ACCT 5327 Exam 2 Review

Hawkeye Company reports current E&P of $300,000 this year and accumulated E&P at the beginning of the year of $200,000. Hawkeye distributed $400,000 to its sole shareholder, Ray Kinsella, on December 31 of this year. Ray's tax basis in his Hawkeye stock is $75,000. c) What is Hawkeye's balance in accumulated E&P as of January 1 of next year?

Accumulated E&P as of January 1 is $100,000, computed as $500,000 - $400,000.

Hawkeye Company reports current E&P of $300,000 this year and accumulated E&P at the beginning of the year of $200,000. Hawkeye distributed $400,000 to its sole shareholder, Ray Kinsella, on December 31 of this year. Ray's tax basis in his Hawkeye stock is $75,000. a) How much of the $400,000 distribution is treated as a dividend to Ray?

All $400,000 is treated as a dividend because the distribution is less than the company's total earnings and profits of $500,000.

Why might a shareholder who is also an employee prefer receiving a dividend instead of compensation from a corporation?

An individual shareholder might prefer a dividend to compensation because, although the dividend is subject to double taxation, both corporate tax rate and the dividend rate can be substantially below the single tax on compensation. For example, the corporate tax rate is 21 percent and the dividend is taxed at 20 percent (ignoring net investment income tax). Whereas,compensation can be taxed at the relatively high ordinary tax rates (37 percent) plus the federal social security (FICA) taxes..

Tax Law Definition of a Dividend

Any distribution of property made by a corporation to its shareholders out of its earnings and profits (E&P) account

What are the three potential tax treatments of a cash distribution to a shareholder? Are these potential tax treatments elective by the shareholder?

A cash distribution to a shareholder can be characterized as 1) dividend to the extent of earnings and profits, 2) tax-free return of capital to the extent of the shareholder's tax basis in the stock, or 3) gain from sale of the stock (capital gain). The tax law (section 301(c)) prescribes the tax treatment of the distribution; it is not elective by the shareholder.

Tax Consequences When a Shareholder receives other property (boot)

A shareholder recognizes gain (but not loss) in an amount not to exceed the lesser of: - gain realized - the fair market value of the boot received Gain from boot in a Sec 351 transaction must be allocated to the property exchanged on a pro rata basis using the relative fart market values of the properties. If a transferor recognizes gain, that gain must be allocated to the property transferred to the corporation and increase the corporation's basis by that gain

What are the potential tax consequences to a shareholder who participates in a stock redemption?

A shareholder who participates in a stock redemption potentially could treat the distribution as an exchange (section 302) or as a property distribution (potentially a dividend under section 301).

When might a shareholder have to rely on the "not essentially equivalent to a dividend" test in arguing a stock redemption should be treated as an exchange for tax purposes?

A shareholder will have to rely on this test if the distribution cannot meet either the "substantially disproportionate test" or the "complete termination of interest" test, which rely on a mechanical set of criteria.

Why might a corporation issue a stock distribution to its shareholders?

Corporations often issue stock distributions as a goodwill gesture to their shareholders when they do not have sufficient cash to make a distribution. Many times, corporations will engage in a stock split to increase the number of shares outstanding and lower the trading price of the stock to make it more accessible to a broader class of investors.

2nd E&P Combination Rule Example

Current E&P = $1,000,000 Accumulated E&P = ($500,000) The corporation distributes $1,000,000 in July 1 The entire distribution is deemed to come from current E&P and is a dividend to the shareholders + & +, only include positive current E&P, ignore negative accumulated E&P

3rd E&P Combination Rule Example

Current E&P = ($1,000,000) Accumulated E&P = $1,000,000 The corporation distributes $1M on July 1 Accumulated E&P as of July 1 = $1M x 6/12 = $500,000 $500,000 is treated as a dividend even though total E&P is $0 3. - & +, pro-rate negative current E&P as of distribution date, then add to accumulated E&P (most complicated, the only scenario where we need to know the distribution date)

3rd E&P Combination Rule Depending on Distribution Date

Current E&P = ($1,000,000); Accumulated E&P = $1,000,000 If distribution date is March 31: Pro-Rate current E&P = (250,000) Accumulated E&P = 1,000,000 Total E&P = 750,000 If distribution date is September 30: Pro-Rate current E&P = (750,000) Accumulated E&P = 1,000,000 Total E&P = 250,000 If distribution date is December 31: Pro-Rate current E&P = (1,000,000) Accumulated E&P = 1,000,000 Total E&P = 0

How does current earnings and profits account differ from accumulated earnings and profits account? Is there any congressional logic for keeping the two accounts separate?

Current earnings and profits represents the corporation's earnings and profits of the current year before reduction ("diminution") by any distributions made during the year. Accumulated earnings and profits represents undistributed earnings and profits from all years prior to the current year. Congress created this distinction in 1936 when distributed current year earnings were taxed at the corporate level at a lower rate than undistributed earnings. This dual level of taxation was repealed in 1939, but the congressional distinction between current and accumulated earnings and profits remained in the law

Assume a calendar-year corporation has positive current E&P of $100 and an accumulated deficit (negative) E&P of $200. In this circumstance, a cash distribution of $100 to the corporation's sole shareholder at year-end will not be treated as a dividend because total E&P is negative $100. True or false? Explain.

False. The $100 distribution will be treated as a dividend because it does not exceed current earnings and profits.

Which members of a family are included in the family attribution rules? Is there any rationale for the family members included in the test?

Family members include spouse, children, parents, and grandchildren. These are the family members that are the most closely related to the shareholder by blood. Family members excluded are grandparents, brothers and sisters, aunts and uncles, and nieces, nephews, and cousins.

Stock Redemptions if the redemption is treated as an exchange to shareholders

Gain is always recognized by shareholder Loss is recognized unless the shareholder is a related person to the corporation (Sec. 267) - shareholder owns more than 50% of the stock's value - ownership is determined using the Sec. 267(c) attribution rules - "family attribution": Individuals are treated as owning indirectly the shares of stock owned by their spouse, children, grandchildren, and parents in addition to stock held directly by the individual. (Lineal descendants) - the new basis of the shareholder property received is fair market value b.c treated as a sale

Discuss the difference between gain realization and gain recognition in a property transaction.

Gain realization occurs when a transaction takes place (that is, there has been an exchange of property rights between two persons) and the "amount realized" exceeds the taxpayer's tax basis in the property sold or exchanged. Recognition is the recording of the gain realized on a tax return. Before gain or loss is recognized, it first must be realized.

Assumption of shareholder liabilities by the corporation

General Rule - a shareholder's liability attached to property transferred is not treated as boot received Two exceptions in which liability assumed by the corporation is treated as boot: 1. Tax-avoidance transactions (personal debt) 2. Liabilities in excess of basis (will cause you to have negative basis)

Taxable Liquidating Distributions

General Rule: Liquidating corporation recognizes all gains and certain losses on taxable distributions of property to shareholders Liquidating corporation does not recognize loss if the property is: - distributed to a related party - distribution is non pro-rata - asset distributed is disqualified property Disqualified property is property acquired within five years of the date of distribution in a tax deferred Sec 351 transaction or as a nontaxable contribution to capital. (Corp realizes that they will have to liquidate so they stuff the corp with loss assets, so the loss assets will offset gains and reduce double taxation Loss on the complete liquidation of such property distributed was acquired in a Sec 351 transaction or as a contribution to capital, and a principal purpose of the contribution was to recognize a loss by the liquidating corporation This rule prevents a built-in loss existing at the time of the distribution from being recognized by treating the basis of the property distributed as being its FMV at the time it was contributed to the corporation This provision is designed as an anti0stuffing provision to prevent shareholders from contributing property with built-in losses to a corporation shortly before a liquidation to offset gain property distributed in the liquidation

Contributions to Capital

Generally not a taxable event - Transfer of property to a corporation by a shareholder/nonshareholder for which no stock or other property is received in return (S/H increase basis) - When property is contributed by a shareholder, corporation takes a carryover tax basis in the property - When property is contributed by a nonshareholder, corporation's tax basis is zero - Shareholder making a capital contribution gets a chance to increase the tax basis in existing stock to an amount equal to the tax basis of the property contributed

Jayhawk Company reports current E&P of $300,000 and accumulated E&P of negative $200,000. Jayhawk distributed $400,000 to its sole shareholder, Christine Rock, on the last day of the year. Christine's tax basis in her Jayhawk stock is $75,000. c) What is Jayhawk's balance in accumulated E&P on the first day of next year?

Jayhawk has a deficit in accumulated E&P of negative $200,000. Current E&P was reduced to $0, leaving a carryover of the beginning of the year accumulated E&P.

Complete Liquidation of a Corporation

Liquidation is fully taxable and causes double taxation - Occurs when a corporation acquires all of its stock from all of its shareholders in exchange for "all" of its net assets, after which time the corporation ceases to do business - For tax purposed, Form 966 needs to be filed by corporation in order to inform the IRS of its intention to liquidate its tax existence - Form should be filed within 30 days after the owners resolve to liquidate the corporation

Earnings and Profits (E&P)

Measures the economic capacity of a corporation to make a distribution to shareholders that is not a return of capital AKA measures the dividend paying ability of the firm and economic income to the corporation

Depreciable Assets Transferred to a Corporation

Practitioners often advise against transferring appreciated property into a closely held corporation - Helps shareholder in creating two assets with the same built in gain as of the original property The federal government can now collect taxes twice on the same gain - When the corporation sells the property received and - When shareholder sells the stock

Hawkeye Company reports current E&P of $300,000 this year and accumulated E&P at the beginning of the year of $200,000. Hawkeye distributed $400,000 to its sole shareholder, Ray Kinsella, on December 31 of this year. Ray's tax basis in his Hawkeye stock is $75,000. b) What is Ray's tax basis in his Hawkeye stock after the distribution?

Ray's tax basis in his Hawkeye stock remains $75,000.

This year Sooner Company reports current E&P of negative $300,000. Its accumulated E&P at the beginning of the year was $200,000. Sooner distributed $400,000 to its sole shareholder, Boomer Wells, on June 30 of this year. Boomer's tax basis in his Sooner stock is $75,000. c) What is Sooner's balance in accumulated E&P on the first day of next year?

Sooner's balance in accumulated E&P is $(150,000), computed as follows: Accumulated E&P, beginning of this year $200,000 Current E&P (300,000)Dividend paid ( 50,000)Accumulated E&P, end of the year $(150,000)The deficit equals the deficit in current E&P that arose after the dividend payment [($300,000) x 6/12].

Hoosier Corporation declared a 2-for-1 stock split to all shareholders of record on March 25 of this year. Hoosier reported current E&P of $600,000 and accumulated E&P of $3,000,000. The total fair market value of the stock distributed was $1,500,000. Barbara Bloomington owned 1,000 shares of Hoosier stock with a tax basis of $100 per share. a) What amount of taxable dividend income, if any, does Barbara recognize this year? Assume the fair market value of the stock was $150 per share on March 25 of this year.

Stock Dividends: Not taxable if paid on common stock and no option to receive cash, after a stock dividend, you won't own anymore of the company than you did before. The stock dividend is not taxable because it is pro rata to all shareholders. Nobody owns more or less than they did before.

Stock Redemption Rules

Stock Redemption - when a corporation buys back stock from its shareholders Key Issue: Has there been a meaningful reduction in stock ownership? Redemption is NEVER meaningful if individual owns more than 50% of company constructively after the redemption If the redemption is meaningful = Qualified redemption = treated as a sale or exchange (individuals want this result to reduce basis) If the redemption is NOT meaningful - Non-Qualified redemption = treated as a property distribution = dividend treatment) There are 5 rules that if passed, indicate that the redemption is meaningful. If none of the rules are satisfied then the redemption is treated as NOT being meaningful = dividend treatment

In general, what causes a stock distribution to be taxable to the recipient?

Stock distributions generally are taxable when they result in, or have the potential to result in, a change in the proportionate stock ownership of the existing shareholders. For example, where a shareholder can choose between cash or stock, there exists the possibility that some shareholders will choose cash and some will choose stock. Those who choose stock will increase their ownership percentage relative to those who choose cash. Where stockholders have the ability to choose between cash and stock, the stock dividend will be taxable to those who choose to receive stock.

Badger Corporation declared a stock distribution to all shareholders of record on March 25 of this year. Shareholders will receive one share of Badger stock for each ten shares of stock they already own. Madison Cheesehead owns 1,000 shares of Badger stock with a tax basis of $100 per share. The fair market value of the Badger stock was $110 per share on March 25 of this year. b) What is Madison's income tax basis in her new and existing stock in Badger Corporation, assuming the distribution is non-taxable?

The new stock is allocated part of the tax basis of the old stock based on relative fair market value. After the stock dividend, Madison will own 1,100 shares of Badger stock (1,000 + 1,000/10), each with the same fair market value. Her basis in each share of stock will be $91 (rounded), computed as (1,000 shares x $100 basis) / 1,100.

Hoosier Corporation declared a 2-for-1 stock split to all shareholders of record on March 25 of this year. Hoosier reported current E&P of $600,000 and accumulated E&P of $3,000,000. The total fair market value of the stock distributed was $1,500,000. Barbara Bloomington owned 1,000 shares of Hoosier stock with a tax basis of $100 per share. b) What is Barbara's income tax basis in the new and existing stock she owns in Hoosier Corporation, assuming the distribution is tax-free?

The new stock is allocated part of the tax basis of the old stock based on relative fair market value. In a 2 for 1 stock split, Barbara would allocate half of the basis of the old stock ($100) to the new stock, making her tax basis in the old and new stock $50 per share. ($1000 x $100)/2,000 shares

Badger Corporation declared a stock distribution to all shareholders of record on March 25 of this year. Shareholders will receive one share of Badger stock for each ten shares of stock they already own. Madison Cheesehead owns 1,000 shares of Badger stock with a tax basis of $100 per share. The fair market value of the Badger stock was $110 per share on March 25 of this year. a) What amount of taxable dividend income, if any, does Madison recognize this year?

The stock dividend is not taxable because it is pro rata to all the shareholders.

What is meant by the term double taxation of corporate income?

The term double taxation refers to the fact that under the U.S. system of taxation, corporate earnings are first taxed when earned by a C corporation and then are taxed a second time when the earnings are distributed to the shareholders as a dividend.

Most Frequent Constructive Dividends

The three most frequent causes of disputes between corporations and the IRS over the characterization of deductible payments made to individuals who also are shareholders involve: 1. Compensation 2. Interest Payments 3. Corporate payments made on behalf of shareholders

3 Rules to Determine if Redemption is Meaningful

Three types of redemptions are treated as exchanges (for purposes of this class) because they meaningfully contract the shareholders ownership: 1. Redemptions that are substantially disproportionate are treated as sales (most objective rule, we go to this rule first) 2. Redemptions in complete redemption of all of the stock of the corporation owned by the shareholder (You can have all of you stock redeemed but can still be deemed to be in control through constructive ownership) 3. Redemptions that are not essentially equivalent to a dividend (subjective, in the court's hands)

Suppose Ginny received 10% of the stock in 360 Air valued at $60,000 in exchange for a catchphrase she created to provide the company with a distinctive logo. Assume her tax basis in the catchphrase is zero because she created it. Will Ginny defer recognition of the $60,000 gain she realizes on the transfer of the catchphrase?

Yes, Ginny defers recognition of the $60,000 gain realized because intangibles are considered property under Sec 351.

Explain whether all shareholders receive the same tax treatment in a complete liquidation of a corporation.

All individuals and corporations owning less than 80 percent of the liquidating corporation generally recognize gain or loss on the receipt of a liquidating distribution. Corporations owning 80-percent-or-more of the liquidating corporation defer recognition of gain or loss on the receipt of a liquidating distribution.

Explain whether the receipt of boot by the shareholder in a §351 transaction causes the transaction to be fully taxable.

Boot taints an otherwise tax-deferred transaction under §351. A shareholder who receives boot in the transferee corporation recognizes gain (but not loss) in an amount not to exceed the lesser of 1) gain realized or 2) the fair market value of the boot received.

Why does Congress allow tax deferral on the formation of a corporation?

Congress enacted the tax laws allowing deferral of property transfers to a corporation in the Revenue Act of 1921 to remove tax consequences as an impediment to forming a corporation and to provide taxpayers with flexibility in choosing their preferred form of doing business.

Explain whether a corporate shareholder recognizes gains and losses on the receipt of distributions of property from the complete liquidation of a subsidiary corporation.

Corporate shareholders owning 80 percent or more of the stock (voting power and value) of the liquidating corporation do not recognize gain or loss on the receipt of liquidating distributions. This nonrecognition treatment is mandatory, and the tax basis in the property transferred carries from the liquidating corporation to the recipient shareholder. All other corporate shareholders recognize gain, but potentially not all losses, in a complete liquidation.

Distinguish between exclusion and deferral in a property transaction

Gain or loss that is excluded (exempt) from taxation will never be recognized on a tax return. Gain or loss that is deferred may be recognized on a future tax return if circumstances trigger recognition of the gain or loss deferred in the current year.

Contrast how a taxpayer's tax basis in property received in a property transaction will be affected if the transaction results in gain exclusion versus gain deferral.

In an exclusion transaction, the taxpayer's tax basis in the property received will be its fair market value. In a deferral transaction, the taxpayer's tax basis in the property received will be its fair market value less the gain deferred.

Under what conditions is it advantageous for a shareholder to hold §1244 stock? Why did Congress bestow these tax benefits on holders of such stock?

Section 1244 allows a shareholder to treat a loss on the sale or exchange of stock that qualifies as §1244 stock as an ordinary loss. Section 1244 applies only to individual shareholders who are the original recipients of the stock. The maximum amount of loss that can be treated as an ordinary loss under §1244 is $50,000 per year ($100,000 in the case of married, filing jointly shareholders). To qualify for this tax benefit, the corporation from which the stock was received must be a small business corporation when the stock was issued. The Code defines a small business corporation as one in which the aggregate amount of money and other property received in return for the stock or as a contribution to capital did not exceed $1 million. There is an additional requirement that for the five taxable years preceding the year in which the stock was sold, the corporation must have derived more than 50% of its aggregate gross receipts from an active trade or business. Congress enacted §1244 to provide a tax benefit to entrepreneurs who create a risky start-up company that ultimately fails rather than succeeds.

List the key statutory requirements that must be met before a corporate formation is tax-deferred under §351.

Tax deferral only applies to transfers of property to a corporation. The persons transferring property to a corporation must receive "solely" stock in the corporation in return. The persons transferring property to a corporation must collectively control the corporation after the transaction.

What tax issue arises when a shareholder receives a nontaxable stock distribution?

The shareholder must allocate some of the tax basis of the existing stock to the new stock received based on the relative fair market values of the existing and newly issued stock.

How does a corporation depreciate an asset received in a §351 transaction in which no gain or loss is recognized by the transferor of the property?

To the extent tax basis carries over from the shareholder, the corporation "steps into the shoes" of the shareholder and continues to depreciate the carryover basis portion of the property's tax basis using the shareholder's depreciation schedule. Any additional basis (from recognition of gain due to boot received) is treated as a newly acquired separate asset and is subject to a separate depreciation election (that is, this one physical asset is treated as two tax assets).

What is a carryover basis as it relates to property received by a corporation in a §351 transaction? What is the purpose of attaching a carryover basis to property received in a §351 transaction?

Under the carryover basis rule, the tax basis of property received by the corporation in a §351 exchange equals the property's tax basis in the transferor's hands (that is, the corporation carries over the shareholder's basis in the property). The carryover basis rule prevents the recipient of the property from getting a basis equal to fair market value in a nontaxable transaction.

Explain whether a corporation's assumption of shareholder liabilities will always constitute boot in a §351 transaction.

Under the general rule, the corporation's assumption of a shareholder's liability attached to property transferred (for example, a mortgage attached to the building and land) is not treated as boot received by the shareholder. Congress created two exceptions in which liability assumption by the corporation is treated as boot. Under the first exception, if any of the liabilities assumed by the corporation are assumed with the purpose of avoiding the federal income tax or if there is no corporate business purpose for the assumption, all of the liabilities assumed are treated as boot to the shareholder. Under the second exception, if a shareholder's liabilities assumed are in excess of the aggregate tax basis of the properties transferred by the shareholder, gain is recognized to the extent of the excess. Liabilities, the payment of which would give rise to a deduction, are not treated as liabilities in making this determination.

What is a substituted basis as it relates to stock received in exchange for property in a §351 transaction? What is the purpose of attaching a substituted basis to stock received in a §351 transaction?

Under the substituted basis rule, the stock received in a §351 transfer equals the tax basis of the property transferred to the corporation. The formula to compute the stock's substituted basis is (see Exhibit 19-4): + Cash contributed + Tax basis of other property contributed - Liabilities assumed by the corporation on property contributed = Tax basis of stock received The substituted basis rule preserves the gain or loss deferred in the transfer. If the shareholder sells the stock received at fair market value in a taxable transaction, the gain or loss recognized will equal the gain or loss deferred.

Disguised Dividends

When the owner or employee of a company takes advantage of the company for their own personal benefit Examples: - unreasonable compensation - bargain sales to employees - shareholder use of corporate assets without an arm's-length payment - loans from shareholders at excessive interest rates - corporate payments made on behalf of the shareholder

How does the tax treatment differ in cases where liabilities are assumed with a tax avoidance purpose versus where liabilities assumed exceed basis? When would this distinction cause a difference in the tax consequences of the transactions?

Where liabilities are assumed with a tax avoidance purpose, the tax law treats all liabilities assumed as boot received by the transferor. The transferor would recognize gain in an amount equal to the lesser of gain realized or the fair market value of the boot received. Where liabilities assumed exceed basis, the excess is treated as gain recognized by the transferor.

Sec 351

- Sec 351 facilitates corporate formations by providing for gain and loss deferral on property transfers that meet its requisites - Sec 351 was enacted in 1921 to remove tax consequences as an impediment to forming a corporation and allow flexibility in choosing the preferred form of doing business - Sec 351 contemplates a transfer of property by person or persons who maintain a "continuity of proprietary interest" in the assets transferred (through stock ownership in the corporation now holding the assets One business form exchanged for another form of business As long as assets are being reinvested fully from one form to another, than there is no reason to tax that transaction

Framework to combine Accumulated and Current E&P to come up with one combined number

1. + & +, add together for total E&P 2. + & -, only include positive current E&P, ignore negative accumulated E&P 3. - & +, pro-rate negative current E&P as of distribution date, then add to accumulated E&P (most complicated, the only scenario where we need to know the distribution date) 4. - & -, total E&P = 0

Two Separate E&P Accounts to be Maintained

1. Current earnings and profits that relate to the current year 2. Accumulated earnings and profits the relate to previous years We will combine the two to come up with out E&P Current E&P not distributed to shareholder is added to accumulated E&P at the beginning of the next taxable year - E&P is similar to retained earnings, the difference is stock dividends and contingency reserves reduced RE but don't reduce E&P

3 Step Framework for Property Distributions of Cash (Calculation of a Dividend)

1. Dividend to extent distribution covered by corporate earnings and profits (E&P) Return "on" investment 2. Tax free recovery of capital (basis) - return "of" investment 3. Excess over basis = deemed sale of stock with no basis left = capital gain

Ordering of E&P Distributions

1. Positive Current E&P and Positive Accumulated E&P 2. Positive current E&P, negative accumulated E&P 3. Negative current E&P, positive accumulated E&P 4. Negative current E&P, negative accumulated E&P

3 Step Framework for Calculation of Current E&P

1. Write down the taxable income number given 2. Subtract federal tax number given (Taxable Income x 21%) 3. Reverse the book-tax effect we learned in Chapter 5.

What stock ownership tests must be met before a shareholder receives exchange treatment under the substantially disproportionate change-in-stock-ownership test in a stock redemption? Why is a change-in-stock-ownership test used to determine the tax status of a stock redemption?

A shareholder meets the substantially disproportionate change-in-stock-ownership test by satisfying three mechanical stock ownership tests:1. Immediately after the exchange the shareholder owns less than 50% of the total combined voting power of all classes of stock entitled to vote;2. The shareholder's percentage ownership of voting stock after the redemption is less than 80% of his or her percentage ownership before the redemption; and3. The shareholder's percentage ownership of the aggregate fair market value of the corporation's common stock (voting and nonvoting) after the redemption is less than 80% of his or her percentage ownership before the redemption. The Code uses a change in stock ownership test to determine the tax status of a stock redemption to distinguish between transactions that resemble sales from transactions that are in substance a dividend distribution (that is, a transaction in which the shareholder does not meaningfully change her stock ownership in the company).

What must a shareholder do to waive the family attribution rules in a complete redemption of stock?

A shareholder must file a "triple i agreement" with the IRS and refrain from having a prohibited interest (shareholder, employee, director, officer, or consultant) for 10 years. The shareholder must agree to notify the IRS district director within 30 days if he or she acquires a prohibited interest within 10 years after the redemption.

Stock Redemption Example

A shareholder owns 60% of the corporation's 100 shares of voting common stock before the redemption. What percentages ownership test(s) must be met for the shareholder to receive exchange treatment under Sec 302(b)(2)? < 50% < 80% x 60% = 48% How many shares of stock must the corporation redeem to meet the Sec 302(b)(2) tests to have the redemption treated as an exchange to the shareholder? (60-x)/(100-x) < .48 60-x < 48 - .48x .52x < 12 X < 23.07 = 24 shares

Oriole Corporation, a privately-held company, has one class of voting common stock, of which 1,000 shares are issued and outstanding. The shares are owned as follows: Larry Byrd 400 Paul Byrd (Larry's son) 200 Lady Byrd (Larry's daughter) 200 Cal Rifkin (unrelated) 200 Total 1,000 Larry is considering retirement and would like to have the corporation redeem all of his shares for $400,000. a) What must Larry do or consider if he wants to guarantee that the redemption will be treated as an exchange?

Because this is a complete termination of his direct ownership interest in Oriole Corporation, Larry can elect to waive the family attribution rules provided he does not acquire a prohibited interest in Oriole over the next ten years. Larry must file a "triple i agreement" with the IRS to waive the election and agree to alert the IRS if he acquires a prohibited interest within the next 10 years. Larry Before Redemption = 800/1000 = 80% Larry After Redemption = 66.6% Substantially disproportionate rule will not work here. Only hope is if all of Larry's shares are redeemed and he files a "triple I" agreement.

This year Sooner Company reports current E&P of negative $300,000. Its accumulated E&P at the beginning of the year was $200,000. Sooner distributed $400,000 to its sole shareholder, Boomer Wells, on June 30 of this year. Boomer's tax basis in his Sooner stock is $75,000. a. How much of the $400,000 distribution is treated as a dividend to Boomer?

Boomer reports a dividend of $50,000. He first computes balance in E&P as of June 30 by allocating the deficit in current E&P pro rata over the year. The deficit in current E&P on June 30 is negative $150,000, computed as [($300,000) x 6/12]. Hence, accumulated E&P as of June 30 is $50,000, computed as $200,000 - $150,000.

This year Sooner Company reports current E&P of negative $300,000. Its accumulated E&P at the beginning of the year was $200,000. Sooner distributed $400,000 to its sole shareholder, Boomer Wells, on June 30 of this year. Boomer's tax basis in his Sooner stock is $75,000. b) What is Boomer's tax basis in his Sooner stock after the distribution?

Boomer's tax basis in his Sooner stock is $0, which is his beginning tax basis of $75,000 less the lesser of the distribution in excess of accumulated E&P ($350,000) or his basis in the Sooner stock ($75,000). The remaining $275,000 is treated as gain from sale of the Sooner stock (capital gain).

Computing Earnings and Profits

Corporation must maintain a separate accounting system, many times the depreciation for E&P is separate as well Corporation begins computing E&P with taxable income or loss Adjustments are made which are required by IRC 3 Step Framework for calculation of Current E&P: 1. Write down the taxable income number given 2. Subtract federal tax number given (Taxable Income x 21%) 3. Reverse the book-tax effect we learned in Chapter 5.

Bulldog Corporation reported taxable income of $500,000 this year before any deduction for any payment to its sole shareholder and employee, Georgia Brown. Bulldog chose to pay a bonus of $100,000 to Georgia at year-end. The bonus meets the requirements to be "reasonable" and is therefore deductible by Bulldog. Georgia is subject to a marginal tax rate of 35% on the bonus. What is the income tax imposed on the corporate income earned by Bulldog and the income tax on the bonus paid to Georgia?

Corporate tax: $400,000 x 21% $ 84,000 Shareholder tax: $100,000 x 35% 35,000 Total income tax $119,000

Basic Tax Law Framework that Applies to Property Distributions

Characterization of a distribution from a corporation to a shareholder has important tax consequences to both parties in the transaction The nondeductibilitiy of the distribution by the corporation, coupled with the taxation of the distribution to the shareholder, creates "double taxation" of the corporation's income Double taxation of the distributed corporate income is a fundamental principle of the U.S. income tax system The recipient of a dividend or payment in exchange for corporate stock generally receives preferential tax treatment on the distribution, in the form of a reduced tax rate (0%, 15%, or 20% depending on income) or as a tax-free return of capital or both If the distribution is characterized as salary, bonus, interest, or rent, the corporation can deduct the amount paid in computing its taxable income, unless the (IRS) asserts the distribution is a constructive dividend (Allows the corp to avoid double taxation) If the distribution is treated as compensation, the corporation and the shareholder employee also must pay employment taxes on the distribution

Jayhawk Company reports current E&P of $300,000 and accumulated E&P of negative $200,000. Jayhawk distributed $400,000 to its sole shareholder, Christine Rock, on the last day of the year. Christine's tax basis in her Jayhawk stock is $75,000. a) How much of the $400,000 distribution is treated as a dividend to Christine?

Christine has dividend income of $300,000, all of which is from the company's current E&P.

Jayhawk Company reports current E&P of $300,000 and accumulated E&P of negative $200,000. Jayhawk distributed $400,000 to its sole shareholder, Christine Rock, on the last day of the year. Christine's tax basis in her Jayhawk stock is $75,000. b) What is Christine's tax basis in her Jayhawk stock after the distribution?

Christine reduces her tax basis in the Jayhawk stock by $75,000 to $0, which is the lesser of the distribution in excess of current E&P ($100,000) or her basis in the Jayhawk stock ($75,000). The remaining $25,000 is treated as gain from sale of the Jayhawk stock (capital gain).

Tax Consequences to the Shareholders in a Complete Liquidation

Depends on: 1. Shareholders identity (corporate, individual, controlled sub) 2. Ownership Percentage in the corporation (80% or more?) All non corporate shareholders receiving liquidating distributions have a fully taxable transaction - individuals Shareholders treat the property received as in "full payment in exchange for the stock" transferred (treated as a taxable sale) A noncorporate shareholder computes capital gain or loss by subtracting the stock's tax basis from the money and FMV of property received in return (always taxable) - shareholder's tax basis in the property received equals the property's fair market value (treated as a taxable sale) Corporate shareholders (Parent Corp) owning 80% or more of the stock of the liquidating subsidiary corporation do not recognize gain or loss on the receipt of liquidating distributions under Sec 332 - the tax basis in the property transferred carries over (tax deferred transaction) to the recipient which allows a group of corporations under common control to reorganize their organizational structure without tax consequences

Framework for Property Dsitributions

Distributions to shareholders will be taxed in one of the following ways: - taxed as income - tax-free return of capital - capital gains When distributions from corporations are taxed to shareholders, this creates double taxation of corporate income.

Overview of Distributions

Dividend distributions are included in the shareholder's gross income Non-dividend distributions are a return of capital (reduce the shareholder's tax basis in the corporation's stock) Non-dividend distributions in excess of the shareholder's stock tax basis constitute a gain from sale or exchange of the stock

Constructive Dividends

Dividend distributions often result in double taxation to the parties to the transaction as the corporation making the distribution cannot deduct dividend paid in computing its taxable income Corporations can avoid this second level of taxation by characterizing the distribution as being made to the shareholder in their capacity as other than a shareholder (e.g., for salary for an employee or rents to a landlord

In general, what is the concept of earnings and profits designed to represent?

Earnings and profits is intended to represent the corporation's ability to pay distributions to its shareholders without eroding its invested capital. Earnings and profits is designed to reflect the corporation's economic income, a broader concept than its taxable income.

Redemptions that Meaningfully Contract the shareholder's stock ownership interest = exchange

First Test to Try: Redemptions that are substantially disproportionate with respect to the shareholder 3 stock ownership tests to be met: 1. Immediately after the exchange, the shareholder owns less than 50% of the total combined voting power of all classes of stock entitled to vote 2. Shareholder's percentage ownership of voting stock after the redemption is less than 80% of his or her percentage ownership before the redemption 3. Shareholder's percentage ownership of the aggregate fair market value of the corporation's common stock after the redemption is less than 80% of his or her percentage ownership before the redemption In computing the percentage ownership tests, the constructive ownership must be considered: - family attribution - attribution from entities to owners or beneficiaries - attribution from openers to beneficiaries to entities - option attribution

Flintstone Company is owned equally by Fred Stone and his sister Wilma, each of whom hold 1,000 shares in the company. Wilma wants to reduce her ownership in the company, and it was decided that the company will redeem 250 of her shares for $25,000 per share on December 31 of this year. Wilma's income tax basis in each share is $5,000. Flintstone has current E&P of $10,000,000 and accumulated E&P of $50,000,000. c) Assuming the company did not make any dividend distributions this year, by what amount does Flintstone reduce its E&P as a result of the redemption?

Flintstone reduces its E&P by $6,250,000, the amount of dividend income reported by Wilma.

Two Conditions for Nontaxable Stock Dividends - Sec. 305

For the nontaxable stock dividend general rule to apply, the stock distribution must meet two conditions: 1. It must be made with respect to the corporation's common stock 2. It must be pro rata with respect to all shareholders (that is, the shareholders' relative equity positions do not change as a result of distribution)

Computing the Tax Basis of Stock in a Section 351 Transaction When Boot is Received

Formula: Cash Contributed + Tax Basis of other property contributed + Gain recognized on the transfer - FMV of boot received - Liabilities assumed by the corporation on property contributed = Tax basis of stock received

Basis Formula for Receiving Corporation Assets under Sec 351

Formula: Substituted basis in property contributed (& cash) + gain recognized on transfer by shareholder - FMV of boot received - liabilities contributed = Basis in stock received

Basis Formula for Initial Stock Basis After Incorporation under Sec 351

Formula: Substituted basis in property contributed (& cash) + recognized gain (protect from double tax) - FMV of boot received - liabilities contributed = Basis in stock received Key thing to note for tax deferral - the role of basis: When we have tax deferral, the deferred gain is deferred with the lower substituted/carryover basis. If there were instead taxability, the basis would step up to FMV. Gain is therefore deferred using the lower basis that keeps the inherent gain "built in"

Computing the Tax Basis of Property Received by the Corporation in a Sec 351 Transaction When Boot is not Received

Formula: Cash contributed by the shareholder + Tax basis of other property contributed by the shareholder + Gain recognized on the transfer by the shareholder = Tax Basis of property received

Boots, Inc. is owned equally by Frank Albert and his daughter Nancy, each of whom hold 1,000 shares in the company. Frank wants to retire from the company, and it was decided that the company will redeem all 1,000 of his shares for $25,000 per share on December 31 of this year. Frank's income tax basis in each share is $500. Boots, Inc. has current E&P of $1,000,000 and accumulated E&P of $5,000,000. a) What must Frank do to ensure that the redemption will be treated as an exchange?

Frank must file a "triple i agreement" with the IRS, in which he agrees he will not acquire a prohibited interest in the next 10 years. By filing such an agreement, Frank can waive the family attribution rules and be treated as having a complete termination of his interest in Boots, Inc. Frank and daughter Nancy have constructive ownership because they are treated as being related (lineal relationship). They are treated as owning each other's shares. Frank Before Redemption = 2000/2000 = 100% Frank After Redempttion = 1000/1000 = 100% Substantially disproportionate rule will not work here. Only hope is if all of Frank's shares are redeemed and he files a "triple I" agreement. If he does, he has the following qualified redemption treatment (capital gain):

Boots, Inc. is owned equally by Frank Albert and his daughter Nancy, each of whom hold 1,000 shares in the company. Frank wants to retire from the company, and it was decided that the company will redeem all 1,000 of his shares for $25,000 per share on December 31 of this year. Frank's income tax basis in each share is $500. Boots, Inc. has current E&P of $1,000,000 and accumulated E&P of $5,000,000. c) If Frank treats the redemption as a dividend, what happens to his stock basis in the 1,000 shares redeemed?

Frank will have a basis of $0 in his stock after the transaction. His unused basis otherwise would transfer to Nancy, the person who attributed stock to him that caused him to fail the exchange test.

Stock Redmptions

Individuals are motivated to seek exchange treatment in a stock redemption because of the preferential tax rates imposed on capital gains Corporate shareholders generally have more incentive for dividend treatment Dividends from domestic corporations are eligible for the DRD, whereas a capital gain is taxed at the corporation's marginal tax rate

Hoosier Corporation declared a 2-for-1 stock split to all shareholders of record on March 25 of this year. Hoosier reported current E&P of $600,000 and accumulated E&P of $3,000,000. The total fair market value of the stock distributed was $1,500,000. Barbara Bloomington owned 1,000 shares of Hoosier stock with a tax basis of $100 per share. c) How does the stock distribution affect Hoosier's accumulated E&P at the beginning of next year?

Hoosier does not adjust its E&P for the stock dividend because it is not taxable to the shareholders.

Stock Redemptions Tax Consequences to the Distributing Corporation

If the shareholder treats the redemption as a dividend, the corporation reduces its E&P by the cash distributed and the fair market value of other property distributed If the shareholder treats the redemption as an exchange, the corporation reduces E&P at the date of distribution by the percentage of stock redeemed, not to exceed the fair market value of the property distributed Reduces its E&P by any divided distributions made during the year before reducing its E&P for redemptions treated as exchanges A corporation cannot deduct expenses incurred in a stock redemption

Tax Basis of Stock Dividends

In a nontaxable stock dividend, we still must allocate basis to the new shares Formula: (FMV of stock received x Adjusted basis of "old stock")/Total FMV of all stock = Adjusted basis of "new stock"

Boots, Inc. is owned equally by Frank Albert and his daughter Nancy, each of whom hold 1,000 shares in the company. Frank wants to retire from the company, and it was decided that the company will redeem all 1,000 of his shares for $25,000 per share on December 31 of this year. Frank's income tax basis in each share is $500. Boots, Inc. has current E&P of $1,000,000 and accumulated E&P of $5,000,000. b) If Frank remained as the Chairman of the Board after the redemption, what is the amount and character (capital gain or dividend) of income that Frank will recognize this year?

In this case even if Frank filed a "triple i agreement" with the IRS, he would have retained a prohibited interest in the company, and this interest will cause the family attribution rules to apply to the distribution. Frank will be deemed to own 100% of the company before and after the distribution. As a result, the distribution will be treated as a property distribution under section 301. Frank's distribution totals $25,000,000 ($25,000 x 1,000 shares). The distribution will be a dividend to the extent of the company's E&P of $6,000,000. The remaining $19,000,000 will be a tax-free return of capital to the extent of Frank's basis in his shares of stock ($500,000) and a capital gain for the remaining amount ($18,500,000). Substantially disproportionate rule will not work here. Only hope is if all of Frank's shares are redeemed and he files a "triple I" agreement. If he does, he has the following qualified redemption treatment (capital gain): Proceeds - $25,000,000 (1,000 x $25,000) Basis - $500,000 (1,000 x $500) Capital Gain - $24,500,000 If Frank does not follow the requirements for the "triple i" agreement, he will have dividend treatment. He must follow the 3 step dividend treatment rules: Dividend - $6,000,000 (5,000,000 + 1,000,000) Recovery of Basis - $500,000 ($500 x 1,000 shares) Capital Gain - 18,500,000 (remaining)

Transactions Subject to Tax Deferral

Meeting the Section 351 Tax Deferral Requirments: Rule 1: Section 351 applies ONLY to the transfer of property to the corporation (Services are excluded) Rule 2: Property transferred to the corporation must be exchanged solely for stock of the corporation - Receipt of the boot will cause the transferor to recognize gain but not loss, realized on the exchnage - Boot: Adding additional property to equalize the exchange Rule 3: Transferor(s) of property to the corporation must be in Control, in aggregate, of the corporation immediately after the transfer - Control: Ownership of 80% or more of the corporation's voting stock and each class of nonvoting stock The IRS has stated that stock received in exchange for services can be counted in the control test if the transferor also receives stock in exchange for property with a fair market value of 10% or more of the services rendered. If you receive stock for services, your stock cannot count as control. In other words, if people who performed services received more than 20% of voting stock, you do not have control. Stock warrants, stock rights, stock options, and debt do not constitute stock for purchases of Sec 351

Let's say Ginny joined with Jim and Al for sec 351 treatment. Ginny received 25% of the corporation's stock in exchange for services and intangibles treated as property. The stock was valued at $150,000. The services were valued at $125,000 and the intangibles were valued at $25,000. Al and Jim received the remaining 75% of the stock in the company in exchange for appreciated property. Will Al and Jim defer recognition of gain they realize on exchange of the appreciated property under Sec 351. Assume Ginny's services were valued at $140,000 and the intangibles were valued at $10,000. Will Al and Jim defer recognition of gain they realize on the exchange of the appreciated property under Sec 351?

No, because Ginny's primary purpose is transferring the intangible property was to qualify the transfer for deferral. The fair market value of the stock received for services ($10,000/$140,000 = 7.14%). As a result, none of the stock Ginny receives in the exchange is counted in the control test. Al, Jim, and Ginny are treated as having received collectively only 75% of 360 Air stock in exchange for property. Consequently, Sec 351 does not apply to any of the transfers of the property to 360 Air.

Oriole Corporation, a privately-held company, has one class of voting common stock, of which 1,000 shares are issued and outstanding. The shares are owned as follows: Larry Byrd 400 Paul Byrd (Larry's son) 200 Lady Byrd (Larry's daughter) 200 Cal Rifkin (unrelated) 200 Total 1,000 Larry is considering retirement and would like to have the corporation redeem all of his shares for $400,000. b) Could Larry still act as a consultant to the company and still have the redemption treated as an exchange?

No. A consultant is considered a prohibited interest in Oriole Corporation.

As part of the incorporation, Ginny received 10% of the stock on 360 Air valued at $60,000 in exchange for her services in setting up the corporation. Will Ginny defer recognition of the $60,000 "gain" she realizes on the transaction?

No. Ginny must report compensation income of $60,000 as a result of this exchange because services are not considered property under Sec 351

Suppose Ginny joined with Jim and Al in the incorporation of 360 Air and received 25% of the corporation's stock in exchange for services. The stock was valued at $150,000. Al and Jim received the remaining 75% of the stock in the company in exchange for appreciated property. Will Al and Jim defer recognition of gain they realize on the exchange of the appreciated property under Sec 351?

No. Taking into account only the stock received in exchange for property, Al and Jim do not collectively control 360 Air immediately after the transaction. Al and Jim own only 75%, not 80%. Consequently, the transaction is not eligible for deferral under Sec 351, and all gain realized is recognized.

Taxable Stock Dividends

Non-pro rata stock dividends usually are taxable as dividends Choice of stock or cash

Tax Consequences to Shareholders Receiving a Stock Dividend

Nontaxable Stock Dividends - Sec. 305 - Stock dividends generally do not provide shareholders with any increase in value - Cash is not potential available

Stock Dividends

Owners receive additional shares of stock, not cash, so tax free A stock dividend increases the number of shares outstanding and thereby reduces the (value) price per share Most stock dividends take the form of a stock split, which is a 2-for-1 stock dividend

Difference between realized gain and recognized gain

Realized gain - most of the time will be taxed immediately Recognized gain - subj to taxation this year When we have a taxable transaction, the gain realized will also be recognized About 95% of the time, the realized gain will be taxed immediately Realized Gain = Recognized gain + Excluded Gain (Very Rare) + Deferred gain (Realized gain is taxed later) Recognized gain - (taxed now) Get basis step up when taxed. We always have basis step up when we have a fully taxable transaction, so we don't get double taxed if we sell tomorrow Excluded Gain - (Never taxed) Ex: Muni bond Interest, Sale of personal residence Deferred Gain - (Taxed Later) Ex: Sec 351 corp formation, Sec 721 partnership formation, Liquidation of controlled sub (Sec 337). Whenever we have deferred gain, we will not have full basis step up. Instead, we have carryover basis Key thing to note for tax deferral - the role of basis: When we have tax deferral, the deferred gain is deferred with the lower substituted/carryover basis. If there were instead taxability, the basis would step up to FMV. Gain is therefore deferred using the lower basis that keeps the inherent gain "built in"

Badger Corporation declared a stock distribution to all shareholders of record on March 25 of this year. Shareholders will receive one share of Badger stock for each ten shares of stock they already own. Madison Cheesehead owns 1,000 shares of Badger stock with a tax basis of $100 per share. The fair market value of the Badger stock was $110 per share on March 25 of this year. c) How would you answer parts (a) and (b) if Badger offered shareholders a choice between one additional share of Badger stock for each 10 shares held or receiving $120 cash in lieu of an additional share of stock?

Regardless of whether Madison choose the stock or the cash, she would have a taxable dividend equal to $12,000 (computed as 1,000/10 x $120) because the distribution has the potential to be non pro rata to the shareholders. If Madison chose the additional shares of Badger stock, the tax basis of the new shares would be the amount of dividend income, $12,000 ($120 per share). Basis Allocation = Total Basis/Total of old + new shares = new basis per share Basis Allocation = $100,000/1,000 + 100 = $100,000/1,100 shares = $90.90 new basis per share Basis Allocated to new shares = $90.90 x 100 = $9,090 Basis Remaining in old shares = $90.90 x 1000 = $90,910

Wildcat Company is owned equally by Evan Stone and his sister Sara, each of whom hold 1,000 shares in the company. Sara wants to reduce her ownership in the company, and it was decided that the company will redeem 500 of her shares for $25,000 per share on December 31 of this year. Sara's income tax basis in each share is $5,000. Wildcat has current E&P of $10,000,000 and accumulated E&P of $50,000,000. b) What is Sara's income tax basis in the remaining 500 shares she owns in the company?

Sara's income tax basis in the remaining shares remains $5,000 per share or $2,500,000 income tax basis in remaining 500 shares. Sara stock redemption (brother and sister are NOT considered related for redemption rules so there is no constructive ownership here surprisingly

Second and Third Test to Try in Stock Redemptions

Second Test to Try: Redemptions in complete redemption of all of the stock of the corporation owned by the shareholder - Prohibited Interest: cannot be a shareholder, employee, director, officer, or consultant - can be a creditor - Triple I agreements - Sec 302(c)(2)(A)(iii) Third Test to Try: Redemptions that are not Essentially Equivalent to a Divided (Sec 302(b)(1))

Wildcat Company is owned equally by Evan Stone and his sister Sara, each of whom hold 1,000 shares in the company. Sara wants to reduce her ownership in the company, and it was decided that the company will redeem 500 of her shares for $25,000 per share on December 31 of this year. Sara's income tax basis in each share is $5,000. Wildcat has current E&P of $10,000,000 and accumulated E&P of $50,000,000. a) What is the amount and character (capital gain or dividend) recognized by Sara as a result of the stock redemption?

Shares owned constructively - shares owned by your family members that are lineal descendants, brothers and sisters are not treated as relatives Sara reduces her ownership in Wildcat Company from 50% to 33.33% (500/1,500). Sara meets the substantially disproportionate test to treat the redemption as an exchange. Under this test, she reduces her ownership below 50%, and her ownership percentage after the redemption is less than 80% of her ownership before the redemption (80% x 50% = 40%). As a result, Sara recognizes a capital gain of $20,000 per share ($25,000 - $5,000). Sara stock redemption (brother and sister are NOT considered related for redemption rules so there is no constructive ownership here surprisingly Sara Before Redemption = 1000/2000 = 50% Sara After Redemption = 500/1500 = 33% Meet both substantial disproportionate redemption tests, will get capital gain treatment as follows: Proceeds: $12,500,000($25,000 x 500) Basis: $2,500,000($5,000 x 500) Capital Gain: $10,000,000 Capital Gain/Share = $10,000,000/500 shares redeemed = $20,000 capital gain per share

Acme Corporation has 1,000 shares outstanding. Joan and Bill are married, and they each own 20 shares of Acme. Joan's daughter, Shirley also owns 20 shares of Acme. Joan is an equal partner with Jeri in the J&J partnership, and this partnership owns 60 shares of Acme. Jeri is not related to Joan or Bill. How many shares of Acme is Shirley deemed to own under the stock attribution rules?

Shirley is deemed to own 90 shares of Acme. She owns 20 shares directly and is attributed 20 shares from Bill (family attribution). She is also attributed 50 shares from Joan (family attribution). Joan owns 20 shares directly and another 30 shares is attributed to Joan from J&J (50% of 60 shares through entity attribution). The 30 shares attributed to Joan are reattributed to Shirley through family attribution. Shirley Direct Ownership - 20 shares Constructive with Mom - 20 shares Constructive with Dad - 20 shares Attribution for Mom Partnership - 30 shares (60 shares x 50% Mom ownership) Shirley Total Constructive Ownership = 90 share

Nontaxable Liquidating Distributions

The liquidating corporation does not recognize gain or loss on tax-free distributions of property to an 80% corporate shareholder under Sec 337 Liquidation-related expenses, including the cost of preparing and effectuating a plan of complete liquidation, are deductible by the liquidating corporation on its final form 1120 Deferred or capitalized expenditures such as organizational expenditures also are deductible on the final tax return

Form of a Stock Redmeption

Tax law defines a redemption as an acquisition by a corporation of its stock from a shareholder in exchange for property, whether or not the stock s acquired is canceled, retired, or held as treasury stock Shareholders exchange their stock in the corporation for property, usually cash Without any tax law restrictions, a sole shareholder of a corporation could circumvent the dividend rules by structuring distributions to have the form of an exchanged (e.g., treated as a sale) which would give them capital gain treatment

Paladin, Inc. reported taxable income of $1,000,000 this year and paid federal income taxes of 210,000. The company reported a capital gain from sale of investments of $150,000, which was partially offset by a $100,000 net capital loss carryover from last year, resulting in a net capital gain of $50,000 included in taxable income. Compute the company's current E&P.

Taxable income $1,000,000 Add: NCL carryover 100,000 Subtract: Federal income taxes (210,000) Current E&P $890,000

Boilermaker, Inc. reported taxable income of $500,000 this year and paid federal income taxes of $105,000. Not included in the company's computation of taxable income is tax-exempt income of $20,000, disallowed meals and entertainment expenses of $30,000, and disallowed expenses related to the tax-exempt income of $1,000. Boilermaker deducted depreciation of $100,000 on its tax return. Under the alternative (E&P) depreciation method, the deduction would have been $60,000. Compute the company's current E&P.

Taxable income $500,000 Add: Tax-exempt interest 20,000 Excess of regular tax deprecation over E&P depreciation 40,000 Subtract: Federal income taxes (105,000) Disallowed portion of meals and entertainment (30,000) Disallowed expenses related to tax-exempt income(1,000) Current E&P $424,000

This year Jolt Inc. reported $40,000 of taxable income before any charitable contribution deduction. Jolt contributed $10,000 this year to Goodwill Industries, a public charity. Compute the company's current E&P.

Taxable income before charitable contribution deduction $40,000 Charitable contribution limited to 10% of taxable income 4,000 Taxable Income $36,000 Federal income taxes $7,560 Taxable income $36,000 Less Charitable contribution carryover (6,000) Less Federal income taxes ($36,000 x 21%) (7,560) Current E&P $22,440

Tax-Deferred Transfers of Property to a Corporation

Without any tax provision to the contrary, transfers of property to a corporation in return for the corporation's stock would be taxable events if the property was appreciated or depreciated (Sec 1001) Gain/Loss to the Transferor Formula: FMV of the stock received - Basis of property transferred = Gain(Loss - If 3 requirements are met, we are allowed to defer the gain on this transfer of property - A loss is disalowed under Sec 267 if the transferor is "related" to the corporation (owned more than 50% after the transfer)

Character of Gain Recognized on Transfer of Property to a Corporation

The character of gain depends on the nature of the asset transferred on which gain is recognized: 1. Sec 1231 (capital) gain: Become netted out with capital gains and results in reduced tax rates 2. Sec 1245 depreciation recapture: Where we change the section 1231 gain to ordinary income 3. Ordinary Income Boot received has a tax basis equal to its fair market value b/c it's not part of the sec 351 deferral, basis step up equal to fair market value

Section 1244 Stock

When you invest in stock that becomes worthless, allows businesses to have an ordinary loss that is deductible instead of large capital loss they cannot use 3 Requirement: 1. Qualifying small business corporation (capitalized for less than $1 million 2. Original holder of the stock (AKA founder's stock) 3. Corporation must meet the active trade or business requirement for 5 years before the stock meets the Sec 1244 requirements If the Sec 1244 requirements are met: - the shareholder can recognize up to $50,000 per year of loss ($100,000 in the case of married, filing jointly) on subsequent sale of the stock as an ordinary loss, rather than as a capital loss (much better than a capital loss) - the balance amount of loss is treated as a capital loss, which can offset other capital other capital gains plus $3,000 of ordinary income

Flintstone Company is owned equally by Fred Stone and his sister Wilma, each of whom hold 1,000 shares in the company. Wilma wants to reduce her ownership in the company, and it was decided that the company will redeem 250 of her shares for $25,000 per share on December 31 of this year. Wilma's income tax basis in each share is $5,000. Flintstone has current E&P of $10,000,000 and accumulated E&P of $50,000,000. d) What other argument might Wilma make to treat the redemption as an exchange?

Wilma could argue that the distribution is not "essentially equivalent to a dividend" (section 301(b)(1)) because she reduced her ownership below 50 percent. This is a subjective test that the taxpayer can assert with proper facts although the IRS may dispute such a characterization upon audit.

Flintstone Company is owned equally by Fred Stone and his sister Wilma, each of whom hold 1,000 shares in the company. Wilma wants to reduce her ownership in the company, and it was decided that the company will redeem 250 of her shares for $25,000 per share on December 31 of this year. Wilma's income tax basis in each share is $5,000. Flintstone has current E&P of $10,000,000 and accumulated E&P of $50,000,000. a) What is the amount and character (capital gain or dividend) recognized by Wilma as a result of the stock redemption, assuming only the "substantially disproportionate with respect to the shareholder" test is applied?

Wilma reduces her ownership in Flintstone Company from 50% to 42.9% (750/1,750). Wilma fails the "substantially disproportionate" test to treat the redemption as an exchange. Although she reduces her ownership below 50%, her ownership percentage after the redemption is not less than 80% of her ownership before the redemption (80% x 50% = 40%). As a result, Wilma recognizes a dividend of $6,250,000 ($25,000 x 250 shares). Wilma stock redemption (again, brother and sister are NOT considered related for redemption rules so there is no constructive ownership here surprisingly) Wilma Before Redemption = 1000/2000 = 50% Wilma After Redemption = 750/1750 = 43%, Wilma fails second test this would be a dividend, not a capital gain Dividend = $6,250,000 ($25,000 x 250 shares)

Flintstone Company is owned equally by Fred Stone and his sister Wilma, each of whom hold 1,000 shares in the company. Wilma wants to reduce her ownership in the company, and it was decided that the company will redeem 250 of her shares for $25,000 per share on December 31 of this year. Wilma's income tax basis in each share is $5,000. Flintstone has current E&P of $10,000,000 and accumulated E&P of $50,000,000. b) Given your answer to question a, what is Wilma's income tax basis in the remaining 750 shares she owns in the company?

Wilma's income tax basis in the remaining shares of stock is $5,000,000. Wilma adds back the "unused" tax basis of the 250 shares redeemed ($1,250,000) to the basis of her remaining 750 shares ($3,750,000). Wilma's new basis per share for her remaining 750 shares = $5,000,000 total basis/750 shares = $6,666.67 per share. Basis per share always goes up when the unqualified redemption is a dividend. Basis per share of remaining shares always stays the same when the redemption is instead a capital gain (qualified redemption).

Let's say Ginny joined with Jim and Al for sec 351 treatment. Ginny received 25% of the corporation's stock in exchange for services and intangibles treated as property. The stock was valued at $150,000. The services were valued at $125,000 and the intangibles were valued at $25,000. Al and Jim received the remaining 75% of the stock in the company in exchange for appreciated property. Will Al and Jim defer recognition of gain they realize on exchange of the appreciated property under Sec 351.

Yes. The stock Ginny received in exchange for the intangibles exceeds 10% of the value of the stock received for the services ($25,000/$125,000 = 20%). For purposes of determining control, Ginny will treat all of the stock she received in 360 Air as having been received for property. Al, Jim, and Ginny will be treated as collectively receiving 100% of the 360 Air stock in exchange for property. Hence, Al and Jim will defer gain realized on their exchanges of property for stock. Ginny will recognize compensation of $125,000 on the exchange, but she will defer recognizing any gain realized on the transfer of intangibles.