As will be seen in Chapter 5, where the major deviations between the corporate income tax and the individual income tax are discussed, the most vexing tax problems in the use of the corporation do not arise in determining its income tax liability. The principal difficulties arise, rather, because (1) distributed corporate income is taxed to the shareholder, while undistributed income is not; (2) an exchange of stock or securities by the investor may or may not be an appropriate occasion for recognizing gain or loss, and a sale may be a dividend in disguise; and (3) transactions between a corporation and its shareholders and affiliates often are not conducted at arm's length. The succeeding chapters of this book address in detail the ramifications of these problems, but a few words of introduction may be in order.But 2003 legislation lowering the top rate on dividends and capital gain to 15 percent effected a profound (albeit temporary) change in the corporate-shareholder relationship which resonates throughout this work.

10.1 A return to higher rates, however, seem increasingly likely.

¶ 1.03 Distributed Corporate IncomeAlthough the accumulated income of C corporations is not subjected to the individual income tax, the other face of this coin is that income distributed as dividends to shareholders of C corporations is taxable to them as ordinary income. This characteristic of the federal tax system—the so-called double taxation of distributed corporate income—must be addressed, since corporations exist to feed their shareholders. It can be illustrated by assuming a single tax rate of 30 percent applicable to both individual and corporate income, applied first at the corporate level to business income of $500,000, and then to the corporation's after-tax income of $350,000 ($500,000 less corporate income tax of $150,000) when distributed in the form of dividends to the shareholder. The result is an after-tax residual of $245,000 ($350,000 less individual tax of $105,000) for the shareholder, as compared with an after-tax amount of $350,000 had the same business been conducted as a proprietorship or partnership.This is not the place for an extended discussion of the equity and economic consequences of imposing independent taxes on the C corporation and its shareholders, but surely the real issue is not whether in legal form there are two separate entities. 22 For many closely held enterprises, which can choose between the C corporation and either the S corporation, the proprietorship, or the partnership as a form for doing business, the Code offers an election; some find it no more, or even less, expensive to follow the double tax route. For those that must use the C corporation for business reasons, the real issue is not the validity of the label “double taxation” but whether corporate earnings are overtaxed (or undertaxed) in relation to other types of income and, if they are overtaxed, whether there are compensating tax or other advantages to the C corporation form. These matters are further discussed later in this chapter. 23 Of course, some closely held enterprises avoid double taxation by an election under subchapter S, which subjects the corporation's earnings, whether or not distributed, to taxation only at the shareholder level. 24 Thus, the owners of the enterprise obtain the nontax advantages of operating in corporate form (such as limited liability) without subjecting the business profits to taxation at the corporate level. As noted previously, another common method of mitigating the potential burden of double taxation on distributed corporate income is the payment of salaries to shareholder-employees of C corporations. 25 Since the corporation can deduct these amounts as business expenses under §   162 , this portion of the business profits is taxed only at the shareholder-employee level. For many closely held businesses, salaries to shareholder-employees afford a method of withdrawing business profits in large part or even in their entirety, with the result that in these instances the federal income tax liability is about the same as it would be if the enterprise had been conducted as a proprietorship or partnership.Such an arrangement to avoid double taxation of distributed corporate income is feasible, however, only to the extent that the compensation paid to the shareholder-employee can be justified as “a reasonable allowance…for personal services actually rendered” so as to be deductible under §   162 ; if the amount is excessive, it can be disallowed as a corporate deduction pro tanto. 26 Although the possibility of disallowance is always present, especially if earnings fluctuate widely and shareholder salaries are adjusted from year to year to exhaust the earnings, many closely held corporations are able to pay out their entire business earnings, give or take a few dollars, year after year. Other methods by which shareholders may withdraw funds from the corporation in a form that will give rise to a deduction at the corporate level are:

1. Interest on shareholder loans to the corporation;

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2. Rent on property leased by the shareholders to the corporation; and3. Royalties on patents owned by the shareholders and used by the corporation under licenses.

As with salaries, however, these payments must be justified as bona fide arrangements rather than as disguised dividends. 27 Entrepreneurs also can avoid a second round of taxation by eschewing distributions of the corporate earnings until the stock can be exchanged for the stock of a publicly held corporation in a tax-free exchange 28 or, as discussed previously, by holding the stock of the original corporation until death, when it passes to the heirs with a new basis equal to the fair market value of the stock at that time. 29 Finally, to the extent that there is a substantial capital gains preference for individuals, as there is now and as there was before enactment of the Tax Reform Act of 1986, the double taxation of corporation income can be greatly curtailed, since the shareholders can convert the corporation's undistributed earnings into cash by selling their stock and reporting the profits as long-term capital gains. For example, if individuals were taxed on ordinary income and long-term capital gains at 30 percent and 10 percent, respectively, and the corporate rate was 30 percent, business profits of $100,000 would result in after-tax income of $70,000 ($100,000 less tax of $30,000) for the corporation; if the shareholders realized this net amount by selling their stock, the tax on their long-term capital gains would be $7,000 (10 percent of $70,000), leaving them with $63,000 ($70,000 less $7,000) net after taxes as compared with $49,000 ($70,000 less $21,000) if the business profits had been paid out as dividends. If the business had operated as a proprietorship or partnership, the individual would have netted $70,000. In practice, of course, such sales are not annual events even in years when a substantial capital gains preference exists. Instead, shareholders often allow the business profits to accumulate for years or even decades so that a sale of stock reflects a long-term accumulation, including the corporation's profits from reinvesting the retained earnings. The regime, under which double taxation was often preferable to a single tax because of the rate differential, ended when the 1986 Act eliminated (temporarily, it turned out) the substantial rate differential between ordinary income and long-term capital gains and imposed a top tax rate higher on corporations than on individuals; but it was partially reinstated when Congress returned to the historic practice of taxing long-term capital gains at a lower rate than ordinary income, and raised the individual income tax rate to a level above the corporate rate. The 1997 tax legislation added an even greater preference for long-term capital gain of individuals (nearly a twenty-point spread); and 1998 legislation reduced the period for long-term treatment from more than eighteen months to more than one year.Finally, 2003 legislation reduced the top rate on capital gain to 15 percent and, even more significantly, extended that treatment to dividends for individuals as well.

¶ 3.01 IntroductoryIn general, a corporation does not recognize either gain or loss upon issuing its stock. 1 As for a shareholder, absent an element of compensation or some similarly intended taxable benefit, the acquisition of stock for cash even at a bargain price similarly entails no immediate tax consequences: The shareholder has made an investment on which the gain or loss will be reckoned only when he sells or otherwise disposes of the stock or when, to his chagrin, the stock becomes worthless. 2 If, however, the stock purchaser (generally referred to in this chapter as the transferor, in reference to his transfer of cash or other property to the corporation) acquires the stock in exchange for appreciated or depreciated property rather than for money, he may have to recognize gain or loss on the transaction. The transfer is a “sale or other disposition” of the property within the meaning of §   1001(a) , upon which the transferor realizes gain or loss equal to the difference between the adjusted basis of the property given up and the value of the stock received in exchange, regardless of whether the transferee is an S corporation or a C corporation. By virtue of §   1001(c) , the transferor recognizes the entire amount of the realized gain or loss unless the transaction falls within one of the nonrecognition provisions of the Internal Revenue Code. 3

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Since corporations frequently issue stock for property other than cash, especially upon organization of a new corporation but also in reorganizations, the following nonrecognition provisions relating to such transactions are of great importance:

1. Section 351(a)—providing that the transferor shall recognize no gain or loss if property is transferred to a corporation solely in exchange for its stock, and if the transferor or transferors control the corporation immediately after the exchange. 4 2. Section 361(a)—providing that a corporation that is a party to a reorganization shall recognize no gain or loss if it transfers property to another corporation that is a party to the reorganization solely for the latter's stock or securities . 5

This chapter deals primarily with transfers under §   351 , which need not be solely for stock, as will be discussed further below. 6 This section of the Code is of particular importance when individual proprietorships and partnerships are incorporated. It also embraces the transfer of property to a previously organized corporation by its controlling shareholders. A transfer may qualify under both §   351(a) and §   361(a) (e.g., when a corporation creates a subsidiary by transferring part of its property for all the stock of the subsidiary and then distributes the subsidiary's stock as described in §   368(a)(1)(D) ). 7 Whether a transaction qualifies under §   351 is a question that may arise either at the time the transaction occurs or at some later date. When the property-for-stock exchange occurs, the applicability of §   351 is critical because it determines whether the transferor recognizes gain or loss on the transfer. The applicability of §   351 , however, may be put in issue later on, when the transferor sells the stock received for the transferred property or when an S corporation shareholder's deduction for passed-through losses is limited by his stock basis, 8 since in both cases, the stock's basis depends on whether the exchange in which it was acquired met the conditions of §   351 . If it did, the normal corollary of nonrecognition applies: The basis of the stock is the same as the basis of the property that was given up. 9 If, on the other hand, the exchange was not within §   351 (so that the transferor recognized gain or loss), the basis of the stock is its cost, 10 ordinarily the fair market value of the property given up. 11 The corporation's basis for the acquired property similarly depends, under §   362 , on whether the transfer met the requirements of §   351 . As a result, controversy over the application of §   351 to a given transaction may arise decades after the transaction occurred, when the stockholder ultimately disposes of the stock or when the transferee corporation disposes of the transferred property. 12 The basic premise of §   351 , like that of most other nonrecognition rules in the Code, is that the transaction does not “close” the transferor's investment with sufficient economic finality to justify reckoning up the transferor's gain or loss on the transferred property. 13 In Portland Oil Co. v. CIR, for example, the Court of Appeals for the First Circuit said: It is the purpose of [§   351 ] to save the taxpayer from an immediate recognition of a gain, or to intermit the claim of a loss, in certain transactions where gain or loss may have accrued in a constitutional sense, but where in a popular and economic sense there has been a mere change in the form of ownership and the taxpayer has not really “cashed in” on the theoretical gain, or closed out a losing venture. 14 The premise on which §   351 rests is in general sound, even though for most purposes the controlled corporation is treated as an entity separate from its shareholders. 15 In point of fact, however, the language of §   351 goes beyond its purpose and embraces some transfers that arguably ought to be treated as sales, because the taxpayer seems to have cashed in on the gain, either in whole or in part. 16 Thus, §   351 is not restricted to transfers by a single individual to a one-person corporation; it also embraces transfers by two or more persons to a corporation that those persons control collectively. Example If A owns a patent with a cost of $1,000 and a fair market value of $10,000 and B owns land with a cost of $20,000 and a value of $10,000, and if A and B transfer their property to a new corporation in exchange for the stock of the corporation (each taking half), §   351 applies to both transfers.It might be argued that this transfer is not merely a matter of form and that A's and B's economic positions have changed sufficiently so that A's gain ($9,000) and B's loss ($10,000) should be recognized. It has long been established, however, that §   351 embraces transfers of property by two or more persons who were not previously associated on the ground that “instead of the transaction having the effect of terminating or extinguishing the beneficial interests of the transferors in the transferred property, after the consummation of the transaction the transferors continue to be beneficially interested in the transferred property and have dominion over it by virtue of their control of the new corporate owner of it.” 17

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While in many cases the transferors of property to a controlled corporation “continue to be beneficially interested in the transferred property,” sometimes the transferor's interest is so attenuated that economically the transaction can hardly be regarded as a mere change of form. For example, if the owner of a corner grocery store transfers his assets to a newly organized corporation for 0.01 percent of the stock, and a national grocery chain simultaneously transfers assets in exchange for the other 99.99 percent of the corporation's stock, the national company certainly continues to be “beneficially interested in the transferred property.” This is hardly true, however, of the corner grocery store owner, who intends to forget his customer's complaints about his pork chops and plans instead to devote more time to reading the Wall Street Journal. Although his part of the transaction fits snugly within the letter of §   351 , the Service might seek to tax his gain, as it has successfully done in analogous transactions falling outside the spirit of the law. 18 Fortunately for the tax adviser, however, marginal cases of this type are relatively rare, and most transactions seeking to qualify for nonrecognition under §   351 are relatively straightforward.As for the details of §   351 , these are its major requirements:

1. One or more persons must transfer property to a corporation;2. The transfer must be solely in exchange for stock in such corporation; and3. The transferor or group of transferors must be “in control” of the corporation immediately after the exchange, as defined by §   368(c) .

If these requirements are met, (1) the transferor or transferors recognize neither gain nor loss on the exchange; (2) under §   362 , the transferee corporation takes over the transferor's basis for the property it receives; and (3) under §   358 , the transferor's basis for the stock received is the same as the transferor's basis for the property transferred. If the transaction fails the §   351 requirements only because the transferors receive other consideration (so-called boot) in addition to stock, the nonrecognition rule of §   351 still can apply in part. 19 These basic rules create an anomaly in subchapter C's two-tier tax regime, under which corporate income is ordinarily taxed first to the corporation and a second time to the corporation's shareholders when distributed to them—a double tax result that contrasts with the treatment of income realized by individuals, which is ordinarily taxed only to them. 20 Cutting across this distinction between corporate and individual income, §   351 alters the treatment of gains and losses on appreciated and depreciated property transferred by individuals to corporations, since after a §   351 transfer, the individual holds the stock and the corporation holds the property with the same basis that the property formerly had in the hands of the transferor. 21 Thus, if the individual sells the stock and the corporation sells the property, each has a gain (or loss); whereas but for the §   351 exchange, there would have been only a single gain or loss, which would have been recognized by the individual. In short, the cost of deferral under §   351 is that gain or loss accruing during the individual transferor's ownership is escalated from the one-tier tax treatment of individuals to the two-tier corporate regime. This is one of the features making life in the subchapter C lobster pot 22 confining, complicated, and costly, even though entry, thanks to §   351 , is usually simple and painless.

¶ 3.02 Transfer of Property

¶ 3.02[1] In General: Cash and the Transferee's StockSection 351 provides that no gain or loss shall be recognized if property is exchanged solely for stock of a controlled corporation. Except for the three specific exclusions found in §   351(d) (relating to services, certain debt of the corporation, and accrued interest owed by the corporation), the statute does not define the term “property,” 23 but the absence of a definition ordinarily has not been troublesome.It is clear that “property” includes money under §   351 , and for a compelling reason. 24 A newly organized corporation almost always needs cash for working capital. If §   351 did not include the transferors of cash in the control group—the group of transferors who must control the corporation immediately after the exchange 25 —the section would either lose much of its usefulness or invite evasion in the form of a transfer

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of cash in an allegedly independent transaction after the other assets had been transferred under §   351 . Moreover, if one of the transferors is a corporation (e.g., where a parent exchanges its newly issued or treasury stock for stock of a controlled subsidiary), its own stock seems to constitute property for purposes of §   351 . 26 The Service has ruled that when §   351 applies to such an exchange, each corporation holds the other corporation's stock with a zero basis. 27 A shareholder's own note to the corporation should be property for purposes of §   351 , but the Tax Court

has refused to count the shareholder's obligation for basis purposes. 28

¶ 3.02[2] Services and Assets Created by ServicesThe first of the three §   351(d) exclusions mentioned previously 29 is found in §   351(d)(1) . As interpreted by the regulations, §   351(d)(1) provides that stock issued for services rendered to or for the benefit of the issuing corporation is not considered issued for property. 30 The function of this restriction is to require the person providing the services to report currently (in most cases) the value of stock received as compensation for services, rather than reporting capital gain when and if he or she sells the stock. 31 An exchange of property for stock, however, is not automatically cast out of §   351 merely because the corporation also issues stock for services. Instead, the effect of §   351(d)(1) is that a person receiving stock in exchange for services cannot be counted in determining whether the transferors of property are in control of the transferee corporation immediately after the exchange. 32 If, however, they are in control, their exchange of property for stock qualifies under §   351 , even though the corporation at the same time issues stock for services to one or more other persons. 33 Moreover, if a person who transfers property in exchange for stock also receives, in the same transaction, additional stock in exchange for services, all of the stock received is counted in determining whether the group of property transferors has control of the corporation.

34 If, however, the property transferred by the service provider is of nominal value, serving merely to camouflage the true nature of the transaction, not even the stock actually received for property will count toward control. 35 Example If A and B transfer property to a newly organized corporation for 78 percent of the corporation's stock, and C, as part of the same transaction, receives 22 percent of the stock for services rendered to the corporation, the property transfer does not qualify under §   351 , because the transferors of property (A and B ) have less than 80 percent of the stock and hence do not have “control,” as defined by §   368(c) for purposes of §   351 . If, however, A and B received 80 percent or more of the stock and C received 20 percent or less, the property exchanges would qualify. Moreover, if A and B received 78 percent of the stock for property and C received 22 percent for a combination of services and property, the property transfers would qualify unless C's transfer of property was nominal in amount or was merely a sham designed to support a claim by A and B for nonrecognition of gain or loss, in which event none of the stock received by C would count toward control and §   351(a) would not apply to A, B, or C . The stock received by C for services would produce taxable income, however, with a possible exception for services that were merely ancillary to the §   351 property transfer. 36 Disqualification under §   351(d)(1) of stock issued for services assumes that the services were rendered to or for the benefit of the issuing corporation. 37 The transaction takes on another complexion if the services were performed for someone else, such as one of the transferors of property. The disqualification of services for purposes of §   351 probably does not apply to stock issued for property that was, in turn, earned by the transferor by performing services for others, 38 although the assignment of income doctrine might apply, with the effect of taxing the assignor. 39 In a more common transaction, an individual proprietor may incorporate his business, taking part of the stock himself and directing that the rest be issued to an employee as compensation for services performed in years past or to a relative as a gift. The regulations treat such a transaction as if (a) the corporation had issued all the stock to the proprietor in exchange for the assets of the business and (b) the proprietor had then used part of the stock to pay his debts or to make the gift. 40 The proprietor's transfer qualifies under §   351 if he retains at least 80 percent of the stock “immediately after” the exchange. If the corporation issues stock simultaneously to the proprietor in exchange for his property and to his employee or donee, it is likely that the existence of control will be tested by reference to the facts immediately after the stock is issued. Thus, if the proprietor gets less than 80 percent of the stock, the transfer will not qualify unless it can be established that issuing the rest of the stock to the employee or donee (who transfer no property) is not an integral part of the incorporation event. 41

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If the proprietor in such a case is regarded as paying his debt to the employee with stock, 42 the proprietor will recognize gain or loss on the difference between the amount of the debt and the adjusted basis of the stock. If §   351 applies to the transaction, the proprietor's stock basis will be his historic basis in the transferred property, and he may both recognize gain or loss on the stock transfer and be allowed a deduction for compensation paid. 43 It is possible that such a transaction might be structured (or characterized) as a nontaxable transfer of property by the proprietor in exchange for stock and an assumption of the proprietor's indebtedness to his employee by the corporation, followed by a payment of the debt by the corporation through issuance of the corporation's stock to the creditor. 44 In practice, of course, it may be difficult to determine whether a corporation issues stock for services performed in the past for one of the transferors, for services performed on behalf of the corporation incident to the corporation's organization, as an incentive (or reward) for the future performance of services for the corporation, or for some combination of these reasons. 45 US v. Frazell is a graphic example of this difficulty. 46 In that case, the taxpayer contracted to receive a contingent 13 percent interest in the income from oil properties owned by an oil partnership for performing geological services. Shortly before this interest was to vest in (and be recognized as compensation by) the taxpayer, the contract was terminated, the partnership's assets were transferred to a newly created corporation, and the taxpayer received 13 percent of the corporation's stock free of any contingency. The court held that the value of the stock measured the taxable compensation for the taxpayer's prior services to the partnership either (1) because a partnership interest of the same value vested as taxable compensation immediately before the §   351 transfer to the corporation or (2) because the taxpayer received the stock in lieu of the vesting of the partnership interest. The meaning of the second alternative is ambiguous because the court's citation of Regulations §   1.351-1(a)(2), Example (3) indicates that that alternative assumed that the stock was issued for services performed for the corporation. The decision did not press that point, however, and it seems that the court was motivated by the fact that the vesting (and, hence, normal recognition) of the compensation occurred simultaneously with the putative §   351 transaction. The second alternative might be explained by the view that the taxpayer was not a transferor of anything in the exchange, that the partnership transferred its assets for stock in the §   351 exchange, and that it then distributed stock to the taxpayer as vested taxable compensation. 47 The transfer of assets created by a transferor's personal efforts often involves two related tax issues: (1) whether a transaction should be characterized as a transfer of property owned by the transferor for stock or instead as a payment of stock for services in creating a corporate asset; and (2) if the former characterization is accepted, whether the transaction is an “exchange” within the meaning of §   351 . 48 Since §   351 was intended to permit the tax-free incorporation of going businesses, the courts generally have interpreted “property,” as used in §   351 , broadly to include such commonly encountered intangibles as legally protectible industrial know-how, trade names, professional goodwill, trade secrets, employment contracts, and so forth. 49 The Service has stated, in connection with transfers of know-how, that the transfer of protectible property interests will qualify unless “the information transferred has been developed specially for the transferee,” in which case the stock may be treated as received for services. 50 In granting rulings, the Service has been vigilant to guard against potential abuses, 51 and in appropriate cases the Service could rightly treat an alleged transfer of property as a device, in whole or in part, to compensate the transferor for past services or to convert an analogous income item whose sale would produce ordinary

income into a block of stock in order to qualify it as a capital asset upon sale.

¶ 3.02[3] Debt of the CorporationSometimes the holder of a corporation's debt obligations transfers the obligations to it in exchange for its stock. Although the obligations themselves qualify as property under §   351 , 52 the transferor must recognize any market discount accrued on the transferred debt. 53 If, however, the obligations are not evidenced by securities (e.g., open-account indebtedness), the debt does not qualify as property by virtue of §   351(d)(2) .

54 This exclusion evidently is intended to permit open-account creditors to claim an immediate bad-debt deduction even though they receive some of the debtor's stock. 55 Conversely, however, this provision could cause a transferor that had purchased a nonsecurity debt at a discount to realize and recognize gain on later exchanging it for stock of the debtor corporation with a value exceeding the transferor's adjusted basis for

the debt.

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¶ 3.02[4] Accrued InterestEven if a debt is evidenced by a security and can therefore qualify as property under §   351(d)(2) , any interest thereon is denied property status by §   351(d)(3) if it accrued on or after the transferor's holding period for the debt. Thus, a transfer for stock of debt evidenced by a security debt with accrued interest can result in nonrecognition treatment as to the principal plus the interest that accrued before the transferor acquired the debt, and recognition as to interest accrued thereafter. Since the transferor can recognize either gain or loss, it would seem that the stock received would be allocated pro rata to the two portions of debt to determine the amount recognized.As discussed later in this chapter, the courts have reached similar results in certain situations involving the midstream transfer of so-called income items in exchange for stock of a controlled corporation.

¶ 3.03 Exchange for Stock: Problems of Classification

¶ 3.03[1] “Exchange” RequirementBy referring to transfers of property in “exchange” for stock, §   351 arguably appears to incorporate the similar requirement of §   1222 that property must be transferred in a sale or exchange to qualify for capital gains treatment. 57 Disputes about whether the transfer qualifies as a sale or exchange (or should instead be classified as a “license” or other arrangement) have arisen most often in the case of assignments of intangibles (e.g., patents or technical information) to a controlled corporation, where the failure to assign all substantial rights in the property may cause the transaction to be treated as a license rather than an exchange. To avoid this treatment, the transfer must encompass the exclusive rights to the use, exploitation, and disposition of the property within a designated area for the foreseeable economic life of the property. 58 The government's view that the requirements for a §   351 exchange are as stringent in all respects as those for a capital gain, however, has not fared well in the courts. Thus, nonrecognition has sometimes been accorded to a transfer even though the transfer would not have been treated as a sale or exchange for capital gains purposes. 59 Treasury proposes to follow DuPont and allow a transfer of less than all rights to intangibles as a good §   351 transaction, but also would require basis to be allocated between the retained and transferred rights. 60 If the transaction extinguishes the transferor's property rights, it may not constitute a §   351(a) exchange but instead be merely a §   1001(a) disposition, so that gain on the transaction would be taxable currently as ordinary income. The government, however, failed in an attempt to apply this rationale to a stockholder-creditor's collection of a debt by accepting additional stock from the debtor corporation, and has acquiesced in the court's conclusion that the conversion of debt into stock can qualify as an exchange. 61 Although the term “exchange” usually implies a voluntary or consensual transaction, the Service has ruled that it embraces the mandatory exchange of stock under the laws of states that require the shareholders of a target corporation to accept an acquiring corporation's stock if enough of them vote in favor of the

takeover. 62

¶ 3.03[2] StockSection 351(a) permits the tax-free transfer of property to a controlled corporation only if the transfer is “solely in exchange for stock in such corporation.” This requirement is designed to ensure that the transferor will retain a continuing equity interest in the transferee corporation so as to justify nonrecognition of the gain or loss that is realized upon the exchange. In the absence of such a continuing interest, the transaction constitutes a sale, to which §   351 would not apply. 63 The regulations have long stated flatly that stock rights and stock warrants do not qualify as “stock.” 64 The inspiration for this statement may be Helvering v. Southwest Consol. Corp., holding that warrants are not “voting stock” within the meaning of §   368(a)(1)(B) , relating to corporate reorganizations. 65 Perhaps potential equity interests such as stock rights and warrants should not be taken into account in determining under §   351 whether the transferors of property are in control of the corporation immediately after the exchange; 66 but if the transferors do have control, there seems to be no good reason for disqualifying from §   351 a transfer of property in exchange for stock rights or warrants or for treating the rights or warrants as

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boot. A Tax Court case accepts this view with respect to nontradable contingent rights to receive additional stock. 67 While this position seems equally applicable to rights and warrants, the Service views tradable rights as beyond the pale. 68 The courts have held that a constructive stock issuance occurs for purposes of §   351 when a shareholder who owns all the stock of a corporation makes a contribution to the corporation's capital. This species of constructive “stock” is discussed below.

¶ 3.04 “Stock or Securities”: Prior LawBefore 1989, §   351 allowed persons transferring property to a controlled corporation to receive both stock and “securities” 70 tax-free, although the securities were not taken into account in determining whether the transferors had “control” of the transferee within the meaning of §   368(c) . 71 Congress withdrew this lenient treatment of securities in 1989 because it permitted a transfer of appreciated property to qualify for nonrecognition of gain even though it was tantamount, in whole or in part, to an installment sale (but did not meet the requirements of §   453 ) 72 and also because it was inconsistent with the rules governing corporate reorganizations and divisions, under which securities can be received tax-free only if the taxpayer surrenders an equal amount of the corporation's securities. 73 As a result of the 1989 disqualification of securities, they now constitute boot when issued in a §   351 exchange.Pre-1989 law is now old, but it is not yet cold: It continues to govern the basis of the stock and securities received by the transferor in pre-1989 transactions, as well as the basis of the property received by the controlled corporation. 74 Moreover, by treating securities received by the transferor as boot in a §   351 exchange, current law on occasion requires purported debt to be analyzed to see if it should be recharacterized as equity, 75 in which event it is tantamount to stock, not boot.

¶ 3.05 “Solely in Exchange”: The Receipt of “Boot”

¶ 3.05[1] Basic RuleSection 1001(c) provides that taxpayers must recognize all gain or loss realized on the sale or exchange of property, “except as otherwise provided.” Section 351(a) provides that no gain or loss shall be recognized if property is transferred to a controlled corporation “solely” in exchange for its stock. If the transferor receives not only stock (nonrecognition property) but also money or other property (“boot”) in the exchange, §   351(b) comes into play and requires that gain (but not loss) must be recognized to the extent of the fair market value of the boot, but not in excess of the amount of the transferor's realized gain under §   1001 . 76 Example If taxpayer A transfers property with an adjusted basis of $10,000 and a fair market value of $50,000 to a controlled corporation in exchange for stock worth $30,000, cash of $10,000, and other property with a fair market value of $10,000, A's “amount realized” under §   1001(b) is $50,000 and A's realized gain under §   1001(a) is $40,000, but only $20,000 of the gain is recognized under §   351(b) . The computation is as follows: 1. Amount realized under §   1001(b) : a. Stock $30,000 b. Cash (boot) 10,000 c. Other property (boot) 10,000 ------- d. Total $50,000

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2. Less: adjusted basis of property transferred 10,000 ------- 3. Gain realized under §   1001(a) $40,000 4. Gain recognized (line 1b plus line 1c, or line 3, whichever is less) $20,000

If the adjusted basis of the property (line 2) were $45,000 instead of $10,000, the gain realized would be only $5,000, and A would recognize this amount under §   351(b) . If the adjusted basis of the property were more than $50,000, there would be a realized loss under §   1001 but by virtue of §   351(b)(2) , A could not recognize the loss despite his receipt of boot. 77

¶ 3.05[2] Boot and Multiple PropertiesIf the property transferred in the previous example consisted of two assets (land and a building), each having an adjusted basis of $25,000, the building having a fair market value of $5,000 and the land having a fair market value of $45,000, there would be no realized gain if the adjusted bases of the two assets were combined on line 2. While neither the Code nor the regulations prohibit such an aggregation of basis, the Service has ruled that each asset should be considered separately.Proposed regulations issued in January 2009 codify the principles of this ruling. 77.1 Thus, there would be a realized gain of $20,000 on the land and a realized loss of $20,000 on the building. 78 The transferor would not recognize the realized loss by virtue of §   351(b)(2) , and the amount of the realized gain to be recognized under §   351(b)(1) would depend on the method used to allocate the stock, cash, and other property received between the land and building. If the consideration received is allocated to the assets in proportion to their relative fair market values (which the Service considers to be the right approach, and now so do proposed regulations). ), 79 the land accounts for nine tenths of the stock, cash, and other property, so that the $20,000 of realized gain on the land is recognized only to the extent of its share of the boot ($18,000), and the transferor receives $2,000 of boot tax-free.If the exchange agreement explicitly adopts its own method of allocating the consideration to be paid for the transferred property (e.g., assigning stock exclusively to the appreciated property and assigning the boot exclusively to assets on which there is no realized gain), is the agreed allocation controlling? In view of the non-arm's-length character of the average §   351 transaction, this does not seem to be a very promising gambit; but if the allocation serves a business purpose and is free of self-dealing because there are several independent transferors, perhaps it will pass muster. 80 Another possibility in this area is a tax-free §   351 exchange of the appreciated property and a separate sale or exchange of the depreciated property for the boot. If prearranged, however, the two transfers may be amalgamated for tax purposes under the step

transaction doctrine. 81

¶ 3.05[3] Timing and Character of Boot RecognitionAs noted earlier, the pre-1989 possibility that property transferors could receive the corporation's debt securities in a §   351 exchange for appreciated property and report their gain periodically as the debt was collected without qualifying under the installment-sale rules of §   453 was one of the reasons Congress removed securities from nonrecognition treatment under §   351(a) in 1989. 82 Therefore, it is likely that §   453(f)(6) now requires application of the installment-sale rules to any corporate debt received as boot. 83 When the transferor must recognize gain because it has received boot in a §   351(b) exchange, the character of the asset transferred usually determines (under the asset-by-asset approach discussed above) whether the gain is ordinary income or capital gain and, in the latter case, whether it is long-term or short-term gain. 84 If the property transferred qualified (or, in the hands of the transferee, will qualify) for depreciation, amortization, or certain other accelerated deductions, the capital gain component of the transferor's recognized profit may be converted, in whole or in part, into ordinary income by several recapture and similar remedial provisions. The most important of these provisions are as follows:

1. Section 1239—providing that gain recognized on the transfer of property to a corporation that it can depreciate must be treated as ordinary income if more than 50 percent of the value of the transferee corporation's stock is owned directly, indirectly, or constructively by the transferor (the same control test as for §   267(a) ). 85

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2. Section 1245—providing for the recapture of the transferor's post-1961 depreciation as ordinary income if the transferor recognizes gain on a §   351 transfer of certain types of property (other than real property). 86 3. Section 1250—providing for the recapture as ordinary income of post-1963 depreciation on similar transfers of real property, but in more limited circumstances.

The foregoing provisions come into play only if the transferor receives boot for the affected property, but it is also possible for various depreciation and business credit capture rules to be triggered by §   351

exchanges that do not include boot, as explained later in this chapter. 87

¶ 3.05[4] Debt-Like Preferred Stock as BootProposed legislation in the Administration's budget bill of 1995 88 classified certain “debt-like” preferred stock as “boot” for purposes of §§   351 and 356, thus resulting in taxable gain but no loss to the recipient of such stock. Preferred stock subject to boot classification treatment generally must be limited and preferred as to dividends, and “capped” on the upside (i.e., it has no significant participation in growth). 89 In addition, the stock must either be (1) mandatorily redeemable (by the issuer or a related party), (2) subject to a holder put to the issuer (or to a §   267(b) related affiliate), (3) subject to a call by the issuer (or a related party) that is more likely than not to be exercised, and (4) one that has a floating dividend rate (e.g., Dutch auction preferred).Several exceptions to boot treatment were provided for various recapitalization exchanges, 90 and regulation authority was granted to provide for §   453 treatment and for the consequences under other Code sections (e.g., §§   304 , 306, 318, and 368(c)). However, the 1997 version states that these regulations will be prospective only.Among the many unanswered questions spawned by this unfortunate foray into subchapter C are the following: (1) what impact, if any, will such stock have under §   1504(a) ; (2) will this stock count in determining §   368(c) control, or general continuity of interest limitations; (3) will it qualify for the §   243 dividends-received deduction; (4) how will the stock be treated under §   332 and §   337 ; (5) how will it be treated under §   338 ; (6) will it constitute boot for §   368(a) definitional purposes if it votes; and (7) who on earth ever thought of such a disruptive and unnecessary provision? The provision passed in 1997, and we are stuck with it, although the Conference Report makes clear that this boot-tainted stock is merely “equity boot” for gain recognition purposes under §   351(b) , and that its status as “stock” continues for all other purposes unless and until prospective regulations under §   351(g)(4) change its status as such. 91 The American Jobs Creation Act of 2004 (the 2004 Jobs Act) 91.1 narrowed the definition of “preferred stock” in §   351(g)(3)(A) by providing that preferred stock will not be treated as participating in corporate earnings and growth (and thus will be preferred stock) unless there is a real and meaningful likelihood of actually participating in earnings and growth. 91.2 On the whole, however, §   351(g) has proved to be a minor irritant at most (and a useful planning tool for those who want its provisions to be invoked).

¶ 3.06 Assumption of Liabilities

¶ 3.06[1] HistoryOn the sale or other disposition of property, the transferee's assumption of the transferor's liabilities (or the transferee's taking the property subject to liabilities) ordinarily requires the transferor to treat the amount of the liability as if it were cash received in the amount of the debt when computing gain or loss realized and recognized; 92 but in the income tax's early years, it was assumed that such a transaction would not require the transferor to recognize gain under §   351 or the analogous reorganization sections. In an important case involving a reorganization, US v. Hendler, however, the Supreme Court held that the assumption and payment by a transferee corporation of the transferor's liability constituted boot to the transferor, at least in some circumstances, under the reorganization provisions. 93 Immediately after winning this decision, the Treasury Department recognized that a host of earlier incorporations and reorganizations that were thought to be tax-free when consummated might, in fact, have

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been partially taxable because of the assumption of liabilities, since virtually all § 351 and reorganization exchanges of going businesses involve a shifting of responsibility for the enterprise's existing debt. If correction of pre-Hendler errors was barred by the statute of limitations and if the doctrine of estoppel did not apply, the transferors could step up the basis of the stock or securities received to market value (to reflect the gain that should have been, but was not, reported), and thereby reduce their gain (or increase their loss) on a subsequent sale of the stock or securities. Similarly, the corporation would be able to step up the basis of the property received to reflect the gain that the transferor should have reported, and thereby increase its depreciation deductions or reduce its gain (or increase its loss) on disposing of the property. Moreover, the immediate recognition of gain when liabilities were transferred in otherwise tax-free §   351 and reorganization exchanges would greatly impair the usefulness of these nonrecognition provisions.The upshot was that in 1939 the Treasury Department urged Congress to enact legislation that would relinquish the victory it had just won in the Hendler case by providing that the transferee corporation's assumption of liability (or its receipt of property subject to a liability) in a §   351 exchange would not constitute boot to the transferor. Congress responded with the statutory principles that are now embodied in

the general rule of §   357(a) and the exception of §   357(b) . 94

¶ 3.06[2] General RuleThe general rule of §   357(a) provides that the transferee corporation's assumption of liability or its acquisition of property subject to a liability is not treated as money or other property, and hence is not boot under §   351(b) . The transferor's gain, therefore, is recognized only if and to the extent that he receives money or other property in exchange for the transferred property. (The liabilities assumed or to which the property is subject are, however, taken into account in computing the amount of gain realized.) 95 The tradeoff for excluding the liabilities from the amount of boot received, as explained below, is a reduction of the basis of the stock received by the amount of the debt. Thus, under current law, the incorporation of encumbered property or of the assets and liabilities of a going business ordinarily qualifies as a tax-free transaction under §   351(a) , even though the corporation assumes or acquires property subject to liabilities. Example A transfers property with a basis of $40,000 and a gross value of $100,000 (but subject to a mortgage of $30,000) to controlled corporation X in exchange for stock worth $70,000 (the net value of the property) and X's assumption of the mortgage. A realizes gain of $60,000 (the value of the X stock plus assumption of A's debt, $100,000, less A's $40,000 basis for the property), but A's recognized gain is zero, since §   357(a) provides that the assumed liability is not boot under §   351(b) . A's basis for his stock, however, is $10,000, rather than $40,000, under §   358 (property basis of $40,000 less the assumed liability of $30,000), but X's basis for the property will be $40,000 under §   362(a)(1) , as it would have been without a debt assumption.

96 Thus, assuming no changes in value, A's realized gain of $60,000 will be taken into account when he disposes of the stock (with a fair market value of $70,000 but a basis of only $10,000) and the transferee corporation will similarly have a potential gain of $60,000, because the property has a basis in its hands of only $40,000 despite its gross fair market value of $100,000.The operation of §   357(a) required both a liability and an assumption of (or taking subject to) the debt. 97 Since §   357(a) is concerned primarily with reversing the earlier rule that the discharge of a debt discharged in an exchange is treated as cash received (which Hendler treated as taxable boot), it is clear that any debt covered by that rule would be covered by §   357(a) . This includes nonrecourse debt secured by transferred property, recourse debt secured by transferred property if the transferee agrees to pay (whether or not the transferor is released), and unsecured recourse debt that the transferee agrees to pay (whether or not the transferor is released). 98 The general rule of §   357(a) also includes recourse debt that the corporation does not formally assume, unless the transferor remains liable to pay that debt (as between the transferor and the corporation) and the transferee pays the fair unencumbered market value to the transferor for the property.

99 Section 357 covers liabilities that are assumed by the transferee corporation even if the transferor is not thereby discharged; but if he is, he does not recognize discharge-of-indebtedness income, 100 even if he is the former debtor. Indeed, since the Hendler case itself involved a prompt (and no doubt prearranged) payment of the assumed liabilities by the transferee corporation, §   357(a) ought to be construed to cover such situations as well as a discharge of the liability that is simultaneous with the exchange.Moreover, if the transferor's liability is not discharged by payment or novation at the time of the exchange, and the transferor remains liable (ordinarily, in the capacity of a surety), a later payment of the debt by the

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transferee ought not to be treated as taxable income to the transferor. 101 Otherwise, the utility of §   357 would be undermined, and many incorporation transfers would become partially taxable, thus frustrating the purpose that prompted Congress to overrule the Hendler decision by enacting §   357 . The statutory language leaves something to be desired in the way of clarity, but the courts have been chary about reopening an area that Congress attempted to put to rest. 102 If, however, the corporation later pays a debt of a transferor that the corporation did not assume or that was not secured by property transferred to the corporation, such payment is likely to be treated as a potentially taxable distribution to the transferor-shareholder. 103 The Treasury's fiscal 1999 budget proposals would “clarify” §   357 by eliminating the distinction between “assumption of” and taking “subject to” liabilities under §   357 ; instead the extent to which a liability would be treated as assumed for §   357 purposes would be a question of fact. 104 Versions of this legislation passed one house of Congress several times in 1998, but never at the same time. The legislation finally passed in 1999. 105 But proposed regulations issued in March 2005 105.1 provide that stock will not be treated as issued for property under §   351 if either (1) the value of the transferred property does not exceed liabilities assumed in the transaction, or (2) the value of the transferee's assets does not exceed the amount of its liabilities

immediately after the transaction (i.e., there is not an exchange of net value). 105.2

¶ 3.06[3] Exception for Tax-Avoidance Transactions: § 357(b)Although the principle of §   357(a) makes good sense as a general rule, it might tempt the transferor of appreciated property under §   351 to borrow against the property just before the exchange, with the intention of keeping the borrowed funds and causing the corporation either to assume the liability or to take the property subject to the liability. For the transferor, this chain of events could be the equivalent of receiving cash boot from the corporation in exchange for unencumbered property; but if the general rule of §   357(a) were applicable, the corporation's assumption of the liability or acquisition of the property subject to the liability would not be treated as boot.To frustrate bailout transactions of this type, §   357(b) carves out an exception to the general rule of §   357(a) : The assumption or acquisition is to be treated as money received by the transferor (i.e., as boot under §   351(b) ) if, “taking into consideration the nature of the liability and the circumstances in the light of which the arrangement for the assumption or acquisition was made, it appears that the principal purpose of the taxpayer…was a purpose to avoid Federal income tax on the exchange, or…if not such purpose, was not a bona fide business purpose.” Section 357(b)(1) goes on to provide that if an improper purpose exists with respect to any liability, the total amount of all liabilities involved in the exchange is considered money received by the taxpayer; the regulations emphasize the point that a single bad apple spoils the entire barrel. 106 Moreover, when the taxpayer has the burden of proof, as in most Tax Court proceedings, 107 he or she must negate both taints (tax avoidance purpose and a lack of a bona fide business purpose) by “the clear preponderance of the evidence.” 108 Although §   357(b) focuses on the transferor's principal purpose, the regulations provide that the income tax returns of both the transferor and the corporation for the year of the exchange must state “the corporate business reason” for the assumption of any liability (emphasis added).

109 In practice, the courts examine both the transferor's purpose for incurring the liability (particularly if the debt was incurred shortly before the assumption) and the business justification for the corporation's assumption. 110 The tax-avoidance approach of §   357(b) probably would condemn not only the hypothetical case of a liability created just before the §   351 exchange in order to wring some cash out of the transaction, but also the assumption by a transferee corporation of personal obligations (grocery bills, rent, alimony, and so forth) that are not ordinarily taken over in a §   351 exchange, unless there was a bona fide business purpose for such unusual action. On the other hand, the general rule of §   357(a) , rather than the exception of §   357(b) , ordinarily should be applicable to mortgages, trade obligations, bank loans, customers' deposits, and the like arising in the ordinary course of business; and this should be true even though the transferor, at the time of the §   351 exchange, is able to pay such obligations himself but chooses instead to have the transferee corporation assume, or take property subject to, the obligations. 111 Moreover, even borrowing on the eve of a transfer under §   351 is not necessarily fatal, since the taxpayer may be able to establish valid business reasons for doing so. 112

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The Treasury's 1999 revenue-raising proposals would tighten the anti-abuse rule of §   357(b) in two ways: (1) They would delete the requirement that the tax avoidance test applies only to the §   351 exchange transaction and (2) they would change the principal purpose to a principal purpose standard. 113 As discussed below, if §   357(b) applies, the basis of the stock received is increased by the amount of gain recognized under §   358(a)(1)(B)(ii) , while the stock basis is decreased by the total amount of the debt

under §   358(d) . 114

¶ 3.06[4] Exception for Liabilities in Excess of Basis: § 357(c)

¶ 3.06[4][a] In GeneralFrom the government's viewpoint, §   357(b) is unsatisfactory because it does not result in self-assessment but operates only through audit detection of a purpose to avoid tax and assessment of additional taxes. Recognizing this limitation, Congress crafted a more objective measure, §   357(c) , which applies by self-assessment (although §   357(b) can trump it) where the aggregate debt assumed, or to which the transferred property is subject, exceeds the transferor's aggregate basis for the property transferred. The excess amount is treated as recognized gain from the sale or exchange of the property. 115 This exception to §   357(a) 's immunization of liabilities from the recognition of gain or loss has two principal aims: (1) to recapture the tax benefit that was enjoyed by the transferor through writing off the basis of the property faster than the purchase-money debt that created the initial basis was reduced, or (2) to tax part of the withdrawal of borrowed cash obtained from loans secured by the assets transferred. Section 357(c)(1) requires an accounting when liabilities exceed the basis of the transferred property because the owner has “cashed out” his investment pro tanto, at least in the case of nonrecourse debts; 116 no matter how low the property's value may sink in the future, he is already home free to the extent of the excess. This gain is recognized by §   357(c) not because the §   351 exchange itself improves the transferor's economic position (the profit has already accrued; indeed, the exchange worsens his position by cutting off his opportunity to profit if the property grows in value, except as this may be reflected indirectly in the value of the stock received), but because the exchange is a convenient time for a reckoning. 117 It is the Service's last clear chance, so to speak, to treat the excess debt as income. Example A exchanges property with an adjusted basis of $10,000 and a fair market value of $70,000 subject to a mortgage liability of $30,000 for stock of a controlled corporation worth $40,000 and the transferee's assumption of the mortgage. A realizes gain under §   1001(a) of $60,000 (the value of the stock received plus the liability assumed, less the property's basis) but does not recognize that gain, because of §   357(a) . Under §   357(c) , however, A must recognize gain in the amount of $20,000. This is the amount of A's economic gain if the stock received is ignored as merely being the property in a different form. A will recognize the balance of his realized gain ($40,000) if he sells the stock for its market value ($40,000), since the basis of the stock will have been reduced to zero under §   358(d) to take account of the liability assumed by the corporate transferee.Although the example just used to illustrate §   357(c) involves a realized gain to the transferor on the §   351 exchange, A is taxed on the excess of liabilities over basis regardless of the amount of gain realized and even if none is realized. Thus, A would recognize $20,000 gain on the transaction above even if the value of the transferred property were only $25,000 (i.e., $5,000 less than the mortgage) and no stock was received in the transaction. 118 A might complain about this result if there is a substantial likelihood of default by the corporation, but the mandate of §   357(c) is clear. 119 As exceptions to §§   357(a) ,   357(b) , and 357(c) both require the transferor in a §   351 exchange to take liabilities into account in computing gain, but they are fundamentally different in two respects: (1) §   357(b) requires a judgment about the transferor's motives (with respect to both tax avoidance and business purpose), while §   357(c) rests on an arithmetical computation (an excess of liabilities over basis); and (2) §   357(b) applies only if and to the extent that the transferor realized gain, while §   357(c) can apply whether the transferor realizes gain or loss. 120 In some circumstances, however, an exchange can fit within both provisions; when this occurs, §   357(b) , which takes precedence by virtue of §   357(c)(2)(A) , necessarily produces at least as much, and usually more, income than §   357(c) . This is true because, if the liabilities exceed the transferor's basis for the transferred assets, as required for §   357(c) to apply, then the liabilities

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plus the value of the stock (and of the boot, if any) must exceed the basis by an even larger amount; and this means that the transferor has realized a gain, which must be recognized if the transaction has a tax avoidance element as required by §   357(b) . 121 Treasury proposed to amend §   357(c) to eliminate the distinction between an “assumption” and “taking subject to” liabilities (including nonrecourse liabilities)—instead, the extent to which liabilities will be treated as assumed for tax purposes would be a question of fact—and Congress finally accepted this

proposal in 1999 legislation. 122

¶ 3.06[4][b] Reducing Excess of Liabilities Over BasisTransferors holding property subject to liabilities in excess of basis can avoid recognizing income under §   357(c) by reducing or paying off the excess liabilities before entering into a §   351 exchange; or by getting the creditors to agree to look for payment solely to them personally or to property that is not to be transferred. 123 If these tactics are not feasible, a much discussed alternative is a promissory note given by the transferor to the transferee corporation: the hope is that the note will eliminate the excess of liabilities over basis on the theory that it has a basis equal to its face amount, thus increasing the transferor's aggregate basis enough to equal the liabilities assumed or to which the property is subject. 124 From a financial point of view, the note—assuming it's bona fides—has about the same effect as a note given by the transferor to a bank or other third party before the §   351 exchange to raise cash to reduce the liabilities to which the transferred property will be subject. To be sure, if this analogy is accepted, §   357(c) would lose its potency; but this would not compromise its function, because the note in fact eliminates the benefit that the transferor gets from transferring property subject to liabilities in excess of basis—the very same protective job assigned to §   357(c) . 125 It is arguable, in short, that the plan does not undermine §   357(c) any more than a tax on the manufacture of assault weapons is undermined when a manufacturer shifts to the production of non-assault weapons. 126 The Service, however, has rejected the transferor-note route around §   357(c) , on the ground that a note has a zero basis in the debtor's hands, so that the excess of the liabilities over the debtor-transferor's basis for the transferred property is not diminished by his note. 127 Looking more to the function of §   357(c) than to its language, however, the Court of Appeals for the Second Circuit ruled in Lessinger v. CIR (1989) that the transferee, by subjecting itself to the transferor's liabilities, acquires a basis in the transferor's note equal to its face amount, and that this basis serves to eliminate the excess of liabilities over basis that would have existed had the note not been issued by the transferor. Otherwise, the court observed, the transferor would be taxed on “a truly phantom gain.” 128 It remains to be seen whether this construction of §   357(c) will gain acceptance outside the Second Circuit's territory. Although the decision obviously puts a strain on the language of §   357(c) , it is not the first time that the meaning of “basis” has been stretched in a good cause: we routinely treat cash as having a “basis” equal to its face amount, although the phrase “the basis of property shall be the cost of such property” as used by §   1012 is an odd way of describing the acquisition of money, except for a tourist's purchase of local currency in a foreign land; and it is also curious that you get a “cost” basis if you borrow money from a friend, but not if you borrow his car. In the same vein, “cost” is an odd—but long-sanctioned—phrase when applied to property acquired in a myriad of offbeat ways—including theft—on the theory that its “cost” is its “tax cost,” when the latter phrase merely means that the property is includible in gross income, not that the owner actually paid any tax on acquiring it. 129 Section 357(c) can be avoided by a transfer of enough cash to eliminate any excess of liabilities over basis; and since a note given by a solvent obligor in purchasing property is routinely treated as the equivalent of cash in determining the basis of the property, it seems reasonable to give it the same treatment in determining the basis of the property transferred in a

§   351 exchange.

¶ 3.06[4][c] Deductible Liabilities of Cash Basis TaxpayersLiabilities of a cash basis transferor that will be deductible when paid are exempted by §   357(c)(3) from the liabilities-in-excess-of-basis principle of §   357(c) . 130 Before the enactment of this exemption in 1978, §   357(c) could be an unexpected pitfall for cash-method taxpayers who transferred zero basis receivables for stock and an assumption of the transferor's accounts payable (such as rent), since §   357(c) , if applied literally, produced taxable ordinary income to the extent that the assumed liabilities exceeded the zero basis of the transferred receivables. 131 Under current law, by contrast, the corporation takes a carryover zero

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basis in such receivables under §   362(a) , 132 the assumption of the payables is ignored for purposes of §   357(c) , and the transferor's stock basis is not increased because of the receivables or decreased under §   358(d)(2) because of the assumption of the payables. 133 Therefore, the transferor's entire potential gain is deferred, and the net income from the collection of the receivables is shifted to the corporation, as discussed later in this chapter. 134 The §   357(c)(3) exemption is denied, however, to liabilities that resulted in the creation of (or increase in) the basis of any property. For example, if a cash-basis taxpayer purchased small tools on credit and transferred them along with liability for the related account payable under §   351 , §   357(c)(1) applies; otherwise the liability would be disregarded under §   357(c)(3) and the transferor's temporary basis in the tools could be used to shelter other liabilities transferred in the §   351 exchange. 135 While cash-basis taxpayers are the prime beneficiaries of §   357(c)(3)(A) , it could also cover the liabilities of an accrual-basis taxpayer that (1) are not presently accruable under the all-events test because contingent

or contested, or (2) are delayed under economic performance occurs under §   461(h) . 136

¶ 3.06[4][d] Character of § 357(c) GainWhen §   357(c)(1) applies to an excess of liabilities over basis, the excess is “considered as a gain” from the sale or exchange of a capital asset or a non-capital asset, “as the case may be.” The term “considered” recognizes that the excess is taxable even if the transferor did not realize gain from the exchange in the sense used by §   1001 ; and by using the term “as the case may be,” §   357(a)(1) leaves the classification of the “gain” to other provisions of the Code. 137 If more than one type of property is transferred, the recognized gain should be allocated among the various classes of assets in proportion to their relative fair market values. 138 Gain recognized by virtue of §   357(c) , therefore, must be reported as ordinary income, long-term capital gain, or short-term capital gain according to the nature and the holding period of the

transferred property.

¶ 3.06[4][e] Computation of Amount of § 357(c) GainIn determining whether §   357(c) is applicable, the aggregate amount of the liabilities is compared with the aggregate adjusted basis of the assets transferred. 139 Example If, in the previous example, 140 A had transferred not only property with a basis of $10,000 subject to a mortgage of $30,000 but also unencumbered property with a basis of $10,000, the gain to be reported would be only $10,000 (liability of $30,000 less aggregate basis of $20,000). 141 Although at first it may seem strange that A can reduce his gain by transferring other property along with the mortgaged property, the theory underlying §   357(c) 's use of the total basis of all property transferred in measuring A's gain may be that the properties transferred constitute a single investment of $20,000 from which A 's total return so far amounts to $30,000.If there are two or more transferors, it seems appropriate to apply §   357(c) on a person-by-person basis, as the Service has ruled, rather than to aggregate the property transferred by all transferors. 142 Recent legislation eliminates the distinction between an “assumption” of liabilities and taking “subject to” liabilities under §   357(c) ; instead, the extent to which a liability would be treated as assumed for tax

purposes will be determined under all the facts and circumstances. 143

¶ 3.06[4][f] New § 357(d)In addition to abolishing the distinction between assumption of liabilities and taking property subject to liabilities, the 1999 amendments to §   357 144 adds §§   357(d) and 362(d) clarifying the effect of liability assumptions under §§   357 , 358(d), 362, and 368. Under new §   357(d)(1) , recourse liabilities would be treated as assumed under §   357 only if the transferee agrees to, and is expected to, satisfy them (whether or not the transferor is released from liability); nonrecourse liabilities are treated as assumed by the transferee of any asset subject thereto, but §   357(d)(2) reduces such amount by the lesser of liabilities attributable to assets not transferred that are also subject to that liability and which the owner of those assets has agreed with the transferee to, and is expected to, satisfy, or by the value of those assets (without regard to §   7701(g) ). 145

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IRS has announced an ambitious regulations project to clarify various issues under §§   357(d) and 362(d)

(and other related provisions as well) which has all the earmarks of a major undertaking. 145.1

¶ 3.06[5] Effect of Default by Transferee CorporationThe special rules of §§   357(b) and (c), as well as the general rule of §   357(a) , compute the transferor's gain on a §   351 exchange on the assumption that the liabilities assumed or to which the transferred property is subject will be paid by the transferee in the normal course of events. If, however, the transferee defaults and the transferor must pay off the liabilities, the outlay should either be deducted as a loss from a bad debt (the defaulting transferee's failure to indemnify the transferor) or treated as a contribution to the transferee's capital and added to the transferor's basis for the stock received in the exchange. 146 If the stock has been sold by the transferor before he is called upon to pay the debt, his loss on payment probably would be treated as a capital loss, at least if the sale of stock was treated as a capital gain or loss transaction. 147

¶ 3.06[6] Overlap Between §§ 351 and 304In a leveraged buyout or similar acquisition of the stock of a corporation from its shareholders, the acquirer often borrows to purchase the stock and then shifts the liability for the debt to another corporation in a §   351 transaction (e.g., by transferring the target company's stock, subject to the debt, to a new holding company). Although this transfer could be viewed as a brother-sister redemption of the target's stock by the new holding company under §   304 (which in turn would bring §   301 into force and create dividend income to the extent of the target company's earnings and profits), this calamitous result is prevented by §   304(b) (3)(B), which provides that §   351 controls when it overlaps with §   304 . 148 The exchange does not trigger gain under §   357(b) or (c), because no gain is realized and the purchase-money debt does not exceed the

basis of the stock transferred.

¶ 3.06[7] Contingent LiabilitiesLiabilities assumed can be so contingent and speculative as to be excluded from the cost basis of property acquired. 149 Similarly, it would seem that if property is transferred under §   351 subject to indeterminent liabilities of this type, or if they are assumed by the transferee, the transferor should not be required to take them into account in determining whether gain is realized and recognized under §   357(b) or §   357(c) at the time of the exchange. If, however, the liabilities are actually paid or ripen into fixed obligations at a later date, the following questions arise: 150

1. Is the transferor still protected by §   357(a) ?2. If the assumption of the liabilities was for tax-avoidance purposes, does §   357(b) apply?3. If the liabilities exceed the transferor's basis in the transferred property, does §   357(c) apply?4. Is the transferor's basis in the stock received reduced under §   358(d) ? 151 5. If the transferor belatedly recognizes gain, can the transferee belatedly increase the basis of property under §   362(a) ? 152 6. If the transferor recognizes income, can he take an offsetting deduction?7. Can the transferee deduct the payment? 153

While there is little in the way of directly applicable law on the subject, it seems that §   357(a) should continue to protect the transferor if the actions that created the transferor's legal liability occurred before the §   351 transfer and if the liability was assumed in the §   351 exchange or the property transferred in the exchange was subject to it. Likewise, it seems that §§   357(b) and 357(c) could have a delayed effect when the liability becomes fixed, under the “open transaction” approach. 154 In such cases, if the transferor subsequently is required to recognize gain, the transferor's stock basis, and the transferee's property basis, should be increased in like amount, subject to the possible application of §   357(c)(3) . 155 If the shareholder has disposed of his stock before the liability ripens into a taxable event, any later gains from that event should be characterized as capital gain or ordinary gain, as the case may be, under the Arrowsmith principle, 156 and the same should be true upon a disposition by the corporation of the property transferred to the corporation. Some of the questions in this area were answered, at least from the Service's point of view, by a 1995 ruling holding that (1) contingent liabilities of an accrual basis parent assumed by its accrual basis subsidiary were covered by the exception in §   357(c)(3)(A) , (2) that no stock basis adjustment was required under §   358(d)(2) , and (3) the subsidiary stepped into the parent's shoes as to later deductibility or

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capitalization of the liability when paid or accruable. 157 But a Treasury proposal introduced in February 1999, however, would require stock basis reduction if a deduction generating liability is treated as boot under tightened §   357(b) amendments. 158 A modified version of this proposal, §   358(h) , finally passed on December 21, 2000. 158.1 IRS has proposed guidelines and procedures for settling §   351 contingent liability shelter cases. 158.2 Moreover, IRS has announced a major regulation project dealing with liabilities, 158.3 and has also issued proposed regulations under §   358(h) on June 24, 2003, which were adopted as temporary regulations in May of 2005, 158.4 and as final regulations on May 8, 2008.

¶ 3.07 Control: The 80 Percent Rule

¶ 3.07[1] In GeneralSection 351 applies only if the transferor or transferors of property are “in control” of the corporation, as defined in §   368(c) , immediately after the exchange. 159 The requisite control need not be acquired through the exchange itself, however; §   351 embraces transfers of property to a corporation already controlled by the transferor, as well as transfers to newly organized corporations. 160 Section 368(c) defines the term “control” to mean the ownership of at least 80 percent of (1) the total combined voting power of all classes of stock entitled to vote, and (2) the total number of shares of all other classes of stock of the corporation. For this purpose, ownership must be direct, and not by attribution, 161 although a consolidated return group's

ownership of the transferee's stock is aggregated. 162

¶ 3.07[2] Voting Stock and Voting PowerIn many cases, the control requirement of §   368(c) presents no problems of interpretation, either because the corporation issues only one class of stock or because the transferors receive all stock of all classes. This is fortunate because there are few guides to the meaning of “total combined voting power” or “stock entitled to vote.” The voting to which §   368(c) refers has been held to mean the power to vote for directors;

163 if it were expanded to include stock that can vote on such extraordinary events as charter amendments and sales of assets, §   368(c) would encompass almost all stock (leaving little if any room for “other classes” of stock), since virtually all states vest the power to vote on such proposals in all classes of stock, at least when the proposed action will affect their interests. As to stock with contingent voting rights, such as preferred stock that may vote for directors if dividends are passed for a stated period, regulations under the stock redemption rules of §   302 state that such stock is generally not voting stock until the specified event occurs, 164 but the automatic transfer of definitions from other parts of the Code can be perilous.Once the stock entitled to vote has been identified and segregated, it is necessary to determine whether the transferors of property own 80 percent or more of the total combined voting power. This, presumably, requires a realistic weighting of the stock's right to vote for directors if the shares are not fungible as regards their power to vote, so that ownership of less than 80 percent of the total market value or of the total number of shares may qualify. It is usually assumed that the computation of total combined voting power does not take account of shareholders' voting agreements or similar arrangements even though such arrangements may alter the balance of power; but the question is not foreclosed by case law or rulings. 165

¶ 3.07[3] Other Classes of StockIf the corporation has nonvoting stock outstanding, the transferors must own at least 80 percent of the total number of such shares in order to qualify under §   351 . Although §   368(c) appears to lump all nonvoting shares together regardless of class or privileges, the Service has ruled that “80 percent of the total number of shares of all other classes of stock,” as used in §   368(c) , means 80 percent of the total number of shares

of each class of stock. 166

¶ 3.07[4] Revision of § 368(c) Control Test

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The Treasury's 1999 revenue proposals would conform the §   368(c) control test to the “affiliated group” definition of §   1504(a)(2) —that is, control would require 80 percent of the vote and value (disregarding §   1504(a)(4) preferred stock for this purpose). 167 Other sections in subchapter C previously have conformed their control tests to the §   1504(a) standard (e.g., §§   332 and 338). 168 This proposal apparently was inspired by several widely publicized transactions using multiple classes of voting stock with disparate values; 169 since all voting stock is aggregated and treated as one class of stock for purposes of §   368(c) , the transaction satisfied the control test for purposes of the applicable nonrecognition provision despite the divergence of values between the classes of voting stock. Such results would no longer be possible if the Treasury's conformity rule is adopted.

¶ 3.08 Two or More Transferors

¶ 3.08[1] Control GroupAs the language of §   351 explicitly recognizes, there is sometimes more than one transferor of property. In such cases, the entire transaction qualifies as tax-free under §   351 if the transferors as a group are in control of the corporation immediately after the exchange. 171 To be included in the group of shareholders whose stock ownership is measured against the 80 percent requirements (the “control group”), each transferor must transfer property, 172 receive only stock in the exchange (or stock plus boot), 173 and own the stock “immediately after” the exchange 174 —all as part of an integrated transaction between the corporation and the other transferors of property.In applying the 80 percent tests, stock previously owned by a member of the control group is added to the stock received by them in exchange for the transferred property, unless the stock received by the preexisting shareholder for his currently transferred property is “of relatively small value in comparison to the value of the stock…already owned…” and if the primary purpose of the transfer is to enable the remaining transfers to qualify under §   351 . 175 In these “accommodation transferor” cases, the remaining transferors of property must satisfy §   368(c) , if they can, on the strength of their own stock ownership.

¶ 3.08[2] Disproportionate ExchangesWhen there are two or more transferors, each one ordinarily receives, as a result of arm's-length bargaining, stock and boot with a fair market value equal to the property transferred. Although discrepancies between the two values do not render §   351 inapplicable to the transaction as a whole, 176 they may have side effects, as explained by the regulations: [I]n appropriate cases the transaction may be treated as if the stock…had first been received in proportion [to the value of the property transferred] and then some of such stock had been used to make gifts [subject to gift tax under §   2501 ], to pay compensation [taxable as income under §   61(a)(1) ], or to satisfy obligations of the transferor of any kind. 177 In addition to these tax consequences, the transferor may have to recognize gain or loss on his constructive disposition of appreciated stock and may be entitled to a business expense deduction under §   162(a) . 178 A realignment of the transaction also may affect the computation of control, since the transferors of property may be treated as constructively owning, immediately after the exchange, more shares than are actually issued to them, at least if their use of shares to make gifts, pay compensation, and so forth is not an integral step in the entire transaction. 179

¶ 3.09 Control “Immediately After the Exchange”Section 351 requires the transferors of property to be in control of the corporation “immediately after the exchange.” The regulations say of this requirement:

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The phrase “immediately after the exchange” does not necessarily require simultaneous exchanges by two or more persons, but comprehends a situation where the rights of the parties have been previously defined and the execution of the agreement proceeds with an expedition consistent with orderly procedure. 180 Under this interpretation, the stockholdings of two or more transferors can be aggregated in determining whether the transferors control the corporation immediately after the exchange if their transfers are part of a single transaction, the §   351(a) “exchange.” Thus, if A owns all 100 shares of the stock of a corporation, and if the corporation is to be expanded under an integrated plan by issuing 200 shares to B for property and 200 shares to C for other property, B and C will be in control of the corporation immediately after the exchange (by virtue of owning 400 out of 500 shares, or 80 percent), even if B's exchange is not simultaneous with C's.Post-exchange transfers of stock can make or break control, depending on whether they are taken into account under the principles discussed below. For example, if A performs services for a newly organized corporation for 25 percent of its stock and transfers 10 percent to B, who transferred property for the remaining 75 percent, the exchange meets the control requirement of §   351 if the A-B transfer is taken into account, but not otherwise. Conversely, if X transfers property for 85 percent of the stock, of which he transfers one-half to Y, who received the other 15 percent for services, X has control if the X-Y transfer is

disregarded, but not otherwise.

¶ 3.09[1] Retransfers Within the Control GroupIf as an integrated part of a §   351 exchange, a member of the control group 181 transfers stock received from the corporation in the exchange to another member of the control group, then the stock ownership of the group members after the second transfer will be the basis for determining whether it has control. 182 If, however, the second transferee is not a member of the control group because that party made no property transfer for stock, then the stock ownership of the original shareholders as diminished by the second transfer is the basis for determining whether the group has control. 183 In such circumstances, the key issue

is whether the second transfer is part of the §   351 exchange, which is further discussed below.

¶ 3.09[2] Step Transaction DoctrineLitigation abounds over the requirement that the transferors control the transferee corporation immediately after the exchange. The principal problem is whether the statute is satisfied if the transferors own 80 percent or more of the stock momentarily, but then drop below that benchmark because they sell or give away some of their stock (e.g., to children) or because the corporation issues additional shares to employees or other investors. 184 Although some early decisions held or suggested that momentary control was sufficient, 185 the control requirement is not satisfied under current law if the transferors of property agree beforehand to transfer enough of their stock to lose control or if such a transfer is an integral part of the plan of incorporation. An illustration of this principle is Manhattan Building Co., which concerned a 1922 transfer of certain assets by one Miniger to Electric Auto-Lite Company in exchange for 250,000 shares of common stock and $3 million in bonds. 186 Miniger had purchased the assets with borrowed funds under an agreement requiring him to transfer the assets to Auto-Lite in exchange for the stock and bonds, to deliver the bonds and 75,000 shares of stock to the lender, and to turn back 49,000 shares to Auto-Lite as a contribution to capital. The question before the court was whether the predecessor of §   351 was applicable to this transaction, under which Miniger fleetingly owned 100 percent of the stock, but less than the requisite 80 percent when the plan was fully consummated. The court held as follows: This depends upon whether the transfer of assets to Auto-Lite in exchange for its stock and bonds and the transfer of stock and bonds to the underwriters were mutually interdependent transactions. The test is, were the steps taken so interdependent that the legal relations created by one transaction would have been fruitless without a completion of the series.…In the present case when the transfer of assets to Auto-Lite occurred on July 17, 1922, Miniger was under a binding contract to deliver the bonds and 75,000 shares of stock to the underwriters and to return 49,000 shares to the corporation.…Miniger could not have completed the purchase of the assets without the cash supplied by the underwriters and could not have had the cash except in exchange for the bonds and stock and could not have secured the bonds and stock except for the assets. After the exchanges Miniger had…less than 80 percent, of the voting stock. At no time did he have the right to hold more.…The 1922 transaction was taxable as the petitioner contends. 187

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In reaching this conclusion, the court cited and distinguished American Bantam Car Co., which also involved a loss of control as a result of an underwriting agreement but which was held to qualify for nonrecognition under the predecessor of §   351 because the arrangement with the underwriters for a sale of preferred stock to the public, for which they were to be compensated with common stock, was not an integral part of the original transfer of property (the assets of a manufacturing business) to the corporation in exchange for common stock, and was subject to cancellation at the option of the transferors. 188 In a later case, the Tax Court summarized this freedom-of-action approach as follows: A determination of “ownership,” as that term is used in section 368(c) and for purposes of control under section 351, depends upon the obligations and freedom of action of the transferee with respect to the stock when he acquired it from the corporation. Such traditional ownership attributes as legal title, voting rights, and possession of stock certificates are not conclusive. If the transferee, as part of the transaction by which the shares were acquired, has irrevocably foregone or relinquished at that time the legal right to determine whether to keep the shares, ownership in such shares is lacking for purposes of section 351. By contrast, if there are no restrictions upon freedom of action at the time he acquired the shares, it is immaterial how soon thereafter the transferee elects to dispose of his stock or whether such disposition is in accord with a preconceived plan not amounting to a binding obligation. 189 As generalizations go, this seems quite satisfactory, with a caveat for situations where the loss of control, although not pursuant to a binding obligation, is both part of a preconceived plan and a sine qua non thereof. 190 It can then be said, in the words of the Manhattan Building Co. case, that “the steps taken [were] so interdependent that the legal relations created by one transaction would have been fruitless without a completion of the series.” 191 It is important to remember that the step transaction doctrine can be brought into play upon either (1) immediate sales of their stock by members of the control group, which can result in a loss of control (because the buyers transfer nothing to the corporation and are not preexisting shareholders and hence do not become part of the control group), 192 or (2) sales of other stock by the corporation itself (since purchasers from the corporation can become part of the control group by virtue of their transfers of cash to the corporation). Rejecting a 1978 ruling, regulations promulgated in 1996 accord the same treatment to firm-commitment and best-efforts underwriting agreements, holding that the ultimate purchasers are the

transferors in either case. 193

¶ 3.09[3] Retransfers of Stock for Personal ReasonsAlthough the courts have not articulated a distinction between commercial and noncommercial transactions when deciding whether a loss of control after the initial exchange is fatal, much can be said for treating these situations differently, and in practice the courts seem to do so. If the transferors of property receive all the stock of the transferee corporation and then reduce their ownership below the requisite 80 percent by giving some of the stock to their spouses or children, the courts usually have found §   351 to apply. One case concerned a transfer of property for all the stock of a newly organized corporation; on the day the transferor received the stock, he gave more than 20 percent to members of his family. 194 The court held that the transfer of property to the corporation was a tax-free exchange under §   351 , not on the narrow ground that the transferor owned the shares of the corporation for an instant but on a broader ground: In the absence of any restriction upon [the transferor's] freedom of action after he acquired the stock, he had “immediately after the exchange” as much control of the [corporation] as if he had not before made up his mind to give away most of his stock and with it consequently his control. And that is equally true whether the transaction is viewed as a whole or as a series of separate steps.…Where the recipient of the stock on the exchange has not only the legal title to it “immediately after the exchange” but also the legal right then to determine whether or not to keep it with the control that flows from such ownership, the requirements of the statute are fully satisfied. 195 The same principle has been applied to a case in which the stock was issued directly to the donees on the sensible ground that what matters is “the power of the transferor [of property] to designate who will receive the stock rather than the precise moment that the power was exercised.” 196 When the property transferor, however, has a long-standing contractual obligation (albeit to a relative) contemplating that he would receive less than 80 percent of the stock, his power can be so circumscribed that he never obtains the

control required by §   351 . 197

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¶ 3.09[4] Corporate Transfers of StockSection 351(c) provides that if a corporate transferor of property receives stock in a §   351 exchange, the fact that it distributes part or all of the stock to its own shareholders is not taken into account. Thus, the corporate transferor's fleeting ownership of the shares is counted in determining whether it is in control of the transferee corporation immediately after the property-for-stock exchange. 198 This option to realign ownership of the stock without losing “control” for §   351 purposes, however, may be too costly to exercise, since the distribution may be both a taxable event for the distributing corporation by virtue of §   311 and a taxable dividend to the distributee shareholders under §   301 . 199 The 1997 tax bill amended §   351(c) by adding new §   351(c)(2) , which applied if the distribution met the requirements of §   355 ; in such a case, shareholders must own more than 50 percent of both the vote and the value of the distributed transferee's stock immediately after the distribution. 200 But legislation enacted in 1998 201 amended § 351(c)(2) (retroactively) to provide that shareholder dispositions of the distributed stock are disregarded in determining §   351 control with respect to the corporation's property transfer transaction.

202 Instead of distributing the stock received in a §   351 transaction upstream, as explicitly permitted by §   351(c) , a corporate transferor of property may wish to transfer the stock downstream to a subsidiary. There is no counterpart of §   351(c) exonerating such transfers; nor is there a statutory sanction for attributing the subsidiary-held stock back to the parent in determining whether the transferors of property (including the parent) own 80 percent of the stock immediately after the exchange. 203 If, however, the transfer of the stock is not an integral part of the plan, the freedom-of-action principle discussed previously would seem to apply so that the control requirement would be satisfied despite the prompt retransfer of part

or all of the stock. 204

¶ 3.09[5] Transferred Property—Multiple Drop-DownsThe control requirement of §   351 looks to the ownership of the transferee corporation's stock immediately after the exchange, but it says nothing about ownership of the transferred property. Under the facts of a 1977 ruling, corporation P transferred property to its wholly owned subsidiary, S-1, in exchange for additional S-1 stock. Immediately thereafter, S-1 transferred the same property to S-1's wholly owned subsidiary, S-2 , in exchange for additional S-2 stock. The Service ruled that the transfers, although admittedly parts of a single plan, constituted two separate transactions, each of which satisfied the requirements of §   351 . Thus, the Service did not succumb to the temptation to rule that in effect, P transferred the property to S-2 in exchange for S-1 stock and that P was not in control of S-2 immediately after the hypothetical exchange. 205 A 1983 ruling amplified the 1977 ruling to cover a similar plan in which the subsidiary transferred the assets to an affiliated partnership rather than to a second-tier subsidiary. 206 IRS applied these multiple drop-down rulings expansively (and mercifully) in a 2003 ruling 206.1 to save a multi-step series of transactions that technically resulted in a loss of control but could have easily been done in “double-drop” mode, so the actual method used did not violate the purposes of §   351 . 206.2

¶ 3.09[6] OptionsDo the transferors of property have control “immediately after the exchange” if another person has an option to acquire enough shares, either from the corporation or from the transferors themselves, to terminate the transferors' control? In the American Bantam Car Co. case, the Tax Court held that an exchange of property for common stock qualified under §   351 's control test even though the transferors would have lost control if the underwriters of an issue of preferred stock sold enough to the public to earn a substantial amount of common stock as compensation for their services—a business bargain that could be viewed as an option. 207 This approach has much to commend it. The option can properly be disregarded if there is a genuine possibility that it will not be taken up; but if exercise of the option is a foregone conclusion (e.g., if only a nominal consideration is payable for valuable stock), it may take the transaction outside of §   351 unless the option holder can himself be regarded as a transferor of property to be aggregated with the other transferors in computing control or unless the transfer of property and the option are not integral steps in a single transaction.

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¶ 3.10 Transferor's Basis for Stock

¶ 3.10[1] In GeneralA recurring theme of fundamental importance in the income tax is that when gain or loss goes unrecognized at the time of an exchange of property for property, the transferor's basis for the property given up is ordinarily preserved and applied to the property received. Section 358 applies this principle to an exchange under §   351 . In the simplest situation—that is, an exchange under §   351 of property solely for stock—§   358(a)(1) provides that the basis of the stock received is the same as the basis of the property transferred. 208 If the transferor receives several classes of stock, §   358(b)(1) requires an allocation of the basis of the transferred property among the classes received in the exchange, and the regulations provide for an allocation in proportion to their market values. 209 Thus, if the basis of the transferred property were $50,000 and the transferor received in exchange common stock worth $60,000 and preferred stock worth $40,000, the basis of the common stock would be $30,000 (60,000 ÷ 100,000 × 50,000) and the basis of the preferred stock would be $20,000 (40,000 ÷ 100,000 × 50,000). Assuming no later fluctuations in value, the transferor would realize $30,000 of gain on selling the common stock and $20,000 of gain on selling the preferred. The total gain of $50,000, it will be noted, is equal to the gain that went unrecognized on the exchange itself because of §   351(a) —the difference between the basis of the property transferred ($50,000) and the value of the stock received in exchange ($100,000). The gain of $50,000 on the stock ordinarily would qualify as capital gain regardless of the nature of the property transferred to the corporation. 210 If the transferred property's basis in the above example had been $150,000, the common stock basis would be $90,000 and the basis of the preferred stock would be $60,000, reflecting a potential loss of $30,000 on the common stock and $20,000 on the preferred stock—equal to the $50,000 loss that was unrecognized because of §   351 .Section 358 also is applicable if the transferor received boot on the exchange. 211 In such a case, §   351(b)(1) requires the transferor to recognize his gain on the exchange (if any was realized, i.e., if the value of what he received exceeded the adjusted basis of the property he gave up) to the extent of the fair market value of the boot. Section 358(a)(2) provides that the boot (except U.S. currency, which, in effect, always has a basis equal to its face amount) be given a basis equal to that same fair market value. In addition, §   358(a) (1) provides that the basis of the nonrecognition property (i.e., the stock received on the exchange) is the same as the basis of the property given up, less the money and the fair market value of the boot received, plus the gain recognized by the transferor on the exchange. Example Assume T transfers property that had an adjusted basis of $4,000 in exchange for stock worth $8,000, cash in the amount of $1,500, and other property worth $500. T realizes gain of $6,000 (value received of $10,000 less adjusted basis of $4,000), which would be recognized under §   351(b) to the extent of the boot, or $2,000. The basis of the other property received by T would be, under §   358(a)(2) , its fair market value, $500. In effect, the basis of the cash would be $1,500. The basis of the stock (the nonrecognition property) would be $4,000 (adjusted basis of property given up, $4,000, less cash of $1,500, and other property of $500, plus gain recognized of $2,000). 212 The computation is as follows:

1. Amount realized: a. Stock $ 8,000 b. Cash 1,500 c. Other property 500 2. Total $10,000 3. Less: Adjusted basis of transferred property 4,000 4. Gain realized $ 6,000 5. Gain recognized (line 1b plus line 1c, or line 4, whichever is less) $ 2,000 6. Basis of property received: a. Cash NA b. Other property (fair market value) $ 500 c. Stock (line 3, less lines 1b and 1c, plus line 5) $ 4,000

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If T then sold the stock for its market value ($8,000), T would recognize $4,000 of gain, which, added to the $2,000 of gain recognized at the time of the §   351 exchange, would equal T 's full economic gain of $6,000 (total value of $10,000 received on the exchange, less adjusted basis of original property of $4,000).Section 358(a)(1)(B)(i), providing for a further upward adjustment if any part of the property received on the exchange was treated as a dividend, is primarily concerned with certain transactions under §   306 , but in unusual circumstances could be applicable to an exchange under §   351 . 213 Section 358(e) excludes from the application §   358 the receipt of property by a corporation for its own stock on the theory that in nontaxable exchanges the corporation should obtain its basis from the other party under §   362(a) , but the service has applied §   358(e) when a parent corporation makes a §   351 contribution of its own stock for stock of a subsidiary, concluding that each corporation had a zero basis in the respective stock received. 214 When and if recognized gain reflected in boot can be reported on the installment method, there is uncertainty as to whether the available basis is entirely allocated to the stock or somehow apportioned in part to the installment debt so as to reduce the recognized gain; obviously, the Service would prefer front loading the basis into the stock so as to increase the gain to be recognized on the installment method. 215 For the shareholders of an S corporation, the price exacted by §   351 for the nonrecognition of gain on the transfer of appreciated property—a low basis for the stock received—is doubly burdensome, because the basis sets a ceiling on the amount of corporate losses that can be passed through to the shareholders under the S corporation regime. 216 The ceiling can be increased, however, by shareholder loans to the corporation (though that may be throwing good money after bad); and losses that cannot be currently deducted because of the exhaustion of stock basis can be carried forward indefinitely and deducted to the extent of any subsequently created basis.For new proposed regulations providing for a limited basis tracking regime (where no liabilities are

allowed), see infra ¶   3.10[5] .

¶ 3.10[2] EstoppelThe reader will have noted that the basis of the property received on the exchange in the previous example (line 6) reflects, under §   358(a)(1)(B)(ii) , the “amount of gain to the taxpayer which was recognized ” (emphasis added) on the §   351 exchange. If the transferor treats an exchange as nontaxable but later claims a stepped-up basis on the ground that he should have recognized gain—when the §   351 exchange occurred—and if the statute of limitations has run on an assessment of additional tax for that year, is he barred by estoppel principles from using a stepped-up basis because he failed to recognize the gain? 217 There is authority by analogy for allowing the recipient of unreported boot to use a stepped-up stock basis, at least where the failure to recognize gain on the exchange was not fraudulent or otherwise blameworthy, 218 but this will ordinarily “mitigate” (i.e., reopen) the statute of limitations otherwise applicable to the year of the exchange under §§   1311–1315 . 219 In short, the spirit of estoppel is that two wrongs make a right, sort of;

but according to §§   1311–1315 , two rights are even better.

¶ 3.10[3] Assumption of LiabilitySection 358(d) provides that the amount of the liability assumed by a transferee corporation or subject to which it takes the transferred property (other than a liability excluded under §   357(c)(3) ) should be treated as money received by the transferor upon the exchange. This requirement, which is applicable whether the liability gives rise to income at the time of the exchange under §   357(b) or §   357(c) , or comes within the general rule of §   357(a) , 220 has the effect of reducing pro tanto the basis that otherwise would be allocated under §   358(a)(1) to the nonrecognition property. Example If A transfers property with a cost basis of $50,000 to a corporation for all the corporation's stock plus the assumption of a $30,000 mortgage, A's basis for the stock will be $20,000 (the basis of the transferred property, minus the liability, which is treated as boot for this purpose). If A then sells the stock for $25,000, A will realize $5,000 of gain. Provided the mortgage is discharged by the corporation in due course, this tax treatment accords with economic reality: A 's net investment was $20,000 (the cost of the land less the amount of the mortgage), and A ultimately realized $25,000.

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If the transferee corporation fails to pay the debt at maturity and A is called upon to pay it, however, A presumably would be entitled either to increase the basis of his stock (if he still owns it) by the amount of his outlay or to take a deduction under §   165 or §   166 . 221 At the time of a §   351 exchange, it is not ordinarily necessary to determine whether a liability that is assumed by the transferee corporation or to which the transferred property is subject is too contingent to be taken into account or is instead fixed so as to qualify for the exemption of §   357(a) ; 222 either way, it does not require the recognition of gain. The debt must be properly classified, however, in applying §§   357(b) and 357(c) (relating to tax avoidance transfers and debt-in-excess of basis, respectively). If a borderline liability is sufficiently fixed for §   357(b) or §   357(c) purposes, then it would seem that the transferor should be required to reduce (or adjust) his basis in the stock received for the property under §   358(a)(1)(A)(ii) . 223 Recourse debt to which transferred property is subject, but which the corporation does not assume, also clearly is debt to which the property is subject, and so reduces basis in the stock pro tanto. 224 In some cases of such recourse debt, the transferor may specifically agree to pay as between the two parties, as discussed previously. 225 Even when §§   357(b) and 357(c) do not apply to such debt, it still is necessary to determine whether such debt results in a decrease in the basis of the stock received under §§   358(d)(1) and 358(a)(1)(A)(ii). Consistent with the Service's view of the income side of such transactions, 226 the answer must be yes. Perhaps, however, the transferor can offset that basis reduction with a corresponding increase based on a contribution-to-capital theory with respect to the transferor's debt assumption; at the least the transferor

should be able to increase the stock basis if and when he pays the debt.

¶ 3.10[4] Holding Period; Tracing BasisUpon selling stock received tax-free under §   351(a) , the transferor determines his holding period under §   1223(1) by including (“tacking”) the period during which he held the property transferred to the corporation, provided the transferred property was either a capital asset or a §   1231(b) asset. 227 This proviso was enacted to prevent the conversion of ordinary income into long-term capital gain by a prompt sale of stock acquired under §   351 in exchange for appreciated inventory.Section 1223(1) applies, however, only if the property whose holding period is to be determined has, for determining gain or loss on a sale or exchange, “the same basis in whole or in part…as the property exchanged.” The stock readily satisfies this requirement if the §   351 exchange is wholly tax-free, but even if part of the transferor's gain is recognized because boot is received, the stock's basis is determined by reference to the basis of the transferred property. If, however, the transferor's gain is fully recognized, the basis of the stock is its fair market value at the time of the exchange and hence is not determined in whole or in part by reference to the basis of the transferred property. 228 If the transferred property consists of a mixture of capital assets, §   1231(b) assets, and noncapital assets, as in the ordinary case of incorporating a going business, it may be necessary to make an allocation under §   1223(1) , with the result that the basis of each share will be divided for holding-period purposes.Can the transferor deliberately transfer some assets for specified shares or a certain class of stock and others for a different group of shares or another class in order to control the basis or holding period of the stock received (e.g., because some of the shares are likely to be sold at an early date)? It is doubtful that such an earmarking of the transferred property would succeed if both transfers were interdependent steps in a single transaction. Section 358 and the regulations promulgated thereunder seem to contemplate that the aggregate basis of the property transferred will be assigned to the properties received (and then presumably allocated among the items in proportion to their relative market values), leaving little room for any planning of basis by the foresighted taxpayer, and §   1223(1) is no more helpful, since its applicability

depends on §   358 . 229

¶ 3.10[5] Proposed Regulations Limited Basis Tracing Rules Regulations proposed in January 2009 provide for a limited basis tracing rule in the case of §   351 exchanges, but only where no liabilities are assumed in the transaction. 229.1 But if liabilities are assumed, the aggregate basis of the transferred properties (after adjustments for boot and gain recognized) is allocated among all the shares of stock in proportion to the value of each share. 229.2 The reason for not applying basis tracing in the liability assumption case is because aggregate basis rules apply for determining §   357(c) gain.

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¶ 3.11 Transferee Corporation's Basis for Assets

¶ 3.11[1] In GeneralSection 362(a) provides that the basis to the transferee corporation of the property received on the exchange is the transferor's basis for the property, increased by the amount of gain recognized to the transferor. 230 In keeping with the transferor's nonrecognition of gain in connection with debt assumed under §   357(a) , an assumption of liabilities by the transferee does not enter into the computation of the transferee's basis for the transferred property except to the extent the transferor recognizes gain under §   357(b) or §   357(c) . In carrying the transferor's basis for the property over to the transferee corporation, special basis adjustments may be required, such as the “lower of cost or value” rule in the case of personal-use property that is converted to income-producing or business functions. 231 What if the transferor erroneously recognized (or erroneously failed to recognize) gain on the §   351 exchange? Does §   362 mean actual recognition, or should this language be read as meaning recognizable? The latter construction has won judicial support, whether the transferor's error was in recognizing or in

failing to recognize gain. 232

¶ 3.11[2] AllocationNeither the Code nor the regulations state how the basis transferred to the corporation is to be allocated by it among the assets received. For example, if the corporation issues stock in exchange for an asset with an adjusted basis to the transferor of $10,000 and a value of $10,000 and another asset with an adjusted basis of $20,000 and a value of $50,000, is the aggregate transferred basis of $30,000 to be divided between the two assets in proportion to their market values, or should the transferor's basis for each asset be preserved? Under the statutory predecessor of §   362(a) , the Court of Appeals for the Seventh Circuit opted for the latter principle. 233 This rule avoids an appraisal of the assets at the time of the exchange, and it ordinarily is helpful to the transferee corporation when a going concern is incorporated, because otherwise a substantial part of the aggregate basis might have to be assigned to goodwill—thereby reducing the amount allocated to inventory (generating a corresponding increase in ordinary income on sale) and to depreciable assets.If the §   351 exchange is taxable in part because the transferor received boot, §   362(a) provides that the basis to be assigned to the transferred assets is to be increased by the amount of gain recognized; but neither the Code nor the regulations state how this increase should be allocated among the assets. Since the Service believes that for purposes of computing the shareholder's recognized gain, the boot must be allocated among the assets on the basis of the assets' relative fair market values, it evidently also believes that the gain thereby recognized on a specific asset should increase the basis of that asset. 234 This has the merit of assigning the increase in basis to the assets responsible for it.If the §   351 exchange is taxable in part because of §   357(c) , then the asset-by-asset approach as applied in the case of boot received by the transferor runs into difficulty because §   357(c) is not based on a calculation of aggregate gain realized on the transfer but rather on the amount of debt in excess of basis. If an assumed debt is not secured by any particular asset, then it would seem reasonable to apportion any gain attributable thereto according to relative asset appreciation. If an item of transferred property is specifically subject to a debt in excess of the property's basis, however, it would seem reasonable to allocate the gain attributable thereto specifically to that property. If both types of debt are involved, an allocation based on either relative asset basis or relative fair market values may be a fair way to avoid needless complexities (but see

discussion of §   362(d) below).

¶ 3.11[3] Corporation's Deductions for Payment of Assumed LiabilitiesThe corporation's payment of assumed liabilities does not increase its basis in the assets acquired, since §   362(a) takes account of only the transferor's basis and the gain recognized by the transferor. 235 If, however, the transferee's payments could have been deducted by the transferor had they been made before the §   351 exchange—as in the case of a cash basis transferor's liabilities for rent, wages, etc.—the Service acknowledges that the transferee is entitled to a deduction. 236 This concession, which encompasses the

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liabilities described by §   357(c)(3) , 237 is subject to two broad limitations: (1) There must be a valid business purpose for the transfer of the liabilities, which usually exists when all the receivables and payables of a going business are transferred, and (2) the liabilities must be transferred together with their related receivables, and both must have arisen in the ordinary course of business and must not have been

accelerated or prepaid for a tax-avoidance purpose. 238

¶ 3.11[4] Installment BootWhen a transferor receives boot in the form of transferee debt and reports gain on the installment method under §   453(f)(6) , 239 the transferor's basis for transferee stock evidently can be increased under §   358(a) immediately by the full amount of the gain, while the transferee's basis in the acquired assets is increased

under §   362(a) pro tanto as the gain is recognized. 240

¶ 3.11[5] Zero Basis ProblemAddressing a specialized §   351 situation—a corporation's transfer of its own stock to its subsidiary in exchange for additional stock in the subsidiary—the Service has ruled that the subsidiary's basis for the stock is zero, because the transferor parent's basis for its own stock is zero and this basis (or lack thereof) carries over to the transferee. 241 If the subsidiary then disposes of the stock in a taxable transaction, the entire amount realized will be gain, although if it had sold its own stock to third party investors and used the proceeds to purchase stock of its parent on the market, and then sold the stock, it would recognize gain or loss, computed by deducting its cost from the amount realized. 242 The subsidiary's zero basis dilemma as described above is sidestepped if the §   351 parent-subsidiary exchange is the prelude to the acquisition of a target company, in which the subsidiary exchanges its shares in its parent for the shares of the target, whose shareholders thus wind up with an equity interest in the parent. In such a triangular corporate reorganization, the Service treats the subsidiary's use of its parent's stock to acquire the target as a tax-free transaction, 243 so that the parent's shares, which had a zero basis in the hands of the subsidiary, acquire a basis in the hands of their new owners equal to the basis of the target shares surrendered by them. IRS rulings also protect the subsidiary against the perils of a zero basis if it uses the stock of its parent to compensate employees. 244 These rulings, however, did not supply an articulated rationale for their conclusions. Proposed Regulations § 1.1032-3, however, would further extend §   1032 nonrecognition protection where the subsidiary is essentially a “conduit” using parent stock (or options) to acquire cash or property or to pay compensation. 245 The regulations adopt a cash purchase model here, treating the subsidiary as if it had purchased parent stock with cash contributed to it for that purpose. 246 Under § 1032-3(c), the parent stock must be contributed to the subsidiary in a §   362(a) carryover basis transaction, the stock must be used “immediately” by the subsidiary (i.e., the subsidiary is a

mere “conduit”), and the payee recipient must take a cost basis for that stock. 247

¶ 3.11[6] Holding PeriodIn measuring its holding period for assets received in a §   351 exchange, the transferee corporation is allowed by §   1223(2) to include the period they were held by the transferor, and can evidently do so even if

they were not capital assets when so held. 248

¶ 3.11[7] Basis Limitation for Assumed Liabilities: § 362(d)Recent legislation now limits basis increases for transferred assets that result from assumed liability gains under §   357 to the fair market value of the transferred assets. 249 A special rule in §   362(d)(2) deals with a case where nonrecourse liabilities secure multiple assets, not all the assets are transferred, and no person is subject to tax on any gain recognized as a result of the liability assumed on the transfer; in that case, any basis increase is limited to the transferee's ratable portion of the liability, based on relative values of the transferred and retained assets. IRS announced a major regulation project to clarify various issues under §§   357(d) and 362(d) (and other

related issues as well). 249.1

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¶ 3.11[8] Basis Limitation Where Transferred Property Has Net Built-In Loss: § 362(e)The Jobs Act of 2004 249.2 adopted an anti-loss duplication rule in §   362(e)(2) where there is an aggregate net built-in loss on the transferred assets; 249.3 in such case, the basis of each loss asset is stepped-down to its share of the asset's proportionate share of the net built-in loss (allocated in proportion to each asset's built-in loss). But if both the transferor and transferee (irrevocably) elect, a basis step-down in the transferee's §   358 stock basis can be made in lieu of asset basis reduction. 249.4 Thus, it is no longer possible to duplicate losses by §   351 drop-downs, whether done domestically or cross-border. 249.5 Proposed regulations under §   362(e)(2) , the “anti-loss duplication” provision of §   362(e) , were issued on October 23, 2006. 249.6 The regulations clarify that §   362(e)(2) applies separately to each transferor (and also must reflect any basis step-up as a result of recognized gain). The proposals also revise and expand Notice 2005-70 249.7 to provide more methods and time periods in which to make elections under §   362(e)(2)(C) . The regulations will not apply, however, if there is no loss duplication as a result of the transaction (e.g., where the transferor distributes transferee stock under §   351(c) without recognizing gain or loss on the distribution).

¶ 3.12 Corporation's Gain, Loss, or Deduction on Issue or Sale of Its Stock

¶ 3.12[1] Section 1032: The Basic Rule and Its PurposeJust as the transferor of property to a corporation in exchange for its stock has made a “disposition” of property that might result in gain or loss recognition under §   1001 , so has the corporation made a transfer (i.e., an exchange of its stock for the property). Section 1032, however, provides an exception to the general recognition rule for a corporation receiving “money or other property in exchange for [its own] stock (including treasury stock).” 250 The reference to treasury stock, although enclosed in parentheses, actually is the crux of §   1032 , since it was enacted to reject the result reached by some cases under pre-1954 law that required a corporation to recognize gain if the corporation “deals in its own shares as it might in the shares of another corporation” 251 —for example, by using appreciated treasury shares, for which the corporation had paid $25,000 to repurchase them from a shareholder, to pay for property with a fair market value of $100,000. 252 By contrast, pre-1954 law did not require gain or loss recognition if a corporation used authorized but previously unissued stock (regardless of its par, stated, or fair market value) to acquire property, because such a transaction did not involve “deal[ing] in its own shares as it might in the shares of another corporation.” Because this tax distinction did not reflect any business or financial differences between treasury and previously unissued stock, it was repudiated by the enactment in 1954 of §   1032 .Section 1032(a) applies the same nonrecognition rule to gains and losses realized by a corporation on a lapse or an acquisition of an option to buy or sell its own stock, including treasury shares. 253 Section 1032, however, explicitly applies only to a corporation's transfer of its own stock and not to transfers of stock of its parent or subsidiary. 254 Although §   1032 itself refers only to transactions involving the issue of stock for money or other property, the regulations apply the same nonrecognition principle to the use of stock to pay for services, 255 a sensible extension, since otherwise the anomalous pre-1954 distinction between treasury shares and previously unissued shares would be perpetuated in stock-for-services exchanges. 256 The Treasury's February 1999 budget plan proposed to carve out two transactions from the nonrecognition protection of §   1032 : (1) The issuance of “tracking stock” for cash or other property that would be taxable to the extent of any built-in gain (though not loss) attributable to the “tracked” asset, 257 and regulatory authority would be granted to classify such stock as “non-stock” (e.g., as debt, a derivative or as stock of another corporation) and increase basis in the tracked asset; 258 and (2) issuance of stock in a “forward sale” transaction would be subjected to time value of money principles by applying §   483 to the deferred payments. 259 However, neither of these proposals has received much, if any, congressional interest

following their submission.

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¶ 3.12[2] “Stock”The term “stock” is not defined in §   1032 or elsewhere in the Code, and on several occasions the courts have had to say whether a corporation was entitled to the benefit of §   1032 on receiving payment for rights embodied in a document of ambiguous character by assessing the equity features of the purported “stock.”

260 Thus, one case held that amounts received for so-called Class B stock, which customers had to purchase as a condition to the receipt of television services to be furnished by the issuing corporation, did not qualify for exemption under §   1032 and thus constituted taxable income to it under §   61 . 261 The stock was redeemable at par and did not entitle the owner to vote, participate in the profits of the company, or share in the company's assets upon liquidation until the Class A stock had been paid in full. A similar result was reached with respect to fees paid for membership certificates in a retail “nonprofit” organization, even though the holders were entitled to vote and to share in assets upon liquidation, because the substance of the transaction was a payment for the privilege of buying goods at a savings rather than an equity investment in the taxpayer. 262 Similar questions of taxability arise when corporations receive contributions to capital and in determining

whether a payment is received for stock or for some other valuable consideration. 263

¶ 3.12[3] Stock Issued for the Corporation's Own DebtIf a debtor corporation issues stock in discharge of its debts, §   1032 —despite its general protective rule—does not shield the corporation from recognizing discharge-of-indebtedness income if the stock is worth less than the face amount of the liabilities thus discharged. An historic exception to the recognition of income in this situation 264 was gradually eroded by a series of statutory amendments between 1980 and

1992, and finally was eliminated in 1993, as explained later in this work. 265

¶ 3.12[4] Exchanges Outside § 351; Cost Basis and DeductionsAlthough §   1032 applies whether or not the transferor's exchange is subject to §   351 , 266 §   1032 applies only to the corporations's receipt of consideration in “exchange” for the corporation's stock. 267 If another transaction occurs in tandem with the issuance of stock, it will be taxed in accordance with its own true character. 268 Moreover, even if §   1032 applies when stock is issued, it does not govern events occurring thereafter; for example, if the corporation takes the buyer's note in payment for stock, it may realize original issue discount income on the note. 269 Proposed legislation in Treasury's 1999 budget plan would tax the corporation on a forward sale contract to issue its stock by applying §   483 and time value of money principles to the deferred payments under that contract. 270 The regulations clarify a statutory ambiguity in determining the corporation's basis for property acquired in exchange for the corporation's stock. Section 1032(b) refers to §   362 as governing the corporation's basis in “certain” exchanges. The regulations limit §   362 to exchanges in which the transferor enjoys the benefit of a nonrecognition rule, and state that the basis of property acquired by the corporation in exchanges that are taxable to the other party will be governed by §   1012 (basis of property is “cost”). 271 Thus, if stock is issued to acquire property from someone other than a controlling shareholder under §   351 , the basis of the property to the corporation will be the fair market value of the stock given up. 272 Section 1032 exempts corporations from recognizing gain (or loss) on the exchange of stock for money or other property, but it does not preclude deductions when stock is issued as coin of the corporate realm—for example, as compensation for services or as a charitable deduction—if a cash payment would have been deductible. 273 If a payment in cash would not be currently deductible but would give rise to deductible amortization or depreciation, the fair market value of the stock should be similarly deductible over time. 274

¶ 3.12[5] Transfer of BootBy virtue of §   351(f) , §   1032 does not protect a corporation from recognizing gain on a §   351 exchange if it transfers appreciated property to the transferor as boot, along with its own stock. Section 351(f), however,

does not sanction the recognition of loss on transferring depreciated property as boot. 275

¶ 3.12[6] Issue of “Tracking Stock”—Nonapplication of § 1032

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Revenue proposals in the Treasury's fiscal year 2000 budget plan would tax a corporation on its issuance of “tracking stock” 276 in an amount equal to the built-in gain (though not loss) inherent in the tracked asset. Tracking stock would be defined as stock whose dividend or liquidation rights are keyed to economic performance of less than all of the issuing corporation's assets. Regulatory authority also would be granted to classify such stock as “nonstock,” 277 and to increase basis in the tracked assets by the amount of recognized gain.

¶ 3.13 Contributions to Capital

¶ 3.13[1] In General: Corporate Nonrecognition of IncomeSection 118(a) provides that in the case of a corporation, gross income shall not include any “contribution to the capital of the taxpayer.” The exclusion of contributions to capital from the corporation's gross income is not an unmitigated blessing, since it requires a reduction of basis that in later years will increase the corporation's gain or decrease its deductions for depreciation and losses, as explained later in this work. 279 A contribution to capital may be in the form of a transfer directly to the corporation, an excessive payment to the corporation for goods or services, or a transfer to a third party for the benefit of the corporation, 280 including a transfer of property by a shareholder to a corporate employee for the corporation's benefit. 281 Section 118(a) applies to three types of transactions, of which two involve shareholders and one involves

nonshareholders.

¶ 3.13[1][a] Shareholder ContributionsFirst, voluntary pro rata transfers to a corporation by its shareholders (by far the most common of the three types, especially in the case of closely held corporations) normally are contributions to capital. 282 Such transfers can be regarded as an additional price paid for the stock, 283 and the exclusion from gross income can be regarded as a corollary to §   1032 , under which the issue of stock does not produce corporate gain or loss, as discussed in the previous section. Second, the same approach can be extended to a non–pro rata contribution by a shareholder who is acting voluntarily in his capacity as such. 284 Whether a shareholder makes a contribution in his capacity as a shareholder or instead as a creditor, customer, or person expecting a commercial benefit from the corporation is a question of fact that is analogous to the determination that

must be made with respect to nonshareholder transfers, discussed below.

¶ 3.13[1][b] Nonshareholder ContributionsThird, §   118(a) can apply to exclude from a corporation's income money or other property transferred by a nonshareholder. Indeed, the primary purpose of §   118 was to give a congressional blessing to pre-1954 cases holding that certain contributions by nonshareholders were not taxable as income. 285 In a 1993 ruling, the Service pledged its continuing allegiance to a Supreme Court listing of the following indicia of a tax-exempt nonshareholder contribution, even though the case involved a transaction governed by pre-1954 law: (1) The contribution must become a permanent part of working capital; (2) the contribution must not be compensation for specific quantifiable services; (3) the contribution must be bargained for; (4) the contribution must forseeably benefit the corporation in an amount commensurate with its value; and (5) the contribution must ordinarily be employed to generate additional income. 286 Although §   118 does not define the term “contribution to capital,” §   118(b) states that the term does not include “any contribution in aid of construction or any other contribution [by a party in its capacity] as a customer or potential customer. 287 Evidently, Congress intended to exclude from §   118(a) any transfer that is a prerequisite to a direct commercial benefit to the transferor, that will result in an acceleration of benefits to the transferor, or that otherwise causes a customer to be favored. 288 The regulations 289 distinguish between (1) contributions “by a governmental unit or civic group to induce the corporation to locate its business in a particular community or to expand its operating facilities,” which qualify under

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§   118(a) 290 and (2) payments for goods or services rendered and subsidies paid to induce the corporation to

limit its production, to which §   118(a) is inapplicable. 291

¶ 3.13[2] Debt ForgivenessUnder §   108(e)(6) , if a shareholder-creditor forgives a corporate debt as a contribution to capital—one of the most common contexts for making a contribution to capital—the transaction is not governed by §   118 (which would exclude the contribution from the corporation's gross income); instead, the debtor corporation realizes discharge-of-indebtedness income as though it had satisfied the debt with an amount of money equal to the shareholder's adjusted basis in the debt. 292 If the shareholder's adjusted basis for the debt is equal to its face amount (e.g., if the shareholder lent the face amount in cash to the corporation and has properly accrued all appropriate interest income), the corporation realizes no income when the shareholder contributes the claim to the corporation's capital, because the hypothetical payment by the corporation does not exceed the claim's adjusted basis in the hands of the shareholder. In other circumstances, however, the as-if rule of §   108(e)(6) can generate taxable income for the corporation if the shareholder-creditor's adjusted basis for the debt is less than its amount. For example, if the debt reflects an amount owed to the shareholder for services performed for an accrual method corporation and the shareholder, being a cash-method taxpayer, did not take the debt into income, then the contributed debt has a zero basis in the shareholder's hands and the corporation realizes debt-discharge income under §   108(e)(6) . If, however, the corporation was on the cash method and had not yet deducted the compensation, it would not have to recognize any income. 293 These rules are superseded for insolvent debtors, whose debt-discharge income is not currently taxable but is instead applied in reduction of the corporation's tax attributes. 294 The capital contribution concept is often invoked in cases involving alleged purchases of property by a corporation from its shareholders for debt if the arrangement shows an intention to commit the property to the risks of the business or if the corporation is thinly capitalized. In this case, it ordinarily is the government, rather than the taxpayer, that seeks to characterize the transaction as a contribution to capital.

295

¶ 3.13[3] Corporate Basis and DeductionsSection 362(a)(2) provides that the corporation's basis for property acquired as paid-in surplus or as a contribution to capital is the same as the transferor's basis, increased by gain recognized to the transferor on the transaction. This is the same result as applied by §   362(a)(1) to property received by the corporation in exchange for stock in a transaction under §   351 . “Contribution to capital,” for purposes of §   362(a)(2) , presumably has the same meaning as under §   118 , 296 which meaning is informed by the reference of §   362(c)(1)(B) to a contribution “by a shareholder as such” (emphasis added). The meaning of “paid-in surplus” is more obscure. That term normally refers to property received by a corporation for the corporation's stock in excess of the stock's par value. 297 Since paid-in surplus can arise outside of §   351 , it may be that §   362(a)(2) applies even to an exchange that is fully taxable to the shareholder. 298 Because an outsider's contribution to a corporation's capital increases the corporation's net worth at no tax cost under §   118 , §   362(c)(1) provides that property that is “not contributed by a shareholder as such” has a zero basis in the hands of the transferee corporation. 299 Section 362(c)(2) provides that if the contribution consists of money, the corporation must reduce the basis of any property acquired within the following twelve-month period with the contributed money, and, that if enough property is not so acquired, the basis of other property held by the corporation must be reduced pro tanto. 300 If a shareholder makes a transfer that is a contribution to capital but the transfer is not made in the shareholder's capacity “as such,” then by definition the transfer is not a payment for goods or services and so must be made, for example, as a civic booster. 301 Section 362(c) is evidently inapplicable to property or money received by a corporation as a gift for the benefit of its shareholders; in such a case the corporation would carry over the donor's basis under §   1015 as if the donor had given the property to the shareholders and the shareholders had contributed property to the corporation. 302 A redemption of stock made by a related corporation formerly was treated as a contribution to capital, and is discussed later in this work. 303 Sometimes a contribution to capital is made in the form of a shareholder payment of a corporate expense, as discussed later in this work. 304 In such cases, the payment is deemed to have been made by the

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corporation with its own funds, and, if the payment is otherwise deductible, the corporation may deduct it.

305

¶ 3.13[4] Treatment of Contributors

¶ 3.13[4][a] Contributions by ShareholdersIn CIR v. Fink (1987), the long-standing principle that a shareholder's voluntary contribution of property to a corporation results in an increase in the basis of his shares equal to his adjusted basis in the surrendered property was extended by the Court to a non-pro rata contribution by two dominant shareholders (husband and wife) of some of their shares in a financially distressed corporation, in order to enhance its appeal to outside investors. 306 The Circuit Courts of Appeals had split on this issue; some viewed each shareholder's investment as a series of separate investments in each share, so that the surrendered shares could be treated as worthless, giving rise to a deduction for the loss, while other courts accepted an “integrated” analysis of the investment, leading to the conclusion that the shareholder realizes no gain or loss until the remaining shares (whose basis would be increased by the basis of the surrendered shares) were sold or otherwise disposed of. The Supreme Court accepted the latter theory, ruling that a contribution of stock “like contributions of other forms of property to the corporation, is not an appropriate occasion for the recognition of gain or loss.” 307 The Court observed that it had no occasion for deciding whether a loss would be deductible if the dominant shareholders had contributed enough shares to lose control of the corporation, but, as a dissenting judge noted, it is difficult to perceive in the Fink opinion “any principled ground for distinguishing a loss-of-control case from this one.” 308 In Fink, the Court did not address the way in which the adjusted basis of the surrendered shares should be allocated among the retained shares, but an equal allocation among all retained shares of the same class seems reasonable, even if they were acquired at different times and prices. But new proposed regulations 308.1 apply a share-by-share basis tracing model to capital contributions (a controversial result).When a contribution to capital is made by a sole shareholder, the prevailing current view is to treat the transaction like a §   351 exchange, even if no additional stock is issued. This makes §   358 applicable in determining the basis of the retained stock, and it would also bring §§   357(b) and 357(c) into force if the contributed property is subject to debt. 309 The 2009 proposed regulations noted above applying a share-by-share tracing model (with a deemed stock issue and a deemed recapitalization) seem to add unnecessary complexity to an area not crying out for reform. 309.1 The search for technical perfection in the new basis regulations, while perhaps elegantly logical, will result in a formidable array of computations for many garden variety corporate transactions without any especially redeeming value to the FISC.In contrast to the treatment of contributions to capital, a shareholder's payment of an assessment is not a voluntary event. Accordingly, gain or loss is probably recognized if the assessment is discharged with appreciated or depreciated property, a result that should be reflected by increasing the basis of the stock

giving rise to the assessment. 310

¶ 3.13[4][b] Contributions by NonshareholdersNonshareholder contributions to a corporation's capital might be deductible business expenses (e.g., if the contributor expects to derive business benefits from the relocation of the corporation to his area). 311 Otherwise, the contributor is probably entitled to nothing more than the community's gratitude for his civic boosterism.

¶ 3.14 Transfer Under § 351 Versus Sale

¶ 3.14[1] In General

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Nothing in §   351 prohibits shareholders from selling property to their controlled corporations for stock (or stock plus debt) on arm's-length terms that would be reached with an unrelated buyer. If the sale is not recharacterized as a §   351 exchange, the seller-shareholder recognizes gain (or loss, unless §   267 applies

312 ) under §   1001 ; and the property gets a cost basis equal to its fair market value basis in the hands of the corporation.These principles were exploited during the 1970s and early 1980s, when residential subdivisions were springing up everywhere, the value of suitable raw land was on its way to the wild blue yonder, and long-term capital gains were taxed at much lower rates than ordinary income. Their tax gambit consisted of purported sales of appreciated land to controlled corporations, so that (1) the gain would qualify as long-term capital gain (sometimes reported over a period of years under the then lenient installment sale provisions 313 ), and (2) the corporation, having a higher starting basis for the land, would report correspondingly less ordinary income from the construction and sale of the houses. 314 Similar tax benefits could be obtained if shareholders sold highly appreciated depreciable business property to their controlled corporations, since they could report their profit as capital gain, and the corporation could depreciate its resulting higher cost basis against its business income.These results, however, were not achieved without resistance by the Service, which sought to undermine their fundamental premise—the claim that the transaction was a bona fide sale of the property to the corporation, rather than a non-taxable exchange under §   351 , resulting in a carryover of the property's low basis. In recharacterizing borderline transactions of this type as tax-free exchanges, the Service found itself in the unusual posture of attempting to force tax-exempt status on unwilling taxpayers; as the analysis below indicates, however, in other situations the Service and taxpayer resume their more normal roles by arguing, respectively, that a purported §   351 exchange is “really” a sale, or that a purported sale is “really”

a §   351 exchange.

¶ 3.14[2] Incorporation Coupled With Purported Sale; Integrated ExchangesIf property is to be transferred to a controlled corporation solely for stock, it is difficult to see how the parties can avoid the application of §   351(a) . Section 351 is applicable “if property is transferred to a corporation…solely in exchange for stock,” and the impact of this language can hardly be avoided by affixing the label “sale” to the transfer. In more naive days, it was sometimes thought that the organizers of a corporation, wishing to deduct a loss on depreciated property, could purchase the corporation's stock for cash in a §   351 exchange and then successfully sell the property to the corporation for the cash just paid in, but the quietus was put on such transactions as early as 1932 by disregarding the cash circular transfers, 315">

https://checkpoint.riag.com.lawezproxy.bc.edu/app/servlet/com.tta.checkpoint.servlet.CPDocTextServlet?usid=134bb4a36cc&DocID=T0BE%3A4056.124&docTid=T0BE%3A4056.124-1&feature=tcheckpoint&jsp=%2FJSP%2FdocText.jsp&lastCpReqId=3294672&lkn=docText&searchHandle=ia744cc630000012cc29d6edbb3ee6089 - FN%20%3Ca%20name=315">315 and the practice is not likely to be revived. Protection against §   351 in these circumstances, moreover, would be indefensible because it would convert §   351 into an optional provision, in contravention of the congressional purpose.Even if the transaction is cast in the form of a “sale” of property for stock plus cash or other property, its tax consequences are governed by §§   351(a) and 351(b), so that the transferor will recognize gain (but not loss) to the extent of the boot. Again, a contrary construction would endow the transferor with an option that was not intended by Congress. If, however, the transferor's purpose is to give the property a stepped-up basis in the hands of the corporation rather than to enjoy a deductible loss, a transfer under §   351 for stock and boot may be a satisfactory alternative to a sale.More commonly, transferors attempt to alter the tax consequences of a §   351 exchange by dividing it into a sale of some of the property for cash or other property and a transfer of the balance for stock. If the two steps are integral parts of a single transaction (a factual issue), the division will not be respected, and the

transaction will instead be treated as a unitary §   351 exchange with boot. 316

¶ 3.14[3] Sales That Are Not Integrated

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On the other hand, if property is transferred to a controlled corporation solely for cash or property and is not part of a related §   351 exchange, the transfer seemingly cannot qualify under either §   351(a) (which requires receipt of stock) or §   351(b) (which permits the receipt of boot, but only if the transferor has also received stock). 317 Moreover, if the payment consists of purported corporate debt that is recharacterized as equity, §   351 will apply. 318 If, however, the transferor does not have (alone or with other transferors) the requisite 80 percent control of the transferee corporation immediately after the exchange, the transfer falls outside §   351 , and gain or loss may be recognized under §   1001 . 319 It would be perilous, however, to assume that a transaction falling outside §   351 is necessarily a sale merely because it bears that label. For example, if property is transferred to a controlled corporation solely for cash, §   351 is inapplicable because it requires that the transferor receive some stock; but the taxpayer still may have to establish that the transfer is a sale rather than a contribution of the property to capital coupled with a distribution of the cash. 320 Moreover, there is precedent for treating contributions to capital by 100 percent shareholders as §   351 exchanges. 321 Since such cases have involved payment for the stock in the form of debt assumption by the corporation, 322 it would be but a small additional step to convert a nominal sale by a 100 percent shareholder to the shareholder's corporation into a §   351 exchange with boot or a contribution to capital coupled with a distribution. The risk of boot treatment is not so great, however, since the gain (but not loss) recognition and basis consequences should be the same either way. Treating

the entire receipt as a distribution could be much more damaging to the shareholder. 323

¶ 3.14[4] Attempts to Avoid Sale TreatmentNote that the shoe may be on the other foot: The taxpayer may seek to apply §   351 to a transaction (usually a transfer of appreciated property) that, for practical purposes, is tantamount to a sale. If the parties characterized the transaction as a sale at the outset, the courts are not likely to welcome a belated claim by the taxpayer that the transaction was “really” a §   351 exchange, even if the technical elements of estoppel are not present. 324 More foresighted taxpayers may attempt to cloak a transaction from its inception in the garb of a §   351 exchange. Several IRS rulings indicate that such efforts may in some cases be frustrated with the aid of the step transaction doctrine 325 when an individual, A, transfers appreciated property for what is initially a large interest in a corporation but that becomes, in the end, a minority stock interest in an acquiring corporation. In one such ruling, A transferred property to newly organized company X for X's stock; company Y simultaneously transferred its assets to X for X's stock and then liquidated so that Y's shareholders became X 's shareholders. Literally, §   351 applied to the transfers by A and Y, but the Service ruled that X should be disregarded because X was organized merely for the purpose of enabling A to transfer his property on a tax-free basis; hence, X was a mere continuation of Y. Since A did not control Y (or its alter ego, X ), as required by §   351 for a tax-free transfer by A to Y for the latter's stock, A's transfer was a taxable event.

¶ 3.15 Statutory Exclusions From § 351

¶ 3.15[1] Transfers to Investment CompaniesAs previously noted, if two or more unrelated persons transfer separately owned property to a controlled corporation in exchange for the corporation's stock, §   351 permits the transferors to achieve a degree of diversification without recognizing gain; 327 and, if the diversification is sufficiently dramatic, the transaction may be financially tantamount to a sale. Exploiting this feature of §   351 , so-called swap funds were devised in the early 1960s to permit unrelated investors holding highly appreciated securities to unlock their positions (without being taxed) by exchanging their securities for the shares of a newly organized mutual fund to be managed by the promoter of the plan. Congress, recognizing that these transactions were more like sales than conventional § 351 transactions, enacted the statutory predecessor of §   351(e)(1) , which makes the nonrecognition principle of §   351 inapplicable to transfers of property “to an investment company.” 328

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The regulations add badly needed flesh to this statutory skeleton by providing that the prohibited transfers are those that (1) result, directly or indirectly, in diversification of the transferors' interests, and (2) are made to a regulated investment company, a real estate investment trust, or a corporation more than 80 percent of whose assets (excluding cash and nonconvertible debt securities) are held for investment and consist of readily marketable stock or securities or of interests in regulated investment companies or real estate investment trusts. 329 Expanding on these criteria, the regulations state that (1) diversification occurs if two or more persons transfer nonidentical assets to the corporation unless these assets are an insignificant portion of the total value of the transferred properties; (2) securities are held for investment unless they are dealer property or are used in a banking, insurance, brokerage, or similar business; and (3) securities are readily marketable if (but only if) they are part of a class that is traded on a securities exchange or traded or quoted regularly in the over-the-counter market. 330 Although the impetus for these restrictions on §   351 's rule of nonrecognition was the transfer of appreciated securities, §   351(e)(1) allows transferors of depreciated securities to recognize their losses, though this is only cold Code comfort for the luckless investors.By setting out a short list of companies encompassed by the broad statutory reference to “investment company,” the regulations may tempt owners of appreciated securities to assume that no other transferees are tainted, but a caveat against pushing the envelope can be found in the Service's list of areas in which rulings will not be issued until unsettled questions are resolved, which includes: [w]hether section 351 applies to the transfer of widely held developed or underdeveloped real property or interests therein; widely held oil and gas properties or interests therein; or any similarly held properties or interests to a corporation in exchange for shares of stock of such corporation when (i) the transfer is the result of solicitation by promoters, brokers, or investment houses, or (ii) the transferee corporation's stock is issued in a form designed to render it readily tradable. 331 But expansion of §   351(e)(1) by the 1997 legislation likewise shows that Congress intends to impose an

expansive scope on this provision. 332

¶ 3.15[2] Transfers by Bankrupt CorporationsWhen a corporation in bankruptcy plans to transfer its assets to a new corporation and to distribute the stock so obtained to its creditors in discharge of their claims, it usually effects the plan through a Type G reorganization (which, with related provisions, regulates the transaction in greater detail) rather than using a §   351 exchange. 333 To clarify the consequences of a transaction's failure to qualify as a reorganization, Congress enacted §   351(e)(2) , which provides that §   351(a) does not apply to the transfer by a debtor in bankruptcy of assets to a corporation to the extent the stock received is used to satisfy the bankrupt's debts. Consequently, the bankrupt's transfer of assets to the corporation will produce recognized loss (or, rarely, gain), and the bankrupt's transfer of the stock to the creditors in discharge of its debts will produce discharge-of-indebtedness income equal to the difference between the bankrupt's cost basis in the stock and the amount of debt discharged. The bankrupt is not required to recognize this income currently, but is instead required to reduce specified tax attributes, such as the basis of its assets. 334 The result is similar to an exchange of the bankrupt's assets for its debts and a hypothetical transfer by the creditors of the assets to the resulting new corporation, with a basis equal to their current fair market value rather than the bankrupt's possibly higher historical basis.

¶ 3.16 Transfer Under § 351 Versus DividendThe regulations under §   351 suggest the possibility that a distribution by a corporation of its stock or securities “in connection with an exchange subject to section 351(a)” may have “the effect of the distribution of a taxable dividend.” 336 Although this part of the regulations does not identify the circumstances under which such a distribution might occur, the possibilities include (1) the receipt by the transferor of property in a §   351 exchange of transferee corporation stock with a fair market value in excess of the value of the property transferred, if and to the extent that the excess is covered by earnings and

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profits, 337 and (2) a receipt of debt securities in the course of an otherwise tax-free recapitalization. 338 Although the regulations speak only of a distribution of stock or securities, it is equally possible that a distribution of money or other property in similar circumstances would be taxed as a dividend under §   301 rather than as boot under §   351(b) . 339 Another transaction that can produce dividend income even though it fits within §   351 is the receipt of the transferee corporation's securities, money or other property in exchange for stock of an affiliated corporation, since such an exchange can also be a redemption subject to §   304 , which by virtue of §   304(b)(3) (enacted in 1982) is controlling when it overlaps with §   351 .

¶ 8.01 Introductory Dividends & other nonliquidating distributionsAs noted in Chapter 1, the corporation is a separate taxable entity under the Internal Revenue Code, so that corporate income is taxed to the corporation and dividends paid by the corporation are taxable to the shareholders. This chapter examines in more detail a subject of wonderful intricacy: the taxation of nonliquidating corporate distributions that are not part of a stock redemption that is treated as a sale of the stock, and that usually are not part of a corporate reorganization or division. 12 Sections 301(a), 301(c), and 316 provide a framework for the taxation of such corporate distributions of property. “Property” refers to all items of economic benefit to shareholders other than the corporation's own stock and stock rights. 13 By virtue of these provisions, a corporate distribution with respect to stock (and not with respect to the shareholder's status as an employee, creditor, seller, and so forth) 14 is a dividend (a subset of distributions) that must be included in the shareholder's gross income as ordinary income under §§   301(c)(1) and 61(a)(7) if, and to the extent that, it comes “out of” either “earnings and profits” (a tax term, discussed below, sometimes referred to as E&P) of the corporation accumulated after February 28, 1913, or the corporation's earnings and profits of the current taxable year. 15 Most property distributions of most corporations fall well within this category of taxable dividends and, hence, are taxed as ordinary income to the shareholders. To the extent that a distribution by a corporation is not out of current or accumulated earnings and profits, however, §   301(c)(2) treats that distribution as a return of capital to the shareholder that is to be applied against, and in reduction of, the adjusted basis of the shareholder's stock. If the distribution exceeds the adjusted basis of the stock, the excess ordinarily is taxed as capital gain, with the exception (of increasing insignificance) for distributions out of an increase in the value of corporate property accrued before March 1, 1913. 16 Assuming that a corporation is newly organized with cash, the reason for gearing the taxability of its distributions to its record of earnings and profits is clear enough. Until the corporation has engaged in profitable operations, any distribution to its original shareholders is a return of the shareholders' investment and not income. Once the corporation has realized profits, however, its distributions may be fairly regarded as income to the shareholders pro tanto.The equity of §§   316 and 301(c) is far less clear in a case in which the stock changes hands after a period of corporate profits and there is a distribution to the new shareholder before additional earnings arise (e.g., the next day). Has there been a return of this shareholder's capital as well? The economist might say that a distribution in these circumstances ought to be regarded as a return of capital, but §§   301(c) and 316 are inescapable. Therefore, to the extent of the shareholder's share of the corporation's earnings and profits passed out in the distribution, the surprised new shareholder realizes income upon the distribution. This “miracle of income without gain” 17 was certified long ago by the Supreme Court in US v. Phellis: In buying at a price that reflected the accumulated profits, [the shareholder] of course acquired as a part of the valuable rights purchased the prospect of a dividend from the accumulations—bought “dividend on,” as the phrase goes—and necessarily took subject to the burden of the income tax proper to be assessed against him by reason of the dividend if and when made. He simply stepped into the shoes, in this as in other respects, of the stockholder whose shares he acquired, and presumably the prospect of a dividend influenced the price paid, and was discounted by the prospect of an income tax to be paid thereon. 18 In point of fact, however, if the stock is publicly traded, the purchaser of stock must bid against many other potential buyers who would be affected in varying degrees by the income tax on a dividend, and some of whom might be tax-exempt organizations, so the price would rarely, if ever, be accurately “discounted by the prospect of an income tax to be paid” on dividends that may be declared immediately after the stock is

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purchased. Moreover, the distribution will be a dividend under §   316 only if it is paid from the corporation's earnings and profits, and, since the calculation of earnings and profits is a complex operation,

19 the purchaser may not know the proper discount to apply (except in the case of stock in traditionally profitable publicly traded companies and possibly in the case of a closely held corporation), even if the purchaser were so foresighted as to anticipate the problem.Just as the use of earnings and profits to taint distributions as dividends may be unfair to a shareholder who buys stock before a corporate distribution, so it may, with equal irrationality, shower the shareholder with riches on occasion. If the corporation into which the purchaser buys has a deficit of earnings and profits, distributions by the corporation may be treated as wholly or partly tax-free returns of capital to the shareholder, even though the distributions reflect earnings by the corporation after the stock is purchased. This bonanza can occur if the corporation has neither cumulative post-1913 nor current-year earnings and profits and if (to reverse the discount theory of the Phellis case) the shareholder did not pay a premium upon purchase for the tax advantage lurking in the corporation's deficit.Another source of complexity in the system of defining “dividends” is that it produces different tax results for different types of shareholders. Individual shareholders generally favor nondividend distributions over dividends because (1) the full amount of a dividend is includible in gross income without offset for stock basis and (2) that amount is taxed as ordinary income (in contrast to any current preference for capital gain). On the other hand, corporate shareholders usually prefer to identify a distribution as a dividend because corporate shareholders enjoy dividends-received deductions. 20 Thus, the government tends to be whipsawed by rules designed to enhance earnings and profits if it forgets about the existence of corporate shareholders. 21 Despite these shortcomings, the existing system of relating the tax status of corporate distributions to the corporation's earnings and profits is an important component of the two-tier taxation of corporate income and is responsive to the need for a method of protecting returns of capital from the tax on dividends. While a better response to this need could no doubt be devised, Congress has shown no disposition to depart significantly from the present method. 22 Before turning to the details of the general rule under which a distribution by a corporation is a dividend if it comes out of current-year or post-1913 accumulated earnings and profits but is a return of capital to the extent of any excess, it should be noted that special rules are provided for certain categories of distributions:

1. Distributions in kind generally (i.e., corporate property other than money (e.g., real estate or marketable securities)); 23 2. Distributions of the corporation's own obligations; 24 3. Distributions in kind of the corporation's own stock or of rights to purchase its stock; 25 4. Preferred stock bailouts; 26 5. Distributions in redemption of stock, including partial and complete liquidations; 27 and6. Distributions in corporate reorganizations and similar transactions.

¶ 8.02 “Dividend”: A Term of Art

¶ 8.02[1] General RuleUnder §   301(c) , a distribution is includible in a shareholder's gross income under §   61(a)(7) to the extent that it is a “dividend” as defined in §   316 ; 29 the balance of the distribution, if any, is a return of capital under §   301(c)(2) , and thereafter taxable gain under §   301(c)(3) . The dividend is taxed despite the fact that it does not enlarge the shareholder's net worth but merely transfers part of the value represented by the shareholder's stock out of corporate solution and into his personal possession. 30 The explanation, of course, is that a realization event has occurred since the shareholder now has converted part of his stock into another form.The term “dividend,” as defined for income tax purposes by §   316(a) , does not correspond to the term “dividend” under state law. Consequently, a corporate distribution may be a “dividend” under §   316(a) even if it impairs capital or is otherwise unlawful under state law. “[W]hat the distributing corporation may

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call a dividend, or what the state law may call a dividend, or even what the recipient thinks of without question as a dividend, is not necessarily a ‘dividend' for federal income tax purposes.” 31 Conversely, it is possible for a distribution to constitute a lawful “dividend” under state law without qualifying as a “dividend” under §   316(a) . 32 The definition of “dividend” in §   316 is two-fold: A property distribution by a corporation to its shareholders is a “dividend” if it is made out of (1) earnings and profits accumulated after February 28, 1913, or (2) earnings and profits of the taxable year. “Earnings and profits” is a term of art that will be examined in detail, 33 but it must be pointed out here that the term is not identical to financial accounting “earned surplus” or “retained earnings”; nor are earnings and profits represented by a bank account or other specific corporate asset (although, if earnings and profits exist, the corporation ordinarily will own roughly commensurate unencumbered cash or undepreciated assets). A distribution is “out of” earnings and profits if the corporation operated profitably so as to generate earnings and profits in the period under consideration, and no tracing or earmarking of funds or assets is required.Many additional dividend-related issues are raised by distributions in kind, and these are discussed later in this chapter. 34 One of these issues that is of possible relevance to cash distributions is the determination of the amount of the distribution when the shareholder assumes a corporate liability in connection with the cash distribution. Such assumption could possibly occur upon a cash distribution, although it is unlikely. In any event, the amount of the distribution would be reduced by the amount of the liability assumed. 35

¶ 8.02[2] Ordering and Tracing RulesThe second sentence of §   316(a) lays down an irrebuttable presumption that every distribution is out of earnings and profits to the extent thereof and that the distribution comes from the most recently accumulated earnings and profits. This prevents earmarking a distribution to control its tax status; for example, a corporation having current-year earnings and profits, post-1913 accumulated earnings and profits, and pre-1913 accumulated earnings and profits cannot make a nontaxable distribution from the pre-1913 earnings and profits until the current and then the post-1913 accumulated earnings and profits have been exhausted. 36 After the corporation's current, post-1913, and pre-1913 earnings and profits have been exhausted, 37 however, the corporation may be able to earmark a distribution so as to qualify the distribution for the exemption conferred by §   301(c)(3)(B) (pre-1913 increase in value) and thus protect its shareholders against a capital gains tax under §   301(c)(3)(A) to the extent the distribution exceeds the dividend portion and the stock basis. 38 In determining whether a distribution is out of earnings and profits of the current taxable year, §   316(a)(2) provides that the earnings and profits for the year are to be computed as of the close of the year without diminution by reason of distributions during the year. 39 This means that a distribution will be a “dividend” if the corporation has earnings and profits at the end of the current taxable year, even though it had none when the distribution occurred; conversely, a distribution that seemed to be a “dividend” when made may turn out to be a return of capital because the corporation has no earnings and profits at the end of the year or for prior years. For cases in which the distributions for the year exceed in amount both the earnings and profits of the current taxable year and the post-1913 accumulated earnings and profits, the regulations prescribe methods of allocating the two categories among various distributions in order to ascertain the “dividend” component of each distribution. 40 Distributions on preferred stock absorb available earnings and profits before distributions on common stock. 41 To the extent stock redemptions that are treated as exchanges reduce earnings and profits, 42 such reduction is made after the reduction for ordinary

distributions from the current-year earnings and profits. 43

¶ 8.02[3] From Current EarningsSection 316(a)(2) provides that a distribution is a “dividend” if it comes from earnings and profits of the corporation's current taxable year. Because the ordering rule discussed above mandates that dividends come first from current-year earnings and profits, and only thereafter from accumulated earnings, it is often unnecessary to compute the latter amount if the distributing corporation is currently profitable.Section 316(a)(2) has a curious ancestry. It was enacted in 1936 as a relief measure when the undistributed-profits tax was in effect. That tax was imposed on the undistributed part of corporate income, computed by deducting “dividends” from total income. Unless a corporation with a deficit in accumulated earnings and

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profits (including a profitable current year) could treat distributions out of current-year earnings as “dividends” for this purpose, the corporation would be unable to avoid the undistributed-profits tax, no matter how large were its distributions to stockholders. To enable such corporations to obtain a credit for distributions out of current-year earnings, Congress enacted §   316(a)(2) . Congress apparently gave no thought to the effect of the new subsection apart from the undistributed-profits tax, and §   316(a)(2) was left intact when Congress repealed that tax in 1939. 44 The impact of such a “nimble dividend” 45 by §   316(a)(2) can sometimes be avoided by postponing the distribution until the next year. If the corporation has no earnings in that year and still has a deficit in accumulated earnings and profits, the distribution will be received tax-free, since it will fall under neither §   316(a)(1) (accumulated earnings and profits) nor §   316(a) (2), as described in an example later in this chapter. 46 Since corporations making distributions generally are currently profitable, §   316(a)(2) often makes it unnecessary to compute the corporation's post-1913 accumulated earnings and profits. While this may be convenient, it means that a distribution may be a taxable “dividend,” even though the corporation has an accumulated earnings and profits deficit. Therefore, if the concept of earnings and profits serves any useful purpose, it is partly undermined by §   316(a)(2) . For the original shareholders of a corporation, there is no economic difference between a distribution made before the corporation has had any earnings, which distribution is not a “dividend” under either §   316(a)(1) or §   316(a)(2) , and a distribution made after the corporation has suffered a cumulative loss. However, the latter distribution is a “dividend” under §   316(a) (2) if there are current earnings, even if those earnings are insufficient to repair the deficit. For shareholders who acquire their stock after the deficit but before the earnings, §   316(a)(2) is, of course, more defensible; however, §   316(a)(2) does not go far enough in this case, since its impact can be avoided if the distribution

can be postponed until a year in which the corporation has no earnings and profits.

¶ 8.02[4] From Accumulated Earnings (Historical Earnings and Profits)Section 316(a)(1), which provides that a distribution is a “dividend” if it comes from earnings and profits accumulated since February 28, 1913, looks to the financial success of the corporation over the long haul. If the corporation has operated profitably in the aggregate since 1913 (or since organization, if the corporation was incorporated after 1913 and did not succeed to the tax history (through attribute carryovers) of a preexisting, pre-1913 corporation), at least some distributions will be taxed to the shareholders as “dividends.” It is notable that the exemption of earnings and profits accumulated on or before February 28, 1913 (the date of the first federal income tax imposed after the adoption of the Sixteenth Amendment) is a matter of legislative grace rather than constitutional right. It obviously affects only corporations organized on or before February 28, 1913, and their successors. 47 Since even a corporation that belongs to this select group is likely to keep its distributions to shareholders well within its current or recent earnings and profits, the complicated network of law built on the 1913 benchmark is of interest to very few shareholders. 48 While the accumulated earnings and profits referred to by §   316(a)(1) , in theory, would include the current year, the effect of the last-in, first-out ordering rule and the alternative route to dividends out of current-year earnings generally is to confine the term “accumulated” to earnings accumulated through the end of the immediately preceding year. Two situations can arise, however, where the accumulated earnings and profits available on the date of the distribution will be relevant. The first occurs when the corporation has accumulated prior-year earnings, but incurs a current-year deficit. In that situation, the earnings accumulated to the date of the distribution will control. 49 Similarly, when there are two or more distributions in a taxable year, they reduce earnings and profits first in the order in which they occur. 50

¶ 8.02[5] No Current or Accumulated Earnings: Return-Of-Capital DistributionsIf the corporation has neither post-1913 accumulated earnings and profits nor current earnings and profits, a distribution cannot be a “dividend”; instead, it is subject to §§   301(c)(2) and 301(c)(3). Under §   301(c)(2) , the distribution is applied against, and reduces, the adjusted basis of the shareholder's stock. 51 If the distribution is greater than the adjusted basis of the stock, the excess is treated by §   301(c)(3) as gain from the sale or exchange of property (and, thus, as capital gain if the stock is a capital asset), unless it is out of a

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pre-1913 increase in the value of the corporation's property, in which event it will enjoy an exemption from tax. 52 Several aspects of the return-of-capital distribution rules of §§   301(c)(2) and 301(c)(3) deserve special comment. The sale gain created by §   301(c)(3) will be entitled to capital gains treatment only if the stock is a capital asset in the shareholder's hands. 53 Moreover, such gain has been held not to be reportable on the installment method. 54 In computing gain under §§   301(c)(2) and 301(c)(3), however, it is not clear whether the shareholder is entitled to recover his aggregate stock basis before reporting any gain. If the gain or loss on the distribution must be computed on a share-by-share basis, the shareholder may recognize gain on low-basis shares, even though the basis of the shareholder's high-basis shares has not been fully recovered.

55 When a stock redemption is treated as a sale under §   302(a) , 56 or when corporate assets are distributed in complete liquidation, 57 the shareholders generally compute gain or loss on a share-by-share basis, and the same approach presumably should be applied to the computation of shareholder gain under §§   301(c)(2) and 301(c)(3). 58 Note that a deficit in accumulated earnings and profits results from an excess of losses over post-1913 earnings; 59 such deficit must be restored by undistributed current-year earnings before the corporation can again have accumulated earnings and profits. Since distributions only reduce earnings and profits under §   312(a) “to the extent thereof, distributions can only reduce earnings to zero, but cannot produce a deficit

therein.” 60 Proposed Regulations issued in January 2009 adopt this latter approach. 58.1

¶ 8.02[6] ExamplesExample  1Current-year earnings.Assume that company X and its shareholders are on the cash-basis, calendar-year method of accounting. X has a deficit of $20,000 in its earnings and profits at the beginning of Year 2, has earnings and profits of $10,000 during Year 2, and distributes to its shareholders $10,000 on July 1 of Year 2. Under §   316(a)(2) , the Year 2 distribution is a taxable dividend, notwithstanding X's deficit.Example  2No current earnings.If company X in Example 1 waits until Year 3 to make the distribution and has no current earnings and profits in that year, the distribution will be treated as a return of capital under §§   301(c)(2) and 301(c)(3), since X's Year 2 earnings and profits will be absorbed by X's deficit, leaving no accumulated earnings to support dividend treatment in Year 3. This distribution is applied on a share-by-share basis as well as upon each class on which the distribution is made. 60.1 Example  3Distributions in excess of current earnings.Company Y has accumulated earnings and profits of $15,000 on January 1 of Year 2, has earnings and profits of $10,000 during Year 2, and distributes to its shareholders $20,000 in April and $20,000 in September of Year 2. Because the current earnings and profits of $10,000 are prorated between the April and September distributions, the April distribution is a dividend in its entirety ($5,000 is out of the prorated current earnings, and the balance comes out of accumulated earnings), while only $5,000 of the September distribution is a dividend ($5,000 from the prorated current earnings, the accumulated earnings having been exhausted by the April distribution). The rest is applied against the basis of the stock, and each shareholder's gain is computed accordingly. 61 Example  4Current deficit.Company Z has accumulated earnings of $20,000 at the start of Year 2, incurs a current operating deficit of $16,000 in Year 2, and distributes $20,000 to its shareholders on July 1 of Year 2. The regulations suggest that the current deficit is prorated throughout the year if it cannot be allocated specifically to a part of the year. If the deficit is prorated, accumulated earnings at the date of the distribution will be reduced by $8,000 (one half of the deficit) to $12,000, and the distribution will be a dividend to this extent. However, if the deficit can be traced and allocated in full to the first half of Year 2, accumulated earnings will be reduced by $16,000, and the dividend portion of the distribution will be only $4,000, while if the deficit is traceable to post-July 1 events, the entire distribution would constitute a dividend.

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¶ 5.05 Dividends-Received Deduction and Related ProblemsDividends received by a corporate taxpayer ordinarily qualify for the dividends-received deduction provided by §   243 (either 70 percent, 80 percent, or 100 percent of dividends received from a domestic corporation subject to federal income taxes), §   244 (at 2005 rates, about 48 percent of dividends received on certain preferred stock of public utilities), or §   245 (70 percent, 80 percent, or 100 percent of a specified portion of dividends received from certain foreign corporations), all subject to the limitations imposed by §   246 . These deductions (complemented by the consolidated return rules) function somewhat imperfectly to tax corporate income only once until it is finally distributed to noncorporate shareholders. 168 The deductions cause corporate investors to favor holding corporate equity (and sometimes to accept a lower rate of return on relatively secure equity, as compared with debt), and they tend to counterbalance the usual preference of corporations for issuing debt when they need to raise capital.Of these provisions, §   243(a)(1) is of principal importance. By permitting the corporate taxpayer to deduct 70 percent of dividends received from other corporations, §   243 reduces to 10.5 percent the effective maximum tax rate on dividends received by a corporation on portfolio stock; that is, the normal top corporate tax rate of 35 percent (2005) is imposed on only 30 percent of the dividends received. If the corporation's taxable income is below $15 million (the start of the top rate bracket), the effective tax rate on dividends received can range from a low of 4.5 percent (15 percent of 30 percent of dividends received) to 10.2 percent (34 percent of 30 percent of dividends received). 169 The tax benefit of this deduction is of

course greater if the dividends qualify for the 80 percent or 100 percent deduction.

¶ 5.05[1] Dividends From Domestic CorporationsSection 243(a)(1) provides generally that 70 percent of the amount received as dividends from a domestic corporation that is subject to federal income taxation may be deducted. 170 If, however, the shareholder owns 20 percent of the stock by vote and value (or more), it is entitled to an 80 percent deduction. 171 The requirement that the paying corporation be subject to income taxation reflects the fact that the purpose of the deduction is to mitigate the multiple taxation of corporate earnings. In harmony with this principle, dividends paid by mutual savings banks and domestic building and loan associations (loosely referred to as interest) and by real estate investment trusts do not qualify for the deduction, and certain dividends received

from regulated investment companies also receive special treatment. 172

¶ 5.05[2] “Qualifying Dividends” of Affiliated GroupsSection 243(a)(3) permits a 100 percent deduction for certain intercorporate dividends received from a member of the same “affiliated group.” This term has the same meaning as for determining whether corporations can file consolidated returns, with certain minor modifications. 173 Thus, complete tax immunity for dividends is ordinarily feasible for an affiliated group, whether or not it elects to file a consolidated return. Indeed, a basis increase similar to those in consolidated returns can be obtained by contributing the deducted dividend back to the paying corporation.To qualify for the 100 percent deduction, the common parent of the group must file an election to which all members consent (a wholly owned subsidiary is deemed to consent). 174 Qualifying dividends must be paid from earnings and profits accumulated during the period of affiliation; indeed, both corporations must have been members of the affiliated group for each day of the year in order for the earnings of the year to count.

175 Thus, a corporation cannot buy into the deduction, although the regulation's last-in, first-out tracking

rule for earnings and profits is favorable to the newcomer. 176

¶ 5.05[3] Dividends on Public Utility Preferred StockIn increasingly rare instances, §   247 allows public utility corporations to deduct a portion of dividends paid by them on preferred stock issued before October 1, 1942, or issued thereafter to refund debt or preferred stock issued before that date. At the 35 percent rate (for 2005), fourteen thirty-fifths (40 percent) of the dividend paid is deductible by the paying corporation. To counterbalance the utility's right to deduct certain dividends paid by it under §   247 , §   244 allows the recipient corporation to take only about 48 percent of the

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dividend into account in computing its dividends-received deduction, in lieu of the normal deduction under

§   243 .

¶ 5.05[4] Dividends From Certain Foreign Corporations

¶ 5.05[4][a] Doing Business in the United StatesDividends paid by a 10 percent owned foreign corporation qualify for the dividends-received deduction under §   245 if (1) the paying corporation is not a foreign personal holding company or a passive foreign investment company; 177 (2) it is subject to federal income taxation; and (3) at least 10 percent (by voting power and value) of its stock is owned by the recipient corporation. If the dividends qualify under these tests, the 70 percent or 80 percent deduction of §   243 is applied to a portion of the dividends, determined by reference to the ratio of the payor's post-1986 undistributed earnings from sources within the United States to its total post-1986 undistributed earnings. By virtue of these complex limitations, the deduction embraces dividends paid by a foreign corporation only to the extent that, roughly speaking, they reflect income that has been subjected to U.S. taxation. Thus, if 60 percent of a 20 percent owned foreign corporation's earnings are from business sources within the United States, 60 percent of its dividends will be eligible in the hands of a recipient corporation for the 70 percent or 80 percent deduction.The 100 percent deduction of §   243(a)(3) for qualifying dividends cannot apply, because a foreign corporation cannot be a member of an affiliated group. 178 If, however, the foreign corporation is wholly owned by U.S. corporate shareholders and if all of its gross income is effectively connected with a U.S. business, the dividends qualify for a 100 percent deduction; in this situation, the foreign subsidiary is

treated as the economic equivalent of a U.S. enterprise. 179

¶ 5.05[4][b] Doing Business Abroad: The Deemed Paid Foreign Tax CreditWhile intercorporate dividends between domestic corporations are substantially relieved from double taxation by the deduction mechanism of §   243 , relief from international double taxation is generally accomplished by means of the foreign tax credit rules of §§   901 through 906. One of these provisions, the so-called deemed paid foreign tax credit of §   902 , allows a domestic parent corporation that owns 10 percent or more of a foreign corporation and receives a dividend therefrom to elect to claim a so-called

derivative foreign tax credit for taxes paid by the foreign corporation. 180

¶ 5.05[5] Deductions by Foreign CorporationsA foreign corporation not engaged in trade or business in the United States is taxed on dividends received from U.S. corporations, but is not allowed the 70 percent or 80 percent dividends-received deduction or, for that matter, any other deductions. 181 Foreign corporations with a domestic business situs, however, are allowed to deduct items that are effectively connected with the U.S. business, including dividends received

if they constitute U.S. business income. 182

¶ 5.05[6] Definition and Amount of “Dividend”Although §§   43 through 245 do not say so explicitly, dividends should not qualify for the dividends-received deduction unless they are includible in the recipient's gross income. For this reason, stock dividends that are excluded from gross income under §   305 should not give rise to a dividends-received deduction. 183 More difficult issues, however, are whether an includible amount qualifies as a “dividend,” as opposed to capital gain or some other type of nondividend income and, if it is a dividend, what is its amount. As discussed later in this book, §   316 defines the term “dividend” for purposes of the entire income tax subtitle, including §§   243 through 245, as a distribution of property by a corporation to its shareholders from its accumulated or current earnings and profits. 184 Section 301 prescribes the treatment of property distributions by corporations to their shareholders, whether such amounts are treated as dividends or as a return of stock basis. In so doing, §   301 defines “amount of the distribution” to be the fair market value of property or the amount of cash received and requires that the resulting dividend portion of that distribution be included as such in gross income. Thus, the rules of §§   301 and 316 for determining the amount of the

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distribution and the dividend component thereof control not only the shareholder's taxable portion of the distribution but also the correlative amount of a corporate shareholder's dividends-received deduction. 185 Furthermore, the taxable recipient of a dividend is the owner of the stock on the dividend record date, even though another person owns the stock on the later ex-dividend date. 186 Nondividend distributions from a corporation that clearly should not be entitled to the dividends-received deduction include (1) distributions in excess of earnings and profits; (2) redemption proceeds that are treated as received in a sale or exchange of the stock under §   302(a) ; 187 (3) liquidation proceeds; 188 and (4) receipts that are not received by a shareholder with respect to his stock but are received in some other capacity. 189 Reorganization boot dividends, however, have been held by the courts to qualify for the §   243 dividends-received deduction, and the Service agrees. 190 Corporate shareholders about to sell stock in a controlled corporation often arrange to receive a dividend shortly before the stock sale for the purpose of stripping value out of the stock at a lower overall tax cost (because of the dividends-received deduction) than would be imposed if they sold the stock and were taxed on their capital gain. Generally, this ploy will work if the proper formalities are observed; that is, if the dividend is actually paid from the controlled corporation's assets rather than from the assets of the acquiring party, a matter discussed later in this book. 191 Similar threshold distributions made in close proximity to the corporation's liquidation also receive close scrutiny as to their true character: ordinary dividends or liquidating distributions. 192 Of course, if the distribution is not made with respect to “stock,” but is paid instead as a return on a “debt,” no dividends-received deduction is allowed, since the corporate investor is receiving interest rather than dividend income. Thus, corporations desiring to raise capital from corporate investors often strive to provide their investors with debt-like paper with a sufficient equity flavor to qualify payments thereon for

the dividends-received deduction. 193

¶ 5.05[7] Overall Restrictions on DeductionsAlthough there are technically three separate dividends-received deductions (§   243 , for dividends paid by domestic corporations in the amount of 70 percent, 80 percent, or 100 percent of the dividend; §   244 , for certain preferred dividends paid by public utilities; and §   245 , for dividends paid by certain foreign corporations), they are aggregated in large part by §   246 for the purpose of imposing the limitations

explained in the following text. 194

¶ 5.05[7][a] Certain Distributing Corporations ExcludedSection 246 (a) provides that the dividends-received deductions of §§   243 through 245 do not apply to dividends paid by corporations that are exempt from tax under §   501 (charitable corporations, federal instrumentalities, 195 mutual telephone companies, and so forth) or §   521 (farmers' cooperative associations). 196 These corporations are disqualified because their earnings are wholly or partially tax-exempt; when another corporation receives their earnings in the form of dividends, the earnings will be

taxed for the first time at the corporate level.

¶ 5.05[7][b] Ceiling on Aggregate DeductionUnless the taxpayer corporation has incurred a net operating loss in the taxable year (computed under the usual rules of §   172 , without any ceiling on the dividends-received deduction), a limit is applied to the aggregate of its 70 and 80 percent deductions plus most of its other deductions under §§   244 and 245. 197 This limitation is computed first by recomputing taxable income without regard to net operating loss carryovers, capital loss carrybacks, and the dividends-received deductions subject to this process, with certain other adjustments. 198 Second, 80 percent of the recomputed taxable income is compared with the normally allowed 80 percent deduction with respect to dividends from 20 percent owned corporations, and the lesser amount is allowed as the actual deduction with respect to those dividends for the year. 199 Third, 70 percent of the recomputed taxable income is compared with the normally allowed deduction with respect to all other dividends subject to the rule (principally, portfolio dividends from less than 20 percent owned corporations, with respect to which a 70 percent deduction normally is allowed), and the lesser

amount is allowed as the actual deduction with respect to those dividends for the year. 200

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¶ 5.05[7][c] Brief Holding PeriodsBefore 1958, the dividends-received deduction held out to the corporate taxpayer the possibility of buying stock just before a dividend became payable and selling it immediately thereafter in order to deduct the loss on the sale (presumably equal to the amount of the dividend, assuming no interim market fluctuations), while paying income tax on only 15 percent (under then applicable law) of this amount. 201 A similar manipulative device was the maintenance of both long and short positions in the stock over the dividend payment date in order to deduct the amount of the dividend paid to the lender of the short stock from ordinary income while reporting only 15 percent of the dividend received on the long stock. 202 To close these loopholes, Congress enacted §   246(c) in 1958 203 and strengthened it in 1984. 204 Section 246(c) denies any deduction under §§   243 through 245 if the stock is not held for more than forty-five days (ninety days in the case of certain preferred stock), the holding period being tolled if the taxpayer substantially diminished its risk of loss from holding the stock. 205 The deduction is also denied if the taxpayer maintained a short position in substantially similar or related stock or securities, or was subject to a similar obligation with respect to the dividend. 206 Proposed legislation in the Clinton 1996 and 1997 budget bills would extend the §   246(c) holding period to include both pre- and post-dividend terms, and this proposal was adopted in the 1997 Tax Act. 207 Note that this limitation also applies to individuals' reduced rate

dividends. 207.1

¶ 5.05[7][d] Debt-Financed Portfolio Stock DividendsSection 246A deals with the tax rate arbitrage effects created by the use of leveraged portfolio stock, under which interest on debt incurred to finance the investment was fully deductible while the associated dividend income on the acquired stock was taxed at a low effective rate because of the dividends-received deduction. Section 246A reduces the recipient corporation's §   243 deduction to the extent of the debt-financed percentage of the stock. Thus, if half of the stock basis is debt-financed, half of the §   243 deduction can be denied; the reduction, however, cannot exceed the amount of deductible interest. 208 This provision does not apply, however, if the taxpayer acquired at least 50 percent of the stock (or owned at least 20 percent, and five or fewer corporate shareholders owned at least 50 percent of the paying corporation); nor does it apply if the taxpayer is entitled to the 100 percent dividends-received deduction. 209

The Treasury has proposed to tighten §   246A by adopting a new and far looser “linkage” test: 210 that is, the new limitation would be the sum of (1) the percentage of stock directly financed by debt and (2) the

percentage indirectly financed by debt determined by using a pro rata allocation concept.

¶ 5.05[8] Basis Reduction for Extraordinary Dividends: § 1059If corporation P buys stock in corporation T, the purchase price will presumably reflect the value of any potential dividends inherent in the stock. If T pays a dividend shortly thereafter, P's dividend income will be reduced by the 70 percent or 80 percent dividends-received deduction (or possibly even the 100 percent deduction if T becomes part of P's affiliated group and the dividend is paid from earnings for a full year of affiliation), and the market value of the T stock should drop by approximately the amount of the dividend; however, P's basis in the T stock (at least prior to 1984) would be undiminished, permitting P to sell the T stock and, assuming no interim market fluctuations, to claim a capital loss equal to the decline in value when the stock goes ex-dividend.These results not only appear to be too good to be true, but they are too good to be true. There are various mechanisms for dealing with this scenario in the context of affiliated corporations filing consolidated returns, as will be discussed later in this book. 211 In the unconsolidated context, the statutory mechanism is §   1059 212 (first enacted in 1984 and later modified in 1986 and 1997), which does not reduce the dividends-received deduction itself but instead imposes a special basis reduction rule that requires a corporate shareholder to reduce its basis for stock owned by it to the extent of the nontaxed portion of any “extraordinary dividend.” The latter is a dividend equaling or exceeding a prescribed “threshold percentage” (5 percent for preferred stock and 10 percent for other stock) of the underlying stock basis, unless the stock was held for more than two years before the “dividend announcement date” or satisfies certain other conditions. 213 Example If corporation P purchased common stock of target T, which then distributed a dividend equal to or greater than 10 percent of P's basis for its T stock, P would reduce the basis of the T stock (but not below zero) by

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the amount of its §   243 deduction unless the transaction satisfied one of §   1059 's exceptions. On a later sale or exchange of the stock, P 's gain or loss would be computed by reference to its stock basis as reduced by §   1059 . If the amount of the dividends-received deduction is not fully absorbed by the stock's basis, the remainder was (between 1986 and 1997) treated as gain at the time of a later stock sale; this deferral rule resulted in the creation of a negative basis for the stock, but was changed in 1997 to an immediate gain recognition rule. 214 Because its consequences are so significant, it is important to understand some significant limitations on the application of §   1059 . Obviously, §   1059 applies only to corporate shareholders who enjoy a dividends-received deduction, and (until regulations are issued to the contrary) it does not apply to dividends from an affiliated group member with which the recipient files a consolidated return. 215 It also does not apply to dividends announced more than two years after the stock acquisition, using a broad definition of “announcement,” 216 or to stock held during the entire period of the payor's existence, provided the payor corporation's earnings and profits have not been augmented by earnings and profits of other corporations (e.g., through mergers) with which the shareholder did not have the same historic relationship. 217 Section 1059 does not apply to qualifying dividends that are eligible for the 100 percent dividends-received deduction, except to the extent attributable to earnings accumulated prior to the time of affiliation, or to gain on the payor's property that accrued before the payor became a member of the affiliated group. 218 It also does not apply to certain preferred stock dividends if the taxpayer holds the stock for more than five years. 219 Certain dividends, however, are automatically deemed to be extraordinary: (1) redemptions that either are treated as partial liquidations or that are non–pro rata but nevertheless are treated as dividends, regardless of the holding period of the stock, 220 and (2) dividends on so-called self-liquidating preferred stock, that is, stock that has a declining dividend rate or a redemption price less than its issue price or stock that is otherwise structured so as to enable corporate shareholders to reduce tax through a combination of dividends-received deductions and loss on the sale of the stock. 221 Moreover, regulations proposed in 1996 and adopted in 1997 222 provide (prospectively) that §   1059(e)(1) trumps any of the exceptions to §   1059 . Finally, proposed legislation would expand the per se basis reduction rules of §   1059(e)(1) (once again) to include all dividends not subject to current U.S. tax, including a proportional part of dividends subject to reduced treaty rates. 223 The Treasury's proposed dividend exclusion 224 would also extend the §   1059 basis reduction rules to tax-exempt dividends and basis step-up allocations to all shareholders, corporate and individual. 225 The normal rules for identifying an extraordinary dividend require a comparison of the amount of the dividend with the underlying stock's adjusted basis. However, since dividends obviously can be segmented, one rule aggregates all dividends received within an 85-day period, while another rule treats as extraordinary all dividends with ex-dividend dates during the same 365 consecutive days if their total exceeds 20 percent of the stock's basis. 226 Finally, the shareholder has the option to show the fair market value of its stock in the payor corporation as of the day before the ex-dividend date, and to use that amount,

rather than its adjusted stock basis, in calculating the 5 percent or 10 percent thresholds. 227

¶ 5.05[9] Proposed Dividend Exclusion: Effect on § 243 Dividends-Received DeductionThe Treasury's proposed exclusion for dividends paid from previously taxed income 228 would apply to corporate shareholders as well as individuals. Thus qualified dividends would be exempt at the corporate level as well and would increase its excludable distribution amount (and hence will remain excludable when redistributed by the recipient corporation). 229 The current 100 percent dividends-received deduction for 80 percent owned corporations would be retained, but the 80 and 70 percent deductions would be phased out under a transition rule. 230 But this proposal failed to pass.

¶ 8.20 Introductory Property distributions in kind

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¶ 8.20[1] General Issues and StakesWhen a corporation distributes cash to its shareholders, the tax consequences to both the recipient and the corporation can be easily determined if the corporation's earnings and profits are known. The distribution is a “dividend” to the extent of the corporation's current and accumulated post-1913 earnings and profits. The balance, if any, is applied against, and reduces the adjusted basis of, the shareholder's stock under §   301(c) (2). Any excess is subject to §   301(c)(3) . The shareholder, having received cash, has no problem of basis. As to the corporation, the distribution itself is not a taxable event. The corporation's earnings and profits are reduced to the same extent that the distribution is a “dividend” to the shareholders.In turning from a corporate distribution of cash to a distribution in kind, 309 however, problems quickly proliferate. The principal issue is whether the mere distribution of appreciated property creates corporate income. Other issues include: does the distribution of depreciated property produce a corporate loss? How does a distribution of property affect earnings and profits? What is the basis of the distributed property in the hands of the shareholders?There may also be a threshold issue of whether the corporation distributed “property,” as defined in §   317(a) , or instead made an anticipatory assignment of income that may be property under state law but that will not shift the taxation of future income away from the corporation to the shareholders transferees.

310

¶ 8.20[2] Pre-1954 Code: Judicial Nonrecognition RegimeSection 1001(c) (and its predecessor) requires the recognition of gain and loss realized upon the disposition of property. Application of this general rule is relatively easy when the taxpayer receives ascertainable value in an exchange, but it appears more difficult when there is no formal exchange present. To the extent that the general recognition rule of §   1001(c) does not apply to corporate distributions in kind, however, the two-tier taxation of corporate income does not result. For this reason, before 1954, in the absence of statutory rules governing this area, the Treasury, on a number of occasions, advanced the theory that upon distributing appreciated property to its shareholders, a corporation realized taxable income just as if it had sold the property for the property's fair market value or had used the property to satisfy an obligation in that amount. The courts consistently rejected the Treasury's argument, usually with a citation to General Utilities & Operating Co. v. Helvering . 311 Actually, the issue had arisen before the General Utilities case, as tax issues often do, in the context of a taxpayer's seeking to recognize a loss. It had been held that a corporation should not recognize loss upon distributing depreciated property to shareholders because Treasury regulations had long denied loss recognition upon liquidating distributions and “no difference exists in principle” between liquidating and nonliquidating distributions in kind. 312 Although the government had argued for the recognition of taxable income upon a distribution of appreciated property simply because a property disposition had occurred in General Utilities, the Supreme Court did not find it necessary to pass on this particular ground in denying the assessment against the distributing corporation. 313

Even though the question was not foreclosed by that opinion, the result was endorsed, at least for the future, by the 1954 enactment of the statutory predecessors of §   311(a)(2) , as to nonliquidating distributions, and

§   336 , as to liquidating distributions. 314

¶ 8.20[3] 1954 to 1986: Rise and Fall of General Utilities DoctrineAs originally enacted, §   311(a)(2) , codified what had come to be called the General Utilities doctrine, namely, that a corporation did not recognize gain or loss on a distribution of appreciated or depreciated property to its shareholders with respect to their stock. 315 The 1954 statutory nonrecognition principle was qualified from the outset by the uncertain judicial practice of imputing some shareholder sales and other dispositions of distributed property to the corporation 316 and by several explicit statutory exceptions in old §   311 317 that required the corporation to recognize gain on certain distributions of appreciated last-in, first-out property and of other appreciated property if subject to a liability in excess of its basis. Moreover, over the course of time, Congress created more and more exceptions to the ostensible general rule of nonrecognition, as far as nonliquidating distributions of

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appreciated property were concerned, while preserving intact the nonrecognition principle for the

corporation's losses on depreciated property. 318

¶ 8.20[4] Repeal of General Utilities Doctrine; Current LawThis legislative trend reached its zenith in the Tax Reform Act of 1986, which effectively repealed both the general nonrecognition rule of §   311(a)(2) for nonliquidating distributions of appreciated property, and the specialized nonrecognition rule of §   336 for liquidating distributions of appreciated and depreciated property, 319 subject to an intricate web of transitional exceptions. 320 In enacting current §   311(b) , which was less a break with tradition than the culmination of a gradual process, Congress offered this rationale: 321 [T]he General Utilities rule tends to undermine the corporate income tax. Under normally applicable tax principles, nonrecognition of gain is available only if the transferee takes a carryover basis in the transferred property, thus assuring that a tax will eventually be collected on the appreciation. Where the General Utilities rule applies, assets generally are permitted to leave corporate solution and to take a stepped-up basis in the hands of the transferee without the imposition of a corporate-level tax.* Thus, the effect of the rule is to grant a permanent exemption from the corporate income tax. * The price of this basis step up is, at most, a single shareholder-level capital gains tax (and perhaps recapture, tax benefit, and other similar amounts). In some cases, moreover, payment of the capital gains tax is deferred because the shareholder's gain is reported under the installment

¶ 8.21 Corporate Gain or Loss on Distributions of Property

¶ 8.21[1] IntroductorySection 311(a)(2) states that “no gain or loss shall be recognized to a corporation on the distribution, with respect to its stock, of…property.” This self-styled general rule, enacted in 1954 to codify the General Utilities doctrine, 322 is general only as to losses on the distribution of depreciated property. For distributions after 1986, 323 §   311(b) requires a corporation to recognize gain on nonliquidating distributions of appreciated property as if the corporation had sold the property for its fair market value except as to distributions in tax-free reorganizations and similar transactions.Before examining these rules, a preliminary comment on the scope of the term “with respect to its stock” may be useful. 324 First, in addition to the nonredemption distributions that are the subject of this chapter, the term encompasses transfers in redemption of stock, whether the redemption is treated as an exchange or as a §   301 distribution. 325 Therefore, while the corporate recognition issue will be discussed again in connection with redemptions, 326 the same rules basically apply to both types of distributions. Furthermore, only complete liquidations are excluded by §   311(a) , so distributions in partial liquidation are covered by its provisions. The regulations expand on the phrase “with respect to its stock” by stating: “Section 311 does not apply to transactions between a corporation and a shareholder in his capacity as debtor, creditor, employee, or vendee, where the fact that such debtor, creditor, employee, or vendee is a shareholder is incidental to the transaction.” 327 Thus, if the corporation sells property for cash to one of its shareholders in the ordinary course of business, the corporation recognizes gain or loss in the usual manner, since the fact that the buyer is a shareholder is incidental to the transaction. 328 A “bargain sale” to a shareholder, however, usually must be treated as a dividend in part. 329 The corporation also recognizes gain or loss under the general rules of §   1001 if it uses appreciated or depreciated property to pay compensation to an employee-shareholder, since the distribution is not made “with respect to its stock,” even though the employee also happens to be a shareholder. The same principle applies if property is transferred to pay a debt owed to a shareholder. 330

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The debt-discharge situation, however, creates a special problem if the underlying obligation was created by a corporate resolution to distribute property as a dividend to the corporation's shareholders. In several pre-1954 cases, corporations were held to realize gain or loss on the distribution of appreciated or depreciated property to their shareholders because the resolution authorizing the distribution created an enforceable obligation in a specified dollar amount (i.e., the resolution created a debt, which was the distribution) 331 and because the corporation satisfied this debt by the disposition of property with a fair market value equal to the amount owing but with an adjusted basis to the corporation that was either less than or greater than the property's value. Indeed, the Service made this argument in General Utilities, but the Supreme Court rejected it on the ground that the dividend resolution in that case did not create a fixed-dollar indebtedness; rather, the obligation was merely to distribute a fixed number of shares of stock, thus establishing the value at which the property would be distributed instead of using its actual value at the date of distribution. The argument was successful, however, where (1) the dividend resolution created an obligation that was treated as the distribution and (2) the transfer of the property to the shareholder was deemed to be a separate event, which treatment, in part, depended on the fact that the quantity of the property was not fixed by the resolution but could vary according to the property's value relative to the debt at the time of distribution. 332 The continued viability of this approach could be relevant to the recognition of losses (discussed in the next subparagraph) and to the different timing, valuation, and earnings and profits results that could flow from treating the step of creating an obligation that itself is the distribution transaction as a step that is separate from a later satisfaction of that obligation. Where the corporation clearly intends the dividend to be paid in the form of a corporate obligation and where satisfaction of the obligation with corporate property clearly is a later separate step (which usually will necessitate the shareholders' agreeing to accept satisfaction in kind), the two steps should be respected as such. Where the corporation contemplates satisfaction of the debt in kind from the outset, and a better tax result is obtained by separating the steps (as in the case of loss

property), a successful step transaction attack can be expected. 333

¶ 8.21[2] LossesSection 311(a)(2) supersedes the general recognition rule of §   1001(c) and provides that a corporation cannot recognize the loss it realizes upon distributing depreciated property to its shareholders. This rule, which has been mandated by §   311(a)(2) since 1954, 334 was carried forward in 1986, even though Congress then repealed the General Utilities nonrecognition doctrine regarding appreciated property and, for the first time, allowed losses to be recognized when a corporation distributes depreciated property in complete liquidation. 335 Despite these dramatic changes, the legislative reports offer no explanation for perpetuating the 1954 rule for nonliquidating distributions of depreciated property; presumably, it was thought that compared to liquidating distributions, nonliquidating distributions are more open to manipulation with respect to both timing and bona fides. 336 Other than the impact on earnings and profits discussed later, 337 there is little more to be said about the nonrecognition rule itself. A surprising ancillary application of §   311(a) , however, has been its use by the Service and some cases to deny not only gain and loss recognition but also any corporate deduction on account of distributions with respect to stock. 338 Corporations wishing only to transfer depreciated property to their shareholders and to recognize the losses thereon may seek to circumvent §   311(a)(2) by a variety of tactics, such as declaring a dollar-amount dividend and later satisfying it with a distribution in kind (as discussed in the preceding subparagraph) or selling the property to the shareholders or to third persons who then resell the same property to the shareholders.Sales directly to shareholders, however, must run the gauntlet of §§   267(a)(1) and 267(b)(2), which disallow any deduction for losses on the sale of property by a corporation to a person owning more than 50 percent (by value) of the seller's outstanding stock. 339 Because stock ownership for this purpose includes stock owned by specified members of the buyer's family, closely held corporations will usually find that sales are not a feasible way of avoiding §   311(a)(2) . Moreover, even if stock ownership is sufficiently dispersed to avoid application of §   267(a) , a purported sale may be brushed aside as a sham or recharacterized as a mere distribution coupled with a functionally unrelated contribution by the shareholders to the corporation's capital of the amounts ostensibly paid by them for the property. 340 Indeed, this approach is potentially more damaging to the shareholders than a simple application of §   267(a) , since

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losses disallowed under §   267(a) may be taken into account when the shareholder ultimately disposes of the property; no comparable relief is available under §   311(a)(2) . 341 An attempt to avoid the application of §   311(a)(2) by the corporation's purported sale of the depreciated property to an outsider may be attacked by the Service as a sham or a step transaction if the property is resold by the ostensible buyer to the shareholders, especially if the two steps are prearranged or occur in such rapid succession that prearrangement can be inferred. 342 If, however, the depreciated property does not end up in the hands of the corporation's shareholders, §   311(a)(2) will not ordinarily pose any threat to the corporation's right to recognize the loss, since that section applies only to a distribution of property “with respect to [the distributing corporation's] stock.”Corporations wishing to recognize losses and to distribute the value of certain loss property to shareholders should simply sell the property at a loss and distribute the proceeds. In unusual circumstances, however, an ostensible corporate-level sale to an outsider might be recharacterized as a distribution to the shareholders followed by a sale by the shareholders to the purchaser. For example, if a distribution-cum-shareholder-sale is planned but called off at the last minute in favor of a sale by the corporation and a distribution by it of the proceeds, the Service might succeed in imputing the sale to the shareholders by analogy to the Court Holding Co. case, which involved the converse situation, namely, a shareholder sale of distributed property that was imputed to the corporation because, at the last minute and without any business purpose, the plan was changed to an ostensible shareholder sale. 343 Such a recharacterization of the transaction would result in nonrecognition of the loss at the corporate level on the theory that, in substance, the corporation did not sell the property but instead distributed the property to its shareholders within the meaning of §   311(a)(2) . The shareholders, whose basis for the property would be the property's fair market value when received by

them, 344 would then realize no loss on their sale to the ultimate purchaser.

¶ 8.21[3] GainsTo correct the deficiencies perceived in pre-1986 law, 345 Congress enacted §   311(b)(1) , which requires that the corporation recognize gain upon distributing property (other than its own obligations, which generally are within the §   317(a) definition of “property”) to a shareholder in a distribution to which §§   301 through 304 apply. 346 This includes a distribution not in redemption of stock, a distribution in redemption of stock, whether treated as a distribution or as in exchange for the stock, 347 and a stock purchase by a related corporation that is treated as a distribution under §   304 . Section 311(b) cannot apply to distributions in complete liquidation, because such distributions are excluded from §   311(a) and because §   311(b) does not require gain to be recognized on distributions governed by other provisions of the Code, such as the rules governing complete liquidations, tax-free reorganizations, and spin-offs. 348 With respect to nonliquidating distributions, there is no exception analogous to §   337 that prevents application of the general recognition requirement to a distribution to a controlling parent corporation, although the gain may be deferred if it arises in a consolidated group. 349 Section 311(b), when applicable, requires the corporation to recognize gain as though the corporation had sold the distributed property “to the distributee” at the property's fair market value. 350 Thus, the statute not only creates a “sale,” which may enable the disposition to meet the definition of “capital gain,” 351">

https://checkpoint.riag.com.lawezproxy.bc.edu/app/servlet/com.tta.checkpoint.servlet.CPDocTextServlet?usid=134bb4a621d&DocID=T0BE%3A4152.208&docTid=T0BE%3A4152.208-1&feature=tcheckpoint&jsp=%2FJSP%2FdocText.jsp&lastCpReqId=3518771&lkn=docText&searchHandle=ia744cc630000012cc343e4c118dac1ba - FN%20%3Ca%20name=351">351 but also identifies the vendee, whose identity also may have other significance. 352 Thus, despite the fact that §   311(b)(1) says nothing about whether the hypothetical sale generates capital gain or ordinary income, this issue (including the impact of any applicable recapture rules) is no doubt governed by the same principles that would apply to an actual sale to the distributee. Unlike an actual sale of a mixed bag of assets, however, which would permit the gains and losses to be offset against each other resulting in a recognized net gain or loss, §§   311(a) and 311(b)(1) together may produce an unappetizing combination of recognized gains and nonrecognized losses. 353 Section 311(b)(1) is buttressed by §   311(b)(2) , which incorporates by reference rules similar to those prescribed by §   336(b) , 354 providing that if a corporation distributes property subject to a liability, or if a corporate liability is assumed by a shareholder in connection with the distribution, the fair market value of

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the property shall be treated as not less than the amount of that liability. 355 This rule will most likely apply on an asset-by-asset basis. 356 Example If the corporation distributes property with a basis of $90,000 and a fair market value of $100,000, subject to a liability of $125,000, the distributing corporation's gain is $35,000 ($125,000 minus $90,000). Section 336(b), and hence §   311(b)(2) , does not distinguish between recourse and nonrecourse liabilities, and so the same result would be reached if the shareholder assumed the $125,000 liability rather than took the property subject to it.Section 311(b)(3) replaces the predecessor rule of § 386(d) and grants regulatory authority to deal with distributions of partnership or trust interests where contributions of built-in-loss property to the partnership or trust have been made for the principal purpose of sheltering potential §   311(b)(1) gain.Although §   311(b)(1) does not explicitly supersede it, the breadth of §   311(b)(1) renders obsolete the case law under which shareholder gains on the sale of distributed property were sometimes imputed back to the corporation. 357 It is possible that such an imputation may be appropriate in unusual situations, such as a shareholder's sale of the property for more than the property's fair market value when distributed, if the sale is effected with the use of corporate facilities or with corporate participation. Also unclear is whether the Service's authority under §   482 to reallocate income among two or more organizations, trades, or businesses “to prevent evasion of taxes or clearly to reflect the income [of the parties]” has any continuing vitality here following enactment of §   311(b) . Before 1986, this provision was successfully invoked by the Service to sidestep the nonrecognition principle of old §   311 in several cases under circumstances that still remain to be clarified. 358 When the distribution involved affiliated corporations, §   482 's prerequisite of two or more organizations, trades, or businesses was easily satisfied; even in the case of distributions to individual shareholders, shareholder activities could be characterized as a trade or business if such activities disposed of the property over time, as in CIR v. First State Bank of Stratford. 359 In that situation, however, §   482 added little if anything to the case law, and, if the distribution involved only a single asset with no continuing association among the shareholders, as in the General Utilities case, §   482 's prerequisite of a

separate organization, trade, or business was not likely to be satisfied.

¶ 8.21[4] Collateral Defenses to General Utilities RepealAlthough the repeal of General Utilities in the 1986 legislation was considered (by some) to have been a stunning coup for the cause of tax reform, the “General” has died hard, and much of the post-1986 Act administrative and legislative activity has focused on attempts to ensure that the corporate-level gain recognition principle is preserved.The major developments along this front are listed in a later section. 360 While these developments have done much to preserve the integrity of General Utilities repeal, they also demonstrate that taxpayers and their advisers will continue to press heavily on the statutory structure in a relentless search for weak spots in its defenses.

¶ 8.22 Taxability of Distributions to Shareholders

¶ 8.22[1] Amount of Distribution and Basis Effects to ShareholdersThe “amount” of a distribution in kind is the fair market value of the property. If this amount is covered by the corporation's current or post-1913 earnings and profits, 361 the distribution is a taxable “dividend” to the extent of the property's fair market value as of the date of distribution 362 under §§   301(b)(1) , 301(c)(1), and 316(a) . 363 If, however, the value of the distributed property exceeds the corporation's current and post-1913 earnings and profits, the regulations provide that the distribution is a “dividend” only to the extent of the earnings and profits, and the remaining amount reduces the shareholder's stock basis and any excess value is recognized as gain. 364 As discussed below, 365 the distribution itself can increase the amount of available earnings and profits as a result of the required gain recognition created by §   311(b) . Example

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If corporation X, with earnings and profits of $10,000, distributes property having a fair market value and basis of $16,000 to its sole shareholder, A, the distribution is a taxable dividend to A in the amount of $10,000. The remaining $6,000 is applied against the basis of A's stock under §   301(c)(2) , and the excess over basis (if any) generates capital gain under §   301(c)(3) . 366 If, however, the basis is less than $16,000, and if the resulting gain is taxed to X under §   311(b) —as will ordinarily be the case 367 —X's earnings and profits will be increased by the gain recognized and reduced by the resulting corporate tax on that gain. 368 This adjustment to the earnings and profits will, of course, alter the calculation set out above. 369 For example, if X's earnings and profits are increased by $4,000, to $14,000, the distribution will be a dividend to A in the amount of $14,000, and the remaining $2,000 will be subject to §§   301(c)(2) and 301(c)(3).The valuation issues here are similar to those that can arise in numerous other places throughout the Code.

370 Although valuation affects both the shareholder and the corporation, 371 the corporation's reasonable determination will ordinarily control the issue by virtue of the corporation's duty to report that value to the shareholder and to the Service. 372 If a distribution is valueless, or cannot be valued with a reasonable degree of accuracy, the distribution may be held not to constitute a present property interest or may be held to constitute taxable property only if and when the property can be valued. 373 The distribution amount is net (but not below zero) of any liability assumed by the shareholder in connection with the distribution and liability to which the property is subject “immediately before, and immediately after” the distribution. 374 While a distribution might be linked to a debt cancellation by a third-party creditor, the statutory requirement of continuation of the debt arguably excludes a debt to the shareholder that is extinguished (by merger) in the distribution; although it would appear that the shareholder ought to get credit for his “payment” (by analogy to the bargain purchase dividend rules) to the extent of that canceled debt. 375 The shareholder takes a fair market value basis in the distributed property, and this basis is not reduced by debt assumed or to which property is subject; 376 this fair market value basis in effect reflects the shareholder's “cost” in the property, and, under a “cost” analysis, debt assumed or to which property is subject normally is included in cost basis under §   1012 . Nevertheless, property basis is probably limited to the property's value if that value is less than debt assumed or to which property is subject. 377 Example Continuing the previous example, A's basis for the distributed property under §   301(d) likewise is $16,000, the same as the amount of the distribution under §   301(b) . If A assumes (or takes the distributed property subject to) a $20,000 liability of the distributing corporation, the amount of the distribution is reduced to zero by §   301(b)(2) ; while A will not take any amount into income, A's basis for the property probably remains at $16,000 (rather than $20,000) under §   301(d) , although authority does exist for claiming the $20,000 figure.The distributee's holding period for the property, determined under the general holding period rules of

§   1222 , begins with the date of the distribution.

¶ 8.22[2] Effect on Distributor's Earnings and ProfitsWhile the effect of a distribution of property on the distributing corporation's earnings and profits was clouded in obscurity for many years, the 1986 revision of §   312(b) adopted in connection with the repeal of the General Utilities doctrine generally clarified and greatly simplified these rules. On a distribution of property whose fair market value exceeds its adjusted basis (note that basis for this purpose is the earnings and profits basis of the property), 378 earnings and profits are first increased by the amount of the excess and then decreased by the property's fair market value (but not below zero). 379 Any earnings and profits reduction that is unused disappears, because a distribution cannot create a deficit of earnings and profits. Example  1If the earnings and profits account is zero at the beginning of the taxable year and the corporation's only transaction is a distribution of property with an adjusted basis of $100 and a fair market value of $1,000, the earnings and profits account is increased by $900 so that the distribution is a “dividend” to the extent of this appreciation. The $900 may be thought of as an interim earnings and profits account, determined following the distribution for the purpose of determining the extent to which the distribution is a dividend. The $900 interim earnings and profits account is then reduced to zero (distributions do not create a deficit) as of the end of the year to reflect the negative effect of the distribution and to determine ending earnings and profits. The $100 “unused” earnings and profits reduction (attributable to the property's basis) disappears.

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Any corporate tax resulting from the recognized §   311(b) gain presumably would reduce the amount of the interim earnings and profits account, and the treatment of accrual-method and cash-method corporations in this regard may differ. 380 Section 312(b), however, has no application to distributions of depreciated property, which are treated as follows: (1) By virtue of §   311(a)(2) , the corporation does not recognize the loss on a distribution of depreciated property, and thus does not generate a §   312(f)(1) reduction to earnings and profits due to recognized loss; (2) the distribution is a dividend to the extent of the property's fair market value up to the amount of any earnings and profits the corporation may have from other transactions (i.e., the distribution does not affect interim earnings and profits); and (3) earnings and profits are decreased under §   312(a)(3) (but not below zero) 381 by the adjusted basis of the property. Example  2If a corporation that already has $15,000 of earnings and profits distributes property with an adjusted basis of $15,000 and a fair market value of $10,000, the distribution is a dividend of only $10,000, but it wipes out the corporation's earnings and profits account.Thus, one slight advantage of a distribution of loss property, which tends to offset the disadvantage of not recognizing the loss, is the ability of such a distribution to sweep more earnings and profits out of the corporation than the shareholder has to recognize with respect to his dividend. 382 If the basis of the distributed property for earnings and profits purposes differs from regular adjusted basis (e.g., because of lower §   312(k) depreciation), the former figure must be used for purposes of both §§   312(a)(3) and 312(b) as well. 383 Example  3If the §   312 bases in Example 1 and Example 2 were $600 and $16,000, respectively, the amount of the dividend in Example 1 would be $400, the amount of earnings generated by the distribution ($1,000 fair market value minus $600 basis). In Example 2 , the earnings and profits decrease still would be limited to $15,000.Section 312(c) requires further adjustment to the adjustments under §   312(a) for liabilities to which the property is subject or that are assumed by shareholders in connection with the distribution. Such liabilities cause an upward adjustment to earnings and profits by reducing the reductions to that account. 384 Example  4If the distributed property in Example 1 was subject to a $200 debt, the net reduction to earnings and profits would be only $800, leaving the corporation with $100 of earnings and profits (but the shareholder's net dividend is only $800 as well). 384.1 If, in Example 2 , the property was subject to a $2,000 debt, the net charge to earnings and profits is only $13,000, leaving the corporation with $2,000 of earnings and profits (but the shareholder's net dividend is only $8,000).Even though §   312(c) refers to adjusting the adjustments in both 312(a) and 312(b), (relating to appreciated property) it should no longer (after 1984 and 1986) have a role to play here because the deemed sale now required by §   311(b) fully reflects the upward adjustment to fair market value also required by §   312(b) and §   312(c) . There may be such a role for §   312(c) , however, when distributed property has debt in excess of value. When debt on distributed property exceeds the value of the property, §   311(b)(2) requires the debt to be used as the deemed sales price, and §   312(f)(1) appears to require the gain so recognized to be added to earnings and profits. 385 Section 312(b)(1), however, limits the increase to the excess of fair market value over basis, and there is no clear indication that fair market value for this purpose is governed by §   311(b) (2). If actual fair market value is used to so limit the increase, interim earnings and profits will not reflect the amount of the corporation's debt relief in excess of the property value. That excess probably should be required to be reflected in the interim earnings and profits. Perhaps §   312(c) has a role to play in this case where debt exceeds value by further increasing the interim earnings and profits increase under §   312(b) to the amount of the excess, instead of applying §   312(c) only after the distribution to increase final earnings and profits by the amount of the excess debt. 386 Example  5X distributes property worth $10,000, subject to nonrecourse debt of $12,000, and having a basis of $5,000. X recognizes a $7,000 gain under §   311(b)(2) (ignoring taxes on this recognized gain for simplicity). Assuming §   312(f)(1) does not apply, §   312(b)(1) would appear to increase interim earnings and profits by only $5,000. However, the transaction arguably will improve X's economic worth by $7,000 because of the debt relief, which improvement should be reflected in the interim earnings and profits account because of the §   311(b) gain recognition computation. This result might be reached by applying §   312(c) to adjust the

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§   312(b) adjustment so that X 's interim earnings and profits account increases by the full $7,000 under §   312(b) (or simply providing for the full increase to reflect the actual gain triggered by §   311(b) here). To account for the impact of the distribution transaction on final earnings and profits, X 's earnings and profits would be reduced by the property's full fair market value of $10,000, which reduction, however, is then reduced by $10,000 (the balance of the debt to be accounted for by §   312(c) ), meaning that there is no reduction in X's earnings and profits in this transaction.The approach of §   312(c) should also be applied to the case of a bargain sale of property to a shareholder, which is treated as a distribution to the extent the fair market value of the property exceeds the amount paid by the shareholder for the property. 387 While the amount paid by the shareholder would not affect the increase in the corporation's earnings and profits, it should reduce the decrease in the earnings and profits under §   312(a) in the same manner as would a debt assumption by the shareholder.One area of unresolved confusion surrounding §§   312(a) and 312(b) relates to the fact that §   312(b) appears to mandate an earnings increase for any distribution of appreciated property, while the decrease rule of §   312(a) is limited by §   312(d) so as not to apply to various nonrecognition distributions. Consequently, §   312(b) seems to require an earnings increase with no offsetting earnings decrease on nonrecognition distributions such as a §   332 liquidation, a Type C reorganization, or a §   355 division. This treatment could cause problems under the alternative minimum tax and consolidated return rules. Since §   312(b) was probably enacted as a “belt and suspenders” supplement to §   312(f)(1) , it probably should not apply at all to nonrecognition dispositions; rather, it should apply only to those distributions that previously enjoyed General Utilities protection but are now subject to deemed-recognition treatment under §§   311(b) and 336 .

¶ 8.23 Distributions of Corporation's Own Obligations

¶ 8.23[1] Identifying the ObligationDistributions of “property” that are governed by §   301 and are potentially taxable as dividends include distributions of the corporation's own obligations, ordinarily evidenced by notes, bonds, debentures, or other securities. 389 A preliminary issue is whether the corporation has actually distributed an obligation, in which case the obligation itself is the distributed property, 390 or whether the corporation has only declared a dividend to be paid in the future, in which case the payment is the distribution and there is no preliminary distribution of a debt obligation. 391 Corporate debt held by shareholders should not be treated as equity simply because it is distributed to shareholders as a dividend. Rather, its status as debt or equity should be

determined under the usual rules. 392

¶ 8.23[2] No Corporate Gain or LossA corporation does not recognize either gain or loss on a distribution of its own obligations. The general rule of §   311(a) applies, and such obligations are specifically excluded from the countervailing recognition rule of §   311(b)(1) . This treatment is consistent with the general principle that the issuance of debt is not a

realization event to the debtor.

¶ 8.23[3] Distribution Amount and Shareholder BasisIn these respects, there is no difference between a distribution of the corporation's own obligations and a distribution of other types of property. 393 The amount of the distribution under §   301(b)(1) 394 is the fair market value of the obligation. 395 Obviously, this amount is not necessarily the face amount of the debt, because its value reflects the interest rate and the creditworthiness of the issuer. 396 The shareholder apparently cannot use the installment method in reporting any §   301 gain resulting from the distribution. 397 An accrual-method shareholder that does not report a debt on the installment method normally must report the face amount of the debt rather than the debt's value. 398 However, this rule may not apply to debt dividends, because accrual-method shareholders have traditionally been placed on the cash method for dividends. 399 If the obligation cannot be reasonably valued at the time of its distribution, “open transaction” treatment has been applied. 400

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Under §   301(d) , the basis of the distributed obligation in the hands of the distributee would likewise be its fair market value, the same amount used in computing the §   301(b) distribution. Collections of the note in excess of its basis are treated as a sale or exchange of the note for capital gains purposes by virtue of

§   1271(a)(1) .

¶ 8.23[4] Effect on Earnings and ProfitsAlthough the fair market value of the corporation's obligations controls both the amount of the distribution and the basis of the obligations, as just described, §   312(a)(2) provides that the distributing corporation's earnings and profits generally are reduced by the principal amount of the obligations. In many cases, these amounts will be identical, but, if there is a difference because the obligation has original issue discount, §   312(a)(2) substitutes the aggregate issue price for the principal amount. That issue price is the obligation's fair market value if the obligation is publicly traded and bears “adequate stated interest.” 401 If the obligation is not publicly traded but bears adequate stated interest, its issue price is the stated redemption price at maturity. 402 If the difference between face amount and value is attributable to some other feature of the transaction (e.g., bond premium), however, the principal amount is controlling.The corporation's obligations are excepted from the category of appreciated property in §   312(b) , and so

there is no upward adjustment of earnings and profits upon their distribution.

¶ 8.23[5] Distributions of “Debt-Like” Preferred StockThe Clinton Administration's budget bills proposed to treat certain debt-like preferred stock as boot for purposes of §   351 and §   356 , 403 and this proposal, which passed in 1997, may extend to §   305 as well. If so, distribution of the recharacterized stock as a purported tax-free “stock dividend” instead would become immediately taxable (either in the manner of a debt dividend, as previously discussed, or under the similar §   305(b) rules discussed later in this chapter 404 ).Although the initially brief description of this provision was menacingly unclear on this point (and numerous others as well), Treasury's broad regulatory authority must be affirmatively exercised to extend taxable boot treatment beyond the §   351 and §   356 nonrecognition areas. 405 The final version of the 1997 legislation adopting this proposal clarified its scope as merely creating “equity boot” for purposes of gain recognition under §§   351 , 354, and 355, and that “stock” status will continue for all other purposes unless and until prospective regulations alter that status.In order to escape classification as tainted debt-like preferred, the stock must either participate meaningfully in corporate growth or, if not, then it must have a twenty-year term and not carry a floating dividend rate. In effect, adoption of this proposal makes preferred stock dividends a risky business for the distributees (unless the stock is “plain vanilla” evergreen preferred with a fixed dividend rate, or unless it has a meaningful upside participation potential).

¶ 9.01 Sale of Dividend: Background and General Concepts

¶ 9.01[1] IntroductoryWhen a shareholder transfers stock to the issuing corporation in exchange for money or other property, the transaction may resemble either an ordinary sale of stock to an outsider in an arm's-length bargain or the receipt by the shareholder of a distribution from the corporation that may be a dividend depending on corporate earnings and profits. The sale analogy is appropriate, for example, when the owner of preferred stock instructs a broker to sell the stock and the broker, by chance, effects a sale to the corporation, which happens to be buying up its preferred stock at the time. The preferred shareholder ought to be able to treat the transaction in the same manner as any other sale, reporting the difference between the adjusted basis and the sales price as capital gain or loss.On the other hand, when the owner of a one-person corporation having only common stock outstanding forgoes dividends for a period of years and then “sells” some shares back to the corporation for cash, the transaction is much more like a dividend (i.e., an extraction of corporate earnings and profits) than a sale.

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Although the shareholder has surrendered some of his stock, his interest in the corporation's assets and his control of the corporation's fate are undisturbed. Moreover, if such transactions were not taxed as dividends under these circumstances, shareholders could embark upon long-range programs of intermittent redemptions to extract corporate earnings, while employing tax-free stock dividends, if necessary, to replace redeemed shares and to restore the corporation's stated capital for the benefit of nervous creditors. If a corporation's shareholders could adopt such a plan of intermittent “sales” of stock, the tax on dividend income would become a dead letter because sale treatment of the redemption allows the redeemed shareholder to include as income only the excess of the amount received in the redemption over the shareholder's basis in the stock redeemed as well as the benefit of any currently available tax preference for capital gains.It should not be surprising, then, that a “sale” of stock by a shareholder to his corporation is sometimes taxed as a dividend instead of as a sale. The knotty problem that has faced Congress, the Treasury, and the courts over the years—to which there can never be a universally acceptable solution—is the determination of which transfers of stock are to be classified as dividends and which transfers of stock are to be treated as sales. For a period of more than thirty years ending in 1954, the general rule was that such transactions were sales unless the transaction was “essentially equivalent to the distribution of a taxable dividend” within the meaning of § 115(g) of the 1939 Internal Revenue Code, 1 in which event the entire distribution was taxed as a dividend to the extent of current and post-1913 earnings and profits. Although current law, as explained below, is much more elaborate, it preserves this ancient and troublesome phrase; thus, a few words of history are necessary before turning to the statutory language of the 1954 and 1986 Codes.

¶ 9.01[2] Evolution of Sale Test: Pre-1954When the “essentially equivalent to the distribution of a taxable dividend” language first appeared, the courts were reluctant to tax redemptions as dividends unless the redeemed shares had been issued as tax-free stock dividends or in anticipation of a later redemption. Later, however, the courts increasingly assumed that any pro rata redemption was equivalent to a taxable dividend, casting on the taxpayer the burden of establishing that the redemption ought to be treated as a sale instead. If the redemption was not pro rata, however, it was ordinarily treated as a sale of stock by the shareholder on which the shareholder would realize capital gain or loss. This exemption for disproportionate redemptions was based both on the regulations, which provided for sale treatment if all of a particular shareholder's stock was redeemed, 2 and on the theory that a redemption of part of a shareholder's stock could be equally efficacious in changing “his interest in the corporation in the same way that redemption of all of his stock would do.” 3 As dividend treatment for pro rata redemptions came to be the norm rather than the exception, taxpayers found that the most promising escape was a judicial doctrine that a redemption resulting from a corporate contraction, or a “legitimate shrinkage” in the corporation's business activities, was not essentially equivalent to a dividend. 4 The courts also agreed that a redemption, for legitimate business purposes, was “not taxable as a dividend”; however, the courts did not agree on the meaning of that phrase. Even less helpful was the solemn announcement that the true test was whether the net effect of the redemption was the distribution of a dividend. In its infancy, this test was an attempt to escape an inquiry into the motives and plans of the shareholder and his corporation. 5 Since virtually all pro rata redemptions have the net effect of a dividend, however, the courts began to transmute this test into a restatement of the “essentially equivalent” language of the statute or, sometimes, into a pseudonym for the business-purpose doctrine that it was created to avoid. 6 The upshot was that in applying § 115(g) of the 1939 Code, there was no escape from an inquiry into all the facts and circumstances of each case, and predictions were hazardous. 7

¶ 9.01[3] Current Law

¶ 9.01[3][a] IntroductoryThe drafters of the 1954 Code sought to bring order to this messy area by distinguishing between distributions that “may have capital-gain characteristics because they are not made pro rata among the various shareholders” and distributions “characterized by what happens solely at the corporate level by

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reason of the assets distributed.” 8 The first of these two categories, which carries forward the non–pro rata concept of pre-1954 law, is governed by §§   302(b)(1) , 302(b)(2), and 302(b)(3) of current law under the 1986 Code. The second category, which preserves the corporate contraction doctrine of pre-1954 law (but only for the benefit of noncorporate distributees), is embodied in §   302(b)(4) .More specifically, §   302(a) provides that a redemption of stock “shall be treated as a distribution in part or full payment in exchange for the stock” if the transaction fits into any one of the following four categories: 9

1. A redemption that is not essentially equivalent to a dividend under §   302(b)(1) ;2. A substantially disproportionate redemption under §   302(b)(2) ;3. A redemption of all the shareholder's stock under §   302(b)(3) ; and4. A partial liquidation under §   302(b)(4) (applicable only if the redeemed shareholder is not a corporation).

By virtue of §   302(d) , a redemption that does not fall within any of these categories is to be treated as a distribution under §   301 (i.e., as a dividend to the extent of current and post-1913 earnings and profits and as a return of capital to the extent of any balance). 10 Exchange treatment under §   302(a) is almost always more advantageous to noncorporate shareholders than distribution treatment, since exchange treatment means that the amount includible in income is not necessarily the full amount received but is rather the full amount received less the adjusted basis of the stock. Furthermore, any gain on the redemption is capital gain if the stock is a capital asset in the shareholder's hands (as is usually the case), and any tax preference for capital gain will favor the sale treatment over the distribution treatment (and such a preference has returned in force in 1997). 11 Moreover, if the redemption that is treated as a sale is on credit, the selling shareholder may be entitled to defer his gain under §   453 if the stock redeemed and the debt received are not publicly traded. 12 For corporate shareholders, however, dividend treatment under §   302(d) may be preferable because the amount received qualifies for the 70 percent, 80 percent, or 100 percent dividends-received deduction of §   243 or is eliminated from income if the two corporations file a consolidated return.

13 Of the four categories of redemptions that §   302(b) treats as exchanges, the most important in planning financial transactions are redemptions under §   302(b)(2) (substantially disproportionate redemptions) and §   302(b)(3) (complete termination of shareholder's interest). 14 The rules of these two sections, if complied with carefully, provide safe-conduct passes to the promised land of sale treatment. Taxpayers who cannot bring transactions within these requirements can try to avail themselves of §   302(b)(1) by establishing that the redemption is not essentially equivalent to a dividend; this, however, is a treacherous route, to be employed only as a last resort. 15 Section 302(b)(4), relating to partial liquidations, is useful only if the redeeming corporation carries on two or more “qualified trades or businesses” (as defined) or is, by reason of extraneous circumstances, able to effect a bona fide “contraction” of its business; further, it applies only

to noncorporate shareholders. 16

¶ 9.01[3][b] Definition of “Redemption”Section 317(b) defines “redemption” for purposes of §   302 as a corporation's acquisition of its stock from a shareholder in exchange for “property,” regardless of whether the stock is canceled, retired, or held as treasury stock. The regulations under §   311 indicate that a shareholder's exchange of stock for corporate property may not be a redemption at all if the distribution is made in some capacity other than the corporation-stockholder relationship. 17 The definition of “redemption,” as well as §   302 itself, presupposes that the redeemed instrument is properly classified as stock. As explained earlier, purported stock is sometimes reclassified as debt (in which event, §   302 is inapplicable) and vice versa. 18 It appears that options to acquire stock generally are not treated as present stock for purposes of §   302 . 19 “Property” means money, securities, and any other property but not stock or rights to acquire stock in the distributing corporation. 20 If the shareholder receives nothing of value for his stock, then no redemption has occurred and the shareholder probably has merely made a contribution to capital. 21 If a corporation redeems its stock by issuing debt that later is reclassified as equity, 22 the transaction cannot be governed by §   302 , because the transaction fails the definition of “redemption” in §   317(b) , which excludes transactions where stock is repurchased in exchange for stock of the same corporation (because §   317(a) denies “property” status for that stock). However, once it is decided that the transaction is not a redemption or that the corporation's obligations are not property, the next step is far from certain. The transaction might be regarded as a tax-free exchange under §   1036 or §   368(a)(1)(E) , with any down

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payment in the form of cash being treated as boot; nevertheless, it is also possible that a later payment of the obligations would be regarded as a redemption. 23 Transactions that do not initially appear to be in the form of a redemption nevertheless can be recharacterized as such, 24 for example, in the case of a “cash-out” reverse merger where cash paid to the target's shareholders comes from the target. 25 On the other hand, as discussed below, a shareholder faced with the bona fide choice of selling his shares to a third person or having them redeemed can normally sell and enjoy exchange treatment even if the buyer subsequently has the stock redeemed. 26 The Internal Revenue Service has, on occasion, asserted that an apparent redemption actually is a sale of corporate assets. 27 Pinpointing the date of the redemption may be important for the reasons discussed previously in connection with §   301 distributions 28 as well as for the determination of relative stock ownership changes. Even if the sale is treated as a distribution, it would seem that the normal rules for fixing the date of a §   1001 sale by reference to the change of beneficial ownership should apply here, except where the special rules governing §   301 distributions overrule them. 29 A redemption often occurs in connection with another transaction, such as a severance agreement with departing employees. In such instance, it may be in the corporation's interest to shift part of the redemption price to a deductible compensatory-type payment, while the shareholder's interest would be the reverse. Thus, even though a stock redemption transaction has in fact occurred, the Service will still be concerned about the transaction's parameters and whether part of the consideration is paid to the shareholder other

than in his capacity as such. 30

¶ 9.01[3][c] No-Ruling AreasBecause each of the exceptions to §   301 distribution treatment depends on some sort of reduction in stock ownership, the Service is sensitive to whether a reduction has in fact occurred. Therefore, the Service has identified several scenarios in which it will not issue private rulings under §   302(b) 31 (although the courts have ruled in favor of taxpayers in several cases involving these scenarios):

1. Redemption for corporate debt with the stock held as security for the debt and with the possibility that the stock may be returned to the seller; 32 2. Redemption for a corporate obligation to pay some amount based on future earnings or a similar contingency; 33 3. Redemption followed by the corporation's using the shareholder's property and paying therefor an amount based on corporate earnings or subordinate to general creditors; and 34 4. Redemption for payments over a period in excess of fifteen years (ordinarily, no ruling). 35

This reluctance to rule is a warning that in appropriate cases, the Service might argue that similar facts justify a finding that a reduction in stock ownership has not occurred either because the shareholder may recover the stock redeemed or because the corporate obligation given in exchange for the stock is tantamount to a continuing equity interest, so that no “redemption” (as defined in §   317(b) ) has occurred.

¶ 9.02 Constructive Ownership of Stock: § 318

¶ 9.02[1] In GeneralIn determining whether a redemption qualifies as an exchange under §§   302(b)(1) through 302(b)(3), which are concerned with the degree of decrease in the shareholder's voting control of the corporation, the constructive ownership rules of §   318(a) must be taken into account. These rules attribute stock owned by one person to another on the basis of various relationships. The rules apply to any transaction within the ambit of subchapter C to which they are expressly made applicable (but not otherwise) and, thus, are by no means confined to stock redemptions. 37 The §   318 attribution rules have taken on special importance, however, in the area of redemptions and are, therefore, discussed at this point. As will be seen, these constructive ownership rules are expressly made applicable to §§   302(b)(2) and 302(b)(3) redemptions by §   302(c)(1) ; 38 and the regulations extend their coverage to §   302(b)(1) redemptions. 39 Because of the

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pervasive effect of constructive ownership on the redemption of the stock of family and other closely held corporations, §   318 is examined here in some detail before consideration of the substantive rules of §   302(b) .A few words on terminology are in order here. Section 318 creates “constructive” stock ownership, also referred to as ownership by attribution. Section 318 generally treats such deemed ownership as if it were “actual” stock ownership. 40 “Actual stock ownership” is referred to in various provisions of §   318 as stock owned “directly or indirectly,” i.e., stock titled in the name of the owner (direct ownership) or held by an agent (indirect ownership). “Indirect ownership,” therefore, does not mean ownership by attribution. 41 Hence, direct and indirect actual stock ownership plus the deemed actual stock ownership under §   318 are combined to determine total stock ownership for purposes of the §   302 rules.Section 318(a) applies to transactions governed by subchapter C (i.e., §§   301 through 385 , covering most, but not all, of the transactions discussed in this work) but only if expressly made applicable by the relevant statutory provision. Intricately devised, §   318 is only one of several sets of constructive ownership rules prescribed by the Code, which rules differ among themselves in such details as the degree of family relationship warranting the attribution of stock from one person to another and in the way stock owned by a trust is allocated to its beneficiaries. 42 Although in theory each set could be crafted to suit the transaction to which it applies, their divergencies are frequently trivial and almost always inexplicable. 43 There is, however, no “common law” of attribution, and so attention to the rules of the particular attribution regime at hand is important. 44 By virtue of §   318(a) , a taxpayer is considered to own stock owned by various other persons or entities; but that stock is not also attributed away from those other persons for purposes of reducing their particular share-ownership interests. 45 In other words, the attribution rules operate to increase, not decrease, stock ownership. Example If A owns 85 percent of a corporation's stock and B, a person unrelated to A under §   318 , owns the other 15 percent and has an option to increase his percentage of ownership to 25 percent by acquiring unissued shares, B's actual and constructive ownership of 25 percent of the stock does not reduce A's percentage of ownership from 85 percent to 75 percent.The types of attribution prescribed by §   318 may be divided into attribution (1) from one member of a family to another (sometimes called collateral attribution ); (2) from an entity, such as a trust or corporation, to persons beneficially interested therein, or vice versa (vertical or direct attribution, where the entity's stock is attributed upstream to its owners or beneficiaries, and back attribution, where the owners' or beneficiaries' stock is attributed downstream to the entity); and (3) from an entity to its owners or beneficiaries and from them to members of their family (or, conversely, from family members to beneficiaries and thence up to the entity), a combination of items (1) and (2) that is sometimes called chain, or double, attribution or is called reattribution.Before 1964, a fourth category of attribution was possible, since stock owned by one beneficiary of an entity could be attributed to the entity and thence to another beneficiary. This type of reattribution is now prevented by §   318(a)(5)(C) . 46 Stock owned by the entity and attributed to a beneficiary thereof, however, is reattributed to the members of the beneficiary's family (and family stock attributed to a beneficiary is reattributed to the entity). This form of reattribution, which can also occur via the option rule of §   318(a) (4), was unaffected by the 1964 change, and it causes much of the complexity and most of the confusion in applying §   318 .

The following paragraphs describe the constructive ownership rules of §   318 in greater detail.

¶ 9.02[2] Family AttributionUnder §   318(a)(1) , an individual is deemed to own stock owned by his spouse, children, grandchildren, and parents. Unlike some other attribution rules in the Code, 47 §   318(a)(1) does not attribute stock from one brother or sister to another. Thus, family blood affinity is lineal only (two steps down and one step up). Stock attributed from family member A to family member B under §   318(a)(1) is not reattributed from family member B to members of B's family. 48 A fortiori, this limitation ensures that stock owned by Bittker will not be attributed to his parents and then from them to their parents, and so on back to Adam and Eve, and then down through the family of man to Eustice. Example

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If H, his wife, W, their son, S, and their grandson, G, own twenty-five shares of corporation X each, then H, W, and S are each deemed to own 100 shares of X by virtue of §   318(a)(1) ; G , on the other hand, is deemed to own only fifty shares (twenty-five directly and twenty-five constructively from his father, S). If G had a brother, B, no stock would be attributed from G to B through their father, S . Note that H and W, G's grandparents, constructively own his stock, even though he does not constructively own theirs.The family attribution rules apply without regard to hostility between the family members, according to the Service and most courts, 49 but they are subject to an important exception in the case of complete redemptions, as discussed below. 50 The Joint Committee Tax'n Staff in its April 2001 simplification report urges (as many did who have gone before) that a uniform definition of “family” should be adopted. 50.1 As

usual, however, nothing has been done to do so.

¶ 9.02[3] Entity-To-Beneficiary (Outbound) AttributionUnder §   318(a)(2) , stock owned, “directly or indirectly,” by partnerships, estates, trusts, and corporations generally is attributed to the beneficial owners only in proportion to their ownership interests. Thus, stock owned by or for a partnership 51 or estate 52 is considered as owned by the partners or estate beneficiaries 53 in proportion to their beneficial interests; 54 moreover, only a “direct present interest” (not a remainder after a life estate) counts as an estate beneficiary for this purpose. 55 Stock owned by a trust (other than a §   401(a) trust for employees) is considered to be owned by the beneficiaries and, thus, the trust's stock is attributed to them 56 in proportion to their actuarial interest in the trust (regardless of how small, remote, or contingent the interest may be). 57 In the case of a so-called grantor trust described in §§   671 through 679, the person taxable on its income is the constructive owner of the stock. 58 Stock owned by a corporation is attributed pro rata only to those shareholders (if any) who own (actually or by attribution) 50 percent or more by value of the corporation's stock. 59 But stock attributed from a beneficiary to an entity cannot be reattributed

out from it to another beneficiary. 60

¶ 9.02[4] Beneficiary-To-Entity (Inbound) AttributionUnder §   318(a)(3) , stock owned, “directly or indirectly,” by partners, beneficiaries, and shareholders generally is attributed in full to the partnership, estate, trust, or corporation. Unlike the proportionality rule in entity-to-beneficiary attribution, however, stock owned by partners or beneficiaries of an estate 61 is attributed in full to the partnership or estate. 62 If the entity is a trust, stock owned by a beneficiary of a trust (other than a §   401(a) employees' trust) is attributed to the trust, unless the beneficiary has only a “remote and contingent interest,” as defined. 63 Stock owned by a person taxable on trust income under §§   671 through 679 (the “grantor trust” rules) is attributed to the trust. 64 If the entity is a corporation, only stock owned by a shareholder owning (actually or by attribution) 50 percent or more of the value of its stock is attributed to the corporation. 65 As noted previously, however, stock attributed from a partner, beneficiary, or shareholder to an entity is not

reattributed out to other partners, beneficiaries, or shareholders of the same entity. 66

¶ 9.02[5] Option AttributionUnder §   318(a)(4) , a person who has an option to acquire stock is deemed to own the optioned stock (but not other stock owned by the optionor). The relationship of §   318(a)(4) to contingent options (e.g., an option exercisable upon a merger or a shareholder's death) and to options on unissued (or treasury) stock is unclear. 67 The regulations state that for purposes of the substantially-disproportionate test, only stock actually issued and outstanding is counted. 68 The Service and several courts, however, have applied option attribution to unissued stock. 69 It is clear that warrants, convertible debentures, and other noncontingent rights to obtain stock at the holder's election will result in attribution of the optioned shares to the optionee. 70 Contingencies that remove the election from the optionee's unilateral control generally prevent attribution; 71 however, an option exercisable by right only after a lapse of time has been ruled subject to attribution. 72 Another issue concerns whether options on unissued stock can be used to increase the total number of shares deemed to be outstanding, which can affect the determination of the proportionate ownership of the taxpayer whose shares have been redeemed. The Service takes the position that the option attribution rules can be applied only to increase the stock ownership of the redeemed shareholders. 73 Some courts, however,

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have allowed the ownership fraction's denominator to be increased by stock optioned from the corporation.

74 If both the option attribution rules and family attribution rules can apply, the option attribution rules take precedence. 75 A reattribution of the optioned stock to another member of the option holder's family is thus permitted. Similarly, if a partnership, estate, trust, or corporation has an option on stock owned by a partner, beneficiary, or shareholder, that stock can be reattributed out to other beneficiaries of the entity. 76

¶ 9.02[6] Other Aspects of § 318The regulations and a ruling clarify two ambiguities in the language of §   318 : (1) a corporation is not deemed to own its own stock by attribution from shareholders or by option; 77 and (2) stock is not counted more than once—for example, stock owned by a beneficiary of a trust is not attributed to the trust and then reattributed to the beneficiary. 78 In determining constructive stock ownership, however, the stock is to be attributed in such a way as to maximize the taxpayer's ownership. 79 Thus, if a 50 percent trust beneficiary has an option on all the stock of corporation X owned by the trust, the beneficiary is charged with all, rather than only 50 percent, of the stock, since the option rules result in greater constructive ownership.Although the attribution rules of §   318 are ordinarily disadvantageous to taxpayers, they occasionally may be used affirmatively to qualify a particular transaction for favorable treatment. Example H owns forty shares of corporation X, W (H's wife) owns ten shares, and A (unrelated) owns fifty shares. A redemption of twenty-three of H's shares and two of W's shares will qualify both H and W for the favorable treatment accorded by §   302(b)(2) to substantially disproportionate redemptions, 80 since §   318 will treat both H and W as owning fifty shares out of 100 before the redemption, and only twenty-five out of seventy-five thereafter. Were it not for §   318 , the change in W's ownership (from ten shares out of 100 to eight shares out of seventy-five) would not be sufficiently disproportionate for favorable treatment under §   302(b)(2) .

¶ 9.02[7] ExamplesThe provisions of §   318 may be illustrated by the following examples, in which it is assumed that the parties are unrelated unless otherwise stated. Example  1Partnership-partner attribution.A, an individual, owns 50 percent of corporation X 's stock. The other 50 percent is owned by a partnership in which A has a 20 percent interest. The partnership is considered as owning 100 percent of X, and A is considered as owning 10 percent in addition to the 50 percent A actually owns. (A's partners also own their proportionate interests of the partnership's 50 percent direct ownership of X, but none of A 's shares that the partnership constructively owns.)Example  2Trust-beneficiary attribution.Corporation X's 100 shares of stock are owned as follows: twenty shares each by A, B, and C, who are brothers, and forty shares by a trust, in which the interests of A, B, and C, computed actuarially, are 50 percent, 20 percent, and 30 percent, respectively. The trust is considered to own all of the stock in X, whereas A, B , and C, in addition to the twenty shares each owns directly, respectively own twenty, eight, and twelve shares by attribution from the trust.If C's interest in the trust were both remote (i.e., worth 4 percent or less) and contingent, C's stock would not be attributed to the trust, but the trust's stock would be attributed proportionately to C. 81 Example  3Corporation-shareholder attribution.A owns 70 percent and B owns 30 percent of corporation X's stock. A and X each own one half of corporation Y's stock. X is deemed to own 100 percent of Y, while A is deemed to own 85 percent of Y. Y, on the other hand, is deemed to own 70 percent of X.If A and B are related family members, B is deemed to own 100 percent of Y (85 percent by attribution from A and 15 percent by virtue of B's 30 percent actual interest in X). That is, 50 percent of Y is attributed from

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A to B under family attribution, 35 percent of Y is attributed from X to A to B by a combination of corporate and family attribution, and 15 percent of Y is attributed from X to B by corporate attribution, B's being subject thereto because B owns 30 percent of X directly and 70 percent by attribution from A. A also owns 100 percent of Y (50 percent directly, 35 percent by attribution from X , and 15 percent by attribution from related family member, B , to whom the 15 percent was attributed from X). Y is considered as owning 100 percent of X (30 percent from B to A, then 100 percent from A to Y).Example  4Reattribution.A and B own 50 percent of corporation X and 50 percent of corporation Y each. X is considered to own 100 percent of Y, and Y is considered to own 100 percent of X. By virtue of §   318(a)(5)(C) , however, A and B own only 50 percent of X and 50 percent of Y each; the stock in the other corporation that is attributed from A to X and Y is not reattributed out to B, or vice versa.Example  5Estate-beneficiary attribution.Corporation X has 100 shares outstanding. W owns thirty shares, S, W's son, owns twenty shares, and E , an estate, owns fifty shares (W is the life beneficiary of the property administered by the estate, and S is the remainderman). E owns 100 shares of X, fifty directly, thirty by attribution from W, and twenty from S to W (by family attribution) and thence from W to E (by beneficiary-to-estate attribution). W also owns 100 shares of X, thirty directly, fifty from E (W is considered to be the sole beneficiary, since W has the direct present interest in estate assets or income), 82 and twenty from S by family attribution. S likewise owns 100 shares of X, twenty directly, thirty from W, and fifty from E to W to S.If S and W were unrelated, however, the estate would own only eighty shares of X (those owned directly plus those attributed from W, since S is not considered a beneficiary), and W would also own only eighty shares as well; S would own only twenty shares, the number owned directly.Example  6Option attribution.B has an option on stock owned by his sister, S; S's stock is attributed to B by the option attribution rules and is reattributed to any children of B and to B's wife under the family attribution rules. Although S's stock is also attributed to S's parents, it would not be reattributed from the parents to B.

¶ 9.03 Substantially Disproportionate Redemptions: § 302(b)(2)

¶ 9.03[1] In GeneralAn ordinary dividend typically effects a distribution of money or property to the corporation's shareholders without disturbing the shareholder's relative interests in the assets and earning capacity of the corporation, whereas a non–pro rata redemption frequently does change those relative interests. 83 For this reason, §   302(b)(2) treats a “substantially disproportionate” redemption as a sale of the stock rather than as a §   301 distribution.In order to qualify as substantially disproportionate, the redemption must meet three requirements:

1. Immediately after the redemption, the shareholder must own less than 50 percent of the total combined voting power of all classes of outstanding stock entitled to vote; 84 2. The shareholder's percentage of the total outstanding voting stock immediately after the redemption must be less than 80 percent of his percentage of ownership of such stock immediately before the redemption; and3. The shareholder's percentage of outstanding common stock (voting or nonvoting) after the redemption must be less than 80 percent of the shareholder's percentage of ownership before the redemption.

These tests are applied on a shareholder-by-shareholder basis, so that multiple redemptions may be substantially disproportionate as to one shareholder but not as to others. The constructive ownership rules of §   318 are applicable in determining whether a redemption is substantially disproportionate under

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§   302(b)(2) , and these rules materially reduce the feasibility of such redemptions by closely held family corporations. For example, if a 50-percent shareholder seeks to avoid the first of the above requirements by gifts to children or grandchildren, the attribution rules put him back where he started, so the gifts are an exercise in futility, like rearranging the deck chairs on the Titanic on the evening of April 14, 1912. Corporate shareholders, on the other hand, have been alert to the planning possibilities offered by §   318 in

seeking to avoid application of §   302(a) . 85

¶ 9.03[2] The 50 Percent and 80 Percent TestsThe 50 percent restriction in §   302(b)(2)(B) is presumably based on the theory that a reduction in the shareholder's proportionate ownership is not significant if the shareholder continues to own (directly or constructively) stock representing 50 percent or more of the voting power. The two 80 percent tests (which coalesce if the corporation has only one class of stock) envision substantial shareholder-level contractions in the redeemed shareholder's equity and voting interest in the corporation.Stock with contingent voting rights (e.g., preferred stock with a power to vote only if dividends are passed) is generally excluded from the term “voting stock.” 86 The common-stock-reduction test is measured on an aggregate fair-market-value basis (rather than on a class-by-class basis, where there is more than one class of common stock outstanding). 87 If the corporation redeems only nonvoting stock (common or preferred), the redemption cannot qualify under §   302(b)(2) , because it will not reduce the shareholder's proportionate ownership of voting stock. A redemption of nonvoting stock can qualify, however, if it is coupled with a redemption of voting stock that would qualify if it stood alone. 88 A redemption of voting preferred stock can qualify even if the shareholder owns no common stock. 89 The regulations set out the following illustration to explain the application of the two 80 percent tests in §   302(b)(2)(C) : 90 Corporation M has outstanding 400 shares of common stock of which A, B, C and D each own 100 shares or 25 percent. No stock is considered constructively owned by A , B, C or D under section 318. Corporation M redeems 55 shares from A, 25 shares from B, and 20 shares from C. For the redemption to be disproportionate as to any shareholder, such shareholder must own after the redemption less than 20 percent (80 percent of 25 percent) of the 300 shares of stock then outstanding. After the redemptions, A owns 45 shares (15 percent), B owns 75 shares (25 percent), and C owns 80 shares (26 2/3 percent). The distribution is disproportionate only with respect to A.This illustration can be recast in tabular form:

under §   302(b)(2) .In computing the percentage of stock owned by each shareholder after the redemption, care must be taken to reflect the smaller number of shares outstanding. In the table above, for example, B owns 25 percent after the redemption (seventy-five shares out of 300 shares), not 18.75 percent (seventy-five shares

outof400 shares). 91

¶ 9.03[3] Step Transaction AspectsApplication of the step transaction doctrine can both cause and prevent the application of §   302(b)(2) . For example, a gift or sale of stock by the redeemed shareholder or an issuance of shares by the corporation that is an integrated part of the redemption transaction will be counted in determining whether a disproportionate redemption has occurred. 92 To prevent an obvious abuse of §   302(b)(2) , the statute explicitly provides that it does not apply to any redemption under a plan that contemplates a series of redemptions that, in the aggregate, will not be substantially disproportionate with respect to the shareholder. 93 Thus, to return to the previously mentioned illustration, if the redemption of the stock of A, B, and C was in accordance with a plan by which seventy-five of D's shares would later be redeemed, the redemption of A's shares would not meet the test of §   302(b) (2). After the second step, A would own 20 percent of the total outstanding shares (forty-five shares out of 225), an insufficient reduction in A's percentage. The redemption of D's shares, however, would apparently qualify, even though it was the occasion for disallowing the redemption of A's shares. 94 As indicated earlier, however, the explicit reference in §   302(b)(2)(D) to a “series of redemptions” is not the Service's

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only weapon against attempts to abuse §   302(b)(2) . For example, if a redemption viewed in isolation is substantially disproportionate as to a shareholder, but the other shareholders have agreed to sell enough stock to him after the redemption to restore the status quo, the “common law” step transaction doctrine

would prevent the redemption from satisfying §   302(b)(2) .

¶ 9.03[4] Disproportionate Redemptions and Corporate Shareholders

¶ 9.03[4][a] GeneralIn response to the widely publicized Seagram-Dupont transaction, 95 legislation was proposed in May 1995 to repeal the basis reduction rule of §   1059(e)(1) and add a per se sale rule for redeeming corporate shareholders that would have been subject to the former § 1059(e)(1) per se basis reduction rule. 96 Under proposed §   302(b)(5) , §   302(a) would apply to a corporate shareholder receiving a partial liquidation-type distribution, or a dividend-equivalent (though not fully pro rata) redemption distribution; also, no loss would be allowed if, and to the extent, regulations so provided. 97 The proposal was not intended to apply in consolidated returns (unless regulations so provided).

¶ 9.04 Termination of Shareholder's Entire Interest: § 302(b)(3)

¶ 9.04[1] IntroductorySection 302(b)(3) provides that a redemption must be treated as a sale if it “is in complete redemption of all the stock of the corporation owned by the shareholder.” 104 If two unrelated persons, A and B, own all the stock of a corporation, a redemption of all the stock of either A or B will clearly qualify under §   302(b)(3) . A redemption of this type would also qualify under §   302(b)(2) unless only nonvoting stock is redeemed. 105

If A and B are related, so that shares owned by one are attributed to the other—a common phenomenon in the case of closely held corporations—§   302(b)(2) is difficult to satisfy. Thus, the principal importance of §   302(b)(3) lies in its waiver, available in certain limited circumstances under §   302(c) , of the application of the family attribution rules of §   318 . This waiver provides an escape route for closely held corporations that cannot meet the tests for a substantially disproportionate redemption under §   302(b)(2) , because, in applying that provision, the redeemed shareholder is charged with the stock owned by the remaining shareholders under the attribution rules.In order to qualify for protection under §   302(b)(3) , a redemption must completely terminate the shareholder's proprietary interest in the corporation. Apart from the more stringent requirement of “interest termination” in connection with use of the attribution waiver, the proprietary interest can be terminated even if the shareholder retains or acquires some other type of interest in the corporation. 106 A termination of proprietary interest is easy to identify if the shareholder is paid in cash. If, however, the shareholder takes notes or other credit instruments in exchange for his stock, the claim that the shareholder completely terminated his proprietary interest may be open to question. 107 The Service has been reluctant to approve credit redemptions where there is a possibility of recapture of the redeemed stock upon default by the corporation or where the payout term is unreasonably long. 108 The courts, however, have been more tolerant, except where the debt obligations seem to represent a continued, although disguised, equity interest in the corporation. 109 In the widely cited case of Zenz v. Quinlivan, 110 the Sixth Circuit held that a §   302(b)(3) termination can occur through the combination of redemption by the corporation of part of the stock and sale of the rest to

third persons provided that both dispositions are parts of a single transaction. 111

¶ 9.04[2] Waiver of Family Attribution

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¶ 9.04[2][a] In GeneralIf all of the stock actually owned by a shareholder is redeemed by the corporation, and no stock outstanding thereafter is attributed to the shareholder by §   318 , §   302(b)(3) easily applies to treat the transaction as a sale. If constructive ownership under the family attribution rules alone prevents an otherwise clean termination, the application of those rules can be waived under §   302(c)(2) , and the transaction may then be treated as a sale. This waiver is permitted if the shareholder (1) retains no interest in the corporation after the redemption (including any retained proprietary interest as well as an interest as officer, director, or employee of the corporation), other than an interest as a creditor; 112 (2) does not acquire any such interest (other than stock acquired by bequest or inheritance) within ten years from the date of the distribution; 113 and (3) agrees to notify the Service of the acquisition of any forbidden interest within the ten-year period.

114 The regulations provide that acquiring an interest in a parent, subsidiary, or successor corporation is equally fatal. 115 If the seller acquires the forbidden interest, then the tax due for the year of redemption must be recomputed on the basis of dividend treatment. 116 It is important to note that §   302(c)(2) waives only the family attribution rules, not the entity-beneficiary or option attribution rules. 117 Entities can waive the family attribution rules, however, but only in limited circumstances. 118 A look-back rule prescribed by §   302(c)(2)(B) also may bar a waiver if certain changes in stock ownership occurred during the ten-year period preceding the distribution. 119 Note also that the family attribution waiver applies only to §   302(b)(3) , redemptions effecting a complete termination of the shareholder's interest, and not to redemptions seeking protection under §   302(b)(1) , §   302(b)(2) , or §   302(b) (4).The theory of the family attribution rules and their waiver may be stated in this fashion: A redemption of all of a shareholder's stock is properly treated as a sale because it terminates the shareholder's interest in the corporation as effectively as a sale to a third person. The sale analogy is not appropriate, however, if, after the redemption, members of the ex-shareholder's immediate family own stock. It is sufficiently possible that the seller will thereby continue his interest in the corporation (without interference from the outside that might have resulted from a sale to a third person) so that an attribution of his relative's shares to him is a reasonable rule of thumb. If the seller is willing, however, to forgo for a ten-year period any interest in the corporation (other than an interest retained as a creditor or acquired involuntarily by bequest), it is reasonable to waive the family attribution rules and treat the redemption as a sale. This exception does not encompass the entity-beneficiary or option attribution rules, however, because they impute stock on the basis of an economic interest, rather than a family relationship that does not necessarily bespeak an identity

of economic interest.

¶ 9.04[2][b] Waivers by EntitiesBy virtue of §   302(c)(2)(C) , 120 partnerships, estates, trusts, and corporations can waive the family attribution rules as applied to stock that the entity's partner, beneficiary, or shareholder owns constructively by attribution from a member of the partner's, beneficiary's, or shareholder's family. Section 302(c)(2)(C) does not apply to stock that the partner, beneficiary, or shareholder (1) owns directly, (2) is considered as owning by attribution from another entity, or (3) can acquire under an option to purchase. This special rule applies if two conditions are met: (1) both the entity itself and each related person must satisfy the normal requirements for a waiver (i.e., no postredemption interest in the corporation, no acquisition of an interest within ten years from the date of the redemption, and filing of the notification agreement) and (2) each related person must agree to be liable along with the entity for any deficiency (including interest and additions to tax) resulting from a tainted acquisition of an interest during the ten-year period. 121 “Related person” is specially defined for these purposes as any person to whom stock is attributable under §   318(a) (1) at the time of the distribution if the stock would be further attributable to the entity under §   318(a)(3) . Example Assume that the stock of corporation X is owned equally by A and by T, a trust of which A's daughter, B, is the sole beneficiary. A redemption of T's shares, on these facts, does not completely terminate T's stock interest in X, because A's shares are attributed to B under §   318(a)(1)(A)(ii) and then are reattributed from B to T under §   318(a)(3)(B)(i) . If, however, T and B comply with the waiver conditions and execute the notification agreement, the redemption qualifies because B (and, thus, T) is not considered as owning A's shares; the redemption is, therefore, a complete termination vis-à-vis T.

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If A owned fifty, T owned twenty-five, and B owned twenty-five shares of stock, a waiver would be fruitless because it could apply only to A's shares, leaving intact the attribution of B's stock to T. This would mean that the redemption of T's own shares would not be “complete” within the meaning of §   302(b)(3) . If, however, X redeemed T's and B's shares simultaneously, a waiver under §   302(c)(2)(C) would evidently be efficacious for both T and B. 122 The waiver would not work if A were not B's parent but rather a corporation in which B was a shareholder or an unrelated person whose shares B held an option to buy. 123

¶ 9.04[2][c] Tainted Postredemption “Interest” in CorporationAs stated previously, a waiver of the family attribution rules is allowed only if, among other conditions, the redeemed shareholder has no direct or indirect interest in the corporation immediately after the redemption and does not acquire such an interest (other than inherited stock) for ten years thereafter. 124 “Interest,” defined by §   302(c)(2)(A)(i) for this purpose, includes an interest as officer, director, 125 or employee but excludes an interest as a creditor. Stock acquired by a distributee in a fiduciary capacity is a tainted interest, 126 unless the fiduciary capacity is testamentary. 127 Although the prohibition of an “interest as officer, director, or employee” might be construed to bar such a relationship only if coupled with a profit-sharing or similar financial “interest” in the corporation, the Service has espoused the stricter view that performing services or simply holding a position as officer or director, with or without compensation, is fatal, 128 and some (but not all) courts, at least, have supported this interpretation. 129 There is, however, some support for viewing independent contractor status as well as other roles that do not actually involve control or compensation as not tainted interests. 130 It would be more consonant with the purpose of §   302(c)(2) to distinguish between conduct supporting an inference that the ex-shareholder did not effectively terminate his financial interest in the corporation and conduct that is consistent with such a termination, and to waive the family ownership rules if the ex-shareholder's conduct falls in the latter category, but some appellate courts have found this effort too difficult. 131 Since §   302(c)(2) permits the retention or acquisition of an interest as a creditor, the shareholder will be able to sell his stock to the corporation on credit rather than for cash. The regulations warn, however, that an obligation “in the form of a debt” may, in substance, give the owner a proprietary interest in the corporation, going on to provide that (1) the ex-shareholder's rights must not be greater than necessary for the enforcement of his claim; (2) the debt must not be subordinate to claims of general creditors; 132 (3) payments of principal must not be contingent on earnings as respects their amount or certainty; and (4) enforcement of the ex-shareholder's rights as creditor upon a default by the corporation will not constitute the acquisition of a forbidden interest unless stock of the corporation, its parent, or (in certain cases) its subsidiary is thus acquired. 133 Other creditor relationships, such as a lessor, are permissible if the rent is

neither dependent upon earnings nor subordinated. 134

¶ 9.04[2][d] Ten-Year Look-Back RuleThe waiver of the family ownership rules granted by §   302(c)(2)(A) is denied in certain circumstances on the basis of events preceding the redemption. Before examining these conditions, which are set out in §   302(c)(2)(B) , it may be useful to give an illustration of their purpose. If A owns all the stock of a corporation and wishes to give his son a gift of cash, A can, of course, use funds that he received as dividends, but only after the funds have been reported by A as income. If A raises the funds by causing the corporation to redeem part of his stock, the redemption will probably be taxed as a dividend. 135 However, what happens if A gives his son some stock in the corporation and then causes this stock to be redeemed? If the transaction is not disregarded as a sham, 136 the son can claim the shelter of §   302(b)(3) by filing a waiver of the family attribution rules under §   302(c)(2) (thus avoiding the attribution of his father's stock to him) and complying with the 10-year post-redemption rules.To frustrate plans of this type, §   302(c)(2)(B) provides that the family attribution rules may not be waived (1) if any part of the redeemed stock was acquired directly or indirectly within the previous ten years by the distributee from a related person, 137 or (2) if any related person owns stock at the time of the distribution and acquired any stock, directly or indirectly, from the distributee within the previous ten years, unless the stock so acquired is redeemed in the same transaction. The second situation could arise where one spouse gives stock to the other spouse and then the rest of the donor's stock is redeemed, leaving the couple with continued stock ownership.

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These limitations on the waiver of the family attribution rules are not applicable if the acquisition in the case of situation (1) above, or the disposition in the case of situation (2) above, did not have “as one of its principal purposes the avoidance of Federal income tax.” 138 The regulations state that a transfer “shall not be deemed” to have the avoidance of federal income tax as one of its principal purposes merely because the transferee is in a lower income tax bracket than the transferor. 139 Therefore, a transfer from a retiring parent to a child who will be active in the corporate business generally will pass muster. 140 Moreover, a ruling suggests that acquisitions of stock during the ten-year look-back period are not fatal unless they manifest a tax-avoidance purpose of a limited type (i.e., an attempt to retain a continuing interest in the corporation

despite the redemption). 141

¶ 9.04[3] Summary and ConclusionIn reviewing the historical progression in the treatment of redemptions terminating the shareholder's entire interest, a series of checks and balances as intricate as a baroque fugue is found. The attribution rules prevent a merely formal termination of the interest of a shareholder who retains an indirect stake in corporate affairs through his family, but this restriction is mitigated by the waiver of the family attribution rules. The waiver, however, becomes retroactively invalid if an interest is acquired during the ten-year period following the redemption. This condition, in turn, is subject to an exception for an interest acquired by bequest. However, the ten-year good-behavior period is available only to shareholders who have not participated during the preceding ten years in transfers to or from a related person. Finally, such a preredemption transfer is disregarded if not motivated by tax avoidance.

¶ 9.05 Redemptions Not Essentially Equivalent to Dividends: § 302(b)(1)

¶ 9.05[1] In GeneralSection 302(b)(1) provides that a redemption will be treated as a sale of the redeemed stock if it is not “essentially equivalent to a dividend.” 142 Because of this provision, a redemption that fails to qualify for exchange treatment under §   302(b)(2) (substantially disproportionate redemption), §   302(b)(3) (complete termination of shareholder's interest), or §   302(b)(4) (partial liquidation) 143 has a last clear chance—more accurately, as will be seen, a last cloudy chance—to qualify by meeting the vague standards of §   302(b)(1) .

144 In applying §   302(b)(1) , a redemption's failure to satisfy requirements of §   302(b)(2) , §   302(b)(3) , or §   302(b)(4) is not taken into account. 145 The Supreme Court held in US v. Davis that neither the absence of a tax-avoidance motive nor the presence of a business purpose for the redemption would protect it against dividend treatment. 146 The regulations, although stating that dividend equivalence depends on the “facts and circumstances of each case,” provide that the constructive ownership rules must be considered in making this determination, 147 and the Supreme Court also endorsed this principle in the Davis case.In addition, the regulations state that if the redeeming corporation has only one class of stock outstanding, a pro rata redemption generally will be treated as a distribution under §   301 , 148 and Davis likewise endorsed this position. 149 Similarly, if the corporation has more than one class outstanding, redemption of an entire class also generally will fall under §   301 if all classes of stock are held in the same proportion. Finally, the only example of a qualified §   302(b)(1) redemption given by the regulations is a redemption of one half of the nonvoting preferred stock of a shareholder who owns no shares of any other class of stock.As with the other exceptions in §   302(b) , it is clear that the relevant “facts and circumstances” should include other integrated stock sales, redemptions, and issuances. 150 But if Treasury's February 2003 dividend exclusion proposal 150.1 had been enacted, qualification under §   302(a) for sale treatment would become less attractive, while dividend equivalency may well be the tax-preferred result. Even under Ways and Means Chair Thomas's alternative proposal to tax dividends of individual shareholders at capital gains rates, the distinction between dividend and capital gains treatment would be neutralized as to tax rates. (This was the version that ultimately prevailed in the final 2003 tax bill). 150.2 But initial holding period problems under §   1(h)(11)(B)(iii) could deny low rate benefits here

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(since the required 61-day and 120 day period “straddles” the redemption date; but retroactive technical connections fixed apparently this problem by raising the test period zone to 121 days). But these low rates are slated to expire in 2011 unless Congress acts to extend them (which seems unlikely at this time).

¶ 9.05[2] Dividend Equivalence: The “Meaningful Reduction” TestIn the Davis case, the Supreme Court was faced with a redemption of preferred stock by a corporation of which the taxpayer directly owned 25 percent of the common stock and all of the preferred stock. The taxpayer's wife and two children owned 25 percent of the common stock each. In reversing a lower court decision in favor of §   302(b)(1) qualification, the majority in Davis held that (1) the constructive ownership rules of §   318 apply to dividend-equivalency determinations under §   302(b)(1) ; 151 (2) redemptions of stock of a sole shareholder, including a constructive sole shareholder, are “always essentially equivalent to a dividend” under §   302(b)(1) ; 152 (3) a business purpose is irrelevant in determining dividend equivalency under §   302(b)(1) ; and (4) in order to avoid dividend equivalency, the redemption must result in a “meaningful reduction of the shareholder's proportionate interest in the corporation.” 153 A dissenting opinion in Davis asserted that the majority opinion “effectively cancels §   302(b)(1) from the Code.” 154 As a prediction, this complaint has proved to be erroneous; the provision has played a real, albeit modest, role by conferring exchange treatment on redemptions that are not “substantially disproportionate” within the meaning of §   302(b)(2) but that nevertheless result in a “meaningful reduction” in the shareholder's proportionate interest in the corporation. This standard, however, can no more be reduced to a mathematical formula than can the emotional ingredients of a “meaningful personal relationship.”

¶ 9.05[3] Nature and Amount of Meaningful Reduction

¶ 9.05[3][a] In GeneralDavis made clear that when a shareholder gets cash or other property out of a corporation through a redemption without changing his proportionate equity interest in the corporation in any significant way (counting constructive ownership), the cash or property received is equivalent to the distribution of a pro rata dividend without any surrender of stock. The same can be said of pro rata redemptions from all shareholders. When some change in proportionate interest results from the redemption, however, it becomes necessary to identify the relevant shareholder interest(s) and the amount of any change therein that will be “meaningful.”The Second Circuit in Himmel 155 (a pre-Davis opinion) correctly observed that stock represents three potentially relevant interests in a corporation: (1) interests in the control of the corporation through voting; (2) interests in the earnings of the corporation through dividends; and (3) interests in the assets of the corporation upon liquidation. 156 For a redemption to be not essentially equivalent to a dividend, the shareholder's proportionate interest in one or more of these three areas must drop to some extent. The corporation in Himmel redeemed some of the taxpayer's nonvoting preferred stock, but this did not change the voting power that he constructively possessed from members of his family. Even so, the court determined that the redemption was not essentially equivalent to a dividend, because the shareholder got twice as much as he would have received (directly or constructively) if the same amount had been paid as a pro rata dividend on common. The Service, with substantial support from the courts, however, rejects Himmel and takes the position that when the redeemed shareholder has a voting interest (either directly or by attribution), a reduction in voting power is a “key factor” (virtually a “super factor”) in determining the applicability of §   302(b)(1) . 157 It may be that the Himmel result would be accepted if the shareholder whose nonvoting stock was redeemed did not belong to a group that actually or constructively owned a controlling interest in the corporation, and hence could be only a lonely voice crying in the wilderness at stockholders'

meetings. 158

¶ 9.05[3][b] Redeemed Shareholder Owns Only Nonvoting StockThe meaningful-reduction principle has been especially important to shareholders owning only nonvoting stock, which, through a quirk of draftsmanship, cannot qualify for the protection accorded to substantially

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disproportionate redemptions by §   302(b)(2) , which requires a reduction in the shareholder's ownership of voting stock. Obviously, the voting interest cannot be used to determine the meaningful reduction in proportionate interest in such cases, and the earnings and assets interests accordingly must govern. 159 Thus, the regulations illustrate §   302(b)(1) —as they did before Davis was decided—with an example of a shareholder owning only nonvoting preferred stock that is limited as to dividends and liquidating distributions, stating that a redemption of half of the shareholder's stock will ordinarily qualify under §   302(b)(1) , even though it does not qualify under §   302(b)(2) . 160 In addition, a 1977 ruling holds that the redemption of an even smaller amount of such stock from a shareholder owning no stock of any other class, directly or constructively, is a meaningful reduction under Davis because “the rights represented by the redeemed shares were yielded to the common shareholders of the corporation and could not be recovered

through the taxpayer's continued stock ownership.” 161

¶ 9.05[3][c] Redeemed Shareholder Owns Both Voting and Nonvoting Stock, and Nonvoting Stock Is RedeemedAs already discussed, Davis held that such redemption is a dividend when the shareholder owns 100 percent of the stock outstanding. Furthermore, the regulations state that the redemption of all of one class is a dividend when the shareholders hold all classes in the same proportions. 162 Other decisions have not followed the Himmel approach of comparing the amount the redeemed shareholder actually received with the amount the shareholder would have actually or constructively received if a dividend on common stock in the same amount had been paid, 163 but judicial consideration of factors other than the power to vote nevertheless has continued. 164 The Service disagreed with the result in Himmel because the shareholder did not lose the potential for joint voting control of the corporation as a result of the redemption. 165 Where the shareholder's voting power is small, however, a redemption of nonvoting preferred has been held to be a sale since Davis. 166 The significance of sole, joint, and other levels of voting control of the corporation will be discussed more fully

in the following paragraph.

¶ 9.05[3][d] Voting Stock Is RedeemedIn rejecting the Himmel case, the Service did not rule that control is invariably more important than the shareholder's continuing direct or constructive interest in current and liquidating distributions. Much can be said, however, for giving special attention to control, at least in the case of closely held corporations, whose controlling shareholders can (1) determine business and financial policies that, in turn, determine the corporation's risk-to-return ratio and (2) avail themselves of corporate perquisites that, in theory, are subject to a rule of reason but that, in practice, can seldom be restrained by the minority shareholders.Some courts have evidenced an interest in state laws that require a high vote, such as two thirds, necessary to cause major corporate changes. Whether or not any such “super-control line” is relevant, if the redeemed shareholder does not drop below that line, or at least drop down to 50 percent of the vote, then the redemption most likely will be treated as a dividend. 167 The Sixth and Eight Circuits have held that crossing such a super-control line distinguishes a sale from a dividend. 168 The Service, however, does not agree to the significance of a super-control line when the redeemed shareholder continues to own more than half of the voting stock. 169 Once a shareholder's vote drops down to 50 percent, however, his ability to control the corporation certainly can be jeopardized. If the only other shareholder is unrelated, the Service has ruled that such a redemption is a sale. 170 The result might be different if the remaining shares are widely dispersed and 50 percent of the vote amounts to effective control. A redemption that results in crossing the 50 percent-control line is most likely not equivalent to a dividend. 171 Reductions of the vote from one level below 50 percent to another level are more troublesome. Courts have held that drops from 43.6 percent to 40 percent and from 45 percent to 42.85 percent resulted in dividends where there was no loss of potential conjunctive control of the corporation. 172 On the other hand, the Service has agreed that voting reductions from 27 percent to 22.27 percent and from 28.57 percent to 23.08 percent resulted in sale treatment when the redeemed shareholders lost conjunctive control of the corporation. 173 Where there is no possibility of control participation by a minority shareholder, even a trivial degree of vote reduction will apparently result in sale treatment, 174 unless the redemption is part of

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an ongoing plan under which the shareholder can choose whether or not to have a small number of shares redeemed each year. 175 Emphasis on the potential for joint control in cooperation with other persons by reason of the way the corporation's voting stock is dispersed is debatable, however. The Service has relied on the fact that there was no reduction in the shareholder's “potential (by attribution from [its sole beneficiary]) for participating in a control group by acting in concert with two other major unrelated shareholders.” 176 Such a continuing capacity for maneuver is undoubtedly important in the real world; but, if taken into account for tax purposes, it could have far-reaching ramifications, since virtually any shareholder—depending on how the other shares are divided—can cast a decisive vote.Finally, many redemptions by public companies involve minuscule reductions in the vote of common shareholders. No matter how small, those reductions qualify the redemptions as sales. 177 This result cannot be disputed—however, is “meaningful reduction” the proper label when an infinitesimal percentage is nudged infinitesimally closer to zero? If, as a result of the responses of other shareholders to a redemption tender offer, the shareholder's voting power happens to remain the same, or to increase by a minuscule amount, the Service will treat the redemption as a dividend.

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