Corporate Tax: Class Notes

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8/23/2007

Revision 0.1


Author: Philip Larson







Corporate Tax: Class Notes

































Corporate Tax: Class notes


Philip Larson


Page
2




Table of Contents

1.

Lect
ure 1

................................
................................
................................
.......................
3

Corporate Tax: Class notes


Philip Larson


Page
3




1.

Lecture 1

1.1

Corporate Tax

-

Professors

o

David Ernick



Treasury Dept. in tax policy. All international tax. Worked in some law
firms.

o

Josh Brady



Senior manager at KPMG specializing in corporate tax. ..., … and Pick
ering.
Used to work at Arthur Andersen.

o

David Ernick
-

(202) 622
-
1754
-

davidernick@hotmail.com

o

Josh Brady
-

(202) 533
-
7042
-

jtbrady@kpmg.com

-

Basic Concepts

o

Formation

o

Liquidate

o

Mergers, Acquisitions

o

Pay Dividends

o

Things done at the end will build on th
e things at the beginning.

-

Background

o

A: BUY STARK & KLEIN
Corporate and Partnership Income Tax Code and Regulations,
Selected Sections
.

o

We are going to look at the words of the statute.

-

Goals of the Courts

o

Not

to calculate a corporation’s federal inc
ome tax liability.

o

Think “outside the box”


we will frequently focus on the shareholders.

-

Course Art

o

Corporations are rectangles

o

Shareholders are ovals

o

Unincorporated Assets are in fuzzy circles

-

Realization & Recognition

o

Remember these from Income Tax.

o

Realization vs. Recognition


what code section addresses recognition? § 1001 is the big.



Realization is a broad concept. It is a hair trigger where you exchange one type of
asset for another. Realization is an exchange. Your relationship to the prope
rty has
somehow changed.



Recognition is the specialized term that says a particular realization is taxable. Not
every realization event is subject to recognition.



§ 1001 is likely to come out and grab you and tax the event.

o

HYPO: A buys 10 shares of

google for $1k total. Basis is what you paid for it. A sells it to B
for $4k.



Amount realized: $4k.



Basis: $1k.



AR


Basis = gain/loss

o

HYPO: A buys 10 shares of Google for $5k and sells it to B for $4k.



Loss = $1k.

o

HYPO: A exchanges 10 shares
of Google of $1k for 100 shares of Yahoo worth $4k.



Exchange





A has income of $3k that is recognized at the time of the transaction.



§ 1031
-

Like
-
kind exchanges are allowed in some cases, but mainly restricted to real
estate and buildings.

o

HYPO: A

buys house, puts $20k down and owes $80k and sells house to B for $500k.



AR = $500k



Basis = $100k (basis assumes the mortgage


you get credit for borrowed money in
your basis which is why you don’t get the deduction when you have to pay off the
bank).


Corporate Tax: Class notes


Philip Larson


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4






This is an amazing thing. With a building, you get to depreciate the building. Each
year you get to depreciate the building and use that as a deduction to offset income.



Can you depreciate land? No, you can’t depreciate land because it doesn’t go away

(except close to the shore).

o

If someone takes a liability off of your hands, that goes into the
amount realized
.
Economically and taxwise, if B takes the mortgage and only pays you $420k, the AR is still
$500k.

-

Nonrecognition Transactions

o

Unless you qu
alify for a nonrecognition transaction, § 1001 is going to come out and tax it.

o

These are a matter of
legislative grace

and usually have strong policy considerations.



Corporate formation, mergers, and stock
-
for
-
stock acquisition.

o

Usually a matter of d
eferral (i.e. timing) via:



Transferred

basis to transferee and



Exchanged

basis to transferor

-

Overarching Themes

o

Character


ordinary income vs. capital gains



Historically, long
-
term capital gains have been taxed at lower rates.



Presently, most capital ga
ins are taxed at 15%



Due to “sunset” on December 31
st
, 2010



Highest ordinary rate for individuals is presently 35%



Due to sunset on December 31, 2010 (and return to 39.6%)



But “qualified dividend income” is taxed at 15% capital gains rate (until
December 3
1, 2010).

o

Corporations as separate taxable entities



Undistributed income



generally not taxed to shareholders



Distributed income



taxed at both the corporate and the S/H level (the “double tax”)

-

Overview of Corporate Income Tax

o

Taxable Income
-

§ 63



Gr
oss income minus deductions allowed



§ 162 Trade or business expenses



§ 163 Interest



§ 164 State and local taxes



§ 165 Losses



§ 167 Depreciation



§ 172 Net Operating Losses (if you lose in yr 1 and 2 but make money in 3)



§ 199 Domestic production


domestic
manufacturers; rate pattern with a
3% rate cut. This is basically a subsidy.



§ 243 Dividends received

-

Do problem on page 23 and 62.


PROBLEM: Page 23

-

Income

o

Gross profit



$2.5M

o

Dividends received


$100k

o

Capital gains



$200k

o

Municipal Bond Interest

$10k

-

Expenses and Losses

o

Operating Expenses


$600k

o

ACRS depreciation (5 yr, $400k cost)


$800k

o

Net loss from passive leasing

$130k

o

Capital losses


$220k


-

A) determine Boots taxable income and its regular tax liability for the current year.

o

Tax rates from

§ 11(b)



15% up to 50k

Corporate Tax: Class notes


Philip Larson


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5






25% from 50k
-
75k



34% from 75k to $10M



35% above $10M



Note: if TI exceeds $100k, tax is increased by lower of 5% of excess or $11,750.

o

Taxable Income = AGI


deductions



AGI = gross income


business expense deductions



Ordinary Income



Add

o

Gross profit


$2.5M

o

Interest Income

$10k

o

Dividends


$100k



Subtract

o

Operating Expenses

$600k

o

Depreciation


$800k



Ordinary Income = $2,610k
-

$1,400k = $1.21M



Capital Gains



Capital Gains


$200k



Capital Loss



$220k



Capital Loss = $20k

o

Potential Answer:
$50k*.15 + $25k*.25 + $1,135*.34 = taxable ordinary income



Note: $20k capital loss

o

Questions?



Can capital loss offset ordinary income?



How do you add ordinary income and capital gain to get adjusted gross income?

-

B) What result in a) if Boots distributes

$330k to Emil and Betty as dividends?

o

They should be able to deduct another $660.

-

C) What if instead of paying dividends, they pay salaries of $500k each?

o

Deduct $1M.

o

Other things Emil and Betty could do? Perks, jet flights, stock options, etc.


P
ROBLEM: p62

-

A, B, C, D and E form X corp. X issues 100 shares of stock.

o

A


$25k for 25 shares

o

B


inventory worth $10k ($5k basis) for 10 shares

o

C


unimproved land $20k (basis $25k) for 20 shares

o

D


equipment worth $25k ($20k depreciated) for 25 share
s

o

E


note in exchange for land w/. $2k

-

a) Tax Consequences (assuming this
group

takes
control

after the transactions, then the following is
the case)

o

A



$25k basis


no tax liability until she sells per § 351 (because she is part of a group
that will have
80% ownership)

o

B



$5k basis


no tax liability

o

C



$20k basis


can’t transfer losses

o

D



$5k basis ($25k
-

$20k depreciation)

o

Questions



We don’t know the value of the 100 shares. Therefore, these transactions are hard to
determine.

-

B) tax consequences to X
corp

o

None. It has just received property in exchange for stock

-

C) per § 362(e)(2)(A)(ii) p61 note 8, Parcel #1 would have basis of $10k (can’t pass on losses), and
Parcel 2 would have basis of $8k.

Corporate Tax: Class notes


Philip Larson


Page
6




-

D) Corporation is taxed on the $5k gain. B also gets ta
xed on the gain. Why is this? No idea.



Lecture 2 (start at “Introduction” slide 14)

8/28/07

-

Incorporation increases marketability, easier to attract capital, you can IPO.

-

Limited liability is a benefit.

-

Tax law has evolved to have an LLC


you ca
n get the limited liability, you also get the pass
-
through
tax that approximates the tax you would get as a partnership (avoid double taxation). That was a big
policy issue.

-

Deductions

o

§ 162


trade or business expense


corporations are presumed to hav
e a business purpose for
most expenses

o

More later.

-

Overview of Corporate Income Tax

o

§ 11 gives the rate schedule

o

Progressive tax rates



o

Bubble brackets


5% additional tax


when you get up to $335,000, it brings your total rate
up. These “Bubble” br
ackets wipe out the progressivity of your previous earnings.
Everything is taxed at a total of 35%.

-

A Look at the “Double Tax”

o

Results from taxes on dividends. One way around this is by paying salary rather than
dividends. Note: taxes on dividends is
at a
qualified rate

of 15%. Preferential capital gains
rate. Same on qualified dividends. By paying in salary, that becomes a business expense that
becomes a deduction. You can loan money to a corporation and the corporation could pay
deductible intere
st. We like to fund it with debt rather than equity because you can reduce the
corporation’s tax that it will pay. Funding with equity, does that help? From a tax point of
view, what is the preference? Debt is better because you can deduct the interest

payments.
There is a
preference for debt
. You would rather loan money to the corporation than put it in
as equity.

o

Ordinary income you pay a 35% rate.

o

If you had a low corporate tax and a high personal rate, you would want to keep your money
in the
corporation. Not too long ago, if the individual tax rate is high (90%) you would
incorporate, put all the money in the corporation, get taxed at 35% and keep the money in the
corporation as long as you can. Defer the tax for as long as possible. There
were various
anti
-
abuse measures to prevent this.

o

Recognition vs. realization.

o

Sole Proprietorship

o

Corporation A Tax

-

Overarching Themes

o

In addition to the IRC, there are common law rules including:



Assignment of Income



Lucas v. Earl
case


pay to my wif
e because she is in a lower bracket.
Court says that you can’t just assign income to somebody else if it is
actually yours.



Substance over form



Look at the substance of the transaction. The form the transaction takes is
not as important as the effect or
substance of what actually happened.



Salary


if you paid someone $10M and he only has a highschool education,
maybe it is more like a dividend than a salary.



Step transaction



You may setup a transaction in multiple steps and applying the tax code to
the

steps would get a different result. If you tax A
-
B, B
-
C, and C
-
D you
may get a different result than taxing A
-
D. Can we set aside what actually
happened and tax the total.



Business purpose

Corporate Tax: Class notes


Philip Larson


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7






What was the business purpose for the transaction other than r
educing
taxes?



Sham transaction/economic substance



Essentially looking at whether the transaction actually occurred. This is
almost fraudulent. Was it a sham transaction? Economically, was there
potential for a profit or were you only trying to reduce

your taxes.

-

Corporate Classification

o

§ 7701(a)(3)



The term “corporation” includes associations, joint stock companies, and insurance
companies.



If you want to be taxed as a corporation, you can basically decide at this point. We
won’t look too much to
the statutory definition. (“check the box” decisions on how
you want to be taxed)


Problem on p23


IN CLASS

o

INCOME



Sales: $2.5M



Dividends: $100k



Capital Gain: $200k



Municipal Bond interest: $10k (excluded under § 103(a))



Total Income = $2.8M

o

DEDUCTIONS



Operating Expenses



Depreciation: § 167



Net Loss: $130,



Capital Loss: $200k (limited to their losses to the extent of their capital gains § 1211)


this is different than individuals that can offset up to an additional $3k of ordinary
income.



Dividends
Received: 70% of dividends received from other corporations
-

§ 243


dividend received deduction
.



Why does a corporation get a dividend received deduction? Promote
corporations investing in other corporations. This prevents a
triple tax
.

o

Total: 1.8M

deductions, 2.8M in gross income. $1M net income.

o

§ 11(b)(1)(a) says to start with the first 50,000



15% * 50,000



25% * 25,000



34% * 925,000



+ $11,750 (
flush language



if TI in excess of $100k)


the effect of this tax…what
effect does this have? It t
axes the company at EXACTLY 34%.


NEW SLIDES


“2 Corporate Formation”

-

Corporate Formation (slides “2 Corporate Formation”)

o

A and B contribute assets to corporation and get back stock.



What is going on here from a tax point of view? They have exchange
d property.
They have engaged in a realization event. Their relationship to the property has
changed. They have given property in exchange for others which creates a
realization event. Is there recognition? Do we have to pay tax on that game?
General

rule…



§ 1001(a) says generally that anytime you exchange property, any realized gain must
be recognized unless it is under a
nonrecognition

section of the code.

o

Is this a good time to impose tax?



No. Valuation problems. Additionally, you want to prom
ote investment in the
company. It is a mere change in form. If you just had A and he put his assets in a
corporation in exchange for all the stock, it is really just a change in form. That
might be different than if we had 100 people contributing proper
ty and now you have
this corporation that has all the land, you have a relationship to NEW property.

Corporate Tax: Class notes


Philip Larson


Page
8




o

What would be the other thing about imposing the tax?



Corporations would happen a lot less. Congress has the
double tax

that discourages
corporations b
ut they try to encourage it with a
non recognition provision
.



§ 351



1) transfer of property



2) solely in exchange for stock



3) transferor must be in “control” of the corporation “immediately after the
exchange” (80%).



§ 368(c) gives definition of “cont
rol” and this requires “ownership of stock
possessing at least 80% of the total combined voting power”



§ 351 is our
non
-
recognition provision



A & B can transfer the assets without
recognizing any gain on the transaction.

-

Applicable Code Sections to
Trans
ferors

o

§ 351(a)


no gain or loss to transferors

o

§ 368(c)
-

defines “
control


o

§ 358(a)


preserves asset
basis

in stock

o

§ 1223(1)


preserves holding period

-

Applicable to the
Transferee corporation

o

§ 1032(a)


no gain or loss on issuances of stock.

o

§ 362(a
)


generally preserves asset
basis

of transferor



§

362(e)


basis stop
-
down for built
-
in losses


step
-
down basis to the FMV.



Why do we have this? Prevents duplication of losses when putting assets
into the corporation. Can’t duplication of loss. This i
s an
anti
-
abuse
provision
. You can’t duplicate the loss.



Why double tax the gain? In most corporations, you aren’t going to turn
around and sell the asset and the stock right away. There are lots of ways
for the corporation to do other things with the
asset (e.g. like
-
kind
exchanges).


8/30/07

-

Overview of § 351 Requirements

o

Property requirement



one or more persons must transfer property to a corporation.



Almost everything counts as property, with a few exceptions.

o

Stock requirement


the transfer
must be solely in exchange for stock of the organization,
and



Look at things that may look like stock but aren’t stock.

o

Control requirement


the property transferor, or transferors as a group, must be in
control

of the corporation immediately after the

exchange.



80% requirement

-

Ov

PROBLEM: p62

-

A, B, C, D and E form X corp. X issues 100 shares of stock.

o

A


$25k for 25 shares

o

B


inventory worth $10k ($5k basis) for 10 shares

o

C


unimproved land $20k (basis $25k) for 20 shares

o

D


equipment worth $25
k ($20k depreciated) for 25 shares

o

E


note in exchange for land w/. $2k

-

a) Tax Consequences (assuming this
group

takes
control

after the transactions, then the following is
the case)

o

A



$25k basis


no tax liability until she sells per § 351 (because she i
s part of a group
that will have 80% ownership) § 358 says they get $25k basis; Corp
-

§ 362(a)
preserves the basis

o

B



$5k basis


no tax liability; § 358(a); § 362(a)

Corporate Tax: Class notes


Philip Larson


Page
9







“Inventory” under § 1221 is not a capital asset, which means that the
holding period
res
tarts

at the time of the transaction.

o

C



$20k basis


can’t transfer losses


what do we call this property? “
Built in Loss
Asset



basis for transferor is $25k (unless they make an election), basis for
transferee is $20k.

o

D



$5k basis ($25k
-

$20k depr
eciation); there will be depreciation recapture at the
corporate side but not at the transferor level;

o

Questions



We don’t know the value of the 100 shares. Therefore, these transactions are hard to
determine.

-

B) tax consequences to X corp

o

See above…

-

C)

per § 362(e)(2)(A)(ii) p61 note 8, Parcel #1 would have basis of $10k (can’t pass on losses), and
Parcel 2 would have basis of $8k.

o

Note: on a transferor by transferor basis, add up all the property they provide and see if there
is a “built in loss”. If

so, the corporation takes the FMV basis and the transferor

o

§ 362
-

You reduce the basis only regarding the “built in loss” assets


therefore, you start
with $15k and you reduce it $3k to get $12k and the basis in #2 is $8k.

-

D) Corporation is taxed on t
he $5k gain. B also gets taxed on the gain. Why is this? No idea.




351(a)


the “Control” Requirement

-

“control, as defined in § 368(c)”

o

§ 368(c)



At least 80% of total combined
voting power

of all classes entitled to vote and



Look at all the stock ent
itled to vote (whether it is 1 vote per share or
10/share doesn’t matter


it all gets lumped into voting stock, of which you
need 80%)



At least 80% of total
number

of shares of all other classes of stock (i.e. non
-
voting
shares)



If you have 100 shares of
non
-
voting Class A stock, and 200 shares of non
-
voting Class B stock. Rev. Rul. § 59
-
259


(revenue rulings are the IRS’s
litigating position and they are bound by these rulings)


you need 80% of
each of the non
-
voting classes of stock.

-

“Immediately af
ter…”

o

What does immediately after mean?
Immediately

has been interpreted as meaning
immediately.
Step transactions



you can’t look at a transaction in a vacuum. You have to
see whether other steps should be included in the transaction to look in substa
nce at what is
happening.

-

Intermountain Lumber Co. v. Commissioner

o

Rule: if the deal is a “
binding commitment
”, you look at whether they own 80% after the
deal.

o

HYPO: form really does matter. Wilson could have taken the $91k and contributed it to the
new corporation for 182 shares. Shook could have contributed a sawmill to S&W for 182
shares in the new company. This would have been a § 351 exchange. Unfortunately, Shook
took 364 shares in the new company in exhcnage for the sawmill, and Wilson took
182 shares
from Shook for $91k.

-

Step transaction doctrine



applies in Intermountain Lumber.

o

Binding commitment test



this is what people look to in a § 351 exchange to see whether
the steps should be
bundled together
.

o

Economic interdependence


tes
t that is somewhere in the middle.

o

End result



test that only looks at the end result

-

§ 351 uses the “Binding Commitment” test, not “economic interdependence” or “End result”
.


Corporate Tax: Class notes


Philip Larson


Page
10




Problem 71

a)

A & B are unrelated individuals. A forms Newco, Inc. on ½ of th
e current year by transferring
property with a basis of $10k and a value of $50k for all 50 shares of Newco common stock. On
March 2, in an unrelated transaction, B transfers property with a basis of $1k and a value of $10k
for 10 shares of Newco nonvotin
g preferred stock.

a.

A


property FMV $50k basis $10k


for all 50 shares of common stock


A’s
transaction is NOT a § 351 transaction and is not taxable because it doesn’t own 80% of
the nonvoting stock.

b.

B


property FMV of $10k basis $1k for 10 shares
of nonvoting preferred stock


B’s
transaction is not a § 351 transaction because they don’t have 80% of the voting stock.

c.

NOTE: however, if this transaction takes place at the same time, you add all of A’s stock
and all of B’s stock, and together they o
wn. This is a § 351 transaction

b)

If part of the same plan, it is a § 351 transaction.

c)

They have control “immediately after” so the gift doesn’t screw up the § 351 transaction. Hard to
say that the gift was part of the original transaction. However, if
the gift took place between the
two transactions that are part of the same plan, it is a much harder problem. This would
potentially cause A to have a valid §351 but not B.


MISSED CLASS LAST WEEK



C. Treatment of “Boot”


Nonqualified preferred stock
(not qualified for purposes of §351), it’s not treated as stock
for purposes of the §351 transaction. For every other purpose, it’s treated as stock.


If you get boot, you recognize the gain to the extent of the boot.


For SH basis of the property giv
en: start with the original basis (§358(a)(1), subtract the
FMV of the property permitted to be received (§358(a)(1)(A)(ii)) and add the amount of
gain recognized on such exchange (§351(a)(1)(B)(ii)).


For Corporation basis of the property received: st
art with the original basis (the SH’s
basis!
--
§362) add the gain recognized by the SH on the transfer


1. In General

IRC §§ 351(b); 358(a), (b)(1); 362(a). Skim § 351(g).

Regs §§ 1.351
-
2(a); 1.358
-
1,
-
2; 1.362
-
1.




IRC § 351(b) provides that if an exchang
e would have qualified under § 351(a)
but for the boot, the transferor’s realized gain (if any) must be recognized to the
extent of the cash plus the FMV of the other property received. No loss can be
recognized.



To avoid double taxation on the gain, SH m
ay increase his basis in stock,
securities, or the other property by the amount of recognized gain



SH’s combined basis in the stock, securities, and other property received from the
corporation is equal to: basis in the property transferred to the corpor
ation plus
the gain in the transfer



For the corporation, § 362(a) provides that its basis in the property received is the
same as the transferor’s basis increased by the gain

Corporate Tax: Class notes


Philip Larson


Page
11






Allocating the gain between multiple items of boot is tricky

Revenue Ruling 68
-
55


Revenue Ruling 68
-
55 (1968)



Gives example of individual who transfers multiple property items and cash in
exchange for stock



Asset
-
by
-
asset approach for computing the gain realized in the exchange requires
that for the purpose the FMV of each category
of consideration received must be
separately allocated to the transferred assets in proportion to the relative FMV of
the transferred assets



The allocation of the boot to the assets is based on their relative FMV



Figure out the total FMV of all assets tran
sferred in. Figure out percentages for
how much each asset is out of the whole. Take this percentage and multiply it by
the total boot received

this allocates the gain between multiple assets.



The holding period of the property received is the same as
the property transferred
in.


2. Timing of § 351(b) Gain

Regs § 1.453
-
1(f)(1)(iii),
-
(f)(3)(i), (ii), (iii) Example (1)




Dealing with installment boot


Problem (p. 81)


Transferor

Asset

Adj.
Basis

FMV

Rec’d from Corp

A

Equipment

15,000

22,000

15 share
s common stock ($15,000)
+ $2000 cash + 100 shares
preferred stock ($15,000)

B

Inventory

7,000

20,000

15 shares common stock ($15,000)
+ $15,000 cash


Land

13,000

10,000


C

Land

20,000

50,000

10 shares common stock ($10,000)
+ $5000 cash + note ($35,000

in
two years)


What are the tax consequences (gain/loss realized and recognized, basis and holding
period) of the transfers described to each SH and X Corp?


Tax Consequences to SH:

Transfer

Gain/Loss
realized?

Gain/loss
recognized?

Basis in stock?

Holdi
ng Period

A

$7,000 (($15k +
$5k + 2k)
-

$15k)

$2,000 (limited
to boot received
by § 351(b)
taxed as
$15,000 ($15k
-

$2k + $2K); you
prorate the basis
b/w the two types
Tack onto corp’s
h潬摩湧= 灥r
i潤o
灥r₧ㄲ㈳=ㄩ
=
Corporate Tax: Class notes


Philip Larson


Page
12




ordinary

inc)

of stock based on
the FMV of each
class.
1


B

$23,000 (($15k
c.st ock + $15k
cash)
-

$7k basis)

$15,000
(limi t ed t o boot
received by §
351(b))

$20,000 ($20k
-

$15k + $15k)

Same as corp’s


Tax Consequences t o Corp:

Trans fe r

Gai n/Los s
re al i ze d?

Gai n/l os s
re cogni ze d?

Bas i s i n as s e t?

H
ol di ng Pe ri od

A


None

$17,000 ($15k +
2k)

Tack ont o corp’s
h潬摩湧= 灥ri潤o
灥r₧ㄲ㈳=㈩
=
B
=
=
k潮e
=
␳㔬〰〠A␲に‫A
␱㕫A
=
=
C
=
=
k潮e
=
␶〬〰〠A␲に‫A
␵欠⬠␳㕫A
=
=
=



9/11/2007

-

Pr o b l e m p 81 Ba c kg r o u n d

o

I g n o r e C

o

He wi l l p o s t t h e a n s we r t o t h i s p r o b l e m o n TWEN. H
e ’ l l p u t u p t h e a n s we r t o C a s we l l.

-

Pr o b l e m p 81

o

A


allocate based on fair market value

o

B


what are the effects to B and what are the effects on X Corp. (
FROM SYLLABUS


AsSUME basis in land is $13k instead of $25k)



If someone transfers assets with a
net built in loss, §362(e) comes into play and the
problem becomes virtually impossible. That is why they change the basis to $25k).



B transfers two pieces of property: 1) inventory, 2) land



If you see more than one piece of property and you see boot, rem
ember
Rev. Ruling 6855? This will be
on the exam
.



Inventory: has a gain



B Land: has a loss



He gets 1) 15 shares of stock and 2) $15k in boot. We have to figure out
what is recognized.



When there is boot and multiple properties, what should you think
about doing?



Some gain and some loss.



We will have to allocate the stock and the boot across the assets. When you
need to allocate things in tax, it should be based on
fair market value
.
Allocate the stock and the boot based on the FMV.



Value of wh
at he transferred is $30k (inent $20k, land $10k). 67% inventory, 33%
land.



Find out what is realized:




1

$15,000 + $5,000 = $20,000


Common stock = 15,000/20,000 = 75% of total gain ($15,000) = $11,250


Preferred stock = $5,000/20,000 = 25% of total gain ($15,000) = $3,750

Corporate Tax: Class notes


Philip Larson


Page
13






$10k in stock in inventory; $5k in stock in land



$10k cash in boot in inventory; $5k in boot in land



§ 351(b) if you get cash boot, you get recognize
d gain in the amount
realized. He will only recognize $10k of the $13k gain in the inventory.
The key here is that he will not recognize any more gain than he received in
cash.



You are never going to recognize loss in § 351(b). No loss is recognized.

Therefore, what he recognizes on transfer is $10k of gain recognized.



Does he owe tax? Yes.



What is his basis in the stock, and what is X corp’s basis in the



X Corp’s basis in the asset: transferee’s basis § 362. § 362 says you look to
the basis of
the transferors. B’s basis in the inventory was $7k in the
inventory and $13k in the land. B recognized gain in the inventory.
Therefore, this increases the basis of Corp. X. It will be $7k + $10k. X
Corp’s basis in inventory will be $17k.



What is B’
s basis in the stock? What statute: § 358. You start by taking the
basis of the assets transferred. Your starting line is what is the basis in the
assets transferred. He will have one basis for all the stock he received. His
starting line is $7k inven
tory and $13k in land or a total basis of $20k. §
358 reduces the basis by the boot received. He has received $15k in boot
($10k in inventory and $5k in land). You then have to add back the gain
recognized ($10k). Now, he has a $15k basis in the invent
ory. This is the
first time where the addition and subtraction don’t get you back to where
you started. This is because we have a proration (67% and 33%) based on
the loss above.



We forced him to recognize all of his gain. If he sold his stock tomorrow
with the same value, should he recognize any more gain? No. He has
recognized all $10k. If he sells the stock tomorrow for $15k, he has no
gain. His basis in the stock is $15k. Therefore, the tax equilibrium seems
to be working. He recognized all of
his gain. That is the purpose of §
358(b). It will tax you to the extent of the boot you get but shouldn’t tax
you any more.



Ask yourself, assuming no more changes in value lets make sure he…


ASSUMPTION OF LIABILITIES (new slides)

-

When talking about §
1001 and the world if you can’t qualify for nonrecognition, if someone assumes
a liability for me I will be better off.

-

HYPO

o

A provides cash for 100 shares in stock.

o

B provides gainacre, that has $100 in value, $40 in basis (what B paid for it). Howeve
r, he
borrowed 30 so he has $30 in liability). The net value of what he is transferring is $70
because it has the liability. He will get 70 shares (each worth a buck).

o

A has 100 shares and B has 70 shares and Venture has Gainacre. Is there any boot in

this
transaction? Not really. No. B doesn’t have cash and neither does A. Don’t have to worry
about § 351. however, we have to account for the assumption of liability.

o

§ 357(a)


General Rule


Except as provided in sections B and C, if 1) the TxP
receives
property which would be permitted to be received under § 351…without the recognition of
gain if it were the sole consideration, and 2) as part of the consideration, another party to the
exchange assumes a liability of the TxP, then such assumption

shall not be treated as money
or other property, and shall not prevent the exchange from being within the provisions of §
351. It will not be treated like $30 is cash. It is not boot.

o

However, this is not a free card because § 358 treats it as if it w
ere cash. § 358 is talking
about B and his stock. Under § 358, in calculating the basis in his stock, it says that the
transferor’s basis gets treated as if it is cash basis and therefore reduces the basis. § 358 is the
way in which assumption of liabil
ity is handled in the tax world.

Corporate Tax: Class notes


Philip Larson


Page
14




o

§ 357(a) says an assumption of liability it is not boot, but § 358 says that it may not be boot
for § 351 purposes, but you have to reduce your basis. These are the basic rules. § 358(d).

o

Therefore, slide 28, B will n
ot recognize any gain because of § 357(a) says the liability will
not be treated as boot. What was his basis in what he transferred? $40. Therefore, § 358 says
to start with $40 and adjust it by decreasing the boot (none), increase it by gain (none), and

§358(d) says to reduce it by the liability $30. Therefore, he has a $10 basis in the stock he
receives. If he sold these shares immediately, he would get $70 with a $10 basis. He would
have $60 in gain which is the same gain if he sold the property for

$100 and used the money
to pay off his liability.

o

What about Venture Corportation. Its basis starts with § 362.

-

§ 357(d)


what is a recourse liability? They can come after the asset you used to buy as well as any
other of your assets. What is a non
recourse liability? They can only take the asset you used to buy.
Most liabilities are recourse liabilities. Recognize that there are differences between recourse and
nonrecourse liabilities. Nonrecourse liabilities can look a lot like an option. If th
e bank can only take
the house and the house is worth $1 and the mortgage is $100, you would just walk away from it. You
would only pay the mortgage if the house is worth more than the mortgage. What is § 358(d) do?

-

§ 358 addresses the issue that banks

don’t always let people off the hook.

-

§ 357(c)


Liabilities in Excess of Basis in Transferred Assets


this avoids a
negative basis
. What do
we do under § 358? We adjust the basis down. Nothing under § 358 says you can’t get negative basis.
§ 357(c)

came about presumably to prevent this.
§ 357(c) prevents a negative basis.

This overlaps
with its original purpose.

-

HYPO 2 (slide 31)

o

We have gainacre worth $100, but the liability of $55 and a basis of $40. His basis is lower
than the liability. Ac
celerated depreciation allows basis to be less than the liability. This is a
frequent problem.

o

B gets 45 shares because that is the net value of the transfer. He has 45 shares. He has to
figure out his basis. § 358 starts with 40, but reduce it by 55
. It is too hard to keep track of
negative basis, so he recognizes $15 in gain. This gain is then added to the basis to make the
basis $0. If you have a § 357(c) incident, they will always walk away with a $0 basis in their
stock.

o

§ 357(c) is an easy
way to prevent levering up assets right before a transaction. If you lever it
up, this is the way we will tax these transactions. § 357(b) looks at intent. Requires IRS to go
to the bank and look at the various transactions. § 357(c) is very mechanical
.

-

Avoiding § 357(c) gain

o

Have corporation assume less liability, or

o

Contribute additional property



More assets/cash



Personal note of the transferor


but what basis?
See Peracchi
.

-

Peracchi v. Commissioner

o

Peracchi didn’t have enough money in the corpora
tion. What did Perachi put in the
corporation? He added land, but he added land with lots of mortgages in which the liabilities
exceeded his basis. He drops in a note. What is his basis in the note? $0. He didn’t’ pay for
it. However, the court says

it is not that simple. You have basis in things that you don’t pay
for. The real key from this case is that if this corporation goes bankrupt, he doesn’t have to
pay it back. It is a sham argument. He is basically paying it back to himself. However,
in
bankruptcy, this is a ticking time bomb. This is not a sham because

o

Takeaway:
there are real world consequences to what you do today that may be different
if circumstances change
. This doesn’t look good today, but if they go into bankruptcy there
is
a real live liability he would have to pay. If he has an IOU to the corporation, that will
become a dividend to him because he no longer has to pay the note.

-

PICK UP ON THURSDAY WITH PROBLEMS ON PAGE 99 and 100. SKIM READING E1


9/13/07

-

§ 351(a)


an a
ssumption of liability is not treated as boot

-

§ 358(d)


even though it is not treated as boot, it is treated as cash and reduces the basis.

-

§ 357(c)


if the basis goes below

Corporate Tax: Class notes


Philip Larson


Page
15





-

problem p99

o

Corp X is organized by A. A transfers inventory (basis $20k and
FMV of $10k) and
unimproved land (basis $20k, FMV $40k) subject to recourse debt (liability of $30k). A
receives 20 shares of X stock (FMV $20k). X took the land subject to the debt.

o

A) will A recognize any gain or loss?



No. He gets something of value
, stock, and stock doesn’t get value. He gets the
liability off of his plate but this is not gain because it is not boot. He is getting
something almost the same as cash, but he does not recognize gain. § 357(a).
However, under § 358 his basis in the s
tock is $40 basis
-

$30k, or $10k basis.

o

B) $25k in basis. $25k
-

$30k (liability) =
-
$5k basis. § 357(c)


he is going to recognize $5k
of gain. That recognition of gain will bump his basis back up to $0k. The shares are still
worth $20k if he sells

them the next day. $20k gain + $5k gain is the same as the $25k he
originally had in basis. § 357 and § 358 seem to be working. If § §357(c) applies, the basis
will
always come back to zero
.

o

C) Extra credit: what is the character of his gain? Genera
lly speaking, if you have gain on a
particular asset it will follow that asset (inventory is ordinary; land is capital). What made
him recognize the gain, the inventory or the land? The answer isn’t clear. The regulations
suggest you would allocate gain
based on the FMV of the assets. Reg. § 1.357. This is not
nailed down specifically in the regulations. $1k would be ordinary and $4k would be capital.
Nothing in the statute says this specifically. This issue has not been litigated.

o

D) What is X’s ba
sis in the properties received from A? X receives the basis of the
transferor…§ 362(a). You have to add in the gain recognized by the transfer which is $5k.
§
362(a
) What asset did he recognize the gain for? Regulations are ambiguous. You should
probabl
y allocate gain based on FMV basis. Basis is $30k.

o

E) How could you avoid the gain in b) above?

-

Problem 2, p100

o

B organized Y Corp and transferred a building (basis $100k, FMV $400k). Building was
subject to liability of $80k incurred two years ago.

Two weeks before incorporation of Y, B
borrowed $10k for personal reasons and secured loan with second mortgage (another $10k
liability). In exchange for the building, Y issues B $310k of Y common stock and takes the
building subject to the mortgages.



A) tax consequences to B.



§ 1001 says you tax gain. However, § 351 says you don’t recognize gain if
you retain control, voting and it is for stock. B has basis in building of
$100k. Under assumption of liabilities, B must decrease his basis by the
amo
unt of liabilities. § 358(d). § 357(b) comes into play to whack him.
This comes in and says that if the
purpose is to avoid federal income tax
and is not a bona fide business purpose
, then the whole amount will be
considered money received by the TxP on
the exchange.



Here, he has $10k in cash (that would otherwise be considered boot except
for the way he did this). Therefore, this smells of a § 357(b) situation. This
requires an assessment of
intent
.

o

Note: while § 357(c) is objective, § 357(b) is a
hammer.
Moreover, the
whole liability becomes boot
. Instead of $10k in
boot, he will have $90k in boot even though $80k is reasonable
debt. § 357(b) you don’t really want to run into. It is very bad. It
grabs all liabilities and treats them as boot.



B) What if B did not borrow the additional $10k and instead, Y Corp borrowed $10k
from the bank and gave $310k in stock and $10k in cash and takes the building
subject to the $80k mortgage.



Here, B would get $310k in stock and $10k in boot. § 351(b) sa
ys he must
recognize the boot in the amount realized of $10k. Therefore, B’s basis is
the $100k + $10k realized = $110k, per § 358. He has gain of $10k and
basis in stock of $110k in the stock. B has the same thing here as he did in
Corporate Tax: Class notes


Philip Larson


Page
16




a) above but he has

to recognize gain, but only to the extent of the cash, not
all $90k of gain. This shows the power of § 357(b).



Lesson: if you want to take money out of the transaction, take out boot,
don’t do something silly that will get you in a § 357(b) situation.



C) is the difference justified? Not really.



THIS WILL BE ON THE EXAM.

-

§ 357(c)(3)


this takes back from general § 357 treatment, in particular the basis reduction, liabilities
that would give rise to a reduction in the hands of a transferor.

o

HYPO: i
f I have assets and want to incorporate them, what liabiltieis might I want the
corporation to have that I might have to deduct myself? 1) business expenses (salaries,
accounts payable). Are these liabilities for which I should have the basis in the stoc
k
reduced? No, that would be whacking the transferor twice.

o

HYPO: A comes into Corp for $500 cash for 500 shares. B transfers assets for 150 shares +
assumption of liability.



B transfers accounts receivable, and expenses



If liabilities were taken int
o account under § 357(c),



B could have transferred all the assets, hold back the liabilities (not have Corp.
assume the liabilities) but take $400 back in cash. If he has $400 in boot. Would he
recognize gain? He would have $400 in gain.



When he actu
ally paid these accounts, he would get a
deduction

of $400. If he took
the cash, he has an offsetting deduction. This is what § 357(c)(3) is about. If he
would have gotten a deduction, they shouldn’t be treated as liabilities at all. This is
simply to
preserve the situation as if he only took cash. This is what § 357(c)(3) is
getting at.

-

Problem p110

o

Architect has been conducting basis and decides to incorporate.

o

Total liabilities of Design: $100k

o

Basis: $60k

o

Think, maybe § 357(c) will apply. Howe
ver, he has two types. A loan of $30k and accounts
payable of $70. He does not have to account for the accounts payable because if he paid
them, he could deduct them. Therefore, this is not a § 357(c) situation because $60k basis
-

$30k liabilities is n
ot less than zero.

o

What is his basis in the stock?



§ 358


starting point is the basis in the assets transferred. His basis in the assets was
$60k. What do we know about assumption of liability? You adjust the basis down
by the amount of the liabilit
y. His basis is $60k. He will only reduce the basis by
the bank loan, not by the accounts receivable. Therefore, we don’t have a § 358(d)
negative basis problem for B.



Two kinds of liabilities: 1) deductible, 2) not deductible. When determining a §
3
57(c) problem and whether you have to reduce your basis, § 357(c)(3) changes this
depending on if the liabilities are deductible.


CHAPTER 3: CAPITAL STRUCTURE OF A CORPORATION

-

the simple examples so far are that we get back cash, stock or something else
. In the real world there
is a lot more stuff.

-

Stock (
equity
) comes in two basic flavors

o

Common stock

o

Preferred stock

-

Debt

-

Note:

o

If you own an instrument that says stock at the top and says “common stock”, is it common
stock? Not necessarily. IRS look
s to state law to determine what it is. However, the IRS
doesn’t have to yield to state law in deciding what it is.

o

Why do we care?

Corporate Tax: Class notes


Philip Larson


Page
17






Under § 351, if I get stock back I don’t recognize gain. If you get debt, you will
recognize gain. Therefore, if you
get debt back in a § 351 transaction you will have
gain that must be recognized.



It also matters in deciding who the
control group is
. The group must have 80% of
the votes of the corporation which only is based on
equity
, not debt.

o

If a corporation pays

a dividend, which it can only do on stock, it
does not get a deduction
.
However, it does get a deduction for
interest on debt
. The ability for the corporation to get
money to the owners and get a deduction for it is huge.



If the corporation pays salar
y, rent, etc. it is transferring value to the owners through
something it gets a deduction for.

-

Background

o

Does stock vote typically? Yes. Every corporation must have somebody who can vote.

o

Debt holders generally do not vote. It is exceedingly rare tha
t a debt instrument would allow
someone to vote. If things go south, they might be able to enforce control over the
organization they may get some extra powers.

o

There are two ways to get money as a debt holder:



1)
interest



typically time interest pai
d based on some rate. Rates will be based on
the amount of principal. You have to have a time period that it must be paid back.
Higher interest rates are great. There is always the
credit risk
. The higher the credit
risk (risk of bankruptcy), the high
er the interest rate. If the interest rate is 25%, it is a
junk bond and the company is probably going to go out of business.



2)
principal

-


o

There are a few ways that stock pays out (no fixed principal…)



1) dividends


this is how you get money out of
a corporation (however,
dividends
are not deductible
, but
interest is deductible
). Now you see the reason that debt is
better than equity for a corporation.






MISSED TUESDAY


Debt/Equity

-

Problem on p146

o

A, B, C form a restaurant. A contributes $80k cash
. B contributes a building ($80k FMV,
basis $20k). C contributes $40k cash and goodwill from proprietorship (FMV $40k, basis
$0). In return each get 100 shares of common stock.

o

HYPO: A, B, and C will loan $300k each and take back a $300k five
-
year corp
orate note with
variable interest payable at one point below the prime rate, determined annually. Unsecured
creditors. Friendly bank’s $900k note is secured by



Debt vs. Equity: this would probably be considered equity. It is proportional to the
investm
ent.



Everyone is kicking in money and nobody’s interests are changing.



Proportionality


this is bad for finding of debt.



Form



the form looks good. They have annual interest payments, five year terms.
Interest rates do not vary with profits of or
ganization. They might just be structuring
this



Length


five years is pretty short. We would be more worried if it was 100 years.



Debt/Equity Ratio


if this ratio is high, if there is a lot of debt and equity is small,
they have a lot of debt and no
t much equity. If you were going to calculate the
debt/equity ratio



Equity = Assets


Liabilities

= $240k



Debt = $900k + $900k = $1
.8M



Anytime you get above 5
:1, you will be worried about the debt/equity ratio.



Note
: IRS will probably say this is equity

not debt. They are getting punitive
payments (interest payments). These would be converted into taxable dividends.
When the corporation makes a payment, they buy back the stock.

Corporate Tax: Class notes


Philip Larson


Page
18




o

B)
$300k with 10% 20
-
yr subordinated income debenture. This will clearl
y be
recharacterized as equity.

o

C)
you still have proportionality, form, etc. however, since they personally guarantee, they
have more risk. We have high debt
-
equity ratio. Nothing has changed with the shareholder
loan. It looks like it may be equity
. However, here the risk is that the shareholders are
guaranteeing the bank loan. IRS may try to recharacterize the bank loan as equity because it
is guaranteed by the shareholders. Isn’t it really just a loan from the bank to the shareholders
and the s
hareholders loan the money to the corporation, which is basically equity. The risk
here is that everything be considered equity. In this case, every time the shareholders pay
interest to the bank, they may not be able to deduct them because it looks like

a
constructive
dividend
. Anytime a corporation pays someone else’s expenses, that looks like a dividend.

o

D)
A loans entire $900k, taking back a note with terms identical to A). Here, this is closer to
debt. You still have the problem with debt
-
equity

ratio, but you don’t have proportionality
problems. If you look at the rate, it isn’t that bad. This is probably
debt
.

o

E)
Same as D), except two years after incorporation, Corp is not paying interest on the notes
because of a severe cash flow problem.



If they aren’t paying the interest on the notes, it looks more like equity. The note
seems to be only paid out of the profits of the corporation.



Factors to look at to determine debt or equity.



Typically don’t want to do an ex
-
post analysis.



Factor:

this case looks at the factor of what the parties are
trying to do
.
Look at their
subjective intent
. Did they intend to set up a debtor
-
creditor
relationship. A doesn’t seem to be acting like a real creditor. A real
creditor would frequently enforce t
he terms, force you into involuntary
bankruptcy, etc. On the other hand, maybe he is just letting the interest
build.


DISTRIBUTIONS

-

§ 301(a)


a distribution is any payment by the corporation to its shareholders with respect to their
stock.

o

Unless so
mething is otherwise classified as a dividend, payments that are not related to stock
are
not distributions
.



Salary payments, interest payments, travel expenses


not typically considered
distributions unless they are recharacterized as a
constructive di
vidend
.

-

Once we have a distribution, we want to figure out what percentage of the distribution is a
dividend

and therefore taxed differently. Something called a dividend under corporate law may be different
under tax rules.

-

STEP 1: Distribution

o

Any pa
yment to shareholders with respect to their stock

-

STEP 2: What portion of distribution is a dividend? § 301(c) and § 316(a).

o

§ 301(c)


tells us the amount that is taxable. It is the portion defined as a dividend under §
316 is included in gross income.

Any part not ia dividend will offset basis.

o

How much is the dividend?

o

How is it taxed to the shareholder?

o

Wt what rate is distribution dividend taxed?

-

§ 301(c)


amount of a distribution that is taxable


says the amount that is a dividend is defi
ned in §
316. That portion is includable in income.

-

§ 316(a)
-

Definition of Dividend


it has to be accumulated E&P of the corporation. It also says you
look to the whole current year. It is basically looking at the E&P for the current year. It wil
l be a
dividend if it comes from E&P (either accumulated or current).

o

If a distribution comes out of accumulated E&P or current E&P, it will be a dividend taxable
and includable in income.

-

Nimble dividend rule



if you have $1M in earnings in the lates
t year, it will be dividends, even if you
have accumulated a large amount of loss over the previous years. Irrebutable presumption that if you
have current year E&P that it is a dividend.

Corporate Tax: Class notes


Philip Larson


Page
19




-

If we don’t have accumulated E&P or current E&P, what do you do
?

If there are no E&P you
apply it against the shareholder basis. That would reduce their basis and would be a nontaxable return
of capital. What happens if you reduce the basis, what is the next thing you look at. The portion in
excess that is not

-

Gain

for the sale of property


this is treated as
capital gain
.

-

Evaluati ng a distribution

o

RULE: If you have E&P, that portion is a dividend. If we wipe out E&P, we look to
shareholder basis and reduce that. If you run out of shareholder basis, anything in

excess is capital gain.

-

HYPO: S/H gets a $12k distribution. S/H has $6k basis, and corp has $5k E&P. She’s going to have a
$5k dividend and will pay $5k at 15%, or $750 in tax.

-

Definintion: Earnings and Profits (E&P) is different than taxable income
, but it is like taxable income.
For financial statement purposes, is there anything close to E&P? It is like
retained earnings
. That is
calculated separate from taxable income and E&P but is analogous to retained earnings. It is a running
balance. Did

the corporation make income, separate from taxable income?

-

Start with taxable income, and then make adjustments to get closer to
economic income
. This includes
adding back certain
excludable items
. 312
-
6b


anything exempt for tax purposes. If you ge
t interest
from a municipal bond, that is typically not taxable. That is an excluded item that you add back in
when calculating
economic income
. We also have life insurance proceeds. If someone dies and you
get life insurance benefits, those aren’t taxe
d but they are part of
E&P
. That is added back in. Book
refers us to 312
-
f1 which tells us realized gains or losses will increase or decrease the E&P only to the
extent it is recognized
.

o

§ 351


nonrecognition provision


312
-
f1 says there is no adjust
ment for something like this.
Your realized gains are not added into E&P unless they are recognized.

o

What about the taxes you have to pay to uncle Sam. You pay federal tax. Say I didn’t have
enough withholding, can I take a deduction? No. However, I

am worse off so earnings would
probably be lower. We can subtract the federal income tax that we owe.

o

What about bribes? You can’t deduct that for federal tax purposes. However, perhaps we can
reduce our E&P by that…

o

What about excess charitable dedu
ctions? Say I make a $1M charitable gift but can only
deduct $400k. The E&P can be reduced by the full amount.

-

Start with taxable income

o

Add back excluded items

o

Add back certain deductible items

o

Subtract certain nondeductible items

o

Add back or subtract

certain timing adjustments (E&P has a different system for depreciation


it is straight line, pro rata depreciation)


Problem p168

-

X Corp


look at their taxable income for the year and look at their E&P as well.

o

Facts



Gross profits from sales

$20k



Sal
aries to employees


$10.25k



Tax
-
exempt interest


$3k



Dividends received from IBM

$5k



Depreciation



$2.8k



LTCG on sale of stock

$2.5k



LTCL on a sale of stock

$5k



LTCL carryover from prior years

$1k



Estimated federal income taxes paid

$.8k

o

Gross income



$20k

gross profits from sales



$5k dividends received



$2.5k LTCG on sale of stock

o

Total Gross income = $27.5k

o

Deductions

Corporate Tax: Class notes


Philip Larson


Page
20






$10.25 salaries



Deduct 70% of $5k of dividends received ($3500). § 243


since it is one
corporation receiving dividends from another, we g
et a 70% reduction.



$2800 in depreciation



LTCL of $5k, we can only deduct to the extent of the gain, so only $2500 was
deductible and the other $2500 becomes carryover for next year.

o

Total Deductions $19050

-

Current E&P

o

Increasing Taxable Income to get
Economic Income



$3k on tax exempt interest



Add back in $3500 that was deducted from the dividends. This gets added back.



Depreciation adjustment of $1.8k

o

Decreases from Taxable Income



We have $5k capital loss that we only could take $2500 for tax purpos
es, but
economically we lost all that money. Therefore, decrease another $2500.



Decrease the federal income tax of $800.



Decrease total of $3300

-

Final E&P value of $13150.


-

Figuring out how E&P are influenced by operations. Now we look to how E&P a
re affected by
distributions. What does distributing money or property to a S/H mean for E&P?

-

HYPO

o

Sole S/H gets distribution of $20k. We had accumulated E&P as of Jan 1 2006 of $10k and
current E&P of $30k. What does the $20k do to earnings and profits
? How will this be taxed
to the shareholder?



This will be a
dividend
. Our current E&P exceeds the $20k distribution, so the
whole thing is a dividend. Therefore, we don’t have to look to accumulated E&P nor
do we need to look to adjust S/H basis or 3) g
et capital gains. As long as we have
enough current E&P, this will be a taxable dividend.



At the beginning of the year, we had $10k of accumulated E&P. During the year, we
got $30k more for a total E&P of $40k. At the end of the year, after the $20k
d
istribution, E&P will be $20k.

-

HYPO

o

Sole S/H gets distribution of $20k, and has accumulated E&P of
-
$50k and current of $30k.
We look to current E&P first, so it doesn’t matter that there is a net loss. The $30k covers the
$50k. Our E&P at the end of th
e year will be
-
$40k.


9/25/07

Distributions of Cash: Distributions Exceed Current E&P

-

Last time

o

first look to earnings and profits. To that extent it is a dividend

o

then it is a tax free return to offset the basis in the stock


if we haven’t used up th
e
distribution, then the rest is considered capital gain.

o

E&P is a running total of the organization’s economic income. To the extent a distribution
comes out of those earnings, it should be considered a dividend.

o

Break
-
down E&P into the one for the c
urrent year. Then look to the accumulated E&P from
all prior years. We are learning how to apply the distribution, whether it comes out of the
current or the accumulated. It comes first out of the current E&P. If you have more current
E&P, then it is e
asy. You simply reduce current E&P by the amount of the distribution.

-

HYPO:

o

Accumulated E&P is negative ($50k)

o

Current E&P is $30k

o

Distribution is $20k.

o

End result: Accumulated E&P for the new year is negative ($40k)

-

HYPO 2: What if the current E&P isn
’t enough to cover the distribution? We are going to allocate the
current E&P to the distribution.

Corporate Tax: Class notes


Philip Larson


Page
21




o

Background



Accumlated E&P as of 1/1/2006 is $5k



Current E&P for year ending 12/31/2006 is $12k



Distributions are $15k on 10/1/2006 and $5k on 4/1/2006.

o

N
ote: we don’t have enough current E&P to cover the distributions so we do a
pro
-
rata
allocation

based on the amount of E&P we have.

o

We have $20k in distributions, and $12k in E&P. 20/12=60%. Therefore, 60% of each
distribution comes out of E&P. .6 * $
5k = $3k out of current E&P. The remaining $2k
comes out of accumulated E&P. We do a straightforward pro
-
rata allocation. Similarly, .6*
$15k = $9 out of the current E&P, leaving $6k to go out of the allocated. Therefore, the $2k
and the $6k reduce acc
umulated E&P. This $8k is greater than the $5k in accumulated E&P.
This $3k will reduce shareholder’s basis in the stock. Therefore, the $3k, if the shareholder’s
basis in his stock is zero, then he will have $3k in capital gains.

o

Note: PRORATE THE CU
RRENT AGAINST THE DISTRIBUTIONS.

o

Note: E&P in this example will be zero. A distribution never reduces E&P below zero.
However, E&P can be a negative number if the company has a loss.

-

HYPO 3: What if we have a negative number. DIFFERENT APPROACH than

before. We do not
PRORATE THE CURRENT BECAUSE IT IS NEGATIVE.

o

Background



Accumulated E&P of $12k



Current E&P of negative ($10k)



Distribution A of $10k on 4/1 and $10k on 10/1



Shareholder has basis of $40k in his stock.

o

Rule: Half the loss goes to the

first part of the year, and half the loss goes to the second half of
the year. Therefore, we can prorate the loss. However, if we know when we got the loss, we
can earmark it at that point.

o

Analysis



APPROACH 1: Proration approach



Step: since we don’t h
ave any current E&P, we look to the accumulated.



Step 2: we prorate the current loss.

o

By April 1, we had lost $2500 in the given year. What does that
mean? We reduce our accumulated amount by $2500. $12k
-

$2.5k = $9.5k.



How will the April 1 distr
ibution be viewed?

o

$9.5k is a dividend.

o

$500 is a reduction of basis, to $39.5k.



As of April 1
st
, we made that distribution

o

Accumulated E&P = $0

o

Current E&P = negative ($7.5k)

o

Proration of the current

o

The October 1, 2006 will be a tax free return of ca
pital. However,
the S/H basis reduces from $39.5k to $29.5k.



What are X’s accumulated E&P and current E&P as of 1/1/2007?

o

Accumulated E&P = $0

o

Current E&P = negative ($7.5k)



NOTE: if accumulated E&P were much larger, we would prorate the
October 1
st

d
istribution as well. In this case, we don’t have any
accumulated E&P left after the first distribution. In that case, the current
E&P would be negative ($2.5k).



APPROACH 2: earmarking approach. Say we lost all $10k in the first quarter. It
was all lo
st as of April 1
st
.



Step: we don’t have any current E&P.



Step 2: Offset accumulated E&P, but we lost $10k all before April 1
st
.
Therefore, all we have left is $2k accumulated E&P. The result is:

o

Dividend = $2k

Corporate Tax: Class notes


Philip Larson


Page
22




o

Basis reduction (tax free return of cap
ital) of $8k.



End of year E&P:

o

Accumulated E&P = $0

o

Current E&P = $0.



Note: proration approach versus earmarking approach affects the dividends and the
E&P calculation.

-

Problem p172

o

Facts: Ann owns all the common stock of Pelican Corp. Prior to the

§ 351 transfer, her basis
is $10k. What



A:



Accumulated E&P = $0



Current E&P: $5k



Distribution of $17.5



Basis is $10k



Calculation

o

$17.5


current E&P of $5k.

o

$5k is a dividend.

o

That leaves $12.5k left. Look to the basis.

o

Basis is reduced from $10k
to $0. This is treated as a tax free
return of capital. There is $2.5k left.

o

Capital gains of $2.5k.

o

Pelican Corp:



Accumulated E&P for 1/1 of following year: $0



Current E&P for 1/1 of following year: $0



B



Facts:

o

Accumulated E&P: negative ($15k)

o

Cur
rent E&P: $10k

o

Distribution $10k

o

Basis $10k



Calculation

o

The whole thing is a dividend.

o

Dividend: $10k

o

Current E&P for 1/1 of following year: $0

o

Accumulated E&P for 1/1 of following year is negative ($15k)



C



Facts

o

Accumulated E&P: $10k

o

Current E&P: $4k

o

4/1

distribution of $10k

o

7/1: ann sells half of her stock to Baker for $15k

o

10/1: distribution of $5k to Ann and $5k to Baker



Calculation Proration of Current

o

When you have a gain in Current E&P, you prorate the
distributions against the current based on the
percentage of each
distribution as a portion of the total.



$10k, $5k, $5k distributions
-

$20k of distributions.



$4k current E&P


therefore, 20% of each distribution
comes out of current E&P, and the rest comes out of
accumulated E&P.



4/1 distributio
n of $10k to Ann

o

20% * $10k distribution = $2k. Therefore, $2k comes out of
current E&P and is a dividend. We reduce current to $2k and we
also reduce accumulated to $2k (the other $8k).

Corporate Tax: Class notes


Philip Larson


Page
23




o

Rule: we take the
accumulated E&P on a first come, first serve
ba
sis
.

o

Result:



Dividend: $10k



Current E&P: $2k



Accumulated E&P: $2k



7/1 Ann sells half of her stock to Baker for $15k

o

Ann Basis: $10k

o

How much gain does she recognize?



Half of her basis is $5k, therefore her gain is $10k.



10/1
-

$5k distributions.

o

20
% of dividends will go to Current E&P. This wipes out our
current E&P.

o

Now, we have $4k left for each of the distributions, but only $2k
left in accumulated E&P.

o

Now, we have $3k left in distributions for each.

o

Ann gets $3k reduction of basis. Her
new basis, of $5k is reduced
down to $2k.

o

Baker’s basis in the stock is what he paid for it: $15k



His new basis is $15k
-

$3k = $12k

o

Current E&P for 1/1 following year is zero

o

Accumluated E&P for 1/1 following year is zero



D



Facts

o

Current E&P: negative (
$10k)

o

Otherwise, same as C above.

o

Note: There are the two approaches. Prorating based on time, or
earmark approach



APPROACH 1



4/1 Calculation

o

4/1


lost $2.5k as of 4/1. Current E&P at 4/1 of negative ($7.5k)
and that reduces the accumulated E&P to $75
00. Therefore, $7500
will be treated as dividend and $2500 will be treated as a tax free
return of capital and reduces here basis to $7500.

o

Note: take the prorated loss in current E&P and reduce the
accumulated E&P.



7/1 sale of half the stock

o

Ann’s basi
s is $7500. She makes $15000 for half. Therefore, her
gain is $15k
-

$3750. Her capital gain is $11250. Her new basis in
the remaining stock is $3750.

o

Baker has a basis of $15k because that is what he paid for it.



10/1
-

$5k distributions

o

Current E&P
is now negative ($7500).

o

No part is going to be a dividend to either Ann or Baker.

o

Baker will reduce his basis of $15k down to $10k.



None of the $5k is a dividend. All of it is a return of
basis.

o

Ann will get no dividend because E&P is negative. T
herefore, we
subtract $5k from $3750 to get her basis to zero. The difference is
a taxable gain to her of $1250.



Corporation as of 1/1 of the following year.

o

Accumulated E&P = $0

o

Current E&P = negative ($7.5k)



APPROACH 2: earmark saying it was lost as
of 4/1



4/1 Calculation

Corporate Tax: Class notes


Philip Larson


Page
24




o

The entire loss of $10k occurred by 4/1. This wipes out the entire
accumulated E&P. Therefore, none of this distribution is a
dividend. This distribution is a $10k tax free reduction in basis.
Her new basis is $0.



7/1 sale

o

Ann
has no basis

o

Baker has basis of $15k.



10/1

o

Ann has no basis, there is no E&P, therefore it is all capital gain.

o

Baker reduces his basis down to $10k.



Corporation at 1/1

o

Current E&P is $0

o

Accumluated E&P is $0.

-

NEW PROBLEM

o

Distributions of Property:
Gain or Loss to Corporation


General Utilities



Sale and Distribution vs. Distribution and Sale

o

HYPO 1:



Property of $1M FMV and $2k basis in corporation’s hands. Say they sell the
property for $1M, they will have gain of $998k. The tax on this will be a
bout 35%.
Therefore, this is $349,300. We have about $650k to distribute to S/H’s. They get a
distribution of $650k. Assuming this is all a dividend, they will pay taxes on this
dividend. They will probably pay about $225,000 in taxes ending up with a

little
more than $420k after taxes.
THIS IS THE NASTY EXAMPLE OF DOUBLE
TAXATION.

o

HYPO 2: distribute the property to the S/H and the S/H makes the sale.



What did the Supreme Court say about this? The SC held that the corporation did
not sell the prop
erty so there is no corporate tax. When the shareholder sells the
property, they have a $1M distribution to them. They pay $350k in taxes and they
are left with $650k in proceeds. We have eliminated this double taxation.



SUPREME COURT SAID THIS WAS OKAY
. Originally, Congress was okay with
this.

-

General Rule: § 311(a)(2)


no gain or loss recognized on a non
-
liquidating distribution of property to
the S/H. Then, Congress later thought this was a bad idea because it was a way of getting around the
doub
le taxation. Congress created the exception in § 312(b)(1) that says that
gain is recognized as if
the corporation had sold the property
.

o

RULE: NOW HYPO 1 and HYPO 2 WOULD BE TREATED THE SAME
.

-

How does this impact E&P of the corporation?


-

HYPO: Corp
oration has Gainacre with $50k FMV and $30k basis.

o

Accumulated E&P of $35k

o

Current E&P of $0.

o

Giving Gainacre to the shareholder creates a gain for the corporation. § 312(b)(1). E&P
increases by $20k. However, we made this distribution which decreas
es E&P. We have
gotten rid of property worth $50k. Therefore, we have $20k of gain but $50k of loss.
Therefore, we increase E&P by $20k and then reduce E&P by $50k. We have $35k +$20k
-

$50k = $5k E&P



Accumulated E&P at the beginning of the next year i
s $5k.

o

What will that do to the S/H? How much of that will be a dividend to the S/H?



$50k distribution.



$20k is dividend coming out of current E&P



The other $30k is a dividend coming out of Accumuled E&P.



$5k left in Accumulated E&P.

o

NOTE: the co
rporation would have to pay tax on the $20k of gain but we are ignoring this for
this example.


FOR NEXT TIME, GET THROUGH 4G on 206.

Corporate Tax: Class notes


Philip Larson


Page
25





MISSED CLASS LAST THURSDAY


NEED NOTES


-

Last time

o

wrap up material on dividends, start looking at
redemptions

o

One of

the important questions that comes up in practicing tax is whether proceeds from a
corporation that is sold may be properly classified as dividends or proceeds of a sale. These
are called “bootstrap sales” in that the sale is being helped along because t
he target of the
acquisition has a lot of liquid assets that the new buyers may not want.

-

Two cases

o

TSN & Waterman Teamship

o

TSN Liquidating Corp v. United States



Facts: CLIC is an insurance company that has two types of assets: bonds and stock.
The stoc
k is typically in closely held corporations, not easily sold. Union was going
to buy CLIC, but didn’t necessarily want to buy the stock that CLIC owned. CLIC