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CORPORATE TAXATION
SPRING 1993
short outline
CORP TAX RATES - assign 1
I. Tax Rates - ∍11
A. 0-50k -- 15%
B. 50k-75k -- 25%
C. 75k + -- 34%
D. However, there is a phase out for incomes over 100k. The marginal rate becomes 39% until the difference between 34 and the lower rates (15 and 25) are recaptured. Therefor, for incomes between 100k-350k there is a 39% bracket, and back to 35% for incomes over 335k. Therefor, corps w/ over 335k income pay a flat 34% tax, b/c the lower rates were recaptured.
II. Passive Loss Rules do not apply to LARGE C corps.
III. A.M.T. - applies to corps. (most C corps fall under this!)
IV. Accrual Acct -- C corps w/ gross reciepts under 5MM MUST use accrual. (FX - they dont get defferral that is assoc w/ cash method).
V. Golden Parachutes -- Rules corps cannot ddct these a bus xps. AND the exec getting the money has to pay an extra 20% excise tax.
VI. Effects of Double Taxation.
A. Increases effective rate. $1(1-34$)(1-31%) = 54% tax rate!
VII. Publicly traded PS taxed like C corps.
VIII. CHCs avoiding corp tax
A. zeroping out w/ compensation. - IRS attacks (constructive div).
IX. WHY C-CORP IS LESS ATTRIACTIVE AFTER 1986.
A. rate inversion.
B. reduction of cap gains pref.
1. Capital gains rate for corps is now 34%
C. GU doctrine repealed.
X. Incidence of the corp tax (who bears the economic burden)
A. Possiblities - customers; shhs; e/ees.
B. Short Run Incidence on shhs b/c profts are lower and shhs cannot react fast enough (they have laready determined their profit maxmizing strategy).
1. Corp tax makes the whole system more progressive b/c people think the incidence of the tax falls on shhs, and corp shhs are usually the wealthierp people.
C. Long Run -- the corp can shift the incidence. Eventually the market will even out and the incidence will fall on all owners of capital (including those owning PS interests).
D. Must more in the notes from 1/21.
INTEGRATION OF CORPORATE TAX - assign 2
XI. See attchment Z.
CREATING THE CORPORATION - assign 3
XII. SECTION 351 - DOES IT APPLY?.
A. General Rule = if transferor (shh) transfers property (not services) to the corp and, in exchange, receives solely stock of the corp, and shh is in control of the corp immediately after the trxtn, then 351 applies. (Result: non-taxable exchange).
B. INVESTMENT COMPANIES - 351 does not apply here.
1. RULE - 351 doesn't apply to contributions of stock to an investment co. 351(e). Treas Reg 1.351(1)(C)(I) says "invest co" = when greater than 80% of the value of the corp consists of readily marketable stocks.
2. GREAT LOOPHOLE. Practically you can still achieve some beneifts of diversifition tax free if you contribute some non-mktable π too! (you will qualify for 351).[1]
C. Have you Contributed of "Property" OR "Serives"? (for purposes of getting 351 treatment).
1. Rule - If you've contributed only services, then 351 does not apply to you; and you are not counted in the control group for 351 purposes -- this cd effect other contributors.
2. What is "property" (see pp 101-102). Cts are IRS disagree. Therefor you are somewhat at risk as to loosing 351 treatment. {See book}.
a. Intangibles can be "property" under 351. However, goodwill proabaly wdn't count, but we aren't sure - cts differ here.
D. Contributions of both Property AND Services by ONE Individual.
1. Threshold Rule - Assume that James contributed 1$ in addition to the services. Treas Reg 1.351-(I)(a)(1)(ii) says that you dont get 351 treatment if the "value of π received is unreasonable small in relation to the value of services received (or the value of stock already owned)" AND the primary purpose is to qualify other people for the control test. The Treas Reg is not quantified, but the 9
a. RULE - IRS requires at least 10% of the value be property for ruling purposes.
2. Control TEst RULE/RESULT - You consider ALL the shares received for purposes of the control test (even tho some of the stock was allocated to services. A generous rule). 1.351 (1)(a)(II) example 3.
3. Shh's Tax RULE - You must allocate the FMV of stock recieved by the ratio of FMV-of-π to FMV-of-services. Although you are allowed to be counted for the control group, the shh contributing π+serivces is still taxed on the portion of the stock earned for the services (wages income).
XIII. FLOWCHART - FX OF A SUCCESSFUL 351 TRXTN - General Rules.
A. Shareholder's FX -
1. Basis in stock received =
substitute basis (from property contributed)
+ any gain recognized
- basis transferred to boot. ∍358.
2. Shh's gain =
a. the lesser of the FMV of boot recieved OR the gain realized on the contributed π.
b. shh will have a gain if the shh contributes π subject to debt and the corp assumes the liability IF the AofL is greater thatn the shh's basis in the constributed property. The gain is equal to the amount of AofL over basis. 357(c) + 351.
3. Future resale of the stock.
a. Character of the Gain/loss on resale of the stock - Great Loophole. - always capital gain/loss (even if π contrib'd was ord inc π). Anti-abuse rules in 341.. If you have a busted 351, then character of shh's gain will depend on the type of property.
b. Holding periods tack. Shh is deemed to have held the stock for as long as shh held the property contributed. 1223(1). Get LTCGs rate (28%) applies if π held over 1 yr.
B. Corp's FX -
1. Corp's basis in π contributed =
carry-over basis
+ any gain recognized. 362(a).
2. Corp never has G/L on contrib of $/π for stock. 1032.
3. Future sale of the contributed property.
a. Character of the G/L = depends on the nature of the π contributed.
b. Holding Periods tack. Corp deemed to have held the property for as long as shh held that property. 1223(2).
XIV. Figuring BASIS in a successful 351 --- Example. Shh contributes π w/ 1000 basis and 3000 FMV in exchange for shares. Corp gets 1000 basis; Shh gets 1000 basis.
A. Contribution of Appreciated Property. NOTICE: DOUBLE GAIN. Rat: None. If cli just sold the π before incorp, there wd be only one gain.
B. Contribution of Deprecated Property - same rules.
1. NOTE: DOUBLE LOSS - GREAT LOOPHOLE! (but there are anti-abuse rules which he didn't mention).
XV. Subsequent Contributions when there is only one Shh. Later, (5 yrs), cli contributes land but cli doesn't receive any stock in exchagne. RESULT: you just increase the basis in cli's shares. (We are assuming that the cli hold 100% of the shs), therefore, it is non-taxable.
A. RAT: although this might not technically fall into 351, we dont want to tax cli b/c of the corporate doctrine re: substance/form (i.e., we wont require cli to go thru the meaningless formality of issuing himself more stock.)
XVI. Subsequent COntributions When there is more than onw shh and shh-1 contibs more P but doesn't get extra stock. EX] Assume that shh-1 owns 85% and shh-2 owns 15%. Shh-1 then contributes π worth 100$ to the corp but doesn't receive any additional stock. RESULT: Basically shh-1 has increased his basis by 85$ and made a gift (or paid off a debt, whatever) to shh-2 of $15.
XVII. BUSTED 351 -- FLOWCHART OF FX. -- Assume A and B are already shhs. C contributes inventory π basis=10, FMV=40 in exchange for 33% of the stock.
A. Result: busted 351 (b/c no "control").
1. C is taxed on 30 ordinary gain,
2. C has a 40 basis in the stock,
3. the corp has a 40 basis in the inventory.
B. NOTE (one good thing): By recognizing the gain now, we avoid a double gain later.
C. The Corp still doesnt recognize a gain, even if you flunk 351. ∍ 1032.
D. Contribution of Depreciated property in a Busted 351.
1. Normal rules say you recognize a loss on the exchange of assets.
2. Rule - In a failed 351, you can recognize the loss w/ limitations. ∍ 276 says you can NOT recognize a loss when you sell π to a corp where you own > 50% of the corp. 267 - people who are related cannot sell π to each other and recognize a loss.
XVIII. S CORPS and 351.
A. 351 applies to S corps in the same manner.
B. Aside: the potential for double tax still exists even in a 351+S Corp sitch b/c when cli sells his stock, this is one level of tax AND when the s corp sells the π, the gain gets passed thru = double tax.
1. PSs can avoid this result b/c upon selling a partnership interest, you can step up assets basis inside the PS with a 754 election.
XIX. BOOT 351(b) -- (now there is a potential for shh to have a GAIN!)
A. 351(b) is an exception to the "solely in exchange for stock" rule of 351(a). Under 351(b) if the corp gives stock and boot to shh, then we are not disqualified from 351(a).
B. RULE -- Gain from the receipt of BOOT. If you get boot, you recognize gain. Gain will be the lesser of:
1. FMV of the boot received; [OR]
2. the gain realized (on the contributed π). (Therefor, you may still get to differ some of the gain on the contributed property).
3. Character of gain - will be ordinary if shh receives inventory.
C. Shh receieving Debt vs. Pref'd Stock.
1. Pref'd RULE - If Pref'd Stock is issued that is NOT boot! Pref'd Stock is also eligible for non-recognition under 351. Good b/c this allows alot of flexibility in planning.
2. Debt RULE - If debt is issued, that is boot! However, w/ debt you may get to use the installment method (recognize gains when received).
3. Debt - Seller (Shh) Financed Contribution. If in a 351 the corp gives stock (fmv=60) and debt (fmv=40) to shh, the old law said that if the debt was a "security"[2] this wd be tax free. But under the current law, debt is treated as BOOT. But there is one saving grace that prevents you from recognizing it now. Code lets shh use the installment method (i.e. shh doesn't recognize gain until the cash is received). Have to use all the complex rules of the installment method (i.e. "qualifying").
a. RAT: avoids liquidity probs.
b. NOTE: good potential for tax planning.
c. Shh getting debt (installment method). B transfers π basis=200, fmv=1000 to the corp in a valid 351, in exchange for a 1000 debt instrument and some stock. If B qualifies for installment method, then no gain now.
d. Corp's basis in the π = 200. (not more b/c no gain was recognized).
e. But as the note is paid down (say $500), then B recognizes 1/2 of the pent up gain = $400 gain to B [AND] the corp increases its basis in the π (b/c of the normal rules, which say corp increases basis when gain is recognized) 200+400=600 basis.
XX. Recognizing LOSSES in a 351
XXI. Boot Allocation Examples (Contributions of 2 pieces of property for stock + boot)
A. Example -
1. Assume contribution of πa and πb in exchange for stock worth $30,000 and boot of $10,000.
2. πa basis=10,000; FMV = $30,000.
3. πb basis=20,000; FMV = $10,000.
4. Rule - gain on receipt of boot is limited to (1) gain rezliazed [OR] (2) fmv of boot.
5. Gain analysis -- For each piece of π we need to knwo the gain realized on that piece of π and teh FMV of boot received in exchange for that π.
a. πa ---
(1) gain realized = $20,000;
(2) FMV boot received = 10k * (30/(10+30)) = $7,500. (10k is the total FMV boot; the the division thing is πa/(πa+πb).
* Therefore we have 7,500 gain recognized on πa.
b. πb ---
(1) gain realized = 0
(2) fmv boot received = 10k * (10/(10+30)) $2,500.
* Therefor we have zero gain recognized on πb.
6. Shh's basis in the stock:
a. 30,000 (substitute basis)
-7,500 (gain recognized)
+10,000 (basis to boot)
27,500 = shh's basis in the stock
7. Corp's basis in the π.
a. πa -- 10,000 (carryover basis) + 7,500 gain = 17,500.
b. πb -- 20,000 (carryover basis) + 0 (gain) = 20,000.
ASSUMPTION OF DEBT (in Creating the Corp) - Assign 4
XXII. Basic Example
A. Assume shh contributed π w/ basis=$800; FMV=$1000; debt=$600 in exchange for $400 stock + AofL.
B. Gain to shh:
1. Rule: gain = lesser of gain realized or fmv boot, but AofL is not boot for this purpose.
2. Result: Since fmv boot = zero, there is no gain recognized.
C. Shh's basis in stock;
1. Rule: AofL is treated as boot here.
2. Result: 800 (substitute) + 0 (gain) - 600 (basis to boot) = $200.
D. Corp's basis in π = 800 (carryover) + 0 (gain) = 800 basis.
XXIII. General AofL Rules -
A. Rules Re: Basis --- 358(d).
1. Rule - Assumption of Liability DOES count as boot, but ONLY when determining shh's basis in the stock. Code cite = 358(d) "for this section". (note: the gain recogniztion is in a different section - 351).
2. EX] π basis=60, FMV=100, mortgage=10. Result: 60 carryover basis - 10 debt assumed = 50 shh's basis in the stock.
B. Rule Re: Gains --- 357(a).
1. General RULE -- Assumption of Liability is NOT treated as boot for determining shh's gain. Shh's gain = the lesser of the FMV of boot received [OR] the gain realized on the contributed π. 357(a).
a. STRATEGY FROM HELL! -- NOTE: you can unload debt w/out it being considered cash to you!!!! Great Loophole.
2. No Negative Basis Exception to 357(a) - If the Corp assumes liabilities greater than the basis of the property contributed, then the shh has GAIN!!!!!! 357(c).
a. This is an excpetion to the "basis to boot" rule in figuring shh basis in shares.
b. EX] Assume that G contributes π with basis=60, fmv=100, debt=70 in exchange for stock.
(1) PROB = negative basis. Yuck. 60-70=(10).
(2) Result = shh has a basis of ZERO. 357(c). Shh has to recognize 10,000 gain, now.
3. Exceptions to 357(a) for Tax Avoidance AND/OR No Bona Fide Business Purpose. RULE - If considering the circs surrounding the AofL, the AofL was done for tax avoidance OR there was no valid business purpose, then the AofL will be considered as BOOT for purposes of determining Gains.
a. Rule Aside: if shh remains Secondarily Liable on the debt, then we probably still have the same result. AofL treates as boot when determining Gains.
b. Rule - 357(b)(1)+1.357(1)(c)-- if any part of the liabilities that the corp assumes for you fails the test (tax avoid/bus purpose), then ALL of the AofLs will fail (i.e., it is treated as if all the AofLs were receipt of cash).. HARSH RULE.
c. EX] personal credit card debt assumed by the corp = no valid bus purpose.
d. EX] Now Assume basis=60,000; fmv=100,000 and the π is unencumbered by debt, but just before contribution, G borrows 50,000 secured by the R/E and the corp will take the π subject to the debt. If this works, the result is that G's basis=10, and G has 50 cash in pocket and NO TAX.[3] Extracting cash and deffering gain. HOWEVER, this is a tax avoidance purpose b/c of the timing of incurring the debt (so close of contribution) and 357(b) says (regardless of the other rules), if the reason you are doing this is tax avoidance or for no valid busniess purpose, then the normal rules apply. Thus, AofL will be treated as cash received.
(1) RESULTs:
(a) G is treated as getting 50,000 cash, so he must recognize 40,000 gain (b/c 351 rules say gain recognized = lesser of FMV boot [OR] gain realized).
(b) Ending basis in the stock = 60+40-50=50.[4]
e. ASIDE: There is no SofL for civil fraud on a tax return. But there is a SofL for good-faith mistakes on your return.
C. S CORPS - All of these rules apply to S Corps.
XXIV. Special Rule for Contributions of A/R + A/P.
A. Why Need for Special Rule? -- A: Assume G transfers assets of his on-going business to the corp in a 351. G is a cash method TP w/ 20,000 A/R and 12,000 A/P. Prob: the basis in A/R (for cash TPs) is ZERO. Hence, we have a sitch where AofL > basis of π contributed, which triggers a 12,000$ gain to shh. CRIT: crappy result b/c you really haven't done anything.
B. Rule - 357(c)(3)(A)(i) says that this will NOT trigger gain.
1. RAT: If G sold π to 3d for 8,000 cash + AofL, then the AofL is treated as receipt of cash (genreral rule), and then G is deemed to have paid off the debt. In this case, G would get a deduction for paying off the A/P (the debt). This reuslts in a wash for G. $12,000 AofL gain less (12,000) ddctn = 0. Thus, w/out a special rule, the shh ahs 12,000 gain where there sd be no g/l.
C. RULE - 357(c)(3)(A)(i) = If shh wd get a ddctn for paying off the liability himself, then "we exclude the liability for purposes of [determining gains under the "liability in excess of basis" rule] AND for purposes of determining the shh's basis in the stock... " AofL here is not BOOT.
1. Thus, the shh doesn't have any gain AND the shh's basis in the stock is zero.[5] (b/c AofL is not boot here).
2. Rule/RESULT: the corp gets the ddctn when it pays off the A/P (to the vendors) and when the A/R is received it is income to the corp. OHRS: what basis does the corp take in the A/R? Zero?
CONTROL RE: 351. - Assign 5
XXV. RULE (2 parts) - "Control" defined in 368(c) as a 2 part test - Practically, you split up all the shares into two groups. All the voting shares (lumped together) are subject only to the first test (voting power) and all the non-voting shares are subject only to the second test.
A. Part 1: You must have at least 80% of the voting power in the stock; AND
1. You must "own" 80% of the voting power (this is does not mean 80% in the number of shares).
2. Shares that only vote on extraordinary items are not counted in the class of voting shares. (b/c to do so wd evisciate the rule). There is still some judgment that goes into what is "voting stock."
B. Part 2: At least 80% of all the other classes of stock.
1. this is a number of shares test. You need 80% of each class. (we do this by number of shares to avoid messy problems of valuation).
XXVI. PEOPLE CONTRIBUTING SMALL AMOUTNS MAY NOT QUALIFY (aggreagtion).
A. RULE - If stock is issued for property which is of relatively small value in comparison to the value of the stock already owned by the shh AND where the primary purpose of the transfer is to qualify for CONTROL, then this shh's stock will not be counted. Treas Reg 1.351-1(a)(1)(ii).
B. Procedurally - just compare the number of shares the shh already owns to the number of shares the shh is buying.
C. Kamborian v. Commissioner--Illistrates that 351 can be used to cover corproate acquisitions (reorganizations).
1. IRS argues that Treas Regs (which came up in the James case) say that when the π transferred is small in relation to what Eliz already owns (in shoe) [AND] the primary purposes of (eliz's transfer) is to qualify other people for 351, then Eliz's shares are not counted toward 351 control.
a. RE: "small in relationship' req:
(1) Trust already owned 5000 shs of Class A and 45,000 of class B;
(2) In the trxtn the trust only bought 42 shares of Class A and 376 shared of class B.
(3) Therefore 42 vs. 5000; and 376 vs. 45,000.
2. TP's args:
a. The treas regs are invlaid b/c not authorized in the statute. CT: NO way.
b. The shares purchased by the trust sd be counted in the group b/c they can be attributed to the trustees (b/c Becka transferred π, these shares sd qualify toward the control amount). CT: no way. The trustee's are not the economic owners of the trust (they are only the legal owners).
c. The reason we bought the shares for the trust was not tax avoidance.
XXVII. CONTROL TEST FAILED B/C OF PRE-EXISTING CONTRACT TO SELL SHARES TO 3D (A NON-CONTRIBUTOR)
A. RULE - To be considered for 351, the contributor must own the shares immediately after the contribution. "Ownership" is defined to mean the freedom to do whatever you want w/ the stock. These are ways to destroy a good 351:
1. A pre existing plan to sell the newly acquired shares to 3d who is a non-contributing party. Step Trxtxn Doctrine (i.e., subsequent sales of stock cd be integrated w/ a contribution) making you fail the control test.
2. Not yourself, but another contributor has a side deal, which takes him out of the control group and fucks you (b/c the remaining legit contributors alone do not have 80%).
a. Ex] Cli + stranger do a deal where after the trxtn they each have 40% of the shs. This is a good 351. howver, stranger has a side deal to sell his shs to 3rd, and it this is integrated via step trxtn dcotrine, your cli is effected b/c now we have a busted 351.
b. SOL'N = Need to have a K between cli and stranger which limits ability to endanger the 351 (tax free treatement), and if you do bust the 351, then you have to are liable to the otehr for contribution.
3. Other applications of step-trxtn doctrine, whereby contributing shh sells his shares to someone else shortly after aquiring the shares.
a. Step Trxtn Doctrine Factors.
(1) Time - how close togetherwere the steps (the trxtns). The longer away the less likely they will be connected - "Old and Cold."
(2) Contract - steps are not separate if connected by a contract. If Shook's contract was not to sell the shares for 50 yrs, this would still be a step b/c the contract was entered into NOW.
(3) ADVISE TO CLIs = there is a risk. If Cli is gonna contribute π and wants to sell the shs shortly thereafter, the IRS might integrate the steps. adivse fo clis - Rule of Thumb = 2 yrs.
B. Intermountain Lumber -- Corporation = TP arguing that a prior trxtn failed 351 so that the corp cd take the assets w/ a steppedup basis. (bigger dep ddctns).
1. Statute says "control immediately after the exchange", but since step trxtn doc will include the later K, you fail even tho technically you complied. You cannot hide in the literal meaning of the statute.
XXVIII. OTHER (SPECIFIC) CONTROL ISSUES.
A. Pref'd Shares Are Included in 351. Assume B gets all the non-voting pref'd shares and E gets all the voting shares in a 351. RESULT: if both parties transferred π together, this will be a valid 351.
1. NOTE: the ability to use pref'd gives alot of flexibility (b/c B and E can have very different interests in the corp).
B. Downstream Transfers OK! - (Parent/Subsid). Ex] Shh gives π to CorpA in exchange for 80% of Corp A stock, AND Corp A gives that same π to CorpB in exchange for 80% of CorpS stock. ALL this is done in one trxtn. RESULT: This is still a valid 351. LOOPHILE CITY- allows for flexibility. IRS has a rev rule that says this is OK. NOTICE: this is actually an exception to the control req b/c in the end Shh effectively owns only 64% of CorpB, which now owns that π. (Less cont of investment).
1. EX] GM has two subsidiaries. This rule allows GM to shift its assets around tax-free. great loophole. GM can give assets to one subsid, which in turn gives the assets to another subsid.
C. Non-Symmetical Trxtns (FMV contrib not equal to FMV shares).
1. Assume E has a daughter and E contributes 300 FMV assets and daughter contributes 100 FMV assets to a Corp. The Corp gives each of them 200 shs. RESULT: E has made a gift to the daughter.
2. General Rule - these non-symmetrical trxtns (i.e. FMV contributed is nto equal to FMV of shs received) are actually disguised gifts, salary, etc. 351 still applies , but E is deemed to have received 300 shs and daugther is deemed to have recieved 100 shs, then there is a deemed gift of 100 shs to the daughter (G&E taxes may apply).
XXIX. GREAT LOOPHOLES IN 351:
A. a "group" can satisfy the control test (even tho they are unrealted).
B. You can also get 351 treatement with Pref'd Stock - The result is tax deferral even tho economically the deal resemebles a sale. Result is deferral (not tax free) b/c you get a low basis, so you may have a gain later.
XXX. 351 CAN CREATE EFFECTIVE SALES TAX FREE!. Now Assume: Mom and Pop own a small store worth 250,000. Multinational Retailing = Corp (worth 100 MM). Mom and Pop (M&P) and Multinational corp transfer assets to a new corp; M&P get .25% of the shs, while mulitnational gets 99.75% of shs. RESULT: this is a good 351. Both transferred π and they are in control.
A. CRIT: 351 gives tax free treatement b/c of Cont of Investment, but here for M&P their investment is radically different (no continuity). They only own .25% and the majority of that is a retailing business. This illistrates how 351 can be used to do tax-free deals that are really sales! Great Loophole!
1. Notice also, we've done the economic equivalent of a Stock-For-Stock merger via 351 (see ∍ 368).
2. a way to do a sale without getting taxed (and M&P are not diversified re: risk).
a. M&P cd sell shs to get the cash.
3. Give M&P pref'd shares with big divs to avoid their liquidity problem (get cash out, just like a real sale).
CAPITAL STRUCTURE -- assign 6.
XXXI. DEBT VS. EQUITY - Summary
A. Issuer (Corp)
1. Debt - int xp is ddctible;
2. Equity - divs (xp) is not ddctible.
B. Holder (shh or cr)
1. Holder is not itself a corporation.
a. Debt - int inc is taxable
b. Equity - div inc is taxable
2. Holder is itself a corporation.
a. Debt - int inc is taxed.[6]
b. Equity - DRD
C. Repayment of Principle:
1. Debt - this is return of capital - NO tax;
2. Equity - retrun of your original investment cd be a dividend is shh owns owther stock.
D. Tranferring Property to the corp in exhange for equity vs. debt.
1. Debt - no benies.
2. Equity - possbile qualify for ∍ 351 tax free.
XXXII. CHARACTERIZATION AS DEBT OR EQUITY? ---
A. Bauer -- IRS says that contibrutions by B and H were equity not debt. If equity, then the corp cannot ddct distributions (int vs. divs).
1. FACTS: On the books these amounts were treated as loans. All the formalities were followed. Corp paid the interest (actal cash out) and took int xp ddction each year. B and H both reported int inc each yr. Tax return of all parties were consistant with this being a loan. EVANS < "since this whole area of the law is economicaaly artificial, careful attys will follow all the formailities so as to keep the artificial distinctions (dont let clis talk you into cutting corners b/c everyone is freindly)."
2. CT OF APPEALS HLD: this is debt. The court lists 11 factors (judicially created factors):
B. RULE - Ultimately a facts and circs test, but the Bauer court listed Factors:
1. Names given to the certificates (debt or equity).
2. Is there a maturity date?
a. A loan w/ no maturity date looks like equity. Also, a "loan" with a 50 yr maturity date looks more like euqity b/c people who makes loans want repayment {they are not buying into the risk that the business will fold as much as an equity investor does - thus 50 yrs looks like bigger risk}.
3. Source of Payments (evans has no idea what this is getting at).
4. Right to Enforce Payments -
a. Cr can enforce repayment of a loan (and even send corp into BK); equity investos cannot.
b. is there an Acceleration Clause? - the presence of this makes it look more like debt {b/c taking away some of the equity type risk.}
5. Participation in Management -
a. cts usually are not allowed to participate and shhs do paarticipate. Do the holders of the instruments have the right to vote?
6. Convertible Debt - loans than can be converted into equity are more susceptiable to recharacterization.
7. Thin Capitalization (i.e., Debt:Equity Ratio).
a. If you are investing in a thinly capitalized co, your investment is risky so you are probably more like an equity investor b/c there is a high change of no repayment. If you were gonna make a loan to the corp, you wd be worried about repayment; worried about the debt/equity ratio. Creditors wont lend to corps w/ high debt/equity ratios.
8. Proportionaltiy of debt to equity among investors. In other words, look at each investors debt and his equity. If each investors debt/equity ratio is similar, than the "debt" is probabaly equity {b/c they are trying to hold the same %age relative interests}.
a. ex] Suppose:
(1) B has 200,000 equity & 1mm debt
(2) E has 600,000 equity & 3mm debt.
* Result: both investors have debt equity ratios of 3:1 -- this looks suspicious (it is probably all equity). If B and E are the only shhs, they do not have alot of incentive to be hard-nosed about repayment of the "loan."
b. Contrast to ex2]
(1) B has 200,000 debt & 3 mm equity
(2) E has 600,000 debt & 1 mm equity.
* Result: now the ratios are 1:3 and 3:1 -- Here, the incentives are to be much more hard-nosed b/c the debt for B is much greater -- the kay is the proportions. When the D/E ratios are the dame, there is a greater chance for screwing around. In ex1 there is no incentive to be hardnosed - you get the same $$ regardless is its debt or equity. Based on the rule that creditors can shut down a business. ex2 gives more incentive to B to act like a cr.
c. RULE - consider repayments when looking at ratios.
C. Code Sections irrelevant for Debt/Equity Characterization. -- 385 is congress's "pathetic attempt" to lend certainty to this area. 358 only gives the treasury the ability to write regs. The treasury has wriiten 3 sets of regs but always pulled them back b/c they were unworkable. So now all we are left with is judge made law.
D. S Corps - the D/E thing is really not as big of a deal in S Corps b/c the whole prob is fueled by the double tax system. Since S corp is a pass thru, D and E are alot alike.
E. Only one owner of a corp that loans money to the corp 6 there is no incentive to be a hardnosed creditors (i.e., your not going to foreclose on yourself). {another set of rules will apply? I think that is what he siad?} OHRS.
F. Refined Distinctions in Debt VS. Equity Law -- Bittker and Eustice (awesome tax treaty) says you have to differentiate between:
1. debt held in Insiders vs. Outisders (b/c of proportionality). Proportionality is a prob when the debt is held by insiders.
2. "straight debt" vs. "hybrid debt".
a. Straight debt = an instrument with all the conventional debt features.
b. Hybrid Debt = an instrument with some characteristics of stock such as debt which is subordinated or convertible.
3. B&E RULES -
a. If you have outsider creditors:
(1) then straight debt will almost always be OK (i.e. not recharacterized by the RIS as equity) unless there is outrageous debt/equity ratios.
(2) Hybrid debt is more risky - must weigh the factors - but there is a good chance it cd be respected as debt.
b. If you have insider creditors and hybrid debt, (say in a CHC) this is extremely risky. Atty sd advise that this area of the law is mushy and this is risky. Even straight debt is risky for insiders if the debt/equity ratios are proportional OR very high.
4. B/c of lack of certainty in this area, Congress has been trying to make this more certain. They have addressed BUYOUTS and MERGERS that are doen with DEBT. See rule re: 2799.
XXXIII. RESTRICTIONS ON INTEREST DEDUCTIONS
A. Certain Corporate Takeovers - interest ddctn limitations - ∍279.
1. RULE - ∍279 reads "General Rule - No deduction shall be allowed for any interest paid or incurred by a corp with resepct to its corporate acquisition indebtedness (which is defined to mean debt that is, inter alia, SUBORDINATED and CONVERTIBLE) to the extent that such interest exceed 5,000,000 reduced by certain weird things (see statute).
2. a. REGS - 279 wd only apply to interest deductions equal to or above 5,000,000 per year AND if the debt was subordinated AND the if the debt was convertible.
b. The KEY ITEM was convertibility. In the 1980's the junk bond were not convertible, so 279 didn't apply.
3. 279 is a Dead Letter - 279 was adopted in 1969 and was therefor geared toward the trxtns that were going on at that time. As a result, when all the funky deals of the 1980s start going on 279 was basically a dead letter law b/c people in the 1980's were able to get around 279.
4. 279 DOES NOT COVER LBOs -- 279 wd apply if Corp A issued debt to buy the stock of CorpB or the assets of CorpB. 1980s LBOs did not fall into these categories b/c in an LBO corpA was buying its OWN stock from its own shareholders (with debt). (i.e. giving debt to the old shhs for theri shs). 279 only applied to buying ANOTHER corp.
B. JUNK BONDS = Applicable High Yield Discount Obligations ("AHYDO") - ∍163(i)(1) - Limitations on Ddctn on OID interest. ohrs - does it have to be a zero coupon bond?
1. Assume the yr=1986 and the corp issues a zero coupon bond (i.e. no interest and 10 yrs from now the holder gets 1000). Holder will pay only $227 if the yield = 16%. This is a AHYDO.
2. Without a special rule, we wd use the OID rules. Under OID rules, as the 227 grows to 1000, the corp gets to ddct the effective interest, but CONGRESS in 163(i)(1) said AHYDOs will be treated diff bc/ these are usually junk bonds, which are used in alot of takeovers (which we are discouraging).
3. AHYDO defined - Any debt instrument if (1) the maturity date of such instrument is more than 5 yrs from the date of issue; (2) the yield to maturity equals or exceeds the sum of the appliable federal rate for the month issued plus 5 percentage points, AND (3) such instrument has a significant original issue discount. 163(I)(1).
a. Recap of Rule = if there is alot of OID AND the interest rate on the 'debt' is very high compared to the mkt rates (when issued), then this will get special treatment (b/c this is not really debt).
b. RAT: why the rules require alot of OID. A: OID means that the debt was issued for say 100 in exchange for the promise of the corp to pay 1000 in 5 years. Congress was concerneed b/c JUNK BONDS used this set-up b/c the issuer corp could not afford to pay the interest currently b/c the i-rate wd be so high (b/c of the risk).
4. RULE/RESULT for falling into 163(i)(1) = The total interest ($900) is split up into two parts:
a. For the Issuing Corp:
(1) Part (#1) of the interst is so risky that Congress felt this was really a dividend -- therefor the corp can NOT deduct it.
(2) Part (#2), the remaining part of the interest, it is so unceratin whether it is going to be paid (b/c the corp cd fold), that the corp is denied the deduction until the corp actually pays the interest. (i.e. when the corp pays out the $1000).
b. For the Investor: One might think that since the corp isn't getting a ddctn, that Congress would go for symmetry and say that part of this was not included in income and the other part is deffered - WRONG.
(1) RULE = w/ re: to the first part of the interest the investor must pay tax on the income even tho the corp cannot deduct it.
(2) RULE = w/ re: to the second part of the interest (the remainder), the investor must treat this like DIVIDEND income, not interest income (this will become important in assginment 9).
5. Recap of Rule for AHYDOs - 163(i)(1)
a. Part of the interest in not ddctible until actually paid (i.e. in 10 yrs); AND the other part of the "interest" is NEVER ddctible. Congress is implicity saying this is like a dividend b/c this is so risky.
b. The bondholders treatment: BH must include the FULL amount in his income just like OID - taxed currently. NOTICE: Non-symmetrical rule (b/c issuer gets diff treatment. VERY HARSH.
c. Therefor, you bifurcate the 16% interest into two components (part ddctible when paid, other part not ddctible). He will give us a handout with examples later.[7]
XXXIV. OTHER (MORE SPECIFIC) FINANCING RULES
A. SMALL BUSINESS INVESTMENT-Captial Loss Conversion Potential.
1. If you sell stock at a loss it is normally a capital loss.
2. Rule - 1244 says that if elected, an individual[8] can transmute up to $50,000 of capital loss into ordinary loss (100,000 for married filing jointly) for losses on "section 1244 stock." Section 1244 stock = small corps (defined as those that have less than 1,000,000 of property paid into the corp for its stock. Determined at the date the stock was issued).
a. RAT: to encourage small business.
b. REMEMBER: capital losses are not usable.
B. NON-SHAREHOLDER CONTRIBUTORS (e.g. Municipalities) ex] Sears gets land and other enticements from a municiaplity so that Sears will build its factor there.
1. RULE: not income b/c this is a contribution to capital made by a NON-SHHS. In distinguishing non-shh cap contrib vs. income, the KEY is that the item will a non shh cap contribution IF sears is NOT performing services (or selling goods) for this item. Kinda like a gift. Notice: here, Sears is NOT giving the muni any stock.
2. RAT: Excluded from income on the grounds that it wasn't earned.
3. BASIS rule. re: the contributed land w/ basis=50; fmv=150. Sears takes the land with a zero basis. NOTE: giving a freebee (the first rule = tax free), but then somewhat taking that away to balance it out. NOTICE: this is just deferral, not a total exemption).
a. Usually the non-shh contributor is a muni that is a non-taxable entity (so the treatment of the non shh is really not a big issue.)
NON-LIQUIDATING DISTRIBUTIONS of CASH - assigns 7 and 8 .
XXXV. Point - Corp tax system = double tax, but 2d layer only happens when E&P is taken out.
XXXVI. BASIC RULES
A. Technical Correctness re: Distributions of Cash / 301 DISTRIBUTIONS.
1. a distribution to shhs w/ respect to their stock is a "301 distribution" (we do not know if its a dividend yet).
2. 301(a) says look to 301(c) to see the tax treatment.
3. 301(c)+316 says if the distribution is out of E&P, then it is a dividend, else it is return of capital, then it is a capital gain. See 301(c)(2,3)
B. DISTRIBUTION HIERARCHY RULE -
1. Distirbution is first out of E&P (earned after 1913) see 301(a) and (c)(1)
2. Next, it is regarded as return of capital (which reduces basis in the stock); and
3. Once basis is reduced to zero, the excess is capital gain.
C. E&P Earned When Corp Owned by Others is Irrelevant.. Notice The Anomoly:
1. SCT RAT: When buyers buys the shs, he will jsut pay less b/c he knows he is buying into a built-in tax gain (i.e. taxes that he will be paying for A, who owned the shs when the gain was earned).
XXXVII. Determing if a Distribution is out of E&P - Nimble Dividends Rule ("NDR") - This is a mechanical rule.
A. First you must identify the:
1. Accumulated E&P ("AEP") as of the prior year end;
2. Current E&P ("CEP") for the entire current yr.[9]
B. Rule - you can have a dividend out of:
1. AEP; or
2. CEP (even if their is a deficit in AEP). (nimlble divs).
C. Mechanics - First look to see if you have a positve CEP.
1. If CEP (at year end) is positive, then the distribution is first used to redcue CEP (and is a dividend to that extent), any remaining amount of the distribution is offset against any positive balance in the AEP (and is a dividend to that extent), if AEP is negative, then the remainder is return of basis.
2. If CEP (at year end) is negative, you need to determine what the accumlated E&P is on the date of the distribution. This entails allocating the CEP (pro rata) based on how far into the year the distribution was made.
D. Examples of the Rule (taken from Rev Rule 74-163 p151).
Assume that on 7/1/87 the corp makes a 15,000 distribution to shh.
1. EX1] Assume:
a. AEP (post 1913 E&P) on 12/31/86= 40,000
b. CEP (on 12/13/87 = 5,000.[10]
RESULT: The entire 15K is a dividend.
2. EX2] Assume:
a. AEP 12/31/86 = (60,000)
b. CEP 12/31/87 = 5,000
RESULT: 5k dividend, then remaining 10k will be used to reduce shh's basis in the stock (if basis is zero, then it will be capital gain.)
(1) Strategy to get around NDR: just wait unitl the next year to make the distribution (i.e. on 1/1/88) b/c then we can aggregate the CEP into the AEP which will result in the AEP still being negative, and if there is no positive CEP in 1988 the distribution will not be a div at all!
3. EX3] Assume:
a. AEP = 40,000
b. CEp 12/31 = (5,000)
RESULT: No NDR (b/c the CEP at year end) so now we look only to AEP on the date of distribtion. To figure out AEP on 7/1 we must allocate the CEP of (5,000) over the current year. Since the distribution happened exactly half way into the current year, half of the CEP will be allocated to the period of the current year before the distribution. THUS, AEP on 7/1 = 40,000 + 1/2(5,000) = 37,500. Thus, since out distribution is 15,000, the whole distribution will be a dividend.
4. EX4] Assume:
a. AEP = 40,000
b. CEP = (55,000)
RESULT: AEP on 7/1 = 40,000+1/2(55,000) = 40k+(27.5k)=12,500. Thus, 12,500 is a dividend and the remaining 2,500 will go to reducing shh's basis in his stock.
XXXVIII. WHAT IS E&P?
A. General Def of E&P
1. E&P is not defined in the code.
2. We have Treas Regs under 312 that gives some examples of what is/and what is not included in E&P. It is a pretty incomplete list - embarrassing.
3. General Rule. E&P = Economic Income.
a. RAT: We use this b/c we only want to tax economic earnings and not get mucked up in other things like paper income/xp.
4. In Practice. In measuring E&P, we start w/ taxable income and adjust from there.
a. ex] tax-exempt municiple bond interest income is added to taxable income to get E&P.
b. ex] You can reduce E&P by the interest xp on loans used to buy tax-free investments (altho these are not tax ddctible). ∍265.
c. ex] Federal Income taxes paid are not deductible (for fed income tax purposes), but they will reduce E&P.
d. ex] 162 wont let you deduct Fines and Bribes and illegal payments, but you can reduce E&P.
B. Specific Items w/ re: to E&P
1. Awaiting insertion of "disribution of property" material
a. E&P when a corp makes a redemption. If the corp recognizes a gain, then E&P increases.
2. Depreciation Xp.
a. Rules:
(1) for taxable income - ACRS allowed.
(2) for E&P - you can only reduce E&P by the SL method (so to get from taxable income to E&P you subtract the diff between ACRS and SL).
b. EX] Assume corp owns equipment using ACRS = $5,000 for this year; but SL wd've been 2000 for this year.
(1) Result: you've hae to add-back 3000 to taxable income to get E&P.
c. RAT: SL is closer to economic depreciation.
3. Installment Sales and E&P.
a. Rules:
(1) for Taxable Income - Installment method of recognizing income is allowed
(2) for E&P - installment method not allowed. Therefor, installment sales revenue is included in E&P (on the date the π is sold). Add-back.
b. EX] Assume corp sells π (basis=1,000; FMV=10,000). Corp gets no cash and a 10,000 n/p (I.O.U.). On the date the π is sold, the corp's E&P is increade by 9,000 (10,000-1,000basis). When you start collecting the note, you can count it in taxable income, so you will have to reduce it from the E&P balance (b/c the full amount has already been recognized - no double counting).
c. RAT: W/out this rule, the corp cd give the shhs cash by borrowing 10,000 against the corp's good credit[11] and the corp cd give the shhs 10,000 cash, which wd not be E&P.
4. Intangible Drilling Costs (oil drilling) and E&P.
a. for Taxable Income - dddctible currently.
b. for E&P - there is an arbitrary rule that makes you amortize this over 60 months. (So add ack a portion).
5. DRD and E&P -
a. The corp (receiving the dividend) taking a DRD must increase its E&P for the amount of the DRD take
6. Bargain Price on Options - see Devine v. Commissioner. p. 153
a. FACTS: Corp makes a big distribution to shh = Devine. Corp tells shh that this is not a dividend b/c the corp has no E&P. IRS says there is E&P here.
b. ISSUE: The corp had been giving stock options to e/ees. The options allowed the e/ee to buy stock at the fixed price of 1000, even if the FVM of the stock was higher when the option was excercised (say 3000).
(1) TAX treatment when the option is excercised:
(a) Not taxable to e/ee even tho he makes big money!!! Great deal for e/ee.
(b) Corp cannot deduct these stock options b/c of a special rule for options. Notice: these two rules ARE symmetrical (not taxable/not ddctible).
(2) PROB: The corp charged the 3000-1000 "bargain element" against E&P. (here it amounted to 3.4MM).
c. OPTIONS RULE -- Although the "bargain element" on options is not deductible, it still reduces E&P.
(1) HLD: J/TP - these options ARE chargeable against E&P b/c it is like a compensation xp to the company. To illistrate:
(a) if the corp gives 3000 FMV of stock to the e/ee for his salary, the corp can deduct 3000 (b/c of the circle of cash theory).
(b) If corp issues e/ee a stock option at 1000, but its worth 3000 FMV, this is economically like giving 2000 salary exepense.
XXXIX. S Corp - generally see fn.[12]
A. Crit Q = "when was the s corp formed"?
1. S Corps formed after 1983 cannot have E&P (thus you can blow these rules off).
2. S Corps formed before 1983 may have E&P.
XL. E&P STRATEGY.
A. Individual shhs do NOT like E&P in the issuing corp (b/c then distributions will be divs and therefor taxable)
B. Corp shhs like E&P in the issuing corp b/c it means the distributions are dividends and they can take a DRD. (If not E&P, then the receiving corp wd just reduce its basis in the stock and then have capital gain.)
XLI.Dividends Recieved Deductions ("DRD").
A. General Rule - Corporate shareholders get a DRD. (The corp shh will include the div in its income, and then get a ddctn).
B. Rat for having a DRD in the Code: Avoid triple taxes.
C. Specific Rules:
1. if corp I owns < 20% of the corp II, then corp I gets a 70% DRD.
2. if corp I owns 20-79% of corp II, then corp I gets an 80% DRD.
3. if corp I owns >= 80% of corp II, then corp I gets a 100% DRD.
D. Rat for various percentages = continuity of investment. If you own >= 80%, then you are treated as one economic unit (i.e. an "affiliated corp")[13] If you own < 20% you only get a 70% b/c this is really only a "portfolio investment." (you are not one economic unit).
1. CRIT - theoretically this result for Just file a paper w/ the RIS - a Non-Taxable Event!).
A. Rule: C 6 PS = taxable; C 6 S = non-taxable.
LVII. Example #1 (Generic)
A. basis in stock = $100; FMV = $1000.
B. Corp liquidates and gives you cash or property (doesn't matter which) worth $1000.
C. RESULT:- Shh
1. Treated as a good redemption (i.e. a sale). $900 capital gain.
2. GREATE LOOPHOLE! E&P is flushed down the john! If the corp had a ton of E&P is doesn't change the result. Shh gets a break!
3. Shh's basis in the π received = $1000.
LVIII. Example #2 (AofL)
A. Stock basis = $1,000.
B. Shh received 10,000 in a liq, but subject to $7,000 debt, wcich shh assumes.
C. RESULT
1. Shh
a. $2,000 capital gain. (deemed receipt of 10-7 = 3)
b. Shh's basis in the π = $10,000. (wierd b/c you only got taxed like you recevied $3,000. BUt basis = 10,000 to give the correct result. If shh sold the π to 3d, 3d wd only five the shh $3,000 + AofL = $10,000. Therefor we need a basis fo 10k so that shh wont have a g/l).
LIX. FX on the Corporation
A. Example #3 - Corp FX
1. Corp distributes π it held w/ a 1000 basis (fmv=5000).
2. Result: Corp has a $4,000 gain.
3. The Anti-GU rule applies to non-liq AND liq distributions.
4. Q: If corp isn't around to pay its tax bill on the gain, the IRS can come after the SHHS (b/c they recevied too much) = "Transferred liability."
LX. Do Not Stuff a Liquidating Corp w/ Aprrecated Property.
A. Shh owns π worth 1000, basis 200. Shh contributes π to Corp in a valid 351. Shh's basis in teh stock becomes 200. Corp's basis in the π = 200. Corp distributed the π in-kind back to shh in a liquidation. RESULT SUX b/c corp has a 800 gain and shh has an 800 gain - DOUBLE GAIN (even tho the gain acfured economically in shh's hands).
LXI. Stuffing a Liquidating Corp w/ Loss Property.
A. Sitch: shh owns stock w/ basis=100. Corp has R/E w/ basis=100 and fmv=600. Regardless of how the corp gets rid of the π, the corp is gonna have a 500 gain. But shh has a great idea. Shh contributes π1 w/ 800=basis, 300=fmv (a built in 500 loss) in a valid 351. Result: the 500 loss will be used twice. Absent a special rule the corp would have zero g/l. And shh (before the liq) had a 900 basis in the stock and gets 900 fmv in the liquidation, thus shh has zero g/l.
B. Anti-Stuffing Rules.
1. WHERE the loss accured. Disting between loss accrued before vs. after contribution. 336.
a. RULE - we will only disallow the loss that accrued in the shh's hands.
2. TIME -- 336(d)(2). Disting on when you stuff in the loss π in relation to the liq.
a. RULE - if you stiff loss π outisde of ____yrs before the liq then you are OK.
(1) Short time looks like an abuse.
(2) 2 yrs of less is "pressumed to be tax avoidnace motive."
b. NOTE: if you have pateince, you can do great deals!
3. Disting on whether the π was distributed to a related party.
C. FX of anti-abuse rules - if they apply, the corp is limited in taking the loss.
1. "In general - No loss shall be recognized to a liquidating corp on the distribution of any property to a realted person if:
a. such distribution is not pro rata; OR
b. such property is "disqualified property."
(1) "disqualified property" means π which is acquired by the liquidating corp in a trxtn to which 351 applies during the 5 yr period wnding of the date of the distribution.
D. CAUTION - if you look at old exams, they are more detailed than he is requiring for this year's exam.
E. We dont have anti-stuffing rules outside of the liq context b/c if we have a non-liq distribution you cant recognize loss b/c of 311. Liq distribs are the only place you can recognize losses.
SUBSIDIARY LIQUIDATIONS - assign 20.
LXII. Sitch - Sub liquidates and distribs all assets in kind to Parent.
A. If P is an individual this wd be a taxable event. If P is the corporate parent of sub (80%) then its non-taxable.
LXIII. 332 REQs
A. P has to own at least 80% of sub's stock starting from the date of adoption of the plan of liq and contintuing at all times until the receipt the property. [To sabotage 332 just drop below 80%.]
B. A 332 liquidation must be done either:
1. withing one year (w/out plan)
2. within three years if you have a plan.
LXIV. 332 is not elective. If you fall into 332 you cannot recognize a g/l.
LXV. RULEs (effects of successful 332)
A. FX on Subsid
1. Distributions to Parent - There is no g/l.
2. Distributions to the Minority Shh - The sub will recognize gain but not loss. 336(d)(3).
a. Rat: no loss on disrtibs of depreciated π to min b/c cherry picking.
3. Special rule if P is a tax-exempt org - now sub will be taxed. 337(b)(2).
B. FX on Parent
1. P has no g/l. 332
2. P gets carry-over basis in sub's property. 334/.
3. P inherits sub's tax attributes:
a. holding period on assets
b. sub's E&P goes up to P
c. sub's NOLs go uo to P.
C. FX on Minority Shh
1. Tax - Will have G/L based on shh's basis in his shares - the FMV of property received in the liq distribution.
2. Basis -
a. If G/L is recognized on the property being distributed, then Shh will have a FMV basis. 334(a).
b. OHRS - what if no g/l was recognized on the distrb?
LXVI. Basis Carrys Over - 332 OHRS - EXPLAIN THIS
A. Assume Sub has assets worth 20mm and 5mm=basis.
1. If P BUYS the stock of sub for 20mm, P's basis in sub's stock wd be 20mm.
2. If S liquidates into P - P takes 5mm basis in assets (carry-over). The 15MM basis DISAPPEARS - so you wd never do this trxtn.
LXVII. If you want to recognize a LOSS, you have to sabotage the trxtn so that you fail 332. This will put you under the regualr rules for liquidations (see above).
LXVIII. Example of Subsid Liquidation w/ a Minority Shh. p 355 prob #6.
A. P corp owns 80% of sub; minority shh owns 20%. We liquidate the sub. RESULT:
1. Majority shh - see above.
2. Minority shh - this is a taxable deal. ∍336.
a. This means that the min shh will have g/l (based on his basis in his shares); and the subsid can recognize gain but not a loss b/c of 336(d)(3).
B. FACTS: X-Corp is owned by unrelated shhs: A-Corp (80%) and B (an individual) (20%).
1. A's basis=300k (fmv=800k). B's basis=600k (fmv=200k).
2. X-Corp has 2 peices of π. π1 has basis=200k (fmv=500k); π2 has basis=800k (fmv=500k). Both parcels were transferred to X in a 351 two years ago. At that time π2 has a basis of 800k (fmv=900k).
3. X-Corp has AE&P on 100k, but no current E&P. What are the tax results if X-Corp distributes the assets pro rata (i.e. A and B will be joint owners of both peices on π)? Notice π2's loss accrued totally inside the corp. (So ther is no problem with that).
4. RESULT:
a. Majority Shh ("A"):
(1) π1 -- A will get 80% of the basis (160,000).
(2) π2 -- A will get 80% of the basis (640,000).
(3) A recognizes no gain or loss.
b. Subsidiary:
(1) Subsidiary recognizes gain on π1 of 20%(300,000) = 30,000.
(2) Subsid has a loss on π2 - but subsid doesn't get to recognize losses, furthermore, there is no netting of g/l allowed.
c. Minority Shh ("B")
(1) B's basis in his shares was 600,000, but B only got 200,000 FMV worth of property. B recognizes a 400,000 loss. 331(a).
(2) B's basis in the property = ??????????????OHRS. see 334 - for each piece of property or does B get to net?
LXIX. Moving property around in realted corps tax free:
A. 351 allows you to drop assets down
B. 332 allows you to liqduiate and send assets up.
LXX. Aside on Consolidated Tax Returns.
A. Can only only used by members of an "affliatied group" = 80=% ownerhsip. RAT: treating these TPs as one TP - one economic entity.
B. Business point - have multi corps b/c of liabiltiy; other purposes; min shhs in the sub but not the parent; stock incentives for sub's e/ees.
C. FX of filng consolidated:
1. can net sub1's losses against sub2's gains. SHELTERING INCOME.
2. Sale of π between grop members is not taxed
3. you can move cash back and forth between entities w/out creating dividends. Tax free cash flows.
PENALTY PROVISIONS - Accum Earning; Personal Holding Co, Collapsible Corps. -- Assign 22.
LXXI. Background
A. 1981 - Inidividual = 70%; Cap gains for individuals = 28%; corp rate = 46%.
B. Individual is a shh in a corp. Corp has $1000 income. It was better for the corp to accumulate then distribute. You wd accumulate in the corp and then bail out at capital gains rates. Congress's response = the penalty provisions for accumualted earnings.
LXXII. Accumulated Earnigns Penalty - 531
A. What - This is an additional tax on corp's excess accumualted earnings - incentive to distribute.
B. Not Moot Post 1986 - it is better to distribute immiediately, BUT 531 is not moot b/c IRS cd atill attack and Clinton is about to make corp rates lower thatn individuals again (accum bailout strategy might be employed again).
C. S-Corps. This doesn't apply
D. A.E.T. Rate = 28%. Rat: 28% was set at a time when the max individual rate was 28%. (AET didn't increase w/ the individual rates - washington just stupid/lazy).
E. Scope of 531. Section 532 says AET only applies if there is a Tax avoidance motive AND 533 says it only applies to accumulated earnings beyond the reasonable needs to the business.
1. Valid business reasons:
a. for cyclical busniess
b. plans for expansion/capital expenditure
c. to retire debt in X yrs.
F. If you fail the test you are only taxed on the amount of accumlated earnings which is unreasonable (i.e. part for which there is no valid bus purpose). 535(c) gives procedure for separating the good from the bad part.
LXXIII. Personal Holding Companies - "Incorporated pocket books."
A. Sitch - when individ rates were 70% and corp rates were 46%, you wd drop your income earnign assets into a corp in a 351 and let income accum at corp's low tax atmosphere. Let the income build up and then bail out. [NOTE on the 351: watch out b/c 351 doesn't apply to investment companies - but there are ways around this. It only covers mkt securities - not R/E. see supra.]
B. Two Prong test to see if this is a PHCo (must satisfy both prongs).
1. 60% of more of your AGI per year (w/ some technical adjs) represents personal holding co income (dividends, incterest, O&G royalties, rents received, etc).
2. More than 50% of the corp has to be owned by 5 or fewer people. So you can avoid PHCo Tax by having 6 unrelated people as owners. Attribution 544 applies.
C. FX of being a PHco -- "the unrestricted PHCo income is taxed at 28%."
1. Note: this is a penalty tax (so the shh is still taxed upon distribution).
D. PHCo rules are very mechanical (unlike the Accum Earnign Tax whcih is pretty subjective re: bus purpose).
E. Currently there is no incentive to accumulate in a PHCo.
F. Overlap w/ A.E.T. NOTE: Corps can not be nailed for both PHCo tax and A.E. tax. 532(b) says if both sets of rules apply, the PHCo rules trump.
LXXIV. Aside -- When is a C corp still good for tax reasons?
A. C corps are exempt from passive loss and at-risk rules.
LXXV. S Corps
A. 1363(a) - S corps are not subject to these rules (makes sense b/c they are pass thru). But there is one exception:
1. A C Corp w/ big E&P. You want to retire. Since you knwo the PHCo rules dont apply to S corps you make an S election and then invest in stocks and securities. The income from the stocks flows thru to you but the E&P goes away. Basically turning a C corp into a PHCo and not being taxed on the E&P. CODE SOLN = there is a special rule for s corps that used to be C corps w/ E&P and alot of passive investments. This rule applies the PHCo penalty tax.
LXXVI. Collapsible Corporations
A. RULE - When selling stock of a collapsible corporation, the gain is treated as ordinary income (not capital gain); But you can still get to use your basis.
B. Sitch - film makes or homebuilders. Set up a corp to build houses. If corp sells houses it will be ord income (b/c its inventory), but if before selling the house the shh sells his stock then the shh will get capital gain. BUt now 341 requires this to be ordianry income.
C. TEST for a collapsible corp - 341(e)
1. RULE - 2/3 of the ord income must be recognized by the corp. Then the corp will not be collapsible.
2. If the corp sells its inventory before you sell you stock, then the corp has the ord income and we are no longer a collapsible corp.
D. Currently, 341 is not important b/c not a big capital gains pref. AND 341(f) allows you to bypass the rule anyway.
TAX FREE REORGANIZATIONS - ASSIGN 23
LXXVII. General Stuff
A. Stock deals (using stock of your corp to buy another corp) are generally nontaxable.
B. Cash deals
1. Sellers are taxed;
2. Buyers get a stepped up basis.
C. 351 may also apply (check that too)
D. Overview - 3 typs of tax-free reorgs:
1. One-Party reorgs (recaps and reincorps)
2. Acquisitive reorgs
3. Devisive reorgs.
LXXVIII. Overview Cateogries
A. Acquisitive Reorganizations (Type A, B and C).
1. RULE Results
a. A takes a carry-over basis in the assets from T corp. 362.
b. T shhs take a substitute basis on the stock of A-corp which they now own. 358.
2. Type A. - Statutory Mergers/Consols. 368(a)(1)(A).
a. T merges into A; T ceases to exist.
b. T shhs now own A-corp stock.
c. Consolidations -- both corps cease to exist and a new corp is formed.
d. Boot is allowed.
3. Type B. - Stock for Stock deals. (tender offers)
a. T shhs exchange their T shs for A-Corp stock.
b. T survives
c. There is an 80% ownership rule.
d. Boot not allowed.
4. Type C - Stock for Assets deals
a. Same result as a merger; T is dead.
b. A-Corp gives its stock in excahnge for Assets of T-Corp. T corp then liquidated and gives its S-corp stock to the T shhs
5. Type A vs. Type C.
a. If you are a public corp you may need to get shh approval from the Aquiring corp to the a Type A. Type C is much easier (no vote req'd).
6. Business Reasons
a. Want T to survive.
(1) Do a Type B.
(2) Reverse Trinagular merger.
b. T's Tort Liability. (Dont want T to ever be inside A).
(1) Do a Type B. (A's assets will never be subject to T's liabilities).
(2) Do a traingular merger. (Drop some A-corp stock into a sub in a 351 and merger T into sub [or] sub into T).
7. Forward Triangular Mergers.
a. T shhs get A corp stock.
b. T's liabilities will go into sub, never into A-Corp.
c. Result: Ex-T shhs and A shhs own A-Corp; A-Corp owns Sub (which includes the former T-corp).
d. 368(a)(2)(D) allows this trxtn.
e. Corp Law - Forward Tris are easily done. For a merger you have to get the shh approval of the corp which is bering merged into (here that is the sub). Since the Parent corp is the only shh of Sub, getting shh approval is no prob. If we did the deal as a Type A, this wd be a big pain in the ass.
f. Cont of Interest is arguable satisfied b/c the ex-T-Corp shhs now own shs of Parent, which owns Sub (where T corp now resides inside).
g. Result looks like a typeA and then dropping the target out of A and into a sub. But better to do it as a forward tri b/c then parent is never subject to T's tort liability.
8. Reverse Triangular Mergers.
a. T survives. Becomes a subsidiary of Parent.
b. Ex-T-Corp shhs get stock of Parent. 368(a)(2)(E).
c. Better than doing a type B b/c here you dont have to convince the t-corp shhs to trade their shs for A-corp stock.
d. A rev tri avoids the problem of fid duties to minority shhs. If there are t-corp shhs who dont want the merger, we can cash them out (via dissenter's rights).
e. Result looks like a Type B but better to do a rev tri b/c less headaches (like fid duty to min shhs)
9. LBO = taxalbe b/c t corp shhs get cash+debt.
10. S Corps can do Type As too.
11. Tax Free Hostile Takeover -- (i.e. management of T is resisting the takeover).
a. Can't do an A or C b/c the BofD will not submit a merger plan to the shhs.
b. Type B (Tender Offer) will work! It will be non-taxable if the consideration to t-corp shhs is solely stock.
c. This results in minority shhs. Therefor we now do a reverse triangular merger to squeeze them out.
B. Devisive Type D.
C. Type E - Recapitalizations.
1. Switiching around the classes of stock
D. Type F - Reincorporations.
E. Type G - Bankruptcies.
LXXIX. Recapitalizations.
A. Q: IS THIS A VALID "RECAP"?
1. Bazley (p360) - A "recap" under state corp law may not be a "recap" under the IRC.
a. Facts:
(1) TP = H&W own all shs of corp. In the recap, old common is exchanged for new common + debentures which were callable by the corp at any time; TPs claim tax free recap
b. HLD: J/IRS. The debentures were more like cash, hence this is not a valid recap. Shhs got a 301 distribution (there is no req that there be a realized gain).
c. See reading notes (4/12).
d. Anaylsis:
(1) IRC does not define "recap" so the cts define it in terms of the policy behind this section. The cts focus on CONTINUITY OF INTEREST.
(2) Here we fail the test b/c the corp cd call the debentures at any time (since H&W were maj shhs). Therfor this is the equivalent of getting cash. SCT interprets the IRC based on its policy. Th epolicy here if to give tax free treatement when your investment is diff form but you still have a continuing participation in the interest. Here H&W just cashed out.
2. Rule for Securities in a Good Reorg (and recap). Under 354(a)(2), if we have a "good" reorg (which we didn't even have that much in Bazley), we have a rule for the receipt of "Securities." (Securities under the code are defined as Long Term Debt.)
a. 354(a)(2) does NOT say this is a bad reorg, it merely says that to the extent there is a GAIN you have income on the debt securities received.
(1) Ex] Shhs give up old securiteis (debentures) with a principle amount of 200 in exchange for new stock and new debentures with a 250 principle amount. Assuming there is plenty of gain realized we have triggered 50 of boot.
(2) EX] If the deal was giving up 100 old debt for 100 new debt there wd not be any booot.
(3) RULE - if there is gain realized in the exchange, the boot will cause the gain to be recognized. In 354 you can get as much boot as you want if its a good reorg and there is NO realized gain. (the boot will just reduce basis)
(a) In 354, gain recognized is limited to gain realized or FMV boot. Just like in 351.
3. Probs on p490 p3+
LXXX. CONTINUITY OF INTEREST REQUIREMENT FOR TAX FREE REORGS.
A. Paulson.
1. S&L merges into a mutual association.
2. Shhs of a S&L exchange S&L shs for "shs" in the mutual.
3. HLD: Taxable deal.
4. Literal compliance w/ the code is not enough to get a tax free reorg. Policy matters too. Here there was no cont of interest b/c we went from shares to basically cash. The ct said the mutual "shs" were more like debt than equity - the equity interest was deminimus.
a. The mutual "shs" were not subordianted.
5. Rule - a mutal assoc merging into another mutual assoc is non-taxable. But a corp merging into a mutual is taxable. This is an embarrasment to the SCT bc/ the theory sd be that you only look at what you receive irrespective of what you give up. Therefor in theroy an M-to-M merger sd be taxable too.
B. IRS's Private Letter Ruling Policy for Cont of Interest. IRS will give a PLR if 50% or more of what the shhs get in the merger is stock of the aquiring corp. 50% in value.
C. May Kass v. Commissioner.
1. Acra corp owned by Kass, Casey (C), Levy (L), and Others.
2. C&L want to take over Acra. C&L form a new corp, Track. C&L give their Acra shs to Track in excahnge for Track stock. So now, Acra is owned by Kass, Track, and others.
3. Track buys 80% of the Acra stock from others (tender offer). Now Acra is owned > 80% by Track, and Kass. Kass didn't tender her shares. Now Track merges into Acra and Kass ends up owning shares of Track (in a 1:1 swap). Now Track is owned by C, L, and Kass.[27]
4. Now, C&L can change the business policies of the company.
5. Kass argues that this is a state law merger and that she sdn't be taxed b/c Kass only got shs of the acquiring corp. (looks like a good type A).
6. HLD: No Cont of Interest. Kass is taxed. No CofI b/c we look at it through the shhs point of view. If Track had held the shs of Acra for 5 yrs there wd've been a prob. Step-Trxtn.
a. There is no significant CofI in the historical shhs of Acra. This is so b/c track specifically bought these shares for CASH as part of the same deal (stepped together). The Step-Trxtn Doctrine intregrates the tender offer and the merger into one trxtn. So we have to look at the people who tendered thier shs too as being in the group of historical shhs. When we look at the historical shhs, only 16% of what they for was stock - the rest was cash -- therefor TAXABLE!
7. Notice how unfair this is to Kass.
8. Notice: we also consider what C&L got in the initial 351 trxtn (which set up track) b/c we've stepped together everything.
9. Notice: Ct held that Kass can't say she was part of the 351. The ct says that the 351 was not distinct for the merger pruposes but was distinct for the 351 control req. This is an inconsistancy in the opinion.
D. MacDonald's p378.
1. Garbs owned various corps and those corps owned various McD franchises. Garbs and McD (corporate) didn't like each other. McDs is thinking of buying the businesses from Garb. In the deal Garb wants cash, but McD wants to do a Pooling of Interests (for financing reporting) b/c in a non-pooling there may be goodwill which will have to be amortized and drains earnings. GAAP rules say you can't use cash in a pooling. So McD wants to do a merger where Garb will get McD stock.
2. Garb doesn't want this b/c of the SEC probs. Garb cannot sell the stock in the mkt b/c these shs were not registered!
3. Gard negotiates for "piggy back rights" -- In the next McD registration, McD will also register the Garb shs. This is the deal that eventually was struck.
4. The assets of Garb were dropped into a subs of McDs in a 351.
5. The merger was done in April.
6. The offering is registered in October; Garb sold its shares in October.
7. TP = The subsidiary. The resulting McD subsids claimed this was not a good reorg. Therfor the merger was taxable and the sub gets stepped-up basis. (i.e. McD's/Subs goal was to do a polling for book, but taxable for tax purposes).
a. Actually McD corporate doesn't care b/c if McD uses stock and buys assets, it is taxable to the sellers of the assets, not McDs (1032). Corp never has gain for issuing its stock to get π.
8. IRS argues this is a valid non-tax reorg (type A). thus, the subs sd have carry over basis.
9. TPs argue the step trxtn doctrine. We step together the april merger and the sale of the stock by Garb in october, so we really bought the assets of garb with cash. Notice, this is only 6 months apart. Cash is not a cont of int therefor not a valid tax free reorg.
10. IRS says thar Garb was NOT OBLIGATED to sell its stock.
a. Diff cts have diff veiws of the strength of the step trxtn doctrine (there are 3 view, one if "the biding committments view." which syas you cant integrate unless these is a binding committment.a
11. HLD: J/TP. Ct doing IRS a favor. The Step-Trxtn doctrine covers this deal. The ct even notes that under the binding committments th of the step trxtn doctrine, the TPs would still win b/c the piggy back rights were hotly bargained for.
12. Next day notes
a. Garb doesn't care if its a good merger b/c they sold the shs w/in the SAME YEAR.
(1) If it is a bad reorg - we wd tax shhs in April (the merger) and on any appreciation between april and october.
(2) If a good reorg then Garb wd just take a low basis and then a big tax hit in october when the shs were sold.
b. If the merger had been in yr-1 and the slae in yr-2, Garb wd care b/c of tax deferral.
c. Also, if Garb sold only SOME SHS. If this is a good reorg then it affects the stock that is retained.
(1) If a good reorg then you get tax free
(2) If not a good reorg then you are taxed on the date of the merger w/ resepct to the stock you keep.
d. Also, atty for Garb sd require a K provision that McD not take any tax position contrary and if they do they have to indemnify Garb.
e. If McD wins (and it is a good reorg), Garb is not bound by Res Judicata b/c Garb was not a party.
E. Other Examples of Cont of Interest.[MAJOR ISSUE = WHAT CONSIDERATION ARE THE SHHS RECEIVING? (EQUITY?)
1. Cash (Boot) + Stock -- Example #1
a. 10 people each own $100,000 of stock in Target.
b. T will merge into A, T shhs each get $75,000 common of A-Corp and $25,000 cash.
c. Result: No CofI problem. Cd even get a Pvt Letter Ruling. B/c >=50% of the value received is stock.
2. Cash (Boot) + Stock) -- Example #1a.
a. Consideration = $25,000 stock + $75,000 cash.
b. Result: Doesn't meet IRS guidlines for givingg PLRs. And in May Kass, they said 16% was not enough.
c. Therefor, if we fail the CofI requirement, the stock will be taxable too b/c you flunk the reorg rules and it will be considered a run-of-the-mill taxable exchange. (Fmv proceeds - basis given up).
3. Non-Voting Callable Pref'd Stock is OK too - Example #2
a. Consideration = $75,000 pref'd stock + $25,000 cash.
b. Same Result (non-taxable). Cts uniformly hold that pref'd stock is counts for CofI.
c. Great Loophole b/c lloks alot like debt.
4. "Securities" (LTDebt) is not counted as Continuity of Equity Interent (for CofI pruposes).
5. Critique of 2 vs. 3. -- Just a formalistic distinction that makes no sense.
6. Other Shhs Actions.
a. Example 1
(1) 10 shhs
(2) Your clients are shh-1 and shh-2
(3) An all stock deal
(4) Shhs 3-10 sell ther stock shortly thereafter (unbeknownst to your clis).
(5) Result: If step-trxtn applies, then 8 shhs got cash and 2 got stock. (only 20%). Not a good reorg for your clients. SURPRISE!
(6) To protect clients, Get contractual reps and wars from other shhs. They warranty that they have no intention to sell and if they do sell they will indemnify you.
(7) How long do you have to hold the stock?
(a) Depends on which version of the step-trxtn doctrine the jur applies.
(b) IRS says 5 yrs is OK and 1 yr is probably not under general circs. However, TP can show change of circs where he need the $ (medical emergency) AND there was not a PLAN to sell when the deal was negotiated, then TP OK.
b. Example 2
(1) 10 shhs
(2) 8 shhs sell all sotck for cash to 8 new shhs.
(3) Then T merges into A and exchange for stock.
(4) Cli = 2 shhs that didn't sell for cash.
(5) Result: If Step-Trxtn applies, then we fail CofI b/c we lok at historical shhs and only 20% of those people received stock. Kass.
c. Hypo
(1) H&E own Mom and Pop store and merge store into General Electric. H&E receive only GE shs.
(2) Result: CofI satisfied.
(3) Crit: nontaxable even tho H&E only own a fraction.
LXXXI. CONTINUNITY OF (HISTORYIC) BUSINESS ENTERPRISE REQ FOR TAX FREE REORGS
A. Judicially developed doctrine
B. RULE - Either the business of T or the significant assets of T have to be retained by A-corp in order to have a good reorg.
C. RAT: To prevent A-Corp from taking the assets and then selling them just after the merger.
D. Examples.
1. Generic
2. T is a lumber will; A makes machinery.
3. T merges into A in exchange for A-corp shs.
4. If A sells the mill just after the deal, it is not a good reorg.
5. Selling Off Assets before the merger
a. If before the merger T sells the mills and becomes an investment co and then does then merger.
b. Result: If under the same PLAN, step-trxtn will apply and the mill is the historic business. Therefor not a good reorg.
c. When T shhs get the A-crop shs they will be taxed.
6. Selling off Only SOME Assets After the Merger
a. T has a mill and a drug store
b. T merges into A
c. A keeps the drug store and sells the mill.
d. Result: This is OK is the drug store is a "significant line of business.
LXXXII. BUSINESS PURPOSE REQ FOR TAX FREE REORGS
A. Rule - if a merger is done for tax avoidance and not a valid business purpose, you will not get tax free treatment.
B. Gregory v. Helvering.
LXXXIII. TYPE A REORGs
A. General stuff - Very Flexible.
1. Can use pref'd stock (no prob).
2. Merger valid under state law (else it might be a C)
3. Cont of Interest test
4. Cont of Business Enterprise test
5. No other reqs
6. Some Boot is allowed (but limited by the CofI test).
a. Can have up to 50% BOOT and still get a private letter ruling from the IRS.
b. Courts have approved deals where there is more than 50% boot.
LXXXIV.TYPE B REORGS (STOCK FOR STOCK)
A. REQS
1. Consideration must be VOTING stock.
2. Must have "control" (80% of T) after the deal. "control defined in 368C9), same as in 351.
3. Continuity of Interest docrine is met here per se b/c NO BOOT is allowed in a type B. You have good contintuity assuming there are no step trxtn problems.
a. T's legal fees (in connection with the deal) may be paid by A - this is not considered boot for purposes of disqualifying you for a type B. Rev Rule Rat: this is considered a reqord xp of the whole deal.
4. Continutiy of Business Enterprise Test applies.
B. General
1. T ends us being a subsidiary of A.
C. Reverse Triangular Merger. - The code allows the consideration to be voting stock of the parent. The parent has to own 80% of the sub.
D. Chapman (p394).
1. RULE - if some of the shs are bought w/ cash (boot) the deal fails even if a control chuck (80%) is bought with voting stock.
2. FACTS:
a. ITT corp wants to acquire Hartford insurance.
b. Nov 1968 - ITT buys 6% of Hartford stock - for cash
c. Jan 1969 - ITT buys 2% of Hartford stock - for cash
d. ITT makes a tender offer: ITT voting stock in excahnge for Hartford stock. The T.O. is successful and ITT ends up owning over 80% of Hartford stock.
3. ISU: Was the acquisition of the early shares (w/ cash) part of the same trxtn (as the T.O)? Is stepped together this wd not be a valid B, which means it wd be a taxable exchange.
a. If this fails Type B -- It wd be a taxalbe exchange of the Hartford shares. No one else wd be taxed b/c ITT deosn't have income for issuing its own stock.
4. TCT HLD: the 8% is irrelevant b/c the tender offer alone would've satisifed the 80% control req, so we dont even look to the earlier shit. Therefor tax free b/c control was acquired solely with voting stock.
5. 1st Cir HLD: Reverse. Step-Trxtn ropes this together.
a. RAT: Evans says there is no rationale for this holding (requirment).
b. 1st Cir Rat: Focuses on the IRC -- "solely" in excahnge for stock is not ambiguous so we cant go beyond the statute. Therefore is cash is used in the same deal, it is not a type B. Stare decisis - everyone has always though no boot in a B.
6. Assume that before the T.O., ITT divested itself of the stock - sold it to 3d. IRS said this wd be a good B. Now assume the there was a gentleman's agreement for 3d to sell the stock back to ITT at anytime. This wd now be a taxable deal b/c 318 says "options" are treated as "stock" and it is not really a sale (ITT still owns the stock).
E. Creeping Acquisitions OK for type B.
1. Ex]
a. 1962 - A buys 20% of T-corp stock w/ cash.
b. 1974 - A buys another 20% of T-corp stock w/ cash.
c. 1993 - A buy the remaining 60% of T-corp stock w/ voting stock of A-corp.
d. RESULT; the 1993 deal is a valid B.. The step-trxtn doctrine will not apply b/c steps are too far apart. (If we did step things together it wd fails B b/c part of teh consideration wd be cash). Note; the first two trxtns were taxable.
e. Note: the only req is that A own 80% of T after the deal.
2. Rule - creeping aquisitions are OK for a type B.
3. EX] A aquired 80% of T for cash in 1960, then in 1993 A acquires 20% of T for A-corp voting stock. RESULT: This is still a good B. The only req is that you have control after the deal. It doesn't matter that you have control immediately before. And since the trxtns are so far apart, no step-trxtn prob.
4. Type B + Liquidation of T -Corp. Caution: - Recharacterization into a Creeping C.
a. Sitch = A acquires T in a B (stock for stock), but as part of the deal, T-corp liquidates. All of T's assets go up to A-corp.
b. FX: Rev Rule says this will be considered a type C (stock for assets deal).
c. Result: If T was acquired in a creeping B, it will probably flunk tax free treatment b/c creeping C's are problematic.
d. RULE - Type-B plus a merger of T into A will be considered a type C (b/c of step trxtn).
LXXXV. TYPE C REORG -- STOCK FOR ASSETS.
A. REQS
1. Consideration must be voting sotck.
2. Must be buying substantially all the assets of T.
a. IRS private letter rulings: "at least 70% of gross or 90% of net whichever is higher."
(1) See ex p409.
(2) Ex] T has 100 assets and 10 debt. Therefor, to get a PLR, you must buy the greater of 70%(100) or 90%(90), which means the greater of 70 or 81. you must buy 81 of T's assets to get a PLR.
b. Case law - TPs have won with less than the IRS %ages.
c. Notice - Forward and Reverse Triangular Mergers also have a requirement of "subtantially all the assets." see (a)(2)(D and E).
3. T must liquidate as part of the deal.
a. RAT: so that we have Cont of Int w/ respect to T-corp shhs.
b. T shhs end up owning A-corp shs (b/c T liquidates).
4. Boot seemingly not allowed (b/c same statutory language as B).
a. AofL is not considered boot (unless you have some other boot too). 368(a)(1)(C).
(1) RAT: b/c purchase of assets is usually accimpanied by AofL.
b. Boot Relaxation Rule - You can use of to 20% boot and still qualify for a good C. However, if you use any boot, then any AofL will also be considered boot (for purposes of the 20% limit). 368(a)(2)(B). Once you use boot, 80% of the targetr corp must be purchased w/ voting stock. Ex in fn.[28]
B. Results of Failed C.
1. Example] A-corp pays 100 cash + 500 voting stock for T-corp which consists of 1,000 assets + 400 debt. RESULT: this is not a good C b/c 50% of the consideration is boot.
2. Tax FX: T-corp shhs are taxed. The cash wd be taxed anyway but not the stock received by the T-corp shhs will also be taxed! T-corp will also be taxed (a separate corp level tax).
C. Concerns of A-Corp
1. Make sure that before the purhcase of assets (C), that the target corp didn't get rid of some of its assets.
a. EX] in June 1993, we are gonna do a C. However, in April of 1993, T took 40% of its assets are redeemed one of the t-corp shhs. Prob = Step-Trxtn cd apply and now A corp has not acquired substantially all the assets. The HISTORICAL assets.
(1) Make sure the prior deal is old and cold.
(2) Get reps and wars + indemnification. ("T corp has doen nothing unusual w/ its assets in the most recent years").
b. Same test applies to triangular mergers. Note: there is no similar req for As and Bs, but they have the Cont of Bus enterprise test.
D. Reasons to do a Type C.
1. Same result as a merger. De Facto merger.
2. Do a C when a merger is not feasible.
a. Sale of assets does not need shh vote of A-corp.
3. Boot relaxation rule.
E. Creeping Cs are Problematic.
1. Bauch & Lomb. TP (B&L) owned 70% of a sub. Completely old and cold. TP then issued its stock for all the assets of sub and then sub liquidated. Therefor we end up w/ TP owning all T's assets and the 21% min shhs now own stock of TP. TP ended up getting some of its own stock back when the sub liquidated.
a. IRS response: Since TP gave its common stock, but got it right back, it didn't use its OWN common stock in the deal. TP really used 70% of sub's stock (+21% of its own) to qcauire the assets of T corp. RESULT: Not a good C b/c this is a massive amount of boot. 79% boot and only 21% of its own voting stock.
b. Therefor if you liquidate your sub, you acquire assets of the sub in exchange for stock of sub.
c. The Boot Relaxation Rules say you can have up to 20% boot.
2. EX]
a. A buys 5% of T in 1974
b. A buys 10% of T in 1988
c. A buy 85% of T in 1999.
d. RESULT; Under Bauch, the olf and cold ownerhsip of T (15%) is viewed as acquiring target w/ the stock of target, which is boot. Now the AofL of target will be included in boot. So it will still be a good C if there is only 5% AofL. (not over the 20% boot barrier).
LXXXVI. REVEIW OF ACQUISITIVE REORGS
A. Types
1. A, B, C, Forward Triangle, Reverse Triangle.
B. Consideration must be Voting Stock??
1. A - NO
2. B - Yes
3. C - Yes
4. FTM - No
5. RTM - Yes
C. How Much Boot is Allowed?
1. A - 50% boot still ok (cont of int)
2. B - 0%
3. C - 20% (plus inclusing of AofI).
4. triagulars - too complicated for this class.
D. Creeping Reorgs (i.e. steps too far apart to bring togehter)?
1. A - yes
2. B - yes
3. C - Not generally. (see Bausch)
4. FTM - Yes
5. RTM - No
E. Substantantially all the assets
1. A - No
2. B - No
3. C - Yes
4. FTM - Yes
5. RTM - Yes.
LXXXVII. DEVISIVE REORGS -- ∍355
A. Rationale for allowing tax free treatement = CofI (shh owns the same thing, just in a different form).
B. FX on Shhs for a tax free D. (when corp gives you stock of another corp).
1. if 355 applies the shh is not taxed
2. Some of the basis in your original shs (AT&T) is spread out (hops over) onto the new stock (SWB) based on reltavei FMVs.
C. Potential Abuse w/ a D.
1. Abuse = Change E&P into capital gains + basis recovery.
2. ex] I and L want to get money out of corp at CG rates and use their bases. They have cash cropped into a new corp in exchange for new corp stock (in a valid 351). Then new corp stock is distributed to I and L in a devise D reorg. Now I and L can either:
a. liquidate new corp (in which case they get cap gains + basis recovery); OR
b. sell the new corp stock to 3d. (cap gains + basis recovery).
3. However, Gregory steps in to say this is not gonna be tax free. FX = shhs willbe taxed as if they got a 301 distribution.
4. Cf partial liquidation - only benefit is that shh gets cg instead of a div. But, corp has gain on a distribution of apprecaited assets.
5. Cf. a valid 355, the corp will not have gain on the spin-off/split-up/split-off of appreciated property AND the shhs wont have gain.
D. Gregory v. Helvering - You will not get tax free treatement if there is no valid busniess reasons for doing the devisive D.
E. Types of Devisive Reorgs. - See attachment #4
1. Spin Off -- X corp dumps assets into Y corp (in exchange for Y corp stock); X then gives y-corp stock to the shhs. This resembles a distribution to the shhs. NOTE: spin-offs can be pro-rata,e ven tho this looks lilke a dividend.
2. Split-Off -- X corp dumps assets into Y corp (in excahgne for Y corp stock); X then gives Y corp stock to the shhs in exchange for the shhs' x corp stock. Loos like a redemption.
3. Split-Up -- X corp dumps some assets into Y corp, some into Z corp (in exchange for the stock of those corps). X corp then distributes the Y and Z stock in the liquidation of X corp. Looks like a liquidation.
4. Busniess POint -- Split ups and Split offs are good to gets rid of shhs that hate each other. This works b/c they are giving up their shs of the old corp.
F. Requirements for a Tax Free D (under ∍ 355).
1. Valid Business Purpose. (Gregory)
2. 5-Year Rule -- Both the distributing corp and the control corp have to be involved in an active business for the last 5 years.
a. EX] I and L own the corp. the corp is a clothing mfger w/ alot of cash inside. The corp takes the cash and buys a dry cleaning business, the drops the dry cleaning busniess into a sub (under 351) and makes a distribution of the sub stock to the shhs in a spin off.
(1) RULE/Result: The busniess cannot be purchased in a taxable trxtn w/in the last 5 years.
b. EX2] Corp gets the dry cleaning business in a valid type C reorg. The dry cleaning business had been around for 10 years (i.e. owned by previos people for 10 yrs).
(1) RESULT: This is Ok b/c its not a taxable deal. (Rat: CofI).. Satisfies the 5 year rule.
c. If new corp is aquired in a tax free reorg (or a 351) then you get to tack the length of ownerhsip of the prior owner (for purposes of the 5 yr rule).
3. Devise Test - the reorg cannot be a deivse for distributing E&P. This is a Facts and Circs test. These are the factors to consider:
a. A pro rata distribution (looks like a devise).
b. If there is a subsequent sale fo the stock by the shhs (this looks like a devise)
c. If there is alot of cash and liquid assets dropped into the new corp. (looks like a devise).
d. If the business is an incidental business that merely serives the original corp and cd easily be gotten rid of. (looks like a devise).
G. FX of failing the rules for Tax Free Devisive D.
1. Corp I will have a taxable gain. (the FMV of the Corp II stock distributed to the shhs minus Corp I's basis in the corp II stock).
2. Shhs will be taxed:
a. If a pro-rata spin-ff, this looks like a DIV.
b. If a split off, then a REDEMPTION.
S CORPORATIONS
LXXXVIII. Income/Loss flows thru to shhs when earned, even if not distributed.
A. Shh recognizes the income/loss
B. Increases/Decreases shh's basis in his stock.
LXXXIX. Cash Disrtibutions
A. Rule For distributions (on any of these three).
1. First, Any cash distribution are non-taxable to the extent that it is a payback of income which was already allocated to you form the S corp.
2. Next, it comes out of E&P (a dividend).
3. Last, any extra distrib will reduce your basis. (then capital gain).
XC. Separately Stated items - tax things flow thru with the same caharacter. (i.e. interest income / capital gain).
XCI. Shh's Basis in their stock -
A. Corp Income (wehn eanred) increases your basis.
B. Corp loss (when earned) decrease basis.
C. Distibutions (this differs depending on the circs).
1. Virgin S (formed afteer 1982).
a. All cash distributions are a reduction of basis. (Remember you were already taxed when the income was eanred). Anything beyond your basis is a capital gain.
2. There are three ways you cd have E&P.
a. Non-Virgin S (i.e. a C corp that elected S status).
b. S Corp participating in Reorgs can have E&P. EX] a valid type A where a C corp merges into an S corp. The acquiring corp inherits all of targets tax attributed including E&P.
c. A pre-1982 Virgin S. (cd have E&P b/c of atechnical problem in the rules).
XCII. S Status Eligibility
A. Only one class of stock
B. 35 shhs (Rat: to avoid revenue loss)
1. Who can be a shh
a. No Non-resident aliens (i.e. an alien living in Mexico)
b. Shh's Estate - OK
c. Trusts allows if the income goes to ONE benef immidiately. Grantor trusts.
d. BK reciever.
e. Corp - NO WAY
(1) However, an S corp can be a shh of a C corp is S owns less than 80%.
f. PS - NO WAY
(1) However, an S corp can be a partner.
XCIII. Terminate S status
A. Violate a rule
B. Get an agreement of more than 50% of the value of the shhs.
XCIV. When S Corp's Pay Corp Level Tax.
A. If C elects to be an S.
1. Special Rule = 1374: If you convert to an S, and w/in 10 years after the election you sell the π, there will be a double tax on the built in gains (all unrealized gains present on the election date - tainted). The S corp will be taxed at 34% (the highest corp rate).
a. EX} C corp had π with 1k basis and 10k fmv. S election is made. The π is sold. S has a 9k gain and pays tax on that gain. 9k gain, net of taxes, flows thru to shh's basis (9k)(1-34%). Shh has to pay income taxes on the 9k(1-34%). Then the S corp can distribute the proceeds (of 6994) to shhs. Shh reduces basis and is not taxed.
XCV. PHCo Tax?
A. S corps are nto subject to PHCo tax, but have somethins similar.
B. 1375 -- If S corp has E&P from being a C corp, and S has passive income 25% of gross receipts of the S, then there is a 34% corp level tax on the XS passive income.
1. Note, the base rule is one sided -- only applies to gains.
2.
C.
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[1] Ex] E owns Intel shs, A owns Exxon shs, and K owns Aspen Ski Co shs. Assume all the shs have apprecaited. Everybody contributes their shs to a new corp in exchange for shs of new corp. NOTICE: we have achieved diversification. (if 351 applies, it will be tax free).
[2] i.e. securties used to be treated the same as stock.
[3] (Notice, the intitial creation of debt does not create taxable income b/c assets(cash)=liabilitiesa(n/p).
[4](good result, b/c titiesa(n/p).
[5](good result, b/c the stock is worth 50,000 - and all the gain was recognized).
[6]OHRS _ CHECK ON THAT STATEMENT
[7] there is no triple tax prob (see immed below) b/c the issuer corp gets a ddction. See result below 9.
[8]OHRS -- find this.
[9] Looks like this doesn't apply for corps.
[10] The book sometimes listed - Current E&P mid-year ("CEPm-y") from the first day of the current yr until the date of the distribution. BUT NOTE: this one is really not nec for any calc.
[11] CEP for the full year.
[12] You cdn't sell the n/p or pledge it as security for the credit b/c this wd trigger the gain.
[13] Incomde of the corp flows through to shh, immediately raising the shh's basis in the stock, but upon distribution he shh reduces his basis.
[14] affliiated corps can also file a consolidated return.
[15] OHRS - I dont understand how the 5 people come into paly -- I thought we were just looking at one corp's DRD.
[16] Assume corp X has pref'd stock outstanding w/ a 9% yield.ssume a 70% DRD sitch. Assume you cd borrow money at 11% to buy the pref'd stock (which gives a 9% yield). this looks like a sucky invesment.
However, absent a sepcial rule this wd be a good investment after taxes b/c:
Error! Main Document Only.. you ddct the interest on the loan (11%)(34%)=3.74 reduciton of taxes. Therefor the after-tax cost of borrowing is 11.0%-3.74% = 7.26%! Thus we have 7.26% vs. 9% = arbitrage. However, you have to compare the 7.26 with the LIMITED DRD. (1-70%)(9%) = 2.7% = the amount taxed. (2.7%)(34%) = .92% = the effective tax rate of this investment. Therefor, the after tax yield on this investment = 9%-.92% = 8.08%. NOTICE: now this is a good investment b/c you can borrow at 7.26 to get a return of 8.08 (all after taxes). It is still arbitrage, but not neerly as abd.
[17]OHRS - check on this - it seems like investors corps SD get a drd.
[18] Repealed in 1986. RAT for repeal: Appreciated property used to fulfill a business purpose is an economic benefit to the corp and therefor is taxable.
[19]OHRS - confirm this.
[20] Remember E&P is an attempt to follow exonomic income. Here, we have an economic loss of 5,000. So, E&P sd go down by 5k; plus we have a distribution of 15k, which causes E&P to go down. Therefor 5+15=20 drop in E&P.
[21]ohrs - run this example by EVANS.
[22]{really it is loke a 5% stock dividend}.
[23] when the effect is that some shhs get π/$ while others get more stock. Surprise to people getting stock b/c the FMV of stock recieved = 301 distribution.
[24] OHRS - I'm not sure why this triggers 304. Is it b/c C and E 'control' B corp BEFORE the trxtn?
[25]ohrs - sd'nt this be "B corp stock"
[26] TO DO -- clarift this when you get the new edition of the outline 304.
[27] See reg 1.306-1(b)(2).
[28] This fact is no longer relevant, but it helps in understanding the case. The reason to have Track buy the assets was 338 gave Tracj a stepped up basis.
[29] Example 1] A-corp pays 100 cash + 800 voting stock for T-corp which consists of 1,000 assets + 100 debt. RESULT: this is still a good C b/c we only have 20% boot, the rest of the consideration is voting stock.
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