists in current and a positive balance exists in accumulated, the two accounts are netted as of the date of the distribution. The distribution is treated as a dividend to the extent of a positive net balance. Deficit in current E & P is allocated ratably throughout the year, unless the parties can show otherwise.
b.
15.
If current E & P is unknown at the end of the shareholders tax year (e.g., when the corporation uses a fiscal year and the shareholder uses a calendar year), current E & P is assumed sufficient to cover all distributions made during the year to the shareholder. If current E & P is determined to be insufficient to cover distributions after the end of the corporations year, then the shareholder may file an amended return to claim a refund for taxes paid.
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ETHICAL CONSIDERATIONS Shifting E & P (page 19-10). Ethical decisions can sometimes be reached via stakeholder analysis. Ideally, all stakeholders will be better off as a result of the solution; costs and benefits should be fairly distributed; and stakeholders rights should be preserved. To move toward an ethical solution, the instructor should encourage a discussion of what each stakeholder stands to gain or lose as a result of Joes decision. Joe: Assuming his tax rates will not change over the two-year period at issue, it is in Joes selfinterest to defer the income until next year because of the time value of money. Joes benefit from deferral is equal to the return he can earn on the tax liability for one year. Frankie: If Joe defers the income until next year, Frankies distribution will be tax free to the extent of his stock basis and taxed as a capital gain if the distribution exceeds basis. If Frankies stock basis is reduced, he will recognize a larger capital gain on the sale of his stock to Cindy at the beginning of next year. In contrast, acceleration of the income into this year will trigger dividend treatment on the distribution with no basis reduction. Thus, for Frankie, the decision trades off dividend income this year with a similarly taxed capital gain next year. Cindy: If Joe defers the income, the distribution to Cindy next year will be taxed as a dividend and her stock basis will be preserved. The present value of savings generated by preserving her stock basis will be small relative to the tax cost of the dividend because she will probably hold her stock for several years. Alternatively, if Joe accelerates the income into the current year, Cindys distribution will be tax-free and reduce the basis in her stock. The basis reduction will create gain potential at some later date, but the present value of the tax cost is probably low, because any stock sale by Cindy is likely to be far into the future. Cindy trades off a tax on dividends next year with a heavily discounted capital gain tax. Comparing the costs and benefits faced by Cindy and Frankie requires some assumption about relative tax rates. If we assume that Cindy and Frankie have similar marginal rates, then Cindy stands to gain more than Frankie will lose if Joe accelerates the income into the current year. The benefit to Cindy probably also outweighs the small deferral benefit accruing to Joe. Consequently, to minimize the overall tax cost for all parties involved, Joes best decision is to accelerate the income into the current year. The proposed solution still falls short of the criteria established for an ethical decision. In particular, one might question whether the resulting distribution of costs and benefits is fair and whether stakeholder rights are preserved. Both Joe and Frankie are made worse off by this decision. To improve the solution, Joe should search for a way for both himself and Frankie to share in Cindys benefits. Frankie might be able to offset the costs of accelerating the income by negotiating a higher stock price with Cindy in return for the income acceleration. Joe might participate in the negotiations and attempt to capture a portion of the benefits as well (assuming the monetary benefits he receives outweigh any good feelings arising from transferring some wealth to his sister).
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Government (The Public): The role of the government as a stakeholder should also be addressed. If one considers the governments position to be improved with larger amounts of taxes collected, the proposed solution appears to be at loggerheads with the governments interests and the criteria for an ethical solution are not met. However, this view can be called into question by discussing the role of government and the role of tax law. In particular, the instructor should lead a discussion regarding whether or not the publics interest is served or harmed by careful tax planning. DIVIDENDS 16. The tax treatment of dividends is affected in part by whether the shareholder is an individual, a corporation, or another type of taxpaying entity. a.
b.
Corporations receiving dividends are taxed at ordinary rates on amount remaining after subtracting the dividends received deduction. Other taxpayers receive a reduced rate of tax on qualifying dividends, while nonqualifying dividends are taxed as ordinary income.
Rational for Reduced Tax Rates on Dividends 17. 18. Reduction in the tax rate on dividends paid to individuals was made to reduce distortions attributable to the double tax on dividends and to stimulate the economy. Reduction in the double tax should also make the U.S. more competitive in international markets, because most other countries assess only one level of tax on corporate earnings.
Qualified Dividends 19. From 2003 to 2010, qualified dividends are subject to a maximum 15% tax rate for most individual taxpayers. After 2010, dividends revert to ordinary income treatment. a. Individuals in the 10% or 15% tax rate brackets are subject to a 5% tax rate on qualified dividends paid between 2003 and 2007 and a 0% tax rate between 2008 and 2010. The special tax rates on qualified dividends also apply under the alternative minimum tax.
b. 20.
To qualify for the special 5% or 15% tax rates, dividends must meet three requirements. a. The dividend must be paid by a qualifying corporation. Qualifying corporations include domestic corporations, foreign corporations whose stock is traded on U.S. markets, and corporations located in a country that (1) has a comprehensive income tax treaty with the U.S., (2) has an information-sharing agreement with the U.S., and (3) is approved by the Treasury.
Corporations: Distributions Not in Complete Liquidation b. c. 21.
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Dividends paid to shareholders who hold both long and short positions in the same stock do not qualify. The stock must be held for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date.
Dividends taxed at 5% or 15% rates are not treated as investment income for purposes of the investment interest expense limitation. Taxpayers can, however, elect to treat dividends as investment income. If they do, the dividends will be taxed as ordinary income.
PROPERTY DIVIDENDS 22. Amount distributed as dividends in the form of property rather than cash are measured by the fair market value of the property on the date of distribution. This amount is reduced by any liabilities associated with the property that are assumed by the shareholder. Shareholders basis in the distributed property is fair market value on the distribution date. Under 311(b), gain but not loss is recognized to a corporation that distributes property as a dividend. a. b. Distribution of appreciated property is treated as if the property were sold to the shareholder at its fair market value. Further, if the property distributed is subject to a liability, or if the shareholder assumes a liability that exceeds the basis of the distributed property, the fair market value of the property shall not be less than the amount of the liability.
23. 24.
25.
Distributing corporations E & P is reduced by the amount of money distributed or by the greater of the fair market value or the adjusted basis of the property distributed less the amount of any liability on the property. a. b. Distributions cannot generate or add to a deficit in E & P. Only corporate losses generate or add to a deficit in E & P.
26.
Distributing corporations E & P increases by gain recognized on the appreciated property distributed. This gain flows through the tax return. CONSTRUCTIVE DIVIDENDS 27. 28. Constructive dividends usually arise in the context of a closely-held corporation. They need not be formally declared or issued pro rata. Examples of constructive dividends are:
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2008 Comprehensive Volume/Solutions to Research Problems Personal use by a shareholder of corporate-owned property (e.g., company-owned automobiles, airplanes, yachts, hunting lodges). The measure of the dividend usually is the fair rental value of the property for the period of its personal use. A bargain sale of corporate property to the shareholders. The measure of the dividend is the difference between the amount paid for the property and its FMV. The bargain rental of corporate property to its shareholders. The measure of the dividend is the amount of the propertys fair rental value that exceeds the rent actually paid. Payments for the benefit of shareholders (1) (2) (3) e. Satisfaction by the corporation of a shareholders personal obligation to a third party. Forgiveness of a shareholder debt to the corporation. Excessive rentals paid by a corporation for the use of shareholder property.
b. c.
d.
Compensation to shareholder/employee that is unreasonable. (1) (2) There are numerous factors that are considered in determining whether compensation is reasonable. See page 19-17 in text for a list. Reasonable investor test is relatively new development in reasonable compensation. ADDITIONAL LECTURE RESOURCE
Court cases concerning reasonable compensation in closely held corporations have received inconsistent treatment. When deciding these cases, the courts rely on two different types of tests. The 13 Federal circuits differ in the use of these tests based in part on earlier precedent in their respective jurisdictions. Multiple Factor Approach. The first type of test uses multiple factors to assess the reasonableness of compensation, such as the companys financial condition, its dividend history, and the size and complexity of its business. The approach also compares compensation to similarly situated employees of comparable companies and considers the employees contribution to corporate profits and the relationship between compensation and level of stock holdings. This type of analysis originated in the 6th Circuit [Mayson Manufacturing Co. v. Comm., 49-2 USTC 9467, 38 AFTR 1028, 178 F.2d 115 (CA-6, 1949)] and is followed in the 10th Circuit [Eberls Claim Service v. Comm., 87 AFTR2d 2001-2075, 249 F.3d 994 (CA-10, 2001)].
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Independent Investor Approach. To examine the reasonableness of compensation to the shareholder-employee, other courts are beginning to use a new approach, involving a hypothetical independent investor. The question asked by the judge is how much would an independent investor be willing to pay the employee, given the profits that are generated? The 7th Circuit Court is the principal advocate for this standard. Other courts (including the 2nd, 6th, and 9th Circuit Courts) have started to use a hybrid approach, considering both the multiple factors suggested in Mayson Manufacturing and the new independent investor test. In many of the cases adopting either a hybrid approach or the independent investor test, opinions have often been critical of the Tax Courts use of the multiple factor approach. A brief summary of a few of these cases follow. Alpha Medical, Inc. v. Comm., 99-1 USTC 50,461, 83 AFTR2d 99-697, 172 F.3d 942 (CA-6, 1999). William Rogers, a pharmacist with a history of successful business ventures in the health care industry, started a medical consulting corporation with a $1,000 contribution to capital. After 4 years of success (largely attributable to the pharmacists efforts), the corporation had taxable income of almost $7,000,000. The corporation paid Rogers $4.4 million as compensation. During audit, the IRS determined that $4 million of the compensation paid was unreasonable. The Tax Court split the difference between the IRS and taxpayer, finding $2.3 million of Rogers pay to be reasonable. On appeal, however, the Sixth Court of Appeals ruled that all $4.4 million of the compensation paid to Rogers was reasonable. In its decision, the Court of Appeals said that, in light of Rogers record of accomplishment, risks he assumed, and amazing growth, reasonable shareholders would have gladly agreed to Rogers level of compensation. Leonard Pipeline Contractors v. Comm., 98-1 USTC 50,356, 81 AFTR2d 98-639, 142 F.3d 1133 (CA-9, 1998). In its decision, the Ninth Court of Appeals judge criticized the Tax Courts failure to explain how it arrived at its reasonable compensation figure (about halfway between amounts argued by the IRS and the taxpayer). The appellate court noted that the Tax Court simply enumerated the factors to be considered when determining reasonableness of compensation and then leapt to an intermediate figure between the IRS and taxpayer. Exacto Spring Corp. v. Comm., 84 AFTR2d 99-6977, 196 F.3d 822 (CA-7, 1999). In this decision, the 7th Circuit Court was sharply critical of the Tax Courts use of the multiple factor approach in general, saying that it led to arbitrary results. The court suggested that the sole use of the independent investor approach is simpler and more purposive than the multiple factor approach. Under the test, the court argued, the higher the rate of return that an employee can generate through their own efforts, the higher the compensation they should be able to command. Menard, Inc., 88 TCM 229, T.C. Memo. 2004-207. Menard, Inc. is a home improvement store that is closely held, with most of the stock owned by the CEO, Mr. Menard. In 1998, Mr. Menard received a $62,400 salary, $3 million in compensation from a profit sharing plan, and approximately $17 million as a bonus (set at 5% of net income before taxes). The corporation earned a higher return on investment than similar businesses in the industry. In its decision, the Tax Court agreed with the
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2008 Comprehensive Volume/Solutions to Research Problems taxpayer that the independent investor test was satisfied. However, the court held that satisfaction of this test merely creates a rebuttable presumption that compensation is reasonable. The court relied on a statement in Reg. 1.162-7(b)(3): It is, in general, just to assume that reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances. Since CEOs of publicly traded companies in the same line of business were paid considerably less for their services than Mr. Menard, the court found that only $7 million of his salary was reasonable. f. g. Advances by a corporation to a shareholder that are not bona fide loans. Imputed interest element on interest-free (or below-market) loans by a corporation to a shareholder. (1) (2) (3) (4) h. i. Shareholder is deemed to make an interest payment to the corporation to the extent of the forgone interest. Corporation is then deemed to make a dividend distribution to the shareholder for the same amount. Although the shareholder may be permitted to deduct the deemed interest payment, the corporation has interest income. No corresponding corporate interest deduction is allowed because imputed interest element is a constructive dividend.
Interest and principal payments made by a corporation where debt owed to its shareholders is reclassified as equity (i.e., the corporation is thinly capitalized). See the Class Exercise on Constructive Dividends appearing at the end of the Lecture Notes for this chapter. This material can be distributed to the group as a take-home or classroom project. Solutions to the Exercise are also included.
Stock Dividends and Stock Rights 29. 30. Stock dividends are not taxable if they are pro rata distributions of stock, or stock rights, on common stock. Various disproportionate distributions are taxable under 305. a. The following are 5 situations where stock dividends are taxable under 305. (1) (2) If one shareholder can elect payment either in cash or in stock, all stock dividends are taxable. Disproportionate distributions of stock dividends are taxable.
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Common stock distributions to some common shareholders and preferred stock to other common shareholders cause stock dividends to be taxable. A stock dividend of convertible preferred on common is taxable if it is reasonable to expect that some shareholders will convert their preferred shares to common shares and that others will keep their preferred shares. Distributions on preferred stock are taxable (except for changes in the conversion ratio of convertible preferred made to account for a stock dividend or stock split). Convertible preferred stock distributions that result in disproportionate distributions are taxable.
(4)
(5) b.
Section 305(c) provides that transactions increasing the proportionate interest of a shareholder are taxable even if they are not actually stock dividends. ADDITIONAL LECTURE RESOURCE
The following examples illustrate the applicability of 305: A corporation has a dividend reinvestment plan that allows shareholders to choose either a stock dividend or a cash dividend. The stock dividend is of greater fair market value than the cash dividend. In addition, for those electing to take the stock dividend and thereby reinvest in the corporation, an optional plan to purchase additional common stock of the company at a price equal to 95% of the fair market value of the stock is available. Those choosing the stock dividend would have a taxable dividend under 305 to the extent of the fair market value of the stock received initially. In addition, for shareholders electing the optional plan, income will be recognized to the extent that the fair market value of the stock purchased at the 5% discount exceeds the purchase price of the stock. Rev. Rul. 78-375, 1978-2 C.B. 130 A corporation has an annual redemption plan whereby shareholders can redeem 1% of their stock annually. While those who tender their stock for redemption have dividend income under 301 (because the provisions of 302 are not met), those who do not tender their stock also have dividend income under 305 because their proportionate share of E & P and assets of the corporation increases. While a distribution of property incident to an isolated redemption does not cause 305(b)(2) to apply (even though the redemption is treated as a 301 distribution), an ongoing plan of annual stock redemptions is subject to 305(b)(2). Rev. Rul. 78-60, 1978-1 C.B. 81 A distribution to common shareholders of preferred stock which is immediately redeemable is taxable as offering a choice of stock or cash under 305(b)(1). Rev. Rul. 719-258, 19719-2 C.B. 95 A corporation has two classes of common, A and B. It makes a distribution of class A common stock to the holders of class A common stock, and a distribution of newly
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2008 Comprehensive Volume/Solutions to Research Problems issued preferred stock to the holders of class B common stock. The Regulations [Reg. 1.3019-4(b)] hold that both distributions are taxable.
A corporation, having one class of common stock, distributes to its common shareholders a new issue of convertible preferred having a six-month conversion period and a conversion price near the market value of the common stock. Regulations The provide that because early conversion by common shareholders is probable (with the result that some common shareholders will hold common stock while others will hold preferred), the distribution of preferred is taxed under 305(b)(3). Reg. 1.3019-4(b) A payment of interest to a holder of a convertible debenture will cause the distribution of a stock dividend to the common shareholders to be taxed under 305(b)(2). The holders of the convertible debentures are deemed to be shareholders; thus, some shareholders have received cash. Reg. 1.3019-3(b)(3) If stock dividends are not taxable, there is no reduction in E & P. If they are taxable, the distribution is treated as any other property dividend. If the stock dividend is not taxable, 307 applies and a basis allocation is necessary. If the stock dividend is taxable, the basis of the stock received is its fair market value.
31. 32.
Corporations: Distributions Not in Complete Liquidation OVERVIEW 33.
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Corporate nonliquidating distributions to shareholders are typically treated as dividend income. However, distributions that qualify as stock redemptions are treated the same as a sale of stock by the shareholders to a third party. Thus, capital gain treatment normally results. a. Qualifying stock redemptions provide greater tax benefits to noncorporate shareholders than nonqualifed redemptions. (1) Since qualifying stock redemptions are treated as sales or exchanges, the shareholders can offset their amount realized by the basis of the stock redeemed. Any gain remaining is treated as a capital gain and taxed at the applicable capital gain rates (long-term rates are 5% or 15%). If the distributions do not qualify as stock redemptions, they are treated as dividend income and taxed at dividend rates (assuming adequate E & P). By increasing the amount of capital gains for the year, redemptions may increase the utilization of capital losses from other sources. Distributions treated as dividends cannot provide this same benefit.
(2) (3)
b.
Corporate shareholders prefer nonqualified stock redemption (i.e., dividend) treatment. (1) With dividend treatment, corporate shareholders receive the benefits of the dividends received deduction. Thus, most of the nonqualified stock redemption income is not taxable. Qualified stock redemptions produce capital gains that are fully taxable at the corporations highest marginal rate. ADDITIONAL LECTURE RESOURCE
(2)
A good example of a redemption transaction structured to fail the qualifying stock redemption provisions in order to obtain the dividends received deduction is DuPont Corporations redemption of stock held by Seagram Corporation. (See, Lee A. Sheppard, Can Seagram Bail Out of DuPont without Capital Gain Tax? Tax Notes Today, 95 TNT 75-4, April 18, 1995). In Rev. Rul. 77-226, 1977-2 C.B. 90, redemption of stock is followed by sale of remaining stock held by corporate shareholder. The two transactions are part of integrated plan resulting in complete termination redemption thus the dividends received deduction on redemption transaction disallowed. Section 1059(a) tempers the advantages of these redemption transactions by requiring the corporate shareholder to reduce its stock basis by the amount of the dividends received deduction, and to recognize gain for any excess over the basis.
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34.
Corporations generally recognize both gains and losses on liquidating distributions thus, preserving the double taxation inherent in operating a business as a C corporation. Some major exceptions apply, however. a. b. Antistuffing rules limit loss recognition with respect to certain distributions (and sales) pursuant to liquidation. Subsidiary corporations do not recognize gains/losses on liquidating distributions to its parent corporation and it is also generally tax-free to the parent.
35.
Shareholders of a liquidating corporation receive sale or exchange treatment; thus, the difference between the fair market value of all properties received and the stock basis is a capital gain (or loss).
STOCK REDEMPTIONSSALE OR EXCHANGE TREATMENT 36. Stock redemptions qualifying under 302(b) or 303 receive sale or exchange treatment. To be qualified, the distribution must meet one of the following requirements. a. b. c. d. e. 37. 38. Not essentially equivalent to a dividend under 302(b)(1). Substantially disproportionate in terms of shareholder effect under 302(b)(2). Complete termination of a shareholders interest under 302(b)(3). Redemption of noncorporate shareholder in partial liquidation of the corporation under 302(b)(4). Redemption to pay decedent shareholders death taxes and the estates administration expenses under 303.
Amount of the shareholders gain/loss is measured by the difference between the amount received and the shareholders adjusted basis in the stock redeemed. Shareholders basis in property received in the redemption is its fair market value.
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ADDITIONAL LECTURE RESOURCE Stock Buybacks Stimulate Redemptions. Stock redemptions often are motivated by corporate reasons. For instance, when a corporation considers its stock undervalued, it may repurchase its shares through a tender offer. By reducing the number of shares outstanding, the corporation may be able to increase its earnings per share and related financial ratios. Although the purchase is motivated by corporate reasons, each redeeming shareholder must consider the qualifying stock redemption rules to determine whether sale or exchange treatment is available. In most cases, however, the shareholders redeeming stock in these buybacks hold small stakes in the corporation and, as such, are not hindered by the qualifying stock redemption requirements. See, Rev. Rul. 719-385, 19719-2 C.B. 92 (redemption of stock from shareholder with de minimis interest qualifies as a not essentially equivalent redemption). However, a de minimis shareholder will not qualify for 302(b)(1) treatment if the redemption is pro rata with respect to all shareholders (Rev. Rul. 81-289, 1981-2 C.B. 82). The Tax in the News on p. 19-5 of the text illustrates a problem encountered by nonresident alien shareholders when their stock is redeemed in tender offers (See Ltr. Rul. 200552007).
ADDITIONAL LECTURE RESOURCE Stock Redemptions Incident to Divorce. Property transferred pursuant to a divorce under 1041 results in no gain (or loss) to the transferor ex-spouse and a carryover basis to the recipient exspouse. The deferred gain/loss is typically recognized when the recipient disposes of the property in a taxable event. When the property is stock of a closely held corporation (e.g., wholly owned by one or both spouses), and the stock is redeemed because of a divorce agreement, an alternative result can occur. In some cases, the redemption transaction will be treated as a distribution to the transferring spouse and a subsequent transfer of the proceeds to the recipient spouse. The transferring spouses remaining stock ownership in the corporation generally precludes qualifying stock redemption treatment, and the result is a dividend distribution to such spouse [See, Craven v. U.S., 2002-2 USTC 50,541, 85 AFTR2d 2000-2229, 215 F.3d 1201 (CA-11, 2000); and Carol M. Read, 114 T.C. 14 (2000)]. The Regulations for 1041 permit taxpayers to establish the tax consequences associated with the redemption of stock pursuant to a divorce. Under Reg. 1.1041-2(c), taxpayers can dictate in the divorce or separation instrument which spouse is be taxed on the stock redemption. Stock Attribution Rules 39. Generally, 318 constructive ownership rules apply in determining whether a distribution is a qualifying stock redemption. a. Individuals are treated as owning stock owned by their spouses, parents, children, and grandchildren.
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2008 Comprehensive Volume/Solutions to Research Problems Example. Keith owns 60 shares of stock in Purple Corporation. The remaining 40 shares are owned by the following relatives of Keith: Keiths wife (5); Keiths son (2); Keiths daughter (3); Keiths father (10); Keiths brother (6); and Keiths aunt (14). Keith is deemed to own a total of 80 shares in Purple. Only the stock of his brother and his aunt are not attributed to him. b. Stock owned, directly or indirectly, by a partnership is considered to be owned proportionately by the partners. However, stock owned by a partner is treated as owned in full by the partnership. Example. Lori has a 20% interest in a partnership which owns 30 shares in White Corporation. Lori is deemed to own 6 (20% of 30) shares in White. However, if Lori owned 30 shares in White (rather than the partnership), the partnership would be deemed to own all of Loris 30 shares.
c.
Stock owned, directly or indirectly, by an estate or trust is considered to be owned proportionately by the beneficiaries; but stock owned by or for a beneficiary is treated as owned in full by the estate or trust. Example. Arnold has a 10% beneficiary interest in a trust. The trust owns 50 shares in Green Corporation. Arnold is considered as owning 5 (10% of 50) of these shares. However, if Arnold owned the 50 shares (rather than the trust), the trust would be deemed to own all of Arnolds 50 shares.
d.
Stock owned by a corporation is considered to be owned proportionately by any shareholder owning 50% or more of the corporations stock. However, stock owned by a shareholder who owns 50% or more of a corporation is considered to be owned in full by the corporation. Example. Nancy owns 60% of Gray Corporation. Gray owns 20 shares of Blue Corporation, and Nancy owns 50 shares of Blue. Nancy is deemed to own 62 shares in Blue, her own 50 shares plus 60% of Grays 20 shares, or 12 more shares. Gray, on the other hand, is deemed to own 70 shares of Blue, its 20 shares and Nancys 50 shares.
e. 40.
Exhibit 19-1 in the text summarizes the stock attribution rules.
The stock attribution rules do not apply in certain cases. a. b. Family attribution rules can be waived in a complete termination redemption. All attribution rules are ignored for partial liquidations and in redemptions to pay death taxes. ADDITIONAL LECTURE RESOURCE
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Courts have addressed the issue of whether family discord should affect the application of 318. In Robin Haft Trust, 61 T.C. 398 (1973), the Tax Court refused to accept a family fight exception to the attribution rules. However, the First Circuit Court of Appeals reversed [75-1 USTC 9409, 35 AFTR2d 75-750, 510 F.2d 43 (CA-1, 1975)] and the Tax Court ruled that the existence of family discord could negate the presumption that related taxpayers would exert continuing control over a corporation after their stock is redeemed. In Rev. Rul. 80-26, 1980-1 C.B. 66, the IRS announced it would not follow the First Circuits decision in Robin Haft Trust because, according to the IRS, the family hostility exception is inconsistent with the legislative history behind the redemption provisions. In Metzger Trust v. Comm., 82-2 USTC 9718, 51 AFTR2d 83-376, 693 F.2d 459 (CA-5, 1982), the Fifth Circuit Court of Appeals agreed with the IRS and ruled that there is no family hostility exception to the attribution rules. Not Essentially Equivalent Redemptions 41. A stock redemption under 302(b)(1) must not be essentially equivalent to a dividend. The Supreme Court in U.S. v. Davis established the following rules as to 302(b)(1). a. b. c. It is immaterial that the redemption has a business purpose and is not part of a tax avoidance scheme to bail out dividends at favorable tax rates. The redemption must result in a meaningful reduction of the shareholders interest, with a reduction in voting control being the most important factor. Constructive ownership rules of 318(a) apply in figuring meaningful reductions. ADDITIONAL LECTURE RESOURCE The meaningful reduction test is based upon the facts and circumstances of each case [Reg. 1.302-2(b)]. A redemption of stock from a shareholder having a de minimis stock interest both before and after the transaction should qualify as a not essentially equivalent redemption (Rev. Rul. 719-385, 19719-2 C.B. 92). However, a de minimis shareholder will not qualify for 302(b)(1) treatment if the redemption is pro rata with respect to all shareholders (Rev. Rul. 81-289, 1981-2 C. B. 82). A 302(b)(2) disproportionate redemption requires shareholders to own, directly and indirectly, less than 50% of the corporations voting stock after the redemption. A redemption can qualify as a not essentially equivalent redemption even though the shareholder owns 50% (or possibly more) of the stock after the transaction. A reduction in shareholder interest from 57% to 50% was held to be a not essentially equivalent redemption when a single unrelated shareholder owned the remaining 50% interest (Rev. Rul. 75-502, 1975-2 C.B. 111). When a shareholders interest after a redemption is more than 50%, the meaningful reduction test will not be satisfied in the IRSs opinion (See, Rev. Rul. 78-401, 1978-2 C.B. 127, interest reduced from 90% to 60%; and Rev. Rul. 77-218, 1977-1 C.B. 81, interest reduced from 60% to 55% did not qualify). However, one court found a reduction in shareholder interest from 85% to 61.7% did satisfy the meaningful reduction test when applicable state law required a two-thirds
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vote for amending articles of incorporation, for merger and acquisition, and for liquidation [Wright v. U.S., 73-2 USTC 9583, 32 AFTR2d 5490, 482 F.2d 600 (CA-8, 1973)]. 42. 43. Redemption of preferred stock, that is not 306 stock, may qualify as a not essentially equivalent redemption. For nonqualifying stock redemptions, the basis of the stock redeemed attaches to the basis of the shareholders remaining stock. a. If the taxpayer owns no stock directly after the transaction, the basis of the stock redeemed attaches to the basis of the stock that was attributed to such taxpayer. (See Example 33 in the text.) There is no guidance provided for basis allocation when the stock of more than one related shareholder is attributed to the taxpayer. The IRS has aggressively attacked tax shelter transactions that utilize nonqualified stock redemptions to shift stock basis to other shareholders. (See the Additional Lecture Resource below.) ADDITIONAL LECTURE RESOURCE IRS Attacks Basis-Shifting Tax Shelters. When a stock redemption does not qualify for sale or exchange treatment, the basis in the stock redeemed attaches to the shareholders remaining shares or to stock the shareholder owns constructively. Clever planners have created a tax shelter utilizing the shift in basis from one shareholder to another shareholder. The shelter works as follows. A U.S. taxpayer and a foreign corporation indifferent to U.S. tax (e.g., a Cayman Island corporation) each acquire a small number of shares in a foreign bank. The U.S. taxpayer also purchases from the foreign corporation an option to acquire at least 50 percent of the foreign corporations stock. The foreign bank then redeems the stock owned by the foreign corporation. Under the attribution rules, the U.S. taxpayer is related to the foreign corporation by reason of the stock option; thus, the redemption results in dividend income to the foreign corporation (which pays no U.S. tax). The foreign corporations basis in the redeemed shares shifts to the shares of the U.S. taxpayer and those shares are then sold for a loss that is used to offset gains from other investments. The IRS has announced (Notice 2001-45, 2001-2 C.B. 129) that it will disallow the basis shift in these tax shelter cases and that it will assess penalties on participants and promoters of the tax shelter. The IRS has achieved some success in this area. (See Justice Announces $456 Million Settlement with KPMG, Tax Notes Today, 2005 TNT 167-15, August 29, 2005). These basis shifting transactions are listed transactions for purposes of 6011, Requiring Disclosure by Taxpayers, and 6111 Requiring Tax Shelter Registration (Notice 2004-67, 2004-41 I.R.B. 1). The IRS recently withdrew Prop. Reg. 1.302-5 which would have required a dramatically different treatment for the basis of stock redeemed in a nonqualifying stock redemption (see Announcement 20019-30, 20019-19 I.R.B. 879 and the Tax in the News on page 19-7 in the text). Under the proposed regulation, shareholders would have recognized losses equal to the amount of the stock basis redeemed in a nonqualified redemption, and such loss would be
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deductible upon the happening of some future event (e.g., shareholders recognizing gain on a subsequent disposition of the corporations stock). The IRS will continue to seek alternatives to the current rule that allows the shifting of stock basis from one taxpayer to another taxpayer. Disproportionate Redemptions 44. Under 302(b)(2) stock redemptions must be substantially disproportionate. To be substantially disproportionate, the following stock ownership requirements must be met. a. b. c. d. Shareholder must own, after the distribution, less than 80% of the total interest owned in the corporation before the distribution, and Shareholder must own, after the distribution, less than 50% of the total combined voting power of all classes of stock entitled to vote. In determining stock ownership before and after a redemption, the constructive ownership rules of 318 apply. For an example of a disproportionate redemption using a bootstrap transaction, see Rev. Rul. 75-447, 1975-2 C.B. 113 (stock issuance to new shareholder followed by redemption of shares by the two original shareholders; two transactions part of integrated plan resulting in disproportionate redemption). ADDITIONAL LECTURE RESOURCE Voting stock requirement. A disproportionate redemption only applies to a redemption of voting stock or to a redemption of both voting stock and other stock (Reg. 1.302-3). A redemption of only voting preferred stock can qualify as a disproportionate redemption if the taxpayer owns (directly or indirectly) no common stock (Rev. Rul. 81-41, 1981-1 C.B. 121). Redemption of only nonvoting stock of one taxpayer can qualify as a disproportionate redemption if combined with the simultaneous redemption of voting stock of a related taxpayer. See, Rev. Rul. 77-237, 1977-2 C.B. 88, where a redemption of nonvoting preferred stock of father owning no common stock directly combined with redemption of voting common stock of son is disproportionate redemption for both taxpayers. Series-of-redemptions rule. Section 302(b)(2)(D) provides that a redemption will not qualify as disproportionate if it is made pursuant to a plan the purpose or effect of which is a series of redemptions that result in the aggregate in a distribution which does not satisfy the 80% and 50% tests (see Reg. 1.302-3(b), for an example). The determination of whether a plan exists is based on all the facts and circumstances. (Reg. 1.302-3) Although there is scant judicial guidance in the area, it appears that the series-of-redemptions rule will only apply when stock is redeemed from a shareholder who has knowledge of an impending redemption of another shareholders stock [See, Rev. Rul. 85-14, 1985-1 C.B. 93 (rule applied even though no agreement existed between the two shareholders regarding their redemptions); Ltr. Rul. 8316019 (rule does not apply to coincidental redemptions of two shareholders within close proximity of each other); and Ltr. Rul. 200441007 (rule does not apply to redemptions pursuant to
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corporations articles of incorporation and with no redeeming shareholder possessing knowledge of any other impending redemption)]. The series-of-redemptions rule does not apply to a redemption merely because a future redemption could be affected under a buy-sell agreement existing between the corporation and another shareholder. See Glacier State Electric Supply Co., 80 T.C. 1047 (1983), where an agreement requiring the redemption of another shareholders stock upon death was not sufficient for the rule to apply. The series-of-redemptions rule has been applied to two redemptions that were 15 months apart (Ltr. Rul. 8137023).
ETHICAL CONSIDERATIONS Convertible Preferred StockConversion or Redemption (page 19-26). Members of a board of directors serve in a fiduciary capacity on behalf of corporate shareholders. They are subject to good faith and fair dealing standards with respect to the investors in the corporations convertible preferred stock. Given the recently developed invention, a conversion of the preferred stock to common stock appears to be more favorable for the preferred shareholders than having their shares redeemed. A premium call price is typical of most callable preferred stock, and the presence of a premium on this preferred stock likely does not relieve the board of their fiduciary duties. The preferred shareholders should be informed of the new invention before any redemption transaction transpires. In addition, even though the stock of the corporation is not selling publicly, the corporation may be subject to the anti-fraud provisions of the Securities Acts for a small offering to members of the public. Nonetheless, the board of directors does not appear to have acted in an ethical manner. Complete Termination Redemptions 45. Section 302(b)(3) provides that a redemption will qualify for sale or exchange treatment if a shareholders interest is completely terminated. In satisfying the requirement, the constructive ownership rules of 318 generally apply. However, 302(c)(2)(A) provides that the family attribution rules do not apply if all of the following requirements are met. a. Former shareholder may not retain any interest in the corporation (including an interest as a director, officer, or employee) for at least 10 years. Being a creditor is not considered an interest for this purpose. Also stock acquired by bequest or inheritance is not prohibited. Former shareholders file an agreement to notify the IRS if a prohibited interest is acquired within the 10-year post redemption period.
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ADDITIONAL LECTURE RESOURCE Section 302(c)(2)(B) provides that 318(a)(1) family attribution rules are not be waived (despite the fact that requirements set out in item 13. above are met) if either of the following apply. Any part of the redeemed stock was acquired, directly or indirectly, within the previous 10 years by the distributee from a related person or Any related person owns stock at the time of the distribution and acquired the stock, directly or indirectly, from the distributee within the previous 10 years, unless the stock so acquired is also redeemed in the same transaction. However, a family attribution waiver is available if the stock transfer in the previous 10 years did not have as one of its principal purposes the avoidance of Federal income taxes.
Example. Paul owns 100% of the stock in Teal Corporation, which has E & P of $200,000. Paul transfers 40% of the stock to his son Seth. Teal redeems all of Seths stock 13 months later for $100,000. The redemption does not qualify as a complete termination of Seths stock because the family attribution rules apply. If the transfer of stock to Seth did not have as one of its principal purposes the avoidance of Federal income taxes, the family attribution waiver could apply, and the result would be a complete termination redemption. Example. Susan owns 100% of Plaid Corporations stock. Plaid has E & P of $300,000. Susan transfers 35% of the stock to her daughter Katrina. Plaid redeems all of Susans stock 15 months later for $150,000. The redemption does not qualify under as a complete termination of Susans stock because the family attribution rules apply. If the transfer of stock to Katrina did not have as one of its principal purposes Federal income tax avoidance, the family attribution waiver could apply, and the result would be a complete termination redemption. Redemptions to Pay Death Taxes 46. Under 303, a decedent shareholders estate receives sale or exchange treatment for a redemption when the stock represents a substantial amount of the gross estate. a. b. To the extent a redemption qualifies under 303, the qualifying stock redemption rules of 302(b) and the stock attribution rules of 318 need not be considered. Section 303 applies when a distribution is made with respect to the redemption of stock of a single corporation, the value of such stock being included in the gross estate of the decedent and in excess of 35% of the value of the adjusted gross estate of the decedent. In determining the 35% adjusted gross estate requirement, stock of two or more corporations is treated as the stock of a single corporation if 20% or more in value of the outstanding stock of each corporation is included in the decedents gross estate.
c.
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d.
Section 303 applies only to the extent of the sum of the death taxes imposed by reason of the decedents death plus the amount of funeral and administration expenses allowable as deductions to the estate. (1) If the redemption exceeds the amount allowed (i.e., total of death taxes and funeral and administration expenses), the 303 amount is still allowed. Only the excess runs the risk of dividend treatment. Section 302 may apply with respect to this excess, but the attribution rules (e.g., attribution from a beneficiary to an estate) may preclude a qualifying stock redemption. Waiving family attribution rules for estates under 302(c)(2) may assist in satisfying the complete termination redemption requirements.
(2) e.
Due to the stepped-up basis the stock receives under 1014, a redemption to pay death taxes generally results in little or no gain (or loss).
EFFECT ON THE CORPORATION REDEEMING ITS STOCK Recognition of Gain or Loss 47. Under 311(b), a distributing corporation recognize gain (but not loss) when distributing property other than cash to redeem its stock. An exception gain recognition requirement applies to regulated investment companies that are distributing appreciated property (e.g., appreciated portfolio securities) to shareholders who demand redemption of their stock [ 852(b)(6)]. See Ltr. Rul. 200509013 for application of this exception.
Effect on Earnings and Profits 48. Under 312(n)(7), E & P is reduced in a qualifying stock redemption by an amount not in excess of the ratable share of the E & P attributable to the stock redeemed.
Redemption Expenditures 49. Section 162(k)(1) disallows a deduction for expenditures incurred in connection with a stock redemption. ETHICAL CONSIDERATIONS Playing Games with the Statute of Limitations (page 19-30). Steve is courting disaster; he cant avoid the gain triggered by the basis reduction in 2000. An obscure set of Code provisions ( 1311-1314) serves to mitigate the effect of the statute of limitations. Based on the concept of equity, these provisions preclude both the IRS and taxpayers from taking current advantage of past errors, the correction of which is no longer possible. These provisions would permit the IRS to reopen tax year 2000 and assess against Steve the tax he would have paid had he properly reported the dividend income.
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On the other hand, if Steve stays with the basis reduction he originally made, he has not taken an inconsistent position. Therefore, 1311-1314 cannot be used by the IRS.