SOLUTIONS TO MODULE 4 PROBLEM MATERIALS

Transcription

1 SOLUTIONS TO MODULE 4 PROBLEM MATERIALS DISCUSSION QUESTIONS 4-1 a. The term redemption is used to describe the sale or exchange by the shareholder of his or her stock back to the corporation. [See p. 4-1 and 317(b).] b. Redemptions are generally used as a financing technique. The shareholder, desiring cash for some reason, extracts the cash out of the corporation by selling some of his or her stock to the corporation. If the redemption qualifies as a sale, the cash is obtained at the cost of a capital gains tax. This technique is particularly useful when the shareholder is the estate of the decedent. A planned redemption provides the estate with the liquidity needed to pay any death taxes and other expenses related to death. Also, a corporation may redeem its stock to fund stock options, to improve its financial ratios, or to avoid a takeover attempt. Redemptions play an important role in so-called bootstrap acquisitions. In this situation, a cash-poor buyer approaches the shareholder who desires to sell the company. If the corporation has cash and other liquid assets unnecessary for operations, the corporation could distribute such items to the current shareholder and effectively reduce the value of the corporate stock and, concomitantly, the price the buyer must pay. In effect, the buyer has financed part of the purchase price through the corporation. (See pp. 4-1 and 4-2.) c. Redemption transactions are not always afforded sale or exchange treatment but in some cases are treated as dividends. This result occurs because, notwithstanding the surrender of stock by the shareholder, the shareholder s proportionate interest in the corporation has not been meaningfully reduced. In such case, the effect of the distribution is a dividend and hence is treated as such. (See pp. 4-2 and 4-3.) Note that for noncorporate shareholders sale treatment is usually far more desirable than dividend treatment for the following reasons. Sale treatment enables the shareholder to recover the basis in the stock surrendered. The effect is to reduce the taxpayer s gain or increase any loss. For example, consider a taxpayer who receives a distribution of $11,000 in redemption of stock with a basis of $10,000. If the transaction is treated as a dividend, the taxpayer must report dividend income equal to the entire amount of the distribution, $11,000. On the other hand, if the transaction qualifies for sale treatment, the taxpayer is allowed to recover the stock basis of $10,000, producing taxable income of only $1,000. Sale treatment generally allows the taxpayer to characterize any income realized as long-term capital gain. Historically, capital gains have received far more favorable treatment than dividend income. For example, prior to 1986, only 40 percent of a noncorporate taxpayer s long-term capital gain was subject to tax, making the distinction between dividend and sale treatment quite significant. To illustrate, assume that in 1986 a taxpayer received a distribution of $11,000 in redemption of stock with a basis of only $1,000. Assuming the distribution qualified for sale treatment, the taxpayer would be taxed on only $4,000 of the gain rather than $11,000 had the distribution been treated as a dividend. While the advantage is not as great today, it can still be significant. Currently, the maximum tax rate that applies to long-term capital gains is 28 percent (14 percent if the stock is qualified small business stock) while dividend income might be taxed at a rate as high as 39.6 percent. Sale treatment is also preferable if the redemption is carried out in installments. For example, assume that a corporation redeems a taxpayer s stock with a $100,000 note that is payable annually in ten equal installments. If the redemption is treated as a dividend, the taxpayer must report the entire $100,000 as a dividend in the year the note is received. In contrast, if the transaction qualifies for sale treatment, any gain may be deferred until the taxpayer receives payments on the note. The distinction between sale and dividend treatment can be significant in several other situations. For example, taxpayers who have capital losses may seek capital gains to absorb such losses. Corporate shareholders are also concerned with the distinction since they prefer 4 1

2 2 Corporate Distributions: Stock Redemptions and Partial Liquidations dividend treatment because of the dividends-received deduction to which they are entitled if the distribution is considered a dividend. In addition, use of the installment sales rules is available only with sale treatment. 4-2 The tax consequences cannot be determined from the information given. The effect of the redemption on T s interest cannot be determined for certain since the total number of shares outstanding is not given. Note that it is clear that T s number of shares has dropped far below 80 percent of what he had before; however, it is T s percentage interest that must drop by 20 percent, and this can be determined only in light of the total number of shares outstanding before and after the redemption. Note that T s redemption cannot be considered in isolation but must take into account shares that were redeemed from other shareholders at the same time. For example, if the same percentage of shares was redeemed from all other shareholders as was redeemed from T, the redemption would not affect T s interest. a. If the redemption transaction is treated as a sale, T recognizes $55,000 capital gain [$60,000 - (50 $100 = $5,000)]. T s basis in his remaining stock would be $2,000 (20 $100). b. If the redemption transaction is treated as a dividend, the entire $60,000 distribution is treated as a dividend since there is adequate E&P. Note that it is not the $55,000 net gain that is treated as a dividend but the entire $60,000 distribution. When the redemption is treated as a dividend, the basis of the shares surrendered is added to the basis of the remaining shares. Thus T s basis would continue to be $7,000 in total but his per share basis would increase to $350 ($7,000 20). (See Example 3 and p. 4-5.) 4-3 Under the Supreme Court test in Maclin P. Davis [70-1 USTC 9289 (USSC,1970)], the redemption distribution is not essentially equivalent to a dividend when there has been a meaningful reduction in the shareholder s interest. Consequently, pro rata distributions typically do not qualify since the shareholder s interest is not reduced. In determining whether a reduction of this type occurs, the critical factor to be considered is the effect of the redemption on the shareholder s right to vote and exercise control over the corporation. The fact that there is a valid business purpose for the redemption is irrelevant. In determining the shareholder s measure of influence over the corporation, relationships between the shareholders must be taken into account using the constructive ownership rules of 318. (See p. 4-9.) The meaningful reduction test is seldom relied upon to secure sale treatment because of its vague scope. Alternatively, Congress has provided two safe harbors: the substantially disproportionate test and the complete termination of interest rule. Under the substantially disproportionate test, the shareholder s percentage interest must drop below 50 percent and below 80 percent of that percentage that was owned prior to the redemption. Under the complete termination of interest test, the shareholder s interest must be entirely eliminated. In this regard, the shareholder is entitled to waive the family attribution rules under certain circumstances. [See pp and 4-12, and 302(b)(2) and (b)(3).] 4-4 a. The redemption provisions are designed to allow sale treatment only when the interest of the shareholder has been meaningfully reduced. In order to determine this, the influence that one family member has over another family member or the influence that an individual has over an entity that owns stock in the redeeming corporation must be considered. In addition, the constructive ownership rules assume that related parties work together for their own best interests. The constructive ownership rules are designed to take these relationships between shareholders into account. (See Exhibit 4-1, Example 2, pp. 4-3, 4-6, and 4-10, and 318.) b. 1. Family attribution: An individual is deemed to own the shares of his or her family (e.g., a father owns the shares owned by his son). Note, however, that reattribution is not permitted. Thus a father does not own the shares of his son s wife, despite the fact that the son is deemed to own his wife s shares. [See p. 4-7 and 318(a)(1).] 2. Entity to owner attribution: An owner is generally deemed to own proportionately any stock held by an entity in which an interest is held (e.g., a partner with a 60% interest in a partnership owns 60% of whatever the partnership owns). [See p. 4-7 and 318(a)(2).]

3 Solutions to Problem Materials 3 3. Owner to entity attribution: An entity is deemed to own whatever its owners own (e.g., a partnership with a 60% partner owns 100% of what the partner owns). In the case of corporations, the corporation is only considered to own stock held by shareholders who own directly of indirectly 50 percent or more of the corporation. [See p. 4-8 and 318(a)(3).] c. Although the rules are to be applied in all redemptions, family attribution may be waived when the shareholder s direct interest in the corporation is completely terminated, assuming certain requirements are satisfied. [See pp and 4-13, and 302(c)(2).] 4-5 a. If the redemption qualifies under 303, sale treatment is afforded the transaction, notwithstanding the fact that the distribution would have been a dividend under 302. This treatment is particularly favorable because the basis of the stock of the shareholder is often equal to the sales price of the stock since it has been stepped up due to the decedent s death. As a result, little or no gain is recognized on the redemption. Thus the same result is achieved as in a sale to a third party. (See pp and 4-17.) b. Section 303 only applies when the stock that is redeemed represents greater than 35 percent of the decedent s adjusted gross estate. In applying this test, stocks in which the decedent held at least 20 percent and which are included in the estate may be aggregated. (See p and 303.) c. The benefits of 303 have shrunk somewhat over the years due to limitations on the amount that qualifies. The qualifying amount is restricted to the sum of death taxes (Federal and state) and funeral and administrative expenses. Since the Tax Reform Act of 1976 and the introduction of the unified credit, fewer and fewer estates are subject to death taxes. As a general rule, only estates greater than $600,000 will be subject to federal estate tax. Consequently, the amount that qualifies for 303 treatment is shrinking as well. 4-6 a. Although the phrase is identical to that contained in 302(b)(1), the determination for partial liquidations is to be made at the corporate level rather than at the shareholder level. In effect, this means that in a partial liquidation there must be a genuine contraction of the corporation s business, while for other redemptions there must be a meaningful reduction in the shareholder s interest. (See p ) b. Under the safe harbor tests, the distribution must be attributable to either the corporation s ceasing to conduct a qualified business or consist of the assets of a qualified business. In addition, the corporation must continue to operate a qualified business. To meet the qualified business test, the activities must constitute a business that was actively conducted for five years prior to the distribution and was not acquired in a taxable transaction during such period. These requirements were designed to keep a corporation from investing its liquid assets in property desired by the shareholder and subsequently distributing them, with the result that the distribution would be treated as one in partial liquidation qualifying for capital gain treatment. [See p. 4-14, and 302(e)(3).] 4-7 Under 302 the distributing corporation must recognize gain, but not loss, on the distribution of property. This rule applies to all distributions of property except those in complete liquidation. Consequently, with respect to recognition of gain or loss, the rules are the same whether the distribution is a dividend, a normal redemption, a redemption to pay death taxes, or a partial liquidation. (See p and 311.)

4 4 Corporate Distributions: Stock Redemptions and Partial Liquidations 4-8 a. If the redemption is treated as a dividend, E&P is reduced by the amount of money distributed, i.e., $70,000. b. If the redemption is treated as a sale, the redeemed stock s proportionate share of E&P is eliminated, but it is not to exceed the amount of the actual distribution. In this case, 60 percent, or $60,000, of the corporation s E&P is eliminated. Note that this amount does not exceed the $70,000 actually distributed. [See Example 23, p. 4-18, and 312(n)(7).] 4-9 a. Without any special rules, the general redemption provisions could be circumvented. For example, a shareholder who controls a related corporation could sell stock in one corporation to the other and not fall within the scope of 302. Since the effect of such a sale is virtually equivalent to a redemption by the acquiring corporation of its own stock, 304 was enacted to test the sale under the redemption rules of 302. Unfortunately, this provision catches many taxpayers unaware. For example, consider a father who owns corporation A and his two sons who own corporation B. Father has decided to retire from the business shortly, so he sells some of his stock to B corporation. Although the father has no direct interest in B, he is considered as owning it through his sons, and, consequently, the rules of 304 cause the sale to be treated as a dividend. (See Examples 24 and 25 and pp through 4-25.) b. The ownership tests of 302 are applied to the selling shareholder s interest in the issuing corporation (i.e., his or her interest in the corporation represented by the stock he or she sold). This rule applies in both a brother-sister and parent-subsidiary situation. (See pp and 4-23.) c. False. The E&P of the two corporations is not combined when determining the amount of the distribution that is a dividend. The distribution is deemed to come out of the E&P of the acquiring corporation first, undiminished by any deficits of the issuing corporation, and then out of the issuing corporation s E&P, undiminished by any deficits of the acquiring corporation. Prior to changes by the Deficit Reduction Act of 1984, the E&P of the two corporations was effectively netted; this is no longer the case. (See pp and 4-22.) 4-10 a. Prior to the enactment of 306, shareholders would have their corporation make nontaxable preferred stock dividends, and sell the stock received to an accommodating third party who would subsequently redeem the stock. With these transactions, the shareholder effectively converted dividends into capital gain. (See p ) b. Section 306 attaches the so-called 306 taint to the stock received as a nontaxable dividend (other than common on common), and, on a subsequent sale, the shareholder must recognize ordinary income or dividend income, depending on whether the sale was to an outsider or a redemption. (See p ) c. In a sale to a third party, the amount of ordinary income is measured by the E&P at the date the nontaxable stock dividend was paid. In contrast, in a redemption, the amount of the dividend is determined in light of the corporation s E&P at the time of the redemption. Thus, redemption treatment could cause the shareholder to have more ordinary income (i.e., dividend) than otherwise would arise had the corporation actually distributed cash at the time of the stock dividend. (See pp through 4-28.)

5 Solutions to Problem Materials 5 PROBLEMS 4-11 a. As determined below, the redemption is considered substantially disproportionate under the tests of 302(b), and the redemption is therefore treated as a sale. D reports a capital gain of $360,000, computed as follows: Amount realized $400,000 Less: adjusted basis (400 shares $100/share) (40,000) Gain realized $360,000 Ownership Preredemption Postredemption Direct Total owned Percentage owned 60% (600/1,000) 33% (200/600) To be substantially disproportionate, D s percentage ownership in the corporation after the redemption must fall below 50 percent and 48 percent (80% 60% preredemption ownership percentage). Because D s percentage fell to 33 percent, it meets both of these tests. Consequently, the redemption qualifies for sale treatment under the substantially disproportionate test of 302(b)(2). D s basis in his remaining 200 shares is still the same, $20,000 (200 $100). (See Example 10 and pp and 4-11.) b. D will report dividend income of $200,000. As determined below, the redemption does not qualify for sale treatment under any of the 302(b) tests. Therefore, the entire amount of the distribution is considered a dividend to the extent of the corporation s earnings and profits. Note that the entire $200,000 distribution is considered a dividend. The dividend is not the portion in excess of the basis of the shares surrendered, $180,000 ($200,000 - $20,000). Because the distribution is treated as a dividend, the $20,000 (200 $100/share) basis of the shares surrendered is added to the basis of the remaining 400 shares. Thus, D s basis for his shares is $60,000. Although his total basis has remained the same ($60,000), his per-share basis has increased from $100 per share to $150 per share ($60,000/400). (See Example 9 and p ) Ownership Preredemption Postredemption Direct Total owned Percentage owned 60% (600/1,000) 50% (400/800) To be substantially disproportionate, D s percentage ownership in the corporation after the redemption must fall below 50 percent and 48 percent (80% 60% preredemption ownership percentage). Because D s percentage ownership fell only to 50 percent, he fails to meet either test and, consequently, does not qualify for sale treatment under the substantially disproportionate test of 302(b)(2).

6 6 Corporate Distributions: Stock Redemptions and Partial Liquidations 4-12 a. The redemption qualifies for sale treatment under the complete termination of interest test of 302(b)(3). Note that the redemption would not qualify for sale treatment under the substantially disproportionate test of 302(b)(2), as shown below. Ownership Preredemption Postredemption Direct through his wife Total owned Percentage owned 80% (800/1,000)75% (600/800) To be substantially disproportionate, H s percentage ownership in the corporation after the redemption must fall below 50 percent and 64 percent (80% 80% preredemption ownership percentage). Because H s percentage ownership fell only to 75 percent, it meets neither of these tests and, therefore, does not qualify for sale treatment under the substantially disproportionate test of 302(b)(1). (See Example 9 and p ) Note that H fails the substantially disproportionate test because he is treated as owning his wife s 600 shares under the constructive ownership rules of 318. However, 302(c)(2) allows H to waive the family attribution rules if the following tests are met: 1. His direct interest is completely terminated; 2. He retains no interest except as a creditor; 3. He does not acquire any interest in the corporation for at least 10 years from the date of the redemption; and 4. He signs an agreement with the IRS indicating that he will notify the Service if a prohibited interest is acquired within the 10-year period. In this case, H satisfies all of these tests (i.e., his direct interest is completely terminated and the only interest he retains is as a creditor through the note receivable received as part of the redemption). Because he is allowed to waive the family attribution rules, there is a complete termination of his interest, and the redemption qualifies for sale treatment under 302(b)(3). (See Example 12 and p ) b. The redemption qualifies for sale treatment under the substantially disproportionate test of 302(b)(2) and the complete termination of interest test of 302(b)(3). Note that E qualifies without having to waive the family attribution rules. Only if he seeks to waive these rules is it necessary for him to terminate his employment (i.e., so he does not have a prohibited interest). Consequently, his continued employment with the company is not a factor. (See p ) c. The redemption continues to qualify for sale treatment. Under 302(b)(3), G cannot acquire a prohibited interest for 10 years from the date of the redemption. The inheritance of his son s shares is not prohibited. (See p )

7 Solutions to Problem Materials Mr. B must recognize dividend income of $150,000. Under 302, a redemption is granted exchange treatment if it is not essentially equivalent to a dividend, substantially disproportionate, or a complete termination of the shareholder s interest. In making this determination, the constructive ownership rules of 318 must be taken into account. In this case, B is deemed to own the stock of his wife and that of his son. B s Ownership Preredemption Postredemption Direct : through his wife through his son Total shares owned Percentage owned 100% (100/100) 100% (70/70) In order for the redemption to be considered substantially disproportionate, B s ownership after the redemption must be less than 50 percent and less than 80 percent of what it was prior to the redemption. In this case, B s ownership has not changed and, consequently, the redemption is treated as a dividend. Note that the amount of the dividend is $150,000, unreduced by the $30,000 basis of the stock surrendered. The basis of the stock surrendered is added to the basis of the remaining stock. (See Exhibit 4-1, Examples 6 and 9, and pp. 4-7 and 4-10.) 4-14 Under the family attribution rules of 318(a)(1), an individual owns the stock of the following persons: parents, spouse, children, and grandchildren. An individual does not own the stock of siblings, grandparents, or in-laws. (See Exhibit 4-1, Example 6, and pp. 4-7 and 4-9.) a. Yes b. Yes c. No d. No e. Yes f. No g. No h. No 4-15 L, an individual, owns 46 shares of the stock of C Corporation, as computed below. Ownership Shares Direct 20 : Partnership A (10% 20) 2 Partnership B (60% 20) 12 Corporation X (not 50%) Corporation Y (60% 20) 12 Total 46 Under the entity-to-owner attribution rules of 318(a)(2), stock owned by a partnership is deemed to be owned proportionately by its partners. As a result, L owns his proportionate share of what Partnership A and Partnership B own. On the other hand, stock owned by a corporation is deemed to be owned proportionately only by shareholders owning at least 50 percent of the corporation s stock. Consequently, L owns his proportionate share of what Y owns since he owns 60 percent of the Y stock but none of what X owns since he owns only 10 percent of X. (See Exhibit 4-1, Example 7, and pp. 4-7 and 4-8.)

8 8 Corporate Distributions: Stock Redemptions and Partial Liquidations 4-16 Under the entity-to-owner attribution rules of 318(a)(2), stock owned by an entity is generally attributable to its owners proportionately. However, under 318(a)(2)(C), stock owned by a corporation is deemed to be owned proportionately only by shareholders owning at least 50 percent of the corporation s stock. a. Under the entity-to-owner attribution rules of 318(a)(2), stock owned by a partnership is deemed to be owned proportionately by its partners. Therefore, A owns 63 percent (70% 90%) of C Corporation while B owns 27 percent (30% 90%). (See Example 7 and pp. 4-7 and 4-8.) b. Under 318(a)(2)(C), stock owned by a corporation is deemed to be owned proportionately only by shareholders owning at least 50 percent of the corporation s stock. Consequently, A owns his proportionate share of what A&B owns, 63 percent (70% 90%), since he owns 70 percent of the A&B stock. B owns none of what A&B owns since he owns only 30 percent. (See Example 7 and pp. 4-7 and 4-8.) 4-17 Under the owner-to-entity attribution rules of 318(a)(3), stock owned by those having an interest in an entity is generally attributed in full to the entity. Stock owned by a partner is considered as owned by the partnership. Stock owned by a shareholder is attributed to the corporation only if the shareholder owns either directly or indirectly at least 50 percent of the corporation. a. Partnership X owns all 100 shares of D corporation, 40 directly and all 60 shares of the stock owned by J. Note that the stock of J is not attributed to the entity proportionately. (See Example 8 and p. 4-8.) b. Corporation X owns 40 shares of D Corporation, all of which are owned directly. The corporation is not treated as owning any of J s shares since J s 20 percent ownership does not meet the 50 percent threshold. (See Example 8 and p. 4-8.) c. Corporation X owns all 100 shares of D Corporation, 40 directly and all 60 shares of the stock owned by J because in this case he owns 80 percent of X s stock, which meets the 50 percent threshold. Note that the stock of J is not attributed to the entity proportionately. (See Example 8 and p. 4-8.) 4-18 This problem involves, in part, application of the rules concerning reattribution contained in 318(a)(5). These rules are not discussed in the text except with respect to reattribution from one family member to another. As a general rule, stock attributed to a person or an entity under the general constructive ownership rules is treated as actually owned by such person or entity and may therefore be attributed again from that person or entity to yet another person or entity [ 318(a)(5)(A)]. However, 318(a)(5) imposes certain restrictions on reattribution. These special rules are summarized below. 1. Stock constructively owned by an individual because of the family attribution rules [ 318(a)(1)] cannot be reattributed to another individual [ 318(a)(5)(B)]. In the language of the Code, an (a)(1) cannot be followed by an (a)(1). Nevertheless, such stock may be reattributed to an entity (e.g., a partnership, corporation, or trust) under the owner-to-entity attribution rules. In effect, the Code allows an (a)(1) to be followed by an (a)(3). 2. Stock constructively owned by an entity because of the owner-to-entity attribution rules of 318(a)(3) cannot be reattributed to another owner under 318(a)(2). Thus, an (a)(3) cannot be followed by an (a)(2). 3. Stock constructively owned by an owner because of the entity-to-owner attribution rules [ 318(a)(2)] may be reattributed to another entity under 318(a)(3). Thus an (a)(2) can be followed by an (a)(3).

9 Solutions to Problem Materials 9 Prohibited reattributions: Stock actually owned by Attributed to Reattribution to Family member Family member (a)(1) Not another family member (a)(1) Partner, shareholder, An entity (a)(3) Not another partner, shareholder or beneficiary beneficiary (a)(2) The ownership interests for each of M s shareholders is summarized below, followed by determination of each shareholder s interest. (The constructive ownership rules are discussed on pp. 4-8 through 4-10.) Ownership: Direct and B D F H J L N B s wife B s brother D s mother Corporation Partnership B s Kids Trust Total B D F H J L N Shareholder B Direct ownership 300 ownership through D, his wife 190 Family attribution [ 318(a)(1)]; a husband owns the stock of his wife J, 60% owned corporation 66 60% 110 = 66; entity to owner: corporation to 50% shareholder [ 318(a)(2)(C)] L, 60% owned partnership 72 60% 120 = 72; entity to owner: partnership to partner [ 318(a)(2)(A)] H, his wife s mother No family reattribution [ 318(a)(5)(B)]; although B generally owns what his wife owns, stock constructively owned by his wife under the family attribution rules is not treated as actually owned for purposes of reattributing it to another family member N, trust for kids 130 Shares owned by the trust are attributed to D s and B s kids under the entity-to-owner attribution rules [ 318(a)(2)(B)]; such shares are treated as actually owned for purposes of reattribution [ 318(a)(5)(A)]; shares attributed from an entity (trust) to an owner (kids) under 318(a)(2) may be reattributed from the owner (kids) to a family member; there is no prohibition under 318(a)(5) Total 758

10 10 Corporate Distributions: Stock Redemptions and Partial Liquidations Shareholder D, B s wife Direct ownership 190 ownership through B, her husband B s direct ownership 300 Family attribution [ 318(a)(1)]; a wife owns the stock of her husband B s indirect ownership J, B s 60% owned corporation 66 60% 110 = 66; J s stock owned by B by virtue of the entity-to-owner rules of 318(a)(2)(C) is treated as actually owned for purposes of reattribution [ 318(a)(5)(A)]; thus J s stock may be reattributed from B to a family member; there is no prohibition under 318(a)(5) L, B s 60% owned partnership 72 60% 120 = 72; same explanation as above Total through B 438 N, trust for her kids 130 Shares owned by the trust are attributed to D s and B s kids under the entity-to-owner attribution rules [ 318(a)(2)(B)]; such shares are treated as actually owned for purposes of reattribution [ 318(a)(5)(A)]; shares attributed from an entity (trust) to an owner (kids) under 318 (a)(2) may be reattributed from the owner to a family member; there is no prohibition under 318(a)(5) H, her mother 70 Family attribution [ 318(a)(1)]; a daughter owns the stock of her mother Total 828 Shareholder F, B s brother Direct ownership 80 ownership through J, F s 40% owned corporation No attribution unless the shareholder owns at least 50% of a corporation [ 318(a)(2)(C)] L, F s 40% owned partnership 48 40% 120; entity to owner; partnership to partner [ 318(a)(2)(A)] B Although B is F s brother, there is no family attribution since brothers are not related; further, there is no attribution of B s shares to J then to F; 318(a)(5)(C) prohibits reattribution from a partnership to its partners Total 128

11 Solutions to Problem Materials 11 Shareholder H, D s mother Direct ownership 70 ownership through D, her daughter Direct 190 Family attribution [ 318(a)(1)]; a mother owns the stock of her daughter Through B, D s husband No family reattribution [ 318(a)(5)(B)]; the stock that D constructively owns through her husband is not reattributed to D s mother Total through D 190 N, trust for D s and B s kids, H s grandchildren 130 Shares owned by the trust are attributed to D s and B s kids under the entity-to-owner attribution rules [ 318(a)(2)(B)]; such shares are treated as actually owned for purposes of reattribution [ 318(a)(5)(A)]; shares attributed from an entity (trust) to an owner (kids) under 318(a)(2) may be reattributed from the owner to a family member; there is no prohibition under 318(a)(5); under the family attribution rules, H owns what her grandchildren own. Total 390 Shareholder J, a corporation Direct ownership 110 ownership through B, a 60% shareholder Owner-to-entity attribution in full if shareholder, B, owns at least 50% of the corporation [ 318(a)(3)] B s direct interest 300 B s indirect interest D, his wife 190 Shares owned by virtue of the family attribution rules [ 318(a)(1)] may be reattributed to an entity under 318(a)(3); 318(a)(5) does not prohibit L, 60% owned partnership 72 60% 120 = 72; shares owned by virtue of the entity, L, to owner, B, attribution rules [ 318(a)(2)] may be reattributed to an entity, J, under 318(a)(3); 318(a)(5) does not prohibit N, trust for kids 130 Shares owned by the trust are attributed to D s and B s kids under the entity-to-owner attribution rules [ 318(a)(2)(B)]; such shares are treated as actually owned for purposes of reattribution [ 318(a)(5)(A)]; shares attributed from an entity to an owner under 318(a)(2) may be reattributed from the owner (kids) to a family member (B); these can be reattributed to an entity under 318(a)(3);no prohibition under 318(a)(5) Total through B 692 F, a 40% shareholder Owner-to-entity attribution occurs only if the shareholder owns at least 50% [ 318(a)(2)(C)]

12 12 Corporate Distributions: Stock Redemptions and Partial Liquidations Total 802

13 Solutions to Problem Materials 13 Shareholder L, a partnership Direct ownership 120 ownership through B, a 60% partner Owner-to-entity attribution under 318(a)(3)(C): partner to partnership in full B s direct interest 300 B s indirect interest D, his wife 190 Shares owned by virtue of the family attribution rules [ 318(a)(1)] may be reattributed to an entity under 318(a)(3); 318(a)(5) does not prohibit N, trust for kids 130 Shares owned by trust are attributed to D s and B s kids under the entity-to-owner attribution rules [ 318(a)(2)(B)]; such shares are treated as actually owned for purposes of reattribution [ 318(a)(5)(A)]; shares attributed from an entity to an owner under 318(a)(2) may be reattributed from the owner to a family member; these can be reattributed to an entity under 318(a)(3); no prohibition under 318(a)(5) J, a 60% owned corporation 66 Shares owned by virtue of the entity, J, to owner, B, attribution rules may be reattributed to an entity under 318(a)(3); 318(a)(5) does not prohibit Total through B 686 F, a 40% partner F s direct interest 80 Owner-to-entity attribution [ 318(a)(3)(C)]; partner to partnership in full Total 886 Shareholder N, a trust Direct ownership 130 ownership through B and D Under the family attribution rules, D s and B s kids own constructively what D and B owns; these shares may be reattributed to the trust [ 318(a)(3)]; no prohibition of reattribution [ 318(a)(5)] B s direct interest 300 Shares owned by virtue of the family attribution rules [ 318(a)(1)] may be reattributed D s direct interest 190 Shares owned by virtue of the family attribution rules [ 318(a)(1)] may be reattributed B s indirect interest J, 60% owned corporation 66 60% 110 = 66; entity to owner: corporation to 50% shareholder [ 318(a)(2)(C)] L, 60% owned partnership 72 60% 120 = 72; entity to owner: partnership to partner [ 318(a)(2)(A)] Total through B and D 628 to an entity; 318(a)(5) does not prohibit H Kids do not own what their grandmother owns; thus these shares do not flow to the trust Total 758

14 14 Corporate Distributions: Stock Redemptions and Partial Liquidations 4-19 Although the question asks only for the shareholder s ownership after the redemption, the solutions also discuss the tax consequences of the planned redemptions. a. No. A owns whatever his spouse owns. Thus, the exchange does not qualify unless A waives the family attribution rules, which he is entitled to do. The effect of the redemption is shown below. A s Ownership Preredemption Postredemption Direct Through B (100% 100) Total owned Percentage owned 100% (200/200) 100% (100/100) (See Examples 6 and 11, and pp. 4-6, 4-7, and 4-11.) b. No. Same as (a). Under the prevailing view, family hostility will not prevent the application of the constructive ownership rules when evaluating a redemption under the meaningful reduction test of 302(b)(1). (See p. 4-9.) A research case (4-36) at the end of this chapter deals with this problem. c. No. A owns proportionately whatever his 50 percent owned corporation owns. As a result, he owns 50 percent of Z s stock after the redemption. Since his ownership does not fall below 50 percent, the redemption is not substantially disproportionate. (See Examples 7 and 11, and pp. 4-7, 4-8, and 4-11.) A s Ownership Preredemption Postredemption Direct Through B (50% 100) Total owned Percentage owned 75% (150/200) 50% (50/100) d. Yes. None of B s stock is attributed to A since A owns less than 50 percent of B. Thus, A s interest is completely terminated. (See Examples 7 and 11, and pp. 4-7, 4-8, and 4-11.) A s Ownership Preredemption Postredemption Direct Through B (none) Total owned Percentage owned 50% (100/200) 0% e. No. As a corporation, A owns whatever its 50 percent shareholders own in full. Thus, A still owns 100 percent of the stock after the redemption. Since A owns at least 50 percent after the redemption, the redemption is not substantially disproportionate. (See Examples 8 and 11, and pp. 4-8 and 4-11.) A s Ownership Preredemption Postredemption Direct Through B (100% 100) Total owned Percentage owned 100% (200/200) 100% (100/100)

15 Solutions to Problem Materials 15 f. Yes. Although the stock of B is attributable to R, A s son, it is not reattributed to A; to do so would extend the definition of family. Thus, A s interest is completely terminated. (See Examples 8 and 11, and pp. 4-7 and 4-11.) A s Ownership Preredemption Postredemption Direct Through B (none) 0 0 Total owned Percentage owned 50% (100/200) 0% g. A, as a trust, is considered as owning whatever its beneficiary owns in full. For this purpose, the stock of B is attributed to his son and then reattributed to the trust. Consequently, the trust is deemed to own 100 shares, or 100 percent of the stock after the redemption, due to the constructive ownership rules as shown below. Thus, the distribution is treated as a dividend. Note: Since the distribution is in complete termination of A s interest, the trust may waive the family attribution rules only if the trust and the beneficiary from which the stock is attributed to the trust, B s son, has an interest after the redemption. Since B s shares are not redeemed, no waiver is available. (See Example 13 and p ) A s Ownership Preredemption Postredemption Direct Through B (100%) Total owned Percentage owned 100% (200/200) 100% 4-20 a. Buck reports capital gain of $41,400 [$46,000 - (23 $200)]. Under 302, the redemption will be treated as a sale since it is substantially disproportionate as shown below. Preredemption Postredemption Directly = 17 ly thru wife 10-2 = 8 Total owned = 25 Percentage owned 50% (50/100) 37% (25/67) To be treated as substantially disproportionate, Buck s percentage ownership after the redemption must be less than 50 percent and less than 80 percent of what it was before the redemption, or 40 percent (80% 50%). Since his ownership falls to 37 percent, both of these tests are met. Note that in determining his postredemption percentage ownership, the denominator of the fraction reflects the redemption of all 33 shares. The basis of his remaining shares is $3,400 ($200 17). (See pp. 4-7 and 4-11.)

16 16 Corporate Distributions: Stock Redemptions and Partial Liquidations b. John will report a dividend of $8,000 ($2,000 4). The distribution is treated as a dividend since the redemption is not substantially disproportionate, as shown below. Preredemption Postredemption Directly 45-4 = 41 ly thru wife 5-4 = 1 Total owned 50-8 = 42 Percentage owned 50% (50/100) 63% (42/67) To be treated as substantially disproportionate, John s percentage ownership after the redemption must be: (1) less than 50 percent and (2) less than 80 percent of what it was before the redemption, or 40 percent (80% 50%). Since his ownership actually increases to 63 percent, the distribution does not qualify for sales treatment. The basis of his stock will remain the same, $9,000. (See pp. 4-7 and 4-10.) 4-21 C recognizes a gain of $65,000 ($75,000 - $10,000) as if it had sold the distributed property. None of the $10,000 loss realized on the equipment is recognized. Under 311, a corporation that distributes property must recognize gain but not loss. Note that the loss is lost forever because the shareholder s basis will be the value of the property, $30,000. (See Example 21 and p ) 4-22 a. Under 311(b), the corporation must recognize gain on the distribution of appreciated property regardless of whether the redemption is treated as a sale or a dividend. Therefore, D must recognize a gain of $40,000 ($100,000 - $60,000). Assuming the distribution qualifies as a dividend, the corporation increases its E&P by the $40,000 gain recognized and reduces E&P by the fair market value of the property distributed, $100,000. This results in a net reduction of E&P of $60,000, as summarized below. (See Examples 21 and 23, and p ) Gain on the distribution $ 40,000 Fair market value of property distributed (100,000) Net decrease in E&P $(60,000) The corporation s E&P after the exchange would be $20,000 ($80,000 - $60,000). b. When the redemption is treated as a sale, the distributing corporation must recognize gain on the distribution of the property, which in turn increases E&P. However, the corporation reduces E&P by the percentage of the value of the stock redeemed, $24,000 [(2,000/10,000 ($80,000 + $40,000). Note, however, that this amount cannot exceed the amount of the distribution. In this case, the amount of the distribution is $100,000; thus the reduction is $24,000. The net effect on the corporation s E&P is summarized below. (See Examples 21 and 23, and pp and 4-18.) Gain on the distribution $ 40,000 Reduction for distribution (24,000) Net increase in E&P $ 16,000 The corporation s E&P after the exchange would be $96,000 ($80,000 + $16,000).

17 Solutions to Problem Materials a. 1. H reports a $15,000 dividend. The $15,000 is dividend income since the redemption is not substantially disproportionate, as shown below. Ownership Preredemption Postredemption Direct Through PAC (80% 20) Total owned Percentage owned 56% (56/100) 45% (36/80) To be substantially disproportionate, H s percentage ownership after the redemption must fall below 50 percent and 44.8 percent (80% 56%). Since H s percentage ownership fell only to 45 percent, the redemption is not substantially disproportionate and thus must be treated as a dividend. Although H s number of shares after the redemption of 36 is less than 80 percent of the number of shares that he owned before the redemption (80% 56 shares = 44.8 shares), the substantially disproportionate test focuses on the change in the shareholder s percentage ownership and not the change in shares. It is interesting to note that the Committee Reports that originally accompanied the enactment of 302 made this same error! (See Example 11 and pp through 4-12.) 2. H s total basis of $5,000 is unchanged; however, his per share basis increases from $125/share ($5,000/40) to $250/share ($5,000/20). (See Example 3 and p. 4-5.) 3. CEL s taxable income is unaffected. (See p ) 4. Since the distribution is treated as a dividend, CEL reduces its E&P by the amount of the distribution, $15,000. (See p ) b. 1. As determined below, H is entitled to sale treatment since the redemption is substantially disproportionate. Thus, H reports a capital gain of $12,500, determined as follows. Amount realized $15,000 Adjusted basis (20 shares $125/share) (2,500) Gain realized and recognized $12,500 Ownership tests: Ownership Preredemption Postredemption Direct Through PAC (none*) Total owned Percentage owned 40% (40/100) 25% (20/80) *None of PAC s stock is attributable to H since H does not own 50 percent or more of PAC. To be substantially disproportionate, H s percentage ownership after the redemption must fall below 50 percent and 32 percent (80% 40%). Since H s percentage ownership fell to 25 percent, the redemption is substantially disproportionate and, thus, treated as a sale. (See Examples 8 and 9, and pp and 4-11.) 2. H s basis in his remaining 20 shares is $2,500, or $125/share. (See Example 3 and p. 4-5.) 3. There is no effect on CEL s taxable income. (See p )

18 18 Corporate Distributions: Stock Redemptions and Partial Liquidations 4. Since the redemption is treated as a sale, CEL must reduce E&P in the same proportion as the proportion of stock redeemed but not to exceed the amount of the distribution. Thus, the reduction is $15,000, the lesser of the distribution, $15,000, or $20,000 [$100,000 (20/100)]. (See Example 23 and p ) c. Since all of F s stock is attributable to S, a redemption of any number of S s shares will not be treated as substantially disproportionate. However, S may waive the family attribution if all of his shares are redeemed, he quits his job, and files the proper agreement with the IRS. Under 302(c)(2), S may not retain any interest in the corporation except as a creditor, he cannot acquire any interest in the corporation for at least ten years except by inheritance, and he must file an agreement to notify the Service if he should acquire the prohibited interest. (See Example 12 and p ) d. CEL must recognize a $20,000 gain [$50,000 - ($40,000 - $10,000)]. When appreciated property is distributed in redemption of stock, the appreciation element must be recognized as gain. (See Example 21 and p ) e. The distributing corporation does not recognize the built-in loss of $25,000 ($50,000 value - $75,000 basis). Under 311, gain, but not loss, is recognized. (See Example 21 and p ) 4-24 In order to satisfy the safe harbor requirements of 302(e)(2) and obtain partial liquidation treatment, the distribution must consist of the assets of or be attributable to the cessation of a qualified business. In addition, the corporation must retain a qualified business, which it continues to operate immediately after the exchange. An activity is a qualified business if it satisfies the following conditions: It consists of active and substantial management operational functions; It has been conducted for five years prior to the distribution; and It was not acquired in a taxable transaction in the last five years preceding the distribution. (See p ) 1. Tavern. The tavern is a qualified business since its activities constitute a business, it has been conducted for five years (since 1988), and it was not acquired in a taxable transaction in the past five years (acquired in 1988). To qualify for partial liquidation treatment, however, HPI must retain another business that is a qualified business. In this case, HPI would continue a qualified business since, as discussed below, the sporting goods store also is a qualified business. (See pp and 4-15.) 2. Sporting goods store. The sporting goods store would be considered an active business. Although acquired within the five-year period preceding the distribution, the acquisition was not taxable but rather tax-free under 351. The acquisition was tax-free because immediately after the transfer of the business, B owned 80 percent of the shares outstanding (400/500) of HPI. The business is also considered as having been operated for the past five years because it has been operated since Note that it is not necessary that HPI, the distributing corporation, operate the business for five years prior to the distribution. It is sufficient that anyone operated it for such period. Since HPI would continue to operate the tavern, which is also a qualified business, the sporting goods store could be distributed in partial liquidation and meet the safe harbor tests. (See Example 16 and p ) 3. The apartment is not a qualified business since it does not constitute a business (rental operations generally are not considered businesses unless substantial services are rendered in connection with the rental) and it was acquired in a taxable transaction within the preceding five years (purchased three years ago). (See Example 15 and pp and 4-15.) (See Examples 14 through 16 and pp and 4-15.) 4-25 a. C reports capital gain of $28,000 [$30,000 - ($ shares redeemed)]. Under the partial liquidation rules, a distribution to a noncorporate shareholder that qualifies as a partial liquidation is treated as a sale. [See Example 17, p. 4-15, and 302(b)(4).]

19 Solutions to Problem Materials 19 b. Since C is a corporation, the partial liquidation rules do not apply. Thus, the treatment of the distribution is governed by the normal redemption provisions of 302. In this case, C s ownership is unchanged after the redemption (100% and 80/80 or 100% after). Thus, the redemption is treated as a dividend. Dividend treatment is favorable, however, since the corporation is entitled to a dividend-received deduction of $30,000 (100% $30,000). In addition, because the stock redemption is part of a partial liquidation within the meaning of 302(e), 1059(e) requires that the dividend be treated as an extraordinary dividend. As a result, the corporation is still entitled to the dividend-received deduction but must reduce the basis of its stock by the nontaxed portion of the dividend, in this case $30,000. Since the $30,000 reduction exceeds the corporation s $10,000 basis in its stock, the corporation also must report a $20,000 capital gain ($30,000 - $10,000). (See Examples 4 and 5 and pp. 4-5 and 4-15.) 4-26 a. Q reports an $11,000 long-term capital gain as determined below. Amount realized $15,000 - Adjusted basis (10 $400/share) (4,000) = Gain realized $11,000 Distributions to a noncorporate shareholder in partial liquidation qualify for capital gain treatment. (See Example 17 and p ) b. $13,000 [$15,000 - ($8,000 - $6,000)] $7, gain and $6, gain. The corporation must recognize gain recognized on the distribution of appreciated property in partial liquidation. [See Example 22, p. 4-17, and 311(b).] c. Since TUV is a corporation, the partial liquidation rules do not apply. Thus, the treatment of the distribution is governed by the normal redemption provisions of 302. In this case, TUV s ownership drops to 16.6 percent (15/90), which is less than 50 percent and is also less than 80 percent of what it was before 20 percent (80% 25%). Thus, the distribution is substantially disproportionate and treated as a sale, resulting in an $11,000 ($15,000 - $4,000 basis) long-term capital gain to TUV. This sale treatment is unfavorable since the corporate shareholder would prefer dividend treatment because of the 70 percent dividends-received deduction. Since the distribution is not a dividend, the extraordinary dividend rules do not apply. (See Example 17 and p ) 4-27 a. J reports $10,000 long-term capital gain as determined below. Amount realized $20,000 - Adjusted basis (20 $500/share) (10,000) = Gain realized $10,000 Distributions to a noncorporate shareholder in partial liquidation qualify for sale treatment. Basis in cash is $20,000. (See Example 17 and p ) b. K reports $5,000 long-term capital gain as determined below and has a basis in the warehouse of $10,000, its fair market value. Amount realized $10,000 - Adjusted basis (10 $500/share) (5,000) = Gain realized $ 5,000 Distributions to a noncorporate shareholder in partial liquidation qualify for sale treatment. (See Example 17 and p )