December 11th, 2009
Corporate Tax
Taxable Acquisitions
Class Notes:
- Taxable Acquisitions Reasons–
- getting a cost basis in taxable transaction and get a carryover basis in a nonrecognition transaction
- primarily about issues of basis and what happens to the target tax attributes – then it is just a matter of what is more beneficial to the parties involved… a taxable transaction can be a very good strategy… you buy assets… fine… nothing wrong with that it’s just a planning issue so corporate acquisitions
- one reason to do taxable acq – not possible to qualify for nonrecognition acquisition – can’t fit oneself into the boxes…. Another business reason one would do an asset acquisition – the opportunity to “cherry pick” assets
- reorgs are about how we devise an acquisition strategy if we’re representing the PC to allow us to take what PC needs for its business/wants to pay for and in a bundle that the target is willing to sell… and have target get rid of stuff PC doesn’t want, sell it to other party… sometimes TC has assets that no one wants…
- at least when we do a taxable deal, the assets are purchased and everything is determined – basis (built in gain/loss) – is determined asset by asset…
- BIG PICTURE: if we can’t qualify for nonrec/exempt transaction – we do a taxable acquisition asset acquisition (if we want to cherry pick)… when does it make sense to do a taxable stock acquisition? Possible scenario – get assets for less by buying the stock… anything is possible… can we get the stock for a lesser amount then we liquidate T up into P… if we want to preserve NOLs/other tax attributes… we do a taxable asset acq if we think we’re going to get such a step up in the basis to cost that we’re paying so much more now for the assets than their current depreciated values so that we could run the depreciation values again that will provide a better tax benefit that preserving the NOLs…
- General Utilities has been repealed except for 337 – can we avail ourselves of benefits of 337 where 337(a) GU doctrine is preserved – what kind of planning options does this open up? That’s basically our grid
- EXAM: LAYOUT SOME FACTS and say tell your clients how to acquire TC… layout ALL the possibilities and DISCUSS the pros/cons of each… don’t do the biz logic… if you don’t have enough information to answer, tell her additional information need to know from client and why you need or say something like client promises to give all information you need but why you want it
- Taxable asset acquisition—
- Would advise to pay dividend to shareholders before liquidation after receiving cash from PC for purchasing assets?
- Depends – do the liabilities go with the assets to the PC? Some liabilities might go w/ the assets and some might not (trade creditors, lines of credit, etc.)
- If creditors not paid à sued
- 331(a) payment to SH of liquidations – sale/exchange transaction… beneficial rule compared to dividend distribution/redemption distribution gets us involved in 301(c) dealing w/ dividends and E&P… if a liquidation, SHs as treated as sold stock to corp in exchange for cash received, so the SHs get a 1001 corporation
- In an asset sale, E&P go away along w/ NOLs… TC is “just cleaning up what’s left” – by doing the liquidation distribution… shareholders prefer liquidation and NOT dividend in this situation… if held for appropriate holding period get cap gains… but rate equivalence? Have to remember rate equivalent about offset of basis for dividend…
- PROF’s view on double taxatio – it’s simply appropriate… but which is why she never talks about it but block talks repeatedly about it… it’s as though the same dollar is taxed at both levels – prof’s view – when engaged in two different transactions someone is getting tested and therefore not double taxation
- PROF’s view – residual method has lost it’s rationale but no one cares… 197 they just picked 15 years out of the air… it just sounded good… in certain circumstances… if there was a different method our clients would have a better result… but that’s that… it’s the rule
- Accountant will write opinion letter about the results of the residual allocation method (done asset by asset)
- Taxable Stock Acquisitions
- PROBLEM: PC doesn’t get cost basis and IRS will view it as a deemed sale under the step transaction doctrine (§338)
- Have to worry about 338… says this is peachy… but must follow series of requirements to get the step up/cost basis for the PC… 338 is raining on the PC’s parade…
- §338 is little used now… it is however still there and may in certain transaction be useful… NOT SPENDING MUCH TIME IN CLASS ON THE DETAILS OF 338 – the price of 338 is reasonably high b/c the target has to realize the gain on any appreciate in their assets on the deemed sale… there are 2 deemed transactions (p. 309) – 338 is about as useful as 306… we just need to know it’s there! People will ONLY DO A 338 if they will get a step up in basis… whole logic is that someone has to pay tax at the time of the transaction for that step up in basis…
- Old TC will have to pay tax on this deemed sale under 338(a)(1)
- New TC is treated as having repurchased by the so called new target… there is tax here… moreover new TC loses it’s tax attributes
- EXAM: very likely to be tested – where do tax attributes go and why do they go there? See below (reasons for 2nd step of 2 step process)
- WANTS US TO BE ABLE TO say that 338 is a possibility and what do we need to know about 338… what info do we need to know before we can properly advise the client… the idea of preventing of trafficking in tax attributes… block discusses… see outline… 338 is prohibition of use of tax beneficial items… it is why in current times w/ the repeal of general utilities, 338 is rarely used
- Talked briefly about the yoc heating case…
- We need to know §338 is there… that’s basically what we need to know… and the essentially of the repeal of GU kind of undermined the desirability of 338… so the planning opportunities that block discusses are pretty attenuated b/c there is going to be a tax of at the TC SH level and the TC Corporate level with these taxable acquisitions
- Main action in acquisitions – 368(a)(1), (b),(c), these provide for nonrecognition at the time of the acq and the party that protected are the target shareholders in these nonrecognition transactions
- Rationale – mere change in form of ownership…
- 368 – stated rationale – continuity of interest is making less and less sense… real reason for keeping 368 and nonrecognition is in fact so that capitalism can be nimble… 368 is actually a way for business people to enjoy freedom to make their own decisions… allows them to do what they want then when they pick their tax strategy… they need to stick with it
- 368 rules are a way of getting tax out of the way and allowing business to go forward
- 368 regs begin to tell us some of the things we hope ot learn about why we do this
- 368-1(a) reorgs—we’re told off the bat they mean ONLY a reorganization as defined in (a) and (b) of 368… then they tell us the transaction must be evaluated under 368 relevant provisions of law including the step transaction doctrine
- PURPOSE OF 368 — -1(b) – purpose is to except to the general rule… rationale for business purpose for reorganization
- If we don’t fit, we don’t get nonrecognition
- Requirements for Reorg that involves nonrecognition:
- Biz purpose
- Continuity of shareholder enterprise
- Continuity of business enterprise
- General form and substance provision – a sale is a sale even though mechanics are setup to look like a reorg… if it’s not a reorg and doesn’t satisfy the 3 requirements, IT’S NOT A REORG! Unlike 338, are reorg provisions elective? Reorg provisions are NOT elective… if we don’t want to do one… we just don’t set it up to look like one
- If we want to do a taxable stock acquisition, we can use any kind of value that is acceptable to target shareholders (i.e., sending each SH a kitten – say thanks to capitalism)… we can use any legal thing of value
- Need to comply w/ transactions and w/ the language… have the template for all the things that are moving parts in reorgs… going to start with the Forms of REORGS… reorg issue is how you get what you want and don’t take what you d on’t want… 2 approaches to planning challenge: 1) you can use the forms in 368 and pick an acquisition form that allows some cherry picking of assets; 2) we can try to work our way through the continuity of biz ent reqs and continuity of s hint reqs so that we are not going to fail to qualify under them but don’t ‘take any more than we need to satisfy them… reorgs have changed a lot in the last few years… much easier to satisfy continuity rules…
- We’re going to start w/ an A reorg
Introduction
- Corporate Acquisitions in General
- Common tax parlance – “corporate acquisition” generally refers to an acquisition of control by one corporation over another.
- Two different transaction types:
- i. ASSET Acquisition à purchasing corp (“PC”) gets direct control over target corp/selling corp’s (“TC”) or (“SC”) assets.
- ii. STOCK Acquisition à TC’s shareholders provide the PC w/ indirect control over the SC/TC’s assets through its ownership of the SC/TC’s stock.
- PC acquires a controlling interest in TCs stock from the TC shareholders, thus becoming a parent to its newly acquired subsidiary. The parent may continue to operate the subsidiary or decide to completely liquidate and distribute its assets.
- If PC decides to immediately liquidate TC, PC acquires control over TC’s assets upon the liquidation distribution (back to PC).
- *** STEP TRANSACTION – WATCH OUT: if purchase of TC’s stock and the subsequent liquidation of TC is viewed as an integrated transaction under the step transaction, the stock purchase transaction looks like a direct asset acquisition. ***
- *** NOTE: Control is defined 80% control requirement under §1504 (“Affiliated Group Defined”) ***
- §338 Elections—provides an election to qualified purchasing corporations to treat certain stock acquisitions as asset acquisitions.
- i. Acquiring Corporation/Purchasing Corporation can choose among three basic techniques for a TAXABLE ACQUISITION OF CONTROL:
- 1) an asset acquisition;
- 2) a stock acquisition w/o a §338 election
- 3) a stock acquisition treated as an asset acquisition pursuant to a §338 election
Choice of Acquisition Structure – 3 basis decisions to make in deciding which approach to take
- Taxable Acquisitions vs. Tax-Free Reorganizations
- Taxable Acquisition – used to indicate the SC is taxable upon the sale of its assets or that the SC Shareholders are taxable upon the sale of their stock.
- Classification classified as TAX-FREE Reorgs in 1 of 3 situations: §368(a)
- i. List 3 transactions here
- ii. *** NOTE: Transfer of property to a controlled corporation in return for stock will be a tax-free transaction under §351 ***
- Classification as tax free depends largely on TYPE OF CONSIDERATION USED BY PC in the exchange—
- i. Generally speaking—when consideration paid by PC provides the TC or its shareholders w/ a substantial interest continuing proprietary interest in the reorganized corporate entity, the transaction is likely to meet one of the 3 reorg definitions
- ii. Consideration paid by PC = cash/notes à TC is taxable upon the sale of its assets or the TC Shareholders are taxable upon the sale of their stock under §§61(a)(3) and 1001.
- iii. Consideration paid by PC = PC voting stock à two situations:
- PC acquires all TC’s assets in exchange for PC voting stock;
- PC acquires all TC’s stock from TC Shareholders in exchange for PC voting stock;
- RESULT: PC voting stock provides TC or its SHs w/ a continuing proprietary interest in the reorganized corporation – BOTH SITUATIONS fit in 1 of the 3 “reorg” definitions of §368(a).
- Differences B/T Tax-Free Acquisitive Reorgs and Taxable Acquisitions
- i. Property classification of taxable acquisition or tax-free acquisitive reorganization is CRITICALLY IMPORTANT to the parties and the government
- ii. Taxable Acquisitions—
- seller typically recognizes gain/loss
- SH does not ALWAYS recognize gain or loss in taxable transaction – if selling shareholder is a corporation, it might escape tax on the stock sale under §338(h)(10).
- BASIS RULES:
- ASSET ACQUISITION à PC is entitled to §1012 cost basis in assets purchased from TC.
- i. “Cost Basis Acquisition” is the term often used to describe a taxable asset acquisition.
- STOCK ACQUISITIONà PC is entitled to a §1012 cost basis ONLY in the TC shares purchased
- i. PC will NOT also get a “cost basis” in TC’s assets UNLESS it makes a proper election pursuant to §338
- iii. Tax-Free Acquisitions—
- nonrecognition treatment
- NOTE: this doesn’t mean TC or its SHs will NEVER recognize gain/loss in tax-free acquisitive reorgs. SHs will be taxable IMMEDIATELY on boot received as part of the transaction as well as payments received for accrued interest.
- BASIS RULES:
- ASSET ACQUISITION à PC gets a transfer basis in TC’s assets – gets the same basis that TC had in its assets… DOES NOT GET COST BASIS LIKE COMPARED TO A TAXABLE ACQ!
- i. RESULT: deferral of gain/loss recognition w/ respect to the TC’s assets until the PC later sells, exchanges, or otherwise disposes of the TC’s assets in a taxable transaction.
- ii. Typically called transferred or carry over basis acquisition – Treasury typically calls it carryover basis – used interchangeably. The correct terminology as defined in the Code is “transferred basis.” Property w/ a transferred basis is defined as property the basis of which is determined “in whole or in part by reference to the basis in the hands of the donor, grantor, or other transferor.” §7701(a)(43).
- STOCK ACQUISITION à PC is NOT entitled to a cost basis in the acquired stock… takes the stock w/ the same basis that it has in TC’s Shareholders’ hands. Also, TC’s assets will retain the SAME BASIS they had immediately before the acquisition, resulting in deferral of gain/loss w/ respect to the TC’s assets.
- Stock vs. Assets – whether the PC will acquire stock or assets in a TAXABLE ACQUISITION—
- Decision may be influenced on many factors:
- i. NONTAX—
- TC unwilling to negotiate transfer of assets; SHs ae unwilling to to negotiate a transfer of stock; or some other outside restrictions prevent the sale/transfer of the assets of the stock
- Choice of stock/asset may be influenced by the PC’s desire to minimize its exposure to any outstanding TC liabilities to its creditors
- Asset acquisition makes it easier for the PC to isolate and avoid any “unwanted assets.”
- ii. TAX RELATED FACTORS—
- Taxable sale of assets results in an immediate taxable gain to the SC and a cost basis in the assets to the PC
- PC’s desire to acquire assets will depend on the extent to which the assets are depreciable or otherwise would benefit from it taking a cost basis.
- SC’s willingness to sell assets will depend on the extent of the gain or loss reflected in the assets and the possibility of using any offsetting losses to reduce gains.
- SC must consider tax consequences to its shareholders
- ASSET ACQUISITIONS involve a double tax (after simple sale of all its assets for cash, the TC presumably will distribute the cash to its SHs in a liquidation distribution taxable to its SHs) – the corporation recognizes gain/loss on sale of its assets for cash and the TC SHs recognize gain or loss on receipt of the cash proceeds upon the liquidation of their stock holdings.
- STOCK SALE – stock sold by TC SHs generally results in immediate recognition of only shareholder level tax – SHs recognize gain/loss upon sale of their stock while the TC’s assets remain w/ the TC and retain their historic basis.
- i. Stock sale results in only one immediate tax, such sales are generally favored over asset sales.
- Election under §338 – should the PC make this election?
- In the case of a qualifying stock acquisition, the parties must decide whether or not the PC will make a §338 election.
- RESULT OF ELECTION: will essentially provide PC w/ a “cost basis” in the TC’s assets, but will also require the TC to recognize gain/loss as if it had sold all of its assets.
Taxable Asset Acquisitions
- The Transaction
- Tax Consequences to the PURCHASING CORPORATION
- BASIS—
- i. §1012 cost basis in assets purchased from TC
- assuming arm’s-length purchase—cost basis should be equal to FMV of the assets
- RATIONALE: since TC is fully reporting gain/loss on the asset transfer, and since the PC is paying full consideration for each asset, there is no reason to deny the PC the same cost basis generally applicable under §1012 for any purchase of assets
- Allocation of Purchase Price—
- i. The overall price paid by the PC must be allocated among all the assets purchased in order to determine the cost basis of each particular asset in the PC’s hands
- §1060-the PC must use the same residual allocation method to compute basis in the purchased assets that was used by the SC to allocate the purchase price in computing gain/loss on the asset sale.
- Tax Consequences to the SELLING CORPORATION and Its Shareholders
- Tax Consequences to the Target Corporation
- i. 1st) cash goes to TC; then 2nd) TC distributes cash to TC SHs
- ii. TC recognizes gain/loss immediately upon sale of assets under §61(a)(3) AND §1001.
- iii. Amount and character of gain/loss on the sale of assets is determined on an individual, asset-by-asset basis. Williams v. McGowan, 152 F.2d 570 (2nd Cir. 1945)
- iv. TC must include in amount realized:
- Any liabilities assumed by PC
- Amount of liabilities to which any property transferred was subject
- Amount realized by TC on any asset transferred subject to a mortgage will include the mortgage amount. The regs state that for purposes of determining the amount of the seller’s gain or loss, the FMV of any property subject to a nonrecourse debt shall be treated as being NOT LESS than the amount of such indebtedness. §1.338-6(a)(2). On the other hand, the FMV used for purposes of allocation of the purchase price is the GROSS FMV.
- If PC assumes liabilities accrued, but as yet unpaid operating expenses
- Liabilities accrued, but as unpaid operating expenses of a cash basis TC ASSUMED by the PC.
- Once TC includes the assumption of operating expenses as proceeds form the sale, TC should be entitled to deduct these assumed operation expenses
- i. Commerical Security Bank v. Comm’r, 77 T.C. 145 (1981)
- v. After sale of all/substantially all TC assets, the TC becomes a “shell” holding the consideration received from the PC along w/ any unsold assets. Usually a liquidation quickly follows the sale.
- vi. If liquidation is NOT to its corporate parent, it will be a taxable event to the distributing target. TC will already have paid gain or loss upon the initial sale of assets.
- There should be no/little remaining gain/loss to be reported by the target upon subsequent liquidation distributions since the distribution of cash to the SHs will not trigger further gain.
- TC will still need to report gain for unsold assets it sells upon the liquidating distribution not sold to the PC as part of the asset acquisition.
- vii. If sale of going biz for lump-sum price à necessary to allocate a portion of the purchase price to each asset sold.
- PROBLEM—some assets will result in capital gain/loss and some will result in ordinary income, the particular method used for allocating the purchase price will be important to the SC.
- Congress requires the “residual allocation method” for purposes of measuring the seller’s gain/loss on the assets sold.
- New §1060 regs explicitly reference and adopt the allocation rules of §1.338-6 and §1.338-7. §1.1060-1(c)(2).
- Tax Consequences to Target/Selling Shareholders
- i. When TC distributes cash/other assets to its SHs in liquidation following TC’s taxable asset sale, the SHs will generally report gain gain/loss upon the liquidating distribution pursuant to §331.
- If TC distributes cash: SHs get §1001(a) treatment and NOT §301(c) treatment.
- If SH is a corporate shareholder, want it treated as a dividend.
- ii. Taxable asset acquisition usually results in immediate double tax—the selling TC is taxed upon receipt of consideration for the assets sold and the TC SHs subsequently are taxed when the target distributes this consideration to its shareholders.
- NOTE: SH level taxation may be deferred to some extent if the TC remains alive. However, in most cases the liquidation follows quickly upon the sale, and deferral is likely to be brief.
- iii. If Consideration paid by PC = Installment NOTESà if PC gives notes to TC and TC subsequently distributes the notes to TC SHs in complete liquidation, the note distribution will trigger TC’s recognition of any gain previously deferred through installment reporting.
- TC would have reported gain from the initial sale of assets only upon actual receipt of installment payments pursuant to §453. A subsequent of the PC notes to the TC SHs upon liquidation would be considered a “disposition of an installment obligation,” triggering recognition of any gain previously deferred though the use of the installment method. §453B.
- iv. Despite §331 nonrecognition, TC SHs who receive PC notes upon TC’s liquidation may be eligible to report payments on the notes under the installment method as if they ahd sold their TC stock on an installment basis directly to PC. See §453(h),(k).
- Allocation of the Purchase Price—
- i. Tax Stakes for Buyer and Seller
- Historically, buyers preferred as much as possible purchase price allocated to assets that are depreciable or amortizable or intended for resale while sellers wanted as much as possible allocated to capital gains as opposed to ordinary income assets.
- Currently—
- §197–general provision for amortization of goodwill and certain other intangibles—specified purchased intangibles that are held in connection w/ the conduct of a trade or business or investment activity are now amortizable over a 15 year period.
- i. MOST IMPORTANT from BUYERS POV—intangibles covered by 197 include goodwill, going concern value, and covenants not to compete, along with several other intangibles.
- ii. This incentive eliminates the buyer’s incentive to allocate as much of the purchase price as possible to covenants not to compete as opposed to goodwill.
- ii. Special Allocation Rules: §1060
- Scope of Allocation Rules
- §1060 special allocation rules for certain asset acquisitions—the rules are limited to taxable asset acquisitions of a GROUP of assets that together constitute a trade or business
- i. “trade or business” – 1060 cross references to §355(b) active trade/biz requirement, but continues to provide that even if the group of assets does not meet trade/biz under 355, it will constitute a trade/biz for 1060 purposes if its character is such that goodwill or going concern value could under any circumstances attach to such group. §1.1060-1(b)(2).
- Classic EX covered by 1060: direct acquisition of all or substantially all of the target’s assets for cash or notes
- NOTE: special allocation rules ARE NOT limited to corporate asset sales
- iii. The Residual Method under §1060
- RULE: consideration received for the assets is allocated to 7 different classes of assets. The overall purchase price for the group of assets is allocated to each class in sequence, with the residual/leftover amount allocated to Class VII assets.
- §1060 and its regs adopt the same allocation method to allocate basis to various assets under §338(b)(5).
- Rationale: to provide roughly parallel treatment for taxable asset acquisitions and taxable stock acquisitions treated as asset acquisitions upon a proper §338 election.
- Treasury Dept has retained the “residual method,” but includes all of the amortizable §197 intangibles (as opposed to just goodwill and going concern value) in the residual Classes of VI and VII.
- Separation of 197 intangibles might reflect the notion that 197 intangibles such as customer lists, workplace in force, and patents (included in Class VI) are slightly more tangible than goodwill and going concern value (now included in Class VII)
- PROCEDURE:
- The total amount to be allocated is first reduced by the amount of Class I assets transferred, effectively allocating the purchase price to these assets on a $ to $ basis. Once subtracted, the remainder is allocated first to Class II, then III, then IV, then V, then VI, then VII in proportion to the FMV of the assets on the purchase date.
- An allocation to any particular asset CANNOT exceed the asset’s FMV. §1.338-6(c)(1).
- i. This restriction ensures that any surplus value paid for the assets will be allocated to Class VII assets such as goodwill.
- ii. See §1.338-6(a)(2) for definition of “FMV” for purposes of §338 §1060 allocations
-
7 Classes:
- I à generally include cash and general deposit accounts. §1.338-6(b)(1).
- II à actively traded personal property, including publicly traded stock, certificates of deposit, and foreign currency
- III à accounts receivable, most debt instruments, and assets that the taxpayer marks to market at least manually
- IV à inventory or property held primarily for sale to customers
- V à all assets other than those in Classes I-IV and VI-VII
- VI à all §197 intangible assets except goodwill and going concern value
- VII à intangibles in the nature of goodwill and going concern value
Taxable Stock Acquisitions
- The Transaction
- Cash goes directly to shareholders of TC… stock goes to PC… SHs of PC have acquiring
- Doesn’t have to be ALL cash… can use other property to go along w/ cash to the TC SHs… and all tax attributes move with TC
- PC has cost basis in TC shares, but basis in assets remains the same
- Tax Consequences to the Selling Corporation and Its Shareholders
- Shareholders
- i. Report gain or loss from TC shares to PC pursuant to 61(a)(3) and 1001.
- ii. If TC SHs receive P notes in exchange for their TC shares, they can report gain under the installment method in §453.
- Target Corporation
- i. No immediate tax consequences
- ii. T remains intact, albeit as a PC subsidiary
- iii. Each T asset after the acquisition retains the same basis as before the transaction
- iv. If TC liquidates, will recognize no gain or loss on the liquidating distribution under §337.
- PROBLEM: TC continuing to use pre-existing Net Operating Losses (“NOL”) AFTER the acquisition—
- i. Where acquisition results in “ownership change” à the carryforward of NOLs is subject to limitations in §382
- In tax avoidance cases, carryfoward of NOLs may be denied ENTIRELY under §269.
- “ownership change” occurs when à as defined in 382(g), if the percentage of target stock held by one or more 5% shareholders has increased by more than 50% over the lowest percentage of stock owned by such shareholders during the three-year testing period defined in 382(i).
- ii. If TC is liquidated or merged into PC after acquisition à PC can continue to use TC’s NOLs subject to restrictions in §382 and in the consolidated return regulations. §1.1502-21(c).
- iii. Generally—the rules allows PC to use NOLs to offset TC’s future income, but NOT to offset PC’s future income.
- Tax Consequences to the Purchasing Corporation
- Entitled to §1012 cost basis in the TC shares purchased
- i. RATIONALE: TC SHs fully report gain/loss on the sale of stock and the purchasing corporation pays full consideration for the shares – there is no reason to deny such a cost basis in the stock
- If PC DOES NOT make a §338 electionà TC (now a sub of PC) retains its assets with no change in asset basis
- If PC distributes TC’s assets in liquidation à P not required to recognize gain/loss pursuant to §332 and the parent will receive the same basis that the subsidiary had. §334(b).
- i. After liquidation to PC, TC assets will retain their historic basis
- ii. Why liquidate TC? If TC liquidates, we’re liquidating a controlled subsidiary. §337(a) – nonrecognition no gain/loss recognized to the liquidating corporation to the controlling parent corp to which 332 applies
- There is NO IMMEDIATE corporate level recognition of gain/loss on TC’s assets, but instead a deferral of gain/loss until the PC sells, distributes, or otherwise disposes of the assets.
- i. This kind of deferral can make a stock acquisition more attractive than an asset acquisition.
Stock Acquisitions Treated as Asset Acquisitions via §383
- Roots & Background—
- Transaction closely resembles an asset acquisition—where PC acquires controlling stock interest in TC followed immediately by receipt of the TC’s assets in a liquidation distribution
- i. Direct asset acquisition à 1 step
- ii. PC acquisition of controlling interest of TC stock followed by liquidation à 2 steps
- Congress has attempted to create equality between certain stock acquisitions and assets acquisitions
- c. Kimbell-Diamond Milling Co. v. Comm’r *** IMPORTANT CASE ***
- i. Facts: Corporate taxpayer Kimbell had fire casualty that destroyed its mill. It found a mill owned by Whaley to replace the mill. Kimbell purchased 100% of Whaley’s stock and shortly thereafter liquidated the Whaley (“TC”), acquiring direct ownership of the mill.
- ii. Issue: What was the proper basis in the mill for purposes of depreciation?
- iii. Kimbell Argument: it legitimately acquired TC, and the mill should have the same basis in its hands that it had in the TC’s hands under the predecessor to §334(b)
- Claiming 332/337 nonrecognition and wanted transfer basis
- iv. IRS Argument: since Kimbell intended an asset acquisition of the mill, the purchase of stock and the subsequent liquidation should be collapsed into one transaction under the step transaction doctrine and viewed as a purchase of assets to give Kimbell a cost basis.
- v. Court Ruling: sided with IRS—should be viewed as an asset acquisition, leaving Kimbell w/ a cost basis in the mill instead of a substituted basis from the TC.
- vi. NOTE: Kimbell had an unusual position in this case – usually the taxpayer WANTS a cost basis because that is usually higher than the historic/transfer basis that would come from the TC. Here, Kimbell’s basis was lower than the TC’s basis in the mill.
- vii. OUTCOME AFTER CASE: led to confusion – Congress enacted old §334(b)(2) to codify the Kimbell approach while attempting to eliminate the uncertainty of an intent-based standard.
- Old §334(b)(2):
- Not elective
- A purchaser of stock was entitled to a cost basis in the TC’s assets if the purchaser acquired at least 80% of the TC’s stock during a 12/mo period and the distribution was pursuant to a plan of liquidation adopted not more than 2 yars after the stock purchase
- 1982 – replaced old §334(b)(2) with §338
- roots of old §334(b)(2) and Kimbell case linger in §338
- Qualifying Stock Purchases (QSPs)
- Unlike old §334(b)(2), §338 is elective.
- §338 is basically an elective step up in basis for taxable acquisitions – doesn’t apply to tax-free reorganizations!
- §338 election available ONLY to corporations that have made a “qualified stock purchase”
- i. Qualified Stock “Purchase”—defined as a transaction (or a series of transactions) in which the purchasing corporation acquires stock in the TC that meets the two part 80% control test of §1504(a)(2) during a 12 month acquisition period
- §338 only applies to stock purchases of control sufficient to mee the 80% ownership test required for consolidated return reporting.
- Control need not be acquired in one transaction alone, it must be acquired during one 12 month period.
- PC must make a timely §338 election – once made, it’s IRREVOCABLE!
- Timely election – block page 307 FN 53
- ii. “Purchase”
- Definition of §338(h)(3) excludes certain stock acquisitions: the following are NOT acquiring by “purchase”—
- Target stock in which the PC takes a transferred/substituted basis from transferor
- Target stock where the PC takes a §1014 basis from a decedent
- Any stock acquired by PC in a §351 or other tax-free reorganization
- i. “Purchase” CANNOT include stock acquired in exchange where §351, §354, §355, or §356 applies. §338(h)(3)(A)(ii).
- Any stock acquired from a person, the ownership of whose stock would be attributed to PC under §318 attribution rules
- Theme of §338 “purchase” definition—§338 should apply ONLY to TAXABLE acquisitions.
- RATIONALE/POLICY: in an ordinary taxable stock acquisition, the SC SHs report gain/loss on the sale of stock and the PC SH takes the stock w/ a cost basis. Congress was willing to allow an elective cost basis in the TC’s assets upon transfer of control that was taxable to SC SHs.
- Exclusions of §338(h)(3) weed out stock transfers that were not taxable to the seller or transferor.
- RESULT: §338 elective step-up in basis is NOT available for acquisitions of control through a tax-free reorganization
- Deemed Sale and Repurchase of Assets by Target
- §338 Scheme
- i. Generally—if PC makes a §338 election following a QSP, TC is DEEMED to have engaged in two significant transactions:
- Step 1 à §338(a)(1)—TC is treated as if it sold all of its assets at the close of the acquisition at FMV in a SINGLE transaction
- RESULT: This triggers recognition of gain/loss to the TC and is often called a deemed sale by “old target” (old TC).
- The acquisition date is the first date on which the purchasing corporation has acquired enough TC stock to meet the 80% control test. §338(h)(2).
- Step 2 à §338(a)(2)—TC is treated as a new corporation which purchased ALL of the old TC assets described in (a)(1) on the following day.
- RESULT:
- i. This deemed repurchase of old TC’s assets effectively provides the PC w/ a cost basis in the TC’s assets
- Often called the deemed repurchase by “new target” (new TC)
- ii. Reasons for 2 step process—
- Step 1 extracts a HEAVY PRICE TAG to the PC to obtain a cost basis in the TC’s assets.
- Congress was unwilling to provide a cost basis (usually a step up in basis) to the PC unless the TC paid tax on the previously unrealized gain/loss in its assets
- §338(a)(1) requires recognition of this kind of gain or loss to the old target
- Step 2 –
- Because new TC purchases the day after, the new TC created by fiction in §338(a)(2) no longer has any tax attributes that the old TC had – i.e., earnings and profits, net operating losses, or other attributes.
- i. Congress meant to eliminate trafficking in tax attributes that might otherwise occur—i.e., PCs might otherwise shop around for target corporations with NOLs
- Isolation of the old TC’s gain or loss from the §338(a)(1) deemed sale
- §338(h)(9) restriction à “the TC shall not be treated as a member of an affiliated group w/ respect to the sale described in (a)(1)” – designed to prohibit trafficking in the tax characteristics of the old target’s deemed sale itself
- Restricts TC’s’ membership in both the selling AND purchasing affiliated groups w/ respect to the deemed sale
- i. RESULT: generally prevents the TC from using gains/losses of other members of the selling consolidated group to offset gains/losses the TC must recognize under the §338(a)(1) deemed asset sale.
- PC not able to use old TC’s gain/loss from deemed sale on PC Group’s consolidated return
- Mechanics of the §338(a)(1) DEEMED SALE
- §338(a)(1) – “the target shall be treated as having sold all of its assets at the close of the acquisition date at “FMV” in a single transaction”
- i. “FMV” – not the traditional “arms length buyer and seller” definition of FMV.
- ii. Regs use the “Aggregate Deemed Sales Price” (ADSP) as the “FMV” sales price instead for purposes of §338(a)(1). See §1.338-4(a).
- Old Regs à used the buyer’s cost for the TC stock as a surrogate for the FMV of T’s assets, reasoning that in an arm’s-length transaction b/t unrelated parties, the buyer’s cost should reflect FMV.
- New Regs à ADSP is NOT linked to the PC’s cost for the QSP. ADSP is now based upon the AMOUNT REALIZED on the sale to the PC.
- RATIONALE/POLICY:
- i. Designed to provide for greater consistency in the treatment of ACTUAL asset sales and §338 DEEMED asset sales.
- ii. Treasury Dept noted that the link in arm’s length transactions b/t unrelated parties the old regs used to provide the sale price doesn’t exist – in actual asset sales the timing and the amount of the seller’s amount realized and the timing of the amount of the buyer’s basis may differ.
- “Amount Realized” – regs refer to the “grossed-up amount realized on the sale to the PC of the PC’s recently purchased TC stock.” §1.338-4(b)(i)
- i. Determination of A/R—determined as if old TC were the selling shareholder and the installment method were not available. §Id. at (c)(1). The amount realized is then “grossed-up” by dividing by the percentage of TC stock (by value, determined on the acquisition date) attributable to that recently purchased TC stock. Id. at (c)(ii). Finally, old TC is allowed to subtract from the amount realized those selling costs that would ordinarily be permitted in a sale of stock to an unrelated 3rd party. Id. at (c)(iii).
- ADSP includes LIABILITIES—
- i. §1.338-4(d)(1)—ADSP Includes any old TC liability that is “property taken into account in the amount realized under general principles of tax law that would apply if old target had sold its assets to an unrelated person for consideration that included that person’s assumption of, or taking subject to, the liability”
- COMPUTATION OF ADSP
- i. The TC’s liabilities also include ANY TAX liability from the deemed asset sale of (a)(1) itself, including recapture items arising from the deemed sale.
- ii. Since gain/loss from deemed asset sale of (a)(1) is determined on an asset-by-asset basis, old TC must allocate the overall ADSP price among its assets.
- This may require trial and error computations. §1.338-4(d)(3).
- iii. Allocation method used for this purpose generally will be the same allocation method used for determining the basis of each asset in the purchaser’s hands
- Residual Method pursuant to §338(b)(5).
- iv. CHARACTER of old TC’s gain/loss as a capital or ordinary will depend upon the character of each asset sold.
- Mechanics of the §338(a)(2) DEEMED REPURCHASE
- Qualified Stock Purchase w/o a §338 Election Followed by Liquidation or Reorganization of Target
ds
Discussion:
An acquiring corporation may structure a taxable acquisition in one of three forms:
Asset acquisition
Stock acquisition
Stock acquisition treated as an asset acquisition under § 338
We will focus on the reasons for choosing to do a taxable acquisition rather than a nonrecognition transaction and on the reasons for choosing to engage in one of the three possible types of taxable acquisitions.
Note Block’s discussions of the relations between various types of taxable acquisitions and the
liquidations provisions, including the effect of the repeal of General Utilities for complete liquidations but the retention of General Utilities in the case of subsidiary liquidations.
NOTE: This is an unusual assignment because it relies on the reasons for particular transactions without then analyzing the detailed steps through which these transactions are structured.
December 10th, 2009
Corporate Tax
Current Non-Liquidating Distributions: Redemptions
Our discussion of dividends provides the foundation for our discussion of redemptions. The distinctions among types of redemptions are relatively straightforward and will not be our primary focus. Instead, we will focus on what is at stake in light of rate equivalence and on planning strategies based on redemptions.
Definitions and Tax Treatment
§ 317(b)
§ 302(a) & (d)
Treas. Reg. § 1.302-1(a)
§ 1059(e)(1)(A)
§ 1059(a)(1) & (2)
Block: 155-58; 179-81
1) Redemptions, GENERALLY—special type of nonliquidating distribution with one major distinguishing factor: the corporation distributes cash or other property in return for its own stock.
a) §317(b) definition of REDEMPTION—“stock shall be treated as redeemed by a corporation if the corporation acquires its stock form a shareholder in exchange for property, whether or not the stock so acquired is cancelled, retired or held as treasury stock”
i) alters the capital structure by reducing the total shares outstanding
b) “Property” defined in §317(a)
c) KEY ISSUE: distinguishing redemptions that should be handled under §301 distribution rules and those that should be treated simply as sales of stock by shareholders to the corporation
d) POINT OF REDEMPTION RULES: distinguish those redemptions that should be treated as sales from those that should be treated as dividends – sales vs. dividends
i) Treated as a Sale—treated as if §301 applies
e) PREFERENCE OF CHARACTERIZATION OF REDEMPTION DEPENDS ON TYPE OF SHAREHOLDER—PLANNING STRATEGY AND IMPACT
i) Individual Shareholders—generally will prefer sale or exchange treatment
(1) Likely to consider §302(b) provisions as “safe harbors”
(2) Allows a basis offset that would not be available if the redemption was treated as a §301 distribution (dividend)
(a) Assuming there is sufficient E&P to cover the distribution, a §301 distribution results in taxable income w/o any basis offset. If there is NOT sufficient E&P, the shareholder may receive a tax-free recovery of basis under §301(c)
(3) If stock has lost value, the shareholder will be entitled to use the loss for tax purposes at the time of the redemption
(a) One needs to consider that the shareholder’s ability to deduct the loss may be limited since the loss is likely to be capital loss
(4) Since stock is a capital asset, sale treatment as a gain results inc capital gains eligible for preferential capital gains rates
(5) Since qualified dividends are included in NET CAPITAL GAIN ONLY for purposes of the tax rate provisions in §1, shareholders will NOT be able to use any loss from the redemption distribution to offset other income in the event that the distribution is treated as a dividend under the §302 rules.
(6) Although individual shareholders can still take advantage of the basis offset and the ability to recognize any loss on the redemption exchange, the reduction in dividend tax rates makes the distinction between dividend and exchange redemptions LESS significant for individual shareholders than it was before
ii) Corporate Shareholders—
(1) Unlikely to consider §302(b) provisions are harbors
(2) Prefer §301 dividend treatment so that they can take advantage of the §243 dividends-received deduction available only to corporate shareholders
(3) §1059 extraordinary dividend rules—Congress’s response to dividends-received deduction abuse
(a) §1059(e)—certain redemption distributions to corporate shareholders are treated as §1059(a) “extraordinary dividends.”
f) COMPARE WITH: nonliquidating distributions discussed earlier (dividends-operating distribution) do not alter the capital structure of the corporation of the relationships among shareholders or between shareholders and the corporation
i) Shareholders recognize taxable dividends
g) PRORATA v. NON-PRORATA REDEMPTIONS—
i) if the redemption is prorata to all shareholders à redemption will NOT alter the relative ownership interests of the shareholders
(1) When redemptions like this take on the quality of an OPERATING DISTRIBUTION, the redemptions will be handled under the §301 distribution rules
ii) if the redemption is NOT prorata to all shareholders à redemption WILL alter the relative ownership interests of the shareholders
(1) EX: Corporation redeems ALL STOCK of one shareholder—shareholder will recognize a sale under §302(b)(3) “complete termination of interest”
2) Tax Consequences to Redeemed Shareholders
a) Overview
i) PROBLEM: Historically, the type of classification of the redemptions was left up to the courts, using a facts and circumstances analysis. This left shareholders w/ tremendous uncertainty as to the outcome as to whether it was to be treated as a sale or dividend
ii) FIX TO THE PROBLEM: Congress enacted §302 in 1954—§302 allows individual shareholders to be certain of sale or exchange rather than dividend treatment upon receipt of redemption distributions meeting the precise tests provided within its §302(b) “safe harbor” provisions. For the most part, the provisions enacted in 1954 are still found in §302(b) today.
3) §302 OUTLINE—designed to distinguish “sale or exchange” redemptions from distribution redemptions to be treated under the nonliquidating distribution rules. UNLESS the exchange fits w/in one of the descriptions in §302(b), the redemption will be treated under the §301 distribution rules.
a) §302(a)—provides that if one of the four paragraphs of subsection (b) DOES APPLY, a corporate redemption of stock will be treated as “a distribution in part or full payment in exchange for the stock”—a.k.a a SALE
b) §302(b)—if the redemption DOES NOT fit w/in one of the paragraphs of subsection (b), the redemption will be treated as a distribution of property to which the distribution rules of §301 apply.
i) §302(b)(1)-(3) focus on the extent of the shareholder’s proportionate reduction in interest in the corporation relative to other shareholders
ii) §302(b)(4) partial liquidation provision views the redemption from the Corporation’s perspective, looking to the extent of corporate contraction
(1) a pro rata redemption distribution might qualify for sale or exchange treatment under §302(b)(4)
(2) §302(b)(4) permits sale or exchange treatment to a noncorporate shareholder if the distribution is “in partial liquidation of the distributing corporation”
Redemptions Qualifying for Sale or Exchange Treatment
§ 302(b)(1): not essentially equivalent to a dividend
Treas. Reg. § 1.302-2
- The determination of whether or not a distribution is within the phrase “essentially equivalent to a dividend” (that is, having the same effect as a distribution without any redemption of stock) shall be made without regard to the earnings and profits of the corporation at the time of the distribution. §1.302-2(a).
- §1.302-2(b)(1)—Whether a distribution in redemption of stock of a shareholder is not essentially equivalent to a dividend under §302(b)(1) depends upon the facts and circumstances in each case:
- Constructive stock ownership of such shareholder under §318(a)
- Factors listed in (b)(1)
- §1.302-2(c)—in any case in which an amount received in redemption of stock is treated as a distribution of a dividend, property adjustment of the basis of the remaining stock will be made with respect to the stock redeemed.
- If redemptions of corporate shareholders treated as extraordinary dividends à see §1059 and the regulations
Block: 161-64
- Modern §302(b)(1) has been quite narrowly construed
- §302(b)(1) is the sale or exchange provision of last resort for most individual shareholders
- “Meaningful Reduction” Test—to be eligible for sale or exchange treatment under §302(b)(1), a “redemption must result in a meaningful reduction of the shareholder’s proportionate interest in the corporation.” U.S. v. Davis.
- “Meaningful Reduction”à must at least be SOME REDUCTION
- Facts and circumstances analysis – each case must be examined on its own merits
- the redemption of a SOLE SHAREHOLDER (or a “constructive” sole shareholder) is ALWAYS equivalent to a dividend and CAN NEVER get sale treatment
- 2 different categories of the test—
- Redemptions from Majority Shareholders—
- RULE: a SH that held a majority interest immediately before the redemption and continues to hold a dominant voting interest immediately after the redemption, virtually NO reduction in interest will be considered meaningful
- WRINKLE—Rev Rule 75-502: majority SH A interest reduced from 57% to 50%, with the other 50% owned by an unrelated party majority SH B. A lost voting control b/c B held effective veto power or the power to effectuate a stalemate.
- Treasury ruled A’s redemption qualified for §302(b)(1). If reduction had been less than 7%, the redemption would NOT qualify under §302(b)(1) b/c A would continue to have dominant voting rights in corp by virtue of its ownership of more than 50% of the corp’s stock.
- If the other 50% of corp’s stock was owned by more than one person, as opposed to a single shareholder B, the remaining 50% interest of A would have left effective dominant voting rights w/ the redeemed shareholder and thus would not be “meaningful” and not qualify under §302(b)(1).
- Treasury’s interpretation of §302(b)(1) allows more flexibility than the rigid 50% threshold test of §302(b)(2) –
- RATIONALE OF TREASURY’S INTERPRETATION: the reduction in interest is not thought to be substantial enough to justify sale or exchange treatment if the shareholder still exercises voting control even after the redemption
- WRINKLE—Wright v. U.S.: SH retains dominant voting rights after redemption and STILL QUALIFIES under §302(b)(1) for meaningful reduction
- Facts: reduction from 85% to 61.7% was meaningful because the SH lost 2/3rds voting control required by state law for various corporate actions. A still had managerial control, but lost organic control (i.e., state requirements of supermajority voting rules in the case of major organic changes such as merger or acquisition, loss of supermajority interest also referred to as loss of organic control)
- GIST—if you lose enough voting power that prevents you from doing something legally you could do before with your starting voting power, then you’ve got a meaningful reduction
- HOWEVER—Treasury refused to consider the loss of organic control of a corporation as a meaningful reduction in a case where no action requiring 2/3rds vote was contemplated at the time of redemption. See Rev. Rule 79-401.
- Redemptions from Minority Shareholders—
- Minority SH will have a much easier time arguing that a meaningful reduction has taken place
- RULE: almost ANY reduction in interest will qualify the minority SH under §302(b)(1).
- Rev. Rule 76-385—a reduction from a .0001118% interest to .0001081% interest in Z corporation was considered meaningful.
- Ruling points out that the redemption involves a minority SH whose relative stock interest in Z is minimal and who exercises no control over the affairs of Z
- Even though a miniscule reduction may be sufficient for minority shareholders, Treasury continues to insist on at least SOME reduction:
- Rev Rule 81-289—the proportionate interest of minority SHs remained at .02% before and after the redemption distribution. The minority shareholders in this ruling were not entitled to sale treatment under §302(b)(1) since they experienced no reduction.
§ 302(b)(2): substantially disproportionate distribution
Treas. Reg. § 1.302-3
Block: 159-61
- Even if the SH’s interest is NOT completely terminated, sale or exchange treatment may be available if his or her interest in the corporation is substantially reduced.
- §302(b)(2) – congress provides precise mathematical tests to measure the extent of the SH’s reduction in interest – provided to give certainty to shareholders concerning the percentage of stock that must be redeemed to qualify as a substantially disproportionate distribution.
- RULE: when there has been greater than a 20% reduction in the SH’s voting interest; AND where the resulting interest is NOT a controlling interest, the shareholder has relinquished sufficient interest in the corporation to qualify for sale treatment.
- §302(b)(2) TWO PART TEST—MUST MEET BOTH TESTS!
- 1) 50% Threshold Test—302(b)(2) shall not apply unless IMMEDIATELY AFTER THE REDEMPTION, the SH owns less than 50% of the total combined voting power of all classes of stock entitled to vote.
- If redeemed SH holds 50% or more of voting power immediately after the redemption, he still has CONTROL of the corporation, therefore, a proportionate reduction that leaves SH w/ a controlling interest immediately after the redemption is not substantial enough to qualify for §302(b)(2) sale or exchange treatment
- 2) 80% Disproportionate Distribution Tests—
- A before and after analysis of stock ownership
- RULE: the percentage of voting stock owned by SH immediately AFTER the redemption must be less than 80% of the percentage of voting stock owned by the SH immediately BEFORE the redemption – there should be at least a 20% reduction of the SH’s voting interest in the corporation
- If less than 20% reduction à transaction is more like a distribution and does not qualify for sale treatment under §302(b)(2)
- If more than 20% reduction à will qualify for sale treatment under §302(b)(2)
- BE CAREFUL: 80% test also applies to the common stock of the corporation, whether voting or nonvoting. Thus, if the corporation has outstanding any nonvoting common stock in addition to voting stock the 80% test must be met for the total common shares AS WELL AS for the voting shares alone.
§ 302(b)(3): complete termination of shareholder’s interest
§ 302(c)(2)
Treas. Reg. § 1.302-4
Block: 158-59
- §302(b)(3)—simplest form of §302(b) rules – provides sale or exchange treatment for redemptions in complete redemption of all of the stock owned by the shareholder
- EX: in a redemption distribution to one of two 50% shareholders in exchange for all his stock – treating the redemption as full payment in exchange for the stock via §302(a) makes sense if the shareholder’s interest in the corporation is terminated by a complete redemption – it shouldn’t matter whether if the “sale” is to a 3rd party of if the purchaser is the corporation itself
- TWISTS on rule:
- 1) Constructive ownership of stock rules of §318 apply for purpose of ALL §302(b) tests—under constructive ownership or attribution rules, the redeemed shareholder is deemed to own shares owned by certain related parties for purposes of testing the redemption distribution under §302(b).
- 2) a series of redemption distributions may be considered part of a complete termination of interest if the individual redemptions constitute, in substance, the component parts of a single sale or exchange of the entire stock interest AND if the redemptions are pursuant to a firm and fixed plan to eliminate the stockholder from the corporation
§ 302(b)(4) and § 302(e): partial liquidation
Treas. Reg. § 1.346-1(a)
- If amounts are distributed in partial liquidation, such amounts are treated under §331(a)(2) as received in part or full payment in exchange for the stock.
- A distribution is treated as in a partial liquidation of a corporation if:
- (1) The distribution is one of a series of distributions in redemption of all of the stock of the corporation pursuant to a plan of COMPLETE liquidation; OR
- (2) The distribution:
- (i) is NOT essentially equivalent to a dividend;
- (ii) is in redemption of a part of the stock of the corporation pursuant to a plan; AND
- (iii) occurs w/in the taxable year in which the plan is adopted or within the succeeding taxable eyar.
- Example of something COVERED—
- A distribution resulting from a genuine contraction of the corporate business such as the distribution of unused insurance proceeds recovered as a result of a fire which destroyed part of the business causing a cessation of a part of its activities
- The fire casued the cessation – they didn’t have to build it up… they could distribute the proceeds to the shareholders as partial liquidation with favorable tax treatment
- Example of something NOT COVERED—
- The distribution of funds attributable to a reserve for an expansion program which has been abandoned does NOT qualify as a partial liquidation within the meaning of §346(a).
- Looks like no plan here
- Is this the cessation of something? What do we want to argue to qualify for 302(b)(4) – we want to argue there has been a cessation of the plan. Will this win? NO – this argument won’t win.
- It looks like we have different standards of a “plan” for different sections of the code
- This can be very useful to closely held businesses with smaller amounts of shareholders – rules designed to keep shareholders from bailing out profits easily… the test at the corporate level gets us past the idea that a solely owned corporation can never has a successful redemption… this is how you get around our
Block: 164-66
- §302(b)(4) partial liquidation provision views the redemption from the Corporation’s perspective, looking to the extent of corporate contraction
- a pro rata redemption distribution MIGHT qualify for sale or exchange treatment under §302(b)(4)
- §302(b)(4) permits sale or exchange treatment to ONLY noncorporate shareholders if the distribution is “in partial liquidation of the distributing corporation”
- Do not have to liquidate the entire corporation, but must cease conduct of a qualified trade or business, AND immediately after distribution, the corporation is actively engaged in the conduct of a qualified trade or business
- “Partial Liquidating” definition is vague
- Two requirements—
- 1) the distribution MUST NOT be “essentially equivalent to a dividend” (determined at the corporate level rather than at the shareholder level). §302(e)(1)(A); AND
- distribution NOT essentially equivalent to a dividend from the corporate perspective à when the distribution reflected a “genuine contraction of the corporate business” §1.346-1(a)(2).
- “corporate contraction doctrine” highly fact specific and the outcome of any particular case was difficult to predict
- Meant to bolster the idea that there has to be a real change in the scope and nature of the business
- CONGRESS SOLUTION TO UNCERTAINTY à a safe harbor w/in a safe harbor in §302(e)(2).
- §302(e)(2) – taxpayers meeting these requirements will be assured that the distribution is a partial liquidation for purposes of §302(b)(4).
- TWO REQUIREMENTS:
- 1) distribution must be “attributable to the distributing corporation’s ceasing to conduct, or consists of the assets of, a qualified trade or business.” §302(e)(2)(A); AND
- 2) the distributing corporation must be “actively engaged in the conduct of a qualified trade or business immediately AFTER the distribution.” §302(e)(2)(B).
- “Qualified Trade or Business” – any trade or business which— (A) was actively conducted throughout the 5 year period ending on the date of redemption, AND (B) was NOT acquired by the corporation within such period in a transaction in which gain or loss was recognized in whole or in part.” §302(e)(3).
- Planning Opportunity OR Problem?
- This is a “patience” rewarded tax provision
- Inconvenient for tax planning b/c this
- Concern here is – are we just bailing out earnings for the benefit of the shareholders of a closely held corporation primarily as a way of getting value in a negotiable form ( like cash) in the hands of the shareholders of a closely held corporation?
- The safe harbor here envisions a corporation that was engaged in two or more businesses and is distributing the assets of, or ceasing to conduct, one of its businesses.
- 2) the distribution MUST be “pursuant to a plan and occur within the taxable year in which the plan is adopted or within the succeeding taxable year.” §302(e)(1)(B).
Operating Rules
§ 302(b)(5)
- Tells us something we already know from the structure of 302 itself – it makes clear that in fact you can satisfy 302(b)(1) even if you fail all the others – the last clear chance
- Introduces really important operating rule w/ respect to (b)(3) – compelte termination of interest – if qualifies under (b)(3) and also under another provision, then normally there is a ban on reacquisition (can’t terminate then turn around and reacquire – 10 year rule), but in this case the 10 year ban won’t apply
Constructive Stock Ownership: Implications for Redemptions
§ 302(c)
§ 318
Block: 166-77; Q.1 at 198 and A.1 at 200
We will not spend a great deal of class time on this section
REVIEW the E&P stuff!!! Reduction limited to 20% of E&P on page 201 – refresh on that
Consequences to Redeeming/Distributing Corporation
§ 311
§ 162(k)
Block: 197-98
- From the corporation’s perspective, the distribution of cash or property to the shareholder in a redemption distribution is a “distribution with respect to stock” for purposes of §311. Thus, the corporate tax consequences are governed by the nonliquidating distribution rules.
- Corporation using appreciated property in redemption distribution à gain will be recognized §311(b).
- Corporation distributing loss property in redemption distribution à loss WILL NOT be recognized §311(a).
- Earnings & Profit Adjustments—
- Redemptions treated as dividend distributions à treated exactly the same as any other dividend distribution would be §311(a).
- Redemptions treated as SALES à
- Treated differently
- Solution: §312(n)(7)—limits the E&P reduction to an amount “not in ECESS of the ratable share of E&P … attributable to the stock so redeemed.” This provision imposes a ceiling/cap on the e&p reduction to the redeemed shareholder.
- EX: X corp completely redeems A’s stock, a 50% shareholder. The redemption distribution could NOT generate an e&p reduction greater than the 50% of e&p attributable to the shares redeemed.
- §162(k)—denies deductions for amounts paid or incurred in connection w/ the corporation’s redemption of its own stock. §162(k)(1).
Redemption by Related Corporation
§ 304
Block: 189-97; Q. 7 at 199-200 and A.7 at 205-06
- Really confusing shit –
- WHOLE POINT OF 304 – to constrain the bailout of cash by closely held corporations
- Block doesn’t think 304 will be used because of §1(h)(11) rate equivalence – she doesn’t think the IRS will bring these cases…
- Only purpose in code for §304 is to provide for a recharacterization that looks like a sale so that it becomes a redemption testable under §302(b)
- Was a powerful deterrent which dividends had a higher rate
- §304 substitutes §318’s 50% interest requirement for 5% interest, then applies the §318 rules
- Measuring Control under §304(c)
- Determining whether §304(a)(1) or (a)(2) applies to a particular sale or exchange of stock will first requires an assessment of two situations:
- 1) whether one or more persons is in CONTROL of each of two corporations (§304(a)(1)); or
- 2) whether one corporation CONTROLS another (§304(a)(2)).
- Constructive ownership rules of §318 apply, with some variations – these variations tend to broaden the application of constructive ownership rules and INCREASE the likelihood a particular transaction will be governed by §304.
- Variation #1—if a person or persons control one corporation, who in turn controls another corporation, the shareholders of the first corporation will ALSO be in control of the 2nd corporation.
- Variation #2—the attribution rules of §318(a)(2)(C) and §318(a)(3)(C) shall be applied by substituting 5% for 50%.
- Ownership “deemed” to person-shareholder—§318(a)(2)(C)—a person who owns, directly or indirectly, more than 50% of stock of a corporation shall be considered as owning stock owned by the corporation IN THAT PROPORTION which the value of the stock owned bears to the value of all the stock in the corporation
- EX: A owns 50% of Corp. X à A is “deemed” to own 50% of the stock that Corp X owns.
- §304 twist—a shareholder who has more than 5% of the stock of a corporation will be deemed to own the stock owned by the corporation in proportion to the value of the stock owned by the shareholder
- EX: if A owns 5% of Corp. X, A will be deemed to own 5% of the stock Corp X owns. So if X owned 100 shares of Y and Z, A will be deemed to own 5 shares (5%) of Y and Z.
- *** NOTE: OWNERSHIP IS PROPORTIONATE ***
- Ownership “deemed” to corporation—§318(a)(3)(C)—if a shareholder owns, directly or indirectly, more than 50% of the value of stock in a corporation, that corporation will be deemed to own the stock owned, directly or indirectly by the shareholder.
- EX: if A owns 50% of Corp X and also owns 10% of Corp Y, Corp X is deemed to own ALL of A’s Corp Y stock.
- **** §318(a)(3)(C) OWNERSHIP IS NOT PROPORTIONATE ****
- Once the shareholder has met the required 50% control, ALL stock owned by the shareholder is attributed to the controlled corporation.
- §304 twist—reduces the 50% threshold to 5%, AND also provides that in any case where §318 would NOT apply but for this variation, the attribution rules shall be applied PROPORTIONATELY. §304(c)(3)(B)(ii)(II)
- EX: A owns 5% of Corp X and owns 10% of Corp Y, Corp X is deemed to own 5% of A’s Corp Y stock.
- §304(a)(1)—Commonly Controlled or Brother-Sister Corporations—
- Property transferred by the acquiring corporation to the shareholder shall be treated as a distribution in redemption of the acquiring corporation’s stock
- Desired tax treatment §1001 – Sale – shareholder will get cash
- Next step – test the deemed redemption to determine whether it will get sale or exchange as opposed to dividend treatment under §302(b) tests—
- TESTING the redemption under §302(b) à §304(b)(1) looks to the stock of the ISSUING corporation.
- If the deemed distribution fails the §302(b) tests and is treated as a §301 distribution à the stock transferred by the shareholder and receiving by the acquiring corporation should be treated as transferred in a §351(a) transaction FOLLOWED BY a redemption by the acquiring corporation of the shares it was treated as issuing in the hypothetical §351 exchange.
- If the deemed redemption is treated as a §301 distribution, the shareholder is viewed as making a §351 contribution to the acquiring corporation. Thus, the shareholder should increase her basis in shares of the acquiring corporation by her basis in the shares he transferred in the issuing corporation.
- If the shareholder owns no remaining shares in the acquiring corporation directly, she may INCREASE her basis in remaining shares of the issuing corporation.
- To the extent that the deemed redemption distribution is treated as a §301 distribution to the “selling” shareholder, §304(a)(1) treats the acquired shares as a §351 transaction. RESULT: the purchasing corporation (the acquiring corporation) will take the shareholder’s basis—a substituted basis—in the acquired stock. §362(a)(2).
- §304(a)(2) – Parent-Subsidiary Corporations
- PURPOSE: 304(a)(2) provides redemption treatment “if in return for property, one corporation acquires from a shareholder of another corporation stock in such other corporation, and the issuing [parent] corporation controls the acquiring corporation”
- Cash received by the shareholder in this situation shall be treated as a distribution in redemption of the stock of the issuing [parent] corporation.
- TECHNICAL DIFFERENCES COMPARED TO §304(a)(1)—
- EX: X corp owns Y corp. Shareholders A and B each own 50% of X and Y. Y is a wholly owned by X. A sells 10 X shares to Y for cash.
- Issuing corporation (X) owns and controls the acquiring corporation (Y). Y acquired stock in the issuing/parent corporation from A.
- If the deemed redemption meets one of the §302(b) sale or exchange tests, the shareholder simply will report the amount received from Y Corp as an amount realized, offset by her basis in the X corp shares transferred.
- If deemed redemption DOES NOT meet §302(b) tests à transaction governed by 301 distribution rules – unlike the brother/sister situation, the transaction in the parent/sub context is NOT envisioned as a contribution to capital.
- SH A will not increase his basis in Y by the basis in X shares transferred – the regs provide the basis in the remaining parent corporation (X) stock is determined by including the basis in the shares sold to the subsidiary
- à A will have the same basis in the 40 shares retained that she previously had in the full 50 shares of X.
- Acquiring Subsidiary’s Basis in Parent Corp Stock à §1012 cost basis
Bootstrap Acquisitions
Block: 181-89
- Inter-Shareholder Transfers—
- Redemptions are sometimes used as part of a plan to transfer control of a corporation
- EX: Shareholders A,B, and C are unrelated. A wants to retire from corporation. If B and C simply “bought out” A’s interest using their own funds, A would report gain or loss upon the sale. In the alternative, the corp might redeem A’s stock using corporate funds. This redemption would eliminate A’s 1/3 interest and simultaneously increase B and C’s interests from 1/3 to ½ each. Since B and C are unrelated, no shares will be attributed under §318, and A will treat redemption as sale/exchange complete termination of interest under §302(b)93).
- B and C will likely prefer the redemption approach since it allows them to acquire A’s interest w/o using their funds
- GENERAL RULE: increase in remaining shareholders’ relative interests resulting from redemption of another shareholder is not taxable
- EX: A, B and C each own 33% of X corp worth $1m. X corp redeems A’s interests for $1m. B and C each hold a 50% interest with overall net worth of $2m; each owning $1m.
- EXCEPTION—Primary and Unconditional Exception: the continuing shareholder’s interest increase resulting from redemption of another shareholder is NOT taxable – when the continuing shareholder is subject to an “unconditional obligation to purchase the retiring shareholder’s stock, the satisfaction by the corporation of his obligation results in a constructive distribution to him.
- EX: B and C had a binding “buy-sell” agreement obligating them to purchase A’s shares upon request. If, instead, the corporation redeems A’s stock, the corporation has relieved B and C’s obligation. Since the redemption distribution satisfied B and C’s “primary and unconditional obligation,” they will be required to report their increase in proportionate interest as a constructive dividend.
- B and C could also have a “deemed” stock dividend taxable under §305(c) – risk of this happening is low as long as their increase in proportionate interest results from an “isolated redemption,” as opposed to a series of periodic redemptions.
- Redemptions Incident to Divorce—
- Common scenario—corporation owned entirely by H and W. Upon divorce, the parties might have the corporation completely redeem the shares of one spouse, leaving the other spouse as the sole owner.
- General Redemption – redeemed spouse would report sale/exchange gain under §302(b)(3) [complete termination of interests]. Nonredeemed spouse would not have any taxable income from the resulting increased interest in the corporation unless the redemption distribution satisfies the “primary and unconditional obligation” to purchase the redeemed spouse’s shares
- Divorce Twist—§1041 nonrecognition rule for property transfers “incident” to divorce.
- Nonrecognition provided in §1041 applies more broadly to transfers of property between spouses generally and to transfers between former spouses that are incident to divorce. S
- Problem Created—unless one of the spouses is subject to tax at the time of the redemption, gain or loss with respect to the redeemed shares will never be recognized for tax purposes, resulting in a “whipsaw” to the government. This is inconsistent w/ §302 which requires SH level recognition of taxable income when funds or property are withdrawn from the corporation in a redemption distribution
- SOLUTION—“Whipsaw” Regulations—specifically address stock redemptions incident to divorce. Treas. Reg. §1.1041-2. – the regulations ensure that one, and only one, of the spouses is taxed on the redemption distribution; the other gets the benefit of the §1041 recognition.
- Stock redemptions in the divorce setting will not be governed by the “transfers on behalf of a spouse” language from the temporary regulations. Instead, the new regs distinguish between two different types of stock redemptions:
- 1) a redemption that IS treated under applicable tax law as a CONSTRUCTIVE DIVIDEND to the NONREDEEMED spouse whose proportionate interest in the corporation is INCREASED as a by-product of the redemption of shares from the other spouse; and
- 2) a redemption that IS NOT treated as a constructive dividend to the nonredeemed spouse.
- CONSTRUCTIVE DIVIDEND à The redemption of stock from one shareholder is treated as a constructive divdend to another ONLY IF the redemption satisfies a “primary and unconditional obligation” of the NONREDEEMED shareholder to buy the redeemed shares.
- The redemption distribution to the redeemed shareholder in exchange for stock will be taxed either as a dividend OR a sale/exchange under §302 and will not be eligible for tax free treatment under §1041.
- If redemption RELIEVES the nonredeemed spouse of primary and unconditional obligation to purchase the redeemed shares à the transaction is DEEMED to be a §302 redemption to the nonredeemed spouse.
- Proceeds actually paid to the redeemed spouse are then DEEMED to have been received from the other spouse tax-free pursuant to §1041
- Other Bootstrap Acquisitions (p.186-189)
- Bootstrap Acquisitions – instead of using their own funds, the remaining shareholders use corporate assets to fund the acquisition. Even outside purchasers can structure a corporate acquisition so that all or a part of the funds for the acquisition come from the target corporation’s assets.
- Landmark Case – Zenze v. Quinlivan
- Buyer B wanted to purchase target corporation X (which was owned by a since shareholder A). Instead of purchasing all shares, according to a plan, B bought a small amount from A. Shortly thereafter, X redeemed all A’s remaining shares. A didn’t care how the transaction was to happen – assuming A’s interest was completely terminated, he could get sale/exchange treatment under §302(b)(3).
- If redemption BEFORE acquisition à would have been a partial redemption from a sole shareholder, and arguably taxable as a dividend to the shareholder
- THESE KINDS OF TRANSACTIONS MUST BE PART OF AN OVERALL INTEGRATED!
- IRS says Zenz even applies to §302(b)(2) test, not solely the complete termination of interest test of §302(b)(3)
- As long as the issuance of new shares and redemption are “clearly part of an overall plan to reduce the shareholder’s interest, effect will be given ONLY to the overall result for purposes of §302(b)(2) and the sequences in which the events occur will be disregarded.
- B’s Viewpoint—transaction structured this way for 2 reasons:
- 1) B was concerned w/ X’s high balances in E&P accounts, which would later prove to be a source of taxable dividends should he receive distributions from the corporation.
- By buying a small amount of stock and having X redeem the rest of A’s shares using its E&P, the E&P account was reduced pursuant to §312
- 2) B didn’t have to use his funds to purchase all A’s stock, B got 100% control and used X’s funds to buyout A (a bootstrap acquisition)
- Court held A met literal requirements of §302(b)(3) and he intended a complete liquidation of his holdings in X.
- Planning for Bootstrap Redemptions
- Individual Taxpayers—
- A bootstrap acquisition may include a redemption as a part of the plan when the selling shareholder is an individual taxpayer.
- Goal of Individual Taxpayer: get §302(b) sale/exchange gain treatment for the amount received for the stock, while simultaneously lowering the purchase price to the buyer.
- Corporate Taxpayers—
- A bootstrap acquisition generally will not include a redemption where the selling shareholder is a corporate taxpayer
- Goal of Corporate Taxpayer: classify any pre-sale distribution as a dividend in order to take advantage of the §243 dividends-received deduction or the consolidated return provisions
Bailouts of Corporate Earnings
Willens, Bailing Out Earnings at Capital Gains Rates, 116 Tax Notes 65 (July 2, 2007)(2007 TNT 128-23)
Other Willens Article
- Can create anything in your private documents – one place where lawyers lose license is where they try to pass off subsequently created documents as contemporaneously created documents
- “The coverup gets you impeached, the original problem is nothing”
- Need a piece of paper – an “integrated plan” – that sets out the steps… this will show that you gave the tax advice based on your judgment that the characterization of the transaction is consistent with tax principles, reasonable, was the basis of your advice, and was is consistent with your testimony.
Using Redemptions to Generate Losses
Treas. Reg. § 1.302-2(c), Ex. 2
- Husband and Wife (H and W) each owned one-half of X. H had originally purchased all the stock for $100k and later gave half to W. A of H’s stock is later redeemed in a transaction determined to be a dividend as opposed to sale redemption. Immediately after the transaction, W holds the remaining stock of X with a basis of $100k.
Block: 178-79
- “Mystery of Disappearing” Basis—search for mechanism to preserve the shareholder’s basis in the redeemed shares after a dividend redemption.
- Two Variations:
- 1) §302(b)(1), §302(b)(2), or §302(b)(4)—a SH may retain stock after a redemption treated as a dividend under these code sections. Mystery is resolved by adding the basis from the redeemed shares to the basis in the shares retained after the redemption.
- 2) §302(b)(3) complete termination of interest— p.178
Question for MONDAY – what is the recharacterized transaction in detail (of the brother/sister corporation) and how does 318 come into it?
October 21st, 2009
- Taxation of U.S. Passive Income of Foreign Persons
- Withholding Taxes
- i. Reason for Withholding Tax—if a foreign taxpayer is not engaged in a USTB but receives investment income from US sources, any fixed or determinable annual or periodical income is subject to a 30% tax rate (or lower treaty rate). §§ 871(a) or 881. HOWEVER, b/c the foreign taxpayer may not have business assets in the US, it might not be possible to enforce the 30 percent tax against a foreign taxpayer that DOES NOT voluntarily pay. ß This is why withholding taxes are created… the Code contains a variety of withholding provisions which apply to the investment income of foreign taxpayers.
- ii. Liability for NOT paying withholding tax—a withholding agent who fails to withhold will be PERSONALLY liable for the requisite tax, penalties, and interest.
- iii. GENERAL RULE: Withholding is required if the following 6 criteria are met:
- The recipient is a foreign person;
- The amount paid is US source income
- The amount paid is fixed or determinable annual or periodical income (FDAP—generally passive investment income from interests, dividends, royalties, and some rents);
- The amount paid is not income effectively connected to a USTB;
- The payor or some agent of the payor is a withholding agent; and
- NONE OF THE EXCEPTIONS APPLY!
- FIRPTA – Foreign Investment in Real Property Tax Act §897
- i. Background
- ii. Effect of §897—designed to counteract the use of various techniques that had been developed to avoid income tax on the disposition of U.S. real property.
- RULE: §897 provides that gain or loss realized by nonresident aliens or foreign corporations on the disposition of U.S. real property interests will be treated generally as if such gain or losses were effectively connected with a U.S trade or business.
- NOTE: §897 also applies to gains on the sale of stock in U.S. corporations that hold 50% or more of specified assets in the form of U.S. real property. The gain from the sale of stock in a foreign corporation will not be taxed, the foreign corporation is taxed if and when it sells U.S. real property interests or distributes such interests to its shareholders.
- iii. Tax on Gain from Disposition of “U.S. Real Property Interests”
- §897 imposes a tax on gain realized upon the disposition of “U.S. real property interests.”
- U.S. Real Property Interests à an interest in real property (including an interest in a mine, well, or other natural deposit) located in the U.S. §897(c)(1)(A)(i). It also includes certain leasehold interests, options to acquire real property and ‘associated personal property,” such as movable walls. §897(c)(6)(A) and (B).
- i. DOES NOT INCLUDE: an interest solely as a creditor in real property. Reg. §1.897-1(d)(1).
- ii. However, a loan in which the lender has a DIRECT or INDIRECT right to share in the increase in value or the proceeds of the disposition of property WILL NOT be regarded as an interest solely as a creditor. Reg. §1.897-1(d)(2).
- Nonresident aliens and foreign corporations are subject to tax on such gains under §871(b) [Income Connected w/ U.S. Business—Graduated Rate of Tax] and §882 [Tax on Income of Foreign Corporations Connected w/ U.S. Business], respectively, as though the gain or loss were effectively connected with a U.S. trade or business. §897(a)(1).
- CAVEAT: If AMT Tax > regular tax à, a nonresident alien may be taxed under AMT rates of §55 if that would produce tax higher than the regular tax. §897(a)(2).
- iv. Tax on Sale of Stock in U.S. Corporation
- U.S. Real Property interest is ALSO defined to include any interest (other than an interest solely as a creditor) in a US Corp unless the foreign person hold such interest establishes that the US Corp was at no time during the five years ending on the date of the disposition a US Real Property Holding Corporation (“USRPHC”).
- U.S. Real Property Interests DO NOT include any class of stock of a corporation that is REGULARLY TRADED on an established securities market
- i. 5% Test EXCEPTION (makes it a U.S. real property interest) : if a taxpayer owns, directly or indirectly, more than 5% of such stock, the stock of the corporation may be a U.S. real property interest.
- USRPHC Defined—includes any corporation (whether domestic OR foreign) where the FMV of its US real property interests EQUALS or EXCEEDS 50% of the sum of its FMV of (1) its U.S. real property interests; (2) its interests in real property located OUTSIDE the U.S.; and (3) any other assets that are used or held for use in a trade or business. §897(c)(2).
- Note: the test depends on comparative asset values – a corporation COULD become a USRPHC even though it did not modify its asset holdings, simply as a result of fluctuating property values.
- Rules to prevent a USRPHC from avoiding tax
- §897(c)(4)—Prevents USHPHC from avoiding tax by having the corporation hold U.S. real property interests through a foreign corporation, partnership, trust/estate, or any corporation (or chain of corporations) that it controls.
- §897(b)(2)(B) & Reg § 1.897-2(e)(2)— look-through rules apply so that a corporation will be treated as owning a proportionate share of assets held by the partnership, trust, or estate.
- Corporations with “Controlling Interests”—(50% or more of FMV of all classes of stock of another corporation) the controlling corporation is treated as holding a portion of each of the assets of the controlled corporation equal to the percentage of FMV of the controlled corporation’s stock held by the controlling corporation. §897(c)(5)(A).
- i. EFFECT of this Section—Thus, a corporation that owns no US real property may be a USRPHC because of the real property owned by its affiliates.
- Gains Realized from Disposition of interest in a USRPHC—taxed at same rate and under the same rules as the disposition of direct holdings in U.S. real property—
- The entire amount of gain realized from the sale of stock in a domestic USRPHC is subject to tax, regardless of the portion attributable to the US real property interests that it holds.
- i. EXCEPTION: §897 will not apply to the sale or other disposition of the stock if the corporation holds NO US real property interest at the time of disposition AND if all U.S. real property interests held by the corporation during the 5 years prior to the disposition (which made the corporation itself a USRPHC) have been transferred by the corporation in transactions in which the full amount of gain was recognized. §897(c)(1)(B).
- v. Anti-Avoidance Measures
- Dispositions of Interests in Foreign Corporations and Distributions by Foreign Corporations
- Election by Foreign Corporation to be Treated as U.S. Corporation
- Nonrecognition Provisions
- Rev Rule 84-160
- vi. Enforcement Mechanisms
- Adoption of Withholding to Replace Reporting
- Exceptions to Withholding Requirements
- Corporate Distributions
- Partnerships, Trusts, & Estates
- Information-Reporting Requirement
- vii. Problems #12, #13, #16 – pages 267-268 .
- #12)
- Leonardo and Verdi should make the §871(d) election to treat the rental income from the Iowa farm as Effectively Connected with the Conduct of a U.S. Trade or Business. This results in L and V being taxable on progressive rates of Net Income.
- If they do NOT make the election, the operation of the farm land would not be treated as income effectively connected with the conduct of a U.S. Trade or Business, resulting in 30% withholding tax on the 100k rental income plus the taxes paid by the tenant. They would not be allowed to take deductions for expenses.
- Class Notes:
- i. If not engaged in T/B subject to whatever is in the Italian Treaty for Real Estate Rents—
- ii. Model Treaty – rate of tax for real estate rents à NO REDUCED RATE OF TAX
- If not engaged in trade or business t
- If in T/B net income would only be 100k at graduated rates which would be tax of about 30k… would save tax by being in a trade or business… congress thought about this in enacting 871(d) to let people in the real estate business get deductions – a little unfair to tax gross real estate rent – mechanism to solve this is to elect people to treat themselves as a trade or business and get their deductions under §871(d).
- #13)
- Yes, Leonardo and Verdi will be taxed on the gain realized from the sale. This is the whole idea of FIRPTA—§897 will treat the disposition of U.S. real property interests by foreign corporations or nonresident alien individuals as if it were effectively connected with a U.S. trade or business.
- No – there’s no way they could avoid tax on this transaction. FIRPTA has built in withholding mechanisms to make sure that tax is to be paid on transactions like this. §1445 requires that when a foreign person disposes of a U.S. real property interest, the “transferee” must withhold 10% of the amount realized by the transferor on the disposition and pay it to the U.S. Treasury.
- i. A “transferee” includes “any person, foreign or domestic, that acquires U.S. real property interests by purchase, exchange, gift, or any other transfer.” Reg. § 1.1445-1(g)(4).
- Class Notes:
- i. Yes – taxed on sale of real property. U.S. sourced tax.
- ii. Could have they avoided? Since they are in the trade/business they get the benefit of graduated rates, so no flat tax.
- No way to avoid – sale of a real property interest is the sale of real property interest… if you sale stock/personal property in the US, unless its effectively connected we don’t tax it… but if real property is sold in the United States we tax it.
- #16)
- First, there are 2 questions here: 1st) Is Paradise, a Bahamas Corporation, a U.S. Real Property Holding Corporation?; 2nd) Is Bluewater, a U.S. Corporation that owns no U.S. real property assets a U.S. Real Property Holding Corporation for purposes of §897(c)(2) after purchasing Paradise?
- i. 1) Paradise’s ALL assets are $40m of U.S. real property with an adjusted basis of $5m. Bluewater purchased all of Paradise’s assets for $40m ( so that’s the FMV). By definition, Paradise was a U.S. real property holding corporation even though it was a foreign corporation under §897(c)(2).
- ii. 2) Bluewater becomes a U.S. real property holding corporation by purchases Paradise. Bluewater would become a U.S. RPHC if the TMV of USRP equals or exceeds 50% of the sum of (1) USRP interests; (2) real property interests outside the U.S.; and (3) any other assets attributable to the U.S. trade or business. §897(c)(2). Here, Bluewater had $30m (FMV) of assets before buying Paradise. Now they have $70m of assets (30m outside the U.S./40m inside the U.S.). $40m US assets exceeds 50% of FMV of all assets, so therefore Bluewater is a U.S. Real Property Holding Corp.
- Gain from Sale of Stock by Casino (nonresident alien individual)
- i. Gains realized from the disposition of an interest in a U.S. corporation that constitutes a USRPHC is generally taxed at the same rate and under the same rules as the disposition of direct holdings in U.S. real property. The entire amount realized form the sale of stock in a domestic USRPHC, regardless of the portion attributable to the U.S. real property interests that is holds.
- ii. So YES à gain of 1m by Casino is subject to tax.
- iii. Less than 5% rule NOT applicable §897(c)(3). Constructive ownership rules are prescribed in §897(c)(6)(C) in applying the 5% test. If a taxpayer owns, directly or indirectly, more than 5% of such stock, the stock of the corporation may be a U.S. real property interest.
October 6th, 2009
I. §911—Tax Exemption for Certain U.S. Taxpayers Living and Working Abroad
a. CHANGES TO §911 in 2005—changes in dollar amounts for housing amount exclusion
i. Class Notes:
1. Deals w/ two problems under 1 code section:
a. 1) baby tax problem – away from home deductions (162(a)(2)—if your trip lasts longer than a year, you’re not away from home temporarily – this created undue burdens w/ US employees going off shore and getting US corps to get employees to go offshore — §911 provides an expanded deduction for away from home expenses)… more
b. 2) 911 is elective – provides an exclusion for income for up to a limit for employees.. if US emp goes to another corp and provides an effective tax rate lower than the US – 911 provides tax relief for employees of both US companies and Foreign Companies… this a political compromise –
2. Bone Fide Resident
a. §1.871-2(b)
3. Assume on exam exclusion will be $80k
4. Housing Cost Amount – §911(c)(3)
a. Can only deduct expenses to the extent you use more than 16% and less than 30%
b. Limitation—§911(c)(2)
b. The Exclusion—
i. Created as a direct response to problem of international double taxation
ii. Alternative to the foreign tax credit, however, certain U.S. citizens and resident aliens who live and work abroad may elect under 911 to exclude a portion of their foreign earnings from U.S. tax.
iii. Must QUALIFY to use §911 exclusion
iv. Exclusion is available to a qualifying U.S. individual regardless of whether any foreign tax is imposed on the individual’s foreign earnings
c. Amount of the Exclusion—Foreign Earned Income within a Specified Exclusion Amount
i. §911 provides an exclusion from gross income of “foreign earned income” NOT in the EXCESS of the “exclusion amount” for the year. §911(b)(2)(A).
1. “Foreign Earned Income”—includes wages, salaries, or professional fees resulting from the performance of services. Since the earned income must be foreign, the services must be rendered OUTSIDE of the UNITED STATES. §911(d)(2)(A).
2. “Exclusion amount” – the exclusion amount for any calendar year after 2007 is $80k adjusted for inflation. §911(b)(2)(D)(ii)
ii. NOTE: compensation income derived from working w/in the US and investment income from any source does NOT qualify for benefits of §911.
iii. Profits from BOTH personal services and capital—PROBLEM: when profits are derived from the conduct of a trade or business where BOTH personal services AND capital are material income producing factors
1. RULE: If profits derive from both personal svcs and capital à NO MORE than 30% of the taxpayer’s share of the NET PROFITS from the business may be considered to be foreign earned income with respect to the §911 exclusion. §911(d)(2)(B).
2. Rousku v. Commissioner
a. Capital = Material Income-Producing Factor
i. Capital is a material income-producing factor if a substantial portion of the gross income of the business is attributable to the employment of capital in the business conducted by the enterprise.
ii. Capital is ordinarily a material income-producing factor if the operation of the business requires substantial inventories or substantial investments in plant, machinery, or other equipment.
b. Capital NOT material income-producing factor
i. Where the gross income of the enterprise consists principally of fees, commissions, or other compensation for personal services.
ii. If capital is utilized merely to pay the cost of salaries, wages, office space, and general business expenses, it is not a material income-producing factor but is only incidental to the production of income.
iv. Where a taxpayer eligible for the benefits of §911 works both within and outside the US, the income must be allocated b/t the US and foreign sources.
v. Amounts paid by the US or a US agency to an employee of the US or US agency DO NOT qualify for §911 exclusion. §911(b)(1)(B)(ii)
vi. PRORATION of Exclusion Limità amount excluded is prorated on a daily basis for a year in which the taxpayer meets the qualification requirements in §911(d)(1) for only part of the year.
1. EX: if TP meets qualification requirements in §911(d)(1) for the period from Jan, 1 2003 through Jan 31, 2006, the TP has a full $80k limit for each of years 2003, 2004, and 2005, but a limit of only $6,792 (31/365 multiplied by $80k) for 2006.
d. Amount of Exclusion—Housing Costs:
i. Exclusion of “Housing Cost Amount”—housing expenses to the extent they exceed 16% of the salary of the US government employee at the GS-14 (step 1) level (the “base housing subtraction”). §911(c)(1).
1. EX for year 2004: ***BOOK IS OLD AND DOESN’T INCLUDE THE HOUSING CAP OF 30%, REMEMBER THIS – SEE THE PROBLEMS FOR EXAMPLES***
a. GS-14 (step 1) level was $72, 381; 16% of that is $11,581. Anything over 16% is the exclusion.
b. If employer pays 15k for employee’s housing, the employee would be entitled to exclude $3,419 of the housing payment from his gross income ($15k – $11,581)
c. The $11,581 base housing subtraction applies ONLY when the maximum foreign earned income exclusion is exceeded and it becomes necessary to rely on the housing cost exclusion.
d. The total amount of the two exclusions combined CANNOT EXCEED the total of the individual’s foreign earned income for the year. §911(d)(7).
2. In some cases, the employee will be able to exclude the entire $15k
a. EX: the payment of $15k housing expenses by the employer will itself be “foreign earned income” to the employee. §911(c)(3)(D)
i. As long as the total of the employee’s salary and housing expense allowance DOES NOT exceed the $80k maximum foreign earned income exclusion for the applicable year (in this case 2004), BOTH can be TOTALLY EXCLUDED FROM GROSS INCOME.
ii. Foreign Income from Self Employment—the housing cost amount is allowed as a deduction
1. Deduction is calculated in the same manner as the exclusion in the case of an employee (Reg §1.911-4(e)), but CANNOT EXCEED a limit equal to the excess of the individual’s earned income over the amount of the §911(a)(1) foreign earned income exclusion. §911(c)(3)(B).
2. ONE-YEAR CARRYOVER—An amount not allowed as a deduction by reason of the limit (listed above in 1) can be CARRIED OVER to the succeeding taxable year—a one-year carryover. §911(c)(3)(C). If in the succeeding year it fits within the limit, it may then be allowed as a deduction. There is no comparable provision in §911 w/ regard to an exclusion of income.
e. Who is Eligible for the Exclusion—need to qualify under one of the following tests and must have a “TAX HOME” in a foreign country under §911(d)(1).
i. Two alternative ways to qualify for §911 exclusion:
1. “Bona Fide Resident” of a Foreign Country. §911(d)(1)(A)
a. §911 exclusion applies to bona fide residents[s] of a foreign country or countries for an uninterrupted period which includes an entire taxable year–§911(d)(1)(A)
b. TEST FOR “BONA FIDE RESIDENT”—facts and circumstances test (intent test)
i. BE CAREFUL: the “objective” tests in §7701(b) used under current law to determine whether an alien is a US resident does not apply for this purpose
ii. Residence Defined–§1.871-2(b)
iii. FACTORS: (from Sochurek v. Commissioner, 300 F.2d 34)
1. Intention of the taxpayer;
2. Establishment of his home temporarily in the foreign country for an indefinite period;
3. Participation in the activities of his chosen community on social and cultural levels, identification with the daily lives of the people and, in general assimilation into the foreign environment
4. Physical presence in the foreign country consistent with his employment;
5. Nature and duration of his employment; whether his assignment abroad could be promptly accomplished within a definite or specified time;
6. Assumption of economic burdens and payment of taxes to the foreign country;
7. Status of resident contrasted to that of transient or sojourner;
8. Treatment accorded his income tax status by his employer;
9. Marital status and resident of his family;
10. Nature and duration of his employment; whether his assignment abroad could be promptly accomplished within a definite or specified time;
11. Good faith in making his trip abroad; whether for purpose of tax evasion
c. NOT ELIGBLE FOR EXCLUSION IF:
i. The taxpayer submits to a taxing authority of a foreign country a statement that he or she is NOT a resident and is as a result exempt from that country’s tax WILL NOT qualify
1. Reasoning behind this—preventing a taxpayer from taking inconsistent positions concerning his or her foreign residence with the US and foreign taxing authorities.
2. Physical Presence Test—U.S. citizens and resident aliens who are present in a foreign country or countries during at least 330 full days in any period of 12 consecutive months. §911(d)(1)(B).
a. No day where any part is spent in the US (for any reason) does not count towards to the 330 days
b. A day spent in a foreign country or no country (at sea) counts towards the 330 target
3. SPECIAL RULES FOR RESIDENT ALIENS—
a. Under §911(d)(1), resident aliens may only qualify by meeting the physical presence test
i. COMPARE: Rev. Rule 91-58—under nondiscrimination article of US income tax treaties (applied w/o regard to the saving clause), resident aliens who are nationals of foreign countries with which the US has entered into an income tax treaty MAY QUALIFY for §911 by either meeting the physical presence test or the bona fide residence test
ii. “TAX HOME”—
1. Tax Home-the place from which traveling expenses are deductible under §162(a)(2), provided that the taxpayer’s abode is NOT in the US. §911(d)(3).
a. GENERAL RULE: a taxpayer’s tax home is at his principal place of business or employment, or if the individual has no regular or principal place or business, then at his regular place of abode in a real and substantial sense. Treas. Reg. §1.911-2(b)
i. EXCEPTION: if an individual’s ABODE is in the United States, then he is legally incapable of establishing that his tax home is in a foreign country. Lemary v. Commissioner, 837 F.2d 681, 683 (5th Cir. 1988).
ii. NOTE: maintenance of a dwelling in the US by an individual, whether or not that dwelling is used by the individual’s spouse and dependents, does NOT necessarily mean that the individual’s “abode” is in the US. Treas Reg. §1.911-2(b).
2. “Abode”— depends on the contest in which the word is used. It does not mean one’s principal place of business. Thus “abode” has a domestic rather than a vocational meaning, and stands in contrast to “tax home” Lemay v. Commissioner, 53 T.C.M. (CCH) (1987), aff’d, 837 F.2d 681 (5th Cir. 1988)
iii. NOTES:
1. A taxpayer who moves abroad for a specific purpose that involves a short, fixed period of time will probably fail the bone fide resident test. Jones v. Kyle, 190 F.2d 353 (10th Cir.).
2. §911(d)(4)–Waiver of eligibility requirements of §911(d)(1) for certain purposes which the Treasury Secretary determines that individuals had to leave because of war, civil unrest, or other similar conditions.
a. TO QUALIFY: individual must have established residency or been physically present in the foreign country on or before the date that the individual was required to leave the country AND MUST SHOW that but for the adverse conditions, the individual could reasonably have been expected to meet the eligibility requirements.
3. §911(d)(8) Countries w/ Travel Restrictions—individuals who are present in a country where travel restrictions are imposed (CUBA) will not qualify
f. Cost of the Exclusion Elections—
i. §911(d)(6) disallows any exclusion, deduction, or credit that is allocable to income excluded under §911(a).
1. PURPOSE: prevent taxpayers from obtaining a double tax benefit—tax-free income under §911 and an exclusion, deduction, or credit for amounts allocable to such income.
2. Disallows any foreign tax credit for foreign taxes allocable to amounts excluded by §911.
3. Taxpayer must compare the relative advantages of the §911 exclusion and the Foreign Tax Credit – has to pick one… the taxpayer can’t use both.
4. Treas. Reg. §1.911-6 contains rules for allocating the taxpayer’s deductible expenses and foreign taxes to determine how much of the taxpayer’s deductions and credits are disallowed by §911(d)(6).
g. Problems—page 433-44, 1-(a)(b); 4-(a)(b)(f)(g)
i. 1(a)—
1. He would need to make his tax home in London and meet the bona fide residence test or physical presence test in order to qualify for §911 income exclusion.
2. §911(d)(5) precludes residency status if submitting a statement of non-residency to the U.K. Inland Revenue.
3. If no election of §911, all gross income and no §911 exclusion, but full foreign tax credit is available.
4. Decision to take foreign tax credit or §911 election
a. Depends on effective rate of tax
5. Prof’s Answer: make §911 election
ii. 1(b)—my answer wouldn’t change at all—don’t have to work for a U.S. employer… doesn’t matter… can elect to get the 911 exclusion
iii. 1(c)—same – no difference
iv. 4(a)—she will be able to exclude her $65k of salary and $13k of living expenses paid by the employer because it is less than the $80k exclusion… total comp is $78k, which is less than $80k…we don’t have to get to housing exclusion
1. PROF’S ANSWER: What law are we going to apply? Current law, but as it appears in the book. The base amount is 80k exclusion and 16% $12,800…. 30% of 80k is $24k (the cap on good housing expenses)
v. 4(b)—her foreign earned income for the year is $90k (75k + 15k housing expenses)… would be able to take the full 80k exclusion under 911… and take $10,200 (23,000 (15k + 8,000) – 12,800 [subtraction amount] and doesn’t exceed the ceiling (24k – 30% of 80k) – so the 23k doesn’t exceed 24k ceiling – total housing does not exceed ceiling, therefore ceiling does not apply) deduction of housing expenses under §911(c)(1)… so total exclusion would be $90,200… can exclude ONLY UP TO amount of foreign earned income, so $90k.
1. or would it be 23k-11,581 for the housing expense? YES – INCLUDE THE 8K THE GUY PAYS
vi. 4(c)—he didn’t assign it to us… but we’re going over it… it’s the same… which means exclude ALL
vii. 4(f) – foreign earned income is $160k (135k + 25k); housing expense exclusion would be 25k-12,800 = 12,200… EXCEEDS 30% CAP OF 24K, so can only exclude 11,200
1. so 80k exclusion + 11,200 housing exclusion = $91,200 which is less than foreign earned income… so okay
2. 30% of 80k = 24kk; 25k housing deduction is greater than than the 30% cap (24k), so can only take 24k-12,200=11,200 – HOUSING AMOUNT MUST BE BETWEEN CEILING AND FLOOR
3. SAME AS ABOVE – there was no cap when the book was written, even though she paid 70k in housing cost she can only exclude 24k, which exceeds cap by 11,200… under current law the results are the same due to the cap… under old law it was different
September 28th, 2009
Current Non-Liquidating Distributions: Dividends
Framework for Taxing Current Nonliquidating Distributions
§ 61(a)(7)
§ 301(a)-(d)
Block: 6-12; 117-20
- BLOCK 6 – 12
- General Computation & Rates
- Both personal and corporate income tax use graduated rates that generally increase as income rises.
- The 35% stated top marginal rate of taxation for corporations parallels the 35% stop stated marginal tax rate for individuals.
- Corporation first determines its gross income (61(a)-no distinguishing b/t individuals and corporations of gross income) and then subtracts available deductions to determine taxable income.
- Difference in Tax Treatment for Capital Gains & Losses v. Ordinary Income
- Gain and loss from sale the sale of “capital assets” is treated differently than ordinary income and loss.
- Corporations are allowed losses from the sale or exchange of capital assets only to the extent of gain from such sales or exchanges – thus for any given taxable year, capital losses may be used only to offset capital gains.
§ 1211(a)-unused corporate capital losses are subject to carryback and carryforward rules under 1212(a).
§ Compare to Individuals- subject to similar capital loss restrictions, but will be entitled to deduct a maximum of $3k in capital losses even if capital losses exceed capital gains for the taxable year
o Capital Loss/Gain broken down into Short Term and Long Term
§ Long term capital gain/loss-a gain or loss from the sale or exchange of an asset held for more than one year. §1222(3) and (4)
- Preferential capital gain rates are generally applicable ONLY to net long term capital gains
- NET long term capital gains-the excess of long-term capital gains for the taxable year over the long-term capital losses for such year – 1222(7).
- Long term capital losses can be used to offset or reduce ONLY long-term capital gain, but short term capital losses cannot be used to offset long-term capital gains.
- Corporations
- Capital loss restrictions and the rate differential for taxation of ordinary income versus capital gains raise especially significant issues for corporate taxpayers and their shareholders
- Dividends vs. Compensation to a shareholder who is an employee vs. interest payments
§ Preferable to avoid dividend classification since corporations CANNOT deduct dividends. On the other hand, corporations CAN generally deduct business interest expense under §163 and compensation to employees under §162
- The “NEW” Qualified Dividend
- Historically-individual shareholders almost always preferred to receive capital gain rather than ordinary income in order to take advantage of the preferential tax rates in 1(h).
§ Sale of stock treatment offers two tax advantages:
- 1) shareholder benefit from deferring tax until they later sell the shares
- 2) shareholders benefit from the preferential rates applicable to sale of stock, which is generally considered a capital asset
- New Qualified Dividend-where shareholders previously took extraordinary measures to avoid dividends and to bailout profit at capital gains rates, they may now welcome dividend income
§ Stock itself is generally considered a capital asset, dividends are not
o PROBLEM: corporations continue to prefer nondividend payments and shareholders who now prefer dividend classification of corporate distributions
o The addition of the “qualified dividend income” rule did not alter the “capital asset” definition provided in 1221 or change any of the capital asset holding period rules of 1223
o IMPLICATIONS of adding QDI only for purposes of §1 rate provisions rather than include such dividend income in the 1221 asset definition
§ 1) although dividends benefit from capital gains rates, they cannot be used to offset capital losses
§ 2) dividends are NOT subject to the one year holding period otherwise used to compute long-term capital gain — §1(h) includes its own unique, and much shorter holding period
- REQUIRED HOLDING PERIOD OF §1(h): dividend must be paid with respect to stock that meets a complex 60 day holding period under which the shareholder must have held the stock for at least 60 days during the 121 day period beginning 60 days before the stock becomes “ex-dividend”
- Used to address perceived abuses of investors who engage in arbitrage, quick trades, hedging transactions, short sales, and the like.
- Capital Asset Definition
- “Capital Asset” expansively defined in 1221(a) as property held by the taxpayer w/ 8 specific exceptions that are NOT considered capital assets.
§ 4 exceptions relevant to corporate business:
- 1) stock in trade, inventory, or property held by the taxpayer primarily for sale to customers in the ordinary course, of the taxpayer’s trade or business — 1221(a)(1)
- when a corporation sells goods or services to customers in the ordinary course of its business, the profit or loss will be treated as ordinary income or loss.
- 2) “supplies of type regularly used or consumed by the taxpayer in the ordinary course of a trade or business of the taxpayer” 1221(a)(8) -
- reduces arguments as to whether or not a particular asset fits the definition of “stock in trade” or property “primarily for sale to customers” under 1221(a)(1) and clarifies that regular business assets, as opposed to investment assets, generally will NOT be classified as capital assets.
- 3) “accounts or notes receivable acquired in the ordinary course of trade or business for services rendered or from the sale of property described in (1)” – 1221(a)(4)
- (4) depreciable trade or business property or real property used in a trade or business
- a corporate sale of depreciable equipment or real estate used for business purposes should result in ordinary income or loss, HOWEVER, §1231 rules apply which treat sale of depreciable property or real property as capital even though the assets have otherwise been excluded from the definition of capital asset
- BLOCK 117-120
- Nonliquidating Distributions-
- Simple pro rata cash distributions-the amount of each shareholder’s distribution is determined according to his or her proportionate interest in the corporation-result: shareholder’s interest after the distribution are proportionately the same immediately prior to the distribution
§ Don’t get this confused with this distribution as a “dividend” – dividend is a term of art with a precise statutory meaning
o Redemptions-corporation distributes cash or other property to its shareholders in return for its own stock, thus reducing the number of outstanding shares
o Liquidating Distributions-the corporation distributes its net assets after payment of liabilities to its shareholders at or about the time of its termination as a going concern
o Other distributions may be made in connection w/ a formal corporate restructuring such as a reorganization
- Statutory Scheme-§301
- 301(c) breaks nonliquidating corporate distributions into three distinct parts:
§ 1) the portion of the distribution that is a dividend is includible in the shareholder’s gross income under 301(c)(1)
- before 2003, dividends were ordinary income… now 1(h)(11) treats “qualified dividends” as eligible for preferential capital gains rates
- 61(a)(7) lists dividends as items to be included in gross income – does not define “dividend”
- Dividend DEFINED in §316 – any distribution of property made by a corporation to its shareholders out of earnings and profits accumulated after 1913 (accumulated E&P) or out of earnings and profits of the taxable year (current E&P)
§ 2) the portion of the distribution that is NOT a dividend shall be applied against and REDUCE the shareholder’s ADJUSTED BASIS in the stock, but not below zero pursuant to 301(c)(2).
- Provides tax-free recovery of the taxpayer’s investment (basis) in the stock
§ 3) any remaining portion of the distribution shall be treated as GAIN from the SALE or EXCHANGE OF PROPERTY under 301(c)(3)
Defining Dividends and Qualified Dividends
§ 316(a)
We will spend virtually no time at all on the concept of earning and profits-for the general concept see Block at 120-23; see Block 126-30 if you want to read more about earnings and profits, but we will not spend class time on this
§ 1(h)(11)
Block: 124-26
The definitional intricacies are less important than are the consequences of the rate equivalence for planning nonliquidating distributions to the three kinds of shareholders
- see above for notes from Block section
Constructive dividends-Block at 143 and Q 10 at 146 and A at 153
Corporations as Shareholders: Benefits and Abuses and Anti-Abuse Provisions
§ 243
§ 246
§ 246A
§ 1059
§ 1(h)(11)(D)(ii)
Rev. Rul. 90-27, 1990-1 C.B. 50
- Is it stock for federal income purposes? Ct will look at all the facts and circumstances
- Ruling considers the applicability of the dividends received deduction to amounts received on preferred stock on which the dividend rate was periodically set under an auction procedure to a rate that would enable the stock to sell at par. The ruling concluded that the dividends qualified for the dividends received deduction. The holder of the stock had no right to receive a sum certain on demand or on a specified date, and, at liquidation or bankruptcy, the holder’s rights were subordinate to the claims of the issuer’s creditors. Moreover, the holder could not compel redemption of the stock.
Rev. Rul. 94-28, 1994-1 C.B. 86
- Y, the security purchasing company held an option to sell the securities for the purposes of 246(c)(4)(A).
- Shares in this case are DISTINGUISHABLE from MANDATORILY REDEEMABLE PREFERRED STOCK that does NOT afford a holder creditors’ rights.
- Shares in this case are DISTINGUISHABLE from Rev Rule 90-27
- §264(c)(4)(A) is generally interpreted as containing an exception for traditional mandatory redemption rights that are common in the terms of many preferred stocks. ß this exception is CONSTRUED NARROWLY-it does not extend to instruments, such as the one in this case, that afford the holders the right to a fixed payment on a specified date and allow the holders to sue as creditors to enforce this right.
- HOLDING: §264(c)(4) applies to an instrument that affords the holder the rights of a creditor and IS NOT stock for CORPORATE LAW purposes but IS STOCK for federal income tax purposes
Block: 126; 130-33
- Dividends-Received Deduction §243
- RATIONALE: when a corporation that is a shareholder receives a distribution from another corporation, it will be subject to the same §301 rules. Unlike an individual, a corporate shareholder receiving a distribution from a domestic (U.S.) corporation will be entitled to special dividends-received deduction under §243
§ Without the deduction, corporate profits would be taxed first to the corporation that earned them, against to the corporate shareholder receiving the distribution, and yet again to the individual shareholder upon receipt of a distribution from the second corporation.
o Special rules for corporations filing a consolidated return-
§ “Affiliated Corporations” — §1504 — entitled to file a consolidated return
§ Differences than regular §301 transaction:
- An intercompany distribution is not included in the gross income of the member receiving the distribution. Treas. Reg. §1.1502-13(f)(2)(ii).
- Permits the distributee to exclude the excess distribution that would otherwise have been taxable as capital gain under §301(c)(3).
- Both the dividend income under §301(c)(1) and the capital gain under §301(c)(3) are deferred through a corresponding negative adjustment to the distributee corporation’s basis in stock in the distributing corporation.
§ §246(c)-holding period requirements to prevent corporations from purchasing stock immediately before and selling immediately after a distribution simple to take advantage of the §243 deduction
- §246(c)(1)(A) no deduction is allowed under §243 with respect to any share of stock that is held by the taxpayer for 45 days or less
- §246(c)(4) purpose – suspend a taxpayer’s holding period, for purposes of meeting the 45 day holding period requirement of (c)(1)(A), for any period during which the taxpayer is protected from the risk of loss otherwise inherent in the ownership of an equity interest
§ §246(a)-disallows §243 deduction when the distributing corporation is a tax-exempt organization
§ §246A-restricts the §243 deductions in the case of dividends on debt-financed portfolio stock through a formula that reduces the dividends-received deduction to the extent of the “average indebtedness percentage”
§ §246(c)(1)(B)-disallows the §243 deduction in certain hedging transactions
§ Dividend Stripping-
- PROBLEM-X corp buys Y corp because it is about to release a substantial dividend. X purchases Y for $200 and receives a $50 dividend. As a corporate shareholder, X gets the §243 deduction w/ respect to the $50 distribution. Given a 70% DR deduction under §243(a)(1), only $15 of the $50 distribution is subject to tax and the remaining $35 is effectively excluded. After the dividend, Y drops to $150. X sells for $150 and takes a $50 capital loss.
- ANSWER: §1059 Extraordinary Dividends-stock held for less than 2 years (certain exceptions apply), the corporate shareholder must REDUCE BASIS in the stock by the nontaxed portion of the dividend.
- Effect: X’s $200 basis is reduced by $35 to $165 – X’s capital loss is limited to $15.
To what kind(s) of shareholders do the various provisions apply?
At what kinds of transactions are the anti-abuse provisions aimed?
Bootstrap Acquisitions
Block: 133-35
- Bootstrap Acquisitions-a substantial portion of the funds for the acquisition appear to come from the seller itself rather than from the buyer. The seller thus uses its own funds to “bootstrap” the sale.
- Waterman Steamship Argument-cash dividend should not be taxed pursuant to the consolidated return regulations, which effectively EXCLUDE inter-corporate dividends in provisions paralleling §243.
- IRS Argument-the subs acted as a mere conduit for passing the payment through to the seller – substance over form – Waterman Steamship ended up with a busted bootstrap acquisition
- Successful bootstrap transaction – p. 134 Block – there was no tax avoidance motive – the property involved in the distribution was property that the purchasing corporation did not want
- PLANNING W/ BOOTSTRAP TRANSATIONS:
- It is possible to successfully structure a bootstrap acquisition through a pre-sale dividend distribution of assets by a target subsidiary, deductible by the selling parent under §243.
- 1st-there should be some business reason for the distribution, usually that the unwanted assets were unwanted by the buyer.
- 2nd-The parent ideally should avoid an immediate sale or exchange of the assets received in the pre-sale distribution
- 3rd-Taxpayer must take into account the basis reduction in its subsidiary stock, and potential taxable gain that can result if the distribution is treated as an “extraordinary dividend” under §1059.
Be prepared to diagram this transaction based on the description in Block.
Do any of the anti-abuse provisions apply to this transaction?
Is this planning technique consistent with the new relaxed approach to continuity of interest we has previously considered in § 351 transactions with respect to “control immediately after” and which we shall consider in far greater detail when we consider § 368(a) reorganizations?
Tax Consequences to the Corporation Making a Dividend Distribution
§ 311
Block: 135-38, 140
- In-Kind Distributions-§311
- A corporation does not realize or recognize any gain or loss upon a simple cash distribution to its shareholders. COMPARE w/ in-kind distributions, which can have significant consequences.
- Application of 311-
§ 311(a) is basically a loss disallowance rule because the exception in (b) eats (a) up.
§ 311(b)-the distributing corporation must treat the appreciated property as if it had been sold to the shareholders, triggering taxable gain
- the creation of §311(b) reflects the congressional judgment that corporations should not be able to escape corporate level taxation on appreciation in corporate assets distributed to shareholders
§ Appreciate Property Example: X corp and Y corp. X has property with FMV 150 and AB 110. Y has property with FMV 150 and AB 110.
- X sells the property for 150 and later distributes 150 cash to its shareholders
- RESULT: X recognizes 40 taxable gain on the sale under §§61(a)(3) and 1001, and the shareholder will report income from the cash distribution under the §301 rules.
- Y corp distributes property directly to its sole shareholder, who later sells the asset for 150
- Y Corp will recognized 40 gain upon the distribution under §311(b) and the shareholder will report gain from the in-kind distribution under §301 rules.
- In each case, the characterization of the corporation’s gain as capital or ordinary will depend on the character of the asset
§ Loss Property Example: X corp sells an asset w/ an AB of 110 and FMV of 100, and later distributes the 100 cash proceeds to its sole shareholder. Y corp simply distributes the loss asset directly to the shareholder
- X is entitled to recognize the 10 loss upon sale of the asset
- Y is NOT entitled to deduct the 10 loss. Since this is not a distribution of appreciated property, the §311(a) nonrecognition DOES NOT apply.
- Reason for Lack of Symmetry in §311
§ Congress has historically been concerned with the possibilities for manipulation of loss recognition. This is particular true where the parties to the transaction are related.
- §267(a), which disallows losses from sales or exchanges b/t related parties. Related parties for §267 purposes include an individual and a corporation in which the individual owns more than 50% in value of the outstanding stock. §267(b)(2).
§ If BOTH gains and losses were recognized upon corporate distributions, corporations might be motivated to leave gains unrealized by holding onto appreciated assets, but realize losses by distributing loss assets.
§ A sale of loss property in the marketplace can be distinguished from a distribution of loss property to its shareholders, however, the marketplace sale actually causes the property to leave the corporate family. Recognition of the loss in this case comes at a price-the corporation AND its shareholders must relinquish control over the property.
§ If losses were recognized upon in-kind distributions, corporations would be able to receive the tax benefit of the loss WHILE keeping the property in the corporate family’s hands.
- No Deductions for Dividends Paid
- Opposed to other corporate payments, dividends are NOT deductible to the distributing corporation.
- Other things are deductible – interest costs incurred by a corporation are generally deductible under §163… reasonable salary payments to employees (including shareholder employees) are deductible trade or business expenses under §162
- Distinguishing b/t NONDEDUCTIBLE DIVIDEND PAYMENTS and other deductible corporate expenses has been a thorny problem w/ significant tax implications for both shareholders and corporations
- Historically, the gov’t position was to argue that corporate payments, particularly those to shareholders, were dividends taxable as ordinary income to the shareholder and nondeductible to the corporation.
- The new “qualified dividend income” rules are likely to alter litigation positions taken by taxpayers and the government – since tax rates of qualified dividend income are lower than ordinary income, the gov’t may not be as vigorous in its dividend assertions
Does § 311(a) state a general rule? If so, to what kind(s) of dividend distribution(s) does it apply?
- It does, but partially – the (b) exception eats up the general rule treating the distribution of appreciated property as the sale at FMV of the property to the distributee, thus triggering taxable gain.
- The “general rule” that is leftover is simply a loss disallowance rule.
- Corporations MUST recognize gain upon distribution of appreciated property, but CANNOT recognize loss upon distribution of depreciated property.
Do you think that § 311 takes a necessary position with respect to in-kind distributions? Is your reasoning the same with respect to public traded and closely held corporations?
Do you think the rules in § 301(b)(2), § 301(d), § 311(b) define a reasonable regime for the taxation of in-kind of distributions of property subject to a liability? Note Block’s discussion at 141-43 and her discussions of Crane and Tufts in this context.
- DISTRIBUTIONS INVOLVING LIABILITIES
- Shareholder Tax Consequences
§ Amount of Contribution-§301(b)(2) provides the amount (FMV of property) of the distribution will be reduced (but not below zero) by the amount of such liability
- When a shareholder takes on a liability in connection w/ an in-kind distribution, the value of the property to the shareholder is reduced to the extent that she must incur debt in order to retain the property
- EX: X corp distributes property with FMV 150 and 100 Mortgage to A. The AMOUNT of A’s distribution under §301(b)(2) is 50 – the net value of the distribution after taking the liability into account
§ Basis in Property Received-§301(d)-basis = FMV of property
- EX: A’s basis in the above situation is 150
§ Liability > FMV-§301(d) à basis is limited to its FMV
- EX: A takes distributed property worth 150 subject to 200 mortgage. §301(b)() prohibits a reduction of basis below 0. A’s basis is limited to 150. A cannot include the full amount of liability in the distributed property’s basis.
- Distributing Corporation Tax Consequences
§ The amount realized to the seller MUST INCLUDE the amount of liabilities when a buyer either assumes or purchases property subject to liabilities. (Tufts & Crane Cases).
§ §311(b) requires the corporation to treat the distribution as a sale to the shareholder-the amount realized in the distribution INCLUDES liabilities taken on by the shareholders
§ EX: X corp distributes property with AB of 80, FMV of 150, and 100 Mortgage. X reports a taxable GAIN of 70 under §311(b). The 150 amount realized includes the 100k mortgage and the 50 of value in the appreciate property.
§ Liabilities > FMV-corporate level gain under §311 is measured by the EXCESS of the LIABILITIES over ADJUSTED BASIS.
- EX: X corp distributes property with AB of 80, FMV of 150, and Mortgage of 200. The AMOUNT REALIZED of the corporation upon distribution is now 200, resulting in 120 taxable gain. This is simply a codification of the Tufts case.
Tax Consequences of Not Distributing Income
Block: 14-16
We are not going to focus on the technical complexities of these provisions but on the reasons for having these provisions in the Code. Do these provisions represent an appropriate matter for the imposition of tax? What tax principle, at any, is at stake? Are these provisions aimed at publicly traded or closely held corporations or both?
